Posts Tagged budgetary policy

Hollande’s budget

Posted by George Irvin in EU on October 1, 2012

François Hollande’s Prime Minister, Jean-Marc Ayrault, claims the new budget (unveiled on 28 September) is ‘fair, economically efficient and allows France to meet its priorities’.  In the carefully chosen words of the Guardian’s economics editor, Larry Elliott, the claim is ‘total moonshine’!

It is true that more than half the €37bn in planned budgetary savings is designed to come from increased taxes on rich households and large companies whilst—in contrast to Britain—cuts in government expenditure spare the poor and the elderly. Particularly welcome is the new 75% tax band for those earning over €1nm a year. But whatever gloss one puts on it, the budget is about reducing the deficit from the current 4.5% to 3% new year—and to near zero by 2017. With the French economy stagnating over the past 9 months and persistent unemployment of 10% or more for over a decade, budgetary austerity—however achieved—is most definitely not the answer.

The success of this budget depends on two key assumptions. The first is that greater budget discipline will bring a return to private sector growth, or to use Paul Krugman’s expression, greater discipline will inspire the ‘confidence fairy’. Thus, the growth rate in 2013 is assumed to be 0.8% rising to 2% annually for the period 2014-2017.  But elsewhere in Eurozone austerity is resulting in growing unemployment and stagnation. And a stagnating economy causes budget deficits to widen. For France to reach even the above modest growth target and to reduce its deficit, a strongly reflationary budget would be needed, particularly under conditions of generalised austerity throughout Europe.

Secondly, Monsieur Hollande’s Prime Minister claims that reducing the budget deficit will enable France to retain the confidence of financial markets and therefore to enjoy continued access to cheap credit. This too is nonsense. Throughout Europe, young people are increasingly angry about unemployment and growing job insecurity. As the French economy continues to stagnate, scenes now seen in the streets of Athens and Madrid will spread to Paris. Financial markets may be impressed by austerity in the short term, but in the longer term nothing rattles financial markets more than political unrest. An austerity budget today sets France firmly on the road to unrest in the coming years.

Why then has Monsieur Hollande reneged on his election promise to reject austerity? Why indeed is France going to ratify a so-called Budgetary Pact (TSGC: Traite sur la stabilité, la gouvernance et la coordination) which entrenches the Golden Rule of eventually reducing the annual structural deficit to zero. Some economists of the PS (Parti Socialiste) know perfectly well that such a rule is not merely illogical, but adopting it means abandoning discretionary fiscal policy altogether (having already ceded monetary policy to the ECB.)  The pact has already created much discord in the PS and its governing allies; eg, Europe-Ecologie-les-Verts (EE-LV) voted against it in late September, resulting in the departure of the MEP Daniel Cohn-Bendit.

The answer is as simple as it is perplexing. François Hollande wishes to please the Germans. He wishes to please not just Frau Merkel—whose coalition will collapse next year—but the German social-democrats (SPD) whose economic beliefs are not so different from those of Merkel’s CDU.  Crucially, Hollande’s argument is that if France is to retain its leading role within Europe and the Eurozone, in the short term it cannot afford to anger either the financial markets (and follow Italy and Spain into spiralling borrowing costs and insolvency) or the northern European austerians.

What is perplexing is that the combination of an austerity budget today and the Budgetary Pact (TSGC) tomorrow ultimately condemns France to long-term economic stagnation. This in itself will kill Monsieur Hollande’s European aspirations. Ironically, some of today’s socialist ministers who in 2005 voted against the EU Constitutional Treaty (eg, Bernard Cazeneuve and Laurent Fabius) now support the TSGC. Indeed, Elizabeth Guigou (Minister in the 2003 Jospin government), who  is on record as strongly opposing the Pact, is now willing to vote for it.  The so-called ‘sovereignty problem’, much discussed by both the left and right in France, is in reality a red herring.

The fundamental issue is about economics. Unless the left of the French socialists forces a change of course, the PS and the centre-left in France will ultimately suffer grave damage. What is need is not austerity, but a massive stimulus to get France—and more generally the EZ—moving again.

Sadly, throughout Europe, the timidity of the social-democratic response to the economic crisis is resulting in unemployment and disillusion of a scale which threatens to destroy social democracy within a generation.

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How long must we wait?

Posted by George Irvin in EU on August 22, 2012

Nouriel Roubini famously described the long decline of the euro as a ‘slow motion train wreck’. Mind you, economists disagree on exactly when the wreck will happen. Professor Vincente Nabarro has argued that the euro will survive for as long as it serves the purposes of the German (and European) elite while, in the Financial Times, Wolfgang Münchau mischievously suggests the crisis could last another 20 years given Germany’s proclivity for muddling through. By contrast, Megan Green at RGE sees the confluence of crises in Greece, Spain, and Italy during September and October, 2012, as potentially lethal. But all agree that—sooner or later—it will happen.

In Greece, the coalition government will have to agree a package of measures with the troika to secure the latest tranche of bailout money. The problem is twofold: first, Mr Samaras has asked for an extra two years to impose further austerity measures required by the troika, a request which the Germans have already rejected. Secondly, the Greek Parliament must approve the measures, failing which another general election would almost certainly need to be called.

