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The Budget’s fundamental flaw

Image: strumski

Yesterday’s budget statement by Chancellor Hammond was followed by the usual tired old pantomime media appearances this morning.

“I’m ending austerity,” Hammond proclaims.

“Oh no you’re not,” says Labour’s shadow chancellor John McDonnell.

“Oh yes I am,” Hammond retorts.

There is, however, a fundamental point of agreement shared by both politicians.  The answer to Britain’s gathering problems is another round of economic growth.  Hammond’s ability to spend additional money – most of which has been given away by raising the income tax level for the highest earners – is based on a growth forecast from the Office for Budget Responsibility (OBR) that sees the British economy growing by 1.3 percent in 2018 and 1.6 percent in 2019.  McDonnell does not challenge this assessment; but argues instead that by borrowing to invest, a Labour government would drive the growth rate much higher.

The OBR uses neoclassical economic models to make its predictions – one reason why they almost always have to be revised downward.  And since neoclassical economists are clueless as to how the economy really works, and especially where money comes from, there is no good reason to believe that their forecasts are any more reliable than, say, holding a piece of seaweed out of your window.

There are just three ways in which money can enter the economy.  First, governments can print it into existence.  In the UK, this was the primary means by which new money was created prior to Margaret Thatcher becoming prime minister.  In the pre-1979 economy, new money entered the economy via government spending, and exited via taxation.  Although banks had some leeway to increase the money in circulation through fractional reserve lending, government remained in control of the money supply.

After 1979, however, Britain rapidly switched to what is now the main means by which new money is created; private debt loaned into existence by the banks:

In effect, Thatcher privatised the money supply.  Save for the relatively small volume of notes and coins printed to replace those that were worn out, government would limit its spending to the amount of money it could borrow into existence in the bond markets.  And since the price of bonds is inverse to the interest rate, interest rate policy would become the main mechanism through which central banks governed the economy.  The overwhelming volume of the currency, however, would be borrowed into existence by private firms and households.

It was the massive expansion of (private) debt-based currency after 1980 that created the boom years in the 1990s and early 2000s.  It was the inability to repay a large part of the debt that had been created following the double whammy of oil price rises and interest rate hikes from 2006 that led directly to the financial crash of 2008.

The failure to allow banks to go bust in 2008 has left much of the unpayable debt in the economy.  Ultra-low interest rates have allowed millions of zombie households and zombie businesses worldwide to service but never repay their debts.  This is a key reason why the economy has been so sluggish in the decade since 2008 – firms and households that are already loaded up with debt do not go out of their way to borrow more.  Nevertheless, sufficient new borrowing on the two big ticket purchases – houses and cars – along with borrowing in the few growth sectors of the economy – particularly the tech sector – has prevented the economy from imploding… until now.

Believe it or not, the UK economy has – according to the official data – been in one of the longest upswings in history since 2011.  One reason for not believing the data is that inflation-adjusted average wages are still below the level reached in 2008.  It is this lack of purchasing power, moreover that is largely responsible for the snowballing retail apocalypse on Britain’s High Streets.

The squeeze on wages for the bottom 80 percent of British households has been impacting the economy for some time.  As Chris Giles at the Financial Times reported back in May 2018:

“If the amount of money people have in their bank accounts is an indicator of future spending, the UK economy is in for an extended rocky patch, monetary economists have cautioned…

“Over the past six months, the growth rate of M1 — a measure of notes, coins and money in current accounts held by people and companies outside the financial sector — has fallen to zero, after adjusting for inflation. Broader measures of money, including savings balances held in interest-bearing accounts has also been very weak.”

Bank of England data reveals that the rate of borrowing has also dropped significantly in the last year, dragging the broad money supply down:

BoE total money and credit Sept 2018
Source: Bank of England

This shrinking of the amount of money in circulation is reflected in and caused in part by the subject of two stories drowned out by media coverage of yesterday’s Budget.  Last week, Caitlin Morrison at the Independent reported that:

“House price growth slowed to a six-and-a-half-year low in September with prices dropping in the southeast of England, according to the latest figures from Your Move.

“The data shows the average price in England and Wales rose 0.9 per cent to £302,626 year-on-year, although it was down 0.1 per cent compared with August, after an annual increase of 4.5 per cent was recorded in September last year.

“The number of transactions dropped significantly, by 16 per cent on a monthly basis, with an estimated 72,500 sales made in September.”

