The UK’s budget deficit is rising not falling

By Michael Burke
The latest public sector borrowing data shows that the UK budget deficit is widening once more. Indeed despite a series of accounting adjustments which obscure the true picture, it is clear that the underlying trend is also towards rising, not falling deficits.

The Office for National Statistics reports that the June public sector borrowing total was £14.4bn, £500 million higher than in the corresponding month in 2011. However monthly data are erratic and subject to significant revision. Taking the data for the first 6 months of this year as a whole is more meaningful and shows that the deficit over that period is £37.3bn.

But this total is flattered by the strange decision relating to the acquisition of the Royal Mail Pension funds ahead of planned privatisation. In effect the government has decided to include the assets of this fund, but not its much greater pension liabilities in its own accounts. This and another smaller transaction lowered government borrowing by £30.3bn. The underlying deficit, excluding these transactions is therefore £67.6bn in the first 6 months of this year.

This compares to a deficit of £60.5bn in the first 6 months of 2011. The deficit is rising, not falling.

Figure 1

Factors Affecting Borrowing

This deterioration in the deficit places British government finances in a growing band of European economies where sharp cuts in government spending are leading to economic contraction, which in turn produces widening deficits.

This should come as no surprise. As the crisis is effectively an investment strike by capital, spending cuts by government will only lead to a further decline in private investment. The reason this logic has taken some time to work through in Britain is due to a number of factors. These are primarily the zig-zag in government policy, which initially saw an very modest increase in government investment under Labour and so produced a reduction in the deficit. This was compounded by the uniquely high level of inflation during the British slump, which eroded the real value of all government spending.

SEB has previously shown that the very moderate increase in government investment from the 2009 Budget under Labour was the catalyst for a modest economic recovery. Because of the increase in government spending (including allowing welfare payments to rise automatically as unemployment and poverty increased) the Treasury forecast that the deficit would rise to £178bn in the following financial year. In the event, the deficit began to decline and was £158bn for the financial year.

In addition, the effects of economic growth are felt on both sides of government accounts. Expenditure is lower than it would have been because more are in work and the benefits’ bill falls. Revenues are higher because incomes, profits and consumption all raise the level of tax revenues.

It is widely known that government policies have led to economic stagnation. Yet it is only now that the deficit has started to rise. The British economy has grown by just 0.5% in the two years since the Coalition came to office. But in nominal terms, before taking account of inflation, the GDP has increased by 6.1%. This surge in inflation during the slump is highly unusual, placing Britain on a par with countries such as Iceland. Britain has an incredible shrinking economy when measured in international currency terms.

Domestically this is reflected in a surge in inflation. While severely denting the purchasing power of all those on fixed or low-growth incomes, the fiscal effect was to increase nominal government revenues by £56bn over the last 2 years. This compares to annualised nominal growth in GDP of £88bn.

The Treasury’s estimate is that every £1 increase in economic activity will lead to a 50p increase in government revenues. In fact the increase over the last two years has been 64p (£56bn of revenues of £88bn increased output). However, government current spending has also risen by £42.3bn over the same period. This is an inevitable consequence of the savings (i.e refusal to invest) by firms.

This points to the essential fallacy of all ‘austerity’ measures, whether from the Coalition’s frontal assault, or the slightly shallower, slower cuts favoured by current Labour policy. Even nominal growth will largely be reflected in increased government revenues. But spending cuts have the effect of weakening economic activity and so drive up government expenditures.

Even in the narrow terms of reducing the deficit, the only effective prescription is growth. The most effective means of promoting growth, as even the cautious 2009 Labour Budget shows, is for the government to increase investment.

What the world economy should learn from China

By John Ross

I have a new article at the Guardian's Comment is Free analysing China's economic success both during the international financial crisis and in general since since 1978. It analyses the theoretical bases of China's economic policies in terms of both Chinese and Keynesian economic theory. The article starts:

'Few things better illustrate the difference between the state of China's economy and that of the rest of the world than the fact that its newly announced GDP growth figures of 7.6% were analysed as a "slowdown". In any other major economy this would have been considered blistering growth threatening overheating. Instead, it is clear China has room for further stimulus measures in the second half of the year.

