Wednesday, 18 March 2015

Economic failure, austerity continues

By Michael Burke

The Tory election campaign is based on the claimed success of the government’s economic policy, as the hype around the latest Budget confirms. In reality the Tories’ economic record has been unprecedentedly poor. Their economic policy is not primarily aimed at increasing growth or prosperity but rather at effecting a fundamental change in the economy which entails a very large transfer of incomes from workers and the poor to big business and the rich. This project is very far from complete and is set to continue.

The relative economic performance under the current government is shown in Fig.1 below. Real GDP has grown by an average of 1.65% under austerity policies. This is remarkably poor by comparison. In the 12 months before the current government took office the economy grew by 2%. Austerity lowered growth even from a feeble pace coming out of recession.

For the entire period from 1997 to 2010 the annual average real GDP growth rate was 2.1%. This includes the recession of 2008 to 2009, the deepest slump in activity since the Great Depression. Yet the performance of the economy under Tory austerity has been even worse

Fig.1 Comparative Real GDP Growth

Einstein said repeating an experiment and expecting a different outcome is the definition of madness. Yet the intention is to repeat austerity. This is because the purpose of the austerity of policy is not to induce growth, or even to cut the deficit.

In the crisis profits fell sharply, even in nominal terms. The Gross Operating Surplus (GOS) was £86.2bn in the 1st quarter of 2008 and fell to £79bn in the 2nd quarter of 2009. At the same time the Compensation of Employees (CoE) fell by just £1.5bn (although in real terms both wages and profits fell by far greater amounts). Since that time and to the end of 2014 the GOS has risen by £16bn and the CoE has risen by £32bn. It should be noted that profits fell once more in the final quarter of 2014, as shown in Fig.2 below.

Fig.2 Wages and Profits
CoE on LHS                                                        GOS on RHS

Despite the fierce impositions of austerity it has proven quite difficult to cut wages in nominal terms (although in real terms wages have fallen substantially). New austerity measures were also suspended after 2011 because of the slump in Tory electoral fortunes. Therefore the plan is to resume austerity with renewed intensity immediately after the election. Austerity is aimed at reviving the profit rate and this is nowhere near being accomplished.

Monday, 9 March 2015

Austerity did not even cut the deficit

By Michael Burke

The Coalition parties are set to feature deficit reduction as a central achievement of their time in office as part of the election campaign.

The economic crisis is driven by the excessive saving of the private sector - its refusal to invest. As the government’s deficit is a response to this private sector saving, cutting the government’s own spending is entirely the wrong approach. It is the weakness of the economy that has caused the deficit, not vice versa. The supporters of austerity look at the world through the wrong end of the telescope and demand we all do the same.

It is also the case that the Coalition has failed even in its own terms. The deficit has not been eliminated. The total deficit (excluding the effect of the public sector banks, that is their bailout) was £153.5bn in 2010 and had fallen only to £93.6bn in 2014. The deficit is far from being eliminated.

The discrepancy between the actual deficit and the forecasts made by the Office for Budget Responsibility (OBR) and the Treasury at the time of the June 2010 Budget is shown in Fig.1 below. The official forecast was that the deficit would be £60bn in the last Financial Year and would fall to £37bn in the current Financial Year ending in April 2015. The actual deficit has been very different. 

It was £97bn last year and will be an estimated £90bn in the current FY. The government claimed it would reduce annual borrowing by £117bn and the fall has been just £63bn, approximately half of what was promised.

Fig.1 Official forecasts for the deficit and the actual outturn

In addition the composition of the deficit belies any claim that austerity has led to an improvement in public finances. In reality a combination of accounting fiddles, reduced investment and inflation more than account for the entire reduction in the deficit to date. None of these are supposed to be part of the central design of austerity policies and none can be relied on to sustainably lower the deficit. This is the case when the entire debate about economic policy in the next five years is framed around even more austerity.

Investment, inflation and accounting fiddles

The factors reducing the deficit should be taken in order of magnitude. By far the biggest contribution to the £60bn reduction in the deficit has been the rise in VAT receipts, which have increased by £44bn over the period or by approximately two-thirds of the total deficit-reduction. The Coalition increased the VAT rate from 17.5% to 20%, but consumer prices have also risen by 12% in the 4 years to 2014. This implies that the contribution from increased VAT rates and inflation were approximately equal. Inflation has since subsided sharply and unless the pound falls again is unlikely to accelerate again in the near future.

