Duncan’s Economic Blog

This CSR appears to be guided more by political economy than economics.

I wrote on Monday that the decision to increase the amount of welfare cuts and decrease the amount of departmental cuts was smart politics, but awful economics.

As we get the detail, it seems even worse. Pensioners, who tend to have much higher savings rates that young people (especially those with families) are being spared. In other words George Osborne has choosen to concentrate the cuts on those most likely to spend their cash. The economic hit will be maximised even if the political hit will be, in the short term minimised.

He is taking the cash from those who actually add to demand, rather than those more likely to vote.

The Keynesian case against cutting during a fragile recovery is by now well known. But, in terms of economic effects, not all cuts are equal – some are more damaging than others.

And all the economic empirical evidence (whether taken from the OBR, the credit rating agencies or the IMF) is that taking money from the poorest will mean the biggest economic hit in terms of slower growth.

This CSR will decrease domestic demand in the economy, lowering consumption and in the long run investment. The picture in terms of external demand already looks dire.

George Osborne is systematically knocking away the drivers of recovery.

We are now firmly on the path of Ireland – lower demand, higher unemployment and lower tax revenue. The deficit will not be eliminated through measures which reduce national income.

So it looks likes Osborne is indeed going to take the axe to welfare spending in an effort to protect departmental spending. (As I guessed he might).

The politics of this are quite smart – match (broadly) Labour’s departmental cuts, cut welfare spending and then attack Labour from now until 2015 as the Party that wants to increase your taxes to spend more on welfare.

Now the implementation of this neat little political stratagem will undoubtedly be more difficult in the real world than it sounds on paper. As a simple rule of thumb, try to remember that cutting £1bn from welfare means taking £1,000 a year from a million people. Then think about what cutting £15bn plus actually means – taking £1,000 from 15 million people?

Practical difficulties aside, the economics of this are horrible.

I wrote a post back in August on fiscal multipliers.

One thing leaps out – no matter which set of numbers one uses (IMF, OBR, Moodys) capital spending and transfers to those most in need (AME Welfare in the UK, food stamps, unemployment insurance, etc in the States) – have the highest multipliers.

In other words cutting welfare spending is likely to be especially damaging to short term demand as those on low incomes have the highest propensity to consume and are more likely to spend rather than save their incomes.

Osborne, in an effort to make political difficulties for the Labour Party, is about to embark on a path that is even more economically dangerous than his original course.

The Economist leads today with the developing “currency war”.

There has been excellent coverage of this from Paul Mason and FT Alphaville.

Paul Krugman is now arguing for tariffs against China, with John Ross arguing against.

For a detailed discussion of what is happening and why, I’d recommend the above links – although I briefly summarised developments here and considered the longer term issues here.

Adam Lent, of the TUC,  has asked if this might not end up over shadowing the coming austerity.

It should also leave us wondering whether the biggest political debate of coming months and years might not be austerity (or at least, not austerity alone) but how the UK should react to a round of competitive devaluations and, more widely, how it should respond to the rise of China.  It might be wise for Labour to start considering its response now.

I agree Adam is right to speculate. This certainly feels bad.

One lesson of the Great Depression, according to Ben Bernanke, is that countries that devalued early returned to grow quicker. The vogue for export-led growth might tempt many countries into pursuing this policy.

The international co-operation that Gordon Brown cobbled together in March 2009 is breaking down with the G20 split on the question of stimulus and split on the question of exchange rates.

A global solution to the unbalanced world economy looks unlikely as countries put their domestic constituencies first.

Flash points at the moment are the US trade deficit (especially in the face of high domestic unemployment), the notion of QE 2 (which to many in the East looks like devaluation by other means), the spat between Korea and Japan over intervention and of course the level of the Chinese renmimbi.

Over the past few weeks there has been currency intervention, or talk of it, in China, Japan, Korea, Brazil, Taiwan, Russian, the Eurozone, Switzerland and India (by my count).

A race to the bottom will help no one.

But being parochial – what are the implications for the UK?

Clearly these developments make the hopes of an export-led recovery more forlorn. Increased currency uncertainty may also hamper the freedom of monetary policy – George Osborne’s only “plan B” if the economy heads South.

Does the coalition have a currency policy? How long will the line that “Sterling is freely floating and its level set by the market” hold if governments ramp up intervention?

We haven’t, in the UK, really had a currency policy since 1992, when Cameron was but a young Spad in the Treasury. Now might be the time to consider one.

… Many appologies for the lack of posts over the past few days.

