November 2010

0%;”>The test of economic analysis

Finally, the test of any theoretical position must be how fact it explains and predicts the facts of the unfolding economic process. The analysis set out in this blog over the last two years has consistently analysed developments in the US and Chinese economics in terms of the trends in fixed investment – the theoretical reasons for this framework have also been set out. This angle of approach has been confirmed in both the case of the US and that of China – as shown in the data above. Failure to analyse the core of the situation via China’s ability to raise fixed investment, and the US’s inability to do so, or even primarily concentrating on trends in consumption, in contrast led to analysis which was proved erroneous by developments both in China and the US.

Michael Pettis of Beijing University, for example, stated at the outset of the financial crisis that: ”I continue to stand by my comment… that the US would be the first major economy out of the crisis and China one of the last.’ In reality, as author of this blog argued, the exact opposite would occur: ‘China will be the first major economy out of the crisis and it will emerge from it before the US.’ The facts clearly confirm that China was the first economy out of the crisis, that it emerged from it before the US, and the analysis that the US would be the first major economy out of the crisis and China one of the last was in error.

Stephen Roach, then Chairman of Morgan Stanley Asia, similarly focussing on consumption rather than trends in investment, argued in his book The Next Asia that it was impossible for China to achieve its 8% growth target for 2009 and that he was ceasing to be an optimist on China’s economy. This analysis was clearly not confirmed by events – China not only met but surpassed its 8% growth target and China and a number of other Asian economies have been able to far outperform developed ones.

Other writers with a different analysis to this blog were evidently confirmed in their prediction that China’s stimulus package would be a success – Jim O’Neill, of Goldman Sachs being a well known example. O’Neill, as with Stephen Roach, however saw the core of the crisis in the US as being deleveraging of the US consumer sector and therefore focused on a perspective of decline

of the US consumer which has not in fact occured – as shown above. Such an analysis, therefore, did not concentrate on the key factor in the US recession, which lay in the fixed investment fall.

The differences in analysis which explain the different prognoses that have been tested over the last two years clearly have continuing different practical conclusions. If the core of the problems in the US economy continues to be in fixed investment then it is unlikely purely indirect measures to influence this, such as a new round of quantitative easing (QE2) and the budget deficit, will be as effective as China’s direct intervention to maintain investment. Not only has China’s economy outperformed the US in the last three years but it will continue to do so – not only due to rapid growth in China but to slow growth in the US.

Only if the US were to turn to a programme of direct state intervention to boost to new investment, as urged by Richard Duncan and others, would there be likely to be a short term revival and increase in investment qualitatively equivalent to that which appeared in China’s stimulus package. However the strengthening of political trends such as the ‘Tea Party’, and the consolidation of right wing Republican control of the House of Representatives, make any such programme unlikely. The US economy will therefore continue to be hobbled, in comparison to China, by anti-statist ideology. The US economy will therefore continue to be strongly outperformed by China’s and the success of China’s stimulus package will stand in contrast to the failure of the measures which have been utilised to attempt to kick start the US economy.

Analysis of the success of China’s stimulus package, and the comparative failure of those in the US, will therefore continue to be of central importance in both practical economic policy making and discussion of economic theory.

* * *

This article orginally appeared on the blog Key Trends in Globalisation.

Footnotes

1. Attempts to point to issues in China such as asset bubbles in property prices and inflationary pressures in food prices simplly do not quantitatively compare to the fundamental fact – the stagnation of US GDP and the thirty per cent increase in China’s GDP over a three year period.T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

.411ZWith Friends Like These- the Dismemberment of the Irish EconomyBy Michael Burke

The mainstream discussion in Britain about the economic and financial crisis that has engulfed Ireland has become dominated by the question of whether British taxpayers should participate in a bailout of ‘the Irish’. Chancellor George Osborne says £8bn will be made available as part of the rescue package as it is Britain’s national interest and is ‘helping a friend in need’, while the hard Right of the Tory Party objects that cuts are being made in Britain while ‘the country pays’ to help out a member of the Eurozone.

The inability of the British establishment to discuss anything to do with Ireland without parading a series of prejudices is well-known – the inability to distinguish between an interest-bearing loan and a gift a little more surprising. The real position is that the £8bn loan will certainly be at higher interest rate (5% or more) than Britain is currently paying (3% or less), consequently making a profitable return on the ‘gift’.

