Sunday, 7 December 2008

There is a way out of this mess

Here is quick inventory of problems now facing the UK economy: falling output; a large external deficit; rising public sector indebtedness; unsustainable levels of household debt; a crashing housing market; quasi-insolvent banks; declining real incomes, and rising unemployment.

Did I leave anything out? Ah yes, Sterling, I forgot. The UK is on the slow side towards a currency crisis. With this nasty brew of tribulations before us, is there a way out?

As the problems have mounted, the Government and the Bank of England have cooked up a response to this crisis. The bare bones of the strategy are quite straightforward; cut the bank rate to the lowest rate in sixty years so that in real terms, rates are negative; nationalize the banks, and run up a series of massive fiscal deficits.

I hate to say this, but I do not think this approach is going to help much. However, a critique is easy, but what about some solutions? Here is what I think might resolve our economic difficulties over the medium term.

Don’t make things worse – no more debt

It is a simple point, but the government should stop making big problems even bigger. This economy already has a major problem with debt. Every major sector of the economy has too much; firms, households and the government.

Trying to encourage people to hold more debt will not restore a degree of sustainability to sectoral balance sheets. It follows, therefore, that the government should not force banks to lend more. It should forget those fantasies about reviving the credit fueled housing bubble. It should encourage people to pay off their debts rather than accumulate new ones. Above all, it should set its own house in order and put a brake on its own unsustainable borrowing plans.

Build a platform of stability

The economy needs stability and fiscal policy is the weightiest anchor available. Darling’s plan to ratchet up the deficit creates huge uncertainty about where the UK economy will be in a year or so. Will a future government have to increase taxes? Will long term interest rates have to rise as government borrowing increases? What is the probability of a fiscal crisis, where the government actually runs out of money? And before you ask, yes, governments can run out of money, just ask the Argentinians or the Icelanders.

This uncertainty feeds into the present. In the absence of any clear idea about the future taxation, firms will defer investment plans. This leads to slower growth, and lower living standards.

Although firms no longer know what the tax system will look like in two years time, they know that taxes will have to go up and that will lead to a future contraction of output. Darling “spend now, tax later” plan will lead to a recession now, and more recession later.

At a minimum, the government should restrict the growth of the public sector and balance its books. Forget this rubbish about spending your way out of recession. It has been tried many times before. It only leads to a bloated public sector that squeezes out private enterprise. Government debt grows remorselessly, leading to higher interest rates. In short, it is a recipe for failure.

Fix interest rates

No economy can prosper with negative real interest rates. When the deposit rate is lower than the inflation rate, people no longer have an incentive to save. It also affects the incentive to work. There is no point putting in a few extra hours of overtime, perhaps to save something for retirement or finance the kid’s education, when it will disappear in withholding tax and inflation.

Negative interest rates also threaten to prolong our banking difficulties. Currently, there is a huge gap between total bank loans and total deposits. Banks need depositors more than ever, but with such low rates, savers have no incentive to put money into banks. In the interim, banks are forced to depend on the Bank of England for liquidity. Banks can not prosper if they waiting cap in hand for financial assistance from the state.

Deposit rates have to increase and exceed the inflation rate. The Bank of England need to push rates upwards, and only reduce them as inflation falls. But what about the real economy? Won’t higher rates lead to recession?

Negative rates will do nothing to prevent a recession. In America, the Fed pushed interest rates below the inflation rate almost a year ago. Since then, the US economy has lost jobs remorselessly. Why? Negative rates are always associated with unstable failing economies, where savings, investment and work are all discouraged.

Tell the truth

The government needs to tell people that we are about to enter a prolonged period of economic decline. As the economy contracts, it will crush all our illusions about asset prices. The housing market is not going to provide anyone with a pension. Likewise the equity market will not generate sufficient capital gains so that we can save nothing and consume as much as we earn. Utimatelely, it is a simple message, we need to know that we must save more, work harder and expect less.

At the same time, the government must tell us that it will not run up huge deficits, and therefore it won’t need to play around with taxes in the future. At the same time, the MPC must also tell us that it will establish a monetary framework that provides price stability and incentives for people to save and work.

In the short run, there will be pain. We are in a right mess, and a recession is unavoidable. However, high deficits and negative real interest rates will guarantee years of instability and uncertainty. But there is a better way; create stability, minimize financial chaos, and create the right incentives; a strategy that requires lower government deficits and higher interest rates.


Anonymous said...

I must admit I do feel rather pissed off that my prudence for the last decade is being destroyed by these interest rate cuts in an attempt to save those who borrowed us into recession. As said before, savers: an oppressed minority.

Still, who needs interest rates if we wind up with deflation? Maybe we should start campaigning for that.

Alice Cook said...


I don't really believe this deflation mumbo-jumbo. Even if it were true, the MPC are quickly painting themselves into a corner. Once they are there, what can they do to escape?


Anonymous said...

