Secular stagnation: the curse that still haunts developed economies

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The financial crash of ten years ago was something of a paradox for conventional economists. It took most of them by surprise, and dented their reputation. And yet economists became more important than ever to the running of our world. But now, to listen to most of them, the equivocation is over. We’re back to normal, as the global economy looks in much better shape. This looks complacent.

The crash was a double shock to economists. The first was how it happened at all, when most economies seemed to be purring on at a relatively steady rate of growth (often referred to as the trend rate), which seemed to relate to growing productivity, and which most economists, driving through the rear-view mirror, assumed to be a law of nature. The second shock was that developed world economies, especially the British one, were so slow to recover. Economists  simply assumed that with a bit of stimulus, economies would not just return to trend growth, but make up for lost ground too. I don’t think any advanced economy has done this – and in Britain we lag far behind. In the years after the crash an expression was coined, or rather resurrected, to describe this second problem: secular stagnation.

The person whose name is most attached to this is Lawrence Summers, who had been prominent in the Clinton administration. By it he meant that economies could only achieve growth by extraordinary and unsustainable efforts to stimulate it. And, as Mr Summers recently pointed out in the FT, you cannot say that it has disappeared. Growth has returned, but the measures required to produce it are unsustainable. What he is referring to is the extraordinarily low interest rates prevailing in the developed world.

This has been going on for so long that we have become accustomed to it. But what do negative real interest rates mean? They mean that in order to use up available savings we have to create investments that have little or no financial return. Now that is at the margin, not on average, but even so it does not suggest an economy that is at all healthy. If investments don’t produce a return, productivity will not advance, and growth will not be sustained. And in particular we will accumulate debt that cannot be paid off. Or not without inflation which destroys the accumulated wealth of the middle classes. And sure enough, many economists are warning us about mounting debt levels. In due course this will lead to a financial crisis.

Why are we in this situation? And what can we do? There are many speculations as to why, and most commentators, including me, tend to gravitate towards the one that suits their overarching narrative. Many blame a skewed distribution of income for creating a surplus of savings that cannot be used properly. Others say that modern businesses don’t need so much traditional capital (Google doesn’t need to issue debt or share capital to keep its investments going). Then there is the gradual ageing of the population reducing the size of the workforce. Others blame the wrong sort of stimulus – if only government spending hadn’t been cut back (“austerity”), we’d have bounced back in no time. My favourite is the Baumol effect which suggests that we are in a transition towards industries, like healthcare, that are less financially productive, though still improve human wellbeing. Whatever it is (and it could be all at once) it’s a problem because it is dragging down the potential growth rate.

And what can we do? People often talk of unconventional policies, but what are they? The most interesting idea is  to run up bigger government budget deficits. Piling up government debt is much safer than piling up private debt, as we are doing now. Why? Because governments can finance that debt by a process that is usually referred to as creating money, and the burden can be shared more equitably.

But piling up debt and creating money often ends in tears. The best current example of that is Argentina, with rampant inflation and impatient foreign creditors. The problem for Argentina is that its monetary system has been mismanaged for so long that much borrowing, public and private, has to be in foreign currency, which the central bank cannot create. But there is an opposite example. Japan has been piling up public debt for decades, and the central bank has been buying up debt, with few apparent ill-effects.

So how do you know whether you are Japan or Argentina (and no doubt Argentina looked like Japan once)? The first, obvious, difference is that Argentina has had a current account deficit for some time, while Japan has generally been in surplus. That means that Argentina is importing more than it exports and requires financing by foreigners – who are less likely to be happy to take payment in domestic currency. Current account deficits usually flow from budget deficits – though not always, as the recent crisis in Spain showed. That would be a bad sign for countries like Britain that also have a current account deficit. But Britain’s standing in international markets looks a lot more like Japan’s than Argentina’s. The government has no trouble in borrowing in sterling, and the same goes for most British businesses.

So why are we in Britain so worried about budget deficits and debt? One explanation is that we have been persuaded into this view by malign political forces who use the analogy of household financial management to make their case. But there are deeper worries. The first is how do you tell when you have gone far enough with budget deficits and need to stop? The traditional economists’ answer is when inflation starts to take hold. But it might be too late by then, and anyway it is not so clear that in a modern, globalised economy inflation works in quite the way economists think. You know it is too latewhen there is a rush of people trying to change domestic currency into foreign, creating a panic and to people, including the government, having to borrow in foreign currency. That can happen without inflation.

The problem behind that is the politics of it. Opening up the possibility of more government spending is a huge boost to the power of central government politicians, who do not have strong incentives to apply the brakes when they need to – any more than those bankers did before the crash of 2008. It is too easy to believe your own hubris. I think this happened to the Labour government in the mid 2000s when the government should have started to tighten spending but decided not to. This didn’t cause the financial crisis, but made it harder than it should have been to manage. Even now, though, it is impossible to get anybody on the political left to accept that. It’s the one thing that unites Jeremy Corbyn with Tony Blair.

Still, we should be able to find ways increasing government borrowing that helps stimulate demand more sustainably. Building public housing is one idea. Other infrastructure policies should help (but not all of them). There’s also a case for taking a longer view on some public spending, like education , community policing, mental health services and public health that heads off future trouble. But not building more navy frigates or, even, hospitals. We might need these, but they need to be securely funded by current taxes. The trick politically is to create a system of checks and balances that lets you invest productively and not let central government managers run away unchecked.

Behind this lies an important but rarely acknowledged idea. It is that, in the 2010s and onwards, public investment is often more productive than private investment. And that, I think, is one of the causes of secular stagnation. So in the developed world we need more public investment, and that we can afford to borrow much more to pay for it than most people think. And we need less private investment, much of which is wasted on asset recycling schemes that will end in tears. It may well take another financial crisis before we start to realise this.

 

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Automation should not lead to a workless society. Bad economic management could.

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The current issue of Liberator, an anti-establishment house magazine for the Lib Dems, bemoans the lack of policy on the advance of automation and robotics:

If we are heading for a world in [which] relatively few people conventionally work – because machines can perform tasks better and cheaper – how will the non-working population be paid, and what will it be paid for?

Such thoughts are prevalent in chattering circles these days. On one occasion I expressed a little scepticism in a Facebook conversation, given that current employment rates have never been higher – and I was quickly shouted down for having my head in the sand. As it happens the Lib Dems are developing policy here, with a working group on the “21st Century Economy” in the advanced stages of deliberation, having already held a consultative session at Conference. But what should liberals be thinking?

The claims about automation and robotics are not all hype, though there is a fair bit of that too. Artificial Intelligence (AI), and its harnessing of “Big Data” is in the process of revolutionising many areas of work. This has proceeded faster than I personally expected, after AI had gone through decades of marginal progress combined with absurd hype. Many jobs  are now threatened, including vehicle drivers and many professional roles. Just how far this is going is very hard to say. Colossal resources are being ploughed in, and there have been some spectacular achievements, and yet few of the breathless boosters of the technology appear to have much idea of what intelligence actually is – they just project present progress into the future and assume that AI will catch up with humans. There is no magic in the human brain, after all, just cells, chemicals and electrical connections. My guess is that at some point AI will hit a point of diminishing returns, and progress will slow.

But not for a while yet. Meanwhile undoubtedly consume many jobs will be replaced there will be a lot of economic disruption. But are we heading to a near jobless society? Here I struggle. Quite a bit of progress has been made already, after all, and yet in many countries, Britain in particular, employment has never been higher. And not just that. We are constantly aware of jobs that need to be done that are being cut. This is a lot of what is behind the fuss about austerity. Not enough care workers, doctors, or police officers: the list goes on. And there are plenty of new fields of endeavour that are opening up: cancer treatments, mental health care, green energy and so on. So the jobless society looks like self-harm rather than an inevitability.

