Why the EU’s leaked document on spending cuts has got me in a rage

By Ann Pettifor

Together with the Prime Minister of Greece, Mr. George Papandreou, I am going to give evidence to the EU’s Special Committee on the Financial Crisis in Brussels this Thursday, March 18th.

So today’s leaked report from the EU, arguing that Labour’s plans for cuts to public spending are not “ambitious enough”, has got me really het up.

Labour, it appears, is just not ambitious enough about its goals for cutting investment and exacerbating unemployment. It does not have punitive enough targets for cutting benefits to the poor and services for the mentally ill and frail.

In the “imbecile idiom” (to quote Keynes) of today’s financial fashion, the EU, it seems, would prefer for unemployment to rise, for people to live in hovels, and for government “to shut out the sun and the stars” – so that we conform to an arbitrary number set in Frankfurt by a group of bankers, under a pact unwisely signed by an earlier British government.

The EU’s so-called Growth and Stability Pact has not led to stability in Greece, Portugal or Ireland and the East European economies. And it has not led to much growth in demand in Germany, an export-oriented economy that threatens to sink first Greece, then Spain, and then the European Project.

No, this pact is simply a banker’s pact; a revival of that barbaric relic, the Gold Standard – only modernised. Bankers frightened that public spending might ‘crowd out’ private investment. Pretty ironic at a time when private investment has collapsed by a massive 10% in the EU.

The economic ideas that underpin the Growth and Stability Pact are archaic, but pervade all of the economics profession, as well as the British establishment.

Keynes tried hard to rid the economics profession of these ideas but, sadly, failed. If we compare Keynes’ revolution in economics to Darwin’s breakthroughs on evolution (and they are comparable British geniuses) then what has happened to economics would be comparable to a return to pre-Darwinian ideas of evolution. Yes, the Growth and Stability Pact is as archaic as that.

Though it pains me to do so, let me explain the logic of this outdated economic theory. I summarise crudely:

“There are not enough savings in the bank. [Which is true, we have been spending and consuming, and not saving.] There can be no investment, no finance, no economic activity, no more employment, without savings. We must now retreat to a proverbial dark cave; suffer hunger and starvation; halt economic activity – until we have hoarded/accumulated enough savings. Only after an agonising process of economic bloodletting, when we have cut our ‘economic weight’ down to a minimal size, can we come out into the light, engage in economic activity, and once again revive the economy.”

The profound flaw at the heart of this theory for economic bloodletting is this: it assumes that we need savings to generate economic activity. We don’t, and we never have. Not, that is, since the Bank of England invented Quantitative Easing in 1694.

“We can afford what we can create”, to quote Keynes again. We are all capable of economic activity – especially the 2.5 million people unemployed. All we need is a little something to get economic activity started.

And, hey presto, it’s to hand. It is something quite magical. It’s called credit, and it takes the form of bank money. Bank money is something that you and I deal with every day – but it’s intangible. We never touch it or see it (except perhaps on our bank statement at the end of the month.) But it is wonderfully powerful, which is why it must be rigorously regulated in the interests of society and industry.

It exists, or can be issued into existence (think QE) out of thin air. For, contrary to most orthodoxy, credit creates economic activity. Credit, believe it or not, creates savings. Credit creates deposits. And not the other way around.

Get your head around that if you can. Most economists can’t.

Of course, credit creation has to be regulated. If it is used for speculation and gambling (as has happened since de-regulation in 1971) then it is inflationary (as it was in the 70s, 80s and 90s). Just think of the massive inflation of assets (to which the bankers turned a blind eye) that helped the rich get richer over the 90s and noughties.)

And if more credit is created than there is potential for economic activity, it becomes inflationary again. But when there is a vast crater of economic inactivity, then credit creation will not be inflationary. In fact, it will halt a deflationary spiral.

It can be used as it has been under QE to finance the British government deficit. The BoE out of thin air, issued £200bn of ‘gilts’ (govt bonds) and other asset purchases in 2009. Private banks bought them – and by doing so, helped finance the government’s £177 billion deficit.

If QE is combined with government investment on public works (not bailing out banks) – economic activity will be stimulated. It boils down to: credit to generate economic activity + income (from that activity) to pay the debt.

This explains why government spending pays for itself; because government budgets are not like household budgets. Tell that to the Tories. When households spend, suppliers drain their bank accounts. They don’t get anything back.

When the government spends (e.g. on subsidies for insulating homes) new employees pay income tax; they have money to spend so pay VAT in the shops; and shopkeepers then pay tax on their profits. So when government invests in productive activity, income returns to government in the form of tax revenues. Add to this, savings from cuts in welfare benefits, and hey presto, government spending pays for itself.

Something that the economists at the BBC, the Tory Party and the EU still have not got their heads around.