Inflation impoverishes the vast majority

By Michael Burke

The latest monthly data show the annual pace of UK inflation accelerating to 4.5% in April, using the Consumer Price Index (CPI). The broader measure of inflation in the Retail Price Index (RPI), which also includes housing costs moderated a little, to 5.2% from 5.3% in March.

The impact of these prices increases is severe. At the end of 2010 the annual level of all wage compensation in the UK economy totalled £800bn. In the February data, average weekly earnings grew by just 0.9%. If sustained the decline in real wages would therefore amount to 4.3%.

For comparison if a decline of 4.3% in real wages were directly translated into total employees’ compensation it would amount to a £34bn annual reduction in incomes. This compares to the government’s already enacted tax increases of £3.8bn and spending cuts of £5.5bn in the previous Financial Year (FY) and £20bn in taxes and £22bn in cuts in this FY.

Unlike the cuts, inflation affects all sectors of society, especially those on low or fixed incomes, in addition to those in the public sector who are seeing their pay fall through a wage freeze and increased pension levy.

Usually the group on fixed incomes would include those receiving the state pension. However for reasons of political calculation, the government has chosen to offer a ‘triple-lock’ on pensions, so that pensioners will receive the highest of earnings growth, the RPI or 2.5%. However it was hardly envisaged at inception that this could mean a pensions increase of perhaps 6% just to keep pace with the RPI. Both the June 2010 and March 2011 Budgets assumed that there would be no additional cost to this policy in the current FY. But if the overshoot in inflation is in line with the Bank of England’s latest quarterly Inflation Report, then the cost to the Treasury will be £2.9bn in this year alone – without leaving pensioners any better off.

If the real aim of policy was to reduce the budget deficit reduction, the government approach would be utterly self-defeating. The rise in pensions and other welfare benefits (although most of these have now been switched to a link with the persistently lower CPI) automatically triggered by higher inflation will cause significant increases in net government outlays, even while entitlements are being cut.

Yet government policy is itself largely responsible for the overshoot in inflation. The chart below is taken from the latest official publication for the Office for National Statistics (ONS). In addition to CPI inflation, which is currently at 4.5%, two other measures of inflation are shown. The CPIY measure shows price increases excluding the direct effect of changes to indirect taxation, such as VAT. This is currently rising at a pace of 3%. The CPI-CT measure is the same as CPI but is adjusted as if all taxes were unchanged during the latest 12-month period (for example, excise duty rose on alcohol and tobacco in the March Budget and these are excluded). This is currently rising at a pace of 2.8%.

Figure 1

The Bank of England’s medium-term target is a 2.0% inflation rate with a tolerance zone 1.0% either side of that central aim. A large part of the current overshoot is a direct effect of government policy, which will also have greater indirect effects too. On both the CPIY and CPI-CT measures which exclude the direct effects of government policies, the inflation rate would be within the target range.

This matters primarily because both the latest data and the Bank’s Report have raised expectations that there will be interest rate increases before the end of the year. At the time of writing the interest rate futures market was pricing in two rate hikes by year-end to take official rates up to 1%.

Government hopes for economic recovery are largely pinned on the ability of very low interest rates to support borrowing by companies and especially households while the cuts are pushed through. If the prop of low interest rates is kicked away the economic outlook will deteriorate sharply. Yet it is in the government’s own hands to lower the inflation rate by reversing the rise in VAT. They could also scrap the rules that allow permanent above-inflation prices rises for the privatised utilities and rail companies, which are set to lead to price rises of up to 14% later this year .

At the turn of the year higher inflation led to calls for significant rate increases and a campaign for a higher pound which Osborne and Cameron were keen to lead. Sterling climbed sharply, as Figure 2 below shows.

Figure 2

But that campaign was punctured by publication of the stagnant GDP data for the latest 6 months. Now there is a gradual realisation of how weak the economy is and sterling finds little support from higher prices or the expectation of higher rates, as the chart shows. Instead the talk has shifted to ‘stagflation’ the combination of economic stagnation and rising prices .

That stagflation is even a possibility after one of the most severe economic contractions on record is itself a damning indictment of policy. Recessions should lead to large excess capacity in the economy allowing a rapid rebound without producing price pressures. Now a combination of government spending cuts, chronically weak investment and excessive monetary creation have created the opposite; flat activity and soaring prices.

