economics – Page 4 – thinking liberal

Mrs Thatcher: the lightning conductor

Oh dear! The death of Margaret Thatcher yesterday has unleashed a flood of comment about how she transformed this or that. Mainly it is praise from the right (it’s everywhere and I can barely bear too read them, so I’ll only link to this one from the FT’s Janan Ganesh which manages to be reasonably objective). But the left do not want to be deprived of an opportunity to vent their precious hatred – like this absurd article from the Independent‘s Owen Jones. What she symbolises seems to be more important that her actual achievements.

When I first studied history (I did History Part 2 at Cambridge, graduating in 1979 just as Mrs Thatcher took office) the Marxist view of history was quite prevalent. This saw history as a sort of clash of tectonic plates (I also studied Geology at Cambridge…) formed by social classes or interests (“the forces of history”), which downplayed the contribution of individuals. If one person had not led such a change, it was held, then somebody else would. This was closely linked to the idea of historical inevitability, used by left wingers to predict their inevitable victory, and so contributing to their tactical ineptitude. The Marxists greatly overplayed their hand, but the fashion seems to have gone too much the other way. We associate the process of historical change too much with individual achievements. And none more so than with Mrs Thatcher (as she is no longer alive, I do not feel the need to use her title: she was always Mrs Thatcher to me).

The period when Mrs Thatcher was Prime Minister of the UK, 1979 to 1990, was one of quite dramatic transformation in both this country and the world. I remember the 1970s all too well. The British corporate settlement was in a state of collapse. In common with many democracies the country had been governed through a sort consensus of trade union bosses, managerial types and civil servants. Unfortunately the management leg of this arrangement was very weak: business leaders were more interested in undercutting each other than showing solidarity in the face of common challenges. In this the system contrasted with Germany and Japan who have used the corporate model much more successfully; and unlike in France, the state element had an anti leadership culture. With management and the state weak, trade unions ran rampant. Edward Heath’s government of 1970-1974 at first tried to work with the consensus, but the unions were too greedy – and he lost power in 1974. Though the public mainly agreed with him on the unions, they saw his government as incompetent, leading to an indecisive election result that Labour’s Harold Wilson skilfully exploited. The world economy was reeling from a massive rise in oil prices, which the government tried to treat as if it was a cyclical rather than structural problem with loose fiscal and monetary policy (following principles espoused in our current environment by Paul Krugman et al). Labour wrestled with the impossibility of trade union economics. The turning point came in 1976, when Britain had to go to the IMF for a bailout. Wilson had bowed out, and the messy job of fighting back fell to Jim Callaghan and his Chancellor, Dennis Healey. But the unions fought back, and the notion arose that the country was ungovernable. Enter Mrs Thatcher.

I voted for Mrs Thatcher in 1979, or rather I voted for Sir George Young in Ealing Acton, in support of the Conservatives. I was growing out of my cold war inspired distrust of Labour, but hated the messy process of fudge and compromise that was Mr Callaghan’s way (symbolised by such outrages as the Dock Labour Bill, which thankfully never got into law). Mrs Thatcher’s economic policies were a real shock: sky high interest rates, causing industrial collapse across swathes of the country. But who else had an answer to the simultaneous inflation and unemployment in which the economy had been stuck? But the style, if not the substance, grated and when the SDP was formed out of the wreckage of the Labour Party, I joined it.

Mrs Thatcher’s government swept away much nonsense: trade union power, nationalised energy and telecoms businesses, City restrictive practices, and so on. These acts of destruction were necessary for the British economy to thrive. On the left the Thatcher government takes the blame for the destruction of swathes of British industry, and the communities they supported. The emotion gets very high in the case of coal mines. And yet there is no modern economy that has not seen destruction of such jobs on a similar scale. Walk into a German factory and you will see lots of production, but few workers. Industrial technology has wiped out a whole category of seemingly safe industrial skilled and semi-skilled jobs that were the bedrock of the working class. After Mrs Thatcher, globalisation has continued the same process, but the main destruction comes from technology, not the export of jobs. And, for all the destruction of these jobs, the extra wealth generated by productivity improvements has spread across the whole of society, even if it has favoured the rich proportionately more. This is one reason why our current recession is inflicting less genuine hardship that previous ones.

