It’s official: UK expected to do worse than Japan during its ‘lost decade’


by Duncan Weldon    
10:57 am - December 10th 2012

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The reaction in the press to this week’s Autumn Statement has mainly – and for very understandable reasons – focussed on the Chancellor’s policy announcements, in particular the real terms cut in working age benefits. What have got a lot less attention are the growth forecasts – which are simply awful.

Compared to the last Autumn Statement, growth has been heavily revised down.

As the chart below demonstrates – this time last year the OBR expected growth over 2012 to 2016 to be 12%, whereas it now expects just 8.3% – almost a third lower.

But what is striking is that the OBR has just lopped a third off forecasts that where already bleak.

After the last Autumn Statement here were the reactions:

FT’s Chris Giles:
It is about as bad as it could get. When George Osborne, the chancellor, was presented with the draft forecasts a month ago, he must have felt a cold sweat.

The Telegraph:
Annual growth forecasts were revised down sharply out to 2014. Growth this year is now expected to be just 0.9pc, compared with the OBR’s March Budget forecast of 1.7pc growth.

The Guardian:
The changes to the growth figures in the short-term are eye-wateringly bleak, with the OBR now predicting that Britain will expand by just 0.7% in 2012 (down from 2.5% in the March forecasts).

Look at the longer-term picture. One year ago the OBR gave forecasts that were variously described as “about as bad as it could get”, “revised won sharply” and “bleak”. It has just taken those forecasts and revised them down by a further third.

During its own ‘lost decade’ the Japanese economy grew by 11.9%, a disastrous result over 10 years. The central forecast of the OBR is now that UK growth, over the decade of 2008 to 2017, will have been 8.7%.

To reuse an old Paul Krugman quote:

The slowness with which Japan’s economy deteriorated was in itself a source of much confusion. Because the depression crept up on the country, there was never a moment at which the public clamoured for the government to do something dramatic. Because Japan’s economic engine gradually lost power rather than coming to a screeching halt, the government itself consistently defined success down, regarding the economy’s continuing growth as a vindication of its policies even though that growth was well short of what could and should have been achieved. And at the same time, both Japanese and foreign analysts tended to assume that because the economy grew so slowly for so long, it couldn’t grow any faster.

So Japan’s economic policies were marked by an odd combination of smugness and fatalism – and by a noticeable unwillingness to think hard about how things could have gone so wrong. (My emphasis)

We’re half way through our own lost decade and the government exhibiting the same behaviour that marked Japan’s – consistently defining down success and seeing any growth as a vindication of its policy even though growth is well short of what it could and should have achieved.

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About the author
Duncan is a regular contributor. He has worked as an economist at the Bank of England, in fund management and at the Labour Party. He is a Senior Policy Officer at the TUC’s Economic and Social Affairs Department.
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Reader comments


And what would you have the government do about it Duncan?

The Keynesian economic solutions of running large deficits and QE haven’t worked there now have they?

Does anyone have any knowledge of the Japanese benefits system? We do hear (or used to hear) about ‘pointless’ Japanese jobs and overmanning in certain areas of their economy but when expectations were being managed down there, did they have a similar ‘bash the poor and disabled’ rhetoric that we have?
It ‘gladdens the heart’ to hear elected public officials paid by the general public purse demonising sections of the public who cannot answer back. Sick, sick, sick.

Also remember that the Japanese lost decade happened when for the most part the rest of the world was growing relatively robustly.

The current UK “lost decade” is during a period where much of the rest of the world is also struggling, let alone the fact that these are forecasts for UK GDP growth – notoriously innaccurate.

4. gastro george

@Tyler

And, like, austerity is just so successful.

5. gastro george

And, BTW, the Keynesian solution is not to run large deficits.

The Keynesian solution is that, in the case of a shortfall in aggregate demand, the state should step in and ensure that demand is sufficient for the economy to recover.

A deficit may be a consequence of this expenditure, but the important word here is consequence. A deficit or surplus is always an outcome, so should never be a target. It’s like trying to target the trade deficit without investing in productive export industries.

Duncan,

given that the consensus forecasts point to a bleak growth performance over the next few years. If we ignore the FTSE 100 as not representative of the UK economy. How do you account for the FTSE 250 being at a three year high?
http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/indices/summary/summary-indices-chart.html?index=MCX
That is also a forecast but a forecast where people have money on the line. The 250 is a large chunk of the UK economy and equity investors appear to be implying that UK growth will not be as bad as the consensus forecasts. Setting up the OBR was a very good decision by the coalition. Unfortunately they have disappointed by being extraordinarily useless in their forecasts of just about everything.

Who are we to believe in your opinion?

And, BTW, the Keynesian solution is not to run large deficits.

5.

When the economy was doing well, I don’t recall hearing anyone arguing for spending cuts or tax increaces on Keynesian grounds. If I had, those people would now sound more credible when they argued for tax cuts or spending increaces.

As it is…

8. gastro george

@7 Maybe you weren’t listening to the right people. If you mean Labour, then they’re not Keynesians, even now.

@Tyler

“The current UK “lost decade” is during a period where much of the rest of the world is also struggling…”

which is exactly the reason austerity is staggeringly stupid. If consumer and business demand is low, and export markets aren’t going to pick up the slack, the last source of demand is Government spending (specifically infrastructure spending, not QE as currently implemented, which just pads bank balance sheets).

