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"Flint-faced accountants"

Economist Anthony Scholefield has sent us his latest paper on the actions necessary for Britain to put its financial house in order before it crashes down around our ears. He originally sent the piece to Conservative Home. Like Labour, the Conservatives are unwilling to grasp the nettle and cut dangerous bureaucratic welfare state debt. But according to both the International Monetary Fund and Standard and Poor, Britain's debt is unsustainable and must be reduced for the health of the nation.

We've attached Scholefield's article. It will give you an idea of the scale of the debt, declining tax revenues, the impact of immigration and what accountants, dealing with hard numbers rather than whipped-cream estimates, would advise us to do.

“FLINT-FACED, TURBO-CHARGED ACCOUNTANTS”

By Anthony Scholefield

In dealing with the public spending crisis, David Cameron said (19th March 2009), that the Conservative leaders would not act as “flint-faced, turbo-charged accountants” but, in fact, these are exactly the essential people required by an incoming Conservative government.

Consider the polar opposites to David Cameron’s negatives. Would he want the Tories to act as “soft-touch, slow-moving innumerates”? Of course, David Cameron would say they should not act as such people either but, well, like somebody in between. Unless there is detailed analysis and hard thinking being carried out confidentially by the Tory leadership which is at variance with the minor and anodyne proposals being put forward in speeches, it appears that the scale of the problem has caused an intellectual freeze up, an aversion from the scale and immediacy of the action required.

The purpose of this paper is to discuss the aim, methods and quantum of the necessary reductions in public spending.

The aim can be simply stated. In line with the recommendations of the IMF and Standard and Poor “to put public debt on a primarily downward path”, it is necessary for government revenue to exceed government expenditure.

The methods should be rapid action, based on correct accounting and the quantum should incorporate the real fact that there must be a fall in the incomes of the beneficiaries of public spending, who have so far not had to feel the downward pressure on incomes experienced in the private sector.

The record of the Thatcher government showed what can be done. In cash terms, the public debt rose from £95 billion to £152 billion over eleven years but, for the last six years, public debt remained static in cash terms.

The Thatcher government had extensively prepared itself, not necessarily with detailed policies but with an analysis of what the problems were. This was called by Sir John Hoskyns, who worked closely with Geoffrey Howe, Keith Joseph and Margaret Thatcher, as ‘a sort of intellectual limbering-up’.

The current crisis is not the one of inefficiency in the production process and trade union power which faced the Thatcherites, but is the fiscal growth of the bureaucratic welfare state. The impact of ‘cuts’ on the voter is therefore, widespread.

In present budget forecasts there will be a deficit of up to £175 billion this year, possibly the same or more next year and a further £140 billion the year after; no sacred cows can be given their usual fodder. These forecast deficits, of course, make no allowance for the fiscal support to the banking sector and contain optimistic assumptions about the future course of the economy.

The Cameron position, outlined in his speech of 5th January 2009, of promising to protect increased government spending on the NHS, schools and overseas aid and confining other departments to a one per cent spending increase, in real terms, is not realistic. Nor is it in line with the recommendations of the IMF and Standard and Poor.

George Osborne has now said that there will be cuts in departmental spending. But a close study of his Times’ article (15/6/09) “it is ridiculous to pretend there won’t be cuts” shows that that is exactly what he is pretending, as he says “many government departments will face budget [sic] cuts” but these are not real cuts, they are ‘funny money’ cuts, that is, cuts in inflation-increased budgets. And the bond market does not deal in ‘funny money’.

The Background

Public spending must be addressed against a clear understanding of what is involved.

a) GDP is expected to fall by about five per cent over the two calendar years 2009 and 2010, but under the Brown plan, government spending will increase, in nominal or cash terms and the two sorts of ‘funny money’, i.e., first as a percentage of GDP and also in inflation-adjusted money, so-called ‘real terms’.

b) There is deflation in the RPI Index and private sector wages (-1.1 per cent) and employment are falling while public sector pay rates (+3.7 per cent) and numbers employed are rising. It is possible now to get labour in the public service at cheaper rates so one can ask why should the taxpayer pay more than market rate or pay above-inflation benefit rates?

c) GDP per head is falling more than GDP because of an increased labour supply from immigration. This immigration also requires capital to be supplied to produce the necessary infrastructure for increased population – now – or there is less capital and wealth per head. That is immediate impoverishment.

d) Annual gross capital investment in the UK was £227 billion (2007), but £145 billion of that is simply replacing capital consumed in the course of a year – so new investment/savings in 2007 were £82 billion. So, little is available to fund government spending without actually consuming capital (not counting foreign borrowing/lending or extra saving) at a time when China is reported to be saving 50 per cent of its GDP and India 25 per cent.

e) The only concrete Conservative plans were outlined by David Cameron in his speech of 5/1/09.

