Intellectual Vacuum Persists Within UK Economic Policy

Northern Rock, the mismanaged bank, collapsed in 2007. Early in 2008 the global banking sector started to creak on its foundations before reaching near implosion in September 2008. Enough time has passed, you would think, for the UK regulatory bodies to have replaced the risk management by “box-ticking” process with something more robust. Wrong.

100 weeks have passed since it was blindingly obvious that a total over-haul of financial regulation was required and the latest government sponsored report, from the Treasury Select Committee, has described the current supervisory framework as a “muddle”. The committee also suggested that the measures to date were “merely re-branding” and that there remains a void of ownership in “strategic decisions and executive action”. They are not referring to the old system. They are describing the current structure.

Britain wasn’t always a 2nd class nation in terms of financial and economic leadership. 80 years ago we were lucky enough to have possibly the most gifted economist that ever lived, John Maynard Keynes, to advise the government on economic and financial matters.

United States of Goldman Sachs, One Dollar One Vote

Democracy is the system of one person one vote. Business is one dollar one vote. It would take a vivid imagination to think that the perfect scenario for a business; securing abnormal profits or a monopoly, is appropriate in a fair and democratic society. Likewise, the managers and shareholders of corporations need to be offered a reward for their time, skills and investment otherwise there would be no motivation to take risks or to employ workers. A fair equilibrium is the logical aim.

But the two, democracy and business, co-exist uncomfortably as there is a finite amount of wealth in the economy and that wealth needs to be shared equitably between two of the three participants in any economy: individuals, (workers, consumers and taxpayers) and businesses. The third participant is the government which should not pursue wealth or power for its own benefit but should act as the moderator and facilitator creating a scenario which allows the two other parties to prosper fairly, in correct proportion and in line with the law. To achieve this fair scenario key governmental decision makers should not have personal interests more aligned with one group, business, than the other, society.

In periods of economic growth when both the individual and corporations as a whole prosper the division of wealth between the two is naturally a concern. But those concerns are magnified significantly when the economic pool of wealth is contracting. In a recession tensions between the individual (the ‘man on the street’) and companies increase as corporations lay off staff to protect the interests of the firm’s owners. Tensions rise further when certain companies or industries receiving preferential treatment at the expense of industries with less political influence or the collective society.

The onus is on the government to ensure fair allocation of stimulus and support so that both individuals and companies exit the recession together, as far as that is possible. But if the country is still struggling to recover, unemployment is rising and the average individual is still suffering whilst certain corporations are already, again, enjoying abnormal profits then the division of wealth and the legislation that created that scenario is flawed. Also, corporate earnings can only grow quicker than GDP growth if the finite wealth of society is being re-allocated from the individual to corporations.

The past 25 years has seen the economic balance of power shift too far from the fair equilibrium. The few are benefiting at the expense of the many. Goldman Sachs is a beneficiary. Wall Street as a whole is another beneficiary. Main St has suffered. But the individual, the workers, the micro-engines of the economy have suffered most. Unfortunately, one dollar one vote is more popular than ever in Washington.

GS to 29th July 2009

Welcome Back John Maynard Keynes

An understanding of economics is greatly enhanced by the study of great economists, men who formed original and ground-breaking theories regarding economic management, foreign exchange mechanisms and monetary and fiscal policy.

If Adam Smith was the founder of economic theory as we understand it today (The Wealth of Nations, 1776) then John Maynard Keynes was the father of modern monetary and fiscal policy. His brilliance, soon to be obvious, went largely unnoticed in his formative years of study and examination. “The examiners presumably knew less than I did”, he famously remarked.

Later, in the years between the two great wars, his work focused on developing theories better able to achieve full employment – in response to the deflation and poverty caused by the global depression. His work relating to interest rate controls and government led stimulus, obvious and accepted now as a cure for recessions, were at the time revolutionary, misunderstood and unproven.

Morally robust, he resigned in protest against the First World War reparations policy, a thorn in the side of Europe for 20 years and a key grievance which led to the rise of militarism across Europe, and the Second World War.

In 1943 Keynes was fundamental to the original proposal for an international monetary authority. In 1944 he led the British delegation in the Bretton Woods Agreement. Late in 1945 he was accredited with almost single-handedly negotiating the American Loan Agreement which helped rebuild Britain, bankrupt in all but name, following six years of war.

The stress and burden of the US loan negotiations contributed to the demise of his health. Americans found Keynes to be “irritatingly brilliant”. But the war, Britain’s earlier guarantee for financial help, was already over. Military cooperation had been replaced with a new economic order. Keynes secured a loan for $3.75bn agreed at a 2% rate of interest. Any other man would have returned to the UK empty-handed. The final loan repayments were made 61 years later by Tony Blair’s government.

Keynes remains famous for his theories tackling monetary deflation and trade depression. His policies embraced the economy as a whole. His understanding of the relationships between money supply, fiscal intervention, investment and job creation were unrivalled. His suggestion that increased economic activity could be best achieved via centralised intervention and sponsorship of capital projects was proved successful during the 1930’s.

During the process of financial market de-regulation from the 1980’s to 2007 the policies of John Maynard Keynes were increasingly viewed as out-dated, too interventionist. Economists cited the modern free market economy to be self-controlling, self-moderating and a capitalistic self-fulfilling prophecy of wealth creation. The past year has seen a return to centralised intervention, all-encompassing economic policies and a return to the theories that were first realised by Keynes 75 years ago.

Born on 5th June 1883, a student of Eton and Cambridge, a renowned teacher committed to helping others learn and a reputation for speed of mind that few could cope with, Keynes’ theories again form the bed-rock of solutions used to resolve recessions and stimulate economic growth.

