Economics & Finance – Page 17

Taxing multinationals – after the sound and fury we need solutions that work

Multinationals like Starbucks, Amazon and Google has been on the wrong end of publicity in recent weeks here in the UK. They don’t seem to be paying very much corporate tax, in spite of well established and successful commercial operations here. But there is something missing from the debate: nobody seems to be offering much of a solution to the problem of taxing multinationals. There’s a lot of sound and fury, but it all ends in a bit of a whimper. We can do better than that – but only by adopting policies the government’s Conservative members will be deeply uncomfortable with.

The problem is easy to see. If a multinational makes something in one place and sells it in another (to take the simplest possible description of a multinational supply chain), then it has the opportunity to apportion profits to more then one place…and to manipulate this to where tax rates are lowest. This has always been so, but with an increasing proportion of costs being attributable to soft things like intellectual property, this is getting much easier to do. The traditional way of fairly attributing profit is through establishing a fair “transfer price” for goods or services as they move between countries along the chain – based on open market value. The idea of open market value has always existed more in theory than practice, and the process often ends up in endless bickering between the company and the tax authorities of the various countries it operates in. And in the end the results are often hard to justify. What are the alternatives? There are two main approaches.

The first approach is to reduce corporate tax rates to make the issue irrelevant, and along the way to make your own jurisdiction very attractive to investors. This is not as crazy as it sounds, and has quite a respectable intellectual pedigree. Companies aren’t people, and ultimately taxation is about people. Taxes are charged whenever people try to extract money from a company, through salaries, dividends and what have you. Money that is left in companies is reinvested, and taxing it merely reduces the amount available for reinvestment. This is an example of the idea that tax should be based on expenditure rather than income and capital. It encourages saving and investment, and most of the time economists think that economies would be healthier if more resources were invested rather than consumed.

This line of reasoning was very popular in the late 20th century, but has since lost much of its appeal, except amongst the very rich. Something has gone wrong with the savings and investment cycle. The amount of constructive, worthwhile investment that comes out of savings is not what economists used to think. A lot disappears into various forms of financial engineering that fatten up an overpaid finance industry and not much else, inflating selected asset values into unsustainable bubbles along the way. Overall savings, especially by the very rich, seem to be a drag on an economy – often requiring “negative savings” from government deficits to keep the economy on track. This process was described by Maynard Keynes in the 1930s and it is still true today.

Low capital taxes, including company taxes, simply seem to exacerbate a growing gap between the very wealthy and everybody else, without generating the needed investment. Profit taxes have a particular attraction: they are economically efficient and do no distort ordinary business decisions, outside the allocation of capital.

So what’s the alternative approach to taxing multinational businesses? This is what we should be talking about a lot more: the top down apportionment of profits. Under this system you establish a business’s worldwide profits, and then apportion it to national jurisdictions by a formula which measures activity: a combination of sales, employees, pay or suchlike. Those jurisdictions can then decide what rate they want to charge.

The idea of top-down apportionment has been developed for some time by US states for allocating profits between the states of that country. In the 1980s California tried to extend the idea to global operations, but was forced to back down, mainly after furious international lobbying from our own British government. There is a nice irony if American companies are now runiing rings rounds us British.

But that example shows the idea’s main weakness: it needs international cooperation to get going. It helps if all countries are doing it, and using the same formula. There is an obvious first step for the British government though: to agree and apply such a system to the European Union. I don’t think there would be much difficulty in mobilising the other EU countries; Ireland, a traditional advocate of tax sovereignty, is not in a particularly strong bargaining position these days, and we can let them keep their low rates. Once the EU has an agreed system for recognising and apportioning profits, we would then need a treaty with the US. Since that country is already a wide practitioner, there is good reason to hope for progress there too. With the EU and US on board, a global critical mass starts to build.

But Britian’s coalition government does not seem to be thinking along these lines. For its Conservative members, no doubt doing deals on tax with the EU is anathema. Instead they are happy to quietly go down the first route and cutting business taxes, in spite of little evidence that this is stimulating investment. Of the Liberal Democrats, however, I had expected better.

The imperial illusion of macroeconomics

Once again the UK Chancellor of the Exchequer’s Autumn statement has provoked a storm of claim and counterclaim among economics commentators. The particular breed of expert whose voice is loudest is the macroeconomist. They have a lot of important things to say. And yet their analysis is often superficial. We end up talking about the wrong things.

There is a magnificent imperial power about macroeconomics. It looks at economies in aggregate, and develops a broad sweep. It deals with national income, growth rates, productivity, inflation, unemployment – all concepts that are represented by neat numbers. Their policy instruments are referred to as fiscal and monetary policy – policies that are meant to influence these aggregates in a fairly direct way, and which

For me, the metaphor of imperial rulers to represent these experts has strong appeal. It conveys the right sense of arrogance. I conjure up pictures of imperial aides to the Russian Czar (or his Soviet successors) implementing arbitrary policies to be implemented across their domain. They deal in the big picture – and refuse to hear the special pleading of provincial representatives. Of course things don’t work out in every detail, they say, but the reach and sweep of their rule means that much more good than harm is done.

