Economic Update May 2015

An open letter to whomsoever wins the election (and with apologies for its length)

To whom it may concern,

I hope you will refer to this frequently to ensure you do not screw up an economy which has been through the worst recession since the 1930s and is now on the mend.

We humans are at the top of the evolutionary ladder. We are animals nonetheless. We are driven by two fundamentals: to survive and to reproduce. To survive requires food, water, shelter, and (in a capitalist society) an income to pay for these things. To reproduce in most but not all cases requires a female to assess wether or not the male will be able to create a cave of sufficient proportions, in a safe place, so that her offspring will grow and flourish. Many but not all males compete to attract females by showing off their ability to provide.

Brief History of the UK Economy

If you had walked through England in 900AD, and then again in 1400AD, you would have noticed almost no change. The vast majority were barely surviving, living off the land most of which was owned by the aristocracy (who were once ordinary working people rewarded by the Monarch for services rendered, usually in war). Vast swathes of the land were owned by the King which he regularly hunted. But change was afoot: King John of Eng-land in 1200 was determined to win back land in France from the French (most of Nor-mandy and the Bordeaux region). This required money, so he raised taxes beyond what was considered fair and reasonable. The leading barons (from the Latin meaning merce-nary) of England rebelled - there was a popular uprising to prevent the King from exploiting his people. The result was the Great Charter of 1215.

For the next 200 years the evolution of our Parliament was to place the authority of the King under the council of the people. The House of Commons was established in 1332, at which time Scotland was an independent country with its own Monarchy. In 1336 the French persuaded King David of Scotland to invade England. They lost, he was captured and Scotland paid a ransom for his safe return.

From its earliest origins Parliament existed to limit the power of the King and then the state over the people. The dominant issue has always been taxation.

Since the Christian Church forbade the lending of money for interest, Jewish immigrants to England, who were barred from ordinary trade, living frugally and not bound by the laws of the Church, filled the need for money lenders.

The Jews, like many foreigners, had come to England at the time of William the Con-queror. They became the King's 'sponges' and his Exchequers, collecting his revenue and lending their own money on usury. The Jews became a hated race but survived due to their protection by the King's troops.

In 1290, to appease popular feeling, the King withdrew his protection from the Jews, who were subsequently treated cruelly by their Christian neighbours and driven out of England, not to return until Stuart and Hanoverian times (1660-1700).

After the Jews were banished in the thirteenth century, a vacuum was left – filled by Italian merchants from the great trading ports of Northern Italy. Lombard Street, which is still the heart of London's financial quarter, takes its name from Lombardy in Italy.

The Italian merchants arrived at a time when England was changing from a feudal com-munity, with virtually all its wealth in land, to a commercial society in which surplus money needed to be stored and used for profit. This happened in the sixteenth century after a long and stable government under the Tudors, which saw an age of discovery and the be-ginnings of colonisation; a time of expansion of trade at home and abroad.

As the Reformation spread through Europe at the end of King Henry VIII’s reign (1546), he repealed the usury laws.. Before this the Church disallowed the lending of money with in-terest; now money could be lent "upon interest according to the King's Majesty's Statute at 10 per cent".This Act was carried further by his daughter, Queen Elizabeth I , and so the foundation of the modern banking system was laid in 1550. She also introduced grammar schools to give ordinary working people an opportunity to improve their children’s education. At the same time Spain was bringing home significant quantities of gold from their newly acquired colonies in South America. This boosted the European money supply, trade and growth.

In 1603 Scotland provided England with a new line of kings, the Stuarts. Coming from Scotland where royal power had not been curbed by Parliament, they had no understand-ing of the more democratic ways that had developed in England. They ruled from 1603-1714, but England and Scotland had separate Parliaments.

The Civil War began in 1642. The Scottish King Charles 1 tried to act beyond the powers given to him by the English Parliament. The people rose up under Oliver Cromwell and a republic was established which existed from 1649 -1660.

