November 2011 – thinking liberal

George Osborne, Ed Balls and the confidence fairy

Paul Krugman, the economics Nobel laureate and New York Times columnist, likes to talk of the “confidence fairy”. It is a critique of right-wing “supply side” economists, who advocate cutting back on taxes and public expenditure and reducing government regulation. These counter the criticism that such policies suck demand out of the economy and cause unemployment with the idea that confidence in the soundness of the government’s policies would boost business investment and consumption, and so create jobs. But such beliefs have no more substance that a belief in fairies.

Mr Krugman believes in solid government management of aggregate demand of a type that is often called “Keynesianism”. He was bitterly critical of the Obama government for not trying to enact a much bigger stimulus programme in 2008, at a time when the usual criticism was that he was spending to much. These same arguments are emerging in the UK between the Chancellor of the Exchequer George Osborne and his Labour Shadow Ed Balls.

To be fair, Mr Osborne and his supporters, especially the Lib Dem ones, never made much use of the confidence fairy in the sense that Professor Krugman uses it. The confidence they that they had in mind in supporting austerity was that of investors in government bonds, and the scary consequences of losing it. But ultimately Mr Osborne does believe that business and consumer confidence will provide the economic growth and employment he seeks. But what fewer people understand is that the policies advocated by Mr Balls and Professor Krugman require the confidence fairy too.

Let us consider the logic of the “Keynesian” stimulus. Cut VAT as Mr Balls suggests and put this money in consumers’ pockets, who go out and spend it, creating jobs, which create further demand. The Keynesian multiplier (no need for quotation marks here) does its stuff and £10bn of government stimulus might increase total demand in the economy by perhaps £20bn in a year. But then what? The extra demand has helped offset the cost (so the £10bn direct cost has been reduced to perhaps £6bn), but the national debt has still gone up. But growth drops back to zero (or worse) unless there is yet another stimulus package of yet more tax cuts or government spending programmes. To the extent that these measures are temporary (such as the temporary tax cuts advocated by Mr Balls, or the job programmes and extensions to unemployment benefit favoured by Professor Krugman) then the whole process goes into reverse, multiplier and all. And if the programmes aren’t temporary, the government structural deficit has just got a lot bigger. Unless the confidence fairy waves her magic wand.

And it is this boost in confidence that lies behind the case for government stimulus. It is reinforced by the metaphors used to describe it, such as “kick-start”, “getting the economy moving” or the word “stimulus” itself. A catalyst that improves confidence and hence gets businesses to invest and consumers spending more and saving less. And the results would indeed be magical. By spending and borrowing more you would reduce borrowings in the medium term by more than a strategy based on austerity. But without the fairy it works no more than the supply-side policies do. The problem is deferred and made worse, not solved.

So can such a stimulus boost confidence? In the right circumstances it certainly could, such as those induced by a temporary external shock, perhaps literally as in an earthquake (one of the reasons why earthquakes seem to do such little damage to an advanced economy). And here there is a genuine divergence of view. Mr Balls, who perfectly literate economically, does not believe that the British economy pre crisis was fundamentally unsustainable, and so thinks that it should be relatively easy to recover the lost ground. In economist-speak the British economy has plenty of spare capacity. A number of professional economists, including the FT’s Samuel Brittan, one of my heroes, seem to agree. But government economists and many others, apparently including the independent Office for Budget Responsibility, disagree. The previous economy was over dependent on debt spending by consumers and government and cheap imports, sustained by an overvalued exchange rate and financial support from abroad that can no longer be counted on. Mr Brittan thinks that the lower capacity of the economy is a self-fulfilling prophesy (i.e the longer the economy is depressed, the more difficult the recovery), but personally I think that the 2007 economy was in a very bad place, and was always going to take a long time to sort out.

But even if you don’t accept this, there is another problem. The extra confidence induced by a stimulus package can be overwhelmed by outside events, such as the Euro crisis. The UK economy, much more than the US one, is dependent on the world economy and is open to such shocks. Right now looks the wrong time to bet on a calm world economy.

