Tag Archives: economics

Economics in the age of information. Why are so many conventional economists wrong?

It feels an unequal battle. On the one side are ranged distinguished Nobel laureates, such Paul Krugman and Joseph Stiglitz, formidable intellects such as the FT’s Martin Wolf, together with any number of media economics correspondents, bristling with PhDs. On the other there’s me with a trifling 2:1 BSc (Econ) awarded in 2008 by UCL. But I’m hanging on in there. Clever as these people are, I think that they are working in the wrong paradigm. The world has changed but their basic views as to how the economy works hasn’t.

In my defence I can usually quote some formidable intellects, though, pronouncing very similar views to mine, such as Adair Turner or The Economists’ Buttonwood column. In this post I sketch a narrative that explains how this divergence of views came about, and why so much intellectual firepower might be ranged on the losing side of the argument.

My narrative pictures the developed world economy moving through a series of ages,  each of which required its own style of economic management and analysis. This is a giant oversimplification, of course. But then the science of economics is a giant oversimplification, and not physics applied to the human sphere.

I start my narrative in what I will call “the age of heavy industry”. This is not the beginning of the story, of course, just a good place to start. This is the century leading up to 1945. In this period economic development is led heavy industry and the construction of public facilities. These include infrastructure such as railways, ships, roads, and houses; intermediate facilities such as coal mines and steel works; and, we should not forget, armaments.  Other things were important, of course: agricultural development released workers from the countryside; the textile industry provided an important consumer goods sector. But world leaders saw their nations’ status in terms of the big, dirty, heavy things. Railways and steel works; dreadnoughts and artillery pieces. “Guns will make us powerful; butter will make us fat,” Hermann Goering said, capturing the spirit of the age. Such concepts as GDP were hardly developed; by modern standards rates of economic growth were unexciting. The view that inflation rates should be small and positive was alien, as the world swung between bouts of positive and negative changes to prices. Classical economics dominated conventional wisdom. “Working class” was synonymous with “poverty”, something which cut through political discourse, and many simply assumed was an inevitability.

After 1945, and starting in America,  this morphed into the age of light industry. Suddenly the domestic consumer became the leading driver of the economy. Technologies developed in wartime – such as plastics, motor vehicles, antibiotics – transformed the lives of ordinary people, and their production and distribution created stable blue and white collar jobs in a virtuous circle of job creation and consumption. Growth was led by increased consumption of ordinary things like cars and fridges; alongside this grew a service economy to support the growing wealth of ordinary people. The Soviet Union, stuck in the mentality of the age of heavy industry, was caught out completely, and in the end collapsed from a complete loss of faith in itself. All those steelworks, nuclear missiles and coal mines did not lead to economic power. Economically the management of GDP started to dominate everything, and an orthodoxy of demand management, whether through fiscal or monetary policy, became taken for granted. Arguments between different schools of economics were vitriolic, and yet they agreed on much. That inflation should be low but positive, for example, or that productivity growth would generate a steady, long term increase of national income, or again that distribution of income and the workings of finance were of secondary importance in economic management. And this is the world still inhabited by the those Nobel laureates, modified only slightly by recent events.  The problem with the modern economy, they say, is a lack of demand. It needs to be stoked up with fiscal or monetary policy; once this has been achieved rising productivity will get us back onto the road of steadily increasing income and the repayment of debt.

But the world has changed. Since the 1990s the age of light industry has been supplanted by the age of information. To understand this, think about a few ideas. First is the idea of satiation. People only need a certain number of things, after which increased consumption becomes pointless. There are still plenty of poor people, of course, but they are in a minority. and it is increasingly hard to understand poverty in terms of a lack of volume of goods in circulation. Many observers define poverty in relative terms, not in terms of physical benchmarks like nutrition and shelter. Thus you might be poor because you lack a flat-screen TV. Not because you need it, but because you feel excluded without it. It is clear that this kind of poverty is not going to be solved by cranking up the volume of goods produced.

Secondly, consider that often what people buy when they spend money is actually rather intangible. They pay a lot of extra money for the right label or provenance. These goods aren’t really being bought for their direct utility, but for what owning them says about the purchaser and where they belong. Again, these things aren’t driven by quantities that are consumed and plays havoc with quantitative notions like productivity.

Thirdly consider how the nature of technology has changed. Information and communications technology, and the services delivered by the new devices,  lead the way.  These advances are not, by and large, driving us into an ever rising cycle of consumption of physical things or even services. We are consuming experiences and information. and these things do not follow the standard laws of economics developed by Marshall and Walras who laid the foundations of modern economic theory.

And fourthly look what is happening to the nature of work. Those steady blue and white collar jobs are disappearing. Once they were considered demeaning and soul-destroying. But we valued the social stability they brought. Instead we have a world of work that is increasingly polarised, and where stability, in all jobs, is becoming rarer.

A further point is worth mentioning. Globalisation, and the rise world trade, especially between the West and the Far East has obscured many of these changes. Driven by the law of comparative advantage, developed economies gained from cheap manufactured imports in the 1990s and 2000s.  But this economic principle is driven by differences in the makeup of the trading economies. But each of the Far eastern economies, starting with South Korea and Taiwan and moving on to China, progressed and became more like the developed world. Comparative advantage, and gains from trade, are falling away. That party is now over. And as for the effect of global financial integration on national economic management… suffice it to say that this has profoundly changed the way nation monetary and fiscal policy works.

All these things point to a world that doesn’t follow the old macroeconomic patterns. Fiscal and monetary policies don’t seem to working as they once did. Variables such as inflation and productivity misbehave. These then join forces which old-fashioned economists understand, or should. Demographic change is reducing the number of workers as demand for labour-intensive health services is rising.

This creates a world in which economic growth cannot be assumed. Distribution of income and wealth becomes of primary importance, as does managing finance, and especially levels of debt. The world is ill equipped with economic models for this new age, and many distinguished economists are contributing nothing, especially when pontificating rather than basing their views on deep and up to date analysis of the data.

We have cause to be worried by the new trends, as it appears that much government and private debt might never be repaid. If that is gloomy, we should also reflect that this is a problem of success. The ages of heavy and light industry have achieved their wider purposes and left us with societies of unbelievable wealth and comfort. But we need to understand that improving the human lot requires a new way of looking economics.

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Inflation – deflation. More evidence that most economists have lost the plot

The economic crash of 2008 took most economists by surprise. As a result many thought tha the discipline was discredited and that it would, or should undergo a rethink. Alas though we underestimated the resilience of conventional thinking. For example, commentary about Britain’s recent low inflation figures, and about inflation in other countries, is straight out of a pre-2008 text book. That’s worrying because the world faces huge economic challenges – while professional economists are looking in the wrong direction.

This week Britain’s lowest annual inflation figures on record – though I’m not clear exactly which set of records this refers to. Overall prices were calculated to have risen by just 0.5% in 12 months of 2014. There was a lot of talk about whether this was good or bad news. On the bad news front the commentators suggested that these figures might presage deflation – negative inflation – which is a Bad Thing. Bad they explained because it undermines demand because people defer purchases, Bad because it makes debts more difficult to repay, or Bad because it makes raises the floor for real interest rates, so making money supply tighter than it should be. Japan since the 1990s is then quoted as the spectre. Some economists will point out that some deflation is not bad – if it is a sign of increased productivity making things cheaper, rather than a spiral of decreasing demand.