But neither has the British Exchequer gone into the development finance business. Not a penny of the £8bn will be used to keep a single Irish worker in employment, or a school or a hospital from closing. In fact it is widely reported that the forthcoming Irish Budget, which will be a condition of the multilateral lending in which Britain is a junior participant, will include a further €8bn welfare and jobs cuts, as well as new cuts to jobs, investment and spending on essential services. The minimum wage is also likely to be cut, further compressing incomes and the total cuts over 4 years at least €15bn.

International Loan-Sharking

Like Greece before it , the population of Ireland within the southern state will experience the true nature of the bailout; a form of international loan-sharking. The economy and government finances have spiralled downwards because huge transfers of wealth and incomes have been made to the rich, led by the banks, to soften for them the effects of the recession. These transfers were from the poor.

The downward economic spiral naturally ran out of control, as incomes plummeted and new debts mounted. These were reflected in the soaring costs of government borrowing in the bond markets as investors viewed eventual default as an increasing likelihood. Now Irish taxpayers are being forced to take on even greater debts and to accept the extremes of further ‘austerity’ measures in a doomed attempt to pay for them. The Dublin government is the borrower – but the funds will be offered to existing creditors. As the Financial Times’s Martin Wolf remarked of the earlier Greek crisis, this is worse than Argentina’s debt crisis, as the creditors are being paid to escape, and there is no-one to replace them.

Who Benefits?

The holders of Irish government debt are mainly Europe’s financial institutions, fund managers, banks, pension and insurance funds. As the chart below shows, about 84% of the Irish government debt is foreign-owned.

Chart 1

In terms of recent bond issuance, this dominance of European financial institutions is if anything increased, with just 9% held in Ireland. European and British financial institutions are playing the leading role in this.

Chart 2

In fact, the British state-owned RBS bank is the biggest single holder of Irish government bonds, owning €4.9bn of these at the end of 2009 and €53bn in total debt assets in Ireland. It is the risk of default on this asset, along with the other holdings of the British finance sector in Irish government and bank debt, which reveals what is the actual so called ‘national interest’ that moved George Osborne to use British taxpayers’ money. This is another bailout for British banks, with the government in Dublin saddling Irish taxpayers with new debts to pay for it. This process is being replicated in all the major economies across the EU.

How Did We Get Here?

Britain and Ireland are very different countries, not least because the former occupied all or part of the latter for centuries. But one thing the London and Dublin governments share is a neo-liberal ideology learnt at the feet of Margaret Thatcher. One of the features of that ideology is a commitment to low taxes and low government spending. In reality, this is a policy which is designed to benefit capital at the expense of labour. Both Irish and British government policy is ‘reverse Robin Hood’ – take from the poor to give to the rich.

Since 1992, average government revenues in the EU have been 44.8% of GDP, compared to 39.8% for Britain and 35.6% for Ireland. Consequently, Britain is also a low-spend country, where government outlays are approximately one-eight below the EU average as a proportion of GDP. ¹ But the Dublin government took such a ‘low tax-low spend’ policy to an extreme. Average Irish government spending over that period was just 33.8% of GDP compared 47.5% for the Euro Area as a whole, that is nearly one-third below average.

For Britain, there was also an over-reliance on tax revenues from banking and financial speculation, whereas Dublin’s tax revenues were overly reliant on property speculation. In both cases the narrowness of the tax base left the economy and government finances especially vulnerable to the Great Recession. Britain had the most severe recession of any of the large European economies, while Ireland had the most severe loss of output of any economy in the Euro Area economy. Ireland’s recession seems set to enter its fourth consecutive year in January 2011.

Uniquely, the Dublin government responded to the crisis by exacerbating the recession through a series of spending cuts and tax increases, mainly the former. It is here that the most important lesson arises for policy in Britain and elsewhere. Ireland’s policy was based on the Orwellian-sounding 1984 speak phrase ‘Expansionary Fiscal Contraction’ (EFC), implying that the economy can grow while government spending is reduced, or in fact because it is reduced. This notion is based on the assumption that lower government spending will reduce interest rates and thereby encourage businesses to invest and consumers to spend. Even The Economist magazine has described recent support for such a policy from academics and, less rigorously, from Goldman Sachs as ‘seriously flawed’ . In fact SEB has already highlighted separate IMF research which argues that every cut in government spending, under current circumstances, will lead to a fall in output of twice that in the first year, and a cumulative fall of six times the initial cut over five years. ²

The Dublin government has introduced five separate Budget or emergency packages, totalling €14.6bn, since the end of 2008 and now intends to repeat the onslaught over another four years. At the outset of the process that would have been equivalent to 7.7% of GDP but is now equal to 9.3% – because of the subsequent economic slump. Irish GDP numbers are themselves inflated, in part, by US multinational corporations who park sales and profits in Ireland accrued elsewhere to avail themselves of the ultra-low corporate tax rates, which at 12.5% are the lowest in the OECD. In relation to the domestic sector, which accounts for the overwhelming bulk of tax revenues, the government measures are now equivalent to 11.5% of GNP.

