Category Archives: Economics & Finance

Reflections on economics, investment and the financial world

The Brexit paradox: its strongest argument is its least attractive

I originally posted this article on Friday 25 March, but there was a problem with either my web host or WordPress or some other technical factor, which mean that although the email was sent out, and it appeared to be published on my browser, the publication never actually happened. This is the second attempt.

I have been relatively quiet about the biggest issue in current British politics: the referendum on membership of the European Union. It’s not that I don’t care – it has defined my politics for well over 40 years. It’s a feeling of inadequacy that I can say much that will heard beyond the babble. When I started this blog in 2011 I posted prolifically on the referendum for electoral reform. All I was doing was cheering along a rather small band of the already committed. No serious debate was actually taking place over the merits of the reform. I don’t want to be just another pro-EU voice that is only heard by other pro-EU voices. Alas, the remains my likely fate.

Still, I do want to engage in serious discussion of the issues, beyond the polemic. That debate will mainly be with myself, no doubt, but it is better than nothing. In this post I will to look at the economic arguments. Life will clearly be harder outside the EU, but might not that actually be a good thing? It is, perhaps, the central paradox of the whole debate.

The most commonly heard economic arguments for leaving the EU are based on three themes: the taxes the country pays to the EU budget; the weight of EU regulations; and the economic problems and slow growth suffered by other EU countries. None of these stands up to close examination. The budget contributions are the price paid for access to the market, and are payable by non-members like Norway and Switzerland for access rights; any savings made post Brexit will be balanced by costs, such as tariffs payable on imports, and loss of exports. This is a hard calculation to make, but the contributions look like small change in the bigger picture for an economy, like the British one, that is so dependent on trade. The argument that a sweetheart trade deal can be secured easily because the country has a substantial trade deficit with the EU is nonsense. That deficit is largely with one country: Germany, and the deal has to be done with 26 others too. And Germany’s support of sanctions against Russia, which were very costly to it, shows that politics trumps economics anyway, in Germany as in all countries.

On regulation it is hard to believe that things wills be much different outside the EU; much regulation will stay in order that the country is able to export goods. Those that don’t will be replaced by home-grown regulations that will be approximately as onerous. Democracy and regulation go hand in hand, and Anglo-Saxon cultures are as prone to this tendency as any other. Just try to set up a hairdressing business in the US. If the Brexit campaigners talked about which regulations they want to throw in the bin (other then fictional ones like those specifying the shape of bananas, etc.) they would quickly provoke a backlash. What they generally mean is employee rights.

And the economic problems of the rest of the EU do not stop Britain from exporting to the rest of the world. After all, one of the most dynamic of the world’s exporting nations, Germany, is at the heart of the EU.

And yet. A while ago I heard an interview on the BBC Radio 4 Today programme with British businessman Peter Hargreaves (co-founder of financial adviser Hargreaves Lansdown, with whom I had many dealings when I worked in financial services). The Telegraph report is here. He spouted a lot of the usual nonsense, waving away concerns about disruption to trade and investment, and suggesting that relations with Commonwealth countries could substitute for those with our European neighbours. It is remarkable about how disciplined and on-message the disparate Leave campaign is, so early. But Mr Hargreaves went onto say something much more interesting. He suggested that life out of the EU would be more “bracing”, and that would stimulate British society to greater efforts that would make it more efficient. He wanted Britain to emulate Singapore after its breakaway from Malaysia.

It would be easy to poke fun at this. Singapore might be a paragon to Mr Hargreaves, but the country is subject to an authoritarian regime that puts British complaints about political correctness (and state paternalism) into the shade. It is also a city-state, without the complexities that a large hinterland brings. But. Think about that persistent trade deficit with the rest of the EU, which contributes an trade deficit. Since joining the EU the country has been living beyond its means. A strong pound, strong inward investment, and drawing down generations’ worth of foreign assets has given the country an illusion of economic success. There are no doubt many reasons for this: North Sea oil, the illusions brought about by global finance, loose fiscal policy after 2001, and so on. But being in the EU has surely contributed. It has anchored the country in a wider international system that makes imbalances easier to sustain; it has been most helpful in drawing in inward investment, a key factor in supplying the country with the foreign currency it needs to keep going. Life outside would surely be more bracing.

An interesting digression from this line of reasoning is how things might have been different if Britain had been part of the Euro, since so much of the economic illusion was sustained by a strong pound. A topic for another time, except that I must point out that the Euro was brought in too late to be of any use – the pound was already too high by then.

And so the best economic argument for Brexit is this: the EU is a comfort blanket that is preventing our political and economic elites from facing up to the country’s true predicament. Leaving the EU would provoke a necessary economic crisis, but this would head off an even deeper crisis down the road. Of course Remainers will hope that the deeper crisis can be headed off by British economic reform within the EU, while Leavers will hope that Brexit will have a delayed economic impact, allowing the crisis to be headed off.

But, of course, the Brexiters cannot sustain this line of argument in public. It is a hair shirt argument, and the wider public would rightly suppose that it would be them that would wear the shirt (the “necessary price”) and the various business elites that would scoop the benefits. In fact the line that life outside the EU would be “more bracing” was distinctly off-message for the Leavers – though the consistent refusal of Brexit campaigners to acknowledge any risk of economic cost or uncertainty is their least convincing line.

Nevertheless, we supporters of Britain’s future in the EU should pause and reflect. Our relationship with the rest of the EU is not quite right. That trade deficit is a worrying sign of weakness. Too much of our country is inward looking. The paradox is that membership of the EU makes that inward focus more sustainable – and yet it is precisely what makes it is easy for so many people to contemplate life outside.



Tax is the Budget gorilla

As a rule I hate clichés. I cringe whenever I hear about a “perfect storm”. But I have a soft spot for the gorilla in the room, who is sometimes an elephant. The huge thing, obvious to everybody, but which it is impolite to talk about. In responding to Britain’s annual (OK, twice yearly) Budget I’m looking at one of them.

Britain’s Budgets are political theatre staged by the Chancellor of the Exchequer, as our senior finance minister is known, annually, or whenever there is new government. There is also an Autumn Statement, which amounts nearly to the same thing. The whole exercise is a process of heavily manipulated speculation in advance, followed by a tumble of instant reaction. All this shows how news is the enemy of information. By the time facts are known, contextualised and properly analysed the news media have long since moved on. People who try to be a bit more serious, like me, are torn. By joining the circus of speculation and premature response we get more readers and more reaction. But this is often at the cost of saying anything that is worth saying. My compromise is not to respond until after I have read the reactions the morning after.

The Budget process seems particularly farcical at the moment. The government is trying to set out its plans over a five year period, and in particular over the five years of a parliament, which in both cases means up to 2020 at the moment. This means they depend on five year projections of the economy. These projections are produced independently of the Treasury by the Office of Budget Responsibility (OBR). Without the smoothing hand of political manipulation, the five year outlook is highly volatile. Last Autumn the OBR “found” £27 billion; a mere six months later they had “lost” £56 billion. I can’t offer much help about what is going on here, except to point out that economic forecasting is a dodgy business, and this sort of volatility simply shows the absence of manipulation. It is no basis upon which to carry out serious economic planning. And yet the government says that it is doing just that. Last Autumn it used the £27 billion windfall to relax its fiscal plans. This time it was forced to tighten up a little, plus deploy a few accounting tricks to pretend that it is on course to meet tis five year target to move the budget into surplus, even as interim targets fall by the wayside.

