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

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

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

Don’t worry about turning into Greece, we always have the option to turn into Zimbabwe instead

Keep the change

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.

The coalition puts this remarkable, and unsustainable, state of affairs down to its much trumpeted austerity. Investors are said to be rewarding Britain with low interest rates for acting early and decisively to curb its ruinous borrowing. The borrowing costs of Greece, Portugal, or Italy are cited as examples of the merciless knee-capping Britain could have expected without it.

With the British public and government up to their necks in debt almost all points on the political map agree that higher interest rates are an evil to be avoided at all costs. So opponents of the ‘austerity’ program have to argue that continued borrowing won’t cause interest rates to rocket. They say that we won’t incur the borrowing costs of the PIIGS because we have our own central bank and can print our own currency.

They are arguing, in other words, that we don’t need to worry about turning into Greece because we always have the option of turning ourselves into Zimbabwe instead.

It might seem eccentric to worry about inflation right now. The Bank of England has forecast that inflation will fall throughout 2012, a prediction borne out by the most recent figures. Indeed, the M4 measure of broad money has been flat.

But this isn’t because the Bank of England hasn’t done everything necessary to generate inflation. Behind these figures lies incredibly aggressive monetary ‘stimulus’. Bank of England base rates have been held at 0.5 percent for nearly three years. Quantitative easing has seen £275 billion spent since the program was launched in March 2009 with another £50 billion announced recently. The Bank of England has seen its balance sheet balloon from 5 percent of GDP to around 20 percent, an increase of 300 percent, exactly the same as its growth in the highly inflationary 1970s.

We have been saved from higher inflation so far because banks aren’t lending the money out but using it to repair balance sheets ravaged by the collapse in mortgage backed asset prices. As demonstrated by banks’ failure to meet their Project Merlin lending targets the money the Bank of England has pumped out in these various manoeuvres has been parked up on banks balance sheets.

So far so ineffective. But banks aren’t in the business of sitting atop ever higher piles of reserves and policy makers at the Treasury and Threadneedle Street speak constantly about the aim of returning to more ‘normal’ lending conditions. If banks do begin to lend and this vast pile of newly printed cash finds its way out into broader money measures then we will see inflation.

We are told that this won’t happen because when this turning point is reached the Bank of England will step in to unwind its positions. It will sell the various financial assets it has bought under QE and remove from existence the money banks use to pay for them. The inflationary money will vanish.

This obviously relies on a bit of split second timing from the Bank. It will rely on the Bank of England retiring its holdings at exactly the rate the market can absorb; hold onto them too long and inflation will result, liquidate them too quickly and interest rates will spike. Anyone who has witnessed its lead footed lumberings of recent years might wonder if it’s capable.

But could the economy withstand it anyway? When the Bank sells the assets it has bought their prices will drop and, inversely, yields and interest rates will rise; the very same interest rates which, we are told, are an evil to be avoided at all costs in a highly indebted economy such as ours. It might, in fact, be the case that the British economy is now so hooked on debt that any rise in interest rates will generate a politically intolerable level of economic pain. If this is the case then vast monetary easing will remain with us until the inevitable point at which it brings collapse.

Of course, the Bank of England might just pull it off. Even so the British economy will have another tightrope to walk.

This article originally appeared at The Commentator

The Fed giveth and the Fed taketh

The Maestro

Alan Greenspan’s pronouncements used to be described as ‘Delphic’ because of their rarity and mystery of meaning. So his blunt attack on the monetary policies of his successor, Ben Bernanke, last week on CNBC was quite striking.

“I am ill-aware of anything that really worked. Not only QE2 but QE1” Greenspan said, elaborating “There is no evidence that huge inflow of money into the system basically worked”. No doubt it will come as a shock to hear the man who gave his name to the use of huge inflows of money into the system to combat any downturn – the ‘Greenspan put’ – turning his back on the method. It will likewise surprise some, perhaps, to see the man who presided over a dollar which lost about a quarter of its value against the euro expressing concern about policies which might “continue erosion of the dollar”. That would be the erosion he played a large part in.

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S**t my economist says #4

Pedal to the metal

Mervyn King is in the news again. He has raised his prediction for inflation and lowered his prediction for growth.

This seems curious. King has been warning for months now that any rise in interest rates, such as would be needed to head off surging inflation, risks ‘derailing the recovery’. Yet the rail-worthiness of the recovery is clearly doubtful even with King’s ultra low interest rates.

