#44. Britain through the looking glass

Starting with Greece this weekend, we could be at the beginning of a series of political earthquakes in Europe. One of these earthquakes might well occur in Britain, even though we have a political system designed to favour the status quo. What I’d like to do here is to discuss the UK outlook, bearing in mind that this has to be set in a broader European context.

Where the UK is concerned, an earthquake is desirable, primarily because our system of governance has become deeply faulted. As I shall explain, this has damaged not just our government but also our economy (which, by the way, is nowhere near as strong as we are led to believe).

First, though, let me deal with the Eurozone (EZ), because at least the problem here is a very simple one. The single currency doesn’t work, and indeed cannot work. This structural absurdity will continue to blight the politics and the economies of the EZ countries until one of two solutions is adopted. These two solutions are the “forwards” and “backwards” options – “forward”, that is, to full political integration, or “backward” to the unwinding of the Euro and the reintroduction of national currencies. One or other simply must happen, even it is hard to see either happening anytime soon.

Since the Euro was introduced, the competitiveness of the EZ countries has diverged. If we in Britain, with our own currency, were to suffer a loss of competitiveness, we would devalue, making imports more expensive and our exports more attractive to foreigners. (Incidentally, I think a big devaluation of Sterling is likely, but more of that another time).

Countries like Greece and Spain, however, cannot devalue in this conventional way. Instead, the only way in which their competitiveness can be restored is through an alternative, unconventional process of internal devaluation. Since Greece (for instance) no longer has a drachma to devalue, the only way she can restore competitiveness is to drive down local costs, which means cutting real wages, thereby reducing the effective international prices of Greek goods and services. Put as succinctly as possible, austerity has been imposed upon Greeks (and others) as the only form of devaluation available.

Despite what Harold Wilson famously and fatuously said about “the pound in your pocket”, conventional devaluation is painful – but internal devaluation is very much worse. Small wonder that Greeks despair of their established political parties.

If statistics are anything to go by, Britain is second only to Greece in the “political earthquake stakes” – Greece seems to be the only European country in which existing parties are held in greater disregard than they are in Britain. As things stand, Labour and the Conservatives will struggle to get 50% of the vote, and even the inclusion of the Liberal Democrats might not push the three parties’ combined vote much over this level.

A widespread public perception seems to be that all three are pretty much the same, despite differences of policy, emphasis and rhetoric. Fundamentally this view is surely right, as Labour, the Conservatives and the Liberal Democrats are different factions within the establishment, and the real divide in Britain is between those who accept the establishment and the increasing number of those who reject it.

Whilst I dislike historical metaphors, this situation is not too dissimilar to England in the seventeenth century. The English civil war had nothing to do either with democracy or with the common people, but was a falling out over religion, influence and wealth within the governing elite. After the execution (or, as I see it, the assassination) of Charles I in 1649, the Parliamentarians held power without effective opposition.

To be sure, there were many contesting factions within the Commonwealth, but their differences had little or no relevance to ordinary people as the Puritan fanatics set out to ban everything from theatres and pubs to country dancing whilst treating the public to a withering diet of political correctness, seventeen-century-style. No wonder there was widespread relief when the monarchy was restored.

Whilst it would not do to push the metaphor too far, the situation in Britain today has distinct echoes of the Commonwealth era. Major ideological differences within the governing elite ended as effectively in Britain in 1997 as they did in England in 1649.

As they showed with their concerted effort to buy off Scots voters at the last minute, all of the major parties have far more in common than they differ over. Beyond a shared taste for moralising – the modern equivalent of Puritanism – the main point of unity between the established parties is their acceptance of corporatism in preference either to socialism or to free market capitalism.

This is reflected in the conduct of the economy, where corporatism seems ever more influential in driving economic policy. Like any ideology, corporatism leads to a frequent rejection of common sense in favour of preferences which suit the ideology. Instead of strengthening competition within the private sector, where greater competition would improve both output and living standards, successive governments have preferred instead to introduce corporatist quasi-markets into the public sector. The reality, of course, is that, whilst many activities are best left to a competitive (not corporatist) private sector, others (such as the provision of healthcare, and arguably of housing too) can better de delivered by the state. In other words, a mixed economy is best.

