Bubble. Burst. Liquidity. Repeat

Increasing both

In March 2000 the dot com bubble burst. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite index had fallen to half that by late 2000. GDP growth slumped and unemployment steadily climbed from under 4 percent in late 2000 to a peak of 6.25 percent in mid-2003.

On January 3rd, 2001, Alan Greenspan acted and cut the Fed funds rate to 6 percent. By June 2003 it was down to 1 percent where it stayed until June 2004. The effects are well known. This wave of liquidity was directed by government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, into a housing bubble.

That bubble burst too. With inflation on its way up from 2 percent in mid-2003 to 4.7 percent in October 2005, Greenspan gradually raised the Fed funds rate, reaching 5.25 percent in June 2006. But this crippled many people who had borrowed at lower rates to buy property. The number of new foreclosure starts in the US increased by more than 50 percent to 1.1 million between 2006 and 2007.

Assets backed with these non-performing loans crashed in value. Banks holding them saw their balance sheets ravaged. Seeing counterparty risk everywhere, banks stopped lending to each other and the LIBOR, usually about 0.15 percent above where the market thinks the bank rate will be in three months’ time, shot up to over 6.5 percent in August 2007. The credit crunch had arrived.

And Greenspan, his academic successor Ben Bernanke, and central bankers around the world reacted as they had to the bursting of the dot com bubble. The Fed funds rate went back down from 5.25 percent in September 2007 to 0.25 percent in December 2008. Likewise, between July 2007 and March 2009 the Bank of England slashed its Base Rate from 5.75 percent to 0.5 percent. Even the supposedly cautious European Central Bank reduced its key rate from 4.25 percent in summer 2008 to 1 percent by the spring of 2009.

When this failed to have the desired stimulative effect central bankers began trying to pull down the long end of the yield curve. Under Quantitative Easing the Bank of England spent £375 billion of newly printed money on British government debt. The Federal Reserve is spending $85 billion dollars a month on bonds.

There is a pattern here. A bubble in assets (dot com stocks) bursts and central banks react by hosing liquidity into the system. But this liquidity inflates another bubble (property) and when that bursts central banks react by hosing liquidity into the system…

In the high Keynesian noon of the post-war period it was widely thought that monetary policy was ineffective for macroeconomic management (it is debatable how much this is actually owed to Keynes). All that could be hoped for from monetary authorities was support for the fiscal policies which really had the clout to equilibrate the economy.

But this Keynesian paradigm fell apart with the stagflation of the 1970s. Money mattered was the lesson and it became the primary tool of macroeconomic management, replacing fiscal action, at least until the ‘Return of the Master’ following the credit crunch.

But what has this meant in practice? As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.

This is what passes for macroeconomic management. As one of the high priests of this bubble-onomics, Paul Krugman, advised in 2002 in the wake of the dot com bust “To fight this recession the Fed needs…soaring household spending to offset moribund business investment…Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble”. And no, that’s not taken out of context.

One of the great myths in economics is that of some sort of stable equilibrium. It is apparent that active monetary policy is little better at producing that than fiscal policy proved. Instead the economy is characterised by crises of increasing frequency and amplitude and the only solutions policymakers appear to have to deal with them will buy ever shorter-lived respite at the cost of increasing both the frequency and amplitude of crises.

We are in an equilibrium of sorts, but it is an equilibrium of crises.

This article originally appeared at The Commentator

Britain’s productivity paradox

In 2012 the British economy created 580,000 new jobs yet output stagnated; more work produced the same amount of stuff. Indeed, British workers were producing 2.6 percent per hour less in Q3 2012 than in Q1 2008. Labour productivity is now 12.8 percent below its pre-recession trend.

This phenomenon, of increasing inputs producing an unchanged or decreasing amount of output, which has been christened Britain’s ‘productivity puzzle’, is one of the most perplexing in current economic debate. Indeed, even Nobel laureate Paul Krugman recently declared himself stumped.  

It’s an important debate both politically and economically. Politically, because Labour can point to grim GDP figures and claim the coalition is failing while the coalition can point to impressive job growth and claim they are succeeding. Economically, because increasing productivity, producing as much with less or more with as much, is the root of increasing wealth.

The Institute for Fiscal Studies recently offered three explanations for this decline in labour productivity. First, the fall in real wages thanks to inflation has seen firms retain and/or take on more labour. Second, business investment remains 16 percent below the pre-crash peak giving workers fewer tools to work with. Third, record low interest rates and forbearance on the part of banks is propping up inefficient enterprises.

There is a grain of truth in all these explanations but we might be missing the wood for the trees. Perhaps the actual explanation for the productivity puzzle is both simpler and more profound. Labour productivity is determined by two things: the skill of labour, and the quantity and quality of the capital at the disposal of that labour. On both fronts Britain has done pretty poorly.

Britain’s labour force is losing its qualitative advantage over others, notably in East Asia, thanks to a hideously dysfunctional state education system. According to the Programme for International Student Assessment which compares students across countries, in 2000 Britain ranked 7th in reading, 8th in maths and 4th in science. By 2008 it had slumped to 17th in reading, 24th in maths, and 14th in science. Any measures which can improve this dismal performance could be expected to improve British labour productivity in the longer term.

It is a similar story regarding the capital available to its workers. In 2001 it was estimated that a British worker had 25 percent less capital to work with than an American worker, 40 percent less than a French worker, and 60 percent less than a German worker. Why is capital so vital and how might we get more of it?

There are two types of goods: capital goods and consumption goods. Consumption goods are those that immediately meet our needs, what Carl Menger called “goods of first order”. Capital goods, what Menger called “goods of higher order”, are those which meet our needs indirectly. Bread is a consumption good, the flour and the milling stone (among others) are capital goods.

If our need is to eat we can satisfy it immediately via the labour intensive method of picking apples from trees or berries from bushes. Obviously this source of food would sustain very many less people on much more monotonous diets than we have today. We are able to eat more and better because we have capital which enables us not only to produce and consume more but also to produce and consume things we couldn’t have before with purely labour intensive methods.

Thus, to borrow Murray Rothbard’s example, Robinson Crusoe could pick 20 berries per hour from a bush by hand but could shake 50 berries out in an hour with a stick. Alternatively Crusoe could make the milling stone, grind the flour, and undertake the other capital production needed to make a loaf of bread. He could enjoy something he couldn’t enjoy in any quantity at all previously.

But making the stick or the milling stone will take time, time we cannot spend either picking berries or relaxing. We must forgo an act of consumption, either of berries or of leisure. We must save, in other words. This is the essential truth of capital accumulation; it comes from saving.