Indeed a conventional economist would say that there is nothing much to worry about. Similar things were being said in the 19th century, as new technology cut swathes through agriculture and textiles. That didn’t work out too badly in the end did it? As one industry becomes more efficient, it simply creates demand for others. I believe that a lot of this has been happening already. A lot of the new jobs are being created in low productivity sectors of the economy, meaning that overall economic growth is not advancing as much as many expected. That’s just the nature of the beast.

But that is too complacent. A closer examination of 19th Century economic development reveals a lot of human misery as workers were thrown out of modernising industries. It was not at all clear for many years that human wellbeing was being advanced. In any case economists tend to overlook the the specifics of how particular technologies affect the overall economy. The massive advances in working class and middle class welfare in many economies after 1945 until the 1970s is often attributed to good management of overall demand in the economy. And yet it had everything to do with the advance of light industry and office work, based on technological breakthroughs made in the war years, which were particularly good for the creation of medium-skilled jobs. We do have to look closely at the specific implications of technologies of the age, and adjust our economic management to ensure the best outcome for overall human wellbeing.

The post war boom was particularly happy on two fronts. It threw up a lot of new things that people wanted to buy, from cars to washing machines to cosmetics and new textiles. And producing them was intensive in mid-level jobs on the factory floor, distribution and administration. Further, other industries, like insurance, produced the same mix of things people wanted and lots of jobs. But modern technology is focusing on efficiency rather than labour intensive new products. A lot of it is about replacing labour with capital, without necessarily producing much more product or service.

But are what people are going to need more of? Overall we do not need to consume more things or eat more food, though in parts of our society that is clearly true. The technology sector itself will generate a lot of demand, in the development of new systems, and in teaching people how to make best use of them. A second obvious area is health and care. The health economy has huge potential to expand, especially here in Britain – it is much larger in the US, even when so much of the population is excluded from it by lack of insurance cover. And an ageing population will not only need more health services, but general care too. Automation and AI in health and care is also likely to generate more work, by opening up new treatments and by making diagnoses more available, faster than it destroys work by making things more efficient. That has been our consistent experience to date. And a third area of potential expansion is what is being called “experiences” – entertainment, travel, games and so on. This is mixed up a further wrinkle: a possible increase in leisure time. People may want to work fewer days and hours. This will both create work (depending on what they do in that leisure time) and reduce time available to work.

But there is an obvious problem with all this: money. And by money I do not mean limits to real resources, but the fact that if there is not an even distribution of spending power, too many people will not able to afford these things, while a minority will have more money than they can actually spend things that create work, rather than being part of a churning cycle of finance and property . That cycle of finance, incidentally will also create some jobs – but this looks more like part of the problem than the solution. The problem is that the jobs being created, in sectors with low productivity, are often too badly paid or insecure for people to buy enough services and things. This is the way things seem to be heading in too many developed societies.

Technological advance should be a good thing. It allows us to do more while consuming fewer of the world’s scarce resources. But s skewed distribution of income means that the changes to work patterns risk suffocating the economy rather than advancing wellbeing. That is one of the central challenges of our times.

 

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The Budget shows that the Tories are in a political cul-de-sac

I will break my self-imposed silence because yesterday’s British Budget is one of those great set-piece occasions which can be used as a moment of reflection. Predictably, most in the news media squander this in a silly game of speculation about the short-term prospects of political leaders. But the Budget poses more profound questions.

The government faces two profound economic problems, which it must either learn to live with or expend political capital to solve. These are low productivity and housing. There are other big problems, of course: Brexit, austerity, regional disparities and income inequalities, for example. But Brexit is more about means than ends; austerity is symptom of the productivity problem; and the other problems are not so high on political agenda right now, though they are important to both housing and productivity. Broadly speaking, the government is being forced to embrace the productivity problem, and is doing its best to confront aspects of the housing problem, without being able to do enough.

Let’s look at productivity first. This is about production and income per hour worked. Since unemployment is now low, and immigration is looking less attractive, increasing productivity is the key to raising incomes, and, above that in my view, to raising taxes. Weak tax revenues lie behind austerity – the cutting of public spending to levels which are now unsustainably low. The government is forced each year to spend extra money to fix some crisis or other brought about by austerity. This time it was Universal Credit and the NHS. Next year it will be police and prisons, after that it will be schools and student loans. And so it goes on – this is no way to build for the future. The government could try to raise taxes, but this is so politically unpopular that not even the Labour Party is talking about it – they persist in thinking that there is easy money to be raised from big business, rich people and confronting tax evasion. So growth it must be, and productivity must rise. But productivity is stuck in a rut. The big news for this Budget is that at long last the Office for Budget Responsibility has given up hoping that there will be a bounce back, and so reduced its forecasts of income growth, which are used to set tax and borrowing assumptions. The Chancellor, Philip Hammond, talked about fixing this, as all politicians do, but in practice has done very little about it. Labour, for all their huffing and puffing, are no better. Both parties propose a number of sensible small things, like increasing public investment and education, but nothing that gets to the heart of the issue.

So the political class have chosen to embrace slow productivity, by their actions if not their words. They are right, though they need to think through the consequences. My take on the productivity puzzle is different from pretty much everybody else I have read. I think that the primary cause is what economists call the Baumol Effect. The problem is not the failure of British businesses to embrace improvements, but the limited demand for goods and services that are susceptible to advances in productivity, such as manufacturing. There are things that can be done to raise such demand, but these mainly have to do with increasing incomes for those on low incomes – people with high incomes consume less as a proportion of income, and spend more on low-productivity items that confer status. Also if demand for exports could be raised, and imports diminished, that would help – international trade is mainly about high productivity goods. But nobody really has much idea how to deal with these problems beyond tinkering at the edges with minimum wage adjustments and such.

So what of housing? What, exactly, is this about? It is about high costs to both buy housing and to rent it. This is a very complex problem with deep roots. Most analysis is superficial, but this article in the FT by Jonathan Eley is a good one. Among a number of interesting points he makes is that the low number of new housing units being built in recent decades compared to earlier ones is a bit misleading. In those earlier decades a lot of housing was being destroyed: slums and temporary housing for victims of bombing in the war. It is not necessarily true to suggest that the problem is that too few houses are being built. In fact there are deep structural problems with the housing market. One is that private borrowing has been made too easy; another is that changes to housing benefit has subsidised demand for private rental accommodation. The result of this and a number of other things has forced up the price of land relative to the housing  built on it, and made trading in land central to economics of private sector developers.

The upshot of this is that it is hard to see any solution to the housing problem without a substantial intervention by the state to directly commission house building, and social housing in particular. Another issue is building on greenbelt land outside cities, which is now forcing suburbs to turn business premises into housing, and turning suburbs into an unhealthy housing monoculture. Caution on greenbelt building is warranted, of course, as suburban sprawl, as demonstrated in so many countries in the world, is not desirable either. Mr Hammond did practically nothing on either of these critical issues. He did try to tackle the housing problem, but mainly through the private sector and private markets which are structurally incapable of making things better for the growing proportion of the population weighed down by excessive housing costs.

That is entirely unsurprising. Solving the crisis, especially in an environment of low economic growth, means that current levels of house prices and rents have to fall. That is a direct attack on the sense of wellbeing of the Conservatives’ core constituency: older and better off voters. And if that isn’t enough, property developers and others with a vested interest in the current system are showering the Conservatives with money. A politically weak government is no shape to take this on.

And that, I think, is the most important political fact in modern Britain. Housing costs are not an intractable problem that we must learn to live with, like productivity. One day it will solve itself in an immense period of pain as land prices, and much of the financial system, collapses. The sooner it is tackled the less the pain will be. Labour may be useless on productivity, but they are much stronger on housing. They have a much better prospect of doing something useful. That does not mean they will win the next election – the forces of darkness on the right should not be underestimated. But it does mean that Labour is looking to be the lesser of two evils.