The late 17th century was a difficult period for Scotland. The country's economy was rela-tively small, its range of exports very limited and it was in a weak position in relation to England, its powerful neighbour. In an era of economic rivalry in Europe, Scotland was in-capable of protecting itself from the effects of English competition and legislation. The kingdom had no significant exports and its once thriving industries such as shipbuilding were in steep decline; goods that were in demand had to be bought from England for ster-ling. Moreover the Navigation Acts further increased economic dependence on England by limiting Scotland's shipping, and the Royal Scots Navy was tiny.

Several ruinous civil wars in the late 1600s had exhausted the people and diminished their resources. In the 1690s there were several years of wide-scale crop failure, which brought famine. The deteriorating economic position of Scotland led to calls for a favourable politi-cal union, or at least a customs union, with England.

However, the stronger feeling among Scots was that the country should become a great mercantile and colonial power like England. And so they conceived the Darien Project, backed by 50% of Scotland’s entire money supply. The colony was to be Caledonia, where Panama is today. It failed; Scotland was bankrupt. The Act of Union 1707 was the result of the Scottish nobility petitioning Westminster to wipe out the debt and stabilise the currency. A lot of Scottish commissioners who had lost a fortune hoped to be reimbursed.

English businessmen followed the example of the Italian merchants. In particular, Sir Thomas Gresham, who as a pioneer of lending and borrowing money in the country, be-came the greatest of the London merchants and is now looked upon as the "Father of English Banking". He served Henry VIII, Edward VI, Mary I and Elizabeth I and founded the Royal Exchange in Cornhill, London, as a meeting place for merchants to conduct their business. Merchant banks existed to extend credit to shipowners prior to cargoes being landed and sold. “My word is my bond” became firmly established.

The First Industrial Revolution 1760-1840

The combination of new technology, innovation, and the creation of credit by newly formed banks enabled the UK textile industry to significantly increase its productivity, thereby ris-ing real incomes. The key was the specialisation of labour,,risk taking, and a stable Gov-ernment which to a large extent accepted the Adam Smith view that the invisible hand (the market) allocated scarce resources to their most productive use.

It also happened because of the changed world view driven by the enlightenment. The ba-sic tenet was that reason, analysis, and individualism should replace authority – in particu-lar the dictates of the Roman Catholic church and the abuses of the state. The widely held view was that individuals should be free to use their intelligence.

Land productivity was significantly increased due to new methods such as crop rotation and enclosure. This released (some would say forced) many workers from the land to work in the newly established factories. It simultaneously boosted added value per hour of work, and hence real wages grew. The emerging banking system was a key enabler of enter-prise through the creation of money (please note money and debt are the same thing).

The factory system contributed to the growth of urban areas, as workers migrated to the cities in search of work. Nowhere was this better illustrated than the mills and associated industries of Manchester, nicknamed "Cottonopolis", and the world's first industrial city. Manchester experienced a six-time increase in its population between 1771 and 1831. Bradford grew by 50% every ten years between 1811 and 1851 and by 1851 only 50% of the population of Bradford was actually born there.

The 1832 Reform Act

In essence this extended democracy to the emerging middle classes who supported the Whigs (the liberals). The new cities were underrepresented in Parliament, which still was based on elected members from the old boroughs and voters with significant holdings of land. All male householders holding property valued at £10 or more were given the vote (£700 in today’s money). There was of course resistance from the House of Lords (the big landowners). But the will of the people prevailed, although women did not get the vote for another 100 years.

Income tax was introduced in 1798 to pay for the Napoleonic Wars. It was 2% on incomes over £5000 (today’s money) rising to a maximum of 10% on incomes over £17000. There were also unpopular taxes: the malt tax on brewers which raised over 10% of revenues, the window tax which hit owners of big country houses and the house tax which hit the new wealthy who had a townhouse in London. London in 1800 was, as today, a leading international city.

The Second Industrial Revolution 1840-1880

This was driven by the growth of the railways which allowed much greater connectivity of people and markets. It enabled further specialisation of labour as individuals could live fur-ther away from their place of work. The commuter had arrived! The telegraph was in wide-spread use after 1850, allowing messages to be sent along wires laid beside the track. Ease of transport and communication – still the basis of the largest global industries.

The dominant ownership structure was the partnership, where the partners were jointly and severally liable for all the debts of the firm. All investments were carefully considered, as an ill-judged decision would put the partners and families at risk. The average number of employees was 20 – so ordinary working people created businesses. Joint stock com-panies with limited liability began in 1854, and the take up was limited.

