December 2011

UK stagnation turns to risk of double-dip recession

.479ZUK stagnation turns to risk of double-dip recession

By Michael Burke

The Construction Products Association (CPA) is forecasting a ‘double-dip’ UK recession for the construction industry in 2012 and compares the latest slump to that of 10 years ago – the last Tory recession under Major when 600,000 construction industry jobs were lost. The CPA is well-placed to judge the near-term outlook as it comprises all the main suppliers to the construction industry.

For most of 2011 the majority of commentary on the British economy veered between expectations of a strong boom and, more recently projections for a double-dip recession. The reality was more prosaic – with the economy stagnating, growing by just 0.5% over the latest 12-month period.

This is because most commentators ignored the actual cause of the prior recovery and the key factor which would reverse it. SEB has previously shown how the recovery was caused by the increase in government spending, both current spending (mainly increased welfare payments but also the Labour government’s cut in VAT) and increased government investment (Building Schools for the Future, etc.).

Reversal of Government Spending

The renewed economic stagnation arises because both parts of government spending have now been cut. Welfare benefits have been cut, which is disastrous for many recipients but also undermines household consumption as does the hike in VAT. Household consumption is the biggest single category of GDP. The policies that supported household consumption added 1.2% to GDP growth during the recovery and until Labour left office. In the period since the Tories took office the decline in household consumption has reduced GDP by 0.6%. Similarly government investment increased under Labour and directly added 0.8% to GDP over the course of the recession. Government investment fell immediately the Tory-led Coalition took office and has subtracted 1.0% from GDP over that period.

Taken together the combined effects of Labour’s increased spending added 1.8% to GDP, while the policies of this government have subtracted 1.6% from GDP.

Effects of Changing Fiscal Stance

The March 2011 Budget detailed a ‘fiscal tightening’, that is tax increases (except for companies) and spending cuts amounting to £41bn. By the 3rd quarter approximately half of that tightening will have taken place as it is 6 months into the Financial Year. £41bn is approximately equivalent to 2.7% of GDP. The previous recovery saw the economy expand by 2.8% over 5 quarters. Therefore the direct effect of the fiscal tightening currently under way is to remove growth almost entirely from the economy, hence stagnation.

Unfortunately the extent of the damage does not end there. The fiscal tightening is only half-complete this year and yet there is already stagnation. This is because each sector of the economy is connected to the other. So, declining government spending in the form of firing public sector workers will lead to falling household consumption, and both will affect business investment.

Since each economic sector responds variably to a change in another sector’s activity, and often with a time lag, it is impossible to assign a precisely distributed causal effect of a change in fiscal policy. But we have noted above that Labour’s increased spending of 1.8% of GDP led to a recovery which added 2.8% to GDP. This demonstrates the way the state can lead economic activity in total. This is what Keynes called the ‘multiplier effect’ as the private sector responds to increased government spending. In this case the multiplier is 1.56 (the ratio of 2.8% to increased spending equal to 1.8% of GDP).

In reality the multiplier is probably considerably higher as there is a pronounced time lag while the business sector responds to changes in government spending. SEB has previously shown that private sector investment has consistently risen or fallen 6 months after changes in output. So, the private sector continued to invest for 6 months after the Coalition took office, and this was in response to the increased spending by the Labour government.

Therefore, without taking account of other factors such as net exports or an unwanted build-up of inventories, the direct and indirect impact of the current government’s cuts should be multiplied by 1.56. This would subtract 4.2% from GDP and almost certainly lead to renewed economic contraction. The government also plans £61bn of fiscal tightening in the next Financial Year, beginning in April.

Construction Investment

The construction sector is highly responsive to the business cycle as it relies on a high level of current investment. The CPA estimate that it is headed for a double-dip recession is therefore highly significant. This will sharpen the already acute shortage of affordable homes, either to buy or rent at a time when 300,000 construction workers have already been made unemployed. Local authorities throughout Britain are desperate for funds to build new homes, from which they could derive an income way above the cost of borrowing even with affordable rents. Instead of providing funds to them, George Osborne has provided £40bn in ‘credit easing’ to small and medium sized enterprises. They will not build homes, provide decent affordable housing and employ workers with these funds.

