Oh my darling … mystery phenomenon spreads!

There is a mystery phenomenon and it appears to be spreading. The dangerous phenomenon is well understood by experts but the contagion is proving difficult to contain. Fortunately there are built-in checks and balances that will arrest the contagion … the only question is will the inflicted show any signs of life once the arrest is made. On Friday, we learned that the US government was running out of money. Overnight, the nasty syndrome has jumped across the Atlantic and the sovereign UK government is signalling that they are short. I suspect the contagion will spread more widely and inflict most sovereign governments before too long. Anyway, all I could do about it was to break into song …

Oh my darling, oh my darling,
Oh my darling Alistair
You are lost and gone forever,
Dreadful sorry, Alistair

My identification of the spread started early this morning when I read that a VAT rise to 20% could ‘choke’ economic recovery and fuel inflation, say leading retailers.

The UK Guardian reported that:

One VAT increase, on 1 January, is already certain, as the … [UK] … government reverses the cut made from 17.5% to 15% last December as an emergency measure to encourage consumer spending in the wake of the credit crunch. But retailers now fear an increase in VAT to 20% as the government seeks to plug a deficit expected to top £175bn this year.

Plugs go into holes to stop liquid flowing out. The analogy is that the government budget is like a drain which needs to be blocked. Once you understand how fiscal policy actually operates on a day-to-day basis you realise the it is a very poor analogy. Government spending and taxation receipts are flows between the government sector and the non-government sector.

A budget deficit arises when the flows into the non-government sector arising from government spending are greater than the flows from out of the non-government sector arising from taxation payments. The “drain” thus has to be open at all times and just the relative flows altered if you want the net outflow to be reduced.

And what exactly is the emergency in Britain that this tax rise is addressing?

The November data from from the UK labour force survey showed an unemployment rate of 7.8 per cent which was still rising from previous periods and 2.0 per cent up on last year. Around 490,000 less jobs are available in November than the corresponding period last year. There are now 629,000 more people unemployed compared to November 2008.

Unemployment was just below 2.5 million despite a “surge in the number of young people staying on in education to avoid the dole”. So the labour force exits serve to suppress the true rise in official unemployment.

Further, unfilled vacancies are not rising and there are almost 1 million people “working part-time because they can’t find a full-time job”. The November quarter recorded a “further large fall in the number of under-25s in work, with the unemployment rate for 18-24 year olds now at a record high.”

All that sounds like an emergency. But it is a real crisis and not one that engenders any financial crisis for the national government.

My economics training tells me that anything that reduces aggregate demand in this environment will further damage employment. If people have less purchasing power then employment falls. Increasing taxation, specifically, will reduce aggregate demand.

Are these characters serious?

The Guardian continued:

For the Treasury, the cash that would be raised is a compelling argument for a 20% rate: the increase would bring in some £12bn – the same as 3p on income tax and it would be an annual boost, rather than a one-off benefit.

What does the British Treasury want extra cash for when it issues the currency under monopoly conditions. The British government should be wanting the non-government spending to have more purchasing power at present not less.

One commentator from the retail industry said:

We understand politicians have got to adopt a credible plan to deal with the deficit, and that is likely to mean an increase in taxes. But significantly hiking VAT would damage demand, stifle recovery … undermine consumer confidence and be a big upward pressure on inflation.

So the deficit has to be cut. Any way you do that will damage demand. But then anything that damages demand will stifle recovery by undermining consumer confidence and … this commentator wants to throw everything into the melting pot … then you get “big upward pressure on inflation”.

It is enough to make one give up being an economist and instead turning to becoming a Saggar maker’s bottom knocker, except I am probably too old. Perhaps they might have a training program for older workers.

First, a VAT increase does not constitute inflation, which is a continuous increase in the price level. A once-off price rise does not constitute inflation.

Second, it is clear that you cannot cut the deficit without undermining demand unless you have some perverted model that says cutting public net spending stimulates private spending – which in this case would be saying – increasing the price of consumer goods is welcomed by consumers and they buy more. This is not plausible under any reasonable set of assumptions.

