Sunday, 28 March 2010

The 2010 budget, bad economics leads to bad political results

by Michael Burke

The main verdict on the 2010 Budget from both The Guardian and the Financial Times was remarkably similar; Alistair Darling should be commended for avoiding any pre-election giveaways. While the FT would have liked more detail of how spending would be reduced in further years, both were agreed that the Budget would offer reassurance to the financial markets. Coverage in the other press is summarised by the BBC here.

With much of the debate in Britain focused on the level of the public sector deficit, there was surprisingly little attention paid to the fact that, with one month to go in the current financial year, this is now projected to be £11bn lower than the Treasury forecast of £178bn made in December. However, an analysis of the decline in the deficit is highly instructive- and completely vindicates the idea that increased government spending and investment are key to the economic recovery and a narrowing deficit. The full document can be found here.

The £11bn improvement compared to the forecast arises primarily from the stimulus measures taken in 2009. Of the total, £2bn arises from the tax on bank bonuses, which was derided at the time by many commentators, not all of them working in financial markets, as likely to produce nothing. Another £1.5bn was the result of lower than forecast interest rates on government debt. So much for the notion that cuts are needed to ‘reassure financial markets’. The interest rate decline took place when the stimulus was taking place.

The bulk of this £11bn improvement also derives from taxation revenue - this was £7.5bn in total (p.192). The stimulus measures taken in 2009 are responsible for this improvement in the deficit. They consisted of just over £5bn in tax and spending measures in current spending as well as just under £24bn in ‘automatic’ rises in spending associated with recession. In addition, there was a £21bn increase in net government investment. Even taken together, these measures are not especially large, amounting to 3.6% of GDP, with just over half of that being discretionary, not automatic spending. This discretionary spending was fractionally below the two per cent average stimulus provided by the G20 economies in 2009.

Stimulus works

This £50bn increase in spending produced a net reduction in the deficit projections of £11bn, of which, as has been seen, £7.5bn was directly attributable to the stimulus itself. Treasury projections are that the deficit will now be £53bn lower over the next 5 years, with further falls after that period. This is a 15 per cent immediate return on government investment, with a payback of the entire outlay in just over 4 years. Further returns are expected in later years.

This experience in Britain is supported by recent analysis from the IMF. The researchers applied seven econometric models (including two from the U.S. Federal Reserve, as well as the European Central Bank, the IMF, the European Commission, the OECD and the Bank of Canada) to the issue of how to revive economic activity via government spending. In the jargon, these are the ‘multipliers’, the economic impact of changes in fiscal policy. The main conclusion was that “the multipliers from government investment and government consumption [general government spending]…are clearly larger than…” all types of tax cuts and only “….targeted transfers [to the poor] come close to having the same multipliers as government spending” (p.16).

Better results were achieved when the fiscal stimulus was over two years rather than one and when interest rates are low. Under those conditions, the US multiplier for government investment was 1.5 after one year and accumulated to approximately three over five years. Similar results were obtained for the European Union. Therefore a $1bn increase in government investment lifts economic output by $3bn over five years. In terms of the boost to taxes alone, the initial government investment would be repaid within that period from the rise in activity. Government spending would also be reduced in other areas, especially on welfare and unemployment entitlements.

Abandoning A Winning Formula

Recent experience and the latest economic analysis both confirm that increased government investment boosts the economy and thereby acts to reduce the deficit. But this highly successful policy was abandoned in the 2010 Budget.

In terms of discretionary measures, the Chancellor offered a stimulus of £1.4bn alongside an ‘automatic’ rise in current spending of £38bn. However there will also be a reduction of £10bn in the government’s own net investment. So, last year’s stimulus of £50bn becomes just £29bn in 2010. If inflation is taken into account the total spending increase falls to just £12bn, and discretionary spending is changed from a positive £26bn last year to minus £8.6bn this year.

The contraction in government investment of £10bn is particularly damaging. The decline in investment (gross fixed capital formation) has been the driving force behind the recession; £46bn of the total decline in output of £80bn in UK GDP is due to the decline in investment. According to the Budget forecasts investment will fall again in 2010, by 2.6 per cent, having already fallen by 19.3 per cent in the recession - more than five times the decline in personal consumption (p.180).

This leaves the economy dangerously unbalanced. Again, using the Budget forecasts, the ratio of household consumption to investment which was 3.67 to 1 in 2008, is expected to be 3.95 to 1 in 2012. Without significantly increased investment, Britain will become an economy ever more reliant on consumer spending, exporting less and importing more, and more likely to suffer balance of payments crises, or experience a long-term decline in the pound... or both.

Outside the rabidly pro-Tory press, the plaudits won by the Chancellor are revealing. Despite the ‘windfall’ of an £11bn lower deficit, the increase in discretionary spending compared to the December Pre-Budget Report was just £200m. The remainder will be used for debt repayment. In that sense, it is a windfall for bond markets only.