But nobody is convinced, and nobody cares. It is far too early to worry about 2020, with so many unknowns. The critical thing is the next year, and nobody disagrees much with the overall thrust of George Osborne’s strategy. The muddle is particularly noticeable on the left. They are trying to capitalise on the fact that the government is missing its short-term austerity targets, while at the same time condemning austerity. Since 2010, the government has taken a pragmatic, Keynesian stance to fiscal policy, while pretending that it is being austere.  This means that the country’s fiscal deficit and levels of public debt are higher than pretty much any other major developed economy apart from Japan, having started the crisis in a much stronger position. That this has still meant dramatic cuts to public spending shows just how out of control the government finances had become under the previous government, as it pursued the illusory goal of Scandinavian public spending backed by US taxes. The left are still in denial about this.

So what did Mr Osborne do? Not much. There were promised tax cuts on personal allowances and higher rate thresholds. He failed to increase tax on petrol, even after petrol prices have fallen so far. There were cuts to company taxes and capital gains. I don’t approve of much of this, though many liberals do. But the impact will not be huge. He stepped up the ratchet on public spending, without being too specific, but pushing the hard decisions way into the future in the hope, no doubt, that the economy will come to the rescue. There were gimmicks and irrelevances aplenty, like a sugar tax, and pushing schools towards academy status, which I comment on in another post.

But here’s the problem. Constraining, never mind cutting, public spending is getting harder. Benefit cuts are causing anguish that even Conservative MPs feel; the ambitious idea for Universal Credit could yet collapse amid its technical problems. The attempt to drive efficiency savings in the NHS through ratcheting up financial pressure annually, a policy that predates 2010, has now collapsed. Hopes that the NHS can achieve substantial savings through re-engineering are vanishing. The ugly behemoth is unmanageable, and the reforms made by the Coalition aren’t helping. Outsourcing bits of it will not help. Meanwhile demand continues to rise. The government’s bid to reform schools finance requires a lot of extra money to placate the losers if it is not going to run into big problems. Social care is in crisis. Attempts to curb the defence budget have collapsed.

Behind this can be spied a strategic problem. Or, rather, two. The first is a growing proportion of older people, with an added demand for public pensions, and health and social care support, while dropping out of the tax base. The second is that the benefits of a modern economy are increasingly going to the richest, leaving many behind without adequate savings, and putting pressure on the social security safety net. Rising property prices are exacerbating this, burdening many younger people with huge rents and no prospect of joining the property bonanza. I could add a number of further issues which suggest that the days of easy economic growth are over.

So demand for public services is rising, but the tax base is shrinking, or at least stagnating. There is a substantial current account deficit, which limits the scope for creative government finance (like “people’s QE) we need lots of foreign currency to buy the all those foreign goods we depend on. There is really only one way out. Taxes will have to go up, and not just on the richest. That means the sacred trio of income tax, national insurance and VAT. But nobody talks about this. Not even the opposition parties.

And that is the gorilla.


Neither fish nor fowl, why I will oppose the economics motion at #ldconf

This weekend the Liberal Democrats meet for their Spring Conference. To most observers of the political scene, this is an irrelevance. But with the growing gap between Labour members and the general voting public,  and the Conservative Party riven by splits on Europe, who knows what opportunities might arrise for the party? I still care about it, anyway.

The party is rebuilding itself after the five year car crash of coalition government ended last year with it being reduced to near irrelevance in the House of Commons. And that followed five years of rather gentler decline after its peak year of 2005. The party conferences are an opportunity for members and leaders to decide what the revitalised party stands for.

One complaint after last year’s meltdown was that the party was weak on economic policy, and so let others set the agenda. No doubt that motivated the submission of a motion on the economy as the first item of policy business on Saturday with just an hour’s debate. Alas the motion plumbs the depths of awfulness.

I can’t find a neat link to it, so I will reproduce it here in full below, so you can judge for yourself. But with its 10 whinges about the current situation, and 15 proposals, I’m not sure I would recommend a close read. It is mostly unobjectionable. It has some worthy ideas, and some airy aspirations. Item 11 od the 15 reads: “Addressing inequality through a renewed commitment across Government and society to analyse and address Beveridge’s Five Giants in modern society.”

In some contexts a list of 15 rather disconnected policy ideas is not a bad idea for a policy motion – for example if the party was planning to negotiate a coalition programme from a position of strength. This is hardly the context now, and even then it fails. Just what would you do with a commitment to tackle the Five Giants in a coalition negotiation? Instead all such a long list of vague ideas serves is to offend people whose own hobby horses are left out of the 15, or are underrepresented, or given too low a prominence.

What the party actually needs from a debate on economics at this stage in the political cycle either of two things.

The first thing it could do is set out a very limited number of general themes, around which to hang more detailed policies. These need to display a bit of vision, and show  what the party is all about. I suggested a few last year: green growth, small is beautiful (or greater diversity and innovation, if you will), problem-solving public services and addressing inequalities and imbalances. It would not be hard to do better than that, and any debate would say something about the party’s values and campaigning priorities. I can find no such clear general themes in the motion. Worse, I am rather shocked to see so few references to environmental sustainability in a party that used to pride itself on environmental consciousness – that alone is reason enough to vote the motion down.

The second thing it could do is develop a particular economic idea or solution to a specific economic problem. There are plenty of places where this needs to be done: investing for green growth; tackling the housing crisis; free but fair trade; taxing businesses. Or the role of fiscal policy in economic management, though the chances of getting a rational debate on that area in a left of centre political party are slim. This is actually where the heavy lifting needs to be done, and where the Lib Dems can make a substantive contribution to the wider political debate on economics.  The real world of democratic politics is evolutionary; revolutions fail. What is needed is a series of practical changes, each of which will works on its own merits, and which collectively will amount to radical change. The motion does point to some specifics, but each of its 15 proposals needs to be picked apart in a debate of its own. Instead we have a series of vague and useless commitments.

And as a result the motion is a complete waste of time. Much hope seems to be being placed on amendments. But unless these are allowed to replace the motion with an entirely new one, which would be an abuse of process, I can’t see how it can either be turned into a general vision or a specific economic proposal. It is neither fish nor fowl.  The best thing to do with it is to throw it out and start again.

Conference re-asserts the Liberal Democrats’ continuing commitment to sound public finances, social justice, an open economy in an open society, and the principle of free markets whenever possible with intervention where necessary by an enabling state.

