Why Paul Krugman is wrong

In today’s FT the economists Paul Krugman and Richard Layard (of the LSE, famous for his work on the economics of happiness) publish an article A manifesto for economic sense calling for looser fiscal policy around the world.  Being in the FT it’s behind a paywall (though I have shared the article on Facebook).  But the simplicity and clarity of their argument make it a particularly good pace to discuss the difficult issues of economic policy as the economic crisis rumbles on.

Back in 2005 I was contemplating taking an Economics degree, with little formal background in the subject.  I asked a tutor at the university (UCL) on their advice for background reading and he said “Anything by Paul Krugman”.  The Professor at Princeton, who subsequently won the Nobel Prize, was famous for the clarity of his writing on economics.  I also discovered, as I devoured anything by him I could find, that he was not a shrinking violet on the subject of US politics – passionately attacking the Republican regime of George Bush.  Now he is a crusader against “austerity” – the focus of governments on healthy finances even as recession stalks the world.  He recently visited London, and appeared on Newsnight.  I didn’t see him, but I am told he made mincemeat of his opponents – and I’m not surprised.

As I took my degree at UCL I read more of Professor Krugman’s work, now in academic papers and discussions, rather than the more accessible stuff I read read before.  The clarity remained – but he came over as a bit wild.  I remember in particular one discussion where he became obsessed with the idea that Japan needed to stoke up inflation to get its economy out of the doldrums.  His wild suggestions for doing so seemed to leave his fellow economists quite exasperated.  Ever since I have viewed his opinions as entertaining, but liable to be impractical, and in the end very unhelpful.  So it is this time.

The article (not very long) starts its main line of argument by talking about the causes of the crisis:

The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – such as Greece – this is false. Instead, the conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.

I think it is highly significant that the authors throw this in so early.  It implies, without actually saying so, that pre-crisis government expenditure in most developed economies was perfectly sustainable, if that pesky crisis hadn’t caused a dip in tax revenues.  It is perfectly true that government debt was not a major problem before the crisis, which was caused by excessive private sector debt.  The trouble is that the boom years gave us false expectations as to what the sustainable levels of tax revenues were.  A large part of the dip is permanent, not temporary.  So substantial cuts will have to be made at some point to bring government debt under control.  It isn’t just a question of waiting for the economy to bounce back (in the UK, US and southern Europe, anyway).

The authors then point out that the crisis is caused by a collapse in private demand – and that it makes sense to make up the shortfall in demand by extra government expenditure until private sector confidence returns.  A failure to act means that unemployment becomes endemic and difficult to put right later.  They point out that monetary policy cannot take up the strain.  They say that there must be a medium term plan to bring government deficits under control – but that it must not be front-loaded.  I have no disagreement with any of this.  Quite a few people think that looser monetary policy would help – but I agree with the authors on this (which I will say more on in a future post).

Where I differ is that I think what they suggest is exactly what governments are now doing, in the UK and US anyway.  In nominal terms government expenditure has not been cut.  The private sector is slowly taking up the slack.  Governments may be talking austerity, to prepare the ground for the real cuts that are absolutely necessary in the medium term, but they are not practising what they preach.

The article concludes by trying to debunk two typical counterarguments to further stimulus.  First is that financial markets would lose confidence and refuse to keep funding government debt.  They point out that there is no sign of this in the UK or the US, where government bonds are at record low yields.  They also say that there is no actual evidence that budget cuts can generate growth.  On the contrary, they suggest (though don’t quite spell out) that looser fiscal policy will help restore confidence and get the private sector moving again, which would allow the deficits to be brought under control.  The trouble, of course, with using past evidence to prove a point is that the current situation is unprecedented.  And the global financial markets are quite unstable; who is to say that UK and US bond markets aren’t in their very own bubble that could burst very suddenly.  The absolute levels of deficit, and, increasingly, overall debt are becoming so alarming that anything is possible.  And what if the private sector remained sceptical in face of government stimulus?

Finally they tackle the argument that stimulus cannot work because there are structural constraints.  In other words, the pre crisis economy was so unbalanced that there is in fact little spare capacity – so that a stimulus would run into trouble very quickly, leading to inflation or a currency crisis.  If this were so, they say, we would see more parts of the economy at full strength.  Here there may be a difference between the UK and the US.  In the UK there are indeed a few signs of trouble.  Inflation has been much more persistent than predicted, though admittedly not through wage rises.  Export businesses complain of a lack of suitably skilled staff.

Straws in the wind perhaps.  But the pre-crisis economy clearly was unbalanced, especially in the UK.  Public service employment was clearly too high, and cannot be afforded at its current strength on any realistic level of taxation.  Also too much of the economy is spent taking care of ultra-rich bankers and foreign exiles – whose numbers and wealth we cannot or should not expect to grow.  And we still need to adapt to a lower energy economy.  I can’t prove that the authors are wrong – but there is enough reason for caution.

The authors make much of not repeating the mistakes of the 1930s.  But that was a very different world for two important, and related, reasons.  First there was a ready solution at hand: the expansion of manufacturing industry with an abundance of good low skilled jobs.  It took the war to unlock this, with the manufacture of armaments and transport, but war production could be converted to civilian use with surprising ease – as there was massive untapped demand for cars, fridges and other manufactured goods.  Second we were much poorer then.  Starvation was a real problem for the unemployed and poor, and the destruction of wellbeing flowing from depression was horrific.  Now we define poverty as lack of access to television and mobile phones.  The hardship is much less – and there is less untapped demand.  Technology has put paid to the number and quality of unskilled jobs.

That bespeaks caution – something that the manifesto economic sense disregards.  There is a case for some sensible investment projects – including the right sort of housing in the UK. But temporary tax cuts would be reckless, and stopping public sector cuts irresponsible.

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Is the US economy heading for a fall?

