The Least Blunt Instrument

I am often accused of being overly critical of the government. I am certainly critical and whether I am overly so depends to some extent on your personal perspective. I should be clear though, that I do think they have been unfortunate to be in power at such a difficult time. If you compare their predicament with those of many previous governments you would have to concede that they didn’t have much luck with the hand they were dealt.

In normal times, the UK has been shown to have a remarkably robust economy, able to deal with a huge amount of bad governing and still somehow manage to achieve growth. These aren’t normal times though and unfortunately for the current government they came to power at a time when the usual robustness of the UK economy could not be relied upon to deliver growth in the short-term. When Labour came to power in 1997, they would have had to implement something fairly ludicrous to avoid economic growth over the next couple of years. Cameron’s government was not so lucky – the choices they would have to make would decide whether, with natural robustness absent, the UK would recover or stagnate.

Anyway, this week the IMF warned that the UK economy was still all busted up and the government should start to think about a Plan B to encourage some growth. Well hoorah for that.

As I mentioned, the government has a tricky economic problem to solve and unfortunately only has four fairly blunt instruments trying to do it. Those four blunt instruments are:

Monetary Policies:

  • Cutting interest rates
  • Increasing the money supply (also, more confusingly, called “quantitative easing”)

Fiscal Policies:

  • Cutting taxes
  • Increasing government spending

With that usual robustness gone, I am very strongly in favour of some action to stimulate the economy. My favourite of the above is to increase government spending but as an alternative, the IMF suggested all three of the others. I suppose they might be reluctant to promote my favourite, having, at the start of the mess, advocated spending cuts to promote growth (oops!), but let’s look at how the other three compare.

Cutting Interest Rates
Cutting interest rates makes borrowing cheaper. If the private sector can borrow more cheaply then they are more likely to do so, thereby financing business expansion and job creation. We do have a problem though.

UK interest rates have been at 0.5% for three years. We could cut them a tiny bit more but we’re already so close to zero, there’s little room to make any real difference.

Despite the current low rate from The Bank of England, the banks themselves have not passed low borrowing rates on to the private sector. I logged onto my Internet banking the other day and saw an advert for me to take out a loan at 7.9% APR. I’m fairly sure I saw the same advert when interest rates were 4%. Banks simply don’t want to lend cheaply at the moment. Due to the economic climate they see people and companies as risky. And in fairness why shouldn’t they? The last time they lent to risky people their lending led to a global financial crisis. Banks are not going to start lending before the economy has recovered. Interest rate cuts won’t solve the problem.

Increasing the Money Supply
The Bank of England can print some money (they have the keys to the money printer). When they create money they can use it to buy bonds and other long term assets from the banks. By doing this they replace those bonds with cash that is free to lend. This blunt instrument has the same problem as the previous one though. It still requires the banks to actually lend to someone. If a bank thought it had a liquidity problem it would sell some bonds to the Bank of England and keep the cash. Its liquidity problem has been solved but no more money has actually been lent.

Don’t misunderstand me, low interest rates and an increase in the money supply have made things better than they would have been otherwise but while banks don’t want to lend, these measures are not enough to solve the problem.

Tax Cuts
Cutting taxes can stimulate the economy because people have more money to spend and in the economy your spending is my income. More spending means more income, more jobs and more growth.

This is ok as an idea as long as the tax cuts actually lead to more spending. So why might they not?

We could aim tax cuts at rich people but rich people already have plenty of money to finance their lifestyles so most of the extra money would simply go into their savings. Your spending is my income; your savings are not. Or at least they aren’t going to be any time soon. This is an inefficient way to try to make a short term stimulus to the economy.

We could aim tax cuts at the middle classes. This would be a bit better as they would spend more of it than the rich people. However, the middle classes at the moment, despite low interest rates, are firmly in save mode. Because the depression has no end in sight, middle income people are still worried about their jobs and many are probably regretting how little they squirrelled away in the good times. It’s more efficient to give them tax cuts than the rich but a lot of the extra money will still be saved. It’s still not that efficient.

So who’s left? Yes, the poor. If we cut taxes on the poor, much more of the money will be spent. Poor people for obvious reasons, save a much lower proportion of their income. If the government puts extra money in their pockets through tax cuts they will spend it.

So tax cuts can be good if they are focused in the right places.

Now that I’ve looked at the first three blunt instruments, I’ll talk about the other one – the one I like the best.

Increasing Government Spending
Let me start by making it clear that I am not such a lefty that I think all spending should always come from the government. I would love it if we had a private sector that was rapidly expanding and eating up all of the job applications from the unemployed.

