Britain is not Japan. Abenomics would stoke inflation

I asked Bing Image Creator to give me a picture of shoppers in an English town buying foreign goods. This is one of the four results. Me neither.

Somewhere over the Christmas holiday I heard on BBC Radio 4 a very authoritative gentleman suggesting that Britain should copy Japan’s economic policies. Alas I didn’t catch who it was, and can’t trace him. I think he was on the World at One, but these days the BBC doesn’t let you search past programmes for particular items. Anyway, it is an excellent illustration of the point that I was making about the British economy a couple of posts ago. It’s worth explaining why he is so wrong. I suspected that the gentleman was a graduate of PPE at Oxford, like former Prime Minister Liz Truss: a degree course that equips its subjects to sound plausible when talking about economic policy, without necessarily grasping even the basics of the subject. Ms Truss did not seem to realise that reducing inflation meant limiting demand.

The particular set of Japanese policies the interviewee referred to dates from a number of years back, and was advocated by the late Japanese Prime Minister Shinzo Abe, and is often referred to as Abenomics. He himself called his approach as the “three arrows”. This was based on the ancient wisdom that while it is easy to break the shaft of a single arrow, it is hard to break the shafts of three arrows bound together. His three arrows were monetary policy (ultra low interest rates supported by Quantitive Easing (QE), i.e. the buying of government bonds by the central bank), fiscal policy (extensive infrastructure investment funded by budget deficits) and supply-side reforms. All these policies were mutually reinforcing. Supply side reforms were required to expand the capacity of the economy, fiscal policy to ensure that aggregate demand met this this expanded capacity, while loose monetary policy made the large government budget deficits implied by this sustainable. Without all three strands of policy, there would be failure. Japan had endured many years of economic stagnation, and Abenomics was an elegant and coherent approach to this – more than can be said for British policy economic policy since 2010, when the different policy levers often seemed to work against each other.

The interviewee did advocate one point of departure from Abenomics. When explaining supply side reforms, he advocated three “Is”. The first of these was “investment” – I can’t remember what the other two were (perhaps “institutions” was another). Investment was not a focus of Abenomics. Fiscal policy was directed at public investment, admittedly, but there was little economic coherence to this – it. was mostly about the dispensation of political favours (“bridges to nowhere”) – and the desired economic impact was to raise aggregate demand, not to expand economic capacity. Supply side reforms were aimed at non-financial barriers that were holding the economy back, such as the low rate of employment of women, and not investment.

So what’s wrong with all this in the British context, skating over its mediocre results in Japan itself? Japan was, and is, in a very different economic place. It has a robust industrial base which routinely delivers export surpluses, in spite of having to import raw materials and energy. It has a high rate of domestic savings (in other words domestic consumption is much less than income). Investment is plentiful. But it has all manner of market inefficiencies due to conservative business practices and cultural mores (for example severe prejudice against working women). Contrast this with Britain: its industrial base is comparatively weak, delivering no trade surplus so far this century; the private savings rate is low; investment is weak; but business practices, regulations and social mores are as conducive to economic efficiency as they are anywhere in the world – with a high rate of overall employment, for example. Both countries share grim demographic trends, with a reducing ratio of people of working age – though Britain has been mitigating this with immigration on a scale that Japan doesn’t.

What ails Britain? Pretty much everybody seems to agree that the country lags other developed countries, though whether you compare with America or with Europe depends on your politics. Apart from the lacklustre growth record since 2007, the main evidence is poor comparative statistics on productivity. A lot of the analysis is very shallow, however. Even many academic economists who should know better are susceptible to the fallacy of composition. While they quickly recognise that national decisions on budgeting and demand management are not the sum of individual household budgets – and what would be right for a household would not be right for the country as a whole – they fail to see the same thing on the supply side. They often talk of the country’s production side as if it is a single business (“UK plc”), but that is grossly misleading.

For a start, the supply side of the economy is very heterogeneous. Computer factories are highly productive; hospitals are the opposite. It doesn’t follow that we would be better off if we closed our hospitals and replaced them with computer factories. Furthermore, if individual businesses become more efficient, it also does not follow that this translates into the whole economy doing so. That depends on what those individual businesses do with their extra efficiency. They might expand production, perhaps helping to expand the economy as a whole – provided that there is latent demand for their product. If this happens there may be a virtuous circle that helps the whole economy grow. Or they might just keep production levels steady and sack some workers, paying extra dividends to investors who use it to invest in other businesses. Or the directors may pay themselves more in bonuses to spend on personal trainers, luxury goods, and other things where low productivity is the essence. Overall there is a well-established pattern, however, referred to by economists as the Baumol effect. As productivity advances in some sectors of the economy, lower productivity industries come to occupy a higher proportion of the economy as a whole. The balance of wealth creation (highly productive industry) to wealth realisation (the part of the economy that prioritises self-actualisation and typically has a high human content – i.e. low productivity) shifts towards the latter. What’s the point of being rich if you can’t access decent healthcare, drive around in Bentleys or eat organic food?

The problem for Britain is that the overall mix of its economy is out of kilter. It imports a disproportionate share of the goods and services where productivity is very high, while producing too much of the goods and (mainly) services that are critical to quality of life, but where productivity is low, and export potential is much weaker. The answer isn’t to try and raise the productivity of the latter goods, as this will tend to kill the quality. It into rebalance the production side of the economy towards high productivity goods that can be exported. There is another way of looking at this problem: it is that British consumption is too high. We are living beyond our means, importing more than we export. Consuming less would give the supply side of the economy the chance to rebalance in favour of exports. This is the opposite problem to Japan, where aggregate demand tends to be too low for economic efficiency. In Britain there needs be more private saving and more investment. In Japan it is the opposite.

So Abenomics would not work here. Looser fiscal policy would push us into inflation. Loose monetary policy would simply build speculative bubbles. Supply side reform would not make enough difference, though doubtless there are some useful things to do.

But the interviewee was right about one thing: the key to progress in Britain is greatly increased investment. Any move to highly productive, high exporting businesses will entail substantial investment. What are these businesses? Basic economics teaches us that these should focus on areas where the country has a comparative advantage – but that is a very slippery thing to identify. We shouldn’t be chasing a past golden age, or trying to directly copy other successful economies. If you care to look, there are areas of promise – for example life sciences, especially if the country can tap into NHS patient data. The government, at least does seem to appreciate this – it talks about building the industries of the future. But it struggles to deliver the right economic conditions to generate the level of investment required. There are not enough private savings to fund the business investment required; too much of what there is disappears into government debt – pushed that way by conservative regulation.

This points to a different three arrows to those advocated by Mr Abe. We need to incentivise more equity investment in businesses with export potential – especially if these are based outside London and the South East. Much of this must be led locally by regional and local governments, able to raise their own revenues. Pension regulations need to be overhauled. Second we need a much tighter fiscal policy in order to damp down private demand and keep inflation in check – this will consist of higher taxes and more efficient government (e.g. coherent public services that solve problems rather than passing the buck). If the public won’t save more of their own volition, then the enforced saving of higher taxes has to do the job. This would then give the government space to kick-start investment and tackle bottlenecks. Third monetary policy should primarily be focused on creating a healthy climate for savers, and ensuring financial stability. That will surely mean higher interest rates.

No politicians can advocate steps two and three of this programme. But the first part is near political consensus – and we could find that it drags fiscal and monetary policy in its wake. British policy usually advances by muddle. It is possible that the country will muddle along in the right direction. That is the best we can hope for.

Higher interest rates would be good for the UK economy

Source: Office for National Statistics

In my last post but one I discussed how Britain’s politicians are in denial over the hard choices that need to be made over taxation – evidenced by a fatuous Autumn Financial Statement from the Chancellor of the Exchequer, and the inadequate opposition response. Now The Resolution Foundation has published a new report: Ending Stagnation: a New Economic Strategy for Britain, based on a substantial amount of research, and again we are coming back to the growth problem.

Unfortunately I haven’t read this worthy and weighty contribution to the debate. It is nearly 300 pages long and describes itself as a “book”. Instead I have read the Executive Summary and some of the commentary, including from Torsten Bell, the Resolution Foundation’s Chief Executive, amongst other reviews. These leave me a bit confused, and clearly a lot of the devil (and perhaps some angels too) is in the detail. Given my substantial reading list, getting round to reading the detail will take some time.

Mr Bell has been trying to paint an optimistic picture – that Britain has the opportunity for catch up growth based on its weak performance: something that I have mentioned, amid my rather dismal assessment of longer term growth prospects. He points to two opportunities in particular: strengths in service industries which can be an engine of export growth, and the ability of Britain’s weaker regions to narrow the gap with the prosperous London and South East.

