The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (61 page)

Osborne’s original hope was that the confidence garnered by low long-term interest rates and fiscal credibility would be enough to excite the animal spirit of investment in jobs-rich infrastructure (Actually, the model infrastructure procurement in Britain tends to focus on a few dozen massive multinational construction companies, with large finance and legal departments. The money does not trickle down to local economies providing the Keynesian boost often cited.) It did not work, and probably never was going to. He then hoped that foreign sovereign wealth funds would fund a wave of power stations, rail links and broadband networks. Again, despite one or two successes, it didn’t work. Pension funds were tapped up, but little money was forthcoming. He then offered up the Treasury balance sheet for contingent guarantees to private companies. Again there was the odd success, such as an extension to the London Tube network. After March 2011, the OBR reported that Mr Osborne had announced contingent guarantees worth £95 billion, that do not count as public borrowing, but might do. One might call it ‘contingent Keynesianism’. But he would not cross his red line of planning to borrow more in order to provide a Keynesian boost to the economy, despite the cheapest borrowing costs in British history. Happening to borrow more because the economy was weak and tax revenues down was fine; planning to borrow more was a fiscal sin that would be punished by the fiery anger of the bond vigilantes.

Even that line was fudged in 2012, when borrowed money was directed to house-builders in return for stakes in homeowners’ new-build property. This ‘Help to Buy’ scheme involved borrowed money, but in accounting terms – rather handily – did not count as increasing the deficit, because the state ‘owned’ 20 per cent of each of the houses bought, as loan collateral. Detractors were withering about Help to Buy, calling it ‘dangerous’ and ‘moronic’.

More broadly, the path taken by Mr Osborne was not greatly different from the one that would have been taken by Mr Darling or by Ed Balls. ‘Osballism’ was the order of the day: the political debate about fiscal policy was a particularly extreme tale of the narcissism of small differences.

There are three things going on in Britain that are obvious but little acknowledged in the fiscal Punch-and-Judy show that has dominated the UK economic debate:

1.  Deleveraging is dragging the economy and is far from over.

2.  Fiscal policy is being used to accommodate failure rather than to plan and strategise for long-term growth.

3.  A large chunk of our economy and our tax base has essentially disappeared for good.

The last point reflects the fact that the City of London was a production house for toxic derivatives and the capital of the shadow banking system. Some of the losses booked by big multinational banks mean that corporation tax will not be paid by those banks for a decade. A choice will be required about whether to replace that missing tax base with a different one (e.g. wealth taxes), or whether the state needs to shrink back.

In the Eurozone, attempts to break the link between oversized banking systems and government support for those systems have been haphazard and often entirely counterproductive. In Britain, such links were not the fundamental problem to begin with.

In Britain, there were broadly two separate financial crises. A conventional consumer and corporate credit bubble, fuelled by lightly regulated demutualised building societies, such as Halifax, Northern Rock, Bradford & Bingley, tapping global flows of hot money in the shadow banking system. But the City of London also had a massive role in creating and mediating these flows, through opaque derivative technology developed, sold and traded by investment banks. Britain consumed the credit madness, but was also the site of its main factory. Reform has been based on some sort of separation between or ring-fencing of these two worlds. London was a production centre, the foremost factory for toxic derivative waste. Understanding and accepting that reality is not to be anti-banker but to recognise the truth. We could have constructed much better solutions to Britain’s banking problems by acknowledging what had gone wrong and not trying to sweep it under the carpet.

Recognising these truths about London banking is intellectually liberating: it helps explain why growth is sluggish, tax revenues are weak and business credit is slow. In future, governments should not rely on such unreliable sources of tax revenue. The Golden Goose is dead.

At the heart of the banking system is the Basel system of formulaic self-regulation. My chapter on the formulae behind the shadow banking system (see
here
), I hope, begins to show that the formulae are not based on science, and, in the round, skew the credit-creation system towards reinforcing the dysfunctional relationship with property. If governments and taxpayers are to implicitly backstop the banking system, why not skew the formulae in favour of growth and job creation and away from property?

