Political choice isn't the same as economic necessity

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One of the most widely-understood concepts in economics is the law of supply and demand, where the price of an item ends up being set at a level where the demand exactly equals the supply. It’s not only the best understood, it’s also an incredibly useful concept, underpinning the way in which markets work. It also gives rise to the idea that price increases happen when demand exceeds supply, and if supply cannot be increased in line with demand, then inflation results. It follows that one way of controlling inflation is to reduce demand – which is usually interpreted in practical terms as reducing people’s ability to spend. One way of doing that – and this is virtually the only tool available to the Bank of England – is to increase interest rates. People who have to spend more on borrowing money have less available to spend on other things, and are forced to concentrate more on the essentials of life.

The theory, though, is much cleaner and simpler than the practice. Not all inflation is caused by such a simple theoretical mechanism. Much of the inflation we are seeing today is a direct result of a perceived reduction in the supply of oil, caused, primarily, by Trump’s reckless bombing campaign in Iran. There isn’t an actual shortage (as yet), and if a real shortage does emerge, it will be more to do with the difficulty in getting the oil to market than with any underlying shortage. The perception of a threat of a shortage has, though, allowed speculators to push the price up, and the oil companies to increase their profits at no additional cost to themselves. Inflation caused by rising demand is not the same thing as inflation caused by a reduction in supply – especially when it’s not even a real reduction. The increase in the price of oil is real enough, however, and works its way through not just to the price of fuel at the pump, but to the price of everything which needs to be transported from one place to another – which is most of the things we buy.

The Bank of England seems poised to respond to ‘inflation’ in the only way it knows how, by increasing interest rates. It’s an example of someone with only a single tool in the box, a hammer, seeing every problem as a nail; but it’s a circumstance in which an interest rate rise does nothing to address the underlying problem. Far from prices rising because people have too much money, this type of inflation is already leading people to cut back on their spending; deliberately reducing their spending power still further just adds to the cost of living crisis. The government and its wholly-owned and controlled central bank cannot seriously claim to be addressing the cost of living crisis whilst simultaneously adding to it.

Then we have the Tories’ latest wizard wheeze of cutting welfare benefits to control inflation. There is no doubt that cutting benefits would reduce the amount of spending power in the economy, which is the stated objective. However, it would do so by reducing the spending power of some of the least well-off, almost all of whose income is already going on essentials rather than discretionary purchases. Reducing the spending power of those already struggling to pay for the basics is applying abstract economic theory without looking at the real impact on real people.

Whether the increase in energy costs is a temporary phenomenon or a longer term change remains to be seen, but either way, it will work its way through the economy in a way that a general  excess of demand over supply would not. Whether it therefore needs action at all is a judgement call, but it seems that judgement is being replaced by a blind commitment to a wholly arbitrary inflation target of 2%. And, as is ever the case in an economy run for the benefit of the few, it is those least able to cope who will bear the biggest burden. It’s a political choice, not an economic law, which underpins that.

We shouldn't be driven by speculators

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The market for government bonds works in what looks to most of us a very strange way. Despite the newspaper headlines about rising interest rates, the interest rate is actually fixed for the whole term of the bond. What appears to make the interest rate change is that the bonds can be traded, and the price at which they are traded doesn’t necessarily bear any relationship to the amount which the government accepted into savings when it issued the bond or the amount which it is obliged to return to the saver when the bond matures. So a £100 bond issued at 3% for 30 years will cost the government £3 a year in interest, and the government will refund £100 at the end of the term. In the meantime, that bond may have been bought and sold many times at varying prices: for anyone buying at less than £100, the interest rate will look higher than 3% and for anyone buying at more than £100, it will look lower than 3%. But, to the government, it is always £3 per year. For any new bonds, the government might need to match the apparent interest rate being paid on existing bonds, but changes in the bond market price do not and cannot affect the cost of existing commitments.

It means that headlines about rises in the rate of interest increasing the cost of ‘borrowing’ and putting huge additional pressure on the government can be misleading. They only increase the cost of ‘borrowing’ on any new bonds issued, not on all bonds currently in existence, although one wouldn’t necessarily understand that from the headlines. There are a number of factors which have pushed the rate for new bonds upwards, not all of which are in the control of the Chancellor. Many of them are part of global rather than local trends. The extent of the impact of the required higher rates depends on whether, and to what extent, the government is obliged to issue new bonds to cover its spending. The Chancellor and government choose to believe that they have no choice in the matter, a conclusion which pushes them inevitably in the direction of austerity and/or tax rises, which just happens to suit their own ideological view. It isn’t the only view, though. As Professor Richard Murphy points out, the government could simply stop issuing bonds and wait for the price to fall, as it inevitably will.

