Is the US economy heading for a fall?

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

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

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

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

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

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

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

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

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Europe and the US: the tortoise and the hare

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

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

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

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

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

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

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

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

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

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

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

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

 

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Globalisation is at a turning point

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Is this the Eurosceptics’ Moscow moment?

Nearly 200 years ago, in September 1812, Napoleon reached the maximum limit of his nominal power when he entered Moscow with his army drawn from right across Europe.  His empire covered France, Germany, Poland, Italy, much of Spain (his lieutenants were in the process of driving back an advance by Anglo-Spanish forces that had temporarily liberated Madrid) and now much of Russia, including its Asiatic capital.  But he could not hold it; by the year’s end he had been forced to abandon Russia altogether, his army destroyed, and he was completely crushed within a year and a half.  For the Russians 1812 had proved a time of incessant retreat, as they avoided battle until just before Moscow (at Borodino), where they lost and were forced to abandon Moscow without a fight, but ultimately a year of triumph.

Is this a fair metaphor for the British Eurosceptics in their moment of victory at the British veto at last week’s EU summit?  Certainly their triumphalism is unbearable.  Bill Cash was described by one of our outraged local Lib Dem members as “the cat that got the cream.”  This follows one long process of retreat by British Europhiles as they conceded the political initiative to the sceptics, practically without a fight, time and again.

But the initial reaction of leading Lib Dems was strangely sanguine.  Nick Clegg was initially quite supportive of David Cameron.  On Friday night the deputy parliamentary leader, Simon Hughes, painted a positive picture to party members at a social event which I was attending.  Mr Clegg has changed his tune today, of course.  Whether that is because of the sceptics’ reaction, or because further details of what actually happened at the summit have emerged (for a flavour of this read the Economist’s Bagehot blog) I cannot say.

But the initial relief at the summit result shown by Mr Hughes has some logic behind it.  A treaty would have required ratification by the UK parliament, and demand for a referendum.  This sort of battle plays to the sceptics’ strengths – strong support by the press and a widespread wariness of extra EU power.  A referendum on a treaty change is the battle the europhiles least want to fight.  The sceptics can deploy a “have your cake and eat it” argument for a no vote – a vote not against the Union as such, but to protest against “Brussels”.  There will be no such battles now.  If there is a referendum it will be about whether we stay in the EU at all.

Instead the sceptics’ position might start to come under the sort of scrutiny that it has hitherto lacked, and be shown to be no more tenable than Napoleon’s hold on Moscow.  The summit has started that exposure process.  The sceptics’ armchair negotiators have said that we can use the British veto to negotiate major concessions, the “repatriation of powers”; but Mr Cameron proved unable to do this.  It has also been said that we were not isolated in the EU, and we could lead a gang of pro-market non-Euro members.  This against has been shown to be a hollow idea, as Germany has greater influence over these potential allies than we do.  Indeed a horrible spectre emerges, that the British blocking tactics make many of the EU’s institutions irrelevant while the other countries set up alternatives over which the British have no say.  The sceptics often complain about Britain shackling its fortunes to a corpse – but the corpse could be the official EU structures, rather than the European project itself…and that would be an outcome entirely of our own making.

And further eurosceptic fantasies will soon be exposed.  Their aim is to set up some sort of free-rider relationship to the Union, where British products enjoy free access without to European markets without our businesses having to comply with those pesky social regulations.  Some think the country can do this within the EU, using opt-outs, others that it can be done outside it, in the European Economic area (like Norway, Iceland and Switzerland).  But this requires the other 26 countries to agree with it.  All of them.  Why should they?

Just as the Eurozone optimists are having their ideas tested to destruction in a gruelling series of financial crises, so the eurosceptics might find themselves on the wrong side of the argument.  In both cases it is clear that the only tolerable escape route involves further European integration, not less.  Perhaps, like Napoleon’s collapse in 1812, it will happen quicker than we think.

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The Euro end game

It’s been a tough year for Europhiles, especially those, like me, who have always supported the single currency and thought Britain should have been part of it.  Most of them have been very quiet, and no wonder.  Whatever one says quickly has the feel of being out of touch and in denial.  And now this week the Economist asks in a leading article  Is this really the end? that has been tweeted over 1,200 times and picked up over 500 comments.  In today’s FT Wolfgang Munchau article is headlined: The Eurozone really has only days to avoid collapse (paywall).  Is now the moment to finally let go, and admit that the whole ill-fated enterprise is doomed?