What’s wrong with all of that? It is based on a logical fallacy that is so commonplace that most macroeconomists don’t seem to realise they are making it. In order to understand a complex thing like  a modern economy they have developed a series of aggregated statistics, of which GDP and its cousin economic growth, is one, and inflation is another. Fair enough – but for them these aggregates take on the properties of single, uniform phenomena. They then go further by inventing theoretical concepts such as “capacity” and “the natural rate of unemployment” which are unmeasurable and unreal, and pretend that they are real physical things. They then create a world rather anecdotal stories around this fictional world of statistical measures to convince themselves and others that this world is real. This fictional world is populated by people and businesses that are all essentially the same.

But reality is meanwhile diverging ever further from the fictional world. Let’s go back to that commentary on inflation. Will people put off purchases if prices are falling? The prices in question are largely fuel and food; deferral seems unlikely. And remember when the prices of electronic goods and imported manufactures was falling in the 2000s? Where people putting off purchases? It all depends on the precise circumstances – getting underneath the detail. Debts becoming easier to pay off if there is inflation? This depends on two things. Firstly that inflation must apply to your household income, so that it rises faster than the principal of the debt. Second that interest rates are less than the rate at which your income is rising. Neither is true for most people, or even close to being true. Inflation is not making debts easier to repay; deflation should not make repaying debts more difficult. And as for the business about money supply, this opens up a whole new parallel world that economists inhabit – that of monetary policy.

To work out what is really happening in the economy, you need to get behind the aggregated figures and ask what is actually happening and why. Most macroeconomists are unwilling to do this. They play with their aggregated statistics and focus on a fairly short to medium term policy options known as “fiscal policy” and “monetary policy” as if these were the only things that really matter. They remind me of Russian Tsars sending directives to distant provinces . We’re too busy and important to bother with the details; Just do what you are told and  it will all work out on average. And the world goes somewhere else, perhaps disastrously as was the case in 2007/08.

We have another case study in this muddled thinking: Japan. Macroeconomists are quite excited about Japan at the moment, because the current government is adopting a highly aggressive economic policies, following decades of stagnation. This includes an aggressive monetary policy that is straight out of the pre-2008 textbook – increasing the money supply and raising inflation expectations. This is not going particularly well, but the macroeconomists have a ready culprit – the Japanese have wrecked things through bad fiscal policy, since they raised the rate of VAT. Actually the fundamental problem with Japanese economic policy was that while prices were rising, pay (other than a few temporary bonuses) was not. In other words inflation has not proved the uniform phenomenon that economists assume. And that simply highlights that the main issue with the Japanese economy is the functioning of its labour market, not the conduct of macroeconomic policy (see this perceptive article in the FT from Bill Emmott). That and some severe secular trends that afflict all developed economies (demographic change, the evolution of the global economy, excess debt, accumulation of stagnant wealth, and changes to technological progress).

To be fair, the Japanese government, under its Prime Minster Shinzo Abe, has always been aware of this wider and more complex picture, and has been attempting to tackle the many roadblocks to change. For that prominent economists, like Joseph Stiglitz, call them “stupid”.

The world economy, and our individual nations, face huge challenges. We need new thinking. The laissez-fair (or “neoliberal” in leftist parlance) approach adopted in the 1980s has run its course. But the aggregate demand-management polices that preceded them are not the answer (I will not call them “Keynesian” out respect for the highly intelligent and flexible mind that Maynard Keynes possessed). Politicians and central bankers are grappling a range of practical problems that most macroeconomic commentators brush aside. and yet these commentators dominate the airwaves and newspaper columns.

Some of the outlines of this new thinking are quite clear. More focus on redistribution and public investment. Moving away from an obsession with economic growth. Tackling excessive debt. But these leave huge questions. For example: how do you tackle excessive debt without economic growth? I wish economists would turn their attention to these vital questions rather than rehash yesterday’s textbooks.

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Slow growth is not bad. If that means debt default, so be it. The world must change

Inflation expecationsThe state of the world economy is worrying economists. GDP growth is lacklustre in the developed world, which in turn poses problems for the developing world. That’s bad enough, but the economist’s nightmare of deflation – prices dropping rather than rising – now beckons around the world. And yet the prescriptions of most economists are shaped by a way of looking at the economy that belongs to the past. A paradigm shift is needed. Debt is at the heart of it, not GDP growth.

For a clear, conventional analysis of the issue read this week’s Economist.  Here’s a brief summary. The developed world economies are suffering from deficient demand. In other words, the economies could easily churn out more goods and services, using existing capital and labour, but don’t because people aren’t asking for the stuff or can’t pay for it. Another way of putting this is that the amount of investment (people spending money on building capital rather than the immediate consumption of goods and services) is less than the amount of saving (the amount by which people’s income exceeds the goods and services they consume). This leads to low growth rates. Now inflation is falling and deflation threatens. Deflation is bad, at least when low demand is its cause, because it makes debts more difficult to repay, and this gunges up the financial system, which makes matters worse.

The conventional answer to this problem, which also goes under the name of “secular stagnation”, is to reduce the prevailing rate of interest. This will encourage people to invest more since the returns to investment, compared to simply sitting on piles of money, would then be higher. But deflation, or low inflation, makes this impossible, because it raises the floor – the lowest real (after inflation) interest rate it is possible to charge. Answer: you raise the level of inflation. The method of doing this is to increase the money supply, since inflation is a monetary phenomenon. All sorts of ingenious ways are then dreamt up of how to do this. But this is all the product of a conventional way of thinking based on aggregate economic statistics, rather than what is really happening in developed societies.

There a number of challenges to make:

  1. Stagnation, in and of itself, is not necessarily a bad thing in the developed world. Surely the current level of consumption of goods and services is sufficient, in aggregate, to secure perfectly decent wellbeing for everybody – and economic growth is not the most efficient way to securing improvement to that wellbeing. And as we judge the potentially catastrophic impact of man’s demands on the planet it is clear that a system based on ever increasing consumption cannot end well. We need to make better choices about what we consume, and distribute the consumption more evenly. But economists seem to worry about the speed of the train, rather than where it is going, or even whether it has arrived at where the passengers want it to go.
  2. Inflation in the modern, developed world does not work in the way the economic textbooks suggest. In particular the rate at which monetary wages rise has become detached from the rate of increase of consumer prices. Macro-economic policies, like monetary policy, aimed at increasing inflation may feed through to consumer prices without doing much for wages. This completely undermines the supposed benefits of a little bit of inflation.
  3. Things are no better in capital markets. Reducing interest rates seems to have little effect on levels of genuine, productive investment. Such investment is driven much more by zeitgeist than interest rates. Excess money either chases a relatively fixed pool of existing assets (land and buildings and shares), or it simply piles up in bank accounts. This makes conventional monetary policy very hard.

