economics – Page 3 – thinking liberal

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

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

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

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

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

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

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

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

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

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

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

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

What went wrong with economics?

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

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

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

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

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

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

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

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

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

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

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

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

Are the Muslims right about debt?

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

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

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

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

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

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

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

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

Positive linking: what do networks mean for public policy?

I ndependent and identically distributed. This assumption about data subject to statistical analysis is so routine that most students reduce it to the acronym “IID”. It means that the data follows a normal distribution and a routine set of analytical tools becomes available for the calculation of such things as confidence levels. Most of the evidence used by economists and other social scientists to support their theories is based on this type of analysis, and an IID assumption in the data. And yet human societies do not behave in accordance with this assumption; most of the choices we make are based on choices that other people have made, and are not independent. They are subject to network effects. It is a problem that most academic economists would rather not acknowledge. But the implications are profound.

This reflection comes to me after reading the book Positive Linking by Paul Ormerod. In this book Mr Ormerod attempts to show that all modern economics is deeply flawed because it ignores network effects, and that in future public policy should promote “positive linking”: promotion through network connections, rather than simply the design of incentives. He is only tangentially concerned with my worry over statistical analysis: he is more focused with the models built by economists based on rational people (or agents in the jargon) making independent choices based on an analysis of their options and preferences. These theoretical models lie behind the bulk of modern economic analysis, such how people might respond to taxes or changes to interest rates.

Unfortunately it is a very disappointing piece of writing. The language flows well enough, but it is full of repetition and digression. This sort of style probably works better orally than on the page, where it is a drag. But it is worse than that. His main concern seems to be to debunk conventional economic analysis rather than to promote a clearer understanding of networks and their implications. This verges on the unhinged sometimes, and you do not get the impression that arguments of the defenders of conventional economics get a fair hearing, and therefore that they are dealt with adequately. There are a lot of illustrations and “evidence”, but these are used anecdotally rather than to build up a coherent logical case. There are many digressions, for example about the rise of Protestantism in Tudor England. These seem to be included because they are good stories rather than taking his argument forward. The debunking of conventional economics is all rather old hat, though, and it has been done more coherently and entertainingly by authors such as Nasim Nicholas Taleb (of Black Swan fame).

The diatribes and digressions leave Mr Ormerod with inadequate space to develop his “twenty-first century model of rational behaviour”. His suggestions about how this might work in practice are left to a few pages at the end, and even this tends to drift into diatribes over how things are done now. For example he claims that sixty years of centralised, big-state social democratic government since the War has been a failure – on the grounds that unemployment is much the same on average as beforehand. But you can easily argue that this is the most successful period of public government in world ever – look at the rise in life expectancy, for example. Neither is it all that clear that everything, or even most things, these governments did was based on conventional economic models of human behaviour. Instead of explaining the religious dynamics of 16th Century England, he could have spent some time and space developing his argument here.

What a pity: because in the end I think he is right, and his suggestions for the way forward are sound. It isn’t that government since the War has failed, it is that its methods have run their course, and its policies now only seem to benefit an elite. Conventional economic analysis has more going for it than he suggests, but they are a blind alley now. But many economists and policy makers are in denial, to judge by the public debate – though some clear network-based ideas, like “nudge” theory are making their presence felt.

But there is a problem at the heart of the new twenty-first century network thinking, which Mr Ormerod acknowledges but dismisses too easily. The new models have weak predictive power. The point about normal distributions and the IID assumption that they are based on is that they produce a relatively tight distribution of data around a mean and few extreme results – “thin tails” in the jargon. There is a sleight of hand here: statisticians’ use of randomised data make their analysis sound more robust than it is; the IID assumption in fact makes the data tightly constrained. Consider a random walk, comprising a series of steps forward and equal steps backward. If the probability that your next step will be forward or backward is always 50% each, and the direction of earlier steps does not affect the direction of the next step, then this is an IID assumption. It sounds truly random. But you are unlikely to get very far from the starting point, which isn’t really very random at all. If your next step was more likely to be in the same direction as your last step than not, then you can end up anywhere. That’s real randomness, but it isn’t IID. There is no normal distribution. What looks like a soft assumption is in fact a hard one.

