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The Pound in your pocket

With a downturn beckoning Frank Lee asks what fool will take on the job at No 11?

After the 1967 devaluation of sterling the then PM, Harold Wilson, was reputed to have said that ‘this will not affect the pound in your pocket.' Whether this story was apocryphal or not has never been established, he himself denied it; however, it seems the sort of folksy type of quip that he would have used. In those days things such as debt, trade deficits and currency devaluations were held to be of prime political and economic importance. Reputations could be made or broken on the wheel of trade imbalances, and exchange rates.

This is apparently no longer the case – or so it seems. Whilst not openly arguing that debt, deficits (government and trade) and deindustrialisation no longer matter, (such a bald assertion would be too much to swallow) this assumption nonetheless seems to underlay most of the economic policies of the present dispensation. I say dispensation rather than government since the whole political elite, regardless of party label, seem to believe it, to say nothing of the media.

Among some of the more harebrained claims of the new conventional wisdom is of course the ‘end-of-boom-and-bust' mantra, which implies a fundamental transfiguration of capitalism from a cyclical system of boom and bust, which is actually systemic and endemic to the system, into a benign mechanism of endless, non-inflationary growth. If only...!

But let us move on. Has the UK experienced 10 years of growth, low inflation and low interest rates since New Labour came to power? Yes. In fact the process started in 1992 with the ejection of the pound sterling from the exchange rate mechanism. So it was five years under the Tories and another ten under new Labour. Whilst not denying the short term successes enjoyed by Tory and Labour governments, it behoves us to examine how that was possible, how valid are new Labour's claims that it has built a new economic system, and how sustainable the policy is in the medium to longer term.

Liberalisation of the economy and labour markets, combined with pro-active monetary policy – i.e. pumping liquidity into the economy to keep aggregate demand at a stable level - gave rise to steady growth, low unemployment and low inflation (depending of course on how you calculated these latter two). It should also be said that this liberalisation meant that democratic control of the economy had effectively ended. As instruments of economic policy, fiscal and industrial policies had long been eschewed. We had arrived at the late Edward Heath's description of a one golf-club economic policy. Interest rates alone would be used to control money supply and inflation targeting. Ceding independence to the Bank of England completed the process whereby the government had no say in how the economy was managed handing this job to the markets and central bank. The government now restricted itself to supply-side measures and trusted in the Bank of England. Fine if you were of a neo-liberal disposition. Fine if it worked.

So has it been a roaring success? One of the effects of the economic liberalisation of society carried out by successive Tory/Labour administrations has been the steady increase in wealth and income inequality. We are of course familiar with the justifications for this policy of making rich people richer: trickle down effects, a rising tide lifts all boats, and so forth. The upshot has been that the UK is now, with the possible exception of the US and Ireland, one of the most wealth/income unequal societies in the developed world. In terms of the Gini coefficient which is used to measure wealth and income inequality, the UK now stands between Georgia and Azerbaijan. All of this is well known and so it is not necessary to further labour the point.

This mal-distribution of income/wealth may be objected to on ethical grounds, but let's not go into this; let's take the neo-liberal bull by the horns and argue that such a policy is inefficient on economic grounds. The long boom of the post war period (circa 1950-1972) was predicated on increasing wealth produced by investment and productivity growth, together with low unemployment and, most importantly, equitable distribution of the new wealth to all socio-economic groups.

It hardly needs pointing out that the higher income groups gain their income not from wages but from profits, dividends, rent and interest, and that this being the case, the share of wages as a percentage of national wealth has fallen in inverse proportion to the level of non-wage income.

As Keynes pointed out in The General Theory if wealth acquisition was cornered by the already wealthy this would result in excess saving. The rich had a greater marginal propensity to save than the rest, and this excess saving would result in a fall of overall consumer demand in the economy, resulting in stagnation and unemployment. If, however, government actively intervened through redistributive policies then, since the lower income groups had a greater marginal propensity to consume, aggregate monetary demand could be kept in line with increased growth and stagnation avoided. Of course the theory (and practice) had its limitations but there was a kernel of truth there.

However, the new dispensation of liberalisation and winner-take-all have managed to combine increasing inequalities of wealth/income with growth, low unemployment (at least since 1992) and, until quite recently, low inflation. How have they managed to pull it off? In short: debt. Aggregate demand has been kept up through increasing levels of consumer indebtedness which has been possible through low interest rates and mortgage equity withdrawal on the basis of appreciating property prices. Okay if the property bubble keeps going, but what if …?

You don't have to look very far to come up with the answer. Both Spain and the US are in the middle of a property bubble meltdown. And we can already bear witness to early results. US growth is headed toward zero with a real possibility of recession looming, and the dollar – the great pariah currency – after its pummelling on the forex markets last year is now coming under fresh attack. And the reason is quite simple: in addition to the collapse of the house price bubble the US is running unprecedented balance of payments deficits. Investors will simply not hold the currency of countries which run intractable balance of payments problems. It has been commented in this respect that the only thing standing between the dollar and oblivion is the Peoples' Bank of China.

Does anyone think that this will not happen here? We have a property bubble waiting to burst; intractable balance of payments problems (last year's deficit was the largest ever recorded) are uncompetitive on world markets, and as a nation we are leveraged up to the hilt. Still believe in Gordon's miracle economy? Latest statistics show that one person in the UK goes bankrupt every 80 seconds. Additionally, there is now a real squeeze on disposable incomes of average wage earners coming from increases in the general level of inflation and taxation (the Council Tax), higher fuel and food bills and now higher rates of interest.

Meanwhile it is boom time in the City. Companies are awash with money. But this money is not being used for productive investment, but for mergers and acquisition activities. All the excess liquidity has to go somewhere so equity, property, and currency valuations have gone through the roof. We are now entering the bubble stage of the financial cycle.

This means that interest rates have to rise otherwise there will be runaway inflation. And with interest rates being ratcheted up the bubble will pop, aggregate demand will fall and the economy will enter recession or possible depression. In fact this process has already begun. Believe it or not that is the purpose of a tight monetary policy.

In addition, it's a good bet that when the forex dealers have finished with the dollar the next currency in their sights will be sterling. One thing is for sure – it won't be the Euro. Why? Because Europe runs a trading surplus. This simple economic law has been completely buried in a mountain of bullshit – known as the knowledge economy, new paradigm, et cetera - emanating from mainstream media and political commentaries.

The downturn is not something waiting to happen in the future. It started in 2005. The Bank of England has two options. Keep the house price bubble going by lowering interest rates, which means that the pound will collapse and imports will become more expensive and we will thus be vulnerable to imported inflation and falling living standards, or, put up interest rates and see the housing market collapse with all that this implies. Between a rock and a hard place? You bet, and it will affect the pound in your pocket.