Category Archives: Economics & Finance

Reflections on economics, investment and the financial world

Is the Euro worth saving?

Anglo-Saxon economists were always sceptical. And so was much of the British establishment, though less so in the early days. But sponsors of the European dream were determined. And at first European Monetary Union defied the sceptics. But now the dreams are vanished and the only people defending the union seem to be those that have face to lose. Is it all over for the Euro?

It is Greece that seems to prove the scheme’s futility. The Greek government cannot repay its debts; its banking system depends on a bankrupt government for solvency and the European Central Bank (ECB) for liquidity. Greece cannot print its own money to inflate its way out of the hole. Instead European institutions and the IMF have to bail it out, and they are demanding conditions that add up to a loss of the Greek government’s sovereignty over its economic policy. Both sides blame the other, and the more the blame game goes on, the more trust and solidarity break down. The Euro is tearing the union apart, when it was supposed to bring Europe’s peoples together.

It doesn’t take hindsight to see what went wrong. Mostly the scheme’s weaknesses were pointed out at the start. Its supporters (who included me) just thought that this time it would be different.

Monetary policy is set at continental level, and yet there isn’t a great deal of economic integration. In order to adjust to local business cycles and local economic shocks, national governments have only a very limited set of tools. And the most important, fiscal policy, is constrained by the Stability & Growth Pact. This was instituted to try and prevent member governments becoming insolvent, a contingency that the zone had no process to deal with. This made it quite unlike a federal system, like the US, the only comparable monetary system that most knew. In the US there is a strong federal level of government, which draws substantial taxes from all parts of the union, and can make big fiscal transfers between the union’s members to compensate for the lack of monetary flexibility.

Funnily enough the problems with this set up did not play out in the way that most critics foresaw.  They thought that different business cycles or local shocks in different parts of the union would be the big problem. This happened – especially when the central economies of Germany and France endured recession, while peripheral economies, such as Spain and Ireland fizzed. But these were not the main cause of the crisis that emerged following the global financial meltdown in 2008.

The first problem was that investors assumed that member governments could not go bust, and that if they got into difficulties somebody would bail them out. As a result, it became much easier for the peripheral governments to borrow, and this allowed them to run their economies with a looser hand than they should. This was most egregious in the case of Greece, who produced misleading economic statistics, which put their government into a completely unsustainable position. And when it was clear Greece could not repay its debts, the system had no set of processes with which to manage the crisis.

Perhaps Portugal and Italy were guilty of something similar without the fraud, though Italy has not needed a bailout. But the other bailout cases (Spain, Ireland, and Cyprus, though I am less confident that Cyprus follows quite the same narrative) the main problem was not government finances, but a reckless private sector that fuelled property bubbles. What added fuel to these bubbles was cross-border flows from elsewhere in the Euro area, and especially German banks. The Euro system had greatly facilitated such flows. When the bubble burst, it brought down the countries’ respective banks, and this in turn draw their governments down with them. Governments couldn’t let the banks go bust, since they controlled local payments systems and economic chaos would have resulted. Like Greece these countries then needed external support and bail-out.

The important point to make about this series of crises was that they were to great extent “endogenous” as economists like to say – they have to do with the way the system itself operated – and not exogenous – the external shocks and uncontrollable factors which most economists thought was the system’s weakness. That suggests that bad systems design was a large part of the problem – and that, in theory, could be fixed. Most suggest that it implies a fully federalised system, with a federal government, supported by federal taxes and federal debt. An alternative route would have two main elements: a national insolvency regime (a bit like US states, but not Puerto Rico, which is on the path to creating a US version of the Greek crisis); and banking reform to produce a more federalised banking system firewalled from member governments.

But either route would leave member governments facing a grim reality. The Euro offers a straitjacket for government finances, and not a liberation. In the fully federalised case, the scope of government responsibilities would be curtailed and handed over to a federal government. In the alternative governments would be heavily restricted by their ability to borrow in financial markets (which would do away with the need for the Stability & Growth Pact). This latter is, in fact, what many supporters of the Euro (including me) envisaged all along (though in my case I completely failed to grasp the difficulties of managing the banking system). It was rather a Thatcherite project. But others thought EMU would be a step along the path towards a federalised Europe. It was the unresolved conflict between these two visions of the Euro that got the system into its current mess.

And this conflict is still unresolved. But the federal vision is losing ground; there simply isn’t the political support for it. That doesn’t stop people in the European Commission from quietly pushing for it though. But those who aren’t convinced by the federal idea, aren’t convinced by the multi-state currency area alternative either. Why opt for a straitjacket? Wouldn’t it be more democratic and easier to say goodbye to monetary union altogether and let each country go its own way with its own currency?

And I don’t have the answer to that. One thing I will say is that the quality of economic commentary in the media is pretty dire. From this you would think that the advantages of having a floating currency make doing anything else foolish. But all Economics students are asked to do an essay on the pros and cons of floating currencies, and frankly it is not that obvious that either route is a winner. As a rule, the smaller and more open the economy, the more there is to be said for a fixed currency regime – which is why the Euro is popular with so many smaller EU members. Floating currencies reduce the effectiveness of fiscal policy, especially in such small and open economies. The rather loose fiscal policy of the Britain’s government in the 2000s caused the exchange rate to be too high, leading to a trade deficit and a hollowing out of British industry the country still have not recovered from. By contrast Germany has been able to maintain its industrial base within the Euro, albeit with some painful restructuring.

And a floating rate does not prevent banking bubbles. Iceland had one in parallel with Ireland, with its own currency. Recovering from the bust best no less painful for Iceland than for Ireland, though arguably not really any worse either.

But setting up a more secure banking system across the Euro area is no small thing, and its feasibility is an unknown. Against this, taking the Euro apart would be a huge undertaking, so there is there is much to say for trying to make it work on a rather less ambitious scope. Inertia is on the side of the Euro. But the starry-eyed enthusiam is gone

 

 

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The political isolation of Britain’s working class: liberals should reach out

Conservative Chancellor George Osborne’s Budget last week, his first without the need to negotiate with the Liberal Democrats, was widely hailed as a feat of political brilliance. It has put the opposition Labour Party into disarray. At its centre was a direct attack on Britain’s working poor. Nothing could demonstrate that group’s political weakness better.

Part of the political acuity was the spread of confusion over where the budget pain was to be felt. Mr Osborne, and the Prime Minister, David Cameron, had earlier set out their intention of wooing working class voters to their party. Huge cuts to tax credits, the Budget’s centrepiece, were camouflaged by rises to the minimum wage, to be renamed “living wage”, by more than even Labour had been proposing before the election.

Britain’s tax credit system was implemented by Labour Chancellor Gordon Brown. It is designed to top up the wages of those not earning enough to meet basic needs, in particular the costs of bringing up children.  Various arguments were used to justify this. It was said that companies were paying workers less because they were anticipating the effect of tax credits. The system was created by Labour so as to create a bank of dependent voters. Aspersions were cast on claimants as being shirkers, or feckless, especially poorer people who dare to have larger families (one proposal is to stop support for children after the second). It would be better to pay people more, and to tax them less, than to hand out state aid.