The Euro end game

It’s been a tough year for Europhiles, especially those, like me, who have always supported the single currency and thought Britain should have been part of it. Most of them have been very quiet, and no wonder. Whatever one says quickly has the feel of being out of touch and in denial. And now this week the Economist asks in a leading article Is this really the end? that has been tweeted over 1,200 times and picked up over 500 comments. In today’s FT Wolfgang Munchau article is headlined: The Eurozone really has only days to avoid collapse (paywall). Is now the moment to finally let go, and admit that the whole ill-fated enterprise is doomed?

There is no doubting the seriousness of the current crisis. While most of the headlines have been about sovereign debt (especially Italy’s) what is actually threatening collapse is the banking system. It seems to be imploding in a manner reminiscent of those awful days of 2007 and 2008. The Germans’ strategy of managing the crisis on the basis of “just enough, just in time” seems to be heading for its inevitable denouement. Unless some of their Noes turn to Yeses soon there could be a terrible unravelling.

The most urgent issue is to allow the European Central Bank (ECB) to open the floodgates to support both banks and governments suffering a liquidity crisis. “Printing money” as this process is often referred to, seems the least bad way to buy time. Two other critical elements, both mentioned by Mr Munchau, are the development of “Eurobonds” – government borrowing subject to joint guarantee by the member states – and fiscal integration – a proper Euro level Finance Ministry with real powers to shape governments’ fiscal policy in the zone. Most commentators seem to be convinced that some sort of steps in both these directions will be necessary to save the Euro.

I have a lingering scepticism about these last two. I thought that the original idea of allowing governments to default, and so allowing the bond markets to act as discipline, had merit. The problem was that the ECB and other leaders never really tried it before the crisis, allowing investors to think that all Euro government debt was secure.

Still the short term crisis is plainly soluble, and most people will bet that the Germans will give the ECB enough room to avert collapse. But that leaves the zone with a big medium term problem, and two long term ones. The medium term one is what to do about the southern members whose economies are struggling: Spain, Portugal and Greece especially, with Italy lurching in that direction. The stock answer, which is to enact is reforms such that their economies become more competitive, seems to involve such a degree of dislocation that we must ask if it is sustainable. This treatment is not dissimilar to that meted out by Mrs Thatcher to Britain in the 1980s (an uncompetitive currency was part of the policy mix here, deliberately or not), for which she is still widely loathed. And she was elected (though “democratically” is a stretch given Britain’s electoral system). How will people react to unelected outsiders imposing such treatment? Better than Britons would, no doubt, since there is so little confidence in home grown politicians , but it’s still asking a lot.

And that leads to one of the two long-term problems: the democratic deficit. A lot of sovereignty is about to be shifted to central institutions, and it won’t be possible to give electors much say. The second long term issue is dealing with the root cause of the crisis in the first place, which is how to deal with imbalances of trade that develop within the Euro economy. Germany simply cannot have a constant trade surplus with the rest of the zone without this kind of mess occurring at regular intervals. But there is no sense that German politicians, still less their public, have the faintest grasp of this. For them the crisis is the fault of weak and profligate governments elsewhere.

So if the Euro survives the current crisis, there is every prospect of another one down the road, either political (one or more countries wanting to leave the Euro and/or the Union) or financial (say an outbreak of inflation).

My hope earlier in the crisis was that it was part of a learning curve for the Euro governments. As they experienced the crisis institutions would be changed and expectations made more realistic, such that zone could get back to something like its original vision. I am afraid that there is a lot more learning to do.

The equality problem

A nasty problem stalks those who think about public policy, especially here in Britain, and in the US. It goes under the general name of “inequality” and is mainly about the growing disparity between the very rich and everybody else. There is a lot of anger (think of the Occupy protests) and shaking of heads, little convincing analysis and and even less in the way of convincing policy ideas. It’s worth everybody taking a few steps back and asking themselves what is going on.

Of course the debate about the justice of inequality is as old as political philosophy. But two new factors have changed the whole nature of the debate. The first is that the people in the middle of the wealth distribution are getting left behind. Depending on the stats and country the median family’s wealth is hardly growing at all, or stagnating, even as the economy as a whole grows (well, until 2007 anyway). So long as the median family is doing nicely the political heat can be contained – people can ask whether the problem really matters. But these stats make it appear that the country is being run for the benefit of a tiny elite – which makes it politically much more awkward.