Despite great fanfare from Osborne and Cameron on the need for investment, there has been no policy action that has made a larger contributor to the fall in the deficit than the cut in government investment. This is shown in Fig. 2 below. In total the fall in net public sector investment from 2010 to 2014 was £25.6bn. Even mainstream Tory opinion nods in the direction of the need for increased public investment and only the most extreme ideologues explicitly argue for cuts in this area. Even so this is the policy which has been carried out to massage the total deficit lower. It is also in the clear hope that the private sector will replace public investment, which has failed to take place.

Fig.2 Public Sector net investment

There have also been a number of accounting adjustments and outright fiddles which George Osborne has conducted in order to get the deficit numbers down and further measures of this type may be expected in the Budget later this month. Perhaps the most scandalous was the £5 billion ‘pencilled in’ from an amnesty for tax evaders agreed with the Swiss authorities which has yielded little more than £1bn. But the most substantial of these fiddles is the £8.7bn in 2014 (and £18.6bn in 2013) from the Bank of England’ s ‘Asset Purchase Facility’ which are part of the wind-down of bank rescue operations and nothing to do with current public sector income.

In other key items of revenue there are some important features. National Insurance Contributions have risen by 11% and £11bn reflecting the growth of employment during austerity. But the level of PAYE income tax has risen by just 5.9% (£7.7bn) as average pay has fallen and there has been no increase at all in the tax revenue on self-assessed income (mainly from the self-employed), despite more than half a million new ‘self-employed’ over the period. This confirms the trend of low-wage, casual job creation.

It should also be noted that Corporation Tax revenues which are levied on profits have actually fallen by £0.5bn over 4 years despite a £67bn rise in nominal profits. This reflects the cut in the tax rate from 28% to 21% which will further fall to 20% in April. The stated purpose of this cut was to spur growth by encouraging business investment. But SEB has repeatedly noted the fall in investment is the cause of the crisis and remains the main brake on any recovery. Instead, the combination of the VAT hike and Corporation Tax cut represented the key mechanism of austerity policies as a whole; the transfer of incomes from poor to rich and from labour to capital.

Austerity was severe - it just doesn’t work as claimed

In terms of expenditure items, the total is considerably below the projection first outlined by the Treasury and Office for Budget Responsibility in June 2010. It is therefore factually incorrect to state that austerity has not been implemented, or has been not severe enough. This is a fiction peddled by right-wing critics of the government. But in June 2010 the Treasury/OBR forecast that total public sector current expenditure would be £692.7bn in 2014/15 and in December this year they forecast that the outturn would soon be £671.7bn. This is also a much tighter spending policy than was planned given that inflation was higher than anticipated. Austerity was applied even more severely than planned. It simply failed to deliver deficit-reduction.

There was also a windfall to government accounts because of much lower debt interest payments as global interest rates plummeted. The British government in common with many others now receives money from investors who are lending to it, paying negative interest rates. This lowered government outlays by £27bn comparted to 2010 forecasts.

Yet the social security bill was also £28bn higher than officially forecast. This serves to highlight a crucial point made at the time by the opponents of austerity; that cuts aren’t savings. Given that the population continues to both increase and age irrespective of fiscal policy, it was always certain that outlays would grow. As austerity also leads to both slower growth and increased poverty then key items such as social security will grow automatically.

By contrast the sole significant item of government expenditure which has seen a fall in cash terms is transfers to local government, which has produced both widespread hardship and increased likelihood of local government bankruptcies.

The change to total Public Sector current Expenditure and the two key components of higher social security and lower debt interest payments are shown in Fig.3 below.

Fig. 3 Change from OBR Forecast to 2014/15 to total Public Sector Current Expenditure and key components, £bn


Austerity damaged the economy austerity and did not even lead to deficit reduction. The deficit has fallen due to growth – that itself has been stifled by austerity.

However this nominal growth has been much more comprised of inflation than real activity. This has created a one-off boost to VAT receipts, which is unlikely to be repeated. The main policy change leading to a lower overall deficit is the cut to public sector investment, which will prove highly damaging in the long run. That aside, the Chancellor largely relies on accounting tricks to massage the deficit lower.