So does maintenance of the capital stock. To borrow from Rothbard again, a truck with a working life of fifteen years which makes 3,000 trips can be said to be using up 1/3,000 of itself each time it participates in the transformation of bread from ‘higher order’ wholesale to ‘first order’ sandwich. If saving is not undertaken to allow for the replacement of the truck at the end of the fifteen years this production process will cease. The capital, the truck, will have been consumed in every loaf it carried on those 3,000 journeys.

This is why countries that grow rich are those that save; they accumulate the capital per worker which enables them to produce ever greater amounts. In the late 18th century British textile workers earned six times what Indian textile workers earned because they had the capital goods to make them six times more productive. This is why we see saving nations in the Far East becoming wealthier as we wonder how our current standard of living will be maintained.

Britain, meanwhile, has some of the lowest savings rates even in the generally savings-averse developed world. We are seemingly attached to the Keynesian idea that consumption, rather than something we do when we are rich, is something we do to become rich. We have a government which can hand out leaflets on budget day telling savers they are on their side while turning a blind eye to quantitative easing and 0.5 percent base rates.

The result is that by deskilling and capital consumption we have become a lower productivity, lower wage economy. There is only a puzzle because we are reluctant to face this grim truth. Greece was recently reclassified as an emerging market. Might Britain be on its way to joining her?    

This article originally appeared at The Commentator

UK’s downgrade: Only spending cuts left to try

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Draw an X on Britain’s economy and win a Mini Metro*

The central, simple fact of British economic and political life is its government’s deficit of £119 billion, about 8 percent of GDP. As I wrote recently, “That works out at about £326 million pounds added to Britain’s national debt every single day, £13.6 million every single hour, £226,000 every single minute, or £3,766 every single second of fiscal year 2012/2013.”

Yet, so far, we have been able to finance this growing mountain of debt incredibly cheaply. As this debt has multiplied, yields on British gilts, the interest rate the government pays to borrow, have been hitting record lows.

There are broadly two schools of thought on this paradox. One, roughly Keynesian, says that these low yields reflect a strong appetite for British government debt in preference to investment in business or spending on consumption. The outlook of investors is, on this view, so pessimistic that they want to stash their wealth in the safe haven of gilts and it is the British government’s job to spend these savings via deficits so as to avoid a collapse of aggregate demand.

Another school of thought is more sceptical. It sees the source of the strong demand for gilts as the Bank of England, which bought up £375 billion worth of them (about a third of the national debt) under its Quantitative Easing program. On this view such fiscal wriggle room comes at the expense of monetary manipulation which would, if continued, lead to even higher inflation.

As esoteric as this might sound it is a debate that matters for all of us. The British government is accumulating so much debt that even with record low interest rates the amount it spent on debt interest increased by 8.7 percent in 2011/2012 to £48.2 billion, more than it spends on defence. Just imagine what would happen to that figure if gilt yields were to rise.

This is not a problem say some, many, though not all, from the Keynesian tradition. The British government never has to worry about whether it can pay back debt denominated in sterling, they say, because it can just get the Bank of England to produce as much new sterling as it needs to cover it.

The idea of George Osborne and Mark Carney running the printing presses to pay their bills might fill you with worries about inflation. Nonsense, the ‘Keynesians’ reply, if anyone thought inflation would be a problem this would be reflected in rising gilt yields and, as we’ve seen, yields are low.

When the coalition came to power in 2010 it rejected the Keynesian thinking and applied four tools to reduce the deficit; First there would be some tax rises; second, some spending cuts (while talking a lot about ‘austerity’ and ‘tough choices’); third, monetary policy, it was tacitly agreed with the Bank of England, would remain exceptionally easy.

But, fourth, most of the heavy lifting would be done by economic growth. In March 2012 the Office of Budget Responsibility predicted that growth would be chugging along at 0.7 percent for 2012 and 2 percent in 2013. George Osborne claimed that low yields on British gilts reflect the bond markets faith in this strategy.

And yet Britain’s economy has stubbornly refused to grow. In December the OBR downgraded its growth forecasts to -0.1 percent for 2012 and 1.2 percent for 2013. This has blown a hole in the coalition’s economic strategy.

The deficit, originally slated for extinction by 2015, will, on revised predictions, be with us until at least 2017. It looks likely that borrowing for 2012/2013 could turn out to be even higher than it was in 2011/2012.

And since the New Year this news, coupled with the Bank of England’s persistent failure to deal with above target inflation, seems to be causing some investors to reconsider Britain’s credit worthiness. Sterling has slumped to its lowest level since summer 2010. In the last six months yields on 10-year index-linked gilts have risen from 2.4 percent to 3.2 percent. The only surprise about Moody’s downgrade on Friday was that they waited this long.

In their bid to stave off the nightmare scenario of soaring yields, policymakers increasingly find their hands tied. Taxes cannot be raised, the failure of the 50p tax rate shows that our heads are bumping up against the Laffer Curve already. Spending to boost growth, which some are, incredibly, still advocating, simply risks immediate disaster. And with inflation stubbornly stuck above target Osborne cannot expect much help from Mervyn King or Mark Carney.

This just leaves spending cuts which have barely been tried so far. Osborne and King have run out of short term fiscal and monetary sticking plasters. Radical surgery cannot be postponed. Just under a year ago I wrote that “The British economy is walking a tightrope. On the one hand it has deficits the size of Greece; on the other it has interest rates as low as Germany.” We might be about to find out which it is that goes.

This article originally appeared at The Commentator

* Not legally binding

Is the Conservatives’ economic trump card warranted?

Let’s roll

It is part of Conservative Party mythology that it is repeatedly elected to clean up Labour’s economic messes. Indeed, 1931, 1951, 1979, and 2010 saw Labour bequeath the Conservatives a steaming pile to deal with. The only possible exception was 1970 when, following the calamitous sterling devaluation of 1967, Roy Jenkins wielded the austerity axe and got the British government’s finances into something approaching order.

Yet, truthfully, Britain has been plagued with economic mismanagement from both sides of the Commons and Labour could make much the same complaint of the Conservatives.

In 1929 Ramsay MacDonald’s Labour took over an economy wrecked by the attempt of Stanley Baldwin’s Conservative government to peg sterling to gold at pre-World War One parity. In both 1964 and 1974 Harold Wilson inherited the messy aftermath of pre-election booms engineered by Conservative chancellors Reg Maudling and Anthony Barber respectively. In 1987 the Conservatives inherited the messy aftermath of a pre-election boom they themselves engineered.