Liquidity trap, plus interest rates that can’t go usefully lower (plus rates on Government borrowing that effectively mean people are **paying us** to borrow from them) has a surprisingly simple solution that the Conservatives can’t admit, because it just doesn’t fit their ideology (plus of course, it would require an admission that they got it spectacularly wrong); Government spending.

We keep hearing the Conservative’s say how there is no easy solution to the problem, the really sad thing is, there is.

@ AndyC

More government spending really isn’t the answer – otherwise Japan would be leading the world in economic growth. It isn’t though, is it. That there is a very real example of a country where government spending has been propping up the economy for what is now decades, and hasn’t proved to be a solution, should give people of the leftist/Keynesian leaning a clue as to it’s effectiveness.

There are many problems with that philosophy. Firstly, even at low interest rates the amount of debt racks up very quickly, normally faster than the GDP growth it is supposed to create. Those debt interest payments can quickly swamp any new tax revenues from growth. Then you have the disaster super low rates and QE do for your pensions industry – a massive problem considering aging populations. Another issue is how you unwind QE/massive deficits. When you stop printing money and return to growth, interest rates are bound to go up, which means debt servicing costs are also going to, tipping a government back into large deficits. It ends up a viscious circle.

I could go on, but I needn’t.

What I can say with some certainty though, is that your mindset is one typical of many on the left. You think “austerity” is the problem, and if the government just spent more and taxed more everything would be solved. In fact, what this spending does is entrench a weak economy with lots of risk – particularly as it means it remains uncompetative and unreformed.

If you really want to solve these problems, you need reform and rationalisiation of the economy, and unburden it from much of the tax and red tape. We have real world examples of this of course. Look at the countries which are doing best in the world and they tend to have low legislative burdens, are economically free and tend to be very market driven, have low debt burdens, often have low tax rates and lower government spending as a % of GDP.

By all means though, argue for the other way, but when it all ends in the sh1t don’t say I didn’t warn you.

@Tyler

People like to bring up the Japan “issue”, unfortunately they completely over-state the decline, and completely miss the underlying reasons, and then completely miss the fact that we are, in fact, doing worse than Japan’s lost decade. Also, the recovery from the 1930s depression is clear evidence that Government spending does work.

Japan’s slow growth has more to do with demographic changes; the size of their working population has fallen significantly since the 90s, reducing productivity (compared to the US, say, where the size of the working population increased by 25% over the same period). If you correct to consider GDP per working age individual, the picture changes quite a lot, and you see that in fact, up to the financial crisis, Japan recovered almost all of its GDP decline from the lost decade (of course, the crisis itself has damaged this progress), so in fact, per working age individual Japanese productivity did recover.

“Firstly, even at low interest rates the amount of debt racks up very quickly…”

But as noted previously, our interest are so low that borrowing doesn’t cost us *anything*. The tiny interest rates are completely offset by inflation, and GDP growth (which will be greatly bolstered by the high multipliers that are *known* to exist for infrastructure spending).

“When you stop printing money and return to growth, interest rates are bound to go up, which means debt servicing costs are also going to”

No, that doesn’t follow. A couple of things, first, the return to growth will come alongside the printing of money that is then used for infrastructure spending. Once the economy becomes self-sustaining, then Government takes its foot off the gas and begins paying down debt; the higher interest rate costs only kick in on new debt after this point, and re-financing of any old debt reaching its expiration date (of which Britain has very little, and the “new” borrowing obviously doesn’t expire for years). The vicious circle is in fact a failure to achieve growth that results in debt as a percentage of GDP rising, as it is *now*, under austerity. If the combination of GDP and inflation exceeds the rate of growth of the debt pile in the long-term, there is no problem (as can be seen from Britain’s past 250% debt to GDP burden, which it paid).

“if the government just spent more and taxed more…”

I actually haven’t mentioned tax, just infrastructure spending.

“unburden [the economy] it from much of the tax and red tape”.

Nonsense. Lack of red tape got us into this mess (not Government spending note), and as for tax, enlighten me as to which corporations are actually paying meaningful amounts of it? Plus, under the tories, corporation tax has already been significantly reduced; it hasn’t achieved anything.

“Look at the countries which are doing best in the world…”

You mean developing nations that can’t be meaningfully compared with advanced economies?

“…but when it all ends in the sh1t don’t say I didn’t warn you.”

As of right now, the evidence is that the people warning about the dangers of austerity are the ones who get to use that line.

@ Andy C

“Also, the recovery from the 1930s depression is clear evidence that Government spending does work.”

Does it? There is no clear evidence for this, short of a lot of people suggesting WW2 govt spending made a difference, which to a certain extent it probably did. There are also plenty of examples when more government spending made the underlying problem worse (certainly in central Europe). You can also argue moving from fixed to floating exchange rate regimes made more of a difference.

You are quite wrong about productivity in Japan. OECD data shows a straight line increase since the 60s, with no interruption for the lost decade. It’s a similar picture when adjsuted for demographci changes.

You then talk about debt and interest rates…and are again totally wrong.

In terms of debt costing us nothing once inflation is taken into account, you fail to take into account that government spending also increases by inflation (or more) each year. Which is why the coalition’s cuts are *real terms*. Nominal spending is increasing. Which means piling up debt stil costs the govt more in servicing costs every year.

You also make the common fallacy that debt costs are fixed. They certainly aren’t. Firstly you have rollover costs, with more and more debt rolling over each year thanks to the ever increasing stock of debt. Doesn’t matter about the duration – have enough debt and at some point it still comes due.

