Tag Archives: Paul Krugman

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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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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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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Inequality should be at the heart of the economic debate

Today the eminent US economist Larry Summers writes in the FT. His subject is the US economy, but the problem he addresses affects most developed economies in some shape or form, and the British economy quite closely. Unfortunately, so many economists of his generation, an obsession with short-term macroeconomic theory means that he doesn’t seem to get the big picture. Inequality lies at the heart of our economic malaise.

This debate is being conducted by academic economists in their own language, but it matters to all of us. I will summarise. Mr Summers’s starting proposition is that the US economy is suffering from “secular stagnation”. What this means is that the economy is stuck in a pattern of slow growth that does not fulfil the potential that population growth and advances in productivity should give it. This certainly seems to be true, though I think that the ability of developed economies to grow consistently at 2% per annum, the “trend rate”, must be subjected to critical analysis, rather than simply assuming it can be continued indefinitely because it has been achieved in the second half of the 2oth Century.

Mr Summers then says that there are three basic ways of trying to tackle this. First is “supply side” reforms; this means trying to fix fundamental bottlenecks in the economy, such as education. Worthy though he says these ideas are, the problem with this is that it does not fix a lack of demand in the economy; there is no point in producing more if nobody buys. This line of reasoning is very much behind the Keynesian critique of austerity economics. While there is a certain logic to it, it sounds too much like saying these problems are too much effort to fix, so let’s try something else – which is a road to nowhere. It used to be that economists blamed politicians for being too short-termist; now it is the other way around.

The second strategy is to loosen monetary policy. The problem is that monetary policy in the US (and the UK) is technically very loose as it is. I say technically, because in some respects monetary policy is quite tight in fact (because banks are reducing their balance sheets) – though there is little the authorities can do about it. Further loosening of policy (as advocated by the likes of Paul Krugman, for example) will simply inflate bubbles and get us back to the fix we found ourselves in 2007. He is surely right here – though I would add that I think that monetary policy is massively over-rated as a policy instrument by conventional economists anyway.

The third strategy is to use government spending to keep up demand, preferably by spending on infrastructure, that will be of long term benefit to the economy. He also says that governments should try to persuade the private sector to spend more, by which he mainly seems to mean the corporate sector to invest more.

The problem I have with this is its superficiality. The “secular stagnation” problem Mr Summers describes is a serious malfunction of the economic machine. This can be seen most clearly if you follow Mr Krugman’s logic. He says that the way out is to reduce interest rates to the point at which investment gets stimulated. And since interest rates are currently low, that means that we should have an effectively negative rate by stoking up inflation a bit. In other words, he is saying that the problem is that profitable investment is impossible, so we need to encourage investment that is marginally unprofitable. How on earth can an economy grow on that formula?

Surely we need to spend a bit more time getting to the bottom of exactly why are in this fix, and then trying to direct public policy to fixing it. Here I follow another prominent US economist: Joseph Stiglitz (or I think I do). The culprit for lack of demand in the economy is quite clear: it is lack of investment, especially from the private sector. You can make up for this shortage of investment by running government deficits, but you are in trouble if this is more than a temporary measure. The problem is that there is systemic reason for the shortage of private sector investment, which running government deficits does nothing to fix. It is rising inequality. Big surpluses are accumulating in some parts of the economy: in the personal wealth of the very rich, and on company balance sheets. This is not being spent on investment, but being held in cash to spend later, or chasing a merry go round of assets, real estate and shares, whose overall quantity is not expanding.

There are two problems here: inequality and the fact that savings are not translated into proper investments. The first of theses is the more fundamental. The Economist published an interesting article on the subject, reviewing the work of a French economist, Thomas Piketty. They point out that the inequality problem has been with us before: in the period up to 1914, giving rise to the critique of Karl Marx, amongst others. Mr Piketty thinks that developed economies are reverting to the 19th century type. The problem is slowing population growth, combined with technology that makes it easy to substitute people with machines. If he is right, the problem is not about to go away. It is the central political question of our time.

So what are the answers? First of all we need to tax the rich harder. Given that so much wealth ends up in slippery multinational networks, this means international cooperation. It also means rebalancing industry and jobs so that we are less over-supplied with unskilled workers. The pressure on the finance industry, especially investment banking, needs to be maintained. All this means reversing the conventional wisdom of the Ronald Reagan and Margaret Thatcher years – but not a recreation of the failed policies that preceded them.

This is an agenda of the left. It will be vigorously opposed by the right. Perhaps at long last the consensus that has ruled developed world politics will break up. But economists like Mr Summers do us no favours by concentrating on palliatives rather than solutions.

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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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Can we learn from the 1930s?

