Another quarter of negative GDP growth in the UK: situation hopeless but not serious

The difference between data and information has been underlined emphatically by the release on Friday, October 23rd, of the UK GDP data for the third quarter of 2009.  Those who make a profession out of providing point forecasts of future GDP had converged on a figure of +0.2% for the quarterly growth rate.  What came out was -0.4%.  Shock horror!  Never mind that anyone providing point forecasts of anything without also offering at least some information about of the rest of the probability distribution of future outcomes  (variance, skewness, kurtosis, single-peakedness etc) is either a fool, a knave (or both) or caters to an audience consisting of bears of very little brain.  No matter that the first release of a quarterly GDP forecast in the UK bears little if any systematic relationship to the ‘final’ release, which is often provided years later.  Although we hope that successive data revisions get us closer the the theoretical concept of GDP, we have, of course, no practical way of verifying that.  We are like the proverbial blind man looking in a dark basement for a black cat that isn’t there.

Economists and their clients spend far too much time looking at data, processing, transforming and statistically analysing them without much understanding of how the data are generated and with far too little attention paid to how the data relate to theoretical economic concepts that happen to have the same name but may not have much else in common. Output, productivity, money, consumption and unemployment are but five concepts that both play a role in economic theory land and have empirical data series named after them.  Whether the theoretical concepts bear any stable relationship to the empirical data series is questionable.

All we knew at the end of Friday 23rd that we did not know at the beginning of the day is that the average expectation of a number of UK GDP forecasters – held with a singular lack of confidence if these practitioners were any good -  of a tiny uptick in UK GDP in Q3, had been confronted with a first official estimate, highly preliminary and unreliable, that suggested a little downtick rather than a tiny uptick.  The information value of the first release of that quarterly GDP number was effectively zip.  Yet the media, politicians on both sides of the House and economic and financial pundits pounced on it as if they had just watched Moses parting the waters of the Red Sea.

We knew before Friday and we still know that the UK has passed through the inflexion point of its business cycle about 3 quarters ago and is now close to a turning point for the level of GDP.  For the foreseeable future (probably until the end of 2011), output will grow more slowly than potential output and unemployment will continue to increase.  The scope for further discretionary fiscal stimuli is effectively zero, because of the dire state of the British public finances.

The UK financial crisis and economic contraction had two parents – a global parent and a domestic parent.  The global parent is the combination of the north-Atlantic financial crisis (made mostly in the US) and the global recession.  The domestic parent is the combination of the recklessly pro-cyclical fiscal policy of the second and third New Labour administrations and the utter failure of UK financial regulation and supervision, not just under New Labour since 1997, but also under the Tory governments headed by John Major and Margaret Thatcher.

Not only was there no end to boom and bust, the UK boom was to a significant extent home-made.  As chancellor of the exchequer, the current prime minister, Gordon Brown bears the primary responsibility for the fiscal malfeasance and the collapse of financial regulatory and supervisory discipline that fed the boom that turned into the mother of all busts in 2007 and 2008.  To recognise the role played by external, international factors in the bust is not to dismiss the domestic fiscal and de-regulatory contributions to the UK’s unsustainable boom during the decade leading up to 2007.

The procyclical fiscal policy and excessive deregulation of the UK financial sector led to an over-expansion of the British financial sector and a massive housing boom.  As long as the credit and asset market booms and bubbles did not turn to busts, these developments flattered the public finances, with tax revenues (income tax, corporation tax, stamp duty, VAT)  rising rapidly.  Sterling appreciated in real terms and contributed to a decade-long misallocation of resources in the British economy.  With the collapse of the financial and housing bubbles, the government’s sustainable revenue-raising capacity has been revealed to be much lower than it had fooled itself into believing during the boom years.

The sharp nominal and real depreciation of sterling over the past two years (sterling’s broad effective exchange rate peaked at 104.7 at the end of July 2007 and stood at 80.7 at the end of September 2009) has helped undo some of the damage caused by sterling’s decade-long overvaluation, but has not done enough to prevent the UK from sliding into the longest and deepest recession-verging-on-depression since World War II.

What is to be done?  The global economic recovery, led by the emerging markets (other than those in Central and Eastern Europe) and the developing countries will provide a favourable environment for UK exporters, especially given the weakness of sterling.  Fiscal policy is on hold and will have to be tightened significantly over the medium term to restore fiscal-financial sustainability.  On a permanent basis, taxes will have to be raised or public spending cut by at least 6 percent of GDP – about £90 bn during the next fiscal year, if the full permanent correction were to be applied then.

