Gordon Brown notoriously claimed that he had ended boom and bust – just before the banking crisis inflicted the deepest recession on us since the Great Depression. But I am not going to sit here just to take pot shots at him, because I too was beginning to develop some confidence that we had cracked the challenge of macroeconomic management. What caught us both out was the emergence of a separate global economic cycle triggered by spikes and troughs in the oil price, which proved to be, and still is, out of phase with our domestic cycle. I am of course overlooking here the additional regulatory failures on both sides of the pond.
That was Keynes’s view too, though as it turned out matters were not so simple in the 1930s either. Keynes’s solution was public works, and it did indeed have some success at first because to ‘dig a hole’ in those days required huge teams of navvies all wielding picks and shovels. They had to be paid of course, and it was the spending of those wages that increased local consumer demand and helped to regenerate the local economy. Nowadays such a project would be carried out by one man and a JCB, so the effect is not the same. As Jim Callaghan succinctly put it in 1979, you cannot spend your way out of a recession.
Keynes has also been criticised for the assumptions behind his famous book The General Theory of Employment, Interest and Money. Classical theory held that supply would create its own demand; in other words if you had a given supply of a commodity, be it fish on the quayside or hours of labour, then if you price it correctly you will just be able to sell it all. He expected to see unemployed workers offering their labour for lower wages. But he didn’t. So he assumed there must be something wrong with the classical laws of economics and, having just witnessed the transition from classical to modern physics, he may have thought something similar was required in the field of economics.
In fact, as we now know, the reason why workers were unable to find work at lower wages during the 1930s was because of the Unions’ closed shop. Even after the war the closed shop continued to undermine our economic performance, eventually manifesting itself in the form of stagflation. Milton Friedman first made the analysis of this in his Nobel lecture of June 1977 when he attributed stagflation to what he called “unanticipated increases in aggregate demand”. In plain English this becomes “Union extorted wage increases above the natural level that balances supply and demand for labour”.
Proof of Friedman’s theory came later with Margaret Thatcher’s reform of the Unions, because since then we have not seen the slightest whiff of stagflation. Indeed the term has practically dropped out of the dictionary, and now we are instead experiencing concerns about deflation. Also the phenomenon of zero-hours contracts indicates that workers are now able to price themselves back into work once again, which is supply creating its own demand as the classical laws predicted. Of course we all want proper full-time employment, but this will depend on the economic recovery. In the meantime surely it is better to have half a job rather than no job. At any given time in the economic cycle there is only so much money in circulation available for wages, so sharing it out this way is surely better than making higher unemployment carry the full burden of the shortfall.
It was the boom and bust of the late 1980’s which fully demonstrated the effects of demand mismanagement. One of the first things Geoffrey Howe did as Chancellor in 1979 was to remove all remaining exchange and credit controls. This led to people taking out ever greater mortgages to chase up house prices, due to the chronic shortage of housing we have always had in this country. By the mid 1980’s the economy was booming and the yuppy phenomenon was upon us. That would have been the time to take your foot off the accelerator and start moderating demand. Instead Howe’s successor, Nigel Lawson, not only failed to reintroduce credit management but also introduced some of the biggest tax cuts in recorded history (just before an election, of course!). The basic rate of tax came down to 25% from 27% (and 29% the year before) and the top rate to 40% from somewhere up in the stratosphere. Immediately people used the extra money in their pockets to jack up their mortgages still further and the whole thing just blew up in their faces. I am all in favour of tax cuts of course, but timing is crucial!
It does however demonstrate the potency of demand-side management. Whilst Jim Callaghan was absolutely right in saying you cannot spend your way out of recession (supply side), that does not mean you cannot cut taxes (or increase benefits) your way out of recession (demand side and increasing the deficit). This is a point the Tories appear to have missed. As I see it stimulating the economy is like trying to move a piece of string lengthways. If you push it, either by fiscal spending or by excessive quantitative easing (QE) the string will just crumple. You have to pull it from the front end. Of course if there is insufficient QE that will pin the trailing end of the string down, so you have to get it just right. The Bank of England (BoE) appear to have been using the FTSE 100 as their indicator since that has been moving sideways for the past fifteen years, but increases in other asset prices, including house prices and the FTSE 250, would suggest they have overdone it.
Which brings us to the introduction of monetary policy in the late 80’s and early 90s, and the exit from the ERM. The big advantage of monetary policy is that it acts directly on consumer demand. Also because it is reviewed on a monthly cycle it provides much finer tuning that the annual fiscal cycle. It could be argued that fiscal policy was always too late to have any counter-cyclical effect, though that said Harold Macmillan’s government seemed to manage it pretty well in the late 50’s and early 60’s. Perhaps the housing market wasn’t so critical then.
