The high-speed rail track is the latest signal that the route to deficit reduction now runs via ‘saving to spend,’ explains Alan Shipman.

Banks’ recent mishaps with ‘financial innovation’ have demanded some unusual displays of Finance-Minister innovation. And George Osborne has confirmed his role as one of the most innovative modern Chancellors, even before he prepares to deliver the next Budget in March.

In expanding the UK government’s infrastructure-building commitments while pushing for another round of welfare spending cuts, Osborne has gone the opposite way to most of his post-war predecessors. They tended to let the welfare budget expand, as the inevitable consequence of falling income and rising social need during recession. To fund it, they traditionally swung the axe over capital projects – trusting that most existing roads, railways, power stations and public buildings could creak along for another year without major upgrades or replacement.

The northern extension of HS2 (see this Guardian video is just the latest in a long line of contrarian Coalition commitments, which also include a revived school rebuilding programme, support for the Crossrail project whose cost was questioned in opposition, and a new way of letting big institutions finance public investment projects. Although capital spending reductions announced in 2010 have not yet been fully reversed, it is now clear that further cuts to the government’s redistribution and running-costs will be used to finance new capital projects, and not directly repay debt.

The Coalition headstand 
Past Chancellors have usually taken the opposite approach to ‘fiscal rebalancing’ because cuts to benefits and tax credits are more socially (and electorally) painful than cuts to most infrastructure projects. Indeed, big civil engineering plans often bring some distinctly uncivil responses from the ruling parties’ supporters, as confirmed by those living close to the proposed high-speed route (see HS2 route set to trigger fresh protests).

Economically, spending more on benefits has the merit of immediately boosting demand, by putting money into some of the poorest pockets – shortening the post-Christmas roster of retail-chain closures, even if not enough on its own to get the economy growing again. A higher welfare bill is traditionally the ‘automatic stabiliser’ that helps to end the recession which gave rise to it. In contrast, even a ‘shovel-ready’ infrastructure project can take months to get into motion.  Those crossing affluent backyards can take years, even when planning procedures are fast-tracked to HS2 speed.

Osborne has taken the opposite approach because investment is the key to long-term expansion. A consumption boost worked in 2009-10, restoring the economy to growth, because there was plenty of spare capacity. But three years and a double-dip later, it’s uncertain how much idle machinery can still be easily switched back on. With unemployment falling, the amount of easily-redrafted labour is also unclear. Some economists fear another burst of inflation as rising demand hits inflexible supply. So investment, which adds to capacity as it boosts demand, looks like the safest way to engineer an upturn.

Investor of last resort
Another powerful argument for more public investment was delivered to the Treasury Select Committee at the end of January, as it probed the impact of Quantitative Easing (QE) – the wholesale purchase of government debt by the Bank of England. QE has enabled the Bank to keep base rates interest at a historically low 0.5% throughout the recession, when the wider public deficit and above-target inflation would normally have been expected to send them up. Low interest rates were intended to promote economic recovery, by boosting business investment and reviving the housing market.

But pensioners’ and pension-fund managers’ representatives pointed out two serious side-effects. Low interest rates widen the deficit on the remaining final-salary pension schemes, forcing big companies to divert funds away from investment so as to plug the gap. Low rates also flatten the incomes of pensioners, and others now living on their savings – squeezing their own expenditure, and tying the helping hand that previously assisted younger family members with home-deposits and other big expenditures (see this article).

So for low interest rates to be sure of stimulating recovery, those who benefit most from them have got to be willing to spend more. The government is the biggest beneficiary, and will still enjoy the country’s cheapest credit even if agencies downgrade its currently top (AAA) credit rating. As the damage to pension funds is already done, QE’s overall success may now rely on the Treasury’s ability to splash the cash.

Infrastructure spending has one other major benefit from the Chancellor’s perspective. Because the public outlay can lever-in substantial private investment , and because much of it will take place beyond the Treasury’s 5-year budgeting horizon, the succession of big projects announced with increasing boldness since 2010 need not undermine the Coalition’s promise to eliminate the structural budget deficit.