The impact of the measures taken by the Irish government are clear, businesses reduced their investment further so that the collapse in gross fixed capital formation is equivalent to the entire decline in GDP. Consumers, frightened by job losses and suffering falling incomes, cut back on spending. As a result, taxation revenues slumped, from €48bn in 2007 to a government projection of €31bn in 2010. It is this €17bn disappearance of taxation revenues that is almost entirely responsible for a budget deficit, which is projected to be €18.7bn this year.³ Meanwhile, despite repeated and deep cuts in social welfare entitlements, as well as in all areas of government spending, the welfare bill has soared from €20.6bn in 2007 to €35.9bn under the impact of a surge in unemployment and growing poverty.

In Britain, the Tory-led Coalition has set out plans that will remove £111bn annually from the economy by 2014/15 4. According to the forecasts from the Office of Budge Responsibility that would then be equivalent to 6.2% of GDP. Of course, if the British Thatcherites were to emulate their co-thinkers in Dublin, each new Budget would be greeted with expressions of disappointment that cuts had not led to savings, and the dose of cuts would be increased. Given that the budget deficit in Britain is actually falling currently, courtesy of modest Labour increased spending in the 2009 Budget, that will be difficult to justify in the immediate future.

But a crucial point remains that all such ‘fiscal consolidations’ are premised on the illogical and disproven notion ‘EFC’. EFC is a mirage, the result is actually ‘Contractionary Fiscal Contraction’. That applies equally to the Tories’ savage cuts as well as all somewhat milder, slower more anguished versions of the same emanating from the Labour frontbench.

Bailout Is Not the End

Reports suggest that the Irish bailout package will be just under €100bn, so immediately doubling Ireland’s stock of outstanding national government debt. Contrary to widespread assertions, including from the Irish Finance Minister Brian Lenihan, this is not solely or even primarily a result of the extraordinary bank bailout which informed observers believe may total €76bn in losses for Irish taxpayers, as these have mostly been met already. Instead both Barclays Capital and Goldman Sachs estimate that more than two-thirds of the bailout is required to cover the public sector deficit over the next three years. It is the combination of fiscal and banking policy that has led to the bailout, and the drain from the banks could be blocked by the removal of the bank guarantee and burning the bondholders.

A similar bailout has not worked for Greece. Even though no Greek government borrowing will be required from the market for three years, Greek long-term bond yields are still 12%, reflecting a growing perception that default will eventually occur. From the mildest recession in the Euro Area in 2009 (except Cyprus), the Greek economy is now in an accelerating decline with Greece’s statistics agency Elstat saying the “significant reduction” in public spending had contributed to the deepening of the country’s recession.

The Irish bailout is widely associated with the IMF but only one-third or so of the funds is likely to come from that source. The bulk will come from the European Finance and Stability Fund (EFSF). This differs mainly in that the usual IMF package often includes some limited default or “restructuring” and losses for the bondholders in recognition of some of the losses in the market already incurred. The role of EFSF and the European Central Bank is precisely to ensure payment in full to European banks . The specific role of the IMF, representing the US, is to oppose any hike in the ultra-low corporate tax rate .

The bailout of Ireland’s economy will fail. Increasing debts and reducing incomes via ‘austerity’ measures will not resolve Ireland’s debt crisis. Moody’s, one of the leading credit ratings’ agencies has already indicated that transferring more bank to the State and the lower growth outlook will lead to a downgrade of Irish government debt , implying an increased likelihood of default. This is not the end of the crisis, either for Ireland or more widely in Europe.

Sources

1. EU, Euro Area Report, Winter 2010, Statistical Annex.

2. Will It Hurt?, IMF, World Economic Outlook, October 2010, Chapter 3.

3. Dept. Of Finance, Information Note on the Economic and Budgetary Outlook, 2011-2014, November 2010.

4. UK Treasury, Comprehensive Spending Review, October 2010.

SEB readers might like to read the piece here by Michael Burke, which appears on the TASC website in Ireland and argues that the Dublin government’s ‘National Recovery Plan’ is an asset recovery plan for bondholders.