The second new fact is that mobility between different levels of wealth appears to be declining. If you start life wealthy, you are increasingly likely to stay that way, and if not, you are less likely to break the barrier into a wealthier world. The traditional divide between those who are concerned about equality of opportunity and those who worry about equality of outcome is becoming a lot less significant. Both lots are angry.

There remains much to debate about how bad for us all this growing inequality really is. But you don’t have to be an equality extremist (like, or so I’m told, the authors of the popular book, the Spirit Level, which I’m afraid I haven’t read) to be worried about all this. The political consent upon which our democratic society is founded is being undermined – and indeed the extreme polarisation of US politics is perhaps one aspect of this.

Why is this happening? For all the quantities of research poured in to economics and the social sciences, there is rather little that is known. Economists don’t like thinking about the distribution of wealth as opposed to those comfortable aggregates that conceal so much. Mathematically it is an entirely different type of problem to the ones they are used to dealing with. I have seen one valiant attempt to grapple with the maths, under concept of “wealth condensation“, which did a good job of modelling the sort of power distributions so characteristic of wealth patterns, but this was not by an economist. Professional economists preserve their elite status through the gratuitous use of advanced mathematics; no doubt they feel very uncomfortable in dealing with problems that require sorts of maths they aren’t good at, or even no maths at all (e.g. through the use mass agent computer modelling). What we get is some rather airy stuff about the impact of technological change and immigration, with the former usually being fingered as the more important baneful influence.

One fact is quite well understood, though, which is the winner takes all effect of mass communications. Thus entertainment stars tend to win big or not at all – and similar can be said of sports stars. The mass market seems to concentrate its attention on a small world elite, ignoring anybody that hasn’t quite made it. This, of course, will increase inequality. But it is a retail phenomenon which ill explains why bankers and big corporate execs do so well.

Because we so ill understand it, it is unsurprising that our solutions seem so inadequate. In Monday’s FT the prominent American economist and policy person Larry Summers (paywall), after moaning about the problem, was pretty lame about what to do next. He suggested looking at three things: challenging the privileged status of the well off (especially the effects of the massive lobbying power of big corporations), a bit of tax reform (which is as much about not making things worse by rolling back estate taxes, etc) and state intervention to even things up, especially through education funding. All worthy, but it is difficult to think that it would have anything more than a marginal effect. The anti-capitalists aren’t any more convincing, of course. It’s the baby and bathwater problem.

Politically there seem to be two distinct poles of argument. The right wing idea is that it is the excesses of the state that is holding back the middle, and if we taxed and regulated more lightly an entrepreneurial boom would help the middle catch up with the top. I have to admit I haven’t seen this line of argument clearly articulated anywhere, but some such logic must lie behind the popularity of the American Tea Party, whose appeal goes well beyond the elite. On the left people seem to think the answer is in a bigger state, which intervenes to help the less well off, cracks down on excessive wealth, and drags pay up by creating masses of comfortable public sector jobs. A bit like Sweden before its economy collapsed in the 1980s. Neither course looks very encouraging to a liberal.

So what to think? I am not really any further forward than Mr Summers. But it would help if we better understood why so many in our society are being left behind. I shall return to the topic

Does the Euro need a Big Bazooka?

It is a commonplace amongst Anglo-Saxon policy makers that the Eurozone leaders need to use a “big bazooka” to solve the currency crisis that is engulfing the continent. David Cameron has been particularly conspicuous in using this expression. Is it all it is cracked up to be?

So what is a bazooka? Originally it was a tubular musical instrument made famous by the comedian Bob Burns in the 1930s (Mr Burns and instrument in second picture). It then became the colloquial name for an American tubular hand-held antitank weapon introduced in the Second World War (the illustration above is in fact of a more modern and shorter weapon). This was a revolutionary innovation, using recoilless technology and the so-called HEAT armour-penetration system – which allowed infantry to threaten tanks in a way not previously possible. The Germans quickly copied it with the bigger and better panzerschrek (“tank terror”). They also developed countermeasures, including thin armoured outer skirts to their tanks, which set off the HEAT system before it could inflict serious damage. In the 1960s the weapon became obsolete, replaced by more powerful technologies.