I think even the austerity fans can probably admit this is not a fair reflection of reality though. So if the private sector doesn’t want to spend on something then the government can do so instead and as long as the public sector isn’t treading on private sector toes then every pound spent is a pound that would otherwise not have been spent and the economy has a very efficient boost. You might say that this logic makes it a policy that only works when we have high unemployment. Yep, it would be a terrible policy to pursue if employment was high and government spending were competing with the private sector. We’re a long way away from that situation at the moment though.

Like tax cuts, government spending needs to be carefully focused. If we choose this option we should spend the money on infrastructure improvements, renewable energy, school buildings etc. These are things we need to spend money on anyway. Far from being an excuse not to do these things, the depressed economy should be seen as an opportunity. The government can, at the moment, spend without any competition with the private sector and can later reduce its spending once the private sector is ready to run. This policy is, I think, efficient.

So in summary, cut taxes for poor people and increase government spending. Yes, I know I sound like a terrible lefty for proposing that but I hope you see that I have taken time to explain why I think those policies have the best chance of ending the depression. If you think that the other options are better I would love to hear from you.

If, like the government, you feel that any kind of stimulus is a bad idea then that’s also ok. But bear in mind – no stimulus = no growth for a long time. It’s that simple.

RedEaredRabbit

Advertisements

Lies, Damned Lies and Austerity

Today David Cameron once again reiterated his intention to continue down the path of austerity in order to sort out the UK’s economy. David does this a lot and continually comes back to his belief that government spending caused the mess and that only a severe reduction in government spending can restore economic growth. As you probably know, in contrast to David, I am in favour of an economic stimulus.

When I write about that on here I often receive comments along the lines of David’s – that government spending caused the mess in the first place and more of it would just cause an even bigger mess. I have perhaps not addressed this directly in the past so, hold on to your hats, I will do so now.

First of all saying that the cause of the mess was purely the previous government’s spending is at best an extremely simplified view. There were many factors that combined to cause the financial crisis. People who say it was caused by government spending are conveniently forgetting what the banks were up to. That’s another story though and I do need to address the misconceptions about government spending. I am going to try to explain why I think spending is sometimes a good idea and sometimes a bad idea and why at the moment I think it is a very good idea indeed. So here goes…

Over time the economy swings between periods of growth and periods of contraction. Governments (despite often making claims to the contrary) have never been able to stop this happening and perhaps this shouldn’t be too much of a surprise. After all, a government has only simple tools at its disposal and economies are complicated things in which bad things have a habit of finding ways to happen.

Although we should accept that there will always be good and bad periods in the economy we should also appreciate that the government is certainly not powerless to help out. A government can use some of its simple tools to reduce the impact and duration of the bad times when they arrive and bring back the good times as soon as possible.

One of these tools is government spending and to see how this can help we need to first take a look at the private sector. Companies in the private sector have important short-term financial goals. They generally seek to make a profit every year and additionally have certain cash flow considerations (e.g. they need to be able to pay salaries, buy stock, pay rent etc). So if their revenue drops off, they may well look to reduce their spending in line with it. If their revenue increases, they may well look to increase their spending accordingly. For example, if a company is doing badly they may reduce their costs by making redundancies and if a company is doing well they may take on more staff. Simple enough. Let’s look at what happens in economic cycles.

In periods of strong economic growth, lots of companies do well and expand and take on staff. In periods of economic contraction, lots of companies do badly and lots of people lose their jobs.

This means that private sector spending closely follows how well the economy is doing as a whole – when the economy is doing well, private sector spending increases and when the economy is doing badly, private sector spending decreases. These spending swings in the private sector actually amplify the effect of the economic cycle. i.e. the redundancies they make during weak economic times weaken the economy further because unemployed people stop having money to spend and rely on benefits and in weak economic times they cannot easily find new employment.

One way the government (or actually the Bank of England since it is now independent) can influence this is through changes in interest rates. By lowering interest rates, it becomes cheaper for companies to borrow money and therefor encourages them to spend.

There is a problem with this approach though as you can only cut interest rates so far. Once they are down to almost zero (as they have been in the UK for over three years) then there is no way to stimulate the economy by cutting them further.

Another way the government can influence things is by spending money. When spending in the private sector dries up the government can step in and fill the gap. Governments of developed economies (who borrow in their own currency) can borrow very large sums over very long periods of time and don’t have to worry about the same short term profit or cash flow issues that companies face.

When the private sector is expanding, the government can reduce public spending and let the private sector fill the gap. When the private sector is contracting, the government can increase public spending and fill the gap. If the gap is not filled then we end up with unemployment and recession.

