A New Macroeconomic Strategy WebReady Final

7/30/2019 A New Macroeconomic Strategy WebReady Final

1/36

Why we need a new

macroeconomic strategy


2/36

nef is an independent think-and-do tank thatinspires and demonstrates real economicwell-being.

We aim to improve quality o li e by promotinginnovative solutions that challenge mainstreamthinking on economic, environmental and socialissues. We work in partnership and put peopleand the planet frst.

nef (the new economics oundation) is a registered charity ounded in 1986 by the leaders o The Other Economic Summit (TOES),which orced issues such as international debt onto the agenda o the G8 summit meetings. It has taken a lead in helping establishnew coalitions and organisations such as the Jubilee 2000 debt campaign; the Ethical Trading Initiative; the UK Social InvestmentForum; and new ways to measure social and economic well-being.


3/36

ContentsExecutive Summary 2

Introduction 4

1. The ailure o the Governmentseconomic strategy 5

Austerity isnt working 5

There has been no private sector-led recovery 7

Export-led growth has oundered 8

2. The state o the UK economy 10

Dependent on the fnancial system 10

Heavily indebted 10

Slowing down 14

Unbalanced 16

Trapped in trade defcit 18

3. Towards a new macroeconomic strategy 20

Path dependency 20

Ending austerity, sustaining demand 20

Shrink and reshape the fnancial system 23

Capital controls 24

Quantitative easing 27

4. Conclusion 29

Endnotes 30


4/36Why we need a new macroeconomic strategy 2

Our approaching triple-dip recession was a direct result o the governmentsawed economic strategy. The case or austerity rests on two alse premises:that the previous government had been spending excessively, and the governmentdebt and defcit are the main threat to our economic stability. But the real threatto stability lies in our fnancial system which, ollowing the crash, led the UK intorecession, decreasing tax revenues while pushing up government debt

The governments austerity strategy was ounded on two other incorrect belie s.First, the Coalition assumed that the private sector would fll the gap created bypublic spending cuts. In act, business investment has grown by less than a third othe rate the government orecast in 2011 and 2012 and shows no sign o rising tothe levels required to prompt an economic recovery.

Second, the strategy relied on export-led growth. Despite the pound alling over20 per cent in value since 2007, exports have been volatile, re ecting globaluncertainties, and the trade defcit shows ew signs o closing. We have littlechance o attracting more European export sales, and our import dependency isincreasing.

Austerity is the wrong response to a demand-led recession. With bothhouseholds and frms reigning in their expenditure the multiplier e ect makesit oolish or a government to behave likewise, particularly given the economicuncertainty abroad.

A longer term analysis o the overall state o the UK economy fnds it to beundamentally weak:

P It is overly dependent on fnance. Our uniquely large, globalised, and poorlyregulated fnance system makes us particularly vulnerable to external shocks.

P It is heavily indebted. The UKs total indebtedness is continuing to rise, with thebulk o the UK debt burden arising rom the private rather than the public sector.

P Relative to other large developed countries, the UK is in a poor position todeliver uture growth. productivity growth in the private sector collapsed in therecession and ailed to recover.

P Britain is the most geographically unequal economy in the EuropeanUnion. Growth over the last decade has been heavily biased towards the SouthEast. While Inner London is now the richest space in the EU, the Welsh valleysare poorer than Slovakia.

Executive summary

Four years on rom the fnancial crisis, the UK economy is still amess. The governments economic strategy is not only ailing onits own terms, it is damaging our undamentally weak economy.The roots o our current problems lie beyond the credit crunch; inthe UKs dangerous dependence on a large fnancial sector, poorcurrent account, low productivity and uneven regional development.It is time or a new macroeconomic strategy one that is moreequal, provides employment or those who want it, minimises ourimpact on the planet, and maximises our well-being.



P The UKs chronic trade defcit has been paid or by ows o fnancerom abroad. The mutual rein orcement between demand or fnance anddemand or imports has turned into an economic deadlock.

P Growth alone is not the best economic objective. Better metrics orassessing economic policy based on work created, real median incomes,well-being and environmental damage would help shape economic policybetter.

We live in a high-carbon, high-debt economy. It used to deliver growth. Now itcannot even manage that. There are clear barriers to growth, and, worse, growthitsel is unlikely to deliver or the majority. But Keynesianism alone boostinggovernment spending will not reverse the course when debts remain high andthe underlying economy is weak.

It is essential we carve a new path, though it will take signifcant e ort andexpenditure to do. A success ul new macroeconomic strategy must recognisethe path dependency o our current situation and shi t to a completely newmode o operating. The frst steps to ensure this will require us to:

P End austerity and sustain demand. When no one else is spending,government has to. The government must act to create jobs, boost demand

and redistribute wealth to the regions. Rising inequality and a alling shareo wages in output are direct drivers o economic stagnation and must bereversed.

P Shrink and reshape the fnancial system. The UKs fnancial system isunsustainably large and requires shrinking: its balance sheets reducedrelative to GDP, its employment reduced as a share o the work orce.Breaking up major banks would help them to operate di erently, witha greater variety o fnancial institutions spreading risks and managingcomplexity better. Localising banks, diversi ying ownership structures, andplacing greater democratic and public control over banking unctions will allhelp to trans orm the fnancial system or the better. Some debt cancellationis likely to be necessary.

P Introduce capital controls. By making movements o capital in and out othe UK more expensive, they become less desirable, reducing speculationMeasures like an emergency tax on capital in ows; unremunerated reserverequirements; legal restrictions on derivatives positions and restrictions onoverseas ownership o residential property could manage the ows o capitalto attract more stable investments.

P Use Quantitative easing or productive activity. The e ects o QE soar have been to support the existing fnancial system. I , instead o pilingnew fnancial assets onto bank balance sheets, QE was used to injectcash directly into the economy, it could start to act to break our economic

deadlock.



No single policy can unpick this tangle o mutually rein orcing weaknesses,ormed over decades. We need an economic strategy : a set o policies designedto break open the deadlock and set us on a better track.

Transfxed on reducing the debt and the defcit, the Coalitions currentmacroeconomic strategy is all too clear: austerity, extended ar into the uture.

This paper proposes a major change o course. It shows not just that austerityis counter-productive on its own terms, leading to widening defcits and risingdebts, but that ar rom overcoming the UKs deep economic weaknesses, itbuilds on them.

Starting rom the gloomy state Britain is in now, this report charts a path towardsa new, and better, economy: one that is more equal, provides employment orthose who want it, minimises our impact on the planet, and maximises our well-being.

It aims to show how the global eatures o this crisis have had their particular,national impact on the UK and how, then, it can develop a particular, nationalresponse.

Introduction

Nearly fve years a ter government bail-outs propped up thefnancial system to prevent total economic collapse, there hasbeen no return to normality. Debts, accumulated during the yearso apparent boom, remain high. Growth is stagnant or altering.Further fnancial panic looms. All the while, the deterioration o theenvironment grows more evident daily.



Austerity isnt workingAusterity is the Coalition governments big-picture solution to the crisis. It arguesthat during the boom years, everyone (the government especially) spent toomuch, and so borrowed too much resulting in a gaping national debt anddefcit that we can apparently no longer sustain. The government must there orerepay its debts as quickly as it can or ace economic calamity; and austerity sharp cuts in government spending backed up by moderate tax rises is how itproposes to do this.

This is arguably the worst single economic argument that any British government

has ever been taken in by, let alone enacted into policy. On its own terms,it is close to economically illiterate, ignoring 80 years or more o theory andexperience.

First o , the argument is built on the alse premise that our previousgovernment had been spending excessively, and in doing so increasingpublic debt and widening the defcit. In act, as Figure 1 shows, the Labourgovernment o 19972010 on average spent less (and taxed less) as a shareo GDP than the two preceding Conservative governments. 2 Moreover, publicexpenditure has been alling relative to GDP ever since the 1970s. So quitecontrary to the myth, New Labour was by historic standards a low expenditure,low taxation government.

Second, the Coalitions argument rames debt and defcit as public enemyNo. 1, when the main threat to our economic stability lies in the structure o ourfnancial system. Last time this system unravelled, the allout was disastrous:

The ailure o the governments economic strategy

Since its ormation a ter the election o May 2010, the Coalitiongovernment has stuck ruthlessly to its central economic case: thatausterity is the only route back to fnancial stability or the UK.

