The Real Economy

Leaving austerity behind - the prospects for the UK

Hector McNeill¹
SEEL

The issue of austerity has become a contentious issue in the UK as in peripheral countries in the EU and, in particular, Greece.

The arguments on both sides of this debate tend to be constructed making use of flawed conventional economic theories and their sparse policy instrument tool boxes; this is why no commonly agreed path is identified. The current exchanges between the SNP and the government, the raving rhetoric in the Labour party leadership fora and, further afield, the Greek situation, are examples of an intellectual impasse of this sort.

This article explains how the Real Incomes Approach can secure the required growth to escape from austerity.

The arguments

Austerity

Panzup made bread and lived well. But one day the miller, Challok said he needed a higher price for his next delivery of flour. He even offered Panzup credit to purchase it. Panzup thanked Challok who delivered the flour. After five years Challok sent Panzup a bill for the credit which was far larger than Panzup expected but under the law Challok could lay claim to all that Panzup owned to pay back the debt. So Challok took Panzup's house, bakery and little shop. Panzup did not even have money to travel to find work and he died in poverty.

Common sense

25 years later it so happened that Challok's grandchild Georgi ran a small business. His competition had reduced their prices so Georgi could see he was in trouble and he needed a loan to invest in better equipment and train his workers. Georgi went to the local bank and quite by coincidence the bank manager happened to be Panzup's grandchild, Hetmud. Hetmud told Georgi about the dealings of their grandparents of which Georgi knew nothing. Hetmud refused to accept Georgi's request for money because he did not explain how the investment would enable him to compete and earn enough to pay back the loan. However, Hetmud explained to Georgi what needed to be in his proposal such as reference to the new technology, the likely costs of operation and the margins he could generate even at the low market prices. Georgi did what Helmut requested, he received his loan, paid it all back within a short period from his cash flow and has since asked Hetmud for another loan to open another business in the neighbouring province.

From: "Simple things"

In basic terms all sides of the austerity debates acknowledge that we need growth to escape from austerity and reduce deficits and debt. It should not be forgotten that private debt is as bad as government debt and this constrains any positive outcomes from policies that concentrate on the reduction of government debt and deficits.

There are two fundamental approaches. One is to essentially asset strip important services from public provisions in an attempt to reduce demands on government revenue. This model regards the whole affair as one about balancing the national accounts without any short to medium term considerations of changes resulting from growth. At best growth comes from "reorganization" or "reallocations". However, policy does not contain effective positive incentives for increased productivity. Others argue that some form of public works such as housing and transport infrastructure can help generate "demand" and "growth" and thereby accelerate the recovery even on the basis of slightly increased debt. Once again, besides talk, there are very few suggestions as to how growth can be generated in the short to medium term to secure an impetus for growth based on increased productivity.

Both of these models apply different interpretations of the aggregate demand model (ADM) of the economy. In the case of cutting public services the "demand" that such provisions generated within the economy is removed and provisions are reduced. In the second, the introduction of debt-based expenditures to support other provisions sees this as a way to increase "demand". These policy options of reducing or expanding demand are typical of the circular arguments put up by adherents to conventional KMS (Keynesian, monetarist & supply side) economic theories.

If we need growth, then policy should support it

Anyone who cares to look through the foundation texts of Keynesianism, monetarism and supply side economics will be struck by the lack of any reference to the factors that generate real growth in the economy. It is well established that growth comes from learning, the evolution in technology and techniques and the accumulation and deployment of tacit and explicit knowledge, all of which are the fonts of innovation and productivity. The main impact of productivity is growth in real incomes, that is, there are usually unit price adjustments based on higher productivity that increases the purchasing power of fixed or nominal incomes; the purchasing power of the currency increases. Policies need to provide a direct incentive for economic units to aim at short and medium term gains in productivity.

