Productivity statistics expose deep weaknesses in theoretical economics

I hadn’t intended to post for another couple of weeks, but this article in the Financial Times is too good to miss. It tackles one of the central issues in modern economic debate: why productivity growth is so slow. Productivity lies at the heart of the conventional view of public policy – and yet it is very poorly understood. This article sheds light on what is happening in the UK – and it should give politicians and economists pause.

Productivity is in principle a very simple idea. It is the amount produced by a unit of labour in a unit of time – the number of widgets per person per hour, for example. This immediately conjures up a clear mental picture of a factory producing cars, say. Count the number of cars produced, and the number of hours of labour required and it is easy-peasy, surely? Alas in a modern economy  it is a much more difficult idea. What if your car factory is producing both Ford Fiestas and Mondeos, and switches to the smaller car? Has productivity gone up if more are produced? And how do you distinguish product enhancement from inflation?  And then there are problems treating capital outputs and inputs, research and development, and so on. In the end the productivity measured across an economy is a bit of a balancing figure, as we accountants would call it – or a bit of a dustbin – what’s left when you’ve taken everything else out. It is just a number relationship without a coherent meaning in its own right. It is not like the concepts that physical scientists are used to dealing with – such as the temperature and pressure of a gas. Macroeconomics is heterogeneous, to say nothing of being subject to capricious social forces that tend to corrupt all attempts at measurement.

Now, what is the productivity puzzle? It is that productivity growth, as measured by macroeconomic statisticians, has slowed markedly since 2008, when the financial crash caused a dislocation in measured income. This applies to all developed economies, but to the British economy most of all – UK productivity growth, according to the article, fell from 1.6% per annum before 2008 to just 0.3% after. This has profound implications, since in the long term productivity growth is what drives income per head, alongside the average hours people work (influenced strongly by workforce participation – such as how many women are in paid employment). And this drives tax revenues, from which public services are funded. Since we assume that quality of life is mainly driven by income, and that public services can constantly be enhanced by extra spending (apart from occasional periods of “austerity”), this has profound implications. Prior to 2008 most economists assumed that productivity growth of 1-2% pa was a law of nature and  main driver of “trend growth”, which could be baked into economic models. The corollary was that weak growth since 2008, and the failure of GDP to catch up with the pre 2008 trend-line, was a failure in macroeconomic policy.

But given the dustbin nature of the productivity statistics, it is very hard to drill down into them to find out just where the problem is – though that there is a problem of some sort is clear. This is licence for all manner of people to project their speculations into a fact-free zone. Mostly these are based on the intuitively obvious idea that the changes to the productivity figures represent trends in the efficiency of workers. Recently Bank of England bigwig Andrew Haldane moaned that the problem was that efficiency was stuck in a rut, especially in a swathe of mediocre firms. He based this on sectoral analysis which showed that the productivity had stagnated across all sectors – with economic growth mainly attributed to rises in employment, not efficiency.

The FT article, authored by Chris Giles and Gemma Tetlow, challenge that. A close examination of the numbers shows that the crash in productivity growth arises from changes in a small number of economic sectors, accounting for just 11% of income. These are banking, telecoms, electricity and gas, management consultancy, and legal and accounting services. Actually Mr Haldane’s and Mr Giles/Ms Tetlow’s analysis can be reconciled. Mr Haldane was taking a general view across the economy since 2008, where productivity growth is now very limited. The FT writers are looking at the transition from before and after 2008. The curious point is why productivity growth was so high in that small number of industries before 2008 – and the realisation that this is what was driving so much of the figures for productivity growth before that date.

And that leaves this blogger asking whether that pre-crash productivity growth – and by implication the pre-crash trend rate of overall economic growth – was in any sense real, other than statistically. In banking we know that in 2008 massive state resources were required to keep the industry alive, and that since then the industry has been much better controlled. This suggests that “productivity” would more correctly be described as “recklessness”. And in each of the other industries you can point to factors that demonstrate that growth was not simply incremental improvements in efficiency. For example in electricity and gas productivity was based on high inputs of fossil fuels and nuclear energy – and the switch away from these destructive sources of power has caused a decline in measured productivity. And how on earth do you assess the output of management consultancy, and accountancy and legal services? The transition may simply be from high margins in boom economy conditions to higher scrutiny when times were harder – or to put it another way, what was supposedly economic growth prior to 2008 was in fact concealed inflation.

All this supports the narrative that I have been promoting for quite a few years about the transition from growth to austerity. This is that the supposed growth of the economy of the early to mid noughties in the UK was down to excess demand, of which reckless fiscal policy was a part  – though you might alternatively argue that it was reckless borrowing by the private sector that the government turned a blind eye to. It also suggests that the lacklustre economic performance of the UK economy since 2008 reflects a lot more than just weak demand management: it is chickens coming home to roost.

This takes me to two very important conclusions. The first is that we have to be very careful about the recommendations of macroeconomists – and the eco-system of commentators and policy types that use macroeconomics as their starting point. The bandying about of aggregate statistics is all very well – but the aggregates hide as well as reveal – and we need to base economic prescriptions on the complexities of the real economy. That is hard, but necessary.

The second point is that overall productivity is indeed stuck in a rut, and has been since well before 2008. It must reflect structural issues in real economy – and not simply laziness amongst mediocre firms or poor macroeconomic management. There is no shortage of potential culprits: demographics; the nature of modern technology; the temporary nature of gains from trade with Asian economies. The world may still be becoming a better place – but because of things that are not captured in GDP, and hence productivity statistics. The problem for public policy is that tax revenues are largely driven by GDP (which is why it is an important statistic) – so we can’t expect an ever increasing flow of tax revenue to fund public services. In the long run we must either reduce the demand for public services (healthier people, fewer crimes, less skewed income distribution, etc.), raise taxes, or compromise what level of services and benefits we think that a civilised state should provide.

And that is a completely new way of thinking about public policy. The political right have grasped this (for the wrong reasons, perhaps) – but the left has not.


The US Republican company tax reform might be a good idea

I like to see the bright side. With the accession of Donald Trump as US President, alongside the Republicans controlling both houses of Congress, that is hard. Mostly, I simply hope that the process of challenge will make liberals stronger and harder. There is too much complacency in liberal thinking. And there is more cosying up to vested interests than we might like to think.

And among the flood of bad ideas coming out ot the new administration, there may be the odd good one. Reforming company tax might be one of them.

What I am thinking of are the plans proposed by Paul Ryan, the Speaker of the House of Representatives.  Liberals should support it, though alas many won’t because of who is proposing it, rather than its merits.  One part of the plan is to cut the rate of company tax to 20%, but reduce the number of deductions. This is an old debate. I am sympathetic to lower marginal rates and fewer deductions, though 20% is aggressive. I do not share the view that company profits should not be taxed, and that the burden of taxation should entirely be on distribution of profit instead.

There’s another old idea in the mix too: 100% write off of capital investments in the year the money is spent. Older British accountants like me will remember that we had that system here in the 1980s – called 100% capital allowances. It was the basis of many a tax avoidance scheme, and perhaps tilted the balance too much in favour of investing in plant rather than people. But there is some merit to it.

