Monday, 24 November 2008

Blinded by the light

This weekend, Brown and Darling dazzled us with a blinding light. They leaked a headline grabbing story that New Labour would put up income tax to 45 percent for a tiny minority of high income earners.

The increase, in revenue terms, will be irrelevant. It did, nevertheless, excite journalists everywhere. In the confusion, the big story slipped away. Behind that 45 percent tax rate, New Labour concealed their confused thinking that led them to one of the greatest feats of fiscal irresponsibility in living memory. The package of temporary tax cuts announced today will leave a legacy of financial disorder that will take a decade to clean up.

An orgy of borrowing

Darling told us today that the government deficit, for this year and next, will rise dramatically. He told us that this year, the government will spend £78 billion more than it raises in taxes. In 2009, that figure is projected to reach £118 billion.

To make matters worse, the government accounts will not reach balance until 2016. It is little wonder that George Osbourne could confidently predict that the national debt will reach one trillion pounds.

Since UK GDP is somewhere between £1.3 and £1.4 trillion, these deficits, in GDP terms, unprecedented. This year's deficit will be around 5.5 percent of GDP, while next year, it will probably hit 8.5 percent.

VAT reduction - keeping the recession going

Next Monday, VAT will fall by 2.5 percent. Presumably, this will boost consumer spending just in time for Christmas. It will certainly empty the shops this weekend as everyone waits until the cut comes into force.

It will also accelerate some spending while the lower rate is in force. But what happens when the tax holiday expires?

A simple question requires a simple answer; consumption spending will slow sharply. Since, Darling is expecting a severe output contraction next year regardless of this fiscal stimulus package, the temporary VAT hike should be sufficient to keep the recession going in 2010, when VAT returns to its normal 17.5 percent level.

Tax cuts heading for Asia

The VAT cut will have most effect on big ticket items like electronic goods. None of these items are made in the UK anymore. So, the major beneficiary of Darling's generosity will be primarily the sweat shop owners overseas.

Taxes will have to go up

The central premise behind Darling's stimulus package is deeply cynical; he gave us money today, but he will have to take it back as soon as New Labour are re-elected in 2010.

This tax cut is nothing more than a cynical loan. Darling borrowed the money, he gave it to the tax payer, and he wants it back in a few years time. Saving this windfall is therefore the sensible thing to do. It is not a permanent rise in our income. It is only a transient flash before our eyes, which will be soon extinguished by a massive and permanent increase in the tax burden.

Interest rates will have to rise

What?? Haven't the Bank of England just cut rates?

Government borrowing means more government debt. The Treasury has to find someone willing to hold all those crispy looking IOUs. As the debt goes up, so must the interest rate. As the yield on government paper rises, it will take other rates with it. Why should a bank hand out a risky mortgage to a buy-to-let investor at 5 percent, when it can invest in a government bond with a near riskless default rate.

With long term interest rates rising, firms will find it difficult to rate capital for investment. In the long run, lower investment means slower economic growth.

Borrow in haste, repent at your leisure

Darling's fiscal package is a dogs breakfast. The 45 percent "tax the rich" ruse conceals the confused short-termism that now passes for New Labour's economic strategy.

The package will fail; the tax cuts will either flow out of the country as imports, or will be used by hard-pressed debtors to pay down their debts. The economy will slide into recession anyway.

The package will, however, leave us with a huge fiscal problem that will encumber the UK economy for at least a decade. Taxes will have to rise, interest rates will go up, and we will all be left worse off.

27 comments:

P said...

It is going from bad to worse.....

Tim said...

Great stuff Alice, thanks!

It is obviously a good idea to get people working building infrastructure at times of high unemployment. But why do we have to borrow the money?!!!

Why not invent a new local currency, backed by land, with a built in expiry date to increase velocity, make it legal tender in the UK, but only redeemable by UK citizens - a local UK currency. That will provide a medium of exchange with no debt!

The answer is currency reform!

Alice? Mark?

Sackerson said...

45 per cent...

