Wednesday, 8 October 2014

There is a ‘magic money tree’ – it’s investment

By Michael Burke

Supporters of austerity have long argued that there is no viable alternative because of persistent government deficits and rising debt. David Cameron put it starkly arguing that ‘there is no magic money tree’.

However these assertions contain two important fallacies. First, it is evident that, if government is increasingly indebted it must be the case that the private sector is also an increasing owner of that government debt- government cannot be a net debtor to itself. Therefore rising government debt represents a transfer of incomes, from the public sector to the private sector.

Secondly, economies can grow. Otherwise human society would still be in its most primitive phase. Therefore there is no fixed amount of output in the economy, or the monetary denominator of that output.

IMF answer

The question posed is therefore, how can a cash-strapped government grow the economy and improve its own fiscal position? The IMF has arrived at an answer. In the latest widely-read World Economic Outlook (WEO), the IMF devotes an entire chapter to the merits of public investment in infrastructure, which it defines as transport, power and other utilities and communications systems. The paper ‘Is it time for an infrastructure push? The macroeconomic effects of public investment’ can be found here (pdf).

Investment is one of the essential components of growth. Private sector investment is driven by the anticipated profit, but it has no magic wand to conjure returns from investment which the public sector does not possess It is possible for government to benefit from the returns on investment in the way that the private sector can. In fact there are additional returns on investment to the public sector that are not available to the private sector at all, in the form of increased tax revenues and lower social welfare payment from increased economic activity.
The key points of the IMF research can be summarised as follows:
  • The stock of public capital, which is mainly responsible for total infrastructure, has declined across all categories of economies over the last three decades
  • There is now a substantial shortfall in both the quantity and quality of public capital
  • There are very high returns available to the public sector from investment in infrastructure
  • In periods of low growth the immediate effect of an increase in investment in infrastructure is a return of one and half times the initial investment, which rises to three times over the medium-term
  • The positive effects of investment are larger when they are financed by debt rather than by budget-neutral cuts elsewhere
  • The positive effects are also larger when they are supported by monetary policy
  • There is little or no evidence that the government’s cost of debt increases when debt is used to fund infrastructure investment
  • In terms of what the IMF calls ‘emerging markets’ this means that the effects of investment are far higher when funded by international loans, rather than transfers from other parts of national budgets (the so-called ‘fiscal policy rule’ usually demanded under IMF country programmes).
The research paper also presents a stylised version of its results for the advanced industrialised economies in the current phase of the economic crisis. The results are shown for the change in GDP and the change in government debt as a percentage of GDP arising from a 1% increase in public infrastructure investment, in Fig.1 below (data from Fig.3.9 in WEO).

Fig. 1 Effects of a 1% GDP increase in public infrastructure investment
Source: IMF

The central estimate is that there would be an immediate increase in GDP and an immediate decrease in government debt arising from infrastructure investment, and that these accumulate over time. By the end of the period 2023 the research estimates that a 1 per cent of GDP increase in public infrastructure investment would raise GDP by 2.8 percent and that government debt would have decreased by 1.75 percent.

Although the IMF does not do so, the same logic could be applied to any investment which increases the productive capacity of the economy, most especially education. Public investment produces growth, which produces lower debt and deficits. Similarly, the IMF research does not explore the mechanisms by which this can be achieved. In those economies where there is a greater weight of public sector corporations, where firms and banks are under public control, they can be a direct conduit of increased state investment. The greater the weight of public corporations, the greater the government’s ability to both increase the level of investment and to regulate it.

What’s stopping them?

IMF research papers are often regarded as very authoritative, but they are not uncontroversial. Much earlier in the current crisis another WEO research chapter (‘Will it hurt?’) argued that austerity policies would be hugely damaging, depress growth and so prevent any significant improvement in government finances. This judgment has been demonstrated to be essentially correct.

Yet austerity has been implemented in most advanced industrialised countries. The effects have been so negative that for many this is the weakest recovery on record, government debt burdens have hardly lifted and now many commentators, the IMF included, are concerned about the prospects for a renewed slowdown.

Neither can there be any confidence that the most recent research will lead to a sharp increase in public investment. The key obstacle to that is hinted at in the IMF research paper. There are a number of references to the impact on private sector investment arising from an increase in public investment (‘crowding out’ effects), even though these are generally downplayed.

This might seem odd. As the authors note, across all types of economies the bulk of investment in infrastructure is made by the public sector. There is an infrastructure deficit and only the public sector can reasonably be expected to fill it. Furthermore, there is a widespread insistence that reducing the level of public debt and deficits must be the overriding or even sole objective of economic policy. As the IMF research shows public infrastructure not only increases GDP but also lowers government debt. Under these circumstances, the marginal impact on private investment levels ought to be immaterial.