But the really interesting idea is the so-called “border adjustment”. This exempts from tax sales outside the US, and disallows as deductions spending on imports. This can be painted in different ways. To nativists this sounds like encouraging exports and discouraging imports. Alternatively it can be presented as a sort of value-added tax, which is well-established here in Europe. Neither presentation does it justice. It is not VAT, not least because the costs paying people is within its scope. And its effect on corporate incentives can be beneficial to the world economy rather than detrimental. It amounts to a constructive proposal to deal with a major problem: the taxation of transnational businesses.

At the moment companies are taxed by the location of profits, apportioned “fairly” using general accounting principles. This falls foul of manipulation through transfer pricing – what country-level subsidiaries within a transnational business charge each other. Thus when a multinational sells you something in Britain, it may treat as part of its costs the use of intellectual property based in a low tax regime, such as the Netherlands or Luxembourg. National tax authorities have been fighting a losing battle against abuse. The G20 recently adopted some new rules to reduce abuse, but this is sticking plaster to repair a fracture. It is best seen as an attempt by corporate lobbyists to stave off more radical approaches.

One such radical approach to reform corporate tax is unitary taxation. This method means that tax authorities assess a business’s global profit, and then allocate it to country based on the location of some combination of sales, employment or property. This is how US states tax the profits of US businesses, mostly allocating them using the Massachusetts formula. I have been advocating this for years internationally, but I have unable to persuade even the Liberal Democrats to pursue the idea.

Mr Ryan’s border adjustments are an alternative idea, and look simpler. In essence corporate taxes would be based on the location of revenues – something that would not be easy to distort. So, applied in the UK, Amazon or Starbucks would not be able to use spurious intellectual property charges to relocate profits to tax havens. Overall the scheme favours countries that have trade deficits (like the UK or US) rather than surpluses (like Germany or China), but that is no bad thing.

And probably unilateral action by the US is the only way much is going to happen. Multinational forums like the G20, and even the European Union, have completely failed to deal with this problem. Only the US has the power for unilateral implementation. Where it leads, others will be forced to follow. And post-Brexit Britain should be able to follow quickly.

Alas the power of corporate lobbyists in our democracies remains massive. They are masters of quietly undermining radical ideas and promoting “compromises” that have only superficial effects. Mr Trump is a sceptic, and that’s a very bad start. The hope must be that Mr Ryan will get his way in the inevitable horse-trading between the presidency and congress. Mr Trump may be sceptical, but he is not strongly against it either.

But even if this reform attempt fails, I hope that liberals everywhere will take on the challenge of corporate tax evasion with a radical approach, such as border adjustment or unitary tax. Alas I am not optimistic.


New monetarism: a challenge to conventional economics

Followers of my blog may have noticed quite prolonged exchanges in the comments section between me and Peter Martin. We are both amateur economists so this kind of exchange helps to sharpen thinking, absent an academic or journalistic environment. In order that I might understand Peter’s critique better, he suggested that I view this video of Stephanie Kelton, professor of economics at the University of Missouri – Kansas City. Ms Kelton advocates a system referred to as “Modern Monetary Theory” or, sometimes, “neo-chartalism”. (I will use “neo-chartalism” henceforth as it is easier to write; the “neo” is needed because I think a lot has been added to the basic idea of chartalism). When, as I recently blogged, mainstream macroeconomic thinking is in a sad state, it behoves us to look at those challenging it. This is an interesting idea to pick apart.

The core idea is in fact quite an old one – the original chartalism dates from 1905 and its ideas can be traced back further than that. It is that money is a state artifact, and as such the state has much more latitude in its management than conventional wisdom allows. This is in opposition to the more conventional view that money evolved primarily as a means of exchange to facilitate a market economy, and that the state’s powers to manage it must be constrained or it will be devalued. It is also contrasted with an idea of money that is intimately linked to precious metals (“metalism”), which is a bit cranky these days.

The chartalist view is that money’s primary function is as a voucher with which to pay taxes. It stems from the need of states to commandeer resources to fulfill its functions; this it does through the imposition of liabilities on citizens, which we call taxes. It uses currency values to denominate these liabilities, and then puts physical currency into circulation so that they can be settled. It does this in the first instance by paying its servants and suppliers in this currency. Since everybody needs currency to pay taxes, it quickly evolves into the primary medium of exchange for the whole economy. This allows a banking system to develop for the provision of credit, which in turn facilitates the evolution of money from precious metal coins, to vouchers for precious metal, to fiat money not backed by anything at all. The utility of fiat money, which people not so long ago would have been quite unable to comprehend, is perhaps the ultimate vindication of chartalism. Money is simply what the state says it is; it needs no greater authority than that. And it follows that the state need never run out of money, because it can create all it needs.

This narrative of money is compelling. Historical research comprehensively refutes the idea in old economics textbooks that money somehow evolved from a barter economy. Indeed the core chartalist narrative of money is now so widely held that it is fair to call it mainstream. I doubt that most modern economics textbooks repeat the barter myth. That states can create all the money they need (usually, and misleadingly, called “printing” money) is old news, though, and, indeed, has been an enduring theme of economic debate since the hyperinflation that followed the First World War in Germany and Austria. The chartalist view on this is distinctive: the act of the state creating money does not of itself devalue it: that depends on the context in which it is done. The problem in post war Germany and Austria was that reparations were making unbearable demands on these states.

But this narrative tells you little by itself. It is what neo-chartalists build on this foundation that sets them apart from other economists. My main disappointment with Ms Kelton is that she spends too much time revelling in the brilliance of the initial insight (including a very useful idea of a pyramid of exchange, which explains why local currencies are unlikely to succeed), and too little in explaining where she thinks it leads and why. In trying to explain it I will identify ideas that are implicit in what she says, rather than part of an explicit structure.

The next key idea, and the one that makes neo-chartalism truly distinctive, is that fiscal and monetary policy should form a unity. The best way of putting more spending power into an economy is for the state to loosen fiscal policy – to spend more or tax less; the best way to cool an economy down is to tighten fiscal policy. Fiscal policy directly affects the amount of money flowing in the economy. And a looser fiscal policy can always be supported by the creation of more money. This is very different from the pre-crash consensus, which suggested that fiscal and monetary policy should often pull in opposite directions – with only a marginal role for fiscal policy at all. And even after the crash the British coalition government had a policy of tight fiscal policy balanced by loose monetary policy. Chartalists say this was a mistake: fiscal policy should have been kept loose up to the point where economic capacity was fully utilised, with monetary policy providing support as required; only then should the brakes be jammed on (although may impression is that they  are reluctant to admit that the brakes should ever be jammed on – I may be being unfair).

