Tuesday, December 01, 2009

In Their Heads But Not Their Souls

The fire last time

Yesterday Tyler had a chat with one of Britain's few sound MPs. We naturally touched on our fiscal crisis, and the risks of a 70s style market meltdown. Tyler wondered if MPs understand the need for urgent and painful action?

"Well, on one level, yes... but it's in their heads, not their souls."
Which seemed a pretty good summary of the entire problem, from the top down.

Brown/Darling have acknowledged the need for some kind of fiscal tightening, but not until way off in the medium-term, well beyond the next election. And even then, they've kept the details hidden, and their numbers only add up on the basis of wildly optimistic assumptions about future economic growth (eg see this blog).

Cam/Os have talked much more of the tightening talk, but their announced measures deliver less than £10bn of the £50-100bn cuts required (eg see this blog). St Vince ditto (see this blog).

The hope seems to be that once again, we can somehow muddle through. Unfortunately, our fiscal hole is now so big, that is most unlikely.

Last week, Tyler attended a session to launch of Politeia's latest paper Booms, Busts & Fiscal Policy - Public finances in the future? (unfortunately not online). It was written by one of BOM's heroes - Ludger Schuknecht, a senior economist at the European Central Bank and co-author of a seminal study on the inefficiency of Big Government (Public Spending in the 20th Century).

Disappointingly, Mr Schuknecht himself wasn't actually in attendance - that's because ECB rules apparently require him to clear anything he ever says in advance with his bosses (Soviet institutions didn't trust their senior staff to go out alone without minders either).

Anyway, Schuknecht reviews the deterioration of public finances across the major economies, and says our fiscal situation is the worst:
"The worsening in fiscal balances [is] staggering... within only three years, public debt is projected to increase by 40 per cent of GDP in the UK [against 30% in the US, and 20% in Japan and the Euro area]...

The first challenge must be the ambitious correction of fiscal deficits so that the debt dynamics do not explode... Given the higher deficits in the UK... their dynamics could be even less favourable..."
So debt dynamicwise, our position is even less favourable than an explosion. Does it get any worse than that?

[Debt dynamics? We've blogged about this before under its everyday label - the Doomsday Machine - and it's the simple idea that once debt gets beyond a certain point, the interest on that debt starts to cumulate faster than the borrower can pay down the debt... leading to all of us having to turn off the central heating and live on baked beans for the next 30 years]

HTF did we get here? Schuknecht highlights something we've blogged many many times on BOM - Brown spent far too much. Either deliberately or recklessly, Brown assumed a temporary boom in tax revenues from the finance and property bubbles was permanent income for him to spend as he wished. Which, coupled with the increase in welfare spending from this recession, means that in 2010 public spending will exceed 50% of GDP. And over the decade of the noughties, public spending will have increased by a pant-wetting 16% of GDP, far more than any other major economy (Germany's increase is 1.4%).

So what to do?

Mr S has a familiar prescription - spending must be cut substantially.

As he points out, deficit reductions based on tax increases are not only damaging to economic growth, they are unlikely to be sustainable from a political perspective - ie people won't tolerate them for long. And as he further points out, there is now considerable evidence (including that gathered by he himself) that government spending much above 35% of GDP is increasingly inefficient - ie it does little to achieve its objectives:

"A ratio below 40% of GDP and ideally 30-35% should be sufficient and allow good outcomes in areas judged to matter in western economies: functioning markets, equal opportunity for market participants, essential public goods and services, infrastructure, economic stability, and income distribution.

The evidence is that ambitious reforms that reduce government spending on public employment and other public consumption and on transfers and subsidies, is the best and most successful way to bring down public spending at little cost to economic cost and wellbeing."
So we need an axe, but the axe needs to be combined with a serious programme of public sector reform... something like school vouchers and competing social health insurers, say.

Oh, and one other thing - the state pension age needs to be increased much further and faster than we currently plan. The truth is we cannot afford it any more, and people are going to have to support themselves for much more of their lives (thereby of course, boosting economic growth and improving the fiscal arithmetic still further).

All very sensible stuff, fully supported here on BOM.

But as it happens, there were a couple of very senior MPs at this Politeia event, and while one of them seemed to get it, the other observed that cuts are all very well but we must not push them so far as to foment social unrest.

Presumably, he was thinking of the riots in Toxteth, Brixton, etc back in the early 80s (pic). And you have to say, you could imagine it happening again - especially given the tensions over mass immigration and British jobs for British workers.

But on the other side, TINA is heading back towards us. And this time she looks mad as hell.

As we've blogged many times, we are standing on the fiscal edge. Buoyed by the Bank of England's massive gilt purchases, and the belief hope that Cam/Os will get a post-Election grip, the markets have so far given us the benefit of the doubt. But if that slips, we are in real trouble. As spelled out in yesterday's report from investment bank Morgan Stanley:

“Growing fears over a hung parliament would likely weigh on both the currency and gilt yields as it would represent something of a leap into the unknown, and would increase the probability that some of the rating agencies remove the UK's AAA status...

In an extreme situation a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The Bank of England may feel forced to hike rates to shore up confidence in monetary policy and stabilize the currency, threatening the fragile economic recovery.”

Hung parliaments... MPs with weak souls... Cam/Os faffing around... TINA looking mad... a long hot summer...

Sounds like it's time to follow the Major and lay in some fire extinguishers. And a shotgun.

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