Then you make the mistake in thinking that a bond’s coupon matters. It doesn’t – it’s yield does. If the coupon mattered governments would simply issue at lower coupons…but in real life a bond with a lower coupon than the prevailing market rate would simply trade at a discount, so the government would not get face value for issuance, as the bond would trade at a discount.

In the end, all 10 UK debt costs the government roughly 1.84% at the moment, and that is not a fixed cost.

I trust you won’t get your head around it and will say something stupid now. Try not to. Please.

Following on from this, if growth increases, inflation tends to follow, and rates will go up. This will be compounded if the govt tries to unwind QE. Higher rates means higher debt servicing costs for the govt.

You also make the typical lefty mistake of simply assuming more spending = more growth, and also ignore that not all proceeds of growth end up as govt revenues. As we have seen, this isn’t always the case. If nothing else, isn’t the already huge budget deficit a stimulus? You can run the numbers, but the UK would need to grow at rates historically well above trend to get debt/GDP and the deficit back into control without any cuts, simply because the extra debt servicing costs into any net government spending at a huge rate. It’s a massive gamble.

Corporations don’t pay tax. Ask any serious economist. Richard Murphy doesn’t count. All those costs are passed down to workers, investors or consumers in the form of lower pay, lower returns and investment or higher prices.

“Look at the countries which are doing best in the world…”

I wasn’t even thinking of any developing nations. I was thinking of places like Switzerland or Australia. Even the Scandi countries govt spending as a % of GDP has reduced, as have their tax burdens, and this is made up for by flexible market based economies. Now compare with France and the UK, which have much higher debt burdens, less flexible economies and government spending as a % of GDP has matched or topped even the Scandi countries levels.

13. gastro george

@Tyler “Following on from this, if growth increases, inflation tends to follow, and rates will go up. This will be compounded if the govt tries to unwind QE. Higher rates means higher debt servicing costs for the govt.”

We’ve been round this before.

Even on your own terms, the “debt” is only “unsustainable” if interest rates are higher then the growth rate. And the government can set interest rates to whatever level it likes if it chose to.

@Tyler

Wow, I didn’t expect you to contradict yourself so much in one post.

“You are quite wrong about productivity in Japan. OECD data shows a straight line increase since the 60s”

So now you’re arguing that Japan has never had a growth problem, in which case, what were you complaining about earlier?

As for Japanese productivity, when you correct for per working age individual, there *is* a relative drop from 1990-2000, which then recovers to 2007.

http://krugman.blogs.nytimes.com/2012/01/09/japan-reconsidered-2/

“You then talk about debt and interest rates…and are again totally wrong…”

Oh dear, this was funny. Note that annual Government spending is spending of money *at its current value*, whereas debt has a value that depends on the value of money at the time the debt was accrued; so inflation devalues debt. Here’s some basic maths:

You take out a loan f1000, with an interest rate of 2%. Inflation is higher at 3%. I’ll be generous to you and assume that the 2% annual interest is not devalued by inflation (though the difference would certainly be minor), just the net value of the loan at the start of each year. So, in the first year, the loan accrues £20 in interest achieving a new value of £1020, but the initial sum is devalued by £30 because of inflation. The real value of your loan (assuming you don’t repay anything): £990. i.e. you repaid *nothing* but the relative value of your debt burden is reduced by inflation.

“You also make the common fallacy that debt costs are fixed.”

Um, no I don’t. If you read more carefully, I actually said

“the higher interest rate costs only kick in on new debt after this point, and re-financing of any old debt reaching its expiration date”

Note that not all debt rolls over every year. Which was my point in the completion of that sentence:

“(of which Britain has very little, and the “new” borrowing obviously doesn’t expire for years)”

“Doesn’t matter about the duration – have enough debt and at some point it still comes due.”

The first point is seriously debatable, but the second is irrelevant. Debt can be refinanced, and as long as the total pile of debt doesn’t grow faster than the combination of GDP growth and inflation, the debt is *always* affordable.

“Then you make the mistake in thinking that a bond’s coupon matters…”

Ok, this is what you call a non-sequitur.

“I trust you won’t get your head around it and will say something stupid now. Try not to. Please.”

You can always tell when someone has a weak argument by their attempts to cut off any further discussion through pathetic insults. Trust me, there is nothing wrong with my mathematical abilities.

“Following on from this, if growth increases, inflation tends to follow, and rates will go up.”

And? Again, increased interest rates apply to new debt and refinancing, the idea here is that borrowing now, when rates are low and growth multipliers high means you get to reduce borrowing when the economy can sustain itself, so those higher rates don’t hurt you.

“This will be compounded if the govt tries to unwind QE…”

QE as it’s been implemented so far has had no impact, because none of it has reached the wider economy, so unwinding of the current QE will have equally little impact.

“You also make the typical lefty mistake of simply assuming more spending = more growth”

Actually no I don’t, I make the statement that *infrastructure spending* means more growth, and this isn’t an assumption, as the IMF.

“and also ignore that not all proceeds of growth end up as govt revenues”

Again, just plain wrong. Government revenues are relative to GDP, as interest payments are relative to debt, so if a Government can afford its debt burden today, and GDP growth matches or exceeds debt growth *in the long term*, then Government can afford its debt burden of the future.

“If nothing else, isn’t the already huge budget deficit a stimulus?”

See above; the nature of the spending matters, hence why I refer to a specific type of spending repeatedly.

“Corporations don’t pay tax.”

Wow, just wow. You’re basically trying to make a statement even stronger than my own to… defend your position?