On the way, probably tomorrow -  the Geddes Axe  and stagnation.

I hope it’s worth the wait.

The BBC Website is leading with the story “Chris Huhne hints at a shift in public sector cuts”, following an interview given to the Telegraph.  I think, as I said last week, that Labour should take this very seriously indeed.

This started on Wednesday with a story in the FT, written by well connected economics editor Chris Giles rather than by their political staff, saying that the Treasury was looking to “reprofile” the programme of spending cuts to due to the “difficulties” of cutting so quickly, such as financial penalties in contracts, etc.

This line of argument has been extended by Chris Huhne who notes that spending cuts could be slowed due to “economic conditions”.

Huhne it is worth noting is a former economist, a former head of a credit rating agency and a member of the “star chamber” having agreed the cuts to his own DECC budget early.

I’m taking these stories seriously and see them as preparing the grounds for a slowing of the pace of cuts.

Some commentators last week couldn’t see this happening – Cameron, Clegg and Co have invested so much political capital in the need to cut the deficit and the “there is no alternative” line that they can’t back down now. I’m not so sure.

Remember the Tories backed Labour spending plans until the financial crisis hit and then totally reversed course at the time of the fiscal stimulus, despite every nearly serious economist writing at that time attacking them.

I wouldn’t put it past Osborne to try a similar political gambit at this stage.

Again, as I said last week, this causes potential problems for Labour.

Obviously we could repeatedly shout “told you so” at Osborne, but I’m not really sure that would feed through to the public mood especially when it means department budgets are being cut by 20% rather than 25%.

And it would mean moving more the pain to 2014/15 and 2015/16, i.e. in the run up to an election. That might help Labour.

But the real danger is what it does to Labour’s response. I’m guessing here but I suspect that Labour’s broad approach under Miliband and Johnson will be to attack Osborne for cutting to quickly and “risking the recovery” coupled with arguing for a halving of the deficit over 4 years using a 50/50 mix of tax rises and spending cuts. Call it “Darling Plus”.

Slowing to broadly Labour’s pace in 2011 to 2013/14 would neatly neutralise the first charge.

Look what this slowing in cuts could do the numbers, and bear in mind that Osborne is looking at £15bn of welfare cuts.

The table below is from an old post.

Note how Osborne is (was?) looking to tighten fiscal policy by £41bn, £66bn and £90bn in 2011/12, 12/13 and 13/14, whilst Labour, using some variant of the Darling plan (either as was or with a 50/50 mix) would be looking at £25bn, £42bn and £56bn.

(Rough numbers to follow, it’s Saturday morning and I can’t face excel).

Imagine Osborne slows to, say, £35bn, £50bn, £70bn.

Now look deeper at what this means in terms of cuts to public spending.

Osborne would presumably be proposing cuts to public spending of around £22bn, £36bn and £49bn.

Labour of £12.5bn, £21bn and £28bn.

That sounds like quite a big difference, and it is. But remember that Osborne has proposed £15bn of cuts to the welfare budget. Subtract that to get the proposed cut to departmental spending (which is the metric Osborne will use) and we get.

In 2011/12 Osborne would claim he was proposing cuts to public services of around £7bn against Labour’s £12.5bn.  In 2012/13 the numbers would be £21bn for Osborne against an equal £21bn for Labour and in 2013/14, it would be £35bn for the Government against £28bn for Labour.

In other words, for two years (and possibly longer), Osborne would be able to claim he was cutting public spending in line with the cuts proposed by Labour before the election and at the rate still supported by them now.

This all has to be viewed through the lens of where George Osborne, a very political Chancellor, wants Labour to be in 2015. My best guess – in a position that can be characterised as proposing tax increases to pay for more welfare spending. Slowing down the pace of his own spending cuts helps him get to that position, and I reckon he’ll calculate that achieving that is worth a few weeks of being taunted with “I told you so”.

Labour needs to prepare ways to maximise the advantage of Osborne backing down, without falling into his neatly set trap.

Potentially very big news. The FT is reporting that the Coalition is considering slowing the pace of deficit reduction. 

The Treasury is working on plans to “reprofile” spending cuts next April, spreading the pain of deficit reduction more evenly over the next few years, senior Whitehall officials have told the Financial Times.

Confronted with the difficulties of quickly cutting spending – including financial penalties for breaking contracts and redundancy costs – ministers have been forced to consider delaying some of the big savings until later in this parliament.

As Left Foot Forward explains:

Speculation is growing that the Coalition government is about to slow the timetable for deficit reduction. Whitehall sources have briefed the Financial Times amid warnings from the World Bank and concerns from Cameron and Osborne’s Cabinet colleagues.