Here too, I think that neo-chartalists are onto something. I was coming to a similar conclusion, albeit by a different route: the application of the Mundell-Fleming model for open international economies. Ironically Mundell-Fleming is an old-school idea, and regarded with suspicion by neo-chartalists (for example Professor Bill Mitchell of the University of Newcastle, NSW, a leading chartalist). Mundell-Fleming suggests that a floating exchange rate neutralises fiscal policy; but not if it is harmonised with monetary policy. Under a fixed exchange rate system, monetary policy automatically harmonises with fiscal policy, and even amplifies it. The neo-chartalists are surely right that monetary policy by itself is a very inefficient means of managing demand compared to fiscal policy – but it can be an important adjunct to it.

Perhaps the difference between me and the neo-chartalists is that I think the aggressive use of fiscal policy leads to state management of exchange rates,which is not, incidentally, necessarily a fixed exchange rate, and certainly not a currency union. But that is a discussion that needs to be taken elsewhere.

A third key building block of neo-chartalism is that a powerful, fully sovereign state is a force for good. Ms Kelton regards the sacrifice of sovereignty involved in the creation of the Euro with near disbelief. Why on earth would anybody want to do something so stupid? This marks neo-chartalism as a political idea of the left, and its faith in a strong state as the instrument of democratic will. The right view a strong state with suspicion or hostility – as something that uses its power to escape democratic control and further the interests of the state sector at the expense of everybody else. To see the importance of this aspect of the debate, you only have to look at Zimbabwe, where the state’s ability to create money has been a critical way for Robert Mugabe’s regime to retain power; in order to curb the political excesses of the Zimbabwe government it was necessary to adopt the US dollar as currency. Now that Mugabe is on top, he is trying to create his own currency again – but to secure his political status, not to advance the Zimbabwean economy. Strengthening the state’s power on money creation will place a real strain on democratic institutions. Things look all very easy when the state needs to create money to stimulate: but can it be trusted to reverse course when the economy overheats? History suggests that governments tend to deny that an economy is overheating until long after inflation has set in. The Argentine government of Cristina Fernandez even went as far as politicising the state statistics bureau to cover up inflation statistics. In Britain we may remember the stagflation of the 1970s, or, more recently, Gordon Brown adjusting his fiscal rules just when they called for tightening. I think this is a big problem, but not necessarily an insoluble one.

Interestingly there is a divergence of opinion on the radical left here.  People such as the former Greek Finance Minister Yanis Varoufakis think that there is virtue in the idea of a supra-national system for the management of money – a sort of new Bretton Woods – that would curb a state’s power to create money. It is no coincidence that this view comes from somebody used to the challenges of managing a small country, whereas Ms Kelton hails from the USA, which in effect has its cake and eats it by controlling a world currency while remaining a sovereign state.

There are some further ideas important to the construction of neo-chartalist policy:

  1. A optimal private sector (i.e. the aggregation of net private consumption and net business income) should operate at a surplus – i.e. they should be net savers. Excessive private sector debt follows if they are net borrowers, and that is destabilising; public debt is much safer because the state can create the currency to repay it. The private surplus must be balanced by either or both of an external surplus (e.g. net exports) or a public sector deficit. Since not all economies may have an external surplus, this means that it will often be the case that a permanent budget deficit is perfectly healthy (with the US and UK economies being examples). An inappropriate budget surplus could lead to a private sector debt boom – which is what happened to President Clinton’s USA in Ms Kelton’s view.
  2. Sovereign states with control over their own money have nothing to fear from an external deficit – which implies that the state or private citizens must obtain funding from foreigners. The key is that the country must borrow in its own currency – so that it can create the money to repay it. That a country might be forced to borrow in foreign currency is a major weakness in the whole edifice, I think. It is far from clear why exporters from surplus countries should always be in a weaker bargaining position than importers from deficit ones, and so be forced to accept the importer’s currency.
  3. The developed world is suffering from a chronic lack of demand. Neo-chartalists follow pre-crash neo-Keynesians in believing that the key indicator of excess demand in an economy is inflation (as opposed to asset prices or trade deficits). And since inflation does not appear currently to be a  threat in any major economy, there must be plenty of scope to expand fiscal policy. Neo-chartalists do not appear to take seriously the idea that their may be darker forces at work in the economy, reducing economic potential – something that I have long argued. Ms Kelton produced a graph to illustrate where the US economy could be by projecting forwards its growth rate from before the crash – something guaranteed to leave me spitting with fury! They also seem to have little truck with the “Austrian school” idea that a certain degree of slack is required in an economy in order to sustain the forces of creative destruction – and that recessions may be positively beneficial.

In summary: the neo-chartalists are re-writing the conventional wisdom on what money actually is, and have useful things to say about the role of fiscal policy. But beyond that my first reaction is that it is a modest idea that has pretensions beyond itself. It seems applicable in some contexts, but not as a general rule. And yet neo-chartalists are a valuable part of the dialectic from which a new economic synthesis will form. They do not deserve the disdain with which conventional economists treat them. Indeed many of the ideas I have briefly discussed here are a well worth a revisit. I want to dig further into to the topics raised in this blog: the role and management of state power; the relationships between public, private and external balances; managing an economy in the wider world; and demand management vs deeper economic forces.

A discipline that still reserves a place for real business cycle extremists, surely has a place for the new monetarists too.


Macroeconomics is becoming a pseudoscience, and that’s not good for us

Recently the FT’s Wolfgang Munchau referred to an article by prominent US economist Paul Romer, The Trouble with Macroeconomics, published in September 2016. Mr Munchau used it as an argument to rethink the conventional wisdom of macroeconomic management, such as independent central banks and inflation targeting. I agree we need a rethink, but Mr Romer’s article is the wrong jumping-off point for that idea. Instead Mr Romer shows that academic macroeconomics has lost touch with the real world.

Mr Romer references the Trouble with Physics an article from 2007 by Lee Smolin. At this time there was a lot of nonsense going on in theoretical  physics, in particular with the idea of string theory. String theory attempts to be a theory of everything, and at its core is a lot of hard mathematics. But it makes no verifiable predictions and, indeed, seems to avoid areas where there is any danger that data might challenge it. It is more metaphysics than physics. And yet it commanded a sizeable academic following, including a number of big hitters – or at least it did in 2007.

Mr Romer suggests that something similar is happening in academic macroeconomics. People are creating elaborate models whose complexity runs well ahead of any data that can test their relationship to reality. This is covered up by sophistry and obfuscation. By itself this is not so strange, except that people are reluctant make public criticisms of these models, and the often prominent academics whose names attach to them. And yet that process of criticism is the stuff very of science. This makes it a pseudoscience – something that adopts the outward language of a science, but where a core set of beliefs and people are beyond criticism. (There is, of course, always a core set of beliefs in any system that are beyond challenge, including science, but I am talking about something wider here).

The prime target of Mr Romer’s criticism is a theoretical system referred to as the real business cycle. This was developed in the 1980s, and commanded supporters such as Chicago Nobel laureate Robert Lucas. It suggests that government actions, such as fiscal and monetary policy, have little effect on the real economy, and that the business cycle is almost entirely driven by changes to technology, a macroeconomists’ way of saying “just noise”. The real business cycle was presented to me as an economics undergraduate in 2006 as a curiosity that was so silly that it didn’t need comment or study. I can think of no serious piece of economic policy in recent years, and certainly since the financial crash of 2008, that makes reference to it. So it was a surprise to me to read that it remains the subject of serious academic support in the US – and that other serious academics look the other way rather than criticise it.

