Economics & Finance – Page 19

The UK GDP figures change nothing

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

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

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

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

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

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

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

The meaninglessness of “money supply”

Where are modern economists most at sea? Some may think it is their over-reliance on GDP to represent the welfare of an economy. But economists are quite comfortable with the theory of all that, even if they often fail to put it into practice. No, the real problem is money supply. It used to be a central concept, but now it is useless.

Economistsused to be very confident about it all, even while I was taking my Economics degree in the mid 2000s. Their ideas had been developed most famously by Milton Friedman, the 100th anniversary of whose birth is being celebrated this year. He was the first to say that managing the money supply was a critical part of managing an economy as a whole. He was an iconoclast at first but gradually the idea became conventional wisdom.

The imagery that economists used to explain money’s role was endearingly folksy but also revealing. Money was explained in terms of dollar bills or pound notes. To increase the supply of money, a central bank simply printed more of it. The role in macroeconomic policy of increasing money supply was often talked of in terms of a helicopter drop of bundles of banknotes. If an economy was suffering from unemployment, then people would rush out of their homes, grab the cash dropped by the helicopter, spend it, and soon the unemployed would be back in work with no harm done! (Of course if there was no unemployment, people would spend the new money, but the result would be inflation). Friedman thought that the Great Depression of the 1930s could be simply explained by a lack of money (banks kept on going bust), and not a lack of government expenditure.

But it’s obvious to everybody that cash plays a very small role in a modern economy. The money we spend is in bank accounts, and often spent via credit cards; pound notes just don’t come into it. But economic theory hasn’t caught up. It is simply assumed that modern money could be managed by a central bank in an analogous way to printing banknotes. A couple of theories were used to justify this. First was an idea of a “monetary base” of deposits held by commercial banks at the central bank, which limited the amount of money these banks could supply to their customers, but this clearly did not reflect reality. A more enduring theory was based on the central bank controlling money supply through the interest rates it set on the deposit, and influenced through “open market operations”. Raise interest rates and money supply would fall as people moved money into interest bearing securities. This seemed to work – though it was hard to reconcile it to the complexities of what was actually going on – the line between non-interest bearing “money” and interest-bearing securities being hardly a firm one. There was no no better idea, though, and an elaborate macroeconomic theory was constructed on the back of of it.

Two ideas were central to this theory. First that people responded to an increase money supply by spending more (or a decrease by spending less), and second that the money supply could be controlled centrally. If an economy was suffering from a lack of demand, you could correct this by loosening the money supply, as an alternative to fiscal policy – increasing government spending or reducing taxes. This was irrestiable to the polical right, who hated the idea of using taxes and public spending to manage the business cycle – since this raised the size of the state sector.

But the idea is now in tatters, though some economists don’t seem to realise it, especially those of an amateur sort, which unfortunately seems to include the UK Chancellor of the Exchequer, George Osborne. Both assumptions are problematic. First, do people respond to an increased money supply by spending more? What if, in the banknotes in the helicopter example, people are so frightened about the future that they simply grab the banknotes and stuff them into their mattresses? There is no extra spending, and no effect on unemployment. This is an old challenge. Maynard Keynes talked of increasing money supply in a recession as “pushing against a string”. With money now a much more complex thing held in bank accounts, this problem is worse. It can be quite rational to leave money in a bank account without wanting to spend it – especially when interest rates are low.

That could be used to explain why very loose money policy by central banks in the developed economies currently has had so little effect, which is indeed what people like the US economist Paul Krugman are saying. But in fact money supply itself does not seem to be responding to the central banks’ wishes. It has been shrinking even as interest rates fall. This causes certain commentators angst – pleading for central banks to loosen policy yet further.

But how is money actually created? Apart from notes and coins it is mainly created by commercial banks. They do so by advancing their customers money. If you borrow £1,000 from your bank, the bank simply adds the money to your current account, increasing the overall money supply, and the bank puts a loan on the asset side of its balance sheet. No central bank or other authority plays any role in this. And if banks decide to cut back their lending, money supply shrinks. What counts is not money supply but credit.

