Suyts on Krugman

Suyts quite rightly criticizes Paul Krugman on the Nobel Laureate’s latest ramblings. However, his analysis misses a couple of issues. This is an extended comment.

You are quite right on two issues here, which I believe have been called the ratchet effect and the debt servicing impact.

The first is that it is easy to increase government expenditure, but much more difficult to scale it back as there are entrenched interests to stop the scale back. It is easy to give people welfare benefits or create jobs. But try to take these away and people will fight like crazy to keep them.


The second on debt servicing you demonstrate very well. As total debt goes up, so does the interest on that debt.

There are other issues that should be taken into consideration on the deficit and debt problem.

The first issue is the size of government. When an economy enters recession, the tax receipts fall and expenditure rises. Corporation tax is the first area to go down, followed by income tax as unemployment rises. In expenditure terms, welfare payments will rise along with (possibly) business bail outs. With small government, taxing little and spending little, this impact was small. With large government – in Britain rising nearly 50% of GDP – this effect is large. A 6% decline in GDP perhaps increased the deficit by 6-7% of GDP. Under the Eisenhower administration, a similar decline would worsen government finances by maybe 2% of GDP. Big government exacerbates the size of cyclical swings.

The second issue is the position at the start of downturn. In mid-2008 both USA and Britain had structural deficits – in the USA to finance the wars in Iraq and Afghanistan, in Britain finance a huge increase in public sector pay and capital spending on schools and hospitals. A structural deficit is the measure of the average government deficit over the course of the business cycle. In Britain at the top of the cycle, the actual deficit was around 3% of GDP, with a planned rise to 4%. The structural deficit was probably greater than 4% of GDP in mid-2008 in Britain and maybe slightly smaller in the USA. Below is my estimate of the impact of Britain’s structural deficit in April 2010. I estimated that the structural deficit built up between 2001 and 2008 would in the long-term increase National Debt by 40% of GDP. I was overly optimistic in my assessment.


The third issue is with the classical Keynesian Multiplier. Crude textbook Keynesianism of the 1960s for a closed economy stated

E = C+I+G

Or national expenditure is the sum of Consumption, Investment and Government expenditure.

The theoretical impact of increasing government expenditure on total output, when the economy is at less than full employment, is Y/G. If government expenditure is 10% of national income, then increase G by $1 and Y will increase by $10. If government expenditure is 40% of national income, then increase G by $1 and Y will increase by $2.50. However, crudely put, if the government expenditure does not take up the slack in the economy (the deficit in aggregate demand), then (in an inflation-free economy) the government expenditure “crowds out” private expenditure. Another way of putting the situation, if the economy is not “stuck in a rut” as Keynes assumed in his “General Theory”, but merely reacting to overinvestment (such as a housing bubble), then increased government expenditure will have no effect on total output, but “crowd out” other expenditure. It will also add to the nominal national debt, without adding to total national income, thereby increasing national debt as a percentage of national income, or expanding national income leading to increased tax revenues and thus closing the deficit.

The fourth issue is fiscal tipping points. If the increased government expenditure fails to stimulate the economy, then the result will be a larger structural deficit. If, like some European countries, there is a further contraction then the deficit will increase. In Greece, Spain, Italy and Portugal, this further downturn has led to increased economic risk, pushing up interest rates. This increases short-term debt costs, further increasing the deficit. The only way to stem total collapse is to massively cut public expenditure and increase taxes to not only pay for the debt-financing costs but to rapidly cut the deficit as well. In climate change there has been much spurious talk about possible tipping points in the remote future if certain things come true. But in OECD economies, with some already having gone beyond the fiscal tipping points, many (including Krugman) seem oblivious to the possibility. Should we not use a smidgeon of the precautionary principle in economics , proclaiming austerity as an insurance against severe depression.?

Kevin Marshall


Is Australia near the fiscal tipping points of Europe?

Although in Australia the current economic situation may seem bad, it is nothing like as dire are Europe.

There is a new issue. After a long period of surpluses in 2009 the government created significant deficits. These do not seem justified by the small slowdown in economic growth. Any ideas?

