Why a Hung Parliament Might Savage the Economy

November 30th, 2009 by The Parallax Brief

Benedict Brogan, on his blog on the Telegraph’s website, today highlights a point that was lost when the political hacks and talkingheads released a week or so ago their flurry of opinion editorials about the potential consequences of a hung parliament.

“Morgan Stanley Research Europe has just put out a note assessing the UK’s future prospects, and its findings are a timely addition to the hung parliament debate…”UK becomes the first of the G10 to have a major fiscal crisis as elections lead to a hung parliament. The context is an ugly fiscal picture, relatively weak economic recovery, aggressive monetary stimulus and political uncertainty”"

The easiest way to think about this point is to consider the criteria for loaning money to someone. Whether or not you loan a person money, and the interest you want for doing so, is based on your view of that person’s likelihood of paying that money back. The more likely you think it is that they will be able to pay your money back, the less interest you would want to loan them money, because the risk of not getting back the money would be reduced.

The bond market is the same. When investors buy government bonds, they set the interest rate, or yield, the government pays on those bonds. This rate is essentially a function of what the investor thinks inflation will be (because as inflation increases the investor needs a higher interest rate on the bond to cover the portion of the investment eaten by that inflation), and his view on how able the government will be to pay that money back, known as “default risk” in the trade.

Right now, the UK has high — but not catastrophically high — debt that’s fast rising because tax receipts have fallen in the face of the crisis while obligations have remained the same, or, in some cases like social security, risen. One might imagine that this would push interest rates up. But as things stand, the interest rates on government bonds in the UK are still low. Some might argue this has something to do with the Bank of England’s quantitative easing program, and there are certainly several, complex reasons for this, but it’s essentially because the UK still has enough of what’s known as “fiscal credibility”: in layman’s terms, the bond market still believes that Britain can, one way or the other, pay back it’s debt.

Paying back all that debt, though, won’t be pleasant. It will involve either tax hikes or painful public spending cuts, and more than likely both at the same time. In short, it will involve actions which will be both unpopular with the electorate and difficult to pass through parliament.

If the Conservatives are elected with a thin majority, or even take control of a minority government, how easy will it be for them to ram through an unpopular budget? Will the right of their own party let them raise taxes? Will the other parties vote for the harsh spending cuts required to get the fiscal house in order?

The bond market will have to assume that Britain’s fiscal credibility had been reduced. Wouldn’t you if it was your money?

The consequences?

The morning after an election had produced a hung parliament, the yield on British bonds would immediately increase — possibly precariously. The pound would fall, likely passing 30-year lows against the Yen, Dollar, and Swiss Franc, as well as all time lows against the Euro. The cost of borring for private businesses would jump immediately. Raising equity for larger businesses would be more difficult, as fewer investors would want to hold assets in pounds. The cost of Government borrowing would also increase, making it more difficult to continue financing the deficit, and making fiscal help for the economy ever more difficult.

The best we could hope for is that any hope of rapid recovery would be nipped in the bud, and a long, turgid slog back — something like the economic stagnation in the late 70s and early 80s — would take its place.

The worst case scenario, albeit a not particularly likely one at this stage, would be an Iceland style monetary crisis in the absence of a quick (and implausibly magnanimous) commitment from all parties to take tough steps and vote for a cross-party budget. Indeed, the effect of this type of hung parliament scenario may well be a some kind of government of national unity to get through the Commons a budget that could stave off a fiscal crisis.

Of course, this isn’t so very likely, but it’s not inconceivable. And it is through this lens that one should view the Labour Party’s decision to increase the top rate of income tax to 50p in the pound. The Parallax Brief believes that this was not to soak the rich in a pique of partisan policy making, but an effort to show the bond market that Britain, and the Labour Party, had the iron will needed to push through unpopular and politically difficult policies to get the country’s fiscal house in order.

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Comrade Portillo: Spending Cuts “Impossible”; Tories Should Raise Taxes

November 23rd, 2009 by The Parallax Brief

Peter Hoskin on the Spectator’s Coffee House blog has an interesting take from Michael Portillo, who the Parallax Brief last remembers in Government as the uber-Thatcherite Dark Prince of the Right.

Ever the contrarian, Michael Portillo makes a case that you don’t hear from many on the right in his interview with Andrew Neil on Straight Talk this weekend. George Osborne has given “a fair amout of detail” about the Tories’ debt-reduction plans, he says, but that could be the wrong approach:

“I wouldn’t seek probably to give very much more detail …. You know, I was with Margaret Thatcher when she came in to Government in 1979, we faced a big public spending problem. It was terrible. It was a hard slog but she didn’t cut public spending. I was Chief Secretary between ’92 and ’94 – big public spending problem – I was trying to cut public spending; I did not succeed in cutting public spending. I don’t think the Tories will succeed in cutting public spending. Now this is what they won’t want to tell you. The reason they’re not telling you the cuts is that I think the cuts are almost impossible to make and what will happen, whoever wins the next election, is not so much that there’ll be public spending cuts, there will be restraint, but that there will be tax rises.”