How much longer can monetary and financial policy help put off a necessary cleansing of UK and European bank balance sheets? Losses are not being realised, which might have helped employment by keeping doomed companies alive. The understandable pain-alleviating forbearance has turned not just into endless extend-and-pretend, but now also into household and corporate zombification. Ultimately there are tens of thousands of companies and households with misallocated capital, arising from prolonged lows in interest rates. ‘Eventually interest rates will have to rise, because capitalism requires capital,’ said one important UK finance chief executive to me. Even more important will be a proper clear-out of the UK bank balance sheets. The risk is that Britain follows Japan’s zombified path and not that of, say, Sweden, where the banks painfully cleansed their balance sheets and fostered new growth.

State-run banks is one thing; a bank-run state is quite another. Alistair Darling recalls the series of identical phone calls received at Number 11 Downing Street from bank chief executives after he dared to introduce a bonus tax on the largely illusory bank windfalls arising out of the 2008–09 bank rescue. In his book
Back from the Brink
(2011), amazingly, Darling describes how the chief executive of J. P. Morgan angrily raised question marks about buying UK government bonds in response to the policy. He wasn’t the only chief executive to make such threats to a finance minister. Banks should fit the state, not the other way round.

The euro crisis is not, essentially an economic crisis. It is a crisis of democracy, diplomacy, legitimacy and burden-sharing. In the economic jargon, the Eurozone is not an optimal currency area. Tax transfers, debt pooling and a transfer union are inevitable to make the union work properly. The move towards banking union could begin this by stealth. As Mr Osborne has said, if the euro is to survive, the inescapable logic is fiscal union and eurobonds. Berlin will decide the speed of this. In the words spoken to me by one leading European financier: ‘it will cost €500 billion [in transfers] to solve the Eurozone crisis. It will cost at least €3 trillion not to solve it from a break-up of the Eurozone. Logic dictates that they know what they have to do.’

The opposition SPD and Green Party at least partially endorse eurobonds, or forms of debt-pooling, ahead of the 2013 federal election. Germany is much more than the economic hawks, inflation aversion and a reluctant Merkel.

Huge strides need to be made on youth unemployment. Enrico Letta, the Italian prime minister, told me in July 2013 about how he had devoted scarce fiscal resources to a massive tax cut for employing young people. ‘We say to the young people: “your problem is our problem”. We want to bring more hope for the youth and more hope for the country.’

Mark Carney suggested an interesting plan in his last speech before becoming Bank of England governor. ‘In the medium term, one of the building blocks of European fiscal federalism could be a pan-European employment insurance scheme built on a common European labour market. This would reduce impediments for those looking across the continent for work, while providing a cross-country automatic stabilizer.’ It was an idea rooted in the experience of a monetary union that works: Canada. Note to Berlin: Canadian monetary union works because of fiscal transfers worth 8 per cent of GDP.

Peter Hartz, the German jobs miracle architect, also told me about a similar new plan for youth unemployment: all European young people would have their talents diagnosed, with unemployed youth sent on a temporary basis to another EU member-state financed with EU funds for training and work. The German labour minister, Ursula von der Leyen, is already planning to offer apprenticeships to young Greeks, Spaniards and Irish. Europe’s youth may need to learn German.

The UK will also renegotiate its relationship with this new, euro-centric and more centralised European Union in a referendum. There are some win-wins available in the renegotiation. Germany might try to leverage the threat of UK exit to galvanise a more dynamic Eurozone, more focused on physics than with farming. France is probably willing to give very little. However, can it really be credible that UK national interest will again be defined by what is good for financial services?

There is another – intriguing – aspect to the fiscal crisis. It is applying acute pressure on Europe’s traditional member-states. In Britain we will see this with the autumn 2014 referendum on Scottish independence. Scottish nationalists feel fiscal autonomy will serve Scotland’s interests and its economy better, but it is difficult to imagine how an Edinburgh-based central bank would or could have coped with the collapse of RBS, HBoS and the Dunfermline Building Society. In Spain, clearly, Catalunya – as the nation’s main economic hub – is even more attracted to greater fiscal autonomy. Spain’s constitutional settlement is up for grabs in its fiscal crisis. If Catalunya or Scotland start the process of national fragmentation, then what chance Belgium – or even Italy – splitting?

