Is this why Sir Alan Budd distanced himself from the Tories?


12:52 pm - July 7th 2010

by Clifford Singer    


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Osborne's Bureau for RebuttalSir Alan Budd’s sudden resignation from Osborne’s Bureau for Rebuttal is the perfect moment to remind ourselves of his astonishing – but essentially correct – analysis of Tory economic policy in the 1980s (from Adam Curtis’s 1992 documentary Pandora’s Box).

(video clip after the fold)

Sir Alan told Adam Curtis:

The nightmare I sometimes have, about this whole experience, runs as follows. I was involved in making a number of proposals which were partly at least adopted by the government and put in play by the government. Now, my worry is … that there may have been people making the actual policy decisions … who never believed for a moment that this was the correct way to bring down inflation.

They did, however, see that it would be a very, very good way to raise unemployment, and raising unemployment was an extremely desirable way of reducing the strength of the working classes — if you like, that what was engineered there in Marxist terms was a crisis of capitalism which re-created a reserve army of labour and has allowed the capitalists to make high profits ever since.

Now again, I would not say I believe that story, but when I really worry about all this, I worry whether that indeed was really what was going on.

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This is a guest contribution. Clifford Singer runs The Other Taxpayer's Alliance website. You can join the Facebook group here.
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Reader comments


This report in The Guardian seems to me to strike the appropriate tone and substance of the situation:

“The chancellor’s two-month honeymoon came to an end today with the news that the OBR’s interim head, Sir Alan Budd, would be stepping down at the end of the month.

“That’s not the way the Treasury sees it, naturally. Sir Alan only had a three-month contract and had always made it clear that he would not be sticking around once Osborne had delivered his debut budget. Although the expectation in Whitehall had been that Budd would remain in place until a permanent chairman was appointed, there was, a Treasury spokesman said, nothing untoward about his departure.”
http://www.guardian.co.uk/business/2010/jul/06/alan-budd-quits-government-spending-watchdog

IMO Alan Budd feels uncomfortable about being thrust into a high-profile, partisan position.

As posted several times before, there’s no shortage of independent commentary and forecasts for the UK economy, including from the widely respected IFS and NIESR. This is HM Treasury’s most recent survey of independent forecasts (dated June 2010):
http://www.hm-treasury.gov.uk/d/201006forecomp.pdf

To recap on two independent assessments of Osborne’s emergency budget on 22 June by widely respected FT economics journalists, try:

Martin Wolf: Two brave gambles in a huge fiscal tightening:
http://www.ft.com/cms/s/0/c4c18be4-7e5e-11df-94a8-00144feabdc0.html

Chris Giles: Osborne delivers kill or cure Budget
http://www.ft.com/cms/s/0/de6ba960-7dde-11df-b357-00144feabdc0,dwp_uuid=ec12e25a-624a-11de-b1c9-00144feabdc0.html

Martin Weale quoted in the Guardian:

“Martin Weale, chief economist at the National Institute for Economic and Social Research, said stagnant demand on the continent and a rise in sterling would stifle the prospects for export-led growth, while the slump in the stock market would hit domestic consumption.”
http://www.guardian.co.uk/business/2010/jul/01/obr-2m-job-forecast-questioned

Btw Martin Weale pf the NIESR has just been appointed to the Bank of England’s Monetary Policy Committee.

A comparison between Alistair Darling’s and George Osborne’s respective prescriptions for paying down the budgetary deficit are set out fairly clearly in this presentation on the BBC website:
http://news.bbc.co.uk/1/hi/business/10390823.stm

Darling’s prescription would have entailed the government borrowing more initially and for longer because the pace of cutting public spending would have been somewhat slower.

Whatever else about the incidence of the spending cuts on poorer v well-off households or the regional impact of Osborne’s budget, the potential risk of the steep, early public spending cuts is that the economy will sink back into recession or stagnate if private sector spending and net exports don’t increase to make up for the cuts.

On the redistributive consequences, thereseems to be a broad consensus that the emergency budget will hit the poor the most:

“Pensioners are the biggest losers – Pensioners came out as one of its biggest losers in George Osborne’s emergency Budget.”
http://www.telegraph.co.uk/finance/personalfinance/how-budget-affect-me/7847875/Budget-2010-Pensioners-are-the-biggest-losers.html

“The IFS estimates that the squeeze on poorer families would increase in the second half of the parliament as welfare cuts kicked in and the two-year increase in child tax credit ended.”
http://www.guardian.co.uk/uk/2010/jun/23/budget-welfare-poor-ifs-report

the potential risk of the steep, early public spending cuts is that the economy will sink back into recession or stagnate

And from the point of view of the LibCons, is that a risk, or an opportunity?

Or something in between, something not to be openly argued for, but also not to strive too diligently to avoid?

@4: “And from the point of view of the LibCons, is that a risk, or an opportunity?”

If you have followed my postings here, you’ll appreciate that I had and have little confidence in the governing competence of the outgoing administration. The one arguable exception is that I believe Alistair Darling made a brave, competent and honest attempt to deal with an impossibly difficult situation which he inherited on appointment as Chancellor.

The IFS was warning back in 2001 of the Budget deficit – as were others. Leading economists were warning of the house-price bubble back in 2002/3 and the IMF in 2003. The trouble is that house-price bubbles tend to be very popular with home-owners – although not with those who can’t afford to buy a house. And over 70% of homes are owner-occupied. The political cry of the Conservatives through most of this was for more and more Deregulation. I’ve often posted supporting citation links.