Most of the worry about the world economy is being directed towards Europe, and the Eurozone in particular.  I am amongst a very small group of optimists on that front – but it is easy to see why people are worried.  In fact it is only through a prolonged period of crisis that Europe will find an enduring solution.  But meanwhile, should we be worried about the US too?

What prompted this thought was this article in Vanity Fair by the eminent economist Joseph Stiglitz (thanks to Marisha Ray for drawing my attention to this on Facebook).  It’s subject is inequality, and why it is corroding the US economy, and why the elite (the top 1%) should worry.  Judging by the FB comments, some readers saw this critique as applying to government thinking right across western world – the view that austerity economics is driven by an idealogical view of the role of government.  But I took it as a very specific critique to the US.

Professor Stiglitz does not spend much time justifying the statement that inequality in the US is high and increasing.  The problem is that almost all the benefits of growth are accruing to the top 1% of the population – and bypassing those on middle incomes.  In other words the problem is not an underclass that is disappearing from sight – but a substantial majority of the population being left behind, with the creation of a fabulously rich elite.  There are many ways of looking at the statistics on this, but for me one of the most important is the historically high level in national income that is taken up by business profits – the benefit of which goes overwhelmingly to the elite.  This may or may not be outrageous in its own right, but Professor Stiglitz points out a number of practical problems that arise from this:

  1. The very rich spend less of their income on consumption and save the rest.  The more wealth that concentrates in their hands, the more consumption overall will fall as a proportion of the economy.  Unless there are enough constructive channels for their savings then unemployment will result – unless alternative demand comes from somewhere.  That alternative might be an investment boom (as with high tech in the late 1990s) or with big government deficits, propping up the economy now.
  2. The rich elite use their power to protect vested interests and direct their energies to what economists call “rent-seeking”: activities that enrich the individuals themselves but not the economy as a whole.  Under his analysis the finance industry is largely based on rent-seeking.  As energies are diverted from genuine economic growth, the economy overall weakens.  What is good for the profits of existing businesses is often not good for the whole economy – which needs new businesses to come forward.
  3. The majority who are seeing their incomes stagnate, and find it more and more difficult to join the elite, get resentful, breaking down the trust that underlies all successful economies.

But there is a political puzzle at the centre of this.  Why is the Republican Party both veering to the right and retaining substantial popularity?  Surely the welling up of resentment against the elite should translate into overwhelming political pressure for a more egalitarian system?  I think the American suspicion of government is to blame.  I don’t think that the majority of American people are particularly happy with the way their living standards are being held back.  But, incredible as it may sound to European ears, many of them think it is “socialist” government policies that are to blame.  Shrink the government, cut taxes and the 99% will start to catch up with the 1%.  Of course, huge funds from the elite are available to support this view in the media – through political campaigning and biased news coverage, such as Fox News.  It hardly helps that a lot Americans seem to think they can have their cake and eat it: huge expenditure on entitlement programmes (especially Medicare) without the need for increased taxes.

If Professor Stiglitz is right then the US would be suffering from long term low economic growth, as the various toxic effects of its skewed income and wealth distribution gradually overwhelm the highly dynamic core economy.  And indeed, measured per capita (i.e. taking into account population growth), the U.S managed annual growth of only about 1.4% in the first decade of this century (compared to the UK 1.7%, or Germany (1.9%) – though France only managed under 1% – figures from Wikipedia).

Still lacklustre growth won’t cause a crash.  Italy has made an art of surviving such a challenge.  But the proximate cause of a crisis is clear enough – the government’s budget deficit of 7.6%, and the lack of any political consensus in how to handle it.  There are three ways in which this could cause a problem.  The first is if the US government should hit the Spanish problem of being unable to borrow because of a loss of market confidence.   This looks implausible.  Investors have too few choices where to put their surplus funds.  The second is expenditure cuts sucking demand out of the US economy, causing a prolonged recession.  This could happen if the Republicans take control in this year’s elections.  The third is political gridlock causing government funding to seize up, and causing technical default.  This looks all too possible if the Republicans control either or both houses of Congress, as looks probable.  Even if Mitt Romney should gain control of the presidency (and he’s doing well on fundraising), he may well run into trouble with Congress as he desperately tries to find practical answers to the deficit problem.

And what if the US survives the budget crunch in 2013?  If growth continues to be lacklustre, and the top 1% continue to hog the benefits, surely US public anger will turn on the elite, as it did briefly in the last days of President Bush?  I share the European view that a smaller government, reduced regulation and lower taxes will make the problem worse, not better.  That will be a sight to watch from a safe distance.

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The Guardian’s bubble – the view from my bubble

It’s nearly a cliché, but it still resonates with me.  People accuse each other of living in “bubbles” – and when they do so, the accusation usually has bight.  But the people who make the accusation are merely living in different bubbles.  We all are; and it helps us if we realise it.

A bubble is a small, self-contained world which contains its own atmosphere, protected by a nearly invisible wall, which lets those inside see the wider world outside, and maybe pretend that they are fully part of it.  And every so often the bubble hits an obstacle in the outside world, and bursts.  Suddenly those inside are subject to a catastrophic shock.

As a metaphor it describes a describes an intellectual process.  We sustain ideas by protecting them from the vicissitudes of what is going on in the real world around us, discounting facts that challenge them, seizing on ones that support them – and a similar process goes on with those that we consort with – we prefer people who support our view and avoid those who don’t.  As this bubble existence continues our strength of conviction is increased by this process.  Until one day, maybe, the idea can’t be sustained and it’s all over.  Actually the bubble rarely bursts so dramatically in real life – though we always fancy that other people’s bubbles will.

What bought on this reflection?  Reading Saturday’s Guardian I reached the “Comment & Debate” section, and there were two articles on the same page which seemed to sum up what I think of as the Guardian’s bubble – one that persists in believing that austerity economic policies are a fraud and a failure.  One was by Robert Skidelsky – U-turn for the better – a direct attack government policy, while welcoming the apparent softening of it in favour of more infrastructure investment.  The other was from Jonathan Freedland – Balls has the rare political right to say: I told you so – praising Ed Balls, and especially that he was amongst the first to criticise austerity.  I didn’t read either article, but just harrumphed and moved on.

