Uncategorized

Economic downturn in the UK now twice as bad as in the Eurozone due to government deficit cutting

Economic downturn in the UK now twice as bad as in the Eurozone due to government deficit cutting
By John Ross

One of the more factually inaccurate pictures being spread by supporters of the policies of the present UK government – with its priority to budget deficit reduction – is that UK economic performance during the financial crisis is superior to that of the evidently crisis hit Eurozone. A typical version of this appears in an article on 3 October in the Daily Telegraph by its international business editor Ambrose Evans-Pritchard.

Evans-Pritchard states: ‘My sympathies go to the hard-working citizens of Germany, Spain, Italy, Portugal, and Ireland for being led into this impasse [the Eurozone] by foolish elites.’ Presumably Evans-Pritchard’s sympathy goes to the inhabitants of the Eurozone, rather than his own country the UK, because he believes the UK has been doing better than the Eurozone.

The factual situation is the exact opposite of the impression presented by Evans-Pritchard. Judged by economic performance, the average citizen of the UK far more needs Evans-Pritchard’s sympathy than the average citizen of the Eurozone – i.e. the UK’s economic performance during the financial crisis is much worse than that of the Eurozone. This may be seen in Figure 1 – which shows UK GDP compared to that of the Eurozone since the peak of pre-financial crisis output. Comparison is straightforward as in both the Eurozone and the UK the peak of the previous business cycle was in the 1st quarter of 2008.

By the 2nd quarter of 2011, that is 14 quarters after the peak of the previous cycle, Eurozone GDP was 2.0 per cent below its previous peak level whereas UK GDP was 3.9 per cent below its previous peak – i.e. UK economic performance was almost twice as bad as that of the Eurozone.

Figure 1

11 10 03 UK & Eurozone GDP

Equally striking is the clear way in which present government’s policies made UK economic performance worse than in the Eurozone. It may be seen from Figure 1 that while the initial decline in UK GDP was greater than in the Eurozone – the greatest decline in UK GDP being 6.4 per cent registered in the 3rd quarter of 2009, compared to a maximum Eurozone drop of 5.5 per cent in the 2nd quarter of 2009 – recovery in the UK was also initially more rapid. This may be clearly seen in Figure 2, which shows year on year GDP changes.

The UK and the Eurozone reached their 1st quarter 2008 peaks with almost exactly the same economic momentum behind them – 1.9 per cent growth in the previous year in the UK and 2.0 per cent in the Eurozone. However by the 3rd quarter of 2010, the one immediately following the departure of the  previous government, UK GDP was rising at 2.5 per cent compared to 2.0 per cent in the Eurozone. Eurozone recovery subsequently slowed somewhat to 1.6 per cent by the 2nd quarter of 2011.

However UK GDP growth under the new government, which gave priority to budget deficit reduction, dropped astonishingly, by more than two thirds, from 2.5 per cent to 0.7%. Under the new government the year on year growth of UK GDP therefore fell from being higher than that of the Eurozone to being less than half that of the Eurozone!

Figure 2

11 10 03 YK & Eurozone YonY

The present author is not a supporter of the present constitution of the Euro. On the contrary I predicted the current events unfolding in Greece and other countries in advance due to fundamental weakness in the design of the Euro. Writing in 1996, i.e. fifteen years ago:’ [the Treaty of] Maastricht’s proposals are … disastrous. It proposes to create the most fundamental features of a common state — a single currency and a central bank. But it does not create any state budget which can deal with the huge regional and sectoral implications of this. The process that would unfold with the creation of a single currency by this method may be predicted with certainty. Substantial parts of the EU… will be pushed into severe recession if they join.There will be sharply deepening regional imbalances and inequalities.’There is evidently no reason to revise that analysis.
It is therefore all the more striking that UK economic performance is actually worse than in the Eurozone. And a substantial reason it is worse is clearly due to the policies of the present government with their priority to budget deficit reduction.

In any discussion of the relative economic performance of the Eurozone and the UK two fundamental facts must be held in mind against unsubstantiated myths:

  • UK economic performance during the financial crisis is substantially worse, almost twice as bad, as that of the Eurozone.
  • And the reason it is that bad is because the present government, through its priority to cutting the budget deficit, reduced the UK’s rate of economic recovery from substantially above that of the Eurozone to less than half that of the Eurozone.

This factual situation evidently has a more general economic significance than merely for the UK and the Eurozone. For reasons dealt with frequently on this blog a policy of simply running budget deficits is inadequate to deal with the consequences of the present financial crisis as it does not tackle its driving force – the decline in investment. But under conditions of private sector weakness any rapid reduction in the budget deficit will lead to rapid economic slowdown or contraction. This is sharply illustrated by the fact that the UK government, by such policies, has reduced the UK’s rate of economic recovery to less than half that of the openly crisis struck Eurozone.

Other countries thinking of embarking on immediate deficit reduction policies, such as those advocated by the Republicans in the US, should look at the UK and draw the appropriate negative conclusions. Do not be totally distracted by financial fireworks: the policies of the present UK government are so bad they have produced an economic recovery which is only half that of the Eurozone!

*   *   *
This article originally appeared on Key Trends in Globalisation.T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

Move towards some sensible ideas from Samuel Brittan

Move towards some sensible ideas from Samuel Brittan
By Michael Burke

The Financial Times’ veteran economics commentator Samuel Brittan has recently argued for the state’s holdings in the banks to be used as the basis for creating a new state bank focused on productive investment.

Echoing calls from Adam Posen, he argues that the disastrous fall in both the money supply and bank lending needs to be corrected by decisive state action. Posen is perhaps the sole member of the current Bank of England Monetary Policy Committee who understands the gravity of the current situation and is not constrained by official orthodoxy in seeking remedies l.

These are similar ideas as those outlined in the recent pamphlet, ‘A Brighter Economic Vision for Britain. Brittan says his own proposal, ‘…is to use the state-owned banks as the nucleus of Mr Posen’s proposed state lending bank for small and medium enterprises. Who knows what obstacles well-paid lawyers could think up? But in principle this could start next week. The main thing needed would be a Treasury directive to these banks to replace profit maximisation with a requirement to promote economic recovery.’

One reason for the renewed slump in the share price of leading British banks is their exposure to the sovereign debt crisis. Yet Lloyds-TSB Bank, for example has seen the price of its shares fall from 74p at the time of the government’s share-buying programme to 34p as at the close of trading on September 23. This compare to the collapse of RBS’ share price to 22p compared to the government purchase price of 52p – despite the fact that (aside from the US and Britain) Lloyds has no significant exposures to sovereign debt markets at all.

This highlights the fact that the main driver of the slump in banks’ shares is not primarily the debt crisis, severe though that it is. The share prices have collapsed because of economic weakness and the deterioration in the banks’ existing loan book, personal, business, mortgage and other loans.