None of this really bears up to scrutiny. The minimum wage and higher tax thresholds are pinpricks on the wider problem for low pay. There was no sign that the public sector, for example, was going to be any more generous in its treatment of lower paid workers, many of which it pays for, directly or indirectly (through outsourcing contracts). Academic research does not support the idea that tax credits lead to lower pay – or at least, not by much. Claimants for tax credits are already working; they are very clearly not part of the army of shirkers, who, so far as they actually exist, claim direct state benefits. With an ageing population it is far from clear that the country needs fewer children with working parents – and poverty can adversely affect the progress of those children, reducing their chances of playing a full and active part in the economy.

This was nicely illustrated the Economist’s Bagehot column this week. He (Jeremy Cliffe) visited a local estate in south London (not all that far from where I live, as it happens), and talked to some of Mr Osborne’s proposed victims. He found a number of working women, with a diverse range of heritages, facing up to a difficult predicament with dignity. At the school where I am governor, such families demand increasing levels of support if their children are to keep pace with those from more fortunate families. We are lucky that the proportion of such families is manageable: but their needs will grow; our funding will not.

What our society is confronting is one of the most important issues it faces. It is the disappearance of mid-level blue and white collar jobs, and their replacement by less secure and less well-paid ones. These new jobs are overwhelmingly in service industries – carers, cleaners, call centre operatives, security guards, and so on.  This change is overwhelmingly due to new technology – but it has been helped along the way by globalisation. These new jobs often do not pay enough to allow their workers to fully participate in society – especially if they have children.

But it is not at all clear what the solution is. Two traditional answers do not look promising. The first is to improve productivity. And yet in these jobs it hard to see how this can be done without increasing general alienation. In any economy some jobs lend themselves to advances in productivity (think factories) and other don’t (think hairdressers). As the former become more productive, the proportion of workers in the second group increases. This is a phenomenon known as “Baumol’s disease” by economists – and it is a large part of what is going on here. The economy is stratifying between a small number of highly productive jobs, and a large number of relatively unproductive ones.  The former can lift up general levels of pay for everybody – but only so far. Improving productivity may simply help an elite of better off workers, without doing much for everybody else.

The second traditional answer is to increase job protection to improve the bargaining power of those in poorly paid jobs. This is the route favoured in such countries as France. It tends to lead to either or both of two things: higher unemployment or a growing army of temporary workers with fewer rights.

We are left with three routes that look inadequate, but must still be pursued. The first is redistribution through tax, benefits and freely available public services. Our tax credit system is a key element of this. The fact that its cost has escalated well beyond the scale originally envisaged simply shows that the problem it is trying to fix has grown. The answer is as surely to be higher taxes and not reduced benefits. The second route is universal education, and initiatives to ensure that children from poorer backgrounds get more support. This gives more people access to better paid jobs, and makes the job market less easy to stratify. Progress has been made on this, but it remains under pressure from lack of finance. The reduction of tax credits associated with children will be a step in the wrong direction.

And third is the strengthening of local communities and local economies. This may not make the economy much more productive in the traditional economic sense of creating more goods and services to consume, but it serves to humanise society and to tackle the exclusion that is the biggest cost of poverty. Tax credits have no role to play in this. They are a giant, soulless centralised system controlled by rules made by bureaucrats and politicians far, far away. They only help by improving incentives to work, and participate in communities that way, rather than dependency on straight benefits – which is corrosive of communities. But nothing the current government is doing, or the political elite is thinking about, is advancing this third, important approach. It does not follow from grand initiatives that make big political careers.

And the sad thing is to see how politically marginalised the modern working class has become. Our old picture is of white men, working in factories and belonging to unions. But this strata of working class is disappearing. Instead we have a growing army of male and female workers from diverse ethnic and cultural backgrounds. They are not unionised, and split into multiple communities. They often do not vote. The Labour Party, the traditional sponsors of the working classes, is now more interested in chasing their more engaged and better off cousins in what is left of the traditional working classes and in the middle classes (“Middle England” as I have called it). Middle England is not very sympathetic to the plight of the new working class. This has weakened the party’s opposition to Mr Osborne’s budget – though thankfully three of the four prospective leaders see that their stop-gap leader Harriet Harman has gone too far in suggesting that Labour will not oppose the cuts to tax credits.

Liberals, I believe, must stand firm behind tax credits, accepting tax rises to support them if need be. We should also support education policies to ensure the full participation of children from poorer families. But the real hope lies in reinvigorating local communities. We should remember that this is not just a middle class thing. The Liberal Democrats in particular have been forced back into a middle class ghetto, and I suspect that many find this a comfortable, if small, place to be. But the real need for liberal solutions is amongst the country’s new working class, and that is an important area for outreach, based on community politics.

 

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Should I apologise for supporting the Euro?

The this week’s FT Janan Ganesh suggests that those who supported Britain’s entry to the Euro back in the late 1990s and early 2000s should own up to to their error and apologise for it. He feels that the arrogance of that generation of Europhiles is undermining the pro EU case as we face a referendum on membership. Well he won’t have me in mind. I am not a prominent politician; I wasn’t even blogging in those days. But I did have an opinion – and that was that that the country should be part of the Euro – though not at the exchange rate then on offer (about 65p per Euro). Should I hang my head in shame?

In fact this also seems to be a rather desperate line of attack by the Eurosceptics, who are at last realising to their horror that they are being out-manoeuvred. They want to discredit the whole pro-Europe cause. In today’s FT , one its other writers, Martin Sandbu, comes out with a robust defence of British entry to the Euro. He suggests that if the UK had been part of the Euro economic disaster would have been averted, because the European approach to fiscal and monetary policy would have been more pragmatically British. I have also heard a that idea suggested by a commentator from within the Euro zone, though I can’t remember who.

I’m not entirely convinced. But it at least raises the big question. It is treated as entirely self evident that the Euro is a disaster, and that British membership would have made things worse for the country. But both these are counterfactuals. We don’t know what would have happened if the Euro had never got off the ground, or if Britain had been a member.

Let’s consider the first of these. When the Euro was being formed the economies of Italy, Greece and Portugal were in real trouble. Their governments were losing the confidence of the markets; stagflation followed by hyperinflation beckoned. The Euro lifted these economies – before joining the governments were forced to bring fiscal policy under control; after joining interest rates fell dramatically. But these countries failed to deal with deeper seated problems, and eventually the chickens had to come home to roost. Membership of the Euro delayed the denouement rather than caused it. Indeed it gave these countries an opportunity to head off disaster which they failed to take. Contrast this, for example, to Belgium, also considered a bit of a basket case before the Euro, whose economy now prospers, relatively speaking at least. And for each of the other members of the  Euro that ran into trouble something similar can be said. Ireland suffered the consequences of a reckless expansion of its financial system not unlike that of Iceland, outside the zone. Iceland’s crash was at least as painful as Ireland’s. Their problems reflect underlying economic weaknesses that governments failed to tackle. The signs were there. Indeed no members inside the zone seem to want to return to life outside it, with the possible exception of Germany (and Finland perhaps).