This highlights the real priority of the Budget and goes some way to explaining the inevitable question; If stimulus has worked so well, why is it being abandoned now? It has been said that Business Secretary Peter Mandelson was the co-author of the Budget. Tradition has it that the Chancellor makes few speeches in the run-up to the Budget. But in a string of recent speeches on everything from railways to higher education to space technology Mandelson has provided important details of the contribution each sector makes to the economy and jobs (the higher education multiplier is 2.6, space 2.1, and so on), and then he goes on to announce that the government will be making cuts. We have already seen that investment is rapidly repaid to government even with multipliers much lower than these. So the cuts actually lead to depressed activity, lower taxes and a widening deficit, just as Mandelson himself has argued.

The Business Secretary and the Chancellor are fixated on improving conditions for the private sector alone to resume investment, rather than the needs of the economy and the improvement in government finances that depend on this overall economic performance. Talk of the economic returns from investment in these sectors is, for the Business Secretary, an invitation to the private sector to boost is profits as the government exits these areas. If necessary, he will smooth the way with subsidies to private business - funded by taxpayers.

This is also the content of the proposed ‘Green Investment Bank’, where a privatisation is used to co-finance investment in green technologies, along with the private sector. Yet on the government’s own forecasts total investment will continue to decline. The green investments are required now, not when the private sector deems them to be sufficiently profitable. And the returns would accrue to the taxpayer, to be used either for further investment or to pay down debt.

A winning formula of government investment has been abandoned in an effort to boost private profits.

The opinion polls showed the results. Prior to the budget the Tory lead had been steadily shrinking until it was down to only two percent in one YouGov poll. But an Angus Reid poll found 54 per cent disapproving of the budget compared to only 30 per cent who approved. An ICM poll found only 9 per cent of the electorate said the budget made them more likely to vote Labour compared to 24 per cent who said it make them less likely. The Tories lead began to expand again. In polls released on Sunday 28 March ICM showed the Tories lead increasing to eight per cent from six per cent. YouGov showed the Tory lead increasing to five per cent from the earlier two per cent.

Unfortunately the budget was not only bad economics it was also bad politics.

Tuesday, 16 March 2010

The scandal deepens in the bizarre logic of the bank bailout

by Michael Burke

Sometimes financial journalists don’t have the background and skills to do a story justice. An experienced crime reporter would be better suited to the task.
The management of Royal Bank of Scotland, which is 86% owned by taxpayers, is considering a buy-back of its own debt, perhaps as much as £10bn.
According to the Financial Times, the plan is in ‘an attempt to boost its capital strength and its standing with bond investors’. But RBS’s capital strength, measured by its ratio of ‘core assets’ to total loans is already 11.6%, much higher than both Lloyds and Barclays, which are below 9%. It is argued that RBS’s loan book is much worse than its rivals and it will face higher levels of default. Perhaps. But, given the disastrous merger of Lloyds with HBoS, it is difficult to see how RBS could be qualitatively worse, certainly not so much worse as to require hugely better capital ratios.
The real reason seems to be contained in the FT’s final phrase; the desire of RBS to improve ‘”its standing with bond investors”. Under EU rules, RBS will be prevented from paying interest to its bondholders for 2 years, because it has received capital from the State. The ban starts at the end of April, hence the rush. But this is the flimsiest protection against taxpayers’ money being shovelled into private hands, as the value of the shares and bonds in virtually all Britain’s major banks would be worthless without the guarantees already provided by the State. The fact is that many institutions, RBS, Lloyds, Bradford & Bingley, Northern Rock, etc., were such basket-cases that they also received direct injections of capital in order to stay afloat.
But even this flimsy protection is too much for RBS’s management. They intend to buy back £10bn in bonds at above market prices in order to curry favour with bondholders, using taxpayer funds to do so. It’s as if the burglar who robbed your home is now being paid to drive the loot away.
In addition the management hopes to pay down at least part of one slug of debt owed to taxpayers by issuing new debt to private bondholders. This will certainly be at a higher rate of interest than the 4% currently being charged, set generously low by government officials.
Now, why would a commercial enterprise pay more than the market rate to buy back bonds? And swap low-interest debt owed to the government for higher-interest rate to private bondholders, who might take a more hands-on approach to how the bank is managed? Why, in fact, would management not take advantage of the 2-year interest holiday imposed by the EU and use it to restore the business?
In an ordinary business, managed in the interests of shareholders, a management team which engaged in any of these actions would be thrown out, if not investigated for corruption. But RBS is no ordinary business. The main shareholder is British taxpayers. RBS is not being run in their interests, but in the interests of the once and future owners, private capital. Meanwhile domestic lending by banks in January is below the level at the beginning of 2007 and continues to decline, and the total bank bailout has cost £126bn.