The process of modernising the British economy was necessary and beneficial. And also, surely, inevitable. Without Mrs Thatcher the changes would have happened more slowly, perhaps. But they would still have been painful, and yes, “divisive”, to use the common word attributed a lot to Mrs Thatcher. But she did take the process of confrontation to extremes. Did this create more social harm that was necessary? We can’t know, though the admittedly smaller and more cohesive country of Sweden managed a very similar transition rather more successfully, I feel. But Mrs Thatcher was a hero to many Swedes.

A more serious criticism of the Thatcher government is that it did little to create sustainable jobs to replace the ones destroyed. The country launched forward on a twenty-odd year credit binge fuelled by North Sea oil. Just how hollow this was is now becoming clear, as the flow of oil slows. A severe devaluation of the pound has not done much to correct a severe imbalance of trade. But it is a little unfair to entirely lay this at the door of Mrs Thatcher, though. The imprints of Labour’s Tony Blair and Gordon Brown are just as firmly on this failure. And it is no so easy to see what should have been done about it.

And on the world stage? Mrs Thatcher’s most conspicuous triumph was taking on Argentina in the Falklands war. This one was about heroes I think, rather than the forces of history. It helped bring down a nasty dictatorship, and secured Britain a stronger international standing – though I am less clear about what good that led to. To suggest that she and Ronald Reagan’s confrontational attitude to the Soviet Union had much to do with its eventual collapse is nonsense: it needed no outside help to do that. And when it fell Mrs Thatcher was flat footed, failing to understand the implications of what was happening. Her contemporaries Helmut Köhl and George Bush (senior) were much more on the ball. Her reservations about a united Germany may have been well founded, but she had no solution.

Still she deserves credit for one important international development, beyond toppling the Argentine generals. She was instrumental in the launch of the single European market in the EU. This project was making little headway as Eurocrats pushed forward a hopeless programme of bureaucratic harmonisation. Mrs Thatcher, with the Commissioner she appointed, Lord Cockfield, turned this around giving a presumption to free trade. It was a classic synthesis British freewheeling pragmatism and the more bureaucratic and formal French approach. She may have felt with hindsight that the Single European Act that enshrined it in UK law went too far, but her vision of Europe as an open market was genuine enough, and she deserves credit for persuading her European colleagues of the idea’s merits.

Mrs Thatcher was a hugely conspicuous character on the British and world stage, both through her sex and her personal style. It is only natural that we project so many positive and negative feelings onto such a person, as a sort of lightning conductor. But many of the changes she wrought were the inevitable march of modernisation; and many of her achievements were undermined by tactical and strategic errors. She did more good than harm. Faint praise. She would not have liked that, but then she would not have like me.

Monetary policy is a useless collective noun

At the time of the financial crisis of 2007 and 2008 it was commonplace to say that modern economics, especailly the macroeconomic variety, was in crisis, and needed a fundamental rethink. Alas, the vested interests of established economists have prevailed. Very little rethinking has occured, and this mainly tweaking rather than anything big. This is most striking in the area of monetary policy. The debates now going on in Japan and Britain remind me of the academic papers and discussions that I read about while an economics undergraduate at UCL in 2005-08. Circumstances have changed (in Britain anyway) but not the economics.

Economists of complain that amateurs are guilty of the fallacy of composition: to assume that was is true for a household, say, is also true of all households grouped together in a single economy. It may sensible for a single household to save more of its income to repay debt: but if a whole economy tries this at once, it could be disastrous. But economists are guilty of their own fallacy, though one for which I have not found a commonly used name. I will call it the fallacy of collective nouns. It is idea that by collecting together a group of disparate elements and giving them a name, that you have created a new entity that allows you to ignore its component parts. Most macroeconomic concepts are such collective concepts: GDP, inflation, and so on. Such collectives are useful only up to a point, and then you have you have to look at their component elements. And yet most macroeconomists, even very intelligent and distinguished ones, can’t bear to let go of their collective concepts and carry on using them long after their usefulness has ceased.