Liberal Democrat conference goers are shaping up to a confrontation in three weeks’ time over economic policy. On the one hand the leadership wants to defend the current coalition government’s record; on the other many activists feel that this policy has been a dismal failure. This confrontation has been brewing for some years. It reflects a wider controversy in the country at large, though one senses that most people are now moving on. In this argument it does not usually take long before the government’s critics refer to the experience of the 1930s recession, or Depression, to back up their case. It’s worth unpicking that a bit.

My main source on this is a pamphlet produced by the think tank Centre Forum: Delivering growth while reducing deficits: lessons from the 1930s by Nicholas Crafts published in 2011. This concentrates on the experience of the UK. The first thing to point out is that the UK experience of the Depression is very different from the US one, though they are often conflated when people refer to the Depression now (just as the current experiences of the UK and US get conflated, especially noticeable when critics of UK policy quote U.S economist Paul Krugman in their support). The U.S. suffered a banking collapse, which then caused a catastrophic collapse in the rest of the economy, with real GDP falling by as much as 36% (hitting bottom in 1931); it only got back to its 1929 level in 1940. Behind the US collapse was a structural transfer of economic activity from agriculture to manufacturing, which it took the war economy to complete. Britain’s crisis was much less severe; it suffered a major loss of exports and economic shrinkage, but no banking collapse. The economy hit bottom also in 1931,  just over 7% down from 1929 and was back to 1929 levels in 1933; by 1940 it was over 20% ahead. By comparison with the U.S. the structural move from agriculture to manufacturing was much more advanced when the recession struck. Britain was, however, struggling to adjust to a world where it could not rely on its Empire to drive its economy.

In fact, after flatlining in 1930 and losing over 5% in 1931, the UK made rather a successful recovery from the recession, as Mr Crafts (a professor of economic history at Warwick University) points out. This was achieved in spite the government cutting expenditure and raising taxes – austerity policies in today’s talk. Mr Crafts is very clear as to why: loose monetary policy. Specifically interest rates where kept low, and the authorities persuaded people that inflation would be persistent (at about 4%), giving negative real interest rates, while the pound was allowed to devalue. Something similar happened in the U.S in the New Deal era. Mr Crafts suggests that this formula should be repeated now, if the Bank of England could credibly suggest that inflation would increase to about 4% for the medium term, instead of its 2% target. This is quite topical, as this is almost exactly the strategy of the current Japanese government, the so-called “Abenomics”.

One point of interest in this is the rival claims of “Keynesians”, who advocate fiscal stimulus (extra government expenditure) and monetarists, who advocate loose monetary policy – though quite a few, like Mr Krugman, advocate both. Both groups refer back the Depression for support. In fact fiscal stimulus was not much used in the 1930s, while loose monetary policy was. Fiscal stimulus only came into its own at the end of the 1930s and in the 1940s, when it was led by rearmament and provoked by fears and then the reality of war.

I must admit that I find the parallels with the 1930s, especially in Britain, to be entirely unconvincing. The one clear lesson I would draw is that a banking collapse, as happened in the US in 1929, can be catastrophic. The world’s authorities were absolutely right to head this off in 2008-2009, even if that leaves awkward questions over how we got into the mess in the first place. That lesson was well learned, but there the lessons pretty much end. Further lesson-drawing leans on a species of macroeconomic blindness, a sort inverse of the composition fallacies that macroeconomists like to accuse their critics of. This entails taking false confidence by examining a collection of aggregated statistics, dipping down only selectively into the realities that lie behind them.

Consider some important differences between the world of the 1930s to the 2010s, for Britain in particular:

  1. Britain’s banking sector was in much better shape in the 1930s. It was less dominated by big institutions (there was a thriving building society movement) and these institutions had not overreached in the way they had in 2008. The main barrier to borrowing was lack of demand for loans, which lower real interest rates incentivised.
  2. There were many fewer barriers to house building in the 1930s. The main source of investment in the 1930s recovery was private sector house building. It clearly helped then that there was a severe house shortage, and inflation encouraged people to bring forward building projects. There is a housing shortage now, of course, and to be fair Mr Crafts says that barriers to house building would have to be tackled. But more than planning barriers are involved here. There is the general zeitgeist around the future direction of property prices; this is largely founded on the idea of restricted supply. Currently developers are holding back on many projects not because of finance, or lack planning permission, but because of doubts over the future direction of property prices.
  3. Nowadays we live in a world of highly integrated financial markets and global trade. This has changed the way fiscal and monetary policy work. It is by no means certain (and in my view highly unlikely) that loose monetary policy would work itself out in such a benign way as in the 1930s. Would inflation in fact increase? If it did would wages stay ahead of prices? And if wages did not stay ahead of prices would companies invest their profits so as to boost domestic demand? (There is a fascinating aside in Mr Crafts’s pamphlet here. In the 1930s the Treasury assumed that prices would indeed run ahead of wages, boosting corporate profits, which would boost the economy. In fact wages kept pace with prices and the domestic demand was behind the growth).  And bumping up inflation would quite likely cause the price of government gilts to plummet, making it harder to finance the national debt: in this day and age it is not as easy to inflate your way out of debt as many economists assume.