A “big bazooka” in the current context is used to mean the deployment by the state (central banks and/or governments) of overwhelming financial resources to bail out troubled banks and others in a financial crisis. The idea is to break a vicious cycle of declining confidence in banks and others, whereby lack of confidence becomes a self-fulfilling prophecy as creditors seek to move their money into safer places. The mere proposition of such resources can be enough to break the cycle, if credible, and prevent the resources ever having to be deployed. The Americans can proudly point out to the use of the technique to solve a series of financial crises, from the Savings & Loan crisis of the 1980s, to the LTCM collapse of the 1990s and the Lehman crisis of 2008. Such tactics are conspicuous by their absence in the Euro crisis, fiercely resisted by the German political class in striking unanimity.

There is an irony that the original bazooka was quite a small weapon – but I suppose it was big for one held by a single infantryman, and the German version conveys all the imagery the metaphor needs. A more telling parallel is that the bazooka, revolutionary when introduced, steadily became obsolete as the world got used to it. No doubt the Germans will point out that the American use of “big bazooka” tactics on repeated occasions shows that there is a flaw. The American financial system suffers a systemic crisis every 10 years or so. This is the first such crisis the Germans have endured since their currency was refounded after the war – and that is because the Germans aren’t running the show.

The have a point. The financial markets are amazingly short-sighted – for example that idea that the US and UK are safe havens because their central banks can overcome any crisis by “printing money”, or monetising debt, in the manner of Zimbabwe. But the long term logic always wins in the end. There seems to be a slowly dawning realisation amongst Anglo-Saxon commentators (for example last week’s Martin Wolf column, as well as the Economist) that the German position in all this amounts to a strategy, “just enough, just in time”, and not the absence of one – even if Mr Wolf grumpily calls it “too little, too late”. The short-term costs of the German strategy are doubtless higher than the American way – but the longer term position is much less clear.

Markets aren’t people – BBC’s Peston is taking anthropomorphism too far

Yesterday there were some rather worrying developments in the market for Euro area bonds, affecting even French and Dutch government stock. This caught the journalists on BBC Radio 4 off guard, including the famed Robert Peston. They quickly fell into the lazy habit of describing the markets as if they were thinking and breathing people, albeit in a plural form, like “Bond markets looked on the Italian government’s plans sceptically and yields rose over 7%”. This formula is usually used to link the movements in market prices to some new information or news event, regardless of whether any such link is actually significant. The idea of this mythical person or people breathing down the the necks of governments is clearly an attractive way to communicate a point. The trouble this morning was that there was no such easy link to make…which led at least one commentator to go a bit apocalyptic, that “the markets” had lost faith in the Euro completely and were expecting it to break up. This was more or less where Mr Peston ended up.

I have always hated this anthropomorphism of markets, which is by no means confined to journalists – market participants clearly enjoy the false sense of power it gives them. But markets are not people, they are mechanism by which buy and sell orders (in this case for securities) are resolved by striking a mutually acceptable price, often by computers these days. When nobody is buying or selling much, and market makers have to quote prices, then indeed human sentiment plays a major part in price movements. The market makers are usually part of a small and social group where collective sentiment can develop and they don’t mind telling outsiders. Journalists can find out what these sentiments are by talking to a couple of people. In this case the anthropomorphism does bear some resemblance to reality.

But as soon as the real money enters the market, then all this sentiment is mere chatter. And it often takes a bit of time for the real reasons for market price movements to emerge. People have to guess, and journalists usually go no further than to tap into the chatter. What moves the money? There are whole variety of things, many which economists would not recognise as rational – like a fund manager simply dumping shares to avoid an awkward situation with a client. Or, sometimes it can be plain errors. Then, of course, with so much automated trading it can simply be the unforeseen interaction of computer algorithms- as happened in the notorious “flash crash” in May 2010.

So what happened yesterday? I don’t know, of course. But the best explanation came to me via the Economist’s Buttonwood column, itself quoting one Michael Derks at a company called fxpro. In essence the Euro zone recapitalision of banks is having some malign effects. The idea was that banks should reserve more capital against their assets, so that they are better able to withstand losses. Reasonable enough (and vital to bring incentives at banks back into the real world, in my view), but banks can comply by dumping assets instead of increasing capital. That is what many banks are doing, and they are choosing relatively liquid government bonds to dump – including those of the French and Netherlands governments, as well as the usual suspects of Italy and Spain. It is a battle to prevent bank ownership being diluted, not a considered opinion on the future of the Euro.