There is no doubting the seriousness of the current crisis.  While most of the headlines have been about sovereign debt (especially Italy’s) what is actually threatening collapse is the banking system.  It seems to be imploding in a manner reminiscent of those awful days of 2007 and 2008.  The Germans’ strategy of managing the crisis on the basis of “just enough, just in time” seems to be heading for its inevitable denouement.  Unless some of their Noes turn to Yeses soon there could be a terrible unravelling.

The most urgent issue is to allow the European Central Bank (ECB) to open the floodgates to support both banks and governments suffering a liquidity crisis.  “Printing money” as this process is often referred to, seems the least bad way to buy time.  Two other critical elements, both mentioned by Mr Munchau, are the development of “Eurobonds” – government borrowing subject to joint guarantee by the member states – and fiscal integration – a proper Euro level Finance Ministry with real powers to shape governments’ fiscal policy in the zone.  Most commentators seem to be convinced that some sort of steps in both these directions will be necessary to save the Euro.

I have a lingering scepticism about these last two.  I thought that the original idea of allowing governments to default, and so allowing the bond markets to act as discipline, had merit.  The problem was that the ECB and other leaders never really tried it before the crisis, allowing investors to think that all Euro government debt was secure.

Still the short term crisis is plainly soluble, and most people will bet that the Germans will give the ECB enough room to avert collapse.  But that leaves the zone with a big medium term problem, and two long term ones.  The medium term one is what to do about the southern members whose economies are struggling: Spain, Portugal and Greece especially, with Italy lurching in that direction.  The stock answer, which is to enact is reforms such that their economies become more competitive, seems to involve such a degree of dislocation that we must ask if it is sustainable.  This treatment is not dissimilar to that meted out by Mrs Thatcher to Britain in the 1980s (an uncompetitive currency was part of the policy mix here, deliberately or not), for which she is still widely loathed.  And she was elected (though “democratically” is a stretch given Britain’s electoral system).  How will people react to unelected outsiders imposing such treatment?  Better than Britons would, no doubt, since there is so little confidence in home grown politicians , but it’s still asking a lot.

And that leads to one of the two long-term problems: the democratic deficit.   A lot of sovereignty is about to be shifted to central institutions, and it won’t be possible to give electors much say.  The second long term issue is dealing with the root cause of the crisis in the first place, which is how to deal with imbalances of trade that develop within the Euro economy.  Germany simply cannot have a constant trade surplus with the rest of the zone without this kind of mess occurring at regular intervals.  But there is no sense that German politicians, still less their public, have the faintest grasp of this.  For them the crisis is the fault of weak and profligate governments elsewhere.

So if the Euro survives the current crisis, there is every prospect of another one down the road, either political (one or more countries wanting to leave the Euro and/or the Union) or financial (say an outbreak of inflation).

My hope earlier in the crisis was that it was part of a learning curve for the Euro governments.  As they experienced the crisis institutions would be changed and expectations made more realistic, such that zone could get back to something like its original vision.  I am afraid that there is a lot more learning to do.

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The equality problem

A nasty problem stalks those who think about public policy, especially here in Britain, and in the US.  It goes under the general name of “inequality” and is mainly about the growing disparity between the very rich and everybody else.  There is a lot of anger (think of the Occupy protests) and shaking of heads, little convincing analysis and and even less in the way of convincing policy ideas.  It’s worth everybody taking a few steps back and asking themselves what is going on.

Of course the debate about the justice of inequality is as old as political philosophy. But two new factors have changed the whole nature of the debate.  The first is that the people in the middle of the wealth distribution are getting left behind.  Depending on the stats and country the median family’s wealth is hardly growing at all, or stagnating, even as the economy as a whole grows (well, until 2007 anyway).  So long as the median family is doing nicely the political heat can be contained – people can ask whether the problem really matters.  But these stats make it appear that the country is being run for the benefit of a tiny elite – which makes it politically much more awkward.

The second new fact is that mobility between different levels of wealth appears to be declining.  If you start life wealthy, you are increasingly likely to stay that way, and if not, you are less likely to break the barrier into a wealthier world.  The traditional divide between those who are concerned about equality of opportunity and those who worry about equality of outcome is becoming a lot less significant.  Both lots are angry.