But the State could because it is a vastly more efficient provider of large-scale housing as well as infrastructure projects. The government and its supporters like to promote the falsehood that ‘there is no money left’. But £40bn of loans to local authorities and public bodies could go a long way to easing the housing crisis. It would also go some way to averting the likelihood of a double dip recession.

From the government’s perspective the only stumbling-block is that it would remove the main responsibility for construction from the hands of the private sector and place it in the hands of the public sector. This is of course what happened to most of the shareholder-held banking sector in Britain during the last crisis. It seems that nationalisation is only permissible when bondholders and shareholders are being rescued. But it is not allowed if it is to rescue the unemployed, those paying extortionate rents for substandard homes or even the economy as a whole.

When British thieves and French thieves fall out – the Anglo-French governmental dispute in perspective

.413ZWhen British thieves and French thieves fall out – the Anglo-French governmental dispute in perspective

By Michael Burke

The French and British authorities are engaged in a war of words over which country will be first to be downgraded by the credit ratings agencies. At least the hostilities are purely verbal – these ‘heroes’ of Tripoli are prepared to use other methods when the odds are overwhelmingly in their favour.

The immediate cause of the dispute was initially the remarks of French central bank governor Noyer. In response to the threat from Standard & Poor’s (S&P), one of the credit ratings agencies, that France would be downgraded, he argued that Britain should be downgraded first because its economic fundamentals are worse than those of France.

The remarks caused predictable uproar in Britain. Even the leadership of the LibDems, the main representatives of the pro-EU business class in Britain discovered its nationalist roots and criticised the remarks. But Noyer argued that, ‘they [S&P] should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping’. Essentially, Noyer is correct on the relative ‘fundamentals’. But this focus on the ‘fundamentals’ also demonstrates a shared and thorough misunderstanding of the nature of the crisis.

The table below shows the relative levels for each of the indicators specified by Noyer. The estimates are taken from the EU Commission Autumn forecasts.

Table 1

11 12 22 Table 1

It is clear that the Noyer observations are correct. The British government’s credit rating is also under threat as the economy weakens. Yet France’s downgrade seems likely to happen even sooner. More importantly, the French government is currently paying over one per cent more for 10 year government debt than the UK so that its effective market rating is already lower than Britain’s. This is despite the lower deficit, lower inflation and higher growth in France.

This demonstrates that Noyer is looking in the wrong place for the determinants of bond yields. Bond yields are not primarily determined by the nominal level even of important economic variables. Ultimately the price of any given financial market asset is determined by the real level of savings that are directed towards it. In countries such as Britain, the US and Japan the very high level of corporate savings must ultimately be held in some financial asset, and in the current circumstances of weak or stagnant growth government bonds have looked far more attractive than their only main alternative, which is stocks. 10 year debt yields are currently below 2% in the US and below 1% in Japan. This is true even though government debt and deficit levels are even higher in the US and Japan than either France or Britain. UK companies cannot invest in financial instruments in another currency without exposing themselves to exchange rate risk.

For investors in French government bonds the situation is different. There is an easy alternative – German government bonds also denominated in Euros. The rising premium on French yields represents the increased perceived risk of the Euro breaking up, in which case investors prefer to hold the debt of the strongest economy in the Euro Area.

The key relevant ‘fundamental’ for the Eurozone is that investors may choose between different governments’ credits. That is, there is a market mechanism for redirecting savings towards one country – and there is no fiscal mechanism to transfer savings in the opposite direction. Just as in other Eurozone economies, bond yields started to rise in France as soon as ‘austerity’ measures were introduced. Investors based in the Euro have greater prospects of being repaid if they invest in government bonds where the economy will grow, not stagnate or decline.

French and British Both Wrong

The growth outlook is sharply deteriorating in both France and Britain. In the Spring Forecast the EU Commission was projecting 2% growth for both Britain and France in 2012. In the Autumn Forecast the Commission is forecasting just 0.6% growth. Both governments are pursuing ‘austerity’ policies which are clearly not working.