So it’s not just a question of changing the maths and updating the models. It is about accepting that social systems are fundamentally more unpredictable than we have previously accepted. It is not hard to see why policy makers and social scientists have struggled to accept this. I like to describe this by invoking the idea of “zeitgeist” – the spirit of the time, a ephemeral and unpredictable quality that in fact runs at the heart of everything. This is closely linked to Mr Ormerod’s ideas of networks, since it is networks that sustain the zeitgeist.

What to do? Mr Ormerod offers some useful rules of thumb. He also suggests investing more into research of network effects, which is self-interested but sensible, so long as we do not expect this to yield insights of anything like the theoretical precision of conventional methods. But ultimately his big idea, which he does woefully little to develop, is much greater delegation and localisation of decision making. Amen to that.

The unbearable lightness of British politics

The economic crisis in the developed world drags on, posing fundamental political and economic questions. And yet politicians here in Britain argue about not very much. The Labour leader, Ed Miliband, is currently attracting a lot of criticism for his lack of progress. But the real problem is that the political left has run out of ideas, while the Right complacently defends the status quo. This state of affairs will continue until we learn to look at our problems in a radically different way.

Nobody should doubt that capitalism is still in crisis. We have been cheered in Britain by some better economic statistics. But average wages remain stagnant, and are not keeping up with inflation. Some people are successfully adjusting to a reduced standard of living; others are running down savings or borrowing money. Private and public investment remains weak, and any benefits of a slightly stronger economy mainly accrue to a small minority of the better off, or to anybody that owns land and buildings, along with a trickle of unemployed people who are now finding rather poor quality work. Other developed economies, from the US to Europe to Japan seem locked into variations of the same dilemma: either the economy is stagnant, or it grows to the benefit of only a few people.

It is not difficult to see what the underlying problem is. Globalisation and the advance of technology are killing off industries that used to be the backbone of developed world employment, destroying lots of middle income jobs. We hear a lot about manufacturing industry, but the same dynamic applies to office jobs. There is not the same need for secretaries and administrators, with jobs tending to be either highly skilled (managers, technicians and so on) or else in soulless call centres; and some of those call centre jobs are being automated out of existence. There is a desperate hunt for the better paid careers, and many people have to settle for poorer quality jobs. In Marxist terms, the balance of power has shifted decisively towards capital and against labour. The process started as far back as the 1980s, with only temporary relief provided by the generosity of the Chinese who sold the developed world lots goods for less than they were really worth. Changing demographics adds to the difficulties of managing this problem.

Meanwhile a growing elite of capitalists and professionals are doing very well, but are under spending their incomes. More is being saved than invested, creating downward pressure on the economy as a whole. This is more or less how Marx predicted the end of capitalism. So if the traditional left-wing critique of capitalism is proving better grounded than many thought, why isn’t the Left benefiting?

The answer is that the Left have no convincing alternative to the capitalist model which does not destroy living standards. Marx could believe that common ownership of the means of production would do the trick, but we now understand that this is killing the goose that lays the golden egg. The turning point for China economically was its recognition that it needed a rampant capitalist economy to drive it forward, even if they also see the virtues of a massive state sector coexisting with it. Modern people love the benefits of capitalism, and in particular its constantly advancing technology, and constantly changing fashion – even as they struggle with capitalism’s consequences.

So what to do? There are still many on the Left, especially trade unionists, who think that the answer lies in a big public sector. This can be constructed to provide lots of well paid middle ranking jobs and, it is hoped, put market pressure on the private sector to treat their workers better. This strategy may be called “Sweden in the 1960s”, since that was when and where it worked best. But most appreciate that it is unviable. Sweden’s economy collapsed into a nasty mess after the 1960s. The state sector has no incentive to be efficient, and drags everybody’s standard of living down with it. It creates unbearable pressure on the private sector as they try to compete in world markets. Constant devaluation of the currency might provide some relief, but in the end this leads to hyperinflation and total seizure (think of various South American economies over the years). In Britain the state sector is too large for the current tax burden, so to sustain it requires putting up taxes. This does not look a realistic political prospect.

So what’s left for the Left? Mr Miliband shows a good grasp of the basic problem but has found only lightweight solutions, such as putting moral pressure on big business to behave a bit better. And without any big ideas we end up arguing about not very much. Is the government’s austerity policy slightly too severe? Should we add a little bit of regulation to this or that industry? Or else do we just moan about various symptoms of the malaise, from immigration to the misery inflected on many who rely on state benefits, without offering any constructive alternative?