On how much to blame Gordon Brown, try this independent assessment by Martin Wolf in the FT:

Can we not at least blame Mr Brown for the bloated public spending and grotesque fiscal deficits? Yes, but also only up to a point. Between 1999-2000 and 2007-08, the ratio of total managed spending to GDP did rise from 36.3 per cent to 41.1 per cent. But the latter was still modest, by the standards of the previous four decades. The jump to a ratio of 48.1 per cent, forecast for this year in the 2010 Budget, is due to the recession. Nominal spending is currently forecast at 3.5 per cent higher in 2010-11 than forecast in the 2008 Budget. But nominal GDP will be 10.3 per cent lower and tax revenues 16.4 per cent lower. Critics of his fiscal policies were right, but the error was far larger than anybody imagined. It is true, however, that Mr Brown must take a share of the blame for Labour’s failure to ensure the extra spending would be well managed.
http://www.ft.com/cms/s/0/3074d7ba-5ec0-11df-af86-00144feab49a.html

As for the costs of the wars in Afghanistan and Iraq:

“[Gordon Brown] said the Iraq war had cost Britain £8bn and the total cost to the UK of the wars in Iraq and Afghanistan had been £18bn, on top of what he repeatedly stressed was an increasing defence budget.”
http://news.bbc.co.uk/1/hi/uk_politics/8552593.stm

The Conservatives were encouraging and supportive of those wars.

@5 BobB

I’m can’t agree with your exoneration of Brown. You blame the recession for the budgetary problems as though he had nothing to do with it. He was intimately involved with government policies reducing banking oversight, a sort of race to the bottom with the Americans.

The best I can say for him is that the crisis was inevitable. Capitalism has these periodic adjustments. It would have taken a truly great politician to have even introduced measures to mitigate the worst effects of the crisis on Britain. Brown was not such a politician.

@ Yurrzem!

As for exonerating Gordon Brown, I quoted Martin Wolf on what generated the current massive Budget deficit.

You’re focused on another – and crucially important issue – on the factors responsible for the international financial crisis 2007 through 2009 – including regulation failures on both sides of the Atlantic.

The historic provenance goes back deep and long – including the huge appetite of the government in China for the monetary authorities there to buy volumes of Dollar securities in order to depress the value of the Renminbi and so maintain export-led growth of China’s economy.

Other factors:

If only we all had taken heed of this warning in 2003 about derivatives from Warren Buffett:

“The rapidly growing trade in derivatives poses a ‘mega-catastrophic risk’ for the economy and most shares are still ‘too expensive’, legendary investor Warren Buffett has warned.”
http://news.bbc.co.uk/1/hi/business/2817995.stm

Alan Greenspan’s in testimony on 24 October 2008 to the US House of Representatives Oversight Committee admitted errors:

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
http://online.wsj.com/article/SB122476545437862295.html

The extravagent bonuses of the financial institutions led their bankers to engage in high risk trading to the ultimate detriment of the owning shareholders of the financial institutions – many of which were and are pension funds.

There’s a history of financial crises going back centuries – try: Carmen Reinhart + Kenneth Rogoff: This Time is Different – Eight Centuries of Financial Folly (Princeton UP, 2009). Professor Reinhart was interveiwed by the FT:
http://video.ft.com/v/82349517001/May-3-800-years-of-financial-crises

I’m not a fan of degregulation regardless. The prescription of of Free Market Capitalism is nonsense IMO.

We mustn’t overlook the role of the credit agencies which were awarding three star ratings to traded securities which turned out to be worthless because the assets underpinning the securities – such as sub-prime mortgages – were worthless:
http://www.ft.com/cms/s/0/aa02a8f0-6db1-11df-b5c9-00144feabdc0.html

There were certainly regulatory failures of UK banking institutions but it’s far from clear that those were attributable to either Gordon Brown or the tripartite structure he set up – HM Treasury, the Bank of England and the FSA – rather than top management and staffing issues in the FSA.

“The Financial Services Authority is guilty of a ‘systematic failure of duty’ over the Northern Rock crisis [in 2007], a key parliamentary committee has said. The Treasury committee said the UK’s financial watchdog should have spotted the bank’s ‘reckless’ business plan.”
http://news.bbc.co.uk/1/hi/business/7209500.stm

Part of the problem was FSA recruiting challenges in competition with banks where bankers hoped to receive huge bonuses. Why would any banker wish to go to work for the FSA?

We need to ask whether Osborne’s prescriptive solution necessarily makes good sense:

Mervyn King, the [Bank of England’s] Governor, will become one of the most powerful central bankers in the world, with a new remit to prevent the build-up of risk in the financial system in addition to his monetary policy role
http://www.ft.com/cms/s/0/0203b99e-797f-11df-b063-00144feabdc0.html?catid=6&SID=google

The inflation-targeting remit to the Bank of England is relatively clear cut – even if challenging to apply in practice since interest rate changes take two years to work through. But the new overarching macro prudential stability remit of the Bank is much less clearly defined and most agree that claims about emerging asset-price bubbles can be contenious as are the appropriate policy responses.

FWIW my impression is that many political activists find these technical issues daunting – or boring – and that narrows constructive, informed debate to motivated professionals with insuffient lay intervention.