Figure 1. Government spending and revenues as % o GDP, 19782010.

50

40

3019801978 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Govt. Spending % GDP

Govt. Revenues % GDP

Source: HM Treasury



P Following the collapse o Lehman Brothers in 2008, the government wasaced with total disintegration o the fnancial system. It believed it hadto take on immense new liabilities and borrowing and o er support to astricken fnancial sector. The total cost o propping up the banking system,according to the Bank o England, was 1.278 trillion, including both directand indirect support.

P By panicking banks and others into cutting back on their lending, thefnancial crash triggered an immediate and very sharp recession. Box 1explains how this credit crunch, through the multiplier e ect, led to severestag ation and rising public costs. The collapse, incidentally, had nothingto do with excessive public spending: as Figure 1 shows, rising spendingrom 2001 had levelled o by 2006.

Third, austerity is no way to end a recession, and has ailed. In act, in thecircumstances, it is the worst possible course o action that the governmentcould have ollowed. With both households and frms reining in theirexpenditure, it is plainly oolish given the multiplier e ect or government tobehave likewise. 3 And with economic uncertainty prevailing globally, exportingabroad can be by no means relied upon to deliver a boost at home, asclaimed or those dubious austerity success stories o Canada in the 1990s,and the Baltic states today. 4

The unprecedented triple-dip recession was a direct result o governmentpolicy. Right up until the Coalition began to ratchet up austerity measures, theUK was beginning to recover rom the immediate shock o 2008 (Figure 2). 5 Now, estimates by the National Institute o Economic and Social Research(NIESR) suggest 5 per cent will be wiped o UK GDP by 2013 as a result oausterity, while the IMFs chie economist now admits that stronger plannedfscal consolidation has been associated with lower growth than expected. 6, 7

Box 1. The recession: What happened?

By panicking banks and others into cutting back on their lending, the fnancial crash produced an immediate andvery sharp recession. This credit crunch, and accompanying economic uncertainty, caused both households andfrms to rein back their spending. Household consumption ell by more than in any previous post-war recession,while investment spending ell by more than 40 billion in real terms since its 2007 peak.

This eature o the recession is essential to understanding what happened next. Both frms and households, aswe have seen, had become increasingly indebted during the boom years. When credit conditions turned sharplyagainst urther borrowing, preventing frms and households continuing to roll over their debts as they had done, theylooked immediately to pay down their debts. They did this by reducing their spending, and paying o their creditors

as best they could.

While it makes some sense or an individual household or frm to pay o their debt, it is disastrous or the economyas a whole. Across the whole economy, what one individual spends is necessarily what another individual earns money spent has to be earned somewhere. So i someone cuts their spending to repay a debt, it means someoneelse is earning less. I they are earning less, they, too, will cut their spending. The e ect o the initial all in spendingis magnifed by this process, known as the multiplier e ect.

This multiplier e ect means that i both frms and households are cutting their spending, others are earning less,and so the whole economy is pulled backwards. A sharp recession broke out, o a kind that had been seen be ore.Richard Koo, investigating Japans recession o the 1990s, called this a balance sheet recession, when heavilyindebted frms and households look to shrink their debts, cut their spending, and so produce a shrinking o theeconomy overall. The UK is going through the same process today, resulting in prolonged stagnation.

Its impact on public fnances has been dramatic. The sharp increase in government spending as a share o GDP in2009 is the direct impact o a recession both shrinking real economic activity and pushing up necessary spendingon unemployment benefts.



There has been no private sector led recoverySo what did the Coalition think would happen as a result o austerity? We can drawsome clues rom the frst set o orecasts and accompanying economic commentaryproduced by the O fce or Budget Responsibility (OBR) in 2010, set up shortly a terthe general election by George Osborne, purportedly to overcome the politicisation oo fcial economic orecasts. 8

These now make or ironic reading. While acknowledging the demand-shrinking e ecto sharp government spending cuts, the OBR proposed that these were nothing to

be eared. In the place o government spending, its orecasters confdently expecteda rebound in the private economy. The private sector would roar ahead, driven byan investment boom so great that it would overwhelm the depressive e ects o thespending cuts. All this would be assisted by a steep recovery in exports. By 2011, theOBR predicted, the whole economy would be growing by 2.3 per cent, rising to2.8 per cent in 2012 (driven by a business investment growth rate o 8 per cent in2011 and 10 per cent in 2012). In short, the recovery rate would be aster than thatachieved a ter any recession since the Second World War.

All this would drive a rapid return to economic growth in which the private sector, notthe public, would dominate: just the economic rebalancing that the Coalition wanted.The economy would be weaned o public spending and private consumption, withinvestment and exports leading the way. That would mean a ew squeezed years onreal living standards or the majority, but with the compensation o a healthier, morecompetitive economy by 2014, driving average earnings growth o 4.3 per cent inthat year. 9 The share o national income taken by labour would continue to decline,as it had done or decades, but a aster-growing economy would compensate thework orce. 10 Shaking out and restructuring driven by austerity in the public sector,although pain ul or most, would be glossed over by a rapid return to boom conditions.

This was an implausible story even at the time. It now looks risible. Businessinvestment in 2011 grew by just 0.8 per cent, and is expected or 2012 to be around3.5 per cent around one-third o the rate predicted. The whole economy, ar romrebounding to health, opped back into recession and continues to ounder. Figure 3shows the prediction and the reality.

The governments core narrative, as expressed in the OBR reports, has ailed. Therehas been no signifcant private sector recovery. That ailure, in turn, is driving the ailureo its stated core economic objective: to reduce the national debt and the defcitthrough a programme o severe austerity measures.

Figure 2. Real GDP.

104

102

100

98

96

94

92

90

88

Real GDP, pre-crisis peak = 100

US

2 0 0 7 Q 1

2 0 0 7 Q 2

2 0 0 7 Q 3

2 0 0 7 Q 4

2 0 0 8 Q 1

2 0 0 8 Q 2

2 0 0 8 Q 3

2 0 0 8 Q 4

2 0 0 9 Q 1

2 0 0 9 Q 2

2 0 0 9 Q 3

2 0 0 9 Q 4

2 0 1 0 Q 1

2 0 1 0 Q 2

2 0 1 0 Q 3

2 0 1 0 Q 4

2 0 1 1 Q 1

2 0 1 1 Q 2

2 0 1 1 Q 3

2 0 1 1 Q 4

2 0 1 2 Q 1

2 0 1 2 Q 2



Export-led growth has ounderedThe other driver in the Coalitions orecast was international trade. The key to its storywas a recovery in international competitiveness, driven by a reduction in the UKs relativecosts: the pound has allen around 30 per cent in value since 2007, making UK exportscheaper or those abroad.

The Coalition predicted this would lead to the UK selling more abroad, helping shrink ourtrade defcit the gap between what an economy imports, and what it exports. This hasnot happened. Exports have been volatile, re ecting global uncertainties, and the tradedefcit reached record levels over the summer. It has since closed, the defcit alling rom4.8 billion in June to 1.5 billion at the end o July largely as a result o the good, ideclining, ortune o North Sea oil. Nonetheless, the general pattern o stagnation isclear, as demonstrated by Figure 4, which shows the UK current account (defned in Box2) as a percentage o GDP, since 1979. The defcit is clearly chronic, and shows ewsustained signs o closing.

The trade defcit in goods alone reached an all-time high over last year, at 100.3 billionin real terms, partially compensated or by a surplus o service exports.

So why didnt the devaluation o the pound bring about a boom in exports, as expected?The answer is simple: the ip side o UK goods costing less abroad is that imports romabroad cost much more here in the UK. Although we may sell more exports, they will not

earn enough to cover the increased costs o the imports we are consuming at home.A ter all, in response to the changing prices o internationally traded goods and services,those consuming imports at home will in general carry on buying them, while thosebuying UK exports abroad may take time to switch to buying cheap UK exports.

The result o this is a widening defcit. When supply chains are internationalised, thee ect can be simply to immediately increase the price (due to the alling pound) onecessary imports or producers, while overseas sales take ar longer to adjust to allingprices.

Box 2. What is the UK currentaccount?The current account measures trade in bothgoods and services. It is the sum o the balanceo trade (export earnings minus purchases oimports), actor income (income rom oreigninvestments minus payments to oreign investors),and cash trans ers.

Figure 3. O fcial orecasts vs. reality o GDP recovery.

