Stand by for the next UK crash! ETA 2016

Even though the economic policies of the US and UK have been markedly different, there has recently been fair bit of talk on both sides of the Atlantic about how cuts in Govt spending have started to work and budget deficits have started to fall. But budget deficits do always rise sharply after a crash and fall afterwards. So are governments just trying to take credit for what would have happened anyway? Surely not!

Spending and taxation are largely still considered in isolation which is just bad economics.  For example one Conservative MP * recently claimed the collection of an “£100bn a year of extra tax revenue, compared to an increase of £66bn in current public spending”. There is no recognition of how  an increase of £66bn works. If it were spent on wages and salaries about a third would come back straightaway in taxes and nearly all the rest would quickly follow in a matter of months. Given that this extra £66bn creates extra economic activity, taking workers off the dole queue, then it is quite likely the government at least breaks even.

We have also seen claims that the “state deficit will have decreased by 40%” by the time of the next election and that “house prices will be up on average by 16% over the five years” . If house prices were rising because of increased personal income that could be argued to be a good thing but this is not the case at all. Incomes are still failing to keep pace with inflation. The UK economy looks to be in a sad state:

House prices are rising because banks have started to lend again into the housing market. As interest rates are currently ultra-low, much bigger loans can be
taken out than would have been possible previously and so are forcing up prices.

It is generally known that credit bubbles are a bad thing and when they burst a recession is likely to follow. But exactly why is this the case? The best explanation you’ll get from even the BBC, who should really know better, is that a hangover usually follows in the aftermath of a party. Surely we can do slightly better than that!

The mainstream don’t at all make the connection between increased bank lending and the reduction we see in government deficits. But they should. When banks lend they create new money. It is often said they “create money out of thin air”.  That’s what banks do. They don’t take in money from depositors and lend it out to borrowers. That’s a myth. They create their own IOUs, or their own new money, and therefore increase the money supply.

This new money when spent, and respent, attracts the usual government taxes: Income tax, VAT, Corporation tax, National Insurance contributions etc etc. After its been spent and re-spent a few times there is hardly anything left in the active economy. Nearly all of it, except for perhaps some 10% or so, which is saved or spent on net imports, has gone back to government. So naturally the deficit falls! It is really little to do with any cuts in spending or increases in taxation. That spending too would have quickly returned to government in taxes in exactly the same way except it wouldn’t have left the private sector in debt.

Of course when the banks stop lending, as they always will when they start to get nervous that asset prices are getting too high, thus causing them to fall back, the amount of money available in the economy to be spent falls. Taxation receipts fall. Workers lose their jobs and apply for welfare payments. The  government deficit shoots up again.  That’s where we were just after the 2008 crash and may well be again after the 2015 election. Politicians then want to make more cuts in spending and raise more taxes to try to reduce the deficit. The recession deepens.

But, eventually the banks will start lending again, as they do, and so incorrect economic policies do appear to have a positive effect. That’s where we are now.

Tory governments are particularly susceptible to falling into the trap of creating this boom -bust cycle. We’ve seen it before under Chancellors Barber and Lawson. Even the Chinese have recently fallen prey to the idea that cheap credit can permanently boost their economic growth. They will be in just as much trouble as anyone soon, unless they realise what’s been driving their incredible growth in recent years and act now, before it is too late. Encouraging private sector lending seemingly offers a quick fix to the economy by letting the commercial banks create new money, so keeping it off the Governments books and off  the Budget deficit,  rather than directly spending it into the economy in the way Keynes or Lerner would have advocated.

It has a similar economic effect to a Keynesian stimulus for a few years but no longer than that.  It is not the right way to run the economy!

* http://johnredwoodsdiary.com/2014/04/25/capital-gains-tax-revenue-down-total-revenue-up-by-almost-100bn-a-year-under-the-coalition-to-pay-for-extra-spending/