Still, this is a blog, not a Twitter feed, and I owe it to my readers to actually read the articles before passing comment, and I did so today.  Mr Freedland’s doesn’t fit my bubble pattern.  He clearly inhabits the bubble, agreeing with Mr Balls’s analysis of the economy, but this only affects one non-critical sentence in the piece.  The article makes perfect sense politically, even if you don’t happen to agree with the economics; it’s a good article, in fact.  Mr Balls has been written off, but he’s winning.

But Professor Skidelsky produces pure bubble fare.  He does report the government logic more fairly than some, merely to dismiss it with this: “This is discreditable nonsense.  But it has an air of plausibility.”  Actually precisely what I think of the professor’s article.  To me the give-away was this sentence: “If the [infrastructure] spending had not been cut, the deficit would now be smaller, because the economy would be larger.”  This is either a suspension of the laws of arithmetic, or shows an astonishing faith in in the multiplier effect of this type of spending  – for each 1% of extra deficit spending you need to add 12% or more GDP as a whole to sustain this argument.  By substituting “debt” for “deficit” it may be somewhat more sensible (you need less than 2% growth for each 1% spend -at the most optimistic) – but it still heavily depends on the multiplier idea.  This is an area of ongoing debate amongst economists – and yet Professor Skidelsky presents it as an accepted fact.  And without it the rest of his argument starts to fall apart.

Professor Skidelsky is not a fully trained economist (though neither am I), and I think it shows in his writing; his main claim to credibility is that he wrote an authoritative biography of Maynard Keynes.  But plenty of fully fledged economists agree with him – but that does not make this argument less contentious.

Or less wrong.  From my bubble.  Because I clearly inhabit my own bubble.  One in which the Government’s economic policies are making the best of a bad situation, and, separately that the Liberal Democrats will not be annihilated for a generation.  A more neutral observer would not share either conviction.

Why do we live in such bubbles?  It’s just very hard to stay on the fence the whole time, or to change your mind every few days with the next piece of passing news.  The only way to do it is by not really caring.  But really it helps to have some self-awareness about this – and this is the only way to appeal to those outside your bubble.

The Guardian is a better newspaper than many.  But what is the point of giving such prominence to purely polemical articles like Robert Skidelsky’s?  They need more serious comment, like that produced by Jonathan Freedland, which do not insult their readers’ intelligence just to give the members of their particular bubble something to cheer at.

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Translating that IMF report into English: the blindness of macroeconomists

Yesterday the IMF released one of its regular reviews (“Article IV consultations”) on the UK economy.  Both government and opposition seized on it to reinforce their narratives.  But for observers trying to make sense of these claims by reading what the IMF’s summary actually says (here) there is a problem: it’s written in economics jargon and not English.  For example, in the passage central to the controversy passage:

Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK’s large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.

What they are trying to say here is that attempting to lift the economy using a fiscal stimulus, i.e. reduced taxes and/or increased public spending, works best if growth is already low and if loose monetary policy isn’t working – which will be the case if the economy does not improve soon.  But any stimulus has to be carefully designed to ensure that the government’s deficit reduction plans retain credibility.  They suggest two types of policy that might achieve that: temporary tax cuts or greater infrastructure spending.  In other words, not a slower pace or reversal of public expenditure cuts.

More on this later: first it helps to get a wider perspective of what the IMF is trying to say.

Their starting point is that the UK economy is currently unsustainable because of the massive government deficit (i.e. that public spending is way ahead of taxes).  That means that the public sector is too large and has to be cut back to rebalance the economy.  This is completely consistent with the Coalition government’s analysis, and it is where the Labour opposition is most uncomfortable.  Labour draws a lot of political support from public sector workers and beneficiaries of government expenditure.  They would rather not admit publicly either that the level of such expenditure before the crisis was unsustainable, or that it needs to be cut back now at anything like its current pace.  But it is difficult to dispute the numbers, so they keep mum or change the subject.

But the IMF also says that there is considerable spare capacity in the economy – in other words that the private sector could expand easily if only consumer and investment demand was stronger. This fits better with the Labour narrative.  Government supporters often suggest that the UK economy’s unbalanced nature was more than just an excessive public sector, which leaves little practical spare capacity, and so it is not so easy to grow through boosting demand: the extra demand might simply go into inflation or imports, for example.  They point to the decline in manufacturing and the size of the “socially useless” investment banking sector before the crisis.

This leads to another point made by the IMF, which is that persistent low growth will cause longer term damage to the economy, as the spare private sector capacity whittles away.  And unemployed people tend to lose their skills and value the longer they are out of work.  There is a nightmare that stalks the minds of economists which they name “hysteresis” (borrowing the word from materials science) whereby people who are put out of work never get back into it, and high unemployment persists long into a recovery.  Europe in the 1980s and 1990s is held up to be a prime example of this, compared to the US in the same period.  The word makes its appearance in the summary.

But they do point out that UK unemployment is remarkably low compared to previous recessions, or what is going on in other economies, including the US.  They put put this down to “labour market performance”, though others suggest that this has more to do with the fact that home construction played a much smaller part in the economic boom than elsewhere, and a lot of the vanished GDP was in sectors, like finance, which weren’t big employers.

The IMF report goes on quite a bit about monetary policy, not criticising the Bank of England’s performance so far, but suggesting that it could be further loosened.  This might be through even lower interest rates or through “quantitative easing” – the buying of bonds by the Bank – especially if the latter was more in private sector bonds, rather then the gilts which the Bank has so far been buying.

The continued fragility of the UK banking sector causes the IMF some worry, as does the possibility of further trouble from the Euro zone.  The former could provoke the government into more bailouts, which would put government finances under strain.  The latter would exacerbate this problem as well as making growth more difficult.  They welcome the government’s attempts to reform banking to expose government finances less to risk.

