Explaining Labour's 'U-turn'...

Danny Finkelstein points out in today's Times that Ed Miliband's new economic policy is to continue to oppose the cuts as 'too far and too fast', but to accept that Labour will not reverse them. To which many will ask what is the point of opposing the management of the deficit if it cannot offer the alternative? Especially since it has argued and voted against each and every measure to manage the deficit created by Labour?

Does Labour accept that it spent too much before the financial crash of 2007? No. Does Labour accept that it spent too much after the crash? No. Does Labour accept that the Coalition's plans to reduce borrowing over the lifetime of this parliament were correct? No. So what exactly is it saying? Two things. Firstly, the Labour party want to increase borrowing in order to cut borrowing. Secondly, they are against the Coalition cuts, but at the same time accept them. Clear? Not really.

So let me explain it to you in a different way.

The Conservative party knows that the Euro is a disaster. They have known this since the Euro's earliest conception, and clearly and repeatedly argued why the Euro was ill-conceived and how it's destruction would come about. The European political class of course, was not listening. They are still not listening. But rather than continue to oppose it with every breathe, Cameron and Osborne have chosen to move on. For the last twenty months they have supported Eurozone members - despite the carping from Sarkozy - by urging them to integrate further and more quickly into one federal country, knowing that only in those circumstances will the Euro as a currency become viable.

The Conservatives fully realise the implications of such a move by the seventeen Eurozone nations, effectively becoming one country. They also know that Britain would never give up its sovereignty in such circumstances. Yet they suggest that the Eurozone do something that they themselves find totally abhorent.

You may call this dishonest, disengenuous or even unprincipled. It is all of these things. And it is exactly what Labour is now attempting in its economic policy.

Jeremy Warner on the economic crisis...

To act as Labour urges and abandon the cornerstone of the Coalition’s economic strategy, namely getting the public finances back under control, would be to risk another catastrophe in the banking system – and, by raising interest rates, a similarly destructive meltdown in household and corporate finances. That is no kind of alternative strategy. Writes Jeremy Warner.

With the benefit of hindsight, it is abundantly clear how the mess we are in came about. For many years now, a number of advanced economies – including Britain’s – have been living in a kind of fool’s paradise. The balance of economic and productive advantage moved decisively from West to East, yet apparently limitless credit allowed living standards to continue rising, even as competitiveness was being eroded. There’s now been a rude awakening – and the adjustment, which is responsible for most of the stresses in the world economy today, is proving long and painful. Debtors are still not properly reconciled to having to live within their means, while creditors won’t accept the inevitability of writedowns. The result is a stand-off that is causing economic activity to seize up.

Repeated bail-outs are as repugnant to the eurozone’s surplus nations – such as Slovakia or Germany – as externally imposed austerity is to its debtors. The Slovak government has already fallen; on the other side of the fence, endless rounds of austerity look as if they might bring the Italian government down as well. In attempting to make the euro work, politicians are riding roughshod over their own electorates. It is as unsustainable as it is insulting to the principle of democracy.

With public sector demand shrinking almost everywhere, governments need the private sector to step up to the plate and provide the jobs and growth they can no longer deliver. For that to happen, a strong financial sector is required, one ready and willing to meet the economy’s credit needs. Yet instead, the reverse is happening. Ever more stringent capital and liquidity requirements, designed to make banks safer, are causing further balance sheet contraction and adding to the atmosphere of extreme risk aversion. As long as banks and businesses remain stuck in this mindset, there will be no sustainable return to growth.

Sustainable growth...

We need growth.

If we are to move decisively out of stagnation, create jobs and pay down the deficit - then we need growth. And not just any growth, 0.2% over the second quarter is just not good enough. Anything less than 0.8% to make up for previously disappointing figures is too small to be of any use whatsoever according to the shadow chancellor. Or is it?

It is now widely accepted that although spending cuts have yet to bite, it is the fear of future cuts that is affecting consumer spending - or the lack of it - directly suppressing demand and leading to low, anaemic growth.

Or is it? You see, those earnings must be going somewhere. I grant you that inflation is currently running at over 4% - which will eat into weekly shopping budgets - and unemployment has risen - even if only marginally, which will devastate a small minority of consumers, but where's the rest going? If the vast majority of employed consumers are not spending, where is that money going?