Governments and central banks can use the creation or withdrawal of money to wreck an economy, as Zimbabwe has done, but not to fine tune it. The sensation of doing so in the 1990s and early 2000s was in fact an illusion. What actually counts is mood and the supply of credit. Movements in the money supply follow what is going on in the economy at large rather than lead it.

There is in fact no alternative for policy makers but to get their hands dirty in the detailed workings of the banking system as a whole, rather than simply adjust central bank interest rates. As the world’s banking crisis continues to rumble on, nobody argues with this – but there is a distinct air of crisis management and an absence of strategy.

What people in practice mean by “monetary policy” is series of policy interventions, such central bank interest rates, bank regulation, managing government debt, credit policy, exchange rate interventions, and so on. Each of these interventions has its impact – but it is disinctly unhelpful to view this impact in terms of any concept called “money supply”.

But we are left with a theoretical vacuum in economics. We know credit and banking are important parts of an economy, and critical to an understanding of the business cycle. But how on earth to manage them? Giving commercial banks free reign subject to a few central bank interventions does not look a good idea any more.

The financial crisis: five years and counting

It is five years since the financial crisis broke. In July and August of 2007 the interbank markets froze over, and it became evident that the boom years were over. Five years on and the world economy still looks in deep trouble. Each of the major developed economies is in a mess, especially if you treat the Eurozone as a single economy. This is a remarkable fact in itself – we are used to economic crises taking a much shorter time to resolve. It is worth trying to take a long view on it.

Looking back at what I was writing in 2007 (when I was in the third year of my economics degree at UCL), I am struck by how much denial there was in the air then. There was clearly a crisis in finance. but this was all about a few loans to poor people in the US – and would not affect the “real” economy by much, so many thought. Share prices held up, and superficially things seemed to be holding together. In the autumn of 2007 the small British bank Northern Rock fell apart. All hell did not let loose until the autumn of 2008, when Lehman collapsed, threatening to take much of the world’s financial system with it. Even so, the press regularly articles from people saying, backed by statistics from previous crises, that things would be back to “normal” soon. Alas, those who were comparing the crisis to Japan’s “lost decade” of the 1990s were closer to the mark. What happened?

At first sight the crises affecting the US, the Eurozone, Japan and the UK all look quite different – and it is very easy to focus on just one of these (as I usually do about the UK) as if the crisis in the rest of the world was something else. But the fact that they are all going wrong at the same time suggests a global pattern underlying all the local variations.

In the developed world, across the board, there has been a collapse in domestic demand – private consumption and business investment. This collapse has been compensated by an increase in net government expenditure (spending less taxes), to varying degrees in each economy. This has stopped, or mitigated, a sort of doom loop in which diminishing demand feeds on itself to reduce demand further. But private sector demand has been slow to revive. This is what is perplexing people.

Here the world is divided – and depending which side you are on, your views on how to tackle the crisis will differ. The optimists suggest that the problem is a temporary loss of confidence which is suppressing business investment and consumer demand. Revive this (some say by government stimulus, others by business friendly polices like cutting taxes) and we can get to something like where we were before, with more employment and rising living standards. The there will be a multiplier effect whereby growth feeds on itself.

I am not an optimist in this sense. I think that behind the crisis lie some big developments in the world economy:

The developed world’s demographics are changing. People are living longer; the post war baby boom is moving into retirement. The proportion of the working age population is shrinking. Many older people want to stop work to retire. It is important to see this in perspective. Many talk of a demographic crisis and of the threat to the wider economy. But it is quite rational to want to experience the benefits of a modern, highly productive economy through increased leisure, rather than through an endless treadmill of work and consumption. And quite rational to take this leisure as retirement rather than a shorter working week, say.
Technological advance is changing the shape of the economy in the developed world. Manufacturing is now so efficient that it requires few people employed in it to satisfy all of our needs. As a result a growing proportion of jobs are in services. It is not so obvious how increased productivity, as conventionally viewed, applies in many services. Too often this comes at the expense of the personal contact we value so much. Another problem is that so often the jobs created by the new economy aren’t matched to the skills that a large proportion of the population has.
The developing world is catching up with the developed world. This can be counted as the biggest success of the global economy, but it is putting pressure on some scarce global resources – such as oil – and forcing their relative prices up in all economies.
And as if that wasn’t bad enough, the amount of carbon the world is pumping into the atmosphere is causing global warming, with the prospect of increasingly disruptive effect across the world – and an imperative to change our ways to reverse it.