The point about services is an interesting one. It flows from two propositions that I agree with. The first is that manufacturing is yesterday’s story; it has become so efficient that there are few jobs in it, and besides there are saturation effects as the link between consuming quantities of stuff and improving wellbeing weakens. The second is that export industries are critical to most models of economic growth. Most successful economies in Europe and the developing world run trade surpluses. The US is an exception, but it is also an export powerhouse – it is just an import powerhouse too. The position of the US in the global economy is unique, however, and it doesn’t offer Britain any kind of hopeful model.

Why should exports be so important? That is a bit harder to answer. The explanation often advanced is that export industries are usually highly efficient (especially if they are not about mining and natural resources), partly because they have to be globally competitive, and partly, doubtless, because supplying things across borders requires a degree of efficiency anyway. There is doubtless a lot of truth to this. And this is linked to another truth, which is that exports and investment go together. This is in turn is linked to basic macroeconomic dynamics. A country with an export surplus consumes less than it earns – otherwise all the exports would be balanced by imports. And that usually means that such a country has high investment levels, as that surplus needs to be spent somewhere. That oversimplifies things quite a bit, of course, and disentangling cause and effect can be hard. But if Britain is going to play the catch-up game I am sure that it means three things that are very closely linked: better balanced trade (currently there is a 2.9% current account deficit – one of the largest amongst bigger economies, though America’s is close at 2.8%); greater levels of investment; and a higher rate of personal saving (currently 9.1%, actually relatively high compared to the pre-covid period, but still much lower than the EU average of 18.2%).

The first two parts of this trilogy are uncontroversial. Pretty much any commentary you care to read on the UK economy mentions the need for more investment, both private and public. People are less explicit about the need for more balanced trade. Back in the 1960s and early 1970s, before floating exchange rates and free capital flows, this used to be a matter of high political drama. Since then it has dropped from the conversation; Britain seemed to be doing just fine in spite of regular and large negative balances. But conversations about growth often turn to greater export volumes, and that implies more balanced trade. But surely something else is true: the country needs to import less if it is to save more and provide the funds for investment. And that means consuming less. There is a strikingly similar conversation to be had about tax. Higher public investment, and better quality public services, and a more adequate social safety net, imply higher taxes… and less consumption.

Looking at the graph of Britain’s savings rate over the last 70 years (above) it is hard not to see the supposedly economic golden years of new Labour, from about 2000 to the crisis of 2007-09, as a bit hollow: a consumption boom based on reduced savings levels. It was linked to a consistent current account deficit (the last surplus was in the mid-1990s). I have always thought this economic achievement was less than it appeared, driven as much of it was by the spurious profitability of the banking sector, which was reversed in the financial crisis. One important aspect of the decline of personal savings in this period was the reduction of corporate pension schemes. I witnessed this at first hand as a finance director in the first part of the 2000s, with presentations from consultants offering to reduce the costs and risks of pension schemes for employees. Final salary schemes were replaced with money-purchase ones, which almost always entailed a simultaneous reduction in contribution rates. This was sold as an advance for personal autonomy over the patronising ways of the past. In truth the potential liabilities associated with final salary schemes, or more correctly defined-benefit ones, were quite scary, and they gave employees who changed jobs a rough ride. Also the general decline in interest rates made those promises more expensive to keep. But now the collapse in pension funds as the source of UK business investment is much remarked on, though people tend to blame the post-crash flight to safety in pensions regulation; its roots are much deeper. Attempts to revive domestic business investment by the Chancellor look puny by comparison with the larger economic forces in play.

How might the savings rate be increased? The best way surely is for the current rise in interest rates to be sustained. This will deliver higher returns on new savings, even as it damages the capital value of past savings. There is a paradox here. It is often claimed that lower interest rates are required to stimulate business investment, but reducing the costs of finance. But the finance director in me says that cheap finance means poor-quality investment. There is nothing like a higher target rate for return on investment to focus minds on the best way to structure an investment project. I have seen it time and again.

Another problem with higher interest rates is that, all other things equal, it will drive up the exchange rate. This would make exports more expensive and imports cheaper – working against reducing the trade deficit. it would tend to make the country less attractive for foreign business investors. But part of the attraction of raising domestic savings is that it reduces the dependence on foreign capital, which is less reliable for a medium-sized economy like Britain’s. Many of Britain’s most successful businesses are foreign-owned and based on foreign investment. And yet, in spite of a relatively cheap pound, these foreigners have not invested much recently, especially since Brexit.

Unfortunately there is no guarantee that higher domestic savings would lead to more productive business investment. The old defined benefit pensions were a particularly effective channel for this purpose, and they are gone for good. More money could be pushed into domestic property – though some funding for this sector would be a good thing, so long as it just isn’t a matter pushing up land prices. Funds could be swept up by government debt, if budget deficits are not also brought under control. But buy and large a higher interest rate environment is more conducive to productive investment, rather than fuelling speculation. High interest rates are not good for the property market, which in current conditions is a good thing. Serious thought needs to be given to pension reform so that there is greater level of collective investment – as this is most likely to be channelled productively. There are examples from other countries of ways that this might be done (the Netherlands and Australia come to mind).

So my recipe for getting the British economy onto a healthier path includes higher taxes and higher interest rates. This is not going to be taken up by any political party – but parties in government might be forced into that route anyway. The Conservatives seem the least likely to do so – with their agenda of tax cuts and supporting property prices. My favoured option is for a Labour-Lib Dem coalition – which would require a hung parliament, and both parties having the stomach for a coalition. On present evidence neither proposition is looking likely. A large part of Britain’s lacklustre performance comes down to our prioritisation of personal consumption. Changing that is a hard road.

Britain’s politicians are in denial – are the voters?

From the Office of Budget Responsibility: Economic and fiscal outlook November 2023

This week’s Autumn Statement by Britain’s Chancellor of the Exchequer, Jeremy Hunt, was a miserable affair, full of political chicanery with little to effort to tackle the country’s deepening problems. Worse yet, the opposition parties (Labour and the Lib Dems anyway), for all their huffing and puffing, are also unable to face up to these problems.

The Conservatives billed the set of measures as the biggest set of tax cuts since the 1980s. And yet the overall tax burden is rising as the freezing of tax allowances and thresholds will bring ever more people into tax or higher rates of tax, and increase the proportion of income people pay as tax. An even bigger problem is that the government has been using inflation to squeeze public spending, while services across the board – health, education, the police, the courts, and the list goes on – are clearly overstretched and in many cases breaking down – with collapsing buildings and rising waiting lists. The Chancellor offered not a penny to alleviate this crisis, while planning a further squeeze in the years ahead. Labour and the Lib Dems gleefully pointed out the first problem, but failed to address the second. They will stand by the announced tax cuts, while offering only gestures (taxing non-domiciled residents, or private schools, for example) to help fund public services. These tax-raising wheezes are nowhere near enough to match the scale of the crisis. Meanwhile all parties suggest that a bonanza of economic growth is coming to the rescue, without acknowledging the severe headwinds that will limit the country’s long-term growth prospects.

I am also highly sceptical of the one measure that seems to be getting widespread support – the full expensing of investment in machinery and systems against corporate profits. It is said that this will boost business investment, which is sorely lacking. It is in a fact the revival of a policy that failed in the 1980s, and was abolished by Nigel Lawson, the Tory tax-cutting Chancellor, who has been about the only holder of that post in memory that had a grasp of how the tax system as a whole worked and could be reformed. Back then it created a tax-avoidance industry and encouraged wasteful investment with fancy kit, rather than the thinking through of business processes which is the real key to improved productivity. That fiasco occurred at the beginning of my professional career as a Chartered Accountant, where I could see the nonsense it was creating up close. Alas the current crop of politicians and their advisers are too young to remember this. And it is of little use to new businesses, where the need is most acute, as these typically do not generate enough profit for this to be of use. What a silly waste!

Meanwhile the fiscal climate is getting a lot worse. Interest rates are rising at time that the size of the national debt is historically very high. If interest rates are higher than the overall rate of growth, and there is a budget deficit, then a debt spiral threatens, which, if it leads to an international loss of confidence in the public finances, could usher in a severe financial crisis. At the moment it is actually quite hard to understand how much of a problem this is. You should be comparing real interest rates to real growth rates – i.e. after inflation. But there are mixed signals on real interest rates. If you compare the nominal rate on government lending, it is if anything less than reported inflation – indicating a negative rate. But yields of index-lined bonds are positive and have risen sharply. Meanwhile the budget deficit is quite high – at 4% of GDP. It wasn’t so long a go when none of this seemed to matter. Interest rates were low, and the Bank of England’s Quantative Easing (QE) programme made large government debt look manageable. But conditions have changed. Inflation has made money much tighter – with interest rates rising, and QE going into reverse. I am starting to suspect a deeper change is afoot in the world’s capital markets. Earlier this century a number of countries ran large trade surpluses – notably China, Japan and Germany. This made trade and budget deficits more stable in countries like the UK and US, as the surplus countries had plenty of spare currency to provide funding. As the world’s trading environment is getting more difficult, this may changing – though it is not yet evident in public statistics. After over-reacting to fiscal risks in 2010, and moving into austerity too quickly, the opposite risk beckons. But the Autumn statement proposes tackling the budget deficit only slowly, leaving the very high level of net debt virtually unchanged. Politicians seem to assume that as inflation comes down things will simply go back to the easy financial environment that pertained before. This is complacent.

