Economics & Finance – Page 2

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

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

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

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

In order to spend money in government the party will need to raise it. There is a very good way to do that. It is to shift the tax burden away from labour and on to capital, away from work and on to wealth.
Harry Lambert, New Statesman 30 August 2023

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

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

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

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

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

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

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

Why the language of economic growth is obsolete

Screenshot from the Bank of England’s Explainers

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lower immigration means paying more for public services

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

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

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

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

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

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

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

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

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

Banking crisis: are we in 2008 again?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Productivity, growth and wellbeing – the awkward triangle

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

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

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

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

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

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

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

Brexit: the capitalist advocates have been proved wrong

The third anniversary of Britain leaving the European Union caused of a spate of comment in the media a couple of weeks ago. For me it was a moment of great sadness, but I’m trying to move on – though I still wish political destruction on every politician that advocated it. But it is as good a moment as any to reflect on what has happened.

Opinion surveys show that people who voted to stay in still think they were right to do so. They think that the arguments made in favour of staying in have been borne out. Some of those who voted to leave feel they made the wrong choice, though. But mostly they don’t – they think that it is too early to tell, or that the opportunities have been mis-handled, or they are actually happy with they way things have unfolded. What unites most from both sides is a sense of gloom, and a lack of confidence in the government. Another thing that seems to unite both sides is a wish not to reopen the debate.

In terms of the economic statistics it is very hard to isolate any economic effect of the change, especially when the Covid pandemic, the war in Ukraine, and the escalation of energy prices is confuses the picture. There is abundant anecdotal evidence that smaller British businesses have given up exporting to the European Union, or indeed to anywhere. But the aggregate trade statistics don’t paint such a clear picture. Investment has fallen since the referendum result: Brexit is an obvious culprit but it would be hard to prove it.

But if we step away from the economic statistics, some things are becoming clearer about Brexit. It isn’t too early to look at how the reality is working out against the vision. There never was a single vision, though. I can see three main ones: the globalist case, the isolationist case and the socialist case. The globalist case is the closest to the one the government espouses. This regarded the EU as a barrier to trade and free enterprise, for two main reasons. Firstly it entailed a substantial regulatory burden, covering not just products, but the way they were made (for example labour and environmental standards), and this raised costs. And second the EU raised barriers to trade with countries outside the union, which included rapidly growing markets in Asia in particular. Britain could be a country of free-wheeling (or even buccaneering) enterprise. Sometimes this was called “Singapore on Thames” – apparently by people who had little idea what of Singapore actually is – though doubtless an authoritarian, technocratic one-party state with a taste for intrusion into private life actually appealed to many of them.

It is becoming clearer by the day that this idea is nonsense. British people draw comfort from regulation, and every attempt to lighten the burden is met by howls of protest. And it is far from clear that changing regulation will have an economically beneficial effect in more than a few limited areas. Indeed it seems to many that life outside the EU involves more red tape, not less – for imports and exports, travel and immigration. Meanwhile almost all trade deals so far struck with countries outside the EU are little different from what the country had inside. The exceptions are Australia and New Zealand, which will have little impact, and probably not much that is positive for British businesses (but maybe better for British consumers). Doing deals with China, India and America – the big prizes, has proved much harder than envisioned. Brexit supporters are now talking darkly of a conspiracy of Remain-supporting establishment types undermining progress – but a lot of the trouble comes from their on side (especially so far s reactions with India and China are concerned). But the logic never was very convincing. The kindest suggestion is that it is 20 years too late – perhaps there would have been more to play for when globalisation was going full throttle, rather than in its current gentle retreat.

But it is unlikely the most people who voted for Brexit shared this vision. They were drawn to an idea of Britain that was less integrated with the world around it, not more. This was focused on one idea in particular: “control over our borders” – limitations to immigration, rather than the free movement within the union. Supporters of this idea, like Nigel Farage of Ukip and the Brexit Party, did not point to any other countries as a model: Britain was one of a kind. Perhaps some people thought of Australia, a fiercely independent Anglo-Saxon heritage nation, with strict immigration rules. Suggesting an “Australian-style points system” to manage immigration received widespread approval, even though few people understood it or its implications. Another model might be Japan. Japan is an island that trades with its giant continental neighbour, China, but emphatically maintains its distance politically. It limits immigration, and, whisper it, prides itself on ethnic homogeneity (unlike modern Australia). It is also a highly successful country, that scores well on many indicators of quality of life. Economic growth in the last thirty years has been anaemic, but that only invites the question of what economic growth is for.

