18 June 2012
The full text of Vince Cable's speech to CentreForum and the City of London at Guildhall. Check against delivery.
Thank you for this opportunity to speak to you about the economic situation.
CentreForum is earning a reputation for being ahead of the curve in providing practical policy ideas. It was the first institution to float ideas such as the pupil premium and community land auctions which are now government policy.
And in the field of macroeconomic policy you gave space to my current Special Advisor, Giles Wilkes, who – two years ago – set out the arguments for what has come to be called credit easing. Nine months ago you published a pamphlet of mine describing what is now commonly described as Plan A+ - combining fiscal discipline with targeted demand stimuli to generate growth. And a few months later you published an excellent paper by Nick Crafts addressing the same issue as me – Delivering growth while reducing the deficit – but based specifically on lessons form the 1930s
I want to draw some out of the lessons from the Crafts paper, while recognising that there are dangers as well as lessons from drawing historical parallels. The four year period 1929 – 33 is the nearest historical approximation to the economic storm which engulfed the Western World after autumn 2008. It also offers encouragement in the form of strong sustained recovery from 1933. And it was also the testing ground for the most influential economic thinking of the last century: the ideas of Keynes.
But there was an absolutely crucial difference. There was no banking crisis in the UK (unlike the USA and in parts of Europe ) as part of the 1929-33 downturn; there was no “credit crunch”. Nonetheless the 1930s experience provides useful insights, not least of how it is possible to build a way out of a slump.
The 1930s versus today
The most striking parallel between the two periods was the sharp contraction of output. In 1932/33 output in the UK was 10% below trend filling an absolute fall of 6% in 1929/31. Similarly in 2011/12 production was close to 10% below trend after a fall of 6 to 6.5% in the period of 2008/10.
Yet from a trough in 1931 growth recovered to an average of 3% pa over the remainder of the 1930s. For all that Roosevelt’s New Deal is celebrated as the dawn of recovery in the 1930s, the UK came out of Depression two years earlier, despite pursuing orthodox fiscal policies.
The reason we now remember the 1930s negatively was partly because of some concentrated misery in manufacturing centres reflected in the Jarrow Marches, but also because unemployment reached levels double those experienced in the current crisis (17% in 1932 as against 8.5% on a comparable measure). This stemmed from real wages growing strongly over the early period, in a world of prolonged deflation. This priced workers out of international markets – what Keynes called the issue of “sticky wages” - a problem we don’t have today.
But a very strong parallel to today was a devaluation of 25% over the 1929/32 period, similar to the devaluation achieved after 2008. The pound was devalued as a result of abandoning gold - Lessons having been learnt form the disastrous, and futile, attempts to maintain the gold standard in the 1920s.
In fact, you learn far more about our recovery in the 1930s from looking at monetary conditions that you can from examining fiscal policy.
It is worth recalling just how brutal were the first dozen years after the First World War. Britain attempted to return to its pre War gold level, which meant chronic deflation to bring us back with world prices (what Southern Europe is attempting today). As a result, the price index which had risen from 100 in 1914 to 250 in 1920, fell to 180 in a couple of years and continued falling all the way below 150 in 1930.
The voices in the City clamouring for the Pound to be kept strong got what they wished.
But the consequences for the real economy were devastating; production fell by 22% between 1918 and 1921. The real value of debts rose and rose. The exchange rate was far too high and so our goods struggled on world markets. On some measures in 1931, our per capita GDP was lower than it had been in 1915.
No wonder Churchill made his lament about wanting industry more content, finance less proud. And when Britain eventually left gold in 1931, monetary conditions became easier, and recovery could finally begin.
The 25% devaluation in the recent economic crisis stems from a very different cause: it was a consequence of the perceived weakness of the economy and the UK’s acute vulnerability to a growing financial crisis. But as in the early 1930s, devaluation prevented the UK economy deteriorating ever further, and from 2009 started a tentative rebalancing towards manufacturing and exports.
It is important that this incentive remains. Any prolonged appreciation of the currency will undermine the hope of recovery. This is one, but not the only, reason we need to retain a loose monetary policy.
Tight fiscal Policy; Loose Money
Both eras also had an adverse international environment, with Europe in turmoil. The 1930s was the most protectionist era ever. Exports collapsed everywhere, and international statesmen effectively gave up cooperating, with Roosevelt famously snubbing the 1933 London Conference.
This time round, adverse conditions are much more about the specific circumstances of the Eurozone, which thus far has not damaged international exports to the same degree, but has a worrying effect on confidence.
