Busting the Myth of European Debt

Everyone's concerned about European debt levels. People have also pointed out that the US is in a better position than Europe. The data do not bear that out:

Gross US debt was 86.4% of GDP in 2009
Gross EU16 debt was 78.7% of GDP in 2009
Gross EU27 debt was 73.6% of GDP in 2009

US Budget deficit was 10.3% in 2009
EU16 budget deficit was 6.3% in 2009
EU27 budget deficit was 6.8% in 2009

In short, yes be worried about Greece, Ireland, Spain and others. But both the Eurozone (EU16) and the European Union as a whole (EU27) is in a more fiscally sound position than the United States. This should be a major determining factor behind risk analyses of European government bonds in comparison to US Treasury bonds.

Data information:

• US GDP in 2009 was $14.2563 Trillion. Source: Fred GDPA.txt
• Gross government debt in 2009 was $12.31134967751203 Trillion. Source: Treasury Direct debt for 2009-12-31.
• Government debt as percentage of GDP is 86.4%
• US Budget Deficit in 2009 was $1.471295 Trillion. Source: MTS0110.txt. Data collated into spreadsheet here.
• US Budget Deficit in 2009 was 10.3% of GDP.
  
• EU16 and EU27 data available in summary table from Eurostat. Source: Provision of deficit and debt data for 2009 - first notification.
  
• Eurostat Provision of deficit and debt data for 2009 states on page 2, footnote 1: "Government debt is the consolidated gross debt of the whole general government sector outstanding at the end of the year (at nominal value).", which corresponds more or less to gross debt levels recorded at US Treasury Direct website. (ie: apples are being compared to apples)

I like Obama and I agree with Keynes. But US government debt needs to be paid off sooner rather than later.

Despite the fact I am increasingly finding my own economic understanding being challenged and improved upon through the views of others, I am yet to change my mind over the issue of government debt. I therefore find myself in one of those uncomfortable "middle" places between ideologies and ideas in which I find myself agreeing with people whom I usually disagree with and disagreeing with those whom I respect.

This is the situation: It is my view that US government debt is a serious problem. It is the prime reason why I publish a "debt watch" every month, since hard data is essential in informing my view. Yet by holding the "debt is a problem" view I find myself aligning with populist conservative economists who deride Keynes and hate government while at the same time I find myself disagreeing with people like Paul Krugman and Obama supporters who see the stimulus as a good thing.

For the record I am not dismissive of Keynesian economics. As a non-American I have seen "automatic stabilisers" such as welfare payments and unemployment benefits being enacted by governments and have even benefited from them directly. I have no problem with government deficit spending during recessions, all things being equal of course. Yet it is that last phrase - "all things being equal" - which is the qualifier that has made me oppose the Obama stimulus package and to align with deficit hawks.

So, what is so "unequal" about the American situation? The problem is that for Keynesian economics to work over the course of the business cycle, any deficit run during recessions must be balanced out by surpluses during expansions. This causes a virtuous cycle, whereby increased tax revenues during expansions pay off the debt accrued by the government during recessions, while also creating net government savings once the debt has been paid off. These savings should then, of course, be used as emergency funds to be tapped when the economy moves back into recession. The idea is that over the course of the business cycle, government deficits are balanced out by surpluses, and the amount of debt accrued is balanced out by the amount of savings.

What is obvious though is that this process falls apart when governments act irresponsibly. Irresponsible actions in this case involve governments running deficits and accruing debt during economic expansions. Since 1981 the United States has run up huge fiscal deficits not just during recessions but during expansions. For this I blame the rise of Supply-side economics and the populist tax complainers who advocate it. The idea that reducing taxes would magically produce more tax revenue has destroyed the fiscal standing of the US government since the early days of Reagan.

Yet it seems to me that some non-supply siders have their own magical thinking to deal with. There's no doubt that the Obama stimulus has boosted the economy, but it is illogical to assume that such a boost in economic growth would provide enough increases in tax revenue to pay off the stimulus in the first place. Despite the presence of multipliers, the end result has been and will continue to be a net increase in debt levels. Those who believe otherwise are merely replicating the error of supply-side economics, except that the deficit is created by spending increases instead of tax cuts.

The fact is that public debt in the US is now just over 58% of GDP and debt servicing represents 2.7% of GDP. Just over 19% of Federal government spending is dedicated to debt servicing, an amount which easily exceeds anything spent on NASA, Education or the Environment combined.¹ Debt servicing is only exceeded in size by defense spending, health and human services and social security. Alarmingly, this amount will only increase the more the economy expands, since an expansion will create a higher interest rate environment and force the government to pay even more on money owed.

It is debt servicing which is the real killer behind running large structural deficits over a long period. As more and more debt is accrued by a government, more and more money is spent on paying interest. As time goes by this increase in debt servicing "crowds out" spending on other government programs: education spending gets cut, science gets cut, health care gets cut, environmental protection gets cut, welfare gets cut - and all getting cut without any actual decrease in government spending since these cuts are being balanced out by an increase in debt servicing. And of course who is the beneficiary of government debt servicing? Investors - households and businesses who fronted the billions of dollars in the first place to lend to the government. This is, of course, the rich, mainly. If there is one government policy that rewards the rich over the poor over the long term, it is having a structural deficit adding to increasing national debt levels.