Mr Peston should have known better, and helped his listeners try to understand what was going on, instead simply plugging this lazy and narcissistic drivel Shame on him!

Occupy: a difficult bandwagon to ride

There was a strained moment at last night’s dinner at the National Liberal Club for the London Liberal Democrats, when the party was challenged by a member over the Occupy protests at the City of London. Both the guest speaker, Paddy Ashdown, and the Mayoral candidate, Brian Paddick, said that the act of protesting was a wonderful, liberal thing to do, and that the party should engage with the protesters (and indeed has), but that there was too little in the way of constructive proposals for the party to take on. Given that the anger that drives the protests is shared widely across the population, this seems a rather inadequate response. But politicians of all stripes struggle to say much more.

The Labour leader, Ed Miliband, has tried to ride the bandwagon. It chimes well with his appeal for greater morality in commercial life. This line seems to play quite well with policy wonks and political professionals, but just seems to underline Mr Miliband’s lack of grounding in the gritty “real” world – a lack which, of course, he shares with most politicians of all parties. His ideas share with David Cameron’s “Big Society” a complete inadequacy when faced with the big issues highlighted by the protesters.

It is easy enough to accept the core of what the protests are about. There has been a lot of irresponsible behaviour in world finance which has helped bring about the current economic crisis; these financiers still seem to be attracting outrageous levels of pay; and taxpayers still underwrite the whole show. After this, however, practical politicians have to deal with four difficult facts in the search for policies.

First: world finance may have failed, but capitalism hasn’t. To many of the protesters world finance is simply the purest form of capitalism and its failure represents the failure of the whole capitalist system. Well greed and profit seeking, familiar parts of the capitalist way, had a lot to do with it – but as much of the problem was uncapitalist politics. Governments borrowing too much money to develop public services; interfering with the market to extend home ownership (especially in the US); China’s distinctly uncapitalist but de-stabilising trade policies, to name but three factors. The real problem was politicians trying to tilt capitalism to their own ends, even if these ends were quite laudable. There is in fact no substitute for capitalism if we are to maintain the living standards in the developed world, and to roll back poverty in the devloping world. Interfering with the workings of free markets is likely to make matters worse, not better.

Mention of politicians brings in the second awkward fact. The public (especially in the developed world) is at least as much to blame for the economic crisis as the bankers. Excessive borrowing was widespread, as was pressure on politicians to ride the boom and expand government. It wasn’t only the bankers that were being greedy. It is natural enough to blame the bankers, saying like children, “It wasn’t my fault, he made me do it!” – but this isn’t very helpful in the search for solutions.

And a third awkward fact is that banking and finance, apart from the greed and the excess, carry out a vital world function. The process of linking savers to borrowers, which is essentially what finance does, is vital for economies to develop and poverty to be fought. It is absolutely no coincidence that the growth in world finance in the last couple of decades happened at the same time as the biggest progress against world poverty that we have ever seen. And the beneficial effects of world trade that finance facilitated completely dwarf the well well-intentioned works of government aid and charities. The problem is that the bankers simply creamed off too much of the benefit for themselves.

Which leads naturally to the fourth, and awkwardest fact of all: the bankers are holding a lot of hostages. We need bank lending to keep productive industries going. Governments needs finance to keep public services going. In the UK, and especially London, world finance includes many perfectly productive jobs which we can ill afford to lose. Vindictive policies will hurt us all.

But finance does need to be tamed. But doing so is a slow process which requires a great deal of patience. There are two key sets of reforms, neither of which are quick:

Separate investment banking from utility banking. There are many abuses in utility banking, but the really dangerous stuff is in investment banking, and allowing investment bankers to run utility banks is a recipe for total disaster. The Vickers Commission’s reforms are an excellent start here – and seem to be leading the way globally. The investment bankers are patiently trying to undermine them – but politicians and the public need to stay on their case.
Make investment banking much less profitable. It is the profits that drive the excessive pay – and policy needs to focus on the causes of the disease rather than wasting time on the symptoms. There are two main causes of excess profits: lack of competition and the failure of organisations to bear public costs (for example of the public’s underwriting of the banking system). In investment banking, it is the second of these that is the most important (in retail banking it is the first…), and the most effective way forward is raising capital requirements. This is being done, and banking profits are duly under a lot of pressure. At first it will be the shareholders who feel the pain – but in due course it will be bankers pay, as shareholders get fed up with their overpaid servants.