With the benefit of hindsight I would say that John Major was wrong to rely solely on interest rate rises to bring inflation back under control. He needed something much stronger than that, and something which would not undermine the rest of the economy as well. I suspect that the reintroduction of credit controls and mortgage limits would have had a more positive and immediate effect. I do see why he was determined to remain within the ERM, as this stopped any devaluation causing further inflation, but what is interesting is that when we did eventually tumble out of the system in September 1992, no inflation resulted. This demonstrates that, contrary to Ken Clarke’s recent remarks, devaluation can be a very useful tool in the right circumstances. In other words if you have high unemployment and a recession, then that is the time to do it if you need to, because the increase in import prices is simply absorbed. The exit from the ERM set us up for the following ten years of solid economic growth, and it was at this time that I started to form the view that we had it sorted. But I had reckoned without New Labour, Gordon Brown and the development of the global economic cycle! Also without his undermining of the Bank of England’s role as City regulator, thankfully now restored.
This piece would not be complete without some reflections on the banking crisis. Four separate factors came together to create the perfect storm that was the banking crisis. Two of these, the subprime housing collapse in the US and the haircutting of Greek sovereign debt (another catastrophic EU decision), both of which caused contagion to spread across the global banking system, were factors beyond the control of any British government. The other two, namely the failure of UK banking regulation and the buildup of national debt, were. Strictly speaking the size of the national debt and deficit did not cause the recession, but it meant that the Coalition had to spend two years reducing the deficit before they could start reducing unemployment.
There has, I think, been a lot of very muddled thinking over the banking crisis. It’s not the bail-outs that were the problem. The taxpayer will come out of these with nice fat profits (which would have been even bigger at RBS if Gordon Brown had taken convertible loan stock in the first instance, until he knew the full extent of the losses, rather than equity), and both depositors and creditors were protected as well. Only shareholders, which of course include you and me through our pension funds, lost out. The recession was caused by a combination of contagion and regulation failure (as the banks in retrospect pulled in their horns). Many of the measures taken by the Coalition, such as the bail-in procedures and the ‘electrified’ ring fence, appear to be designed to make it easier for banks to go bust rather than less, which means that any future recession will be even greater! And the decision to increase equity ratios in the middle of a recession is crazy. Surely it would have been better to leave decisions to raise or lower equity ratios to the discretion and timing of the Bank of England?
One small and rather technical point we could look at however would be to remove limited-liability status from retail bank subsidiaries. As I am sure you know, under company law the creditors of a bankrupt subsidiary company have no recourse to the holding company for restitution. Normally this encourages investment and economic growth, but in the case of retail banks security is more important. Such a change would place the group at first port of call for any bail out instead of the tax-payer, and create a more arms-length relationship preventing the group from treating its retail subsidiary as a cash cow for its rather more dodgy ‘casino’ activities.
But the real problem is the relationship between shareholders and directors. It was the former who lost money whilst the latter were swanning about playing ‘masters of the universe’, and paying themselves the earth to boot. The Coalition is proposing yet more red tape to hold directors more directly responsible, but I suggest that such an interventionist approach may well backfire and undermine the status of the City. Instead I am proposing the introduction of Supervisory Boards for all publicly quoted companies (not just the banks), not to put Unions on them like the Germans do, but to comprise the five or six largest shareholders on the register when the meeting is called, together with perhaps a couple of non-execs and the Chairman and Chief Executive, so that the shareholders have the majority. Company law would give these boards authority over capital reconstructions, takeovers and mergers, and over the appointment and remuneration of the directors. Such an approach would enable the principal shareholders to be involved in these key decisions well before resolutions for general meetings are formulated, whereas the Coalition has merely given shareholders a slightly larger rubber stamp than they had before. Such a structural change would reflect the ownership of the company rather than have the government intervening with yet another raft of red tape.
So where are we now? What are the challenges facing the first UKIP Chancellor? I suggest these can broadly be considered under following four headings:-
1). Wage compression and the cost of living,
2). Employment, the output gap and eliminating the deficit,
3). Funding our public services to an acceptable standard,
4). Paying down the National Debt.
Wage compression is simply dealt with by coming out of the European Union combined with imposing consequently a complete moratorium on the immigration of unskilled labour. That’s the only way to do it. Simples – it’s just old-fashioned supply and demand, the price mechanism as it applies to wages. General inflation is the least of our problems at present, and that in turn suggests that an increase in the minimum wage might not only help people struggling with the cost of living but also provide some protection against deflation. I accept that increases in the minimum wage can make reducing unemployment more difficult, but there are other ways we can do that, again not least by limiting immigration. At present a third of all new jobs are going to new immigrants. Ending the green deal will also help.
