Tag Archives: monetary policy

Why do governments follow austerity when orthodox economists advise against it?

It’s by turns annoying and amusing: the way people on the left complain that orthodox economics has gone off the rails, and that we need fresh thinking to inform government policies. Apart from coming up with a lot of age-old tropes that economic models do not mimic real behaviour, or take account of information asymmetries, the main item of evidence is the persistance of austerity policies in the developed world.

But the main critics of austerity turn out to be…. orthodox economists. People like Joe Stiglitz, Paul Krugman and Martin Wolf. And newspapers struggle to find economists to make the case for the defence. The Financial Times often resorts to Niall Ferguson, who is a historian, not an economist, and no match for a Nobel laureate like Mr Krugman. The British Labour party is even roping in economics professors to bolster its economic credibility.

In fact there is a brand of orthodox pro-austerity economists. These are the old “supply-siders” from such institutions as the Chicago Business School, who developed a line of “neoclassical” economics, and rebelled against what was once the Keynesian orthodoxy. This branch of thinking grew out to the economic crisis of the 1970s, but proved utterly useless when the crisis of 2007/08 hit. Neoclassical economists pipe up here and there in America, but are mostly silent, their credibility shot-through. That leaves the field nearly unchallenged for the neo-Keynesians – at least far as the public debate in newspaper columns is concerned, in Britain, anyway.

Which leaves us with a mystery. Why are governments, from Europe to America (though not Japan, interestingly), ignoring the orthodox economists? Two explanations are usually offered by their critics. One is rank incompetence or wilful blindness. The other is a political agenda that austerity plays to, usually involving making the rich richer. Neither explanation stands up to close examination.

I am wary of accusations of incompetence, especially when made about clearly intelligent people, such as most politicians and technocrats involved in government finance. This is something I learnt as a history undergraduate (I studied both science and history in my original undergraduate incarnation, long before my study of economics as a mature student). Such accusations are bandied about freely down the ages, but never stand up to scrutiny. Mostly the wilful blindness comes from the people making the accusation, who cannot entertain the idea that there is a rival point of view to their own. Modern economic policy is no exception.

The political agenda is a bit more plausible. Perhaps governments are in hoc to big business interests and those of the wealthy? But if the last 150 years of history has taught us anything, it is that if poorer members of society are prospering, the rich will prosper also, and be left in peace. This is even more true of big corporate interests than anybody else. It is harder to make money in a stagnant economy. Those malign influences are there in politics, but their effects are altogether more subtle than doing down poor people to help line the pockets of the rich.

Sensing that these explanations don’t work, many on the left build up an idea of “neoliberalism”. This is a philosophy based on the old supply-side or neoclassical economics that may be waning in academic economics, but still holds a grip on the lesser mortals who staff finance ministries and banks, and other parts of the “elite”. But this too is inadequate as an explanation. Certainly it is possible to identify a series of beliefs and biases amongst policymakers that equate to economic liberalism. But they do not explain austerity as a macroeconomic policy. And besides, we need to understand why the hold of these beliefs is so strong. Clearly some on the left think that an outdated economic orthodoxy is to blame. But surely such theoretical constructs cannot by themselves have such a grip on so many intelligent and practical minds?

Instead of a conflict between different types of theory, what is really going on is a conflict between theory and practice. The theoreticians may be gung-ho about fiscal and monetary stimulus, but the people who implement policy are acutely aware of the practical problems and risks. There are three particular practical issues about which the theoreticians are dismissive, but which weigh heavily on the practical types: economic efficiency; public investment; and financial markets.

First take economic efficiency. Pretty much everybody agrees that, ultimately, living standards depend on economic efficiency, or productivity. This piece of orthodoxy could be challenged, but that is not what most on the left mean (traditional Greens being the exception, along with liberal voices in the wilderness like mine) when they call for fresh thinking. They see slow economic growth as a sign of failure as much as any conservative does; and that ultimately is based on productivity. But economic efficiency is hard work politically. Both businesses and workers like to protect their patches with taxes, government agencies and regulations that keep the winds of change at bay. This is especially the case in Europe and Japan. And yet, in order to achieve long-term growth, these vested interested must be tackled, and reforms enacted. This has been shown in countless contexts in both developed and developing world. Mostly reforms have an economically liberal character – but only because this approach genuinely unlocks long-term efficiency.  Far-sighted politicians and officials want to use every possible chance to advance reforms. That includes the pressures created by economic hard times. Theoretical economists might suggest that boom years are the best time to push through reforms, or that reforms can be covered by macroeconomic leniency. Politicians know that the opposite is the case – it too difficult to muster the political imperative in easy times, or if short-term macroeconomic policies take the heat off.

