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Don’t believe the myths: Capitalism has performed well since the financial crisis

Don’t believe the myths: Capitalism has performed well since the financial crisis

Ten years ago, the financial crisis began to grip the Western economies. During the course of 2007, GDP growth slowed markedly everywhere. By the end of 2008, output was in free fall.

A key theme in economic commentary is the sluggishness of the subsequent recovery of the developed economies.

The picture is not quite as bad as it is usually painted. True, last week the Office for National Statistics announced a dip in UK growth in the first quarter of this year. But from 2009, the trough of the recession, to 2016, GDP growth averaged 2.0 per cent a year.  Not exactly a stellar performance. But from 1973, the year prior to the major oil price shock, to 2007, the British economy expanded by just 2.3 per cent a year on average. The contrast between the two periods in the US is slightly greater. From 1973 to 2007, growth averaged 3.0 per cent a year, and since 2009 it has been 2.1 per cent.

There is a very stark contrast with the experience of the 1930s, the last time there was a global financial crisis. This time is different, things have only got better. The recovery may be slower than desirable, but it has been much more widespread than in the years following the Great Depression of the 1930s.

A decisive indicator is the length of time it took not just for growth to resume, but for the previous peak level of GDP to be regained.  So in the UK, for example, the economy started to grow again in 2010. But it was not until 2013 that there had been enough growth for the economy to get back to its 2007 size.

Looking at a group of 18 developed economies, which includes all the main and medium sized ones, GDP had regained its previous peak within 3 years in no fewer than 8 of them. By 2016, everyone in the group except Finland, Italy and Spain had a GDP which exceeded its previous peak.

Three years after output began to fall in 1930, not a single economy had managed to regain its 1929 level of output. Even by 1938, output was below its 1929 level in Austria, Canada, France, the Netherlands, Switzerland and Spain.

Perhaps Keynes’ most powerful insight was why the slump was so prolonged. He developed the concept of “animal spirits”, which are not a mathematically based prediction of the future, but the sentiment of the narratives which companies form about the future. He wrote: “the essence of the situation is to be found in the collapse of animal spirits…. this may be so complete that no practicable reduction in the rate of interest will be enough.”

Zero interest rates and low growth! Keynes got there before us.

Still, capitalism has performed much better in the aftermath of the financial crisis of the late 2000s than it did in the crisis of the early 1930s. Animal spirits may not be buoyant, but they are in much better shape than in the 1930s.

As published in City AM Wednesday 2nd May 2017

Image: Day 20 Occupy Wall Street by David Shankbone is licensed under CC by 2.0
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Government debt addiction means you can be sure of one thing: Stealth taxes will rise

Government debt addiction means you can be sure of one thing: Stealth taxes will rise

Elections create uncertainty. But we can be sure of one thing. Regardless of the result, during the course of the next Parliament, stealth taxes will rise. This week, we have a sharp rise in speeding fines. Even doing between 31 and 40mph in a 30mph zone can now land you with a penalty of 50 per cent of your weekly income.

Governments across the West are running out of ways to pay for the spending levels which the electorates appear to demand.

A key way in which public spending has been financed over the past 40 years has been through debt. Almost everywhere, the level of public sector debt relative to GDP has risen sharply.

A few years ago, the International Monetary Fund (IMF) published long runs of historical data on the public debt to GDP ratio for countries across the globe. The Bank of International Settlements (BIS) updates the ratio regularly.

In 1977, gross public debt in the United States was 39 per cent of GDP. In 2016, it was 98 per cent. Over the same period, the UK, using the IMF and BIS definitions, the rise was from 49 to 115 per cent of GDP. In France, the ratio went up from 15 to 115 per cent. Even in debt-wary Germany, there was an increase from 27 per cent in 1977, to 78 per cent in 2016.

There are different ways of defining public debt, and no two measures are the same. But regardless of how we put the figures together, the conclusion is clear.

Public sector debt has risen massively. The simple fact is that most governments in most years now routinely spend more than they dare raise in taxes. The resulting deficit has to be financed by issuing debt. But the limits are now being reached, a lesson the Greeks have learned so harshly in recent years.

Over the course of history, public sector debt, relative to the size of the economy, has been at much higher levels than it is now, with no apparent serious consequences. In 1946, for example, UK public debt was 270 per cent of GDP.

