Tag: monetary policy

Britain is not Japan. Abenomics would stoke inflation

I asked Bing Image Creator to give me a picture of shoppers in an English town buying foreign goods. This is one of the four results. Me neither.

Somewhere over the Christmas holiday I heard on BBC Radio 4 a very authoritative gentleman suggesting that Britain should copy Japan’s economic policies. Alas I didn’t catch who it was, and can’t trace him. I think he was on the World at One, but these days the BBC doesn’t let you search past programmes for particular items. Anyway, it is an excellent illustration of the point that I was making about the British economy a couple of posts ago. It’s worth explaining why he is so wrong. I suspected that the gentleman was a graduate of PPE at Oxford, like former Prime Minister Liz Truss: a degree course that equips its subjects to sound plausible when talking about economic policy, without necessarily grasping even the basics of the subject. Ms Truss did not seem to realise that reducing inflation meant limiting demand.

The particular set of Japanese policies the interviewee referred to dates from a number of years back, and was advocated by the late Japanese Prime Minister Shinzo Abe, and is often referred to as Abenomics. He himself called his approach as the “three arrows”. This was based on the ancient wisdom that while it is easy to break the shaft of a single arrow, it is hard to break the shafts of three arrows bound together. His three arrows were monetary policy (ultra low interest rates supported by Quantitive Easing (QE), i.e. the buying of government bonds by the central bank), fiscal policy (extensive infrastructure investment funded by budget deficits) and supply-side reforms. All these policies were mutually reinforcing. Supply side reforms were required to expand the capacity of the economy, fiscal policy to ensure that aggregate demand met this this expanded capacity, while loose monetary policy made the large government budget deficits implied by this sustainable. Without all three strands of policy, there would be failure. Japan had endured many years of economic stagnation, and Abenomics was an elegant and coherent approach to this – more than can be said for British policy economic policy since 2010, when the different policy levers often seemed to work against each other.

The interviewee did advocate one point of departure from Abenomics. When explaining supply side reforms, he advocated three “Is”. The first of these was “investment” – I can’t remember what the other two were (perhaps “institutions” was another). Investment was not a focus of Abenomics. Fiscal policy was directed at public investment, admittedly, but there was little economic coherence to this – it. was mostly about the dispensation of political favours (“bridges to nowhere”) – and the desired economic impact was to raise aggregate demand, not to expand economic capacity. Supply side reforms were aimed at non-financial barriers that were holding the economy back, such as the low rate of employment of women, and not investment.

So what’s wrong with all this in the British context, skating over its mediocre results in Japan itself? Japan was, and is, in a very different economic place. It has a robust industrial base which routinely delivers export surpluses, in spite of having to import raw materials and energy. It has a high rate of domestic savings (in other words domestic consumption is much less than income). Investment is plentiful. But it has all manner of market inefficiencies due to conservative business practices and cultural mores (for example severe prejudice against working women). Contrast this with Britain: its industrial base is comparatively weak, delivering no trade surplus so far this century; the private savings rate is low; investment is weak; but business practices, regulations and social mores are as conducive to economic efficiency as they are anywhere in the world – with a high rate of overall employment, for example. Both countries share grim demographic trends, with a reducing ratio of people of working age – though Britain has been mitigating this with immigration on a scale that Japan doesn’t.

What ails Britain? Pretty much everybody seems to agree that the country lags other developed countries, though whether you compare with America or with Europe depends on your politics. Apart from the lacklustre growth record since 2007, the main evidence is poor comparative statistics on productivity. A lot of the analysis is very shallow, however. Even many academic economists who should know better are susceptible to the fallacy of composition. While they quickly recognise that national decisions on budgeting and demand management are not the sum of individual household budgets – and what would be right for a household would not be right for the country as a whole – they fail to see the same thing on the supply side. They often talk of the country’s production side as if it is a single business (“UK plc”), but that is grossly misleading.

For a start, the supply side of the economy is very heterogeneous. Computer factories are highly productive; hospitals are the opposite. It doesn’t follow that we would be better off if we closed our hospitals and replaced them with computer factories. Furthermore, if individual businesses become more efficient, it also does not follow that this translates into the whole economy doing so. That depends on what those individual businesses do with their extra efficiency. They might expand production, perhaps helping to expand the economy as a whole – provided that there is latent demand for their product. If this happens there may be a virtuous circle that helps the whole economy grow. Or they might just keep production levels steady and sack some workers, paying extra dividends to investors who use it to invest in other businesses. Or the directors may pay themselves more in bonuses to spend on personal trainers, luxury goods, and other things where low productivity is the essence. Overall there is a well-established pattern, however, referred to by economists as the Baumol effect. As productivity advances in some sectors of the economy, lower productivity industries come to occupy a higher proportion of the economy as a whole. The balance of wealth creation (highly productive industry) to wealth realisation (the part of the economy that prioritises self-actualisation and typically has a high human content – i.e. low productivity) shifts towards the latter. What’s the point of being rich if you can’t access decent healthcare, drive around in Bentleys or eat organic food?