Researchers agree that the real average annual growth rate was 2% throughout the peri-od. The first industrial revolution depended on a massive supply of cheap labour as work-ers left the land. This supply kept wages low and there was little in the way of employee education. The second depended on captive export markets to which we sold textiles and machinery. There was significant inequality of incomes between the regions and within the labour force, and here was no income redistribution through the tax system.

By 1880 the UK was losing competitive advantage. The rise of Germany and the USA pro-duced formidable competitors. Germany in particular invested more heavily in human capi-tal, recognising that the new scientific age and the application of electricity needed superi-or skill sets. The British were slow to adapt and the great depression began in 1880. It was to last 20 years.

The Great Depression 1880-1900

The great depression hit everybody. Researchers are generally agreed that at the begin-ning (around 1876) the money supply dropped sharply as banks realised they had lent too much to industrialists who were hit by falling prices across most products. The collapse in prices was due to excess supply, which was the result of over investment in productive ca-pacity on a global scale. As the price level fell, real growth actually improved, but there were widespread failures in banks and partnerships, and as a consequence ordinary work-ing people suffered.

Government spending was primarily on defence and interest payments on the debt in-curred through paying for wars. In 1880 it was £135m: 11% of nominal GDP!

There was no direct stimulus at all from the Government in 1885 and yet the economy re-covered.

The basic instinct of humans kicked in. In order to survive firms went through radical trans-formation; the pace of innovation increased. The 1870 Education Act required local gov-ernment to educate all children aged between 5 and 13. It was pushed through Parliament by the Liberals- an important contributor to the improving quality of the work force.

Towards the end of the 19th century, big changes in the economy took place. The screw propeller for steam ships extended their range and increased their speed, refrigeration, the internal combustion engine, electricity, the telephone (from 1880). These innovations clus-tered and with new bank finance the economy propelled itself into the Edwardian age.

The Edwardian era stands out as a time of peace and plenty. There were no severe de-pressions, and prosperity was widespread. Britain's growth rate, manufacturing output, and GDP (but not GDP per capita) fell behind its rivals, the United States and Germany, but Britain still led the world in trade, finance and shipping, and had strong bases in manu-facturing and mining.

The industrial sector was slow to adjust to global changes, and there was a striking prefer-ence for leisure over entrepreneurship among the elite (who were the sons and daughters of the successful entrepreneurs who created the second industrial revolution and became rich in the process).

London was the financial centre of the world — far more efficient and wide-ranging than New York, Paris or Berlin. Britain had built up a vast reserve of overseas credits in its for-mal Empire, as well as in its informal empire in Latin America and other nations. It had huge financial holdings in the United States, especially in railways. These assets proved vital in paying for supplies in the first years of the World War. The amenities, especially in urban life, were accumulating — prosperity was highly visible. The working classes were beginning to protest politically for a greater voice in government, but the level of industrial unrest on economic issues was minimal until about 1908.

The Labour Party was created in 1900: a new party for a new century. Its formation was the result of many years of hard effort by working people, trade unionists and socialists, united by the goal of changing the British Parliament to represent the interests of every-body. Ignored by the Tories and disillusioned with the Liberals, a coalition of different inter-ests came together to push for change at a Conference on Labour Representation in Lon-don's Memorial Hall in February 1900.When the Liberal Party split in 1916, the Labour Party was well placed to make a chal-lenge for power. But for the next 100 years it was only in power for 23 years. Indeed for most of the 20th century, British Governments were coalitions. Single party Government is only a feature since 1950.In the early 1900s it was the Irish Nationalists who held the bal-ance of power!

The Edwardian age ended with war in 1914-18. Afterwards a much diminished UK tried to re-establish itself as the leading nation in Western Europe by returning to the gold stan-dard, which fixed the exchange rate at a level rendering UK exports uncompetitive. At the time the established view was that the lack of competitiveness was due to the new trade unions pushing up wages.

