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...)

Nick Clegg and the Tories - deal or no deal?

So who should Nick Clegg and the Lib Dems do a deal with? And what should they seek to get in return?

Clearly their first priority must be electoral reform. This is clearly their best opportunity yet to secure a set of reforms that could completely change the dynamic of British politics. Unfortunately, there are a number of major obstacles standing in the way that could prevent them from achieving this.

The first problem is this. On issues of policy (tax, electoral reform, Europe, the economy) the Lib Dems are much closer to Labour than the Tories, and so are most Lib Dem activists. Unfortunately, the same cannot be said for most Lib Dem voters, particularly those in many of the seats in the South of England where the Lib Dems are the main opposition to the Tories. So while most Lib Dem party members and MPs would be much happier forming a coalition with the outgoing Labour government, they could face a backlash from some of their voters and the Tory press if they did. David Cameron may not have won the election last Thursday, but there is no doubt that Gordon Brown lost it. Therefore Nick Clegg would be committing electoral suicide if he was seen to be supporting a Prime Minister who had been rejected by the voters.

The alternative Lib Dem-Labour scenario is that a coalition between the two parties could be agreed, but with Gordon Brown stepping down as PM. But would Gordon Brown ever agree to that? I suspect not, but even if I'm wrong, who would replace him? No-one from within the Labour Party has the mandate, and a new leadership election would take too long. So how about if Nick Clegg were to be the new PM? That might be more popular with the electorate, but then the problem switches to the question of who would be his Chancellor of the Exchequer. The public would also want Vince Cable, but it is inconceivable that any coalition between the Lib Dems and Labour could be agreed with the Lib Dems holding both of the two top posts in Cabinet when they are by far the smaller party. And the alternative is that Gordon Brown might demand his old job back.

Finally there is the problem of stability. A Lib Dem-Labour coalition would still fail to command a majority in the House of Commons. It would need the additional support of the SDLP, the Greens, and either Plaid Cymru or the SNP or both in order to govern. Yet the greater the number of partners, the greater the risk of collapse. The question the Lib Dems should therefore be asking themselves is this. How long would such a coalition need to exist in order for it to deliver electoral reform in time for the next election? And how likely is it that it would happen? The doomsday scenario is that this coalition would collapse before any real reform could be enacted, and that at the ensuing general election the Tories went on to win decisively, with the Lib Dems routed. Electoral reform could then be off the political agenda for another generation.

So if a Lib Dem Labour coalition is fraught with difficulty and danger, how about a pact with the Tories? At first sight it is hard to see, though, how a pact between the Tories and the Lib Dems (whether in the form of a formal coalition or an informal one) could work given the massive differences in policy between the two parties and the mutual hostility of many of their respective MPs. Moreover, the Tories would never agree to electoral reform of the House of Commons. However there is one thing that the Tories could deliver that would be a total game changer - reform of the House of Lords.

David Cameron and the Tory Party claim to support a fully elected upper chamber, so now Nick Clegg needs to call their bluff. The outgoing Labour government has claimed that it was opposition from the existing Tory life peers and hereditary peers that blocked and delayed reform of the House of Lords in the final years of Gordon Brown's premiership. David Cameron on the other hand can deliver the necessary votes in the House of Lords needed to get reform through quickly. That should therefore be the price that Nick Clegg should demand for limited support of a minority Conservative government in the House of Commons. The critical factor here is speed. If reform of the House of Lords is not in place before the next general election, not just in legislation but in operation as well, it can always be repealed by a new (Tory) government in the House of Commons that may seek to break any promises and cancel any deals agreed previously. There is little honour in politics, particularly if it gets in the way of the exercising of unbridled power. However, once an elected House of Lords is up and running though, no House of Commons will be able to abolish it unilaterally. It would need a broad consent in The new House of Lords as well, and turkeys don't usually vote for Christmas. In short, once it is up and running, a directly elected House of Lords is here to stay. It is irreversible.

