Economics & Finance – Page 18

Does Britain need the City?

The British governing class has reacted furiously to the European Parliament’s attempt to limit bankers’ bonuses. Once again their central argument is that it is a threat the wholesale financial services businesses that are based in the City of London, which they say is critical to the British economy as a whole. This is an argument that is regularly wheeled out by not just the establishment, but even by normally sensible commentators such as The Economist. The British public at large seems largely unmoved, however. This is a topic that could do with closer examination.

The City is an astonishingly successful business cluster, where I worked for 18 years up to 2005. The main controversy surrounds an very well-paid elite of traders, fund managers and investment bankers. These people, or the businesses they are part of, contribute disproportionately to national income – though exactly how much I am less clear about. Financial services consist of nearly 10% of the country’s GDP, but this includes a lot of businesses that are clearly not part of the City (retail bankers, estate agents, financial advisers, and so on), in spite of attempts by many commentators to conflate the two. But their high income reminds me of the joke about Bill Gates wandering into your local bar and the average income there soaring (this joke needs updating – Bill Gates’s income will have dropped alot in the last few years). If the City bankers leave, the country’s GDP may suffer, but that doesn’t been that everybody else is necessarily poorer.

But, the argument goes, these well-paid people spend their money here and create jobs. This argument is much weaker than it first appears. Rich people don’t spend all that much of their incomes on the sorts of things that create local jobs. A lot of their income is saved, with little of this saving going into productive investment in the UK economy. A more immediate problem is that a lot of their money is going into property, and other things where supply is limited (plumbers, school teachers at private schools, etc). All this does is bid up the price and put them out of reach of ordinary people. Still, if these businesses really are global, and having them on British soil contributes to the British trade balance, then some sort of net economic benefit is plausible.

A sounder argument can be made through taxes. City businesses and their employees pay a lot of tax under Britain’s progressive tax system (mostly income tax and national insurance on those bonuses – global businesses are very slippery on the matter of corporate taxes). How much? I don’t know: but it could amount to 1-2% of GDP (that’s guesswork working from the 10% of GDP for financial services income as a whole). There is an irony here. Very often we hear that our high taxes are damaging the City – but if they didn’t pay tax there would be little point in having it.

But behind this there is a deeper question. Are the services the City provides socially useful? In principle they should be. Our complex economy depends on finance to link those with surplus money with those who have productive investment projects to get off the ground. It’s what pays most people’s pensions. In principle fund managers, even those in hedge funds and private equity, should be helping this along. But a great deal of scepticism is in order. Too much energy is wasted in various intermediate devices – such as derivatives – whose value is difficult to see. Too much money is lost between one end of the process and the other. High profits, an economist will tell you, are a sign of economic inefficiency. It is the industry operators that are getting rich, not their clients. The aim of public policy should be to bear down on the industry to make it much less profitable, while maintaining its socially useful purpose.

But if it a global industry, can’t the British economy rake in the benefits of this inefficiency at the expense of the rest of the world? There are problems. First is that as global governments get to grips with the dysfunctional wholesale finance industry, it will gradually become less profitable, and the benefit reduces. The EU tussle on bonuses is but one part of this process, even if it is badly directed. The second problem is that the British taxpayer can become more embroiled in the industry than it should be. The bailout of British banks in 2009 surely wiped out many years of tax revenues derived from them. In any case income from financial services tends to be volatile, and so less useful – it disappears when you need it most. A further problem is that high City pay diverts the brightest local people away from more socially useful work.

So overall I find the case for special treatment for the City to be unpersuasive. What we actually want is for London to be a global hub for a smaller, less profitable and more functional financial services industry. The government is doing some quite sensible things: raising capital requirements, and separating investment from retail banking. This should limit the government’s exposure to bailouts, and reduce the level of finance (“leverage” in the jargon) available for trading operations, which believe is the critical issue. Other actions are more ambiguous: tougher regulation sounds fine, but it is in danger of harming decent retail banking businesses and reducing the level of competition as a by-product.

And as for the EU bonus regulations: I don’t think they will help much. They do not tackle the central issue, which is why banks are making so much money in the first place, and able to pay such large bonuses. But neither do I think they will do any real harm. Lower variable pay, and hence higher fixed pay, for banks may sound as if it increases risk, but it will force managers to ask more searching questions about what they are doing. And if more whiz-kids go to Singapore, so be it.

The public’s foul politcal mood: symptom or disease?

Is depression an illness? It can be. Many people suffer depression that is so severe that it overwhelms them. They need help and we categorise it as mental illness: a condition with a life of its own, where medical intervention is recommended.

But for most of us, most of the time depression is just part of the ordinary fabric of living. It is a necessary step in the way the mind adapts to new realities in the world around it, especially changes that are unexpected or unwelcome. We don’t understand why the human mind has evolved in this way, but it clearly is not a malfunction. We must accept it and work through it. This common wisdom is summarised in popular models such as the Kübler Ross model of the five stages of grief (denial, anger, bargaining, depression, acceptance).