It’s much easier for the Right at one level. Their sponsors are doing quite well, so they can try to create smokescreens to pretend the problem doesn’t really exist. Some go further to try and suggest that we should place even less restrictions on the capitalist economy – though that line of argument is as discredited as Sweden in the 1960s. But ultimately they will have to confront the same problem: the economy doesn’t work well enough for most of the people most of the time.

And what is the answer to the problems of capitalism? Clearly this isn’t easy. I think we have start looking at our situation in a completely different way. We are stuck on grand policies that can be implemented by governments in London, accruing lots of prestige to national politicians. But this is just sucking power into an elite based in the country’s southeast. Is it an accident that Scotland is now doing relatively better as real power was devolved to Edinburgh? We cannot continue to destroy local networks and hope that people will be better off as a result. This is completely beyond the grasp of our political elite, left or right. But until politicians start to understand that they are part of the problem, not its solution, we are condemned to an unbearable lightness in our political debate.

The GDP obsession

Today initial estimates of Britain’s quarterly GDP figures have been published. It has become a very silly circus. The BBC Today programme was giving it a lot air time this morning, in spite of not knowing what the crucial number was. Instead they made do with economists’ guesses. This is what they usually do, in spite of the fact that the guesses are often very wrong – though this time they were spot on. A much more informative discussion will be possible once the figures are released, and experts have had a chance to root around the detail. But by then it won’t be news, and the BBC won’t cover it. Meanwhile some even more meaningless political posturing is taking place. I just wish economists, journalists and politicians would show a bit of humility on the topic. As a measure GDP is not all it is cracked up to be.

The first problem is that, although it is quite a simple concept in theory, it is very complex in practice, making the implications of movements difficult to understand. In the UK economists have been puzzling over the fact that the current economic downturn (often trumpeted as being one of the worst in history) has not affected jobs nearly as much as previous downturns. This is often articulated as a “productivity gap”, since if income, and hence production, is falling faster than the number of jobs, productivity (production divided by jobs) must be falling. The Institute of Chartered Accountants’ Economia magazine ran a vey interesting article on this (Measure for Measure), which simply asked a whole series of prominent economists what they thought was going on. It was very revealing. Quite a few took a very superficial view, without probing behind the numbers much, speculating a bit, and then launching into some hobby horse or other, such as the need to stimulate aggregate demand, or let companies go bust more readily. But a number had clearly taken some trouble to get behind the numbers to understand what was going on. And when they did this, they picked up a very complicated picture, and they started to worry that the numbers were at all meaningful or accurate. Several speculated that the official figures were understating the level of GDP because they were not measuring some aspect of the economy properly, usually associated with services and new technology. They further speculated that, though GDP was artificially low now, this would be corrected in due course, when artificially high growth numbers would come through.

Another point that came through was that a large part of the “gap” arose from the fact that North Sea oil and financial services had shrunk. These sectors gave rise to a lot of product (albeit largely fictitious in the case of financial services) but not many jobs. Which leads me to a second problem with GDP: it doesn’t measure economic wellbeing very well. If these two sectors shrank, and it mainly affected a small number of very wealthy people, surely we can take its loss with a bit of a shrug? A big problem with the growth before the downturn in 2007 was that it benefited so few people (especially a problem in the US). Median real incomes and unemployment levels tell you a lot more. (There is an interesting article in todays FT by Richard Lambert on this). And, of course, there is the whole issue of wider wellbeing, which depends on the quality of personal relationships, the environment, and so on.

So, where does that leave any assessment of the current state of the British economy? The first point is that, although GDP numbers may not be as bad as we thought, economic wellbeing is not good for large parts of the population. Pay is not keeping up with prices. It is particularly hard for those with public sector jobs or dependent on benefits. A little bit of confidence is returning, and this will be good if, and only if, it leads businesses to invest more. If ordinary people simply decide to save less, and spend more, we will get a short-term lift to economic wellbeing, but it will not be sustainable.