Macroeconomists themselves no doubt would prefer an analogy with classical 19th century scientists. They did not concern themselves with the movement of individual atoms, but derived physical laws that worked at a higher level. In aggregate the behaviour of atoms and people are predictable.

The idea that leaders deal with big strategic matters, and leave the details to their underlings is an old one, that has enduring appeal. It enhances the egos of the leaders. It doesn’t work, though. The best leaders find themselves having to command both the strategic sweep and the tiny detail. The Russian Czars came acropper. And the theroties of 19th century scientists turned out to have much less value than they thought in the real world.

This is true of macroeconomics too. In the first couple of years of taking an Economics degree, you learn about macroeconomic models – about the use of fiscal and monetary policy to guide the aggregate movements of an economy. It is tremendous fun – but by the third year you really should be growing out of it. In the end economies are driven by what is happening at the level of individual people and businesses – and as people are highly adapable, and behaviours change – never mind the evolution of technology – what works one year may not the next. Unfortubately too many economists can’t seem to get past the imperial illusion.

Take the current furure over the British economy. It’s full of growth rates, deficit levels – and demands for this and that on fiscal and monetary policy. Two elements of the macroeconomist’s stock in trade are prominent: international comparisons (the British growth rate is less than Germany’s, etc.) and comparisons with the past, going all the way back to the Great Depression of the 1930s. And the analysis usually stops there – few attempt to pick apart the differences and similarities that these comparisons invite.

And yet there are a number of big changes taking place in the British and world economies that are bound to affect the choices open to our policymakers. These get superficial coverage, if at all. Here are a few:

Finance’s role in the economy is diminishing, as we understand that much of its alleged value is illusory. This means that a sector that appeared to be highly productive in macroeconomic terms is shrinking. That is not a bad thing – but people seem to be screaming blue murder when the national income figures suffer the inevitable outcome.
Likewise the benefits of North Sea oil are fading – another statistically highly productive sector shrinks, though this one has more underlying substance.
Banks’ lending practices are changing, as credit to private individuals becomes less easy, and loans to property developers more difficult. This is inherently a good thing, as it helps get the economy onto a sustainable path – but it is playing havoc with the macroeconomic statistics.
The gains from globalisation are going into reverse. For years in Britain the prices of imported goods fell or stayed the same while wages and domestic prices rose steadily at 3-4%. These “gains from trade” added a lot to the feel-good factor and growth before the crisis- even though we whinged about loss of manufacturing and overseas call centres. Now import prices are rising steadily while pay remains frozen. These gains from trade were not permanent, bankable changes – but reversible. This is nothing to do with protectionism, by the way, but arises from the perfectly predictable workings of the economic law of comparative advantage.
Meanwhile “additive manufacturing” and other technology changes mean that fundamental technological change is alive and well, bringing both new opportunities and continued obsolesence – but of quite unknown impact on conventional economic measurements.

I could go on. These factors, and others, should be very much part of the discussion. They invalidate historical and international comparisons – until and unless we dig a lot deeper. To me the wider message is that we can’t simply wind the clock back to where we were in 2007, and it is not self-evident that a sustainable growth rate of 2% or even 1% can be regained just a lifiting levels of confidence a bit. Therefore using fiscal policy to stoke up aggregate demand may simply bring short-term relief followed by an even bigger crisis. Increasing government sponsored investment is almost certanly a good idea, but it matters where this goes. But neither the government’s critics, nor even its defenders seem interested in such details.

In an excellent article in this week’s FT, Sebastian Mallaby shows how macroeconomic success leads to microeconomic complacency, which in turn leads to breakdown. The developed world has just gone down this route. Now the BRICs are doing it. China shows no sign of dealing with the baleful influence of its state owned enterprise; India is content to let curruption and inadequate infrastructure go unaddressed; Russia sees no reason to change its contempt for the rule of law; and Brazil’s government is releuctant to take on vested interests. All these economies are now slowing.

Meanwhile, back in the developed world you would have thought that we had been cured of macroeconomic complacency. And yet almost nobody seems prepared to take on the deeper issues that lie behind the crisis and any solution to it.

Why healthcare may grow to 50% of GDP and still be affordable

I can’t over-emphasise how important the concepts in this article in last week’s Economist are: An incurable disease, and I would urge my readers to try and get to grips with it. If you want to understand how our economy is changing, and the implications for public services, the idea it describes is critical. It ranks alongside Ricardo’s law of comparative advantage (gains from trade) and Keynes’s multiplier (fiscal policy) as a counter-inituitive idea that explains so much.

What it describes is something usually referred to as “Baumol’s cost disease”, and reviews a book by the eponymous William Baumol, “The Cost Disease: Why Computers Get Cheaper and Health Care Doesn’t”. It stems from the observation that productivity grows in some parts of the economy faster than in others. The paradox is that the more productivity in a sector advances, the smaller its share in the the economy at large. Thus agriculture used to dominate the economies of the current developed world – but as agriculture became more productive, it needed less people and so shrank to a negligible propertion of GDP – while generating ever larger larger quantities of agricultural produce. The same effect is clearly visible in manufacturing industry – producing more goods than ever, but from a shrinking workforce. The more these areas advance, the bigger less productive sectors bulk in the economy as a whole. It is, misleadingly, referred to as a “disease” because these less productive sectors, within the service economy, then act as a drag on economic growth as a whole. It is not in fact a disease, but a symptom of success. The failure of economists to understand the difference between creating wealth and realising it (i.e. turning that wealth into something that actually benefits humankind) is one the biggest failures of the dismal science, and it is a shame that Mr Baumol perpetuates it in the title of his book.

