The Challenges Raised by the Global Financial Crisis (Collected Essays)

Home , Global financial system, John Peet (born 1954)

W B (Ben) Vosloo

July 2015

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About the Author

Ben Vosloo was born in the Empangeni district, Natal, 4 November 1934. After completing his schooling in Vryheid, he went to the University of Pretoria where he majored in political science and economics taking the BA and MA degrees with distinction After serving as a teaching and research assistant, he obtained a Ph.D degree in 1965 at Cornell University, Ithaca, New York.

On his return to South Africa, Dr Vosloo began his long association with the reform process in the fields of constitutional change, educational reform and economic development. He served as Professor of Political Science and Public Administration at the University of Stellenbosch for 15 years. He was inter alia member of two direction-setting Commissions: the Erika Theron Commission concerning constitutional reform and the De Lange Commission on educational reform. He published widely in academic and professional publications in the fields of management science, political science and development issues. He held offices as a founding member of a number of academic and professional associations such as the S A Political Science Association, the S A Institute for Public Administration and the S A Institute of International Affairs. During his academic career, Prof. Vosloo received several meritorious scholarships and academic awards.

Ben Vosloo started his “second” career in 1981 when he was appointed as the founding Managing Director of the newly formed Small Business Development Corporation. He steered the SBDC to its successful track record and its unique position of prominence as a private sector led development institution (1981 to 1995). In recognition of his work, Dr Vosloo was made Marketing Man of the Year (1986), Man of the Year by the Institute of Management Consultants of Southern Africa (1989), given the Emeritus Citation for Business Leaders by the Argus Newspaper Group (1990) and the Personnel Man of the Year by the Institute of Personnel Managers (1990), named as one of the Business Times Top Five Businessmen (1993) and by “Beeld” as one of South Africa’s Top 21 Business Leaders in the past 21 years (1995). He acted as co-author and editor of a trend-setting publication Entrepreneurship and Economic Growth (HSRC Publishers, Pretoria 1994) and was awarded an Honorary Doctorate by the University of Pretoria in December 1995.

In 1996 Ben Vosloo started his “third” career. He initially served as a business consultant on strategic policy matters and later became involved in export marketing in the USA, Canada, Europe and Asia. He obtained permanent resident status in Australia in the category “Distinguished Talents” and eventually became an Australian citizen in 2002. He is now retired and resides in North Wollongong, NSW.

The Challenges Raised by the Global Financial Crisis

(Collected Essays)

by W B (Ben) Vosloo ------

INDEX Chapter Page

Preface i

1 The Causes of the 2007 Global Financial Crisis 1

2 The Impact of the Global Financial Crisis 6

3 The Damaged Economies of the Advanced Countries 22

4 Policy Options for Advanced Economies in Distress 41

5 Fixing the Flawed Financial System 54

6 The Perilous Rise of Public Debt 74

7 Unresolved Questions Relating to Deficit Budgeting 84 and Debt Levels

8 Choosing Sound Economic Growth Strategies 91

9 Essentials of Sound Growth-Enhancing Public Finances 106

10 Maintaining Public Sector Responsibility and Accountability 111

11 Major Theories on Economic Growth 120

12 The Limitations of Applied Economics 135

13 Germany’s Precarious Political-Economic Challenges 141

14 The Imperative of Budget Discipline and Monetary Restraint 149

15 Global Growth Patterns and the Risks of Contagion 160

Preface

When the financial markets of New York started to crumble in August 2007, millions of people were unaware of the impending meltdown of the world of finance. The world economy was facing its gravest threat since the Great Depression of the 1930s. By the middle of 2015, the average debt-to-GDP ratio, even in the rich countries, had risen by about 50 percent since 2007. In some cases debt levels have more than doubled. Millions of people have lost much of their savings and investments. Millions more have either lost their jobs or the prospects of finding employment. Experts were at odds trying to explain what exactly caused the crisis. Policy-makers were at a loss selecting the correct measures to deal with the consequences of the crisis. Was it caused by a generic failure of the “free market model” or a specific failure of the Anglo-American finance and banking world? Have those responsible been brought to book? If not, why not? What is the likely outcome of the heavy public debt levels, stubborn unemployment and sclerotic economic growth patterns saddled on so many countries? Is it possible to avoid these economic catastrophes by means of more regulation? Who is to regulate the regulators? Why did all the clever economists fail to see the catastrophe coming? Do they now know exactly how to avoid similar crises in the future? Are the key governmental institutions of society such as parliaments, cabinets and central banks equipped to fight the next financial crisis? What is the best way to generate economic growth? What needs to be done to stimulate business entrepreneurship and investment in order to ignite the engines of economic growth? Should growth be achieved through fiscal stimuli, structural reform, austerity measures, monetary easing or a combination of these?

The essays in this collection have been written over a period stretching from the middle of 2010 to the middle of 2015. The author is a retired professor of Political Science who has developed, over many decades, a special interest in political-economic policy questions – first in relation to South Africa and since his retirement in 1998 in Australia, in relation to social democracies at large.

The impetus to write about these political-economic issues stems from an abiding desire to contribute to a better understanding of the underlying policy options. It is meant to provide useful information and perspectives on important aspects of our lives at the intersection of our economic and political interests.

The significance of the statistical information quoted in each essay should be interpreted within the context of the time at which it was written. Any examination of chronologically arranged economic data shows expansion and contraction of trends. Linear trends are less common, which is the main reason why uncertainty is the condition of all human life.

The author wishes to thank his wife, Madalein, for taking care of the typing, collating and editing of the essays assembled in this collection.

Wollongong July 2015

1. The Causes of the 2007 Global Financial Crisis (2010)

Much has been said in recent times about possible causes of the 2007 global financial crisis. Some blame it on the unbridled greed of the financing network in New York and London; others on the lax regulatory regimes in the USA and the UK. Leftist ideologues claim that the root of the problem lies in the free enterprise system associated with “Anglo-Saxon capitalism”. It is clear that glib single-cause explanations are totally inadequate.

Dodgy Financial Instruments by the Shadow Banking System

A major triggering role was played by the world-wide marketing of toxic securitised instruments by Wall Street investment banks. These institutions bundled sub-prime housing mortgages into a hierarchy of collateralised debt obligations (CDO’s) which they then offloaded on unsuspecting (trusting?) investors around the world. The investors at the end of the chain evidently were not able to monitor the quality of the securities because they were too far removed from the mortgage originators to be able to evaluate the quality of the underlying lending decisions. Moreover, they were snowed under interminable pages of documentation which defied proper scrutiny.

The Economist ‘s “Special Report on the World Economy” dd. October 11th 2008, p.8, states “... the bright new finance is the highly leveraged, lightly regulated, market-based system of allocating capital dominated by Wall Street ... The new system evolved over the past three decades and saw explosive growth in the past few years thanks to three simultaneous but distinct developments: deregulation, technological innovation and the growing international mobility of capital.”

As explained by The Economist, the hallmark of the new finance is securitisation. Banks that once made loans and held them on their books now pool and sell the repackaged assets, from mortgages to car loans. In 2001 the value of pooled securities in America overtook the value of outstanding bank loans. Thereafter the scale and complexity of this repackaging (particularly of mortgage-backed assets) hugely increased as investment banks created an alphabet soup of new debt products. They pooled asset-backed securities, divided the pools into risk tranches, added a dose of leverage, and then repeated the process several times over. Increasing computer wizardry made it possible to create a dizzying array of derivative instruments, allowing borrowers and savers to unpack and trade all manner of financial risks. The derivative markets have grown at a stunning pace.

According to the Bank of International Settlements, the notional value of all outstanding global contracts at the end of 2007 reached $600 trillion, some 11 times world output. A decade earlier it had been only $75 trillion, a mere 2.5 times global GDP. In the past couple of years the fastest growing corner of these markets was credit-default swaps, which allowed people to insure against the failure of the new-fangled credit products.

Although the heart of the new finance is on Wall Street and in London, the growth of cross-border capital flows vastly extended its reach. As a result, financial markets, particularly in the rich world, have become increasingly integrated.

Excessive Lending Creating a Credit Boom

Innovative financing enhanced a much broader access to credit, mainly by a loosening of lending standards. Computers enabled lenders to use standardised credit scores, and the risk-spreading from securitisation made it appear safer to lend to less creditworthy borrowers – particularly at the low end of the American housing market.

Easy credit spread like an infectious disease around large parts of the English-speaking world since the 1980s and subsequently around the world. On the individual level it was manifested by the granting of housing loans to people who could not afford repayment obligations. In addition, loosely controlled credit card facilities were given to minors and under-employed persons. Hire-purchase agreements were made with over-borrowed persons. Household debt in the USA rose from under 80% of disposable income in 1986 to 100% in 2000 and then soared to 140% by 2007. On the level of financing institutions, the accumulated credit derivatives were passed on like a pyramid scheme in ever-expanding concentric circles from centres like New York and London to other financial capitals like Zurich, Paris, Amsterdam, Vienna, Brussels, Frankfurt, Tokyo and Singapore.

Excessive Optimism Created an Asset Price Bubble

Widespread optimism coupled with easy credit, played a major role in driving up asset prices – particularly houses and stock market levels – often in reciprocal interaction. People tend to take rising prices as a cause to buy. Hence, in boom times over-confident investors drive up prices of houses and stock market shares.

The Economist of 20th January 2009, in a special report on the future of finance entitled Greed – and fear, p.8, describes the effect of a virtuous circle of optimism: “Asset prices pull themselves up by their bootstraps. As houses become more valuable, house owners feel richer. If they then spend more, companies make more money, which in turn increases the value of shares and bonds. Profitable companies invest and create jobs. As the economy thrives, there are fewer defaults. Lenders are therefore willing to lend more on easier terms. This extra credit makes asset markets liquid: if ever you need to sell something, there always seems to be a ready buyer. Ample credit also seems to feed into spending and asset prices. That makes people feel richer. And so it goes on ... for as long as people are optimistic...”

Residential, commercial and real estate prices rose at unprecedented rates. Rampant speculation drove the US housing market in the period 2005-2006 to an annual increase rate of 11 percent. By mid-2007 the value of the multi-trillion dollar pool of lower-value mortgages that had been created over the 2003-6 period, started to fall in a self-reinforcing downward cycle which has caused markets to plunge across the globe.

An additional category of mortgage loans called “Alt A”, dressed up as “mid-prime”, to supposedly better-heeled Americans were also soaring at a disconcerting rate. The Economist claims that this market was trumpeted as a means of extending home ownership to those, such as self-employed, with a reasonable credit standing but unsteady income. This market specialised in loans with scant documentation and exotica such as negative-amortisation mortgages, which allowed borrowers to pay less than the accrued interest, with the difference added to the loan balance! (See The Economist, February 7th, 2009, p.64)

Reportedly half of all “Alt-A” borrowers were in negative equity by the beginning of 2009 as a result of falling house prices. Their woes spilled over to holders of these securities. Banks were selling these holdings to hedge-funds and other asset-management firms, often at large discounts. Several European and American banks were holding on to billions worth of noxious assets, exposing themselves to the danger that as unemployment in America increases, even strongly underwritten loans may go bad.

Huge amounts of investment flowed into stock markets and a speculative frenzy drove price indexes up to unprecedented levels across the world in the period 2003-2007. But by August-September 2008 markets tumbled. By early November 2008, the S&P500 in the USA was down 45 percent from its 2007 high. Stock market investors financed by bank credit were forced by margin calls to sell their assets which created a downward spiral. Institutional investors responsible for investing insurance premiums and pension contributions were faced with a massive decline in the value of their investments.

Roger Altman in his recent article entitled “The Great Crash, 2008 – A Geopolitical Setback for the West” (Foreign Affairs, January/February 2009, Vol.88, No.1, p.5) claims that in the USA the “... damage is most visible at the household level. Americans have lost one-quarter of their net worth in just a year and a half, since June 30, 2007, and the trend continues. Americans’ largest single asset is equity in their houses. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008. Total retirement assets, Americans’ second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.”

Global Financial Imbalances

In its January 24th 2009, issue, The Economist, p.65, argued that the “... damage done to the financial system by lax controls, rotten incentives, and passive regulation is plain. Yet underlying the whole mess was the deeper problem of imbalances. A growing number of policymakers and academics believe these lay at the root of the financial crisis.”

The underlying argument is that over the past decade unprecedented levels of liquidity were built up in New York and London as a result of a “global savings glut”. Enormous financial surpluses were realised by the major exporting countries, particularly China, Singapore, South Korea and the oil- producing states of the Persian Gulf. Their balance-of-payment surpluses were consistently recycled back to the West in the form of portfolio investments at investment banks in Wall Street and the City of London. This mountain of liquidity faced lowering yields. Huge amounts of capital started flowing into the higher yields of weak assets such as sub-prime mortgages.

The tidal wave of surpluses kept flowing to Wall Street and the City of London because they were considered to be the most developed financial markets offering the best and safest returns. In most emerging countries, the local financial markets are relatively “immature” in the sense that they do not offer enough trustworthy savings vehicles to absorb the “savings glut”. The USA, and to a lesser extent Britain, was considered the favourite destination for global capital flows on account of its broad and liquid markets for securities.

The tidal wave of capital inflows apparently encouraged financial market operators to create a range of dodgy instruments. Marginal loans were packaged into supposedly safe securities. This supply of

4 credit spurred residential and commercial real estate prices to rise at unprecedented rates. It spilled over into a boom in stock market price levels.

As the USA was sucking in vast amounts of savings from abroad, its own current account (balance of investments and savings) plunged into the red to the level of 6% of GDP in 2006. The USA needed to borrow from abroad to pay for its deficits. A by-product of the vast trade surplus was the piling up of reserves of US dollars, which Beijing then placed mostly in US government securities as well as quasi- state institutions such as Fannie Mae and Freddie Mac. Eventually the upward spiral reversed itself with a vengeance: a catastrophic downward spiral.

Contagious International Capital Markets

In their treatise on the battle between government and the market place that remade the modern world, entitled The Commanding Heights (New York: Simon & Schuster, 1999) the authors Daniel Yergin and Joseph Stanislaw made several observations which are remarkably relevant to the ongoing danger of contagion.

Responding to the question whether confidence in market systems would be affirmed or eroded by the continued move toward markets, they observed that one of the most dramatic signs of confidence was the degree to which people around the world were entrusting their savings and their retirement provisions to the stock market. In mid 1997, mutual fund assets in the USA already exceeded assets in bank accounts by 25 percent – despite the fact that results could not be guaranteed because volatility and risk are inherent to the market system.

“Of all the dangers” they wrote on p.394, “... perhaps the greatest threat ... would arise from massive disruption of the international financial system. Capital markets are growing far faster than the capacity to regulate them – or even to understand them. The very scope and reach of the integrated global markets create financial risks on an unprecedented scale. These dangers result from the inter- connection of currency markets, interest rates and stock markets, along with the extraordinary growth in the various ancillary markets that hinge on them. In the past, financial panics took weeks or even months to unfold. Now contagion can sweep through the world’s markets in hours, endangering the entire edifice.”

At the end of the 1990s an unlucky conjunction did occur. A financial crisis that began in Asia in 1997 spread around the world as a result of the hyper-connection of global capital markets. But many countries did not have the regulatory and surveillance machinery to cope with the ebb and flow of funds – particularly to comprehend the scale of short-term debt that lacked sufficient collateral.

At the time, the IMF led the rescue efforts to reform and repair financial systems in many countries: inter alia South Korea, Indonesia, Russia, Mexico, Brazil and Poland. The strength of the USA economy provided an expanded demand for goods and services. But the first years of the new century also saw the extraordinary ballooning of the US current account deficit, threatening the stability of both mature and emerging markets.

Towards the end of 2007 the unexpected did happen again. This time the convergence of several shocks reverberated simultaneously throughout the global economy – and the contagion started in Wall Street with no apparent stabilising rescue team in sight.

Collapse of Confidence

When pessimism sets in, a self-reinforcing downward spiral is set into motion. As asset prices fall, people spend less, businesses postpone investments and cut employment expansion. Liquidity and credit facilities decline and a value-destroying uncertainty takes hold. Banks become more cautious in granting credit and demand stringent security standards. In a downturn, banks themselves are subject to stringent capital cover requirements. Forced asset sales drive down price levels and markets go into a regressive tail spin.

The failure of the investment bank Lehman Brothers, and the losses that spilled over to money-market operators that held its debt, prompted a global run on wholesale credit markets. This made it harder for banks to find finance. Even healthy banks and companies have been cut off from all but the shortest-term financing. This credit freeze raised concerns about the prospects of the real economy, which in itself added to concerns about the solvency of banks.

Corrective Action Taken

These concerns required prompt action to unblock clogged credit markets by way of central bank action e.g. by buying commercial paper from companies or by guarantees for debts issued by banks. It was clear that the reparation of dysfunctional credit markets would be a prerequisite for opening the road to recovery.

A further plank in the crisis-management policy platform was to boost banks’ capital. By increasing the capital cover banks held in relation to the amount held in their loan books, government injections would catalyse the rebuilding of banks’ balance sheets. Government guarantees of the security of bank deposits were required to stave off the much dreaded “runs on banks”.

The restoration of the health of the real economy proved to be much more complex and demanding. It required various efforts to cushion the negative effects of the economic fallout: growing unemployment, residential property foreclosures, tumbling stock markets, poverty. The traditional tools involved demand management by way of anti-cyclical fiscal and monetary policies. The fiscal side involved stimulatory packages aimed at distributing large amounts of government hand-outs to boost demand, including “pump-priming” through government deficit spending. The monetary side involved the control of money supply through influencing the volume of borrowing and lending by commercial banks by way of lowering interest rates.

The inherent danger of over-zealous efforts to fix American capitalism was seen as governmental over- reaching. It was important to realise that America experienced a failure of its financial system, not of the free enterprise system. To restore confidence required fixing the financial system and to address market failures. This could not be done simply by demonising business leaders and by imposing limitations on performance-related remuneration. The financial systemclearly required better oversight, not more oversight.

In the aftermath of the financial crisis, the worst since the 1930s, the economy shrank by an estimated 2.4 percent in 2009. There was much damage to be repaired: high unemployment, millions of foreclosed homes and a huge hole in the public finances. The world’s biggest economy was faced with the challenge to begin its long overdue rebalancing. American consumption and borrowing could no longer be the engine of its own and the world’s economy.

2. The Impact of the Global Financial Crisis (September 2013)

As the world economy appeared to be slowly recovering from the global financial disaster by the end of 2012, many important questions remained unanswered. What causal factors played a key role? What mistakes were made precipitating the meltdown? Which persons and institutions should take the blame? How can they be brought to book? What policies assisted the recovery? What is the cost of the havoc and expense of the crisis? How is the bill going to be paid? What are the consequences and implications for current and future generations?

Economic Contraction

The overall manifestation of an economic downturn is a “deterioration” of all economic indicators. The most commonly used economic indicators include the “gross domestic product” (GDP), output by sectors, private consumption, retail sales volume, employment/unemployment, average earnings, investment, productivity, price levels and inflation, current account levels, volume of trade in goods and services, exports and imports, public debt and interest rates.

An overall decline in economic activity, mainly observed as a slowdown in output and employment, lasting at least for two successive quarters, is usually called a “recession”. A prolonged period of abnormally low economic activity and abnormally high unemployment – accompanied by falling prices – is usually called a “depression”. Applications of the terms “recession” and “depression” have become a matter of semantics and political propaganda. The underlying issue is the severity of the economic contraction involving a significant decline in economic activity spread across the economy, lasting more than a few months and visible in real GDP, real income, employment, investment as well as output and sales levels.

Counting the Cost

By the end of 2008 the GFC left a trail of economic devastation around the world; a shattered financial system; shrunken tax revenues; rising unemployment; insecure markets; diminished trade; retreating investments; stagnant growth prospects; and, heavily indebted households and governments. Economists were debating the significance of stimulus packages. Friends and foes of free markets were debating the future of capitalism.

According to the IMF’s World Economic Outlook of October 2009, researchers counted the cost of 88 banking crises over the past four decades. They found that, on average, seven years after a crash an economy’s level of output was almost 10 percent below where it would have been without the crisis.

In a recession business enterprises shed labour and mothball capital equipment. The skills of unemployed workers tend to atrophy when they are left on the shelf too long. While assembly lines, computer terminals and office blocks are sidelined, capital stock and production ceilings sink to lower levels.

As reported in The Economist’s “Special Report on the World Economy” of October 3rd, 2009, the investment bank Goldman Sachs calculated that from the start of 2008 to the spring of 2009, the financial crisis knocked $30 trillion off the value of global shares. These losses amounted to about 75 percent of world GDP. In 2009 world output probably shrank by more than 1 percent – the first time

7 since 1945 that the global economy actually got smaller. By the end of the crunch as many as one in ten people in the rich OECD countries had lost their jobs. In the rest of the world it could have been hundreds of millions – no one really knows how many.

In contrast to natural disasters, the damage done by a financial disaster is reflected in the balance sheets of businesses and countries. The higher the climb, the longer the fall. In much of the Western World the assets held by households, businesses and banks were not only pushed to inflated highs but were also accompanied by vast debts. After the crisis the value of these assets was shattered but their liabilities remained standing. After the bubble burst, liabilities far exceeded assets. Hence the crisis has been described as a “balance-sheet recession”. The heavy legacy of debt on the balance sheets of households, businesses, banks and national economies allows past losses to depress future gains. It takes time to return to growth trends. Paying down the stock of debt would inevitably push down output levels below its pre-crisis trajectory.

The direct cost of the stimulus packages is reflected in the sea of red ink spilled over public finances. The stimulus packages wiped out existing surpluses in a few lucky countries such as Australia and created a mountain of public debt accumulating in the wake of annual budgetary deficits. In the G20 as a whole, budget deficits have swung from 1.1 percent of the group’s collective GDP in 2007 to 8.1 percent in 2009. According to IMF calculations, economic decline and fiscal rescues will increase gross government debt in the advanced G20 countries from an average of 79 percent of GDP before the crisis to 120 percent forecast for 2014.

In order to repair their damaged public finances, heavily indebted governments will have to lay out a restoration strategy to calm the markets and forestall a rise in bond yields. With few exceptions governments will be obliged to tighten their budgets: cutting spending and raising taxes. Both strategies will have serious political and economic implications.

On February 25th, 2012, The Economist published the Proust Index showing that advanced economies have gone backwards by a decade as a result of the crisis. The index used seven indicators of economic health which fall into three broad categories: first, household wealth and its main components, financial-asset prices and property prices; second, annual output and private consumption; and third, real wages and unemployment. Stock markets in America lost a quarter of their value in the month after the collapse of Lehman Brothers in September 2008. By February 2012, the S&P 500 regained about 90 percent of its peak value in the late 1990s. So many investors would not have made any capital gains in 13 years. House prices also went backwards by a decade.

Since debts are set at past values (unless creditors specified inflation-indexed accounting), growth and inflation tend to make the burden of borrowing more manageable. But a shrinking economy makes it worse. Indebted countries face the problem of having to repay their debts from an eroded tax base. Measured by real GDP per person, a third of the 184 countries the IMF collects data for are poorer than they were in 2007. Of the G7 group, only Germany has not gone backwards. Asia has also performed much more strongly. In the USA unemployment in 2012 stood at 8.3 percent of the labour force, its 1983 level. In the UK it is at its worst for 17 years and in Greece, Ireland and Portugal employment totals have deteriorated to the levels of two decades ago. Because unemployment scars workers, the time lost to the crisis will never be recovered.

Finance and Banking Turmoil

In the aftermath of the crisis millions of households and business enterprises and scores of banks were left with a stock of debt that, in many cases, will take many years to pay off. It left big holes in their balance sheets. With the financial system on the verge of collapse, governments in many countries had to step in with a variety of measures: to guarantee bank deposits to enhance public confidence and to avoid runs on banks, to guarantee inter-bank loans to increase liquidity, to inject capital into banks with volatile capital structures, to bail out banks on the verge of bankruptcy, to prop up the banking sector through insurance schemes to protect their assets, to lower interest rates to encourage bank lending, to inject capital into “too-big-to-fail” companies to protect jobs, to distribute large cash payments to the general public in order to boost consumer spending and to raise confidence levels. Almost the entire banking industry around the world has had to be bailed out in some way during this crisis.

In the wake of the financial crisis, it is commonplace to demand better surveillance of the financial system by regulators. Yet there is no consensus on the specific measures required. Much attention is focused on the task and toolkits of central bankers. Much emphasis is placed on the central bankers’ prime task to keep inflation low and stable by way of specific targets achieved through transparent interest-rate decisions. But central bankers are now also urged to “lean against asset bubbles” and take responsibility for “macro-prudential supervision” in order to counter financial excesses. Unlike “price stability”, it is less clear how “financial stability” is to be defined, nor is it clear what tools are to be used: eg. higher capital charges for big banks, the use of rating agencies, quantitative easing, or “price-level targeting”. It is clear that the task of central banking is now much harder than before.

Because financial risks recur periodically, there is a tendency to expect regulators to anticipate and prevent them. To avoid a repetition of financial meltdown, governments are considering the appointment of “systemic regulators” – hoping that watchful overseers will ward off financial disasters. Watchdogs are also expected to establish data repositories which will give them proper access to dealers’ trades and inter-bank exposures. Of particular importance is the need to keep a watchful eye on the use of derivatives which are generally considered to be a root cause of the recent financial market mayhem through shifting risks to other institutions in the form of futures, options, forwards and swops. The complexity of these instruments and the ingenuity of derivatives traders call for a vigilant circumscription of its use. If financial institutions are “too big to fail” and if financial instruments are “too complex to understand”, the time is overdue to upgrade scrutiny.

Unemployment

According to Strauss-Kahn, the former head of the IMF, the labour market around the world was struck by the “third wave” of the GFC when it spread from the financial markets to the broader economy. Private sector enterprises, the only long-term sustainable sources of employment, were the first entities to experience a decline in turnover and hence in profit potential. Their survival depends on containing costs – of which the labour component constitutes a major part. The impact of a crisis on employment patterns are determined by several factors: the structure of the economy, market conditions for specific products and labour-market policies. Structural factors refer to the sectoral composition (eg. agriculture, mining and services) and the structural characteristics of business enterprises (eg. Large, medium-sized and small businesses).

The Economist of October 3rd, 2009, reported that in Cambodia 30,000 workers were laid off in the clothing industry as the collapse in trade took hold. In South Africa the closure of mines and smelters cost 40,000 people their jobs. In China an estimated 670,000 small firms went out of business in the coastal cities of Guangzhou, Donguan and Shenzhen.

In its special edition The World in 2010 – Beyond the Economic Crisis, p.80, The Economist’s John Peet comments as follows on what he saw as Europe’s prospects: “A spectre will haunt Europe ... not communism, but the return of mass unemployment. The European economies will recover slowly ... unemployment is a notoriously lagging indicator. The OECD, a think- tank of rich countries, expects it to reach a post-1945 high of 10 percent, or some 57 million people, for the whole OECD club in late 2010; by then some 25 million jobs will have been lost since 2007. In several countries – Spain, Ireland, France, Germany and Poland – the rate will rise above 10 percent.” At the start of 2013 unemployment in Spain stood above 20 percent!

Rising unemployment makes it harder to push through needed labour market reforms. It makes it politically impossible to scrap or blur the divide existing in many countries between protected “insiders” on permanent contracts and unprotected “outsiders” stuck with temporary arrangements. This means that the first and biggest losers from rising joblessness will be the “outsiders”, a group disproportionately made up of the young, women and people from ethnic minorities. Governments are reluctant to weaken job-protection laws or to spend more public money to create public sector jobs.

Since the 1980s, many European governments encouraged schemes to promote early retirement, to shorten working hours and to reduce part-time working. These policies were based on an “atavistic” belief in the “lump-of-labour” fallacy, which holds that there is a fixed amount of work to be spread around. Easing some people out of jobs generates additional jobs for others. Both economic theory and experience have shown this to be false.

When the economic crisis unfolded in Europe, a variety of measures was either already in place or newly introduced to combat unemployment. Traditionally European countries have been saddled with high levels of entrenched joblessness, rigid labour markets and extensive unemployment benefits. The euro-countries entered the downturn with unemployment rates in excess of 8 percent, but managed to contain a rapid rise by way of coherent strategies which use government money to subsidise a shortened work week, to cut labour costs and offer tax subsidies to support new jobs. According to the OECD as many as 22 out of 29 of its member countries have extended support for workers on furlough and 16 have cut payroll taxes and other social contributions. Europe’s governments have focused on keeping people in work in order to avoid lengthy joblessness which leads to skill-erosion and social alienation as people drop out of the labour force.

The German government’s Kurzarbeit-scheme encouraged employers to cut hours rather than jobs. If a worker agreed to shorter hours, the government subsidised wages to offset 60 percent of the loss of income. The number who took advantage of the scheme surged from under 80,000 in 2008 to 1.4 million in 2009 – thereby slowing the rise of unemployment. Subsequently the Kurzarbeit-scheme was imitated in 22 OECD countries.

Britain’s Labour Government introduced a “New Deal” scheme in 1997 requiring young people on benefits for more than ten months to sign up for full-time education, charity work or a subsidised job in the private sector. If they refuse they lose their benefits. The scheme has been extended to lone parents, people over 50, disabled persons and even idle musicians.

OECD countries spent an average of 0.6 percent of GDP on services to get the jobless back to work in 2007. Since the crisis, 23 OECD countries have provided extra training for job-seekers and 21 members have provided extra assistance for finding employment. The main benefit of these policies was to offset the effects of generous and extended unemployment benefits. It is realised that these benefits can tempt the unemployed into welfare dependency. In a financial crisis policy makers are keen to relieve distress and to shore up demand. But it is also crucial to minimise the moral hazard that accompanies comprehensive insurance by way of active labour-market policies. In general governments find it difficult to police benefit abuse and to monitor individual effort by way of public bureaucracies. Equally dysfunctional is the creation of jobs in the public sector for workers who might otherwise become detached from the labour market. These schemes are costly and have a poor record of preparing people for unsubsidised employment. The public sector can hardly be considered as a bastion for the ethos of mutual obligation.

According to the OECD about a third of all workers in their 30 member countries part from their employers every year. Roughly the same number find new jobs. In the USA the proportion is 45 percent. This process of churn allows economies to renew themselves. The entry and exit of firms in business accounts for about a third of this turnover in jobs.

The short-term propping-up of jobs may bribe employers to hoard workers and help to shore up business confidence and consumer demand, but the long-term effects may be costly. Propped-up demand could result in fossilising a country’s job structure, preventing the shift of workers from industries with excess capacity to more vibrant industries. Rather than encourage labour hoarding, governments should promote hiring – increasing a business enterprise’s incentives to hire new workers by waiving or reducing high payroll taxes, especially for additional hires. Heavy labour taxes explain why Europe entered the downturn with far higher unemployment than America.

Consumer Spending

Some of the blame for the financial turmoil of the GFC can be placed on the American consumer spending splurge that reached its climax during the “decadent” years from 2002 to 2007. During the 1950s and 1960s, America experienced a healthy growth rate of around 5 percent, sensible asset markets, balanced budgets and modest trade surpluses. American households saved around 8 percent of disposable income. By the 1980s Americans discovered that they had considerable amounts of equity locked away in their houses. In 1982 their property was worth 106 percent of GDP while their debts amounted to less than 50 percent of GDP. New laws then unlocked this wealth by making it easier for households to refinance their mortgages and borrow against the value of their homes. What followed was a borrowing binge which lasted for 25 years. Eventually household debt peaked at 138 percent of disposable income in 2007. After 2007 households watched in horror how their net worth plunged and started to save more. With a huge decline in the net worth of households, it is to be expected that anxiety would lead households to replenish their buffer stock of wealth as a hedge against misfortune. Historically, household net worth averages at around 500 percent of disposable income. With uncertainty in the air, it was to be expected that households might require a fatter cushion which, in turn, would require a higher savings rate.

For many years before the crisis, the world economy relied heavily on the American consumer. It provided a major market for the products of Japan, South Korea, Taiwan and, in recent years, also for China. It is clear that new markets had to be found elsewhere. According to the Economist Intelligence Unit, China’s current account surplus was projected to be at least half of Asia’s surplus and 30 percent

11 of those around the world for the period 2010-2013. The counterparts to these surpluses were deficits in places such as Britain, Spain and most notably America.

One reason why the Chinese save so much is that they have to pay for such things as education and health care which are not provided by the state. China’s pension system leaves out over half of urban workers and 90 percent of their rural counterparts. In addition, Chinese find it hard to borrow. Only a small percentage of younger households have a mortgage and those who do try to repay it in five years. It is even claimed that households with sons accumulate assets, especially houses, in order to compete in the marriage market. This bids up asset prices and encourages saving. The Economist calculated that the share of wages and other household income as a proportion of GDP has fallen from 72 percent in 1992 to 55 percent in 2007. That explains why China’s consumption accounts for only 35 percent of GDP. Household income accounts for a small slice of the national cake. A larger share of national income flows to capital in the form of profits. These earnings mostly stay with the companies that generate them as about 45 percent of listed companies do not pay dividends. Aggrieved shareholders seem to have little clout. Small firms retain earnings to finance their ventures because they are neglected by China’s banks. Thus it appears that saving by companies, not households, accounted for most of the increase in China’s thrift in recent years.

China’s savings financed its strong investment activity which, in turn, added to the economy’s capacity to produce things. By keeping the Yuan competitive, the products were sold on world markets. Over- investment led to under-consumption which the Chinese authorities solved through under-valuing of their currency. The exporters that benefited from the cheap Yuan provided a large proportion of China’s jobs.

Wealth Redistribution

In Australia a Reserve Bank study found that the GFC was a wealth leveller, bringing a reduction in social inequality. The poorest fifth of the population enjoyed an increase in the value of its assets averaging 5 percent a year since 2006. The richest 20 percent, by contrast, saw their wealth rise by only 1 percent a year. The large bulk of Australians between these two extremes increased their wealth by 2 percent a year. This divergence is explained by the fact that high-income households had a larger share of their wealth in high-risk asset classes, such as shares and trusts, which fell in value between 2006 and 2010. Falling markets reduced the value of financial assets by 5 percent a year. Real estate continued to appreciate in value over the period. It was also found that wealth remained more unequally distributed than income. In 2010 the wealthiest 20 percent of the population held 62 percent of total wealth with the average in this group holding assets of $1.5 million. This was four times the assets of the middle 20 percent of the population, which held assets of $400,000 and ten times the wealth of the second lowest 20 percent, which held $150,000. (The Australian, 16 March, 2012, p.4)

Persistent China-USA Economic Imbalances

In the aftermath of the GFC, the world’s trade and currency patterns continued to be dominated by the China-USA economic imbalances. China’s economic ascent during the past twenty years followed the pattern set by Germany and Japan in the post World War II years: an export-led growth. By pegging its currency to the US dollar, China avoided the appreciation of the renminbi and thereby promoted its own export competitive strengths. Its soaring exports allowed China to build up large foreign currency reserves.

This dilemma is well described by two economic historians, Niall Ferguson and Moritz Schularick in an article entitled “Death Throes of a Monster”. (See Weekend Australian, November 21-22, 2009). The combination of the Chinese and American economies (described as “Chimerica”) covers 13 percent of the world’s land, about 25 percent of its population, accounted for a third of global economic output and two-fifths of world-wide growth between 1998 and 2007. The two authors claim that the “Chimerica” symbiosis consisting of a combination of Chinese exports and American over- consumption enabled China to quadruple its gross domestic product between 2000 and 2008, to raise its exports to a factor of five, to import Western technology and to create tens of millions of manufacturing jobs for its rural poor. For the USA “Chimerica” meant being able to consume more, save less and maintain low interest rates. Over-consumption meant that between 2000 and 2008 the USA outspent its national income by a cumulative 45 percent – with goods imported from China accounting for about a third of that spending spree.

The Chinese intervention in its currency exchange rate resulted in a growing distortion in the global cost of capital, significantly reducing long-term interest rates and helping to inflate the real estate bubble in the USA. The Chinese credit line allowed the USA to continue over-spending while China’s foreign reserves continued to soar. Its undervalued currency continued to give Chinese export firms a major competitive advantage. Despite much talk to reduce the glaring global imbalance, China has continued to buy American debt to keep its own currency low and hence its exports cheap. Likewise, the Americans remained eager to encourage the Chinese to continue buying the piles of dollar- denominated securities offered by the American Treasury.

As the US dollar weakens against other currencies (eg. the euro and the yen), so does the Chinese renminbi, thereby magnifying China’s already large advantage in global export markets. The spill-over effect is that the burden of post-crisis adjustment falls disproportionately outside the US-China relationship.

Ferguson and Schularick described the US-China relationship (“Chimerica”) as a 10:10 deal which serves China better than America. The Chinese get 10 percent growth and the Americans get 10 percent unemployment. The deal was even worse for the rest of the world – including the US allies in Europe. The heavily undervalued renminbi was considered by Ferguson and Schularick as the key financial distortion in the world economy today. It could bring to an end the existing open global trading regime.

Inflationary Pressures

Many factors contribute to inflationary pressures: high levels of unproductive government spending, wage increases for unproductive labour, higher producer prices for uncompetitive products, higher energy prices and transportation costs as a result of cartel manipulation, carbon pricing, or a general mismatch between aggregate demand and aggregate supply.

The inflationary impact of the comprehensive interventions of governments around the world in the last four years is still not clear. The jury is still out on the question whether demand-side policies and supply-side policies were kept in proper balance. Inflation pressures could in the medium term be held in check by surplus (or idle) capacity in many countries. Interest rates were lowered to unprecedented levels to enhance spending and investment.

Massive amounts of money have been pumped into most economies by huge stimulation packages – mainly to strengthen demand and to contain unemployment. Outside of China, relatively little was done by way of supply-side measures. The impact of the vast volume of money that was brought into circulation by quantitative easing implies very strong inflationary pressures in the future. The gap between the massive growth rate of monetary expansion and the growth rate of the GDP is huge. Much depends on how the rich world manages its debt position. As debts grow, the threat of inflation grows too because the measures a country needs to take to prevent inflation are so difficult. There are only three ways to reduce the debt: raising revenue, cutting expenses and inflation.

Growth of Big Government

A lingering consequence of the financial crisis is the world-wide expansion of the state’s reach: its debts, its taxes, its authority, its scope – in short, the burden of its interventions. The ratchet effect of a crisis on the reach and authority of the state does not recede when the crisis passes: the state never returns to its previous limits. As a result of the emergency measures taken to avert economic collapse and the general mood to introduce new interventions to expand welfare state benefits and to combat climate change, the role of government is rapidly expanding. But the resources to support the Leviathan are limited. Tax revenues have been shrinking and public debt levels growing. The average budget deficit in the 16-country euro area rose to 7 percent for the year 2010. Total public debt is expected to rise to 120 percent of GDP in the euro area by 2014. For 2012, of the 40 countries listed in The Economist’s Economic and Financial Indicators, only 5 (Norway, Switzerland, South Korea, Chile and Saudi Arabia) could claim budget balances in surplus. Public debt could spiral out of control unless spending is reduced or taxes are raised.

Floods of money have been allocated to cash handouts, make-work projects and hiring extra government employees. In the depth of the crisis governments focused on the short term: on preserving jobs rather than structural reform or investment in productive assets. Many countries now face the challenge of repairing their balance sheets.

There is a striking variation in the size of the state and the structure of taxation among the various countries covered in the table entitled Government Taxation in Selected Countries (2007). The table shows government revenue and its sources for some of the world’s biggest rich and emerging countries. The state’s role is most prominent in France where almost 50 percent of GDP flowed through the state’s coffers in 2007 (the most recent year for which comparative statistics are available). In China, government revenue accounts for less than 20 percent of GDP. Total government revenues are a bigger share of the economy in Europe than in Anglo-Saxon economies and are higher in richer countries than in poorer economies without generous social safety nets. Brazil’s government revenue is bigger relative to the size of its economy than is the case in America.

Government Taxation in Selected Countries (2007)

Advanced Economies Developing Economies

Australia Britain Canada France Germany Italy Japan USA Brazil China India Russia

Total revenue, % GDP 35.9 41.8 41.4 49.6 43.8 46.4 34.5 33.7 34.8 18.1 22.3 47.7

Total tax, % GDP 29.5 37.7 34.8 44.7 40.4 43.0 28.2 28.0 32.3 16.4 18.9 33.2

Total tax, $bn 268.5 1055.6 496.7 1161.2 1344.6 910.5 1230.2 3941.7 430.7 435.9 207.8 429.7

Structure, % of total tax

Income and capital 59.2 37.8 49.9 23.4 30.9 34.2 35.4 48.3 32.3 28.4 47.7 26.0

People 37.5 28.7 36.2 16.7 23.5 26.7 18.5 37.5 na 7.4 17.1 na

Companies 21.2 9.1 12.4 6.6 3.4 7.5 17.0 10.8 na 21.0 30.7 na

Employment 4.5 nil 1.9 2.7 nil nil nil nil 6.0 nil nil 7.9

Property 9.1 12.0 9.7 10.2 2.1 1.9 9.1 10.9 0.1 0.9 0.1 nil

Goods and services 25.4 28.1 22.4 24.1 26.2 28.7 18.6 15.6 25.3 64.9 34.1 24.2

consumption 13.2 17.0 13.7 15.7 17.0 14.1 9.2 7.6 na 49.0 0.2 na

Excise 7.4 8.5 4.4 4.5 6.5 4.8 7.4 3.5 na 15.3 23.8 na

Other 1.9 nil 1.0 Nil nil 4.4 nil 0.7 11.5 5.8 18.0 22.0

Social contributions nil 22.0 15.0 40.2 40.8 30.8 36.6 24.5 24.9 nil 0.2 18.3

(Based on information in The Economist, November 21st, 2009, p.79)

The table indicates that taxes of varying kinds form the bulk of government’s revenues. Non-tax receipts, eg. profits from state-owned enterprises are often significant sources of cash, especially for commodity exporters. Russia’s overall government revenue, which includes oil proceeds, is almost 50 percent of GDP. Government tax income is closer to 30 percent.

There are significant differences in how governments raise their funds. Anglo-Saxon economies tend to rely most on income taxes (on wages, profits and capital gains). In Australia 60 percent of tax revenue is raised from such levies. In the USA it is almost 50 percent. Most governments derive the bulk of their income tax revenue from individuals. European countries derive a bigger share of revenue from payroll taxes and other social contributions as well as indirect taxes on spending. Brazil’s tax structure mirrors that of European countries. China and India raise a large proportion of their revenue from expenditure taxes. Although the top rate of marginal income tax in OECD economies has fallen from an average of almost 70 percent in 1981 to just over 40 percent in 2007, the total tax take and the total share of the state in the economy has risen to alarmingly unsustainable levels. (For detailed analysis see “Public-sector Finances: The State’s Take”, The Economist, November 21st, 2009, pp.78-79)

Under the title “Leviathan Stirs Again”, The Economist, January 23rd-29th, 2010, turned its focus on the recent world-wide growth of the state. As global markets collapsed, governments intervened on an unprecedented scale injecting liquidity into their economies and taking over or rescuing banks and other companies considered “too big to fail”. In the USA the government bailed out the banks and took control of General Motors and Chrysler. The British government stepped in to run some of its largest banks and guaranteed deposits.

But The Economist pointed out that the state was on the march in much of the world long before the onset of the GFC. In the UK public spending was gradually increasing through much of the 13 years of Labour Party government. Public spending increased from 40.6 percent to 52 percent of GDP in 2008.

During Labour’s government, two-thirds of all new jobs created were driven by the public sector. In addition, the salaries and pensions of public sector workers rose significantly faster and higher than those in the private sector. Even the Bush administration in the USA presided over a period of increased government spending on the wars in Iraq and Afghanistan and on homeland security. He also increased entitlements under Medicare. It is expected that as a growing number of Americans become eligible for Social Security and Medicare assistance, entitlement spending will grow from 9 percent of GDP in 2009 to 20 percent in 2025. Demography is expected to push state spending to ever-increasing levels. The United Nations predicted that the proportion of the world’s population that is over 60 will rise from 11 percent in 2009 to 22 percent in 2050. In the rich world one in three people will be pensioners in 2050 and one in ten will be over 80 years of age.

Apart from raising their spending levels, governments are also expanding their regulatory roles. Policymakers are drawing up new rules on more aspects of societal life from carbon emissions to bank capital. In the UK the government has installed one CCTV camera for every fourteen people.

State capitalism has also been given a major facelift. New corporate entities have emerged on the international scene in the form of state-owned or state-controlled companies. Many of these are based in China, Russia and the Gulf States. Sovereign wealth funds are also of increasing importance in the world’s financial markets. An estimated 75 percent of the world’s crude-oil reserves are owned by national oil companies. The new form of “state capitalism” is using the market as an instrument of state power. Malaysia’s Petronas and China’s National Petroleum Corporation are said to run businesses in some 30 countries. Governments are the hidden hands behind companies that are scouring the world for raw materials and investment opportunities.

It is clear that the 20th century debate on the proper role of the state is back on the world’s agenda with a vengeance. The recent examples of “market failure” have re-opened much scope for the re- emergence of “government failure”. Barack Obama, in his inaugural address, stated that the question today is not “... whether government is too big or too small, but whether it works”. This type of open- ended pragmatism is not encouraging. Governments need to clean up the irresponsible looseness of the finance industry while they simultaneously stem the growth of entitlements and public sector privileges. If they do not succeed, financing disaster will strike again while the welfare state collapses under its own weight. The re-emergence of the Leviathan state should be a matter of great concern.

Deficit and Debt Reduction

Although continued fiscal austerity and a return of business confidence may hold the promise of gradual economic recovery, the road to recovery in the rich countries is going to be long and steep. On both sides of the Atlantic the rich countries are struggling to reduce their budget deficits – let alone the task of reducing their mountainous piles of public debt. It is not enough to aim at stabilising the public debt as a share of GDP. As long as deficit budgeting continues, the gross debt will continue to rise.

There are essentially two categories of debt reduction: the reduction of mandatory spending and the reduction of discretionary spending. All the long-term pressure on the deficit comes from mandatory spending on the large entitlement programmes (eg. on health care and spending on the poor and elderly) that are taking up a hefty portion of every year’s budget expenditure side. Spending cuts on the discretionary side are politically more appealing because it arouses less anger than cutting entitlements or raising taxes.

Public sector spending cuts have important consequences not only for the GDP accounts but also for investments in intellectual and physical capital. These investments are not part of mandatory expenditure – they depend on explicit discretionary allocations. It includes research and transport infrastructure. Cuts in these areas hit the wrong kind of spending and do not solve the long-term problem of debt reduction. To really solve the debt reduction problem would be to combine entitlement reduction with modest tax increases.

Public discussions of debt reduction are generally obfuscated by semantic problems: what is the real magnitude of the outstanding debt? Does it encompass the gross national debt which includes total public sector and private sector debt to cross-border creditors? What part of government debt is locally held and what impact does it have on future prospects? At what level does the size of national debt become excessive? What strategies are available to reduce excessive debt levels?

In the case of a private individual the calculation of net debt offsets the value of assets owned by the debtor against the amount owed. Much depends upon the accurate valuation of those assets. In the case of a country or the government sector of a country, calculating both the gross and the net debt positions is much more complicated. Governments have the power to tax and to print money. In the case of the EU or euro zone countries, governments can rely on the guarantees or transfer payments from other member governments. Some of the major European banks such as the Rothschild Group, Barclays, Standard and Deutsche Bank have branches or divisions in several countries which raises the question whether the creditor is local, national or international. A country’s credit standing depends upon the nature of their financing problem: eg. whether it is solvency or liquidity. The total debt of a country should be roughly equal to its accumulated budget deficits, but their debt could be much larger if they moved their borrowing off their balance sheets in order to meet their deficit targets.

The history of official obfuscation and denial (or simply cooking the books), shows that little faith should be placed in official statements of reassurance. Debtors usually claim they can service their debt, just as alcoholics deny they have a drinking problem. Fiscal straitjackets to tackle debt problems come in many shapes and sizes such as balanced budget rules, constitutionally ensconced “debt brakes”, offsetting budget fixes, limits on debts or spending, etc. The problem lies with compliance or enforcement.

The euro area’s stability and growth pact (Maastricht Treaty) was supposed to trim their structural deficits by 0.5 percent of GDP per year or face fines if they ran deficits larger than 3 percent of GDP. But sanctions were never applied. America’s “debt ceiling” has been raised 76 times since 1962. Every time, amid a heated political battle, the ceiling has been raised to stave off default.

Another alternative strategy to deal with excessive debt is for creditors to accept some form of “restructuring” or “reprofiling”. Restructuring usually involves partial debt write downs and reprofiling involves deferring payments over a longer maturity period. Putting off bond repayments for a few years would mean that official rescue funds would last longer and put the finances of the ailing country onto a sustainable footing. But in serious cases, such as Greece since 2011, reduction, not temporary rescheduling, was needed. Reducing the principal and lengthening maturities would be less painful than default.

17 excessive debt. It claims that austerity hurts economic growth because it damages demand levels. It says that what matters is how austerity is imposed and what other policies accompany it. As for other policies, the main lesson is that austerity hurts more if it is not accompanied by bold monetary loosening. (The Economist, October 27th, 2012, p.11).

In its enthusiasm to promote monetary loosening, The Economist overlooks the simple reality that you cannot solve deep-rooted structural problems by monetary engineering. Failing economies with mountainous debt burdens require a growth strategy based on igniting the engines of business entrepreneurship on a decentralised scale. A few Googles, Facebooks and Apples in America cannot do the trick. The Economist itself has moved a long distance to the left from the classically liberal policies of James Wilson, its founder. Its policy proposals should be carefully scrutinised.

The Price of Uncertainty

Since the onset of the GFC, a cloud of uncertainty has hung over the global economy. Political decision makers and experts have been at odds over how to solve the co-existing debt and financing crises. Consumers and investors are the main victims of this uncertainty: collapsing house prices, falling stock markets, failing financial institutions, anaemic growth prospects, persistent unemployment, etc. As uncertainty looms, consumers hang on to cash or even withdraw deposits while looking for secure places to keep enough money to cope with day-to-day needs. Investors delay or even postpone investment decisions because they don’t know how the crises will unfold.

Uncertainty curtails growth. Investment, the prerequisite for growth, depends on expectations which, in turn, are subject to wide fluctuations. Since investment is not reversible without cost, uncertainty increases the value of more relevant information and thus discourages investment. Uncertainty raises the value of hoarding cash and waiting to see what happens. Policy uncertainty and traumatic economic conditions are detrimental to economic growth because it deters consumer spending and defers the hiring and investment decisions of business leaders. As a result, the downward pressure on the economy is intensified.

Roads to Recovery

In the wake of the Global Financial Crisis, an avalanche of monetary and fiscal policy measures was introduced around the world. Political leaders had to set a course between the Scylla and the Charybdis of macroeconomic policy-making: avoiding the dangers of deflationary pressures that could lead to a fully-fledged depression while at the same time keeping an eye on the dangers of inflationary pressures that could unleash hyper-inflation. A prolonged contraction of economic activity (particularly output and sales levels) results in a confidence-shattering downward spiral. A zealously leveraged expansion of economic activity based on lavish public and private debt inevitably unleashes the inflationary pressures of cumulative price increases that can spiral out of control.

In the post-crisis period the world’s wealthiest nations piled on an unprecedented debt load to finance their stimulus packages. They were able to acquire the debt on the strength of their good credit reputations, their steady income streams and plenty of friendly investors prepared to buy their bonds. Less developed nations could not rely on similar strengths and had to fall back on international agencies such as the World Bank and the IMF. Some countries like Japan and Italy now carry debt that exceeds their annual output. Emerging economies such as Argentina have crumbled under such burdens in the past.

As government spending soared to bail out banks and resuscitate their economies, their tax revenues fell because of declines in the incomes or profits of taxpayers. Most governments faced the challenge of doing enough to end the crisis without digging an inescapable debt hole. It was imperative to do whatever it took to restore confidence and stop a recession from becoming a depression. Confidence is a pre-condition for economic growth based on the widespread resumption of productive economic activity. Governments of the hugely indebted countries faced the task of producing credible fiscal retrenchment plans or exit strategies to reduce their debts.

The scale of this task proved to be larger than anticipated. It encompassed injections of public capital into banks and manufacturers as well as guarantees on bank debt. As a result, rich world financial markets were heavily underpinned by potential government liabilities of trillions of dollars. Interest rates across the biggest economies have remained at or below 1 percent. As a result of their lavish “quantitative easing” to pump in liquidity, the balance-sheets of central banks in Britain, America and the ECB have risen to over double their pre-crisis size of less than 10 percent of GDP. Central Banks adopted policies to do whatever was thought necessary to revive their economies by expanding the monetary base and by reducing interest rates.

There are no “one size fits all” solutions to the dilemma of choosing the right mix of policy settings between short-term looseness and longer term prudence. Countries in bad shape have no alternative but to tighten fiscal policy and ride out the pain of spending cuts and raising taxes. Surplus countries could stabilise interest rates and allow their currencies to rise. Euro-zone members, however, remained constrained by monetary union rules – despite their diverse economic conditions.

By the beginning of 2013, it was still not clear which active monetary or fiscal policies staved off the onset of a deep economic depression since 2008. Was it the extensive stimulatory fiscal activity, the conventional monetary interest rate reductions, or the unconventional balance sheet operations that saved the day? It is not even clear what exactly caused the “mess”, or when a recovery will be well and truly on its way.

In retrospect, it could be said with justification that it was the general infatuation with short-termism – whether within individual households or within the business and political environments – that precipitated the economic malaise of the recent past. The obsessive focus on the short term penetrated board rooms, regulators and the 24/7 media cycle. It permeated investment decisions, performance ratings, news coverage, policy objectives, career planning, employment practices, bottom line priorities, strategic horizons, executive rewards, share option schemes, equity market volatility, untamed derivative extravaganza, etc.

There is much to be said for a return to basic principles: to promote savings to finance investments; to reward innovation and productivity; to advance efficiency standards; to enforce responsibility and accountability; to safeguard transparency; to pay staff for performance – preferably in deferred stock awards as well as cash to ensure long-term success; to ensure that banks are better capitalised; to improve accounting standards; to clean up derivatives trading practices; to root out insider trading and the financing of world cronyism. When the battle against the GFC and its aftermath eventually winds down, the critical question will remain: what needs to be done to avoid similar disasters in the future?

A few indisputable facts of economic life stand out. The creation of wealth by a society requires value- adding, productive work. You cannot sustainably raise the standards of living in a society by handouts, gifts, robbery or inheritance. These forms of wealth acquisition represent merely the transfer of existing wealth. Without economic growth which is strongly embedded in a vibrant economy, society will be condemned to impoverishment. A better quality of life for all generally calls for higher incomes to spend on consumption. It goes without saying that the average consumption per capita cannot sustainably increase unless the average production per capita, i.e. productivity, has increased. Thus living standards essentially depend on productivity. It is the purpose of all economic activity to create the maximum amount of wealth while preserving the environment and distributing this wealth fairly among all the contributors. Productive efficiency depends on the ratio between the goods and services produced on the one hand and the resources used to produce them on the other.

Why have some countries succeeded while others have failed? Discrepancies are partly to be explained by unique factors such as rich natural resources, a strong work ethic, a literate and skilled population, a sound industrial base, a sound infrastructure, efficient public sector services and a progressive frame of mind. Countries that have succeeded in achieving significant economic growth in recent decades have several features in common:

- they invested wisely in education, training and in physical capital infrastructure; - they achieved high productivity from their investments by giving private initiative and enterprise in the form of markets, competition and trade leading roles; - they encouraged new ideas, technological innovation and efforts to achieve efficiency in the production of goods and services; - they found complementary ways of interaction between government and market roles for efficiently organising the production and distribution of goods and services; and - they have nourished entrepreneurship as the link between innovation and production to identify new economic opportunities, to take risks, to change methods of production and distribution, to do long-range planning, to assume individual responsibility and to marshal and manage production skills and resources.

