The UK GDP figures change nothing

Today the Office for National Statistics delivered its first estimate for the UK's GDP in the second quarter.  With a fall of 0.7% they were a bit shocking - we have had a number of quarters with it being cose to no change, and this looks like a proper lurch downwards.  This has provoked some predictable "told-you-sos" by the government's critics, who say that it shows that the Coalition government's policies are failing, and call for less austerity.  But what do the figures actually mean?

Making sense of it all is not easy.  The first point is that GDP is not of huge importance in its own right - only as a proxy for the population's overall wellbeing.  But in a dveleoped economy this latter is more closely tied to employment - and here that statistics  seem to be slowly moving in the opposite direction.  This has created a headache for economists, since this behaviour isn't in the script.  Some even say that the GDP figures may be in error.  But they have been saying this for some time now, and revised estimates have not made the figures any better.  We need more evidence from the real world to see if anything very harmful is going on.  If, for example, the decline in GDP is a result of a shrinkage of investment banking, where they is lots of money and few jobs, we needn't lose any sleep.  Or if it results form people taking time off, e.g. for the Jubilee holiday, then again it is no real cause for concern - provided people enjoy their time off.  The truth is that we don't have a clear understanding of what is happening, and whether it is in fact particulalry bad.

Well, not quite.  We rely on money income, measured by GDP, to generate taxes to fund the services and benefits supplied by the state.  And to pay off the debts left by past governments.  Given that taxes still fall well short of what they are supposed to pay for, this is a worry.  For now things are OK.  The financial markets aren't taking fright (even as they are in Spain, whose finances are not in such bad shape).  If they do then we can expect all sorts of nasty consequences as interest rates rise, and possibly inflation too.

But what of the argument that austerity is slowly strangling the economy, and we need to ease off?  This is a topic that I have blogged about many times before.  The austerity sceptics are those who basicly think that a sustainable economy is within our grasp, and it just needs a bit of confidence and an upward demand cycle to reach it.  I remain sceptical.  Slowing austerity may simply be postponing a necessary adjustment - and runs greater risks with those financial markets.  These figures do not provide additional evidence either way on this debate.

The problem for the government is that GDP - and tax income - is falling behind their projections, which makes it look like a failure.  But this is more a criticism of the art of economic forecasting than it is of government policy.  But economic forecasting has long been known to be inaccurate, and it always will be.  Many people, on both sides of the austerity argument, are not surprised that the recovery is so slow.  And the forecasts weren't even politically motivated - since the government transferred responsibility to an independent body - the Office for Budget Responsiiblity.

Still, the case for using the government's weight to progress worthwhile investments in house building, transport infrastructure and education remains strong, and no doubt their advocates will use this data to pressure the Treasury to loosen up.  But these investments must be for items that will be of genuine benefit - the right sort of homes in the right places, for example - and not just expenditure for its own sake.  And that makes the process slow.

So, in short, these GDP figures are nothing to get excited about.

Why Paul Krugman is wrong

In today's FT the economists Paul Krugman and Richard Layard (of the LSE, famous for his work on the economics of happiness) publish an article A manifesto for economic sense calling for looser fiscal policy around the world.  Being in the FT it's behind a paywall (though I have shared the article on Facebook).  But the simplicity and clarity of their argument make it a particularly good pace to discuss the difficult issues of economic policy as the economic crisis rumbles on.

Back in 2005 I was contemplating taking an Economics degree, with little formal background in the subject.  I asked a tutor at the university (UCL) on their advice for background reading and he said "Anything by Paul Krugman".  The Professor at Princeton, who subsequently won the Nobel Prize, was famous for the clarity of his writing on economics.  I also discovered, as I devoured anything by him I could find, that he was not a shrinking violet on the subject of US politics - passionately attacking the Republican regime of George Bush.  Now he is a crusader against "austerity" - the focus of governments on healthy finances even as recession stalks the world.  He recently visited London, and appeared on Newsnight.  I didn't see him, but I am told he made mincemeat of his opponents - and I'm not surprised.

As I took my degree at UCL I read more of Professor Krugman's work, now in academic papers and discussions, rather than the more accessible stuff I read read before.  The clarity remained - but he came over as a bit wild.  I remember in particular one discussion where he became obsessed with the idea that Japan needed to stoke up inflation to get its economy out of the doldrums.  His wild suggestions for doing so seemed to leave his fellow economists quite exasperated.  Ever since I have viewed his opinions as entertaining, but liable to be impractical, and in the end very unhelpful.  So it is this time.

The article (not very long) starts its main line of argument by talking about the causes of the crisis:

The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – such as Greece – this is false. Instead, the conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.