The most important of these unproductive services are healthcare and education. Personal contact go the very heart of what these services are: to succeed these services must accept that people are individuals, and that a solution which works for one person may well not work for her superficially similar neighbour. But, while productivity grows only slowly, if at all, costs, i.e. rates of pay, must reflect the increased productivity of the economy as a whole. So costs advance faster than productivity. Sound familiar? But this only happens because we can afford it.

The eye-catching claim in the book is that on current treads healthcare will take up 60% of the US economy in 100 years, and 50% of the UK one. But this is all paid for by the fact that other parts of the economy have become more efficient – and in fact it only takes up such a large part of the economy because these parts of the economy have become more efficient. Actually this projection is a bit silly. I think the advance of conventionally measured productivity will slow, as technological change now affects quality rather than quantity. Also other sectors of the economy will reverse productivity as people value personal content more (think of the return to craft food production). But it is rather a good way to make the point.

Which means that the challenge with healthcare and education is not that growing costs are unaffordable, as various right-wing types claim, but something much more subtle. There are three issues in particular:

A lot of healthcare is indeed inefficient, both in the UK and the US, and political pressure must be brought ot bear to address this. But don’t expect it to halt or reverse the share of health costs in the economy in the long run. The NHS “Nicholson challenge” in the UK may therefore be a valid policy goal, but it will not solve the long-term funding needs of the health service.
The larger the share of the economy healthcare takes up, the more difficult it will be to fund it entirely from tax. In the UK this either means that a parallel private sector will flourish and undermine the NHS (as has already happened in dentistry), or that the NHS will need to be a lot less squeamish about co-payments.
There is a temptation for the owners and workers in the highly productive parts of the economy to keep the rewards to themselves, creating inequality and undermining public the public sector. And yet we still want productivity to advance so that we can all afford a higher standard of service. Higher taxes are part of the solution, but only part. Again this points to the fact that a higher proportion of healthcare (and education) services will have to be delivered and paid for privately – allowing the remainder of the public services to pay decent wage rates.

I hope that provides food for thought!

Plan B

One of the reasons why I suspect Labour will win the next general election here in the UK is that they are showing impressive discipline. This was on show yesterday at a fringe meeting at which both John Cruddas and Andrew Adonis spoke, alongside Jo Swinson and Menzies Campbell. Amid warm words there was a disciplined message about the urgent need for “Plan B” to rescue the economy. Neither is close to the centre of power in Labour, but both were impressively on message. How are Lib Dems responding?

The Labour narrative is this. The Coalition’s economic plan, if it was ever valid, has now clearly failed. It is time for something else, unless you are an evil Tory who simply wants to use the crisis to dismantle the state and don’t care at all for the less well off. It helps them that quite a few, even most, respectable economists support something like this point of view. This allows many to portray Nick Clegg in particular as economically illiterate. These feelings are quite widespread in the Lib Dems – hence the Labour pressure. How are the Lib Dem leadership responding? With equally impressive discipline at this week’s conference.

At several points, and from several different members of the parliamentary party we got a consistent message, but one that had clearly been crafted for the occasion. The economic plan, they said, was always flexible, and it is responding to the changed economic circumstances by putting off the target date for eliminating the deficit by two years. This sounds to be an ingenious way to make a virtue out of necessity. I don’t remember anybody touting flexibility last year – except, to be fair, for Chris Huhne, the former energy secretary who does not appear to be here in Brighton. And so far that discipline is holding. The party overwhelming backed a supportive motion on the economy this morning, rejecting a wrecking amendment from Plan B supporters. The message was helped by lots of warm words and promises about investment in housing and infrastructure.

As readers of this blog will know, I don’t think that the government’s economic policy has failed, but that expectations of how quickly growth would return were too high. And I don’t think that Mr Clegg is economically illiterate, though I have some doubts about George Osborne, the Conservative Chancellor. Far too many economists are basing their views on aggregate statistics, without asking deeper questions about how the economy has been evolving, in a sort of imperial arrogance worthy of Russian Tsars. More on that another time.

Capitalism in crisis. A smaller state and lower taxes will make things worse, not better.

The advanced capitalist economies are in trouble. Economic growth is anaemic or negative; government debt mounting; banking systems are on life support. There are big differences between the individual economies, but some combination of these three, or at least two of them, afflicts more or less all major economies – Australia and some Scandinavian economies excepted perhaps. The crisis may not be as severe as the one in the 1970s (it is if you measure GDP statistics but not by any other measure), but there is a pervasive sense of hopelessness. Nobody seems to have a convincing solution.