If a household goes into an unsustainable debt spiral, they end up being declared bankrupt. Bankruptcy can also apply to businesses, but businesses also have the option of dissolving. Both the borrower and the lender in this situation are "losers". Sovereign governments do not have the option of bankruptcy or dissolution. Too much debt can be controlled through inflationary seigniorage (since the government controls the money supply) or by defaulting. Markets respond to the threat of default by dropping sovereign debt investments and thus causing a rise in bond rates (eg the recent problems with Greece).

Bankruptcy, dissolution, inflationary seigniorage and defaults are processes which cause massive economic damage. If a sovereign government inflates its debt or defaults, the pain and damage is passed on to the market and to households and businesses, who in turn are rendered bankrupt or are dissolved and the problem escalates. So while the government may survive, the people and businesses it supposedly serves ends up badly hurt.

The US is not close to defaulting on its debt, but it is closer now than at any other time in history. The reason why I believe the Obama stimulus was a bad move was not because I somehow oppose Keynes or have embraced Grover Norquist, but because US debt levels were already too high for such a stimulus package to be sustainable. One of the problems that caused the great financial crisis was lax US fiscal policy, so it seems illogical to assume that loose fiscal policy can be used to solve it. While this may seem merely axiomatic, it is nonetheless important in my thinking on the issue.

One response from stimulus supporters in the face of this complaint can be summed up in one word: Hoover. Didn't Hoover make the depression worse by cutting government spending, and didn't Roosevelt make the depression better by increasing government spending via the New Deal? My retort? I agree - but neither Hoover nor Roosevelt was lumbered with government debt the size and proportion of which Obama was lumbered with when he took office in 2009. Debt levels were already too high before the great financial crisis hit, and they have grown even higher throughout.

At some point the US must deal with its debt decisively. The government must agree to run fiscal surpluses over a long period in order to pay off the "national credit card". Supporters of Obama's stimulus argue that the economy must recover first and that any changes must occur later rather than sooner. I disagree. I can't see the US economy returning to its pre-GFC glory for some time. Financial market imbalances have gone on for too long and have messed up too much money for things to return quickly to 2005-style balance sheets. Unemployment is unlikely to drop below 7% for the next few years and there is always the threat that a second credit crunch might hit and make the current recession even worse. After all, there has been a domino effect of sorts - the subprime crisis of 2007 leading to credit crisis of 2008 leading to the European sovereign bond crisis of 2010 leading, inevitably, back to US households and businesses, a process which looks like it is already hitting with further drops in house prices being experienced.

Yet if I got my way, what would result? Let's say Obama rings me up and says "OSO, you're a wise man. Tell me what to do and I will do it." Well apart from awarding myself a few million dollars to feather my own nest I would:

• Increase taxes, especially on the rich.
• Introduce a Market Capitalisation tax to tax public companies according to their market wealth.
• Cut defense spending by 25% (Iraq and Afghanistan would be handed over to the United Nations and troops brought home)
• Leave spending levels where they are proportionally for the next five years.
  

In short, I would aim to run an immediate fiscal surplus of around 1% of GDP, and then sit back and wait as this surplus increased over time.

Of course such an action would result in an economic contraction. It would push the US into a deep recession. Yet the alternative would be an even deeper and even more damaging recession later on. Moreover, forcing the country into a recession is exactly what Paul Volcker did when he began work as Chairman of the Federal Reserve and it was he who is seen by many as the real reason behind America's 80s recovery and expansion (and not Reagan). If Volcker can cure the economy via harsh monetary medicine then so can Obama and Congress cure the economy via harsh fiscal medicine. Of course such a decision by Obama and Congress (acting on my wise counsel) would push the US into a far worse recession than Volcker ever did, but Volcker's recession resulted from, and cured, 10-15 years of monetary madness, while an OSO directed recession would result from, and would cure, some 30 years of fiscal madness.

The point is, though, that a reckoning has to occur. Had George W. Bush in his first term of office decided to keep taxes where they were and run more Clinton-inspired fiscal surpluses, the current GFC would probably be much milder, or may have never occurred at all. Had Clinton and the Gingrich Republicans in the second half of the 90s been less concerned with White House interns and more dedicated to running fiscal surpluses, the current situation would be even less severe. Had Walter Mondale been inaugurated president in 1985 on the back of fixing Reagan's fiscal stupidity with tax increases (one of his actual election promises that seemed crazy at the time but quite prescient in hindsight), we'd probably never be in this predicament in the first place.

The thing about learning from history is to ensure that we don't repeat the mistakes of the past. In 1996 Australia had 8% unemployment and government debt levels of around 20% of GDP (which at the time was quite high, but is quite low in comparison to other nations now). Despite the economic torpor of the time, the new conservative government chose to cut spending and aim for a surplus within a few years. The immediate result was predictable - the economy barely grew and unemployment increased. But as years passed the economy grew more strongly, unemployment dropped and the government began running regular, healthy budget surpluses. By the mid 2000s the Australian government was debt free.² Comparing Australia to the US has its problems, but there is no doubt in my mind that this conservative government (under PM John Howard and treasurer Peter Costello) did Australia a great favour through running constant, incremental contractionary fiscal policy. Not only did Australia manage to avoid going into recession in 2001 but it has also avoided recession throughout the GFC. The economy has expanded almost continually from about 1994 until the present and unemployment, once always lower than the US, is nearly half the US rate. There are certainly other factors involved (eg the resources boom) but even when those are factored in, there is no doubt in my mind that intelligent fiscal policy has provided Australia with a huge safety net to turn too once the GFC hit - PM Kevin Rudd instituted a stimulus package which has created the potential for economic overheating, a problem certainly NOT experienced by most western countries at this moment. The point I am making here is that Rudd' stimulus, on the back of over ten years of fiscal prudence and the retirement of government debt, was quite sustainable and probably saved the country from recession. Obama's stimulus, by contrast, was not, and will come back to bite.