Therefore it is possible to differ with Brittan’s analysis in two respects. First, the banks’ refusal to lend is driving both the fall in profits and the share price on which it rests. They are not ‘maximising profits’ but hoarding capital in order to preserve it. A government instruction to lend is the only way to break the lending and investment strike. Secondly, it is a widespread misconception that small and medium-sized enterprises (SMEs) are the key to growth. In reality, outside the personal services sector they mainly provide inputs to much larger firms. Bundling up loans to SMEs will not create the investment demand for smaller firms’ output. The largest firms show no intention of increasing their own investment – which is what is required.

Instead, only government can break the log-jam by initiating investment in housing, in infrastructure, in transport and in education. The private sector would benefit. These contracts would mainly be awarded to large firms but they tend to sub-contract or purchase inputs from SMEs and individuals. It is this process which creates employment at the SMEs.

But this is a disagreement only about the nature and direction of the required policy. The basic thrust of the Brittan analysis is correct. Bank lending and money supply are collapsing along with the banks’ share prices. The banks contain the resources to correct the slump, yet refuse to do so. They are in public ownership. All that is required is a government instruction to fund the large-scale investment that is required to produce a recovery.T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

Eurozone rescue packages will continue to fail until they deal with the central issue in Europe’s recession

Eurozone rescue packages will continue to fail until they deal with the central issue in Europe’s recession
By John Ross

The international financial system is passing through the agony of a new round of the Eurozone debt crisis for the simple reason that European governments, like that in the US, refuse to deal with the core of the economic recession in Europe for reasons of economic dogma.

Anyone who looks at the economic data for the Eurozone without wearing ideological blinkers can see the situation at once – it is charted in Figure 1. The Eurozone recession is due to a collapse in fixed investment. Taking OECD data, at inflation adjusted prices and fixed parity purchasing powers (PPPs), then between the last quarter before the recession, the 1st quarter of 2008, and the 2nd quarter of 2011 Eurozone GDP fell by $204bn. But private consumption declined by only $29bn while the net trade balance increased by $32bn and government consumption rose by $91bn.

However fixed investment fell by $290bn – i.e. the recession in the Eurozone was wholly due to the fixed investment decline

Figure 1

11 09 17 Eurozone GDP

Equally evidently, due to its scale, until this fall in investment is reversed it will take a prolonged period for the recession to be overcome. Therefore to restore growth, which by now is generally realised is the core to turning round the budget deficit problem, the fixed investment decline must be overcome.

Nor is there anything mysterious about how to do this – the state has entirely adequate means. To take the most decisive international case China made the core of its stimulus package direct state investment particularly aimed at infrastructure and housing – the result being that China’s economy has grown by over thirty per cent in three years.

Europe and the US clearly do not have the scale of state sector, nor the political willingness, to act on the scale China did. But US history shows that even without proceeding to a socialist scale of measures direct state intervention on investment is entirely possible.

Roosevelt expanded US state investment from 3.4% of GDP to 5.0% between 1933 and 1936 (data from US Bureau of Economic Analysis Table 1.5.5). Jason Scott Smith, in his study of New Deal public spending, summarises such investment as including 480 airports, 78,000 bridges, 572,000 miles of highway – which, in addition to its immediate effect in stimulating demand, reinforced the productive position of the US economy. Roosevelt, it is superfluous to point out, was neither a socialist nor a communist (despite claims to the contrary by the US right!).

Quarterly, up to date, data is regrettably not available on what is occurring across the Eurozone for state investment, but it is available for the US and there is no reason to suppose, with  current policies, that the situation in Europe is any better. Between the peak of the previous US business cycle, in the 4th quarter of 2007, and the 2nd quarter of 2011 US private fixed investment fell from 15.8% of GDP to 12.2% – i.e. a decline of 3.6% of GDP. Yet in the same period US state investment did not compensate but also fell marginally – from 3.3% of GDP to 3.2% of GDP. Therefore while Roosevelt expanded the weight of US state investment current US administrations have been letting it fall.

Instead of directly addressing the core issue of the investment fall European administrations are either attempting to stimulate it indirectly – which, as it is ineffective, has led to fiscal/sovereign debt crises, or are acting via expansion of the money supply – which, in a situation whereby companies and households are paying down debt, is merely the famous ‘pushing on a piece of string’.
The most favourable outcome of such a situation is that eventually the debt will be paid down, but only after several years of stagnation. The less favourable variant, of course, is that the banking system breaks under the strain and renewed recession is further propelled by fiscal cutbacks. All these problems simply arise from the fact that, under the rubric of the dogma ‘private equals good, state equals bad’, European governments refuse to use the state tools available to deal with the investment fall which is at the core of the Eurozone recession.

Some European politicians are now beginning to call for state measures to increase investment, UK Business Secretary Vince Cable being one. But the action they envisage so far is inadequate to deal with the scale of the investment fall.

China’s economy, which does not have such ideological inhibitions, will continue to expand while the Eurozone remains relatively stagnant for a significant period – and as long as economic stagnation continues there will be no resolving of the Eurozone debt crisis.T Walkerhttps://www.blogger.com/profile/11107827543023820698noreply@blogger.com0

A Brighter Economic Future For Britain

A Brighter Economic Future For BritainBy Michael Burke

‘A Brighter Economic Future for Britain’ is the title of a new pamphlet co-written by the present author and Professors George Irvin and John Weeks. In the Guardian we set out the rationale for the publication:

‘The UK depression has already lasted three years, and NIESR argues that is likely to last five years or more – longer than that of 1930s.

Yet economic debate is dominated by counterproductive attempts to reduce the deficit through cuts in public spending, which are now the single most important cause of the depression.’

The full article can be read here.

In an argument that will be familiar to regular readers of SEB, the pamphlet argues that public spending cuts are counter-productive both in terms of reviving growth and in reducing the public sector deficit. This is because the deficit itself is primarily a product of the depression.

Further the underlying cause of the depression is a private sector investment decline, which by the end of the 1st quarter of 2011 accounted for 80% of the total lost output since the economy began to contract 3 years earlier – that, is £44.9bn of a total of £56.3bn.

Therefore breaking that investment strike is a pre-requisite to any sustained recovery. By investing in areas such as housing, transport, infrastructure and education, the government can lead an economic recovery that meets acute economic needs and reverses the rise in joblessness.

The pamphlet puts forward two related solutions to the crisis- the creation of a state-owned Investment Bank and using the excess capital at the state-owned banks to fund the needed investment.

Importantly, this analysis is beginning to win political support. In welcoming the attempt to turn the debate towards an investment-led recovery Jon Trickett MP argues in a foreword to the pamphlet,

‘Collapsing investment hits current growth and long-term productivity…..Working on the premise that we must tackle investment and long-term competitiveness the authors argue that one way forward which would increase demand in the economy, and raise both employment and productivity, would be to take action now to address this issue…..The pamphlet sets out one idea from the authors to tackle this collapse investment; a National Investment Bank, using the government’s majority stake in Lloyds-TSB and RBS…..There are those who would argue that this would indeed be poetic justice.’