We can compare this personal mental phenomenon to current public attitudes to politics, especially here in Britain, but elsewhere too. This is partly a simple metaphor; but also some of the same psychological forces are at work. The public mood with politics is foul. Is this a disease, or merely a symptom of an inevitable change that is taking place in our society, that we simply have to come to terms with? And how should politicians respond?

The latest evidence for the public’s mood comes from the recent Eastleigh by-election. The main established parties locally, the Liberal Democrats and the Conservatives, both lost votes, and much of their support was grudging, based on keeping somebody else out. The grumpy anti-establishment protest party Ukip jumped from nowhere into second place. The official opposition, Labour, made no headway. And, in more classic depressive behaviour, turnout fell significantly from the General Election in spite of an extremely intense campaign, where voters were getting daily leaflet drops and their phones did not stop ringing.

If this is an inevitable response a changed reality, we don’t have to look very far for a culprit. In the 15 years from 1992 to 2007 Britain has enjoyed steady economic growth. If the benefits of this growth have gone disproportionately to the rich, they have neverthless been spread widely. Pay-rises regularly beat inflation. The benign effects were reinforced by easy money which supported both consumption and rising property values. This didn’t seem like a golden age at the time (though there was a brief note of euphoria at the turn of the Millennium), but it served to set some fairly stable and benign expectations. Politicians squabbled of the extra things they could do with “the proceeds of growth”.

But this collapsed in 2007, when the financial crisis started, with a sharp economic contraction in 2008-09. Worse, in 2013 there seems no sign of things getting any better. While politicians on the left and right argue that growth can be restored, the public remains entirely unconvinced. You have to be a real optimist to think that Keynesian stimulus would offer more than temporary alleviation; and it could make things worse in the long run by taking the national debt sky high. The right wing’s supply side revolution would make things worse for most people in the short term, and probably only better for the already wealthy after that. Monetary loosening seems to involve sucking life out of the Pound, and so making things like energy, cars and foreign holidays yet more expensive – probably with only share and bond prices showing any benefit.

What on earth has happened? The public suspects that something has changed about the economy and society which means that the benign years before 2007 will not return. This builds on the natural human tendency to project current circumstances into the future. It so happens that I feel that this public instinct is well grounded. Slow growth is here to stay. Much of the growth before 2007 was a mirage.

This need not be a bad thing in itself. There is plenty enough resources to ensure a decent standard of living for everybody. But the political priorities in a low growth world are very different from what they used to be. Distribution of wealth becomes a top political issue. Government must learn to be frugal. We must focus on improving wellbeing rather than monetary wealth. But these changed priorities require a big psychological adjustment, so it is no wonder that there is anger, frustration and depression amongst the public.

If that is all, then the bad mood is simply a symptom of the changing times, and politicians should see through it to focus on the changed priorities. Politicians need to show empathy with the public, but not be panicked into populist policies. Aided and abetted by an unhelpful press, much public anger is directed at such things as immigration, the European Union, health and safety legislation, and human rights. But politicians should not be fooled by this anger; the public is in fact deeply ambiguous about all of these things. Deep down they sense they are necessary to the way we want to live our lives, the odd silly excess notwithstanding. Instead politicians should focus on reform to the tax and benefits system, improving public services, developing a housing strategy, securing energy supplies and fixing the still-broken financial system.

But many thoughtful observers, Paddy Ashdown for example, are convinced that the bad public mood is much deeper than this. Its beginnings predate the financial crisis of 2007 after all. There is a deeper feeling of disenfranchisement that will not go away. This needs more direct intervention. While I am not apocalyptic as Lord Ashdown, I think he has a point. British politics is not corrupt, but it is conducted by an elite class that does all it can to avoid being held to account. Reforming this will be hard work though. Devolving more power to local level is surely part of it – though fraught with danger. Whether the current government’s localism reforms have achieved anything useful is open to doubt – though the growing number of City Deals are more promising. Taxation powers are the critical issue, and nobody shows signs of grasping this particular nettle. The opportunities to re-enfranchise voters are surely mainly at the local level – but that means the delegation real power, and responsibility for real trade-offs – rather than the one-sided lobbying of the centre that currently dominates local politics.

The public mood is both a symptom of change that is running through our economic system, and also a deeper problem in its own right. Both call for honest liberal reforms, and not the sour populism that it immediately encourages. Let us hope that the public, through its anger and frustration, recognises this. They often do, if any politician has the courage put the case to them.

Britain’s economy: is the right right?

Britain’s economic performance since the Coalition government took over in 2010 has been as dismal as today’s cold, damp and grey London weather. Negligible economic growth; government finances that stubbornly refuse to improve, even as services and benefits are cut; and although unemployment is trending down, this is at the cost of pay and hours being squeezed. In political and media circles most of the debate about this state of affairs is around managing total economic demand: the “Keynesian” critique (quotation marks since using a dead economist as a source of authority does not do justice to the critique). Much less prominent is a right-wing critique. Yesterday Allistair Heath, Editor of City AM produced a 10-point plan in The Telegraph online, which neatly summarises this perspective. It is worth thinking about this a bit.

