Small mercies at the Bank of England

Martin Weale is taking Andrew Sentance's mantle as the Monetary Policy Committee's resident clown.

The minutes of June's Monetary Policy Committee (MPC) meeting were published this morning. They were rather more dovish than the markets had expected and raised the prospect of a further round of quantitative easing. The relevant quote was: "It was possible that further asset purchases might become warranted if the downside risks to medium-term inflation materialised."

Once again, my good friend Adam Posen voted for a further £50bn of asset purchases. It is increasingly looking like he is on the right side of this one. The two misguided inflation hawks -- the chief economist, Spencer Dale, and Martin Weale -- voted for a 25 basis-point increase. They know not what they do, honestly.

The majority on the MPC is right to worry more about growth than inflation right now. This week, there was more evidence that George Osborne's nightmare scenario of zero or even negative growth is unfolding before our eyes. The Confederation of British Industry's Industrial Trends Survey for June, published yesterday, was not encouraging.

The drop in the output expectations index from May's 20 to 13, the lowest figure since December last year, added to other recent evidence suggesting that the previously strong manufacturing recovery is disappearing. The slowing economy is also holding back tax receipts that, according to data released this week, were up only 3 per cent in April and May together.

The monthly public-sector borrowing figure of £17.4bn was a little below last May's figure of £18.5bn. But, in the first two months of the fiscal year together, borrowing totalled £27.4bn, compared to last year's £25.9bn.

Jonathan Loynes at Capital Economics has pointed out that, although it is early days yet, at this rate, borrowing will overshoot the Office for Budget Responsibility's Budget forecast of £122bn by almost £30bn. Loynes argues: "Overall, the public finances figures provide a clear warning that the weakness of the economy could derail the government's deficit-reduction plans and will add fuel to the debate over whether it should scale back the size and speed of the fiscal tightening." Hence, the concern of the majority on the MPC that more stimulus may be needed.

This afternoon's Opposition Day Debate in the House of Commons on the anniversary of Osborne's first Budget makes the case for the government to "adopt a more balanced deficit plan which, alongside tough decisions on tax and spending cuts, puts jobs first and will be a better way to get the deficit down over the longer term and avoid long-term damage to the economy". There is a realistic alternative (Tiara).

Of particular interest was how the MPC's newest addition, Ben Broadbent, voted at his first meeting. It turns out he voted along with the majority: for no change.

While he was at Goldman Sachs, Broadbent was the co-author of an article written with Kevin Daly that advocated the macroeconomic benefits of an "expansionary fiscal contraction". This is the idea that Larry Summers dubbed as "oxymoronic". The empirical evidence suggests that such a policy has never worked without being accompanied by a big loosening of monetary policy. Given that there seems to be a contractionary fiscal contraction going on, Broadbent was always likely to vote for a stimulative monetary policy as his Plan B. Plus, I understand that he is pals with Osborne's chief economist, Rupert Harrison, who would no doubt be most unhappy if he voted for a rate rise.

I gave a speech last week at a conference in London where I said that there are few things that Osborne, Mervyn King, Alistair Darling and Blanchflower would agree on right now other than that interest rates shouldn't rise any time soon. The next speaker after me was Lord Lamont, who kindly came up to me afterwards and said that he agreed on my comments on the need to keep monetary policy loose.

I recall being told by Steve Nickell, whom I replaced on the MPC, that it was a good idea to wait for two or three meetings before doing much, so you could work out which way was up. This was great advice. I remember, though, that Andrew Sentance, in his first meeting in 2006, voted in the minority along with Tim Besley, who was attending his second meeting for a rate rise in a 7-2 decision for no change.

One of my ex-colleagues on the MPC commented to me at the time that it was interesting that the only two members of the MPC who believed the August inflation and growth forecasts were the ones who weren't there when they were being constructed.

Over the past few weeks, there were three speeches by MPC members that were of particular interest. Sir Mervyn's Mansion House speech didn't say much of note, other than that Osborne, who presumably had approved his knighthood, couldn't do anything wrong and should keep on going slashing and burning the economy. His comment on fiscal policy was interesting. "Of course, there can always be differences of judgement about the overall stance of policy but to change the broad policy mix would make little sense." Maybe Merv still doesn't realise that he is the likely fall guy when the coalition's economic ship hits the rocks.

The external MPC member Martin Weale made a speech in London, in which he argued that bank rate should be raised now, even though inflation is likely to fall sharply as the temporary factors drop out. There is no evidence of any second-round effects from wages; consumer confidence is at levels only seen previously in the depths of the great recession and growth is anaemic -- all before austerity hits. Weale argued that:

The case for a rise can be put quite simply. An early increase in bank rate makes it more likely that the inflation target can be met in two to three years time because it allows for greater subsequent flexibility. If inflationary pressures subsequently prove more severe than the central part of our forecast suggests, then it will be a help to have started to raise interest rates earlier. But if they prove less strong then subsequent increases can be slower than would otherwise be the case. Indeed, if the economy is extremely weak, interest rates can be reduced again.

What a load of tosh. An increase now would slow the economy at a time when the economy has stagnated. Raising rates now only to have to reduce them in the future would be a major policy mistake. There is no empirical support whatever for Weale's claim in the June minutes that: "A small increase in bank rate would afford the committee greater subsequent flexibility in responding to possible future developments." Weale is taking over Sentance's mantle as the MPC's resident clown.

Fortunately, there are some sane voices on the MPC. I was much encouraged to read the excellent speech by my old friend and colleague Paul Fisher at the Global Borrowers and Investors Forum in London on 21 June. Paul made it clear that he is especially worried about risks to the downside.

Over the past couple of years, the challenge has been dealing with a succession of real changes in relative prices (via negative supply side shocks) which have pushed up on prices whilst depressing demand and output. That is extremely uncomfortable for everybody. But there was, and is, no easy way for monetary policy to deal with the impact of such shocks. In our current projections there are very major risks to either side of the central case. On one side, higher inflation expectations could become entrenched making it very costly for the MPC to subsequently bring inflation back to target. On the other side, the economy could be much weaker than we expect pushing down on inflation and risking deflation. Recovering to the target from that could be even harder (at least in my personal view).

Phew, Fisher gets it but Weale and Dale sadly don't. At least Sir Mervyn continues to vote the right way (along with Posen, Broadbent Tucker, Bean, Fisher and Miles). I am grateful for small mercies.

David Blanchflower is economics editor of the New Statesman and professor of economics at Dartmouth College, New Hampshire

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We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?