The problem for Britain is that the overall mix of its economy is out of kilter. It imports a disproportionate share of the goods and services where productivity is very high, while producing too much of the goods and (mainly) services that are critical to quality of life, but where productivity is low, and export potential is much weaker. The answer isn’t to try and raise the productivity of the latter goods, as this will tend to kill the quality. It into rebalance the production side of the economy towards high productivity goods that can be exported. There is another way of looking at this problem: it is that British consumption is too high. We are living beyond our means, importing more than we export. Consuming less would give the supply side of the economy the chance to rebalance in favour of exports. This is the opposite problem to Japan, where aggregate demand tends to be too low for economic efficiency. In Britain there needs be more private saving and more investment. In Japan it is the opposite.

So Abenomics would not work here. Looser fiscal policy would push us into inflation. Loose monetary policy would simply build speculative bubbles. Supply side reform would not make enough difference, though doubtless there are some useful things to do.

But the interviewee was right about one thing: the key to progress in Britain is greatly increased investment. Any move to highly productive, high exporting businesses will entail substantial investment. What are these businesses? Basic economics teaches us that these should focus on areas where the country has a comparative advantage – but that is a very slippery thing to identify. We shouldn’t be chasing a past golden age, or trying to directly copy other successful economies. If you care to look, there are areas of promise – for example life sciences, especially if the country can tap into NHS patient data. The government, at least does seem to appreciate this – it talks about building the industries of the future. But it struggles to deliver the right economic conditions to generate the level of investment required. There are not enough private savings to fund the business investment required; too much of what there is disappears into government debt – pushed that way by conservative regulation.

This points to a different three arrows to those advocated by Mr Abe. We need to incentivise more equity investment in businesses with export potential – especially if these are based outside London and the South East. Much of this must be led locally by regional and local governments, able to raise their own revenues. Pension regulations need to be overhauled. Second we need a much tighter fiscal policy in order to damp down private demand and keep inflation in check – this will consist of higher taxes and more efficient government (e.g. coherent public services that solve problems rather than passing the buck). If the public won’t save more of their own volition, then the enforced saving of higher taxes has to do the job. This would then give the government space to kick-start investment and tackle bottlenecks. Third monetary policy should primarily be focused on creating a healthy climate for savers, and ensuring financial stability. That will surely mean higher interest rates.

No politicians can advocate steps two and three of this programme. But the first part is near political consensus – and we could find that it drags fiscal and monetary policy in its wake. British policy usually advances by muddle. It is possible that the country will muddle along in the right direction. That is the best we can hope for.

New monetarism: a challenge to conventional economics

Followers of my blog may have noticed quite prolonged exchanges in the comments section between me and Peter Martin. We are both amateur economists so this kind of exchange helps to sharpen thinking, absent an academic or journalistic environment. In order that I might understand Peter’s critique better, he suggested that I view this video of Stephanie Kelton, professor of economics at the University of Missouri – Kansas City. Ms Kelton advocates a system referred to as “Modern Monetary Theory” or, sometimes, “neo-chartalism”. (I will use “neo-chartalism” henceforth as it is easier to write; the “neo” is needed because I think a lot has been added to the basic idea of chartalism). When, as I recently blogged, mainstream macroeconomic thinking is in a sad state, it behoves us to look at those challenging it. This is an interesting idea to pick apart.

The core idea is in fact quite an old one – the original chartalism dates from 1905 and its ideas can be traced back further than that. It is that money is a state artifact, and as such the state has much more latitude in its management than conventional wisdom allows. This is in opposition to the more conventional view that money evolved primarily as a means of exchange to facilitate a market economy, and that the state’s powers to manage it must be constrained or it will be devalued. It is also contrasted with an idea of money that is intimately linked to precious metals (“metalism”), which is a bit cranky these days.