Even if one assumes that Greeks can be paper over their differences once again (or else that Greek default does not produce catastrophic contagion), Portugal is likely to remain locked out of the financial markets and thus forced into a second round of difficult negotiations with the troika. Because the ESM comes into existence in September—assuming the Germans Constitutional Court rules in its favour—Spain too will require negotiations with the new body both on bailing out its private banks and on sovereign bond purchases.

Elsewhere, the campaign in Italy for the April 2013 general election will begin in earnest and Mr Berlusconi can be expected to launch his political comeback on an anti-euro platform, having said quite plainly earlier this year that either Italy gets bailed out or it leaves the EZ. However one views Berlusconi, there should be no doubt about the seriousness of this threat. In September too, France’s President Hollande will advance a budget which is bound to be controversial, while at the same time the Dutch will hold a general election likely to lead to a euro-sceptic coalition.

The situation might not be so dangerous were it not for growing euro-scepticism in Germany. While a majority of Germans may still favour remaining in the euro, over a third of those questioned favour a return to the old currency, the highest percentage in the large EZ countries. Public opinion, moreover, is strongly against what is perceived as further German ‘aid’ to the Club-Med countries (which is reality is ‘aid’ to their own banking system). Spurred by such neo-liberal economists as Hans-Werner Sinn, centre-right German politicians continue to insist that: (a) neither commonly backed Eurobonds nor bank insurance are an option; (b) further ECB sovereign bond purchases are dangerous, and (c) there can be no bank recapitalisation without EZ banking union, and such banking union must be preceded by political union.

But the strong EZ banking union required is not what the German centre-right has in mind, and even were it to accede on this point, German actions (and inactions) to date mean that the chance of achieving political union is growing ever more remote. Nor can we expect much to change were the SPD to enter into a new grand coalition in late 2013. After all, it was the previous SPD-CDU coalition which embedded austerity into the German constitution in the form of the debt-brake law, and the then SPD Finance Minister Peer Steinbrük—now a strong candidate to lead the party into the 2013 election—famously dismissed the Keynesian notion of a pan-European economic stimulus package. Moreover, the ex-central banker, Thilo Sarazzin , whose 2012 book Europa braucht den Euro nicht (Europe doesn’t need the euro) has been a best-seller, is a well-known SPD member.

Without a fundamental shift in the German position—not just on the above issues but on domestic demand reflation and trade imbalances–the euro seems doomed. Since there is no sign of such a shift, Europe sits on its hands awaiting the inevitable economic shock. One source has put the cost to Germany in the first year alone as a 10 per cent collapse in GDP. Perhaps this is the sort of price which, sooner or later, all of us will pay as a result of accepting the deep flaws in the initial structure of the common currency.

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Can Holande walk the walk?

Posted by George Irvin in EU on April 28, 2012

At the moment, the Euro Area is stagnating, unemployment is rising and the entire banking system is dangerously fragile—in Nouriel Roubini’s phrase, we are watching a slow motion train wreck. But if the opinion polls are right, François Hollande will very soon be President of the French Republic and economic policy in the Euro Area (EA) could become decisively more progressive. ‘Austerity’ could be ditched and Europe could go for growth and jobs.

Hollande can talk the talk, but can he ‘walk the walk’? Whether genuine change is possible depends on a number of factors difficult to evaluate; eg, how markets will react, how Hollande manages the relationship with Germany in the coming months, whether the German SPD can form a government after the 2013 general election and, crucially, whether social-democrats in the EU scrap the current economic orthodoxy. Let us consider each in turn, bearing in mind the speculative nature of any such discussion.

How will markets react to a progressive government in France? The knee-jerk reaction is to invoke Mitterrand’s experience in 1981-3 when financial turbulence forced the social-democratic left to change course within two years and into ‘cohabitation’ within five. And, yes, it must be added that financial markets are far more powerful today. Nevertheless, there are important differences. First, the once-powerful French Communist party (PCF) is no longer of any significance, so there is no red revolution to fear. It is easily forgotten, too, that Mitterrand’s policy failed largely because of rising inflation which rocketed in 1983; inflation is no longer a serious threat today.

An even more important difference is that, with every passing day, politicians and financial ‘experts’ are becoming aware that fiscal austerity leads to a dead end. Far from leading to budget balance, deep expenditure cuts leads back to recession which makes things worse—as we see in Greece, Portugal and Ireland and will soon see in Spain too. Hollande’s message is simple: in a recession, fiscal rectitude is achieved through state-led growth—it is higher national income that generates higher savings, not the other way ‘round. Even the IMF appears to agree.

Doubtless there will be capital flight from France as a result of higher taxes on the rich, but it is unlikely to be massive. Young middle-class French people migrate not because of high taxes but because there are too few jobs, and the extra income from higher taxes on the rich—and from clamping down on tax dodges—can be used to create jobs. Unlike the early 1980s, the French today are far more aware of the inequities of neoliberalism and the time-bomb of unemployment. But if Hollande wants jobs and growth, his proposed ‘stimulus’ will need to be far more than 1% of French GDP.

Hollande’s most difficult task upon coming to power will be calming the Germans while renegotiating the so-called Stability Treaty. There are two issues here. First, Angela Merkel, by openly backing Sarkozy, has declared war on the Hollande camp, presumably because she believes that by so doing she can preserve her own brittle CDU-FDP coalition government. But even assuming she can remain in power until the German general election deadline of September 2013, her popularity is on the wane and numerous polls suggest the most likely electoral outcome to be either an SPD-Green coalition or else a ‘grand coalition’ without Merkel.

