In a speech on 17 November, the leader of the UK Labour Party urged the Prime Minister to “change course” on economic policy or have another recession or worse. What would be a “new course” that effectively revived the economy?
The answer derives from the cause. The stagnation of the UK economy is the result of a collapse in private investment and a depressed world market, whose knock-on effects has been unemployment and lower household consumption. The solution is a substantial fiscal stimulus to restore aggregate demand.
The Coalition government has repeatedly stated that its rejection of this obvious route to recovery is not ideological. Their spokespeople claim that the size of the overall fiscal deficit, about ten percent of gross national product, precludes any further public expenditure. On the contrary, the urgent need is to reduce public expenditure to close that deficit. Let us suspend disbelief and momentarily accept the hypothesis that the government is not cutting out of ideological zeal.
If the cuts are not ideological, then the question immediately presents itself, what danger does a deficit of ten percent of GDP create? A search turns up four “deficit danger” arguments: 1) people will expect the government to raise taxes in the future to payoff the debt and they reduce current expenditure in anticipation (so-called Ricardian Equivalence); 2) the interest on the deficit presents an unmanageable burden now and “for our children”; 3) deficits push up interest rates, crowding out private spending; or/and 4) unless the deficit is reduced, financial markets (aka speculators) will drive up the interest rates on UK bonds, as has happen to Greek, Italian and Spanish bonds.
The first argument is simply silly, literally silly in a simplistic way. It is flawed economic logic based on a series of assumptions so unrealistic that they are absurd (for example, continuous full employment). The second and third arguments require a specific outcome, rising interest rates, and the opposite has happened. In 2007 the overall fiscal deficit was less than three percent of GDP and the UK government short term bond rate was 5.5 percent.
In 2009-2011 the deficit averaged about ten percent, and Figure 1 shows the result, a continuous decline, then slight rise, in the interest rate (“bond yield”) to level off at one-half of one percent for the last twenty months. At well less than one percent, the interest rate on pubic debt implies a small public debt service, as well as being far too low to nudge much less crowd anyone.
Even more important than the level of UK bond yields is the absence of any hint that they might rise. To the contrary, the Euro scares of October and the first half of November resulted in speculators shifting their ill-got gains into British public securities. Far from being in danger of becoming the next Greece, Spain, Italy, etc., the bonds issued by the UK government are viewed as a “safe haven” (aka, “rush to quality”, among other clichés).
Is it possible that further borrowing might dangerously weaken the pound (an argument the UK Chancellor has made from time to time)? While it is hard to imagine a combination of capital flow into UK bonds and a weakening pound, we have direct evidence, so I need not speculate (so to speak). As Figure 2 shows on a larger vertical scale than Figure 1, the three month “forward” rate of exchange between the US dollar and the UK pound hardly moved during 2011 except to rise, before returning to its level at the beginning of the year. Indeed, it moved less than the bond rate.
The changes in the bond rate and exchange rate shown in Figure 2 may look substantial, but only because of the scale of the chart. At the beginning of 2010, the betting rate for the pound (what a speculator expected it to be three months hence) was $1.62, and in August 2011 it was $1.63. The decline in September, about 3.5%, was the direct result of a simultaneous rush into US and UK bonds from Euros. That is, both currencies strengthened, the dollar by slightly more.
In summary, at the end of 2008 the Bank of England began to cut interest rates drastically. The three month bond yield stood at about one-half of one percent when the Coalition government took power. Since then the bond rate has hardly changed, varying from .57 to .46 (a difference of yield of 11 pence for a £100 bond). As for the pound and dollar question, if there is a problem, it lies in the pound being too strong for the government’s hopes of an export-led recovery.
The conclusion is obvious: so-called financial markets do not present an obstacle to a fiscal stimulus in Britain (i.e., more debt). On the contrary, the last few month have demonstrated beyond reasonable doubt that the demand for UK government bonds is strong despite their meager yield. “Markets” are greedy for UK debt. Therefore, the government should feed that greed and use the proceeds from bond sales to “kick-start” the economy. By how much and the implication for public finances over the rest of the decade I treat in a second article.
Figure1: Nominal Interest Rate on 3 month UK Bonds, January 2009-October 2011
Figure 2: UK Nominal Bond Rate and the 3 month Forward Rate, US dollar to UK pound, monthly deviations, period average = 100, January 2010 – October 2011
Data source: Bank of England website