While Mr Romer spends most of his paper taking apart models based on the real business cycle, he makes it clear that this is a general problem, affecting Keynesian models too. And in particular the Dynamic Stochastic General Equilibrium (DSGE) models that are used for economic forecasting, and so hard-wired into economic management. Economists like to create huge models with lots of variables, and then pump huge amounts of data through them. But it is mathematically impossible to identify, that is to fix, the variables without building assumptions into the model about how they relate to each other – which the model is then unable to test. The models are therefore more a product of their assumptions than a test of those assumptions against data. Mr Romer complains of a conspiracy of silence not to undermine the fragility of all this. This ressembles string theory and other hobby horses of theoretical physics – though these days I read a lot about constructive work going on in physics, as scientists grapple with the problems of dark energy and dark matter. Also I think theoretical physicists are much more transparent about what they are doing – so far as I can see they aren’t even pretending that what they do is useful, except in some abstract sense of advancing the boundaries of human thought. Macroeconomists are dishonest by comparison.

How has all this come about? I don’t think it helps that macroeconomics has been politicised, and in the highly polarised environment of US politics. Real business cycle models are beloved of the right, as a basis for cutting government down to size; DGSE models are liked by the left, as the basis of fiscal and monetary intervention. Pretty much any important development in macroeconomics is parsed for its political significance. Neutrality does not seem to be an option – and yet cloaking policy prescriptions in academic mumbo-jumbo make them look more authoritative, and so demand for academic economists remains strong. US academics used to knock seven bells out of each other (the famous dispute between “salt water” and “fresh water” institutions) – but no doubt they now realise that this just devalues the whole discipline, and so the different schools ignore each other instead. Besides, they both rely on similar conceits.

How much does this matter? Those involved in the practical business of running economies have long since ignored real business cycle theory. Econometric models are used, but with a great deal of caution. Alternative ways of constructing models might be fruitful (for example Kingston’s Professor Steve Keen suggests the use of non-equilibrium complexity theory, as used in meteorology) – but these are liable to suffer from same identification problem. The future is inherently unpredictable. Practical economists can get on with the job without help from an increasingly irrelevant academia.

And yet there is a clear crisis in economic management. Too many people in developed economies feel left behind, fueling political instability that will not help economic management. The authority of the western democratic and inclusive system of government is waning as a result. If academic macroeconomists coud somehow change the direction of their discipline, rather than resorting to obfuscation to insist they were right all along, and deluding themselves that massive computer models are telling us anything useful, then the outlook would be better.


Why did the dollar rise with Trump but the pound fall with Brexit?

If you are part of the conventional liberal “elite” like me, 2016 has been marked by two colossal acts of democratic self-harm: Brexit and the election of Donald Trump. It is easy to understand why the pound sunk after Brexit. By why has the US dollar being doing so well after the election of Donald Trump as president? It is a useful lesson in macroeconomics.

The first thing to say, though, is that the way most of the media cover such market movements is unhelpful. They talk of sentiment and emotional judgements made by anthropomorphised “markets”. These may provide a satisfactory story line for a journalist, but they yield no real insight and no predictive power. They are simply projections onto past events. But very often, and this is no exception, far more satisfactory explanations are available, based on the way money flows through economies and financial markets.

Take Brexit. The obvious explanation is that markets (sticking with the anthropomorphism for now) take a dim view of Britain’s prospects amid the confusion and uncertainty thrown up by Brexit. But by itself that explanation is inadequate. The fall in Sterling was not matched by falls in stock markets (after an initial wobble) and other markets which also depend on future economic prospects. In fact there seems to be much more of a wait-and-see approach by the people and institutions who set market prices.

But wait-and-see is not so neutral. The UK runs a substantial current account deficit (5.7% of GDP according to the Economist, the highest of the 43 countries in its data table – and the second largest in money terms, at nearly $150bn in the last year). That means that the country is consuming much more than it is producing, which in turn means that the country is spending more pounds than it is getting back from exports, etc (or spending more foreign currency on imports than it is getting from exports). This deficit must be made up from the capital account – by investors buying UK assets of one sort or another (or Britons selling off foreign assets). Wait-and-see means that foreigners are more likely to defer making investments, which reduces the demand for Sterling on capital markets, causing its price to fall. This makes UK assets more attractive, UK exports more competitive and imports less attractive. All perfectly textbook.

So, what about the US? This country has a current account deficit too (2.6% of GDP which is $488bn in money terms, the largest current account balance in any direction by some margin, in the Economist table). Surely there is a lot of waiting and seeing to be done here, as Mr Trump’s policies, shall we say, lack clarity? But there are a number of differences with the UK. The first of these is that the US is an economic superpower, which dominates global financial markets, with the dollar used as the top reserve currency. It is much easier for the country to draw in investment that the aging middle-ranking country that is the UK. It has much more secure access to liquid, short-term funding. And with a huge domestic market the outlook for its businesses look less precarious than that for British ones.

But the most important difference is that, for all Mr Trump’s lack of clarity, what is known about him, and the Republicans who control Congress, points to a loosening of fiscal policy. This mainly takes the form of tax cuts. This increases the demand for dollars, because it will increase spending in the US domestic economy. Exactly how remains to be seen. On one version US corporations will repatriate foreign profits and invest in infrastructure. This is all uncertain – but Mr Trump and the Republicans in Congress certainly agree on tax cuts, especially for the wealthiest. And this happens at a time when most people are convinced that the US is running at close to capacity – so there is no question of fiscal laxity being complemented by monetary laxity, which would allow the increased demand for dollars to be met by extra supply. Indeed the Federal Reserve is in the process of tightening policy, and increased interest rates this month.

This economic dynamic is often not appreciated – that in a world of freely floating currencies and open capital markets, loose fiscal policy leads to an appreciation of the currency. But there are plenty of examples if you look for them. When Germany unified in the early 1990s, it involved a considerable relaxation of fiscal policy – which caused the Mark to appreciate, and a crisis in the European Exchange Rate Mechanism in 1992 that forced Sterling to leave, shredding the credibility of John Major’s Conservative Government. My Economics lecturer at UCL used the British government of the mid-noughties as another example – the government ran a larger budget deficit than was warranted at that point in the economic cycle, at a time when banking laxity had already led to excess demand in the economy.

The effect of fiscal policy on a floating currency is part of what is known by economists as the Mundell-Fleming model, proposed independently by economists Robert Mundell and Marcus Fleming, leading theorists of floating currencies. It is one of the reasons that floating currencies are not quite the free lunch suggested by many Anglo-Saxon commentators. It means that a floating rate tends to neutralise fiscal policy (just as a fixed rate neutralises monetary policy). As a currency appreciates, the current account reduces (or deficit gets larger), and any increase in aggregate demand is lost across the world economy. Unless monetary policy operates in the same direction (including “printing money” to monetise the budget deficit), in which case you are in effect operating a managed exchange rate policy. This often ends in inflation or default.