There has been a very substantial windfall too from the fall in debt interest payments, in common with nearly all the industrialised economies. This reflects widespread economic weakness and fears of deflation. It is not a positive sign about growth. The cuts have been even more severe than was first planned by the Coalition when inflation is taken into account. But the supporters of austerity ignore the crucial point that it creates economic weakness, which in turn leads to both higher government spending and lower tax revenues.

The real cure for the deficit and for the economy is the same. Investment-led growth will produce a sustainable increase in economic activity and under those circumstances the deficit would take care of itself.

Friday, 27 February 2015

The money exists for investment in Greece

By Michael Burke

The fraught negotiations between the new Greek government and representatives of the EU institutions are likely to be prolonged. They have centred to date on Syriza’s efforts to find room to alleviate some of the worst effects of austerity and address what is called the ‘humanitarian crisis’.

This is entirely justifiable given the depth of the fall in living standards with widespread malnutrition in Greece, a health crisis, hundreds of thousands of homes cut off from electricity supply and other ills.

Policies aimed at income redistribution can help in this key area, so it is entirely correct to attempt to increase tax revenue from the rich in order to ameliorate the effects of poverty on the poor. But any sustainable improvement in living standards must be based on increasing the productive capacity of the economy which requires investment. Any transfer of income will be a one-off effect if income does not grow. Yet the austerity measures imposed by the Troika (EU Commission, European Central Bank and IMF) and the existing burden of debt interest payments prevent the government from investing and provide a further disincentive for the private sector to invest of its own volition.

Domestic sources of investment

There are two key sources of funds that could be tapped for investment; domestic and international.

Domestically the Greek business class claims the highest share of national income in the whole of the OECD. In 2013 (in nominal terms) the Gross Operating Surplus of Greek firms was €102.2bn from a GDP total of €182.4bn. This profit share in GDP of 56% is way in excess of the customary levels in the OECD. By comparison the German profit share in the same year was 39.3%.

A high profit share is not itself directly harmful to growth and prosperity. If firms were investing profits the productive capacity would be rising rapidly and new high-quality and high-paid jobs could easily be created. But the opposite is the case in Greece, which also has the lowest rate of investment as a proportion of GDP in the whole of the OECD. Again in nominal terms investment (Gross Fixed Capital Formation) in Greece in 2013 was just €20.5bn or 11.3% of GDP. By comparison the German proportion of investment was 19.8%.

This is not to hold up the German economic model to be emulated. Like all the Western economies (including Britain) the rate of investment in the German economy has slowed dramatically over several decades, which is the cause of the ‘secular stagnation’ of the Western economies over the same period.

Even so, the disparity in the profit rate and the investment rate is exceptional in Greece. The proportion of uninvested profits in Germany is equivalent to 19.5% of GDP (profits equal to 39.3% of GDP minus an investment level equivalent to 19.8%). This level of uninvested profits is very high by historical standards. But the proportion of uninvested profits in Greece is 44.7% (profits of 56% of GDP minus investment of 11.3%). The nominal level of profits and investment is shown in Fig. 1 below.

Fig.1 Profits and Investment in Greece, 1990 to 2013, €billions (nominal terms)

The charge of indolence and feckless aimed at Greek workers, which is a slur repeated and not solely confined to northern European tabloid newspapers, is entirely misplaced. It is Greek capitalists who refuse to invest a vast proportion of profits who have caused both long-term low productivity growth and the relative crisis. This is true not just on a relative basis but also on a historic one. In 1990 Greek investment was equivalent to 42.8% of profits. In 2013 it was just 11.3%.

International sources of investment

A structural flaw in the Euro Area economy is that it represents an effort to create a single, continental-sized economic entity to compete with the scale of the US and Chinese economies by purely monetary means. The Euro Area has a single exchange rate and single short-term interest rate. But fiscal policy remains overwhelmingly as a national responsibility.

This is a structural flaw as all economic development is uneven. An exchange rate or interest rate policy which may be appropriate to the average will necessarily cause dislocations or worse to economies whose level of development differs significantly from the average. In all other modern economies fiscal transfers occur between regions, usually automatically via common tax and spend systems. In the United States, a federal system of taxation and transfers does not prevent individual states levying their own taxes or making transfer payments (social security, subsidies to farms, etc.). But these federal transfers amount to more than 10% of US GDP.

