Who is afraid of the bond market? The paradox of Keynesianism

One of the added benefits of Brexit is that it has finally forced the government to kill off George Osborne's tenure at No. 11 Downing Street and thus abandon his insane attempts to balance the country's finances through austerity. But it would nevertheless be unfair to blame George Osborne entirely for the austerity of the last six years. Why? Because he was only doing what most mainstream economists and the opposition Labour Party were telling him to do, only doing it better.

The problem is this. Cast your mind back to the 2010 general election and remind yourself of the options that were available to the electorate. In essence there were only two: Osborne with his austerity-max, and the Labour Party with its austerity-lite. Neither were very appealing, but more pertinently, neither had any basis in macroeconomic theory, or more specifically in that part we consider as pure Keynesianism.

According to Keynes, the appropriate fiscal response of a government in a recession is to cut taxes and increase spending. The aim is to increase aggregate demand in the economy to compensate for the fall that has induced the recession thereby helping to rebuild confidence and restore output to pre-recession levels. Unfortunately there is a problem with this plan: nobody seems to have the necessary bottle to carry it out. This is because the plan as it is conventionally implemented contains a fundamental flaw. That flaw is debt.

In a recession incomes and employment levels fall and hence so too do tax revenues. In contrast unemployment levels rise and so consequently does social security spending. As a result the government budget deficit grows more negative and the national debt increases. And the bigger the recession, the bigger the deficit and so the bigger the borrowing requirement will be. Now in theory this shouldn't matter because a government that prints its own currency can never run out of money, but in practice it does matter because economists and the financial markets obsess about debt to GDP ratios and sovereign default, and driving this fear are the IMF, the bond market and the credit agencies.

The consequence of this is that in a recession when Keynesian theory demands that governments borrow whatever is necessary to get the economy moving again and operating back near full capacity, the bond market is urging caution and threatening to restrict credit. So in 2010 even though UK gilt yields were at historic lows and government borrowing was dirt cheap, all the talk was about reducing borrowing as quickly as possible to prevent market bond rates rising and our credit rating falling. Yet paradoxically, before the crash when the economy was booming and the government should have been discouraged from borrowing, there was no such alarm in the markets about UK debt and borrowing was positively encouraged.

This is the paradox of current Keynesian economics. When your economy is in a deep recession and Keynes says "borrow borrow borrow", the bond market wants to do the opposite. Yet when the economy is booming and Keynes says governments need to operate a surplus, the bond market is quite happy to lend you anything you want. Just ask Gordon Brown.

So in 2010 instead of both main political parties promising to cut taxes, raise welfare payments and increase investment as Keynesian theory demands, both political parties promised to do the opposite, but by slightly different amounts (obviously) in order to at least maintain a pretence of economic and political pluralism. All of this should therefore make economists think seriously and critically about what they really understand by Keynesian policies and how they can implement them because what this clearly demonstrates is that the current paradigm that they adhere to just isn't working. Not only that, it can NEVER work.

Fortunately there is a solution. That solution is Modern Monetary Theory or MMT. (To be continued...)

The Big Lie #1 - Austerity is needed to appease the bond markets

It is often said that truth is the first casualty of war. It could equally be the first casualty of politics as well. Given the extent to which politicians have appeared to play fast and loose with language and semantics in recent times it is perhaps unsurprising that their collective credibility and reputation, both at home and abroad, appears to be following the same trajectory as that of a test firing of a North Korean rocket. Whether it is politicians being "economical with the actualité", or Orwellian doublespeak of the type invoked by David Cameron recently where the term austerity has been magically redefined to mean "efficiency", the first casualty of UK political debate now always seems to be the English language. Of course none of this is accidental. It is all designed to disguise the reality behind a particular policy or action so that the voters are hoodwinked into believing in an illusion. 


One of the biggest fictions we are currently being expected to swallow is the one regarding the necessity of the current coalition government's deficit reduction measures and their apparent success. The argument that has been advanced by those on the Right on an almost daily basis since the last general election in 2010 is that the only way the Government can finance its deficit is if it can establish the confidence of the bond market. And the only way it can do that is if it slashes spending. And the central piece of evidence used to corroborate this claim has been the yields of government bonds or gilts. 


Gilt yields are currently at historic lows despite the Government running up record budget deficits over the last four years. Now we are told that these low yields are a direct result of the confidence that the bond market has in the Government's economic strategy. We are told that the Government cannot, or dare not, borrow any more money to stimulate the economy otherwise gilt yields would rise dramatically. We are told that our economy would then go the same way as that of Italy, or Spain, or worse still Greece! But how much of this is really true? The answer is hardly any of it. The reality is that our gilt yields are low because our borrowing has been almost completely self-financed over the last four years. That self-financing has come in the form of Quantitative Easing (QE). 