If the US government institutes fiscal policy of the sort that I am suggesting, the result would be a sharp but short term contraction which, on the back of the current recession, would obviously be quite damaging. Nevertheless this is the harsh medicine that America must swallow if a) it wants to rebalance its fiscal state over the long term, and b) if it wants the government to not expand in its size. This last point can obviously change, and I would not be unhappy if the US instituted:

• A NHS-style universal health care system.
• Building enough renewable energy plants to exceed total US electricity demand.
• Massive industrial biochar production aligned with afforestation programs.
• Doubling public transport infrastructure
• More money into public education
• And other OSO-approved polices that would make me happy.

Of course I would not oppose such spending, but spending of this sort would probably double the size of the US government and for that to succeed without adding to the deficit, it needs to be accompanied by tax increases - tax increases which result in more revenue that is needed to pay for the spending increases. The issue here is not whether government spending should be expanded (I think it should) but whether a surplus should be run (which is absolutely essential). Given that the US hasn't as yet reached my own enlightened levels of social and economic understanding, whatever increases in government spending are enacted should always come second to the need for a fiscal surplus (or, more properly, the need for debt to be paid off over the long term which will, in the short term, require a reduction in the deficit).

<sup>1: MTS Report April 2010, Table 3, "Budget Outlays - current fiscal year to date": Department of Defense-Military $396,452 million, Department of Education $61,232 million, Department of Health and Human Services $503,984 million, Interest on Treasury Debt Securities (Gross) $224,414 million, Environmental Protection Agency $5,586 million, National Aeronautics and Space Administration $10,781 million, Total Outlays $1,998,847 million

2: Debt free here in a net sense. A bond market for government debt was still needed and still continues to operate. Government surpluses since the mid 2000s have been directed instead to a "future fund" which allowed government savings to eventually exceed debt levels. So Australia still had gross debt but no net debt - at least until the GFC hit and returned the government into net debt, although at a very low level.</sup>

OSO's Debt Watch - June 2010

GDP = $14.6014 Trillion (Current Dollar, 2010 Q1 second estimate)
Public Debt = $8.4784148925952 Trillion (2010-05-25)
Total debt owed to foreign holders of treasury securities = $3.8846 Trillion (2010-05-17)
Debt/GDP ratio = 58.07%
Foreign ownership of debt/GDP ratio = 26.60%
Population = 309,410,800 (Resident Population + Armed Forces Overseas, 2010-04-01)
GDP per capita = $47,190.98
Public Debt / person = $27,401.81
Foreign Public Debt/ person = $12,554.83
GDP per capita minus Public Debt per person = $19,789.05
Tax Receipts = $2.047615 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-04-01)
Tax Receipts as percentage of GDP = 14.02%
Debt/Receipt ratio² = 414.06%
Federal Government Outlays = $3.460717 Trillion (Twelve month moving average¹, Monthly Treasury Statement, 2010-04-01)
Federal Government Outlays as percentage of GDP = 23.70%
For every $1.00 the US government gains, it spends $1.69
Fiscal Surplus/Deficit = -$-1.41310 Trillion
Surplus/Deficit as percentage of GDP = -9.68%
Interest paid on Treasury Debt Securities (Gross, Twelve month moving average, Monthly Treasury Statement, 2010-04-01) = $0.391855 Trillion
Interest paid on Treasury Debt as percentage of revenue = 19.14%
Interest paid on Treasury Debt as percentage of GDP = 2.68%

Notes:

• Debt/GDP ratio has now passed 58% of GDP
• Americans owe $7144.68 more than they did in October 2008.
• Americans net worth has dropped by $6427.63 since October 2008
• Federal deficit has increased slightly to 9.68% of GDP

In October 2008, GDP was $14.2003 Trillion (Current Dollar, 2008 Q4 final estimate)
In October 2008, Public Debt was $6.18964742400511 Trillion (2008-10-20)
In October 2008, the total debt owed to foreign holders of treasury securities was $2.9797 Trillion
In October 2008, the Debt/GDP ratio was 43.59%
In October 2008, the foreign ownership of debt/GDP ratio was 20.98%
In October 2008, the Population (resident population + Armed Forces overseas) was 305,554,049 (2008-10-01)
In October 2008, GDP per capita was $46,473.94
In October 2008, Public Debt / person was $20,257.13
In October 2008, Foreign Public Debt/ person was $9,751.79
In October 2008, GDP per capita minus Public Debt per person was $26,216.81
In October 2008, Tax Receipts were $2.578156 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Tax Receipts represented 18.16% of GDP
In October 2008, the Debt/Receipt² ratio was 240.08%
In October 2008, Federal Government outlays were $2.747197 Trillion (Twelve month moving average¹, November 2008 Monthly Treasury Statement)
In October 2008, Federal Government outlays represented 19.35% of GDP
In October 2008, for every $1.00 the US government gained, it spent $1.07.
In October 2008, the Fiscal Surplus/Deficit was −$0.169041 Trillion
In October 2008 the Surplus/Deficit as percentage of GDP was -1.19%
In October 2008, interest paid on Treasury Debt Securities (Twelve month moving average, Monthly Treasury Statements) was $0.429994 Trillion
In October 2008, interest paid on Treasury Debt as percentage of revenue was 16.68%
In October 2008, interest paid on Treasury Debt as percentage of GDP was 3.03%