Conference notes:

a) The Liberal Democrats’ effective record in Government in stabilising the public finances and major contributions in the fields of apprenticeships, banking regulation, the British Business Bank, the Green Investment Bank and the promotion of innovation through the Catapult network.

b) The fragile nature of economic recovery following the 2008 crash, evidenced by interest rates which are historically low and continued Eurozone uncertainty.

c) The growth of house prices carrying the threat of a price bubble and subsequent crash.

d) The Chancellor’s unhelpful and arbitrary re-definition of the deficit, doubling the total by including capital spending, in his attempt to justify Tory spending cuts.

e) The medium-term risk to the UK economy posed by increasing and unsustainable private and household debt.

f) The threats to the UK economic prospects posed by Conservative approaches to UK membership of the European Union and immigration.

g) The International Monetary Fund’s advice to reduce debt through growth not cuts.

h) The UK economy’s over-dependence on London and the South-East.

i) The UK’s bad record in allowing the growth of an increasing number of young people with low levels of education, training and aspiration.

j) Growing inequalities in wealth and income, coupled with unfair and regressive action against the poorest people in the country, now exacerbated by the assault on welfare spending.

Conference calls for effective measures to support and grow the UK economy, including by many established Liberal Democrat policies:

1. Increased investment, both directly by Government financed by public borrowing, and stimulated by Government, particularly in affordable housing including social housing and infrastructure to support balanced growth throughout the UK.

2. Support for planning reform, institutional lending to small builders and action by local authorities for planned development, including assembling land for auction.

3. Further measures to improve and regulate banking services by promoting efficient lending, particularly to small and medium-sized enterprises, encouragement of challenger banks and increased personal accountability.

4. Strengthening takeover legislation to protect the country’s science base.

5. Reversing cuts in the development of green energy and promoting investment in green business initiatives.

6. Further development of the Government’s industrial strategy, promoting co-operation and supply chain development in key sectors for the long-term.

7. Re-balancing the economy towards manufacturing industry and regions, based on the coherent and substantial devolution of political and financial power.

8. Further reform of corporate governance to encourage ‘long-termism’ and to discipline executive pay, including an employee role in determining executive pay.

9. Renewed emphasis on vocational education and training, particularly through effective apprenticeships and especially higher-degree level and engineering and construction apprenticeships.

10. Coherent efforts across Government Departments to address the needs of young people who are excluded from the labour market and participation in wider society.

11. Addressing inequality through a renewed commitment across Government and society to analyse and address Beveridge’s Five Giants in modern society.

12. Investigating sustainable ways of funding universal services, including a cross-party, cross-society settlement on funding health and social care.

13. A new commitment to taxing unearned wealth, including Land Value Taxation.

14. Measures to dampen the growth of asset bubbles in opposition to Conservative approaches which tend to increase that growth.

15. Support for more diverse ownership models including worker ownership, social enterprise, mutuality and co-operation.


Economics essay 2: why global trade is going into reverse

Now for the second essay on economics that I wrote in 2008. The topic is trade, and it investigates the theory of trade between developed and developing nations. It turns out that standard trade theory, based on comparative advantage, works rather well here. But it contains a prediction that goes largely unremarked. Apart from Paul Samuelson (in 2004) I haven’t seen anybody else raise the point. And yet it does much to explain what is going on in the world now, especially between Britain and China.

The theory of comparative advantage is part of what Americans call “Economics 101”: basic first year economics. It explains how mutual trade can benefit economies even when one is manifestly more efficient than the other. But generally this wonderful piece of logic, made famous two centuries ago by David Ricardo, fails to advance much beyond Economics 101. Modern economists have not found ways of using it to make concrete predictions. Attempts to make the theory more specific, for example by relating it to availability of factors of production (like land, capital, etc.) have come to not much. Instead the idea is used to give a warm glow to the idea of trade being a Good Thing, and the basis of patronising comments to non-economists advocating protectionism, while economists get on with the day job without touching it.

That is a pity, because the theory repays more examination. Its central idea is that gains from trade are based on opportunity costs of the various products in an economy, or comparative advantage – that is how much of one product you have to forgo to produce a given quantity of another. The corollary is that where the differences in opportunity cost are minimal, the gains from trade are likewise minimal. As different economies converge, the less incentive there is to trade.

In fact trade does take place between similar economies, but it is driven by other factors, such as economies of scale, and is quite sensitive to transport costs. But the theory of comparative advantage does explain trade between developed and emerging economies rather well. These economies are self evidently very different from each other, and gains may be made between countries on opposite sides of the globe. But as emerging economies develop; they converge with developed economies. What happens then?

To explore this I created a simple mathematical model. I divided the economy into four sectors: agriculture, where productivity grows, but which is not traded; services, also not traded, but where no productivity changes happen; and two types of goods, high and low tech, which are tradable and where productivity changes at differing rates. I looked at three stages of development. The first, undeveloped stage has a huge and inefficient agriculture sector. In the second, intermediate, stage, low tech manufacturing has got going. In the final developed economy stage, productivity has advanced in all sectors apart from trade, but especially in high tech goods.

I then looked at how trade would work between the developed and undeveloped economy. There was no major impact, but the undeveloped economy would buy all its high tech goods from the developed one, in exchange for low tech goods.  The undeveloped economy’s currency traded at well below purchasing power parity. Next I considered what would happen if the undeveloped economy moved to the intermediate stage. Now trade becomes much more important to both economies; once again the intermediate economy buys all its high tech goods from the developed one, in exchange for low tech goods. But the developed economy imports a high proportion of its low tech goods. Both sides gain substantially.

But what happens as the economies converge further? The trade disappears; the developing economy supplies an increasing proportion of its high tech needs, and exports fewer low tech goods, substituting productivity gains for gains from trade. The developed economy has to supply its own low tech goods again, and loses gains from trade. It is worse off.

All this models what has been happening between Britain and China quite well. Nothing much at first, but as China’s agriculture became more efficient, and so its low tech manufacturing could grow, then trade ballooned, with gains to both sides. This took place in the 1990s and early 2000s. The price of manufactured goods in Britain dropped because of cheap imports, allowing other goods and services, and pay, to grow at a healthy 4% per annum or so, while keeping overall inflation at about 2%; the components of the inflation statistics became very revealing. A lot of the economic growth that took place in Britain in this period was surely driven by this, rather than advancing productivity.

But even in 2008 I could see that the party was coming to an end. Chinese costs were rising; they were moving increasingly into high tech areas. It has become harder for Britain to compete for high tech goods, but easier to repatriate lower tech manufacturing and services. This latter has been good for British jobs, but not for living standards, as what is being repatriated has lower productivity. Volumes of trade have fallen – though it is a complex affair so cause and effect are hard to prove.

Won’t China be replaced by other countries? Japan started the trend after all, to be replaced by the “Asian Tigers” (South Korea, Taiwan, etc.), before China entered the picture. There are emerging economies that are taking up some of the slack – Vietnam and Bangladesh, perhaps. Africa has huge scale. But not only are many of these economies slow to transition to the intermediate stage, with a strong export manufacturing base, but the sheer scale of China changes things. The emerging economies are as likely to trade with China (and India, whose emergence takes a different but parallel path) as they are with the developed world. And perhaps low tech is becoming more high tech too – making it hard for the newly emerging economies to find enough of scale where they have a comparative advantage.

