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A constitutional economic policy - Part 5
The government and constituent's revenue-seeking trap

Hector McNeill1

The inevitable result of a government that follows the aggregate demand model based on monetary policy, is that, in a time of crisis, the payments made in support people and businesses who have fallen on hard times as a result of Covid-19, need to be recouped because they have been raised as debt by the government. The knee-jerk response to this reality is that this will lead inevitably to rises in taxation and cut backs in public service outlays. The static national accounts approach to the economy would point to this conclusions and is the cause of this sort of policy-induced instability which will, as usual, be justified by politicians who claim that there is no alternative.

The 3rd article in this series set out why this is not the only way to manage the economy. However, tackling the post Covid-19 crisis represents a particular challenge because of the impact of the epidemic on modes of operation of production units and service companies causing below capacity operation and an anticipated slow recovery.

Currently, both wage earners and government face a rising real revenue-seeking trap which needs to be resolved. While extolling the benefits of the private sector the recent evolution under the government's monetary policies have undermined confidence in the private sector's commitment to contributing effectively to a resolution of this serious state of affairs.

This article sets out a problem and the 6th article in this series sets out the basis for a solution.

Due diligence applied to loan advances

Now after 50 years working on investment projects its is remarkable how many fail. The failure rate of international economic development loans, for example, is around 35% or a loss of around $75 billion annually. Many loans are advanced to businesses by banks who are paying more attention to the collateral used to guarantee a loan than to the quality of the intended commercial use of the loan and any expected rate of return. Mortgage seekers sometimes exaggerate their ability to repay. The sub-prime mortgage crisis starting in 2007 leading to the 2008 financial crisis, was caused in good part by banks not applying adequate due diligence and permitting loan issuance against very small, or even no deposits.

Inappropriate policy instruments

OQSI2 and SEEL3 have completed studies that show the intricate relationship between the levels of return on investments and the nature of the macroeconomic policy environment. The rigid top down Keynesian-Monetarist (KM) single valued interest base rate and monetary volume targets have never addressed the homogeneity of the conditions of individuals and companies but seem to address an "average" or "typical" consumer or corporate entity and fix their decisions on these; this is exceptionally inefficient. It generates winners and losers and invariably loses traction. Designing policy to create an environment that enables each to respond to economic conditions in line with their needs and capabilities more efficient and can reduce the inevitable generation of winners and losers. It helps distance the economy from a situation of zero-sum gains towards one where more find profitable business easier to develop in a closer to win-win situation. The central theme here in where does productivity occur and how does this translate into real economic growth?

Productivity - what is it?

Many Chancellors who have attempted to "manage" economic affairs under the KMADM (Keynesian-Monetarist Aggregate Demand Model) based policies, have asserted that public works "grows" the economy and "spade ready projects" will get the economy "going". The question is, going where? Economic growth can be measured in terms of the rise in nominal currency units circulating in the economy. However, as far as constituents are concerned, economic growth is measured in terms of their being able to purchase more desired goods and services with their real disposable incomes. Real disposable incomes can rise as a result of increases in nominal incomes, and/or, falls in unit prices. At the production unit level, and in both cases, the decision leading to the payment of higher nominal wages and/or reductions in unit prices has to balance the cost impacts of higher nominal wages on operational margins and profits. Where the reduction in margins and profits is significant, the only way to compensate this decline is by raising unit prices and/or increasing physical productivity of production and service provision processes. From the standpoint of a company's profits, productivity is measured in financial terms by activity gross margins and overall return on investment. These economic and financial measures vary with productivity or the fundamental engineering basis of the technologies deployed. However, with time, less attention is now paid to the corporate operational structure concerning physical productivity or production engineering and more attention is paid to financial engineering at the expense of physical productivity. Thorstein Veblen noted this transition in 1921,

"Half a century ago it was still possible to construe the average business manager in industry as an agent occupied with the superintendence of the mechanical processes involved in the production of goods and services. But in the later development the connection between the business manager and the mechanical processes, has on average, grown more remote; so much so, that his superintendence of the plant or of the processes is frequently visible only to the scientific imagination... His superintendence is a superintendence of the pecuniary affairs of the concern, rather than of the industrial plant; especially is this true in the higher development of the modern captain of industry."

Today, this is a dominant state of affairs where return on investment, reflected in share price-earning ratios, no longer relate to the fundamentals of corporate prospects and productivity because the main motivation of "investing" has reverted back to the pre-1929 state of affairs, where the process is now one of speculation on the share price as an asset. Large companies manage their "innovation" by buying up smaller innovative companies and who otherwise would represent competition.