U K G D P ( 2 0 0 7 =

1 0 0 )

102

100

98

96

94

92

902007 2008 2009 2010 2011 2012

OBR June 2010

Actual

Box 2. What is the UK current account?

The current account measures trade in both goods and services. It is the sum o the balance o trade (exportearnings minus purchases o imports), actor income (income rom oreign investments minus payments to oreigninvestors), and cash trans ers.



And this is nothing new: currency devaluations have led to worsening currentaccount defcits several times be ore. Harold Wilsons 1966 devaluation, orinstance, worsened the trade situation decisively. 11

This defcit should, all things being equal, gradually close over time as consumersadjust their spending away rom (expensive) imports and those abroad buy more(cheaper) UK exports. 12 The September 1992 devaluation, ollowing the UKs exitrom the Exchange Rate Mechanism (ERM), had this impact as can be seen inFigure 4 with the current account defcit starting to head back towards a balance.

This gradual closing o the trade gap is not guaranteed, however, and has in thepast been problematic. Since the Second World War, when governments haveattempted to boost the domestic economy either by relaxing credit controls andsetting low interest rates or (less o ten) deliberately loosening fscal policy, the resulthas also been to orce the current account still urther into defcit. With increaseddisposable incomes, frms and households in the UK have simply chosen to buymore rom abroad increasing imports and worsening the defcit. As a result,governments have then reined in activity again by tightening monetary policy andpulling back on spending.

This swing between loose and tight policy has been dubbed the stop-go cycle, inwhich successive governments have aimed or domestic expansion but run up hard

against constraints imposed by the UKs position internationally.13

But what is truly unique about the UK governments current strategy is that,committed to the exact reverse o a domestic expansion in spending, it is managingto produce the same results as post-war governments while aiming at precisely theopposite target. We have precluded the stop-go cycle but instead arrived at a stop-stop: a government committed to austerity in a recession that fnds its clampdownon domestic activity rein orced by the UKs international position. That ailure toimprove the UKs international position in turn places urther pressure on domesticreal incomes.

The UKs largest trading bloc, the Eurozone (covering around 40 per cent o ourinternational trade) is also in worsening recession and pushing hard at austerity. Asa result, we have little chance o attracting more European export sales. Finally, theUK is also a growing net importer o energy and o ood, with import dependencyrom all energy sources rising to 36 per cent o total domestic availability lastyear. 14 As North Sea oil and gas supplies decline, this situation will worsen notwithstanding the dubious benefts o expensive shale gas. 15

Figure 4. UK current account, as share o GDP.

1 9 7 9

1 9 8 0

1 9 8 1

1 9 8 2

1 9 8 3

1 9 8 4

1 9 8 5

1 9 8 6

1 9 8 7

1 9 8 8

1 9 8 9

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

% G

D P

2

1

0

-1

-2

-3

-4

-5



Dependent on the fnancial systemDuring the crash, fnancial systems everywhere turned in on themselves. Financialows into the UK economy, which had been critically responsible or sustainingthe apparent prosperity o the boom years, reversed sharply, alling rom an inwardinvestment o 1074 billion in 2007 to a disinvestment o 490 billion in 2008, asthose resident elsewhere ditched UK fnancial assets in enormous volumes. 17 Theseout ows, driven by depositor withdrawal rom UK banks and the disposal o fnancialassets held in UK accounts, were matched by a similar withdrawal rom abroad bydepositors and institutions based in the UK.

The act that UK domestic consumption is so dependent on international owsis dangerous: it means that sharp shi ts in international fnancing act as a directconstraint on the domestic economy.

But aside rom the vulnerability to external shocks (or, or that matter, shocks arisingentirely rom the fnancial systems own baroque practices) there is a longer-termproblem: external fnancing will continue to ow into the UK or as long as it can o eracceptable rates o return, relative to elsewhere. For nearly two decades, assistedby complaisant politicians and the seeming ability o the UKs fnancial sector too er high rates o return or low degrees o risk, this has been the case. Finance haswillingly owed into the UK, and owed out only when subjected to a major shock

in 2008. Otherwise, since 1991, the UK has been a net recipient o fnancial ows,resulting in those abroad piling up fnancial claims against the UK economy.

But i , or instance, it becomes apparent that the stock o claims held by thoseabroad is now too large to be supported by economic activity that ow will dryup. This will leave the whole economy deeply exposed, because the most likelyresponse o our fnancial system will be to drag up interest rates in an e ort to drawin capital hitting households and frms in the process. Should growth not recover,it will become increasingly apparent that the UK cannot sustain the huge volume oexternal claims now held against it. As rising interest rates urther choke o growth, avicious circle will be set in train.

As long as the UK remains dependent on external fnancing, it is vulnerable to along-term decline in that fnancing; and as long as the UK retains a major fnancialcentre, it is permanently and excessively exposed to uctuations in the globaleconomy. Either option is troubling. The capacity o fnancial activity to exaggeraterather than dampen shocks is a urther cause or concern, particularly i we believethat the general picture or at least the next ew years is likely to contain signifcantinternational fnancial uncertainty. The Eurozone remains the single biggest risk inthis respect, and is likely to do so or some time. 18

Heavily indebtedThe UKs total indebtedness is continuing to rise. Indebtedness is about morethan the so-called national debt, which covers only the debt o the government.Households, corporations, and fnancial companies are all enormously in debt. Thetotal debt o these di erent sectors o the economy has risen unstoppably in the lasttwo decades and at an accelerating rate over the 2000s. It stood at 310 per cent oGDP in 2000, already higher than any other major economy with the exception oJapan. By 2008 (be ore the crash) the UKs total debt had climbed to 487 per cent oGDP higher than Japan.

The state o the UK economy

The UK, possessor o a uniquely large, globalised, and poorlyregulated fnancial sector, was the worst a ected by the crash oany major economy. 16 Its recession was the sharpest and its bailoutwas the largest, relative to GDP.



Since the crash, and despite the e orts o households, frms, and governmentto remove their debt, this burden has actually continued to rise, hitting 511 percent o GDP. Britain vies with Japan as the most highly indebted major developedeconomy in the world.

This is not, however, as a result o government debt. The UKs public debt isaround 81 per cent o GDP higher than has been typical in the last ew decades,but signifcantly lower than the G7 average o 105 per cent o GDP. It is onlyslightly above the USA, on 80 per cent, and below Germany on 83 per cent. It iscurrently below Reinhart and Rogo s widely cited fgure o 90 per cent, abovewhich (it claims) economies will start to experience di fculty in fnancing growth. 20

The bulk o the UK debt burden, instead, arises rom the private sector. UK households are the most heavily indebted o any major economy, holding debtto the value o 98 per cent o GDP. Its non-fnancial corporations are second onlyto Italy in their debt holdings, on 109 per cent o GDP. But truly spectacular is thedebt held by the UKs fnancial corporations. Banks and other fnancial institutionshold debt to the value o an eye-watering 219 per cent o GDP. This increasedrom 47 per cent in 1987 (at the beginning o the period o deregulation) to 122 percent in 2000, and then accelerated upwards to todays fgure. The crash o 2008made little di erence to this: UK fnancial corporations debt has risen rom 209per cent o GDP that year by a urther 10 percentage points.

To put this in perspective, a recent IMF paper ound robust evidence, rom arange o countries, that private sector debt above a threshold o 80100 per cento GDP had a directly negative e ect on growth. 21 Even without including thefnancial sector, the UKs private debt is currently 205 per cent o GDP. Meanwhileits fnancial sector debt alone is the highest o any G7 economy, and by somedistance.

Figure 5. UK debt liabilities by sector, 19872011.

% G

D P

600

500

400

300

200

100

0

1 9 8 7

1 9 8 9

1 9 9 1

1 9 9 3

1 9 9 5

1 9 9 7

1 9 9 9

2 0 0 1

2 0 0 3

2 0 0 5

2 0 0 7

2 0 0 9

2 0 1 1

Government

Households

Non-nancial corporations

Financial corporations

Source: National Statistics (2012) Blue Book. 19



Government debt, too, is still growing. Because the defcit the gap betweenwhat the government spends, and what it takes in, in taxes is still wide, andbecause the Coalition is ailing to close this gap, the UKs public debt burdenwill continue to grow into the uture. But it is not rising as ast as total debt,which is being pushed upwards by the fnancial sector.