The most fascinating aspect of this historical parallel however is a potential similarity of policy response. In the period from 1929 until 1938 the UK government was in approximate fiscal balance, although some fiscal tightening was blamed, by Keynes and others, for a ‘double dip’ recession in 1932 when the economy seemed to crawling out of slump.
Yet, without a noticeable relaxation in fiscal policy, the economy surged into strong growth which was becoming apparent mid 1933. As I said earlier the obvious explanation was a sharp loosening of monetary policy. Today’s consensus between Keynesians and monetarists in favour of easy money to sustain aggregate demand has prevailed because of the demonstrated effectiveness of monetary policy in the Depression.
The right way to understand loose monetary policy is in terms of expectations: of whether future money demand will be growing fast enough to make borrowing to invest or spend worthwhile. It is not enough just to look at the base rate. Look at Japan: because of its persistent deflation, its zero-interest rates still do not reflect easy money conditions. Anyone investing is facing the persistent pressure of falling prices and falling profits.
In the 1930s, the abrupt departure from Gold – so much condemned by the City – had the strongest possible effect on expectations of rising money GDP.
For the first time since the War people had a reason to invest now, and expect a rising level of spending to reward their investment.
And as I said before, the banking system was functioning so people who wanted to borrow, could borrow.
This recipe worked spectacularly well. Real short term interest rates fell from about 10% in 1931 to well under 1% for the rest of the 1930s. Low interest rates fuelled a private investment boom – with industrial production surging after 1932 - and a burst of mortgage borrowing to finance house purchase – and building. Consumption also rose strongly.
The hope today is that a comparable recovery will be generated. In nominal terms interest rates are lower than at any time in the 1930s. In real terms, risk free rates seem set to be negative for a long period. However, families and small businesses are not enjoying these low rates, a problem the Mansion House speeches were specifically designed to address.
Aggressive monetary policy, enhanced by QE, has now been operating for four years. And the IMF has recently argued strongly for a reinforcement of supportive monetary policy through the liberal provision of liquidity to the banking system– as announced on Thursday -, QE (with a wider range of assets) and more aggressive interest rate policies.
I would supplement these useful moves with an observation about how monetary policy is communicated. Quantitative Easing can sound like a powerful instrument – but if it does not succeed in making people expect rising money spending in the economy, it is likely to be far less effective than leaving gold proved in the 1930s.
The Big Differences
As I stated at the outset, historical parallels are seductive but often seriously misleading. We need to understand the important differences and in particular why we are arguably facing even more challenging circumstances than the interwar Coalition government.
One relates to private consumption. Consumption was helped by falling agricultural prices, and access to cheap credit from building societies for home purchase. There was no household debt problem and once consumer confidence recovered on the back of rising real wages, consumption rose rapidly, driving the economy. By contrast, today’s UK households have faced a cut in real living standards, with inflation in excess of 3% caused mainly by higher import prices, (commodity prices driven up by rapid growth in Asia).
And with household debt to GDP ratios the highest in the developed world, after a “bubble” in mortgage fuelled house prices, there is little appetite for more household debt. The obvious sources of demand growth to stimulate business investment are therefore blocked: private consumption by borrowing; public consumption by deficit reduction; and exports by European problems.
Another fundamental difference relates to a breakdown in the money transmission mechanism following the banking crisis. In the 1930s there was a system of relationship banking for business which may not have been particularly innovative – and depended on the Big 5 who had 80% of all deposits – but was reliable in marked contrast to the wild excesses followed by remorseless deleveraging of banks today. Once the government devalued against gold, money was able to flow freely.
And for households deemed to be prudent, almost 1,000 locally based British building societies were dependable, non-profit, mortgage lenders. A virtuous circle was created: more mortgage demand leading to more house building leading to more houses; leading to lower prices and greater affordability; leading to more demand.
Houses built by the private sector rocketed from around 130,000 in 1931 to almost 300,000 in 1934 and it is estimated that house building contributed almost a third of all employment increases in this period.
By contrast we are now in a downward, opposite spiral. A key reason is the destruction of the British building society movement – or much of it – in the two decades after the late 1980s. This was one of the great acts of economic vandalism in modern times. And the commercial banks largely abandoned locally based relationship banking in the decade before the recent financial crisis. There is now no institutional structure in place to offer countercyclical lending, particularly small and medium sized businesses, in place of the banks. A major and urgent task of government today is to ensure that we have banks that meet that requirement, alongside counter cyclical regulations and liquidity measures of the kind set out at last Thursday’s Mansion House speeches. We now look enviously at Germany where the Sparkasse and KFW underpin a business and mortgage lending system which works.
