When British thieves and French thieves fall out - the Anglo-French governmental dispute in perspective

By Michael Burke

The French and British authorities are engaged in a war of words over which country will be first to be downgraded by the credit ratings agencies. At least the hostilities are purely verbal - these ‘heroes’ of Tripoli are prepared to use other methods when the odds are overwhelmingly in their favour.

The immediate cause of the dispute was initially the remarks of French central bank governor Noyer. In response to the threat from Standard & Poor’s (S&P), one of the credit ratings agencies, that France would be downgraded, he argued that Britain should be downgraded first because its economic fundamentals are worse than those of France.

The remarks caused predictable uproar in Britain. Even the leadership of the LibDems, the main representatives of the pro-EU business class in Britain discovered its nationalist roots and criticised the remarks. But Noyer argued that, ‘they [S&P] should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping’. Essentially, Noyer is correct on the relative ‘fundamentals’. But this focus on the ‘fundamentals’ also demonstrates a shared and thorough misunderstanding of the nature of the crisis.

The table below shows the relative levels for each of the indicators specified by Noyer. The estimates are taken from the EU Commission Autumn forecasts.

Table 1

It is clear that the Noyer observations are correct. The British government’s credit rating is also under threat as the economy weakens. Yet France’s downgrade seems likely to happen even sooner. More importantly, the French government is currently paying over one per cent more for 10 year government debt than the UK so that its effective market rating is already lower than Britain’s. This is despite the lower deficit, lower inflation and higher growth in France.

This demonstrates that Noyer is looking in the wrong place for the determinants of bond yields. Bond yields are not primarily determined by the nominal level even of important economic variables. Ultimately the price of any given financial market asset is determined by the real level of savings that are directed towards it. In countries such as Britain, the US and Japan the very high level of corporate savings must ultimately be held in some financial asset, and in the current circumstances of weak or stagnant growth government bonds have looked far more attractive than their only main alternative, which is stocks. 10 year debt yields are currently below 2% in the US and below 1% in Japan. This is true even though government debt and deficit levels are even higher in the US and Japan than either France or Britain. UK companies cannot invest in financial instruments in another currency without exposing themselves to exchange rate risk.

For investors in French government bonds the situation is different. There is an easy alternative - German government bonds also denominated in Euros. The rising premium on French yields represents the increased perceived risk of the Euro breaking up, in which case investors prefer to hold the debt of the strongest economy in the Euro Area.

The key relevant ‘fundamental’ for the Eurozone is that investors may choose between different governments’ credits. That is, there is a market mechanism for redirecting savings towards one country - and there is no fiscal mechanism to transfer savings in the opposite direction. Just as in other Eurozone economies, bond yields started to rise in France as soon as ‘austerity’ measures were introduced. Investors based in the Euro have greater prospects of being repaid if they invest in government bonds where the economy will grow, not stagnate or decline.

French and British Both Wrong

The growth outlook is sharply deteriorating in both France and Britain. In the Spring Forecast the EU Commission was projecting 2% growth for both Britain and France in 2012. In the Autumn Forecast the Commission is forecasting just 0.6% growth. Both governments are pursuing ‘austerity’ policies which are clearly not working.

They have both also invested an enormous political capital in the maintenance of the AAA rating for their government debt and argued that their policies would reduce their budget deficits. As we have seen, both governments debt ratings are likely to be downgraded in 2012. And both countries are projected to have a deficit in 2013 which, five years after the recession began, is still double the level it was in 2007, before downturn began.

The failure of their policies has led not to a re-think, but in both cases to blaming foreigners. The unwillingness to correct a failed policy is the cause of the diversionary war of words between the two governments.

The most ridiculous aspect of their policy is that both governments claim that their policy is driven by the demands of financial markets. Yet the government bond markets are sending a very clear signal. Long-term interest rates are either at the current inflation rate as in France, or below it in Britain. They are so low because businesses are saving, not investing. Businesses feel more confident lending to the government than investing on their own account. But both governments insist on cutting spending. If that leads to renewed recession the effect will be to cut further the level of savings in the economy - and bond yields may start to rise.

Corporate savings are being lent to the governments at exceptionally low interest rates. This glut of corporate savings could be used to invest for recovery. Since businesses themselves refuse to do this, only the state can end the company investment strike.