9. Richard W

5. Bob B

‘ Leading economists were warning of the house-price bubble back in 2002/3 and the IMF in 2003. The trouble is that house-price bubbles tend to be very popular with home-owners – although not with those who can’t afford to buy a house. And over 70% of homes are owner-occupied. The political cry of the Conservatives through most of this was for more and more Deregulation. I’ve often posted supporting citation links. ‘

Just as well then we did not have a housing bubble. One of the great myths of the financial crisis is the UK housing bubble. There was no residential property bubble and there has been no housing collapse. In the 1989-1995 period house prices fell around one-third in real terms. They were flat until 1997 when they started to rise until the credit crunch mid-2007. Prices then started to fall but quickly stabilised at around the beginning of 2006 prices. So only the gains of 18 months were lost. That is not a collapse comparable to the US, Ireland, Spain etc where there was a bubble. Low interest rates can’t explain the lack of a collapse because those countries also have low interest rates. Repossessions in the UK are not even half the level of the early 1990s. UK banking sector losses on UK residential mortgages were much higher in the early 1990s than current, and have very little to do with the UK banking crisis. None of that means property prices will not collapse in the future, but the fact that in contrast to other places they have not suggests there was no bubble and high prices in certain areas are caused by supply problems.

“The Financial Services Authority is guilty of a ‘systematic failure of duty’ over the Northern Rock crisis [in 2007], a key parliamentary committee has said. The Treasury committee said the UK’s financial watchdog should have spotted the bank’s ‘reckless’ business plan.”

Northern Rock did make a lot of reckless lending decisions but that was not what caused their demise. Every bank makes losses on some loans over the economic cycle but the good loans pay for the bad loans. What brought down Northern Rock was they could no longer finance themselves from the interbank wholesale market because the liquidity completely dried up as the market seized. You could say it was reckless to be so reliant on the wholesale market rather than financing through deposits but it was not bad loans that sunk them. Bradford & Bingley also sunk through financing and derivatives through buying a load of bad overseas mortgages. HBOS got into trouble from their corporate loan book and had quite a good residential mortgage book. Contrary to what seems to be received wisdom none of those banks got into trouble through losses on UK residential mortgages.

@ Richard W

You and I will need to agree to disagree over whether there was a house-price bubble financed by 100% and better loan-to-value mortgages nurtured by a belief that house prices would continue rising indefinitely so it would be an excellent bet to invest in residential property either to live in or to let out. This was possibly driven by intentions to create personal pension portfolios on the premise that investing in house purchases offered the prospect of better or more secure returns than investing in equity on the stockmarket or via venture capital funds or put on deposit with hedge funds.

“The International Monetary Fund said British property was overvalued by 40% and the growing credit crisis is likely to have a ’sizeable impact’ on property prices. It said house-price rises in the UK, Ireland and Spain have been surging even faster than those in the US before the recent market collapse, making these countries particularly vulnerable to market volatility.”
http://www.thisismoney.co.uk/mortgages-and-homes/house-prices/article.html?in_article_id=425420&in_page_id=57#ixzz0qSU8yUWg

Just how inflated house prices became, can be judged from this graph of the ratio between average house prices and average earnings:
http://www.housepricecrash.co.uk/graphs-average-house-price-to-earnings-ratio.php

The long-term ratio between average house-prices and average earnings is a multiple of about 3.8 but this ratio rose to nearly 6 by the time the market bust in 2007.

It’s true that the immediate cause of Northern Rock going bust is because it ceased being able to borrow enough on the wholesale money market to finance its asset holdings, which led to a loss of confidence on the part of retail depositers followed by a run on the bank as depositors sought to withdraw their balances.

But there are two fundamental underlying questions: (a) why did the wholesale money market seize up and inter-bank interest rates soar as banks refused to lend to each other (usually because of fears that the collateral used to support inter-bank borrowing would turn out to be worthless were a bank to default on repaying its borrowing); (b) the quality of NR’s own investment portfolio and its mortgage lending practices.

One way for the management of NR to have lessen the pressure to borrow on the wholesale money market would have been to dispose of some part of its assets. But how many buyers would there have been for the sort of mortgage deals that NR had contracted?

11. Richard W

@ 10. Bob B

“The International Monetary Fund said British property was overvalued by 40% and the growing credit crisis is likely to have a ’sizeable impact’ on property prices. It said house-price rises in the UK, Ireland and Spain have been surging even faster than those in the US before the recent market collapse, making these countries particularly vulnerable to market volatility.”
http://www.thisismoney.co.uk/mortgages-and-homes/house-prices/article.html?in_article_id=425420&in_page_id=57#ixzz0qSU8yUWg

Bob, the problem with the IMF forecasters are they are utterly useless forecasters. I would be quite happy to be on the opposite side of any IMF forecast. They use crude price aggregates with no discretion for supply constraints. Moreover, you can’t just come up with a model based on ratios of price to income and apply it internationally in all circumstances. They have great analysis of why something happened after the event, but I would not rely on them to tell me what was going to happen to UK house prices.

Just how inflated house prices became, can be judged from this graph of the ratio between average house prices and average earnings:
http://www.housepricecrash.co.uk/graphs-average-house-price-to-earnings-ratio.php

Although the house price to income is above its average. The ratio has been trending higher for 40 years. The obvious reason is an expanding population coupled with constrained supply. However, in the UK context there is also a high income elasticity of demand for housing. A fair value for housing based on rents is a better comparison than the income ratio. People need shelter. Therefore, the choice is between buying or renting, not spending or saving the money. So there is a lot of imputed information in rents. The long-run national rental yield is 3.6%, it might seem low but the national rental yield includes vacancies and subsidised social housing. Rental yields are currently around the long-run average, implying property is not overvalued based on rents. Moreover, household interest payments as a percentage of disposable income is below 7%, this is historical lows but would not be captured using just a price income ratio.