The historical tables of the FY2010 budget (page 24-25) show that:

Highest tax receipts as percentage of GDP: 20.9% in 1944 and 2000.
Lowest tax receipts as percentage of GDP: 2.8% in 1932.
The last time tax receipts were lower than they are now: 13.3% in 1943.
Highest Federal Government outlays as percentage of GDP: 43.6% in 1943 and 1944.
Lowest Federal Government outlays as percentage of GDP: 3.4% in 1930.
The last time Federal Government outlays were higher than they are now: 24.8% in 1946.
Fiscal Deficit - Worst: -30.3% in 1943
Fiscal Surplus - Best: 4.6% in 1948


¹ Measures total tax receipts/outlays over the previous 12 months from the last month measured. eg April 2009 to March 2010.
² The Debt/Receipt ratio measures government revenue (twelve month moving average) as a percentage of current public debt. A good way to compare it would be to compare your current income to what you owe on your mortgage.

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Econ 101 with interest rate spreads

There's only one thing better than learning something you never knew before and this is discovering it yourself.

I've been busy with spreadsheets recently, entering in all sorts of inflation and interest rate data for the United States since about 1954 or so. Then I start creating various equations and some interesting patterns arise. In this case, it is the spread between the 10 year Bond Rate and the Federal Funds Rate:

Of course what I have discovered is that whenever 10 Year Bond Rates (10YBR) exceed the Federal Funds Rate (FFR), it is an indicator of a possible recession. As you can see above, the spread between the 10YBR and the FFR went negative in July 2006 and continued that way until February 2008. That was the period leading up to the Great Recession we are now in. In fact I have factored in the NBER cycle into the spreadsheet. This is not an isolated experience. Here is the early 2000s recession:

What is interesting is that you can see conditions worsening in 1998 as a result of the Asian Financial Crisis (not mentioned) and the Russian Financial Crisis. This means that whenever things go into "the red" (10YBR exceeding FFR), there is a danger of recession but not always an inevitable decline into one. Here's the early 90s recession:

That shows a period of red which ends about 6 months before a recession begins. Again, though, we have a period of 10YBR exceeding FFR preceding a recession. Here's the early 80s recession:

Here's the 73/74 recession:

By way of contrast, here's a period of steady growth:

And this is where we are now:

Interesting stuff. More later.

Eurozone thoughts in no particular order

Perhaps what the Eurozone needs is a tax imposed upon all member nations as a way to solve the various fiscal crises going on there. By taxing businesses and individuals in Euro nations and then using the revenue to retire government debt, the Eurozone can work together to fix their fiscal problems.

Of course such a tax would be unpopular but the alternative would be to allow member nations to continue their public indebtedness.

One of the agreements that member nations signed way back in 1992 (an agreement that has since been replaced by the Lisbon Treaty) was to limit budget deficits. This was implemented as an essential macroeconomic policy to ensure the smooth running of the Eurozone. Unfortunately this part of the treaty was neither honoured by members nor allowed to punish wrongdoers. The current fiscal crisis in the EU is a result of the inability of member nations to honour the treaty.

To reiterate my position on the EU: I see the Eurozone as an important step towards a more internationalist culture in our world - a culture that should act to benefit all who join. A single currency zone is better than a mixture of different currencies since it allows a broader and stronger trade relationship between member nations. Unlike many on the English speaking political left and the English speaking political right, I am very supportive of the single currency. Yet membership of the currency is not a "one way street". A member nation both enjoys the benefits and adheres to the responsibilities that such a union brings. Nations who have joined the European Union have done so because they have concluded that the benefits outweigh any loss of national sovereignty.

In days gone by, the problems of Greece and other PIIGS nations would have been borne solely by those nations. Since the Eurozone was introduced, any problems encountered by one nation end up being transferred to all of them. Without the Euro, markets would have dumped the Greek Drachma, forcing the country into a currency crisis not unlike that which has engulfed Iceland. Instead, the markets dumped Greek Euro bonds and bought German and French Euro bonds. While this did force bond rates in Greece through the roof, the punishment was mainly inflicted upon the government and anyone who had invested in Greek government bonds. But what of those Greek citizens who did not borrow and spend but who saved and were responsible? For these people the market shocks did not directly affect them - their savings are safe. But in a world where the Euro was not adopted and the Greek Drachma was still the currency, these people would've lost a huge amount of real wealth as the currency depreciated.

But Greece's problems did affect the Eurozone as a whole - the market began dumping the Euro. Yet this drop in the value of the Euro was manageable and not unexpected. All nations in the Eurozone thus experienced a drop in real wealth as a result of Greece's problems. So while membership of the Eurozone certainly helped Greece when Greece was suffering, it also resulted in the suffering being transferred to the whole. Greece has thus become one of the first nations to benefit from the single currency zone's advantages and it won't be the last. But while Greece has enjoyed this benefit, they must also be responsible in adhering to the treaty that binds these nations together and fix their public finances.