And this is yet another reason why developed economies appear to be stagnating, and why much of the growth that took place before the crash of 2008 was unsustainable. Trade has a reverse gear that is nothing to do with protectionism and ignorance of economic theory. Economic theory predicts it.


Economics essay 1: economic growth will come to an end naturally

Last week I was looking for something I had written a few years ago, and I found two essays that I had written in 2008. I was trying to clarify my thinking on economics, using the device of explaining the discipline to a non-economist. They were meant to be the start of a longer series, but alas the rest of life intruded. I have decided to publish them through this blog, and to try and extend the series.

My blog posts are long enough (over 1,000 words a piece, usually), but they are not long enough to develop thinking properly. And the pressure to get two posts out a week is not conducive to deep thought either, as the rest of my life is proving quite active, even though I am now retired.   These essays are longer (the first just under 2,500 words), and certainly more considered.

Both of the essays developed ideas that I have used in my blogging since. The first is that there is a natural limit to economic growth – which I am now convinced we are reaching. The second looks at trade, and especially that between developed and developing nations – and why this leads to gains that are then reversed in developed economies. A further feature of the essays is that they frame economic ideas in a historical, or evolutionary, context. One thing leads to another and society changes. This is a break from the idea of a static equilibrium that dominates much economic thought. Economists even try to give a static quality to dynamic concepts, like growth and productivity change, by treating them as constants. Sometimes they produce data series of 200 years and more, as if to suggest that nothing really changes.

I wrote the essays just after I finished my degree in Economics at UCL as a mature  student. But it was before the collapse of Lehman Brothers precipitated what we now understand as the Financial Crash, though it had been clear from 2007 that the world’s financial system was teetering on the brink.

I have edited the essays (a job not yet finished for the second one) so as to correct mistakes and clarify language – but I have avoided a rewrite, even though I would write differently now. Partly this is to preserve authenticity; mainly because a rewrite would take much longer. What you read is how I saw things then. I will use the covering blog post to offer any new insights.

So what of the first essay: Wealth, wellbeing and growth? This explores the idea that economic growth might come to a end simply through the freely made choices of the people. This is not a line of thinking that I can remember any modern economist trying to develop, although it was foreshadowed, as so much in modern economics is, by Maynard Keynes.

This idea follows from four observations: that consumption for personal needs will reach saturation; that productivity gains allow increased consumption of things, but cannot change human content, and so make their products less attractive; that leisure holds a compelling attraction to those who can afford it; and that the quest for status is a zero-sum game.

Increasingly we want things that economic growth cannot deliver in greater quantities: land, leisure and fame. Technology change is not necessarily leading to increased productivity, while still delivering things that we want. Wellbeing may advance without growth. Though many in our society clearly need to consume more than they do – we still have poverty – that does not imply that increased consumption for everybody, even as an average, is the way forward people will choose. Economists are quite unready for this.

So what has changed since 2008? The crash may suggest the unsustainability of ever increasing consumption, especially if it fuelled by debt. I hint at this idea without developing it. Since then growth has become a political obsession – so the idea that it might not be considered to be an outright good has even less currency. The Greens have dropped their low growth rhetoric and replaced it with something that is quite ambiguous. The left has chosen “austerity” as top of their most hated abstract nouns, on the grounds that it is an attack on growth, though also on grounds of another abstract idea: “social justice”.

So we have a long way to go before my idea will get any political traction. And yet the idea of secular stagnation, is gaining ground. This is seen as a Bad Thing, of course, but its roots can be traced to as far back as the 1990s.  This is the idea that there is a structural excess of savings over investment in developed economies, which undermines growth – which is only sustained, by ever increasing cycles of debt growth and asset price bubbles. I think the ideas that I am suggesting in the essay are part, even most, of the explanation for secular stagnation.

There are some twists, though. Inequality may be an important factor in the process of saturation of consumption – a growing share of income is going to a rich elite, who are unable to spend it. This may imply that a more efficient distribution of wealth would increase consumption and lead to growth. But only up to a point, surely.

There clearly is a dark side to my idea. Demand for tax-funded services is voracious (hence the anger of some against “austerity”) – but what is to be taxed in a low-growth world? And the addiction of our economies to debt requires growth to feed it; it will not be broken without a lot of social stress.

But that is the way the world is heading – and it is as well that we think the implications through.



Why do governments follow austerity when orthodox economists advise against it?

It’s by turns annoying and amusing: the way people on the left complain that orthodox economics has gone off the rails, and that we need fresh thinking to inform government policies. Apart from coming up with a lot of age-old tropes that economic models do not mimic real behaviour, or take account of information asymmetries, the main item of evidence is the persistance of austerity policies in the developed world.

But the main critics of austerity turn out to be…. orthodox economists. People like Joe Stiglitz, Paul Krugman and Martin Wolf. And newspapers struggle to find economists to make the case for the defence. The Financial Times often resorts to Niall Ferguson, who is a historian, not an economist, and no match for a Nobel laureate like Mr Krugman. The British Labour party is even roping in economics professors to bolster its economic credibility.

In fact there is a brand of orthodox pro-austerity economists. These are the old “supply-siders” from such institutions as the Chicago Business School, who developed a line of “neoclassical” economics, and rebelled against what was once the Keynesian orthodoxy. This branch of thinking grew out to the economic crisis of the 1970s, but proved utterly useless when the crisis of 2007/08 hit. Neoclassical economists pipe up here and there in America, but are mostly silent, their credibility shot-through. That leaves the field nearly unchallenged for the neo-Keynesians – at least far as the public debate in newspaper columns is concerned, in Britain, anyway.

Which leaves us with a mystery. Why are governments, from Europe to America (though not Japan, interestingly), ignoring the orthodox economists? Two explanations are usually offered by their critics. One is rank incompetence or wilful blindness. The other is a political agenda that austerity plays to, usually involving making the rich richer. Neither explanation stands up to close examination.

I am wary of accusations of incompetence, especially when made about clearly intelligent people, such as most politicians and technocrats involved in government finance. This is something I learnt as a history undergraduate (I studied both science and history in my original undergraduate incarnation, long before my study of economics as a mature student). Such accusations are bandied about freely down the ages, but never stand up to scrutiny. Mostly the wilful blindness comes from the people making the accusation, who cannot entertain the idea that there is a rival point of view to their own. Modern economic policy is no exception.

The political agenda is a bit more plausible. Perhaps governments are in hoc to big business interests and those of the wealthy? But if the last 150 years of history has taught us anything, it is that if poorer members of society are prospering, the rich will prosper also, and be left in peace. This is even more true of big corporate interests than anybody else. It is harder to make money in a stagnant economy. Those malign influences are there in politics, but their effects are altogether more subtle than doing down poor people to help line the pockets of the rich.

Sensing that these explanations don’t work, many on the left build up an idea of “neoliberalism”. This is a philosophy based on the old supply-side or neoclassical economics that may be waning in academic economics, but still holds a grip on the lesser mortals who staff finance ministries and banks, and other parts of the “elite”. But this too is inadequate as an explanation. Certainly it is possible to identify a series of beliefs and biases amongst policymakers that equate to economic liberalism. But they do not explain austerity as a macroeconomic policy. And besides, we need to understand why the hold of these beliefs is so strong. Clearly some on the left think that an outdated economic orthodoxy is to blame. But surely such theoretical constructs cannot by themselves have such a grip on so many intelligent and practical minds?