I, like many others (notably, in the political arena, Ed Balls) have repeatedly warned that Osborne’s planned pace of deficit reduction risks at worst a double dip and at best more sluggish growth than would have been the case otherwise.

The Cameron/Osborne/Clegg “there is no alternative” line has been based around a claim that without rapid action now the bond markets might panic, the UK might get downgraded and borrowing costs would spiral.

Interestingly enough, the FT pieces quotes Ben Broadbent of GS making the opposite case.

Ben Broadbent of Goldman Sachs said that any move to delay spending cuts was unlikely to make “an enormous difference” to the economy or to Britain’s credit rating.

“If people were clear about the reasons for any delay [to spending cuts] rather than suspecting a political wobble … I don’t think [investors] would change their mind about the risk premium on gilts,” he said.

If the Treasury going to slow the pace of deficit reduction (and we should remember none of this is official yet) it’s certainly somehing I would welcoem and something that is right for the UK.

But the politics of it are potentially explosive.

The FT speculates that:

Labour politicians would surely accuse the government of backsliding and the political pain of the cuts would be pushed close to the next general election.

Both of these factors are certainly true – if Osborne slows the pace there will be, rightly, a lot of Labour spokespeople shouting “we told you so” and more the pain will be moved closer to a 2015 election.

But, but, but…

Where does this leave Labour’s response to the CSR in two weeks time?

Surely the really salient political point here is that Osborne is about to throw a handgrenade right into the middle of Labour’s approach.

If he were to slow the pace so that for 2011/12, 2012/13 and potentially 2013/14 he essentially matched the Darling 4 year plan, where would that leave Labour?

Forced either argue for a longer timetable than we one we argued for 6  months ago or forced into backing the overall size of the Osborne plan. It would also neatly neutralise the “risking the recovery” attack as Osborne replied “I’m matching your plans”.

Take this analysis a step further. What if Osborne matches the pace of the Darling plan, but does more of it (as seems likely) through cuts to welfare spending than Labour planned? How do Labour respond? By arguing for higher taxes or more cuts to public services to preserve the existng system?

Osborne’s dream scenario is one where Labour go into the next election arguing for higher taxation to fund greater welfare payments. This takes him one step closer to achieving it.

We need an agreement on a  watertight deficit plan and we need ASAP.

As the argument around means testing child benefit heats up, I’d recommend a quick read of the following.

The National Archives have an excellent quick history of Child Benefit. Previous attempts at reform have not been especially popular.

A good example would be 1957:

In 1957, the Chancellor, Peter Thorneycroft, proposed cuts in public expenditure including family allowances. He argued that in removing the allowance for a second child, more money would be available for larger families where nutritional problems were more severe. Boyd-Carpenter effectively presented counter arguments. Thorneycroft resigned after the Prime Minister, Harold Macmillan, vetoed his proposals.

As ever, the IFS have put out a superb and impartial analysis.

A third implication, and the most serious from an economic point of view, is that this reform seriously distorts incentives for some families with children. In particular, adults with children whose income places them below the higher-rate income tax threshold might be find themselves considerably worse off from a small rise in income. This is because such a family would effectively lose all their child benefit as soon as the adult’s income rose just above the higher-rate income tax threshold.

A family with two children currently receives £1,750 a year in child benefit, so a one-earner couple with two children with a gross income between £43,876 and £46,850 would be worse off than if their income were £43,875. Equivalently, a one-earner couple with an income of £43,875 would need a pay rise of £2,975 or more to ensure they were no worse off after paying income tax and national insurance and losing child benefit.

Nicola Smith has an excellent article on Left Foot Forward defending the notion of universal payments.

Today’s announcement is extremely bad news for working families – both those who will no longer receive Child Benefit and those who will now inevitably see the value of their benefits and Tax Credits fall in the future as the principle of universal welfare in the UK is further eroded.

Finally Cathy Newman assesses the politics of all this.

This is going to be politically painful. Ministers are pretty gobsmacked by the chancellor’s announcement, and they fear a backlash. It might not sound like big numbers in the scheme of things but this is a cut which  will affect very vocal middle England voters. Mumsnet is also on the warpath. I’m off to a reception hosted by them now. David Cameron and George Osborne are invited – will they dare to turn up? I’ll report back.

Today George Osborne once again compared the government to a household. 

And we have £109bn of it. It’s like with a credit card. The longer you leave it, the worse it gets. You pay more interest. You pay interest on the interest. You pay interest on the interest on the interest. And we are already pay £120m of interest every single day.