They have both also invested an enormous political capital in the maintenance of the AAA rating for their government debt and argued that their policies would reduce their budget deficits. As we have seen, both governments debt ratings are likely to be downgraded in 2012. And both countries are projected to have a deficit in 2013 which, five years after the recession began, is still double the level it was in 2007, before downturn began.

The failure of their policies has led not to a re-think, but in both cases to blaming foreigners. The unwillingness to correct a failed policy is the cause of the diversionary war of words between the two governments.

The most ridiculous aspect of their policy is that both governments claim that their policy is driven by the demands of financial markets. Yet the government bond markets are sending a very clear signal. Long-term interest rates are either at the current inflation rate as in France, or below it in Britain. They are so low because businesses are saving, not investing. Businesses feel more confident lending to the government than investing on their own account. But both governments insist on cutting spending. If that leads to renewed recession the effect will be to cut further the level of savings in the economy – and bond yields may start to rise.

Corporate savings are being lent to the governments at exceptionally low interest rates. This glut of corporate savings could be used to invest for recovery. Since businesses themselves refuse to do this, only the state can end the company investment strike.

EU Summit Is Another Failure for ‘Austerity’

.047ZEU Summit Is Another Failure for ‘Austerity’

By Michael Burke

The outcome of the EU summit has widely been hailed in the British media as a triumph for David Cameron. It is rare that a complete rupture and isolation in multi-party negotiations is regarded as a triumph – but this is a function of the dominant and still growing xenophobia of the British press.

The EU Commission will now impose further spending cuts and rules to enforce deficit limits across the whole of the EU. David Cameron did not oppose these measures because they lead to public spending cuts- he is cutting public spending by a greater proportion of GDP than any major country which has not been in receipt of EU/IMF funds for its creditors.

Cameron’s stated objective was a defence of the interests of the City of London. There is a question mark over whether he has even be able to achieve that. Angela Knight, former Tory MP and chief spokesperson for the British Bankers Association guardedly told The Times that she hoped that City’s interests would not be harmed by Britain’s isolation.

Holding Back the Tide

‘Let all men know how empty and powerless is the power of kings’. So said King Canute in demonstrating to sycophantic courtiers the impossibility of instructing the advancing tidewaters to retreat. But it seems that the thinking of the EU Commission has retreated behind even that of Dark Age monarchs.

In response to the economic, fiscal and balance of payments crises in Europe, the EU summit in Brussels agreed to issue a series of regulations- to prevent these crises being manifest at the level of government deficits. A new rule that so-called structural deficits will not exceed 0.5% of GDP has been introduced . The EU Commission will be given prior oversight of the national Budgets. Given the impossibility of factually establishing the level of the structural deficit (which depends on extremely approximate estimates of potential output) then the combination is a recipe for complete control by the EU Commission – the economic geniuses who have led Greece and Ireland to disaster.

While it is impossible to precisely quantify the structural deficit it is practically impossible to determine the level of the government deficit simply by controlling spending. This is because the deficit reflects the gap between government spending and income. Government incomes are overwhelmingly taxation revenues and these are determined by the spending of consumers and the spending of businesses (primarily investment).

To achieve the precise control over its own income, as demanded by the new agreement, the European governments would have to determine the incomes and spending of both other main sectors of the economy, consumers and businesses. And, in a currency union it would also have to ensure that the overseas sector was not a significant net lender or borrower (through large trade or current account deficits/surpluses). Otherwise, if the other domestic sectors remained in broad balance, a large trade deficit could only result in a large government deficit.

This is show in Figure 1 below. The chart shows the sectoral balances in leading EU economies and the EU as well as the change between 2006 and 2009. The chart is taken from the Financial Times and is based on OECD data.

Figure 1


Simple national accounting identities mean that the increased savings of one sector of the economy must be reflected in the increased deficit of another. In all cases the balances shown below, the government balance (the public sector deficit/surplus), the private sector balances (the savings/consumption of the private sector) and the overseas sector (the current account balance) sums to zero, as they must.

Within each national economy of the EU it is impossible to legislate for the deficit of the public sector without determining the savings, consumption and investment decisions of all other sectors of the economy.

