Monday, March 25, 2013

Plan B Kicks Off


Get used to this

So here we are with a government spending far more than it can raise in revenue, building up a catastrophic pile of debt, and facing an election in just two years time. Spending cuts are needed to balance the books, but more cuts this close to an election just ain't gonna happen. What on earth can be done? George is prepping Plan B.

George's Plan A is to pray for growth, and in both the 80s and 90s it was a resurgence of growth that came to the fiscal rescue. Unfortunately, with debt overhangs and busted banks all around us, we're now in a much more difficult position than we were back then. The growth rescue looks to be way off, and George knows it.

Which is why he's now busily working on Plan B. It's the traditional plan for over-borrowed governments everywhere, and its ingredients are as follows:
  1. Engineer higher inflation by printing money - in an open economy like the UK it's quite easy because currency depreciation soon gets prices moving up.
  2. Fail to index tax thresholds in line with higher prices - that boosts income tax revenues as earnings respond to higher prices (aka fiscal drag), adding to the higher revenues flowing from VAT. 
  3. Limit spending in cash terms- hold spending departments to strict cash limits.
Over the last several months, George has taken action on all three components.

First, he confirmed in the Budget that under his new flexible friend Governor, the Bank of England will no longer be restricted to a 2% inflation target. In future, it will be allowed to set itself "intermediate thresholds", such as keeping "interest rates low while unemployment is high, provided inflation is not expected to rise too much". How much inflation is too much? That's for him and the Governor to choose, and you to fret about as you watch your savings disappear down the plughole.

Second, he's increasing the higher rate income tax threshold by only one percent a year, even though inflation is running much higher. The £150,000 threshold at which the top rate of income tax applies is frozen altogether, as is the £100,000 threshold above which the personal allowance starts being clawed back. The higher is inflation, the more harshly these measures will bite, with around half a million additional taxpayers being dragged into higher rate tax over the next two years. Similarly, the threshold for Inheritance Tax has been frozen at £325,000 since 2009.

Third, he announced in the Budget a huge increase in the scope of departmental cash limits. He said:
"The public spending framework introduced by the previous government divided government spending into two halves: fixed departmental budgets and what is called Annually Managed Expenditure. Except in practice it was annually unmanaged expenditure – and it includes almost the entire welfare budget as well as items like debt interest and payments to the EU.  
We will now introduce a new limit on a significant proportion of Annually Managed Expenditure. It will be set out in a way that allows the automatic stabilisers to operate – but will bring real control to areas of public spending that had been out of control."
Exactly how it's going to work is unknown, but the intention is clear enough. And it promises a revolution in the way that welfare spending is controlled. Because instead of pre-committing to pay whatever bill the agreed rates of welfare benefit generate, he's saying the total amount will be cash limited. Benefit rates and entitlement rules will have to be flexed to fit within a cash ceiling, and that will have to include upratings to cover inflation.

As for debt, higher inflation will obviously erode the real value of government obligations fixed in cash terms, notably its issues of so-called conventional gilts. True, its index-linked gilts will have to be adjusted in line with the higher inflation, but since they only comprise one-quarter of total gilt issues, the Chancellor comes out well ahead.

Of course, there is a serious risk that what he gains on the debt erosion swings he will lose on the debt interest roundabouts. If the markets lose confidence, as they did when a similar scam was tried back in the 1970s, interest rates on new gilt issues will shoot up and debt servicing costs will take off. Even so, because the existing stock of debt has such a long average maturity, it will take a couple of decades before the full impact is felt.

So that's Plan B. And it's worth noting what the world's most successful central bank ever has to say about it:
"Government debt fosters the risk of inflation. Central banks, too, are usually exposed to the strong pressure that burdens states with high levels of debt. This is because the higher the pressure on the government to get the public debt under control, the greater is the temptation to exert pressure on the central bank to lower interest rates via monetary policy measures... 
If, in order to safeguard its solvency, the government pressures the central bank to set a lower interest rate than is compatible with price stability, demand increases too quickly, and this ultimately leads to higher inflation. In this case economists speak of a regime of fiscal dominance: interest rates are no longer set according to the requirements of price stability but instead are dictated by the state’s need to reduce its financing costs. 
Measures taken by central banks in the past, under the influence or control of the state, to lower interest costs or to reduce the overall debt burden, have ranged from straightforward interest rate reductions to purchasing government bonds in secondary markets and to direct monetisation of government debt.  
To be able to resist this political pressure, central banks have traditionally been granted a high degree of independence. This was, among other things, a response to the experiences of the 1970s and 1980s. This era of oil price shocks posed a major challenge to monetary policy-makers. It became apparent that countries with independent central banks had much lower inflation rates – and similar or even higher growth – than countries whose central bank was answerable to the government.  
Central bank independence is therefore essential to inspire confidence that the central bank will keep inflation low. However, a high government debt burden can generate doubts about its actual independence and undermine its credibility, even if it has not actually changed its monetary policy course. Once doubts arise about of the monetary policymakers’ capability to defend their independence against political interference, they risk losing control of inflation expectations and thus over inflation itself."
That's the Deutsche Bundesbank speaking - the rock-solid guardian of German economic stability right up to   when the Germans were bounced into the Euro.