Anticipated future fiscal tightening is expansionary today

It would not be sensible, unless the markets lose confidence in the ability of the UK authorities to restore fiscal-financial sustainability – to front-load the necessary tax increases and public spending cuts.  What should be front-loaded is the credible commitment to a somewhat deferred fiscal tightening.  The reason is that the credible commitment/announcement today of future fiscal tightening is expansionary today.  The reason is that asset markets are forward-looking and the current announcement of future fiscal tightening leads to an immediate reduction in long-term interest rates and a weakening of sterling.  Indeed, some would argue that the weakness of sterling and the surprisingly low level of long-term rates observed in the UK today are the reflection in the market of future fiscal tightening that will be undertaken by whatever party or coalition of parties that form the next government.  I am not so sure.

When the fiscal tightening measures whose anticipation provides a boost to aggregate demand today are actually implemented, demand will fall, of course.  It is only the anticipation of future fiscal tightening that is expansionary.  The actual implementation of fiscal tightening is contractionary when it occurs.  Making a credible commitment to a future fiscal tightening is therefore going to be difficult.  If a government promised that it (or its successor) would raise taxes and cut public spending not by 6 percent of GDP forever from now on, but by some larger number, say 8 percent forever, starting 20 years from now, would it be believed?  Not be me it wouldn’t!

Sometimes the only way to gain credibility about your future intentions is to give a painful early demonstration.  Certainly if, against all odds, Labour were to form the government after the next election, its fiscal credibility, and specifically its capacity to commit to future fiscal pain, would be nil.  Although Alistair Darling has been a good chancellor, the years of Brownian fiscal irresponsibility have, I fear, undermined the credibility of any fiscal tightening program announced by Labour that was not significantly more front-loaded that it could have been and should have been had the government possessed a reputation for fiscal rectitude.

The Tories are untried and untested.  They did the right thing pointing out the inevitability of major fiscal pain; their apparent desire to start the fiscal tightening immediately and thus not to take full advantage of the announcement effects of future fiscal tightening may have been motivated by a recognition that they start out without a track record, without a reputation and therefore without any credibility capital to spend.  A hung government might have some fiscal credibility if Vince Cable were the chancellor, but I am not holding my breath.

What kind of fiscal tightening?

Public spending cuts will have to be quite savage, but even if they have to be front-loaded for credibility reasons, they can be structured to minimize their adverse impact on aggregate demand.  Cutting public sector pensions for future retirees would make sense.  So would raising the age of eligibility for the state pension by one year each year starting immediately (fiscal year 2009-2010) until it reaches 70 for both men and women.  After that, the eligibility age would be ‘indexed’ to the evolution of life expectancy conditional on reaching 70 (or whatever the age of eligibility might be).  The state pension should be linked to earnings of course.  The increase in the age of eligibility for the state pension would be accompanied by the abolition of the mandatory  age of retirement – an outrageous form of age-discrimination in any case.

When the reduction from 17.5 to 15.0 percent ends on January 1, 2010, the government should not just put the rate back up to 17.5 percent, it should also announce a further future increase to 20 percent a year later, say.  Apart from the immediate expansionary effect of the credible announcement of any future tax increases, the anticipated increase in the VAT rate would also work to boost consumer expenditure, especially on durables, through the ‘intertemporal substitution effect’  of future higher prices.  I would also extend the coverage of the VAT to all consumer goods and services, including food and children’s clothes.

VInce Cable proposed a tax on expensive residential housing.  The fact that he forgot to consult his party before making his proposal does not detract from its merits.  Better even than a tax on property would be a land tax.  Practically, the valuation of the land can be obtained from the valuation of a property (land plus structures) minus the insured value of the structures.  This tax is non-distortionary and could be designed with a rate structure that would permit the abolition of the distortionary and plain silly property-related taxes, like the local property tax and stamp duty on home sales.  All land (residential, commercial, industrial and agricultural) should be taxed according to the same schedule.

Public spending cuts with minimal negative aggregate demand effects would include the down-scaling or abolition of the UK nuclear deterrent.  This would make sense even if there were no budgetary emergency, as it is unclear whom the deterrent is meant to deter.  Cuts in health and education also seem unavoidable.  I would focus the education cuts on higher education, at the same time setting the universities free to charge what the market will bear.  Scholarships and student loans would have to take care of the unacceptable distributional consequences of market-driven fee structures.

The illusion of health care free at the point of delivery has become an increasingly bitter joke as technological progress expands without bound what is medically feasible but not what is financially affordable. A civilised society ensures that health care at a socially acceptable standard is available to all, regardless of ability to  pay.  This is not the same as health care on demand, free at the point of the delivery.  Better to start making sure that those who can afford to pay for their health care do so.

Unused monetary ammunition

With not much joy to be expected from fiscal policy as a means for boosting aggregate demand in the UK in the short run, what of monetary policy?  Inexplicably, the Bank of England has not made full use yet of the instruments it has at its disposal.

Bank Rate still stands at 0.50 percent?  Why not zero (or even some slightly negative number)?  With Bank Rate at zero, the rate paid by the Bank of England on reserves held with it by the commercial banks and building societies could be set at the same level as Bank Rate for some limited level of normal or ‘required’ reserves.  All reserves above that level would be paid a rate 75 or 100 basis points below Bank Rate, that is at -0,75 percent or -1.00 percent if Bank Rate were at zero percent – as it ought to be.