Broadly two narratives are offered. On the left the crisis is attributed to greedy bankers and corporate bad behaviour – and the answer is to ratchet up state spending to provide a Keynesian stimulus together with some very vague ideas on improving regulation of big business. On the right the crisis is attributed to an excessive state, and the answer is to roll it back to get out of the way of free enterprise. Neither is very convincing. For a much more convincing narrative, go to the eminent American economist and Nobel Laureate Joseph Stiglitz. He recently published a book on the topic: The Price of Inequality: How Today’s Divided Society Endangers our Future. I haven’t read it, alas, but it is reviewed by the Economist here, and Professor Stiglitz wrote an article for the FT here. A weakness is that his comments are focused especially on the US – but they have a global resonance.

This crisis has been evolving since the 1980s, while two important trends have been evident: the advance of technology and globalisation. These have rendered much of the earlier economic infrastructure obsolete and forced a major restructuring of the world economy, with big impacts in both the developed and devoping worlds – many of them very positive. Running alongside this has been a major shift in the balance of economic power from labour to capital. This is evidenced by a declining proportion of GDP attributed to wages and salaries and an increasing proportion to business profits. This in turn has led, especially in the US, to a dramatic rise in the inequality of wealth and income distribution. I have not been able to lay my hands on a clear set of statistics to demonstrate this – and not being a student any more I do not have access to the OECD or other statistical databanks – or not in a form I can work with. But this is widely attested to. Incidentally income inequality is not the only aspect of this problem, the amassing of corporate power that we can see in Japan and Germany, for example, is another dimension of the same problem.

This is where it gets interesting. One of the characteristics of the very wealthy (including big corporations) is that they do not spend as much of their income as poorer folk. They like to amass wealth, to exercise power, to pass on to later generations, or simply because they are too busy creating it to spend it. This creates a problem made famous by Maynard Keynes, and explored by all Economics undergraduates: if there is a surplus of saving over investment opportunities then the economy as a whole starts to shrink: people are producing more than is being consumed. That, in essence is what the crisis is about. Changes to the world economy have skewed the distribution of income in such a way that it is slowly suffocating the economy as a whole. This is not unprecedented: something like this happened in the early days of capitalism in the mid 19th century, but was resolved when the balance of power shifted back to labour. I have read a claim that there was a similar crisis in the 1920s and 1930s – but I am less convinced that skewed income played such an important role in then.

Now there are broadly four ways that sinking domestic demand from excess savings can be countered. First, an economy can run an export surplus which transfers the excess supply to other economies; this might be called the German solution. Second investment levels can be stoked up to absorb the surplus savings: this is roughly what happened in America in the 1990s with madness of the high-tech boom. Third consumption can be ramped up amongst the less well off by encouraging private debt, usually aided and abetted by a property bubble – the US and UK economies did in the 2000s. Finally government spending can take up the slack, either financed by taxes or, more usually, by borrowing.

Each of these four solutions has been tried by the major world economies, and all have given rise to problems. Export surpluses simply transfer the problem elsewhere – and are only globally sustainable where the counterpart deficits are being used to finance worthwhile investment. But the developing world, where most such investment is taking place, has often been running trade surpluses. Otherwise surpluses build up into assets that have to be unwound painfully. Investment looks like a good idea, but to work these investments have to pay back, otherwise you simply postpone trouble. This has proved much more challenging than many have allowed – I did not use the word “madness” in connection with the high tech boom of the 1990s for nothing. Private debt amongst the less well off might work if their incomes are rising – but the problem arises because they are not. And finally excess state funding carries its own problems. It is economically inefficient, and, financed by debt it simply builds a future financial crisis.

So what to do? It is worth noting that the left’s narrative on the crisis is closer to mark than the right’s. Cutting taxes and the power of the state will not unleash a flood of new investment, as the right claims – it will make matters worse by choking demand further. The left is right (as it were) to see that a large state is part of the solution, rather than the problem. Where they are wrong is to think that a bit of fiscal stimulus will restore the economy back to health – because it fails to deal with the root causes of the problem. Taxes have to rise, and especially on capital and the rich. And there is rather a tough consequence. This may help break the cycle of the rich not spending enough – but at a cost to the overall efficiency of the economy. We have to lower our expectations of what an economy can deliver.

And what of the megatrends that caused the problem in the first place? As I have argued on this blog before, I think globalisation is running its course and will not be the force it once was. There will be less pressure on developed societies from developing world competition. As for technology, let us hope that it starts to fulfil its promise of empowering the individual. Only this will ultimately restore the balance of power between businesses and their employees in a way that does not suffocate enterprise.

The UK GDP figures change nothing

Today the Office for National Statistics delivered its first estimate for the UK’s GDP in the second quarter. With a fall of 0.7% they were a bit shocking – we have had a number of quarters with it being cose to no change, and this looks like a proper lurch downwards. This has provoked some predictable “told-you-sos” by the government’s critics, who say that it shows that the Coalition government’s policies are failing, and call for less austerity. But what do the figures actually mean?

Making sense of it all is not easy. The first point is that GDP is not of huge importance in its own right – only as a proxy for the population’s overall wellbeing. But in a dveleoped economy this latter is more closely tied to employment – and here that statistics seem to be slowly moving in the opposite direction. This has created a headache for economists, since this behaviour isn’t in the script. Some even say that the GDP figures may be in error. But they have been saying this for some time now, and revised estimates have not made the figures any better. We need more evidence from the real world to see if anything very harmful is going on. If, for example, the decline in GDP is a result of a shrinkage of investment banking, where they is lots of money and few jobs, we needn’t lose any sleep. Or if it results form people taking time off, e.g. for the Jubilee holiday, then again it is no real cause for concern – provided people enjoy their time off. The truth is that we don’t have a clear understanding of what is happening, and whether it is in fact particulalry bad.

