Peter Riddell slams Labour and Tory “peripheral initiatives” on economy

Peter Riddell is the doyen of Times columnists and his insights into politics are usually pretty spot-on. It was therefore gratifying to see him arguing in yesterday’s column that the “irrelevant initiatives and hectic trips around the country” of Gordon Brown and David Cameron are merely a substitute for action, and that their many and varied proposals are economically flawed and designed to buy-off political constituencies rather than achieve macro-economic recovery.

Brown's pledge to create 100,000 jobs and Mr Cameron's new savings package do not address the cause of the deepening recession: the lack of credit. Everything else is secondary… [T]he job and savings initiatives are distractions. They address symptoms not causes…

Both the Brown and Cameron initiatives are about political positioning: to demonstrate their concern about the recession and to show they are doing something. The most damaging charge now is of inaction. The plans are also aimed at potential supporters, with Mr Cameron generating a positive response from Tory websites and activists seeking tax cuts, even though he has been criticised by independent commentators.”

Riddell is entirely correct. The only way this recession will end is if the equilibrium between borrowing and lending is established, and preferably at a level that sees interest rates reflecting real time preferences, rather than being massaged down by governments in an effort to stimulate short-lived but vote-winning “booms” (today rebadged as “soft-landings” and even “recoveries”).

I am not entirely sure I agree with his thrust that this should be achieved by the Government pumping vast sums of extra money in to the banking sector: today’s Times headline brings tears to the eye. Excess credit expansion is what brought us to this sorry state and further credit expansion is only going to bring us her again in the future (‘If you are in a hole, the first thing to do is stop digging’). However, whether one accepts that the economy needs to go through a period of readjustment or you believe that masses of liquidity needs to be pumped into the banking sector to stop an outright collapse, the fact remains that bail-outs for car companies, government make-work schemes and financial gestures are not only going to fail in their objectives, but will in the process make the situation a lot worse.

Riddell is not nearly firm enough in this, however, and occasionally lapses into Keynesian fantasy. “Bringing forward capital projects makes sense,” he claims, before admitting that it “is unlikely to have more than a marginal impact.” Similarly, he thinks that “There is a case for boosting saving in the long term, but not in the short term when the need is to raise spending,” ignoring the fact that money saved equals money spent: banks can’t hang onto money for long, and sooner or later it has to be invested in businesses or – as the result of more misguided government intervention – used to buy government bonds, which means that either way it ends up in the “real economy”. One man’s saving is another man’s (or company’s) borrowing and spending.

He also gives his blessing to the idea of extended state guarantee for loans that has been proposed by both the government and the Tories. But this is an extremely dangerous proposal for two reasons. Firstly, businesses are currently going bust because lenders are not willing to extend credit to them for fear that they will go bust anyway and thus default. If government guarantees these loans, banks will have no reason to exercise one of their primary roles – as arbiters of who is credit-worthy and who is not – and will be inclined to loan money to all and sundry, knowing that the bank is shielded from loss. The result will be that the government will end up with huge numbers of loan defaults to cover.

And that creates the second problem, which is the moral hazard facing the government as a result of these loans. According to Riddell, “The answer is not unconditional bailouts, as in the 1970s, but some way of breaking the credit logjam”. But once a firm that has outstanding loans backed by government guarantee is faced with bankruptcy, it will have a far more powerful hold over government when it seeks a bail-out. The argument that a subsidy of a few million will avert a collapse and default that saddles the taxpayer with a debt of tens of millions will be hard for government to resist. Conversely, the flood-gates of industrial policy will be open as government will expect influence in return for its largesse: as Riddell himself admits, “the larger that government guarantees become - and they could be enormous - the greater the demand for specific commitments in return.”

A few words from Gordon Brown

"Under this Government, Britain will not return to the boom and bust of the past."
Pre-Budget Report, 9th November 1999

"Britain does not want a return to boom and bust."
Budget Statement, 21 March 2000

"Mr Deputy Speaker, we will not return to boom and bust."
Budget Statement, 7 March 2001

"As I have said before Mr Deputy Speaker: No return to boom and bust."
Budget Statement, 22 March 2006

"And we will never return to the old boom and bust."
Budget Statement, 21 March 2007


Hat-tip to Eamon Butler for pulling all these together. I'm sure that there were more!