Against this, of course, the established parties would point out that the British economy is out-growing its competitors, and that unemployment has fallen sharply. Though true, both need to be qualified. Unemployment has indeed fallen, but at the price of a general lowering of real wages to the point where the tax take still cannot meet the costs of the corporatist state.

Economic growth, meanwhile, remains something of a statistical phenomenon. GDP may have risen by a nominal £80bn last year, but the State alone is borrowing more than that (around £90bn), even before we include increases in mortgage and consumer debt.

More seriously, our current account imbalance has crashed to an annualised £100bn, which means that an unsustainable 6% of GDP now comes courtesy of foreign lenders and trade creditors (see chart).

UK BoP annualJAN 15

Successive current account deficits have been bridged by asset sales and borrowing from overseas, to the point where we have built-in a major (and increasing) net outflow of dividends and interest. Meanwhile, the State continues to spend more than the economy can afford.

When looking ahead to the election, of course, we need to bear in mind that our “first past the post” system biases the process in favour of the established parties. This said, the likeliest outcome seems to be that an electorate which cannot oust the established parties might visit upon them instead a chaotic imbalance, as the next best thing to outright rejection.

Bring on the earthquake.

20 thoughts on “#44. Britain through the looking glass

  1. Are you familiar with Modern Monetary Mechanics? That’s the Reserve Bank of Chicago’s description of what is also known as MMT, Modern Monetary Theory, except it’s basically not a theory. It just explains how the monetary world works today.
    So, to take one of your comments, about insufficient tax take, MMT shows that government revenue is not via any tax take. Revenue comes from accounts at the central bank. Any Central banker will tell you this, even back during the depression it was done that way
    Today the tax take deducts money from the economy, destroys it, to reduce aggregate demand. Along with the CB setting interest rates tax is used to steer the economy away from excess inflation or if needs be, to stimulate it. There’s a whole lot more fallacies in standard government rhetoric pointed out by MMT but that’s one biggie.
    Thought you would like to know!

    • John

      Thanks. I have a problem with MMT, not so much as theory but as practice. My approach to these issues is one of fundamentals. As an analyst, I concentrated on cash flow when virtually everyone else was still interested only in EPS. Likewise, to me the economy is fundamentally about goods and services, with money acting as a proxy for (a claim on) these ‘real’ entities. So – subject of course to velocity – the creation of money logically creates inflation.

      Now, as the monopoly issuer of money, government can of course manipulate this relationship (and I like the comment from someone that “I now understand QE – what I now fail to understand is the concept of money”). It can manipulate things to bring in revenue without necessarily changing tax rates (just for instance, there is fiscal drag). It can – and in my view, has – employed QE to inflate capital markets, thereby lowering interest rates (and, incidentally, handing a lot of money to the mega-rich).

      But MMT – ‘monetary manipulation tricks’? – risks impairing the credibility of money in its critical role as a claim on goods and services, and thereby, ultimately, changing the relationship between money and these ‘real’ entities.

    • I have plenty of respect for your opinions Tim, as evidenced by your work “Perfect Storm” But MMT is a real explanation of what goes on with fiat or credit money today.
      It’s not a new theory but has by dint of being so explanatory lifted a lot of the confusion bedevilling the economies of the world. It has made economics understandable to outsiders like myself [I am an Architect]. It’s still weird, though not because of MMT.
      It’s so annoying hearing Treasurers pushing the line that the [sovereign] government is running out of money, that we are burdening our children with debt, that welfare is broken, that government deficits take away savings, that we need savings to provide funds for investment, that the government revenue depends on taxation and borrowing, etc. These are all false.
      How can that be a manipulation trick?

    • John -If MMT contends that government isn’t running out of money, that we’re not burdening our children with debt, that we don’t need saving to fund investment, that government spending isn’t limnited by availability of revenue, and that government revenue doesn’t depend on taxation and borrowing, then my problem is with the prescriptive flip-side of this. Does MMT therefore contend that governments can borrow limitless amounts, spend limitless amounts and (if they feel like it) reduce tax rates to zero? If that IS what MMT says, then it suggests (to me) that money is no more than a con-trick.