Left Foot Forward has already outlined why this analogy is not only wrong but dangerous.  But if George genuinely does believe that the government is like a household, he really should understand that the best way to deal with debt is to grow.

Because it was the subject of a House of Commons’ inquiry, we know a great deal about Mr Osborne’s mortgage and his own household finances.

In 2003, he took out a mortgage for £450,000 on his home in Chesire.

In 2005 he, quite rightly, extended that mortgage to £480,000 to “pay for necessary repairs”. The Chancellor clearly understands, in his personal life, that smetimes one should borrow in order to invest for he future, or to cover necessary expenses (such as, maybe, preventing a second great depression).

In 2005, when he took out the £470,000 mortgages (which it is worth noting is interest only, he’s not trying to pay back the capital just yet, of no), Mr Osborne’s salary (as an MP) was just £59,095.  

His debt to income (GDP) ratio was a scary 812%, much more than the UK’s projected 80%.

This year, assuming no capital payments on that interest only mortgage, that ratio has fallen to 357%, still way higher than that of the UK government, but less than half it’s level of 5 years ago.

How was Mr Osborne acieved this phenomenal reduction in his debt to income ratio without paying down a penny of debt?  By increasing his salary to £134,565, on becoming a cabinet member.

The lessons of Mr Osborne’s household then are as follows – sometimes it makes sense to borrow and the easiest way to deal with debt is to grow your income. Maybe he should apply these insights to his handling of the Treasury.

This is my 250^th post, not too bad for 18 months of blogging with a 7 month enforced break in the middle.

I thought I’d mark the occasion by asking for any general comments for readers and recapping my “top 5” posts, as ranked by views.

I’m always unsure of quite where to pitch this blog – should be more technical? Less so? Would people like more politics? Less? Should I do more on finance and banking? More of international economics? Less long rambles on quantitative easing? More short posts and updates on the economy?

Any thoughts would be greatly appreciated.

And on to the top 5, as ranked by page views.

1/ Crisis? What Crisis?

From March 2009, and day two of the blog, a longish post attacking the notion of a Sterling crisis.

2/ Ireland – A warning?

From only two weeks – a recap on Ireland over the past two years and the warnings for he coalition.

3/ Labour’s Economic Debate – Kalecki, Dalton, Clinton and David Miliband

A self-indulgently long post from August, on the economic plans of David Miliband.

4/  The US Economy: A Crisis of Capitalism?

Yet another long post, and yet another long one! This time of the US’s broken economic model.

5/ Savings, Investment & IS/LM: An Answer for Tim

From July last year, requested by Paul an answer to Tim Worstal on the (post) Keynesian view of savings and investment. It had an excellent debate in the comments.

Maybe, looking at these top five, there is indeed an appetite for longer, more thoughtful posts?

In both the UK and the US, monetary policy makers tip-toeing towards a second round of quantitative easing, already dubbed QE2.

In as much as George Osborne has a “plan B” for the UK, this is it – continue to cut spending and hope that Merv and the MPC will take up the slack by printing more cash to stimulate demand.

I am deeply concerned by this strategy.

In April last year, as QE 1 began I wrote a long post setting out my views on the money, credit and the likely impact of the policy, a policy that really was a leap in the dark.

I was half right. QE did have relatively little effect on the actual real economy. 

I suspect, given my views on credit, that the bank lending channel is one of the more important ways that monetary policy effects the economy. I also suspect that the bank lending channel is currently blocked. If I am right, QE will see an extra £75bn pumped into the economy (as gilts are taken out and cash put in through central bank purchases) and, probably, a £75bn rise in the money supply. The worry is that this will have little effect on the actual economy.

However I was also complacent.

So, should we try QE? Of course. Either it works and provides a stimulus that prevents, or lessens, a slide into deflation or it doesn’t and nothing happens. Either way it does not cause hyper inflation as some seem to suggest.

I entirely (a big failure) neglected to consider the effects on asset prices. In my defence I was working as a fund manager at the time – I had watched the near implosion of the global financial system from a ringside seat and was all too aware of what has happening in the economy, in the banking system and in the wider markets. I convinced myself that against such a backdrop, surely a bout of money printing wouldn’t lead to an asset price boom? Surely fund managers wouldn’t committ money to equity markets whilst the real ecoomy remained on life support? Surely banks, in  midst of a the burstng of a real estate bubble, won’t start lending against still over-valued property again?

I was wrong.

By the October of 2009 I was concerned. 

