The economics of bond markets and stimulus - or why George Osborne isn't stupid...

LauraW10

tomterm8 wrote: »

I haven't read the FT article, I am over my quota for the week.

Forget Plan B. It’s Plan A+ Britain needsBy Paul Collier
Published: February 3 2011 23:10 | Last updated: February 3 2011 23:10

One snowfall does not make a winter but the prospect of a double-dip recession in Britain is back on the agenda. While Thursday’s purchasing managers’ index, showing a healthy rebound in the services sector, to an extent staunched the pessimism following sombre fourth-quarter gross domestic product data, we can expect a rerun of the debate on how quickly to reduce the deficit – “Do we need a Plan B?”

This is doubly sterile. Since it would amount to a fundamental reversal of policy, it would happen only in the case of political and economic meltdown. More fundamentally, the fears of both sides may be correct: without a stimulus we risk a double-dip recession; with a stimulus we risk a crisis of market confidence. The urgent task for economists is to improve the menu beyond a choice between a 2009-style recession and a 1976-style crisis.

To reduce the risk of a return to recession it would be right to stimulate aggregate demand. The challenge is to find ways of doing this that do not risk a loss of confidence in government debt. Bondholders can reasonably be concerned about a demand stimulus: it indicates a lack of resolve, and it accumulates liabilities. How to address these fears?

Confidence in government resolve is a judgment call on the mettle of the people who are taking public decisions. The economic theory of signalling gives a useful insight as to how markets make these judgments. Essentially, bondholders must look for actions that reveal type: an action by a “good type” is revealing if a “bad type” would not be prepared to imitate it. This is why a government cannot base its reputation on what it says: talk is cheap. To avoid markets interpreting a stimulus as a lack of resolve, a resolute government must distinguish itself from a weak one. It can only do this if it designs a stimulus package which, despite increasing spending, is unpopular. Since increased spending is inherently popular, the package must therefore include offsetting measures that are politically toxic. In effect, a successful package would combine reductions on items that were politically sensitive with larger increases on politically unexciting items. Bondholders can recognise this is something that would be too costly for a populist government of weak resolve.

Even if a stimulus can avoid making the government look weak-willed, by design it cannot avoid increasing liabilities. Bondholders might fear that regardless of government resolve, it is leading the country into insolvency. Appropriate design of the stimulus package can also address this concern. Insolvency is not determined by the size of gross liabilities but by the balance sheet: liabilities relative to assets. An increase in liabilities that is matched by a larger increase in assets actually reduces the risk of insolvency. Feed this back into the design of the stimulus package: the government should reduce recurrent spending, while having a larger increase in spending on investment.

Now bring the two design features together. A stimulus package can avoid increasing the risk of a crisis of confidence if it combines a cut in highly popular recurrent expenditures with a larger increase in those investments that generate only modest political support. The more politically toxic are the chosen cuts in recurrent spending, and the less attractive are investments, the larger can the net stimulus to aggregate demand be for each pound of spending reductions. In effect, the government should cut the budget for the royal wedding of Prince William in April and sack nurses, while building motorways and nuclear power stations. Economic infrastructure should take precedence over social infrastructure, not only because it is less popular, but because the future return in tax revenues is likely to be larger: indeed the recent surge in social infrastructure worsened the prospective fiscal position by creating commitments to recurrent spending. Now is the ideal time for Britain to address its appalling deficit in economic infrastructure: low interest rates and a construction slump will minimise its cost.
Whereas a “Plan B” would require a fundamental reversal of government policy, the proposed package is consistent with existing government priorities. It is a supplement, not a reversal: a Plan A+. It would work by combining three vital properties. It would increase aggregate demand, and hence constitute a stimulus: we cannot tell whether such a stimulus is needed to avert a double-dip recession, but it would be an acceptable insurance policy. It would be politically costly: this would signal a deepening of resolve rather than a weakening. And it would improve the government balance sheet, and so keep Britain clear of the road to insolvency.
The writer is professor of economics at Oxford University

http://www.ft.com/cms/s/0/a0928838-2fcd-11e0-91f8-00144feabdc0.html#axzz1D0Rh91wZ

LauraW10

So please "Nick Mason" explain to me again how this article doesn't make George Osbourne look stupid?

nickmason

LauraW10 wrote: »

So please "Nick Mason" explain to me again how this article doesn't make George Osbourne look stupid?

I somehow think that I won't be able to explain to you - because your perspective and syllogisms seem to work on the "George Osborne [et al] are stupid and evil...therefore" basis. And who knows, maybe I am equally daft and unable to see objectively.

But my interest in the article was that it appears to illustrate that Osborne understands the bond markets, and that he understands the psychology of international perspectives on a country which has got used to living beyond its means. Changing a government is a damned sight easier than changing public expectation - talking about cutting is easy until you see the job cuts, or the removal of services to which we've grown accustomed.

The "observers" will be looking to see the political resolve that Osborne is showing, which will force the public to recognise that the party is over.

IronWolf

Laura what you don't understand is that you can stimulate the economy without a huge budget deficit. Conversely, a huge budget deficit does not equal economic stimulus. This is were Labour fall flat on their face because they assume this fallacy.

I think you missed the entire point of the article, but no surprises there.

tomterm8

nickmason wrote: »

http://www.ft.com/cms/s/0/a0928838-2fcd-11e0-91f8-00144feabdc0.html#axzz1D0Rh91wZ

It's a fascinating article. I'd be interested to hear people's responses - both in terms of economic reality and social acceptability - on the points raised - a few of which:
1) Suggestions that the government should change direction are facile (and so effectively purely political)
2) Government needs to do unpopular things to be credible
3) Stimulus Investment on economic infrastructure not social
4) "Sack nurses, build nuclear power stations".