For my party, the Lib Dems, this is important. It means its stance of equidistance between Labour and the Tories needs to be modified. The turning point, in hindsight, should have been that moment in coalition with the Tories when the then Chancellor George Osborne said that he could not support the building of more council houses because that meant more Labour voters. The coalition should have been ended then and there. Just as in the 1990s when the Lib Dems leaned towards Labour, the party needs to accomplish the same feat now. It is much harder because Labour has abandoned the centre ground. But that is where the country is at.

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Household debt: the slowly developing crisis of capitalism

This week there is much debate on whether the Bank of England or the US Federal Reserve should raise interest rates from their current rock-bottom level. Behind this lies an important debate on the future of our economic system. A crisis, arising from high levels of household debt, is in the making.

Let’s set this in some sort of context. In the 1950s and 1960s levels of household borrowing (that is mortgages, car loans, consumer debt and such) were strictly managed, in a system designed to ensure financial stability as part of the global Bretton Woods system of managed exchange rates. This era is often viewed as something of a golden age by people on the left, as there was steady growth across all levels of income, and high levels of social mobility. There is a tendency to attribute this to the Keynesian consensus, of which the Bretton Woods system was a part. In fact it also had a lot to do with the explosion of  consumer goods industries which set in motion a virtuous circle of job creation and increased household consumption.

By the 1970s this system had broken down. The Bretton Woods system collapsed as the United States sought to finance the Vietnam war without raising taxes. We entered the world of floating exchange rates, which allowed much greater freedom for both public and private sectors to borrow money. Middle East tensions saw a spectacular rise in oil prices, which disrupted developed world industries. The consumer boom started to reach saturation, and growing productivity halted the job creation machine. Much heavy industry, such as coal-mining, and steel production, became obsolete, along with other job-rich industries like textiles. Keynesian economic management simply led to inflation while unemployment continued to rise.

Enter the neoliberal era, starting in the 1980s. Governments embraced the freer financial system. Consumer demand was now sustained by growing levels of household borrowing. Alongside this came an expansion of world trade. Developed countries bought growing amounts of goods from developing economies in Asia; the first wave were the “Asian Tigers”, especially South Korea and Taiwan; these were followed by the giants of China and India. This expanded trade reduced prices for consumer goods, and allowed a period of steady, if somewhat uneven, income growth in the developed economies. Slowly the developed economies reshaped themselves to a combination of highly productive high technology jobs, and a mass of low productivity service jobs, especially in healthcare. But the uneven nature of income growth, sustained by household borrowing was creating strains by the mid 2000s. In Britain household debt had increased from about 50% of national income in 1980 to 160% in 2007.

Then the great financial crisis struck in 2007, reaching its climax in 2009. This was only indirectly linked to high levels of household debt. The crisis mostly arose because the finance industry was allowed to grow in a very unstable way. This gave the illusion of growth, especially in Britain, in the years before 2007, only for the awful truth to be revealed when the government had to bail the system out. By and large, that source of instability has been fixed. But meanwhile globalisation as a source of growth for the developed world has run its course, while increasing productivity has become like running up a down escalator. Improvements in one area of the economy are most likely undermined by the creation of low productivity jobs in another, in a process economists call the Baumol effect. We are stuck in an era of low economic growth in the developed world.

Which is why some people are starting to worry about levels of household debt. Since the crisis household debt in Britain has been bumping along at about 140% of income, and it has been trending up in the last two years. But people’s capacity to repay debt is weakening. Back in the 1980s it was assumed that rising incomes would make debt more affordable. This is plainly not the case.

A further risk factor is that central bank interest rates are rock bottom. These interest rates are not the same as what is charged to real people and businesses (something we learned during the crisis, when the central bank cut interest rates, but most consumer interest rates went up). But it doesn’t look as if the interest rates people pay are going to get any lower, and so debt become more affordable. In the past central bankers could help alleviate crises by cutting interest rates, but now they have run out of road.

A third risk factor is asset prices: the price of property, shares and bonds. All three look high by objective measures, and so could fall. The process by which asset prices are set is complex and mysterious. But if assets are sold to unwind debt, then prices are liable to tumble.

Stagnant incomes; interest rates that can’t be cut; asset prices that look too high. This is a toxic brew. Some people hope that by raising interest rates gradually, we can slowly normalise the financial system, with overall levels of debt stabilising or even falling. Others fear that any rise in central bank rates will trigger a downward spiral.

But we need to understand that wider perspective. The neoliberal system has become unsustainable, and developed countries (especially the British and American ones that embraced it so wholeheartedly) need some fresh thinking.

One point should be clear, but still remains under-appreciated. Levels of private debt need to fall, and the safest route to doing so, without a disastrous collapse in demand, is for public debt to replace it. In other words we should not be so worried about budget deficits and national debt. However government spending needs to focused on things that will support the transition to something more stable, rather than just propping up structures that will be unsustainable in the long run. Ultimately national debt can be unsustainable too (though just when that point is reached is very much a matter of context; Japan has public debt of 200% of income without much sign of trouble). This is a national debate we badly need to have.

A second point also seems quite clear to me: asset prices must fall. This includes property, shares and bonds. This is required to correct some of the toxic inequalities of wealth. That will clearly create hardships and problems, but the government must stand ready to tackle these. Putting off the evil day will not help. That is why I think that central banks need to start the process of raising interest rates.

And a third point is that we need some serious policy ideas on how to tackle the issue of low pay for low-productivity jobs. It is no use hoping that productivity is going to resume the steady growth it saw in the later 20th Century. The forces that drove that – automation of manufacturing, and globalisation – are played out. In my view that means a much bigger role for the state in supporting society – but not by an unaccountable and out of touch central government.

These are radical changes. History teaches us that such radical change only comes from crises. There will be a new economic crisis. The only question is when, and whether our leaders will be intellectually prepared to manage its aftermath.

 

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Economists are failing to understand the 21st century economy

When is a fact not a fact? When it is an economic statistic. Economists use  statistics like GDP, productivity or inflation, as if they were facts. And because economists set the terms of public policy debate, the rest of the world follows them. But they are abstract artefacts, designed to help us see the facts, but which conceal as much as they reveal. There may have been a time when this didn’t matter much. That is certainly not the case now. We are missing something very important.

Economists like to accuse others of the fallacy of composition. That is the assumption that the finances of a nation work on the same principles as that of the households that make it up. For example, the budget constraints in a household work in an entirely different way to those for state finances – which doesn’t stop politicians lecturing us about the absence “money trees”. But economists are the world’s worst at a very similar fallacy: assuming that national level statistics represent the truth for individual households and businesses.

This is very striking with discussions about productivity, such as on this morning’s Radio 4 Today. This is newsworthy here in Britain. Growth in productivity grew at about 2% a year in Britain until 2008, during the financial crisis. It then stopped growing – creating what is often called the “productivity puzzle”. This is happening, to a lesser extent, in other developed countries too. It is the news now because the Office for Budget Responsibility has admitted that its assumption that productivity growth would revert to historical norms has failed to materialise for yet another year. That matters because it affects forecast tax revenues, around which the Chancellor of the Exchequer must base his annual budget, due next month. It is also the explanation offered for the fact that rates of pay seem to have stagnated for many Britons.

What is productivity? It is output per worker per period worked (typically a day or an hour). If you work in a ball-bearing factory it is relatively easy to understand what this actually means. You count the number of ball-bearings produced in a month, say; you count the number of hours worked in that month; you divide one by the other. Because of this simplicity it is easy to imagine the national economy made up entirely of ball-bearing factories or close equivalents, so that if productivity rises, it means that more ball bearings are being produced for the same number of hours. And most of the discussion about productivity uses something like this mental picture. Economist speculate about businesses using cheap labour as a substitute for upgrading capital equipment, for example. This is like the butler in Kazuo Ishiguro’s The Remains of the Day who immerses himself in his familiar daily duties so as not to confront the realities of the changing world around him.