UK: Up Debt Creek Without a Paddle

Government debt always increases sharply in recessions. Falling tax revenues, a function of lower corporate profitability and weaker receipts from a shrinking workforce are combined with the fiscal burden of higher benefit payments to the growing numbers of unemployed. No one expects government debt to fall in such a scenario but today’s news that June’s government borrowing, at £13bn, was the largest 3rd fiscal month increase ever has reinforced the concerns that UK PLC is sinking into a unsustainable debt spiral that the government has to tackle urgently.

National debt as a percentage of annual GDP is now at 57%. Even optimistic forecasts suggest this burden will increase to 77% by 2013. Pessimistic predictions quote government debt will rise to 100% of annual output. That figure would put the UK in an awful mess and it’s not debt burden that can be re-paid in one year, or even in one economic cycle. It’s a level of debt that could take decades to clear. Add into the equation the next inevitable recession; length, cost and depth yet unknown, and the picture could get very grim indeed.

So tax rises are inevitable, even if the current government are doing their best to avoid the subject. Value Added Tax will be a likely tool. Reduced funding for councils, forcing local authorities to help relieve pressure on central government expenditure is also a certainty. They may as well just call the next extortionate council tax increase a “local income tax”. It will feel like it and that’s what it is. Petrol, alcohol and tobacco will also suffer tax rises ahead of inflation, motives hidden behind health and environmental arguments.

Income tax thresholds will be tweaked to squeeze marginal tax payers into the neighbouring unfavourable band and no-doubt the tax-system as a whole will be complicated further so that the average consumer has no idea whatsoever of their total direct and indirect tax burden. These measures are near certain.

But in all probability the government will just give up the façade and increase the basic rate of income tax as well. Such a move is political suicide before an election so expect it to be introduced just after the 2010 election and reduced back to the status quo just in time for the following 2014/15 vote. Also, sure as night follows day, expect an announcement increasing the retirement age from 65, by-passing 67, straight to 70. I can hear the longevity and anti-age discrimination sound bites already.

In the very short term rating agencies will dissect the new borrowing data. Sterling will come under renewed pressure as a growing consensus realises the current government is putting off unpopular but obviously necessary decisions, preferring to persist with the current ostrich-head-in-sand fiscal policy in an effort to stem the collapse in their popularity this side of next year’s election. The country is still going to recover from the current global recession, that is evident, but the next two decades will be grim indeed relative to the boom years of 1997 to 2007.

US Government Bonds – A Legalized Ponzi Scheme

The current coupon on 30 year Treasuries is 4.25%. The yield until redemption is 4.32%. Source: Bloomberg and CNN Money. Since 1967 the average annual US rate of inflation, measured by the urban consumer price index has been more than 4.50% Source: Bureau of Labor Statistics. If you strip out the fairly unattractive income and just focus on a $10,000 30 year bond investment the real purchasing power of that $10,000 subscription in 30 years time, if we continue to suffer the same long term CPI rate of circa 4.50%, is $2,512. Unattractive? I think so.

Let’s also look at the shape of the US budget deficit and the ongoing borrowing requirement. This year the US government has borrowed more through new bond issuance than it has paid off. This is not an unusual occurance. It has happened more often than not over the past decade. That’s why the US government owes trillions of dollars. The current US recession and bank bail-outs have further ruined the US balance sheet moving it deeper into debt.

If you use the capital from today’s new buyers to meet your redemption obligations that is a receipe for diasaster isn’t it? It’s unsustainable. It sounds uncomfortably like a Ponzi scheme. Ponzi schemes collapse when the buyers dry up and the sellers come calling in volume.

Chart: 30 Year US Treasury Bond Prices.

30 Year US Tres Weekly Chart to 5th July 2009

Prior to the release of the BoE financial stability report (summarised below), Mervyn King the Bank of England Governor, suggested he had not yet received a copy of an unrelated and imminent government sponsored White Paper discussing changes to the current banking sector supervisory framework. An extraordinary statement considering the BoE is responsible for stability with the banking industry. An unnamed government bureaucrat privy to the White Paper publication defended the government’s corner and responded stating the Chancellor, Alistair Darling, had discussed the proposals with King less than a week ago. Children, please.

Government sourced inflation data is often close to worthless. For example the basket of goods they use here, in the UK, includes items that the average family can’t afford in a recession. The real basket of goods for lower-middle and working class families is much more exposed to food and energy costs than the official government basket suggests. It doesn’t matter if iPods, DVDs, vacations and new cars are falling in price when food, oil, electricity, etc are rising (as they have for most of the past 2-3 years). Families can’t afford the former luxuries and have to buy the latter necessities. Add into the equation stalled personal earnings growth and in this recession you have a much higher real inflation rate for most people than the official government data suggests. Unfortunately the central bank and governmental bureaucrats can’t empathise with real people from their 2nd home in the Hamptons (or Tuscany for Euro-zone box-tickers).

I’ll give you another example of how out-of-touch the bureaucrats are in the UK. The government is giving a £2,000 cash grant for new car purchases if the buyer part-exchanges their old, less fuel efficient car. Well you still need to put down say £13,000 to secure the average new family car. So the middle class and wealthy who have £13,000 or more sloshing around their bank account get a nice discount to buy a car. If someone doesn’t have £13,000 spare to buy a new car, (and I humbly suggest consumers like that need the help more), you get nothing. It’s redistribution of tax-payers money from the poor to those rich enough to buy new cars. Madness.