The Green Road to Nowhere

History is repeating itself, though whether as tragedy or farce awaits to be seen. As our economy enters another of its periodic recessions, caused as ever by government meddling in the economy, politicians race to solve the problem with further doses of the same poison.

Sadly, in an age where politicians fear differentiating themselves from one another and parties squabble over a consensus they disingenuously call the middle ground, there seems to be no real debate over how best to ensure that the recession that we are now in is as brief as possible. Just as President Hoover’s failed interventions were succeeded by President Roosevelt’s even greater interventions, so today politicians seem to be in a bidding war to intervene in the economy.

The latest dose comes from the Liberal Democrats, who have joined the chorus with their latest call for action. Nick Clegg has announced a Green Road Out of the Recession that is built on the same errors that underpin Labour’s proposals and the $4.61 trillion US bailout.

It is a simple error, summed up by Henry Hazlitt when he notes that “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” It is the error of looking at the immediate results of what one does but not the damage that doing it causes; specifically, of believing that one can utilize a resource (in this case, money) for one purposes without denying it to another.

So let us be utterly clear: when the Lib Dems say “Now is the time for big investment to get the wheels of the economy turning again”, any rational observer should immediately ask “From where is the money coming, and what will be sacrificed so that this investment can be achieved?”

It is an impressive list the Lib Dems have compiled: new trains; new railways; new track; social homes; insulated lofts; smart meters. It will “create jobs and ensure that once this recession is over, we have something to show for the money we borrowed.” All of which is true, but what it does not show is all the jobs that will not be created because the money that would have been spent creating those jobs has been siphoned off by government to pay for its own projects.

There is absolutely no reason why government spending of £12.5 billion (as the Lib Dems propose) should create more jobs than private spending of £12.5 billion. On the contrary: while markets operate specifically to maximise economic efficiency – by, for example, allowing people to spend money on projects that will maximise their own utility – government’s have no such built-in discipline and no means of weighing the efficiency or efficacy of different projects. In fact (as the sorry litany of failed government projects demonstrates) governments all too often blow vast sums of taxpayers’ money on projects that promise big benefits but deliver dubious or disappointing outcomes.

I should add that this is not a criticism of any individual project and certainly not of the environmental (“green”) thrust of the proposals. That the “road out of recession” is “green” is irrelevant. We could as easily talk about the white heat of technology or indulge in some blue-skies thinking. The point is that this is being sold on economic, not environmental, grounds; if the Lib Dems were as keen on agriculture as we are on environmentalism, we could as easily advocate policies akin to President Hoover’s New Deal farm programme, and the proposals would be no less flawed. Government cannot spend the country out of recession.

The reason for this is that government money must come from somewhere, and not matter what its source, it merely transfers money from one use to another. If we spend £12.5 billion on new trains to “create jobs” and “stimulate industry” then the money, workers and materials that are diverted to those ends are no longer available to make shoes, televisions, meals or whatever else we might buy. The net effect in jobs created, wages spent and economic activity stimulated is zero.

Indeed, while we may scoff at the 2.5% cut in VAT and say that the £12.5 billion could be better spent insulating lofts, it ignores the fact that the £12.5 billion would otherwise have been spent by consumers on (for example) carpets. The criticism that the VAT cut would not in fact encourage people to buy is valid in as far as an individual price reduction of 2.13% is not going to make a product hugely more attractive to buy. But the fact that the money remains in people’s pockets means that it will eventually be spent somewhere. It will still represent an increase in consumer demand and so will stimulate growth.

Thus the one part of the Green Road Out of the Recession which is sound is the bit that promises “big, permanent tax cuts”. It is the bit that has been policy for over a year and upon which conference voted. It would transfer spending from inefficient governments to efficient consumers and so allocate resources in the marketplace (that is to say you and me and our respective savings) most efficiently.

A couple of additional points need to be made, to head off possible comments (welcome though all comments are, of course!). Firstly, it makes no difference if the government gets the money through taxation, inflation or borrowing. Borrowing has exactly the same effect as taxation in as much as it diverts savings from being invested in industry and instead invests it in public services; there is still no net gain. It also lands future taxpayers with a bill, so diverting money from future generations to the present. Inflation is effectively a flat tax: if we “print” an additional 1% of money, we are reducing the value of everybody’s savings and wages by 1% - an “inflation tax” that falls as heavily on the poor as it does on the rich (except that rich people are more likely to own commodities or foreign assets that are inflation proof, so inflation may actually be regressive). It also creates imbalances in the economy that will lead to further crises in the future.