How is Britain doing under this isolationist vision? Free movement of people between Britain and Europe is now gone; many people from other European countries have left, and immigration from there is is now a trickle. All immigration is now subject to bureaucratic controls. If labour shortages have resulted, then this may simply be a first step towards giving local workers more opportunities. On this vision, things are going much better. There are three problems, though. One is an influx of refugees and others arriving in small boats on the Kent coast. I don’t think anybody had expected this to be so much harder to manage outside the union than within it; but the country can’t simply deport people back to France as it could before. This has turned into a major headache, especially for the authorities in Kent, and there are no convincing solutions that don’t involve doing a deal with the EU, which would involve accepting many more refugees legally, and undoing one of the perceived benefits of Brexit to isolationists. It is possible to take a bigger view of this: even allowing for this influx the country is taking fewer refugees than before. Unfortunately for the government, people supporting the isolationist view tend not to get such things in perspective. It is undoubtedly disorderly – though chicken feed to what Italy or Greece have to deal with.

A second issue is that, notwithstanding the hurdles, immigration has not reduced overall. Instead of people arriving from the EU, they are coming in from elsewhere. Fortunately for the government, the public seems much less stressed by this than by the boats. It is a relatively orderly flow of people after all, and by and large they are going into better-paid (or “high-skilled”) jobs that the economy needs, or paying extortionate student fees. But it does complicate the scorecard. The government can’t claim reduced immigration as a Brexit achievement. Indeed, every idea for reducing numbers, like cutting back on foreign students, looks like self-harm.

The third problem is that real wages are in steep decline, as inflation runs ahead of increases in pay. And the government is aiding and abetting this by putting maximum pressure on public sector pay. Brexit was supposed to increase wages by stopping low-skilled immigration. Perhaps supporters of the isolationist case, often retired, aren’t so bothered. But it is a long way from the case made for Brexit at the time of the referendum.

All this is indicative of a hole in the heart of the isolationist case. Australia has abundant natural resources it can exploit (or pillage, if you prefer – sustainability is not high on the Aussie agenda); Japan has a manufacturing industry that is still world-beating. There are world-beating bits of the British economy, but not enough. Nostalgia won’t bring back Britain’s once world-class manufacturing industry. Coal, oil and gas are in steep decline, if not dead. And some of the successful bits of the economy, like global financial services, benefit few, in the wrong parts the country, and have a distinctly dark side (the country was very popular with Russian oligarchs for a reason). The country has been running a current account deficit for over two decades, and, notwithstanding the depreciation of sterling, it isn’t getting any better. This turns out to be more sustainable than many economists thought – in the sense that it does not seem to be leading to the sort of financial instability that other deficit countries (like Argentina or Turkey) have suffered. But it does seem to be affecting the country’s terms of trade – though it is statistically hard to pin this down. According to one calculation the country’s real effective exchange rate is 83% of what it was in 2005 (i.e a fall of 17%). British people can buy less foreign goods and services with each hour’s earnings than used to be the case. There isn’t enough high-productivity, export-generating industry in the country. This problem has its roots in the relative industrial decline of the 1950s to 1970s, and the hollowing out of the the manufacturing economy under Margaret Thatcher. This largely pre-dates membership of the EU, and arguably was made worse by it. But somehow it was easier to cover the cracks within the Union.

