Why now is the right time to cut. Probably.

June 12, 2010

Disclaimer: Everything I know about economics is almost entirely derived from people like Joseph Stiglitz and random educated blogs on the subject. What follows may very well likely be wrong and will take the form of me thinking outloud (or outblog, however we have to use words these days), as it’s entirely based on received knowledge, but to me seems a logical explanation of why now is an appropriate time to begin cutting the deficit.

Let’s begin by defining our terms, starting with the deficit. The huge, scary deficit that’s coming to eat your babies, or so the Conservative election campaign appeared to claim. The deficit is the difference between the amount of money the government spends this year and the amount of money they receive in taxes, border duties, pocket money and extortion. This differs from the debt, which is the accumulated total of deficits over the years the government has been running a deficit, as well as all public sector borrowing. This is an important distinction, but one which appears to be lost on many journalists. The deficit is currently about £145.4 billion, and the debt is about £893.4 billion.

This deficit is different to our balance-of-payments deficit. Balance-of-payments refers to the difference between how much money we send overseas to buy things or just out of the goodness of our hearts, and the amount other people send to this country to buy knick-knacks and support the British victims of the great Marmite Famine. This stood in deficit at the end of 2009 to the tune of 0.5% of GDP, or about £1.7 billion. It’s probably different now.

Gross Domestic Product is the sum total of the market value of all the goods, products and services our country produces each year. It’s someone’s job to add all that up. I assume they use a very big calculator. Currently this is about £1438.6 billion. It’s been increasing by tiny amounts like 0.2% and 0.3% since around mid 2009. Despite the small percentages, 0.2% of £1438.6 billion is still quite a lot of money.

How does GDP get bigger? This is a central question in economics, and one I won’t answer in any real way here. However, broadly it’s a question of demand and supply. In our glorious capitalist system, the value of any good is given by the complex interplay between seller and buyer and all the factors therein. The seller attaches a value to the product based on what it cost him or her to make it, and the amount they want to receive in profit. The buyer attaches a value to the product depending on how much they want it and how much they want to pay for it. Somewhere between these values, the story goes, a deal is struck and the market price of the product is given.

It’s therefore clear that if no-one wants to buy the things we produce (or the consultancy services we offer), GDP will fall. Similarly, if we’re producing too many things for the number of people who want to buy them, GDP will also fall – the value the seller attaches to the good has to decrease in order to reach accommodation with the buyer (as there’s lots of the same product they could buy instead), so the market value of our goods decreases. The first situation is an example of insufficient demand, the second excessive supply, but they’re both two sides of the same GDP-reducing coin.

So why are we in our current pickle? While lots of big words have been tossed around (sub-prime mortgages, collaterised debt obligations, Mervyn King), it comes down, in the end, to insufficient demand. No-one wanted to buy the exciting debt products our clever chaps in the city had been putting together, because they’d realised they had a tendency to not produce any returns when the poor people who’d been sold expensive mortgages couldn’t afford to pay them back. The market value of one of our main exports, ‘financial services’, collapsed, and so did our GDP. All of a sudden, the vast amounts of money flooding into banks and bankers’ pockets slowed to a trickle, and so the demand that bankers generated – for fine wines, fast cars, and lovely cheeses – collapsed too. Naturally, this meant that demand generated by cheesemongers decreased too, if one takes cheesemongers as representative of the workers of our nation as a whole. GDP fell, which is what’s called a recession.

The Government pushed money into the banks, which increased the value of their debt products by ensuring that they had enough money to not default on them, thus making these products a good thing to buy again. Alongside various regulatory measures designed to ensure (although not really) that the banks couldn’t make such bad products again, the Government also created money from nothing (‘Quantitative easing’, hem hem) and used it to buy debt products, reducing the supply of bad debt on the market.

The value of these products (and hence all the products dependent on bankers being rich) rose again, and our GDP began to climb, albeit marginally. Then came the election, and the question of £6 billion of cuts.

Gordon Brown made a big play during the debates of ‘taking £6 billion out of the economy’ and hence risking the recovery. This is a reference to the implications for GDP of the Government stopping spending £6 billion on public services, including the cost of staff, the cost of equipment & premises and all the various externally provided services things like the Child Trust Fund required. The argument is that this removal of demand will decrease the market value of these services (and all the services purchased by those staff whose jobs were dependent on that £6 billion of funding) and hence decrease GDP. It’s fairly clear that this will have this impact upon that particular part of our economy; it will decrease demand for these services and for the services purchased by staff, and so will decrease GDP.

