A look at the possible problems with a fiscal squeeze

 

The fatal error of austerity

The only black hole we need to worry about is recession

AMBROSE EVANS-PRITCHARD15 November 2022 • 3:25pm

Sunak and Hunt risk committing the greater and longer lasting error of Austerity 2.0 CREDIT: Jessica Taylor/UK Parliament

Here we go again. The Office for Budget Responsibility (OBR) has discerned an enormous deterioration in public finances, allegedly reaching £70bn a year by the middle of the decade.

Upon this macroeconomic conjecture, it is bouncing the British Government into pro-cyclical fiscal tightening just as the country enters what is forecast to be the most protracted slump since the Great Depression, with an output gap (slack) reaching 3pc of GDP by 2024 under the Bank of England’s forecast. The Sunak-Hunt duumvirate appears willing to be bounced.

They deserve our national gratitude for eliminating the sovereign risk premium on the Truss mini-budget – a fleeting episode, ultimately of no importance – but they now risk committing the greater and longer lasting error of Austerity 2.0. That way lies certain failure.

Perhaps Chancellor Jeremy Hunt is talking up his “eye-watering” cuts as political theatre, only to surprise us on Thursday with milder shock therapy than feared. He clearly intends to push most of the pain into the mid-2020s - backloading in the jargon – which gives him a way out later.

Rishi Sunak backed a rise in public investment to 3pc of GDP when he was Chancellor, the highest since the 1950s and a level closer to the OECD norm, though still far short of the productivity stars (Korea, Nordics, et al) at 4pc or more. But the signs so far are that this target has been abandoned. 

The Government plans to hack away at infrastructure spending because it is easy to cut, repeating the core economic mistake of Osbornian obscurantism.   

Let us clear up one misunderstanding before it becomes lodged in the public discourse: the UK does not face a sovereign debt crisis, any more than it faced the “Greek” fate alleged by Mr Osborne in 2010. Credit default swaps measuring bankruptcy risk are currently lower for the UK than for the US or France.

The rankings this week are: Sweden (20), Germany (22), UK (26), Belgium (27), France (29), US (30), Japan (31), Canada (56), Spain (56), China (79), Italy (137), Brazil (273), Pakistan (502), Turkey (566), and so forth.

The International Monetary Fund (IMF) says the UK already had one of the most restrictive budgetary policies in the developed world before Jeremy Hunt entered 11 Downing Street, as measured by the cyclically-adjusted primary deficit.

The Fund’s Fiscal Monitor estimated that the UK’s public debt ratio will fall to 68pc of GDP by 2027, while it rises to 118pc for France, and 135pc for the US. The IMF may be wrong but this is not the portrait of a country facing a solvency crisis.

“The reality is that the UK’s public debt position is in the middle of the international pack and there are almost no discussions in other countries with similar debt levels of the need for a new round of austerity,” said Prof Karl Whelan from Trinity College Dublin.

Markets rejected Trussomics because the package was incoherent, not because the deficit was out of line with global peers. The original message of supply-side measures was contaminated by uncovered tax cuts. Global Big Money will finance borrowing that raises productivity. It will not so lightly finance further consumption in a country importing beyond its means with a structural current account deficit near 4pc of GDP. 

Liz Truss walked into a minefield. She tried to push through her mini-Budget during the greatest global bond shock for a century, in turn exposing hidden leverage in the UK pensions industry. But that bond shock is already subsiding. 

Yields on 10-year US Treasuries are declining as inflation rolls over, restrained by falling commodity and semiconductor prices, and a 70pc fall in oceanic shipping costs, soon to be followed by a wave of goods deflation from China.

This in turn is bringing down the cost of borrowing for the international financial system. Hedge funds are already betting on the Great Disinflation of 2023 and a global bond rally to match. Anybody still fretting about gilt yields has missed the story.

“The problem for the UK’s public finances has been grossly exaggerated,” said Prof Peter Spencer from York University and the Item Club. The one-off inflation spike of the pandemic – or more accurately from money created by the Bank of England during Covid – has whittled down the real burden of the debt. That adjustment in the price level automatically boosts tax revenues via bracket creep. 