Our whole economy needs rebalancing from relying on consumption to drive growth, to investing in productive capital (manufacturing and exports). All govt interference in business in the productive sectors should be abolished, tax rates slashed for them too. Make the UK a simple and bureaucrat free zone for manufacturing. Drastic measures are needed to reverse the decline in our productive base before it is too late.
Vast areas of govt spending should be cut and the money returned to taxpayers and/or business so it can be more productively used. The govt should be reduced in size by 50%. The public sector produces no wealth and consumes vast amounts. It has grown to such a size that the rest of the economy cannot carry it any longer.

Anonymous said...

Sad to say but this government already has a strategy.

In no particular order:

* Spend loads of money in all directions in order to bribe everyone and get re-elected.

* Drive sterling into the ground to re-establish manufacturing.

* Trigger wreckless amounts of inflation to diminish the debts at all levels (and hide the ultimate extent of house price drops).

So far as I can tell everything else is spin that will stretch this crisis out far longer than need be.

Frankly you present uncommon sense but I won't get the chance to vote for you - will I ?

Anonymous said...

AC: "The UK is on the slow side towards a currency crisis. With this nasty brew of tribulations before us, is there a way out?"

'Sterling crisis'.

What does this actually mean?

I expect it means the UK government will no longer be able to fund it's spending **.

We might have to withdraw our troops from middle and far east, but in reality that would be no bad thing.

We could no longer buy those spanking new plasma TVs, I got one two years ago and am anticipating it last for as long as the old Sony 26" --> ten years.

Who would a sterling crisis impact.

Holiday makers, and folk ( Poly T ) who have second homes in foreign parts.

We might see the more exotic foods disappearing from the shelves, but it might be a good thing for domestic farmers.

So what else would happen - given that we are already in a recession and trending to depression - that won't already happen because folk simply don't have that much discressionary income any more?

** I am afraid I have long thought that reduced government spending might actually be a good thing.

Anonymous said...

The UK has, more's the pity, a pretty poorly skilled workforce, and thinks it can run an economy on selling mortgages, coffee and throwaway fashion made in Asia by workers earning a few pence an hour. The UK "Business Model" does not work. All down the line shirkers make money off the backs of Asian manufacturers: "designers" "marketing people" "distribution" etc. But it is all predicated on the assumption that the currency can buy those cheap Asian manufactures, or those quality European ones.

Hold the currency with a firm interest rate, and hire a lot more police; abandon the wasteful target culture in the public sector and excessive bureaucracy; create a school system where the teachers actually know something worth passing on, where the class sizes are half what they are, and there is iron discipline; soak up some labour producing necessary socials housing; and reduce wage costs by 50%.

Or just leave the country.

B. in C.

Anonymous said...

A very informative article.

Anonymous said...

So more debt is the answer to the debt problem.

We are heading for disaster.

Anonymous said...

Well done Alice!
This is the most cogent summary I have seen of the crisis we are in and some constructive solutions. The Government is suffering "re-electionitis" which means everything after the next election eliminated from their thinking so, we are witnessing the politics of extreme short termism. I wholeheartedly agree that nothing the government has done so far will relieve the pain of transition to a more stable & enduring economic platform & is simply compounding the medium to longer term structural problems in our economy.
Whenever I need an injection of realism as antidote to the incessant government spin I read your blog. Many Thanks.
Mr Leatherhead

Anonymous said...

I think you need to think about reverse logic. Here is Bob Prechter:

'Robert Prechter (who has long been warning that deflation was inevitable rather than hyperinflation...which will likely come later) is more confident than ever that “ DEFLATION IS WINNING”. In his November edition of Elliott Wave Theorist he goes on to say ... “cash is soaring in value, as creditors demand dollars and debtors sell everything they can to come up with them. Cash now buys 1.7 times as much stock and real estate, twice as much silver, and 2.5 times as much oil as it did a short time ago. Is that a bull market, or what? This trend is far from over. The longer you hold onto your money, the more it will be worth, until deflation ends.”

We will go to Zero interest rates and start quantitative easing as we need to get the long-end gilt down to 2.5%. If you have cash you are king. If you have debt you are sinking into a depression.

I think you need to think more about Japan and their L shaped economy. That will be our fate. So if you have no debts and a secure job, just watch the Debt Junkies fry in the coming depression.

Anonymous said...

Alice, well done. You might add that before we can begin to rectify matters Britain and its populations needs to embrace honesty. Since 1945, well before really, we have fantasised about just about everything. WE need a change of approach from top to bottom. While going bankrupt will do it, it would be better in the long run if we managed this for ourselves.

Anonymous said...

This is marvellous. On the BBC today:

Q: Why is the price of my home so important to the state of the wider economy?

A: The value of your house is probably your biggest valued asset, so when house prices rise above inflation, you get richer and you can spend more.

The extra spending increases sales for businesses, supports more jobs and fuels economic growth. Of course, when house prices fall, the opposite happens, spending falls, jobs are lost and the economy slows.

Q: Is it possible to get to a stage when banks and building societies simply lend out what they get in as deposits?

A: If bank shareholders want high profits then banks make these profits by expanding loans.

They can't do this with deposits alone. Even with tighter controls on bank lending, the government would need to nationalise the banks to achieve this.

RenterGirl said...

