Back to the Future

So after nearly 3 years I've decided to return to my blog.

Looking back over what I was writing in 2009 is a little sobering. I'm not sure I'd agree with all of it now. In particular I was fretting tremendously about the deficit, and how dangerous I thought it was. Today I'm far more worried about unemployment and the output gap.

It's interesting to consider why I thought what I did, and what's changed my mind since then. There are plenty of commentators tearing their hair out at the government for not changing its mind in a similar way - however, from what I can tell, they are the commentators who never agreed with the government in the first place. So perhaps I have a different perspective to add.

Back in 2009 I was declaring that I couldn't overstate how dangerous I thought the deficit was. What seems to have driven my fears was:

a) the threat of a gilt strike - there had been a wobble on the markets where it looked like the government might struggle to sell all its debt. At a time when we selling a lot, and would have a lot more to sell in the future that looks scary. It was big news at the time, but we've probably nearly all forgotten about it now.

b) driving up interest rates - I had a conviction that nearly all the governments and firms were trying to borrow at once. Had this been true then there would have been a risk of driving up interest rates and crowding each other out. However, it errrr wasn't true. Firms in particular aren't trying to increase borrowing - in fact they've been doing the opposite. I failed to spot a liquidity trap when we were in one.

c) the long time horizons - the deficit and debt projections in 2009 were frightening. I remember being in a public debate at the London School of Economics where two professors were giving the opposite arguments about the deficit. They showed the projection that had the UK only managing to balance the budget by 2020. Ten years of deficits looked utterly, and horrifyingly, unreal to me. At the time I declared that a plan that didn't assume you did it by the end of the Parliament didn't assume you did it at all. I was, and really still am, very distrustful on the stated ability of governments and politicians to do things which involve long-term decisions. What I failed to recognise was that solving the deficit is easier said than done if austerity depresses the economy.

I suspect the government shared some of my fears, but I also suspect they had some reasons that were all their own:

a) a conviction that public spending was out of control before the crisis, and that it needed to be reined in and the state shrunk. Hence, quite a few of the spending cuts we've seen touted already sound a lot like things this government might have liked to do anyway (benefits cap for example). This, alas, is opportunism dressed up as pragmatism, exploiting a crisis to satisfy an ideological agenda. Some of it is very unpleasant, as the usual checks have been turned off. Whereas ordinarily those wishing to cut benefits would have been subjected to a lot of scrutiny and contest on all sides (because it can be quite controversial), the advocates of such cuts are able to escape the criticism by declaring its all necessary because of the need to close the deficit.

b) being scarred by Black Wednesday. This, I think, drives senior Ministers (PM and Chancellor) more than anything, and likely underscores their fear that the markets will turn against the UK is they don't stick to austerity. Cameron was working in the Treasury as a press adviser to then Chancellor Norman Lamont during Black Wednesday in 1992. He saw the markets turn against the UK, and break the government's economic policy at first hand. The power of the markets is therefore a very real thing for Cameron - he doesn't imagine, he remembers. Now the lesson might not be valid, but politicians are informed by the circumstances in which they cut their political teeth. Just as Blair was unable to raise income tax because he remembered Labour's defeat in 1992; Cameron is unable to consider disagreeing with financial market commentators because of Black Wednesday.

Green Shoots of Radicalism

Over the weekend David Cameron gave his speech to the Conservative Spring Forum at Cheltenham. I had thought I might try and analyse the speech, but instead I'll just focus on one very important aspect: the singling out of tax credits for the chop.

Now Cameron didn't say he'd obliterate them totally, but rather that the situation whereby someone on £50,000 receiving tax credits was unsustainable and in need of reform. I agree, but was pleasantly surprised to see a politician say it (Vince Cable also said this was a problem last weeek). Tax credits are a nice handout to the middle classes, so removing them will be politically painful if not traumatic. But removed they must be.