So where does that leave us?  the Government can take comfort from what amounts to a strong endorsement of its policies.  But by leaving open the idea of a fiscal stimulus, especially through a temporary tax cut, it gives Labour ammunition.  Labour’s shadow chancellor Ed Balls can quite reasonably suggest that things are bad enough now for such a policy, without having to wait.

But, while wading through the dense economic jargon, I am left with an overwhelming impression of the blindness of macroeconomists, hiding behind their aggregated statistics and theoretical models.  They don’t look far enough behind the figures.  This is starkest in their faith in monetary policy.  The theoretical models of money have entirely broken down in the wake of the financial crisis – but economists have placed so much weight on them that mostly they still cannot admit that they are so much garbage.  The monetary authorities are left with a number of policy levers, interest rates and so on, whose effects are not properly understood. Whether looser policy will lead to any significant stimulus in demand that will lead to job creation is in fact very doubtful.

And talk of multipliers and other economic mumbo-jumbo gets in the way of trying to see if a particular form of fiscal stimulus might do more harm that good.  An example of the kind of thinking that is needed comes in an article by  US economist Raghuram Rajan in today’s FT: Sensible Keynesians see no easy way out.  The problem with stimulus is that you have to balance the benefits now against the costs later.  If the stimulus addresses the problem of unemployment, especially the long term sort, then the trade off is likely to be worth it.  If it doesn’t then it won’t.  Would a temporary tax cut, such as in VAT, achieve this?  Personally I think the effects are likely to be marginal, and that most of the stimulus would disappear in higher prices, higher pay and increased imports.  A more cogent case can be made for infrastructure spending if the infrastructure is genuinely useful to the future economy.  That’s a harder test than theoretical economists allow – it is difficult to see much benefit from Japan’s massive infrastucture spending in the 1990s, for example.  And the spending may not help provide jobs where they are most needed.  In the UK there seems a good case for more house building: but by and large we do not need more houses where most of the unemployed people are living.

In last week’s Bagehot column in the Economist, the writer describes how people are hoping to wake up from the austerity nightmare so that they can get back to real life before the crisis.  But the nightmare is reality and the pre-crisis existence is the dream.

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Europe and the US: the tortoise and the hare

Comparing the European economy to that of the US reminds me of Aesop’s fable of the race between the tortoise and the hare.  The US’s flexible labour and product markets, and decisive interventions in time of crisis, give it the ease of the hare.  To US politicians you only have to mention Europe to conjure up a picture of stagnant, over taxed and socialist economies.

But the tortoise wins the race in the fable.  And indeed, if you look beyond crude GDP growth statistics the race looks close, depending on the precise time frames and so on.  GDP per head tells a different picture to aggregate GDP (this is regularly quoted by The Economist, though I haven’t found a recent example to link to).  Other statistics on the incidence of poverty, life expectancy and so on, show Europe in a better light – though the US still does well in self-reported wellbeing, but not as well as Scandinavian countries.

All of which demonstrates how commentators, especially in the US and here in the UK (whom I shall collectively call the Anglo Saxons, following French practice – though this is a dangerous shorthand) don’t understand the dynamics of European economic policy.  As the EU lurches into another round of crises, this is worth taking on board.   Once again the US hare looks better placed than the European tortoise.  But look closer, and it isn’t so clear.

This is not to underestimate the scale of the crisis facing the Eurozone in particular.  Massive problems confront the economies of Greece, Spain, Italy and Portugal; the French economy is not in a place of safety either.  But Anglo Saxon commentators tend to relentlessly focus on the short term problems, to the exclusion of longer term issues, which they assume best dealt dealt with at a later time.  Europeans (from which I exclude the British, for now, though for most purposes the British are very much European) tend to look at the problem differently.  A crisis is one of the few opportunities to tackle longer term problems, and fixing the crisis while neglecting the long term is criminal.

The southern European economies are inefficient by developed country standards, and uncompetitive within the current Euro structure, and can’t sustain the level of social benefits that their electorates have come to expect.  This lack of competitiveness was not invented by joining the Euro – it predates it, and is based on decades of poor economic leadership.  Joining the Euro gave these economies a boost by reducing government borrowing costs – but this boost was used to put solving the bigger problems off until later.  Their northern European partners are to blame for going along with this, until a crisis threatened to engulf them all.  When the Euro project was launched, its supporters advocated it on the basis it would force governments to confront the inefficiencies of their economies, rather than rely on devaluation to put the problem off – a strategy that ultimately leads to stagflation, and even hyperinflation.  But somehow these supporters seemed think that the omelette could be made without breaking eggs.  But Europe’s leaders are keenly aware of their mistakes now.

The position of the southern European economies is not unlike that of Britain in the 1970s.  A massively inefficient and uncompetitive economy had been kept alive by a benign international economic climate, until the 1973 oil shock knocked it over.  There was no quick fix, no macroeconomic palliative to ease the pain.  A floating currency hindered rather than helped.  The turning point came in 1976, when the Labour government had to call in the IMF.  Then started a painful process of government cuts and market reforms.  This wasn’t what the party had promised when elected in 1974, and the government was grudging in the reform process.  They lost the election in 1979, with Margaret Thatcher being swept to power, redoubling the pace of the reform process through the 198os.  This cut huge swathes through much of British industry – making the current economic crisis in the UK look like a picnic, whatever the GDP figures say.  It took about a decade of pain from 1976 before clear benefits started to show.

A similar hard road awaits the southern European economies.  Leaving the Euro and devaluing won’t help (during the Thatcher years, to continue the comparison, the pound stayed high), and is institutionally much more difficult than most Anglo Saxon commentators assume.  Europe’s politicians know this, and so aren’t looking for quick fixes.  They are looking at a process of near continuous crisis in which the institutions, and political culture, required to make the Euro work are gradually put in place.   Greece may be a casualty – it faces a real danger of being expelled from the Euro and probably the Union as a whole (it’s difficult to disentangle the two).  It is slowly but surely being isolated to make that option less and less of a threat to the zone as a whole.  But unlike many British commentators assume, Greece will find life no easier outside the Euro.