Despite the double-talk of political campaigns and occasional lapses into populist rhetoric, no important country in today’s world looks to socialism – defined as a political doctrine of class conflict rooted in the rejection of private ownership and a faith in social control of the means of production – as a model for development. Most growth strategies today in most parts of the world usually involve a diminished role of the public sector and a greater reliance on the private sector. The rise of the market sector continues to be a mega trend in today’s world. China’s spectacular ascendancy as a world power was based on the market-friendly reforms introduced by Deng Xiaoping by the mid 1980s. It gradually reduced the government-owned sector to around 30 percent nationally today. Unfortunately, the iron- grip of the Communist Party has not been diminished simultaneously.

During the global economic meltdown producers of sophisticated machinery such as Germany, France and other West-European countries faced grave problems with the shrinking markets for their export products. Germany retained its position as the powerhouse of Europe by successfully persuading its people to adopt appropriate austerity programmes and by working harder and longer. The USA and the UK have been severely battered by the collapse of financial services. Resource-based economies like Canada, Australia, South Africa and Brazil were well served by their mining sectors. But without the marketing opportunities offered by China, Japan, South Korea, Taiwan and India, all resourced- based economies would have been in dire straits. On the whole, the political and economic

20 consequences of the GFC have been milder than predicted. Loss of output in emerging markets was less than had been expected. The biggest emerging markets – China, India, Brazil and Russia – appeared to have accounted for much of global growth since 2009. Rich-country bail-outs and monetary loosening can be credited with stemming the world-wide panic and helping to maintain an appetite for emerging-market exports. But it is clear that the economic power of the Asian giants is rapidly overtaking the predominance of the Western economies. The advanced economies of the West are sinking under the weight of their socialist welfare spending, expansive public bureaucracies and chronic deficit spending.

As the fiscal crises in European countries, the USA and Japan continue to stagger along, the arsenal of corrective policy measures are ominously depleted. Financial markets are disrupted and the steeply rising social cost of austerity measures are spilling over into political resistance. The voting publics of Greece, Spain, France and Italy are increasingly refusing to take their required medicine. The growing fiscal pressures are putting Western democracies under heavy strain. It is not clear how the Western democracies will cope with the challenges of fiscal consolidation facing them.

Understanding the ups and downs of economic trends requires a sharp insight into the interaction of the many factors in operation within and between economic systems. An economic system does not resemble a mechanical system. It is more like an organic system, with a flow and ebb of activity of its own. It cannot be easily primed and pumped or manipulated by government policy. It depends on the inputs of millions of role players as human beings: their preferences, fears, expectations, needs and motivation. The role of human and social cognitive and emotional factors and, above all, their creativity, cannot be underestimated.

For generations banks played a key role in financing individuals and companies to expand their business enterprises. Banks refrained from proprietary trading or direct participation in speculative activities. They were expected to keep adequate capital cushions to cover their lending activities. It is time that banking institutions should be reined in and forced to stick to their proper role: financing the real economy - not speculative financial bubbles and stratospheric incentives. Governments need to stay within the parameters of prudent budget rules: reducing the dead weight of public bureaucracy and balancing their budgets. Sustainable human existence requires living within your means.

Bibliography

Arlidge, J (2009) “Inside the Goldmine” – an Exclusive look at Goldman Sachs, Weekend Australian Magazine, November 21st-22nd,2009, pp.19-28 Beddoes, Z.M. (2009) “Looking for a Way Out”, The World in 2010, The Economist, Special Edition Bishop, M. (2009) “Now for the Long Term”, The World in 2010, The Economist, Special Edition Cox, S. (2009) “The Long Climb”, Special Report, The Economist, October 3rd, 2009, pp.3-16 Ferguson, N. (2009) “Chimerica is Headed for Divorce”, Newsweek, August 24th, 2009 Ferguson, N. (2009) “Wall Street’s New Gilded Age”, Newsweek, September 21st, 2009 Ferguson, N. & Schularick “Death Throes of a Monster”, Weekend Australian, (2009) November 21st-22nd, 2009 IMF (2009) World Economic Outlook, October 2009 Laqueur, W. (2012) After the Fall: The End of the European Dream and the Decline of a Continent, Thomas Dunne Books, 2012 O’Sullivan, J. (2009) “Holding Together”, Special Report on the Euro Area, The Economist, June 13th, 2009, pp.13-16 Peet, J. (2009) “Europe isn’t Working”, The World in 2010, The Economist, Special Edition Tanzi, Vito (2011) Government versus Markets – The Changing Economic Role of the State, Cambridge University Press, 2011 The Economist (2010) “Leviathan Stirs Again”, January 23rd-29th, 2010, pp.21-23 The Economist (2012) The Proust Index, February 25th, 2012, pp. 67-69

3. The Damaged Economies of the Advanced Countries (February 2013)

The profligate social democracies are facing mountains of debt and gripped by political-economic paralysis: the advanced countries are in crisis. They are drowning in their private and public debt while at the same time facing very weak economic growth prospects. They have for many decades been living above their means, financing generous welfare benefits and bloated public sector bureaucracies by way of chronic deficit spending.

The accumulated government debt of advanced economies is expected to reach an average of 120 percent of GDP by 2015 – unless very drastic changes are made. Of the advanced economies, the resource-based Canadian and Australian economies and the industrious Germans are amongst the better performers. But for the bulk of the advanced economies, including the USA, Britain, France, Italy, the Netherlands, Belgium, Sweden, Norway, Denmark, Finland, Austria, Spain and Japan, the average growth rate for 2011 and 2012 is not expected to rise above 1.5 percent. The containment of their debt levels requires sharp reductions of budget deficits and healthier growth rates of as close as possible to 4 percent per annum to lift their taxable incomes to viable levels.

What went wrong in recent decades? What caused the advanced countries to lose their way? Are they prepared to come to grips with the underlying causes of their malaise? There is a general consensus amongst economic analysts that the GFC was largely triggered by the dodgy financial engineering of Wall Street financiers. They contaminated financial institutions throughout the world with their toxic securities. This contamination gave rise to a liquidity crisis that required governments to step in to recapitalise struggling banks, to provide bridging finance to job-shedding enterprises, to provide fiscal stimuli to shore up demand levels and to reduce interest rates to enhance credit facilitation. Despite these efforts, the GFC gradually transformed into a persistent and contagious contraction in the advanced economies: persistently high levels of unemployment, stagnant business expansion, depressed confidence levels and sclerotic growth patterns.

When the GFC struck in August 2007, many advanced economies were already vulnerable to contagion on many fronts. Government debt levels were already unsustainably high as a result of the cumulative effect of deficit budgeting over many years. Governments were already committed to high levels of spending on welfarist benefits, public sector employment and, in the case of the USA, heavy defence and security spending. Private households were also already saddled with high debt burdens as a result of their deep-rooted addiction to credit financing for their spending on housing and consumer goods – without proper regard to affordability.

It is now essential to heed the time-tested truism: a problem well defined is a problem half solved. Solving the malaise of the advanced nations requires the proper understanding of its many inter- connected disorders: - the prevalence of Socialist welfarism; - open-ended expansive government; - chronic deficit spending; - oversized bureaucracy; - exorbitant labour costs; - entrenched interest groups; - the deeply flawed financial system; - policy indecision and drift in the EU zone; - big spending in English-speaking countries;

- chronic economic stagnation; - excessive trade-union power; and - failure to foster business entrepreneurship.

These disorders need to be carefully examined because they are not “cyclical” in nature, they are systemically deep-rooted in the structures of advanced nations: ingrained in their ideological, social, political and economic DNA. Severally and jointly these ailments have emerged over a period of several generations and constitute a serious malaise that cannot be cured by a single magic broad spectrum societal antibiotic. It requires systematic treatment over a broad front by way of decisive leadership, cultural change and a return to time-tested values and practices in regard to the real value adding sources of wealth creation and progress in society.

In order to repair damaged public finances, heavily indebted governments will have to lay out a restoration strategy to tighten their budgets: drastically cutting spending and raising as well as efficiently collecting taxes. Banks will have to be required to stick to their key role in financing the real economy – not speculative bubbles and stratospheric incentives – and be forced to keep adequate capital cushions to cover their lending activities to individuals and business enterprises. Governments need to stay within the parameters of prudent budget rules: reducing the dead weight of interventionist public bureaucracy and balancing their budgets. These changes will have serious political, social and economic implications and will take decades to achieve. It requires national as well as community leaders with a long-term perspective – and electorates that give support to leaders who look beyond the next election.

The Prevalence of Socialist Welfarism

Ironically, the first system of compulsory health insurance and old age pensions was introduced by a “non-socialist”, Otto von Bismarck, in Germany in 1880. He embraced the “state socialist idea” as a vote-winner in a system of rapidly widening electoral franchises where the rich were outnumbered by the poor. In the UK, David Lloyd George, a man of the Left, shared Bismarck’s insight when in 1909 he introduced a state pension to be paid for by raising taxes. The two world wars expanded the scope of government activity in every field, but a new level of social insurance was advocated by the Beveridge Report of 1942. Ironically, it was again a “conservative”, Winston Churchill, who as Prime Minister in 1943 announced the introduction of a system of “national compulsory insurance for all classes and all purposes from the cradle to the grave”: the reduction of unemployment by government policies, a broadening field of state ownership and enterprise, more publicly provided housing, and greatly expanded public education, health and welfare services. The “welfare state” became the template in the years following the Second World War. It became known as the “Attlee consensus”.

The underlying doctrinal foundations of the “welfare state” are deeply embedded in the emergence of the socialist ideology which has permeated European intellectual life since the Industrial Revolution. It pervaded the writings of founders of “democratic socialism” such as Bentham, James and John Stuart Mill, Robert Owen and the Fabian Society. Revolutionary socialism was promoted by Blanqui, Marx and Engels and later given practical expression in the system of totalitarian communist dictatorship by Lenin, Trotsky, Stalin, Mao Zedong and ultimately revised by Gorbachev and Deng Xiaoping.

The socialist premise is based on the conviction of collectivist provision. The welfare state should take responsibility for providing a minimum standard of cradle to the grave support for every person in society. In time this conviction – no longer a monopoly of socialist parties – became generally accepted

24 by all major parties in democratic nations as badges of a “civilised” society. Social-democratic parties (alone or in coalitions) have been in power during much of the post World War II years in Western Europe.

The “welfare state” became the economic, social, cultural and organisational expression of the desire to promote equality and social wellbeing. Some political parties are stronger supporters of it than others. Some favour more benefits than others, but the principle that every citizen is entitled to a minimum standard of living gradually became no longer a matter of partisan controversy – it became part and parcel of the social-democratic consensus.

The social-democratic movement was generally based on mixed economies, combining elements of free enterprise competition with state ownership and control. The nature of the mix depended on the party in power. In most Western democracies only key industries or utilities were placed under direct government ownership, the rest were left to market forces in private hands but under varying degrees of public control. Individual choice and initiatives were assigned a secondary role.

The period since 1950 can be described as the “golden era of social-democracy” in the Western World. Emerging from the devastation of the Second World War, most Western nations rebuilt their economies to unsurpassed levels of prosperity and wellbeing. The per capita income levels of Germany, France, Italy, Sweden, Norway, Denmark, Finland, Austria, the Netherlands and Belgium could only be challenged by the USA, Canada, Japan and Australia where the social-democratic model was also followed to varying degrees.

Socialism has always based its appeal on social equality and the abolition of poverty by way of collectivist action. Although most advanced economies have gone a long way towards reaching these objectives, the costs of providing these benefits were too easily ignored. The sustainability of the welfare state was not properly understood as being determined by the ability of these countries to pay for their benefits. The income side was taken for granted.

Profligate politicians and ideologues obsessed with the redistribution of wealth were ultimately confronted with a reality check – the challenges of economic stagnation – of expenses chronically outstripping income. The simple truth was ignored that spreading the gains of material progress throughout society depends on sustained, innovative, value-adding, productive economic growth – not on government largesse.

Open-ended Expansive Government

The underlying problem faced by all social democracies concerns the role of government. What should it do? What can it do? What are the limitations to government action?

The expansion of government can only be checked by a clear understanding of the limitations of government’s capabilities. Too often government has been regarded as the ultimate answer to most social problems. This expansive philosophy lies at the root of huge budget deficits. Deficits cannot be controlled unless societies become more questioning in their use of government action.

But the much larger truth is that once established, programmes achieve virtual immortality in the budgetary process. They are protected by affected constituencies and lobbies. Programmes survive long after their public justification has vanished. Thus the momentum of government activity becomes

25 open-ended. Pressure groups portray their own interests as pressing public concerns that demand national action. In this way anything with public support becomes an integral part of the government agenda and becomes a fixed item in the annual budgeting process.

Politicians and bureaucrats do not seem able to adequately scrutinise policies that favour healthcare spending, shorter work weeks, higher pensions for the elderly and other forms of unproductive consumption spending. The political courage seems to be lacking to clear the way for activities that would guarantee economic growth: tax cuts to stimulate private initiative and investment; research and development to promote technological innovation; on-the-job training to raise productivity; the inculcation of self-reliance to reduce the current dependency on government provision. Most European governments seem to have lost the battle of curbing deficits and bringing their budgets into balance. A negative correlation has emerged between the size of government and the rate of economic growth.

Chronic Deficit Spending

The crucial issue of the welfare state is financing. In most instances its services and benefits have become too excessive to be affordable. It led to confiscatory tax levels, chronic budget deficits, excessive public debt levels, inflation, overgrown public sectors and persistently declining growth rates coupled with rising unemployment. Over several decades European governments provided over- generous unemployment benefits and pensions. They focussed on income redistribution, guaranteeing people a comfortable standard of living whether they work or not – and hence reduced incentives to work. The cost of these benefits has continuously been financed through deficit spending which ultimately resulted in too much debt and too little political will to deal with its consequences. Since 1974 France has run consecutive deficit budgets. In 2011 gross government debt stood at 85% of GDP.

The slippery road of deficit financing was taken when a traditional rule of thumb of prudent financing was abandoned: avoid financing current expenditure by raising loans. In both private and public households prudent financing required a clear understanding of the distinction between earning income and raising loans. Current income (eg. tax receipts and fees) should be used to finance current expenditure (eg. public salaries and welfare payments), whereas loans could be used to finance productive assets (eg. infrastructure) of a capital nature. Collapsing this distinction leads the financing of any household (private or public) down a slippery road. Like many private households, social democracies have become addicted to deficit budgeting and loan financing. The result is mountains of public debt coupled with declining income levels. Apart from the recipients of government largesse, the beneficiaries of rampant government debt levels are the hedge funds, equity funds and wealth funds trading and investing in bond market instruments. The burden rests on the shoulders of present and future taxpayers.

The lesson for prudent fiscal policy is that, technically speaking, deficits are not necessarily bad – it depends how the borrowed money is spent. Spending on growth inducing projects can be beneficial to the economy as long as the economic growth rate in the long run exceeds the interest rate paid on the leveraged funds. However, if the expenditure is on items that are not growth-inducing (such as administration, salaries and welfare handouts) the interest rate could exceed economic growth and lead towards a debt trap, i.e. where a rise in the debt-to-GDP ratio cannot be serviced. The debt-to-GDP ratio increases when the deficit, as a percentage of total debt, is greater than the economic growth rate.

Solving a debt problem caused by continuous deficit budgeting requires serious fiscal restructuring: increasing revenues and reducing spending, monetising the debt or by selling off state assets (privatisation). Fiscal restructuring normally involves politically unpopular austerity measures in terms of reducing public services or raising taxes. Thus it has limitations as a solution to the debt problem. Monetising the deficit means redeeming government bonds by printing money (“quantitative easing”). However, a massive increase in the money supply could cause inflation which, in turn, could cause prices to spiral out of control. Very high and fluctuating inflation rates are bad for growth because they increase risk for investors. If monetising the deficit leads to inflation, the real value of government bonds decreases and bond-holders would then be inclined to demand higher interest rates to compensate for this risk. Consequently, interest costs to government will increase unless the government issues inflation-linked bonds. By privatisation, or selling off state assets, a government can use the revenue to redeem government bonds in order to reduce the debt burden. But to sell government monopolies to become private monopolies will not improve competition and efficient operations. It could also unleash a negative political backlash. Long-term macroeconomic stability requires prudent use of deficit spending practices.

Oversized Bureaucracy

Like all governments, social democracies have to function through their civil service. Every form of government action requires public servants to come into action. The public service bureaucracy has become the most prominent part of any political system because it endures while political leaders come and go like passage birds.

Like any other organisation that provides its members with a livelihood and status, the public bureaucracy has become self-protective. It is to a considerable extent governed from within, and it uses its resources to strengthen itself. It gladly undertakes programmes that enhance its role, but it resists the liquidation of existing functions. Officials remain in place whether or not they have real work to do. Measuring their productivity is, at best, a complicated task.

Civil servants have generally obtained remarkable security of tenure for themselves in all social democracies. The possibility of dismissal for economic reasons is virtually unknown. Dismissal for incompetence requires such cumbersome procedures that it is seldom tried.

Most bureaucracies lack an adequate criterion of efficiency such as profitability or some other objective standard to measure quality of performance. A business has to retreat from areas of unprofitability in order to survive. But a bureaucracy can even expand to cover failures. Bureaucracies in social democracies normally favour socialist measures because they involve governmental controls and greater bureaucratic power. Hence the drive for socialism and welfare services amounts to an idealisation of the bureaucratic order. There is constant pressure for more responsibilities, bigger budgets and larger staff.

Much of the blame for the unmanageable bureaucracy falls on the public, which clamours for more protection, regulation, services, support, etc. As a result, demands on government usually outpace its capacity to deliver. Hence expenditure chronically outpaces income.

In all social democracies, containing public bureaucracy has become one of their gravest problems: keeping it responsible and efficient and ensuring that bureaucrats serve the public interest and not

27 their own. In most social democracies the public sector is now the power base of the trade union movement and it wields considerable electoral clout.

During the Kennedy era, collective bargaining practices which were developed in the private sector were naively transferred to the public sector in the USA. Since then this trend has emerged around the world. Today it is clear that serious questions have to be asked about collective bargaining in the public sector and its inherent contradictions of conflict of interest and unsustainability.

In the private sector the bargaining process is subject to the discipline of the bottom line: the profitability of the enterprise in relation to the productivity of the workers. In the public sector there is no effective measure of productivity and the discipline of the bottom line is totally absent. The people who are assumed to represent the “employer” are also “employees” dependent on the taxpayer. The taxpayer only has an indirect, much delayed influence on the bargaining process and is forced to rely on very blunt instruments of control. Taxpayer interests are certainly not adequately represented. The results are obvious. It has created disparities and cost burdens that are not sustainable. Moreover, the system is patently unfair: as well as shouldering much of the burden of their own retirement, private- sector workers pay for generous public-sector pensions via their taxes.

During the economic downturn since 2008, millions of private-sector workers have lost their jobs. The instances of public-sector sackings as a result of the downturn are few and far between. To add insult to injury, it is the profitable private sector firms that provide the taxable income base for all public- sector activities and emoluments. Unprofitable businesses go bankrupt and stop functioning.

Increasing government intervention and the resultant high costs of government spending lead to crowding out of private sector incentives to expand and produce. It also leads to a declining rate of economic growth. It is essential to keep in mind that only value adding productive enterprise creates “base-load” taxable income – everything else consumes tax.

Exorbitant Labour Costs

In Europe workers enjoy five to six weeks off every year; its companies are obliged to make large payments to the fringe benefits and social-security system for every worker on their payrolls and its unions hold sway over major corporate decisions. As a result, European manufacturing wages are significantly higher than those of its competitors – even before “social costs” like pension, unemployment insurance and severance packages are added.

The fact that European companies are saddled with much higher costs than their competitors means that they are at a disadvantage. In the past the economies of the West were less exposed to the international competition that is today provided not only by China, but by several newly industrialised countries in the Pacific Rim. The competitive strength of these countries is enhanced by a well-trained workforce, an environment where work is a virtue and being idle is a vice, where labour relations are non-disruptive and trade union power less exploitative.

Most governments in advanced economies are not only sympathetic to labour, but are beholden to it for electoral support. As a result they are reluctant to challenge the status quo. It would take a brave set of politicians to challenge the operating systems of wage indexation or to call for a rollback in worker benefits. Advanced economies are permeated by laws and regulations, arrangements and customs that many workers and their political camp followers hold dear. The benefits are regarded as

28 rights rather than privileges and it is virtually impossible to get rid of employees without payment of exorbitant severance costs. These “turnover costs” not only raise labour costs for ongoing businesses, they also discourage new investments because of exorbitant start-up costs. Would-be entrepreneurs are scared off by the high price of failure and even large companies hesitate to hire people they may not be able to use later. In this way the existing system actually contributes to growing unemployment and the dearth of investment in business creation and expansion.

Entrenched Interest Groups and Lobbyists

A major factor that is easily overlooked is the burden imposed on “post-industrial” societies by entrenched “rent seekers”: the “parasite economy”. This sector includes the activities of a wide array of professionals, lobbyists, unions, associations, consultants, bureaucrats who are operating as “rent collectors” in advanced societies and they generate what is euphemistically called “transaction costs”. In effect they are constantly pushing up costs of production without necessarily increasing productive output. They are overwhelmingly orientated towards gaining a share of existing income and wealth, rather than towards the production of additional output. The great majority of people involved in the parasite economy redistribute income rather than create it. They reduce economic efficiency and output. Mansur Olson in The Rise and Decline of Nations described the special-interest organisations as “distributional coalitions” (rent seekers) who increase regulation, bureaucracy and political intervention in markets and, by the barriers they impose, reduce an economy’s dynamism and capacity to grow. (See Olson, 1982, pp.41-47) Since Olson wrote these words, this trend has intensified.

The Deeply Flawed Financial System

The malaise afflicting the West’s financial system has largely been left untreated. New rules forcing banks to set aside more capital against losses in their trading business and bigger pools of liquid assets (Basel III) are only to be phased in by 2019. For all their might, banks are surprisingly fragile entities. The mismatch between liquid debt and illiquid assets or the maturity mismatch where banks use short-term funding to buy long-term assets makes banks susceptible to sudden losses of funding. Investors in interbank loans are retreating because they do not trust the value banks ascribe to their assets. The potential loss that many European banks face on their holdings of sovereign debt is a major concern and spreads uncertainty to interbank transactions – thereby limiting Europe’s capacity to finance growth.

The euro-zone’s financial world is particularly volatile because the European Union was not designed to deal decisively with crises. It is run by a cast of technocrats operating in a vacuum where there is no direct political responsibility and accountability for the outcomes achieved. The political decision makers are passage birds who are accountable to their own parliaments who, in turn, are not inclined to share their sovereignty or their purses.

Stock markets which are supposed to be the major source for financing business expansion and a marketplace where business entrepreneurs can sell their assets to the investing public at large have degenerated into a casino for algorithmic day-traders and speculators. Market volatility seems to be driven by rumours, gossip, media comments, sentiments and herd instincts that are often far removed from the underlying fundamentals of real business economics. It is not clear what proportion of the scores of commentators in the printed and electronic media are at least able to interpret a company balance sheet!

Towards the end of 2012 the Financial Industry Regulatory Authority (FINRA) in Washington at long last decided to turn its spotlight on stock exchange trading systems known as “dark pools”. In “dark pools” investors post buy and sell orders away from the public market. These secretive operators have become a source of controversy on account of their growing prominence by handling about one in seven stock trades, but unlike stock exchanges, which are regulated by the Securities Exchange Commission, the “dark pools” are not required to regularly tell market regulators details about how they handle orders.

Do “dark pool” clients get more information giving them an edge? What is the purpose of “indicators of interest” (IOISs) where “dark pool” operators electronically flash information about planned action (buy or sell) to exchanges, brokers or other “dark pools”? Are they designed to pull in trading interests for specific stocks? How secretive are these “dark pool” communication networks? How do prices in the dark pool networks compare to prices on public stock exchanges? Is important large volume client- trading information confidentially shared between backers of certain dark pools? As Justice Louis D. Brandeis said: “Sunlight is said to be the best of disinfectants”.

A further complication arises from the interpretation of official statistical and economic information. The problem with statistical and economic projections by public sector institutions is that it is hard to judge their credibility. Large elements of self interest and political spin have to be factored in. This makes any calculation or projection more art than science.

In recent times the concept of “moral hazard” has often been used to describe the problem of stepping in by collective action to save failing institutions such as large banks or even debt-ridden countries that are “too big to fail”. That means monetary or fiscal rigour must be sacrificed to stave off a country’s default or a global depression. The problem with this approach is that it expands the “moral hazard” and allows the opaque world of financial engineering to thrive, perfectly ring-fenced to continue on its exploitative path being “too complex to be understood” by ordinary folks.

A strong case can be made for the tighter regulation of banking, financing and trading. All free-market advocates (like this author) must concede that a financial system that has become too complex to be understood and any business enterprise that becomes too powerful should be curtailed. Others should be regulated when their proper functioning is a sine qua non for protecting the public interest. Commercial banks are examples of institutions playing a central role in the proper functioning of a country’s financial system. They are examples of an unusual mix of hazardous might and fragility. It makes them candidates for proper regulatory oversight to ensure that their capital and access to liquidity providers are sufficient to meet a cash squeeze. Banking regulation needs to put as much emphasis on banks’ liquidity as on their solvency.

Civilised societies are based on the assumption that those who enjoy its benefits are also prepared to pay their share of the costs. Individuals and companies that avoid tax by sheltering in tax havens and using questionable accounting tricks to dodge their tax liability are undermining the foundations of civic life. Yet there are dozens of tax havens scattered around the world from numerous offshore islands to citadels like the City of London, Monaco, Luxembourg, Miami, Delaware, Singapore and the whole of Switzerland – to name only a few well-known centres – where scaly individuals and companies can squirrel away their takings without searching questions asked about the provenance of their funds.

A tax haven is a place that tries to attract non-resident funds by offering little or no regulation, low or zero taxation and secrecy. There are around 60 such havens serving as domiciles for more than two million companies and thousands of banks, hedge funds, private equity funds, family trusts and private numbered accounts. Nobody really knows how much money is stashed away, but The Economist states that estimates vary from way below to way above $20 trillion. (See The Economist, Special Report on “Offshore Finance”, February 16th, 2013, pp.3-16)

It is important to note that dodgy offshore financing is not limited to individual or family trusts and the banks that assist them to transfer funds, it also includes large corporations like Starbucks, Facebook, Google, Apple, MacDonalds, etc. who are able to use clever accounting tricks to book profits in tax havens while reducing their bills in the countries where they do business. The UK’s Prime Minister, David Cameron, placed corporate tax avoidance at the top of the G8 agenda in February, 2013. The USA has taken aim at tax-dodging individuals and the banks that help them by way of the Foreign Account Tax Compliant Act (FACTA) which forces financial firms to disclose their American clients. But America also needs to clean up its own backyard and plug the holes in its tax system. Delaware is home to close to one million companies – most of which are dodgy shells. Miami is a massive offshore banking centre offering protection to depositors from emerging markets. The City of London is the fountainhead of money laundering. It pioneered offshore currency trading and still provides the archetypical structures and procedures required in helping non-residents to circumvent the rules. Luxembourg is famous for providing platforms to companies diverting profits to “brass-plate subsidiaries” in low-tax countries like Ireland and the Netherlands. Reform should focus on rich-world financial centres as well as offshore islands.

The Economist leader article “The missing $20 trillion” (February 16th, 2013, p.11) argues that the best weapon against illegal activities is transparency, which boils down to collecting more information and sharing it better. Authorities should crack down on the use of nominee shareholders and directors to hide the provenance of money, making sure that information about the true “beneficial” owners of companies is collected, kept up-to-date and made more readily available to investigators. Financial centres and incorporation hubs are likely to fight any attempt to tighten their rules, but that is where the missing $20 trillion will be found. There are possible costs to transparency but they are outweighed by the benefits of shining more light on the shady corners of finance.

Policy Indecision and Drift in the EU-zone

The Treaty of Rome which was concluded between Germany, France, Italy, the Netherlands, Belgium and Luxembourg in March 1957, paved the way for the formation of the European Economic Community (EEC) which ultimately transformed into today’s European Union (EU) with 27 members. The underlying purposes were to prevent the recurrence of Europe’s internecine conflict, to promote cross-border trade and investment, adoption of a single currency, a common foreign policy, a passport-free travel zone, common policies on justice and social welfare and a defence alliance.

The “Euro” was introduced on 16 December 1999 as official currency of 17 out of 27 EU members: Germany, France, the Netherlands, Belgium, Austria, Italy, Spain, Portugal, Greece, Ireland, Luxembourg, Malta, Slovakia, Slovenia, Estonia, Finland and Cyprus. The currency is also used by a further five smaller European countries. It is currently used by some 332 million Europeans and an additional 174 million people worldwide use currencies which are pegged to the Euro, including 150 million people in Africa. The Euro is the second largest reserve currency as well as the second most traded after the US dollar. The euro-zone as a whole is today the second largest economy in the world.

At the heart of the EU, is the European Commission to which each national government appoints one commissioner for a five-year term, a 30,000 strong bureaucracy, a European Council made up of the 27 heads of government which meets four times per year and also nominates the Commission’s president. The European Council is supported by the Council of Ministers, the main law and budget-making body which assembles national ministers (eg. finance, foreign affairs, agriculture, etc.). The presidency of the Council rotates every six months. The Council makes decisions by qualified majority voting (a weighted system), but on some issues (eg. taxation) it has to be unanimous. Today it takes on the character of a confederation of sovereign states, but EU protagonists are working towards a closer federal association along the lines of the USA.

The implications of a closer bonding of EU members is a move towards a deeper “transfer union” to limit financial contagion. The European Financial Stability Facility (EFSF) has been created to extend short-term loans to members, to recapitalise struggling banks and buy bonds of troubled sovereigns in the markets. Apparently this institution is intended to function as a “European Monetary Fund” which could provide long-term low interest bail-out loans to crippled members. It also implies an inexorable move towards a fiscal union which would oversee economic and budgetary policies and supervise the financial sector. It would mean that the strong members would be committed to stand behind the weak.

The economic downturn during the GFC starkly exposed the fiscal vulnerability of the EU members: they entered the crisis with limited fiscal ammunition because of their high accumulated levels of public debt. Governments have allowed their countries to live beyond their means: expanding entitlements and bureaucracies through deficit spending without proper regard for income constraints and the conditions required for job-creating economic growth. It was a crisis of their own making. It destroyed their capacity to deal with the unfolding economic crisis.

The “European social model” which served as the basis for prosperity and social peace for much of the post-war era now proves to be unsustainable. It failed to respond to the overriding policy challenge: how to reconcile incremental inflation-indexed expenditure rises with lagging income levels which resulted from poor business conditions. Expenditure on social benefits and public sector costs continued to outstrip available income. As taxable income sources declined, budget deficits piled up to create a mountain of public debt which became a sovereign debt crisis for the European Union as a whole.

Since the formation of the EU, a number of constraints arose which are seriously endangering the survival of the “European experiment”: - a “stability-and-growth-pact” (Maastricht Treaty) which is not effectively implemented to curb government over-spending (debt levels to be kept under 60% of GDP); - labour regulations protecting trade union privileges which stand in the way of job creation for the benefit of new entrants; - unrestrained and unsustainable income redistribution based on welfarism and over taxation; - the ratchet-effect of incremental inflation-indexed social and public sector benefits which are outstripping taxable income sources; - the creation of a single currency (the Euro) coupled with the imposition of a single interest rate (monetary policy) on diverse economies with different national governments.

Some analysts, cheered on by the bondholders, argue that the answer lies in a closer banking and fiscal union. It would involve placing banks under a single banking supervisor (thereby severing the link between national governments and banks), larger rescue funds in the form of common deposit- insurance and bank-resolution funds, as well as centralised control over banks’ ability to buy the debts of their own governments. A closer fiscal union would involve restraints by Brussels on the budgets of European members with the aim of disciplining spending. It also involves the creation of the European Stability Mechanism (ESM), which is intended as a permanent emergency lending mechanism for countries in trouble. The ultimate objective is the mutualisation of debt in the form of jointly issued Euro-bonds – collectively backed by all EU members. But the problem is too complex to be dealt with by simplistic “quick fixes”.

A closer union between the EU members per se would simply allow the profligate to free-ride on the backs of the virtuous. The answer clearly lies in the reduction of entitlements to affordable levels and systematic labour relations reform to promote job-creating economic growth. Pooling of debt by issuing joint bonds implies effective EU veto powers over national budgets and close supervision of all banks in the region. Transferring financial risks and responsibilities to the EU level would require changes to the EU treaties and also national constitutions. This would trigger referendums in several countries since it implies the surrender of national sovereignty. Such grassroots approval does not seem very likely and it is hard to see such vital reforms taking shape in the near future. In the long run however, the “European experiment” involves the gradual, but inexorable, transfer of sovereign powers into the hands of unrepresentative bureaucrats in Brussels.

Big Spending in English-Speaking Zones

The most active ideological rivalry affecting the policy debate in the USA, Britain and its former colonies Canada, Australia and New Zealand are the well-known dichotomies: “liberal” versus “conservative”, “capitalist” versus “socialist” and “left” versus “right”. At the heart of this rivalry lies the contest between free enterprise versus government intervention which inevitably became a question of smaller government versus bigger government or more market versus more government.

All English-speaking countries have vibrantly democratic political systems with bi-cameral legislatures, mostly single-member constituencies, usually with two dominant political parties who sometimes come into power in coalition with third parties. In all cases the major parties are either left of centre (like the Labour Parties of the UK and Australia, the Democratic Party in the USA and the Liberal Party in Canada), or right of centre (like the Conservative Parties in the UK and Canada, the Republican Party in the USA and the Liberal-National Party coalition in Australia).

The left-right spectrum is associated with the degree of state (government) intervention propagated by political parties. To the left are parties that support expansive state intervention in the economy: more regulation and control, increased welfare services, a progressive tax system, higher tax rates on the “top-end”, deficit spending and pro-union labour policies. To the right are parties in favour of deregulation, less welfare entitlements, lower taxes, less bureaucracy, more individual choice, supportive of free enterprise.

Left-wing parties tend to derive support (in terms of voting and money) from working class members and trade unions, minority and immigrant groups, lower status and income persons, teachers and academics. Right-wing leaning parties normally draw support from higher income groups, business circles, rural constituencies, persons with a protestant religion affiliation and professionals. Professors

33 teaching American Government 101 used to say about financial contributions to parties and candidates, that “copper comes from the rank-and-file, silver from those who hate the opposite side and gold from those who want something from the winner”.

During the past 100 years, Britain in particular played a trend-setting role in the emergence of the “welfare state” in theory and in practice, and also in the field of commerce and banking. In close association with the USA and its Commonwealth off-shoots, it faced off the onslaughts of Germany in two world wars.

After World War II, the centre of gravity shifted to the USA during the Cold War period. During the Reagan-Thatcher era towards the end of the 20th century it co-sponsored a brief revival of free- enterprise economics in the tradition of Adam Smith and later Friedrich von Hayek. It ended the period of stagflation which resulted from an overdose of the “Attlee consensus” interventionist welfarism.

Britain had traditionally been a minimum-government state. The census of 1851 registered less than 75,000 civil employees, mostly customs, excise and postal workers, with only 1,628 manning central departments of civil government – at a time when the corresponding figure for France (1846) was 932,000. In the century that followed, the proportion of the working population employed in the public sector rose from 2.4 percent to 24.3 percent in 1950. In the period when the Labour Party was in power, the proportion of the national income accounted for by public expenditure rose to 45 percent in 1965, 50 percent in 1967, 55 percent in 1974 and 59 percent in 1975.

After the Conservative Party won the election in 1979 public borrowing and spending was restrained under the Thatcher government. The political-economic culture of the country changed from Keynesian macroeconomics and the world of the “government-spending multiplier” to Hayek-style micro-economics and the world of the individual firm where value-adding wealth was actually created. During the 1980s, “Thatcherism” involved a combination of privatisation, patriotism, hostility to trade unionism and above all a belief in people taking responsibility for themselves. She maintained that government was doing too much and set out to replace the “nanny state” with its “cradle to grave coddling” with the rewards of an “enterprise culture”. Most of her policies were emulated throughout the world – particularly by left-wing governments at the time in Australia, New Zealand and Canada. Her influence also extended to subsequent “Third Way” policies followed by Labour leader Tony Blair after he abandoned traditional interventionist Labour policies. Subsequently Labour policies of tax and spend were again restored under the Gordon Brown government.

The United States is one of the few modern nations in which the general ideology of favouring the free market commands strong support. Americans trace their mistrust of government to their historical roots. The Pilgrim Fathers relocated in America as refugees from state-sanctioned persecution and later revolted against English-imposed taxes – the first “tea party” movement. John Locke’s famous words that “... government is best that governs least” have found much resonance amongst Americans since the seedtime of their republic.

For much of the first century of the USA’s existence, the federal government’s role was small. Thereafter it expanded steadily. The era between the 1890s and the 1920s brought anti-trust laws, regulation of interstate commerce, the regulation of food and drug quality and income tax. The Great Depression years in the 1930s and the two world wars pushed the ideological bias against government

34 intervention into retreat. By the 1950s opinion leaders, political parties and the general public readily turned to government when they saw a problem they thought should be solved.

The Cold War Period (1946-1989) played a predominant role in the growth of the public sector and the rise in government spending in the USA. The USA assumed the core leadership of the Free World in its efforts to contain the expansion of the Communist World. A long list of military stand offs ensued: Berlin, Korea, Vietnam, Cuba, Hungary, Angola, the Persian Gulf and Afghanistan. These were accompanied, in addition, by a weapons development and space exploration contest that required astronomical amounts of government spending. The expansion of the US government’s role increased the public sector’s share of the GNP from 14 percent in 1940 to 26 percent in 1990. The annual budget of the US Department of Defence rose to a level that was claimed to be larger than the entire national income of the UK.

When Reagan became the President in 1981 he declared, “Government is not the solution to our problems: government is the problem.” Reagan’s legacy was to entrench lower taxes as part of a small- government philosophy. Reagan, however, did not succeed in shrinking the size of the government sector, he merely stopped it growing.

Before the onset of the GFC, the state was already on the march in much of the English-speaking world. In the UK public spending had gradually increased through much of the 13 years of Labour Party government. Public spending increased from 40,6 percent to 52 percent of GDP in 2008. During Labour’s government, two-thirds of all new jobs created were driven by the public sector. In addition, the salaries and pensions of public sector workers rose significantly faster and higher than those of the private sector.

In the USA, even the Bush administration presided over a period of increased government spending on the wars in Iraq and Afghanistan, on homeland security, and on the dodgy mortgage finance underwriting experiments of the government sponsored enterprises Fannie Mae and Freddie Mac. He also increased entitlements under Medicare and Social Security. The number of Americans who will be eligible is expected to drive expenditure on such entitlements to grow from 9 percent of GDP in 2009 to 20 percent in 2025.

As global markets collapsed in 2008/09, governments intervened on an unprecedented scale injecting liquidity into their economies and taking over or rescuing banks and other companies considered “too big to fail”. In the USA the government bailed out the banks and took control of General Motors and Chrysler. The British government stepped in to run some of its largest banks and guaranteed deposits. Bank debt was added to mountains of public debt.

Economic Stagnation

Serious questions must be asked about the causes of the economic stagnation that has taken root in most advanced countries. Is the problem “cyclical” or of a “structural” nature? How can the downward trend be reversed? Is the welfare state a state that cannot stop growing? How can bureaucratic hegemony be curtailed?

The average growth rate of every major advanced country has been on the decline for several decades. Only resource-based economies like those in Australia and Canada have grown consistently. The economic sclerosis afflicting the advanced economies manifests itself in many symptoms:

35 unemployment rates around 10 percent; chronic budget deficits with levels of government spending approaching, and exceeding in several cases, 50 percent of national output; social welfare systems placing an unsustainable tax burden on society; public debt levels creating “debt traps” where a government has to pay more interest than it can service; and, inflationary expectations undermining confidence.

During the Great Depression of the 1930s it was believed that the economy could be stimulated significantly simply by redistributing income: taxing the upper-income, high-saving groups, while paying benefits to low income, low-saving groups. The resultant effect on spending was called the “redistribution multiplier”. But the practical possibilities of this approach proved to be limited because the amount of income available for redistribution is limited and not sustainable over extended periods; cash handouts boost short-term artificial consumer spending without adding to value-adding productive capacity; and, results in a bloated public sector which in turn institutionalises inflationary pressures since a large proportion (more than 50 percent) of all government spending is absorbed by the running costs of institutions (employees and bureaucrats) paid out of the public purse.

Extended periods of deficit spending in the past generated a disease that Keynes never anticipated – “stagflation”, i.e. stagnant growth, unemployment and rising prices at the same time. Reliance on the effect of the “automatic stabiliser” – as an exit strategy from chronic deficit spending and mounting public debt – is based on a national accounting delusion. It is the very source of stagflation. It assumes that the debt incurred during the downturn as a result of lower tax receipts and higher spending in the form of stimulatory “handouts” will be automatically reversed when the upswing takes effect. But in reality this “stabilising” process can only come into play if and when there is an upswing – which, in turn, depends on the nature and realistic value-adding effect of the deficit spending. If the spending fails to produce a macroeconomic turnaround, the whole deficit spending process will prove to be a gigantic Ponzi scheme financed by ballooning institutionalised inflation.

The “redistribution multiplier” approach, coupled with the presumption of an “automatic stabiliser” at work, tends to focus on abstract, immeasurable macroeconomic variables, away from the visible micro-economic world of the individual enterprise where real wealth creation and job creation takes place. Increasing “gravy train” handouts to promote short-term consumer spending by unemployed or under-employed persons can help as a welfare measure to alleviate poverty and hardship, but such measures are not likely to have a positive impact on business investment and expansion – the ultimate source of future growth, employment and the generation of taxable income.

During the 1950s and 1960s, many economists thought Keynesian deficit spending was costless. Governments thought they could fine-tune their economies out of recession. Eventually it was realised that the ultimate result of too much stimulus was higher inflation, mountains of government debt and excessive government involvement in the economy. Fiscal expansion was augmented with the “monetary approach” which involved lowering interest rates and pumping out liquidity by central banks by way of “quantitative easing”. The experience of recent years has demonstrated that such discretionary monetary measures had its costs too.

By keeping interest rates low, central banks usually intend to ease the granting of credit by banks with a view to encourage consumer spending and business investment. Yet credit balloons tend to finance asset bubbles and to increase inflationary pressures if gaps between expanding domestic demand and supply are not neutralised by rising exchange rates and/or increased imports. Much depends on the way the credit boom is financed: by domestic savings, foreign capital inflows in the form of equity

36 investments or by domestic or cross-border borrowing. It is important to keep a vigilant eye on the negative side-effects of permissive finance. Low or negative real interest rates, i.e. at or below inflation rates, can lead to the misallocation of capital in both the public and private sectors of the economy. On the level of the individual household, cheap credit can fuel over-exposure to debt-financing – living beyond your means – with dire consequences for household balance sheets. The same danger applies to the balance sheets of business enterprises – including banks becoming too optimistic about the ability of borrowers to repay and failing to make adequate provisions for bad debts. The public sector is particularly vulnerable to artificially low interest rates and the “quantitative easing” method of creating new money to buy bonds. Forcing down longer term interest rates can lead to a distortion of the borrowing costs of profligate governments resulting in a chronic addiction to deficit budgeting and rising debt levels. A flood of liquidity, per se, cannot ignite economic growth when business confidence is low. It is not clear what effective ammunition central banks have left when their monetary arsenals are depleted.

The interactions of reciprocal spill over effects unleashed by discretionary fiscal and monetary policy measures have economic implications that are far reaching and potentially harmful. Pension liabilities which are usually linked to bond yields become unaffordable as yields fall. This deficit then requires employers or members of self-managed retirement funds to divert more money into their schemes. Without positive returns, the suppliers of capital (or savers) are discouraged to accumulate the capital required to finance investments. Without investments there can be no prospects of sustainable job- creating economic growth. It is deceptive to assume that deficit financing or the balance sheets of central bankers can be used to solve every economic or financial problem. With historically low near- zero or negative interest rates in the USA, Japan and the EU for an extended period and mountains of public debt resulting from years of deficit budgeting, economic growth prospects in the advanced economies remain sclerotic. This dismal scenario is likely to prevail as long as investors and entrepreneurs – both large and small – remain on the sidelines of the real economy.

Excessive Trade-Union Power

The UK is a prime example of the impact of trade union power on a country’s growth pattern. During the period between 1913, when the Trade Unions Act was passed, and the 1980s, when Margaret Thatcher introduced curtailments of union privileges in the Employment Acts of 1980 and 1982, British trade unions exercised excessive power and enjoyed excessive privileges. They eventually brought the British economy to a standstill. They changed Britain from a prosperous minimum- government state to a country where public expenditure accounted for around 60 percent of GDP in 1980. The burden of union domination destroyed Britain’s growth potential in three ways: first, its restrictive practices inhibited growth of productivity and discouraged investments; second, it increased the pressure of wage inflation on the back of inflation-indexed collective bargaining (where the index is calculated by public sector agencies); and thirdly, trade union demands on government had a cumulative tendency to increase the size of the public sector and government’s share of the GDP.

In several social-democracies the collective bargaining muscle of public-sector unions has created what investor Warren Buffett called “a time bomb with a long fuse”. He referred to the hugely unfunded pension fund obligations on local, regional and national government levels in the USA. For decades the contributions of public-sector employees have been systematically reduced while at the same time increasing their benefits. As a result many local and regional governments are driven to the brink of bankruptcy by their pension obligations. The gap between the promised benefits and the money set aside for them has increased as a result of a substantial decline in the rate of return on

37 pension fund investments – a rate much lower than the underlying actuarial assumptions. In the private sector this problem has been reduced by the introduction of defined-contribution schemes where the pension levels depend on the rate of return earned on the combined contributions made by employees and employers to their pension funds. In the public sector, the unions have insisted on “defined-benefit schemes” which depend essentially on final salary levels – not on affordability by the pension fund. These benefits are usually enshrined in law.

In Australia public-sector pension funding obligations were handled by the creation of a multi-billion “Future Fund” under the Howard government. This fund underwrites the pension obligations vis-a-vis public-sector workers and politicians. It is not a “rainy day” fund for old-age pensioners. The legislation which created this fund passed through both houses of Parliament totally uncontested. In the USA the under-funded position of public-sector pension plans has taken on serious proportions in several municipalities and states. The Economist of June 23rd, 2012, reports that in 2010 only one state out of 50 was adequately funded. The others were funded under the 80 percent level recommended by the Government Accountability Office. The majority of states and municipalities are now grappling with the challenge of either increasing employee contributions and retirement age requirements, or cutting benefits. The funding gap in 2012 was estimated to be in excess of $4 trillion.

In today’s world the “trade union movement” is dominated by “public sector employees” who are well placed to dominate the collective bargaining process. Many political leaders who are supposed to represent taxpaying electorates, are also in effect beneficiaries, or ex-employees of the government sector or ex-executives of the trade unions. The beneficiaries – public sector employees and their families – form around 25 percent of the total electorate. This stranglehold does not bode well for the future of both representative democracies and free-enterprise economies. A self-serving bureaucracy could destroy the creative potential of society.

Failure to Foster Business Entrepreneurship

The lingering hold of the socialist mindset amongst large segments of the intelligentsia and rank-and- file populations in advanced economies has created a misconception of the real value-adding sources of wealth creation and progress in society. There is widespread ignorance of the role of business enterprise in job-creating growth and the generation of taxable income. This ignorance is more acute on the European continent than in English-speaking countries. Within the latter, the USA is by far the most business friendly with its deep-rooted entrepreneurship culture. Unfortunately the rewards of the American business prowess is totally outweighed by its recently ballooning public sector spending on welfare entitlements, excessive public sector payrolls, the expanding costs of military, security and regulatory activities, and the interest on the growing mountain of national debt.

The Economist of July 28th, 2012, published an article entitled “Briefing European Entrepreneurs” which outlines the lack of European economic growth within the context of the chronic failure to encourage business entrepreneurship. It argues that Europe’s culture is deeply inhospitable to entrepreneurs. It quotes the research findings of the Global Entrepreneurship Monitor which compiled comparable data across several countries. It found that in 2010 “early stage entrepreneurs” made up just 2.3 percent of Italy’s adult population, 4.2 percent of Germany’s, and 5.8 percent of France’s. European countries are well below America’s 7.6 percent, China’s 14 percent and Brazil’s 17 percent.

Europe’s “entrepreneurial gap” dates back to the period since the First World War. According to an analysis by Breugel, a Belgian think tank, of the world’s 500 biggest publicly listed firms, Europe gave

38 birth to just 12 new big companies between 1950 and 2007 in contrast to the USA’s 52 in the same period. Between 1975 and 2007 Europe produced only 3 new listed firms. Most of Europe’s big privately held firms were born around the turn of the last century – including much of the German “Mittelstand” and clusters of manufacturers from Lombardy to the Scottish Lowlands. It was found that many aspiring entrepreneurs simply leave Europe. There are about 50,000 Germans in Silicon Valley, and an estimated 500 start-ups in the San Francisco Bay area with French founders.

Trying to discover what holds back entrepreneurs, The Economist lists a number of obdurate obstacles. First, are the onerous insolvency regimes in Europe which treat honest insolvent entrepreneurs like fraudsters, whereas in America it is seen as a chance to make a fresh start by shedding liabilities through insolvency procedures. Some countries, like the UK, discharge a bankrupt from his debts after 12 months. In Germany it takes 6 years to get a fresh start and in France a failed entrepreneur is kept in limbo for 9 years. The second hurdle is finance: seed capital to get started and venture capital to expand. Usually start-ups have to rely on family and friends. The third big obstacle is labour law. The complexity and cost of firing in Europe stands in the way of fledgling firms to reduce staff costs quickly and cheaply when necessary. The cost of paying out large severance packages (even for recent hires) can be a huge drain for a small company and discourages hiring people in the first place. The legal complexity of giving new hires free shares or stock options is prohibitive to European business founders. With the odds so heavily stacked against them it is not surprising that potential entrepreneurs are discouraged or seek greener pastures elsewhere in the world.

In most countries small businesses are the main drivers of job creation. The SME sector is the natural home of the entrepreneurial spirit of free enterprise. Since governments are net consumers of taxable income government spending should be directed to catalyse private sector driven job-creating growth. Small businesses, in particular, are by far the most mobile, flexible and versatile form of enterprise. They are the least bureaucratic and the most creative. They are adaptable by being quick to adopt new ways when conditions change. They use competition, customer choice and other non-bureaucratic mechanisms to get things done as creatively and efficiently as possible. Everything possible should be done to promote the SME sector: access to financing, a flexible employment regime and the removal of burdensome regulatory obstacles to starting or expanding a business. Although a large percentage of new small businesses fail in the first five years, it is the successful entrepreneur who knows how to calculate and manage risk.

Concluding Remarks

In all advanced economies, during the past half century, government sectors have grown faster than the private sectors – the ultimate source of taxable income. For a brief period from the mid-1970s to around 2007, several advanced countries have seen a small decline in the rate of increase in government spending’s share as a percentage of GDP. However, since the onset of the downturn in mid-2008, government spending on stimulation packages shot up at an unprecedented rate. Post-crisis expenditures simply levelled out on a higher plateau than pre-crisis expenditures. The impact of these expanded activities have to date not been properly measured and evaluated independently. It is clear that the cost of these government interventions will be felt in many ways: requiring governments to continue to rescue banks, to slash interest rates, to intervene in markets and to run large deficits. That means the “moral-hazard” problem takes on gigantic proportions.

Even the best-case example presented by the USA, the leading rich country, offers a discouraging scenario: too much debt, too little growth and continued deficit spending. By the middle of 2012 the

39 debt to GDP ratio in the USA was above 120 percent, not far below Greece’s level. Since 2001 federal spending has more than doubled to US$3.6 trillion, while the economy has grown by only 50 percent. Unemployment hovers around 8 percent and economic growth barely breaks the 1 percent level.

Many questions remain. What will bond markets do when central banks start unloading the large holdings of paper assets acquired over time? What can the banks’ creditors do to protect their investments/deposits from near-zero interest rates and floating exchange rates? What are the side effects of an extended period of negative interest rates? These are vexing monetary issues, but there are more momentous fiscal questions to confront. Is a social-democracy inherently unable to live within its means? Is a welfare state a state where the role of government, as regulator and collective provider of entitlements, continues to grow? Can the wealth redistributive sentiments and practices (liabilities) of the modern “transfer” state be tamed or counter-balanced by the more “productive” wealth creation elements (assets) of society? Further questions pertain to the sustainability and survival of social democracies as political-economic systems. What is the inevitable outcome of chronic deficit spending? What is required for a democratically elected government to be able to balance its budgets: tax rises or spending cuts or both? What is the optimal pace of deficit reduction? Can austerity programmes also deliver structural reforms by way of enhanced labour-market flexibility, curtailed welfarist entitlements or handouts and the deregulation of business enterprise expansion? It is clear that fundamental choices have to be made between increasing direct and indirect tax burdens on the one hand, and reducing entitlements, concessions, subsidies and cash handouts on the other. Experience has shown that people tend to exploit the system of welfare benefits. Unfortunately, political party competition tends to bid up benefits over time. Our desire to support people in need should not undermine people’s willingness to look after themselves.

Apart from the problem of moral hazard, the main problem area arising from the expansion of welfarist entitlements relates to affordability. Financing the services and benefits has become too excessive to be affordable. It has led to confiscatory tax levels, chronic budget deficits, excessive public debt levels, rising inflation levels, overgrown public sectors, persistently declining growth rates coupled with rising unemployment.

To deal with the financing crisis and the weight of public debt requires the restoration of a clear connection between the rights and duties of citizens and between contributions made and eligibility to receive benefits. Contributors and recipients of benefits should not be obscured by a cloak of anonymity. Governments should be forced to cut their cloaks according to their cloths. Financial responsibility for the expenditure side should rest on a corresponding financial responsibility on the revenue side. Generous, compassionate welfare ultimately depends upon two details of demography: enough people of working age, productively employed, to fund the claims of those in need; and, enough working persons who are willing and able to pay the necessary taxes. Even the industrious Nordic countries eventually buckled under the weight of their bloated welfare systems in the early 1990s and were forced to adopt far reaching reform measures.

Throughout the recent history of the rich countries, the trials and tribulations of economic depressions and war devastation was overcome by the combined endeavour and energy of ordinary men and women as well as supportive government institutions. It involved initiative, organising skills, hard physical labour, management ability and dedication. It meant keeping bureaucratic waste, rent seeking, free riding, rorting, exploitation, violence and criminality under effective control. It is difficult to see how job-creating economic growth can be generated by welfare-on-credit policies or by

40 increasing public sector workers as well as public-purse financed “privatised” employment. The future seems to be more fragile than is commonly perceived.

It is essential to realise that government per se cannot turn around the lack of economic growth – it can only alleviate or cushion the unfavourable effects of a severe downturn in the short term. Growth depends on business activity – producing goods and services for which there is a realistic market, either nationally or internationally. Profitable business activity is the mainspring of all taxable income without which all the desirable public goods remain out of reach.

4. Policy Options for Advanced Economies in Distress (July 2012)

Many developed economies are in serious distress: they are drowning in their debt while at the same time facing very weak economic growth prospects. They have for many decades been living above their means, financing generous welfare benefits and bloated public sector bureaucracies by way of chronic deficit budgeting. Based on current trends the accumulated government debt of developed economies can be expected to reach an average of 120 per cent of GDP by 2015. The resource-based Canadian and Australian economies and the industrious Germans are amongst the better performers. But for the bulk of advanced economies including the USA, Britain, Germany, France, Italy, the Netherlands, Sweden, Belgium, Norway, Denmark, Finland, Austria, Spain and Japan, the average growth rate for 2011 and 2012 is not expected to rise above 1.5 per cent. The containment of government debt levels requires sharp reductions of budget deficits and healthier growth rates close to 4 per cent per annum to lift their taxable income levels.