The second—and crucial— issue is that of the Stability Treaty. This Treaty requires countries wishing to borrow from the European Stability Mechanism (ESM) to adopt a German-style ‘debt brake’ law limiting their structural fiscal deficit to 0.5% of GDP. As shown in detail elsewhere , the debt brake law is only possible in Germany because of the country’s current account surplus—it is economic nonsense to think such a law can resolve the problem of deficit countries. (This is not a matter of Keynesian economics but follows from simple National Accounting identities.)

Although many EA governments are in the process of ratifying it, the Treaty is deeply unpopular—-and not just in Greece, Portugal and Ireland. In Italy, Signor Monti has made it clear that he thinks it foolish and that jointly-backed Eurobonds constitute a better solution. Belgium’s Guy Verhofstatd agrees and even Sr Barroso appears to support this position. In demanding that the Treaty be changed, François Hollande would have the support not just of the EA periphery but of some of its major players and many of its economic experts. One should bear in mind that the poll indications for Italian Parliamentary elections to be held next spring suggest a centre-left coalition will emerge. Whether the Germans and their Dutch and Austrian allies could long hold out against a majority of the larger EA economies is doubtful.

In short, the victory of François Hollande on the 6th of May might well mark a turning point for the economic future not just of France, but of the EU and of Europe as a whole. While the chain of events outlined above is necessarily speculative, what is certain is that the coming 15 months will see fascinating changes take place. After all, two centuries ago France’s revolution embedded the Enlightenment values of liberté, égalité, fraternité which inform the European centre-left today, values which today’s Europe disregards at its peril. Without a growth strategy, the euro—and the European project—is doomed.

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Europe’s debt trap

Posted by George Irvin in EU on January 14, 2012

Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting.1 Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times. As Larry Elliot puts it: “The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.2

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets. But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially, Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the Eurozone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well. The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted. Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing? In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages. Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk. Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector. So ‘public debt’ is not a burden passed on from one generation to the next. The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable? Sustainability means keeping the ratio of debt to GDP stable in the longer term. If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.3 But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn. Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged. By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly.  The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise. Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch. In a modern economy, the public sector accounts for about half the economy. If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession. When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate). The gloomy prophecy of growing public indebtedness becomes self-fulfilling.

This is exactly the sort of ‘debt trap’ which faces much of the EU and other rich countries. The way out cannot be greater austerity. What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot. If everybody saves more, national income falls. Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them. When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible. Even if all could devalue, what would follow is 1930s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort. It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal). What matters is growth.

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[1] See Joe Weisenthal http://articles.businessinsider.com/2011-11-10/markets/30380618_1_fiscal-consolidation-economic-growth-slow-growth

2 See Larry Elliott, http://www.guardian.co.uk/business/economics-blog/2012/jan/08/eurozone-crisis-angela-merkel-whip-hand?

3 See Paul Segal http://www.guardian.co.uk/commentisfree/2010/sep/03/government-debt-growth-unemployment

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The Eurozone is already a transfer union

Posted by George Irvin in EU on June 1, 2011

Five years ago I wrote a book supporting the euro, but saying inter alia that Eurozone governance was fatally flawed and that a European Treasury was needed.[1] Although not taken very seriously at the time, this view has today gained wide currency. Like it or not, a US-style Treasury is needed to guarantee states’ financial system and to effect fiscal transfers within the Eurozone. Yes, the Eurozone is a ‘transfer union’ and the sooner the rich countries face up to this reality the better. The alternative could be collapse of the euro, followed by financial chaos.

Intra Euro debt: Claims between national central banks (£bn)


 

 

 

 

 

 

 

source: M Wolf, ‘Intolerable choices for the Eurozone’ FT, 31 May 2011.

In a series of excellent pieces in the Financial Times, Martin Wolf has spelled out a compelling case for fundamental reform.[2] The eurozone, Wolf reminds us, started life as a reincarnation of the gold standard. Eurozone member states were meant to finance a trade deficit by borrowing abroad; ie, by emitting their own central bank bonds. If markets were unwilling to buy these, a member-state would have no option but to find the money internally by means of a squeezing labour costs, or what is euphemistically termed ‘internal devaluation’.

There are two problems here. One is that squeezing wages may have an unacceptably high political cost. While it is true that cutting aggregate demand sufficiently will balance the books at some (very much) lower level of national income, the patient may stop breathing as a result. (For example, Ireland has now experienced four years of recession and the young are emigrating in droves.)

The second problem is the banking system. Since private credit died up after 2008, the ECB (and the Bundesbank) have acted de facto as the Eurozone’s lender of the last resort, both in buying the sovereign debt of the periphery’s Central Banks and helping Europe’s large private banks to do so. Indeed, the accompanying figure illustrates the unnerving symmetry between Germany’s position as chief central bank creditor and the growing indebtedness of the Eurozone periphery—unnerving because the Germans are indirectly financing the periphery through the banking system rather than through explicit fiscal transfers. Although this has helped peripheral states to weather the storm, what happens if peripheral countries default?

