Economics & Finance – Page 16

Pensions, savings: sensible steps forward

This week’s UK Budget has revealed the usual muddle amongst politicians, journalists and the public over the whole issue of pensions and savings – with opinion strongly favouring several flavours of having your cake and eating it. This masks some profound and sensible reforms carried out by the coalition government.

First version of the cake. We like people to save. But we want them to spend to promote economic growth. We worry that a large part of the population will become dependent on the state and taxes because they save too little. But when they do, as in the early part of the 2008/09 crisis, we bemoan that fact that people aren’t spending and so causing economic slump. So interest rates crash to the floor in an attempt to reduce savings and increase consumption (alongside the vain hope that companies will be encouraged to invest more).

Next version. We want people to save more to not be dependent on the taxpayer, but we also want target state spending on the less well off, and tax the rich to pay for it. So we encourage people to save, and then confiscate the proceeds.

Another version of this is that we love the idea of exempting pension saving from tax but think that people who have accumulated sufficient savings for a reasonable pension (a million pounds for a pension of £35,000, for example) are part of a rich elite whose broad backs should carry the largest burden.

There is a genuine dilemma at the heart of this of course. For that reason a lot of hope resides in get-out-of- jail-free cards. One of these is strong economic growth. But that requires lots of people to work – which means retiring later and allowing immigration. We are clearly entering an era of low growth, thanks to demographics, personal preferences (i.e. people choosing unpaid leisure over work) and the changing nature of technological advance and the global economy. Remarkably few people have tried facing up to the consequences of this. Even some intelligent economists think that “trend growth” is a law of nature. Another get-out-of-jail-free card is that rising property values will compensate for lack of saving. Collectively this cannot make sense, but it has worked for many individuals, who therefore don’t engage with wider worries about the future.

Now let’s consider some difficult facts. I have already mentioned that economic growth is likely to be much lower in future. The next difficult fact is that private pension saving has collapsed in the last 25 years. Generous final salary schemes have been replaced by inadequate money-purchase schemes. It is now use just blaming Gordon Brown’s tax raid on pension schemes in the later 1990s for this (or Mrs Thatcher’s ill advised liberalisation of pension selling before that) and some are prone to do when you mention this. This at worst mildly accelerated a growing trend. The economics of businesses supporting these pension schemes became toxic even without the tax changes. This means that, as a generality, most people will not now have adequate private sector pensions. Instead as they approach retirement they will have accumulated a few tens of thousands of pounds in probably several schemes.

The next difficult fact is that the economics of long-term saving are toxic for all but the very well off (liquid assets of over £0.5m, say). The poor face the prospect of losing entitlements to state benefits if they accumulate wealth. Everybody will see any savings eaten away by costs which, even without a host of rip-offs, will always weigh most heavily on those with smaller savings. It becomes perfectly rational for a lot of people to not to bother with pensions savings – unless you count trying to own your own home.

When you consider all this, the attraction of tax funded state pensions become clear. That is why the current government has been right to make it reasonably generous, notwithstanding criticism form the right that we can’t afford it. It was also right to make this pension independent of private saving.

Now, what about the tax treatment of savings? To simplify, there are three groups of tax privileged savings. The first is domestic property. To buy your own home you pay out of taxed income and stamp duty on the purchase price, but the gain is exempt from tax. The second is Individual Savings Accounts (ISAs), which, like property, are paid for out of taxed funds (subject to an annual limit) but income and capital gains are tax free. And third are pension plans, for which contributions are exempt from income tax, but it is taxable on drawdown.

The first and last of these are problematic. Domestic property because its tax exempt status has made it a highly attractive investment – but instead of this fuelling much in the way of building new, efficient property, it has simply driven prices up, making ownership out of reach for many younger people and driving a wedge between families with property and those without. Pensions are a problem because that particular route for providing tax exemption makes for maximum complexity. In fact they have become so hedged about in rules that most people don’t understand them.

ISAs, on the other hand, have an elegant administrative design which makes them easier to own than even taxed assets. They also have more chance of channelling investment into more productive parts of the economy.

Here’s why this week’s proposed reforms make sense. Currently money purchase pensions are forced to buy annuities, except in some carefully crafted circumstances, which tend only to apply to the better off savers. The original fear behind this annuity rule was the worry than pensioners would blow their savings quickly and then throw themselves into the arms of the state. But the state of private pensions is such that most people will rely on the state anyway, and most pension pots are so small that the amount of income that would be derived from an annuity would be derisory (and, presumably, a lot of value would be lost in administration costs). And those with larger pots are likely to be prudent with their wealth. If done properly, this will simplify the pension system, and make private pensions more attractive.

