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By Prof Kevin Dowd, on 23 August 10
Although few people yet realise it, the UK is bankrupt: the Government cannot pay its debts.
This might sound a little pessimistic. After all, the UK debt to GDP ratio is still under 70%, and the debt to GDP ratio for some other countries is much higher.
However, for peacetime the current UK debt to GDP ratio is high and rising fast. Furthermore, observers of the UK economy have been sounding warnings for some time: one major bond investor early in the year warned his clients that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine”.
Unfortunately, the Government’s official debt is not the real problem: the Government’s ‘official’ debt is only a small percentage of its true debt exposure. The official debt is merely the tip of a very large hidden iceberg.
The Government’s true debt is the present value of all the commitments it has entered into, on the expectation that these commitments will be paid for by future taxpayers. Some prominent examples are the commitments implied by the public sector pension system, the state pension system, the health system and PFI. The costs of these commitments are staggering.
One recent Institute of Economic Affairs study by Nick Silver put this figure at 333% of GDP. Another, by Christian Hagist and his colleagues at Freiburg University, put the figure at 530% of GDP. Two different methodologies by reputable researchers, both painting a very bleak picture. The latter study also carries out an international comparison – and, relative to other countries, the UK comes out as a basket case along with the US: the US is bankrupt too.
Let’s take the first figure. This means that a typical UK citizen will be expected to pay well over three times’ their annual income just to cover this debt. If we go with the larger figure, then he or she will be expected to pay well over five times their annual income.
With an average income of about £22,000 for per person, these figures suggest a future tax bill in the range between approximately £73,000 and almost £117,000 for each man, woman and child in the country.
Yet even these figures are over-optimistic, in so far as they refer only to the unfunded tax burden that has already been incurred, whereas the reality is that this burden has been rising rapidly before the current crisis, and is rising even more rapidly now. So we are looking at an obligation on the future taxpayer that is not only very large, but still rising sharply.
The problem is made worse still because of the way the tax burden will be distributed. For some older people – such as those in retirement – there isn’t much problem at all. They benefit from the government’s commitments, but are unlikely to have to pay much towards their cost. For young people, it is the other way round: they are expected to pay large amounts into the system and get little back in return; and the younger the person, the worse the deal.
So we have an average, per person, tax burden of £73,000 if we are feeling optimistic and nearly £117,000 if we are feeling pessimistic – but in either case possibly much higher, and certainly rising – that is distributed very unevenly across the population: younger people paying much more, and older people less, if anything at all.
One recent estimate suggested that a UK citizen born in 2011 will inherit, on birth, a debt of perhaps £200,000, and it could easily be much more.
It is simply inconceivable that debts on this scale will be paid off in full.
Nor should they. These were not debts that youngsters freely took on, but obligations incurred on their behalf in many cases before they were even born.
The uncomfortable moral question then naturally arises: at what point does the debt become so large that our future children will be born into a new form of slavery, entering the world shackled by the debts of their forbears?
This highlights the underlying moral as well as fiscal bankruptcy of the system. For years, politicians yielded to the temptation to increase spending commitments and put off the costs of those decisions into the future, when it would be someone else’s problem. The political system itself encouraged them to do so – handing out goodies is so much easier to sell politically than handing out pain. Even the voters themselves were complicit, because they voted in governments committed to ‘spend now, [someone else] pay later’ policies, instead of penalising governments for long-term fiscal irresponsibility. Most of those who will pay the burden did not yet have the vote, so they didn’t count. No-one took responsibility for the long-term.
In so doing, our political system created a huge intergenerational Ponzi scheme, passing the buck from one generation to the next, until the whole rotten system inevitably collapses under its accumulated weight.
The long-term, even medium-term, outlook is therefore deeply unpleasant. Taxes will rise, sharply, but these rises will not be enough, and will leave younger people with little incentive to work or to save. Benefits across the board will be cut, massively: the government will renege big-time on many of its commitments, breaking its health, pensions and other promises on a huge scale. The social and economic consequences don’t bear thinking about. And of course there is the very real danger that even these draconian measures will not be enough: that the government will lose all control of its finances and end up printing money to pay off its debts, so leading to hyperinflation and economic collapse.