The ambiguity of Germans is understandable. The interesting thing about that country though is that they were the only, or at least the first, country in the zone to understand the implications of membership for economic management. In the early days they realised they were uncompetitive, and embarked on a programme of “real” devaluation. This was a combination of holding pay rates down and economic reforms to improve productivity. The reluctance of other countries to embrace this style of economic management is the main failure of the Euro project.

And what of the second counterfactual? What if the UK had joined? Well the first thing to be said is that the country did not do so well out of the zone. The financial crash of 2008 was deeper, and the recovery slower, than the major Eurozone economies. Britain suffered a persistent current account deficit, supported by an unsustainable exchange rate. We were in a not dissimilar space to countries like Spain and Ireland, going through a financial boom offering the illusion of wealth while not enough was being done to fix the fundamentals. It is not so self-evident that things would have been worse inside the zone.

Or perhaps not. I would like to think inside the Euro the UK would have been locked into an exchange rate that suited exporting industries (like Germany after its reform/adjustment programme) and not so subject to financial shenanigans. That would have left the economy in a stronger position after the bust. But such an exchange rate wasSterling Euro X ratesnot on offer. The chart above shows the average exchange rate between the Euro and Sterling for each year of the currency (source: stastica.com). My view is (and was at the time) that the rate of 65p was high (or too low in terms of the graph). It was distorted by excessive government spending and a booming financial sector – there was a substantial current account deficit to show that it was unsustainable. It did not drop to a more realistic level until 2007-2008. That was too late. There was no chance that the government would have followed Germany’s example in conducting reforms to improve the real exchange rate – not while everything was rosy on the surface.

So If Britain had joined the Euro at its start or early in its existence, then the exchange rate would have been too high. Which would have made the adjustment period after the crash even more difficult. I’m not going to apologise for this because I understood that at the time (or that’s how I remember it!).

But there is a bigger issue that I will have to own up to. The design and operation of the Euro zone was flawed. There are two sustainable ways of running such a common currency area. One is part of an explicitly federal system of government, which allows substantial fiscal transfers between its members and a robust system of federal political control to match.  In this system members bail each other out if they get into trouble.To judge from most commentary, you would think that this is the only way to run the zone – and that because the European polity is not ready for such a federal system, then it will never work. But there is an alternative, where each member is not so tied to the others. Each country is left to run its affairs as it sees fit, and if it can’t pay its debts, it goes bust. It requires a sovereign insolvency regime. Nobody bails failing states out.

This latter arrangement is what the Germans wanted, and it is what most Britons that supported membership wanted too. But Euro-federalists in Brussels and the southern states saw the currency as a step towards federalism. The Germans didn’t help matters by insisting on  system of fiscal rules for members – the “Stability & Growth Pact” – which is only necessary if you are heading for a federal arrangement. The idea that the system was in fact of the federal type was implied by the fact that government bond rates for the different members were almost identical for much of the Euro’s life before the crisis. This was a bad sign – and yet most European leaders though it was a good one. When crisis approached European leaders were complacent. And when things went wrong, there was muddle and confusion. This problem is still not resolved.

And here I have to own up. While I saw some of the signs, I did not appreciate the full implications of this ambiguity. I thought it was a problem that could be solved by evolution from within.

I still believe that. But the politics of EU membership in Britain are toxic enough as it is. It is better that the country is not part of the tortuous politics of the Eurozone. That is why I accept the consensus that Britain probably never will be be part of  the Euro zone. Or not until firstly the zone finds a new and sustainable equilibrium, and secondly that Britain sinks into an economic mire that destroys its self-confidence as an independent nation. Both are possibilities.

Meanwhile I am not a fan of an independent Sterling. It has a way of distracting the political elite from dealing with deep-seated economic issues, like our current account deficit, our inefficient underlying economy and our over-dependence on volatile financial flows. But, it has to be admitted, that, with the exception of Germany, the Eurozone members were equally blind to the self-same issues. I apologise for not appreciating that enough.

 

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Election issues: the economy

The quality of debate in Britain’s General Election campaign is predictably awful. Arguments are reduced to simple sound bites. And parties try to muddy the waters on their opponents’ key issues rather than engage with them properly. Many issues are hardly discussed at all. In a doubtless futile mission to raise the level of debate I will look at a number of issues from rather more objective perspective, and handle the arguments on an altogether deeper level. I am not, of course, an objective observer: I will generally make the case for voting for the Liberal Democrats.

Let’s start with the issue the Conservatives most want to talk about: the economy, and which party is best placed to manage it. Their argument runs something like this: Labour cannot be trusted with the economy because they presided over the economic crash in 2008 and haven’t admitted their culpability. The Conservatives have a “long-term plan” that is yielding results without getting the country into too much debt.

Labour are more reticent. They don’t accept that their party was responsible for the crash (or no more responsible than anybody else). They are severely critical of the coalition’s economic record, which, they say, swung to much to “austerity” (i.e. too many spending cuts, benefits savings and a rise in VAT), which choked off and delayed the recovery. They point out that Tory plans for the next few years imply vicious cuts to welfare. They also point to stagnant living standards for most people. Their plans for the next parliament involve significantly more public borrowing, supposedly supported by higher levels of investment.

Arguments over the records of both sides over the last two parliaments are interesting enough. I mostly support the narrative of the coalition partners – but Labour can call on the support of many independent economists with real heft. But past record only counts to the extent it tells us about the future – and in this case it doesn’t tell us much at all. Both sides are placing more faith in the robustness of the British, European and world economies than is prudent.

Many economists and politicians assume that there is a natural rate of growth of about 2% per annum, based on improvements to productivity, that the economy can be guided towards by governments with sensible macroeconomic policies. This seemed to be true before 2008, but it is surely questionable now. Demographic changes, with the proportion of working age people falling, are only the most obvious reason for scepticism; there are plenty of others, about which I have written often. That leaves us with two critical problems. How would the parties cope with the likely possibility of continued economic stagnation? How might they reduce the risks of such stagnation by making the best of any opportunities the country does have for growth?

In the first case prolonged stagnation points to renewed austerity. In order to keep the national debt under control expenditure will have to be cut, or tax increased, or both. The deficit between taxes and spending is still high, and deficits are much harder to sustain if growth is low, even if, as now, interest rates are also low. Japan has managed to get away with prolonged deficits in spite of stagnation, it is true, but that is because they have trade surpluses and accordingly are less dependent on foreign borrowing. What will happen if Britain fails to get to grips with government finances? That is hard to say. In the modern, globalised economy, inflation looks much less of a risk, unlike the last time this situation arose, in the 1970s. Instead stagnation may become more entrenched, and unemployment rise, until there is a financial crisis and our banks start failing again.

