Why Increasing Government Spending Won't Work

A number of politicians and journalists are increasingly putting forward the case for increasing Government spending rather than cutting it. I thought I'd outline a few points on the issue. I will throw forth a few bullet points for consideration here because this is far too large a subject matter to effectively deal with succinctly...

• It is precisely because Cameron/Clegg have managed to sell their austerity programs, that the UK is able to borrow money at low levels. If they had indulged in more spending than, in my humble opinion, the market would have punished the UK. Moreover, the UK has a system of 'elected dictatorship' which means that the market is not pricing in the likelihood of Ed Balls getting anywhere near the public finances

• Corporate cash balances have helped hold back market rates because traditionally in recoveries (and I accept this one is anaemic) they push up yields as they search for capital

• Promulgating Government investment requires you to be unencumbered with any notions of inherent efficacy differences between public and private sector investment. I am not free of such prejudices; in fact, I think less Government spending is usually a good thing. Who is doing the investment is arguably more important than the absolute level

• Throughout history, whenever Governments have cut deficits (Sweden, Canada et al) it has always been through cutting spending rather than raising revenue. This doesn't tally well with raising expenditure.

• In my opinion, the expansion of Commercial & Industrial loans and business investment usually follow a cyclical upturn in consumer expenditures. I think what is different, this time around, is that the banking sector (the issuers of capital) has faced significant challenges this year.

• It was a mistake not to allow the forces of creative destruction to eradicate the leadership of the banks and destroy their perverse incentive structure. The management are clearly not fit for purpose, are only interested in siphoning off the assets of the banks at the expense of the shareholders, and have thus far demonstrated no ability whatsoever to generate shareholder value when the taxpayer isn't supporting the direction of their underlying assets by buying them up 

• Japan has undergone an experiment in stimulating expenditure and supporting 'Zombie industries' with the aim of sustaining employment and growth and, it has failed miserably. Governments simply aren't the best authorities when it comes to productive investment.

• The US underwent a significant expansion of public sector spending without raising the revenues to pay for it. This is why their deficit is so large. Noticeably, it was the Republican administrations of Reagan and George 'W' Bush than engaged in expanding spending whilst cutting taxes.

So frankly, the idea that the UK or any other Government should actually be increasing public expenditures is folly of the highest order. The key is to cut spending yet seek ways in which to encourage the private sector to invest, by rolling back the frontiers of the state. In the UK this might involve things like relaxing planning restrictions on new house build in the South East or encouraging research into genetically modified foods. There are many ways to promote growth, but the worst of which, is wanton Government expenditures. It's been tried. It doesn't work.

Let's Hear it for Nick Clegg

I’m serious. The much maligned Nick Clegg, leader of the Liberal Democratic Party- the smaller coalition partner in the UK Government- is actually deserving of praise for his role in supporting the Government sell its austerity efforts to a fretful bond market. Well, at least, in the view of this blogger!

Government Austerity Plans and Bond Markets

There are two issues with Governments being able to convince investors that they have put together a credible plan to deal with their deficits. The first is the plan itself, and the second is the credibility of their ability and willingness to carry out the plan. For a British observer, the latter point can be seen as a display of the lack of fortitude and consistency that categorises Continental European style coalition politics.  All it takes is the opposition of a few extremists within a coalition Government and significant resistance can be generated. 

Greece has had to deal with its main opposition leader (Antonis Samaras) opposing austerity programs. Angela Merkel is constantly engaging with mounting opposition to ‘bailing’ out the rest of Europe. Berlusconi appears to be at loggerheads with Economy Minister Giulio Tremonti (the most credible austerity hardliner in Italy) and the opposition parties are calling for his head. The list goes on and on in Continental Europe, however, the British system is seen as being a kind of ‘elected dictatorship’ whereby the Government can-more or less- get legislation through parliament with ease. Or can it?

Ed Balls the Most Dangerous Man in Britain?

The fact is that, the UK Government is a Conservative/Liberal Democrat coalition. The election did not deliver any one party as a decisive victor. Moreover, for the benefit of non British readers, the Liberal Democratic party has- in recent years- been seen as even more willing to ‘tax and spend’ then the former Labour Government. In addition, the shadow chancellor in the UK is Ed Balls, a man widely seen as the architect behind Labour’s failed economic policies which lead to the UK’s public finances looking as weak as, say Italy’s.

