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The truth behind Britain’s incredible shrinking economy

Images of money under a CC Licence

The latest public sector borrowing data shows that the UK budget deficit is widening once more. Indeed, despite a series of accounting adjustments which obscure the true picture, it is clear that the underlying trend is also towards rising, not falling deficits.

The Office for National Statistics reports that the June public-sector borrowing total was £14.4 billion ($22.3 billion), £500 million ($776 million) higher than in the corresponding month in 2011. However, monthly data are erratic and subject to significant revision. Taking the data for the first six months of this year as a whole is more meaningful and shows that the deficit over that period is £37.3 billion ($57.9 billion).

It is widely known that government policies have led to economic stagnation

But this total is flattered by the strange decision relating to the acquisition of the Royal Mail Pension funds ahead of planned privatization. In effect, the government has decided to include the assets of this fund, but not its much greater pension liabilities in its own accounts. This and another smaller transaction lowered government borrowing by £30.3 billion ($47 billion). The underlying deficit, excluding these transactions is therefore £67.6 billion ($105 billion) in the first six months of this year.

This compares to a deficit of £60.5 billion ($93.9 billion) the first six months of 2011. The deficit is rising, not falling.

Factors affecting borrowing

This deterioration in the deficit places British government finances in a growing band of European economies where sharp cuts in government spending are leading to economic contraction, which in turn produces widening deficits.

This should come as no surprise. As the crisis is effectively an investment strike by capital, spending cuts by government will only lead to a further decline in private investment. The reason this logic has taken some time to work through in Britain is due to a number of factors. These are primarily the zig-zag in government policy, which initially saw a very modest increase in government investment under Labour and so produced a reduction in the deficit. This was compounded by the uniquely high level of inflation during the British slump, which eroded the real value of all government spending.

Socialist Economic Bulletin has previously shown that the very moderate increase in government investment from the 2009 Budget under Labour was the catalyst for a modest economic recovery. Because of the increase in government spending (including allowing welfare payments to rise automatically as unemployment and poverty increased) the Treasury forecast that the deficit would rise to £178 billion ($276 billion) in the following financial year. In the event, the deficit began to decline and was £158 billion ($245 billion) for the financial year.

In addition, the effects of economic growth are felt on both sides of government accounts. Expenditure is lower than it would have been because more are in work and the benefits’ bill falls. Revenues are higher because incomes, profits and consumption all raise the level of tax revenues.

Spending cuts have the effect of weakening economic activity and so drive up government expenditures

It is widely known that government policies have led to economic stagnation. Yet it is only now that the deficit has started to rise. The British economy has grown by just 0.5 per cent in the two years since the Coalition came to office. But in nominal terms, before taking account of inflation, the GDP has increased by 6.1 per cent. This surge in inflation during the slump is highly unusual, placing Britain on a par with countries such as Iceland. Britain has an incredible shrinking economy when measured in international currency terms.

Domestically, this is reflected in a surge in inflation. While severely denting the purchasing power of all those on fixed or low-growth incomes, the fiscal effect was to increase nominal government revenues by £56 billion ($86.9 billion) over the last two years. This compares to annualised nominal growth in GDP of £88 billion ($136 billion).

The Treasury’s estimate is that every £1 increase in economic activity will lead to a 50p increase in government revenues. In fact the increase over the last two years has been 64p (£56 billion of revenues of £88 billion increased output). However, government current spending has also risen by £42.3 billion ($65.7 billion) over the same period. This is an inevitable consequence of the savings (i.e refusal to invest) by firms.

This points to the essential fallacy of all ‘austerity’ measures, whether from the Coalition’s frontal assault, or the slightly shallower, slower cuts favoured by current Labour policy. Even nominal growth will largely be reflected in increased government revenues. But spending cuts have the effect of weakening economic activity and so drive up government expenditures.

Even in the narrow terms of reducing the deficit, the only effective prescription is growth. The most effective means of promoting growth, as even the cautious 2009 Labour Budget shows, is for the government to increase investment.

This article first appeared on the Socialist Economic Bulletin website. Crossposted with permission of the author.

What do bond markets think of ‘austerity’?

François Hollande

Jean-Marc Ayrault under a CC Licence

The victory of François Hollande in the French Presidential contest provides a further insight into the operation of the bond markets. It is frequently argued that there can be no retreat from ‘austerity’, which in reality is simply the transfer of incomes from labour and the poor to capital and the rich, because the bond markets will recoil and long-term interest rates will soar. This is important as significantly higher long-term interest rates could, unchecked, choke off recovery.

