Debt is Bad, Debt is Good – Has Cameron signalled a Plan A+ re infrastructure spending?

At the same time as Kate Henderson was giving speech on the TCPA’s new report calling for new funding mechanisms (off government balance sheet),  for new housing/Garden Cities David Cameron was giving his big economics speech to the IoD, where he hinted at just such mechanisms.

I say ‘economics’ with some caution as I expected to read the speech for any economics ideas rather than just crude sloganeering, and 90% of the speech is just such self-justifed sloganeering with phrases such as:

‘we must resist dangerous voices calling on us to retreat. Yes, we are doing everything we can to return this country to strong, stable economic growth. But no, we will not do that by returning to the something for nothing economics that got us into this mess.

We cannot blow the budget on more spending and more debt.’

But read between the lines, these phrases are there to give the political impression of no u-turns, that plan A is being kept to.  But what is noticeable there is no attempt whatsoever, as Osborne did in speechs when the coalition did when it took office, attempt to expand any concept of ‘expansionary fiscal contraction‘ as economic justification for an austerian fiscal policy, that private consumption will rise with austerity because consumers will expect to be taxed less to pay for higher debt servicing costs in the future.  That theory, which the Treasury Taliban so pressed on the ‘Quad’ when they took office is in intellectual tatters.  It simply has not been borne out by events.  There are two factors at play here, firstly not just austerity but change in debt throughout the economy has depressed aggregate demand in the economy.  Banks are unwilling to invest and expand private credit and hence overall demand because of the weak outlook.  Secondly the expansionary fiscal contraction theory was based on high government debt leading to high debt servicing interest rates, and the debt dynamics of these high interest rates overriding any impacts on demand from austerity.  But for countries that enumerate those debts in their own sovereign currency – like the UK, Japan and US – interest rates have fallen not risen, they are in the UK lower than at any point since the 16th Century.  Cameron’s Speech does not make the easy attack that Greece shows us the way ahead for Britain if we dont reduce debt.  I imagine because Treasury and BoE economics now understand what nonsense that idea is – because of course the euro periphery does not enumerate debts in their own currency.  Why are interest rates so low?  Well its a classic example of where new economics has got it right and neo-classical economics have got it wrong.

As Wilhem Buiter wrote in the FT last Week

As with Japan, the fiscal positions of the UK and US have become much worse since the crisis. Yet, as in Japan, these two governments have managed to borrow far more cheaply than they could before the crisis…Importantly, bond yields have continued to fall in these countries even after central bank buying of government bonds has ceased…. bond yields have continued to fall in these countries even after central bank buying of government bonds has ceased….

Countries with huge fiscal deficits are being rewarded with huge falls in bond yields. Is that the wages of virtue? Surely, this ought to disturb those right-thinking people who have frequently foretold a bond market meltdown in the UK and, still more importantly, the US.

What, then, is going on? What are markets telling us? The most important thing they are telling us is that the conventional view of the relationship between fiscal deficits, debt and interest rates is nonsense in balance-sheet recessions.

The best explanation of this lies in the work of Richard Koo, Chief Economist of the Nomura Research Institute in his book, The Holy Grail of Macroeconomics (John Wiley, 2009). He updated the argument in a presentation he made at the April 2012 conference of the Institute for New Economic Thinking in Berlin.

In essence, Mr Koo argues that the experience of the US and UK looks like that of Japan because it is: all these countries are experiencing balance-sheet recessions.

During asset price bubbles and, in particular, property bubbles, credit and debt explode unsustainably. After these bubbles burst, businesses and households are left with what they now believe to be excessive debt. Moreover, the financial system is also damaged by the same process of deleveraging. In this environment, businesses and households seek to run down their debts by trying to ensure that they spend less than their incomes. The result is the threat of a huge contraction in aggregate demand.

If affected economies are to escape deep depressions, they need huge swings either towards current account surpluses or towards fiscal deficits, as vents for the excess desired savings of the private sector. If the government reacts to its deficit by trying to eliminate its deficits too quickly, domestic demand will collapse. This is particularly true for relatively large and closed economies (such as the US or even the UK), which are unable to shift their external balances swiftly, other than via depression-induced collapses in imports.

The iron law of balance-sheet recessions is, in brief, that it is impossible for every sector of the economy to run a financial surplus at the same time without a collapse in aggregate demand.

This is the story for aggregate demand. But it has, of course, a direct corollary in the demand for assets.

By running a large financial surplus in order to deleverage and improve net worth, the private sector generates a huge aggregate excess demand for the financial liabilities of other sectors, domestic and foreign. For a country with a floating exchange rate, some combination of two things must then happen: a fall in the exchange rate and/or a rise in the price of the other domestic sector’s liabilities. But the latter sector is, of course, the government.

One would, therefore, expect to see a huge increase in demand for the liabilities of the government. That is exactly what we do, in fact, see. This is why bond yields collapse even though the supply of government bonds explodes: both are the direct consequence of the balance-sheet induced weakness in private sector spending and its move into huge financial surpluses.

So the private sector looking for a safe haven has high demands for government bonds.  Given the low interest rates it would be a good idea to invest no.

There is good debt and bad debt, debt which fuels speculation and consumption which will not in the medium – long term create net assets and growth, and good debt, debt spent on investment on assets such as infrastructure which does create long term growth.  Some of these non-neoclassical ideas must be getting through the thick skulls of the Treasury Taliban because Cameron’s speech only attacks the former types of Debt not the latter.  Indeed he specifically states:

 I welcome the opportunity to explore new options for such monetary activism at a European level, for example through President Hollande’s ideas for project bonds.

Cameron didnt mention it but Hollande was imply backing an EU idea.

The aim is to attract institutional investors to the capital market financing of projects with stable and predictable cash flow generation potential by enhancing the credit quality of project bonds issued by private companies.

As the PM mentions in his speech that he wanted to

pass on the benefits of low interest rates to businesses and families. We have the credit easing programme for small businesses we have mortgage help for people who want new homes and then there are the guarantees for new infrastructure projects.

I want us to go further, so I’ve asked the Treasury to examine what more we can do to boost credit for business, housing and infrastructure.

So the idea here is to to directly inject money into the economy to underwrite private sector credit creation, using government guarantees secured through low interest rates and the UKs long terms debt funding.

This would only work though if the assets created through investment accrue in value, if the aggregate demand being sucked from the economy through austerity is greater than the boost to the economy from the investment which supplies demand to assets then austerity will still prove counterproductive.  The second problem is that in trying to shift expenditure off government balance sheets it requires infrastructure which has positive externalities to privatize and charge service users at a price which recovers the debt rather then marginal cost  – this simply results in much more expensive infrastructure debt financing, a price paid for by consumers and future generations.  It might make much more sense for this debt to go on the government balance sheet.  The obsession with government debt alone neglects the contraction in spending from consumers paying for high costs infrastructure and deflating future taxation receipts.

So there are important shifts in economic thinking at the Treasury, being held back however by the need to provide political cover for failed osbournomics. A full plan B is awaited.