T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

.086ZBank of England Monetary Policy Committee Member Gets It

By Michael Burke

Adam Posen, one of the external members of the Bank of England’s Monetary Policy Committee (MPC) has warned that the government’s spending cuts will cause ‘significant headwinds’ for the economy. In an interview with The Times (October 28), Posen says, ‘My forecast is that the Government’s plans for 2011 and 2012 will have a material down-drag on growth.’

Posen also highlighted key areas which would have a ‘particularly high short-term impact’- public sector job cuts, cuts to welfare spending and the VAT hike, with all of these reducing the incomes of middle-income earners and the poor- who will be forced to cut back spending. In a similar vein, the chief economist for the Chartered Institute for Personnel Development argues that not only would raising VAT hurt the same groups, but would also create an additional 200,000 job losses in retailing and related sectors, bringing the likely total job losses up to 1.6 million, not the 490,000 claimed by the Tory-led Coalition.

Posen is a US academic who has closely studied the ‘lost generation’ of slow growth and recession in Japan which has been in place since 1990, warns of increased risks have of too slow growth with a negative impact on prices. He also argues that Coalition policy choices have increased those risks, whereas an increase in Capital Gains Tax would not. (In fact from the June Budget higher rate tax payers will pay just 28% on this unearned income, compared to 50% on their salaries).

But in an echo of what SEB , Green and anti-poverty campaigners have called for, Posen’s boldest proposal is that the State-owned banks should not be privatised, but instead used to increase productive lending. ‘You can take the large banks in which the UK Government has a controlling stake and change their lending behaviour,’ he says.

‘….In my opinion the Government should be saying it is more important to the UK taxpayer right now that we have banks under our control providing more lending than that we maximise the privatisation proceeds in the near-term.

‘The historical record is it is penny-wise and pound-foolish to try to maximise the returns from the rapid resale of your nationalised banks. It is better to use them to help get out of the credit crisis and the recession….’.

A sensible word from inside the Bank of England at last.

T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

.844ZUK’s Q3 GDP figures were -an endorsement of government spending, not austerity

By Michael Burke

The UK GDP data for the 3^rd quarter have received more than usual attention, with many commentators claiming that the 0.8% growth rate provides room for the government’s ferocious cuts in government spending – even that they provide a justification for them.

The BBC’s Stephanie Flanders leads the way, arguing not only that the data will cheer the Cabinet but that these are the strongest 3^rd quarter numbers in a decade- precisely one of the lines advanced by George Osborne. If we concede that it is the BBC’s economic editor who is writing the Chancellor’s script, not the other way around, it is certainly a happy coincidence for the government to have such a like-minded and highly visible commentator. Even the Tory-supporting media were generally more circumspect than the BBC, with the exception of The Times, which declares that, ‘the deficit reduction strategy appears to be working’. Countering Nobel Laureate economist Paul Krugman’s assessment of ConDem policy that, ‘premature fiscal austerity will lead to a renewed slump’, The Times’ leader writers argue ’the evidence so far suggests that the Government’s approach is not endangering recovery’.

The essence of the Osborne/Flanders/Times argument is based on the following propositions:

• The data is strong and reflects the impact of current government policy
• This strength will mean that the private sector is well able to withstand cuts in public spending
• Because the cuts boost the confidence of the private sector

All three propositions are entirely false.

The last argument is thoroughly demolished by another Nobel Laureate Joseph Stiglitz specifically referring to Britain, where he argues that Britain cannot afford austerity and needs another stimulus package, focused on investment in education, infrastructure and technology. SEB will deal here with the first two propositions.

Impact of Policy

The first estimate of GDP is an output measure, while later assessments are based on incomes and expenditures. As such, the initial estimate can be, and frequently is revised substantially. For the time being the data shows that the recovery has been in place for a year and that the economy has grown by 2.8%, only a little more than its 2.5% long term trend growth rate. This follows a 6.4% decline over six quarters, so that the economy is still nearly 10% below its pre-recession trend growth.

One of the more absurd claims is that this recovery is in response to current government policy, since the first three quarters of the recovery took place before it came to office. Further, £6bn in cuts were announced in June and are only just being implemented. Yet the latest GDP data show direct government spending rising in both this quarter and in the 2^nd quarter, when the economy expanded by an even stronger 1.2%.

These rises in government spending represent the outcome, with a time lag, of the spending decisions of the previous Labour government in its 2009 Budget. This direct spending on government services has made a contribution to growth in both the recent quarters and cannot possibly be attributed to current government policy.