More from the OBR report – government plans make little impact on public debt

If that is complacency, the politician’s attitude to economic growth is outright denial, though some economists who should know better seem to be in the same place. It is assumed that the UK’s poor performance has an easily fixable cause. More investment perhaps, or encouraging more people into work, or perhaps lower taxes. Rachel Reeves, Labour’s Shadow Chancellor, blithely talks about sorting out public services through economic growth – even applying the first-person to the process, as if growth was the gift one individual, and not the collective result of many millions of decisions. International comparisons seem to show that Britain’s productivity lags against peers. All that we need to do is fix this, the argument goes, and we will unlock growth. Well it may be that a burst of catch-up growth that is obtainable – but I suspect that these comparisons reflect an irreversible de-industrialisation, when a swathe of high-productivity industries left the country in the 1980s and 1990s and will not return. But stepping back, most or all of the developed world faces a number of headwinds that reduce growth potential, and in some case send it into reverse:

  • Demographics: more people are retiring as lower birth rates take their toll. Immigration can make up some of the difference, but is politically fraught, and stresses housing resources.
  • Trade: as globalisation runs into reverse, gains from trade are turned into losses. The UK is spared the American obsession with “near-shoring” or the reversal of the off-shoring of industries – but we have our own demons unleashed by Brexit.
  • Overdevelopment. The increasing consumption of goods, a critical driver of past growth, is simply a phase in economic evolution that has clearly ended. People move on to improve their quality of life in other ways. Meanwhile massive increases to the productivity of manufacturing industry mean that its impact on the total economy is much reduced. All this means that lower productivity parts of the economy, including many public services, loom larger. Productivity gains are harder to get, and where they happen the result is not so much increased production, but a transfer of resources to low-productivity sectors.
  • The energy transition. The country needs to make big investments to sources and distribution of energy, and its more efficient consumption. While the end result is desirable, in the meantime this will push down consumption. This, in fact, applies to pretty much all forms of investment. The country has become used to high consumption and low savings – reversing this won’t necessarily reduce growth as it usually measured, but to many people it will feel that way.
  • Housing. One way of achieving growth, or at least burst of catching up, is to allow people to move to places where the most productive jobs are. But these areas lack enough housing to accommodate this. Britain’s house builders have growth rich on the skilful management of land portfolios, rather than the actual building of houses, which many are actually very bad at. They have no incentive to increase the pace of building. And if the pace is increased, skill shortages quickly become evident. And I haven’t even mentioned slow and restrictive planning processes. Politicians at least show some awareness of this issue, but action never matches the promises.

The days of steady economic growth over the medium to long term are over, whether we like it or not. The best we can hope for is a short-term spurt. There is plenty of potential for human wellbeing to improve, but this will manifest itself in other ways.

The central problem is the funding of public services and maintenance of social safety-nets. A combination of two things are required here. The first is higher levels of taxation – and mainstream taxes which directly affect demand, and not gimmicks around capital and wealth (the latter may help make debt more manageable, but won’t suppress demand and prevent inflation). The second is a radical reform of public services so that demand for them is reduced – reducing the level of social problems, so that we require fewer police, courts, hospital beds, etc – and managing those problems so that they are solved early rather than passed from agency to agency. Alas we have very little idea how to bring such a change about – though we can see that some countries do this better than us (Japan, Switzerland, Denmark perhaps). A radical reform of government is clearly a part of this, with less centralised control – but it needs much more than this: decentralisation by itself could actually make things worse. With the possible exception of education (which has become more effective rather than cheaper) the reform efforts made by our governments in the last twenty years have taken us in the wrong direction – from Labour’s over-centralisation, to the de-skilling and outsourcing of the Conservative and coalition years. Unfortunately the choice between the two approaches of higher taxes or radical reform is not a binary one. Reform will require substantial investment, and that is likely to mean higher taxes in the short term at least.

If our politicians are in denial about all of this, how about the public? They surely understand that public services are in a dire state – and that fixing this will not come cheap. But they are too wrapped up in their own personal struggles to spend any energy on demands for change. Politicians are in denial for a reason: they don’t just a lack imagination and perception, but they also know a voter-loser when they see it. Still, Labour are clearly presenting a more realistic prospectus than the Conservatives, even if it is based on wishful thinking. Their poll lead at least seems to show some wider awareness by the public at large. And we must grasp at that straw.

Why The Economist is wrong about the global economy

The Economist print edition was published before Hamas’s shocking attack from Gaza, and led on one its own stories. I will stick with that story today. This blog isn’t meant for instant reactions and the dust is a long way from settling. All I will say is that I was a volunteer at one of the kibbutzes (Be’eri) attacked on Saturday back in 1979 – long ago but it still adds depth to my reaction.

The Economist‘s lead is a challenge to “homeland economics” – the rejection of globalisation in developed economies, with the rise of protectionism and massive state subsidies to locate manufacturing in home country. The case is made by an extended essay (“special report”) on the world economy by Callum Williams, senior economics writer. This in turn is fronted by a leading article, Are free markets history?, which frames the issue as a challenge by politicians to the ideas of free market economics, which will lead to bad things. “Governments are jettisoning the principles that made the world rich,” it says. Having free market instincts myself, I find much to agree with in this critique. Most of the justifications offered for the increase in protectionism and extended government programmes don’t add up. But the newspaper’s writers are making three mistakes. They are taking the political narrative at face value without trying to understand the forces that shape it. They underestimate how much free markets themselves are driving the changes to the economic system. And they don’t know what they want. “The task for classical liberals is to prepare…a new consensus that adapts their ideas to a more dangerous, inter connected and fractious world.” Yes, but what on earth does that look like? It may turn out to be surprisingly close to what the world is doing now, but in slightly different clothes.

I see things differently – while at the same time using classical liberal economics as my basis. The expansion of global trade has been one of the most critical aspects of the development of the world economy since the Second World War. At first the main beneficiaries were the Western European and American economies – but this started to run out of steam in the 1960s – as the war-damaged economies of Europe recovered. Then Asia burst onto the scene, in three distinct phases – first Japan, then the “tiger economies” of South Korea, Taiwan, Hong Kong and Singapore – and finally and most dramatically with China – with India, Vietnam, Thailand, Indonesia, Malaysia and Bangladesh playing a significant role too. This last phase, from the mid 1990s up to the financial crash of 2007-09, was the most dramatic of them all and was given the monicker of “Globalisation”. The impact was dramatic – many scores of millions were lifted out of poverty; China rose to be a superpower; and living standards in the developed world (now including Japan) steadily advanced as falling prices of manufactured goods fed through. These advances had three critical ingredients: free trade, technology and comparative advantage. The weakness of The Economist‘s argument is that it concentrates on the first part of this holy trinity without appreciating the impact of the other two.

Let’s consider technology. The first critical development was the rise of manufactured consumer goods. Technological developments from the Second World War – from manufacturing technology to the use of plastics – saw a massive rise in the production of cheap goods from cars to washing-up liquid which came to occupy a dominant position in the economy. Advancing agricultural technology also led to huge agricultural surpluses in some countries. These goods are readily tradable and thus gave rise to a huge opportunity for trade. The second critical development was the advance of information technology in 1980s and onward, which allowed the development of long, global supply chains and the relocation of manufacturing and other economic activity, sometimes to the other side of the world. This again greatly expanded the scope for increased trade.

Then there is comparative advantage. This classical piece of economics has been well understood for two centuries and more. It gets taught in basic economics courses (“Economics 101”) as a wonderful illustration of the power of counterintuitive thinking. Then, after Economics 101, it quietly gets forgotten by trained economists. While its strategic impact is obvious, it is very hard to incorporate it into the mathematical and computer models that are at the heart of professional economics. That is unfortunate, because its dynamics are critical to understanding patterns of trade. It suggests that benefits from trade exist when two economies have structural differences that lead to different opportunity costs for different economic goods and services – for illustration the amount of wheat production that must be foregone by redeploying resources (typically labour) to make a car, say, or vice versa. In an undeveloped economy, like China in 1990, agricultural productivity is very low and you don’t have to forego much wheat to make a car. In America, agricultural productivity is sky-high, and the amount of wheat forgone to make that extra car is much higher, even allowing for much higher manufacturing productivity. So China is said to have a comparative advantage in car production, and America in wheat production – even if America is much more efficient at car production. So if China redeployed labour from the farms to factories and imported wheat from America to make up the shortfall, it could make more cars than the Americans would forego to redeploy labour to produce the extra wheat. Of course, that specific example is flawed: America can’t simply send workers to the countryside and expect that to raise agricultural production. But the general principle stands: export where you have comparative advantage; import where you don’t – and everybody should be better off. Exchange rates gravitate to levels that make the exchange beneficial to both sides, allowing for the differences in absolute productivity. This is one of the main reasons that exchange rates do not follow purchasing power parity.

