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Budgetary constraint
Jun. 28th, 2010 01:45 pmOne thing has always puzzled me about whenever someone objects to a spending cut because it is "investing for the future". How come they never talk about paying dividends on all of that "investing in the future" that we did in the past? I mean, education must be the greatest sector of all for saying that "our youth is our future", but they rarely seem to mention that today's adults are yesterday's youth, which means that yesterday's investing for the future" should be paying dividends with the adults today.
Unfortunately, we get this:
http://www.theregister.co.uk/2010/06/28/bt_boss_blames/
where BT boss Mike Rake commented that
I guess my point here would be that, if anyone ever justifies or pleads for an expense on the grounds that it is "investing for the future", we should ask them to show a track record that such investments in the past have been financially efficient.
Anyhoo, that's just one area of coming budgetary cuts -- spending. That's the bit that most people are focusing on. But, (and here I fear I almost have to side with Alistair Darling for a second, which is frightening) of more worry is the revenue side.
Put simnply, Income Tax and National Insurance swamp everything when it comes to governmental income. Even if you cut unemployment benefits to zero, the cost to the government of an increase in unemployment from 5% to 10% would be about £12bn a year, solely from lost direct taxation revenue. Throw in the multiplier effect on VAT, fuel duty and so on, and you are probably approaching £20bn a year. If you add in the losses from less corporation tax and things I can't think of at the moment, you could be loking at £25bn a year.
In other words, the government can't afford a Japan-like deflationary recession. Its response to this is that "no worries, it will all work", rather than "well, yes, it might not work, but the alternative is worse".
The Office of Budgetary Responsibility (OBR) showed its "objectivity" by marking down the expected growth rates in the UK over the next couple of years. It then negated that by becoming more bullish from 2012 on. PricewaterhouseCoopers agreed with the OBR analysis, looking for 2.8% growth from 2012 on.
Now, it's hard to overstate how much the government needs these numbers to be right. But it's also hard to overstate how much a "golden scenario" is required for them to actually be right.
As I've said before, I feel that the UK has not come out with a solution that can be applied globally. It only works for us if it fails to work for many of our competitors. The IMF and World Bank have come to a slightly different conclusion, basically suggesting that the UK's answer will work (i.e., that the deficit-running G20's plans will work) provided the Germans and the Chinese play ball in readjusting global trade imbalances.
There's just one flaw here. It isn't going to happen.
The IMF and the World Bank seem to imagine that were are still in some kind of command economy. The problem is, the one part of the globe that is closest to a command economy — China — is not going to encourage a maassive increase in domestic consumption. This would either lead to regional imbalances (which are already the source of tensions) or to regional resentments at the lack of "extra" reward for working somewhere such as Shanghai (which are already the source of tensions...)
Now, it would seem to be a bit of an uneven contest -- me on one side, the IMF, the World Bank, PricewaterhouseCoopers, the Treasury and the OBR on the other — but I am not dismayed. Because the markets appear to be on my side.
What percentage of companies with corporate debt would you think could be classed as "speculative"? -- i.e., offering at least 10pp more than government bonds? Well, as of last month, it was 16.7% of the total. On April 30, the percentage was 9.2%.
Junk bond sales, a very good measure of market confidence, have fallen off a cliff — the lowest since March 2009, and we all remember where the markets were then. Goldman Sachs reckons that the 2010 default rate could hit 6% by the end of the year, simply because refinancing will not be available.
To be fair, JP Morgan is more optimistic -- it reckons 2%. And the difference is important. If I am an institutional investor and I reckon default rates will be 6% (i.e., about a third of "speculative" bonds) then my investment strategy will be very different from the strategy I would adopt if I thought only 2% (an eighth of speculative investments).
Now, I don't want to be the last inflationist to throw in the towel, but it's hard to deny that the Deflation Armageddonists are looking better than they did a year ago. On the plus side, much of my financial strategy in the past 12 months (paying down debt) has actually been the deflationist strategy, although my reasoning has been more prosaic -- even if inflation does hit us in the teeth in three or four years' time, paying down debt is still the right thing for me to do, given boring things like expected future cash flow blah blah blah. And I retain my belief -- with recent figures from India and China (inflation hitting double figures) to back me up. The longer deflation is seen as the threat, the longer people will happily print money, citing Japan in the 1990s. And then, when the "flip" happens (with frightening speed) we suddenly see ourselves in the land of 15% inflation.