The Parallax Brief has argued for a long time that the Right are going to be sorely disappointed if they think that an incoming Conservative government will be able to stabilize Britain’s desperate and exigent public finances through spending cuts alone. But he also believes, as does the Spectator, that the scale of the problem suggests that tax hikes alone cannot solve the problem either — public expenditure will have to be cut after the economy starts to right itself.

It’s interesting to see key figures on the right, such as the Spectator and Portillo, now supporting this view. The Parallax Brief wonders if they are paving the way for a more gentle approach to spending from the Conservative Party than many on the Right had hoped, and in the media had assumed?

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Blanchflower Favours Higher Inflation

October 21st, 2009 by The Parallax Brief

David Blanchflower, the professor of economics at Dartmouth College, New Hampshire and former (outspoken) member of the Bank of England’s Monetary Policy Committee (MPC), has drawn the ire of the right for a New Statesmen article in which he argues that inflation might be the spoon full of sugar that helps the medicine go down for the British economy.

“Moderate inflation would lift people out of negative housing equity. A few years of inflation of roughly 5 per cent or so would be very attractive right now. Maintain the monetary stimulus and if necessary expand it further for the foreseeable future, and keep the fiscal stimulus going. Too much is better than too little. And, for goodness’ sake, don’t start paying back the public debt until we are well out of recession.”

This passage so infuriated the highly respected (and, the Parallax Brief admits, usually superb) blog on the libertarian Adam Smith Institute that it was posted with no analysis — as if its content was self evidently outlandish — under the headline, “Blanchflower Blather”.

The Parallax Brief often disagrees with libertarian views but can at least understand them. On this matter, however, he’s at a loss. What exactly is so bad about inflation?

The main objections tend to be that it discourages investment; that it is a tax on the poor as prices on essentials rise, eating into ever larger chunks of their wages; that it destroys wealth; and that it tends to self-reinforce — the argument that once the pandora’s box of inflation has been opened, it proves increasingly difficult, and economically ever more painful, the tackle its evils.

But these issues don’t particularly apply to the level of inflation Blanchflower is proposing, or at least shouldn’t be of concern now.

First, it is true that in the economic Somme that was the stagflation of the late seventies and early eighties, inflation shackled the economy. But inflation was running well into double figures, and, as Blanchflower points out, at levels like 5%, it wouldn’t be too difficult for investors and savers to inflation-proof themselves.

And besides, given the subsequent successes of both Fed Chief Paul Volker’s and the Margaret Thatcher government’s inflation-targeting monetarist formulae for setting interest rates, it seems reasonable to assume that the MPC would have the tools now to target inflation at 5% with little concern that it would lose control.

Second, and more important, deflation is a far larger concern. Deflation increases the real burden of wealth — something that would be disastrous given current levels of debt in the UK — while providing powerful incentives for consumers to hold off on purchases — why would you buy now when it’ll be cheaper next month? — adding a further drag on economic performance. Japan’s lost decade went missing as a result of deflation. The privations of the Great Depression were brought forth by massive debt-deflation.

Given deflation is clearly the far greater evil, and remains a clear and present danger in the current environment, hand-wringing about the dangers of inflation seems rather like finding a Mars bar during a famine and fretting about getting fat.

Blanchflower is right: not only is inflation not worth worrying about, it would actually serve a useful purpose in the next several years by reducing Britain’s debt burden.

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More Mickey Mouse Economics, Please

October 20th, 2009 by The Parallax Brief

Kenneth Clark, the Shadow Business Secretary and Tory Big Beast, yesterday became the latest Conservative MP to blast away at the government’s economic policy. Clarke, according to the Guardian’s Parliament round up, ‘warned that to continue increasing public spending next year amounted to “Mickey Mouse economics”.’ Given what is expected to be lethargic recovery accompanied by high unemployment in the first half of next year, the Parallax Brief is seriously concerned for Britain’s economic prospects under a Conservative government if Ken Clarke genuinely believes that immediate cuts in spending are the prudent course of action.

Clearly, Britain’s finances are in a parlous state. No Government can go on spending more than it earns indefinitely, and ours is spending so much more than it earns that it must now borrow an eyewatering GBP493 mn every single day simply to stay afloat. Left and Right might disagree on whether the problem is best tackled through tax increases or spending cuts, but any sensible observer knows that when the recession ends there will have to be a ruthless and painful rebalancing.

When the recession ends. Because while under usual circumstances such an exploding deficit would have to be crushed remorselessly, in the current situation doing so would be calamitous.