Instead of a conflict between different types of theory, what is really going on is a conflict between theory and practice. The theoreticians may be gung-ho about fiscal and monetary stimulus, but the people who implement policy are acutely aware of the practical problems and risks. There are three particular practical issues about which the theoreticians are dismissive, but which weigh heavily on the practical types: economic efficiency; public investment; and financial markets.

First take economic efficiency. Pretty much everybody agrees that, ultimately, living standards depend on economic efficiency, or productivity. This piece of orthodoxy could be challenged, but that is not what most on the left mean (traditional Greens being the exception, along with liberal voices in the wilderness like mine) when they call for fresh thinking. They see slow economic growth as a sign of failure as much as any conservative does; and that ultimately is based on productivity. But economic efficiency is hard work politically. Both businesses and workers like to protect their patches with taxes, government agencies and regulations that keep the winds of change at bay. This is especially the case in Europe and Japan. And yet, in order to achieve long-term growth, these vested interested must be tackled, and reforms enacted. This has been shown in countless contexts in both developed and developing world. Mostly reforms have an economically liberal character – but only because this approach genuinely unlocks long-term efficiency.  Far-sighted politicians and officials want to use every possible chance to advance reforms. That includes the pressures created by economic hard times. Theoretical economists might suggest that boom years are the best time to push through reforms, or that reforms can be covered by macroeconomic leniency. Politicians know that the opposite is the case – it too difficult to muster the political imperative in easy times, or if short-term macroeconomic policies take the heat off.

Reform and austerity are not necessarily the same thing, but they almost always are.  This debate, of course, dominates discourse in the Euro zone, where economic hardship is concentrated in less efficient economies. Critics of austerity there offer no way forward for improved efficiency, beyond the hope that public infrastructure investment will deliver the growth they seek.

Which brings us to the difficulties of public investment. To theoretical economists this is the magic bullet. Public investment in infrastructure both yields gains to long-term efficiency, and a short term fiscal stimulus. The economists are exasperated that so few governments seem to follow their advice. And yet public investment is a graveyard of roads to nowhere and white elephants. When the imperative to  invest is political, the choice of project becomes political too. It is very hard to make sensible choices. China was much lauded for its infrastructure investment programme following the crash. This has now turned into a major headache, as so much of the money was wasted on empty cities and useless infrastructure. Something similar happened in Japan in the 1990s. Finance ministry officials are rightly wary.

And then there are the financial markets. If I’ve heard one economist here in Britain suggest that now is a fabulous time for the government to borrow, or even “print”, money, I’ve heard it from a hundred. With so much demand for government bonds in the markets, and inflation looking mortally wounded, just what are you worrying about? But none of these economists work at the sharp end of government finance. If they did, such sanguinity would remind them of the sort of thinking that got the world’s banks into the disaster in the first place: a reckless confidence that markets would behave in future as they do now.

Alas life is much more complicated than that. Grounds for confidence in the financial markets is stronger in some places than others. Japan has a massive export industry that sees to all its foreign currency needs, so that the state can borrow and even print the Yen with reasonable confidence. Which is what it has been doing, in prodigious quantities, for the last two decades, although to little apparent effect. The US is another country that can feel reasonably secure, even though its balance of trade is less benign than Japan’s. The dollar is the world’s de facto reserve currency. The United Kingdom, however, shares neither of these strengths. It needs to draw on overseas institutions and businesses, and its own private sector, in order to finance its significant current account and trade imbalances. This is not a problem that printing the Pound can help with. The state has been extraordinarily adept at handling this risk over the last few decades. But that is because of the conservatism that is currently attracting so much criticism.

To me the theoretical economists, the practical policymakers, and most of their leftist critics are all trapped by an orthodox way of looking at the world through economic aggregate statistics. This means that they are failing to take on the deeper problems that society faces: economic and environmental sustainability, alienation, and the gravitation of wealth to successful people and places. That has very little to do with the politics of austerity. People on the left who call for fresh thinking should be careful what they wish for.



The economy is for Labour what tuition fees is for the Lib Dems

If there is something that unites British Labour Party people, from rightist Blairites, to Brownites, through to the leftist Corbynistas, it is that the Labour government of 1997 to 2010 should not be held responsible for the financial crash of 2008/09, and the terrible state of government finances that followed. They are made indignant by Conservatives (and Liberal Democrats) who go on about how Labour is to blame for the financial mess the government left the country in in 2010, when the budget deficit had ballooned to over 10% of GDP. But the public finds the Tory line more convincing. And if Labour are to throw off this albatross, it will have to move on from its air of injured innocence.

There are two dimensions to this question. The first is a question of fact, or purports to be: how much responsibility did the Labour government actually have for what went wrong in the economy? The second is what is going on in people’s heads when they think of Labour and the economy, and how the party might address it.

On the first question, Labour have quite a few sympathisers outside the party. And certainly the direct line of attack made by Tories is not all it seems. The Tory narrative is that Labour went on a spending splurge in the boom years, which then  proved completely unsustainable, leaving their successors  choice but to implement austerity policies. Defenders of Labour’s record point out that there was no big government deficit before the crash. It was a relatively modest 2.5% or so in 2006 and 2007, and not regarded as irresponsible at the time. Nobody foresaw the financial turmoil, which originated in American sub-prime mortgage markets.

The Labour defence against this charge is mostly true. But not quite. Gordon Brown, as Chancellor (he became Prime Minister in 2008), claimed to operate government expenditure on a “golden rule” which meant no net borrowing over the economic cycle. But he had taken to moving the goalposts rather than applying the rule strictly. Had he followed his own rules as originally intended, there may not have been a deficit as the economy turned in 2007. But that only accounts for 2% of the problem. There was another 5% that came from somewhere else, allowing for a normal cyclical swing of 3%, and which cannot be blamed on Labour profligacy.

If you take a wider view, however, Labour’s defence becomes more difficult. British government finances were worse affected than other major industrial countries, from France to the USA, and much worse than some, like Canada. There are broadly two reasons for this. The first is that Britain had a bigger financial crisis, because it had a bigger banking sector, especially in international banking, and so was more affected by its collapse. The second is that tax revenues fell unusually sharply in Britain. Both aspects have government fingerprints on them.

Take banking. Labour lauded the rise of the international banks, and celebrated Britain’s “light-touch” regulation that helped bring this about. They gave RBS’s Fred Goodwin a knighthood for no other reason than that he had expanded his bank, recklessly as it turned out – there were none of the usual good charitable works to point to as supporting a general aura of public-spiritedness, as is customary in such matters. Meanwhile, Britain’s success as an international banking hub helped drive Sterling up and manufacturing exporters out of business. Mr Brown tried to wriggle out of responsibility by suggesting that he wasn’t responsible for banking regulation under Britain’s tripartite system of financial regulation (between the Treasury, the FSA and the Bank of England). This is pretty damning, because this system was of his own design, and it was clear that overall responsibility for making sure the system was working lay with the Treasury. It couldn’t be anywhere else.

