Economics & Finance – Page 21

A brief guide to Keynesianism and the economic crisis

Hardly a day goes by without the dead British economist John Maynard Keynes being invoked, such as this article from this morning’s Independent. Generally it is the critics of austerity that use his name, although this article is more nuanced, blaming George Bush and Gordon Brown for getting us into this mess by ignoring Keynes’s prescriptions. And many more economists, including big names like Paul Krugman, use ideas that most people understand as “Keynesianism” even if they do not evoke the great man directly, rightly thinking it is better to appeal to logic and evidence rather than dead men, however great. Inevitably a lot get taken for granted in these arguments. For the benefit of amateur economists like me, in this long posting I want to explain and re-examine Keynesianism, in order to assess its relevance to the current crisis, especially here in the UK.

What do we mean by “Keynesianism”? It is the idea that government fiscal policy, public expenditure and taxes, should be used to counteract a deficiency in demand in the total economy. It originated with the insights of the great economist, and his reflections on the Great Depression of the 1930s. Its starting point is that a whole economy does not work like a household budget. It may be very sensible for a household to choose to spend less than it earns, but a whole economy cannot do this. Supply must equal demand; you cannot store more than a trivial amount of production from one period to the next. If across a whole economy more people want to spend less than they earn, in other words to save, then there isn’t enough demand to meet supply and the economy must shrink; people are put out of jobs and so on.

Not so fast. Things balance out of the net saving can be channelled into investment. Investment, in economics, refers to production for future benefit. This usually refers to business investment (machines to make future production more efficient) but can also refer things like building houses which are “consumed” over a long time period . But if savings are not matched by investment there is trouble.

The possibility of trading with another economy complicates the picture, of course. Net saving can be balanced out by net exports. But net exports across the world economy are zero, so this option isn’t available to everybody.

In classical economics there is no lasting mismatch between savings and investment, because markets balance the two out. If there is too much saving, then this stimulates the supply of investment opportunities, for example by reducing the rate of interest. Keynes’s great insight was to see that often this market mechanism doesn’t function properly, leading to prolonged unemployment. And unemployment is a waste; production lost forever. Much better to use this surplus labour inefficiently than not at all.

Extra spice is added to this logic by the idea of the multiplier effect. If, for example, you stimulated the economy by paying extra benefits, then the recipients of the benefit would go out and spend them, and the people receiving this spending will spend more in turn, creating further demand and so creating more work. The same logic applies in reverse; austerity tends to multiply itself too. This effect is probably what students remember best about Keynesianism. It gives the idea of Keynesian stimulus gravity defying properties – so that government spending on stimulus can pay for itself in extra taxes generated by multiplied demand (and the reverse, of course, with cuts being self-defeating).

Keynesians point to the Great Depression as an example of how things can go wrong, where excessive austerity turned a setback into a disaster, only rescued by the War (and what could be more wasteful than fighting a war?). Critics of this view, incidentally, point out that the primitive state of the world’s banking systems had a lot to with this disaster, and so you can’t really compare it to now.

After the war, demand management by governments using fiscal policy became pretty much the orthodoxy. But this went wrong in the 1970s, when a Keynesian response to the oil crisis simply led to rampant inflation, rather than reduced unemployment. What are the problems?

First of all, Keynesian stimulus can’t push an economy beyond the limits of its economic infrastructure. To do so simply creates inflation. After the oil crisis disaster, economists modified their ideas to take account of this, bringing in such ideas a as a “natural” level of unemployment, and giving a major role to monetary policy alongside fiscal policy. This set of ideas became “neo-Keynesianism” and the orthodoxy of the 2000s. It was what I was taught in my macro-economics course in 2005-08 at UCL.

A more subtle criticism is that fiscal stimulus is undermined by human behaviour. If people respond to extra money in their pockets by saving more, the stimulus effect evaporates. An idea of “Ricardian equivalence” has been developed to postulate that extra government spending would always be offset by extra saving, because people know it would lead to more tax, for which they must save. Responding to this, proponents tend to suggest stimulus to areas where this is less of a risk. For example, benefits to the hard up, rather than tax-breaks for the rich.

Another idea, in floating exchange rate economies like Britain’s, is known as the Mundell-Fleming effect, which predicts that fiscal stimulus simply causes the exchange rate to appreciate and crowds out exports (or is lost in imports). This idea is quite difficult to get a grip on, and anything to do with predicting exchange rates turns out to be impossible to prove. But it does offer an explanation of why the pound appreciated after British government’s stimulus programme following 2001. And the basic idea that fixed exchange rates undermine monetary policy while floating ones undermine fiscal policy has the undoubted merit of symmetry. So British austerity should be offset by a lower pound which stimulates exports. The first part of this prediction seems to be working, but the second is slow to come about, not least because so many of our usual trading partners are in crisis too.

But the strongest objections to Keynesians come from the so-called “Austrian” school, because its more famous advocates (Schumpeter and Hayek in particular) were born in Austria. This sees unemployment as a essential to a process of creative destruction, as inefficient and unwanted businesses go to the wall, to be replaced by better ones. Keynesian stimulus interferes with this process, in particular by leading to wasteful investment; any temporary relief is offset by longer term problems.