My advice? Get down to the building society, draw out all your cash, and get yourself some of these:


Yes, I know - easier said than done. Personally I'm going to contact the Major's old mucker Mr Gomulka who apparently has a lock-up full of them.

8 comments:

  1. Anonymous9:47 am

    Yup. Many of us have seen this coming. Rosette colour of the windbags in government is irrelevant - they're all out to rob us. It's irretrievable & those who can should bail out before the roof falls in.

    Now, where in the world makes sense? Those nations with which many of us have family & friend connections seem to be in just as bad a state. The Ozzies, Kiwis & Cannucks might appear to be in better shape at the moment, but there's plenty of grief creeping up to bite them shortly. The bill for those purchased votes will be due soon. The US is bonkers but gets away with it for the time being. Moving anywhere else in the EU is frying pan & fire.

    Where else should we be looking to go? Singapore? HK? China itself? Thailand? Brazil? I'd appreciate some informed opinion as to desirable destinations. The requirements seem to be where there is economically literate government and whatever equates to the public sector is no more than 25% of GDP. Respect for the rule of law and a dim view of theft or fraud might seem to suggest an Arabic nation, but I can't be doing with their superstitious nonsense.

    Instead of trying to guess what George/Ed/David/Boris' plan 'C' might be, how about working on an alternative? An exit plan for the dwindling band of taxpayers and burden bearers in the UK would be useful. I'm past ballot boxes & would like to vote with my feet.

    Cheers,

    Ray.

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  2. Anonymous12:38 pm

    It's great to read your blog again. Welcome back. a-tracy

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  3. Anonymous7:01 pm

    Nice of you to flag up that Oik budget quote about AME - I think he and the writers were quite proud of it, and the way it cleverly subverts what AME is - expenditure which by its very nature cannot be easily calculated inn advance as it is subject to in year fluctuations, and therefore has to be "annually managed" .. and that attempts to "cap it" in advance might possibly send out "the wrong signals" - which is why an Treasury spokesperson was up and out there smartish to "clarify" to the medja what the Oik had meant ..

    "A Treasury source said earlier the chancellor would outline a "forward-looking limit on AME spending" in his spending review on 26 June that is due to cover 2015-16. The source denied that capping AME spending would hit the state pension – "It certainly does not affect our commitment to the 'triple lock'," the source said, referring to the chancellor's pledge that the state pension will rise by the highest of either average UK earnings, CPI inflation or 2.5%".

    As you say "Exactly how it's going to work is unknown, but the intention is clear enough". Yes it is, the Oik was dissuaded from any further "upfront" reductions in the welfare budget so it has to come via other routes. And provided of course nothing is done to directly impact the grey vote, in-work and out of work benefits really can now be "cash limited" - that is if you really believe that Universal Credit will be fully up and running and saving the day (it is going to save £billions of course) during 2013 - 2014 or even by 2014 - 2015. I wouldn't bet on it being so myself, and so I doubt very much whether the Oik's revised AME gambit will amount to much either ...

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  4. Great to see you blogging again, it was always entertaining to read your economic analysis even though they confirmed my suspicions that the pension fund I struggled to amass was going to be worth peanuts by the time I really need it.

    A lot of us saw the great devaluation coming a while back, the politicians must know they're fooling nobody, why don't they just come out and say "As of tomorrow the pound in your pocket is only thirty pence".

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  5. I've got a house and a mortgage. What's not to like?

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    Replies
    1. Harold Wilson Refugee12:12 am

      A fixed rate, long term mortgage is a fine thing in inflationary times, provided you have a secure job. You still need the means to eat, pay utilities, insurance, transportation though, they are all subject to hyper-inflation.
      You might have the most desirable residence in Zimbabwe, but it is not much use without a secure income.

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    2. 'Secure incomes' have never existed. The recent End of the Pier Show, Cyprus style, shows just how 'secure' secure is.

      Good to see BOM back.

      Delete
  6. Hugo Tillinghast5:01 pm

    Great to have you back and a welcome return (from where exactly?) of Mr Gomulka.

    ReplyDelete