I am not arguing in favour of high prices. I just do not believe there was a significant national bubble and the lack of a bust supports my opinion. Most of the large increases were in areas where desirable supply was constrained through land shortages. The city centre flats type of development was a bit of a bubble inflated by the buy-to-let market, caused by local authority green belt policy. It is this type of development that has rightly seen the largest falls. There is zero chance of it happening but the British government are able to borrow at a real interest rate of less than 1%. They should be taking the opportunity to massively invest in good quality social housing. It is one-off spending so does not add to the fiscal structural deficit.

Here is a John Kay article arguing that there was no bubble.
http://www.johnkay.com/2010/03/31/bankers-can%E2%80%99t-blame-the-uk-housing-market/

‘ The long-term ratio between average house-prices and average earnings is a multiple of about 3.8 but this ratio rose to nearly 6 by the time the market bust in 2007. ‘

Bust? You mean fell back to 2006 prices and then started rising again.

‘ It’s true that the immediate cause of Northern Rock going bust is because it ceased being able to borrow enough on the wholesale money market to finance its asset holdings, which led to a loss of confidence on the part of retail depositers followed by a run on the bank as depositors sought to withdraw their balances.

But there are two fundamental underlying questions: (a) why did the wholesale money market seize up and inter-bank interest rates soar as banks refused to lend to each other (usually because of fears that the collateral used to support inter-bank borrowing would turn out to be worthless were a bank to default on repaying its borrowing); (b) the quality of NR’s own investment portfolio and its mortgage lending practices. ‘

Well the wholesale market seized up for everyone not just NR, because no one knew who had crap for collateral and who had a healthy balance sheet. Those who relied on the money markets for financing rather than a deposit base were suddenly snookered. For example, HSBC had massive losses in US sub-prime but were never in any danger because they have such a healthy deposit ratio.

‘ One way for the management of NR to have lessen the pressure to borrow on the wholesale money market would have been to dispose of some part of its assets. But how many buyers would there have been for the sort of mortgage deals that NR had contracted? ‘

Well they could have have used their MBS in a repo with the BoE. However, Mr King sunk them by saying the Bank would only accept government debt securities. He obviously knew they did not have gilts but only had mortgage securities as the Debt Management Office had not been issuing much short-dated government debt. The DMO to keep the pension funds happy had in recent years only been issuing long-dated gilts, hence why the UK banks were forced to load up their balance sheets with RMBS in the first place. By the time King relented and decided he was a central banker after all the damage was done. A fire sale of assets would not have helped them. The model of financing from wholesale was dysfunctional. However, if the BoE had done their job they would not have needed to be nationalised.

@ Richard W

It wasn’t just the IMF remarking on the house-price bubble in Britain.

Charles Goodhart has been remarking on the bubble since 2002 and saying the inflation target of the Bank of England should have contained an element to include housing costs – which it did when the target was expressed in terms of an inflation rate of 2½% as measured by RPIX. But Gordon Brown changed the target from February 2004 to 2%, as measured by the CPI, which doesn’t include housing costs. Roger Bootle was also warning of the inherent dangers of the boom in house prices – hence his book: Money for Nothing (2004).

The two indices – the CPI and RPIX – diverged post 2004 with the RPIX running at much higher levels during the house-price boom. Had the old RPIX target at 2½% been retained, the result would have been that interest rates would have been set higher by the BoE to rein back a measured inflation rate that included housing costs. That would have curbed not only mortgage advances and house price increases but also the growth in consumer borrowing which led to the creation of the consumer debt mountain amounting to £1.4 trillion by 2008.

An incidental complication is that had Gordon Brown reined back the budget deficits from 2001 onwards, through tax increases or curbing public spending growth, the BoE would have had less need to raise interest rates to achieve its inflation target – but then lower interest rates would have led to an even greater demand for mortgages which the banks, motivated by their bonus culture, would have sought to have met in (imortantly) the absence of any new regulatory measures to constrain pro-cyclical bank credit booms that ultimately collapse.

That’s what happened in Japan during the 1980s through 1992 so those who keep watch on international finance markets were well aware of what could happen. Subsequent public debate on reforming banking regulations has included the issue of provision for contra-cyclical regulations to rein back bank credit booms, perhaps by discretionary increases in the capital requirements for banks.

True that house prices lapsed back to 2006 and then started raising again, albeit very, very slowly and with periodic hiccups. Evidently, the market has an entrenched belief that personal or household investment in residential property still represents a better bet than the stock market, venture capital funds, creating and running new small businesses etc because no government will have the cojones to: (a) set up contra-cyclical regulatory measures to rein back unsustainable bank credit booms; (b) block silly mortgage lending, like 100% loan-to-value mortgages and more; (c) build or finance more social housing.

IMO the Labour government embarked on the £1 billion “Schools for the Future” building programme, not so much for substantive educational reasons, but to create work for the construction industry after housebuilding collapsed to the lowest levels since 1946.

In other words, the market fundamentals favour the resumption of renewed increases in house prices but most of those fundamentals depend crucially on expectations that government policy failures will continue.

Btw these challenging and contentious policy debates – boring as they may be – often have far greater relevance for the basic welfare of much of the electorate than exciting ideological disputes.

