Britain's Export Performance Is Woeful

By Michael Burke

A number of commentators have recently called for a currency devaluation as a way to revive the British economy and outgoing bank of England Governor Mervyn King has described a recent very modest rise in the value of Sterling as ‘unwelcome’.

These calls tend to ignore the fact that Britain has already had very substantial devaluation. As the Bank of England chart shown in Fig. 1 below shows the decline in the pound’s exchange rate index (ERI) from 2008 onwards. The ERI fall was nearly 30%, with a slightly larger fall against the US Dollar and a less pronounced fall versus the Euro. The recovery in the currency’s exchange rate has only been a partial one.

Figure 1

There are usually two main effects arsing from a sharp currency devaluation. One is to increase the price of all imported goods which cause inflation. This is what happened and the British economy was the only major economy to experience both a sharp economic downturn and a rapid rise in inflation during the crisis. The other usual effect of currency depreciation is to cheapen the price of exports in foreign currency terms, and so provide a boost to exports and the growth and jobs that depend on them. But following that devaluation exports have barely grown in volume terms.

Figure 2

From their pre-recession peak exports fell by 11.3% to their low-point. They have since recovered but were still 0.8% below that peak in the 2^nd quarter of 2012. Since George Osborne announced the ‘march of the makers’ as the theme of his first budget in 2010 export volumes have actually fallen by 0.4%. This is possibly the only time in British history where there has been a very substantial currency depreciation and no recorded improvement in export performance.

This is a remarkably bad performance given that world trade has expanded since the recession of 2008 to 2009, according to the World Trade Organisation, by 13.8% in 2010 and by 5% in 2011. It is also a remarkably poor performance even compared to sluggish major trading partners. Fig. 3 below shows export volumes compared to both the US and the Euro Area. Euro Area export volumes are now 3.6% above their pre-recession peak while US exports have increased by 8.3%.

Figure 3

Of course, these are not the strongest performers. As a group, Newly Industrialising Countries’ exports have risen by approximately 50% over the same period according to WTO data.

There are numerous reasons for the exceptionally poor export performance of the British exports over the recent period. Patterns of trade are highly dependent on the weak export markets of the industrialised countries, financial services played a disproportionate part in the exports of services during the upturn, exporters responded to the devaluation by raising prices rather than winning market share, and so on. But all of these can be essentially reduced to the current problem of not producing enough goods or services that the rest of the world needs to buy. To correct that requires investment.

Given that the private sector remains on an investment strike, the government could respond as a minimum by investing in high-speed rail links, improved port facilities, super-fast broadband and through investing in education by scrapping fees and bringing back EMA. It could also remove the restrictions on visas including student visas so as to increase trade and educational ‘exports’. A government committed to creating hi-tech jobs would invest directly in carbon-reduction and renewable technologies for which there are very large and growing export markets. But that would all require a very different type of government.

Lessons from Japan

By Michael Burke

Japanese GDP contracted by an annualised 3.5% in the 3^rd quarter of 2012. This annualised rate means that GDP fell by 0.9% in the quarter compared to the 2^nd quarter. The Japanese economy had barely found its footing after the onset of the global economic crisis when it was hit by the devastating earthquake, tsunami and nuclear disaster at Fukishima. Government support for recovery has already ended.

The natural disasters are specific to Japan. But each economy is a unique combination of global economic developments and Japan remains the world’s third largest economy. Therefore developments in Japan have a direct impact in the global economy and illuminate those general trends. For example the halt to Japanese production caused by the disaster led to disruption of output in British and other European factories. There may also be wider lessons to be learnt from the Japanese economy and how economic policy responded to the crisis.

At the turn of this century it was already commonplace to speak of a ‘lost decade’ for Japan as the economy had barely grown since the collapse of the combined property and stock market bubble in 1989. But since the beginning of 2000 to the 3^rd quarter of 2012 the Japanese economy has grown by just 8.5% in over 12 years. This is an annual average real growth rate of 0.7%. It would have been mediocre growth for the Chinese economy in a single year over the same period. It effectively amounts to two lost decades.