Actually progress is rather good. We don’t need gimmicks like the “Tobin Tax”. we need vigilance and patience. I am proud of the way the Liberal Democrat ministers have been keeping the pressure up (Vince Cable is the star, but Nick Clegg is clearly on side). The bankers are waiting for the Occupy bandwagon to move on. It will, but I hope and trust that the Liberal Democrats will still be on their case.

The Norwegian Exception

Vigeland Park, Oslo — Vigeland sculpture, Oslo

Last weekend my wife and I went to Oslo, to visit my brother and his partner (who is a local). It wasn’t my first visit to Norway, but the first time was on a tour. Norway comes up periodically in conversation here in the UK, especially as a country that does well outside the EU. What to make of it?

The first thing to say is that Norway is a spectacularly beautiful place. The weather was mostly dull when we were there, but we had sunshine on Saturday, rendering beautiful views of a totally calm Oslo Fjord. The architecture is mostly pleasing, if unspectacular – with some lovely 19th and early 20th century houses. We caught the short season of autumn colours perfectly. And of course the mountains and fjords are justly famous.

And the second is that, unsurprisingly, it has a very Scandinavian feel, from the language to the architecture and the people on the orderly and tidy streets. But there’s a difference, with Sweden and Denmark anyway. Norway has only recently emerged into what we would recognise as civilisation, that is a city based culture, with the exception of Bergen, perhaps. The medieval, renaissance and the baroque eras have left the country almost untouched, notwithstanding spectacular advance in the 19th century, in Oslo at least. Push back into history and you are into the land of trolls in no time. Of course what we call the Dark Ages was their Viking era, and that too was spectacular, though it has left relatively few traces.

Stave church — Gol Stave Church at Folk Museum

The Norwegians appear to have had some struggle in coming to terms with this advance, with an excessive value placed on modernity. The most spectacular old monuments, undoubtedly world-class, were the ancient wooden stave churches. And yet many of these were torn down in the modern era as being old and useless reminders of a time they would rather forget. This has changed, with many wonderful wooden buildings preserved in the open air Folk Museum, including one of the stave churches. But family memories of the hard, poor rural life are widespread and fresh, especially compared to the long urbanised Britain.

All this has given Norway a clear national identity, albeit a more complex one that outsiders are generally aware of (is this not always so?). In modern times the country suffered further trauma under Nazi occupation in the War. And then came the oil. But the oil wealth found a well educated and cohesive society with strong, honest government. It has been socialised in a way that few, if any, other countries have managed, to make Norway one of the world’s wealthiest nations, while also remaining one its happiest.

Wealth comes with its problems. The exchange rate is high, and labour in short supply. Immigrants have been drawn in. Swedes are working everywhere in Oslo, and black and brown faces are common. High standards of political correctness (to give good manners their modern name) are maintained (plenty of brown faces in public ads and so on), but such changes naturally bring their own tensions.

So why does Norway stand apart from the European Union, unlike their Nordic neighbours? Well it’s not because they dislike regulations. Norway, I am told, is a much more regulated society than Britain. Perhaps that’s one reason that they have been given a generous deal under the EEA – i.e. full access to EU markets in exchange for partial compliance with EU regulations and some contributions to EU funds – which many British Eurosceptics somewhat unrealistically think would be available to the UK if it left the Union. While this deal exempts them from many aspects of EU regulation (notably competition laws), they still find that much of their law is based on EU directives over which they have no say.

No doubt Norwegians fear that, in the EU, the other members would eye up their wealth and seek to extract generous contributions. If they think that, they are almost certainly right. Norway is not ungenerous with its wealth, but no doubt prefers to contribute on its own terms.

The truth is surely that Norway is not in the EU because it does not need to be. Oil provides the country with all the exports it needs. It can negotiate other benefits. It carries no weight in the development of EU law, but how much weight would it carry if it was in? Norway is governed by a cosy elite that does not want to dilute its power. The population seems basically content with their elite. Not many lessons for the British there.