If there is renewed austerity the question arises as to how much of the strain is to be taken by tax rises and how much by public spending cuts. As a nation, we have higher expectations of our public services and benefits than most: the NHS, schools, social care and pensions in particular. I cannot see how such expectations can be met without raising taxes. And here there is a big snag.

Both Labour and the Conservatives have ruled out any increase to Income Tax, National Insurance or VAT. These are the main taxes that the general public pays, and account for some two thirds of all taxes. Tax rises without touching these three mean, generally, that somebody else is paying. The trouble is that the “somebody else” idea is wearing thin indeed. Tax breaks for the rich have been steadily pared back (most recently on pension contributions), making our tax laws more complex and draconian in the process. Company taxes are considered off the agenda because that threatens investment (this may not be right – but treating company taxes as a football is clearly bad for investment). The wealthy are already paying for a large part of the services which they never use. Apart from practicality, we are threatening the idea that everybody should pay something towards public services, in order to maintain solidarity and consent. No party is facing up to this issue.

Labour is particularly vulnerable. Their spending plans are more generous than the Conservatives’, as they hope to borrow more against infrastructure investment. Their plan to cut university tuition fees is particularly foolish. The SNP and the Greens are even worse. The Tories are more realistic, if you take their formal plans, laid out in this year’s Budget, with a pinch of salt. These envisage an unrealistically vicious attack on benefits in the first two or three years, followed by a relaxation. This is likely to be smoothed out in practice. But the party gives the impression that they would squeeze public services and working-age benefits rather than raise taxes. This probably is not what most people want.

So, if the parties would rather not contemplate stagnation, how would they create the growth in productivity that would head this fate off? How might this be done? The traditional formula is so-called “supply-side” reforms – deregulation for the most part. The trouble is that these tend to benefit the lucky few, both in terms of skills and income, and geographical location, largely London and the south east of England, where property prices are already through the roof. So the most promising idea is to promote growth in the regions of England, and also Wales (Scotland is the one region of the UK has seems to have bucked the gravitational pull of the South East). There is no sign that any party wants to relax planning controls that might allow this swing to the prosperous areas to occur more smoothly. There is a growing realisation that more balanced growth can only be done through the devolution of political power, and the release of funds for infrastructure investment between and within the regional centres. The Coalition has been feeling the way forward with its City Deals, with Greater Manchester being the flagship.

Once again, the main parties are disappointing. The Conservatives seems to place too much faith in deregulation – and their hostility to the EU and immigration represent roadblocks to future growth. Labour shows an alarming impracticality when it comes regulating and taxing businesses – and tackling such issues as low pay and insecure temporary contracts. While both parties are starting to talk the game on regional devolution, there is reason to doubt their commitment. Labour’s attack on the decentralisation of the NHS to Greater Manchester was particularly revealing. On both sides there is a lack of fresh thinking. The Greens, SNP and Ukip, in their different ways, are worse.

What of the Lib Dems? They are silent on raising tax rates – which undermines their commitment to funding the NHS, for example. They are closer to the fresh thinking needed for regional growth – with a real understanding of what devolution means. They also have interesting ideas on developing a more diverse banking system and promoting alternative business ownership structures. But these ideas aren’t fully formed. They are the best of a bunch that ranges from weak to hopeless.

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Britain’s politicians scrabble over a weak economy.

Yesterday was one of the great annual set-pieces of British politics: the Budget. The Chancellor of the Exchequer, George Osborne, set out his plans for government finances: taxes and spending. This year, behind the theatricality, it was a bit of a non-event. There were few changes to previously announced plans. Mr Osborne rowed back somewhat in his longer term plans to cut government spending. There were some cheap gimmicks. Political inactivity is not necessarily a bad thing. But what is most remarkable is that neither he, nor the Labour opposition, were prepared to talk about the British economy as it really is. Is it any wonder that politicians fail to be trusted?

Mr Osborne’s speech contained a quite astounding piece of hubris. He claimed that Britain was on the path to becoming the most prosperous country in the world – overtaking Germany in the process.  But there is a big flaw in this notion. Britain’s output as a nation is lagging the impressive growth in the workforce. Britons are working harder but have little to show for it.  Mr Osborne sneered about the French economy – and yet French workers are over 20% more productive. Further, Britain is running a substantial current account deficit – which means that, like its despised Labour predecessor, the economy continues to be built on debt supplied by foreigners (or, perhaps, running down the nation’s overseas assets).

Dwelling on this weakness would have made the political message too complicated. His mission was to point out that Labour’s dire forecasts for the economy had not come to pass. So we heard little of any ideas about how lift the economy from its evident mire. Some talk of making life easier for manufacturing. There was the core idea of economic liberalism (that the left calls “neoliberalism”) that a smaller government will allow the total economy to be more productive. Little was heard of the government’s most promising idea – greater devolution of power to regional centres.

Weak fare. But while Labour love to point out the economy’s weaknesses – especially the low wages of many workers – they haven’t any better ideas of their own. Indeed their thoughts on a more intrusive state clamping down on “predator” capitalism seems destined to make the economy smaller, if a little less unequal. Many of their supporters, including journalists at the Guardian, seem to rely on half-digested Keynesianism. Increased state spending (or less austerity as they prefer to put it) will raise demand in the economy which will then lead to growth. As a formula in 2010 or 2011 this might have had some merit. In the near full-employment world of 2015 it does not. Such policies are more likely to lead to an even worse current account deficit, and an economy even more dependent on debt, public or private. It does not address the productivity problem. To be fair, the Labour leadership seems to understand this – but they are still bereft of ideas to tackle it.

So the Tories say the economy is gathering strength fast, and Labour that it is still on its knees. There is a paradox though. The Conservative fiscal policies are appropriate to the idea of continued economic weakness, and Labour’s on confidence in the economy’s continued strength.

How so? If you think the economy is weak, you need to make sure that government expenditure is kept in check. There is nothing certain about future projections of economic growth – and with a weak economy there will be risks on the downside. With the European and world economies looking weak also, this is easy to appreciate. Fiscal restraint may not appear to be necessary based on forecasts, but it gives the government more options in an uncertain world. In contrast, if you think the economy will bounce back strongly, and that the productivity problem sort itself out, then Labour’s much more relaxed approach to government finances make much better sense.

The problem is, of course, that nobody understands why the British economy remains as weak as it does. Is it because deep structural problems, based on poor skills, changing industrial needs and changing consumer preferences (e.g. towards more work-life balance)? Could it be the progressive hollowing out of local economies outside the main economic centres? Is it because North Sea oil is running out, and the apparently highly productive finance sector just a chimera? Or is it just a temporary blip? Will businessmen respond to the right signals to launch an investment drive that builds economic strength? Perhaps labour shortages will force businesses to use their existing workers more efficiently and pay them better.