As the new French President has made some gestures in the direction away from ‘austerity’, then it should be expected that at least French long-term interest rates would rise as a result. But French government bond yields have fallen since the Socialist victory, by 18bps (basis points, equivalent to one hundredth of a percentage point, or 0.18 per cent). Ten-year French government bond yields declined to 2.79 per cent1, lower than before the election.

‘Austerity’ in reality is simply the transfer of incomes from labour and the poor to capital and the rich

It could be argued that financial markets do not believe Hollande will carry through a genuine alternative to cuts in wages and public spending programmes. He was certainly cautious enough in his pronouncements to support that idea. Even so, he is not Sarkozy, who directly promised further cuts, and some uncertainly remains among financial market commentators about whether, or how quickly, the new President will change course. At the very least his commitment to verbal support for austerity is less than his predecessor. Clearly, the assertion that the bond markets will punish any slight step away from ‘austerity’ is incorrect.

In fact, the German powerhouse has increased economic divergence within the EU because it has not adopted itself the prescription it has insisted on for others. The latest departure from orthodoxy is the call for higher German wages from Finance Minister Schauble.2 Yet German yields also fell to 1.55 per cent and remain the lowest in the Euro Area.

Role of bond markets

It is important to distinguish between the views expressed nightly on our TV screens by ‘experts’ from the financial markets and the actions of the main bond investors, pension, insurance, sovereign wealth funds and others. The most famous ‘expert’ in the world is Bill Gross, Chief Investment Officer for one of the world’s largest bond funds, PIMCO. Previously, he very publicly announced he was selling all US government debt holdings because of quantitative easing in the US and Obama’s fiscal stimulus. He was later forced to apologize to investors and buy back US government bonds he had sold, having missed a huge rally in bond prices (which leads to lower yields).

It is necessary to explain briefly the role of bond investors. The creation of a national debt is one of the primary ways in which financial capital establishes its dominance over the rest of the economy. Debt interest is supplied by diverting income from the productive sectors of the economy. Since all value is created by labour, labour is also the ultimate source of all debt interest. This entails a transfer of income from labour to capital. In fact, given the regressive tax changes that have taken place in many industrialized countries, including Britain, labour and the poor are also the direct source of that transfer of incomes, as they supply the bulk of all tax revenues (income tax, VAT, etc.).

For any sector of capital the main motivation, its raison d’être, is the maximization of capital. Ordinarily this means the expansion of capital at the maximum sustainable rate. But in a crisis where losses are anticipated, maximization can mean simply preservation. Industrial capital is currently being hoarded via the investment strike. It is being preserved. For finance capital, specifically the portion that is allocated to government bonds, the main important indicators are, usually, growth, inflation, government deficit levels and so on. All of these are gauged in order to optimize the sustainable expansion of capital through interest payments.

The assertion that the bond markets will punish any slight step away from ‘austerity’ is incorrect

But in a crisis the focus will switch to the preservation of capital. This is why Germany, with its large external surpluses and falling budget deficits, remains the strongest borrower in the EU even while increasing investment and wages. Investors believe they are certain to get their money back. In an extreme crisis, these investors may even been willing to accept the prospect of small losses in order to preserve the bulk of their capital, and interest rates have occasionally been negative in countries like Switzerland and Japan.

The very modest changes in French government bond yields are evidence of this dominant factor. The possibility of even a very modest adjustment in the drive towards ‘austerity’ has increased the likelihood that French bond investors will be repaid, that there will be no default on French government debt. The productive sectors of the economy, which finance the debt interest, may be in a slightly stronger position to do so if they are faced with slightly fewer cuts.

Varied responses

Not all EU government bond markets rose in the wake of the French Presidential poll. Those countries where bond prices fell, so pushing up interest rates, include Greece (with its own inconclusive election), but also Ireland, Italy, Portugal and Spain. They have all adopted a programme of public spending and other cuts, with different degrees of severity.

Their policies are the opposite of the verbal gestures Hollande has made in the direction of stimulating growth. The most extreme case is Greece where 10-year yields are over 23 per cent. But in a country like Ireland, which is routinely held up as the example of successful ‘austerity’, yields on some debt have risen by 50bps in the last week alone.