Mr Heath’s 10 points, in his “Supply-Side Manifesto” are as follows:

1. Cut corporation tax to 11pc; abolish capital gains tax

2. Cut current government spending by 2pc this year

3. Wage war on zombie firms

4. Reform the labour market

5. Allow private sector to finance big transport projects

6. Build 300,000 homes a year

7. Scrap renewable energy targets

8. Create mini-jobs for welfare recipients

9. Allow for-profit firms to run schools

10. Make it easier for consumers to switch suppliers

The basic premise of this is that it is what Britain needs is a supply-side revolution to get going. In other words it must be made easier for businesses to grow, and there must be greater incentives for private sector investment. There is something to this. Britain’s economy before the crisis struck in 2007 was unsustainable, and much of the growth in the preceding half-dozen years was a mirage. The most convincing evidence of this is the country’s current account deficit – consistently 2-3% of the economy (and the trade deficit much worse). This seemed to be the result of an inflated exchange rate. As the crisis struck, the pound duly depreciated. And yet, as the Economist pointed out a couple of weeks ago, the current account deficit has not recovered (unlike after 1992, when the pound fell out of the ERM). This bespeaks a deep malaise in the economy. This is much more that a dip in the business cycle that can be cured with fiscal stimulus and/or loose monetary policy. Indeed both such policies could make things worse by pushing out needed investment.

It is common wisdom that the British economy needs to be “rebalanced”: but this seems to be happening only very slowly. Reduced dependence on financial services and public expenditure are clearly both part of any such rebalancing, and we do seem to be making some headway here. But what is to take their place? Thinking about the “supply-side”, or how the economy actually delivers the goods and services it needs, is a welcome relief from banging on about aggregate demand, and its assumption that all this can be left until later. But it is here that I mostly part company commentators such as Mr Heath. Let’s have a quick look at the ten points.

Cut capital taxes to encourage investment. This idea has a respectable intellectual history, but there is a problem. It tends to encourage wealth creation by the rich without much impact on the rest of society. And as the rich tend to save rather than spend their incomes, this doesn’t do much to fix the wider malaise. I’m not so sure that attracting footloose international capital will help much in an economy of our size anyway, (unlike Ireland).
More cuts to government spending: no ring-fences. I do agree that government has to be smaller and more efficient – but the country is very dependent on government sponsored services, such as education and health. We are up against what economists call “Baumol’s Disease”, as well as demographics; there is a limit to amount we can expect from efficiency savings. There is plenty to discuss about how these services are to be funded and structured, but crude cuts are a blind alley.
Allow more companies to go bust. I have more sympathy with this one, though I am not convinced that this is really what is blocking investment.
Labour market reform: reduce job protection. I am more ambiguous on this than most liberals, perhaps hardened by my experience as a middle manager. Improvements can be made, but the evidence that this is what is holding us back is weak.
Big transport projects financed by private sectors (tolls, etc). Easier said than done. The cost of big capital projects is escalating, and returns less certain. I think the current government is pushing ahead with this as fast as politics will allow.
Housebuilding. Here the right wants to unleash the private sector by overcoming planning constraints. Mr Heath is being a bit disingenuous here: he means plastering the green-belts with cheap and shoddy new housing estates. But there is a housing shortage; and we do need to compromise on the green belt. But we need good quality homes and more social housing, with development gains being used to finance social infrastructure, such as schools.
Junk renewables for coal and gas. I’m not sure that an economy built on cheap, carbon intensive energy is the right way to go. I expect that Mr Heath does not believe in climate-change. Moving away from cheap energy dependence is one of the pieces of rebalancing that has to be achieved. Green energy should be part of any growth strategy.
9., & 10. These are throwaway ideas given a sentence each. I don’t necessarily disagree, even with for-profit state schools, but I don’t think they will help the supply side by much.

So there’s me being very negative about a whole series of practical ideas. So what do I think? First point is that we need to accept that, for a whole variety of reasons, growth in most developed countries will be very slow for the foreseeable future. We need to adapt our expectations to this, and think more clearly on how to deliver improved human wellbeing without it. Second, we need to think hard about under-used human resources: that means mainly people living outside the English South-East and a few other hot-spots. Simply building more houses across London’s greenbelt and moving people there does not feel right. There are no big ideas here, but lots of little ones. Dumping big government agencies in these places is not one of them, though. Third we have to rethink public services. The reforms need to focus on improved commissioning and getting results. But we also need to think about such politically toxic issues as co-payment – since taxes will not be enough to fund the nation’s needs. Plenty of ideas for future blogs, but that’s enough for now.

So the left bangs on about Keynesian demand management, in the hope that longer-term problems can be solved later; the right chases a fantasy of growing businesses unleashed by smaller government. The public seems sceptical of both. Rightly so.