The opposite policy is required to produce non-inflationary growth, centred on increased government spending and investment.

Problems deepen at Lloyds Bank - but it could be part of the solution

By Michael Burke

The initial market reaction to the announcement that Lloyds Bank had made a £3.5bn loss in the first quarter of this year was for the share price to fall by nearly 6%. Every British taxpayer has a material interest in Lloyds as the state effectively controls it through a 41% shareholding.

At the time of writing the share price had fallen to a little over 54p per share, whereas the average purchase price by the state was 68p – see Figure 1. Taxpayers are now nursing direct paper losses amounting to nearly £1bn on the share purchases. However this is a tiny fraction of the total costs incurred by the state in bailing out the banks, which has mainly been in the form of providing funds to the stricken banks rather than share purchases.

Figure 1 – Lloyd’s Bank Share Price

According to the Office for National Statistics (ONS) the total debt incurred in ‘financial market interventions’, that is the bank bailout, was £1,335bn, significantly more than the level of state debt incurred via spending and taxation which currently amounts to £903bn.

For all the lurid headlines about both, the debt and the budget deficit actually fell in the last Financial Year (FY) from £156bn to £141bn under the impact of the recovery fostered by Labour’s increased spending - which has now stalled under the Tory cuts. Similarly, the debt level, excluding the bank bailout,t amounts to 59.9% of GDP which is fractionally below the Maastricht Treaty limit and lower than British public debt in every year between 1916 and 1970.

A chunk of Lloyds’ net loss come from a charge of £3.2bn from the miss-selling of payment protection insurance to individuals, many of whom could never have claimed on the insurance. Many other High Street banks are also guilty of the same swindle. Even so, without this charge there would still have been a loss compared to a profit of £721mn in the previous year.

This renewed loss is a product of the banks own current business practise. Income fell 20% as it reduced its assets and curbed its lending. However, losses on its existing loans are increasing (to £2.6bn in the latest quarter) as borrowers continue to struggle and the economy stagnates. In effect this is a policy of hoarding its capital and hoping that something positive will turn up which will improve the existing loan book. However, this is also the policy of all the other banks too and total bank lending to non-financial businesses and individuals has fallen by £74bn in March from a year ago, which was itself £102bn lower than the previous year.

Worse, government policy now exacerbates this trend as it also cuts spending and investment and makes incredible forecasts that something (net exports?, business investment?) will turn up. As a result of capital hoarding and reduced government spending, nothing is turning up.

But Lloyds, in common with the other High Street banks has considerable capacity to increase its lending. SEB has previously shown that the banks are sitting on large capital assets which could be used to increase loans. The Financial Service Authority (FSA) has performed rigorous ‘stress tests’ on all the major banks. The stress test show what would happen to the banks’ balance sheets from a series of events which include a double-dip recession, a rise to 12.5% unemployment, a further 60% fall in house prices and default by one or more European government. Even if all of these events happened simultaneously the FSA estimates that Lloyds Bank would have Tier 1 capital equal to 9.2% of its assets to act as a cushion against losses, compared to 8.0% set as the international standard. Lloyds is actually the weakest of the banks on this measure.

Even so, this implies that Lloyds could increase its lending by 15% and still meet international safety limits for its capital under an extreme economic scenario. The current policy of hoarding capital and accumulating losses is having the opposite effect, the Tier 1 capital ratio fell by 0.2% in the quarter. The bank is becoming more, not less risky as a result .

The opposite approach would be one which benefitted Lloyds shareholders (including the state) and the whole economy. This would be driven by a sharp increase in productive lending, with a positive investment return. Here the role of government is decisive. It could instruct Lloyds to make a sure-fire investment in state-owned housing. The housing shortage in Britain is both chronic and acute, with the lowest number of homes built in 2010 since 1923. 1.8 million households are on council waiting lists and even those who could afford to buy a home cannot find the mortgage financing, where Lloyds has led the way in reducing its lending.

A state-led investment programme in housing, in conjunction with local authorities and financed by state-controlled banks, could produce affordable homes yielding 6% or 7% a year in rents, double the government’s cost of borrowing and so provide a net return to invest further, or to reduce the deficit. Ed Balls has previously called for £6bn investment in 100,000 new affordable homes. This could be done via the State-controlled banks without any increase in borrowing at all. It would also create 750,000 new jobs in a sector decimated by unemployment. 750,000 new jobs would also have a twofold benefit to public finances, much higher tax revenues from both income and consumption and much lower welfare payments.