Many economists are anyway convinced that governments should borrow for public investment, and that the UK should follow standard accounting practice by separating its capital budget (on which rising debts are usually justified by rising assets) from its budget for current expenditure, where debts incurred in downturns should be paid down during recovery. The Treasury’s own forecasting model was highlighting the need for more public capital spending, even before the release of disappointing fourth-quarter growth figures. Osborne’s break with tradition, to boost investment, is fast becoming the new orthodoxy. It should help sidestep the awkward question of whether HS2 will eventually get him (First Class) from Plan A to Plan B.

Alan Shipman 6 February 2013

Alan Shipman is a lecturer in Economics at the Open University. He is responsible for the modules You and your money:personal finance in context and Personal investment in an uncertain world,  part of the foundation degree in Financial Services.

Cartoon by Gary Edwards

There may be more trouble ahead as prospects for the economy grow more scary, argues economist Alan Shipman…

The publication on 6 June of an open letter by 58 economists gave a welcome opportunity for two of my colleagues, Mariana Mazzucato and Susan Himmelweit, to explain in detail why UK economic policy may be on the wrong track. Their key message, fully in tune with those from Nobel laureates Joseph Stiglitz and Paul Krugman, is that closing the fiscal deficit requires redirection of public spending towards infrastructure and ‘green’ investment, not its reduction - and fairer enforcement of direct taxes, not further rises in indirect ones. 

While sharing Chancellor George Osborne’s commitment to deficit reduction, these economists make clear that restrictive budgets won’t achieve this. By restraining economic growth, too much austerity actually worsens the risk of spiralling public debt (through lack of the income growth to repay it), and recurrent banking crisis (because nonperforming debts won’t come back to life).
That’s already the reality in Greece, where public spending cuts and tax increases had proved economically unsustainable even before they became politically unenforceable. Ireland and Portugal stand on the brink of similar confrontation. [Belgium will escape because its government hasn’t formed, so is immune to collapse]. In Europe the only successful recoveries from dramatic budget and wage reduction have been by Estonia and Lithuania. But these are micro-economies whose cost reduction could spark a quick export boom (helped by Swedish banks underpinning their financial systems), and which still ran wide fiscal deficits until their production recovery was well under way. Larger economies like the UK, Spain and Italy can’t expect to mimic the Baltic bounce-back, as their export sectors aren’t big enough to lift the whole economy (and if they were, their Eurozone and North American markets would quickly deflate). 

A day after the economists’ protest letter, the press announced that the IMF had ‘endorsed’ UK policy. But this claim rests rather heavily on the accompanying statement by IMF acting managing director John Lipsky, with scant reference to the actual text. Released on 6 June, this contains a hefty dose of bad news for the UK:

“Growth was flat over the last two quarters, as the inventory cycle – which helped power growth through much of 2010 – came to a close and with consumer confidence impaired by spiking commodity prices, a soft housing market, and headwinds from necessary fiscal consolidation. Going forward, the latter two factors and the ongoing process of household and bank balance sheet repair will continue to weigh on growth.” 

In other words, output began to recover last year only because producers were rebuilding stocks, not because anyone was buying from them – so unless consumer demand revives this year, production will decline again. But consumer demand isn’t going to recover because households have debts to repay, fear losing their jobs, are living in devalued houses or struggling with higher rents, and are finding any extra cash drained by higher energy and food bills [and, the IMF might have added, any remaining income squeezed as prices rise faster than wages and welfare benefits are reduced]. Until now the government was offsetting this private-sector slump by spending more than it took in taxes, but the wizardry of Osborne is to close this yellow-brick road to recovery.