The chartalist view is that money’s primary function is as a voucher with which to pay taxes. It stems from the need of states to commandeer resources to fulfill its functions; this it does through the imposition of liabilities on citizens, which we call taxes. It uses currency values to denominate these liabilities, and then puts physical currency into circulation so that they can be settled. It does this in the first instance by paying its servants and suppliers in this currency. Since everybody needs currency to pay taxes, it quickly evolves into the primary medium of exchange for the whole economy. This allows a banking system to develop for the provision of credit, which in turn facilitates the evolution of money from precious metal coins, to vouchers for precious metal, to fiat money not backed by anything at all. The utility of fiat money, which people not so long ago would have been quite unable to comprehend, is perhaps the ultimate vindication of chartalism. Money is simply what the state says it is; it needs no greater authority than that. And it follows that the state need never run out of money, because it can create all it needs.

This narrative of money is compelling. Historical research comprehensively refutes the idea in old economics textbooks that money somehow evolved from a barter economy. Indeed the core chartalist narrative of money is now so widely held that it is fair to call it mainstream. I doubt that most modern economics textbooks repeat the barter myth. That states can create all the money they need (usually, and misleadingly, called “printing” money) is old news, though, and, indeed, has been an enduring theme of economic debate since the hyperinflation that followed the First World War in Germany and Austria. The chartalist view on this is distinctive: the act of the state creating money does not of itself devalue it: that depends on the context in which it is done. The problem in post war Germany and Austria was that reparations were making unbearable demands on these states.

But this narrative tells you little by itself. It is what neo-chartalists build on this foundation that sets them apart from other economists. My main disappointment with Ms Kelton is that she spends too much time revelling in the brilliance of the initial insight (including a very useful idea of a pyramid of exchange, which explains why local currencies are unlikely to succeed), and too little in explaining where she thinks it leads and why. In trying to explain it I will identify ideas that are implicit in what she says, rather than part of an explicit structure.

The next key idea, and the one that makes neo-chartalism truly distinctive, is that fiscal and monetary policy should form a unity. The best way of putting more spending power into an economy is for the state to loosen fiscal policy – to spend more or tax less; the best way to cool an economy down is to tighten fiscal policy. Fiscal policy directly affects the amount of money flowing in the economy. And a looser fiscal policy can always be supported by the creation of more money. This is very different from the pre-crash consensus, which suggested that fiscal and monetary policy should often pull in opposite directions – with only a marginal role for fiscal policy at all. And even after the crash the British coalition government had a policy of tight fiscal policy balanced by loose monetary policy. Chartalists say this was a mistake: fiscal policy should have been kept loose up to the point where economic capacity was fully utilised, with monetary policy providing support as required; only then should the brakes be jammed on (although may impression is that they  are reluctant to admit that the brakes should ever be jammed on – I may be being unfair).

Here too, I think that neo-chartalists are onto something. I was coming to a similar conclusion, albeit by a different route: the application of the Mundell-Fleming model for open international economies. Ironically Mundell-Fleming is an old-school idea, and regarded with suspicion by neo-chartalists (for example Professor Bill Mitchell of the University of Newcastle, NSW, a leading chartalist). Mundell-Fleming suggests that a floating exchange rate neutralises fiscal policy; but not if it is harmonised with monetary policy. Under a fixed exchange rate system, monetary policy automatically harmonises with fiscal policy, and even amplifies it. The neo-chartalists are surely right that monetary policy by itself is a very inefficient means of managing demand compared to fiscal policy – but it can be an important adjunct to it.

Perhaps the difference between me and the neo-chartalists is that I think the aggressive use of fiscal policy leads to state management of exchange rates,which is not, incidentally, necessarily a fixed exchange rate, and certainly not a currency union. But that is a discussion that needs to be taken elsewhere.

A third key building block of neo-chartalism is that a powerful, fully sovereign state is a force for good. Ms Kelton regards the sacrifice of sovereignty involved in the creation of the Euro with near disbelief. Why on earth would anybody want to do something so stupid? This marks neo-chartalism as a political idea of the left, and its faith in a strong state as the instrument of democratic will. The right view a strong state with suspicion or hostility – as something that uses its power to escape democratic control and further the interests of the state sector at the expense of everybody else. To see the importance of this aspect of the debate, you only have to look at Zimbabwe, where the state’s ability to create money has been a critical way for Robert Mugabe’s regime to retain power; in order to curb the political excesses of the Zimbabwe government it was necessary to adopt the US dollar as currency. Now that Mugabe is on top, he is trying to create his own currency again – but to secure his political status, not to advance the Zimbabwean economy. Strengthening the state’s power on money creation will place a real strain on democratic institutions. Things look all very easy when the state needs to create money to stimulate: but can it be trusted to reverse course when the economy overheats? History suggests that governments tend to deny that an economy is overheating until long after inflation has set in. The Argentine government of Cristina Fernandez even went as far as politicising the state statistics bureau to cover up inflation statistics. In Britain we may remember the stagflation of the 1970s, or, more recently, Gordon Brown adjusting his fiscal rules just when they called for tightening. I think this is a big problem, but not necessarily an insoluble one.