Martin Wolf’s gloomy article in today’s FT illustrates the difficulty Anglo Saxon commentators have in viewing the scene – and Mr Wolf is no shallow commentator.  He makes reference to the comparison with Britain, thus:

This leaves “structural policies”, which is what eurozone leaders mean by a growth policy. But the view that such reforms offer a swift return to growth is nonsense. In the medium run, they will raise unemployment, accelerate deflation and increase the real burden of debt. Even in the more favourable environment of the 1980s, it took more than a decade for much benefit to be derived from Margaret Thatcher’s reforms in the UK.

Structural reforms are dismissed as taking too long.  But is there any other way that such necessary reforms can be taken forward?  Surely the British case illustrates that miserable economic performance for an extended period is unavoidable?

How different from the US approach!  By comparison, the US’s economic problems are nowhere near as great as those facing southern Europe: at the core the US economy remains wonderfully competitive.  But they have a terrible problem of government finance and social justice, which neither politicians nor public want to confront.  Instead we get a series of short term fixes, which look decisive, but which simply increase the scale of the problem that has to be tackled later.   Americans have to choose between higher taxes and reduced Medicare and Social Security benefits, or some combination of both – and yet neither are seriously on the political agenda.

In the fable the hare loses the race because he is so confident he takes a nap.  A similar misjudgement by America’s political class, abetted by British and American observers is in the process of unfolding.

 

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A tale of two City rogues

Too often people condemn City financiers without asking what it is that they do.  But we must try to distinguish the good from the bad.  The tale of two larger than life City financiers who have got into trouble brings this into focus rather neatly.

The first is Conservative donor and hedge fund manager Lewis Chester.  He, or rather the fund he manages, has been hit with a massive fine by the US Securities and Exchange Commission (SEC) for abusive trading in mutual funds, the US equivalent of unit trusts and OEICs.  These collective funds provide opportunities for retail investors to take a share in a portfolio of investments without owning the shares individually, and are one of the best ways for ordinary investors (even very wealthy ones) to invest.  But they aren’t priced real-time, and that can leave them open to abuse.  In this case Mr Chester’s fund is supposed to have bought stakes late in the day, after prices had been fixed but when there was reason to think that they were under priced.    The fund was able to make a handy profit by selling the stake back later – but it came at the expense of the fund’s ordinary investors.

Hedge funds are investment funds given an unconventional or aggressive brief compared to the plodding ordinary funds which merely manage portfolios of shares and bonds.  Often the exploit pricing anomalies.  This isn’t very pretty, but usually it’s a way of transmitting information across financial markets and ensuring that everybody gets a fairer price.  On balance this is positive.  But when it comes to exploiting anomalies in mutual fund pricing there is no such information transmission.  It is simply theft, and there are rules against it. And even if rules aren’t actually broken, it is unethical, and anybody perpetrating it should be shunned by respectable society.

In this case Mr Chester still seems to be denying wrongdoing, dismissing his rather juicy emails as “banter” (gems like: Poor souls, working past cookie and milk time…for once in your lives, you can work like real men and do a proper day’s work. (You really are a bunch of women of the first order).).  But it’s gone through four years of judicial process and the fine has ended up at $100 million – though an appeal may be on its way.  I really hope that our own FSA is on his case, as if this is true he is hardly a fit and proper person to be conducting business here.

The second case is receiving much more attention, including two opinion pieces in todays FT.  It is Ian Hannam, a specialist in mining investments and friend of David Davis, the Conservative MP.  Like Mr Davis, and unlike Mr Chester, he is not a classic City smoothie who came up through the usual channels.  He got his boots dirty by travelling out to various dodgy parts of the world to take a closer look at the investments he was advising on, and talk tot he people that matter.  This is a striking contrast to so much of the City game of trawling through statistics and devising new computer programs.  He advised on investments and facilitated big deals.  Not pretty I’m sure, but you can see how this type of work can justify a big salary.  The net result is that more resources get mined to keep the world going in the style to which it has become accustomed.

Mr Hannam has been fined by the FSA £450,000 for flouting rules on insider information, for revealing too much about deals he was working on to clients.  I have no feel for the facts of this case, and Mr Davis has leapt to Mr Hannam’s defence.  What I do know is that the rules on insider information are tricky, and that there is a lot of grey in amongst the black and white.  If well connected insiders are getting all the best deals and making money out of the outsiders, this undermines confidence in markets.  But information is the lifeblood of markets, and restrict it, even amongst insiders, and markets will suffer.  It is already becoming more and more difficult for smaller companies to go public due largely to restrictions on information flow – and this will have a baleful influence on innovation.  Regardless of the rights and wrongs of Mr Hannam’s case the rules seem to be drawn too restrictively at the moment.

The last few decades have seen astonishing advances in the battle against world poverty.  A more globally integrated economy has been a key part of this, and global finance has been a key facilitator.  It has also been wildly abused, with too many fortunes being made to no socially useful end.  The public needs to take a closer interest in what goes on, to condemn the unethical (whatever side of the law they are on), but admire the people that genuinely make new connections and keep things moving – even if they cross the odd arbitrary line and get themselves into trouble.

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The budget – the coalition at its best

George Osborne is gradually cementing a reputation as an effective Chancellor of the Exchequer and skilful politician.  He certainly understands coalition politics and how to play for the longer term.  Yesterday’s was a very interesting budget.

There a two schools of thought about coalition governments.  One may be characterised as “lowest common denominator”: all the bold ideas are knocked out and we are left with a few messy compromises that lack any kind of coherence.  The second is the “natural selection of ideas”  in which the ideas of the various parties have to compete on their merits and the weak ones don’t survive, the sum being better than any party would produce individually.  Britain’s first post-War coalition, formed by politicians unfamiliar with how coalitions work, has seen both types of policy formation at work.