Many commentators (including myself) believe that some form of default is now inevitable[3]—but default could have dire consequences too. The insolvency of periphery governments would almost certainly threaten the solvency of debtor country central banks, leading to large losses for creditor country central banks (eg, Germany), which national taxpayers would need to shoulder. Doubtless this is a major reason for Signor Smaghi’s implacable opposition to default. And in the absence of support from the ECB and other creditor central banks, the threat of default by Greece or Ireland would hasten contagion and paralysis. Banks would not want to rink continued lending to any potential defaulter, credit would seize up and, ultimately, the existing financial transfer mechanism would collapse.

The options for the eurozone are narrowing. Either default will result in weaker countries leaving the eurozone—a lengthening list as contagion and financial collapse spreads—or the eurozone must undergo radical reform. This means tearing up the current system under which Greece and its banking system depend on selling sovereign bonds to the market and establishing in its place a Eurozone Treasury which would, like its US counterpart, guarantee the integrity of the Eurozone’s financial system as a whole. Needless to say, other key reforms would be necessary (true e-bonds, smaller trade imbalances) which I shall not dwell on here.

All this boils down to a single basic point: Europe already has a central bank ‘transfer union’, but it is under growing threat. Either Europeans bite the bullet and accept the need for true fiscal union and economic governance, or they can stand aside and watch the Eurozone disintegrate. Just as in the case of climate change, it’s too late to think that we can merely wish for the best and ‘muddle through’.

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1 See George Irvin, Regaining Europe; an economic agenda for the 21st century, London: Federal Trust, 2007.

2 See http://www.ft.com/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O2IdJ0I6; also see http://on.ft.com/lCP0jT

3 See http://ftalphaville.ft.com/blog/2011/05/10/564346/roubinis-guide-to-a-greek-debt-restructuring/.

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The big bailout scam

Posted by George Irvin in EU on April 11, 2011

Suppose that my rich neighbour down the road mortgaged his mansion up to the hilt to bet on the horses, ran up millions in debt and asked me, an ordinary punter, to pay off his debts plus interest. Suppose that foolishly I accepted, and while I struggled to pay it off while barely able to feed my family and pay off the mortgage, my super-rich neighbour acquired an even bigger mansion. To make matters worse, he used all sorts of clever dodges in the Caymans to pay negligible taxes, while if I failed to pay mine I knew I’d be sent to prison.

It may sound like total madness, but that’s pretty well what’s happening to a growing number of Europeans (including Brits) today.

How did we get here? In Britain, the 2008 credit crunch produced a massive recession which played havoc with government finances. In Ireland the government took over the entire debt of its banking system, while in Greece, the rich paid minimal taxes and successive governments, unwilling to challenge them, indulged in creative accounting.  That’s somewhat simplified, but it’s the essence of the story.

Everywhere in Europe, voters are being told that decent pensions and universal welfare provision are no longer affordable and that we must all tighten our belts. Governments can no longer borrow because the credit rating agencies might downgrade their bonds. First it was Greece and Ireland, today it is Portugal, and tomorrow perhaps Spain, then Italy, and then … who knows?

But ordinary punters are starting to wake up. Instead of enduring years of economic depression, the Greeks and the Irish will probably have to default, as will the Portuguese if their economy reacts the same way to belt-tightening.[1]   And what if Spain has to be bailed out, still less defaults? That would spell a major hit for banks in Germany, France, the UK (and elsewhere), all of which could easily add up to another major financial crisis.

Are we really so vulnerable? The answer is indeed yes—-because so little has been done to address the underlying causes of the 2008 crisis.

While the recent Basle Three agreement requires banks to carry a slightly higher cash cushion, nothing has been done to re-establish the division between investment banking and commercial high-street banking, a division which disappeared with the repeal in the US of Glass–Steagall in 1999. Except for a temporary ban on naked short sales in Germany, the derivatives trade remains mainly unregulated.[2]  Credit default swaps (a form of insurance on risky financial products) are still sold over-the-counter rather than through an official market, the US President having failed to follow up his 2009 promise to re-regulate these.[3]

Meanwhile, the trillions poured into the big banks since 2008, instead of going to cash-starved small business or being used to build infrastructure and to create jobs, have largely helped fuel a new stock market bubble.[4] The extraordinary rise in the value of companies such as Facebook and Zynga provides a worrying parallel with the dotcom bubble of 2000.

Tax dodging is now a major growth industry—witness the latest GE scandal. As for making the bankers pay by introducing some form of Tobin tax, there’s been much talk but little action.

Perhaps most galling of all is the injustice of using Keynesian economics to justify the need for state intervention in banking bailouts while claiming today that the profligate state caused the problem, as politicians now argue in London, Brussels and Frankfurt.[5] How long will sensible people go on accepting this nonsense before venting their anger on our ruling classes?[6]

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(An earlier version of this piece first appeared at http://www.social-europe.eu/2011/04/the-big-bailout-scam)

1 http://www.bbc.co.uk/news/business-12864413

2 http://online.wsj.com/article/SB10001424052748703957904575252611852571860.html

3 http://www.cnbc.com/id/30731157/Regulating_Wild_West_CDS_Market

4 http://www.marketoracle.co.uk/Article19523.html

5 See Ha-Joon Chang, ‘The revival—and the retreat—of the state?’ Red Pepper, Apr/May 2011.

6 http://www.france24.com/en/20110312-300000-protest-job-insecurity-portugal

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UK Targeting Stagflation

Posted by George Irvin in EU on March 2, 2011

However circumspect Mervyn King may have been about raising interest rates in the Bank of England’s (BoE) quarterly inflation report issued in February, it is clear that the City wants him to do so. Indeed, judging from the fact that 12-month interest rate futures are now 1.4%, it is generally thought that there will be three to four quarter-point hikes over the next twelve months, while over the coming two years the rise may be twice that figure. One must ask, first of all, is such a rise justified by inflation; and secondly, if not, what damage will raising UK interest rates do?