How about, they say this to the resentful and poorer-paid masses, and intend to do no such thing after the election (no mass Beatles-style exodus) - and are reassuring the higher-paid even now, privately, that it'll never happen?

Nick von Mises said...

Tim

"Why not invent a new local currency, backed by land, with a built in expiry date to increase velocity, make it legal tender in the UK,"

Go have a look at a Zimbabwean bank note. They have just got a new currency, it's called a "special agro cheque" and has homely pictures of farming (and giraffes) on it. It's legal tender and the note in my wallet expires 1st July 2008.

It's one hundred billion dollars. I'd have needed a few of them to buy a loaf of bread.

John Pickworth said...

I have nothing like your expertise Alice but you're telling it pretty much as I read it.

I fear though that once the small print has been examined it will be even worse than the headlines are telling us.

And where is all that borrowed money going. At least £80bn this year, £120bn next year (yeah, right!) and yet the cash stimulus is supposedly worthy a paltry £20bn?

Mrs Smallprint said...

Hi Alice

An interesting post, I'm not sure about the sweat shops though. I think retailers will take the reduction as a 2.5% bonus and there will be very little effect on the price the consumer pays. Even the oh so prudent Mr Brown can't dictate prices charged!

Mrs S.

Tim said...

Nick,

Yes but the Zimbabwe notes are not backed by land (land is better than gold, for several reasons). And they are the only legal tender in Zim. And they are subject to foreign debt.

Do you get the main point, that currency has different purposes (store of wealth, medium of exchange..), and that different currencies have different rules (how it is created and destroyed, by whom and in what quantity) that have a crucial impact on its behaviour, and that what we need in a depression is high velocity liquidity. Debt is not the only sort of money.

dearieme said...

So those things that attract VAT at 17.5% will have their prices dropped by about 2%. Your 99p bauble will drop to 97p. Seems implausible to me - it might even be a cack-handed way of sparing some businesses from part of a profits collapse, but more likely it's just an act of incompetence. But the whole dismal charade showed just how dreadful a pickle we're in. What a bloody awful government.

electro-kevin said...

"This is Brown's last ditch attempt to stave off a depression."

BBC today - from memory, but yes, the word 'depression' was used.

Oh well. That's us stuffed then.

Anonymous said...

Any government handouts to consumers will result in little new buying (see Bush's last tax rebate to US). People are slowly beginning to wise up--even the Brits, dumb beasts that they are: the days of profligation are over.

Housing prices must come down 50%+ to start up some sort of demand again. That will take 1-2 years at least, even in this rapidly falling market.

The fiscal future, of course, is irrelevant to the government in power. Let the next lot deal with the problems. That's how it's always been.

As usual, no culprits are blamed and no one takes responsibility for the last decade. The least we might expect are a few suicides by government ministers.

Nick von Mises said...

Tim,

Sure I was joking a little about Zimbabwe. Money is a means of exchange, and every other one of its characteristics is dependent on that. I don't think you should specify what money is "backed" by. Government should get away from money and let the market pick it's own money. Invariably it'll end up picking gold.

Barry said...

The consequences of current events will last for the foreseeable future Alice. We cannot nor will we go on like this. Both in North America and Europe living beyond our means has become the accepted practice for nearly everyone. That will have to change. What has the potential to make this disaster truly frightening are ill judged policies motivated by fantasies, Messers Brown and Darling and their colleagues in the EU are fully capable of doing just that. Except that this time the US will no longer be able to bail us out for they have been equally foolish.

Anonymous said...

Cuba has duel currencies: the tourist peso and the local peso. If you want some government rations (rice, beans and a bit of pork), you buy it with local peso. If you want to brush your teeth, wash your hair, have underpants and a pair of jeans, you use tourist peso (about a Euro). Guess what you have to do to get tourist peso? Well, if you are a young lady it is easy, but for everybody else, hustling tourists is very difficult.

roym said...

"Why should a bank hand out a risky mortgage to a buy-to-let investor at 5 percent"


GOOD! i thought that was what we wanted?