From within the neo-Keynesian camp there are also those who advocate the use of monetary policy to manage the business cycle, as being much more efficient and effective that fiscal policy. These seem to include the British Chancellor of the Exchequer, George Osborne.

So how to apply to the current economic crisis, and in particular to Britain? The first point is that the pre-crisis economy was built on false premises, with unsustainable borrowing and a property boom. It cannot be recreated by applying stimulus. Not everybody accepts this, but almost everybody without a political axe to grind does. The serious Keynesian argument is not about stimulus, but about the effects of austerity. Austerity policies are reducing demand, setting up a multiplier effect and causing pointless unemployment before the replacement jobs can be created.

It helps the Keynesians that there does not seem to be a big risk of inflation – or not wage inflation, anyway, which is the critical issue. This seems to be held in check by strong market forces, in the developed world at least. High price inflation in Britain is not matched by pay inflation, and it is much more about forcing Britons to accept a lower standard of living as a result of a lower pound and shortages of key raw materials.

Advocates of monetary policy are also in a weak position. It simply does not seem to be all that effective. Interest rates are rock bottom, and all quantitative easing seems to do is to keep asset prices at unrealistic levels.

Would extra saving undermine a looser fiscal policy? Britons are heavily indebted, after the borrowing binge. That might encourage them to save any stimulus money – but it also suggests that they can’t respond to lower income by borrowing more. Since we are talking about simply slowing a downward trajectory, the latter is the more relevant argument.

For me the most persuasive case for some kind of Keynesian influence on policy is made by the Financial Times’s Martin Wolf (behind the FT paywall). This goes back to first principles. Consumers are over indebted and need to spend more than they consume. Business confidence is low, which means that it is difficult to persuade businesses to invest. The potential for more exports (or less imports) is certainly there, but is limited because to many other economies are trying to play the same game. So we are exactly in danger of the doom loop of excess saving that Keynes worried about. The government’s massive deficit offsets these problems to a great extent, but reducing it too fast could well lead to excess unemployment.

But we don’t know. Austerity policies are stronger in rhetoric than practice. We can’t avoid major cuts to government services, so there is something to be said for getting them over with as quickly as practical. But there is also something to be said for having a “plan B” should unemployment start to escalate. But if the government had one, they wouldn’t tell us.

Cutting VAT is one idea, advocated by Labour Shadow Chancellor Ed Balls, since it is quite likely that it will stimulate some extra expenditure – though it is very unclear by how much. That is probably too much of a humiliating U-turn for the government. But it is a better idea than cutting the top rate of tax, advocated by some Conservatives, since that is unlikely to have much immediate effect on demand, even if it does have longer term benefits. Another idea is to ramp up investment projects – but it is very difficult to do this efficiently in the sort of quantities that would have a major impact on the overall economy. Personally I would favour a go-slow on benefit reform, which is where a lot of the cuts are focused, since mostly benefits get spent. Given how tricky this programme is already, it might happen anyway.

It would not be surprising if the government missed its deficit reduction target over the five year term. What will not be clear is whether this happens because Keynesian policies were applied (i.e. by slowing the pace of austerity) or because they weren’t (i.e. austerity strangling the economy at large). That won’t stop people being firmly on one side of the argument or the other.

Economic growth and the media circus

Today the ONS released their first estimates for economic growth for the second quarter. These quarterly figures have become the centre of a media frenzy; the papers and the BBC have been speculating about them and their implications for days. Some commentators have worked themselves up into a real state, saying these numbers will be critical to the government’s future (see this comment on one which gives quite a good idea of the general coverage before the figures have even been released). This is getting very silly.

The first problem is that these numbers aren’t very accurate; the second is that they don’t mean very much to ordinary people anyway. GDP, and the growth figures based on them, have become very interesting to economists, especially in making comparisons between countries, and looking at trends over a period of time, and compiling all manner of ratios. But they are obscure aggregates that mean very little to us day to day. The economic statistics that matter are those on unemployment, pay rates and consumer prices. Taken together these figures give you a much better idea of what life is like for real people. Further light is thrown by various other measures, like trade figures, retail sales and so on, though these are bit too volatile for single month’s figures to mean very much.

These statistics are painting a clear enough picture of the British economy. Unemployment is high, especially amongst the young, though not as bad as in previous downturns. It remains steady, with employment overall growing. Inflation remains persistently high, largely thanks to higher import costs and taxes. Remarkably, average pay is not keeping up with inflation, so we know that people are being squeezed. The fact that so much of the squeeze is being spread across the working population, rather than concentrated in rising unemployment, is the truly remarkable thing about the economy right now. This is surely a better way for the country to adjust to the new reality. But it does mean that gloom is spread far and wide.

The government should really start to worry if one of two things start to happen. First that unemployment starts increasing again. Second if pay inflation creeps up beyond about 3% (it is now about 2%), since this means that an inflationary spiral might be on hand, so interest rates have to go up. Likewise they should start to feel relief if and when unemployment gets significantly lower, and when inflation falls below 2%. The betting is that the economy will keep bumping on somewhere in between the good and the bad news for some time to come.