Make no mistake about it: the country is bankrupt.
By Prof Kevin Dowd, on 19 July 10
In today’s Telegraph Ambrose Evans-Pritchard gives a splendid analysis of the dire fiscal problems facing the developed economies, but a dreadful analysis of their monetary problems.
With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice. The Government is indeed very fortunate to have kept its credit rating – even at the beginning of the year, one big bond investor was warning that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine” – but this cannot last unless the Government provides a credible plan to map the country back towards solvency.
We must also keep in mind that the ‘visible debt’, the debt on the Government’s balance sheets, is just the tip of the iceberg: when one takes into account all the hidden commitments the Government has entered into – PFI, public sector pensions, state pensions, etc. – the situation is far far worse: we are looking at debt to GDP ratios in the range of perhaps 350% to 500%.
The true fiscal situation is, thus, even more dire than Mr. Evans-Pritchard makes out. Nonetheless, he is absolutely right that fiscal expansion is not an option. Instead, the Government is drinking in last-chance saloon and it is a choice between painful spending cuts now and much more more painful cuts later.
However, Mr. Evans-Pritchard also tells us that “ultra-loose monetary is the only option for Europe, the US and Japan”. He suggests that in the US, M3 has fallen at a 10pc pace for much of this year, telling us that this was the “Great Depression rate” and so the economy hit the buffers with the “usual lag” along textbook Quantity Theory lines. The clear implication is that this needs to be reversed to get the US economy going again.
This analysis is nonsense. First off, there is no “usual lag” – Milton Friedman spoke spoke of “long and variable lags”, but most economists interpret this in the region of perhaps 12-24 months – so it is pushing it to blame very recent falls in M3 for the decline in the US economy. But in any case, the Fed discontinued publishing M3 statistics back in 2006 – one suspects, because they painted an embarrassingly expansionary picture about the true stance of US monetary policy in the bubble years.
Instead, we need to take a broader picture and look at how the monetary aggregates over a much longer period. If we do so – and lets look at the official statistics published by the St. Louis Fed on its Federal Reserve Economic Data site – we get a picture of seriously expanding monetary aggregates over a sustained period of time. Even if we look at the most recent year-on-year data we find:
- St. Louis adjusted monetary base up by about 15% (though having fallen in recent months a little to $2 trillion, itself up from about $800 billion before the crisis – a big expansion in my book!);
- M1 up about 5%;
- M2 up about 2%;
- MZM (the closest now to M3), down about 2 to 3%.
By contrast, in the early 1930s, US monetary aggregates fell by about a third.
And one should never look at monetary aggregates alone; we also need to look at real interest rates, and in this respect the difference between recent years and the early 1930s is again very pronounced. In recent years, real interest rates have been strongly negative – this of course has been a key problem, repeatedly fuelling boom-bust cycles; by contrast, in the US in the early 1930s, real interest rates were VERY highly positive, sometimes in double digits.
So the overall monetary policy stance in recent years is anything but contractionary, and there is no comparison to the 1930s.
Monetary expansion has merely created an inflation time bomb and fuelled repeated speculative cycles, the latest one being in the banking sector itself, by allowing the banks one last lending binge at negative real interest rates subsidised by the long-suffering taxpayer. Further monetary expansion would merely give the patient more of the poison that is already doing much to kill him.
Fortunately, there are solutions, but one has to think outside the washed up Keynesian macroeconomic toolbox. The reason the economy is doing so badly is because the banking system is still broken, and the economy will continue to do badly until the banking system is properly fixed. Some of us have been hammering on about this for years.
This is, I would suggest, also a matter of some urgency: the Bank of England’s latest Inflation Report suggests that CDS spreads on UK banks are rising very sharply, and are nearly as high now (200 basis points) as they were at the height of the crisis (almost 240 basis points, as opposed to a mere 10 basis points before the crisis hit). The storm clouds are gathering again for everyone to see, and no expansionist ’solutions’ are going to help.
By Prof Kevin Dowd, on 2 December 09
This article is an expanded version of the Second Chris R. Tame Memorial Lecture delivered by Professor Dowd at the National Liberal Club, London, March 17th 2009. A recording of the original Lecture, with an introduction by Dr Tim Evans, President of the Libertarian Alliance and CEO of The Cobden Centre, can be found here. The original paper is available here: please see that paper for appendices and endnotes.