The third case for Brexit I mentioned is the socialist one. This case has not yet been tested. According to this the EU is a capitalist-designed, anti-democratic system that prevents governments for taking their economies in a socialist direction. Not all (or even most) socialists followed held this view – hoping to reform the union from within – but its logic is solid enough. Holders of this view are fiercely defensive of national sovereignty – their aim being to take democratic control of the country, and drive through radical reform from there. Their economic reform ideas are not particularly popular (though perhaps not that unpopular either), but their ideas about national sovereignty are widely shared. Ironically, since the main advocates of Brexit were at the more aggressive end of capitalism, it is perhaps socialist policies that present the main national opportunities after Brexit. These will not fix the country’s export problem – export industries, other than mining or drilling perhaps, tend to need capitalist leadership succeed. But it may set in train a fairer distribution of income and wealth. I suspect that there is a hybrid of modern socialist and liberal ideas that could lead to a thriving society – and perhaps it is easier to pursue that path outside the EU, though I doubt it would make all that much difference. Other European citizens would be at least as interested in such ideas as the British are. Alas there are too few people anywhere who are pushing in that direction.

Is Liz Truss right about the “economic establishment”?

UK Treasury: Picture by Carlos Delgado, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=19020165

Last weekend former British prime minister Liz Truss reentered the public sphere with an essay in the Sunday Telegraph, and an interview with The Spectator, publications that are both relatively sympathetic to her cause. This has occasioned much derision in the wider media. While I share much of this derisive view of her, I’m not going to join the chorus – it’s been said too well by others. Ms Truss has simply reminded most people why they dislike her so much. I want talk about the issues she raises, both in terms of economic policy, and how it can be implemented in Britain’s institutional environment.

Ms Truss’s starting point is what is widely seen as the UK’s dismal economic performance since the great financial crisis of 2008-09. Economic growth has been dismal, and if Britain has been able to maintain the pre-crisis trend of growth, then, according to Tim Harford in the Financial Times, it would be a staggering 40% better off. She attributes this to policy mistakes – a view that seems to be widely shared, even if not many agree on what those mistakes were. Personally, I differ from this – I think that the lack of growth is a reflection of adverse economic conditions, which started before the crisis – principally demographics and a changed world trade environment, made worse by Britain’s lack of a strong manufacturing industry. Liz Truss’s solution is to go back to policies popularised by the US president Ronald Reagan in the 1980s, and often attributed to Britain’s Margaret Thatcher too, though in fact she was much more cautious. These are mainly a matter of tax cuts, especially for businesses and the well-off, and deregulation. What she particularly favours is to proceed with tax cuts without regard to short-term effects on the public budget deficit, in the belief that an expanding economy will make things good in the longer run. She was always reluctant to talk about cutting public spending, and in the case of defence, advocated a substantial increase.

Her views on tax are largely magical thinking. Tax cuts might directly stimulate growth by increasing demand, but not as efficiently as many other policies, such as more generous state benefits, and not at a time when inflation is running riot. Lower corporate taxes might attract inward investment – but they are not widely thought to be a major factor, especially when the country’s politics seem so unstable. To her credit, though, apart from tax cuts, she advocated supply-side reforms that stand a much better change of promoting growth. These included easing immigration rules and making it easier for parents of small children to reenter the labour market. These weren’t popular in her own party, though. In her speech to the Conservative Party conference she decried an anti-growth coalition – which it struck many observers as being mostly her own party. However, her supply-side ideas had nothing like the heft to make more than a small difference to the country’s growth rate. Tax cuts (or forgoing tax increases) were her only big idea.

She has a second huge blind spot: inflation. She does not appear to understand that this usually arises from excess economic demand – and therefore that taming it requires deliberately crimping economic growth. She persistently seemed to think that inflation was somebody else’s problem – in particular the Bank of England’s. I find it astonishing that somebody whose degree course included economics (PPE at Oxford) can have thought this way. Everything interacts with everything else, and if you are the head of government, you are ultimately responsible for all the tools of macroeconomic management. What individuals do with their personal time may not be government’s problem; what public institutions do most assuredly is, even if they are run at arms length.