That’s what happens if the government does nothing but now imagine an even worse situation. In this situation the government spending tracks that of the private sector. i.e. when things are going well, the government increases spending and when things are going badly the government reduces public spending. Pushing up government spending when the private sector is trying to expand will help boost the economy a bit but it is an inefficient use of funds because the public and private sectors are in effect competing against one another. Essentially we create a strong supply of jobs for which there is weak demand. In contrast, reducing government spending when the private sector is contracting further amplifies the effect of the downturn. In this situation we are reducing the supply of jobs when there is strong demand. In the latter situation the government may cause a full-blown economic depression from which the economy may take many years to recover.

Actually, that sounds familiar.

Anyway. During the years preceding the economic crisis, the UK was experiencing some unspectacular growth. The Labour government at the time coupled this with some unspectacular increases in government spending when they should have, if they were sensible, made some unspectacular reductions in public spending.

So yes, I agree that they got things wrong. Their increase in spending was certainly fairly benign compared with the current government’s version of what happened but yes, they would have been better to reduce spending overall.

Since the crisis hit, however, the economy has contracted hugely and the private sector has shed hundreds of thousands of jobs. Now we have one of those spending gaps I mentioned and it’s a really big one. This is why government spending now would be a good idea – we’re not competing with the private sector, we are simply trying to increase the supply of jobs to help meet the huge demand for them. Let me be very clear – I am not saying that fiscal policy under the previous government was right but just because they got it wrong does not mean that we should be backing a plan now that is even wronger.

If it is this simple though, why is our government backing an austerity plan at all? Given the above argument, isn’t it the exact opposite of what they should be doing? Yes it is. Politicians are people with agendas though.

Let me give an example of an agenda. Suppose you were a politician who very much liked rich people. Your ideal UK might consist of low taxes on rich people but that’s expensive so you might try to fund those tax cuts by severely cutting public spending. Of course, since most people are not rich, you couldn’t just say that’s what you were doing because you need more than just rich people’s votes to stay in power. You might therefore invest significant time and effort trying to convince people that government spending during bad economic times was a terrible thing and the only way to restore economic growth was through reducing spending and cutting taxes on rich people.

The government has managed to get away with it quite well so far because the economy is complicated so it’s very hard for people to know whether they are telling the truth or have a hidden agenda. Additionally, the government is extremely effective at misleading the electorate. For most people the “reduce spending when things are bad” makes a lot of sense because they are able to relate it directly to their personal finances. If I have a big credit card bill and my household income drops I’d better cut back spending and pay off my credit card, right? Yes, that’s right for your household but there is a subtle and very important difference between household finance and the economy as a whole.

In your personal finances you are only concerned about your own personal incomings and outgoings. In the economy though, your spending is my income and visa versa. If we decide to kill off spending in the economy we by definition kill off income too. The government continually draws an analogy with personal debt and never takes the time to explain this distinction.

You might say that you accept the above arguments but it’s too late for us to borrow money because we already have so much debt no one will lend to us. You’d be wrong though – we have people queuing up to lend to the UK at the moment. A developed economy borrowing in their own currency (this importantly excludes the Eurozone) has a truly amazing capacity to borrow money cheaply. If you think we’re anywhere near the limit then have a look at Japan’s government debt in comparison:

And guess what? They can borrow even more cheaply than us!

Also worth pointing out on this graph is how little our debt actually increased during the years preceding the financial crisis. Yes, it should have been reducing but it wasn’t exactly the mad spending spree that everyone seems to think it was. Labour had, on the eve of the financial crisis, more or less the same amount of debt they inherited when they were elected in 1997.

In summary there are three important points in this post that David Cameron doesn’t want you to know because if you know them his argument falls to pieces:

  • Government spending during a period of economic growth and spending during a period of economic contraction are very different things. Just because the former is bad does not mean the latter is, especially when interest rates are at zero.
  • The personal spending analogy does not work when considering the economy as a whole because one person’s spending is another person’s income.
  • There is plenty of scope for the UK to borrow money

I know this post is quite a lot to digest but I have done my best to explain why I think the things that I do. Perhaps you’ve read through the post and think my reasoning is wrong and David Cameron’s is right. Perhaps you think austerity really is the way to restore economic growth. That’s fine, after all David and I each have a theory and at the end of the day that’s all they are – theories.

I suppose though, if I were being really picky, I might point out that the growing evidence strongly supports my one.

RedEaredRabbit

Taking it on the Chin

…when the facts change, the responsible thing to do is to examine the decisions you have made and to be willing to change your mind, however inconvenient that may be…not burying your head in the sand and ploughing on regardless…

So said Defence Secretary, Philip Hammond this week.