Extending the ISA allowance is more controversial. Many simply view this as benefiting the wealthy, as nobody else can save up to the £15,000 a year limit. There is some truth to this, but it will help level the playing field between financial investments and owning your own property. Since it is unthinkable to tax capital gains on homes, it may help to make other assets comparable in their tax status.

A lot of nonsense has been uttered as commentary: fears over people blowing money on cruises and fast cars – or rushing into buying property. My main worry is that the reforms will make it easier for better off people to save for their children, to pass on at death. This could reinforce the effect of inherited wealth, which is already growing. There may be mounting pressure to reduce Inheritance Tax.

But overall this looks a sensible step forward – and actually quite brave. It is surely no accident that unlike its predecessors the current government’s Pensions Minister, Steve Webb, really knows his stuff, and has been kept in post for the whole period. Liberal Democrats can take pride that he is one of theirs. There is strong political consensus in his reforms, and no party political benefit. But it is nice to feel that our party has contributed something useful to the process of government.

Economics is in denial. A new crisis builds

When the financial meltdown of 2008 to 2009 occurred, most people said that the science of economics was in state of collapse. And yet conventional economics ploughed on with barely a wobble. To see this you only have to listen to the commentary around central banks, which uses language from old text books, with only slight adjustments to modern jargon, such as “forward guidance” and “quantitative easing”. And this in spite of the fact that monetary economics was at the heart of the failure of economics in 2008. This is leading to false optimism about the prospects for the world economy. It is the economics of denial.

The story so far. The collapse in 2008 exposed gaping holes in textbook economics. Standard microeconomics, with people regarded as welfare-maximising, rational agents, had long been a laughing stock, unless you had to use it to pass exams or get academic papers published. But the crisis showed that macroeconomists were not paying much attention to the financial system – and yet the crisis that unfolded had finance at its heart. And the question of how wealth and income was distributed was treated as an afterthought, with the real attention being on how aggregated statistics (like GDP and inflation) behaved. For these reasons, most economists failed to see the crisis coming, and they failed to understand how long-lasting the following recession would be.

To be fair, many at the fringes of economics are asking deeper questions. I get a glimpse of these through The Economist’s Buttonwood column (written by Philip Coggan). In this week’s print edition he reviews a book by fund manager George Cooper which tries to rethink economics. Mr Cooper sees the world in terms of social competition – which has the virtue of putting wealth distribution at the heart of the narrative. I am debating as to whether to buy this book- but I have been disappointed in this genre of writing on economics – long on criticism of conventional wisdom, short on substantive new ideas.

But on Monday Mr Coggan looked at another book, Capital in the 21st Century by the French economist Thomas Piketty. This book, published in French last year, with an English version about to be released, is in a different league. It has the weight of data behind it, and some serious thinking. It could conceivably change the direction that conventional economics takes. It puts distributional issues at the heart of economics – which is surely where it should be. Mr Piketty suggests that if economic growth slows down, the elites who own productive assets accrue a disproportionate share of the wealth. We are in just such a slow growth era now in the developed world, mainly because of demographics, but also because technological advance does not seem to be translating into higher economic productivity in the way that it used to. I am rather afraid that I will have to buy Mr Piketty’s book, even though I already have a substantial backlog of reading.

But none of this stops the incessant chatter around monetary policy and growth statistics. The narrative is now that growth in the developed economies has returned, so that we can get back to familiar old track of steady economic growth (about 2% a year). Asset prices have jumped. And yet the fundamental problems that led to the last financial crisis have not been fixed.

Now let me develop my personal take on the world economy, building on some of the ideas that these authors have raised.

The fundamental problem of the developed world economy is that a disproportionate share of the wealth is accruing to a small elite. This may be because of globalisation and newer technology. It may just be a fundamental law of economics that was concealed by temporary factors in the 60 years after 1945 (as Mr Piketty seems to be suggesting).

Many would consider this to be problem in its own right. But it also creates a wider problem. The rich elite does not spend all that it earns. This, as going back to the circularity of economic flows that forms the basis of macroeconomics, will cause the economy as a whole to shrink. The textbook way in which that shrinkage is prevented is if the surplus earnings (aka savings) are channelled into investments; indeed basic economics holds that savings equal investment as a law of nature (with the dread qualification of “in equilibrium”). But this investment involves giving people jobs to do real things – like building ships or factories or even just houses. It does not work if the investment is simply a financial merry-go-round chasing speculative profits – or bidding up the prices of pre-existing assets such as land. But this is exactly what is happening, and a burgeoning industry has been created to support it.