EU Summit Is Another Failure for ‘Austerity’

By Michael Burke

The outcome of the EU summit has widely been hailed in the British media as a triumph for David Cameron. It is rare that a complete rupture and isolation in multi-party negotiations is regarded as a triumph – but this is a function of the dominant and still growing xenophobia of the British press.

The EU Commission will now impose further spending cuts and rules to enforce deficit limits across the whole of the EU. David Cameron did not oppose these measures because they lead to public spending cuts- he is cutting public spending by a greater proportion of GDP than any major country which has not been in receipt of EU/IMF funds for its creditors.

Cameron’s stated objective was a defence of the interests of the City of London. There is a question mark over whether he has even be able to achieve that. Angela Knight, former Tory MP and chief spokesperson for the British Bankers Association guardedly told The Times that she hoped that City’s interests would not be harmed by Britain’s isolation.

Holding Back the Tide

‘Let all men know how empty and powerless is the power of kings’. So said King Canute in demonstrating to sycophantic courtiers the impossibility of instructing the advancing tidewaters to retreat. But it seems that the thinking of the EU Commission has retreated behind even that of Dark Age monarchs.

In response to the economic, fiscal and balance of payments crises in Europe, the EU summit in Brussels agreed to issue a series of regulations- to prevent these crises being manifest at the level of government deficits. A new rule that so-called structural deficits will not exceed 0.5% of GDP has been introduced . The EU Commission will be given prior oversight of the national Budgets. Given the impossibility of factually establishing the level of the structural deficit (which depends on extremely approximate estimates of potential output) then the combination is a recipe for complete control by the EU Commission - the economic geniuses who have led Greece and Ireland to disaster.

While it is impossible to precisely quantify the structural deficit it is practically impossible to determine the level of the government deficit simply by controlling spending. This is because the deficit reflects the gap between government spending and income. Government incomes are overwhelmingly taxation revenues and these are determined by the spending of consumers and the spending of businesses (primarily investment).

To achieve the precise control over its own income, as demanded by the new agreement, the European governments would have to determine the incomes and spending of both other main sectors of the economy, consumers and businesses. And, in a currency union it would also have to ensure that the overseas sector was not a significant net lender or borrower (through large trade or current account deficits/surpluses). Otherwise, if the other domestic sectors remained in broad balance, a large trade deficit could only result in a large government deficit.

This is show in Figure 1 below. The chart shows the sectoral balances in leading EU economies and the EU as well as the change between 2006 and 2009. The chart is taken from the Financial Times and is based on OECD data.

Figure 1

Simple national accounting identities mean that the increased savings of one sector of the economy must be reflected in the increased deficit of another. In all cases the balances shown below, the government balance (the public sector deficit/surplus), the private sector balances (the savings/consumption of the private sector) and the overseas sector (the current account balance) sums to zero, as they must.

Within each national economy of the EU it is impossible to legislate for the deficit of the public sector without determining the savings, consumption and investment decisions of all other sectors of the economy.

It is also entirely impossible in a single currency area for all other economies to maintain government balances if one or more key countries have large current account surpluses, as is presently the case with Germany and others. Other countries must then run current account deficits and to simultaneously maintain a government balance they are faced with two unacceptable alternatives. They must either hugely increase household savings even though incomes are declining; that is, household spending must fall even faster than incomes. Alternatively, businesses must reduce investment to well below the level of its income, which could only lead to a further reduction in competitiveness and a renewed widening of the current account deficit. This is the downward spiral that countries like Greece have already entered.

The Tory Position

David Cameron did not object to any of this because he is a champion of increased government spending, or a defender of the welfare state. Nor has his government shown any appreciation of the fact that reduced government spending will also reduce the incomes of other sectors of the economy.

Instead, his objection was to the threat to the City’s ability to siphon off funds from other businesses in Europe. He may not have been successful even in that limited aim. Ed Miliband writing in the Evening Standard argued that Cameron was ‘a prisoner of the Tory Right’ and had isolated himself and Britain from the continuing evolution of policy in Europe.

While willing the other EU national leaders to act decisively to halt the crisis, Cameron himself acted to prevent that happening. Defending the sectional interest of the City and relying on some of the most backward political forces in Britain, Cameron has finally crossed a line that even Thatcher only threatened to do. There will be no benefit to the British economy from this decision and the consequences could prove extremely negative. If, for example, overseas multinationals decide they want a base in the EU, will they choose semi-detached Britain or one of the other 26 countries who continue to have a common regulatory regime? If the British economy suffers as a result, it should be remembered this was done to benefit the City of London and to appease the Tory Eurosceptics and Union Jack-wavers.