The technical arguments against a zero or slightly negative Bank Rate are unconvincing, not to say pathetic.  The latest iteration on the ‘it cannot be done’ theme is that some building societies aren’t capable of setting deposit rates at negative values.  If that is really true, then shame on the FSA and the Bank of England.  It’s been clear for at least a couple of years that interest rates were headed for the lower bound.  During that interval, a joint posse from the FSA and the Bank of England could have toured the shires to show the building societies how to write the additional lines of code required to permit interest rates on deposits and saving accounts to be negative.

These lame British technical excuses are reminiscent of an argument often heard in the US about the impossibility of a zero or slightly negative Federal Funds target rate: it would make it highly likely that money market mutual funds would ‘break the buck’, that is, return less than a dollar for a dollar invested.  Indeed it would.  And…?

After setting Bank Rate at zero and the rate on excess reserves at, say, minus 0.75 percent, the Bank could start implement Credit Easing (CE) in earnest.  The Asset Purchase Facility of the Bank of England, which has been in operation since the beginning of 2009 has been wasted on purchases of government securities (QE).  It was wasted, because there were no anomalies in the market for government debt that made it desirable for the central bank to absorb large quantities of public debt.  If anything, long-term interest rates (nominal and real) have been anomalously low in the UK, creating a range of unnecessary problems for DB pension funds and other organisations required to discount their future outlay commitments at rates related to the yield on long-term public debt.

It is possible that the Bank of England’s asset purchases (it tripled the size of its balance sheet, while the Fed doubled the size of its balance sheet and the Eurosystem increased its balance sheet size by at most 20 percent) have contributed to the weakness of sterling.  I personally believe that this is unlikely.  The official policy rate in the UK is between those in Japan (0.10 percent) and the US (0 to 0.25 percent) and those in the Euro Area (1.00 percent).  I believe that the nominal and real depreciation of sterling reflects a re-rating of the country and its financial sector: a higher risk premium is now required for this small open economy, with its large, internationally exposed financial sector, its strictly local currency (sterling is no longer a major-league reserve currency) and its limited fiscal capacity.

As of 22 October 2009, the quantity of assets purchased by the creation of central bank reserves was £170,590 mn.  This almost fills up the envelope of £175 bn granted the Bank by the Treasury.
The breakdown of this almost £171bn of Quantitative and Credit Easing was as follows:

Commercial Paper: £673mn
Corporate Bonds: £1,342mn
Secured Commercial Paper:  £0mn
Gilts: £168,575mn

In round figures, £ 2 bn of outright purchases of private securities, £169 bn of Treasury securities.  What are they thinking?  The remaining anomalies and disfunctionalities are in private securities and credit markets.  What the Bank should have done instead of purchasing enough public debt to finance the entire estimated general government financial deficit for the fiscal year 2009-10 (around £175 bn), is to purchase, say, £ 50 bn worth of UK covered bonds and gold-standard new asset-backed securities.  If the banks and other potential issuers of such securities had been unable or unwilling to issue in the required volumes, the Bank could have used its much enhanced powers of persuasion to resolve any coordination problems, free rider problems, fear of stigma problems or any other problems, if necessary in concert with the FSA and the Treasury, to guide the fearful sheep in the desired direction.

Serious additional spontaneous or voluntary intermediation through the banks is not going to happen in the UK for the time being because the banks are undercapitalised and fearful of any actions that could increase the hold of the state over them.  So bypassing the banks by using the capital markets, e.g. by boosting new gold standard RMBS issuance or new covered bond issues by large, high-grade borrowers, is the way most likely to boost intermediation and ultimately lending to the real economy, short of nationalising the banks outright and forcing them to lend.

When markets function well and banks are properly capitalised and not in government avoidance mode, it makes little difference whether the Bank of England buys gilts rather than the domestic private sector or the rest of the world.  When domestic banks are zombified and capital markets continue to splutter, focusing the unquestioned liquidity of the central bank on the heart of the market failure, by purchasing systemically important private securities outright, is the obviously dominant strategy.  I can see no coherent argument for the Bank of England using virtually all of the APF for gilts purchases.  If it is politically awkward for the Bank to dump £50 bn of gilts in the market to obtain the resources for outright purchases of, say, £50 bn worth of private securities, it should request an enhancement of the size of the APF by £50 bn to £225 bn.

Even if the Bank of England cuts Bank Rate to zero, sets the rate on excess reserves at minus 75 basis points and does £50 bn worth of outright purchases of covered bonds and gold-standard ABS, the UK recovery will remain slow and hesitant.  The damage done by a decade of global and local excess cannot be undone in a hurry.  It will take years.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website