Reform and austerity are not necessarily the same thing, but they almost always are.  This debate, of course, dominates discourse in the Euro zone, where economic hardship is concentrated in less efficient economies. Critics of austerity there offer no way forward for improved efficiency, beyond the hope that public infrastructure investment will deliver the growth they seek.

Which brings us to the difficulties of public investment. To theoretical economists this is the magic bullet. Public investment in infrastructure both yields gains to long-term efficiency, and a short term fiscal stimulus. The economists are exasperated that so few governments seem to follow their advice. And yet public investment is a graveyard of roads to nowhere and white elephants. When the imperative to  invest is political, the choice of project becomes political too. It is very hard to make sensible choices. China was much lauded for its infrastructure investment programme following the crash. This has now turned into a major headache, as so much of the money was wasted on empty cities and useless infrastructure. Something similar happened in Japan in the 1990s. Finance ministry officials are rightly wary.

And then there are the financial markets. If I’ve heard one economist here in Britain suggest that now is a fabulous time for the government to borrow, or even “print”, money, I’ve heard it from a hundred. With so much demand for government bonds in the markets, and inflation looking mortally wounded, just what are you worrying about? But none of these economists work at the sharp end of government finance. If they did, such sanguinity would remind them of the sort of thinking that got the world’s banks into the disaster in the first place: a reckless confidence that markets would behave in future as they do now.

Alas life is much more complicated than that. Grounds for confidence in the financial markets is stronger in some places than others. Japan has a massive export industry that sees to all its foreign currency needs, so that the state can borrow and even print the Yen with reasonable confidence. Which is what it has been doing, in prodigious quantities, for the last two decades, although to little apparent effect. The US is another country that can feel reasonably secure, even though its balance of trade is less benign than Japan’s. The dollar is the world’s de facto reserve currency. The United Kingdom, however, shares neither of these strengths. It needs to draw on overseas institutions and businesses, and its own private sector, in order to finance its significant current account and trade imbalances. This is not a problem that printing the Pound can help with. The state has been extraordinarily adept at handling this risk over the last few decades. But that is because of the conservatism that is currently attracting so much criticism.

To me the theoretical economists, the practical policymakers, and most of their leftist critics are all trapped by an orthodox way of looking at the world through economic aggregate statistics. This means that they are failing to take on the deeper problems that society faces: economic and environmental sustainability, alienation, and the gravitation of wealth to successful people and places. That has very little to do with the politics of austerity. People on the left who call for fresh thinking should be careful what they wish for.

 

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Secular stagnation: the dark cloud hanging over the world economy

A dark mood is overtaking those who contemplate the world economy. Today Britain’s Chancellor George Osborne will join a growing chorus of worry. Weak outlook in emerging economies is undermining efforts to revive developed ones like Britain’s. So far the prognosis is stagnation rather than economic disaster – a mood caught by the FT’s Martin Wolf, who tells us not to be too pessimistic. But these are dark clouds and policymakers would do well to prepare for rough waters.

Mr Wolf bases his relative optimism on the fact that world economy has being growing steadily for some two centuries, and with particular steadiness since 1945. Until the potential for further growth is exhausted, which he doesn’t think is anywhere near the case, that growth will carry on. But macroeconomics has changed profoundly in the last ten to twenty years. And even orthodox economists are starting to appreciate this.

The leading piece of evidence is that in the developed world central bank interest rates are stuck at very low levels, even though the recession of 2008-2009 was over five years a go, and there has been steady recovery since. And inflation, as it relates to pay and consumer prices, remains low. What had once been seen as a special case and compounded by policy mistakes, Japan after 1989, has become general. The Economist’s Free Exchange column has run a couple of articles on this. Orthodox economists had simply assumed that the way out of economic doldrums was through conventional short-term policies, such as loose monetary or fiscal policy. Japan’s problem, a whole queue of people, such as Paul Krugman, said, was simply a matter of a “liquidity trap” – when interest rates become too low to reduce. By the time I was studying Economics at UCL in 2005-2008, this was literally in the textbooks. Mr Krugman suggested that the solution was to raise inflation expectations in what seemed to me, even then, as a case macroeconomics gone mad.

But even Mr Krugman now thinks something deeper is afoot. Larry Summers was the first orthodox economist to raise the alarm, and he gave the problem a name: “Secular Stagnation” – or rather he resurrected a theory of that name that had long been treated as a theoretical curiosity. The world economy is profoundly out of balance. This is because the amount people want to save is more than what people want to invest, causing aggregate demand to drain out of the system. This is an idea that Maynard Keynes made famous in the 1930s – but he assumed that such an imbalance was temporary, and specifically a feature of recessions. But what happens if the imbalance continues right through the cycle? We find that attempts to stimulate growth through monetary or fiscal policy run out of steam, and simply lead to asset price bubbles, as surplus money chases the same assets round in circles.