Interestingly there is a divergence of opinion on the radical left here.  People such as the former Greek Finance Minister Yanis Varoufakis think that there is virtue in the idea of a supra-national system for the management of money – a sort of new Bretton Woods – that would curb a state’s power to create money. It is no coincidence that this view comes from somebody used to the challenges of managing a small country, whereas Ms Kelton hails from the USA, which in effect has its cake and eats it by controlling a world currency while remaining a sovereign state.

There are some further ideas important to the construction of neo-chartalist policy:

  1. A optimal private sector (i.e. the aggregation of net private consumption and net business income) should operate at a surplus – i.e. they should be net savers. Excessive private sector debt follows if they are net borrowers, and that is destabilising; public debt is much safer because the state can create the currency to repay it. The private surplus must be balanced by either or both of an external surplus (e.g. net exports) or a public sector deficit. Since not all economies may have an external surplus, this means that it will often be the case that a permanent budget deficit is perfectly healthy (with the US and UK economies being examples). An inappropriate budget surplus could lead to a private sector debt boom – which is what happened to President Clinton’s USA in Ms Kelton’s view.
  2. Sovereign states with control over their own money have nothing to fear from an external deficit – which implies that the state or private citizens must obtain funding from foreigners. The key is that the country must borrow in its own currency – so that it can create the money to repay it. That a country might be forced to borrow in foreign currency is a major weakness in the whole edifice, I think. It is far from clear why exporters from surplus countries should always be in a weaker bargaining position than importers from deficit ones, and so be forced to accept the importer’s currency.
  3. The developed world is suffering from a chronic lack of demand. Neo-chartalists follow pre-crash neo-Keynesians in believing that the key indicator of excess demand in an economy is inflation (as opposed to asset prices or trade deficits). And since inflation does not appear currently to be a  threat in any major economy, there must be plenty of scope to expand fiscal policy. Neo-chartalists do not appear to take seriously the idea that their may be darker forces at work in the economy, reducing economic potential – something that I have long argued. Ms Kelton produced a graph to illustrate where the US economy could be by projecting forwards its growth rate from before the crash – something guaranteed to leave me spitting with fury! They also seem to have little truck with the “Austrian school” idea that a certain degree of slack is required in an economy in order to sustain the forces of creative destruction – and that recessions may be positively beneficial.

In summary: the neo-chartalists are re-writing the conventional wisdom on what money actually is, and have useful things to say about the role of fiscal policy. But beyond that my first reaction is that it is a modest idea that has pretensions beyond itself. It seems applicable in some contexts, but not as a general rule. And yet neo-chartalists are a valuable part of the dialectic from which a new economic synthesis will form. They do not deserve the disdain with which conventional economists treat them. Indeed many of the ideas I have briefly discussed here are a well worth a revisit. I want to dig further into to the topics raised in this blog: the role and management of state power; the relationships between public, private and external balances; managing an economy in the wider world; and demand management vs deeper economic forces.

A discipline that still reserves a place for real business cycle extremists, surely has a place for the new monetarists too.

Why did the dollar rise with Trump but the pound fall with Brexit?

If you are part of the conventional liberal “elite” like me, 2016 has been marked by two colossal acts of democratic self-harm: Brexit and the election of Donald Trump. It is easy to understand why the pound sunk after Brexit. By why has the US dollar being doing so well after the election of Donald Trump as president? It is a useful lesson in macroeconomics.

The first thing to say, though, is that the way most of the media cover such market movements is unhelpful. They talk of sentiment and emotional judgements made by anthropomorphised “markets”. These may provide a satisfactory story line for a journalist, but they yield no real insight and no predictive power. They are simply projections onto past events. But very often, and this is no exception, far more satisfactory explanations are available, based on the way money flows through economies and financial markets.

Take Brexit. The obvious explanation is that markets (sticking with the anthropomorphism for now) take a dim view of Britain’s prospects amid the confusion and uncertainty thrown up by Brexit. But by itself that explanation is inadequate. The fall in Sterling was not matched by falls in stock markets (after an initial wobble) and other markets which also depend on future economic prospects. In fact there seems to be much more of a wait-and-see approach by the people and institutions who set market prices.