But there are two other ways to stop surplus savings from causing the economy to shrink. The first is to lend money to the not-so-well-off to support a lifestyle beyond their financial means. We have witnessed this, strikingly in the USA, since the 1990s. The second is for the government to make up the shortfall in demand by running large deficits. This is what took over after the crisis. The trouble is that neither path is ultimately sustainable. Both cause the build-up of debt that cannot be repaid, and onto a crisis of default, involving the mass destruction of financial assets. That process of default comes in quite a few guises: hyperinflation, revolution, depression – with war often associated. This is what the developed world experienced between 1914 and 1945. The wealth of the elite is destroyed, with substantial collateral damage on the poor. And then we start the process all over again.

Is disaster inevitable? No. A conventional economist would offer two ways out. First we could switch those savings from the merry-go-round to real, productive investment. Second we could generate economic growth through increased productivity and further globalisation, and with new wealth generated outside the property-owning elite.

But I’m afraid there is a fairy-tale quality to these ideas. There is only a limited amount of potential commercially-worthwhile investment out there. It is difficult to understand how rapid productivity growth can happen in developed economies. This leaves us with the need for tough political action, to pre-empt disaster by forced redistribution of the elite’s income and assets.

Once conventional economists start recommending these sorts of strategy, rather than treating them as suicidal, we will know that they are making the transition. This is happening only at the fringes at the moment. Meanwhile we are sailing serenely into the next financial crisis.

It will probably take this next crisis to shake things up, and finally break the world of denial that most politicians and financial professionals currently inhabit.

Re-shoring: good news that does not make us feel better

The British economy is perplexing economists. The economy as a whole is growing but we as individuals don’t seem to be any better off. Unemployment tumbles but pay stays rooted to the spot. This is called the “productivity puzzle”. Added to this puzzle is the phenomenon of “re-shoring”: the reversal of offshoring, the process by which manufacturing and services were migrated abroad, typically to China or India. David Cameron, the Prime Minister, made a speech promoting it last week. It is worth stepping back to think through just what is going on.

After all, when offshoring was popular, in the years of the Labour government from 1997 to 2010, it was hailed as a good thing in the long term, worth a little disruption in the short run. It meant that prices for goods and services were kept down, and therefore our collective living standards improved. Looking at the components of retail price inflation in the 2000s told quite a startling story: prices of manufactured goods were actually falling. Locally produced services could advance in price by 4% or so, and the Bank of England could still meet its 2% inflation target. That 4% reflected the advance in average pay – so advancing living standards were largely explained by lower priced imports. Offshoring was a very important part of this phenomenon.

And this conformed very neatly to the elementary economic theory of Comparative Advantage, first explained by 18th century economist David Ricardo, and part of any first-year economics course. This says that the benefits of trade arise from differences in opportunity cost, or comparative advantage, and not actual cost, or absolute efficiency. The Chinese had a comparative advantage in basic manufacturing; Britain had a comparative advantage in high-end services. So, even if British workers were more efficient than Chinese ones in basic manufacturing, it still made sense for Britons to import from China – and both countries drew benefits. Trade between the developed and developing world follows the predictions of Ricardo’s theory very closely. And supporters of globalisation, like the Labour big beast Peter Mandelson, pointed this out endlessly.

But economists rarely follow through the logic of Comparative Advantage. If two identical economies have identical opportunity costs for different goods, there are no gains from trade (not on the basis of this theory, anyway). Trade arises from differences in the shape of economies. Since developed and developing economies are very different, big gains from trade are to be expected. But what happens as the developing economy starts to catch up with, and resemble the developed one? The gains from trade reduce. I have taken the trouble to work this out with a crude model of a developed and developing economy. The catch up process is marked by an appreciation of the developing country’s exchange rate, so that it converges with purchasing power parity. The interesting thing is where the loss in gains from trade falls. The developing economy becomes more productive and efficient, so its losses from reduced trade are made up for by gains in productivity. But for the developed economy, there is no corresponding level of compensation; the gains from trade disappear and the economy is worse off as a result.

And this is exactly what seems to be happening now. China and (in a rather different way) India are catching up; their exchange rates appreciate relative to ours. Their wages rise faster than ours. The gains from trade disappear, and it is the developed countries (us) that pay the price. Re-shoring is simply part of this process. The great gains from globalisation prove to be quite temporary, in this respect at least.