13. Richard W

Although I am not a market fundamentalist, in this case based on the evidence I guess Charles Goodhart and Roger Bootle were quite simply wrong and the market was right. As I and others have pointed out sometimes prices rise as a rational response to fundamentals and it is not always due to a speculative mania. The change in the inflation index is an interesting point. However, you are expecting the central bank to determine what are price rises due to speculation and what are rises for fundamental reasons. Good luck with that project.

If the BoE during that period had increased the interest rate differential vis-a-vis the eurozone and the US, sterling would have appreciated further from its grossly overvalued levels. The result would be exporters were uncompetitive and imports would have been sucked in adding to your ‘ debt mountain ‘ leaving the economy even more unbalanced.

Incidentally, having housing costs as a component of the CPI basket did not stop the US having a housing bubble. They have a 25% weighting in the CPI basket for owners’ equivalent rent (OER). It is a notional payment by homeowners to themselves for accommodation and is estimated based on market rents.

@ Richard W

The challenging problem of recognising exactly when an asset-price bubble is in progress of inflating is widely recognised but (curiously or otherwise) there seems to an emerging consensus for monetary or regulatory authorities to have discretionary powers to vary bank capital requirements contra-cyclically, which is one of the tools that would be needed to curb inflating asset-price bubbles.

I cheer on regulatory reform of financial services. The fact is that the inflating and eventual bursting of asset-price bubbles can wreck absolute havoc on an economy.

Japan’s economy stagnated from 1992 throughout the 1990s after the bubble there burst in 1991 bringing years of continuous price deflation in which it made good sense for households and businesses to postpone buying almost anything whenever feasible because the price with virtual certainty would be lower in a year’s time. Attempts by Japan’s government to prevent an even greater slide into deep depression by running almost continuous fiscal deficits have resulted in the position where Japan’s national debt is currently about 200% of its GDP.

We need to reflect on what initiates and sustains asset-price bubbles. In Britain now, with all the warnings in the heavyweight financial press about the looming risk of a double-dip recession as public spending cuts bite from next spring onwards, an investment in houses must look a relatively good personal bet compared with investing in stockmarket tracker stocks or creating and running a new business: according to this official source dated August 2006: “Small and medium-sized enterprises (SMEs) together accounted for more than half of the employment (58.7 per cent) and turnover (51.1 per cent) in the UK.” By definition, SMEs are counted as businesses employing up to 249 people.
http://www.dtistats.net/smes/200612/SMEstats2005pr.pdf

Foreign exchange rates can and do change for reasons other than changing interest rate differentials. Since March, the cost of a Euro has dropped from 91 pence to around 82 or 83 pence now with no change in the interest rate differential between the Eurozone and the UK. The Bank of England has no remit to use monetary policy to vary the exchange rate except in so far as changes in exchange rates are predicted to affect the CPI price index downstream.

Btw those inclined to spurn economic modelling and all its works may like to observe that the BoE – and any other central bank committed to inflation-targeting – engages in economic modelling to assess the downstream effects on the inflation rate of changing the Bank rate.

News update:

The problems of hedge funds and financial institutions are not behind us:

“John Paulson – one of the world’s most prominent hedge fund managers – has suffered a second consecutive month of steep losses for his flagship hedge funds, most of which are heavily geared towards a recovery in the US economy.

“Amid volatile stock markets, the $3bn Paulson & Co Recovery fund, which has large positions in US banks such as Citigroup and Bank of America, lost 12.39 per cent in June, according to an investor in the fund.”
http://www.ft.com/cms/s/0/ee448ab8-8ab4-11df-8e17-00144feab49a.html

News update 2:

The front page of Friday’s FT carries this news report by Chris Giles, the FT’s economics editor:

“The Office for Budget Responsibility made last-minute changes to its Budget forecasts that had the effect of reducing the impact of the emergency Budget on public sector job losses, the government has acknowledged.

“In a move that will raise further questions about its independence and relevance, the new office revised its assumptions by trimming its official forecasts for public sector job losses by about 175,000 by 2014-15.”
http://www.ft.com/cms/s/0/c3e077ca-8adf-11df-bead-00144feab49a.html

News update 3:

More news on Friday relating to the credibility of the OBR:

“The government rejected criticism on Friday that a new economic watchdog had compromised its credibility by changing job loss forecasts in a way that enabled ministers to put a more positive gloss on spending cuts.”
http://uk.reuters.com/article/idUKTRE66838V20100709

18. Matt Munro

“which re-created a reserve army of labour and has allowed the capitalists to make high profits ever since”.

Sounds remarkably like Nu Liebours immigration “policy” to me.

19. Richard W

A new organisation such as the OBR, which incidentally is a good idea needs to strive very hard for credibility. Without their forecasts being seen to be credibly independent they are nothing. It is quite worrying that these revelations have undermined their credibility so early.

No matter what their forecasts this George Soros lecture succinctly explains why the King/Osborne tight fiscal and loose monetary with export-led growth is doomed to failure if everyone is doing the same thing.

The Crisis & the Euro

by George Soros

I believe that misconceptions play a large role in shaping history, and the euro crisis is a case in point.

Let me start my analysis with the previous crisis, the bankruptcy of Lehman Brothers. In the week following September 15, 2008, global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit—backed by the financial resources of the state—for the credit of financial institutions that had ceased to be acceptable to counterparties.

As Mervyn King of the Bank of England explained, the authorities had to do in the short term the exact opposite of what was needed in the long term: they had to pump in a lot of credit, to replace the credit that had disappeared, and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macroeconomic balance.