Now the point that isn’t made in most Economics 101 courses, and fails to be fully appreciated by even trained economists, is that these gains from trade arise from differences in the structure of economies. If two national economies are identical, there will be no gain. And, in principle the more economies differ, the bigger the potential gains. Sometimes these differences arise from geography – if one country can drill oil in its jurisdiction it will certainly have a comparative advantage in oil over one that doesn’t – and production of oil will tend to drive out production of other goods (one reason why British de-industrialisation was particularly acute when North Sea oil was plentiful). But other differences are less rooted. The main difference that drove globalisation was the state of development – and in particular a vast, unproductive agricultural workforce compared in developing countries compared to a fully mechanised one in advanced ones. This did not necessarily drive agricultural trade, which is often subject to heavy protectionism, but led to low manufacturing wages, and thus an advantage in lower-tech manufacturing. But as these economies developed, starting with Japan, and moving on to China, they converged with the developed world. Manufacturing wages rose and the exchange rate of the developing nations appreciated. The gains from trade were based on much more subtle differences, and there were generally less of them. Outsourcing manufacturing from America to China is a much more nuanced economic proposition now, even without all the political baggage.

The role of technology in trade has changed too. Manufacturing technology has advanced to the point of being so productive that its role in the overall economy is much less dominant than it was. Indeed The Economist points out that one of the issues with relocating it “back home’ is that it doesn’t bring many jobs with it – it will not be recreating the good old days of plentiful mid-level jobs in the 1970s. Technology itself continues to evolve at a rapid pace, but it is far from clear that it is doing so in a way that opens opportunities for trade. It may even be doing the reverse by making it easier for economies to be self-sufficient after paying due homage to the technological giants that control so much of it. And the tech giants do not employ all that many people.

So it’s not at all surprising that the bottom is falling out of globalisation. There are just fewer opportunities to make profits. And with this tightness comes political sensitivity. It is much more likely that government policies will affect trade patterns because it takes less effort to turn the tables. And other issues such as resilience and security weigh more heavily. In particular China’s unsubtle effort to tilt economic advantage its ways in particular economic sectors, and use economic leverage to bully (countering, no doubt they would suggest, the American propensity to do the same) is drawing an understandable political reaction.

Where The Economist is right is to suggest that the new developments in structure of the world economy will yield disappointing results, especially in the developed world. The loss of gains from trade as a result of convergence adversely impacts the world economy. By and large they result from increased productivity in developing nations, who are able to offset the loss of trade gains by banking the extra productivity. The developed world can’t offset the loss in the same way. The costs of imported goods rise relative to domestic goods and this amounts to a headwind against living standards. A tailwind turns into a headwind for economic growth, to be added to other headwinds such as adverse demographic changes.

These are, funnily enough, the problems of success. Globalisation has done a huge amount to advance human development, but we’ve reached the top of the escalator (leaving aside, for now, the issue of what happens to the remaining less developed economies, in Africa for example). Much the same can be said of developments to manufacturing technology. We must look in a different direction to make future advances.

That different direction may include market economics, and surely it includes a trade in ideas – but physical trade will play a lesser role. Restoration of the environment, a better appreciation of human psychological needs, and a rethink of public services will be the critical elements. We can’t look to the recent past as our guide.

Tax reform must be properly thought through before going to the country

Oh dear! The New Statesman magazine is returning from its summer break with what it obviously hopes to be a major piece by Harry Lambert, its editor, to challenge Labour Party policy. Mr Lambert shows his credentials as a journalist with extensive reportage. But there is nothing here that anybody who wants to seriously understand tax and the economy to get their teeth into – it is the intellectual equivalent of ultra-processed food. Your taste buds might be excited but it is not nutritious fare. To be fair, it’s not immediately apparent that either the Labour leader, Sir Keir Starmer, or the Shadow Chancellor, Rachel Reeves, are seriously interested in economics – and these are the people the article sees to influence. But the pair are very much interested in hard politics, and the article fares no better in that department.

The article reinforces my suspicion of anything in a journal billed as a “long read”. I’ve noticed a propensity to do this both in The Guardian and the Financial Times. I take this as a warning to stay clear, to avoid articles that aren’t properly edited and waste a lot of reading time*. Mr Lambert’s article was not billed as a long read, but it should have been – there is a mass of verbiage, which you have to wade through before you come to his three policy proposals, and even these aren’t stated succinctly. These proposals are: to replace Council Tax with a 0.5% tax on property values (covering just domestic property, as far as I can see); applying National Insurance to property rental income; and raising the rate of Capital Gains Tax. These, he estimates would raise £28 billion a year (though the property tax reform would be revenue-neutral): not coincidentally the amount of Labour’s proposal for spending on the green energy transition, which they are now backtracking from. More sensibly he suggests that the extra revenue is used to reduce tax on work (income tax, or better still, National Insurance).

I will start by reflecting on the overview, which is summarised by this statement:

In order to spend money in government the party will need to raise it. There is a very good way to do that. It is to shift the tax burden away from labour and on to capital, away from work and on to wealth. 

Harry Lambert, New Statesman 30 August 2023

There are two words of warning on this. The first is that the words “wealth” and “capital” are treated as synonyms (as are “labour” and “work” more justifiably). They can be, but when talking about economics they are different things. Capital refers to the assets tied up by businesses in order to be able to operate: premises, machinery, working capital and so on. By and large it isn’t a good idea to tax this directly, as it would reduce investment. Taxes on profits generated by the capital before it is distributed to owners – such as corporation tax – is another matter. This is in effect a tax on capital, but a very efficient one. It is one of the few things that the Prime Minister and Chancellor Rishi Sunak has insisted on raising, in contrast to his predecessor as Chancellor, George Osborne. Wealth, on the other hand, is owned by individuals for their disposal. The proposed property tax is a tax on wealth, not capital, unless it is applied to businesses too. That applies to Capital Gains Tax too (demonstrating that the word “capital” has yet another nuance when applied to taxes). Where the proposed extra tax on property rent sits is ambiguous.

The second word of caution comes from Modern Monetary Theory (MMT). This way of looking at things seems to be currently out of fashion, but I think that it captures many economic realties quite well. Supporters of MMT suggest that the main purpose of taxes is to manage demand in the economy, to prevent excess demand leading to inflation. It isn’t to manage the national debt, which can be paid off by creating money – if that is under national control, as it is in the UK. MMT was popular on the left once because it was suggested that the country could expand public spending without raising taxes, because inflation was dormant. Alas the excess spending across the Covid pandemic has led to inflation, showing that the inflation constraint is a real one, even if the national debt wasn’t – though to be fair that is also because the pandemic and other factors, such as the Ukraine war, constrained supply. The problem is that taxes on “work” (or spending, such as Value Added Tax) are much more effective at this demand management job than are taxes on wealth, as the wealthy spend a much lower proportion of their assets on consumption. So taxing more on wealth to tax less on incomes is in practice a much trickier exercise than it might first appear. Which is not to say that there aren’t good reasons to tax wealth, of course. It is good for managing the national debt (which is harder some supporters of MMT appear to think) , but much less so for funding increases in public spending.

But the main problem with Mr Lambert’s proposals is that they clearly haven’t been thought through. The country is surely sick of half-baked policies that turn out to be nightmares (Brexit, NHS reform – don’t even mention Liz Truss). The new property tax and the tax on rental income are radical changes which raise a lot of important questions of detail. Council Tax may be awful, but it contains a warning. There has not been a revaluation of the tax since it was introduced 30 years ago because of the political and logistical difficulties. How are property valuations to be determined and maintained? Then there are other questions: how would business assets be treated? Wouldn’t it be better to tax land values instead (there is a long history of advocacy of Land Value Tax)? And tax on rental income? What about properties owned by companies? And what would be the impact on rents and the availability of property to let? Mr Lambert can point to no major piece of research that tackles the details.

The fuzziness of such details would make the policies very easy to attack should Labour try to adopt them – and in fact they would take years to design and implement. The best way for the Labour leadership to take them forward is to propose them after they take power, as part of a comprehensive review of taxes to make the system fairer, and use the full resources of government to design them – and then put them to the country in the election after next. Meanwhile they wouldn’t need to even put the idea into their manifesto. Raising tax on capital gains is another matter – this has gone up and down periodically, and could be done relatively easily. And it would be not at all surprising if Labour did this in government. But there’s no need to highlight it now.