The sum of these trends it to suggest two things: that the developed world economy before the crisis was unsustainable so that we can’t return to it; that the prospects for economic growth, as conventionally measured, in the developing world are weak.

That means that the world after the crisis will be a very different place to the one before it. It is one where people in the developing world escape the tyranny of poverty, and where in the developed world people consume less but enjoy life more. But to get there means resolving some awkward tensions:

It’s all very well to say that we should be less focused on economic growth and consumption, and more on wellbeing. Except that so much of what we expect from a modern society depends on the state, and on taxes to fund it. Taxes are driven by the conventional economy. We have to reduce our expectations of what the state can provide.
As growth in the economy as a whole slows, tackling poverty and deprivation through growth alone won’t work. Distribution of wealth grows in importance. That leads to a dense thicket of economic problems and challenges to social values.
At a global level we are hardly beginning to understand how to reconcile tackling poverty in the developing world with the need to reverse carbon emissions. While this battle continues, the developed world has to lead from the front and reduce its own net emissions to less than zero.

And here we are. 1,000 words on the economic crisis and I have mentioned debt and globalisation, or even the problems of currency unions – factors which have dominated discussion of the crisis since it began. But debt, trade and currency are the tactics, not the strategy. We won’t solve these mammoth problems without a clear understanding of strategy. as the crisis drags on though, people will perhaps realise that the problems are a bit deeper that a bit of stimulus here and there will fix.

Behind the theatrics on Barclays, what needs to be done?

Predictably enough the Barclays Libor scandal is generating rampant theatrics amongst both journalists and politicians. It is not easy to keep grip on what actually matters. And yet this is vital when it comes to deciding what the next steps should be.

One piece of theatre is a sort of whodunnit, amongst Barclays senior managers, and government and regulatory officials. How much did they know? What did they authorise? One line of attack concentrates on Bob Diamond, the former Barclays Chief Executive, whose evasions at a parliamentary select committee yesterday created predictable anger. The real point behind this is the question of how far up the chain of command should responsibility for unethical behaviour go? Should bank chief executives be like Royal Navy captains, as John Kay suggested yesterday in the FT, and take full responsibility for everything that happens on their ship?

A further twist comes from the thought that there may have been an element of government connivance in the second phase of manipulation, as the financial crisis was in full swing. The hope amongst government politicians is that something can be pinned on Labour figures such as Shadow Chancellor Ed Balls. That looks a long shot. Experienced political operators like Mr Balls don’t leave fingerprints, and there were legitimate reasons at the time for an interest in the behaviour of Libor. But the Labour’s case wasn’t helped by a radio interview with Baroness Vadera, Gordon Brown’s economic adviser, yesterday lunchtime. She was evasive, confusing the two very different phases of the scandal (i.e. the first phase of manipulation for to make trading profits, and the second of official manipulation for wider politcal purposes). It gave the impression there was something to hide. Other key Labour figures, such as Mr Balls and Lord Myners, the former City minister, are giving much more confident performances, though.

Centre stage for the theatrics today is the argument as to whether any enquiry should be a full judicial one, like the Leveson Inquiry into the press, which Labour are asking for, or the government’s preferred option of a quicker parliamentary one. Both options have merit. A judicial enquiry gives the whole thing an air of importance, and legal interrogators are much more effective than grandstanding politicians; it would keep the City types on the ropes for longer. But lawyers are unlikely to contribute much of value to designing a solution. A parliamentary enquiry would be a quicker way to actually change the law, as well as creating less complications for any parallel criminal investigations. What is actually needed is an expert commission – but we’ve already had one of those, the Vickers Commission – which indeed pointed towards some of the solutions.