This points to one of the tensions in Mr Trump’s economic policy. Fiscal laxity will lead to a widening trade deficit – exactly the opposite to what he promised on campaign. That will tend to force him into protectionist policies, which in turn could create a doom-loop of global proportions. Many believe that we have the makings of another global financial crisis, especially given developments in the Chinese economy – for example read this from Yanis Varoufakis.

But another tension could be that Mr Trump’s fiscal stimulus proves ineffective. The rich people and corporations that benefit from the tax cuts save most of their winnings; planned infrastructure spending is lost to political friction; and Congress insists on dismantling the social safety net, especially Medicare, sucking demand out of the system by hitting the less well-off. That would mean that growth is disappointing, breaching another Trump campaign promise.

But that’s in the future. For now participants in the financial markets are readying themselves for more demand for dollars, and weaker demand for pounds. They aren’t taking a view on the wisdom or otherwise of either Brexit or the new US regime.


Back to the village? Globalisation is changing direction

The human mind is hard-wired to think that present trends will continue, as many a study cited by behavioural economists attests. It takes a real effort to see things another way, even when there is evidence aplenty. So it seems inevitable that technology change and globalisation will continue to hollow out society, destroying jobs while a rich elite enjoys the high life in specially protected enclaves. But a change of direction is coming.

Recently I read a review in the Economist of a book by Richard Baldwin: The Great Convergence Information Technology and the New Globalisation. This is another variation on the same old story of advancing globalisation, but it offers a narrative that is useful.

Mr Baldwin sees the advance of technology affecting the human economy in two waves. Originally mankind was stuck in a village economy, forced to produce virtually all it consumed. The first wave of technological revolution detached production from consumption through advances in the technologies of transport. Goods (and energy) could be moved cheaply and easily. Society rearranged itself around industrial centres that produced things that were distributed worldwide. But knowledge, ideas and skills did not move so easily, which meant that production was concentrated in integrated geographical clusters.

The second revolution came with information technology, which allowed the spreading of knowhow, which in turn allowed the traditional clusters to fragment. Sub-assemblies could be manufactured far away. And indeed whole factories could be transplanted from Detroit to Mexico. This proved wrenching for the developed countries, but a big opportunity for the rest of the world. It is a backlash against this process which is behind the current wave of political turmoil. Mr Baldwin seems to assume that this process has further to run, and that we should facilitate its progress.

He may be right, but we should not miss two further dynamics, both based on conventional economic theory. The first dynamic is convergence – a different aspect to that suggested in the book’s title. Just why is it that so many factories have been relocated to developing world countries? The knowledge economy facilitates the move, but does not tell us why it is happening. It happens because workers in the developing world are paid less than those in the developed countries. But why?

The reason is that developing world economies have very low productivity. This low productivity is mainly because they have very inefficient agriculture, which ties up a huge proportion of the workforce, and which is massively uncompetitive in world terms. This drags down the cost of labour. But as developing world societies adopt modern technologies, and as more of their populations flock to cities, the productivity gap between town and country reduces. We have witnessed this in Japan, followed by South Korea and Taiwan. Now mainland China is following these exemplars. This means that what economists call comparative advantage (driven by the balance between different sectors of an economy, and considered to be the main engine of trade) is equalising. It’s quite a subtle point (which I explore in my economics essay on trade on why global trade is going into reverse), but the upshot is that the economics of outsourcing overseas is becoming less attractive.

There is plenty of evidence that this trend is quite advanced. It does not mean that large numbers of manufacturing jobs are coming back to developed countries though – because many of the jobs have been automated away. It does mean that future disruptions wrought by technology (and there are more to come, especially in white-collar work) will be less international in scope.

The second dynamic comes from looking at the economic impact of consumption. Not so long ago, the world’s consumption was mainly food. The agriculture sector comprised most of the economy. Now agriculture takes up a tiny share of national consumption in developed economies, and we take it for granted. That same process is evident with so much else of what we consume. Manufacturing industry is vanishing as a proportion of the economy. Various parts of service industry are following suit. So what does that leave? Increasingly our economic activity is about interpersonal contact with people in or around our neighbourhoods: hospitals, care homes, schools, gyms, restaurants, cabs and so on.

And what about technology itself? Though we hear much about it driving a process of mass automation, including through the use of algorithms in artificial intelligence, we may not have noticed that much technology is not about this at all. It is about the empowerment of individuals. Think about what you can do with your smartphone. Think of the personal liberation that comes about through such services as Uber (though not for the drivers perhaps, admittedly). And think about additive manufacturing (or 3-D printing) that makes it more economic to have a production run of one. And think of energy technology. The idea of massive nuclear power stations at the heart of a huge grid of high voltage cables is fading, as it becomes harder to make the economics work. It is being replaced by the idea of localised renewable energy sources, much more efficient consumption, supplemented by medium-sized power stations.

Put these things together and you might start to see the village coming back together again. The centrifugal forces are becoming centripetal. Not yet, to be sure, but the idea is becoming more technologically viable. And there is human need: most people crave denser social networks where recent trends have weakened them.

The new village will be very different from the old one. The old village was very insular, with people rarely mixing with their neighbours. In the new village people will travel freely, and the interchange of ideas will be global. And the new village remains dependent on national and global supply networks and information infrastructure. But most economic activity will be within the village (which could be a small town or suburb or network of actual villages in fact- or perhaps even a large town). The old village was a prison. The new village, or the liberal vision of one, should not be.

Let me hazard a further guess at this new village economy: public services will comprise a very high proportion of what it does. Education, health care, public protection, social care; I do not think these will be marked by high productivity gains in the future, so their importance in the overall economy will rise. And much of the infrastructure that the new society will depend on will be provided by natural monopolies, many of which will end up being run publicly, if not run publicly already. That poses some big challenges for governance and tax.

Those challenges will be among the many for public policy posed by this trend. Another is the status of that liberal icon, free trade. We are stuck in an old way of thinking about it, appropriate to older phases of technological advance. We will be still be dependent on the free trade of things, even if the distances shrink: but things will be less important to us, compared to the services we receive from our neighbours. Free trade may hollow these out by sucking resources away to centres of power elsewhere. Compare a Starbucks to a locally run café.

And another point is that I am coming at this with a very optimistic and liberal gloss, but there may be darker ways that these trends can take shape, with a return to insularity.

But that said, we need to adapt our political ideas to the world as it is, and what it is becoming. We should neither expect current trends to continue forever, nor for the past to return. Not enough political thinkers are responding to this challenge.



What TalkTalk can teach us about the modern economy

I don’t often read George Monbiot. He is far too polemical for my taste. But for some reason I read an article of his last week in the Guardian, and I found myself mainly agreeing.

The article was an attack on the idea that Donald Trump’s victory will bring prosperity back to the rustbelt. Its conclusion was that war is becoming more likely. That was not what drew me to the article, though. It was the way he invoked society’s failure to deal with complexity as one of the real cause of its economic and political malaise. And here he is onto something very important. He links to an article by blogger Paul Arbair as his source, which he rates as “the most interesting essay I have read this year”. Well, see for yourself by all means, but I found that the article uses a lot of words to say not very much that is new. Attentive followers of this blog may remember that I have raised this issue myself, through the book by Cesar Hidalgo, “Why Information Grows”.