Meanwhile there is a very unedifyng argument about the economy going on, with people talking at each other without any serious attempt at improving their understanding. Consider this little discussion on Lib Dem Voice to which I made a couple of contributions. I think the founders of economics as a social science hoped that it would improve people’s understanding of the world around them, but so often economic arguments are just used as ammunition to support prejudices. And you can use them to argue just about anything.

All the more reason to ignore the media coverage of the quarterly growth figures.

Europe’s financial crisis gets dangerous

While the British news media and politicos alike obsess with the unfolding of the News of the World hacking scandal, Europe’s financial crisis enters a dangerous stage. In fact this crisis seems to unfolding just as quickly, and with much more important potential consequences. Was I being too sanguine last Friday, when I blogged that it was a learning curve rather than a fundamental problem? Well, probably.

I had hardly posted it than a flood of dire articles about the crisis came out. One of the best is by eminent US economist Larry Summers in this morning’s FT(£); alongside it an equally gloomy article from FT regular Wolfgang Munchau (£). Mr Summers points to the critical issue of confidence that could be destroyed in a default, drawing a parallel with Lehman in 2008. He then offers quite a plausible way out. But the problem, as Mr Munchau points out, is:

I often hear that Ms Merkel in particular has moved a long way from her original position 18 months ago, when she ruled out any money for Greece. This is true. But the crisis now moves at a rate that exceeds her political speed limit.

There’s clearly a problem. One issue is the expectation that European leaders will muddle through, as they always have. This, unfortunately, is a self-destroying prophesy. Because Europe’s leaders expect everything to come right in the end, they don’t have the incentive to make it actually happen. Actually Europe’s greatest achievements have required some strong leadership, with Helmut Kohl, Germany’s Chancellor in the 1990s standing out. Mr Kohl achieved German unification on his own terms, pushed through monetary union and the massive eastward expansion of NATO and the EU right into the former Soviet Empire. Mrs Merkel does not fill his shoes.

Still, there are plenty of bright ideas for ways out, without the Eurozone collapsing, Mr Summers’s among them. They will all require Mrs Merkel to shift her current stance. Things could get worse before they get better. At any rate it looks more soluble than the US budgetary stand-off.

The Euro crisis: structural failure or learning curve?

Coverage of the crisis in the Eurozone is astonishingly poor. Commentators scarcely try to analyse the situation properly; instead they revert to one of two unsatisfactory critiques. First, the Eurosceptic one, is that the Eurozone was always an unworkable idea and the best thing to do is abandon the whole thing. The alternative, the Europhile critique, is that a currency union without political integration was a major mistake, and the best thing to do is move further towards the political integration of the union.

These positions are both unhelpful. The Eurosceptics fail to see the benefits of the currency union, the awful logistics involved in unpicking it, or the unsatisfactory nature of floating currencies for most countries. The Europhiles want to drag European peoples down a road they do not want to go. There is a third way: that Eurozone governments change their countries’ economic arrangements so that they can live within the currency zone, more or less as it is currently configured. This crisis is a learning experience.

The more far-sighted of the Eurozone’s designers did not want full political integration. It was never to be a currency zone like the USA, with a federal government able to make massive fiscal transfers across the union to help balance out asymmetric crises. Instead the single currency, alongside the single market, was meant to act as a discipline on national governments. This would address the widespread failure of floating currencies, which allowed governments to buy time through currency depreciation rather than addressing economic inefficiency. This was a process leading inexorably to hyperinflation and economic collapse – which was very clearly beckoning for Portugal in particular before the Euro project was taken on board.

Discipline was required in two particular areas: government finances and labour markets. In the former case discipline is to be provided by the threat of default; in the zone it was impossible to evade default by debauching the currency. The consquences of a sovereign default are very severe, and European leaders sought to prevent it through the muddled Growth & Stability Pact, which sought to restrict deficits and levels of government debt. For labour markets the discipline was that without flexible labour markets, economies would become uncompetitive, creating unemployment.

But things went badly wrong almost immediately. Bond markets did not seem to believe the default story, as spreads between the more creditworthy governments (like Germany) and the less so (Italy and Greece) were impossibly narrow. Governments in the shakier countries (especially Italy, Portugal and Greece) found it much too easy to borrow cheaply and used this as an excuse for not proceeding with reform.

Labour markets were largely untouched by reform, as were other economic inflexibilities. This caused major problems in Spain, Portugal, Italy and Greece whose economies became increasingly uncompetitive. Only one country (apart from Ireland perhaps) really grasped the implications of living inside the Euro, and that was Germany. After unification the German economy lost competitiveness and unemployment became a real problem. But through its system of corporate deal-making between employers and unions, pay was restrained and other reforms instituted. Competitiveness was duly restored, as was employment. Unfortunately that made things worse for the laggards.

While the Eurozone had proved a failure in these two areas it proved a bit too successful in another: capital flows. There was a lot of reckless lending, with quasi-public banks in Germany in prominence. Capital flowed freely to countries, like Spain and Ireland, that didn’t really deserve it, allowing problems to be hidden in a property bubble. And then Pop! The Eurozone has lurched from one crisis to the next.