The continued economic stagnation in Britain and some other leading economies will force a reconsideration of policy even among the architects of the current crisis and their supporters. In Britain , though, a Tory economic ‘Plan B’ is likely to include privatisation, deregulation as well as attacks on social protections such as maternity/paternity leave, pensions and an abuse of youth ‘training’ programmes to provide unpaid labour. But none of this will alter the basic problem that private firms are sitting on hoards of cash that they refuse to invest, while also leading to further impoverishment for the overwhelming majority of the population.

Likewise, since at least the ‘worse than Thatcher’ New Labour Budget of 2010 there are many now on the opposition benches who fundamentally agree with the ‘austerity’ policy. They merely advocate slower, shallower, more anguished cuts. But as the economy has already stalled under the impact of less severe cuts than they would now be implementing, the Labour supporters of cuts are also obliged to look for a ‘Plan B’. Whether they move towards Osborne, or in the direction of state investment to generate recovery remains to be seen.

In any event, as the pamphlet argues there can be no suggestion of a sustained recovery without replacing the policy of cuts with a government-led investment recovery.

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

Social Unrest and Government Policy

Social Unrest and Government Policy

By Michael Burke

There’s a very good piece on LabourList titled ‘Who Didn’t Predict a Riot?’ It lists many of the bodies or leading individuals who warned that deep cuts to public spending would lead to social unrest and violence. The short piece is worth reading in full, but here is a (far from exhaustive) list of those who did predict riots and civil disturbances because of the policies of the Tory-led government:

  • Derek Barnett, president of the Police Superintendents’ Association
  • The Commissioner of the Metropolitan Police
  • Karen Ward, senior economist at HSBC
  • The Governor of the Bank of England
  • The Archbishop of Canterbury
  • Nick Clegg, and not least,
  • Youth workers in some of the affected areas

The latter prediction was made in response to the closure of most of the youth clubs in Haringey, but all the warnings were made in an assessment of the impact of the cuts.

The disturbances were therefore not only a predictable cause of the government’s policies, they were predicted by a broad array of specialists and commentators, many of whom are not particularly hostile to the government (and one is a leading member of it). Based on historical experience, not least the effects of Thatcher’s cuts in the early 1980s, it was inevitable that riots and other disturbances would follow as a consequence of government policy. The list is a bit long and comprehensive for the Tories to dismiss them all as excusing rioting – although doubtless that won’t stop them.

Analysis from the Guardian has shown that, while rioting and looting include many layers of society and has many motivations, the striking fact is that of those currently charged with offences, 41% live in the most deprived 10% of areas in England. This too is predictable. As bodies such as the Institute for Fiscal Studies have pointed out, the poorest have been hardest hit by the cuts. Therefore, just as it is inevitable that deep cuts to public spending will lead to social unrest, those most harmed by the cuts, or at least some living in those communities will be at the forefront of that unrest. Latest analysis from the TUC shows that in some of the riot-affected areas there are 20 jobskeekers for every job vacancy.

Of course, even in the most deprived areas, the majority of people do not riot, still fewer engage in looting or approve of it. But opinion polls also show that while most think the police responded well to the riots (despite widespread media criticism of them) most also believe that David Cameron, Theresa May and Boris Johnson did not respond well to the riots.

Strikingly, while a majority of between 8% and 10% believe that government policies on welfare, education and law and order will make matters worse, double that level, 20% believe that government economic policies will have the same effect. A net 23% also oppose the cuts to police budgets.

Although opinion polls only ever represent a snapshot, and views expressed are often contradictory, this set of opinions reflects a fundamental truth. Government policies are not only impoverishing the majority, they have predictably led to violent social unrest. The continuation of these policies will only exacerbate those trends.

Tory policies are making the overwhelming majority worse off while also making their neighbourhoods and town centres less safe.

Economic Crisis Is Cause of Deficits, Not Vice Versa

Economic Crisis Is Cause of Deficits, Not Vice Versa

By Michael Burke

SEB has repeatedly argued that it is the economic crisis which has caused the rise in government budget deficits, not vice versa. This view is reinforced by the recent gyrations in global financial markets. .

This issue is crucial for the debate on economic policy, as understanding the real factual situation clearly leads to promoting growth as the means to tackle the deficits. By contrast, an analysis which suggests that it is the increase in government spending which has caused the economic slowdown can simply be addressed by cutting that spending.

The latter is the policy pursued by the Tory-led Coalition. It has strong ideological support across the media, including the BBC. It is not at all based on the facts. Before the Great Recession began in 2008 the public sector deficit in the UK economy was 2.7% of GDP. It rose to nearly 4 times that level in 2010 at 10.4% of GDP. The same is true across the Euro Area as a whole, where the deficit was a negligible 0.7% of GDP in 2007, and rose to 6% last year.1 The same pattern is evident in the US where the deficit rose from 2.8% to 10% of GDP, and in Japan from 2.4% to 9.7%. The public sector deficits in all cases rose under the impact of the recession and the varied efforts of governments to offset its effects. There is a very useful dissection of the sources of the US deficit here from Professor John Weeks . In the US as elsewhere, the deficit is driven by the fall in both income and corporate tax revenues, and a rise in unemployment benefit payments as the jobless total rose.

The recent turmoil in financial markets arises because of the accumulating evidence of a renewed slowdown in economic activity, including both in the US and Europe. But this has not prevented the widespread assertion that the turmoil was caused by the European debt crisis. This is to compound the initial error, which also views the world through the wrong end of the telescope and holds that deficits are causing the slowdown.

A characteristic example of this incorrect assertion comes from the BBC’s business editor Robert Peston. On August 7 Peston wrote: ‘Although bankers say the downgrading of America’s credit rating was unwelcome, their more pressing worry is the rising price Italy has to pay to borrow – the rising price of Italian government debt’. Italy is extremely important, as it is both the third largest economy in the Euro Area and has the largest level of outstanding government debt. But the yields on Italian government debt had peaked on August 4, and as the chart below shows fell continuously through the following week.

Figure 1 Italian government debt yields

11 08 16 Italian bonds

Bond prices rose for all EU governments and their yields fell as the ECB bought €22bn in EU government debt. This is a welcome departure from the ECB, and represents a further small step in the direction of EU-wide solution to the crisis rather than further attacks on ‘peripheral’ economies. It is also likely to be insufficient given the scale of the deficits and existing debts in the Euro Area. But it is clear from the chart that the continued turmoil in stock markets is not driven by EU bond markets – they had stabilised.

At the time of writing, most major stock markets are falling once more in reaction to the weak German GDP for the 2nd quarter, up just 0.1% in the quarter. By contrast government bond prices are rising and yields falling – in the case of Germany and the US to new record lows . And bond yields for the crisis-hit European countries are now back at levels last seen a month ago, before the EU summit on Greece.

The same cannot be said for stock markets. The chart below shows the performance of leading stock markets. All the major stock indices of the US, Germany, France and Britain are nursing losses in the range of 5-10% – the exception is the Shanghai Composite Index which has recovered all the recent lost ground.

