Tuesday, June 22, 2010


The first thing I liked is the return to a traditional plain dark red cover for the budget report, hopefully meaning no more New Labour PR spin, but that would be a revolution in politics.
In his speech Chancellor Osborne rose several notches in everyone's estimation, as did Harriet Harman too, labour's acting leader, in one of the best opposition responses to a government budget for years, which balanced excoriating attack whilst welcoming some of the Coalition's measures.
The Budget Report begins, "The British economy has become unbalanced. It has been too reliant on growth from a limited number of sectors and regions. Overcoming these challenges will require a new model of economic growth built on saving, investment and enterprise instead of debt. This Budget is the first step in transforming the economy and paving the way for sustainable, private sector led growth, balanced across regions and industries." This is wonderful for being the first statement in a long time on economic policy in our party politics that looks round the corner past the question of government finances and talks about more than just supply-side notions, or am I being over-hopeful? The June Budget report does state that the UK private sector has become the most indebted country in the world at five times GDP (or ten times higher than government) and a graphic is supplied to show this.But, this is hyperbole because the information ignores the other side of the account of what the rest of the world owes back to UK banks and other factors such as the quality of collateral offered to banks by domestic borrowers etc., all of which would show a small net surplus. The point should be that lending and borrowing are not necessarily signs of anything unless you look at both sides of the balance sheets.
The June Budget Report instead of doing that says "Between 2002 and 2007 there was a near tripling of UK bank balance sheets and the UK financial system had become one of the most highly leveraged in the world, more so than the US. As a result, the UK was particularly vulnerable to financial instability and was hit hard by the financial crisis. The loss of confidence and withdrawal of credit that followed precipitated the deepest and longest recession since the Second World War: output fell by more than 6 per cent." This is nonsense on several counts. "The UK" was not highly "leveraged" in terms of the references above, and the fall in output was exceeded by other countries such as Germany, which was not at all "highly leveraged" in the sense implied above. More such guff follows including quoting the ratings agency Fitch & Co. who make errant assumptions about 'public sector' when they mean 'central government' and are no better than newspapers at in depth analysis - another set of jokers in my view, playing with fire. I can show that if the Bank of England was counted within the public sector then the extreme opposite is true that the UK was massively reducing its net debt position in both 2008 and 2009 to the lowest in the OECD!
The Budget report discusses UK competitiveness, but this is interpreted in tax competitive terms. Hence there is a clear plan to lower corporation tax significantly and introduce other measnures to retain and attract investment.
The fact of the matter, to be absolutely clear about this, and so on, in my view the UK economy's problems lie elsewhere, mainly in extreme imbalance in UK bank lending of 70% to mortgages and property, only 1.5% to small firms (who employ half of all private sector jobs) and only 23% to business that is not related to property and only 5% of all lending is to UK industry making tradable goods on whom we rely for a fifth of our economy and most of our exports! That the UK is the 7th biggest manufacturer in the world and not far further down the league table is no thanks to UK banks! These are the issues that government has to address in "rebalancing" the economy to compete in the world. German banks lend ten times more to domestic industry and small firms than UK banks. UK banks lend more to foreign industry in foreign countries than to businesses in the UK.
Like its predecessor the Coalition is keen to improve funding access for small and medium sized firms, but I doubt it understand the scale required to compete, for example, with Germany or China, in banking lending available to SMEs. The measures it discusses might increase funding for SMEs by about £1bn or 2.5% when 100 times this is required to grow over the medium term.
We have to look hard at the fact that the UK was a leading credit-boom economy alongside USA, not an export-led growth economy like Germany or China, which is not good idea either. The OBR forecasts predict a surprisingly significant improvement in the UK trade balance, partly due to the weaker pound but at the same time continuing deterioration in the balance of payments? Also, the forecast expects employment to continue growing and unemployment falling, which counters Labour's fear of double-dip recession and half a million job losses with 25% cuts over time in central government departments. The forecasts expect the contributions to growth of business investment and improving trade balance to exceed household spending's contribution to growth. The June Budget report shows this graph of economic growth to show the historically steepest fall of any post-WW2 recession, as if most shocking. The UK performance was in good company. It mattered little if one was an export led surplus or credit boom deficit country, all fell together in 2008.I do wish that mandarins and politicians would have the temerity not to exploit partial facts and do more to discuss the global picture.
In case anyone thinks there is a pragmatism at work in the Budget Statement in place of merely the 'make government smaller' kneejerk Conservatism, there is a page 1 in the budget statement: "Reducing the deficit is a necessary precondition for sustained economic growth", which is purist rhetoric that makes no actual macro-economic sense except to signal the balance of the coalition's conservative stance. It is good politics, however, when most people have a grossly exaggerated idea of the size of government in the economy. Figures of 40-60% are bandied about as cast-iron fact when the true figure is only 20% and best not get too much smaller than that! UK government sector has always for example during the twentieth century been smaller as a % share of the economy than in the USA, but most people would imagine the opposite to have been true!