What was he changing his mind about? I don’t know, something about ordering the wrong type of aeroplane; the details are not material to my point. My point is that whether or not he made a bad decision previously, no matter how terrible his judgment at the time was, it is still a good thing to be able to adapt his policy now based on how things are going. The alternative would be, as he said, ploughing on regardless with a strategy that he knew wasn’t working. He may have made a bad decision in the past but this week he made the right choice.

Shadow Defence Secretary, Jim Murphy was not impressed though, gleefully calling it a U-turn and finding another occasion to use Labour’s new favourite word, omnishambles.

Omnishambles was very funny when Malcolm Tucker used it and still a bit funny when Labour used it the first time but (shambolic as the government is) it won’t be funny if we have to hear it every week until the next general election. Perhaps they should steal another Malcolm Tucker quote to keep things fresh. For example when David Cameron and George Osborne next take their seats in the House of Commons, Ed Miliband could shout:

Laurel and fucking Hardy! Glad you could join us. Did you manage to get that piano up the stairs ok, yeah?

Or they could just think of their own jokes.

Where was I? Oh yes. It is an unreasonable expectation that the government should get every policy perfect in the very beginning and never have to change it. If they implement a policy that later turns out not to be delivering the benefits that they predicted and they change it, not only should they not be ridiculed, I would say that they should be praised.

A more reasonable expectation would be that the government should continually monitor their policies, keep them if they are working and adapt them if they aren’t.

I wrote a whole post on this subject last year, Creationist Economics and in it I was fairly scathing of politicians’ ability to admit when they were pursuing a bad strategy and adapt it into a better one.

So could it be that politicians have learned their lesson and have abandoned Creationist Economics in favour of Evolutionary Economics? Let’s recap on what Philip said:

…when the facts change, the responsible thing to do is to examine the decisions you have made and to be willing to change your mind, however inconvenient that may be…not burying your head in the sand and ploughing on regardless…

And let’s have a look at how the government has applied these words of wisdom to their economic policy.

Last week, the government got a fairly massive kicking at the local elections and therefore had the perfect opportunity to review the policies that weren’t working and adapt them. The early signs were good:

George Osborne:

The government understands your message. We take it on the chin and we have got to learn from what you are saying.

David Cameron:

The message people are sending is this: focus on what matters, deliver what you promise – and prove yourself in the process. I get it.

But does he really “get it”? David Cameron a couple of days later:

…we can’t let up on the difficult decisions we have made to cut public spending…

David and George say they understand exactly why they lost loads of votes and it was because, although their economic policy was really popular, they lost votes because they were focusing on other things too – people were worried they would reform the House of Lords or legalise gay marriage rather than purely focusing on their excellent work on the economy. In other words, this seems to be the government’s interpretation of the message the electorate were sending:

Dear David and George,

We love what you are doing with the economy, high five! Absolutely love this economic depression and always thought that having a job was overrated.

But, (and this is a big but) we have to let you know that we are voting for someone else because of your evil attempts to have a discussion about whether all of your unelected posh mates should be responsible for deciding the laws of the land. Additionally we are all intrinsically homophobic and hate the fact that you might consider treating homosexuals as equal citizens.

And in any case, it’s not like the government can possibly do more than one thing at once.

Kind regards,

The Electorate

P.S. In addition to the above, this vote is definitely in no way influenced by your NHS reform, which was also really popular.

David and George say they “get it” and want to “take it on the chin” but in reality all they are doing is trying to market a disastrous election result as support of a failed economic strategy, and opportunistically trying to bin some other proposals that don’t fit in with their own idealism.

Since I don’t think they did “get it” I’ll offer an alternative interpretation of the message from the electorate:

Dear David and George,

You said that you could revive the economy through spending cuts. You said that in 2011 we would have 2.6% economic growth but we had none and now we are in a recession again. You said that your spending cuts in a depressed economy would bring growth through “confidence” but two years later there is still no growth. We are in the worst depression in recent history, worse than The Great Depression of the 1930s – and your continual refusal to change course has put us here. Your policy is not working and while the opposition’s is at best vague, we need to send you a message to let you know that we think you have no idea what you are doing.

Kind Regards,

The Electorate

P.S. Don’t try to get out of this by saying something pathetic like we want you to put House of Lords reform or gay marriage on the back burner – you should be able to do more than one thing at once.

David and George’s public interpretation of the electorate’s message is so ridiculous that it’s funny. What is less funny though is that two years after promising growth and prosperity through spending cuts all we have is economic depression. But what exactly should they do about it? Let’s ask Philip Hammond:

…when the facts change, the responsible thing to do is to examine the decisions you have made and to be willing to change your mind, however inconvenient that may be…not burying your head in the sand and ploughing on regardless…

Well said, Philip. I couldn’t have put it better myself.

RedEaredRabbit