But amid all this foolishness and and failure to understand how things actually work, she did touch on something that is true. She railed against the “economic establishment” (the Sunday Telegraph unhelpfully added “left-wing” to this in their headline, but she neither said that nor meant it). She was particularly vehement about Treasury orthodoxy, which she saw at first hand in two years as a Treasury minister. The power of this orthodoxy undermines, usually fatally, any attempt to implement policy that contradicts it. That included her fiscal policies. They didn’t have her back when things got rough, and they forced an about-turn on most of them. What is a bit less clear is how Ms Truss fits the people controlling the world’s financial markets into this orthodoxy. She and her supporters are trying to blame the derivative based policies used by many pension funds for creating an unstable situation, about which nobody warned her or her Chancellor, Kwasi Kwateng. The Bank of England, also part of the orthodoxy, should have handled this better, they suggest. Rather interestingly, when she describes these polices as allowing the funds to invest more in businesses rather than bonds, they sound like just the sort of pro-growth idea she should be supporting. Of course the real problem here was the imperious arrogance with which she and Mr Kwateng treated financial markets. And as for the Bank of England, it was widely known that it was struggling to manage markets because inflation had caused a reversal of its loose-money policies, especially Quantitative Easing, upon which markets had come to depend..

I have some radical economic ideas of my own, though quite unlike Ms Truss’s. These are that Britain is far too centralised, and that responsibility for the many trade-offs required in financial and wider policy need to be radically decentralised. It’s not surprising that people oppose housing or industrial investments in their local area, when they will not be accountable for the benefits. The tough decisions are made in Whitehall, leaving with nothing else to do but complain. But this is part of the Treasury orthodoxy too – they don’t want a chaotic decentralisation, with corrupt nobodies taking decisions without the Treasury having ultimate sign-off. When the government wanted to distribute funding for its “Levelling Up” agenda, it didn’t distribute funds for disposal by the city regions and councils, it made these institutions put in bids for the imperious mandarins to pick from. To be fair, government leaders seem a bit embarrassed about this, and say there will be changes in future. But how did they allow this in the first place? And what credibility do their promises to do things differently next time have? The Treasury will undermine any effort they make to reform things. It is now reported that the Treasury is refusing to authorise any capital projects proposed by the Department for Levelling Up. The Treasury isn’t all in the wrong here: the levelling up funding was originally envisioned by former prime minister Boris Johnson as a politically directed slush fund to help win marginal constituencies. The power of the orthodoxy is that it is often right.

So the “economic establishment” would undermine my ideas for reform just as surely as they did Ms Truss’s. It’s a real thing. Any serious attempt at political reform therefore has to take on the orthodoxy and beat it. It can be done. Mrs Thatcher did it, and, to some extent, so did Tony Blair and Gordon Brown for Labour in the early 2000s, especially with their radical expansion of health funding (and it required both of the double-act to do it). It took these leaders years and all their political skill. The remarkable thing about Liz Truss is that she thought she could break the Treasury in an afternoon, based on a mandate she had won from 100,000 or Conservative Party members.

And that is the point. We need political leaders who understand the orthodoxies and how to challenge them – people with political skills high and low. The current government possess few, if any, people of that description. Do Labour? I really don’t know. I haven’t been that impressed with Sir Keir Starmer, their leader, or Rachel Reeves, his Shadow Chancellor. But I could be wrong – they are becoming more effective. One opposition politician I am sure has the necessary heft and skill is the Liberal Democrat leader Ed Davey, having honed those skills as energy minister in the coalition government of 2010-2015. Perhaps he will get another chance.

The Economist advocates turning the clock back on trade

Last week’s Economist led on the dangers of changing political attitudes to world trade. The paper suggested that the rise of “zero-sum thinking” threatens capitalism, liberal democracy and the livelihoods of many. But we live in a world were the conventional wisdom of economists is being challenged – from inflation to interest rates to economic growth. The conventional wisdom on trade needs to be challenged too: not because the economics is wrong, but because the context has changed.

There are two central foundations to economists’ understanding of the benefits of trade. One is the logic of comparative advantage, one of the first insights of modern economics when it got going more than two centuries ago. What matters when resources are constrained (as they almost always are) is opportunity costs, and not absolute costs. It is more efficient for for a less productive supplier to produce goods, if the more efficient one is better able to produce other goods that are in short supply. It is one of the first things economics students are taught, and one of the most important challenges to “zero-sum thinking”, which suggests that imports are bad because they put local people out of work. Those people can be redeployed to make things things more productively in world terms, meaning that everybody can benefit.