The EU and the Euro Area have both had fiscal transfers. These have been set through the European Social Fund, the Common Agricultural Policy and others but have usually amounted to little more than 1% of GDP. Disastrously, they have also been cut at a time of crisis, which David Cameron and others boasted as an achievement. The 7-year budgeting round has seen the 2014 to 2020 European Social Fund cut from €961bn to €367bn in nominal terms. The European Regional Development Fund will be €453bn, an increase from €347bn over the preceding period. But this does not compensate for cuts elsewhere and inflation further erodes the total. It is also widely misunderstood that big countries are also recipients of EU funds. Fig.2 below shows for example that Germany received twice as many as ESF funding as Greece over the period 2007 to 2013.

Fig. 2 National Distribution of ESF funding 2007 to 2013, € billions
Source: EU Commission

The cuts to internal transfers have taken place at the worst conjuncture, coinciding with the gravest economic conditions in Europe since the aftermath of World War II. The cuts will accelerate centrifugal tendencies with the EU and unless the trend is reversed they will be key factor in the potential of a break-up of the Euro Area.

While this is a strategic issue, which would need to be addressed by a supplementary budget, there are funds at hand which could immediately be deployed in Greece. One of the many large funding institutions sponsored by the EU is the European Investment Bank (EIB), which has ample scope to increase lending.

As part of a general trend, the EIB has not provided funds for investment that could have alleviated the crisis despite having the financial capacity to do so. Prior to the crisis in 2007 the main components of the EIB’s balance sheet were capital of €35bn and borrowing of €276bn. From this it had made outstanding loans of €285bn. By 2013 the bank’s capital had increased substantially but the growth of its loan portfolio has lagged significantly.

Table1. Key components of EIB’s balance sheet, €bn
Source: Author’s calculations, EIB annual reports and accounts

The EIB is part of an elite group of the world’s most highly-rated borrowers, with a very high capital buffer (own funds) and the explicit guarantee of all the EU governments. As a result it can borrow at extraordinarily cheap interest rates. Maintaining the same ratios as in 2007 and based on the increase in its own funds since it could raise its borrowing to €457bn and its loan portfolio to €472bn.

Given the immediate priority is reviving the Greek economy this could easily be the recipient of the extra €45bn in funds for investment that would become available. A similar pattern applies to the European Bank for Reconstruction and Development, which mainly lends to Eastern Europe (pdf). Since 2011 new investment in projects has fallen by €9bn even though bank capital has increased by €1.7bn. But funds are needed to both develop and integrate the region with the richer West and geographical reasons mean Greece should also be a key destination for that purpose.

Beyond Greece, the subscribing EU countries to both banks can now borrow at exceptionally low interest rates and earn far larger returns from the banks’ investments. Neither the EIB nor EBRD are charitable institutions. The focus for investment would be all the crisis economies of Europe East and West. But these sources of investment could also form part of the overall solution both to the investment crisis and the growing strains on the Euro Area and European Union economies.


There is a pressing need to address the humanitarian crisis in Greece. It remains to be seen how much breathing space Syriza’s fight can win from the EU institutions.

But sustainable growth requires investment. The trend of cutting investment and other transfers within Europe, and cuts to development lending fit with the general austerity policy across Europe of cuts to state investment which are exacerbating the private sector investment strike.

However, this not only deepens the current crisis but threatens to undermine the entire Euro and EU project from within. It is not only the Greek economy which is at stake; it is just the most extreme example of general trends.

Within Greece the key source of funds for investment are the uninvested profits of the business sector. Internationally, EIB and EBRD funds already exist for major infrastructure and other forms of investment. These should be tapped immediately to rescue the Greek economy. And much larger funds could be applied to all the crisis countries of Europe, in a win-win for them and for the key investing countries. The alternative is ongoing crisis and increased risk of Euro break-up.

Monday, 23 February 2015

How the austerity con works

By Michael Burke

‘The Austerity Con’ is the title of a recent article in the London Review of Books. It is written by a leading Keynesian economist Professor Simon-Wren Lewis, who is also a fellow of Merton College, Oxford. The article is available to non-subscribers here. It deserves to be widely read because it contains two important arguments against austerity.