The average growth rate of every major advanced country has been on the decline for several decades. Only resource-based economies like those in Australia and Canada have grown. The economic stagnation afflicting the advanced economies manifests itself in many symptoms: unemployment rates around 10 percent; chronic budget deficits with levels of government spending approaching, and exceeding in several cases, 50 percent of national output; social welfare systems placing an unsustainable tax burden on society; public debt levels creating “debt traps” where a government has to pay more interest than it can service; and, inflationary expectations undermining confidence.

There is a general consensus amongst economic analysts that the GFC was largely triggered by the dodgy financial engineering of the Wall Street financiers. They contaminated financial institutions throughout the developed world with their toxic securities. This contamination gave rise to a liquidity crisis that required governments to step in to recapitalise struggling banks, to provide bridging finance to jobs-shedding enterprises, to provide fiscal stimulus to shore up demand levels and to reduce interest rates in order to enhance credit facilitation. The global economy was pushed to the edge of deep recession. The GFC gradually transformed into a persistent and contagious contraction in the advanced economies. This contraction is accompanied by persistently high levels of unemployment, stagnant business expansion, depressed confidence levels and sclerotic growth patterns.

When the GFC struck, most advanced economies were already vulnerable to contagion on several fronts. Government debt levels were already unsustainably high as a result of the cumulative effect of deficit budgeting over many years. Governments were already committed to high levels of spending on welfare benefits, public sector employment and defence and security spending in the case of the USA. Private households were also saddled with high debt levels as a result of their deep-rooted addiction to using credit financing for their spending on housing and consumer goods – euphemistically called “leveraging”.

The lingering hold of the socialist mindset amongst large segments of the intelligentsia and rank-and- file populations in advanced nations created a misconception of the real value adding sources of wealth creation and progress in society. The result was general ignorance of the scope of the emerging challenges facing their countries. Mentally and institutionally advanced societies were incapable of confronting the imbalances and discrepancies in their fractional reserve banking systems, their reliance on supra-national bond markets and capital flows. Their regulatory frameworks were ill- equipped to manage the risks associated with the debt to equity ratios of its financial institutions. The policy-making structures such as political parties, pressure groups and representative rule-making

42 institutions were unable to understand the emerging challenges and even less equipped to take decisive remedial action. The result was decision-making paralysis and policy drift.

In order to repair their damaged public finances, heavily indebted governments will have to lay out a restoration strategy to tighten their budgets: cutting spending and raising as well as efficiently collecting taxes. Banks will have to be required to stick to their key role in financing individuals and companies to expand their business enterprises, to refrain from proprietary trading and speculative activities, and to keep adequate capital cushions to cover their lending activities. They should be reined in and forced to stick to their proper role: financing the real economy – not speculative financial bubbles and stratospheric incentives. Governments need to stay within the parameters of prudent budget rules: reducing the dead weight of public bureaucracy and balancing their budgets. These changes will have serious political, social and economic implications and will take decades to achieve. It requires national as well as community leaders with a long-term perspective – and electorates that give support to leaders who look beyond the next election.

The sad reality is that major left-wing segments of the electorates in the advanced economies are so addicted to the culture of entitlements and redistributive hand-outs that they are not prepared to accept the budget-cutting and structural reform measures which are a sine qua non for economic recovery and growth. They are ill prepared to face the stark reality of national insolvency and refuse at their own peril to swallow the required medicine – an electoral frame of mind that does not bode well for the immediate future. The previous era that advanced countries faced hardships and mountains of public debt was during and after the Second World War when the general populace and their leaders were inspired by a dedicated spirit of reconstruction and development to build a better future.

The various policy options available need to be carefully examined and evaluated.

Reducing Debt Burdens

Reducing their excessive debt burdens is a sine qua non for all advanced economies. The Maastricht Treaty’s fiscal criteria for monetary union prescribed that total government debt should be no more than 60 percent of GDP and that budget deficits be no bigger than 3 percent. But these generous rules were easily broken – even by Germany – without effective punishment. Based on current trends, total government debt in the EU countries is projected to be heading for around 125 percent by 2015. These levels of debt are unsustainable, especially when nervous capital markets and speculators drive up the cost of the growing debt. Official deficit and debt levels are exacerbated by the over-extended bank debts and private sector debts on top of the overweight public sectors.

The critical variables are the level of confidence of the buyers of government bonds, the interest rates required to buy government debt and the repayment terms involved. These requirements, in turn, depend on perceptions of the relevant government’s fiscal rectitude and the economic potential of the country and the willingness of its taxpayers to shoulder the commitments made by their governments. A country with a firm growth potential, a stable political system and a convincing record of sound economic management is likelier to raise loans domestically or internationally to cover its debt requirements. The ability of a country to service its loans depends on its projected disposable income stream.

To avoid public debt spiralling out of control requires raised taxes, reduced spending and a higher growth rate. But in several EU countries the tax base has been eroded by the economic downturn and

43 their expenditure budgets committed to welfare entitlements and ballooning public sector emoluments. Hardly any euro-zone country has any reason to be optimistic about their growth prospects.

Servicing the national debt by way of tax rises could damage the economy by reducing incentives to work or by causing distortions in capital and labour markets that reduce income and wealth levels. Government borrowing tends to reduce private investment – and so reduces the capital stock that future generations have to rely on, causing a lower standard of living. The reason is that government absorbs the savings that would otherwise have gone into more productive investment. The impact of the “crowding out” of private capital formation largely depends on the productivity of government spending. Financing welfare payments and public sector emoluments at the expense of productive investments constitutes a major burden, whereas financing a new road, railroad or harbour development is likely to be a boon.

Fiscal adjustments that rely on spending cuts are more sustainable and friendlier to growth than those that rely on tax increases. Cutting public sector wages and transfers is better than cutting public investments in infrastructure. Spending cuts achieved through raising the pension age and slashing farm price subsidies have the double benefit of improving public finances and boosting economic growth through raising productivity and promoting more efficient resource allocation.

Most European economies have seen average growth below 2.5 percent over the past two decades. If growth declines below the level of real interest rates, debt burdens will continue to rise. The debt level becomes excessive and unsustainable when a vicious circle is set in motion: rising debts boost interest payments which in turn require extra borrowing to service earlier debts and so on. Governments then have only three ways to break away from the debt trap: raise taxes, slash spending or let inflation rip (eg. by “quantitative easing” or printing money if they are not part of a monetary union and/or the central bank agrees to buy the debt of delinquent governments). If the above measures are exhausted, the only remaining option is default – and eventually failed state status, unless debt restructuring can be arranged with creditors taking a “hair-cut”. Defaulting countries are likely to be locked out of international capital markets because creditors are forced to accept large losses of principal. When defaulting countries re-enter markets once debt-restructuring is complete, their reduced credit rating is likely to lead to escalating cost of funds, not only for their governments, but also for private companies in the defaulting countries.

In the current situation several advanced economies have dealt with their accumulated debt burdens in different ways. Japan, the country with the highest debt burden, has raised its loans from the frugal savings of its domestic population. In addition it still benefits from the export prowess of the Japanese economy, the productivity of its manufacturing sector and its skilful foreign investments and low-cost manufacturing abroad. Japan is the third largest national economy in the world and since the Second World War it has managed to capture foreign markets with its vehicles and electronic goods. Japan is also the world’s biggest creditor nation. Over the past three decades Japan’s economy has shown slower growth rates than the Euro area and the USA. However, due to the ageing of its population – half is over 45 – its per capita GDP has increased faster and its unemployment rate has remained significantly lower. Moreover, Japan also has the lowest tax take of any country in the OECD at just 17 percent of GDP. That means that with modest tax increases on consumption or incomes, Japan could wipe out its fiscal deficit. However, the elderly, being a major voting bloc, staunchly resist higher taxes or benefit cuts.

The USA has managed its huge sovereign debt levels by virtue of the US dollar being the reserve currency of the world and the size and sophistication of the US financial market. It has managed to sell the bulk of its Treasury bonds in China, Japan and Middle Eastern countries. All countries running current account surpluses happily park their capital surpluses in US bonds – in lieu of other reliable destinations. The UK relies on the City of London to provide banking and other financial services to many parts of the world – particularly to EU countries. The UK prefers to exploit the benefits of an open EU market without the obligations imposed by euro-zone integration. Switzerland has traditionally been the major “safe haven” for unrecorded fortunes with its system of “numbered accounts”. These destinations for surplus capital are increasingly challenged by new competitors such as Luxembourg, Hong Kong, Singapore and several Caribbean Islands. In the case of Greece, solutions to its debt problems are sought in a combination of fiscal and monetary austerity measures and seeking bailout assistance from euro-zone partners. Seeking debt restructuring and bailout assistance and, perhaps, eventual default, implies deflecting the crisis back to the bondholders who provided the credit in the first instance!

The bond holders and their camp followers, are keen to see the “mutualisation of government debt”, i.e. for Germany and other creditor countries to step forward to commit themselves to ring-fencing “solvent” governments, to beef up rescue funds (such as the EFSF), to support the issuance of euro- bonds which would be less vulnerable to speculation and to authorise the European Central Bank (ECB) to buy the debt of wobbly countries such as Italy, Spain and possibly even France. No practical proposals have been advanced so far to ensure that delinquent borrowers do not continue to exploit these facilities by running up more debt for others to guarantee.

Spending Cuts and Tax Rises

A crucial decision in the highly indebted countries is determining the nature of the mix of spending cuts and tax rises that are required. It is clear that spending cuts would be better for their economies than adding substantially to the tax burden. It is also more likely to produce healthier fiscal outcomes. A state that has over expanded for decades is seriously in need of vigorous pruning. Spending cuts are certainly a source of misery for all the beneficiaries of governmental largesse, but they are essential for remodelling the Leviathan state – shedding some functions altogether and carrying out those that are retained more efficiently. Spending reviews are essential in the field of the armed forces, public-sector earnings and pension benefits, welfare entitlements (child benefits, free bus travel, transfer payments on electricity and fuel bills), tax-free concessions, etc. A sound approach would be to require justification for all programmes from scratch. No activity should be immune from “zero-based budgeting”.

Because rising levels of government spending on regular as well as ad hoc entitlements, have a remarkable staying power as a result of populist political pressure for their retention and expansion. Hence the expansion of all public expenditure needs to be scrutinized with a sharp eye. “Hand-outs” should be limited to those in dire need. Wasteful and corrupt use of public money (e.g. in the allocation of government contracts) must be avoided at all cost. The creeping culture of entitlement must be confronted by all responsible opinion leaders.

Although spending cuts should bear the brunt of fiscal reform, the holes in the budgets of advanced countries are so large that tax increases will be hard to avoid: income tax on individuals, taxation on the profits of companies and indirect tax on the sale of goods and services. The least damaging way to raise tax revenue is to tax consumption, preferably by broadening the base by reducing exemptions.

The available options to increase tax revenue are either to increase the tax base, or to increase the efficiency of tax collection. But the best way to increase the size of the tax base would be through economic growth. Ideally, a tax system should raise revenue in a manner that is efficient, fair and conducive to economic growth.

Should tax rates be raised on the wealthy because they are able to pay more? In the USA the richest 1 percent of Americans pay more than a quarter of all federal taxes – and fully 40 percent of income taxes – while taking around 20 percent of pre-tax income. But knee-jerk rich bashing is not a good policy. High marginal tax rates tend to discourage entrepreneurship and higher tax rates on the rich, per se, cannot close the USA’s deficit. But deficits can be reduced by methodically cutting inefficient bureaucratic spending in a sensible ratio to progressive rises in the tax rate. Electorates are more likely to support marginal tax rises to fall progressively on the well-off who have been generously rewarded in recent times. However, sharp tax increases could easily become counterproductive.

Much can be done to raise the efficiency of tax collection: tax code simplification, reducing the cost of tax compliance, culling tax deductions, narrowing the gap between taxation on income (salaries and bonuses) and taxation on dividends and capital gains. Of special importance is a sharper focus on tax deductions by hedge funders and private-equity investors. But tax reforms should not hurt the dynamism of the economy. Tax changes do affect the domiciles and activities of corporate investors and talented workers. When top earners change their behaviour, it distorts economic activity and business strategies. But by closing loopholes governments can reduce avoidance and fewer loopholes also mean a broader tax base and more revenue for a given tax rate.

Managed Inflation

In terms of monetary theory, inflation occurs when there is a more rapid increase in the quantity money than in output. In terms of real life experience on the community level, it means a general decline in the purchasing power of money because of the rise in prices of goods, labour, property – of everything. Letting inflation rip raises serious questions.

Can the churn of inflationary pressures be roped in to unleash growth in a sclerotic economy? Is a little inflation a good thing for the economy – spurring growth momentum by enhancing confidence, rising expectations, promoting consumer spending and encouraging investment? Would inflationary pressures replace hoarding instincts with expectations of a better future: bidding up prices and boosting production? Or is stripping inflation from our national accounts akin to chasing “fool’s gold”? Can runaway inflation be avoided or tamed?

Economists generally consider wage and salary increases, higher food prices, higher energy prices and exchange rate depreciation as “cost-push” factors causing inflationary pressures on the supply side of the economy. The “demand-pull” factors precipitating inflationary pressures are increased money supply, generous credit extension, lowering interest rates and other measures fuelling consumer spending. Normally the interaction of these factors drives inflationary pressures along a circular path. Increased government spending financed by way of increased government borrowing through a central bank creates the expansion of the money supply. Pressure group action based on inflationary expectations lead to higher prices for labour and goods. So the inflationary pressures keep spiralling along, securely buffeted by inflation-indexed wage or salary increments and inflation-indexed government funded welfare entitlements. The pace of this spiral normally outstrips the pace of real growth in output which, if unrestrained, can escalate into hyperinflation.

In specific instances, several additional factors can impact on inflationary pressures: speculative capital flows, surges in government military spending, pressures from external creditors and trade patterns. Of special significance is the potent influence of human factors such as the social and psychological trauma generated by hyped-up inflationary expectations. It undermines confidence in the purchasing power of money to such an extent that it not only shipwrecks the economy, but also destroys the foundations of orderly civic life.

It is important to give careful consideration to the undesirable effects of inflation. Most importantly, it creates uncertainty that undermines business confidence and depresses investment in economic expansion. It alters the rewards accruing to the different types of economic activity (eg. consumers, producers, workers, savers, investors, entrepreneurs) leading to weaker output and lower real income levels. By eroding the purchasing power of money, it reduces the value of fixed wages and salaries, fixed pensions and interest on fixed deposits. It induces redistribution from lenders to borrowers if nominal interest rates do not fully compensate for inflation. Volatility in inflation expectations creates uncertainty regarding economic prospects and hence militates against investment in productive assets. It enhances speculative activities which crowd out production.

For several decades some form of inflation targeting has been adopted as policy objective in most advanced economies. The main purpose being to reduce inflationary expectations by providing a credible anchor for economy-wide price and wage adjustments. It also provides a yardstick for assessing current economic trends and to promote transparency and accountability in the conduct of government monetary and fiscal policy. It also helps the general public to form more accurate expectations about inflationary trends. A low and stable rate of inflation creates a stable financial environment which must be considered crucial for sustainable growth and equitable distribution of resources.

It has become conventional prudent central banking policy to target inflation at fixed margins in order to make their currencies credible and their policies predictable, for instance keeping consumer prices growing at 2 to 3 percent per annum. For the past few decades this approach succeeded in taming inflationary pressures. But, per se, it failed to safeguard economies against serious decline. Some analysts argue that if central banks tweak interest rates to very low levels and at the same time use quantitative easing to bring more money into circulation, the additional liquidity would drive up the nominal GDP and thereby spur growth momentum. But many questions remain.

How do you put the inflation tiger back in its cage? A range of practical problems arise: selecting an appropriate ceiling, selecting a credible underlying price index, keeping a lid on public and private sector trade union demands for higher salaries and wages, keeping global financial interests and their destructive instruments under control, turning around a culture of short-termism, controlling cross- border liabilities, neutralising the reciprocal induction between wage inflation and price inflation, managing the trade-off between supply-side and demand-side policies and between unemployment and inflation, monitoring the redistribution of wealth from creditors to debtors which can lead to populist battles between lenders and borrowers as voter identification moves away from the middle and closer to extremes. Unconventional policies will have to be disciplined by political realities.

47 unsustainable current account deficits that were financed by the printing of more and more paper money. This process was accompanied by excessive public spending on generous public union wage settlements and insufficient tax collection. Although the downward slide of the mark boosted German exports, the inflationary pressures continued unabated until 20-billion mark notes were in everyday use. Eventually money – including all forms of wealth and income fixed in terms of marks – was rendered worthless. The collapse of the currency led to the collapse of the economy: soaring unemployment, poverty, moribund banking, social and psychological distress and, ultimately, political disorder and the beginning of the Great Depression era. Other countries where rampant inflationary pressures ultimately led to disaster during the past century include, inter alia, Argentina, Chile and more recently, Zimbabwe. Nassim Taleb of Black Swan fame, claims that our inability to predict outliers, implies our inability to predict the course of history.

Downsizing the Public Sector

In all advanced economies, during the past half century, government sectors have grown faster than the private sectors – the ultimate source of taxable income. For a brief period from the mid-1970s to around 2007, several advanced countries have seen a small decline in the rate of increase in government spending’s share as a percentage of GDP. However, since the onset of the downturn in mid-2008, government spending on stimulation packages shot up at an unprecedented rate. Post-crisis expenditures simply levelled out on a higher plateau than pre-crisis expenditures. The impact of these expanded activities has to date not been properly measured and evaluated independently. It is clear that the cost of these government interventions will be felt in many ways: requiring governments to continue to rescue banks, to slash interest rates, to intervene in markets and to run large deficits. That means the moral-hazard problem takes on gigantic proportions. Many questions will remain. What will bond markets do when central banks start unloading the large holdings acquired over time? What can the banks’ creditors do to protect their investments/deposits from near-zero interest rates and floating exchange rates? The future seems to be more fragile than the past.

It is essential to realise that government cannot turn around the lack of economic growth – it can only alleviate or cushion the unfavourable effects of a severe downturn in the short term. Growth depends on business activity – producing goods and services for which there is a realistic market, either nationally or internationally.

Curtailing Union Power

The burden of union domination destroyed Britain’s growth potential in three ways: - first, its restrictive practices inhibited growth of productivity and discouraged investments; - second, it increased the pressure of wage inflation on the back of inflation-indexed collective bargaining (where the index is calculated by public sector agencies); and

- thirdly, trade union demands on government had a cumulative tendency to increase the size of the public sector and government’s share of the GDP.

In today’s world the “trade union movement” is dominated by “public sector employees” who are well placed to dominate the collective bargaining process. Many political leaders who are supposed to represent taxpaying electorates, are also, in effect, ex-employees of the government sector or ex- executives of the trade unions. The beneficiaries – public sector employees and their families – form around 25 percent of the total electorate. This stranglehold does not bode well for the future of both representative democracies and free-enterprise economies. A self-serving bureaucracy could destroy the creative potential of society.

Keynesian Anti-cyclical Fiscal and Monetary Measures

To do justice to this influential political economist, a brief digression into Keynesianism is required. Keynes started from the assumption that in times of economic uncertainty savings will exceed investment and aggregate demand will fall short of aggregate supply. Hence it is the duty of government to counter the “market failings” through the judicious application of economic policy. Keynes provided the theoretical foundation for the demand-management policies that are today considered the essence of Keynesianism. It boils down to the idea that an economy can be revived by stimulating aggregate demand. As demand rises, prices and output are likely to rise as buoyant business conditions are reflected in rising profits and falling inventories. Business enterprises will respond by increasing output and employment. If aggregate demand is less than expected, businesses will experience rising inventories and falling profits, and reduce employment and output accordingly. Thus economies decline as a result of a deficiency in aggregate demand.

The working kits of modern econometrics provide a variety of analytical devices utilised by Keynesians to interpret national accounts and economic trends in order to formulate policy proposals. The most important are anti-cyclical fiscal and monetary interventions to manage demand aiming at stabilising the cyclical variations of the economy. It is particularly relevant to take a closer look at the impact of the “multiplier effect” of government spending and the role of the “automatic stabiliser” as fiscal devices to be used as part of discretionary fiscal policies.

The theory behind the “multiplier effect” is that an increase in demand (as a result of government stimulus) will initially boost income by an equivalent amount. This increase gives rise to further rounds of demand stimulus and output growth. This “multiplier” is driven by the marginal propensity to consume. For example, if the government increased spending on poverty relief by $20 million in order to pay unemployed people to repair rural roads, then the “multiplier effect” on the total national income would be that a portion of the $20 million paid to the workers, say 80 percent (i.e. $16 million), would immediately be spent on such items as food and clothing. This would mean that the income of retailers would rise by $16 million. They, in turn, would spend 80 percent (i.e. $12.8 million) on supplies and stocks. Then 80 percent of this income, which would end up in the hands of producers and retailers, would be re-spent. This cycle would continue until no extra income is generated. Adding up all the injections of income ($20 million + $18 million + $12.8 million, etc) could total up to a sum in excess of $100 million. This means that by manipulating the demand level, the government could, in theory, stimulate available resources into productive use. The underlying idea is that people would spend a certain portion of their income on consumer goods and services. Thus injections of government spending can have a magnified effect (Keynes called it a “cumulative force”) on economic output.

Government is the only institution in society with the ability and incentive to promote demand on a large scale over a wide range of products and for an extended period. Rooseveldt’s New Deal programmes created demand on a large scale over several years which led to strong economic growth in the USA. Similarly, the Second World War with its huge war expenditures illustrated the effectiveness of fiscal demand management on a large scale. For many, this was proof that the policies proposed by Keynes could work well. Optimism over macroeconomic government intervention became widespread. As a consequence a strong arsenal of Keynesian policy instruments was developed.

Throughout the post-war boom of the 1950s and 1960s governments acted on the assumption that the state could regulate aggregate demand and ensure full employment. This “Keynesian” policy hegemony was curtailed by the rise of inflation in the 1960s and “stagflation” in the 1970s. Extended periods of deficit spending generated a disease that Keynes never anticipated. It was called “stagflation” because it entailed stagnant growth, unemployment and rising prices at the same time. It illustrated the practical difficulties of applying fiscal expenditure decisions timeously and in correct quantities. Experience also showed that monetary measures are very blunt instruments.

The corrective action introduced around the world since 2008 to counter the massive economic downturn signalled a rediscovery of Keynesian measures – anti-cyclical deficit spending by governments combined with lowering interest rates and the unconventional central bank policy of quantitative easing to pump liquidity into the financial system. So far, these measures have not produced significant results. After four years of extremely low discount rates, the advanced economies are still moribund and demand still sagging. With persistent unemployment and excess capacity and fiscal policy paralysed by large debts, central banks have ballooned their balance sheets in terms of the volume and range of assets held. Central banks are constantly under pressure to buy government debt. The next step would be to consider purchases of private debt such as bank and corporate bonds in order to expand credit facilitation – and hope for a positive outcome!

Reliance on the effect of the “automatic stabiliser” - as an exit strategy from chronic deficit spending and mounting public debt – is based on a national accounting delusion. It is the very source of stagflation. It assumes that a debt incurred during the downturn as a result of lower tax receipts and higher spending in the form of stimulatory “handouts” will be automatically reversed when the upswing takes effect. But in reality this “stabilising” process can only come into play if and when there is an upswing – which, in turn, depends on the nature and realistic value-adding effect of the deficit spending. If the spending fails to produce a macro-economic turnaround, the whole deficit spending process will prove to be a gigantic Ponzi scheme financed by ballooning institutionalised inflation. Automatic stabilisers fail when both rising unemployment and high inflation are present.

In the wake of the global economic meltdown that started in 2007, the world saw the biggest fiscal expansion in history. Across the world countries sought to counter recessionary pressures by cutting or keeping taxes on hold and by boosting government spending in terms of their “fiscal multiplier” expectations. During the fiscal years 2009 and 2010, the G20 economies introduced stimulus packages worth an average of around 2 percent of GDP. It is not clear how well, or indeed whether, such stimulus packages work. The question hinges on the scale of the “fiscal multiplier” which, in turn, depends on a range of economic factors such as the scope of spare capacity and the ability of the economy to spur its productive factors (capital, labour, natural resources, technology and entrepreneurship) into action. The multiplier is also likely to vary according to the type of fiscal action (eg. national infrastructure projects versus consumer spending on imported goods). It also depends on the way governments finance their stimulus spending – taxes or loans.

On balance, the history of policies aimed at managing aggregate demand is not encouraging. Because of time lags and misdirection of deficit spending, both recessions and inflationary pressures are exacerbated by fiscal intervention. Governments become addicted to “welfare on credit” payments and thus render fiscal policy more disruptive than constructive. Not all expenditures nor taxes have the same multiplier effects. Continued deficit financing has “crowding out” effects on private investment and expenditure, whilst rational expectations of consumers may neutralise the multiplier effect of a government’s deficit spending. A major problem associated with fiscal expansion is the resulting public sector growth which increases inflationary pressures. Since a large portion of all government spending (more than 50 percent), is absorbed by the running costs of institutions paid out of the public purse, it escalates institutionalised inflation to levels that are not easily reversed.

Reliance on the “multiplier effect” approach, coupled with the presumption of an “automatic stabiliser” at work, tends to focus on abstract, immeasurable macroeconomic variables, away from the visible micro-economic world of the individual enterprise where real wealth creation and job creation takes place. Increasing “gravy train” handouts to promote short-term consumer spending by unemployed or under-employed persons can help as a welfare measure to alleviate poverty and hardship, but such measures are not likely to have a positive impact on business investment and expansion – the ultimate source of future growth, employment and the generation of taxable income.

Austerity and Growth

Recently the EU policy debate has shifted towards a false dichotomy: choosing between austerity and economic growth as if they are mutually exclusive. The Merkel government in Germany is identified with austerity as a necessary part of Europe’s healing – cutting wasteful spending and working harder and longer. The anti-austerity camp is essentially driven by the recipients of government largesse and the mouthpieces of the bondholders who are making money out of deficit-spending governments. Germany is trying to persuade European leaders to agree to a “fiscal pact” that would toughen budget rules and enshrine balanced budgeting in national constitutions, monitored by the European Court of Justice. The UK opponents to such a new pact argue that it might help to prevent future crises, but would do little to halt the current one. Egged on by its banking interests, the UK wants the European Central Bank to buy as many sovereign bonds as it takes to calm bond markets, i.e. the mutualisation of the euro-zone government debt with Germany providing supportive guarantees.

During the 2011 financial year Germany, France, Spain and Italy all managed to reduce their structural budget deficits marginally, largely on account of austerity measures. But some IMF economists are reported by The Economist to have detected a correlation between austerity measures and weaker

51 growth! However, these findings must be considered as highly questionable. It should be clear that correlation over a brief recessionary period does not indicate causation. At this point in time, any budgetary item will correlate with a weak growth outlook. Profligate chronic deficit spending to unsustainable levels has been the prime cause of the economic quagmire in the first place. At best it should be argued that austerity measures to decrease debt should be systematically phased in and accompanied by efforts to accelerate growth. The mountains of debt have been accumulated over many decades and it would require a massive cultural change to turn around the weak growth potential of the advanced economies. It requires a rediscovery of the real sources of economic growth: striving to become more industrious, self reliant, innovative and entrepreneurial. They must use their resources in new ways to heighten their efficiency, effectiveness and productivity. Rewards must be tied to productive efforts.

Ironically, it is the private sector that bears the brunt of the economic downturn. Private sector employers are subject to the discipline of the “bottom line” as determined by market conditions in order to survive – and ultimately to the “iron law” of the insolvency act. Hence the private sector employee is constantly subject to productivity standards and is the first to be retrenched, or to be required to work fewer hours or to forfeit wage increases. In contrast, public sector employees, who in most Western countries represent about 20 to 30 percent of the total workforce, are not subject to stringent productivity standards, retrenchment or salary reductions. Their emoluments are, on average, much higher than the private sector and a very small proportion are temporary or part-time workers. In contrast, a very small proportion of private sector employees are high-flying CEO’s or professionals or investment specialists with flourishing bonus-driven packages.

Unfortunately, no amount of modern computerised modelling can tell how deep and how long the economic meltdown is likely to be. What we do know with certainty is that there is no long-term future in short-term “gravy-train” handouts. We know that sound government policies, an appropriate rate of savings, a high rate of productive capital investment, a skilled and non-disruptive labour force and the availability of strategically important natural resources have a vital role to play. We also know that throughout the world free enterprise economies have consistently outperformed socialist command economies in terms of higher levels of health, life expectancy and income.

Revitalising Economic Growth

A country’s economic growth is usually measured in terms of increases in its gross domestic product, i.e. the total output of all final goods and services produced by all productive resources of a country. The rate of growth depends on increases in the quantity of available productive resources (capital, labour, natural resources, technology and entrepreneurship) on the one hand, and on the “total factor productivity” on the other, i.e. the improvement of the productive efficiency of the productive resources. Enhancing total factor productivity, in turn, depends upon the suitability and durability of the capital equipment, the skill levels as well as the motivation of the workers, the non-disruptive nature of industrial relations, the acceptance of superior and innovative production techniques, and on the willingness of business entrepreneurs to invest and reorganise their business enterprises to their maximum competitive advantage.

Supporting economic growth is as desirable a goal as striving for peace and happiness: most people agree that it is a critically essential objective, but few know how to achieve it. The key to rapid economic growth is business entrepreneurship. Governments need to nurture enterprise development – both large and small. In the final analysis it is only value adding, productive, profitable business

52 enterprise that is the basic source of taxable income – everything else consumes tax. Without taxable income, desirable public goods fade out of reach. One can only survive on debt for a brief transitional period – if you can find sympathetic creditors.

Since governments are net consumers of taxable income, government spending should be directed to catalyse private-sector-driven job-creating growth. In most countries small businesses are the main drivers of job creation. They are by far the most mobile, flexible and versatile form of enterprise. They are the least bureaucratic and most creative. They are adaptable by being quick to adopt new ways when conditions change. They use competition, customer choice and other non-bureaucratic mechanisms to get things done as creatively and effectively as possible. Everything possible should be done to promote the SME sector - access to financing, a flexible employment regime and a removal of burdensome regulatory obstacles to starting or expanding SME activities. The SME sector is the natural home of the entrepreneurial spirit of free enterprise. No entrepreneur can be sure that his or her planned investment will succeed, but if they do not take risks the other production factors (labour, resources, capital and technology) will remain idle. Optimistic people tend to gravitate to entrepreneurship. Although a large percentage of new small businesses fail in the first five years, it is the successful entrepreneur who knows how to calculate and manage risks. Also of critical importance are flexible industrial-labour relations for job contracts and wage determination. Inflexibility distorts job markets and sets up rigid distinctions between protected insiders and vulnerable outsiders.

Whenever governments step in to revive sagging demand and to restore investors’ confidence in job- creating growth, time-limited stimulus plans should be guided by the sustainability of debt levels and the restoration of market-led growth based on a credible exit strategy. Over-reaction to a crisis is as much a danger as under-reaction. Getting the right balance between supply-side and demand-side policies is the biggest challenge facing political decision-makers. The role of government, including the role of monetary policies, is to uphold and, if possible, to strengthen the private sector’s incentives to work, save, invest and innovate, and to take legitimate risks. The government also has a legitimate role to play in providing education, training and the development of productive skills and in maintaining or strengthening macroeconomic efficiency through ensuring the existence of well-functioning markets in goods, services, labour, credit and capital. A bleak scenario of an economy spiralling downwards can only be avoided by creating a climate for enterprise which allows confident business entrepreneurship to re-ignite the engines of economic growth and prosperity for all. The restoration of investors’ confidence is of overriding importance.

Concluding Remarks

It is clear that the current crisis is not per definition a generic failure of markets. It is a specific failure of financial markets coupled with profligate government spending. The need for regulating the world of finance cannot be denied. It has always been prone to bubbles, panics and crashes since the early days of international finance. Governments have always been involved in the regulation of financing: monitoring risky strategies, punishing scams and prescribing capital cover. But in recent years financial innovation has outpaced governmental rule making. Derivatives such as collateralised debt obligations and credit default swaps flowed undetected into the international financial circuit. The imbalances caused by China’s intervention to hold down its exchange rate (against market trends) sent a wash of capital into the American market. At the same time, the citizens of the rich countries have saddled their political economies with unaffordable privileges, bloated bureaucracies, rigid labour relations and welfarist benefits.

The distress of the advanced economies was caused by policy mistakes as well as the financial world’s market excesses. The way out seems to be more a matter of better regulation than more regulation. What is needed is better government, not more government.

Can the advanced nations re-ignite their powers of recuperation and renewal? They can only avoid the bleak scenario of seeing their economies slowly spiralling downwards by balancing their budgets and by creating a climate for enterprise which would allow business entrepreneurship to ignite the engines of economic growth and prosperity for all. Those who are habitually clamouring for more collective action by national or supra-national governments should do well to heed the words written by Samuel Johnson more than two centuries ago:

“How small of all that human hearts endure That part which Laws or Kings can ... cure.”

5. Fixing the Flawed Financial System (November 2012)

Since the onset of the GFC meltdown, a consensus has grown amongst observers and analysts that several possible causes must be considered: dodgy financial practices and instruments, the operation of a shadow banking system, an excessive lending boom, excessive optimism creating asset price bubbles, global financial imbalances, contagious international capital markets, a collapse of confidence, lax regulatory regimes (particularly in the USA and the UK), manipulative speculation by the capitalist cronies in New York and London. Left-leaning ideologues claim that the root of the problem lies in the free-market system associated with fat-cat “Anglo-Saxon Capitalism”.

It is clear that single-cause explanations are totally misleading, but it is also true that some factors are more central than others. The general public have shown a strong sense of anger first and foremost with the financiers of Wall Street. Their fury is particularly directed against bailed-out bankers, obscene fat-cat bonuses and overpaid, under-achieving captains of capitalism. The proverbial “man-in- the-street” does not understand what a “credit-default-swap” is, but they understood that Wall Street messed up because they felt the consequences: losing a job, seeing their wages frozen or the value of their savings tumble. They expected the “animal spirits” of Wall Street to be tamed.

The Impact of the Global Financial Crisis

The economic history of the Western world is punctuated with crises and disasters. Booms have often given way to busts. The business cycle seems to be a pulse common to all free enterprise economies. When it comes to explaining these cycles, economists differ on their emphasis upon causal factors: inventions, demographic changes, political warfare, financial practices, waves of optimism and pessimism, multiplier reactions to government spending, consumption or saving levels and investment patterns. Generally speaking, it is much easier to explain past events and trends, than to accurately predict the future.

The two major financial catastrophes that occurred over the past century were the Great Depression of the early 1930s and the Global Financial Crisis that was unleashed in 2007. Much has been written about the causes and consequences of both crises, but the simple truth is that they originated in crashes of the New York financial markets. The Great Depression was unleashed by the crash of the New York Stock Market in 1929 which spilled over into the failure of many banks. The Global Financial Crisis started with the collapse of investment banks Bear Sterns and Lehman Brothers, followed by a widespread collapse of financial markets across the globe.

The overall manifestation of the crisis was reflected in a serious deterioration of all economic indicators: gross domestic products, consumption levels, retail sales, employment levels, investment levels, current account levels, exports and imports, public debt, interest rates, etc. Economic activity contracted across the board. The financial system around the world was shattered, tax revenues plummeted, household debt levels sky-rocketed, vast amounts were knocked out of the values of stock market shares and world output shrank to dangerously low levels. Searching questions were asked about whom or what was to blame.

The GFC was a devastating blow to the integrity of the finance and banking world – particularly the operators and cronies of Wall Street and the City of London. The credibility of the fraternity of professional economists was also called in to question: they did not predict the crash and afterwards

55 were unable to agree on the best way to handle the crisis. The proverbial “man in the street” realised that the crisis started somewhere in the world of finance. Unfortunately few persons had a comprehensive understanding of the intricacies and components of the world of finance.

The Building Blocks of the Modern Financing System

Niall Ferguson, in The Ascent of Money, identifies three innovations that played key roles in the evolution of banking. The first was exchange banks set up in the Netherlands in the 17th century which pioneered the system of cheques and direct debits or transfers to allow commercial transactions to take place without the need for coins. One merchant could make payment to another simply by arranging for his account at the bank to be debited and the counterparty’s account to be credited, i.e. cashless intra-bank and interbank transactions. The second innovation was initiated in Sweden in 1656 with the introduction of “fractional reserve banking”, which meant that banks could advance loans in excess of the deposits kept in their reserves. It is based on the assumption that depositors were highly unlikely to reclaim their deposits en masse. The bank could profitably grant multiples of the money kept on deposit as interest-bearing loans to others. The third innovation occurred in London when the Bank of England was created in 1694 to assist the government with war finance. It purchased government debt in exchange for the issue of promissory notes (banknotes).

Jointly these innovations became the essential building blocks of the much more elaborate modern financing system. In time fractional reserve banking became a cornerstone of financial credit on the commercial retail level. Central banking became the cornerstone of the public financial system. Money, now invisible, represented the sum total of specific liabilities (deposits and reserves) incurred by banks as reflected in account statements. Relationships between debtors and creditors were brokered or “intermediated” by increasingly numerous and complex banking institutions – all trying to maximise the difference between the cost of their liabilities and the earnings on their assets. Underlying all of these relationships is a crucially important element of confidence – in the ability of all the banking institutions to satisfy their clients (depositors, investors and lenders) that they can meet their liabilities.

The next important component of the modern financial world was the evolution of the bond market. It is based on the securities (paper assets) issued by governments, large corporations or financial institutions undertaking to make payment of a certain amount at a certain interest rate to its certified owners at maturity. Redemption periods may vary and interest rates may be fixed, variable with notice or linked to some financial index. Government bonds, as well as those of well-established firms, are normally regarded as safe, while financially adventurous firms issue “junk bonds” where it is recognised that the borrower may default. The market price of a security is sensitive to changes in current and expected interest rates. Bond-rating agencies specialise in assessing the creditworthiness of governments, municipalities and corporations issuing bonds.

Over several centuries, bond markets have become important sources of finance for governments for bridging as well as longer term finance, e.g. for short and medium term deficit budgeting as well as the financing of long term capital projects. Large corporations and banks are also regular users of bond market financing. The total value of internationally traded bonds is difficult to establish with accuracy, but can be expected to approach US$50 trillion – bigger than the world’s stock markets put together.

Bond markets are also important determinants of the availability and cost of credit to governments as well as business corporations. They are in a position to pass daily judgement on the credibility of every

56 government’s fiscal and monetary policies. Its real power lies in its ability to facilitate government borrowing, to punish a government with higher borrowing costs and even to dictate policy direction.

The investors in bond markets include several governments of Asian emerging economies as well as oil exporters in the Persian Gulf who have been running current-account surpluses. These assets are kept in currency reserves or in sovereign wealth funds. It made government controlled funds a considerable force in global capital markets. The rest is made up of global insurance companies, global wealth funds, money-market funds and large pension funds. Concentrated ownership of large wealth funds by authoritarian governments is a serious strategic and economic concern – particularly in view of the general lack of transparency. Interactions are highly secretive and not subject to public responsibility or accountability. Total assets in the hands of “investors” in the bond markets world wide could be as high as US$150 trillion. Jointly they are the main creditors of governments, business corporations and banks.

A major deficiency of the bond market as it functions today is what has been called the “scarlet pimpernel” roll of bondholders. They normally end up as privileged creditors whenever the losses on defaulting debtors (eg. countries, banks or corporations) are allocated. Shareholders and unsecured debt holders (including bank depositors) are the first creditors to take a “haircut”. Bondholders usually own “secured” debt – in the form of “covered bonds”, derivatives or contractual loans. They are “secured” in the sense that they have prioritised calls on the available assets to be divided up amongst the creditors. In the aftermath of the GFC it was left to taxpayers to provide “bail-out” money to the failing banks or corporations. This plunged the respective countries into debt in order to repay the banking system’s bondholders. Regulators did not impose the losses on bondholders in order to avoid a wave of panic in financial markets. It was also feared that imposing losses on bondholders would spook financial markets and drive up the cost of bank debt and hence the level of interest rates charged to their borrowers.

The Global Financial Crisis and its aftermath exposed many dark spots in our knowledge about and understanding of the global financial system. A bewildering list of financial exotica played a significant role in the meltdown and subsequent contraction. Regulatory bodies normally have national footprints whereas investment banks and other financial operators work on a supra-national scale – beyond national borders. Without reliable data, regulators cannot exercise “macro prudential” oversight over the quantity, quality and maturity dates of the financial assets kept by banking institutions to cover the loans they grant. Many questions have been asked about the “shadow banking system” which refers to non-bank financial firms that operate outside the regulatory perimeters. Then there are questions relating to off-balance-sheet positions, untamed derivatives trading, cross-border trading and lending exposures and securitised lending. The constant evolution and footloose nature of the international financial system not only complexifies matters, it complicates the interpretation of trends and the choice of remedial action. Private equity firms and hedge funds are mostly funded by banks to finance their deals. Yet they operate mostly in the shadows. The catastrophic crash in 1998 of the Long-Term Capital Management (LTCM) hedge fund showed that failure in their ranks can inflict major damage, not only on capital markets but also on the economies of nations. The use of subsidiaries, offshore deposits and tax havens make it impossible to quantify debt levels and risk – eg. the scope of hedge funds trading in exotic derivatives.

Improving the Integrity of Financial Markets

The quality of information flowing to investors and many ordinary members of the public is an important ingredient of the proper functioning of a competitive financial market. What is at stake is the integrity of financial statements and much depends on the role played by accounting firms and information systems. But every audit involves many fine judgment calls.

A controversial issue is the extent and timing of information disclosures. Who should be in the know? Much depends upon whether certain favoured security analysts and portfolio managers are provided with information at the same time as the general public. The famous Supreme Court Justice, Louis Brandeis, remarked that “sunlight is the best of disinfectants” for market and societal failures. Selective disclosure is not reconcilable with fairness and transparency and should not be tolerated.

The Securities Industry Association argues that special privileges given to rating agencies and the media is necessary because they are “conduits to the public”. But the simple truth is that access to extra information is a way to earn pots of money – particularly on Wall Street where there is a long tradition of trading to benefit a small group of insiders. It is essential to eliminate conflicts of interest in the production of financial information and barriers to distributing it. It is a source of stock manipulation. With a growing number of citizens with direct stock holdings, it is essential that market information should be placed in the public domain freely and fairly.

The Securities and Exchange Commission (SEC) was created by Congress to supervise financial market practices. As the first chairman of the SEC, Franklin Roosevelt chose Joseph Kennedy – a man who had first-hand experience of every trick in the exploitation handbook – who then became an extremely prosperous fox in the henhouse. The Financial Accounting Standards Board (FASB) was created to set the rules for company accounting. A decade ago the FASB proposed the introduction of a sensible plan to require companies to charge the cost of employee share options against profits. It also proposed to make companies reveal clearly the costs of merging instead of “pooling” their accounts to avoid charging the difference between the purchase price of a company and the value of its assets against profits. The FASB wanted to replace this practice with “purchase accounting”, which forces companies to run the true cost of an acquisition through the accounts, dampening their apparent “post-merger” performance. In both instances the “independent” FASB was pressured by Congressional Committees (in turn pressured by Wall Street lobbies) to abandon their control initiatives.

The American regulatory scheme is based on the premise that government can best support financial markets by ensuring that investors get accurate information. To manage the massive volume of American security issuance, a system has been constructed that operates with a relatively small staff, relying on the integrity of the accounting profession, the securities bar and private rating agencies. After several decades of fiascos and breakdowns, the credibility of that system is at risk. The recent financial crisis was to a great extent the consequence of allowing too much scope for the financial industry.

On balance, it appears that too much hope should not be placed on the regulatory prowess of “independent” agencies. They seem to be easily “captured” by vested interests. The best defence against malpractices seems to lie in competitive pressures. Another avenue to let the “sunlight” in is direct electronic access to information by the general public.

The Scope of the Malaise

The experience of the GFC illustrated beyond all reasonable doubt that the American financial system has gone seriously amiss. The system ended up with the government taking over some of its biggest institutions, which required an injection of $700 billion in public money to stave off a catastrophe. The disappearance of all five big American investment banks – either by bankruptcy or rebirth as commercial banks – is powerful evidence that Wall Street failed the test of the market place. Financiers make mistakes and everyone else has to pay for them.

Explanations for the malaise have been sought in a variety of causes: the speculative greed of the Wall Street crony network, financial misconduct by unscrupulous Wall Street money magnates, inherent instabilities and weaknesses in the financial system, inadequate regulatory oversight, to mention but a few. The new system evolved over the past few years in conjunction with three simultaneous but distinct developments: deregulation, technological innovation and growing international mobility of capital. The rationale behind financial deregulation was that freer markets produced a superior outcome. Unencumbered capital would flow to its most productive use, boosting economic growth and improving welfare. Innovations that spread risk more widely were said to reduce the cost of capital, allow more people to access credit and make the system more resilient to shocks.

There are many solid reasons to question the validity of these claims. The highly leveraged, lightly regulated, market-based system of allocating capital dominated by Wall Street and the City of London have failed. It led to the questionable and misleading trading practices of hiding highly risky assets under the cloak of safe securitization, and to gluttonous excess. It caused incalculable damage around the world as a result of the collapse of the financial system. The loss of growth opportunities and trade elsewhere in the world more than cancelled the dubious benefits American sub-prime borrowers might have derived from the innovative dodgy financial instruments dumped on foreign banks. Even domestically the broader access to credit clearly fuelled a housing bubble. Demand for complex mortgage securities led to a loosening of lending standards which, in turn, drove housing prices higher. Wall Street’s fancy computer models underestimated how much the innovation was pushing up house prices, understated the odds of a national house-price decline in America and so encouraged an unsustainable explosion of debt. By 2007 household debt had risen to 140 percent of disposable income. To the extent that the innovative financial instruments fuelled the bubble, so it exaggerated the bust by adding serious and destructive instability.

In theory, derivatives, securitization and a choice of financing instruments should spread risk, increase the financial sector’s resilience and reduce the economic damage from a shock. In actual fact, uncertainty bred illiquidity. High leverage ratios and a reliance on short-term wholesale funding rather than retail deposits left the system acutely vulnerable to panic. Thus the dodgy financial instruments of investment banks and hedge funds and other creatures of the new finance have made the economy less resistant to financial shock.

There is clearly a need to move financial markets away from highly geared investment banking operations towards the safety of lower leverage and better regulated style of commercial banking. A further improvement required to the existing financial infrastructure is the creation of a clearing house for trading credit-default swaps, so that the collapse of a big force in the market (such as AIG) does not threaten to leave its counterparties with billions of dollars in worthless contracts.

The evidence is also mounting that the institutional framework for exercising supervision and control was totally inadequate. This problem was particularly acute in the USA with its fractionated system ridden with corruption and conflicts of interest. Also in the UK, the machinery created to monitor, supervise and control the financial system left much to be desired. Taxpayers need reassurance that the excesses which led to a global financial crisis will not be allowed to repeat themselves. It requires revamping the regulators as well as the regulated.

The most vexing challenge is to reconcile the sanitising and upgrading of the regulatory regime with the operational freedom of the chief suspects responsible for the infection and toxification of the financial markets: the hedge funds, the private-equity firms and the sovereign wealth funds. It is a contradiction in terms to talk about the need for accountability, transparency and public responsibility while simultaneously singing the praises of these “innovations” as contributing to the liquidity, diversification and efficiency of financial markets. You cannot have a secure international peace without identifying, isolating and containing secretive, unaccountable, rogue regimes brandishing nuclear and chemical weapons. You cannot have a free flow of international trade and investment if the shipping lanes are constantly exposed to clandestine pirates and raiders and their murky operations.

During the recent decades these financial market “innovations” emerged with the specific purpose to evade, escape or circumvent the rules and regulations applicable to regular financial institutions. Protagonists claim that hedge funds, private-equity companies and sovereign wealth funds have contributed to liquidity, diversification and efficiency of resource allocation in financial markets. These claims are not supported by convincing evidence. Recent experience shows very much the contrary. These institutions are destabilising financial markets by their use of undisclosed transactions, toxic instruments, covert operations, overwhelming financial clout and, in the case of sovereign wealth funds, intimidating political and strategic posturing.

Today’s world is facing a growing asymmetric distribution of political and economic power which not only marginalises smaller countries and business enterprises (e.g. banks, manufacturers, miners and service providers), but exposes them to unavoidable exploitation and manipulation. In this international jungle of “locusts”, “barbarians”, “crony networks”, “sovereign domestic interests” and hidden agendas, the financial world has become too volatile, inconsistent and dysfunctional.

The oceans of international finance are now roamed by pirates and raiders who can hold governments to ransom. They are free to raid banks and companies with impunity. They are not subject to the normal rules of public responsibility, public accountability and the rule of law: their operations are clandestine, their wheeling and dealing “off-the-record”, their membership anonymous and their assets undisclosed. They are allowed to borrow heavily from banks, who are themselves highly geared and dependent on taxpayer support when they run into trouble. They are only answerable to a relatively small clique of cronies with undisclosed incomes and fortunes stashed away in numbered accounts in tax havens. Why should public corporations be subject to public scrutiny, while for shadowy operators anything goes?

In the USA the Sarbanes-Oxley Act was passed in 2002 to tighten the auditing, accountability and disclosure burdens placed on public companies. It was intended to improve corporate governance and reduce the kind of fraud that led to the collapse of high-flyers like Enron. Now private equity firms are largely exempted from complying with Sarbanes-Oxley because their stock are not held by the public. Yet they carry large amounts of debt to public companies which could create serious problems when

60 credit conditions are tight and interest rates are rising. To what extent is their success due to distortions in the US tax code, which taxes equity financing more heavily than debt financing – hence encouraging more debt – which allows private equity firms to pay lower taxes on their earnings. This inequity makes a mockery of the US tax code, particularly given the huge sums of money being earned by the principals of private equity groups. What is the point of expecting disclosure and high standards of corporate governance from public companies, while the private equity group can get away with secretive business stealth?

It is difficult to see how the secretive funds and firms help to allocate capital more effectively and enhance the productivity of the economy. How is it measured? To what extent are they acting as “Trojan Horses” for money launderers, smugglers and gangsters – or for foreign invaders using unaccountable sovereign funds from undisclosed sources?

The simple fact is that hedge funds, private-equity firms and sovereign wealth funds have been created expressly in order to circumvent existing regulations. The answer clearly lies in a regulatory regime that requires more “daylight” exposure: less secrecy and more transparency. What is the rationale for regulation if it only applies to institutions operating in the “daylight”, while the real shadowy suspects carrying infections and toxins are allowed free reign?

The Fundamentals of Better Regulation

Where, how much and by whom should financial regulation be extended? It is clear that better rules and sharper-minded regulators would help. Recent experience has shown that regulators are fallible and that financiers tend to gain advantage of their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant. As many countries are trying to dig out from the severe financial markets debacle, it is necessary to restore effective oversight.

1. A Macro-prudential Prescriptive Approach to Regulating Capital and Liquidity Requirements There is a growing consensus that the answer lies in coupling stricter regulatory oversight with higher capital requirements: equity and other risk capital (e.g. using bonds that automatically convert to equity when trouble strikes). Regulation cannot prevent financial crises altogether, but it can minimise the devastation. Loading banks with higher capital requirements would slow the creation of credit to manageable proportions. In the aftermath of the recent severe downturn, serious questions have arisen about what the appropriate levels of bank capital should be. There is a strong momentum behind the idea of fixing a stern leverage ratio, i.e. conservative measures putting fixed ceilings on the total amount of assets that a bank can hold relative to its capital. The Swiss have already introduced such a ratio to be phased in by 2013, to sit alongside the international “Basel 2” capital rules. Basel 2 imposes limitations in relation to the risky nature of the relevant assets. Banks facing meagre capital charges in their trading books have a built-in tendency to over-expand their assets – particularly if they are allowed to make disastrously optimistic assumptions about the liquidity, risk profile and price stability of the assets (e.g. mortgage-backed securities).

The liquidity of banks’ balance sheets also needs to be regulated more intensively. Banks should be required to hold a greater cushion of liquid assets e.g. “prescribed” assets such as government bonds. In the past the UK’s Financial Services Authority (FSA) tended to take a passive, less prescriptive approach to its regulatory role. It focused primarily on management controls and systems. In future it should be required to replace this flexible, passive approach with a more intrusive regime. In the

61 aftermath of the GFC, much has been said about the need for a “macro-prudential” approach to regulation. Instead of simply looking at the soundness of individual institutions, regulators are now urged to think harder about the stability of the system as a whole.

2. Independent Unified Regulatory Systems The important challenge is to determine the purpose of regulation and then to let the appropriate structure follow the contours of the functions. It is clear that the clumsy, inchoate, complicated, decentralised and overlapping system of federal and state financial supervisors in the USA is ridiculous by any standard of professionalism. Many calls have been made for higher capital cover, better disclosure, more transparency, more public accountability, better expertise, higher standards of professionalism and a keener sense of public responsibility. Professional independence must be seen to be maintained – particularly in respect of the revolving doors between Wall Street and regulatory agencies.

In the UK suggestions have been made that the Bank of England should be in charge of not only interest rates but should also be given two big tasks of regulation: guarding the overall system’s stability (macro-prudential regulation) and supervision over individual financial institutions (micro regulation). Until 1998 the Bank of England was responsible for supervising the banks, when the Labour Government established the Financial Services Authority (FSA) to oversee financial markets and securities trading. This system failed in its task and has been overhauled by the Conservative Government. The functions of the FSA have brought under the umbrella of the Bank of England.

For years most central banks concentrated on using a single tool, interest rates, to achieve a single goal, price stability. They ignored, or failed to identify, huge asset bubbles and the destructive actions of individual banks. Experience has shown that central bankers should consider the economy as a whole as well as the state of the financial plumbing behind it. By using tools such as bank-capital requirements and credit controls, they can try to prevent excesses building up again.

If they are to take responsibility for maintaining stability, the central banks must have the power to act. That implies the authority to swoop on individual firms that pose a threat to the system. Central banks should be able to do more than merely issue sermons. The responsibility to handle the day-today supervision of individual financial firms is a harder task. It requires access to reliable current information and an arms-length relationship with the banks. It raises the risk of supervisors being “captured” by bankers.

Any regulatory regime faces a few crucial challenges: finding competent financial policemen, slaying the dragon of moral hazard and managing the risks of political pressures. The way to proceed is to inculcate the full understanding and realisation in the public mind that any new extended responsibility of the regulatory regime did not come about by accident – it was born out of previous laxity and failings. A single entity of decision-making should be responsible for overseeing both price and financial responsibility. They need to reform the operation of the banking system so that it poses fewer risks to society. Taxpayer guarantees must be reduced by forcing banks to build up capital buffers to absorb losses. Otherwise the future will consist of more banks that are too important to fail and central banks that are destined to fail with their tasks.

3. Strengthening Banks A common strategy followed by governments around the world during the meltdown, was to stabilise and prop up the banking system. Governments have been taking over failing banks, injecting capital, endorsing high bank leverage and guaranteeing bank deposits. That meant that banks could thrive: keep their profits, palm off losses on the taxpayers, raise loans at low interest rates, pay plentiful depositors next to nothing and desperate borrowers queuing up for loans – promising handsome margins and bonuses.

The bottom line is that the measures required to counter the financial crisis created a bonanza for the banking fraternity. After their write-downs, the banks gained a huge bargain from the state (meaning the taxpayers): a safety net against collapse in exchange for a continued flow of payments and credit that would otherwise have resulted in a depression. The result is that governments are now deeply embedded in their banking systems.

