Tag Archives: Martin Wolf

Are politicians as stupid as Joe Stiglitz says?

Our politicians are being stupid. Thus says the eminent US International Festival of Literature in Cologne, Germany - 13 Oct 2012economist Joseph Stiglitz in a recent article The Politics of Economic Stupidity. In spite of its title, however, the article spends most it words explaining the economics, and actually says very little about the politics, beyond saying it is stupid in pretty much all of the developed world. He is venturing similar views to fellow US academic and Nobel Laureate Paul Krugman (who is even more vocal about stupidity) and the FT’s Martin Wolf (whose comments are more closely argued and less polemical). All three are formidable intellects. Why are they saying this? And why are their views having such little impact on those responsible for economic policy?

The starting off point is the meagre rate of economic growth enjoyed by developed economies (mainly the USA, Japan, the Euro area and the UK) since the economic crash of 2007/08. The politicians cheer from the rooftops if growth occasionally reaches the rate of 3% per annum. But all economies are well below where they expected to be at this point by forecasters in 2007. Growth is meagre and living standards for the median citizen are hardly advancing at all. After a recession you should expect a rapid bounce-back, and then a resumption of steady growth of 2-3%, referred to as the “trend” rate, observed since the 1950s.

The proximate cause of this slow growth is, as these economists have it, a lack of demand. In other words our economies are producing enough goods and services, but not enough people are buying them. This shouldn’t happen. Economics is a circle: what we pay people to produce things is spent by them, creating demand. Demand and supply should balance out. But this can go wrong. If people save too much, and this isn’t balanced by investment, then there can be a downward spiral, in a process brought to popular consciousness by the economist Maynard Keynes in the 1930s. This is what seems to be happening across the various world economies now.

The traditional answer to this problem is for governments to stoke up demand artificially and thus stabilise things. In recent decades the consensus was that he best way of doing this is through monetary policy, usually low interest rates. This encourages people and businesses to spend more; once they spend more the system stops leaking, growth picks up and things settle back to a nice even flow. This should all be a nice self-adjusting process which does not lead to worse problems down the track. But, as Mr Stiglitz points out, this process does not seem to be working. I think he is right here, as I have blogged before, although most economists are in various states of denial about this state of affairs – so central has a particular idea of money and monetary policy become in conventional economics.

That leaves a second weapon in the conventional toolkit: fiscal policy. This means that the governments deliberately spend more than they raise through taxes, creating extra demand that then plugs the gap. This has been the incessant cry of “Keynesians” ever since 2008. But this isn’t as simple as it looks. It is not self-adjusting the way that monetary policy is supposed to be. The risk is that you build a pile of government debt that cannot be repaid, causing another economic disruption down the track that undoes all your good work. Or to put it another way, it often means prolonging unproductive and unsustainable activities that will drag the economy down in due course. It is meant to be a temporary corrective, not a long-term solution.

But, Mr Stiglitz and Mr Wolf say (I’m not so sure about Mr Krugman – he has become so polemical that I’ve stopped reading him), there is a way to square the circle. There is a magic bullet (they don’t actually say that). Public investment. If fiscal policy can be directed towards investment projects it will be sustainable. These projects will generate a return from which government debt can be repaid, either through direct revenues, or through higher taxes. And when government borrowing rates are as low they currently are, it doesn’t take much of a return to achieve this. And yet the developed world governments are reluctant to do this. This is what Mr Stiglitz is calling economic stupidity.

But alas life is not so easy. Public sector investment is an elephant trap. Investment projects that generate their own revenues and collateral don’t need the public sector to run them. Indeed it is almost always better to let them run in the private sector, where management and accountability is sharper. And by and large all the easy ones are being done already. It leaves some big projects that turn out to be very risky – like, for example, Britain’s HS2 fast railway. And because they are risky they are slow to get up and running, and not much use as tool for temporary fiscal policy.

But there is another set projects where the returns are indirect – they come from taxes in various guises. These include things like roads and bridges (given the difficulty of charging economic tolls), schools and hospitals, under Britain’s NHS. But the returns are difficult to judge and projects are selected not through a process of objective rating of financial return, but through political arm-twisting in a bid for short-term prestige. And the more urgent the need to create economic demand, the worse in quality these decisions are.

