economics – Page 7 – thinking liberal

Inflation and the British economy

There is an excellent article in today’s FT by Chris Giles. Unfortunately this is behind the FT paywall so I don’t think clicking through will help most of my readers.

Mr Giles considers what has gone wrong with the British economy over the last year – since growth forecasts are being consistently revised downwards. Two explanations are often offered – “it’s the Euro crisis” or the government is cutting “too far, too fast”. In fact both are wide of the mark. The simple fact is that while rates of pay have stuck broadly on forecast (2% increase), consumer prices have increased by more (over 5% compared to just over 3%). The gap is plenty enough to explain the lowering of real terms growth.

Why have prices shot ahead of forecast? Mainly external factors to the British economy – oil prices, global prices for food and clothing and so on. I really don’t like calling these price rises “inflation”. Inflation suggests a degrading of money which, inter alia, makes debts easier to afford. But incomes aren’t keeping up, so debts aren’t eroding by more than the 2% a year or so that incomes are rising. Similar considerations apply to government debt – taxes largely depend on income. VAT is an exception – but many benefits (like pensions) are linked to the rate of increase of consumer prices – so the national debt doesn’t get any more affordable.

The economic pain of these external price rises is being spread widely. Surely the Bank of England is right not to tighten policy – which would only cause unemployment and concentrate the pain on an unlucky few. Our comparatively low rate of unemployment, compared to previous crises of this economic scale, is one of the wonders of the British economy.

Five Eurosceptic fallacies

I caught a bit of last night’s Radio 4 Analysis programme driving home from a meeting, on Euroscepticism in Britain. One speaker (I didn’t catch who) suggested that the case for Britain being in the EU was mainly economic – that we could put up with a bit of lost sovereignty because we were being hitched to an economic powerhouse that would do our economy good. This he said, was now clearly nonsense. In evidence he said that the EU used to be 26% on the world economy and now it is 18% (I may have misremembered the numbers). “We are being chained to a corpse.” I was apoplectic. But it is typical of the drivel that is being spread across our media. It’s worrying that so few people bother to argue back.

Let’s clear the decks with some points of general agreement. The Euro is in crisis, and this crisis could lead to an economic disaster. This in some measure results from severe mismanagement of the currency by the EU’s leaders, aided by the European Central Bank (ECB). The stock of European institutions is low in public eyes, not just in Britain, but across most of the continent. This has something to do with a democratic deficit – with the institutions wielding power with little apparent democratic consent.

But it is possible to accept all this, and to think that the EU, and even the Euro, is fundamentally a good idea, and that Britain would be mad to consider leaving it. The country may even be forced to join the Euro – though that event is surely a long way off.

Let me try to help the feeble defenders of British membership by elaborating four critical fallacies behind the Eurosceptics’ arguments, and fifth that is a bit more arguable.

First fallacy: there is such a thing as “just” a free trade area. It often said the the country joined something that was just a free trade area, but this has morphed into something else. But free trade across borders is a complicated business – and not just a matter of border controls and tariffs. Its implications quickly reach into vast swathes of ordinary life. Most of the US Federal government’s powers rest on its right to regulate interstate trade. And the unhappy experience of the North American Free Trade Area (NAFTA) shows how politics gradually undermines transnational free trade projects that do not involve a significant pooling of sovereignty.

Fallacy no 2. Britain is being ripped off by the rest of Europe because we have a trade deficit with them. This leads to the idea that outside Europe we would get a sweetheart deal (like Norway of Switzerland, or at least in popular myth) because they need us more than we need them. But the British trade deficit arises from the chronic mismanagement of the British economy, which led to a prolonged period (since the late 1990s) where the Pound was too high for many of our export businesses to be competitive. This uncompetitive exchange rate has now been reversed, and so our trade balance with the EU will correct. And as for bargaining power, there is a fatal flaw to this line of reasoning: the relative size of the UK against the rest of the EU. EU trade is a major part of our economy; UK trade is not a major part of the EU economy.

