Category: Blog

 

            Yesterday’s papers were alight with jeremiah comments saying the economic strategy could not work and we need a Plan B. The headlines and quotes often said the Chancellor needed to slow the pace of the spending cuts, yet the truth kept popping out of the analysis. Both the Observer and Guardian allowed statements that so far public spending has risen and has contributed positively to the GPD outcome over the last year. They both acknowledged that the government is trying to cut the  rate of increase in the debt, not seeking to cut the debt itself. Both saw that if the government  continued to borrow too much markets could lose confidence and interest rates could be forced up damagingly.

The problem comes from the reluctance of economists to say what the figures say – so far the squeeze has been  on the private sector, not the public. So far the biggest cause of the squeeze has been rising inflation thanks to the weak pound engineered by the Bank’s strategy,followed by tax rises on income and spending. Probably the single most important cause of slow growth is the weakness of the banks, or the insistence of the regulators that the banks put increasing cash and capital above financing the recovery.

All last week I wrote about how Plan A could be made to work. It will need more changes to get the private sector led recovery the strategy requires for success. The economists who criticise the lack of a Plan B need to understand Plan A. In a way it is their own plan. It rests on tax revenue increases, not on spending cuts, to deliver most of the reductions in the deficit. The last  budget saw a substantial increase in borrowing and a relaxation of the targets for deficit reduction from the first Coalition budget, less than a year into the strategy. Why don’t the economists welcome that flexibility, and why isn’t their recommendation which the Chancellor adopted in March   working as they say it should? Don’t they bother to read the Red Book which sets out very clearly extra spending and extra borrowing?

Whilst they are pondering that question, they might also like to answer this one. Why are the largest deficit countries like Greece, Ireland, Portugal and now the UK growing more slowly if at all than the lower deficit countries like Germany and China? Doesn’t international evidence show that fiscal stimuli can backfire if they are linked to over tough regulation of banks, broken banks, or to rising rates owing to a lack of confidence in the fiscal strategy?

 

               The government has three main arguments for supporting Euroland countries with bail out money. The first is the EU market and banking systems are important to UK prosperity. The second is the UK does not have to put up new cash, as the IMF, the European Financial Mechanism and the European Central Bank already have money to lend. The third is the money is only loans, which will be repaid.

                 There are problems with all these arguments. Of course it is in our interest that Euroland prospers, avoiding a banking crash. Sensible critics of the government do not wish the Euroland economy harm or want to see a banking collapse. The question in dispute is can lending more money to overborrowed countries solve their problem of overborrowing?  Why didn’t the first Greek bail out, or the revised bail out work?  Can the weaker members get out of their difficulties without leaving the Euro and devaluing? If they and their weakest banks  need to reduce the amount of interest and capital they repay on past debts, wouldn’t it be better to agree that now instead of lending them more money to pay the interest on what they cannot afford? The UK also needs to remember that it imports a lot more than it exports to the EU, and the trade is subject to global as well as EU rules to prevent protective measures against us.

                  The three main mechanisms for lending these countries more money through international institutions could end up with those institutions needing more capital from the sponsor states including the UK if they lend and lose too much. It is  true that the UK has not subscribed much capital to the ECB and is not meant to be liable for losses or to benefit from profits. The UK should make it clear that it has no intention of subscribing any more capital to the ECB, which owns too many loans to countries at risk and to banks in difficulty. It should also press for less of the new lending to come from the EU fund and more from the Euroland fund. It should be questioning why the IMF thinks it a good idea to lend money to countries that share a currency which does not work for some of its members,, when it would be better for them to recreate their own currencies and follow their own policies subject to market disciplines on their borrowing.

             Finally, it is  important to heed the message of the markets, that there could be serious realised losses in due course on some Euroland sovereign debt and banking paper. A country seeking to strengthen its own financial position by moving towards better control on its own deficit should be wary of having to stand behind too many possible losses. If we had to mark to market – take the true current value – of these loans to Euroland in trouble, we would already have lost substantial sums through the various mechanisms and on the direct loan. The market thinks Greece should pay 23% for 2 year money – that’s a long way from the 5% or so Greece is being charged for the bail out.

 

                 This week’s commuters’ survey should not have come as a huge surprise. There have been many studies of transport patterns before, and all have shown that outside London most people travel by car. Bus and train take less than 10% of the average market unless you are talking about rush hour travellers into the capital city.

