Is Plan A Working?

With economic foreboding reaching fever-pitch again in recent months, we asked two of the UK’s leading commentators on the economy to give us their take on quite how bad things are and what it all might mean for local authority cash managers. Starting with home, and “Is Plan-A Working”, we spoke to Philip Booth and Steven Bell.

Steven Bell is a Director and global-macro portfolio manager with the London-based fund manager, GLC Ltd. Before joining GLC he was Chief Economist with Deutsche Asset Managament and prior to that an advisor to the UK Treasury.

Prof Philip Booth is Editorial and Programme Director at the IEA and professor of insurance and risk management at Cass Business School, City University. Philip has written widely on pensions, social insurance and financial regulation and was formerly an advisor on financial stability issues at the Bank of England.

Room151: Is Plan A working?

Steven Bell (SB): Yes, for three reasons. Firstly, markets regard our deficit-reduction plan as credible. Secondly, a Plan B that involved a fiscal relaxation big enough to make a meaningful difference to the economy would leave us with a manifestly unsustainable fiscal position. Thirdly, we have achieved the maximum benefits in terms of low yields and a stable but weaker exchange rate so there is little to be gained from a Plan A+ with an even tighter policy

Philip Booth (PB): To the extent that Plan A was designed to get the government deficit under control and stabilise national debt, it is working. To the extent that it was supposed to be reviewing the functions of government so that we can have lower levels of spending and taxation going forwards, it has been a
failure. Spending will be rising over the coming years and real spending is being cut by less than one per cent a year. We are not going to have the radical reform we need in many areas to ensure a much more effective welfare, education and health system – with the possible exception of education. In these respects, the government will leave much to be done in 2015 and an opportunity has been missed.

R151: If we’re going to have another round or rounds of quantitative easing, what should the Bank of England spend the money on?

SB: The Bank of England feels reluctant to buy anything but gilts and has eschewed ‘credit easing’. I think
they are correct in this regard but the Treasury rather than the Bank of England should intervene in these areas (I’m sceptical of their ability to avoid wasting public money in this regard).

PB: There are only two choices. The central bank could buy government bonds or private sector instruments. Without question, I believe that the central bank should do the former. The central bank should not be taking private sector investment risk onto its limited balance sheet and is not in a position to distinguish between good and bad risks. Once the newly-created money is in the hands of private sector institutions that have sold the gilts to the Bank of England, they can choose how that money is reinvested. It is through that –indirect – mechanism that private sector investment is supposed to be stimulated. Whether another round of quantitative easing was justified is another matter – however, I strongly believe that such quantitative easing should focus on government debt purchases when it happens.

R151: Do you see a conflict between the need for growth and deficit reduction?

SB: It’s partly a question of growth today v. growth tomorrow. Expansionary fiscal policy today mandates contractionary fiscal policy tomorrow. However, when the threat is one of sustainability, a failure to address the deficit today can reduce growth today and tomorrow. In reality we still have a trade-off but, as argued above, there is little to be gained from easing off on the brakes now.

PB: There is no conflict. The evidence suggests that open economies on floating exchange rates with well-developed financial markets and a high level of indebtedness do not suffer a loss of national income if there is a reduction in government spending – this is true even in the relatively short run. Britain ticks all those boxes. Government spending crowds out private sector spending and that effect is especially rapid
and substantial in the case of the UK because capital inflows from abroad tend to raise the exchange rate. Once we get up to high levels of indebtedness, confidence can disintegrate and consumers rein in spending in anticipation of future tax increases.

The evidence from previous recessions in the UK and elsewhere corroborates this point. From the early
1930s to the early 1980s, we failed to spend our way out of recession when we tried and did not delay the end of recession when we followed conservative fiscal policies.

There is an additional problem in the case of the UK. We have probably reached our taxable capacity. Increases in government spending – if followed by increases in taxation – have a second-round impact on growth because of the effect on the supply side of the economy and on entrepreneurship. We have reached a dangerous point in terms of the size of the state in Britain and we will not delay recovery through the modest proposed spending reductions. I am nervous, though, about the sequencing of policy. Tax increases do, as noted above, affect the supply-side of the economy. It would have been better to reduce government spending first and then increase taxes only if necessary. Instead, the government has decided to reverse this approach and the tax increases will have affected growth. It would have been better if more weight had been put on spending cuts in the deficit reduction programme or – as a minimum – if spending cuts had come before tax increases.

R151: If you were a local authority assessing counterparty risk which banks would you be keeping a close eye on?

SB: Answering this question in reverse: a  UK local authority can hardly be blamed for having exposure across a range of large UK banks or shortish-dated exposure to AAA rated entities. That may be highly restrictive but yes, keep your eyes on the rest, and indeed the above.

PB: No Comment

R151: Given the great uncertainty surrounding the European and global economies, what would your advice be to local authority cash managers?

SB: My advice, related to the above, is to focus on avoiding disaster. If you take risk, you won’t be rewarded if it works out well, but you may be punished if it doesn’t. Act accordingly.

PB: Diversify, monitor counter-party risk and monitor counter-parties of counter-parties.