The second foundation for the economic benefits of trade is economies of scale and the benefits of specialisation (or economies of scope). Industries may not have critical mass in their own market – but through trade they can access bigger markets, benefiting everybody. This idea can work alongside comparative advantage (the concentration of watchmakers in Switzerland presents economies of scope and scale, which in turn leads to comparative advantage, for example). That makes them easy to muddle. Economies of scale and scope do not necessarily lead to comparative advantage, and you can have comparative advantage in a particular area without economies of scale or scope. This needs to be picked through with care – which alas The Economist seldom does. Now let’s step back and look at how world trade has evolved in the last 40 years or so.

The massive explosion in global trade in the 1990s and 2000s is mainly explained by comparative advantage. The thing to understand about comparative advantage is that it is driven by differences in economic structure, which create differences in opportunity costs: it is a function of difference. China, the largest driver of this surge in global trade, was a very different place to the developed countries it traded with in 1990. A vast number of people were still employed on the land, in highly inefficient agriculture; in the developed world the agricultural workforce was nearly insignificant, while producing much more food than it could consume. By shifting workers from agriculture to manufacturing in China, a lot more manufacturing goods could be produced, with any shortfalls in agricultural production made up for by developed world production with a negligible increase in workforce. This meant that Chinese manufactured goods were dirt cheap, while its agricultural produce was expensive – a colossal opportunity for world trade, even if Chinese manufacturing productivity was much lower than in the developed world. The process worked something like this: low agricultural productivity ensured low wages; low wages meant cheap manufacturing products, even with low manufacturing productivity. The picture was a lot more complicated than this – it wasn’t actually a case of China importing grain while exporting washing machines (they imported more capital goods than food) – but comparative advantage was the driver.

That is all Economics 101. But while economists understand how comparative advantage works in principle, they are surprisingly ignorant of how it works in practice. It has improved impossible to model the dynamics of comparative advantage in a way that produces the detailed results and predictions that are most economists’ day job. So, after they have completed their undergraduate studies, few economists think much about it. If they did they would me more alive to the issue of convergence. The Chinese economy, like the Japanese and South Korean economies before it, did not stand still. Productivity shot up, especially in agriculture, and the agricultural workforce rapidly diminished, while that of manufacturing and services rose. Convergence with the developed world happened at astonishing speed, and as that happened the differences that drove comparative advantage diminished. Developed countries started to find Chinese products becoming more expensive. The incentives for long range trade between China and the rest of the world diminished. This hurt developed countries much more than it did the Chinese – as the Chinese benefited directly from increased productivity and rising wages. It is, I believe, one of the reasons for sluggish growth in the developed world since the great financial crisis of 2007-09, though it is almost never mentioned as a factor (and certainly not by The Economist), in spite of the great economist Paul Samuelson drawing attention to it.

This is where the second factor can come into play – economies of scale and scope. In Europe, for example, the leading economies converged in the late 19th and early to mid-20th centuries. Comparative advantage diminished. But, after the Second World War, trade within the continent flourished, so clearly something else was behind it. Why, for example, did Germany, France, Britain and Italy all have substantial car industries, all with a lot of cross-border trade? This shouldn’t happen under comparative advantage, unless the cars each country made were somehow very different from each other. In fact the economics of motor manufacture meant consolidation into larger and larger firms was required to be competitive. Cross-border trade gave consumers more choice, and the other benefits of competition, if their own country only had room for one or two car firms. As Europe developed its single market, economic benefits flowed – but on nothing on scale that flows between more diverse economies. There are two sorts of benefit here. The first is that the benefits of economies of scale lifting productivity; this can work in quite a similar way to comparative advantage, with some countries specialising and others happy to have cheaper products (the aero industry is a bit like this). The second derives from good old fashioned competition between businesses in different countries. This is very different, as this only works if multiple countries are making similar products. We must also bear in mind that as the gains or more limited, it requires a level playing field to work; if one country suffers a systemic disadvantage, such as high transport costs because they two oceans away, then the benefits of trade diminish. That is one reason that Europe had to develop detailed rules for free trade, while the Asian economies’ rise was based on much cruder arrangements, such as World Trade Organisation (WTO) rules.