Fallacy no. 3. Being outside the EU means that we don’t have to comply with EU regulations. This is largely true of the labour market, it has to be said. But far from true of product markets – since we need to sell our products in the EU. Also, if foreign manufacturers are forced to comply with separate British product standards before they can export here, they will either charge us extra or not bother. If you are in any doubt about this ask a Norwegian or Swiss about how much better life is without the burden of EU regulations. You will get a lecture about how they have to comply anyway, without any input into how they are made. This is of particular relevance to one of the areas where Britain has a competitive edge: financial services. Our representatives in Europe are forever batting back ideas for new rules that would disadvantage the City; I wonder what would happen if they weren’t there any more?

Fallacy no 4. We would save money by leaving the EU, because we are a net contributor to the EU budget. This is an illusion. We may pay less in net contributions, but we would pay more in tariffs And if we charge more tariffs in return? Any economist will tell you that this is a road to nowhere. Our net contribution is a small price to pay for access, and, besides, some of it helps to develop new markets in the Union’s less developed countries.

Fallacy no 5. Britain would have been worse off by joining the Euro at the start. This contention is unprovable, as is the opposite: that we would have been better off in it. The Euro, of course was badly managed. But so was the Pound. While the Euro was going on, the pound shot up in value, destroying many of our exporters and creating a big trade deficit. Borrowing ran amok, as did, to a lesser degree, government expenditure. When it all blew up, it left the British economy in a terrible state, one that it will take many years to recover from. Won’t the devaluation of the pound help our recovery? Yes, but it should never have got that high in the first place. What would have happened if we were inside the Euro? Almost certainly no better – except that our problems would have been more transparent, so we might have started to fix them a more quickly. My point: an ugly mess either way. Look at our Eurozone colleagues and the British economic performance does not look stellar. A floating currency is no free lunch.

Of course there is a lot wrong with Europe and the Eurozone. That does not mean that this country is better off outside. The best case for a referendum in this country is that it would force supporters of the Union to make the case more forcefully, and expose the fraud behind the anti-EU case. But on their performance to date, who can be confident of that?

Lib Dems and the Quality of Life

One of the more entertaining episodes of the last Lib Dem conference was the debate on the party’s new Quality of Life policy paper. This paper had wended a long but largely uncontroversial path through the policy formation process, including extensive consultation, before reaching the conference – and I was a member of the working group – interest declared. And generally policy that has followed this path gets more or less nodded through. Not this time. The motion and paper got the backs up of many representatives, and there were a number of well-delivered and entertaining speeches against. For a flavour of this ire see Alex Wilcock’s blog – scroll down past the Dr Who stuff to 20 September. If you click through to the comments page, you will find Alex describing yours truly as “not so much a thinking liberal as a sneering one”! The paper was passed, but the margin was quite narrow by the usual standards of these things.

And that’s a bit of a problem. This is policy that stands behind other policy – important not so much for its direct recommendations as its influence on subsequent policy. I hesitate to call it philosophical – since it does not attempt to develop the core values of the party, but rather to apply them in a new way. But if it is considered contentious, it may get ignored. And for all that it is official policy, this would be quite easy.

What’s the fuss about? The starting point of the paper is that public policy is too dependent on “hard” economic statistics, such as income and economic growth, to measure success. But these are only intermediate measures – in other words we like them because they lead to good things, rather than being good of themselves. That is because of the difficulty of measuring success in itself – the hitherto rather woolly concepts of wellbeing and quality of life. But social science has been advancing rapidly and it is now possible to measure wellbeing in a rigorous way – mainly through asking people to make subjective judgements on their state of mind.

What the paper recommends is to make wellbeing an explicit policy goal, alongside the traditional economic measures. To ensure this is done rigorously, it recommended that a National Institute of Wellbeing is established to promote standards. Various other devices (a cabinet champion, for example) were recommended to get it embedded into the business of government.