“These two proposals (abolish tax on savings for base rate taxpayers and raise allowances for pensioners to £2000 p.a.) would be more than paid for by maintaining the government’s spending plans for the NHS, schools, defence and international development but restricting other departments to a one per cent increase in real terms.”

So far as can be seen, for at least the year 2009/10 David Cameron did not propose any net cuts in government spending.

f) It should be noted how the £175 billion deficit has built up.

In 2007/8, the net borrowing was £35 billion, the now standard structural deficit Gordon Brown was running during the boom years.

Since then, tax revenues are forecast to decline by about £50 billion by 2009/10, according to the Budget. To some extent, tax revenues were inflated by the bubble in the city and in property, masking the real size of the structural deficit built up under Gordon Brown.

Additionally, expenditure will rise by £88 billion between 2007/8 and 2009/10.

Adding the three factors together, the total budgetary deficit is, therefore, an estimated £173 billion but is expected by outside forecasts to be about £200 billion due to further falls in tax revenue and more expenditure

The unreal controversy between Andrew Lansley, David Cameron and Gordon Brown is all about re-arranging spending by £26 billion p.a. in 2013/4. By 2013/4 debt, even according to Alistair Darling, will be £1370 billion, well over double 2008/9. The £26 billion they are talking about is moving spending from some programmes to pay for interest and unemployment but with no net reduction.

Turbo-charged

Standard and Poor’s conclusion on its recent visit was that the Triple A bond rating “could be lowered if we conclude that, following the election, the next government’s fiscal consolidation plans are unlikely to put the UK debt burden (note: not deficit burden) on a secure, downward trajectory over the medium-term.”

The IMF’s recent report stated that fiscal commitments would be strengthened by “targeting a more ambitious medium-term fiscal adjustment path for implementation as the economic recovery is established. The focus of this adjustment profile should be to put public debt (note again – not deficit) on a firmly downward path faster than envisaged in the 2009 budget.”

In fact, the 2009 budget did not envisage any downward path in any reasonable timeframe to reduce debt. The debt total would continue to rise to £1370 billion in 2013/4 from a total of £609 billion in 2008/9.

So both Standard and Poor and the IMF are talking about reducing debt, not just reducing the deficit. But, of course, they are not infallible. Their proposals should be audited but, in this case, they seem eminently sensible.

The simple fact is that to get the debt burden on a downward trend means cutting the deficit to such an extent that there is a surplus of government revenue over expenditure.

Moreover, the sooner the deficit is eliminated, the less compound interest comes into play and the burden of paying interest on debt and on accumulated interest is reduced. Therefore, the eventual debt piled up which has to be paid by future taxpayers is reduced and the less likely “the Triple A borrowing rating” will be lost.

At present, Standard and Poor estimates debt levels would be 100 per cent of the then GDP in 2012/3 or £1644 billion, that is £382 billion more than Darling estimated in his budget (£1262 billion).

We need turbo-charging which means acting now. That means the Tories need a worked-out plan to cut spending which will be implemented the moment they come into power.

Andrew Lilico correctly stated in his excellent Platform article on Conservative Home, “it is much easier not to raise spending than to cut it later” to which one can add “it is much easier to cut spending than to pay it back long after the benefits of the spending have been consumed and when it has to be paid back with interest added.”

Accountants

Despite the fact that proper accountancy was founded in the fifteenth century by Fra Luca Pacioli, who was such a distinguished thinker than he taught Leonardo da Vinci, modern accountants have allowed themselves to be relegated below the salt. David Cameron rather ignorantly used the term ‘accountants’ as a term of denigration. Despite the fact that many macro economists recently have lost faith in their own nostrums, it is to economists that politicians defer.

Take what Brad de Long confessed in a speech in Singapore on 5/1/09:

“This is also a bad time to be a macroeconomic theorist. . .Take any introductory economic principles text; it is of no greater help. Perform the difficult and arcane task of reading the technical papers that we make graduate students read in their first and second years of macroeconomic courses – you gain little of anything more of use. The economic theories we professional economists typically teach do not do their job of helping us to understand the world in which we are now living.

In part, this is because the current global recession is a different kind of recession than the ones we have grown used to since World War II and that are in the text books.

This is the key to what Paul Krugman calls ‘depression economics’.”

Yet it is accountants who have a much greater grasp of costs and revenue and the interaction of the assets and liabilities of balance sheets with income and expenditure which are at the heart of the present financial crisis.

Macro-economists generally obsess about the changes in the GDP figure. This indicator, which was changed from GNP in the 1980s to give more optimistic figures, has been fiddled by all sorts of statistical changes and is totally dependent on the GDP deflator being correct, which it usually is not.

GDP or even GDP per head are only some of the possible indicators of overall economic health.

Accountants would look beyond output to changes in the balance sheet – what’s happened to the assets and liabilities. For example, you can raise GDP by importing capital and labour but both of these increase your liabilities, so your increased production must be of such an amount that it can pay back the capital cost of the increased labour and capital. Technically, National Income Accounting should (and in some countries partially does) provide a national balance sheet but, as far as the UK is concerned, the only capital statements ever produced are very late, incomplete and never taken notice of by the macro-economists.