But wait-and-see is not so neutral. The UK runs a substantial current account deficit (5.7% of GDP according to the Economist, the highest of the 43 countries in its data table – and the second largest in money terms, at nearly $150bn in the last year). That means that the country is consuming much more than it is producing, which in turn means that the country is spending more pounds than it is getting back from exports, etc (or spending more foreign currency on imports than it is getting from exports). This deficit must be made up from the capital account – by investors buying UK assets of one sort or another (or Britons selling off foreign assets). Wait-and-see means that foreigners are more likely to defer making investments, which reduces the demand for Sterling on capital markets, causing its price to fall. This makes UK assets more attractive, UK exports more competitive and imports less attractive. All perfectly textbook.

So, what about the US? This country has a current account deficit too (2.6% of GDP which is $488bn in money terms, the largest current account balance in any direction by some margin, in the Economist table). Surely there is a lot of waiting and seeing to be done here, as Mr Trump’s policies, shall we say, lack clarity? But there are a number of differences with the UK. The first of these is that the US is an economic superpower, which dominates global financial markets, with the dollar used as the top reserve currency. It is much easier for the country to draw in investment that the aging middle-ranking country that is the UK. It has much more secure access to liquid, short-term funding. And with a huge domestic market the outlook for its businesses look less precarious than that for British ones.

But the most important difference is that, for all Mr Trump’s lack of clarity, what is known about him, and the Republicans who control Congress, points to a loosening of fiscal policy. This mainly takes the form of tax cuts. This increases the demand for dollars, because it will increase spending in the US domestic economy. Exactly how remains to be seen. On one version US corporations will repatriate foreign profits and invest in infrastructure. This is all uncertain – but Mr Trump and the Republicans in Congress certainly agree on tax cuts, especially for the wealthiest. And this happens at a time when most people are convinced that the US is running at close to capacity – so there is no question of fiscal laxity being complemented by monetary laxity, which would allow the increased demand for dollars to be met by extra supply. Indeed the Federal Reserve is in the process of tightening policy, and increased interest rates this month.

This economic dynamic is often not appreciated – that in a world of freely floating currencies and open capital markets, loose fiscal policy leads to an appreciation of the currency. But there are plenty of examples if you look for them. When Germany unified in the early 1990s, it involved a considerable relaxation of fiscal policy – which caused the Mark to appreciate, and a crisis in the European Exchange Rate Mechanism in 1992 that forced Sterling to leave, shredding the credibility of John Major’s Conservative Government. My Economics lecturer at UCL used the British government of the mid-noughties as another example – the government ran a larger budget deficit than was warranted at that point in the economic cycle, at a time when banking laxity had already led to excess demand in the economy.

The effect of fiscal policy on a floating currency is part of what is known by economists as the Mundell-Fleming model, proposed independently by economists Robert Mundell and Marcus Fleming, leading theorists of floating currencies. It is one of the reasons that floating currencies are not quite the free lunch suggested by many Anglo-Saxon commentators. It means that a floating rate tends to neutralise fiscal policy (just as a fixed rate neutralises monetary policy). As a currency appreciates, the current account reduces (or deficit gets larger), and any increase in aggregate demand is lost across the world economy. Unless monetary policy operates in the same direction (including “printing money” to monetise the budget deficit), in which case you are in effect operating a managed exchange rate policy. This often ends in inflation or default.

This points to one of the tensions in Mr Trump’s economic policy. Fiscal laxity will lead to a widening trade deficit – exactly the opposite to what he promised on campaign. That will tend to force him into protectionist policies, which in turn could create a doom-loop of global proportions. Many believe that we have the makings of another global financial crisis, especially given developments in the Chinese economy – for example read this from Yanis Varoufakis.

But another tension could be that Mr Trump’s fiscal stimulus proves ineffective. The rich people and corporations that benefit from the tax cuts save most of their winnings; planned infrastructure spending is lost to political friction; and Congress insists on dismantling the social safety net, especially Medicare, sucking demand out of the system by hitting the less well-off. That would mean that growth is disappointing, breaching another Trump campaign promise.

But that’s in the future. For now participants in the financial markets are readying themselves for more demand for dollars, and weaker demand for pounds. They aren’t taking a view on the wisdom or otherwise of either Brexit or the new US regime.

Fiscal activism makes a comeback. But it won’t help savers

Even the Prime Minister Theresa May is saying it. Low interest rates are not lifting the economy in the right way. So time for government spending and tax cuts to take over? Or, as economists call it, active fiscal policy. She joins a chorus of academic economists and newspaper commentators.