And that’s just the start. The more you investigate and think about the rights or wrongs of different policies, the less relevant the 1930s looks. It is just as bad for fiscal policy. In the 1930s and 1940s rearmament was a useful outlet. It soaked up surplus labour quickly and led to the building of industrial capacity that, as it turned out, could be readily reassigned to more constructive and benign uses. And the threat of war was horribly real, allowing the public to be mobilised behind the dislocation of the civilian economy. I cannot see what the modern equivalent is. Rearmament now, even if you can find a wider justification, would require the wrong skills and capabilities. The building of social housing is a possibility, I think, but would be insufficient in its own right.

Indeed I think the real issue of substance that divides critics of the coalition from its supporters, among Liberal Democrats anyway, is whether there is a pool of £20 billion or so of capital projects that the government can immediately and profitably get in motion. In the 1930s and 1940s it was weapons. In the 2010s it is what?

 

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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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How is Labour’s economic stimulus meant to work?

ON Monday at lunchtime Labour’s leader Ed Miliband was subjected to a fierce interview by Martha Kearney on the BBC Radio 4’s World at One. The main subject of contention was Labour’s economic policy, and in particular whether the party’s plan for a temporary cut in Value Added Tax would increase government borrowing. Mr Miliband did not want to say this, only that, because it would stimulate growth, it would help bring down government debt in the medium term. This was not an assured performance by Mr Miliband, but beyond that it seemed to me, perhaps unfairly, that he only had a superficial grasp of the economics involved. If so, he shares this superficial understanding with many members of his party, who lap up quotes from economic commentators such as Paul Krugman, and marry it to half-digested economic theory. So how is it meant to work? How can a temporary tax cut reduce government debt?

Let’s start with the Keynesian multiplier, which is widely taught in basic economics, and which I suspect comes to mind to most people here. You really have to do a bit of maths to understand the implications. Suppose you have an economy with a national income of £100bn a year, and an average tax take of 40%. You decide on a 1% stimulus with a temporary tax cut of £1bn. As people receive the extra money, 40% of it goes in tax, and they spend, say 80% of the rest on domestic goods and services (it doesn’t work if people use it to pay off debt or spend it on a foreign made car…). This adds £480m to the economy with extra expenditure straightaway. And this process continues in a virtual but diminishing circle, as that £480m is taxed, spent and so on.  If everything turns out to be mathematically consistent the stimulus adds over £900m to the economy. You have nearly 1% growth! This has cost the taxpayer (added to national debt) of £1bn in the first instance, but a lot of this has come back in extra taxes from the growth.

This is what people half remember when economic experts like Mr Krugman say that stimulus can reduce debt. But there are two problems. First of all, although on my fairly realistic assumptions most of the cost is clawed back, about a quarter of it isn’t. Keynesian stimulus cannot pay for itself at this simple, basic level unless people increase their spending by more than the stimulus itself. And secondly, it is a one-time event, so that you get 1% growth for one year, and then it stops, unless you repeat the giveaway. This tax cut is temporary. When you put taxes back up again, the whole process goes into reverse and the economy shrinks back to where it started. Something very like this happened to the last Labour government’s temporary cut in VAT: a small bounce that was undone when the cut had to be reversed, which, of course, they then blamed on the Coalition.

All this is well known to the Paul Krugmans of this world though, otherwise they wouldn’t be writing economics textbooks and winning Nobel laureates. When they advocate stimulus they are actually talking about something else: the effect of such a stimulus on the national zeitgeist. That 1% lift may make people and businesses happier. Businesses go out and invest more money; people save less, perhaps thinking that their share and property values will go up, and consume more. If this happens then all bets are off; the economy grows further, the government gets more taxes and the stimulus can pay for itself quite quickly and easily. Investment is particularly important; Maynard Keynes’s critical insight was that recessions happen when investments don’t match the amounts people save.

What to say about this? There are two potential snags and an irony. The first snag is that  the zeitgeist is a hard thing to manage. The whole thing can be undone by another crisis from the Eurozone, for example, which might reduce prospects for exports and dent confidence generally; or there could be some other crisis. The second snag is that this model of short-term growth assumes that there is spare capacity in the economy. When people and businesses go out and spend, domestic companies can readily ramp up production, employ new people and so forth. This is usually the case in a recession. But not always. In the 1970s, after the price of oil skyrocketed, the economy had to be restructured in order to grow – which was particularly hard because of the trade unions. Attempts to stimulate the economy simply led to high inflation while doing nothing for unemployment. Today, more flexible and globalised markets seem to have reduced the inflation threat – but stimulus can still be dissipated on imports and asset prices. What of the British economy now? Many commentators think that the British economy should be “rebalanced”, reducing its dependence on financial services and North Sea oil, as well as excessive private consumption fuelled by debt and property prices.