The coalition started well.  The initial policy programme was full of bold ideas, while dotty ones (cutting inheritance tax for example) did not make the grade.  But things soon degenerated, as activists on both sides sensed betrayal.  This was especially evident on the NHS, where we are left with a messy compromise that is almost certainly worse than either party would have produced on its own.  But the 2012 budget shows a reversion to the “natural selection” model, for which credit must go to both George Osborne and the Lib Dem leader Nick Clegg.

One of the interesting features of the budget has been the disappearance of budget “purdah” – the absolute secrecy surrounding budget proposals.  Mr Clegg made the early running in the media game with his bid for an acceleration of increases to personal allowances.  But Mr Osborne clearly understood this to be an opportunity rather than a threat – in this case to reverse the top rate of income tax of 50%, which until a month or so ago looked to be entirely off the agenda.  A few years ago the Lib Dems had a big conference battle over this top rate (before Labour introduced it, as it happens) and rejected the 50% – so there was evidently some Lib Dem ambiguity over the tax, which Mr Osborne was able to exploit.  And indeed world thinking has long since turned against such high marginal rates, even for the very rich.

Meanwhile, weaker Lib Dem ideas about how to tax the rich more efficiently did not make the cut.  This applied to the Mansion Tax on high valued property.  Such an idea (though based on land rather than total property value) appeals to theoretical economists, but has two major practical problems.  First is that property is not the same as cash, and that owners of such valuable properties may struggle to pay, and hence create a fuss.  The wider the scope of tax, the more of a problem this is.  The second problem is that it has to be based on a theoretical valuation rather than hard and fast fact.  This is one of those things that becomes more of a problem the more that you think about it.  Property (or anything else) is worth what you persuade somebody else to pay for it, which depends on many factors unique to the individuals taking part in the transaction and the time they make it.  A host of practical issues follow.  The eventual compromise of an increase in stamp duty for properties over £2 million, combined with a clampdown on stamp duty avoidance, looks like a much better idea to me.

The idea of limiting allowances to higher income people so that effective tax is no less than 25%, the “Tycoon Tax” – attributed to Mr Clegg in the proposal process, though not coming out of any Lib Dem official policy – also looks like a very sensible proposal – and this made the cut.

Mr Osborne was also able to push through further cuts to the main Corporation Tax rate.  I have some reservations about this: companies are sitting on too much cash – if they don’t invest it, then the best way of getting this wealth back into the economy is to tax it.  But there is logic to it to help retain footloose international capital, something that the country has been quite good at, but needs to stay in the game.  And it’s not as generous as it looks, since allowances have been kept in check.  In fact the big thing UK companies have been asking for is more generous capital allowances – but the footloose companies aren’t so bothered about this, and the Chancellor did not budge.  I’m not sure that capital allowances have been set at the most efficient level – but I do know that business leaders always ask for too much, and the game is often more about tax avoidance than real investment.

One idea was not leaked in advance.  This was the phasing out of the age-related personal allowances.  This “granny tax” has attracted most of the press attention this morning, with howls of protest that the Labour opposition are seeking to exploit.  Yet the reasoning behind this change is solid enough.  Pensioners have done pretty well under the reforms already implemented by the government, and this is a nasty, complicated piece of work.  Although it is true that many pensioners have been punished by the general reduction in the value of savings since the crisis began, this allowance is a bad way to deal with the problem.  What is actually needed is for the economy to return to health, so that we can get back to a real interest rate of about 2% or so from its current negative value.  It was brave to take on the pensioner lobbies like this, and Messrs Osborne and Clegg (to say nothing of the PM David Cameron) deserve credit.  Critics suggest it may go down as a fiasco like Gordon Brown’s cut of the 10% tax band, or the negligible increase to state pensions the last government implemented when inflation appeared to be very low.  Both were politically very damaging, to Mr Brown and to Tony Blair respectively.  But this policy does not create cash losers (denying benefits to those who haven’t got them yet – rather than taking them away from those that have).  It may even mark a turning point in the battle of the generations, as younger voters start to appreciate just how generous the state is to pensioners, and shift their ire away from the much less costly immigrants and benefit claimants.

The budget does nothing for macro-economists.  There is no bold, imperial stimulus to “get the economy moving”.  But nobody was expecting that.  Overall this budget is a credit to the Coalition government.

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Lesson from the banking industry: sometimes people need to be treated as people.

This article from the Economist struck me like a bullet on reading it today.  Not so much for the subject matter itself (US banking practices) but what the whole episode says about the modern world.  We have never had more data readily available on people – but we seem less able than ever to take decisions on their individual merits.  More data, less information.  This problem is usually shrugged off y economists and reformers with a laugh; it shouldn’t be.

The story starts in the US property boom, when banks were falling over themselves to offer mortgages, based on the vague idea that since these loans where secured on property, and property values always go up, you couldn’t have too much.  The banks stand accused of approving loans robotically, without any consideration of individual merits – and as a result often lending to people who could not afford to keep up with the repayments.  This accusation was commonplace, but, as the article points out, little effort seems to have been made to substantiate it against hard evidence.

Then came the crash, and many people who had taken out loans could not or would not keep up with the repayments – and stood at risk of having their homes repossessed.  And the banks once again stood accused of carrying out repossession without due care and attention, again on mainly anecdotal evidence.  This became a hot political issue, and the individual US states set about suing the banks, with the Federal government becoming involved too.  And now an umbrella settlement is proposed, to which the five main US banks and 49 out 50 state Attorney Generals have agreed to.  The banks are making a blanket payment to make the problem go away.