The proximate cause of the problem is that the Retail Price Index (RPI) has jumped to just over 5% in the UK, mainly reflecting rising world food and energy prices, but also the effect of a sterling devaluation of over 20% in 2008 working its way through the economy as well as January’s VAT rise. Even the Consumer Price Index (CPI), which strips out housing costs, is rising at a rate of 4%, twice the BoE’s 2% target.

Of course, stripping out food and energy, core inflation is well below the BoE’s target, but inflation hawks would argue that several other factors must be taken into consideration. First, inflation is rising not just in the UK but in the US and the core Eurozone countries such as Germany and France, in part reflecting strong inflationary pressures in countries such as China and Brazil. Secondly, UK firms may be raising prices to recoup the profits lost during the credit squeeze, or even in anticipation of lower future profits. Finally, the fact that the recession has pulled down UK trend growth means that the weight of the structural deficit is all the greater;  ie, a return to (lower) trend growth would leave a larger proportional gap between public spending and receipts than would have been the case before the recession. On this view, the larger the structural deficit, the higher are domestic inflationary expectations.

The counter-argument goes roughly as follows. First of all, the main domestic culprits—devaluation and the VAT rise—are once-and-for-all events, so their inflationary impact can be expected to decline over time. Secondly, with regard to the key imported components, mainly food and energy, it is not so much a case of gradual price inflation; rather, these prices have exhibited strong fluctuations. Energy prices peaked in 2008, then fell and have now risen again; there is every reason to believe that they will fall again. And even if imported inflation continues to rise, raising domestic interest rates will not seriously arrest this rise. Thirdly, there is no sign of wage inflation in the UK economy—indeed, with unemployment at 2.5 million and rising, real wages are falling. Moreover, with the bulk of government spending cuts still in the pipeline, unemployment will rise (and real wages fall) further. This being the case, ‘inflationary expectations’ are groundless. As one academic colleague put it, ‘there has been no Phillips curve [expectations augmented or otherwise] in the UK for a generation’.[1]

Little wonder then that Mervyn King is being circumspect about raising interest rates when the prospects for UK growth are so poor and their impact on inflation is likely to be negligible. Nevertheless, it is equally clear that George Osborne wants higher rates and that the MPC, which has been dovish on the matter, is now split and edging towards hawkishness.[2] Such hawkishness will come at a cost. In the words of one commentator:

‘charts in the Inflation Report suggest the Bank now believes the UK economy must grow by about 0.25 percentage points less than it thought in November to avoid sparking inflation. That is a loss to economic output which accumulates by roughly an additional £4bn every year, making fiscal consolidation even more difficult.’[3]

Indeed, such a loss would come on top of the cuts. A recent report by the IMF suggests that, even if interest rates remain near zero, public sector cuts equivalent to 1.5% of GDP per annum over the next four years will subtract an equivalent amount from growth, or about £20bn every year.[4]

According to the IFS ‘green budget’, between 2010 and 2015, the UK is forecast to have the third largest reduction (behind Ireland and Iceland) in the share of government borrowing in national income among 29 high-income countries.[5] As Martin Wolf has noted, using the OBR’s latest figures, the implicit (compound) rate of growth of GDP between 2007 and 2015 is just 1.2% per annum.[6] And if interest rates rise in response to a perceived inflationary threat, the growth rate will be even less.

In a word, Britain under the Tory-led government faces years of not merely stagnation, but quite possibly of something worse: stagflation. Perhaps Monsieur Trichet at the ECB should be pondering the lesson for the Eurozone.

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*diagram source: N Cohen, ‘King denies interest rate rise certainty’ FT, 16 Feb. 2011
1 In private correspondence with Martin Hoskins.
2 David Blanchflower is more optimistic and believes the MPC will remain dovish; see http://www.newstatesman.com/blogs/david-blanchflower/2011/02/mervyn-king-growth-inflation
3 See C Giles, ‘Slower growth seen as inflation buster’, FT, 16 Feb 2011; http://www.ft.com/cms/s/0/3279a6ee-3a0c-11e0-a441-00144feabdc0.html#axzz1EDbJnmWK
4 See Duncan Weldon ‘The danger of spending cuts: some advice from the IMF’; http://duncanseconomicblog.wordpress.com/2011/02/15/the-dangers-of-spending-cuts-some-advice-from-the-imf/
5 See http://www.ifs.org.uk/publications/5460.
6 See M Wolf, ‘Britain’s experiment in austerity’ FT, 8 Feb 2011; http://www.ft.com/cms/s/0/5e5a6d1e-33c9-11e0b1ed-00144feabdc0.html#axzz1EDbJnmWK

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VAT and voodoo economics

Posted by George Irvin in EU on January 5, 2011

Whatever else can be said about the British Chancellor, George Osborne, he certainly does not lack chutzpah. His latest canonical pronouncement is that VAT (value added tax) is a progressive tax. For sheer guile, this statement must rank alongside Arthur Laffer’s famously misleading advice to Ronald Reagan that cutting income tax for the rich would actually increase tax revenue, a statement (rightly) dismissed by the then US Vice-President, George H W Bush, as ‘vodoo economics’.

