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

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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