Examples about. After 2008 China embarked on a massive and urgent infrastructure programme. But although the country remains underdeveloped, much of this money was wasted; whole cities have been built and lie empty. The Chinese government is now grappling with a rising tide of bad debts from the state banks that backed these projects. Japan in the 1990s invested massively in infrastructure projects; the country is littered with “bridges to nowhere” and its economic problems are as intractable as ever. In Britain in the early 2000s the country invested in a whole host of Public Private Partnerships. Many of these are turning sour because it turns out the facilities (notably in the NHS) were not actually needed. Though the political opprobrium surrounds the PPP structure, and the way that there was no real risk sharing with the private sector, we mustn’t forget the problem at the heart of it all – public sector organisations are very bad at choosing investment projects. (Actually private sector organisations aren’t any better if the accountability is weak – but that’s another story). I could go on with other examples of government expenditure that were sensible in principle but badly designed in practice (Labour’s Building Schools for the Future, for example).

The upshot is that public investment is no magic bullet. It’s a good idea, and we should do more of it – but a top down blitz directed by the need to rebalance the economy in the short term is asking for trouble. Each project needs to be properly thought through and well managed. That means you can’t get them going in a hurry.

So what to do? I think we need to be more realistic about the direction our economy is going. Things are changing. The demographics are adverse. The excessive wealth of an elite is economically inefficient. Modern businesses require less physical investment. Technological innovation is more about improving the quality of life than ramping up consumption. Economist such as Mr Stiglitz and Mr Wolf are well aware of these pressures. I think their time would be better spent helping us to craft long term solutions rather than ranting on about “stupidity” that turns out to be not so stupid after all.

 

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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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Where Keynes and Beveridge turned out to be wrong

The Spring 2013 edition of the Journal of Liberal Democrat History has a fascinating article on the role of Maynard Keynes and William Beveridge in developing Liberal Party policy, culminating in the party’s manifesto for the seminal election of 1945. These men took the party’s thinking decisively into what is now called “social liberalism”. Their vision was inspiring and coherent; much of it is now simply accepted wisdom. But I detect a tendency to treat these men’s ideas as holy writ. But nobody can be right on everything, and the world was changing fast. It is interesting to pick out the places where they got it wrong. This will perhaps help us to reflect on the challenges we face today.

Beveridge (in his report to the wartime coalition government) memorably set out the challenges to society presented by the “five giants” of Want, Disease, Ignorance, Idleness and Squalor. The answer was to extend what we now call the Welfare State, establish the National Health Service, nationalise a series of critical industries (railways, coal and power in particular) and to adopt a system of macroeconomic demand management, which we know as “Keynesianism”. These policies were largely adopted by the subsequent Labour government, albeit with more enthusiasm for their collectivist aspects, and retained by the Conservatives that followed them. The success of their ideas on the wider political stage contrasts with the Liberals’ disastrous performance in the 1945, when Beveridge lost his seat, and the Liberal Party faced extinction – in a crisis that makes its successor party’s current woes look like a picnic. Which only goes to show that winning the battle of ideas and having coherent policies is on a small part of how a political party succeeds.

But what has gone wrong? The Welfare State grew to be a monster of a size that Beveridge would have been horrified at, though it made much headway in combating Want and Squalor. The contributory principle, central to Beveridge’s vision, has largely broken down, with entitlement being based on need rather than past contribution. It has never broken free from the dependency problem, where people don’t have enough incentive to sort out their own problems – an issue that Beveridge foresaw. It strikes me how Beveridge’s system was overwhelmed by the breakdown of the traditional family, and of traditional working class communities. These were inevitable consequences of economic progress, as well as the march of liberal social values. But needs that used to be met within the community were now thrown at the state’s door, and, perhaps, the breakdown of discipline in some communities (about starting families in particular) added to the problem. Beveridge’s carefully worked out system of benefits and entitlements was not equal to the task.

Nationalisation has proved another disappointment. Keynes was convinced that these critical industries would not be managed for society’s overall benefit if they continued in private ownership. He also wanted to incorporate them into his system of macroeconomic management. But the state proved inept at setting strategy, and was often a prisoner of the short term interests of managers and workers. Strategic decisions tended to be made badly, and investment declined. They were all subsequently privatised and, except arguably the railways, have performed much better since. Regulation has proved a much more effective answer than state management.

Keynesian economic management has proved highly controversial, after two major economic crises, in the 1970s and now. But it is clear that widespread adoption of Keynesianism has moderated the economic cycle, and this has been of huge benefit. We have to accept though that it cannot deliver full employment sustainably unless the overall economy is in the right shape. In the 1970s it was too dependent on cheap oil. Now it is too dependent on finance and government jobs and funding.

But it is interesting to read that in 1945 Keynes thought that the main means of managing the business cycle was investment. He understood that private sector investment tended to follow the cycle (i.e. increase in the good times, and fall back in the bad – just what we are currently experiencing), and so make it worse. Government investment should counterbalance this – and he wanted to nationalise key industries so that the scope of government investment increased. This just hasn’t happened. Instead the expansion of the welfare state has created a counter-cyclical dynamic (called “automatic stabilisers” by economists) that has proved perfectly sufficient until now, with a few tweaks here and there.