In the USA government efforts to rescue banks dates back to the Depression era when the Glass- Steagall act of 1933 created the Federal Deposit Insurance Corporation (FDIC). Since then, similar deposit-guarantee schemes have been created around the world to help persuade savers, who are otherwise unsecured creditors of their bank, not to remove their money in troubled times. When the total market capitalisation of the banking industry fell by more than half in 2008, erasing all the gains it had made since 2003, the federal government introduced the Troubled Asset Relief Programme (TARP). That made the US government the largest shareholder and guarantor of its liabilities of the largest bank, the Citigroup. In Britain the government, representing the taxpayers, became the majority shareholder of the Royal Bank of Scotland (RBS) and the Lloyds Banking Group. In Sweden, Nordbanken, was fully nationalised in 1992 and partly refloated three years later, but the state remained its largest shareholder under its new name of Nordea. It took four years for the government’s liability guarantees to be lifted.

The duration of the government’s involvement depends on the quality of the relevant banking assets and the duration and severity of the downturn. As long as the banks’ loan losses continue to rise, the presence of governments is necessary to reassure creditors and counterparties. Struggling institutions are often vulnerable to attack from short-sellers. The likely torrent of government borrowing could make it harder for banks to attract private funding. The more government-backed debt is issued, the greater the risk of creating another refinancing problem when state guarantees expire. Governments also need to stay engaged in the banking world to counter the tendency of banks to lend less during slowdowns. Although it is a good thing for banks to be cautious lenders, after a downturn there is an urgent need to lend more in order to prop up the economy. It is also necessary to realise that the longer governments stay involved in banking, the more they will tend to distort competition. Government involvement is usually heavily politicised. The rescue and propping up of banks (including explicit government guarantees) gave rise to a huge expansion of the “moral hazard” problem in the world of finance: the danger that the existence of government safety nets encourages market participants to take bigger risks than they would otherwise have done.

4. Separating Retail Banking and Investment Banking The GFC that started in the USA in 2007, focussed attention on two serious structural questions: distinctions between “utility” retail banks and “casino” investment banks: and, what to do about banks that are too big to fail. Both problems have become more acute as a result of post mortems done on the causes and consequences of the crisis. The boundaries between retail and investment banks have been blurred by recent take-overs in the USA. J.P. Morgan Chase (retail bank) has taken over Bear Sterns

(investment bank) and Bank of America (retail bank) has taken over Merrill Lynch (investment bank). Similarly, combinations like those of Wells Fargo and Wachovia, Lloyds TSB and HBOS, Commerzbank and Dresdner Bank, have bloated the biggest institutions, not slimmed them. Statistical information indicates a trend towards concentration of deposits among America’s top banks. These trends question the likely success of purging the big banks by cordoning off those parts of their activities that pose a systemic risk – in effect breaking big banks up into smaller more focussed and manageable parts. The counter-argument is that limiting the size of banks could prevent them from attaining the size and scope to finance global business.

The US evidence does not provide unqualified support to the contention that the separation of retail and investment banking, and higher capital charges based on size, or the breaking up of institutions, offer easy clear-cut solutions. Stand-alone investment banks, such as Lehman Brothers, and pure retail banks also failed. Which bit of investment banking is casino? How artificial is the distinction between deposit-taking institutions and wholesale-funded entities? Much of wholesale funding comes ultimately from individual investors in the form of pension and mutual funds, thus blurring the distinction. There are similar problems with defining the borders between acceptable and unacceptable activities. Many banks perform tasks such as cash management, trade finance, estate planning, that fall outside the definition of narrow banking. But these problems are not insurmountable. It is true that any form of lending ultimately entails risk. Extension of credit to a small business is a very risky activity, but enjoys taxpayer support. Credit-default swaps are vilified, but according to some proponents could serve a valuable function – although this cannot be an unqualified assessment.

A re-classification of the structuring of banking finance is likely to raise an untidy set of choices. Systemic changes to institutions’ balance sheets will have a substantial impact on the types of businesses banks become. The alternative is to rely on flexible judgments on the quality of management, rather than the business model. But this option inevitably takes us back to where we started – in the wake of a major breakdown of the status quo ante. Once the market realises that banks are considered too important to fail, financiers are likely to continue taking on too much risk. As taxpayers will continue to subsidise banks’ funding costs, they will also be subsidising the dividends of their shareholders and the bonuses of their staff. The implication is that in finance and banking, both the twin evils of excessive risk and excessive reward can ravage the economy.

How can this dilemma be resolved? Step one is to make the problem less likely by boosting their safety buffers by prescribing higher capital levels of at least 15 percent of risk-adjusted assets. The next step would be to impose some losses on their creditors. This may include overnight loans from other banks, money-market funds and bonds held by pension funds. Regulators could be given the power to convert the bottom of the debt pile into equity if a bank runs into serious trouble. New rules on funding and liquidity should force banks to keep more liquid assets that could be easily sold should they need to raise funds urgently. In essence a new regulatory regime should aim at introducing convertible capital instruments and “bail in debt”, whereby creditors are turned into shareholders if losses rise high enough. The advantage of these arrangements is that losses fall where they ought on those who funded the banks. It should go a long way towards providing a ready-made pool of capital that should be able to refinance banks in emergency situations: a thick buffer of equity and convertible debts.

In the past banks have been allowed to build complex capital structures made from inferior components. Equity is the preferable sort of capital because it directly absorbs losses and can thus cushion against systemic shocks. Core capital is expensive, which explains why banks have sought to

64 dilute it with “hybrid capital” and other fancy instruments. Banks used these instruments because they carry tax-deductible interest. In Germany these instruments were called “profit-participation certificates” requiring an interest only when the banks are profitable. The misuse of these instruments could be avoided by clear-cut legislative restrictions.

5. Monetary and Fiscal Easing In terms of conventional monetary theory, cutting interest rates usually eased credit facilities, expanded investment and increased economic growth. Policymakers also had to keep in mind that very low interest rates could result in over-heating an economy and often ignited inflationary pressures. From the mid 1980s onwards central banks relied heavily on interest rate cuts to deal with financial setbacks. After Black Monday in October 1987, when the Dow Jones fell by 23 percent, the central banks cut interest rates. The same simple measures were taken during the Asian crisis of 1997- 98. After the dot-com bust, monetary easing did not rescue shares, but led to a housing boom and the under-pricing of risk in credit markets since the early days of the new millennium.

The popularity of monetary easing was based on its lowering of borrowing costs for companies, home buyers and debtors in general. To the extent that savers earned lower returns on their deposits, they were largely compensated by a rebound in the value of their equity holdings. During the period from the mid-1980s to the end of the first decade of the New Millennium, monetary easing appeared to be costless: low interest rates did not appear to be igniting inflationary pressures. Whether that was due to new ways to measure inflation or the deflationary pressures emanating from China and India entering the Western markets, is still an open question.

Since the mid-1990s government authorities, particularly in Japan, resorted to considerable volumes of quantitative easing: using the balance sheets of central banks to ensure the funding of clearing banks and to keep a lid on bond yields – which became necessary on account of the huge levels of fiscal easing (deficit spending by governments). In several countries budget deficits had soared to 10 percent of GDP. It is clear that fiscal easing is now seen to be more costly than monetary easing. Initially, fiscal easing by way of deficit budgeted stimulus packages, were seen as bail-outs for greedy financiers. But the focus of criticism has shifted to the deterioration of government finances and the potential for higher future taxes, borrowing costs and inflation.

During the 1950s and 1960s, Keynesian stimulus packages were also seen as costless. Governments thought they could fine-tune their economies out of recession. Eventually it was realised that the ultimate result of too much stimulus was higher inflation and excessive government involvement in the economy. Keynesian demand management was abandoned in favour of the monetary approach. The recent couple of years have demonstrated that the use of monetary policy had its costs too, not in consumer inflation, but in rising debt levels and growing asset bubbles. It is essential to realise that government action – whether on the fiscal or the monetary front – come at large costs. Every time governments rescue the largest banks, slash rates, intervene in the markets and run huge deficits, the moral-hazard problem grows in size – astute market participants, fully aware of the extent of the safety nets push their risk taking to new levels.

6. Disclosure and Transparency Disclosure and transparency should be improved across the board, including opening up the quantitative models that financial institutions and rating agencies use to assess risks, to greater scrutiny. Lack of transparency was one of the main factors behind the sub-prime crisis. Greater

65 transparency is one of the best forms of regulation in financial markets, which thrive on information and seize up when it is in short supply.

7. Forced Lender Risk Retention Lenders should be forced to retain explicit exposure to the securitized loans that they are bundling and selling. In this way, banks and other institutions will not be able to unload all the risks of the questionable securities that they are peddling, thereby reducing the excesses that led to the sub-prime crisis.

8. Reviewing Incentive Structures Another popular suggestion is to change the incentive structures within financial institutions to discourage reckless short-term behaviour. An asymmetrical bonus system with unlimited upside potential and zero downside limits encourages risk taking with other peoples’ money without accountability. Guaranteed bonuses should be abolished and bonuses should be based on long-term performance rather than current year or previous year performance.

9. Re-regulating Credit-rating Agencies – Certain targets for re-regulation are credit-rating agencies which are blamed for encouraging the creation of mortgage securities by publishing misleading assessments of their quality. The markets and regulators use ratings to determine the riskiness of an asset. Yet credit-rating agencies are paid by the issuers of securities and so have an in-built incentive to tailor their ratings to their clients’ needs. Clearly a different business model is required that avoids the blatant conflict of interest.

10. Upgrading Accounting Standards The practice of fair-value accounting – valuing financial assets, mainly securities, at market prices – has led to huge write-downs when market prices fell. The volatility and variability of market levels created a patchwork of accounting standards and results that led to the erosion of the value of accounting results as an analytical tool in the hands of shareholders, investors and regulators. Without reliable, comparable and verifiable accounts, the world of financing and banking becomes a jungle of deceit and uncertainty. The International Accounting Standards Board (IASB) which sets rules for accountants and auditors outside America has proposed two categories of financial assets. In the first category, loans and securities which share the characteristics of loans (i.e. assets that derive their value only from interest and repayment of principal), to be held at cost. In the second category everything else, including equities, derivatives and more complicated securities, to be held at fair value.

Although defining the boundary between the two types of assets is likely to prove tricky, such distinctions would pave the way towards a simpler and more reliable outcome. Simple, clear-cut assets will be held in less opaque categories and dodgy things will be held at market prices. It is essential to merge international and American standards into a single rulebook governed by an independent body. Conducting business operations with unreliable accounting data is like flying an aircraft with faulty fuel gauges.

11. Revamping Competitive Self Control Some commentators argue in favour of competitive self-control. It is generally assumed that bankers have a vested interest in safeguarding their own survival. Millions are invested in technologies to measure risk and to impose stress-tests on their own liabilities and assets. It is also generally assumed that regulators routinely scrutinise the risk-weighted capital ratios of the banks. But even if they do,

66 capital is only one line of defence. The underlying ability of a bank to cope with liquidity crises and credit crunches is harder to gauge. Financial markets send out mixed messages about the confidence of investors – both inside and outside the institutions themselves. Spin and propaganda are integral parts of marketing and image promotion. Generally speaking, banks are unlikely to blow whistles on themselves. Competitive self-control is a necessary condition, but by itself is not sufficient as an instrument of sound financial regulation.

Recognising the Limits of Markets

The Chicago School of Economics argued that government resource allocation always reduces productivity, but as a blanket proposition it is evidently wrong. It depends. The authoritative allocation of values is beneficent or not, depending on what it is used for. Public spending often tends to be wasted and public agencies tend to become inefficient and bureaucratic. Public intervention often creates major distortions. The financial industry in the USA is a prime example of a coddled, fattened industry: fertilised with free money, propped with unusual tax advantages for fund partners and lavished with fresh funds whenever it stumbles.

But at the present point in time we are faced with a serious market stumble. Clearly, markets do not always achieve the best outcomes. Our current dilemma is well described by Charles R. Morris, a seasoned lawyer-banker and commentator on the finance industry: “Only the most invincible dogmatists could survey the history of financial booms and busts and come away with the notion that markets are always right. But the confidence of even the truest believers might be shaken by the disastrous results of our latest experiment. There is no benevolent genie behind the curtain, diligently ensuring least-squares approximations to efficient frontiers – just the usual motley of sharks, decent people, charlatans, and some serious intellectuals, mostly playing with other peoples’ money.” (See Charles R. Morris, 2009, op.cit. pp.163-164)

The agenda for re-regulating finance proposed by Morris includes the following:

Caveat emptor – Be aware of the potential dangers of spastic regulatory twitches that may act as crisis accelerants. The regulatory failures of the recent past were predominantly failures of supervision, rather than failures of regulatory design. The US Federal Reserve, the Comptroller of the Currency and the Securities and Exchange Commission had an abundance of actual and implied powers to cut off the worst of the credit fiascos before they reached the danger point. This is evidenced by the rich menu of unused powers that the Fed and the Treasury have discovered now that the banks are losing money. The real problem was that regulators and their industries “... both worshiped at the same shrine of efficient markets ... intervention was against their religion.”

Focus on leverage – A root cause of the credit crisis was the shift over the early 2000s to the new “Basel 2” system of calculating leverage through model-based “value at risk” (VAR) analysis. “Basel 1”, established by global agreement in reaction to the banking excesses of the 1980s, imposed a fairly simple-minded, but effective, risk-adjusted 8:1 leverage limit on depository banks. In the USA, Basel 1 lined up well with a long-standing SEC limit of 15:1 leverage for broker-dealers. Both were replaced by the ostensibly more sophisticated Basel 2 rules in 2004. Gross leverage quickly increased by about 50 percent, not including the concealed leverage in off-balance-sheet vehicles.

The failure of VAR-analysis has been cataclysmic. Morris argued that VAR may be a useful tool for balance-sheet analysis, but that regulatory thresholds should shift back to simpler, more visible, numerical standards. Model-based regulation may look more elegant, but trillions in losses are a big price for elegance.

Transparent bank balance sheets – Morris argues that everything with any retained risk should be shown on the balance sheet, including contingent liabilities like guarantees. Greater transparency is the prime attraction of “covered bonds”, a quasi-securitization technique whereby a bank issues bonds secured by specific assets, like residential mortgages, which reduces borrowing costs, but the entire liability remains a general obligation of the issuer. Transparency should penetrate beyond nominal balance-sheet asset values to the embedded leverage in the asset. Heavy capital charges should apply to loans to highly leveraged entities, or against highly leveraged assets.

Concentrate on the depository banks – Morris argues that it is not possible to regulate hedge funds and private-equity funds effectively because they can choose to be domiciled in Madagascar or other obscure havens. Therefore it is important to wall them off from depository banks and the payments system. Federally insured depository banks are major providers of prime brokerage services, including margin lending, to hedge funds and similar entities. That creates an infection vector for converting hedge-fund excesses into systemic risk. Restrictions on bank lending to highly leveraged entities would close off those infection channels. Morris also points out the need to limit the size of non-regulated entities, to head off the “too big to fail syndrome”. He argues that “entity” should be defined by control parties rather than legal structure. The size of assets should trigger intrusive regulation.

Once the depository banks are walled off from high risk enterprises, the regulatory challenge should be simplified. Credit analysis should dominate over financial engineering. Trading functions should be in support of customer services. Trading in immature instruments, like credit default swaps, should be limited to exchange-traded, standardised paper. Morris refers to the success of the Royal Bank of Canada to show that “borrowing banks” can be quite profitable. He says “... bankers can be successful again if they just go back to being banks – and there’s nothing mysterious about regulating banks”.

Beware the Universal Bank – Morris is highly sceptical of the recent conversion of the last free- standing investment banks – Morgan Stanley and Goldman Sachs – into Federal Reserve member banks. Ostensibly it is supposed to signal a new era of tighter regulation and lower leverage. Morris maintains that this move is a ploy to gain more entitled access to the Fed’s balance sheet without changing basic business activity. Three-quarters of Goldman’s 2007 pre-tax profits came from Principal Transactions. Universal banks cannot be killed, but regulators will have to concentrate hard on creating internal walls. Morris is pessimistic about their success.

Create a Fiduciary Structure around Government Interventions – Morris makes a strong point about the need to regularise the process of government taking ownership positions in many private companies. He argues that the major interventions, so far, have been rushed, inconsistently priced and poorly documented. It is essential that standing working parties be established (including highly regarded professionals) to establish pricing rules, to review and approve terms on individual deals and to create audit trails of negotiations. The randomness of the current process creates serious reputational and financial risk. In addition, the security holdings created by such transactions should not be at the disposal of either Congress or any member of the executive branch. Depositing the securities in the Social Security Trust Funds, under the supervision of an independent board of

68 directors with fiduciary obligation to the beneficiaries of the Trusts, would greatly reduce the possibility of political manipulation in the management of portfolios.

Morris concedes that the reigning in of the destructive impulses of financial institutions might render credit more expensive and perhaps shave a fraction of a percent off GDP growth. But he feels it is necessary to protect the public interest. He argues that it comes down to taste, and balance, and judgment. He believes “... that the 1980s shift from a government-centric style of economic management towards a more markets-driven one was a critical factor in the American economic recovery of the 1980s and 1990s. But the breadth of the current financial crisis suggests that we’ve reached the point where it is market dogmatism that has become the problem, rather than the solution. And after a quarter-century run, it’s time for the pendulum to swing in the other direction”. (See Charles R. Morris, op.cit. pp.161-177)

Facing Networks of Speculative Manipulation

There are millions around the world investing in financial assets – shares, property or even works of art – with the expectation of selling at a later stage at a profit. Some of those are regarded as investors and some are pejoratively called speculators. Some investors make a living out of speculative investments in a range of complex financial instruments in the national and the international arenas. Some professional speculators – moguls or tycoons – control massive resources enabling them to influence markets in unexpected – often manipulative – ways.

Without the need to rely on conspiracy-theory explanations, economic history abounds with examples of manipulative networks: the kleptocratic courtiers and oligarchs of post-Soviet Russia, the “Berkeley Mafia” of technocrats in Suharto’s Indonesia, the feudal fiefdoms of the Japanese “Keiretsu”, the “chaebol” industrial conglomerates of South Korea, the mercantile Parsi rais of India, the Jewish Randlords of Johannesburg, the Sicilian “Cosa Nostra” Mafia of New York and Chicago, the finance and banking cronies of Wall Street and the City of London, the Wahhabis of Saudi Arabia. Some of these networks are based on ethnic bonds, but more often than not on a strong religious culture.

Paul Johnson ends his remarkable tome, A History of the Jews (Phoenix Press, London, 2003, p.587), with the following observation: “The historian may say: there is no such thing as providence. Possibly not. But human confidence in such an historical dynamic, if it is strong and tenacious enough, is a force in itself, which pushes on the hinge of events and moves them. The Jews believed they were a special people with such unanimity and passion, and over so long a span, that they became one. They did indeed have a role because they wrote it for themselves. Therein, perhaps, lies the key to their story.”

As argued by Paul Johnson, the Jews made a contribution to the development of modern capitalism quite disproportionate to their numbers. They invented several financial instruments: bearer-bonds, bills of exchange, banknotes and a variety of financial securities. They dominated the Amsterdam stock exchange, held large portfolios in the Dutch VOC and both the British West and East India Companies. They were the first professional stock jobbers and brokers in England. In 1792 they took the lead in creating the New York Stock Exchange. As a people without a country, the world was their home: the further the market stretched, the greater were the opportunities. Jews built the first textile mills in India and acquired control of the first diamond and gold mines in South Africa. The Jewish Randlords in conjunction with Cecil John Rhodes and Lord Milner succeeded in pushing the British Colonial Office into war with the two Boer Republics. Afterwards the trading of gold and diamonds became the mainstay of the City of London trading accounts in the first decades of the 20th century. In modern

69 times the centre of the world’s financial markets shifted to the Jewish bankers in Wall Street, New York. Then, in the first years of the New Millennium, these bankers and brokers dumped their toxic financial instruments (all kinds of derivatives) onto other financial markets and so precipitated the Global Financial Crisis when it brought the fragile European economies into turmoil. These economies, in turn, have been brought to the fringe of insolvency by their practice of chronic deficit spending financed by the unfathomable bond market – also a creature of Jewish financial acumen.

In Niall Ferguson’s financial history of the world called The Ascent of Money (Penguin Books, 2008) p.2, he states that “... for centuries, financial services in countries all over the world were disproportionately provided by members of ethnic or religious minorities who had been excluded from land ownership or public office but enjoyed success in finance because of their own tight-knit networks of kinship and trust.”

Examples discussed in this remarkable historical survey, include the famous Jewish banker, Nathan Rothschild, who, by speculating in government bonds, did as much behind the scenes as the Duke of Wellington to defeat Napoleon at Waterloo. Subsequently, the Rothschild family’s bank, N.M. Rothschild & Sons, as masters of the British bond market, allegedly influenced the outcomes of the American Civil War and the Anglo-Boer War. Their fingerprints were also to be found on bond issues in Austria, Prussia, Russia, Egypt, Chile, Italy, Japan, Spain and Turkey. They were the founders of a system of paper securities called government bonds, which were “… more fluid than water and less steady than the air” (Quoted by Ferguson, op.cit., p.89)

A recent pronouncement of anti-Semitism was that of Malaysia’s Prime Minister for 22 years, Dr. Mahathir Mohammad, addressing the summit of the Islamic Conference on October 16th, 2003, said: “The Europeans killed 6 million Jews out of 12 million, but today the Jews rule the world by proxy. They get others to fight and die for them.” When his remarks drew outrage from Jewish groups around the world and from Western governments, Dr. Mahathir claimed that the reaction to his comments proved his point, for it showed the Western media was controlled by Jews. The Economist of 25th October, 2003, published an editorial under the title “Words that Kill” stating that Dr. Mahathir’s words are “… reinforcing the notion that Israel, or rather the conflict between Arabs and Jews, epitomises the Muslims’ problem. It doesn’t. Bad government, and dysfunctional social and religious institutions, are what does. That pattern has been epitomised in their different ways by Saddam Hussein in Iraq, by the failed theocracy in Iran and by the corrupt Suharto dictatorship whose collapse left Indonesia, the world’s largest Muslim country, in a terrible mess in 1998. To that dismal pattern, Dr. Mahathir’s Malaysia has been an exception. Muslims would do far better to look at that example than to pay heed to Dr. Mahathir’s paranoid words”. The Economist’s words could have carried even more weight if around half of its ownership did not rest in the hands of the Rothschild group.

A latter-day tycoon with incredible tipping power, is George Soros, a Hungarian Jew by birth, educated in London and currently controlling an enormously influential financial power base in New York.The Soros’ hedge fund made a lot of money with short positions (a short sale is any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller). Soros also exploited long positions, from buying assets in the expectation of future price rises such as taking a long position on oil in 1972 before prices rose to unprecedented levels. On 16th September, 1992, Soros took a position that the English pound was overvalued so he effectively borrowed sterling in the UK and invested in German currency at the pre- 16 September 1992 price. When later , the same day, British Chancellor of the Exchequer, Norman Lamont, announced sterling’s exit from the European Exchange Rate Mechanism (thereby allowing the

70 pound to devalue by 20 percent), Soros repaid the sterling he had borrowed but at the new lower exchange rate and pocketed the difference – more than 1 billion dollars. It is a technical question what constitutes “insider trading” and how one succeeds in borrowing 10 billion dollars for a secret overnight transaction. In 2007 the veteran hedge fund manager, Soros, made a profit of $2.9 billion. The New York investment bank, Goldman Sachs’ net revenues of $46 billion that year exceeded the entire GDP of more than a hundred countries. (See Ferguson, op.cit., pp.1-2 and 317-319)

In 2012 Edward Luce, an Oxford trained British journalist and Financial Times correspondent, published an interesting book entitled Time to Start Thinking – America and the Spectre of Decline (Little Brown, London), in which he paints a disturbing picture of the state of American society. According to Luce, the American elites fail to come to grips with the real problems facing the country. He points his finger in accusation at the Republican Party and “Tea Party” leaders of the conservative Right rather than the American style “socialist-liberal” Left: “... because there is no such thing as a liberal ‘movement’; angry liberals are not as unified as angry conservatives ... and they are not nearly as numerous.” (Luce, op.cit. p.268)

But Luce misses the point. Most of his contacts and sources of information are Obama-supporting Democrats: Wall Street financiers, Washington lobbyists, leftist academics or lawyers, teachers or journalists. Luce is not a reliable guide to the intricate policy-making structures of the American society. To understand the functioning of the complex American political-economic society, proper regard must be had to the demographic determinants of party and voter allegiances – which categories predominantly vote Republican or Democrat out of population cohorts embracing young and old, inner city and suburbia, professionals and blue-collar workers, civil servants and private-sector workers, Blacks, Latinos, Jews, WASPS, etc. Regard must also be had to the prominent role of the well- financed lobbyists on all levels of government where money buys results. The media are also neatly divided between the Fox channels and the Wall Street Journal on the conservative side and the rest on the left (including the New York Times, Washington Post, Los Angeles Times, CNN, NBC, ABC, CBS and a plethora of others). There can be no doubt in whose hands the power strings of money are held.

In the aftermath of the Global Financial Crisis, Washington demanded no scalps from Wall Street. No directors were brought to book. When the US Congress introduced what actually became the “Wall Street Reform and Consumer Protection Act”, the financial interests of Wall Street evidently resolved that reforming Wall Street was too delicate a task to be left to Capitol Hill. The Obama Administration left it to the Secretary of the Treasury, Tim Geithner (a former New York Federal Reserve President and Wall Street confidante) to design a mild overhaul of Wall Street regulation. After numerous consultations with interested parties such as Blankfein of Goldman Sachs, the voluminous Dodd-Frank Act was chaperoned through Congress by Wall Street lobbyists (the largest contributors to the President’s campaign fund). The new system enshrined the “too big to fail” principle without effectively creating a straight-jacket for the banks. It created a mechanism for seizing and winding down big failing firms and reinforces capital and liquidity buffers throughout the financial system, hoping thereby to reduce the danger of contagion caused by failing institutions. The changes effectively reshuffled the status quo and added additional regulatory bureaus to Washington’s already balkanised regulatory arrangement which ensured that the regulated would continue to have opportunities to play off one regulator against the other. The “moral hazard” problem remained as large as ever.

During the bill-writing process, interested parties such as Blankfein appeared before Congressional Committees. The Sunday Times of November 8th, 2009, reported Blankfein saying in an interview with

John Arlidge, that Wall Street was doing “God’s Work”. No one was reported to be commenting on God’s need to employ a good auditor to look into Wall Street’s shenanigans and possibly also a good prosecutor to seek out the culprits – the scapegoat Bernie Madoff aside. Subsequently, in 2012 it was reported in The Economist that the board of Goldman Sachs had awarded Blankfein the largest remuneration package ever received by a bank chief executive. God evidently rewards his “workers” very generously.

The important point is not merely the immensity of wealth accumulation, but the disproportionate concentration of influence and power in a few hands. It is not clear at what stage the concentration of power becomes excessive and manipulative. Lord Acton said “all power corrupts and absolute power corrupts absolutely”. The Wall Street tycoons do not wield absolute power, but as an active minority they do wield a remarkable lot of influence and power. Unified minorities, well organised and well financed, usually prevail over other groups (or even majorities) who are less focused, less organised, less coherent and poorly financed. People with effective influence and power are able to achieve intended consequences. Some people may even wield enough influence and power to make self- fulfilling predictions. Business enterprise is the engine of economic growth and should be conducted within the parameters of fair and transparent rules – whichever vested interests may be involved. As Lord Hewart said: “Not only must Justice be done; it must also be seen to be done.”

Scrutinising the dominant role of Jews in the world of finance should not, per se , be tar brushed as anti-Semitism. The hatred of Jews in much of the Middle East and throughout the Jewish diaspora is a fact of history. The diaspora of the Jews, particularly since the second century AD, took them to many countries. Everywhere they distinguished themselves as an isolated, closed community of assiduous traders with wide-spun family, religious and financial networks. As traders they became stockpilers, hoarders and accumulators of money. They developed a reputation as money lenders which raised the question of usury. They were permitted by their Bible to charge interest rates on loans to Gentiles but not to other Jews. Thus their charging of interest became synonymous with something hostile. It became calamitous for Jews in their relations with other peoples. It became a source of dislike and mistrust. It gave Jews a bad name and gave rise to anti-Semitic outbursts wherever they settled all over the world. Prime examples are the burning at the stake of thousands of Jews under the Spanish Inquisition and the ultimate banning of all Jews from Spain in the 1490s, the ghettoing of Jews in Italy, Germany, Poland and Russia, and eventually the horrible extermination camps under Nazi rule in the period 1940-1945 when around 6 million Jews were mercilessly killed. During the centuries of persecution, many thousands of Jews converted to the local religions in order to survive and prosper. By the time Hitler’s Nazis struck, some 6 million Jews were safe in North and South America and in Britain and France, with several million more living in the Soviet Union. The Sephardic communities in North Africa and the Levant, long a minority within Jewry, together with survivors of Nazi-occupied Europe who where not welcomed elsewhere, became the core populations of the new state of Israel.

In its issue of July 28th, 2012, The Economist, a financial newspaper owned by Jewish interests, published a Special Report entitled Judaism and the Jews. Its subtitle read “Alive and Well”. It reported that Judaism was flourishing both in Israel where 43 percent of the world’s 13.6 million Jews now live, and throughout the Jewish diaspora. Jewish is “cool” in America, with 5.3 million Jews living there as the ethnic group with the highest per capita income. In modern times Jews also flourished in France and Anglophone countries where they enjoy constitutionally protected civil rights and flexible economic opportunities.

It is important that critical comments about Israel’s role in Palestine and the role of the Jewish tycoons of Wall Street should not be labelled as anti-Semitism. In the Muslim world anti-Israelism and anti- Semitism coincide, with Iran’s President, Mahmoud Ahmadinejad, acting as cheerleader. It would be an ideal outcome if the creation and consolidation of Israeli territory could be seen as an opportunity to create a viable and sustainable Jewish society that is not based on pushing Palestinians from their place of birth and where their ancestors have been living for thousands of years. The Israelis cannot escape sharing the land with Palestinians – either as one state or a negotiated two or more territories.

Concluding Remarks

As political leaders grapple with the task of overhauling the regulation of financial markets, several issues should not be left out of that agenda.

One task is to work out what central banks should do about bubbles. It is clear that they appear from time to time and when they burst – as they inevitably, eventually do – they can cause a lot of damage worldwide. No serious arguments are advanced that central banks should try setting prices in financial markets. But strong arguments are made that government agencies should “lean into the wind” more to reduce the volatility of bubbles and crashes. Freddie Mac and Fannie Mae could have demanded higher down-payments as a proportion of the purchase price. In addition, an age-old principle is that monthly down payments should not exceed a certain percentage of after-tax income – say 30 percent.

Another task is to get a better understanding of “systemic” risk by keeping the “aggregate picture” in mind. Data should be collected from individual firms and aggregated and the overall data regularly published. This information could be used to determine the required levels of capital reserves against losses. Each category of asset should have clear-cut risk-capital reserves, which could not be shared with other assets.

Equally important is the management of “moral hazard”. It is, after all, the existence of government regulation and safety nets that encourage market participants to take bigger risks than they might otherwise have done. Letting Lehman Brothers fail in the middle of a crisis ultimately exacerbated the moral hazard problem. This could only have been avoided by preventative action.

The financial crisis that began in 2007 is a devastating blow to the credibility and integrity of the finance and banking world – particularly the operators and cronies of Wall Street and the City of London. Andrew Lo of MIT has come up with a splendid suggestion of how the air could be cleared: creating a financial equivalent of the National Transport Safety Board which investigates every civil- aviation crash in America. He would like a similar independent, after-the-fact scrutiny of every financial failure, to see what caused it and what lessons could be learnt. Not the least of the difficulties in the continuing crisis is working out exactly what went wrong and why – and who should take the blame.

Millions of people around the world have been adversely affected by the flighty financial techniques and dodgy schemes of Wall Street and City of London financial cronies and operators. Bernie Madoff took the rap on behalf of many other schemers and fraudsters. If the culprits are not exposed and brought to book, the credibility of free-enterprise as a whole will be jeopardised.

Soviet Communism imploded as a result of many factors: inter alia, international over-reaching, the fault lines inherent to its diverse composition and the exploitative corruption of its unaccountable

73 leadership clique. It is time to take a hard look at the crony networks in New York, Washington and London. Are the fortunes of the Western World also in the hands of an unaccountable, exploitative network of oligarchs? It might require an Aristotelian inquest to find answers.

Bibliography

Beddoes, Z.M. (2008) “When Fortune Frowned”, Special Report, The Economist, October 11th, 2008, pp.3-32 Behravesh, N. (2009) Spin-Free Economics, New York: McGraw Hill Buiter, W. (2009) “Fiscal Dimensions of Central Banking”, Parts 1 and 2, FT-sponsored Blog, Maverecon, March 24th, 2009. Carr, E. (2009) “Greed and Fear”, Special Report, The Economist, January 24th, 2009, pp.3-32 Crook, C. (2003) “A Cruel Sea of Capital”, Special Report, The Economist, May 3rd, 2003, pp.1-26 Ferguson, Niall (2008) The Ascent of Money, London: Penguin Books Johnson, P. (2003) A History of the Jews, Phoenix Press, London Levine, Ross (2005) “Bank Regulation and Supervision”, NBER Reporter, Fall 2005, pp.1-4 Luce, E. (2012) Time to Start Thinking – America and the Spectre of Decline, Little Brown, London Morris, C.R. (2009) The Two Trillion Dollar Meltdown, Melbourne: Black Inc. Olson, M. (2000) Power and Prosperity – Outgrowing Communist and Capitalist Dictatorships, New York: Basic Books Palmer, A. (2009) “Rebuilding the Banks”, Special Report’ The Economist, May 16th, 2009, pp.3-22 Tricks, H. (2007) “The Alchemists of Finance”, Special Report, The Economist, May 19th, 2007, pp.3-26

6. The Perilous Rise of Public Debt (March 2013)

Whenever revenues fall short of expenditures, governments borrow. Over decades this cumulative process has left many governments with large outstanding debts. Historically speaking, warfare was a major reason for governments to incur additional debts, but since the Great Depression and the emergence of the “welfare state” in the middle of the 20th century, many advanced countries have committed themselves to unaffordable social spending programmes which resulted in an alarming level of borrowing. Initially borrowing served the purpose of providing bridging finance in the worlds of both private and public finance, but it gradually acquired the function of financing living and expenditure levels which were beyond affordable levels. The total public debt is the accumulation of all past deficits, less surpluses (if any) of any given country. In today’s world the level of public debt in many advanced countries has become a subject of great controversy and a source of great concern.

Deficit Budgeting

When Shakespeare, in Hamlet, wrote down Polonius’s famous words of advice to Laertes, he was expressing sentiments deeply ingrained in the popular mind: “neither a borrower nor a lender be”. From the perspective of the individual household or the business enterprise, continued shortfalls between expenditure and income levels lead to bankruptcy. Concerned citizens who are tax payers rather than tax takers also tend to believe that government expenditures should be matched by government revenue and that a surplus should be looked upon as a provision for a “rainy day”.

Since ancient times people have frowned upon debt and also upon payment of interest by borrowers to lenders. In the Old Testament, Jews were not allowed to charge interest to other Jews, but they were permitted to charge interest to strangers. During the diaspora of the Jews over many centuries to many parts of the world, the close involvement of Jews with money-lending and the world of finance gave rise to anti-Semitism. Jews, inadvertently, became an element in a vicious circle of money lending and being disliked. In time, debt itself, acquired a negative connotation – as something to be avoided.

As early as 43BC, Cicero expressed his dismay about public debt: “the national budget must be balanced, the public debt must be reduced. The arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced if the nation does not want to go bankrupt. People must learn to work instead of living on public assistance.” (Quoted by V. Tanzi, Government versus Markets – The Changing Role of the State, Cambridge University Press, 2011, p.340)

In similar vein are the words of David Hume (1711-1776) who was a pre-eminent philosopher and forerunner of Adam Smith. He wrote “... The practice of contracting debt will almost infallibly be abused in every government ... The consequences must indeed be one of two events: either the nation must destroy public credit, or public credit will destroy the nation”. (Quoted by Tanzi, ibid)

Balanced budgeting as an objective used to be the classical view of economics. Public finance accounting used to keep a clear-cut distinction between the “current” and the “capital” budget. The current budget was financed by taxes and fees and it was used to pay for current expenditure such as public salaries, administrative costs and welfare payments. The capital account was financed out of current account surpluses and loans and it was used to pay for all expenses of a capital nature such as

75 roads, hospitals, bridges, harbours, railroads and airports. Few countries succeeded in balancing the budget every year, but deviations from this objective were thoroughly scrutinised and frowned upon.

The vast increase in government activities during and after the Great Depression of the 1930s coupled with changes in the theory of public finance brought about by J.M. Keynes and others, led to a fundamental change in budgetary principles and practices. Classical views were replaced by the view that balancing the budget adds to economic instability rather than reducing it. It is argued that this is caused by the effects of the expanding and declining phases of economic cycles. Keynesians maintain that government budgeting should play an anti-cyclical role by expanding during downward phases and by contracting during expansionary phases of the business cycle. Thus anti-cyclical budgeting results in deficits when the economy contracts and surpluses when it expands. This approach implies that government budget policies relating to spending and taxing should be calibrated over the course of the business cycle, measured from trough to trough or from peak to peak. Keynesians are less explicit about the proper steps to take when debt levels rise to mountainous proportions.

The concept of a cyclically adjusted budget policy has gained widespread support among economists because it provides a useful way of manipulating fiscal policy towards achieving a variety of objectives: model-based projections, transfer payments to favoured constituents, enhanced public-purse financed employment figures and other preferred outcomes. The impact of deficit budgeting on debt accumulation is normally not reflected in budgeting models apart from showing interest payments on outstanding debt as part of total expenditures. In terms of cyclically adjusted budget policy, surpluses are meant to be used to retire some of the outstanding government debt or held on to as reserve funds in order to withdraw money from the economy when it overheats. However, budget surpluses are rare in social democracies. On the contrary, since the beginning of the 21st century, most advanced economies have piled up huge debt burdens as a result of chronic deficit budgeting to such an extent that they are faced with debt piles of problematic proportions.

The Emergence of the Bond Market

As described by Niall Ferguson in The Ascent of Money – A Financial History of the World (Allen Lane, 2008), the birth of the bond was, after the creation of credit by banks, the second greatest revolution in the ascent of money. Governments (and large corporations) issue bonds as a way of borrowing money from a broad range of creditors. Ferguson estimated the value of bonds traded domestically in 2008 at a staggering $50 trillion. Today, in 2013, that amount could be close to double. It requires astute forensic public accounting skills to trace and accurately calculate the total amount of public debt in today’s world – let alone accurate reporting of the identity of the bondholders.

From modest beginnings in the 14th and 15th centuries, when the city-states of northern Italy sold bonds to finance the wars with each other, bonds became the major instruments used to finance government debt. Each city-state hired military contractors (condotierri) to raise armies to conquer land and lost treasure from its rivals. Wealthy citizens were obliged to lend money to their own city- states and received interest payments in return. Since it was obligatory it was not classified as usury but as compensation (damnum emergens). Because such loans could be sold to others, they were liquid assets. The Medici family were major bondholders and became a central part of the oligarchical power structure.

In time all European monarchs – Spanish, French, Dutch and English – became active buyers of bond market credit. The French and the Spanish crowns became known as serial defaulters in the late 16th

76 and 17th centuries. After Charles II had suspended payment of his bills, the gold standard was adopted in 1717 and royal finances were subjected to parliamentary scrutiny. By mid 18th century there was a thriving bond market in London – particularly attractive to Dutch investors. The “British consol” was particularly popular because they were perpetual bonds (had no fixed maturity date) and paid a handsome annual yield.

The bond market also made some families, such as the Rothschilds, fabulously rich. Nathan Rothschild, who was born and raised in the Frankfurt Judengasse, became master of the European bond market during the intermittent wars between Britain and France. Between 1793 and 1815 the British national debt increased by a factor of three to £745 million, more than double the annual output of the British economy. The Rothschild family had a banking network which spanned Frankfurt, Paris, Amsterdam and London which enabled them to exploit price and exchange rate differences between markets – selling gold for bills of exchange and sending these to London to be used to buy more gold. The Rothschilds became what was called “Die Finanzbonaparten” as dominant players in the increasingly international London bond market. Their capital base and infrastructure network was superior to their nearest rivals, the Barings. Although British government bonds were the principle security they marketed to investors, they also sold French, Prussian, Russian, Austrian, Belgian and Brazilian bonds. Apart from bond traders, they were also currency traders, bullion dealers, private bankers as well as investors in mines, insurance and railways. By 1899 the value of the Rothschild assets were larger than the five biggest German joint-stock banks put together. The largest part of their assets consisted of a vast portfolio of government bonds.

Throughout the 19th century, the City of London served as the biggest financial market in the world. According to Niall Ferguson, the number of bondholders were less than 250,000, barely 2 percent of the British population, but their wealth was more than double the entire national income of the UK and their income in the region of 7 percent of national income. Whereas initially the bondholding “rentiers” were principally in the hands of a few wealthy families, the rise of savings banks, insurance companies and pension funds – often mandated to hold government bonds – gave other segments of society exposure to government bonds.

War, Weaponry and Security as Drivers of Public Debt

Since its origins in Renaissance Italy, the growth of the bond market has been closely associated with the financing of government expenses of a military nature. In the 20th century this association became commonplace throughout the Western world. During the First World War, all the warring countries went on war-bond sales drives, persuading thousands of small savers that it was their patriotic duty to do so. The Allied Powers enjoyed the benefit of the depth of the London, New York and Paris financial centres. Germany and Austria were thrown back on their own resources – mainly their own central banks. Government bills in the hands of the central banks increased the money supply and was a harbinger for growing inflationary pressures.

After the First World War, the victorious Allied Powers used the Versailles Treaty to impose enormous war-reparation debt on Germany – equivalent to three times the national income. This created unsustainable current account deficits that were financed by the printing of more and more paper money. This process was accompanied by excessive public spending on generous public service wage settlements and insufficient tax collection in the Weimar Republic. Although the downward slide of the mark boosted German exports, the inflationary pressures continued unabated until 20-billion mark notes were in everyday use. Eventually money – including all forms of wealth and income fixed in

77 terms of marks – was rendered worthless. The collapse of the currency led to the collapse of the economy: soaring unemployment, poverty, moribund banking, social and psychological distress and, ultimately, political disorder and the beginning of the Great Depression, which provided a fertile seedbed for the rise of Hitler’s Nazism. The important lesson from this historical experience is that hyperinflation is a political-economic phenomenon. The malfunction of the Weimar Republic’s political-economy within the context of a dysfunctional international political-economic climate provided the fertile ground for the trauma of the Great Depression and the build-up to the devastation of the Second World War, 1938-1945.

The most important episode in the history of the association of the bond market with the war financing of governments occurred during the Second World War and its aftermath. It is estimated that the cost of this war to Britain amounted to around $30 billion – a quarter of its net wealth – accumulating $12 billion of foreign debts. Exports in 1945 were less than a third of the 1938 figure. (Paul Johnson, A History of the Modern World, Weidenfeld and Nicolson, 1983, p.439)

During the First World War, the USA borrowed $25 billion to finance its war operations, but about one-third of this debt was repaid in the 1920s courtesy of the remarkable achievements of the Calvin Coolidge presidency. The years of the Great Depression saw the debt increase from $16 billion to $40 billion. To fight the Second World War, the USA’s debt increased from around 44 percent of GDP in 1942 to 105 percent of GDP in 1945, reaching around $260 billion. Starting in 1942, the Fed agreed to buy as much government debt as necessary to keep interest rates below prescribed ceilings. The stimulus of military mobilisation produced an immediate and powerful impact: unemployment fell from around 15 percent to 2 percent and from 1940 to 1945, GDP grew by 12 percent per year. Wage and price controls were necessary to contain inflation.

The years 1946-1990 are generally known as the “Cold War” period. It was characterised by a profound competitive struggle between the Western World led by the USA and the Communist World led by the USSR and China. At stake were not only national strategic and security interests, but a pervasive conflict of the socio-economic-political cultures of these super powers. At the end of the Second World War, the Soviet Union occupied all of Eastern Europe including East Germany. The USA assumed the core leadership of the Free World in its efforts to contain the expansion of the Communist World. A long list of military standoffs ensued: Berlin, Korea, Vietnam, Cuba, Hungary, Angola and Afghanistan. These were accompanied by a weapons development and space exploration contest which required astronomical amounts of government spending. Other allied powers also participated but the financing brunt was carried by the US government. The expansion of the US government’s role increased the public sector’s share of GNP from 14 percent in 1940 to 26 percent in 1990. The US debt rose from $272 billion in 1957 to an estimated $874 billion in 1979.

During the second half of the 20th century, private debt increased much faster than public debt in the USA. Public debt as a percentage of GNP remained around the 50 percent level. By 1980 the private debt rose to about four times as large as the public debt. But during this period interest rates on public debt increased much faster than the debt itself. The government had to pay higher interest rates to refinance its older low-interest securities. During that period the bulk of the public debt was raised from internal sources. Money was simply transferred from the bond buyers to the government which, in turn, expended the funds for public purposes. Interest and repayment charges did not transfer resources outside the country. Internally held debt represents only a commitment to effect a transfer of money within the country. It does not commit the country to give up real output to another country. However, since 1974, the USA has been borrowing increasing sums from oil-producing countries and

78 from Japan, who became major investors in US Treasury securities. Since the 1990s, China became the single largest investor in US debt obligations.

Socialist Welfarism as Driver of Public Debt

The doctrinal foundations of the “welfare state” are deeply embedded in the socialist ideology which had permeated European intellectual life since the Industrial Revolution. It pervaded the writings of the founders of “democratic socialism” such as Bentham, James and John Stuart Mill, Robert Owen and the Fabian Society. Revolutionary socialism was promoted by Marx and Engels and later given practical expression in the system of totalitarian communist dictatorship by Lenin, Trotsky, Stalin and Mao Zedong, and ultimately revised by Gorbachev and Deng Xiaoping.

The socialist premise is based on the precept of collectivist provision. The welfare state should provide a minimum standard of cradle-to-grave support for every person in society. During the Great Depression of the 1930s, the massive unemployment and poverty forced governments everywhere to take on a much expanded role. After the failures of capitalism in the 1930s, the Soviet Union enjoyed an economic prestige and admiration in the West that is hard to imagine today. After the Second World War, the Soviet economic model of rigid central planning gained even further respect from its successful defeat of the Nazi war machine. Altogether, these things gave socialism a good name because the brutality and suppression of the Stalinist system was not yet revealed or generally known. The Soviet model was a rallying point for Left-wingers. The Labour Party in Britain under the leadership of Clement Attlee was committed to install socialism by incremental reform – “step by step towards collectivism” in G.B. Shaw’s words. The Beveridge Report of 1942 became the blueprint for government policies to reduce unemployment, a broadening of state ownership and enterprise, expanded publicly provided housing, greatly expanded public services in the field of health, education and welfare. The “welfare state” became the template for the Western World in the years following the Second World War. It became known as the “Attlee consensus”. Although tax rates were vastly increased, budget deficits were covered by borrowing.

Communism was considered quite respectable, but a blend of Socialism and Christian Democracy became the mainstream political orientation on the European continent. The system of proportional representation that was adopted in various new constitutions accommodated a range of political parties: from trade union connected formations on the extreme left to left-centre Catholic parties to centre-right Christian Democratic parties with social-market sentiments. European socialism gradually shed its emphasis on the class struggle, pressing instead for social justice within a free enterprise system. Tax rates were pushed to unprecedented heights, but it became common practice to cover budgetary deficits with additional borrowing.

The social-democratic movement in Europe was generally based on mixed economies, combining elements of free enterprise competition with state ownership and control. The nature of the mix depended on the party in power. Emerging from the devastation of the Second World War, most Western nations rebuilt their economies to unsurpassed levels of prosperity and wellbeing. The per capita levels of Germany, France, Italy, the Netherlands, Belgium, Austria and the Scandinavian countries could only be challenged by the USA, Canada, Japan and Australia where the social- democratic model was also followed in varying degrees.

The success of post-war reconstruction must also, in large measure, be attributed to the fact that national populations gallantly assisted by turning their national economies into common causes rather

79 than arenas of class conflict. As was well illustrated by the Americans, Germans and Japanese, a society can be spurred into action by a spirit of co-operation in the face of a national emergency.

Although most advanced economies have gone a long way towards reaching the objectives of social equality and the abolition of poverty by way of collective action, the costs of providing these benefits were too easily ignored. The underlying foundations determining the sustainability of the welfare state was not properly understood. The ability to pay for these benefits was taken for granted. Economic realities were ignored. During the period between 1960 and the middle 1990s, most European countries witnessed the fastest increase in public spending and in tax levels of their history. The growth in spending exceeded the very fast increase in tax collection resulting in fiscal deficits which, in turn, spilled over into the piling up of public debts that inevitably had serious macroeconomic implications. For the 12 original members of the European Monetary Union, the share of public debt in GDP rose from 31 percent in 1977 to 75.4 percent in 1996. (See Tanzi, op.cit. p.98).

During the next decade, serious efforts were made to reduce debt levels in terms of the Maastricht Treaty which set a target of 60 percent of GDP. However, by the time the GFC struck in 2007, the eurozone public debt already stood at 66 percent of GDP.

The Bond Market Today

Over several centuries, bond markets have become important sources of finance for governments for bridging as well as longer term finance, e.g. for short and medium-term deficit budgeting as well as the financing of long-term capital projects. Large corporations and banks are also regular users of bond market financing. The total value of internationally traded bonds is difficult to establish with accuracy, but can be expected to approach US$50 trillion – bigger than the world’s stock markets put together. Bond markets are important determinants not only of the availability, but also the cost of credit to governments as well as business corporations. They are in a position to pass daily judgment on the credibility of every government’s fiscal and monetary policies. Its real power lies in its ability to facilitate government borrowing, to punish a government with higher borrowing costs and even to dictate policy direction.

This market is based on the securities (paper assets) issued by governments, large corporations or financial institutions undertaking to make payment of a certain amount at a certain interest rate to its certified owners at maturity. Redemption periods may vary and interest rates may be fixed, variable with notice or linked to some financial index. Government bonds, as well as those of well-established firms, are normally regarded as safe, while financially adventurous firms issue “junk bonds” where it is recognised that the borrower may default. The market price of a security is sensitive to changes in current and expected interest rates. Bond-rating agencies specialise in assessing the creditworthiness of governments, municipalities and corporations issuing bonds.

80 wide could be much higher than US$150 trillion. Jointly they are the main creditors of governments, business corporations and banks.

A major deficiency of the bond market as it functions today is what has been called the “scarlet pimpernel” role of bondholders. They normally end up as privileged creditors whenever the losses on defaulting debtors (eg. countries, banks or corporations) are allocated. Shareholders and unsecured debt holders (including bank depositors) are the first creditors to take a “haircut”. Bondholders usually own “secured” debt – in the form of “covered bonds”, derivatives or contractual loans. They are “secured” in the sense that they have prioritised calls on the available assets to be divided up amongst the creditors. In the aftermath of the GFC it was left to tax payers to provide “bail-out” money to the failing banks or corporations. This plunged the respective countries into debt in order to repay the banking system’s bondholders. Regulators did not impose the losses on bondholders in order to avoid a wave of panic in financial markets. It was also feared that imposing losses on bondholders would spook financial markets and drive up the cost of bank debt and hence the level of interest rates charged to their borrowers.

According to the Global Macro Monitor (http://www.macromon.wordpress.com/2012/04/11, 3/03/2013), in the case of the United States, foreign investors dominate the market for US Treasuries (48.2 percent) in view of its large size and its depth and its high perceived degree of safety. However, since the GFC, monetary stabilisation efforts (QE) increased the prominence of the Federal Reserve as a holder of government debt to 18.2 percent. Domestic banks hold 18.7 percent. In the United Kingdom, insurance companies and pension funds have traditionally been holders of substantial quantities of government securities, but since the GFC the Bank of England assumed a prominent role with holdings around 20 percent. In the Euro area, domestic banks hold 26.5 percent and non- residents 52.1 percent. In Japan the domestic banks and the Japan Post jointly hold around 55 percent of outstanding sovereign debt.

The Prospects Facing Debt-Laden Countries

The total amount owed by the 27 governments of the European Union in 2012 amounted to €10,320,106,100,000. Of that amount €8.2tn was owed by governments in the euro zone and it represented 87.4 percent of the combined GDP of those countries. It was up from 67.7 percent in 2008. For most countries bonds of one kind or another made up the bulk of the debt.

The total amount owed by the United States in 2012 stood at around $15,000,000,000,000 ($15tn). To service this gigantic debt as well as maintain existing spending and tax levels has led to an annual fiscal contest between profligate spending Democrats and increased tax averse Republicans. Fear of a “fiscal cliff” which is a combination of expiring tax cuts and automatic spending reductions worth 5 percent of GDP, was scheduled to occur at the end of 2012. A last-minute deal in Congress is relied upon to prevent a fiscal disaster by raising the debt ceiling and spreading efforts to reduce spending over a number of years. A more sensible approach would be to revamp the tax code by eliminating loopholes in exchange for lower rates, while simultaneously reducing wasteful spending. Central Bank money printing could keep the GDP growing by around 2 percent. The 2012 election was fought largely over differing prescriptions from Republicans and Democrats of how to bring down America’s budget deficit from its unsustainable 7 percent of GDP in 2012. Obama’s re-election tilted the nature of action to be taken in favour of the Democrats which implies higher taxes without cutting spending. It is inevitable that a compromise will have to hammer out a framework to reform both taxes and spending – based on trade-offs and probably murky accounting.

Gross National Debt in Selected Countries, 20111)

Gross Debt Debt Time Horisons Government as % as % to reach of of Debt GDP GDP 60% of GDP Country 2011 2010 2011 at 1% of GDP Retirement Rate2) (Euro)

Belgium 361,378 98.8 98.5 2035 Denmark 118,199 44.5 49.3 na Germany 2,089,756 75.7 81.8 2028 Greece 347,204 138.8 159.1 2031 Spain 706,340 58.7 66.0 na France 1,688,890 82.0 85.2 2029 Netherlands 388,829 63.1 64.5 na Sweden 137,851 38.6 37.0 na Italy 1,883,738 119.1 119.6 2060 United Kingdom 1,474,920 78.3 82.5 2028 United States USD15tn - 102.9 2033

1) Based on Eurostat figures. 2) Calculated by the World Competitiveness Centre, Swiss Business School IMD. The IMD defines "bearable" public debt as being 60% or less of GDP and estimates the "time horizons" in which the nations will revert to "bearable" public debt, assuming they gradually reduce their budget deficits and devote 1% of GDP to repayment of debt. It also assumes that by 2015 each nation resumes a GDP growth rate equivalent to its average growth rate from 2000 to 2009.

In the euro zone the continuation of the status quo, which is a mixture of German-backed bailouts and European Central Bank credit easing, depends in large measure on the willingness of the German electoral public to sustain their support for Angela Merkel’s coalition government. In the course of 2012, Merkel had to rely on the support of opposition parties, the SPD and the Greens, to obtain support in the Bundestag. Major portions of her own coalition supporters voted against Merkel’s proposals as a result of growing anxiety about more German tax euros being pledged to bail out partner countries. The outcome of Merkel’s dilemma to maintain a “chancellor’s majority” depends on the uncertain results of the September 2013 elections.