Which brings us to the high politics. Alas opinion polling on subjects like this that are not a matter of intense national debate are nearly useless. I can draw a parallel with electoral reform. In polls most people supported the idea: until a referendum in 2011 made it politically contested, when it was crushed. The political problems is as ever, is what people are now starting to once again call the petty bourgeoisie (or petit bourgeoisie if you prefer). These are self-employed people, or others who aren’t tied to major businesses or government agencies, who have the idea that they have made their own way in life with little help from government. They are electorally decisive but sceptical of big government and taxes of any sort. The political right are absolute masters of presenting taxes on the very wealthy as attacks on this group. This is why the Labour leadership are treading so carefully on tax. They think they are going far enough already by proposing changes to the taxation of private schools and non-domiciled taxpayers.

Harry Lambert’s ideas just aren’t ready to present to the electorate. That is the reason that the Labour leadership will ignore them – and wait until they have the resources of government to develop them.

*Readers might consider this cheeky as my own articles aren’t short by journalistic standards – but I don’t like things very short either!

Why the language of economic growth is obsolete

Screenshot from the Bank of England’s Explainers

I apologise for not posting for some time. Feelings of futility and despair at politics have made gardening and painting model soldiers a more attractive pastime. I started an article last week, but this collapsed in a muddle. This time I want to step back and set current debates over the political economy in the broader historical context – to suggest that we need to adjust our expectations to profound changes to the way economies work. Above all this means letting go of ideas about economic growth and all the baggage that goes with it. The implications for our politics are profound.

Economists sometimes like to portray their discipline as the description of immutable laws. They show tables of statistics (or rather graphs – see above) going back centuries – with uniform metrics such as income, prices and productivity. The idea is to present the economy as a continuum, even if as the world behind it changes. This might lead us to think that the tools of economic management are of timeless relevance. What if Keynesian demand management had been discovered earlier! But this is really an attempt to project the present back into history. The world has been changing profoundly over the last three centuries and the economy with it. With these changes come changes to our ideas of what economic management is about, and politics with it. But the process is slow and complex, and it can be hard to appreciate it at the time. That’s why I think it is helpful to paint a picture of how things have changed in the past, to give an idea about how things might be changing again now. I like to rationalise the past into a series of epochs – but, of course, each each moved seamlessly into the next. This narrative is based on how things were in Western Europe in particular, and by extension its colonies in North America.

The first epoch was the Age of Subsistence, from Medieval times into the 18th Century, which was overwhelmingly agricultural and marked by stasis. There were important technological developments, and the changes to trade patterns also had important impacts. Textiles, mining and iron working played a role, leading to occasional local booms and some nice stone buildings for us to see today. There was sufficient agricultural surplus to support a number of cities and towns. But the overall picture was fairly static and based on agriculture, mostly of a subsistence nature. The vast majority of people worked on the land in a very low-productivity agrarian economy. The big political idea was that people should know their station and not get beyond themselves. The idea of abolishing poverty was considered to be delusional nonsense. God created a world ever divided between the aristocratic rich and the peasant poor, and that was that.

Then came the Industrial Revolution, which was initially based on textiles and agriculture. Farming became more efficient, not so much directly from changes in technology, as from the application of scale economies, with enclosures and evictions. Agricultural surpluses could be moved by canal, and the cash economy expanded. Labour moved to textile mills, where mass production techniques were developed. Also at this time slave labour was used in overseas colonies to produce such products as sugar, tobacco and cotton. Trade grew in importance and a substantial middle class emerged. Social mobility became more of a feature of society. A lucky few managed to climb from working class to middle class; an even luckier minority of middle class people aspired to the aristocracy. But the labouring classes saw no improvement in their lot. There was no move to reduce poverty. But the new middle classes questioned the ways of the governing elites and this had a profound political impact – most notably be the American and French revolutions – but also with such things as the anti-slavery movement in Britain.

This moved, in the 19th century, to the Age of Heavy Industry. This saw the rise of railways and steel. Infrastructure (railways, ships and sewers for example) and armaments became the centre of attention. Right though until the middle of the 20th Century, economic success was measured in terms of the rise of heavy industry. Hermann Göring’s statement that “Guns will make use powerful; butter will make us fat,” summed up the way that most people thought about economic policy. Stalin’s building of Russian heavy industry at the cost of millions of lives was generally considered to be tough but rational. But improving the lot of the poorest did start to command political attention, as working class movements rose. Sanitation improved, free education was offered to all, and a welfare state started to emerge. This age culminated during the Second World War, which was largely decided by industrial production. But it quickly morphed into the Age of Light Industry. Many of the technological developments forged in the war, such as plastics, turned out to have applications in consumer products. And the need to switch away from war production offered the opportunity to greatly expand the production of mass market consumer goods. Pretty soon mass consumption was considered to be the top priority for the political economy. The concept of economic growth was developed to reflect this and the prospect of abolishing poverty. The West won the Cold War because the Soviet empire could not compete in the production of consumer products, and its leadership lost confidence in their raison d’être.

Something else profoundly important developed alongside the consumer economy: the rise in the role of the state. The state greatly expanded in wartime, intruding into all aspects of life. People noticed that rationing meant that austerity in the nation as a whole did not mean that the poor had to starve – indeed nutrition for the poorest improved in Britain. This vindicated a role for the state in providing a social safety net, with health insurance, unemployment pay, expanded pensions and so on. Productivity was high enough for agriculture and consumer goods that there was room for a growing state sector. Politics became managerial, with politicians promising to offer prosperity to all. Social mobility exploded.

But the world has moved on. Many noted a major change in political and economic thinking in the 1980s, following he economic travails of the 1970s. There was a push-back on the growth of the state and on organised labour. De-industrialisation started to take hold as productivity continued to advance in manufacturing. The rise of Asia, starting with Japan, offered gains from trade as cheaper manufactures could now be imported. But growth in consumption still dominated expectations. Manufacturing industry was still considered to be the core of the economy, much as agriculture would have been in the 18th Century.

How things have changed… More from the Bank of England article

To understand how things have changed, consider a few things about the world around us, in developed economies. First are the signs of saturation in consumer demand. Of course there are plenty of people struggling with the basic necessities – but they are a minority. Meanwhile people buy cars absurdly over-specified for their needs, and leave them parked outside their homes doing nothing most of the time. People buy clothes to wear once or twice before they are discarded. Much of people’s wealth is spent chasing things that are not made – notably land for homes, even if just for temporary residence rights. A lot of “consumption” is in fact about the acquisition of status symbols.

Then there is the idea that consumption is actually bad for us. Environmental degradation is one example; climate change is another. And then there is health. Highly processed foods, where agriculture and manufacturing meet, are clearly damaging to our health, and one reason that life expectancy is now in decline. And yet to economists they are ideal commodities: based on high productivity and promoting over-consumption, and thus with beneficial economic impacts. Better off people increasingly choose products that are healthier with reduced environmental impacts (though still prone to massive over-consumption) – but these imply reduced productivity – the biggest crime there is in the Age of Light Industry.

And then there is changing meaning of “quality of life”. Once this meant being able to consume commercially produced things to the maximum extent. But increasingly this is taken to mean working less hard. People take earlier retirement if they can – notwithstanding that many are physically able to work for longer (your blogger is guilty as charged). The recent pandemic has led to an explosion of demand by employees to work from home – even if it means being paid less. Evidence mounts that this reduces productivity, but most employers are forced to compromise. Working longer – or expanding the workforce – is, after raising productivity, one of the core strategies of a growth economy, and it is being thwarted.

Consider health care too. This comprises a growing share of the economy (in some places it employs more than manufacturing, I suspect). But it is is peculiarly ill-suited to the sort of quantitative analysis that likes to see things in terms of output and productivity. New therapies are developed; these solve problems that were unsolved before – but often require a greater level of inputs. Demand is insatiable; the share taken of the total economy grows.

And economic growth is slowing, much to the worry of economists. Many of these point admiringly to the more “dynamic” American economy – but Europeans question whether small holiday entitlements, poor life-expectancy, terrible inequality, and high environmental degradation are actually worth it. What if slow growth is the result of the freely made choices by those welfare-maximising agents, beloved of classical economists? Economists and politicians have to adapt to the reality – rather than try to make people behave according to an outdated model. This was the terrible strategic mistake made by British prime minister Liz Truss’s catastrophic regime.

The overall narrative is easy to see if you are willing to look. Technology has so advanced, and environmental imperatives have so grown, that a focus on people’s true interests and wellbeing does not involve increased levels of consumption – and will often lead to reductions. Investments in new, cleaner energy infrastructure will create jobs but not lead to economic growth in the sense that we have understood it since 1945. But where this leads is harder to discern. Politicians are right to worry about the lack of growth. Demand for public services remains high, but the economic model for managing supply and demand is breaking down. The current model is that people pay taxes, which limits demand for private sector goods, allowing economic space for public services. But if demand for private services stagnates or declines, while that for public services expands, this means that taxes have to rise. That is a political challenge – the connection between what you personally pay in tax and how you personally benefit from publics services is a weak one. That becomes even harder if the size of the workforce stagnates or declines because people would rather not work, and have sufficient savings to fulfil that desire.