Murphy isn’t alone in challenging the tyranny of the bond markets. There was a letter from another professor in Wednesday’s Guardian addressing the question of bond markets very succinctly. To quote Professor Kushner, bond traders “…strive to reduce long-term stability to short-term volatility in order to multiply transactional opportunities”; in other words the price (and therefore the headline interest rate) is very largely being driven by gamblers and speculators out to make a quick buck rather than by investors making long term decisions. A half-decent Chancellor would seek to isolate us from, rather than fall into line with, the interests of such casino capitalism. It really is time to challenge and smash the hold which these people have on economic policy rather than allow them to cripple the ‘real’ economy in which most of us live in order to satisfy their greed and selfish interests.

Giving with one hand and giving with the other

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The theoretical basis for reducing taxes on the highest paid is that they will invest the money saved in ways which boost economic growth. It’s a sweeping assumption. There is no doubt that ‘some’ of the money will be invested like that, but no-one knows how much, and it isn’t the only option. Some will simply be spent, which is another way in which the economy might be boosted a bit. But some will be saved, and no doubt a significant amount will find its way into secretive offshore tax havens. One of the big unknowns at the heart of the gamble is how the money ends up being split between those four options. That in turn depends on the calculations that those in receipt of the unexpected windfall make before deciding what is in their own best interests. And one of the factors in those calculations will be expectations about the future, which make it unlikely that much of the money will end up being used as the government might wish.

Investing in new businesses and innovation is a long term decision, so one obvious question is whether those making the decisions really believe that this is a good time to be taking long term decisions. With a government which looks as though it might, just about, limp through to an election in two years time, but which has an obvious potential for collapse a lot sooner than that if things go horribly wrong; with a major war raging in Europe, whose progress and outcome, to say nothing of its effect on energy availability and prices, remains highly unpredictable; and a pandemic which is far from being over with the potential for large new waves, many are likely to conclude that ‘certainty’ is a little lacking at present. Major investments look to be riskier than they have been in the past, and the rate of return on savings may be a better bet for many.

We know that interest rates on both borrowing and saving are likely to be rising, a trend which the not-a-budget-at-all will only accelerate, whilst the volatility of the pound adds to uncertainty. All that also has a negative impact on a willingness to take investment risk, and provides a positive incentive to find a safe haven for cash, whether overseas or in the UK itself. And one of the safest havens of all in the UK is government bonds, the interest rate on which rose sharply in the aftermath of the ‘fiscal event’. There is a common belief that when the UK government borrows money, it borrows it from other countries or overseas investors; but in reality, most borrowing is on the domestic market. Most is, effectively, borrowed from UK citizens; sometimes directly, but more often through financial institutions, such as pension funds, investment funds, banks and insurance companies. In a sense, therefore, most of us (through our pension funds etc.) are actually lending money to the government, even if we don’t realise it. This is, on the whole, something which benefits most of us. It’s worth noting, though, that the wealthier people are, the more money they are likely to have in their pension pots (as well as insurance, investment funds, banks etc.), and the more, therefore, that they lend the government. The interest on those loans, however, is paid by all taxpayers, even those who have loaned precisely nothing, either directly or indirectly, to the government. It’s one of the hidden ways in which wealth is transferred from those who have little to those who already have a lot, and that transfer is far more significant than the intergenerational transfer as which it’s sometimes inaccurately painted (the nonsense about future generations paying for today’s borrowing), because future generations, collectively, will inherit not only the liability but also the asset. The issue is that the people inheriting the asset aren’t the same ones who inherit the liability; it’s an inequality issue, not a generational one.

There is another effect here. Those traders who have been betting so substantially against the pound in expectation that the budget would lead to a crash have not only made small fortunes for their banks, they have also made it certain that interest rates will go up – maybe this week, and possibly even as soon as today. The traders can now receive bumper bonuses for their efforts, pay less tax than they previously would have done, lend the difference to the government, and be paid for the privilege at the higher rates of interest which they themselves have done so much to bring about. Verily, this is a government which giveth with one hand and then giveth a bit more, just to be certain, with the other. To the select few.

All models are wrong - and some aren't even useful

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On Monday, the Tory group leader in the Assembly demanded that the First Minister dissociate himself from Corbyn’s policies, claiming that they would result in around £4,000 of extra debt for each person in Wales, and that the UK would end up paying around £5.8 billion a year in additional interest payments if Labour’s plans were implemented.  It’s the stuff of good political knock-about, but without a lot more information on how they’ve done their sums (and the Tories don’t exactly have a brilliant record when it comes to financial arithmetic), it’s difficult to know what, if any, relationship exists between his figures and ‘truth’, in the mathematical sense of the word.