Another major determinant of the euro zone’s difficulties is the French economy. Apart from Greece, Spain and Italy, France has become a prime example of a country that has given an unaffordable role to the state. The reach of the state has grown to consume around 57 percent of GDP, the highest share in the euro zone. Because of its failure to balance a single budget since 1981, public debt has risen to over 90 percent of GDP. Without counting employees of para-statals, France’s “civil servants” constitute

82 around 22 percent of the workforce. The large French public sector has become a dead weight dragging down economic growth. France’s businesses lack competitiveness because they are burdened by a rigid labour and product-market regulation and “social charges” on payrolls. New companies are rare and France has fewer small and medium-sized enterprises – the engines of growth – than other members of the EU. Over 10 percent of the workforce and over 25 percent of the young are unemployed. The external current account has declined into one of the euro zone’s biggest deficits. While all euro zone countries are introducing structural reforms and more flexible labour markets, France is going in the opposite direction: increasing tax rates on companies and high-income individuals and lowering the pension age. To add insult to injury, the French voters do not appear to have any sense of the crisis they are in: they have elected a president who dislikes business and have put a party in government that chronically resorts to more public spending and debt. France has become the archetypical example of a social democracy living beyond its means – a pathalogically bloated welfare state. In 2011 France elected the leftist Francois Hollande as president, a total ignoramus of macroeconomic principles. Hollande promised the electorate that only the rich would face tax hikes. Since reducing government spending goes against his leftist instincts, he is unlikely to lead the French economy into a recovery phase. Over more than a decade the French economy lost out to Germany’s lower cost levels. The Netherlands, with a quarter of France’s population, exported more than France in 2011. Rigid redundancy rules and high payroll charges deter job creation in France and stunt small business growth that could pave the way to economic recovery.

Because France’s economy is more vulnerable to the crisis than Germany, Hollande’s view of restoring the public finances of the euro zone is based on the concept “integration solidaire”, meaning reliance on Germany’s willingness to accept further risk sharing. With markets losing confidence in the future of the single currency, France urges Germany to stand behind the euro by accepting the pooling of sovereign debt and collective action to shore up the banking system. Merkel, on the other hand, insists that if there is to be any mutualisation of liabilities, there must be greater central control. That means giving European institutions more power to determine national budgets and economic policies and to oversee the financial sector. Such power can only be legitimised by democratising EU bodies and strengthening the European Parliament. It also means that France would be relegated to just another region of Europe: political integration for the sake of fiscal discipline. As an interim measure, EU officials are in favour of starting with some short-dated bills, limiting the size and duration of liabilities. The euro crisis is confronting the European experiment with an existential challenge: more integration versus national self government.

The worst news for Europe’s economic prospects comes from Italy. It is said that Italy’s economy, the third largest on the European continent, is too big to save. After its inconclusive election result in February 2013, Italy will continue to be trapped in a continuation of dysfunctional politics and economic stagnation. Its paralysed political system seems to be congenitally unable to address the root causes of Italy’s problems: entrenched distortions that prevent growth. These distortions refer to employment protection laws that make retrenchment of unproductive workers virtually impossible; government subsidies equal to 15 percent of the corporate sector’s value added; government spending growing from about 30 percent of GDP in the 1960s to more than 50 percent today and tax revenues increasing by much less than that; and the budget deficit which had been below 1 percent in the early 1960s, blew out to more than 10 percent of GDP today. Initially these unsustainable distortions could be dealt with by a combination of inflation and a series of devaluations, but after Italy joined the euro zone, it could no longer find refuge in such stop-gap measures. It seems that Italy is destined to continue on the brink of becoming a “failed state”. (See Henry Ergas, “Weakest Link in the euro zone”, The Weekend Australian, 2-3/3/2013). Italy’s precarious public finances are exacerbated by its

83 extravagant regional bureaucracies. Sicily is a notorious example with its 18,000 employees – five times as many as the regional government of Lombardy, which has twice the population. The governor of Sicily has a bigger staff than the British prime minister!

The British economy has been faltering since the onset of the GFC. When the GFC struck, the UK was already reeling under the profligacy of the Browne Labour government. The gush of public spending racked up a huge pile of unsustainable debt. After the Conservative Party’s Chancellor Osborne took over, he introduced severe austerity policies, but the private sector continued to remain on the sidelines. Osborne’s austerity measures could hardly be described as too much too fast for one of the world’s most debt-laden countries. He was prepared to tackle the profligate energy and welfare budgets, making himself personally unpopular and exposing himself to constant harping in the editorial pages of The Economist in view of its close connection with the bondholders. Unfortunately, the British economy remained uncompetitive, debt laden and reluctant to grow and was downgraded by Moody’s, one of the three big rating agencies, from Aaa to Aa1 on February 22nd, 2013. The UK henceforth shared the same credit rating as France and the USA. In the fourth quarter of 2012, the UK’s economy was around 3 percent smaller than it was in the first quarter of 2008.

Concluding Remarks

The prospects of the heavily debt-laden countries depend essentially on their ability to reduce their debts to sustainable levels by carefully managed spending coupled with vibrant economic growth. A more sustainable fiscal path implies budgetary policies that include both revenue increases and spending reductions. Given their poor growth performance over the past two decades their outlook is not promising. They are not only hampered by the dead weight of government intervention and public sector bureaucracy, but by an inability to deal with the obstacles they have to overcome. These obstacles are deeply rooted in the systemic weaknesses of the welfare state. In the case of the EU countries they are also burdened by the enduring weaknesses of the euro project which is not supported by grass-roots anchored political coalitions capable of bearing the costs and sharing the benefits. The result is most likely a continual process of muddling on, coupled with continued economic stagnation. Bibliography

Ferguson, N. (2008) The Ascent of Money – A Financial History of the World, Allen Lane, London Johnson, P. (1983) A History of the Modern World, Weidenfeld & Nicolson Tanzi, V. (2011) Government versus Markets – The Changing Role of the State, Cambridge University Press Vosloo, W.B. (2010) Understanding Economic Trends, Biblaridion & Crink

7. Unresolved Questions Relating to Deficit Budgeting and Debt Levels (March 2013)

How should public debt be defined? What are the benefits of deficit spending? What are the real costs of servicing debts? Should public deficits be financed by higher taxation or by borrowing? What levels of deficits and debts are excessive? How can debt traps be avoided? What strategies should be followed to exit from overwhelming debt levels? Which policies are prudential?

Gross and Net Debt

Public debt (also called “government debt”) includes all money owed by the government sector to creditors within the country as well as to international creditors. Gross government debt refers to short- and long-term debt of all institutions in the government sector. To be accurate and reliable this amount should also include such government liabilities as future pension payments and payments for goods and services the government has contracted but not yet paid. Figures are often quoted that do not include these liabilities and are therefore not reliable. Government net debt refers to gross debt minus all financial assets. The difference between gross and net debt could be large for some countries. However, the statistics offered by government spokesmen do not always include the same type of financial assets in their calculations. As a result international comparisons are often not reliable. Gross government debt as a percentage of GDP is the most commonly used government debt ratio.

The Feasibility of Credit Financing

For the individual household the availability of credit is a source of bridging finance. It finances spending on consumer goods which are not immediately affordable, but could be repaid at a later, more convenient date. When it comes to larger items such as household goods, cars or even homes, the availability of credit enables a buyer to acquire a needed asset, provided that the repayment conditions are reasonable in terms of interest rates payable and affordability in terms of the proportion of current income absorbed by servicing existing debt. There is nothing admirable about unaffordable debt levels that absorb all available income without reducing outstanding debt obligations. A person or household that is forced to rely on loans to cover current needs such as food on the table would be in dire straits.

In the case of the business world, raising a loan is often required to start a new business or to expand an existing operation. The creditors for such loans normally require a proper feasibility analysis of the proposed business activity based on a reliable business plan setting out expected marketing share, turnover levels, cost structures, management ability and a realistic repayment schedule. The success of such financing operations depend upon the viability of the assumptions made and the accuracy of the data fed into the feasibility analysis. Miscalculations and faulty projections can shipwreck new as well as existing enterprises. Predicting the future is unfortunately not an exact science.

Granting credit (whatever the form of loan finance) to a state is based on less reliable feasibility analyses. Decisions are made in the political arena and predictions of future economic outcomes are much more fragile because of the myriad of variables that can influence the future course of events. According to Nassim Nicholas Taleb, the author of The Black Swan – The Impact of the Highly Improbable, “Predictions of socioeconomic variables are as dependable as the horoscope”. Taleb, a former derivatives trader who became a professor of risk engineering, argues that those who risk their

85 own funds put a premium on simplicity and practicality, while others – such as academics, management consultants, economic experts and financial analysts, working with other people’s money – have an incentive to indulge in complexity and muddle. Taleb believes that unpredictability is part of any system that is prone to “fat tails”, that is, systems whose properties are dominated by rare events – what he has called “black swans”. (See Nassim Nicholas Taleb, “From Fat Tails to Fat Tony” in The Economist’s The World in 2013, p.143)

In terms of Keynesian budgetary policy, in exceptional circumstances the creation of public debt is preferable to increased taxes. If an economy is in recession, prudent fiscal policy calls for increased government spending and reduced taxes. Then a deficit would be unavoidable, inevitably resulting in an increase of government debt. If additional locally produced goods and services – preferably capital goods – are financed by the borrowed funds, society benefits from the extra deficit spending. However, if the deficit spending is squandered on “pork barrel” and constituent pleasing handouts, the deficit spending would be wasted. Frederich von Hayek, the Austrian economist, was critical of Keynesian demand management to deal with deflationary pressures. He maintained that Keynesian deficit spending could counteract an economic slump, but would institutionalise inflation. As a result of inflationary effects a 2010 US dollar buys less than 5 cents of the purchasing power of a 1970 US dollar.

Deficit Budgeting and Growth

There is much controversy surrounding the relationship between deficit budgeting and growth patterns. When an economy is at full employment deficit spending unleashes inflationary pressures. When an economy is in a contraction phase with high unemployment levels, the Keynesian approach supports the use of budget deficits to stimulate the economy by injecting demand. This in turn boosts output via the multiplier, resulting in increased capacity utilisation and higher employment. But the impact of deficit budgeting on the economy depends on the size of the deficit, how it is financed and how wisely the government of the day invested the extra spending. Different methods of financing the deficit have different outcomes: domestic borrowing can increase interest rates and “crowd out” private investments; money creation can lead to inflationary pressures; foreign borrowing is exposed to exchange rate fluctuations and foreign interest rate hikes. If government spending is not efficient and does not add to growth, deficits should be avoided. Deficits and growth are negatively correlated because the negative “crowding out” effects of deficits tend to be stronger than the positive “crowding in” and increased aggregate demand effects. Consequently, deficits have generally been associated with low economic growth – either due to ineffective government spending or to bad deficit financing practices.

Deficit spending on growth-inducing projects can be beneficial only insofar as the economic growth rate in the long run exceeds the interest rate. However, if the deficit spending is made on items that are not growth inducing (such as public administration and salaries), the interest rate could exceed economic growth and the country might find itself moving towards a debt trap.

Debt Traps

The biggest danger in chronic deficit budgeting is that a government could find itself caught in a debt trap. This is a situation where the conventional deficit (total government expenditure minus total government revenue for any given year), as a percentage of total debt, is greater than the economic growth rate. High levels of accumulated public debt lead to high annual interest payments. If the debt is increasing faster than the rate of economic growth, the government will have to keep borrowing to

86 service the old existing debt. Under such circumstances, a government’s ability to redeem old debt becomes highly problematic. When the government’s creditors (bond market) no longer believe that a government will be able to finance interest payments through higher taxation, let alone to redeem the debt, it will not be able to borrow. Government would be effectively insolvent and the only way it can service or redeem its debts would be through money creation. When the growth of money supply gets out of hand, it results in hyper inflation.

Costs of Deficit Financing

The financing required to service existing debts, either as repayments or as interest payments, is a constant charge on the output capacity of an economy: it is a recurrent charge that reduces investment in the expansion of productive capacity. Government borrowing inevitably always competes with private borrowing. It “crowds out” private investment because of increased interest rate levels or a decrease in the availability of capital to borrow. If the reserve bank provides extra bank reserves to allow an offsetting increase in the money supply, the effects could be negative when the general public and investors become alarmed over the size of the public debt. The loss of confidence could result in the curtailment of investment activity. The bottom line is that servicing a large pile of government debt has a damaging impact on the long-term growth of a country as a result of its opportunity costs: soaking up investment capital and adding billions of interest costs to the taxpayer’s annual burdens.

Robbing Posterity

Deficit financing through the issue of government bonds shifts the burden of expenditure (past or present) into the future. Future generations have to pay interest to the bondholders (or their inheritors). To redeem those bonds would require direct taxation. Thus debt financing rather than tax financing gives the current generation a claim against the income of future tax payers. If the money was spent on productive assets, current and future generations of tax payers should have fewer grounds to complain. However, if borrowed funds are used to finance current consumption spending, future generations would be given a toxic burden as legacy. Merely servicing existing debt levels creates intergenerational stress. President Eisenhower called the national debt “our children’s inherited mortgage” accusing profligate governments of robbing their grandchildren.

The Delusion of Automatic Stabilisers

The tacit assumption underlying deficit budgeting is that economic cycles somehow eventually turn around. It is assumed that economies contain automatic stabilisers which would assist in smoothing out the peaks and troughs of economic cycles like an automatic pilot that keeps an aircraft on course. But even if automatic stabilisers do play a limited stabilising role through the tax system and the social security system, this role does not eliminate the need for deliberate counter measures to reduce debt levels in order to bring down the interest payments due every year. Above all, it does not, even remotely, address the problem of re-igniting the engines of economic growth when an economy faces a persistent decline coupled with a large public debt burden.

The Return of Big Government and Increased Debt Levels Since the GFC

In the wake of the GFC, massive amounts have been pumped into most economies by huge stimulation packages – mainly to strengthen demand and to contain unemployment. A lingering consequence of these interventions is the world-wide expansion of the state’s reach: its debts, its taxes, its scope – in

87 short, the burden of its interventions. Floods of money have been allocated to cash handouts, artificial make-work projects and hiring extra government employees. In the depth of the crisis governments focused on the short term: on preserving jobs and electoral support rather than structural reform or investment in productive assets. Many countries now face the challenge of repairing their balance sheets. The ratchet effect of a crisis on the reach and authority of the state is that it does not recede when the crisis passes: the state never returns to its previous limits. The debt-laden economies have been saddled by the weight of public debt for years to come.

Deficit Reduction

There are essentially two categories of debt reduction: the reduction of mandatory spending and the reduction of discretionary spending. All the long-term pressure on the deficit comes from mandatory spending on the large entitlement programmes (eg. on health care and spending on the poor and elderly) that are taking up a hefty portion of every year’s budget expenditure. Spending cuts on the discretionary side are politically more appealing because it arouses less anger than cutting entitlements or raising taxes.

Public sector spending cuts have significant consequences not only for GDP accounts but also for investments in human and physical capital. These investments are not part of mandatory (recurrent) expenditure – they depend on explicit discretionary allocations. It includes education, research and transport infrastructure. Cuts in these areas hit the wrong kind of spending and do not solve the long- term problem of debt reduction. Solving the debt reduction problem requires combining entitlement reduction with modest tax increases.

Debt Reduction

In the case of a private individual the calculation of net debt offsets the value of assets owned by the debtor against the amount owed. Much depends upon the accurate valuation of those assets. In the case of a country or the government sector of a country, calculating both the gross and the net debt positions is much more complicated. Governments have the power to tax and to print money. In the case of the EU or euro zone countries, governments can rely on the guarantees or transfer payments from other member governments. Some of the major European banks such as the Rothschild Group, Barclays, Standard and Deutsche Bank have branches or divisions in several countries which raises the question whether the creditor is local, national or international. A country’s credit standing depends upon the nature of their financial problem: eg. whether it is solvency or liquidity. The total debt of a country should be roughly equal to its accumulated budget deficits, but their debt could be much larger if they moved their borrowing off their balance sheets in order to meet their deficit targets.

The history of official obfuscation and denial (or simply cooking the books), shows that little faith should be placed in official statements of reassurance. Debtors usually claim they can service their debt, just as alcoholics deny they have a drinking problem. Fiscal straitjackets to tackle debt problems come in many shapes and sizes such as compulsory balanced budget rules, constitutionally ensconced

“debt brakes”, offsetting budget fixes (like “sequesters”), limits on debts or spending (like “debt ceilings”), etc. The problem lies with compliance or enforcement. America’s “debt ceiling” has been raised 76 times since 1962. Every time, amid a heated political battle, the ceiling has been raised to stave off default.

The Maastricht Treaty’s fiscal criteria for monetary union prescribed that total government debt should be no more than 60 percent of GDP and that budget deficits be no bigger than 3 percent. Structural deficits above the prescribed limits were required to be trimmed by 0.5 percent per year. Those members who broke the rules were supposed to face fines. But in practice these rules have been easily broken and the sanctions were never applied.

In October 2009, The Economist published its findings that total government debt in the big rich countries was expected to reach an average of 100.6 percent of GDP in 2009 and heading for 119.4 percent of GDP in 2014. It was clear that these increases could not be sustained for long, especially when nervous capital markets drive up the cost of servicing the growing debt. The critical variables in such a situation are the confidence levels of the buyers of government bonds, the interest rates required and the repayment conditions involved. These requirements, in turn, depend upon perceptions of the relevant government’s fiscal rectitude and the economic potential of the country and its tax payers. A country with a firm growth potential, a stable political system and a convincing record of good economic management will find it easier to raise loans domestically and internationally to cover its debt requirements. Thus, the payback potential of a country depends on its projected disposable income stream.

Austerity and Growth.

In recent times a lively debate has been sparked off by arguments over debt reduction by austerity cuts in budget expenditure levels. A newspaper such as The Economist, representing bond market operators, argues that there is a “deficit of common sense” to follow a tough fiscal policy as a cure for excessive debt. It claims that austerity hurts economic growth because it damages demand levels. It says that what matters is how austerity is imposed and what other policies accompany it. It claims that past experience argues against sudden sharp cuts. As for other policies, the main lesson is that austerity hurts more if it is not accompanied by bold monetary loosening. (The Economist, October 27th, 2012, p.11). Unfortunately The Economist did not supply a credible economic growth strategy to assist the failing economies with the mountainous debt burdens, or a credible exit strategy from their chronic deficit budgeting practices.

Most European economies have seen average growth of below 2½ percent over the past two decades. If growth declines below the level of real interest rates, debt burdens will continue to rise. The debt level becomes excessive and unsustainable when a vicious circle is set in motion: rising debts boost interest payments, which in turn requires extra borrowing to service earlier debt, and so on.

Governments then have only three ways to break away from the debt trap: raise taxes, slash spending or let inflation rip. If those measures are exhausted, the only option remaining is default – and eventually the status of a failed state, unless debt restructuring can be arranged with creditors. Defaulting countries are usually locked out of international capital markets because creditors are forced to accept large losses of principal. When defaulting countries re-enter markets once debt restructuring is complete, their reduced credit rating leads to escalating costs of funds, not only for their governments, but also for private companies in the defaulting countries.

Dealing with Excessive Debt Levels

Since the GFC started in 2007 some countries, like Germany, Austria, the Netherlands, Canada and Australia, faced the financial crisis situation in a much stronger position than those with higher debt levels. Several countries in the Euro area such as Greece, Portugal, Spain, Italy and France are saddled with huge debt levels and have provoked a crisis of confidence in the Euro area as a whole and the sustainability of the single currency. The United States also faces unsustainable debt levels and has so far been saved by the fact that the US dollar is the reserve currency of the world and that the US Federal Reserve Bank has been in a position to use quantitative easing (creating money by buying government credit) to avoid the financial crisis sliding out of control. The UK and Japan are similarly facing sclerotic growth prospects in the face of rising public debt liabilities. All of these countries came out of the GFC with fiscal accounts in a far worse shape than they were facing before the crisis struck.

In 2012, the average public debt of the G20 countries stood at an estimated average of 106 percent of GDP and was expected to reach 110 percent of GDP by 2013, possibly rising much higher during the next decade as a result of continued deficit financing. In 2012 Japan’s sovereign debt stood at a level of around 220 percent of GDP. Fortunately for Japan, most of its debt has been financed by domestic investors. In contrast, in 2012 most of the US sovereign debt was foreign owned. It would seem that the advanced economies are facing a “debt curse” that could last for decades into the future. It would seem that the efforts needed to bring the fiscal situation back to sustainable levels are neither properly discussed nor understood.

The required “exit strategies” will have to choose among a combination of several options: stimulation of higher growth levels, lower public spending based on a reduction of public sector activities, a significant increase in tax levels, an induced increase in inflation rates coupled with the creation of money, and, increased austerity measures that share the burden fairly and effectively supported by co- operating political coalitions.

What is Prudential?

Prudent monetary policy aims at keeping prices stable just as fiscal policy should aim at reducing government debt to the lowest levels possible. There is nothing commendable about mountainous government debt levels. Supplying millions of dollars of reserves to banks and reducing interest rates to zero cannot force banks to lend or households and companies to borrow. For governments to spend borrowed money indiscriminately in order to spur consumer spending is not an alternative to growth through investment in productive assets. The only beneficiaries of loose monetary and fiscal policies are the bondholders and the manufacturers and exporters of low-priced consumer goods.

Concluding Remarks

A continuation of large government deficits inevitably causes an increase in the size of government debt. Increasing government debts lead to increasing interest payments. A critical point is reached when government debt grows at a faster rate than the GDP growth. If this discordant anomaly persists, interest payments on debt would take up an overwhelming proportion of government spending and “crowd out” essential spending categories (education, national defence, health, social security, etc.) until a government has no alternative but to repudiate the debt. Deficits and interest rates rising at the same time should always be a cause for concern. It requires constant vigilance to keep the levels of public debt as low as possible.

A cavalier attitude towards incurring debt has ruined countless individuals, shipwrecked many business enterprises and, at the current time, is threatening the demise of many advanced countries of the modern world. What is needed from debt-laden governments, is not more spending on the consumption of imported goods, but more effective efforts to raise government investment in infrastructure like railroads, roads, modern technology and all forms of productive assets that give their economies a boost in productivity. The ultimate objective of government interventions should be to spur private sector business investment. Funding for small business investment and expansion would be the quickest way to inject productive capital into the sclerotic economies on a decentralised scale.

The quickest and most effective way to reduce the mountains of government debt is to curtail wasteful government spending and to ignite the business engines of economic growth. Profitable businesses carry the base load of generating taxable income – the mainspring of all desirable public goods.

Bibliography

Haberler, G. (1941) Prosperity and Depression – A Theoretical Analysis of Cyclical Movements, League of Nations, Genoa Henderson, H. (1947) Supply and Demand, Cambridge University Press Lundberg, E. (1957) Business Cycles and Economic Policy, George Allen & Unwin, London Nattrass, N. (2000) Macroeconomics, David Philip, Cape Town Taleb, N.N. (2008) The Black Swan – The Impact of the Highly Improbable Penguin Books, London Tanzi, V. (2011) Government versus Markets – The Changing Role of the State, Cambridge University Press Vosloo, W.B. (2010) Understanding Economic Trends, Biblaridion & Crink

8. Choosing Sound Economic Growth Strategies (April 2013)

In an ideal world a sound economic growth strategy would meet a number of important criteria: - activating the productive resources of society (capital, labour, natural resources, technology and entrepreneurship); - improving the productive efficiency of the productive resources; - keeping prices stable by way of prudential fiscal and monetary policies, i.e. keeping a lid on deficit spending, government debt, tax levels, inflationary pressures and wasteful public bureaucracy and corruption.

Meeting these laudable criteria is easier said than done. The literature is replete with efforts to describe appropriate pathways to sustainable economic growth, ranging from the writings of the pioneers of political-economy, such as the French physiocrats and British pioneers Adam Smith, Malthus, Ricardo and Marshall to 20th century trail blazers such as Keynes, Von Hayek, Schumpeter, Samuelson, Solow, Friedman and a raft of modern exponents of macroeconomics. Today several schools of thought compete for pre-eminence and reputations are created or lost – sometimes more on account of peer-group ascribed eminence than on substance or evidence-based validity. When it comes to prescribing appropriate policies and actions in specific situations, many contentious and unanswered questions remain.

Defining Economic Growth

A country’s economic growth is usually measured in terms of increases in its gross domestic product, i.e. the total output of all final goods and services produced by all productive resources of a country. The rate of growth depends on increases in the quantity of available productive resources (capital, labour, natural resources, technology and entrepreneurship) on the one hand, and on the “total factor productivity” on the other, i.e. the improvement of the productive efficiency of the productive resources. Enhancing total factor productivity, in turn, depends upon the suitability and durability of the capital equipment, the skill levels as well as the motivation of the workers, the non-disruptive nature of industrial relations, the acceptance and exploitation of superior and innovative production techniques, and on the willingness of business entrepreneurs to invest and reorganise their business enterprises to their maximum competitive advantage.

The requirement that a society should have a growing economy is not based on an acquisitive dogma, it is a sine qua non for the improvement of the quality of the lives of its citizens. Economic growth is the requisite for providing so many of the basic goods which people strive for: education, health services, housing, security, as well as a stable and fair political system. Without means, these goods slip out of reach and society is impoverished. What matters is a successful formula for achieving economic growth.

Supporting economic growth is as desirable a goal as striving for peace and happiness. Most informed people agree that it is a critically essential objective within the framework of sound geo-physical parameters. But how to achieve it remains an open question. What can be achieved by government intervention? How can the main drivers of job creating growth be activated?

Recent Policy Mistakes and Market Excesses

The current distress of the advanced economies was caused by policy mistakes as well as the financial world’s market excesses. The failure of financial markets was coupled with profligate government deficit spending. The world of finance has always been prone to bubbles, panics and crashes. Governments have often been involved in the regulation of financing practices: monitoring risky strategies, punishing scams and prescribing capital cover for banks. But in recent years, dodgy financial innovation has outpaced skilful governmental rule making. Derivatives such as collateralised debt obligations and credit default swaps float undetected into the international financial circuits. The imbalances caused by China’s intervention to hold down its exchange rate against market trends, sent a wash of capital into Western capital markets. At the same time, the citizens of the advanced countries have saddled their political economies with unaffordable privileges, bloated bureaucracies, rigid labour relations and welfarist benefits.

The Way Forward

The way out seems to be more a matter of better regulation than more regulation. What is needed is better government, not more government. Since governments are net consumers of taxable income, government spending cannot continue to grow unabated. Government intervention should be directed to catalyse private-sector driven job-creating growth. Also of critical importance are flexible industrial-labour relations for job contracts and wage determination. Inflexibility distorts job markets and sets up rigid distinctions between protected insiders and vulnerable outsiders.

A bleak scenario of an economy spiralling downwards can only be avoided by creating a climate for enterprise which allows confident business entrepreneurship to re-ignite the engines of economic growth and prosperity for all. The restoration of investors’ confidence and a spirit of enterprise, are of overriding importance in any growth strategy.

A Growth Strategy Based on Conventional Precepts of Prudent Economics

These precepts refer to an economic system with a strong proclivity towards competitive free enterprise, limited government intervention, a strong emphasis on productive output, non-disruptive labour relations, conventional application of anti-cyclical monetary and fiscal policies and the illumination of the shady corners of the world of finance.

1. Create an enabling environment for confidence building

Underlying principles  The creative action of people is the key resource available to any society. Their actions as economic role players – i.e. as producers, savers, investors and consumers – are determined by their needs, aspirations, expectations, values and ways of doing things. But in crisis situations the general way of thinking as expressed in the confidence levels are of critical importance.  In an economic downturn overriding perceptions are of key importance: - the safety of bank deposits; - the security of jobs and income streams; - reduction of uncertainty about the causes of the crisis; and - convincing collective action to deal with the causes and culprits of the crisis.

Policies and Programmes 1.1 Guarantee the safety of bank deposits to avoid runs on banks. 1.2 Subject lending institutions to “stress” tests to determine their degree of volatility. 1.3 Set up transparent funds or schemes to assist in the rescue or bail-out operations. 1.4 Relentlessly pursue a forensic operation to bring the culprits in financial markets to book and to root out undesirable financial practices and instruments. 1.5 Recalibrate financial regulatory practices and institutions. 1.6 Replace the management of failed financial institutions and regulatory institutions to ensure that justice is seen to be done.

2. Create a climate for enterprise and investment

Underlying principles  Business creation and business expansion are the key instruments of job- and wealth-creating growth. Wealth creation means more resources will be available – with reasonable levels of taxation – to generate public revenue to spend on social, health and education services as well as essential infrastructure.  Vibrant market forces are required to generate a sustainable level of taxable income to finance essential government spending.  Public expenditure and borrowing must be kept down, otherwise government would be taking away the very resources the private sector needs to invest and grow. In reality, investment can only be financed by savings – either domestically or cross-border based.  An expanding, entrepreneurial economy based on business creation and business expansion is the most important welfare policy, urban policy, labour policy, affirmative action policy a country can have.

Policies and Programmes 2.1 Monetary policy should aim at maintaining a stable macroeconomic environment. 2.2 Tax policy should encourage savings as well as investments in productive assets. 2.3 Labour policy should be based on the improvement of productivity and the maintenance of non-disruptive labour relations. 2.4 The legal and regulatory framework should be predictable and transparent and aimed at facilitating competitive business transactions and the exploitation of innovative production techniques.

2.5 Development capital should be mobilised through appropriate development schemes (preferably private sector schemes) into small and medium size (SME) development programmes. SME’s are, after all, the largest, most agile and most versatile market-driven creators and providers of employment.

3. Essential forms of government intervention and spending should be carefully scrutinised and monitored

Underlying principles  The proper functioning of a people-based, market-orientated, enterprise-driven economy requires a small, efficient and professional public service which can justifiably be endowed with dignity and social recognition.  Even J.M. Keynes suggested that the “... important thing for government is not to do things which individuals (or companies) are doing already ... but to do those (necessary) things which at present are not done at all”.  It is unavoidable that societies turn to the state (which is after all the organised community) to relieve distress and to help solve problems. But it is vital to prevent the state from becoming so beneficent that it undermines the people’s will to help themselves.  Next to market economies, the advance of political pluralism is an important megatrend throughout the world. The predominant emerging political framework is that of a democracy based on the recognition of human and civil rights, popular sovereignty and government accountability. There is strong evidence that political checks and balances, a free press and open debate on the costs and benefits of government policy tend to give a wider public stake in the benefits of development and growth. It also increases governments’ incentives to perform well. Authoritarian governments are objectionable for many reasons, but the preservation of stability and civilised law and order are absolutely indispensable.

Policies and Programmes 3.1 Keep a lid on government spending to avoid a situation where government intervention “crowds out” market-driven creativity and innovation. 3.2 Keep a sharp surveillance on the quantity of government activity: its allocative efficiency as well as its productive efficiency. 3.3 Maintain accountability of public officials by measures such as an independent auditor or controller-general, media access to public information and surveillance by popularly elected political representatives. 3.4 Improve the professional competence in government institutions responsible for handling key functions such as tax collection, the administration of social security, the collection of statistics, as well as regulatory agencies that oversee banks and preserve competition. 3.5 Strengthen the effective functioning of the “rule of law” to ensure that governments are kept accountable, that free markets can function and that individual and commercial rights can be exercised effectively. 3.6 Public sector employment on all levels of government (i.e. all employees receiving the bulk of their total emoluments from the public purse) should be kept below 15 percent of the workforce and never be allowed to rise above 20 percent of the workforce.

4. When stimulus packages are considered essential to counter major economic meltdowns, ad hoc spending increases should be focused on productive assets such as infrastructure projects as well as emergency relief for the needy

Underlying principles  For the period since the onset of the GFC, the G20 economies have introduced stimulus packages worth an estimated average of 2 percent of GDP each year. Some politicians and commentators have claimed that these stimuli played an important mitigating role. But economists are not in agreement about the success of either tax cuts or stimulus spending. The debate hinges on the scale of the “fiscal multiplier”, which is bound to vary according to economic conditions. If the economy is operating at full capacity, the fiscal multiplier would be zero because there would be no spare capacity to utilise. However, when workers and factories are idle, a fiscal boost could increase overall demand. If a stimulus package triggers a cascade of investment, the multiplier can well be more than one.  The overall size of the multiplier depends on how people react to higher government borrowing to finance budgetary deficits. If the government’s actions bolster confidence, the multiplier would rise as a result of private investment. However, if deficit spending drives interest rates higher, private investment could be “crowded out”. If consumers expect higher future taxes in order to finance government borrowing, they would spend less and thereby reduce the fiscal multiplier.  It seems to be a very complex task to isolate the short-term impact of changes in government spending or tax cuts. It is also difficult to determine what proportion of the stimulus might “leak” abroad via imports (eg. of Chinese goods).  The simple truth is that the impact of fiscal measures is not properly understood. Fiscal multipliers are likely to be lower in heavily indebted economies than in prudent ones. But it can be said that stimulus measures do tend to bolster confidence levels.  Stimulus packages are appropriate to the extent that they help to restore confidence, contribute to the provision of essential infrastructure, assist in providing urgent welfare relief to the needy and remain within the parameters of affordability, i.e. create a debt burden that does not stifle growth or lead to an unmanageable inflationary spiral.

Policies and Programmes 4.1 The more aggressive the stimulus programmes the greater the urgency to outline a clear strategy to shrink deficits. Concerns about inflation or even default could push up interest rates. 4.2 A credible programmed reduction of the scale of deficits would pre-empt corrosive uncertainty. It would reassure markets and allow an orderly exit from fiscal stimulus. Monetary policy should be tightened when inflation threatens to emerge. 4.3 Spending cuts could be achieved by way of the judicious curtailment of entitlements, wage freezes for the public sector and reductions in the number of employees in the public sector. 4.4 One way to handle these highly controversial policy decisions would be to establish non- partisan commissions to fix entitlements, taxes and spending cuts, coupled with non-partisan public education programmes which are subject to public scrutiny.

5. Public expenditure should be limited to sustainable levels

Underlying principles  Economic history shows that the state is not a successful creator of wealth. It is better known as a consumer of wealth, or a redistributor of wealth. If its allocative powers are wisely used it could serve as a facilitator of development and growth.

 In recent years we have witnessed a consistent tendency for government expenditure to rise as a share of GDP. This growth rate has consistently outpaced that of the economy as a whole. This trend would inevitably lead to the “crowding out” of the taxable income generating private sector.  The issue of the sustainability of public expenditure is intricately related to how it is paid for. To pay for public expenditure (consumption as well as investment expenditure) governments have to rely on taxes and borrowing (from domestic or foreign savings).  Increasing taxes are associated with disincentives to work, to save and to invest. These disincentives have a negative impact on economic growth.  If higher government spending results in larger fiscal deficits, then the government is forced to turn to deficit financing by either creating money (quantitative easing) or borrowing from the domestic private sector or foreign markets. Money creation invariably leads to inflation and rising public debt raises the question of sustainability, the “crowding out” of private sector investment and the spectre of a “debt trap”.  The pursuit of a fiscal policy that is not sustainable from a macroeconomic point of view will result in insolvency and the destruction of the economy’s productive capacity.

Policies and Programmes 5.1 Special efforts should be made to channel a larger portion of the contractual savings in the hands of institutional investors into projects directly involved in job- and infrastructure creation. An allocation of up to 10 percent of the cash flows generated by contractual institutionalised savings should be allocated to independently prioritised, parliamentary approved, investment projects creating productive assets. 5.2 Suitable investment instruments should be devised (with acceptable returns and security cover) to attract investment funds from institutional investors. 5.3 Governments should avoid using funds derived from loans on the capital market for the financing of government consumption expenditure or any expenses of a non-capital nature.

Unconventional Interventionist Strategies

In recent years a number of unconventional options have entered the arena of the policy debate particularly in the wake of the impact of the Global Financial Crisis on the highly leveraged public finances of the neo-socialist profligate welfare states. The “unconventional” policy options emerged because it was felt that the conventional anti-cyclical weapons had run out. Central banks had pushed interest rates to zero and governments were drowning in debt caused by continuous deficit budgeting. Hence, a different sort of weaponry was introduced.

Unconventional policy instruments cover everything from negative interest rates to a change in inflation targets and the use of “quantitative easing” (QE), meaning the creation of money to buy assets. QE, coupled with reduced interest rates, became weapons of choice in several troubled countries. Raising inflation-rate targets is the latest addition to the unconventional policy arsenal.

The Bank of Japan (BOJ) pioneered QE in 2001 with the object of ending deflationary pressures. By buying increased quantities of securities in the market, through its “open-market operations” (buying or selling securities), the BOJ was aiming to supply more reserves in the hands of banks, keeping interest rates low and encouraging spending and investment which would boost the economy. Subsequently QE has come to include several forms of asset-purchasing programmes. One version is called “credit easing” which aims to support the economy by boosting liquidity and reducing interest

97 rates when credit channels are clogged. The US Fed’s purchases of mortgage-backed securities fall into this category. A second type of asset purchase aiming to boost the economy without creating new money is the Fed’s “Operation Twist” where the Fed sells short-term debt and uses the proceeds to buy long-term debt. Giving investors cash for long-term debt held in their hands, should, theoretically, prompt them to invest more money in other assets. The third type of QE, the most straight forward, is meant to promote “portfolio balancing”. The investors sell securities to the central bank and then take the proceeds to buy other assets, thereby raising their prices. Lower bond yields encourage borrowing, helping investment and boosting demand. When the central bank holds onto the government debt it buys, QE supports the economy by cutting government’s borrowing costs and reducing the future burden of taxation.

The actual results of these unconventional interventions are, as yet, not entirely clear. Unconventional monetary tools had not been in general use before the GFC struck. It is not easy to isolate its impact after such a brief trial period. It is clear though, that QE exercises exert a downward pressure on interest rates and an upward pressure on equity price levels. But the critical question is whether these monetary quirks boost the broader economy.

It should be clear that these unconventional measures are not risk free. Some of the risk affects the functioning of financial markets in their role as suppliers of credit when interest rates are at zero levels. Another danger is the artificial lowering of the costs of government debts. With their borrowing costs reduced, governments have no incentive to cut their deficit spending habits. In addition, with their cost of borrowing so low, financial markets are deprived of their monitoring role on the maintenance of public finance discipline. If the financial market loses confidence in sovereign debt, the central bank inevitably also loses control over inflationary pressures.

Welfare State Excesses

The modern “welfare state” came about with a heavy political-economic price tag. The question of affordability was generally ignored as deficit spending became standard fiscal policy and practice. More and more countries started to finance running government expenses – including welfare transfer payments – with borrowed funds. These practices created unsustainable fiscal positions. The growing demands on the public purse outstripped the tax and income base of the “welfare state”. Governments were committed by their multi-year budgetary cycles to unaffordable benefits and entitlements to their citizens. They became totally dependent on over-sized, inefficient and ineffective bureaucracies. The “welfare” state became a “big government” state. Competition between political parties started to bid up benefits over time – with scant regard to affordability. Continued inflation-driven price rises across the board sapped economic efficiency and competitiveness which eventually caused economic growth to decline and unemployment to rise. Mountains of rising public debt also started to become a standard feature of public finance in social democracies: chronic deficit budgeting coupled with declining revenues.

When the Global Financial Crisis struck, all the Western social democracies retreated to more interventionist social and economic policies by way of massive “stimulation plans” and large-scale interventions to rescue banks and large business corporations and special measures to maintain employment levels. By the end of the first decade of the New Millennium, the rich countries found themselves deeply entangled in the suffocating coils of the welfare state: over-extended banks, over- indebted governments, overweight public sectors and too many citizens depending on government support in proportion to those contributing to the public purse.

In view of the general reluctance to cut “mandatory” expenditures on entitlements and public sector emoluments (the beneficiaries of which provide electoral support to left-wing political parties), the focus turned to the productive elements of society to rescue the sinking economies by raising taxes on incomes and other assets such as savings and retirement funds. It instigated a battle between the productive and the redistributive forces in society with the latter counting on the majority support of the beneficiaries of welfare state handouts.

In modern democracies, public policy making takes place in a highly politicised environment. Left- wing political parties, cheered on by trade unions and affiliated economists (mostly academic) are propagating more government involvement: deficit spending on welfare and unemployment entitlements, demand enhancing stimulus packages, interest rate reductions, quantitative easing, liquidity injections, tax increases on high income earners, expanding public sector employment and emoluments, etc. Right-wing political parties, cheered on by business interests and affiliated economists (mostly private sector or independent) are propagating a range of austerity measures such as debt-reducing spending cuts, balanced budgets, deregulation, infrastructure directed stimulus packages, tax concessions, limitation of welfare and public sector payments as well as growth strategies based on entrepreneurship and business expansion.

Progressive Liberalism

The Economist, a newspaper that used to be a supporter of classical “liberal” economic policies, has now switched to become a propagandist for the “progressive liberalism” of the American left. It supports continued deficit budgeting, which is understandable in view of its ownership by major bond market interests, without taking a stand on devising a credible exit strategy. It has taken a populist stand against austerity measures, paradoxically juxtaposing austerity measures and growth.

The Economist argued that austerity measures are ill-advised because it would lead to a decline in GDP as a result of a decline in consumer spending. Hence, to avoid such a decline, governments should continue to pump liquidity into the economy with the assumption that such liquidity would somehow generate growth. The instruments of choice to finance continued government deficit spending are bond issue borrowings and quantitative easing by central banks combined with negative interest rate policy guidelines. The question of inflationary pressures is considered to be a manageable problem in view of the under-utilised capacity present in most economies. In view of the fact that in 2012 the US government borrowed around 30 cents of every dollar it spent, failure to raise the debt ceiling would force spending cuts equal to an estimated 6 percent of GDP. The Economist of January 12th, 2013, argued that failure to raise the American debt ceiling would send the American economy into recession, depriving millions of people of meeting their own obligations, setting off a chain of defaults and turmoil in the global financial system.

The solution offered by The Economist of 2nd February, 2013, to stimulate the British economy (and supposedly also other inert economies) is to persuade the head of the Bank of England, Mark Carney, to lift the nominal inflation target to a level that is at least 10 percent higher than today’s 2 percent. It should be done by increased “quantitative easing” (printing money to buy bonds) and to push interest rates further down. They should guide people’s expectations of the future path of inflation by credible promises to keep interest rates low and so boost the economy.

There are serious deficiencies in the solution proposed by The Economist. Its national accounts optic only focuses on GDP, the “turnover” part of the national economy. GDP figures are simply “snapshot” aggregates of monetary transactions, they do not provide qualitative information about the causal relationships and interaction of microeconomic determinants. It ignores important qualitative components of national accounts such as the assets and liabilities on the balance sheet, non-monetary activities, non-market transactions, quality improvements and other creative, value-adding, wealth- generating activities. Ironically, GDP figures do include welfare transfer payments which are not of a value-adding, wealth-expansion nature. Such transfers may actually divert available funding from wealth-generating activities. Distinctions must be made between transfers of wealth and wealth creation, between the quantity and quality of the growth measured, between costs and returns within the context of the timeframe analysed (long, medium or short terms).

The accuracy of GDP calculations – whether nominal or real – is at best highly questionable and often highly politicised. The GDP is not the only important barometer of a country’s economic health. GDP numbers can be dangerously misleading when they do not reflect the real strengths and weaknesses of an economy. It is essential to look at the balance sheets of national economies, of individuals and businesses – but particularly at the position of middle-class households – the backbone of free enterprise economies. It is the size and well-being of the middle class that determine the balance between consumption, saving and investment, the real tax base of government spending and the mainspring of the productive output of society.

Monetising Government Debt

It is important to quote The Economist’s challenged proposal verbatim: “ By promising to keep monetary conditions loose until nominal GDP has risen by 10%, the Bank would provide certainty that interest rates will stay low even as the economy recovers. That will encourage investment and spending. At the same time an explicit target of 10% would set a limit to looseness, preventing people’s expectations for inflation becoming permanently unhinged. It is an approach similar in spirit to the Federal Reserve’s recent commitment not to raise interest rates until America’s unemployment rate falls below 6.5%.” (See The Economist, February 2nd, 2013, p.11)

This proposal raises more questions than it answers. Economists brought up to believe that inflation is a bad thing, choke at the idea of welcoming more of it as a policy objective. It is a slippery slope from QE to monetising government debt and then to sanctioned inflation. As soon as inflation expectations soar, the central bank loses control of price levels. Soaring inflation also discourages saving and investment which really are crucial propellants of growth. There is always a risk that inflation could get out of control. Runaway inflation is usually the result of fiscal excess, financed by printing money, or rigid labour markets which produce a wage-price spiral that is difficult to stop. Is it possible to anchor inflation expectations by setting an explicit inflation target as high as 12 percent? Normally interest rates on bank deposits need to be raised in line with inflation to encourage households to keep their money in the bank rather than speculate in property or shares. Otherwise negative real interest rates will inflate asset bubbles. How accurately can the nominal GDP be measured in the light of declines in productivity? If all the growth comes through inflation, is this a case of chasing “fools gold”? The most serious problem with artificial, manipulated “solutions” to major structural problems, is the possibility of unintended consequences.

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Dangers of Sanctioned Inflation

Can the churn of inflationary pressures be roped in to unleash growth in a sclerotic economy? Is a little inflation a good thing for the economy – spurring growth momentum by enhancing confidence, rising expectations, promoting consumer spending and encouraging investment? Would inflationary pressures replace hoarding instincts with expectations of a better future: bidding up prices and boosting production? Or is stripping inflation indicators from our national accounts akin to chasing “fool’s gold”? Can runaway inflation be avoided or tamed?

It is important to give careful consideration to the undesirable effects of inflation. Most importantly, it creates uncertainty that undermines business confidence and depresses investment in economic expansion. It alters the rewards accruing to the different types of economic activity (eg. consumers, producers, workers, savers, investors, entrepreneurs) leading to weaker output and lower real income levels. By eroding the purchasing power of money, it reduces the value of savings, fixed wages and salaries, fixed pensions and interest on fixed deposits. It induces redistribution from lenders to borrowers if nominal interest rates do not fully compensate for inflation. Volatility in inflation expectations creates uncertainty regarding economic prospects and hence militates against investment in productive assets. It enhances speculative activities which crowd out production.

101 expectations about inflationary trends. A low and stable rate of inflation creates a stable financial environment which must be considered crucial for sustainable growth and equitable distribution of resources.

The best example of how runaway inflation can turn into hyperinflation is the experience of Germany during the 1920s under the Weimar Republic. After the First World War, the victorious Allied powers used the Versailles Treaty to impose enormous war reparations debt on Germany. This created unsustainable current account deficits that were financed by the printing of more and more paper money. This process was accompanied by excessive public spending on generous public union wage settlements and insufficient tax collection. Although the downward slide of the mark boosted German exports, the inflationary pressures continued unabated until 20-billion mark notes were in everyday use. Eventually money – including all forms of wealth and income fixed in terms of marks – was rendered worthless. The collapse of the currency led to the collapse of the economy: soaring unemployment, poverty, moribund banking, social and psychological distress and, ultimately, political disorder and the beginning of the Great Depression era. Other countries where rampant inflationary pressures ultimately led to disaster during the past century include, inter alia, Argentina, Chile and more recently, Zimbabwe. Nassim Taleb of Black Swan fame, claims that our inability to predict outliers, implies our inability to predict the course of history.

The Potential for Currency Wars

The danger of currency wars emerges when all the struggling economies follow the same unconventional measures: suppressing interest rates while buying heaps of government bonds with newly created money (QE) inevitably results in putting pressures on currency values which, in turn, boosts exports and discourages imports. With all struggling economies explicitly following the same “inflation-driven” recipe coupled with exchange-rate adjustments, the relative international trade and investment pattern would remain unchanged with a “merry-go-round race to the bottom” in full swing.

In the world of monetary and fiscal policy the dividing line between rhetoric and active intervention is a faint distinction. It can easily unleash a currency war to attain or protect export markets. Aggressive

102 monetary expansion by the USA, China, Japan and the EU, could all be justified as efforts to stimulate domestic spending and investment. But because lower interest rates usually weaken currency levels it also depresses imports. Countries with strong currencies like Australia, Switzerland, Japan and euro zone Germany, would all benefit from increased exports on the back of lower currencies. Hence, these countries would be tempted to look at capital controls (even concealed import control) to avoid currency speculation – or join the club which is inflating away their debt burdens. If all countries join the club, the underlying structural deficiencies would not be faced and resolved.

The Need to Scrutinise Monetary Pumping

The Economist, is an important source of current economic news around the world, but all readers should be fully aware of its editorial bias. It is not a source of expert knowledge about the fundamentals of economic growth. The “ghost writers” of The Economist may be experts on the political economy of finance and banking. But when it comes to generating economic growth they seem to rely on monetary pumping solutions. Economic growth problems are certainly not always and everywhere simply monetary phenomena. There are multiple causes and consequences that do not appear on the monetary radar or cannot be dealt with on the strength of the arsenal of monetary measures. Unconventional monetary policies must be scrutinised with a watchful eye.

Maintaining Prudent Monetary and Fiscal Policies

Prudent monetary policy aims at keeping prices stable just as fiscal policy should aim at reducing government debt to the lowest levels possible. There is nothing admirable about mountainous government debt levels. Supplying millions of dollars of reserves to banks and reducing interest rates to zero cannot force banks to lend or households and companies to borrow. For governments to spend borrowed money in order to spur consumer spending is not an alternative to growth through investment in productive assets. The only beneficiaries of loose monetary and fiscal policies are the bondholders and the manufacturers and exporters of low-priced consumer goods.

Scrutinising Deficit Budgeting

There is much controversy surrounding the relationship between deficit budgeting and growth. When an economy is at full employment deficit spending unleashes inflationary pressures. When an economy is in a contraction phase with high unemployment levels, the Keynesian approach supports the use of budget deficits to stimulate the economy by injecting demand. This in turn boosts output via the multiplier, resulting in increased capacity utilisation and higher employment. But the impact of deficit budgeting on the economy depends on the size of the deficit, how it is financed and how wisely the government of the day invested the extra spending. Different methods of financing the deficit have different outcomes: domestic borrowing can increase interest rates and “crowd out” private investments; money creation can lead to inflationary pressures; foreign borrowing is exposed to exchange rate fluctuations and interest rate hikes. If government spending is not efficient and does not add to growth, deficits should be avoided. Deficits and growth are negatively correlated because the negative “crowding out” effects of deficits tend to be stronger than the positive “crowding in” and increased aggregate demand effects. Consequently, deficits have generally been associated with low economic growth – either due to ineffective government spending or to ill-advised deficit financing.

The biggest danger in chronic deficit budgeting is that a government could find itself caught in a debt trap. This is a situation where a rise in the debt-to-GDP ratio can no longer be prevented by fiscal

103 measures, eg. when the conventional deficit (total government expenditure minus total government revenue for any given year), as a percentage of total debt, is greater than the economic growth rate. High levels of accumulated public debt lead to high annual interest payments. If the debt is increasing faster than the rate of economic growth, the government will have to keep borrowing to service the old existing debt. Under such circumstances, a government’s ability to redeem old debt becomes highly problematic. When the government’s creditors (bond market) no longer believe that a government will be able to finance interest payments through higher taxation, let alone to redeem the debt, it will not be able to borrow. Government would be insolvent and the only way it can service or redeem its debts would be through money creation. When the growth of money supply gets out of hand, it results in hyper inflation.

Improving Productivity

The momentum of growth in a country is reflected in improvements in productivity. If the standard of living in a country is measured as the average consumption per capita, it implies that increasing the average production per capita holds the key to achieving higher living standards, generating higher economic growth, creating employment opportunities, ensuring competitiveness and curbing inflation.

Productivity is measured by the ratio between goods and services produced in the national economy, in an industry, or any individual organisation on the one hand, and the resources used to produce them on the other. It indicates the productive efficiency with which labour, capital, materials, technology and other inputs are combined and used to produce goods and services.

What drives productivity? What can be done to increase productivity? Historical experience shows that the answer to these questions lies in the intricate linkages between all the factors exerting an influence on the level of productivity in a society: technological progress, education, practical training, culture, demography, policies, institutions, political stability, non-disruptive labour relations, climate and the level of creative human dynamism as manifested in the constructive activities of people as economic role players as workers, savers, investors, managers, innovators and entrepreneurs.

The concept of efficiency is central to a proper understanding of productivity. Efficiency describes a situation where goods and services are produced at minimum cost or the least possible wastage of resources required for competitive productive output. Outputs must be maximised with given inputs and the input mix must reflect opportunity costs (i.e. the cost of foregoing alternative uses). Like inefficient, uncompetitive, unproductive companies, unproductive societies usually end up as losers. The ultimate dynamism that drives development is the inventiveness and creativity of people to improve their productivity.

Entrepreneurship and Economic Growth

Surprisingly, the causal relationship between entrepreneurship and economic growth has been relegated to the periphery of the theoretical concerns of economics as an intellectual discipline. Not surprisingly, even the question of economic growth does not occupy the centre stage of the theoretical

104 models of mainstream economics. Hence the time is overdue for putting the interaction between entrepreneurship and economic growth back on the agenda of scholars, policy makers, government and corporate executives, public news commentators and enlightened citizens.

The role of entrepreneurship comes into play as the prime mover of the factors of production: labour, resources or materials, technology and capital goods. These elements of productive capacity must be put together and organised into producing units, with their productive efforts directed as successfully functioning operations. The business persons who are performing these functions are commonly called entrepreneurs. They perform the initiating, innovating and directing business roles to get things done in practically effective ways. The entrepreneur performs the key role in the rough and tumble process of establishing, running and expanding a business enterprise. Hence entrepreneurship is the primary source for providing the dynamism of economic progress.

In most countries small businesses are the main drivers of job creation. They are by far the most mobile, flexible and versatile form of enterprise. They are the least bureaucratic and most creative. They are adaptable by being quick to adopt new ways when conditions change. They use competition, customer choice and other non-bureaucratic mechanisms to get things done as creatively and effectively as possible. Everything possible should be done to promote the SME sector - access to financing, a flexible employment regime and a removal of burdensome regulatory obstacles to starting or expanding SME activities. The SME sector is the natural home of the entrepreneurial spirit of free enterprise. No entrepreneur can be sure that his or her planned investment will succeed, but if they do not take risks the other production factors (labour, resources, capital and technology) will remain idle. Optimistic people tend to gravitate to entrepreneurship. Although a large percentage of new small businesses fail in the first five years, it is the successful entrepreneur who knows how to calculate and manage risks.

Concluding Remarks

The processes driving economic growth and development are by no means fully understood - let alone effectively harnessed. That is why poverty remains such an obdurate problem in many parts of the world. Even in advanced economies many unresolved questions remain: some are related to the systemic monetary intricacies of the world of finance; others are deeply imbedded in the socialist mindset of the political culture of the welfare state financed by deficit budgeting. What will bond markets do when central banks start unloading the large holdings acquired over time? What can the banks’ creditors do to protect their investments/deposits from near-zero interest rates and floating exchange rates? What are the side effects of an extended period of negative interest rates? These are vexing monetary issues, but there are even more momentous fiscal questions to confront. Can the wealth redistributive sentiments and practices (liabilities) of the modern “transfer” state be tamed or counter-balanced by the more “productive” wealth creation elements (assets) of society? What is the inevitable outcome of chronic deficit spending? What is the optimal pace of deficit reduction? How can the seeds of economic growth be generated? Job-creating economic growth can certainly not be ignited by welfare-on-credit policies.

It is essential to realise that government per se cannot turn around the lack of economic growth – it can only alleviate or cushion the unfavourable effects of a severe downturn in the short term. Growth depends on the interaction of human creativity, technological breakthroughs and business activity – producing goods and services for which there is a realistic market, either nationally or internationally.

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Profitable business activity is the mainspring of all taxable income without which all the desirable public goods remain out of reach.