Figure 2 Major Stock Market Indices

11 08 16 Stocks

There is a clear message from the divergent paths of major financial markets in recent days. Stocks have fallen and bonds have risen because growth is weakening once more. The markets have taken fright not from public sector deficits, which remain large – yet bond yields are falling. They have taken fright from slowing economic activity. Financial markets are not clamouring for spending cuts, VAT hikes and job losses. The remedy they seek is the one that is necessary for the economy- a return to growth.

Notes

1. Eurostat, Euro Area Spring Forecasts 2011,

More than three years without full economic recovery in the developed economies – the latest GDP figures in context

More than three years without full economic recovery in the developed economies – the latest GDP figures in context

By John Ross

The publication of the European Union (EU) and German 2nd quarter GDP figures, following those for the US and Japan, completes the data regarding the state of the business recovery in the main developed economies. The picture is completely clear – Figure 1:

  • By the 2nd quarter of 2011 none of the major regions among the developed economies has recovered their peak level of GDP more than three years after the high point of the previous business cycle.
  • US GDP is 0.4% below its peak level in the the 4th quarter of 2007.
  • EU GDP is 1.8% below its peak level in the 1st quarter of 2008.
  • Japan’s GDP is 6.0% below its peak level in the 1st quarter of 2008 – Japan’s data is of course affected by the earthquake and tsunami.

Overall, taking the period as a whole, this represents over three years of net negative growth in the developed economies. The key economic issue is not the possibility of a double dip recession, which the media is speculating on, but this extremely low growth rate even without one.

For comparison it may be noted that China’s economy has grown by over 30% in this same three year period.

Figure 1

11 08 16 GDP since max

* * *

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

John Rosshttps://www.blogger.com/profile/08908982031768337864noreply@blogger.com0

What lies behind the renewed international economic crisis – and what policies are required to deal with it?

What lies behind the renewed international economic crisis – and what policies are required to deal with it?

By John Ross

Given the onset of a renewed round of the international financial crisis it is useful to draw together its various elements in an analysis of its overall determinants, its course, and the policies necessary to deal with it. This is the aim of this article.

* * *

For the second time in three years almost all parts of the world economy are being shaken by a renewed financial and economic crisis. The most important immediate drivers of this are not Standard and Poor’s downgrading the US’s credit rating, or political struggles between President Obama and Republicans in Congress, but weak US economic recovery, Europe’s widening debt crises, the consequent $8 trillion loses on international share markets by 9 August with knock on effects on balance sheets and spending, the continuing decline of US house prices and a new developing crisis of the banking system.

Reasons for the open reappearance of crisis

The reason severe crisis has reappeared, and what determines its dynamic, is the failure of US and European government policies to resolve the issues which created 2008’s financial collapse. The policies pursued since then, which were adapted to deal with much more minor economic events than the ones which occurred, postponed the unwinding of the crisis without removing its underlying causes. As a result the focus of the crisis changed but it was not resolved.

The immediate cause of the financial crash of 2008 was an unsustainable build-up of US private sector debt – this debt being accumulated due to the attempt to maintain the growth of the US economy and to ensure political stability by sustaining US living standards. By the 4th quarter of 2007, the peak of US economic expansion, total US household, private non-financial company, and government debt was 218 per cent of US GDP – Figure 1. That the fundamental debt build up was private, and not government, is shown by the fact that household and non-financial company debt was equivalent to 168 per cent of GDP compared to 51 per cent of GDP for government debt – i.e. private debt was more than three times as large as government debt.

Figure 1

clip_image002

Interest rate increases introduced leading to 2008, in order to deal with inflation, resulted in the inability of the US private sector to finance this debt burden. The US sub-prime mortgage crisis was simply the weakest link in the overall excessive US private debt.

In 2008 the inability of the US private sector to meet its debt obligations, with consequent falls in asset values, initially in housing and then in shares and other financial instruments, destroyed US financial institutions’ balance sheets. The US financial sector overall became insolvent. Therefore a stronger and more centralized financial instrument, the US state, had to step in to rescue the private financial system – with a similar process occurring in other countries. The new crisis has broken out because of the risk that the tools available to the US and European states themselves will be insufficient to restore stability.

Transfer of private sector debt into the public sector

The debt data clearly show the process of transfer of the original excessive US private debt into the public sector – the changes in US debt since the peak of the previous business cycle are shown in Figure 2.

Following the onset of the US economic downturn in 2008, the overall US debt burden rose, reaching 247 per cent of GDP in the 3rd quarter of 2009 – these changes reflecting the decline in US GDP as well as increasing debt. Since then up to the 1st quarter of 2011, the latest available data, US debt fell only marginally to 243 per cent of US GDP – still 26 percentage points above pre-recession levels.

However the internal structure of US debt shifted. US private sector debt peaked at 180 per cent of GDP in the 2nd quarter of 2009. It then fell to 163 per cent of GDP – still 5 percentage points above its pre-recession level. But any recent decline in private sector debt has been almost entirely offset by increases in government debt created by budget deficits exceeding 10 per cent of GDP.

Figure 2

clip_image004

The US therefore simply ‘nationalized’ its debt problem – replacing private with public debt. The mechanisms by which this occurred were the indirect consequences of the financial crisis, with recession increasing welfare payments and reducing tax receipts, as well as transfer of funds to the private sector in bank bailouts and similar measures.

John Mauldin and Jonathan Tepper therefore put it correctly in their book Endgame: ‘Debt is moving from consumer and household balance sheets to the government. While the debt supercycle was about the unsustainable rise of debt in the private sector, endgame is the crisis we will see in the public sector debt.’ (p25)

In short, although the US crisis may currently appear in the form of a government deficit and debt issue, the origins of the problem lay in the private sector and the government debt issue is the consequence of nationalization of private sector debt.

The European debt crisis

Europe followed a similar path to the US but with some countries, e.g. Greece and Italy, building up large public sector debts alongside the private ones in Spain and other states. Europe’s situation is structurally more potentially threatening than the US as the Federal Reserve has greater resources than the European Central Bank and the US state is able to react in a more centralized way than the decentred structure created by the different states of the European Union.

The European Central Bank simply does not have sufficient resources to be able to deal with a spread of the debt crisis into the larger EU economies such as Spain and Italy. Given the exposure of European banks to national state debt the spreading of the European sovereign state crisis to major economies therefore has the potential to bring down the European banking system. For this reason there have been rising European interbank lending rates, reflecting banks decreasing willingness to lend to each other, extremely high rates for bank insurance in a number of countries, and sharply falling bank share prices in both Europe and the US.

Kenneth Rogoff, author of the notable quantitative study of debt crises This Time is Different, and former chief economist of the IMF, accurately summarized the situation in the financial sector as follows:

‘Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed… the financial system remains on government respirators… in the US, UK, the euro zone, and many other countries today.

‘Most of the world’s largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages. As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity, and hedge funds. As governments try to avoid outright nationalization of banks, they will find themselves being forced to carry out second and third recapitalizations.