In fact it was a massive policy error, and it set the scene for 10 miserable years. Classical economists were convinced that the economy would find a new equilibrium level, providing wages were cut low enough. John Maynard Keynes showed why they were wrong and how an increase in public spending on infrastructure renewal financed by debt would im-prove the colour of businessmen’s livers and get them taking risks again. And wage cuts would only depress demand further. Keynes did not think the increase in Government spending should be permanent, but a short run stimulus to enterprise.

Then the misery of the second world war took place, with an appalling loss of life, produc-tive potential, and cruelty of man to fellow man. But the war did drive innovations which in the 1950s clustered to create new products, services and jobs. We never had it so good!

But in the early sixties there was a succession of currency crises. The UK was living be-yond its means, and the 1964 Labour Government launched the National Plan. Here is the introduction:

We must pay our way in the world and produce more wealth inside this country. Our target is an increase of a quarter in output by 1970. This is necessary if we are to enjoy the living standards we want, improve our social services and play our part in world affairs.

This required the annual real GDP growth rate to be 4%.

To achieve our objective action is to be taken on the following eight points.

1. A sharp brake is to be put on Government spending abroad, which has been rising much too quickly.

2. Private investment abroad is to be reduced to a level that we can afford.

3. Government spending in this country will be kept within our means and the money that is available will be spent more in ways that help to improve efficiency. More will be devoted to items like industrial training and technology, while the rise in defence spending will be brought to an end.

4. The Government are working together with managers and trade unionists, to put new zip into British industry. Nearly every industry is making its own plans for improving effi-ciency, pushing up exports, or saving imports. More help is already being given to ex-porters and work is going on to encourage longer runs, provide better training for man-agers and to improve efficiency in other ways.

5. Industry will need to step up its plans for buying more plant and equipment. The Gov-ernment is looking at the incentives to do so; but firms themselves must look further ahead in making their plans.

6. Agreement has been reached on a policy for productivity, prices and incomes. Employ-ers and trade unionists have undertaken to carry out their part in this policy and the Na-tional Board has begun to pronounce on individual cases. If necessary, the policy will be strengthened.

7. A programme is well under way to cover the human effects of industrial change. This includes redundancy compensation, wage-related unemployment benefits, and better in-dustrial training. In return management and unions have promised an all-out effort to get rid of restrictive practices.

8. More work will be brought to those parts of the country where there are still not enough jobs. In providing more industry, transport and housing for a rising population, we aim to build up a country in which it is pleasant to live and work, and where all parts share in the growing prosperity.

The Government have not hesitated to give a lead and to act themselves. But everyone has a part to play in carrying cut the National Plan if we want the benefits that its success can bring.

It didn’t work, chiefly because no one calculated out how many new workers would be needed to boost output by 4% a year.

The growth rate of 2.5% continued until the oil price quadrupled in 1973. This price in-crease transferred income from oil importers to oil exporters. The standard of living would inevitably have to fall. But organised labour refused to accept this fact, and the seventies was a period of strikes, disputes and unrest.

The inflation rate did however reduce real incomes in the end. The winter of discontent (1979) did result in a major change: the Thatcher Government. She was economically illit-erate but instinctive and courageous. The surge in oil prices in 1980 caused another re-cession (not Thatcherism). It also caused the pound to be overvalued by 35%. It was this which caused the collapse of many firms in the chemicals, motor, shipbuilding and me-chanical engineering sectors. And there was the miners’ strike, again a human response to the massive increase in the global supply of low cost open cast coal from Columbia and Australia.

But the need to survive drove innovation, restructuring, a changed attitude, and recovery.

The evolution of the British Economy has never been smooth or stable. Our real growth rate has not exceeded 3% a year since 1780, and has averaged around 2.5%. Frankly Government makes no difference to our growth rate but it does make a difference to social and working conditions through legislation. Good examples are the equal pay act, equal opportunities, and the legislated responsibilities of company directors.

Government can create the conditions for enterprise to flourish but it cannot create enter-prise. Government has no money of its own. All it has it what it taxes or borrows. It cannot end austerity, but it can create conditions for business to end austerity. And there are pub-lic goods which should be funded from general taxes. Examples: health, defence, educa-tion, infrastructure and the rule of law.

The current election campaign is full of absurd promises which are undeliverable, or if ap-plied will destroy what they are trying to fix.