Then on taxes, Mr Brown engineered a switch from taxes on income, and Income Tax in particular, to an array of other taxes, like stamp duty, that turned out to be about milking financial bubbles. At the time, his reduction of the basic rate of income tax to 20% was lauded as a triumph. This proved a colossal misjudgement, as it has proved politically impossible to raise income taxes, even in supposed more left-leaning Scotland.

On top of this, a broader claim can be made. The world financial crisis was not some storm that happened somewhere else with unfortunate consequences for Britain. Britain was the world’s leading international centre of finance; Britain’s bankers were at the heart of it, Two of Britain’s big banks, RBS and HBoS, collapsed, not helped a Britain’s own reckless mortgage lending, which also affected smaller banks, like Northern Rock and Bradford & Bingley. These banks had all adopted highly risky business models, whose main assumption was that global banking markets would be stable. Sitting on top of one of the most prestigious finance ministries in the world, and trumpeting his own reputation as a financial manager, Mr Brown and his acolytes can’t really escape the charge of incompetence for not appreciating these risks. And these risks were plan to some, including his Lib Dem shadow, Vince Cable, whose warnings were pooh-poohed.

Labourites are on stronger ground when they suggest that, once the crisis emerged, their government handled it well. It wasn’t pretty (amongst innocent victims of the government’s shoot-first approach were Icelandic banks and Britain’s own Lloyd’s bank), but largely stands up to scrutiny. Another argument is over whether the Tory/Lib Dem coalition that took power in 2010 was too tight with its austerity policies, compared to how Labour would have handled the same situation. Many independent commentators agree with at least the first part of that proposition, though I don’t.

So, I don’t think Labour were quite as innocent as they claim, even if much of the direct criticism is misplaced. But, in politics, such arguments actually count for little. A more important question is how the public perceives things. This is where Labour’s real problem lies. What the public sees is a classic hubris to nemesis story, which is one of the oldest storylines in humanity, and takes some rebutting. Labour’s problem is their boastfulness before the crisis. Labour appealed to voters because a Labour government meant “no more boom and bust”, unlike with the Tories. And then one of the biggest busts in history happened.

And there is trust issue here. Labour’s position is a bit like that of the Lib Dems over tuition fees. The Lib Dems vowed not to vote for an increase in student tuition fees before the election, and yet later that year they supported the trebling of fees. Many Lib Dems will give you a convincing intellectual explanation as to how this not nearly as bad as it sounds, and that anyway there was little they could do in coalition. But this cuts no ice with the public, because of the way the party presented their policies before the election.

Labour are onto an equally losing wicket if they try convincing the public that the economic crash of 2008/09 was not their responsibility. Ed Miliband, their leader at the last election, was quite right not to even try. Besides, the alternative argument that Labour were the hapless victim of world events hardly counters the public’s perception of the post-Brown leadership (Mr Miliband and his successor Jeremy Corbyn) of being nice but ineffectual. The usual advice for when you are in a whole is to stop digging. The idea that if the party had come out fighting, public perception would be swayed, is pure nonsense.

The only way forward is for Labour to acknowledge their responsibility, and put forward hard economic policies that show they are capable of taking tough decisions if in power. And that means they have to stop banging on about austerity and get tough with some of their own supporters. For now, though, there is no chance of that.


2016 is nothing like 2008, but there’s trouble ahead for the world economy

In my New Year post I did not write much about finance, but made some rather throwaway comments that the economy could take a turn for the worse in 2016.  Having just read Martin Wolf’s rather sanguine piece in the FT, I hadn’t quite understood that my views were in line with conventional wisdom in the financial markets – and this not at all a position I like to be in. But pessimism is in, and reflected by lower share prices worldwide. This has filtered through to left wing commentators, like Will Hutton, who gleefully want to show that “austerity” or “neoliberalism” is leading to a repeat of the 2008 crash (though Mr Hutton is too good a writer to use those particular totems). This is definitely company I don’t want to keep. Time to dig a bit deeper.

It helps to think back to what happened in the last turndown, the crash of 2008 – as this is foremost on people’s minds. At the start of 2008 the banking system was in deep trouble, although on the surface things were quite calm, if gently sinking. “Holed below the waterline” was the description that I used at the time – alas I was not publicly blogging until three years later, or my reputation might have been made. Trust was breaking down because the banks were dealing a lot with each other, or off-balance sheet offshoots, rather than with the public or businesses. And things were starting to go wrong, beginning with US sub-prime mortgages. The huge tangle of interbank transactions and derivatives meant that nobody knew how the losses would play out or where – so everybody was tainted. Things kept superficially calm until quite late in 2008, when Lehman Brothers collapsed, threatening a chain reaction that would have brought much of the world’s banking system to a screeching halt. Since the banking system is at the centre of everyday life in developed economies the result could have been catastrophic.

That catastrophe was largely avoided, but only because governments bailed banks out to keep the whole system afloat. Even then the damage to the non-banking economy was severe, and government finances, especially here in the UK, were ruined. What was so alarming about the whole episode was that a fairly routine downturn in the business cycle infected part of the US mortgage market, which then completely disproportionately went on threaten the whole system. Defenders of Britain’s Labour government still can’t believe it was anything to do with them – though in fact ten years of complacent economic management had left the country highly vulnerable to such a chain reaction.

Why are people worried now? Well one thing that helped the ameliorate the disaster in 2008 was that emerging markets, especially China, were less badly affected, and in China’s case, government stimulus helped keep things afloat. Now that side of things is unravelling. The Chinese economy is slowing, and in the process it is undermining world markets for commodities such as oil, which presents the threat of widespread damage in the developing world. The Chinese situation arises partly because the country has hit an awkward point in the evolution of its development, and partly because their stimulus package after 2008 was largely wasted and bad debts are threatening its banking system. Indeed the whole soundness of China’s growth strategy is coming into question (its second, state-directed phase , rather than Deng Xiaoping’s original liberalisation from 1978).

This is serious, and no mistake. The role China has played in the world economy in the last quarter century is hard to exaggerate. What is happening there is much bigger than the US subprime crisis that was at the heart of the 2008 debacle. But it doesn’t have the same destabilising features that caused such a fierce chain reaction – which were in plain view as 2008 started. China is not at the heart of a cat’s cradle of complex derivatives sitting in off-balance sheet funds, with almost every international bank taking part. And the huge power of the Chinese state, and the depth of its financial reserves, means that the country’s financial system will collapse slowly rather than suddenly. The western banking system is a much soberer thing than it was in 2008 too, even if many left wing commentators would have you believe that nothing has changed. For these reasons 2016 does not look like 2008. A meltdown, or near meltdown, does not look likely.

But there could be a slower moving form of trouble. Secular stagnation, the affliction of the world economy I referred to recently, is here to stay. Western economies will slow. Worse things may be in store in the developing world. Share prices may well fall badly – many markets have been overpriced for some time.