What is causing this imbalance? Unfortunately, notwithstanding the large number of brilliant minds devoted to economics, the massive computing firepower at their fingertips, and the size of what is at stake, there is practically no quantitative evidence. Indeed, macroeconomists actually know little about what is actually happening in the world behind the artificial creations of their aggregated statistics. Instead we have a series of speculations which people gravitate towards depending on political preferences. Here the main ones:

  1. Inequality – the popular explanation on the left, including Mr Krugman and Robert Reich. A greater share of income is going to a very wealthy minority, or is stuck in corporate balance sheets. This is saved rather than spent, contributing to a surplus of savings.
  2. Trade surpluses. China, Germany and (until recently) some oil states have been running up structural trade surpluses, which again creates surplus savings globally. This makes people like Mr Wolf hot under the collar.
  3. Excessive levels of private debt. This theory is favoured by heterodox economists like Steve Keen. Private borrowing as a ratio to income has been steadily rising and is at record levels. Bank balance sheets are clogged so they can’t lend to fund new investment. Meanwhile private individuals are spending too much on debt repayments and interest to spend on consumption.
  4. Modern businesses require less capital, reducing demand for investment. Microsoft and Google required no bank loans and little new capital to develop their businesses, unlike the industrial giants of old. This may be a function of technology, or simply “Baumol’s disease” – the fact that productivity improvements are tilted towards particular industries, whose weight diminishes as they become more efficient. Mr Summers seems to incline towards this explanation, while not dismissing the others.
  5. Demographics. The proportion of workers compared to retired people is diminishing in the developed world and some other countries, like China. This squeezes the supply side of the economy and hence investment.  It also undermines any benefits of productivity growth, the traditional engine of economic advance. This was clearly a factor in Japan, which led the trend.

Is this just a developed world problem? Surely, with so many countries still poor, there are opportunities to raise productivity, and hence global growth in poorer countries? The growth of developing East Asian economies, starting with Japan, and latterly dominated by China, has been an important component of recent world growth. And yet there are few signs than other developing economies can move much beyond exporting natural resources, while China is picking up some distinctly developed world issues. India may be an exception, but the jury is out there.

So what is the solution? That, of course depends on how important each of the above factors is. But there is a big question behind this. Most economists assume that economic growth is a natural state of being, and simply want to remove obstacles to future growth, by raising the level of investment, for example. Others feel that slowing growth is part of a bigger development cycle and something we had better get used to. I incline to this second view.

But the way forward surely does not lie in grand, sweeping policies based on a single, overarching theory. We have to tackle smaller problems as they arise, bearing in mind the overall sense of direction. With that in mind, I think these are the main areas to watch:

  • Private debt. You don’t have to subscribe to Mr Keen’s ideas to understand that growing levels of debt are part of the problem, whether symptom or cause.
  • Big business. These are accumulating too much power, and skewing the distribution of resources.
  • Asset values. In much of the world, excessive asset values, especially land values, are a sign of economic dysfunction. This is especially the case in Britain. This is not a simple matter of supply and demand – excessive debt is part of the problem.
  • Migration. This is one of the ways that economic pressures can be relieved. But as we know all too well, a host of problems follow in its wake.
  • Government debt. In the short to medium term, for most developed economies, high levels of government debt will be much easier to sustain than conventional wisdom suggests. And yet in the long term this could lead to economic breakdown, as is happening in some South American economies.  The left have a strong theoretical case in opposing austerity, but undermine it by opposing almost any reform designed to improve economic efficiency and promote sustainability.

It is also important to point out the dogs that won’t bark. These are things that economists bang on about which don’t matter so much in our “new normal”:

  • Free trade. Free trade is an important part of the current global system, and it won’t help to reverse it. But the rapid globalisation of supply chains which was such a feature of the last two decades, is going into reverse, as the East Asian economies mature. This is one reason why growth is slowing – but it is the reversal on a phenomenon that was always going to be temporary. Further liberalisation of trade poses challenging questions, as TTIP and TPP are demonstrating, and may simply benefit big business.
  • Inflation. It used to be thought that inflation was a matter of managing expectations by the central bank, and of paramount importance. This is still true in some less developed economies. But in those exposed to global trade this is an entirely unhelpful way of looking at things. More powerful forces are keeping prices stable and inflation is less and less an issue that central banks need to act on.
  • Interest rates. These are set to stay low for a long time yet. The betting is that the recent rise in the US will be just one of a long line of failed jail-breaks, started by the Bank of Japan in the 1990s.

We live in interesting times.

