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George Osborne is wrong, wrong, wrong, says the Nobel-Prize winning economist Joseph Stiglitz

2010 June 27
by Paul Vallely

George Osborne will probably not be very bothered that there is a man who thinks he got last week’s emergency budget almost entirely wrong. But he should be. Because that man is a former chief economist at the World Bank who won the Nobel Prize for Economics for his work on why markets do not produce the outcomes which in theory they ought to.

Professor Joseph Stiglitz, who has been described as the biggest brain in economics, is distinctly unimpressed by the strategy of George Osborne which he predicts will make Britain’s recovery from recession longer, slower and harder than it need be. The rise in VAT could even tip us into a double-dip recession.

Stiglitz, who was once senior economic advisor to Bill Clinton, is now professor at Columbia Business School. He was in the UK this week at University of Manchester where he chairs the Brooks World Poverty Institute but he lifted his head from the detail of international development to scrutinise the economic strategy of the Conservative Chancellor and his Liberal Democrat partners who recently reversed their judgement that massive public spending now would endanger the economy and joined in the Tory slash-and-burn strategy.  They were deeply wrong to do so, according to the judgement of Joseph Stiglitz.

It would be a mistake to ignore Stiglitz on this. He has a track record of getting his predictions right. He was one of the few economists who predicted the global financial meltdown long before it occurred. “What happened was very much in accord with what I expected,” he tells me when we meet for a coffee in bright sunshine outside Blackwell’s bookshop in the centre of the university. “The data was pretty clear about that.” And the scale of the crash? “That wasn’t a surprise,” he adds in a matter-of-fact manner. “The bigger the bubble, the bigger the burst”.

“The thing that most economists did not fully grasp was the extent to which the banks engaged in murky risk-taking activities. They were taking a risk with our money, their shareholders’ money, the bond-holders’ money,” he says. Banks were demanding up to 40 pc of the corporate profits, saying their innovative financing was adding value. But “all this talk about innovation was a sham” because it did not relate to any real increase in productivity of the economy.

“There was prima facie case of something screwy going on [with all the] perverse incentives that would lead them to take excessive risk. But there was no way that anyone could know or believe that the banks were [conducting themselves] at that level of stupidity. I predicted that there was going to be a collapse because of the information asymmetry problems that were being created.” His Nobel prize came for exactly that – showing how markets fail because different people in them hold different levels of information.

Yet there is no tone of I-told-you-so about Stiglitz as he asks the waiter for coffee. He orders decaffeinated but suggests that the British economy needs the exact opposite – a stiff stimulant rather than the “fiscal consolidation” which is George Osborne’s economic euphemism for cuts.

Fiscal stimulus is out of fashion now. World leaders embarked on that strategy – injecting money to re-energise the economy – after the banking crash three years ago. It was widely perceived not to have worked because the money governments pumped into the banks was not passed on to ailing businesses or individuals in trouble with their mortgages.

“The problem was that, in the US, the stimulus wasn’t big enough,” he says. “Too much of it was in tax cuts. And when they gave money to the banks they gave it to the wrong banks and as a result credit has not been restored – we can expect a couple of million or more homes to be repossessed this year than last year – and the economy has not been restarted.” And instead of concluding that the government should have done more it has created disillusion that government can do anything.

The result is that, following the attacks by the financial  markets on Greece and then Spain, everybody is now in a mood of retrenchment. “It’s not just pre-Keynsian, it’s Hooverite,” he says.  By which he means that governments are not just refusing to stimulate, they are making cuts, as the President Herbert Hoover did in America in 1929 – when he turned the Wall Street Crash into the Great Depression. “Hoover had this idea that whenever you go into recession deficits grow so he decided to go for cuts – which is what the foolish financial markets, who got us into this trouble in the first place, now want.”

It has become the new received wisdom throughout Europe. But it is the classic error made by those who confuse the economics of a household with those of a national economy.

“If you have a household that can’t pay its debts you tell it to cut back on spending to free up the cash to pay their debts. But in a national economy if you cut back on your spending then economic activity goes down, nobody invests, the amount of tax you take goes down, the amount you pay out in unemployment benefits goes up – and you don’t have enough no money to pay your debts.

“The guys in finance are extraordinarily simple-minded. They are see flailing around using old arguments like: government spending is crowding out more productive private spending; but if that were the case interest rates would be high, but long-term interest rates have never been so low. So you can’t really use that argument, but they’re using it anyway.

“The old story is still true: you cut expenditures and the economy goes down. We have lots of experiments which show that, thanks to Herbert Hoover and the IMF,” he adds. The IMF imposed that mistaken policy in Korea, Thailand, Indonesia, Argentina and hosts of other developing countries in the 1980s and 1990s. “So we know what will happen: economies will get weaker, investment will get stymied and it’s a downward vicious spiral. How far down we don’t know – it could be a Japanese malaise. Japan did an experiment just like this in 1997; just as it was recovering, it raised VAT and went into another recession.”

Then why have we not learned from all that?  Because politicians like George Osborne are driven by ideology; the national deficit is an excuse to shrink the state because that is what he wanted anyway. Because the financial market only cares about one thing – getting repaid. And because other European governments are panicking because of the markets wild attack on Greece and Spain and other governments don’t want to be next.

