The Coalition’s fiscal austerity package is unavoidable and should be pursued, even if this country is tipped into recession by a global sovereign debt crisis.

To be clear: our structural deficit, the second largest in the world as a share of GDP, has nothing whatsoever to do with the recession. The recession revealed it, but did not cause it. Its cause was unfunded government spending in the good times.

A good reason for running a big structural deficit was to defeat Napoleon or win the World Wars – looking back over centuries of data on British government debt, those episodes stand out. But the deficit this time did not balloon to finance anything like that. Nor was it a function of a grand ‘New Deal’-style infrastructure project that would transform long-term growth prospects across the economy as a whole: the contribution of government investment to the growth in total government spending post-2000 was tiny. The deficit financed higher public sector wages and employment.

There is a perfectly respectable argument that calls for the public sector to take up a larger share of the economy, and for public servants to be rewarded more generously as part of that. The evidence on the impact of such a policy on long-term growth prospects is mixed – some countries appear to thrive with a large public sector (the Scandinavian economies for example), while others can prosper with a tiny one (Hong Kong is the outstanding example).

But there’s no respectable argument that says higher government spending is a good thing in and of itself. If you want bigger government, that means higher taxes.

Spending more without raising taxes in the good times is a recipe for disaster. It leaves you with no buffer to absorb negative shocks to growth, such as the global recession that struck in 2008. That policy is unsustainable, and a sharp correction is therefore unavoidable.

The missing piece of the story is monetary policy, which will sugar the bitter fiscal pill. There is plenty of monetary sugar out there at the moment, but it will stay there only for as long as the Coalition remains committed to the austerity package.

Any backtracking on fiscal austerity would trigger a sharp tightening of monetary policy, the impact of which would be just as damaging for growth in the short term as the austerity package (though the blow would land on a different part of society – homeowners and employees of private businesses, rather than public servants). It would push up long bond rates too, as markets reassessed the risk of sovereign default. Neither the government nor the household debt position would improve – in fact, both would deteriorate sharply. And it would risk a sovereign debt crisis like the one that is currently threatening to engulf Greece, Ireland and Portugal.

Some commentators argue that the way out of debt is not to pay it back but to inflate it away. Simply allow inflation to drift up over time and our real debt burden will fall. That is a feasible strategy only for as long as you can fool the markets. The scope for that is slim to none right now.

And, more importantly for me, that strategy is a recipe for permanent relative economic decline. We’re finished as an economy, let’s just accept it. Everything good is in the past; the future is managed decline. The UK as the sick man of the developed world. We know what that recipe tastes like. I, for one, can’t stomach it. I want us to do better than that.

We need to take our medicine. It’s bitter but it does you good and we’ve got the monetary sugar to help it down.

So where will China find a market for the new productive capacity I talked about yesterday? The answer has to be within China itself.

The final demand has to come from the Chinese consumer, either directly or via increased current government spending. It is worth considering what that means. The average Chinese consumer spent $1,500 during 2010; the Chinese are still extremely poor on average by international standards, even though there is a substantial and growing minority of wealthy individuals in the coastal cities. And the government spent roughly the same amount again, notionally on their behalf, on current consumption.

If net trade makes no further positive contribution to Chinese growth, and the contribution from fixed investment falls back, there will be a great deal of slack to pick up. Private consumer spending will need to grow by over 10% a year in real terms over the next fifteen years. That implies a five-fold increase in average consumption per head, in real terms, over that period.

It is not exaggerating to say that such a transformation in the real standard of living for the typical Chinese consumer would be revolutionary. It’s hard to see how it could be achieved without threatening the regime.

Without such a revolutionary change, though, China is storing up a massive problem of excess capacity – a problem for its own prospects and, given China’s size, for the rest of the world too. Excess capacity means falling prices; unless this is resolved, the world is facing a huge deflationary impulse that could run for a decade at least.

This matters for us as much as for China. High inflation is miserable and difficult to deal with – but we’ve been through it before, in recent memory, and in the end we won that battle. Deflation, however, is another matter. There simply is no precedent for any individual economy or the world as a whole emerging smoothly from a sustained bout of deflation. And the problem is even worse when, as now, debt levels are high. Japan entered a prolonged deflationary period in the 1990s, and is still in it, though it has now accumulated eye-watering levels of government debt to compound the problem. The last time the global economy was deflationary was the 1930s, and we know how that ended.

It is vital that we avoid deflation. For that to happen, Chinese (and other emerging-market) consumers need to spend rather than save. At the moment they save nearly a third of their income. That needs to come right down, perhaps to zero. That will only be possible if they either run down their savings, or borrow against their future earnings if they have no savings. And that means having a banking and financial services industry intermediating between individuals and capital markets. Chinese consumers need access to basic financial products: current accounts; deposit accounts; life, health and unemployment insurance; secured and unsecured credit. Savings are so high precisely because those basic products do not exist for the vast majority of the Chinese population.

The market for those products in China is potentially huge, once it is unlocked. And we in the UK and the US are natural providers of them.