However, the entire austerity policy has not delivered growth or improved government finances, exactly as the earlier IMF research warned. The governments continuing to pursue it, as in Britain, are not foolish. Austerity has another purpose. This is to restore the rate of profit for firms. If large scale public investment in infrastructure risks even a minimal reduction in private investment (as the IMF says is possible, but not likely under current circumstances) then it will be fiercely resisted by those firms and those acting on their behalf.

This explains why political parties who talk about growth and deficit-reduction are wedded to an austerity policy which delivers neither. It also explains why all the forces arguing for an end to austerity and for state-led investment should expect a long struggle ahead.

Thursday, 2 October 2014

Productive investment has not increased, so there is no sustainable recovery

By Michael Burke

The latest GDP data showed that the British economy is a little stronger than previously thought. The economy is now 2.6% above its previous peak in the 1st quarter of 2008 and surpassed that peak in the 3rd quarter of 2013.

However, the fundamental character of the current crisis is unaltered by the revised data. The Office of National Statistics (ONS) is correct to state that, ‘The worst recession since our records began in 1948 has been followed by the weakest recovery’. The path of the current recovery is shown in Fig.1 below, an ONS chart which compares the level of GDP in previous recessions.

Fig.1 GDP levels (quarterly) from peak for previous and latest economic
Source: ONS

This very weak recovery is also confined to the services sector of the economy. All other sectors of the economy, manufacturing, production and construction remain in a slump. This is shown in Fig. 2 below, which records the change in the sectors of the economy from the beginning of the recession.

Fig. 2 GDP levels (quarterly) for output components
Source: ONS

It is clear from this chart that there was a severe ‘double-dip recession’ caused by austerity which affected the productive sectors of the economy excluding services. A number of service industries were boosted by a combination of ultra-low interest rates and specific measures adopted by the government to boost consumption. The industries to benefit included finance, and retail and business services. Far from a ‘march of the makers’ promised by Osborne, the current situation is repeat of the errors of the Lawson Boom and the ‘candy-floss economy’, on a much weaker basis. The former Tory Chancellor argued that it was immaterial that manufacturing was collapsing under Thatcherism as long as there were overseas buyers of any good or service produced in Britain (including candy floss, in reality financial services). This was before the boom turned to bust.

The disparity shown in the different sectors of the economy is a function of the great divergence in the components of GDP. All the main components of GDP have now surpassed their level when the recession began in 2008 except for investment. Household consumption, government expenditure and net exports are all higher, only investment (Gross Fixed Capital Formation, GFCF) remains below its previous peak. The change in GDP and its components in the recession is shown in Fig. 3 below.

Fig.3 Change in Real GDP & components since the recession began
Source: ONS

Key parts of the service sector can grow without significant investment, at least for a period. Industry, manufacturing and construction cannot. Investment is the main brake on the economic recovery. It is not the case that the crisis is caused by a deficiency of ‘demand’. Both household and government consumption have risen but investment is still below its previous peak. Previously, the decline in business investment was mainly responsible for the decline in GDP. But that is no longer the case.

Business investment declined far more sharply than the economy as a whole, down 23% from the peak to the low-point in 2009, compared to a 65 decline for GDP. But it has now made a feeble recovery in line with GDP.

Now it is government investment which accounts for the decline in fixed investment. Even taking into account the highly seasonal variability in government spending, the current level is 15.5% below the peak. The absolute decline (not taking account of seasonal variations) is 54%. The change in real business investment and the main component of government investment (not including investment by public corporations) is shown in Fig. 4 below.

Fig.4 Real Business and Government investment, GFCF
Source: ONS

This illustrates a central plank of the austerity policy. The decline in business investment proceeded the recession, driven by a declining rate of profit. (This point ought to be wholly uncontroversial as even the mass of profits fell in nominal terms at the beginning of 2006). After the fall in profits in 2006 the level of investment in the productive sectors of the economy began to decline and then fell rapidly producing the recession. For the period which includes most of 2006 and 2007 this decline was masked by the last stages of a housing and financial bubble. The level of real investment in the productive sectors is shown in Fig.5 below.

Fig. 5 Real productive investment
Source: ONS

This important decline in the productive capacity of the economy is masked by the statistical practise of referring to Gross Fixed Capital Formation in its entirety, which includes both productive investment and other large items such as residential investment and the transaction costs of investment in buildings, including estate agents, surveyors and the like. While these may be necessary and can provide a social good, they do not increase the productive capacity of the economy.