How does Osborne justify his position? The simplest argument–as advanced on 4 January by the BBC’s flagship Newsnight programme–is that VAT is progressive because the poor pay less in absolute terms than the rich; ie, if  (say) you earn only £10 a day, the £2 you pay in VAT is far less than the £20 in VAT paid by somebody on £100 a day. Since £20 is greater than £2, the conclusion is that the rich ‘shoulder the heaviest burden’. Note that this holds true even if the rich man saves half his £100-a-day income, paying total VAT of only £10. The accompanying diagram illustrates admirably how to mislead the public with numbers.

That television presents data in such a manner says a good deal about the near contempt with which our elite view the average member of the viewing public, but never mind. More to the point, the above argument is just plain wrong. A progressive tax is one which takes a larger proportion of one’s income as income rises. This is true by definition. The principle that tax should be linked to the ‘ability to pay’ comes from Adam Smith’s Canons of Taxation in The Wealth of Nations (1776).[1] We accept as fair an income tax system based on rising marginal rates of taxation, just as we reject (say) a flat poll tax. Equally, we make the distinction between a direct tax (such as income tax) which is progressive, and an indirect tax (such as VAT) which is regressive, precisely because it is thought unfair to tax the rich and poor at the same flat rate.

When I was an undergraduate, Alfred Marshall’s Principles was required reading: Marshall, perhaps Britain’s best known neo-classical economist, famously set out the principle of ‘diminishing marginal utility of money income’—in everyday English, that an extra daily £2 is worth much more to a poor man than to a rich one.

Consider the example. If the rich and poor consume all their income, each pays 20% of income in VAT. But if the rich man saves half his income and pays only £10 in VAT, he pays out only 10% of his income. So where the rich save more than the poor, the proportion of income paid out in VAT is actually lower for the rich; ie, the tax is highly regressive.

So far so good, but apologists for Osborne don’t stop there. Rather, they roll out three further (and logically distinct) arguments. The first argument can be dealt with fairly rapidly. Because some basic necessities (food, children’s clothing) are VAT exempt in the UK, it can be argued that VAT is ‘mildly progressive’, a view apparently shared by Vince Cable.[2] But for this to be true, the share of non-VAT rated items as a proportion of the bottom decile’s income would need to be greater than the savings propensity of the top decile.

In the UK, the poorest 10% of the population spend about 15% of their income on food.[3] Look again at the above example. For simplicity’s sake, let us assume I receive £10 per day but that instead of paying £2 per day in VAT, I pay £1.70 (because only £8.50 of my daily income is spent on VAT rated items); the effective rate of VAT I pay is 17% of income. Now look at savings behaviour. Roughly speaking, in normal times the average British household saves about 7% of its total income; moreover, the higher your ‘financial capability’ (the richer you are), the more likely it is that you will save more.[4] So take our rich man who receives £100 per day; he can safely be assumed to set aside twice this proportion (or £15), spending the remaining £85 on which he will pay 17% effective VAT—no progressive element discernible there.

The second argument is that the above calculations depend on looking at the economy in ‘snapshot’ mode rather than considering the lifetime behaviour of economic agents. When people are young—so goes the argument—they earn little and pay little VAT, but as they get older and earn more, their VAT increases (and of course when they retire, consumption falls as does the VAT burden). But the counter-argument is simply that the lifetime consumption profile doesn’t matter. What we want to know is the likely impact of the VAT rise today and in the months to come. For example: a tax/benefit system which comprised a tax system with a personal allowance of (say) £10,000, a 40% flat income tax rate above this, a proportional VAT on all goods and no benefit system at all (including pensions) might be highly progressive in a lifetime incomes context, but it would also leave a lot of low-income people dependent on charities, or dead in the streets.[5]

The third argument is perhaps the most important, since it comes from the much-respected Institute of Fiscal Studies (IFS). IFS argues that instead of looking at the distributional impact of VAT as a proportion of income, we should take income net of direct tax and savings and look at VAT as a proportion of consumption. Of course, if there was zero household savings and direct tax across the income distribution, using such a measure would make no difference. But since the rich consume less than they earn (and the poor use their credit cards to consume more), the consumption pyramid is far flatter than the income pyramid. Combining this with the fact that the poor spend more of their income of zero-rated essentials such as food produces a mildly progressive VAT impact.

However, such an argument is simply disingenuous. As a matter of accepted convention, calling a tax ‘progressive’ depends not on looking at consumption propensities but rather (as Adam Smith argued) on comparing people’s ability to pay. The IFS has simply dragged out yet again an old argument about ‘not taxing savings’ since future investment depends on the ‘supply of loanable funds’, an argument disposed of long ago by Keynes but still echoed by the UK Treasury.

Let me leave the reader to ponder the apparent paradox that according to Tim Montgomerie, a leading right-wing blogger, four of London’s leading conservative think-tanks have now attacked the rise in VAT as a bad idea.[6] We should perhaps recall that although George H W Bush was a fiscal conservative who attacked ascendant neo-liberalism as ‘vodoo economics’, much of that same voodo is still picked over today.