To understand this, consider two groups of problems. The first type of problem is how do you actually measure output? The more you consider this, the harder it gets. Start with some obvious problems: what is the output of a squadron of jet fighters? Then how do you compare organic carrots with carrots grown on a farm pumped with environment-degrading chemicals? Or an iPhone 6 with an iPhone 8? Or is a loss-making factory with few people and overpriced robots really more efficient that a profitable one with lots of labourers and primitive machinery? Economic statisticians wrestle with such questions, but largely hidden from view. Economics undergraduates are barely troubled with such issues, and are quickly ushered on to the certainties of supply and demand curves and medium term fiscal policy. The result is a series of estimates and fixes, but not enough discussion about what they all add up to. Occasionally a conservative politician will pop up to suggest that lower-paid workers should be much happier because improvements in technology aren’t properly reflected in inflation. But that’s about it.

The second group of problems is conceptually somewhat easier: it is variations in the composition of the economy. Overall productivity may be improving not because individual businesses, or even industries, are becoming more efficient, but because industries with a higher measured productivity are taking a larger share. In fact it turns out that this was largely the case in Britain before 2008, with the expansion of banking and professional services. Just how productive these industries were in reality was thrown sharply into question in the following year, when banking threw up eye-watering levels of losses, from which government finances have never recovered.

These difficulties have been known about for a long time, and professional economists are more aware of them than the public whom they lecture. But they are shrugged off, with the assumption that it all comes out in the wash. Policymakers should be doing something about productivity, they say. This needs some serious challenge. And the consequences of that challenge are profound.

My first challenge is known as the Baumol effect, or more usually known, revealingly, as “Baumol’s cost disease”, as if it was something to be eradicated rather than an ordinary physical constraint. Suppose a legal firm adopts a highly efficient artificial intelligence system and makes most of its workers redundant. And then those workers take up jobs such as being personal trainers or producing craft pottery. All the positive productivity effects of the firm’s investment in AI is neutralised by the displaced workers moving into low-productivity jobs. Perhaps we are at state where most productivity improvements are being statistically neutralised in this way? After all, the more efficient an industry becomes, the fewer jobs in that industry there are overall.

Now let’s get into territory that mediocre economists really want to avoid: human alienation. One way of looking at productivity is that it advances by two alternative means: cutting wastage and cutting human content. By and large nobody will argue with cutting wastage. Vacuum cleaners have liberated home-keepers; time spent in queues is good for nobody; and so on. But cutting human content, and human contact, is distinctly two-sided. This is the world of standardised products, specialisation and automatic interfaces that may reduce costs but leave workers and users alike cut off from their fellow human beings, and being forced to conform to somebody else’s idea of what they should be. That is alienation, an idea first made famous by none other than Karl Marx in the Communist Manifesto – a document of startling insight. Alienation can be to the good overall, but it often isn’t. And there are bad signs all around us, from the obesity epidemic, the poor mental health of teenagers (especially girls), to the breakdown of community activities in our cities. Now, to back to my example of the legal firm, what if one of those displaced admin assistants finds life much more fulfilling as a personal trainer, even if the pay is miserable? A conventional economist would fret that surely it is better for her clients to download a demo video from You-Tube so that the trainer can work in a soulless call-centre? Well it would for those aggregated statistics, but not necessarily for the state of the human condition. In fact many economists suffer from acute double-think. On the one hand they praise markets and the wisdom of freely made choices of individuals over bureaucratic planners. And yet when those freely made choices go to more leisure, low productivity work and locally-sourced vegetables, they moan like mad.

But there is one sense in which those economists are right. Those aggregate statistics have one useful purpose: in planning taxes. Taxes are based on the money economy, which is the foundation of those statistical measures. If the stagnation of productivity is a fact of life, and actually represents a struggle against human alienation, then tax revenues are going to stagnate unless the rates increase. And since demand for tax funded services is liable to keep rising, we are going to have to think very hard how we order people’s relationship to the state. We are surely heading for an era of higher taxes. But how to design these taxes?

Instead we just get useless calls for action to raise productivity. Time to move on.

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Universal Basic Income is a problem dressed as a solution

Slowly but surely Universal Basic Income (UBI) is becoming a totem policy on the left. Longer standing readers of this blog will know that I am sceptic. But should I be reluctantly reconciling myself to the idea in some form?

Recent impetus for UBI has come from the US, where it is favoured by high tech businessmen worried about the implications of progressive automation. They worry that there is a great hollowing out going on, with mid-skilled jobs disappearing, and the workforce being divided between a very well paid elite of professionals and business owners, and a majority of low skilled proletariat in ill paid and insecure jobs. If the latter can have their income topped up by some form of UBI, then they will be able to afford a higher standard of living, and they will be less beholden to the elite. Many businessmen think that the latest advances in artificial intelligence are about to make the problem much worse – hence the need for such an intervention.

The left is worried by similar issues. The more thoughtful are concerned by a breakdown of consent for the welfare state, where state aid is doled out based on need. If everybody is entitled to the same level of state aid (with allowances for age and disability, perhaps), then there will be less resentment by the slightly better off members of the working class against those receiving aid. Since the left is generally bereft of ideas that are not simply reinventing the 1970s, this one is getting a lot of support. The Green Party in Britain has adopted it; many in Labour (and the Lib Dems) are sympathetic.

Various small-scale pilots are being set up in America and Europe. In fact something like it has been in operation in various places in the US for some time. Alaska pays all its citizens a dividend from its natural resources wealth (the Alaska Permanent Fund). The amount is modest and variable: since 2010 it has ranged from $878 to $2,072 a year – but it is popular. Meanwhile a number of Native American reserves pay a fixed income from gambling concessions. The social effects of this are not so benign, which is no doubt why so few UBI never mention them. The money does not make up for a lack of decent jobs and social infrastructure, and the money is spent on things that do not engender long-term well-being, though enriching unscrupulous salesmen.

One thing should be very clear from any but the most superficial analysis. If the level of UBI is to be set high enough to deal with basic human needs, so that it can replace the bulk of state benefits, then taxation will have to be unfeasibly high. So high that instead of fostering consent it is just as likely to breed resentment as the current system, and a massive drive by businesses and rich people to smuggle their profits abroad to evade payment. That is before recipients of UBI start complaining that the system is unfair because their circumstances (living in a high-cost area, educational needs, health problems, disabilities) create greater need. The idea that UBI can replace a whole series of benefits with a massively simplified system is for the birds. I also think such a system would lead to alienation which would exacerbate social ills. Alienation results unless people are engaged in genuine dialogue resulting in some form of contract; the idea behind UBI is to reduce the need for dialogue and contract.

If UBI-max – the replacement of most state benefits -is ruled out, what we are left with is  much more modest. It might replace the personal tax allowance and extend it to those who aren’t working, and re-badge the basic state pension, removing it from the contributory principle (something that the Coalition advanced in the UK in 2010 to 2015). This would effect a modest level of redistribution and ease life slightly for some groups of hard-pressed. No doubt it would mean higher taxes, though some benefits might be clipped to help pay for it. I’m not sure that this is worth it – and it is hardly very radical. The tax free allowance is only worth a couple of thousand pounds a year.

But there is another approach that is worth mentioning – suggested by the former Greek Finance Minister Yanis Varoufakis. This goes back to the Alaska Permanent Fund. The state acquires stakes in major businesses, and especially the big monopolistic businesses that are increasingly dominating our daily lives. A dividend would be distributed annually from the income generated by this fund. Over time this fund would grow and start to produce respectable sums.