The right outcome for the world economy is that China continues to export manufactured goods to advanced economies, since manufacturing is its strong suit. But it must become a net importer, and it should import from our strong suit: financial (and business) services.

Sceptics will argue that China may not be as good at financial and business services as it is at manufacturing, but it can still provide them more cheaply than we can. The counter to this is “comparative advantage” – an economic theory that demonstrates that trade is in the interests of both parties even if one party can do everything cheaper and better than the other (Nobel laureate Paul Samuelson once described it as the only proposition in all of the social sciences which is ‘both true and non-trivial’).

The gist of it is this. I, Erik Britton, am much better at cutting grass than I am at fixing cars – but both tasks need to be done if our neighbourhood is to function properly. Jason who lives over the road from me can cut more grass and fix more cars than I can in a day, since he’s pretty good at both. The most efficient thing for our neighbourhood is for him to spend most of his time fixing cars, while I cut grass. In fact, we will both benefit if he fixes my car and I cut his grass – because I have a comparative advantage in grass-cutting and he in car-fixing, even though he has an absolute advantage in both. Jason will end up richer than me, but we’ll both benefit from trade.

This can be demonstrated algebraically, but I won’t bore you with that. It is both true and important. And it means none of us should be afraid of trade. We should embrace it, as it presents the best, perhaps the only, way out of this mess.

So where will China find a market for the new productive capacity I talked about yesterday? The answer has to be within China itself.

The final demand has to come from the Chinese consumer, either directly or via increased current government spending. It is worth considering what that means. The average Chinese consumer spent $1,500 during 2010; the Chinese are still extremely poor on average by international standards, even though there is a substantial and growing minority of wealthy individuals in the coastal cities. And the government spent roughly the same amount again, notionally on their behalf, on current consumption.

If net trade makes no further positive contribution to Chinese growth, and the contribution from fixed investment falls back, there will be a great deal of slack to pick up. Private consumer spending will need to grow by over 10% a year in real terms over the next fifteen years. That implies a five-fold increase in average consumption per head, in real terms, over that period.

It is not exaggerating to say that such a transformation in the real standard of living for the typical Chinese consumer would be revolutionary. It’s hard to see how it could be achieved without threatening the regime.

Without such a revolutionary change, though, China is storing up a massive problem of excess capacity – a problem for its own prospects and, given China’s size, for the rest of the world too. Excess capacity means falling prices; unless this is resolved, the world is facing a huge deflationary impulse that could run for a decade at least.

This matters for us as much as for China. High inflation is miserable and difficult to deal with – but we’ve been through it before, in recent memory, and in the end we won that battle. Deflation, however, is another matter. There simply is no precedent for any individual economy or the world as a whole emerging smoothly from a sustained bout of deflation. And the problem is even worse when, as now, debt levels are high. Japan entered a prolonged deflationary period in the 1990s, and is still in it, though it has now accumulated eye-watering levels of government debt to compound the problem. The last time the global economy was deflationary was the 1930s, and we know how that ended.

It is vital that we avoid deflation. For that to happen, Chinese (and other emerging-market) consumers need to spend rather than save. At the moment they save nearly a third of their income. That needs to come right down, perhaps to zero. That will only be possible if they either run down their savings, or borrow against their future earnings if they have no savings. And that means having a banking and financial services industry intermediating between individuals and capital markets. Chinese consumers need access to basic financial products: current accounts; deposit accounts; life, health and unemployment insurance; secured and unsecured credit. Savings are so high precisely because those basic products do not exist for the vast majority of the Chinese population.

The market for those products in China is potentially huge, once it is unlocked. And we in the UK and the US are natural providers of them.

The right outcome for the world economy is that China continues to export manufactured goods to advanced economies, since manufacturing is its strong suit. But it must become a net importer, and it should import from our strong suit: financial (and business) services.

Sceptics will argue that China may not be as good at financial and business services as it is at manufacturing, but it can still provide them more cheaply than we can. The counter to this is “comparative advantage” – an economic theory that demonstrates that trade is in the interests of both parties even if one party can do everything cheaper and better than the other (Nobel laureate Paul Samuelson once described it as the only proposition in all of the social sciences which is ‘both true and non-trivial’).

The gist of it is this. I, Erik Britton, am much better at cutting grass than I am at fixing cars – but both tasks need to be done if our neighbourhood is to function properly. Jason who lives over the road from me can cut more grass and fix more cars than I can in a day, since he’s pretty good at both. The most efficient thing for our neighbourhood is for him to spend most of his time fixing cars, while I cut grass. In fact, we will both benefit if he fixes my car and I cut his grass – because I have a comparative advantage in grass-cutting and he in car-fixing, even though he has an absolute advantage in both. Jason will end up richer than me, but we’ll both benefit from trade.

This can be demonstrated algebraically, but I won’t bore you with that. It is both true and important. And it means none of us should be afraid of trade. We should embrace it, as it presents the best, perhaps the only, way out of this mess.

