Monetary Crisis … A New Bretton Woods?


It has been almost comical watching the politicians falling over each other in the scramble to get on the fiscal band wagon … good old Keynesian stuff. If the economy is flagging give it a shot in the arm with fiscal medicine far quicker than any monetary stimulus. Then of course Gordo Brown starts calling for a new Bretton Woods agreement, pure obfuscation.

Yes Germany have chosen to adopt fiscal stimulus … they are working out of a surplus not a deficit and the measures will probably have the desired impact. China have chosen to do the same … also out of surplus, so the actions in both cases are non-inflationary. In our case we have a massive budgetary deficit and worse, a growing current account deficit, which means that any fiscal package to stimulate the economy is going to involve further money creation … all Keynesian equations will tell you that that is more likely to result in increasing prices than increasing output.

To solve any problem we need to put all the facts on the table … you can never solve anything while you are working in the dark. Gordo has taken most of the UK capital expenditure off balance sheet so we need to know the true extent of the public debt.

At July 2007 our Public debt was officially a shade under £600 billion, to this we need to add an estimated £200 billion in respect of public/private partnership initiatives, £500 billion in respect of unfunded public sector pension liabilities (as at 31st March 2005 per Mr Timms in a written answer to a question in parliament June 2007) and finally a difficult to quantify number but for the sake of argument let's assume another £150 billion in respect of the “Bank Bail Out” although this could be a much bigger number. We now reach a figure of public Debt equal to £1.5 trillion or roughly 125% of our GDP … not the fancy 40% Gordo claims.

Anyway I will make use of this number in an attempt to see if there is a rational solution to the problems we face. In addition we have to look at external debt of the private sector equal to about £5 trillion.

Our problem is not so much the level of debt but the fact that we need it to grow at a rate equal to 40% of GDP to maintain our current levels of consumption and investment and hence GDP.

Most of us don't understand GDP and think it is some kind of measure of the outputs of the country or exports … well no it is simply the sum of incomes within a country … more accurately the sum of consumption expenditure within the country and personal saving.

Our quickest way to influence GDP is to manipulate Government spending. If we increase Government spending and fund that increase through higher taxes we will have virtually no impact as the increased taxes will reduce the amount available for personal savings. If we increase Government spending and fund that out of Government borrowing we will have increased GDP … whether this increase is real or not will depend on whether the productive economy increases output to a corresponding value.

If the productive economy fails to increase output the increase in GDP will prove illusory as prices will simply rise to mop up the increased money supply (inflation … however this usually has a time lag), or imports will increase.

From this we see that fiscal policy (taxation and government expenditure) is the easiest way of influencing an economy. However we need to be aware that both Vincent Cable and David Cameron have made proposals that use fiscal policy but will fail to increase GDP. Why? … Well if we reduce some taxes and make a corresponding reduction in Government expenditure we have not changed the situation. All government expenditure, to the extent that it is not import related, ends up as income for some or other person (or entity) in the country and therefore adds to GDP … they will either spend or save it and either choice increases GDP. We can see that their proposals only have an effect on who benefits … they will create a winners and losers scenario. That is unless they can find cuts in expenditure that will reduce imports.

We haven't yet seen Gordo's fiscal proposals, however we can expect to have a lot of smoke and mirrors as he continues on his merry way of increasing government borrowing. I have no doubt that he will bring forward future capital works which will have a strong stimulatory influence on the economy … the problem is … will it prove illusory. By this we mean result in inflation or vastly increased imports.

I don't believe our problems are GDP related and am therefore unsure of the effects of fiscal stimulus.

Before looking at solutions I must visit Gordo's call for a new Bretton Woods agreement.

Fundamentally Bretton Woods implied that Governments would manage their economies responsibly. That is with good fiscal discipline, also keeping their trade balance in rough harmony.

My conversion to Monetarism from Keynesianism actually came in the 1990's as I looked at the formation of the Euro. I had developed a total scepticism of politicians, by and large the political leaders of countries are ego maniacs. Monetarism places the market at the heart of everything … perhaps not such a popular idea at the moment. While markets are anarchic in nature they are still more efficient than any government can ever be.

In the Euro system we take away a lot of ability of the governments to play silly games with money supply, interest rates and the like, leaving that in the hands of the technocrats at the Central Bank. The government now has fiscal policy as its primary focus, in other words it has the obligation to balance its books, with penalties for failing to do so … or within pre-defined parameters unless there is a short term reason to do otherwise. The discipline in the Euro system is not dissimilar to Bretton Woods before Nixon threw it out the window, the only difference is that the Euro defined a penalty for failure.

For me the biggest attraction of this system was that governments actually chose to subject themselves to discipline. The Central Bank would have the charge of regulating money supply, steering the economy clear of the excesses that are the wont of politicians.

Gordon Brown pretended to do the same when he, made the Bank of England independent … but he took away its teeth … he created a politically controlled FSA to regulate the Banks and Financial services industry and left the Bank of England to keep consumer price inflation under control. With interest rate policy as its only real weapon, it has done extremely well. I am aware of Mervyn King, several times over the last 3 years, expressing concern over what he saw happening in the property market, this was not in his remit … the FSA had to regulate the financial sector and curb excessive credit creation by banks.

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