I think it is highly significant that the authors throw this in so early.  It implies, without actually saying so, that pre-crisis government expenditure in most developed economies was perfectly sustainable, if that pesky crisis hadn't caused a dip in tax revenues.  It is perfectly true that government debt was not a major problem before the crisis, which was caused by excessive private sector debt.  The trouble is that the boom years gave us false expectations as to what the sustainable levels of tax revenues were.  A large part of the dip is permanent, not temporary.  So substantial cuts will have to be made at some point to bring government debt under control.  It isn't just a question of waiting for the economy to bounce back (in the UK, US and southern Europe, anyway).

The authors then point out that the crisis is caused by a collapse in private demand - and that it makes sense to make up the shortfall in demand by extra government expenditure until private sector confidence returns.  A failure to act means that unemployment becomes endemic and difficult to put right later.  They point out that monetary policy cannot take up the strain.  They say that there must be a medium term plan to bring government deficits under control - but that it must not be front-loaded.  I have no disagreement with any of this.  Quite a few people think that looser monetary policy would help - but I agree with the authors on this (which I will say more on in a future post).

Where I differ is that I think what they suggest is exactly what governments are now doing, in the UK and US anyway.  In nominal terms government expenditure has not been cut.  The private sector is slowly taking up the slack.  Governments may be talking austerity, to prepare the ground for the real cuts that are absolutely necessary in the medium term, but they are not practising what they preach.

The article concludes by trying to debunk two typical counterarguments to further stimulus.  First is that financial markets would lose confidence and refuse to keep funding government debt.  They point out that there is no sign of this in the UK or the US, where government bonds are at record low yields.  They also say that there is no actual evidence that budget cuts can generate growth.  On the contrary, they suggest (though don't quite spell out) that looser fiscal policy will help restore confidence and get the private sector moving again, which would allow the deficits to be brought under control.  The trouble, of course, with using past evidence to prove a point is that the current situation is unprecedented.  And the global financial markets are quite unstable; who is to say that UK and US bond markets aren't in their very own bubble that could burst very suddenly.  The absolute levels of deficit, and, increasingly, overall debt are becoming so alarming that anything is possible.  And what if the private sector remained sceptical in face of government stimulus?

Finally they tackle the argument that stimulus cannot work because there are structural constraints.  In other words, the pre crisis economy was so unbalanced that there is in fact little spare capacity - so that a stimulus would run into trouble very quickly, leading to inflation or a currency crisis.  If this were so, they say, we would see more parts of the economy at full strength.  Here there may be a difference between the UK and the US.  In the UK there are indeed a few signs of trouble.  Inflation has been much more persistent than predicted, though admittedly not through wage rises.  Export businesses complain of a lack of suitably skilled staff.

Straws in the wind perhaps.  But the pre-crisis economy clearly was unbalanced, especially in the UK.  Public service employment was clearly too high, and cannot be afforded at its current strength on any realistic level of taxation.  Also too much of the economy is spent taking care of ultra-rich bankers and foreign exiles - whose numbers and wealth we cannot or should not expect to grow.  And we still need to adapt to a lower energy economy.  I can't prove that the authors are wrong - but there is enough reason for caution.

The authors make much of not repeating the mistakes of the 1930s.  But that was a very different world for two important, and related, reasons.  First there was a ready solution at hand: the expansion of manufacturing industry with an abundance of good low skilled jobs.  It took the war to unlock this, with the manufacture of armaments and transport, but war production could be converted to civilian use with surprising ease - as there was massive untapped demand for cars, fridges and other manufactured goods.  Second we were much poorer then.  Starvation was a real problem for the unemployed and poor, and the destruction of wellbeing flowing from depression was horrific.  Now we define poverty as lack of access to television and mobile phones.  The hardship is much less - and there is less untapped demand.  Technology has put paid to the number and quality of unskilled jobs.

That bespeaks caution - something that the manifesto economic sense disregards.  There is a case for some sensible investment projects - including the right sort of housing in the UK. But temporary tax cuts would be reckless, and stopping public sector cuts irresponsible.

The Guardian’s bubble – the view from my bubble

It's nearly a cliché, but it still resonates with me.  People accuse each other of living in "bubbles" - and when they do so, the accusation usually has bight.  But the people who make the accusation are merely living in different bubbles.  We all are; and it helps us if we realise it.

A bubble is a small, self-contained world which contains its own atmosphere, protected by a nearly invisible wall, which lets those inside see the wider world outside, and maybe pretend that they are fully part of it.  And every so often the bubble hits an obstacle in the outside world, and bursts.  Suddenly those inside are subject to a catastrophic shock.

As a metaphor it describes a describes an intellectual process.  We sustain ideas by protecting them from the vicissitudes of what is going on in the real world around us, discounting facts that challenge them, seizing on ones that support them - and a similar process goes on with those that we consort with - we prefer people who support our view and avoid those who don't.  As this bubble existence continues our strength of conviction is increased by this process.  Until one day, maybe, the idea can't be sustained and it's all over.  Actually the bubble rarely bursts so dramatically in real life - though we always fancy that other people's bubbles will.