Up until April 2002 the last Labour government ran a financial surplus in its accounts. Then over the next six years this turned into a modest deficit of approximately £35bn per annum. While not ideal, these deficits were nevertheless sustainable in the long term as they typically increased the national debt by a smaller proportion than the corresponding annual increase in GDP due to economic growth. As a result the debt-to-GDP ratio was actually declining after 2006 despite the nominal debt level still increasing, and as a result it was actually more serviceable. It is therefore economic fantasy to suggest, as some on the Right have done, that these deficits caused the financial crash. The real cause was the set of economic policies implemented by the Thatcher and Major governments in the 1980s and 1990s, particularly with regards to the liberalization of consumer credit, laissez-faire bank deregulation and a wholly disfunctional housing policy. The result was the worst recession in living memory and a national debt that has increased to £1022bn. Of this total, over £500bn has been added since the start of 2008 - almost half the total. So why have gilt yields remained so low when the supply of gilts from the Government to the bond market has been so huge? The answer is QE. 


Since 2008 the Bank of England (BoE) has "printed" an additional £325bn of new money in the form of Quantitative Easing and used this money to purchase UK gilts. Irrespective of the fact that this was done through the secondary bond market, the net result is that 65% of all the new gilts issued by the Government since 2008 have in effect been acquired by the BoE. That means that only about £180bn have actually been purchased by the private sector, or £45bn per annum. That is only fractionally more than were purchased each year prior to the crash, and this has been going on for nearly four years now. In fact QE has been operating for so long now that the financing of government deficit spending has become semi-detached from the bond market to such an extent that it is almost operating in a parallel economic universe. That is partly why yields are so low and as you can see it has nothing at all to do with the international financial markets supporting the deficit reduction plans of the coalition. 


But that is not the whole story, for one of the additional consequences of the financial crash is that UK banks are now forced to hold more assets to strengthen their balance sheets. As a result UK banks have needed to buy more UK gilts themselves in order to increase their own financial stability. It is therefore highly debateable if there has been any significant increase in the purchase of UK gilts by overseas investors in recent years, yet capital flight from the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has driven up the relative demand for UK gilts.


Only yesterday did we see further worries about the Spanish economy driving yet more capital away from the Eurozone and forcing it to look for safer havens elsewhere. The result was a further drop in UK gilt yields. And all of this is happening at a time when the supply of UK gilts, contrary to popular opinion, has actually been significantly reduced, or has at least been far less than the headline figure of the UK government deficit. So, given these two complementing drivers, it should hardly be any surprise that UK gilt yields are so low, irrespective of the general state of the economy, which in case you had missed it, is lurching from one recession to another. That is hardly the sort of performance that is usually associated with inspiring the confidence of international investors. 


You can of course look at all this from another perspective: that of the balance between supply and demand and its effect on market prices. Low gilt yields are an indication of excess demand and insufficient supply. Consequently they represent a market price signal that says: "The market wants more!" In which case why should we not supply more gilts to the market, particularly when we can put those gilts to good use? Those who believe in the power of markets, and the price signals that they send, cannot have it both ways. If high yields are a sign that government borrowing is too high, then low yields can be a sign that it is too low. And as I pointed out previously, when it comes to low interest rates you can have too much of a good thing. Ultimately banks, including central banks, cannot push money out into the economy when there is no demand, or no cost to holding it. In such circumstances monetary policy is like pushing against of piece of string and a coordinated and complementary fiscal policy is then also needed. 


Of course the real tragedy is that despite having access to what has effectively been free money for four years, both the last Labour government and the current coalition have failed to do anything effective or imaginative with it. Rather than using it to stimulate a programme of infrastructure investment, it has instead been used to refinance the banks, and indirectly to prop up house prices. Once again successive governments and the Bank of England have shown that they are more worried about negative equity than they are about unemployment; that they prize inflated asset values over real economic growth. As a result, all this free money has in effect been used to insulate the rich from the consequences of their own mal-investment rather than improving and protecting the lives of the poor. 


The choice of austerity is therefore a political choice not an economic one. Just because there is a lot of debt in the economy does not mean that there is no money at all. It just means that all the money is in the pockets of the wrong people. The current government with its tax cuts for the rich and its attacks on the incomes of the poor clearly wishes to keep it there.

Why the 50p tax rate is bad politics and bad economics

The issue of tax has long been a thorny issue for the Labour Party, due in large part to the suspicion that it was the one single issue that cost it both the 1987 and 1992 elections. Hence Tony Blair's pledge before 1997 not to raise income tax in the first term of a Labour government. However, last year Alistair Darling did indeed announce an intention to raise income tax for those earning over £150k by introducing a new 50% tax band for those high earners. The intention of the tax seemed clear: to increase wealth redistribution and to make Britain a fairer and more equal society. There is just one problem with this proposal. Any objective analysis of it suggests that it will probably fail miserably to achieve any of its aims. In short, it is a rubbish policy.