In the current crisis, bond market investors are obliged to consider whether they will preserve their capital, not just how they may be able to increase it. They have already experienced final losses of a partial default in Greece. In many of the crisis-hit countries current bond prices are considerably below where they were issued.

They have been faced with a new choice of at least a verbal commitment to growth from France, and persistent ‘austerity’ in many other countries. The response has been to buy French government bonds and sell those where the governments, via the ‘Troika’ in some cases, are committed to further cuts. This is because the judgment is that the investors’ capital is more likely to be preserved via growth than through austerity.

The repeated assertion that pro-growth policies cannot be adopted because of the negative reaction of the bond markets is a false one.

  1. All yields taken from Financial Times, benchmark government bond yields, 9 May 2012
  2. ‘Schauble backs wage rises for Germans’, Financial Times, 6 May 2012

Michael Burke
This article first appeared on the Socialist Economic Bulletin website. Reproduced with permission.

EU summit is another failure for ‘austerity’

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The outcome of the EU summit has widely been hailed in the British media as a triumph for David Cameron. It is rare that a complete rupture and isolation in multi-party negotiations is regarded as a triumph – but this is a function of the dominant and still growing xenophobia of the British press.

The EU Commission will now impose further spending cuts and rules to enforce deficit limits across the whole of the EU. David Cameron did not oppose these measures because they lead to public spending cuts – he is cutting public spending by a greater proportion of GDP than any major country which has not been in receipt of EU/IMF funds for its creditors.

Cameron’s stated objective was a defence of the interests of the City of London. There is a question mark over whether he has even been able to achieve that. Angela Knight, former Tory MP and chief spokesperson for the British Bankers Association guardedly told The Times that she hoped that City’s interests would not be harmed by Britain’s isolation.

Holding back the tide

‘Let all men know how empty and powerless is the power of kings’. So said King Canute in demonstrating to sycophantic courtiers the impossibility of instructing the advancing tidewaters to retreat. But it seems that the thinking of the EU Commission has retreated behind even that of Dark Age monarchs.

It is rare that a complete rupture and isolation in multi-party negotiations is regarded as a triumph – but this is a function of the dominant and still growing xenophobia of the British press

In response to the economic, fiscal and balance of payments crises in Europe, the EU summit in Brussels agreed to issue a series of regulations – to prevent these crises being manifest at the level of government deficits. A new rule that so-called structural deficits will not exceed 0.5 per cent of GDP has been introduced. The EU Commission will be given prior oversight of the national Budgets. Given the impossibility of factually establishing the level of the structural deficit (which depends on extremely approximate estimates of potential output) then the combination is a recipe for complete control by the EU Commission – the economic geniuses who have led Greece and Ireland to disaster.

While it is impossible to precisely quantify the structural deficit, it is practically impossible to determine the level of the government deficit simply by controlling spending. This is because the deficit reflects the gap between government spending and income. Government incomes are overwhelmingly taxation revenues and these are determined by the spending of consumers and the spending of businesses (primarily investment).

To achieve the precise control over its own income, as demanded by the new agreement, the European governments would have to determine the incomes and spending of both other main sectors of the economy, consumers and businesses. And in a currency union it would also have to ensure that the overseas sector was not a significant net lender or borrower (through large trade or current account deficits/surpluses). Otherwise, if the other domestic sectors remained in broad balance, a large trade deficit could only result in a large government deficit.

This is shown in Figure 1 below. The chart shows the sectoral balances in leading EU economies and the EU as well as the change between 2006 and 2009. The chart is taken from the Financial Times and is based on OECD data.


Simple national accounting identities mean that the increased savings of one sector of the economy must be reflected in the increased deficit of another. In all cases the balances shown below, the government balance (the public sector deficit/surplus), the private sector balances (the savings/consumption of the private sector) and the overseas sector (the current account balance) sums to zero, as they must.

Within each national economy of the EU it is impossible to legislate for the deficit of the public sector without determining the savings, consumption and investment decisions of all other sectors of the economy.

It is also entirely impossible in a single currency area for all other economies to maintain government balances if one or more key countries have large current account surpluses, as is presently the case with Germany and others. Other countries must then run current account deficits and to simultaneously maintain a government balance they are faced with two unacceptable alternatives. They must either hugely increase household savings even though incomes are declining; that is, household spending must fall even faster than incomes. Alternatively, businesses must reduce investment to well below the level of its income, which could only lead to a further reduction in competitiveness and a renewed widening of the current account deficit. This is the downward spiral that countries like Greece have already entered.