Well, that is my personal view. Optimists, like the Observer commentator William Keegan, who also writes an article in Economia, think that there is a lot of spare capacity in the economy (people who are underemployed, for example, and working part time) so that any lift in demand will be self-sustaining, and that it doesn’t matter where it comes from – his preferred choice being from government, by cutting VAT and slowing down government cuts. Once this capacity is being used, we will be in a better position to reduce the size of government, if that is what is needed to make the economy sustainable in the long term. You hear a lot of this sort of view from professional economists, even very distinguished ones. To such an extent, indeed, that austerity policies are described as “discredited” by many, on the grounds that they have not delivered the steady GDP growth that these economists say is feasible.

Supporters of austerity are gloomier about the longer term economic outlook. The spare capacity highlighted by Mr Keegan and his friends is illusory: it is mainly in the wrong places. The economy before the crisis was unsustainable: too dependent on borrowing and a trade deficit. Furthermore, there are huge headwinds, in particular from an aging population and a workforce that will shrink (though Britain is not as badly off in this respect as many other economies, thanks in large part to a more liberal view of immigration, which politicians now regret). The economy has to be rebalanced and made more efficient: that means destroying a lot of the less efficient jobs, and creating new ones elsewhere. The wrong sort of economic growth will slow this down and simply create a bigger crisis later. There is no alternative to a slow and painful path of adjustment.

It is an old argument, with resonances of that between Keynes and the Treasury in the 1930s. Keynes is usually held to have been right then: the main problem was lack of demand, and it just needed to be kicked into place by government action. Many economists use this as evidence that we should repeat that prescription this time. But the world was a very different place then; there is no equivalent of the incipient manufacturing revolution to sustain growth now.

And this seems to be the biggest cost to an obsession with GDP. It gives economists the illusion that the issues are much the same, regardless of what is happening in the real economy. It is only when you try to get behind the numbers and ask searching questions, that you can start to understand the real policy options. Today’s figures will tell us very little.

Where Keynes and Beveridge turned out to be wrong

The Spring 2013 edition of the Journal of Liberal Democrat History has a fascinating article on the role of Maynard Keynes and William Beveridge in developing Liberal Party policy, culminating in the party’s manifesto for the seminal election of 1945. These men took the party’s thinking decisively into what is now called “social liberalism”. Their vision was inspiring and coherent; much of it is now simply accepted wisdom. But I detect a tendency to treat these men’s ideas as holy writ. But nobody can be right on everything, and the world was changing fast. It is interesting to pick out the places where they got it wrong. This will perhaps help us to reflect on the challenges we face today.

Beveridge (in his report to the wartime coalition government) memorably set out the challenges to society presented by the “five giants” of Want, Disease, Ignorance, Idleness and Squalor. The answer was to extend what we now call the Welfare State, establish the National Health Service, nationalise a series of critical industries (railways, coal and power in particular) and to adopt a system of macroeconomic demand management, which we know as “Keynesianism”. These policies were largely adopted by the subsequent Labour government, albeit with more enthusiasm for their collectivist aspects, and retained by the Conservatives that followed them. The success of their ideas on the wider political stage contrasts with the Liberals’ disastrous performance in the 1945, when Beveridge lost his seat, and the Liberal Party faced extinction – in a crisis that makes its successor party’s current woes look like a picnic. Which only goes to show that winning the battle of ideas and having coherent policies is on a small part of how a political party succeeds.

But what has gone wrong? The Welfare State grew to be a monster of a size that Beveridge would have been horrified at, though it made much headway in combating Want and Squalor. The contributory principle, central to Beveridge’s vision, has largely broken down, with entitlement being based on need rather than past contribution. It has never broken free from the dependency problem, where people don’t have enough incentive to sort out their own problems – an issue that Beveridge foresaw. It strikes me how Beveridge’s system was overwhelmed by the breakdown of the traditional family, and of traditional working class communities. These were inevitable consequences of economic progress, as well as the march of liberal social values. But needs that used to be met within the community were now thrown at the state’s door, and, perhaps, the breakdown of discipline in some communities (about starting families in particular) added to the problem. Beveridge’s carefully worked out system of benefits and entitlements was not equal to the task.