The thesis runs that the human mind can only handle a certain amount of complexity, and that we find arbitrary ways of trying to make our lives fit within that limit. The result is that we are continually hitting sub-optimal solutions, and we find the world running away from us. In Mr Arbair’s and Mr Monbiot’s view this human capacity to manage complexity is one of the main limiting factors to our current society’s development. I agree.

Let’s now try to make this less abstract. Over the last few weeks I have been trying to get a new landline installed for my 90-year old aunt, who lives on her own and has never succeeded in grappling with mobile technology. How she lost her phone line in the first place is another revealing story, but the issue for now is how to get a new connection. This has involved dealing with a major phone company, TalkTalk – though I am sceptical that their competitors manage these things any better. This initially involved an hour-long phone call, which I could only start by working out how to break the system so that I could talk to a human being – albeit that the human being only spoke with an accent that I could understand 75% of the time over my mobile connection (my aunt herself, when her consent was needed at one point, could understand almost nothing at all). Whether intermediated by a human or not, it meant navigating a set of pre-mapped options, without access to any real context. For example we were told that she could not have access to her old phone number – but I had no idea what the problem with this was. On the date installation was due I called again (even though the line offered to check progress required you produce a current TalkTalk number to proceed – before a number had been allocated!) and was then told  that the whole order had been lost. I started the process again, though, having thrown my toys out of the pram, I was talking to somebody more senior with a stronger command of English. I was given a distant future date for connection, which was blamed on BT Openreach, whose lines carry the calls. This date is later today; we will see what happens.

This story will be familiar to anybody who negotiates the modern world. At every turn you are made to conform to a simplified structure that makes as few concessions as possible to context. Navigation requires a degree of cunning on the customers’ part or  they end up in a dead end. It often takes the customer a lot of their time – though suppliers limit any time spent by their operatives. And disappointment is usually blamed on somebody else. Companies that use a more contextualised, intelligent approach can’t compete in the market, apparently – or else they only can do so if part of an exclusive service aimed at the wealthy. There is a limit to the complexity that a company like TalkTalk can handle, and you must pay that price if you want to use their services. Many people, like my aunt, could not hope to navigate this system without somebody to do it for them. The many failures that this approach leaves are simply shrugged off.

Now let’s reflect that so many politicians and economists tell us that one our society’s biggest problems is a lack of productivity growth. But more productivity means more experiences like ordering a new phone line with TalkTalk. To most people it is simply replacing one imperfect world with another that is not necessarily better. Is it really any wonder that progress is so slow?

In my view, this kind of problem – information processing and our capacity to deal with it – lies behind many of our society’s problems, including the rise of inequality between people and regions. It hollows out jobs while leaving many human problems unsolved. And yet amongst the intellectuals who analyse society’s problems it seems largely unrecognised. We lack a clear language with which to communicate and analyse it. One important question, for example, is how much artificial intelligence can help, or whether it can help at all.

What is the way forward? We need to recognise that limits to handling complexity affect how efficient political and economic organisations can be designed. You have to be able to manage complexity somehow. One favoured method, used by the likes of TalkTalk, is to create a system of simple scope but far reaching extent – able to deal with a small number of needs for large numbers, millions, of people. This thinking is grounded in the way modern societies have embraced the world since scientific discovery took hold in the 18th Century. You tackle a large scope by breaking it into pieces and then examining each piece in depth. This gets you a long way – but how do you fit the pieces back together again?

The other to tackle complexity way is to broaden the scope but reduce the reach – deal with smaller numbers of people, but handle a much broader array of issues. This is a commonly used technique in business and politics. The 1990s craze of “business process reengineering” was based on the idea – I built a large part of my professional career applying it to financial services. But it has fallen from favour. It would be interesting to understand why –  I think it is because there are strong incentives for business leaders to increase the size of their organisations, because their own wealth and prestige grows with it. This delivers a natural bias towards large organisations of narrow scope – even though these are not necessarily the most efficient. Our legal, political and regulatory systems have in inbuilt bias towards such large organisations too. When the BSE crisis hit the British meat industry in the 2000s, for example, the men from the ministry simply assumed that small abattoirs had to be closed down, and so produced regulations that made it virtually impossible for them to operate.

Which is not to say that the world does not need big businesses, and big government too – but we need to rebalance these to make small government and small businesses more viable – because these will deal with more complex problems more efficiently.

But what on earth will it take to make people realise that?


Britain’s economic outlook is dismal. We need a new direction.

Yesterday the British Chancellor of the Exchequer, Philip Hammond, gave his Autumn Statement. It was his first big set-piece in that role, and the time the government has attempted to set out its financial plans since the country voted to leave the European Union. Amid the noise and kerfuffle that such events generate, it is easy to miss the big picture: Britain’s politicians have no answer to a dismal outlook.

What drives my pessimism? The most important piece of public life that I am involved with is schools. Looking back over the last decade there is much to be proud of in this patch of inner London. The professionalism and dedication of school leaders and staff have grown. The imagination they have used to reach out to disadvantaged children is wonderful to see, and the results impressive. Where once teachers vehemently defended their little classroom empires against any outside scrutiny, and blamed poor results on social conditions, I now see a new generation of professionals, willing to accept advice and scrutiny, and enthused by a team mission to ensure that all pupils achieve potential. Political credit needs to be spread widely. The New Labour government started the process by putting pressure on London schools to break out of the tyranny of low expectations. The Conservatives sharpened the focus on teaching quality. The Liberal Democrats’ Pupil Premium policy led to a step-change in the treatment of disadvantaged pupils, and will be their most enduring achievement in coalition. But the clouds are gathering.

Education funding is being squeezed. London schools are funded generously by comparison with many parts of the country, and so the pressure is being applied there sharply. Teaching Assistants, who do not have professional qualifications, are feeling the squeeze the most – just that section of society that is finding it hardest to make ends meet. And services, slowly but surely, are under threat. Children’s Centres, which provided pre-school support, we the first to be hit. Now nurseries are under threat. A system that was tackling the gap between the haves and have-nots is slowly being dismantled. And this picture is being repeated across public services generally. Health and social care services are gradually failing to cope with the steady rise in older patients. Neighbourhood police teams have been cut drastically, choking the process of community links and intelligence gathering. And so on. All this is slowly creating a society divided by education and the lottery of property ownership.

The Chancellor offered us no hope of relief. The government budget deficit is still 4% of GDP, a level not usually thought of as sustainable. A large current account deficit shows that the country as a whole is consuming more than it is producing, as it has been for the last two decades. To be clear, neither of these deficits is a cause to panic. In current global economic conditions they look quite sustainable for a good while yet. But they show that there are limits to what the state can fund. In conventional analysis what is needed is a bit of economic growth, and more productivity from British workers. But, for all sorts of reasons, that productivity growth has dried up globally. Mr Hammond boasted that growth in Britain compared favourably with other developed world economies. That is not good news, because it demonstrates that the country’s problems are deep-seated and unlikely to be solved by a bit tweaking here and there. We are all in the same swamp.