“There are all sorts of magical effects. Inflation has lowered the debt ratio through the denominator effect, and tax revenues are highly-geared to the rise in money GDP. People have got the wrong end of the stick,” he said.

Prof Spencer said the UK's enveloping recession cries out for rapid activation of ‘shovel-ready’ infrastructure, and the National Infrastructure Commission can oblige with a long list of urgent projects. 

The timing is propitious. S&P Global’s new order index for construction is already signalling a building slump, implying rising slack in the industry. The overwhelming global evidence is that infrastructure projects in today’s circumstances have a fiscal multiplier well above 1.0, meaning that they pay for themselves handsomely through extra economic growth.   

A recent meta-study by the World Bank concluded that the average multiplier on public investment is around 1.5 over time, and more potent during downturns.

“The worst possible thing we could do right now is to cut investment, but I am afraid that is what is going to happen,” said Prof Spencer.

In my view, the OBR bears much of the blame for deterring investment. It has not updated its model to keep up with the IMF, the World Bank, and global best practice, and still relies on a multiplier of 1.0 or less for infrastructure projects. It has persisted despite informed criticism, and swatted aside calls from the Trades Union Congress for a review.

It is beyond depressing that the dismal Treasury View is once again in the ascendant, and worse yet George Osborne’s austerity overkill is being dusted off as a successful template. Is there no recognition in Treasury circles that this episode is viewed by the global economic fraternity as an awful misadventure, a policy error on a par with the self-defeating fiscal retrenchment of the 1920s, but without the excuse of pre-Keynesian ignorance or the Gold Standard. 

George Osborne’s austerity overkill is being dusted off as a successful template CREDIT: Stefan Rousseau/PA

It both lowered the growth trajectory of the economy and slowed the organic fall in the debt ratio, and was therefore futile in every respect. The US made the same mistake (up to a point), and the eurozone inflicted a full-blown depression on its southern half. It was this collective error that explains the lost decade that followed in the liberal democracies, and led to corrosive over-reliance on quantitative easing. But the US and Europe are not repeating that mistake today. Only the UK is ramming through such rapid consolidation.

“It is as if we’ve learned nothing: they’re back to the same austerity, using the same models, and the same multipliers, talking about the same imaginary black holes and imaginary bond vigilantes, and the fanciful need to keep the markets happy,” said Dario Perkins, a former Treasury official now at TS Lombard.

“It is all absolute nonsense. We have tried a decade of austerity and if they seriously do it again, they will be unelectable for a generation,” he said.

Chancellor Jeremy Hunt has even gone so far as to recruit the architect of that fiscal squeeze, Rupert Harrison, to help formulate Austerity 2.0.

There is a revealing conversation with Mr Harrison in Aeron Davis’s new book on the Treasury - Bankruptcy, Bubbles, and Bailouts - that captures what happened. “When I asked him directly about the broader inspirations of his economic thinking, Harrison responded that he had no interest in macroeconomic thought. His policy views were ‘shaped by more general reading’ and by being ‘a centre-right leaning person’.”

Indeed, the fiscal squeeze from 2010 to 2015 never had anything to do with economic science. It was an ideological use of the global financial crisis to shrink the state, creating the OBR along the way as a screen of policy legitimacy, and all dressed up with the discredited theory of “expansionary fiscal contractions”.

We will find out soon how OBR came up with a £70bn fiscal shortfall, but a large part of it must come from assumptions of a permanently higher “terminal” interest rate for the Bank of England for this cycle, currently priced by the futures markets at 4.5pc. Each one percentage point rise in rates costs the Treasury £21bn or 0.8pc of GDP under this mechanical accounting.

If so, this is a very bad reason to push through fiscal cuts in a recession. The markets have massively mispriced the Bank of England’s rate trajectory, as deputy-governor Ben Broadbent made crystal clear in a recent speech. 

Rate-setter Silvana Tenreyro has since gone further, arguing that the Bank has “already done enough” after raising rates to 3pc in the fastest tightening cycle since monetary independence. “Calibrating the required level of interest rates needs to take account of the rapid pace of tightening to date and the lag before its full impact on the economy,” she said. At least somebody is talking sense.