Households are attempting to repay their debts. Figure 7 shows the very sharpswing by households rom negative net savings (borrowing, in the aggregate) topositive savings, as heavily indebted households attempt to repay their debts.But since the aggregate e ect o this ow o repayments is to undermine the

economy, their debt position is barely improving, with household debt (unlikethat o other heavily indebted countries) scarcely declining, relative to GDP.

Figure 6. Financial sector debts, G7 economies, 2011 Q2.

Source: McKinsey Global Institute (2012) Exhibit E4

% G

D P

200

150

100

50

0United States Canada Italy Germany France Japan UK

Figure 7. UK net household savings, 19972011.

Source: ONS (2012), Blue Book 2012Table 6.1.6

m

( c u r r e n

t )

20000

10000

0

-10000

-20000

-30000

-40000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011



Our countrys total debt burden matters because, as 2008 proved, governments maybe orced to bail out heavily indebted fnancial institutions to enable them to continueunctioning.

The IMF estimate the total cost to the UK o bailouts during the credit crunch tobe 1.28 trillion about 88 per cent o GDP. To put this in perspective, The Fundsestimate or the global costs o government bailouts is 6.8 trillion. The UK fgure,

more than twice the US equivalent, is the highest cost, relative to GDP, or any largedeveloped country. 22

This exceptional cost o our bank bailouts was a direct result o the size and reacho the UKs fnancial sector. The crisis both pushed up national debt, through thebailouts, and led to a widening o the government defcit as a result o the recession.A crisis o private fnance, emerging in the fnancial system itsel , was not ended buttrans ormed into a burden or public fnance; and through austerity, the immensecost o the trans ormation is now imposing itsel on society.

What the bailouts revealed, in dramatic ashion, is that risks apparently residing withprivate institutions can suddenly present themselves on the public balance sheet.

What previously might have been considered an immutable barrier between privateand public sector fnances can suddenly disintegrate; debt created by the privatesector and held outside o direct government control can be orced onto the public.

What is more, the apparently private (but essentially public) risks are amplifed bythe size o our fnancial system. Empirical evidence suggests a direct correlationbetween the size o a fnancial sector and fnancial volatility. 23 So as the fnancialsystem grows, it becomes more unstable.

Despite the act that this ever more precarious pile o debt is a threat to the whole osociety, it is not subject to the same standards o management or control as publicsector debt. And while the UK public sector has a long history o success ul debtmanagement (the UK is one o only six countries in the world to have not de aulted

on its public debt in modern times), the UK private sector has not, with privatefnancial crises having occurred on a regular basis. 24

As it stands, UK fnancial corporations are exposed to at least one major source oexternal risk. They have lent 198 billion to the crisis-hit countries o Portugal, Ireland,

Figure 8. Support pledged to the banking sector, 2009.

Source: IMF (2010) A air and substantial contribution by the fnancial sector: fnal report or the G-20, Table A1.4

100

90

80

70

60

50

40

30

20

10

0

% G

D P

Italy Australia Japan Korea Canada France Germany US UK



Italy, Greece, and Spain (a fgure that excludes the potentially large contingentliabilities rom the Eurozone that may reside in UK institutions, like credit de aultswaps and other orms o insurance against fnancial events). Only France has alarger direct exposure to high-risk euro debt. 25

Any uture crisis in private fnance can lead rapidly to an expansion in our public,sovereign debt. The burden o the crisis last time, now imposed on wider societythrough austerity, was huge, but not unbearable. Further crises will impose urtherburdens on a weakened economy.

It is highly unlikely that the UK economy, and there ore the UK state, would havethe capacity to cope with another fnancial crisis o anything near the scale wehave seen recently. It would not be able to summon up the resources neededto do so without creating exceptional additional costs. Researchers at the IMFhave suggested that its fscal space (the capacity o the government to expandborrowing i needed), while bigger than Japan and crisis-hit euro members, islimited, and its size very sensitive to uture interest rate increases. 26

Slowing down

Decade by decade, the British economy is slowing down (Figure 9).

This slowdown is common to the developed world,and has been exacerbatedeverywhere by the crisis. 27 The possibility o the slowdown becoming permanent that the 250-year burst o economic growth that accompanied capitalism was justan historic anomaly is now being openly entertained in mainstream economics. 28 Robert Gordons recent paper on experience o growth since 1300 pointed to thepaltriness o current innovations in driving current economic expansion, and to thelikelihood that growth will continue to dwindle as time goes by. 29

Capitalism without growth would be redder in tooth and claw than the capitalismwe know today. Each individual frms restless drive to expand and accumulatewould remain, but the impossibility o system-wide growth would push deeperand deeper redistribution against labour and society, assisted by the nation-states.Gordon entertains this possibility in his description o a uture USA in which thepoorest 99 per cent are held urther and urther away rom a 1 per cent acceleratinginto the stratosphere.

Figure 9. UK GDP growth rate, by decade since 1950.

Source: Bank o England fgures

3.5

3

2.5

2

1.5

1

0.5

0

1950s 1960s 1970s 1980s 1990s 2000s



O course, growth is not an end in itsel (Box 3), but the major actor in the healtho the system as a whole. Growth makes improvements in living standards andwidening prosperity easier to achieve, but, as we shall see, does not guaranteethem. A lack o growth, however, makes li e much harder or most. This helpsexplain why, since the Second World War, economic growth has assumed suchprime importance or governments.

Relative to other large developed countries, the UK is in a poor position todeliver uture growth. Rising productivity is the critical determinant o overallgrowth in a developed country. Increasing productivity means that or each hourworked, more is produced, and so the economy grows even i hours workedstay the same, or (i productivity growth is ast enough) even all. In the UK,however, productivity growth has been historically weak relative to comparablenations, with anxiety about our sliding productivity stretching right back to thenineteenth century. 30

The sources o the slide have been debated continuously. Low rates o domesticcapital investment, poor education, and antagonistic workplace relations haveall been popular explanations at one point or another. Nonetheless, the periodsince 1979 appears at least at frst glance to look like one o recovery.

The initial shock o deindustrialisation, with manu acturing employment allingmore than two million rom 1978 to 1987 was driven by a shaking-out o Britishindustry: under intense competitive pressure, less e fcient plants and actoriesclosed, leaving the more e fcient still standing and so driving up reportedaverage productivity. 31

Under Labour, this process o shaking out in manu acturing continued, albeit ata slower pace. Researchers at the London School o Economics have claimed,in addition, that the economy under New Labour was relatively success ul atsustaining productivity increases in the now-dominant service sector. Theyattribute this to improved skills and technological advances, particularly inbusiness services and distribution, and note that GDP per capita grew asterthan Germany, France, and the USA, while productivity grew second only to theUSA itsel . 32

Since the crisis, however, productivity growth has collapsed, and ailed torecover. 33 This is highly unusual: the more usual pattern, ollowing a recession,is or productivity to rebound strongly and recover rapidly to its trend levels.

Box 3. Growth is no golden bullet

Growth is not an end in itsel , as the underlying conditions o the early 2000s show. These years were oncelabelled by Mervyn King, who presided over most o them as Governor o the Bank o England, as the NICEdecade, meaning Non-In ationary, Continual Expansion. Everything seemed to go right. In ation was low, growth(i not especially rapid) was continuous, unemployment was low. In economic theory the New MacroeconomicConsensus prevailed: the touching belie that all the major problems o the macroeconomy had been essentiallysolved, both theoretically and in policy practice, by a combination o technical wizardry, modelling prowess, and

good governance.

This happy prognosis turned out a little inaccurate. But even during the years o hubris, it was or should havebeen clear that all was not well. Growth, considered since at least the 1950s as the panacea or all economicproblems, was not delivering. The real incomes o low-to-middle-income households stagnated or even ell duringthe boom, with median weekly earnings alling by 0.3 per cent over 20022008. Both have, o course, allen sharplysince the onset o the crisis, and are widely expected to all urther.

During the NICE decade, rising consumption was sustained by growing indebtedness. At the peak o the boom,UK households were the most heavily indebted o any major economy, with 163 per cent o average householddisposable income held as debt. And the environmental damage this boom was in icting most notably in itsgreenhouse gas emissions showed no signs o abating. The energy e fciency o the UK economy has improvedsharply over time. But these improvements have not been enough to cut back on total carbon emissions andbiodiversity loss, given economic growth. The so-called boom produced no real prosperity or most and caused realdamage or all. Growth defnitely did not deliver.



