Tuesday, June 2, 2009

Thoughts on the 2009 budget

(This is a guest-blog by Dr. Stephen Poletti. Dr. Poletti is a lecturer in the Department of Economics at the University of Auckland and an executive member of the Child Poverty Action Group (CPAG). This blog is an edited version of comments made by Dr. Poletti at the Ninth Annual Budget Breakfast organized by the CPAG on May 29, 2009. The views expressed are those of Dr. Poletti and not mine; though, for the most part, I agree with the sentiments expressed in this blog.)

The background to the budget is the world financial crisis which has developed over the last year. Despite the rally in world equity markets since mid march the outlook for the next year is grim. The IMF recently downgraded their January prediction for world growth this year from plus 0.5 per-cent to minus 1.3 per cent - the worst slowdown since the great depression. They dryly note that “Recovery will take longer than normal because the slump was precipitated by a world wide financial crisis.”

The numbers are unnerving. Just to take a few recent announcements. In the last six months Japan’s GDP has fallen 8%, Singapore registered a 10% drop in GDP over the last year and German GDP fell 4% in the first three months of 2009. A recent article by respected economists Barry Eichengreen and Kevin O’Rourke looked at the trends for a number of key variables over recent months compared to the great depression. They conclude that the initial stages of the world financial crisis are at least as bad as the early days of the depression. However they go on to analyse the fiscal and monetary response of governments globally which are much more stimulatory than during the depression and conclude that “the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.”

Underlying the financial crisis has been the huge increase in income inequality in the countries at the heart of the world financial markets. Financial markets have come to dominate the real economy. Global financial assets have increased from 100% of world GDP in 1980 to 360% of world GDP in 2007. 40% of US corporate profits were from the finance sector, up from 20% to 30% in the 1990s. Coupled with this has been a dramatic rise in inequality as the top few per cent skimmed off most of the extra income generated as the economy grows. From 1993 to 2006 the top 1% in the USA captured 52% of the growth in income of the country. Between 2002 and 2006 they managed to grab a staggering 72% of the growth in GDP. The top 10% of income earners in the US now get 50% of national income up from 35% in 1982. The last time things were this extreme was just before the great depression. On the other hand the real income of the bottom 90% of society in the US actually fell between 1973 and 2006.

How could such a state of affairs persist in a democracy? Part of the answer is that those at the bottom managed to borrow to supplement their income ensuring that consumption kept growing. Much of the funds for this were imported from Asia (particularly China) which ran up big surpluses. At the peak, America absorbed about 70 per cent of the rest of the world’s surplus savings. House prices went up and up creating “ the biggest asset bubble in human history”. Household debt in the English speaking countries went up dramatically after 1980 more than doubling in many countries which fuelled the growth of the financial sector.

Finally as we know the whole pyramid scheme unravelled as people with “sub-prime” mortgages in the US started to default on their loan payments and it slowly dawned on people that house prices weren’t going to keep going up forever. As the crisis intensified bank lending almost dried up completely.

Here is a quote from the economics editor of the Financial Times in England. “The proposition that sophisticated modern finance was able to transfer risk to those best able to manage it has failed. The paradigm is, instead, that risk has been transferred to those least able to understand it.”

In summary, the present global economic crisis is likely to persist for a lengthy period of time. It is unlikely to be as severe as the great depression because governments are stimulating demand much more. At the heart of the meltdown is the fact that the financial sector started to dominate the real economy. This in turn was associated with a dramatic rise in inequality, the impact of which was ameliorated by households funding increased consumption by borrowing and a resulting housing asset bubble.

Turning now to New Zealand we see a similar story. Household debt sits at 160% of GDP (compared to 170% in the UK and 130% in the US). Real house prices have increased by a similar amount to that experienced by the US and UK. To finance this we have borrowed from the rest of the world – a sort of pyramid scheme where we borrow to service our debt payments. On a per capita basis we are one of the most indebted countries in the world. The tragedy is that the vast bulk of this debt has not been used to make the country more productive and the economy stronger and more able to service the overseas debt. Instead much of it has fuelled a housing asset bubble in the first instance which then flows on to increased consumption as housing equity is drawn down.