The question is whether that GDP decrease will be compensated for elsewhere in the economy, and here’s where we get to the crux of the issue. You see, national debt isn’t like household debt, even though that’s the metaphor most conservatives (with a small ‘c’) feel instinctively comfortable with. If you don’t pay your household debts, bailiffs can come and take away your plasma telly to make good on your poor financial management. However, if we don’t pay our debts, no-one can come and repossess the Isle of Mann. They just won’t lend us any more money – or if they do, they’ll demand an extortionate rate. This is what happened in Greece – everyone suspected them of not being able to pay back the money used to buy their government debt products, and so they demanded higher rates of return to compensate for the perceived risk. It therefore became more expensive for the Greek government to pay for the debt they already had, as much of their Government debt needed to be refinanced – which means the time limit on the original debt product (‘bond’) was up, the Government needed to repay it, and so they had to take out another loan to repay the first loan.

The argument put forward by the Tories is that if we don’t start cutting now it’ll cost us more to refinance our debt, wiping out any increases in GDP that have arisen from the Government spending that’s raised demand. However, this argument only works if private demand is such that it can take the place of Government demand in maintaining economic growth. Otherwise, the increase in GDP from increased demand is lost, and the cost of refinancing our debt rises regardless as it becomes clear a shrinking economy is less able to repay its debt.

It’s therefore clear that the crucial in determining whether to cut or not to cut is the strength of private demand. It’s important to be clear that all demand is ultimately private: debt-generated Government demand is ultimately sourced from the private investors who buy Government debt. The questions is whether the private demand for fairly secure Government debt products can be translated into demand for private debt products or for other products, both financial (e.g. shares) and physical. To understand this, let’s look at who owns Government debt now.

Pulling this information out of the Office of National Statistics has proven extremely tricky, as I suspect it involves a significant amount of work in pulling together different figures from different accounts. I don’t really have the expertise to do that reliably, so I’m forced to go to the BBC for some work they’ve done previously:

‘Gilts’ is the name given to Government debt products. The bar that includes the Bank of England includes all the debt that the Government bought itself by printing money. The price of gilts varies over time:

This is a price chart of gilts with a 5-10 year redemption period – the time until the Government has to pay the gilt back. It represents – amongst other things, including future changes to the interest rates paid out for gilts – demand for medium-term UK Government debt products. As you can see, demand for these products has risen dramatically since the start of May, following the election of the coalition Government.

It’s therefore clear that private demand for government debt products is high. But will that demand be pushed into the rest of the economy when, as a result of the cuts, the Government lowers the expected supply of gilts?

To answer this, let’s quickly look at the two largest holders of gilts. The first, insurance companies & pension funds, are organisations who’ll be naturally looking for long-term, stable investments with a guaranteed rate of return, to service their customers. It’s interesting to note that high government debt results in a rising proportion of taxes being directly transferred to those who hold private pensions in the form of interest payments on gilts – i.e, a direct transfer from the taxpayer to the better-off. It’s not clear how this can be considered ‘progressive’ in any sense of the abased term.

These organisations will be looking to pay back their UK customers in sterling, so will most likely opt for financial products held in sterling with a significant level of stability in the absence of new gilts being put onto the market. We can therefore – perhaps – assume that this demand will be moved into debt products issued by major UK banks and into shares in reliable FTSE 100 companies (like, err, BP). These organisations can’t stop investing just because there’s no gilts for them to buy – they need to service their customers.

The second big holders of debt are overseas purchasers of gilts. To look at where this demand will go, we need to look at exchange rates – overseas investors will need to convert their currency into sterling to buy gilts as well as other products produced by the UK. Let’s look at the Euro and the dollar for this purpose. First, a chart of how many pounds you need to buy one dollar:

And one of how many pounds you need to buy one Euro:

The picture is obviously mixed. While there’s been a general flight from people buying things in Euros to people buying things in sterling, there’s been a similar flight from people buying products in sterling to those in dollars – although the latter appears to have plateaued since the start of May. We can therefore anticipate that overseas demand from the Eurozone will either increase or remain constant, while demand from the USA will either decrease or remain constant. I don’t know enough to anticipate the relative volume of this demand from both currency areas, although the majority of our trade is within the EU.

From this brief discussion, we can gather several things. Firstly, economics is endlessly complicated but sometimes needlessly so – if the terminology of the subject were cleared up and made more accessible, it would greatly aid the debate. Secondly, on balance from the information I’ve presented above, it would appear that now is, if not a good time to cut, certainly an acceptable time to cut, as it doesn’t place the economy in significant risk of further decline. However, it’s important to consider the human impact of all this high-brow chat about gilts and similar pompous re-labellings of relatively simple concepts, which will be on families, on jobs and on deprived areas. But it’s better to minimise the pain now rather than causing much greater pain in the future.

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One Response to “Why now is the right time to cut. Probably.”

  1. […] construction. I predicted the continued expansion of financial services as a result of early cuts here, but construction is something else – indeed, the furore around the cancellation of the […]

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