Using World Bank Data, many of the Eurozone countries have been running large, structural deficits for years. Australia only went into deficit in 2009.


As a result, Australia’s national debt is small relative to GDP compared with the European nations.


The relative problem can be seen from the growth rates. Australia has yet to go into a full year of recession. That is growth of less than zero.


Neither has growth dipped much below the average for 1998 to 2007.

Joseph Stiglitz on the causes of the current crisis

Roger Pielke Jr. takes a critical look (here and here) at a novel theory of the recession from Nobel Laureate Joseph Stiglitz in Vanity Fair, the eminent economics journal. This is an extended version of the comment that I made on the second posting.

The Stiglitz theory would make a bit of sense if it were not for what he misses.

  • Your evidence that other countries, like, Germany, have similar increases in productivity but not the endemic problems.
  • That output per capita is identical in National Income Accounting with income per capita. Therefore, the long term rise in per capita income is a result of increased productivity per capita.
  • Since the start of the industrial revolution, real per capita output has risen (in the wealthy economies) more than 200 times. If there has been no corresponding increase in per capita income, unemployment would be greater than 99%.
  • Stiglitz quite rightly points to the rise in personal debt. He makes no mention of public sector debt. In the USA and in Britain in the period 2000 to 2007 government finances swung from a small structural surplus to significant structural deficit. If deficit-financed investment is expansionary, it was not just the low interest rates that kept the boom going but the fiscal stimuli. Similar structural deficits were present in many European countries like Greece, Portugal and Italy.
  • In the 1990 Japan entered a prolonged slump. In the following decade the economy stagnated despite huge public works investment like Stiglitz advocates. The Japanese national debt spiralled to 300% of GDP, with nothing to show for it, except a lot of fantastic roads to nowhere.
  • Japan was fortunate in that its borrowings are at near zero interest rates. The European economies are not so fortunate. Those European economies with large deficits reached a crisis tipping point when interest rates exceeded 7%. To save the economy, radical contractionary policies have been implemented.

I would therefore contend that Keynesian fiscal expansion in the USA or elsewhere would not only be ineffective (coming on top of other fiscal expansion), but carries a huge risk of making matters dramatically worse. Morally I believe that economic policy-making has a powerful analogy to medical practice. It is not just a matter of diagnosing properly the type and extent of the ailment. It is providing, at a minimum, a remedy for which there is a reasonable expectation that the patient will be better off being treated than not. Like with a GP, an economist has a duty of care in what they advocate, particularly when there are very clear and evident risks. Joseph Stiglitz seems to take no such care.

Prejudiced economic analysis in South Manchester

Have responded to a letter in the South Manchester Reporter of 3rd June.

GM’s letter of last week is prejudiced against a small minority and ignorant of economics. The need to cut is mostly due to the government running up a deficit during the boom years, and then going on a wild spending spree to try to shore up the vote as an election approached. (The cyclical part will be (mostly) taken care of by a strong economic recovery.) So in this area, we can look forward to some shiny new trams and gleaming school buildings along with a generation of cuts to pay for it. For instance, the £120m for the Didsbury spur of the Metrolink alone is equivalent to over 30,000 teachers and nurses doing without a 3% annual pay rise for five years.

The consequence of this fiscal irresponsibility is not just financial. People will lose their jobs or have careers de-railed, others will be made ill through over-work, or through seeing their livings standards fall salaries are frozen, whilst taxes, prices and interest rates rise. Rather than opposing cuts now, people should look to areas where they are least painful. That means shelving some of the recently signed-off “investments”, such as the extra bus lanes on Wilmslow Road; less government advertising; or finding better value for money in the provision of local services. The consequence of not doing so is even bigger cuts later, and lower living standards for the next generation.

But why call somebody prejudiced and ignorant? I quote

“Once again, those who really control the wealth and power (the gambler’s in our casino economy and the obscenely wealthy) have demanded that their government makes the poorest people in society pay for the economic crisis.”

 

“….John (Leech MP) will no doubt remind him (The Chancellor) that the multi-millionaires are unlikely to feel any effect whatsoever from the cuts to education, benefits and the health service that will inevitably follow in 2011”

The underlying cause of the recession, I believe, are:-

-         The prolongation of the last boom through cutting interest rates after the dot-com bubble burst in 2000, and again in 2001.