Mr Varoufakis is a socialist; the idea of states taking over chunks of privately held capital will not bother him. Others might be nervous; the state has not proved to be an effective shareholder on the whole, the less so the more management is politicised. It might also create public acquiescence with monopoly profits, compared to more efficient models. But it is an intriguing idea. It does go to the heart of the problem – the excessive accumulation of capital in the hands of relatively few people, and its control by corporations that funnel disproportionate rewards to a few. It also starts to tackle another often-overlooked problem: how hard it is for people on modest incomes to accumulate savings without them being eaten up by transaction costs. This is why so many private sector pension plans are so ineffective, and why a state-funded basic pension is such a good idea.

How would the state fund its capital acquisitions? There are broadly three ways: appropriation, taxation or borrowing. Appropriation is simply tax by another name – maybe businesses could be forced to offer shares to the state instead of corporation tax; and by the same process a minimum distribution might also be forced. There a couple of problems with this, though. First of all it would confine the fund to domestic assets, when so much of the surplus capital is held by international businesses. Second, businesses come in all sorts of legal structures, some of which are more conducive to income distribution than others. Any attempt to appropriate shares could cause businesses to evade by changing legal structures.

But a sovereign wealth fund funded by taxation or borrowing gets around the need for direct appropriation. The problem is that it would take an awful lot of money before it reached a size that it could generate an income that the public would notice. Take the UK. One thousand pounds for 60 million people is £60 billion. At a 2% yield that is £3 trillion capital value – getting on for twice the level of the national debt. Even a New Monetarist might that feel state borrowing on this level carries risks. Of course the idea is that capital growth will help to fund this over time, and if built up slowly, it would be easier to accommodate – but cash distributions would also be tiny for a long time.

All this leaves me thinking that UBI is a symptom of the problem, and not the solution. The world is becoming too dominated by big institutions, such as companies like Google or governments and state agencies. These try to simplify processes in order to make them manageable – and this leads to excessive accumulation of power by elites, in government and business – and the alienation of the majority. UBI is just another simplified solution designed to fit this general pattern. It is advocated by people that support such one-size-fits-all approaches – be the monopolist businessmen or advocates of a mighty central state (such as socialists) .What we actually have to do is tackle those excessive concentrations of power. And that is much harder.

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Neoliberalism’s three blind spots and how we move on

In my last proper post I examined the idea of neoliberalism, a set of ideas that is at the heart of modern economic policy. I concluded by saying that most people think it has failed. But how can we move on?

The first point to make is that the two central insights of neoliberalism seem as valid as ever. The first is that markets provide the best way of processing information on complex human needs and how to meet them – and they do this far better than bureaucracy. The second is that governments and regulators are beset by dysfunctional incentives – and tend to serve the interests of elites and client groups, rather than the people as a whole.

This is the starting point for those that continue to defend the philosophy, though rarely by that name. They suggest that the problems that have arisen since the 1990s have much more to do with the advance of technology and globalisation than anything else. This is a rather pessimistic view. It suggests that society in the 1990s was faced with the choice of embracing technological change, with the benefits to health and wellbeing that resulted, or a futile attempt to keep change at bay for the sake of social stability. It is hard to think of any society that has successfully followed the latter path. The collapse of blue-collar and white-collar middle-income jobs was pretty much inevitable. And countries that seem to be more successful in embracing this change, like Germany, have done so by adopting policies that have undermined their global neighbours’ attempts to do the same thing. Germany preserves swathes of middle-ranking jobs only by exporting large quantities of manufactured goods to other countries compared to what it imports. By this pessimistic view, the world is being swept forward by technological change and governing elites are powerless to stop it. We may be alarmed at the political backlash, but any new leadership that this sweeps into power will most likely make things worse than better.

There is doubtless some truth to this. It is very striking how the political backlash seems bereft of new economic thinking. The right wants to create higher national boundaries and limit free trade between countries. This thinking recalls policies that deepened and prolonged the Great Depression in the 1930s. The left wants to expand state control. The Labour manifesto in Britain in the recent general election recalls to me the failed development policies in places like India in the 1950s and 1960s before a turn to neoliberalism unleashed massive growth. That isn’t entirely fair, of course, as both left and right also indulge in some new thinking. But it is really quite worrying that the only new idea on the left that has any currency is universal basic income – an idea that has no chance of meeting the huge expectations being placed on it.

But there are clear problems with neoliberal thinking. I think the three key blindspots are capital markets, Baumol’s disease and human organisational capacity. Add these together and you get pointers to what a post-neoliberal economic philosophy might look like.

First: capital markets. Hayek’s insights on the efficiency of markets does not to apply to assets, as distinct from goods and services. The market value of assets does not reflect their future economic worth. Bubbles build and burst, creating ruin in their wake. The problem is as old as the capital markets themselves – but that does not stop these markets from causing society’s resources from being allocated inefficiently. Another problem is that asset price inflation reinforces a gap between the haves and have-nots, and, in Britain, between the young and the old. Neoliberals (like the Economist newspaper) often say that the sky-high prices of land in popular cities simply reflect the laws of supply and demand, and that we should build more homes where people want to live. Whatever the truth of this, it is surely clear that excessive levels of personal debt are a large part of the problem – as well as the issue of human organisational capacity that I will come to. This causes the prices at which supply and demand balance to be much higher than they would be otherwise.

To cut a long story short, modern developed economies (especially the Anglo-Saxon ones) place far too much reliance on private debt, and this leads to instability and inequality. The risks associated with state debt, by comparison, look easier to manage. One leg of the neoliberal system of economic management, monetary policy, is broken.

The second issue is what economists call Baumol’s disease. This idea has been in circulation for decades, and is taught to economics undergraduates. It is amazing how little its implications seem to be understood. Baumol pointed out that as productive sectors of the economy develop in efficiency, the less productive sectors bulk up in proportion. Agriculture used to account for the bulk of the British economy; but as it became more efficient it eventually sunk to a small fraction of it. The same is now happening to manufacturing. As we become more efficient the bulk of jobs will be in sectors where high productivity is impossible or undesirable. And in the current situation they will increasingly be in sectors where market solutions have been found wanting. These include healthcare, education and law enforcement. These sectors are dominated by government and the public sector. We must expect the public sector to grow, and we must learn how to manage this, rather than trying to push the boundaries of the state back.

My third issue is what I have rather clumsily called human organisational capacity. The human brain can only handle a limited number of connections efficiently. And humans are at the centre of human organisations. Artificial intelligence won’t change that; it will simple extend the reach of what individual humans can do. This human capacity sets limits to the size and scope of human organisations. Organisations that grow eventually face a stark choice. They either become staggeringly inefficient, or their operating systems have to be very lean, requiring few people to operate them. Commercial organisations are forced into the latter category by competition. Dealing with a large corporation now, like Google, Amazon or PayPal is extremely frustrating for ordinary human beings, unless you manage to stick to the automated procedures that they prescribe – which are unable to handle any degree of complexity. Modern technology is allowing these commercial organisations to extend their reach by cherry-picking things that are simple to deal with, and leaving behind the difficult ones. This is creating a hollowing-out effect that is one of the big drivers of inequality.

Governments, meanwhile, are left to pick up the pieces. But they are subject to similar limitations. They have to choose between monstrous inefficiency or simplification. As tight finances force them into the latter course, power accretes to an elite in geographically concentrated centres of power. Neoliberals tend to shrug at this, and simply say that this is price we pay for a more efficient society. But I think it points in a different direction: to towards the decentralisation of political power, and the development of local democracy. One country has taken this idea further than any other: Switzerland. But if you go there you do not find grinding poverty as people are forced to choose between local control and drawing the benefits of modern society. You find one of the most prosperous societies in the world, with economic activity geographically spread out. One key thing to note: the Swiss have not just found ways to devolve political power to relatively small units, but they have also found ways to involve their citizens in taking responsibility for the society that they live in.

All this raises many, many questions. But the overall direction of travel is clear. We need to expand the scope of the public sphere (I am being careful not to use the word “state”), but also to shrink it geographically and allow people to take more ownership of it. Markets are useful, but we need democracy too.