Nationalisation has proved another disappointment. Keynes was convinced that these critical industries would not be managed for society’s overall benefit if they continued in private ownership. He also wanted to incorporate them into his system of macroeconomic management. But the state proved inept at setting strategy, and was often a prisoner of the short term interests of managers and workers. Strategic decisions tended to be made badly, and investment declined. They were all subsequently privatised and, except arguably the railways, have performed much better since. Regulation has proved a much more effective answer than state management.

Keynesian economic management has proved highly controversial, after two major economic crises, in the 1970s and now. But it is clear that widespread adoption of Keynesianism has moderated the economic cycle, and this has been of huge benefit. We have to accept though that it cannot deliver full employment sustainably unless the overall economy is in the right shape. In the 1970s it was too dependent on cheap oil. Now it is too dependent on finance and government jobs and funding.

But it is interesting to read that in 1945 Keynes thought that the main means of managing the business cycle was investment. He understood that private sector investment tended to follow the cycle (i.e. increase in the good times, and fall back in the bad – just what we are currently experiencing), and so make it worse. Government investment should counterbalance this – and he wanted to nationalise key industries so that the scope of government investment increased. This just hasn’t happened. Instead the expansion of the welfare state has created a counter-cyclical dynamic (called “automatic stabilisers” by economists) that has proved perfectly sufficient until now, with a few tweaks here and there.

But since the size of the welfare state and government generally is now part of the problem, using it to manage the cycle has hit its limit without the job done. A lot of economists (like Martin Wolf of the FT) now urge that we go back to Keynes’s original idea and increase the level of government investment. But I suspect that the reason why governments did not follow Keynes’s original system, apart from the growth of automatic stabilisers, is that this is much more difficult in practice than in theory. Examples of where it has been tried, such as Japan in the 1990s, and China in the present crisis, are not particularly encouraging. Vested interested and construction businesses close to the government have reaped benefit, leading to wasted investment and a corrupted political system. As a developing country China’s investment needs are huge, so they may still end up ahead, but the case for developed economies is much weaker.

What does this say to us now? The five giants are still with us, although they may not loom as large as they did. But I think the era of grand political projects established by clever men from on high has run its course. What is needed is a reshaping of government to make it more local, participative and people centred. But that is a very long journey.

Nowadays it seems to be the economists who are obsessed with the short term

The relationship between economists and politicians is often strained. It’s easy to think that economists are taking a detached view of public policy and its long term effects, while politicians simply jockey for advantage at the next election. But, strangely, that doesn’t seem to be the pattern right now. It’s the politicians who are urging short term pain for long term gain, while the economists say it can all be left for another day. It is the politicians who have a better grip on reality.

The nature of the relationship between political leaders and economists has changed as economics has evolved. I think it was President Truman in the late 1940s who said he wanted to find a one-handed economist, so fed up was he with his economic advisers saying: “One the one hand this, but on the other hand that”. He wouldn’t have that problem today: there is no species of public policy commentator that is more one-handed than an economist nowadays, so confident do they seem about what they are saying.

In the late 20th century supply-side economics took hold, after the economic traumas and stagflation of the 1970s. This held that the route to economic success was in making sure that markets worked efficiently and government expenditure kept on a tight reign. Economists bewailed the fact that their advice was so often ignored by politicians, who found their prescriptions unpalatable. Only the unelected President Pinochet seemed to take economists at their word, as he implemented a series of reforms in Chile. The expression “politically impossible” was frequently used in discussions of economics. In fact politicians, starting with Britain’s Margaret Thatcher, largely implemented the supply-side economists’ advice, but this was only really acknowledged by most economists after the event.

But things seem to have moved on again. Politicians in Europe, including Britain, are grappling with the size of government in the wider economy, and pushing ahead with supply side reforms. This is hard political work, with scant reward on offer at the ballot box. But do politicians get credit from professional economists? Not a bit of it. Instead austerity policies are blamed for anaemic growth and high unemployment. Scarcely a day goes by without some economist, like Paul Krugman, Martin Wolf or Samuel Brittan thundering away that all this is foolish and bound to end badly: looser fiscal and monetary policies are needed, and the problems of government deficits can be sorted out another day.