'Indeed, as the international financial crisis has unfolded, there have been few starker contrasts than those between China, the US and the EU. Europe has combined loose monetary policy with little or no stimulus to the productive economy – the "austerity" approach. The result has been that the EU's economy shrank by 2% over four years – the UK's shrank by 4.4%. The US has combined loose monetary policy with a consumer stimulus delivered via the budget deficit. The result? The US economy has grown by 1.2% in four years. India, which followed the US model of a budget deficit delivering a consumer stimulus, saw its growth decline from 9.4% in the first quarter of 2010 to 5.3% in the first quarter of 2012.

'Meanwhile China, which combined expansionary monetary policy with an investment-led stimulus, has experienced more than 9% annual average growth throughout the four years of the financial crisis.'

The rest of the article can be found here.

Cancel The Greek Debt

By Michael Burke

The Greek general election on June 17 presents a clear political choice on whether to continue with the ‘austerity’ measures imposed by the Troika of the ECB, EU and IMF which have caused a disastrous economic slump. Greek GDP fell by over 13 per cent between 2007 and 2011 and contracted sharply again in the 1^st quarter of 2012. In real terms the compensation of employees has fallen by approximately 15%. The cause of the slump is the investment strike by capital, down nearly 47 per cent since the slump began and accounting for nearly 90% of the entire fall in output.
Yet Greece is just the sharpest expression of the European crisis, which at the very least is likely to see the continent as a whole remain in a depression. This is a Europe-wide crisis and it requires continent-wide solutions.

As the first step, it is necessary to address the claim that the ‘austerity’ measures (which are actually designed to cut wages and non-wage benefits) are necessary to close the deficit in public finances. As EU Commission projections show, the Greek government’s ‘primary balance’ is a deficit of just 1 per cent of GDP (see table below). The primary balance is the balance on government finances once debt interest payments are excluded. The very large total public sector deficit arises because of interest payments amounting to 6.3 per cent of GDP. The EU projection is that the primary deficit will rise to no more than 2 per cent of GDP in 2013.

Table 1

Therefore a key component of the Greek crisis could easily be resolved simply by cancelling the debt. The interest payments would no longer be made. This is necessary as it is widely recognised that the debt is unsustainable and a default is inevitable. The EU estimates that the level of public sector is currently over 160 per of GDP. The formula used for assessing debt sustainability is that the real growth rate must exceed the real interest rate multiplied by the debt as a proportion of GDP. More succinctly, government revenues must be growing at a greater rate than the interest payments on existing debt.

Using that formula, if Greece were growing in real terms at 2.4 per cent per year (the average of the 10-year period 1992-2001) then the real interest rate would need to be 1.5 per cent to be sustainable, given the current level of debt. Instead the Greek economy is contracting, at a rate of over 6 per cent a year, and market interest rates are close to 30 per cent.

Previously, the claim was that ordinary citizens in the rest of Europe would suffer through their pension and other funds if there were a cancellation of the debt, or if any Greek government abrogated the debt. Whatever the previous merits of that argument it has been nullified by the exit of most private sector investors from the Greek government bond market. Any private sector investors who remain cannot be ordinary pension funds, as these are not allowed to invest in such high-risk, lowly-rated bonds.

The public sector, through the ECB and through Greek institutions are now the majority holders of Greek government debt. The ECB, as the central bank which stands behind the Euro, cannot possibly go broke as a result of a Greek default; it has unlimited recourse to Euros. It has in any event made significant profits on its previous purchases of Greek government debt.

The main negative impact would be felt on Greek banks who remain holders of their government debt. But these are rapidly heading towards insolvency in any case as the effects of the economic contraction takes hold. Whatever the outcome of the election Greek banks are facing nationalisation at some point As a result there will be a pressing need to recapitalise the banks under public ownership, which is a process that has already begun in Spain under the auspices of the ECB and EU.

Apart from the impact on hedge funds, vulture funds and other speculative vehicles, no disaster follows a Greek default if there is a recapitalisation.

In Britain, the equivalent of US$7.8bn in total Greek debt is held by these speculators. Less than US$3bn is held by British banks or public bodies (mainly the Bank of England). No negative consequences follow from writing this down to zero.