A number of authors have drawn important parallels between Japan at the onset of its crisis and the current situation in many western economies, including the US and Britain. In The Holy Grail of Macroeconomics Richard Koo analyses the Japanese crisis as a ‘balance-sheet recession’, where the debt liabilities of firms have become far greater than their assets. This means that profits are used to pay down debt, not to invest.
The firms themselves are kept afloat often by banks simply foregoing loans as they fall due. This leads to the creation of both ‘zombie’ firms and ‘zombie’ banks, without any ability to grow. This in turn places an enormous burden on government finances, as the state supports consumption by increasing borrowing and acquiring debt.

The main drag on growth over the entire period has been the decline in Japanese investment (Gross Fixed Capital Formation), which has fallen from over 30% of GDP before the crisis to under 20% now (which is still more than countries such as Britain). If investment had just kept pace with the virtually stagnant level of GDP rather than declining GDP would now be over 11% higher.

Figure 1

But this decline took some time to gather pace as the chart in Fig.1 above shows. At a comparable period in the current global crisis, 5 years in to the Japanese crisis of the 1990s investment had fallen by 5.5% from its peak level. By contrast US investment is 16.8% below its peak level. Investment in the Euro Area is 12.8% below its peak. In Britain it is 16% below its peak.

SEB has consistently argued that the state should increase its own level of investment as the necessary response to the crisis and use the growing resources of the private sector to fund that investment. Japan is important in this respect. Many commentators, such as Harvard Professor Robert Barro, have argued that Japan’s frequently announced government investment programmes prove the futility of that idea. However, the chart in Figure2 shows that as Japanese investment has been falling, the government share of that falling total has also been in decline.

Figure 2

The solution of state investment to combat balance sheet recession and a private sector investment strike has not been tried and failed in Japan. It has not been tried at all. Falling government investment has led a generalised investment decline. This has led to economic stagnation and now renewed crisis.

Yet even now its proportion of GDP devoted to investment at 20% is considerably higher than in countries such as the US or Britain which are just 15%. It is unlikely that either economy will be able to grow more strongly than Japan over the medium-term, or to be able to withstand external shocks, unless this rate of investment is increased.

If two lost decades and zombie firms sounds outlandish in relation to Britain it is noteworthy that the latest Bank of England Inflation Report predicted a prolonged period of slow growth ahead, when the current slump is already longer than the Great Depression. The Bank has also led a discussion of an estimated 30% of British firms who are ‘zombies’ able to fund interest payments but not to investment, expand or hire. But with banks unwilling to lend the Bank was oddly silent on the growth of zombie banks in Britain. Like Japan, this is a decisive feature of the current crisis in Britain.

The starting-point for the British economy is not as favourable as that of Japan as it has a lower proportion of GDP devoted to investment. Without increasing the rate of investment there will be even more negative consequences for growth.

Ireland's 'austerity' is working - for profits

By Michael Burke

The Central Statistical Office (CSO) has produced its latest institutional sector accounts for the Irish economy in 2011. The title would suggest they are among the driest economic data possible - from a long list. In fact they are among the most important data available because they reveal the sources of income for all the main sectors, or classes, operating in Irish society.

This situation in Ireland is not unique and it actually represents a specific combination of general trends that apply in all the capitalist economies. The CSO has simply set these out with unusual clarity.

The chart below shows the profits of non-financial firms operating in the Irish economy (Figure 1), as well as the profit share, that is profits as a proportion of total Gross Value Added (GVA). GVA is the same as GDP, except the effects of subsidies and taxes on production are excluded.

Figure 1



The profit share has been rising since 2008. This is when ‘austerity’ policies were first adopted in Ireland. This is not coincidental. Clearly the purpose of policy is not to foster economic growth. GDP data in Ireland is highly distorted by the activities of overseas multinational corporations operating in
 Ireland who falsely book activity in order to avail themselves of ultra-low corporate tax rates.