But the basic idea remains intact. Markets now fully appreciate the risks of default and are pricing debt accordingly. This is applying pressure on governments like Italy’s that the Growth & Stability Pact simply could not. And the pressure to make market reforms is likewise proving unbearable. It’s been a horrible experience for many, but this is not a structural failure: it’s a learning curve.

So what next? The Greek government must default, and default properly (i.e. the principal must be cut rather than repayment simply deferred). Maybe it will be forced out of the Euro. If so, it will be a terrible example. Some eurosceptics make it all sound rather easy (“decouple, default, devalue”), but it involves the utter collapse of the Greek economy with private savings being wiped out. The hope would be that it would be easier to rebuild from the ashes than interminable limping along inside the zone. Portugal and Ireland (whose crime was not to manage its banking system properly) may also go through some form of de-facto default. But they will stay in the zone. Portugal must go through a painful period of reforms, but at least for them this path is clearly better than being outside the Euro.

Meanwhile the Euro governments need to keep “kicking the can down the road”. This is not as short-sighted as it sounds, since with each kick the various parties invovled understand the situation better and what needs to be done. The default word is now openly talked of. German bluster over not bailing out the profligate is gradually having to come to terms with the role German banks played in the disaster. There is learning for the Germans too. Bold decisive action can be disastrous – it didn’t help the Irish. This way things are properly thought through.

Reforms? Fiscal reforms are unnecessary. But the banking system does need serious attention. The regulatory system is badly coordinated. There are too many cosy quasi-public banks who have been allowed to make silly investments. Banks remain largely national affairs, with only a limited number of transnationals. There is strong case for a centralised banking regulator. And cross-border banking mergers need to be encouraged.

But the Eurozone is not dead; and neither are we on the verge of a more centralised European government.

Is Britain about to go bust?

The debate about Britain’s economic policy rumbles on, with a speech by the Shadow Chancellor Ed Balls last week. In previous posts I have dismissed the claim made by some that the government’s cuts are unnecessary, and most commentators, including Mr Balls, seem to accept this, even if they don’t say so explicitly. But there is a furious debate about how quickly the cuts should be implemented: 5 years as the government plans, or 8 years as Labour suggests, apparently including Mr Balls, though in the past he has been suggested longer. An impressive array of economists seem to support the Labour argument.

The basis of the critics’ argument rests on conventional macroeconomics, and runs that cutting too fast creates needless unemployment and risks a spiral of lower demand which will make things worse. This argument is open to challenge on its own terms (see The Economist’s Buttonwood column here, or Bagehot here), but the government’s defenders don’t generally try; instead they trump it with an argument about unsustainable levels of government debt. I want to look at the macroeconomic argument in a future post. Today I will consider whether unsustainable debt really is such a risk.

If government debt gets too high, it can derail the whole economy. A default, when governments renege on the terms of their debt, can be absolutely catastrophic. The problem is that if governments can’t raise the money then all the functions of government are threatened. For countries like Greece who are part of the Euro, this means that they literally can’t pay the bills – salary payments are stopped and so on. This is such a frightening prospect that there are strong incentives for other members of the zone to organise a rescue. Countries like the UK do have another option: they can debauch their currency by paying bills with newly created money. That’s how hyperinflation starts; the most recent example is Zimbabwe, and its implications are hardly less disastrous than default.

So what are the risks for Britain? The good news is that before the crisis struck overall debt was modest by international standards at a shade over 50% of GDP. Even better, the maturity profile of this debt, i.e. how soon it has to be rolled over, was long term – longer than any other major economy. The bad news is the massive size of the current deficit – 11% in 2009, and the fact that 8% is “structural” or won’t bounce back with the economic cycle. That means that total debt is increasing rapidly; by the end of 2010 it was already 75% of GDP. This gives two main problems.

The first problem is that debt risks spiralling out of control. Few think that the current economy is capable of more than modest growth, austerity or not, which means that extra wealth is not being generated fast enough to get us out of trouble. And debt comes with an interest bill. There are some classic economic models of this, and on these the warning lights are flashing red furiously. At some point lenders (characterised as the “bond markets”, but potentially including you and me) refuse to lend, or at least start to put the rate of interest up, making things worse.

The second problem is more subtle. If total national debt levels off at a high level, this will drag down the whole economy for a long while to come, as we spend too much resource servicing the debt. One study suggested that serious problems start to happen when debt reaches 90% of GDP – less than two years away at the current trajectory. Taking longer to eliminate the deficit means that overall debt will level off at a higher amount, unless the aggressive option really does lead to meltdown.

There are three further overlapping problems for the UK. Debt markets are very open; there is a degree of dependence on overseas support; and the pound is a floating currency. Government debt problems are much easier to handle if there is ready access to lenders who are effectively forced to lend to you; this has helped such high debt countries as Japan and Italy. Superficially the UK seems to look this way: pension funds are massive, and traditionally hold lots of government debt (gilts) for actuarial reasons. But such funds are aggressively and independently managed, helping to make our financial services industry internationally competitive. That means they switch away from buying gilts as soon as they think it is not such a good deal. Dependence on overseas investors appears to be relatively modest, as buyers of gilts are overwhelmingly domestic (or so I believe). But the country still runs a significant current account deficit (unlike Japan, and even Italy), meaning that the economy as a whole does need foreign lenders. The floating pound is often presented as a get out of jail free card – but the benefits of being able to devalue are two edged. Foreign investors will be wary of sterling if they think it will devalue; domestic investors will likewise increase their overseas exposures in the same event, reducing their ability to buy gilts (unless these are issued in foreign currency, but let’s not go there).

