interest rates – thinking liberal

Is Britain about to go bust?

The debate about Britain’s economic policy rumbles on, with a speech by the Shadow Chancellor Ed Balls last week. In previous posts I have dismissed the claim made by some that the government’s cuts are unnecessary, and most commentators, including Mr Balls, seem to accept this, even if they don’t say so explicitly. But there is a furious debate about how quickly the cuts should be implemented: 5 years as the government plans, or 8 years as Labour suggests, apparently including Mr Balls, though in the past he has been suggested longer. An impressive array of economists seem to support the Labour argument.

The basis of the critics’ argument rests on conventional macroeconomics, and runs that cutting too fast creates needless unemployment and risks a spiral of lower demand which will make things worse. This argument is open to challenge on its own terms (see The Economist’s Buttonwood column here, or Bagehot here), but the government’s defenders don’t generally try; instead they trump it with an argument about unsustainable levels of government debt. I want to look at the macroeconomic argument in a future post. Today I will consider whether unsustainable debt really is such a risk.

If government debt gets too high, it can derail the whole economy. A default, when governments renege on the terms of their debt, can be absolutely catastrophic. The problem is that if governments can’t raise the money then all the functions of government are threatened. For countries like Greece who are part of the Euro, this means that they literally can’t pay the bills – salary payments are stopped and so on. This is such a frightening prospect that there are strong incentives for other members of the zone to organise a rescue. Countries like the UK do have another option: they can debauch their currency by paying bills with newly created money. That’s how hyperinflation starts; the most recent example is Zimbabwe, and its implications are hardly less disastrous than default.

So what are the risks for Britain? The good news is that before the crisis struck overall debt was modest by international standards at a shade over 50% of GDP. Even better, the maturity profile of this debt, i.e. how soon it has to be rolled over, was long term – longer than any other major economy. The bad news is the massive size of the current deficit – 11% in 2009, and the fact that 8% is “structural” or won’t bounce back with the economic cycle. That means that total debt is increasing rapidly; by the end of 2010 it was already 75% of GDP. This gives two main problems.

The first problem is that debt risks spiralling out of control. Few think that the current economy is capable of more than modest growth, austerity or not, which means that extra wealth is not being generated fast enough to get us out of trouble. And debt comes with an interest bill. There are some classic economic models of this, and on these the warning lights are flashing red furiously. At some point lenders (characterised as the “bond markets”, but potentially including you and me) refuse to lend, or at least start to put the rate of interest up, making things worse.

The second problem is more subtle. If total national debt levels off at a high level, this will drag down the whole economy for a long while to come, as we spend too much resource servicing the debt. One study suggested that serious problems start to happen when debt reaches 90% of GDP – less than two years away at the current trajectory. Taking longer to eliminate the deficit means that overall debt will level off at a higher amount, unless the aggressive option really does lead to meltdown.

There are three further overlapping problems for the UK. Debt markets are very open; there is a degree of dependence on overseas support; and the pound is a floating currency. Government debt problems are much easier to handle if there is ready access to lenders who are effectively forced to lend to you; this has helped such high debt countries as Japan and Italy. Superficially the UK seems to look this way: pension funds are massive, and traditionally hold lots of government debt (gilts) for actuarial reasons. But such funds are aggressively and independently managed, helping to make our financial services industry internationally competitive. That means they switch away from buying gilts as soon as they think it is not such a good deal. Dependence on overseas investors appears to be relatively modest, as buyers of gilts are overwhelmingly domestic (or so I believe). But the country still runs a significant current account deficit (unlike Japan, and even Italy), meaning that the economy as a whole does need foreign lenders. The floating pound is often presented as a get out of jail free card – but the benefits of being able to devalue are two edged. Foreign investors will be wary of sterling if they think it will devalue; domestic investors will likewise increase their overseas exposures in the same event, reducing their ability to buy gilts (unless these are issued in foreign currency, but let’s not go there).

But, the government’s critics maintain, there’s no sign of trouble, and never has been. The government has had no trouble selling gilts, at very low interest rates. The trouble with this argument is that markets can turn in an instant, and you won’t know until too late. An investment decision depends on a judgement looking far into the future, and this can move very quickly. Government ministers seem to have got a genuine fright in May 2010 with the Greek crisis. By and large the closer a commentator actually is to the debt markets, the less sanguine they are about the whole thing. There are just too many risk factors.

So what to think? The Labour plan is probably viable, if backed by a real determination to follow it through (and Alistair Darling, the outgoing Labour chancellor would have been an excellent figurehead, unlike Mr Balls). But it undoubtedly takes more risks with catastrophe. Whether it is worth doing so does come back to your view on the macroeconomic risks. If you think that the austerity programme really will lead to meltdown, then this has real power. But neither is the government argument implausible. It’s about the risks you are prepared to run.

Who is to blame for the UK’s economic mess?