But, if that reasoning is hard enough to fathom then try this statement reported by Guardian to have been made by the boss of a big department store who said he:

… would not rule … [another increase] … out … {because the UK is] … skint as a country …

There you have it. The business sector thinks Britain has run out of money. If that is so, where will the extra taxes come from anyway?

But what does the British Government think?

After that article I read of Chancellor Alistair Darling’s £40bn cut in public spending. So it is not just a tax hike the British government is considering but deep spending cuts as well.

The Times article said:

Alistair Darling will this week tell government departments that the money has run out and they face a three-year cash freeze on spending. The message, the toughest to be delivered by a chancellor since the last Labour government was bailed out by the International Monetary Fund in the 1970s, will mean public sector pay freezes and big job cuts. The cash freeze in Whitehall will mean a “real” cut of nearly £40 billion in spending over three years.

So the Department store manager was right … not only is the country skint but the British Government itself has run out of money. Which led me to immediately ask the question … why plug a hole that is not going to leak any more if the flow has run out?

I am sorry to be flippant about this clear issue. The British government has run out of money. That is serious. Especially when it is a sovereign government which issues its own currency under monopoly conditions – which means it should never run out of that currency.

So there is something mysterious going on. How could it run out of money I thought? Perhaps all electronic cables between the government and non-government sector might have been cut so that the Government keyboard operators couldn’t credit bank accounts any more.

I hadn’t read anything about that in the papers. So perhaps, there has been a terrorist attack on the cables and the Government is keeping it quiet to avoid scaring the population.

Then again perhaps all the keyboard operators have quit. But then why wouldn’t they just post cheques directly to the non-government sector. Perhaps they have run out of paper to print the cheques on?

More likely I thought as my mind was racing with ideas on how the British government had run out of money … they had run out of stamps to put on the envelopes that they were going to place the cheques in and the post office had already shut down for the weekend. That must be it.

So on Monday, things will be fine again. They will order some new cables and hire some new keyboard operators and in the meantime they will buy some stamps and start posting out cheques again.

See, things will be fine over there after all. I might let President Obama know that since I read his plaintiff plea that the US Government was running out of money I have been considering sources of their plight – cables, keyboard operators, envelopes, stamps etc. This intelligence might help them also.

A good day’s analysis – no?

I read some more of the Darling report … in between repeating the refrain

Oh my darling, oh my darling,
Oh my darling Alistair
You are lost and gone forever,
Dreadful sorry, Alistair

The Times reported that:

* Brown wants deeper cuts to ease debt fears

* Hospitals ‘must share the pain of cuts’

My medical knowledge is limited but I would assume that the patients in the hospitals are already in a bit of pain from their surgical cuts. So what is the government planning to do to make this worse?

Yes, the first of the “sub-headlines” gives the game away. The British PM wants the surgeons to make deeper cuts to ensure more patients die on the operating table which will then make it easier for the hospitals to claim the outstanding fees (debts) from their deceased estates. That sounds like a dastardly public health plan.

I am sorry, I cannot make any more sense out of these two “sub-headlines” than that. Sorry. We move on.

The Times continued:

Darling is said to believe that public sector workers will have to match the sacrifices made by private sector employees during the recession in which government jobs and pay have continued to grow.

The chancellor’s tough message comes as a new report predicts that Britain will slide alarmingly down the global league table in the coming years.

The Centre for Economics and Business Research (CEBR) says Britain, which was the world’s fourth largest economy as recently as 2005, has slipped to seventh this year behind America, China, Japan, Germany, France and Italy.

By 2015, it predicts, Britain will be outside the world’s top 10, behind Russia, Brazil, India and Canada. Slow growth and a weak pound will be responsible for the slide.

All this speculation is in the context of the Chancellor’s Pre-Budget Report which is due on December 9, 2009. The 2009 GDP forecast is expected to be -4.75 per cent (annual) (Source).

That means the UK economy has shrunk by nearly 5 per cent in 2009. This is why the labour market data summarised above is so bad. Further, there is very little business activity emerging in the UK at present.