The Conservatives’ playing of their economic competence trump card always required a fair bit of bluff.

Recent developments suggest that George Osborne might think of delving into the same old bag of Conservative chancellors’ tricks as Maudling, Barber and Lawson. This government has nailed itself to the mast of the economy. Put simply, if the economy is growing healthily come 2015 the Conservatives will win. If not they are toast.

So far it’s not looking good. News that GDP contracted by 0.3 percent in the fourth quarter of 2013 meant that the UK economy continues to flat line. This is nothing to do with so called ‘austerity’ but the entirely predictable and unavoidable consequence of a massively indebted economy trying to reduce its indebtedness.

Either way, whether the dreaded ‘triple dip’ is avoided or not, it is looking increasingly unlikely that GDP growth in 2015 will be of the magnitude necessary to bring re-election.

So with 2015 approaching, Cameron and Osborne might come to look favourably on incoming Bank of England governor Mark Carney consummating his flirtation with Nominal GDP Targeting (NGDPT).

NGDPT starts from the observation that money supply targets proved a poor rudder for monetary policy due to problems of defining the money supply and changes in velocity, and inflation targeting proved unable to prevent asset price inflation. With NGDPT the idea is that the central bank sets a path for nominal GDP growth and manipulates the money supply sufficiently to achieve it.

So, if it’s decided that nominal GDP should grow by 5 percent a year, and nominal GDP looks to be increasing above that rate, the monetary authority engages in the sale of securities so as to suck money out of the economy to get nominal GDP growth back on target.

Likewise, if nominal GDP was growing at a rate below 5 percent, the situation we are currently in, the monetary authority engages in the purchase of securities so as to pump money into the economy and get nominal GDP growth back on target.

NGDPT and the market monetarists who propose it have faith in the power of monetary policy. Austrian liquidation or Keynesian liquidity traps can be blasted out of existence with a sufficient charge of base money. Or, as Ben Bernanke put it in one of market monetarism’s foundational statements:

“the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

You can see the attraction of all this to Cameron and Osborne but will they be allowed to get away with it? The mass production of sterling dictated by NGDPT in our current predicament would, in theory, have the effect of reducing sterling’s value on the exchange markets which will make imports into Britain more expensive and Britain’s exports to everywhere else cheaper.

In practice this is exactly what has been happening. The massive expansion of its balance sheet by the Bank of England has seen sterling crash by 15 percent since 2008 which has propped up British exports (it is this avenue which wasn’t open to Ireland).

But if you devalue to boost your exports of goods and services, any increase in those exports is matched by a reduction in someone else’s. This is why the competitive devaluations of the 1930s, as countries scrambled for a share of diminishing world trade, became known as ‘beggar they neighbour’.

And it looks unlikely that our neighbours are going to let themselves be beggared by Britain’s NGDPT. The Federal Reserve continues to buy $85 billion of bonds each month. In Japan Shinzo Abe is pushing an inflation target of 2 percent in a bid to boost its flagging exports. This will come at the expense of German exports which might cause policymakers in Berlin look more kindly on François Hollande’s calls for a devaluation of the euro. The race is on to see who beggars who first.

This article originally appeared at The Commentator

Is the bond bubble the biggest yet?

Forever blowing bubbles

In March 2000 the NASDAQ Composite index broke. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite had slumped to half that by the end of the year.

The bursting of the dot com bubble sent unemployment shooting up from less than 4 percent in late 2000 to 5.75 percent in late 2001. And it stayed there. Indeed, American unemployment didn’t peak until mid 2003 when it hit 6.25 percent.

As unemployment refused to budge and inflation slowed in early 2001 Alan Greenspan acted. Between January 2001 and June 2003 Greenspan slashed the Fed funds rate from 6.5 percent to 1 percent where it stayed until June 2004.

The effects are well known. With the economic foundations in place for an asset boom, institutional factors took over to decide which asset would do the booming. In this case government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, combined to direct the flood of credit into housing.

All booms and busts follow this pattern. An expansion of credit unsupported by real savings provides an economic base for a boom bust cycle and the institutional superstructure dictates which asset or assets will be the locus.

Since the credit crunch of 2007, and especially since the collapse of Lehman Brothers in 2008, central banks around the world have indulged in a massive expansion of credit not backed by savings. This looks very much like the foundation for another boom bust cycle. Where will it originate?

The trick is to follow the money and this means examining the institutional factors. Central banks have pumped their money into banks, who have sat on it, and, via Operation Twist, the EFSF, Quantitative Easing, or whatever, into government bonds. Is this where we will see the next bubble?

Let’s take a moment to explain how bonds work. If I want to borrow £100 I can issue a £100 bond with a maturity of one year, meaning that a year from now I will have to pay the buyer of the bond £100.

But I am unlikely to be loaned the full £100 by the person who buys the bond. If they did they would be giving me £100 now in return for £100 365 days from now. But to a buyer these two things, £100 now and £100 next year, are not the same.

The reason for this is time preference which is the basis of interest. If you are offered £100 which you can have today or £100 which you can have next year (the situation our lender is in) time preference dictates that you will prefer to get the £100 today. In other words, even though £100 is £100, time has a value so that the same thing offered at different points in time will be valued differently.

Put simply, something today is valued higher than the same thing at some future point. A bird in the hand is worth two in the bush, as they say.

To offset your preference for the £100 today over the £100 next year I would need to change the offer so that you give me £100 now and I repay £105 next year. An interest rate of 5 percent has emerged.

So if you issue a £100 bond you might only get £95 for it, this being the bond price. But you will still have to hand over £100 on maturity; the £5 difference is the interest, or the yield in bond market parlance. (The yield would be given as 5.26 percent as it would be a percentage of the bond price not its face value)

From this it should be obvious that bond prices and yields move in opposite directions. If the price rose to £96 the yield would fall to £4 (4.16 percent) and if the price fell to £94 the yield would rise to £6 (6.38 percent). In some cases bond prices can rise above face value giving a negative yield, meaning that lenders are paying for the privilege of lending.

Bonds prices are subject to the same supply and demand pressures as any other. So when demand rises/supply falls we will see higher prices and lower yields, and when supply rises/demand falls we will see lower prices and higher yields.

Let’s step back into the real world. Greek bond yields are high because few believe they will get the face value on maturity which, given Greece’s hideous debt problems, is a reasonable assessment. There is little appetite for Greek bonds and, with budget deficits of 8 percent of GDP, there is plenty of debt for sale. Germany, meanwhile, has a relatively sounder economic outlook and low (even negative) yields.

