Monday, 8 March 2010

We must avoid the Japanese problem

Anatole Kaletsky wrote an interesting piece in the Times today highlighting the Japanese problem. In an attempt to stimulate its way out of recession in the early 1990s Japan increased government spending and borrowed to pay for it. This went on for several years and now, almost twenty years later, the cost of servicing the borrowing is so high there is no additional money available to repay the principal sums borrowed. Japan's economy has, as a result, seen virtually no growth in GDP.

In effect the "spare" money that could have fuelled growth has been used paying interest on the massive sums borrowed. There should be no surprise in this because growth comes from the bottom up it is not created by government. It comes from individuals and businesses exploiting new ideas and new processes, almost always that requires an initial injection of capital and weekly costs of production. Reduce the amount of available capital and/or add to the costs of production and even a half-wit can see that new ideas and processes will not get off the ground to the extent they could. It doesn't actually make any difference whether the factor reducing available cash is taxes or any other alternative use of the money. A business owner who takes a massive salary and spends it on expensive booze and cheap women, or cheap booze and expensive women, reduces his ability to invest in the business in just the same way that a government taking the same sum in tax reduces the ability of the frugal factory owner to expand. The difference, of course, is that the spendthrift owner can console himself with happy memories and a trip to the clap clinic.

It by no means follows that every government that borrows vast sums in a vain attempt to prop up its national economy will find itself trapped in the long term as Japan is trapped today. However, the trap will always arise if there is no political will to reduce borrowings. That is where we have a real problem in the UK. Decades of brainwashing the masses into believing government has a magic money tree combined with a decade of making as many people as possible directly dependent on the state for their ability to put food on the table, results in upwards of one third of those polled saying they plan to vote Labour in the coming election. More than that, it makes the Conservatives too scared to tell the truth about the need to slash government spending because their focus groups tell them it will be a vote loser.

Poor Gordon and the hapless Mr Darling tell us government spending should not be cut this year because it will have an adverse effect on demand and will upset prospects of recovery from recession. Occasionally they say reductions can be made from 2011 onwards, but if their current reasoning is sound it will apply until a strong recovery is underway and there is absolutely no guarantee that that will happen next year or the year after or the year after that.

The one thing that is an absolute certainty is that we either follow Japan or we pay back some or all of the borrowings. Actually something else is certain. Whether we retain the debt and pay buckets of interest or reduce the debt by paying a combination of interest and principal, the money used cannot be used for anything else. Debt is a millstone around the neck of a national economy just as it is a millstone around the neck of individuals, indeed it is a millstone around the neck of a national economy precisely because it is a millstone around the neck of individuals. That is because, in reality, there is no such thing as a national economy. There are millions of individual little economies comprising each separate business and household and the combined value of them all is what we call the national economy. It is actually no more realistic a notion than the economy of Sussex or the economy of Acacia Avenue, it is simply a statistical construct. The real economy is the millions of businesses and households.

Mr Ordinary with a disposable income of £20,000 can spend £20,000 or he can save some and spend the rest, or he can invest some in a business venture and spend the rest or he can split his money three ways with some spending some saving and some investment. Whatever he does he can only dispose of £20,000 because that is all he has. Take £3,000 from him to repay debt and his choices are the same but with an overall limit of £17,000 rather than £20,000. There are knock-on effects of his choices which operate in much the same way as fractional reserve banking. If he spends £20,000 at Mr Patel's Merrymart, Mr Patel makes £5,000 profit which he then spends at Mr Khan's Kurdish Kasbah, Mr Khan makes £1,000 profit which he spends at Madame Fifi's Sauna and Hanky Panky Parlour, in turn Madame Fifi and the girls receive money they spend elsewhere. When the amount entering Mr Patel's till falls from £20,000 to £17,000 so Mr Khan receives less and one of Madame Fifi's girls misses out on business. The national economy is depressed because the individual economies of Mr Patel, Mr Khan, Madame Fifi and Tiffany the trainee tart are depressed, as are those of all the suppliers to Mr Patel, Mr Khan and Madame Fifi.

In other words, debt depresses the economy. It also boosts the economy for so long as the principal sum borrowed is sloshing round the system. Thus, Mr Ordinary could borrow £5,000 at 10% and have £24,500 to spent at the Merrymart thereby increasing Mr Patel's profit, and Mr Khan's and Madam Fifi's and that of the manufacturers of intimate rubber items. But that can only happen once. The key question is whether the boost provided by an injection of borrowed money outweighs the depressive effect of reduced disposable income in future years.

Japan illustrates that too much borrowing can lead to a long-term depressive effect far in excess of any short-term benefit. It is a self-perpetuating problem because the only way out is to increase GDP but that requires "spare" money and there is no spare money because of the need to pay interest. There is only one way out of this spiral of stagnation, it is to reduce taxes and other costs that government imposes on business. No other course has the potential to raise GDP because GDP can only increase through profitable business activity. In the short term that might lead to a need for further government borrowing to cover the reduction in tax receipts, although that can be ameliorated by paring back government activities. Even that short-term problem is by no means a certainty because marginal businesses will become profitable instantly, already profitable businesses will become more profitable and new ventures will pay tax from their first day.

Given the choice between (i) cutting government costs and taxes now and taking my chance on it producing a quick benefit and (ii) maintaining taxes and state spending in the hope that GDP will expand to pay for it, I would go for the first option every time. It involves uncertainty but to that I say "so what?" Just look at the track record of private business for expanding, creating jobs and making taxable profits. You don't need to be able to identify exactly what businesses will make what profit to know that reducing overheads will make business more profitable and create new jobs. None of it will be by direction of the government, it will all be the result of government getting out of the way.

It is the only certain method of avoiding the Japanese problem.

1 comment:

Mark Wadsworth said...

Yes, but the Home-Owner-Ists won't like your plan (i).

a) They need the government to continue propping up the banks with vast amounts of money to enable the banks to keep propping up house prices. Which needs taxes to pay for it and which diverts money away from productive uses in real economy.

b) They certainly don't want any new factories or roads or anything built that could spoil their view.

The good news is, the Home-Owner-Ists will get their way and we'll be in for at least twenty years of decline with an ageing population, just like Japan, with house prices sliding downwards gradually for twenty years, rather than just letting them crash now and get it over with.