I do want to rephrase one paragraph from my previous post, as rereading it doesn’t make the point I wanted to make in its entirety:

“Note that annual Government spending is spending of money *at its current value*, whereas debt has a value that depends on the value of money at the time the debt was accrued; so inflation devalues debt.”

I should add to that, that Government spending need not always increase at the same rate as GDP. If GDP growth is strong (higher than inflation), then Government can achieve the same goals as in a previous year with a lower relative level of spending (absolute value rises with inflation, but value relative to GDP falls). This is exactly what I think we should be aiming for; higher relative Government spending when the economy is weak, lower when it is strong.

@ 13 Gastro

“And the government can set interest rates to whatever level it likes if it chose to.”

No, governments can set short term interest rates. Long term rates are set by the markets. This should be obvious in so far as the ECB base rate is 0.75%, but German 10y rates are 1.33%. French ones are 1.97% and Greek ones are 12.43%.

@ 14 AndyC

Firstly, on Japan: You’ve mixed up growth and productivity. Productivity in Japan, even when adjusted for working age population, has increased slowly over time, unaffected by recessions. GDP hasn’t increase din the same way. Krugman’s article doesn’t really tell you much either – all he says is GDP went down in a recession….and correlation doesn’t mean causality.

On interest rates:

I’m an interest rate trader, of 10 years experience. I know my trade pretty well, but from what you’ve written I’m pretty sure you don’t know what you are talking about. Like I said, you went on to say something pretty stupid.

You are correct in saying that inflation will affect the real yield of a bond. Indeed, this is why governments issue inflation linked or “real” bonds.

Normal Gilts have a fixed coupon. That doesn’t mean though that the debt is at a fixed rate, or yield to maturity though. If inflation or rates go up, as an investor I’m going to want a higher yield…which means the government effectively has to pay me more to hold their debt.

In simple terms, what you are saying is that interest rates are fixed at the price government issues debt at auction. If this was so, why do Gilts have a tradeable secondary market which moves all the time?

“Trust me, there is nothing wrong with my mathematical abilities.”

OK, it’s just your bond maths which is deeply flawed then.

“And? Again, increased interest rates apply to new debt and refinancing”

Which this sentence proves – old debt is also affected by chaging interest rates.

“The first point is seriously debatable, but the second is irrelevant. Debt can be refinanced, and as long as the total pile of debt doesn’t grow faster than the combination of GDP growth and inflation, the debt is *always* affordable.”

Some 10-20% of debt is refinanced every year – at current market rates. That is before “new” issuance to fill the budget deficit hole. If rates go up significantly, debt servicing costs very quickly become unnafforable – one of Japan’s myriad of problems, and something Greece has found out the hard way. Please don’t talk nonsense.

“QE as it’s been implemented so far has had no impact, because none of it has reached the wider economy, so unwinding of the current QE will have equally little impact.”

That’s a pretty bold statement. I assume you mean “no effect on growth” which is pretty hard to unpick from all the other factors, but QE certainly has had a massive effect on Gilt yields. I’m also very sure that unwinding QE, with the BoE selling 350+ bn of Gilts back into the market place will have a major effect on Gilt yields – forcing interest rates up dramatically.

“and also ignore that not all proceeds of growth end up as govt revenues”

Not sure how this can in any way be wrong. Tax revenues run at 30-40% of GDP growth.

“so if a Government can afford its debt burden today, and GDP growth matches or exceeds debt growth”

A lot of “ifs” there. What if interest rates go higher? Like in Italy, Spain or Greece? What if, depsite all this deficit spending, even on infrastructure, GDP doesn’t grow or does so only marginally….like Japan? In a perfect world you might be right, but it’s a massive punt straight from the Gordon Brown school of “no more boom and bust” economics.

“Corporations don’t pay tax.”

OK, what I should have said was that the cost of corporation tax is not carried by the faceless corporate entity. All those corporation taxes paid are at the cost of lower wages for employees, lower returns for investors, less investment or higher prices for consumers. All of which are bad for an economy.

@ 15 AndyC

What you say here is true Keynesian counter-cyclical spending. And probably makes sense if you can afford it.

Unfortunately, it rarely if ever happens, and certainly didn’t under Labour, who engaged in massive pro-cyclical spending. Which when the crisis happened left the UK with a 10+% budget deficit. Leaving little or no room for more counter-cyclical spending without forcing interest rates up.

@ Andy C

let’s run a little experiment.

You are a bond investor, for your pension fund say. You are forced to buy some bonds for your portfolio.

Government 10y Gilts are trading at a 2% yield (for the purposes of this example).

The government issues 2 new 10y bonds, and there is an old one on the market you can buy.

The 2 new bonds have annual coupons of 2% and 5%, and the old bond also has an annual coupon of 5%.

Which one is the best for you to buy?

18. gastro george

@16 Tyler

Anybody who compares the Eurozone to the UK wrt bonds doesn’t know what they are talking about.

@Tyler

“Firstly, on Japan: You’ve mixed up growth and productivity.”

No, I haven’t. You’ve shifted the goalposts. You started by saying:

“Also remember that the Japanese lost decade happened when for the most part the rest of the world was growing relatively robustly.”

effectively claiming it as an example that Government spending doesn’t bolster growth. My point was that you can’t simply ignore the fact that the working age population in Japan has gotten smaller, that will clearly limit the potential for growth (i.e. it’s harder for a smaller number of people to generate the same GDP as a larger number of people).

“What if interest rates go higher? Like in Italy, Spain or Greece?”