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Vince Cable and economics – what he says in Newswire

No time for a proper post from me this week. But I was intrigued by an article in Mark Pack’s Newswire (a Lib Dem newsletter), with an extensive quote from Vince Cable.

This shows how hard he is to pin down into conventional categories of economic thinking. But that’s for the best possible reason – he has studied and thought about the issues for a long time, and observed economic policy in practice in many different situations.

Here it is:

The roots of Vince Cable’s political beliefs

Placing Vince Cable on the left-right political spectrum never quite works because he combines both a passion for intervention to deal with market failures with a suspicion of the failings of big government. The roots of that combination are well illustrated in his excellent memoirs, Free Radical. They highlight how his work on development issues in Africa helped give him both those passions – seeing both the need for action and the consequences of government failure. Writing here exclusively for Lib Dem Newswire, Vince Cable sets out the roots of his political views in more detail.

My earliest political views were a reaction to the extremes I encountered growing up. My father was an upwardly mobile, working class, Tory who sought to inculcate some good values (hard work, thrift, respect for the law) and some bad ones (racism, which split the family when I married an East African Asian, my late wife Olympia). He died after contracting pneumonia delivering leaflets for Mrs Thatcher in the snow. My mother secretly voted Liberal, defying his instructions to vote Tory.

My best teenage friend was a card-carrying Communist like his father, a shop steward at York carriage works. His revolutionary zeal got him expelled from college, allegedly for arson. He tried to re-educate me in sound ideological principles but concluded that I was a ‘bourgeois liberal’ with Menshevik tendencies.

When I went to university I sampled both the Liberals, becoming their President, and also a student branch of the social democratic wing of the Labour party. Sensing that they were saying the same thing but using different language, I tried to achieve a merger. Both sides were outraged and the merger collapsed ignominiously, 20 years ahead of its time. I joined Labour, beguiled by Harold Wilson’s white-hot technological revolution.

As a young economist, educated by the disciples of Keynes, I was then exposed to real world economics as a Treasury official in Kenya. Experience of African development quickly taught me that textbook ideas of ‘planning’ – or Keynes for that matter – had little relevance. The state was usually a vehicle for predation and patronage. Wealth was created by farmers, especially by entrepreneurial African small-holders; by mainly Asian businessmen; and by professionally run multinationals. And then looted by politicians and civil servants

I moved on to Latin America where the fashionable nationalistic ideology of ‘self-reliance’ merely entrenched vested interests and reinforced extreme and often appalling inequalities. Much of my development writing would now be described as ‘neo-liberal’ but I think is right in that context.

The country which most influenced my thinking was India which I have visited many times over 50 years for family and professional reasons. I have seen India’s remarkable transformation, much of it based on the adage that ‘the economy grows at night, when the government goes to sleep’. I have always been torn between torn between my admiration for India’s democratic and dynamic ‘anarchy that works’ and my admiration for the technocratic revolution in modern China which has produced an economic, poverty reducing, miracle, albeit seriously illiberal.

Between the travelling I got involved in British politics and became a Labour councillor, helping to run Glasgow. The establishment was pure Tammany Hall, so I moved to the Left where the idealistic and capable people were. I marched proudly down Sauchiehall Street alongside the charismatic Communist leader of the shipyard workers, Jimmy Reid and Tony Benn, and contributed to Gordon Brown’s Red Papers on Scotland.

I led a somewhat schizophrenic existence teaching students Adam Smith’s economics in the morning and practising municipal socialism in the afternoon. I found a more comfortable place campaigning for Britain to join the EU alongside Labour figures like John Smith, for whom I later worked as a Special Adviser, and Liberals like David Steel.

My Fabian, centre-left, eclectic, version of social democracy didn’t long survive a move to London where the Militant Tendency and assorted Trots, including today’s leadership, were in control of the Labour Party. In the civil war which followed, I joined the SDP, albeit after some heart-searching, unsuccessfully contesting my home town of York in the 1983, and then the dispiriting 1987, election.

In the long period in the political wilderness before becoming MP in Twickenham I had two other formative political experiences. One was spending several years working on global environmental issues in the late 1980’s: helping to write the Brundtland Report on Sustainable Development and then one of the first intergovernmental reports on climate change. The other was when Shell recruited me into their long-term scenario planning team, later to be Chief Economist. I found the management culture admirably professional and honest, albeit conservative, and I like to think I helped to steer them towards a future in emerging economies and to a greater sense of social and environmental responsibility.

For the rest, my record as a Lib Dem MP after 1997 is reasonably well known. As an economic spokesman, my approach initially reflected the social liberal consensus of the time. The financial crisis changed everything. My intellectually eclectic background in economics helped me to see ahead and better understand the nature of the crisis, to write coherently about it – in The Storm – and to advocate correct but controversial measures like nationalisation of the banks and the taxation of property wealth.

The Coalition was a classic head-heart dilemma. My head told me that joining the Coalition was right and that we had no alternative but to address the massive budget deficit which was the legacy of a crisis of financial capitalism. My heart was definitely not with the Tories. But I found a useful role as an interventionist Business Secretary promoting industrial strategy and state-led banking, German-style innovation and training policies and applying a pragmatic, problem solving, approach to government. In a sequel to The Storm After the Storm – I set out where I think we should be going as a country, now, in terms of economic policy.

There is one more important strand in my approach to politics. I have long been interested in, and worried about, the politics of identity. Bringing up a multiracial family and fighting racism; experience of the tangled web of religious sectarianism and incipient nationalism in the west of Scotland; immersed for over 50 years in the movement to anchor Britain in Europe: these have been major, often dominant, concerns. I wrote the first of two pamphlets for Demos in the mid-1990’s on identity politics and have seen its growing influence, culminating in the Brexit vote.

My first venture into fiction, the novel Open Arms – due out in a few weeks – involves the interplay of identity politics and personal relationships. And in the real world, I anticipate that the future of the UK and our party will be determined by whether national identity or a broader, more outward-looking, more European, view of the world dominate politics.

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The rise and fall of neoliberalsim

The left loves to frame politics in terms of abstract nouns. And as is the human way, they are happier talking about what they are against rather than what they are for. Two abstract nouns in particular are top of the left’s hate list: “austerity” and “neoliberalism”. For the left’s challengers, it is usually best ignore this war on the abstract. It convinces few, after all – the left is much more effective when it campaigns on the concrete: food banks and bedroom tax, for example. Yet abstract ideas have their place, and it is worth exploring them more deeply sometimes. Austerity I will leave for now; I want to look a little more deeply at neoliberalism.

To most on the left “neoliberalism” is a scattergun term to brand all right and centre economic thinking that prevailed from the 1980s, after the collapse in confidence in the system known as “Keynesianism”, though Maynard Keynes would have disapproved of much of it. But if we are to understand what was actually going on we need to distinguish it from neoclassical economics, which was an important strand of thinking in this period. As its name suggests, neoclassical thinking harks back to classical economics, that evolved in the late 19th and early 20th century, before Maynard Keynes revolutionised economic thinking. This saw economies as self-correcting systems that did not need state interventions. At any point an economy is in an equilibrium, and any attempt to shift it would be self-defeating. Attempts to kick against this system would simply lead to such ills as inflation and unemployment.

Keynesianism fell out of favour in the stagflation of the 1970s, following the collapse of the Bretton Woods system of managed exchange rates and the an explosion in the price of oil.  Some economists used this to go back to classical ideas, saying that Keynesianism was a big mistake. In America these economists were often based in Chicago and the Midwest – and were known as “freshwater” economists in contrast to the “saltwater” sort on the American east and west coasts. They turned to the idea of “real business cycles”, which proposes that the fluctuations from boom to recession  are driven by changes to the “real” economy in equilibrium – and not a process of disequilibrium, as Keynes had suggested. So, for example, in pre-industrial societies the cycle might reflect the effect of weather and plague. In the modern age economists call this changes to technology. The true heroes of a neoclassical economy are the entrepreneurs who advance the productivity that make us all wealthier – the American author Ayn Rand was something of a hero. The state and taxes were loathed.