Secondly, it makes no difference that this is supposedly “investment” rather than mere “spending”. It is certainly true that this sort of government spending will ensure that “once this recession is over, we [will] have something to show for the money we borrowed.” I have a house to show for the money I borrowed in December, but it does not follow that I made a sound “investment”. Had my internal chancellor not borrowed and spent, my internal taxpayer would not now be saddled with debt.

As Adam Smith noted over two centuries ago, “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom”. What is more, the fact that we can see what the borrowing has financed should not blind us to the fact that we cannot see the things that the borrowing has denied us: other investments will have been sacrificed. And finally, even spending on consumer fripperies stimulates long-term investment: if demand for MP3 players and trainers increases, so does investment in the production and retailing of these (so creating jobs) and in the infrastructure needed to move them about. Indeed, as taxes/inflation/borrowing tend to make it particularly hard for new businesses to arise, because capital formation (i.e. saving) is harder and credit is absorbed by government, new start-up businesses such as those marketing new solutions to environmental problems struggle to get off the ground. Big government spending may therefore be counter-productive even environmentally!

I also ought to add that members of other parties shouldn’t’ take too much pleasure in seeing me demolish my own party’s latest policy initiative. Neither Labour nor the Conservatives have exactly covered themselves in glory during the present economic crisis and both are participating in the flawed concensus politics outlined above. This article focuses on Liberal Democrat policy only because errors are doubly galling when they come from within one’s own camp and I would like to see the Lib Dems taking a braver, more distinctive and more honest approach to the current crisis that did not argue that more government can get us out of a problem that government made in the first place. The alternative norm of passing money through the hands of politicians instead of citizens has been Labour and Conservative policy for the last century and it has been a tragic disappointment.

Why the Government’s plans to rescue the economy don’t seem to be working

The Times captures the mood perfectly: “The economy is plunging deeper into recession despite emergency tax cuts and the multibillion-pound bank bailout, the Bank of England said yesterday.”

What it fails to mention is that this is all utterly predictable and indeed inevitable. The reason that “Cutting the base rate to its lowest level in more than 50 years, the Bank said the outlook now was worse than a month ago, with manufacturing and consumer spending in sharp decline” is that cutting the base rate is not going to have much impact.

The base rate is just one driver of credit, and it is not by far the most important. What is more, it does not address the real problems in the economy, which is that the credit expansion of the last decade has fooled entrepreneurs into thinking that investments were viable when in fact they were not. In some cases, whole businesses will now need to be liquidated as reality crashes in on those who had been fooled by artificially-low interest rates.

Reducing interest rates again cannot solve the problem. Just as the first rule when one finds oneself in a hole is to stop digging, so the first rule when one finds oneself facing the inevitable crash following an inflationary spike is to stop inflating. Further interest cuts (as preached by all political parties) are simply attempts to stimulate more credit expansion, which means further inflation. This will lead to more poor decisions by entrepreneurs and more unviable businesses being created, expanded or propped up. That can only lead to an even bigger crisis in the long run.

“The Bank of England pinned much of the blame for the economy’s slide on the borrowing drought that high street banks have inflicted on consumers and businesses alike” according to The Times, but in doing so the Bank misses the point. The borrowing drought is the result of banks making sensible economic decisions in avoiding making the same kind of loans that got us into this mess in the first place.

For let’s be clear about this: the loans that the banks are currently proving reluctant to make are those that they fear may not be repaid; those that, in American parlance, are “sub-prime”. In a market where asset prices are falling, many homeowners are in negative equity and many businesses are destined for bankruptcy, further lending would not only be stupid, it would be irresponsible.

Far from cutting interest rates, the Bank of England should be raising them so as to reduce the demand for credit and increase the desire of savers to provide it. In doing so, it will not only redress the massive imbalance between saving and borrowing that has led the West to borrow trillions of dollars of the (thrifty) Asians as well as creating money through government-backed central banks, but it will also accelerate the reallocation of “factors of production” between unviable and viable industries. As a result, it might just make this a sharp but short recession, instead of another painfully-drawn-out one.