What bought on this reflection?  Reading Saturday's Guardian I reached the "Comment & Debate" section, and there were two articles on the same page which seemed to sum up what I think of as the Guardian's bubble - one that persists in believing that austerity economic policies are a fraud and a failure.  One was by Robert Skidelsky - U-turn for the better - a direct attack government policy, while welcoming the apparent softening of it in favour of more infrastructure investment.  The other was from Jonathan Freedland - Balls has the rare political right to say: I told you so - praising Ed Balls, and especially that he was amongst the first to criticise austerity.  I didn't read either article, but just harrumphed and moved on.

Still, this is a blog, not a Twitter feed, and I owe it to my readers to actually read the articles before passing comment, and I did so today.  Mr Freedland's doesn't fit my bubble pattern.  He clearly inhabits the bubble, agreeing with Mr Balls's analysis of the economy, but this only affects one non-critical sentence in the piece.  The article makes perfect sense politically, even if you don't happen to agree with the economics; it's a good article, in fact.  Mr Balls has been written off, but he's winning.

But Professor Skidelsky produces pure bubble fare.  He does report the government logic more fairly than some, merely to dismiss it with this: "This is discreditable nonsense.  But it has an air of plausibility."  Actually precisely what I think of the professor's article.  To me the give-away was this sentence: "If the [infrastructure] spending had not been cut, the deficit would now be smaller, because the economy would be larger."  This is either a suspension of the laws of arithmetic, or shows an astonishing faith in in the multiplier effect of this type of spending  - for each 1% of extra deficit spending you need to add 12% or more GDP as a whole to sustain this argument.  By substituting "debt" for "deficit" it may be somewhat more sensible (you need less than 2% growth for each 1% spend -at the most optimistic) - but it still heavily depends on the multiplier idea.  This is an area of ongoing debate amongst economists - and yet Professor Skidelsky presents it as an accepted fact.  And without it the rest of his argument starts to fall apart.

Professor Skidelsky is not a fully trained economist (though neither am I), and I think it shows in his writing; his main claim to credibility is that he wrote an authoritative biography of Maynard Keynes.  But plenty of fully fledged economists agree with him - but that does not make this argument less contentious.

Or less wrong.  From my bubble.  Because I clearly inhabit my own bubble.  One in which the Government's economic policies are making the best of a bad situation, and, separately that the Liberal Democrats will not be annihilated for a generation.  A more neutral observer would not share either conviction.

Why do we live in such bubbles?  It's just very hard to stay on the fence the whole time, or to change your mind every few days with the next piece of passing news.  The only way to do it is by not really caring.  But really it helps to have some self-awareness about this - and this is the only way to appeal to those outside your bubble.

The Guardian is a better newspaper than many.  But what is the point of giving such prominence to purely polemical articles like Robert Skidelsky's?  They need more serious comment, like that produced by Jonathan Freedland, which do not insult their readers' intelligence just to give the members of their particular bubble something to cheer at.

Translating that IMF report into English: the blindness of macroeconomists

Yesterday the IMF released one of its regular reviews ("Article IV consultations") on the UK economy.  Both government and opposition seized on it to reinforce their narratives.  But for observers trying to make sense of these claims by reading what the IMF's summary actually says (here) there is a problem: it's written in economics jargon and not English.  For example, in the passage central to the controversy passage:

Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK's large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.

What they are trying to say here is that attempting to lift the economy using a fiscal stimulus, i.e. reduced taxes and/or increased public spending, works best if growth is already low and if loose monetary policy isn't working - which will be the case if the economy does not improve soon.  But any stimulus has to be carefully designed to ensure that the government's deficit reduction plans retain credibility.  They suggest two types of policy that might achieve that: temporary tax cuts or greater infrastructure spending.  In other words, not a slower pace or reversal of public expenditure cuts.

More on this later: first it helps to get a wider perspective of what the IMF is trying to say.

Their starting point is that the UK economy is currently unsustainable because of the massive government deficit (i.e. that public spending is way ahead of taxes).  That means that the public sector is too large and has to be cut back to rebalance the economy.  This is completely consistent with the Coalition government's analysis, and it is where the Labour opposition is most uncomfortable.  Labour draws a lot of political support from public sector workers and beneficiaries of government expenditure.  They would rather not admit publicly either that the level of such expenditure before the crisis was unsustainable, or that it needs to be cut back now at anything like its current pace.  But it is difficult to dispute the numbers, so they keep mum or change the subject.

But the IMF also says that there is considerable spare capacity in the economy - in other words that the private sector could expand easily if only consumer and investment demand was stronger. This fits better with the Labour narrative.  Government supporters often suggest that the UK economy's unbalanced nature was more than just an excessive public sector, which leaves little practical spare capacity, and so it is not so easy to grow through boosting demand: the extra demand might simply go into inflation or imports, for example.  They point to the decline in manufacturing and the size of the "socially useless" investment banking sector before the crisis.