But Britain has Greek levels of debt and German interest rates, a new bond market conundrum. One reason is that of the vast expansion of credit undertaken by the Bank of England since at least 2008 much has flowed into British government bonds. Currently the Bank holds about 25 to 30 percent of British government debt.

A bubble is where asset valuations become divorced from the fundamentals of that asset’s ability to produce a return. A government with sound finances backed by a robust economy should enjoy low bond yields. But does this sound like Britain’s government or economy?

By pumping bond prices up and yields down this monetary action has helped inflate a bubble in bonds just as surely as previous credit expansions have inflated other bubbles.

Is the bond bubble the biggest yet?

This article originally appeared at The Commentator

Is the developed world merely illiquid or actually insolvent?

Coming up empty

Wherever you look in the world today you see economic problems. And whether it’s Britain, Europe, or the United States, with governments struggling under spiralling debts, what power there is to solve or at lease ease these problems is said to rest in the hands of central bankers.

Central banking grows out of maturity mismatch in banks. For example, you might pay £100 into a bank and be able to withdraw it at any time. The bank, on the other hand, might lend it to someone with a repayment date decades in the future, a mortgage for instance. If the bank has loaned your £100 out with a maturity of 30 years, if you turn up before those 30 years is up, the bank cannot give you your money.

In this case the bank faces a problem of liquidity. It has the assets (in the form of future mortgage payments) to cover all the claims that depositors could make against it. But it might not, in fact it rarely will have, enough liquid cash on hand to meet these demands if depositors all made them at once because these payments are not due until some point in the future.

It was because of repeated shortages of liquidity which lead to bank failures and economic disturbance that central banks evolved their role as ‘lender of last resort’ to the financial sector (many, like the Bank of England, had come into being solely to fulfil the ‘lender of last resort’ role for the government).

When banks were faced with depositors trying to withdraw lots of deposits against assets which wouldn’t return until a future date, central banks would tide them over. In the words of Walter Bagehot in his 1873 book Lombard Street, central banks should “lend freely at a high rate, on good collateral”

It should be obvious how far modern central banking has deviated from Bagehot’s principles. True, lending could hardly be any freer, but rates are at all time lows and the collateral stinks. But there’s a more fundamental problem: central banks were designed to assist with liquidity crises – what we may be seeing is a solvency crisis.

Solvency refers to whether an institution has enough assets to cover its liabilities. If it doesn’t, if a bank, for example, is owed mortgage payments of £9 billion but has liabilities of £10 billion, it is insolvent. There is no way, even if it could liquidate its £9 billion of assets into cash immediately, that it could cover its liabilities.

Governments around the world are racking up vast debts even on official figures. Between 1990 and 2009, according to a McKinsey report, government debt rose from 57 percent of GDP in 1990 to 67 percent in 2009 and from 32 percent of GDP to 59 percent in Britain in the same period. Coming up to three sluggish years later those figures are up to around 100 percent for the US and 85 percent for Britain.

But it’s not just governments. In the US financial debt was up from 24 percent to 53 percent of GDP between 1990 and 2009. In Britain it was up from 60 percent to 154 percent of GDP. Household debt in the US rose from 59 percent to 97 percent of GDP over the period; in the UK, from 65 percent to 103 percent. Corporate debt in the US rose from 65 percent to 79 percent of GDP and in Britain it rose from 66 percent to 110 percent of GDP.

So those figures for national indebtedness which we often hear, usually around or hurtling towards 100 percent of GDP, is only the government part of the story. All told, the indebtedness of the US is around 300 percent of GDP and for Britain the figure is close to a staggering 500 percent of GDP. And this doesn’t factor in long term liabilities like pensions. It is a story repeated around the developed world.

Are these countries really suffering from a temporary tightness of cash which can be helped with a little central bank greasing? Or are they drowning in debt? Are they merely illiquid or are they actually insolvent?

As Mitch Feierstein puts it in his excellent recent book Planet Ponzi,

“Above all, where excessive debt is the problem, there exists one and only one solution: less debt. If that means that dumb creditors lose money, that’s good, a positively beneficial outcome. Simply put: too big to fail is too big to exist. The failure of some creditors will remind all the others that credit discipline matters, just as it always has done, just as it always will.

In particular, we need to relearn an old lesson: that you cannot solve a problem of excessive private sector debt by getting the government to take it over. Or by extending government guarantees to soften the hit. Or by printing money to bail out failed financial institutions. Or (in the case of the wonderfully named EFSF) by creating a rescue fund that contains no funds, only guarantees, and which is itself going to be as highly leveraged as those Eurocratic minds can devise”

The grim possibility exists that there may be too much debt in the world ever to be paid off. That means default, either overt (the PIIGS) or covert via inflation (everywhere else). Either way, there are lots of people are going to find out that their assets aren’t worth anything.

This article originally appeared at The Commentator

Forget LIBOR, QE is the real scandal

About ten days ago most people wouldn’t have known the LIBOR from an ice sculpture of Vin Diesel. Now the London Interbank Overnight Rate (the rate at which banks lend to each other overnight – not everything in economics is as obtuse as it sounds) is at the centre of a furious political storm and will soon be at the centre of a Parliamentary inquiry.

A flavour of the passion roused by Barclays’ actions came when the normally measured Mervyn King spoke of “the deceitful manipulation of a key interest rate.” This was especially striking coming from him as his job, Governor of the Bank of England, is all about manipulating interest rates.

And it was even more striking as he said this just as he was about to administer another dose of Quantitative Easing, £50 billion, taking the total so far to £375 billion since the scheme started in March 2009. That’s about a quarter of GDP.

QE’s stated purpose is to put money into banks and lower long term interest rates, spurring borrowing, investment, and economic growth. There hasn’t been much sign of this but QE’s defenders tell us that we have to compare what weak growth we do have with the cataclysm which would have befallen us without QE. We’ll never know.

But QE has had a number of definite effects. By handing over £325 billion to banks in return for long term assets QE has boosted the bank’s profitability and, of course, those bonus pots for executives. And it is not just any old long term security that the Bank of England has been buying but British government debt. This has had the handy effect of helping George Osborne keep gilt yields down.

While banks and the Treasury have done rather nicely out of QE, savers, particularly retirees, haven’t. The driving down of long term interest rates by QE has driven down annuity rates, which are linked to long term interest rates, by 27 percent since 2008.

