Too Late For Plan B?

In recent weeks there has been a lot of talk about the need for a Plan B. If not for a Plan B to be implemented now as Ed Balls would advocate, then at least for a Plan B to be drawn up, just in case as the IMF have suggested things don't go as the Liberal-Tories expect, and we enter a double-dip. But, the question now is, is it too late for a Plan B. Moreover, what exactly would Plan B be?

The original idea of Plan B put forward by Ed Balls was that the Liberal-Tories should slow down their programme of spending cuts, and introduce something more in line with the programme of spending cuts that Labour had proposed. But, the IMF in its latest report suggested instead that Tax Cuts would have a more immediate effect, pumping quick additional spending power into the economy. Now Balls seems to have hitched himself to the IMF tax cutting wagon, proposing an immediate £51 billion cut in VAT, reducing the level back to 17.5%

Let's be clear about a few things. The Liberal-Tory argument about the crisis being due to a profligate Labour Government is nonsense, as I showed previously - Here - the vast majority of the debt was accumulated after 2007, when the Credit Crunch began. As I wrote there,

"Public Sector Borrowing and Repayments shows that, contrary to Mike McNair's account, in the period after 1999 up to 2002/3, Labour was actually paying down the debt rather than intervening with Keynesian stimulus under instruction from Capital. Between 1979 and 1997 borrowing accounted for 3.4% of GDP, between 1997 and and 2005 it averaged just 1.2%. Moreover, even when Labour did begin to act counter-cyclically, under Brown, the increase in the deficit was nothing extraordinary. It is clear from the data that the significant change DID come in 2008/9, when, even excluding the amounts pumped into the Banks, net debt rose from 36.5% of GDP, to 43.2%, a bigger cumulative rise than in the previous 7 years combined!"

But, it is also true that, precisely because the injection of all of this spending was an emergency, counter-cyclical measure, it would at some point have to be reduced. So it is true to say that the deficit has to be tackled, the question is how?

In reality, as I have shown in several blogs the Liberals, even during their Coalition discussion with the Tories, continued to believe that the issue of the deficit had been “hyped-up” - Liberal Economy With The Truth. They continued to believe that it would be a mistake to begin to introduce Cuts until the recovery had been secured, which meant not until 2011.

But, the problem is that although, in reality, the Cuts have not started until now, for more than a year, we have had both the Liberals and Tories telling us in the most catastrophic language that the deficit was a huge problem that needed to be dealt with immediately, that we were in the same position as Greece and so on. It was no surprise then that given this massive talking down of the economy, it has its effects last year on what Keynes called the “Animal Spirits”. Workers in the State Capitalist Sector told that they would have their pay frozen, that more than likely they would lose their job, and that they would have to pay more into their pension, not surprisingly pulled their horns in, and began to reduce their spending.

Workers in the private sector warned of tough times, and considering the effects that the Cuts would have on them did likewise. And, businesses reliant on the State capitalist sector for work, or for spending by its workers, also began to take a more cautious approach.

It was no surprise then that the growth that had been established and was beginning to take hold as a result of Labour's fiscal stimulus, began to quickly fade under the Liberal-Tory Government, and by the end of 2010, had actually already gone into reverse. Although, the preliminary figures for 2011 Q1 showed a modest rise in GDP, it only cancelled out the fall from Q4. Yet, all of that is before the cuts have begun to be introduced. All of that was at a time when the rest of the global economy was growing as a result of being pulled along by Asia, and the more dynamic economies, as well as from the fiscal stimulus introduced in the US and elsewhere.

By contrast, in recent months, China has introduced measures to slow down its economy for fear of it overheating. The US, as a result of similar animal spirits taking hold after the election of Republicans, and Tea Partiers, has also begun to slow down. Northern Europe has continued to grow strongly despite introducing its own austerity measures to reverse the fiscal stimulus they had introduced in 2008/9. But, those economies are also reliant to a degree on exporting goods within the EU, including the debt ridden periphery. If Greece defaults to a significant degree – and especially if it is an unplanned default – then EU economies will be sent into a tailspin, and their resources to deal with it, will not be the same as they were to deal with the consequences of the Financial Meltdown of 2008.

For one thing interest rates are already at rock bottom. In fact, as Paul Mason writes the BIS is already warning that global interest rates have to rise to avoid serious problems developing. Paul Mason says, that its unlikely that the Bank of England, under pressure from the Government to keep rates low, will raise rates any time soon. But, that assumes that Monetary Policy is controlled by the Bank of England. It isn't, its controlled by the private financial institutions that create credit, and who also determine market rates through their buying and selling of Bonds.

The Liberal-Tories have made a big deal over the low yields on UK Government Bonds. In fact, the yield on the 10 Year Gilt at the beginning of 2010 was not much different than it is today. It was, in fact, falling as UK growth picked up, unemployment was falling, and borrowing was coming in lower than expected. After the Liberal-Tories came in, the yield, after their June Budget, rather than falling, actually rose to over 3.8%. Today, yields in the UK, as well as in the US, Germany and other large economies are falling to new lows. But, the reason for that has nothing to do with fiscal restraint.