Destructive macroeconomic & microeconomic assumptions

On the side of macroeconomics, monetary policies have reduced the real benefits from any productivity and stability in the currency, where these have occurred it has been a result of group and individual initiative and effort as opposed to the impacts of conventional policies. For some 70 years monetary policy has considered a 2% rate of inflation to represent "price stability" whereas this in fact devalues the pound by around 18% each decade and undermines the realization of the full benefits of productivity in terms of real incomes. More recently, the low interest rates and quantitative easing have channelled money into asset markets rather than productive investments to increase financial productivity. Productivity has become equated with the return on finance measured in financial terms as opposed to a more general measurement of the rise in real incomes of the economic and social constituents resulting from growth. This excessive financialization which obscures the need for increases in technical productivity and output per person hour, is substituted by a concentration on profit, measured in nominal terms.

On the side of microeconomics, most allocative decision-making is concerned with increasing profits and, indeed, the aggregate demand model operates on the basis of an assumption that the profit motive provides the impulse for response to changes in levels of "demand". However the effects of the profit paradox have become a dominant feature in distorting allocative efficiency and transparency as a result of the mutually contradictory roles of profits. Indeed, the inappropriate legal frameworks covering accountancy and audit treatment of profits have created a socially and economically divisive situation. This has led to widespread evasion and avoidance of corporate tax as well as the hiding of profit streams and finally the perversity of setting profit as the prioritized decision analysis objective over employee skills and income (see "The profit paradox").

The population endures cuts in public provisions and falling real incomes because government is giving no consideration to alternative policies that can stimulate productivity...

Income illusion

As a result of falls in productivity associated with the imposed interest rate cycles, people's cost of living increases and, in order to sustain their standard of living, people have had to resort to credit, loans and remortgages. This contributes to an "income illusion" or feeling of wellbeing associated with the ease of raising additional cash to spend. But this is based on an ever increasing spiral of debt. Poor productivity eventually leads to faltering sales and unemployment resulting in the magic spell of the "income illusion" being broken by the reality of house repossession and an imposed poverty.

Irresponsible legality

The combination of monetary policies and the profit paradox has resulted in wages as a proportion of GDP to decline and profits, in spite of a considerable degree of mis-reporting, to increase as a proportion of GDP. The tendency is for government revenues to decline in real terms resulting in a need to raise government revenues and the declining real wages make raising revenue more difficult. There is therefore a constitutional question as to why does our macroeconomic framework encourage these perverse trends? Since there is a strong bias towards declining productivity and a rising cost of living there is a need to review the terms of agreements that are imposed in financial contracts. One of the most striking elements is that those who lend money can asset strip those who borrow money if for some reason they are unable to repay loans. There is therefore a question as to the mutual responsibilities of those who enter into loan contracts. A healthy tendency towards caution should be shared by both parties so that the lender ensures that the probability of successful repayment is high and this means assessing the borrower's ability to repay from the subsequent cash flow. The fact that lenders are particularly lax in this respect can be seen in the collateral demands made to cover loan risk. Thus, sometimes the value of the collateral, such as a house, is several times the size of the loan. As a result the risk is all on the side of the borrower. This sort of situation is essentially an irresponsible legality. The argument is that lenders have to protect their shareholder's funds but in a societal context the decision-making should also protect the interests of the borrower. More mutuality in decision making can be attained through loan requests being subject to a higher standard of practical due dilligence that is overseen by the lender and borrower and this is only possible if banks have more expertise in the area of lending and knowledge about the lender and the lender's environment. The highly centralized nature of bank operations with branch managers having very low levels of discretion and decision-making power and relying on filling in "application requests" on a computer to be sent an approval or rejection. Local representation has no incentive to be more curious nor do they have the capabilities to do an adequate and responsible job. This system is also subject to loopholes if the borrower is unscrupulous.

It is interesting that when bank's fail there is an interest in a graceful termination so as not to "destabilize the market" in the case of debtors who cannot pay at the moment, an aggressive asset stripping occurs with no thoughts being given to the destabilization and suffering of the borrowers and their families and their associates.

Oh, and productivity?

Stating that a government seeks to defend key public services is unconvincing when no economic policies are deployed to guarantee their sustainability through enhanced productivity ...