As Simon Rose, from pressure group Save Our Savers says, “QE is government-sanctioned theft from those who are trying to make provision for themselves. It is wreaking havoc on pension funds with the National Association of Pension Funds reckoning QE has cost pension funds a massive £270 billion.”

That’s not to say that all pensioners are suffering. The fall in gilt yields has been accompanied by a rise in gilt prices (the two move in opposite directions) which is great news for anyone whose pension pot is invested in gilts. Like Charlie Bean and Paul Tucker, deputy governors of the Bank of England, who, thanks to the rise in gilt prices they engineered, saw the value of their pension pots rise by £1.04 million and £1.35 million pounds each last year to a total value of £3.56 million and £5 million respectively.

One effect QE hasn’t yet had is inflation. Yes, CPI has been above the Bank of England’s target range for two and a half years, but the inflation figures we have seen are way below what you might expect from an expansion of narrow measures of the money supply by an amount equal to a quarter of GDP.

Quite simply, the money pumped into banks via QE has stayed there. Banks have not lent it out, as Vince Cable keeps complaining, but if they ever did, if QE worked as the prospectus says it should, we would see inflation.

The diagrams below illustrate how this would work. Money is a tricky thing to define so there are several measures. We count the stock of notes and coins in circulation and call it M0. But there are bank current accounts which can be converted into cash quickly, so we add these to M0 and get the M1 measure. Add some deposit or interest-bearing accounts and we have M2, add some other deposits and we get M3, and add building society deposits and we have M4.

Figure 1 is a simple, stylised illustration of how these various measures of the money supply relate to each other, with the black box in the bottom left representing M0, red M1, orange M2, yellow M3, and white M4.

Figure 1

Figure 2 shows a situation where QE has doubled the narrow money measures of M0 and M1, but, either because banks are hoarding or individuals and enterprises aren’t borrowing, this has not filtered through into the broader monetary aggregates and appeared in inflation figures.

Figure 2

Figure 3 shows what would happen if the increase in narrow money shown in Figure 2 found its way out of the banks and into the wider money supply.

Figure 3

Assuming a proportional increase in broader monetary aggregates in response to an increase in narrow money to maintain existing ratios, a doubling of narrow money will lead to a doubling of broader money. Anyone who doubts the possibility of such a scenario in Britain ought to consider the effects of QE on the monetary base; it has nearly tripled since 2008.

NB: This graph shows the move from the situation in Figure 1 to that in Figure 2

This is the curious thing about QE; even if it works, it doesn’t. If banks do “use these increased deposits as the basis for increased lending to businesses and households” we will see inflation. If they don’t then there’s no point doing it.

Reflecting on Japan’s experience with QE in his book, The Holy Grail of Macroeconomics, Richard Koo argued that “As long as there are no borrowers, no amount of quantitative easing will harm the economy. But if the policy is continued after borrowers return to the market, it can lead to dangerously high money-supply growth and inflation”. The same applies with hoarding banks.

Koo called Japan’s QE a “non-event”. We ought to hope that ours is as benign, if it isn’t we’ll all feel the same pinch our savers already are. That, not LIBOR, is the real scandal.

This article originally appeared at The Commentator

The euthanasia of the rentier: Why the assault on savers must end


Take that thrift!

With the British economy flat lining, America’s stumbling, and Europe’s in a nosedive, the clamour is growing for policymakers to ‘do something’. The Bank of England is, once again, being urged to deploy the weapon of Quantitative Easing – the spending of newly created money on long term assets.

Would this do any good? It hasn’t so far. The truth is that money is not wealth, goods and services are, and a central bank simply producing more money does not make us wealthier. But if central banks can’t create more wealth by creating more money they can redistribute the wealth there is.

This has been happening in Britain for nearly four years. Between October 2008 and March 2009 the Bank of England slashed interest rates from 5 percent to the historic low of 0.5 percent. When this failed to reignite economic growth the Bank resorted to £325 billion worth of QE. Whereas the Bank usually works on the short term end of the Yield Curve when setting the base rate, with QE it set out to pull down the long term end.

The stated aim was to put money into banks to get them lending again. I’ll leave it to you to judge how far the programme has succeeded in that aim, but one predictable side effect has been to lower returns all along the curve.

And this matters. With policymakers pulling every trick to keep interest rates everywhere as low as possible, Britain’s savers are being ravaged. On one estimate they are being robbed of £18 billion per year. Simon Rose, of pressure group Save Our Savers, puts the figure savers have been stripped of at £100 billion since the start of the crisis, “a staggering amount of money” he says “given that it would pay for the Olympics ten times over.”

The Bank’s monetary shenanigans haven’t boosted growth (cheerleaders have fallen back on the old argument that they have, at least, staved off catastrophe – again, I’ll let you be the judge). They have caused a vast transfer of wealth away from Britain’s savers and towards debtors and zombie banks and this is bad economic policy for reasons of growth and stability.

An entrepreneur with an idea must spend money on premises, wages, and all kinds of other possible outlays before seeing a single penny in revenue. The only way the entrepreneur can fund this outlay is from savings, either their own or other people’s channeled through a financial institution.

An increase in saving allows this period between embarking on production and sale of the product to lengthen (or fund other production periods for other goods). The lengthening of the production period, in turn, permits more stages of production,increasing ‘roundaboutness’ as the Austrian economist Eugen von Böhm-Bawerk put it.

Take shelter, a basic human need. Without the savings to sustain us over a prolonged production period, the period between embarking on production and using the shelter must be short, perhaps as long as it takes us to find a cardboard box. But with savings we can extend the production period and introduce many more intermediate stages. We can purchase land, draw up plans, purchase materials, hire labour etc.

The story of human material progress can be characterized as the lengthening of production processes enabling ever more intermediate steps. In short, savers are the difference between a three bed terrace and a cardboard box.

This much is not controversial; almost all economists agree that saving is an indispensable ingredient of increasing wealth. But the attack on savings risks shorter term instability too.

Lowering the base rate and QE works the same way, just on different ends of the Yield Curve; assets are purchased from banks with money newly created by the Bank of England.  From the point of view of a bank there is no difference between money deposited with it by savers and money it receives from the Bank of England in return for financial assets; it can lend out and earn profits on both.

But from the point of view of the wider economy there is a huge difference between the two types of ‘savings’. When savers deposit their funds with a bank they are doing so because they wish to withdraw this money in the future to fund consumption then. The resultant fall in interest rates, which makes it possible for firms to borrow to invest in the means to supply this future consumption, represents the actual time preferences of economic agents.