The large fall in the volume of transactions is more significant than the drop in price, as it indicates that far fewer people are interested in buying (and borrowing) than was the case a couple of years ago.  Nor is it only house sales that are suffering.  The second most expensive item that most ordinary folk buy is a car.  Yet even as Hammond was delivering his Budget speech, the BBC was reporting that:

“A fall in new car sales has fuelled a slow down in borrowing by consumers, the Bank of England said.

“Its data showed that the annual growth rate in consumer credit slowed to 7.7% in the year to September. This is down from 8.2% in August – and the weakest pace since June 2015.”

What we are currently witnessing is more money leaving the economy (via debt repayments) than is entering (via new borrowing).  What all of this suggests is that those OBR 1.3 and 1.6 percent growth predictions should have been in red ink and should have had a minus sign in front of them.  Government could – were it not wedded to the ideology of budget surpluses – spend new money into the economy to compensate for the loss of privately borrowed debt-based currency.  This, to some extent is what John McDonnell is promising as an alternative to Hammond’s tinkering in yesterday’s Budget.

According to McDonnell a full scale public investment programme to build new infrastructure will kickstart GDP growth back to where it was prior to the 2008 crisis.  This brings us to the third means by which new currency can enter the economy; foreign investors.  When a government wishes to carry out the kind of infrastructure spending proposed by McDonnell, it can do one of two things.  First, it can turn on the metaphorical printing presses (these days it would simply add digits in a computer programme) and conjure new money into existence to spend on its chosen projects.  Second, and more usual, it can borrow in the global marketplace by issuing new government bonds.  Since the UK government is generally regarded as a low risk, a future Labour government could, it is argued, borrow at low interest rates to finance its investments.

The problem with both of these approaches is that they only work for countries that have a current account (aka balance of payments) surplus.  Britain, unfortunately, does not.  In June this year, Britain was running a deficit of £17.7 billion – around 3.5 percent of GDP.  This means that Britain depends upon inward investment (or a massive increase in exports) to bridge the gap.  Although this obliges the UK to create an economic climate that is attractive to foreign investors, it is easily managed and currently allows the Bank of England to maintain very low interest rates.  This, however, is primarily because the UK government has pursued austerity since 2010; attempting to pay off more old debt than it borrows in new debt.  The risk is that any attempt by government to either print or borrow much larger amounts of new money to finance infrastructure spending will lower the value of the pound and lead to investor-flight; as investment in the EU or the US becomes more attractive.  The result of such a flight would be that the UK government would have to raise interest rates significantly to avoid a balance of payments crisis of the kind that was all too common in the 1970s.  And since even the modest 0.5 percent interest rate rises made by the Bank of England in the last two years has already led to a collapse in new borrowing and the probability of a recession in the coming months, it is doubtful that the UK economy could withstand the kind of interest rates that will be needed to finance a pre-2008 rate of GDP growth.

Budgets, of course, are largely irrelevant these days precisely because government no longer controls the money supply.  Hammond has used the convenient excuse of the looming Brexit crisis as an excuse for cancelling all the measures set out in yesterday’s speech if need be.  And, given the experience of our history, we would be foolish to take opposition economic policies too seriously.  An incoming Labour government is likely to find itself overwhelmed by a new crisis borne out of the failure to deal with the causes of the 2008 crash.  In such circumstances, the best we might expect is a small degree of redistribution coupled to a far more modest increase in infrastructure spending.

Far more problematic, however, is the shared assumption by politicians and economists across the spectrum that further economic growth is both possible and desirable.  What all of the political parties – including, sadly, the Greens – struggle to understand is that the global economy as a whole has reached the limit to growth; because growth requires ever more consumption of real energy and resources.  No amount of financial alchemy can make up for the fact that the energy and resources required to maintain our advanced industrial economy stopped growing in the first decade of this century – yes we are getting more fossil fuels and mineral resources out of the ground, but it is costing us even more energy and mineral resources to get them.

In Britain, we have the dubious honour of being the first of the G7 states to drop over to the other side of the industrial growth bell curve.  Because, while we can issue an infinite amount of new currency, we cannot do the same with energy and resources (and, of course, if we could, we would destroy the biosphere in the process).  So unless and until someone can find a means of utilising some new high-density/carbon-free energy source (I don’t rule it out but I’m not optimistic) then our foreseeable future is one of economic de-growth.  And the problem with this is that nobody has developed an economic or political model for managing a shrinking economy.  Instead, we have moved into a schism economy in which an ever smaller part of the population continues to pursue the business as usual economics of the late twentieth century while an expanding disenfranchised mass gets increasingly desperate and angry.

This is a fundamental flaw in our economic and political outlook that will not end well.

As you made it to the end…

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