It is over the output gap that the Tories are really going wrong. Last week the TaxPayers’ Alliance published a massive tome designed to cut public expenditure by £77bn, the element of the total deficit of £90bn they claim to be structural. Now I am not against cutting expenditure where it should properly be transferred to the private or charitable sectors, e.g. overseas aid, or where it is identifiable waste. I dare say the TPA have come up with all sorts of excellent ideas on that score. What I am concerned about here is the assumption that most of the deficit is structural, and cannot therefore be reduced by reducing unemployment. The TPA offer no support for that figure.
Historically the output gap has been defined as the percentage of unutilised industrial capacity. Once all your productive assets are being fully utilised you cannot increase real GDP any further. That means unemployment cannot be reduced any further, which in turn means tax revenues cannot be increased and welfare payment reduced; what is known as the cyclical element of the deficit. However two points arise. The first is that industrial capacity is not the only resource that is involved, labour including relevant skills are also critical as are energy supplies and other resources. The question is which lie on the critical path. The second point is that few of these resources are inelastic in the longer term. Indeed the more slowly you approach them, the less inelastic they will be. It all depends on what timescales you are looking at, but if we cap immigration as we intend then labour will in due course be the critical factor once full employment is achieved, not industrial capacity.
At present British industry is generally profitable and has accumulated substantial savings which it is holding back from investing. That suggests to me that industrial capacity should be viewed at least over the medium term as non-critical. Energy I will leave for another discussion. Labour is the interesting one. It all depends on whether you believe the government’s employment figures. Given the high incidence of part-time working and zero-hours contracts, the level of self-underemployment and the number of people sanctioned off benefits even though they are still fully unemployed, frankly I don’t. It’s all smoke and mirrors designed to win an election. This assumption is backed by reports from HMRC that income tax revenues are below expectations. One of the first things a UKIP Chancellor will have to do is get himself some decent employment statistics.
So if at present neither industrial capacity nor employment are critical, the deficit is not structural. For every one percent reduction in unemployment, the deficit reduces by between 20 and £25bn. So a further reduction in unemployment of between 4 and 5% is possible and would wipe out the deficit entirely without either cutting essential expenditure, like the Conservatives, nor increasing taxes, like Labour. But you can only reduce unemployment by this amount by limiting immigration, and you can only do that by leaving the European Union. QED.
In the longer term of course UKIP wants deliberately to restrict the availability of unskilled labour, other than on a temporary basis. You therefore eventually come up against a choice between full employment and crude GDP growth. I say crude because of course GDP is a nominal figure which includes both inflation and population growth. We should instead be concerned with real average standards of living, and these have plummeted over the past ten years. Two years ago I downloaded some statistics from the ONS website and constructed an index for real average standards of living which I set at 100 for the year 2000. It rose to 105.3 in 2005, dipped to 105.2 in 2006, up to 105.6 in 2007 and then plummeted to 83.4 in 2012. Obviously the fall after 2007 is principally caused by the recession, but it is the very slow growth before that and the dip in 2006 which are interesting. If one allows 1% pa for normal productivity growth, modest when you consider the phase of the cycle, there is no reflection of the growth in personal credit and the fact that we were living ‘beyond our means’ by 2007. Both strongly indicate an adverse effect from immigration. Also the sheer size of the fall afterwards surely cannot be attributed solely to the recession? This is logical when you consider that standard of living is real GDP divided by population. So if population rises faster than real GDP our standard of living falls. It’s just mathematics. That is the evidence.
Many people overlook the fact that anyone living here is consuming as much as they are producing. You have to be a higher rate taxpayer or net saver to be contributing more than you take out, and at the other end of the scale those on benefits, living on increasing credit or sending money overseas are taking out more than they are putting in. Everyone else in the middle is neutral, except that any increase in population spreads our available resources more thinly leaving less for each. This is as true for an increase in the birth rate as it is for immigration, but that is another story.
There are other impediments to reducing unemployment of course, and our strategy must include them. Principally these are:
1). A regional policy designed to achieve an even level of percentage employment across the land (see my previous post),
2). Effective welfare reforms designed to provide a better balance of carrots and sticks to entice the unemployed back into work. I advocate a big increase in the earnings disregards to really ‘make work pay’, and
3). Better education for the least able or most distracted children. We must introduce procedures to identify these children much earlier, perhaps by introducing GCPEs, so that we can then tailor their education directly to their needs.
As listed elsewhere UKIP’s policies are likely to make over £40bn of extra money available both for funding public services and for cutting taxes. It is money the other parties simply won’t have. Leaving the European Union is central to achieving it.
Finally there is the question of how we deal with the National Debt itself. As I set out in my election address, the answer is obviously to set up a Sovereign Wealth Fund to hedge it. With interest rates on the floor we have had a golden opportunity to do this, yet Osborne has completely flunked it. Sheer negligence.