What we need to understand is that these problems follow from profound changes in the world around us. Developed world populations are aging – by which I mean that the proportion of older people is rising and leaving the productive workforce. Technological change is wiping out working class jobs, pushing economic rewards towards a minority of professionals and the owners of capital. Globalisation was making things worse in some ways for developed economies, but provided solutions in others – but in any case it is slowing down as the Chinese economy in particular matures.

And to this rather gloomy picture we are adding wonton acts of self-harm. Climate change is helping to destabilise the world, creating waves of refugees. In Britain, Brexit will make things worse. It is not that economic integration of the type offered by the European Union was helping particularly, but the act of leaving the union is creating a colossal distraction for both government and businesses.  It has also given populism, a turning inwards and the rise of charlatan political leaders bent on self-aggrandisement, a big lift, Donald Trump’s American isolationism promises to do more harm than good both inside and outside the USA.

Politicians  left and right are responding mainly by trying to turn the clock back to imagined happier times. The right imagine a world of self-sufficient, ethnically homogenous nation-states undistracted by the pressures of global integration and technological change. The left fondly recalls a time of institutional Keynesianism and an ever-expanding state. Neither confronts the challenges of technological change and the need to heal fracturing communities.

So what about hope? We have some things to play with. The current younger generation is the best-educated and most cosmopolitan ever in the developed world. By and large they are not fooled by the lure of the past – one reason why they are so disengaged by current politicians. That their expectations of an easy, inevitable and prosperous life are being dashed means that at least they will be open to positive change. Technological change has its plus points too, by enabling cooperation and personalisation. The advance of renewable and energy-efficient technologies offers plenty of hope too.

But we do need to start thinking of different ways of organising political and economic activity. Ways that offer less power to corporate monopolies, and better able to tax and recycle their profits (perhaps the most persuasive reason for staying with the European Union is  its ability to confront the multinationals). We also need to place less faith in highly centralised systems that struggle to deal with complex problems, while concentrating political and commercial power. We  need better schools, better public healthcare, and stronger, local public services to support struggling communities – and controlled by those communities rather than the whims of politicians in a far-off capital.

As blogger David Boyle wrote recently, we are in a dark tunnel, but we need to press towards the light at the end of it, not try to turn back.



Making America small again. Trump’s victory marks the decline of the USA

“Make America Great Again.” That was the slogan of Donald Trump’s insurgent campaign to take the US presidency. It resonated with many Americans. They felt that the US had been subject to serial humiliations in its international dealings, and that Mr Trump’s more robust and confrontational leadership would help to reverse it.

But politics is full of paradox. To exercise power is to diminish it. Power accumulates to those who understand restraint. In Britain English and Welsh voters took to heart the slogan of “Take Back Control” and voted for Brexit. The country is now basking in the thrill of exercising direct power in its relations with its fellow European neighbours. And yet the result will be a medium-sized power adrift in a friendless world, seeking to trade freely when everybody else is becoming more protectionist It will be more rather than less subject to the whims of foreign powers. Britons may prefer it that way, but they will come to understand that the keys to “taking back control” actually lie in Westminster and their local council chambers, rather than in Brussels.

So it is in America. Mr Trump’s supporters will revel in the assertion their country’s direct power. And yet he will exercise this assertiveness in order to carry out a retreat. The result can only be diminishment, relegating the US to the middle part of a medium-sized continent.

Let’s look at some specifics. Consider the Trans Pacific Partnership (TPP): the multinational trade deal put together by President Obama. This was a central element of his Asian diplomatic strategy, designed to collect a number of Asian countries into America’s orbit in trading terms, conspicuously excluding China. Mr Trump (along with many Democrats) denounces this as a bad deal and will scrap it. That leaves a vacuum into which China is ready to pounce. It plans its own version of a free trade area, involving most of the same countries. Mr Trump has also questioned the value of America’s military alliances in the region. The clear message to countries there is that they must acquiesce with China’s increasingly imperial ambitions. The Philippines’ President Duterte looks a little less eccentric in his pivot to China. The USA is suddenly a much less important country.

Mr Trump’s promised assertiveness in trade relations with China makes little sense either. It comes at an important moment in the evolution of China as a nation. It has built its economy on international integration, especially with the US, and developed a large trade surplus in the process. But there is nothing particularly beneficial in a trade surplus – it implies that a country’s citizens are consuming less than they could – an act of self-denial. A trade surplus has political advantages – it makes you less beholden to foreign creditors – but China is already powerful enough for this not to matter much. So it is in the process of carrying out an economic pivot to  develop its consumer economy, and away from integration with developed economies – though the scope for integration with less developed economies remains. An economic model where it exports less to America and integrates more with other Asian countries, and even African ones, suits it just fine strategically. Mr Trump means to hurry it along, but it will disrupt the US economy more than the Chinese one.

In Europe the issue is not so much trade. The proposed trade deal between the US and the European Union, TTIP, looks dead in the water without any help from Mr Trump. The main issue for Europeans is military and diplomatic support for the European countries against Russia in particular. Mr Trump has said that the current balance involves America in a disproportionate level of commitment. He has a point. If America steps back from its military commitments, and caves in to pressure from Vladimir Putin to create and extend a Russian sphere of influence, then it will put European countries in a very tough position. It is not very clear where this will lead – but one thing is very clear: America will be less important to Europe. This is not necessarily a bad thing for Europe, but it will be very uncomfortable.

And then there is economics. We are still guessing what will emerge from Mr Trump’s presidency – but there could well be a short-term lift for America. Some form of fiscal stimulus is in the offing. Mr Trump and his advisers hope to lure in US corporate profits that are stacked offshore for tax reasons, and to use the proceeds to fund infrastructure investment. Unlike many of his Republican colleagues, Mr Trump will be reluctant to cut state handouts, like pensions or healthcare – though health insurance is under threat. This could give a short term lift to the US economy . And, as this week’s Economist points out, much of this gain will be at the cost of other world economies.

That should please Mr Trump’s supporters. But the problems will start quickly. The stimulus is badly timed. In many aspects the US economy is running at close to potential output. All the stimulus might do is suck in imports and push up prices. But there may well be a lot of hidden potential in the US economy – more workers could be drawn into the workforce, and other workers could be made to work more productively. But if Mr Trump is serious about rolling back free trade and driving out foreign workers, then he will cut the capacity of the US economy when it needs to be increased. A financial crisis is in the offing.

The truth about the American economy is that, far from being taken for a ride and funding lavish lifestyles of foreigners, American consumption is being supported from abroad. This is what a trade deficit means. A transition to a more self-sufficient economy, as wished for by Mr Trump’s supporters, will entail economic shrinkage. Americans may rail at the loss of jobs in many industries, but they exchanged these for cheaper products, made abroad or with automated technologies, or both. Reversing that means reducing living standards.