Domestic demand (primarily personal consumption, government spending and investment) has fallen continuously for 4½ years and is now 25.6% below its peak in 2007.

The stated aim of policy is to reduce the government budget deficit. However as the separate National Income and Expenditure Accounts for 2011 show from 2008 to 2011 government current receipts have fallen by €6.3bn while current expenditure has risen by just €0.5bn, a total increase in the deficit of a little over €6.8bn despite all the fierce ‘austerity’ measures (Table 21). The current budget deficit is that part of the public sector accounts which ‘austerity’ is supposed to be addressing, yet the deficit on this measure has risen from 2.2% of GDP over that time to 6.7%. Yet this policy will be maintained even though its stated objective is not being achieved.

In fact the total public sector deficit has only stabilized because the government has cut its own investment over the same period, by nearly 60%. This has exacerbated the total decline in investment (Gross Fixed Capital Formation) which has fallen at the same rate. The decline in GFCF significantly exceeds the fall in GDP. Investment has fallen by €23.6bn in the recession, compared to a fall of €14.6bn in GDP.

This hoarding of capital - a refusal to invest - is the source of the recession. A government committed to boosting the profits of the private sector would reduce benefits and pay in the public sector in order to lower private sector wages. This is what mainstream economists refer to as a ‘demonstration effect’ . At the same time the government would reduce its own investments, say in schools, hospitals, housing or transport in order to facilitate private sector investment at a later date. This is the content of current policy.

Investment has declined throughout the crisis, even after profits have begun to recover. The chart below shows the level of investment of non-financial corporations versus GVA, and the relationship between the two which the CSO calls the investment rate.

Figure 2


But another way of expressing the investment rate is as a proportion of total profits. The chart below shows non-financial firms’ profits versus the level of investment. Profits have risen from their low-point of just over €39bn in 2009 to €46.3bn in 2011, close to the peak in 2007. At the same time the level of investment has fallen by €9.4bn (all expressed in nominal terms, not taking inflation into account).

Figure 3


To put this in perspective firms operating in Ireland formerly invested about one-third of their profits before the crisis. Even this investment rate was very low by international standards. In 2011 the investment rate on this measure was that about one-seventh of all profits were invested. This is also below non-financial firms rate of capital consumption, which was €8bn in 2011. They are producing profits but not forming any new capital.

Yet this cause of the crisis points to its own resolution. A €15bn increase in investment would restore all the output lost in the recession. A larger increase would be required to restore the entire loss of investment. The alternative is to allow firms to continue to hoard capital, with all the consequent damage to the economy, living standards and jobs that entails. At some point in the future they are likely to resume investment even on current trends. But that would required an increase in the profit rate and, with the economy stagnating, that could only arise if living standards and wages are driven even lower.

The importance of the debate on the IMF's 'multipliers'

By Michael Burke

It is unusual for ‘academic’ research published by the IMF to find its way into popular media. But this has happened to the latest World Economic Outlook where the IMF deals briefly with the issue of ‘multipliers’ that is, the economic impact of changes in government spending.

The short article has caused an usually high level of commentary among economists and commentators because the data suggests that the multipliers are perhaps more than double the level generally implied by official research and forecasts. Nobel Laureate Paul Krugman has commented that the research shows that, ‘the reason for the worsening outlook is that policy makers have gotten the basic economics wrong’. In Britain Chris Giles economic editor of the Financial Times has led a counter-attack by questioning the validity of the research. A string of other commentators have joined the debate on both sides, including a Greek finance minister.

The key point in the IMF research is that the multipliers are much higher than previously thought by leading bodies such as the IMF, OECD and others. ‘The main finding, based on data for 28 economies, is that the multipliers used in generating [IMF] growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2….’ Whereas the IMF’s (and others) own forecasts implied a multiplier of 0.5, the actual multipliers may be in the range of 0.9 to 1.7.