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

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

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

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

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

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

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

Growth: the deeper questions

Today first estimates of the UK’s final quarter GDP show that the economy shrank by 0.3%. There will be a lot of posturing around this but it doesn’t mean that much. GDP is not a direct measure of wellbeing (unlike unemployment, for example), and it isn’t that clear how one quarter’s statistics have a bearing on people’s day to day lives. Besides these early estimates are not very reliable. Still these GDP figures do prompt some wider questions.

The first is about short-term economic strategy. A large number of government critics, loosely referred to as “Keynesians” though no professional economist would accept that label, say that a series of poor GDP returns reflect a failure of economic management. Firstly that cutting government expenditure reduces demand, which has a multiplier effect to shrink the economy as a whole. Second that the government should in fact be doing the opposite: using fiscal policy to use the same multiplier effect to boost the economy at large. I don’t intend to discuss this much further today, except to make this point. These arguments have weight because the UK economy is in recession, with high unemployment. This means, or should mean, that there is slack. Slack is usually inefficient, especially when unemployment is involved, and evidence that the slack is being taken up would come from better GDP growth figures. But what people are talking about is a short-term effect: once the slack is taken up the economy bumps into more substantive constraints and “Keynesian” stimulus would have undesirable effects, such as inflation or an unsustainable trade deficit. But what are the prospects for growth in the longer term, and does it matter?

There is now quite widespread pessimism about the long term prospects for growth in the UK and other developed economies. Mostly this is ephemeral. People assume that current trends simply continue; a few quarters of stronger growth and the mood will lift, even if this says nothing about longer term prospects. But more serious questions are being posed. Mostly these are based on demographics – the aging of the baby boom generation – and an allegedly slowing pace of innovation. The Economist had an interesting article on the latter a couple of weeks ago. This explained the reasons why people are becoming pessimistic – but then pointed to reasons for counterbalancing optimism. I think The Economist is right as far it goes: innovation picks up in some areas just as it slows in others. But they miss an important wider question about the role of economics itself. They too easily assume that innovation will lead to increased productivity and this to growth, in accordance with conventional economics. I think this may be breaking down.

Try to think about this in terms of three ways in which economic wellbeing advances. First is the conventional consumption which dominates economists’ thought. People consume more goods and services, and the economy is able to deliver these because productivity rises. Second is the consumption of what I would describe as personal goods and services. This superficially resembles the first sort of consumption, but the very nature of these goods and services is that productivity cannot grow. Think about personal therapy – shorter sessions or sharing sessions with more people undermines the product we want to buy. Another example is status goods – often the whole point is to show status by buying goods or services that are produced at low productivity. And finally people may opt out of the conventional economy altogether: take time off, pursue hobbies and so on.

So what if people direct their energies (and use innovation) to consuming personal goods and/or opting out, rather than consuming conventional goods? Economic wellbeing advances but GDP growth does not; in the case of opting out, GDP actually shrinks. Economists tend to be very dismissive of this, and try to assume their way out the problem: in particular that than economy advances on all three fronts at once, so that conventional consumption is representative of the whole. This has worked well enough for the “opt out” option: I am assured that there is good evidence that leisure increases alongside consumption, not in opposition to it. But there is a logical problem with the advance of personal goods, and economists have a name for it: Baumol’s disease, after the economist who pointed it out. The more productivity advances on conventional goods, the higher share of the economy is taken up with personal goods – and you have to work that much harder to improve productivity on conventional goods to achieve the same level of growth. Economists may have named it, but they still usually ignore it and its implications. They usually just have a quick moan that we should spend more energy trying to improve the productivity of services (the problem is usually defined in terms of agriculture, manufacturing and services – with what I am calling personal goods being part of services).

But I think the whole balance is shifting. There are limits to the extent that people will want to improve wellbeing by simply consuming more mass-produced goods and services. An increasing proportion of the population has reached that limit (I certainly have), instead increasing leisure or buying “quality” (lower productivity) goods. And look at innovation. I consider my smartphone to be a fantastic technical advance that has improved my life a lot. But has it helped the conventional economy by helping me to produce more services for other people to consume? It hasn’t. Quite apart from the demographic issue, which is real enough (and you could say this is actually the same thing, with people choosing more leisure by retiring for longer and consuming more personal services through hospital and other care), the rate of conventional economic growth is slowing in the developed world.

Does it matter? After all economic wellbeing may still progress. Unfortunately there are two reasons that it may: debt and taxes. These two lie at the very heart and purpose of the conventional economy. Debt and credit tend to get washed away in a high growth economy – but it will get increasingly difficult for people, businesses and governments to service past debts in a low growth environment. And a lot of the personal services that take up a higher and higher proportion of our economy (like health) are funded through taxes, as well as support for leisure (pensions) – and yet if the conventional economy does not grow this will bulk larger.

Debt and taxes. These issues are destined to dominate developed world politics in the century to come.