The answer of course is savings. People are making sure that they live within their means. They are paying down their debts, re-paying mortgages, credit cards and loans. The banking figures - a net re-payment of over £2.5 billion over the last quarter - bear this out.

Now I understand that growth is essential to an expanding and thriving economy trying to attract investment. What I am suggesting here is that as well as re-balancing the economy both structurally - through greater reliance on manufacturing rather than financial services - and geographically - to address the north/south divide - we should also be seeing these figures in human terms. These are not just cold figures. These are people voting with their wallets, telling us that they want and are pursuing, sustainable long-term growth. That is, a lower level of overall consumer spending in order to ensure it is both sustainable for the long term, as well as being backed up with a level of individual wealth (or savings) that is both substantial and therefore induces confidence in the future.

Once consumers have built up that blanket of savings security, we will again see a further rise in consumer spending. But I think it is not unreasonable to expect - and indeed the government should be encouraging through active promotion - long term sustainable growth that consumers - always ahead of governments - appear to want.

The wisdom of Brittan

"There is indeed not all that much urgency to cut the deficit, when economic recovery is far from assured and output is well below optimal capacity rates. But government expenditure is probably too bloated and needs to be curbed on its own merits or rather demerits. The logic of this position is that expenditure curbs should be offset by tax cuts."

Samuel Brittan writing in todays FT.

Economic stimulus

Smart blog from Ben Brogan who quotes Matthew Hancock MP (formerly George Osborne’s chief of staff) in showing how 2 & 3 year interest rates have halved since the coalition took over in the spring. Even 

10 year rates are down from 3.96 to 2.91%  As Hancock says:

when a country has a debt problem, getting to grips with the finances will keep interest area lower for longer. This is just what’s happened since Britain elected a government prepared to clear up the mess created by its predecessor. Interest rates on borrowing for 2 years or 3 years – the sort of rates fixed mortgages are based on – have halved. That’s a huge economic boost to families and businesses up and down the country.

Low interest rates of course are the greatest economic stimulus that businesses and consumers need.  

Fiscal Stimulus

Interesting post on Greg Mankiw's blog showing the outcome of Obama's fiscal stimulus showing what was projected for the rate of unemployment back in January with and without the stimulus package. The graph comes from the presidents own economic team in a report from January 2009. The reality - shown by two red triangles for March & April 09 - should make Brown & Mandelson think very carefully before pronouncing that their stimulus package in the UK had 'saved' more than half a million jobs.

Good Banks Needed

With the luxury of hindsight it’s easy to see the first signs of what should have been done to tackle the present financial crisis. Savers - the innocent party in all this mess - should have been protected. And the core issue - toxic debt - squarely addressed. Until that is solved, credit markets will remain blocked, lending to consumers and businesses will remain inadequate and the real economy slide towards depression. Almost everything the government has done so far has treated the symptoms of this problem. Not the root cause. In a well argued piece in today’s Times Anatole Kaletsky urges exactly this point, but falls short of the right solution.

When gridlock in the wholesale credit markets first emerged back in summer 2007 - more than 18 months ago - re-capitalising the banks should have been the governments only priority. This is a debt crisis. No amount of liquidity will alter untradeable and seemingly unquantifiable toxic debt on their balance sheets. By abolishing taxes on savings, a natural cascade of private money would have allowed balance sheets to be at least partially re-built and savers rewarded for their prudence and self-sacrifice.

A lot of comment has also centred on ‘protecting’ taxpayers from banking excesses by re-introducing Glass-Steagall type legislation separating ‘safe’ retail banking functions from inherently risky investment banking activities at the heart of our present problems. The return of Captain Mainwaring is widely called-for. But as anyone can see, smart and effective regulation will keep stuffy and arrogant amateurs like Captain Mainwaring safely on our TV screens, not in our banks.

In truth the vast majority of investment banking functions – fund management activities, equity, bond & foreign exchange trading and traditional corporate finance functions like mergers & acquisitions – are perfectly legitimate banking activities that any properly integrated financial institution should be able to offer corporate clients. They may be inherently more risky than asset-backed lending, but even with existing regulation, could never produce the toxic mess which has blocked credit lines and now holds the entire economy to ransom.

