Tuesday, March 08, 2011

Over-labouring Labour's labours

The past few weeks have definitely been a period of "buy everything" even if things haven't actually moved that much. Commodities of course, energy, base, precious, softs you name it. Equities too, which is a bit of a surprise considering that energy is getting hiked on fears of Middle East-inspired Armageddon. The only thing being sold is effectively cash and as indicated by the FX markets, USD cash specifically. Which means that if you hadn't noticed the Middle East unrest, the wobbles in Asia, the widening European periphery spreads, the earthquakes and floods in the southern hemisphere and just looked at prices alone, you would imagine that the only trade in town is the purest of them all - the QE induced USD Inflation trade. But its more complex than that, we just seem to have ended up at a simple solution to a complex problem. Much as e to the power of pi*i = -1.

Speculative positioning seems to be showing that this theme is pretty stretched as every punter has suddenly started waving the macro arguments for their short term trades. Now whilst we know that some believe that the macro is the macro and the micro is the micro, TMM do believe that the Macro is a sum of the Micro and the Micro is a fraction of the Macro. But we also know that when a Macro theme becomes a day trader's mantra, it’s gone Tabloid with a high TDI ( Taxi Driver Indicator) and the wheels normally fall off. So with everything going up against USD cash the interesting part should be if it all unwinds and then everything falls against it.

We should apologise for not having posted yesterday. The day started as usual with TMM debating the normal run of market developments and interpretations but the recent headlines on UK banks swiftly led us into a somewhat turbid debate again over the who/what/where and when, did/should/would and will happen in that sector. Unfortunately, the lack of consensus and agreement on a topic so widely and emotionally debated ended with us deciding we really didn’t want to air our dirty laundry in public. So no post, but instead TMM decided to share just a small part of the complex debate which occurred that doesn't really have too much relevance to trading.

Having become fed up by the naivety of much of the discussions around the issues both in the press and political sphere we thought it may be worth putting something together to try and address the myths on both sides. So today, the non-partisan TMM will attempt to look at the UK Labour party's involvement in laying the economic background and illustrate just what they did or did not do wrong as far as fiscal policy goes, in its 13 years in power. While intended to abstract a little further than the standard "they spent too much" or "they didn't spend too much", it is certainly well-beyond the scope of this humble blog to be anything approaching the exquisite analysis of TMM's mates at the IFS.

So... here goes...

One of the sound-bites that has flown around is that at over 50% of GDP, UK Government spending is too high. Now this may or may not be true, but simply looking at the overall government share of GDP is something of a misnomer and, while politically expedient for the Right, does not provide an accurate picture of how big the State is and whether that share of GDP was unsustainable. TMM reckon that to answer this question, we need to look at the main components that make up that 50%+ number:

  • Central Government Current Expenditure on Net Social Benefits ("Welfare Spending").
  • Public Sector Net Investment ("Investment Spending").
  • General Government Consumption Expenditure ("Current Spending").

On top of those are all the smaller things like depreciation, interest costs and various other things which are beyond the scope of this piece. However, any proper analysis of the government's share of the economy requires an analysis of the main three components above.

So, firstly, Welfare Spending (See chart below). Believe it or not, as a share GDP actually *fell* under Labour, only rising as the effects of the recession began to bite sending spending higher and GDP lower. Note also the spikes in the early-80s and early-90s recessions under the Conservatives. TMM is pretty certain that the Daily Mail would be horrified to learn this, as it has been certain that all those council tenants living in million pound houses were responsible for this "great big fiscal mess"... Whatever the rights and wrongs of welfare reform under New Labour, and loopholes that have resulted in an impossibly high share of people declaring themselves to be unable to work, it is not obvious to TMM that Labour did anything particularly wrong here. Welfare spending covers is defined by the moniker "Central Government Current Expenditure on Net Social Benefits" and covers pretty much all of what one might expect of the Welfare State in the form of automatic stabilisers and redistribution to the poor and needy. So it doesn't look to us as though Welfare Spending got out of control.

Moving on... Labour's big plan (and Golden Rule) was to "borrow to invest over the cycle and not to fund Current Spending". The idea being that investment in hospitals, schools and infrastructure by the government results in higher trend GDP as the discount rate that the private sector would have to apply to such investment would have to be so high to compensate for the risk of such projects would be way to high for them to be worth enacting (there are plenty of defaulted Railroad bond stock and bond certificates on Ebay to attest to this fact), and there is a clear benefit to business and society as a whole. TMM strongly agree with this view. The chart below clearly shows that investment was increased, though only to levels seen in the early-1990s by 2007, prior to the recession. The bulk of the spending share increase came in 2008-10 and is obviously mainly the result of the fall in GDP optically.