The ‘fake savings’ of Bank of England deposits, however, represent no such thing. While they can be lent and borrowed to fund investment projects with longer production periods there has been no change in the time preference of economic agents. There will be no real savings to purchase the output of these enterprises in the future.

When this is revealed these unprofitable enterprises will be liquidated causing recession. It is, thus, only the deposits of savers which can provide the capital which allows for longer production processes and increasing wealth on a stable and sustainable basis.

In his ‘General Theory’ in 1936, John Maynard Keynes looked forward to “the euthanasia of the rentier” when interest rates would be driven to zero and capital would be free and abundant. This nonsense, as much as anything else he said, represents a threat to our economic growth and stability. The assault on savers must end.

This article originally appeared at The Commentator

The euro – lessons from history

Dinner money

When currencies and monetary arrangements have broken down it has always been because the currency issuer can no longer fight the lure of the seigniorage to be gained by over issue of the currency. In the twentieth century this age-old impulse was allied to new theories that held that economic downturns were caused or exacerbated by a shortage of money. It followed that they could be combated by the production of money.

Based on the obvious fallacy of mistaking nominal rises in wealth for real rises in wealth, this doctrine found ready support from spendthrift politicians who were, in turn, supported by the doctrine.

Time and again over recent history we see the desire for seigniorage allied with the cry for more money to fight a downturn pushing up against the walls of the monetary architecture designed to protect the value of the currency. Time and again we see the monetary architecture crumble.

The classical gold standard

At the start of the twentieth century much of the planet and its major economic powers were on the gold standard which had evolved from the 1870s following Britain’s lead. This was based on the twin pillars of (1) convertibility between paper and gold and (2) the free export and import of gold.

With a currency convertible into gold at a fixed parity price any monetary expansion would see the value of the currency relative to gold decline which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5 and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5 note to the bank, swap it for an ounce of gold and sell it on the market for £7.

The same process worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.

In both cases the convertibility of currency into gold and vice versa would act against the monetary expansion or contraction. In the case of an expansion gold would flow out of banks forcing a contraction in the currency if banks wished to maintain their reserve ratios. Likewise a contraction would see gold flow into banks which, again, in an effort to maintain their reserve ratios, would expand their issue of currency.

The gold standard era was one of incredible monetary stability; the young John Maynard Keynes could have discussed the cost of living with Samuel Pepys without adjusting for inflation. The minimisation of inflation risk and ease of convertibility saw a massive growth in trade and long term cross border capital flows. The gold standard was a key component of the period known as the ‘First era of globalisation’.

The judgement of economic historians Kenwood and Lougheed on the gold standard was

One cannot help being impressed by the relatively smooth functioning of the nineteenth-century gold standard, more especially when we contemplate the difficulties experienced in the international monetary sphere during the present century. Despite the relatively rudimentary state of economic knowledge concerning internal and external balance and the relative ineffectiveness of government fiscal policy as a weapon for maintaining such a balance, the external adjustment mechanism of the gold standard worked with a higher degree of efficiency than that of any subsequent international monetary system

The gold exchange standard and devaluation

The First World War shattered this system. Countries printed money to fund their war efforts and convertibility and exportability were suspended. The result was a massive rise in prices.

After the war all countries wished to return to the gold standard but were faced with a problem; with an increased amount of money circulating relative to a country’s gold stock (a problem compounded in Europe by flows of gold to the United States during the war) the parity prices of gold were far below the market prices. As seen earlier, this would lead to massive outflows of gold once convertibility was re-established.

There were three paths out of this situation. The first was to shrink the amount of currency relative to gold. This option, revaluation, was that taken by Britain in 1925 when it went back onto the gold standard at the pre-war parity.

The second was that largely taken by France between 1926 and 1928. This was to accept the wartime inflation and set the new parity price at the market price.

There was also a third option. The gold stock could not be expanded beyond the rate of new discoveries. Indeed, the monetary stability which was a central part of the gold standard’s appeal rested on the fixed or slow growth of the gold stock which acted to halt or slow growth in the currency it backed. So many countries sought to do the next best thing and expand gold substitutes to alleviate a perceived shortage of gold. This gave rise to the gold exchange standard which was put forward at the League of Nations conference in Genoa in 1922.

Under this system countries would be allowed to add to their gold reserves the assets of countries whose currency was convertible into gold and issue domestic currency based on this expanded stock. In practice the convertible currencies which ‘gold short’ countries sought as reserves were sterling and dollars.

The drawbacks were obvious. The same unit of gold could now have competing claims against it. The French took repeated advantage of this to withdraw gold from Britain.

Also it depended on the Bank of England and Federal Reserve maintaining the value of sterling and the dollar. There was much doubt that Britain could maintain the high value of sterling given the dire state of its economy and the dollar was weakened when, in 1927, the Federal Reserve lowered interest rates in order to help ease pressure on a beleaguered sterling.

This gold exchange standard was also known as a ‘managed’ gold standard which, as Richard Timberlake pointed out, is an oxymoron. “The operational gold standard ended forever at the time the United States became a belligerent in World War I”, Timberlake writes.

After 1917, the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money.

The contention that Federal Reserve policymakers were “managing” the gold standard is an oxymoron — a contradiction in terms. A “gold standard” that is being “managed” is not a gold standard. It is a standard of whoever is doing the managing. Whether gold was managed or not, the Federal Reserve Act gave the Fed Board complete statutory power to abrogate all the reserve requirement restrictions on gold that the Act specified for Federal Reserve Banks (Board of Governors 1961). If the Board had used these clearly stated powers anytime after 1929, the Fed Banks could have stopped the Contraction in its tracks, even if doing so exhausted their gold reserves entirely.

This was exacerbated in the United States by the Federal Reserve adopting the ‘real bills doctrine’ which held that credit could be created which would not be inflationary as long as it was lent against productive ‘real’ bills.

Many economists, notably Ludwig von Mises and Friedrich von Hayek, have seen the genesis of the Depression of the 1930s in the monetary architecture of the 1920s. While this remains the most debated topic in economic history there is no doubt that the Wall Street crash and its aftermath spelled the end of the gold exchange standard. When Britain was finally forced to give up its attempt to hold up sterling and devalue in 1931 other countries became worried that its devaluation, by making British exports cheaper, would give it a competitive advantage. A round of ‘beggar thy neighbour’ devaluations began. Thirty two countries had gone off gold by the end of 1932 and the practice continued through the 1930s.

