Sunday 27 June 2010

Economic structure is more important than detail

Now that some tentative first steps have been taken on the long path to reducing government spending to affordable levels it is worth asking whether the forecasts included in the Budget papers are as important as the shift of emphasis away from big government. I don't mean the "structural deficit" because that is just a way of describing part of the shortfall between spending and income. I mean the general ethos of reducing the influence of government in people's lives and, therefore, reducing the cost of government.

What is it that those who bail-out bankrupt governments require? One thing first - reduced government spending. Other conditions apply in most cases, but that is and always will be the first requirement. No individual, company, council, state or nation can stay solvent if it spends more than it can afford to repay. Our Keynesian friends babble on about the knock-on effects of reduced spending and argue that cuts now result in the loss of later gains that their spending choices would deliver.

How can the International Monetary Fund and the European Central Bank require spending to be cut hard and quickly if the effect of doing so is to make the borrower country less able to repay the loan? Yet they do impose that requirement whenever they lend to a western government. It is sheer madness according to the ex-Chancellor Mr Darling and now according to the current US President, Mr Obama, who has encouraged European governments to continue trying to stoke-up consumer demand. Both sides cannot be right. It cannot even sensibly be said that they are addressing different issues because the lenders need to be repaid over time and any step taken now that limits the chance of being repaid next year is not one they would be wise to encourage.

I wonder whether the key to understanding the apparent conflict lies not in economics but in politics. It is good politics to be able to boast of economic growth. We saw that first-hand in the UK as the housing price bubble delivered votes for the Labour government because it made people feel wealthier and allowed them to borrow and spend against their new-found wealth. For very obvious reasons the government claimed credit for that feel-good factor and, when the level of unaffordable debt was exposed, distanced itself from the other side of the bubble coin. So far the new government has not taken any steps to deflate the house price bubble because they know it could lose votes.

Interestingly, under John Major's government house prices fell hugely between 1989 and about 1991 and then flat-lined for a few years. During that period came the general election of 1992 and little evidence appeared that deflation of the house price bubble cost the government any substantial number of votes. I didn't hear anyone blaming the government for the nominal value of their house falling by more than half because they knew it had jumped artificially and very quickly in the previous few years. As an example, some friends of mine had their house valued at £375,000 in 1989 and at £150,000 in 1992, they had bought for about £120,000 in 1986. In a six-year period it had risen in value by 25%, an average of more than 4% a year which wasn't all that far away from general inflation. The huge spike was not real and people knew it was not real. The recent huge spike is not real and people know it is not real but the game has changed somewhat because far more people have borrowed against the bubble equity. Now bursting that bubble would raise fears that didn't arise to the same extent eighteen or so years ago.

Not only do people feel wealthier if they are told the "value" of their home has increased, they also feel the country is wealthier if GDP rises. There is no counterbalancing factor of the type evidenced by perceptions of the false spike of house prices in the late 1980s, yet the situation is the same. Why did GDP rise constantly through the 2000s? Of course numerous factors applied but one was the increased economic activity caused by borrowing money we could not afford to repay. Every time quarterly figures appear and inform us that GDP has risen by 2.7% is seems to be treated as setting a new lower benchmark for the acceptable level of economic activity in the country. We have achieved a level of activity and will suffer if that level of activity falls, or so goes the theory. It is as artificial as my friends' house going up in "value" from £120,000 to £375,000 because it has foundations of sand.

To Mr Obama and Mr Darling the maintenance of a falsely inflated GDP figure is an end in itself, presumably because of the possible political consequences of the figure falling. They cannot want to maintain that false and unaffordable level of GDP for reasons of economics because the price of continuing to spend more than you can afford is serious long-term penury. The lenders and the governments of European countries seem to take the view that it is time to stop pretending that unaffordable consumer debt should be replaced by unaffordable government debt simply to maintain a level of economic activity that is necessarily dependent on unaffordable debt.

It really doesn't matter if this approach leads to a fall-back into recession because the substance of the matter will be that the economy shrinks to the size we can afford rather than being kept at a size we cannot afford. At the moment the structure is wrong. Getting the structure right is the only way of ensuring both stability and affordability in the future. To my mind it is far more important than the technical detail of whether GDP is going up, down, in, out or shaking it all about. If our current government had the courage to include deflation of the housing bubble in its plan we could get there much quicker. It doesn't matter whether their predictions are accurate, what matters is that the balance of the economy - the structure - is sustainable. They could be billions out in their predictions of borrowing and spending levels a couple of years down the line, but that will not concern those on whom they rely to fund our broken economy while the costs of Gordon Brown's decade of incompetence are wrung out bit by bit.

While throwing these words together I noticed that the good Mr Economicus has written on the same subject in far more erudite terms, he is always worth a read (his marvelous piece on the illusion of GDP should be branded into the wallpaper at the Treasury).

1 comment:

Barnacle Bill said...

Half the trouble has been that people have been sold the myth that property is an "investment" not a home.
An endless escalator of free money, but what they have ignored is than to maintain the flow on this conveyor of effortless wealth you need people getting on at the bottom, as well as those escaping at the top with their profits.
Setting the property escalator at a steady pace and gentle incline it can maintain it's self.
Unfortunately it has been allowed to run out of control with the angle of it's incline growing ever steeper.
Now it has reached an angle where those on it are finding it harder to maintain their upward motion.
An increase in interest rates will put the angle of incline into dangerous territory.
It is going to take some strong and distasteful medicine to bring the escalator back to a safe angle.