In a globalising economy fighting for multinational investment and a tax base, it is often suggested that a larger superstate is the natural response. Over decades, the opposite may be true. ‘City regions’ could become the natural unit of government. In the UK, for example, the rest of the country has to cope with the benefits and disbenefits of hosting the world’s capital city nearby. A Manchester or a Leeds could eventually need tax-varying powers in order to compete. Already plans are afoot to devolve spending powers away from Whitehall towards the city experts who know best how to get young people off benefits in their localities.

Economics has developed into something of a state-backed theology in public policy. It is social science that has become a language for the calculation of costs and benefits. Its magical powers have been overstated, however. Many of these economic analyses are just extrapolations and the only accurate analysis is provided with hindsight.

Conventional market-clearing equilibrium economics inculcates a mindset of econofatalism: a belief that nothing can be done to change the inevitable financial fate of a nation’s economy. Milton Friedman developed the concept of the ‘superneutrality’ of money. Superneutrality is an apt description of the approach to public policy that arises out of the overuse of economics. I know enough about economics to appreciate its flaws. It is a useful and occasionally wonderful lens on the world, and provides some principles to follow. But as a guide to how to create a sustainable society that works? No chance. Politicians need to show some spine and some vision, some competence and some bold daring. The theory of laissez-faire has been substantially undermined by the successful strategising of emerging economies and indeed the economic history of the developed world. We need, humbly, to learn from these emerging economies. The most successful ones have smashed most of what they were told by the IMF, bond markets, media-friendly PIMCO analysts and the like. The supposed bastions of the free market, such as financial services and the housing market, have proven nothing of the sort, and were largely parasitic upon government balance sheets.

I would call myself basically a new Manchester liberal. I believe in fundamental market principles (as Nobel prize-winning economist Amartya Sen once suggested, to be against the free exchange of goods and services is as absurd as being against the free exchange of words in a conversation), but few markets are truly free. Convoluted attempts to create them in railways, in British toll motorways, in toxic mortgage finance, in infrastructure and in carbon, have failed utterly – and expensively. When I visit parts of the world that are growing fast and see companies that are thriving there, more often than not, a smart and subtle hand of the state is never far away. Politicians have hypnotised themselves into believing the economic fates and meteorology are so immutable, that they dare not even think they can change things. They have become superneutral.

Central bankers have been key to the use of economics. As the crisis raged in 2008, I got the chance to put it to Alan Greenspan, chairman of the US Federal Reserve from 1987 to 2006, that it was basically his fault. He told me: ‘The housing bubble in the US is fully explained by global forces, and indeed we at the Fed could not control long-term rates, which are the rates that effectively drive mortgage rates, which essentially said to us that our power to affect the forces driving the bubble were
de minimis.
And we tried but we failed. And every other central bank failed because the international markets took long-term rates out of the hands of central banks. It’s essentially a problem of bubbles emerging periodically half a generation at a time – and I think we’re learning that it’s very difficult to stop these from occuring and the best thing we can do is to focus on how we prevent them from having catastrophic effects.’

British politics meanwhile is still trapped in an absurd 1980s culture war between Thatcherites and unionistas. By contrast, in 2009, Angela Merkel responded to the collapse in world trade by spending two days in a hotel with union and business leaders, thrashing out a balanced engineered response to maintain employment and demand. It combined ‘right-wing’ policies on wage restraint with ‘left-wing’ policies on borrowed stimulus. The result was an economy that powered back to health, regaining all of the lost ground in one of the sharpest V-shaped recoveries in modern history. Germany engineers finances towards productive industry and innovation. Britain has financialised our engineers towards useless financial innovation. In the 1990s and noughties, the latter approach appeared to conquer all. However, financialising the housing market does not an economic strategy make. The German government sees a house and considers it a home. Successive British governments see a house and consider it a piggybank. Now Britain needs a broader economic plan, one that stretches beyond deficit reduction and financialisation. To begin with, the generation of politicians that failed their nations need to reflect on, to account for and learn from their mistakes. This is a massive political opportunity.