In spite of some rather superficial empirical studies which provided some evidence to support it, real business cycle theory is almost self-evident nonsense. Modern economies are almost never in equilibrium; state interventions are frequently helpful. Neoclassicism kept going because it was politically convenient to a certain class of wealthy American, who funded supportive institutions – and it was, and remains, politically influential amongst US Republicans. It lost all credibility to everybody else in the aftermath of the financial crash of 2008-2009, when the neoclassicists had nothing helpful to say. It was also clear by then that their advice in such places as Russia (post the fall of communism) and Iraq (post the US invasion) had been disastrous – they had advised the Republican US government to stand back and let things take their course – it was the economic wing of neoconservatism. Still, almost no idea is completely without merit. Technology has important implications for the workings of macroeconomics, and yet it is almost universally ignored by macroeconomists, who think that the economy worked much the same way in 1900, 1950 and 2000, and that all changes are explained by decisions in fiscal and monetary policy. In fact if you want to understand why Keynesianism worked so well in the 1950s and so badly in the 1970s, technology provides the most convincing explanation.

So, what is neoliberalism? It is an altogether more subtle economic analysis that sought to built on the insights of Maynard Keynes rather than throw them out. Indeed their ideas evolved into something referred to as “neokeynesianism”. At its heart are two ideas. First is that markets function as processors of information, and are the most efficient way that information about supply and demand can communicate and coordinate in our highly complex society. This is an idea developed by the Austrian economist (and sparring partner of Keynes) Friedrich Hayek, and who is the patron saint of neoliberalism (and much more pragmatic than his leftist critics pain him – he formed a common front with Keynes during the war). The second is that the incentives of people who manage institutions that are not subject to market forces, such as regulators and governments,  are generally not aligned to the public good. These insights lead to the conclusion that even well intentioned state interventions often do more harm than good – and that it is best to try and design such interventions so that they work closely with market forces, aligning incentives and making better use of information.

Neoliberals sought to repair the tattered state of the Keynesian conventional wisdom with the idea of “equilibrium unemployment” – a state of the economy at which any increase in demand would simply lead to inflation – with the insight that the level of this equilibrium could be much higher than what was conventionally regarded as full employment. It depended on the state of labour markets and technology – best addressed through “supply-side” policies, which often meant deregulation. In the 1970s, they said, the trouble arose from over-managed labour markets (the effect on trade unions in particular) and technological disruption (especially the relative rise of energy prices) that rendered much of the industrial economy obsolete.

In terms of economic management, neoliberals liked free capital markets, including floating exchange rates (in contrast to Keynes’s preference for managed international capital flows, exemplified by the Bretton Woods system). They disliked the use of fiscal policy (i.e. the deliberate management of government budgets to regulate deficiencies in demand), as it was rendered useless by misaligned incentives – there would be a tendency to let booms run too long. They did like the idea of “automatic stabilisers”, being tax and benefit policies that tended to increase or reduce demand according to the state of the business cycle – and as such accepted a large state sector – unlike the neoclassicists. Instead they preferred to regulate demand through government intervention in interest rates, delegated to arms-length central banks (an idea which neoclassicists hated, incidentally – they want to leave interest rates to the market).  Like their Keynesian predecessors, they thought that inflation was the critical sign of whether or not supply and demand in an economy were in balance – though they developed the idea that inflation could be built on expectations, as well as simply mis-matched supply and demand (i.e. if people expected inflation to be high, they would demand extra wages, turning this into a self-fulfilling prophecy). For all their scepticism of government, they still saw it as playing  a central role in the management of the economy – and searched for optimal levels and designs of intervention.

Neo-liberalism became the conventional economic wisdom in the 1990s, all the way through to the great financial crash. This period saw an unprecedented advance in living standards across our globe. So why do most people think it has failed? Because the picture in developed economies in that period is much more mixed. In the US in particular, the economic gains have been concentrated amongst the wealthy, with large companies amassing unprecedented levels of profit. The destruction of many industries through technological obsolescence and globalisation left a huge legacy in ruined lives and failing local communities. And finally there was the crash itself, which most neoliberals had failed to see coming and to head off – and whose fall-out they proved ill-equipped to deal with.

And yet. The main advance in human well-being in the neoliberal ascendancy came in the developing world – and the adoption of neoliberal insights was clearly responsible for this – in China, India, and many other countries. And the failure of attempts to defy neoliberalism, in France under Francois Hollande and, more dramatically, by the Kirchners in Argentina, has led to local revivals of neoliberal ideas. Something has clearly gone wrong, but is the whole system really rubbish?

I will examine that question in a future post.

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The real questions behind the politics of tax and spend

Warning: this is a longer read for those interested in achieving a deeper understanding of political choices, especially here in Britain. I write it to release some my internal tensions after a tough few weeks helping to organise my party’s general election campaign, while tackling questions posed by tightening school budgets.

The politics of tax and spend is close to the heart of Britain’s general election campaign. And yet the quality of economic commentary is very shallow. Here is my attempt at something deeper.

Running government finances is not like running a household budget. The primary constraint on a household budget is money, which can be treated as a fixed resource, and can be stored for use at a future date (so long as inflation is not a major factor). But looking at an economy as a whole, money is just an economic tool, a means to an end. Hoarding it is pointless. Money is tactics, not strategy.

So to look at matters strategically we need to take money out of the picture, and ask what it is that we are trying to achieve. A higher level of public services? More private consumption? More investment for the future? All of these things are constrained by real resources. By which we mainly mean people. If we want to increase the level of consumption or investment, more people need to be put to work, or the same number of people need to work harder or more productively. The latter may also be a function of capital assets, but capital assets are created by people working in earlier periods and forgoing consumption.

So, if you want to expand public services, the question arises as to where the extra resources are to come from. If you are hiring 10,000 extra policemen, those individuals may be doing nothing now, in which case the economy as whole expands costlessly. Or they may be doing important jobs elsewhere, in which case the recruitment will potentially reduce the production levels of their previous employers. And what if you simply raise the level of pay for the same work? Or increase the level of a cash benefit. That is a way of raising the levels of consumption for those targeted individuals. Who is to produce those extra things they are to consume?

And so we come to a central question of fact, which is discussed surprising little. The left claim that there is plenty of spare capacity in the economy, so if we expand the consumption of the disadvantaged, or the reach of public services, the economy as a whole will respond by utilising those spare resources, and nobody is disadvantaged. This idea goes by the term “Keynesianism”. It is more likely to be true in a recession than at the height of a boom. The right thinks that spare capacity is not so easily manipulated, and such expansion will usually come at the cost of private consumption, whether that is intended or not. And in Britain, when employment is at record levels, and we are still net importers of goods, this is not so easily dismissed. Some on the left counter with the hope that any reduced consumption will be by the rich, of luxury goods.

But many more thoughtful observers think that there is still spare capacity in the economy. They point to low levels of pay and productivity in many places. If there was more pressure from the demand side of the economy, then private sector produces might sharpen up and become more productive. And if the extra public resources were directed well, into investment, then that will help expand future capacity too. The likelihood of these outcomes depends a lot on the tactics.

But before considering the tactics – the details of taxation and monetary policy – we need to reflect that modern, developed economies are quite open. We can import resources from abroad. And we can import workers. For certain advantaged economies, like the USA, a high level of net imports is completely sustainable. And there are economies out there (Germany, for example) that are happy to be net exporters, for their own tactical reasons. But for others a prolonged period of net imports, especially if not used to create productive assets, can lead to a financial crisis and the seizing up of the economy. Where the UK stands between these two poles really is unclear; the country has been a net importer for most of recent history, and financially stable for most of that period too. But there will be a level of net imports that is unsustainable; and a financial crisis can take many years to build, as we found in 2008.