The OBR and the Treasury seem to think that we are in a new era of capital scarcity akin to the Great Inflation of the 1970s where debt costs bite in earnest. If so, that is a massive historical misjudgment. 

The broad money supply in the G7 global economies was growing at a galloping pace all through the 1970s. This time the pandemic money surge is evaporating. The aggregate M3 figures have slowed to crawl. They have been falling in absolute terms in the US since September.

This pandemic episode is more like the inflation spike at the end of the First World War when supply-chains were in chaos and peace led to soaring pent-up demand. By mid-1920 the storm had largely blown itself out. By 1921 the UK and the US were in deflation. 

The only black hole we need to worry about is recession eating into the productive economy and eroding the tax base. The OBR’s interest rate scare on the national debt is leading to dysfunctional economic government. This is not how policy should be formulated in a mature democracy.

Against the Phillips Curve

The Phillips Curve is the very basis of monetary policy. Is it actually valid? Many economists would argue not - you have to see both sides:

The Phillips Curve Myth

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10/09/2018Frank Shostak

It is a well-known belief that by means of monetary policy, the central bank can influence the rate of real economic expansion. It is also held that this influence however, carries a price, which manifests itself in terms of inflation.

For instance, if the goal is to reach a faster economic growth rate and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher rate of inflation.

It is held that there is a trade-off between inflation and unemployment, which is depicted by the Phillips curve. (William Phillips described a historical relationship between the rates of unemployment and the corresponding rates of rises in wages in the United Kingdom,1861-1957, published in the quarterly journal of Economica,1958).

The inverse correlation between the rate of inflation and the unemployment rate has become an important element in the theory of price inflation. The lower the unemployment rate the higher the inflation rate. Conversely, the higher the unemployment rate the lower the inflation rate is going to be.

The events of the 1970’s came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless. During the 1974-75 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labelled as stagflation.

In March 1975, US industrial production fell by nearly 13% while the yearly growth rate of the consumer price index (CPI) jumped to around 12%.

Likewise, a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly growth rate of industrial production stood close to nil while the growth rate of the CPI stood at over 13%.

Again the stagflation of 1970’s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the inflation rate and not an increase.

Some economists such as Milton Friedman and Edmund Phelps were questioning the popular view arguing that there cannot be trade-off between economic growth and inflation in the long-term. They were suggesting that this could only occur in the short term. Based on this way of thinking they have formulated the stagflation theory.

The Friedman-Phelps (FP) Explanation of Stagflation

Starting from a situation of equality between the current and the expected inflation rate the central bank decides to lift the rate of economic growth by lifting the growth rate of money supply.

As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. Because of this increase, every individual is of the view that he has become wealthier.

This raises the demand for goods and services, which in turn sets in motion an increase in the production of goods and services. All this in turn lifts producers demand for workers and consequently the unemployment rate falls to below the equilibrium rate, which both Friedman and Phelps labeled as the natural rate.1

According to FP, the increase in people’s overall demand for goods and services and the ensuing increase in the production of goods and services is of a temporary nature. Once the unemployment rate falls below the equilibrium rate this starts to put upward pressure on the rate of price inflation.2

Because of this, individuals begin to realize that there was a general loosening in the monetary policy. In respond to this realization, they start forming higher inflation expectations.

Individuals are now realizing that their previous increase in the purchasing power is starting to dwindle. Consequently, all this works to weaken the overall demand for goods and services.

A weakening in the overall demand in turn slows down the production of goods and services while the unemployment goes up – an economic slowdown emerges.

Observe that we are now back with respect to unemployment and real economic growth to where we were prior to the central bank’s decision to loosen its monetary stance but with a much higher inflation rate.

What we have here is a fall in the production of goods and services – a rise in the unemployment rate – and an increase in price inflation i.e. we have stagflation.

From this, Friedman and Phelps have concluded that as long as the increase in the money supply growth rate is unexpected the central bank can engineer an increase in the economic growth rate.

Once, however, people learn about the increase in the money supply and assess the implications of this increase they adjust their conduct accordingly. Consequently, the boost to the real economy from the increase in the money supply growth rate disappears.

In order to overcome this hurdle and strengthen the economic growth rate the central bank would have to surprise individuals through a much higher pace of monetary pumping.