But as China and India catch up with the West and Japan, won’t other developing countries take their place, just as China and India took the place of South Korea and Taiwan? Vietnam, Indonesia and African economies stand ready. But these emergent economies are as interested in dealing with China’s and India’s vast economies as they are with the developed world’s. The world is rebalancing and the old economies of the west cannot expect to stay in the driving seat.

So, what’s the bottom line? I think re-shoring is one of the factors that explains Britain’s productivity puzzle. We had outsourced lower productivity jobs abroad, and they are returning. It is good news for employment, and will help balance the country’s trade. It will make the British economy more sustainable. But it will not make us feel any better off.

Britain’s improved growth points to more government austerity

The UK economy has improved dramatically in the last six months. This is one of the most important developments in British politics. This week’s good news on employment is just part of a wide spectrum of measures showing the economy’s improving health. Economic commentary, with its narcissistic obsession with monetary policy, has concentrated on the implications for interest rates. But a more important question I whether the economy’s recovery is sustainable. And the answer to that seems to be… not yet. And while it isn’t government austerity has to be the priority.

The political debate around the economy has focused on the wisdom or otherwise of the government’s austerity policies, designed to fix the country’s massive gap between public expenditure and tax. The Labour opposition suggested that there should be less austerity, and even some temporary tax cuts to try and push the economy into a virtuous circle of growth. But the country is now embarked on just such a virtuous circle without the need for any fiscal stimulus. Additional private consumption is the main cause of this stimulus, according to the latest bulletin from the Office of National Statistics (ONS). This shows that the Labour policy might well have worked (i.e. that a bit of stimulus could set off a virtuous circle), though in the event proved unnecessary.

So intellectually developments have far from proved Labour wrong. But they are the big political losers. Labour’s policy might have been sensible in the circumstances, but they also suggested that the Coalition’s policies were doomed to failure, which has proved not to be the case. It gets worse for them. This level of growth undermines the case for any reduction in austerity polices – which could cause inflation. And yet their hard-core supporters have been rallying to the idea that the cuts in government services and benefits are ideological and unnecessary. Labour have switched their attack to the cost of living, which is still running ahead of personal incomes, but this too runs the risk of being undone by events. Politics is a momentum business, and all it would take is a general improvement in wage levels before the election in 2015 to sink their propaganda offensive. Their poll lead has already shrunk.

Meanwhile press attention has switched to the Bank of England, which has embarrassingly been taken by surprise by the growth spurt. It is not long ago that it suggested that unemployment would not fall to 7% until 2016 – we are nearly there now. I find the focus on monetary policy very irksome though. It allows commentators to pontificate well inside their comfort zone, and talk about short-term developments in financial markets. But, as longer term followers of my blog will appreciate, I think that the usefulness of monetary policy is exaggerated, and the theory behind it has been comprehensively shredded.

Instead the big question should be sustainability. Mainstream economic commentators don’t seem to be that concerned by this. Their analysis is based on the idea that sustainable growth depends on whether or not growth exceeds the trend rate. This trend rate, about 2% per annum, is the average rate of growth since the 1950s, and is primarily driven by a steady increase in productivity. Up to 2007 the UK economy was neatly conforming to this trend. Then the recession hit, putting it well behind the trend rate, with a lot of catching up to do. This sort of commentator often mentions a large gap between the current size of the economy, and what it would have been if it had stuck to the trend – with the implication that this gap is a matter of policy failure. Chief amongst these commentators in my eyes is the FT’s Martin Wolf. In a recent article he dismissed the idea that growth up to 2007 was unsustainable.

This is macro blindness: a failure to question the neat patterns created by aggregate economic statistics. In my view the UK economy cannot sustain a growth rate as high as 2% in the long term, hasn’t been able to do so since perhaps 2000. The reasons are demographics, the changing impact of technology, and a reversal of the gains from trade achieved with the rise of China and India. The main evidence, not mentioned by Mr Wolf in his article, was provided for me in a lecture in 2007 by Professor Wendy Carlin, my economics tutor at UCL. It is the combination of an appreciating real exchange rate and a wide trade deficit. This provides an illusion of growth, but it is not supported by the advances in productivity that are required to sustain growth in the longer term. It was not fashionable to say this at the time, but it proved prophetic. Productivity, incidentally, is an almost impossible factor to measure satisfactorily, and can only really be inferred indirectly. It is my feeling, not sustained by hard analysis, that a lot this growth illusion was from the reduced costs an increasing amount of goods, and some services, bought from China and India, and an important element of that trade deficit. This boost to the economy had “temporary” and “reversible” written all over it.