My analysis of real interest rates has led me to the conclusion that the Eurozone is due for some good economic growth over the next six months. Real interest rates have dropped considerably in Germany, France, Switzerland and other nations. Greece is a notable exception to this as the effects of the market dumping Greek government bonds has resulted in higher bond rates in Greece. So while Greece is due for a recession and the deflationary effects that result from it, the rest of the Eurozone is due for growth - and it will be growth in the rest of the Eurozone that will end up helping Greece back into growth as well. The same is true for Ireland, which has suffered a major economic downturn since the beginning of this financial crisis and debilitating deflation along with it. Like Greece, Ireland will recover.

At present many commentators are questioning the very existence of the Eurozone. Since very few commentators in support of the Eurozone live in English speaking nations, there is little in the way of rebuttal that ends up getting published. Moreover, much of the modern criticism of the Eurozone seems to focus mainly on the differences in culture and language that prevent a true currency zone from being effective - the idea being that Spanish unemployed are less likely to move to Germany for work because of language and culture differences, while the comparable situation of people living in California moving to Texas for work is different since the cultures are more similar and the language the same. While the European Union does suffer from language and cultural barriers, these are being slowly removed the longer member nations remain in the zone. Moreover, many Europeans are bilingual and if information from this list is compared to this list, we find that somewhere around 136.5 million people in the Eurozone speak English, more than 40% of the total. Whatever barriers exist within Europe to hinder free trade and free movement of labour are not insurmountable and certainly do not offer any real evidence that the Eurozone was a bad experiment.

All we have learned so far is that governments who borrow too much tend to create problems later on. That has nothing to do with the Euro.

Q: It is obvious that the company did not fit reliable safety equipment to the machine before it exploded. Had safety equipment which meets government mandated standards been fitted, the disaster would not have happened.

A: The fact that the safety equipment failed is not the company's fault. The government mandated safety standards did not prevent the explosion. If we didn't have these safety standards, things would be safer.

Sound stupid? Compare this to:

Q: It is obvious that companies did not follow financial regulations and this caused the market crash. Had these companies followed regulations this financial collapse would not have occurred.

A: The fact that regulations did not work is not the fault of the financial company. These regulations did not stop the financial crash from occurring. If we didn't have all these regulations, there would never have been a financial crash.

Follow-up on real interest rates

I obviously picked the right time to ruminate on real interest rates. As regular readers know, I posted an article the other day that examined the impact that real interest rates would have on various economies.

I placed Germany in "Group 2", meaning that real interest rates had decreased moderately and this would help boost any economic output. Well the BBC has just reported that the German economy grew by 0.2% in Q1 2010. Eurostat has interpreted these figures to be a 1.5% growth in GDP over the past 12 months.

I placed Greece in "Group 4", meaning that monetary conditions had sharply deteriorated and that an increase in real interest rates would act to dampen any economic growth. The Wall Street Journal has reported Greek GDP declined by 0.8% in Q1 2010, while Eurostat sees it as a decline of 2.3% in GDP over the past 12 months.

You can download the Eurostat report (which the BBC and WSJ have reported from) here (pdf, 122kb).

Other "Group 2" nations include Spain (-1.3% but better than the previous 3 quarters), France (1.2% growth), Italy (0.6% growth) but nations like Ireland and Sweden have yet to have their GDPs reported. The Euro area itself has grown by 0.5%, which is good news, and has grown faster than the European Union generally (0.3% growth).

"Group 1" nations - those whose real interest rates were dropping too quickly and were in danger of inflation, include the UK, whose economy declined by 0.3% (thus developing into a "stagflationary" environment) . Switzerland and Iceland have yet to report.

The sole "Group 3" nation - Poland - has yet to report GDP too.

The fastest growing EU nation was Slovakia with 4.6% growth. Latvia is the worst, with -5.1% (following on from -17.1% the quarter before)

PM Cameron and the future of UK politics

David Cameron is the new UK Prime Minister. Good on him. He led the Conservative party to gain a plurality in seats and votes in the recent general election. Since I share the same surname as the new PM, I am also ever so slightly chuffed that the secret plan for world domination hatched centuries ago by the clan leaders is currently running well.

What makes the 2010 general election so unusual from Britain's history is that it has resulted in a hung parliament. The last time the UK elected a hung parliament was in February 1974 and it was so distasteful for everyone involved that they had to have another election in October 1974 to get rid of it. This time around, however, it appears as though a real workable coalition has been settled between Britain's largest political party, the Conservatives, and the third largest party, the Liberal Democrats. As a result, Lib-Dem leader Nick Clegg's star has risen further and he has become deputy Prime Minister under Cameron.

This is all good news. As I have pointed out in previous posts (here and here) the electoral system used in the U.K. stinks to high heaven and should be replaced by a proportional system, my preferences being either STV or MMP. A reform of Britain's electoral system has been a central plank of Liberal Democrat policy since the 1983 election, which saw the Lib-Dems receive 25% of the votes but only 3.5% of the seats. I am hoping that Clegg was able to convince the Conservatives of the need to change the electoral system as a part of their coalition agreement, though I am not putting it past him to ditch it for the sake of his own personal ambitions (which would naturally include becoming Prime Minister at some later date).

