Tuesday, 25 November 2008

Government purchases worst share rights issue in history - taxpayer loss £2.6 billion in one day

The government's recovery package has gone in the right direction in the area of seeking to maintain consumption during a recession.
The cut in VAT will concentrate tax relief on the average and lower paid - which is what is required from the point of view of both keeping up consumer demand and social justice. There can be discussion about whether the consumer spending stimulus package should have been larger, and whether the restrictions on government spending are necessarily the best thing in current economic circumstances. But overall the package is a commitment to an unambiguously Keynesian approach and, in the fields of consumer and government spending it can, if necessary, be boosted later in any case.
But it is vital to realise that in a recession what is decisive is neither consumer nor government spending. What, above all, occurs in a recession is that investment declines or, in the most severe cases, collapses.
In order to illustrate this Figure 1 shows the changes in the main domestic components of US GDP in the most classic of all recessions/depressions - that in the US following 1929. [1]


Figure 1

As can be seen the pattern is clear. The economic decline in US was extremely severe - on a far larger scale than anything occurring at present. The fall in US GNP (Gross National Product) was 29.7 per cent between 1929 and 1933.[2] The 1929 US level of GNP was not regained for a decade - until 1939.
Looking at the components of this decline in GDP, however, a clearly differential pattern shows itself.
Government spending increased throughout the recession - not only after Roosevelt became president in 1933 but even under Hoover.
The decline in personal consumption expenditure after 1929 was severe but less than the overall decline in GNP. By 1933 US personal consumption expenditure had fallen by 19.7 per cent compared to the 29.7 per cent drop in GNP. Personal consumption expenditure regained its 1929 level by 1939.
But the collapse in investment was extreme, far exceeding the decline in GNP - explaining the difference between the drop in personal and government consumption expenditure and the drop in overall output
By 1933 US private domestic fixed investment had fallen by 73.9 per cent from its 1929 level. Or, put another way, by 1933, US private domestic fixed investment was only 26.1 per cent of its 1929 level. This was by far and away the most severe element of the depression - which, by multiplier effects, spread its consequences through the rest of the economy.
The reason for this differential decline is that while 'demand' may be spoken of in general, in fact the different components of demand are controlled by quite different mechanisms.
Decisions on the level of government spending are taken directly by the state and can therefore be relatively easily controlled.
Regarding personal consumption, the aim of the mass of the population is to have as good a living standard as possible. The most powerful issue affecting personal consumption is the level of income, not the desire to consume. [3]
However, private investment decisions are not controlled by consumption but by profit. Therefore investment decisions are not controlled by the same mechanisms as personal and government consumption - and can fall to almost any level. It is this decline in investment which is by far the largest in a recession.
Why, therefore, cannot the government intervene directly to stop the decline in investment? The issue here is private property in the means of production. If the government takes decisions on investment out of the hands of the private owners of the means of production it, in fact, limits or abolishes that private ownership of the means of production. Therefore, in such circumstances, if the government continues to accept as private ownership of the means of production as an absolute right if cannot halt the decline in investment. Whereas if, in such circumstances, the government aims to halt the decline in investment it must encroach on private ownership in the means of production.
The practical consequences in terms of economic policy are clear. If a recession is relatively mild, acceptance of private ownership in the means of production, and therefore the inability to control investment, may at worst be wasteful but it will not be fatal. The government still has tools to increase its own, state funded, consumption demand - it can, for example, embark on huge new health or education programmes. In terms of personal consumption there is a very severe issue in terms of maintaining demand which is posed by unemployment - overall consumer spending can fall not only because wages drop but because the number of those in work falls. However the government can still carry out large increases in welfare benefits, cuts in taxation, or public works schemes that can significantly support consumer spending.
But in the area of investment the government has no comparable instruments. Approaching one fifth of the economy is accounted for by investment - and this investment also determines the long term economic growth. Public investment is a tiny fraction of this. While the government has powerful levers in the areas of state and personal consumption it has no comparable ones in investment. Nor can it have them without a encroachments on private ownership of the means of production. [4]
This will, therefore, determine the unfolding of the economic situation. There is going to be a severe recession - in terms of comparison to those since World War II. But a severe recession, in those terms, is naturally relatively mild compared to the type of economic crisis after 1929. While the financial crisis is clearly the largest seen since 1929 the downturn in the real economy does not remotely approach that of the Great Depression. The probability is that the current crisis will remain a very severe recession and but there will not be an economic depression - although this depends on the US adopting policies that avoid the type of disastrous errors that followed 1929.
If the economic downturn remains at the level of a recession then Keynesian measures will succeed, after a period, in bringing about a new economic upturn without any severe incursions into private ownership of the means of production - outside of the financial sector where they have already taken place. That is, put in other terms, the moral case for socialism will remain. But, while the role of the state, in a capitalist economy, will require to be increased in order to overcome the economic crisis - something which is already happening, it will not require a transition to a socialist society to overcome the economic downturn. If, however, the present severe recession were to pass over into an economic depression then another outcome would be posed.
It is at this point that the moral and economic cases for socialism become inseparable. A capitalist economic solution says private property in the means of production must be regarded as absolute, and untouchable, even if that means economic collapse - this answer says the rights of capital are absolute and the rights of society subordinate. A socialist solution says that if, in order to avoid economic collapse, it is necessary to make encroachments into the rights of private property in the means of production then this must be done - it is the rights of society that are absolute and the rights of capital are subordinate to this.
These 'cold' figures on the movement of components of GDP during a recession therefore spell out, in their own way, the structure of society - that one part of the economy is controlled by the desire of people to consume, that is to enjoy a better standard of life. That another part of the economy is controlled by profit. And that the interests of the two may clash.
How far they will clash during this economic downturn, and with what outcome, remains to be seen. But the socialist answer is simple. It is society, that is people, which comes first - not the private ownership of the means of production.


Notes
[1] The international source of demand is net exports. There was a drastic contraction of international trade after 1929 which seriously deepened the depression. However this does not affect the argument regarding the components of domestic demand dealt with here. Inventories also declined after 1929, adding to the recessionary effect, however changes in stocks, by their nature, are cyclical and again the concentration here is on the long term elements in economic shift.
[2] Gross National Product (GNP) differs from Gross Domestic Product (GDP) in that is equal to GDP plus net income earned from abroad. Long term US historical economic data is in GNP terms. The size of difference to GDP is, however, small and does not seriously distort comparisons to other countries GDP figures.
[3] In a recession personal consumers may decide to save more - among other reasons to protect themselves from the threat of future economic hardship or unemployment. However there are relatively effective mechanisms to tackle this, and in any case if the extra savings are invested by the government or companies no fall in aggregate demand takes place - the savings by individual are merely spent somewhere else in the economy. The biggest effect is the fall in income due to either declines in real wages or unemployment.
[4] Such encroachments may be through large scale expansion of areas of public investment, taking over areas at present controlled by private investment, or both.

What happens in a recession?

