Thursday 31 March 2016

A plan to turn the Euro from zero to hero

(this post is available in full as a guest post on Frances Coppola's excellent blog Coppola Comment)

It is difficult to read the history of inter-war Europe and the US without feeling a deep sense of foreboding about the future of the Eurozone. What is the Eurozone if not a new gold standard, lacking even the flexibility to readjust the peg? For the war reparations demanded at Versailles, or the war debts owed by France and the UK to the US, we see the huge debts owed by the South of Europe to the North, particularly Germany.

The growth model of the Eurozone now appears to be based largely on running a current account surplus. Competitive devaluation is required to make exports relatively cheap. While this may have been a very successful policy for Germany during a period of high economic growth in the rest of the world, it cannot work in the beggar-thy-neighbour demand-starved world economy of today.

As I've explained elsewhere, reasonably large government deficits are very important for sustainable economic growth. However, in the Eurozone this is prohibited both by the Stability and Growth Pact (SGP) and by the fear of losing market confidence in the national debt. At the same time credit growth for productive investment is constrained by weak banks and Basel regulation. And the Eurozone as a whole is already running a large current account surplus; the rest of the world will not allow much more export-led growth. Helicopter money would be a solution, but politically this is a long way away. Summing up, if economic growth cannot be funded by government deficits, private sector debt, export growth or helicopter money it is very difficult to see where nominal GDP growth can come from.

In a way, this can be seen as a Prisoner’s Dilemma. Every country knows (or should know) that if all states provided fiscal stimulus, the Eurozone would benefit from more economic growth. However, for any individual state, a unilateral fiscal boost would increase their own government debt whilst giving a fair amount of the GDP growth to other states (because some of the stimulus would go to increasing imports from the other nations). And if all others provide stimulus, then it is in an individual state’s interest to take the benefit of the other states’ stimulus, and become more competitive versus the rest.

The huge imbalances created by the fixed exchange rate system, described in this great piece by Michael Pettis, are still there. The enormous current account surplus built up by Germany makes it extremely difficult for the less competitive countries to run a current account surplus. The only way for this to happen, without German inflation, is by internal devaluation; a long and painful process to lower wages, which may succeed in achieving a current account surplus, but only at the expense of shrinking the economy. The debt owed to the creditor nations therefore gets larger in real terms. In the end, the debts owed by the South to  the North are unpayable without the Northern countries running a current account deficit and using the savings built up during the amassing of the surplus to buy goods from the South. But the Northern surpluses are only getting bigger.

On top of this, all countries in the Eurozone are committing the "original sin" of borrowing in a foreign currency. This can only be a time bomb, waiting to devastate Europe.

Read the rest of this post on Coppola Comment

Wednesday 2 March 2016

The Economy Simply Explained

Sometimes my friends tell me that they try to read them, but my posts are too complicated. I am using jargon that they don't understand and probably they are too long and confusingly written. To remedy this, I have decided to try to write a simplified version of this piece I wrote about how the economy works.

How can one picture the economy? The economy should be viewed as a flow of money. This may seem straightforward, but mainstream economic models do not include money at all. And yet, a lot of the workings of the economy can be understood by looking at who receives money and how much of it they spend.

 If everyone is working and producing goods and services, then people need to buy these goods and services. In order for people to buy these products they need to have enough money.

Money received by people for producing things is then spent by these people on more things. This cycle repeats itself and makes the economy run.

What if people don't have enough money? They can't buy the goods and services. In a perfect world, the price of everything would go down so that all of what is produced can be bought. Unfortunately, in reality this is not the case.

Why can't prices go down very easily? The reason that prices can't adjust very easily to not enough money is that people's wages tend not to go down. This is called 'stickiness of wages'. Because people generally don't like having pay cuts, producers can't reduce prices or they will be making goods at a loss.

If they can't reduce prices, what do they do? Instead they cut production and make people unemployed. This then, in turn, reduces the amount of money that people have to buy things. Leading to further job losses.

Eventually what would happen? Without any government intervention, in the end prices and wages would fall enough so that everyone could have a job again. But it is a long and painful process. It is much better to ensure that the correct amount of money is running therough the system.

How much money is the correct amount? A generally accepted nominal GDP growth target is 5% per year. This means that in total 5% more value in goods and services are produced each year. Some of this increase is due to inflation - one pays more for the same number of goods. And some of this is growth - more goods are produced.

If too much money is spent then we get more inflation. That is to say that the growth in production of goods can't keep up with the rise in amount of money spent. Consequently prices go up.

But if 5% more £ worth of goods and services are produced, doesn't that mean that people need to spend 5% more money each year than the year before? Exactly. Every year, for the economy to be healthy, 5% more money needs to be spent than the year before.

Where does this extra money come from? This is a very good question. And it is one that seems to be ignored by most economists.

The problem we have with the economy today is that actually it is being drained of money. If £1m of goods are produced and sold, then in the next year only approximately £970,000 will be spent. People are saving the other £30,000.

To be more exact, the gap between the amount people are saving and the amount of people's savings from previous years that they are spending comes to 3%, maybe even 4%, of GDP.