This leads to another point made by the IMF, which is that persistent low growth will cause longer term damage to the economy, as the spare private sector capacity whittles away.  And unemployed people tend to lose their skills and value the longer they are out of work.  There is a nightmare that stalks the minds of economists which they name "hysteresis" (borrowing the word from materials science) whereby people who are put out of work never get back into it, and high unemployment persists long into a recovery.  Europe in the 1980s and 1990s is held up to be a prime example of this, compared to the US in the same period.  The word makes its appearance in the summary.

But they do point out that UK unemployment is remarkably low compared to previous recessions, or what is going on in other economies, including the US.  They put put this down to "labour market performance", though others suggest that this has more to do with the fact that home construction played a much smaller part in the economic boom than elsewhere, and a lot of the vanished GDP was in sectors, like finance, which weren't big employers.

The IMF report goes on quite a bit about monetary policy, not criticising the Bank of England's performance so far, but suggesting that it could be further loosened.  This might be through even lower interest rates or through "quantitative easing" - the buying of bonds by the Bank - especially if the latter was more in private sector bonds, rather then the gilts which the Bank has so far been buying.

The continued fragility of the UK banking sector causes the IMF some worry, as does the possibility of further trouble from the Euro zone.  The former could provoke the government into more bailouts, which would put government finances under strain.  The latter would exacerbate this problem as well as making growth more difficult.  They welcome the government's attempts to reform banking to expose government finances less to risk.

So where does that leave us?  the Government can take comfort from what amounts to a strong endorsement of its policies.  But by leaving open the idea of a fiscal stimulus, especially through a temporary tax cut, it gives Labour ammunition.  Labour's shadow chancellor Ed Balls can quite reasonably suggest that things are bad enough now for such a policy, without having to wait.

But, while wading through the dense economic jargon, I am left with an overwhelming impression of the blindness of macroeconomists, hiding behind their aggregated statistics and theoretical models.  They don't look far enough behind the figures.  This is starkest in their faith in monetary policy.  The theoretical models of money have entirely broken down in the wake of the financial crisis - but economists have placed so much weight on them that mostly they still cannot admit that they are so much garbage.  The monetary authorities are left with a number of policy levers, interest rates and so on, whose effects are not properly understood. Whether looser policy will lead to any significant stimulus in demand that will lead to job creation is in fact very doubtful.

And talk of multipliers and other economic mumbo-jumbo gets in the way of trying to see if a particular form of fiscal stimulus might do more harm that good.  An example of the kind of thinking that is needed comes in an article by  US economist Raghuram Rajan in today's FT: Sensible Keynesians see no easy way out.  The problem with stimulus is that you have to balance the benefits now against the costs later.  If the stimulus addresses the problem of unemployment, especially the long term sort, then the trade off is likely to be worth it.  If it doesn't then it won't.  Would a temporary tax cut, such as in VAT, achieve this?  Personally I think the effects are likely to be marginal, and that most of the stimulus would disappear in higher prices, higher pay and increased imports.  A more cogent case can be made for infrastructure spending if the infrastructure is genuinely useful to the future economy.  That's a harder test than theoretical economists allow - it is difficult to see much benefit from Japan's massive infrastucture spending in the 1990s, for example.  And the spending may not help provide jobs where they are most needed.  In the UK there seems a good case for more house building: but by and large we do not need more houses where most of the unemployed people are living.

In last week's Bagehot column in the Economist, the writer describes how people are hoping to wake up from the austerity nightmare so that they can get back to real life before the crisis.  But the nightmare is reality and the pre-crisis existence is the dream.

The budget – the coalition at its best

George Osborne is gradually cementing a reputation as an effective Chancellor of the Exchequer and skilful politician.  He certainly understands coalition politics and how to play for the longer term.  Yesterday's was a very interesting budget.

There a two schools of thought about coalition governments.  One may be characterised as "lowest common denominator": all the bold ideas are knocked out and we are left with a few messy compromises that lack any kind of coherence.  The second is the "natural selection of ideas"  in which the ideas of the various parties have to compete on their merits and the weak ones don't survive, the sum being better than any party would produce individually.  Britain's first post-War coalition, formed by politicians unfamiliar with how coalitions work, has seen both types of policy formation at work.

The coalition started well.  The initial policy programme was full of bold ideas, while dotty ones (cutting inheritance tax for example) did not make the grade.  But things soon degenerated, as activists on both sides sensed betrayal.  This was especially evident on the NHS, where we are left with a messy compromise that is almost certainly worse than either party would have produced on its own.  But the 2012 budget shows a reversion to the "natural selection" model, for which credit must go to both George Osborne and the Lib Dem leader Nick Clegg.

One of the interesting features of the budget has been the disappearance of budget "purdah" - the absolute secrecy surrounding budget proposals.  Mr Clegg made the early running in the media game with his bid for an acceleration of increases to personal allowances.  But Mr Osborne clearly understood this to be an opportunity rather than a threat - in this case to reverse the top rate of income tax of 50%, which until a month or so ago looked to be entirely off the agenda.  A few years ago the Lib Dems had a big conference battle over this top rate (before Labour introduced it, as it happens) and rejected the 50% - so there was evidently some Lib Dem ambiguity over the tax, which Mr Osborne was able to exploit.  And indeed world thinking has long since turned against such high marginal rates, even for the very rich.