Both the 1930s government and the present Coalition had a massive fiscal problem. Theirs was public debt – 180% of GDP, far higher than today’s levels; debt service was 8% of GDP, compared to 3% today. There was every reason to be concerned that the UK might be at risk of a debt “trap”, with ever expanding commitments to debt service exceeding the expansion of the economy. That is not a risk today, thanks to our prudent management.
Ours is the deficit, a record structural deficit for peace time that demanded a clear plan for its elimination in order to maintain the confidence of markets. Our policy is far more flexible than our opponents claim – we have shown this by extending the period from 4 to 6 years for bring the budget to structural balance. Automatic stabilizers still function. But no-one within the Coalition doubts the need to get the deficit under control over a sensible time frame.
Given these constraints, what tools does the Government have? The first is continued use of monetary policy, and stronger communication of the policy aim it is meant to achieve – robust recovery in money spending and GDP. The Mansion House speeches signalled a clear intention to continue aggressive monetary policy.
I am sure that all the candidates to take over from Mervyn King are thinking very had about how best to do this.
A second approach is to use government guarantees, which do not count as public sector liabilities but are sufficient to trigger investment which would not otherwise occur. For example, my department operates the Entreprise Finance Guarantee under which we might guarantee £100m of borrowing but only score, say, £20m against the deficit. Arguably the conservatism of the banks is preventing this scheme from achieving as much as it should but it has undoubtedly ensured that many thousands of companies can survive and expand.
There is little doubt that these models could be expanded on a large scale in other sectors, and particularly infrastructure. One sector where progress could be made rapidly is in housing. The main vehicle for social housing for rent (as well as shared ownership) is housing associations. These are independent, not for profit, institutions which can – and do – borrow in capital markets. There is large unmet demand for social housing which may be self-financing if built, in conjunction with private housing. Indeed, some major UK contractors are doing just that with access to long term – 10 years plus finance – with access to guarantees. This activity could be multiplied.
There are now some interesting ideas out there for government guarantees could trigger a significant volume of housing investment, replicating the recovery model of the 1930s and leading hopefully to a virtuous circle of new building lending to increased affordability and also increased private demand. Construction products account for 20% of manufacturing. Insofar as these ideas reduce uncertainty, they can encourage significant investment from the private sector. Recovery requires a big expansion in social and private house building.
The Industrial Strategy that I am promoting has the same underlying purpose: providing certainty about ongoing government support to encourage greater supply chain investment. This can come through regulatory certainty as much as ongoing subsidy. Co-financing private house building alongside council house building could be an extension of the same principle. The potential is large.
And like in the 1930s there is no reason in principle why such innovative thinking should not be applied at a local level instead. There are already examples: some councils (Eastleigh, for example) use prudential borrowing powers – at negligible interest rates – to invest in projects with a commercial return (and they have to be commercial to meet state aid rules). The spread between yield and borrowing cost generates a surplus, strengthening the councils’ finances as well as creating real economic activity. The Government’s “City Deals”, starting in Manchester, adopt this principle also. The approach of tapping into very low borrowing costs is scalable and could be multiplied many times.
Some of the government’s critics argue that what is necessary for recovery is to abandon deficit reduction.
The experience of the 1930s tells us, however, that it is possible to build, and grow, out of deep economic crisis without abandoning doing so. Indeed, growth in the 1930s radically improved the Government’s debt position. That happened while the Government more than doubled public investment.
Some of the policy ingredients are already in place – expansive monetary policy and devaluation. But the government is now looking at even more radical solutions in order to provide a platform for a 1930s style recovery.
First, all aspects of monetary and financial policy should be focused on ensuring that the advantages of loose monetary policy are felt everywhere, not just in low government borrowing rates. This encompasses monetary policy, liquidity policy, credit easing and banking policy to ensure that financial institutions perform the role played by building societies and banks in the 1930s but not currently being pursued by damaged and ultra-conservative banks.
Second, the public sector balance sheet has to be used to leverage in private capital, particularly in housing. Demand has to be created, it does not emerge simultaneously. There is scope here to both create demand and solve a pressing supply need at the same time. Innovative approaches to public policy - making the most of the fact that our resolute action has given us a strong balance sheet - are the key to unlock this potential.
Thanks again to Centre Forum. In China politicians conduct their debates using the thoughts of Confucius, here we use the thoughts of Centre Forum.