Winners and losers from the credit crunch - August 2008

As I travelled up to Scotland in 1997 with Gordon Brown to speak at a Labour Party event about a month before New Labour’s landslide victory in May 1997, he asked me whether I would make the Bank of England independent. I said on reflection I would probably not, as I would not trust the money men in the City with the economy.

He has never listened to my advice since either.

I believe it is in fact a good idea to take the printing of money away from politicians with an independent Central Bank, as long as this is not a total surrender of economic policy to an un-elected body. But, unfortunately, that state of affairs is more or less what we have today. As Labour felt the need to counteract its former image of the “tax and spend” party, it delegated its responsibility for macro-economic affairs largely to the Bank of England and the Monetary Policy Committee.

No-one had any interest in admitting in the following years that lower inflation measured by the Retail Price Index (RPI) was not brought about by any action they took – let alone the fact that the Bank had become independent. The internationally benign inflation scenario was caused by the opening of Eastern Europe after the collapse of the Soviet empire and of the Asian and South American markets through the GATT free trade agreements. All this caused an enormous surge of low-cost traded goods and services outstripping any normal demand.

This is what is called globalisation and it is the true reason for low inflation in the last decade. Global issues will also be at the root of higher inflation in the future, whatever the Central Banks do or don’t do.

Central Banks’ influence over inflation through varying interest rates has no direct effect on the price of oil, gas, wheat, rice or copper.

Central Banks still believe that, even if they cannot influence “international inflation”, they can at least influence second-round “home-grown inflation”, brought about by subsequent wage rises. That concept makes little sense: consumers who are already hit by commodity and energy price rises are doubly handicapped by higher mortgage costs. Far from bringing wage induced inflation down, such interest rate increases strengthen the likelihood of trade unions launching strikes for more money, wherever the chances of success are best, namely where employers can’t set up businesses in cheap countries. I predict that the public sector will become a battlefield over such action in due course.

Interest rate hikes in such an environment can have an indirect effect through influencing exchange rates and thus easing or worsening the effects of “international inflation” in local terms. While the rising oil price has had a direct effect on US consumers, the appreciation of the Euro and sterling appreciation against the dollar have cushioned the impact on the UK and the rest of Europe.

Central bankers are meanwhile clinging to the belief in their omnipotence. The Anglo-Saxon Central Banks in particular failed miserably during the last decade, as they could have curtailed the exuberance of the private household credit explosion in time by killing off the excesses of home-made asset inflation in the housing market.

Alan Greenspan has a lot to answer for. As a Republican with a Republican in the White House, he probably felt obliged to support the apparent economic miracle of uninterrupted growth. He was also a Wall Street banker and supported his clan in their incredible amassing of wealth and the contamination of the world’s financial services industries through the highly debatable selling of trailer park mortgages. He and many of his admirers believed he was infallible.

On this side of the Atlantic a Labour chancellor and his main advisor watched the US miracle unfold and bought into it hook, line and sinker. The philosophy was: Who needs manufacturing and the smokestack industries of “Old Europe”, when one can have the City with its vibrant financial services? 

Had the United Kingdom become a member of EMU and adopted the Euro, would things have been different? I doubt it. The examples of Ireland and Spain show that home-made asset price inflation and private household debt surges were not tackled in time. They are paying for it now and are causing strains across the EMU area.

The so-called “one size fits all” policy of a common interest rate throughout the EMU zone did nothing to prevent it, and indeed was one of the main causes of this outcome. The Irish and Spanish  governments stood idly by, hoodwinked by relatively low inflation and bathing in the sunshine of an economy growing faster than that of its neighbours. They could of course have taken appropriate fiscal action, smothered the excesses of the boom and stored budgetary proceeds for a rainy day – but, in typically short term politicians’ fashion, they did not do so.

The Maastricht target of curtailing new government debt to a maximum of 3% of Gross Domestic Product was a typical German demand, as the underlying assumption is clearly that governments’ excesses can bring about inflation. It was wrong in two ways. First it did not take into account of the fact that private household debt increases could have a similar inflationary effect. Second, the Maastricht procedures did not foresee that inflation would be (temporarily) extinguished by globalisation.

In the UK in 11 years under Labour private household debt has increased from £500 bn to £1.4 trn. The increase can be broadly split into mortgage debt of around £750 bn and credit card and other household debt of £150 bn. It is fair to assume that about a third of the mortgage increase has gone into consumption – from holidays to cars and new kitchens – in other words £250 bn of the £750 bn. When this is added to the £150 bn other debt increase, it is clear that, in the UK over the last 11 years, the astonishing sum of £400bn has been channelled into consumption purely financed by credit - around  2% of GDP annually.

In previous – pre-globalisation – times that would have resulted in huge inflation; because of the influence of globalisation,  it has now resulted in huge imports and a catastrophic balance of payments deficit. On a much larger scale, that has been what has been happening in the US, too.

The disappointing side-effect of all this is that the hoped-for “trickle down” from the rich to the poorer has not taken place. Instead the income and wealth gap has widened under the Republicans in the US and under Labour in the UK. As over a million £20-per-hour industrial jobs were replaced by 2 million service sector jobs at £7.50 per hour, the worse-off members of society made up their income shortfalls with credit card and mortgage debt. Now that this has become more difficult, the high streets face a blood bath. Income redistribution is not just a social necessity but also an economic one. There is at least one piece of good news: imports will decrease substantially.

Germany alongside other  core EMU states with relatively stable house prices, broadly intact manufacturing industries and healthy saving rates has much less to fear from the credit crunch that the UK and US. So the tide has turned again.

 

Click here for past articles by Bob Bischof.