But, the government’s critics maintain, there’s no sign of trouble, and never has been. The government has had no trouble selling gilts, at very low interest rates. The trouble with this argument is that markets can turn in an instant, and you won’t know until too late. An investment decision depends on a judgement looking far into the future, and this can move very quickly. Government ministers seem to have got a genuine fright in May 2010 with the Greek crisis. By and large the closer a commentator actually is to the debt markets, the less sanguine they are about the whole thing. There are just too many risk factors.

So what to think? The Labour plan is probably viable, if backed by a real determination to follow it through (and Alistair Darling, the outgoing Labour chancellor would have been an excellent figurehead, unlike Mr Balls). But it undoubtedly takes more risks with catastrophe. Whether it is worth doing so does come back to your view on the macroeconomic risks. If you think that the austerity programme really will lead to meltdown, then this has real power. But neither is the government argument implausible. It’s about the risks you are prepared to run.

Who is to blame for the UK’s economic mess?

As time passes it is clear that the UK’s economic crisis is amongst the worst of the major developed economies, though Japan may beat it on some measures. It’s not in the league of some smaller economies, like Ireland or Greece, although a comparison with Portugal may be more nuanced. Some people (notably Labour politicians) struggle to accept just how bad things are; others don’t get much beyond railing deficits and the National Debt. It’s worth pausing to consider what went wrong, and to try and attribute responsibility.

What happened? Until 2007, the UK had an astonishingly consistent record of economic growth. This started with the departure from the European Exchange Rate Mechanism under John Major in 1992, and continued until early 2008. Economists had taken an average annual growth rate of 2.5% for granted. Unemployment fell, and most people felt better off, though the very wealthy did much better than the rest. Public expenditure rocketed, with massive investment in the NHS in particular. A recent study by the Institute for Fiscal Studies (IFS) shows that poverty was reduced, largely because of increased benefits and tax credits.

And then bang! GDP shrank by 6% in a year, stayed flat for the year after that, before struggling to a bit under 2% growth in the year after that (taking the year to the 1st quarter from the ONS). Forecasts are for consistently anaemic growth. This is striking. When economies hit a recession due to a temporary shock, they bounce back quite sharply, as temporarily unused capacity comes back on stream; this is what has happened in Germany this time. Not for us; a good 7% of the economy has vanished never to return. What makes this particularly bad is that this 7% produced an awful lot of taxes, while public expenditure carried on regardless (with benefits increasing due to the extra unemployment and hardship). This has left the country with a “structural deficit” of about 8%. This is the excess of public expenditure over taxes after you strip out temporary factors; the actual deficit was much larger (it reached 11% and has now dropped to 10% per annum). Now I’m not sure how we ended up with an 8% structural deficit after losing just 7% of GDP, of which presumably no more than half would will have been taxed. The government was already running a bit of a deficit when disaster struck; I think that capital taxes must account for the difference, now that the property boom has disappeared.

What this comes down to is that a lot of the pre-crisis growth was not for real, and government finances were built on unsustainable foundations. What was happening? This phantom growth seems to have been related to a boom in personal borrowing to finance property purchases and good old fashioned consumption. Symptoms included an over-sized finance industry (in earnings if not jobs) and unsustainable levels of consumption.

Who was to blame? The three commonly cited answers are everybody-and-nobody/events-beyond-our-control, bankers, or the Labour Government. Some Labour politicians still seem to subscribe to the first idea. It was an international storm (I never want to hear the phrase “perfect storm” again) and we were caught in it; nobody was seriously criticising government policy before the crisis. As the economy has failed to bounce back, this has become unsustainable; why are we having so much difficulty when other countries caught by the crisis are having an easier time? Of course some try to say this is because of Coalition policies over the last year. But almost all of the many critics of the Coalition policies accept that we were in a terrible mess in the first place.

So the critics shift to another target: Britain’s bankers. These are an easy target, paying themselves handsomely while their organisations required government bailouts. There is also a widespread conception that the bailouts cost a lot of money, and that this is one of the reasons that government debt is a problem. Actually the government has largely got away with it, for which Gordon Brown and Alistair Darling deserve some credit (contrast the terrible hash that the Irish government has made). A lot of government money was put at risk, yes, but the banks were charged for it, and the money lent will largely be repaid, and the guarantees not called on. Where the bankers were culpable was in rampant lending, supporting excessive consumption and a property bubble. But the lending was nothing like as reckless as in the US (or Ireland for that matter). If the government had awakened to the idea that consumer lending needed restraint, something could have been done. Let me be clear; the banks were reckless; we need to regulate them much better – but they were not the fundamental cause of the crisis. We had a narrow escape.