It is useful to assess why this seemingly arcane debate has created such controversy and why that is taking place currently.

Importance of the controversy

Because of the division of labour all changes in production have a wider impact on the economy. Increased output of one sector necessarily requires increased inputs either of labour, or of capital, or of production goods or raw materials, or some combination of all factors. This is not necessarily true of changes in incomes (which might be saved) or even expenditure (which might be met from existing stocks).

There can be no single multiplier effect. The size of the impact of changes in government spending must depend on firstly on the type of change in government spending. At the same time, even where an increase or decrease in government spending has a very large impact in terms of altering output in other sectors, the impact is not infinite. The size of the impact is itself constrained by the existing capacity of the economy. Therefore the largest multiplier effect can be found where government spending requires the greatest degree of inputs from other sectors (that is, where the division of labour is at its highest level) and which increases the productive capacity of the economy as a whole.

As a result, the overwhelmingly majority of research finds that the greatest multiplier is attached to direct increases in government investment. These are usually held to be much higher than inducements to private sector investment (which may simply be saved and from which profits must be deducted). They are also higher than the multipliers attached to consumption (which does not increase the productive capacity of the economy).

In Table 1 below the Office for Budget Responsibility’s (OBR) own estimates of the different multipliers are set out. These were first published in June 2010 and have not been altered. They are characteristic of thinking among most policymakers.

Table 1


The OBR has not altered these estimates even though in its latest publication its estimates show GDP will have grown by 3.6 per cent over 3 years compared to their forecast of 7.8 per cent. In addition, the OBR concedes that an assumed average multiplier of 1.3 would fully explain the shortfall in growth compared to its own forecasts. 1.3 is in the middle of the IMF’s 0.9 to 1.7 range.

It is the insistence on unchanged estimates of the multipliers which is most significant, rather than the OBR’s own very poor forecasting record. In particular there is virtually a religious Golden Rule in (semi-) official literature which places the upper limit on all multipliers at 1. A multiplier lower than 1 implies that GDP will be reduced by less than the total change in government spending. Implicitly, the private sector will always respond in the opposite direction, increasing its spending when government reduces its spending, and vice versa.

This is the crux to the whole debate on multipliers. If government spending ‘crowds out’ private spending then it should be avoided as detrimental to total economic activity. At the same time, it is claimed that ‘austerity’ measures will not prove damaging as they will be offset by increased private sector activity. This false logic explains why the OBR forecast a 20.3% rise in business in the last two years while the actual increase has been 2.5%.

It is also extremely rare that the literature acknowledges the multi-year impact of the multipliers. Very little private investment achieves its return within 12 month. The same is true of government investment. The full yield on investment in transport takes place over the life of the railway or bridge, investment in education is returned over the working life of the pupil, and so on.

Essentially, the insistence on 1 as the ceiling for fiscal multipliers and confining them to a single year is to minimise the role of the state in the economy and its capacity to determine the trajectory for the economy as a whole, in both directions.

Timing of the controversy

This is not the first time IMF research has estimated the multipliers at very high levels. Daniel Leigh, one of the co-authors of the latest piece has previously written in a chapter of the IMF World Economic Outlook (‘Will it Hurt?’) that the 5-year multiplier of a cut in government investment when interest rates are close to zero and main trading partners are also cutting is 6.

This finding was almost exactly mirrored in an IMF Working Paper (‘Effects of Fiscal Stimulus in Structural Models’ ) which used its own econometric model and those of six other institutions including the OECD, the US Federal Reserve Bank, the EU Commission, and others. The key finding was that the 5-year impact of an increase in government investment has a multiplier of 5 or more.

Since the latest IMF research is shorter, no more prominent and modestly focuses on 1-year outcomes compared to previously published research, the unusual controversy it has generated must be due to other factors. Almost simultaneously, writing in the Financial Times, ex-US Treasury Secretary and current Harvard Professor Larry Summers highlighted ‘deep differences of opinion.....between the ‘orthodox view’ [which supports austerity]....and the ‘demand support view’ [which pushes for steps o increase demand in the short run]’ (‘The world is stuck in a vicious cycle’).