We can look beyond these challenges to recognise some issues that might be behind these challenges. Interestingly, these are, for the most part, not particularly controversial amongst modern economists – it is just that they seem unable to accept the implications:

  • Distribution of wealth and income matters more than aggregates. This is the complete opposite of  late-20th century conventional economic wisdom. The problem is that wealthy people have too much income to meat their needs, and that there are inadequate channels to invest the surplus productively (as opposed to bidding up property values, etc.). To try and balance out the deadening impact of this, the answer has been to get poorer people to consume more by piling up debt. That would be fine if those poorer people turned into rich people later in their lives – but that is not what is happening. This is unsustainable – and yet most conventional economic advice boils down to cranking this system around one more time.
  • Modern businesses require much less capital investment than previously. The modern business giants of Microsoft, Apple and Google never needed much debt and did not need much capital to get going. This is simply the way that technology has evolved. There remains demand for public infrastructure: railways, hospitals, power stations and so on, but the risks and returns, and their often monopolistic nature, makes this a difficult area for private businesses, as opposed to governments, to lead. This is one aspect of what economists refer to as “Baumol’s disease” – the paradox that the more productive the efficient areas of an economy become, the more the lower-productivity areas predominate in the economy as a whole.
  • Globalisation has changed economic dynamics profoundly. Amongst other things it has weakened the bargaining power of workers – one reason that prices and wages are becoming more detached from each other. Also,  less talked about and perhaps controversially, I believe that globalised finance means that developed world governments have less control over their currencies and monetary policies. This is one reason why it is more difficult to use monetary policy to manage inflation. It is also the reason that Europe’s currency union makes much more sense than conventional economists allow – but I digress.
  • Technology is changing the way the jobs market is working. Many middle-range jobs, in both manufacturing and services, are disappearing. This week Britain’s Lloyds Bank announced the loss of 9,000 such jobs in its branches and back office. This, and not the flow of immigrant labour, is the reason why the labour market has turned against so many.
  • And finally, I think that many consumers appreciate that additional consumption, and the income to support it, are not the answer to improved wellbeing. It is better to stop earning and pursue low-cost leisure activities. I notice this most in middle-aged middle-class types like me – who are retiring early. It is perfectly rational. And yet economists can’t seem to understand why reduced consumption and income might be a rational choice for an individual. There is a tendency to tell us to go out and spend more for the good of the economy. This is a perfectly liberal and rational downward pressure on national income – which surely should be encouraged for the sake of the planet.

Some of the consequences of these trends are straightforward. Redistribution of income and wealth are now at the heart of political and economic policy, rather something that can be ignored. A much greater proportion of economic investment must be government-led, which imposes a massive challenge for political management. Governments and central banks trying to tweak the inflation rate by a few percentage points is a fool’s errand. Also trying to revive the economy by getting the banks to lend more money to poorer people is unsustainable, even if the lending is collateralised on residential property. The appeal by many economists, such as the FT’s Martin Wolf, that developed country governments should borrow more to invest in infrastructure makes a lot of sense. Using monetary policy to help finance such investment makes sense too. Making sure this investment is directed sensibly is a bigger problem than most allow, though.

And the conventional economists are right to worry. A world of stagnant growth and low to negative inflation creates major problems. In particular many debts, in both private and public sector, will not be repayable. At some point there will be default, since the other options, inflation and growth, are off the table. Or to put it another way, much of the financial wealth that many people currently think is quite secure is anything but, in the longer term. This may a problem for many pension and insurance schemes, as well as wealthy individuals and corporations.

The consequences of this are quite profound. Our society must break its addiction to debt. The banks and the financial sector must shrink. “Leverage” should be a rude word in finance. If low growth is the result, or if a new financial crisis is hastened, then so be it. Let us learn to manage the consequences better. Borrowing to support genuine productive investment (not excluding the building of new houses where they are needed) is to be encouraged, including government borrowing to finance public infrastructure. But other borrowing must be discouraged. Taxation should increased, especially on the wealthy. If that causes a loss of productivity, then so be it – this should be compensated by more efficient financial flows from rich to poor. Political reform must run in parallel to ensure that public investment is conducted efficiently, rather than just disappearing into the pockets of the well-connected.

This is a daunting programme. Stagnating national income and deflation are not inevitable consequences – since these policies do address some of the causes of deficient demand. But we must not think that these statistics are the lodestars of public policy. We need a much more nuanced appreciation of the wellbeing of our planet and the people that live on its surface, and put it at the heart of economics.

Such sound eco

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Is austerity an economic failure or a fact of life?

The British Labour Party conference proved a bit of an anti-climax. After the excitement of the last week’s Scottish referendum this was probably inevitable. All the more so since the Labour leadership did not want to talk about the important issues that referendum has raised on for the British constitution. But this conference marked in important stage in the evolution of the Labour leadership’s policy platform. They have finally, publicly and unequivocally accepted austerity as the centrepiece of their economic policy. This is rather muted, of course. The right wing press, who still set the country’s news agenda, do not want to give Labour any credit for this. Labour’s left wing supporters still think that austerity is a failed economic strategy, promoted by a “neoliberal” elite as a means of shrinking the power of government. These supporters do not want to be too vocal this close to a General Election; besides they were soothed by some diversionary promises regarding Britain’s National Health Service (NHS) and the minimum wage. But this left wing critique of austerity bears further examination.

It is expounded with some clarity in today’s Guardian by the journalist Seumus Milne: Austerity has failed, and it isn’t only Labour’s core voters who want change. To start with Mr Milne points out that Labour’s core voters, working class people, are unhappy and Labour can’t take them for granted. In Scotland they defected en masse to the SNP’s Yes campaign – and its claim that Scottish independence meant that they could roll back austerity. In England Ukip is making inroads into Labour’s core vote. Labour can’t simply take these voters for granted and then go after the “centre ground” voters who are liable to be swayed by the right wing press. This is perfectly true, of course, but not very helpful in its own right.

He then goes on to the familiar critique of austerity (cutting back public expenditure), which is that it has failed both in Britain and elsewhere in Europe. In Britain, growth is based on shallow foundations: unfunded consumer expenditure; average living standards are still sinking and many poorer people are suffering real hardship. In other European countries, notably France, there is no growth at all. This critique builds on that of Keynesian economists. In the earlier years of the government’s austerity programme they suggested that by cutting demand, or refusing to stimulate it, austerity simply created a doom-loop of shrinkage – or failed to ignite a virtuous circle of positive demand. The cuts were simply too early. This critique was eagerly seized on by the left. The trouble is that in Britain it has been overtaken by events. Growth has returned, mainly as the result of increased consumer borrowing, but also through higher business investment. There is not need to use public money to stimulate the economy further. Now is the “later” that the Keynesians were talking about when they said the cuts should be made later. It is does not matter that the initial spurt of growth was based on shallow foundations, as Keynesian fiscal stimulus is open to exactly the same criticism.