      Of course, governments can do all of these things simply by printing money. But history suggests that, whenever this has been done, money loses value through inflation and/or forex deterioration, AND that these results drive interest rates upwards. To be sure, velocity comes into this – the reckless money-printing of Weimar Germany would not have led to hyperinflation if poeople hadn’t spent it, but had stuffed it under the mattress instead.

      Any thoughts?

    • Yes Tim, Thanks for engaging. I learn along the way too! I’ll start with hyperinflation. As I’m sure you know, the confidence in money is ONLY the “full faith and credit ” worthiness of the government. That is the government’s collateral. Every hyperinflation in history has been due to a collapse in the sovereign government’s standing. This always precedes the money printing stage [which is what we generally remember]. It’s primarily a political problem

      MMT in no measure recommends unlimited money creation. Excess money printing is surely damaging. No argument there. MMT experts, like Bill Mitchell, Randall Wray, Warren Mosler, et al all say money supply is limited to what the real goods and services the economy produces/ consumes. The government has to work out what that capacity, real or latent, is. An economy must constantly outgrow its debt. It’s an endless treadmill. Interest is due on every dollar in creation. It is always greater than the dollar amount, so the reward for owning money is interest.
      What seems to be understood is that there is ample room in a sovereign economy for a government to stay in deficit. Exceptions are rare and depend on large export surpluses, like Norway has had, even Australia 10 years ago.
      “Government spending provides the net financial assets [bank reserves] which ultimately represent the funds used by the non-government sectors to purchase the debt” – Bill Mitchell.
      Central government debts are not inflationary. They can only buy what is for sale!
      Deficits don’t matter [to paraphrase Dick Cheney] as long as the government owns the creditor bank. This explains Japan’s situation.
      Government surpluses occur because it Taxes more than it spends. This means the non government sector gets squeezed and that can lead to recessions. It’s what Austerity has been doing in the Eurozone. Government surpluses exactly balance to zero the non government deficit, and the same vice versa. [it’s an accounting condition]. The private sector needs to be in surplus for the economy to grow.

      Hope that helps. I haven’t said anything about the private/commercial banks here. They are responsible for 97% of the money supply in the UK. Another time maybe.

    • Thanks for this. Let me say that I’m aware of the maths of this, so let me take this point-by-point. First, of course, “full faith and credit” is indeed the only collateral, though government’s monoply (“seigneurage”, I think) helps, because we all need a medium of exchange. Governments are therefore wary of alternatives to its monopoly of this medium of exchange. Governments have never been too happy about gold – where, by the way, strange things have been going on, I hear – and the US actually confiscated all privately-owned gold under the notorious Executive Order 6105. Also, governments are troubled by bitcoin, and would hate to see it succeed. So, whilst the only collateral is “full faith and credit”, the lack of an alternative helps.

      I like your point about the collapse of faith preceding money-printing – but couldn’t it be that a government, by running the presses, thereby loses its credibility? In this context, private banks may indeed account for 97% of credit (M4 credit), but the state controls “base money”, and the amount of the remainder is determined by this equation – base money x permitted multiple (i.e. the inverse of the reserve ratio). Thus, in the bubble preceding the 2008 crash, the real problem wasn’t an excess of base money but an unduly lax approach to reserve ratios. The logic would be that, if the reserve ratio is too loose (or isn’t enforced), the broad money supply expands, and asset prices must rise to accommodate this increase. Thus, for instance, loose reserve ratio rules allowed credit to expand, forcing house prices upwards.

      Velocity comes in here too, of course. The “effective money supply” (as I call it) isn’t the simple quantity of money/credit, but must include the rate of turnover as well, i.e. “effective money supply” = quantity of broad money x velocity.

      Now, if people turn cautious (so velocity drops), the “effective money supply” falls because: quantity (unchanged) x velocity (reduced) produces a lower number. Now, following from this, the state can redress this by increasing the quantity of money, thus: quantity (increased) x velocity (reduced) = same “effective money supply” as before.