I have read recently that the Conservative party faithful are dead against any reform of the political system of the sort promoted by the Liberal Democrats, mainly because it would result in a permanent "locking-out" of absolute power for their party. Their fears are not unfounded - a proportional system would rip away a quarter of the current conservatives seats in parliament and award them to Liberal Democrats or smaller parties. Yet it must be pointed out that, historically, the Conservatives are Britain's most popular political party. My own research into UK general elections since 1918 has shown that the Conservatives have, on average, won 40.9% of the vote. Labour comes second with 37.8%, the Liberals (in their various guises) are a distant third with an average of 14.8% with remaining parties and independents making up an average of 6.5%. Thus if any proportional system of government were introduced the Conservative Party would still control a sizeable portion of it, assuming the nation doesn't permanently abandon them.

The advantage of Proportional Representation (PR) is that it forces individuals and parties to compromise in order to pass legislation, assuming that one party does not control a majority of seats. This means that any political decisions that are made not only have to take into account the various political factions within the parties themselves, but upon the positions of other political parties. Without a clear majority, politicians in all parties need to work with each other - as opposed to against each other - in order to produce legislation that more represents the desires of the people.

And while the UK has yet to introduce a proportional system, this election has nevertheless brought about a hung parliament and an eventual coalition between two major parties who have chosen to rule together. In other words, what will be experienced under a proportional system is already being experienced by the current hung parliament.

As a recent visitor to a number of Lib-Dem forums (Liberal Democrat Voice and Social Liberal Forum) I have been struck by a sense of betrayal that many people are feeling that Clegg chose to align himself with Cameron and the Conservatives. The feeling is that the Lib-Dems have essentially become a de-facto arm of the Conservative party. Such a feeling is understandable but not very realistic, since it misunderstands the very nature of a coalition government (something that the UK has not experienced since 1929). In many ways I think that people simply hoped that Clegg would align himself with Labour since the two parties were closer together in political and economic ideology. Yet a Labour/Lib-Dem coalition would have its own problems, not least being the fact that the people of Britain rejected a Labour government after 13 years in power as a result of the recent election. Clegg had to form a coalition in order to promote stability and he obviously chose the party that was less likely to cause problems - not to mention that a Lib-Lab coalition would've required the inclusion of the various minor parties to gain a majority of seats to govern effectively (Labour seats + Lib-Dem seats = minority). Besides, the Liberal Democrats are a centrist party and their history includes the defection of Labour party members in 1983 whose politics were more moderate and less left wing than the party they defected from. In other words, the Lib-Dems, while promoting social liberalism, are not social democrats of the sort which dominates in the Labour Party. In practical terms this means - gasp - that some policies promoted by the Conservatives might seem quite sensible to their Lib-Dem coalition partners. Moreover, the Lib-Dems are big on civil liberties, and many would feel very uncomfortable in aligning themselves with the Labour party, who has spent the last 8-9 years eroding civil liberties.

What the Lib-Dems offer, though, is the ability to moderate Conservative legislation. There is no doubt that within the ranks of conservative politicians there are some who want to destroy the welfare state, eliminate the NHS, sell off government schools, kick out Muslims, cut taxes for top income earners and possibly even invade France. With the Lib-Dems controlling the balance of power, any legislation presented by the Conservatives that appears too radical would be nixed. In order for any sort of meaningful legislation to be passed, the Conservatives need to take into account the position of their coalition allies, which means that any legislation that will pass will more likely be centrist in nature.

Checks and Balances are important in moderating government power, and a coalition of parties in a Parliament is a natural check and balance. If the Conservatives try to force bad legislation down the Lib-Dem throats then there is always the threat that the Lib-Dems might dissolve the coalition and force either a minority government (Cameron remains as PM but he and the conservatives have little real power) or join together with Labour and the minor parties to form a centre-left coalition (which would result in a new Prime Minister, probably from the Labour party). Such moves would be a serious setback to Conservative power, so it is in the interests of the Tories to tread softly, negotiate intelligently and aim for consensus - political behaviour that has been sadly lacking in UK politics since, well, ever.

Of course there is the danger of Lib-Dem corruption. The financial backers of the Conservative party can quite easily begin throwing money and influence at the Lib-Dems. This would ensure the Lib-Dems becoming de-facto members of the Conservative party as time goes by, so it it important for the individuals who back the Lib-Dems to keep their politicians honest and accountable.

The real test of Lib-Dem influence will be in their ability to force electoral reform. Even if the Conservatives reject it outright, it is more than likely that reform would be backed by the minor parties (with the exception of the DUP who would lose out because of PR, and Sinn Fein who never turn up to Parliament). Together the Lib-Dems and the minor parties control about 71 seats - enough to form a voting bloc to force PR by refusing to sign any other legislation until their demands are met. A very aggressive strategy, of course, but it will force Labour and the Conservatives to either join the PR voting bloc (and thus have enough votes to pass any PR legislation) or, more amusingly, to create a loose Labour-Conservative coalition to pass legislation.