But since the size of the welfare state and government generally is now part of the problem, using it to manage the cycle has hit its limit without the job done. A lot of economists (like Martin Wolf of the FT) now urge that we go back to Keynes’s original idea and increase the level of government investment. But I suspect that the reason why governments did not follow Keynes’s original system, apart from the growth of automatic stabilisers, is that this is much more difficult in practice than in theory. Examples of where it has been tried, such as Japan in the 1990s, and China in the present crisis, are not particularly encouraging. Vested interested and construction businesses close to the government have reaped benefit, leading to wasted investment and a corrupted political system. As a developing country China’s investment needs are huge, so they may still end up ahead, but the case for developed economies is much weaker.

What does this say to us now? The five giants are still with us, although they may not loom as large as they did. But I think the era of grand political projects established by clever men from on high has run its course. What is needed is a reshaping of government to make it more local, participative and people centred. But that is a very long journey.

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Nowadays it seems to be the economists who are obsessed with the short term

The relationship between economists and politicians is often strained. It’s easy to think that economists are taking a detached view of public policy and its long term effects, while politicians simply jockey for advantage at the next election. But, strangely, that doesn’t seem to be the pattern right now. It’s the politicians who are urging short term pain for long term gain, while the economists say it can all be left for another day. It is the politicians who have a better grip on reality.

The nature of the relationship between political leaders and economists has changed as economics has evolved. I think it was President Truman in the late 1940s who said he wanted to find a one-handed economist, so fed up was he with his economic advisers saying: “One the one hand this, but on the other hand that”. He wouldn’t have that problem today: there is no species of public policy commentator that is more one-handed than an economist nowadays, so confident do they seem about what they are saying.

In the late 20th century supply-side economics took hold, after the economic traumas and stagflation of the 1970s. This held that the route to economic success was in making sure that markets worked efficiently and government expenditure kept on a tight reign. Economists bewailed the fact that their advice was so often ignored by politicians, who found their prescriptions unpalatable. Only the unelected President Pinochet seemed to take economists at their word, as he implemented a series of reforms in Chile. The expression “politically impossible” was frequently used in discussions of economics. In fact politicians, starting with Britain’s Margaret Thatcher, largely implemented the supply-side economists’ advice, but this was only really acknowledged by most economists after the event.

But things seem to have moved on again. Politicians in Europe, including Britain, are grappling with the size of government in the wider economy, and pushing ahead with supply side reforms. This is hard political work, with scant reward on offer at the ballot box. But do politicians get credit from professional economists? Not a bit of it. Instead austerity policies are blamed for anaemic growth and high unemployment. Scarcely a day goes by without some economist, like Paul Krugman, Martin Wolf or Samuel Brittan thundering away that all this is foolish and bound to end badly: looser fiscal and monetary policies are needed, and the problems of government deficits can be sorted out another day.

What accounts for this? It is tempting to conclude that there is simply a time lag in economic thinking between the academics and the politicians. In academic circles the supply-side mania has run its course. It was always incomplete, and too often, not least during the great economic crisis of 2007-09, it had very little of value to say. Neo-Keynesianism had taken hold, with an updated series of macroeconomic models designed to deal with the issues that arose in the 1970s. The politicians, perhaps, haven’t moved on.

But I think there is a different explanation. It is that the politicians are much more aware of what is really happening in our economies, and the changes that are needed, while the macroeconomists are blinded by their use of aggregate statistics. The politicians can see that there are some fundamental problems with the way their economies are functioning, especially here in Europe. The first problem is that the state has become too large and inefficient. A second is that the progressive aging of populations is progressively weakening economies. A third is that globalisation has changed the rules of economic management. I could add a fourth issue, which is that the world’s financial systems have become dysfunctional, except that I think this is confusing politicians and economists alike, and is not a driver of tension between the two.

Economists agree with this analysis of problems by and large, of course, except that I don’t think that most have woken up to the implications of globalisation, and its profound implications for the way prices and wages rates are set. What the politicians appreciate is that these problems are desperately hard to fix, and that putting off the evil day is not going to help. In particular the central problem is to shrink the state. Politically it is much easier to put through tough changes in hard times, and not when things seem to be ticking along nicely. And if you look at the political forces that seize on what the economists are saying, you will find that they are mainly those that do not see the need to shrink the state at all.