The deep split within mainstream economics and the controversy over the IMF research are associated with the same trends. Countries which have adopted the ‘orthodox view’ have generally experienced sharp slowdowns and renewed deterioration in government finances. Other countries, such as the US and Germany, which have ‘supported demand’ have experienced mild but slowing recoveries. In the US this has required the maintenance of large budget deficits. While the latter policy has clearly been more effective in restoring growth it is not sustainable over the medium-term. There is little official enthusiasm in either Germany or the US for further measures to support demand. In effect both ‘austerity’ and ‘demand support’ are running out of road.

Across the OECD government spending rose during the crisis in 2009 and 2010. But this was already being reversed by 2011. Belgium, Denmark, Greece and Slovenia were the only counties where total government spending rose as a proportion of GDP in 2011. In every other OECD economy where it was recorded, government spending fell, as was the case in the OECD as a whole. Despite government investment producing the biggest impact on the economy, all the OECD economies cut investment in 2011. The solitary exception was Denmark, where government investment rose fractionally.

The well-known efficacy of increased government investment has not prevented it from being cut in all the major economies. SEB has previously shown that the cut in government investment entirely accounts for the latest recession in Britain. Evidently, even though government investment would restore growth or even improve government finances it cannot be countenanced as it would interfere with the prerogatives of the private sector.

Conclusion

The debate on the size of the multipliers is effectively debate about the role of the state in determining economic activity. The official literature tends to minimise both the scope and the timescale of the impact of changes in government spending. The latest controversy arises because in their different ways both ‘austerity’ and ‘demand-support’ policies are failing.

The alternative is government-led investment. But this has been cut in all the major OECD economies in order to facilitate an increase in the profits of the private sector. The opposite policy is required, one which increases government investment in order to boost growth, jobs and the productive capacity of the economy.

Lloyds Bank Can Fund Investment

By Michael Burke

A number of media reports suggest there is a dispute between the management of Lloyds Bank and its regulators at the Bank of England and the Financial Services Authority (FSA). The dispute centres on Lloyds’ estimated profits, which one set of City analysts forecasts will be £800 million. Management wants to use the profits to pay out dividends to shareholders. The regulators argue that prospective losses at the bank in future years mean that the profits should be retained, and used to bolster the bank’s capital.

Lloyds Bank is 43% owned by the state following the bail-out in 2009. In common with all deposit taking banks operating in Britain, it can only function because of government guarantees. It also benefits from liquidity provision and Quantitative Easing. Without these Lloyds Bank would collapse. The government is also the major shareholder and therefore has the capacity to determine the policies of the bank.

The attempted payout to shareholders is not the first instance in which bailed out Lloyds has used taxpayers’ funds to benefit either capital or the rich. Over the 3 years to 2011 Lloyds has paid out £1.385 billion in bonuses. It made a big fanfare of clawing back just £2 million in bonuses to former executives.

SEB has previously shown that the driving force behind the recession is the refusal of firms to invest. Capital is being hoarded rather than invested. Non-financial corporations alone currently have £391 billion on deposit at banks that report to the Bank of England. Retaining capital for prudential reasons is clearly preferable to wasting it on shareholders who have little inclination to invest and will simply increase those deposits. But Lloyds Bank adding to the cash hoard and then waiting for its existing loan books to deteriorate under the impact of the economic slump is hardly much preferable.

Instead, new investment would provide a return on investment for state-owned Lloyds and so reduce the risk of another bailout. The regulators could insist that profits cannot be used for either bonuses or shareholder dividends. An instruction from the government as the major shareholder to invest the profits in productive investment, say housing, high-speed broadband or rail would have a number of positive effects. It would boost economic growth and provide jobs. The effect of that would be to reduce the government deficit, without a penny of increased government borrowing.