Could the government have seen the vulnerability of the British economy? There were not many prominent critics at the time, though Vince Cable was clear enough, for exactly the right reasons. But it was a matter of undergraduate economics to see that economic policy was on an unsustainable path. Literally. As a second year economics undergraduate at UCL in early 2007 my macroeconomics lecturer, Professor Wendy Carlin, used the UK economy as a case study to illustrate her model for an open economy. It was also used as an exam question. Was the UK’s strong economic performance due to increasing economic efficiency or excess aggregate demand, she asked. It was clearly the latter: the giveaways being the appreciating real exchange rate, and a large current account deficit (the economy as a whole consuming more than it was spending).

What should the government have done? The first thing should have been to raise interest rates and tighten monetary policy much earlier. Unfortunately this was genuinely difficult, because this was the Bank of England’s main target was inflation, and not the general standing of the monetary system. And the inflation rate seemed benign (thanks in large part to the overvalued pound). The second thing would have been to regulate the banks harder, to restrain lending. This was the FSA’s job, although the degree of independence of this agency is less strong. Finally the government could have tightened fiscal policy to reduce the level of demand in the economy, through expenditure cuts or tax increases. Nominally the government’s policy was to run a zero structural deficit, but it chose to fiddle with the statistics on the economic cycle so as to argue that it did not have to do anything. The government was not egregiously profligate, as Coalition politicians like to suggest, but it was pushing the wrong way.

What comes over, above all, is a failure of leadership, especially from Gordon Brown, as a formidably powerful Chancellor of the Exchequer. The tripartite arrangement for managing the financial system (between Treasury, Bank of England, and FSA) did not help, but it is very clear that if in doubt it was the Treasury’s job to lead. They didn’t. They could have leant on the FSA and Bank of England, as well as tightening fiscal policy directly. But Mr Brown either refused to recognise the gravity of the situation, or his political courage failed him. Given his constant level of denial about the seriousness of the crisis, I suspect it was mainly the former. He could not face admitting that so much of economic achievement was unsustainable. It is invidious to blame one man, when the hands of many were involved. But Gordon Brown had the authority; there was enough evidence for him to act on; and he made things worse not better. A career in the Treasury that had started so brilliantly ended catastrophically.

My next topic on the economy: is the Coalition economic policy making matters worse or better?

Upside down economic thinking

Couldn’t resist commenting on this story in yesterday’s FT. This behind the paywall, but this summary from City AM is a good start:

PACE OF UK GROWTH UNDER THREAT
Britain’s economy is unlikely to grow as fast as before the financial crisis because its most productive sectors have been hardest hit, jeopardising government plans to cut the deficit. A Financial Times analysis of the sectorial performance of the economy before and after the crash highlights how much banks and insurance companies boosted economic growth between 2000 and 2008.

What it says is that the finance industry contributed a lot to measured GDP up to the crisis, but not to jobs. In that sense the finance industry is said the be “productive”. But these industries bore the brunt of the crash. The article also says that this is one of the main reasons why unemployment did not rise as much as the fall in GDP suggested. Because finance is unlikely to recover fast, since the burden of accumulated (private sector) debt still has to be worked off, then we can’t expect to repeat the pre-crash growth rates. Bad news.

This is the kind of thinking that takes hold when you accept GDP as the ultimate arbiter of progress. Let’s look at in another way. A lot of the growth prior to the crash was down to financial services which created few jobs and which was based on expanding indebtedness, not supplying services that people actually wanted or needed. It was illusory, in other words. Highly productive is hardly the right description.

In one sense the article is right. The finance industry contributed a lot of taxes, whose disappearance is one of the causes of our massive structural deficit. We can’t hope for illusory growth to rescue our tattered public finances, so it could be a long grind.

This type of upside down thinking is one of the reasons why we need to supplement GDP with other measures that aren’t so affected by such illusory “production”. Cue the forthcoming Lib Dem policy paper on Quality of Life to be published later this year (which yours truly is helping to write…).

Are the cuts necessary?

In the latest issue of Liberator magazine there is a letter from Peter Wrigley, a retired economics teacher who blogs as KeynesianLiberal. It’s actually about a review of David Laws’s book, but it contains a wonderful statement that summarises why some people think the the government’s strategy of cuts is wrong-headed. It is deeply flawed, but it strikes me how very little attempt is made to explain the UK’s economic plight beyond shallow sound bites. I will try make a small contribution to correcting this. But first, the quote from Mr Wrigley’s letter:

Distinguished economists and commentators, including David Blanchflower, Martin Wolf, Jospeh Stiglitz, Paul Krugman and William Keegan, have all pointed out that Britain’s debts are not historically high (in fact the debt-to-GDP ratio is quite modest by comparison with many similar economies); that Labour’s expenditure was reasonably prudent up to 2008, the year of the crisis; and that the current deficit is a result of falling revenues arising from the recession rather than profligate expenditure. Above all, we are not Greece, are not and never have been in danger from “the markets”, which are, after all, largely institutions within our own economy, including many pension funds, lending to their own government. Clearly, the “savage cuts” are far from a matter of necessity but are ideologically driven.