The long-term liabilities of demographic change and its impact on health and pension liabilities have not been quantified as is done in the US. In the boom, GDP was supposed to be increasing because consumption was going up faster than production, producing balances of payment deficits as the other part of double entry bookkeeping. Worse still, government spending was going up faster than revenue and the other bookkeeping side of that is also increased liabilities and it is much harder to cut than consumption. In both cases, future savings will have to pay for past excesses.

The current government proposals to increase borrowing to finance consumption and prop up the GDP figure and not to finance investment is the road to ruin.

In the commercial world, the production of income and expenditure accounts (the GDP equivalent) without balance sheets are not treated as serious accounts as they lack the self-checking systems enforced by balance sheets.

Anyone in the denigrated class of accountants can work out that the sooner the current deficit is reduced, the smaller the eventual debt pile. Accountants work with cash figures rather than working on percentages of GDP. Basing spending on GDP percentages, as is done by macroeconomists, falls apart when GDP falls as it is doing now. Of course, GDP is one of a range of indicators to be taken into consideration but, for spending, it is not the lodestar.)

Flint-faced

The bill for out-of-control spending is now being presented and it can be quantified. Look at 2010/11. Revenues are estimated to increase but come to £528 billion, expenditure is £702 billion, that is a shortfall of £174 billion, or 25 per cent. 2011/12 shows a shortfall of £140 billion, or about 20 per cent, when spending is to be £717 billion. So, an absolute minimum of £150 billion, or 20 per cent, has to be carved off spending in each of 2010/11 and 2011/12. This is the amount required by Standard and Poor and the IMF to get the deficit down to zero and stop the debt pile increasing.

Words such as David Cameron’s “it is time for those who work behind the front line in public administration to show pay restraint” are simply not up to the scale of the problem.

The IMF forecasts that the UK economy will shrink by 4.5 per cent over 2009 and 2010. This will leave the economy at the end of 2010, roughly at the size of the economy of 2005/6. As Andrew Lilico says, “Why should we expect the state to spend more in 2010 than it did in 2005/6. So to return expenditure to 2005/6 levels would imply spending in 2010/11 of some £100 billion less than in the 2009 budget plans.” Andrew Lilico makes allowance in this for some essential extra spending in unemployment and debt interest.

This will not be enough. An extra £40 billion reduction at least has to be found.

The sheer magnitude of the necessary reductions in public spending has triggered a natural human reaction to simply not think about what action is required.

Many Conservatives do not realize that the IMF and Standard and Poor are both looking for public debt to be put on a downward path in the medium term if not immediately, not simply for a small reduction in ballooning public spending. That means fiscal surpluses pretty soon which is a long-way from current Shadow Cabinet thinking.

The IMF’s final bit of good advice is:

“And finally, building a public consensus on the critical need for sizeable fiscal adjustment to assist in meeting fiscal challenges.”

The recent squabble over exactly how the public spending will be allocated in 2013/4, with no net reduction in spending, is precisely the opposite of this good advice.

Comments (3)

Paul:

As a former Accountant, and student of Economics as part of my degree, I totally agree with this article.

The 'Economy' is not really any different in kind than one's household accounts, and no one can borrow their way out of debt.

As an old saying goes, "You run into debt, but you crawl out of it."

The scale of debt being incurred seems to indicate a reckless disregard of the fact that borrowing for consumption, today, means producing but not consuming the amount borrowed, plus interest, for the foreseeable future.

Paul

o:

Politicians spend, spend & spend because it is not their money.

There should be a constitutional limit on Parliament to balance the budget each financial year (except in times of declared war & or natural disaster). If they fail to balance the budget (same goes for local government), the total amount overspent is divided by 646 & sent to each MP for him/her to personally pay off, even at the risk of losing his/her own assets.

Only when they exercise the same restraint on the public purse that they do in their own personal expenditure will they be fit to represent British citizens.

Katie:

Excellent article. It is quite easy to spend someone else's money. It is also easy to borrow against someone else's future money, while crossing your fingers that the money will be there to repay the debt. As an accountant, I believe the balance sheet is of primary target when auditing, and a comparison of historical balance sheets gives us a picture of what has changed in the operations of the entity in the interim. However, a government's ability to ignore its own balance sheet works to their advantage, so that they can avoid fact and historical trends, but rather rely on unreliable assumptions of conveniently chosen economists. Denigrate accountants? Hardly. Factual numbers don't lie. Unlike a business that must focus on increasing revenues and cost containment to maximize profit, the government must focus on increasing private sector revenues through business development, while doing so at the absolutely most efficient cost to the taxpayers while delivering necessary services. There should be no pie in the sky borrowings to spend wishfully on programs that barely deliver a bang for each borrowed buck.

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