Apparently the agreement between the Conservatives and the Lib-Dems involves having a five year term, which means that the next UK general election should be held in 2015. These next five years will be a crucial test of whether the UK's political parties can actually work together to create meaningful and effective legislation, and especially whether the Lib-Dems can co-govern effectively. Considering what happened in 1974 and 1929, an eventual breakdown of the coalition and the calling of a new election is a real possibility.

The most pressing problem is the current economic downturn. The Conservative and Lib-Dem coalition need to fix up public finances and this will no doubt result mainly from spending cuts with a few tax rises added here and there. Will the Lib-Dems succeed in scrapping Trident and saving billions of pounds? You'll probably find that the Tories will seek help from Labour to prevent that from occurring. My own personal feeling is that UK public finances will still be a mess in five years since the Conservatives didn't exactly promote healthy fiscal policy even during the Thatcher and Major years (Thatcher's conservative credentials suffer at that point), meaning that the UK government was already deep in debt when Blair took over in 1997 (who, in turn, put the government into even more debt). In short I don't trust either the Conservatives or Labour in fixing up Britain's government debt, since neither party has any recent history of fiscal intelligence.

A second important issue is the introduction of Proportional Representation. Hopefully the 2015 election will be held under a MMP or STV electoral system. A national referendum on PR was one of the "non-negotiables" that Clegg presented to both Labour and Conservative parties as part of any coalition deal, but it remains to be seen whether the Lib-Dems will force the issue or end up becoming too in love with the new power granted to them. Will their deal with the Conservatives be the beginning of a new era in UK politics? Or will it turn out to be a deal with the devil? Only time will tell.

Some predictions using real interest rates

My study of real interest rates has been continuing, though without any publishing on this blog due to data collection. There are some predictions though which I have decided to publish today.

I've broken up nations into four groups.

Group 1 - Plunging real interest rates. These are nations whose monetary conditions have dramatically changed over the previous six weeks to promote inflation. These nations are:

• Britain
• Argentina
• Brazil
• Iceland
• Switzerland
• Mexico
• China
• Russia
• Turkey
  

Now of these nations, the one with the lowest CPI is Switzerland, which means that the inflationary growth will not be as serious, while Turkey and Argentina already have high levels of inflation. High inflation levels are bad for an economy because they act to distort prices which, in turn, leads to more inaccurate "money direction" - the choices money holders have in spending or saving or investing or borrowing currency. This inevitably leads to a "peak" in growth, followed by a trough - inflation usually precedes a deflationary economic downturn.

Group 2 - Real Interest rates dropping moderately. These are nations whose monetary conditions have favoured economic growth over the previous six weeks.

• Japan
• Canada
• Euro Area
• Australia
• Ireland
• Spain
• Germany
• France
• Italy
• Sweden
• India
• New Zealand
  

While inflation may result from these monetary conditions such an increase is not likely to be serious. While these conditions do not guarantee economic growth they do act to either improve growth already occurring or to limit any contraction. Of these nations, Ireland is the only one with a contracting economy experiencing deflation, so it is likely that Ireland will experience only moderate contraction and more stable prices in the coming months. Conditions in the Euro Area are improving, which should affect the PIIGS in a positive way. While India's real interest rates have improved moderately, very high inflation continues to afflict them and there is evidence from my data to suggest that India is likely to have some form of economic contraction (ie either a downturn or lower growth rates) soon. Of the nations on this list, Japan and Germany, with price changes close to zero, are more likely to experience sustained growth.

Group 3 - Real interest rates increasing moderately. These are nations whose monetary conditions have favoured economic contraction over the previous six weeks.

• United States
• South Korea
• Poland
  

Again this is not a prediction of economic decline but a contractionary effect upon growth/decline already being experienced. I have collected more data on US CPI and interest rates than any other nation and the data suggests that conditions in the US are not improving. Growth in GDP for Q1 2010 was 3.2%, following on from 5.6% in Q4 2009, which shows that the Obama stimulus of 2009 has passed its peak and is headed on its way down. Real interest rates in the US declined considerably between July and December 2009. In fact "considerably" is too conservative a word to use - real interest rates declined from 5.7% to 0.62% over that six month period. The US would be in "Group 1" in December last year, which indicates that the US economy is beginning to slow down. Considering the speed of the decline and the growth experienced in Q4 2009 and Q1 2010, I would be very surprised if growth ended up exceeding 1.0% for Q2 2010 (which is now).

Group 4 - Real interest rates increasing substantially. These are nations whose monetary conditions have seriously deteriorated over the previous six weeks.

• Greece

Greece has suffered mainly from the market's fear of a sovereign debt crisis - and such a fear is not unfounded. With increasing austerity measures being put into place, Greece's economy looks set to contract - ie shrink - some time this year. Inflation in Greece is still running a little high (3.9%) but increases in bond rates have more than exceeded this amount. Inflation in Greece is likely to turn into deflation as soon as the economy begins to shrink. Growth in the Euro Area, though, is likely to moderate any Greek downturn (and also help Ireland stop its current economic decline).

And that's Stephan Bibrowski in the picture.

Random thoughts on the UK electoral system

Here's some grotesque figures for you all:

The numbers on this graph represent percentages - first of amount of votes and then in amount of seats in parliament. As you can see both the Labour and Conservative parties have, on average, enjoyed greater percentages of seats in parliament than the percentage of votes they gained. UK Labour is especially at an advantage here. Of course the main loser has been the Liberal Party/Liberal Democrats, who have, on average, had 10.6 percentage points less seats in parliament than they gained from votes, which is an enormous amount at the best of times but especially so for a party which has taken an average of 13.6% of the vote.