Why? I fear that tax credits have been a time bomb sitting within the public finances. Ordinarily governments set up automatic stabilisers which kick in during a recession. The classic example is unemployment benefit - tax revenues are falling because people are losing their jobs so no longer paying things like income tax or national insurance, but at the same time they start collecting unemployment benefit from the government. This causes the government to need to borrow money, but stops the economic fallout being too horrendous (the people have got some money). Tax credits act as souped up automatic stabilisers. Now you don't need to lose your job to start costing the state more money. If your income simply falls you pay less tax, but become eligible for more tax credits to be paid to you. Given that these tax credits can start once your income falls below £50k, that affects an awful lot of people. So many that it represents a real threat to the stability of the public finances, whose stabilisers can cause it to fly out of control. A small downturn can quickly create a huge need to borrow, so a deep recession can create a gargantuan need to borrow.

Therefore tax credits represent a threat to the stability to the public finances, but ordinarily would be a political hot potato no-one would like to pick up. That Cameron and Cable have attempted to pick it up is heartening. It shows that they get how big the problem is, and what may be needed to solve it. This could be the start, the green shoots if you will, of a radical reshaping of economic policy in the UK.

The Red Budget of 2009

Whilst I don't regard the borrowing figures as too outlandish compared to what commentators like John Redwood have been warning, it's apparently spooked the markets - who've been especially troubled by the government's apparent need to try and sell £220bn of gilts. It's gotten so bad that the Debt Management Office has, according to Robert Peston, syndicated out selling £20-£30bn of it to the banks.

I'm quite worried that having ignored the systemic risks around CDOs, credit default swaps, hedge funds etc. we're going to ignore the systemic risks around such colossal borrowing. Firstly, this borrowing is going on globally (after all, we are in a global downturn) - both governments and firms are needing access to credit on a big scale. It therefore looks extremely dangerous to assume that this is a 'normal' borrowing environment, that there are no limits, that there are no risks of failure to raise cash. We face a twin peril that we may start to run up against the buffers of what the markets are prepared to bear for us at 'reasonable' rates, and that we are competing for the money with the other governments and firms of the world. Are we as attractive a proposition as the USA or Germany? More importantly, are we prepared to adjust to a world where the global credit markets simply aren't as awash with cash now that the banks are in retreat, the sheikhs have seen oil lose two-thirds of it's value, and the Chinese discover their own need for cash?

I don't think I can state how dangerous I think this level of borrowing in this economic environment is.


It's to be expected that the budget would contain some attempt at help for job creation, training, housing etc.. In general they look like small two-bit schemes so nothing to really frighten the horses. However, it's very disappointing not to see any proper attempts at spending cuts. If the list given above is accurate then it's really disappointing, as that appears to be a list of the usual suspects for quick 'efficiency' gains - ie those bits of spending that don't have powerful/effective defenders within Whitehall such as flood defence and university research grants. Flood defence last saw savage cuts 3 years ago when Defra was fined by the EU (and had to pay out of it's own budget). Research was 'reorganised' 4 years ago when Uni departments with an RAE rating of 5 was targetted as where the lion's share of the research cash would go. How much there is really to cut there remains to be seen. Personally I think the answer will be sod all, so we'll run them down a la 'death of a thousand cuts' to avoid the 'pain' of actually scrapping a big ticket item.

Darling has at least had the courage to announce some proper tax increases though. Raising fuel duty shouldn't be horrendously painful seeing as oil prices have plummeted. The problem with trying to soak the rich as he has done is that whilst it does raise some revenue (and we're sailing so close to the wind financially every penny counts) the real point of doing something like that (at least from Cameron and Osborne's perspective apparently) is that it provides the necessary political cover for really going after big spending cuts. A 50% income tax rate is a big step in political psychology. Accompany that with taking a big bite out of government expenditure and you demonstrate how serious the situation is, and show that the idea that there is a choice between cutting spending and taxing the rich is false - the circumstances are so dire we have to do both. Darling and Brown may have attempted to shoot that fox by bigging up the tax rises, and downplaying the spending 'cuts'. If they have succeeded that have bequeathed their successors a poisoned legacy of political scorched earth.

In the spirit of the times, with the G20 trying to reshape global policy, and all sorts of changes happening in Britain (we now own several banks, and are running unheard of deficits), I thought this was a chance to strike a more radical pose. What's gone wrong with our economy and what ought we aim to do in the future?