This is the result of a small band of largely unregulated financial wizz-kids more interested in securing short-term multi-million pound arrangement fees (which provided their bonuses) by layering ‘clever’ and now largely unquantifiable financial instruments – preferably with three letter acronyms that only they could ‘understand’ - on top of securitised debt. These should be regulated out of existence.

But we are where we are. And with the benefit of hindsight, protecting taxpayers from the stupidity of bankers is exactly what we need. Just not through ineffective 1930’s style legislation.

Our starting point is debt. And no amount of additional debt, whether through wildly expansionist monetary policy – which initiated and continues to underpin our current problems – or through a massive fiscal stimulus, will in any way address the core issue. This government has yet to recognise the real problem and until it does, it is incapable of providing a solution. The government is – and always has been - part of the problem. Running around like headless chickens announcing daily policy initiatives which saddle the country with even more debt may make Gordon Brown feel happy, but it does not address the real problem. Until that happens we continue on the road to a deep and lasting depression. What is needed here is leadership and vision. As Jeremy Clarkson pointed out last week, Gordon Brown is incapable of either.

If large toxic debt is the problem, what then is the solution? Firstly, look at the size of those toxic debts. Several trillion dollars which would overwhelm the financial capabilities of taxpayers for several generations. Buying up toxic debt is not an option we should be considering. It simply rewards banks for failure and socialises debt to the taxpayer. Too much moral hazard there.

In an excellent explanation by Willem Buiter - further expanded on 8th February - a practical and equitable solution to the banking crisis is offered in the form of a split between ‘good’ and ‘bad’ banks. It is supported, with small variations, by George Soros and Joseph Stiglitz among others and has already been successfully used by the IMF in the Uruguayan banking crisis of 2002. As Monica B. de Bolle, a commentator on this article wrote:

“I thought you might be interested to know that something akin to your model was applied in Uruguay to resolve the banking crisis of 2002. As a result of both contagion from Argentina and some degree of mismanagement at the affected institutions, the Uruguayan banking system came under severe stress in late 2001/2002, leading to the failure of the country’s four largest banks. To resolve the crisis, the authorities embarked on a massive bank restructuring operation (with support from the IMF, where I was working at the time on the Uruguayan team), which involved creating a new (temporarily state-owned) bank out of the "good" assets and liabilities (deposits) of the failed institutions. The old "bad banks" kept the non-performing assets and were effectively transformed into asset management companies, responsible only for managing the assets and attempting to recover whatever was deemed "recoverable". The operation was hugely successful in restoring stability to the Uruguayan financial system.”

I will leave the above links to explain the full intricacies of such a scheme. No doubt further details would need to be sorted out to scale-up and apply this model to western banking systems, but by using taxpayer’s money to support new lending – not throwing it down the drain on unquantifiable toxic debt – we address the real issues. We stabilise the banking system. We achieve our “…medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective” as Buiter puts it, and finally we achieve an equitable solution that is fair to the taxpayer: “the polluter pays or, you break it, you own it.” Furthermore, it commits the taxpayer to a fraction of the costs being currently demanded by those profligate bankers and their political masters currently in government. Additionally, it allows the prospect of a future return on taxpayer’s money, whilst putting its supporters on the right side of the argument - supporting new lending and borrowing, not the interests of the bankers.

The two failed banks – RBS and Lloyds – now substantially owned by the taxpayer - should immediately be fully nationalised. Each should be split into ‘good’ banks (NatWest and Lloyds?) whilst the toxic mess at their heart is ring-fenced into ‘bad’ banks (RBS and HBOS?) which the current crop of directors can manage as best they can. No doubt they’ll find some way of paying themselves bonuses.

The taxpayer-owned and capitalised ‘good’ banks by contrast, with clear unblemished balance sheets, can begin to lend confidently to a credit-starved economy. They already have an extensive geographical branch network. They are already involved in the full range of banking functions. And with carefully designed regulation, they can begin to provide the banking services whose absence in the last eighteen months has turned Gordon’s recession into Brown’s depression. Tackling that will have to wait for another article…