Bibliography

Bell, D. & Kristol, I (1981) The Crisis in Economic Theory, Bane Books, New York Drucker, P. (1985) Innovation and Entrepreneurship, Heinemann, London Vosloo, W.B. (ed) (1994) Entrepreneurship and Economic Growth, HSRC Publishers, Pretoria

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9. The Essentials of Sound Growth-Enhancing Public Finances (September 2013)

A quick glance at a modern social democracy’s national accounts shows a gradual increase in the public sector’s share of the national product. As the governmental sector absorbs a growing segment of the national income, it exercises a growing influence on its economic life. It collects a growing proportion of national income as taxes which it redistributes as social contributions in various forms.

Keeping a Lid on the Public Sector

The experience of all countries shows that the powerful trend of increasing the public sector’s share of the national expenditure has given an added strength to inflationary pressures. In most instances, inflation target ceilings have to be set to discipline government spending. The public sector share grows faster than the gross national product. Public sector spending grows faster than private sector spending which, after all, is the original source of all taxable income. The reason is that public spending under electoral pressures can be adapted upwards more easily than downwards. There are more tax beneficiaries than income tax payers.

Direct taxes determine how large a part of the incomes of private persons and businesses is available for consumption and investment. Direct transfer payments, i.e. pensions and social contributions of all kinds amount to very large sums – up to 50 percent of the annual budget. Indirect transfers, eg. interest payments on loans drive expenditure even higher. In addition, the public sector’s activities, through its income and expenditure patterns, also have an influence on liquidity and the supply of money. The amount of government borrowing and its cash holdings influence the amount of money and liquid assets available to banks and different spheres of the economy. Central bank action plays a central role in the determination of interest rate levels and the volume of money in circulation. The economic effects of fiscal policy revolve around the levels of total public sector revenue and expenditure as shown in current and capital budgets. Of importance is the difference between actual and planned totals of income and expenditure, i.e. on budget surpluses and deficits.

Surpluses and Deficits

When is a surplus desirable? At what level is a deficit excessive? The targets of budgetary policy should be set up in the light of a systematic consideration of the state of the economy as a whole. Various aspects of a government’s income and expenditure levels have important effects on the national economy: on the demand and supply of goods and services, on income formation (and thus on demand), on liquidity and interest rates (and thus indirectly on both income and demand levels). Budget policy inevitably has either restrictive or expansive effects on an economy through its impact on savings and investment activities. Fiscal policy influences demand levels, incomes and price levels. Sums paid out as subsidies lead to real expenditure. But the income-creating effect of social transfer payments has an income-destroying effect if it is financed by rising taxes. Taxes and expenditure have redistributive effects by reducing disposable incomes for some and increasing them for others. An increase in company tax may cause business investments to be curtailed. The effects of curtailing social transfer payments may depend on the marginal propensities to save and to consume by the social groups affected by these changes.

Increases in various types of expenditure or decreases in various tax levels may have varying marginal effects on the general economic situation. But the formulation of economic policy is not merely

107 concerned with aggregate effects on income, demand and prices. It is also concerned with policy desires for specific results such as inculcating a desire to “live within your means” as a principle of sound public finances.

The choice of appropriate policy measures ultimately depend on what is considered to be a desirable macro-economic outcome such as the net contribution to the creation of real national income and the avoidance or elimination of factors that stand in the way of such an outcome. In macro-economic terms such an outcome could be measured as improved total factor productivity or any acceptable gauge of increased general economic efficiency that does not involve increased balance sheet debt liabilities for the economy as a whole but adds to the optimal use of productive resources.

The “Fools Gold” of GDP Growth on Credit

High levels of public debt, particularly if the loans have been raised abroad, require high levels of annual interest payments which crowd out other spending priorities. Repayment of such loans requires sending money out of the country. Loans raised locally benefit the local bondholders and redistribute income.

By adding to the national income simply by way of government handouts financed by loans is like chasing “fool’s gold”. Loans are reflected in the balance sheet and have to be serviced and repaid. A large loan account requires to be serviced by annual interest payments as well as staggered repayments of the capital amount. These payments “crowd out” other desired expenditures such as on education, disability care and infrastructure. Chronic deficit budgeting and a rising debt pile could land a country in a debt trap where the debt increases faster than the rate of economic growth and a government has to keep borrowing to service the old existing debt. When a government’s creditors no longer accept a government’s ability to finance interest payments on existing debt through higher taxes, let alone to redeem existing debt, it will not be able to borrow and would be tightly caught in a debt trap.

Because government spending is treated in the national accounts as final outputs, it adds to the money in circulation and hence to an increase in the GDP. But this can be a deceptive benefit because deficit financing creates a debt entry on the country’s balance sheet and may constitute a “deadweight debt” if it does not create any specific asset from which the cost of servicing the debt can be met. It is impossible for a government to finance its debt service without cutting other expenses or raising taxes which distort the incentives or real wealth of taxpayers by more than the amount the government receives. To cover running expenses with loans is not an advisable long-term financing strategy. The government should always generate a useful and positive result with the resources it extracts from the national economy. Policies promising a better future need to be costed and subjected to feasibility and cost-benefit analysis.

Capital and Current Expenditure Budgets

Traditionally governments used capital budget accounts to finance their long-term assets and current budget accounts to finance their operating expenses. The former, capital budget accounts, were usually financed with borrowings whereas current budget accounts were financed essentially out of taxation paid by individuals and companies.

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In recent years these budgetary categories were collapsed so that governments no longer use separate capital budgets. It means that on the expenditure side the distinction between expenses of a capital nature on assets that have a continuing value and expenses of a current nature (such as welfare entitlements) can both be funded out of borrowings. That means government debt no longer has a clear-cut relationship to investment in capital assets.

It is now argued by a new generation of economists that all money is “fungible”. However, as a principle of sound financing it is essential to understand the implications of financing your expenditure with borrowed funds! Borrowed funds must be serviced and repaid.

Cash Accounting versus Accrual Accounting

Traditionally governments used “cash accounting” rather than the “accrual accounting” used by business enterprises. “Cash accounting” means that expenses are only added in when money is actually paid or received. As a result governments could actually rack up large future obligations far beyond their ability to repay, while their budgets appear to be well balanced. “Accrual accounting” means that any future obligation incurred (a debt or a pension obligation) is counted as an expense. The “cash accounting” approach to public sector accounting led to inadequate funding provisions to cover future funding obligations.

Towards Economic Efficiency

Taxes always impose economic costs because it distorts people’s consumption and investment choices. It may also curtail productive people’s incentives to work. Inflation-indexed government expenditures also exacerbate the “inflation ratchet” effect on the proportion of income paid into taxes. The end result is a gradual decline in the after-tax income levels of taxpayers unless they are given inflation- offsetting income rises. But the “inflation ratchet” pushes income earners into ever higher income tax brackets. Increases in tax rates discourage workers and businessmen from producing and investing. You hit the “fast ox” to your own detriment! High marginal tax levels impact upon productive efforts as well as saving and consumption levels.

Progress towards a higher level of economic efficiency would have to include high levels of employment and work participation. It also requires a well functioning competitive price system which creates favourable conditions for the efficient use of productive resources while giving a tolerably accurate expression of the valuations of consumers. Where there are inefficiencies in the price system, eg. in excessive inflationary or deflationary conditions, a market-based price system loses its rationality with the result that the price elasticities of demand and supply decline. Changes in exchange rates as a result of foreign trade fluctuations may also exercise a distorting influence on the operation of the price mechanism. Interferences with the price system – whether public or private – have a considerable influence upon income distribution, price levels, productivity and consumer choice. When governments use price instruments to obtain income redistribution or social policy objectives, they are “intentional distortions” of price relations. This applies to all price fixing for agricultural products, housing facilities, wages, etc. It exerts an influence on the distribution of income, the direction of consumption and thus to a sub-optimal allocation of the society’s productive resources.

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Productivity Growth

Productivity growth is the most reliable gauge of progress towards a higher level of economic efficiency for society as a whole. It implies increasing the average level of production per capita, generating higher economic growth, expanding employment opportunities, raising competitiveness and curbing inflation. Productivity is measured by the ratio between goods and services produced and the resources used to produce them. It indicates the productive efficiency with which labour, capital, materials, technology and other inputs are combined and used to produce goods and services. The level of productivity is driven by technological progress, practical training, a work culture, non- disruptive labour relations and the level of human dynamism manifested by entrepreneurs, workers, investors, innovators and governments. Efficiency describes a situation where goods and services are produced with the least possible wastage. Outputs must be maximised with given inputs. Unproductive businesses and societies usually end up as losers.

Avoiding Market Distortions

It should be clear that the impact of market distortions, whether by private interests or by government intervention, should be carefully scrutinised. The monetary policy of a government and central bank interventions have serious impacts on money and capital markets. Excessively low interest rates may lead to an imbalance between savings and the investments required for growth.

Ultimately the smooth functioning of a market-based price system is a matter of degree. The more rigid a credit market is or the more monopolistic a product market, the worse the market system functions from the point of view of the most productive allocation of resources to different economic activities. Whenever government-directed determinations of prices (eg. of wages, retail margins, credit) are made, it takes on the same character as the physical regulation of products and prices. Considerations of profitability are thrust aside in favour of the priorities determined by the regulating authorities while simultaneously price relations are distorted. The central regulation of credit would distort the price system to such an extent that profit calculations become misleading and discouraging to new initiatives. Once price controls are established, additional regulations become necessary to control power concentrations or monopolistic tendencies in production and labour relations.

Whenever control measures are considered necessary in money, credit or commodity markets, the methods or instruments used should be as general as possible. Economic controls and specific interventions should be used for purposes of stabilising general economic development only as a last resort in crisis situations. Too much detailed intervention allows too much room for the exercise of arbitrary decisions and the risk of abuse of power. The operation of the price system which is the driving force of competition, promotes the rational use of productive resources and the sub-division of economic decisions on a decentralised scale. A highly decentralised market economy does not allow for much room for the exercise of private and public monopolistic power and arbitrary decisions in economic life. Competition offers alternatives to consumers and reduces the risk of the abuse of power. The balance between savings and investments, as well as between expansion and contraction in the markets for goods and services, have far-reaching implications for the maintenance of a high level of macro-economic efficiency and a desired rate of economic progress.

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A Sound Growth Strategy

The essence of a growth strategy is revitalising, activating and improving the productive efficiency of the productive resources of society.

The current distress of the advanced economies was caused by the financial world’s excesses which were compounded by policy mistakes. The failure of financial markets was coupled with excessive profligate government deficit spending. Over many decades the governments of the advanced economies have saddled their political economies with unaffordable privileges, bloated bureaucracies, rigid labour relations and unaffordable welfarist benefits. Then dodgy financial innovation outpaced the skill levels of governmental rule making.

A growing economy is a sine qua non for the improvement of the quality of the lives of its citizens: it is a requisite for providing the basic goods people strive for to improve their lives – education, health services, housing, security as well as a stable and fair political system. The momentum of growth in a country is reflected in improvements in productivity. Productivity is driven by efficiency: the maximisation of outputs with the available inputs of capital, labour, technology and management. The ultimate dynamism that drives development is the inventiveness and creativity of people to improve their productivity.

Small businesses are the main drivers of job-creating growth because they are the most mobile, flexible and versatile form of enterprise. The SME sector is the natural home of the entrepreneurial spirit of free enterprise.

Public purse dependency leaves little scope for the productive creativity that generates taxable income. What is needed is not more government and more laws, but less government and less legal and regulatory restraints. The way forward is not more regulation but better regulation – not more government, but better government.

Economic Imbalances and Harmful Interventions

It would seem that the one area of economic life where “collective” control in some measure appears to be inevitable, is the total supply of money and central bank credit. It is the most delicate, most difficult and most central task of control. There are no absolute certainties about the “correct” monetary policies (eg. about the correct volume of money in circulation, about interest rate levels, about the volume of savings and investments). There are no certainties about the “correct” economic balance.

In the final analysis, the most important justification for a decentralised market economy is to be found in the realm of politics. Regulations and interventionist economic policies involve a concentration of power that tends to grow of itself. As Lord Acton remarked: “power corrupts and absolute power corrupts absolutely”. Adam Smith observed that power and authority should not be entrusted to a council or senate or whatever and nowhere “... in the hands of a man who has folly and presumption enough to fancy himself fit to exercise it”. A good system requires such arrangements that bad politicians, bad bureaucrats, bad economists and bad business leaders have the least possible chance of doing harm.

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10. Maintaining Public Sector Responsibility and Accountability (May 2013)

As early as 1787 James Madison, one of the American “Founding Fathers” of the world’s first written democratic constitution stated that public sector responsibility and accountability could not be taken for granted. He argued that internal and external controls are necessary. In Federalist Paper No. 51 he wrote: “If men were angels, no government would be necessary. If angels were to govern men neither external and internal controls on government would be necessary ... A dependence on the people is, no doubt, the primary control on the government, but experience has taught mankind the necessity of auxiliary precautions”. Since the era of the American “Founding Fathers”, the need for additional precautions has increased a fortiori in the wake of the vast expansion of government functions during the past two centuries.

How can responsibility and accountability, particularly in the field of public finance, be enhanced? This question has generated much debate, controversy and varied solutions. Some solutions refer to external control measures; others rely on the civic culture as reflected in the systematic way of doing things or on the internal values of institutions and individuals. Once a large bureaucratic system is set in motion, it develops a momentum of its own like the heavy flywheel of a large machine.

The Growth in Government Functions and Spending

In 1883, Adolph Wagner, an influential German scholar, upon surveying the expenditure records of several countries in Western Europe, formulated a theory that was subsequently known as “Wagner’s Law of Ever-Increasing State (Government) Activity”. He attributed this “law” (inevitability) to a variety of factors: increasing regulatory services required to control a more specialised and complex society, increasing involvement of government in economic enterprise through the devise of the public corporation, as well as increasing needs for economic and social services in the postal, transport, education, public health and welfare fields. Thus Wagner’s Law portrayed growth in government activity as an inevitable accompaniment of a developing society and predicted that its role will inexorably keep growing in the future.

Wagner’s Law seems to fit well with the experience in many countries. Public spending as a share of gross domestic product (GDP) grew in a sample of around 20 industrial countries from around 10 percent in 1870 to over 40 percent of GDP in 2010. Vito Tanzi, in his survey Government versus Markets – The Changing Economic Role of the State, reports that a large part of this growth came in the decades after World War II and again during the first decade of the 21st century. Quoting George Bernard Shaw, Tanzi argues that the public spending role created its own strong constituencies: “A government that takes from Peter to give to Paul”. But what happens when the “Pauls” of society start outnumbering the “Peters” of society – the tax consumers outweigh the taxpayers?

Tanzi identified two fundamental assumptions that accompanied the growing intervention of the state. First, that citizens are myopic, they do not (individually or collectively) take precautions against economic risks such as saving for old age, insuring against sickness, unemployment or other eventualities. Second, that even if they tried to act through religious or charitable private associations, they would not have been capable of making adequate provision to satisfy needs at the desirable level. These two assumptions provided the underlying justifications for paternalistic, collectivist provisions by the state. The state thus became a huge insurance company despite the fact that, for specific citizens, there was no connection between taxes paid and benefits received. Some individuals were

112 bound to gain or lose more than others – and many became “free riders” or “zero-cost” beneficiaries. Some even learned to game and manipulate the system to their advantage. Moreover, by creating a “cancer of perverse incentives” welfare handouts often lead to a “poverty trap” of welfare dependency in which the advantage of starting to work are too small to get out of bed for. At the same time politicians learned to get votes by providing government jobs and public purse benefits to their supporters. Public employment and public spending increased while spending in productive assets was reduced. In the case of all social democracies government spending outpaced population growth, inflation and affordability.

If we compare government spending to the Gross Domestic Product (GDP), which measures the sum of all goods and services produced in the nation’s economy, we find that government spending has grown faster than the economic output of society as a whole. More and more countries are now facing vexing questions about the spending burden of the constantly expanding scope of government activity. How far can a nation’s wealth and income be absorbed by government before its productive capacity starts to collapse?

Allocative and Productive Inefficiency

Allocative inefficiency manifests itself as public activities that do not meet the very objectives in terms of which the programme intervention has been initiated and justified. The most obvious examples are ostentatious prestige projects and activities that serve no apparent economic or social purpose. They are “white elephants” such as misplaced highways, wasteful civil engineering projects, extravagant broadband networks, prestigious international events, ostentatious airports, office facilities, parades and displays, etc. Improvements in allocative efficiency require that expenditures be subjected to strict cost-benefit analysis. In principle every expenditure should yield a benefit at least equal to the value of goods and services foregone in the private sector or should not prevent a more valuable public expenditure in some other field. Thus the benefits of marginal expenditures should exceed opportunity costs both in the public and private sectors.

The root causes of productive inefficiency overlap with those that give in to allocative inefficiency. These include ever increasing indexed budget provisions tied to salary and wage setting mechanisms that neither reward efficiency nor penalise inefficiency. These budgetary practices create a fiscal illusion that leads the uninformed public and media commentators to inadvertently accept both increases in the number of public programmes and the rising costs of running them. Indexation not only institutionalises inflation, it also leads to ineffective monitoring and control of public spending, poor management practices and inflexible public sector labour markets. After all, the income side of public finance is not “indexed” to rise. When the economy turns down, the government’s income levels also decline as the taxable incomes of business enterprises decline.

In recent years the price of public sector output has risen faster than the price of private sector output. Wage costs have risen faster and are not tied to effective detailed productivity measurement as a result of the lack of a competitive bottom-line discipline. There is an in-built tendency for public expenditure to grow as a percentage of national income, without any commensurate increase in productivity. Because the wage bill of government employees represents a large share of government expenditure, the government’s wage and employment policy has an important bearing on productive efficiency. The private sector employs labour solely for the purpose of reaping the value of its productive services. The demand for labour services will depend on the cost of labour relative to the value of the output it produces and the cost of other inputs into the productive process. By contrast,

113 public sector employment is not influenced by cost minimisation and therefore has a dynamic of its own. In many countries the wage bill of governments constitutes the largest single item of their current expenditure with one in four people employed in the formal sector of the economy employed in the public sector – or indirectly paid out of the public purse. If the array of “shadow beneficiaries” in the form of part-time and full-time contractors and sub-contractors acting as consultants and professional advisers are included, the ratio could be higher. In many countries the “parasite economy” is larger than is commonly realised.

In some countries the realisation that resources have been wasted on excess public employment has prompted various measures to restrain public sector employment: eliminating ghost workers, firing temporary workers, hiring freezes, partially replacing departing employees, early retirement, dismissal coupled with generous severance pay, and, last but not least, privatisation. However, past experience with policies to reduce public sector employment points to the conclusion that it is easier to avoid hiring new employees than to reduce existing employees: an ounce of prevention is worth a pound of cure.

Influence of the Tax System

Taxation is by far the most important source of income for the modern state: direct and indirect taxes imposed on individuals and business enterprises. There are many controversial issues involved in the design of a tax system in relation to its fairness, its administrative efficiency and the distribution of the tax burden. The most important issue, however, is that it must be designed to minimise any negative impact on the performance of the main drivers of the economy – the business enterprises and their workers. They are, after all, the primary sources of taxable income which finances the delivery of all public goods.

There is a close relationship between the tax system and the growth of an economy’s capacity to produce. Higher taxes create a disincentive to supply effort and discourages savings. More effort means more output; more savings lead to more investment and more productive capacity. If higher government spending results in larger fiscal deficits, the government is forced to cover its deficits by borrowing from the private sector, by money creation or by foreign borrowing. Money creation leads to inflation and rising public debt raises the question of sustainability and “crowding out” of private investment. Hence, fiscal policies that are unsustainable in macroeconomic terms, result in the destruction of an economy’s productive capacity and ultimately, national insolvency.

A former French finance minister, Colbert, once said the problem of taxation resembles the problem of plucking a goose ... getting the largest amount of feathers with the fewest squawks. Perhaps, like Francois Hollande, he misunderstood the real underlying problem of public finance: the sustainability of tax levels depend upon the geese that lay the golden eggs.

Unpicking the Befuddled Budgetary Process

Budgets are said to represent government policies with price tags attached. But in today’s world the budgetary practices of central governments are so perplexing that even informed citizens find it difficult to understand the intricacies and dimensions of government spending. National emergencies such as wars and economic downturns usually bring about significant increases in government activity and spending. However, when an emergency ends, government activity and spending do not decline to their old levels but stay on a higher plateau. This phenomenon implies that national emergencies tend

114 to condition citizens to tolerate major increases in government activity and spending – including unwarranted expenditure.

Another explanation for the ever rising plateau lies in the incremental nature of the budgetary process. It is incremental because decision makers usually consider last year’s expenditures as a base. Increases or new items are considered in relation to the last year’s platform. Existing items tend to become non-discretionary as fixed commitments (often enshrined in law and indexed) with discretionary items limited to a narrow range of increases in spending. Departments are usually not pressured to defend existing or current appropriations, only increases or new items require explanation. The only effective way to counter the status quo is to introduce “zero based” budgeting. This approach eliminates unnecessary spending protected by incrementalism and forces agencies to justify every dollar requested, not just requested increases.

A further problem with current trends in budgetary procedures is its fragmented nature. The result is that it has become almost impossible for the legislature (Parliament or Congress) to view the total impact of a budget. For ordinary citizens it is a baffling conglomerate of officialese and obfuscation. In Australia the budget decision processes usually occur between September each year and the following May. Spending and reporting activities are ongoing throughout the budgetary cycle which could extend over several years. How a government entity spends money depends on what type of entity it is, how it obtains money in the first place and for what purpose, and how much money it will be spending in a specific financial year. In order to monitor the use of public money in Australia, it is necessary to analyse Budget papers and agency Portfolio Budget Statements (PBS). The actual use of Commonwealth resources is reported through monthly financial statements during the Budget financial year and at the end of the financial year through Consolidated Financial Statements (CFS), the Final Budget Outcome, and agency annual reports. To properly understand this process requires a sound training in Public Finance and possibly also in Forensic Accounting.

The budget lies at the heart of public policy. Hence, the process of public budgeting takes place in a highly politicised environment: it involves the spending of public money, making choices among alternative expenditures and determining what programmes and policies are to be increased, decreased, lapsed, initiated or renewed. Governments usually stand or fall by virtue of their economic and financial management. But more often than not, governments dig their own graves when they are not frank and transparent with their economic management and financial accountability.

During the period 2011, 2012 and 2013, the Australian voters experienced an avalanche of news reports of corruption scandals in the ALP-led State Government of New South Wales. It led to a crashing defeat of the Australian Labour Party in the state elections. On the federal level a related, though different, problem unfolded in 2013. After promising a budget surplus as a sign of sound economic management, the ALP government suddenly revealed a sharply widening deficit while at the same time promising large unaffordable spending programmes in education and disability care. In view of its unpromising standing in the opinion polls, these spending programmes created the impression of “locking in” unaffordable commitments to saddle any alternative future government with “poisoned fiscal wells”.

Underlying this phenomenon of fiscal manoeuvring, is the emergence of the “multi-year budget cycle”, which is an off-shoot of “programme budgeting”. It lead to the implausibility of income and spending projections, not only in relation to a fungible “multi-year budget cycle”, but also to a contrived revival in the “business cycle”. The problem is that both “cycles” are imagined and based on unreliable

115 actuarial GIGO modelling on the computers of Treasury or other hired hands. In the world of esoteric modelling, tax hikes and levies are renamed “structural savings” and the calculation of the “multiplier- effects” of government spending is reduced to a guessing game. The impact of tax and spending measures are presented as certainties and “austerity” measures as “growth killers”. In this make- believe world the quantification of the “automatic stabiliser” has become a form of macroeconomic wizardry and rising public debt is laughed off as an old-fashioned concern that could be countered with money creation. It is easy to massage the national accounts into showing a rise in GDP if you create the rise by way of deficit-financed handouts. GDP accounts do not reflect debt burdens. Without proper budgetary procedures coupled with transparent financial accounting practices in place, it is virtually impossible to maintain public responsibility and accountability.

Legislative Oversight

Legislatures have a vital role in directing government policies: they pass the laws, approve the budgets, determine the structures of agencies and sometimes prescribe operational detail. They monitor progress and achievements through committee hearings, special investigations, parliamentary questions and debates. Yet we know that legislative attempts at scrutiny and control are spasmodic and post hoc and only rarely does it assume the initiative in policy-making.

Legislatures have extreme difficulties in exercising an incisive review of appropriations. The use of committees as an investigatory instrument has inherent defects in that it is sporadic, transitory and remedial rather than preventive. Legislative control often seems to be of limited effectiveness in technical fields such as defence spending, and where transfer payments are concerned (e.g. for social security benefits and in support of vested interests) there is reasons to doubt the strength of the legislature’s desire to control public spending. The control of the Auditor-General, who is supposed to act as “watchdog” in the field of public spending, scrutiny is occurring only after the money has been spent. There is also reason to doubt the legislature’s desire to control public spending on public sector emoluments because political representatives and public officials are basically on the same payroll.

Executive Control

It has often been said that we live in an “executive-centred era” in which the effectiveness of government depends substantially upon executive leadership, both in policy formation and in policy execution. Legislation often delegates significant policy making authority to the executive branch, particularly in the areas of foreign policy and security matters. In modern industrial societies, the technicality and complexity of many policy matters and the need for continuing control, have led to the delegation of such discretionary authority, often formally recognized as rule-making power, to the executive branch. The executive branch, in turn, relies heavily on administrative agencies. Consequently these agencies are in effect, as advisors to executive office-bearers, making decisions that have far-reaching consequences.

In a democratic society executives do not operate in a vacuum. Their decisions are influenced by a variety of factors: their value commitments, their political party affiliation, their constituency interests, their perception of the public opinion and the applicable decision rules. The styles of decision making depends on the individuals concerned as well as the political system and political culture within which they operate. In most developing countries strong executive policy-making prevails, whereas in open political systems there are numerous autonomous organized group interests in action: labour unions, business organizations, professional associations, environmental groups, sports clubs and civil rights

116 groups. In this environment decision-making involves negotiation, give-and-take, compromise and persuasion. Nevertheless, policy-making and policy execution is in large measure at the mercy of executives and administrators. To rely heavily on executive control is to put the fox in charge of the hen house!

Judicial Control

Although legislatures occasionally insulate administrative agencies from judicial review, the courts usually are in a position to question most administrative decisions in terms of official powers as defined by the law. An injured party can appeal to the courts to seek redress and in this way the courts can exercise surveillance to prevent unfair treatment and the observance of procedural requirements. But there are many limitations to judicial control. The most important point to recognise is that responsibility is always after the fact: that is to say all the courts can do is to alleviate or punish wrongs that have occurred. This deficiency also applies to the office of the Ombudsman as an agent of control. Moreover, courts of law can hardly play any role of significance in the area of exacting responsibility in the area of public finance.

Citizen Participation

Generally speaking, citizen participation in policy-making, or in surveillance on public administration, is relatively thin. Many people do not want to vote, engage in party activity, join pressure groups, or even display much interest in politics. A great many citizens do not avail themselves of their opportunities to influence public affairs because of inertia or indifference.

That does not mean citizens in a democracy have no impact on public affairs. The mere fact that citizens have the right in democratic regimes to elect their representatives, as well as the existence of genuine periodic elections, puts a stamp of approval on citizen participation. Citizens have a right to be heard and officials have a duty to listen. Moreover, through their intellectual activities, citizens contribute new ideas and directions to the policy process.

In many parts of the world efforts have been made to include citizens, either in their individual capacity or as members of organized interest groups, to participate in the administrative process. The most common form that citizen participation assumes is the advisory committee or the citizen group acting in a governing capacity in a specific policy area or an area of activity. In most democracies there are a multitude of advisory committees on the various levels of government and within units of government. Administrators use these bodies to obtain information, advice, opinions from affected interests and they act as sounding boards for ideas, strategies and viewpoints.

The track records of these institutions are not entirely encouraging. They are often merely used as instruments to pacify dissatisfied groups by way of co-optation, or as a vehicle by which a bureaucracy builds a clientele, or as a method for transferring responsibility elsewhere. At the same time, such committees may be misused by outside interests in instances where the more powerful groups represented on them, may dominate committee deliberations. In such cases these committees provide a distorted view of public opinion and provide a focus through which strong and strategically placed interests may exert a disproportionate amount of influence.

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Media Surveillance and Exposure

The power to determine what the people will read, see and hear about is vested in today’s mass media. The press, television, radio and electronic media are the major sources of information and the instruments of public opinion formation for the vast majority of people. Particular problems or issues attract the attention of the media and, through their reportage, could either be converted into public agenda items or be given more salience.

The leaders of mass media often claim that they do no more than “mirror” reality. But news people decide what the news will be, how it will be presented and how it will be interpreted. They decide what issues will be given attention and what issues will be ignored. Issues which will receive the greatest attention in the media are also more likely to be viewed by voters as important. As important opinion shapers, the media help structure the political agenda. Normally television networks, electronic media and the national press interact with one another. The topics they select for coverage reflect, and often create, newsworthy events, trends or issues worthy of public attention. To capture the attention of readers, viewers or listeners, the media often require drama, action or confrontation. Shocking incidents, dramatic conflict, violence, corruption in government are favourite topics because of popular interest. More complex problems such as inflation, government spending, development strategies must either be simplified, dramatized or ignored.

The media’s exposure of scandals, abuse, mismanagement and corruption in government, or what is wrong in society, can play an important role in producing a reformist and constructive frame of mind. Hence their role in the surveillance of government activity cannot be underestimated. By conducting “investigative reporting” the media can produce a continuous flow of information of what goes wrong in the public sector and thereby can help instil a sense of responsibility in the ranks of public officials and elected office-bearers.

To perform these “watchdog” functions, the media has to be unfettered by the powers that be. It also requires them to be staffed by competent reporters who are able to delve into the large volumes of complex and intricate public reports and statistical tables. To research and establish the levels of expenditure and employment on the various levels of government in the numerous public institutions, requires technical expertise and highly trained and experienced analytical skills. Meeting this requirement is probably the biggest constraint on the effectiveness of the media to act as watchdogs of the public.

Inner Checks

By “inner checks” is meant an individual official’s own sense of responsibility to the public. This can be enhanced by incorporating codes of ethics, professional codes and conceptions of the “public interest” as key elements into the value hierarchy of the public sector. As a result of the frailties of human nature, most observers are highly sceptical about the success potential of “inner checks”. Yet it is of critical importance that every effort should be made to influence public sector employees “from within”. Public servants must be sensitized to the true nature of responsible action: recognition of an obligation to meet a standard or a need outside of and superior to one’s own interests; regard for the consequences or outcomes of one’s decisions and actions; respect for the element of rationalism and prudence; and, awareness of a time perspective that transcends the present moment, recognizing that the future is as important as the present.

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Effective Checks and Balances

Can sufficient checks and balances be introduced to enhance administrative responsibility and accountability? No artificial system of organizational or legal safeguards can enforce responsibility or prevent unethical behaviour. The ultimate control is the internalized value system of individual employees. They must themselves be able to discern which actions can be held up to public scrutiny and which cannot.

While there are many competent and dedicated public servants, the number of persons on the government’s payroll who are not earning what the taxpayers are paying them is one of the most daunting challenges of the modern state. Most modern democracies tend to overspend, i.e. their expenditure chronically outpaces their income. But it is particularly significant to note that in many countries the emoluments of civil servants and politicians make out around sixty percent of all government spending. This means that any reliance on the state to perform any task is more likely to increase job opportunities and benefits for civil servants than benefits for the taxpaying public. In addition, it should be noted that most modern countries have introduced “collective bargaining” practices into the public sector. But they have transferred the practices evolved in the private sector without its concomitant “checks and balances”. Hence the beneficiaries of the outcome (i.e. civil servants and politicians) sit on both sides of the bargaining table. The taxpayer’s real interest is not represented. This problem has taken on gigantic proportions in modern democracies.

In Australia’s state of Queensland a special commission led by former Commonwealth Treasurer, Peter Costello, found that the iron grip of public-sector unions over the former ALP-led state governments over a period of 15 years pushed public-sector wage costs above the national average to unaffordable levels. Between 2007-08 and 2011-12 public hospital spending increased 43 percent while the volume of service activity increased only 17 percent! The search for public sector responsibility and accountability has become a major concern in modern public life. Centuries of human experience has shown that if it is to exist at all, it needs to permeate the lives of men and institutions alike. Responsible people create responsible institutions, and responsible institutions develop responsibility in people.

Concluding Remarks

At the start of the second decade of the new millennium the majority of the social democracies of the world found themselves facing chronic fiscal deficits accompanied by staggering debt piles. The economies of the social democracies cannot afford the spending levels of their governments.

The USA annually faces a big Congressional squabble over raising the debt ceiling which already stands at around USD17 trillion. Finding a credible way to reduce the debt is an additional issue about which there is even more political strife. To keep down the cost of servicing the debt, the Federal Reserve Bank continues with spurts of money creation by buying Federal Treasury securities. Most recently it has been revealed that public pension fund liabilities add another USD4 trillion to the total USA debt pile. The magnitude of this problem can have catastrophic consequences for the world economy.

In Japan, the world’s third largest economy, serving the public debt at ¥1000 trillion – 240 percent of GDP – eats up more than a third of tax revenues annually. So far, Japanese domestic savers have stepped in to soak up new debt every year. A strong current account – courtesy of Japan’s remarkable

119 export ability, combined with Bank of Japan (BoJ) monetary easing, have saved the country from fiscal collapse. But an ageing population means a falling savings rate. In addition, growing competition from Japan’s south-east Asian neighbours is reducing its current account surpluses. Early in 2013 the BoJ embarked on an effort to boost the moribund economy by injecting a 2 percent spurt of inflation through doubling the bank’s purchase of bonds and by doubling the country’s monetary base in terms of currency in circulation and deposits held at the central bank. The BoJ’s goal of expanding the monetary base through “quantitative easing” was said to be coupled with “qualitative easing”, meaning that the BoJ would be buying longer-term securities (eg. government bonds with maturities of up to 40 years) in a bid to keep longer-term rates low. By depressing bond yields the BoJ aimed to encourage investors to put their money into purchasing foreign assets as well as in domestic business expansion that would lead to economic growth and to reducing the value of the Yen. It is not clear what effect the expanding pool of ultra-cheap money would have on the real Japanese domestic economy or on asset markets around the world (eg. equities, bonds, real estate precious metals, etc).

The economies of the EU countries continued to feel the stress of unemployment, the recessionary impact of austerity and the lack of economic growth prospects. Across the board, EU countries were struggling with the question of how much political capital they had available to press forward with deficit-cutting. Austerity medicine does not go down well and opens the door to political exploitation. The essential structural reform and austerity measures tend to increase short-term pain, while the benefits take a long time to take effect. Making labour and product markets more flexible, boosting productivity and culling public-sector jobs are easier said than done. Ultimately, only crisis conditions might force the necessary change to come about. Budget deficits can only be reduced in one of three ways: tax increases, spending cuts and economic growth which increases taxable income.

On the Australian front, the year 2013 saw the budget predictions and projections of the Gillard-led labour government continuously unravelling. As late as the publication of the Mid-Year Economic and Fiscal Outlook of 2012-13 (MYEFO) in October 2012 Commonwealth Treasurer Swan reported that “the government is returning the budget to surplus in 2012-13, notwithstanding a weaker global economy that has weighed heavily on the receipts ... returning to surplus provides ongoing scope for monetary policy to respond to economic developments and underpin confidence in Australia’s public finances at a time of global economic uncertainties”. By the beginning of May, 2013, the budget predictions and projections continued to unravel. The bad news was leaked piecemeal to prepare the public for the stark truth that the ALP government was facing “black holes” on every front. There was a rush to announce as many broken promises as possible before the full details of the budget deficit was to be laid bare in the budget: an estimated total of AUD18 billion not counting the additional cost of education and disability-care spending.

When the ABC’s 7.30 programme tried to saddle the travails of the Labour Government on the previous government’s shoulders, the former Commonwealth Treasurer, Peter Costello, explained in an interview how he had succeeded over a period of 11 years to balance his budgets and to leave the Consolidated Revenue Fund with a positive balance of billions. He claimed that under the Howard-led government he had repaid all the debt left by the preceding Keating-led Labour Government and had succeeded in delivering surpluses for 10 years in succession while putting aside AUD60 billion in the Future Fund. He claimed that he had left the budget in “structural surplus” (meaning excluding the effect of cyclical boom conditions) and had some sage advice for all future Treasurers: “When a budget is in deficit, you don’t introduce new spending which requires additional borrowing ... the easiest spending cut you’ll make is the new spending you don’t go into.”

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11. Major Theories on Economic Growth (November 2013)

One of the best kept secrets of the science of Economics is its limited understanding of practical and sustainable ways to achieve economic growth. There are many theories of how economic growth could be stimulated, but when it comes to prescribing appropriate growth generating policies and action in specific situations, many contentious and unanswered questions remain. The processes driving and sustaining economic growth are by no means fully understood – let alone effectively harnessed. That is why poverty remains such a formidable problem. The mysterious code that would unlock sustainable economic growth has eluded applied economics around the world.

Although economic theories have some overlapping elements, they can be distinguished in terms of their primary analytical focus. In modern times three such theories have emerged: “demand management”, “supply-side” and “monetary management” theories. Each of these theories seeks to explain the drivers of economic change in terms of specific sets of variables which are believed to be subject to discretionary policy settings. It is believed that by changing the policy settings, different macro-economic outcomes can be achieved over time. However, no policy setting can guarantee results within a specific timeframe because our control over specific economic growth determinants is limited. No one can predict the next economic upturn or downturn with certainty.

It should be pointed out that all economic theories have undergone a process of transformation in the course of time. Theories change under the influence of feedbacks from practical experience with specific policy applications or through the ideas, contributions and observations of new generations of scholars.

Today, most economists take an eclectic approach in the sense that they combine elements of the various determinants to explain economic trends or to advise on appropriate policy settings to deal with recessionary or inflationary conditions. Supply-side measures are used to free up markets and to stimulate employment-creating economic growth. Monetary measures such as interest rates are usually advised when inflationary or deflationary pressures develop. Fiscal stimulatory measures are advised when private hiring and investment decline significantly and it becomes essential to stimulate aggregate demand to prevent a recession. Government monetary and fiscal policies can assist in offsetting booms and slumps, but misdirected government intervention can exacerbate problems and lead to systemic rigidities in the employment of a nation’s productive resources. The overriding question is which policy settings or combination of measures are appropriate within a specific set of circumstances.

The Meaning of “Theory”

The word “theory” is usually used to designate attempts to explain something in general terms. In the world of the natural sciences, theories seek to explain factual causal regularities based on empirical verification. Factual regularities of nature are referred to as “laws” in analytical terms. But in the world of human sciences, causal regularities are not easily empirically verifiable because the behaviour of humans are influenced by a multitude of variables and are not easily amenable to controlled experiments. The analysis of human related behavioural trends often has to rely on historical data or comparative information which may be subject to variation and problems of measurement.

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When used to designate an entire school of thought on a certain subject, for example when we speak of the Keynesian School, the Austrian School or the Chicago School in Economics, the term then comprehends, in addition to the theoretical “explanation” of facts or trends as perceived by representatives of the “school of thought”, a set of goals or ethical principles such as stability, progress and fairness. However, the explaining function of a theory should not be confused with “proposals of policy” to achieve certain desirable ends. Proposals of policy are part of theories only to the extent that they offer explanations in their own support. The validity of a theory does not depend on the number of people giving it support. Throughout history, nonsensical conclusions have been regarded as truth by a multitude of people. Thus the validity of a theory cannot be determined by its popularity.

Demand Management Theories

This approach is usually associated with the English Political Economist John Maynard Keynes, but his theories have been amplified by a multitude of followers and disciples. Keynesians usually assert that aggregate demand is the driving force in the economy and that by using government-based demand management by way of fiscal and monetary policy interventions, governments can influence the level of aggregate real effective demand in the economy. Keynesians advise governments to use fiscal and monetary measures to stimulate economic activity when there is a downturn, or to dampen inflationary price levels when an economy appears to be over-heated.

Keynesian economics prevailed in the 1950s and 1960s, until a combination of high levels of unemployment, stagnant growth and high inflation was simultaneously experienced in the 1970s. It was called “stagflation”. It implied that Keynesian intervention was not a panacea and that Keynesian theory was not based on universally sound economic assumptions, both on the micro-economic and the macro-economic levels.

Since the advent of the GFC, several governments in the advanced economies have reverted to heavy reliance on Keynesian stimulus spending to lift their economies out of a severe economic downturn. However, in all cases fiscal expansion was generally supplemented with monetary tools such as the variation of interest rate levels and money creation.

Leftwing governments are attracted to Keynesian spending solutions and argue against budgetary rigour or “austerity” solutions such as deficit reduction. In the euro area in the post-GFC period a heated debate has raged over whether fiscal rebalancing is needed and, if so, how fast to do it. Some Keynesian advisors argue that deep austerity creates more unemployment, greater poverty and political resentment amongst the voters. Although even Keynesians accept that belt-tightening is necessary, they argue about the extent and pace of austerity measures required. The IMF in particular has counselled against severe deficit-reduction targets. However, a great deal of uncertainty exists about the tempo of deficit reduction required and the targets that need to be selected.

It appears that multipliers change with time and between countries. Going slow on austerity requires bigger loans from creditors or bail-outs from friendly neighbours. In the case of Greece, the creditors had to accept substantial “write-offs” of outstanding debt. Since the start of the Global Financial Crisis economic growth has remained an illusive ideal amongst the heavily debt-laden advanced economies.

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The Downside of Keynesian Interventions

Keynesian interventionism appears to sit comfortably with welfarism. However, it is a recipe for fiscal disaster if the revenue side is neglected. Keynesianism appears to provide a theoretical justification for deficit budgeting or debt financing, although Keynes himself held that during economic upturns governments should produce surpluses to repay their loans and thereby repair their balance sheets. But socialist welfarists ignored this part of the Keynesian fiscal recipe and continued to pile up deficits and debts. The average debt levels of the 12 original EU members stood at 31 percent in 1977. By the time the GFC struck, the average debt level of the euro zone countries already stood at the level of 66 percent of GDP. Since then deficit budgeting has pushed their debt levels to above 100 percent of GDP with no prospect of significant economic growth in sight. It meant that significant portions of their annual budgets for years to come would have to be used to service their mountainous debt levels, thereby “crowding out” other essential spending priorities. Debt piles increase when non- discretionary inflation-indexed welfare entitlements accumulate. It reaches unaffordable levels when there is a chronic revenue shortfall that cannot be fixed by tax increases.

Continued deficit budgeting resulting in rising debt piles confronts a government with stark choices: spending cuts or tax rises. Both policy options expose a national economy to contraction, i.e. a decline in the GDP. This dilemma has been aggravated by bad deficit spending priorities in the past such as unaffordable welfarist consumption spending rather than building productive assets such as essential infrastructure projects (eg. roads, harbours, railroads, bridges, etc.). Hence the critical issue is how well the borrowed funds have been spent by the government. Was it wasted or wisely invested?

If the deficit spending does not raise the national output by more than the amount of the fiscal stimulus, the national debt continues to rise without a benefit to the GDP. Spending cuts are beneficial to the national economy if it eliminates unproductive and inefficient government spending or, more positively, if it generates national saving which can finance productive investment as a result of improved credit availability to national business enterprises and improved business confidence. If business confidence is lifted, private investment increases and economic growth prospects are raised.

The idea that cutting government spending leads to declining economic growth is based on the Keynesian notion that government spending next to private consumption, investment spending and net exports are essential components of the aggregate output of an economy (Y=C+G+I+X-Z where Y=GDP, C=private consumption, G=government spending, I=investments, X-Z=Exports-Imports)

What is neglected in this line of reasoning is that government spending affects the other components of the GDP equation. More government consumption spending at the expense of private consumption or investment spending does not ipso facto add to economic growth or to improved living standards. Much depends on the quality of government spending and on the way it is financed. If financed by tax rises it takes assets away from independent private consumers and investors. If government spending is financed by borrowings (domestic or abroad) it becomes a balance sheet liability that needs to be serviced and repaid. There is certainly no long-term future in continued deficit financing! Sooner or later serial debtors come to grief – irrespective of whether it is private individuals, businesses or national economies.

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Supply-side Theories

Supply-siders take the view that real growth in an economy depends essentially on factors affecting “effective supply”. Supply-side measures include reform of tax systems to encourage investment and innovation, the removal of restrictions to market entry (deregulation), improvements in the infrastructure of transport and communications, better training and education and flexibility in labour relations. In recent years pragmatic uses of elements of the “supply-side” approach in combination with conventional elements of monetary policy, such as the manipulation of interest rates, have become major policy tools.

Supply-side theories are usually associated with the names of members of the Austrian School, such as Von Mises, Schumpeter and Von Hayek. But members of the Chicago School such as Milton Friedman are also considered strong supporters of free-market fiscal conservatism. This approach is sceptical about governments trying to spend their way out of recessions. They believe that the allocation of resources is best decided by market forces. They advise against inflationary meddling with aggregate demand and in favour of micro-economic measures to strengthen the supply-side. Resources should be allowed to be used flexibly in response to market forces. That implies liberalisation, deregulation, privatisation and removing the dead hand of government.

Supply-siders do not dispute that there is a role for government intervention in specific areas such as the break-up of monopolies or the promotion of competition amongst suppliers. Their scepticism is directed at the destabilising influence of government spending at the macro level. They assert that Keynesian interventionism provides an excuse for governments to increase spending. Once you let the genie out of the bottle, you will not easily get it back in. Public officials tend to keep on overshooting their budgets resulting in a constantly growing public sector that “crowds out” the private sector and suppresses its dynamism and its potential for supporting the national economy over the long term.

Although Friedman believed that central banks ought to create enough money to maintain adequate liquidity levels, he argued that inflation was and is the result of central authorities allowing excessive monetary growth. To cure the problem, money supplies should grow at a steady rate commensurate with the rate of growth of all goods and services in the economy. Friedman argued that for all their imperfections, markets are better than the attempts by politicians and bureaucrats.

The supply-side approach was used by Margaret Thatcher to rescue the UK economy from bankruptcy in the 1980s and also by Ronald Reagan in the USA. Thatcherism and Reaganomics became the predominant policies in the 1980s and 1990s throughout the Western world. Governments were required to balance their budgets, live within their means and refrain from inflationary spending. Welfare payments and handouts were to be reduced as well as the marginal tax rates on individuals and businesses.

The supply-side approach to policy making focuses on the incentives prevailing in the economic activities of individuals and companies. Why should industry improve efficiency and productivity if government bails out failures? Why should an individual work hard if earned income is highly taxed and unemployment brings you benefits that are generous enough to make a good living?

Since the 1980s a raft of loss-making nationalised industries were privatised and the proceeds used to retire the mountains of public debt built up since the Second World War. Barriers to entry and exit in private industry were reduced. Labour markets were made more flexible by reducing the power of

124 restrictive trade unions. Restrictions on the international movement of finance were lifted and the demarcation of loan markets between building societies, banks and other money houses were removed. The operation of the price mechanism was enabled in many fields: domestic money, employment practices, currency movements. Interest rates, wages and foreign exchange dealings were left to the market mechanism and not fixed by governmental rules and regulations. The operation of central banks was removed from the political arena – independent from direct control by the government of the day.

Supply-side measures have proved to have a positive impact on an economy because it would make the economy more dynamic, entrepreneurial and expansive. If the national income grows faster, everyone’s living standard would be raised. This approach enhanced the growth patterns of economies around the world during the 1980s, 1990s and during the first part of the first decade of the 21st century. It was driven by what was called the “Washington consensus” and was strongly supported by influential international institutions such as the International Monetary Fund (IMF) and the World Bank.

The Downside of Supply-side Policies

Opponents of supply-side policies argue that cutting industrial subsidies, closing down uncompetitive industries and reducing public sector spending normally results in increased unemployment in the affected activities. Consequently it would inevitably spill over into increased poverty and hardship for the people involved. Critics also maintain that supply-siders’ propagation of “broadening the tax base” means imposing taxes on a wider range of goods and services. The lower paid sectors in society would be more severely affected than high-income earners. As a result the gap between extremes of wealth and poverty would be widened.

Critics of the “supply-side” approach also argue that these policies may provide good guidelines for governments in normal times but do not provide remedies for economies in distress. Supply-side solutions involve a long and painful process whereas direct deficit spending measures provide faster relief to the impecunious. Supply-siders respond that “financial malfeasance” and governmental overreach cause economic disasters in the first place. Economic downturns are the inevitable consequences of past excesses of deficit budgeting and loose monetary policies. Supply-side measures are considered by its supporters to be the only reliable way to create incentives for job-creating economic growth.

Monetary Theories

Monetarists maintain that the level of money supplies and the cost of money hold the key to demand and investment levels. When money supplies are cut back, demand levels fall, industrial activity declines and unemployment levels tend to rise. As inflation lowers, the real value of money increases and more workers offer themselves for employment. Inflation expectations fall when the money supply decreases. Monetary theorists argue that monetary measures combined with micro-economic reforms to liberalise markets contain both inflationary and deflationary pressures. Hence monetary measures hold the key to stabilising economic growth trends.

Central banks are at the heart of the financial system of society. They control the national money supply, hold accounts of all recognised financial intermediaries and determine the reserve assets ratio they have to observe. They conduct open market operations like lending money to some institutions

125 and borrowing from others. They use financial instruments such as bonds and bills (securities which all involve promises to pay sums of money over different periods). They determine the discount rate (the interest rate it charges on its own loans) and thereby influence the supply and demand for money. Central banks act as bankers to governments and so have a direct role in arranging a country’s financial affairs.

Central banks can create money by buying government securities (“quantitative easing”). In this way a central bank can boost aggregate demand and facilitate economic growth. However, continued money creation can unleash inflationary pressures if the amount of money in circulation outpaces the capacity of the economy to produce matching or countervailing goods and services. As a result of its pivotal role, a central bank ought to act as independently and professionally as possible to avoid partisan manipulation of monetary policies.

Traditionally the commonly held aims of monetary policy were to maintain relatively stable price levels, a sound external position (in relation to the balance of payments, exchange rates and foreign reserves), a stable level of employment and a sustainable level of economic growth. Often monetary policy making involves a trade-off between these objectives because attempts to reduce inflationary pressures may result in rising levels of unemployment and attempts to hold down unemployment may give rise to inflation.

Over many years several theories developed with regard to the supply of money as a factor determining the level of prices and the rate of economic growth. The famous Swedish economist Gustaf Cassel spoke of the “inexorable economic laws of supply and demand” and emphasised in his writings during and after the First World War the simple connection between the volume of notes in circulation and the price level. It was known as the “quantity theory of money”. Irving Fisher then added his simple exchange equation: MxV=PxT (quantity of money x velocity of circulation = price level x volume of transactions). The position of the different variables in the order of causation was subsequently much debated. Keynes wrote in A Treatise on Money in 1930 that the level of investment is not simply determined by interest rates but by the “availability of credit”. It followed that a central bank could use as part of its arsenal of monetary policy, not merely the weapon of interest rates, but also its control over the supply of central bank money and thus its indirect control over the availability of credits granted by commercial banks (independent of the bank rate). Then, in The General Theory (1936), Keynes modified his explanatory system by stating that the quantity of money exercises its influence through the interest rate. An increased quantity of money lowers the interest rate at a given “liquidity preference function”, while a decreased quantity of money raises it. Interest rates, in turn, affect investment and changes in investment affect the total incomes and employment of the community via the multiplier effect.

Experience in subsequent years has shown that monetary policy can only achieve success through its influence on future expectations among lenders and borrowers concerning interest rates, liquidity and cyclical changes. The central bank has to grope its way forward, always ready to modify its policy, depending on the effect on the level of economic activity. In contrast with fiscal policy and regulatory action which have direct consequences, monetary policy can only be defined in terms of broad aims and vague effects. Monetary measures are blunt instruments and subject to time lags.

For much of the period since World War II, theorising about monetary policy – its objectives, operational variables and instruments – was dominated by Keynesian thinking. The direct objective was the preservation of high levels of employment with the maintenance of an adequate volume of

126 effective demand as an underlying objective. Monetary policy was considered to have little effect on either the government’s or the private sector’s propensity to spend. However, it was considered a good thing if interest rates could be kept low, inter alia, to exercise a positive influence on the propensity to invest.

Rapidly accelerating inflation in the late 1960s and the 1970s (partly as a result of the Vietnam War and the oil crisis) coupled with recalcitrant hard-core unemployment manifested itself in the slackening of economic growth in the mid-1970s. It became a serious problem to distinguish between the interest rate effects and the quantity effects of monetary policy. Hence questions were asked about the ability of monetary policy to effectively stabilise or “fine tune” the economy in the short term. Sceptics argued that monetary policy should aim at medium-term objectives, concentrating on containing inflation and refrain from short-term “stop-go” policies involving the “pumping up” of a flagging economy by cheapening credit and accelerating the expansion of the money supply. Zero or low single-digit inflation rates became the commonly accepted monetary policy objective.

As a result of extraordinary high levels of inflation during the 1980s, it became common cause during the 1990s that inflation defined as a sustained rise in the general price level – should be avoided. It was argued that inflation raises the unpredictability of the future values in real terms of all undertakings, obligations and entitlements involving future money payments or receipts – and therefore the “risks” of such undertakings. This risk normally discourages both saving and investment. It adds to exchange rate risks and weakens the allocative and regulatory powers of the price mechanism and reduces macro-economic efficiency. It creates arbitrary and unjust redistributions of real income and wealth, it reduces the propensity to save by lowering real returns, causes shifts in private saving patterns and among savings media utilised. Real fixed investment is skewed towards inflation-resistant assets which add little to labour productivity, employment or real output. Strongly progressive, non-indexed tax systems and high marginal tax rates in an inflationary environment discourage work effort and shift real income from taxpayers to the government. Real productive resources become tied up in attempts at inflation-hedging and tax evasion schemes.

Apart from containing inflation, a “moderation” movement was set in motion, involving a lower rate of monetary expansion (money supply), creditability (consistency and transparency) in monetary policy, a stable price environment (involving financing practices and dealing arrangements) that is responsible and accountable, and generally preserving and strengthening the incentives to work, save, innovate and invest.

The Downside of Monetary Theories

Despite the widespread belief in the effectiveness of interest rate variations and money creating activities on the part of central banks, the realisation is gradually dawning on observers and scholars that monetary measures cannot be relied on to resolve structural problems in the economy. Ill-advised monetary measures can create more problems than it can solve on its own.

After the experience of the GFC, it is now clear that monetary measures such as “quantitative easing” cannot be easily wound back. Experience has also shown that if interest rates are reduced to “zero lower bound”, a policy tool that had been the mainstay of monetary policymaking for decades is no longer available. In such cases a reserve bank has to rely on “forward guidance” as a promise to keep interest rates low for an extended period.

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If monetary theory is not an exact science, the design of appropriate monetary policy settings is even less of a clear-cut task. The mistakes made have far-reaching consequences. Too much money creation inevitably opens the door to inflationary pressures and prolonged low interest rate levels destroy incentives to save which, after all, is the source of investment funds. Much depends on the way in which the extra money pumped into an economy is used.

If quantitative easing is simply used to buy government bonds (rather than on-lent to business enterprises), the extra liquidity is likely to flow into financing wasteful spending as part of deficit government consumption spending. This boils down to money borrowed from the future to finance current consumption – exacerbating repayment difficulties, diverting resources from investment and thereby impairing an economy’s future productive capacity.

In the USA quantitative easing pushed government debt from 67 percent of GDP in 2006 to 103 percent in 2011. Yet, there was no payoff in terms of significant growth.

The 2007 Global Financial Crisis

Since the start of the Global Financial Crisis in 2007, many questions have been asked. What caused the catastrophe? Which persons and institutions or what practices and policies should take the blame? What are the consequences for current and future generations?