So far politicians, economists and, indeed, the public at large cannot imagine a way of meeting the crisis in public services without stoking economic growth. The Labour leader, Sir Keir Starmer, says that growth is at the heart of his strategy for government. But it won’t work. And this fact, and its consequences, will dominate politics in the coming decades.

Advances in technology give us the opportunity to continue advances to human wellbeing, even while reducing harmful impacts on the environment. But assuming that this will come abut through economic growth is mistaken. We need a new language to describe the economy. In future posts I will try to develop ideas about what his actually means.

The mood darkens on inflation, but there is no sign of a sensible political debate

Yesterday Britain’s state statistical agency, the Office for National Statistics, released inflation figures for May 2023. The headline figure of 8.3% was unchanged from April, but the “underlying” rate (CPI excluding energy, food, alcohol and tobacco in the above chart) continued to rise. Commentary on the BBC Today programme and in today’s Financial Times was notably dark. There seemed general agreement that the Bank of England would have to increase interest rates, and keep them higher for longer than previously expected. And indeed the Bank raised rates by a full 0.5% later in the day; 0.25% had been widely expected.

Until now two overlapping narratives about inflation had been prevalent among the commentariat. The first, call it “global shock” is that the rise in inflation since 2021 has been essentially a temporary one – driven by higher oil and gas prices, and exacerbated by the war in Ukraine, which affect all developed economies. The thinking was that these would either reverse or get baked in (i.e., drop out of the 12 month statistics). When the prime minister Rishi Sunak set out his five main priorities at the start of this year, halving the rate of inflation came top. The general view at the time was that this target would be achieved without any government action so that the Mr Sunak could take credit for a statistical artefact. While it was popular to criticise central bankers for thinking that inflation would be “transitory” when it first started to rise, it hasn’t stopped many people from thinking that themselves subconsciously. The second narrative, “supply shock”, was a bit more subtle: it was that inflation this time was a supply-side phenomenon and not resulting from excessive demand. The upshot is that the solution is not to crimp demand by raising interest rates, but to wait for the supply side of the economy to correct – indeed raising rates would only reduce the investment needed to fix the problem. The supply side issues referred to included the energy crunch, but also the repercussions of the covid-19 pandemic on supply chains.

These narratives are breaking down, especially as the rate of price increases in services persists. This seems directly related to rising levels of pay, which have also come through in the statistics. While some academics suggest that the “wage-price spiral” of 1970s fame is no longer a major dynamic (see here in The Economist), there seems to be what The FT’s Chris Giles calls a “ratchet”. Pay rates increase in response to energy prices, and this feeds into service costs, which in turn might lead into further payrises. Meanwhile supply side issues do not seem to be sorting themselves out; labour shortages are ongoing. This seems to be particularly strong in the UK. Various things catch the blame for this: EU nationals going home after Brexit; lack of flexibility in the post-Brexit immigration system; more chronic illness; people retiring earlier than expected: take your pick. What is now clear is that if inflation is to be limited something has to be done to limit demand.

At this point the economic illiteracy of the political class becomes evident. Many hang on to the idea that responsibility for managing inflation rests with the Bank of England alone. Some seem to believe that this can be done in some kind of immaculate way without hurting economic growth, or at any rate that there was an opportunity to do this if the Bank had reacted to initial energy price shock sooner. The previous Prime Minister, Liz Truss, seems to have held this view, and now a number of government advisers are briefing the press along these lines. In fact the Bank was following a firm consensus shared by the government, and the political stink that would have arisen if it had tried would have been a sight to behold, with the “global shock” and “supply shock” narratives being widely trumpeted. Now at least people are understanding that “if it isn’t hurting, it isn’t working”, an idea that was widespread dung the last inflation crisis in the 1990s. And yet the hurting seems to be concentrated on one particular group: home-owners with mortgages. Well there are others: public sector workers, where the government is fighting hard to limit payrises, and people living in rented accommodation, as rents are on the rise (although the reasons for the rental problems seem to be complex, with interest rates only one factor). Many others, such as people who own their homes with mortgage paid off (like me) are under no special pressure. All this does not seem to be especially fair.

The political debate around this is laughable. Labour’s priority is to try and blame the crisis on the Conservatives. And yet they cannot point to a clear “told-you-so” moment to show how they might have done anything differently. Neither are their ideas on tackling the crisis now conspicuously different. They give the impression that they would be easier on public sector pay, but not how they would manage the fiscal consequences of this. Their very limited tax raising ideas to cover extra spending would do nothing to manage demand in the economy. The Lib Dems suggest a hardship fund to help the most pressurised home-owners; this is not as mad as the thoughts of some Tory backbenchers to offer tax relief to all people with mortgages – but would still need to be balanced with a tax rise that hurts demand, which various forms of tax on excess profits would not. Supporters of Liz Truss would focus more clearly on various supply-side problems, like the need to build more housing, but wreck this with their advocacy of lower taxes. Instead of this hot air, two particular ideas should be current in political circles.

The first is that we could manage the demand side of the economy more fairly through raising taxes. By this I don’t mean the various tax gimmicks that opposition parties try out which could raise funds without hurting most people (windfall taxes, taxing rich people’s perks, non-doms, and so on) – as the “if it’s not hurting, it’s not working” mantra applies here too. It means putting up taxes on the big three – income tax, VAT or National Insurance. In practice, that means income tax. National Insurance lets rich pensioners off; VAT is too hard to explain when trying to fight price raises, at its short-term effect is to increase inflation. To be fair, the government is raising income tax by refusing to raise allowances and thresholds, causing “fiscal drag”, though they don’t want to draw attention to this. But more needs to be done – and if it was, there would be less pressure on interest rates.

The second idea is to suggest that inflation might not be such a bad thing after all, if it means a rebalancing of pay to those currently earning less. This would flow from policies to limit immigration of lower-skilled workers, for example. The corollary of this would be to temporarily raise the Bank’s inflation target, and to find ways of cracking down on profiteering by businesses (so that the benefits of laxity went to the workers, not business owners). That, incidentally, is a bit harder than it might seem, as one of the side-effects of inflation is to create false profits from the time lag between paying for inputs and billing for outputs. That would be a distinctly socialist approach, but surely no madder making mortgage holders bear the brunt of the fight against inflation. A bit of dialectical debate around this idea, and that of tax rises, would do no harm. But both are politically toxic.

High inflation, and increasing hardship for a growing number of people, is the result of multiple problems in the British economy. Strong political leadership will be needed if the outcome is to be a fairer society – which it could be. Alas no such leadership is in sight.

Lower immigration means paying more for public services

“A sensible politcal debate” is surely an oxymoron. Politics is a battle of personal ambitions in which popular prejudices provide the most useable ammunition. If you catch two politicians having a sensible debate, it is away from public attention, about an issue with no real salience. Immigration is an issue of high political salience – and always has been, so we shouldn’t wonder that so little of what is said by politicians makes any sense in the round. But in the end effective policy needs to be based on reality, and a sensible debate is needed to tease that out. Immigration is a case in point.

Immigration is currently moving up the political agenda. This is in spite of the fact that the leaders of none of the major political parties would rather talk about other things, and opinion polling shows that it is relatively low on the list of public concerns. That is because a group of conservative politicians see it as an opportunity to create mischief and further their political careers. The proximate cause are statistics that show immigration at record levels – though these statistics are highly unreliable as data collection is weak. The numbers have been driven up Ukrainian and Hong Kong refugees, the need for universities (and the country at large) to extract money from foreign students, and widespread labour shortages. Each of these causes seems to be understood by most of the public. So what’s the fuss?

There seem to be two main, mutually supporting strands raised by conservative politicians (with Labour leaders happy to echo them in their bid to show their conservative side): cultural and economic. Immigrants are usually culturally distinct (we can argue whether this is true of Australians…) – with different languages, religions and customs, and often maintain distinct communities. This is blamed for corroding traditional British culture. There is more than a tinge of racism here, though it is notable that many of the the leading public conservatives are themselves from ethnic minorities, and these ideas resonate with settled ethnic minority communities. There is plenty of irony here. Immigrants are keeping the churches full and often have conservative social values. One leading conservative politician claimed that immigration was leading to the declining number of people professing to be Christian, when the opposite is true. Of course this person (Nigel Farage) was seeking to exploit the trope that Western countries were being taken over by Muslims. It is easy for cosmopolitan liberals to laugh at all this, so many are the inconsistencies, but the message resonates well with older and less-educated people. There is a real conflict here between the cosmopolitans, typical of larger and more successful cities, and nativists, typical of more rural areas (though my own rural abode of Sussex is pretty cosmopolitan, it needs to be said) and smaller towns. If you take the Brexit referendum as an indictor of how the two outlooks divide (and it is more complicated than that) – then the country is split fairly much 50/50. It currently helps that, apart from the Ukrainains perhaps, the bulk of existing migrants tack onto communities that are already well established here – Indian, Chinese and Nigerian in particular.