What accounts for this? It is tempting to conclude that there is simply a time lag in economic thinking between the academics and the politicians. In academic circles the supply-side mania has run its course. It was always incomplete, and too often, not least during the great economic crisis of 2007-09, it had very little of value to say. Neo-Keynesianism had taken hold, with an updated series of macroeconomic models designed to deal with the issues that arose in the 1970s. The politicians, perhaps, haven’t moved on.

But I think there is a different explanation. It is that the politicians are much more aware of what is really happening in our economies, and the changes that are needed, while the macroeconomists are blinded by their use of aggregate statistics. The politicians can see that there are some fundamental problems with the way their economies are functioning, especially here in Europe. The first problem is that the state has become too large and inefficient. A second is that the progressive aging of populations is progressively weakening economies. A third is that globalisation has changed the rules of economic management. I could add a fourth issue, which is that the world’s financial systems have become dysfunctional, except that I think this is confusing politicians and economists alike, and is not a driver of tension between the two.

Economists agree with this analysis of problems by and large, of course, except that I don’t think that most have woken up to the implications of globalisation, and its profound implications for the way prices and wages rates are set. What the politicians appreciate is that these problems are desperately hard to fix, and that putting off the evil day is not going to help. In particular the central problem is to shrink the state. Politically it is much easier to put through tough changes in hard times, and not when things seem to be ticking along nicely. And if you look at the political forces that seize on what the economists are saying, you will find that they are mainly those that do not see the need to shrink the state at all.

Alongside this disagreement about the best time to reform is an economic judgement. Politicians are sceptical that sustainable economic growth is at all easy to find. Many economists think back to the decade before 2007, when 2% annual growth was more or less taken for granted, and assume with a wave of the magic confidence wand, this growth will come back – and that we might even be able to make up some of the lost ground. Even now I have seen some economists who should know better projecting trend growth before the crisis, to estimate the true cost of the recession. So in the five years since the crisis, the economy should have grown by 10%, they say; in fact it has shrunk by 4% (I haven’t checked that number), so the crisis and bad economic management has cost the economy 14%! But what if that 2% tend growth wasn’t for real? What if it was simply pumped up by borrowing and trade deficits? And what if the progressive aging of the population makes sustainable growth of 2%, or even 1%, unreachable? Blinded by their aggregate statistics, not enough economists are asking these questions, and still less following through their implications. But it is all too obvious to most politicians, and businessmen, come to that.

The gap between politicians and economists isn’t helped by the fact that the former keep using government debt as the main driving force of their argument. This is politically convenient, but the economists rightly spot that it is insufficient of itself. If the economy could readily be kicked back into a 2% growth trend with a bit of fiscal pump-priming, then the debt argument would not hold water. In today’s FT Samuel Brittan accuses politicians of falling for the fallacy of composition: that whole economies work like family budgets. In fact there are deeper reasons for what politicians are doing.

There is further disagreement over investment spending. Many economists think that they have found the magic bullet. Government funded infrastructure investment can both act as a short-term fiscal stimulus while delivering longer term benefits to the economy. So why are the politicians so reluctant to spend more on capital projects, and even cut them back? And yet this is another blinded by aggregates issue. The economists’ argument only holds water if the investment projects actually deliver economic benefits. This is much more difficult in practice than it is in theory. Under the last government investing in hospitals must have looked a sure-fire winner, given the ever rising demand for healthcare services. But we are now finding, as hospitals are collapsing under unaffordable PFI debts, that it wasn’t so easy. Too often they built the wrong sort of facilities. This is situation normal. The usual result of a public sector infrastructure project is to end badly. Japan’s investment splurge in the 1990s, in similar economic circumstances, simply caused many “bridges to nowhere” to be built.

And so, in this debate, my sympathies are with our political leaders.

Japan: are there lessons for other developed economies?

A while ago I wrote that the radical economic policies of Japan’s new government under Shinzo Abe would be an interesting experiment for the world. They were much lauded by austerity sceptics, such as Paul Krugman, who drew attention to aggressive monetary policies and fiscal stimulus, which they were advocating for other developed economies. I was sceptical. But early results have exceeded expectations. There is a good analysis here from the Economist, which also discusses the new government’s nationalist tendencies. Is this evidence that the austerity policies being pursued by much of the rest of the developed world are mistaken?