The important thing to realise about economies of scale and scope is that they are dependent on technology and not any iron logic of economics, as is the case for comparative advantage, although you wouldn’t think it from the way many executives from large businesses talk. And technology changes with time. The late 20th Century was particularly good for economies of scale, but that is changing. And that is for two reasons. The first is the rise of technologies that diminish the costs of short production runs and individualisation (indeed the same edition of The Economist featured this in its business section – a new theory of the firm – one of the articles featured on the cover). The second is the diminishing importance of manufactured products in the economy as whole, compared to services, such as healthcare, which are largely untradeable. All this points to reduced benefits from trade, especially between big geographical blocks like America, Europe and East Asia, as opposed to within them.

Where does that leave the current debate on trade? The first point is that I don’t think the benefits of trade are diminishing because of political obstacles; I think those political obstacles are arising because the benefits of trade are diminishing. The second thing is that, for developed economies, there is no great box of goodies that can be unlocked through trade liberalisation to help flagging growth along. Doubtless there are further benefits to be had – and especially with less developed countries if done in the right way, but not on the scale that saw the economic transformation of the 1990s and 2000s.

Now let’s look at biggest specific issue bothering The Economist – the problem of US government subsidies for green industries. Europeans are worried that this will make their own industries uncompetitive. That is a legitimate worry, but if Europeans match those subsidies with their own, the damage will be limited – and, indeed, it might hasten the transition to clean technology, with the benefits that will flow from that. The Economist worries that it will lead to inefficiency and, horror, duplication. And yet duplication is a prerequisite of competition.

Still, trade remains integral to the modern way of life and deserves continued political attention. For some things, the importance of both comparative advantage and economies of scale and scope remain undiminished. Only a few countries have direct access to metals such as cobalt and lithium, which play a critical role modern industries. And serious economies of scale or scope remain in others, such as the mining of iron ore (Australia has unmatched scale economies), or the manufacture of advanced microchips (Taiwan leads in scope economies). But the key the issue is not just economic costs, it is the potential for serious dislocation if supplies are interrupted. The modern economy contains many bottlenecks. We have to balance the benefits of short term cost savings with the risks of natural disaster and conflict. Alas the solutions are likely to make manufactured products yet more expensive.

The reason for the rise of “zero-sum thinking” is that the economics of trade is moving in that direction too, though the benefits of free trade remain substantial. It is not surprising that other issues loom larger than trade freedom, such as security of supply and the need to accelerate the transition to clean energy. It is easy to understand why The Economist wants to turn the clock back to the days of easy trade gains and steady economic growth – but it does not help prepare its readers for the hard choices ahead.

The British Left needs to moderate its obsession with austerity

I’m not reviewing this book, but title reveal the left’s attitude to austerity

As a Liberal Democrat I’m often described as being on the political left. One word shows that this is far from true: “austerity”. To people on the left, especially in Britain, this word brings up a visceral reaction. To them austerity is the quintessence of evil: the crushing of all attempts to promote the public good, perpetrated by a brutal government out to protect the interests of the rich. But to me austerity is a government policy that is often necessary – and is part of a healthy tension that keeps the state efficient. Still, I always like to understand the arguments of people I disagree with, and when I saw a link on my New Statesman email to an article by William Davies entitled Fascism’s liberal admirers, I thought I’d take look. The sub-title was Austerity is a fiction designed to uphold capitalism – and it has a dark history. The pretext (I would not call the article a review) for the was a book by Clara Mattei called The Capital Order – How economists invented austerity and paved the way to Fascism. The subheadings demonstrate what I mean about the left’s attitude.