So far, so good, perhaps – but for liberals some loud alarm bells should be ringing by now. This could be a charter for highly paternalistic government. And especially when you come up against the evidence that many people seem to have a poor understanding of what is good for their wellbeing. So the beating heart of this policy paper is the insight that individual autonomy (“agency” in wonks’ jargon) is central to wellbeing. The idea is to help people help themselves, and not bullying and cajoling them into making better choices.

Education is central. And, to make a small digression, this takes you in a very interesting direction. A lot more is understood about life skills – emotional intelligence, resilience, and such – and the wellbeing insight gives these a much higher priority at all levels of education.

Fortunately there is a wealth of evidence to support the liberal view. There one further thing – the measurement mechanism of choice for social sciencists, self-reported wellbeing, is a thoroughly liberal idea. Wellbeing is what the population says it is, and not an arbitrary idea imposed by policymakers. It’s like voting.

What were people objecting to? One faction distrusted anything with so little in the way of concrete recommendations – especially when those few recommendations sounded like more bureaucracy and a new quango. At best they interpreted it as harmless, and so a cost-free policy to rebel against; at worst they thought it was opening the party up to being criticised for being irrelevant in times of widespread economic hardship. Others, Alex was amongst these though he was not called to speak, understood how dangerous the the quality of life idea could be in the wrong hands, and felt that it was too toxic to touch. Or, possibly, that the detail of the policy paper did not live up to its liberal intent. At any rate that is my reading of what they were saying.

All this put the promoters of the motion in a bit of a difficulty – it is really quite difficult to push abstract ideas in this kind of debate. In a short speech you don’t really have much opportunity to say more than “I think this is a good idea” rather than why you think it is good – at least not in a way that will connect to more than a minority of the audience.

Does it matter? The problem is that the wellbeing agenda is slowly but surely infiltrating itself into the public policy process already. The word (or “well-being”, the spell-check compliant variant which I don’t like) and quality of life come up with increasing frequency in all kinds of public policy contexts, and especially in health. The concepts, if not the measurements, lay behind so much of the last government’s meddling in people’s lives. And David Cameron is an enthusiast too, though with an entirely different agenda -but no doubt paternalist in a different way. Liberals need to get into this debate and push back hard against paternalism – but using the language of wellbeing, and not just pronouncing the plague on all its works.

And there is something else, even more important in my view, which the paper doesn’t really touch. And this is the usefulness of the idea in promoting a more environmentally sustainable economy. It is important to break through the tyranny of current economic measurements to show that a more sustainable way of life does not equate to poverty – and indeed that it can be better for everybody. This is why the New Economics Foundation is so interested in wellbeing. I particularly like their paper on Measuring our Progress.

So we need to keep pushing. As one of the motion’s supporters said to me afterwards “Who remembers how close Nick Clegg’s margin of victory was for the party leadership?”. Still, we that understand and support the policy have a selling job on our hands.

Understanding the Euro Crisis

My favourite contemporary economist is UCL’s Professor Wendy Carlin. She was my tutor at UCL, and led my second year macroeconomics course, and a third year course on European institutions. Her patient, dispassionate analysis is worth so much more than all that shoot-from-the-hip banging on by celebrity economists, Nobel Laureates and all. It was her analysis, well before the current crisis broke, that demonstrated to me that the last government’s economic “miracle” was unsustainable (the combination of an appreciating real exchange rate and a trade deficit being the giveaways). She also helped me understand the Eurozone, and pointed out the trouble ahead, again well before it happened, arising from diverging real exchange rates within the currency bloc – in other words Germany was becoming more competitive while Italy, Spain and others were becoming less so.

So I was delighted to read her summary of the Eurozone crisis – 10 questions about the Eurozone crisis and whether it can be solved. The is a wonderfully clear summary of the whole situation, written in early September. Her central point is that the zone’s banking system is at the heart of the crisis, and tackling the banks will the heart of any solution. European politicians have been trying to avoid this, no doubt because it shows that Northern European countries have played an important role in creating the crisis. However, not least thanks to the new IMF chief Christine Lagarde, this is changing.