At the very least this ought to throw more dirt on the coffin of the idea that printing money/lowering interest rates can pull you out of recession. It’s a bit like whipping the horses without them being tied to the buggy. Your inflationary nags will gallop into the distance but your real economy buggy will stay right where it is.

A looming crisis

Friends for now

John Maynard Keynes said that “not one man in a million” was able to understand the process of inflation. If we are to give credence to Keynes’ view, it appears that the Governor of the Bank of England Mervyn King is certainly no exception.

In January 2011 the inflation rate was above the Bank of England’s target range for the 13th month running, requiring King to write an open letter to Chancellor of the Exchequer George Osborne explaining why. As in his November 2010 letter to the Chancellor, King blamed a number of “temporary effects”, namely “the rise in VAT relative to a year ago, the continuing consequences of the fall in sterling in late 2007 and 2008, and recent increases in commodity prices, particularly energy prices”.

One could be forgiven for detecting a certain sense of déjà vu here. In November’s letter King blamed the failure of the Bank to meet its inflation target on “temporary influences” including “the restoration of the standard rate of VAT to 17.5% in January, past rises in oil prices and the continued pass through of higher import prices following the depreciation of sterling since mid-2007”. Indeed, looking back at his letters from August, February and May last year, we see VAT rises, oil prices and depreciation as the villains of the inflationary piece back then as well. We also find a similar reassurance that they will only have a “temporary impact” (August 2010), are a “short-run factor” (February 2010), or will be “temporary effects” (May 2010). Temporary seems to be a long time in King’s economic thinking.

The truth is that the monetary policy of the Bank of England is itself inflationary. Interest rates were slashed from 5% in September 2008 to an unprecedented 0.5% in March 2009. When you stop to think how this works it’s obvious that inflation will be the result.

The interest rate is the price of money. Like any price it is determined by supply and demand factors. If you want to reduce the price of something, in this case the interest rate, you supply more of it, in this case money. Via Open Market Operations central banks buy bonds from commercial banks and pay for them with newly printed (or digitally created) cash thus lowering interest rates. But, obviously, if the amount of money sloshing around in an economy increases at a greater rate than the amount of goods or services in it the prices of those goods and services will rise, creating higher inflation. Quantitative easing has simply poured more fuel on the smouldering inflationary fires.

This inflationary monetary policy risks torpedoing the coalition government’s economic strategy. The whole point about the austerity drive is to try and keep private sector borrowing costs down. Following the crowding out theory of government spending, there is held to be a fixed amount of money which can be borrowed at any one time. The more demand there is for this money then, like anything else, the higher the interest rate or, to repeat, its price. By restraining government spending, demand for these funds will be lessened and the price (interest rate) will fall.

This could be negated by the Bank’s monetary policy working via another economic mechanism, the Fisher Effect. If inflation is at 5% over a year then £100 lent to on January 1st will be paid back on December 31st with £100 but, crucially, it will only be able to buy the equivalent of £95 worth of goods today having lost 5% of its value. To compensate for this a lender charges 5% interest on the loan so that she is repaid £105 on December 31st which buys the same amount, £100 worth, of goods today.

If, however, inflation rises then so does the interest rate to protect the purchasing power of the loaned money. Thus, the important interest rate in an economy is not the nominal rate but the real rate which is the nominal rate minus expected inflation. From this we can see that the nominal rate is the real interest rate plus expected inflation. This is the Fisher Effect. A rise in expected inflation caused by the Bank of England’s loose monetary policy will lead to a higher nominal interest rate negating any effects of the coalition’s austerity drive.

Markets are already upping their inflation expectations and charging more to lend. In six months the yield on 10 year Treasury gilts has risen 1% to 3.87%. In so far as the Bank of England’s inflation erodes government debt George Osborne might be secretly grateful for these figures on the one hand. But, on the other, if inflation causes a spike in interest rates undoing the coalition’s work, the Treasury will be gunning for the Bank.