The first argument nails the lie that austerity was necessary because of an immediate crisis of government funding. The second argument exposes the myth that austerity has been responsible for an improvement in government finances. Both of these arguments will be familiar to regular readers of SEB and Prof. Wren-Lewis will give them a far wider airing. Given that averting the crisis in government finances is offered by the supporters of austerity as its main justification, the title of his piece is fully justified.

However there is a difference of view among opponents of austerity about the nature of the current crisis. It is important because it underpins both the overall analytical framework and the suggested policy prescriptions. Prof. Wren-Lewis says, “The place to begin is 2009. By then the full extent of the financial crisis had become apparent.” He goes on, “The financial crisis was leading consumers and firms to spend less and save more. That made sense for individuals, but the problem was that because everyone was doing it, the total amount of demand in the economy was falling. As demand fell, firms produced less, so they reduced their workforce.”

This is not entirely accurate. Demand is comprised of two components, consumption and investment. By taking a step back to 2007 it possible to see more clearly how the crisis arose. Regarding the industrialised countries as whole grouped in the OECD it is possible to see that only one of these experienced a sharp fall. This was investment not consumption.

Fig.1 below shows the level of real GDP and its key components, consumption, investment and net exports. The data is presented in both in constant prices in constant Purchasing Power Parity exchange rates and is itemised in the box below.

Fig. 1 Real OECD GDP and components, US$ PPP trillions, OECD base year

OECD GDP & Components, US$ trillions, PPPs
Source: OECD (data may not sum due to rounding and omissions)

By 2009 the OECD economies as a whole had experienced economic contraction compared to 2007 (the 2008 data is almost identical to 2007). But the direct contribution of falling consumption to the overall economic contraction was non-existent. It had even marginally increased.

The cause of the slump in 2009 was the decline in investment. In round terms GDP in the OECD fell by US$800billion in the two years to 2009 and investment (Gross Fixed Capital Formation) fell by US$1,100 billion. Over the same period, consumption rose fractionally.

It is the case that household consumption fell, just as Wren-Lewis says. But this was more than off-set by the simultaneous rise in government consumption. As he correctly states this was largely because of the operation of what are known in the jargon as ‘automatic stabilisers’. In economies where there exists significant provision of social security and other payments, these tend to rise automatically as unemployment increases along with in-work poverty and other aspects of social deprivation.

Yet taken together the effect of falling household consumption and rising government consumption was a small net increase in total consumption. More important than either a small net rise or fall, what is also clear is that a broadly steady level of consumption was not enough to prevent a sharp fall in investment, which was more than responsible for the entire slump across the OECD.

It is also the case that consumption in the OECD has recovered and now exceeds its pre-recession peak, but investment has not. This is not to say that ordinary households, workers and the poor have not suffered in the crisis. That is true in most countries and is at an extreme in a country such as Greece. But the decline in investment was both the cause of the economic crisis and is responsible for the weakness of the subsequent partial recovery in activity.

Furthermore, recent experience shows that increases in government consumption can at most soften the effects of the downturn (and some cost to government long-term finances, if not the apocalypse conjured up by the supporters of austerity). Rising government consumption during the crisis did not prevent the sharp fall in investment. The slump in investment cannot be corrected by ever more consumption. Consumption has risen since 2009 and is above its pre-recession peak.

The fall in investment was not only responsible for the economic crisis. It was also directly responsible for the deterioration in government finances. Falling investment is a form of saving (unwillingness to spend on investment). As the private sector of the economy increased its savings the public sector was obliged to increase its borrowing which creates the deficits on public finances.

The crisis was not caused and is not perpetuated by a fall in both the components of demand. Only investment fell and it alone has failed to recover. Analysis needs to take account of this key factor, and the policy prescriptions which flow from it. Prof. Wren-Lewis is entirely correct to highlight the ‘Austerity Con’. The biggest con is that the crisis was caused by the public sector, when it was actually caused by the refusal of the private sector to invest. This cannot be addressed by government increasing consumption, or subsidies for consumption. It needs state-led investment.

Monday, 16 February 2015

Fake Anglo-Saxon recoveries are damaging global economy

By Michael Burke

Official economic opinion from the IMF is that the US and the British are the only industrialised economies that are growing strongly and that their growth model should be reproduced generally.