The US has the world's largest deficit, and could technically default itself in August if a deal to raise its debt ceiling is not reached. Yet rates on the 10 Year Treasury Bond are lower than on the 10 Year Gilt. The reason these yields are low and falling, is because there is so much fear about conditions in the rest of the developed world.

If you are a Capitalist, or a large financial institution, you have to invest your money somewhere. At current deposit rates that is even more necessary. But, if you think the European, and large parts of the global economy could be about to be thrown into crisis, you will not want to be over exposed to Equity Markets, where the value of your shares could drop 10, 20, 30 or more per cent, or be wiped out altogether of companies go bust. And, although the yield on Greek Bonds is as high as 30%, you will not want to invest in them if you think Greece will default on those Bonds. So lots of available Capital is being forced to buy UK Gilts, German Bunds, US Treasuries etc. It is also why, CNBC reported a few days ago, that central banks around the globe have stopped selling and started buying Gold. It is why as Paul Mason reports, Switzerland has reported a 50% rise in Gold watches exported to Greece, as people there fearful of a return to the drachma, which could have as much value as a piece of toilet paper, begin to hoard things of real value.

But, a look at the UK demonstrates the problem. The Yield on the 10 Year Gilt is currently 3.2%. But, inflation in the UK is already running at more than 5%. In other words you are paying the UK Government 2% to borrow money from you, because when the Bond is redeemed it will be worth 5% less than you paid for it in real terms. Sooner or later, Bond investors decide that is not a good deal.

The the so called Bond Vigilantes appear. These are the institutions that control huge sums of money that invest in Bonds. They can essentially go on strike, simply refusing to buy Bonds unless their price is substantially lower. A lower Bond price, means a higher yield, and consequently higher interest rates. With increasing opportunities to buy alternative investments through the development of Exchange Traded Funds, for things such as Gold, Silver, and other precious metals, there comes a point when an avalanche of money, a momentum trade simply sweeps out of one asset class such as Bonds, and into these other avenues. At that point, when the prices of UK Bonds falls dramatically – not because of the debt or deficit, but because of rising inflation – actual market interest rates, the rates that firms pay to raise money, the rates that Banks and Building Societies pay to borrow money to lend out as mortgages etc., will rise sharply, whatever rate the Bank of England sets its Bank rate at.

And herein lies the major problem for the UK Government. Its argument has been that by introducing the austerity measures, it could keep interest rates low, and this would facilitate borrowing and investment by the private sector, which would then employ workers from the State capitalist sector, and would generate business via exports.

It was never possible. The degree to which exports needed to rise was greater than Britain has been able to accomplish in living memory. To do so, when its main export markets in Europe, and particularly in Ireland, are themselves suffering economic contraction due to similar austerity measures, is totally unrealistic. But, at a time when the scare stories the Government was forced to tell for the last year to play up its austerity narrative, have already depressed economic activity, and now that the actual austerity measures are set to depress it even more, it is clear that the rash of high street store closures now being seen are just a taste of things to come.

In fact, just as austerity measures in Ireland led to a 60% housing price crash, and a renewed recession, which made paying back its debts even harder, and as we now see the same thing playing out in Greece on an even more acute basis, so the austerity measures in the UK will have a similar counter-productive effect.

When a group of leading economists wrote a letter setting this out a few weeks ago, the Government and others responded that economists had written a similar letter in 1981 in response to austerity measures by a Tory Government, but that in the months to follow the economy actually did grow strongly. But, this is a re-writing of history. In reality, although the Government in 1981 did announce Cuts, in reality it failed to implement them.

Source Data:UKPublicspending

Milton Friedman at the time expressed his frustration saying that, in fact, Tory Ministers had become hostage to their Departments, and the Departments were able to use the Ministers to fight their corner in Cabinet. We can see plenty of instances of Government Departments, already attempting to repeat the experience today, with almost daily stories coming out of the Ministry of Defence for example.

But, the early 1980's were not a period of rapid economic growth, but of rapidly rising unemployment, which is why the Peoples Marches for Jobs were organised. The Unemployment Rates were: 1979 5.1; 1980 6.6; 1981 9.9; 1982 11.4; 1983 12.6; 1984 13; 1985 13.2; 1986 13.3. It is why the Government introduced twenty changes to the calculation of Unemployment to try to reduce the official numbers.

It is why they introduced schemes to encourage older unemployed workers to cease seeking work in return for a higher level of benefit, and its why they introduced various schemes through the Manpower Services Commission, such as the Enterprise Allowance Scheme, which encouraged unemployed people to start up their own business, and in return paid them an allowance for a year that was higher than their Unemployment Benefit.