But what actually needs to be done? In principle this isn’t difficult. Investment banking activities do play a useful role in the modern economic system, and aggressive trading culture can help the process of what economists call “price discovery” – spotting and correcting where the prices of financial instruments don’t reflect the world’s realities. Short-selling the shares of badly performing companies looks ugly, for example, but it does improve accountability. But the usefulness of investment banking is distorted by two problems:

Using other people’s money. Where traders use borrowed money to trade with, which is the bulk of what they do, then they are not taking full responsibility for the rsiks they are taking, and the whole balance of incentives gets skewed. Trading soon escalates to levels beyond the socially useful. The volume of borrowed money used has risen massively over the last couple of decades, and many traders probably don’t even understand the idea of using their own capital to bet with.
Trading culture struggles to recognise ethical boundaries. A disagreement over price is one thing, but manipulating systems designed help people is another. Fiddling Libor (especially in the first phase of this scandal) was one such transgression, as are various scams to exploit the way mutual funds are priced. The UK regulatory authorities can be too soft on this.

So in essence what needs to happen is this:

Isolate banks’ trading and derivative activities from ordinary economic deposit-taking and commercial lending, and attach separate regulatory regimes to each.
Clamp down hard on unethical behaviour – with chief executives and directors taking full responsibility for what happens in their organisations. Ignorance should not be a defence – and if that means some organisations become impossible to manage, then they should be broken up. Sanctions should hurt, and include the criminal law (though remember that its higher burden of proof can get in the way).
The money supply to investment banking operations needs to be choked off, so that only those that fully understand the risks are supplying it. Isolation will help here, but may not be enough.

The principles are easy, but the details are all important. The problems are global but it will be very hard for us in Britain. The City is so important for our overall economy that we are easily scared away from being too tough. But if the attraction of the City is that it is easier to do unethical business, then this is not a recipe for long-term success. We can still have a thriving financial services industry with niche operations based on genuine knowledge and expertise of the real world, and the provision of solid, well designed infrastructure and systems.

Next steps? I think an enquiry is a bit of a distraction, so the government’s option is probably better. the government perhaps using this enquiry as cover, must go back to the Vickers proposals and implement them in full. Going beyond Vickers to enforce the full separation of investment and commercial banking should be considered. And as for culture change, that needs to happen at the regulators, including the Bank of England, as much as the banks themselves. A change of senior personnel would help here.

Barclays scandal: culture isn’t the problem, it’s the money

City traders live in a world of their own. After the news of Barclays Bank’s fine for falsifying LIBOR returns, its share price rose slightly. The scandal had been rumbling on for months, and they were relieved that it had been resolved. They had no idea about the approaching firestorm – which took a big toll on its price later that day. Later an investor was reported by the BBC (who may have been quoting a newspaper) that all this mob rule had to end. But as the hue and cry continues (this morning the Barclays chairman resigned), politicians and media commentators seem to be equally out of touch with what lies behind the scandal. Unfortunately that may mean that nothing useful comes out of it.

The LIBOR issue itself is being blown out of all proportion. That is understandable. So much of the unethical practice in the industry go unpunished that when somebody gets caught a disproportionate response is quite rational. That is the point that City insiders probably missed in their sanguine early reaction. But most of the comment has focused on the idea that the industry culture is thoroughly cynical and corrupt, and it is this culture that is the main problem needs to change. Criminal penalties are spoken of for unethical behaviour, and the familiar idea that the payment of big bonuses should be limited. The Business Secretary Vince Cable has called for banks’ investors to rein the managements in.

That’s all very well as far as it goes. The culture is awful. We shouldn’t be too romantic about how things used to be, though. In the old City it may have been the case that “my word is my bond”, but ripping off clients and living off fat commissions was rife. One point frequently made is that traditional upright commercial banking culture, such as displayed by Barclays’s Quaker founders, has been corrupted as investment bankers have taken over. This is also true, but that fusty, conservative, self-absorbed commercial banking culture had to change. I well remember having lunch once at Barclays HQ in the 1980s: what a gloomy experience, for all the uprightness of those involved – there was no hope of us doing business with them because they would never be ready! We must look deeper.