Of course Professor Carlin cannot point to an easy escape. She points to two alternatives paths, other than the breakup of the zone:

Scenario #1 – a more decisive approach based on current policy (bailouts)
Policy-makers need

the existing bailout schemes to be successful and to be seen to be working in the next year

to keep Italy out of the bailout regime

to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime.

Scenario #2 – large-scale restructuring of bank and government debts (defaults)
Policy-makers need

to move decisively now to end the high moral hazard regime by accepting that default on bank and government bonds on a much larger scale than envisaged in Scenario #1 is necessary

to engage in restructuring sovereign debt and bank debt by, for example, forcing bond-holders to swap existing short-term bonds for long-term

European politicians are attempting the first path, but the problem is contained in Professor Carlin’s third bullet: devising a financial scheme that avoids moral hazard by banks and sovereign states – this reckless behaviour in the belief that it will be underwritten by everybody else. The favoured answer of many is a “Eurobond” – i.e. government borrowing underwritten collectively, combined with a toothier version of the failed Stability & Growth pact. But this decisive step towards a more federal Europe runs well beyond any democratic mandate. The German Chancellor, Angela Merkel, is rightly suspicious.

Which leaves the second scenario, which is favoured by American commentators, based on their experiences of Latin American debt crises. This is surely much more convincing, and I hope that the IMF will use its influence to push down this path. Bank regulation clearly needs to change, but beyond that it doesn’t need a more federal Europe. We can use bond spreads to act as a break on government profligacy – which is how the Eurozone should have been run from the start.

A final point worth making from Professor Carlin’s analysis is that dropping out of the Eurozone wouldn’t really help Greece or any other country that much. They would still have to run a government surplus, and so still have to go through a very painful reform programme sucking demand out of their economies. Of course the hope is that a rapid devaluation would kick start exports – but it does not stop the need for painful supply-side reforms if these countries are to recover anything like their former standards of living.

Time for Plan B?

Predictably, the heat is mounting on the British government to soften its fiscal policy in light of weak economic growth. Today the new IMF chief Christine Lagarde seems to be adding to the pressure, even if she wasn’t explicit. The code for changing this policy is referred to by political types as “Plan B”. I am now convinced that some sort of Plan B may now be a good idea – but it would not take the form that a lot of Plan B advocates, especially the Labour opposition propose.

First, why? I have been progressively convinced by the FT’s economics editor Martin Wolf. I have found him to be easily the most cogent commentator on the current economic situation, better than any number of economics Nobel Laureates or former members of the Bank of England monetary policy committee, who seem to think that their past glories can compensate for the shallowness of their analysis. Paul Krugman, Ken Rogoff, Joseph Stiglitz, to name a few, have disappointed somebody that has respected their weightier works; David Blanchflower has turned downright silly in order to widen his audience. Mr Wolf has been consistent, logical, and has gone further than most to try and understand all facets of the arguments.

The problem in the UK economy is not lack of consumer demand, since consumers are right to pay down debt as a priority right now. The problem is lack of business investment, and a weak world economy, and hence potential export markets. And excessively tight fiscal policy may send investment into a doom-loop, since so much depends on confidence. Add to that the fact that current levels of public expenditure are unsustainable, and the massive size of the public deficit, and you will understand that most versions of Plan B are unconvincing. Reducing the cuts simply creates problems for later, and builds up a false confidence in what this nation can afford. Cutting VAT temporarily, as advocated by Labour, addresses the wrong problem.

The answer must be to promote investment. As Mr Wolf points out (here but behind the FT paywall), there is a golden opportunity for the government to do so because its borrowing costs are so low. The trick is finding projects that deliver a convincing financial return; borrowing against such projects does not undermine the country’s finances. Unfortunately this is easier said than done. A lot of public projects make extravagant claims about their worth, but are in reality wasteful prestige initiatives – think of the Building Schools for the Future programme. Or else they turn out to be so badly managed that promised returns are never delivered – think of NHS IT, or Edinburgh trams, or anything undertaken by the Ministry of Defence.