It is worth touching on the issue of immigration. What if the extra workers needed for expanded public services could themselves be imported, either directly or to substitute for home recruits?  These workers will create demands of their own, but it is one way of squaring the circle. Indeed in the mid noughties, when the Labour government undertook a significant expansion of the public sector, this was one of the ways they were able to sustain it, using workers from the new entrants to the EU from central and eastern Europe. That Labour leaders are now saying that this influx was a serious mistake is a piece of hypocrisy; they love to take credit for the expansion of public resources at the same time.

It is worth trying to establish these basic rules on strategy – but it is not hard to see the strategy that public leaders converge on, from left and right. It is to expand public services and benefits (such as pensions and hardship relief) while taking up slack in the country’s productive capacity, or expanding that capacity through higher productivity.  And so we turn to the tactics. If the tactics of expanding the public sector go wrong, there is a more or less disorderly reduction in the levels of consumption by the general public in order to make room.

We need to understand what we mean by this. In the conventional view of economists this about one thing above all: inflation. Most economists like the idea of a little bit of inflation (I don’t agree, but because I think inflation erodes trust in public institutions rather than its effect on short-term incentives, the obsession of most economists). But inflation can quickly become unhealthy, so that an increasing amount of effort is placed in managing money rather than valuable production, and it clogs the process of exchange, which is the foundation of a healthy economy. Inflation occurs when demand outstrips supply. Its effect in this context is either to undermine the attempt to expand the public sector, by eroding real wages or the real value of the benefits, or by reducing public consumption as real incomes are reduced. The so-called neo-Keynesian consensus of the 1990s and early 2000s built an entire edifice on this idea – using a targeted rate of inflation as the primary way of determining whether an economy was in balance. The idea still stalks the conventional wisdom.

But that was dealing with yesterday’s problem. Neo-Keynesianism was built in response to the 1970s phenomenon of stagflation, when the old-fashioned “Keynesian” model broke down (quotation marks because though Maynard Keynes’s fingerprints are on this old conventional wisdom, such a flexible mind would surely have moved on as the facts changed). But what emerged in the 1980s and 1990s was different. It was changed by two things – a shift in the balance of power in the political economy towards employers, and away from employees and unions; and the process of globalisation. Globalisation, we must understand, is a combination of more advanced production and communication technologies, and the opening up of new Asian economies into the global trading system, starting with Japan and moving by way of South Korea and Taiwan to the giants of India and China. This has broken down the previous relationships between demand, supply and price.

First, it has broken the link between prices and pay. It used to be easy to identify a single rate of inflation that, give or take, would apply to both prices and wages. At first this seemed to work in workers’ favour. Cheap imports from Asia held price inflation in check, but workers’ pay kept ahead. But since the crash in 2008 this has flipped. Rises in prices (often from those same Asian imports) are not reflected in pay levels. It makes no sense to talk of a single level of inflation, and to use consumer price inflation as a lone yardstick of economic health. And the second change is that other ways that excess demand can be satisfied have been made easier. It is easier to import goods and services either directly, by buying from foreign firms, or indirectly by domestic firms outsourcing production. We are still trying to understand what the impacts of these changes are. But excess demand is likely to lead to two things: fat profits by businesses as they are able to increase their prices while holding wages down, and an increasing trade deficit. It is also means that the risks of excessive inflation are much lower, as it quickly feeds into lower real incomes and dampening demand.

At this point we need to think about money. This, too, has changed dramatically, as technology has moved us away from physical currency to a much more flexible system of paying for things. The idea of “money supply” as being a physical thing that needs managing as such is increasingly old-hat – another nail in the coffin of neo-Keynesianism. Instead, policymakers need to think about interest rates, exchange rates and controls of the physical transfer of capital (in this case money balances not required for consumption) within economies (banking controls) and between them (exchange controls). If this goes wrong, people lose confidence in the means of exchange, and the economy rapidly melts down – as we can see happening now in Venezuela. This is what spooked so many governments in 2008 and 2009 when they launched into a series of panicky bail-outs of banks.

And so in this brief overview (that is already much longer than my usual posts) we at last come to where most of the political conversation starts: taxation and public debt. Looked at through the eyes of an economist (money is not a thing in itself, remember) the main purpose of tax is the regulate demand so that we have an orderly economy. Not enough tax, and the financial system becomes unstable, with or without inflation. Too much tax and it is a self-inflicted wound – living standards are lower than they need to be. Tax has other important functions too, of course. It is a means of wealth redistribution (and too skewed a distribution of wealth leads to a poorly functioning economy), and managing incentives. Whether an economy needs more or less tax at any given point depends on a wide variety of factors, of which the size of public spending is only one. This has led to a lot of tension between economists and politicians, especially in the austerity years from 2010. Politicians insist on talking as if public accounts were like household accounts; economists (or many of them) say this is self-harm. Actually a lot of the  argument is at cross purposes. What the politicians do, and what they said were different things. Oddly enough, I suspect that politicians were in fact thinking long term, and trying to rebalance the economy, while economists were obsessing about the moment – a reversal of the usual characterisation.

And what of public debt? This again is not all it seems. Many governments, including the US, the UK and most spectacularly, Japan, have asked their central banks to quietly buy up government debt. This acts to in effect cancel it. The world has not ended, as some conservative commentators have suggested it would. What is going on? The central bankers are reacting to an unbalanced financial system. For one reason or another there is too much hoarding of money, by business organisations and rich individuals. This hoarding is sucking demand out of the economy. And it is also creating excess demand for short-term financial instruments. Governments are taking advantage of this by satisfying this excess demand by buying back longer term debt. They hope that in the process they will restore some of the lost demand by encouraging more genuine capital investment, as opposed to a continuing financial merry-go-round. There is little evidence for this working, though.

This makes it an extremely easy time for governments to finance budget deficits and investment – at least tactically. And that is why calls for more public investment at a time of high national debt only outrages conservative politicians and their allies. But the strategic question remains. As real resources are mobilised towards these ends, what will the impact be? There may indeed be spare capacity to be utilised, but that actually be what happens?

To me the key point to arise from this is that managing public finances is a matter of competence and discipline. The left may well be right that in the short term that we can expand the public sector with few real risks, even without raising taxes by much. But that could turn bad very quickly. Do they have the competence to appreciate when that moment arrives, and the discipline to act?

This is where the Labour government of the mid-noughties fell down. They expanded the public sector, while holding, or even cutting, taxes on mainstream income and consumption (as opposed to capital transactions). They secured growth with low inflation (those cheap Asian imports helped a lot), but not based on genuine productivity (supposed advances in productivity were in sectors such as finance where it turned out to be chimerical). Rapid immigration helped sustain this, but it created tensions, especially in working class communities. And they failed to grasp that the extent of the financial boom, which generated a lot of short-term tax revenue, was creating systemic risk. As a result the financial crisis was a rout for the UK, unlike the relative calm of better-managed economies such as Canada or even France.

And yet there is no sign that either wing of the Labour Party has learnt from this. They want to stoke up demand but have no understanding of when enough will be enough. The Conservatives have many faults (and their idea of eliminating the budget deficit is plain nutty), but to my mind they show a greater grasp of the strategic risks, and the need for discipline and competence (as do my own Liberal Democrats, come to that – indeed Vince Cable showed more awareness of the dangers in the mid-noughties than any other leading politician).

But quite apart from party differences, I feel that there is a deeper need to reform the process of governance so that these risks are managed more securely. There is a slo a need to reform the workings of the economy so that extra demand for goods and services does not simply end up in fat profits and foreign jobs. Alas there is little talk from any of the parties of how this is to be done.

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