The government's recovery package has gone in the right direction in the area of seeking to maintain consumption during a recession.
The cut in VAT will concentrate tax relief on the average and lower paid - which is what is required from the point of view of both keeping up consumer demand and social justice. There can be discussion about whether the consumer spending stimulus package should have been larger, and whether the restrictions on government spending are necessarily the best thing in current economic circumstances. But overall the package is a commitment to an unambiguously Keynesian approach and, in the fields of consumer and government spending it can, if necessary, be boosted later in any case.
But it is vital to realise that in a recession what is decisive is neither consumer nor government spending. What, above all, occurs in a recession is that investment declines or, in the most severe cases, collapses.
In order to illustrate this Figure 1 shows the changes in the main domestic components of US GDP in the most classic of all recessions/depressions - that in the US following 1929. [1]


Figure 1

As can be seen the pattern is clear. The economic decline in US was extremely severe - on a far larger scale than anything occurring at present. The fall in US GNP (Gross National Product) was 29.7 per cent between 1929 and 1933.[2] The 1929 US level of GNP was not regained for a decade - until 1939.
Looking at the components of this decline in GDP, however, a clearly differential pattern shows itself.
Government spending increased throughout the recession - not only after Roosevelt became president in 1933 but even under Hoover.
The decline in personal consumption expenditure after 1929 was severe but less than the overall decline in GNP. By 1933 US personal consumption expenditure had fallen by 19.7 per cent compared to the 29.7 per cent drop in GNP. Personal consumption expenditure regained its 1929 level by 1939.
But the collapse in investment was extreme, far exceeding the decline in GNP - explaining the difference between the drop in personal and government consumption expenditure and the drop in overall output
By 1933 US private domestic fixed investment had fallen by 73.9 per cent from its 1929 level. Or, put another way, by 1933, US private domestic fixed investment was only 26.1 per cent of its 1929 level. This was by far and away the most severe element of the depression - which, by multiplier effects, spread its consequences through the rest of the economy.
The reason for this differential decline is that while 'demand' may be spoken of in general, in fact the different components of demand are controlled by quite different mechanisms.
Decisions on the level of government spending are taken directly by the state and can therefore be relatively easily controlled.
Regarding personal consumption, the aim of the mass of the population is to have as good a living standard as possible. The most powerful issue affecting personal consumption is the level of income, not the desire to consume. [3]
However, private investment decisions are not controlled by consumption but by profit. Therefore investment decisions are not controlled by the same mechanisms as personal and government consumption - and can fall to almost any level. It is this decline in investment which is by far the largest in a recession.
Why, therefore, cannot the government intervene directly to stop the decline in investment? The issue here is private property in the means of production. If the government takes decisions on investment out of the hands of the private owners of the means of production it, in fact, limits or abolishes that private ownership of the means of production. Therefore, in such circumstances, if the government continues to accept as private ownership of the means of production as an absolute right if cannot halt the decline in investment. Whereas if, in such circumstances, the government aims to halt the decline in investment it must encroach on private ownership in the means of production.
The practical consequences in terms of economic policy are clear. If a recession is relatively mild, acceptance of private ownership in the means of production, and therefore the inability to control investment, may at worst be wasteful but it will not be fatal. The government still has tools to increase its own, state funded, consumption demand - it can, for example, embark on huge new health or education programmes. In terms of personal consumption there is a very severe issue in terms of maintaining demand which is posed by unemployment - overall consumer spending can fall not only because wages drop but because the number of those in work falls. However the government can still carry out large increases in welfare benefits, cuts in taxation, or public works schemes that can significantly support consumer spending.
But in the area of investment the government has no comparable instruments. Approaching one fifth of the economy is accounted for by investment - and this investment also determines the long term economic growth. Public investment is a tiny fraction of this. While the government has powerful levers in the areas of state and personal consumption it has no comparable ones in investment. Nor can it have them without a encroachments on private ownership of the means of production. [4]
This will, therefore, determine the unfolding of the economic situation. There is going to be a severe recession - in terms of comparison to those since World War II. But a severe recession, in those terms, is naturally relatively mild compared to the type of economic crisis after 1929. While the financial crisis is clearly the largest seen since 1929 the downturn in the real economy does not remotely approach that of the Great Depression. The probability is that the current crisis will remain a very severe recession and but there will not be an economic depression - although this depends on the US adopting policies that avoid the type of disastrous errors that followed 1929.
If the economic downturn remains at the level of a recession then Keynesian measures will succeed, after a period, in bringing about a new economic upturn without any severe incursions into private ownership of the means of production - outside of the financial sector where they have already taken place. That is, put in other terms, the moral case for socialism will remain. But, while the role of the state, in a capitalist economy, will require to be increased in order to overcome the economic crisis - something which is already happening, it will not require a transition to a socialist society to overcome the economic downturn. If, however, the present severe recession were to pass over into an economic depression then another outcome would be posed.
It is at this point that the moral and economic cases for socialism become inseparable. A capitalist economic solution says private property in the means of production must be regarded as absolute, and untouchable, even if that means economic collapse - this answer says the rights of capital are absolute and the rights of society subordinate. A socialist solution says that if, in order to avoid economic collapse, it is necessary to make encroachments into the rights of private property in the means of production then this must be done - it is the rights of society that are absolute and the rights of capital are subordinate to this.
These 'cold' figures on the movement of components of GDP during a recession therefore spell out, in their own way, the structure of society - that one part of the economy is controlled by the desire of people to consume, that is to enjoy a better standard of life. That another part of the economy is controlled by profit. And that the interests of the two may clash.
How far they will clash during this economic downturn, and with what outcome, remains to be seen. But the socialist answer is simple. It is society, that is people, which comes first - not the private ownership of the means of production.


Notes
[1] The international source of demand is net exports. There was a drastic contraction of international trade after 1929 which seriously deepened the depression. However this does not affect the argument regarding the components of domestic demand dealt with here. Inventories also declined after 1929, adding to the recessionary effect, however changes in stocks, by their nature, are cyclical and again the concentration here is on the long term elements in economic shift.
[2] Gross National Product (GNP) differs from Gross Domestic Product (GDP) in that is equal to GDP plus net income earned from abroad. Long term US historical economic data is in GNP terms. The size of difference to GDP is, however, small and does not seriously distort comparisons to other countries GDP figures.
[3] In a recession personal consumers may decide to save more - among other reasons to protect themselves from the threat of future economic hardship or unemployment. However there are relatively effective mechanisms to tackle this, and in any case if the extra savings are invested by the government or companies no fall in aggregate demand takes place - the savings by individual are merely spent somewhere else in the economy. The biggest effect is the fall in income due to either declines in real wages or unemployment.
[4] Such encroachments may be through large scale expansion of areas of public investment, taking over areas at present controlled by private investment, or both.

Monday, 24 November 2008

Raising the top rate of income tax, a second very good step - by Ken Livingstone

Further good news about today's economic package comes in briefings to the BBC, Financial Times, Guardian and other media that the top rate of income tax is to be raised to 45p in the pound for those earning over £150,000 a year.
Yesterday, in strongly welcoming the decision to cut VAT, I argued: 'this should be the beginning of a reshaping of the taxation system. It is being briefed that this reduction in VAT will be temporary, and it will then be restored to its previous level to reduce the budget deficit during an economic upturn. This is not what should occur - any increase in VAT would be deeply regressive for the reasons already outlined. Instead, when taxation increases again to reduce the budget deficit during an economic upturn, an increase in direct taxation on the highest incomes should take place. That is, any reduction in VAT should be used to begin a reshaping of the tax system in a more equitable direction.'
Clearly a rise in the top rate of income tax to 45p is therefore a step in the right direction. At present the fiscal arithmetic shows that it does not go far enough. This increase in income tax on the higher paid by itself will raise £2 billion, which would not by itself be sufficient to avoid the need to increase VAT as it becomes necessary to reduce the overall budget deficit during an economic upturn. An increase to 50p would have been better and the left must continue to argue that VAT must not be re-increased at a later date after the present cut.
But nevertheless the fact that for the first time direct taxation on the very highly paid is to be raised is a hugely symbolic, and important practical, step. It would be wrong at this stage to quibble and this measure increases the attractiveness of the economic package still further.
Reduction in VAT, and this increase in direct taxation on the high paid, are measures that are good for economic recovery and social justice and should be strongly supported by the left.
Note also how Labour's popularity has been transformed since it has been campaigning centrally on the economy, with measures that combine economic rationality with social justice, rather than making its central thrust being on attempting to appear right wing on crime and immigration. That must be a key lesson up to the general election. There is now a total dividing line with the Tories and their economically damaging and socially unjust policies. The party that sets the agenda has a key advantage in an election. Focusing on this economic divide is the agenda that can win Labour the election.