Incidentally, in saying that growth was flat, the IMF commits a basic arithmetical error. UK GDP fell by 0.5 per cent in fourth-quarter 2010 before increasing by 0.5 per cent in Q1 2011. If you reduce a total by x per cent and then increase the result by x per cent, you end with less than the original total - something any Level 1 OU economics student would be happy to explain to Mr Lipsky, who perhaps got adept at optimistic addition is his previous job as Chief Economist at Salomon Brothers. That’s the deceased investment bank which pioneered bond arbitrage (whose leading lights formed Long-Term Capital Management and almost triggered a global financial crisis in 1998), before disappearing into CitiCorp and requiring rescue from global financial crisis in 2008. 
Immediately after its broadside on the downside, the IMF report delivers a deceptive piece of good news:

“However, recovery should be buoyed by private investment, as it rebounds from unsustainably low levels and is supported by low interest rates and corporates’ strong cash positions. In addition, net trade is improving along with global recovery and may benefit further if labour productivity – which has been depressed in part due to relatively high labour hoarding in the UK – rebounds and improves competitiveness.”

So, magically, private companies are expected to start investing again even though there is no demand (because consumers and governments are tightening their belts) and no investment finance (because banks are still repairing their balance sheets, partly because of all those devalued houses and struggling mortgage-holders). They are expected to start exporting again even though the Eurozone and US economies are also slowing, with Asian markets threatening to follow. 

In pointing to corporates’ strong cash positions, the IMF ignores the fact that these were exceptionally strong in the years before 2008 and did not lead to higher investment even when markets were buoyant – and have been strong since 2008 only because big companies must now store cash because the banks won’t lend any to them. It also ignores much evidence that growth depends on investment not by large corporates but by small and medium businesses, which still can’t raise enough capital as banks fail to deliver on their ‘Project Merlin’ promises. The low interest rate set by the Bank of England (held at 0.5 per cent in June) is not translating into low interest rates for private-sector borrowers - because it is still being used to rebuild the finances of the banks, which prefer to lend it back to government at immediate profit. 

The IMF wilfully overlooks the sinister obverse side of banks’ strong cash positions: the erosion of real wages which is squeezing consumer demand and government tax revenue. It glosses over the fact that net exports are rising because the UK is importing less (due to suppressed demand) and raising the price of its exports, not actually selling more goods and services abroad.  And it blithely assumes that ‘hoarded’ labour will soon be put to work more productively, when the sad implication of its own data is that many will soon lose jobs because there’s no demand for what they do.

'Growth depends on investment not by large corporates but by small and medium businesses'

An unguarded Moody’s analyst quickly spoilt the IMF’s Downing Street party by pointing out that the UK could soon lose its top investment-grade credit rating if the decline in public debt – sole justification for Osborne’s savage spending cuts – is interrupted by slow growth. Moody’s is traditionally the credit rating agency most attuned to the public finance risks arising from weakened banking sectors. It could hardly stay silent after the Treasury missed its borrowing targets by a record margin in April, as stagnation reduced its revenue and raised its spending obligations. 

Ironically, letting these ‘automatic stabilisers’ keep the public deficit wide until private-sector activity recovers is one of the key prescriptions of economists’ ‘Plan B’ – as is maintaining the tax on bankers’ bonuses, whose abandonment accounted for £300m of April’s lost revenue according to the Treasury. Without more Coalition lapses towards the milder deficit reduction plans of its predecessors, UK economic growth is unlikely to reach even the IMF’s anaemic forecasts of 1.5 per cent in 2011 and 2.5 per cent n the medium term. This pace is still too low to keep public debt on a sustainable downward course once base interest rates start to rise. 

Economic commentators with longer memories greeted the economists’ latest protest by recalling that in 1981, 365 prominent ‘Keynesians’ wrote in similarly alarming terms about the policies of another Conservative chancellor, Sir Geoffrey (now Lord) Howe. Most of these commentators then suffered an extraordinary memory lapse by declaring that Howe was later “vindicated” for ignoring their advice. The first Thatcherite chancellor can certainly be credited with dramatically raising the productivity of real-world economists - so that 58 can now raise the alarm as effectively as 365 three decades ago. But before venerating Howe, it’s worth noting that he based his ‘monetarist’ programme on economic theories whose shaky foundations at the time were blown away by subsequent events. 