In fact the government’s application of austerity never lived up to the rhetoric. The cuts have been relatively modest, and as a result the deficit (excess of government expenditure over taxes and other income) has not been reduced by anything like as much as the original plans. The government finances still look very shaky and unsustainable. To a large extent things have been propped up by the Bank of England buying up government debt (“Quantitative Easing”, or “printing money” as some economists would have it). This only works when inflation is not a serious threat, and the Bank has indicated that continued purchases are no longer sustainable.

Things get worse when you look at the details more closely. The Economist points out that the country’s tax revenues are not keeping up with the country’s growth rate, making the deficit harder to cut. The reasons are not entirely clear, but two contributory factors should cause those on the left to worry. The first is that the government has been rapidly advancing tax free allowances, a flagship policy of the Liberal Democrats. This has helped relieve the economic pressure on the oft-forgotten marzipan layer of Britain’s poor. Those who are working and do not qualify for state benefits. But it also means that if wages are stagnant the government sees little benefit from growth. The second, related, factor is that Britain’s tax take is heavily dependent on the very rich. The Economist says that the top 1% of earners are thought to contribute 28% of income tax receipts. The position of other taxes may not be so very different. That means that pressure on the very rich, and notably the banking sector, is choking off tax receipts. All this suggests that raising taxes without hurting the ordinary working classes will be very difficult to achieve.

The serious economic case against austerity is not quite dead, though. The FT’s Martin Wolf, for example, suggests that prolonged fiscal (and trade) deficits may be required to counterbalance the insistence of some countries, notably China, to run export surpluses, and so create a surplus of savings. But his suggestion is that state funded investment is the best way of achieving this, not the continued propping up of the benefits system and a high volume of public services. That still leaves the most painful aspects of austerity intact.

The fact is that some very powerful forces, global and local, are bearing down on economic growth. These include demographics, the evolution of the Chinese economy (reducing the supply of cheap exported manufactured goods – so important to developed world living standards in the 1990s and 2000s) and (perhaps) by a focus amongst the slightly better-off on quality of life rather than income maximisation. It was once thought that any well-functioning developed economy could grow at 2% a year. That now looks infeasible. Which makes the management of government debt (and private debt for that matter) a serious long-term problem. It gets worse, as to achieve any sort of growth requires the economy to become more efficient, not least in public services. This involves the sort disruptive changes that the left’s core supporters hate most of all.

To be fair on the left, though, one of the causes of low growth is the excessive accumulation of wealth by the very rich – and this can only be tackled using an agenda that looks leftwards. But chasing down this wealth is increasingly a global problem, that needs global solutions, and not socialism in one country. This is ironic, as one of the symptoms of working class disillusion is a rejection of internationalism. It is no coincidence that the right wing press is happy to undermine international institutions, though.

Mr Milne calls for some kind of post capitalist economic reform, with increased state intervention. It is hugely unclear what this reform agenda would comprise, and whether it could work. The last country to vocally reject capitalism was Venezuela, whose oil wealth allowed it to cock a snook at the capitalist world. That is ending in utter economic and social disaster. Starvation and oppression in North Korea, and terminal economic stagnation in Cuba offer no better way forward.

The world is changing, and many Britons hate it. But with large trade and fiscal deficits Britain must embrace change or face economic catastrophe. That is the truth that Labour’s leaders are facing up to – and it is not a spineless surrender to the forces of big business.

 

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The revenge of the 50-somethings. Is this why productivity is sinking?

Last weekend I met up with a number of other 50-somethings. Only one of us was still working. The universal advice to her was that she should stop as soon as she could. It wasn’t worth it. Anecdote is no substitute for serious analysis, but it can offer some interesting insights. Economists usually ignore the idea of satiation – that enough is enough – because this wrecks their mathematical models. But it is a growing fact of life in the developed world, and one reason why it is unrealistic to expect everlasting economic growth.

Of course, many 50-somethings are not as lucky as me and my friends. They have inadequate pensions and other savings; they are forced to keep working, and may well have to do so long after their state pension kicks in at 65 to 67. There were two common factors to our group: no children and property ownership – though by no means all of us had had well-paid jobs. There are plenty of others in the same boat, even if we are a minority.

What was striking was how we had found that work had become demoralising, across a spectrum that covered high-flying project management through to ordinary clerical. And looking for new jobs is even worse. The youngsters are pushing ahead, with all their politics and superficiality. Competence and people skills are devalued compared to bluff and fast-talking. Age prejudice is rife in recruitment markets, but impossible to prove case by case. Such sentiments are largely “grumpy old man” (though most of us were female…), rather than substantive; no doubt our predecessors felt the same about us. But work used to be the centre of our lives, providing us with purpose, a social life and the wherewithal to consume.

But now we’d rather move on. Even if that means constraining our consumption somewhat – though our generation are the ones sitting on high value property, which helps quite a bit. We will retire early if we can. Many of us are winding down, into part-time work, often thinly disguised as self-employment. This pattern of reduced work level can continue until well into the 60s and even beyond.

Is this showing up in the economic statistics? This is difficult to say. Overall workforce participation is increasing, including the older age groups. This suggests that the number of people who have dropped right out of the workforce is less than those who struggle on after retirement. But the number of self-employed has been rising sharply, and we have what economists call the productivity puzzle. Labour productivity is not rising in the way technological progress suggests it should. Perhaps the winding-down of the 50-somethings is part this.

Economists stress about this. They had assumed that steady economic growth, arising from improved productivity, was simply a law of nature. When growth fails to materialise, they condemn this as a policy failure, looking to fiscal or monetary policy to correct it. But when low growth arises from free choices made by the public to produce and consume less, this is not a policy failure. But it does create policy problems – especially over the affordability of debt. It would be better for all if economists would stop whinging and help us to understand and address these policy challenges. Low growth future is here to stay. Because that’s what people want.

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Rethinking Liberalism 5: pensions and the state

In my previous essay I concluded that we had no choice but to tax the wealthy more, and this was the most divisive issue in current British politics. The reason for this is that state commitments on pensions and the health service, and potential commitments on social care, would force the state to expand, and for taxes to rise. The hollowing out of the economic middle meant that the wealthy would have to take up an increased share of the burden. But what are liberals to think about these state commitments? It is easy to see why socialists favour them, but less clear for liberals.

At the recent CentreForum seminar on the Orange Book, more than one speaker referred to the coalition government’s commitment to a “triple lock” on the state pension as being disastrous and illiberal. This guarantees that the state pension will rise by the higher of consumer prices, earnings or 2.5%. So as the proportion of older people grows the cost of this promise will mount. The same demographic trend means that we cannot look to economic growth to camouflage the policy’s generosity. And yet pensions are something that people should be able to sort out for themselves through saving over their lifetimes. Relying on the state just fosters dependency – and it can only be funded by increasing the tax burden, largely on people who will not directly benefit. If liberalism is about fostering self-sufficiency and independence, this is surely a step in the wrong direction?

A similar logic applies to health care for the elderly. In Britain it is widely assumed that this will remain free and funded by the taxpayer. As the population ages the overall cost rises. Greater efficiency in the state spend can only get you so far. Social care for the elderly is a similar issue, except that this is only a universal benefit in Scotland – though there it was enthusiastically supported by the Liberal Democrats.