This is clearly the case with the idea called “monetary policy”. The conventional idea is that an economy has something called a “money supply”, which can be manipulated through policy instruments under the control of a central bank. In turn this money supply affects the behaviour of the people that form the economy with fairly predictable effects on things like consumer prices,wages, investment and output. All of this is very questionable in a modern economy. It is much more helpful to think of the particular components of “monetary policy”: central bank interest rates, state purchases of its own and other bonds, bank regulation, and so forth, and how these affect the various parts of the economy acting through the financial markets.

The conventional economic thinking runs something like this: the economy (Britain and Japan in particular) is stagnating with relatively low levels of inflation, but high or rapidly rising levels of government debt. In order to pay back this government debt you need to break out of the stagnation and grow, or (whisper it) let inflation make the debt more affordable. To do this you need to “loosen” monetary policy and increase the supply of money. With more money in their pockets, people go out and spend more, leading either to growth or inflation. To do this the central bank lowers interest rates, and where this does not work, use other measures like Quantitative Easing. Cue lots of debate about the relevance of inflation targeting and its alternatives (nominal GDP targets for example), all well within the comfort zones of economists.

There are very many problems associated with this line of reasoning. It is far from clear what money is. However it is clear that commercial bank accounts form the most important part of it, and this is a function of commercial bank policies, not those of a central bank, whose influence is increasingly marginal. It isn’t clear that large bank balances lead to increased spending, least of all on constructive economic things like consumption or proper investment (as opposed to chasing up the value of assets in fixed supply). Rising prices do not necessarily make debt more affordable: that requires rising income for the people holding the debt. And it goes on.

All the verbiage around “monetary policy” is clouding the issue. There are two problems being faced the British and Japanese economies: weak output and excessive debt. Weak output in turn has two components: using spare capacity (i.e. that created simply because of slow demand) and strucural problems. In Britain there is a big argument about how much of the problem is spare capacity and how much is structural. If it is largely spare capacity then simple macroeconomic solutions may have merit: you just need to boost confidence a bit to lift demand. But even here it is not self evident that any of the loose money policies will be much help. In Japan there seems to be even less spare capacity.

I can’t help thinking that what policy makers really mean by “loose monetary policy” is higher wages. Increasing consumer spending power through increasing wages will lift confidence, and even if it is not based on increased productivity, it will make debts easier to pay off, including public debt through higher tax revenues. This lurks behind a lot of the talk about greater tolerance for inflation. But in Britain we have the wrong sort of inflation: rising import costs through a lower pound, and increased government charges. This really isn’t helping. If policymakers want higher pay it would be better to throw away the weasel talk about loose money, and talk about pay. There is some evidence for that in Japan, but this only serves to show how difficult the policy is in practice.

The Japanese government also deserves some credit for the fact that it is not advocating looser monetary policy by itself, though you wouldn’t guess that from much of the coverage here. It is one of three prongs, the other two being fiscal stimulus and structural reform. There is plenty of scope for structural reform in Japan, and this gives their economic policy some hope for ultimate success if they follow it through. But it is the prospect of quick and easy solutions through fiscal and monetary policy that is exciting people.

In Britain a chronic trade deficit shows major structural problems, no doubt partly as a result of reduced North Sea oil. This requires the economy to be producing different things, not just more all round. Loose talk using economic collective nouns is making this harder to see and address.

David Graeber’s Debt the First 5,000 years – the emperor has no clothes

One of the books I received for Christmas was David Graeber’s Debt, the First 5,000 Years. Mr Graeber is an American anthropologist, now working at Goldsmiths in London, who has been active in the anti-capitalist Occupy movement, and describes himself as an anarchist. The book promises to give some intellectual heft to the anti-capitalist case, by examining the origins and history of debt and money, and how we need to rethink it. So far so good. But after the book promised so much at the beginning, I can hardly contain my disappointment with its limp ending.