It is also entirely impossible in a single currency area for all other economies to maintain government balances if one or more key countries have large current account surpluses, as is presently the case with Germany and others. Other countries must then run current account deficits and to simultaneously maintain a government balance they are faced with two unacceptable alternatives. They must either hugely increase household savings even though incomes are declining; that is, household spending must fall even faster than incomes. Alternatively, businesses must reduce investment to well below the level of its income, which could only lead to a further reduction in competitiveness and a renewed widening of the current account deficit. This is the downward spiral that countries like Greece have already entered.

The Tory Position

David Cameron did not object to any of this because he is a champion of increased government spending, or a defender of the welfare state. Nor has his government shown any appreciation of the fact that reduced government spending will also reduce the incomes of other sectors of the economy.

Instead, his objection was to the threat to the City’s ability to siphon off funds from other businesses in Europe. He may not have been successful even in that limited aim. Ed Miliband writing in the Evening Standard argued that Cameron was ‘a prisoner of the Tory Right’ and had isolated himself and Britain from the continuing evolution of policy in Europe.

While willing the other EU national leaders to act decisively to halt the crisis, Cameron himself acted to prevent that happening. Defending the sectional interest of the City and relying on some of the most backward political forces in Britain, Cameron has finally crossed a line that even Thatcher only threatened to do. There will be no benefit to the British economy from this decision and the consequences could prove extremely negative. If, for example, overseas multinationals decide they want a base in the EU, will they choose semi-detached Britain or one of the other 26 countries who continue to have a common regulatory regime? If the British economy suffers as a result, it should be remembered this was done to benefit the City of London and to appease the Tory Eurosceptics and Union Jack-wavers.

George Osborne Shows He’s Learnt Nothing from Greece or Ireland

.654ZGeorge Osborne Shows He’s Learnt Nothing from Greece or Ireland

By Michael Burke

The Autumn Statement was widely presented as facing up to harsh realities of slower growth, but with George Osborne offering a series of cunning schemes in order to resolve the crisis .

The stagnation of the British economy is a function of government policy and plans to increase investment by increasing the credit available to smaller firms will founder because they will not invest when they don’t expect to make profits .

SEB has long argued that government needs to increase investment in a series of areas. Surely, the government’s plans to increase investment in infrastructure should be welcome? But the government’s planned increase amounts to less than £3.8bn spread over four years, or less than 0.1% of GDP in each year. In addition, most of the wish list for infrastructure and capital projects is dependent on investment in the private sector. So, George Osborne and Boris Johnson stood outside Battersea power station in London and talks of new tube lines, enterprise zones and 25,000 jobs. Just two days later the private developer central to the project collapsed into receivership.

Worse, the government’s planned increase in capital spending is paid for by taking money from the pockets of the poorest and most vulnerable in society. These will bite much harder in later years, long after the pathetically small planned increased in investment has come to an end. This is shown in the table below, from the Autumn Statement.

Table 1

11 12 05 Table 1


So, there are total cuts in current spending in 2012/13 of £910mn and total cuts over the next 3 years of £3.8bn, shown as a positive sign in the Treasury bookkeeping method. This is in order to pay for tax cuts (fuel duty) and a projected increase in capital spending. But in the two following years the projected cuts to current spending increase dramatically for a total of over £27bn cuts in all. Although these are mostly unspecified, the itemised cuts include child tax credits, working tax credits, real public sector pay cuts and the breaking of the promise to uphold overseas development aid at 0.7%.

This is a very damaging but much milder version of the same logic that has led Greece and Ireland to disaster – every failure to meet budgetary targets because of the impact of ‘austerity’ is met by further ‘austerity’ measures. But the deficit is and borrowing totals are likely to go higher still as the economy stagnates- or worse. It may only be a matter of time before this same logic produces comparably savage cuts in spending- with the same economic consequences.

Politically, by pre-announcing needed cuts for the next Parliament Osborne hopes to bind all parties to further ‘austerity’ measures. For the LibDems, Danny Alexander has already proved obliging, signing up to Tory cuts of £23bn in the next Parliament. The key question is whether Labour will go down the same path in accepting the need for cuts even when they have demonstrably failed to deliver economic growth or even deficit-reduction. It is the path that leads to Athens and must be resisted.