The IMF's prediction China will overtake the US to become the world's largest economy in 2016 – chart

This is a link to the chart showing the IMF’s widely discussed prediction that the size of China’s GDP will overtake the US in 2016 in Purchasing Power Parity (PPP) terms.

The chart is interactive. By ticking the boxes on the left-hand side, readers can make their own comparisons. Amongst other comparisons we found interesting; China surpassed the combined economic size of Germany, France, Britain and Italy in 2010; India surpassed all these countries individually in 2006, Brazil in 2011 will have surpassed all those countries individually except Germany.

British Economic Stagnation Caused By Tory Policies

By Michael Burke

The preliminary estimate of the UK’s 1^st quarter GDP showed a rise of 0.5% which exactly matched the rate of contraction in the previous quarter. Consequently over the latest six months the economy has stagnated, registering no growth at all over the period. This follows a 12-month period in which the economy expanded by 2.8%.

A number of right-wing commentators, including the Adam Smith Institute have expressed their disbelief at the data. Yet the 0.5% rise was in line with the consensus estimate by economists and, while there may well be revisions to the data in later releases, the average revision over the last five years has been negligible. This refusal to accept reality is a function of adopting an economic framework that does not correspond to reality.

The initial release focuses solely on output measures of growth – income and expenditure measures will follow in May and June. But it is clear from the output data alone that the government policy of cutting investment has been decisive in the stagnation.

When the Tory-led coalition took office the economic recovery was expanding. In mid-2010 the economy expanded by 1.8%. Of this increase 0.3% was accounted for by a rise in manufacturing, which was mainly a function of the pick-up in world trade and the depreciation of the pound. But the biggest contributors to growth were all government-related. Current Government spending on services such as health and education directly contributed 0.2% of that growth. The state-supported finance sector contributed another 0.5% and the construction sector contributed 0.6%. SEB has previously shown that government construction spending both before and during that period led an increase in private sector investment. Therefore both directly and indirectly, government activity contributed 1.3% of 1.8% growth in mid-2010.

But the effect of Tory led coalition policy has been to reverse that increased government spending. Contrary to those who cannot accept reality, government activity has three effects on GDP; directly, through its own spending; indirectly as its activity causes the private sector to alter its own spending, and an ‘induced’ effect as sectors of the economy not directly related to government activity are affected by changes in spending (for example, consumer spending by workers in firms that supply to government).

When the further date releases are published, it will be possible to analyse this dynamic in greater detail. But it is already clear that government investment fell after the June 2010 Budget and just three months later the economy began to contract. A key area was the fall in government construction spending. The latest data show public construction investment falling by between 13% and 19% from a year ago, depending on the secto. While increased government activity has a triple benefit to the economy, this cut in spending will have had a threefold negative effect on economic activity.

The 1^st quarter 2011 data mark three years since the recession began. This should be a period of robust and above trend growth. Instead government policy has produced stagnation. The chart below shows the change in economic activity from the peak prior to recessions.

Figure 1

In this business cycle it is now 36 months since the recession began and the latest data leave the economy still 3.5% below its prior peak. The only cycle where activity was lower at this point was in the Great Depression of the 1930s (-5.2%). The current cycle is more severe than the next sharpest recession, under Thatcher in the early 1980s, when output was 2.8% lower than the peak level after three years.

In both the downturn of the 1930s and that of the 1980s output was back to its previous peak after four years. This is just one year away in the current cycle and to match that now the economy will have to grow by 3.5% over the next 12 months – which would represent a wholly extraordinary acceleration from present stagnation. Even the Office for Budget Responsibility, whose remit seems to include rosy forecasts, is only forecasting growth at half that rate this year. Anything below 3.5% means that this business slump will exceed even that of the Great Depression, at least in duration although not in severity.

Another deeply worrying aspect of the data is that the economic stagnation arises from £9.4bn in fiscal tightening in the Financial Year just ended, £5.5bn of which was spending cuts. The government plans £41bn of fiscal tightening in the 12 month period beginning in April. New Labour had planned £26bn of fiscal tightening this FY, £14bn of which was spending cuts. Continued support for slower, slightly shallower cuts is not tenable given the evident negative impact of much smaller cuts so far.