For all the talk of green shoots, we still have rising unemployment and collapsing investment levels. What little ‘growth’ we are seeing is  the result of companies rebuilding inventories (which will be temporary in the absence of private sector final demand) and government spending.

And yet despite this, asset prices are rising. House prices are up 3 months in a row. The FTSE 100 has rallied a massive 46% since March.

Now as someone who works in fund management, maybe I should just keep quiet and be thankful. Rising asset prices are good for my clients and good for me.

But I do have to question what is causing this?  Irrational exuberance on the likely strength of any recovery?  A side effect of quantitative easing? Future inflation worries? An excess of global liquidity, which is simply being used to purchase assets rather than help the real economy?

The economy needs to be rebalanced. But not in way that favours holders of assets over the real economy. This is raising serious questions about the manner in QE is pursued, something I shall return to in a further post this week.

I returned to the topic with another post in which I advocated using QE to finance a new National Investment Corporation.

Let’s be clear about what’s happening here. The original intention of QE was to increase the amount of money circulating in the economy and bank lending. This isn’t really working (with the important caveat that things would probably be even worse without QE). So now QE is aiming to prop up the economy via the mechanism of raising asset prices.

This allows corporates to issue bonds cheaper (in effect borrowing money whilst side stepping the banks). It also allows companies to re-capitalise themselves by issuing fresh equity cheaper. Both of these effects are helpful.

But a deliberate central bank policy to raise asset prices also poses questions. What are the distributional effects of this policy? Again let’s be clear, the policy of the Bank is to raise the raise the price of assets – this necessarily favours the wealthy over the poor and increases inequality.

For how long can asset prices be artificially supported? Do we risk a new bubble?

Economically how does this policy help the economy re-balance, how does it help small and medium sized businesses that can’t access the equity or corporate bond markets?

I’m a long term supporter of  policy of low interests to encourage investment. (See this very long post if especially intersted).

But I didn’t quite grasp back in April last year was quite how powerful finance capital could be. This is a them I have since turned to several times. Beginning here and more throughly set out here: 

A deliberate policy of low interest rates, aiming to increase the volume of financial capital and fund the ‘green stimulus’ that we desperately need, is achievable. But simply giving money to finance capitalists – essentially the current policy of quantitative easing – will achieve nothing more than supporting asset prices. What is called for is Keynes’s ‘somewhat comprehensive socialisation of investment’, with the ultimate goal of the ‘euthanasia of the rentier’. A social democratic economy requires that finance is challenged directly.

And this is why I’m worried – we are about to do it all over again – hand over billions of pounds to finance capital and keep out fingers crossed that some of it leaks into the real economy.

I’ve got a long essay in Renewal on this topic (here, but not free online – you should all read Renewal though, it’s excellent). I’ll finish with an extract from it:

A Tale of Two Economies

Perhaps the most vivid example of the decoupling of physical and financial capital identified by Keynes can be found in the period from March 2009 until March 2010, the year of quantitative easing. The Bank of England’s decision to essentially print £200 billion of electronic money and inject it directly into the financial system by buying government bonds from banks.

            During that year lending by UK banks, themselves the recipients of much of the £200 billion, to financial companies rose by £81.0 billion whilst lending to non-financial firms contracted by £21.4 billion pounds, whilst the financial sector found itself with ample liquidity, the real economy was starved of credit.

The results were striking. Unemployment, by the International Labour Organisation definition, rose from 7.3 per cent to 7.7 per cent – an extra 200,000 people out of work. Business investment, the primary driver of future prosperity, fell by 7.7 per cent. Industrial production recovered by a modest 0.6 per cent. The real economy struggled forward in March 2009 – March 2010 with sluggish growth, falling investment and rising unemployment.

In the financial sector things were very different. The FTSE 100 index of leading shares rose by a staggering 44.7 per cent. House prices (as measured by Halifax) rose by 5.5 per cent. Bonuses returned, with an estimated payout of £6 billion to staff, up from £4 billion in 2008.

Although a temporary tax was charged on bank payrolls (raising £2.5 billion pounds) little attempt was made to ensure that the £200 billion of ‘new money’, created by the State, found its way into the real economy. Gordon Brown announced the creation of a new National Investment Corporation in his 2009 conference speech although nothing of substance emerged from this. Even nominally state-controlled RBS continued to make excessive payouts to staff in the ‘Global Markets’ division. In short little attempt was made to challenge the power of finance capital, despite the mess it had made of the economy and the near universal public distaste for bankers evident throughout 2008-2010.