However, after some time lag people will learn about this increase and adjust their conduct accordingly. Consequently, the effect of the higher growth rate of money supply on the real economy is likely to vanish again and all that will remain is a much higher rate of inflation.

From this, Friedman and Phelps have concluded that by means of loose monetary policies the central bank can only temporarily create real economic growth. Over time however, such policies will only result in higher price inflation. Hence, according to Friedman and Phelps there is no long-term trade-off between inflation and economic growth and unemployment.

Can Money Grow the Economy?

We have seen that according to FP loose monetary policy can only grow the economy in the short-term but not in the long-term. In this way of thinking, because of the increase in the money supply growth rate a greater supply of money enters the economy and each individual now has more money at his disposal. This is, however, not a tenable proposition.

When money is injected, there must always be somebody who gets the money first and somebody who gets the new money last. Money moves from one individual to another individual and from one market to another market.

The beneficiaries of this increase are the first recipients of money. With more money in their possession, (assuming that demand for money stays unchanged) and for a given amount of goods available, they can now divert to themselves a bigger portion of the pool of available goods than before the increase in money supply took place. This means that less goods are now available to those individuals who have not received the new money as yet (late recipients of money).

This of course means that the effective demand of the late recipients of money must fall since fewer goods are now available to them. Observe that because of the fact that people are not identical, even if their respective money holdings have risen by the same percentage, as implied by Friedman-Phelps analysis, their response to this will not be identical. This in turn means that those individuals who spent the new money first benefit at the expense of those who spend the new money later on.3  

Hence an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods this can be achieved. The more goods an individual produces the more of other goods he can secure for himself. This means that an individual’s effective demand is constrained by his production of goods, all other things being equal. Demand therefore, cannot stand by itself and be independent - it is limited by production, which serves as the mean of securing various goods and services.

Increases in Money Supply Actually Weaken Economic Growth

Money permits the product of one specialist to be exchanged for the product of another specialist. Alternatively, we can say that an exchange of something for something takes place by means of money. Things are, however, not quite the same once money is generated out of “thin air” because of loose central bank policies and fractional reserve banking. Once money is created out of “thin air” and employed in the economy it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy. So contrary to Friedman-Phelps way of thinking, money cannot grow the economy even in the short-run. On the contrary, an increase in money only undermines real economic growth .

What Causes Stagflation?

We have seen that an increase in the money supply out of “thin air” results in an exchange of nothing for something. As a result, the process of real wealth formation weakens and this in turn undermines the economic growth rate. The increase in the money supply growth rate, coupled with the slowdown in the growth rate of goods produced results in the increase in price inflation. (Note that a price is the amount of money paid for a unit of a good). Observe that what we have here is a faster increase in price inflation and a decline in the growth rate in the production of goods. However, this is exactly what stagflation is all about i.e. an increase in price inflation and a fall in real economic growth. Stagflation is the natural outcome of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase of the prices of goods and services.

The fact that a strengthening in monetary growth may not always manifest itself as visible stagflation does not refute what we have concluded with respect to the consequences of increases in the rate of monetary pumping on economic growth and prices.

Consider the following situation. On account of past increases in the growth rate of money supply and the consequent softening in the growth rate of goods produced the rate of price inflation is going up.

Now, because the underlying bottom line of the economy is still strong notwithstanding the damage inflicted by a stronger money supply growth rate, the growth rate of the production of goods only weakens slightly. Within such a situation, the unemployment rate could continue falling. What we have here is an increase in price inflation and a fall in the unemployment rate.

Any theory, which concludes from this inverse correlation that there is a trade-off between inflation and unemployment, will be false since it ignores the true consequences of increases in the money supply growth rate. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of inflation.

Conclusion

The events of 1970’s have unsettled the view that there can be a trade-off between inflation and unemployment.

During the 1974-79 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labeled as stagflation.

Milton Friedman and Edmund Phelps have shown that a trade-off between inflation and unemployment can exist in the short term but not in the long-term. By Friedman and Phelps the phenomena of stagflation depicts the lack of the long-term trade-off.

Given the fact that monetary pumping undermines the process of real wealth formation, however, it is not possible to have trade-off neither in the long term nor in the short term. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of what sets in motion price inflation.