Introduction
Good evening everyone. I would like to start by thanking my friends at the Libertarian Alliance for inviting me to give this lecture. It’s good to see so many other friends here as well. I would like to thank you all for coming.
For those of us who were fortunate to know him, Chris Tame was an inspiring mentor and a loyal friend; he showed remarkable dignity and courage in the face of the illness that ultimately cost him his life, and his death was a massive loss. I owe him an immense personal debt myself, so it’s a very special honour to speak at his memorial lecture.
Chris was a central figure in the rebirth of Classical Liberalism in this country and it is very appropriate that we meet here in the National Liberal Club. But the Liberalism that Chris espoused was not the watered down ‘liberalism’ of the 20th Liberal Party—the liberalism of Lloyd George or Jeremy Thorpe—but the Classical Liberalism of an earlier age—the Liberalism of Gladstone, and earlier still, the Classical Liberalism of the great moral philosophers of the 18th century Enlightenment.
My topic this evening is the current financial crisis. My theme is that the Classical Liberal perspective can help us both to understand the crisis and to find a way of out it.
I always like to begin with a nice quote, and we are spoilt for choice when it comes to quotes about the financial crisis. Amongst those I can quote in mixed company, my favourite one is a comment by a Wall Street passer-by when asked his thoughts about the bank bailouts: “Its like not being invited to a party and then being given the bill for it”, he said.
This comment goes right to the heart of the matter—the widespread perception amongst the public that there is something wrong with the current financial system, i.e., that it lacks legitimacy. I agree with this view entirely: the current system does lack legitimacy and I am sure every right-thinking person would agree with me that it is manifestly indefensible.
Though correct, however, this perception is also dangerous, as it provides fodder for interventionists who argue that the current crisis is due to unconstrained market forces. Free markets have failed, they argue, so let’s have more state control instead.
Such arguments are mistaken in every respect. The current system involves limited competition within the constraints of a large variety of state-mandated parameters – a managed (or rather, mismanaged) economy, but not nothing like laissez-faire. And it is this ‘managed’ economy that has failed us all so badly.
The roots of this managed economy back a very long way:
- We had the establishment of the Bank of England in 1694 and the subsequent development of centralbanking.
- We had the establishment of the limited liability statutes in the 1850s, passed against bitter opposition by those who claimed—rightly—that they were a recipe for irresponsible risk-taking at other people’s expense.2 This might sound familiar.
- We had the stage-by-stage destruction of the commodity monetary standard. The pound, which was originally—and literally—‘as good as gold’, was replaced with the current inconvertible pound, which is intrinsically worthless. One consequence of this was the horrendous inflation of the 1970s and 1980s, not to mention the danger that inflation will return again if current monetary policies persist.
- We had the development and widespread adoption of Keynesian macroeconomics from the 1930s on. Keynesianism was discredited and then abandoned in this country in 1976, but the Keynesian legacy—in essence, the belief in a managed economy—still survives and poses a grave threat to our future.
- In the late 20th century, we had the establishment of state-mandated deposit insurance.
- And, over this same period, we had the growth of vast systems of financial regulation: these included the establishment of the Financial Services Authority and the growth of international bank capital adequacy regulation. Contrary to what one
- often hears, banking is not the epitome of laissez faire, but a heavily regulated industry.
My point here is each of these pillars of the current system—central banking, limited liability, inconvertible currency, the managed economy, deposit insurance and financial regulation—represents a major and profound state intervention into the economy, i.e., the opposite of a free market.
What I would like to do this evening is give my own view of the crisis as a Classical Liberal economist. Naturally, I can’t pretend to have all the answers, but I think there is a way out: we can put together a workable reform package. We then need to be confident in it and advocate it with all the powers of persuasion that we can muster. Above all, as Chris always maintained, we need to win the battle of ideas against those who would argue that we need even more of the interventionist medicine (or rather, poison) that has already caused so much damage—and threatens to do so much more.
The stakes haven’t this high since at least the 1930s.
Continue reading “Lessons from the financial crisis: a libertarian perspective”
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