This required a delicate two-phase maneuver—just as when a car is skidding, first you have to turn it in the direction of the skid and only when you have regained control can you correct course. The first phase of the maneuver was successfully accomplished—a collapse has been averted. But the underlying causes have not been removed and they surfaced again when the financial markets started questioning the creditworthiness of sovereign debt. That is when the euro took center stage because of a structural weakness in its constitution. But we are dealing with a worldwide phenomenon, so the current situation is a direct consequence of the crash of 2008. The second phase of the maneuver—getting the economy on a new, better course—is running into difficulties.

The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus. Keynes taught us that budget deficits are essential for countercyclical policies in times of deflation, yet governments everywhere feel compelled to reduce them under pressure from the financial markets. Coming at a time when the Chinese authorities have also put on the brakes, this is liable to push the global economy into a slowdown or possibly a double dip. Europe, which weathered the first phase of the financial crisis relatively well, is now in the forefront of causing the downward pressure because of the problems connected with the common currency.

The euro was an incomplete currency to start with. In 1992, the Maastricht Treaty established a monetary union without a political union. The euro boasts a common central bank but it lacks a common treasury. It is exactly that sovereign backing that financial markets are now questioning and that is missing from the design. That is why the euro has become the focal point of the current crisis.

Member countries share a common currency, but when it comes to sovereign credit they are on their own. This fact was obscured until recently by the willingness of the European Central Bank (ECB) to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany, and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. These positions now endanger the creditworthiness of the European banking system. For instance, European banks hold nearly a trillion euros of Spanish debt, of which half is held by German and French banks. It can be seen that the European sovereign debt crisis is intricately interconnected with a European bank crisis.

How did this connection arise?

The introduction of the euro in 1999 brought about a radical narrowing of interest rate differentials. This in turn generated real estate bubbles in countries like Spain, Greece, and Ireland. Instead of the convergence prescribed by the Maastricht Treaty, these countries grew faster and developed trade deficits within the eurozone, while Germany reigned in its labor costs, became more competitive, and developed a chronic trade surplus. To make matters worse, some of these countries, most notably Greece, ran budget deficits that exceeded the limits set by the Maastricht Treaty. But the discount facility of the European Central Bank allowed them to continue borrowing at practically the same rates as Germany, relieving them of any pressure to correct their excesses.

The first clear reminder that the euro does not have a common treasury came after the bankruptcy of Lehman. The finance ministers of the European Union promised that no other financial institution of systemic importance would be allowed to default. But Germany opposed a joint Europe-wide guarantee; each country had to take care of its own banks.

At first, the financial markets were so impressed by the promise of the EU finance ministers that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but the differences in interest rates on government debt within the eurozone remained minimal. That was when the countries of Eastern Europe, notably Hungary and the Baltic States, got into difficulties and had to be rescued.

It is only this year that financial markets started to worry about the accumulation of sovereign debt within the eurozone. Greece became the center of attention when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated.

Interest rate differentials started to widen but the European authorities were slow to react because the member countries held radically different views. Germany, which had been traumatized by two episodes of runaway inflation, was allergic to any buildup of inflationary pressures; France and other countries were more willing to show their solidarity. Since Germany was heading for elections, it was unwilling to act, but nothing could be done without Germany. So the Greek crisis festered and spread. When the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had acted earlier.

In the meantime, the crisis spread to the other deficit countries, and in order to reassure the markets the authorities felt obliged to put together a €750 billion European Financial Stabilization Fund, with €500 billion from the member states and €250 billion from the IMF.

But the markets are not reassured because the term sheet of the Fund, i.e., the conditions under which it operates, was dictated by Germany. The Fund is guaranteed not jointly but only severally, so that the weaker countries will in fact be guaranteeing a portion of their own debt. The Fund will be raised by selling bonds to the market and charging a fee on top. It is difficult to see how these bonds will merit an AAA-rating.

Even more troubling is the fact that Germany is not only insisting on strict fiscal discipline for weaker countries but is also reducing its own fiscal deficit. When all countries are reducing deficits at a time of high unemployment they set in motion a downward deflationary spiral. Reductions in employment, tax receipts, and exports reinforce each other, ensuring that the targets will not be met and further reductions will be required. And even if budgetary targets were met, it is difficult to see how the weaker countries could regain their competitiveness and start growing again because, in the absence of exchange rate depreciation, the adjustment process would require reductions in wages and prices, producing deflation.

To some extent a continued decline in the value of the euro may mitigate the deflation. But as long as there is no growth, the relative weight of the debt will continue to grow. This is true not only for the national debt but also for the commercial loans held by banks. This will make the banks even more reluctant to lend, compounding the downward pressures.

The euro is a patently flawed construct, which its architects knew at the time of its creation. They expected its defects to be corrected, if and when they became acute, by the same process that brought the European Union into existence.

The European Union was built by a process of piecemeal social engineering: indeed it is probably the most successful feat of social engineering in history. The architects recognized that perfection is unattainable. They set limited objectives and firm deadlines. They mobilized the political will for a small step forward, knowing full well that when it was accomplished its inadequacy would become apparent and require further steps. That is how the six-nation Coal and Steel Community was gradually developed into the European Union, step by step.

Germany used to be at the heart of the process. German statesmen used to assert that Germany has no independent foreign policy, only a European policy. After the fall of the Berlin Wall, Germany’s leaders realized that unification was possible only in the context of a united Europe and they were willing to make considerable sacrifices to secure European acceptance. When it came to bargaining they were willing to contribute a little more to the pot and take a little less than the others, thereby facilitating agreement. But those days are over. Germany doesn’t feel so rich anymore and doesn’t want to continue serving as the deep pocket for the rest of Europe. This change in attitudes is understandable but it did bring the process of integration to a screeching halt.