You mean countries that don’t have their own currency? One of the reasons the UK hasn’t seen interest rates go up is its capacity to print money at will. It’s the lack of this flexibility that is hurting these countries so much (Greece had/has numerous other problems too of course).

“What if, depsite all this deficit spending, even on infrastructure, GDP doesn’t grow or does so only marginally….like Japan?”

Then we’d be living in some strange parallel universe in which spending money within our own economy doesn’t cause it to grow.

“Indeed, this is why governments issue inflation linked or “real” bonds.”

But conventional bonds remain the largest single component of UK debt.

You claim to be an interest rate trader, which makes what you say immediately afterwards completely bizarre.

“In simple terms, what you are saying is that interest rates are fixed at the price government issues debt at auction. If this was so, why do Gilts have a tradeable secondary market which moves all the time?”

Um, for conventional bonds, yes, I am saying that interest payments are fixed. Secondary markets exist because different investors can have differing views on the value of the remaining income stream from a bond that pays fixed coupons, because of… inflation. You seem to be implying that the Government is somehow liable for deals done by investors independently of Government. These decisions by secondary markets don’t cause the cost of bond that has already been sold by the Government to increase from the Government’s perspective. Sure, investor perceptions may force the Government to reduce the price, or increase the coupon on *new* debt, but the old debt only changes if it needs to be refinanced. Hence I stand by my point that it makes sense to take advantage of the current low rates. By the way, I think the question was pretty disingenuous for someone claiming to know how this stuff works.

Which of course, brings me to this:

“You are a bond investor, for your pension fund say…”

An interest rate trader neglected to draw any distinctions between these bonds with different yields? Really?

No mention of, say, price? Or were you hoping I wouldn’t notice?

Also, the recovery from the 1930s depression is clear evidence that Government spending does work.

In the UK, the Government slashed public spending to balance the budget, came off the gold standard to ease monetary policy and was back in sustained growth by 1932. The UK ran budget surpluses in 1933 and 1934.

http://www.cps.org.uk/files/reports/original/120312164231-Metroboom.pdf

As far as the UK is concerned, the evidence from the 1930s is that cutting Government spending works (in conjunction with loosening monetary policy).

@Tim J

You’re omitting some major factors in your statements and there are some timing issues.

It ignores the extent of the post WWI slump in Britain, relative to other countries, hence the relatively mild slump (in Britain) in the 1930s could be characterised as “catching up”. Furthermore, Britain was not a high investment nation in the 1920s. In fact, between 1918 and 1920 the Government cut spending by 75% (the cuts of the early 30s were far more limited, but even these cuts were sufficiently damaging to push Britain into the abandonment of the Gold Standard, with BoE reserves nearly gone), which could certainly help to explain the poor performance of the 1920s. Thus, there was not nearly as significant a financial bubble to burst in 1929. With the lead weight of the Gold Standard removed from the economy, unlike in France, and BoE’s loosening of monetary policy through interest rate cuts from 6% to 2% (something that can’t happen today) Britain faired better than its neighbours.

Then of course, it is of note that British banks had more foreign assets than liabilities at that time; today’s institutions fair rather less well.

Significantly, the government was also able to take advantage in a reduction in bond rates to convert the 5% War Loan to 3.5%, and used the extra money to for unemployment benefits and public sector salaries, with an immediate impact on demand (this sounds familiar). A house building project then contributed enormously to the early part of the recovery.

From 1936 rearmament provided any additional boost to the economy.

So, on that basis, I would say the tale of Britain in the 1930s (and 20s) paints a very different picture from the one you present.

16. Tyler

” Firstly, on Japan: You’ve mixed up growth and productivity. ”

Growth and productivity are pretty much the same thing. When people speak about growth they usually mean real growth in GDP.

The feature of any economy is to take factor inputs labour, capital, and raw materials and convert them into useful products. This relation between factor inputs and output of the economy is its production function. Thus we might write

Y = A F(K,N),

Y is output (real GNP), K is the stock of physical capital (plant and equipment), and N is labour (the number and hours of people working). The letter A measures what we call productivity. A higher value of A (productivity) means that the same inputs lead to more output i.e. higher GDP. The rate that A is increasing will determine the rate that real GDP is increasing. The level of A, that is the total factor productivity of the whole economy will determine the total GDP of the economy. Therefore, productivity and growth are pretty much the same thing.

Productivity can be used in different ways. If we were speaking about the productivity of the whole economy we would use A as signifying total factor productivity. In the context of average labour productivity, then Y/N would be appropriate.

” I’m also very sure that unwinding QE, with the BoE selling 350+ bn of Gilts back into the market place will have a major effect on Gilt yields – forcing interest rates up dramatically. ”

The BoE would have no intention of selling 350+ bn of gilts all at the same time by the unwinding QE. One can’t separate the size of the BoE balance sheet ( assets- minus liabilities) from its monetary policy remit. The size of its balance sheet is how it fulfills ts remit. As interest rates rise the BoE will automatically reduce its balance sheet by selling assets to maintain its policy rate i.e. unwind QE. They would be unable to fulfill their monetary policy remit without selling assets. Interest rates rising is the same thing as contractionary monetary policy. Moreover, contractionary monetary policy is the same thing as the BoE reducing their balance sheet by selling assets.

@ Andy C

You’ve pretty much answered my question (by not answering it).

“An interest rate trader neglected to draw any distinctions between these bonds with different yields? Really?

No mention of, say, price? Or were you hoping I wouldn’t notice?”