Breaking the fgures down, while UK manu acturing productivity is above its pre-crash levels, productivity in the services sector remains below its peak. 34 Sinceservices account or around 70 per cent o the whole economy, productivitygrowth overall is there ore weak or even negative. 35

This unusual pattern points to deeper problems within the economy. A heavydependence on fnance and services, apparently a beneft during the boomyears, has now turned into a major drag.

One problem, o course, is the measure o productivity used. By treatingproductivity as solely the contribution to Gross Value Added (GVA), a measureonly o output sold, a sector or industry can look hugely productive when inact it is doing little more than capturing value created elsewhere. Much o ourfnancial services activity now appears to have been o this character.

Moreover, i productivity growth in services is now weak, a ter a curiouslyexceptional decade, it is returning to a long-run trend: lagging productivitygrowth in services now appears central to the UKs relative economic decline inthe post-war years. Existing productivity problems in manu acturing back thenwere exacerbated by a loss o a productivity lead over other countries in servicestraded internationally. 36 Services, too, have been consistently poor at creating

jobs, with only 60 000 net jobs created in fnance over 19792007, compared to

our million lost in manu acturing over the same period. Government spendingtook up the slack, under both Conservative and Labour administrations, with ully57 per cent o new jobs created since 1979 unded by the public sector. 37

The recession we are in is something like a mirror o that o the early 1980s.The recession then provoked sharp increases in unemployment and the closureo less competitive plants and producers in manu acturing, driving up reportedproductivity. The recession now has seen ar more muted rises in overallunemployment and declining productivity in the services sector, driving down reported productivity. 38 This is the so-called productivity conundrum: that allingGDP has not produced a collapse in employment, but instead has led to a slidein productivity.

The all in productivity growth imposes another constraint on the recovery.The output gap measures the distance between what an economy actuallyproduces, and what it could produce a measure, in e ect, o spare capacitythroughout the whole country. I this gap is wide, there is obvious scope orimmediate government action, through increasing expenditure that brings sparecapacity into use. I the gap closes, conventional economic theory would predicta risk o increased in ation. But the longer measured productivity continues toag, the more the output gap will shrink, o necessity. 39 Should the productivityparadox continue to hold, the scope or Keynesian solutions, dependent only onboosting government expenditure, will close.

Unless either a dramatic recovery in services productivity growth occurs, or a

signifcant shi t is made out o services and into manu acturing, the prospectsor a convincing, sustained economic recovery must remain bleak. The ormer isrankly unlikely. The latter implies a 1980s or the service sector, with job losseson a very wide scale as less productive frms shut up shop.

At present, precisely the opposite movement is happening: high-productivitymanu acturing is shrinking, while low-productivity services continue to expandtheir output. The whole economy is moving urther away rom a secure recovery.Growth, under these circumstances, is a chimera.

UnbalancedBritains economic landscape is notoriously uneven. That unevenness hasworsened over time; today, it has the most geographically uneven distributiono economic activity o any EU member state. As Figure 10 shows, the spreadbetween its poorest and its richest region is much larger than elsewhere inEurope. Inner London is the richest space in the EU; but the Welsh valleysare poorer than Slovakia. London itsel is, notoriously, the most unequal city inthe OECD.



Growth over the last decade has not helped close this gap. It was, crudelyput, growth o the wrong sort, concentrated in the wrong sectors. Forty-fveper cent o the fnancial sectors output is produced in London, or example.Expansion o fnancial services necessarily tends to avour London and thesouth-east. 40

One way the previous government tried to combat this was through RegionalDevelopment Agencies (RDAs), established in 1998 to promote growth withinthe English regions. Although these Agencies now abolished had somelocal impacts,their comparatively limited budgets, aligned with a belie thatthe role o public authorities was limited to ostering markets and promotingclusters, did not do enough to tap into the ow o wealth rushing to London or, more accurately, to the prosperous within London. 41

Market-led growth meant, in practice, the continuation and deepening o apattern o development heavily biased towards the south-east that had beenin train since at least the close o the First World War. Despite governments

Figure 10. Variance in Gross Value Added (GVA) across regions within EU members, 2008.

United Kingdom

Sweden

Finland

Slovakia

Slovenia

Romania

Portugal

Poland

Austria

Netherlands

Malta

Hungary

Luxembourg

Lithuania

Latvia

Cyprus

Italy

France

Spain

Greece

Ireland

Estonia

Germany

Denmark

Czech Republic

Bulgaria

Belgium

0 25 50 75 100 125 150 175 200 225 250 275 300 325 350

EU 27 = 100

Capital region

Median GVA

Regional GVA



apparently committed to regional policy (and despite at least the patina osuccess in some older inner cities and urban areas) the 2000s accelerated theow o wealth southwards.

Regional development spending has more than halved since the ormation othe Coalition government, with weaker local bodies replacing the RDAs. I theweak e orts o the previous administration could not prevent regional disparitiesyawning wider, the still more limited e orts o this government will have no

discernible impact. Market-led growth, untrammelled by serious public action,spells London-centred growth and the continuing decay o the rest.

Trapped in trade defcitAll trade defcits require fnancing. And over the last 20 years, the UKs chronictrade defcit has been fnanced by a similarly chronic ow o fnancial investment(and accumulation o debt) rom abroad. 42 Our well-established inability toexport su fciently is compensated or by our exceptionally large fnancialservices industry, with banking activity dominating the bulk o transactionsbetween 2000 and 2008.

The two sides are mutually rein orcing: the weakness o the UK economy, beingunable to export in su fcient volume, created a permanent demand or fnancing.Our desire to purchase rom abroad was, unsurprisingly, matched by thewillingness o those abroad to fnance these purchases. During the boom years,this ostered an illusion o prosperity.

Researchers at the IMF recently used a simulation exercise to model thissituation or the UK. They ound that rising inequality between the richest 5 percent o our population and everybody else is being exacerbated as ordinaryhouseholds, who in an attempt to maintain living standards borrow romthe top 5 per cent. The top 5 per cent mobilise savings rom abroad to fnancethis borrowing, leading to a worsening o the UK current account. The IMFseconometric estimates suggest that almost the entire UK current account defcitsince the 1970s has come about as a result o this process,which has been

urther exaggerated by fnancial liberalisation.44

But with the collapse o the boom and no realistic prospects or its return, thismutual rein orcement between demand or fnance and demand or importshas turned into an economic deadlock. Rebalancing the economy shi ting

Figure 11. Percentage variation rom national average Gross Value Added (GVA) per capita, 2011.

1989 1999 2009

North East -18.2 -22.7 -23.5

North West -10.5 -11.7 -15.6

Yorkshire and Humber -12.3 -12.1 -17.4

East Midlands -7 -9.2 -12.4

West Midlands -10 -10 -17.0

East o England -6.6 -3.9 -7.3

London 53.8 60.1 73.9

South East -1.8 6.1 6.3

South West -9.9 -8.2 -9.1

Wales -17.2 -23.3 -26.7

Scotland -5.9 -5.7 -1.2

Source: ONS



it away rom fnancial services will be all but impossible when our trade positionis so pro oundly weak. Alternatively, shi ting the chronic trade imbalance will be allbut impossible with the immense weight o fnancial claims that now exist againstthe UK economy. The entire economy is deeply exposed to changes in international

sentiment, as the immense reversal o fnancial ows in the a termath o the crisishelped demonstrate.

It is this lack o space or uture manoeuvre that helps explain the drive to austeritynow. Unlike the economies o southern Europe, the UK does not belong to a singlecurrency and is not compelled to adopt severe austerity measures. It is, instead,chained to a dys unctional, overexposed fnancial system that is symbiotically linkedto a weak real economy. A weak economy sucks in imports, requiring fnance;a continual demand or fnancing helps support a bloated fnancial system; thepermanent risk o fnancial crisis produces austerity. The key to breaking the grip oausterity is to undermine the fnancial sector. The key to undermining the fnancialsector is, in turn, to rein orce the real economy creating jobs and supportingmeaning ul economic activity.

This twin approach must be at the heart o a viable new economic strategy. Havingdescribed both the recession we are in, and the barriers to ending it, we are in aposition to describe the steps that must be taken to clear a path to a new economy.The critical barriers, on this analysis, are:

1. A commitment to austerity that cripples real economic activity.

2. A real economy that is ine fcient and import-dependent, demanding fnancing.

3. A fnancial system that is bloated with debt and over-exposed to risk.

We can envisage a new, more socially just and e fcient economy that does notharm the environment. But getting there requires policy moves made today that willclear the barriers.