China rode through the recent global recession almost unaffected, posting real growth of 9% in 2009 and 10% last year. For an economy whose growth has been so dependent on trade, that was a startling performance – world trade fell by 11% in 2009, having not posted an outright decline in any previous year since 1982 (when it fell by only 1%).

How was it done? The answer is that the contribution to Chinese growth from net trade fell sharply, with both imports and exports falling, but the difference in GDP terms was made up by domestic demand.

Crucially, though, the biggest driver of that domestic demand was fixed investment, not consumer spending. In the UK, that balance would be seen as overwhelmingly benign – fixed investment increases the stock of fixed capital and boosts the long-run productive capacity of the economy. That is just the medicine the UK economy needs.

But in the Chinese case it is a problem – potentially a devastating problem. And not just for China.

China is re-investing half of its output each year in fixed capital. A company which did that would (rightly) be asked serious questions by its shareholders about the return they expected to achieve on that investment, and whether that’s the right choice as opposed to distributing the revenue as dividends. In China’s case, though, the ‘shareholders’ are the population at large, and ‘dividends’ are their real standards of living. But the oversight and control they can exert over the actions of their government is, let us say, limited.

China’s investment-led growth strategy only works if there is a market for all the extra productive capacity that will flow from it in the years to come. Over the last decade, that market was in developed economies around the world, particularly the US. But over the coming decade, that market will be very weak: consumers and governments in those economies are overburdened with debt and will (or at least should) spend the next decade paying it back. Advanced economies were net borrowers from abroad on a grand scale over the last decade. Over the coming decade, though, they will endeavour to become net lenders abroad.

China cannot rely on net trade with advanced economies providing the same boost to their growth again. If anything, it will be a drag on growth.

Other emerging markets are growing very rapidly too. But their growth strategy is built around net exports, on the whole, just like China’s. Hence the widespread resistance to allowing currencies to appreciate in countries like Brazil, Chile, Turkey, India, and others.

China cannot expect net exports to drive its growth over the coming decade. At best, the share of net exports within GDP will stay the same. More likely, it will fall.

So where will China find a market for its new productive capacity? The answer has to be within China itself…

For the second installment of this blog – about what this means for the world economy, and why the UK’s financial services could help save the day – check back tomorrow.

John Stuart Mill, of his own free will, asserted that the state should aim for ‘the greatest happiness for the greatest number’. But, finding that happiness was very hard to define, he shifted towards a new, more easily measurable concept – utility, or ‘use-value’ – and, along with Bentham and others, devised a new doctrine called utilitarianism, which has occupied the commanding heights of public policy making ever since.

But, like the war between North and South Korea, the struggle between happiness and utility has never actually concluded, even if there has been an informal truce for many years. Now, battle has been rejoined, and happiness has gained ground – as MT editor Matthew Gwyther’s recent blog pointed out – with some commentators calling for a measure of national happiness or well-being to supplant GDP (which is essentially a measure of national utility) in the minds of policy makers.

The debate is current among economists too, as the archetypes that inform classical economic theory appear ever more distant from reality. Economists are very fond of building models around ‘utility-maximising consumers’ – weird obsessive-compulsives who are constantly weighing risk against return in every decision they take, with a view to maximising their expected lifetime ‘utility’.

We were taught that the typical consumer is risk-averse, rational and utility-maximising. To understand what that means, consider the following choice. Would you prefer me to give you 50p or a lottery ticket that had a 50% chance of returning £1 and a 50% chance of returning zero? If you are rational, you will weigh the risk against the return in each option. The expected return is identical. If you are risk-averse, you will take the 50p, to maximize your expected utility. If you are risk-loving, you will take the lottery ticket. If you are risk-neutral, you will not care either way.

In fact there is plenty of evidence that we as individuals are neither risk-averse, nor rational, nor utility-maximising. Read More »

I am an economist, and I am a partner in a small business, Fathom Consulting.  As the former, I am often reminded of the tendency of economists to sit on the fence. As the latter, I am in the awkward but exciting position of having to make decisions based on imperfect information – decisions about employment, wages, investment. These are life-and-death decisions for the company, where I do not have the luxury of sitting on the fence.

Right now, one choice facing Fathom and the rest of the UK corporate sector is whether or not to invest. The outcomes of these thousands of individual decisions will have a dramatic effect on the macroeconomic prospects for the economy as a whole. In fact, this is likely to be the decisive factor influencing whether we recover at all, or slide back towards a prolonged recession. A mood of assertive confidence in the UK corporate sector would be self-fulfilling.  A mood of fear and anxiety would have the opposite effect.

The British economy needs to find a source of sustained demand.  It will not and should not come from the Government – huge public spending cuts are coming, as we all now know. Neither will it or should it come from consumers – like the Government, consumers have borrowed too much and now they have to pay that back. And it will not come from external demand – at least not from the developed world, since those countries are in much the same position as the UK.  If it comes from the emerging economies, which is possible, that will require investment, to allow UK firms to tap into their growing markets.

If we are to have a sustained recovery, it will be led by private sector investment.

Read More »