 

 

 

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Osborne uses an accounting trick to implement People’s QE

When Jeremy Corbyn, was running his successful campaign for the leadership of Britain’s Labour Party, he floated the idea of “People’s QE”. “QE” stands for Quantitative Easing, the means by which central banks try to loosen monetary policy in an economy without reducing interest rates – handy when interest rates are near zero. It attracted quite a bit of attention from economists, much of it quite approving. That is because the idea touches on one of the most important aspects of modern economic policy: the suggestion that governments can sustain quite big deficits simply by “printing” money. In the end we find, not for the first time, that the current Conservative government acts much further to the political left than it talks, as did its Conservative-Liberal Democrat predecessor.

Back in the 1980s, when monetary policy first became the height of fashion, we had uncomplicated views about what it was about. Although most money was in bank accounts, economists painted a picture as though it was all in notes and coins, and the various actors behaved as if they were kids spending pocket money (and even then was probably too simplistic…). They talked of a “money supply”, which could be manipulated, and the size of which affected spending behaviour. We are older and wiser now, though many economists and journalists still talk about “printing money”, even though physical money has almost no role to play, and bank accounts are different in very important ways. Even trained economists who should know better sometimes trip themselves up in this way. For example there is much excited talk about how commercial banks create money rather than the central bank – which turns out to be a red herring on reflection [That link from Paul Krugman includes a broken link to a masterful essay from James Tobin in 1963, read it here]. It is better to look on monetary policy as a series of policy instruments under the control of the central bank, which have not entirely knowable effects on the economy at large.

The most important of these instruments is the short-term interest rate the central bank charges to commercial banks in their interactions with it. These ripple right through the economy. But when they are very low, as they are now in the UK, it is very hard to lower them further. Some European banks are using negative interest rates without the sky having fallen in, but these negative rates aren’t very high – fractions of a percentage point. So how to “loosen” policy – that is encourage a greater level of economic activity? Here the invention of QE comes in, pioneered, as so much of modern policy, by Japan in the 1990s and early 2000s. This is often talked of as if it means printing physical money and handing it out to the kids to spend on sweeties. What it actually means is that the central bank goes into the market and buys bonds, usually government bonds, like British gilts.

How does that help? Well the people who held the bonds now hold cash instead, which they should spend on something else – which might include new capital investment, after it has changed hands a few times. And it might reduce bond yields, which will reduce long term interest rates right across the economy, and increase asset prices. This creates a “wealth effect” that might encourage the mass affluent to spend a bit more money on stuff that people make. Or all that could happen is that there is a merry-go-round of money chasing various flavours of pre-existing asset to create an asset price bubble. It’s not very clear what has happened to the Bank of England’s QE over the years. The bank produces various statistical associations as evidence that it has helped stimulate the wider economy. Others are sceptical.

Which is where People’s QE comes in. What if, instead of buying government bonds in the market, the money went into extra government spending, such as infrastructure investment, or even current spending. Because the Bank controls the currency in the UK, it can fund the government’s deficit without the need to borrow money from investors. It borrows money from itself. This amounts to supporting looser fiscal policy (i.e. government tax and spend), which should provide a more predictable stimulus to the wider economy.

Mr Corbyn’s advisers developed the idea with the suggestion of administrative structures to channel the extra money into infrastructural investment. This puzzled some economists. There is no need for such engineering. All the government has to do is spend the money, increasing its deficit, issue bonds as normal, which the Bank of England then buys in the existing QE programme. If the Bank is buying bonds, the government is less beholden to the bond markets. In Japan, which has been practising QE on a massive scale, the government now issues little net debt to the bond markets, making large deficits sustainable.

But how does this work? Surely it is something for nothing? The answer to that is that it only works if there is slack in the economy, and the government steps in to create demand because businesses are investing less than the public is saving, creating an imbalance. If this is not the case, you can get inflation, which is what happened to Germany and Austria in the 1920s, Zimbabwe more recently, and is happening in Argentina now. Alternatively you get a asset price bubble. Which in the modern, globalised financial and trading system is in fact more likely for developed economies – though this seems to be a blind spot for many economists, who think that asset markets are too efficient for that.

But in the developed economies, including the US, the Eurozone and Japan, as well as the UK, there does seem to be scope to do this kind of stimulus. There is a lack of business investment, while, it appears, too much money ends up in the hands of rich people, who don’t spend it. Nobody knows how long-term this problem is, but it does look as if large government deficits are much easier to sustain than before. If the bond markets refuse to fund all of the deficit, then central banks can simply “print the money” as the popularisers would put it. Prominent British economist (Lord) Adair Turner (whom I am something of a fan of) suggested that this could be a long term policy in a recent book.