Figure 12. UK current and fnancial accounts, 19872011.

Source: National Statistics (2012), Pink Book 2012 43

m ,

r e a

l

40000

30000

20000

10000

0

-10000

-20000

-30000

-40000

-50000

1 9 8 7

1 9 8 8

1 9 8 8

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

Net nancial ows Trade in goods and services



Path dependencyFor the whole economy, it is always easier to return to a amiliar path o growththan it is to shi t to a di erent mode o operating. For the environment, thisproduces a situation o carbon lock-in: institutions and markets evolve in sucha way as to trap the whole economy on a high-carbon path. It is only withsignifcant e ort and expenditure that this path can be convincingly broken, anda new one carved. 46

Path-dependency makes much current discussion o rebalancing the economysingularly idle. 47 There will be no rebalancing without a clear break with the past quite the opposite: as is now happening, in the absence o this break many othe dys unctional eatures o the UK economy, like its dependence on fnancialservices, are becoming more, not less pronounced. And even i by somemiracle a return to the levels o growth seen in the 2000s was made, there areno real reasons to anticipate they will be anything other than as illusory as they

were back then. We live in a high-carbon, high-debt economy. It used to delivergrowth. Now it cannot even manage that. There are clear barriers to growth,and, worse, growth itsel may not deliver the economic goods not, at least,or the majority.

The economic problem, then, is not one that can easily be solved throughtinkering o the kind that dominated during the boom years. Back then, withmacroeconomic problems apparently resolved, successive governmentsconcentrated on microeconomic questions, in ormed by a peculiarly ingrainedbelie in the e fcacy o ree markets: competition would drive productivity,deregulation would ree up entrepreneurs. None o this is appropriate in dealingwith a crisis on the scale we are con ronted with. The macroeconomy, its deepproblems smothered in the smug years o the credit bubble, has returned with aterrible vengeance.

Ending austerity, sustaining demandThe Coalitions own economic strategy has ailed. It was, at best, based on aseries o deep misconceptions about the nature o the crisis. Austerity cripplesweak economies. The starting point in any new economic strategy must beto end austerity. Quite apart rom its social e ects, and the obvious injusticesinvolved, it is economically oolish. When everybody else is not spending,government must. There is no credible macroeconomic case or cuts almostwithout historical or international precedent, as the Institute or Fiscal Studiesput it, under present economic circumstances. 48 Even the IMF now admits thismuch.

This is a distinct argument rom that about the supposedly ideal size ogovernment spending. The arguments about re orming the state and provisiono public services should be disentangled rom the macroeconomic argumentabout spending cuts. They should not become entangled with an argument

Towards a new macroeconomic strategy

It is always easier to do tomorrow what you did today. The costso moving to a di erent way o working or living are signifcant.This problem is magnifed in the whole economy, since many othe costs o moving to a di erent mode o li e are dependent onothers actions. I they do not act the same way as you do, witheveryone co-ordinating their behaviour over time, the costs ochange can be so great that no one will make the shi t. 45



about excessive benefts, or skivers, however much Coalition ministers haveattempted to do just that. We could all agree that spending on social security istoo high. But that is precisely why government must act to create jobs and boostdemand, so that those now languishing on benefts can fnd work.

That will mean thinking more care ully about the objectives o economic policy.Chasing GDP alone, as we have seen, is no longer appropriate i it ever was.We need instead to think in a more nuanced way about what we expect oureconomy to do: sustaining well-being, ensuring a reasonable distribution o li e

chances, delivering secure, decent work, and doing so within clear environmentallimits. GDP tells us very little about this and, worse, no longer delivers on itsblunt promise o rising real incomes. Better metrics or assessing economicpolicy a sharper ocus, or example, on work created, real median incomes, andenvironmental damage would help shape economic policy better. 49

Capitalism in the UK has been bad at providing jobs, and singularly poor ato ering work o a decent standard. Since the 1970s, it has destroyed middle-income, generally more secure jobs in manu acturing to gain instead a thincrust o well-paid white-collar jobs that cover up a growing mass o poorly paid,insecure, service sector employment. Low levels o job creation overall have beencompensated or by a sharp expansion o state or state- unded work. Labour

markets have polarised sharply, a key eature in rising inequality, and the share onational income going to labour has declined precipitously.

A detailed comparative study by the International Labour Organization ound thatgrowth internationally is wages-led: it is pushed along by rising average incomesand signifcant labour share in national income, rather than being pulled alongby the alleged virtues o entrepreneurs and profts. 50 I real incomes continueto decline, and household debt burdens remain threatening, prolonged generalstagnation will result. There is a critical role here or government in both creatingdecent, secure work, and in redistribution. The case becomes still stronger shouldproductivity remain weak, since earnings will not rise without it. Redistribution, ona wide scale, will be necessary to secure continued prosperity.

For the regions, redistribution is now an iron necessity. There is no plausibleprospect o regions lagging behind the prosperous parts o the south-east evercatching up without it. Take Wales: i London grows at just 2 per cent a year below its average since 1979 Wales will have to grow at 2.5 per cent or

Figure 13. Wages as a proportion o GDP, 1955 to 2008, percentages.

e r c e n t a g e

70

65

60

55

50

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005



the next 30 years to close the gap. In other words, it would have to repeat theexperience o the entire post-war boom, but at a higher and more sustained rateo growth. This is a antasy scenario. Wealth needs to be drawn out rom the greatpools held and controlled not so much by the 1 per cent, but a still tinier raction,the 0.1 per cent, and applied to the reconstruction o regions and nations.

That reconstruction, across the country, cannot be led by the market. The marketwill attempt to ollow the path o least resistance the same path we ollowedinto the mire: high debt, high carbon, and low wages. We can see, under theCoalition, precisely this route opening out in ront o us.

Decisive public action, instead, is needed. A ter all, industrial strategy is back inashion: ormer Conservative minister Michael Heseltine recently presented astrong business case or government intervention. David Cameron has in the pastspoken o investing in industries o the uture. But this should not be industrialstrategy tied to the ailed metrics o the past, such as boosting GDP, or to theimmediate demands o business. Instead, national and regional schemes need tothink more closely about meaning ul measures, creating secure, sustainable jobs,and protecting the environment. 51

The strategy will need a clear goal to reduce the UKs dependence onimports, or both environmental reasons and as we have seen to break its

dependence on the City. Local and regional economies, supported by fnancialresources and national government, can act to break their carbon dependenciesand drive local recovery. Two obvious contenders or localisation are ood andenergy production: both impose heavy environmental burdens; both are netcontributors to the trade defcit.

But what about the markets?The continual retort, rom those insisting on sel -de eating austerity, is that thefnancial markets would turn against a government committed to increasing itsspending. Interest rates would soar, as bond markets became concerned aboutthe governments ability to meet the additional liabilities it was taking on. Theanswer to this alls in two parts.

First, government spending can increase without widening the defcit. Over thelast two years, the obscenity o tax avoidance by Britains wealthiest individualsand corporations has become a political scandal, thanks in no small part tothe activities o protest group UK Uncut and dogged tax justice campaigners. Aserious clampdown on avoidance would deliver billions in additional revenue,with even HMRCs very conservative estimate suggesting 35 billion is lostannually other, credible estimates, range much higher. 52 But we can movebeyond merely closing existing loopholes, and do something to reverse thedecades-long rise o inequality. The Green New Deal group has proposed a suiteo taxes or the wealthiest that could immediately raise 26.4 billion in additionalrevenue, and potentially a urther 21.9 billion a ter consultation. 53 Since Britainsrich and its major corporations are not spending their wealth, this is economic

good sense: by taking money out o the hands o the hoarders, and ensuring it isspent on productive activities invested, or example, to create sustainable jobs the whole economy will beneft. 54

Second even i wholly or partly fnanced by borrowing, government spendingmade on productive assets such as public transport improvements orrenewable energy will not substantially alter Britains net debt position. Althoughwe will have increased our public liabilities through borrowing, adding to grossdebt, we will have gained an asset o the same value. O course, it is gross debtthat requires continual fnancing, since it is the total debt that demands interestpayments (and assets cannot be disposed o easily or quickly to meet theserepayments); but an investment plan producing steady, long-term returns wouldmeet this requirement.