Meanwhile, weaker Lib Dem ideas about how to tax the rich more efficiently did not make the cut.  This applied to the Mansion Tax on high valued property.  Such an idea (though based on land rather than total property value) appeals to theoretical economists, but has two major practical problems.  First is that property is not the same as cash, and that owners of such valuable properties may struggle to pay, and hence create a fuss.  The wider the scope of tax, the more of a problem this is.  The second problem is that it has to be based on a theoretical valuation rather than hard and fast fact.  This is one of those things that becomes more of a problem the more that you think about it.  Property (or anything else) is worth what you persuade somebody else to pay for it, which depends on many factors unique to the individuals taking part in the transaction and the time they make it.  A host of practical issues follow.  The eventual compromise of an increase in stamp duty for properties over £2 million, combined with a clampdown on stamp duty avoidance, looks like a much better idea to me.

The idea of limiting allowances to higher income people so that effective tax is no less than 25%, the "Tycoon Tax" - attributed to Mr Clegg in the proposal process, though not coming out of any Lib Dem official policy - also looks like a very sensible proposal - and this made the cut.

Mr Osborne was also able to push through further cuts to the main Corporation Tax rate.  I have some reservations about this: companies are sitting on too much cash - if they don't invest it, then the best way of getting this wealth back into the economy is to tax it.  But there is logic to it to help retain footloose international capital, something that the country has been quite good at, but needs to stay in the game.  And it's not as generous as it looks, since allowances have been kept in check.  In fact the big thing UK companies have been asking for is more generous capital allowances - but the footloose companies aren't so bothered about this, and the Chancellor did not budge.  I'm not sure that capital allowances have been set at the most efficient level - but I do know that business leaders always ask for too much, and the game is often more about tax avoidance than real investment.

One idea was not leaked in advance.  This was the phasing out of the age-related personal allowances.  This "granny tax" has attracted most of the press attention this morning, with howls of protest that the Labour opposition are seeking to exploit.  Yet the reasoning behind this change is solid enough.  Pensioners have done pretty well under the reforms already implemented by the government, and this is a nasty, complicated piece of work.  Although it is true that many pensioners have been punished by the general reduction in the value of savings since the crisis began, this allowance is a bad way to deal with the problem.  What is actually needed is for the economy to return to health, so that we can get back to a real interest rate of about 2% or so from its current negative value.  It was brave to take on the pensioner lobbies like this, and Messrs Osborne and Clegg (to say nothing of the PM David Cameron) deserve credit.  Critics suggest it may go down as a fiasco like Gordon Brown's cut of the 10% tax band, or the negligible increase to state pensions the last government implemented when inflation appeared to be very low.  Both were politically very damaging, to Mr Brown and to Tony Blair respectively.  But this policy does not create cash losers (denying benefits to those who haven't got them yet - rather than taking them away from those that have).  It may even mark a turning point in the battle of the generations, as younger voters start to appreciate just how generous the state is to pensioners, and shift their ire away from the much less costly immigrants and benefit claimants.

The budget does nothing for macro-economists.  There is no bold, imperial stimulus to "get the economy moving".  But nobody was expecting that.  Overall this budget is a credit to the Coalition government.

Is cutting Corporation Tax good for growth?

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

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

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

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

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

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

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

Ballsed up – Labour’s economic narrative implodes

Labour's economic narrative was always a bit of a balancing act, and now it is coming apart.  It is tempting to blame the messengers (Ed Balls and Ed Miliband), but its own contradictions are the real problem.

But what is this narrative?  It is rarely reported sympathetically, so confusion is widespread.  This is how I understand it:

  1. The Labour government's careful middle way between free markets and social democratic intervention rewarded Britain with a prolonged period of economic growth, and growth too in public services.  Contrary to what political opponents and a hostile media claim, this was perfectly sustainable.  Indeed by 2007 Labour had won over most of its critics and the Tories were saying that they would do much the same.
  2. But in 2008 it collided with a global economic storm, originating in foolish economic policies elsewhere in the world, and misguided financial management, mainly in America.  Since full participation in globalisation was part of Labour's economic policy, and had delivered enormous benefits, Britain could not but be affected.  After the first shock, sensible economic policies under Gordon Brown were delivering a sustained recovery.  These policies were based on maintaining aggregate demand in the economy, in particular by sustaining government expenditure, with only a gradual, carefully measured slow down.
  3. This was all undone by the coming to power of the Coalition in 2010.  They panicked (or else were driven by a malign wish to undo Labour's good works) and cut back too far, too soon.  This has set off the classic Keynesian doom loop, where reduced government expenditure reduces private demand, causing further hardship.  There are any number of distinguished economists who point out the folly of excessive austerity (Paul Krugman being a favourite).
  4. The Coalition policy is failing, as growth has tailed off and government forecast after forecast is being missed.  This is doing long-term and lasting damage to the economy.
  5. Because of this long term damage, by the time we reach 2015 it will not be so easy to pump things back up again to where they were before.  As a result, Labour cannot promise to restore the cuts - even as we now declare they are foolish.