Regular readers of my blog will know I tend to the more pessimistic of these explanations – though this is based more on instinct than data. I believe it is perfectly possible to advance human wellbeing in spite of an economy that is weak in terms of income growth. But that does mean that we must break our addiction to debt, public and private. For that reason I like the right’s focus on government parsimony, and the left’s focus on inequality. Alas neither of our main political parties seem to grasp the real nature of our economic plight.

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British economy: neither Tories nor Labour have the answers

The political parties are playing a blame game on the British economy.  Yesterday another report by the Institute for Fiscal Studies (IFS) was the unedifying battleground. This debate is interesting but unresolvable. And what matters is what the parties might do now if they were in charge. And on that neither Labour nor the Conservatives are convincing.

The controversy starts with the financial crash which began in 2007, and let to wider economic collapse in 2008 and 2009. The crash was a huge surprise to most politicians, and their electors. Before this steady growth of about 2% a year seemed to be a force of nature. There were squabbles about how best the proceeds of growth should be used. The downturn was very sharp, statistically the worst recession since 1945; comparisons with the 1930s are made. But in human terms things were not so bad as , for example, the early 1980s; we are a wealthier country with more fat to draw on – and unemployment did not rise as fast as earlier downturns.

But two things stand out. Firstly, thanks to steady inflation and frozen levels of pay, real incomes have been squeezed since the crash. Previously those in work tended to do better, but there would be more unemployed. Secondly the recovery was very slow – and not the rapid bounce back typical of previous recessions. There is a very powerful graphic in the IFS report which shows how average household incomes changed, adjusted for cost of living, which illustrates both points:

IFS household income

This shows that household incomes were level at first and then dropped steadily for the 22-30 age group until a year ago and then rose. For the 31-59s the squeeze levelled off at the end of 2011 with a gradual rise since. The over 60s have not done so badly, depending on how you measure their cost of living. Individually many people may be better off (things have get better as we advance through the age brackets), but overall the country has not recovered its economic standard of living.

The Labour narrative runs something like this. The economy was hit by a global financial crisis while they were in power, but a rapid fiscal response limited the damage. Measures included a temporary cut to VAT, as well as maintaining benefit levels, and, of course, a big bailout of troubled banks. In 2010 the Coalition took power and cut back these fiscal measures prematurely and increased taxes, causing standards of living to plunge, with only an anaemic recover since. Labour spokesmen claim, and their more partisan supporters fervently believe, that the government’s austerity has been a disastrous policy mistake, especially for the worse off. There is also a claim that the rich have escaped the pain and inequality risen.

The coalition counter-narrative is that the crisis in the first place was Labour’s fault, through profligate public expenditure and lax regulation of the banks. And the fiscal measures after the crash came at a staggering public cost, with a deficit of over 10% in 2010. This was unsustainable, and the current government’s austerity policies have saved the country from huge levels of debt and a huge future tax burden. If the recovery was anaemic, that was because of deeper weaknesses in the British, European and world economies. Now these weaknesses have been largely overcome, we are doing very nicely thank you. And a previous IFS study has shown that inequality has actually fallen, with the richest 10% paying a greatly increased fiscal burden – though admittedly things have been tough for the young and poor.

What to make of these competing narratives? I think the coalition argument is closer to the truth, even if they play up Labour’s mismanagement a bit more than is fair – not so much because there wasn’t severe mismanagement, but because that insight comes mainly from hindsight. But I’m biased and many learned people think that Labour’s narrative is in fact fairer. There is no decisive way of resolving the conflict, which requires the building of counterfactuals with economic models that are deeply flawed. But that’s the past and the important question is what is the best thing to do now.

And the answer to that question must start with this fact: the British economy is displaying a striking level of weakness. Three signs of this are worth drawing attention to. First is the lack of economic productivity growth. The IFS makes much of this. Employment levels are quite healthy, but this has not led to the levels of production that it should – which means there is no money to pay people more.  Economists have been stressing about this for some years now, but they have not provided a clear analysis of what this is all about. Personally I think a lot of it comes about from the diminution of the finance and oil sectors. The former’s high level of productivity was in fact a mirage; the latter is trying to make the best of ageing oilfields. I also think there is a wider issue in all developed economies, as we transition to a world where improved wellbeing does not depend on higher levels of consumption – which used to be the motor of economic growth.

The second sign of weakness is more concrete. Our trade balance, which was strongly negative before the crisis, is not getting much better, in spite of a weaker pound sterling. This is strikingly different from the previous recovery from a recession, in 1992 – when a trade deficit was converted to a surplus quite quickly, and was the first part of a period of continuous growth that lasted until 2008. Martin Wolf, the FT  economics commentator, has said that in the Euro zone an adverse trade balance was a surer sign of trouble than a fiscal deficit. He seems more relaxed in a UK context, but I think it is highly significant. The country is living beyond is means, and has not solved the problems that led to the 2008 crash.

The third sign is closely related – the other side of the same coin. The vaunted recovery is mainly led by increased consumer demand rather than increased investment. The public (as well as the government) is trying to borrow its way out of the crisis. A strong level of investment would lead us to be more relaxed about a trade deficit – but this is not the case. Investment is recovering, but not by enough. And levels of debt remain stubbornly high.

A lot of the problem is actually beyond the control of any government. It is down to the freely made choices of individuals and businesses, and changes in technology, not just here, but in the countries we trade with.  But we do need our politicians to be on the case.

The Conservatives are unwilling to acknowledge the current level of economic weakness. They keep talking about their long-term plan for the economy, but this mainly boils down to further austerity, mainly cuts to expenditure, to bring government finances onto a more stable footing. They hope that private sector investment will pick up, and focus on things that will improve efficiency and wellbeing, rather than the merry-go-round of property prices. But further austerity will cause public investment in infrastructure to suffer, as well as education. Further, the party wants to “renegotiate” the country’s relationship with the European Union and put membership to a national referendum. The country’s international standing has already been a victim of this policy. Since so much of the country’s fate depends on the wider world, this is sheer folly.

Labour gloat about the current weakness of the economy, but have few answers. I have not heard a Labour spokesman willing to talk about increasing the economy’s productivity. They have ideas to tackle some of the symptoms, like raising the minimum wage to deal with low pay, but have no answers for the disease. And the party lacks a unity of purpose. Its left wants an end to austerity and attack on private business bosses; others talk of devolving power from the centre but have little understanding of what this really means. They do not look like a coherent government in waiting.

Meanwhile there are plenty of things we should be talking about. Encouraging weaker local economies to develop without permanent subsidy from the centre; choosing the right public infrastructure investments; developing a more complete and rounded education of our children and young people; working internationally through the EU and other institutions to tackle multinationals and tax evaders. But these do not reduce to bite-size policies and 140-character debates. So we will keep banging away at the unwinnable blame game.

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Greece: can you have reform without austerity?

The standoff between the Greek government and most other EU governments continues. The other governments are happy to extend loan facilities, but only if Greece stands by the conditions it had previously agreed. For the Greeks that is anathema, because it means holding to austerity. Many observers here in Britain seem to sympathise with the Greek side. And they offer a middle way: reform without austerity.