Except that most Americans could still end up better off. If the country can share out income more evenly, with lower profits and higher wages, and more of those wages paid to middle and lower level employees and less to the top layer, then this shrinkage need not be painful to the majority. But what chance is there of a Republican administration, run by senior businessmen, achieving that? To Mr Trump exploitation is simply good business practice, and profits are reward for enterprise. There is no sign of a mindset that wants a different distribution of the fruits of economic success.

America and the world is in for a rough ride. But strategically it has been clear for a long time that American power, relative to the rest of the world, is in decline. That is not such a bad thing  – it results from a fairer distribution of the world’s wealth. After the diminishment of Europe, it is now America’s turn. Mr Trump’s victory marks a big step along that journey. But it should surprise no follower of politics that he is claiming to do the opposite.


Fiscal activism makes a comeback. But it won’t help savers

Even the Prime Minister Theresa May is saying it. Low interest rates are not lifting the economy in the right way. So time for government spending and tax cuts to take over? Or, as economists call it, active fiscal policy. She joins a chorus of academic economists and newspaper commentators.

The story goes back to the 1930s when the Depression was rampant. This hit government tax revenues and the conventional wisdom was that government spending had to be cut to balance the budget. Enter the great economist Maynard Keynes.

Keynes pointed out that the problem with the economy was a shortage of demand – not enough people buying things to pay for the people in jobs. Or to put it another way, there was excess saving. If people are saving, they are spending less than they earn. That means that there isn’t enough spending across the economy to pay everybody’s wages, so the economy sinks. Or it will sink if the savings are not spent on investment, which is another type of spending. Stuffing cash into mattresses is not investment. Neither is putting the money into a bank account unless the bank lends it to somebody who in their turn pays somebody to do something. In a depression people are unwilling to invest, and so saving tends to be higher than investment. And so the economy enters a doom-loop. Before the 1930s economies were marked by severe boom and bust cycles.

Keynes pointed to a way through. If government increased its spending or cut taxes, they would put money in people’s pockets, which would be spent, neutralise the excess saving and bring the economy back to life again. Slowly governments followed his advice, most famously US President Franklin Roosevelt with his New Deal.  The most spectacular success came in Hitler’s Germany, which spent freely on infrastructure (think of the autobahns) and armaments. Keynes pointed out that it did not matter what the spending was on provided it was spent at home, or at any rate it didn’t matter at first. As the economy approaches capacity wasteful government spending is a problem, but not before then. The rapid expansion of the US economy as it was placed onto a war footing in the 1940s proved Keynes right beyond doubt. Thus was born fiscal policy as an instrument of economic management, and economics as a discipline entered a golden age. The swings from boom to bust were notably reduced in the 1950s and 1960s.

Then it came off the rails. In the 1970s things changed. The first shock was the breakdown of the Bretton Woods system of managed exchange rates – it could not handle the excess of US spending on the Vietnam war. This destabilised the international financial system. Then came the oil shock in 1973, as OPEC ramped up oil prices massively. The governments that tried to spend their way out of the subsequent recession merely created inflation and not jobs. The governments that applied stricter fiscal policy, West Germany and Japan in particular, suffered much lower inflation. Enter another economist: Milton Freidman.

Freidman suggested that Keynes had it all wrong. The issue was not managing government spending and taxes, it was managing the money supply. The Depression was severe because the banking system collapsed, and people couldn’t borrow money. A lot of what Freidman said turned out to be nonsense, but what evolved was the neo-Keynesian consensus. This relegated fiscal policy to a relatively minor role. In the conventional wisdom of the time (often referred to nowadays as “neoliberalism”), government spending could easily get out of hand, destroy inventives and make economies less efficient. Instead the main responsibility for managing the business cycle came to something referred to as “monetary policy”, run by  central banks.

Monetary policy is a bit of misnomer, a hangover from Freidman’s emphasis on money supply. To this day people often explain monetary policy as if people paid for things in banknotes, which are printed at will by the central bank. In fact money has moved almost entirely to accounting systems of debtors and creditors, with banknotes relegated to a very minor role. The economic implications of a bank account are utterly different from those of a pile of banknotes. The idea of money supply is nearly meaningless. Instead of that, as regular commenter to my blog Peter Martin put it in a post to Lib Dem Voice, what we have is interest rate policy. Money supply in the economic models taught to students has become a completely theoretical concept that cannot actually be measured . If demand is falling in an economy, this is corrected by reducing interest rates, which should encourage people to spend more. If things look like getting out of hand, then interest rates are raised.

Through the 1990s and early 2000s this system seemed to be working, but it came under increasing criticism. Central banks used inflation targets to judge whether the level of demand was too high or too low. But this measure excluded asset prices, which were directly influenced by interest rates. Asset bubbles were allowed to develop. Then they popped in 2007 to 2009, in the financial crash and the big recession that ensued, which interest rate policy proved unable to correct.

Fiscal policy made a return. But it was tentative. As soon as the worst of the recession was over, governments cut back (widely referred to as “austerity”). Critics argued that this was stalling any recovery. Then the victims of low interest rates, those saving for pensions in particular, started to get agitated. This is most evident in Germany – but Mrs May was voicing concerns amongst her constituents in the UK.

So can fiscal policy help lift economic growth, in place of low interest rates? There is a strong case for this, but caution is warranted. Most economic commentators hedge their bets by recommending that extra spending is on infrastructure projects, that will yield economic returns in their own right.

This hints at the first of three reasons for caution. What if the reasons for slow growth are structural and not to do with low aggregate demand? Are we making the same mistake as the mid 1970s, when economists saw high unemployment and low growth and assumed that this meant lots of spare capacity? In fact economies then had suffered a major dislocation from the oil shock, and were slow to adapt because of excessively unionised and corporatist economic management. That was then, but there are plenty of suggestions as to what the capacity restraints might be now, starting with demographics. Investing in infrastructure should help overcome these constraints, killing two birds with one stone.

The second reason for caution is that economies have internationalised. A lot of the benefit of fiscal stimulus can leak abroad, especially if other countries have a deficiency of demand too. Fiscal stimulus might simply drag in imports from countries eager for export-led growth. Globally coordinated fiscal policy works much better. This was achieved in 2009, but consensus has broken down since. The risk of stimulating other people’s economies can be reduced if the stimulus programme is carefully designed. But it can be quite hard to tell where best to direct spending or tax cuts.

And the third reason for caution is the difficulty in understanding when to turn the tap off and tighten policy. Politicians are prone to fiddling the figures to put the evil day off. British Chancellor Gordon Brown was notorious for this in the mid-2000s, contributing, in my view anyway, to the severity of the financial crash in 2007-09. Anti-austerity has become a political totem on the left – and yet there must come a point in any business cycle when austerity is required. This is also a problem with using infrastructure investment as the prime instrument of fiscal policy – it is not so easy to manage according to the business cycle. Lead times can be long and if an investment project is worth doing, it is probably worth doing at all points in the cycle.

And a final point. looser fiscal policy is unlikely to help savers with raising interest rates. Interest rate policy and fiscal policy should not be working against each other. To raise interest rates we need to see a healthier British and world economy. That looks some way off.