Viewed in retrospect, the crisis had multiple causes. First in the line of accomplices are the public agencies who initiated the irresponsible mortgage lending in the USA to “sub-prime” borrowers, then the financial engineers of Wall Street who pooled or “securitised” these toxic financial instruments. Then follow the complicit credit rating agencies paid by and beholden to the sellers of the “collateralised debt obligations” who allured remote foreign investors into buying these toxic financial instruments by the ratings agencies’ seal of approval. Low interest rates caused by the flood of savings flowing from developing economies into “safe” American government bonds, prompted American banks, hedge funds and other investors to hunt for assets that offered higher returns. Many investors “leveraged” their purchases of longer-dated, higher-yielding securities and thereby increased their exposure to toxic financial instruments. Layer upon layer of toxic financial instruments were spread throughout the world. Once trust, the essential glue of financial systems, began to dissolve, banks started questioning the viability of their counterparties. Sources of wholesale funding began to withhold short-term credit, causing those reliant on it to founder. Complex chains of debt between counterparties were rendered vulnerable to their weakest links. Protective instruments such as credit- default swaps turned out to be worthless. When Lehman Brothers declared bankruptcy, AIG, the American insurance giant collapsed under the weight of the expansive credit-risk protection it had sold. The whole system proved to have been built on flimsy foundations with regulators asleep at the wheel.

Significant internal financial imbalances also occurred in Europe. Southern European economies racked up huge current-account deficits in the first decade of the euro while countries in northern Europe ran offsetting surpluses. The imbalanced were financed by credit flows from the euro zone core to the overheated housing markets of countries like Spain and Ireland.

Both the American Federal Reserve and the European Central Bank did nothing to stem the credit surges in their respective monetary realms. Both ignored the potential implications of chronic current- account imbalances. The Bank of England, having lost control over banking supervision after the

128 creation of the Financial Services Authority by the Labour government in 1997, lost its mandate to maintain financial stability.

Lax capital ratios in the world of banking proved to be a general deficiency in both the USA and the European countries. The capital cover banks had to hold relative to their assets was not clearly defined. Forms of debt were smuggled through the back door that did not have the necessary loss- absorbing capacity as equity. Hence, banks operated with minimal equity and were allowed to set up their own internal models of risk assessment. There was a general complacent optimism and a “collective delusion that lasting prosperity could be built on ever-bigger piles of debt”. (See The Economist, September 7th, 2013, p.65)

The GFC Impact on Economic Theory

The Economist of July 18th, 2013, felt obliged to publish a leader article under the title “What went wrong with economies”. It stated that of all the economic bubbles that had been pricked, few had burst more spectacularly than the reputation of economics itself. It went on to say that in the wake of the biggest economic calamity in 80 years, the reputation of economics had taken such a beating that the pronouncements of economists are viewed with much scepticism and that the profession itself is suffering from guilt and rancour. But it raised an important question: if economists got things wrong, will politicians do better?

At the onset of the GFC, macroeconomists did not provide adequate inputs to financial policy-making. They failed to provide the tools or insights to identify the coming crisis, they failed to identify its worst symptoms and they could not agree on how to resolve the crisis. Some over-estimated the power of monetary measures such as interest rate variations or central bank purchases of government bills to restore stability. Others dismissed the power of fiscal policy (such as stimulus packages) to strengthen demand levels. Paul Krugman wrote in the New York Times that most macroeconomics of the past 30 years was “spectacularly useless at best and positively harmful at worst”. Willem Buiters argued in his blog that training in macroeconomics was a “severe handicap” at the onset of the financial crisis. These comments were not particularly helpful.

In retrospect it appears that economists and commentators placed too much faith in financial markets and ignored the dangers of Wall Street financial engineering. They paid too little attention to the dark corners of the inner workings of the financial system. They failed to understand the impact of financial intermediation and did not scrutinise the role of financial middlemen and the financial market complications they cause. They believed that banks and shadow banks could always roll over their short-term debts or sell their mortgage-backed securities should the need arise. When funds dried up and markets thinned out, a liquidity crisis arose with investment banks frantically selling whatever they could and commercial banks hoarding reserves. Economists kept faith that central banks had the tools to contain the damage at a manageable level. But the continued lowering of interest rates proved insufficient to the task so that Keynesian followers turned to bold fiscal expansion in order to set the multiplier in motion.

The Keynesian fiscal stimulus option was rapidly and widely implemented around the world. It was vigorously propagated by the IMF as well as Treasury Departments or Finance Ministries in many countries. As a result most advanced economies engaged in active deficit spending which saddled them with vast mountains of public debt.

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After five years of economic stagnation, “small green shoots” started to appear in Japan, in the European countries and in the USA towards the end of 2013. Retail sales and production orders started to show modest rises and a supply-side boost started to emerge from the shale-gas industry. But the reluctance of governments to tackle serious structural reform of labour markets and welfare spending stood in the way of a self-sustaining growth recovery. By postponing fiscal consolidation the struggling advanced economies only shifted their problems into the future. Cuts in public spending remain the hardest part of fiscal consolidation and deficit reduction. It involves reducing generous welfare benefits and an oversized public sector, as well as tackling the difficult task of timing the correct tempo of deficit cutting. Only the Germans were prepared to use the term “austerity”.

The Post-GFC Policy Debate

Since the start of the GFC, much has been said and written by policy-makers, policy-advisers, scholars and commentators about the causes of the crisis and the desired policy response. Supply-siders blamed the profligate spenders for the malaise and advised the reduction of wasteful public spending. Keynesian demand managers blamed the shortfall on lack of demand and advised fiscal interventions such as drastic deficit spending coupled with higher taxes on the wealthy. The monetary school looked to money supply in the form of drastic interest rate reduction, asset purchases or money creation (“quantitative easing”) as well as “forward guidance” on the part of central banks to stimulate growth.

Each of the three main approaches was practised in various parts of the world in varying degrees. Governments in many parts of the world used deficit spending to prop up demand by expanding unemployment and welfare assistance to the needy. In several instances they, at least, paid lip-service to cutting wasteful public employment and spending under the influence of the Merkel and Cameron governments. In all instances central banks drastically reduced interest rates and in the cases of the USA, the UK and the euro zone countries, central banks undertook to “do whatever it takes” to save their currencies and economies from disintegration.

Since the onset of the GFC in 2008, the debate on selecting appropriate economic policies has moved beyond the pages of academic journals to an array of newspapers such as The Economist, The Wall Street Journal, The New York Times, The Times, The Guardian and others. Other media such as the BBC, CNN, Fox, Bloomberg and Aljazeera also weighed in by way of news commentaries, documentaries and reviews. At the same time the blogosphere has opened the economic debate to thousands of bloggers, ranging from eccentric and frivolous to erudite, well-researched and thoughtful. The news media often suffer from advocacy journalism promoting a vested interest (eg. The Economist vis-a-vis the interests of its banking owners, or the Guardian vis-a-vis Labour Party interests and The Wall Street Journal vis-a-vis business interests).

The experience of the GFC has shown that dealing with problematic economic conditions requires a range of policy measures. Keynesian interventions by way of stimulus spending to raise general consumption levels and infrastructure construction can play an important role to lift sagging demand for goods and services and to employ construction workers on a decentralised scale. Similarly central bank interventions to lower interest rates do result in stimulatory effects on consumption and investment levels. The “forward guidance” or “announcement” effects of central bank governors do play a role in the decision-making of savers and investors. Both fiscal and monetary interventions have a role to play at various stages of an economic cycle. But these ad hoc emergency measures cannot replace the need for prudential, stable, predictable and sustainable policy settings as a guide for good governance. Prudential policies may not provide a “quick fix” for an economy in distress, but they

130 certainly provide a sound foundation for a return to economic stability and efficiency. Prudential policies prescribe balanced budgeting, limited government, thrift, austerity and the avoidance of “financial malfeasance” such as money creation and distorting, “wasteful” spending or investment. Public bureaucracies should be downsized, wages be kept flexible and workers be kept mobile. Entrepreneurship is seen as an essential ingredient of a growth strategy in order to mobilise the other factors of production.

When the GFC struck, central banks in the advanced economies faced a frightening collapse in output and soaring unemployment. Across the board they reduced interest rates close to zero, using the mainstay of monetary policy for almost a generation. Thereafter they followed the example set by the Bank of Japan in the 1990s when they introduced the unconventional monetary tools of large-scale asset purchases and “forward guidance”. The USA’s Federal Reserve had for many years before bought Treasury bills and other bonds with short maturities to increase the supply of money and reduce short-term interest rates. But when its benchmark rate fell close to zero, the Fed began buying longer- term securities, including ten-year Treasury bonds and mortgage-backed securities to bring down long-run borrowing costs.

Printing money is euphemistically called “quantitative easing” (QE), because central banks sometimes announce purchase plans in terms of a desired increase in the “quantity” of bank reserves. After the Bank of Japan bought huge amounts of government bonds in 2001 to raise the level of reserves, central banks in the USA and the UK also engaged in QE since the GFC struck, buying a vast stock of financial assets.

Quantitative easing by central bankers is believed to have a “portfolio-balance effect” which means that when a central bank buys bonds with newly created money, they rebalance their portfolio by buying assets of different risk and maturity. Thereby they boost asset prices and depress interest rates because increased demand for bonds allows them to be sold at lower rates. Cheaper borrowing, in turn, could prod businesses and households to invest. Lower interest rates also reduce government borrowing costs and so lower expected future taxation. At the same time the central bank can shape expectations of inflation because by announcing a new, higher inflation target which will flow from an increase in the amount of money in circulation (higher prices). People may be led to expect that their money will be worth less in the future and thus have an incentive to spend more of it sooner. (See The Economist, “Monetary policy after the crash”, September 21st, 2013, p.62)

The use of “forward guidance”, as an unconventional tool, is an attempt to boost the economy by signalling central banks’ future policies more clearly. It means, in effect, that central banks attempt to talk the economy back to health. It promises, for instance, to keep interest rates at low levels for extended periods until deflationary concerns (such as unemployment) subside, or until a certain benchmark of inflation is reached. By promising to tolerate a higher level of inflation in future, a higher level of economic activity in the short term may be stimulated, just as the threat of higher prices due to an expanded money supply does. Similarly, a promise to hold short-term rates low for a long time should reduce long-term rates as well. Investors usually respond to “real” interest rates (i.e. nominal rates minus expected inflation) as it influences their decisions to hold on to cash or hard currency deposits. The underlying intention is to influence investors and consumers to save less and to borrow and invest or spend more. (See The Economist, op.cit. p.63)

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Unresolved Questions

As the GFC lingers on after five years of fiscal easing and unconventional monetary measures, it is not yet clear to what extent fiscal stimulus, money creation and forward guidance have played a role in lifting output levels. Have borrowing costs and the availability of credit for businesses and consumers improved significantly? The underlying question refers particularly to business borrowing. Is it a question of the cost of borrowing or of access to borrowed funds? Investment, after all, depends on the assessment of risk and expectations of potential market expansion that influence business start-ups and expansion plans. Business leaders know that when central bankers decrease interest rates, they do it because the economy has become weaker. Interest rates are normally raised “to keep a lid on inflation”.

Towards the end of 2013, the developed world’s economies were still struggling. Output in Britain remained below its pre-crisis peak. Unemployment levels in the euro area remained in double digits. The USA moved ahead only marginally in the wake of the coal-seam gas boom. Some economists maintain that monetary policy would come into play if and in conjunction with fiscal easing by way of more government spending and lower taxes. But how can businesses, households and governments respond to lower interest rates by borrowing more if they are already heavily indebted? What are the crucial determinants of a business investment decision – cost of capital, easy access of loans or confidence of an expanding market share?

The Economist newspaper, as well as a few economists such as Christina Romer, argue that central banks should explicitly raise inflation targets to much higher nominal rates. These raised targets (as high as double digits) would provide a psychological jolt to rouse the economy. These radical ideas do not sit well on the ears of a generation of economists steeped in the culture of low inflation and stable prices. Traditional economic policy wisdom requires that policy settings should be stable and predictable.

Can structural problems in the economy be resolved by monetary manipulation? Massive increases in money supply may destabilise currencies across the world and ultimately lead to hyperinflation. Much depends on the functioning of the fundamental driving force of value-adding wealth creation: investment in job-creating, productive assets.

Misguided monetary and fiscal policies have in the past entrenched economic dislocations. During the early part of the Great Depression years a liquidity problem was exacerbated by allowing banks to flounder. Some observers say Lehman Brothers should not have been allowed to go bankrupt, thus unleashing another liquidity crisis in 2008. Others point to the “too big to fail” extravaganza of the world of finance. Similarly, the application of Keynesian theories is blamed for the chronic deficit budgeting in the developed economies that institutionalised inflationary pressures and unsustainable mountains of public debt in the first place.

The GFC was caused by the machinations of the world of finance’s manipulators entrenched in Wall Street and the City of London. From these fortresses, several newspapers and other media channels are used to influence decision makers in central banks in Washington, Westminster and Brussels. Sound money is discredited as “dangerously outdated”. Looser monetary policies are propagated. These include pushing prices upwards to counter deflationary pressures, attacking austerity measures, artificially lifting nominal GDP figures by expanding deficit-financed government spending, encouraging central banks to strengthen “forward guidance” by guarantees to hold interest rates down

132 for extended periods and to continue monetising government debt. The underlying reasoning is that low inflation makes it too difficult for uncompetitive and highly indebted countries to escape from their predicament. Central banks and governments are now pressured to venture still further into unconventional territory guided by untested policies devised by the originators of the financial crisis.

It is believed that holding down long-term borrowing rates would encourage borrowing, investment and spending without much additional risk of inflation or creating unexpected bubbles. But without broad consensus on the desirability of these strategies, the credibility of central banks’ commitments would be at risk. It is not clear to what extent and for how long artificial measures such as suppressing interest rates, stoking inflation and monetising government debt can be continued without unleashing other unintended consequences. We are in uncharted territory.

What can be said with certainty is that understanding the ups and downs of economic trends requires a sharp insight into the micro-foundations of the economic system and the interaction of the many factors in operation within and between economic systems. An economic system does not resemble a mechanical system. It is more like an organic system with a flow and ebb of human-driven activity of its own. It cannot be artificially primed or pumped by central bank or government policies alone. Many socio-economic behavioural trends boil down to cultural patterns and ways of thinking and reacting, the evidence of which cannot be easily gathered or quantified. Some important elements of human behaviour cannot be easily measured and statistically indexed. It depends on the inputs of millions of role players as human beings: their preferences, fears, expectations, needs, motivation and, above all, on their creativity.

Much can be learnt from analysing historical or comparative experience. However, the interpretation of such data requires a proper understanding of the difference between causation and correlation in the association of sets of variables. Examples of the controversial association between variables are the debt-growth relationship, the harm that high inflation can do, the investment-growth relationship, the wage-price relationship to export success, the fiscal tightening-GDP growth relationship, the government spending-GDP growth relationship, the influence of government employee-total workforce ratio on productivity growth, the influence of carbon pricing on global warming reduction, etc. These are thorny issues which have remained unresolved. But despite the many unresolved questions of causation, there are several basic political-economic realities that are based on time- tested world-wide experience over several generations that could be used as policy guidelines.

Firstly, we know that there are important limitations to the size the public sector should take in relation to its income base. Diminishing returns apply to the size of government: the larger the size, the smaller the benefit of additional spending. Even in communist countries such as Russia and China, the shrinking of the state sector since 1990 brought significant overall economic growth in its wake. OECD countries have found that increases in their tax ratio to GDP levels resulted in negative effects on real GDP per capita. Taxation not only takes resources from the private sector, but also generates cumulative alternative cost burdens and reduces economic growth. In free enterprise economies, all government expenditures ultimately depend on the taxable income generated by profitable business enterprises.

Secondly, “living within your means” applies as much to businesses and governments as it does to individual households. The only real question to answer is at what level debt becomes destructive. Financing interests are quite relaxed about granting credit to what they consider “credit-worthy” borrowers. But too much debt is destructive to any household. Debt becomes too much when servicing

133 the debt grows faster than income growth. Assessing debt levels depends on what the borrowings are used for and what effect it has on growth prospects. Using national debt to finance productive assets is much better than financing additional government consumption expenditure. There is undoubtedly a negative association between debt and growth, but it is not clear at what stage a tipping point is reached. It should be clear, however, that there is nothing admirable in facing mountains of debt. You cannot spend yourself out of debt with borrowed money.

Thirdly, it can be said with certainty that the momentum of economic growth in a country is reflected in improvements in productivity. Increasing the average production per capita holds the key to achieving higher living standards, creating employment opportunities, ensuring competitiveness and curbing inflation. Productivity is measured by the ratio between goods and services produced on the one hand and the resources used to produce them on the other. It indicates the productive efficiency with which labour, capital, materials, technology and other inputs are combined and used to produce goods and services. Productivity is driven by positive linkages between technological progress, practical training, political stability, non-disruptive labour relations as well as creative and dynamic management. Outputs must be maximised with the least possible wastage of inputs. The ultimate dynamism that drives development is the inventiveness and creativity of people to improve their productivity.

Fourthly, entrepreneurship must be recognised as the prime mover of the factors of production: labour, resources or materials, technology and capital goods. These elements of productive capacity must be put together and organised into producing units. The business persons who are performing these functions are commonly called entrepreneurs. They perform the initiating, innovating and directing business roles to get things done in practically effective ways. The entrepreneur performs the key role in the rough and tumble process of establishing, running and expanding a business enterprise. Entrepreneurship is the primary source for providing the dynamism of economic growth and the small business sector provides the most mobile, flexible and versatile form of business enterprise. They are the least bureaucratic and most creative. Hence everything possible should be done to promote small and medium enterprise entrepreneurship: access to financing, a flexible employment regime and the removal of burdensome regulatory obstacles for starting, running and expanding SME activities.

Finally, it is essential to realise that government, per se, cannot turn around lack of economic growth. Governments can only facilitate business development and alleviate or cushion the unfavourable effects of an economic downturn in the short term. Growth depends on the interaction of human creativity, technological breakthroughs and business activity – producing goods and services for which there is a realistic market, either nationally or internationally. Profitable business activity is the mainspring of all taxable income without which all the desirable public goods remain out of reach.

Most parts of the Western world are now imperilled by slow economic growth patterns. Increases in government spending on social welfare are outrunning increases in taxable income levels. This mismatch has led to structural deficits and political strife over debt ceilings.

In the “too hard basket” is the question of debt reduction and repayment. The full implications of existing mountainous debt piles are neither fully debated nor understood. EU members will have to raise taxes or cut spending by as much as 6 percent of national income just to bring public debt to the 60 percent of gross domestic product benchmark. The USA would require a higher turnaround in spending just to stop the current debt to GDP ratio from rising. In Japan an even larger fiscal

134 consolidation is required in order to stabilise its debt to GDP ratio. (See Henry Ergas in “It Ain’t Over Yet: Global Crisis Lingers On”, The Weekend Australian, September 28-29, 2013) Ergas concludes that “central banks face stimulus dilemmas as states confront fiscal impossibilities”.

It is tempting to think that stronger growth will make choices easier: extra income to buy more desirable things. But has the West perhaps reached the end of its affluence? Has the era of ongoing progress come to an end?

Most Western economies have not been able to average more than 3 percent economic growth since 1950. There is little reason to expect significant increases in growth in the foreseeable future – despite greater labour force participation, better educational standards, more capital investment per worker and widespread technological advancement. Growth prospects have shifted to the Asian world.

In the past economic growth served the Western world with optimistic expectations. It provided political and social solidarity and bridged gaps. Without growth prospects, political-economic life threatens to become a fixed sum game where one person’s gain is another’s loss.

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12. The Limitations of Applied Economics (May 2012)

The famous British Political Economist, John Maynard Keynes, wrote in The End of Laissez Faire (1926), that “... the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else ... the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas”. Equally revealing are the words of famous Swedish economist, Erik Lundberg, in Konjunkturer och Economisk Politik (translated as Business Cycles and Economic Policy, 1957): “One of the most important elements in my study was to consider the accuracy and the limitations of the economist’s knowledge of events and of causal relationships; an important part of my case rests on my scepticism towards the accuracy of national income statistics and towards the possibility of interpreting accurately the effects, ex ante as well as ex post, of all types of governmental economic policy”.

The onset of the world financial crisis proved that economists failed to provide adequate inputs to economic policy making. They failed to provide the tools or insights to identify the coming crisis, they failed to identify its worst symptoms and they continued to disagree about how to resolve the crisis.

Paul Krugman, a Nobel Laureate (Princeton University) stated in a lecture at the London School of Economics on June 10th, 2009, that most of macroeconomics of the past 30 years was “... spectacularly useless at best and positively harmful at worst”. Willem Buiter (London School of Economics) stated in his blog that a training in macroeconomics was a “severe handicap” at the onset of the financial crisis, when policy-makers had to “switch gears” from preserving price stability to safeguarding financial stability.

Subsequently the debate on appropriate policy prescriptions and settings continued unabated fluctuating between more government intervention through fiscal and monetary measures and more encouragement and scope for market forces to operate and various combinations of the two opposite tilts. The intellectual traditions involved in this policy debate have deep historical roots.

Dealing with the substance of economic life on the level of individual and community households dates back to pre-historic times. Reflections passing through the mind of man on the ordinary business of life must have happened ever since he was capable of reflection at all. In the words of Alexander Gray in The Development of Economic Doctrine “... all customs, institutions and laws must contain implicitly a certain measure of economic theory, even if it be never expressly propounded”. To this extent, the Code of Hammurabi, Mosaic Law, Plato’s “Republic” and “Laws”, the Roman “ius gentium”, Thomas Aquinas’s “De Regimine Principum”, the Magna Carta of 1215, the Huguenots’ “Vindiciae contra tyrannos”, etc., all contained in embryo an economic doctrine.

A backward glance at the development of more systematic thought and opinion about economic affairs, inevitably takes one back to the age of Mercantilism, the Physiocrats, David Hume, Adam Smith, Malthus, Ricardo, Sismondi, List, Marx, the Austrian School, Jevons, and eventually John Maynard Keynes. It serves as a reminder that “Economics” as a systematic field of academic inquiry was originally called “Political Economy” – terminology first used by Francois Quesnay (1694-1774), the major representative of the Physiocratic economic doctrine. The Physiocrats maintained that the nature of wealth, the conditions of its production and the laws of its distribution are matters to which scientific and precise reasoning may be applied with the object of arriving at universal truths.

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Out of an interactive telescopic analytical process of observation and reasoning the discipline of Political Economy gradually emerged as a coherent body of knowledge with its own accredited methodologies and accumulated findings and interpretations. Schools of thought competed for pre- eminence and reputations were created or lost – sometimes more on account of fortunate associations than on substance.

Prior to the First World War, the policy advocacy roles of economic scholars were limited. The role of governments in society was much smaller. For the first century of the USA’s existence since 1776, the federal government’s presence was usually less than 2 percent of GDP, compared with 25 percent now. In other social democracies such as EU countries the proportional growth of the government’s share of GDP is more than twice as large as a result of their ballooning welfare spending and expansive interventionist policies in the form of regulations, physical controls and taxes affecting the affairs of private firms and individuals. The “mixed economy” became the standard template. But the debate continued about the proper nature of the “mix”. New conceptions of economic causality emerged as justification for new policies to deal with actual economic situations.

During the inter-war period the part played by economists in formulating economic policy increased substantially. The language of Economics became more specialised and complicated. Proposals had their basis in economic theory which, in turn, was also transformed and expanded. At the beginning of the 1920s, the quantity theory of money had an important place in explaining the effects of the measures introduced to stabilise the general price level or the exchange rate. It was assumed that the general price level was determined by the quantity of money via the discount rate policy and that relative prices were determined by the laws of supply and demand, via the workings of a system which was harmonious and automatic. In the 1930s these theories were changed by the Great Depression and insights earlier contributed by economists such as Knut Wicksell, Erik Lindahl and Gunner Myrdal in Sweden and later by Fisher and Keynes. Disequilibria in the system resulting from discrepancies between saving and investment, and deficiencies in aggregate demand, were now recognised. The publication of Keynes’s General Theory of Employment, Interest and Money in 1936 brought in its wake new programmes to achieve full employment during the war years and in the early post-war period. Beliefs in the close connection between the economic laws of supply and demand within a system of free competition and the “natural functions” of price which went with it (i.e. self-adjusting and market-clearing), have been replaced by an increased faith in the ability of government bureaucracies to “correct market failure” and to re-distribute income through the “judicious” and “appropriate” application of economic policy.

In the period since the Second World War the use of anti-cyclical fiscal and monetary demand management policies became routine government practice amongst the advanced economies to smooth out excessive upswings and downswings in economic trends. The articulation of what today is called “Keynesianism” was initially done by Hicks, Lerner, Hansen and particularly by Samuelson and an array of economists trained at American and English universities – including disciples like Summers, Krugman and Blanchard. It was done with the aid of the working kits of modern econometrics: extensive macroeconomic statistics; reams of national accounts data; a plethora of charts, diagrams and mathematical formulae; and, in addition, extensive computerised modelling – albeit with limited predictive accuracy. Keynesians have great faith in the ability of civil servants to understand the macro picture, to act reasonably and appropriately – and to rise above self interest, greed and political power-play.

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Following the theories of Keynes, economists claimed that governments should manage aggregate demand through fiscal policies to such an extent that it can expand or contract the economy by way of changes in taxes and expenditure levels. The Keynesian demand managers believe that government deficit spending on stimulus packages involving both social entitlements and infrastructure projects – depending on the scale of the multiplier effect - would shore up effective demand levels. But this policy response provided no answer to the problems facing economies with high debt levels (around or in excess of 100 percent of GDP) and sclerotic growth prospects, low confidence levels and facing obdurate welfarist political pressures – hence no convincing exit strategies to escape from falling into debt traps. Expansionary government seems to develop a cumulative momentum of its own.

The monetarist theories of Friedman and others claimed that by raising or lowering interest rates (using “open market operations” or by “announcement effects”) and by “quantitative easing” (buying government debts with newly created money) central banks can influence the money supply, credit levels, price levels, exchange rates, the balance of payments and growth rates of an economy. After four years of contractionary pressures since the start of the global financial crisis, central banks in the advanced countries have kept interest rates close to zero in order to stimulate demand, used quantitative easing to push liquidity into the government sector, provided soft loans to the banking and corporate sectors to enhance liquidity and in the process ballooned their own balance sheets with a range of paper assets. These highly unconventional measures have not as yet significantly prevented the increase of household debt levels and contractionary pressures in grass roots business activity and employment.

The Austrian school as exemplified by Von Mises, Hayek, Schumpeter and others see economic downturns as the inevitable consequence of past excesses of deficit budgeting and loose monetary policies. They prescribe balanced budgeting, limited government, thrift, austerity and the avoidance of “financial malfeasance” such as quantitative easing and distorting “malinvestment” orchestrated by central banks. Public bureaucracies should be downsized, wages be kept flexible and workers be kept mobile. Entrepreneurship is seen as the essential ingredient of a growth strategy in order to mobilise the other factors of production. This “prudential supply-side” policy formula provides good guidelines for governments in the normal course of events, but does not provide “quick-fix” remedies for economies in distress. Hence economic recovery is bound to be a long and painful process.

Underlying and in many ways intermingled with the various intellectual traditions, is the more fundamental question of the proper role of the state. This question spilled over into the main ideological contest of the 20th century: capitalism vs communism, socialism vs individualism, government intervention vs free enterprise. As rationalisations for specific political-economic arrangements, these ideological concepts still resonate with prevailing images of reality and the policy debate over appropriate policy measures to deal with current problems: mountains of public debt, the prevalence of collective welfare provisions drowning social democracies, open-ended expansive government, oversized public bureaucracies, deeply flawed financial systems and sclerotic economic growth prospects. The average economic growth rate in every major advanced country in the Western World has been in decline for several decades. Hence economists face serious questions about the causes of this economic stagnation. How long can societies continue living beyond their means? Is the welfare state a state that cannot stop growing? Will the countries of the West succeed in significantly rolling back the state and carrying out deep structural reforms, particularly of labour laws and oversized public sectors? How can a viable process of economic growth be set in motion?

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Much of today’s world is still in the grips of political-economic relics of the 20th century. Despite the implosion of communism in Eastern Europe and the USSR, the communist system is still in control in China, North Korea, Cuba, Venezuela and Bolivia. The Islamic model of autocratic closed societies, sharia law, sukuk wealth funds, political theocracy and global networks still hold sway over as much as 1.4 billion people spread over more than 50 countries in the Middle East, North Africa, the former USSR Republics and South and South-East Asia. Less than one billion people live in advanced social democracies, covering less than 15 percent of the world’s population.

In democracies, public policy making takes place in a highly politicised environment. Left-wing political parties, cheered on by trade unions and affiliated (particularly academic) economists are propagating more government involvement: deficit spending on welfare and unemployment entitlements, demand enhancing stimulus packages, interest rate reductions, quantitative easing, liquidity injections, tax increases on high income earners, expanding public sector employment and emoluments, etc. Right-wing political parties cheered on by business interests and affiliated economists (mostly private sector or independent) are propagating a range of austerity measures such as debt-reducing spending cuts, balanced budgets, deregulation, infrastructure directed stimulus packages, tax concessions, limitation of welfare and public sector payments as well as growth strategies based on entrepreneurship development and business expansion.

Since the onset of the world financial crisis, the economic policy debate in the English-speaking world has moved beyond the pages of academic journals to an array of newspapers (The Economist, The Wall Street Journal, The New York Times, The Times, The Guardian), to TV media networks (such as the BBC, CNN, Fox, Bloomberg and Aljazeera) by way of news commentaries, documentaries and share market reviews. At the same time the blogosphere has opened the economic debate to multiple thousands of bloggers – some frivolous or eccentric taking pot-shots at different intellectual schools, but many bloggers are erudite, well-researched and thoughtful. The news media generally suffer from advocacy journalism and limitations of space and time. They are often limited to spreading generalities and clichés. The blogosphere, in contrast, has given voice to a range of new ideas and perspectives and has generally improved the global conversation about economics. This conversation could be further enhanced by paying more attention to other-language contributions, eg. German, French, Dutch, Scandinavian, Japanese, Chinese and others.

Despite considerable progress in the advancement of econometric modelling techniques, the interpretation of the data remains problematic. Although much can be done to describe economic phenomena and to record economic trends, the explanation of causal relationships remains an open- ended problem. Hence the rise of many schools of thought forming part and parcel of the economic intellectual portfolio: some considered “mainstream” and others “marginal” – depending on the classification criteria of the observer. Journalistic participation in the debate often depends on the sponsorship of the news media. It ranges from the “mutualisation of government debt” exhortations of The Economist vis-a-vis the issuance of Euro bonds, to the “greedy bankers” accusations of The Guardian. Some argue for more Anglo-Saxon “pragmatism”, others for more Teutonic “rigidity”. The “occupy” protesters have yet to articulate their arguments against the status quo.

Economics is not an “exact science” such as chemistry or physics. It deals with human behaviour and expectations in conditions of uncertainty and imperfect information that cannot be analysed by way of controlled experiments on a macroeconomic scale. Although things are more rigorous and refined than a hundred years ago, disagreements remain – albeit within set limits. But the measurements, models, survey data and statistics, which are all very much in vogue, are blunt instruments. They yield some

139 information and suggest some clues, but do not accurately reveal the complexities of economic life – nationally and internationally. These analytical instruments rely on human interpretation of what is true or false, good or bad, right or wrong, wise or foolish. There are no examples of modelling focussed on policy options that can provide guaranteed outcomes. Computer models do not produce empirical data. They only provide projections based on a priori or ceteris paribus assumptions and presuppositions. Who can predict the next economic upturn?

Understanding the ups and downs of economic trends requires a sharp insight into the micro- foundations of the economic system and the interaction of the many factors in operation within and between economic systems. An economic system does not resemble a mechanical system. It is more like an organic system, with a flow and ebb of activity of its own. It cannot be easily primed and pumped or manipulated by government policy. Many socio-economic problems boil down to culture and ways of thinking, the evidence of which cannot be easily gathered or quantified. Can what is really important about mankind be measured and statistically indexed? It depends on the inputs of millions of role players as human beings: their preferences, fears, expectations, needs, motivation and, above all, on their creativity.

Scientific endeavour is a discipline that lives off doubt and advances by disproving or confirming accepted theories. Prevailing theories and orthodoxies must be constantly tested against evidence. Questions of validity cannot be resolved by a majority show of hands. There is no inherent validity or morality in the majority principle. Today’s “mainstream” theories may be invalidated by tomorrow’s information and insights. Although the econometric toolkits of modern macroeconomics are standardised, the availability of reliable comparative and longitudinal statistical records is limited. Figures don’t lie, but men (including bureaucrats, politicians and economists) do figure! The misuse of made-up or unreliable pseudo-scientific numbers is a constant hazard in political campaigning and public policy-making. We cannot be sure that all official statistics or projections are trustworthy. Statistical offices vary in their technical sophistication and ability (or courage) to resist political pressure. Can we rely on the good faith of government statisticians? Large elements of self interest and political spin have to be factored in.

It is important to realise that there are still serious shortcomings in the accurate quantification of key economic data. Some obvious examples include the following: levels of inflation, total government deficits and debts, global current-account balances, the calculation of exchange rates, details of bondholders, the size of the bond market, the taxable income of multi-national corporations, the total amount of global off-shore deposits, the debt and risk profiles of hedge funds, the risk profiles and volumes of derivative markets, the volume of transfer pricing done by multi- nationals, measurement of the level of public sector productivity, the scope of unfunded future liabilities in public pension systems and, last but not least, the determinants of economic growth. Dodgy statistics can only lead to miscalculation and policy mistakes. In his Nobel Prize acceptance speech, Friedrich von Hayek seriously warned against what he considered the “pretence” or “arrogance” of knowledge.

One of the best-kept secrets of economics as a scholarly discipline is that the question of economic growth has been largely relegated to the periphery of theoretical concerns. The result is that the relative importance of the various factors that determine the dynamics of economic growth are not properly understood and explained. To the lay citizen, this deficiency may come as a disappointing surprise. One would have thought that economists are experts in the subject of economic growth and that their expert knowledge should enable policy-makers to generate policies and take remedial actions to deal with economic crises. The simple truth is that when it comes to prescribing appropriate

140 growth generating policies and actions in specific situations, many contentious and unanswered questions remain. Although economics, as a scholarly discipline, may have accumulated a large body of knowledge, the uncharted terrain is still very large. The processes driving economic growth are by no means fully understood – let alone fully harnessed.

Another major problem in today’s macroeconomic analytical models is the neglect of the micro- foundations of economic systems and the heavy reliance on aggregate statistics as key variables: aggregate demand, aggregate agricultural output, aggregate mining output, aggregate consumption, aggregate public sector expenditure, aggregate savings and investment, etc. Aggregate data categories need to be dissected in order to identify its “active” and “passive” ingredients. In addition, aggregate variables do not adequately reflect the “upstream” and “downstream” interaction of economic variables. The “farmgate” aggregate income does not reflect the role of the agricultural sector in the sustenance of regional towns and villages; of mechanical services, transport- and marketing services; of wholesale and retail marketing services; of export earnings, etc. The “upstream” role of mining (eg. companies such as BHP-Billiton, Rio Tinto, Woodside Petroleum and others) act as major “fly-wheels” in the Australian economy and played an overridingly predominant role in safeguarding the Australian economy against the onslaught of the GFC meltdown. Other resource-based economies like Canada, South Africa and Brazil were equally well served by their mining sectors. Without the marketing opportunities offered by China, Japan, South Korea, India and Taiwan, all resource-based economies would have been in dire straits.

In today’s world political and business leaders are obliged to rely heavily on the advice of experts trained in a variety of fields of academic specialisation: natural sciences, social sciences, medical sciences and economic sciences. Yet a blind unquestioning belief in the authority of experts can lead to disappointing and even fatal outcomes. Science-based expertise is limited by the parameters of the variables in their field of inquiry. Hence any claim of “scientific clairvoyance” must be thoroughly scrutinised – particularly in the case of experts taking policy advocacy positions. It is up to civic society to evaluate “science-based” advice in terms of society’s values and priorities. It is clear that the advancement of scientific endeavour is too important to become embroiled in political posturing. In the wise words of Winston Churchill “scientists should be on tap not on top”.

Adam Smith wrote in a well-known passage of The Wealth of Nations (Book IV, Chapter 11, p.421): “The statesman who should attempt to direct private people in what manner they ought to employ their capital, would not only load himself with the most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.”

It is not clear what the ailing Western societies would do if the current persistent economic crisis takes on catastrophic proportions. The options are stark: unelected expert technocrats, unaccountable bondholding plutocrats, independently appointed bipartisan panels or agencies, or by some form of autocracy – either party based, populist, military, totalitarian or some combination of these. Although people throughout history have yearned for competent and principled government, they usually get the governments they deserve. Our ongoing collective challenge is to design and maintain systems of policy making where bad politicians, bad bureaucrats, bad businessmen and bad experts – all of whom are always amongst us – have the least possible chance of doing harm.

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13. Germany’s Precarious Political-Economic Challenges (August 2012)

In the period since the Second World War, Germany’s work ethic, export success, fiscal discipline and wage restraint enabled the country to become the engine room and financial anchor of the euro zone. Now, at the end of the first decade of the 21st century, Germany is confronted with two political- economic challenges of momentous importance. The one deals with safeguarding its economic prowess in the face of the far-reaching changes in its energy provision initiated by the coalition government between the Greens and the Social Democrats (SPD) under Gerhard Schroeder around the turn of the century. The other challenge is avoiding being swamped by the weight of its debt-ridden, economically stagnant euro-zone neighbours expecting Germany to share their debt burdens and to stand behind their bankrupt banks and profligate governments.

The Energiewende, as the Germans call their energy policy U-turn, involves a shift from nuclear and fossil fuels to renewables. The dislocations and distortions caused by this enforced transformation is now casting a shadow of uncertainty over the country’s manufacturing prowess. The problems involved with this transformation of energy provision and pricing is now exacerbated by the fall-out of the Global Financial Crisis (GFC) which started in 2007. As the GFC contagion spread from the USA and the UK into the euro zone, it exposed the broken balance sheets of the major European banks. The already heavily indebted European governments, Germany’s included, had to step in with additionally borrowed bail-out funds to rescue the banks.

As the GFC gradually transformed into a prolonged economic contraction, Germany, together with its northern neighbours, managed to return to a modest growth path. This was achieved through maintaining their export markets and repairing their public balance sheets through austerity programmes. Now Germany is being urged to stand behind the euro by accepting the “mutualisation of sovereign debt” and to shore up the banking system through “collective action”. These measures are, in effect, relying on German guarantees because the southern members of the euro-zone face mountains of debt and sclerotic growth prospects. To add insult to injury, Moody’s – an American ratings agency – has already sounded a warning that the AAA status of industrious Germany could be jeopardised by looming bail outs.

The Impact of the Energiewende Policy

The German economy was saddled by the Energiewende policy of the left-wing government under Chancellor Gerhard Schroeder. He came to power after the fall of Chancellor Helmut Kohl in 1998 when the Social Democrats (SPD) formed a coalition with the Greens. Chancellor Schroeder was pressured by the Greens in 2000 to introduce an ambitious, but highly risky policy to cut carbon emissions with renewable energy. The initial plan was to phase out nuclear power by 2050.

After the Fukushima disaster in 2011, Chancellor Merkel, in a knee-jerk reaction, decided to order the immediate closure of seven reactors and to phase out the remaining 17 reactors by 2022. Germany reaffirmed its clean-energy goals which involved cutting greenhouse-gas emissions from 1990 levels by 40 percent by 2020 and by 80 percent by 2050. It meant those targets were to be met without nuclear power.

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In 2010 Germany’s nuclear power stations supplied 23 percent of its electricity. Around 86 percent of its electricity was provided by an oligopoly of big suppliers: EON, EDBW, RWE and Vattenfall. Then the fortunes of Germany’s energy suppliers started to change very swiftly. First the European Commission (EC) forced them to spin off their transmission networks. Then the German government ordered them to take their nuclear plants – their most predictable source of revenue – offline by 2022. In addition, the power companies are obliged to pay a nuclear-fuel tax of around €2.3 billion a year until 2016.

The Energiewende policy also opened the door to thousands of heavily subsidised wind farms and solar arrays across the countryside. The renewable energy law entitles anyone who puts in a solar panel or a windmill to sell surplus power to the grid, receiving a generous “feed-in tariff”, guaranteed over 20 years. This gives electricity generated by renewable power priority over conventional power and pushed up its contribution to close to 20 percent of electricity output. The government’s plan is to push renewable energy’s target up to 35 percent by 2020.

The renewable energy push has unleashed an avalanche of “energy co-operatives” – from less than 100 in 2008 to around 600 in 2011. Solar parks have migrated in many cases from the countryside to the rooftops of family houses and apartment blocks. These changes have perked up local economies in windy areas and became important sources of revenue in smaller settlements as surplus power supplies are intermittently fed into the grid.

But the Energiewende has a serious downside too. It raises the cost of electricity, unsettles supply and is provoking rising resistance at the local level. The cost element is a very serious matter. Wholesale electricity prices have already risen significantly and are predicted to be 75 percent higher by 2025. Further capital expenditure on transmission lines is required to accommodate the many smaller input points. Intermittent wind and sun power create a need for back-up or base-load generators while making it difficult to develop business models that justify investment in such standby power generators.

From a macroeconomic perspective significant electricity price increases have cumulative effects on all facets of economic life: industrial costs, household budgets, transport costs, export prices, etc. In particular, it affects the competitive strength of the German industrial output, which is in many ways the mainstay of the German economy. In addition, the intermittent nature of wind and solar electricity generation affects the reliability of energy supply. It urgently requires backup generation facilities which, in the absence of nuclear generators, have to fall back on gas and coal power stations – defeating the reduction of carbon emission objectives. The subsidy-fed explosion of wind and solar power generation has distorted the allocation of capital investment. It not only pushed up industry’s electricity bills relative to its competitors, but exposed them to the instability of power interruptions. Since most energy intensive consumers are shielded from higher tariffs, other segments of society including ordinary folk, have to foot the bill. Subsidy distortions to the market destroy normal market dynamics and expose the energy industry to bureaucratic intervention, pressure from the renewable lobby and a wasteful transition from fossil and nuclear fuel to unreliable renewable energy. The price will by high and the risks are large. Extra subsidies may be needed to encourage investment in standby generation capacity.

Chancellor Angela Merkel has taken charge of the implementation of the Energiewende policy in the hope of staying ahead of the risks and pushing back against the cost escalation. Germany is now exposed to a greater dependence on the gas and oil exports of Putin’s Russia. If the possibility of increases in the charges for carbon emissions remains open ended, investment in standby gas and

143 coal-fired power stations will remain uncertain. The total impact of the Energiewende policy has cast a cloud of uncertainty over the future of the German manufacturing prowess.

Chancellor Merkel is likely to lose the support of the bulk of her own political base, the Christian Democrats (CDU) and the Free Democrats (FPD). She now seems to rely on the support of her traditional opposition, the Social Democrats (SPD) and the Greens in addition to her own dwindling conservative supporters. These support groups are unlikely to return to nuclear power generation or to support the introduction of the technology of “directional drilling” to tap coal-seam gas resources. Thereby Germany would not be allowed to tap into the potential of an important new technological breakthrough in the field of energy generation.

The Euro Zone Imbroglio

The German economic model together with its highly decentralised federal political system makes it a distinct partner and player in the European Union. It means that the German Chancellor is directly influenced by political-economic factors on the home front. Hence, the interplay of these factors determines what can be expected from German inputs and reactions to efforts to solve euro zone problems. Germans have their own unique set of expectations, priorities and contributions. It requires proper understanding of their post-war emergence as Europe’s economic powerhouse, its intricate sensitivities about its Nazi history and its understanding of the causes and implications of the euro zone’s current frailty.

Germany entered the post World War II era split in two parts as the victors divided the country according to the lines drawn by the occupation forces. The Soviet Union held the eastern parts which later became the Democratic Republic of Germany. The Western allies held the western part which became the Federal Republic of Germany. It took several decades until the end of the Cold War before Chancellor Helmut Kohl managed to secure the unification of East and West Germany after the fall of the Iron Curtain.

During the period 1946 to 1949, the German population went through terrible hardship: food shortages, unemployment and poverty were the order of the day. On the Western side the bulk of the population had to rely on American food aid. The economy was kept afloat with the aid of the American-funded Marshall Plan. General Clay, the Commander of the US military occupation, appointed as head of the American and British occupation zones an economist from the Freiburg School of “Ordoliberals”, Dr Ludwig Erhard. This proved to be an inspired choice. Erhard succeeded in getting approval for the re-introduction of the German currency, the D-mark, in 1948 – thereby enabling the German economy to take off.

With capital provided by the Marshall Plan, small and medium sized companies (Mittelstand) sprang up and became the backbone of the German economy. They were the first enterprises to start producing goods and services for the local market and to start employing the vast reservoir of unemployed people on a decentralised basis. Today they still employ 70 percent of the workforce, account for 46 percent of investment, creating 70 percent of all new jobs. As export companies they compete at the top end of the market by devising excellent technical solutions, supplying reliable goods and building long-lasting relationships with their customers. German manufacturers, small, medium-sized and large, became famous for their obsession with detail and strong emphasis on safety and durability. Their products were expensive but top quality. Their brand names became well known around the world: Mercedes Benz, BMW, Volkswagen, Bayer, BASF, Miele, Behr, Bechstein, Trumpf,

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Siemens, SAP, etc. Most are dedicated to improving their products rather than the fast moving, mass consumer markets ruled by pushy marketing. In time, Germany’s export prowess pushed it to the top three exporters in the world, creating a current account surplus varying between 6 and 10 percent of GDP.

West Germany’s first Chancellor was the highly respected Konrad Adenhauer. He was ably assisted by Ludwig Erhard, his Finance Minister. The result was the German Wirtshaftswunder – an economic miracle. In the miracle years of 1950-1973, GDP grew by an annual average of 6 percent. With the bounty the government was enabled to extend the benefits of the welfare state. The core of Erhard’s Ordnungspolitik was the concept of a “social market economy” which came to describe the German economic model in the post-war years. It holds that competition was the best way to prevent public or private concentration of power, the best guarantee of political liberty as well as providing a superior economic model. It looked in many ways like a typical “mixed economy” because at all levels of government – federal, state (länder) and local – public ownership was broad in scope. In included transportation systems, telephone, telegraph and postal services as well as radio and television networks and utilities. Partial public ownership also extended to coal, iron, steel, shipbuilding and other manufacturing activities. But in contrast to the practice in France, the German state did not take control. It created a network of institutions to enable the market to function effectively. The economy operated under the tripartite management of government, business and labour, called Mitbestimmung. This corporatist system was embodied in supervisory boards called Betriebsrätte, consisting of representatives of all three sectors. It propelled Germany to the centre of the European economic order within a decade and firmly established it as the locomotive of European economic growth. Germany also provided job opportunities to millions of migrants (guest workers) from Turkey, Greece, Italy and Spain.

Chancellor Gerhard Schroeder took office with the support of the Green Party. The Chancellor squeaked home by polling just 6000 votes more, in an electorate of 61.4 million, than the conservative Christian Democrats and their Bavarian sister party, the Christian Social Union. Mr Schroeder persuaded the Ossis that he was their friend and offered cash and a spirit of national solidarity. With the two main parties finishing neck and neck with 38.5 percent of the national vote each, the Greens provided coalition support for a centre-left alliance. But the Greens were more focussed on environmental issues and less concerned about economic fundamentals.

The first years of the new millennium saw the German economy weakening. Germany was plagued by severe economic stagnation. Although its economy was the biggest in Europe, larger by a third than both Britain’s and France’s, the German economy showed the lowest growth figures in the whole of the European Union. The German economy was still struggling to fully absorb the bankrupt East Germans; it was stifled by a hugely restrictive and intrusive web of regulations, an inflexible and protected labour force and an over-generous welfare system. Unemployment stood at 10 percent of the workforce in 2002. Germany’s biggest firms were setting up plants abroad to manufacture products more cheaply. Bankruptcies increased to unprecedented levels. The hourly cost of labour in the manufacturing industry in Germany (including wages, social security and pension contributions) was 13 percent higher than the USA, 43 percent more than the UK and 59 percent more than in Spain. Its global share of exports declined from around 12 percent in 1992 to around 9 percent in 2002. Venerated firms became vulnerable to hostile foreign raiders. Commentators described Germany as the “sick man of Europe”.

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During his second term which started in 2002, Chancellor Schroeder appointed Peter Hartz, a top VW manager to propose reform measures to Germany’s onerous labour-cum-welfare system. Mr Hartz’s proposals were aimed at making the labour market more flexible by reducing job protection and lowering social security contributions for part-time jobs. It involved the creation of “personnel service agencies”, to be run by private enterprises which would take on people who had previously been unemployed and hired them out as temporary workers. Those who rejected an offer for employment from such an agency faced the risk of having their benefits docked. He also proposed “mini jobs” with private households where employers only paid a flat-rate of 10 percent social security contribution. Self-employed people were given tax incentives to set up companies with a minimum of paperwork and earnings of up to €25,000 taxed at a nominal rate of 10 percent. The onus was placed on job seekers to explain why a job offer was unsuitable before the state would provide welfare benefits.

Since 2006 the German economy experienced a healthy rebirth. Its exports exceeded any other country’s in the world – and remained world class. The economy started growing again at a rate close to 2 percent. After years of chronic depression, the general mood started to improve. The new Chancellor, Angela Merkel, engendered a feeling of optimism and the political-economic system started delivering the incremental changes expected by the methodical new Chancellor. A doctor of physics, she took office in 2006 at the head of a grand coalition of the two major parties. the CDU and the SPD. By taking “small steps” she succeeded in reducing the budget deficit, increasing the value- added tax rate from 16 percent to 19 percent and to curtail the veto rights of länder over federal affairs in return for gaining more local powers over education.

Despite the best efforts of the Hartz proposals, Germany’s labour market remained bureaucratic and over-protective of vested union interest. Wages are still set by national peak-level bargaining. The effect on labour costs is magnified by the way the country finances its welfare state: through a payroll tax with matching contributions from employees and employers. Contributions added up to 40 percent of gross income in 2006 compared to 28 percent in 1970. In effect, the de facto minimum wage is set by welfare benefits.

It is within this intricate, fine-tuned, minutely structured and finely balanced society that the struggling Mediterranean members of the euro zone are seeking to find assistance to help them recover from decades of deficit spending, mountains of public debt and sclerotic economic growth. Germans do not appear to be fundamentally opposed to European co-operation. They have been core members of the “European project” since the Treaty of Rome in March 1957 which paved the way for the formation of the European Economic Community (EEC) which later transformed into the European Union (EU) with its 27 members today. The Germans also allowed their cherished Deutsche Mark to be replaced by the Euro as the legal tender in the 17 member euro zone currency union. They also agreed to accept the authority of the European Central Bank (ECB) to set a single interest rate for the whole euro zone. They appear to see no alternative to a continuation of the “European project” on condition that it proceeds “step by step” – in the words of Angela Merkel. But the Germans do not want to be its milk-cow and resent being made the object of special burdens and impositions. Monetary policy has been handed over to its own independent central bank, the Bundesbank. Their political system is based on a broad consensus: checks and balances to restrict the power of government, a set of social and political institutions which have primacy over the market (the law, the constitution and a supreme court to interpret it), the corporate governance principle of mitbestimmung and consensus politics relating to modest tax rises and cuts in the budget deficit. These are the factors that produce the stability and progress of German society. On what ground should these factors be jeopardised?

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As a member of the EU and more directly the euro zone, Germany is now confronted with a conundrum: how to deal with the dangers of being dragged down into a political-economic abyss if they jump into the whirlpool to help out their profligate co-members along the Mediterranean. How much of its resources can Germany afford to sacrifice before it also drowns? Germany only recently recovered from lifting its 17 million Eastern compatriots out of the tribulations of Soviet Communist rule. Can the German economy with its 82 million citizens, with its head barely above the water, rescue its numerous neighbours along the Mediterranean with a combined total approaching 200 million? Even a strong swimmer can only save a limited number of drowning swimmers.

Concluding Remarks

It is important to realise that all the social-democracies in Europe and elsewhere suffer from the same political-economic disease: living beyond their means, financed by compliant bond markets allowing over-spending governments to use chronic deficit budgeting to cover their spending on unaffordable welfarist benefits and oversized bureaucracies. In all the advanced countries, both public and private households are saddled with heavy debt burdens as a result of their deep-rooted addiction to credit financing - without proper regard to affordability. Sooner or later the reality of bottom line discipline comes into play.

When the GFC struck, many advanced economies were already vulnerable to contagion on many fronts. Government debt levels were already unsustainably high as a result of the cumulative effects of deficit budgeting over many years. Governments were already committed to high levels of spending on welfarist benefits, public sector employment and, in some cases, heavy defence or security spending. In most cases spending levels increased much faster than income levels when the GFC virtually pulled the plug on economic growth.

The average growth rate of every major advanced country has been on the decline for several decades. The economic sclerosis affecting the advanced economies manifests itself in many symptoms: unemployment rates around more than 10 percent, chronic budget deficits with levels of public spending approaching, or exceeding in several cases, 50 percent of national output, social welfare systems placing an unsustainable tax burden on society. Public debt levels have created “debt traps” where interest rates charged by bond financiers have raised to levels where governments have to pay more interest than they can service (as in the cases of Greece, Portugal, Spain, Italy and France). Inflationary expectations are undermining confidence to invest in job-creating economic growth. In most social democracies, public expenditure burdens have risen faster than economic growth.

The critical variables are the levels of confidence of the buyers of government bonds, the interest rates they require and the repayment terms involved. These requirements, in turn, depend on perceptions of the relevant government’s fiscal rectitude and the economic potential of the country and the willingness and ability of its taxpayers to shoulder the commitments made by their governments. A country with a firm growth potential, a stable political system and a convincing record of sound economic management is likelier to raise loans domestically or internationally to cover its debt requirements. The ability of a country to meet its debt obligations depends on its projected disposable income stream. You cannot spend yourself out of debt with money you don’t have.

The Economist, an influential newspaper owned by financial interests in the UK and beholden to financial interests in the City of London and in Wall Street, has systematically been propagating the idea that “... the fate of the world economy depends on Germany’s Chancellor, Angela Merkel” (see The

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Economist, June 9th, 2012, p.13). It argues that the fate of the Mediterranean stragglers has been compounded by errors in Europe’s creditor countries: their overwhelming focus on austerity, a succession of half-baked rescue plans, the refusal to lay out a clear path for the fiscal and banking integration that is needed for the single currency to survive. Since Germany has largely determined this response, The Economist preferred to pick on Angela Merkel, completely ignoring the fact that the mayhem of the GFC was unleashed in the USA’s Wall Street in the first place. It argued that a “consensus” has developed that Merkel had to shift from austerity to far greater focus on economic growth (ignoring Germany’s strong growth record), complementing the single currency with a banking union (with euro wide deposit insurance, bank oversight and joint means for the recapitalisation of failing banks) and embracing debt mutualisation to cover the mistakes of wayward members. This message has been repeated in several issues of The Economist and refrained in the Anglophone media. It is clear that the interests of the bondholders are deeply involved in this sustained propaganda campaign.

In the world of finance, it is the investors in the bond market (largely sovereign wealth funds, private equity funds, hedge funds and pension funds) which are the “Scarlet Pimpernels” who operate with impunity under cover in the dark pools of the shadow banking system without proper public accountability. They are the financiers of the deficits of government institutions, large companies and banks. They can manipulate interest rates in capital markets by virtue of sheer size, share prices in stock markets through high-frequency algorithmic trading and negotiate secured debt instruments such as covered bonds or derivatives where creditors are first in line to be repaid. They can plunge a country into more debt in order to repay its banking system’s debt. Imposing losses or “hair cuts” on bondholders is not something that meetings of finance ministers are likely to do because of their dependency on bond markets to finance their budget deficits. To avoid moral hazard, bondholders should be required to bear the losses they incur when they make bad loan decisions.