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[1] See Book V, Chap 2, part 2.
[2] See http://www.libdemvoice.org/vince-cable-why-the-vat-rise-had-to-happen-20039.html
[3] See http://www.foodsecurity.ac.uk/issue/uk.html
[4] See http://www.cfebuk.org.uk/pdfs/CRS02_Financial_capability_and_saving_summary.pdf
[5] This argument comes from Howard Reed who is gratefully acknowledged.
[6] See http://conservativehome.blogs.com/thinktankcentral/iea/

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Could the euro disappear?

Posted by George Irvin in EU on December 1, 2010

Let me make it clear that I strongly support the euro; I’m a Brit who believes in European integration and who has little time for Euro-sceptics. But I can also see the writing on the wall. The euro—and with it the whole EU integration project—is in grave danger. It is entirely possible that in five years’ time, travelling from Paris to Berlin and thence to Madrid or Rome will entail queuing to change money and struggling through customs posts once again.

Why should the euro be in danger? After all, the Eurozone taken together is in quite good shape, considering the fact that we’ve been though the worst recession since the 1930s. The 16 euro-states’ budget deficit in 2010 as a percentage of GDP is 6.9% (versus 10.2% for the USA); the ratio of public debt to GDP is 84%, far lower than the US figure of 94%.[1] So what’s the problem?

The problem is the peculiar architecture of economic governance. Since tax receipts fall and spending rises in a recession, government deficits necessarily swell and must be financed by borrowing. Because the Eurozone has no federal treasury and cannot emit federal bonds, smaller member states whose domestic bond markets are too narrow must go to the international market to sell their own Eurobonds.

In normal times, member-states’ government bonds are considered a safe bet by the market. But as past financial crises show clearly, bond markets tend to be driven by the herd instinct; ie, once the rumour circulates that one country’s bonds are at risk, everyone joins in. This is commonly known as ‘contagion’, and there’s lots of it about today. Witness the fact that not just Greece, Ireland, Portugal and Spain are under threat, but in the past week Belgium and Italy have been added to the list.

The joint European/IMF bailout plan agreed earlier this year provided some €750bn (€860bn if Greece is included) in potential relief to afflicted countries—with plenty of nasty strings attached, one must add. The plan covers the period 2010-14, but the combined borrowing requirement over 2011-14 of Italy, Spain, Portugal, Greece and Ireland totals nearly €650bn and is growing. Add to this Belgium’s public debt of about €350bn, and the total is €1tr, far larger than the bailout package. The size of the package is unlikely to increase because of political resistance and possible required changes to the Lisbon treaty; per contra, what is likely to increase is the troubled states’ borrowing requirements. The financial markets have already done their sums, the main reason they are betting against the longer-term success of the rescue.

What are the options? First, Chancellor Merkel and President Sarkozy recently agreed on a sovereign debt default mechanism for troubled Eurozone countries thus forcing bondholders to share the bailout pain. Doubtless such a scheme will appeal to taxpayers and sacked public-sector workers alike, but as Paul De Grauwe has noted forcefully, legitimating sovereign debt restructuring makes speculative runs more likely, not less so; ie, the new mechanism increases potential turbulence.[2]

Of course, it is not just the troubled states that are being rescued; it is the major banks holding troubled Eurobonds that are in danger. Everybody knows—except apparently the German electorate—that when Germany ‘bails out’ Greece, the main beneficiaries are German banks (just as the main beneficiary of the recent UK ‘bailout’ for Ireland will be RBS). As ever, these are deemed to be ‘too big to fail’. To ensure their solvency, the European Central Bank (ECB) has been lending them money at a typical rate of 1 percent, money which is then on-lent to Greece or whomever in the form of bond purchases yielding 5 percent or more.

The problem here (quite apart from the big commercial banks making huge profits) is that the resources of the ECB are finite. It simply cannot conjure up another trillion euros if required. Of course it could do so by engaging in Quantitative Easing (QE)—a form of monetisation—but politicians think this will lead to inflation.

And here lies another trap. Although core inflation in the Eurozone remains very low, once energy and food are added back into the measure the rate goes up. In the next few years, food and energy inflation (both largely imported) are likely to accelerate. And if the ECB prints money, politicians—most of whom still believe in the simple ‘quantity theory of money’—will take the blame.

Finally, there is the fundamentalist solution preached by the deficit hawks: make all the ClubMed countries (including those not bordering the Mediterranean) cut their spending and balance their budgets! But there are two problems here. First, budget balancing might be feasible for one country when the world economy is buoyant, but in a world where the OECD economies are stagnating, asking many countries to balance their budget is not feasible. As a recent IMF study shows, ‘expansionary fiscal contraction’ is not the answer.[3]

So what is the answer? The answer is twofold: first, the ECB, not member states, should be able to issue Eurobonds, an idea which has recently gained limited traction. Secondly and more important, in the long term there must be a Eurozone Federal Treasury, akin to the US Federal Treasury. As the President of the ECB, Jean-Claude Trichet, said in the summer “Nous sommes une fédération monetaire. Nous avons maintenant besoin l’équivalent d’une fédération budgetaire” (Le Monde, June 1st).[4] He repeated this warning to a European Parliamentary Committee on 30 November.