As time passes it is clear that the UK’s economic crisis is amongst the worst of the major developed economies, though Japan may beat it on some measures. It’s not in the league of some smaller economies, like Ireland or Greece, although a comparison with Portugal may be more nuanced. Some people (notably Labour politicians) struggle to accept just how bad things are; others don’t get much beyond railing deficits and the National Debt. It’s worth pausing to consider what went wrong, and to try and attribute responsibility.

What happened? Until 2007, the UK had an astonishingly consistent record of economic growth. This started with the departure from the European Exchange Rate Mechanism under John Major in 1992, and continued until early 2008. Economists had taken an average annual growth rate of 2.5% for granted. Unemployment fell, and most people felt better off, though the very wealthy did much better than the rest. Public expenditure rocketed, with massive investment in the NHS in particular. A recent study by the Institute for Fiscal Studies (IFS) shows that poverty was reduced, largely because of increased benefits and tax credits.

And then bang! GDP shrank by 6% in a year, stayed flat for the year after that, before struggling to a bit under 2% growth in the year after that (taking the year to the 1st quarter from the ONS). Forecasts are for consistently anaemic growth. This is striking. When economies hit a recession due to a temporary shock, they bounce back quite sharply, as temporarily unused capacity comes back on stream; this is what has happened in Germany this time. Not for us; a good 7% of the economy has vanished never to return. What makes this particularly bad is that this 7% produced an awful lot of taxes, while public expenditure carried on regardless (with benefits increasing due to the extra unemployment and hardship). This has left the country with a “structural deficit” of about 8%. This is the excess of public expenditure over taxes after you strip out temporary factors; the actual deficit was much larger (it reached 11% and has now dropped to 10% per annum). Now I’m not sure how we ended up with an 8% structural deficit after losing just 7% of GDP, of which presumably no more than half would will have been taxed. The government was already running a bit of a deficit when disaster struck; I think that capital taxes must account for the difference, now that the property boom has disappeared.

What this comes down to is that a lot of the pre-crisis growth was not for real, and government finances were built on unsustainable foundations. What was happening? This phantom growth seems to have been related to a boom in personal borrowing to finance property purchases and good old fashioned consumption. Symptoms included an over-sized finance industry (in earnings if not jobs) and unsustainable levels of consumption.

Who was to blame? The three commonly cited answers are everybody-and-nobody/events-beyond-our-control, bankers, or the Labour Government. Some Labour politicians still seem to subscribe to the first idea. It was an international storm (I never want to hear the phrase “perfect storm” again) and we were caught in it; nobody was seriously criticising government policy before the crisis. As the economy has failed to bounce back, this has become unsustainable; why are we having so much difficulty when other countries caught by the crisis are having an easier time? Of course some try to say this is because of Coalition policies over the last year. But almost all of the many critics of the Coalition policies accept that we were in a terrible mess in the first place.

So the critics shift to another target: Britain’s bankers. These are an easy target, paying themselves handsomely while their organisations required government bailouts. There is also a widespread conception that the bailouts cost a lot of money, and that this is one of the reasons that government debt is a problem. Actually the government has largely got away with it, for which Gordon Brown and Alistair Darling deserve some credit (contrast the terrible hash that the Irish government has made). A lot of government money was put at risk, yes, but the banks were charged for it, and the money lent will largely be repaid, and the guarantees not called on. Where the bankers were culpable was in rampant lending, supporting excessive consumption and a property bubble. But the lending was nothing like as reckless as in the US (or Ireland for that matter). If the government had awakened to the idea that consumer lending needed restraint, something could have been done. Let me be clear; the banks were reckless; we need to regulate them much better – but they were not the fundamental cause of the crisis. We had a narrow escape.

Could the government have seen the vulnerability of the British economy? There were not many prominent critics at the time, though Vince Cable was clear enough, for exactly the right reasons. But it was a matter of undergraduate economics to see that economic policy was on an unsustainable path. Literally. As a second year economics undergraduate at UCL in early 2007 my macroeconomics lecturer, Professor Wendy Carlin, used the UK economy as a case study to illustrate her model for an open economy. It was also used as an exam question. Was the UK’s strong economic performance due to increasing economic efficiency or excess aggregate demand, she asked. It was clearly the latter: the giveaways being the appreciating real exchange rate, and a large current account deficit (the economy as a whole consuming more than it was spending).

What should the government have done? The first thing should have been to raise interest rates and tighten monetary policy much earlier. Unfortunately this was genuinely difficult, because this was the Bank of England’s main target was inflation, and not the general standing of the monetary system. And the inflation rate seemed benign (thanks in large part to the overvalued pound). The second thing would have been to regulate the banks harder, to restrain lending. This was the FSA’s job, although the degree of independence of this agency is less strong. Finally the government could have tightened fiscal policy to reduce the level of demand in the economy, through expenditure cuts or tax increases. Nominally the government’s policy was to run a zero structural deficit, but it chose to fiddle with the statistics on the economic cycle so as to argue that it did not have to do anything. The government was not egregiously profligate, as Coalition politicians like to suggest, but it was pushing the wrong way.