Sunday, 23 November 2008

A cut in VAT should be strongly supported - by Ken Livingstone

It would be astonishing if, after the briefing to the Sunday Times, Observer, Sunday Telegraph, The Independent and other newspapers, tomorrow's government economic statement did not centre on a reduction in VAT. If so this is measure which should be strongly supported - not only for immediate but for strategic economic reasons.

One of the most iniquitous features of Tory tax policy, particularly from Thatcher onwards, was the shifting of the tax burden from direct to indirect taxation.

Indirect taxation hits the lowest paid proportionately more than the high paid and is therefore deeply socially regressive - which is exactly why it was a policy pursued by the Tories and Thatcher. Cutting VAT will therefore hit two birds with one stone.

First, as part of the government's measures to combat the economic downturn, this is one of the most effective measures in keeping up consumer demand. A reduction in VAT will aid all sections of the population. But, precisely because indirect taxation is socially regressive, reducing VAT will aid the lowest paid most.

The lower an income the more certainly any available income is spent, as the low paid can least afford to save. A reduction in VAT has almost exactly the same effect as a boost in income because it allows a greater quantity of goods to be bought with the same money. Reduction in VAT is therefore one of the surest ways to ensure that the maximum amount of any economic package is translated into an increase in consumer demand - one of the key measures required to fight the economic downturn.

Reduction in VAT is also, politically, just the type of measure required to ensure Labour holds together the alliance of those on around average incomes and the low paid which it should be based on.

Second, strategically, this should be the beginning of a reshaping of the taxation system. It is being briefed that this reduction in VAT will be temporary, and it will then be restored to its previous level to reduce the budget deficit during an economic upturn. This is not what should occur - any increase in VAT would be deeply regressive for the reasons already outlined. Instead, when taxation increases again to reduce the budget deficit during an economic upturn, an increase in direct taxation on the highest incomes should take place. That is, any reduction in VAT should be used to begin a reshaping of the tax system in a more equitable direction.

Discussion on the future of taxation will continue, as will that on other measures such as the proposal for the government to purchase bank shares at above market prices. But tomorrow one thing is decisive. The left should give the strongest support to a reduction in VAT and applaud the government for it. Such a measure provides a striking contrast to the economically disastrous and socially regressive policies being openly advocated by the Tories.

Saturday, 22 November 2008

A lovely comment on bank shares by Tony Peterson

Socialist Economic Bulletin has had a number of posts dealing with the economic errors in the government's policy to purchase shares in Royal Bank of Scotland (RBS), HBOS and Lloyd's TSB at what are now far above market prices. But sometimes someone puts something not in the most scientific way but in one that beautifully captures its essence. One example is a comment by Tony Peterson on The Independent's article on the threat to nationalise banks that refuse to lend at an appropriate level this morning. He comments on the Lloyd's TSB decision to 'allow' the government to purchase shares in it at 173.3p each.
'Here's a good one to watch for. At the Lloyds egm [Emergency General Meeting] I warned the board that they were likely to follow in the footsteps of the 1929 bankers who bought their own worthless stock and became the first men in history to swindle themselves. [Lloyds TSB chairman Sir Victor] Blank promised us that all his board would take up their full entitlement to new shares at 173.3p That evening the value fell to 118p. I've checked their holdings and calculated the level of self-swindle they are pledged to. Negative bonuses this year, chaps.'
The difference however is the following. If the directors of Lloyd's TSB want to 'swindle themselves' by buying their own company's shares at far above market prices that is their affair. It is quite a different one if the government forces everyone in the country, aka the taxpayer, to buy bank shares , through the bail-out package, at far above market prices regardless of whether they wish to or not. That would be to allow bank shareholders to swindle the taxpayer.
It is merely to add insult to injury when these same banks, having pocketed the taxpayers money at far above market prices, then don't lend to the rest of the economy.

Banks refusal to lend demonstrates the relation and difference between Keynesian and socialist economic approaches