On top of this is depreciation and the PFI/PPP stuff which you can see in the below chart basically either were roughly constant or just increased a bit. Anyway, the main point here is that there *was* an increase in investment spending, but it was not a massive increase that could justify the very large structural deficit that was being run consistently over the past decade, as Ed Balls keeps trying to claim. TMM suspects that this would surprise many Guardian readers... TMM have avoided delving into the impact of the off-balance sheet aspects of PFI/PPP precisely for the reason that they are not included in the official debt figures. If anything, they undoubtedly worsened the UK's fiscal position, but TMM believe that to consider these here would risk over-complicating things.

Finally, General Government Consumption as a %age of GDP. This is the State's spending on current goods and services, and includes the public sector wage bill, the pension Ponzi scheme, non-welfare-related NHS spending (e.g. the Nurses, Doctors, Administrators etc), Defence etc. The chart below is where an international comparison is more appropriate as this is the type of spending that affects the Real Exchange Rate (more on that below) and also the extent to which fiscal policy was sustainable. TMM reckon the above argue that Welfare Spending was sustainable and Investment Spending was not out of line with historical norms, and generally provides an asset on the other side of the State balance sheet, and was not necessarily unsustainable unless one counts the off-balance sheet liabilities of the PPP activities. TMM's personal view is that the Government was ripped off by the various companies that won these contracts and figured they had a free put option to the Government if things went wrong (which sounds to TMM a lot like the Bankers...!).

We digress...

In the chart below of General Government Consumption Expenditure as a share of GDP, the white line is the UK, the yellow line is the US, the pink line is the EU average and the green line is France, the orange line is Switzerland and the blue line is Germany. As you can see, from 2000-onwards, Gordon Brown went to town, employing vast swaithes of administrators and wasting huge amounts of money on computers, electronic whiteboards and all manner of consumables which are now gone and wasted, take the consumption share of GDP up to levels not seen since Thatcher began a structural consolidation of the State in 1981. By mid-2009, partially as a result of the bank bailouts and recession this measure had risen *above* that of the mid-1970s, arguably the height of the Big Government and Statism. Not only did Britain do this, but it also overtook the EU average in 2003! In TMM's view, this was where Labour was irresponsible, because this was *NOT* investment as laid out in their 1997 and 2001 manifestos, but a pure expansion of the government's share of consumption spending within the economy, and was money wasted, not invested. The key with this metric is that it was already running at a ridiculous level prior to the recession and therefore there was not any room for a proper Keynesian discretionary stimulus in the worst recession for 80years and, as a result, the UK enacted one of the smallest fiscal stimuli globally at a time when it clearly needed a very large one.

An international comparison argues aiming for this share of the economy to sit somewhere around 17%. TMM pick that number because it is where Germany was prior to the recession, and above the level of the US (which does not have an NHS as such) but below the EU average because we are not one of the low growth and rigid Mediterranean economies. Given the presence of the financial services industry, one could also argue that this share needs to be even lower - Switzerland, for example, only runs 11%, but this was structurally rising prior to the crisis.

So that's the fiscal side of things, but what about other effects? Regular readers will recall the below chart, one of TMM's favourites (inspired by the BoE's newest member, GS's Ben Broadbent), showing the Mundell-Fleming framework of the effect of General Government Consumption Expenditure (white) line upon the Real Exchange Rate (orange/green lines - two overlapping BoE series). According to this theory, as the government's share of current spending increases, it pushes up the Real Exchange Rate because domestic goods, services & wages get pushed up relative to those externally. And vice versa for decreasing consumption shares. It is clear that as this share moves up and down the Real exchange follows. In 1997 the market anticipated this and rallied as the market correctly priced in a Labour victory and increased government share of spending, but from 2006 onwards, the market realised that fiscal policy was unsustainable and didn't rally much. And furthermore, during the crisis anticipated a very dramatic fiscal tightening, with the market consistent with this measure expected to fall to about 18% of GDP.

