Shop till you drop? Here’s a better plan!

We have got into a whole heap of trouble by doing too much shopping funded by borrowing.  So what is Brown & Co’s plan to get us out of this hole?  A marginal cut in the rate of VAT to encourage more shopping funded by more borrowing!  You couldn’t make it up.

At least until now we as individuals have had the freedom to choose whether or not to live above our means.  Monday’s Pre-Budget Report nationalises this decision and removes our freedom to choose.  It also proves beyond reasonable doubt that the government has little idea what’s going on in the real economy or how to respond to the crisis.  Moreover, since the government has also been living beyond its means for years, it doesn’t actually have the financial capacity to do as it now proposes (indices that measure risk on government debt are soaring) and can make it ‘work’ only by fiddling the figures with a wholly unbelievable forecast of a quick economic rebound.

Debt is perfectly fine when its adequately supported by underlying cash flows but governments have allowed banks to compound debt to levels far in excess of anything sustainable with a monstrous bubble in house prices.  Hence this is a ‘balance sheet recession’ caused by the collapse of a house-of-cards edifice of debt far in excess of sustainable levels.   It’s an avalanche that, once started, can’t be stopped until it reaches the bottom.

Now there is a further risk – that many perfectly viable and healthy businesses will be hit by what the military coyly call ‘collateral damage’ – killed in the crossfire.  But this further reduces the underlying earnings in the economy which is the only thing that will eventually stop the avalanche.  If this happens and large numbers loose their jobs, default on mortgage and credit card payments etc., the whole process turns into a death spiral and recession becomes depression.

It follows that one of the things the government badly needs to do is to improve the strength of the underlying economy.  To an extent they are doing that in leaning on the banks to keep lending but that is more about damage limitation than being proactive and it’s a tough call because lending capacity is just exactly what the banks are short of (hence ‘credit crunch’) although the government is doing its best to ignore this important detail.

I don’t think people are stupid enough to be bribed back into the shops by a 2.5% VAT giveaway at a time like this.  (Particularly so since much of the 2.5% will probably be absorbed by retailers).  In promoting more shopping the government is treating symptoms, not causes.  So what should the government do? 

Firstly, Vince Cable is absolutely right to call for a reduction in the tax burden on low earners.  In hard times people near the bottom of the pile always suffer most so social justice demands no less, especially since the whole credit crunch crisis was born and raised in the top echelons of society.

But we need to do more; we need to think about what can be done to help business weather the storm.  For if businesses stay healthy then salaries get paid, debt is affordable (even if uncomfortably high) and confidence will soon come flooding back – and flow into the shops. 

One way this could be done is to change the basis of taxation for small businesses so that they are taxed only on drawings (or dividends if incorporated as a company) rather than on profit.  Then, provided their owners choose to live modestly and keep profits in the business, they would be free to save or invest their money as they saw fit without the government grabbing it.  This would quickly make a big difference since one of the biggest problems for small businesses (even in normal times) is accumulating sufficient capital.  For those with ambitions this would make it much easier to accumulate a modest amount of capital and then expand, diversify or whatever.

(As an aside; this is the same strategy that successive governments have used vis a vis the illegal drugs trade and which has helped make it one of Britain’s most ’successful’ industries.   Although never any government’s intention, the practical effect has been that with drug seizures – their equivalent of tax – normally at very low levels, the backers have had ample capital from retained profits to develop and diversify their criminal business).

With stronger cash flows small business would be less beholden to bank lending policies.  Many would be able to increase their bank deposits (or reduce their overdrafts) which would in turn help stabilise the banks. A proportion would soon accumulate the capital to consider an expansion and take on staff.  BERR estimates that there are over 4.6 million small business (with less than 50 staff) in the UK.  If just one in 5 of these took on just one extra person over the next two years, that is a million new jobs and many times that with renewed confidence in their job security.  It  also creates a high probability of a recovering economy.

Moreover, small businesses collectively have an enormous fund of experience; anecdotal evidence suggests a high proportion are rather well run so new investment would automatically flow to areas where it would do most good.  It is unlikely that much would go into retailing or building (although there must be some good niches even there).  In other words, helping small business would improve the accuracy and flexibility of the economic response to the crisis.

From the government’s point of view there would be a hit to cash flow into the Treasury, but only a temporary one as sooner or later owners would increase their drawings (and in any case not all owners would be willing or able to reduce drawings).  In the meantime the government revenues would benefit from increased PAYE, NI and VAT on increased economic activity.   

It could also be good politics.  If each small business influences the voting intentions of just four people (partners, family, employees etc.), that is more votes than the Lib Dems got at the last election!

The Threat from the BNP

In the wake of the leaking of the BNP’s membership list, it is sobering to note that in the 2007 local elections they won a total of 300,000 votes for 754 candidates.  They now have 55 councillors on 22 different councils. 

Writing in Our Kingdom blog, Stuart Weir of Democratic Audit comments that while their overall share of the vote is only 1 – 2% nationally they have been successful at exploiting geographical concentrations and using electoral strategies modelled in part on the Lib Dem’s pavement politics to achieve unparalleled levels of representation.

Stuart Wilks-Heeg, who has recently updated earlier work on the BNP, is quoted a saying that their breakthrough represents a stark warning about the “advanced state of decay of local representative government in England”.  Apparently, in Burnley local representative democracy is sustained by a core group of activists who constitute just 0.1% of the town’s population!

At a time when Government nationally has palpably failed and when government locally is starved of resources, the danger local discontent leading to a major breakthrough are very real.  Certainly my sense is that outside of ‘planet politics’ the pressure is building fast.  Either mainstream parties channel it to useful ends or it will blow.

The Real Great Depression

The Credit Cruch is certainly a big event but how apt are the frequent comparisons with the Great Depression of 1929?  

In a fascinating piece, historian Scott Reynolds Nelson suggests that the Panic of 1873 is a much closer model.  He recalls that his 96 year old grandmother says her grandparents had a much harder time in what she calls the “Real Great Depression”.  As he puts it:

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad. Britain, the biggest importer of wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872 kerosene and manufactured food were rocketing out of America’s heartland, undermining rapeseed, flour, and beef prices. The crash came in Central Europe in May 1873, as it became clear that the region’s assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.

He notes that in much of eastern Europe the problems were widely blamed on foreign banks and Jews.  Americans tended to blame themselves and many turned to what became fundamentalist religion.  He goes on to conclude that:

…when banks fall on Wall Street, they stop all the traffic on Main Street — for a very long time.

And that:

In the end, the Panic of 1873 demonstrated that the center of gravity for the world’s credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India.

I agree although I think better and more honest leadership in the Whitehouse will make a huge difference.