The Office for Budget Responsibility (OBR), in its pre-Budget forecast stated that "without further action to tackle the deficit":
•• public sector net borrowing would remain at 4% ratio to GDP in 5 years time,having
been above 5% for 6 consecutive years, unprecedented in the post-war period;
(This is so; the Maastricht criteria of a maxima of 3% ratio to GDP and 60% national debt were based on long run UK experience - don't tell the other signatories in the EU. But 4% would be a good result and actually is an exaggeration because OBR took no account of one third of Government Debt held by government itself or the income and sales revenue to be gained when disengaging from interventions that saved the banks!)
•• the structural deficit would be 2.8%/GDP in 2014-15, while the structural current
deficit would be 1.6% and national debt would still be rising in 2014-15 to 74.4%/GDP, with annual debt interest reaching £67bn in that year. (But those are only the gross figures, and could easily be greatly reduced by deploying the government's financial assets that balance the other side of the account- more later).
The fiscal consolidation that is additional on that planned by Labour is shown in the following table: The Government states that its mandate is to achieve "cyclically adjusted current balance by the end of the rolling five-year forecast period" (2015-16). That is a very welcome statement, much more sensible than the idea of totally eliminating the structural deficit.
The plan is for £40bn deficit reduction (4/5 by spending cuts, 1/5 by higher tax rates), which sounds ok, representing 7% of the budget and only 3%/GDP. But, this is on top of budget balancing plans inherited from the outgoing government's March Budget. The June Budget plus plans the Government inherited represent a total consolidation of £113bn by by 2014-15 and £128bn by 2015-16, of which £99bn per year
comes from spending reductions and £29bn per year from net tax increases. Over 5 years this amounts to about £460bn and to about 15% lower government spending that will make the government, according to Conservative commentators, shrink by one quarter in financial terms by the end of a full government term. The liklihood of this being accomplished is not high given the strong possibility of a Euro Area and EU recession soon when the government will have to cyclical adjust its spending upwards again. Actually public spending does not fall:The spending increases approach 5% and debt interest falls modestly. These values are within rounding errors of inflation, interest rates and other factors. Therefore, arguably, there is something of a joke here in ratio to the almost hysterical banter about debnt and deficit in the election politicking. Marshall McLuhan quipped that behind every joke lies a grievance. Looking at the figures they do not appear too different from the inherited projections. In a stable democracy stability in handover of government is important. The projected differences for the year 2010-11 in my view are within error margins and not as yet cause for alarm. The Coalition Government cannot be accused of playing fast and loose with the inherited projections and the differences do little more than reflect a slightly faster economic recovery than forecast. Here are Labour's projections.The big moves that are possible in public sector finances from unwinding government support for the banks will not happen for another year.
What is on the Treasury butcher's block?
1. earlier than planned spending cuts, but actually not much
2. cut structural deficit to zero within 5 years but subject to cyclical factors
3. spending cuts building up to £120+ billions = c. 15% of government budget.
Labour had spending efficiency savings in mind of about £80bn over 5 years plus £100bn of asset sales not counting shares in the banks etc. But,someone in HMT or OBR must know that to cut the deficit by £100 requires a £128 spending cut, while a £100 spending increase generates £28 in directly related taxes plus £12 in same year indirectly and another £20-£30 over the next 3 years depending on the line items and £20 leaves the economy to pay for imports. The Budget forecasts expect about £450bn in spending cuts and higher tax revenue, but a net £115bn higher spending, which is a 20% restructuring of government finances over 5 years.
In my view any government can and should legitimately seek to achieve that degree of policy flexibility if politics is to have any meaning.
What I dislike has been the electioneering rhetoric, much of it false or empty:
- UK heading for highest national debt ratio in EU or G20 or merely highest debt
- Public finances in a mess; largest borrowing requirement in UK history; debt interest costing as much as Defence or Police (£41bn) and some say about to exceed Education
- Tax burden for future generations (unspecified - decades or a century?)
- UK 48% or more than 50% or in some regions 60% and 70% of the economy, of GDP etc.!
- Government unproductively too big etc. £90bn hidden black hole etc.
My arguments:
The hysteria about public finances is normal in election campaigns; same plank that got Labour elected in '97 when it unrealistically accused the Major Government of over-borrowing and no one batted back to ask what Labour would have borrowed had it been in power to reflate out of the recession in the early 1990s.
The hysteria is also important to holding the coalition parties in government together on a predominantly Conservative financial agends albeit one that assumes if only the government finances are in balance then everything else in the economy will be ok and enterprise freed to grow?