                    The same is true of goods. Trains take well under 10% of the freight, with trucks hauling the main loads. I have even seen pictures of  railway  engines and carriages on trucks to get them to where they need to be. Road transport has the flexibility and pricing to win most of the market for most forms of travel.

                   In order to promote the growth that the government wants we need more transport capacity of all kinds. We need more broadband capacity so more data can travel and people stay at home or in the office more often. We need  more commuter train capacity. It would be good if rail freight could expand and offer more price competitive packages to more potential users. It will need to raise efficiency to  do that. Above all we need more road capacity to handle all the extra journeys the growth will generate.

                 We are also going to need urgently much more electricity generating capacity. More than ten years have been wasted in pursuit of the great debate on nuclear, the development of windfarms and in discussion of how much power we actually need. Meanwhile the EU regulations are about to close down our coal stations and old age will pension off many of our nuclear stations. We need more power generation just to stand still, let alone to handle growth in industrial activity.

                  We could do with more water reservoir capacity to service the ever growing populations of London and the south, and to help irrigate crops when we do have long dry spells as we have from time to time over many years. More gas storage is being put in, but that too is necessary to get us through the occasional cold winter like the last two.

                   Government need not pay for all this. It may need to pump prime projects, or pay for part of their costs in remote areas, but the bulk of this expense can be paid for out of private finance with user charges. New roads can be built on the M6 tollway model. Electricity, water and communications already pay their way from prices.

                    Government is needed to do two things. The first is to grant the permissions and licenses needed – to sort out planning permissions and approvals promptly. In some cases it needs to hold a competition and to regulate prices where it is alloiwng a local monopoly. The second is to regulate the banks in such a way that they can add more utility lending to their balance sheets to help pay for these large projects. Growth certainly needs these investments. Just keeping the lights on is quite a challenge, given the current inadequacy of the UK’s overstretched infrastructure.

 

For most of the last year I have been explaining that the public sector squeeze much commented on and debated has hardly started, whilst the private sector squeeze thanks to inflation and tax rises is tough. The latest figures support those forecasts. Over the last year public spending rose more than 5% in cash terms, was up in real terms, and made a positive contribution to GDP growth. Meanwhile, 5% RPI inflation against 2.5% income growth with increases in VAT, Income Tax and National Insurance have squeezed private consumption. The latest figures show signs of predictable slowdown in the economy and even a growing headwind for the previously successful manufacturing sector.

In 2009 I called o n the MPC/Bank of England to raise interest rates to head off the entirely predictable inflation, which hit us badly at the end of last year because the MPC could not see it coming and did not understand weak sterling was behind much of it. Last year I called for  relaxation of the banking squeeze by the FSA and Bank to avoid the current slowdown. Again they did not seem to understand the threat. Today they need to wake up to the world slowdown likely to  hit early next year. China, India and Brazil are all applying the brakes to their monetary systems. The US may slow next year as the tax breaks and quantitative easing drop out of the picture.  The UK’s money supply is falling again already.

This week I have been mainly writing about ways they could stimulate private sector led growth. They boil down to more sensible banking regulation, less expensive regulation of general business, and more competitive tax rates. Centrica has confirmed it will not reopen Morecambe  south  for gas production owing to new taxes. It is a simple example of business locked out by tax. We will import the gas and lose the jobs in the UK as a result.

The UK needs faster growth. The banking regulators are hindering that. The big tax increase to pay for all the extra public spending still going through in cash terms is increasing the squeeze on the private sector. If the government truly wants private sector led growth it needs to relax  the private sector squeeze to allow it to happen.

Tomorrow I will  complete the growth suggestions by looking again at infrastructure and other major investment.

 

Many people in the EU think EU countries should be able to carry on with state spending at ever higher levels. They also seem to go along with a political class which by and large stands behind banks whatever balance sheet horrors they throw up, probably because the banks also lend lots of money to the governments.  There has been no serious and widespread political move to apply more normal approaches to the   near bankruptcy of some  banks –  requiring them to sell assets, cut costs, close down and write off poorly performing areas. All this could be done whilst still ensuring depositors were protected and a system collapse was avoided.