And in Britain? In my New Year post I suggested that 2016 might be the year the economy here started to turn sour. That comment wasn’t based on any deep thinking. Britain is unusually dependent on the international economy, as is evident from persistent trade and current account deficits, and a value for Sterling that is hard to justify based on its “real” economy. So, with things going awry in the world economy, Britain might be vulnerable. The Pound could come under pressure; foreign investors could desert London’s property market causing a chain reaction; or a downturn in the City’s finance sector could do the same thing. On the other hand, capital flight from the developing world could benefit London in particular, allowing the country to weather the storm. Some left wing commentators have been trying to stoke alarm about the level of personal debt – but that doesn’t stand up to close scrutiny. Neither should we pay much heed to Labour’s economic adviser, David Blanchflower, who on the radio this morning suggested that Britain was less ready to deal with a crisis than in 2008, because interest rates were already rock bottom. That vastly inflates the effects of interest rate policy on crisis management. David Cameron’s and George Osborne’s luck could hold. I struggle to understand the alarmism on the political left – it will merely undermine its already shaky reputation for economic grasp.

it seems to me that 2016 will be the start of a good old-fashioned cyclical downturn for the world economy, with no more than the usual localised financial crises. Personally I think this will morph into a period of more prolonged secular stagnation that will put paid to economists’ lazy assumption that 1-2% rates of growth are a law of nature.

And that should pose some very challenging questions for the art of economics. But that’s a topic for another day. Meanwhile government bonds are a better bet than shares; cash is not a bad bet either; don’t mortgage up to your eyeballs in property; and interest rates aren’t going up.



Secular stagnation: the dark cloud hanging over the world economy

A dark mood is overtaking those who contemplate the world economy. Today Britain’s Chancellor George Osborne will join a growing chorus of worry. Weak outlook in emerging economies is undermining efforts to revive developed ones like Britain’s. So far the prognosis is stagnation rather than economic disaster – a mood caught by the FT’s Martin Wolf, who tells us not to be too pessimistic. But these are dark clouds and policymakers would do well to prepare for rough waters.

Mr Wolf bases his relative optimism on the fact that world economy has being growing steadily for some two centuries, and with particular steadiness since 1945. Until the potential for further growth is exhausted, which he doesn’t think is anywhere near the case, that growth will carry on. But macroeconomics has changed profoundly in the last ten to twenty years. And even orthodox economists are starting to appreciate this.

The leading piece of evidence is that in the developed world central bank interest rates are stuck at very low levels, even though the recession of 2008-2009 was over five years a go, and there has been steady recovery since. And inflation, as it relates to pay and consumer prices, remains low. What had once been seen as a special case and compounded by policy mistakes, Japan after 1989, has become general. The Economist’s Free Exchange column has run a couple of articles on this. Orthodox economists had simply assumed that the way out of economic doldrums was through conventional short-term policies, such as loose monetary or fiscal policy. Japan’s problem, a whole queue of people, such as Paul Krugman, said, was simply a matter of a “liquidity trap” – when interest rates become too low to reduce. By the time I was studying Economics at UCL in 2005-2008, this was literally in the textbooks. Mr Krugman suggested that the solution was to raise inflation expectations in what seemed to me, even then, as a case macroeconomics gone mad.

But even Mr Krugman now thinks something deeper is afoot. Larry Summers was the first orthodox economist to raise the alarm, and he gave the problem a name: “Secular Stagnation” – or rather he resurrected a theory of that name that had long been treated as a theoretical curiosity. The world economy is profoundly out of balance. This is because the amount people want to save is more than what people want to invest, causing aggregate demand to drain out of the system. This is an idea that Maynard Keynes made famous in the 1930s – but he assumed that such an imbalance was temporary, and specifically a feature of recessions. But what happens if the imbalance continues right through the cycle? We find that attempts to stimulate growth through monetary or fiscal policy run out of steam, and simply lead to asset price bubbles, as surplus money chases the same assets round in circles.

What is causing this imbalance? Unfortunately, notwithstanding the large number of brilliant minds devoted to economics, the massive computing firepower at their fingertips, and the size of what is at stake, there is practically no quantitative evidence. Indeed, macroeconomists actually know little about what is actually happening in the world behind the artificial creations of their aggregated statistics. Instead we have a series of speculations which people gravitate towards depending on political preferences. Here the main ones:

  1. Inequality – the popular explanation on the left, including Mr Krugman and Robert Reich. A greater share of income is going to a very wealthy minority, or is stuck in corporate balance sheets. This is saved rather than spent, contributing to a surplus of savings.
  2. Trade surpluses. China, Germany and (until recently) some oil states have been running up structural trade surpluses, which again creates surplus savings globally. This makes people like Mr Wolf hot under the collar.
  3. Excessive levels of private debt. This theory is favoured by heterodox economists like Steve Keen. Private borrowing as a ratio to income has been steadily rising and is at record levels. Bank balance sheets are clogged so they can’t lend to fund new investment. Meanwhile private individuals are spending too much on debt repayments and interest to spend on consumption.
  4. Modern businesses require less capital, reducing demand for investment. Microsoft and Google required no bank loans and little new capital to develop their businesses, unlike the industrial giants of old. This may be a function of technology, or simply “Baumol’s disease” – the fact that productivity improvements are tilted towards particular industries, whose weight diminishes as they become more efficient. Mr Summers seems to incline towards this explanation, while not dismissing the others.
  5. Demographics. The proportion of workers compared to retired people is diminishing in the developed world and some other countries, like China. This squeezes the supply side of the economy and hence investment.  It also undermines any benefits of productivity growth, the traditional engine of economic advance. This was clearly a factor in Japan, which led the trend.

Is this just a developed world problem? Surely, with so many countries still poor, there are opportunities to raise productivity, and hence global growth in poorer countries? The growth of developing East Asian economies, starting with Japan, and latterly dominated by China, has been an important component of recent world growth. And yet there are few signs than other developing economies can move much beyond exporting natural resources, while China is picking up some distinctly developed world issues. India may be an exception, but the jury is out there.

So what is the solution? That, of course depends on how important each of the above factors is. But there is a big question behind this. Most economists assume that economic growth is a natural state of being, and simply want to remove obstacles to future growth, by raising the level of investment, for example. Others feel that slowing growth is part of a bigger development cycle and something we had better get used to. I incline to this second view.

But the way forward surely does not lie in grand, sweeping policies based on a single, overarching theory. We have to tackle smaller problems as they arise, bearing in mind the overall sense of direction. With that in mind, I think these are the main areas to watch:

  • Private debt. You don’t have to subscribe to Mr Keen’s ideas to understand that growing levels of debt are part of the problem, whether symptom or cause.
  • Big business. These are accumulating too much power, and skewing the distribution of resources.
  • Asset values. In much of the world, excessive asset values, especially land values, are a sign of economic dysfunction. This is especially the case in Britain. This is not a simple matter of supply and demand – excessive debt is part of the problem.
  • Migration. This is one of the ways that economic pressures can be relieved. But as we know all too well, a host of problems follow in its wake.
  • Government debt. In the short to medium term, for most developed economies, high levels of government debt will be much easier to sustain than conventional wisdom suggests. And yet in the long term this could lead to economic breakdown, as is happening in some South American economies.  The left have a strong theoretical case in opposing austerity, but undermine it by opposing almost any reform designed to improve economic efficiency and promote sustainability.