Bretton Woods and its breakdown

Towards the end of World War Two economists and policymakers gathered at Bretton Woods in New Hampshire to design a framework for the post war economy. Looking back it was recognised that the competitive devaluations of the 1930s had been a driver of the shrinkage of international trade and, via its contribution to economic instability, to deadly political extremism.

Thus, the construction of a stable monetary framework was of the most utmost importance. The solution arrived at was to fix the dollar at a parity of 1oz = $35 and to fix the value of other currencies to the dollar. Under this Bretton Woods system currencies would be pegged to gold via the dollar.

For countries such as Britain this presented a problem. Any attempt to use expansionary fiscal or monetary policy to stimulate the economy as the then dominant Keynesian paradigm prescribed would eventually cause a balance of payments crisis and put downward pressure on the currency, jeopardising the dollar value of sterling. This led to so called ‘stop go’ policies in Britain where successive governments would seek to expand the economy, run into balance of payments troubles, and be forced to deflate. In extreme circumstances sterling would have to be devalued as it was in 1949 from £1 = $4.03 to £1 = $2.80 and 1967 from £1 = $2.80 to £1 = $2.40.

A similar problem eventually faced the United States. With the dollar having replaced sterling as the global reserve currency, the United States was able to issue large amounts of debt. Initially the Federal Reserve and Treasury behaved reasonably responsibly but in the mid-1960s President Lyndon Johnson decided to spend heavily on both the war in Vietnam and his Great Society welfare program. His successor, Richard Nixon, continued these policies.

As dollars poured out of the United States, investors began to lose confidence in the ability of the Federal Reserve to meet gold dollar claims. The dollar parity came under increasing pressure during the late 1960s as holders of dollar assets, notably France, sought to swap them for gold at the parity price of 1oz = $35 before what looked like an increasingly inevitable devaluation. Unwilling to consider the deflationary measures required to stabilise the dollar with an election due the following year, President Nixon closed the gold window on August 15th 1971. The Bretton Woods system was dead and so was the link between paper and gold.

Fiat money and floating exchange rates

There were attempts to restore some semblance of monetary order. In December 1971 the G10 struck the Smithsonian Agreement which sought to fix the dollar at 1oz = $38 but this broke down within a few months under the inflationary tendencies of the Federal Reserve. European countries tried to establish the ‘snake’, a band within which currencies could fluctuate. Sterling soon crashed out of even this under its own inflationary tendencies.

The cutting of any link to gold ushered in the era of fiat currency and floating exchange rates which lasts to the present day. Fiat currency gets its name because its value is given by governmental fiat, or command. The currency is not backed by anything of value but by a politicians promise.

The effect of this was quickly seen. In 1931 Keynes had written that “A preference for a gold currency is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now” But, as D R Myddelton writes, “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”

In 1976 the pound fell below $2 for the first time ever. Pepys and Keynes would now have been talking at cross purposes.

Floating exchange rates marked the first public policy triumph for Milton Friedman who as long ago as 1950 had written ‘The Case for Flexible Exchange Rates’. Friedman had argued that “A flexible exchange rate need not be an unstable exchange rate” but in an era before Public Choice economics he had reckoned without the tendency of governments and central banks, absent the restraining hand of gold, to print money to finance their spending. World inflation which was 5.9% in 1971 rose to 9.6% in 1973 and over 15% in 1974.

The experience of the era of floating exchange rates has been of one currency crisis after another punctuated by various attempts at stabilisation. The attempts can involve ad hoc international cooperation such as the Plaza Accord of 1985 which sought to depreciate the dollar. This was followed by the Louvre Accord of 1987 which sought to stop the dollar depreciating any further.

They may take more organised forms. The Exchange Rate Mechanism was an attempt to peg European currencies to the relatively reliable Deutsche Mark. Britain joined in 1990 at what many thought was too high a value (shades of 1925) and when the Bundesbank raised interest rates to tackle inflation in Germany sterling crashed out of the ERM in 1992 but not before spending £3.3 billion and deepening a recession with interest rates raised to 12% in its vain effort to remain in.

Where now?

This brief look back over the monetary arrangements of the last hundred years shows that currency issuers, almost always governments, have repeatedly pushed the search for seigniorage to the maximum possible within the given monetary framework and have then demolished this framework to allow for a more ‘elastic’ currency.

Since the demise of the ERM the new vogue in monetary policy has been the independent central bank following some monetary rule, such as the Bank of England and its inflation target. Inspired by the old Bundesbank this is an attempt to take the power of money creation away from the politicians who, despite Keynes’ high hopes, have proved themselves dismally untrustworthy with it. Instead that power now lies with central bankers.

But it is not clear that handing the power of money creation from one part of government to another has been much of an improvement. For one thing we cannot say that our central bankers are truly independent. The Chairman of the Federal Reserve is nominated by the President. And when the Bank of England wavered over slashing interest rates in the wake of the credit crunch, the British government noisily questioned its continued independence and the interest rate cuts came.

Furthermore, money creation can reach dangerous levels if the central bank’s chosen monetary rule is faulty. The Federal Reserve has the awkward dual mandate of promoting employment and keeping prices stable. The Bank of England and the European Central Bank both have a mandate for price stability, but this is problematic. As Murray Rothbard and George Selgin have noted, in an economy with rising productivity, prices should be falling. Also, what ‘price level’ is there to stabilise? The economy contains countless different prices which are changing all the time; the ‘price level’ is just some arbitrarily selected bundle of these.

An extreme example, as noted by Jesús Huerta de Soto, is the euro. Here a number of governments agreed to pool their powers of money creation and invest it in the European Central Bank. The euro is now widely seen to be collapsing. So it may be, but is this, as is generally assumed, a failure of the architecture of the euro itself?

Let us remember that the purpose of erecting a monetary structure where the power to create money is removed from government is to stop the government running the printing presses to cover its spending and, in so doing, destroy the currency.

The problem facing eurozone states like Greece and Spain is presented as being that they are running up debts in a currency they cannot print at will to repay these debts. But is the problem here that these countries cannot print the money they need to pay their debts or that they are running up these debts in the first place? The solution is often offered that either these countries need to leave the euro and adopt a currency which they can expand sufficiently to pay their debts or that the ECB needs to expand the euro sufficiently for these countries to be able to pay their debts. But there is another solution, commonly called ‘austerity’, which says that these countries should just not run up these debts. As de Soto argues, the euro’s woes are really failures of fiscal policy rather than monetary policy.