The story goes back to the 1930s when the Depression was rampant. This hit government tax revenues and the conventional wisdom was that government spending had to be cut to balance the budget. Enter the great economist Maynard Keynes.

Keynes pointed out that the problem with the economy was a shortage of demand – not enough people buying things to pay for the people in jobs. Or to put it another way, there was excess saving. If people are saving, they are spending less than they earn. That means that there isn’t enough spending across the economy to pay everybody’s wages, so the economy sinks. Or it will sink if the savings are not spent on investment, which is another type of spending. Stuffing cash into mattresses is not investment. Neither is putting the money into a bank account unless the bank lends it to somebody who in their turn pays somebody to do something. In a depression people are unwilling to invest, and so saving tends to be higher than investment. And so the economy enters a doom-loop. Before the 1930s economies were marked by severe boom and bust cycles.

Keynes pointed to a way through. If government increased its spending or cut taxes, they would put money in people’s pockets, which would be spent, neutralise the excess saving and bring the economy back to life again. Slowly governments followed his advice, most famously US President Franklin Roosevelt with his New Deal.  The most spectacular success came in Hitler’s Germany, which spent freely on infrastructure (think of the autobahns) and armaments. Keynes pointed out that it did not matter what the spending was on provided it was spent at home, or at any rate it didn’t matter at first. As the economy approaches capacity wasteful government spending is a problem, but not before then. The rapid expansion of the US economy as it was placed onto a war footing in the 1940s proved Keynes right beyond doubt. Thus was born fiscal policy as an instrument of economic management, and economics as a discipline entered a golden age. The swings from boom to bust were notably reduced in the 1950s and 1960s.

Then it came off the rails. In the 1970s things changed. The first shock was the breakdown of the Bretton Woods system of managed exchange rates – it could not handle the excess of US spending on the Vietnam war. This destabilised the international financial system. Then came the oil shock in 1973, as OPEC ramped up oil prices massively. The governments that tried to spend their way out of the subsequent recession merely created inflation and not jobs. The governments that applied stricter fiscal policy, West Germany and Japan in particular, suffered much lower inflation. Enter another economist: Milton Freidman.

Freidman suggested that Keynes had it all wrong. The issue was not managing government spending and taxes, it was managing the money supply. The Depression was severe because the banking system collapsed, and people couldn’t borrow money. A lot of what Freidman said turned out to be nonsense, but what evolved was the neo-Keynesian consensus. This relegated fiscal policy to a relatively minor role. In the conventional wisdom of the time (often referred to nowadays as “neoliberalism”), government spending could easily get out of hand, destroy inventives and make economies less efficient. Instead the main responsibility for managing the business cycle came to something referred to as “monetary policy”, run by  central banks.

Monetary policy is a bit of misnomer, a hangover from Freidman’s emphasis on money supply. To this day people often explain monetary policy as if people paid for things in banknotes, which are printed at will by the central bank. In fact money has moved almost entirely to accounting systems of debtors and creditors, with banknotes relegated to a very minor role. The economic implications of a bank account are utterly different from those of a pile of banknotes. The idea of money supply is nearly meaningless. Instead of that, as regular commenter to my blog Peter Martin put it in a post to Lib Dem Voice, what we have is interest rate policy. Money supply in the economic models taught to students has become a completely theoretical concept that cannot actually be measured . If demand is falling in an economy, this is corrected by reducing interest rates, which should encourage people to spend more. If things look like getting out of hand, then interest rates are raised.

Through the 1990s and early 2000s this system seemed to be working, but it came under increasing criticism. Central banks used inflation targets to judge whether the level of demand was too high or too low. But this measure excluded asset prices, which were directly influenced by interest rates. Asset bubbles were allowed to develop. Then they popped in 2007 to 2009, in the financial crash and the big recession that ensued, which interest rate policy proved unable to correct.

Fiscal policy made a return. But it was tentative. As soon as the worst of the recession was over, governments cut back (widely referred to as “austerity”). Critics argued that this was stalling any recovery. Then the victims of low interest rates, those saving for pensions in particular, started to get agitated. This is most evident in Germany – but Mrs May was voicing concerns amongst her constituents in the UK.

So can fiscal policy help lift economic growth, in place of low interest rates? There is a strong case for this, but caution is warranted. Most economic commentators hedge their bets by recommending that extra spending is on infrastructure projects, that will yield economic returns in their own right.