Governments have become over-concerned with maintaining asset prices by injecting increasing amounts of cheap money that, rather than flow into productivity-enhancing investment, takes the easy route to the purchase of assets leading to a significant rise in inflation in these markets. The paradox is that stock market "performance" is interpreted to represent a measure of national economic health, prosperity and economic growth while the nominal incomes of wage earners, and their real incomes, stagnate or decline. This is because companies are by-passing issues of physical productivity to focus on financial productivity. Where companies have introduced better productivity in their physical production and delivery of service processes they have quite often not raised wages. The incentive for them to deny wage earners a fair share in productivity related unit cost reduction and profit enhancing changes, the corporate taxation codes have created an incentive for managers not to raise wages (See, "RIO and Locational State Theory -Rational laws and regulations").

The reasons for the evolving state of denial

This analysis is not gravitating towards an appeal for hand outs and welfare. At the moment the volume of welfare provided directly through KM policies to wealthy asset holders and the financial services sector far exceeds anything that has been spent on those in need in this country, including the NHS. After a decade quantitative easing which has turned out to be a case study in the generation of absurdly wealthy winners and a majority of losers, this practice has become a bad and abusive habit resulting the cut backs of many worthy activities.

Quantitative easing has been highly destructive as a result of cheap money being channeled into assets as opposed to productive investments in the goods and services sectors. This destruction continues even although this continuing impact is more widely understood by increasing number of the voting public. So why does the government continue this destruction?

It is remarkable that in the face of this generally acknowledged dilemma there has been virtually no public consultation on this matter. There has been a clamp down on pubic participatory reviews or citizen's juries arising from a certain arrogance on the one hand that the public could never understand the intricacies involved in order to come up with anything better that the currently calamitous system. It also arises from the fact that the government is only serving out the interests of the party benefactors in the form of financial services industry, significant asset holders and media moguls who keep the public, and opposition, in order. The additional, perhaps more pertinent reason, its that there is a fear that new propositions might harm their benefactors and so the strategy is to muffle processes suggesting any new economic policy propositions while keeping a close eye on such developments. That policies potentially harmful to party benefactors should not be allowed to see light of day since the result could be withdrawl of support and the demise of the party.

Therefore, the "deft" way to handle this reality is to simply state, there is no alternative and refuse to indulge in any public discussions on monetary policy because some urchin might confront the KM emperor with a pointing finger and the exclamation that, "'E ain't got no clothes". The appeals to the gallery that decisions have something to do with the good of the nation are wearing so thin as to have become an insult to general intelligence of a population who have become very aware of their precarious economic states of affairs and are now faced with the prospects of significant tax rises and further austerity.

Unless the policy analysis mindset does not move from the static national accounts approach (See, Production, innovation and national accounts) it is unlikely that macroeconomists will ever venture into territories that hold out the promise of more beneficial options. The national accounts approach creates a zero-sum game approach to economics which is very negative because it creates a fixation that whoever is ahead now will become a loser under any other scheme for wealth distribution. Thus, the fear of the government of even contemplating any other options given that the levels of income disparity have reached intolerable levels. It is policy that has driven the economy to this state of affairs and therefore policy outcomes that have generated the justified criticism of extreme income disparity as a serious issue that needs to be addressed. The past destruction of the trade unions means the unions cannot be blamed for this state of affairs. We are left with economic policies that create incentives for companies to marginalize their own work forces by not raising wages sufficiently in line with productivity in those cases where companies have in fact achieved higher productivity. But in general, under quantitative easing investment and productivity have declined, exacerbated by the behavioural factor of management chasing shareholder value and purely financial return to owners, largely based on speculative dealings in shares, land, real estate and other assets.

A step by step analysis of self-evident truths

In exploring the alternatives, it is best, when one interest group fears the outcome of such an exploration, to start with the principles of the current system on which all agree. A common refrain of Keynesians has often been that people should "spend their money" to "keep the economy going". Monetarists have a similar refrain linked to the defunct Quantity Theory of Money (See, A Real Money Theory).
Physical productivity

In a supply side economy where payments made to work forces circulates back through the economy as a result of consumption based on the purchases of the workforce and companies purchasing inputs and capital equipment, growth occurs as a direct result of increases in physical productivity. Much of the successful growth in the 1940s through 1960s the result of productivity enhancing investment based on savings-related finance.

Where the increased productivity permits a penetration of the economy as a result of reduced unit costs matched by reduced unit prices, the market growth for such products and services accelerates leading to rising corporate income and a further reduction in unit costs as a result of the learning curve. This can lead to marginal increased in wages which in turn boost the levels of disposable income and consumption; a win-win situation.