Three columns in the FT make the case. I have provided links, but beware – the FT operates a paywall with a very limited number of free goes. First was the weighty (intellectually) Martin Wolf. He condemns the EU programme for focusing too much on austerity and not enough on reform. Austerity sucks demand out of the economy, causing mass hardship; reform would make Greece’s economy more efficient. Next came the intellectually much lighter Tony Blair: Two false paths for Europe – and a new third way. This puts the idea into more overt political terms, though conjuring up memories of his own British “third way” that was politically successful for a while, but whose reputation is now somewhat tarnished. As an aside this is interesting because it shows that Mr Blair accepts uncritically the basic left wing economic narrative – looser fiscal and monetary policy will lead to growth. On Monday was regular FT columnist Wolfgang Munchau: Athens must stand firm on failed policies. This is positively vitriolic about the EU conventional wisdom on austerity, which he regards as economically illiterate and a complete failure. This article contributes to the picture by exploring Greece’s options in the event of breakdown, including the intriguing one of the country printing its own money.

So what to think? Austerity refers to the reduction of public spending and the increase of taxation. It is considered economically counterproductive because it sucks demand out of the economy, which in turn knocks tax receipts – which makes things worse by creating a downward spiral. In Greece’s case the object of vitriol is the target that the government should run a primary budget surplus of 3% , to pay for debt interest, which comes to about 3%, after the recent restructurings (and a remarkably low figure for debt of 175% of GDP). Surely even prudent governments should be allowed a deficit in a recession? So what about reform? It is here that each of these commentators is awkwardly silent. Just what on earth do they mean?

Economic reforms to promote efficiency usually mean changes to product and labour market regulation to make them more open to free market forces. These are undoubtedly required in Greece.  But they promote short-term insecurity to jobs and businesses. They are not politically popular, and I doubt very much that there that the Greek public distinguishes between these reforms and austerity. They all part of the same hateful phenomenon.

And the problem goes deeper. Regulation tends to create public service jobs., which deregulation threatens. Besides it is the scale of the public sector, both in terms of jobs and transfer payments, that is a large part of the problem. In several ways this undermines a dynamic private sector. They tie up resources; they undermine labour markets, and so on. For too many people the way to wealth involves politicking rather than delivering things that people actually need and want. And so reform often means cuts – which is back to austerity.

In fact to find ways of stimulating demand without blocking reform is quite hard. There is the economists’ old favourite: investment. But efficient public investment requires an efficient state to direct it. Otherwise the money simply lines the pockets of well-connected people. Surely Greece is vulnerable to this? More bank lending? Another can of worms. Frankly I will not be convinced that reform without austerity is a possibility until somebody can spell out a programme which delivers it. The Greek government is proposing a reversal of both austerity and reform. Once again British (and American) economists are guilty of using macroeconomic analysis to skate over practical problems that turn out to be the very heart of the issue.

There may be some hope a middle way though. Perhaps some fudge around economic cycles can be used to cut the target for primary surplus. And there must be some opportunity to reshape the austerity/reform programme to put more weight on collecting tax from wealthiest – which the new Greek government seems much better placed to do that the last.  Alas I am too far away from it all to have any feel for how likely such a deal might be. All I will say is that British commentators are generous with the taxpayers’ money of other nations, but their credibility would rise if they suggested that British taxpayers should join in. All the talk of respecting Greek democracy would then be put into a clearer perspective.

Meanwhile it seems quite likely that there will be some kind of Greek default. Following Mr Munchau it looks quite likely that the Greek government would issue some form of electronic currency of its own, in the from of IOUs, to keep things going. This may well be against the letter of the rules for the Euro area, but it could buy enough time for a compromise to be reached. And perhaps the development of a safety mechanism for the Euro currency area. The Eurozone needs to find some sort of middle way between the inflexibility of a gold standard, and the creation of a federal state without democratic consent. Might what amounts to local currencies be part of this?

Meanwhile, as the saying goes, if something looks too good to be true, it probably is. That is surely the case for reform without austerity. Sorry Mr Blair.

 

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Economics in the age of information. Why are so many conventional economists wrong?

It feels an unequal battle. On the one side are ranged distinguished Nobel laureates, such Paul Krugman and Joseph Stiglitz, formidable intellects such as the FT’s Martin Wolf, together with any number of media economics correspondents, bristling with PhDs. On the other there’s me with a trifling 2:1 BSc (Econ) awarded in 2008 by UCL. But I’m hanging on in there. Clever as these people are, I think that they are working in the wrong paradigm. The world has changed but their basic views as to how the economy works hasn’t.

In my defence I can usually quote some formidable intellects, though, pronouncing very similar views to mine, such as Adair Turner or The Economists’ Buttonwood column. In this post I sketch a narrative that explains how this divergence of views came about, and why so much intellectual firepower might be ranged on the losing side of the argument.

My narrative pictures the developed world economy moving through a series of ages,  each of which required its own style of economic management and analysis. This is a giant oversimplification, of course. But then the science of economics is a giant oversimplification, and not physics applied to the human sphere.

I start my narrative in what I will call “the age of heavy industry”. This is not the beginning of the story, of course, just a good place to start. This is the century leading up to 1945. In this period economic development is led heavy industry and the construction of public facilities. These include infrastructure such as railways, ships, roads, and houses; intermediate facilities such as coal mines and steel works; and, we should not forget, armaments.  Other things were important, of course: agricultural development released workers from the countryside; the textile industry provided an important consumer goods sector. But world leaders saw their nations’ status in terms of the big, dirty, heavy things. Railways and steel works; dreadnoughts and artillery pieces. “Guns will make us powerful; butter will make us fat,” Hermann Goering said, capturing the spirit of the age. Such concepts as GDP were hardly developed; by modern standards rates of economic growth were unexciting. The view that inflation rates should be small and positive was alien, as the world swung between bouts of positive and negative changes to prices. Classical economics dominated conventional wisdom. “Working class” was synonymous with “poverty”, something which cut through political discourse, and many simply assumed was an inevitability.

After 1945, and starting in America,  this morphed into the age of light industry. Suddenly the domestic consumer became the leading driver of the economy. Technologies developed in wartime – such as plastics, motor vehicles, antibiotics – transformed the lives of ordinary people, and their production and distribution created stable blue and white collar jobs in a virtuous circle of job creation and consumption. Growth was led by increased consumption of ordinary things like cars and fridges; alongside this grew a service economy to support the growing wealth of ordinary people. The Soviet Union, stuck in the mentality of the age of heavy industry, was caught out completely, and in the end collapsed from a complete loss of faith in itself. All those steelworks, nuclear missiles and coal mines did not lead to economic power. Economically the management of GDP started to dominate everything, and an orthodoxy of demand management, whether through fiscal or monetary policy, became taken for granted. Arguments between different schools of economics were vitriolic, and yet they agreed on much. That inflation should be low but positive, for example, or that productivity growth would generate a steady, long term increase of national income, or again that distribution of income and the workings of finance were of secondary importance in economic management. And this is the world still inhabited by the those Nobel laureates, modified only slightly by recent events.  The problem with the modern economy, they say, is a lack of demand. It needs to be stoked up with fiscal or monetary policy; once this has been achieved rising productivity will get us back onto the road of steadily increasing income and the repayment of debt.