And the bad news is that the current spate of growth has suspiciously similar symptoms. The trade balance reported by the ONS deteriorated from under negative 2% of the economy in mid 2013 to over negative 3% in November (the latest data). I don’t have direct figures for real exchange rate (a rather tricky calculation), but sterling has appreciated since a low in about March. There seems to be no offsetting productivity gain, since employment figures have been very positive (a very good thing, in spite of some economists moaning about productivity). So we’ve just reverted to the unsustainable growth patterns of the early 2000s, without the benefit of cheaper imports to sustain living standards.

What, of course, we need to see is a rebalancing of the economy to something more sustainable. This will show through in increased levels of investment (still low) and a stronger trade balance. The confidence engendered by the recent spurt of growth may help with this. Meanwhile the government’s austerity policies need to be strengthened, if anything – otherwise the economy will be even less sustainable. Grim news for politicians of all persuasions.

Inequality should be at the heart of the economic debate

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

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

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

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

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

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

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

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

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

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

The glorious irrelevance of Paul Krugman

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

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

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

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

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

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

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

What is neoliberalism? The left’s muddle does not help reverse its progress

Political movements tend to be united by what they oppose, rather than any positive things they stand for. Today the political left unite against a universal enemy, which they name “neoliberalism”. The word is bandied about much as “socialism” is by the political right. But what is it? And is it a useful descriptive term? I believe it is, but that the left is muddled by what it is and is not.

According to Wikipedia neoliberalism started its life in the 1930s as a middle path between classical liberalism on the one hand, and the state planning ideologies of fascism and communism on the other. Classical liberalism advocated a minimal state, and, in practice, a world in which big capitalist corporations could thrive. It was widely blamed for the economic catastrophe that followed 1929 in capitalist economies. Neoliberalism stood for something called a “social market”, backed by a strong state. Nowadays, the left make no real distinction between classical liberalism and neoliberalism. This speech by Susan George in 1999, and posted recently on Facebook by a friend, illustrates this quite well – a lot of what she rails at should in fact be defined as classical liberalism. This is interesting, and not necessarily wrong. Neoliberal ideas have provided cover for a lot of classical liberal ideas – and neoliberals have seen state socialism as their main enemy, rather than unfettered capitalism.

I think it is best to understand neoliberalism in terms of three core ideas:

Markets are an unbeatable information exchange. Markets are idolised, because they are seen as the most efficient possible way of reconciling the masses of information that modern societies require to keep moving. This idea of the market as an information exchange, famously advanced by Freidrich Hayek, is a very powerful one, and an advance on the rather abstracted ideas of classical economists.
People respond to incentives. Pretty much all human behaviour, good or bad, can be understood as a response to external incentives. This is often developed into the idea of all people being independent agents rationally responding to the opportunities around them according to a set of pre-defined preferences – often referred to as homus economicus. However, the idea is deeper and stronger than this theoretically convenient way of looking at things.
Direct state management is inefficient. This actually follows from the previous two ideas, but takes on a life of its own in the minds of its followers. The state is incapable of processing information about people’s wants and needs with the efficiency of a market; the state’s officers generally respond to their personal incentives, often simply to secure a stable and easy job. Result: gross inefficiency. When any of the known theoretical weaknesses of markets are presented to neoliberal advocates, their response is often to accept them, but to point out that to try and solve them through a state managed solution would make things even worse.

There is a general view, supported by Ms George’s speech, that neoliberalism took hold in the 1980s, under Britain’s Margaret Thatcher and America’s Ronald Reagan’s political leadership, and the economist Milton Freidman providing theoretical heft. From these beginnings it developed into an orthodoxy across the developed world that, according to the left, still grips the political establishment today. The financial crisis of 2007-09 has not drained it of power, as the left thinks it should have done.

There is some puzzlement on the left as to how this neoliberal takeover happened. Ms George paints a glowing picture of the Keynesian consensus that preceded it, and derides any idea that neoliberal ideas had any real persuasive power in their own right. She resorts to a sort of conspiracy theory of coordinated and determined vested interests. Well, I was there, and voted for Mrs Thatcher in 1979 (though not afterwards), and find the rise of neoliberal ideas entirely unsurprising. Britain, in particular, was in a miserable state: and the “Keynesian” consensus was an evident failure. It had failed to respond to the changed world that followed the oil crisis, resulting in unemployment and inflation. We were surrounded by national bureaucracies and nationalised industries of an inefficiency that today people would find unbelievable. Much of what they said, especially about state directed solutions, rang true. Many politically powerful vested interests opposed the change – but the neoliberals were pushing at an open door in the world of ideas.

