Monday 4 July 2016

The Incalculable Cost of our Aversion to Government Debt

I was speaking to Tom Streithorst at the FT Festival of Finance last week and he was pointing out that almost every single person there knows that the government needs to run larger deficits and invest more. But what we don't know is how to get that idea into the public consciousness. The public, by and large, along with the departing Conservative administration, see the government budget as like that of a household. One should not live outside of ones means, the argument goes.

It came to me that if I were forced to choose just one thing that I wish could be conveyed and understood, it would be that in a sovereign money state (a state that can print its own currency) the size of the government debt is more or less irrelevant.

Why is this? Simply speaking, a government can print its own money, through its central bank. The government produces money so it can never run out. It has no need to ever default. Assuming that the buyers of bonds have confidence that inflation will not devalue their savings, the government can always borrow to pay the interest and to keep spending. And in the last resort, the central bank can buy the bonds. Markets know this, which is why the interest rate on 10 year UK government debt fell below 1% per year after Brexit. Time and time again, the market proves that credible sovereign governments can borrow as much as they want at a reasonable rate; Japan being the obvious example with over 200% government debt to GDP (note that this is not true in the Eurozone, where the governments negligently gave away their necessary central bank functions to the ECB and now effectively borrow in a foreign currency). Frances Coppola actually argues that more government debt can be actually better than less because it allows savers safe assets to put their savings into.

Does that mean that the government can spend anything it wants? Absolutely not. There is a real resource constraint. In the end, the available labour in a country must be allocated somewhere. If a government, for example, spends more on the NHS then it must take labour from elsewhere. If the government spends too much money overall, then wages will rise and, in turn, so will the price of goods and services; we will get inflation.

But there are two important points here. The first is that the constraint on government spending is only the constraint on inflation. If domestic inflation is under 3% then, although one could argue that the government mis-spends (eg. too much on defence and not enough on education, or that it should spend less and tax less), one should not (in my opinion) argue that the government is running too large a deficit. Whatever deficit exists is a necessary deficit because it keeps enough money flowing through the economy to keep economic activity running smoothly. This idea is explained in more detail in this post.

If one accepts that the size of the debt doesn't matter assuming bond buyers are confident that the government keeps its inflation credibility, then it logically must follow that hitting the inflation target is the right level of borrowing.

Some people worry about huge inflation in the future if we keep borrowing. All this money is produced, they argue, so when people decide to spend it, it will cause hyperinflation. This is to misunderstand what is happening.

The economy is structurally saving money every year due to a large share of the product of the economy going in dividends, rentals and interest to people who save most of their income. A shrinking share is going in wages to workers who spend most of their income. For more money to be spent, this structural shift will have to reverse. This is a very slow process. Hopefully this shift will happen, and at that time the government can reduce its deficits and possibly one day run a surplus again. But there can not be a sudden change where everybody decides to spend all of their money. A possible exception to this would be if everyone expected hyperinflation, but certainly it will not happen if the government keeps its credibility regarding inflation.

The second point is to do with productivity. It is not a zero-sum game. At the aforementioned FT Festival, there was a panel discussing the productivity puzzle, or why productivity has declined. Typically all sorts of reasons can be found, from demographics to the fact that many services are now free (like Wikipedia) which do not show up in GDP. All of these are valid, but at the same time we have great hubs of technology and our world networks are more connected than ever before. Information spreads faster than ever and thus so should the rate of progress. I can't believe that all productivity improvements have been given away for free.

But regardless of what I think about this, I would like to ask you to look at the below graph (from this post on the UK productivity puzzle). It can be clearly seen that productivity, far from slowly declining, was all going well until 2008. Then, suddenly, it stopped. Did suddenly everything become free in 2008? Did everyone become old in 2008? The only thing that really changed in 2008 was that we stopped sending enough money around the system. First with the financial crisis, and then with the austerity imposed.

The gap between where we should be now and where we actually are is huge. The economy could be producing 15% more now if we kept up the trend. I was speaking about this to Steve Keen at the weekend and neither of us can see any reason why, given enough money to keep demand up, the productivity of each working person in the UK should not keep smoothly rising. If there is enough demand, enough money running through the system, then wages will go up and businesses will invest in new technology that increases productivity. If demand is low and wages are low, there is no point in investing in improving productivity. The fact that productivity is so far below trend is a failure of government.

Even now, the technological improvements have happened and a period of sustained investment in the newer technology should see considerable catch-up growth without high inflation.

The departing government claims great success with the economy, citing the lowest unemployment rates in years. But they did not create jobs by increasing demand for labour. They created jobs by a carrot and stick benefits policy forcing people into work at the bottom end of the market. They kept up demand by using monetary policy (lower interest rates and Quantitative Easing) rather than government spending, which gave money to asset holders but not workers. I talk more about why using monetary policy is so bad here. Thanks to austerity there is both a non-growing pie and workers receiving a smaller share of it (due to austerity forcing interet rates down).

So there is low demand because of low government spending and high supply of labour because of benefit sanctions.

The inevitable result of this is a low wage economy. This can be seen in the graph below (not the easiest graph to read, I admit). What it shows is that whilst Gordon Brown's economy pushed wages up and produced jobs above the living wage, the Conservative government actually greatly reduced the number of jobs above the living wage and created millions of jobs below the living wage.
This actually further exacerbates the problems of the economy. It is the reason why Osborne was never going to hit his deficit target. But worse than this, it creates an underclass of millions of minimum wage earners who are struggling to get by.

Even without the help of a scaremongering press and irresponsible politicians, it is not hard for the people on the low wages to make the link between their low wages and rising house prices, and the incoming immigrant population. In 2005, when there was a peak of immigration, wages were still rising. Not so this time. The difference; in 2005 there was enough money flowing through the economy that productivity was rising and wages were rising too. Since 2010 this money has stopped and wages have stagnated.

This is not to talk about the shutting of youth clubs, the cutbacks to education, the university tuition fees leaving our young with large debts, the rising house prices (a consequence of the lower interest rates because of the shrinking growth) and (because house prices are unaffordable) rents, the closing of libraries, the cuts to charities, the struggles of the NHS that is underfunded enough for the Leave campaign to put it on their battle bus.

The economic damage of austerity in the UK is calculable. I would put it at around 15% of GDP. That is to say that we would be 15% richer if productivity growth were to keep going as before. 

But the social damage. That is going to show up in the years to come. The EU referendum highlighted some of the divisions in society. As long as policy is run for the benefit of asset holders and the detriment of workers and the young, the discontent will, I fear, keep rising.

And a sobering thought is that the UK has not suffered the worst of the austerity by a long way. The austerity required by Euro membership is much worse than that in the UK. The Brexit vote is childs play compared to what will happen in the economically less competitive parts of the Euroland.