This hints at the first of three reasons for caution. What if the reasons for slow growth are structural and not to do with low aggregate demand? Are we making the same mistake as the mid 1970s, when economists saw high unemployment and low growth and assumed that this meant lots of spare capacity? In fact economies then had suffered a major dislocation from the oil shock, and were slow to adapt because of excessively unionised and corporatist economic management. That was then, but there are plenty of suggestions as to what the capacity restraints might be now, starting with demographics. Investing in infrastructure should help overcome these constraints, killing two birds with one stone.

The second reason for caution is that economies have internationalised. A lot of the benefit of fiscal stimulus can leak abroad, especially if other countries have a deficiency of demand too. Fiscal stimulus might simply drag in imports from countries eager for export-led growth. Globally coordinated fiscal policy works much better. This was achieved in 2009, but consensus has broken down since. The risk of stimulating other people’s economies can be reduced if the stimulus programme is carefully designed. But it can be quite hard to tell where best to direct spending or tax cuts.

And the third reason for caution is the difficulty in understanding when to turn the tap off and tighten policy. Politicians are prone to fiddling the figures to put the evil day off. British Chancellor Gordon Brown was notorious for this in the mid-2000s, contributing, in my view anyway, to the severity of the financial crash in 2007-09. Anti-austerity has become a political totem on the left – and yet there must come a point in any business cycle when austerity is required. This is also a problem with using infrastructure investment as the prime instrument of fiscal policy – it is not so easy to manage according to the business cycle. Lead times can be long and if an investment project is worth doing, it is probably worth doing at all points in the cycle.

And a final point. looser fiscal policy is unlikely to help savers with raising interest rates. Interest rate policy and fiscal policy should not be working against each other. To raise interest rates we need to see a healthier British and world economy. That looks some way off.

 

Should central banks raise their inflation targets?

About this time of year the world’s central bankers converge on Jackson Hole, Wyoming for a conference. This is an opportunity for many to think about what this important set of government officials should be doing. To judge by the coverage in the Economist, one of the main topics is whether the developed world’s leading central banks should raise their inflation targets, from, say, 2% to 4%. The Economist thinks they should. I am sceptical.

Monetary policy, and in particular the manipulation of interest rates, has a special place in the neo-Keynesian conventional wisdom that became mainstream in government circles from the 1990s through to about 2007, when things started to go badly wrong. The idea was that economies are best regulated at the macro level through interest rate policy, alongside “automatic stabilisers” in fiscal policy; this replaced an approach centred on fiscal policy alone that fell apart in the 1970s. Essentially central banks cut interest rates when the economy needs a lift, and raise them when it needs cooling down. The way this is managed is in relation to an inflation target, typically of 2%. If inflation dropped much below the target, it was time for a lift, if it rose above, it was time to remove the punchbowl from the party, as one central banker put it. Inflation is the main way policymakers are supposed to judge whether an economy is running above or below its natural capacity, around a target rate which is supposed to be neutral.

For a decade or so this all seemed to go very well, as the leading economies experienced steady growth and low but steady inflation. Japan was the exception, as it suffered from deflation and weak economic growth – and the country’s central bankers and political leaders were much criticised as a result. It was all too good to be true. After 2007 all the leading countries looked like Japan, and proved unable to use monetary policy to give their economies the lift they generally thought was needed. Central bankers had to deal with low inflation and near zero interest rates, meaning that they could not use interest rate policy to achieve stimulus – since they could not reduce rates below zero (a boundary that some have tried testing more recently, with mixed results). They resorted to buying bonds instead (which they called “Quantitative Easing”). Amongst other problems with this policy, it threatened to blur the line between central banking an ordinary government treasury management. There remains little sign of a serious breakout from the lacklustre post-crash economics.

Hence the idea of raising the inflation rate target. The theory behind this is that it would allow central bankers to put more oomph into their monetary easing , once they have found a way to raise inflation up to the target. The advantage of a higher rate of inflation is that it becomes much easier for central banks to implement a negative real interest rate, should that be warranted. If inflation rates are 4%, and interest rates zero, the thinking is, people and businesses will rush out to buy things rather than watch their monetary assets shrink. That then corrects the imbalance savings and investment that they think is dragging economies down.

This idea is unlikely to get very far. The first reason, and probably the most important, is that allowing inflation to rise breaches what many see as a sacred bond of trust between a government and its people. This is something that liberal economists struggle to understand. To them money is just another tool to be used in the process of managing an economy; a means to an end. But many others have a different view – a theme explored by Lionel Shriver’s recent novel, the Mandibles. This sacred bond view is why linking currency to gold is so persistently popular. And it has particular strength in the US and Germany, in spite their very different histories. Using inflation as a state policy is abuse of power in this way of seeing things. At the very least it needs a democratic mandate.