Trying to put all this in perspective is made harder by the following things that have accompanied the rise of neoliberalism:

There has been a dramatic change to the industrial and economic base to developed societies since 1945 (well since long before that, of course). In the first phase manufacturing industry advanced, in such a way that much of the capacity built to support the war effort could be readily redeployed (in contrast to what followed the 1914-18 war); this was the basis of an unambiguous economic miracle that lifted many out of poverty. In the second phase, from the 1980s, manufacturing industry became much more efficient, while the appetite for its production hit saturation; the economy switched to services. This has created huge dislocation, and, more recently, the disappearance of mid level jobs. It has driven overall growth in wealth, but also tended to increase inequality. Neoliberal policies have helped this transition forward, but were not the underlying cause of it.
Capitalist corporations have remained as strong as ever, and have grown increasingly able to press forward their interests in the political system, especially in America. They are not fundamentally neoliberal in outlook (their aim is to rig markets and not empower them, but they usually camouflage their lobbying in neoliberal terms. We should be careful not to exaggerate their power though. The corporations have not had it all their own way: their life expectancy has dramatically reduced over the period. Neither are these faceless corporations entirely managed for the benefit of a small elite; they have also benefited armies of employees, and their institutional shareholders are often pension funds that likewise transmit their gains to ordinary people.
A lot of theoretical economists have got carried away with their models based on homus economicus, and these have become a soft target for neoliberalism’s critics. But often these criticisms amount to criticising the tactics and not the strategy: about how people respond to incentives, and not the idea that incentives drive behaviour.

Ms George manages to be muddled by all of these things, leading to a speech that can only be called paranoid. I suspect many on the left share her views, though, and feel that they have been vindicated by the events of the decade and a half since. This muddle, and their failure to clear identify and advocate alternative approaches to the neoliberal consensus, means their persuasiveness is doomed to be very limited.

Meanwhile political centrists seem to be trying to recover something of the original neoliberal outlook: the social market. The use of market mechanisms within a society that is still dominated by the state. As somebody who tends to the political centre I would like to say that this offers the most constructive way forward. But I have to point out that the great financial crisis of 2007-09 resulted from the collapse of just such a middle way philosophy, in the world of finance and banking. While the left blames it on rampant capitalism and greed, cack-handed state intervention was just as much of a problem, and the combination was lethal. It was a neoliberal project in the original sense of the word.

Where does that leave us? A lot of what neoliberals say is true. We need to grow up and recognise that. But a lot of it isn’t; and its failures are currently more important that its successes. Our societies’ institutions have not kept pace with the changed nature of society and the economy. But it will require a large dose of state direction, especially in education and housing, to fix this.

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

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

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

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

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

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

What went wrong with economics?

It is commonplace to suggest that economics, as taught in our schools and universities, badly failed prior to the great financial crisis of 2007/08. But beyond this, things get a lot less clear. People tend to pipe up and attack aspects of the discipline that they have never liked; in the circles I move this tends to be the “neoliberal” ideas of well-functioning markets. This does not seem to be based on any real analysis, though. And universities plough on teaching the same old stuff as if nothing had happened, no doubt because nothing particularly coherent has replaced the old models. It is worth looking at the substance behind the remarkable failure of this discipline, which attracts so much intellectual heft in our era.

The failure of economics, and the imperious discipline of macroeconomics in particular, has been described brilliantly by Adair Turner in a recent lecture. I have already referred to this in an earlier post, but now I have been able to lay my hands on a copy of the text. It’s a challenge to read the 38 pages if you don’t have an academic economics training; but it’s well worth a try if you are not too daunted by this.

My personal perspective comes from the fact that I was a mature student on the BSc undergraduate course in Economics at UCL in the years 2005-08, just as the boom years were coming to an end, and the crisis started to develop, though before the seminal bankruptcy of Lehman Brothers, and the full blown crisis that followed in its wake. We were taught the standard macroeconomic model, referred to as the neo-Keynesian model, which nearly comprised a consensus at the time, although our lecturers were not beyond a little healthy scepticism.