“But cutbacks in Germany, Britain and France will mean all of Europe will suffer. The cuts will all feed back negatively. And if everyone follows this policy their budget deficits will get worse, so they will have to make more cuts and raise taxes more. It’s a vicious downward spiral. We’re now looking at a long hard slow recovery with the possibility of a double dip if everybody cuts back at the same time. The best scenario is long and hard… and the worst is much worse. If any one of these countries are forced into default the banking system is so highly-leveraged that it could cause real problems. This is really risky, really scary.”

So what should we be doing? “The lesson is not that you cut back spending but that you redirect it. You cut out the war in Afghanistan. You cut a couple of hundred billion dollars of wasteful military expenditure. You cut out oil subsidies. There’s a long list of things we can cut. But you increase spending in other areas, such as research and development, infrastructure, education” – areas where government can get a good return on the investment of public money. “I haven’t done the calculation for Britain but for the US all you need is a return on government investment of 5 to 6 per cent and the long-term deficit debt is lowered.”

Taxes also need to be restructured. George Osborne has increased capital gains tax for high earners from 18 to 28 per cent. “There’s absolutely no reason why you could tax speculative gains [from rising house or land prices] by 40 per cent.  There’s no social return on it and land is going to be there whether people have speculated or not. But you lower the tax on investment in things like R&D.”

Mention of Afghanistan draws Stiglitz away from economics and into politics. The war there is misconceived, he believes. “Securing a small area of territory in the world is not the way to combat terrorism. We moved them out of Iraq and they moved somewhere else.” It is like squeezing a balloon. “There are enough empty spaces; terrorist can move elsewhere – to Pakistan or Sudan, to Yemen or Somalia,” he says.  “There are much better ways of spending money on security. If the US spent $200bn on assistance to help developing countries grow it would do far more to address the problems of instability than killing a few more Taliban.”

Stiglitz’s disatisfaction with the presidency of Barack Obama is clear. “A lot of us were more hopeful that he would be able to tale advantage of the perception of him as a more neutral person to become amore effective arbiter in the Middle East. He’s more effective than George Bush but he’s not a game-changer so clearly that’s a disappointment. But it’s not so big as the disappointment over Afghanistan. When he said ‘I’m not against wars, but I’m against stupid wars’ about Iraq, you’d have thought the corollary was not a surge in Afghanistan. And there’s even more disappointment on human rights issues.”

But the dramatic disappointment in recent months has been the US president’s support for drilling for oil in the Gulf of Mexico. “He should have said: ‘it’s highly risky, won’t solve our energy problems, and the focus should be on conservation’,” Stiglitz says. “The oil that’s underneath there is not going to go away. If all our energy innovations fail we can come back to it in 10 years time, when technology will be safer. This Drain America First policy because it’s bad for us and bad for the world. One would have thought that he would have made this argument but he expanded drilling just as the biggest environmental disaster in the history of the world occurs.”

Perhaps surprisingly Stiglitz is not so harsh about the company responsible, BP. “The argument should have been against oil, not against one particular company,” he says. “BP was unlucky; any one else drilling there could have had exactly the same problem. They probably pushed the envelope, so they deserve to get some criticism but all the evidence in the congressional testimony showed that the other oil companies have no better safety proposals.”

Turning back to the global economic crisis Stiglitz has one more practical solution to offer. Governments should set up their own banks to restart lending to businesses and save struggling homeowners from repossession. “If the banks aren’t lending, let’s create a new lending facility to do that job,” he says. “In the US we gave $700bn to the banks; if we had used a fraction of that to create a new bank we could have financed all the lending that was needed.”

Indeed it could be done for far less. “Take $100bn, lever that at 10 to 1 [by attracting funds from the private sector] and that’s a trillion dollar new lending capacity – more than the real economy needs.”

Such a move would help ordinary people more than all George Osborne’s rhetoric about being tough but fair. Stiglitz is sceptical too about the moral underpinning to a Budget which claims that “we are all in this together” but then hits the poorest hardest.

Analysis by the Institute for Fiscal Studies has suggested that the Chancellor’s budget will cost the poor 2.5 per cent of their income while the rich loose just 1 per cent. “I’ve not made an independent study on that point but cuts in public services will have a disproportionate effect on the poor,” Stiglitz says. Mr Osborne’s budget “may be well-intentioned but it takes an enormous amount of work to make sure that a package of public spending cuts of that magnitude does’t hit the poor disproportionately.”

His big fear is that aid to the developing world, which has been protected in this first round of cuts, will not escape a second. “Developing countries have redirected themselves to towards Asia, and China in particular, in recent years so growth in Africa will be more robust than one might have expected given the severity of the downturn,” he says.

Even so aid remains vital to poor countries. “If aid is cut back then growth will be very badly affected,” he says. China is providing aid, but its aid is all in infrastructure whereas aid from the US and Europe is mainly in education and health – areas in which ordinary people will suffer most if there are cuts.”

Professor Stiglitz has come full circle. What the world needs now – developing and developed – is not retrenchment but greater economic stimulus.  It is not a message many are in the mood to hear. But they didn’t listen to him last time either. And he turned out to be right, and they wrong – and at what a cost to us all.

from The Independent on Sunday

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