On housing: all the policies are about the demand and price side, nothing tangible on sup-ply. Cameron is crazy to sell off social housing. Miliband is nuts to impose rent controls (all

that will happen is the non-returnable deposit will rise significantly), and to freeze utility prices.Cameron should not have promised no increases in the major taxes, he was badly advised on this. UK demographics and the pension bill will require taxes to increase (if not, the na-tional debt will just go up!)

Since 2008, Government spending has risen every year. The rate of increase slowed after 2010 because Government income collapsed. Because of the inexorable rise in the pen-sions and social support payouts, other parts of Government have been cut back. The cut in the capital spend budget is the most serious for school buildings and the road network.In 2010 as a percentage of GDP Government spending hit 47%, this is because realGDP fell by 6%. Government has NOT been the cause of austerity.

The Causes of Austerity

Austerity is the inevitable consequence of the excess of debt taken on by ordinary working people from 2000 - 2008. Light touch regulation of the banks (thanks to Ed Balls) allowed them to expand their balance sheets recklessly. They in conjunction with all those who lied about their income when applying for a mortgage created the biggest spurious increase in wealth we have experienced as house prices shot up.

In 2008 Barclays, RBS and HBOS were technically insolvent; they had unwisely lent to in-dividuals and property companies who would only be able to repay the principal if the property boom continued forever. 70% of all bank lending is on property. To restore their balance sheets banks, began to destroy what they created – they destroyed £350Bn. This is about 20% of the UK money supply.

When the flow of spending in the economy slows or contracts, the automatic stabilisers kick in. These are the balance between Government income from tax (it goes down) and Government spending on social support (it goes up). It is these which caused the spike in Government as a proportion of the economy in 2010.

Since 2008 the Government has spent £600bn more than it has received in taxes. Most of this has been spending on ordinary working people. The biggest bills are for pensions, health and education. None of these have been cut back in cash terms, but unfortunately capital spend has, by 15%. It has fallen from £57bn to £42bn.

The Banks are now fixed, their solvency restored, as a result they are creating new money which is flowing through our system. The consequence of this will be the end of austerity. Government income is growing again and so the deficit will drop automatically. The arith-metic is straightforward: a 5% growth in nominal GDP should increase Government in-come by the same amount. Income is approx. £660Bn, 5% is £33Bn. Spending is £740Bn. If this grows by say 3% a year, then each year the deficit comes down!

The earnings of those employed in the same job for over a year are growing at over 4%. It is likely that next year and beyond they will rise to 5% as the labour market continues to tighten.

A note for Nicola Sturgeon:

Although you are the most seemingly honest and human candidate, you seem to be mis-taken when it comes to the demise of Scottish industry. It was killed by an overvalued Ster-

ling which was due to North Sea oil. The first oil landed in Aberdeen in 1975. By 1977 the

flow was strong. The British chemical industry, motor industry, heavy engineering and computer industries faced a 35% increase in their export prices due to the exchange rate driven up by North Sea Oil. It was this oil which killed off your industry (and the rest of the UK), not the Tories. Have a good look at the graph on the next page:

The Value of the Pound Against the Dollar

The price of oil went from $45 to $100 a barrel in 1979 and sterling from $1.80 to $2.40 . On top of this, the first Thatcher Government was trying to reduce the rate of growth in the money supply to bear down on inflation. Interest rates moved between 10 and 15 percent.

The Scottish Financial Position Today

The tax yield from petroleum revenue tax (PRT) last year (2014) was £1.1bn. Excluding PRT, the Scots tax receipts were £9400 per person. Spending by Scottish government was £12500 per person. Giving Scotland all the PRT gives them £226 per person extra. That would increase their tax income to £9626 leaving £2874 per head to be borrowed. The population is 5.3 million. The Scottish Government would have to borrow £15Bn. Their GDP is £150Bn, thus a budget deficit of 10% of GDP. In 2015 PRT is likely to drop to around £700m. The deficit then rises to approximately 13% of GDP. England is subsid-ising Scotland, and a close look at the numbers indicates that most of the money comes not from London but from the South East.