‘Even the extravagant bailout of financial giant Citigroup, in which the US government has poured in $45 billion of capital and backstopped losses on over $300 billion in bad loans, may ultimately prove inadequate.’

Political struggles are the symptom of the renewed crisis and not its cause

Given the scale of the debt situation none of the means used for tackling the debt problem in the US and Europe can avoid severe economic pain. The political fighting which has broken out is simply over how this pain should be shared. The political struggles which have occurred, for example between President Obama and Republicans in Congress, or between Germany’s government and other European states, are therefore not the cause of the renewed economic crisis but its result. Analysing the different responses however leads directly to the issue of the necessary policies to deal with the financial and economic crisis.

The necessity to run budget deficits

The most ideologically right wing forces – the US Tea Party and those in Europe sharing the views of the British Conservatives – advocate limiting the public debt build up by radically reducing government spending. This is linked to a theory that the state is ‘crowding out’ the private sector. This entire analysis is false. Because of its ideological blinkers it fails to see that the origin of the crisis lay in the private sector debt. It is also extremely dangerous in terms of economic policy.

The main transmission belt from excessive debt into recession is the fall in private investment. As may be seen in Figure 3 the entire decline in GDP in the G7 economies between the 1st quarter of 2008, the peak of the previous business cycle, and the 1st quarter of 2011, the latest available data, was accounted for by the decline in fixed investment. In fixed price parity purchasing powers (PPPs) the decline in G7 GDP was $381 billion and the decline in fixed investment was $591 billion – the decline in fixed investment can be greater than the decline in GDP as it is offset by increases in household and government consumption.

Figure 3

clip_image006

The theory of ‘crowding out’ argues that resources used to finance the budget deficit would be used to generate economic expansion if released to the private sector – for example US financial analyst John Mauldin argues ‘increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity.’ (Endgame p59)

But reducing budget deficits by cutting public spending cannot create an economic way out in present conditions. Reducing budget deficits cuts demand. But resources released to the private sector are used to pay down debt, so private spending will not increase sufficiently to compensate for the fall in public spending. Total demand will fall, increasing recessionary pressure.

In short, it is vital in the short term to maintain budget deficit spending, including by targeting maintaining or expanding consumption – state spending on investment is analysed below. Attempts to immediately reduce budget deficits must be strongly resisted. Countries facing an economic slowdown should run, or increase, budget deficits to compensate for the shortfall of private sector demand.

Richard Koo, in his important books Balance Sheet Recession and The Holy Grail of Macroeconomics, has dealt with this correctly in analysing the experience of the decades long fight against the consequences of over-indebtedness in Japan. As Koo noted:

‘What sets Japan’s Great Recession apart from the U.S. Great Depression is that Japanese GDP stayed above bubble peak levels in both nominal and real terms despite the loss of corporate demand worth 20 per cent of GDP and national wealth worth ¥1,500 trillion… The financial deficit of the government sector mounted sharply, leaving in its wake the national debt we face today. But it was precisely because of these expenditures that Japan was able to sustain GDP at above peak-bubble losses despite the drastic shifts in corporate behavior and a loss of national wealth equivalent to three years of GDP. Government spending played a critical role in supporting the economy…

‘Japan was left with a large national debt. But if the government had not responded with this kind of stimulus, GDP would have fallen to between one-half and one-third of its peak – and that is an optimistic scenario. U.S. GNP shrank by 46 per cent after falling asset prices destroyed wealth worth a year’s worth of 1929 GNP during the Great Depression, and the situation in Japan could easily have been much worse. This outcome was avoided only because the government decided early on to administer fiscal stimulus and continue it over many years…

‘In summary, the private sector felt obliged… to pay down debt… Disastrous consequences were avoided only because the government took the opposite course of action. By administering fiscal stimulus, which was also the right thing to do, the government succeeded in preventing a catastrophic decline in the nation’s standard of living despite the economic crisis.’ (The Holy Grail of Macroeconomics p22-25)

Naturally the form the budget deficit takes is itself extremely important. Government spending on those on average and low incomes, and on investment, is not only socially more just but is far more effective as a stimulus than tax cuts for the best-off – who save, rather than spend, a higher proportion of their income. Equally spending on investment is far more effective in expanding the economy that military spending – which does not add to productive capacity. But overall it is necessary to fight moves by fiscal conservatives to reduce the budget deficit in the short term. As an immediate response to the financial crisis countries facing the threat of economic downturn should run or maintain stimulus packages funded, if necessary, by budget deficits.

Budget deficit and the medium term

While budget deficits with a large component targeted at maintaining consumption are immediately vital to prevent short term economic decline they are not sufficient, faced with deep economic problems, to relaunch substantial growth because they do not deal with the most fundamental issue driving the downturn – the investment fall. This is in addition to the fact that few countries have Japan’s financial strength, which enabled it to sustain a very large budget deficit over a long period. For most countries large budget deficits can be run in the short term but are financially unsustainable in the medium term.

A policy of running large budget deficits is often inaccurately described as a ‘Keynesian’ one – inaccurately as Keynes own central concern was factors affecting investment and not budget deficits.1 Paul Krugman in the New York Times, for example, regularly but wrongly argues that the budget deficit is both the most central issue in economic policy and the core of Keynes views. US economist Paul Davidson similarly claims in The Keynes Solution: ‘Anything that increases spending on goods and services increases the profitability of business firms and the hiring of workers.’ (p54) But this is false – for example, an increase in spending on goods and services accompanied by cost increases may lead profits to fall.

However, even if profit did increase due to increases in demand, companies may not reverse the cuts in investment that are the core of the recession. Keynes pointed out that to generate investment a price must be paid to overcome ‘liquidity preference’ – the advantages of holding assets in cash and other liquid forms. In circumstances of high uncertainty, such as at present, the cost of overcoming liquidity preference may be prohibitive and therefore it will prevent investment taking place even if such investment would yield a positive profit.

Low interest rates necessary but not sufficient

Even more fundamental than liquidity preference in the present situation is that, given excessive indebtedness, companies use resources to repay debt, that is to build up their balance sheets, and not to invest even if demand increases. Therefore stimulating demand by budget deficits may prevent worse declines in production but does not produce significant output increases.

In such conditions low interest rates are also insufficient as an economic policy to provide a way out. Low interest rates are necessary to prevent interest payments becoming unsupportable and to remove a block to borrowing for investment. But they do not lead to investment under conditions where companies are intent on paying down debt and have no intention of borrowing for investment.

International redistribution of debt

As any solution to the present situation must involve medium term debt reduction a number of states are seeking to achieve this at the expense of other countries even without formal defaults on debt payments. In particular the US, via falls in the exchange rate of the dollar, reduces the real value of its debt at the expense of countries which hold dollar assets. Such policies however clearly only aid one country at the expense of others, effectively redistributing the debt without reducing the overall debt burden.