The Tory position

David Cameron did not object to any of this because he is a champion of increased government spending, or a defender of the welfare state. Nor has his government shown any appreciation of the fact that reduced government spending will also reduce the incomes of other sectors of the economy.

Defending the sectional interest of the City and relying on some of the most backward political forces in Britain, Cameron has finally crossed a line that even Thatcher only threatened to do

Instead, his objection was to the threat to the City’s ability to siphon off funds from other businesses in Europe. He may not have been successful even in that limited aim. Ed Miliband writing in the Evening Standard argued that Cameron was ‘a prisoner of the Tory Right’ and had isolated himself and Britain from the continuing evolution of policy in Europe.

While willing the other EU national leaders to act decisively to halt the crisis, Cameron himself acted to prevent that happening. Defending the sectional interest of the City and relying on some of the most backward political forces in Britain, Cameron has finally crossed a line that even Thatcher only threatened to do. There will be no benefit to the British economy from this decision and the consequences could prove extremely negative. If, for example, overseas multinationals decide they want a base in the EU, will they choose semi-detached Britain or one of the other 26 countries which continue to have a common regulatory regime? If the British economy suffers as a result, it should be remembered this was done to benefit the City of London and to appease the Tory Eurosceptics and Union Jack-wavers.

This article first appeared on the Socialist Economic Bulletin website. Reproduced with permission.

Greek debt: drastic haircuts and uncertain regrowth

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In what may be an important development, the Financial Times reports that, in return for accepting much larger ‘haircuts’ (imposed losses on the value of the bonds they own) bondholders are demanding that there must be a growth strategy for Greece.

In a piece headlined ‘Bondholders Demand Greek Growth Plan’ the paper quotes the Managing Director and chief negotiator for the Institute of International Finance, which represents the largest bondholders – mainly the banks. The call for a growth plan is not given much substance in the article.

‘Austerity’, a generalized attack on the living standards of the overwhelming majority, has failed to provide reassurance to bondholders

But there is a logic to the demand. Bondholders are most concerned about cash flow from interest payments and the final repayment of debt principal. In all the Euro Area economies where severe ‘austerity’ measures have been applied, bond yields have risen – Greece, Ireland, Portugal, Spain and now Italy. This implies that the bondholders’ risk of not receiving those cash flows and principal has risen, and that a higher interest rate is demanded to compensate. ‘Austerity’, a generalized attack on the living standards of the overwhelming majority, has failed to provide reassurance to bondholders that they will get all the bond repayments. Instead, the reduction in incomes and economic crisis that has followed has increased the risks that the governments will default. If it proves to be the case now that the bondholders are demanding not more austerity, but growth, this would reflect the accurate judgment on their part that the risk of default has increased because of massive cuts in government spending. It is a demand that the European governments provide funds to Greece to help the economy recover, not impose more cuts.

Can ‘austerity’ work?

Of course, the bondholders – mainly the banks but also increasingly other parasites such as hedge funds and ‘vulture funds’ – had no qualms about massive assaults on pay, jobs, pensions, services and welfare benefits while they thought it improved their own prospects of being repaid by EU governments. But even at an earlier stage it was clear to some that cuts in government spending would not work. This is shown in the actions of the credit ratings’ agencies – who effectively represent the interests of the bondholders – and have repeatedly campaigned for large cuts in government spending, only then to downgrade countries such as Greece, Ireland, Portugal and Spain because of the negative economic impact of those same cuts.

By now it is increasingly clear in the case of Greece that any further cuts will be equally counter-productive in restoring the growth required to service debt. But the IMF, ECB and EU Commission are holding up another example of how their impositions can be made to work – Ireland. The ‘Troika’ argue that successive Irish governments (the current coalition of the rightist Fine Gael and Irish Labour Party having replaced the populist right of Fianna Fail) have stuck to the measures agreed, that growth has resumed and that therefore the deficit is falling.