Taxing multinationals – after the sound and fury we need solutions that work

Multinationals like Starbucks, Amazon and Google has been on the wrong end of publicity in recent weeks here in the UK. They don’t seem to be paying very much corporate tax, in spite of well established and successful commercial operations here. But there is something missing from the debate: nobody seems to be offering much of a solution to the problem of taxing multinationals. There’s a lot of sound and fury, but it all ends in a bit of a whimper. We can do better than that – but only by adopting policies the government’s Conservative members will be deeply uncomfortable with.

The problem is easy to see. If a multinational makes something in one place and sells it in another (to take the simplest possible description of a multinational supply chain), then it has the opportunity to apportion profits to more then one place…and to manipulate this to where tax rates are lowest. This has always been so, but with an increasing proportion of costs being attributable to soft things like intellectual property, this is getting much easier to do. The traditional way of fairly attributing profit is through establishing a fair “transfer price” for goods or services as they move between countries along the chain – based on open market value. The idea of open market value has always existed more in theory than practice, and the process often ends up in endless bickering between the company and the tax authorities of the various countries it operates in. And in the end the results are often hard to justify. What are the alternatives? There are two main approaches.

The first approach is to reduce corporate tax rates to make the issue irrelevant, and along the way to make your own jurisdiction very attractive to investors. This is not as crazy as it sounds, and has quite a respectable intellectual pedigree. Companies aren’t people, and ultimately taxation is about people. Taxes are charged whenever people try to extract money from a company, through salaries, dividends and what have you. Money that is left in companies is reinvested, and taxing it merely reduces the amount available for reinvestment. This is an example of the idea that tax should be based on expenditure rather than income and capital. It encourages saving and investment, and most of the time economists think that economies would be healthier if more resources were invested rather than consumed.

This line of reasoning was very popular in the late 20th century, but has since lost much of its appeal, except amongst the very rich. Something has gone wrong with the savings and investment cycle. The amount of constructive, worthwhile investment that comes out of savings is not what economists used to think. A lot disappears into various forms of financial engineering that fatten up an overpaid finance industry and not much else, inflating selected asset values into unsustainable bubbles along the way. Overall savings, especially by the very rich, seem to be a drag on an economy – often requiring “negative savings” from government deficits to keep the economy on track. This process was described by Maynard Keynes in the 1930s and it is still true today.

Low capital taxes, including company taxes, simply seem to exacerbate a growing gap between the very wealthy and everybody else, without generating the needed investment. Profit taxes have a particular attraction: they are economically efficient and do no distort ordinary business decisions, outside the allocation of capital.

So what’s the alternative approach to taxing multinational businesses? This is what we should be talking about a lot more: the top down apportionment of profits. Under this system you establish a business’s worldwide profits, and then apportion it to national jurisdictions by a formula which measures activity: a combination of sales, employees, pay or suchlike. Those jurisdictions can then decide what rate they want to charge.

The idea of top-down apportionment has been developed for some time by US states for allocating profits between the states of that country. In the 1980s California tried to extend the idea to global operations, but was forced to back down, mainly after furious international lobbying from our own British government. There is a nice irony if American companies are now runiing rings rounds us British.

But that example shows the idea’s main weakness: it needs international cooperation to get going. It helps if all countries are doing it, and using the same formula. There is an obvious first step for the British government though: to agree and apply such a system to the European Union. I don’t think there would be much difficulty in mobilising the other EU countries; Ireland, a traditional advocate of tax sovereignty, is not in a particularly strong bargaining position these days, and we can let them keep their low rates. Once the EU has an agreed system for recognising and apportioning profits, we would then need a treaty with the US. Since that country is already a wide practitioner, there is good reason to hope for progress there too. With the EU and US on board, a global critical mass starts to build.

But Britian’s coalition government does not seem to be thinking along these lines. For its Conservative members, no doubt doing deals on tax with the EU is anathema. Instead they are happy to quietly go down the first route and cutting business taxes, in spite of little evidence that this is stimulating investment. Of the Liberal Democrats, however, I had expected better.

The imperial illusion of macroeconomics

Once again the UK Chancellor of the Exchequer’s Autumn statement has provoked a storm of claim and counterclaim among economics commentators. The particular breed of expert whose voice is loudest is the macroeconomist. They have a lot of important things to say. And yet their analysis is often superficial. We end up talking about the wrong things.

There is a magnificent imperial power about macroeconomics. It looks at economies in aggregate, and develops a broad sweep. It deals with national income, growth rates, productivity, inflation, unemployment – all concepts that are represented by neat numbers. Their policy instruments are referred to as fiscal and monetary policy – policies that are meant to influence these aggregates in a fairly direct way, and which

For me, the metaphor of imperial rulers to represent these experts has strong appeal. It conveys the right sense of arrogance. I conjure up pictures of imperial aides to the Russian Czar (or his Soviet successors) implementing arbitrary policies to be implemented across their domain. They deal in the big picture – and refuse to hear the special pleading of provincial representatives. Of course things don’t work out in every detail, they say, but the reach and sweep of their rule means that much more good than harm is done.