There remains much to debate about how bad for us all this growing inequality really is.  But you don’t have to be an equality extremist (like, or so I’m told, the authors of the popular book, the Spirit Level, which I’m afraid I haven’t read) to be worried about all this.  The political consent upon which our democratic society is founded is being undermined – and indeed the extreme polarisation of US politics is perhaps one aspect of this.

Why is this happening?  For all the quantities of research poured in to economics and the social sciences, there is rather little that is known.  Economists don’t like thinking about the distribution of wealth as opposed to those comfortable aggregates that conceal so much.  Mathematically it is an entirely different type of problem to the ones they are used to dealing with.  I have seen one valiant attempt to grapple with the maths, under concept of “wealth condensation“, which did a good job of modelling the sort of power distributions so characteristic of wealth patterns, but this was not by an economist.  Professional economists preserve their elite status through the gratuitous use of advanced mathematics; no doubt they feel very uncomfortable in dealing with problems that require sorts of maths they aren’t good at, or even no maths at all (e.g. through the use mass agent computer modelling).  What we get is some rather airy stuff about the impact of technological change and immigration, with the former usually being fingered as the more important baneful influence.

One fact is quite well understood, though, which is the winner takes all effect of mass communications.  Thus entertainment stars tend to win big or not at all – and similar can be said of sports stars.  The mass market seems to concentrate its attention on a small world elite, ignoring anybody that hasn’t quite made it.  This, of course, will increase inequality.  But it is a retail phenomenon which ill explains why bankers and big corporate execs do so well.

Because we so ill understand it, it is unsurprising that our solutions seem so inadequate.  In Monday’s FT the prominent American economist and policy person Larry Summers (paywall), after moaning about the problem, was pretty lame about what to do next.  He suggested looking at three things: challenging the privileged status of the well off (especially the effects of the massive lobbying power of big corporations), a bit of tax reform (which is as much about not making things worse by rolling back estate taxes, etc) and state intervention to even things up, especially through education funding.  All worthy, but it is difficult to think that it would have anything more than a marginal effect.  The anti-capitalists aren’t any more convincing, of course.  It’s the baby and bathwater problem.

Politically there seem to be two distinct poles of argument.  The right wing idea is that it is the excesses of the state that is holding back the middle, and if we taxed and regulated more lightly an entrepreneurial boom would help the middle catch up with the top.  I have to admit I haven’t seen this line of argument clearly articulated anywhere, but some such logic must lie behind the popularity of the American Tea Party, whose appeal goes well beyond the elite.  On the left people seem to think the answer is in a bigger state, which intervenes to help the less well off, cracks down on excessive wealth, and drags pay up by creating masses of comfortable public sector jobs.  A bit like Sweden before its economy collapsed in the 1980s.  Neither course looks very encouraging to a liberal.

So what to think?  I am not really any further forward than Mr Summers.  But it would help if we better understood why so many in our society are being left behind.  I shall return to the topic

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Does the Euro need a Big Bazooka?

It is a commonplace amongst Anglo-Saxon policy makers that the Eurozone leaders need to use a “big bazooka” to solve the currency crisis that is engulfing the continent.  David Cameron has been particularly conspicuous in using this expression.  Is it all it is cracked up to be?

So what is a bazooka?  Originally it was a tubular musical instrument made famous by the comedian Bob Burns in the 1930s (Mr Burns and instrument in second picture).  It then became the colloquial name for an American tubular hand-held antitank weapon introduced in the Second World War (the illustration above is in fact of a more modern and shorter weapon).  This was a revolutionary innovation, using recoilless technology and the so-called HEAT armour-penetration system – which allowed infantry to threaten tanks in a way not previously possible.  The Germans quickly copied it with the bigger and better panzerschrek (“tank terror”).  They also developed countermeasures, including thin armoured outer skirts to their tanks, which set off the HEAT system before it could inflict serious damage.  In the 1960s the weapon became obsolete, replaced by more powerful technologies.

A “big bazooka” in the current context is used to mean the deployment by the state (central banks and/or governments) of overwhelming financial resources to bail out troubled banks and others in a financial crisis.  The idea is to break a vicious cycle of declining confidence in banks and others, whereby lack of confidence becomes a self-fulfilling prophecy as creditors seek to move their money into safer places.   The mere proposition of such resources can be enough to break the cycle, if credible, and prevent the resources ever having to be deployed.  The Americans can proudly point out to the use of the technique to solve a series of financial crises, from the Savings & Loan crisis of the 1980s, to the LTCM collapse of the 1990s and the Lehman crisis of 2008. Such tactics are conspicuous by their absence in the Euro crisis, fiercely resisted by the German political class in striking unanimity.