But, the truth is that public finances are not in a mess, not compared to private sector debts at three times government's (not counting banks' foreign assets & liabilities at 8 times governemnt gross debt and that matters not a jot as much as the confidence required for UK banks to competitively borrow five times as much as government this year to refresh their funding gaps.
The Public Sector's net position in financial assets is very solid e.g. 1/3 of national debt is owned by government and could be cancelled by fiat or sold off without increasing the national debt. 1/3 of debt interest is paid by government to itself. And after debt interest is taxed net interest cost is only half the gross budget figure. Last year, QE buying in gov. bonds exceeded new borrowing by £30bn = actual net negative government borrowing!
The structural deficit cannot be reduced to zero because it includes £100bn national savings, currency in circulation, and because banks, insurers and pension funds need an annual supply of new gilts for investment and capital reserve purposes (recent auction were four time over-subscribed). banks especially need a handsome supply or they will be buying foreign government bonds instead in large quantities.
National debt heading for £900bn is offset by off-budget items such as £240bn of the debt owned in gov. accounts, £50bn bank shares, £30bn financial assets in public sector enterprises, £30bn reserves, c. £500bn bank assets swapped for £260bn gov. paper = £140bn surplus (off balance sheet), and a stock of other assets conservatively calculated that roughly match or exceed the total of the national debt.
The budget deficit is narrowing with recovery faster than expected, leaving the 'structural deficit' calculated to persist in 'normal' years, of about £70bn - though this seems high. But given this is for necessary capital investment (and actually Osborne in his speech all but said that Brown's Golden Rule lives on). But in rebalancing the economy, Osborne is cutting public sector capital investment when capital investment in the UK is one of the lowest in the G20 and it needs serious rethinking. Serious attention should be given to measures to ensure UK banks lend far more to business and far less for property and mortgages. The governmen plans to discuss with banks the regional distribution of their lending and to SMEs. This should extend to a lot more, in the ontext of to what exten the UK must be less credit-boom led and more export-led, especially concerning long term lending to business sectors.
The money markets have the UK, Euro and Euro countries they hope cornered like a highway robber having stopped the stagecoach and is levelling pistols and demanding gold watches. The markets are presuming everyone is more scared than wise to them and unable to call their bluff. I would call their bluff.
In UK (and US too) the profit from off balance sheet bank bail-outs (replacing private sources of profitable funding gap finance) alone can recover half of budget deficits over the 5 year medium term. The tax rake-back on the other half over recovery to higher growth plus small doses of inflation will see budgets 'normalised'. There will be no perceptible burden on 'future generations' and the borrowing and off balance sheet financing is in any case more tax-cost effective than higher tax rates.
The OBR forecasts expect residential property values to grow much more slowly than in past years and for commercial property values to recover significantly faster. This suggests that the OBR expects there will be a significant shift in bank lending including property development and mortgage lending from households to business. The basis for believing this would be interesting to enquire into.The Coalition government believes that private enterprise will grow more with the budget redaction. Labour's view is that the economic cake risks being made smaller not larger by shrinking the state and that half a million jobs will be at risk. Spending is now projected to fall from 48% ratio to GDP to 40% by 2015-16 and receipts are projected to rise from 37% to 39% ratio to GDP. Cyclically adjusted
public sector borrowing will be reduced by 8.4% to 0.3% ratio to GDP in 2015-16. This is based on the following GDP forecast.

In conclusion my point is that balancing or normalising the budgets and debt positions are only a matter of time once the hysteria about public finances has calmed down. A quarter of all the budget consolidation (£110bn) over 5 years is expected from lower government capital investment and asset sales. It is my expectation that considerably more can be done and that should also be done to sustain a much higher level of capital investment. There may be an element however of battening down the hatches in anticipation of a Euro Area recession or prolonged low growth?
For the Euro Area fiscal problems are rather different. In part this is because all Euro Area national central banks gave away theo money market activities to the ECB and have much less flexibility than the UK, such as when calling on the ECB for responses on a scale commiserate with the UK and USA. The UK can roll over £100bn of treasury bills off budget, while that is not feasible for Euro Area members except indirectly via complicated negotiation with ECB, which is in any case not set up to assist with state governments' financing.
Therefore, Euro Area states' banking sector funding support interventions had to be 'on budget' and this is essentially the Greek and Irish problem, but others too, including Germany where the banks are extremely vulnerable to falling business profits causing loan losses and vulnerable to disappearing net interest income becauser the banks lent 60% of all loans to industry.
The EU and Euro Area have much bigger problems to solve in determining how to reform the Euro system as they head into serious trade winds that should propel them soon into a year long recession!

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