There is no doubt some scope for increasing funding to standard public projects. But actually what needs to be done is to provide more support for medium sized and small businesses, especially growing ones. The banks are not stepping up to the plate, demanding ludicrous returns for their efforts. Surely there is scope for the government to beef up regional development funds and increase funding for institutions such as the Green Investment Bank. This will not open the floodgates to usher in an era of rapid growth. But surely it would help.

The Euro: Thatcherism by other means

It’s a grim time for supporters of the Euro project like me. Hardly a day goes by without hearing some highly patronizing person going on about how a country fixing its exchange rate is a terrible idea because it can’t then devalue when it hits trouble, and how the austerity policies in the Euro zone are doomed to fail. One irony is that many of these people are from the the political right; the sort of people who think that the Thatcher revolution of the 1980s was not just a good thing, but a turning point for the British economy. In fact the Euro advocates are proposing very similar medicine for southern Europe.

The UK economy inherited by Mrs Thatcher in 1979 was a mess. Both unemployment and inflation were persistent, and the country was referred to to as “the sick man of Europe”. Mrs Thatcher’s solution was to focus on the long or medium term drivers of success, with utter contempt for short-term palliatives. She progressively liberalised the economy, and in particular the labour market, then dominated by trade union power, and taxation, which had reached punitive levels on the rich (and not so rich, come to that). In macroeconomic policy she believed in squeezing down inflation through tough monetary and fiscal policies. Interest rates soared. Amongst other things, the pound rapidly appreciated. This was all part of the medicine.

The results were indeed dramatic. Unemployment got much worse, with devastation sweeping through great swathes of industry – all of which makes our current troubles look like small beer, even though, according to GDP statistics, we are supposed to be in a worse mess now. But in due course the economy prospered and reached undreamed of heights – though some parts of the country never recovered.

Back to the Euro zone. The underlying problem with all of the currently struggling economies, except Ireland maybe, is not entirely dissimilar to that faced by Britain in 1979. A host of product market, labour market and tax inefficiencies have conspired to make their economies relatively uncompetitive. The political will to tackle these problems has been lacking. Before the Euro they could simply let their currencies slide to offset this lack of competitiveness. But all this did was to ensure that the living standards of citizens stayed below their potential. And it was unsustainable in the long term; eventually you get to stagflation and even hyperinflation – a fate which Portugal in particular was reaching before the Euro project offered rescue. Once in the Euro devaluation is not an option, and so politicians have to focus on medium and long term reforms. This is what they are now doing, some with more enthusiasm (say Portugal) than others (say Italy).

Mrs Thatcher, of course, would never approve of a country joining the Euro – she treasured national sovereignty too much – but she would have approved of many of its consequences. Mrs Thatcher did not believe in devaluation.

But this is hardly an advertisement for the Euro for many. A lot of people still think that the Thatcher years were a period of gratuitous violence with adverse consequences that we are still suffering. It was she that was responsible for the trashing of so much British manufacturing, with the appreciating pound very much part of this. And the work she started was capably continued by Messrs Brown and Blair, since a high pound, together with aggressive exporting practices from China and India, had a similar effect in the 2000s – albeit compensated by unsustainable jobs in finance and building.

And there is no avoiding that the southern European economies need to go through a process of harsh economic reform, or else suffer a slow slide into poverty. Euro advocates had always foreseen this; what they had not foreseen was that reduced government borrowing costs once in the Euro would allow these countries to put off the evil day, only to make it infinitely worse when it arrived.

A brief guide to Keynesianism and the economic crisis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economic growth and the media circus

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

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

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

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

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

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

Europe’s financial crisis gets dangerous

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

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

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

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

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

The Euro crisis: structural failure or learning curve?

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

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

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

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

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

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

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

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

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

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

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

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