-         Failure to raise interest rates in 2003. This would have been very difficult politically.

-         Failure of the regulatory authorities to realise the systemic risks building up in the financial sector, and the risks building up in individual banks.

-         Deficit spending in the boom years, which kept the boom going at the expense of creating structural deficits.

-         Political spin, and dubious accounting (PFI contracts to put liabilities outside the National Debt figure), to hide the reality.

Whether I have highlighted all the points, I am sure to be closer than someone who just blames the rich. The reason is that I, at least, attempt to understand the issues.

Inflation – How NOT to eradicate the deficit.

Nobel Laureate Paul Krugman makes a sensible comparison of the debt crisis in Britain with Greece in the New York Times.

His major error to say that an advantage for Britain of retaining its own currency is in possessing the ability to reduce its real debt levels through inflation. However, to do so could be quite dangerous for the economic health of Britain for two reasons linked to a simple fact. Nominal interest rates tend to follow inflation so real interest rates tend not to be negative for long.

1. Borrowing for house purchase tends to be on variable interest mortgages. Fix rate mortgages are uncommon. Assume inflation rose to 10% (halving the real value of debt every 7 years). People would, in the short-term see monthly repayments more than double. My own monthly repayment mortgage (lower than average) would go up from 20% of income to 50%. The impact would cause house prices to fall again and consumer spending to plummet. So far the UK has avoided the house price crash of the 1990 to 1992, when tens of thousands of homes were repossessed. Mortgage debt is relatively higher now than then.

2. If inflation took off before the deficit was much reduced, the average rate of interest on the national debt would increase rapidly. This could mean in the short term the real cost of interest payments could increase, increasing the primary surplus. Further, the experience in Britain both in the late 1980s and mid 1990s is that after inflation, real interest rates remain high for a long period.

Possessing a constraint is a positive advantage of the euro. However it is only feasible if member nations had stuck to the original rule of maintaining the government deficit to less than 3% of GDP. However, it did not work without an additional rule – to keep the budget in a small surplus when the economy was at, or above, the long-term growth rate of the economy – the project was bound to fail in a deep recession.

Hopi Sen is aggrieved, with a slight justification, that Paul Krugman makes similar points to his post of a day before.

Risk, Volcanic Ash, Regulation and the Leaders debate 2

John Redwood today makes some brilliant observations on “Bash the banks and Praise the Regulators”. His comparison with the ash cloud and the banking regulation is particularly apt. But it is not just the cost of inappropriate regulation that there is a similarity. The leaders’ debate of tonight showed crystallised the issue for me. It is how do the authorities deal with an unprecedented situation? The risk-averse say let us do nothing until there is full information. On the financial system, nothing was done to control the excesses. On the ash cloud everything was stopped until the scope of the problem could be assessed by the experts.

There is a way of going into the unknown without full information. You set general rules and assess the magnitude of any problem.

-         On the ash cloud, you compare the risk with the size of the eruption, the size of the particles and the distance from the volcano. From this, you would have found no evidence of large jet aircraft getting into emergency situations 1,000 miles from an eruption, in an ash cloud that is hardly visible.

-         From the financial system, the situation was evident that house prices and consumer borrowing was going to unsustainable levels on an unprecedented scale from 2003 onwards. The 0% interest credit cards and the large discounts for changing mortgages were evidence of this in the UK. The sub-prime boom, with mortgages deals agreed whereby in 3 years the borrowers could not meet their repayments was evidence of this in the USA. It was the very magnitude of the problem that should have merited special attention. The action should have been to raise interest rates and increase cash requirements for banks.

On the surface the action was the opposite – One to stop what was already happening, the other that immediately stopped anything from happening. But the cause is the same – by requiring detailed rules and acting on how others will perceive our actions, the authorities took wrong course of action.

 The Leader’s debate crystallised it for me. There was one leader who stood out. His reaction to any problem is not to take any risks.

-         He will not risk safety by letting planes fly.

-         He will not start cuts now to risk the recovery.

-         He will not risk banks ever getting into trouble again.