Inflation is not a relatively harmless solution

It is important to remove an illusion currently being suggested that inflation would be a relatively painless and non-harmful way to reduce debt. The idea behind this is that while the monetary volume of debt, its nominal value, would remain the same its real size would be reduced. Kenneth Rogoff, for example, has argued this:

‘It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass…. Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective. ‘

Similarly the British economist Will Hutton has argued:

‘As the IMF’s chief economist, Olivier Blanchard, has suggested, if the options are public and private default, continuing bank weakness, economic stagnation (perhaps depression), or inflation, then the least bad option is to accept inflation, but to manage it within bounds.

‘Since inflation will happen anyway as governments seek the least bad way out, the choice in reality is whether to accept and manage it or not. Once debt is at a sustainable level and growth has resumed, then the world’s financial system can be redesigned to avoid a repeat, and price stability restored.

‘This is the truth that cannot speak its name: as a senior financial policy official told me, even to raise it at home or abroad merely as an issue for debate is to invite universal disapproval. But truth must be faced. Britain should provide a lead – both for its own economic fortunes and to set the new international standard. As a minimum it should announce a new programme of quantitative easing, in effect printing money; insist the Bank of England uses the money it prints to buy the broadest range of private debt; and immediately replace the 2% inflation target with a target for the growth of money GDP – so getting Britain off the hook of its unpayable private debts.’2

However someone will have to suffer the loss in real resources created by the inflation. Usually this is the majority of the population as the rate of increase of incomes fall behind the rate of inflation. Politically a policy of lowering debt by inflation is therefore likely to be drastically unpopular for whoever implements it.

Furthermore economically inflation, striking at the majority of the population by reducing living standards, will actually cut consumption – which strengthens recessionary tendencies. Inflation also does not deal with the issue of increasing investment – the fall in which drove the recession. In short inflation is not a solution either politically or economically to a crisis of the depth which currently exists.

Indirect means of stimulating investment

If the way out is turned to, the necessary policies cannot be separated from the analysis of the depth of the crisis.

If the current economic crisis were of small or moderate dimensions then it could indeed be tackled by increases in budget deficits which primarily raised or maintained consumption. Such deficits would increase demand while liquidity preference, lack of profitability and debt levels would be insufficient to prevent companies responding to the increase in demand by raising investment – therefore substantial economic recovery would occur. This, however, has clearly not occurred in the crisis since 2008 despite large budget deficits being run.

Given budget deficits have been insufficient, attempts are also made to raise investment by extremely low interest rates and by seeking to reduce liquidity preference – the latter being a key goal of the talk regarding the need to ‘restore confidence’. These measures have also clearly not succeeded.

Confronted with this impasse more logical economic commentators are therefore beginning to address the need to raise investment. Such discussion currently primarily centres on advocating indirect means such as tax breaks. For example Joseph Stiglitz recently argued:

‘those worried about the shortage of policy instruments are partially correct. Bad monetary policy got us into this mess but it cannot get us out. Even if the inflation hawks at the Federal Reserve can be subdued, a third bout of quantitative easing will be even less effective than QE2. Even that probably did more to contribute to bubbles in emerging markets, while not leading to much additional lending or investment at home.

‘The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy’s plight. But, even if it succeeds in stopping, at least temporarily, the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down. Corporations are awash with cash, but the banks have not been lending to the small and medium-sized firms… The Fed and Treasury have failed miserably in getting this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015.

‘But the real answer, at least for countries such as the US that can borrow at low rates, is simple: use the money to make high-return investments. This will both promote growth and generate tax revenues, lowering debt to gross domestic product ratios in the medium term and increasing debt sustainability. Even given the same budget situation, restructuring spending and taxes towards growth – by lowering payroll taxes, increasing taxes on the rich, as well as lowering taxes for corporations that invest and raising them on those that do not – can improve debt sustainability.’

By identifying raising investment as the key target Stiglitz does address the central dynamic of the recession. But the issue is once again quantitative and related to the depth of the crisis. Will measures such as tax breaks be sufficient to raise investment if they are added to other policies such as running budget deficits and low interest rates? If the economic crisis is not deep they will suffice. If the economic crisis, and the necessity to pay down debt, is stronger then indirect measures to target investment, such as tax breaks, will not be sufficient.

The current indications, given the scale of the economic problems and debt burden, is that indirect means to stimulate investment by policies such as tax breaks will be insufficient to relaunch substantial economic growth.

Direct means of raising investment

The most decisive way to overcome the current situation flows from the above trends. Its practical effectiveness was shown by its use by China in its successful 2008 stimulus package, which was followed by over 30 per cent GDP growth in three years. Keynes also analysed and advised it. This is that the state must overcome the reality or threat of a fall in investment by itself undertaking and organizing investment. Keynes noted this in The General Theory of Employment, Interest and Money: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.’ (p378)

Such an analysis flowed from Keynes practical experience regarding the relation between the depth of economic crisis and lack of sufficient efficacy of other economic instruments: ‘Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.’ (p164) Therefore: ‘‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes naturally did not advocate an administered economy. But he therefore explicitly argued in the General Theory that the state should have the ability to intervene sufficiently to determine overall investment levels.Keynes also noted that this ‘somewhat comprehensive socialisation of investment’ and ‘the duty of ordering the current volume of investment’ did not mean the elimination of the private sector, but socialised investment operating together with a private sector: ‘This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.’ (p378)

The country which most approximates to this economic system is China. China, of course, describes its economy in a different way and using Marxist terminology. China defines itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However it is not the important question whether China’s definition of its own system should be accepted, or whether its economy should instead be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how such an economic system works and to note that China has been able to run the world’s largest stimulus package without an unsustainable budget deficit, and why its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe – and why China’s economic system has generated, during the last thirty years, the most rapid economic growth of any major economy in the world.

China’s economy

The difference between China and the US and Europe, of course, lies in economic structure. After its 1978 economic reforms China abandoned an administered economy. But it did not abandon the ability of the state to set the overall level of investment, and it maintains a state owned banking system which is stronger in a crisis than the ones in the US and Europe and which can be instructed to expand lending in order to sustain stimulus packages. China therefore actually implements Keynes point that ‘the duty of ordering the current volume of investment cannot safely be left in private hands.’ That is, a ‘somewhat comprehensive socialization of investment’ does exist in China, not in the sense that the private sector is eliminated, on the contrary China’s private sector is large and dynamic, but in the sense that the state has sufficient levers to determine the overall level of investment. In contrast in the US and Europe the conditions outlined by Keynes do not exist, and the state sector is insufficiently large to deliver an investment-led stimulus.

As a conseuence of these differences China has come through the financial crisis far more successfully than the US or Europe

Implication of the differences

Once again the interaction of these different factors cannot be separated from analysis of the scale of economic crisis itself. China’s economic structure clearly gives it a superiority which has allowed it to avert serious downturns, as shown both in the 1997 Asian debt crisis and in the international financial crisis since 2008, and to maintain very long term rapid economic growth. But how serious the lag in the US and Europe compared to China is depends on how serious the economic crisis is.

