Thursday, 28 October 2010

Economic Theory & The Cuts - Part 4

Almost immediately after the Budget, we saw the large Building Maintenance and Social Housing business Connaught go bust as a result of the announcements. The share prices of many IT Companies went a similar way, as the idea that lucrative Public Sector contracts would disappear for these companies. In the past, Councils have always been somewhat reluctant to simply close facilities, not just because of the public backlash, but because it meant paying out redundancy pay, and losing workers who could not easily got back. With much of the manual work of local Councils now already transferred to private companies, they will have less restraint, and that will immediately hit all of those private companies that have taken over that work. The large number of workers in these private companies likely to face the sack will have a good reason to link up with workers in the Public Sector.

There is another reason that the Cuts will have a bigger effect. One reason that the multiplier is only 1.2 even though most people spend the largest part of their income, is that many of the things we buy are not made in this country. Much of the stuff we buy in the shops is made in China, or other parts of Asia. As soon as the money goes out of the country to pay for those Imports, it ceases being able to act as a multiplier. On the contrary, it acts as a multiplier in China or wherever it ends up. However, a lot of Public Sector spending at least in its early cycles of the multiplier is spent on employing local workers, buying local materials and so on. That is much less likely with say a tax cut, which benefits mainly the better off, and particularly benefits the better-off where they are most congregated in London and the South-East. Spending Cuts, which will have a more pronounced effect in those parts of the country most deprived will then have a multiple negative effect.

Before moving off this point, it is useful to also look at another economic concept connected to the multiplier, to see how this will also have a much bigger effect as a result of Cuts, and particularly in these areas. That concept is known as the Accelerator Effect. It works like this. Suppose a firm makes machines – let's say ride on lawn mowers used by Councils for cutting the grass. It may have work maintaining these machines, but let's say that its main work comes in repalcing them when they wear out. If Council A has 10 of these machines, which wear out at 1 a year, then our company has a regular order for 1 new machine a year. In fact, it would no doubt supply many other Councils on a similar basis. Now, if there is a pickup in economic activity of 10%, which means that new housing estates are built with grass verges to mow, new playing fields are established and so on, all of these Councils find they need additional mowers. They all buy an additional mower as well as replacing the usual worn out one. A 10% increase has led to the demand for mowers rising not by 10%, but by 100%! The mower firm has to hugely increase its productive potential, and of course, the usual multiplier effect then also kicks in.

But, the reverse is devastating to such a company. In conditions where the Councils have to cut back, they not only do not buy additional mowers, but decide to not even replace the worn out ones, cutting back on the grass cutting to make the remaining mowers do. Now the supplier has no work at all – and possibly none for more than year. Not only will many of these firms go bust, but the knock-on effect through the loss of income of its workers, the loss of orders for steel etc. to its suppliers will be significant too. Once again, it can be seen how varying the economic consequences of this can be. Down in Esher, a company engaged in such business might be able to survive, even if it has to cut back, because it will have a demand for its mowers from all of the Stockbrokers and other City types with huge gardens to be maintained. But, up in Gateshead there are not so many Stockbrokers, not so many people with huge gardens or the money to buy sit-on mowers. If Public Sector contracts are lost then in these areas there is very little of an alternative market that these private companies can turn to.

In fact, despite the Tories crowing about the 3rd Quarter GDP figures that came out on Tuesday, showing growth of 0.8%, this shows the problem. A large part of that figure, as with the Q2 figure was accounted for by a large rise in Construction activity. Part of the Q2 figure was explained by changes in the way the number is calculated, and part by the fact that the bad weather in Q1, meant that work was held over. But, nearly all of that work was a direct result of the fiscal stimulus that the Labour Government had introduced in 2009. Without that stimulus, the Q2 figure would have been much less, and Q3 would have been close to zero. Indeed, this is only the Flash Estimate of GDP, which covers just the first two months of the quarter. All of the survey data done by industry organisations, and by Finance Houses over recent weeks, has shown that Construction activity has all but ceased. When the revisions to this figure come out, it is likely that the initial estimates of a figure around 0.4-0.6%, will be closer to the mark, and the trend is very bad news for the likely reading for the Fourth Quarter. However, the Fourth Quarter of any year tends to be stronger, and with the rise in VAT in January, it is possible that spending might be brought forward to avoid the increase. Given the months of announcements by the Liberal-Tories that the economy was as bad as Greece, that we were bankrupt, and that the world's financiers were about to stop lending to us, other than at interest rates through the roof, is it any wonder that many people believed them? Seeing the proposals in the Budget was enough to bankrupt Connaught. The CSR announcements on the cuts in Housing Benefit, and on Social Housing Construction at a time when the private residential market is going into freefall – a picture of the future is presented in Ireland where house prices have already fallen by 50% in the last year – is not going to encourage construction companies to go out and take on apprentices, or buy new equipment, or be buying up large plots of land. Big Capital is already complaining that the Tories Immigration Cap has prevented them from recruiting some of the high level, skilled workers they need, and now Boris Johnson has even come out to declaim the Liberal-Tories proposals on Housing Benefit, as potentially leading to a Kosovo style “social” cleansing of Inner London. Its no wonder that Boris has spoken out, because Big Capital must be concerned that many of those upon whom it depends to keep the cogs of the City Machine working, but who are unseen – the cleaners, the porters, the tube workers – in large part, are the ones who depend on the Housing Benefit, and if they simply disappear, it will not only cause them great problems, but the resulting labour shortage will push up wages considerably for these types of jobs, with a consequent knock-on effect. The announcement of the scrapping of the Building Schools For the Future Programme will mean that the building contracts that many of these companies had been looking forward to have disappeared too, along with the IT contracts to fit them out with computers, networks and other high-tech equipment. Although, the Tories announced some high profile Capital investment such as in Merseyside, the go ahead with Crossrail, and of HS2, the reality is that, as is always the case with Public Sector cutbacks, Capital Spending has taken a proportionately bigger hit than Revenue spending, if Welfare Benefits are set aside.