Three related failures stand out. The first was an indifference to the potential macroeconomic impact of finance, and debt in particular. The fact that debt levels were exploding did not affect the models at all. You may think that economists are obsessed with money, but they treat it as a veil, and they try to see through it to a “real” economy of people and things. Finance is just tactics; a means to and which should not bother the imperial-level grand strategists too much. Besides, debt is two sided; for every debtor there is a creditor, and it all cancels out. If Matthew lends Mark £100, who in turn lends it to Luke, who in his turn lends it to John, who actual invests it in something, what has happened? £100 of debt has turned into £300 but there is still only £100 of investment. The bottom line is that Matthew lent £100 and John spent it; Mark and Luke are where they were beforehand. Do the machinations of intermediaries really matter?

This was much too complacent. Suppose Matthew, Mark, Luke and John are financially stretched, and a £100 loss will push them over the edge. If John’s investment fails, and he goes bust; he can’t pay Luke, who can’t pay back Mark, who can’t pay back Matthew. All four go bust, whereas just two would have done if Matthew had lent directly to John. The more overall levels of debt ramp up, the more likely it is that such contagion effects occur. I remember British policymakers expressing disbelief that a little trouble in the U.S. subprime property market could possibly have such a big global impact. And it isn’t just bankruptcy that is the issue; financial difficulties could simply cause a reduction in consumption – which would cause excessive saving in the economy at large, with bad macroeconomic effects, which can be very widespread from a rather small proximate cause.

The second problem was the fact that so little of the borrowing was invested in new investment projects, as theory supposed, with the majority being directed towards buying existing assets, and some to support additional consumption based on increased asset values. Hyman Minsky long ago pointed out that this type of investment simply led to asset price bubbles. And even if it had been directed towards “proper” investment, a similar bubble effect can occur. The latter was a point made by Friedrich Hayek. In spite of these warnings, the possibility of asset price bubbles, and what to do about them, was widely ignored.

The third problem centred on monetary policy. Economists used a theory of money that had scarcely moved on from the use of notes and coins. They assumed that bank money works in an equivalent way; that banks only lend money that has already been deposited, and that the whole money creation process is controlled by the central bank. Over a century ago the Swedish economist, Knut Wicksell pointed out the absurdity of this. Commercial banks effectively have the power to create money out of nowhere. And in any case, it really isn’t possible to distinguish the “transaction money” on which the theory depends, from other sorts of money, for example that being held just for safekeeping. I have frequently blogged about this blindness of conventional economists, shown by their frequent references to non-existent printing presses, and talk of throwing bundles of banknotes out of helicopters. This is almost as nonsensical as a metaphor as it is literally, and shows an utter failure of imagination.

The outcome of these failures was that most economists thought that high levels of debt, and the possibility of asset price bubbles, were just details that should not detain the grand strategist, and that the main thing was for central banks to watch consumer price inflation, while finance ministers should simply keep budget deficits small.

So, as the world’s finance sector boomed, finding ever cleverer ways to hide slimmer margins by increasing leverage, and debt levels exploded in many developed economies, the world’s policymakers looked on without too much concern. Inflation and budget deficits looked fine; everything else would sort itself out in due course. Indeed, since the world economy was delivering steady growth, many thought they had found the answer to life, the world and everything. If it ain’t broke, don’t fix it. And many economists made a fortune from the finance boom. Most of the students on my course chose it as a path to get rich via investment banking or management consultancy.

It is, incidentally, easier to say that economists were wrong, than it is to say that the disaster was their fault. If more economists had piped up to sound warnings, the political pressures to ignore them would have been overwhelming. If they had been heeded, then maybe banking would have been a bit less out of control. But there were other factors driving the instability, including the huge export surpluses of China and oil exporters – which pumped money into the developed world financial system, creating near-on insoluble problems. The situation would have been a bit like global warming – strong awareness from the academic community quite unable to stop overwhelming global political forces and the power of sheer human greed.

Still, the discipline of economics has been left in a sorry state. As Lord Turner points out, in the 1950s they had all the knowledge and insights needed to take it in a less blinkered direction. Wicksell, Hayek and Minsky were all highly respected economists; Maynard Keynes highlighted all the issues lucidly in his General Theory. But instead economists went up a forty year blind alley, becoming more sophisticated with the detail even as the fundamentals became more and more unrealistic. East coast liberals were as badly off track as Chicago supply-siders. It’s no wonder that so many are still in denial and still teaching the discredited models, as if only a few details here and there need to fixed. How can you discard such a huge volume of thinking in one go?

But the economic disaster is too big to be glossed over. Whether or not economic theory has caught up, policymakers understand that the banking system is a major problem, and that you can have too much debt. The last time such a disaster hit economics was in the stagflation era of the 1970s; let’s hope economists’ response to this crisis is more robust than that one!