Well, not quite. We rely on money income, measured by GDP, to generate taxes to fund the services and benefits supplied by the state. And to pay off the debts left by past governments. Given that taxes still fall well short of what they are supposed to pay for, this is a worry. For now things are OK. The financial markets aren’t taking fright (even as they are in Spain, whose finances are not in such bad shape). If they do then we can expect all sorts of nasty consequences as interest rates rise, and possibly inflation too.

But what of the argument that austerity is slowly strangling the economy, and we need to ease off? This is a topic that I have blogged about many times before. The austerity sceptics are those who basicly think that a sustainable economy is within our grasp, and it just needs a bit of confidence and an upward demand cycle to reach it. I remain sceptical. Slowing austerity may simply be postponing a necessary adjustment – and runs greater risks with those financial markets. These figures do not provide additional evidence either way on this debate.

The problem for the government is that GDP – and tax income – is falling behind their projections, which makes it look like a failure. But this is more a criticism of the art of economic forecasting than it is of government policy. But economic forecasting has long been known to be inaccurate, and it always will be. Many people, on both sides of the austerity argument, are not surprised that the recovery is so slow. And the forecasts weren’t even politically motivated – since the government transferred responsibility to an independent body – the Office for Budget Responsiiblity.

Still, the case for using the government’s weight to progress worthwhile investments in house building, transport infrastructure and education remains strong, and no doubt their advocates will use this data to pressure the Treasury to loosen up. But these investments must be for items that will be of genuine benefit – the right sort of homes in the right places, for example – and not just expenditure for its own sake. And that makes the process slow.

So, in short, these GDP figures are nothing to get excited about.

The meaninglessness of “money supply”

Where are modern economists most at sea? Some may think it is their over-reliance on GDP to represent the welfare of an economy. But economists are quite comfortable with the theory of all that, even if they often fail to put it into practice. No, the real problem is money supply. It used to be a central concept, but now it is useless.

Economistsused to be very confident about it all, even while I was taking my Economics degree in the mid 2000s. Their ideas had been developed most famously by Milton Friedman, the 100th anniversary of whose birth is being celebrated this year. He was the first to say that managing the money supply was a critical part of managing an economy as a whole. He was an iconoclast at first but gradually the idea became conventional wisdom.

The imagery that economists used to explain money’s role was endearingly folksy but also revealing. Money was explained in terms of dollar bills or pound notes. To increase the supply of money, a central bank simply printed more of it. The role in macroeconomic policy of increasing money supply was often talked of in terms of a helicopter drop of bundles of banknotes. If an economy was suffering from unemployment, then people would rush out of their homes, grab the cash dropped by the helicopter, spend it, and soon the unemployed would be back in work with no harm done! (Of course if there was no unemployment, people would spend the new money, but the result would be inflation). Friedman thought that the Great Depression of the 1930s could be simply explained by a lack of money (banks kept on going bust), and not a lack of government expenditure.

But it’s obvious to everybody that cash plays a very small role in a modern economy. The money we spend is in bank accounts, and often spent via credit cards; pound notes just don’t come into it. But economic theory hasn’t caught up. It is simply assumed that modern money could be managed by a central bank in an analogous way to printing banknotes. A couple of theories were used to justify this. First was an idea of a “monetary base” of deposits held by commercial banks at the central bank, which limited the amount of money these banks could supply to their customers, but this clearly did not reflect reality. A more enduring theory was based on the central bank controlling money supply through the interest rates it set on the deposit, and influenced through “open market operations”. Raise interest rates and money supply would fall as people moved money into interest bearing securities. This seemed to work – though it was hard to reconcile it to the complexities of what was actually going on – the line between non-interest bearing “money” and interest-bearing securities being hardly a firm one. There was no no better idea, though, and an elaborate macroeconomic theory was constructed on the back of of it.

Two ideas were central to this theory. First that people responded to an increase money supply by spending more (or a decrease by spending less), and second that the money supply could be controlled centrally. If an economy was suffering from a lack of demand, you could correct this by loosening the money supply, as an alternative to fiscal policy – increasing government spending or reducing taxes. This was irrestiable to the polical right, who hated the idea of using taxes and public spending to manage the business cycle – since this raised the size of the state sector.

But the idea is now in tatters, though some economists don’t seem to realise it, especially those of an amateur sort, which unfortunately seems to include the UK Chancellor of the Exchequer, George Osborne. Both assumptions are problematic. First, do people respond to an increased money supply by spending more? What if, in the banknotes in the helicopter example, people are so frightened about the future that they simply grab the banknotes and stuff them into their mattresses? There is no extra spending, and no effect on unemployment. This is an old challenge. Maynard Keynes talked of increasing money supply in a recession as “pushing against a string”. With money now a much more complex thing held in bank accounts, this problem is worse. It can be quite rational to leave money in a bank account without wanting to spend it – especially when interest rates are low.