I was actively betting you wouldn’t understand exactly that point. You don’t seem to understand the difference between a bond’s coupon (the fixed amount you get paid every year), it’s yield to maturity (the actual return you get) and it’s price. You clearly also don’t seem to understand yield to maturity is inversely proportional to a bond’s cash price.

All those three bonds in my example will have *exactly* the same yield to maturity. They pay different coupons though. How can this be? Simples….the 5% coupon bonds will trade at a higher face value – so for example you will have to pay 110 for 100 face amount of the 5% bonds. You get proportionally less (or have to pay more for) of the 5% coupon bonds till the total returns of each bond, for the same maturity, are the same. It’s a function of the market. If one bond were cheaper or offered more yield, people would buy that for choice until the yield on both was once again the same.

The question was intentionally a trick question – anyone who actually knows how this stuff works would give the same answer, which is that it doesn’t matter, as they all give the same total return as they all have the same yield to maturity.

You also fail to realise that between the rollover of old bonds into new ones, you also have to finance those coupon payments. Normally by issuing new debt. The present value of those coupons actually works out far larger than the bullet repayment of the original bond….the net result being that roughly speaking the overall cost of government debt financing changes with the market long Gilt rate.

What it 100% CERTAINLY ISN’T is fixed.

For the same reasons a government doesn’t get an advantage if it refinances at the new lower yields. Those old 5% coupon bonds will be trading at that premium on price, so the government would have to pay 110 to buy back 100 of it’s debt….and the yield on the new debt it would issue to fund the repurchase of the old debt would be exactly the same.

—————————————————–

“effectively claiming it as an example that Government spending doesn’t bolster growth. My point was that you can’t simply ignore the fact that the working age population in Japan has gotten smaller, that will clearly limit the potential for growth (i.e. it’s harder for a smaller number of people to generate the same GDP as a larger number of people).”

You are saying that demogrpahic changes should have decreased productivity, and thus GDP. OECD data shows productivity *increased* slowly, every year since the 60s. I’m sure there are many reasons for this but mechanisation is probably the main one. However, even after all the massive government spending (including on infrastructure) in Japan, their growth has been very poor for years – which CAN’T be explained by a decrease in productivity, because there wasn’t one.

“You mean countries that don’t have their own currency? One of the reasons the UK hasn’t seen interest rates go up is its capacity to print money at will.”

I could pick plenty of countries which do have their own currency and make the same point, as it’s totally generic. The MARKET controls long term interest rates, the Government/Central bank short ones.

The “money printing” has to be reversed at some point, by selling those bonds bought during QE, which sends rates higher, or you can go the Zimbabwe route and just print outright, but then the inflation you cause will destroy your pension system and economy. If people lose trust in your currency as a store of value, the country’s ability to repay it’s debt or see inflation going higher they will require higher yields/rates to invest.

“Then we’d be living in some strange parallel universe in which spending money within our own economy doesn’t cause it to grow.”

See Japan, again. If an economy has too much spare capacity, infrastructure spending doesn’t necessarily give you a multiplier effect.

@ Richard W

On productivity/growth in Japan see above…I hope I’ve explained better the point I was trying to make.

“The BoE would have no intention of selling 350+ bn of gilts all at the same time by the unwinding QE”

Agreed, but knowing the BoE was going to turn seller from being a buyer would do unquantifiably nasty things to bond yields. No-one knows how much they will go up, given QE has never been unwound before. My bet is all the extra bonds on top of new issuance will flood the market, so QE will have to be unwoud incredibly slowly over many years, and the government/BoE will probably take large losses on the back of it.

@Tyler

OMG, this is getting ridiculous. You tried a trick question that failed, and then decided I still didn’t understand it.

“I was actively betting you wouldn’t understand exactly that point.”

Then you were clearly wrong, how about acknowledging that?

“You don’t seem to understand the difference between a bond’s coupon (the fixed amount you get paid every year),
it’s yield to maturity (the actual return you get) and it’s price.”

Again, OMG, my last post clearly distinguishes price and coupon, once the coupon has been bought, the price is completely irrelevant to the Government (and as of right now, whether you consider price, or coupon, borrowing is cheap)!

Your “example” is pointless because it compares fictitious bonds against themselves (minus important information), it completely ignores what the alternative (and higher risk) investments are, which is why an *investor* would tolerate a lower yield in the first place!

“market long Gilt rate. What it 100% CERTAINLY ISN’T is fixed.”

And I’ve clearly said nothing different. Oh, and the current long rate is also…. very low.

“For the same reasons a government doesn’t get an advantage if it refinances at the new lower yields.”

See my post regarding the War Loan.

@Tyler

One more thing, just to drive it home before I stop wasting time on this conversation; the whole point of this “debate” is that borrowing cheaply for infrastructure now, in order to boost the economy and make it self-sustaining, is that in the future, when interest rates rise because alternative investments become more attractive due to growth, the Government can start paying down its debt with the proceeds, and therefore not actually have to refinance this debt at the higher rate. i.e. the new debt doesn’t become a permanent fixture of the national debt.

“once the coupon has been bought”

obviously I meant to say “once the bond has been bought”

28. gastro george

@Tyler

“I could pick plenty of countries which do have their own currency and make the same point, …”

Go on then …

“The MARKET controls long term interest rates, the Government/Central bank short ones.”

Isn’t QE designed to reduce long-term rates? No sign of market control there.

“The “money printing” has to be reversed at some point …”

No it doesn’t.

@ Andy C

Quite simply, you are wrong and bordering on too stupid for words.