There is an irony that the original bazooka was quite a small weapon – but I suppose it was big for one held by a single infantryman, and the German version conveys all the imagery the metaphor needs.  A more telling parallel is that the bazooka, revolutionary when introduced, steadily became obsolete as the world got used to it.  No doubt the Germans will point out that the American use of “big bazooka” tactics on repeated occasions shows that there is a flaw.  The American financial system suffers a systemic crisis every 10 years or so.  This is the first such crisis the Germans have endured since their currency was refounded after the war – and that is because the Germans aren’t running the show.

The have a point.  The financial markets are amazingly short-sighted – for example that idea that the US and UK are safe havens because their central banks can overcome any crisis by “printing money”, or monetising debt, in the manner of Zimbabwe.  But the long term logic always wins in the end.  There seems to be a slowly dawning realisation amongst Anglo-Saxon commentators (for example last week’s Martin Wolf column, as well as the Economist) that the German position in all this amounts to a strategy, “just enough, just in time”, and not the absence of one – even if Mr Wolf grumpily calls it “too little, too late”.  The short-term costs of the German strategy are doubtless higher than the American way – but the longer term position is much less clear.

 

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Occupy: a difficult bandwagon to ride

There was a strained moment at last night’s dinner at the National Liberal Club for the London Liberal Democrats, when the party was challenged by a member over the Occupy protests at the City of London.  Both the guest speaker, Paddy Ashdown, and the Mayoral candidate, Brian Paddick, said that the act of protesting was a wonderful, liberal thing to do, and that the party should engage with the protesters (and indeed has), but that there was too little in  the way of constructive proposals for the party to take on.  Given that the anger that drives the protests is shared widely across the population, this seems a rather inadequate response.  But politicians of all stripes struggle to say much more.

The Labour leader, Ed Miliband, has tried to ride the bandwagon.  It chimes well with his appeal for greater morality in commercial life.  This line seems to play quite well with policy wonks and political professionals, but just seems to underline Mr Miliband’s lack of grounding in the gritty “real” world – a lack which, of course, he shares with most politicians of all parties.  His ideas share with David Cameron’s “Big Society” a complete inadequacy when faced with the big issues highlighted by the protesters.

It is easy enough to accept the core of what the protests are about.  There has been a lot of irresponsible behaviour in world finance which has helped bring about the current economic crisis; these financiers still seem to be attracting outrageous levels of pay; and taxpayers still underwrite the whole show.  After this, however, practical politicians have to deal with four difficult facts in the search for policies.

First: world finance may have failed, but capitalism hasn’t.  To many of the protesters world finance is simply the purest form of capitalism and its failure represents the failure of the whole capitalist system.  Well greed and profit seeking, familiar parts of the capitalist way, had a lot to do with it – but as much of the problem was uncapitalist politics.  Governments borrowing too much money to develop public services; interfering with the market to extend home ownership (especially in the US); China’s distinctly uncapitalist but de-stabilising trade policies, to name but three factors.  The real problem was politicians trying to tilt capitalism to their own ends, even if these ends were quite laudable.  There is in fact no substitute for capitalism if we are to maintain the living standards in the developed world, and to roll back poverty in the devloping world.  Interfering with the workings of free markets is likely to make matters worse, not better.

Mention of politicians brings in the second awkward fact.  The public (especially in the developed world) is at least as much to blame for the economic crisis as the bankers.  Excessive borrowing was widespread, as was pressure on politicians to ride the boom and expand government.  It wasn’t only the bankers that were being greedy.  It is natural enough to blame the bankers, saying like children, “It wasn’t my fault, he made me do it!” – but this isn’t very helpful in the search for solutions.

And a third awkward fact is that banking and finance, apart from the greed and the excess, carry out a vital world function.  The process of linking savers to borrowers, which is essentially what finance does, is vital for economies to develop and poverty to be fought.  It is absolutely no coincidence that the growth in world finance in the last couple of decades happened at the same time as the biggest progress against world poverty that we have ever seen.  And the beneficial effects of world trade that finance facilitated completely dwarf the well well-intentioned works of government aid and charities.  The problem is that the bankers simply creamed off too much of the benefit for themselves.