Which is why I was expecting a lot of nonsense – and by and large that is where the article ended up. But along the way it constructed a narrative that was fr from nonsense. The book is about the rise of Fascism, and how the pre-Fascist government in Italy in the 1920s was being pressured by Britain (as a creditor nation) to adopt austerity policies. The British ruling establishment had taken on the austerity narrative after the First World War, and was delighted when the Fascists in Italy followed through with these policies after they took power. Ms Mattei’s and Mr Davies’s point is that this narrative came about as a reaction to a socialist narrative that the success of war economies showed that there was an alternative to market capitalism, with economies led by, and substantially owned by, the state. Revolution was in the air. The capitalists needed to stamp this thinking out, and they aggressively promoted pro-market policies and a rolling back of state intervention. It was not a narrative based on economic necessity, but one developed to protect vested interests. It is but a short step for Mr Davies to suggest that this is what has been happening in the 21st century, following the financial crash of 2008, and now – with the fall of the Liz Truss government. That, historically, support for austerity led capitalists to embrace Fascism shows how they will turn on democracy to protect their interests, and economics is just camouflage. The fight against austerity is the fight to preserve democracy.

There’s something in this. Pretty much all economic policy, whether capitalist, socialist or anything else, is a conspiracy of vested interests: people try to persuade the public at large that their ideas are for the public good, using any argument that they think might gain traction, spurious or otherwise. That is how large, complex societies get anything done. Truth is incidental. And, though I’m not an expert, I think that the British ruling establishment over-reacted to the prospect of more socialist ways of working in the 1920s, and their arguments in support of the package of policies that Mr Davies calls “austerity” do not stand the test of time (though economies in the 1920s swiftly moved to growth after austerity – and it was not until the depression of the 1930s that the narrative seriously came to be questioned). After all they did something quite different after the next war, and capitalism (and wider society too) has never flourished more. It is a stretch to say that the same applies to 21st century episodes of austerity in Britain and the Eurozone, but there is a case to answer. Many of the justifications put up by the supporters of austerity policies were nonsense. So if you want to believe that austerity is always and everywhere economic nonsense promoted by self-interest, you will always find plenty of evidence. That is the insight I gained by the article. Evidence, but not proof.

The resources required to make an economy work are always limited. The bottom line is that economic policy will always be limited by resources, and that the more efficiently those resources are used, the more successful an economy will be. There are times when it pays a government to spend money to do things that are useless. Keynes wrote of getting people to dig holes and fill them in again; Hitler ramped up spending on armaments. That is when the economy is running slack and needs pump-priming. The people digging holes or making tanks spend their wages buying other things, creating a virtuous circle of job creation. Austerity is a bad idea at such times. But when the economy is running at close to capacity, or overheating (as is the case in most developed economies in 2022) then that logic disappears. If anybody, anywhere is employed doing things that don’t enhance society, it is means that the economy is running less efficiently than it should. If the government is running inefficiently, then austerity policies can be justified to cut waste, and move people from doing useless things in the public sector to being more useful in the private one. That is the basic intellectual case for austerity. And it is why governments of all economic stripes, capitalist and otherwise, will often carry out austerity policies. For example, Cuba’s socialist government after Soviet subsidies were withdrawn in the 1990s.

It goes deeper. All human organisations have a tendency to become complacent, and settle into inefficient ways of working to minimise internal conflict. In private enterprise this tendency is tempered by the need to compete, and by downturns in the business cycle. I well remember this from my work days. Things would seem to be going well, and then there would be a crisis. Savings had to be made, usually, eventually, entailing job losses. Workers were disappointed and often angry; but the overall effect of this stop-start was a more healthy, efficient and focused organisation. Some good things might be lost in the process, but that was outweighed by the reduction in waste and follies curtailed. The public sector is generally insulated from such commercial pressures, and so has an even greater tendency to become inefficient. Bouts of austerity act as a check on this, and force managers to focus on what needs to be done – though they won’t thank you for it.