There is always the possibility of unforeseen events, perhaps a collapse in the currency or a build-up in unwanted inventories either of which might statistically boost GDP without altering the underlying picture of extreme weakness. But outside of these quirks it seems that the best that can be hoped for is a prolonged economic stagnation. A policy-induced return to recession, a ‘double-dip’ cannot be ruled out. It seems certain that employment will fall once more and tax revenues decline. Both of which will lead to a widening of the public sector deficit, contrary to the claims of the government and its supporters. Instead of these, seriously rescuing the economy, creating employment and reducing the deficit will all require a complete change of policy.

Poland Escapes Recession By Public Investment

By Gavin Rae

Prior to being elected Poland's Prime Minister in 2007, Donald Tusk declared that he wanted to repeat the ‘Irish economic miracle’ in Poland. As Tusk comes to the end of his first term in office, he can claim that an ‘economic miracle’ of sorts has actually occurred. Poland has been the only EU country to have avoided an economic recession since the outbreak of the global financial crisis. However, this relative economic success has been made possible by carrying through policies that are diametrically opposed to those being implemented in Ireland. Furthermore this is now being threatened by attempts to carry through austerity policies similar to those currently being introduced by the Irish government.

It is not the case that Poland has not suffered an economic downturn during the international financial crisis. GDP growth slowed from 6.8% in 2007 to 1.2% in 2009, before growing by more than 4% in 2010. Unemployment has risen again above 13%, with around 25% of young people now jobless. The budget deficit has risen to nearly 8% of GDP and public debt is edging towards 55% of GDP. With social inequalities widening, inflation rising faster than wage growth and public services deteriorating, Poland is far from meeting the ideas of an island of economic stability propagated by Tusk and his Citizens’ Platform (PO) government.

Yet the fact that the Polish economy has continued to expand has lessened the negative effects of the economic crisis. Why has the Polish economy continued to grow? Poland was fortunate not to have experienced a banking crisis similar to that in many other countries and entered the crisis with a relatively low level of private debt. However, the major reason for Poland avoiding negative growth has been that it has managed to increase public investment at a time when private investment has slumped.

Socialist Economic Bulletin has consistently pointed out that the global economic crisis has primarily been driven by a collapse in fixed investment, which has accounted for around 96% of the fall in GDP in the OECD area. The economic contraction has tended to be deepest and most prolonged in those countries where fixed investment has fallen the most; and the greatest success has been achieved in countries which took measures to sustain or increase fixed investment - most notably China. Such an understanding fits the case of the Polish economy.

One result of the financial crisis was a collapse of private investment in Poland. In 2010 private investment declined by 7.4% in relation to 2009 and by 20% compared to 2008. In June 2010, the overall year-to-year fall in private investment was 17.7% - declining, for example, by 20.8% in construction and 15.6% in purchases of machines, tools and vehicles. This decline in private investment has been spurred by a sharp fall in Foreign Direct Investment.

Although Poland is less reliant on FDI than some of the smaller ‘financialised’ economies in Central-Eastern Europe (most notably the Baltic States) it has still suffered a large decline in private capital inflows. Net inflows of FDI fell in Poland from €16.7bn in 2007 to €8.4bn in 2009 and then down to €5.5bn in 2010.

While private investment has slumped in Poland, public sector investment has taken up the slack. Poland has had the good fortune to have entered the financial crisis at a time when it is eligible to receive large direct transfers from the EU. In the 2007-13 EU budget, Poland has been allocated up to €67bn in structural and cohesion funds, which is almost equal to the government’s total revenue in 2010. It has become the largest single receiver of EU funds – gaining, by February 2010, a net sum of around €21.4bn. Furthermore, over 1.4 million Polish farmers have obtained agricultural subsidies adding up to €5.3bn (in 2009 the total figure was €2.98bn, rising to more than €3bn in 2010.) The Polish government estimates that around half of the country's growth in 2009 was directly created by investments, jointly financed by the EU. A total sum of 18bn zloty was spent on building roads, bridges and sewage works in 2009, growing to around 25bn zloty in 2010.