The public row which has developed between the private banks and the government, reported in both the Financial Times and The Independent today, demonstrates both the limits of Keynesianism and makes clear the relation and difference between it and a fully socialist economic approach.
Regarding the row, as The Independent notes in its leading article today: 'The Government has already bailed out the banks with extra liquidity and injections of new capital. The Bank of England has acted drastically to reduce interest rates and is poised to go further. But so far the banks have still not responded with loans, mortgage rates or credit lines to their customers. As yesterday's CBI survey of smaller businesses illustrated, most firms are experiencing a drastic reduction in bank credit and a tightening in terms.'
These actions by banks threaten the entire economy - and therefore the well being of everyone. As The Independent notes of any proposed Keynesian economic recovery package to meet the economic downturn: 'The sort of fiscal stimulus now being planned can counter this by putting more money into people's pockets and providing more jobs through public investment. The problem of today – as in the great crash – is that the contraction comes hard on the heels of a banking and stock market crisis. Putting more money in the pockets of taxpayers, particularly at the lower end of the scale, can help. But it cannot work alone. For that you need credit to become more freely available at an attractive price.'
The paper then notes: 'From the banks' point of view, that [refusal to lend adequately] may be understandable. They badly need to rebuild their capital base and avoid a return to excessive risk. But from the nation's viewpoint, this is only making a bad situation worse. Banks must support the reflation package by restoring lending. If they will not do it of their own accord, then the Government should use the influence of its new shares and its powers to push them into more responsibility.'
The Financial Times, similarly in an editorial, deals with the same topic - warning of a threat of nationalisation if banks continue to act in their present fashion: '“Neither a borrower nor a lender be” was not intended as advice for bankers. Someone should tell them.
'The purpose of the recent round of recapitalisations was to strengthen banks so that they could continue lending during a global downturn. But banks are not doing so. They must. They are vital utilities – a modern economy cannot function without credit...
The Financial Times notes: 'Banks around the world have been recapitalised. Governments bought shares in them, increasing the banks’ risk-capital buffers. The banks were injected with enough capital not only to make up for the losses they were expected to make in the downturn, but also to allow them to expand their lending without the capital cushion becoming too small relative to the banks’ assets.
'Newly fortified, banks were supposed to become trustworthy borrowers and confident lenders. Expecting further losses, however, they have clammed up. They are wary of extending their balance sheets further. This is, in part, because they are still traumatised after a near-death experience. Many banks have also seen their top management decapitated. Finally, investors and banks have become so risk-averse that even government guarantees on lending are not convincing. Despite being underwritten by the US government, perceptions of the risk on Citigroup’s debts have remained stubbornly high.
The Financial Times argues: 'Governments can do more to support lending. They can reassure markets that capital ratios are supposed to fall in the downturn and that they stand behind the banks. Finance ministries around the world can recapitalise further. Central banks can expand their lender of last resort functions.
'If evidence emerges that banks are not lending because they are hoarding cash to pay off the expensive preference shares taken by governments, the rescue can be restructured. One option would be to give governments more control of the banks; another would be to reduce the short-term costs of the capital.
The paper concludes: 'even if governments ensure that lenders are solvent and liquid, it could still be rational for each bank not to lend. Banks want safety in numbers when it comes to lending. But a lack of credit would force sound companies under because of a working capital squeeze.'
The Financial Times therefore warns: 'If bankers do not start lending of their own accord, governments will force them to.... Faced with this prospect [of lack of adequate lending], governments will have no choice but to step in.
'Politicians may attempt to lend directly, taking on credit risk to stimulate certain categories of lending and insurance. But banks, which have always been dependent on the largesse of taxpayers, could be forced to adopt central targets for new lending. This would overcome the problem of no institution wishing to be the first-mover. And banks would have little choice but to obey; if they are unco-operative, they could end up in public ownership.'
Regarding the same threat of bank nationalisation Nigel Morris, The Independent's deputy political editor, notes: 'The Government is using the threat of a wholesale nationalisation of banks in an attempt to force institutions to lend billions to small companies struggling to survive as Britain slips into recession.
'Downing Street yesterday made plain its fury over high street banks which refuse to use the massive injection of taxpayers' money they have received to come to the rescue of businesses hit by the credit crisis...
'The financial stimulus package is designed to breathe new life into the economy but Mr Darling fears the behaviour of the banks could undermine the moves... He is expected to announce controls on the interest rates charged on small business loans...
'Ministers are irritated that banks the Treasury bailed out are dragging their feet over passing on the money. The Treasury took stakes in HBOS, Lloyds TSB and Royal Bank of Scotland in return for £37bn of public funds. The banks promised to return lending to last year's levels. John McFall, the chairman of the Treasury select committee and an ally of Mr Brown and Mr Darling, raised the prospect of state control, saying: "If the banks do not play ball, and will not resume lending, then the demand for full-scale nationalisation may well grow."
'No 10 refused to rule out such a step, regarded by officials as the "nuclear option". Mr Brown's spokesman said: "In these circumstances, of course we have got to look at all the options. But we want to work constructively with the banks to ensure they fulfil the commitments they have entered into."
'Asked a second time about full nationalisation, he replied: "It would clearly be foolish for anybody to rule out specific options at this stage."The Government has made little effort to disguise its frustration at the behaviour of banks towards small businesses and mortgage-payers.
Morris concludes: 'Mr Darling is preparing to use his pre-Budget report to fire a shot across their bows with tough demands on lending. He is not expected to impose further legal sanctions on banks, such as the appointment of a powerful watchdog to monitor lending rates, but officials want to keep options in reserve if the banks fail to respond. '
This is the dilemma of Keynesianism. What if the banks refuse to respond to voluntarily to government 'influence'? Will the government then say 'private property is sacrosanct. We know that banks refusal to lend is disastrous for the economy. But private property, in this case in banks, comes before the health of the economy and therefore of society. To preserve private property, we must surrender and allow the economy to go into slump'. That is the capitalist answer.
Or will a government say: 'We have tried indirect methods of stimulating bank lending but these have not worked - the banks are using their claimed right as private companies, that is as private property, to refuse to lend. The interests of society, that is of economic development, come before those of private property. Therefore such decisions will be taken out of the hands of the banks. The banks will be nationalised, that is their position as private property abolished, in order to commence the necessary lending to maintain the economy.' That is the socialist answer.
The dilemma of Keynesianism, at least as orginally put forward by Keynes, is this: because it accepts capitalism, that is private property, as the basis of society Keynesianism can only use indirect methods (fiscal deficits, monetary policy, interest rate policy), to attempt to influence the most fundamental issue - the investment decisions in the economy. For, if you take away the right of companies to take investment decisions, you in fact abolish them as private property - that is you abolish capitalism.
Keynesianism can, therefore, deal with minor or moderate economic crises - in these indirect methods are sufficiently powerful to cause investment to recommene and therefore to overcome the economic downturn. But if the economic crisis is really deep such indirect methods are not sufficiently strong. Private compaies will not resume investment and the economy will go into a downward spiral. In those circumstances the only economic way out is take the investment decisions out of the hands of the capitalists and into the hands of society by nationalisation - which means going forward from a Keynesian solution to a socialist one.
In the UK will the present financial crisis require a Keynesian or a socialist solution to overcome it? Regarding the overall economy that depends on how deep the economic crisis becomes. Does the UK face a severe economic recession or an economic depression? Socialist Economic Bulletin at present, for reasons it has outlined, analyses that the UK faces a severe economic recession not a full blown depression - although the reverse outcome could occur if the US makes catastrophic economic mistakes. While the moral case for socialism remains overwhelming it is unlikely, in this country, that it will be impossible to get out of the current economic downturn without resorting to fully socialist measures - that is a wholesale programme of nationalisation. Considering the economy as a whole, a Keynesian/capitalist way to overcome the economic crisis will be carried out.
But that overall perspective not only does not apply to every country in the world it does not apply to every part of the UK economy. In the financial sector, both in the UK and in the US, what is faced is not recession but a catastrophic collapse comparable only to 1929. It is already the case that the most rational, and by far the cheapest, way to sort out the disastrous situation in the UK financial sector would be to proceed immediately to wholesale bank nationalisation. The immedite crisis, whereby the banks are refusing to lend even after the bail out packages, may make it the case that the only way out of the economic downturn is by wholesale bank nationalisation - a sort of Keynesian solution in the overall economy and a socialist solution in the catastrophically affected financial sector.
Indeed, t may be put more strongly. If the government retreats in face of the present policies by the banks, with their refusal to lend then it will not be possible to apply a Keynesian policy in the overall economy. Truly socialist policies, nationalisation, in the financial sector may well turn out to be the only way to apply Keynesian policies in the economy as a whole.

Thursday, 20 November 2008

Dow Jones so far continues to track its 1929 decline

Socialist Economic Bulletin has emphasised the significant danger in current economic and government policy of underestimation of downside risk in share prices. This is fully confirmed by the latest movements of the Dow Jones Industrial Average which are illustrated in Figure 1.
This graph compares the daily movement of the Dow following its peak on 3 September 1929 with its movement following its peak on 9 October 2007. As may be seen the decline in the Dow in the current financial crisis is entirely comparable in magnitude, at this stage, to its fall in 1929-32 - this data updates trends analysed in SEB in October.


Figure 1


In order to show that such a severe decline in nominal share prices is a specific feature of the 1929 and 2007 crises, and not typical of any recession, Figure 2 shows a similar graph for the four most serious declines in the Dow in the last century - those starting in 1929, 1973, 2000, and 2007.
For the three earlier declines the data covers the period from the peak price preceding the decline to its low point. The data for the decline starting in 2007 are up to the latest available date - the close of trading on 20 November 2008.



Figure 2


It may be seen that the falls in nominal prices starting in 1973, associated with the oil price increases and recession of that year, and in 2000, following the bursting of the dot com financial bubble, were far less severe than the drops in either 1929 or in 2007.
The fall in real terms following 1973 is understated by this graph, as at that time inflation was far higher than in 1929, 2000 or 2007, while the decline in real terms following 1929 is somewhat exaggerated as at that time the overall price level in the economy was falling. But the differences of order of magnitude are sufficient to make the pattern clear. The fall in nominal share prices following both 1929 and 2007 far exceeds that of any other drop in the last century.
From the angle of share prices it is entirely justified, and without exaggeration, to speak of the present crisis as comparable only to 1929.
The difference between the fall starting in 2007 and that in 1929 is only, at present, the duration of the decline. The decline after 1929 continued for 712 trading days before reaching its bottom on 7 July 1932. The decline following the peak of 9 October 2007 has so far continued for 284 trading days - slightly under forty per cent of the period of the decline following 1929.
Far more prolonged falls in share prices than in 1929 are, however, possible. The Japanese Nikkei, to take the extreme case, was still setting new lows 18 years following its peak at the end of 1989.
For these reasons, to return to the point made at the beginning, there continues to be considerable underestimation of downside risk in share prices in current economic and government policy.