Germany now wants to treat the Maastricht Treaty as the scripture that has to be obeyed without any modifications. This is not understandable, because it is in conflict with the incremental method by which the European Union was built. Something has gone fundamentally wrong in Germany’s attitude toward the European Union.

Let me first analyze the defects of the euro and then examine Germany’s attitude. The biggest deficiency in the euro, the absence of a common fiscal policy, is well known. But there is another defect that has received less recognition: a false belief in the stability of financial markets. As I have tried to explain in my writings, the crash of 2008 conclusively demonstrated that financial markets do not necessarily tend toward equilibrium; they are just as likely to produce bubbles. I don’t want to repeat my arguments here because you can find them in my lectures, which have recently been published.1

All I need to do is remind you that the introduction of the euro created its own bubble in the countries whose borrowing costs were greatly reduced. Greece abused the privilege by cheating, but Spain didn’t. Spain followed sound macroeconomic policies, maintained its sovereign debt level below the European average, and exercised exemplary supervision over its banking system. Yet it enjoyed a tremendous real estate boom that has turned into a bust resulting in 20 percent unemployment. Now it has to rescue the savings banks, called cajas, and the municipalities. And the entire European banking system is weighed down by bad debts and needs to be recapitalized. The design of the euro did not take this possibility into account.

Another structural flaw in the euro is that it guards only against the danger of inflation and ignores the possibility of deflation. In this respect the task assigned to the European Central Bank is asymmetric. This is due to Germany’s fear of inflation. When Germany agreed to substitute the euro for the Deutschmark it insisted on strong safeguards to maintain the value of the currency. The Maastricht Treaty contained a clause that expressly prohibited bailouts and that ban has been reaffirmed by the German constitutional court. It is this clause that has made the current situation so difficult to deal with.

And this brings me to the gravest defect in the euro’s design: it does not allow for error. It expects member states to abide by the Maastricht criteria—which state that the budget deficit must not exceed 3 percent and total government debt 60 percent of GDP—without establishing an adequate enforcement mechanism. And now that several countries are far away from the Maastricht criteria, there is neither an adjustment mechanism nor an exit mechanism. Now these countries are expected to return to the Maastricht criteria even if such a move sets in motion a deflationary spiral. This is in direct conflict with the lessons learned from the Great Depression of the 1930s, and is liable to push Europe into a period of prolonged stagnation or worse. That will, in turn, generate discontent and social unrest. It is difficult to predict how the anger and frustration will express itself.

The wide range of possibilities will weigh heavily on the financial markets. They will have to discount the prospects of deflation and inflation, default and disintegration. Financial markets dislike uncertainty. Meanwhile, xenophobic and nationalistic extremism are already on the rise in countries such as Belgium, the Netherlands, and Italy. In a worst-case scenario, such political trends could undermine democracy and paralyze or even destroy the European Union.

If that were to happen, Germany would have to bear a major share of the responsibility because as the strongest and most creditworthy country it calls the shots. By insisting on pro-cyclical policies, Germany is endangering the European Union. I realize that this is a grave accusation but I am afraid it is justified.

To be sure, Germany cannot be blamed for wanting a strong currency and a balanced budget. But it can be blamed for imposing its predilection on other countries that have different needs and preferences—like Procrustes, who forced other people to lie in his bed and stretched them or cut off their legs to make them fit. The Procrustes bed being inflicted on the eurozone is called deflation.

Unfortunately Germany does not realize what it is doing. It has no desire to impose its will on Europe; all it wants to do is to maintain its competitiveness and avoid becoming the deep pocket for the rest of Europe. But as the strongest and most creditworthy country, it is in the driver’s seat. As a result Germany objectively determines the financial and macroeconomic policies of the eurozone without being subjectively aware of it. When all the member countries try to be like Germany they are bound to send the eurozone into a deflationary spiral. That is the effect of the policies pursued by Germany and—since Germany is in the driver’s seat—these are the policies imposed on the eurozone.

The German public does not understand why it should be blamed for the troubles of the eurozone. After all, it is the most successful economy in Europe, fully capable of competing in world markets. The troubles of the eurozone feel like a burden weighing Germany down. It is difficult to see what would change this perception because the troubles of the eurozone are depressing the euro and, being the most competitive of the countries in the eurozone, Germany benefits the most. As a result Germany is likely to feel the least pain of all the member states.

The error in the German attitude can best be brought home by engaging in a thought experiment. The most ardent instigators of that attitude would prefer that Germany leave the euro rather than modify its position. Let us consider where that would lead.

The Deutschmark would go through the roof and the euro would fall through the floor. This would indeed help the adjustment process of the other countries but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative and there would be widespread unemployment. German banks would suffer severe exchange rate losses and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations: pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Let me emphasize that this scenario is totally hypothetical because it is extremely unlikely that Germany would be allowed to leave the euro and to do so in a friendly manner. Germany’s exit would be destabilizing financially, economically, and above all politically. The collapse of the single market would be difficult to avoid. The purpose of this thought experiment is to convince Germany to change its ways without going through the actual experience that its current policies hold in store.

