Policy Research in Macroeconomics

Has Labour just dodged a bullet?

Target Practice by WAVES  , California, 1943

Target Practice by WAVES, California, 1943

While Labour and LibDem activists mourn, and political opportunists seize the moment, is the loss of the election such a bad thing? Might this be a good time to lose an election?

I think so. The reasons can be found in both domestic and global financial imbalances, in the advance of de-globalisation trends that are manifest in shrinking capital flows and growing nationalist movements; and in rising geopolitical tensions.

As I write, out in the big wide world there are upheavals in Eurozone and other sovereign bond markets.  Whether this violent volatility will lead to a global bond market crash is an open question, but in just two weeks markets have already marked up almost €1tn of losses.  Shares in booming stock markets have begun to slide, while currency movements are increasingly erratic.

The causes of bond market volatility are unclear. But what we do know is that both the United States and China are slowing down, and emerging markets are dogged by too much foreign-denominated debt. Chinese local governments and households too are heavily indebted (Chinese private debt is 6x larger than in 2007 at about 150% of GDP in 2014) and so the central bank of China is forced to ease monetary policy – by lowering bank rates.  This seems to have sparked an uptick in global oil prices, which in turn has led to fears (irrational in my view) of rising inflation.  Inflation, it is argued, will erode the value of highly priced, low yielding government bonds, and hence the big bond sell-off. (I happen to think disinflationary and deflationary trends are still dominant, driven by weakness in demand from both the Eurozone (‘austerity’), China and increasingly the United States. But hey, deflation is bad news too.)

Given that we were all expecting such bond market sell-offs and instability to occur when central bankers inevitably raise base rates; and given that central bankers are clear such rises are a year or so away – this bond market turbulence seems premature. But let us not forget: central bankers long ago gave away their powers to influence market interest rates. Today these are effectively controlled by a global ‘invisible hand’ that moves in mysterious ways.

Because everyday interest rates are influenced by bond market yields, we can expect today’s rise in yields to translate into higher interest rates on UK and US mortgages and other forms of lending.

This is not good news for British debtors. As a famous (February, 2015) McKinsey Report noted, the UK experienced the largest increase in total debt  (i.e. private finance sector, corporate, household and government debt) as a share of GDP from 2000 – 2008 with its ratio to GDP reaching 469%.  Even adjusting for London’s role as a global financial sector, the McKinsey team concluded that the UK has the second-highest ratio of debt to GDP in the world – second only to Japan.

This is not an economy that will be amenable to higher rates of interest.

Does the new Conservative government have a strategy for dealing with the consequences of rapidly rising interest rates and indebtedness while real wages are still low, and the recovery still precarious?

The threat from a volatile bond market is new. Just as worrying is data from the United States that indicates a slowing recovery there. And then there is the Eurozone – stuck in the stagnant morass of a brutal and sclerotic economic theory: that contracting domestic economic activity, lowering wages and investment and increasing unemployment does the very opposite of what economists would rationally expect. Austerity, it is argued, stimulates economic activity, competitiveness and investment. That theory is once again being tested. But add to the austerity mix imbalances in the form of Eurozone current account surpluses and deficits, and the stage is set for an increase in ‘beggar-thy-neighbour’ policies, social and political unease and increased nationalisms and protectionism.

Britain’s demand for a referendum on membership of the EU, the Scottish demand for independence, and the election campaign itself, are typical of the hostility to ‘globalisation’ and of the growth in inward looking nationalisms across the European Union.

That’s the international picture. Back home we have a lot to worry about. At the top of the list is our ballooning overdraft with the rest of the world.  Will foreign investors continue to finance our global shopping mania? Will they turn a blind eye to our declining ability to manufacture things that will earn income and help repay foreign debts?  Will they continue to buy British services? Or will they expand their own service industries?