Because of the clash of cultural attitudes, and the need to draw support from both sides, perhaps, most politicians choose to make their main arguments on immigration in terms of economics. It is said that excessive immigration is causing public services to be overstretched, exacerbating housing shortages pushing up property and rental costs, and pushing natives out of decent jobs, or at least pushing the level of pay down. The public services argument is the least serious. Public services are often amongst the most dependent on immigrant labour, and would be under even more strain if immigration was reduced. But a local influx can cause problems, and the system can be slower than it should be to adapt.

The argument on housing is more convincing. Pretty much everybody agrees that the supply of housing is failing to keep up with supply – though new housing developments seem to be popping up everywhere I travel to. After that vested interests take over, and it is very hard to get an objective take on things. One group of people blames restrictive planning laws which stop new homes being built, especially on rural and green belt land. The other side says that this would simply give developers carte-blanche to build lots of poor quality houses in ecologically vulnerable beauty spots, together with some high-end properties to act as stores of financial value for footloose foreigners. Clearly high levels of immigration make the problem worse – but the middle ground between developers’ search for an easy profit and nimbies trying to protect the value of their existing properties is largely uninhabited – and draws little serious, well-funded research. Economists tend to side unthinkingly with the developer lobby. Politicians may talk as if they are in the middle ground, but lack well thought-out policies that might do any good, and I’m practice end up at one of the extremes. Arguments over immigration just add grist to the mill. It is very hard to understand the implications of immigration strategies for housing without having a clearer idea of about housing strategy. But it clearly doesn’t help.

What about immigration and jobs? Recently changes as a result of Brexit caused a shortage of lorry drivers. Their pay shot up as a result; training schemes were upgraded, and more locals are now taking up the work. This is exactly how conservatives arguing for lower immigration say things should work. Using immigrant labour is an easy shortcut – but we would be better off we raised pay and brought more locals in to do the jobs. This is the vision conjured up by the Tory former leader Boris Johnson at the last election. But there’s a problem. This should mean that public sector wages need to be raised to help draw more people into the workforce. And yet the government wants to do the opposite: to use inflation to reduce real levels of public pay, and use the resulting surplus to fund tax cuts. They do this in the name of reducing inflation – but offer no long term solution to the problem of public sector pay. In fact a rebalancing of the economy in favour lower paid jobs will surely result in a degree of of inflation. It may also require taxes to be raised. The issues are quite complicated here, but a limited supply of labour creates something of a zero-sum game. Raising wages for the lower-paid is going to hurt somewhere.

Politicians sometimes talk about the need to improve training so that more locals can do jobs where we currently need immigrant labour. This clearly won’t work for things like fruit-picking, but is more convincing for doctors, nurses and social care workers. The problem here, as Stephen Bush of the FT points out, is that skilled labour is mobile, and the freshly trained workers will simply gravitate to where the best paid jobs are – which are often not in the UK. It is putting the cart before the horse. As the case with lorry drivers shows, if you fix the pay issue first, training is a much easier problem to solve.

The big, unspoken issue lying behind the fuss, is the country’s demographic development, with retired people taking up an increasing share of the population, while at the same time driving up demand for public services. Immigration is the obvious answer to this problem, though not in the long term, as the immigrants themselves will retire. If immigration is not the answer, then what is? Politicians place hope on increased productivity – but for a number of reasons this will not cut the mustard. The areas where productivity needs to advance to make the sort of impact required – in health care and social care services – seem to be those with the fewest practical proposals. Indeed, health and safety worries tend to push them in the opposite direction. Big investments in hi-tech factories may be a very good idea, but they will make little difference to economic growth overall, and impact the labour market even less.

The idea that the country should limit immigration is a perfectly respectable one. But it has a cost – we must pay more for critical services that are subject to labour shortages. That will involve a rebalancing of the economy and some painful economic adjustments. It would help if more people would talk about what this, exactly, means.

Banking crisis: are we in 2008 again?

The US Federal Reserve.
Picture: By AgnosticPreachersKid – Own work, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=6282818

The more people pop up to say that the situation in financial markets is not like 2008, when the Great Financial Crisis got going, the more we will worry. But while a crisis like that of 2008-10 looks unlikely, a prolonged period of wealth-destruction is in prospect.

The current bout of nerves comes from the collapse of two mid-sized American banks, and from a globally big one: Credit Suisse. Technically Credit Suisse hasn’t gone bust – it was taken over by Swiss rival UBS. But shareholders were bought out very cheaply, and some bondholders were wiped out in a move that has raised a lot of eyebrows. This follows a period of tightening monetary policy, responding to a period of inflation – after a prolonged boom based on very low interest rates. There are many parallels here with 2008. But the differences are striking too.

It’s worth taking a deep breath, stepping back, and trying to get a broad view of what is happening. At issue is the financial system – the world of money, rather than the “real” world of things and services – though there is quite an element of the real directly tied up in finance, which is a substantial employer in many economies. Money is a means to an end, and not an end in itself – in principle anyway. Because of this, economists, especially the macro sort, tend to ignore it, or treat it in a very cursory way with very basic models for money supply. And yet money is essential to the modern way of life; we can do little without it. If the financial system seizes up, disaster strikes. The episode that looms most over economists is the Great Depression of the 1930s, when some little local difficulties within the financial system were allowed to explode, causing mass unemployment. In a depression, lots of people want to work, but can’t; and lots of people want to buy goods and services that employ people, and can’t either. It is a colossal social waste – and one that in the 1930s fed into racism, fascism and ultimately war and genocide. The financial system matters.

At the centre of the financial system are banks. In the days of Henry VIII the monetary system was controlled completely by the state, which had a monopoly on minting coins – and the state has always played a central role in the financial system. But these days money means bank accounts – the role of notes and coins is negligible. Because of their critical role, banks are heavily regulated, with a central bank, accountable to the state, playing a keystone role. Banks provide access to money, but what do they do with it? They can just park the money with the central bank, but they will make no profits that way. So they find various ways of lending it out – further, they may create money through their lending. They make loans directly to members of the public and businesses and to governments, sometimes on a short-term basis, sometimes for terms of many years. This creates a source of instability – if the the public withdraw their deposits, the banks may not be able to liquidate their loans fast enough to give them their money back. But this “maturity transformation” is generally profitable, and it is at the heart of a healthy economy, which allows resources owned by people that have too much to be used by those that have too little.

So far, so good. This is as far as classical economists got. Interest rates are set by a process of supply and demand between lenders and borrowers, spiced up by credit risk. More modern economists then added in a role for government/central bank intervention – monetary policy. By one means or another the government could tighten or loosen monetary conditions, mainly through setting interest rates, or through “quantitative easing” (QE) – the creation of money by the central bank buying bonds through its reserves. In many accounts monetary policy brings back the idea that the government/central bank controls money like Henry VIII and the Royal Mint. The process of QE is often referred to as “printing money”. This conjures up a happy picture of a world of governments, consumers and businesses buying things with banknotes, with banks making loans to cover investments in houses or industrial machinery, or to smooth ordinary cashflow fluctuations of businesses and the public. It is at least easy to visualise this world, but, alas, too many people who should know better seem to get stuck in it.

The trouble is that we don’t use banknotes any more. And banks lend to a range of financial intermediaries rather than to “real” people and businesses; businesses and governments don’t borrow directly from banks but via these intermediaries, often through tradable instruments – “securities”. This creates the modern financial system, and instead of being a simple machine for the transmission of funds from “real” lenders to “real” borrowers it becomes a merry-go-round of speculation fuelled by the chance to make money from trading securities. Money becomes an end in itself, rather than mere lubricant. One spectacular example of this are fans of cryptocurrencies such as Bitcoin, touted as alternatives to “fiat money” created by central banks. They meet scepticism with the rejoinder “Have fun staying poor”. The point for them is to make money as intermediaries, not facilitate financial transactions. The money merry-go-round becomes a complex frenzy when monetary conditions are loose – when banks have more deposits than they know what to do with, either because there is a lack of serious lending opportunities, or because of “liquidity risk” – the risk that depositors will suddenly withdraw their deposits. At this point banks seek out opportunities for short-term speculations based on securities or short-term loans to financial intermediaries.

This was the situation in the run-up to 2008. Monetary conditions had been very loose. The narrative on why this was so varies. Many of a libertarian bent blame irresponsible monetary policy by the developed world central banks trying to fight deflation while asset prices were in a bubble. This was through low interest rates – only in Japan was there serious QE. Others point to the entry of China into the world trading and financial system with its huge excess saving. It brought in vast quantities of funds from its exports, and only used a proportion of these to buy imports, depositing a surplus of money in developed country financial markets. An oil price spike added to this with oil producers generating a similar financial surplus. Banks then had the headache (though mostly they thought of it as an opportunity rather than a problem) of where to put this surplus money and how to make a profit. Quite a lot of money went into sub-prime lending in the US property market. German banks, and others, happily lent money to the Greek government, which had entered the Euro and was fiddling its financial statistics. There was a frenzy of securitisation as banks sought to evade their regulatory straitjackets. It was like picking up pennies from in front of a steamroller. One thing I find striking from reading up my observations at the time was how much “risk management” featured in the jargon of bank professionals. They gave the impression that they had sophisticated risk models which meant that the massive profits they were making were simply the result of increased global productivity from the more efficient use of resources. There are still commentators that look back at the statistics of the mid-noughties and ask why productivity growth has slowed since then – insert pet theory here. It was a work of fiction – the trend in lost productivity growth in the developed world goes way back to way before the financial crash. Massive amounts were being lent off bank balance sheets supposedly to long-term investors like insurance companies. In fact the money was going round in circles amongst thinly capitalised intermediaries which often came back to haunt the banks themselves.