      So, from 2008:

      – Velocity declines (public caution)
      – Quantity increases (QE); so
      – Effective money supply restored to prior level.

      Now, if public confidence recovers (i.e. velocity increases), whilst quantity remains enlarged (QE), then what I call the “effective money supply” (quantity x velocity) has increased – so inflation takes off?

      So, why has QE not sparked inflation? Answer, it seems to me, is that velocity falls (or at least remains reduced)?

      More later………………

    • The BOE paper says that most money gets created by the private banks and then it discuss how BoE must keep an eye on price stability.
      It is really ridiculous that most money creation is done for mortgages while house prices are not included in the CPI.

      It is a mockery of what BoE is supposed to do.

    • I think it needs to be kept simple too. I am a biologist, which leaves me comfortable with mess and not being able to describe in maths. Keep it simple, money is a social construct, it has value because we all believe it has value today, and believe that it will have some value tomorrow. Money is a store of promises. I give you this voucher today for work/service/asset, and you will accept it, because tomorrow you can exchange the voucher for some other labour/service/asset. Hyperinflation occurs when society no longer believes in that money vouchers will retain their value tomorrow and therefore no price is too high to obtain labour/service/asset.

  2. It would be VERY IMPORTANT, Tim
    I am now one of a few who “get” the credit money mechanics. I’m probably only 5% along the way, but I have come to recognise that we the public are having the wool pulled over our eyes due to widespread ignorance of how money works today.
    It is abused by called neo-liberal thinking [David Graeber describes it as “a form of capitalism that systematically prioritises political imperatives over economic ones”] The left is just as ignorant.
    Since today neo-liberal agendas dominate right across the western world, we need an antidote, one which will inoculate the public against such distortions marketed as essential policy, but which only serve to enrich the privileged cohort.
    For example here is a list of false statements frequently made by politicians. Here in Australia we have a particularly idiotic treasurer in Mr Joe Hockey. Fortunately his ignorance is tripping him up!.
    So, It is false to say the government has to fund expenditure from taxation and borrowings, that the government is broke.
    It is false to say taxes provide finance for government spending
    It is false to say the government borrows money from the private sector.
    False also when they say budget surpluses take pressure off interest rates
    Again false to say persistent budget deficits will burden future generations with inflation and higher
    False too to hear that running budget surpluses now will help build up savings necessary to cope with the ageing population in the future.
    False to say social security is broken.
    And more.
    I’ll leave it to you to expound further!

    Going back to QE, I found an interesting idea in an essay by Richard Werner today.
    He writes that QE’s purpose is to add to GDP through reserve expansion via bank credit creation. To achieve it finance ministries should avoid government bonds and go instead to enter into individual loan contracts with the banks.
    The beauty of this is that individual loan contracts are non tradable. In other words unlike tradable bonds which the banks can play with and will add to their profits while tying them up internally [the problem in the USA] These will actually add to GDP.

  3. John, Adam

    Thanks – I share the view that it is important to address this, and I agree, too, that it should be explained in a simple, user-friendly way. So I’ll put this ahead of what I was going to do next (either the euro as a study in failure, or corporatism, a pamphlet) (the latter prompted by Davos and Chilcott).

    You will know, I’m sure, that my book talks of “two economies” – the “real economy” of goods and services, which I describe as energy-based; and the “financial economy”, consisting of “claims” on the real economy. I need to try to link this in to a discussion of money.

    As I see it, money as an IOU or money as a “claim” (on the real economy) is an interchangeable idea – and we must never forget that there is a real economy of work, food and travel attached to the theoretical one!

    This won’t be quick to do, but I’ll do my best!


    • Thanks. Totally agree with you. A boom is where the promises are made, a recession is where they are called in. I see this as an evolutionary process, promises that can be fulfilled, will be, those that can’t won’t. Sensible capital controls to prevent wild excesses, and some social provisions to prevent the worst social outcomes in the busts.