What remains characteristic of the whole story, from the original alleged malpractices right up to the settlement, is a failure to reconcile it to what actually happened to real people in real homes.  No attempt is made to distinguish between whether some banks are more culpable than others; and no attempt to distinguish between arrears that arise from people in genuine hardship, and those who are trying to beat the system.  All that is just too difficult.

And this type of thing is happening all around us.  Decisions are made about us using computer algorithms based on data that may or may not be accurate – or based on our membership of some or other broad group of people (men, women, over 50,  etc.) and the law of averages.  Companies calculate that it is cheaper that way.  To consider people as real people, and base decisions on the individual merits of the case, well that requires the intervention of skilled staff, and they cost a lot of money.

And so the flip side to ever advancing productivity (one of the things that makes skilled people cost so much) is that we are subjected to an increasing volume of de-personalised services and arbitrary decisions; and around the fringe a spectrum of fraud arises, as people learn to take advantage of system weaknesses.  I have been the subject of mild identity theft several times; this looks quite safe for the people who perpetrate it, since nobody bothers to find them – it’s just a cost of doing business.

But what’s the moral of the story?  We gain a lot from the increased wealth that arises because of all this added productivity.  And what’s more part of becoming a more equal society is that well off people like me can’t expect to have armies of people running around fawning on their every need.  So should I just stop whinging, and get on with all the things I can now do that would have been unthinkable in a previous age?

Up to a point.  I think there are two important consequences that many people overlook.  One big picture, and the other of more urgency.  The big picture point is that are are physical limits to economic growth, and it is no wonder that the pace of growth slows in developed societies.  Higher productivity means we consume more services with diluted human content.  But huge part of the pleasure we derive from some services is exactly because we get one-on-one attention from somebody (hairdressing perhaps, a personal trainer, dinner at a posh restaurant, and so on); as productivity advances, the proportion that these non-negotiable services comprise in the total economy rises – and so growth slows.  Economists refer to this as “Baumol’s Disease” after the economist who originally pointed it out.  But it is not a disease; it is the product of success – it’s the process of arriving at the promised land, so to speak – the place that is so good that progress is impossible.  An increasing proportion of services cannot be improved without detracting from their value, and people will resist buying them at any price; and that’s saying nothing of the distortion to incentives that arises from making decisions based on averages.  We can’t rely on economic growth to wash away society’s problems – we need to confront them more directly.

The more urgent point applies to the reform of public services.  Too many people assume that to make these more effective we must follow a similar process of sucking the human content out of them as we see in so many commercial services.  In some cases I’m sure that’s true; some Indian organisations are doing amazing things to improve the productivity and effectiveness of certain medical procedures by using economies of scale.  But in most cases the effectiveness of public services depends on joining up the dots; seeing people as people rather than collections of unrelated needs that can be picked off one by one.  An individual who is committing serial antisocial behaviour offences, may have mental health problems, addiction issues, a dysfunctional family life, educational under-achievement, and inadequate housing.  Just from listing them you can see how all these problems are interrelated and feed off each other.  We stand a much better chance of making progress if we design solutions based on looking at this individual and his exact personal circumstances and negotiating with him as a human being.  Productivity in public services is not about rate of throughput, its about solving problems and reducing demand.  This needs a completely different mindset than that needed from the commercial world.  Alas too much (though certainly not all) public service reform misses this key point.

 

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Is cutting Corporation Tax good for growth?

Everybody agrees that the UK economy needs more growth, like pretty much every other developed economy.  On the right it seems to be taken for granted that cutting corporate taxes will help.  This view deserves to be challenged.

An example of the argument for lower tax rates is this one from Tim Knox on the LSE website, promoted by the conservative think tank CPS.  Mr Knox suggests cutting the main rate from 28% to 20%, while simplifying a lot of the deductions.  The logic is simple.  The economy needs businesses to invest and expand.  A high corporate rate of tax is a disincentive to do so; a cut in rates would give businesses a shot of confidence that would get them moving.

This line of reasoning is not nonsense – and his ideas for simplifying the system on capital allowances and capital gains may make sense, though would be fiercely contested by lobbyists.  There is a lot nonsense talked about corporate taxes.  Companies aren’t people, and the payments companies make to people are taxed as employment or investment income.  There is quite a cogent argument (a classic essay topic for undergraduate economics students) that companies shouldn’t be taxed at all – though this would certainly open up opportunities for tax avoidance.

But a different way of looking at the predicament of the UK economy comes from Martin Wolf in the FT (paywall, I’m afraid).  He points out that one of the macroeconomic problems with the UK economy is the large value of the corporate surplus – in other words businesses are making too much profit and not spending enough.  He agrees with Andrew Smithers of Smithers and Co who published  a report entitled “UK: Narrower Profit Margins and Weaker Sterling Needed”.  Mr Wolf does not advocate raising corporate taxes, but he nevertheless poses an awkward question for those who advocate a cut.  The basic macroeconomic problem for the UK is that the government deficit is too high and its mirror image is a corporate surplus that is also too high.  Going back to Year 1 Economics, you can’t cut one without cutting the other (not entirely true, but the alternatives involve private individuals getting even more indebted, or an unrealistic export surplus).  How on earth does cutting corporate taxes help, without using voodoo concepts like the Laffer Curve?

In fact economically corporate tax is one of the more efficient ones in microeconomic terms – it does not distort incentives as much most other taxes, because it is based on profits, not inputs or outputs.  It amounts to a tax on capital – but capital is already having it very easy in the world economy, one of the drivers of increased inequality within nations (as opposed to between them…).

Strategically we should be thinking of more ways of taxing companies, on the basis of “use it or lose it” – it isn’t healthy for companies to sit on surplus profits.  A logical way would be to raise the tax rate but make dividends deductible – but this is probably a nightmare in practice.  Another idea is to cut the tax relief for debt interest – which would help restore the balance between debt and equity funding.  In the long term this would no doubt be very healthy and discourage companies from becoming over-indebted; in the short run it would be a bit like bayoneting the wounded after the battle, so implementation would need a great deal of care.