The answer to this puzzle comes in two familiar guises: the need for a safety net, and market failure. A safety net allows people who succumb to bad luck to get back on their feet. I am sure that highly sophisticated arguments can be made in their defence, but to most people it is simply being part of a civilised society. Once families and social solidarity could have taken most of the strain, but the demands of economic efficiency have broken these institutions down; so economic efficiency, and the taxes they can generate, should provide the solution.

The safety net idea isn’t entirely satisfactory when providing for old age, however. The capacity to earn at this stage in our lives is limited, so it is rather more than a just a temporary helping hand. However, it still means that your life can’t be entirely ruined by bad luck. But everybody is entitled to the state pension, not just those down on their luck. The triple lock may be required to keep the state pension for the destitute at an acceptable level, but should it apply to everybody?

What lies at the heart of the problem is a market failure. Start with an obvious problem. If pensions are means tested, then the incentive to save is destroyed until you get past an amount that gives you a reasonable pension. Let’s use some numbers to get this into perspective. The new basic state pension will be about £7,500 per annum in today’s money. To get an annuity of this amount, indexed to RPI (admittedly a mathematically flawed measure of inflation that tends to distort upwards) would cost in the region of £220,000 for somebody of 65, the current pension age. For a forty year working life, with zero real investment returns (I’m coming to that), that £220,000 takes a saving of £5,500 per year, which is over 20% of the average rate of pay (£26,500) before tax. Average savings rates are, of course, much less than that (typically 5-10% of household income).

But surely people can earn more than o% real return on their assets? Actually most people can’t. There are two problems. First is that investment returns are very low at the moment. Central bank interest rates are less than inflation (negative in real terms). All other returns take their cue from that. The prospects for higher interest rates are bleak; that’s they way the world economy is. There are too many savings chasing too few investment opportunities. To break this stranglehold you need a combination of three things: low transaction costs of investment, an ability to take greater investment risk by spreading it, and access what economists call economic rents – income that is not earned through adding wealth to society, but by exploiting an “unfair” advantage. These advantages are usually only available to the better off. For the first two you need a decent sized starting portfolio (over £1 million, say). For the last you need some kind of economic privilege. While the economy was expanding, and before the demographic crunch, you could, in fact achieve these ends by owning your own house. Rising house prices are a form of economic rent, earned by the ownership of land, which is in limited supply. That covers an awful lot of people, but these are now a privileged elite: it is getting harder to join them.

Can’t people band together to get a better return? That is what an old-fashion final salary pension scheme used to do. Administrative costs were low (because you the calculation of entitlements is simple), and investment costs and average risk was low because there was single, large investment pot. Unfortunately such collective schemes are another victim of the drive to ever greater economic efficiency, which destroys the large and relatively stable employers who are needed to sponsor such schemes. Collective action means the state.

The state is the only institution that can take effective collective action. And, with private sector investment opportunities in such short supply, increasingly the state has access to the best investment opportunities too (consider much infrastructure investment). And they have the chance to tax those economic rents. That is the central logic behind the new triple locked state pension. A basic minimum, which the public has every incentive to improve through private saving, which will, unfortunately, rarely add up to a great deal more.

Meanwhile, the various distortions of tax and regulation that inhibit private savings can be gradually dismantled. The government has started by dismantling the rules compelling people with pension plans having to buy annuities. Personally I would start to dismantle income tax relief on pension contributions, increasingly of benefit only to a wealthy elite, and which comes with a dense thicket of rules to prevent abuse. That is a formidable political challenge, though, and can only be achieved in small stages.

Because efficient long-term savings are not accessible to the vast majority of people, especially those without access to property assets, the state must intervene to fill the gap. That makes the economic liberal dream of a low-tax society an impossibility – the alternative is mass destitution, or a needs based system that will be economically less efficient. And if you add health costs and social care into the picture, the problem gets bigger.

The state must get bigger. The question is how to do this in the most liberal way?

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Rethinking Liberalism 4: taxing the wealthy

There is a growing view that”inequality is one of the main problems confronting the modern world. This is quite a change. Distribution of income or wealth (or indeed the difference between the two) was not a major concern in the previously dominant neoclassical economic world view. But now that the benefits of growth in the developed world go almost exclusively to a tiny elite, while median incomes stagnate, this view has become complacent. And the work of the French economist Thomas Piketty has drawn attention to the potential power of the very wealthy. This presents a major challenge for liberals.

The problem is that liberals should have no particular problem with inequality of income and wealth in their own right. We believe in individual responsibility and free choices. We have unequal economic outcomes because people want and choose different things. So what? In fact inequality is cover for a series of issues which liberals should care about. Today I am writing about one of them: the wealthy elite.

The problem is known colloquially as the “1%”, because a disproportionate share of developed world income is going to the top 1% (or 10%; or 0.1% depending on how you want to present the figures). Rather than providing evidence for this assertion, and how it specifically might apply to Britain (perhaps less than in some countries), I will take it as a given, and look at some of the issues of principle that it uncovers.

Why does it matter? To some it is a simple matter of social justice. Inequality is one thing, but the justification for these extremes is another. There is more than a suspicion that the lucky few are winning because of unfair advantages, rather than just ordinary luck and talent. But regardless of this is a further problem. This wealthy elite has the chance to consolidate its advantages with political influence, so as to rig the economy in its favour. The growing influence of big money in politics, and the enormous lobby industry in places like Washington DC, points in this direction. There is an economic problem too: excess wealth is deadweight. The wealthy do not consume as high a proportion of their income as poorer people. And only a small proportion of their savings get channelled into constructive investment  (paying people to build things) rather than various forms of speculation in pre-existing assets.

Why is the problem growing? It seems to be a case of a weakening middle. In other words it is not a question of rising poverty, but a hollowing out of the middle class. It is easy to see the culprits: technologies that automate medium-skilled jobs, and globalisation that weakens local bargaining power. Thus we have the problem: the economy becomes more productive, but the benefits do not go to most workers. Can this trend be reversed? That is a central challenge for progressive policymakers, and it is a question I will return to.

But if we take the trend as a given, which I fear we must, then what can be done about it? The answer is clear: redistribution via taxation, public services and transfers. This issue divides politics like no other. On the right, we have “economic liberals”, who think that lower taxes and smaller government will unleash economic growth that will benefit all of society. On the right we have what I will call progressives (not all liberal), who appreciate that with today’s skewed power structures such growth will only benefit an elite, and will in any case be undermined by the deadweight effect of excessive wealth. Like most Liberals, I am in the progressive camp here.

Apart from the deep flaws in the economic liberal logic, progressive thinkers can see something else. The state has no choice but to grow. We have signed up to a society which seeks to (more or less) guarantee minimum levels of access to health care and old-age pensions.  The aging of developed world populations will increase the burden of these. And much of the investment needed to keep a modern economy growing, from education to roads and bridges, requires some level of state support. Meanwhile the ability of the middle classes to fund their own needs through savings is under pressure – both because their own incomes are not keeping pace with inflation, and because returns on saving are diminishing, a little appreciated aspect of the “hollowing out” process – with the exception of those able to own property in prosperous parts of the country.