The book starts well enough. He immediately focuses on modern economics’s weakest point: the theory of debt and money. He may labour the nonsense of the economist’s creation myth of a barter a economy a bit too much: economists aren’t really interested in history after all. But economists’ confusion over the role and meaning of money is evident; personally I wouldn’t use the barter myth to illustrate this, but the way economists still talk about printing preses and helicopter drops when trying to explain monetary policy. Mr Graeber runs his hand across the soft underbelly of economics, but then, instead going in for the kill, he throws away the knife. He rejects the whole, quantitative, mathematical language of economics. He thinks that the discipline’s attempt to preserve moral neutrality is in fact condoning immorality and violence. Like it or not, numbers and mathematics are central to our society’s workings, and rejecting these tools out of hand leaves Mr Graeber’s arguments with very little purchase.

The full, awful implications of this are not immediately clear, however. Mr Graeber puts the question of money and debt into an anthropological context, and this is a good read. I found his categorisation of human interactions into three types very illuminating. These types are exchange, what he calls “communism” and hierarchical. The exchange relationship is the typical arms length commercial one: one item is exchanged for another, typically money, and there are no further implications for the relationship between the parties; it ends with the transaction. A communistic (or perhaps communal would be a less provocative word) transaction is typical of close communities: transactions aren’t exchanges, those who are able give to those who are in need, all a part of a wider, long term relationship. Relationship is also key to hierarchical transactions, but it is one of authority. A lower individual pays tribute to a higher one, while the higher one may cast beneficence to those beneath. Mr Graeber is careful to say that none of these is inherently superior to the others, and any society needs to use all three. But he complains that the modern world puts exchange relationships on a pedestal at the cost of communistic ones, costing the quality of human relationships.

All this leads into a broad historical narrative – the 5,000 years – of the Eurasian continent. Originally money develops as a credit relationship, and is not seen as a thing in itself: its accounting function is the critical element, and it is woven into the fabric of society, based on trust. But then the idea of precious metals, gold and silver in particular, becoming money in its own right rapidly took hold across the entire continent. The effect, in his telling, was malign. Money existed independently of states and relationships. Soldiers could loot money from one place as they destroyed it and spend the proceeds elsewhere. It facilitated both the running of armies and trading of slaves. Sinister, cynical empires came to dominate the world in Europe, India and China in the centuries before and after Christ.

These empires then broke down (or changed nature in China) as precious metal (bullion) money was drained from the system. In Mr Graeber’s telling this has much to do with the new world religions (Christianity, Islam and Buddhism) in what he calls the Middle Ages. His account is admirably even handed in its geography, rather than the customary focus on Europe. In this age Europe is a barbaric offshoot from the civilised worlds of the Middle East and China. Credit becomes central to commerce, which operates independently of the state, and is based on trust. This is something of a golden age to Mr Graeber, though not the European end.

This unravels in the Renaissance, with the Europeans leading the way. Gold and silver is looted in America and then traded with the Chinese. An age of violence and destruction is born, as trust is no longer required in trade and commerce. Then, in the 17th and 18th centuries the malign instruments of modern finance, bonds and shares, are invented in order to fuel society’s appetite for war. Meanwhile, the slave trade takes off, destroying African society amongst other victims. An age often portrayed by western historians as one of progress, Mr Graeber portrays as one of a descent into destruction. This is deliberately provocative, but he has a point: this is an age of war, colonialism and slavery.