What would be the right policy for Germany to pursue? It cannot be expected to underwrite other countries’ deficits indefinitely. So some tightening of fiscal policies is inevitable. But some way has to be found to allow the countries in crisis to grow their way out of their difficulties. The countries concerned have to do most of the heavy lifting by introducing structural reforms but they do need some outside help to allow them to stimulate their economies. By cutting its budget deficit and resisting a rise in wages to compensate for the decline in the purchasing power of the euro, Germany is actually making it more difficult for the other countries to regain competitiveness.

So what should Germany do? It needs to recognize three guiding principles.

First, the current crisis is more a banking crisis than a fiscal one. The continental European banking system was never properly cleansed after the crash of 2008. Bad assets have not been marked-to-market—i.e., valued according to current market price— but are being held to maturity. When markets started to doubt the creditworthiness of sovereign debt, it was really the solvency of the banking system that was brought into question because the banks were loaded with the bonds of the weaker countries and these are now selling below par—the price at which they were issued. The banks have difficulties in obtaining short-term financing. The interbank market—i.e., for borrowing and lending between banks—and the commercial paper market have dried up and banks have turned to the ECB both for short-term financing and for depositing their excess cash. They are in no position to buy government bonds. That is the main reason why risk premiums on government bonds have widened, setting up a vicious circle.

The crisis has now forced the authorities to disclose the results of their stress tests of banks, which assess the extent to which their resources are sufficient to meet their obligations. We cannot judge how serious the situation is until the results are published, presumably before the end of July. It is clear however that the banks are greatly overleveraged and need to be recapitalized on a compulsory basis. That ought to be the first task of the European Financial Stabilization Fund, and it will go a long way to clear the air. It may be seen, for instance, that Spain does not have a fiscal crisis at all. Recent market moves point in that direction. Germany’s role may also be seen in a very different light if, in recapitalizing its -Landesbanken, it becomes a bigger user of the stabilization fund than contributor to it.

Second, a tightening of fiscal policy must be offset by a loosening of monetary policy. Specifically, the ECB could buy Spanish treasury bills, an action that would significantly reduce the punitive interest rates, set by the German-inspired European Financial Stabilization Fund, that Spain now must pay on its bonds. This would allow Spain to meet its budget reduction targets with less pain. But that is not possible without a change of heart by Germany.

Third, this is the time to put idle resources to work by investing in education and infrastructure. For instance, Europe needs a better gas pipeline system, and the connection between Spain and France is one of the bottlenecks. The European Investment Bank ought to be able to find other investment opportunities as well, such as expanding broadband coverage or creating a smart electricity grid.

It is impossible to be more concrete at the moment but there are grounds for optimism. When the solvency situation of the banks has been clarified and they have been properly recapitalized, it should be possible to devise a growth strategy for Europe. And when the European economy has regained its balance the time will be ripe to correct the structural deficiencies of the euro. Make no mistake about it: the fact that the Maastricht criteria were so flagrantly violated shows that the euro does have deficiencies that need to be corrected.

As I said at the beginning, what is needed is a delicate, two-phase maneuver, similar to the one the authorities undertook after the failure of Lehman Brothers. First help Europe to grow its way out of its difficulties and then revise and strengthen the structure of the euro. This cannot be done without German leadership. I hope Germany will once again live up to the responsibilities. After all, it has done so in the past.
Postscript

Germany went into the G-20 meeting in Toronto on June 26–27 largely isolated. Before the meeting, President Obama publicly pleaded with Angela Merkel to change her policies. At the meeting the tables were turned. Canada’s Stephen Harper as the host and David Cameron, the newly elected Conservative prime minister of the UK, lined up behind Merkel, leaving Obama isolated. Supporting Merkel’s approach, the G-20 endorsed a halving of budget deficits by 2013 as the target. This has extended the threat of a deflationary spiral to the global economy, making the experience of the 1930s even more relevant than it was when I gave much of the preceding text as a speech at Humboldt University.

The political leaders claim to take their cue from the financial markets but they are misreading the signals. Sovereign risk premiums have widened in Europe because of the situation of the banks; but yields on the government bonds of the US, Japan, and Germany are at or near all-time lows, yield curves are flattening, and commodity prices are declining—all foreshadowing deflation. Equity markets have also come under pressure but that is because of the lack of clear leadership. The range of uncertainties is unusually wide: markets need to discount inflation, default, and disintegration, all at the same time. No wonder that equity prices are falling.

The world’s leaders urgently need to learn that they have to lead markets and not seek to follow them. Of course, they also need to get their policies right and forge a consensus—a difficult trifecta. Right now the G-20 nations are converging around the wrong policy.

—July 8, 2010


Reactions: Twitter, blogs
  1. Liberal Conspiracy

    Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  2. gwenhwyfaer

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  3. Little Metamorphic O

    Frightening how little they know of economics RT@
    libcon Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  4. Derek Bryant

    RT @libcon Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  5. P. S. Wong

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  6. Stuart Vallantine

    RT @DerekJohnBryant: RT @libcon Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  7. James McCollom

    RT @DerekJohnBryant: RT @libcon Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  8. leebo

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  9. Teresa Cairns

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  10. Philip Painter

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg

  11. Rachael

    RT @libcon: Is this why Sir Alan Budd distanced himself from the Tories? http://bit.ly/9EVHgg <<depressing

  12. John Halton

    It's a shame Alan Budd is leaving the OBR. His brand of reckless candour could have greatly enlivened things. See also: http://s.coop/1pu

  13. TheBiPolarBearMD

    RT @johnhalton: It's a shame Alan Budd is leaving the OBR. His brand of reckless candour could have greatly enlivened things. See also: http://s.coop/1pu





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