  4. In your future paper on credit, the euro etc. would you please add a section on deflation. Why is it that bad and why are we all afraid of it? Could it be the natural and logical evolution towards “life after growth”?

  5. Dear Tim
    Having read the very erudite comments and your equally detailed explanations I am still at a loss to understand what is going on and more importantly where we are heading. If the economy is not performing as brilliantly as Osborne and Cameron tell us are they in fact lying? Perhaps you could also tell me what “paying down the deficit means” often trotted out by Cameron and co. What deficit? or should I say which deficit?!

    • Paul:

      The facts used by the govt (growth, employment) are fine in themselves – but what they don’t add is that Britain’s debt is very high, government debt is rising and our financial balance with the outside world has lurched dangerously into the red.

      “Paying down the deficit” is a non-sequiter. Debt is how much you owe whilst the deficit is how much you add to it each year. The deficit has been reduced, so the govt is adding less to its debt each year than it used to. But it are still adding to it. It could only “pay down” debt by turning the deficit into a surplus…..

  6. Paul, The government doesn’t understand how money works. They are replete with false assumptions. The deficit in the budget is ESSENTIAL for growth to happen. If the government doesn’t spend enough into the economy, or taxes too hard, such that it creates a surplus, the result
    will be a recession. Why? Because it starves the private sector of funds to spend in the economy and add to GDP.. The government sector debt exactly matches the non government sector surplus, and vice versa;

    • John, Paul

      I’m still writing my paper on money and its creation so I’ll put things tentatively, if I may.

      I know the authorities sometimes make idiots of themselves – for instance, ‘QE isn’t money printing because it is done electronically’. LOL.

      But I think it’s going a bit far to assume that MMT is completely right and the British and other governments are completely wrong. Deficits are additions to debt, and studies (including Rhinehart-Rogoff) have shown that government debt in excess of c80% of GDP impairs growth.

      I also know that the ‘private surplus/government deficit’ thing is logical, not least because it simply reassembles GDP components.

      But I think we need to distinguish between money and value. Mr A takes out a mortgage of £100,000. The bank lending to him creates this money by the simple act of lending. The bank now has a £100,000 liabiity (money in Mr A ‘s account) and a matching £100,000 asset (the debt owed to the bank by Mr A). Mr A, likewise, has a £100,000 asset (his bank account) and a £100,000 liability (his debt to the Bank). The BoE and the MMT side both agree on this. It balances.

      BUT, let’s follow up. Mr A spends the £100,000 on buying a house. Assets and liabilities still match up. THEN, however, the value of the house falls to £80,000. The various assets no longer match, do they? We now have an impaired or “toxic” asset of £80,000 where a £100,000 asset used to be. Who has lost? Mr A, initially, but the bank if Mr A becomes insolvent. Now the balancing equation no longer balances.

      Ergo, value is variable even if money isn’t?

    • In so far as the governments talk about the budget as a household analogy, and related assumptions they are seriously wrong! I wouldn’t be giving them an ounce of credit, because it is destructive to the running of the economy.
      I’m not sure you can make value add up like money. The missing 2o,ooo pounds won’t show in the banks books until it is sold or revalued for a roll over etc. The bank will book that loss into the new contract or Mr.A will have to make up the difference, with whatever he can arrange.
      Bank money is horizontal money because for every asset there is a matching liability so it balances to zero. Banking complexity won’t alter that. Banking money changes every day with every transaction. Federal governments have no money themselves. All money is in the private sector.
      Deficits can be a problem under MMT but it has to be major structural issues not the normal budget cycle. Just because there is a large government debt to GDP ratio is not a serious concern, unless it is not in its own currency. This lets Japan off the hook as the debt is due to its own citizens. Japan owns the creditor bank.
      By the same token creating sovereign funds, like superannuation funds we have in Aus, are totally unnecessary. In fact it’s just a vehicle for bank etc fees. It makes no difference to the government’s abilities to fund all its future liabilities.
      Paying off the national debt is just subtracting numbers of maturing securities from one account at the Fed and transferring them to another account all in the same spreadsheet at the fed.

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