But, despite some uncertainty about the data, the biggest single contribution to growth is made by the construction sector as Gavyn Davies, former global chief economist for Goldman Sachs has pointed out. Construction, together with government services comprises more than half the entire rise in GDP in the latest 2 quarters. With in construction activity, public spending accounts directly for 42% of the overall increase. Yet its impact is actually much greater, and plays a determining role in the construction sector’s contribution to growth- in what might be described as a textbook example of the leading role of the State in the whole economy. The table below shows the year-on-year growth rate of different components of construction and the source of spending.

Table 1

The public sector led the way in the strongest growth categories of construction (including infrastructure, where it predominates), and is actually the source of the entire rebound. Where the public sector activity was weak, in housing repair, the private sector did not supplement that weakness with anything more than reasonable strength of its own.

The strength of current data, which is actually modest, reflects the increased spending of the Labour government in 2009.

Economic Outlook

This increased government spending is already fading away. The year-on-year growth of direct government spending, as well as in areas where it contributes to spending such as construction, is at or close to zero. New construction orders for example, fell by 13.9% in the 2^nd quarter. Reflecting the disastrous impact of Alistair Darling’s March 2010 ‘worse than Thatcher’ Budget, it is public demand that has led the way, with public housing orders down a scandalous 22.7% in the 2^nd quarter alone.

This is before the Coalition sets to work. The table below is reproduced from the Comprehensive Spending Review (CSR) which shows the Departmental capital spending cuts. The final column shows the real terms decline after inflation, although even this is an underestimate as it comprises both a favourable inflation estimate and ignores depreciation. The roll call of savage cuts is relentless.

There has been much discussion of whether this will provoke a ‘double-dip’ recession. It is entirely possible, but this should not be the litmus test of policy. It is quite possible, for example, that a collapse in demand arising from this policy, both for consumption and investment goods leads to a slump in imports. Statistically, this would provide a boost to GDP even while the economy is decimated. As Stiglitz says, cutbacks ‘will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties.’

It is this destructive force of government policy, especially as manifested by the persistence of falling incomes, job losses and long-term unemployment which will be the true measure of its effect. And, from Keynes’ dictum that ‘take care of the unemployed and the deficit will take care of itself’, there can be no confidence that the purported aim of government policy to reduce the deficit will be advanced in any significant way.

The Destruction of Employment

The Lib Dems’ chief secretary to the Treasury Danny Alexander leaked to the press that there would be 490,000 job losses arising from the CSR. This is to manage expectations lower; the Guardian had already obtained a Treasury estimate of 500,000 to 600,000 public sector and 600,000 to 700,000 private sector job losses. This is not the same as unemployment, as there is a trend growth in the labour force of around 30,000 per month, implying that employment has to grow at that rate simply to stabilise the unemployment level.

The chart below shows the total jobs in the British economy since the beginning of 1978. The first peak in employment during that period was 27.4mn jobs at the end of 1979. Thatcherism destroyed 2 million jobs by the beginning of 1993 and the previous peak level in jobs was not recovered until the end of 1987, 8 years later. Meanwhile, the workforce had grown by a further 2million, leading to mass long-term unemployment which hit youth, women and black and other ethnic minority communities especially hard. A new peak in employment was reached in mid-1990, at 29.2mn jobs. But 1.8 million jobs were lost over the next 3 years, so that by mid-1993 there were actually 30,000 fewer jobs than the total Margaret Thatcher had inherited in 1979. This new peak of 29.2mn jobs was not recovered until the 2^nd half of 1999.

Chart 1

The most recent recession began in 2008 and in terms of severity was almost as great as the 1980 and 1990 recessions combined – output fell by 6.4% compared to a combined decline of 7.1%. However, the total decline in jobs was 1.05mn. This is very severe loss of jobs, but not on the same scale as the total of 3.8mn lost jobs in the 1980s and 1990s. In the most recent quarter there were a net 71,000 jobs created, although these were overwhelmingly part-time jobs.

As shown in the chart below total hours worked (a measure which removes all the distortions by shifts between full-time and part-time work, as well as those introduced by repeated changes to the unemployment register) grew by 2% in the latest 2 quarters.

It is absurd of the Government Ministers and their supporters to claim credit for a job rise that took place even before they took office. Their handiwork will only become apparent in employment totals next year.

In fact, given that the employment decline has already halted, there will be no-one to blame for the destruction in jobs next year except this government.T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0