The very significant growth in digital devices has been based on this capability and philosophy and this can be repeated in most productive and services sectors with varying rates of advance because such innovation is technology-specific. Therefore government legal frameworks should not be constraining wages as a result of incentives created by inappropriate corporate taxation structures but rather policy should be providing incentives to boost productivity, market penetration and wage rises.
The basic theory is that supplies and economic activities depend upon the population spending their disposable incomes on requirements. So, the understanding is that supply is equal to consumption which in turn is equal to disposable income used to purchase needs. The obvious conclusion is that in order to boost the economy, that is production for increased supplies, disposable incomes need to rise. All grades of economic theory would agree with this simple statement. It is when one begins to investigate how to raise disposable incomes to raise consumption, and therefore economic activities producing needed supplies, that inconsistencies begin to show up in economic theories.

The change in emphasis in monetary thought processes has been recorded several times in articles on this site. The current "theory" is growth is directly related to "demand" levels. This sounds clear enough, but it isn't. This is because demand today is associated with the amount of money in the economy and not just that in disposable incomes of constituents. The previous state of affairs was very close to the operation of the economy described by Jean Baptiste Say which simply states income earned from contributions to production processes is the disposable income spent on consumption (See, A clarification of the role and significance of supply side operations). The money volume is essentially endogenous money generated within the economy's productive or supply side sector. However, in the quest to raise economic growth monetarism has relied on additional funds originally based on fractional reserve banking to introduce additional money not extant in the current economy, as exogenous money. At the same time, monetary policy has aimed at a 2% inflation rate that devalues the currency at a rate of 18% every ten years. However, exogenous money is exclusively based on debt and increasing amounts end up not circulating as savings or purchased assets. As the purchasing power of wages is eroded at around 18% each decade the only way people can maintain their "standard of living" is to make use of debt. However, payment of premiums for debt include a premium made up of a base rate plus the interest rate applied by banks which usually exceeds an additional 6%. So on debt and asset purchases such as a house, by wage earners this particular class of assets drain disposable income by a cumulative rate of 6% p.a. or 45% each decade. Without rises in nominal wage rates to compensate these additional burdens it is more than apparent that these policies are stripping away the net disposable real incomes of wage earners. On the other hand, asset purchases such as land, real estate, gold and shares rise on a speculative basis at rates of increase that far exceed the 2% p.a. monetary policy target inflation rate. As a result, those who have used low interest loans, such as has occurred under quantitative easing, have a constantly rising wealth both nominally as well as in terms of real purchasing power if some assets are made liquid (sold). For asset holders the cost of living is falling while for wage earners the cost of living is rising.

During the last 30 years, and more obviously during the last decade, investment in physical productivity has declined and nominal wages have stagnated. The reasons are self-evident and the cause is misdirected policy that emphasizes exogenous money-based "expansion" and "demand management" which favour a small asset-owning class and prejudices the majority of wage earners.

In reviewing wage settlements in such sectors as public services it is obvious that the spacing of upgrades to beyond an annual basis and rises of 3-4% following prolonged periods of devaluation under inflation rates built into policy framework objectives clearly do not compensate of the actual fall in purchasing power of wages. It is notable that after the extraordinary efforts of the NHS staff and the dangers to which they have been exposed during the Covid-19 crisis an offer of 3.1% is an affront.

The emerging general revenue seeking trap

The complaint from government against criticism is that there is not enough money in the public purse to raise NHS salaries/wages. Given the increasing inability of wage earners to pay tax as a direct result of policy, it is necessary to look at how government, and indeed, companies can raise their revenue. By taxing companies within an accounting code that marginalizes wages as a cost item in competition with profits, the government undermines its ability to raise revenue from wage earners. The very same incentive to cap wages, created by the tax code, is also an incentive for companies to make use of creative accounting and make use of invoice transfer procedures to lower tax obligations. These tendencies, combined with a monetary policy that constantly devalues real disposable incomes of wage earners and the disincentive for companies to raise nominal wages because of the tax code, echoes the very cynical request by central bankers that the financial services industry under central bank supervision has done all they can to "help" and now it is up to "fiscal policy" to provide additional support.

Since monetary policy has reduced the value of real wages and, therefore, also reduced the feasible sources of revenue and therefore the future purchasing power of government, it becomes self-evident that the government's revenue seeking activities have been severely limited by monetary policy. The government can, of course, borrow more money which will only exacerbate the future state of affairs which will require more taxation to pay these loans back.

However, rather than address this systemic issue the government of the day simply pleads with the constituency with the lament that given the very high public debt which needs to be paid back it is necessary to raise taxes or enter into a phase of "austerity". This is purely a means of not solving the fundamental problem and to safeguard the interests of the political party benefactors. However, it is increasingly evident that this has become a game of survival of the government party and, as a result, no constructive action is taken in the interests of the majority.

1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.

2 OQSI-Open Quality Standards Initiative.

2 SEEL-Systems Engineering Economics Lab.

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