This 50% tax targets a miniscule proportion of the population, it is too easy to avoid, and so it will raise virtually no extra money. In fact by encouraging tax avoidance, it may even reduce the overall tax receipts by also decreasing the number of 40% tax payers in the economy. In addition, the level and threshold at which it is set are so arbitrary that the signals it sends out are entirely negative. To put it simply, if the Government can tax at 50% today, then why not 66% or 90% tomorrow? With no logical reason to doubt that the tax rate could go even higher in the near future such a policy completely destroys any confidence in Labour's future tax plans. Instead it raises the spectre of the bad old days of the 1970's and Dennis Healey's pledge to "tax the rich until their pips squeak." It therefore destroys confidence in the Government without even having the positive compensating effect of raising significant amounts of extra money. So, instead of a win-win scenario, we have a lose-lose one. Brilliant!

If the Government was going to raise the tax rate for high earners, it should at least have done so based on some underlying guiding principle. That principle should be one of equality or fairness. The questions then become, how can we justify such a higher rate of income tax for higher earners, and what should it be?

Historically, government expenditure has tended to hover around 40% of GDP, at least in recent decades. In the light of this one could reasonably argue that anyone who is paying less than 40% of their income in tax is clearly not paying their fair share. At first sight that might appear to encompass the majority of the population who only pay income tax at 20%. However, that argument doesn't account for the additional 11% they pay in National Insurance (soon to increase further), Council Tax (which averages out at another 4%) and the VAT and other consumption taxes that they pay on most other basic costs including transport, food and clothing. So in practice a person on an average income (which is currently about £25k) pays significantly more than 40% of their total income in tax, almost all of which is unavoidable.

As the average Briton is clearly being taxed at a rate that is greater than the overall taxation ratio of 40%, it is therefore only fair that those on higher incomes should also be expected to be taxed at an overall tax rate that is commensurate with the ratio of Government expenditure to GDP as well. However, any additional income that the richest 10% of the population earn in excess of the average household income (currently about £45k) is predominantly disposable income. It is income that is above and beyond that which is required to cover most daily living expenses. Therefore, it seems only reasonable that this should be taxed at the same overall ratio as the national average. That seems to me to be the justifiable rationale behind imposing a higher tax rate for the top earners in society, and perhaps why it has been set at 40% for most of the last few decades. However, there is now a problem. The current recession means that the ratio of Government expenditure to GDP is increasing above 40%, while tax receipts are declining. With public sector net borrowing (PSNB) predicted to exceed £175bn this year, and the bond markets getting increasingly nervous about the scale of our national debt, politicians need to come up with credible policies to tackle this problem. However both the solutions advanced so far have a dark side.

On the one hand is the spectre of tax rises, as exemplified by the recent announcement by Alistair Darling to raise National Insurance contributions, for both individuals and employers. This, though is a tax on both jobs and consumption, both of which could slow any economic recovery. On the other hand the Tories are baying for spending cuts. Yet this also risks prolonging the recession by increasing government spending on benefits even more while reducing government procurement and economic consumption. What is needed is a 'third way' that reduces the deficit without taxing jobs and reducing revenues from consumption. That way is to tax surplus wealth, and one such source is the disposable income of higher earners. I would therefore argue that rather than introducing a new 50% tax rate that benefits no-one, the Government should have raised the existing 40% rate.

My reasoning is this. Given that the ratio of Government expenditure to GDP has now increased to nearly 44% for this financial year (2009-10), and is expected to remain at such a level for the foreseeable future, and tax receipts have plummeted to only 33% of GDP due to the recession, gradually raising the upper tax rate from 40% to 44% would have represented a far better policy than the introduction of a new 50% rate. Not only would it have been fairer, it would have been based on a clear and transparent principle that would have reassured the public that such rates were not arbitrary and vindictive. It would have also raised ten times as much in tax as the 50p rate (£10bn versus £1bn). As such it would have made a significant impact on our underlying budget deficit (currently estimated at about £50bn), while having little or no adverse effect on either levels of employment or consumption (due to it being targeted at the disposable income of the affluent that would normally be invested in assets and savings). It would also be far less prone to the problems of tax avoidance as it is highly unlikely to cause a mass exodus of higher rate tax-payers from the country.

So the essence of this tax policy is this. Rather than having a fixed 40% tax band, or introducing a new 50% band, the current 40% band should 'float' with its level set by the current ratio of government spending to GDP. Under the current financial circumstances we find ourselves in that would mean gradually increasing the rate from 40% to about 44%.

There would of course still be great howls of protest from those with salaries in the top decile of the earnings league who would be the most affected by the raising of this tax level. However, these are to a large extent the very people who enjoyed the largest percentage growth in their earnings during the boom years, earnings that we now know (or at least suspect) were, in a large measure, based on fictitious or inflated profits, particularly in the financial sector. In which case, these were, in large part, salary rises that were unearned.

These are also the people who, more than any other sector of society, invested those earnings in the property bubble that caused the boom and the resulting crash in the first place. So, given that many of them were the largest beneficiaries of the credit boom, and partially responsible for it, isn't it fair that they should also be the ones who should contribute most towards restoring the economic stability of the country? Given that they are also the only ones with the spare cash to do so shows that they also have the means to do so. And if they don't like this policy? Well, they can always vote for a party that will promise to slash public spending in order to keep it below 40% of GDP. But then don't most of them do that already?