* * *

This article is a shortened version of one which appeared on Key Trends in Globalisation.


Tuesday, 18 November 2008

Where financial gangrene threatens to develop in the US financial system

Socialist Economic Bulletin has noted that the huge financial effort put into trying to prevent the collapse of the most important, that is the system making, banks is draining resources out of the rest, i.e. 'the periphery', of the financial system.
Alongside the effect this is having on countries such as the Ukraine, Pakistan, and Argentina, an important new paper by Victoria Ivashina and David Scharfstein of the Harvard Business school analyses the operation of this process within the US financial system itself.
They note that in the US: 'new loans to large borrowers fell by 36% during the peak period of the financial crisis (August-October 2008) relative to the prior three-month period and by 60% relative to the peak of the credit boom (May-July 2007)...
'Although new lending has fallen, since September 2008, there has been a sharp increase in commercial and industrial (C&I) loans reported on the balance sheets of U.S. banks... [Some analysts have] interpret[ed] this as new bank lending; however, our evidence is inconsistent with this view. Instead, we suggest that the rise in C&I loans on bank balance sheets comes in good measure from an increase in drawdowns on pre-existing revolving credit facilities ("revolvers").
'These drawdowns are not just from high quality borrowers who are shifting from the commercial paper market because of disruptions in that market. Many of them are very large, low credit-quality borrowers, who are now borrowing on the generous terms that were offered during the credit boom, though they are now much riskier. While this may help these firms, it may also crowd out new lending to other firms. The amount of outstanding revolvers is very large, and banks may be holding back on new loans to protect against flood of draw-downs if the economy continues to deteriorate.'
They conclude: 'New lending in 2008 was significantly below new lending in 2007, even before the peak period of the financial crisis (August-October 2008)... new lending to large corporate borrowers peaked in the period, May-July 2007. In September 2007, concerns about the credit risk of all types of collateralized debt obligations (CDOs), led to a drop in institutional demand for syndicated loans... By May-July 2008, lending was 38 per cent lower than the peak of the credit boom....
'The decline in new loans accelerated during the financial crisis, falling by 36 per cent in the August-October 2008 period relative to the prior three-month period. Thus, bank loans fell from $667.4 billion in May-July 2007, the peak of the credit boom, to $414.8 a year later, and then to $264.7 billion three months later in the August-October 2008 period. The drop in October, 2008 was particularly steep. Lending during the peak financial crisis period was just 40 per cent of peak lending little over a year earlier...
'During the peak period of the financial crisis (August-October 2008), non-investment-grade loans fell by 50% relative to the prior period, while investment grade loans fell by 19%. '
This analysis describes graphically how blood is being drained out of the US financial system despite the huge increase in taxpayer bailout activites to the banks.
Noting the operation of this process the Wall Street Journal comments: The worst of the credit crisis is being felt not in banks but in financial markets. Loans from a bank might stay on its books. Increasingly in the past decade, loans were packaged into securities and sold to investors around the world - pension funds, endowments, mutual funds, hedge funds and others. Institutional investors gobbled up this and other kinds of credit that didn't come via traditional commercial banks, such as junk bonds or commercial paper.
'To get credit flowing, policy makers need to repair financial markets as well as banks. But investor confidence in credit markets has been shattered, in part because many debt securities performed so much worse than their credit ratings suggested they would.
'Issuance of asset-backed securities - instruments used to package credit-card and auto-loan debt during the boom - was down 79% in the year through October from last year, to $142 billion, according to Dealogic data. In 2005 and 2006, investors snapped up more than a trillion dollars of these instruments. Junk-bond issuance was down 66% in the first 10 months of the year from the same period in 2007. '
In short, the system making banks have been propped up through very large transfers of taxpayers funds. Financial circulation has been restored in the core of the system. But circulation is stopping in the periphery of the system both geographically and in terms of financial markets within the most economically developed economies themselves. This is now where the credit crunch is most advanced.
In addition to the importance of this development itself a key issue will be whether the poisons being produced from this financial gangrene will invade the core of the financial system again.

Monday, 17 November 2008

Mounting dangers to the taxpayer of the government proposal to buy shares in RBS, HBOS, and Lloyd's TSB

Socialist Economic Bulletin (SEB) has repeatedly warned of the danger of very serious losses to the UK taxpayer if the government proceeds with its proposal to buy shares in Royal Bank of Scotland (RBS), HBOS, and Lloyds TSB. The government agreed to purchase these at a price per share of, respectively, 65.5p, 113.6p and 173.3p. It was claimed these were being bought 'at the bottom of the market'. SEB warned that, first, it was not an acceptable risk to the taxpayer for the government to become involved in attempting to judge the price of shares, and second any view that these shares had reached their bottom was likely to be seriously flawed as the government was underestimating the historical dangers of very prolonged depression of share prices. Other commentators have since strongly made the same point.
This danger is graphically revealed by the movement of these bank share prices under the impact of the further deepening of the international financial crisis. At noon on 17 November the prices of RBS, HBOS, and Lloyds TSB were respectively 49.1p, 77.0p and 149.6p.
This means that Lloyds TSB shares were 14 per cent below the price the government proposed to purchase them at, RBS shares were 25 per cent below, and HBOS shares were 32 per cent below.
This shows, first, that it was false to say that the proposed purchase prices were 'at the bottom of the market' and second that is is quite wrong for the government to be using taxpayers money to purchase shares at prices that are far above the market level. Purchase of shares at far above market prices is to subsidise shareholders while taxpayers suffer large losses.
The government should stand ready to take over companies that fail in order to ensure functioning of the banking system - as it did with Northern Rock and Bradford and Bingley. It should not be purchasing shares at far above market prices.

Why China and Saudi Arabia have refused to prop up the IMF and Japan has agreed

The emerging US government plan to attempt to salvage its position in the economic world order is now relatively clear.
The US government has pumped gigantic resources into bailing out its most central financial institutions. It knows that this will involve great domestic political unpopularity as ordinary US taxpayers are asked to pay hundreds of billions of dollars to shareholders of US banks - a point strongly made not only by Socialist Economic Bulletin but also by other observers.
But the US government also knows that these bailouts have left little financial oxygen for the 'periphery' of the international financial system. Therefore the financial system of a whole series of countries faces destablisation or even collapse.
The US has then decided which countries it considers it wishes to attempt most closely economically to bind to itself and will offer them the little financial aid it has left. Brazil, Mexico, Singapore and South Korea have therefore been chosen for $30 billion dollar swaps with the Federal Reserve to prop up their financial system.
This leaves the problem, however, of what to do with other countries, including the real basket cases of the international financial system - those countries where huge losses are possible. The US government proposes that these be saved through the IMF. The US government, however, has no extra resources to put into the IMF and proposes that the China, the oil producers and Japan come up with the necessary money.
Saudi Arabia and China, acting with financial sense, have politely declined that they prop up an international financial system that benefits the US at the expense of their suffering further huge losses. That is, they have refused to put further money into the IMF.
Japan has, however, agreed to put in $100 billion - which is not enough to meet the type of financial resources the IMF is likely to require but represents a considerable financial exposure to loss even for a country with such large financial resources as Japan.
Once more this illustrates the political subordination of Japan to US economic interests. Any country acting in its own economic interests, as with Saudi Arabia and China, would have declined this US offer. Japan has gone along with it because it wants an alliance with the US against China and Russia. The price Japan pays for this is tremendous damage to its own economy - as the whole economic history of Japan since 1973 shows.