But the world has changed. Since the 1990s the age of light industry has been supplanted by the age of information. To understand this, think about a few ideas. First is the idea of satiation. People only need a certain number of things, after which increased consumption becomes pointless. There are still plenty of poor people, of course, but they are in a minority. and it is increasingly hard to understand poverty in terms of a lack of volume of goods in circulation. Many observers define poverty in relative terms, not in terms of physical benchmarks like nutrition and shelter. Thus you might be poor because you lack a flat-screen TV. Not because you need it, but because you feel excluded without it. It is clear that this kind of poverty is not going to be solved by cranking up the volume of goods produced.

Secondly, consider that often what people buy when they spend money is actually rather intangible. They pay a lot of extra money for the right label or provenance. These goods aren’t really being bought for their direct utility, but for what owning them says about the purchaser and where they belong. Again, these things aren’t driven by quantities that are consumed and plays havoc with quantitative notions like productivity.

Thirdly consider how the nature of technology has changed. Information and communications technology, and the services delivered by the new devices,  lead the way.  These advances are not, by and large, driving us into an ever rising cycle of consumption of physical things or even services. We are consuming experiences and information. and these things do not follow the standard laws of economics developed by Marshall and Walras who laid the foundations of modern economic theory.

And fourthly look what is happening to the nature of work. Those steady blue and white collar jobs are disappearing. Once they were considered demeaning and soul-destroying. But we valued the social stability they brought. Instead we have a world of work that is increasingly polarised, and where stability, in all jobs, is becoming rarer.

A further point is worth mentioning. Globalisation, and the rise world trade, especially between the West and the Far East has obscured many of these changes. Driven by the law of comparative advantage, developed economies gained from cheap manufactured imports in the 1990s and 2000s.  But this economic principle is driven by differences in the makeup of the trading economies. But each of the Far eastern economies, starting with South Korea and Taiwan and moving on to China, progressed and became more like the developed world. Comparative advantage, and gains from trade, are falling away. That party is now over. And as for the effect of global financial integration on national economic management… suffice it to say that this has profoundly changed the way nation monetary and fiscal policy works.

All these things point to a world that doesn’t follow the old macroeconomic patterns. Fiscal and monetary policies don’t seem to working as they once did. Variables such as inflation and productivity misbehave. These then join forces which old-fashioned economists understand, or should. Demographic change is reducing the number of workers as demand for labour-intensive health services is rising.

This creates a world in which economic growth cannot be assumed. Distribution of income and wealth becomes of primary importance, as does managing finance, and especially levels of debt. The world is ill equipped with economic models for this new age, and many distinguished economists are contributing nothing, especially when pontificating rather than basing their views on deep and up to date analysis of the data.

We have cause to be worried by the new trends, as it appears that much government and private debt might never be repaid. If that is gloomy, we should also reflect that this is a problem of success. The ages of heavy and light industry have achieved their wider purposes and left us with societies of unbelievable wealth and comfort. But we need to understand that improving the human lot requires a new way of looking economics.

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Syriza’s victory. This is going to end badly for somebody

Last weekend the anti-establishment, far-left party Syriza won the general election in Greece, and did better than most people forecast. Under Greece’s unique electoral system, which gives the largest party a bonus of 50 seats, they almost won an overall majority. Guardian journalists jumped for joy. For them it showed that their hated austerity policies can be challenged and beaten. Elsewhere there are quite a few calming voices; things can be worked out, seemed to be attitude. Both views are naïve.

First, in fairness, a couple of positive things need to be said about Syriza. The Greeks have been badly let down by their political establishment, represented in two political parties: New Democracy and Pasok. And yet it is these establishment parties that have been entrusted with sorting the mess out so far. Syriza are coming to government with fresh eyes and should be in a better position to clean things up and distribute the burden more fairly. They should certainly be given the benefit of the doubt for now.

And one of their central positions, that Greece should be forgiven much of its debt, is perfectly coherent. We need more caveat emptor from buyers of sovereign debt. Repayment of debts is not a sacred duty that comes before basic human needs. A more liberal attitude to debt is one of the ways in which progress can be made in unfamiliar economic environment we find ourselves in. There are, of course, trying consequences to such liberality: it will become more difficult to borrow.

That I think is were the more moderate commentators start. But difficulties with Syriza’s position start come thick and fast after that. This is what Syriza’s leader Alexis Tsipras said immediately after his victory:

Greece is leaving behind catastrophic austerity, it is leaving behind the fear and the autocracy, it is leaving behind five years of humiliation and pain. Your mandate is undoubtedly cancelling the bailouts of austerity and destruction. The troika for Greece is the thing of the past.

This is rage against austerity: the need to cut back government expenditure and raise taxes in response to the economic crisis. And this is what those Guardian writers like. The left wing narrative, applied to countries as diverse as Britain, France and Greece, runs something like this. In the 1980s a malign conventional wisdom infected the governments of the western world: neoliberalism. This sought to reduce the scope of government and regulation, and in its place rely on free markets.  All this did was to enrich an elite at everybody else’s expense. And it ended in banking madness that led to economic collapse in 2008. And yet these neoliberals remain in charge! They have used the crisis as a reason to pursue austerity policies. But these policies are an evident failure: everywhere they have been applied growth has been stagnant. When will the world come to its senses, reverse austerity and let growth return?

Syriza’s victory will test this narrative to destruction. The first problem is the debt renegotiation. Sovereign debt is about 175% of Greek national income. This sounds unsustainable. Surely all Syriza is doing is asking for common sense to be applied so that everybody can move on? But all is not what it seems. The size of that debt is a bit of an accounting fiction. Debtors have already conceded a lot on both interest rates and repayment schedules; the debt is not anything like as burdensome as the headline figure suggests.

And there are powerful reasons for preserving that accounting fiction. First, outright debt forgiveness is unpopular right across northern Europe – and not just Germany. Conceding ground on it will nourish the far right from France to Finland. And of course, it will undermine mainstream governments in Europe’s periphery: Portugal, Ireland, Spain and even Italy. The original Greek deal, put together with the hated Troika (the European Commission, the European Central Bank and the IMF) was an elegant compromise designed to balance these destructive forces. The best the Greek government can hope for is a bit more of the same fudge. Allowing Greece to drop out of the Euro and the EU would be very destabilising for the rest of Europe; but it is hardly clear that conceding a lot of ground to “renegotiation” (a euphemism I have always hated) is any better.