Some ideas from me:

The diagnosis:
The Credit Crunch:
Banks and other financial institutions started trading in derivatives and suchlike that they didn't really understand (or more accurately, thought they understood but didn't). These were not properly assessed, and their regulatory badging from the ratings agency heavily relied on (this becomes an even bigger problem when they are cut up and repackaged - eg the AAA component of a new CDO is actually BBB, it's all wrong). Likewise they started engaging in credit default swaps (a kind of insurance). This is all supposed to reduce risk by spreading it around. But because all the buyers and sellers are the same people it introduces a systemic risk - losses can reverbirate and magnify through the system. Indeed a moral hazard is introduced - you don't have to worry about your bad decisions if you can sell the risk on. But at the same time you're buying up other people's risk (which is based on decisions you didn't make). This might make things better if a 'buyer-beware' attitude prevailed (you'd only take risks you were confident you could sell to sceptical client) but with the ratings agencies badging everything, and everyone believing the system is safe rather than at risk itself, the opposite happens.
So, when people start defaulting on their mortgages, the losses start charting their way through the CDO market. Firstly the losses are far bigger than any of the models predicted (bad maths - see Taleb and Mandelbrot), and no-one's sure where the losses are going to pop up because the mortgages have been cut and re-sold so many times. Through it credit default swaps exposing people to other firms mistakes, and paranoia grips the market. The buyers are suddenly very beware because they don't know where the risks are.

The Real Economy:
Bank credit dries up for businesses causing them to cut back. A lot of the 'real' economy is also built on heavy borrowing (made available from banks making so much money) and taking money out of a property market than was a bubble (fuelled by mortgages that were artificially cheap because lenders could sell the mortgage on). So, when the credit dries up and the market crashes people have to adjust their spending accordingly and bring it more into line with actual productivity.

The Public Finances:
We were already fiscally stimulated since 2001. We've been racking up debt and shovelling it into NHS like it's going out of fashion. Add to that, a lot of capital investment has been financed through PFI, which is dependent on the credit markets, and so are now being underwritten by the government. The PFI are also being used to hide debt, so there's even more debt being accumulated.
Now, with the economy taking a sharp downward adjustment as people get sacked, those in employment see their wages fall, and companies lose profits - tax revenues go down, and spending go up. Traditionally, automatic stabilisers are thought of as unemployment benefit. But, in the UK under Labour a far far bigger component is tax credits for people in work. It's akin to the reverse of the poverty trap - your income declines, so your tax paid declined, but the state (despite the loss of tax revenue) starts paying out more tax credits to you. And so, the public finances start to spiral out of control.
This crisis is especially hard on Britain, because we've become so dependent on the City, and so a recession based on the City will be especially problematic.


The Road Ahead:
Financial Regulation:
- return to buyer-beware
- restoration of the Bank of England, with a look at the system
- look at Glass-Steagall
- move pensions towards defined-contributions and away from defined-benefits. This should be accompanied by splitting pension funds away from the parent companies. This should help corporate governance as companies will not be owning one another, and instead there will be more a division between owner firms (the pension funds) and producer firms (the standard companies)

Work & Pensions:
- any chance of restoring the earnings link to pensions has gone. It's simply unaffordable now.
- we need to urgently scale down the scope of tax credits. They represent a dangerous risk to the health of the public finances.
- US/Australian style welfare reforms are probably needed, but this is politically unfeasible until the economy starts to recover.

Energy & Climate Change:
- there is an urgent need to rebuild our energy infrastructure anyway. The priority ought to be nuclear and renewables, in particular the proposed Severn barrage. Energy is the only way we will make any serious dent in UK emissions, especially if cars switch to electricity or hydrogen cells, and domestic cookers move from gas to electric, and we see a big rise in our electricity demand.

Environment:
- there is an opportunity for ecological restoration. In particular reflooding coastal wetlands is cheaper than conventional coastal defences. Uneconomic farmland could be reforested. Agricultural subsidities ought to switch away from production and towards environment, ecology and culture (we'll never persuade the French or Poles to scrap them).

Defence:
- the military is underresourced and overstretched. It is the most pressing case for budgetary increases.

Education:
- if effective school competition is unaffordable (it involves funding for far more places than we currently have), then focus school budgets on early years provision to prepare kids as well as possible.
- urgently refocus HE spending. Cut student numbers overall. Boost subsidies for priority subjects such as engineering, physics, chemistry and mathematics. Introduce grants and subsidies for postgraduate courses and PhDs.