None of the productive sectors has yet seen a recovery in the level of investment from their peak level. Investment in offices and factories is the largest component and is 16.4% below its previous peak, a fall of £23.1bn.

There is therefore no ‘puzzle’ at all to the crisis of productivity in the British economy. The productive capacity of the economy is not growing and may even be declining once capital consumption and real depreciation are taken into account. If more labour is deployed, which is the case currently, output can increase. But if the productive capital of the economy is stagnating or even contracting, then this can only be reducing average output per hour. This is the underlying cause of the crisis of living standards and of real pay. Workers are working longer in less productive ways and so are being paid less.

The austerity policy includes a deep cut in government investment with the false assertion that the private sector will fill the gap. Evidently this has not occurred. The fact is that the fall in government investment is now the largest single impediment to recovery. Given the interrelationship between government and the private sector, this will have a depressing effect on private sector investment. The reverse is also true. A large increase in government investment would lead the whole economy to a sustainable recovery.

Wednesday, 1 October 2014

Is Ireland experiencing a boom?

By Michael Burke

The economy in the Republic of Ireland expanded by 1.5% in the 2nd quarter and by 6.5% from the same period in 2013. This leaves the economy well below its previous level but is actually much stronger than the annual growth rates in the same period in Britain’s ‘boom’, of 0.9% and 3.2%.
For a number of decades the Irish economy has grown more rapidly than the British economy and per capita GDP is higher in the Irish Republic. According to the OECD this is true if constant prices and Purchasing Power Parities are used, or whether current levels are used for both.

This relative outperformance is likely to continue in the future. This is because the Irish economy is more thoroughly integrated into the world economy (or, put in classic terms, it has a higher participation in the international division of labour). This is true even taking into account the effect of multi-national corporations booking profits in Ireland based on production that takes place elsewhere.

The British economy too has its own mechanisms for facilitating international tax avoidance, including the network of overseas territories Guernsey, Jersey, Gibraltar, BVI and so on.
Once this ‘soufflĂ© effect’ is removed it is clear that the export of goods from Ireland is a vastly greater proportion of GDP than are British exports. This, combined with the tendency for an increase in the international division of labour, which is expressed as the faster growth of world trade than domestic GDP, means that the Irish economy is set to grow faster than Britain over the longer term.
But faster growth than Britain is a poor yard-stick. It is utterly foolish of British supporters of austerity to gloat over the relatively better performance of the British economy than the French economy. Declining prosperity elsewhere does not constitute economic well-being here.

Similarly, the focus should be on what is the maximum sustainable growth rate for the Irish economy and the mechanisms to achieve that. In light of the Irish economy’s degree of integration into the world economy, the current rebound in Irish GDP falls well short of what is possible or desirable.

A version of the article below first appeared on Irish Left Review under the title Investment Remains the Key to a Real Recovery.

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The Irish recession which began in the final quarter of 2007 is the most severe in the history of the state. GDP contracted by 12.1% in a little over two years ending in the 4th quarter of 2009. That slump is not over. The latest data for second quarter of 2014 show that the economy still remains 3.4% below its pre-recession peak. In effect it is likely to take 5 years or more simply to recover the output that was lost in in the slump.

Even then, the economy will remain way below its previous trend rate of growth. This is illustrated in Fig 1 below, which shows real GDP and real GNP from 1997 to the present. The average annual growth rate of the Irish economy from 1997 to 2007 was approximately 6%. Maintaining the trend rate of growth would have led the economy to be approximately 50% larger than it is currently, and there is a danger that this potential is lost permanently.

Fig.1 Medium-Term GDP & GNP

The causes of the slump are very clear. Over the entire period of the crisis the fall in investment more than accounts for the entirety of the decline in aggregate measures of output, either GDP or GNP. GDP in the 2nd quarter of 2014 is still €6.6bn below its late 2007 peak. Investment (Gross Fixed Capital Formation, GFCF) is €14.4bn below its peak. There are other components of GDP which have also failed to recover, notably personal consumption and government expenditure. But even taken together, their combined fall of €10.1bn is less than the fall in investment. The only component of GDP which has risen is net exports. The change in components of GDP is shown in Fig.2 below.

Fig.2 GDP & Components In the Slump
Source: CSO

This data belies the notion that there is an ‘export-led recovery’ under way. Recorded net exports have grown very strongly, up €30.5bn over the period. But only one quarter of this or €7.4bn is a rise in the export of goods. A much larger statistical contribution has arisen from the decline in the imports of goods, down €14.6bn. As both investment and consumption have fallen, this simply suggests that both firms and households have been priced out of world markets by reduced purchasing power. The remainder of the rise in net exports is derived from international trade in services. These are particularly prone to the tax-induced flow of funds that plague the Irish economy and completely distort the economic data. There is little benefit from attempting to unravel them.
More importantly, it is clear that exports have not led a broad-based recovery at all. All the main domestic indicators of activity, consumption, government spending and investment are still far below their pre-recession peaks.