And then there are those austerity policies on which the Troika have insisted. These are often portrayed as economic nonsense by the left, because of their effect on aggregate demand, which leads to a sort of doom loop. That is indeed a problem, but their fundamental aim is to put the Greek economy on a sustainable footing. Government expenditure and taxation were way out of line with each other; Greek industry was internationally uncompetitive. Unless these problems are tackled no solution is credible, which means that nobody will lend the Greek government money. Read the more thoughtful “Keynesian” critics and you will suggest that stimulus is focused on initiatives that do not undermine sustainability – infrastructure investment is a favourite. And that, as I have pointed out before, is not as easy as it appears.

Now the Syriza leaders are not stupid, even if some of those Guardian commentators are. Elements of their programme address the issue of sustainability: improving tax collection and targeting the wealthy elite more effectively. But many of their promises seem to go in the absolute opposite direction – reinstating government jobs and raising salaries; reversing changes to employment protection.

Now it is possible to sketch out a fudged way forward; changing the balance of Greece’s reforms, allowing a little more short-term slack, and a little more debt rescheduling.  But how is this “leaving behind catastrophic austerity”? It is impossible for Syriza to meet the expectations it has raised. The Vox Pops broadcast by the BBC over the last week or so suggest that the Greek voters themselves largely understand this – which is one reason to think that maybe such an outcome is what is in store. Mr Tsipras will simply follow the trail blazed by France’s Francois Hollande. In that event it will be the far left in other countries that will be left empty handed.

But a Greek exit from the Eurozone, and the EU, is the other likely outcome. If that happens Greece will indeed have banished the Troika and liberated itself from its debt burden. But the austerity that the Greek populace have suffered to date will look tame.

There is very little middle ground. This is not going to be an easy year. Behind that we can see a flaw in the leftist narrative. The economic policies of the 1990s and 2000s did not just benefit a wealthy elite in developed countries; benefits were spread right across society, including an expansion of government programmes. But these advances were built on sand. Lacklustre growth since 2008 is shaped by fundamental economic forces. It is the new normal. We had better get used to it.

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Inflation – deflation. More evidence that most economists have lost the plot

The economic crash of 2008 took most economists by surprise. As a result many thought tha the discipline was discredited and that it would, or should undergo a rethink. Alas though we underestimated the resilience of conventional thinking. For example, commentary about Britain’s recent low inflation figures, and about inflation in other countries, is straight out of a pre-2008 text book. That’s worrying because the world faces huge economic challenges – while professional economists are looking in the wrong direction.

This week Britain’s lowest annual inflation figures on record – though I’m not clear exactly which set of records this refers to. Overall prices were calculated to have risen by just 0.5% in 12 months of 2014. There was a lot of talk about whether this was good or bad news. On the bad news front the commentators suggested that these figures might presage deflation – negative inflation – which is a Bad Thing. Bad they explained because it undermines demand because people defer purchases, Bad because it makes debts more difficult to repay, or Bad because it makes raises the floor for real interest rates, so making money supply tighter than it should be. Japan since the 1990s is then quoted as the spectre. Some economists will point out that some deflation is not bad – if it is a sign of increased productivity making things cheaper, rather than a spiral of decreasing demand.

What’s wrong with all of that? It is based on a logical fallacy that is so commonplace that most macroeconomists don’t seem to realise they are making it. In order to understand a complex thing like  a modern economy they have developed a series of aggregated statistics, of which GDP and its cousin economic growth, is one, and inflation is another. Fair enough – but for them these aggregates take on the properties of single, uniform phenomena. They then go further by inventing theoretical concepts such as “capacity” and “the natural rate of unemployment” which are unmeasurable and unreal, and pretend that they are real physical things. They then create a world rather anecdotal stories around this fictional world of statistical measures to convince themselves and others that this world is real. This fictional world is populated by people and businesses that are all essentially the same.

But reality is meanwhile diverging ever further from the fictional world. Let’s go back to that commentary on inflation. Will people put off purchases if prices are falling? The prices in question are largely fuel and food; deferral seems unlikely. And remember when the prices of electronic goods and imported manufactures was falling in the 2000s? Where people putting off purchases? It all depends on the precise circumstances – getting underneath the detail. Debts becoming easier to pay off if there is inflation? This depends on two things. Firstly that inflation must apply to your household income, so that it rises faster than the principal of the debt. Second that interest rates are less than the rate at which your income is rising. Neither is true for most people, or even close to being true. Inflation is not making debts easier to repay; deflation should not make repaying debts more difficult. And as for the business about money supply, this opens up a whole new parallel world that economists inhabit – that of monetary policy.

To work out what is really happening in the economy, you need to get behind the aggregated figures and ask what is actually happening and why. Most macroeconomists are unwilling to do this. They play with their aggregated statistics and focus on a fairly short to medium term policy options known as “fiscal policy” and “monetary policy” as if these were the only things that really matter. They remind me of Russian Tsars sending directives to distant provinces . We’re too busy and important to bother with the details; Just do what you are told and  it will all work out on average. And the world goes somewhere else, perhaps disastrously as was the case in 2007/08.

We have another case study in this muddled thinking: Japan. Macroeconomists are quite excited about Japan at the moment, because the current government is adopting a highly aggressive economic policies, following decades of stagnation. This includes an aggressive monetary policy that is straight out of the pre-2008 textbook – increasing the money supply and raising inflation expectations. This is not going particularly well, but the macroeconomists have a ready culprit – the Japanese have wrecked things through bad fiscal policy, since they raised the rate of VAT. Actually the fundamental problem with Japanese economic policy was that while prices were rising, pay (other than a few temporary bonuses) was not. In other words inflation has not proved the uniform phenomenon that economists assume. And that simply highlights that the main issue with the Japanese economy is the functioning of its labour market, not the conduct of macroeconomic policy (see this perceptive article in the FT from Bill Emmott). That and some severe secular trends that afflict all developed economies (demographic change, the evolution of the global economy, excess debt, accumulation of stagnant wealth, and changes to technological progress).

To be fair, the Japanese government, under its Prime Minster Shinzo Abe, has always been aware of this wider and more complex picture, and has been attempting to tackle the many roadblocks to change. For that prominent economists, like Joseph Stiglitz, call them “stupid”.

The world economy, and our individual nations, face huge challenges. We need new thinking. The laissez-fair (or “neoliberal” in leftist parlance) approach adopted in the 1980s has run its course. But the aggregate demand-management polices that preceded them are not the answer (I will not call them “Keynesian” out respect for the highly intelligent and flexible mind that Maynard Keynes possessed). Politicians and central bankers are grappling a range of practical problems that most macroeconomic commentators brush aside. and yet these commentators dominate the airwaves and newspaper columns.

Some of the outlines of this new thinking are quite clear. More focus on redistribution and public investment. Moving away from an obsession with economic growth. Tackling excessive debt. But these leave huge questions. For example: how do you tackle excessive debt without economic growth? I wish economists would turn their attention to these vital questions rather than rehash yesterday’s textbooks.

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