Inequality in New Zealand has also increased dramatically in recent years where in terms of the Gini index (a measure of inequality) our degree of inequality is on a par with the UK and only slightly better than the US. New Zealand’s degree of inequality is the 23rd worst out of the 30 OECD countries.

Over the last couple of decades we have taken advantage of the worldwide expansion of the financial sector to borrow well beyond our means year in and year out to fund consumption a circumstance that cannot continue. We have also seen dramatic increases in inequality and child poverty.

Over the last year GDP in NZ fell 1.8% and the first quarter figures are certain to be bad. In Budget 2009 Bill English does acknowledge the severity of the world economic outlook and our reliance on overseas debt to fund consumption. Having acknowledged these concerns he then does almost nothing to address them.

As expected he made no mention of inequality in this budget. No mention of child poverty. And he has no conception that the events of the last year must fundamentally change the way we manage capitalism. To quote from Martin Wolfe “Another ideological god has failed. The assumptions that ruled policy and politics over three decades suddenly look as outdated as revolutionary socialism.”

A lot of weight was put on the fact that Standard and Poor might downgrade the New Zealand government credit rating. If one was cynical one could argue that this was no accident and the government was quite happy to use this as an excuse to bear down on social spending. Already we have seen 1400 jobs lost in the public sector. It should be noted that Standard and Poor gave Enron an AAA rating weeks before it went down.

Spending on health and education continue to increase at a similar rate to that seen under Labour. It is also encouraging to see extra money ($323m over four years) to help insulate houses making them warmer and healthier. We welcome the cancellation of the tax cuts but point out that this now broken election promise was never plausible.

Overall however this is a bland budget that offers no vision and no coherent response to the economic crisis that is buffeting New Zealand. There is almost no fiscal stimulus to speak of. Instead the economy will just drift along with a bit of spending bought forward here and there balanced by cuts to government spending elsewhere.

Bill English has the approach of a shop keeper when facing hard times – trim costs and hunker down. This is exactly the response which turned the financial shock experienced in 1929 into the great depression. I would have liked to see a billion dollars invested in public transport and an electric rail system in Auckland, and also several billion dollars put into building decent state houses. We know that decent housing would make a huge difference to the health and well being of many of the poorest and most vulnerable in our society. It also makes good economic sense. It is an effective way of stimulating demand.

The government could have announced that taxes would be raised when the recovery is well underway to finance this in the longer term. It could also have followed the British and US government’s initiatives to increase the top tax rates and start to reduce the vast inequalities in our society.

The elephant in the room is housing investment. This budget does nothing to change the incentives around housing investment which has seen Kiwis borrow from overseas to fund the housing asset bubble as discussed earlier.

Unemployment is expected to rise to 7.5% next year and could go as high as 9%. That means that up to 200,000 people will be forced to rely on inadequate benefits. Many families will suffer extreme financial stress. Their children will suffer. Where in this budget is a reversal of the 1991 benefit cuts or an announcement that the in work payment would be extended to cover all children. I remind you that the Child Poverty Action Group (CPAG) estimates that over 150,000 children in New Zealand live in severe or significant hardship.

Already we are seeing extra stress in communities. Budget service managers are describing 40 to 400% increase in demand for services; Food bank demand has increased 50-60%. Family counselling demand is up 30%. And this is before the expected dramatic increase in unemployment.

We are supposed to be pleased that they have not cut WFF- but all the problems of poor children who miss out because they are not working enough or on a benefit remain. CPAG have calculated that it would take $450m to pay the IWTC part of the WFF to all those families that miss out at the bottom. This is worth $60+ per family. The Restart package acknowledges that families who lose their jobs need this payment, but the restart package is woeful—only a handful of families around 700 have qualified and they can receive the payment for only 16 weeks. CPAG estimates the government is spending 0.5% of what it should be spending.

Instead of initiatives to lift children out of poverty there was a lot of talk about building new prisons. Instead of investment in innovation and programs to increase the skills and productivity and pay of workers the main contribution the government has determined it can make to growth is to cut red tape for business. One wonders do they really believe that this is a serious response to the worst crisis we have seen since the great depression?

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