It is not my point today to pick holes in the economic logic of this.  Both Mr Balls and Mr Miliband are economically literate, and we have every reason to believe that they believe what they are saying.  It is not falling apart in terms of economic logic - and the likely future turn of events is not likely to undermine it.  The only thing that would be a problem for them is if the economy should start to pick up some serious speed.  Nobody believes that it will.

The problem is the politics.  Labour have been trying to achieve a tricky balancing act here.     The dismantling of so much of Labour's legacy by the Coalition has sent their supporters into a frenzy of anger.  Labour needs to harness this anger to sustain its political "ground war" - the hard graft of daily political advance, for the most part achieved by unpaid volunteers, even if the wider public seems more sceptical.  This angry brigade has not accepted that any cuts are necessary, and grasp at the writings of Krugman et al, adding a little A-level economics, to sustain the idea that all the economy needs is more government expenditure to reflate its way back all the way to 2008.  They think that the Coalition is waging economic warfare on the poor, as one commenter on this blog put it, with the naive Lib Dems being taken for a ride, along with a large part of the public.

The angry brigade hears what it wants to from the "too far, too fast" mantra and thinks that the Labour front bench is on its side.  But the Labour leaders also know that the economy has shrunk so much that many, indeed, most, of the cuts will have to be made eventually.  Labour's plans to cut the deficit before they left office weren't so very different to the current government's, and very little at all compared the surprisingly slow pace at which the deficit has actually been cut.  Their plan is actually to win back and exercise power again, rather than simply have fun as an opposition party.  They know they need to present credible policies for when they are in power again - after all, look what happened to the Lib Dems when they promised that they could cut university tuition fees to harness student anger for their own ground war.  And a close reading of what Mr Balls and Mr Miliband have been saying is not nearly as reckless as the mood music of anger.

But Labour have encountered a wider political problem.  The passion and anger of their activists burns as bright ever, but the public are simply not convinced.  Why?  It is tempting to blame economic naivety, which allows the government and its supporters to present the government's finances as if they were a household budget.  Actually I think the feeling runs deep that the economic prosperity of the late Labour years was unsustainable. There is no naivety about that standpoint.  Government debt catches the blame - but in fact it was private sector debt that was more to blame.  And for those that did not have a government job, the suspicion the state was too big and benefits too generous ran deep.  In my description of the narrative most people can't get past the first paragraph.

And so the two Eds have started to reach out to the sceptics by emphasising paragraph 5 - that the cuts will have to stay.  The hope is that this will then give them an opportunity to get a hearing for whatever else they have to say, on corporate greed, the NHS reforms and so on.  But the activists are apoplectic.  The Guardian's weekend article has attracted a whole host of disbelieving and hostile comments from a group of people that is now feeling disenfranchised.

But the narrative is too complex to be accepted by the sceptics either.  Only a confession that the economy before 2008 and unsustainable, even without a financial crisis, will do that.  Alas the two Ed's don't think they can say that.  And so politically the narrative falls apart.  I would be surprised if Ed Miliband lasts the year.  He has had some bright ideas, and has begun to take Labour out of its denial phase.  But as denial moves into anger, he will surely be a victim.

 

Time to wake up to the de-industrialisation of advanced economies

Trying to understand the global economic crisis?  This article from Joe Stiglitz is required reading.

I have flagged it already on Facebook and Twitter, but without much in the way of reflection. In fact it has produced an epiphany moment for me.  I have maligned Professor Stiglitz in a past blog as producing only superficial commentary on the crisis, alongside his fellow Nobel laureate Paul Krugman.  This was based on one or two shorter articles in the FT and some snatches on the radio; I wasn't reading or listening carefully enough.  Professor Stiglitz is one of the foremost economists on the current scene.  He used to be part of the Clinton administration, and worked at the World Bank in the 1990s, but his views proved politically unacceptable.  He also wrote the standard text book on public economics, which I used in my not so recent degree course.

The article is wonderful on many levels, but the epiphany moment for me came with his observation that, underlying the current crisis, is a long-term decline of manufacturing employment in the US, and by implication, other advanced economies too.  He draws an interesting parallel with the Great Depression, which was caused, he claims, by a comparable shift from agricultural employment - again in the US; I think that such a shift was less marked in Britain, but the depression was also less severe.  This decline in employment brought about a doom-loop of declining demand across the economy as a whole - which was only reversed by World War 2.  The war effort caused a boom in manufacturing industry which was readily redeployed into the postwar economy.  This view of the Great Depression rises above the fierce controversies over fiscal and monetary policy, and places them in a proper context.