Alongside this disagreement about the best time to reform is an economic judgement. Politicians are sceptical that sustainable economic growth is at all easy to find. Many economists think back to the decade before 2007, when 2% annual growth was more or less taken for granted, and assume with a wave of the magic confidence wand, this growth will come back – and that we might even be able to make up some of the lost ground. Even now I have seen some economists who should know better projecting trend growth before the crisis, to estimate the true cost of the recession. So in the five years since the crisis, the economy should have grown by 10%, they say; in fact it has shrunk by 4% (I haven’t checked that number), so the crisis and bad economic management has cost the economy 14%! But what if that 2% tend growth wasn’t for real? What if it was simply pumped up by borrowing and trade deficits? And what if the progressive aging of the population makes sustainable growth of 2%, or even 1%, unreachable? Blinded by their aggregate statistics, not enough economists are asking these questions, and still less following through their implications. But it is all too obvious to most politicians, and businessmen, come to that.

The gap between politicians and economists isn’t helped by the fact that the former keep using government debt as the main driving force of their argument. This is politically convenient, but the economists rightly spot that it is insufficient of itself. If the economy could readily be kicked back into a 2% growth trend with a bit of fiscal pump-priming, then the debt argument would not hold water. In today’s FT Samuel Brittan accuses politicians of falling for the fallacy of composition: that whole economies work like family budgets. In fact there are deeper reasons for what politicians are doing.

There is further disagreement over investment spending. Many economists think that they have found the magic bullet. Government funded infrastructure investment can both act as a short-term fiscal stimulus while delivering longer term benefits to the economy. So why are the politicians so reluctant to spend more on capital projects, and even cut them back? And yet this is another blinded by aggregates issue. The economists’ argument only holds water if the investment projects actually deliver economic benefits. This is much more difficult in practice than it is in theory. Under the last government investing in hospitals must have looked a sure-fire winner, given the ever rising demand for healthcare services. But we are now finding, as hospitals are collapsing under unaffordable PFI debts, that it wasn’t so easy. Too often they built the wrong sort of facilities. This is situation normal. The usual result of a public sector infrastructure project is to end badly. Japan’s investment splurge in the 1990s, in similar economic circumstances, simply caused many “bridges to nowhere” to be built.

And so, in this debate, my sympathies are with our political leaders.

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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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Is cutting Corporation Tax good for growth?

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

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

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

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

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

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

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

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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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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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Time for Plan B?

Predictably, the heat is mounting on the British government to soften its fiscal policy in light of weak economic growth.  Today the new IMF chief Christine Lagarde seems to be adding to the pressure, even if she wasn’t explicit.  The code for changing this policy is referred to by political types as “Plan B”.  I am now convinced that some sort of Plan B may now be a good idea – but it would not take the form that a lot of Plan B advocates, especially the Labour opposition propose.

First, why?  I have been progressively convinced by the FT’s economics editor Martin Wolf.  I have found him to be easily the most cogent commentator on the current economic situation, better than any number of economics Nobel Laureates or former members of the Bank of England monetary policy committee, who seem to think that their past glories can compensate for the shallowness of their analysis.  Paul Krugman, Ken Rogoff, Joseph Stiglitz, to name a few, have disappointed somebody that has respected their weightier works; David Blanchflower has turned downright silly in order to widen his audience.  Mr Wolf has been consistent, logical, and has gone further than most to try and understand all facets of the arguments.

The problem in the UK economy is not lack of consumer demand, since consumers are right to pay down debt as a priority right now.  The problem is lack of business investment, and a weak world economy, and hence potential export markets.  And excessively tight fiscal policy may send investment into a doom-loop, since so much depends on confidence.  Add to that the fact that current levels of public expenditure are unsustainable, and the massive size of the public deficit, and you will understand that most versions of Plan B are unconvincing.  Reducing the cuts simply creates problems for later, and builds up a false confidence in what this nation can afford.  Cutting VAT temporarily, as advocated by Labour,  addresses the wrong problem.

The answer must be to promote investment.  As Mr Wolf points out (here but behind the FT paywall), there is a golden opportunity for the government to do so because its borrowing costs are so low.  The trick is finding projects that deliver a convincing financial return; borrowing against such projects does not undermine the country’s finances.  Unfortunately this is easier said than done.  A lot of public projects make extravagant claims about their worth, but are in reality wasteful prestige initiatives – think of the Building Schools for the Future programme.  Or else they turn out to be so badly managed that promised returns are never delivered – think of NHS IT, or Edinburgh trams, or anything undertaken by the Ministry of Defence.

There is no doubt some scope for increasing funding to standard public projects.  But actually what needs to be done is to provide more support for medium sized and small businesses, especially growing ones.  The banks are not stepping up to the plate, demanding ludicrous returns for their efforts.  Surely there is scope for the government to beef up regional development funds and increase funding for institutions such as the Green Investment Bank.  This will not open the floodgates to usher in an era of rapid growth.  But surely it would help.

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