Moreover, as is usually the case with Big State projects, those that have been announced are drawn out over such a long period as to be almost certainly a waste of money. Just as the UK wasted money on introducing diesel engines on to the railways in the 1950's rather than go for a rapid electrification, so today the timescale for introducing a high-speed rail network is so prolonged that it is almost certain that by the time it is completed, conditions and technology will have changed, and it will be out of date. The same is true of the proposals on high-speed broadband. Where the UK is only taking about introducing high-speed broadband nationally within ten years, countries like South Korea already have a fully developed high-speed broadband network covering the country using fibre, 3G, and wi-fi giving around 100 mbps, and are looking now to move to speeds of 1 gigabit per second!

If we look at the Tories proposals they amount to taking around 7% of GDP out of aggregate demand over the next four years. If we just apply the multiplier of 1.2 to that figure we get around 8.4% taken out over four years or an equivalent of around 2.1% p.a. Reduction in growth. In fact, because the proposals are back-ended, and we are already half way through the current financial year, its likely that we may see something more like 2.5% p.a. taken out in the last three years, and something less than 1% taken out in this year. But, additional demand will be taken out as a result of Tax changes. At best, this paints a picture of stagnation for the next 4 years. But, the reality is that economic growth also depends upon momentum, and confidence. Over the last six months the Tories have done everything they could to damage confidence with their announcements about how bad things are, and were going to become. By emphasising how deep and painful the Cuts were going to be they have added to the despondency and lack of confidence in the future. They have created the very worst conditions they could have done for implementing economic policies that actually will impact on economic activity significantly.

On that basis I would expect the actual growth figure for the whole of Calendar 2010 to struggle to reach 2.5%. That is because I expect the economy to contract or be flat in the Fourth Quarter. It is likely to be that momentum, and the lack of confidence that engenders to be what carries forward into 2011, when a significant reduction in Aggregate Demand will hit the economy early on with £12 billion taken out with the VAT rise in January. Soon after that, workers – though not employers – will be hit with a rise in NI, and, at the same time, they will probably face closure of facilities and increases in Rents, Charges, and Council Tax, as Local Authorities respond to Central Government reduction in their financing, which has been loaded more heavily on to 2011-12. Under those conditions, it is far more likely that the economic growth that had been underway would be choked off anyway. Taking an additional 2.5% out of the economy under those conditions is almost bound to lead to recession.

Of course, the Tories could be right. I continue to believe that globally Capitalism is in rude health. Unfortunately, for Britain and the US and other western economies the centre of global capitalism now revolves around Shanghai, and Mumbai. Britain may, as the Tories hope, be saved by an avalanche of exports on a scale we have not seen for decades. There are some companies capable of doing that, but I fear far too few to make a difference for now. The UK might be saved by an increase in economic activity, in the rest of Europe and North America, but its hardly likely given that the Tories co-thinkers in Europe can see no alternative to austerity, and in the US, Sarah Palin and the Tea Party are in the ascendant. Indeed, despite all the tea and sympathy at the G20 last weekend, the reality is that it is all those policies, being pursued by the same right-wing populist politicians that created the conditions for the Great Depression, and, just as they did then, they tried to look after their own backyard, by various forms of currency devaluation, and Protectionism. The US has already passed the necessary legislation to impose protectionist measures against China, and it can be used against others such as Europe too. In Trade wars as with any other fight, getting the first strike in is always a strategic advantage. That was the lesson the US learned in the 1930's.

In fact, This Report In The Guardian, shows that already happening. Given the close trade ties between the UK and Ireland, it is clear that the fact of Ireland going into recession once again as a result of its austerity measures will have a serious effect on UK Exports.

China and other Asian economies have the advantage that the US had in the 1930's. If the world goes into a Depression, they have huge potential domestic markets, and they have the resources to be able to introduce the kind of Keynesian stimulus that the US did in the 1930's, to be able to ride it out. China, in particular would come out of such a situation as probably the leading global economic power, and would have gained huge global strategic advantage in Africa and Latin America where it has large numbers of bilateral trade agreements. It would occupy the kind of role economically, and militarily that the US did as the world went into WWII. But, for the reasons I have set out elsewhere this is not yet the 1920's or 1930's. This is more like 1900 or 1960. If the West goes into a Depression, it will be brutal, deep, and could last for up to 40 months. But, a consequence will be a massive restructuring and rebalancing of western economies, and with it the world economy. It will set the stage for a massive development of economic forces. But, just as that same kind of process after 1900 and up to 1914, created massive contradictions, and frictions that eventually could only be resolved by WWI and II, so the much greater development this time, will result in even greater contradictions, and an even more violent resolution of them.

Back To Part 3

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