In Britain there is an accounting wrinkle which is having an important impact. The Bank buys government bonds, but it holds them rather than cancelling them, so that it can sell them should it want to tighten policy. So the government still pays interest on the gilts the Bank holds, and this used to count towards the publicly declared deficit. But the Coalition government changed the rules, so that it does not count the interest on the Bank’s holdings against the deficit. That reduces the fiscal deficit and allows the government to spend money on other things instead. Also the effects of QE on longer term gilt yields reduces the deficit projected by the Office for Budget Responsibility (OBR), which plays such a pivotal role in longer term government spending plans. According to the FT’s Chris Giles £22.4bn of the £27bn that the Chancellor, George Osborne, “found” to allow him to loosen austerity measures in the Autumn Statement resulted from these accounting tricks. This boils down to People’s QE, and Mr Osborne used it to fund his U-turn on tax credit cuts, amongst other things.

The problem, as Mr Giles points out, is what happens when the Bank feels the need to tighten policy in, say, a year or two’s time? Then the whole thing goes into reverse. Politicians have seen gain in blurring the distinction between fiscal and monetary policy. That could return to haunt them, at both ends of the political spectrum.

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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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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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Reinventing liberal economics

CooperIn a recent post I expressed frustration that conventional economics seems to have survived the meltdown of 2008 almost unscathed, as evidenced the chatter around the discussion of monetary policy. I mentioned one book, George Cooper’s Money, Blood and Revolution, that sought challenge it. On the strength of that the publisher sent me a review copy – and I have read it. It is interesting because the paradigm shift Mr Cooper advocates gives coherence to the idea of liberal economics, after its original conception turned out to mean libertarian economics.

Mr Cooper’s main thesis is that economics is a science that is in crisis (as opposed to the alternative view that it should not be considered scientific at all). He compares it to four specific cases of sciences in crisis: astronomy before Copernicus, anatomy before William Harvey established the principles of blood circulation, biology before Darwin/Wallace’s idea of evolution by natural selection; and geology before the acceptance of continental drift. Nearly a third of the book is devoted to developing this idea, before he gets to the discipline of economics itself.

The geology example is close to my heart. My father is a geologist, and I studied it at my first stint at university, at Cambridge in 1976-78 (I studied History in my final year – another story). My father had accepted the idea of continental drift – the notion that the continents are moving across the surface of the earth – by the 1960s, before the scientific establishment completely accepted it. By 1976 the idea of plate tectonics was conventional wisdom, and continental drift was treated as an obvious fact. What had made the difference (actually not mentioned by Mr Cooper) is that mapping of the ocean floor showed that the oceans were spreading, neatly illustrated by stripes of different magnetic polarity, following reversals in the earth’s magnetic field when the ocean crust was formed. It was new, killer evidence.  Mr Cooper rather suggests that it was looking at existing evidence in a new way that led to the revolution. But that is a minor quibble – there was growing opinion behind the continental drift idea before the oceanographic evidence emerged.

The book is not a heavy read. It is less than 200 pages and it goes at quite a clip. It is well written, apart from a couple of quibbles. He uses the word “experimental” in place of “empirical” for real-world evidence. Perhaps his publisher advised him it was more accessible, but in my book experimental means carrying out experiments. There is a branch of experimental economics, but it is tiny. Empirical evidence in economics is gleaned from examining the shape of the real world, only rarely with controlled studies – a bit like astronomy, geology and evolutionary biology, in fact. His use of “principle” when he means “principal” looks accidental but I counted two instances.

This lightness of touch has advantages and disadvantages. It will help him with general readers; it will leave professionals picking holes. His focus is on the former since he judges that the demand for a paradigm shift is likely to be strongest from those outside the discipline. But we still need people in the discipline to flesh out the new ideas.

Moving on from the idea of scientific revolutions, Mr Cooper then explores the state of current economics, describing all the main schools of thought, each with ideas incompatible with others. I found this section illuminating and enjoyable. He could perhaps have brought out more the capacity for professional economists to engage in double-think – for the same people to hold incompatible ideas in their own heads, never mind the presence of warring factions who look on the same facts in different ways.

But Mr Cooper rightly says that it is not enough to prove the existing ideas wrong; you have to replace them with new ideas that work better. He outlines a new system of thought, based on two new concepts: competition and circulation of wealth.

Economists have much to say about competition, but it turns out that what they mean by the word is an artificial, anaemic version of the concept, operating within tightly constrained rules, where the object is to maximise individual welfare. The real human competition that drives human behaviour is about survival and status; it is about getting ahead of the other guy and staying there. Crucially it is about relative position and not absolute wealth. If competitive behaviour dominates, then human society will tend to stratify into a feudal system with a hereditary elite maintaining its dominance by force. Since such feudal societies are very common, including in newly developed social systems like that of North Korea, it is clear that such competition often dominant. It undermines the idea of libertarianism, which advocates minimal government and regulation, since these last two are required to counteract the tendency to feudalism.

