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A UK Recovery Program: Go Keynesian (Part 1)
In a speech on 17 November, the leader of the UK Labour Party urged the Prime Minister to "change course" on economic policy or have another recession or worse. What would be a "new course" that effectively revived the economy?
The answer derives from the cause. The stagnation of the UK economy is the result of a collapse in private investment and a depressed world market, whose knock-on effects has been unemployment and lower household consumption. The solution is a substantial fiscal stimulus to restore aggregate demand.
The Coalition government has repeatedly stated that its rejection of this obvious route to recovery is not ideological. Their spokespeople claim that the size of the overall fiscal deficit, about ten percent of gross national product, precludes any further public expenditure. On the contrary, the urgent need is to reduce public expenditure to close that deficit. Let us suspend disbelief and momentarily accept the hypothesis that the government is not cutting out of ideological zeal.
If the cuts are not ideological, then the question immediately presents itself, what danger does a deficit of ten percent of GDP create? A search turns up four "deficit danger" arguments: 1) people will expect the government to raise taxes in the future to payoff the debt and they reduce current expenditure in anticipation (so-called Ricardian Equivalence); 2) the interest on the deficit presents an unmanageable burden now and "for our children"; 3) deficits push up interest rates, crowding out private spending; or/and 4) unless the deficit is reduced, financial markets (aka speculators) will drive up the interest rates on UK bonds, as has happen to Greek, Italian and Spanish bonds.
The first argument is simply silly, literally silly in a simplistic way. It is flawed economic logic based on a series of assumptions so unrealistic that they are absurd (for example, continuous full employment). The second and third arguments require a specific outcome, rising interest rates, and the opposite has happened. In 2007 the overall fiscal deficit was less than three percent of GDP and the UK government short term bond rate was 5.5 percent.
In 2009-2011 the deficit averaged about ten percent, and Figure 1 shows the result, a continuous decline, then slight rise, in the interest rate ("bond yield") to level off at one-half of one percent for the last twenty months. At well less than one percent, the interest rate on pubic debt implies a small public debt service, as well as being far too low to nudge much less crowd anyone.
Even more important than the level of UK bond yields is the absence of any hint that they might rise. To the contrary, the Euro scares of October and the first half of November resulted in speculators shifting their ill-got gains into British public securities. Far from being in danger of becoming the next Greece, Spain, Italy, etc., the bonds issued by the UK government are viewed as a "safe haven" (aka, "rush to quality", among other clichés).
Is it possible that further borrowing might dangerously weaken the pound (an argument the UK Chancellor has made from time to time)? While it is hard to imagine a combination of capital flow into UK bonds and a weakening pound, we have direct evidence, so I need not speculate (so to speak). As Figure 2 shows on a larger vertical scale than Figure 1, the three month "forward" rate of exchange between the US dollar and the UK pound hardly moved during 2011 except to rise, before returning to its level at the beginning of the year. Indeed, it moved less than the bond rate.
The changes in the bond rate and exchange rate shown in Figure 2 may look substantial, but only because of the scale of the chart. At the beginning of 2010, the betting rate for the pound (what a speculator expected it to be three months hence) was $1.62, and in August 2011 it was $1.63. The decline in September, about 3.5%, was the direct result of a simultaneous rush into US and UK bonds from Euros. That is, both currencies strengthened, the dollar by slightly more.
In summary, at the end of 2008 the Bank of England began to cut interest rates drastically. The three month bond yield stood at about one-half of one percent when the Coalition government took power. Since then the bond rate has hardly changed, varying from .57 to .46 (a difference of yield of 11 pence for a £100 bond). As for the pound and dollar question, if there is a problem, it lies in the pound being too strong for the government's hopes of an export-led recovery.
The conclusion is obvious: so-called financial markets do not present an obstacle to a fiscal stimulus in Britain (i.e., more debt). On the contrary, the last few month have demonstrated beyond reasonable doubt that the demand for UK government bonds is strong despite their meager yield. "Markets" are greedy for UK debt. Therefore, the government should feed that greed and use the proceeds from bond sales to "kick-start" the economy. By how much and the implication for public finances over the rest of the decade I treat in a second article.
Figure1: Nominal Interest Rate on 3 month UK Bonds,
January 2009-October 2011
Figure 2: UK Nominal Bond Rate and the 3 month Forward Rate,
US dollar to UK pound, monthly deviations, period average = 100,
January 2010 - October 2011
Data source: Bank of England website.