That could be used to explain why very loose money policy by central banks in the developed economies currently has had so little effect, which is indeed what people like the US economist Paul Krugman are saying. But in fact money supply itself does not seem to be responding to the central banks’ wishes. It has been shrinking even as interest rates fall. This causes certain commentators angst – pleading for central banks to loosen policy yet further.

But how is money actually created? Apart from notes and coins it is mainly created by commercial banks. They do so by advancing their customers money. If you borrow £1,000 from your bank, the bank simply adds the money to your current account, increasing the overall money supply, and the bank puts a loan on the asset side of its balance sheet. No central bank or other authority plays any role in this. And if banks decide to cut back their lending, money supply shrinks. What counts is not money supply but credit.

Governments and central banks can use the creation or withdrawal of money to wreck an economy, as Zimbabwe has done, but not to fine tune it. The sensation of doing so in the 1990s and early 2000s was in fact an illusion. What actually counts is mood and the supply of credit. Movements in the money supply follow what is going on in the economy at large rather than lead it.

There is in fact no alternative for policy makers but to get their hands dirty in the detailed workings of the banking system as a whole, rather than simply adjust central bank interest rates. As the world’s banking crisis continues to rumble on, nobody argues with this – but there is a distinct air of crisis management and an absence of strategy.

What people in practice mean by “monetary policy” is series of policy interventions, such central bank interest rates, bank regulation, managing government debt, credit policy, exchange rate interventions, and so on. Each of these interventions has its impact – but it is disinctly unhelpful to view this impact in terms of any concept called “money supply”.

But we are left with a theoretical vacuum in economics. We know credit and banking are important parts of an economy, and critical to an understanding of the business cycle. But how on earth to manage them? Giving commercial banks free reign subject to a few central bank interventions does not look a good idea any more.

The financial crisis: five years and counting

It is five years since the financial crisis broke. In July and August of 2007 the interbank markets froze over, and it became evident that the boom years were over. Five years on and the world economy still looks in deep trouble. Each of the major developed economies is in a mess, especially if you treat the Eurozone as a single economy. This is a remarkable fact in itself – we are used to economic crises taking a much shorter time to resolve. It is worth trying to take a long view on it.

Looking back at what I was writing in 2007 (when I was in the third year of my economics degree at UCL), I am struck by how much denial there was in the air then. There was clearly a crisis in finance. but this was all about a few loans to poor people in the US – and would not affect the “real” economy by much, so many thought. Share prices held up, and superficially things seemed to be holding together. In the autumn of 2007 the small British bank Northern Rock fell apart. All hell did not let loose until the autumn of 2008, when Lehman collapsed, threatening to take much of the world’s financial system with it. Even so, the press regularly articles from people saying, backed by statistics from previous crises, that things would be back to “normal” soon. Alas, those who were comparing the crisis to Japan’s “lost decade” of the 1990s were closer to the mark. What happened?

At first sight the crises affecting the US, the Eurozone, Japan and the UK all look quite different – and it is very easy to focus on just one of these (as I usually do about the UK) as if the crisis in the rest of the world was something else. But the fact that they are all going wrong at the same time suggests a global pattern underlying all the local variations.

In the developed world, across the board, there has been a collapse in domestic demand – private consumption and business investment. This collapse has been compensated by an increase in net government expenditure (spending less taxes), to varying degrees in each economy. This has stopped, or mitigated, a sort of doom loop in which diminishing demand feeds on itself to reduce demand further. But private sector demand has been slow to revive. This is what is perplexing people.

Here the world is divided – and depending which side you are on, your views on how to tackle the crisis will differ. The optimists suggest that the problem is a temporary loss of confidence which is suppressing business investment and consumer demand. Revive this (some say by government stimulus, others by business friendly polices like cutting taxes) and we can get to something like where we were before, with more employment and rising living standards. The there will be a multiplier effect whereby growth feeds on itself.

I am not an optimist in this sense. I think that behind the crisis lie some big developments in the world economy:

The developed world’s demographics are changing. People are living longer; the post war baby boom is moving into retirement. The proportion of the working age population is shrinking. Many older people want to stop work to retire. It is important to see this in perspective. Many talk of a demographic crisis and of the threat to the wider economy. But it is quite rational to want to experience the benefits of a modern, highly productive economy through increased leisure, rather than through an endless treadmill of work and consumption. And quite rational to take this leisure as retirement rather than a shorter working week, say.
Technological advance is changing the shape of the economy in the developed world. Manufacturing is now so efficient that it requires few people employed in it to satisfy all of our needs. As a result a growing proportion of jobs are in services. It is not so obvious how increased productivity, as conventionally viewed, applies in many services. Too often this comes at the expense of the personal contact we value so much. Another problem is that so often the jobs created by the new economy aren’t matched to the skills that a large proportion of the population has.
The developing world is catching up with the developed world. This can be counted as the biggest success of the global economy, but it is putting pressure on some scarce global resources – such as oil – and forcing their relative prices up in all economies.
And as if that wasn’t bad enough, the amount of carbon the world is pumping into the atmosphere is causing global warming, with the prospect of increasingly disruptive effect across the world – and an imperative to change our ways to reverse it.