-         He will not risk a foreigner being unidentified.

-         He will not risk existing jobs.

-         He will not risk offending our European neighbours by disagreeing with them.

-         He will not risk independent MPs, by banning them from second jobs and monitoring every penny they spend.

-         He will not risk independent thought, by stipulating what religions should believe.

-         He will not risk diversity in education by allowing independent schools to be formed in the state sector.

 In so doing, after another 5 years of his leadership we will have no recovery; we will have no decision-makers in government – just be taking orders from Brussels and the IMF; we will have no risk-takers in business as most will not want to overcome the ever-higher regulatory hurdles for achievements that are taxed away and vilified.

We will also have no future.

Labour bashing business to save facing their awful reality

John Redwood wonders when the Labour Party will stop attacking business.

Not this side of the election and perhaps never is the simple answer.

 

This war with business started with blaming the banks for the current crisis. In the Labour view their wild excesses created the crisis, and so must be now tightly regulated to prevent this happening again. Once you go down this route, it is only a small step to saying that all business is only beneficial to the general welfare if tightly controlled.

To go back on this might be to admit that the banks were not entirely to blame for the crisis and the mounting debt. Allow this chink in the anti-bank defence, and the debate in the general election campaign will be as to how far the tripartite structure of central banks, regulatory authorities and government policy was to blame.

The further stage is then to lay bare how poor the state of the government finances were during the boom years. That is, through creating an ever-increasing structural deficit when at least budget balance should have been attained. By my calculations about half the forecast National debt of £1400 billion in 2014 will be down to economic mismanagement since 2001.

During the forthcoming election campaign I expect a constant barrage of attacks on bankers in particular and business in general. The hope from the spin doctors is that people will be distracted enough not to look at the true causes of the current crisis. If the Labour party – the self-proclaimed defender of public services – were to admit that they have wrecked the public finances for a generation, the party would implode. If they have any let-up on the business-bashing, then Gordon Brown will end up with a bigger defeat than Michael Foot in 1983.

The Economic Legacy of Labour – A Summary for the Tories

Thirteen years of Labour has increased the National Debt by £600bn or £10,000 for every person in this country.

How is this worked out?

  1. A prudent government would have kept the National Debt at a constant level of GDP in the boom years. From 2001 to 2007, Labour let this grow by around 15% of GDP.
  2. A prudent government balance the budget over the course of the business cycle. In 2007 Labour were at least 4% short of that. That is, they had a structural deficit.

 

Take the two together. Under current forecasts the structural deficit will still be around in 2014. That is after four years of strong growth, the economy will have grown maybe 15% from the bottom in 2009 and be nearly 10% above the 2007 level. Yet the deficit will still be over 5% of GDP. Seven years at 4% is 28% of national income.

15% + 28% is 43%. Translate this into pounds by multiplying 43% by national income of £1400bn, gives £600bn.

Some could be a little less generous by adding compound interest to the extra £200bn of debt acquired in the good years and 4% structural deficits for seven years the at least £150bn to add to the end of 2014. So that is £750bn.

Under a Prudent Government, this very severe recession would have added up to £300bn to the National Debt. It would have peaked slightly higher than Labour managed in 2007 before the downturn. Most of that could be reduced with a sustained strong recovery and without real cuts in public expenditure.

Instead, the legacy of 13 years of economic mismanagement by a Labour government will be high taxes and a squeeze on public expenditure for a generation.

More detail for my earlier posting at http://manicbeancounter.wordpress.com/2010/03/21/the-impact-of-labour-on-the-current-crisis/.

This is prompted by John Redwood’s posting “Labour Government’s end in Economic Chaos“.

Thanks to Stuart Fairney for the suggestion of passing this idea to the Tory Front Bench.

The Impact of Labour on the Current Crisis

UPDATE 11th APRIL – I WAS RIGHT IN SAYING THAT THIS WAS TOO LOW AN ESTIMATE. IN THE BUDGET REPORT NATIONAL DEBT REACHES OVER 91% OF GDP, NOT 87% AS MODELLED HERE.

John Redwood today claimed that

“Labour governments typically devalue the currency, run out of money, and preside over industrial chaos. Welcome to the spring of discontent.”