Macroeconomists themselves no doubt would prefer an analogy with classical 19th century scientists. They did not concern themselves with the movement of individual atoms, but derived physical laws that worked at a higher level. In aggregate the behaviour of atoms and people are predictable.

The idea that leaders deal with big strategic matters, and leave the details to their underlings is an old one, that has enduring appeal. It enhances the egos of the leaders. It doesn’t work, though. The best leaders find themselves having to command both the strategic sweep and the tiny detail. The Russian Czars came acropper. And the theroties of 19th century scientists turned out to have much less value than they thought in the real world.

This is true of macroeconomics too. In the first couple of years of taking an Economics degree, you learn about macroeconomic models – about the use of fiscal and monetary policy to guide the aggregate movements of an economy. It is tremendous fun – but by the third year you really should be growing out of it. In the end economies are driven by what is happening at the level of individual people and businesses – and as people are highly adapable, and behaviours change – never mind the evolution of technology – what works one year may not the next. Unfortubately too many economists can’t seem to get past the imperial illusion.

Take the current furure over the British economy. It’s full of growth rates, deficit levels – and demands for this and that on fiscal and monetary policy. Two elements of the macroeconomist’s stock in trade are prominent: international comparisons (the British growth rate is less than Germany’s, etc.) and comparisons with the past, going all the way back to the Great Depression of the 1930s. And the analysis usually stops there – few attempt to pick apart the differences and similarities that these comparisons invite.

And yet there are a number of big changes taking place in the British and world economies that are bound to affect the choices open to our policymakers. These get superficial coverage, if at all. Here are a few:

Finance’s role in the economy is diminishing, as we understand that much of its alleged value is illusory. This means that a sector that appeared to be highly productive in macroeconomic terms is shrinking. That is not a bad thing – but people seem to be screaming blue murder when the national income figures suffer the inevitable outcome.
Likewise the benefits of North Sea oil are fading – another statistically highly productive sector shrinks, though this one has more underlying substance.
Banks’ lending practices are changing, as credit to private individuals becomes less easy, and loans to property developers more difficult. This is inherently a good thing, as it helps get the economy onto a sustainable path – but it is playing havoc with the macroeconomic statistics.
The gains from globalisation are going into reverse. For years in Britain the prices of imported goods fell or stayed the same while wages and domestic prices rose steadily at 3-4%. These “gains from trade” added a lot to the feel-good factor and growth before the crisis- even though we whinged about loss of manufacturing and overseas call centres. Now import prices are rising steadily while pay remains frozen. These gains from trade were not permanent, bankable changes – but reversible. This is nothing to do with protectionism, by the way, but arises from the perfectly predictable workings of the economic law of comparative advantage.
Meanwhile “additive manufacturing” and other technology changes mean that fundamental technological change is alive and well, bringing both new opportunities and continued obsolesence – but of quite unknown impact on conventional economic measurements.

I could go on. These factors, and others, should be very much part of the discussion. They invalidate historical and international comparisons – until and unless we dig a lot deeper. To me the wider message is that we can’t simply wind the clock back to where we were in 2007, and it is not self-evident that a sustainable growth rate of 2% or even 1% can be regained just a lifiting levels of confidence a bit. Therefore using fiscal policy to stoke up aggregate demand may simply bring short-term relief followed by an even bigger crisis. Increasing government sponsored investment is almost certanly a good idea, but it matters where this goes. But neither the government’s critics, nor even its defenders seem interested in such details.

In an excellent article in this week’s FT, Sebastian Mallaby shows how macroeconomic success leads to microeconomic complacency, which in turn leads to breakdown. The developed world has just gone down this route. Now the BRICs are doing it. China shows no sign of dealing with the baleful influence of its state owned enterprise; India is content to let curruption and inadequate infrastructure go unaddressed; Russia sees no reason to change its contempt for the rule of law; and Brazil’s government is releuctant to take on vested interests. All these economies are now slowing.

Meanwhile, back in the developed world you would have thought that we had been cured of macroeconomic complacency. And yet almost nobody seems prepared to take on the deeper issues that lie behind the crisis and any solution to it.

Why healthcare may grow to 50% of GDP and still be affordable

I can’t over-emphasise how important the concepts in this article in last week’s Economist are: An incurable disease, and I would urge my readers to try and get to grips with it. If you want to understand how our economy is changing, and the implications for public services, the idea it describes is critical. It ranks alongside Ricardo’s law of comparative advantage (gains from trade) and Keynes’s multiplier (fiscal policy) as a counter-inituitive idea that explains so much.