George Osborne Shows He’s Learnt Nothing from Greece or Ireland

By Michael Burke

The Autumn Statement was widely presented as facing up to harsh realities of slower growth, but with George Osborne offering a series of cunning schemes in order to resolve the crisis .

The stagnation of the British economy is a function of government policy and plans to increase investment by increasing the credit available to smaller firms will founder because they will not invest when they don’t expect to make profits .

SEB has long argued that government needs to increase investment in a series of areas. Surely, the government’s plans to increase investment in infrastructure should be welcome? But the government’s planned increase amounts to less than £3.8bn spread over four years, or less than 0.1% of GDP in each year. In addition, most of the wish list for infrastructure and capital projects is dependent on investment in the private sector. So, George Osborne and Boris Johnson stood outside Battersea power station in London and talks of new tube lines, enterprise zones and 25,000 jobs. Just two days later the private developer central to the project collapsed into receivership.

Worse, the government’s planned increase in capital spending is paid for by taking money from the pockets of the poorest and most vulnerable in society. These will bite much harder in later years, long after the pathetically small planned increased in investment has come to an end. This is shown in the table below, from the Autumn Statement.

Table 1

 

So, there are total cuts in current spending in 2012/13 of £910mn and total cuts over the next 3 years of £3.8bn, shown as a positive sign in the Treasury bookkeeping method. This is in order to pay for tax cuts (fuel duty) and a projected increase in capital spending. But in the two following years the projected cuts to current spending increase dramatically for a total of over £27bn cuts in all. Although these are mostly unspecified, the itemised cuts include child tax credits, working tax credits, real public sector pay cuts and the breaking of the promise to uphold overseas development aid at 0.7%.

This is a very damaging but much milder version of the same logic that has led Greece and Ireland to disaster - every failure to meet budgetary targets because of the impact of ‘austerity’ is met by further ‘austerity’ measures. But the deficit is and borrowing totals are likely to go higher still as the economy stagnates- or worse. It may only be a matter of time before this same logic produces comparably savage cuts in spending- with the same economic consequences.

Politically, by pre-announcing needed cuts for the next Parliament Osborne hopes to bind all parties to further ‘austerity’ measures. For the LibDems, Danny Alexander has already proved obliging, signing up to Tory cuts of £23bn in the next Parliament. The key question is whether Labour will go down the same path in accepting the need for cuts even when they have demonstrably failed to deliver economic growth or even deficit-reduction. It is the path that leads to Athens and must be resisted.

Desperate Osborne's Subsidies to Businesses Won't Work

By Michael Burke

George Osborne has told the BBC that there will be £40bn in ‘credit easing’ so that small firms can obtain both cheaper and more readily available loans. Osborne has called the scheme a ‘game-changer’. If the funds had the stated impact, of increasing investment by small and medium-sized enterprises (SMEs), then it would certainly provide a significant lift to the economy. £40bn is equivalent to 2.8% of GDP.

The strength of this overblown rhetoric may be judged by the fact that there are widespread reports that the Office for Budget Responsibility is set to slash its growth forecasts for 2012 to just 1% from 2.5% previously.

How is it that significant funds for new investment by business will actually lead to no improvement in the outlook for growth, even on the usually over-optimistic forecasts from the OBR?

There are to be at least two, possibly three funds. The first will be guarantees to increase the availability of credit. The second will be a fund to lower the cost of that credit to SMEs. Since SEB continually argues for increased investment, surely this is a good thing?

Private Sector Failure

Even official forecasts do not assume that growth will significantly improve as a result of this policy. This highlights the fallacy that underlies all current attempts to persuade, cajole, demand or bribe private firms to increase their investment. The fallacy is that those firms are struggling under the burden of insufficient funds to invest. Of course certain individual firms may have such difficulties. But in aggregate that is not the case.

In a previous bulletin SEB showed that in 2010 the total Gross Operating Surplus of the business sector in Britain was £475bn. These are akin to profits. Yet the entire level of investment (Gross Fixed Capital Formation) was just £214bn in 2010. As this includes the investment by both private individuals and government, it is clear that businesses have vast resources already from which they could increase investment.

The chart below shows the decline in total Gross Fixed Capital Formation (GFCF) and corporate sector GFCF. Both these measures of investment began falling one quarter before the recession itself began. The fall in both at their low-point in the 4^th quarter of 2010, of over 20%, is approximately three times as great as the fall in GDP of at 7.1%. Both chronologically and arithmetically the decline in investment, led by declining business investment, led the recession.