The problem is that it is far too easy for big banks to make lots of money without too much effort. That is absolutely corrupting. Bankers naturally think that this money is added value for the highly skilled work they do to ensure that money flows to and from the right parts of the real economy. The rest of us are entitled to be sceptical. The profits which happen most years are wiped out in the bad years, when shareholders and taxpayers pick up the tab. The investment bankers have found a number of ways to make bets with other people’s money, take the benefits for themselves, and make sure somebody else picks up the tab if things go wrong.

But that’s not the only problem, here in the UK at least. There is also lack of meaningful competition. It is impossibly difficult to set up a new bank to compete with the existing oligopoly. The remaining banks have been allowed to consolidate into a small number of behemoths. The regulatory authorities, including the Treasury and the Bank of England, as well as the FSA, have been complicit in this. They prefer a cosy club of large organisations with big compliance departments than the rough and tumble of competition that, for example, the Americans or Germans experience.

The aim of public policy should be to make banking less profitable, so that the banks can’t pay massive salaries and bonuses, and more competitive, so that customers benefit from real innovation. This needs the British authorities to do three things in particular:

Make it much more difficult and expensive for investment banking and financial trading operations to secure finance. Separating investment banking from commercial banking, as recommended by the Vickers Commission, is a good first step, though may not go far enough. Increased capital requirements, as now being imposed globally, is another. Regulators need to be particularly hard on bigger institutions, and not let the idea that larger operations are more efficient take hold.
It must be much easier to set up new banks, both in commercial banking and investment banking. The issue isn’t the amount of regulatory capital required, but a host of other obstacles placed in the path of new banks.
While regulation needs to lighten up on the creation of new banks, it needs to be tightened on the regulation of lending operations. We should not allow runaway growth of credit, especially that linked to the purchase of purely financial investments, and, it has to be said, to real estate.

All easily said. But the trouble is that it is quite painful. Attacking bank profits will look like an attack on one of a limited number of industries where British based operations are internationally competitive. Easing up on creating new banks means tolerating more banking failures and creating a more challenging environment for regulators. Restricting credit means curtailing the British love affair with property ownership.

It is easier to bang on about culture and lock a few people up. The one good thing about the crisis is that it helps keep the pressure up on the Vickers reforms. But when the dust settles the usual City types will be having a quiet word with their counterparts in the Treasury, Bank of England and the Prime Minister’s office about not throwing the baby out with the bathwater. The reforms will be quietly defanged. Bankers will continue to lord up. Taxpayers will continue to be exposed. And the British public will continue to be let down by bankers and politicians alike.

Let’s hope that this does not come to pass. Critics of the banking industry will need to keep the pressure up.

Why Paul Krugman is wrong

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

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

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

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

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

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

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

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

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

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

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

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

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

Is the US economy heading for a fall?

Most of the worry about the world economy is being directed towards Europe, and the Eurozone in particular. I am amongst a very small group of optimists on that front – but it is easy to see why people are worried. In fact it is only through a prolonged period of crisis that Europe will find an enduring solution. But meanwhile, should we be worried about the US too?

What prompted this thought was this article in Vanity Fair by the eminent economist Joseph Stiglitz (thanks to Marisha Ray for drawing my attention to this on Facebook). It’s subject is inequality, and why it is corroding the US economy, and why the elite (the top 1%) should worry. Judging by the FB comments, some readers saw this critique as applying to government thinking right across western world – the view that austerity economics is driven by an idealogical view of the role of government. But I took it as a very specific critique to the US.

Professor Stiglitz does not spend much time justifying the statement that inequality in the US is high and increasing. The problem is that almost all the benefits of growth are accruing to the top 1% of the population – and bypassing those on middle incomes. In other words the problem is not an underclass that is disappearing from sight – but a substantial majority of the population being left behind, with the creation of a fabulously rich elite. There are many ways of looking at the statistics on this, but for me one of the most important is the historically high level in national income that is taken up by business profits – the benefit of which goes overwhelmingly to the elite. This may or may not be outrageous in its own right, but Professor Stiglitz points out a number of practical problems that arise from this:

The very rich spend less of their income on consumption and save the rest. The more wealth that concentrates in their hands, the more consumption overall will fall as a proportion of the economy. Unless there are enough constructive channels for their savings then unemployment will result – unless alternative demand comes from somewhere. That alternative might be an investment boom (as with high tech in the late 1990s) or with big government deficits, propping up the economy now.
The rich elite use their power to protect vested interests and direct their energies to what economists call “rent-seeking”: activities that enrich the individuals themselves but not the economy as a whole. Under his analysis the finance industry is largely based on rent-seeking. As energies are diverted from genuine economic growth, the economy overall weakens. What is good for the profits of existing businesses is often not good for the whole economy – which needs new businesses to come forward.
The majority who are seeing their incomes stagnate, and find it more and more difficult to join the elite, get resentful, breaking down the trust that underlies all successful economies.