And it is here, as the industrial revolution begins, that Mr Graeber’s account runs out of steam. All the building blocks for capitalist society are in place, and its evil roots clear; he almost says “and the rest is history”. He swiftly moves on to his final chapter, where a new era begins with the collapse of the Bretton Woods system, and with the inevitable collapse of capitalism in its wake. I was expecting to read an account of the era of economic growth, but there’s practically nothing there. And the awful truth dawns. Up to this point I had been giving Mr Graeber the benefit of the doubt, for all his provocations. But the emperor has no clothes. When it comes to describing the modern world he is utterly out of his depth and as a result anything of consequence he has to say (and there are some) seems a matter of random chance. An example is his idea that the purchase of US Treasury securities, which will always be rolled over rather than repaid, is in fact paying tribute to the primary military power. the USA. He spots a problem with this account: the Chinese are amongst the largest buyers, and they are power rivals. He then has to concoct a story that this is part of a long term Chinese game. This is really very silly. The Chinese are buying US Treasury stock because they are running a big trade surplus and there is nowhere else for its surplus dollars to go; the power transfer implied is minimal; but the trade surplus is an important element of the Chinese development strategy, which involves building up production in advance of consumption, and in the great scheme of things the dollar surplus isn’t that important to them; it’s only money – if they lost the lot in a crash tomorrow, how much does it really matter? The Chinese seem to have grasped Mr Graeber’s message about money rather better than he has himself. Mr Graeber’s lack of economic literacy has him floundering to comprehend what is happening around him.

His thesis is that modern capitalism is a typical bullion economy based on power and violence, and the absence of trust, with exchange and hierarchical transactions driving all else out. Most people in developed economies are little better than slaves, tied to their employers and struggling to pay off debt. Debt is used to enslave people. But this system is fundamentally unstable and is in the process of collapsing.

But after the emperor-has-no-clothes moment there is no aspect of Mr Graeber’s thesis that doesn’t look questionable. Is is really true to say that capitalist transactions are based on the ultimate sanction of force, and not on trust? Is it not trust that distinguishes advanced capitalism in say, Denmark, from the less developed versions in Russia and China?

And he misses the whole issue of growth. This process, driven mainly by increased productivity, has improved the lives of countless millions – and is genuinely popular with most people in both the developed and developing world. It is by no means evident that today’s workers can be compared to Roman and African slaves. And debt has played a critcal role in lubricating this growth process, by allowing investment: payment now for a later gain. The whole culture of investment is omitted from Mr Graeber’s analysis: debt for him has but one purpose: to enslave the debtor by forcing him to make a promise he cannot keep.

Mr Graeber’s failure is underlined by the absence of any practical ideas about how the world should change to make it better. His only idea is a Jubilee: a systematic forgiveness of debt. But he hasn’t thought about the social chaos that would result as all savings were wiped out. The modern way of doing a Jubilee is called hyperinflation. It is hardly evident that the phenomenon that created Nazism is necessarily helpful to the development of society and the empowerment of the poor.

Is there anything to be retrieved from Mr Graeber’s spectacular collapse when confronted with the modern economy? He happens to be right about an awful lot of things. Money is best regarded as an abstract concept, a social invention without underlying reality. Debt also is a social convention that can outlive its usefulness, and should not be treated as sacred promise. The exchange method should not be idealised as model for all life, as Chicago School economists do. And economic growth in the developed world does seem to have hit natural limits, whose consequences we still don’t understand. Capitalism may indeed collapse if it continues in its current form.

But the answer is not to condemn capitalism as the work of Satan, and hope for something better to turn up. Mr Graeber’s work is pure antithesis. Progress is made by synthesis: by taking capitalism and making it better. And you can’t do that by rejecting the discipline of economics, for all its manifest faults.

Does Britain need the City?

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

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

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

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

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

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

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

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

Britain’s economy: is the right right?

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

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

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

2. Cut current government spending by 2pc this year

3. Wage war on zombie firms

4. Reform the labour market

5. Allow private sector to finance big transport projects

6. Build 300,000 homes a year

7. Scrap renewable energy targets

8. Create mini-jobs for welfare recipients

9. Allow for-profit firms to run schools

10. Make it easier for consumers to switch suppliers

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

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

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

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

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

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

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

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

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

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

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

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

Growth: the deeper questions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The imperial illusion of macroeconomics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I hope that provides food for thought!