Health:
- accept that we are now in a period of 'normal' spending increases.
- try to move NHS priorities towards improving quality of life, rather than simply extending lifespan. The demographic challenge means that we are going to need to work for much longer, and we need to be healthy in order to do that.

Housing:
- attempts to rejuvenate the North have failed. If we are to house ever more people in the South then we'll need to have higher density housing. Currently, this has meant cheaply built little detatched houses with tiny gardens. This 'rabbit hutch' planning has to stop.
- instead, high rise ought to be the order of the day - make the apartments deliberately large, minimise communal gardens and instead have public parks (based on the Royal Parks - ie big, with plenty of variety in the landscaping), and have plenty of space for car parking (perhaps nearby multi-story garage).
- where houses are built bring back semi-detatched, build an accessible and usable basement, and have the loft ready-converted.

Regions:
- introduce regional corporation tax rates
- consider regional minimum wages (although this may make it difficult to avoid poverty traps)

Taxes:
- Income tax will need to rise to 45%
- Roll employees National Insurance at least into income tax
- Make reducing corporation tax the first priority of any tax reduction
- The second priority is to increase savings rates. It ought to appall us that the West is begging Chinese peasants for their savings to bail us out.

Transport:
- Eventually replace Heathrow with Boris Island
- High speed intercity rail, and east-west rail lines restored (once money allows)

Europe:
- attempts at a European FSA ought to be resisted - Spanish banks escaped the worst of this crisis because they were regulated differently. Europe-wide regulation could have made everyone like Spain, or it could have made everyone like the UK.
- joining the Euro ought to be ruled out. It's hurting Spain and Ireland very very badly.
- closer co-operation on foreign policy has been shown to be a sham. Britain was far more effective acting as it's own player at G20, rather than having to agree a line with the rest of the EU before the summit.

Taxing Times

Those who keep a close eye on British politics may have spotted a small dispute growing in the Tory party about how to respond to Labour plans for a 45% rate of income tax. Some may simply say there is one side that wants to implement the new rate, and another that opposes such a move. Life is, however, rarely that simple. The debate appears to have moved in an interesting direction. A number of distinct camps seem to be emerging:

1. The Political Capital Builders - see that spending cuts can no longer be a gentle erosion of spending, but instead are going to have to bite hard. They argue that it's political suicide to argue for strident spending cuts and at the same time strenuously ensure that those on £150k+ are mollycoddled and protected from any adverse impacts of the recession. If the rest of us are going to accept spending cuts, they ought to accept tax rises. Besides, it's the only way there's any chance of getting people to accept the cuts on the gargantuan scale needed.

2. The Finance Pessimists - those who look upon the current state of the public finances and fall into a deep despair. They view the current borrowing requirements, let alone if you relax the currently optimisitc projections, as necessitating tax rises. The debt accumulation is an horrendous economic risk (it's huge, it's growing fast, the rest of the world is borrowing at the same time, the risk of credit downgrading is too high), then spells real economic disaster if we lose control of it. All other considerations pale into insignificance next to balancing the books and getting a grip on the government borrowing requirement. Borrowing is in fact so large, that spending cuts cannot be enough - you simply won't be able to cut spending fast enough. Tax rises are necessary.

3. The "Wait-and-See"-ers - those who wish to wait and see in the hope that something will turn up, and save us. They regard tax rises as a wholly unnecessary commitment, and that the correct course of action is to wait and see. They therefore are more relaxed about the public finances that the Finance Pessimists - believing that things may not be that bad. However, they don't rule out tax rises in principle, and accept that they may turn out to be necessary.

4. The Ideologues - those who will not countenance the Conservative party raising taxes under any circumstances whatsoever. The state of the public finances are an irrelevance, if you want to balance the books cut spending. If that doesn't work cut spending more.

The debate in large part isn't really about whether the party should raise taxes on principle or not. Rather, it is about what we believe about the state of the public finances, and what scale of action is required to return them to a semblance of health.

To my mind, whatever their protestations, I think those who oppose the 45% rate are actually those who are least ambitious about spending cuts - that's why they don't think you need to build any political capital to get them through, and you don't need to cover the fiscal gap. It's rather ironic really. But maybe I'm biased - I firmly count myself in the second camp.