This post is an excerpt from the pdf that I started this blog off with. I’ve posted it because I hope it also makes sense as a stand alone post.
When Margaret Thatcher made her economic policy changes in the 1980s many economists predicted that the UK would be plunged into a vortex of impoverishment. In fact although the deindustrialization they predicted took place it coincided with increased prosperity by many measures. The resulting economic transformation was viewed as such a success that a broad political consensus was formed supporting those “neoliberal” economic policies. The Labour Party became New Labour and embraced financial deregulation and a transfer of taxation away from property and onto consumption. Wealth boomed for the wealthiest and everyone else was swept into greater prosperity along with them. Similar measures were taken in the USA and had similar results.
When reading recollections of those involved in the instigation of the Thatcher economic policies it is clear that the key aim and result was to shift from an economy where wage inflation out-paced asset price inflation to the opposite. The resulting benefit to those who already were wealthy before the transition is obvious. What needs to be understood however is how the country overall became richer on a wave of asset price inflation. How were we able to afford imported goods so much more easily than before? Seemingly by simply bidding up the price of pre-existing (or even purely paper) assets we were able to pay foreigners to do our manufacturing and provide us with natural resources that much of the rest of the world couldn’t afford.
The answer becomes apparent when the financial connections with the rest of the World are drawn into the picture. The UK became the piggy bank of the world. Foreigners were able to join in and further inflate the stock market, bond market and real estate bubble. Across the developing world, the immensely rich elite of those countries sought secure and lucrative ways to hold their wealth. The UK became a repository of choice for this “capital flight” from the developing world. When the UK bought imported goods, the money paid for them was returned back to the UK to bid up the value of our asset markets. In effect, trade became a flow of real goods (and migrant workers) to the UK in return for account statements. All that the UK needed to produce were electronic or paper documents.
To kick off this wave of financial inflow, interest rates were raised significantly above the (high) rate of inflation. This offered a potential bonanza to those buying UK treasury bonds especially if the consumer price inflation rate could be reduced. Limits on bank lending were relaxed and tax breaks were offered to those taking on debt. The government curbed labour union powers and disengaged from efforts to limit unemployment. This quashed wage inflation and so the inflationary impetus of credit expansion was channelled into asset price inflation.
The flip side of this flow of funds to the financialized developed economies was painfully manifested across the “developing” world. In fact, it made a mockery of the term “developing”. From the time of independence in 1960, Nigerian GDP increased 135% during the 1960s and then 283% during the 1970s. By contrast it shrank by 66% in the 1980s. The Nigerian Naira / USD exchange rate went from 0.78 in 1980 to 2.83 in 1985 to 8.94 in 1990 to 102.24 in 2000. With economies drained by capital flight, the developing world was no longer as able to afford global commodities such as oil, coffee, metal ores etc. That caused a slump in commodity prices and consequent further slumps in the economies of commodity exporters and so yet more incentive for capital flight.
Economic depression in the developing world was further fuelled by USD denominated loans made by UK and US banks to third world governments. A sovereign government has no need for borrowing in a currency other than its own. Any public services such as school teaching, road building or construction of sewerage systems etc. could have been provided using local currency issued by the government to pay local people to do the work with taxes payable in the local currency ensuring the value of the local currency. Countries such as Nigeria had trade surpluses. That provided an ample potential immediate source of foreign currency to fund any imports for government use (such as weapons). The only role for USD denominated loans was for adding to capital flight. Meanwhile the western banks profited from the interest payments on the government debt. Political power in third world countries rested on being able to win over powerful cronies with the prospect of facilitated capital flight and so the dire arrangement became further entrenched.
Since 2000 however the developing world has in many cases resumed development. Hundreds of millions of people in the developing world have escaped poverty over the last decade. This has been applauded as evidence that neo-liberal economic policies have extended their benefits to everyone. Perhaps a more accurate view would be that a stage in the process of financialization has now been fully wrung out and so the choke hold over the developing world’s economies is slipping. In order to attract financial in-flows, the ideal monetary arrangement is to have high interest rates above the rate of consumer price inflation and an expectation that both inflation and interest rates will subsequently fall. The market price of any asset that provides a long term cash flow will tend to rise if interest rates fall. If an asset costing $10 yields $1 per year when interest rates are 10% then (very crudely) a drop in interest rates to 5% will tend to reset the asset price to $20. Bringing interest rates down from >10% to <1% provides a phenomenal impetus to asset markets as has occurred since 1980. However, once it is done, it is done and so wealth managers will start looking elsewhere.
A whole raft of other such policies also harvested a one off boost for asset prices. Curtailing labour union power, shifting taxation from property onto consumption, encouraging private pension saving and facilitating private sector credit expansion all added to the performance of asset holdings. What provides a real bonanza for asset holders is when there is a transition from an unfavourable financial climate to a favourable one. Once that transition has been fully priced in, much of the gain has already occurred -especially when asset values are elevated and so assets don’t provide much of an income stream. Once everything has been done to make an economy as hospitable as possible for global “hot money”, the market will price in that favour and then global “hot money” will look for a new home where the next price rises are going to occur. This makes attracting capital flows an inherently one off rather than a sustainable way to achieve prosperity. Capital flows may unfold over decades and that may give the impression that they have provided a timeless prosperous equilibrium but ultimately sustainable prosperity depends on the real economy.
It is vital to appreciate that macroeconomic malign effects don’t require any malign intent on anyone’s part. En-mass, people simply endeavouring to manage their finances as best as possible can inadvertently cause massive waste and destruction whilst all the while being entirely oblivious of it. It is analogous to tragic incidents when people get crushed to death in large crowds. No one person is to blame, the crowd surges and crushes without any person in the crowd acting reprehensibly. That is not to say that there is not a responsibility to take crowd control seriously – quite the opposite. Some of the politicians and technocrats at that vanguard of neo-liberalism actually aimed to alleviate poverty. Their reasoning was that if money is pampered then it will spring forth rewards that can be dispensed to good causes. In their view, capital flight supposedly means that global money is continuously being deployed wherever it can earn the most. That is taken to mean that overall global wealth is maximised and so there is more to go round. The key mistake in this is that it conflates claims over real tangible sources of wealth with the underlying real tangible sources of wealth themselves. Whenever that mistake is made, policy makers inevitably fall into the trap of simply facilitating an expansion in the paper claims over wealth whilst losing sight of the underlying reality required to back-up those claims with the real economy. The true responsibility for policy makers is to ensure that the monetary framework is constructed so as to align with the real economy such that what is best for money becomes what is best for the real economy. If left to its own devices, the financial system will wander away from that ideal. A financial system built by the financial system will direct resources towards expanding the financial overhead borne by the real economy.