I guess this Oxford economics professor votes Tory....

I guess I didn't actually get the same thing from your post as I got from the article. What I read in the article seemed to imply that George Osbourne had talked himself into a corner, and the economy needs stimulus, so we need to find a way to have stimulus that minimizes the bad effects of an about turn.

Labour, by the way, proposes no stimulus at all, they want fiscal tightening rather than stimulus (just less of it than the Tories).

I've got to say, I can't agree with him on this. I don't think, now the government has commited itself to cutting the deficit, it can increase public spending creditably in any form if they are to meet the public targets they have already set out.

In any case, while it is hard to disagree with him stimulus is needed if we are about to enter a recession... the idea that sacking nurses and building infrastructure is going to deliver a stimulus now is something I would think any A level economics student would know is a load of hogwash.

Sacking a nurse has an immediate economic impact, because that nurse spends money every month NOW. And she or he would not have that money to spend. Building a nuclear power station will employ most people in five years time. It will take a couple of years to get it past legal stages and planning.

Similar lead times apply to most infrastructure projects.

It is not credible that there are enough such government projects to deliver a stimulus, because the labour government actually brought forward most construction spending on existing projects.

He is an economics professor, it is amazing that he is arguing these things. The only way they make sense is if you think we are going to have a recession that will last more than two and a half years, which, coming so close to the last recession would almost certainly mean a confidence crises anyway.

patman99

I remember a report that 100 top financiers (including the-then chair of the Bank of England) put forward in 1996 stating that due to Tory mis-management of the budget, if Labour were to win the forthcoming election, it would take them to 2018 to get spending ack under control. However, should the Tories win one more term, it would take a Labour Govt until 2035 to undo the damage.

That so-same (now former) Chair of the B of E was quoted on the radio and in the press last week as declaring that we are just 2 months away from a double-dip recession brought-on by the austerity measures introduced by David Cameron, and that even had we not had the snow, growth would have been 0% for the last Q of 2010.

Strangely, of all the countries that introduced 'Austerity measures', only those with GDP on the rise were successful. Those in the same state as us (stagnant growth, rising unemployment) have all gone back into recession.

nickmason

patman99 wrote: »

I remember a report that 100 top financiers (including the-then chair of the Bank of England) put forward in 1996 stating that due to Tory mis-management of the budget, if Labour were to win the forthcoming election, it would take them to 2018 to get spending ack under control. However, should the Tories win one more term, it would take a Labour Govt until 2035 to undo the damage.

Really? I'd love to see that report - your commentary seems so completely and utterly at odds with reality that I'm lost to understand how anyone could see it so. So did Labour manage to do it? Or did they need another 7 years? What, if the economy was such a mess, were they doing sticking to Conservative plans?

My recollection was that the country was sick to the back teeth of the Conservative government, but that the only remaining concern about the Labour government was that it would destroy what was recognised by everyone to be an economy in fantastic shape. Which was precisely why they promised to stick to plans, and precisely why Gordon Brown pacified the city with his golden rules.

That so-same (now former) Chair of the B of E

which one?

Thrugelmir

tomterm8 wrote: »

Sacking a nurse has an immediate economic impact, because that nurse spends money every month NOW.

Many NHS trusts are already running sizable deficits. A legacy of previous funding decisions. As they have had to provide more services for less money progressively every year. So cutting staff will have happened even without the change in policy. As at a point there is little else that can be done to reduce costs.

Labour should have frozen public sector pay. Rather than create an artificial boom with a temporary VAT reduction.

Kohoutek

patman99 wrote: »

I remember a report that 100 top financiers (including the-then chair of the Bank of England) put forward in 1996 stating that due to Tory mis-management of the budget, if Labour were to win the forthcoming election, it would take them to 2018 to get spending ack under control. However, should the Tories win one more term, it would take a Labour Govt until 2035 to undo the damage.

That's a strange story, because there was virtually no budget deficit when Labour won the 1997 election. In their first term, Labour stuck with the outgoing Tory government's fiscal policies, putting the UK into a budget surplus.



The reason the UK had a budget deficit in the early 90s was because of a recession, just like the reason we have one now...Party politics has got little to do with it.

tomterm8

Thrugelmir wrote: »

Many NHS trusts are already running sizable deficits. A legacy of previous funding decisions. As they have had to provide more services for less money progressively every year. So cutting staff will have happened even without the change in policy. As at a point there is little else that can be done to reduce costs.

Labour should have frozen public sector pay. Rather than create an artificial boom with a temporary VAT reduction.

Even under the TORY budget, spending on the NHS is increasing in real terms.

I'm not sure what your point is, to be honest, because if it is that the NHS already need to cut some staff is necessarily getting into the heart of what the article is saying. They would still have to do that in any case if you were to follow the articles advice.

The article is talking about doing those steps, but also cutting the NHS further than already decided in the previous budget to deliver a stimulus in infrastructure projects.

Such an action wouldn't prevent a recession in the near term, it could have no positive effect on the economy until at least two years down the tracks.

The labour governments decision not to freeze public sector pay was a mistake, I was saying they should do so a year ago. I was also saying, well before the election, that the NHS should not be excluded from any cuts that are necessary.