This situation is due to Britain's electoral system which rewards vote plurality. Although it is the simplest voting system that can be implemented it really only works in a two-horse race, in which it becomes a majority vote by default. The danger of an electoral system based upon a plurality of votes is that the party in power inevitably governs with the consent of a minority of people. Realising the dangers of such a system means that voters either give up voting altogether (their vote does not count if they live in a safe seat) or end up voting for one of the two main parties instead of the party they want.

Perhaps the worst case of a government being elected that did not have majority support was the 1983 election in which Margaret Thatcher was returned to power ostensibly on the back of a successful Falklands War campaign. If we look at the figures, though, we see an interesting situation, namely that Labour and the Liberals gained a total of 53% of the popular vote while the conservatives gained only 42.3% of the vote (a percentage of votes which, in other times, has led to electoral defeat for that particular party). Now while it would be remiss to assume that all of that 53% voted against Thatcher, the history of the time is important to consider. 1983 saw a massive drop in the amount of Labour votes - at 27.6% it was their worst post-war electoral result ever - while, at the same time, a huge increase in the amount of votes directed towards the SDP-Liberal alliance, the forerunner of today's Liberal Democrats. The SDP-Liberal alliance came about when a number of MPs defected from the Labour Party to form the Social Democratic Party in order to promote a more moderate social agenda than that being promoted by the Labour Party. They teamed up with the UK Liberal Party which had been marginalised for decades as the perennial third party with little to no influence. While the two parties had their differences, they obviously felt that their similarities were such that an alliance could be formed. Confronted with the prospect of voting for a hard-line leftist Labour party or a hard-line conservative party, many moderate Labour voters abandoned the party to vote for the SDP-Liberal alliance. In other words, the creation of the SDP and its alliance with the Liberals caused many Britons to reject both the reigning party and their traditional opponents. In effect, therefore, 53% of Britons did, in fact, vote against Margaret Thatcher in 1983 and probably did so because of her policies at the time. Yet the electoral system was such that it delivered Thatcher a second term in office. The election also kept the Labour Party entrenched as the opposition instead of being threatened by a resurgent third party, commanding 32.2% of the seats in Parliament as a result of gaining 27.6% of votes. The SDP-Liberal alliance, of course, were punished by Britain's electoral system, resulting in a paltry 3.5% of seats in parliament despite gaining 25.4% of votes. This result eventually led to electoral reform naturally becoming an integral part of Liberal Democrat policy since then.

The Liberals have, in fact, been a consistent force in British politics since 1974 when they gained 19.3% of the vote and were probably the reason for the hung parliament of the time. The United Kingdom in 1974 was, of course, reeling from various social and economic problems and electors turned to the third party to show their lack of faith in the two main parties - a situation which is being repeated now. The difference between now and 1974, and, more importantly, now and 1983, is that neither the Labour Party nor the Conservatives are likely to gain more than, say, 36% of the vote - Labour especially is likely to end up with less than 30%. Yet despite the problems with UK Labour, the Conservatives are not leading in the same way as they led between 1979 and 1992.

My own personal desire is for the Lib Dems to win a majority of seats in Parliament and for Clegg to become PM. Although the chances of that are low, they have improved somewhat since the first debate. Nevertheless the most likely result appears to be a hung parliament with the Conservatives having a plurality of seats and David Cameron thus becoming PM, and with the Lib Dems controlling the balance of power. Hopefully this situation will force electoral reform.

My own preferred electoral system is and will remain Demarchy. I doubt that Clegg and Cameron will introduce a British Demarchy, so what is my wish list for UK electoral changes?

1. Abolish the House of Lords. Don't replace it with anything. This would create a unicameral system with only Parliament operating as the legislating body. Amount of politicians removed = 733. These guys are not elected anyway. Besides, the house of Lords is an historical oddity and has no place in a modern democracy.
   
2. Halve the amount of constituencies from the current 650 to 325.
3. Introduce a Hare-Clarke voting system and have 4 seats for every constituency. Amount of politicians added = 650. With four seats for every constituency, a politician could enter parliament with 25% of the vote, thus giving voters a good reason to vote for their minority party.
   

What I like about my proposed system is that it results in a net drop of politicians from 1383 (733 Lords + 650 elected MPs) to 1300 (1300 elected MPs) while increasing a more proportional system of government. I prefer unicameralism over bicameralism (ie two legislative bodies) because it will make legislative activities simpler and more decisive once a decision has been made. While it is true that a secondary legislative body introduces checks and balances to the system, my argument is that a singular legislative body that is appointed by a proportional electoral system will itself provide the necessary checks and balances.

I also like a Unitary system of government. I may have Scottish blood in me but the idea of devolving too much power to Scotland, Wales and Northern Ireland is not necessarily a good thing. I don't want a Federation. Besides, the Scots the Welsh and the Irish already have MPs that can act on their behalf.

Getting rid of the Monarchy and having an elected executive would be a good idea too, but I doubt that Clegg will be able to pull that off. That would be too much too quick and something that would need some level of public support behind it. It would also need a decisive referendum and should probably be considered only after a more proportional system of government is introduced. Say, maybe in 10-15 years when Charles ascends to the throne?