A third argument against fnancial doom greeting the end o austerity is moredistinct. Britain, as many commentators have argued, is not Greece or someother now heavily indebted Eurozone member. For a start, it retains its owncurrency and its government can there ore always repay debt denominated in



pound sterling even by printing money, in extremis. I anything, it su ers romthe opposite problem: that o being perceived as a sa e haven,with possibleconsequences we consider brie y below. 55

However, the constraints imposed on the UKs domestic economy by itsinternational position are, as we have seen, binding. A programme or recovery,and especially one built around an increase in government spending, is liable tovery rapidly run up against both its current account defcit and its dependenceon fnancial ows. A fnancial system choosing to panic in response to a seriouse ort at re ating and restructuring could provoke capital ight and underminethe government. The next element in the strategy there ore must consider theUKs peculiar relationship to the fnancial system.

Shrink and reshape the fnancial systemIt should be obvious rom the above that the UKs fnancial system isunsustainably large. At this size, it constitutes a direct barrier to economicrecovery. It there ore requires shrinking: its balance sheets reduced relative toGDP; its employment reduced as a share o the work orce. 56 But shrinking alsoimplies restructuring, as Andrew Haldane has recently argued. 57 Increases inthe systems size have, over the years, delivered a deepening complexity ooperations, particularly associated with the management o risk. Disentanglingthat complexity will allow the system to be sa ely de ated and brought into

e ective public control.

One particular aspect o that complexity is the extent to which di erent orms ofnancial transactions have been brought under the control o single institutions.At the same time, enormous pressures to increase the complexity o theiroperations are brought to bear, through competition globally or business.Financial innovation, the deliberate pursuit o complexity, is compelled on thebanks and the major fnancial institutions by their participation in global fnancialmarkets. The creation o new and more complex fnancial instruments cangenerate short-term returns, but at the price o rising systemic complexity andrisks. Those risks, still poorly understood and managed, remain hidden insidegiant fnancial institutions.

The arguments or a greater variety o fnancial institutions, to spreadrisks and better manage complexity, are clear . Breaking up the major bankswould require also that they trans orm how they operate. At root, a bank shoulddo little more than provide somewhere sa e to place savings, and create somecredit. Localising banks, diversi ying ownership structures, and placing greaterdemocratic and public control over banking unctions will all help lead themtowards that ideal.

Nonetheless, the liabilities o the whole system remain vast. An immensepile o debt, equating to 214 per cent o our GDP, has now developed insideUK fnancial institutions. 58 (And even this is a conservative estimate, havingexcluded fnancial derivatives and more complex instruments. Including these

would push the ratio o liabilities to GDP within the fnancial system to nearly 750per cent o GDP.)

There are three ways to remove a debt:

P Repay it but as we have seen, this creates a sel -de eating spiral ostagnation and decline. Trying to repay a debt can make the real debt burdenworse.

P Allow in ation to whittle it away but, even i this were politically possibleor the government debt, the total debt burden is too great to make it aconvincing prospect. Even i we assume exceptionally low, economy-wide,nominal interest rates o 1 per cent, in ation at 5 per cent and an immediatereturn to a trend rate o growth o 2.5 per cent, the UKs total debt-to-GDPratio will not reach even its 1996 level until 2026. Any deviation rom steadygrowth and low interest rates pushes that date still urther into the uture. 59 Toreach the current US debt-to-GDP ratio, under these assumptions, would takeuntil 2025. E ective repayment through in ation is not a plausible scenario.



P Cancel it I debts can neither be repaid, nor in ated out o existence, thatleaves only one option: cancellation. Without a high (and sustained) rateo growth, high (and sustained) in ation, or low (and sustained) interestrates or some combination o all three the debt burden will not diminish.For households and businesses, it will be a permanent drag on activity; orthe fnancial sector, it is a permanent exposure to risk. O all the sectors,government is the least directly burdened by debt, but instead is caughtbetween the others receiving diminished tax receipts on one side, andexpected to support fnance on the other.

Yet cancellation would impose severe political challenges. The burdens ocancellation would all on creditors within the fnancial system. However wellmanaged, and it is critical that it is done so airly, cancellation would imposegreat strains on fnancial institutions. Some o these would not cope, and couldrequire nationalisation. But should a sustained recovery ail to materialise, thedemand to write o debts will become more insistent.

Capital controlsThe danger o a fnancial crash remains very real. The most recent IMF GlobalFinancial Stability report suggests the risks are as high now as they were priorto the crash o 2008. 60 As we have seen, the UKs exceptionally large fnancialsector exposes the whole economy to uctuations and crises happening right

across the world. And the dependence the UK now has on fnancial in ows tocompensate or chronic trade imbalances creates a urther uncertainty, withvolatile ows o capital able to reverse very rapidly in the event o a crisis.

The biggest danger here is contagion, where chaos spreads rom countryto country through our tightly connected international fnancial system. Asone economy ails, those in fnancial markets start to believe other, similareconomies will ail. Perhaps those economies nearby, or those with similarindustrial structures come under attack. Speculators move in, sensing weakness,looking to proft rom the collapse, perhaps through fnancial devices likederivatives. More risk-averse investment rushes out, with ormer investorsdumping their holdings o the economys currency and fnancial assets.Meanwhile, economies seen as strong can su er the opposite e ect: a panickedin ow o capital, eeing turmoil elsewhere, can be just as destabilising as apanicked out ow. Contagion can work both ways.

We know rom previous recent episodes o fnancial panic that contagion canbe devastating. When market sentiment turned against East Asian economiesover 1997/1998, a recession o exceptional severity erupted across the region.None o the economic undamentals had changed the economies weremuch the same the day be ore the panic, as when it started. But when belie sshi ted rapidly ollowing the unplanned devaluation o the Thai bhat, liberalised,electronic markets were able to move ast; hot money pulled ast out oeconomies, as speculators gambled on urther devaluations.

Something similar could happen as a result o deepening crisis in the Eurozone,with contagion spreading in two ways. First, because banks across Europe haveloaned each other immense sums o money, they are all exposed to each other.Should a bank or a government de ault on its loan repayments, its creditors willall get hit. French banks, or example, still have a very major exposure to Greece.A Greek de ault would hit them hard. UK banks have dropped most o theirGreek holdings, but since they still have a large exposure to French banks, theycould still su er.

The other route is through the capital markets themselves. The UK is exposedprecisely because it is not in the Eurozone and is seen as a sa e haven orinvestors looking or low-risk investments. This is, in part, why the borrowing rateor the UK government is so low. Those in fnancial markets believe to be lowrisk, and will not ask or high interest rates to compensate when lending moneyto the government here.

In the event o a crisis, capital could rush into the UK, seeking sa ety. This



would be enormously destabilising: the exchange rate would appreciate,urther worsening the UK current account position, and money ooding intospeculative assets would promote urther expansion o property and fnancialbubbles. The net result would be to urther undermine real economic activity,while promoting fnancial activity in other words, to shi t the whole economystill urther away rom a rebalancing.

Alternatively, we might ace a rapid out ow o unds similar to that o2008. This could occur without any change in policy: the mere combinationo a continued recession, a poor current account, and low productivity

growth could be enough to promote an old- ashioned sterling crisis, as hashappened fve times since 1945. 61 Speculators would ditch sterling andsterling denominated assets, earing that the economic undamentals werenow too weak to sustain activity. While in the long term this may, as a ter thedevaluation o the ERM crisis in 1992, promote a recovery in exports, in thefrst instance it would create an immediate fnancial crisis and sharp rises inreal interest rates. And given the slow response o imports to exchange ratechanges, the most likely immediate e ect would be to perversely widen thedefcit on the current account. Again, the damage to the economy could besubstantial.

The introduction o direct controls on the movement o capital in and out

o the economy would help prevent either possibility. Growing empiricalevidence, recently summarised by the IMF itsel , suggests that, despite therhetoric o globalisation, well-applied controls can work in a range o di erenteconomic circumstances. The examples in Box 4 back this up.