As a result we now have a combined banking and state debt crisis in several countries. The size of the banking problems guaranteed or supported by the state weakens the state. The size of the state’s borrowing and debt undermines the value of the state bonds the banks own. The two can move from  propping  each other up to threatening the solvency of each other.

So the argument is over who should pick up the bills for the excess spending and the losses? There are various candidates put forward:

Banks

1. Shareholders – after all they took the dividends in the good times, own the banks and have committed risk capital.Unfortunately now taxpayers own a lot of the shares in the weaker banks. Many shareholders have rightly lost out from poor banking.

2. Bondholders. So far junior bondholders have taken a hit in the weaker banks, but senior debt holders have not. Some say all bondholders should suffer losses in banks that need to restructure and write off losses. Others say to do so would make it much more difficult to refinance these banks. The EU seems to think bondholders after 2013  should be at risk but not current senior bondholders.

3. Depositors and other counter parties. There has been general agreement they should not lose money, other than in Iceland.

4. Taxpayers. In many cases taxpayers have been made to take troubled assets off the banks or to underwrite bank activities.

States

1. Some say the answer is simply to raise more in tax revenue. The private sector should shoulder more of the burden and pay up for the large public sector. Thoughtful politicians propose this should be done through more taxation resulting from growth in economic activity. Other politicians identify sectors like banks and oil companies, or rich people that they think could contribute more. All EU countries with a debt problem are aiming for more tax revenue. though the worst cases are suffering from falling output or slow growth making this difficult to achieve.

2. Some say there should be cuts in spending. Most countries at risk claim to be cutting spending, though it is often cuts in real terms not cash terms. The pace is variable by country but on the whole is slow compared to the scale of the debt build up.

3. Some say they should borrow more. If a country gets into trouble the IMF and EU should ride to its rescue with larger loans on easier terms. Otherwise countries should simply carry on borrowing very large sums on the public markets. The problem with this approach is you can get into a debt trap, where more and more spending is absorbed on paying debt interest, and forcing even more borrowing.

4. Some say countries should simply print more money to pay the growing bills. The sophisticated way of doing this is for the relevant Central Banks to buy in state bonds, keeping the interest rate lower than would otherwise be the case, and creating the money to do so. Critics say this simply results in inflation and a worse crisis in due course.

What should be clear to the political establishments is these problems do not suddenly vanish. If banks do not write off, cut costs and seek to get back to a profitable and sustainable level of business, they will need more support. If the action is delayed or ducked, it will be that much longer before the relevant economy has strong banks capable of normal financing of growth.

Nor does a state budget suddenly swing into balance or surplus because it has been able to borrow more. A sensible government works out what is its sustainable revenue, what level of taxation it can impose without damaging economic performance too much. It then budgets to spend that much and not more.

When will EU governments get it? Do you prefer any of the other options? How do you avoid a work out? Surely European countries need work outs not bail outs.

 

The last government made much of the supposed independence of the Monetary Policy Committee of the Bank of England. The present government  places similar emphasis on the independence of the Office of Budget Responsibility.

Both bodies find forecasting their main targets difficult. The Bank of England has regularly had to revise its forecasts for inflation upwards in recent years. Over its lifetime it has shown substantial bias in its typical forecast by being too optimistic about inflation, the very thing it is meant to be targetting and controlling.

The Office of Budget responsibility has to  forecast and help control the public finances. These turn out to be very sensitive to the overall economic growth rate. Given the fact that the government pockets around 40% of all the activity in the economy through taxation, government finances are much healthier when there is robust growth. In such conditions extra revenue comes in automatically without any need to change rates. In its first reappraisal of its growth forecast the OBR had to revise down both its 2011 and 2012 estimates.  I do not ascribe much importance to its decision to increase its forecast for more distant years.

Errors in these crucial forecasts by the very bodies that have to make decisions or publish warnings based on them is dangerous for our economy and recovery. The Bank may have thought it was helping by keeping  interest rates low, yet the inflation it unleashed over the last couple of years has done more to depress living standards than any other feature of our economic performance. The OBR’s early optimism over growth led to a downward revision of crucial figures for controlling the deficit within nine months of the first forecast. This has not yet mattered, but it will be important in the future that they have a better track record to keep market confidence in the figures and the system.