The reality is very different. Both recoveries are the weakest on record and are fuelled by an unsustainable (debt-fuelled) rise in consumption. The international effects of this are negative, acting to provoke further instability in the world economy. The Anglo-Saxon recoveries cannot possibly be widely copied without deepening crises.

First, it is necessary to dispose of the myth that either the US or Britain is enjoying a robust recovery. In sharp recessions there is frequently a large amount of spare capacity in the economy as hours or jobs are cut and factories and offices lie idle or under-used. As a result, recovery from deep recession is often rapid. But that is not the case. Neither the US or British economies has accelerated beyond a 2.75% year-on-year growth rate in the entire recovery period. As a result, they are the weakest recoveries on record.

Fig. 1 below shows the current US recovery phase compared to previous recoveries.
Source: Wall Street Journal

The US recovery is the worst on record as it is also worse than the recovery from the Great Depression. But the performance of the British economy is worse still, significantly slower than any previous recovery phase.

Fig. 2 shows the current British economic recovery compared to previous upturns.
Source: NIESR

Recent trade data also demonstrates the underlying weakness and fragility of even these feeble economic upturns. The US recorded a trade deficit of almost $47bn in December and the British economy had a trade gap of £35bn for 2014 as a whole. These were, in both cases, a return to respective 4-year low-points.

The US trade gap is on a sharply widening trend once more, despite the much lower level of oil imports because of the shale gas boom. In real terms, after accounting for inflation, the US trade deficit excluding oil is at a record, as shown in Fig. 3.

Fig.3 US Monthly and Annual Real Trade Balance, excluding Oil
Source: Census Bureau

As a matter of logic the world cannot emulate an economy where the trade deficit is widening dramatically. The world cannot run a trade deficit with itself. Holding up the Anglo-Saxon recoveries as a model to be followed elsewhere is simply foolish, or overblown rhetoric which has no practical value in policy formulation.

The same increase in effective net overseas borrowing applies to Britain where there are new record deficits on trade balance and on the current account (trade plus current payments overseas, mainly interest and share dividends). In fact the situation is qualitatively more grave for the British economy, for a number of historical and structural reasons which will be examined in a future post. For now it is enough to note that that a very mild British recovery is being funded by record overseas borrowing.
The latest current account deficit is 6% of GDP, an all-time record.

In effect the weak British recovery is being funded by unprecedented borrowing from overseas. Because this has been a continuous process, it has also led to an unprecedented deterioration in Britain’s international investment position. The continuous accumulation of new overseas debts has formed a record level of overseas liabilities, which is shown in Fig. 4 below.

Fig. 4 Britain’s Net International Investment Position as a per cent of GDP
Source: ONS

Both the US and British economies are uncompetitive even at previous exchange rates and are dependent on borrowing from abroad to fund recovery. But the funds they are borrowing from overseas are not being used to fund further economic expansion, via investment. Instead the recoveries in the Western economies are almost exclusively driven by consumption.

This is shown in Fig. 5 below, which shows the real change in both US and British consumption and investment since the recession began to the end of 2014 (Q3 in the case of the UK data). The data is shown in common US$ purchasing power parity exchange rates for comparative purposes.


In real US$ PPP terms the US has increased consumption (combined government consumption and household consumption) by $1,064bn since the recession while investment (Gross Fixed Capital Formation) has increased by just $40bn. In Britain consumption has risen by US$88bn, while investment has increased by just $4bn. This belies any notion that the economies are struggling with the lack of ‘effective demand’. The weakness of the recovery and its dependence on increased overseas indebtedness is due to the virtual absence of growth in investment.

Complete data for the major industrialised countries has yet to be published. But any growth at all for either the Euro Area economy or for Japan is likely to have been almost entirely driven by consumption with investment either flat or contracting once more.

This is placing unbearable pressures on the rest of the world economy, the so-called ‘emerging markets’ and other non-industrialised economies. In part the rise in consumption in the industrialised countries is only possible because prices for basic commodities have fallen sharply. But it is also leading to capital outflow from poorer nations to richer ones, mainly the Anglo-Saxon economies to fund their increased consumption. This outflow of savings is preventing a rise in investment elsewhere, or significantly increasing the costs of that investment. This will both prolong and deepen the global economic crisis.

The industrialised countries as whole led by the US and copied by Britain are consuming, not saving or investing. This produces weak and unsustainable growth in their own countries and is causing a global slowdown and further crises.