By making movements o capital in and out o the UK more expensive, theybecome less desirable. While in theory capital markets should allocate capitale fciently, in practice this does not apply and, in conditions o fnancialcontagion, it applies even less, as market signals are drowned out in themelee. European law, otherwise strongly in avour o ree capital movement,allows the implementation o capital controls by non-euro members, in theevent o emergency, without prior EU-wide approval. 62 There is, as we haveindicated, a serious risk o fnancial crisis either externally, most likely viathe Eurozone, or internally, as the weaknesses o the UK economy revealthemselves. The Treasury is reported to have already drawn up plans or theemergency introduction o capital controls, in the event o a fnancial collapse.But it would be sound policy to design these with a view to retaining long-term restrictions on the ree movement o capital.

Box 4. Capital controls in action

MalaysiaMalaysia was engul ed by the East Asian fnancial crisis. But its government defed the IMF position at the time tointroduce sharp restrictions on the ability o investors to withdraw capital. The amount o the currency, the ringgit,that could be taken abroad was restricted and investors in the country were subject to a one-year stay periodduring which they could not remove unds. Measures like these are now widely credited as having helped Malaysiaweather the storm.

BrazilTo prevent its exchange rate rising too rapidly as the economy expanded, in 2009 Brazil introduced a 2 per centtax on oreign purchases o stocks and bonds, later backed up with a tax on the sale o oreign deposits, and anincrease in the original tax to 4 per cent. These were estimated, by the IMF and others, to have slowed the rate oBrazilian currency appreciation, reducing the value o its currency by around 1.2 per cent.

South KoreaEconomic expansion a ter the crash o 2008/2009 has led to speculation on the rising value o the South Koreanwon, which was appreciating rapidly. In response, the Korean government fxed limits on the value o oreign-exchange derivatives that banks can hold no more than hal their capital base or local banks. Although the woncontinued to rise in value, the rate o increase slowed and was lower than the regional average.



There should be no domestic legal barriers to imposing controls, and recentUK governments have acted to restrict international fnancial activities orinstance in combating terrorism. Notoriously, anti-terrorism legislation was usedby Gordon Browns government to reeze Icelandic fnancial assets held in theUK when it became apparent its economy was imploding in October 2008. TheLandsbanki Freezing Order was dra ted to prevent the repatriation o unds heldby Landsbankis UK subsidiary back to Iceland, and, while the merits o the actionare contested, it illustrates the ease with which a determined government canregulate fnancial activity through legislation.

For the UK, measures to consider could include, but are not limited to:

P An emergency tax on capital in ows , similar to that levied in Brazil againstpurchases o UK fnancial assets. Existing stamp duties could be increased.

P Unremunerated reserve requirements , requiring those buying fnancialassets to also place an amount in oreign currency, equal to a proportiono the capital ow, with the Central Bank. Success ully used in Chile andColumbia to break capital surges, these work to increase the cost o holdingfnancial assets in a country.

P Legal restrictions on derivatives positions , similar to those implemented in

South Korea, as a means o dampening speculation in oreign exchange.P Restrictions on overseas ownership o residential property, particularly via

o shore companies based in tax havens.

By managing the ows o capital we can structure a suite o controls so as toattract longer-term, more stable investments. Controls that a ect the quality ocapital ows invested are, IMF and other evidence suggests, generally moree ective than those seeking only to impact on quantity although these can alsobe important. The type o ow matters: we might want to attract Foreign DirectInvestment into new plant and machinery, in line with the priorities o a greeninvestment plan, but deter more speculative investments in fnancial derivatives.Capital controls can allow this degree o discrimination to be imposed.

Quantitative easingThe case or a State Investment Bank, either by trans orming an existinginstitution (like majority state-owned RBS) or boosting the Green InvestmentBank, has been well made, and is increasingly accepted. The need to providefnance or investment to meet clear public objectives, a ter years o su eringclearly dys unctional private banking, is now obvious. There remains, however, aset o arguments over how such an institution should itsel be unded, and whereits liabilities should sit. Mobilising fnance on the scale needed to trans ormthe economy implies the creation o signifcant liabilities or the state. Yet thegovernment has, or nearly three years, been creating liabilities on a huge scale.

Since early 2010, the Bank o England has delivered 375 billion through itsquantitative easing (QE) programme. O ten re erred to as printing money, theoperation is slightly more nuanced than simply fring up the presses. The Bank oEngland uses its powers to create money in order to buy back government bondsrom fnancial institutions. These bonds then sit on its own balance sheet, while in return or parting with the bonds the banks receive cash. There is a certainsleight o hand involved here, since i the government-owned Bank o England isbuying government bonds, there is no change in the total liabilities o the publicsector: instead o sitting on private banks balance sheets, they sit on the centralbanks. The government is, in e ect, lending money to itsel .

Elsewhere, the European Central Bank (ECB), in defance o European law, hasbeen issuing liquidity since November 2011 through the Long-Term RefnancingOperation (LTRO), with ECB President Mario Draghi more recently committingthe ECB to buying Eurozone debt without limit. Bank o Japan head MaasakiKirashawa has announced an extension to the BoJs monetary easing scheme.And Federal Reserve Chair Ben Bernanke is launching an open-ended assetpurchasing programme or the Fed. The details di er, but the general intent and



mechanism is the same the use o unconventional policies to release ood-tides o liquidity into the worlds banking systems.

The net e ects o these operations are, despite their scale, not well understood.They were motivated originally by the belie that, with interest rates at or near azero bound, only unconventional monetary policy would operate. 63 Empiricalresearch has suggested that over the last 18 months, QE in the UK has helpedmaintain asset prices (like property) at the expense o some slight increasesin in ation. The net result has been strongly to the beneft o those who holdfnancial assets which means principally those at the very top o the incomedistribution. 64 It is also likely that the immense purchases o existing governmentdebt through QE, by supporting demand or debt, have helped drive downinterest rates. In other words, the e ects o QE so ar have been to support theexisting system o widening inequalities sustained by the fnancial system. Theeconomic deadlock is maintained, not broken, by current QE.

But it could, just as easily, be used to undermine the system, breaking thedeadlock. I , instead o piling new fnancial assets onto bank balance sheets,QE was used to inject cash directly into the economy, it could start to act tobreak the deadlock. Because at present the UK is so critically dependent onlarge fnancial ows rom abroad to sustain its weak domestic economy, itcannot success ully rebalance. The ows rom external sources result in large

external claims against the economy, which themselves then become urtherbarriers to recovery.

But i those fnancial ows came instead rom a domestic source, and wentdirectly into domestic economic activity, the deadlock would be at leastcircumvented. And to the extent that continuing ows o fnance, mobilised abnihilo by the Central Bank, move into domestic activity and remain distinct romthe private fnancial system, that system is undermined. With domestic banksunwilling to lend, and with the great tide o QE doing little more than to helpragile banks rebuild their own balance sheets, there is a clear role or moredirect government intervention.

This is how QE could play a central role in rebalancing and repositioning theentire economy. Were the Bank o England to mobilise its capacity to create newfnancial assets, and push them towards real economic activity, investmentscould be made and economic activity restarted without running immediately intothe barrier o the fnancial system. Green QE has been proposed as an idealmeans o raising fnancing or long-term investments in sustainability. Thesewill need to be very substantial: at the upper end o the scale, Dieter Helm hasestimated that 500 billion o investment in in rastructure will be needed overthe next ten years to upgrade it to a more sustainable basis.

The objection conventionally raised to the use o QE or any purpose other thanthe purchase o government debt is that to behave otherwise is to break downthe important distinction between fscal and monetary policy: that without a

government clearly able to maintain the distinction between the two, marketswill assume the government to have no sense o fscal or monetary discipline,and will start driving up interest rates. Further, at present, QE has limited marketimpact it has driven up some asset prices, but to a very great extent has gotno urther than banks balance sheets. Were it to be released into the economy,there is at least a plausible chance that it would lead directly to increasedin ation, as extra volumes o money in circulation acted to bid up prices withoutsubstantially a ecting output.

These two objections stem rom a similar source, which is a theoreticalmisunderstanding o how money operates in the economy. In both cases,the underlying assumption is that a basically fxed stock o cash is used andcirculated at a regular pace that is determined largely by the rate o economicactivity. Attempting to add to this fxed stock or instance, through QE doesnot increase the pace o activity, and there ore leads only to increases in prices.The distinction between fscal and monetary policy is critical, since changes infscal policy are (in this world) simply attempts to alter the ow o an existingstock o cash, shi ting it rom one purpose to another. Without a clear distinction


30/36Why we need a

A New Macroeconomic Strategy WebReady Final

Documents

Transcript of A New Macroeconomic Strategy WebReady Final