We have been witnessing the decline in manufacturing employment for some years, and grappling with its social consequences.  The important point is that it is mainly irreversible. It has been brought about by technological change, which has improved productivity.  There is a limit to the number of manufacturing products that we can consume - just as there is a limit to the food we can consume, and we are at that limit.  So the number of jobs declines.

Of course the picture is complicated by the rise of manufacturing in the developing world, and especially China, and their exports to the developed world.  In the US I am sure, and certainly in the UK, more manufacturing output is now imported than exported, causing a further loss of jobs.  This is reversible, though, and in due course will reverse, as the developing world advances and loses its temporary competitive edge.  But this won't be enough to reverse the overall trend of rising productivity.

But advancing productivity should be good news in the long run.  It releases the workforce to do other things, or, if people prefer, to increase leisure time.  So what replaces the manufacturing jobs, in the way that manufacturing took over from agriculture?  Services, of course.  What is, or should be, the product of these services?  Improved wellbeing.

Services have rather a poor reputation in our society.  Traditionalists see them as ephemeral, compared to the real business of making things - a bit like Soviet planners were obsessed with producing steel rather than consumer goods.  More thoughtful people associate them with poor quality jobs in fast food restaurants or call centres.  But it doesn't have to be this way.

We need to develop clearer ideas of what tomorrow's service-based economy will look like. That's important because the way out of the current crisis is through investments that will take us closer to this goal, just as war led to investment in manufacturing in the 1940s (and earlier in Europe).

And the key to this is thinking about wellbeing.  This is important because one of the answers could be an increase in leisure, hobbies and voluntary activities - which is not normally regarded as economic activity at all.  Reflecting on this, I think are two areas whose significance will grow and where investment should be made, both of which raise awkward political problems - health and housing.

It is easy to understand that health and social care will take up a higher proportion of a future economy than they do now, and not just because of demographic changes.  These services are vital to wellbeing.  But we are repeatedly told that we can't afford to expand them.  And that is because we are reaching the limits of what state-supplied, taxpayer funded services can deliver in the UK. (In the US it's another story for another day).  The health economy of tomorrow will have a larger private sector component, whether integrated with the NHS or parallel to it.  But what should our priorities now be, while this private sector is on the back foot?  It seems sensible to make the NHS more efficient and effective, but foolish to cut jobs.  We should be building the skill base alongside the reform programme.  The chief critics of the government's NHS plans (including the Labour front bench) are that NHS reforms should be stopped so that they can focus on the critical business of raising efficiency.  But maybe it should be the other way round - we should be pushing ahead with reform, but relaxing the efficiency targets and letting the costs rise a bit until the economy starts showing greater signs of life. then, as any cuts are made the private health sector can take up the slack.

Perhaps housing is pushing at the boundaries of what "services" are.  We traditionally view this as a capital investment.  But what I mean is providing more and better places for people to live in, whether they own them or not.  Most of the country is quite well off here, but poor housing is probably what divides rich from poor more than anything else - and more investment in the right places (decently sized social housing) could rebalance things nicely and dramatically improve wellbeing.

But beyond this we badly need to get out of a manufacturing mindset, both in the private and public sectors.  We should not view division of labour and specialisation as the ideal form of organisation (massive call centres, and so on), and we should value listening skills much more - I nearly wrote "communication skills" but most people understand this about getting over what you want to say, not understanding what your customer or service user actually needs.  This is happening only very slowly.

So I would add a third priority: education.  We need to greatly expand the teaching of life skills at school and elsewhere.  This would not only help build the skills that tomorrow's economy needs.  It would help people make better choices in a changing world.

 

Inflation and the British economy

There is an excellent article in today's FT by Chris Giles.  Unfortunately this is behind the FT paywall so I don't think clicking through will help most of my readers.

Mr Giles considers what has gone wrong with the British economy over the last year - since growth forecasts are being consistently revised downwards.  Two explanations are often offered - "it's the Euro crisis" or the government is cutting "too far, too fast".  In fact both are wide of the mark.  The simple fact is that while rates of pay have stuck broadly on forecast (2% increase), consumer prices have increased by more (over 5% compared to just over 3%).  The gap is plenty enough to explain the lowering of real terms growth.

Why have prices shot ahead of forecast?  Mainly external factors to the British economy - oil prices, global prices for food and clothing and so on.  I really don't like calling these price rises "inflation".  Inflation suggests a degrading of money which, inter alia, makes debts easier to afford.  But incomes aren't keeping up, so debts aren't eroding by more than the 2% a year or so that incomes are rising.  Similar considerations apply to government debt - taxes largely depend on income.  VAT is an exception - but many benefits (like pensions) are linked to the rate of increase of consumer prices - so the national debt doesn't get any more affordable.

The economic pain of these external price rises is being spread widely.  Surely the Bank of England is right not to tighten policy - which would only cause unemployment and concentrate the pain on an unlucky few.  Our comparatively low rate of unemployment, compared to previous crises of this economic scale, is one of the wonders of the British economy.