If the economic crisis is not deep then gradually time, and greater application of the measures which are available to the US and European economies – budget deficits, low interest rates, tax breaks for investment – will overcome the investment decline. China will still grow more rapidly, but the US and Europe will also resume growth. If the crisis is deep then only adoption of full scale Chinese methods of direct state action to implement ‘the duty of ordering the current volume of investment’ would suffice. That, however, would require a huge extension of the state sector of the economy, and therefore greater application of the indirect methods available in the US and Europe will be tried first.

One clear implication, of course, is that in all these different circumstances China continue to will grow much more rapidly than the US and Europe even if the latter escape a ‘double dip’ recession.

Conclusion

The realistic conclusions which follow from the present renewal of the international financial crisis, in terms of both analysis and the required policy response, are therefore clear:

  • The International financial crisis has recurred because the economic policies to deal with the 2008 crash in the US and Europe did not remove its underlying cause – excessive debt build up in an attempt to sustain US economic growth and living standards. The post-2008 policies failed because they were designed to deal with much less serious economic events than the ones which unfolded.
  • The effect of the policies pursued after 2008 has been to nationalize large part of the debt that originated in the private sector. Therefore, in most cases, and in particular in the US, even if the crisis reappears around state finances the actual origins of the problem lay in the private sector debt.
  • The strategic failure to overcome the debt crisis creates strong pressure to a renewed crisis of the banking system.
  • The debt crisis transmits itself into the real economy above all though a collapse in investment – taking the G7, the entire decline in GDP is due to the fall in fixed investment.
  • In the short term it is necessary to deal with the crisis by continuing to run budget deficits, and countries that have not done so may well need to introduce budget deficit spending. China is an exception because its economic structure allows it to run large stimulus packages without budget deficits due to its ability to directly stimulate investment. Only a handful of other countries, however, have a state sector large enough to fund and run such investment programmes and therefore other economies will have to run budget deficits in the short/medium term. However while budget deficits are necessary to avoid sharp economic decline the experience of the last three years has shown that the economic crisis is too deep for budget deficits by themselves to stimulate significant growth because they do target the core of the recession, the investment decline.
  • Very low interest rates must be maintained in order to lighten the burden of interest payments on the overextended debt, and to remove an obstacle to investment. However, once again the experience of the last three years has shown that the economic crisis is too deep for low interest rates themselves to relaunch investment and substantial economic growth.
  • China possesses the advantage that it can directly stimulate investment. In other countries there is also a growing realisation that the core transmission of the economic problem lies in investment falls. But without a sufficiently large state sector most other countries do not have the means to directly launch investment. Therefore indirect methods such as tax incentives for investment and similar measures are being proposed. It remains to be seen in practice, if these are introduced, whether they are effective. Given the depth of the crisis the probability is that even if such measures are introduced they will not be enough to sufficiently overcome the low investment level. Consequently growth will continue to be very slow in the US and Europe even if a new recession can be avoided.
  • The world economy will therefore see a further period in which China’s economy will grow rapidly while the US and Europe remain at best relatively stagnant.
* * *

This article originally appeared on Key Trends in Globalisation.



Notes

1. See Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

2. The British newspaper The Observer made the same call:

‘The only alternative to default is inflation – governments printing money to get out of the corner they, their banks and their citizens are in. The question facing policymakers in the years ahead will be which of the unpalatable options they confront – economic stagnation, public and private default together with endemic bank weakness, or uncontrolled or managed inflation – they are going to choose…

‘The British government’s policies are locked in the same impotent stasis as the rest of the world’s – battening down the hatches, cutting public spending and borrowing, and refusing to accept realities. The government should declare independence. It should abandon the suffocating 2% inflation target and replace it with a target for the total volume of spending in the economy. It should prepare to stimulate the economy with more quantitative easing – in effect printing money – using the proceeds to lend directly to public agencies and departments prepared to lift capital spending.’John Rosshttps://www.blogger.com/profile/08908982031768337864noreply@blogger.com1

The financial crash and macro-economic policy – why the US and Europe have budget crises and China does not

The financial crash and macro-economic policy – why the US and Europe have budget crises and China does not

By John Ross

The events precipitating the renewed financial crash were the combination of debt crises and confirmation of slow US economic growth. Regarding the former countries were either trying to cut deficits (the US, Greece, Italy, the UK) or feared they will have to bail out those running unsustainable ones (Germany, France). But these large deficits were not accompanied by strong economic growth – although it can be cogently argued that they were necessary to stave off sharp economic downturn.1

Japan is currently preoccupied with overcoming the consequences of the tsunami and earthquake, but it also will soon have to face the reality that, due to decades of budget deficits, it has the largest government debt as a percentage of GDP of any country – twice that of the US.

In contrast China in 2008 launched the world’s largest state stimulus package to counter the international financial crisis. But it is not running any substantial budget deficit – this year it will only be around two per cent of GDP. But China has enjoyed rapid economic growth.

It has been claimed that China is applying ‘Keynesianism’, but if budget deficits were the key issue defining such policies then China is clearly not pursuing ‘Keynesianism’ at all.

Actually, the core of Keynes’ analysis did not lie in advocating budget deficits, and in some ways China has a policy which more corresponds to his views than that pursued in the US and Europe. This is is briefly outlined below. But before dealing with this it is illuminating to contrast the nature of the economic policies pursued by the US and Europe in the last three years on the one hand, and by China on the other, and to analyse why the latter was able to launch such a large stimulus package without a significant budget deficit.

The actual core of the Great Recession

The core of the difference between the policies pursued in the US and Europe on the one hand, and that followed in China on the other, requires understanding what actually occurred during the ‘Great Recession’ after 2008. A more extensive analysis has been given elsewhere but to summarise in the US and Europe the Great Recession was dominated by an investment collapse. To take the largest example, in the 2nd quarter of 2011 US GDP was still $56 billion below its 4th quarter of 2007 peak. However all major components of US GDP except fixed investment were already above their previous peak levels – inventories were $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. But US private fixed investment was $388 billion below its 4th quarter 2007 level. The entire decline in US GDP was therefore due to the fixed investment fall.  These changes are shown in Figure 1. A similar pattern exists in almost every major developed country.

Figure 1

11 08 01 Figure 1 - US

 

This investment fall, by driving and maintaining the downturn, produced a decline in personal and company income and therefore a fall in tax revenue – the latter being the primary reason for budget deficits. The crucial issue, both for economic development and to close the budget deficit, is therefore how to relaunch growth.

China’s situation was different and explains why it ran no significant budget deficit. China abandoned administrative running of its economy with the economic reforms beginning in 1978, but it still has a sufficiently large state sector that this could be, and was, instructed to increase investment. As the key banks are state owned they could be instructed to increase lending to companies – in the US the opposite occurred and lending to companies fell sharply. The rapid economic growth initially generated by China’s state companies in turn stimulated the private sector.