But there is a political puzzle at the centre of this. Why is the Republican Party both veering to the right and retaining substantial popularity? Surely the welling up of resentment against the elite should translate into overwhelming political pressure for a more egalitarian system? I think the American suspicion of government is to blame. I don’t think that the majority of American people are particularly happy with the way their living standards are being held back. But, incredible as it may sound to European ears, many of them think it is “socialist” government policies that are to blame. Shrink the government, cut taxes and the 99% will start to catch up with the 1%. Of course, huge funds from the elite are available to support this view in the media – through political campaigning and biased news coverage, such as Fox News. It hardly helps that a lot Americans seem to think they can have their cake and eat it: huge expenditure on entitlement programmes (especially Medicare) without the need for increased taxes.

If Professor Stiglitz is right then the US would be suffering from long term low economic growth, as the various toxic effects of its skewed income and wealth distribution gradually overwhelm the highly dynamic core economy. And indeed, measured per capita (i.e. taking into account population growth), the U.S managed annual growth of only about 1.4% in the first decade of this century (compared to the UK 1.7%, or Germany (1.9%) – though France only managed under 1% – figures from Wikipedia).

Still lacklustre growth won’t cause a crash. Italy has made an art of surviving such a challenge. But the proximate cause of a crisis is clear enough – the government’s budget deficit of 7.6%, and the lack of any political consensus in how to handle it. There are three ways in which this could cause a problem. The first is if the US government should hit the Spanish problem of being unable to borrow because of a loss of market confidence. This looks implausible. Investors have too few choices where to put their surplus funds. The second is expenditure cuts sucking demand out of the US economy, causing a prolonged recession. This could happen if the Republicans take control in this year’s elections. The third is political gridlock causing government funding to seize up, and causing technical default. This looks all too possible if the Republicans control either or both houses of Congress, as looks probable. Even if Mitt Romney should gain control of the presidency (and he’s doing well on fundraising), he may well run into trouble with Congress as he desperately tries to find practical answers to the deficit problem.

And what if the US survives the budget crunch in 2013? If growth continues to be lacklustre, and the top 1% continue to hog the benefits, surely US public anger will turn on the elite, as it did briefly in the last days of President Bush? I share the European view that a smaller government, reduced regulation and lower taxes will make the problem worse, not better. That will be a sight to watch from a safe distance.

The Guardian’s bubble – the view from my bubble

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

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

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

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

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

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

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

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

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

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

Translating that IMF report into English: the blindness of macroeconomists

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Europe and the US: the tortoise and the hare

Comparing the European economy to that of the US reminds me of Aesop’s fable of the race between the tortoise and the hare. The US’s flexible labour and product markets, and decisive interventions in time of crisis, give it the ease of the hare. To US politicians you only have to mention Europe to conjure up a picture of stagnant, over taxed and socialist economies.

But the tortoise wins the race in the fable. And indeed, if you look beyond crude GDP growth statistics the race looks close, depending on the precise time frames and so on. GDP per head tells a different picture to aggregate GDP (this is regularly quoted by The Economist, though I haven’t found a recent example to link to). Other statistics on the incidence of poverty, life expectancy and so on, show Europe in a better light – though the US still does well in self-reported wellbeing, but not as well as Scandinavian countries.

All of which demonstrates how commentators, especially in the US and here in the UK (whom I shall collectively call the Anglo Saxons, following French practice – though this is a dangerous shorthand) don’t understand the dynamics of European economic policy. As the EU lurches into another round of crises, this is worth taking on board. Once again the US hare looks better placed than the European tortoise. But look closer, and it isn’t so clear.