Saturday, 15 November 2008

G20 agree to avoid the main issues - and Britain will be hit

The G20 Washington meeting of the leading economic powers avoided all the main issues that are really driving the international financial crisis.
Adding a fiscal stimulus, via tax cuts and increased government spending, to the measures already announced for taxpayer purchasing of bank shares is like administering a pain killer in an attempt to treat a serious disease. It might, at best, make the patient feel a little better. It does nothing to treat the underlying causes of why they are feeling so bad nor will it prevent the symptoms of the disease breaking out again.
The main driving force of the financial crisis remains that the dollar is overvalued and the US economy is over stretched to an extent that destabilises the world financial system. To stabilise the world economy there must, therefore, be a reduction of expenditure by the US.
The only way this can be achieved, without the US population suffering the consequences of this via drastically reduced personal consumption, is if US military expenditure is drastically reduced - which will involve measures such as withdrawal from Iraq. Refusal to acknowledge such economic realities is why the Bush presidency was such a drastic failure - leading first to an unsuccessful war in Iraq and then a financial disaster. However, so far, the US government shows no serious signs of understanding this lesson and therefore the US population will continue to suffer - along with the rest of the world.
Regarding reform of international financial institutions, a 'new Bretton Woods', the only way the IMF could be strengthened is to increase the voting weight of China, India and other new rapidly growing developing countries - as otherwise they will not give meaningful injections of funds. But that means reducing the role of the US - which, so far, it will not agree to. So there is an impasse on that front.
In Britain, meanwhile, the conditions are accumulating for a new financial storm. While other countries will agree to prop up the dollar temporarily for political reasons no major country sees any reason to prop up the pound. The UK therefore faces, in a more immediate form, the same choice as the US. Given the UK's real purchasing power in international terms will fall, as the pound's exchange rate declines, it will either have to cut military expenditure or reduce the living standard of the population below what is required. A fiscal stimulus of tax cuts and increased public spending will, at best, only delay that choice for a short period - and they will only be able to do that provided financial markets do not rebel. Meanwhile the government faces the immediate dilemma that the price at which it agreed to purchase shares in RBS, HBOS and Lloyd's TSB is in every case now above the market price for the same shares - threatening the taxpayer with substantial loss.
It is even clearer in this situation that only the policies of the left - reduction in UK military spending to avoid attacking the living standards of the population, targeted economic aid to those worst affected by the financial crisis to maintain consumer spending, increased state spending on infrastructure to keep up investment and improve the competivity of the economy - have a realistic way out of this financial crisis. The left's case is not only morally superior it is the only economically rational one - as the G20 meeting vividly illustrated.

Tuesday, 11 November 2008

Cost of bailouts rises as welfare state for corporations gets ever wider

If ever anyone wanted a clear illustration of the class based character of our present economic system, and the moral hypocrisy of capitalism, they need only look at the newly created and rapidly expanding welfare state for corporations and shareholders.
In both the US and Britain we have been told for decades that benefits must be cut back, that the unemployed are work shy, that probably most of those claiming incapacity benefit are fraudsters, in general the welfare state is a bad thing, and we must all be exposed to the full rigour or market forces or the country will be brought to its knees by 'scroungers'.
The moment banks and large corporations were in trouble, however, literally trillions of pounds and dollars were mobilised to help save their money.
In Britain Royal Bank of Scotland, HBOS and Lloyd's TSB were propped up by taxpayers money being used to support their shares. In the US the latest news shows both the still increasing cost of the financial crisis and the widening welfare state for shareholders.
Taking first two US companies in which shareholders were wiped out before their nationalisation, the insurer AIG and the mortgage company Fannie Mae, the cost to the taxpayer of the previous decisions of these companies is rapidly mounting.
Fannie Mae has announced it is losing money so rapidly, $29 billion in the third quarter of 2008, that it may need a cash infusion from the US Treasury Department by the end of the year from a special $100 billion fund the US Treasury set aside in September to aid the company. The already nationalised AIG announced a quarterly loss of $24.5 billion and has won approval from the US Federal Reserve to change to a bank-holding company - thereby opening it up for further government aid by participating in the Paulson bank bail out plan.
Turning to privately owned companies, American Express, the credit card and finance giant, has been granted bank-holding company status - as earlier were Goldman Sachs and Morgan Stanley. The Wall Street Journal reports that under these bank bailout plans the US government had promised: 'not to force banks receiving government assistance to lend out those funds to consumers and small businesses.' That is the main beneficiary will be bank shareholders.
In a surprise tax ruling the US Treasury has simultaneously handed up to a further $140 billion to US banks. The Washington Post commented: 'The financial world was fixated on Capitol Hill as Congress battled over the Bush administration's request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention... corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.
'The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal... "Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."... The guidance issued from the IRS [Inland Revenue Service] caught even some of the closest followers of tax law off guard because it seemed to come out of the blue when Treasury's work seemed focused almost exclusively on the bailout.
"It was a shock to most of the tax law community. It was one of those things where it pops up on your screen and your jaw drops," said Candace A. Ridgway, a partner at Jones Day, a law firm that represents banks that could benefit from the notice. "I've been in tax law for 20 years, and I've never seen anything like this."'
Simultaneously speaker of the US House of Representatives Nancy Pelosi was calling for a special session of Congress to bail out General Motors and other stricken US car manufacturers.
As the Wall Street Journal noted on 11 November: 'It was a day when even the monolithic U.S. government might be forgiven a sense of being overwhelmed by the current financial and economic situation.' Or as one one figure the newspaper quoted put it about the US government: 'The rescue efforts are "evolving in ways that I don't think anyone anticipated," said Camden Fine, president and CEO of the Independent Community Bankers of America, a trade group. "Things are just hitting them from every single direction, every day, and I don't think they know whether to spit or go blind."'
What conclusions should be drawn from all this? They are both economic and moral.
First, the claim that capitalism is a beautiful market self-regulating system has been shown to be simply untrue. This crisis shows it requires the state to step in to keep it stable.
Second, capitalism's moral hypocrisy and bankruptcy is breathtaking. A poor person on unemployment benefit or a pension can be thrown to the wolves. But if you are a rich US or UK corporation you must be bailed out immediately. It remains to be seen how much and how rapidly public opinion draws the conclusions from all this.
But to adapt Christopher Wren's words in St Paul's cathedral - 'if you want to know the case against capitalism just look around.'

Sunday, 9 November 2008

Arrogance of the private banks

Socialism holds that the rational development of the economy, and therefore the welfare of society, can come into conflict with private ownership in the large scale means of production. In such a conflict socialists hold it is the interests of society that must take precedence over the private owners of the means of production.
Two such conflicts are already being seen in the current financial crisis. The first is that the recession threatens a collapse in investment. However both to keep up demand in the economy, that is to be able to carry out effective counter-cyclical measures, and to ensure long term economic growth, maintenance of investment is crucial. For that reason it may be necessary to carry out nationalisations in key industries such as construction in order to sustain investment. Economies with larger state sectors, such as China, are also able to carry out more effective counter-cyclical measures.
But the second key area is with the banks. In order to counter recession it is imperative that interest rates are radically reduced. The rate at which the state lends to banks, set via the Bank of England's base lending rate, has been radically reduced. However the private banks are continuously either dragging their feet or refusing point blank to pass such interest rate cuts on to their borrowers - as shown clearly this week when major banks attempted not to pass on the one and a half per cent Bank of England rate cut. Simultaneously they are attempting to abolish their lowest rate tracker mortgages. The reason is because they are attempting to make profits that are to be passed on to their private shareholders.
As Phillip Inman puts it rather delicately in the Guardian, shareholders: 'want their banks to increase profit margins. If banks can increase the spread between mortgage lending and paying savings interest, then they can recover more quickly. At the height of the boom, mortgage rates were little more than 0.5% above savings rates. Today, banks want that figure to expand to 2%. If mortgage rates track down with further cuts in the base rate to 1%, which some commentators believe will happen next year, it will be difficult keeping the savings rates above 2%.'
In other words policy is not to be set by the needs of the economy and limiting recession, which requires the sharpest possible reduction in interest rates, but by the desire of bank shareholders to make profits.
Many of these shareholders, incidentally, have just been saved from their holdings being make completely worthless by a huge injection of taxpayers money. Now they not only want their share prices propped up by the taxpayer but that bank lending policy should be dictated not by the needs of the economy but by their desire to make the highest profits.
If anyone ever wanted to know why private property in the means of production can come into conflict with economic development, and the case for bank nationalisation, they need merely study current developments.
Having brought the economy to the brink of disaster through their wrong decisions private bankers now demand that the interests of the entire economy be subordinated to their interests.