My scepticism when I last posted was based on two things. First that the policies hinged on companies raising wages, when their profits were under pressure. Second was that, based on Mr Abe’s previous form, I did not think that structural reforms to Japan’s economy would be pursued with vigour. On both counts it looks as if I was too pessimistic. This means that Japan’s economy might well get a sustained period of growth, and that it will reduce the burden of government debt. But applying its policies to other developed economies is problematic. There are three reasons for this.

The first is that for longer term success it is still the element of structural reform that is critical. Mr Abe refers to his programme as “three arrows”, in reference to a Japanese folklore story that you can snap the shaft of a single arrow easily, but not three held together. These three are monetary easing, fiscal stimulus and structural reform. Austerity policies in Europe and America are firmly based on structural reform: especially in reducing the size of the state. Opponents of austerity tend to want to halt or slow down structural reform. Some say that it should wait until growth is resumed; others would rather avoid the reform process altogether. The three arrows approach would in fact promote reform, alongside the monetary and fiscal palliatives, and, indeed, the more considered critics of austerity do say this. But here there is a problem: Japan does not have an oversized state, so cutting back government expenditure is not a major reform priority, as opposed to opening the economy up to more competition and reforming corporate taxes. In Britain, France, Italy, Spain and so on the size state has run beyond what the economy can sustain, and so it has to be cut back, which in turn drains demand from the economy in the short term. There is good reason to doubt whether fiscal or monetary stimulus, beyond their current levels, are compatible with the need to shrink the state.

There is a second important difference in Japan. Its economy has a trade surplus and (which is linked) a savings surplus, albeit temporarily challenged as it has to import energy while its nuclear programme is in abeyance. That means that a fall in the exchange rate, as has happened to the Yen, will generate an immediate bonus to businesses, easily outweighing the extra costs imposed on the economy. This allows companies to put wages up. The savings surplus also means that the economy is not dependent on borrowing from overseas investors, who might be shaken by such currency depreciation. This is not the case with the austerity economies. Where their exchange rates have fallen, as in Britain, this has simply contributed to the squeeze on consumers without benefiting business to anything like the same degree.

Mentioning the exchange rate brings me to a third observation. It is that a lot of Japan’s success so far has less to do with with the country’s actual economic policies than with the effect of announcements on the zeitgeist. Implementation has hardly started, and yet the exchange rate has already plummeted and stock market risen, which is having the necessary warming effect, and set off a virtuous circle. The same can be said, in reverse, for austerity policies in the West, of course. But where reforms are necessarily painful, this is almost impossible to do. Economists have long been reluctant to admit the role of psychology in macroeconomic policy, and have let it in only gradually (through such ideas a inflation expectations). Governments and central banks have long known it – and Mr Abe’s government is acutely aware. The question for Europeans, in particular, is whether further aggressive monetary easing, linked to higher inflation expectations, combined with some fiscal stimulus would lift the zeitgeist and get the economies moving again. We have reason to be sceptical.

Almost all the developed economies in the world are experiencing difficulties. It is easy to fall in with the idea that this must be for similar reasons and that the solutions for each economy are similar. In fact each major economy is unique. And the differences between Japan and the others is amongst the largest. Abenomics may work for Japan, but that does not mean they will work anywhere else.

Britain’s austerity policies under attack

Since the coalition government came to power in 2010 the British economy has been stagnant. Unlike other advanced economies, the United States in particular, national income has failed to recover back up to the level it reached before the crisis struck in 2007 (a more correct turning point, in my view, than the more commonly used 2008). In particular the government has failed to meet its own projections, with plans to reduce the government deficit behind target. A common view in the media, backed by a number of distinguished economists, is that the government’s austerity policies are “not working”, and need to be loosened. This view was strengthened this week by two events: some comments in the IMF’s World Economic Outlook, and the discrediting of an influential academic paper Growth in a time of debt by eminent economists Carmen Reinhart and Kenneth Rogoff (you can read The Econonist’s coverage here). This had put forward the idea that economic growth collapses when government debt reaches 90% of GDP, and had been used to give intellectual heft to the country’s austerity policies. Stepping back from the political ding-dong, what lies behind this controversy.