In Howe’s first two years, unemployment rose from one to three million, under a government elected on claims that ‘Labour Isn’t Working’. Almost 25 per cent of the UK’s industrial capacity disappeared, made unviable by absurdly high interest rates and a correspondingly overvalued exchange rate. Britain’s industrial training system vanished with it, creating a structural skill shortage that has never been overcome. Howe sent inflation to almost 20 per cent by doubling VAT to finance income tax cuts - launching the inexorable rise in income inequality that continues today as nonperforming managers collect bonuses while their employees’ real pay falls. 

To crown these achievements, Chancellor Howe allowed the UK’s newly emerging oil surplus to be spent on further income tax cuts and a consequent consumer spree, whose boom-and-bust whirlwind was reaped by his successor Lord [Nigel] Lawson. Howe and Lawson ensured that the UK is the only country in history to have instant consumed a natural resource windfall (and large privatisation receipts), rather than building up a sovereign wealth fund to benefit future generations. If this is vindication, put Ratko Mladic on the Nobel Peace Prize shortlist.

But the future Lord Osborne is clearly intent on being comparably ‘vindicated’, by ignoring all advice to change course. If the economic vindicators don’t yield, the economic indicators could look exceptionally scary in the months ahead.   

 

Posted 22 June 2011

Cartoon by Catherine Pain

My final furlong approaches. I have less than two weeks until my EMA is due in, but it’s not just any old EMA. It’s the last EMA I have to write for my Honours Degree; the last piece of work I EVER have to do as an undergraduate. Aah, feels good.

Or at least it would feel good if it was the last piece of work I was actually going to do as an undergraduate. The trouble is, it’s not. I’ve already begun another module which I stupidly signed up for to ‘bridge the study gap’ between the end of undergrad and the start of postgrad, so from now until October I’m doing a 30-point level 1 ICT module (then I move on to a 10-point level 1 science short course, why do I punish myself so?).

Undergrad isn’t actually my issue at the minute anyway. I don’t have a problem with undergrad; I’ve been doing it for years, I know how the OU works and am dangerously comfortable with it and know that I can pay for it sensibly using my OUSBA account (god bless OUSBA accounts, I’d be completely stuck without mine!), so undergrad is my safe zone.

What my worries are now turning to is my postgrad. My mind is consumed at present with thoughts not about which one I’m going to do, I already have that sorted; apply to Uni 1 which has entry criteria which I’ll struggle to achieve but have been told it’s still worth applying to anyway. If I don’t get in there, I have Uni 2 to fall back on as it has no entry criteria other than that I must have an honours degree so I will almost undoubtedly get accepted. No, my worry isn’t about entry or applications. My worry is about finance. Neither uni’s offer reasonable payment plans (one offers payment split over five months - £750 a month, where on earth will I get that from?!), the window has passed for funding at Uni 1 which is a part-time course and no funding is available for Uni 2 which is distance learning (funding for DL courses just doesn’t seem to exist!), I don’t have rich parents, I don’t have a secret stash of savings and I refuse to borrow extra money on my mortgage when I’m so close to paying it off. The only option I seem to have is to apply for a Professional & Career Development Loan which would be great, if I thought I stood a chance of getting accepted for one. It’s a loan from the government to help towards re-training or doing higher level study, it’s basically to help out those who aren’t eligible for a standard student loan but it’s still a loan from a bank on which they have to carry out credit checks etc which is where my concern lies, I’m not the greatest when it comes to financial matters.

Doesn’t it seem to be the case though that no matter where you’re at and no matter how much progress you think you’re making (or indeed ARE making), there’s always something else right round the bend for you to worry about. I’m a natural-born worrier anyway, so if I’m not worrying about SOMETHING it worries me why not. I’m inclined to think that’s healthy; if I’m worrying about something then it means I care about it and am passionate enough about it to have concern, but then 99.9% of the time I show myself up because, and without wanting to sound like an utter cliché, these things do have a tendency to work themselves out somehow and a solution will likely reveal itself in time.

I want to do my Masters so much. I’ll feel like a failure if I don’t even manage to scrape together enough money for it, how pathetic is that?! I’ll find a way somehow. I need to lose some weight anyway, maybe I’ll just not eat for the next year, that ought to save me a fortune!