The result, during the crucial period 2008-2009, is shown in Figure 2. Instead of China’s investment falling it rose by $420bn. Consequently there was no recession. Under the impact of the increase in jobs and incomes created by the stimulus package, China’s household expenditure also rose by $160bn. Therefore despite the combined effect of a fall in net exports and inventories of $160bn China’s GDP in 2009 rose by $440bn.

As there was no recession there was no fall in tax revenue and no major budget deficit. As this process continued, by 2011 China’s GDP had increased by over 30 per cent, $2.3bn in current price terms, compared to pre-crisis level. In contrast by the 2nd quarter of 2011 US GDP was still 0.4 per cent below its 2007 peak level.

Figure 2

11 08 01 Figure 2 - China

 

In the US and Europe the budget deficits were increased by government attempts to restart growth. China could instruct its state companies to invest and its state banks to lend, but the state sector in the US and Europe is too small for this to be effective. Only indirect means, such as quantitative easing (printing money) and budget deficits were available as policy tools. Both proved ineffective in restarting rapid growth. But the latter policy worsened the deficits. China, due to the rapid growth resulting from the investment stimulus, had no significant budget deficit.

Relative scale of economic problems in the US, Europe and China

Naturally the above does not mean China escaped all economic problems – particularly food price inflation, but these are not on the same scale as the budget deficit crises gripping the US and Europe.

Nor do such developments mean China does not face economic policy choices. It is impossible to judge the size of a stimulus package perfectly in advance. The crucial thing in 2008, confronted with the worst economic crisis for eighty years, was to act rapidly and forcefully to head off downturn. This was achieved.

Indeed, so successful was the stimulus that by the 2nd quarter of 2010 China’s GDP growth was 11.9 per cent – well above the average 9.9 per cent since its economic reforms began and unsustainably high. Also, despite the government’s efforts, it is always impossible to prevent some part of a stimulus spilling into unintended areas  – creating a too high rate of increase in China’s house prices.

In summer 2010 world food price inflation also began. China suffered from this less than other comparable BRIC countries – Brazil, India and Russia. But countering these price rises required monetary tightening and slowing the economy

Finally, a medium term problem must be tackled. It is impossible to implement a huge lending increase, under conditions of international economic downturn, without some increase in bad loans. When China’s government launched the 2008 stimulus package it anticipated this by making banks increase provisions for bad loans and stating they would have to raise extra capital. The government’s calculation was simply that large scale economic growth resulting from its policies would generate more than sufficient resources to deal with any bad loans problem of the type now appearing in municipal debt – i.e. far more would be gained than lost. With more than 30 per cent growth in three years China’s economy has easily enough resources to deal with bad loans.

In short China’s economic structure does not produce perfection – which only exists in heaven. But the problems it faces are far smaller than the budget deficit and debt crises in Europe and the US.

China’s economy grew by more than 30 per cent in three years while Europe and the US remain below their peak levels of output. It is therefore easy to see which policy has been more successful.

Keynes and Chinese descriptions of China’s economic system

How is such an economic system as that operating in China to be described? China itself, of course, uses Marxist terminology – it describes itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However there is another, more familiar in the West, way of looking at it.2

Keynes in the General Theory of Interest, Employment and Money evidently did not advocate an administered economy.3 But he did explicitly argue that the state would have to intervene sufficiently to determine the overall level of investment: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes, as is well known, attached great weight to changes in the rate of interest in affecting the investment level. But he did not believe these would be sufficient by themselves: ‘Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.’ (p164)

This led Keynes to the conclusion: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.’ (p378)

Keynes noted that ‘somewhat comprehensive socialisation of investment’ and ‘the duty of ordering the current volume of investment’ did not mean the elimination of the private sector, but socialised investment operating together with a private sector: ‘This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.’ (p378)

It does not seem the most interesting question whether we should accept China’s definition of its own system, or whether its economy instead should be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how China’s economy actually works, why it has been able to run the world’s largest stimulus package without a budget deficit, and why therefore its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe.

*   *   *

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

Notes

1. For an analysis of this see Richard Koo’s The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.

2. A more detailed discussion of these issues can be found in Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

3. All page references are to the 1983 Macmillan edition of the The General Theory of Employment, Interest and Money.

Panic on world markets

Panic on world markets

By Michael Burke

International business news and other TV channels are offering a Babel-like interpretation of the current slump in world financial markets. European (including British) stations are reporting the Wall Street-led declines as a response to the continued debt crisis in Europe. But this makes no sense. An EU crisis would have been felt first in EU markets and perhaps not at all in the US – US stocks had been rising over a prolonged period while Europe has been in turmoil. (And, despite what we may think, Greece or Ireland might fall into the sea while causing barely a ripple in the Hang Seng and the other plummeting Asian stock indices).

US channels have no explanation at all for the crisis- and analysis is limited to individual stocks, the scale of losses for investors and a generalised antipathy to Washington.

The Asian networks come closest to identifying the source of the current crisis- which isn’t in Europe at all. Their consensus is that markets are plunging because of the slowdown in the US economy.

But, why now? We are repeatedly told that financial markets react instantaneously to new information. The US GDP data for the 2nd quarter of 2011 were truly awful, up just 0.7%. As the BEA annualises quarterly data (multiplies by 4) this means that the US economy grew by under 0.2% from the 1st quarter.

On closer inspection the data were even worse. Large downward revisions to both the prior quarter and further back mean that economy fell by 5% in the recession, and has not recovered that prior peak in activity yet, as had been previously thought. This is the weakest US recovery from recession in the post-WWII period. Yet these data were published last Friday. If they were the immediate cause of the panic, it is a slow motion reaction.

No, the new news is the compromise agreement in Congress on Tuesday to raise the Federal debt ceiling in return for large scale cuts in Federal spending. This can only have one consequence- slower growth. Since the anticipated profits derived from growth drive stock prices, it is natural for stocks to fall when growth prospects are lowered. As Wall Streeters say, the US has just suffered a derating.

The crisis is driven by ‘austerity’- US austerity.

EU financial markets are caught in the backwash of this, as slower US growth certainly harms global growth prospects. This is felt most keenly in their weakest link, the sovereign debt markets, since these have assumed all the stresses of the EU economies and financial systems. But we should not expect stock and other markets in Europe to remain unscathed, especially bank stocks.

In particular, as reaction to the latest bailout of Greece’s creditors shows, bond markets do not reflect any confidence in these repeated prescriptions. Instead a first bailout of the economy is required, in Greece, Ireland and elsewhere.

There was a fondness before for asserting that Ireland was closer to Boston than Berlin. With the German economy recovering far more robustly than the US, we will hear less of that in the years ahead.

It might be wise instead to focus on the German and other answers to the crisis. This was not just short-term economic stimulus, but long-term productive investment.

For too long this economy has been a weigh-station for US companies counting their profits. Instead of listening to their self-serving advice on economic policy (while following German strictures on fiscal policy) policymakers in Ireland should emulate what works, in Germany, Sweden and most of Asia, investment-led growth initiated and guided by the State.