What comes over, above all, is a failure of leadership, especially from Gordon Brown, as a formidably powerful Chancellor of the Exchequer. The tripartite arrangement for managing the financial system (between Treasury, Bank of England, and FSA) did not help, but it is very clear that if in doubt it was the Treasury’s job to lead. They didn’t. They could have leant on the FSA and Bank of England, as well as tightening fiscal policy directly. But Mr Brown either refused to recognise the gravity of the situation, or his political courage failed him. Given his constant level of denial about the seriousness of the crisis, I suspect it was mainly the former. He could not face admitting that so much of economic achievement was unsustainable. It is invidious to blame one man, when the hands of many were involved. But Gordon Brown had the authority; there was enough evidence for him to act on; and he made things worse not better. A career in the Treasury that had started so brilliantly ended catastrophically.

My next topic on the economy: is the Coalition economic policy making matters worse or better?

Time to rethink the Bank of England

It seemed a great idea at the time. Independent central bankers managing our economy on a strictly technical basis, preventing politicians from mis-managing it for short-term ends. Alas, even if this was not an illusion then, it surely is now. Central bankers across the world are becoming politically controversial. Meanwhile their policy decisions, be they changes to the interest rates under their control or buying bonds (“quantitative easing” – QE), either have no effect on the real economy or do not have the effect intended. But the recent coverage of the Bank of England’s latest interest rate decision shows than most observers are still stuck in the old narrative. The present system is obsolete; the real question is what the Bank’s role should now be.

Monetary policy, as now conceived, arose in the 1980s, after confidence in economic policy collapsed, amid a toxic combination of high inflation and high unemployment in most countries. Out of this wreckage came the idea that the economy at large responded to changes in the money supply, which influenced the decisions people made in output and employment, and in prices and wages. By managing the money supply we could manage the overall economy. And what was more, we could make this a relatively objective, technical process, by limiting growth to what the economy was able to produce, and keeping inflation into a nice, tidy band. Fiscal policy, taxes and public spending, were pushed into a relatively minor role, and became politically suspect. A new economic orthodoxy grew, sometimes called neo-Keynesianism, with Economics students given new sets of diagrams to learn, while economic modellers translated this into more complex mathematical equations. Then, in 2007, it all went horribly wrong. Two basic problems are now quite evident.

The first is trying to understand how exactly monetary policy works. Its advocates had always been vague about this, their case based mainly on historical correlations rather than actual, practical mechanisms. To the public, policymakers talked about printing presses, as if it was all about the number of banknotes printed and put into circulation…which was clearly nonsensical in a modern economy. During the 1990s the process focused on the setting of interest rates, with the central bank using its power as banker of last resort to manage interest rates on the overnight deposits made by commercial banks, a process which indirectly affected the supply of money. While I was studying economics at UCL (in 2005-08) our lecturers admitted this was pretty thin. Long term interest rates were more important, and yet the central bank’s influence over these was marginal. More important, as electronic money and “shadow banking” exploded, it was not at clear how central banks were supposed to manage the volume of money supply at all; even defining it became impossible. The whole thing completely fell apart in 2007 when the interbank market seized up, leaving the central banks’ instrument of management broken. The central banks pulled their levers one way, and yet the actual supply of money, in practice if not in statistical definition, went the other.

The second problem with monetary policy is more fundamental still. Real people and markets don’t respond to changes in money supply as they theoretically should. The main effect of policy changes seems to be on the prices of shares and property – not the amount people consume. So loosening policy merely inflates asset prices, having little effect on output, prices and employment. Alan Greenspan, the US Federal Reserve’s previous chairman even seemed to make a virtue out of this – suggesting that strong share prices helped sustain investment and consumer demand. But this leads central bankers into a very dark place, as the Economist’s Buttonwood column has recently pointed out. What on earth are central bankers doing trying to manipulate asset prices? Surely asset prices should be set by a properly functioning free market?

So central banks have comparatively little influence on the real economy, and what influence they do have is mainly on asset prices, rather than on employment and consumer prices. Accept this and you quickly see that asking them to manage inflation as we do in the UK (or inflation and employment, as in the US) is absurd. It may not even be healthy to confine inflation to a narrow band – there can be perfectly good reasons why it is right to allow inflation to run ahead at a particular time in a particular economy, or, indeed, to let the supposedly wicked deflation to run. Central banks’ role should be much more limited. They should control seigniorage (profits made on the creation of currency) and ensure that the markets for money are orderly. And that’s about it. Even managing exchange rates is toxic, as the Swiss are finding.

This is the best reason for raising interest rates in the UK (and US) at present. They are so low that money markets can’t do their job properly – it is much healthier if savers can expect some rate of return. And, frankly, asset prices are too high anyway. Not that anybody on the Bank of England’s MPC seemed to offer anything like this reason for raising rates in their minutes. George Osborne still seems to believe that the Bank can help him out if fiscal policy seems to be too tight. The level of denial remains astonishing. The game goes on; it’s not going to end well for the Bank, I fear.