Alasdair Macleod – 21 February 2010
Last week the UK saw the publication of three letters from economists. The Sunday Times carried a letter signed by twenty economists, who claimed the UK Government needed to accelerate the pace of public expenditure cuts. The economic establishment swung into action and the Financial Times reflecting its pink colour, on Thursday carried a letter from sixty Keynesians pointing to the economic disasters that would ensue from premature spending cuts, and a further letter from another group of nine economists arguing that government spending should be maintained because strong growth will certainly ensue. To contrarians, this is not as risible as 364 economists telling Geoffrey Howe in 1981 he was wrong, but the majority advice amounts to the same thing. Amazingly, Lord Peston (the father of the journalist Robert) signed both the 1981 letter and one of the FT letters, proof if any were needed of the inability of Keynesians to learn from experience. Twenty nine years ago the government had an economic policy; today it has no real economic policy for economists to tilt at, since most of them agree with it.
Today’s problem can be reduced to a simple statement: since adopting the economics of Keynes and the monetarists, governments in the West have pursued policies of wealth destruction. Socialists support this because they believe in the redistribution of wealth, but very little wealth is actually redistributed. The redistribution that happens is done very inefficiently, and those that think they are net beneficiaries forget that their savings are being raided through inflation, leaving as net gainers only those living on welfare with no savings .
Wealth destruction has been a continual process, with less wealth to destroy tomorrow than there was available yesterday. This truth is obscured by the printing of money and credit, which creates an illusion of wealth replacement: we borrow money to buy houses that rise in price so we can borrow more to finance our lifestyles. This is not wealth creation, because it is at the cost of loss of purchasing power of money and from a hidden inflation tax on everyone’s money savings.
A litany of economic destruction must also include the misdirection of investment, which occurs in two basic forms. There is the obvious one when government requisitions the electorate’s savings to cover the budget deficit and to spend on political priorities, savings that alternatively would be put to better use in the private sector. Less obvious are the investment distortions arising from inflation. In an inflationary environment savings are misdirected to speculation, from financing future production . People no longer look for interest or a yield to give a positive return and to compensate for risk; they look instead for capital gains to beat inflation and cover their borrowings to finance their dreams.
The distortions that have built up from Keynesian and monetarist policies are at the point where they are now overwhelming the economy. The levers and tools of these theories are having little or no effect when applied. Record breaking quantitative easing is not putting Humpty together again, and Keynesian-inspired deficits in excess of 12% of GDP are failing to rescue the economy. Worse, the funding of these deficits is monopolising any savings that exist, leaving none for the private sector to develop the products and services of the future. Furthermore, interest rates held close to zero discourages any saving[i], and there are now insufficient domestic savings available to finance government deficits. The situation in the UK has become so bad that over the last year the entire UK budget deficit had to be financed by printing money. There were no buyers of gilts on a net basis other than the Bank of England.
The letter-writing economists are right to be worried, if indeed they are, but they are like quack doctors arguing over a dying patient. If the supposed stimuli of excessive government spending and monetary inflation are withdrawn, a slump will immediately occur. What they don’t understand is that the slump has to happen: it cannot be stopped, nor is stopping it desirable because it is a necessary cleansing process, washing out the credit excesses built up over the decades from the distortions created by the application of quack economic theories. This is happening in all developed economies at the same time. Alles ist kaput: credit deflating, savings collapsing, government borrowing out of control; it all adds up eventually to print, print, print.
The tenuous basis of the economists’ argument is a hope that economic recovery will occur from this year, closing the budget gap. It is the last throw of the dice; recovery is failing and the probability is that deficits will continue to rise from 10%+ of GDP for the reasons stated above. And governments collectively need so much in the way of savings from their respective private sectors they will destroy the very consumption they are trying to encourage.
When the depredations of the state become too great to bear, a sovereign state is insolvent. Now that we are at that point, the market will force higher interest rates upon the central banks of the profligate nations, a process that began last week with poor US bond auctions. The Fed had to raise the discount rate to steady the market. It is acutely aware of the diminishing pool of savings, which cannot finance $1.5 trillion deficits any more, particularly when the largest foreign holder, China, is selling Treasuries. A shortage of savings of this magnitude can only be resolved through dramatically higher interest rates, andiIt is not just the Fed facing this difficulty.
We may criticise or even laugh at Greece and their corrupt government with its shady dealing, but do not forget that the UK has a further 10% of its outstanding debt concealed in off-balance sheet PFI deals. The Italians have even resorted to securitising the future proceeds of their state lottery, and Spanish local authorities are collapsing under unpaid bills, a hidden burden on central government finances. All governments under-provide for future welfare commitments.
There comes a point when governments that behave like this lose the compliance of the markets, and so lose their power to dictate interest rates. It happened in the UK in the 1970s on several occasions when interest rates had to be jacked up dramatically to sell gilts, and it happened in September 1992 when sterling was ejected from the Exchange Rate Mechanism. There is an increasing possibility markets will jack up rates against profligate governments in an international bond buyers strike. An investment in Treasuries or gilts, for example brings with it a lot of risk, and the risk increases as the recovery is deferred and the funding gap is printed. Surely, that risk will be recognised, as will the passing of the point where we have no option but to print, print, print.
There is no escape from the Grand Reconciliation the economists are desperate to avoid, and in their souls some of them know it. Except presumably, Lord Peston and his like, who seem incapable of letting the real world interfere with cherished theory.