So this comes back a stark truth. Taxes on the rich must rise. This serves to recycle wealth that would otherwise drop out of productive economic flows, and it helps fund the basics the state has to provide. So how to do this? There are broadly three directions: income, assets and capital gains.

Until now, most of the argument has been over income taxes, and in particular the best top rate of tax. When I started my first accountancy job in 1976, the top rate of tax was 83%, which rose to 98% for investment income. Conventional wisdom turned against the wisdom of such high rates. They dropped to 60% and then to 40% in the UK, before rising to 50% in 2010, and then being clipped to 45%. Economists are less sure about the wisdom of cutting such high rates. They did think that cutting tax rates would mean that rates of pay (for the elite) would fall, as it was cheaper to provide the same net salary. In fact the opposite has happened. This seems to point to senior salaries being more about power politics than market forces. Companies paid their executives more because they could; they did not do so when tax rates were high, because they did not like to see so much of the extra money disappearing in tax.

I can see no harm in reinstituting the 50% top rate of tax, though experience suggests that this won’t bring in a huge amount of extra revenue. Such high rates create a tax avoidance industry. There is a problem with very high rates of income tax though: they tend to entrench a wealthy elite, because they make it more difficult for outsiders to join them. The way to become wealthy becomes to to inherit rather than earn. This was the rather interesting conclusion of a quite wonderful contemporary study of the British tax system of the 1970s by Mervyn King and John Kay – which was recommended as a model piece of economic writing 30 years later by the UCL Economics department.

So should we not look at taxing wealth? This is the recommendation of Mr Piketty, who worries that the rate of return on the elite’s assets is too high, and entrenches their dominance. Such a tax would probably be about 1 or 2% per annum – which may not sound much, but is enough to dent annual returns significantly. Such a tax exists in the Netherlands, hardly as basket-case economy. A variation on this general idea is just to tax land – an idea (Land Value Tax) that has an ancient history in the Liberal movement. I personally have a difficulty with taxing a theoretical value of an asset, rather than a realised one – given that the reliability of asset valuations is weakening. But I have to admit the idea is growing on me, especially the land-only version.

A further way of taxing assets is at death. This is theoretically very sound, but too easy to avoid in practice. The rates here can be very high. In order to make this more watertight such taxes should no doubt be applied to large gifts as well. This used to be the case in the UK. But taxing legacies and gifts seems to attract a particular political opprobrium, and we have to tread carefully.

Finally we should mention capital gains: where assets and incomes meet. These are the commonest loopholes in tax systems. Aligning such taxes with income tax seems the best way of dealing with this. But this may undermine the case for an asset tax: the Netherlands does not tax capital gains.

But in discussing such details we must not miss two big and interrelated issues. The first is that our elites tend to be globally mobile. Taxing them will require growing levels of transnational cooperation. And indeed the need to tax such mobile elites puts greater importance on such transnational cooperation. The EU’s tax dimension should grow. Such bodies as the G20 need to focus on the matter too. It is not particularly surprising that so many rich businessmen are in favour of the UK leaving the European Union.

Which brings me to the second issue: politics. The rich seem to be of an economically liberal mindset (which is actually a recent development, as this article in the New Yorker observes). They increasing fund political movements with an economically liberal agenda. This is already poisoning the politics of the USA. It will make taxing the wealthy harder. But not impossible. If the public understands that the alternative is to cut basic pension and health systems the economic liberals will lose. But whereas we used to think that politics in the developed world was getting dull, this growing clash of economic interests will inject real conflict into it. Class war is back.

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Rethinking Liberalism 2: economics

The discipline of economics pervades all reflection on public policy. This is only right, as it is this discipline that tries to reconcile supply and demand for resources, and present a rational framework for choices. But it can be pernicious. It can frame the policy debate in the wrong way. As we refresh liberal policy ideas so as to put sustainability and human needs at the heart of public affairs, this is becoming a major problem. Liberals must challenge many tenets of conventional thinking.

First of all, let me say what I’m not going to talk about. There has been much heated debate on the value of austerity policies in tackling the recent economic crisis. I have read some liberals who say that “Keynesianism” is a core liberal belief, something given added resonance by the fact the Maynard Keynes was a Liberal. These tended not to be professional economists, who are careful not to label their beliefs with the name a of a dead economist, however inspirational. And it is based on a misunderstanding that Keynesian policies implied free public expenditure at all times, rather than being a temporary measure in response to a short term crisis. The problem that I have with economics applies as much to conventional, liberal “Keynesian” economists, such as Paul Krugman, as it does to the neoclassical ideologues – though the liberals are the more pragmatic, and the more likely to support changes to the conventions of the discipline. Having said which, I am sure Keynes would have recognised the value of what I am trying to say.

The problem that I want to deal with lies at the boundary of what professionals call “positive” economics, which refers to the factual or “scientific” side, and “normative” economics, which deals with policy recommendations, and where personal value judgements play a role. Much normative economics is presented as if it positive. Policy makers have taken simplifying assumptions used in positive economics, and used them as the basis of concealed value judgements.

I need to get more specific. These are the sorts of things I mean:

  • Economic growth is good for a society and should be an objective of public policy.
  • High productivity, the key to economic growth, is therefore a critical policy objective.
  • Free trade promotes economic welfare and drives economic growth forward, and should therefore be maximised.
  • The more people consume the better off they are, and the healthier an economy is, provided that spending does not outreach income.

I could keep going. The issue is not that these assumptions are wrong – they have served policy makers well – it is that life is not as simple as that, and we should always question them before using them in the decision-making process. And increasingly they are taking us in the wrong direction.

To be fair, economics does not stand still. I did not put on that list that aggregated income is the critical measure of success, and how it is distributed is of secondary importance. Economists (some of them at least) are at last seeing through that idea, which had been universally accepted. Also a worship of open market mechanisms for allocating resources is coming under question. And indeed, you can have perfectly sensible conversations with professional economists in which it is clear that they understand the limitations of their discipline. But when they get back to their desks and analyse policy options, the same old things keep coming up.

The result is that policymakers are trying to push the economy in a direction that it does not want to go. Growth remains obstinately slow, distribution becomes more skewed, public services struggle for funding. We worship highly centralised, “efficient” and specialised models of business and public services that are failing to meet human needs. And we are heading in slow motion for an environmental disaster.

Economics needs to adapt to the modern world. To do so it must start to take on board ways of thinking. Consider the following, none of which are particularly wacky in terms of economic theory, but all of which undermine the conventional wisdom of public policy making.

