Sunday, 21 May 2017

Damien Green Does Not Understand Economics and Finance

On The Andrew Marr Show, this morning, Damien Green accused John McDonnell of not understanding the way government borrowing and capitalism works, in relation to the financing of Labour's proposals for renationalising various utilities.  In fact, it is Green who showed that he does not understand economics and finance.

John McDonnell set out the way that Labour would undertake come of these nationalisations by swapping bonds for shares in the companies.  As I've previously described, I would not even do that.  I would simply pass new company law legislation on corporate governance that made all shares non-voting shares, so that shareholders no longer have any right to determine company policies, or to appoint Boards of Directors.  I would introduce industrial democracy so that the Boards of Directors were democratically elected by the whole of a company's workforce from the senior managers down to the labourer who sweeps the floor.  In that way, shareholders would receive only what they are economically entitled to receive, and what any other lender to the company receives, which is the market rate of interest on the money they have lent to the company.

In fact, the same thing could be achieved by converting such shares into bonds, a reversal of the procedure with so called CoCo's, where bonds are issued by a company, which at a future date can be converted into shares.  McDonnell, however, was talking about issuing government bonds, and using those proceeds to buy the outstanding shares in the company's to be nationalised.  That s what opened a door for Green's comments, but Green was still wrong.

Incidentally, if Labour were to issue bonds to raise money to buy shares, it only needs enough to be able to buy around 30% of the shares in any of the company's because its generally recognised that around that proportion of shares gives you a controlling stake, as the rest of the shareholders are divided, many do not vote etc.  Moreover, Labour could by taking over one or more of these companies, use the balance sheet of that company to be able to buy a controlling stake in other companies, without the government itself raising additional financing.  In addition, it could use the company balance sheet, rather than the government balance sheet to lever up its finances to buy shares in these other companies, as well as issuing additional shares from any of the companies it controlled to raise finance for the purchase of these other shares.   All of that could be done without increasing the size of the state balance sheet.

However, assuming that the government decided to simply issue sufficient bonds to raise the money to buy all the shares in all the companies that it intends to nationalise, Green is still wrong.  Johnathan Portes of the NIESR last week explained that issuing shares to buy shares does not constitute either revenue or capital spending for the government.  It is not revenue spending because it does not relate to current spending, but nor is it capital spending, because it is a below the line debt for equity swap, that simply results in an increase in the size of the government balance sheet.  In other words, on one side of the balance sheet arises an addition liability in the shape of the debt, but cancelling it out on the other side of the balance sheet is an asset, i.e. the company shares, of equal amount.

Green argued that if someone takes out a mortgage to buy a house, the mortgage still represents a debt, even if the house represents an asset, but that is failing to recognise the value of the asset, whilst only recognising the value of the liability!  If we take the revenue consequences then in terms of a house, one way this is often dealt with is to take an imputed rent, as the revenue obtained by the home owner.  In other words, if I was a tenant in the house, or a house of similar value, I would have to pay rent for its use.  As a home owner I do not pay rent, but I either forego interest on the money I have paid cash for the house, or else I pay interest on the mortgage I have taken out to buy the house.  Whether buying the house, by cash or by mortgage is a good deal or a bad deal - setting aside any question of capital gains or losses that might arise as a result of changes in the market price - depends upon how much I would have paid in rent, (the imputed income from the asset) as against what I am losing in interest on my money-capital, or what I am paying in mortgage interest.

In fact, in relation to the purchase of shares as actual revenue producing assets the more appropriate comparison that Green should have made is with that of a landlord who takes out a mortgage on a buy to let property.  There the landlord takes out a mortgage and buys a property, which then then let out and receive rent.  Their anticipation is that the revenue they obtain in rent will cover the interest they pay on the mortgage, and still prove them with excess revenue over and above it.

The case that Labour is making is the same.  They issue bonds, on which they currently would pay around 1-1.25% interest (fixed) dependent upon whether they issued 10 or 30 year bonds to finance the share purchase, whilst they would expect to receive currently around 5-6% in dividend yield from the shares they buy.  In other words, this would contribute around 4% on the investment to Treasury coffers, which would go towards reducing the budget deficit.

Anyone who actually understands finance would think this was quite a good deal.  Unfortunately, Green like most of the Tories actually understand neither economics nor finance.

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