The critical question for Germany is how to safeguard its own national interests. Will Merkel’s demands for austerity and her refusal to bail out her peers in the euro zone bring about structural reform in Europe? Is it appropriate to take the lead to achieve deeper political-economic integration in the euro zone? Deeper integration means handing more decision-making power to Brussels and saddling Germans with the debts incurred by others. It would move the EU at large or the euro zone in particular towards a federal state, with a common fiscal policy and more representative political structures. Berlin argues that European leaders like to talk of mutualising national liabilities, but avoid mentioning sharing national sovereignty. Are the citizens of the euro zone countries uber haupt ready to give up more sovereignty to save the Euro? A process of deeper euro zone integration lacks a clear democratic mandate – not only in Germany, but also in France and other member countries.

Jens Weidemann, President of the German Bundesbank and former economic adviser to Angela Merkel, recently expressed the German perspective as clearly and unambiguously as can be expected from a central banker: “Communalising risks weakens the foundations of a currency union based on fiscal responsibility.” It is unrealistic to expect the German taxpayer to shoulder responsibility for profligate public spending in the Mediterranean countries with workers retiring at ages below 60 whereas Germans have to work until the age of 67 and where workers work fewer hours per week than in Germany. No German government can realistically expect to remain in power when it is pressured by foreign interests to commit Germany to accept such debt and risk sharing – in whatever form it is disguised by deft financial engineering devised in the City of London or in Wall Street, USA. Moreover, it is unrealistic to expect the German economy to successfully carry the burden of lifting the euro zone stragglers out of the economic holes they have dug for themselves. During the first two

148 quarters of 2012, the German economy grew by only 0.3 percent. France, Italy and Spain did not show any growth at all during the same period.

It requires more objective and independent analysis to determine how the responsibility for fixing the economic distress of the euro zone should be apportioned. If the economic future of the world at large is at stake, then it is a problem requiring the serious attention of all stakeholders: creditor nations as well as trading partners and bondholders. In the world of business there are insolvency laws to deal with the distressed assets of bankrupt enterprises and with the status of creditors who may be financiers, suppliers or employees. In some cases it is possible to steer a business out of trouble: cutting costs, mobilising productive assets and nurturing markets for their products and services. Ultimately, it is the discipline of the bottom line that determines success or failure.

Even under the most favourable conditions, the German economy finds itself in a precarious balance. It currently faces the Herculean task to pull its elaborate and highly subsidised carbon emissions reduction scheme into a system providing reliable and affordable electricity. Much could go wrong with this ill-conceived intervention that was initiated by the former left-wing coalition government between the Social Democrats and the Greens. It is doubtful that the German economy would be strong enough to stand behind trillions of euro’s worth of European debt.

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14. The Imperative of Budget Discipline and Monetary Restraint (March 2015)

Since ancient times people have frowned upon debt and also upon payment of interest by borrowers to lenders. In time, money lending and debt itself acquired a negative connotation – as something to be avoided. Initially, borrowing served the purpose of providing bridging finance in the worlds of both private and public finance, but it gradually acquired the function of financing expenditures which were beyond affordable levels.

Historically speaking, warfare was a major reason for governments to incur additional debts, but many advanced countries have committed themselves to unaffordable spending programmes following the downturn of the Great Depression of the early 1930s, the massive spending during the Second World War 1939-1945, the emergence of the “welfare state’s cradle to grave” support programmes in subsequent years and subsequently the splurge of government spending in the wake of the Global Financial Crisis which struck in 2007-2009. Whenever revenues fell short of expenditures, borrowing was required.

In today’s world the level of national debt – which includes government debt, corporate debt, household debt and financial sector debt – has become a subject of great controversy and a source of great concern. It is a matter of great urgency to reform and improve the way debt is created, used, monitored and discharged.

Of particular importance is the chronic budget deficits racked up by governments which resulted in rising mountains of public debt. In the political arena the beneficiaries and generators of debt tend to overlook the negative implications of high debt levels while the fiscally responsible leaders have to face the political backlash of austerity measures.

Why is it imperative to repair the national accounts after a period of chronic profligate deficit budgeting? This challenge can be explained through three questions that are simple to ask but complex to answer: - What is the scope of the public debt problem? - What drives the accumulation of public debt? - What can be done to fix the problem of chronic deficits and rising debt levels?

The Scope of the Public Debt Problem as Part of the National Debt

In recent months McKinsey Global Institute, a London-based consultancy, assembled a very competent research team to collect and assess comparative data on the evolution of debt across 47 countries – 22 advanced and 25 developing. This analysis was published on the internet (www.mckinsey.com/mgi) under the title “Debt and (not much) deleveraging”.

The wealth of comparative data spread over the 116 pages of the McKinsey Report can provide answers to many questions, but it requires technical and contextual insight to understand its policy implications. The quantification of debt burdens also requires a proper clarification of terminology used in relation to the various components of the national debt: government debt (or public debt), corporate debt, household debt and financial sector debt.

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The gross public debt (or government debt) includes all the money owed by all levels of government – central, regional and local – to creditors within a country as well as cross-border creditors. To be accurate this amount should also include contingent liabilities such as contracted future pension payments, guarantees to semi-state institutions and services governments have contracted out but not yet paid for. Figures that do not include these contingent liabilities are not reliable. Government net debt refers to gross debt minus all financial assets – which is an illusive quantum because the extent and nature of these assets must be clearly identified. Because statistics offered by politicians or journalists do not always include all the relevant liabilities or assets in their calculations, such statistics should be handled with caution. Because net debt is difficult to calculate, gross debt as a percentage of GDP is the most commonly used government debt ratio. Governments usually do not have significant financial assets except in countries where sovereign wealth funds or special contingency funds have been created.

It is also important to take into consideration the central bank holdings of government debt. The central banks of the United States, the United Kingdom and Japan have accumulated large positions in their nations’ government debt as a result of quantitative easing policies, holding 16, 24 and 22 percent, respectively, of government bonds outstanding. In January 2015, the European Central Bank announced its intention to start purchasing up to €720 billion ($840 billion) of sovereign bonds per year. Since a central bank’s ownership of sovereign bonds in reality represents a claim by one part of government on another, this debt is essentially an accounting entry. In assessing the risk and sustainability of government debt it is the size of net public debt (excluding holdings by government agencies) rather than the gross figure that really matters. Excluding the bonds owned by central banks, the government debt-to-GDP ratio in the United States declines from a gross level of 89 percent to 67 percent, from 92 percent to 63 percent in the United Kingdom and from 234 percent to 94 percent in Japan.

International comparisons are not reliable when different accounting systems are used. Some systems used “cash accounting” methods whereby expenses are not counted until money is actually paid. Others use the business method of “accrual accounting” in which any future obligations (commitments to pay) are counted as expenses. Governments often rack up enormous future obligations, far beyond their capacity to pay – while the accounts they display to the public look perfectly balanced. Future- blind accounting is highly deceptive.

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Debt to GDP Ratio by Country by Sector/Change 2007-14*

Financial Financial Govt. Govt. Corp. Corp. Household Household Sectors Sectors Country Rank Debt to Debt to Debt Debt to Debt Debt to Debt Debt to Debt GDP % GDP % Change % GDP % Change % GDP % Change % GDP % Change %

Japan 1 400 234 +63 101 +2 65 -1 117 +6 Ireland 2 390 115 +93 189 +90 85 -11 291 -25 Spain 8 313 132 +92 108 -14 73 -6 89 -2 Greece 7 317 183 +70 68 +13 65 +20 5 +1 Sweden 10 290 42 +1 165 +31 82 +18 125 +37 France 11 280 104 +38 121 +19 56 +10 93 +15 Italy 12 259 139 +47 77 +3 43 +5 76 +14 UK 13 252 92 +50 74 -12 86 -8 183 +2 Norway 14 244 34 -16 86 +16 124 +13 93 +16 USA 16 233 89 +35 67 -2 77 -18 36 -24 Canada 21 221 70 +18 60 +6 92 +15 25 -6 China 22 217 55 +13 125 +52 38 +18 65 +41 Australia 23 213 31 +23 69 -1 113 +10 61 -8 Germany 24 188 80 +17 54 -2 54 -6 70 -16 South Africa 32 133 45 +18 49 +2 39 -2 21 -3 Brazil 34 128 65 +3 38 +15 25 +9 32 +13 India 35 120 66 -5 45 +6 9 -1 15 +5 Russia 43 65 9 +3 40 +9 16 +7 23 -4 Nigeria 46 46 20 +7 22 +1 4 +2 3 -1 Argentina 47 33 19 -14 9 +1 5 +2 7 -5

* Based on McKinsey Global Institute, op.cit. Exhibit E3 and Exhibit A2

The above table is based on the data covered in the McKinsey Report in respect of a selected number of countries. It conveys the following information: first, the rank order of countries in terms of their level of indebtedness; second, the percentages expressing the national debt to GDP ratios; third, the percentages of the components of the national debt to GDP ratios (government, corporate, household and financial sector); fourth, it indicates the percentage change (positive or negative) for each component of the national debt for the period 2007-2014.

The overall finding of the McKinsey Report is as follows: “Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.” (McKinsey Global Institute Report p.1)

The McKinsey Report further indicates that debt-to-GDP ratios have risen in all advanced economies in the sample by more than 50 percentage points in many cases. They pinpoint three areas of emerging risk: the rise in government debt, the continued rise in household debt and the quadrupling of China’s debt, fuelled by real estate and shadow banking.

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In relation to government debt, the McKinsey Report states that such levels of debt are unsustainably high in several countries. Since 2007, government debt in the 47 countries surveyed has grown by $25 trillion and is likely to continue rising given current economic fundamentals. Much of this debt has been incurred to finance bailouts and stimulus programmes following the outbreak of the GFC. For the most highly indebted countries, starting the process of deleveraging would require implausibly large increases in real GDP growth or extremely deep “fiscal adjustments” such as extensive asset sales, tax increases and more efficient debt-restructuring programmes.

The McKinsey Report also finds that household debt has been reaching new peaks. Only in Spain, Ireland, the United Kingdom and the United States have households deleveraged. In many others - such as Australia, Canada, Denmark, Sweden and the Netherlands – household debt-to-income ratios have continued to rise, exceeding the peak levels before the crisis struck. To manage high levels of household debt safely, these countries could employ more flexible mortgage contracts as well as tighter lending standards and macro prudential rules.

The rise in China’s total debt, quadrupling from $7 trillion in 2007 to $28 trillion by mid-2014, could be attributed to being fuelled by real estate and shadow banking activities. Unregulated shadow banking accounts for nearly half of new lending and the debt of many local governments. The challenge will be to contain future debt increases without putting the brakes on economic growth.

The McKinsey Report recommends that policymakers need to learn to live more safely with high debt levels. That will require new approaches to manage and monitor it, to reduce the risk of crises and to resolve private-sector defaults efficiently. Policy makers will need to consider more ways to reduce government debt and to re-evaluate how incentives in the tax system encourage the amassing of debt. When there are signs of credit bubbles, regulators ought to seek cooling markets with countercyclical measures, such as tighter loan-to-value rules and higher capital requirements for banks. The Report finds that although debt remains an essential tool for financing economic growth, its usefulness depends on how it is created, used, monitored and discharged.

Drivers of Budget Deficits and Debt Levels

Crisis situations coupled with the “Socialist Welfarism” that permeated the Western World since the Industrial Revolution, have acted as drivers of collective provision and expanded public services in the field of health, education, housing, social protection and aged care. Since the Great Depression of the 1930s and in the wake of the perceived benefits of the Communist economic model after the Second World War, an incremental process of expanding the role of governments in society was set in motion. This growth of public sector services gradually absorbed a growing proportion of the national product, pushing up taxes and cumulative additional borrowing to cover chronic budgetary deficits.

Although most advanced economies have gone a long way towards reaching the objectives of social equality the abolition of poverty by collective action, the costs of these benefits were too easily ignored. The underlying foundations determining the sustainability of the “welfare state” was not properly understood. The ability of countries to pay for these benefits was taken for granted and the need to live within their means was abandoned.

The average level of government expenditures as a percentage of GDP in the advanced economies of the West rose from less than 10 percent before the start of the First World War in 1914 to 18 percent in 1920, 24 percent in 1937, 30 percent in 1960, 40 percent in 1980 and 48 percent in 2009. During

153 the period between the 1960s and the 1990s, “social democracies” witnessed the fastest increase in public spending and tax levels in their history. The growth in spending exceeded the fast increase in tax collection resulting in fiscal deficits which, in turn, spilled over into the piling up of public debt with serious macroeconomic implications. (See Tanzi, Government versus Markets – The changing Role of the State, Cambridge University Press, 2011, p.98)

The United Kingdom is a typical example of the fiscal malaise. Britain’s Labour Government came into power in 1997 on a frugal fiscal policy platform, but soon went on a fiscal splurge raising the state’s share of GDP from 37 percent in 2000 to 48 percent in 2008 and 52 percent in 2010. During Labour’s 13 years in power, two-thirds of all new jobs created were driven by the public sector with pay levels growing more than 50 percent faster than in the private sector. (See The Economist, 23 January 2010, pp.21-23)

During the decade 1997-2007 serious efforts were made by the original members of the European Monetary Union to reduce debt levels in terms of the Maastricht Treaty which set the target of 60 percent of GDP and annual budget deficit levels not to exceed 3 percent of GDP. However, when the Global Financial Crisis struck by the end of 2007, the euro zone debt levels already stood at an average of 66 percent of GDP. It is now expected to reach an average level of 125 percent by the end of 2015.

The case of Greece is a telling example of serial fiscal recklessness. With debts over 175 percent of GDP and consistently declining income levels the country faces insolvency. It expects its euro partners to provide “bail-out” assistance – even including debt “write downs” – while it refuses to impose sensible policies of “austerity” such as reducing spending on the public sector, privatising public assets and reducing tax collection loopholes. Since 2009 Greek unpaid taxes accrued to €76 billion as a result of Greece’s vast underground economy equal to an estimated quarter of the country’s GDP. The OECD estimates that tax evasion in Greece equals about 90 percent of annual tax revenue. During the country’s centuries-long occupation by the Ottomans of Turkey, avoiding taxes was a sign of patriotism. Today this distrust is focused on the corrupt, inefficient and unreliable standards of Greek government. Hence, many Greeks consider taxes as theft. Tax evasion is endemic in the common practice not to record retail transactions. The Syriza party which came to power early in 2015 campaigned on an anti-tax platform. Now it is feared that the Greek economy could collapse if the government forced taxpayers to fully comply with their tax obligations. The vast majority of tax evasion is said to occur among small and medium-sized enterprises whose accounts are seldom audited and who customarily supplement their workers’ pay under the table to avoid having to pay higher payroll taxes. Other employers give their workers special coupons that they can cash in supermarkets, restaurants and for other services. It is difficult to see how this Mediterranean business culture can be reconciled with the North European Germanic standards.

Japan, the third largest economy in the world, is often referred to as an example of how a highly indebted public sector can be coupled with high standards of living. At the end of 2014, Japan’s gross national debt stood at around 400 percent of GDP. But, fortunately, the bulk of this debt has been financed by domestic investors (including the Bank of Japan) so that money required to service and repay the huge debt remains in Japan. Japan has the advantage of huge foreign investments which can be used as assets to offset against its debt liabilities. A major factor in Japan’s rising debt level is the country’s extraordinary low tax levels. In 2013 the government’s total spending on pensions, healthcare, nursing care and family benefits amounted to ¥124.5 trillion, or 26.1 percent of GDP. Government revenue amounted to only ¥59.2 trillion, or 12.5 percent of GDP. Borrowing largely made

154 up the difference. Japan’s debt can easily be reduced by increased taxation, e.g. increasing consumption tax and income tax rates which are the lowest of all advanced economies. It seems Japan is, generally speaking, not keen on adaptive change – they tend to stick with things as they are until they become intolerable.

The Global Financial Crisis (GFC) which struck towards the end of 2007 also substantially expanded government deficits and debt levels. To face the GFC crisis governments focused on the short term: on preserving jobs and electoral support rather than structural reform (such as introducing flexibility in labour relations) or investment in productive infrastructure assets. The already debt-laden countries had been saddled with the weight of expanded government spending and additional debt. Massive amounts were pumped into their economies by way of stimulus packages – mainly to strengthen demand and to contain unemployment. Floods of money were allocated to cash handouts, artificial make-work projects and hiring extra government employees. Only Australia entered the crisis without debt.

As a result of the splurge in deficit spending, practically all social democracies now face the uphill task of repairing their balance sheets – a task that could last for decades into the future. The efforts needed to bring the fiscal situation back to sustainable levels are neither properly discussed nor understood. Public discussions of national accounts are often clouded not only by ignorance of the technical detail, but also by political spin. The magnitude of problems is often obscured by semantics. At what level does the size of the national debt (public and private) become excessive? What strategies are realistically available to reduce excessive debt?

Dealing with Chronic Deficits and Rising Debt Levels

Seven years after the onset of the Global financial Crisis, the majority of advanced economies were still facing sclerotic economic growth patterns, high levels of unemployment and limited prospects of reducing their deficits and debts. The only advanced economies that could manage to produce a modest level of economic growth were the USA, the UK, Germany, Australia, Canada and New Zealand.

The USA could manage modest growth levels largely on account of the expansionary impact of coal- seam oil and gas exploration. Producing significant levels of oil and gas domestically meant a smaller outflow to pay for the import of gas and oil supplies. The UK was well governed by its Conservative Coalition which managed to reduce its deficit government spending and to revive its major financial services sector. Australia and Canada were both well served by their exports of mineral resources such as oil, gas, coal and iron ore – even at reduced export price levels. Germany was also well served by its efficient car and industrial machinery manufacturing industries and singularly well managed public finances to produce a balanced budget in 2014. All the heavily debt-laden advanced economies were facing uphill battles to increase their economic growth prospects.

On the fiscal side there were a number of measures that could be taken to reduce deficits and debt levels: setting “debt ceilings”; refinancing existing debt at lower interest rate levels where possible; extending repayment timetables; negotiating debt write-offs with creditors; adopting more stringent austerity measures to reduce spending levels; raising income and consumption tax rates; and, closing tax loopholes to increase tax receipts.

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The most effective measures would be to simultaneously reduce spending levels and to raise direct and indirect tax levels. However, few elected governments have enough political capital to be able to cut spending and raise tax levels without being punished with electoral defeat.

There are no quick fixes on either the spending or the income sides of the budget. Fiscal sustainability can only be achieved through long-term prudential tax and spend policies supported by informed and balanced community expectations – however politically challenging and technically complex such an objective it may be.

The only real solution lies in generating sustainable, job-creating economic growth. However, countries with chronic fiscal deficits, large piles of debt, low levels of investment in income producing assets generally experience low prospects of economic growth. The main reason is that economic growth generally flows from investment in productive assets. Sometimes expanded consumption of goods and services can also contribute to economic growth, but it is essentially investment in productive assets (whether private or public) that increases national income by a significantly multiplied amount. This amplified effect of investment on income is the “multiplier” effect – the numerical coefficient showing how large an increase in income results from each increase in investment. Primary investment spending can set in motion a chain of secondary consumption expending and reinvestment. High investment goes hand in hand with high consumption and feeds economic growth.

Achieving economic growth is not a simple task. That is why poverty has not been eradicated in today’s world. Although economists are quite adept in measuring economic growth and explaining growth paths ex post facto in general terms, they are not yet able to advise policymakers with certainty how to achieve significant economic growth in specific low-growth circumstances. Subsequent to the Global Financial Crisis, economists were accused that they did not only fail to foresee the looming crisis, they could not agree on exactly what caused the crisis and even had diverging opinions on what needed to be done to solve the problems caused by the crisis. Applied economics is not an exact science.

For many years an intense debate raged between the anti-cyclical demand management school that followed Keynes, the supply side supporters who followed Hayek and the monetarists who followed Friedman. In time all of their proposed recipes for growth were implemented with varying degrees of success because the obstacles to growth are varied and cannot be resolved by simplistic policy frameworks.

Since the onset of the GFC all three of the above approaches were followed by policymakers. Japan, the USA and the UK lavishly applied “monetary easing” by reducing interest rates and by quantitative easing (also known as “printing money”) by way of using their reserve banks to buy government (and other) bonds with newly created money. The idea behind this policy measure is to improve liquidity in the financial system which, in turn, would spur business owners and managers to invest in business expansion and encourage the general public to invest and spend the cheap credit on consumer goods and services. In all three cases quantitative easing was combined with supply-side and demand- creating stimulatory spending. In the USA and the UK these measures succeeded in arresting the decline in their economic growth trends, but it is not clear to what extent it strengthened growth trends because other factors were also in play such as coal-seam oil and gas exploration and public sector austerity measures.

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In the UK the Conservative Government led by David Cameron since 2010, managed to restore sanity to the public finances, although after four years of growth under a Tory-led government, the budget deficit running in 2015 still stands close to £100 billion a year. The Tories are aiming to close the deficit by 2017 by cutting spending, partly reducing benefits and partly imposing savings on government departments. The Tory government also undertook to increase capital projects by around £25 billion per annum.

In Japan, despite their exhaustive efforts to exploit all the policy options of their Economics textbooks, the economy has remained stuck in its twenty-year flat line growth trend. After many years of quantitative easing, policymakers came to the realisation that the Bank of Japan’s ability to continue buying government bonds may run into practical limits. The Bank of Japan’s programme of QE is already proportionately four times larger than that undertaken by the US Fed. The sheer size of the BOJ’s purchases of financial assets is likely to compound the risk of global asset price bubbles. The flood of liquidity is likely to weaken the yen, which is good for exports, but would place pressure on Japan’s competitors such as South Korea. The BOJ already owns nearly 25 percent of Japanese Government Bonds – a level which may cause a distortion of the bond market. Continued easing may inflate asset-price bubbles in Japan, such as the property market without stimulating demand or investment so that the extra money languishes in stagnant pools where it creates obligations without offsetting assets.

The case of Germany represents a unique illustration of the deep-rooted conflict of divergent fiscal and monetary cultures within the membership circle of the euro community. This divergence between the euro zone’s northern members and the Mediterranean members is reflected in the wide differences in their understanding of what constitutes prudential monetary and fiscal policies. Leaving Greece aside as a hopeless case of profligacy and mismanagement, France and Italy have not produced a balanced budget for decades. By contrast, Germany, the Netherlands and the Scandinavian countries are all imbued to some degree with the proverbial “Swabian Hausfrau” economic mindset. It involves a culture of hard work and thrifty spending habits. Although stereotypes never completely fit individual cases, the German model represents taking pride in hard work, opting for quality over quantity, delayed gratification and a focus on long-term goals. Germans are famous for being frugal, hating debt and prizing industrious lives. Wolfgang Schäuble, the German finance minister, a native of Baden- Württemberg, tirelessly tries to persuade his colleagues from southern Europe to adopt the virtues of hard work, self improvement and saving. He insists on structural reform rather than monetary easing to reduce debt levels. The fiscal history of southern European countries such as Italy, France, Portugal, Spain and Greece tells a story of shortened work weeks, chronic budget deficits, disruptive labour relations and mountains of public debt.

The bottom-line reality is that it is impossible for 80 million Germans (even with the assistance of another 60 million of North-West Europeans) to rescue the debt-laden economies of Southern Europe with a total population of around 200 million. The Germans faced an uphill battle when the “Wessies” had to uplift the “Ossies” to their level of productivity. That process involved around 60 million in West Germany absorbing around 20 million persons in East Germany. There are limits to what a minority cohort of “lifters” can achieve in a vast sea of parasitical “leaners”.

In recent months economists have revived the concept of “secular stagnation” – an analytical concept that was developed in the early 1940s by Harvard Economics Professor Alven Hansen. Hansen claimed that a country in the grip of “secular stagnation” experiences a lack of investments to soak up available savings. Weak demand leads to under-consumption and a glut of savings. This combination of over-

157 supply and under-use of savings leads to weak growth which cannot be remedied by the lowering of interest rates by the central banks because interest rates may be already deep into negative territory. Under such conditions monetary policy is virtually powerless and merely floods the market with idle cash.

The stagnating effect of under-used savings is currently exacerbated by demographic changes in many advanced economies. As the population ages, a growing number of retirees tend to stash away more savings for their own aged care. Longer life spans continue to spur savings to still higher under- invested stockpiles. As long as savings are not invested in job-creating growth, economies will remain stagnant.

The McKinsey Report, cited at the beginning of this essay, concluded its analysis with a chapter entitled “Learning to Live with Debt”. Acknowledging that for more than 2000 years debt has been an invaluable means of funding the investments required for economic growth, they list a number of important provisos: - excessive debt repeatedly leads to financial crises; - nations reduce total debt relative to GDP only rarely so that debt ratios around the world today continue to rise; - there is no clear answer so far what maximum level of public and private debt a country can sustain; - whatever the limit is, a clear challenge today is to develop better tools to monitor and manage debt to avoid highly destructive boom-bust credit cycles and resolve bad debt with the least disruption to the economy; - find ways of reducing private sector reliance on debt by removing incentives that favour debt over equity financing; - use countercyclical policies to slow growth in debt when leverage of the overall economy is rapidly rising.

In summary, the McKinsey Report states that “a clear challenge today is to develop better tools to monitor and manage debt, avoid destructive boom-bust credit cycles and resolve bad debt with the least disruption to the economy”. They claim that significant progress has been made in making the global financial system more stable. Banks today have more capital and less leverage and advanced economies have put in place processes to monitor systemic risk. But more can be done to manage risk more effectively, to avoid dangerous leverage and decrease excess debt.

Of particular importance is their recommendation to consider a broader range of tools for resolving sovereign debt. They believe that for heavily indebted governments today, neither promoting economic growth nor pursuing fiscal austerity alone is a plausible solution for deleveraging, given the magnitude of change needed. A broader range of drastic debt resolution mechanisms for governments may be needed such as debt write-offs, restructuring debt and rescheduling debt. Collective action clauses could be introduced to facilitate orderly restructuring by forcing all bondholders to agree to modification by way of a majority vote.

Much depends on whether debt is held by external or domestic creditors and whether the debt has been issued in local or foreign currencies. For sovereign debt held primarily by internal creditors, a restructuring programme could impose heavy losses on domestic banks, pension funds and other local investors, which can have harsh effects on retirees and the broad population. Otherwise, a government

158 may pursue a programme to raise revenue by taxes on wealth and also by large-scale asset sales as a means to pay off debt. Such programmes are likely to lead to serious political upheavals!

Another option mentioned by the McKinsey Report is to rethink the treatment of central bank holdings of government debt. As a result of their active quantitative easing policies, the central banks of the United States, the United Kingdom and Japan have accumulated large positions in their nations’ government debt. The Report argues that government debt owned by the central bank (or any other government agency) does not pose the same threat as bonds owned by private creditors because this debt, “in a sense”, is merely an accounting entry, representing a claim by one part of the government on another. Interest payments on such debt are typically remitted to the national treasury, so the government is effectively paying itself!

The McKinsey Report does not clarify the issue whether allowing central banks to cancel their government debt holdings would be putting the government legally into default. But it should be clear that such action would certainly spark a loss of confidence in the nation’s currency and would lead to uncontrollable market turmoil. A write-down in their value would wipe out the central bank’s capital and is likely to create a storm of financial market turmoil – despite the fact that central banks cannot become insolvent in view of their ability to print money. It is suggested that a simpler measure would be for central banks to simply hold the accumulated government debt in perpetuity and for the broader public to shift its focus to net rather than gross debt. It is self-evident that printing money is not a universal panacea for highly leveraged countries!

Concluding Remarks

There is nothing admirable about facing mountains of debt. This holds true for individuals, businesses and countries – unless convincing claims can be made that the borrowed money has been wisely invested in productive assets and can be serviced and repaid out of realistically projected future income streams. If, however, you have to borrow money to put food on the table for your family, or to pay instalments on your company’s equipment or to pay generous welfare entitlements to the voting public, your financial position would be in dire straits.

The proverbial “man in the street” thinks of money as a store of value and a means of exchange to pay for goods and services. Such ordinary folks are not conversant with the intricacies of the world of finance. They normally rely on political and business leaders as well as properly educated academics to keep an eye on the integrity of the world of finance. When people lose their confidence in the financial system, the consequences could become catastrophic.

A central bank has considerable powers over the size of its own assets, and on the size of the member banks’ cash reserves, and hence on the money supply of the public. Its investments are, in the main, subject to its own initiative and its loans are influenced by the level of its bank rate. The two great powers of a central bank are its power to buy and sell securities (traditionally called “open market operations”) and its power to raise or lower the rate of interest it charges for loans (“bank rate policy”). But the use of these weapons cannot be exercised without limitations because they influence the quantity of money in circulation. By making the borrowing of money expensive, a central bank is likely to have the effect of curtailing economic expansion through the restriction of credit. By making the borrowing of money cheaper a central bank can increase the volume of business which obviously also requires a greater quantity of money (or an increase in the velocity of circulation). But market fluctuations are not solely influenced by the cost and quantity of money in circulation. Lack of demand

159 may play a role and so does the under supply or over supply of goods and services as well as the dearth of investment coupled with a mood of pessimism amongst consumers and investors. When consumers and investors are optimistic about the future, an economy flourishes.

Historical experience has shown that the power of the banking system to stop the inflationary rise of prices appears to be considerably greater than its power of arresting a deflationary fall of prices. No one can prevent the general public from increasing its savings or diminishing its consumption or its investments. The mere willingness of central banks to create new money does not mean that the new money created will actually be spent on growth-inducing investment.

Real economic growth stems from the investments made by entrepreneurs who identify opportunities to start new enterprises or to expand existing enterprises to produce goods and services for which there is a market. These enterprises are normally coupled with new inventions, the discovery and development of new resources or markets and the growth of the population. Each of these stimuli, severally or in combination, opens investment avenues. Whenever there is a lack of balance between savings and investments, or a decline of investment prospects caused by weak population growth, or a decline in employment-creating technological innovation, economic growth trends will decline. Deadweight debt or lavish money creation is not an answer – it only creates obligations without offsetting assets.

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15. Global Growth Patterns and the Risks of Contagion (March 2013)

For much of the past five hundred years the “West” played a predominant role in the history of the world. It served as the mainspring of scientific and technological development and the spread of the Christian religion and its associated cultural characteristics. Today the “rich world” encompasses the West European countries and the United States, Canada and Australia – all countries with per capita incomes of around $40,000 per annum and above. It represents almost 700 million people – around 10 percent of the world’s population.

The “rest” of the world, the other 90 percent of the world’s population, is much poorer, with only a few outliers where per capita incomes are above $10,000 per annum. Around 70 percent of those living in the “rest” of the world have per capita incomes of less than $5,000 per annum. The few outliers such as Israel, the United Arab Emirates, Saudi Arabia, Singapore, Taiwan, Japan, South Korea and Hong Kong have been assisted by their close ties with the “West” by way of occupation, investments and trade.

A major paradigm change started to unfold early in the 21st century. By 2010, in the aftermath of the global financial crisis, the cumulative downward spiral in the Western World generated a circular blame game. Who or what was to be blamed for the malaise? Ironically, there was enough blame to go around: the financial markets for pushing dodgy instruments, the regulators for not insisting on the necessary precautions, the loose monetary policies of the authorities, the excessive spending on cheap Chinese imports, inadequate saving levels in the USA and the UK, the inadequate domestic demand in China and the inadequate funnelling of emerging-market savings into emerging-market projects.

There could be little doubt that the root cause was to be found in the world of finance – particularly the use of derivatives through which finance houses in New York and London could shift risks to other institutions in the form of futures, options, forwards and swops. The complexity of these financial instruments and the ingenuity (if not the cunning) of the derivatives traders called for serious scrutiny of the practices of the banking world: financial institutions that were “too big to fail” and financial instruments that were “too complex to understand”.

Emerging Market Dynamism

For many years the “rest” of the world has been described as the “under-developed” world, then as the “Third World”, thereafter, euphemistically as the “developing world”. Today it is called the “emerging world” and it seems to be entering an era of spectacular growth. Its share of global GDP (at purchasing-power-parity) increased from 36 percent in 1980 to 45 percent in 2008. Emerging market consumers have increased their share of global consumption to 34 percent. Their economic growth rate is expected to outpace the growth rate of the “rich” world by a considerable margin in the next decade. Much depends on continued export-led growth and strong growth in domestic consumption.

Export-led Growth - In the aftermath of World War II the USA provided important market opportunities for Japanese and German manufacturers. In time the Japanese and German development models were followed by France and Italy in Europe and in Asia by South Korea, Taiwan, Malaysia and ultimately also by China. Since 1990 China’s booming economy steadily built its wealth on export revenues particularly based on Western demand. Similarly, since the 1950s, vast volumes of crude oil were exported from the Gulf States to the USA, Europe and the Far East.

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Built on the strong demand in Western countries, the economic transformation of Asia must be considered as one of the most phenomenal developments of the 20th century. Export was the key to Japan’s success and its development model became a template for Asia’s “tigers”. They all prospered on variations of the Japanese model of export-led growth. By emphasising exports, Asian countries replaced reliance on foreign capital with a dependence on foreign demand – particularly Western markets. In turn, Western countries have exported some of their dirty industry to the developing world: steel, cement, fridges, kettles and all the paraphernalia of modern life, the production of which used to cause pollution in developed countries.

In an article entitled “Tamed Tigers, Distressed Dragon” (Foreign Affairs, Volume 88, No.4, 2009, pp.8- 16), B.P. Klein and K.N. Cukier claimed that excessive focus on exports led to economic distortions. Corporate investment, government spending and foreign direct investment flooded into the export sector at the expense of the broader domestic economy. Social goods such as public education, health care, unemployment insurance and social security were neglected. This imbalance is said to explain why Asians save as much as they do: “self-insurance” to protect themselves. A typical household saves between 10 and 30 percent of annual income. National savings, including government and corporate savings, amount to as much as half of GDP. The authors claimed that thrift, which is normally a virtue, becomes a vice pulling money away from consumption where it could be used to improve people’s living standards and their countries’ overall economies. They also argued that lending within Asian countries was disproportionately oriented toward powerful economic and political interests such as state-controlled and family-owned enterprises and mega-conglomerates.

In China small and mid-size firms represent 70 percent of GDP, but tap only 20 percent of the country’s financial resources. They claim that too much power is concentrated in the hands of elites in Hong Kong, Malaysia, Singapore, Philippines, South Korea and India. The concentration of wealth and power has contributed to weak corporate governance across the region. It has stunted the growth of Asia’s middle class which, in turn, curtails private consumption and wages as a proportion of the region’s overall GDP. In China, where exports and corporate earnings soared between 1997 and 2007, wages actually declined from 53 percent to 43 percent of GDP.

Government’s Role - Klein and Cukier claimed that centralised planning was suppressing entrepreneurship and more robust domestic growth in Asia. The Chinese government still owned 76 percent of the country’s wealth. It controlled the banking sector and oversaw state-owned enterprises that accounted for one-third of the economic output. Likewise in India, where the government had dismantled the jumble of rules known as the “licence raj”, red tape continued to strangle business activity.

Many emerging countries rely heavily on state-owned enterprises which partly resemble the European trading companies of the 16th-19th centuries, such as the Dutch East India Company and Britain’s East India Company. They borrow money from government at subsidised rates, have ties to central and local authorities and enjoy legal privileges. These enterprises are prominent in the energy and resources sectors. The world’s 13 largest oil companies (measured by reserves) are all controlled by governments. China’s largest companies are all state backed or hybrid companies. It is not clear whether they are responsible to the government or to the marketplace. They are subject to political meddling, are considered part of the state’s “strategic” interests and are used to oil the ruling party’s patronage machine. Foreign businesses find it hard to know whether to treat them as businesses or as arms of government.

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Recycled Surpluses - During the past two decades, enormous financial surpluses were realised by the major exporting countries, particularly Japan, China, South Korea, Taiwan and the oil-producing states of the Persian Gulf. These surpluses were consistently recycled back to the West in the form of portfolio investments at investment banks in Wall Street and the City of London. These financial centres were considered to be the most developed financial markets offering the best and safest returns. In most emerging countries, the local financial markets were relatively “immature” in the sense that they did not offer enough trustworthy savings vehicles to absorb the savings glut. The USA, and to a lesser extent Britain, were considered favourite destinations for global capital flows on account of their broad and liquid markets for securities.

As the USA was sucking up vast amounts of savings from abroad, its own current account plunged into the red. The USA needed to borrow from abroad to pay for its deficits. A by-product of the vast trade surplus in China was the piling up of reserves of US dollars which Beijing then placed mostly in US government securities as well as in quasi-government securities such as Fannie Mae and Freddie Mac.

Sources of Global Growth - The global recession sent the economies of the rich world into a tailspin, but merely caused the emerging economies to slow down somewhat. Developing countries subsequently started recovering much faster than the sclerotic “rich” world. According to the IMF virtually all of the world GDP growth in 2009 (measured on a purchasing-power basis) came from developing countries. The advanced economies outside the USA were expected to be a drag on global growth in 2010. The IMF also predicted that by 2015, around three-quarters of global growth will come from China and other developing countries.

In a special report on innovation in emerging markets called “The World turned Upside Down”, written by Adrian Wooldridge (The Economist, April 17th, 2010), it was stated that developing countries were becoming the hotbeds of business innovation, reinventing systems of production and distribution and experimented with entirely new business models. The Economist claimed that the world’s centre of economic gravity was shifting towards emerging markets. Over the preceding five years China’s annual growth rate had been more than 10 percent and India’s more than 8 percent. They were producing breakthroughs in everything from telecoms to car making to health care. They were redesigning products to reduce costs by wide margins. By redesigning business processes, they did things better and faster than their trade union dominated rivals in the West.

The emerging world’s growing ability to make established products at dramatically lower costs – called “frugal innovation” – is based on the principle of redesigning products and processes to cut out unnecessary costs. Entrepreneurs in the developing world are applying the classic principles of division of labour and economies of scale to new areas. They are combining technological and business-model innovation to produce entirely new categories of services.

The Chinese are using flexible networks – powered by guanxi or personal connections – to reduce costs and increase flexibility. They rope in networks of thousands of companies operating in dozens of countries to create customised supply chains and to serve as partners to help solve problems. The Chinese also excel in “guerrilla” innovation, known as shanzhai. It involves “parasitizing” on existing information networks or technology by ingenious copying, or modification or forcing technology transfer on foreign suppliers trading in China.

Indians rely on their tradition of jugaad – meaning making do with what you have and never giving up. Their “frugal” products on the market are growing rapidly: cheap mobile handsets, small cars, small

163 fridges, low-energy stoves. They produced the business model of “contracting out”, using existing technology in imaginative ways and to apply cost-cutting mass-production techniques in new and unexpected areas.

Shifting Centres of Economic Gravity - As the slow-growth rich world lumbers on, emerging market leaders are advancing faster and gobbling up investment opportunities in many parts of the world. Western consumers and governments have been on a debt-fuelled spending spree for many years. The Economist reports that American household debt rose from 65 percent of GDP in the mid-1990s to 95 percent in 2009. The American government was cutting taxes and raising public spending even before the recession struck. The British government increased public spending from 35 percent of GDP in 2000-01 to 43 percent in 2009-10.

The IMF reported that the scale of write-downs on loans or securities that banks worldwide would have to make between 2007 and 2010 amounted to $2.3 trillion. Of this amount more than 95 percent of the write-downs involved the “rich” countries in the West. Less than 5 percent involved emerging countries. But the IMF cautioned that mortgage delinquencies continued to rise in the USA where almost a quarter of American borrowers owe more on their mortgages than their houses are worth. By early 2010 Western governments and households were placed under growing pressure to put their financial houses in order. Consumers started cutting back on their spending in the face of high unemployment levels and shrinking wealth. It became necessary to rediscover the connection between effort and reward and to reduce the number of people subsisting on state benefits.

Historically, big financial crises have been followed by long periods of slow growth and economic malaise. Oliver Blanchard, the IMF’s chief economist, predicted that painful retrenchment in Europe could last for 20 years. As growth headed south, debt headed north. Comparative analysis of concentrations of investment wealth also shows a gradual shift from west to east. Governments in Asia and oil exporters control some US$7 trillion of financial assets – most of it in currency reserves and sovereign wealth funds. Some analysts predict that the total of such funds could reach US$15 trillion by 2013. That would make government-controlled funds a large force in global capital markets with the equivalent of 41 percent of the assets of global insurance companies, 25 percent of global mutual funds and a third of the size of global pension funds. Capital-starved western banks seem to be desperately seeking cash infusions from eastern sovereign wealth funds and other state-controlled investors. The Economist of January 18th, 2008, published the following information about the scope of sovereign wealth funds (US$ bn): UAE 875, Singapore GIC 330, Saudi Arabia 300, China Investment Corporation 200, and Qatar Investment Authority 50. Concentrated ownership by authoritarian governments is a serious strategic as well as an economic concern.

A report by Capgemini, a Merrill Lynch Global Wealth Management firm, claims that of the total world’s population of approximately 7 billion, around 10 million are high net worth individuals (i.e. persons with investment assets of at least US$1 million excluding their residential homes). These high net worth individuals are distributed as follows: USA 2,866,000 Japan 1,650,000, Germany 861,000, China 477,000, Britain 448,000, France 383,000, Canada 251,000, Switzerland 222,000, Italy 179,000, Australia 174,000, Brazil 147,000 and Spain 143,000. The global average wealth of the world’s millionaires stood at US$3.88 million and their total wealth stood at US$39 trillion in 2009. The total wealth of Asia’s 3 million millionaires (largely concentrated in Hong Kong and India) surged to US$9.7 trillion in 2009, compared to the US$9.5 trillion held by Europe’s richest. (See The Australian, June 24th, 2010, p.25)

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In contrast with the sclerotic West, China and India, in particular, have become the world’s two biggest construction sites. Their populations are much bigger than all the developed countries added together and growing much faster. Asia’s population is expected to change from around 4 billion in 2010 to 5 billion in 2030; Africa’s from around 1 billion in 2010 to 1.5 billion in 2030; Europe’s from around 800 million in 2010 to 750 million in 2030; Latin America’s from around 650 million in 2010 to 800 million in 2030; and, North America’s from around 350 million in 2010 to 450 million in 2030. In the emerging world hundreds of millions of people will enter middle class levels in the coming two decades. Their economies are set to grow faster too. Brainpower too, will be relatively abundant. This combination of challenges and opportunities will produce an unstoppable momentum of creativity. (See Adrian Wooldridge, “The World Turned Upside Down”, The Economist, April 17th, 2010, Special Report, pp.1-16)

The Volatility of Global Financial Markets

For many generations, from the late 17th to the mid-19th century, English and American securities markets were heavily regulated. On both sides of the Atlantic, both authorities and the general populace were ambivalent about speculative activity. Such activity was either illegal or tightly regulated. The wider population has largely been suspicious of the power and practices of financial professionals. Rules were made against deception and price manipulation.

In recent decades, financial innovation has proceeded much faster than regulatory practices. Hedge funds and private equity funds have ballooned to account for trillions worth of assets world wide. They also bear responsibility for the precarious volatility of global financial markets. Complex new products that are created in one financial centre involve assets in another and are sold in a third.

Capital markets are racing ahead of the regulators which remain rooted in their national systems. Financial firms are straddling borders, using technology that has made electronic transactions faster and cheaper – also making regulatory barriers less visible and transactions riskier. Risk is being dispersed more widely across geographical areas, financial institutions and investors. This dispersion, the argument goes, allows the financial system to absorb the stresses of the rapidly growing system. But the experience of the recent global financial crisis has shown that the dispersal of financial risk also carried the germs of a contagious global financial disaster.

Predominant Financial Hubs - Although many cities like Zurich, Paris, Frankfurt, Dubai, Singapore, Tokyo, Mumbai, Hong Kong and Shanghai promote themselves as financial hubs, New York and London are by far the leaders of the pack. They score well on a package of key attributes that global financial firms are looking for: plenty of skilled people, ready access to capital, good infrastructure, attractive regulatory and tax environments and low levels of corruption. Location and use of the English language, the language of global finance, are also important. In terms of these criteria, New York, London and Hong Kong are considered as the world’s top three financial centres.

Governments are paying much attention to wooing and keeping financial firms because of the benefits they bring with them: highly paid jobs, large tax revenues and international connections. Such cities are teeming not only with banks and exchanges, but also with legal, accountancy and public-relations firms and consultancies.

New York and London are ahead of the others by a large margin. They dominate their own national markets and surrounding regions. Their success generates a “network effect” that creates a cumulative

165 momentum for more success: air link and communications networks, sound legal systems, robust financial exchanges, multinational talent pools, attractive lifestyles and playgrounds for rich financiers and fluent English language facilities. Nearly 15 percent of New York’s workforce is employed in the financial sector. Slightly more than 15 percent of its gross output comes from the financial sector as did more than one-third of its tax revenue in 2006. The New York Stock Exchange is by far the world’s biggest market for share trading. NASDAQ, its other big stock exchange, deals mainly in technology and start-up companies on a global scale. Together the two stock exchanges accounted for nearly 50 percent of global stock trading in 2006. It houses more hedge funds and private equity funds than any place on earth. It handles around 40 percent of the world’s private-banking and wealth-management business.

London’s roots as a centre of commerce stretches back many centuries, when the sun never set on the British Empire. In the early 1960s, London’s status as a financial centre was in gradual decline, reflecting Britain’s waning importance in the global economy. Then the American government helpfully imposed regulations and tax levies that encouraged investors to hold a lot of dollars offshore. These interventions enabled London to develop a lucrative offshore lending business (the Euromarket). Over the years, London built on that opportunity by welcoming foreign market-makers and by offering a regulatory structure that seemed more appealing than those on offer in Paris or Frankfurt. Favourable tax laws encouraged the global elite to spend part of their time in Britain. In 1979, when exchange controls were scrapped, the free flow of capital opened the city to broader international markets. The “Big Bang” reforms introduced by Margaret Thatcher in the mid-1980s modernised the City of London’s financial practices and lured a host of big American banks to London. A plethora of financial regulators were replaced by a single authority, the Financial Services Authority (FSA) that oversaw all of London’s financial markets. The old city’s “Square Mile” expanded to Canary Wharf in the old docklands area of east London. Heathrow became the destination of more than 70 million passengers per year as London became a hub in areas such as fund management and derivatives trading.

London supporters claimed that it surpassed New York in structured finance and new stock listings. It accounted for 24 percent of the world’s exports of financial services (against 40 percent for all of the USA). It had a two-thirds share of the European Union’s total foreign-exchange and derivatives trading and 42 percent of the EU’s share trading. The London Stock Exchange (LSE) claimed to be the world’s “most international capital market by a considerable margin”. (See Julie Sell, “Magnets for Money” – a special report on financial centres, The Economist, September 15th, 2007, pp.3-11)

Although the financing services of New York and London provide a dizzying array of financial products, they also exercise inordinate power and influence over the ebb and flow of international finance. Sometimes they acted as a force for good, but also, in recent times, as a force for manipulation and destruction.

Regulating Financial Centres - Regulators, who are generally appointed by and report to national governments, are expected to keep financial practices under control. But the complexities of rapid trading, particularly across multiple borders and asset classes, are exceeding the capacity limitations of even the most advanced regulators. Increasingly, financial institutions have choices about where they do their transactions, list their shares and keep their staff. The practice of “regulatory arbitrage” means that financial firms look for the most favourable environments to conduct their operations and to locate their staff. Thus regulatory regimes inevitably play a major part in deciding where to base

166 themselves. By the end of 2007, it became commonplace to talk about the possibility of London replacing New York as the world’s financial centre.

In September 2007, when The Economist published its special report on financial centres, it stated that “current American financial regulation – divided among many agencies at both federal and state levels – strikes many firms as complex and confusing” ... and that there are worries in financial circles that New York “... may be losing some of their business to financial centres abroad” such as London. The report also states that the Sarbanes-Oxley act “... passed five years ago, which imposed far tougher controls on public companies, is also often blamed for making America a less attractive place for doing business”.

In contrast, Britain’s financial regulatory system was considered to be more “user friendly”, based on “broader principles” and a “risk-based” approach. Stocks, futures, banking, insurance and over-the- counter products were grouped under a single regulator, the Financial Services Authority (FSA). (See Julie Sell, The Economist, op.cit., pp.21-22)

After the onset of the Global Financial Crisis, the UK’s regulatory system came under severe scrutiny: its cosy relationship with financial institutions based on dialogue rather than strict discipline and also its insider trading practices embedded in the old-boy network. In June 2010, the new Lib-Con coalition government’s George Osborne announced that the FSA was to be recast as a subsidiary of the Bank of England. In anticipation of the EU’s plans to revamp the financial regulation of banks, securities and insurance, George Osborne announced attacks on banks’ short-term financing, e.g. overnight interbank borrowing, generally used by banks to finance speculative bets. In late 2008, when banks stopped extending short-term loans to each other, it led to the cumulative freezing of global credit markets. It became obvious that the functioning and structure of the UK’s financial system required fundamental reform. Viewed from the British perspective, it also became clear that the only thing worse than relying heavily on the City of London, is not having the City (and its “locusts”) at all.

In Search of Better Regulation - Under the caption “London risks losing its global appeal”, The Economist, December 19th, 2009, pp.111-112, described some of the post GFC woes facing the British taxpayers. After punching above Britain’s economic weight as a financial centre for several decades, commentators observed that London’s position was threatened on various fronts. Several polls showed that Singapore, Shanghai and Zurich could challenge the prominence of London within the next decade.

According to information provided by The Economist of December 19th, 2009, Britain took the lion’s share of EU- wholesale finance in 2008. Of the total amount of €218.7 billion, the distribution was as follows: Britain - €79.4; Germany - €28.6; France - €23.5; Italy - €15.1; Netherlands - €14.2; Spain - €13.8; and Ireland - €11.8. It was also stated that Britain collected the lion’s share of any tax collected from the “nomadic non-doms” – the itinerant hedge-fund and equity-fund managers and overpaid bankers. According to The Economist, the British government estimated that the top one percent of all taxpayers (many of whom work in finance or related industries) would pay 24.1 percent of all income tax revenues in 2009-10. In the decade before the crisis, financial companies were paying 20-27 percent of all corporation tax receipts.

Anger at the bankers’ and financiers’ bonuses became widespread in Britain, the USA and elsewhere in the world. Even Pres. Obama was reported to have said “I did not run for office to be helping out a bunch of fat-cat bankers on Wall Street”. Britain responded with a special levy on bonus payments. In

167 the USA the question of reforming the financial system remained bogged down in endless congressional hearings and political posturing.

In both the UK and the USA, the financial system constitutes the lifeblood of their economies. It is vital that its pathology be properly diagnosed and treated. There are no simple cures, but several remedial regulatory measures are available: raising the size and quality of capital and liquidity buffers banks must carry; lifting the accountancy and reporting standards to determine the fair value of loans on their books and the transparency and reliability of their accounting information; reducing the structural reliance of banks on short-term funding; removing the low quality and dodgy financial instruments from the core capital of banks; shrinking or breaking up financial giants that are “too big to fail” and causing “moral hazards”; barring banks from proprietary trading and from owning hedge funds and private equity firms; establishing industry-financed funds and resolution regimes to deal with failing firms; lowering implicit government support for failing firms; and, raising the standards or requirements for granting credit in all financial institutions. The challenge is to keep the financial system as free as possible without giving free rein to the raconteurs and racketeers.

In a leader article dd. 19th December, 2009, The Economist stated that: “London now risks losing its reputation as a hub of international finance, driving away mobile capital and taxpayers at a time when the government’s deficit is above 10 percent of GDP.” Unfortunately, The Economist did not focus on the much more serious dilemma – the international ramifications of global financial hubs that are not subject to effective supra-national regulatory scrutiny. Under the status quo, the manipulators of the capital markets in New York and London effectively manipulate the capital markets of today’s world. Perhaps more daylight on the identity, structures, assets and modus operandi of the financiers would be helpful. More transparency would restore a sense of trust and confidence.

Offshore Finance and Tax Havens - In recent years widespread anger increased against wealthy individuals and big firms using offshore financial centres as tax havens by using clever accounting tricks to book profits in tax havens while reducing their bills in the countries where they do business. In 2012 the USA passed the Foreign Account Tax Compliance Act (FATCA) which forces foreign financial firms to disclose their American clients. The main focus of the anti-tax-haven campaign is to ensure that wealthy individuals and international companies pay their dues. It also requires that the countries involved should clean up their own backyards and reform their tax systems.

Tax havens are generally looked upon as places that try to attract non-resident funds by offering light regulation, low or zero taxation and secrecy. Around the world there are 50 to 60 such tax havens serving as domiciles for more than 2 million companies, thousands of banks, investment funds and insurers. Nobody knows how many millions of individuals are involved or how much money is stashed away. Estimates range to as much as $20 trillion. (See The Economist, February 16th, 2013, pp.3-16)

The list of such offshore centres or tax havens ranges from distant islands such as Cayman Islands, Bermuda, Virgin Islands, Channel Islands, Isle of Man, Mauritius, Seychelles, Marshall Islands, to onshore cities such as Singapore, Panama, Miami, Dubai, Lichtenstein, Luxembourg, Hong Kong, or to whole countries such as Switzerland, Israel and Monaco. Even the City of London would be looked upon as the pioneer of offshore currency trading in the 1950s and still helps non-residents to get around the rules by providing shell companies and limited-liability partnerships. Money laundering has continued unabated for many decades in the various financial centres.

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The boundary lines between illegal (money laundering and tax evasion) and legal (fancy tax avoidance) activities are faint and shifting. These practices lack transparency in relation to the use of nominee shareholders and the provenance of money – thus hiding the true beneficial owners of companies and funds. Transparency will help curb all forms of corporate tax avoidance such as “transfer pricing” and force companies to book activity where it actually takes place.

The Complexity of Contagion Risks

The very scope and reach of the integrated global markets create financial risks on an unprecedented scale. These dangers result from the inter-connection of currency markets, interest rates on bonds, stock market prices, along with the growth of ancillary markets. Contagion can sweep through the world’s markets in hours – endangering the economic stability of the entire world.

Over the recent three years, the complex global economy changed from boom to bust conditions. Some American borrowers defaulting on their sub-prime mortgages caused highly leveraged financial institutions to flounder. When pessimism set in, a self-reinforcing downward spiralling collapse of confidence was set in motion. As asset prices fell, people spent less, businesses postponed investments and reduced employment expansion. As liquidity and credit facilities declined, a value-destroying uncertainty took hold. Forced asset sales drove prices down and markets went into a regressive tailspin.

The failure of investment bank Lehman Brothers, and the losses that spilled over to money-market operators that held their debt, prompted a global run on wholesale credit markets. As it became harder for even healthy banks to find finance, businesses were cut off from all but the shortest term financing. So the credit freeze spilled over into the prospects of the real economy, which in itself added to concern about the solvency of banks – which in turn, raised the spectre of runs on banks.

Central banks reacted to unblock clogged credit markets by buying commercial paper from companies or by guarantees for debts issued by banks. Governments intervened to guarantee the security of bank deposits and by way of fiscal and monetary policies tried to cushion the negative effects of the economic fallout: unemployment, residential property foreclosures, tumbling stock markets and the rise of poverty. Stimulatory packages were introduced to boost demand, including “pump-priming” through government deficit spending. The monetary side involved the control of the volume of money supply by banks and by the lowering of interest rates. To restore confidence required fixing the financial system and addressing market failures.

As the debt levels of governments kept piling up, a new set of problems arose: perceptions of failure and expectations of sovereign debt default. Investors in government bonds demand higher interest rates if expectations change about future government solvency, intensifying an already bad fiscal crisis by driving up interest payments on new debt – thereby plunging a country into fiscal and political crisis.

This scenario played out in the case of Greece in early 2010. Anxiety about Greece spilled over into concerns about the state of public finances in Portugal, Ireland, Spain, Italy and potentially also the UK. Each country suffered under some combination of big budget deficits and high public debt levels.

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