Figure 1

Both measures of investment have experienced a small recovery. Business investment began to rise in the 1^st quarter of 2010. This was two quarters after both total investment and GDP began to rise in the 3^rd quarter of 2009.

Private sector investment led the recession. But it cannot lead the recovery. This is demonstrated in the chart below, which shows corporate GFCF and GDP.

Figure 2

The recovery in business investment occurred two quarters after the economy as a whole began to recover. This is because the increase in investment did not depend on the availability of resources, as profits have exceeded investment by some distance throughout the entire crisis.

Corporate investment rises and falls in line with expected returns. The purpose of capital is the preservation or expansion of capital. If the economy is not growing a main motive will be to preserve capital. If the economy is expanding, it will be increase capital through profitable returns on investment.

This is what happened in 2009-10. GDP began to expand in mid-2009 and six months later corporate GFCF began to increase. Precisely the same time lag operated in the reverse situation. Corporate GFCF fell once more in the 1^st quarter of 2011. This was six months after the modest recovery peaked n the 3^rd quarter of 2009.

Public Sector Leadership

The new factor which caused the recovery was the increase in public sector investment (both by general government and the remaining public sector corporations). At its highpoint in the 4^th quarter of 2009, public sector investment was over 20% higher than its pre-recession level.

This led directly to the increase in GDP which in turn eventually prompted the private sector to increase its own investment. The Tory-led Coalition immediately cut public investment on taking office, and six months afterterwards private investment began to contract once more.

Instead of subsidising the private sector to invest, the proven means of achieving that end is for government to increase its own investment. It could divert the support for borrowing costs to agents who are willing to invest, such as local authorities who want to invest in housing, infrastructure, transport and education.

Even on official forecasts the borrowing subsidy to SMEs will not work. But the recent history of the British economy shows that investment by the public sector will have the effect of restoring growth which in turns leads o a revival of corporate investment. Subsidies and bribes to businesses to invest will not work while there is no growth. Increasing, not cutting, the investment of the public sector will lead to recovery.

Latest UK GDP data even worse than it looks

By Michael Burke

The latest release for British GDP in the 3^rd quarter was unrevised – but the composition of that growth was awful. GDP rose by 0.5% in the quarter and is just 0.5% higher than a year ago. But analysis of the components of growth suggests the outlook is deteriorating.

Household consumption did not grow at all in the quarter and contracted by 1.5% over the course of the year. Investment (gross fixed capital formation) fell by 0.2% in the quarter and by 1.8% from a year ago. In terms of domestic expenditure only government spending rose in the quarter, up 0.9% on the quarter and 2.9% over the year. This is testimony to the multiplication of ‘austerity’ measures: If unemployment and poverty are increasing at a faster rate even than you cut welfare benefits your total welfare bill will rise.

Taken together UK domestic expenditure rose by £3bn in real terms in the quarter. But inventories rose by £2.9bn at the same time and therefore account for almost the entirety of domestic growth in the quarter. Since GDP rose by just £1.8bn in the 3^rd quarter, the rise in inventories indeed exceeds the growth in GDP as well as accounting for almost the entirety of growth in domestic spending.

Inventory Build-Up

Inventories are a cyclical and erratic component of growth. But a persistent rise in inventories over a number of quarters only occurs if businesses are receiving new orders and are restocking as they become increasingly confident about a sustained upturn. This is sometimes called a voluntary rise in inventories. But this is not at all the situation presently. Domestic demand is stagnant and exports have also fallen in the last two quarters. It seems unlikely that order-books are filling up and businesses becoming more confident about future prospects. In fact the respected Market Purchasing Managers’ Index shows that new orders have been slowing dramatically, as shown in the chart below.

Figure 1 – PMI New Orders, National & London

Therefore the current build-up in stocks is likely to be an involuntary. Inventories are most likely rising because sales have not met expectations. If so, businesses will tend to meet new orders by depleting those existing inventories rather than increasing output. At the very least this rise in inventories is unlikely to be repeated over several quarters. The addition to growth in the 3^rd quarter arising from rising inventories is unlikely to be repeated over several quarters.

As we have seen domestic demand would have been close to zero and GDP would have contracted without rising inventories. To avoid that fate in subsequent quarters some other component(s) of growth will have to begin to grow once more. Otherwise the British economy will begin to contract once more.