The share of UK GDP attributable to the making (manufacturing) of things fell to 14% in 2013. In 1948 it was 41% and in 1990 it was just over 20%. And while manufacturing has declined in most OECD economies, UK manufacturing has declined at the fastest pace of the G7 economies.

The Labour Party had no real policies for reversing this trend, and for correcting the nation’s foreign ‘overdraft’ – and nor does the new Conservative government show much inclination or even promise in this field.

And both parties are relaxed about income from our most valuable assets flowing to foreign governments and investors. As the Telegraph noted “UK Plc is majority-owned by foreigners.” These include the Asian, African, Russian and Middle Eastern ownerships of London property; the Chinese purchase of the Lloyds of London building; the French, German and Spanish ownership of British energy firms. Then there’s the loss of great British firms and institutions to foreign buyers: Abbey National, Boots, Cadbury’s, BAA, Corus (once British Steel), Jaguar, Land Rover, MG Rover, P&O and Pilkington, not to mention football clubs, including Chelsea, Liverpool, Manchester City/United, Aston Villa, Southampton, Sunderland, Cardiff City and Fulham. And some British railway firms have been ‘renationalised’ by foreign governments, as in the case of Deutsche Bahn’s £1.59 billion takeover of Arriva.

Of course Brits mirror these activities and acquisitions abroad – buying new assets or negotiating mergers that generate earnings and income that flows back home.  Until 2011 such UK overseas investments generated more cash than foreign investments in the UK.

But in 2011 the flows reversed. We now have a persistent current account deficit with the rest of the world; at 5.5% of GDP it is the highest since records began.  And those debts, that dependency, ain’t pretty. Foreign lenders could quickly turn tail – and cause the newly elected government big trouble.

There are other UK imbalances – most notably a housing bubble (which may already be deflating) and the credit/debt bubble needed to finance property purchases. Over the last 40 years, house prices have risen faster in the UK than in any other OECD country, far outstripping household earnings growth.

The financial analysts Verum argue persuasively that  “While in the past those aged 35 to 44 have been the main drivers of economic growth, they are now the age group with the highest level of debt, burdened by mortgages and struggling to pay them back amid low wage growth.”

So while British households have used low interest rates to pay down some of their debts, the Coalition government’s determination to push up house prices with a £55bn government subsidy to the private banking sector has stretched the borrowing capacity of the economically active.

And what if there is a sudden crisis or downturn? What tools are available to government or the Bank of England with which to ameliorate the crisis? Interest rates can’t be cut much lower – they are zero bound. Government borrowing is apparently a no-no. And as Frances Coppola argues, more so-called QE is going to have publicly owned central banks “owning all of the world’s government debt” – and a fair amount of private debt.

The fact is that Gordon Brown, Alastair Darling, George Osborne together with Mervyn King and Mark Carney have more or less exhausted the tools and policies available to the UK government with which to tackle the next crisis. And given the latest global market volatility, that might be imminent.

So yes, Labour might just have dodged a bullet.

4 Responses

  1. Considering, chancellors et. al. have used all economic tools …. Actually, Professor Simon Wren Lewis (Oxford, Merton College), and over 30 other top British economists believe, they have not tried all other options; namely, New Keynesian, economic growth stimulus. You could also read Paul Kruegman’s thoughts on this matter. That stated, I’ve thought the same myself and where it not for the fact I’m severely disabled it gave me the thought before the election that it would better for Labour to loose the forth coming election.

  2. Great article. The fact that the Conservatives were so easily able to pin the effects of the banking crash purely on Labours alleged "overspending" shows how ignorant and results orientated the voters are. If Ed Milliband had got in to office his very mild version of social democracy(portrayed as Marxist extremism by the papers) would have been slaughtered if the economy had crashed for one or more of the external factors you outlined. Ed Milliband might be hurting now but will probably be smiling in a couple of years when Cameron/Osborne get found out.

  3. Good post: the rather worrying inference from this, however, is that British people haven’t.

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