The interesting thing is that the facts cited in the statement are not widely out, if you separate them from the opinions. But the last sentence is a glaring non-sequitur. Of the various people he cites in support, all are critics of the government’s policy, but I have only followed the writings of two: Martin Wolf (of the FT) and Paul Krugman (Nobel Laureate and New York Times columnist). Mr Krugman has not made any commentary on the British economy to anything like the detail that Mr Wrigley implies, or not that I have seen – but he does seem to come to the same conclusion – that Britain’s austerity is madness and not an example for the US to follow. But it is the US that is his interest. Mr Wolf has given some excellent, clear analysis (such as this article, behind the paywall I am afraid). I don’t think he would describe Labour’s expenditure up to 2008 as “reasonably prudent”. He actually says of the deficit before the crisis struck:

The deficit was surely too large for that stage of the cycle, even on what was then thought about prospects. But it was not a disaster.

A quibble, perhaps, since coalition politicians certainly imply it was a disaster.

Britain’s debts are indeed not frighteningly large. Yet. But the same cannot be said about the deficit – i.e. the rate at which we are adding to the debt. Over 10% per annum will soon take the debt up to the 90% level where most commentators suggest it really starts to weigh the economy down. The frightening element is the estimate that 8% of the deficit is structural; in other words such a deficit won’t disappear as the economy bounces back. This is the point that Mr Wrigley appears not to have understood, or perhaps not to have accepted.

That 8% number is truly astonishing because it suggests that much of the economy pre-crisis was built on air, and has been lost never to return. We can’t just bounce back. Remarkable, but it isn’t seriously disputed. Certainly not by Labour’s last Chancellor, Alistair Darling, and not Mr Wolf either. I can’t speak for the other commentators. In a later post I will return to how this situation arose.

It will be necessary to close this deficit – and nobody denies that either. A lot of people are suggesting that the government is doing so too quickly and too aggressively (and I’m sure that goes for all the distinguished names cited). It hardly follows that the cuts “are far from a matter of necessity”. To understand the problem it is necessary to put aside the timing issue, and to ask how will the finances be put straight when they are eventually addressed. There are three ways: growth, taxes and cuts.

Let’s think about growth first. To claw back 8%, the economy has to grow by at least 16% (though 20% is probably more realistic). If we can get the economy to grow by about 4-5%pa this looks reasonably feasible, perhaps. But if you accept the view that there is not a lot of spare capacity, then a growth rate of 2.5% is more realistic, and this, or close to it, is already built into the government’s plans. The government can’t stimulate such high growth rates by increasing the deficit – because ultimately this growth must come from the productive part of the economy. The argument about austerity is about the government not making things worse, not about stimulating a boom.

So how about higher taxes? Many on the left hope that the UK can move to a more Scandinavian style of economy with perhaps 50% of income taken in taxes, rather than the typical 40% odd typical of the British economy. Many hope this can be done by just taxing the rich more. Actually it is hard to see how this last can be done, beyond what the government already has. Not much money can be made from corporate taxes, contrary to popular belief, because there just aren’t enough taxable profits around. The various soft targets postulated don’t look so soft closer up, and wouldn’t make enough difference anyway. It is a game of diminishing returns: the more you tax, the less incremental revenue you get – and there are costs to the wider economy. It gets worse, since if you actually succeed you become over-dependent on rich people and big corporations to fund government. There is clearly a problem that companies are making too much money, and that a lot of people are being paid too much; but taxing this inequality even further not a sustainable solution to the country’s fiscal problems – even if you think it is right to do anyway. To raise taxes sustainably you have to aim lower. At the “squeezed middle”. There are two problems. First that this may be economically inefficient, by reducing incentives to work; so you keep having to raise the bar. Second, and more certain, it is politically toxic. To say the least we do not have the necessary political consent across society.

Which leaves cuts as carrying the main burden. This seems to be what the last Labour government concluded. And if you are going to make big cuts, to public services, and to benefits, there is a lot to be said for getting on with it to let people get used to it and move on – rather than leave the Sword of Damocles dangling – and especially with public services.

But what if you think the government is cutting the deficit too quickly? The best thing to have done would have been to delay the increase to VAT. The second thing would be to delay cuts to benefits. But benefit cuts have been pretty limited so far, and may yet take place slower than planned. Perhaps other tax cuts might be considered. The logic of the public service cuts is powerful, I am afraid.

Which leaves with two questions. How did we get into this mess? And is the government right to move so quickly? More of that another day.

Why I won’t invest in gold

Want to see the world’s financial system at its most dysfunctional? Visit a gold mine. Huge expenditure of human and physical energy; destruction of landscape; poisoning of local people with its polluting by-products; lots of horrid, dangerous jobs. All for what? Digging up something that the world doesn’t need, and adds no value to anything.

Gold has real value as a decoration. It is soft and easy to work; best of all it is inert and does not lose its shine in the air; it is virtually indestructible. But most of the world’s gold is not used for decoration; it sits unseen in vaults. It is used as money. And the thing about money is that producing more of it (printing paper money or digging gold out of the ground) does not make the world any richer. It is just an attempt by one person to pull a fast one on somebody else.