When growth did begin to increase in the late 1980's, and into the 90's, it was not stellar then, and was punctuated by crises every few years, such as the crash of 1987, and the recession of 1991. But, the reason for the growth that did occur was quite simple. In the late 1980's the Tories deregulated financial markets. They opened the monetary spigots, and encouraged everyone to borrow money as though there was no tomorrow. Coupled with what seemed like free money if you bought shares in the privatisation schemes, where share prices rose by 50% overnight, or if you bought your Council House with up to 60% discounts, and so on, this created a credit boom.

It could work, because at that time, very few people had any substantial amounts of debt. Part of the result was a house price bubble that continues until today, which in turn gave people the illusion that they were better off, and encouraged them to go into even more debt to buy more goods. In addition, many of these goods were falling in price rapidly due to them now being imported from China where costs were a fraction of what they had been when those goods were made in the UK.

But, the very opposite of that is true today, that trick cannot be repeated. In fact, at £2 trillion, private sector debt in the UK, tied up in mortgages, credit cards, student debt, store cards and so on, is more than twice the Public Debt. Instead of being able to take on more debt to finance consumption, households are needing to deleverage, to pay down the debt they have.

In fact, just as the problem for the Greek economy today, of the impossibility of repaying its debt, will lead to a default at some point – and in Greece too private debt is likely to be much greater than Public Debt leading to an even bigger default – so for individuals and families in Britain, a new recession or simply just stagflation is likely to result in those individuals defaulting, which in turn will have a cascading effect throughout the economy.

But, as I said at the beginning, it could be too late now for Plan B. If the Liberal-Tories were to turn around and perform yet another U-Turn, this time on the economy, it would confirm the view that has been quickly taking hold for the last year that this is a weak, inept, and incompetent Government.

That would be likely to send waves of concern through international markets, that would bring a sharp drop in confidence, and rise in risk premium for all UK assets. The only way around that, which is similar to what needs to happen, and, based on news coming out from France today, looks like might happen, in relation to Greece.

My guess, is that in the background the EU has been saying to the Greek politicians, particularly of the opposition, “Vote through these measures even if you have no intention of implementing them. Then we have cover to give you the money.” But, in fact, it looks like even if the Greek Parliament does not vote through the austerity measures, the EU will find a way to stump up the money. It has to because it cannot let Greece fail.

If Greece defaults – and to be clear a default does not mean not paying back all the money it has borrowed, it only means not paying it ALL back, or paying it back over a longer period than originally agreed – without arrangements having been put in place, that will cause panic that will spread throughout the financial markets, with dire consequences as no one knows where counter party risk resides. If, however, Greece effectively defaults, but in advance someone else agrees to pick up its tab, then no such panic results.

What is happening at the moment is EU capitalist States attempting to allow individual Capitalists, and Capitalist Institutions to get their money out, before they lose a large chunk of it. Lending money to Greece as even the Governor of the Bank of England has said cannot solve Greece's problems. But, it can solve the immediate problem of all those Capitalists, and capitalist institutions who hold Greek debt.

Transferring it to EU states, to the ECB, rescues the Capitalists, and leaves EU taxpayers i.e. workers instead holding the debt. But, the EU could then deal with that problem as I've stated before. It could establish something approaching a Federal EU state over the broken backs of the Tory Eurosceptics and their co-thinkers elsewhere in Europe. The irony is that the Eurosceptics were right at the beginning to say that the EU, and certainly the Euro could not survive without Fiscal Union, which also entails a Federal State. The representatives of Big Capital failed to address that issue head on, and instead settled for the usual bureaucratic fudge. Pretty much every Economist is now saying that the survival of the Euro means establishing Fiscal Union. And, its no accident that Tony Blair is talking about the need for a European President elected by popular vote across Europe. Every previous crisis like this in Europe has brought greater centralisation, and it is in the interests of Big Capital to push through such a change now, and once again that interest coiuncides with the interest of European workers. It could then sell EU Bonds, raising all the money needed on global Capital Markets to refinance, and recapitalise European Banks, and State coffers.

Essentially backed by the power of the German State such Bonds could be sold at prices not much lower than current German Bunds. It could then put in place the kinds of policies, like a modern day Marshall Plan, that is needed to invest in and restructure European capital, particularly in the periphery, so as to be globally competitive.

But, that could also be done as far as Britain is concerned too. If the IMF, for example were to stiffen its latest report, and to say that global economic conditions called for a global response from Governments, it could sanction a Plan B, based on fiscal expansion in the UK. It could then be co-ordinated with a similar expansionary policy in Europe.

But, in reality such a development would not be to abandon Plan A, for the kind of Plan B being currently discussed. It would be to go to Plan C or D or F, straight away.

Are UK and EU politicians up to such a move? Time will tell, but in considering their options they should consider the consequences of failing to act decisively and radically in respect of Lehman's.