Which leads naturally to the fourth, and awkwardest fact of all: the bankers are holding a lot of hostages.  We need bank lending to keep productive industries going.  Governments needs finance to keep public services going.  In the UK, and especially London, world finance includes many perfectly productive jobs which we can ill afford to lose.  Vindictive policies will hurt us all.

But finance does need to be tamed.  But doing so is a slow process which requires a great deal of patience.  There are two key sets of reforms, neither of which are quick:

  1. Separate investment banking from utility banking.  There are many abuses in utility banking, but the really dangerous stuff is in investment banking, and allowing investment bankers to run utility banks is a recipe for total disaster.  The Vickers Commission’s reforms are an excellent start here – and seem to be leading the way globally.  The investment bankers are patiently trying to undermine them – but politicians and the public need to stay on their case.
  2. Make investment banking much less profitable.  It is the profits that drive the excessive pay – and policy needs to focus on the causes of the disease rather than wasting time on the symptoms.  There are two main causes of excess profits: lack of competition and the failure of organisations to bear public costs (for example of the public’s underwriting of the banking system).  In investment banking, it is the second of these that is the most important (in retail banking it is the first…), and the most effective way forward is raising capital requirements.  This is being done, and banking profits are duly under a lot of pressure.  At first it will be the shareholders who feel the pain – but in due course it will be bankers pay, as shareholders get fed up with their overpaid servants.

Actually progress is rather good.  We don’t need gimmicks like the “Tobin Tax”.  we need vigilance and patience.  I am proud of the way the Liberal Democrat ministers have been keeping the pressure up (Vince Cable is the star, but Nick Clegg is clearly on side).  The bankers are waiting for the Occupy bandwagon to move on.  It will, but I hope and trust that the Liberal Democrats will still be on their case.

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The Norwegian Exception

Vigeland sculpture, Oslo

Last weekend my wife and I went to Oslo, to visit my brother and his partner (who is a local).  It wasn’t my first visit to Norway, but the first time was on a tour.  Norway comes up periodically in conversation here in the UK, especially as a country that does well outside the EU.  What to make of it?

The first thing to say is that Norway is a spectacularly beautiful place.  The weather was mostly dull when we were there, but we had sunshine on Saturday, rendering beautiful views of a totally calm Oslo Fjord.  The architecture is mostly pleasing, if unspectacular – with some lovely 19th and early 20th century houses.  We caught the short season of autumn colours perfectly.  And of course the mountains and fjords are justly famous.

And the second is that, unsurprisingly, it has a very Scandinavian feel, from the language to the architecture and the people on the orderly and tidy streets.  But there’s a difference, with Sweden and Denmark anyway.  Norway has only recently emerged into what we would recognise as civilisation, that is a city based culture, with the exception of Bergen, perhaps.  The medieval, renaissance and the baroque eras have left the country almost untouched, notwithstanding spectacular advance in the 19th century, in Oslo at least.  Push back into history and you are into the land of trolls in no time.  Of course what we call the Dark Ages was their Viking era, and that too was spectacular, though it has left relatively few traces.

Gol Stave Church at Folk Museum

The Norwegians appear to have had some struggle in coming to terms with this advance, with an excessive value placed on modernity.  The most spectacular old monuments, undoubtedly world-class, were the ancient wooden stave churches.  And yet many of these were torn down in the modern era as being old and useless reminders of a time they would rather forget.  This has changed, with many wonderful wooden buildings preserved in the open air Folk Museum, including one of the stave churches.  But family memories of the hard, poor rural life are widespread and fresh, especially compared to the long urbanised Britain.

All this has given Norway a clear national identity, albeit a more complex one that outsiders are generally aware of (is this not always so?).  In modern times the country suffered further trauma under Nazi occupation in the War.  And then came the oil.  But the oil wealth found a well educated and cohesive society with strong, honest government.  It has been socialised in a way that few, if any, other countries have managed, to make Norway one of the world’s wealthiest nations, while also remaining one its happiest.

Wealth comes with its problems.  The exchange rate is high, and labour in short supply.  Immigrants have been drawn in.  Swedes are working everywhere in Oslo, and black and brown faces are common.  High standards of political correctness (to give good manners their modern name) are maintained (plenty of brown faces in public ads and so on), but such changes naturally bring their own tensions.