Now at first sight this might all seem like a small and insufficient concession for the Lib Dems to extract from the Tories given that most people see the House of Lords purely as a revising chamber. I believe, though, that reform of the House of Lords is the real key to total electoral reform in this country. It represents the small crack in the dam that will eventually bring down the whole structure. As the new House of Lords would be elected by PR, it would be more proportional, more democratic, and therefore more legitimate than the House of Commons. It could act as a block on extreme policies promoted by governments with Commons majorities but minority support from the electorate. In effect it would lead to coalition governments without the need to reform the voting procedure for the House of Commons, though that would surely follow. In short, it would totally change the rules of the game. That is why Clegg must seize the opportunity now. He may never get another chance.

The real issue is house prices, not bank regulation.

This week the FSA published proposals to increase and improve the regulation of mortgage loans, principally by banning self-certification mortgages where applicants were not required to provide any proof of income. At the same time much of the wider political discussion has been about more general regulation of the banking industry. Unfortunately, both this strategy of the SFA and the wider discussion seem to me a bit weak at best. They are both based on the flawed assumption that the current economic crisis was caused by the reckless behaviour of banks and bankers, when in fact it was at least partly caused by an unregulated house price bubble that, together with the securitisation of debt, encouraged bad lending practices. To suggest otherwise is to put the cart before the horse. Banks like Northern Rock, HBOS and RBS did not collapse or require government intervention because they indulged in the reckless trading of derivatives. The problem was they borrowed in order to lend into an inflated property market, and it was the rate of inflation of that market that encouraged them to borrow so excessively.

The issue is this. Fundamentally, there are two distinct problems that need to be solved, not one. These problems are the risky lending practices of banks as they sought to inflate their profits, and the boom in house prices that both underpinned those policies, and was driven to even greater extremes by them. In this chicken and egg world, it is both of these failures that need to be addressed. Unfortunately our politicians and regulators so far only seem interested in tackling the first of these. They are only interested in saving the banks and the financial system while appearing quite happy for laissez faire free-market ideology to go on unchecked in the rest of the economy, and particularly in the housing market. This is partly because in doing so such actions reinforce the current received wisdom that all the current economic woes are the fault of nasty, greedy bankers, and not the way banks and bankers were (or were not) regulated, because obviously if it were the latter then politicians would also have to share in the blame, and that would never do.

So, one year on from the collapse of Lehman Brothers and the almost complete nationalisation of Scottish banking, and it seems it is not only bankers who have learnt nothing from the experience. Listening to the latest proposals from the FSA on the regulation of mortgages, it is clear that most politicians and regulators still haven’t got it either. What is worrying about the latest FSA announcement is not so much the proposals that are being advocated: it is the total disregard for the ones that were omitted. Fundamentally, though, it is about the complete failure to even acknowledge the elephant in the room that still no-one will talk about. That elephant is house price inflation and how to control it. The conventional wisdom is that such control is beyond the power of governments or regulators. I disagree. I believe it is both possible and essential that this rampant source of inflation is killed off once and for all time if we are ever to return to sustainable economic growth, or if Gordon Brown’s dream of no more boom and bust is ever to be realised. Moreover, I will demonstrate precisely how it can be done.

This antipathy towards controlling house price inflation also highlights the hypocracy of our politicians and leading economic thinkers. If economic stability is so critical to ensuring long-term economic prosperity, and if the control of inflation is so critical to maintaining economic stability, why is the control of house price inflation not sought with equal enthusiasm? After all, was it not the housing boom that ultimately caused our current economic problems? And it’s not the first time such a boom has been the cause of recession in this country, is it? So, unless we do something to change things, it won’t be the last either. So why the reluctance amongst so many politicians to do anything to change things?