Lets take a real life example of Uk Gilts.

lets take the 8% Coupon maturing in Jun21 and the 3.75% Coupon maturing Sep21. By your logic the 8% bond is more expensive for the government to finance, and thus is a better bond for the investor to buy.

In reality though, the 8% coupon bond yields 1.44%, and the 3.75% yields 1.58%, the latter yielding more because of the steepness of the curve. If they issued a new bond with the same maturity as either, it would yield the same. Even if the bond was a zero coupon….it would still yield 1.44% if it matured in Jun21 (simplifying for duration and conovexity adjustments, not that I expect you to know what that means).

The market is dictating where those rates are, and in price terms the former bond now trades at 152.2 for 100 face, and the latter 117.6. So for the government to retire that debt it has to pay those amounts to buy back 100 face. So price *isn’t* irrelevent to the government.

Now, considering that the government issues it’s bonds unhedged, debt rollovers account foor 10-20% of total issuance per annum, and coupon payments over the life of a bond are *much more* than the basic repayment of the face amount, and are financed entirely by new debt, then it turns out that the government’s financing costs turn out to be roughly where long bond yields are.

You think that the government’s costs are fixed, and because rates are low it’s cheap to borrow now, with no exposure if rates go up. I am telling you as a fact that this is nonsense, and if rates start to go up the cost of government financing will do the same – it’s basically re-investment/re-financing risk.

Indeed, one of th efunds I run is for a City municipality, who have issued bonds, and we manage their exposure to this risk. You’ll also find plenty of articles on the internet relating to what will happen to Japan if their rates go up.

Lastly, again on this magical infrastructure to boost growth beast. Yes, it can work if your economy is running at or near capacity. It will even add a temporary boost to GDP. Turing that into long term growth, and making it more than self-financing is NOT a given though, as the experience of Japan shows. If you have a large productivity gap and excess capacity in the economy it doesn’t necessarily help, and can even be a cost.

Using real world examples in the UK, you don’t need new ports if the ones you have are running at half capacity, but you might need a new airport because Heathrow is full. Likewise you might need more roads or housing, but it’s not clear you need a new high speed rail line at massive cost to shave just 40 mins off a journey time, especially if the current line isn’t at capacity. Ultimately, governments have horrible track records on designing and delivering these kinds of infrastructure projects, yet you seem to think they are some magical economical cure-all, without bearing previous experience into account.

It’s actually pretty scary how little people like you understand about economics and finance, yet feel confident to go off making assertions about it and what we should do to fix the economy. What do you do for a living? Public sector somewhere?

30. gastro george

@Tyler

“Indeed, one of the funds I run is for a City municipality, who have issued bonds, and we manage their exposure to this risk.”

Repeat after me, a monetarily sovereign nation is not a City municipality …

“You’ll also find plenty of articles on the internet relating to what will happen to Japan if their rates go up.”

And yet they don’t …

@Tyler

Yeh right, because Governments fund infrastructure investment by selling bonds that expire in 6 months. Stop picking stupid examples.

21 – So, you’re saying that a combination of unique historical factors make the UK in the 1930s an inappropriate and inapplicable comparison to the UK today, but that the USA in the 1930s is proof that “government spending works”?

Significantly, the government was also able to take advantage in a reduction in bond rates to convert the 5% War Loan to 3.5%, and used the extra money to for unemployment benefits and public sector salaries

Unemployment benefits and public sector salaries were slashed massively in 1931. So massively that it caused a mutiny in the RN (it was this mutiny that ultimately tipped the UK off the Gold Standard – not because the cuts were so large, but because it looked as if the cuts couldn’t in fact be achieved).

From 1936 rearmament provided any additional boost to the economy.

By 1936 the UK economy had been growing for four years. It grew by 6% in 1934 alone. If you’re arguing that this public spending helped the UK out of recession, you’re stretching the timing a touch.

In fact, between 1918 and 1920 the Government cut spending by 75% (the cuts of the early 30s were far more limited, but even these cuts were sufficiently damaging to push Britain into the abandonment of the Gold Standard, with BoE reserves nearly gone), which could certainly help to explain the poor performance of the 1920s.

Should the British Government have carried on spending money on munitions to explode in Northern France? In 1918 public spending was 56% of GDP – spending on defence was about 40% of GDP. The end of a war is going to knock something of a hole in that – by 1921 defence spending was less than 5% of GDP again.

Before WW1 British Govt spending ran at about 10-15% of GDP. After the war it never dipped below 25%. It’s hard to see how a non-defence increase of that magnitude is going to push relatively poor performance in the latter 20s.

29. Tyler

” Lastly, again on this magical infrastructure to boost growth beast. Yes, it can work if your economy is running at or near capacity. It will even add a temporary boost to GDP. Turing that into long term growth, and making it more than self-financing is NOT a given though, as the experience of Japan shows. If you have a large productivity gap and excess capacity in the economy it doesn’t necessarily help, and can even be a cost. ”

Tyler, you have that back to front. It would be the wrong time for the government to be spending on infrastructure when the “economy is running at or near capacity”. The government competes with the private sector for capital and at capacity the government spending would crowd out private sector spending. Moreover, government spending on infrastructure when the economy is at capacity only adds to inflation and not real growth. At capacity the additional government spending means private sector firms have to bid up wages beyond their productivity increases and thus raise inflation.