This graph tells you something about the state of confidence in the UK economy at present. It is taken from the Bank of England’s Trends in Lending, 2009. It shows the net lending flows in £ billions from the first quarter 2006 to the third quarter 2009. There has been a dramatic decline in the provision of credit.

While the Bank of England has spent £200bn on its quantitative easing programme and still shows no signs of abandoning this mostly ineffective strategy (having extended it by £25bn in November) banks are still not lending. Only mainstream economists who do not understand how the monetary system operates would be mystified by this.

Commercial banks were always able to make loans. They were not in need of reserves. What they needed and which remain in short-supply given the trends in the data are – credit-worthy customers seeking loans at the current rates on offer. QE was never going to increase the number of these customers. The best way to stimulate lending is for the government to stimulate overall economic growth which remains negative.

From my understanding it is lucky there has not been discretionary cuts in the public sector. Why would any government in its right mind want to recess the public sector every time private spending forced unemployment to rise in the private sector?

It is not a game of “sharing the costs of recession”. The correct response of the British government should be to minimise the costs for those bearing them and that doesn’t mean you impose costs on others.

And what of this new report from the CEBR who (I don’t care to link to them) claim they are pretty smart cookies who understand the quantitative dimensions of the economy?

It is possible that Britain will shrink as much as they claim and slip down the GDP rankings. As an aside I don’t think the size of the economy is particularly important as a stand-alone measure. There is a huge debate about concepts such as Genuine Progress Indicators, for example.

But I probably agree, if the UK government allows the economy to continue shrinking then per capita incomes will fall and things will get grimmer.

So what does the CEPR say? Well the Times quotes its spokesperson as saying:

Public opinion in the UK has not yet caught up with the potential impact of this change … It means that, whether we like it or not, we are going to have to be prepared to put up with economic, political and social decisions made in other countries.

Maybe in political terms if as this character claims “Britain would find it hard to maintain a seat at top diplomatic tables” decisions will be made by others that will influence Britain.

But from an economic and social perspective, the British government is sovereign. It can reduce unemployment and stimulate domestic economic growth irrespective of what other nations think of it.

The claim is spurious and tells me about the so-called “independent” status of the CEPR rather than anything about constraints that might exist on the British government’s capacity to stimulate the economy and improve social outcomes.

The fact is that the British government has as much spending capacity as it needs to improve the outcomes for its population. All this talk about needing to cut back is ideologically-based and unfounded in terms of an understanding of the monetary system it is at the apex of.

The Times article analysed how the Government might best cut the deficit and said the Government

… have played down the prospect of a “soak the rich” budget, however. Wednesday’s statement is not expected to include any changes in capital gains tax or a new raid on pensions.

Well we couldn’t let the rich take any cuts in corporate welfare. That would be decidely unfair.

Further, why I would not vote for the current PM Gordon Brown to retain office is captured in his latest podcast where he
said the “pre-budget report would set out”:

… the further savings needed to protect our frontline services, cut the budget deficit and go for growth.

Cutting the budget deficit will damage savings because it will reduce aggregate demand and national income will fall. Savings are a funciton of GDP (national income).

Cutting the budget deficit when you have a current account deficit and the private domestic sector is desiring to increase its saving ratio will undermine growth.

The crazy thing about all this is that if they understood the relationship between aggregate demand and income adjustments then they would realise that the strategy they are outlining, given how flat private activity is in the UK at present, will likely result in higher budget deficits as activity declines further.

If they are really worried about public debt levels then they would be better advised to get the economy moving quickly so that tax revenue can outstrip the debt interest servicing component.

They must understand that. So if they do then they are making political statements to assuage the UK electorate as the national election approaches. But then they are going to have to follow through and make the cuts to maintain credibility in this “political context”.

If they do that they must be hoping the worst of the ramifications start manifesting after the election. You would then conclude that they are shameless crooks.

My bet is they are getting terrible advice and are pursuing an ideological game to look resolute. Pity the poor Brits.

Oh my darling, oh my darling,
Oh my darling Alistair
You are lost and gone forever,
Dreadful sorry, Alistair