However, Redwood fails to attempt to quantify the extent of this economic mess. Gordon Brown would counter that the current situation is none of his doing. The Labour Spin Doctors might try to imply that the Tories are saying that the worsening of the deficit & national debt is 100% down to them. This is literally untrue. The opposite – that none of the current economic crisis is due to Labour’s economic management – is equally not true.

It is important to be able to split out the worldwide impact from the Labour Government’s

economic ineptitude.

I did some simple calculations comparing two situations (all as a % of GDP)

1) An actual (Labour) one where in 2007, at the top of the cycle there was a budget deficit of 3.5% and a national debt of 44%.

2) A fiscally prudent (Prudence) one where budget deficits had not been incurred in the good years, so in 2007 the budget surplus was 0.30% and the national debt just under 30%.

Let us assume there is a similar worsening of public finances of 8.5% of GDP, so under Labour the deficit peaks at 12.2%, under Prudence 8.6%.

Under a Labour the national debt peaks at 87% of GDP in 2015; under Prudence 48% in 2013.

Under Labour we have a structural deficit of at least 6% of GDP; under Prudence at most 2%.

This is graphed below.

That is, the Labour (or specifically Brown) effect  is an increase if the National Debt of over 40% of GDP and a structural deficit of £90bn that must be eradicated. Under Prudence the increase in National Debt is less than 20% of GBP and a structural deficit of £30bn.

This is, however, much too generous on Labour, as I have assumed.

1)     Growth Rates are the same.

2)     The average level of interest on the National Debt is the same.

3)     The worsening of the Government Finances is the same from peak to trough.

4)     The effectiveness of the fiscal stimulus is the same.

5)     The turnaround in the public finances is the same.

6)     The growth forecast through to 2015 is 3.2% growth. This is roughly as forecast in the 2008 Autumn Pre-Budget forecast. Thereafter the growth rate will settle at 2% per year.

Therefore, by implication:-

-         There is no impact on the recovery through massive cuts in government spending and/or real tax rises.

-         There is no rise in interest rates as a result of the ballooning deficit.

-         There is no real problem in reducing public spending by 12% of the total in five years (or by around 30% of the total excluding the health sector, education and transfer payments), as against a 4% reduction.

-         The existing deficit pre-downturn had no impact on the size of the downturn.

-         The effectiveness of the economic stimulus was the same regardless of the size of the deficit, or whether it was on the back of a fiscal stimulus (through public expenditure increases) for the last seven years.

So going forward, it is fair to say that as long as the recovery is strong and interest premium does not rise in relation to the euro area, and the government achieves the deficit reduction targets, the national debt is at least 80% larger due to Labour, and the fiscal squeeze is at least 3 times greater.

Nationwide and Halifax house price recovery is fragile

The recovery in house prices reported in the Nationwide and Halifax indices underlies a significant issue – that many existing borrowers would see a much higher rate of interest if they moved mortgages. As an example, my own repayment mortgage is currently 1.9% annual interest rat, or 1.4% above base rate. If I moved house Nationwide’s best deal on a tracker is 2.44% above base rate for 2 years and the reverts to 3.9%. There is also a nearly GBP 900 fee. Halifax are similar- 2.69% above base rate for 2 years, then reverts to 3.5%. A GBP 1200 fee here.

These are the cheapest deals, for a loan less than 60% of the house price and are competitive in a thin market. Halifax reports August 2009 approvals were 51% lower than in August 2007. The Nationwide’s measure of private housing sector turnover rate is now 4% , from a peak of 7% and a low of 3%.

As the driving force for the Housing Market is people upgrading to a better house, there may be a considerable number of people delaying moving house for this very reason. It is better to save for a new house by paying down existing borrowings than move to the more expensive house.

Paradoxically, a rise in base rates may prompt a narrowing of this differential and therefore perk up the housing market. The reason being that the marginal cost of moving will have diminished. However

-  there are other reasons for the low levels of housing activity – uncertainty over jobs and the need to pay off debt.

- a rise in interest rates may tip many existing hard-pressed borrowers towards selling. In particular buy-to-let landlords who have seen rents diminish this year.

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