But even if either of these ideas look impractical, the argument for cutting the tax rate looks distinctly weak.

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Globalisation is at a turning point

After a period of relative silence the idea of “globalisation” is re-entering political commentary.  But almost none of the commentators seem have seem to have grasped its dynamics – and that its pressure on developed economies is easing rapidly to both good and bad effect.

Maybe it’s Davos.  But globalisation has been coming up a lot lately.  It is the subject of this week’s Bagehot Column in the Economist, which claims that its effect lie behind a lot of the political debate in Britain.  An FT article drew attention to recent speeches by President Obama and French Presidential hopeful Francois Hollande apparently attacking its effects. And the IPPR launched a heavy (108 page) report on The Third Age of Globalisation, recommending that Britain in particular develops a proper industrial strategy.

I have already worried about how much political debate centres on abstract nouns, in particular “capitalism” and “neoliberalism” (a favourite on the left).  “Globalisation” has to be added to this list.  It is much better for the debate to move to the concrete (income and wealth distribution, for example).  But there is value in trying to unpick the concept a bit.  And what arises from this, at least in my view, is that the globalisation process is changing in way that few commentators recognise.

“Globalisation” is used as a collective word to refer to three inter-related phenomena in particular: international trade, cross-border investment, and international finance.  These three have worked together in the last couple of decades (the IPPR’s “third age”) to transform the world economy, with developing economies being at the heart of it.  It is associated with positive outcomes: the rise of so many developing economies, and negative – the increase in inequality in developed and developing nations alike.  But to understand how this process will evolve it is best to consider the trade aspect, from which all the rest flows.

The central phenomenon had been the growth of trade between less developed economies and more developed developed ones, with the former taking over the manufacture of many consumer goods, and also many services too.  Economists find this type of trade particularly easy to understand: it is a straightforward application of the principle of comparative advantage, first described some 200 years ago by David Ricardo.

Comparative advantage is one of those ideas that tend to separate “proper” economists from those that just try to follow economics from newspapers.  I think many of the latterle think it is similar to the much more familiar idea of competitive advantage – but it is quite different.  Basically it says that benefits in trade between two economies arise when there are differences between them in the opportunity costs of producing different goods.  So if one economy can produce 10 tons of wheat to one of beef, and another 5 tons, there are benefits in trade which each economy specialising in the good where it has comparative advantage.  In this case the first economy has a comparative advantage in beef and the second in wheat.  It makes no difference how efficient each economy is in producing either good.  And a comparative advantage in one good means a disadvantage in another – unlike competitive advantage (which applies to individual businesses rather than to whole economies) where one party can dominate the other.

So this theory predicts that there will be trade between economies that are different to each other – which is why the trade between developed and developing economies is to easy to explain.  Economists struggle in using the theory to explain trade between similar, developed economies – but that’s another story, and it is a different type of trade.

Developing countries have emerged with a comparative advantage in low and middle tech manufacturing.  Developing countries typically have the balancing comparative advantages in higher-end goods and services, raw materials (where they have endowments) and agriculture.  Of course what we notice is the very low wages in developing countries, which make us think that the whole business is unfair.  But it is a sideshow, and very easy to explain using basic economics.  Wage rates are low because the developing economy as a whole is massively unproductive.  The manufacturing plants may be relatively efficient, but other industry, and especially agriculture, is so unproductive that it drags wages down for the whole labour market.  If factories paid higher wages, nobody would man the farms and people would starve (to greatly oversimplify things).  It takes some getting used to the idea that developed countries have a comparative advantage in agriculture, when so much of a developing country’s resources are tied up in the sector – but that is what is going on.  Full free trade in agriculture would put most developing world farmers out of business – except where tropical conditions gave them an advantage (bananas, perhaps).

And here’s the point.  As the developing economy advances this picture changes.  More and more people come off the land, and agriculture becomes more productive.  Wages across the economy rise, and the developing economy slowly comes to resemble a developed one.  The gains from trade disappear.  Trade continues but it is on much more equal terms and much more about the competitive advantage of particular businesses than about the circumstances of a whole economy.

And this is exactly what has happened.  In the 1990s the globalisation trend was mainly about the so-called “tiger” economies, of Taiwan, South Korea, Hong Kong, Thailand, and so on.  I remember Tory ministers wandering around saying how this country was under existential threat unless workers’ pay and conditions were cut so that we the country would be competitive.  But eventually a South Korean firm decided to build a factory here because it was cheaper producing goods here than at home.  South Korea had caught up.  But as the Tigers caught up and went to the next phase, China and India entered the picture, and gave the process a boost.  The two most populous countries in the world were bound to have a massive effect and the whole process accelerated.

But these countries are catching up.  This is especially clear in China, where rising wages have become a big issue.  This week’s Economist has a very interesting briefing on the subject.  The same processes are visible in the rather more chaotic India too.  In both cases the attention is shifting to raising the standard of living for the domestic population, rather than international competitiveness.  The worm has turned.

And on to the next wave?  There are plenty of less developed economies in the queue: Vietnam, Bangladesh, Pakistan, and various countries in Africa.  But none have the size and weight of the big two.  And it’s not just a matter of supply: the developed world is becoming that much bigger as new countries enter it – so impact of these poorer countries entering the market will be spread more widely; they will be busy exporting to India and China.

So the basic driving force behind the globalisation trend of the last 20 years is grinding to a halt.  What effect does that have on us in the developed countries?  The good news is that the pressure to offshore will ease, producing a bit more stability on our work landscape.  The bad news is that the gains on trade will vanish.  This has been an important part of the general rise in living standards in the last couple of decades, which we have been relying on to produce forward momentum to a greater extent than many realise.  Another reason why the “new normal” is slower growth.

So the developed countries will stay grumpy, but more from the slowdown of globalisation than from its continued rise.  But the big question is whether the trends to inequality will reverse.  On that score things are much less clear.

 

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