To date, Europe’s political class has been unwilling to listen. They argue, inter alia, that Germany’ constitutional court would never cede fiscal sovereignty. Indeed, the tradeoff between monetary and fiscal sovereignty was at the heart of the Maastricht Compromise of 1992. It is most certainly not in Germany’s interest to allow the euro to flounder. Let’s hope Europhiles wake up before it’s too late.

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[1] See FT Alphaville 23 Nov 2010; http://optionalpha.com/european-national-debt-2010-as-a-percentage-of-gdp-9001.html
[2] See P De Grauwe ‘A mechanism of self-destruction in the Eurozone’ 9 November 21010; http://www.ceps.eu/book/mechanism-self-destruction-eurozone
[3] See http://www.social-europe.eu/2010/11/expansionary-fiscal-contraction-and-the-emperor%E2%80%99s-clothes/
[4] See G. Montani, ‘European Economic Governance and fiscal sovereignty’; http://www.thenewfederalist.eu/European-Economic-Government-and-Fiscal-Sovereignty

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The mistake of the century

Posted by George Irvin in EU on October 26, 2010

In Brendan Barber’s words, Britain has been experiencing a ‘phoney war’—living in anticipation of what the cuts might mean, without experiencing their reality.[1] Although high-profile academic economists, from Robert Skidelsky to Paul Krugman and Joe Stiglitz, have warned about the consequences of Osborne’s reckless gamble, it is only now that the results of the spending review have become official that one can begin to appreciate the irreversible nature of the deed.[2] It was David Blanchflower who put it most succinctly in The Guardian on 18 October: ‘The austerity package is likely to turn out to be the greatest macro-economic mistake in a century.’[3]

George Osborne has pursued his goal of emasculating the welfare state with unswerving determination and ruthlessness. What is more, according to a recent YouGov poll, nearly half the electorate believe that the last Labour government was responsible for Britain’s current economic plights—less than one-fifth blame the Coalition.[4]  Cameron et al have endlessly chanted the mantra of Labour’s irresponsible spending as the cause of the crisis, which flies in the face of everything we know about the origins of the banking fiasco, the OECD-wide recession following the credit crunch and the collapse of Britain’s fiscal balance which until 2008 had been reasonable.

The Coalition’s message may be totally at odds with most economists’ take on the need to react to an economic slump by stimulating aggregate demand, but Osborne has capitalised on the widespread belief that when times are bad, everybody—starting with Government—must tighten their belt. The Tories have put right-wing LibDems like Nick Clegg and Danny Alexander in key positions, marginalised Vince Cable and kept out the rest. It has been an object lesson in the realpolitik of the Thatcherite legacy.

There is a real sense in which Labour share the blame for all this. For a decade Brown boasted of his ‘fiscal prudence’, attempting to offset what New Labour perceived as the damaging legacy of its tax-and-spend image. The Brown-Darling response to the credit crunch was as Friedmanite as it was Keynesian, while the economic downturn which followed produced a puny stimulus package.[5]  Early in 2010, Alistair Darling caved into the IFS-led chorus of deficit cutters and proposed cuts ‘deeper than Thatcher’.[6]

Nor does the change in leadership appear to have radicalised Labour. Ed Milliband, sensitive to the accusation that he was elected by the ‘union bosses’, was visibly absent from the TUC rally against the cuts on 19 October. Alan Johnson, the new shadow chancellor, has little bark and no credible bite, while within the shadow cabinet the row continues over the proportion of spending cuts and tax rises in Labour’s own deficit reduction plan.[7]

In truth, the economic crisis presented both Labour and the Tories with an opportunity for radical change—an opportunity which Labour squandered and which the Tories were quick to capitalise on.

If Labour really had been a party of the left, it would have taken the bailed-out banking sector into genuine public ownership, re-introduced mutualisation, thoroughly reformed the tax system using the proceeds for public-led investment in sustainable growth and jobs, and reversed the creeping privatisation of public services. In Brussels, Britain would have called for an EU-wide stimulus package and backed improved economic governance and better financial regulation.

The single-mindedness with which the Tories have capitalised on the crisis to drive through draconian measures stands in stark contrast to Labour’s inability to seize the moment. In a decade’s time, history may judge Osborne’s cuts with the same disdain as it does the poll tax and similar Thatcherite policies. But by then it will be too late—Slasher Osborne will have killed the welfare state in Britain.

It goes without saying that there’s a wider lesson for the rest of Europe to draw about what’s happening in Britain.

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[1] See http://www.guardian.co.uk/politics/2010/sep/10/tuc-brendan-barber-spending-cuts

[2] See http://www.guardian.co.uk/commentisfree/cifamerica/2010/oct/19/no-confidence-fairy-for-austerity-britain; also see http://www.skidelskyr.com/site/article/the-wars-of-austerity/

[3] See http://www.guardian.co.uk/commentisfree/2010/oct/18/george-osborne-spending-review

[4] See http://www.guardian.co.uk/commentisfree/2010/oct/19/osborne-public-wrath-labour-blame-game

[5] See http://www.social-europe.eu/2010/08/running-a-permanent-fiscal-deficit/

[6] See Larry Elliot, ‘Alistair Darling: we will cut deeper than Margaret Thatcher’, Guardian, 2010; http://www.guardian.co.uk/politics/2010/mar/25/alistair-darling-cut-deeper-margaret-thatcher

[7] See http://www.guardian.co.uk/politics/2010/sep/26/darling-balls-labour-deficit-clash

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