Cancelling the debt would remove one of the huge burdens on the population of Greece. It would not lead to any disastrous financial consequences for the ordinary citizens of the rest of Europe. For those who oppose ‘austerity’ across Europe, cancelling the Greek debt is the main practical contribution that can currently be made in support of those leading that struggle in Greece.

To get out of its economic crisis Europe needs to learn from China

By John Ross

Four years into the international financial crisis, it is clear that the economic policies followed in Europe to deal with it have failed to do so. For a long time, there was a refusal to examine the real facts of Europe's economic situation and take the appropriate policy measures. Once Europe does start to analyse its economic problems correctly, however, it will see that it has a lot to learn from China. Naturally this does not mean that Europe can mechanically copy China's approach, but there are important trends which Europe can study.

The fundamental trends in Europe's economy are illustrated in Figure 1. This shows the changes in different components of the European Union (EU)'s GDP since the first quarter of 2008 – the peak of the last business cycle and immediately before the onset of the financial crisis. It may be seen that the negative trend in the EU economy is entirely dominated by its fall in investment. The EU's trade balance has improved during the financial crisis, government consumption has risen, and the fall in personal consumption is relatively small. But the fall in fixed investment is huge, amounting to 150 percent of the total decline in GDP. This fall far more than offsets the performance in other economic sectors. The economic situation in Europe is therefore entirely dominated by this investment fall.

Figure 1

After four years of failing to look at the real situation, an identification of this actual core problem in Europe's economy is beginning to emerge. European Parliament President Martin Shulz recently wrote on Europe's crisis: "…what is to be done? First, targeted investment should be given priority." José Manuel Barroso, the European Commission president, and Olli Rehn, the European commissioner charged with dealing with the euro crisis, have now said it is likely that EU leaders will agree next month to increase the capital of the European Investment Bank by €10bn ($13 billion), which could be used as collateral to start large infrastructure "pilot projects" on a pan-European scale.

These policy changes, while a step in the right direction, are too small to turn the situation around. The EU is a US$16 trillion economy. The idea that a $13 billion program, only 0.06 per cent of the EU GDP, can offset the US$343 billion decline in EU investment since the first quarter of 2008 is clearly unrealistic.

The European Commission admits that there is €82 billion (US$106 billion) in unused structural funds in the EU's medium-term budget. This could theoretically be used to tackle the investment decline. But firstly, even the use of this entire sum is less than one third of the decline in investment which has taken place in Europe. Secondly, national governments have not yet agreed that these funds can be used for a European investment program.

Therefore four years after the beginning of the crisis, EU governments are beginning to discuss the right issues, but the practical measures they are proposing are still much too small to deal with the scale of problems that Europe faces.

The difference with China can be seen clearly in Figure 2, which shows the results of the stimulus program launched by China in 2008 to counter the international financial crisis. This stimulus program directly targeted raising investment – in particular infrastructure and now housing. The results are evident. Far from falling sharply, as in Europe and the US, China's investment rose.

Consequently, compared to the situation on the eve of the financial crisis, China's economy expanded by over 40 per cent in four years compared to growth of 1 per cent in the US and a contraction of 2 per cent in Europe. China's stimulus program was $586 billion, or about 13 per cent of China's 2008 GDP – the majority part directly targeted investment.

Figure 2

China's stimulus, in terms of proportion of GDP, is equivalent to a program of US$2 trillion in the EU today. An investment program on that scale would be substantially too large in the EU at present – the situation is not as critical as in 2008. Nevertheless it is only necessary to compare this number to the $13 billion discussed by EU commissioners today, to see how inadequate is the scale of the proposed EU response to the present situation.

Jens Weidman, president of Germany's Bundesbank, has complained about the lack of policy tools available in Europe: "Now that fiscal stimulus has reached the bounds of feasibility in many countries, monetary policy is often seen as the 'last man standing'…However…contrary to widespread belief, monetary policy is not a panacea and central banks' firepower is not unlimited." But Weidman's conclusion exists only because Europe, somewhat arrogantly, refuses to study the country which passed most successfully through the international financial crisis – China.

Two years ago I wrote: "The dispute… between the US and Europe over'economic stimulus' versus 'deficit reduction' convincingly demonstrates the superiority of China's system of macro-economic regulation. China has faced no similar dilemma. It has simultaneously carried out the world's biggest economic stimulus package while running a budget deficit which is entirely sustainable – under 3 percent of GDP. China has therefore not had to face the choice between continuing fiscal economic stimulus measures and placing the priority on budget consolidation."