But the timing is often difficult to decide. It is not always easy to tell if an economy is running slack or close to capacity. There is an argument to be had about that in Britain in the 2010s. But the real problems happen over resources transferred between countries. Economies are often sustained by using resources provided by other countries. But this creates international obligations – as well as the temptation to profligacy. If people in one country supply resources to people in another one, they do so because they expect to be repaid in some shape or form, usually profitably. If it turns out that poor economic management (or any other problem) puts the repayment in jeopardy, then the creditor countries will often insist on austerity. This is not always the right thing to do, but the basic premise that the debtor country is consuming more resources than it is producing, and needs to adjust to something more sustainable. This can be a capitalist conspiracy, but it doesn’t have to be. The politics around it get messy with truth, as usual, a casualty; creditors accuse debtors of profligacy – debtors accuse creditors of gratuitous cruelty. Some governments practice austerity simply to prevent getting into this sort of situation – the socialist president of Mexico, Andrés Manuel López Obrador, is an exemplar of this.

All this is common sense. Austerity – and this is best understood as cuts to government spending, rather than raising taxes – can simply be about the management of finite resources in a changeable environment, and doesn’t have to be ideological. So why do the British left react so violently to the idea? I’m not sure how deep the history goes. The New Labour of Tony Blair and Gordon Brown of the mid-1990s embraced austerity, but they were hardly of the left – but the left seemed happy enough to keep in tow. I think the issue originated from the coalition government of 2010. In the five or so years before this, the state payroll, direct and indirect, had expanded considerably. Many parts of the state had become very inefficient. At the time I could see this in both education (I was a school governor) and health (I was following health affairs closely, as I was looking for a job there). In both areas I could see over-complicated management structures and performance grids, and lightweight policies implemented to placate some lobbyist or other. Capital funding was tied to a bidding process that required the use of consultants on both sides. The bidding process was a matter of verbiage – the trick being to find the right trigger phrases. I read my borough’s bid for primary school expansion (which was successful), and it seemed to carefully saying nothing at all – but it was the work of many senior people, with external advice. In the NHS, funding was driven by something called “World Class Commissioning” – a vastly over-engineered superstructure designed to provide employment to consultants and middle managers. I could go on. The writing was already on the wall before Labour lost the election of 2010, as the crash put government finances under strain, but the government had been slow to apply austerity. Not so the incoming Conservative-Lib Dem coalition. They put in place a vicious programme of spending cuts. Suddenly a whole class of public sector employee found their livelihood at risk – and worse, political leaders were suggesting that their endeavours had all been a waste of time. That triggered an angry backlash. And just as the right tends to be controlled by the interests of capitalists, the left tends to be controlled by the interests of state employees.

By and large the angry people were university graduates trained to look for abstract principles to make sense of events. So instead of just protesting against the concrete adverse effects of particular cuts, they spied an abstract idea to focus their anger on: austerity. Austerity was evil; the cuts were not necessary but ideological. Many economists criticised the cuts as excessive, causing a needless recession and economic wasted resources – and this was seized on as evidence of the evils of austerity. As this line of thinking developed in the usual echo-chambers of social media and friendly journals, it morphed into the idea that austerity is always and everywhere evil. Mr Davies’s article shows how entrenched that thinking remains.

And that is a problem. The left seeks to achieve political power, and to do so democratically they must persuade people that they can be trusted. But most people’s attitude to austerity is pragmatic: sometimes it is required. Most people probably have their own hobby horse of perceived government waste that austerity could be used to sort out – though there will be no general agreement on what these actually are. A class of politicians that cannot let the idea that austerity can ever be justified pass their lips are going to find it very hard to win that trust. And yet it is more than easy to campaign convincingly against specific cuts – at a time when so many public services are wilting under pressure, and the public safety net is obviously inadequate in many places. The politically sensible thing to do is to allow for austerity in theory, but oppose it in the here and now: or to follow the example of Gordon Brown who advocated austerity in the mid 1990s, but once in power and having established public trust, launched the expansion of the British state.

The left are part of the Labour Party, but do not control it. The Labour leadership understand well enough the politics of all this. Polls show that they are maintaining credibility on economic management. The left’s obsession with austerity in the abstract undermines their political influence. Which means the advocacy of any good ideas they have is weakened. In a world when many long-held beliefs are being challenged, the left should challenge this shibboleth.