It is also important to point out the dogs that won’t bark. These are things that economists bang on about which don’t matter so much in our “new normal”:

  • Free trade. Free trade is an important part of the current global system, and it won’t help to reverse it. But the rapid globalisation of supply chains which was such a feature of the last two decades, is going into reverse, as the East Asian economies mature. This is one reason why growth is slowing – but it is the reversal on a phenomenon that was always going to be temporary. Further liberalisation of trade poses challenging questions, as TTIP and TPP are demonstrating, and may simply benefit big business.
  • Inflation. It used to be thought that inflation was a matter of managing expectations by the central bank, and of paramount importance. This is still true in some less developed economies. But in those exposed to global trade this is an entirely unhelpful way of looking at things. More powerful forces are keeping prices stable and inflation is less and less an issue that central banks need to act on.
  • Interest rates. These are set to stay low for a long time yet. The betting is that the recent rise in the US will be just one of a long line of failed jail-breaks, started by the Bank of Japan in the 1990s.

We live in interesting times.





Osborne uses an accounting trick to implement People’s QE

When Jeremy Corbyn, was running his successful campaign for the leadership of Britain’s Labour Party, he floated the idea of “People’s QE”. “QE” stands for Quantitative Easing, the means by which central banks try to loosen monetary policy in an economy without reducing interest rates – handy when interest rates are near zero. It attracted quite a bit of attention from economists, much of it quite approving. That is because the idea touches on one of the most important aspects of modern economic policy: the suggestion that governments can sustain quite big deficits simply by “printing” money. In the end we find, not for the first time, that the current Conservative government acts much further to the political left than it talks, as did its Conservative-Liberal Democrat predecessor.

Back in the 1980s, when monetary policy first became the height of fashion, we had uncomplicated views about what it was about. Although most money was in bank accounts, economists painted a picture as though it was all in notes and coins, and the various actors behaved as if they were kids spending pocket money (and even then was probably too simplistic…). They talked of a “money supply”, which could be manipulated, and the size of which affected spending behaviour. We are older and wiser now, though many economists and journalists still talk about “printing money”, even though physical money has almost no role to play, and bank accounts are different in very important ways. Even trained economists who should know better sometimes trip themselves up in this way. For example there is much excited talk about how commercial banks create money rather than the central bank – which turns out to be a red herring on reflection [That link from Paul Krugman includes a broken link to a masterful essay from James Tobin in 1963, read it here]. It is better to look on monetary policy as a series of policy instruments under the control of the central bank, which have not entirely knowable effects on the economy at large.

The most important of these instruments is the short-term interest rate the central bank charges to commercial banks in their interactions with it. These ripple right through the economy. But when they are very low, as they are now in the UK, it is very hard to lower them further. Some European banks are using negative interest rates without the sky having fallen in, but these negative rates aren’t very high – fractions of a percentage point. So how to “loosen” policy – that is encourage a greater level of economic activity? Here the invention of QE comes in, pioneered, as so much of modern policy, by Japan in the 1990s and early 2000s. This is often talked of as if it means printing physical money and handing it out to the kids to spend on sweeties. What it actually means is that the central bank goes into the market and buys bonds, usually government bonds, like British gilts.

How does that help? Well the people who held the bonds now hold cash instead, which they should spend on something else – which might include new capital investment, after it has changed hands a few times. And it might reduce bond yields, which will reduce long term interest rates right across the economy, and increase asset prices. This creates a “wealth effect” that might encourage the mass affluent to spend a bit more money on stuff that people make. Or all that could happen is that there is a merry-go-round of money chasing various flavours of pre-existing asset to create an asset price bubble. It’s not very clear what has happened to the Bank of England’s QE over the years. The bank produces various statistical associations as evidence that it has helped stimulate the wider economy. Others are sceptical.

Which is where People’s QE comes in. What if, instead of buying government bonds in the market, the money went into extra government spending, such as infrastructure investment, or even current spending. Because the Bank controls the currency in the UK, it can fund the government’s deficit without the need to borrow money from investors. It borrows money from itself. This amounts to supporting looser fiscal policy (i.e. government tax and spend), which should provide a more predictable stimulus to the wider economy.

Mr Corbyn’s advisers developed the idea with the suggestion of administrative structures to channel the extra money into infrastructural investment. This puzzled some economists. There is no need for such engineering. All the government has to do is spend the money, increasing its deficit, issue bonds as normal, which the Bank of England then buys in the existing QE programme. If the Bank is buying bonds, the government is less beholden to the bond markets. In Japan, which has been practising QE on a massive scale, the government now issues little net debt to the bond markets, making large deficits sustainable.

But how does this work? Surely it is something for nothing? The answer to that is that it only works if there is slack in the economy, and the government steps in to create demand because businesses are investing less than the public is saving, creating an imbalance. If this is not the case, you can get inflation, which is what happened to Germany and Austria in the 1920s, Zimbabwe more recently, and is happening in Argentina now. Alternatively you get a asset price bubble. Which in the modern, globalised financial and trading system is in fact more likely for developed economies – though this seems to be a blind spot for many economists, who think that asset markets are too efficient for that.

But in the developed economies, including the US, the Eurozone and Japan, as well as the UK, there does seem to be scope to do this kind of stimulus. There is a lack of business investment, while, it appears, too much money ends up in the hands of rich people, who don’t spend it. Nobody knows how long-term this problem is, but it does look as if large government deficits are much easier to sustain than before. If the bond markets refuse to fund all of the deficit, then central banks can simply “print the money” as the popularisers would put it. Prominent British economist (Lord) Adair Turner (whom I am something of a fan of) suggested that this could be a long term policy in a recent book.

In Britain there is an accounting wrinkle which is having an important impact. The Bank buys government bonds, but it holds them rather than cancelling them, so that it can sell them should it want to tighten policy. So the government still pays interest on the gilts the Bank holds, and this used to count towards the publicly declared deficit. But the Coalition government changed the rules, so that it does not count the interest on the Bank’s holdings against the deficit. That reduces the fiscal deficit and allows the government to spend money on other things instead. Also the effects of QE on longer term gilt yields reduces the deficit projected by the Office for Budget Responsibility (OBR), which plays such a pivotal role in longer term government spending plans. According to the FT’s Chris Giles £22.4bn of the £27bn that the Chancellor, George Osborne, “found” to allow him to loosen austerity measures in the Autumn Statement resulted from these accounting tricks. This boils down to People’s QE, and Mr Osborne used it to fund his U-turn on tax credit cuts, amongst other things.

The problem, as Mr Giles points out, is what happens when the Bank feels the need to tighten policy in, say, a year or two’s time? Then the whole thing goes into reverse. Politicians have seen gain in blurring the distinction between fiscal and monetary policy. That could return to haunt them, at both ends of the political spectrum.