Money is a confidence trick, literally. Things can only act as money by mutual agreement and confidence. Money has no intrinsic value of itself. Gold has been used as money since Croesus in 550BC, with widespread acceptance in both Europe and Asia. But not everywhere. In the American cultures found by European explorers gold was valued as a decorative resource, but not as money. The explorers could not buy anything with gold coin. In the modern age of paper and electronic money, there is no good reason why gold should fulfil this role. Its advocates point out that, unlike these modern forms, its supply is physically limited, with just those hateful mines and the melting down of works of art adding to supply. Some suggest that it is real money compared to potentially valueless “fiat” money. Well yes, but how to value it? Just what law of nature says how much wheat, or wine, or how many haircuts an ounce of gold should buy? At least proper money is hardwired into a mass of contracts; and the fact that we can regulate its supply more easily is a benefit, as well as a risk. Gold as money is obsolete. Or, as economist Willem Buiter put it (in his days as an FT blogger) Gold is a 6,000 year old bubble, with no more inherent value than cowrie shells (though according to Neil MacGregor of 100 objects fame it is only been going 2,500 years) .

Gold is an emotional investment. Its advocates feel some sort of connection with the ancients who originally started to use it as money. It is in the Bible. My emotions are at least as strong. Gold is the essence of evil when used for anything other than its beauty. And that view has plenty of biblical support too. I will not pay real money to invest in the stuff.

As gold shoots through $1,500 an ounce it is time to question what it is for. Let’s stop using it as money. Let all central banks sell off their stocks for use as jewelry and gold leaf. The world would be a much better place.

Vickers Commission: so far, so good

I have deliberately paused before commenting on the interim report of the Vickers Commission on UK banking reform. I wanted to read more about it; it didn’t help that the post office delivered my Economist several days late. Unfortunately I still have not had time to read the report itself; let me come clean on that. Most of the commentary seems to be that the banks have largely got away with it, and are heaving a sign of relief. My answer is “not necessarily”. It may be clever politics not to go for the more totemic ideas, like a full split between retail and investment banking, since that clears the path for the reforms that really matter.

The report primarily concerns itself with two things: preventing a future UK government being forced into bailing out or underwriting banks, and increasing competition between the banks. The latter was behind one of the more controversial recommendations: the breakup of Lloyds Bank. But I don’t think that’s the main battle. I despair about the lack of competition in UK retail banking, but I don’t see that the costs to the economy are that large. The main game is preventing the next bailout.

The suggested strategy makes plenty of sense. Ring-fence retail banks, force them to hold more capital, and leave investment banks to their own devices. The significance of the second part of that proposition needs to sink in (as this article from John Gapper in the FT (£) makes plain). An investment bank may be “too big to fail” in global terms, but the UK government will say is that this is somebody else’s problem, so long as our retail banks are protected. This is an entirely realistic admission that the UK government is now just a bit part part player in the world of global banking. If one our big investment banks fails, then we don’t mind if it is bought up by foreigners. This is a striking contrast to the approach taken by the Swiss government.

But it leads to an obvious issue. How do you prevent a meltdown in investment banking infecting the supposedly ring-fenced retail banks? The collapse of Lehman’s in 2008 caused such chaos not because it was so big and important in its own right, but that it was too entangled with banks that had big retail deposit bases. A retail bank will gather in lots of retail deposits; the question is where does all this money go? If the bank is to make money it needs to get lent out. If this lending gets into fancy investment banking products, then the ring-fencing has failed. There must be some pretty heavy restrictions; the assets don’t need to be absolutely safe, but we want to insulate these banks from the complexities of the investment banking melee. This will not be easy, as John Kay points out (in another FT paywall article, I’m afraid); all that is needed is an oversized treasury department, which is supposedly there just to oil the wheels of the machine. Mr Kay knows this from bitter experience; he saw (as a non-exec director in the earlier days) how a runaway treasury department at the former building society The Halifax took that institution down a route that led first to demutualisation and eventually its own destruction; each step presented as innovative and sensible. The detail must be subject to intense scrutiny.

But what of those excessive bankers’ bonuses and all the outrage that goes with them? To the extent that this is a retail banking problem, the Vickers reform surely deals with it adequately. The only way of tacking with it properly is to turn these banks into less profitable, lower risk utility organisations which can’t afford to pay big bonuses. That is what ring-fencing and higher capital requirements should achieve.

But the bigger problem is investment banking. This is an international issue, and Vickers is really about damage limitation. As I have said before, the answer is not directly regulating remuneration, but cutting the profits. This industry must be made much smaller and less profitable. The two most important ways are through increased capital requirements and choking off its finance (or “leverage” as they like to call it). The Basel committee is already making headway on the first. Retail ring-fencing, if it is done properly, will help a lot with the latter.

Banking reform is a long hard road. There is a danger that we have “wasted a good crisis”, and the passing of the crisis’s worst peak means that the pressure on politicians to deliver has eased. But the crisis has not passed, though many financial types waving graphs seem to disagree. A lot of banks are still in a shaky condition – and so are many governments’ finances, including those of the USA and UK. There may well be a steady stream of aftershocks to remind our leaders that the journey is not over. So far the Vickers Commission is playing its part.