This remains the key problem. Unless Europe is prepared to grasp the nettle of a large "China style" program, one based on state-led investment, Europe is likely to face, at best, years of economic stagnation.

China's authorities have always rightly clarified that it is not arguing for its economy to be a model for others. It rightly insists every country is specific and therefore no country can or should mechanically copy another. But nevertheless China learned many things from other countries. For its own sake, Europe should start to learn from China

*   *   *

This article originally appeared at Key Trends in Globalisation.

The economic consequences for Germany of the crisis in the Eurozone

By Michael Burke

Germany derives enormous benefits from the existence of the Euro. As Europe’s most productive major economy, it has a ‘home’ market where currency risks have been eliminated, along with the possibility of competitive devaluations. Its trade with the rest of the world also benefits from the existence of the Euro. This is because the Euro is comprised mainly of economies that are less productive than Germany, and so the Euro is weaker on the currency markets than a Deutschemark would be.

Germany is even deriving immediate benefits from the current crisis. The yield on 2-year German debt (‘Schatz’) offered at the latest auction of government bonds was zero. Germany is able to borrow in the international markets for free as capital is switched away from government bonds in the crisis-hit economies. Some in the financial markets believe this also heralds a renewed fall in the Euro versus the US Dollar, which would provide a further boost to German exporters (although also raising the cost of imported goods and raw materials). In the chart below the US Dollar/Euro exchange rate is shown on the orange line, while the 2-year Schatz yield is shown on the yellow line.

Figure 1

But these are crisis effects and are unlikely to be sustained over time. Two other important factors are likely to weight heavily in the deliberations of German policymakers. The first is shown in the chart below, which is the share price of Germany’s leading bank Deutsche Bank.

It is widely asserted that the EU and the Euro Area can contain any ‘contagion’ effects arising from a Greek exit from the Euro. This is mainly, but not exclusively, argued by those currently threatening the voters of Greece against voting for anti-austerity parties. The argument runs that this is a referendum on the Euro (when it is clearly a referendum on ‘austerity’) and that, if the bailout terms are rejected, Europe is strong enough to withstand the impact of a Greek exit. An obvious rejoinder is that the so-called firewall of €750bn to protect the private sector from a Greek exit is not in place and that crisis-hit countries such as Italy, Spain, Ireland and Portugal are supposed to provide one-third of that fund between them. They are clearly in no position to do so.

But Deutsche Bank’s share price provides its own verdict. Half of its value has been lost since April 2010, and one third has been lost in the last 3 months. It seems likely that Deutsche Bank holds significant levels of government bonds in the crisis countries. It also continues to have very significant loans and other exposures to the crisis countries in the areas of consumer credit, mortgages and business loans.

Figure 2

Germany is also not immune from the economic crisis engulfing the rest of Europe. Given that approximately two-thirds of its exports go to Euro Area economies this would be impossible. The latest estimates for output in the whole of Europe are grim, Germany included. This is shown in the chart below, which is the latest Markit/PMI survey for Gemany. The equivalent April survey for the Euro Area as a whole shows a sharp contraction and the lowest level of activity in nearly 3 years. In Germany that reading on this survey has fallen to 49.6, and anything below 50 signals economic contraction. The chart shows the Markit/PMI survey versus GDP (orange line), where the correlation seems to be reasonably strong and points to recession.

Figure 3

Conclusion

The strategic benefit that Germany derives from the existence of the Euro is being augmented currently by plummeting yields on government bonds and the currency’s weakness. But this loosening of monetary policy can only a partial offset the contraction in export markets, which looks as though Germany too may head back into recession. The notion that Germany can be immune from the ‘contagion’ effects of the crisis in Greece and elsewhere is dangerous self-delusion. The performance of its leading banks already demonstrates the negative impact on German capital, while surveys show the negative impact on German output.

Parties across Europe who argue against austerity are right to do so. If the Euro breaks up the factors providing a loosening of German monetary conditions would go into reverse. Germany would be a very big loser in the event of Euro break-up and threats to engineer that collapse are reckless and ill-founded.