The sum of these trends it to suggest two things: that the developed world economy before the crisis was unsustainable so that we can’t return to it; that the prospects for economic growth, as conventionally measured, in the developing world are weak.

That means that the world after the crisis will be a very different place to the one before it. It is one where people in the developing world escape the tyranny of poverty, and where in the developed world people consume less but enjoy life more. But to get there means resolving some awkward tensions:

It’s all very well to say that we should be less focused on economic growth and consumption, and more on wellbeing. Except that so much of what we expect from a modern society depends on the state, and on taxes to fund it. Taxes are driven by the conventional economy. We have to reduce our expectations of what the state can provide.
As growth in the economy as a whole slows, tackling poverty and deprivation through growth alone won’t work. Distribution of wealth grows in importance. That leads to a dense thicket of economic problems and challenges to social values.
At a global level we are hardly beginning to understand how to reconcile tackling poverty in the developing world with the need to reverse carbon emissions. While this battle continues, the developed world has to lead from the front and reduce its own net emissions to less than zero.

And here we are. 1,000 words on the economic crisis and I have mentioned debt and globalisation, or even the problems of currency unions – factors which have dominated discussion of the crisis since it began. But debt, trade and currency are the tactics, not the strategy. We won’t solve these mammoth problems without a clear understanding of strategy. as the crisis drags on though, people will perhaps realise that the problems are a bit deeper that a bit of stimulus here and there will fix.

Behind the theatrics on Barclays, what needs to be done?

Predictably enough the Barclays Libor scandal is generating rampant theatrics amongst both journalists and politicians. It is not easy to keep grip on what actually matters. And yet this is vital when it comes to deciding what the next steps should be.

One piece of theatre is a sort of whodunnit, amongst Barclays senior managers, and government and regulatory officials. How much did they know? What did they authorise? One line of attack concentrates on Bob Diamond, the former Barclays Chief Executive, whose evasions at a parliamentary select committee yesterday created predictable anger. The real point behind this is the question of how far up the chain of command should responsibility for unethical behaviour go? Should bank chief executives be like Royal Navy captains, as John Kay suggested yesterday in the FT, and take full responsibility for everything that happens on their ship?

A further twist comes from the thought that there may have been an element of government connivance in the second phase of manipulation, as the financial crisis was in full swing. The hope amongst government politicians is that something can be pinned on Labour figures such as Shadow Chancellor Ed Balls. That looks a long shot. Experienced political operators like Mr Balls don’t leave fingerprints, and there were legitimate reasons at the time for an interest in the behaviour of Libor. But the Labour’s case wasn’t helped by a radio interview with Baroness Vadera, Gordon Brown’s economic adviser, yesterday lunchtime. She was evasive, confusing the two very different phases of the scandal (i.e. the first phase of manipulation for to make trading profits, and the second of official manipulation for wider politcal purposes). It gave the impression there was something to hide. Other key Labour figures, such as Mr Balls and Lord Myners, the former City minister, are giving much more confident performances, though.

Centre stage for the theatrics today is the argument as to whether any enquiry should be a full judicial one, like the Leveson Inquiry into the press, which Labour are asking for, or the government’s preferred option of a quicker parliamentary one. Both options have merit. A judicial enquiry gives the whole thing an air of importance, and legal interrogators are much more effective than grandstanding politicians; it would keep the City types on the ropes for longer. But lawyers are unlikely to contribute much of value to designing a solution. A parliamentary enquiry would be a quicker way to actually change the law, as well as creating less complications for any parallel criminal investigations. What is actually needed is an expert commission – but we’ve already had one of those, the Vickers Commission – which indeed pointed towards some of the solutions.

But what actually needs to be done? In principle this isn’t difficult. Investment banking activities do play a useful role in the modern economic system, and aggressive trading culture can help the process of what economists call “price discovery” – spotting and correcting where the prices of financial instruments don’t reflect the world’s realities. Short-selling the shares of badly performing companies looks ugly, for example, but it does improve accountability. But the usefulness of investment banking is distorted by two problems:

Using other people’s money. Where traders use borrowed money to trade with, which is the bulk of what they do, then they are not taking full responsibility for the rsiks they are taking, and the whole balance of incentives gets skewed. Trading soon escalates to levels beyond the socially useful. The volume of borrowed money used has risen massively over the last couple of decades, and many traders probably don’t even understand the idea of using their own capital to bet with.
Trading culture struggles to recognise ethical boundaries. A disagreement over price is one thing, but manipulating systems designed help people is another. Fiddling Libor (especially in the first phase of this scandal) was one such transgression, as are various scams to exploit the way mutual funds are priced. The UK regulatory authorities can be too soft on this.

So in essence what needs to happen is this:

Isolate banks’ trading and derivative activities from ordinary economic deposit-taking and commercial lending, and attach separate regulatory regimes to each.
Clamp down hard on unethical behaviour – with chief executives and directors taking full responsibility for what happens in their organisations. Ignorance should not be a defence – and if that means some organisations become impossible to manage, then they should be broken up. Sanctions should hurt, and include the criminal law (though remember that its higher burden of proof can get in the way).
The money supply to investment banking operations needs to be choked off, so that only those that fully understand the risks are supplying it. Isolation will help here, but may not be enough.