The recovery

The low-point for the Irish economy was reached in the 4th quarter of 2009. There is not yet a recovery. But there is a rebound from that low-point, which has not always made smooth progress. Every year since 2009 has seen at least one quarter of economic contraction. It is hoped that 2014 will be different.

One reason for this volatility in the data is the activity of multinational corporations. For example one large order for aircraft, none of which are produced in Ireland but are booked in this jurisdiction, can provide a large one-off boost to GFCF and to GDP.

The engine of the recovery is also clear if we take the inflection point from the 4th quarter of 2009 to the most recent data. This is shown in Fig.3 below.

Fig. 3 Change in GDP & Components in the recovery
Source: CSO

The rebound in both GDP and GNP since the end-2009 low-point is driven solely by the rise in net exports. Of the €24bn rise in net exports over that period just €8bn is a rise in the net export of goods.
Otherwise there has been no improvement in the other components of GDP even during this phase. Personal consumption and government expenditures have fall by a combined €2bn. Again, this is exceed by the fall in investment, down €2.7bn since the end of 2009.

The motor force of the Irish economic slump has been the fall in fixed investment. Ireland’s openness to the world economy (its high degree of participation in the international division of labour) provides a real benefit to the economy, even if that is vastly overstated in the official data.

But for exports to lead the economy investment must grow. Otherwise Irish goods (and genuine services) become priced out of world markets. The investment strike in Ireland has not ended. Until it does there can be no confidence in the sustainability of any eventual recovery.

Tuesday, 16 September 2014

Austerity is on course to be a lot worse

By Michael Burke

The Office for Budget Responsibility (OBR) has produced its latest assessment of the economic crisis and its impact on government finances (pdf here). In common with the UK Treasury the OBR tends to underestimate the impact of austerity policies and consequently has a persistently over-optimistic outlook for the British economy. This is no surprise as the OBR uses the Treasury economic model.
Even so the detailed analysis by the OBR is very valuable as it reflects official thinking on the economy and on economic policy. This view will continue to be shared by the OBR and Treasury beyond the next election.

A key conclusion of the latest report is the assessment that austerity policies are set to continue for some time to come. The chart below shows the OBR’s assessment of the austerity policies and their composition from 2008/09 with projections until 2018/19. The policy measures of government spending cuts and tax change changes are expressed as a percentage of GDP.

Fig.1
Source: OBR

The OBR persists in projecting the effects of Labour policy over the entire period even though the Coalition has been in office since May 2010. Labour’s austerity measures (announced by Alistair Darling in March 2010) are shown in purple. The additional measures introduced by the Coalition in June 2010 are shown in green. The further measures after that time (beginning with the Austumn Statement in 2010 and March 2011 Budget) are shown in orange.

Currently we are approximately midway through the Financial Year 2014/2015, when the fiscal tightening rises from 5.1% of GDP to 5.6% of GDP. So the current fiscal tightening is approxumately 5.35% of GDP. By 2018/19 the OBR projects the entire austerity policy will reach 10.3% per annum.
In effect we are currently only half way through the austerity programme.

At the TUC, Geoff Tily points out that that the entire OBR analysis is based on an incorrect framework (adopted from the Treasury). This framework assumes that austerity reduces the deficit while doing little damage to the economy. Yet the OBR’s own data show this assumption is incorrect.

The data below is extracted from the OBR’s Chart 1.3 in its latest report. It shows the level of Total Managed Expenditure versus Current Receipts as a proportion of GDP during the entire period of the crisis to date.

Fig.2  Expenditure & Receipts, % GDP
Source: OBR

Since FY 2008/09 expenditure has fallen by just 0.6% while receipts have also fallen by 0.2% of GDP. The OBR forecasts that this will improve imminently, but forecasts of that type have been made ever since the OBR was established. The latest data for the current Financial Year actually show the deficit widening once more. The effect of austerity policies is to produce the weakest recovery on record while the reduction in the deficit has been minuscule. If 5% or more fiscal tightening has been required to reduce the deficit by just 0.4%, the OBR projections of further policy measures shown in Fig. 1 are likely to be a significant underestimate.

A continuation of austerity policies is unlikely to produce a different outcome. Unless there is a radical break with OBR/Treasury thinking, austerity is set to get a lot worse.