In most cases of excessive debt there are common causes, these include unexpected changes in conditions that determine the success of a loan's performance such as market conditions or a mortgagee losing their job. Quite often these changes cannot be predicted at the time a loan is made but they are always a possibility so there needs to be a practical allowance within legal agreements for such eventualities. The reporting on change, within management systems that might be used to manage an investment based on loan finance, is quite often inadequate with the frequency of reporting too low to enable timely and effective responses when change is detected. In the majority of cases loans do not get into trouble if there is growth in the cash flow of the lender. In the case of business investment this is best guaranteed through investment being made in activities that increase productivity and margins. In the case of mortgagees or those taking out second mortgages for other purchases, incomes need to be stable to rising so as to provide a similar situation as increasing productivity.

So productivity is a means to lower the risks of debt and austerity and where debt has become excessive the concentration of effort should be on investment to increase productivity in the short to medium term so as to realize benefits immediately. The tendency is for those who adhere to conventional economic theories to imagine that productivity increases can only arise from investment in long term research and development, the training of medical practitioners and the taking on of apprentices. Yes, such moves can augment productivity in the long run but in a crisis productivity impacts need to be immediate.

Securing a positive impulse for raised productivity with immediate beneficial effects

Whether we are considering the United Kingdom, or even Greece, the generic nature of the Real Incomes Approach, and Price Performance Policy (PPP) in particular, makes possible an immediate productivity impact because productivity is expressed in the form of moderated or reduced unit prices. As prices are moderated real incomes of those working in the companies responding to PPP incentives, are increased. The PAC Model provides the explanation of the immediate impact on consumption and growth (see "The PAC Model of the Economy"). It should be noted that this growth in productivity receives its initial impulse from price-setting and often there is no need for any investment or "more debt" (see "The growth impetus" and also "The real growth multiplier"). Also the corporate cash flow increases, even after payment of incomes, so that the equity available for investment increases, lowering the requirements for loans and the associated financial servicing overhead.

The evil public services

Because of the way in which public services are currently funded and managed it is difficult for them to stimulate growth when in fact they can be centres of growth. Therefore they become the most direct target under "austerity". There is invariably a widespread assumption that public services are "inefficient". There is often a jaundiced view of the potential of the public services to "reform" on the part of a considerable part of those in politics as if public services are a hopeless case.

However, under Price Performance Policy (PPP) (see Bare Bones PPP) public services are subject to the same productivity incentives as the private sector with civil service pay bonuses, spread across all levels of staffing, being dependent upon service productivity. In reality, under PPP, the productivity incentives are as effective within the public as well as the private sectors and there is no reason why the private sector would hold any specific operational advantages over public services. Indeed, depending upon the processes being deployed within the public sectors in terms of technologies and techniques, they can become growth centres based on the degree to which they can reduce their PPRs (see The price performance ratio)and PPLs (see The price performance levy).

It should not be overlooked that public services cannot be considered to be some sort of backwater of the economy when it represents some 40% of the UK's GDP.

The combination of currency value stability under PPP achieved through both the private and public service productivity initiatives rises and the overall increase in real incomes resulting from lower unit prices can result in the necessary public service outlays falling in nominal terms to attain the equivalent results as were achieved previously with higher nominal budgets. This results in a reduction in the absolute value and proportion of GDP that needs to be raised by government to support public services; there is therefore a reduction in need for "cuts" when better real provisions can be serviced for the same or even reduced nominal budgets.

The prospects for the UK to leave austerity behind are good if only serious consideration were given to the Real Incomes Approach. The same is true for Greece.

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

Updated: 23rd June, 2015: sections rewritten maintaining the same sense but hopefully more clarity; substituted word lender by borrower to correct error.

Updated: 23rd June, 2015: added section entitled "Income illusion".

Updated: 24th June, 2015: elaborated section entitled: "The evil public services".

Updated: 5th August, 2015: some small sections rewritten but sense maintained.

Updated: 14th August, 2015: corrected inversions of sense caused by the word "lender" being used instead of "borrower" and vice versa.

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