The principles are easy, but the details are all important. The problems are global but it will be very hard for us in Britain. The City is so important for our overall economy that we are easily scared away from being too tough. But if the attraction of the City is that it is easier to do unethical business, then this is not a recipe for long-term success. We can still have a thriving financial services industry with niche operations based on genuine knowledge and expertise of the real world, and the provision of solid, well designed infrastructure and systems.

Next steps? I think an enquiry is a bit of a distraction, so the government’s option is probably better. the government perhaps using this enquiry as cover, must go back to the Vickers proposals and implement them in full. Going beyond Vickers to enforce the full separation of investment and commercial banking should be considered. And as for culture change, that needs to happen at the regulators, including the Bank of England, as much as the banks themselves. A change of senior personnel would help here.

Barclays scandal: culture isn’t the problem, it’s the money

City traders live in a world of their own. After the news of Barclays Bank’s fine for falsifying LIBOR returns, its share price rose slightly. The scandal had been rumbling on for months, and they were relieved that it had been resolved. They had no idea about the approaching firestorm – which took a big toll on its price later that day. Later an investor was reported by the BBC (who may have been quoting a newspaper) that all this mob rule had to end. But as the hue and cry continues (this morning the Barclays chairman resigned), politicians and media commentators seem to be equally out of touch with what lies behind the scandal. Unfortunately that may mean that nothing useful comes out of it.

The LIBOR issue itself is being blown out of all proportion. That is understandable. So much of the unethical practice in the industry go unpunished that when somebody gets caught a disproportionate response is quite rational. That is the point that City insiders probably missed in their sanguine early reaction. But most of the comment has focused on the idea that the industry culture is thoroughly cynical and corrupt, and it is this culture that is the main problem needs to change. Criminal penalties are spoken of for unethical behaviour, and the familiar idea that the payment of big bonuses should be limited. The Business Secretary Vince Cable has called for banks’ investors to rein the managements in.

That’s all very well as far as it goes. The culture is awful. We shouldn’t be too romantic about how things used to be, though. In the old City it may have been the case that “my word is my bond”, but ripping off clients and living off fat commissions was rife. One point frequently made is that traditional upright commercial banking culture, such as displayed by Barclays’s Quaker founders, has been corrupted as investment bankers have taken over. This is also true, but that fusty, conservative, self-absorbed commercial banking culture had to change. I well remember having lunch once at Barclays HQ in the 1980s: what a gloomy experience, for all the uprightness of those involved – there was no hope of us doing business with them because they would never be ready! We must look deeper.

The problem is that it is far too easy for big banks to make lots of money without too much effort. That is absolutely corrupting. Bankers naturally think that this money is added value for the highly skilled work they do to ensure that money flows to and from the right parts of the real economy. The rest of us are entitled to be sceptical. The profits which happen most years are wiped out in the bad years, when shareholders and taxpayers pick up the tab. The investment bankers have found a number of ways to make bets with other people’s money, take the benefits for themselves, and make sure somebody else picks up the tab if things go wrong.

But that’s not the only problem, here in the UK at least. There is also lack of meaningful competition. It is impossibly difficult to set up a new bank to compete with the existing oligopoly. The remaining banks have been allowed to consolidate into a small number of behemoths. The regulatory authorities, including the Treasury and the Bank of England, as well as the FSA, have been complicit in this. They prefer a cosy club of large organisations with big compliance departments than the rough and tumble of competition that, for example, the Americans or Germans experience.

The aim of public policy should be to make banking less profitable, so that the banks can’t pay massive salaries and bonuses, and more competitive, so that customers benefit from real innovation. This needs the British authorities to do three things in particular:

Make it much more difficult and expensive for investment banking and financial trading operations to secure finance. Separating investment banking from commercial banking, as recommended by the Vickers Commission, is a good first step, though may not go far enough. Increased capital requirements, as now being imposed globally, is another. Regulators need to be particularly hard on bigger institutions, and not let the idea that larger operations are more efficient take hold.
It must be much easier to set up new banks, both in commercial banking and investment banking. The issue isn’t the amount of regulatory capital required, but a host of other obstacles placed in the path of new banks.
While regulation needs to lighten up on the creation of new banks, it needs to be tightened on the regulation of lending operations. We should not allow runaway growth of credit, especially that linked to the purchase of purely financial investments, and, it has to be said, to real estate.

All easily said. But the trouble is that it is quite painful. Attacking bank profits will look like an attack on one of a limited number of industries where British based operations are internationally competitive. Easing up on creating new banks means tolerating more banking failures and creating a more challenging environment for regulators. Restricting credit means curtailing the British love affair with property ownership.

It is easier to bang on about culture and lock a few people up. The one good thing about the crisis is that it helps keep the pressure up on the Vickers reforms. But when the dust settles the usual City types will be having a quiet word with their counterparts in the Treasury, Bank of England and the Prime Minister’s office about not throwing the baby out with the bathwater. The reforms will be quietly defanged. Bankers will continue to lord up. Taxpayers will continue to be exposed. And the British public will continue to be let down by bankers and politicians alike.

Let’s hope that this does not come to pass. Critics of the banking industry will need to keep the pressure up.