  1. Wealth must circulate for a healthy economy. This is the main idea of George Cooper’s book Money, Blood and Revolution. If wealth is accumulated by a rich elite, it drains the life out of an economy because they don’t spend it, or don’t spend it efficiently. They save too much, and the bulk of their saving goes into unproductive assets and speculation, and not enough into productive investment. Worse, they use their accumulated wealth to skew the workings of society in their favour. This presents an economic argument for progressive taxation and the taxation of wealth – as well for trying other interventions which distort the way incomes are set.
  2. Consumption should be optimised, not maximised. Once basic human needs are met, the utility of consumption rapidly diminishes, and often gets tangled in a zero-sum game of status competition. This challenges the idea that economic growth is the be-all and end-all, as well as bringing distributional issues to the fore.
  3. Don’t confuse the acquisition of wealth with its realisation. This is a related point. The conventional wisdom, based on the gods of maximising consumption and productivity, is that we should go out in the world and work as hard as possible for the common good. But what if somebody wants to work less and consume less? Or if she prefers to consume less goods, but which are made in a less “efficient” way (organic vegetables, say rather than mass farmed ones, for example). Provided that she does not consume more than she produces, does this really matter? What is the point of piling up wealth if we can’t use it in the way that we want? Economists frown on organic vegetables as they reduce productivity, but the ability to choose such low productivity goods is a sign of a wealthy society. They are confusing the creation of wealth with its realisation. This suggests that the more developed a society becomes, the less worried it should be about productivity and income growth.
  4. Trade is a means to an end, not an end in itself. No human activity has done more to banish poverty than trade. Yes we should celebrate it, and yes protectionism usually ends badly. But there comes a point when its uses diminish. Trade between the developed world and China had economic benefits when China had a pool of very unproductive agricultural labourers who could be used to make cheap industrial goods. But these benefits diminish as China catches up, and as this happens, it is more than likely that the volume of trade (and its benefits to the developed world) will diminish. That’s economics. Don’t panic. The party was fun while it lasted. Globalisation remains key in the world of information and ideas. Trade of physical things remains is important to helping undeveloped countries to develop (though the locus of that trade is likely to be mainly with middle income countries rather than developed ones, as these bulk larger). But trade of physical things over huge distances is not so important for the sustained progress of developed economies.

Liberals should believe that an economy should develop based on free human choices, long term sustainability and a degree of human solidarity which diminishes with distance. Increasingly human preferences, technology and world development will take us away from the mass-produced, high productivity, high consumption, global trading society that policy makers favour, guided by economic conventional wisdom. It isn’t what people want (free human choices), it isn’t sustainable (carbon emissions and world resources) and it is less needed for human solidarity (developing countries are increasingly able to look after themselves, while the need for more localised solidarity grows). The discipline of economics needs to catch up.

 

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The complacency of salt-water economists

In his recent book on economics (reviewed by me here), George Cooper presented the discipline as being an irretrievably fracture, in need of a radical step change. There is an alternative view. This is that in fact the profession is split between two orthodoxies, with a diverse bunch of heterodox economists on the fringe, unable to get serious traction. The two orthodoxies are often given the names “salt-water” and “fresh-water”, because the former are popular in U.S. universities on the east and west coasts, and the latter with those in the Midwest – especially Chicago. This is worth picking apart.

Followers of each of the orthodoxies assume that criticism of economics is directed mainly at the other orthodoxy, and not at them. The heterodox say that the whole lot is in a mess. The fresh-water school do seem be in eclipse. This school, often termed “neoliberals” outside the US, believe that free markets are the fairest way of allocating economic resources, and that government interference almost always makes things worse. Many assume that they were cheerleaders for the rampant excesses of the financial sector before the crash, and hence have had their come-uppance. This criticism is wide of the mark, however. The banking boom arose at least as much from lop-sided government intervention as it did from “light-touch” deregulation. Fresh-water economists can plausibly blame the crisis on government intervention, not its absence – and in particular the crazy desire of politicians to boost property lending to all and sundry.

In fact there are other fatal problems for fresh water economists. First is that they opposed serious government intervention once the bubble blew. This was self-evident nonsense, ignored to a greater or lesser degree by practically everybody – except where government borrowing presented a practical problems. There have been loud arguments over austerity that have been so loud, but these have been on degree of intervention (big or massive?) and on completely different territory to that advocated by non-interventionists. A second problem is posed by what is usually called “inequality” – whereby it appears that the benefits of growth in developed economies go predominantly to the rich – and that most people in the US have seen little or no benefit from decades of economic growth. It is a central facet of fresh-water thinking that distribution of wealth and income is not an important concern for economists and policymakers. They have almost nothing to say here. And people are starting to notice that in countries with minimal governments (Somalia, say), the economy tends to be in pretty bad shape. Of course fresh-water economists remain well funded, as their views provide convenient support to many vested interests, and they are not about to go extinct. But you don’t hear very much from them these days.

Unlike the salt-water types. These are popularly referred to as “Keynesians”, and are now very well entrenched right across the political establishment. Their most visible cheerleader is Nobel Laureate and columnist Paul Krugman. They were as wrong-footed by the crisis as any of them, but quickly found the groove again. They provided the intellectual heft required to support government intervention after the crisis, though they usually complain that this intervention was inadequate.

Salt-water types do not consider that the crisis showed that their thinking was seriously flawed. Consider this piece a few weeks ago by Mr Krugman. He simply suggests that salt-water economists were a bit misinformed – because they underestimated the practice of shadow banking. Shadow banking, in this context, refers to the practice of banks hiding their dodgier lending by creating off-balance sheet entities to take them. To be fair on Mr Krugman, in the run up to crisis his writing was hardly cheerleading for the supposed economic miracle – though that seemed to derive from his hatred of the then Republican establishment, and their attachment to fresh-water thinking.

I can understand some of Mr Krugman’s frustration with the so-called heterodox economists. They tend to be pretty unconstructive – picking at the orthodox modelling assumptions (incidentally, largely shared across both orthodoxies), without suggesting much that could replace them in a useful way, to give the discipline a better predictive power. The beauty of the salt-water orthodoxy is that it finds it easy to tack on new ideas and integrate them – they have done this quite spectacularly with many of Milton Friedman’s ideas (on money, inflation and unemployment), even though he is one of the spiritual fathers of fresh-water thinking. They are now trying to do so with ideas on inequality, an issue that they acknowledge. Thomas Piketty, the French economist who is making a splash on inequality, looks more like somebody extending the salt-water orthodoxy, rather than challenging it.

For me this is much too complacent. Regular followers of this blog will not be surprised to read that Exhibit A for the prosecution is thinking on monetary policy. Salt-water economists inhabit a world where the ideas of money supply, demand, interest rates and inflation interact in a relatively predictably way, to form an important way of regulating economic growth. Thus there is talk of raising inflation a bit, so that negative real interest rates can be implemented, which in turn will boost demand and get the economy growing. It is not that I think this line of reasoning is entirely mistaken, it is that it is an oversimplification that is more likely to lead to policy mistakes than insights.

Take Japan. This country is probably further down the path of accepting salt-water economics than any other. It has drastically loosened monetary policy (through a process of quantitative easing) with the aim of raising inflation, which in turn will help the process of managing interest rates and boosting sagging demand. But there is a snag: while prices are rising to a degree, wages are not keeping pace. Employers will consider giving employees a temporary bonus, but not raising basic pay. Without raising pay, all the nice things that are supposed to arise from inflation – like making debt easier to bear – will not happen. Economists simply assume that if inflation gets going in consumer prices, wages are bound to follow. But this does not seem to be true of a modern, globally integrated developed economy. There are plenty of other pitfalls in Japan’s strategy too.