Keynesian and Marxist analysis of the financial crisis - part 2

Socialist Economic Bulletin has previously noted the great increase in interest in both Keynesian and Marxist economic analysis under the impact of the international financial crisis. On the blog 21st Century Socialism Noah Tucker has a far more extensive piece surveying the latter issue.
This notes, among other things, that: ''The President of France has been improving his understanding of the current crisis by reading Marx's Capital, and Germany's Finance Minister has grudgingly conceded the correctness of "certain elements of Marxist theory". '

Saturday, 8 November 2008

China and the international financial crisis

China's reaction to the international financial crisis will play a crucial role not only for its own but for the world economy. However, seen from China's perspective, the international financial crisis has features which differ significantly from those in Europe or the US. This post looks at some of these.
The first point is that in confronting the international financial crisis direct financial turmoil is not a key feature of the situation in China - unlike the spectacular manifestations of this seen in Europe or the US. China's banks had almost no exposure to now heavily discounted, or worthless, sub-prime mortgage or similar financial products. While in Hong Kong there is some concern over the direct financial fallout, no mainland Chinese bank has suffered significant losses in this field. The immediate issue for China is the effect on its productive economy and on the renminbi’s exchange rate. But underlying these is a still more fundamental issue – maintenance of China’s savings and investment rates.
Indeed. seen from China, the international financial crisis might be posed from a different angle. It may be viewed as the 'third great Asian financial crisis' – the first being that of Japan and the yen in 1973-90, and the second that of the South East Asian debt and currency crisis of 1997. To emerge successfully will require from China an enormous response and a new stage of its economic development.
Socialist Economic Bulletin has noted that the fundamental determinant of the much higher rates of growth of a number of Asian economies, compared to the US or Europe, is their far higher investment rates. Therefore for the US and Europe to regain competitiveness with Asia one of two things has to happen. The US and Europe have to raise their investment rates up to Asian levels, or the Asian economies have to lower their investment rates down to US and European ones.
These two courses have very different implications for world economic growth. If the US and Europe raise their investment levels towards Asian ones then Asia will essentially maintain its present economic growth rate and that of the US and Europe will increase – i.e. world economic growth will accelerate. If, however, Asian investment levels are reduced towards US and European levels then the growth rate of the Asian economies will also fall, while economic growth in the US and Europe will not increase – i.e. world economic growth will decline. It is, therefore, far preferable that the US and Europe increase their investment rates rather than that those in Asia fall.
Nevertheless, in successive economic crises of the last thirty years, the outcome was the opposite of the preferable one – the US and Europe did not increase their investment rates, indeed those in Europe fell, but the investment rates of a number of Asian economies declined.
To illustrate this process in more detail, Figure 1 shows the level of fixed investment as a percentage of GDP for the US, Germany and France. As may be seen, the US fixed investment level has been essentially constant for the last half century at around 20 per cent of GDP – itself a continuation of a very long term trend in US investment rates. The German and French levels were somewhat higher than that for the US for the period up to the early 1970s, at around 25 per cent of GDP, and then fell to levels comparable to the US. Such investment levels generate rates of growth of 1.5-3.5 per cent a year.

Figure 1
US, Germany, France GDFCF 1950


If these US and European trends are compared to the situation in Asia there is a clear contrast. Asian economies have achieved far higher levels of investment, reaching over 40 per cent of GDP, and far higher rates of growth – in some case approaching or achieving double digit rates. However, the effect of both the post-1973 crisis in Japan, and the 1997 crisis in South East Asia, was to reduce these investment rates and with them also rates of growth of growth of GDP.
Considering this trend in a number of Asian countries in greater detail, Figure 2 shows the proportion of GDP accounted for by gross fixed capital formation in Japan. Japan’s fixed investment level peaked at 36.4 per cent of GDP in 1973. At this time, averaging the preceding five years, the annual average rate of growth of Japan’s GDP growth was 9.3 per cent.

Figure 2GDFCF


The economic events which commenced in 1973, and which were accompanied by the first ‘oil shock', greatly affected Japan. The proportion of GDP devoted to gross domestic fixed capital formation declined to 27.5 per cent by 1986, and Japan’s average annual rate of growth of GDP, over the preceding five years, fell by two thirds to 3.1 per cent. By 1986 the Japanese economy, which had been expanding almost three times as fast as the US in the early 1970s, was growing more slowly than the US – in comparison in 1986 the average annual growth rate of US GDP over the preceding five years was 3.5 per cent.
Japan’s investment rate then temporarily rose under the impact of the hyper lax monetary regime during the ‘bubble’ economy in the late 1980s – a consequence of Japanese financial policies introduced to aid US economic stability following the 1987 Wall Street stock market crash. Following the bursting of Japan's financial bubble in 1990, the investment rate fell again and by 2002 gross domestic fixed capital formation had declined to 25.8 per cent of GDP while Japan’s five yearly annual growth rate of GDP had declined to 0.2 per cent.
Summarising these processes, under the successive impacts of the oil price increase and the monetary effects in Japan of the measures it chose to take to respond to the 1987 Wall Street crash, the proportion of the Japanese economy devoted to fixed investment fell by 10.6 per cent of GDP, and Japan’s annual growth rate decelerated from 9.3 per cent to 0.2 per cent - a 98 per cent decline.
If Japan post-1973 was the first great Asian economic/financial crisis, the second was the debt and currency crisis of the South East Asian economies in 1997. The similarity of the outcome to the earlier crisis in Japan’s is striking.
Figure 3 therefore shows South Korea’s rate of gross domestic fixed capital formation. This rose progressively to 39.0 per cent of GDP in 1991. By that year the average annual rate of growth of South Korea’s GDP over the preceding five years was 9.4 per cent.
By 1996, the last year before the currency crisis, South Korea was still investing 37.5 per cent of GDP and its five yearly annual average rate of growth of GDP was 7.3 per cent.
Following the 1997 debt and currency crisis, however, the proportion of South Korea’s GDP devoted to fixed investment fell sharply, to only 28.8 per cent of GDP in 2007, and its five yearly annual average growth rate of GDP declined by almost half to 4.4 per cent.

Figure 3S Korea GDFCF


Figure 4 shows the similar process in Thailand. By 1996 the proportion of Thailand’s GDP devoted to fixed investment was 41.1 per cent of GDP – although this level was clearly unsustainable as it far exceeded the domestic savings available to finance it, resulting in a balance of payments deficit of 8.2 per cent of GDP. Thailand’s five yearly average annual rate of GDP growth was 8.1 per cent.
Following the currency crisis, by 2007 the proportion of Thailand’s GDP devoted to gross domestic fixed capital formation had declined to 26.8 per cent and the five yearly average annual rate of GDP growth had fallen to 5.6 per cent.