What it describes is something usually referred to as “Baumol’s cost disease”, and reviews a book by the eponymous William Baumol, “The Cost Disease: Why Computers Get Cheaper and Health Care Doesn’t”. It stems from the observation that productivity grows in some parts of the economy faster than in others. The paradox is that the more productivity in a sector advances, the smaller its share in the the economy at large. Thus agriculture used to dominate the economies of the current developed world – but as agriculture became more productive, it needed less people and so shrank to a negligible propertion of GDP – while generating ever larger larger quantities of agricultural produce. The same effect is clearly visible in manufacturing industry – producing more goods than ever, but from a shrinking workforce. The more these areas advance, the bigger less productive sectors bulk in the economy as a whole. It is, misleadingly, referred to as a “disease” because these less productive sectors, within the service economy, then act as a drag on economic growth as a whole. It is not in fact a disease, but a symptom of success. The failure of economists to understand the difference between creating wealth and realising it (i.e. turning that wealth into something that actually benefits humankind) is one the biggest failures of the dismal science, and it is a shame that Mr Baumol perpetuates it in the title of his book.

The most important of these unproductive services are healthcare and education. Personal contact go the very heart of what these services are: to succeed these services must accept that people are individuals, and that a solution which works for one person may well not work for her superficially similar neighbour. But, while productivity grows only slowly, if at all, costs, i.e. rates of pay, must reflect the increased productivity of the economy as a whole. So costs advance faster than productivity. Sound familiar? But this only happens because we can afford it.

The eye-catching claim in the book is that on current treads healthcare will take up 60% of the US economy in 100 years, and 50% of the UK one. But this is all paid for by the fact that other parts of the economy have become more efficient – and in fact it only takes up such a large part of the economy because these parts of the economy have become more efficient. Actually this projection is a bit silly. I think the advance of conventionally measured productivity will slow, as technological change now affects quality rather than quantity. Also other sectors of the economy will reverse productivity as people value personal content more (think of the return to craft food production). But it is rather a good way to make the point.

Which means that the challenge with healthcare and education is not that growing costs are unaffordable, as various right-wing types claim, but something much more subtle. There are three issues in particular:

A lot of healthcare is indeed inefficient, both in the UK and the US, and political pressure must be brought ot bear to address this. But don’t expect it to halt or reverse the share of health costs in the economy in the long run. The NHS “Nicholson challenge” in the UK may therefore be a valid policy goal, but it will not solve the long-term funding needs of the health service.
The larger the share of the economy healthcare takes up, the more difficult it will be to fund it entirely from tax. In the UK this either means that a parallel private sector will flourish and undermine the NHS (as has already happened in dentistry), or that the NHS will need to be a lot less squeamish about co-payments.
There is a temptation for the owners and workers in the highly productive parts of the economy to keep the rewards to themselves, creating inequality and undermining public the public sector. And yet we still want productivity to advance so that we can all afford a higher standard of service. Higher taxes are part of the solution, but only part. Again this points to the fact that a higher proportion of healthcare (and education) services will have to be delivered and paid for privately – allowing the remainder of the public services to pay decent wage rates.

I hope that provides food for thought!

Plan B

One of the reasons why I suspect Labour will win the next general election here in the UK is that they are showing impressive discipline. This was on show yesterday at a fringe meeting at which both John Cruddas and Andrew Adonis spoke, alongside Jo Swinson and Menzies Campbell. Amid warm words there was a disciplined message about the urgent need for “Plan B” to rescue the economy. Neither is close to the centre of power in Labour, but both were impressively on message. How are Lib Dems responding?

The Labour narrative is this. The Coalition’s economic plan, if it was ever valid, has now clearly failed. It is time for something else, unless you are an evil Tory who simply wants to use the crisis to dismantle the state and don’t care at all for the less well off. It helps them that quite a few, even most, respectable economists support something like this point of view. This allows many to portray Nick Clegg in particular as economically illiterate. These feelings are quite widespread in the Lib Dems – hence the Labour pressure. How are the Lib Dem leadership responding? With equally impressive discipline at this week’s conference.

At several points, and from several different members of the parliamentary party we got a consistent message, but one that had clearly been crafted for the occasion. The economic plan, they said, was always flexible, and it is responding to the changed economic circumstances by putting off the target date for eliminating the deficit by two years. This sounds to be an ingenious way to make a virtue out of necessity. I don’t remember anybody touting flexibility last year – except, to be fair, for Chris Huhne, the former energy secretary who does not appear to be here in Brighton. And so far that discipline is holding. The party overwhelming backed a supportive motion on the economy this morning, rejecting a wrecking amendment from Plan B supporters. The message was helped by lots of warm words and promises about investment in housing and infrastructure.

As readers of this blog will know, I don’t think that the government’s economic policy has failed, but that expectations of how quickly growth would return were too high. And I don’t think that Mr Clegg is economically illiterate, though I have some doubts about George Osborne, the Conservative Chancellor. Far too many economists are basing their views on aggregate statistics, without asking deeper questions about how the economy has been evolving, in a sort of imperial arrogance worthy of Russian Tsars. More on that another time.

Capitalism in crisis. A smaller state and lower taxes will make things worse, not better.