Why is this gap so large? There are a number of reasons but it mainly has to do with the difference in spending of the people who receive the money. Working people on low and medium incomes tend to spend most of the money they receive. But savers receiving interest and dividends spend less of it in the economy.

Private sector debt in the economy has increased hugely over the past 40 years, meaning more money goes to interest payments. And corporate profits as a percentage of GDP are at record highs. Meaning that workers receive less of the money from their work than they used to. And because of this, less money is spent.

On top of this, widening inequality means more income goes to richer people, who tend to have a higher saving rate than poorer people.

In the UK and US there is also a trade deficit - meaning that more money spent by people in the UK and US goes to other countries.

Currently, the average annual saving rate in the UK is probably 3-4%. The exact figure each year depends on how confident people are in the economy. 20 years ago, the average saving rate was probably only around 2-3%, and 40 years ago it would have been closer to 1-2%. These are approximate guesses but it shows the problem caused by the financialised economy we live in today.

So that means we need to send a lot more money through the economy every year? That's right. If we have a 3% saving rate, and we are looking to achieve a 5% nominal increase in GDP each year, we need people to spend an extra 8% of GDP worth of money each year.

So, again, where does this money come from? Historically it has come from two places.

First, governments normally run deficits of on average 4-5% per year. The multiplier of this on GDP (ie. how much of this gets spent on GDP additive goods and services) is approximately 1. So around two thirds of the historical gap comes from government deficits.

Second, private sector debt has increased year on year.This consists of, for example, money borrowed by individuals for mortgages or credit cards, and by companies for investment or to buy back shares. This has grown by 10% of GDP per year since the 1970s. Effectively 10% of GDP more money has been printed by banks and corporations every year.

However the private sector debt is not as efficient at getting people to actually spend the money. Much less of it is spent on GDP. So the increase in private sector debt, despite being twice as large,  makes up about a third of the new money spent every year.

Why is the economy struggling at the moment? Because private sector debt has hit such high levels. This means that interest rates are low, and that makes house prices very high. Because many people can not buy homes any more they do not take out more mortgages. Because the economy is not growing so much, companies want to borrow less. So we do not have the new money coming in from new private sector debt.

So what has the government done? Central banks have tried to do what they can to make more money be spent. They have enacted a policy called Quantitative Easing which prints new money and uses it to buy bonds. This pushes down long term interest rates and pushes up the prices of assets (like shares and houses). This makes (generally) richer people even richer and encourages them to spend more.

Our elected government has been working against this though, cutting money from poorer people who spend more, and trying to get the government deficit to zero.

Can the government cut the deficit to zero? No. Or they can, but if they did they would shrink the economy so much that the debt to GDP ratio of the government would rise hugely. This is because, as mentioned above, there is not enough other new money flowing through the economy.

In fact, austerity, if anything increases the government debt to GDP ratio as a) GDP does not rise as much as it could and b) private debt rises instead making financial crises more likely.

What is the effect of their attempts so far? Economic growth since 2008 has slowed hugely. As I discuss here, government policies to push the unemployed into low paying work has reduced the number unemployed, but the economy is not healthy. The graph below (taken from here) shows what has happened to productivity per hour worked in the UK. Historically this has grown by 2-3% per year, but since 2008 it has not grown at all. The low wage austerity economy has meant that increases in employment are in more menial rather than more productive labour. This is not to mention the human cost of austerity.

Also, by using lower interest rates instead of government debt to get the economy going, the government has pushed house prices up even further out of the reach of most of the population.

So the money to grow the economy must come from the government? YES.

The government must run larger deficits. As shown in my last post,by spending more money we get three beneficial impacts:
  1. The economy grows much faster, meaning more and higher paid, better jobs. Productivity (which has stagnated in the UK's low wage austerity economy) will increase and the country will produce a lot more.
  2. Interest rates will be able to rise, meaning private sector debt levels will fall. This makes economic crises far less likely.
  3. Government debt to GDP actually will probably end up being lower - as although debt rises, GDP rises by just as much, and we don't get debt crises.  

But if the government spends too much money won't it go bankrupt? No. At least not in countries where the government has control of its own currency and borrows in that currency. In the UK, the Bank of England could print money to buy government bonds if there were ever the need. The Eurozone is a different story. For this reason, the Eurozone will suffer from permanently low growth (probably ending with a disastrous crisis).

But if we print money we'll end up like Zimbabwe won't we? No again. Inflation is created when money is spent. If we are going to have inflation it will be at the time the debt is taken out. If the central bank swaps newly printed money for government bonds at a later date, then all that happens is that people in the future will have their savings in cash rather than government bonds.

Doesn't the government borrowing more money now steal from our children? No. It does affect how future prosperity is distributed. But if you think about it, the way to give a prosperous future to our children is to invest in our productive capacity now so that the economy they inherit is blooming. The only way we steal from them is by penny pinching now and not investing. And of course destroying the environment, but I'll leave that lesson to Leonardo DiCaprio.

I understand it all now, thank you Ari. You're welcome, my imaginary friend.