The OBR’s downward revision to the growth forecast for 2011 and 2012 will lose the country around £5 billion of revenue in a full year, a continuing loss unless and until the growth loss can be made up. Whilst this is not a large sum compared to the £1500 billion of National Income, it is a large sum in terms of the political debate. Some of the strongest arguments over spending and taxes in Parliament are over sums less than the £5 billion of error in the official June 2010 forecast.

It would be good if these official forecasters would apply a little more scepticism to the balance. It would be good to outperform the forecasts from time to time, to show they are as balanced and as accurate as possible. As we have been discussing this week, the government is going to  need a strong and convincing growth policy if it is to hit the exacting OBR targets for growth in 2013, 2014 and 2015, when they expect growth each year to be well above the old trend, let alone the more recent one.

 

Past governments and the present government speak the language of deregulation, but end up regulating more.

Opponents always try to blame deregulators for whatever ills in society regulation was trying to cure. Sensible deregulators no more want fraud, credit bubbles, unsafe factories or bad employers than anyone else.

There are  two  main issues. How effective is each regulation – does it really reduce the incidence of the ill you dislike?  Is  the cumulative burden of all the regulation tolerable, or does the burden in turn create worse ills like too few jobs and lower living standards?

My main argument has been countering Labour’s persistent attacks on me for allegedly favouring less banking regulation prior to the Credit Crunch. What the study I chaired actually said was we needed tougher regulation of cash and capital in banks, as credit was too easy. Events proved that right. We also said that Labour’s expensive and complex mortgage regulation would not work. It clearly failed to keep the mortgage banks safe. No sooner had Labour regulated, than for the first time in a century mortgage banks were at risk.  This is a good illustration that you need to know what regulation is for, and how to make it effective. You can have too much of the wrong type of regulation.

Today the total costs of regulation on British business are high. It is not all necessary and it is not all doing a good job. I have sent numerous proposals to the government to take action to sort this out. I am told that the latest exercise will produce results.

One simple example of what could be done is the question of anti money laundering.  The aim is a sensible one. The means are bureaucratic and not convincing. The system assumes that if every bank and financial business  handling money  demands a passport and utility bill proof of the person’s identity we will be spared money laundering. It is an odd idea, as money launderers presumably have passports and utility bills. If they do not, they would be the kind of people who could forge suitable documents for their purpose.

A simple change would cut down the paperchase and record keeping. Surely any business in the UK receiving funds from a major UK, EU or US regulated bank could be spared having to make checks. They should be able to rely on the checks made by the bank which first took on the deposit. This would remove the overwhelming majority of all the checks in the current system, and allow people to concentrate on the cases where money laundering is more likely – where money comes in in suitcases or cheques drawn on dodgy banks in fringe jurisdictions.

Deregulation is the tax cut that can save the government money. We need  a strong deregulation policy – not to make the world less safe, but to make UK businesses  more competitive. So far this government has put in many more regulations than it has repealed. It needs to get better at confining regulation to the best of causes, and ensuring that the regulation they do put in actually works. They will also discover that the origin of much of the needless, expensive and ineffective regulation is the EU where they will have their work cut out to reduce it.

 

Taxing the rich is always popular with all save the few who realise they are rich. Many socialists who love higher taxes do not seriously believe  they themselves should be paying a lot more. I remember how much they protested when a  past Conservative government (against my advice)gave everyone the opportunity to make a bigger contribution to better local services through the Community Charge. Labour had  continuously argued for more local spending and here was the opportunity. It soon showed that those who want more tax and spend do not usually want to pay it themselves.

Taxing the rich more right now would be especially popular. Top bankers and celebrities with enough money to issue  a super injunction or two, are far from popular. The question should be how do you do it?

Many think that is obvious. You raise the rate of income tax and captial gains tax. Then anyone rich has to pay more out of their income, or is caught if they try to shift it into capital. The problem with this theory is it does not work. Rich people leave the country. Rich people employ better accountants and tax advisers and find ways round the rules. They delay selling assets with gains. They refuse to invest in riskier ventures. They sit on their money or leave it abroad. Fewer rich and enterprising people come here,a nd fewer already here venture or work as hard. There is less point because the marginal tax rate has gone up.