This article originally appeared at Global Politics

Back to the 80’s


It’s never hard to find somewhere in London that is hosting an 80’s night. Charity shops are raided for ra-ra skirts and leg warmers so that people can dance the night away to Wham and Erasure. The 80’s are back in fashion but far more than the music and clothes are back in vogue.
To the party goers rolling their jacket sleeves up like Don Johnson it probably rarely occurs that we face an economic situation very similar to that of the decade of Dynasty and 3 million unemployed. In June Mervyn King, Governor of the Bank of England, said “The lesson of the past fifty years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment. Price stability – returning inflation to the target – is a precondition for sustained growth, not an alternative”. This could almost be a justification for the 1981 budget which prompted the famous letter of protest from 364 economists. Like re runs of Airwolf, monetarism is back.

In the 10 years before Margaret Thatcher’s election victory in 1979, inflation averaged close to 12%. Various explanations were put forward. The most popular was the ‘oil shocks’ of 1973 and 1979 when disruptions in Middle Eastern oil production sent prices skyrocketing. Another was the pay demands of trade unions which brought the country to a shuddering halt in the winter of 1978.

Indeed, both of these arguments have echoes today. The rise in oil prices since 2003 has been presented by the government as a major factor in current inflation and the trade unions are squaring up to Gordon Brown and demanding higher pay to match inflation.

In 1979 the incoming Conservative government largely ignored both of these arguments armed as it was with the theory of monetarism. Popularised by Milton Friedman monetarism held that “Inflation is always and everywhere a monetary phenomenon”. The key, indeed probably the only, determining factor in inflation was the increase of the money supply.

The money supply is the total amount of money available in an economy at a particular point in time. It includes cash, deposits, checking accounts, liquid assets and much else besides. The exact make up depends on which measure of the money supply you happen to be using. In essence, monetarism held that if the growth in the money supply matched the growth of the economy then prices would remain stable. If it exceeded economic growth however, the resulting gap would be inflation.

In the case of rising oil prices being a cause of inflation, monetarism held that they were not, that in the 1970’s as now, they were merely price rises reflecting relative demand and supply. Inflation is not the rise in price of a particular good or service but “the increase in the general level of prices over a specified period”

Likewise, the wage demands of trade unions need not be inflationary. If the government raises wages by £X but raises taxes by £X to cover this, the money supply has not increased, rather a portion of it has simply been shifted from one large and disparate group (taxpayers) to a smaller and more concentrated group (the public sector). If the government funds wage increases by taxation, it will not be inflationary, if it funds them through an increase in the money supply, it will not only be inflationary but will prompt another bout of demands in the future.

This is what happened through the 1970’s. Government expenditure eventually reached the limits that taxation could support with marginal rates of 90% but even this was insufficient to fund it all. So the government took to expanding the money supply, “printing money” in the popular phrase of the time, which fuelled inflation. And as wage settlements caused further inflation unions came back with further wage demands. This became known as the ‘wage-price spiral’. But according to the monetarist doctrine of the Thatcher government and its Chancellor Geoffrey Howe, the inflationary factor was not rising wages but the governments’ expansion of the money supply to pay for them.

How relevant is this today? We have inflation albeit not of the double digit variety the Conservatives inherited in 1979. As we have seen, we also have people eager to blame oil prices and public sector wage demands. But what’s been happening to the money supply? Simon Heffer explained back in June.

“There is not inflation because of rising prices, or rising wages…Growth is at present about 2 per cent, and predicted to fall to about 1.4 per cent over the next year.

Inflation, on the bogus measure of Consumer Price Index, is more than 3.3 per cent. Even if we believe these two figures, their sum is about 5 per cent. How fast is the supply of money increasing in the M4 measure? More than 12 per cent.”

This is the real cause of inflation now at its highest rate since 1992. Since Gordon Brown ditched the Conservative spending plans he adhered to in the first Blair administration, public spending as a share of GDP has risen by nearly 5% of GDP to 42% for 2007-2008. This has been paid for by government borrowing which has produced a deficit of 2.8%. This avalanche of cash has flowed straight into the money supply.

It is likely that an incoming Conservative government in 2010 will have to deal with circumstances similar in their fundamentals to the situation of 1979. Sadly, the remedy is likely to be similarly painful with unemployment and higher interest rates. One note of comfort comes from the new monetarist consensus as demonstrated by Mervyn King, it is hard to imagine 300 economists taking up their pens in anger now.

Ultimately it proves the truth of Kenneth Clarke’s observation that Labour governments are elected for as long as it takes them to wreck the economy and Conservative governments are then elected to sort it out.

(Printed in The Caerulean, Issue 11, September 2008)