Great explanation of how the Tories have got it wrong

This was posted as a comment on a BBC blog by someone called Richard Bunning. It is long but worth reading and sharing. We must counter this ConDem lie that the economy was in a mess when they took over

In order to understand our current predicament we need a reasoned analysis of the Brown economic legacy, then we can discuss Osborne’s plans in a reasonable context.

Basic economics:

The role of government & BoE in the economy is to:

1. Take the heat out of inflationary periods by taxing more, running a surplus and raising interest rates.

2. Take the sting out of a recession by borrowing and spending more and BoE cuts interest rates.

This combination of fiscal and monetary policies is described as COUNTER-CYCLICAL action – it irons out the effects of booms and busts, which makes UK PLC more efficient because it prevents the worst excesses at either end of the cycle – Brown’s gold rule was that the surpluses and deficits should balance each other out over the cycle – “prudence” in his own words – but IMHO he didn’t change this rule – the whole rulebook of the global economic game were changed overnight and he was powerless to do anything about it.

What happened to cause this – and was Brown to blame for it?

Firstly, the economy was going into a mild recession – then the world’s banking system self-destructed overnight and there was a huge risk of the commercial banking sector disappearing. This was caused by a number of factors virtually exclusively from the USA – sub-prime mortgages and worthless paper dressed up as “special financial vehicles” – i.e. a massive con trick – suddenly Leaman Bros et al were caught out and had to realise these huge loses and went bust.

What should the UK government do?

Firstly UK PLC invested vast sums in buying equity in the banks to recapitalise them – the alternative? No banks, deposits disappear, unforseen collapses in companies suddenly without credit or access to their money – back to bartering until a new state bank could be established – the choice to prop the commercial ubanks p was the least worst option – and we can sell UK PLC’s stockholding in the banks at a later date – currently showing a healthy profit.

The paralysis of the banks resulted in the credit squeeze – no money to lend, so no money to borrow. The effect of the credit tap being turned off was a sharp fall in demand – and a recession heading for a global slump.

What should government do now?

Counter-cyclical doctrine and the experience of the Great Depression of the 1930s tells us that governments need to inject demand into the gloal and domestic economy to stop it going off a cliff – this means borrowing and spending.

The difference in this case was the scale of the borrowing – add in the bank recapitalisation and the stimulus package and critics are right in saying it’s a record.

Where they are wrong is that you cannot view the bank recapitalisation as the same thing as running a “normal” deficit – for start there is an ASSET there which can be sold – bank shares – and unlike hiring a council worker or commissioning a new road, the bank holdings can be unravelled and the borrowing repaid without recourse to tax rises of spending cuts.

If you blame Brown for all this you are simply shooting the messenger – he had nothing to do with the credit crisis and if he hadn’t recapitalised the banks, then god help us.

These figures mark the end of the benefit of the stimulus package Alistair Darling put in place – but we are about to feel thev full force of the “negative stimulus” of the spending cuts which are yet to bite – and as Stephanie Flanders points out, the rest of the world economy is squeezing us harder than George Osborne.

What would a sensible, pragmatic economist do as Chancellor now?

Firstly in assessing the level of UK PLC debt, he/she’d discount the value of the bank holdings from the total debt because they are a realiseable asset we will eventually cash in and use the money to replay the debt – next he/she’d accept that the credit crisis wasn’t “business as usual” it was a very serious crisis unrelated to the normal economic cycle – and one that should not be balanced out over a single cycle – i.e. probably two parliaments or more.

Should Brown have thrown on the brakes earlier, cutting spending harder, sooner, as the coalition endlessly restates?

Clearly with the benefit of 20:20 hindsight, we now know that cutting spending would have kept UK PLC in recession with lower GDP, lower incomes and higher unemployment, all of which would probably have produced the same level of deficit anyway due to higher welfare payments and lower tax take.

The ConDems believe that they can cut the deficit over just this parliament and that there is “no alterntive”. They propose to do this by £110 Bn of tax rises and spending cuts. As each £ borrowed and put into the economy circulates and changes hands several times, taking £110 Bn out is magnified – I’d say by a factor of up to ten. We call spending money in UK PLC as “aggregate demand” – and if you take my figure of 10, that equates to a fall of £1Tn.

In an economy barely keeping its head above recession that looks today that it is in real danger of going into reverse, with our export markets in a similarly fragile state, conventional wisdom says UK PLC will be tipped into a deep recession by the negative demand effect of the cuts.

However, the Office for Budgetary Responsibility says we’re going to get loads more new private sector jobs, billions of investment and our exports will surge – yesterday the CBI called this into serious question.

This is because of a quasi-religious belief that the public sector “crowds out” the private sector, so hack back public spending and the private sector will expand to fill the gap – the “magic of the market” will ensure that underused resources are snapped up and applied to make money.

So who do you believe? did Brown splurge our money and leave us in so much debt that we need a stiff dose of spending cuts to pay them off?

Or do you see the current plan as a dangerous gamble based on ideology not economics?

Luckily we will find out who was right in the next 18 months.

The coalition claim that the public spending cuts won’t have a deflationary impact on th economy and that critics overstate its impact.

Steph’s piecehttp://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2011/01/the_world_is_squeezing_us_more.html

is a salutory reminder that the economic backdrop is also an important factor in UK PLC’s prospects for growth, jobs and paying off our public AND private debts.

There is however a precedent for Osborne’s plan – a very similar austerity plan was implemented in Eire, which he described as a “shining example” of a successful economy.

Eire is now on its knees unable to service its debt and unable to stimulate its economy because the spending cuts have so surpressed demand that GDP shrank by 17% last year and house prices fell by 40%.

The verdict of history will be that Brown was a boringly conventional Chancellor faced with an unprecedented crisis that left him little or no choice.

Osborne on the other hand is likely to be seen as the man who drove UK PLC over a cliff in the winter of 2011/12. The “world squeeze” means that we pay more for less – Osborne’s plan to cut aggregate demand by £1Tn as well flies in the face of both Keynesian and Monetarist economic theory – the risk of drastic deflation is simply too high and cutting public spending this rapidly will cause GDP to fall,which in turn cuts tax revenues and drives up the welfare bill – which will INCREASE public debt, not shrink it.

Let’s spin forward 18-24 months – I predict we will be reaching 5M unemployed and GDP will be shrinking fast. Public borrowing will be rising and inflation caused by the collapsing Pound will be over 10%.

At this point we will hopefully have learnt our lesson – Hayek’s “Road to Serfdom” is the ONLY theortical basis for the coalition’s current economic policy – and as there will be millions of people trapped without work living on poverty benefits chasing non-existent jobs at the behest of private sector barons running “workfare” programmes, the poorest in our society will have reached Hayek’s destination – they will be serfs, pure and simple.

Another commenter points out:

1: The economy was recovering before the election. The deficit had shrunk by £18 billion as a result of Keynsian investment in the economy by Labour (which has now been reversed).

2: The deficit is large, but as a % of GDP it’s smaller than it was for 8 of the 11 years under Thatcher. It wasn’t a crisis then, it’s not a crisis now. The coalition has an idiological reason for shrinking the state, not an economic reason.

3: The weather doesn’t affect spending as much as the politics. For entirely political reasons (i.e. get it into everybody’s mind that the last government was a disaster, so that any action taken by this government can be justifiable) the coalition spent the last 6 months endlessly talking down the econimy and terrifying the electorate. No wonder we all stopped spending money.

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