First, some perspective on this week’s two events. I have had a look through the IMF report to see what it says about the UK economy, and it is … almost nothing. With a world perspective it is, of course much more interested in the US, the Euro zone, and even Japan, never mind less developed economies, whose influence on the world economy is growing. There is a single sentence that causes the furore, repeated in the executive summary: “Greater near-term flexibility in the path of fiscal adjustment should be considered in the light of lackluster private demand.” Still, the IMF will be looking at the UK in more detail shortly, and today’s Financial Times, no less, is billing this as a major confrontation. Does the IMF matter? IMF analysis is academically rigorous, politically neutral and based on detailed factual analysis. This stands it apart from most economic comment, even that from distinguished economists, which is little more than grandstanding. It also has an institutional bias towards conservative financing of government. Criticism from that quarter saying that the government should relax fiscal policy lends weight to the notion that the government’s economic policy is based on a naive Treasury orthodoxy that has changed little since Maynard Keynes railed against it in the 1930s.

As for the Reinhart-Rogoff paper, I give this a lot less weight. Its core claim is based on the statistical analysis of past episodes growth and debt. Such regressions used in macroeconomics are always flaky, never mind any mathematical errors, as the various assumptions needed to give them validity rest on wishful thinking. We looked at a few when I was an economics student, and noted how no two independent statistical regressions came close to agreeing with each other. There are no economic laws of motion out there waiting to be discovered by careful data analysis. And if there were, their validity would generally be broken by the act of discovery and its effect on people’s behaviour. The value in such studies is in posing questions, not answering them.

So what issues of disagreement might there be between supporters and critics of the government’s policy in terms of generally accepted economics? First let’s start on the points what they should agree on. The reason why the UK has not met government forecasts made in 2010 has been weakness in demand from two areas: exports and investment. Consumer demand has been fairly much as expected. It is difficult not to see the shadow of the Euro crisis in both, though a case might be might be made for a weak banking sector causing lack of investment (though I wouldn’t buy it). This weakness in demand is damaging because it causes persistent unemployment, which in turn may damage the economy’s longer term prospects as longer term unemployed people become unemployable. Meanwhile living standards are being squeezed by the depreciation of the pound, which is spreading hardship and pain far and wide. A further point of agreement amongst most is that the economy needs to rebalance: for some areas of the economy to shrink relative to others, in particular towards areas of the economy that strengthen exports, rather than just fuel borrowing. This point is not accepted by many Labour politicians, especially those close to the last government though (for example Tony Blair in his recent New Statesman article). It implies that the last government’s economic strategy was mistaken in causing these imbalances. However I suspect most neutral observers accept that substantial rebalancing is needed.

There are probably two important points of disagreement. The first is the extent to which any fiscal relaxation will slow or prevent rebalancing. Will it just prop up areas of the economy that will need to be shrunk for the economy to progress? This line of argument is particularly strong when it comes to the expenditure side of the austerity policy. Cuts to government services and reform to the benefits system are not just about cutting the deficit: they are about making the economy more efficient. However, when it comes to temporary tax cuts, it is a lot less clear that it has anything to do with rebalancing. Also expenditure to invest and improve the economy in the long term is not affected by this line of argument.

The second area of disagreement is the ability of the government to borrow money to finance fiscal stimulus, and the effect of borrowing on growth. This was where the Rienhart-Rogoff article was deployed. I won’t attempt to explain it in today’s blog: it gets fiercely technical. In the more public arena both sides like to deploy spurious arguments on this topic. I disagree with most of the arguments used by government supporters, but that does not make them wrong in the round.

Government supporters, especially of a Lib Dem hue, will suggest that the government has already been flexible by stretching out its targets in face of the disappointing economy. There remains a case for some kind of shock treatment, though: a change in policy that is a pleasant surprise to people, and which will improve confidence.

And that is an issue that is at the heart of the matter in my view, but which economists don’t like talking about because it seems so ephemeral. The economy is driven more than they will admit by the zeitgeist: common expectations, confidence, mood, world view, etc. There is little fiscal and monetary policy can do in the face a determinedly depressed outlook that increases saving but reduces investment. That is what we have now. One aspect is welcome: it means that inflation is unlikely to take off. A positive shock can change the mood: but Britain is a small country which depends a lot on what goes on in the rest of the world. There is a real risk that what goes on in the wider world undermines domestic attempts to change the mood, which means that the whole exercise makes things worse. The outlook remains grim, I’m afraid.