While the cuts have certainly had a negative impact on Irish growth, the level of impoverishment of the entire economy is not in the same category as Greece

In fact, the previous government imposed cuts in 2008, before any international agency demanded them. The current government is set to announce its own first budget, which will also impose greater cuts than those demanded by the Troika. It is also widely understood, if not by the Troika, that Irish GDP is artificially inflated by the activities of (mainly) US multinationals booking activity and profits in Ireland to avail of its ultra-low corporate taxes. This has seen GDP rise in the latest two quarters. But domestic demand fell again by 1.1 per cent in the second quarter of this year, a 3 ½ year-long slump collapse, and is now 24.8 per cent below its level at the end of 2008. According to the IMF, the Dublin government’s deficit will be 10.3 per cent of GDP this year, having been 7.3 per cent before the cuts began to bite in 2008. Even so, the Troika are increasingly determined that the deficit will decline and prove their case. They point to the fact that, excluding enormous bank bailouts equivalent to over 20 per cent of GDP last year, borrowing fell from €23.5 billion in 2009 to €19.3 billion in 2010, an improvement of €4.2 billion. Yet this is simply because the value of bonds redeemed in 2010 was €4 billion lower. Otherwise, there is no underlying improvement in the level of borrowing at all.

But there is an important difference with Greece. Following big tax increase Athens’ taxation revenues have fallen by 4.2 per cent in the first 9 months of this year, whereas Dublin’s tax revenues are 8.4 per cent higher, reflecting the imposition of new income taxes. The key difference is that Ireland was a much more prosperous country than Greece prior to the crisis. Per capita incomes were 50 per cent higher, even adjusted for Purchasing Power Parities. Therefore, while the cuts have certainly had a negative impact on Irish growth, and the domestic economy continues to contract, the level of impoverishment of the entire economy is not in the same category as Greece, where even bondholders may now accept that further cuts are counter-productive. Instead, the impact of the cuts in Ireland might be said to be Greece in slow-motion.

Who benefits?

The new caution in imposing further cuts in Greece is the worry of the loan-shark that the borrower may go bankrupt. But while there is still blood that can be squeezed in countries like Ireland cuts remain the sole policy agenda. The effect of this policy is clear from the recent publication of the sectoral accounts for the Irish economy.

This is shown in the chart below, which shows that as Gross Value Added continues to decline, profits have started to recover and therefore the profits’ share of national income has increased.

According to the Central Statistical Office (CSO), ‘the operating surplus or profits of non-financial corporations (NFCs) increased from €35.2bn in 2009 to €37.8bn in 2010. The other main component of value added is compensation of employees or wages and salaries which declined from €37.3bn in 2009 to €34.9bn in 2010. Therefore the improved profit share relates more to a decline in payroll costs for these corporations rather than to an increase in overall value added.’

Yet this increase in the incomes of the corporate sector, wholly achieved by reducing wages, has not led to an increase in investment. It has led to the opposite, as the chart below shows.


In the words of the CSO, ‘expressing gross fixed capital formation as a percentage of gross value added gives the investment rate. Gross value added is largely unchanged between 2009 and 2010 while investment fell from €7.5bn to €5.8bn in the same period resulting in a fall in the investment rate between 2009 and 2010.’

While there is still blood that can be squeezed in countries like Ireland cuts remain the sole policy agenda

But there is also another way of expressing the investment rate – investment as a proportion of corporate incomes, or profits. On this measure, the investment rate has fallen by €1.9 billion even as profits have increased by €2.9 billion, by reducing wages by €4.9 billion. The total investment rate has fallen on this measure from 21.3 per cent to 15.3 per cent.

From the point of the view of the economy as a whole, this transfer of incomes has been disastrous. The corporate sector has €32 billion in unspent (uninvested) income from profits. But the household sector – which spends more than 90 per cent of its income – has had its income reduced.

The thrust of policy is not to produce an economic recovery. It is to produce a recovery in profitability. In this, it has been a qualified success. The absolute level of profits has recovered from its low and the profit share of output has also increased to more than 50 per cent, even if profits have not recovered their previous peak. The intention is clearly to achieve that goal at the expense of wages.

The thrust of policy is not to produce an economic recovery. It is to produce a recovery in profitability. In this, it has been a qualified success

In Ireland it has become commonplace to suggest that, while all sorts of investment projects and welfare provision are desirable, ‘there is no money left’. On the contrary, the €32 billion level of uninvested profits in 2010 alone is almost exactly equal to the entire reduction in GDP in the recession which began in 2008: €34 billion.

This is the thrust of the entire ‘austerity’ policy across Europe, the transfer of incomes from labour to capital in order to increase profitability. In a subsequent blog, The Socialist Economic Bulletin will examine the effective of this policy in the leading European economies, including Britain.

This article first appeared on the Socialist Economic Bulletin website. Reproduced with permission.