The advanced capitalist economies are in trouble. Economic growth is anaemic or negative; government debt mounting; banking systems are on life support. There are big differences between the individual economies, but some combination of these three, or at least two of them, afflicts more or less all major economies – Australia and some Scandinavian economies excepted perhaps. The crisis may not be as severe as the one in the 1970s (it is if you measure GDP statistics but not by any other measure), but there is a pervasive sense of hopelessness. Nobody seems to have a convincing solution.

Broadly two narratives are offered. On the left the crisis is attributed to greedy bankers and corporate bad behaviour – and the answer is to ratchet up state spending to provide a Keynesian stimulus together with some very vague ideas on improving regulation of big business. On the right the crisis is attributed to an excessive state, and the answer is to roll it back to get out of the way of free enterprise. Neither is very convincing. For a much more convincing narrative, go to the eminent American economist and Nobel Laureate Joseph Stiglitz. He recently published a book on the topic: The Price of Inequality: How Today’s Divided Society Endangers our Future. I haven’t read it, alas, but it is reviewed by the Economist here, and Professor Stiglitz wrote an article for the FT here. A weakness is that his comments are focused especially on the US – but they have a global resonance.

This crisis has been evolving since the 1980s, while two important trends have been evident: the advance of technology and globalisation. These have rendered much of the earlier economic infrastructure obsolete and forced a major restructuring of the world economy, with big impacts in both the developed and devoping worlds – many of them very positive. Running alongside this has been a major shift in the balance of economic power from labour to capital. This is evidenced by a declining proportion of GDP attributed to wages and salaries and an increasing proportion to business profits. This in turn has led, especially in the US, to a dramatic rise in the inequality of wealth and income distribution. I have not been able to lay my hands on a clear set of statistics to demonstrate this – and not being a student any more I do not have access to the OECD or other statistical databanks – or not in a form I can work with. But this is widely attested to. Incidentally income inequality is not the only aspect of this problem, the amassing of corporate power that we can see in Japan and Germany, for example, is another dimension of the same problem.

This is where it gets interesting. One of the characteristics of the very wealthy (including big corporations) is that they do not spend as much of their income as poorer folk. They like to amass wealth, to exercise power, to pass on to later generations, or simply because they are too busy creating it to spend it. This creates a problem made famous by Maynard Keynes, and explored by all Economics undergraduates: if there is a surplus of saving over investment opportunities then the economy as a whole starts to shrink: people are producing more than is being consumed. That, in essence is what the crisis is about. Changes to the world economy have skewed the distribution of income in such a way that it is slowly suffocating the economy as a whole. This is not unprecedented: something like this happened in the early days of capitalism in the mid 19th century, but was resolved when the balance of power shifted back to labour. I have read a claim that there was a similar crisis in the 1920s and 1930s – but I am less convinced that skewed income played such an important role in then.

Now there are broadly four ways that sinking domestic demand from excess savings can be countered. First, an economy can run an export surplus which transfers the excess supply to other economies; this might be called the German solution. Second investment levels can be stoked up to absorb the surplus savings: this is roughly what happened in America in the 1990s with madness of the high-tech boom. Third consumption can be ramped up amongst the less well off by encouraging private debt, usually aided and abetted by a property bubble – the US and UK economies did in the 2000s. Finally government spending can take up the slack, either financed by taxes or, more usually, by borrowing.

Each of these four solutions has been tried by the major world economies, and all have given rise to problems. Export surpluses simply transfer the problem elsewhere – and are only globally sustainable where the counterpart deficits are being used to finance worthwhile investment. But the developing world, where most such investment is taking place, has often been running trade surpluses. Otherwise surpluses build up into assets that have to be unwound painfully. Investment looks like a good idea, but to work these investments have to pay back, otherwise you simply postpone trouble. This has proved much more challenging than many have allowed – I did not use the word “madness” in connection with the high tech boom of the 1990s for nothing. Private debt amongst the less well off might work if their incomes are rising – but the problem arises because they are not. And finally excess state funding carries its own problems. It is economically inefficient, and, financed by debt it simply builds a future financial crisis.

So what to do? It is worth noting that the left’s narrative on the crisis is closer to mark than the right’s. Cutting taxes and the power of the state will not unleash a flood of new investment, as the right claims – it will make matters worse by choking demand further. The left is right (as it were) to see that a large state is part of the solution, rather than the problem. Where they are wrong is to think that a bit of fiscal stimulus will restore the economy back to health – because it fails to deal with the root causes of the problem. Taxes have to rise, and especially on capital and the rich. And there is rather a tough consequence. This may help break the cycle of the rich not spending enough – but at a cost to the overall efficiency of the economy. We have to lower our expectations of what an economy can deliver.

And what of the megatrends that caused the problem in the first place? As I have argued on this blog before, I think globalisation is running its course and will not be the force it once was. There will be less pressure on developed societies from developing world competition. As for technology, let us hope that it starts to fulfil its promise of empowering the individual. Only this will ultimately restore the balance of power between businesses and their employees in a way that does not suffocate enterprise.