Cooper’s second idea, that of circulation, stems from the observation that feudal societies are economically inefficient (look at North Korea again). Once the ruling elite have secured their status, they hold the rest of society in a static position so as not to present a threat. Economies are drained of vitality because the poor have no spending money, and the elite tend to hoard their wealth rather than spread it around. Democratic societies, on the other hand, have developed institutions, like progressive taxation, universal welfare and so on that recycle wealth from the wealthy to the rest, and competitive elections that ensure that political elites are recycled too. This creates a productive tension. Competition gives people the motivation to build successful businesses (and political careers) and innovate; governments recycle the wealth thus generated to prevent it from stifling the system.

This is a very liberal view. The right sees only a limited role for government and taxes, and does not accept that the presence of a very wealthy elite stifles the wellbeing of society. The left thinks that competition is destructive and tries to stifle it through excessive government. Liberals understand that people must be free to compete, but that government institutions are required to prevent all the power accumulating to the wealthy.

What does that mean in policy terms? Mr Cooper is particularly critical of the idea of monetarism – the management of the economy through regulating money and credit in the economy as a whole. He thinks this idea is largely to blame for the crisis, and it won’t help us out of it. The extra spending power it creates goes to the wrong people, i.e. the very wealthy. They either let the new cash fester unspent, or use it to create an asset bubble. Spending power needs to go the other end of society, which means Keynesian stimulus, focusing especially on productive investment. This sounds quite sensible. I am personally deeply sceptical of monetarism, though I don’t take the argument quite as far as Mr Cooper does.

How to take this new paradigm forward? It is starting to happen. Politicians and economists are talking a lot more about the distribution of wealth; this needs to be put back at the heart of macroeconomics – as it was two centuries ago with the ideas of Thomas Malthus. The publication of and interest generated by Thomas Piketty’s Capital in the 21st Century is big step in the right direction. This adds a lot of flesh to the high level analysis, and may provide the first evidence of magnetic stripes on the ocean floor.

But there is a problem at the heart of economics which Mr Cooper barely considers, and which has to fixed. It is the public’s insatiable desire for economic forecasts, both to gauge the general economic weather, and to answer what-if scenarios (such as global warming). So far the only practical way of delivering these is through the use of neoclassical models using the ideas of independent, rational agents, optimising behaviour and equilibrium. The whole infrastructure of these ideas has to be taught to economics students to satisfy this demand. It is no use just saying that forecasting is going to be more difficult. If the discipline is to be regarded as a science, then new methods must be developed. I suspect that economics has much to learn from weather forecasting – another system that is never allowed to achieve equilibrium. Weather forecasts require very big computers which are able to model complex interactions between many component parts. Work is needed on something similar – massive multi-agent models, using insights into real human behaviour.

Beyond that, I would like to see ideas on human behaviour, such as tendencies to cooperation and competition, developed in a much more realistic and nuanced context, harnessing the disciplines of anthropology, sociology and psychology – replacing the rather crude Darwinism that Mr Cooper advances.

That said, liberals everywhere should take Mr Cooper’s ideas seriously.

 

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The glorious irrelevance of Paul Krugman

The economic crisis that started in 2007 exposed deep flaws in conventional macroeconomics. This was wonderfully exposed by Adair Turner, as I have posted before. But many of the macroeconomics’s big beasts seem to plough on regardless. Most shameless of these is Nobel Laureate and New York Times columnist Paul Krugman. This has become apparent in the latest kerfuffle to take the world of macroeconomists: the idea of “secular stagnation”.

This can get very technical very quickly (indeed the technicality of it is something of a hiding place), and I will try to spare my readers of these technical details. The idea of secular stagnation that is the natural rate of interest in many developed economies is less than zero, and has been for some time; since about 2003 according to some, or the 1990s to others. The natural rate of interest is that which is required to balance the supply of savings with their consumption in investment projects. If this rate is negative, then actual interest rates are doomed to be above this rate, and hence not enough investment happens. And because of this, growth rates are dragged down to stagnation levels, while the surplus savings are pumped into assets, creating bubbles, or else excessive debt-fuelled consumption occurs. If you want to read more about there is this excellent article by Gavyn Davies in the FT. This is behind the FT paywall. More accessible in is the speech by Larry Summers, another big beast of old macroeconomics, that set the whole fuss off, which is on YouTube. Unfortunately this takes quite a bit of reading between the lines to understand its implications. And then there is Mr Krugman, who weighs in after the speech with this blog post. This much the most accessible article in all senses – Mr Krugman is one of the best people at explaining economics ideas there is.