Whenever someone mentions and end to 'bureaucracy' in manufacturing, I think of good red tape ie safety standards. Without these rules, we will see an increase in industrial/workplace acccidents. Deregaulated economies like China suffer vast amounts of horrific workplace accidents. While we demonise Health and Safety, they save people.

RenterGirl said...

Whenever someone mentions and end to 'bureaucracy' in manufacturing, I think of good red tape ie safety standards. Without these rules, we will see an increase in industrial/workplace acccidents. Deregaulated economies like China suffer vast amounts of horrific workplace accidents. While we demonise Health and Safety, they save people.

Electro-Kevin said...
This comment has been removed by the author.
Anonymous said...

Renter girl: the logic of your argument then is to prevent imports from places with worse employee protection than the UK? I don't see many people saying they won't buy that cheap plasma TV because its made in China in a factory that uses dangerous chemicals that harm its employees, and discharges its waste into the nearest river.

If we allow imports from such nations as China & India, while setting high standards of production here in the UK, we are effectively exporting the industrial injuries and environmental damage to a far away land where we can't see it. Out of sight, out of mind.

If we wish to trade cheap goods for maimed employees/damaged environment surely it would be better to sh!t on our own doorstep, not palm it off on someone else? Or just ban imports than do not reach our high flown standards. Its an either/or issue. What we have now is hypocrisy of the highest order.

Electro-Kevin said...

If only Alice were Chancellor then my insipid avatar might be restored to its vibrant red, white and blue.

James Purnell was being interviewed by Andrew Marr today and what I saw of it (I was at work at the time) unemployment was being downplayed (only 1 million) and Purnell said of immigration "I believe in an open and competitive job market"

How so when a life on benefits affords one a better quality of life than one on minimum wage ?

Welfare is distorting our economy grotesquely - it is also subsidising truly awful parenting at the expense of good parenting.

Welfare is our greatest challenge as David Cameron writes correctly today.

Have we the stomache to deal with it ?

I really don't think so. The socialist experiment is going to be persued to destruction.

Nick Drew said...

excellent, Alice

except ...

tell the truth

who, Gordon Brown ? hmm, there's a flaw in that one

Nick von Mises said...

There's a much easier solution. The government needs to get out of the way. Step one is to stop meddling with "solutions". Step two is to reduce the dead hand of government in the economy by shrinking the public sector until there's nothing of it left beyond police, immigration, courts and armed forces. Undo all the silly regulations too.

Oh, and abolish the BoE. The market sets interest rates, not a bunch of clueless theiving bankers.

Anonymous said...

That's it: introduce a 100% sumptuary tax on "folk ( Poly T ) who have second homes in foreign parts."

Electro-Kevin said...

Slightly off topic, but we're forgetting the elephant in the room.

I appologise for what must seem like self-promotion but linking to my blog was the easiest way to make the point.

Anonymous said...

It is clear the government took the decision to hyperinflate its way out of the crisis. In a few years, you will be able to see it in books and secret government memos.

Anonymous said...

As soon as the next election is over, we are going to get clobbered with a massive hike in taxes. That much is clear.

Anonymous said...

Sobers, we do have a standard for safe imports. To sell goods in the EU they must be CE marked. In theory those marks indicate that EU Health and Safety, and other directives are complied with. Two problems however arise. I understand that bribery is endemic in some countries we import from, and that marks are falsified. Secondly, we may not be able to test everything that is being imported as there is such a tide of the stuff.

I have watched over the years as Chinese produce has flooded the bit of engineering I inhabit. Its getting better. The build quality is as good as fully developed countries now on many things from China. Canute was right, we cannot stop the tide.

Anonymous said...

Hi Alice,
The extent of the deflation, in terms of credit contraction and the impact on the real economy is so concerning, central governments are looking to offset private sector weakness in the short term.

Keynes suggested the Treasury should “fill old bottles with bank-notes, bury them at suitable depths in disused coalmines and leave it to private enterprise to dig the notes up again”. Better this than let millions of men stand idle for lack of work.

This is his message in a bottle or maybe we should all just turn to drink.

Anonymous said...

On the other hand,
We could raise interest rates, slash spending, throttle the money supply, impose tariffs on imports, cut the external deficit and return to the Gold standard.

Yeah, that sort of thing. That sort of "dust bowl" economics.

It's a tough choice.

Anonymous said...

Just because a child's Teddy Bear (for example) has a CE mark does not guarantee that it was produced in conditions that match those in the UK for worker protection/health'n'safety/environmental protection. It merely ensures that it is safe for the poor diddums of a european child that will be given it for Xmas. IE its eyes are securely sown in, it doesn't contain lead or toxic chemicals, and has a safe stuffing.
It could be produced by a child no older than that being given it, in a factory that discharges pollution into the atmosphere, and has many industrial accidents. There would probably be no employment protection for the workers as in the UK.
If people are happy to purchase goods produced in similar ways from abroad, so be it. But don't think that does not have an impact on the economy of the UK. If we don't produce stuff here eventually we go bankrupt. Then the last thing on our minds will be health'n'safety and employment laws. It will be where is my next meal coming from, and how do I protect my family from rampant crime?