When the economy has an output gap, that is the level where it is performing compared to its potential i.e. excess capacity. It is in that scenario that government spending on infrastructure can increase real growth. You do not need to be a believer in Keynesian multipliers and I am a skeptic to understand through simple logic that such spending will raise RGDP by putting into use idle resources. Whether the RGDP is sustainable will depend on whether the infrastructure spending increases the supply potential of the economy. A bridge to nowhere will be useless, but a bypass to relieve a traffic bottleneck is sustainable because it increases the efficiency of the economy.

@Tim J

I’m saying context matters yes. Our current economic position is more akin to the position of the US and other European nations of the 1930s than it is to Britain of the 1930s, which went through a very different scenario leading up to 1929.

I’ll post a link to the details of this when I have access to it.

Ed Conway ?@EdConwaySky

Dwell on this for a moment: Investors just committed to PAYING the UK government a record amount to LEND it money (and inflation-proof it)

@Tim J

Just to be clear, if we were not in a liquidity trap, with interest rates at a lower bound, I would not advocate increases in infrastructure spending. But we are, so I am :-)

Ed Conway ?@EdConwaySky

Dwell on this for a moment: Investors just committed to PAYING the UK government a record amount to LEND it money (and inflation-proof it)

@ 30 Gastro

I was talking about the hedging or re-financing/re-investment risk….in that regards, as well as others (namely tax raising powers) they are very similar.

Japanese nominal rates have been low for ages, but they have been in deflation for ages too…so if you look at Japanese real rates vs UK real you will see that the Japanese 10y real yield is 1.19% vs the UK equivalent at -0.88%.

So in real (i.e. return after inflation) terms, Japanese rates are *much* higher than UK rates.

If you read those articles you will also see that people are seriously concerned that rates will go up because the Japanese now have so much debt that the interest payments alone are starting to dominate, and pensioners are starting to eat into their savings rather than net contributing. Which means bond yields will go up and the country will fall on it’s ar$e.

@ Andy C

The fund I mentioned has liabilities out past 20 years. It’s actually a pretty good microcosm equivalent of goovernment financing.

I notice that you are now clutching at straws….

@ Richard W

I think we are talking in terms here, and it’s very situation dependent. Whilst to some extent I agree with you, that govt spending can crowd out private infrastructure spending, there are some cases where it can kickstart it – normally on the projects so large they physically can’t be backstopped privately. Or unclogging your bottlenecks, for example. I think these are the type of projects that Andy C was trying to get at, whilst blindly shooting for everything.

There are also the projects which, as you say, crowd out private investment or simply aren’t necessary as the capacity already exists. Reinforcing the main point that not all government infrastructure spending is good or worthwhile, and it’s certainly not some magical ecomonical cure.

Significantly, the government was also able to take advantage in a reduction in bond rates to convert the 5% War Loan to 3.5%

Further to this by the way, a) this happened in 1932, after the economy had returned to growth, and b)it was the conversion of the 5% War Loan that led to falls in interest rates and rises in gilt yields, and not the other way around.

40. gastro george

@Tyler

If you’re seriously saying that “the markets” are saying that Japan is doomed because their long-term rates are nudging over 1%, then you’re clutching at straws. Not exactly Greece, is it.

@ Gastro

Markets aren’t saying that yet, as Japanese debt is still primarily domestically owned, and they have huge US treasury holdings which they could sell and use the money to pay off debt. That would massively strengthen the already strong yen and hurt the economy even more though.

Long term its doomed, shorter term people are simply alarmed….which is expressed in foreign investors tiny holdings of JGBs.

Good explanation here, from SocGen’s Dylan Grice.

http://www.zerohedge.com/article/upcoming-government-funding-crises-japan-edition

The thing to take away is this:

“The biggest problem for Japan, however, is that it can not afford to ween itself off bond issuance. Japan’s current debt service amounts to 35% of pre-bond issuance revenues, while the ratio of revenues from bond issuance to that from tax collection is expected to rise over 100% in 2010: “tax revenues will be less important than borrowing as a source of income.”

It’s downright effing scary, but a story which will take years if not decades to play out.

42. gastro george

@Tyler

For a sovereign country, debt is optional (as you can see with QE). Long term the strain will be taken by the exchange rate. As you say, the yen is currently strong and their economy could actually do with some devaluation, seeing as their traditional trade surplus has vanished. That would import some inflation but, considering they are deflating at the moment, that’s not an immediate worry.

@Tyler

I’m not clutching at straws, I can’t be bothered to waste my time going back and forth for another 20 posts before you actually get somewhere near the scenario I’m actually describing, rather than inventing “consider these 2 bonds…” Scenarios that have nothing to do with the scenario I’ve mentioned (especially after your recent infrastructure contortions).

@ Gastro

“For a sovereign country, debt is optional (as you can see with QE).”

The stupid, it hurts! QE does not remove debt! It still has to be unwound and repaid!

45. gastro george

@Tyler

The idea that the state has to “unwind” the bonds is as risible as paying itself interest on the bonds that it holds.

@ Gastro

Doh! You’ve been reading too much of that window-licker Richard Murphy, haven’t you.

When those bonds the BoE holds mature, they either need to remove cash from the system, or issue new bonds to redeem the old ones. Simply wiping them off the balance sheet without doing either of the options above is pure money printing Zimbabwe style…

It is 100% incorrect to say that QE does not have to be unwound in some way. It does, and that debt is very real.

47. gastro george

@Tyler

So if a bond held by the BoE matures, what actually happens?

[Zimbabwe! Weimar! Let's play hyperventilation bingo!]

48. gastro george

You know, in asset/cash flows.


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