On Inequality

In the election campaign it has been repeatedly stated that ordinary working people are getting poorer while business owners are getting richer. There is no evidence for this.

The share of added value going to the owners of business enterprises is broadly stable. The rise in inequality has mainly been the result of the big company club where non-exec-

utive directors sit on each other’s’ remuneration committees and bid up rewards for each other, as well as a small number of investment bankers running trading operations. If the tax rate on these high earners is increased they will only bid up the top line even more to compensate.

Last year 300,000 earned more than £160,000; they paid £47 million in income tax. This is 30% of income tax receipts.

The biggest change is not in incomes but in wealth – there has been a marked increase in wealth inequality. This is primarily caused by the regional differences in house prices, and the secondary impact comes from those who placed some of their income into private pensions. The increase in share prices has boosted the value of these funds.

The Outlook

The Economy slowed in the first quarter of this year as projects were delayed due to polit-ical uncertainty. It has been impossible for any supplier to the public sector to obtain sign off because the public servants do not know who their new boss will be. When the data is

revised, I think growth will have been better. After the 8th May it will all depend on whether a Government has a working majority. A Lib Dem/Conservative coalition has served the UK well over the past 5 years. If you believe the rhetoric, an SNP/Labour coalition will be bad for growth, investment, confidence and the value of Sterling. Failure to win a majority will result in another election in the Autumn. Bad for growth in the short run (i.e. for 6 months).

The USA has experienced a slower first quarter, which the markets believe will delay the increase in interest rates. The dollar immediately dropped in value. The Eurozone is re-sponding to significant money creation (QE) and is likely to show a much improved output 9 months from now. Greece has told the EU that it has some red lines which are inconsist-ent with creditor demands for reform. A default is likely, but the impact will be minimal be-cause the markets have priced it in, and European banks have made provisions for expec-ted losses.

China continues to slow down (although the official data says not) and their stock market bubble is likely to burst soon.

The overall outlook is still positive although patchy around the world.

For the UK: no increase in interest rates this year, exchange rates: $1.54 average for the rest of the year, but swings based on political events. For the Euro, 1.35 average but big swings here too.

And finally

A young woman was about to finish her first year of university. Like so many others her age, she considered herself to be Labour Party minded, and she was very much in favour of higher taxes on the higher income earners to support her education and for more gov-ernment spending to redistribute income. She was ashamed that her father was a staunch Conservative, a feeling she openly ex-pressed. Based on the lectures she had attended and the occasional chat with her eco-nomics professor, she felt that her father had for years harboured a selfish desire to keep what he thought should be his. One day she was challenging her father on his opposition to higher taxes on the rich and the need for more government spending. The self-professed objectivity proclaimed by her professor must be the truth. He responded by asking how she was doing at university. Taken aback, she answered rather haughtily that she had a 90% average, and let him know that it was tough to maintain, insisting that she was constantly studying, which left her no time to go out and have fun like other people she knew. She didn't even have time for a boyfriend. Her father listened and then asked, how is your friend Liz doing? She replied, Liz is barely getting by. She never studies and she barely has a 50% average. She is so popular on campus; university for her is a blast. She's invited to all  the parties, often she doesn't at-tend lectures because she's too hungover.

 Her wise father asked his daughter, Why don't you go to the Dean’s office and ask him to deduct 20% off your average and give it to Liz who only has 50%. That way you will both have a 70% average, it would be fair and you would both be equal. The daughter, visibly shocked by her father's suggestion, angrily fired back, That's a crazy idea. How would that be fair? I've worked really hard for my marks. I've invested a lot of time, and a lot effort. Liz has done next to nothing toward her degree. She played while I worked my tail off. The father slowly smiled, and said gently, welcome to the Conservative side of the fence.

Yours Faithfully

Roger Martin-Faggrmfagg@aol.com

Prepared May 1st 2015 

PS As a behavioural economist I am well aware of confirmation bias and what I have writ-ten exhibits much of this. I am also acutely aware that our record as a Nation in respect of human rights as we experienced the industrial revolution and undertook colonisation is certainly nothing to be proud of. But our democracy with all its faults does slowly advance civilisation and on May 8 we will see the will of the people exercised as it has been since 1382 ( although from limited beginnings!)