Is Britain about to go bust?

The debate about Britain's economic policy rumbles on, with a speech by the Shadow Chancellor Ed Balls last week.  In previous posts I have dismissed the claim made by some that the government's cuts are unnecessary, and most commentators, including Mr Balls, seem to accept this, even if they don't say so explicitly. But there is a furious debate about how quickly the cuts should be implemented: 5 years as the government plans, or 8 years as Labour suggests, apparently including Mr Balls, though in the past he has been suggested longer.  An impressive array of economists seem to support the Labour argument.

The basis of the critics' argument rests on conventional macroeconomics, and runs that cutting too fast creates needless unemployment and risks a spiral of lower demand which will make things worse.  This argument is open to challenge on its own terms (see The Economist's Buttonwood column here, or Bagehot here), but the government's defenders don't generally try; instead they trump it with an argument about unsustainable levels of government debt.  I want to look at the macroeconomic argument in a future post.  Today I will consider whether unsustainable debt really is such a risk.

If government debt gets too high, it can derail the whole economy.  A default, when governments renege on the terms of their debt, can be absolutely catastrophic.  The problem is that if governments can't raise the money then all the functions of government are threatened.  For countries like Greece who are part of the Euro, this means that they literally can't pay the bills - salary payments are stopped and so on.  This is such a frightening prospect that there are strong incentives for other members of the zone to organise a rescue.  Countries like the UK do have another option: they can debauch their currency by paying bills with newly created money.  That's how hyperinflation starts; the most recent example is Zimbabwe, and its implications are hardly less disastrous than default.

So what are the risks for Britain?  The good news is that before the crisis struck overall debt was modest by international standards at a shade over 50% of GDP.  Even better, the maturity profile of this debt, i.e. how soon it has to be rolled over, was long term - longer than any other major economy.  The bad news is the massive size of the current deficit - 11% in 2009, and the fact that 8% is "structural" or won't bounce back with the economic cycle.  That means that total debt is increasing rapidly; by the end of 2010 it was already 75% of GDP. This gives two main problems.

The first problem is that debt risks spiralling out of control.  Few think that the current economy is capable of more than modest growth, austerity or not, which means that extra wealth is not being generated fast enough to get us out of trouble.  And debt comes with an interest bill.  There are some classic economic models of this, and on these the warning lights are flashing red furiously.  At some point lenders (characterised as the "bond markets", but potentially including you and me) refuse to lend, or at least start to put the rate of interest up, making things worse.

The second problem is more subtle.  If total national debt levels off at a high level, this will drag down the whole economy for a long while to come, as we spend too much resource servicing the debt.  One study suggested that serious problems start to happen when debt reaches 90% of GDP - less than two years away at the current trajectory.  Taking longer to eliminate the deficit means that overall debt will level off at a higher amount, unless the aggressive option really does lead to meltdown.

There are three further overlapping problems for the UK.  Debt markets are very open; there is a degree of dependence on overseas support; and the pound is a floating currency.  Government debt problems are much easier to handle if there is ready access to lenders who are effectively forced to lend to you; this has helped such high debt countries as Japan and Italy.  Superficially the UK seems to look this way: pension funds are massive, and traditionally hold lots of government debt (gilts) for actuarial reasons.  But such funds are aggressively and independently managed, helping to make our financial services industry internationally competitive.   That means they switch away from buying gilts as soon as they think it is not such a good deal.  Dependence on overseas investors appears to be relatively modest, as buyers of gilts are overwhelmingly domestic (or so I believe).  But the country still runs a significant current account deficit (unlike Japan, and even Italy), meaning that the economy as a whole does need foreign lenders.  The floating pound is often presented as a get out of jail free card - but the benefits of being able to devalue are two edged.  Foreign investors will be wary of sterling if they think it will devalue; domestic investors will likewise increase their overseas exposures in the same event, reducing their ability to buy gilts (unless these are  issued in foreign currency, but let's not go there).

But, the government's critics maintain, there's no sign of trouble, and never has been.  The government has had no trouble selling gilts, at very low interest rates.  The trouble with this argument is that markets can turn in an instant, and you won't know until too late.  An investment decision depends on a judgement looking far into the future, and this can move very quickly.  Government ministers seem to have got a genuine fright in May 2010 with the Greek crisis.  By and large the closer a commentator actually is to the debt markets, the less sanguine they are about the whole thing.  There are just too many risk factors.

So what to think?  The Labour plan is probably viable, if backed by a real determination to follow it through (and Alistair Darling, the outgoing Labour chancellor would have been an excellent figurehead, unlike Mr Balls).  But it undoubtedly takes more risks with catastrophe.  Whether it is worth doing so does come back to your view on the macroeconomic risks.  If you think that the austerity programme really will lead to meltdown, then this has real power.  But neither is the government argument implausible.  It's about the risks you are prepared to run.