So what is the way to tax the rich more? The answer is a paradox – set internationally competitive rates, so rich people want to come here, invest here and create jobs here. In the 1980s the then Conservative government cut the top rate of tax from 98% on unearned income and 83% on earned income to 40%. The rich not only paid a lot more tax as a result, but they paid a higher proportion of total income tax.

When this government  raised CGT to 28% they said anything higher would lose them revenue. I agree. Now I see that their forecast for CGT revenue shows that even with a top rate of just 28%, they expect some temporary fall in revenue. UK and US past experience suggests you collect more CGT if you keep the rate below 20%

Right now we need all the jobs, investments and growth in revenue we can get. That requires competitive rates, to tax the rich more. Tony Blair did not allow the Income Tax rate to rise above 40%, and Gordon Brown cut CGT to a very competitive 18%. The Coalition goes in for higher tax rates. They may in turn keep the growth rate down and cost the state lost revenue. We need to tax the rich more. That requires knowledge of the maximum rates to maximise the revenue.

 

Between the peak of the credit boom and the end of the first quarter this year the balance sheet of RBS contracted from £2.2 trillion to £1.4 trillion. In other words, the bank felt the need to cut its assets and liabilities, its financing of the UK and world markets, by a massive £800 billion.

Let’s allow for the fact that a lot of this was global, not UK. Let’s allow for the fact that a lot of it was cutting positions in derivatives and futures. Nonetheless, it was a huge reduction in liquidity and credit for world markets. What the Bank was doing just in the UK market was bound to have an impact on growth and activity.

What RBS was doing on a huge scale other banks were doing to a lesser extent. The banking regulators lurched from being too easy, allowing a credit binge, to being too tough. Their new belief in better cash and capital ratios meant that all banks decided to cut their loan books and take other action to improve their balance sheet ratios.

The government became aware that smaller and medium sized enterprises were finding it difficult to get bank finance. Large companies regained access to the corporate bond market and the equity market on acceptable terms, options not open to the broad mass of UK companies. So Ministers invented Project Merlin. The banks have promised to do better and lend more to UK companies.

Let’s hope they do, and let’s hope such loans are well based and successful. It would be easier if the banks at the same time were told they now have enough cash and capital, so they do not have to keep squeezing the loan book down to improve the ratios. Ratios are much healthier than in 2007-8. The time for the Regulators to demand more cash and capital is once growth has picked up and credit is flowing freely. It is not a good idea to demand more when the economy is growing slowly and credit is still scarce.

Many now say they believe in counter cyclical regulation, but there is no evidence of it happening. Regulators fuelled the boom, and helped create the bust by lurching from too easy to too tough. The UK economy needs a bit more help at the moment from credit, not a further hair shirt.

We also need more competition  n the banking market. We need more banks on the High Street, with some banks pioneering a newmodel – or recreating an older model- of local relationship banking to banks the smaller businesses sensibly.  That can be done through the Vickers Report remodelling. I would also link it with returning the state owned banks to the private sector as soon as possible.

 

           The government’s whole financial strategy rests on growth. Deficit reduction is planned primarily through a surge in extra tax revenues, which grow as the economy grows. By 2014-15 the government forecasts £172 billion a year more from taxation than in the last Labour year.

           This big increase in taxation is needed to pay for the increased total public spending, up by £73 billion a year over the same time period, and to cut the deficit substantially.  Public spending cuts have been cuts in Labour’s planned increases, or cuts in certain programmes in order to fund larger increases in the government’s priorities that include overseas aid, the EU budget and assistance to Euroland.

            Most commentators and politicians agree that growth is needed to help the UK out of the financial hole it is in. Growth reduces the need for spending cuts and tax rises. If growth does not move to above trend from next year and stays there for the following three years, there will be a shortfall in revenue and extra public spending.

              Critics of the government say it has cut too far and too fast and jeopardises growth as a result. As the government plans to borrow an additional £485 billion over its planned five years, more than the total state debt just ten  years ago, it is difficult to sustain the argument that it has been too tough. Given that public spending rises by a substantial cash amount, the argument is more one over what that money can buy. If the government enforces a fairly successful public sector pay freeze for a couple of years, and manages to buy things more cheaply as it has promised, the cash increase could even translate into a real increase in spending.

              Promoting faster growth requires changes to banking, regulation and taxation. We will look at each of these in turn this week.