But in the past, governments with high debt levels typically did one of two things. They either defaulted, or they tried to pay it off. The left wing Labour government of Clement Attlee ran huge budget surpluses in the late 1940s, peaking at around £100bn a year in today’s terms.

Most debt used to be incurred as a result of war. In 1861, US public debt was less than 2 per cent of GDP. The Civil War bumped this up to 30 per cent. In the late 1810s, as a result of the Napoleonic Wars, the first truly global conflict, British debt was 260 per cent of GDP. It took decades to get it down to sustainable levels, but governments did succeed and pay it off.

In stark contrast, debt has been built up in the late twentieth and early twenty-first century to finance the services provided to voters. It is simply unsustainable.

As published in City AM Wednesday 26th April 2017

Image: Speed Trap by Peter Holmes is licensed under CC by 2.0
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Britain’s debt dilemma: Not too high, not too low or the UK economy risks disaster

Britain’s debt dilemma: Not too high, not too low or the UK economy risks disaster

The Bank of England Financial Policy Committee (FPC) has signalled that it has become worried again about debt. Its specific focus is households. Consumer credit, for example, grew by 10 per cent during 2016, far faster than the economy as a whole. A lot of household debt is in the form of a mortgage, so there is at least an asset which might support the loan. The particular concern of the FPC is unsecured loans, such as credit card balances, personal loans and the like. If someone becomes unemployed, he or she will no longer have the income to repay the money. And if a shock were to hit the economy as a whole, defaults on loans would rise sharply.The intense competition in personal finance markets is making credit much easier to obtain. The Halifax, for example, is offering up to 41 months interest free if you switch your credit card balance to them. In the laconic words of the FPC minutes, the recent rapid growth in consumer credit “could principally represent a risk to lenders if accompanied by weaker underwriting standards”. In other words, the risk to lenders could become too high.

How justified are these fears? The Bank for International Settlements publishes data on the stocks of debt held by consumers, companies and governments as a percentage of the economy. There is a bit of delay before its data comes out, so we only have it to the end of September 2016.

In the first quarter of 2007, just prior to the financial crisis bursting onto the scene, the debt of UK households was 90.7 per cent of GDP. In the third quarter of 2016 it was 87.6 per cent, and the FPC indicates that it has risen since then. So in terms of household debt, we are back to pre-crisis levels.

The German economy is in a much more comfortable position in this respect. In early 2007, household debt was 63.7 per cent of GDP, much lower than in the UK, and it has since fallen to 53 per cent. Germany’s problem is the loans its banks issued to both the personal and public sectors in economies like Greece and Spain.

The FPC is in something of a dilemma. In the late twentieth and early twenty-first centuries, consumer credit boomed. In 1977, household debt was only 29.6 per cent of GDP, compared to the 90-plus in the late 2000s. Even in Germany, the percentage rose from 40 to 64 over this period. A substantial amount of the increase in spending over the past 40 years was financed not by income but by debt.

Loans are denominated in money terms, so high inflation erodes their value. But in our current low inflation economy, these debts are for real. They are a genuine burden. Yet if consumers suddenly started to pay them off big time, spending would collapse and we would be in a major recession.

Getting consumers to manage their debt is the baby bear’s porridge problem facing the FPC. Not too little, not too much, but just right.

As published in City AM Wednesday 12th April 2017

Image: Rainbow of Credit by Frankieleon is licensed under CC by 2.0
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Brexit was the final straw: it’s time to scrap the IMF

Brexit was the final straw: it’s time to scrap the IMF

Sports fans will all be familiar with the commentator who almost always gets things wrong. “Arsenal are very much on top here” he – it is invariably a “he” – will pronounce, or “Root is looking very settled”, only for the opposition to score a goal immediately and for the Yorkshireman to be clean bowled. In economics, a similar role is played by the International Monetary Fund (IMF).

In the middle of July, Remain fanatics had a field day. “The IMF has slashed its forecasts for the UK economy for next year after Brexit”, crowed the Financial Times. Maurice Obstfeld, the Fund’s chief economist, claimed that Brexit “has thrown a spanner in the works”. Global growth projections for 2017 were cut back, but most of all for the UK.

But on the first day of September, the IMF was forced to admit that growth in Britain had, in a splendidly bureaucratic phrase, “surprised on the upside”. On the same day came the news that manufacturing activity in August had posted its biggest monthly rise in 25 years. On Monday this week, the Markit purchasing managers’ index for the service sector registered the biggest monthly increase in its 20 year history.