These potential snags to stimulus are why many critics of the government, such as the FT’s Martin Wolf, and many Liberal Democrats, such as the Social Liberal Forum, say that any stimulus should take the form of added public expenditure on investment, in infrastructure and homes. Since these have an inherent value, and help expand the economy’s capacity, there should be much less risk. This is a sensible idea in theory that is a lot less easy in practice. The public sector has a tendency to invest in wasteful projects for political rather than economic reasons.

This is where Labour’s plans are quite distinctive. They talk about temporary tax cuts, and hint at increased current expenditure. This is founded on a belief that there was not much of a problem with the pre-crisis economy, or unsustainable about the growth rates achieved in the years leading up to it. The crisis was simply a problem with the global financial system, and the country’s poor performance since is down to incompetent economic management from the Coalition. This is pretty much what Tony Blair said in his recent piece for the New Statesman. If you believe this then capacity is not at issue, and the zietgeist should be readily easy to fix.

And the irony? Left wing economic commentators like to laugh at the “Voodoo economics” of Laffer curves and self-funding tax cuts advocated by far-right commentators. Paul Krugman talks about their belief in the “confidence fairy”. But the left’s economic beliefs are no less dependent on their own confidence fairy.

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Abenomics: why it doesn’t look good for Japan’s economic experiment

A few years ago, as the Greek crisis unfolded, an Economist blogger suggested that its austerity programme would be an interesting experiment. Did the then fashionable idea of austerity growth have any validity? The answer to that experiment seems to be a clear no, though now doubt there are get out clauses. Now a very different economic experiment is taking place in Japan, after the election of Shinzo Abe and the Liberal Democrat Party last December. It is popularly referred to as “Abenomics”.

Abenomics, described by the Economist here,  has three elements: increased infrastructure expenditure, looser monetary policy (through focus on a higher inflation target), and “supply-side” structural reform. This coordinated nature of the policy is one of its most important aspects. Here in Europe we are used to fiscal policy pulling one way, while monetary policy and structural reform pulls in the other. All this has “Keynesian” economists like Paul Krugman in raptures (I used the inverted commas because no self-respecting economist accepts that label, it’s just common sense after all, though their political supporters love it). Japan has been stuck in the economic doldrums for two decades, and these economists feel that at long last the country might be digging its way out. Better still, success in Japan will show that these policies can be applied in other developed economies. But this analysis is deeply flawed – a case of macroeconomic blindness, a sort of failure to see the trees for the wood.

Look again at Japan. Its unemployment rate is currently a shade over 4%, having fallen from a peak of 5.5% in 2009. Compare that to the UK’s rate, which has hovered around the 8% mark since 2009, compared to about 5% before the crisis. This does not suggest a huge amount of slack in Japan, even allowing for distortions in the way it measures its unemployment. Growth will have to come about either through productivity growth or new people entering the workforce (e.g. through immigration). There is plenty of scope for both. Japan may have some of the world’s most efficient companies, but these dominate its export economy only; there is a lot of inefficiency in domestic markets. Japan has long eschewed immigration as placing an unacceptable strain on its social infrastructure. All this depends on the third prong of Abenomics, structural reform. And yet the government already seems to be going slow on this, afraid that the public will disapprove, with bad consequences for upper house elections due later this year.

In fact what Abenomics really seems to be about is to make government debt more affordable through setting off inflation (specifically of incomes, and hence tax revenues). Japan’s inflation has been very low, and negative for much of the stagnant period. Even this may not work – economists understand little about how inflation actually comes about, assuming that it is some kind of endogenous variable in that depends on such things as aggregate demand and money supply. Instead the policy may simply lead to state bankruptcy – though that is no doubt a long way off.

What are the implications for the rest of us? The justification for “Keynesian” policies in most developed economies, including th UK, remains intact because our high unemployment shows that there is quite a bit of slack, though we don’t actually know how much (the 1970s stagflation crisis arose because economists too readily assumed that unemployment meant economic slack). But they are not the answer to raising long term growth rates. And Japan’s agonies with inflation and government debt may well foreshadow future dilemmas our own governments will face.

What arrogant economic commentators, like Professor Krugman, need to accept is that economies are the sum of freely made choices of individual citizens, excercised through both markets and the ballot box, as they try to shape the world they live in. They are not the creation of governments and policy makers playing with their economic toolkits to win prize for the biggest d**k growth rate. Japan’s stagnation is the result of choices that Japanese people are making about the sort of place they want to live in, one which consideres wider factors than monetary income. Get over it.

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