It couldn’t go on forever. Central banks increasingly felt they had to do something about loose financial conditions, especially as that oil price spike was causing headline inflation. In early 2007 the US sub-prime market started to show strain. Then in August 2007 the financial system broke when the interbank market – banks lending to each other to manage daily fluctuations – froze over. The complexity of financial securities meant that nobody knew who owed what to whom. I wrote this in September:

The ship has hit a reef below the waterline.  There isn’t much visible sign at first; the ship slows down; it has a slight list, perhaps.  But the crew looks worried even as the captain voices reassuring words to the passengers.  Will the watertight compartments limit the damage until the ship makes it to port for repairs?

The ship limped on for more than a year, as market professionals and commentators went through the process of denial and then attempted to negotiate with their fate. And then the collapse of Lehman Brothers in October 2008 created a free fall. If governments had not indulged in massive bailouts of the system, the 1930s might have been repeated with institutions essential to our way of life going down. Alas that meant many undeserving people made out like bandits. The crisis kept going for two or more years, with the drama moving to the Eurozone in 2009.

So how do things compare in 2023? We are similarly in a period of monetary tightening following period of very loose policy, this time featuring the heavy use of QE in every major developed country market. Things were loose before the Covid pandemic struck in 2020, but this stayed the hands of central bankers, and unleashed a flood of fiscal intervention by the government to offset the effects of lockdowns as well as the direct impact of the disease. And then Russia started a war with Ukraine which completely disrupted the markets for oil and natural gas, forcing yet more fiscal interventions. This loose policy similarly unleashed a riot of financial speculation. But it is different this time. Banks are better regulated, though regulation of mid-sized banks in the US is still too light. There seems to be a lot less off-balance sheet lending. Paradoxically it is good thing that banks don’t tout sophisticated risk management these days – in 2007 this was justification of excessive risk. But inflation is much higher, and nominal interest rates have gone up much more, with big losses on government (and other) bonds that was not evident in 2007-08. This played a critical role in the demise of Silicon Valley Bank. Others presumably have similar exposures. There may be no substantial sub-prime market in the US, but many are worried about US commercial property lending.

And then there is the madness of cryptocurrency. I have not written much on this craze of the last few years. It is such deep, multi-layered nonsense that I couldn’t bring myself to take it seriously enough to write about it. The problem is that more respectable institutions started to take the phenomenon seriously and lent money to facilitate speculation. One of the biggest blots against current British prime minister and former Chancellor Rishi Sunak is that he wanted to make Britain a crypto hub. This is going predictably badly – an idea billed as an escape from the the tyranny of fiat money turns out to be even more dependant on fiat than fiat money itself. I understand that it contributed to both US bank collapses.

But the biggest difference between now and 2008 is that in 2023 we are in the shadow of the Great Financial Crisis, which remains in recent memory to those in charge. This is evident in the extraordinary level of intervention by the US Federal Reserve, in effect guaranteeing all bank deposits, even those outside the scope of deposit insurance. This has prevented such spectacular events as the freezing of the interbank market which led to my holed below the waterline image. A more apt image is the one conjured up by FT columnist Megan Greene: Schrödinger’s cat. We don’t know whether the system is stable or not – so it is both at once.

The striking thing is that with each crisis in the financial system the power of the central banks seems to grow. At the start of the 20th century the Americans didn’t even think they needed a central bank. Now the west seems to be converging with communist China in the use of both formal and informal state power. But power does not necessarily mean control, and the Federal Reserve especially is confronted with a series of very difficult choices. Inflation remains rampant but the banking system is fragile.

As I reflect on this the more it seems to me that the modern banking system is not fit for purpose. Steadily essential parts of the system are being nationalised. We are slowly moving to a system whereby deposits are in effect placed with the central bank – something which is happening rather rapidly in the US as the Federal Reserve gives support to money market funds. How, then, do banks fund loans? This is a role that central banks are ill-equipped to perform and should not be nationalised beyond a few specialist agencies. I guess they will need to provide longer term investment products – but the transition is bound to create casualties – and destabilise the banking system.

For now though we must expect this period of wealth-destruction to continue. Bank deposits may be safe, but inflation is eating their value away, as the prospect of positive real interests diminishes. Bond markets are undermined by the cessation and reversal of QE. Share markets need a growing economy. A weakened financial system will undermine property prices. And yet unemployment is low, minimum wages are in place and there are strong social safety nets. It is, surely, the wealthy that are being squeezed. That is not a bad thing.

Productivity, growth and wellbeing – the awkward triangle

Two recent developments have tickled this cynical old veteran of office work. There was a successful trial of a four day working week. And there is general excitement at the latest thing in Artificial Intelligence – ChatGPT (generative AI, apparently). Both seem to point to improved productivity. But if that’s true it doesn’t follow that economic growth will result.

To my cynical mind office work can be divided into two broad categories: problem-solving and bullshit. The latter seems to take up most of people’s time: talking about solving problems rather than actually solving them. In any office-based environment remarkably few people in organisation actually seem to be productive problem-solvers. The others supervise, communicate, convene meetings, make calls, write presentations, set deadlines, monitor project plans, strategise and so on. Doubtless a lot of the activity I am describing as bullshit contains an element of necessary work, but it often doesn’t feel that way.

So it’s no surprise that some businesses have found that they can reduce office hours without impacting adversely on output when implementing a four-day week. The saving seems to have been in the region of four hours in a five-day week – four eight-hour days making up for five seven-hour ones, for example, though that’s a saving of three hours. ChatGPT, meanwhile, automates the production of bullshit. It manufactures a lot of plausible but unreliable verbiage that you would be unwise to stake much on. Since producing such verbiage is what so many people spend such a lot of effort doing, it’s not hard to see why people are getting so excited. Both ideas offer ways of spending less time doing pointless things. So productivity should improve.

But, of course, it is much harder to see how either invention increases the production of useful things. The idea of a four-day week isn’t to give people the time for side-hustles. The idea is that people get more time for unpaid domestic things (“leisure” is probably an mis-description of this). The study reported high levels of improved wellbeing among employees – which was seen as the main benefit. As for ChatGPT, it’s not meant to solve tough problems or make hard professional calls – the things you most want service providers to do for you – or provide the warmth of human company, though doubtless some people hope that it will help robots to do that job, it sounds a poor substitute.

Doubtless I exaggerate. But there is a more substantial point here. A lot of improvements made to workplace efficiency – improved productivity in economic speak – won’t have much impact on the sort of economic growth you can measure in money and tax – the holy grail for economists and politicians. But that doesn’t mean that people won’t be better off. Wellbeing and per capita economic income or consumption are quite different things. Some people have been saying this for quite a while – Professor Richard Layard for one, and he still is. I met him when I was part of a Liberal Democrat policy working group looking at the issue more than a decade ago. Lord Layard’s big idea is to use self-reported wellbeing as a measure of progress. I am more sceptical – I don’t think the measure is robust enough to do heavy lifting, though it is interesting nevertheless. Still I wish politicians would take up the mantra of improving wellbeing a lot more. The Lib Dem policy paper I co-authored was adopted as official policy and then forgotten. But people are voting with their feet. If growth is slowing because people are opting out of the money economy and improving their health and wellbeing, then that’s to be celebrated. Economists rarely consider this possibility, though. And Conservatives who advocate cutting taxes don’t suggest this so that people can afford to work for fewer hours – though this could be the result. Indeed they think it will increase GDP rather than reduce it.

In my youth I remember a story of some western development experts and going to an African rope factory. They gave them a machine that improved output per poker ten-fold. A year later they returned and were surprised to find the factory empty. “Why aren’t people working,” they asked. “Well, we finish the production in an hour, and then everybody can go home,” was the replay. Doubtless the original story was play on African stereotypes, but even at the time, we weren’t clear the the joke was supposed to be on.

The goal of advancing wellbeing while economic growth remains lacklustre is a perfectly feasible one. Improvements to workplace organisation and continued automation have their part to play. But public services and infrastructure can be better directed towards this goal too. And political reform to reduce the feelings of powerlessness will also help. This remains a long way off – but eventually public pressure will force it. If the four-day working week starts to take hold, it will be a major step forward.