The IMF has real form. In 1998, East Asia was experiencing a major economic crisis. Yet in May 1997, the IMF was predicting a continuation of very strong growth in most countries for the year ahead: 7 per cent for Thailand, 8 per cent for Indonesia and 8 per cent for Malaysia. They revised the projections down by December, but even these proved wildly optimistic, as the economies collapsed during 1998, registering a fall in output of over 15 per cent in Indonesia, for example, worse than America in the Great Depression of the 1930s.

Macroeconomics is the study of variables such as GDP which describe the economy at the aggregate level. Since the 1980s, it has been dominated by the concept of equilibrium. Highly mathematical models have been developed, resting on the premise that the economy can correct itself and absorb any shocks. Olivier Blanchard, the IMF’s previous chief economist, was a great enthusiast for this project. In August 2008, he published a paper which concluded with the claim “the state of macroeconomics is good”. Three weeks later, Lehman Brothers collapsed.

Apart from the European Commission itself, the IMF has been probably the biggest cheerleader for the euro. Since the inception of the single currency in 1999, a whole series of statements and technical articles from the IMF has eulogised its mystical benefits. At the end of July this year, the IMF’s own Independent Evaluation Office (IEO) was totally scathing of the Fund’s record on this. The top staff became impervious to other points of view and ignored warning signs of the financial crisis. In their view of the world, it simply could not happen.

The IMF exercises enormous influence and power. Yet its persistent ineptness makes England football managers look like world beaters. To add insult to injury, its staff enjoy tax free salaries. It’s time to close the Fund down and go back to the drawing board.

As published in CITY AM on Wednesday 7th September 2016

Image: Valsts kanceleja/ State Chancellery is licensed under CC BY 2.0

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The coming explosion in natural debt is a serious risk to the economy

The coming explosion in natural debt is a serious risk to the economy

Martin Feldstein of Harvard is an economist who should always be taken seriously. Writing in 1997 about the forthcoming introduction of the euro, for example, he argued that “the adverse economic effects of a single currency on unemployment would outweigh any potential gains from trade flows”. He went on to predict that the euro was likely to lead to increased conflicts within Europe. Looking at the current state of the continent, his forecasts appear spot on.

In the latest issue of the American Economic Review, he reminds us of the crucial importance of reducing government deficits. The Brexit referendum has essentially frozen David Cameron’s government from taking almost any action at all. But despite a convincing General Election victory, the drive to cut the deficit was already slowing down. In particular, the government appears to have lost its nerve in terms of cutting public expenditure. At the slightest sign of protest or opposition, it backs down.

Feldstein’s paper on the American experience should spur Cameron to think again. Feldstein begins with an optimistic view of the US economy. Since the 1970s, the unemployment rate has only briefly dipped below 5 per cent, its current level, so America effectively is back at full employment. Inflation remains low, despite employment rising by 14m since 2010. Economic growth is limited by the absence of excess capacity rather than by demand.

In the longer term, the most serious risk to the American economy, Feldstein believes, is the explosive growth of national debt as a percentage of GDP which will happen unless there are serious measures taken to cut spending. The public sector deficit is the difference between income from taxation and public spending in any given year, and a deficit adds to the stock of debt which is outstanding.

Feldstein points out that the debt to GDP ratio has risen from less than 40 per cent 10 years ago to 75 per cent now. The comparable numbers in the UK are from 35 to 85 per cent. He suggests that a very effective way of controlling future increases is to raise the retirement age even more. He has a neat suggestion to counter legitimate worries that life expectancy has gone up more for the better off than it has for the poor. Just link the retirement age to lifetime earnings. The lower they are, the earlier you can give up work.

The shape of the recovery in the United States suggests that there is little to fear from following Feldstein’s arguments and really getting to grips with public expenditure. The trough of the recession was in 2009. By 2015, GDP in real terms had increased by 13.3 per cent. Despite scare stories that growth has been driven by unsustainable consumer spending, this rose at a virtually identical rate, by 13.9 per cent. Corporate investment, in contrast, has shot up by 51 per cent. And current public spending has fallen by 7.5 per cent.

Despite siren voices such as those of junior doctors, the UK government should keep its nerve too. The American experience shows that cutting public spending can expand the economy.

As published in City AM on Wednesday 1st June 2016

Image: National Debt Clock by Nick Webb licensed under CC BY 2.0

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The IMF is in trouble – and not just due to its poor forecasts

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by is licensed under CC BY 2.0

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