The people at the heart of the salt-water school, like Mr Krugman, are a clever bunch. Heterodox economists do not seem to be unsettling their intellectual grip. Perhaps they are right that the orthodoxy must evolve rather than make a step-change. But if so it surely needs to evolve a lot faster.

 

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Does money really grow on trees?

A few months ago David Cameron, the Prime Minister, defending the government’s austerity policy said that “Money doesn’t grow on trees!”, a well used expression when discussing household budgets. The Financial Times economics columnist Martin Wolf responded that money did indeed grow on trees, and the money tree went was the Bank of England. Can Mr Wolf be right?

Mr Wolf was referring to the Bank of England’s policy of buying government bonds, known as Quantitative Easing or QE. One arm of the government, the Treasury issues bonds to pay for government spending; another, the Bank of England, buys them by simply adding to its reserves – creating money. Actually, the Bank doesn’t buy the exact same bonds, it buys others that had been issued earlier – but it amounts to nearly the same thing. The extra money ends up in the accounts of major investors such as insurance companies or pension funds, at home and abroad. Government spending has been financed by the creation of money. Hence money seems to grow on trees.

This type of financing is associated in the public imagination with disaster – such as the hyperinflation in Germany and Austria after the First World War, or more recently in Zimbabwe. In conventional economic theory an increase in money supply, if not matched by expansion of the economy, leads to inflation. But there is no increase in inflation in either Britian or the USA, which are both practising QE, and in Japan, where increasing inflation is actually a policy objective of QE, the increase in inflation is anaemic. So what is going on?

There are three problems with the conventional economic theory of money. First is that only trivial amounts of money are represented by notes and coins, whose circulation is controlled by the government. Instead we use bank accounts provided by commercial banks. Economists have tried to understand this type of money in equivalent terms to notes and coins. People bank money and the banks then lend it; the banks do not create money, though the central bank may. But further reflection reveals that this is not the way it works, as the Bank of England has recently admitted. It is the other way round: banks create money by lending it to people. With this more realistic idea of what money is, we can see that far from the money supply expanding with QE, it is shrinking as banks reduce their balance sheets after the boom years when they created money freely. You could then argue that QE is simply offsetting the shrinkage of credit from the banks, balancing the whole thing out. All will be well until the banks turn the corner and start creating money again.

But there is a the second problem. The overall supply of money, as far as it can be measured, does not strongly correlate with either the size of the economy or inflation, as monetary theory predicts. That’s because money doesn’t flow round the system at a constant speed. If you print banknotes, and people simply stuff the new notes under the their mattresses, the real economy doesn’t change. The electronic equivalent is people holding bank deposits which they don’t spend. That’s been happening a lot. Standard monetary theory, such as that put forward by people like Milton Freidman, is based on the idea that money circulates at a reasonably constant speed. But in fact people don’t behave that way.

But even if they did, there’s the third problem. Excess monetary expenditure does not necessarily lead to inflation; in fact in a modern developed economy it rarely seems to. Instead of people raising consumption which pushes up consumer prices and then pay, people spend it on assets or imported goods. Asset prices don’t seem to behave in a rational way, being subject to a price bubbles. In the modern globalised economy it is easy to import goods to satisfy any increase in consumer demand. And in any case the link between consumer prices and levels of pay has been broken. The wage-price spiral, at the heart of the way economists view the world, does not seem to happen in developed, globally integrated economies. Incidentally this is the problem that the recent aggressive monetary expansion in Japan (“Abenomics”) has bumped into; prices are edging up but companies remain reluctant to let wages follow suit, so that inflation simply makes people poorer. The concept of central banks targeting inflation as their main objective, the big idea of the 1990s, has simply led to complacency.

So the theory of monetary economics is in ruins. That does not stop usually quite economically sane publications. like The Economist, discussing whether central banks should adjust their inflation targets from 2% to 3%, or use nominal GDP as their reference point instead of inflation. This is rearranging the deckchairs on the Titanic (apologies for the over-used metaphor). Fortunately central bank professionals are highly pragmatic and they don’t seem to be letting the vacuum in economic theory lead them into being too dangerous, with the possible exception of Japan.

And the upshot is that in many developed economies, including the British one, governments can get away with the monetary financing of government spending, without much in the way of immediate adverse consequences. Money really does grow on trees! How on earth to understand this – and any not so benign consequences?

Well you have to recognise that money is simply a means to an end: a social construct to enable economic activity and regulate societal relationships. It often helps when thinking about an economy to take the money away and see what is going on in what economists call the real economy.

Let’s look at the real economic flows, which are at the heart of Mr Wolf’s analysis. The government is consuming more resources than it is receiving from taxation. This deficit must be supported from outside (you can’t print money in the real economy), and in general terms this is from two places: the private sector and outside the economy. The private sector, as a whole, is consuming less resources than it is producing and this surplus, in various direct and indirect ways is helping to support the government deficit. This is partly because people are working off their debts, but also because private businesses are hanging on to profits. Also the economy (in Britain and the USA in particular) as a whole is in deficit with the outside world: importing more than it exports. The government can safely run, or even increase, its deficit because it is balanced by surpluses by the private sector and the outside world.

But this is not sustainable in the long term, because persistent deficits lead to excessive debts, and the monetary economy breaks back into the real one. If the  government has cleverly got out of financing its deficit with debt, it is simply passing on the affordability problem to somebody else. The assets being accumulated by the private sector and foreigners are not worth as much as they think. The government has avoided the risk of a solvency crisis by increasing the risk of a currency crisis or an asset price collapse. This may be localised, or it may be part of a gathering global financial crisis.

But if by running a deficit the government is staving off a wider economic disaster, or even bringing the country back to the path of economic growth, it is opting for a lesser evil. Mr Wolf argues for continued government deficits, financed by QE if necessary, on just these grounds. Austerity will simply precipitate the economic crisis rather than buying time to fend it off. He has a strong belief in a “trend rate” of economic growth of about 2% per annum which can be readily unlocked and get us out of jail.

That’s where I disagree. That trend rate may sound a small number, but it is in fact a very large one for an economy that is fully developed (China can grow faster because it is catching up). A special set of circumstances combined in the period 1945 to about 1990 or 2000 to make it seem normal – but we are in a slow growth world now.

So keeping government deficits going using QE to bypass the bond markets caries risks. The main priority for governments is to reduce their countries’ vulnerability to future crises and improve their resilience. That means rebalancing. Between public expenditure and tax; between rich and poor; between imports and exports; between financial engineering and productive investment; between young and old; between environmental degradation and restoration.

Government deficits may or may not play a role in this rebalancing process. For what it is worth I think the British  government has it more or less right in terms of its overall austerity policies. QE may or may not be helping. But any money plucked from trees will, to mix metaphors, go off if it isn’t spent wisely.

 

 

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