There are two main problems with increasing Current Spending: one is that it has often resulted in fiscal crises in the UK (1976 and the past year are clear examples, but also 1967), and the other is that, as demonstrated above, it forces up the Real Exchange Rate due to the State tending to buy domestic goods and services and push up real wages as a result of hiring a great many more people. This contributes to a fall in economy-wide competitiveness, export businesses face a harder time, their balance sheets deteriorate and this leaves them vulnerable to foreign takeovers or bankruptcy. A lot of UK manufacturing has fallen victim to this, and TMM note that a significant amount of UK Plc has been sold off over the past 10years in order to help fund the gaping Current Account deficit.

And that, dear reader, was just part of it... Enough said. We hope to be back to more markety things tomorrow. Especially as we think March is going to be open season for all things European. We may be a'goin' Eurostriche huntin'.


Anonymous said...

Interesting UK analysis. Aligns with what some of us thought was the case.

I'd say the US$ is about to to take a bite out of the 'theme' trades.Across the board on the majors it looks like a mean reversion time is on us.

Mark Thyme said...

Very fine bit of analysis. I'd make a couple of points though. The first is that although welfare spending looks well behaved, given that unemployment was at a 30 year low in 2007, spending should have declined even more. So black mark for Mr Brown there. Second, maybe you should have mentioned the income side of the P&L account. Brown's Treasury made catastrophically stupid assumptions about revenue growth. As in Ireland, too much of the government's income was dependent on forever rising levels of household and financial service sector debt.

Love the blog by the way.

FX said...

Thanks for lighting up my conformation bias indicator (CBI),would've liked a further investigation in regard to inflation-imported-REER,but that's good enough :).....

Methinks now the UK is getting really handled by this "euro", I just don't have the resources to put my finger on it though.

Anonymous said...

short conclusion: UK is a small island with 90% effective tax rate, negatve effective public sector investment and an everest of promises built upon other (unrealized) promises. Through in inert (real0 import-oriented economy. stay clear. PS: doesn't mean u should short the sterling every morning either - after all the majority is still paid in sterling and spends it overseas. well - loosing ground to the swissie in that respect.

Anonymous said...

so does contraction of fiscal policy and hence government led expenditure imply that betty is a sell? or has it all been priced in ...?

are most street economists like Broadbent underestimating the impact policy will have ... cause the risk is that they don't hike as much as is priced in (casual observation all gs central bankers seem to become doves once they get their cushy slot)

cpmppi said...

Mark Thyme,

Thanks for your kind words.

Yes, that is a fair point about unemployment being at a 30 year low. As you point out, there was certainly on the revenue side plenty of, perhaps, misplaced optimism. One only has to look at the Terms of Trades shock Latin America experienced in the 1970s and how extrapolation of revenues related to this resulted in a fiscal crisis by the early-1980s in that region. And that is precisely why I think looking at the expenditure side for sustainability testing is appropriate, because you never know what the future holds. Perhaps Dr Brown's successors will pay more attention to this fact, but I am not optimistic on that.


cpmppi said...

Anon @3.42,

I would interpret the chart as indicating that the market has largely priced in the contraction of fiscal policy, and therefore downside in Betty is unlikely to be significant from here. That said, it also makes it unlikely that Sterling will trade pre-crisis heights for a very long time absent a significant improvement in labour productivity, something that I have very low confidence in.

As regards the impact of fiscal policy, I tend to think that both market, media and political consensus is that it will be utterly ball-crunching, and thus if anything, is likely to be less-painful relative to expectations. I have some interesting data on the early-80s, in this respect, but that will have to wait for another day.

As far as the BoE goes, the only thing we are certain of is that Merv is a moron :-)


Mark Thyme said...

Is Merve a moron? Or a swindler?

Leftback said...

Not sure, but we know he does have a good Swerve.

Regarding cuts and hikes, isn't it possible that we are going to go through a protracted period of extensive woofing, jawboning, BSing and general oratory, rather than seeing very much actual action?

One view of the next decade is that, rather than experiencing hyper-inflationary spirals or deflationary busts, we actually go through a rather tedious series of zig-zag mini-booms and busts, enlivened only by the ever-popular inflation v deflation debates among market prognosticators, as they watch the US dollar (and/or its carry trade cousin JPY), sink to its knees repeatedly and cyclically, only to be reincarnated time and time again, to wreak havoc on those excessively leveraged against it.

Anonymous said...

if merve doesn't like bankers or being one himself he should graciously step aside. especially now that he has given himself a nice big pension. hypocrisy stinks.

and agreed on LB comment about more frequent ans hence shallower perhaps cycles.