This is not to underestimate the scale of the crisis facing the Eurozone in particular. Massive problems confront the economies of Greece, Spain, Italy and Portugal; the French economy is not in a place of safety either. But Anglo Saxon commentators tend to relentlessly focus on the short term problems, to the exclusion of longer term issues, which they assume best dealt dealt with at a later time. Europeans (from which I exclude the British, for now, though for most purposes the British are very much European) tend to look at the problem differently. A crisis is one of the few opportunities to tackle longer term problems, and fixing the crisis while neglecting the long term is criminal.

The southern European economies are inefficient by developed country standards, and uncompetitive within the current Euro structure, and can’t sustain the level of social benefits that their electorates have come to expect. This lack of competitiveness was not invented by joining the Euro – it predates it, and is based on decades of poor economic leadership. Joining the Euro gave these economies a boost by reducing government borrowing costs – but this boost was used to put solving the bigger problems off until later. Their northern European partners are to blame for going along with this, until a crisis threatened to engulf them all. When the Euro project was launched, its supporters advocated it on the basis it would force governments to confront the inefficiencies of their economies, rather than rely on devaluation to put the problem off – a strategy that ultimately leads to stagflation, and even hyperinflation. But somehow these supporters seemed think that the omelette could be made without breaking eggs. But Europe’s leaders are keenly aware of their mistakes now.

The position of the southern European economies is not unlike that of Britain in the 1970s. A massively inefficient and uncompetitive economy had been kept alive by a benign international economic climate, until the 1973 oil shock knocked it over. There was no quick fix, no macroeconomic palliative to ease the pain. A floating currency hindered rather than helped. The turning point came in 1976, when the Labour government had to call in the IMF. Then started a painful process of government cuts and market reforms. This wasn’t what the party had promised when elected in 1974, and the government was grudging in the reform process. They lost the election in 1979, with Margaret Thatcher being swept to power, redoubling the pace of the reform process through the 198os. This cut huge swathes through much of British industry – making the current economic crisis in the UK look like a picnic, whatever the GDP figures say. It took about a decade of pain from 1976 before clear benefits started to show.

A similar hard road awaits the southern European economies. Leaving the Euro and devaluing won’t help (during the Thatcher years, to continue the comparison, the pound stayed high), and is institutionally much more difficult than most Anglo Saxon commentators assume. Europe’s politicians know this, and so aren’t looking for quick fixes. They are looking at a process of near continuous crisis in which the institutions, and political culture, required to make the Euro work are gradually put in place. Greece may be a casualty – it faces a real danger of being expelled from the Euro and probably the Union as a whole (it’s difficult to disentangle the two). It is slowly but surely being isolated to make that option less and less of a threat to the zone as a whole. But unlike many British commentators assume, Greece will find life no easier outside the Euro.

Martin Wolf’s gloomy article in today’s FT illustrates the difficulty Anglo Saxon commentators have in viewing the scene – and Mr Wolf is no shallow commentator. He makes reference to the comparison with Britain, thus:

This leaves “structural policies”, which is what eurozone leaders mean by a growth policy. But the view that such reforms offer a swift return to growth is nonsense. In the medium run, they will raise unemployment, accelerate deflation and increase the real burden of debt. Even in the more favourable environment of the 1980s, it took more than a decade for much benefit to be derived from Margaret Thatcher’s reforms in the UK.

Structural reforms are dismissed as taking too long. But is there any other way that such necessary reforms can be taken forward? Surely the British case illustrates that miserable economic performance for an extended period is unavoidable?

How different from the US approach! By comparison, the US’s economic problems are nowhere near as great as those facing southern Europe: at the core the US economy remains wonderfully competitive. But they have a terrible problem of government finance and social justice, which neither politicians nor public want to confront. Instead we get a series of short term fixes, which look decisive, but which simply increase the scale of the problem that has to be tackled later. Americans have to choose between higher taxes and reduced Medicare and Social Security benefits, or some combination of both – and yet neither are seriously on the political agenda.

In the fable the hare loses the race because he is so confident he takes a nap. A similar misjudgement by America’s political class, abetted by British and American observers is in the process of unfolding.