29 September 2009

Debt or Depression

The Tories seem to think that debt is worse than depression. Here is one more reason why they are wrong.

Government debt is manageable in a growing economy. Get the economy moving and a little bit of growth and a little bit of inflation will deal with the debt. Even with inflation kept to its 2% target, growth at the UK average of 2.5% is enough .

In thinking about government debt and deficits, I find this little equation helpful:
where d is the government deficit (as % of GDP), D is government debt as (% of GDP) and y is the nominal growth rate.

This is the equilibrium debt-deficit equation. If the government consistently ran a deficit of d% then its debt would converge to D%, given a growth rate of y%.

What does this mean for the UK today? Let's take 4.5% as the nominal growth rate (ie growth rate before inflation is stripped out):

This year the deficit is 13% of GDP. If it stayed at that level then debt would stabilise at 289% of GDP. If we felt comfortable with debt almost 3 times national income then a 13% deficit would be sustainable. We don't feel comfortable and the people lending the money wouldn't either.

If debt of 80% feels better then, government needs to bring the deficit to d= 4.5% x 80% = 3.6%.

The good news is that to stabilise debt, government doesn't need to run a surplus. It doesn't even need to balance the budget; it only has to hold the deficit to 3.6% for a (longish) period of time. (Compare that with the Maastricht Treaty rule that deficits should be below 3%).

If we want to get back to the old debt rule of 40% GDP, then the deficit needs to fall to 1.8% and the magic of a little bit of growth and a little bit of inflation will do the rest. (In practice the government would not keep the deficit constant; it should make the deficit smaller when growth is good and larger when growth is low.)

So far I have taken y= 4.5%. (You could work on 5% to make the calculations easier, but 4.5% is consistent with 2% inflation and 2.5% real growth.) What happens if nominal growth is say -1%? That could happen with low growth and deflation, the Japanese scenario.
d= -1%xD
Say the debt is at 70%:
d= -1% x 70% = -0.7%

So the government would need to run a surplus of 0.7% of GDP just to avoid adding to the debt ratio.

Even with slightly positive growth, say 0.5%, the figures are bad. To bring the debt level down from 70% , the Tories would need to cut the deficit below d= 0.5% x 70% = 0.35% of GDP, almost a balanced buget.

The conclusion is obvious: fix the economy first and then a little bit of growth and a little bit of inflation will make fixing the debt a whole lot easier.

24 September 2009

No Time for Cuts Part 2

From the New Statesman via Mil.

David Blanchflower says:
The time for cutting public spending is not now, not next year and not the year after.

Two years ago the Bank of England was raising interest rates out of fear that rising oil and food prices would spark demands for higher wages leading to persistent inflation. I thought they were wrong, the US was already in recession and we were at risk. I discovered that there was a lone voice on the monetary policy committee arguing against rate rises, David Blanchflower. He was proved right.

I think he is right again.

Could it be that the fight against early cuts in spending is gaining momentum?

23 September 2009

This is no time for cuts

The story of the moment is that government borrowing is too high and spending will need to be cut. Here is someone who disagrees:

"The big error of the present economic discussion is to treat national budgets as on a par with the budgets of individuals or firms, which need to balance except for narrowly defined investment projects. Even if you also favour a balanced budget at the national level, it is at most a second order rule to give way if it impedes the achievement of broader economic objectives.

"In fact the public sector balance has an entirely different function: that of offsetting gross disequilibria in the national and international economy. If attempted savings exceed investment opportunities, public sector deficits are needed for as long as necessary to fill the gap - a job which will otherwise be done by stagnation and unemployment. When economic recovery has reached a certain stage, the time may come to roll back public sector borrowing. But we have certainly not reached that stage yet and it is far too early to rule out a second or even third leg of the recession."

He points out that the national debt has been far higher in the recent past and it came down without dramatic upheaval. (Well, 1956 when debt was 150% of GDP seems recent to me.) In the aftermath of the Napoleonic wars and WWII debt was approaching 200% of GDP.

"Of one thing I am sure. If we had the misfortune to engage in a major war we would have far higher deficits and debts than anything now in prospect, and few except some pacifists would worry. Why should it be more alarming for governments to get into debt to put people into useful work satisfying human needs, than to borrow for guns and tanks whose only aim is to kill other human beings?"

Who is pushing this good old Keynesian line? Samuel Brittan, not someone I ever expected to agree with.

22 September 2009

Economic Churnalism

The BBC reports:
The pound has fallen to its lowest level since April against the euro after a warning that UK public debt levels may not be sustainable.

Except, it didn't happen. The pound has fallen against the euro, but the warning about debt levels didn't happen. This is the "warning" as it appears on the BBC News website:

"In its quarterly bulletin, the Bank of England noted that the UK had run current account deficits for more than a decade - sustainable as long as the deficit was offset by foreign investors' purchases of UK financial assets.

" 'But the financial crisis may have led overseas investors to reassess their willingness or ability to purchase sterling assets and thereby finance the UK trade deficit,' the Bank of England said."

So the warning is about financing the trade deficit, not the government deficit and not the accumulated government debt.

There is a link between government deficit and the trade deficit. Government debt, in the form of gilt edged bonds, is one type of "sterling asset" foreign investors can buy. So too are corporate bonds, commercial paper, shares, property and currency.

Government debt is the "story du jour", and linking the fall in the value of the pound to public debt makes for a better article, according to the values of modern churnalism. By trying to fit the real news (a fall in sterling) to the popular narrative (frightening levels of public debt) the BBC has gone off the rails.

Actually, it gets worse if you read the Bank of England bulletin from which the quote is taken. Chapter 3 is a study looking at the causes of recent changes in the exchange rate. The attractiveness of sterling assets to foreign investors is only one of a number of factors which the study says affect the exchange rate. It concludes: "there is substantial uncertainty about the precise role of each factor"

Finally, I am not sure that sterling has fallen. It seems to me that the euro has risen; it is up against the dollar as well. Fog in the channel; continent cut off.

16 September 2009

SproutWatch - September

The recession may be coming to a close but the economic crisis goes on.

There have been reports of real green shoots over the last few weeks. A number of leading indicators have not just ticked up but risen above the threshold signalling renewed growth ahead. Indeed one of my sprouts has turned green; and not the one I was expecting.

A reminder - I am watching three numbers which relate to three aspects of the economic crisis and using traffic lights to show when we get to "go".

Banking Crisis: I measure this crisis using the spread between the policy rate and the LIBOR, which is down to 10pb, giving our first green light. This doesn't mean that the banking crisis is over only that it has improved immensely with interbank lending taking place on near normal conditions.

Debt/Demand Crisis: The Economist poll of polls forecast for 2010 has increased to 1.1% GDP growth. Despite all the talk of growth resuming in the third quarter of this year, the majority view is that next year will see a growth rate well below trend and certainly too low to stop unemployment from continuing to rise.

Trade Crisis: The deficit/surplus of the big four still averages 5.5% of GDP. Getting better but way too high.

Are we on the raod to recovery? I think not yet. The economy in Britain and elsewhere has had a boost from the fiscal packages enacted around the world. Sadly, there remain big imbalances in the economy which need to be worked out before recovery is assured:
  • The finance sector has yet to reform itself or be reformed.
  • Stimulus packages begin to run out, from January in case of the UK.
  • Trade imbalances remain.
  • Houses and shares are seriously overpriced.
I doubt that we are close to the end; more likely we are just taking a break on the way down.