"With long term interest rates rising, firms will find it difficult to rate capital for investment. In the long run, lower investment means slower economic growth"

If this transpires, I would hope that as you state the belief that people will be paying down debt back to the banks, aiding the latter to rebuild balance sheets. Only once this is well underway will lending to firms be back to anything remotely normal so they had better spend the next 6/12/18(?) coming up with solid investment plans.

On initially hearing Osbourne's idea for guaranteeing business loans in the short term i thought it quite a good idea, but whats the detail? he said they would charge a "fee" but how much? who to? the bank or the borrower?

powerman said...

Tim, I'm all in favour of commodity backed money, but the problem with backing a currency with land is that an acre of land doesn't have uniform value in the way that an ounce of gold or silver does. Can you imagine trying to redeem your one-acre note ?

"I'll take that choice bit of the Thames Valley, thanks"

"Sorry, we've run out, here, have this hillside in North Wales. There's a plan to build an access road in 2015, and we expect that the water mains and electricity supply will be available no later than 2020!"

It wouldn't work as a store of value. You'd end up trying to say that the note was worth x-pounds sterling worth of land, which would make it entirely equivalent to a sterling note, i.e. back to fiat money.

Oh, and I'm really not convinced that dealing with unemployment caused by debt profligacy by taking unemployed people as temporary workers who largely won't have applicable skills will get much useful infrastructure built. It's more likely that the burden of paying for the programmes will simply cause further private sector unemployment whilst thousands of former office workers get given pointless bureaucratic non-jobs.

The Guardian jobs page writ larger, basically.

Anonymous said...

I agree with Mrs Smallprint. The retailers will keep the cut. Would they really want to remark every item in their shop at this time of year?
ZanuLabour don't have a clue. Interesting to see first hand the policy decisions leading to a wrecked economy.

Markbaldy said...

I am following Gordon Brown's advice... I am a warehouse operative on £8 an hour and have mortgage debts of £350K and another £100K credit card debt.
This afternoon I am seeing the nice man at the bank and will borrow £500K from him to pay off my debts and that will still leave me with £50K profit.
At the weekend I am going to Bright House to buy a new flat screen TV, then to Ikea to buy new stuff I don't really need and then to M&S to buy food and drink for the party on Saturday.
You should all follow my shining example and get the economic recovery going ! LOL !!!

Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...

@ Tim.

The perfect way of funding public infrastructure (esp. transport infrastructure) is Land Value Tax. Whoever proposes the scheme works out by how much it will increase local land values and whether those receipts cover the costs.

If "yes", the proposal goes ahead, land values jump in anticipation and hey presto, there's the money to pay for the new road, the flood defences, railway station, bridge, local park, whatever.

If "no", then it's a White Elephant and shouldn't go ahead (Olympics Park etc).

Mrs SP is one of the few people who understand this VAT thing. You have to ignore the Big Fat Lie that VAT is a tax on spending.

It is not.

It is a tax on the turnover of businesses. Prices are what the markets dictate. If struggling businesses can keep an extra 2p for every £1 turnover, that might make the difference between survival and failure for a lot of them.

Mark Wadsworth said...

Sorry about that - my comment appeared six times so I deleted the first five.

Alice Cook said...

Mark

I was going to ask "what happened"

Dodgy internet connection, I presume.

Alice

Tim said...

@Anonymous

Interesting point about cuba. Castor has done an incredible job there. I have heard it is the only sustainable economy in the world. Maybe we could learn something from them!

I guess if they weren't subject to a punitive illegal blockade by the US, getting tourist pesos might be easier, through international trade.

And I guess the UK is big enough to make its own jeans, soap and toothbrushes - in fact almost everything!

Nick von Mises said...

MW is correct to remind everybody of that basic economic principle that the entire MSM is currently ignoring - the MARKET sets prices based on when effective demand meets supply. It's only loosely connected to cost-plus pricing.

As for Cuba. Any country that restricts emigration has already admitted failure.