Maybe the obvious answer is that there were too many vested interests in politics, business and the media that were benefiting from the boom, or at least thought they were. And with so many MPs using their second home allowance to play the property market themselves, perhaps it is understandable that there was little appetite amongst many of them to kill the goose that was (temporarily) laying the golden egg for the privileged few. Yet in 1997 we were told that things would be different. As Gordon Brown stated in his first budget speech as Chancellor: “I will not allow house prices to get out of control and put at risk the sustainability of the recovery”.

The mistake Gordon Brown made was the same one that many others continue to make. He tried to counter house price inflation through taxation. In 1997 he reduced mortgage tax relief and raised stamp duty. Unfortunately neither measure had any effect. Nor could they, because the plain fact is that you do not dissuade people from speculative behaviour merely by taxing a proportion of the profits of that speculation. That is why stamp duty doesn’t work, nor capital gains tax, nor a land value tax. In order to control inflation in house prices you have to get back to fundamentals and control supply and demand.

Many on the Left have been advocating house building as a solution, particularly the building of more social housing. While this supply-side approach would have many benefits, it is also very slow to implement. On average it takes between three and five years for a house to get built, so a supply-side solution will always lag behind the market and will always be playing catch-up. When the market turns, the change will be exacerbated and the boom and bust cycle maintained.

The only viable solution is to control demand. Traditionally governments have done this using interest rates with some limited success, but this approach also damages the wider economy, particularly with regard to business investment. What is needed is a lever that the State can pull that only affects the number of potential house-buyers. That lever is the one that controls the supply of mortgages. If you control this, you ultimately control the number of buyers in the market. Unfortunately, the Government and the FSA have just rejected the two measures that would do just that. As Lord Myners said last week, “...we’re not going to have a mandatory limit on loans to value or loans to income but rather a prudential limit...”

Yet it is only these policies of either a manditory limit on loans-to-value or loans-to-income that can ever work. They can, after all, be defined and quantified objectively within a legal framework. How do you define and quantify prudence? More importantly, however, by setting changeable limits on what people can borrow for a mortgage you can adjust those limits and thereby adjust the qualifying criteria for mortgages as economic circumstances change.

As the deposit required for a mortgage goes up, the number of people who can summon up such a deposit will decline until the balance between buyers and sellers shifts in favour of the remaining buyers. Therefore the price of housing will eventually stop rising and begin to fall. Similarly, if the criterion is the ratio of earnings to mortgage value, reducing the ratio removes lower income applicants from the bidding process for each house and also reduces the eventual sale price. Thus both mechanisms should result in lower house prices and a control of inflation in that sector of the economy.

No doubt the naysayers will ask, how do you know such a policy would work? Where is your evidence? Has it ever been applied anywhere?

Well the answer is yes, right here, right now.

Why do you think house prices have crashed over the last two years?

• Was it because of higher interest rates? No!
• Was it because of higher tax rates? No!
• Was it because of increasing supply of houses? No!
• Was it because of a shortage of potential buyers? No!
• Was it because of a shortage of mortgages? Not exactly.

It was because the banks raised the deposits that prospective buyers needed to provide in order to qualify for a mortgage. A year ago this deposit was so large that most prospective buyers were forced out of the market. The result was that house prices crashed. Now, though, those deposits have fallen from over 20% last year to as little as 5% in some cases this month. And the result? Well over the last six months house prices have been on the rise once more as the buyers have returned. If that isn’t convincing what more evidence do you need?

The problem is that all this has happened by accident, or at least in a haphazard and totally indeterminate manner. Yet it needn’t be so. All that is required is for the Government to give the Bank of England (or some other independent financial authority) the power to set these deposit levels on a monthly basis, in much the same way as Bank of England interest base rates are currently set, and then house prices can be brought under control once and for all.

So if this Labour government is truly interested in delivering economic stability and a fairer society then it must commit itself to the control of house price inflation. Without such a commitment any housing policy it tries to implement in the future will at best be no more than mere palliative care, and any economic policy will ultimately be wrecked on the same rocks that scuttled the last policy.