It is thus possible to argue that the euro is working. By halting the expansion of currency to pay off debts and protecting its value and, by extension, preventing members from running up evermore debt, the euro is doing exactly what it was designed to do.

There is a growing clamour inside Europe and outside that ‘austerity’ alone is not the answer to the euro’s problems and that monetary policy has a role to play. The ECB itself seems to be keen to take on this role. But it is simply the age-old idea, based on the confusion between the real and the nominal, that we will get richer if we just produce more money. Germany is holding the line on the euro but history shows that far sounder currency arrangements have collapsed under the insatiable desire for a more elastic currency.


ANDERSON, B.M. 1949. Economics and the Public Welfare – A Financial and Economic History of the United States 1914-1946. North Shadeland, Indiana: Liberty Press

BAGUS, P. 2010. The Tragedy of the Euro. Auburn, Alabama: Ludwig von Mises Institute.

CAPIE, F., WOOD, G. 1994. “Money in the Economy 1870-1939.” The Economic History of Britain since 1700 vol. 2: 1860-1939. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 217-246.

DRUMMOND, I. 1987. The Gold Standard and the International Monetary System 1900-1939. London: Macmillan

FRIEDMAN, M. 1950. “The Case for Flexible Exchange Rates” Essays in Positive Economics. 1953. Friedman, M. Chicago: University of Chicago Press, pp. 157-203.

HOWSON, S. 1994. “Money and Monetary Policy in Britain 1945-1990.” The Economic History of Britain since 1700 vol. 3: 1939-1992. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 221-254.

HUERTA DE SOTO, J. 2012. “In defence of the euro: an Austrian perspective”. The Cobden Centre, May 29th

KENWOOD, A.G., LOUGHEED, A.L. 1992. The Growth of the International Economy 1820-1990. London and New York: Routledge

KINDLEBERGER, C.P. The World in Depression 1929-1939. London: Pelican

MYDDELTON, D.R. 2007. They Meant Well – Government Project Disasters. London: Institute of Economic Affairs

ROTHBARD, M. 1963. America’s Great Depression. BN Publishing

SAMUELSON, R.J. 2010. The Great Inflation and its Aftermath – The Past and Future of American Affluence. New York: Random House

SELGIN, G. 1997. Less Than Zero – The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs

TIMBERLAKE, R. 2008. “The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis”. Cato Journal, Vol. 28, No. 2 (Spring/Summer 2008), James A. Dorn, ed. Washington DC: Cato Institute, pp. 303-312.

VAN DER WEE, H. 1986. Prosperity and Upheaval – The World Economy 1945-1980. London: Pelican

This article originally appeared at The Cobden Centre

Austerity is under attack


An end to the Broken Window fallacy

Austerity is under attack. Last weeks news that the UK has slipped back into recession was blamed on the government’s ‘austerity’ program. This weekends election of Francois Hollande to the French presidency, electoral gains in Italy for anti austerity parties, and chaos in Greece strengthen the hand of the so called ‘growth bloc’ which looks at the withering economies on Europe’s fringes and seeks an alternative to the tax rises and spending cuts of the austerity they hold responsible.

Across Europe it is being said that ‘austerity’ is not the answer. The choice is being as framed as austerity versus growth, as though riches are just a choice away. Sadly, and not surprisingly, it is not that simple.

When people say ‘growth’ what they really mean is increased government spending. But there is no connection between government spending and economic growth, if there were the Soviet Union may still be with us.

Indeed, for all the controversy about austerity across the west we see government’s borrowing and spending sums utterly unprecedented in peacetime.

Greece, with a national debt officially approaching 150 percent of GDP is going to run a deficit of 7 percent of GDP this year. The governments of Spain, Portugal, and France will all borrow around 5 percent of GDP this year. Britain, though, tops the lot. The British government will borrow over £120 billion this year, nearly 8 percent of GDP. The ‘cruel’ and ‘ideological’ cuts actually come in at a distinctly unaustere couple of percent.

In short, we are seeing massive borrowing and spending and our economies are still tanking. The argument that government spending = growth is plainly false. And with that the idea that there is a simple choice between growth and austerity disappears.

Anyone who after all this still clings to the idea that we can generate growth through increased government spending is suffering from some sort of hyper Keynesian psychosis; that we must push our deficits to 10, 15 or 20 percent of GDP, our debts to 150 or 200 percent of GDP. You could call this economic or suicide. If you were Monsieur Hollande you could call it an economic policy.

The ground upon which the ‘growth vs austerity’ plant has taken root was sown, to some extent, by those economists who pushed the idea of the expansionary fiscal contraction – the idea that the very act of cutting spending itself it would spur growth. But while budgetary balance might not be sufficient on its own for economic growth it is a necessary condition.

As countries borrow more and lenders come to doubt their ability to pay it back, the costs of borrowing increase. We’ve seen this with spikes on bond yields for governments in Greece, Italy, Spain, and Portugal during the euro crisis. These governments have had to pay more and more to borrow necessitating further spending cuts in other areas of government spending.

One alternative is to have the central bank buy the governments bonds with newly printed money. The European Central Bank has been doing as much of this as it can within its anti inflationary remit and seeks the power to do more. The Bank of England and Federal Reserve have been doing it lots and calling it Quantitative Easing. This has held down borrowing costs in both countries at the price, in Britain, of high inflation.

Inflation has been less of a problem in the US (on official figures anyway) but only due to the dollars status as global reserve currency which means that other nations will absorb almost any amount of dollars. Almost. The Federal Reserve’s monetizing of the debt is placing great strain on the dollar. The consequencesof a collapse would be catastrophic.

Either way, whatever people lose in austerity they will lose also with the inflation of the alternative, the decline in the purchasing power of their money. There really is no painless way out; no box to tick or lever to pull labelled ‘growth’ or anything else which will return us to the debt fuelled boom times before the credit crunch. As I’ve said before, as bad as it is, is as good as it gets.

The worrying thing about the anti-austerity backlash is that it indicates that voters still don’t really accept this. When asked if spending should be cut, taxes raised, and debt brought under control they generally agree in the abstract. But it seems they flinch from the reality of what this actually entails.

On official calculations, the debts of western countries are huge and growing. Unofficial calculations paint a much grimmer but probably more accurate picture. If even moderate attempts to slow the increase in debt – all austerity really promises in the short term – prove electorally unpalatable then western voters will be faced not with the bumpy landing of austerity but with the fatal crash of economic collapse. That, not debt fuelled growth vs austerity, is the real choice.

This article originally appeared at The Commentator