Leaving aside the qualitative aspect of this investment – with the government spending far more on roads than railways for example – its positive impact on the Polish economy is undoubted. A recent report from the European Commission into the role of public investment in Poland underlines this. It points out how the significant increase in public investment - following Poland's accession into the EU - helped to smooth the economic downturn during the crisis and that increasing the extensive use of EU funds as a means to invest in the country's infrastructure would now help to support its recovery. The report also points out that while public investment has increased significantly over the past few years (rising from 3.5% to 4.5% of GDP between 2005 and 2008) this was from an initially very low level of capital expenditure. There had been no investment into the country's infrastructure (such as transport) throughout the ‘post-communist’ transition prior to EU accession, with funds designated to maintaining a steadily degrading infrastructure.

It is interesting to look at a graph provided in the report that shows the relationship between public investment and economic growth in Poland. As we can see, the recovery in public spending helped to pull Poland out of the recession it had entered at the beginning of the transition. Then from the late 1990s (during the term of a right-wing coalition government) public investment fell sharply helping to significantly slow the pace of economic growth. Public investment then began to grow rapidly around 2005, soaring above its pre-EU accession level. Contrary to the ideologues - that have dominated public debate in Poland - economic growth has increased when the government has invested more and slowed when its investment has reduced.

Figure 1

The maintenance of positive economic growth through public investment is threatened by political attempts to rein in spending. These come both domestically from the Polish government and externally from the European Union. In order for a national government to receive EU funds for any investment project, it must first provide at least 15% of its overall cost. It is therefore essential that the Polish government commits as large amount of its own funds as possible in order to gain the optimum amount of EU money available for investment from the present EU budget – which runs until 2013. However, there is increasing pressure for Poland to reduce its spending and comply with other European austerity programmes.

Written into Poland’s public finance law are a number of ‘safety thresholds’. If public debt exceeds 55% of GDP, then the government would need to reduce the debt to GDP ratio; and if it goes above 60% then according to the constitution the next year’s budget must be balanced. Also, Poland is obliged to meet the Maastricht criteria by 2012 and has - for example - committed itself to bringing down its budget deficit to below 3% of GDP by next year. It has also voluntarily signed up to the so-called ‘competitiveness pact’ proposed by the German and French governments for the eurozone. The proposed pact aims to draw up a set of commitments that are more ambitious and binding than those already agreed to by the EU member states. Amongst the pact's proposals are maintaining public debt below 60% and the budget deficit below 3% of GDP; reducing the tax burden for companies and linking the retirement age to life expectancy.

The Polish government has already laid out a series of spending cuts and regressive tax rises that it will introduce if public debt crosses 55% of GDP (presently public debt equals around 53%). A partial reform of the privatised pension system (which has been met with scorn by international financial institutions as it effectively nationalises part of the private pension scheme) has helped to ease the public finances. However, the government has also announced a series of public spending cuts, raised VAT to 23% and importantly is seeking to force local governments to decrease their spending.

From the beginning of 2011 all local governments have been compelled to balance their income and current expenditures. In this way the PO central government is attempting to pass the responsibility of cutting spending onto local governments. Local governments have been at the forefront of gaining access to EU funds, leading investment projects in the country's infrastructure and carrying through the preparations for the EURO 2012 football championships.

The longer term ability of Poland to continue its course of public investment driven growth will be largely determined by the shape of the next EU budget that comes into force in 2014 and runs till 2020. Already divisions around the shape of this budget are emerging – with David Cameron continuing his role as an advocate of austerity in Brussels. The richer EU countries are actively trying to reduce the amount that they pay into the EU’s budget, with the UK attempting at the end of 2010 to form a coalition of net-payer countries with the aim of reducing this budget from the current 1.13% of EU GDP to 0.85% - i.e. by €250bn.

After the collapse of ‘Communism’ there was a prolonged phase of de-industrialisation and de-investment in the Polish economy and its infrastructure. Simultaneously the richer Western European economies benefited by buying up and dominating large sectors of the Polish and CEE economies, having new access to expanded markets for their goods and gaining a new pool of cheap and well-skilled labour. It is only during the past few years that this has partially been reversed and some investment in the country’s infrastructure has begun. This is woefully inadequate – leaving out large areas of the country’s neglected industry and services – but has still allowed the economy to grow during a period of global recession. The greatest impediment to growth in Poland would be the curtailment of this public investment.

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