A UK Recovery Program: Go Keynesian (Part 2)
An occupier in Zuccotti Park has the solution to recession.
The latest statistics show that real household earnings in Britain fell by 3.5% over the last year (The Guardian 24 November 2011), a decline unprecedented in peacetime. What can be done to stop this unfolding disaster? While the private sector is dangerously in debt ("over-leveraged"), the public sector is not as I showed in my last article. On the contrary, by any accepted financial measure, the UK government is under-indebted, the ratio of net debt to GDP, debt service capacity or marginal borrowing cost.
The solution to falling comes and the looming second recession is for the government to borrow and spend. If that sounds like bad economics, it is only because the economics profession degenerated into free market metaphysics long ago, turning out reactionary propaganda against rational policy.
To be rational for a moment, begin with the basic policy questions: 1) how much borrowing would be necessary to fund the stimulus to revive the economy; 2) how much would the deficit increase as a result; and 3) how would the deficit subsequently be reduced? We have been through this numerous times in many countries, notably in the United States in the 1990s. When Bill Clinton became president at the end of a recession in 1993, the federal budget balance was a negative US$ 290 billion. When his successor Bush II gave his inauguration address in January 2001, that negative 290 billion had become a positive US$ 236 billion (see the statistical tables in the Economic Report of the President 2011). The dramatic reversal was not the result of either tax increases or expenditure cuts (spending increased every year). It resulted from eight years of growth at over four percent per year on average.
National income grows, taxes increase and deficits disappear ("structural" or otherwise), not terribly complicated to understand if one is non-ideological. Not only do tax revenues rise with growth, some expenditures fall - on unemployment compensation and a range of family support payments. Growth undermines the deficit (not the reverse) like the blades of scissors, cutting into it with more revenue and less expenditure. Indeed, if the Coalition ideologues have concern for the impact of current policy on future generations, they might shed fewer tears over debt service and more on unemployment payments which are considerably larger.
How much additional borrowing would be necessary to stimulate growth depends on the growth target. My calculations (available on request) suggest that if the Coalition had increased public expenditure by two percentage points of GDP in 2011 instead of reducing it, output would have grown at two percent rather than stagnated below 0.5 percent. This is less than the three percent growth rate 1994-2007, thus modest by past performance. The two percent expenditure estimate would compensate for the fall in private investment in 2010. This is pragmatic policy - when the private sector's expenditures and expectations are depressed, the public sector temporarily takes the lead.
The obvious initial impact of an increase in borrowing of two percentage points is to raise the deficit by the same amount. Almost immediately the growth from the fiscal stimulus begins to generate more tax revenue and reduce recession-linked expenditures. Estimating how much the one would rise and the other would fall requires a bit of calculation. To keep things simple, I show my estimates in shares of national income in the chart. Economic growth at a steady two percent per annum, starting this year, would reduce the public deficit to four percent by 2015 (when the current parliament would end if it runs its full term, heaven forbid), and come into balance before the end of the decade.
While the calculations are approximate, the central point holds generally: with the economy is depressed it makes economic sense for the UK government to borrow for a fiscal stimulus, and thus reduce the public sector deficit through growth. Almost any growth rate no matter how low reduces the deficit through the effect of rising income on tax revenue. In a depressed economy, it falls to governments to provide the demand stimulus for growth, which is most effectively done through fiscal expansion. To put it simply, the fiscal stimulus is funded by borrowing, and this borrowing is self-liquidating through the growth it generates.
UK Overall Budget Balance, actual and for Growth Rates
of 2 and 2.5 percent after 2010, share of GDP, 1994-2017
The process is a quite straight-forward one, considerably easier to understand than fairy tales about cutting basic public services bringing us prosperity. The government increases borrowing and distributes the funds between current and capital expenditures (about £30 billion in total). The current expenditure might be to the National Health Service, state school running costs and university education. The capital expenditure could be quickly allocated to the back-log of repair and expansion needed in health, education and transport.
The increased public expenditure creates an excess demand by households and businesses that is partly met by imports, but most of it by domestic production (about 70 percent). The rise in household demand and the increased public investment induce private companies to invest to meet the expanding demand, tax revenue rises, unemployment and welfare benefits fall, and the recovery is underway with the public deficit falling.
Growth, less unemployment, less poverty and a lower deficit. Of course, the Coalition could go for budget cuts, stagnation, rising unemployment, more poverty and a larger deficit. But politicians are not that stupid, are they?
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