Mr Krugman says that his idea encapsulates what he has being saying or feeling for years; and having read him for years, I have no reason to doubt him on that. mr Krugman’s main interest is in an  old battle: that between his own liberal-inclined system of “Neo-Keynesian” theory, and the “Neo-Classical” approach favoured by conservatives. To him the crisis and its aftermath simply proves that the Neo-Classicists were wrong. He is right there, but that’s a very old story.

The interesting point is that neo-Keynesianism failed too. It failed for two main reasons. First was that it ignored the implications of the financial system, and levels of debt, in particular. And second it stuck to a theory of money and monetary policy that had barely moved on from the days when most transactions were settled in notes and coins. This blinded them to the scale of the crisis that was building, and blinds them still to the effectiveness of different policy options. In particular they place too much faith in the usefulness of a loose monetary policy, and an obsession with the rate of inflation. Their support for loose fiscal policy is much better grounded. There is not a hint of these problems in Mr Krugman’s writing.

There is something very striking about Mr Krugman’s article. He doesn’t seem that bothered about the forces that driving the economic statistics. There is a bit of speculation that it is something to do with an aging population, but no attempt to get behind the implications of this. Instead he obsesses with good old-fashioned fiscal and monetary policy: the idea being that we need to fix short term problems, and that the more fundamental, structural issues, such as inequality, finance and the efficiency of government, can be fixed in due course later. His signature policy idea is that the rate of inflation should be raised deliberately so that negative real interest rates can rise, which will then help the economy back to growth. Mr Krugman has long advocated just such a policy for Japan and feels entirely vindicated that the Japanese Prime Minister Shinzo Abe is now following his advice.

This insouciance towards the details of what is happening to economies is quite wrong-headed, though. He is right that growth rates in the developed world are stagnating, and that this problem dates back to well before the crisis of 2007. But we need to have a better idea of why. If it is for fundamental reasons, such as demographics and the changed nature of technological innovation, what is the point trying to take the economy to a place that it cannot go sustainably? And surely policy solutions must be sensitive to the complexities of an evolving economy? If labour markets work in a very different way, thanks to technological change and globalisation, then the old assumptions about inflation could be wrong. We are in danger of misreading the implications of a low inflation rate, and policies designed to increase its level could have malign effects. In Japan, employers are refusing to raise wages in the face of increased inflation expectations, so Mr Abe’s policy is starting to unravel.

Mr Krugman comes through as gloriously irrelevant to modern policymakers. Right some of the time, wrong on other occasions, and with nothing to say on many crucial questions, his ideas are so disconnected from the realities of the modern economy that they have become quite useless. Macroeconomics needs to learn and move on. The likes of Mr Krugman and Mr Summers should either embrace new ideas or bow out.

 

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The Twitter launch tells you all you need to know about financial markets

Yesterday Twitter launched itself onto the financial markets by offering a small proportion of its share for sale. The company sold them for $26 each. By the close of the day they were being sold for $44; during the day they had been even higher. Last week The Economist carried out a sober assessment of what they thought the shares were worth. They thought that investors should not pay more than $18. So what is going on?

No new information was revealed last week that might raise the share valuations. Instead we get a lot candyfloss arguments about why investors should buy the shares: arguments that taste sweet but disappear as soon as you try to digest them. There is talk of growth potential and strategic value – but studious avoidance of how much these are already built into the price. For those of us brought up to believe that share values reflect the discounted value of future cash flows this sobering. But serious money is behind the price movements. Who is buying at these stupid prices?

The answer is that people are buying because they think they will increase in value in the short term, and that they can sell out at a profit before any trouble starts. They are not watching long term value; they are watching the other guy. This logic may make some sense for an individual investor (or perhaps more correctly “trader”), but collectively it is madness. It simply leads to asset price bubbles. And there is a lot of it about.

This leads to a massive source of instability at the heart of the world’s financial system. But what to do about it? The first thing to say is that the world’s central bankers should stop treating asset price bubbles as a minor aberration of the system whose damaging effects can be contained. They are the big deal: a more important source of instability than the consumer price inflation that they still tend to focus on. Such policies as quantitative easing should be assessed in that light.

You can’t and shouldn’t stop people speculating on financial assets with their own money. Ultimately this leads to more realistic prices. What fuels bubbles is when people speculate with other people’s money: “leverage” in the jargon. Banks and financial institutions should lend money for proper investment projects, and a modest amount for purchases of existing property for people to live in or use productively. They should not be lending to speculators. Since 2008 people are more aware of the dangers. Alas we have a long, long way to go.