On paper, it seems right to want to balance the budget. When the Parallax Brief’s household income is reduced, he must curb his extravagant ways. And so it stands to reason that the country should do the same. In practice, however, the economy is tumbling essentially because people all over the country are cutting back on spending all at once, and in this environment any government effort to try to balance its budget by slashing spending and raising taxes would only reinforce vicious cycle.

Many tens of thousands in the public sector would lose their jobs or have their wages cut and would therefore spend much less, which would mean private sector workers would lose their jobs as the businesses they worked for were forced to cut back. That in turn would feed back through the economy. Public works projects and spending plans would be frozen, putting suppliers out of business, worsening the situation. Meantime, on the income side, those who still had their jobs would all have less money to spend as income taxes were increased, while the money they did spend would travel less as indirect taxes like VAT were ramped up.

Make no mistake: slashing public spending right now to balance the books would make the current slump deeper, longer and harder to escape.

Conservatives would likely retort that this argument does not hold because eventually the bond market will take fright at the mountainous debt and start demanding higher interest rates to loan us money, choking off any recovery in the process.

But, like the idea that spending should be reduced to match income during a crisis, fears of the bond market’s reaction sounds convincing, but is in fact misleading. It appears to makes sense: if Britain looks like a riskier loan prospect, you’d want a higher return for lending to it. If the interest rates for gilts, the bonds Britain sells to finance deficits, increases, mortgage and loan rates will move up in lockstep, stymieing economic activity.

However, when the market judges a country’s ability to pay back its debt, it’s not really the absolute total debt that’s important but its size in relation to GDP. Think of it this way: if you were a bank manager, wouldn’t you be more willing to loan a hundred thousand pounds to a man who earns a million a year than to a man who earns twenty thousand a year? So, in fact, if the government immediately started cutting back on spending to reign in debt, the real burden of that debt would increase as GDP (the denominator) collapsed while total debt (the numerator) remained constant.

Economists call this the paradox of thrift, and it’s a phenomenon to which the Parallax Brief is certain George Osborne and Kenneth Clarke are not ignorant.

Why, then, are they choosing to ignore it? Could it be that the Conservative Party, traditionally the strongest party on economic matters, has mistaken austerity for orthodoxy in a macho effort to serve up some red meat to the faithful by showing it really is the party of public spending parsimony?

Whatever the reason, it says much for the Conservative Party that it is being outperformed on the economic debating floor by a party with a record as abject as Labour’s.

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Debt: Whose Fault is it, Anyway?

October 20th, 2009 by The Parallax Brief

The Parallax Brief has noticed recently the resurgence of the insidious and wholly egregious belief that what ‘really’ led us to the economic morass in which we currently find ourselves mired was people irresponsibly taking on too much debt. The idea that the financial crisis and subsequent recession were the fault of folk who took on debt they could never afford in order to live beyond their means has been around pretty much since the word sub-prime first entered the lexicon of economic disaster, but most recently it cropped up in an Observer piece written by Heather McGregor, an executive headhunter, to defend the bonuses paid to bankers. “What got us into this crisis,” McGregor argues, as if she were making a statement of irrefutable fact, “was over-borrowing, both personally and corporately…”

It’s easy to understand why this idea has become received wisdom throughout much of the conservative Right on both sides of the Atlantic. First, within this paradigm, the credit crunch was a kind of biblical punishment for the paucity of discipline shown by the great unwashed during the last decade — teaching a wholly justified and welcome lesson about moral hazards which befall those who succumb to consumerist gluttony. Second, it serves the purpose of getting the banks (key financial and ideological supporters) and the market (perfectly efficient and a panacea for all society’s ills) off the hook.

But being a convenient fit doesn’t make it right.

When someone applies for a mortgage or a credit card, there are essentially only two sides to the transaction. The first side is someone like you or the Parallax Brief: perhaps a primary school headmaster, or a couple who run their own bed and breakfast, or a call centre team leader, or the person sitting at the next to you in the office — but anyway, whatever their occupation or background, it’s a person who has more than likely had no training in the detailed criteria and methodology banks use to decide when to award loans to people and how much to give them if they do.

On the other side of the deal is a professional who has.

When the mortgage is finally approved or the credit card limit set, that wasn’t the decision of the layman applicant: it was the decision of the bank, the expert.

Nobody really knows if they can get a mortgage or exactly how much they’ll be approved for when they apply. Of course, we often have an idea, but that’s usually based on what has been awarded to friends whose financial situations we can compare to our own, rather than intrinsic knowledge of the banks’ methodology and rating system. Nor can the school headmaster or the B&B owner force the bank to give him them money. They can only apply then wait to see the bank’s diagnosis their ability to pay back the money.

Unequivocally, it’s the bank who decides on whether to hand out money, how much a person gets and for what, so doesn’t it seem more than a little disingenuous to defend banks by arguing that the credit crunch is our fault for taking on too much debt?

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