But, for the sake of argument, let’s suppose his figures are accurate ones.  Is it really the economic disaster as which he paints it?  Of course, £5.8 billion sounds like a very large sum of money to be paying in extra interest every year, but that’s in absolute terms.  And it makes a number of unstated but implicit assumptions.

The first comparison that has to be made is not, as the Tories effectively claimed, with the status quo, but with what the outcome would be over the same period with a Tory Government.  The implicit assumption in what Davies said is that Tory spending plans would not lead to a similar outcome, but given the way in which out-turn has varied from predictions over the last few years, and the way in which much of the (uncosted) Tory manifesto has been ditched, that looks to me like an invalid assumption.  If there is a gap between the likely outcome under a Corbyn government and the likely outcome under a Tory government (and even that is a significant ‘if’) then it is probable that the gap would be much smaller than Davies is suggesting.  All the signs are that the Tories will also increase borrowing to pay for their programme; the honest question is not how much Labour would need to borrow, but what is the difference in borrowing levels between the two.

The second question is about what proportion of GDP the debt would represent, and what proportion of expenditure any extra interest payments would represent.  Both of those are dependent on a range of assumptions and guesses about the likely level of inflation, economic growth, and interest rates.  Given the propensity of all involved to get such estimates wrong, it would be a very brave person who would claim to know the correct value of any of those variables over a five-year parliament.  But in principle, simple mathematics shows that a debt which increases in absolute value by a smaller percentage than the rate of economic growth will end up reducing the ratio of debt to GDP, which is why the absolute value being used by Davies is irrelevant.  The same mathematics also demonstrates that when interest rates are lower than the rate of inflation, paying more interest in absolute terms can still result in a reduction in the percentage of government income committed to paying interest.

What we do know is that, as things stand today (and I accept that’s a very important caveat), the UK Government is effectively borrowing money interest-free.  It’s costing us, in real terms, absolutely nothing, and given the demand from people who want to lend money to the government, there is no immediate problem in borrowing more.  Indeed, some would even argue that increasing government spending actually generates more tax income than the amount spent: the calculation all depends on the value assigned to the infamous ‘multiplier’.

Now of course it is true that different economists will give different answers to questions such as these, but that merely serves to underline that economists base their predictions on models rather than on absolute truths, and there are a number of different models available.  As the famous statistician, George Box, said, “All models are wrong, but some are useful”.  It’s a point worth bearing in mind that when politicians state categorically what the outcome of a particular policy will be for the economy they are depending on a model of some sort, whether they admit it - or even realise it - or not.

As I said at the beginning, this sort of guff from Davies is all good knock-about politics, but it’s really froth; he has no more clue than do I about the accuracy of what he says.  The real question is why one particular model – the idea that the government is like a giant household, which is used by the Tories when they come out with this stuff – is taken as gospel truth by a media which regularly demands that politicians from other parties explain themselves in the terms mandated by that model.  It would be more useful to political debate – let alone to economic policy – if the idea which underlies much of what they say was challenged more forensically rather than being simply accepted.  And it’s a shame that more opposition politicians don’t appear to have the understanding or the confidence to do that.

Euro is no panacea

Tweet Back in September, I suggested that the economic downturn meant that it was time to look again at joining the Euro. It was interesting to see others turning to the same theme last Friday, although I was concerned that some of them were seeing it as a simple panacea. It is not.

There are three real advantages, as I see it, to the Welsh economy in becoming part of the Euro-zone, but none of these are instant fixes to the problems that we face.

The first is that, for many businesses, fluctuating exchange rates are an unmanageable risk which they could well do without. Of course it's important to fix the exchange rate on entry at the 'right' level, but there is a sense in which the mere removal of the uncertainty is more important to many businesses than getting the rate precisely right.

The second is that, for most of recent history, the European interest rate regime would have been better for Welsh industry than the UK interest rate regime, set as it has been largely in response to the overheated housing market in the South East of England rather than according to the needs of industry and commerce.

And the third is that it would give our currency greater protection from the speculators and gamblers who have done so much damage to the economy. Smaller currencies are inevitably easier to target than larger currencies, and the coming of the Euro has unquestionably relegated the pound to the minor league, a fact which the post-imperialist mindset in London still seems unable to comprehend.

Of course it matters that the timing and the rate are as 'right' as we can make them, but the current crisis has destroyed the argument that the Sterling economy was 'too strong' to join the Euro, and that was always the main (stated) objection. (Is it really the same people now arguing that the problem is that the UK economy is 'too weak'?) In reality, the real objection has always been a result of the Little Englander separatist attitudes which prevail amongst LabourTory politicians. Those attitudes remain as strong as ever, and I suspect that, yet again, the long-term interests of Wales will be over-ridden as a result.