_________________
Unfortunately, we get this:
http://www.theregister.co.uk/2010/06/28/bt_boss_blames/
where BT boss Mike Rake commented that
“They were unable to complete the form because they could not spell, put it together or read properly — completely illiterate. It’s a disgrace. The politicians have a huge amount to answer for over the past 50 to 60 years.”
I guess my point here would be that, if anyone ever justifies or pleads for an expense on the grounds that it is "investing for the future", we should ask them to show a track record that such investments in the past have been financially efficient.
Anyhoo, that's just one area of coming budgetary cuts -- spending. That's the bit that most people are focusing on. But, (and here I fear I almost have to side with Alistair Darling for a second, which is frightening) of more worry is the revenue side.
Put simnply, Income Tax and National Insurance swamp everything when it comes to governmental income. Even if you cut unemployment benefits to zero, the cost to the government of an increase in unemployment from 5% to 10% would be about £12bn a year, solely from lost direct taxation revenue. Throw in the multiplier effect on VAT, fuel duty and so on, and you are probably approaching £20bn a year. If you add in the losses from less corporation tax and things I can't think of at the moment, you could be loking at £25bn a year.
In other words, the government can't afford a Japan-like deflationary recession. Its response to this is that "no worries, it will all work", rather than "well, yes, it might not work, but the alternative is worse".
The Office of Budgetary Responsibility (OBR) showed its "objectivity" by marking down the expected growth rates in the UK over the next couple of years. It then negated that by becoming more bullish from 2012 on. PricewaterhouseCoopers agreed with the OBR analysis, looking for 2.8% growth from 2012 on.
Now, it's hard to overstate how much the government needs these numbers to be right. But it's also hard to overstate how much a "golden scenario" is required for them to actually be right.
As I've said before, I feel that the UK has not come out with a solution that can be applied globally. It only works for us if it fails to work for many of our competitors. The IMF and World Bank have come to a slightly different conclusion, basically suggesting that the UK's answer will work (i.e., that the deficit-running G20's plans will work) provided the Germans and the Chinese play ball in readjusting global trade imbalances.
There's just one flaw here. It isn't going to happen.
The IMF and the World Bank seem to imagine that were are still in some kind of command economy. The problem is, the one part of the globe that is closest to a command economy — China — is not going to encourage a maassive increase in domestic consumption. This would either lead to regional imbalances (which are already the source of tensions) or to regional resentments at the lack of "extra" reward for working somewhere such as Shanghai (which are already the source of tensions...)
Now, it would seem to be a bit of an uneven contest -- me on one side, the IMF, the World Bank, PricewaterhouseCoopers, the Treasury and the OBR on the other — but I am not dismayed. Because the markets appear to be on my side.
What percentage of companies with corporate debt would you think could be classed as "speculative"? -- i.e., offering at least 10pp more than government bonds? Well, as of last month, it was 16.7% of the total. On April 30, the percentage was 9.2%.
Junk bond sales, a very good measure of market confidence, have fallen off a cliff — the lowest since March 2009, and we all remember where the markets were then. Goldman Sachs reckons that the 2010 default rate could hit 6% by the end of the year, simply because refinancing will not be available.
To be fair, JP Morgan is more optimistic -- it reckons 2%. And the difference is important. If I am an institutional investor and I reckon default rates will be 6% (i.e., about a third of "speculative" bonds) then my investment strategy will be very different from the strategy I would adopt if I thought only 2% (an eighth of speculative investments).
Now, I don't want to be the last inflationist to throw in the towel, but it's hard to deny that the Deflation Armageddonists are looking better than they did a year ago. On the plus side, much of my financial strategy in the past 12 months (paying down debt) has actually been the deflationist strategy, although my reasoning has been more prosaic -- even if inflation does hit us in the teeth in three or four years' time, paying down debt is still the right thing for me to do, given boring things like expected future cash flow blah blah blah. And I retain my belief -- with recent figures from India and China (inflation hitting double figures) to back me up. The longer deflation is seen as the threat, the longer people will happily print money, citing Japan in the 1990s. And then, when the "flip" happens (with frightening speed) we suddenly see ourselves in the land of 15% inflation.
_________________