Are the Muslims right about debt?

The Biblical invocation against usury, making loans for interest, has been discarded by the two older Abrahamic religions, the Jews and the Christians, though it persists in Islam. I used to think the prohibition was another obsolete idea, based on a misunderstanding of the usefulness of finance. But as time goes by, the more I come to see that the biblical fathers, or God if you prefer, were on to something. The dysfunctional nature of financial markets is one of the modern world’s most pressing problems.

This reflection comes on the fifth anniversary of the collapse of Lehman Brothers, which was the point at which the current financial crisis broke out into the open. This has lead to a flurry of newspaper comment. I was most drawn to an article by Gillian Tett in the FT, covering a talk given by Adair Turner, the former head of Britain’s financial regulator, the FSA. Unfortunately this behind the FT paywall, and I cannot find coverage anywhere else. Lord Turner produced a blog, but this only covers part of the subject matter, and not the most interesting bit reported by Ms Tett. Lord Turner says that we have not really come to grips with the failure of financial markets that became evident with the Lehman episode.

The most eye-catching thing about financial markets, which is the main point made in the blog, is the explosion of private sector debt. In 1960, according to Lord Turner, household debt in the UK was just 15% of total income; by 2008 it has risen to 200%. If you start to add up loans made by financial institutions to each other, then even that figure looks pretty tame (837% according to this rather good Economist School’s Brief on the subject – though this suggests a little confusion in Lord Turner’s numbers on household debt). But the statistic that hit me most forcibly was the claim that only 15% of the money that flows into financial products actually gets invested in proper wealth-creating projects.

Macroeconomists have long been dismissive of the significance of debt and financial markets in their imperious declarations about the state of national and global economies. These are just means to an end, and they all cancel out – one person’s debt is another’s asset; what matters is the real world of what is produced and consumed. Economists are reluctantly having to rethink this, though most would still rather divert the discussion into conventional subjects about austerity and money supply. Lord Turner’s 15% statistic, however, should translate the issue into one which even an old-fashioned macroeconomist can understand. There is a massive gap between what people set aside to save, and what is actually invested. Financial markets are meant to be the channel by which savings are turned into investments – but instead they are simply a smokescreen hiding a black hole, as it were.

Let’s pause for breath, and look at the problem from another angle. One of the critical points of economics, too often forgotten, is that money and financial assets have no intrinsic value. They are simply useful tools by which we can coordinate the process of producing work and consuming its output. You can think of it as being a bit like electricity. You cannot store it. If people want work now, and consume later at leisure, the simple act of putting aside money won’t do the trick. You have to persuade other people to be around to do the work for you when you want to do your consumption. The wider purpose behind financial products is to help us to do this, to balance our over-production now (i.e. saving) with over-consumption later, or vice versa. Theses activities depend on coordination with people who want to do the opposite, and that is what financial markets are meant to do. How? Through investment. Investment is work that is done now to produce things that can be consumed later. This allows production without consumption in money terms to be balanced by a real world equivalent. Maynard Keynes’s great breakthrough was understanding that the failure of the money and real worlds to match was the main cause of recessions.

So if 85% of savings are not actually invested, there is a problem. Where does the money go? There seem to be two main places. Firstly a lot of it consumed by intermediaries – those fat-cat salaries included – to no real purpose. Secondly a lot of it goes into inflating the prices of assets, real estate or financial assets, that exist already. In other words it is a colossal waste of time which simply serves to make a lucky few rich. And meanwhile huge volumes of debt are being created, much of which can never be repaid. Or, to put it another way, we have manufactured vast banks of financial assets which are not worth anything like what we think.

This spells trouble ahead, as this situation will only resolve itself through, one way or another, debt being forgiven and assets written down. The owners of those assets show no sign that they understand this; or if they do, they simply assume that it is somebody else that will pay. Meanwhile the best we can do is not to make things worse. Amongst other things that means continuing to make life miserable for the banks and the financial sector, and hope that, as they shrink, they concentrate on the more socially useful aspects of it work.

What those old Jewish and Christian fathers understood, and Islamic scholars still understand, is that debt creates moral problems by dehumanising the relationship between debtor and creditor. Financial assets are in fact human relationships between real people, which we are attempting to abdicate responsibility for. Alas though, it is unthinkable that our current economic system, with its manifold benefits, can be created or sustained without them. But we would all be better off if we understood the moral and personal implications, and consequent limitations, of financial assets and the markets through which we acquire them.