 If we put these ingredients together, it’s not hard to envisage a nightmare scenario where a failing coalition Government causes the market to start pricing in the return of Ed Balls. Frankly, I think it is a disgrace that Balls has been appointed the shadow chancellor and, I regard him as the most dangerous man in Britain. I suspect that the slightest notion of Ed Balls in Dowing Streeet would cause a significant hike in market yields for UK debt. You could call this event a ‘Balls Up’.

Let’s Hear it For Nick Clegg

So what of Nick Clegg? Frankly, I think Clegg has behaved admirably. He is a sitting duck for criticism from his own party, yet he has supported Cameron in his efforts at selling the austerity program. Unlike so many others, he has rarely played Party political games which act as a detriment to his country. I’m not so naïve as to not understand that towing the Cameron line is the best way for the Liberal Democrats to exert some influence (at the cost of devaluing some of the principles of some in his Party) but in his support for Cameron, he has displayed a willingness to do the right thing for his country even at his own expense. A quality which Berlusconi, Samaras et al would do well to emulate.

UK PMI Numbers and M4 are Indicating Growth

Don't Count Off UK Engineering Just Yet

UK Manufacturing PMI numbers rose to a new high at the start of 2011. According to the report

"UK manufacturing steamed ahead in January as the sector continues to expand quicker than even the most optimistic amongst us could have predicted. As well as improved market conditions abroad, demand in the UK market also showed signs of growth. This is the much needed kick start to 2011 everyone in the sector was hoping for,particularly in the light of last week's poor GDP figures.'

and this demonstrates the resilience of the sector in the face of considerable cost pressures.


It also suggests that the UK is capable of developing a thriving and competitive manufacturing sector in spite of increasing global competition. There was some other good news from the Bank of England.



Bank of England M4 and Lending M4 Figures 


Source: Bank of England



They indicate that some lending is returning to the Household sector and to Private Non Financial Corporations (PNFCs).

Whilst this is nowhere near the levels of the early naughties, I doubt that anyone would want it to be!

What it does indicate is a gradual transition to the much talked about 'new normal' of lending.

Source: Bank of England

The lending effect can be seen when taking a look at the second chart which excludes the effects of securitisation.

Excluding securitisation, M4 growth remains negative. All of which goes to reiterate the importance of getting the capital markets going again in 2009. The recovery would not have been sustainable without it.

Cameron's Economic Priorities

The UK manufacturing sector has demonstrated that it can be competitive and generate growth. The 2001-2003 recession was caused by the aftermath of excess of capital spending which was aided and abetted by a stock market boom. UK corporations learnt the lesson and when the recent recession hit, they were in pretty good shape to handle it. Moreover, they generated good growth in the recovery, despite a major resumption of bank lending. Indeed, Industrials have led the stock market rally.

Unfortunately, by insulating financial corporations from the full effects of creative destruction, the same learning process may not be taking place in the banking sector. I have to gaze on in incredulity as the UK banking sector prepares to award itself £7bn in bonuses, meanwhile its assets are threatened by ongoing doubts about some peripheral European Sovereign Debt.

It gets worse. The last few years have seen a massive shift of resources from the taxpayer (households and PNFCs) towards the financial services industry. I need remind no one that this is a failed industry.

As a consequence, it is fairly easy to see what Cameron and Osbourne should be focused on.

1. Enforce the separation of investment and commercial banks in the UK. Too Big To Fail can never be allowed again. Lending is too important to the economy
2. Allow the market to increase the supply of housing by deregulating. This will spur growth and employment and slowly wean the UK of housing speculation as a career path
3. Support manufacturing and IP based endeavour as a growth opportunity for the UK. Not only by doing the above, but also by encouraging private sector investment

The simple fact is that the default position of UK politicians is to kowtow to the Financial Services industry. In fact this practice has got so insidious that it directly impacts the growth opportunities for the rest of the economy. UK manufacturing doesn't even have to ask for any favours. It just needs a level playing field.

Source:

Sectoral Breakdown of M4 and M4 Lending Bank of England Website (Accessed 1st February 2011)

Markit/CIPS UK Manufacturing PMI  Markit website (accessed 1st February 2011)

The Bank of England released statistics for M4 money supply. These figures are important because historically M4 growth has correlated nicely with future GDP growth. I've added the charts.