Forecasting myopia

The consensus opinion among investment managers, strategists and economists is that economic recovery may be disappointing, but that it will occur, perhaps more slowly than originally hoped.  These professionals adhere to Keynesian and/or monetarist theories, so they have been taught to believe the economic medicine being meted out will eventually work. So an alternative approach is called for if this elite is to be made aware of an impending economic crunch, not drawing overly on contentious economic arguments but more on political realities.

Electorates generally believe that governments are a continuing source of welfare, which will guarantee their education, health, pensions and protection from hard times. Governments have fostered this belief. Both parties believe that government has the money, or at least can obtain the money from the rich and from profitable businesses, particularly the banks, to discharge these functions. After all this is the commonly accepted objective of a civilised modern society. And the majority of people assume they are net beneficiaries of the welfare state, the value of the benefits being greater than the taxes they pay.

Besides miscalculation and omitting many indirect taxes in this assessment, people rarely take into account the invisible tax on their savings through inflation. They are only aware of it through the general disincentive to save, and have naturally responded by reducing their savings to a minus figure (by going into debt) or at best to a level insufficient to provide themselves with financial security without assistance from the state.

The escape from this problem is to believe the state will provide. The state reinforces this belief through the actual implementation of welfare, because to qualify for it there is usually some form of means test. The effect is to further discourage savings, because people with savings are denied access to many state benefits. This has led to the widespread understanding that you are better off relying on the state for your health and old age.

This is dangerously wrong. Governments do not have the resources to pay for welfare. But what government really has is ultimate power over its citizens.

Governments exercise this power to obtain revenue in the form of taxes.  Over time, they require increasing amounts from taxpayers, since the possession of ultimate power always leads to an increase in its use. Governments justify this expansion of its power as being in the public interest. It makes a virtue of its self-appointed tasks. These tasks, whether they are defending territory and trade or expanding welfare for deserving cases, increase government spending further to the point where simple taxation becomes insufficient.

At this point there arises a growing disconnection between the objectives of government and the interests of its people. This is overcome in a number of ways: government uses propaganda to make its objectives appear to serve the electorate’s interests, it withholds information, it misleads, it penalises wealthy minorities and it relies on inflation.

This situation can continue for some time with little apparent harm.  However governments today have a major problem.  Having convinced their electorates that they are entitled to all those welfare benefits, the cost is now too great to be borne out of taxation or from penalties on minorities. The UK government has become aware of this problem, while it seems the US government has not.

The dilemma for the UK is that there is not much the government can do to bridge the gap between reality and the electorate’s commitment to welfare. It is too late to persuade the electorate that the direction of welfare has to be reversed by cutting education, health, unemployment benefits and state pensions: these are now accepted as the people’s rights, and in recognition, all politicians agree that welfare should be protected while somehow needless bureaucracy is cut. Only this week in the UK, a proposal to cut school milk for children under five, a questionable benefit, was countermanded by Downing Street. There is no attempt to tell the truth and every attempt to duck it: that government does not itself have and cannot raise the money.

The problem for the US is if anything worse. The newly elected president is still trying to expand his way out of trouble. The Federal Government is actively increasing its role as welfare provider, putting further distance between the actuality and the welfare expectations of the electorate.

So, to summarise the position, both these governments have a disconnection between what they can do and what their citizens believe they can provide. Neither government is able to correct this misconception. In this respect, both economies are now destabilised, there being no politically acceptable retreat from this position.

It is commonly agreed that a government’s most likely weapon when facing these difficulties is further monetary inflation. Keynesians and monetarists are even recommending it for other reasons.  The attraction of monetary inflation as a policy tool is simple: the public does not understand it. Furthermore, politicians have delegated control of money to the central banks, so they do not have to understand it either. As a stealth tax it is perfect.

Whichever way one looks at it, the outcome is simple. If governments cannot address the expectations of their electorates, they will have to continue to fund the disconnection between them. The relationship has moved from stability to instability, and accelerating monetary inflation is now the only significant source of funds. But this becomes self-defeating since monetary inflation will eventually increase the cost of welfare further through the inevitable price inflation.

The idea that this accelerating trend can be avoided or somehow replaced with increasing amounts of government debt is defeated by simple arithmetic and political reality.  The day-to-day economic problems that have occupied most of our waking thoughts are only a part of the crisis facing us. Implementing supposed remedies for the economy without a grasp of the wider problem leads to a severe myopia.

So we must treat the optimistic forecasts of conventional economists, investment strategists and fund managers with scepticism. And they should at least have the honesty, after reflecting, to not mislead us all with their unfounded optimism.

10 August 2010

 

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