Figure 4Thailand GDFCF


Figure 5 shows the similar process in Malaysia. By 1996, the last year before the debt/currency crisis, Malaysia’s gross domestic fixed capital formation was 42.5 per cent of GDP - although again this was being unsustainably financed by a balance of payments deficit. Malaysia’s five yearly annual average rate of growth of GDP was 9.6 per cent.
By 2007, ten years after the currency crisis, the proportion of Malaysia’s economy devoted to fixed investment had fallen to 21.7 per cent and the five yearly average annual rate of growth had dropped to 6.0 per cent.

Figure 5
Malaysia GDFCF


Therefore, although the mechanisms of the crises were different, the outcomes in Japan in 1973-90, and South East Asia in 1997, were essentially the same - the proportion of the economy devoted to investment fell drastically and therefore so did the growth rate.
The impact of these two previous Asian economic crises, therefore, clearly illustrates the challenge facing China. China’s level of investment is significantly higher than Japan’s in 1973 – China's fixed investment rate is over 40 per cent of GDP compared to Japan's 30-35 per cent at that time. China's annual average annual rate of growth for the last five years is over ten per cent compared to Japan's nine per cent in 1973. In a number of South East Asian states, on the eve of the 1997 crisis, their very high investment rates were unsustainable, as they far exceeded domestic savings levels and were financed through extremely high balance of payments deficits. In contrast China’s savings level, running at over 50 per cent of GDP at nominal exchange rates, is even higher than its level of investment – see Figure 6. China, therefore, does not fact the international financial constraints facing South East Asia in 1997. There is, therefore, nothing inherently financially unsustainable in China’s very high investment rates. It has more than adequate domestic savings to finance its current investment levels and, therefore, approximately its present growth rate.

Figure 6
China Savings and GDFCF


But it is the international context that has changed significantly and poses the economic challenge. With many economies moving into recession, and virtually all slowing, China's export growth will become significantly harder - even more so as simultaneously the renminbi is becoming a ‘hard’ currency.
As illustrated in Figure 7, the renminbi's exchange rate moved up against the dollar prior to the outbreak of the international financial crisis and it has remained constant against the dollar since its onset. As, however, the dollar has moved up against almost all currencies, except the yen, this means that the renminbi has undergone an upward revaluation against almost all other currencies.

Figure 7
Main currencies versus $ 2000

China’s exporters, therefore, face a double squeeze. First, the markets in the economies into which they are exporting are either contracting or growing far more slowly. Second, the renminbi’s exchange rate is rising. This combination squeezes China’s exporters while simultaneously cheapening imports. China's balance of payments surplus may, therefore, decrease from its current level – the last available data being for 2007 showing a surplus of $372 billion.
However, statistically, the balance of payments is necessarily equal to the difference between domestic savings and investment - China’s balance of payments surplus reflecting that its savings level is even higher than its investment level. If China’s balance of payments surplus declines this can therefore only be achieved by its investment level moving up towards its savings level or its savings level declining towards its investment level, or a combination of the two.
Which of these two occurs will have a huge influence on both the Chinese and the world economies. As already noted, in the case of both Japan and the South East Asian economies, faced with crisis, investment levels fell. Their economies consequently drastically decelerated – negatively influencing the rate of growth of the world economy. A major deceleration of China’s economy, particularly under conditions of recession in other major economies, would have very negative consequences for international growth.
The health of the world economy, therefore, requires that if China’s balance of payments surplus is to shrink this should be by moving its domestic investment rate up towards its savings rate, not by its savings level falling towards its investment rate.
Domestic economic requirements China push in the same direction. The exchange rate of the renminbi has not merely moved upwards but will remain higher due to the underlying strength of China’s economy. A clear lesson of the current crisis is that any primary use of China’s financial resources not for domestic investment but fundamentally to attempt to maintain a low exchange rate of the renminbi will not work as a strategy – even in cases where the renminbi is stabilised against the dollar it moves up against other currencies.
China will, therefore, have to learn to compete at a higher exchange rate. This requires that its whole economic mechanism become more efficient, which can only be achieved through investment. China will cease to compete as a pure low wage economy – Vietnam and other economies now occupy the place China did twenty years ago. High levels of investment are therefore vital if China's economy is to compete in this new context.
Put in other terms, China's traditional strategy has been to keep its currency's exchange rate down to the level of productivity of its economy. In the future China will have to raise the level of productivity of its economy up to its appreciating exchange rate - requiring gigantic further investment in its productive base.
Consequently the cyclical requirements of economic management, that is ‘Keynesian’ anti-recessionary measures, coincide with the structural requirements of a high investment level. So far the Chinese government is heading in the right direction in announcing successive waves of infrastructure and other investment – railways, roads, housing. The fact that China has a large state owned economic sector allows it to take far more direct ‘Keynesian’ measure to sustain investment than are available in the US or Europe.
Nevertheless the scales of the programme’s which are required are gigantic. If, to take a hypothetical example, China’s balance of payments surplus were to fall by half under the impact of pressure on exporters and cheaper imports due to the higher exchange rate, while its savings level remained the same, this would required $175-$200 billion extra a year investment in China’s domestic economy. While there is no financial constraint on this, due to the high savings rate, the task of physically gearing up the economy for such a scale of extra-investment programmes is gigantic.
Naturally this particular example is arbitrary, and China’s balance of payments surplus may not fall to this degree, but it shows the scale of economic forces and shifts which are involved.
At the same time China faces new economic challenges it has not experienced previously. The fact that China is acquiring a 'harder' currency will undoubtedly lead to central banks of other countries wishing to hold the renminbi as part of their foreign exchange reserves – an issue China has not faced on a significant scale before.
Simultaneously China will come under pressure to use its financial resources for measures other than investment in its domestic economy. The US has announced that it is arranging dollar swaps for four economies that it considers systemically crucial – Brazil, Mexico, Singapore, and South Korea. But there will be a whole series of much weaker economies in deep trouble and it will undoubtedly be proposed that China should finance these, probably via intermediaries such as the IMF, rather than investing its resources in its domestic economy. When China attends the international economic summit in Washington on 15 November the US will also almost certainly propose that China accelerate a programme of buying US Treasury bonds.
So far China is rightly adopting the approach that 'the most important task for us now is to manage our own affairs well', as vice-premier Wang Qishan put it. But pressure put on China to change that stance, and divert resources away from its key goals, will increase. In other words many other people also have their eye on the funds which China could invest in its domestic economy.
With all these pressures, together with domestic programmes of improving social welfare and attempts to improve conditions in rural areas taking place simultaneously, not to mention other issues to manage, Chinese economic policy makers are going to be kept extremely busy in the coming months.
However, as noted, while there are many specific issues to tackle they are all within the framework of one decisive strategic choice. If China responds in the same way that Japan did in 1973-90, and South East Asia did in 1997, that is by reducing its savings and its investment levels, this will be bad not only for the Chinese economy but for the world economy. If, however, China is able to maintain its savings and investment levels through the present ‘third’ Asian currency crisis, which is a crucial aspect of how the international financial crisis appears from its perspective, not only will that be good for the world economy but it will be one of the greatest pieces of macro-economic management, not to speak of practical management of huge investment programmes, ever seen.
China since 1979 has achieved one of the greatest economic miracles in history. Confronted with the third great Asian financial crisis China again faces a gigantic challenge to its macro-economic management. How successfully it confronts that will have profound consequences not only for its own but for the entire world economy.

Note:
This article is adapted from one that appeared on the blog Key Trends in Globalisation.

Update 10 November:
China has announced a further large scale stimulus package.