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Monetary policy is a useless collective noun

At the time of the financial crisis of 2007 and 2008 it was commonplace to say that modern economics, especailly the macroeconomic variety, was in crisis, and needed a fundamental rethink. Alas, the vested interests of established economists have prevailed. Very little rethinking has occured, and this mainly tweaking rather than anything big. This is most striking in the area of monetary policy. The debates now going on in Japan and Britain remind me of the academic papers and discussions that I read about while an economics undergraduate at UCL in 2005-08. Circumstances have changed (in Britain anyway) but not the economics.

Economists of complain that amateurs are guilty of the fallacy of composition: to assume that was is true for a household, say, is also true of all households grouped together in a single economy. It may sensible for a single household to save more of its income to repay debt: but if a whole economy tries this at once, it could be disastrous. But economists are guilty of their own fallacy, though one for which I have not found a commonly used name. I will call it the fallacy of collective nouns. It is idea that by collecting together a group of disparate elements and giving them a name, that you have created a new entity that allows you to ignore its component parts. Most macroeconomic concepts are such collective concepts: GDP, inflation, and so on. Such collectives are useful only up to a point, and then you have you have to look at their component elements. And yet most macroeconomists, even very intelligent and distinguished ones, can’t bear to let go of their collective concepts and carry on using them long after their usefulness has ceased.

This is clearly the case with the idea called “monetary policy”. The conventional idea is that an economy has something called a “money supply”, which can be manipulated through policy instruments under the control of a central bank. In turn this money supply affects the behaviour of the people that form the economy with fairly predictable effects on things like consumer prices,wages, investment and output. All of this is very questionable in a modern economy. It is much more helpful to think of the particular components of “monetary policy”: central bank interest rates, state purchases of its own and other bonds, bank regulation, and so forth, and how these affect the various parts of the economy acting through the financial markets.

The conventional economic thinking runs something like this: the economy (Britain and Japan in particular) is stagnating with relatively low levels of inflation, but high or rapidly rising levels of government debt. In order to pay back this government debt you need to break out of the stagnation and grow, or (whisper it) let inflation make the debt more affordable. To do this you need to “loosen” monetary policy and increase the supply of money. With more money in their pockets, people go out and spend more, leading either to growth or inflation. To do this the central bank lowers interest rates, and where this does not work, use other measures like Quantitative Easing. Cue lots of debate about the relevance of inflation targeting and its alternatives (nominal GDP targets for example), all well within the comfort zones of economists.

There are very many problems associated with this line of reasoning. It is far from clear what money is. However it is clear that commercial bank accounts form the most important part of it, and this is a function of commercial bank policies, not those of a central bank, whose influence is increasingly marginal. It isn’t clear that large bank balances lead to increased spending, least of all on constructive economic things like consumption or proper investment (as opposed to chasing up the value of assets in fixed supply). Rising prices do not necessarily make debt more affordable: that requires rising income for the people holding the debt. And it goes on.

All the verbiage around “monetary policy” is clouding the issue. There are two problems being faced the British and Japanese economies: weak output and excessive debt. Weak output in turn has two components: using spare capacity (i.e. that created simply because of slow demand) and strucural problems. In Britain there is a big argument about how much of the problem is spare capacity and how much is structural. If it is largely spare capacity then simple macroeconomic solutions may have merit: you just need to boost confidence a bit to lift demand. But even here it is not self evident that any of the loose money policies will be much help. In Japan there seems to be even less spare capacity.

I can’t help thinking that what policy makers really mean by “loose monetary policy” is higher wages. Increasing consumer spending power through increasing wages will lift confidence, and even if it is not based on increased productivity, it will make debts easier to pay off, including public debt through higher tax revenues. This lurks behind a lot of the talk about greater tolerance for inflation. But in Britain we have the wrong sort of inflation: rising import costs through a lower pound, and increased government charges. This really isn’t helping. If policymakers want higher pay it would be better to throw away the weasel talk about loose money, and talk about pay. There is some evidence for that in Japan, but this only serves to show how difficult the policy is in practice.

The Japanese government also deserves some credit for the fact that it is not advocating looser monetary policy by itself, though you wouldn’t guess that from much of the coverage here. It is one of three prongs, the other two being fiscal stimulus and structural reform. There is plenty of scope for structural reform in Japan, and this gives their economic policy some hope for ultimate success if they follow it through. But it is the prospect of quick and easy solutions through fiscal and monetary policy that is exciting people.

In Britain a chronic trade deficit shows major structural problems, no doubt partly as a result of reduced North Sea oil. This requires the economy to be producing different things, not just more all round. Loose talk using economic collective nouns is making this harder to see and address.

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