So why does Norway stand apart from the European Union, unlike their Nordic neighbours?  Well it’s not because they dislike regulations.  Norway, I am told, is a much more regulated society than Britain.  Perhaps that’s one reason that they have been given a generous deal under the EEA – i.e. full access to EU markets in exchange for partial compliance with EU regulations and some contributions to EU funds – which many British Eurosceptics somewhat unrealistically think would be available to the UK if it left the Union.  While this deal exempts them from many aspects of EU regulation (notably competition laws), they still find that much of their law is based on EU directives over which they have no say.

No doubt Norwegians fear that, in the EU, the other members would eye up their wealth and seek to extract generous contributions.  If they think that, they are almost certainly right.  Norway is not ungenerous with its wealth, but no doubt prefers to contribute on its own terms.

The truth is surely that Norway is not in the EU because it does not need to be.  Oil provides the country with all the exports it needs.  It can negotiate other benefits.  It carries no weight in the development of EU law, but how much weight would it carry if it was in?  Norway is governed by a cosy elite that does not want to dilute its power.  The population seems basically content with their elite.  Not many lessons for the British there.

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Solving the Euro crisis means a stronger ECB

I do not regret paying my access fee to the FT website.  This morning there are two excellent articles on the Euro crisis from the two regular Wednesday morning columnists: Martin Wolf and John Kay.  It has helped clarify the way ahead for me.

Mr Kay comes in at high level to give an overview of the crisis.  It is not comfortable reading for supporters of the Euro project like me, but, as usual for this author, pretty much spot on.  The main problem is not that the currency area lacks appropriate institutions at the centre, but that local institutions in many member countries are not strong enough to cope with the pressures of being in the single currency.

The eurozone’s difficulties result not from the absence of strong central institutions but the absence of strong local institutions. A miscellany of domestic problems – rampant property speculation in Ireland and Spain, hopeless governance in Italy, lack of economic development in Portugal, Greece’s bloated public sector – have become problems for the EU as a whole. The solutions to these problems in every case can only be found locally.

So the answer will not come from strengthening the EU’s central institutions.  This goes back to the original design of the Euro: the whole idea was to put pressure on governments to reform themselves, by denying them the easy escape route of devaluation. Unfortunately the EU’s politicians forgot this in the first decade of the Euro, so no real pressure was brought to bear, making the crisis infinitely worse once it hit.

This article does not say much about how to go forward from here, beyond suggesting that grandstanding at summits like today’s may be part of the problem rather than the solution.  Mr Wolf’s looks at one aspect of how to manage the crisis itself.  This in turn in is based on a paper by Paul de Grauwe of Leuven university, who literally wrote the textbook on the Euro (I know, since I read it as part of my degree course).

Professor de Grauwe points out an interesting fact: the bond markets are much harder on the Euro zone fringe economies of Italy and Spain than they are on the UK, even though the underlying positions of the countries is not all that different.  The difference is that the UK markets are stabilised by having the Bank of England as a lender of last resort which is able to deal with liquidity crises (i.e. an inability to raise cash for temporary reasons rather than underlying insolvency).  The European Central Bank does not do this, or not enough, for the Eurozone economies.  Mr Wolf, who structures his article as an open letter to the new ECB president Mario Draghi, argues passionately that it should.  This would stop the contagion spreading from the insolvent economies of Greece and maybe Ireland to solvent but challenged economies like Italy, Spain and indeed France.

This must be right.  The Germans, who are the main sceptics, must be persuaded – and convinced that such interventions would only apply to liquidity crises and not solvency problems, and that the ECB has the integrity and independence to tell the difference, in the way that politicians never do.

Giving the ECB a wider and stronger remit will be a big help.  This should extend to supervision of the European financial system (preferably for the whole EU and not just the Eurozone).  This will help deal with one of the biggest problems for modern central banking – that of coping with spillover effects, as described in this thought-provoking paper from Claudio Bono of the BIS (warning: contains mild economic jargon, such as “partial-equilibrium”).

So a reconfigured ECB will help the Euro through the crisis and prevent self-fulfilling prophesies of doom in financial markets having to be solved in grandstand summits.  That still leaves the longer term problem of how the less competitive Southern European economies can have a long term future in the zone.  But then again, I think they would have just as challenging a future outside the zone – even if it were possible to devise an orderly exit mechanism for them.

 

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