This is no small political obstacle, though I personally incline the liberal economist view, and feel that gold used as money is an outright evil. But I am sceptical that inflation works in the way it used to in the world’s leading, developed and globalised economies. Raising the central bank target is one thing, but persuading the rate of inflation to follow in an economically constructive way is another (it doesn’t help if consumer prices race ahead at 4% while wages are stuck at zero).

What’s the problem? I think global markets for goods and capital have become so integrated that efforts to raise inflation are rapidly undermined. Furthermore wages and prices seem to be driven by different forces. Public expectations of inflation, the critical driver of inflation in the neo-Keynesian model, have lost their force. The idea that there is a universal rate of inflation reflecting the depreciation of money is an idea that is becoming distinctly unhelpful. Inflation, for example, does not make private debt more affordable if it does not feed through to pay (quite the opposite, in fact); and something similar happens to public debt, as tax revenues are more likely to be driven by pay than the prices of goods and services. This is a problem that does not seem to occur to many commentators on economics.

A further problem is how low interest rates or QE transmit themselves to raised prices anyway. The old idea of expectations being managed by the government and the central bank has signally failed in Japan, for example, when Shinzo Abe’s government tried to do just that. Companies did not want to raise pay unless they really had to, and would not raise prices of goods either. It is true that a loose monetary policy can cause the currency to fall and raise import prices – but this does not necessarily transmit to the rest of the economy. In Japan it took much bullying by the government of big businesses to have any effect, and their response was so grudging that no lasting change was made. Other governments and central banks may have even less power. Imagine how German firms would respond to the ECB saying they wanted a bit of extra inflation?

So what does a looser monetary policy achieve? First there seems to be a lot of idle cash. Money that hangs around unused does not stimulate anything. And then the prices of some assets may be raised, both at home and in wider capital markets, which the globally liberated world has made very easy, without the creation of new assets. In other words, asset price bubbles start to inflate.

In short the conventional neo-Keynesian theory should be given a decent burial for the leading developed economies. It is a bit different in less globally integrated countries, or in developing countries that are subject to rising in productivity where we can expect pay to be more buoyant.

Instead of chasing this particular phantom, economists and policymakers need to ask themselves more searching questions. Why is the rate of investment so sluggish, and unable to keep up with savings? Why is conventionally measured productivity stagnant? This is the real problem. And what if low investment and low growth are facts of life in a mature economic system, rather than ills to be cured?  And meanwhile we economic chatterers might ponder the role that the constancy of money plays in the social contract, and how, perhaps, we take a bit too lightly sometimes.

Why do governments follow austerity when orthodox economists advise against it?

It’s by turns annoying and amusing: the way people on the left complain that orthodox economics has gone off the rails, and that we need fresh thinking to inform government policies. Apart from coming up with a lot of age-old tropes that economic models do not mimic real behaviour, or take account of information asymmetries, the main item of evidence is the persistance of austerity policies in the developed world.

But the main critics of austerity turn out to be…. orthodox economists. People like Joe Stiglitz, Paul Krugman and Martin Wolf. And newspapers struggle to find economists to make the case for the defence. The Financial Times often resorts to Niall Ferguson, who is a historian, not an economist, and no match for a Nobel laureate like Mr Krugman. The British Labour party is even roping in economics professors to bolster its economic credibility.

In fact there is a brand of orthodox pro-austerity economists. These are the old “supply-siders” from such institutions as the Chicago Business School, who developed a line of “neoclassical” economics, and rebelled against what was once the Keynesian orthodoxy. This branch of thinking grew out to the economic crisis of the 1970s, but proved utterly useless when the crisis of 2007/08 hit. Neoclassical economists pipe up here and there in America, but are mostly silent, their credibility shot-through. That leaves the field nearly unchallenged for the neo-Keynesians – at least far as the public debate in newspaper columns is concerned, in Britain, anyway.

Which leaves us with a mystery. Why are governments, from Europe to America (though not Japan, interestingly), ignoring the orthodox economists? Two explanations are usually offered by their critics. One is rank incompetence or wilful blindness. The other is a political agenda that austerity plays to, usually involving making the rich richer. Neither explanation stands up to close examination.

I am wary of accusations of incompetence, especially when made about clearly intelligent people, such as most politicians and technocrats involved in government finance. This is something I learnt as a history undergraduate (I studied both science and history in my original undergraduate incarnation, long before my study of economics as a mature student). Such accusations are bandied about freely down the ages, but never stand up to scrutiny. Mostly the wilful blindness comes from the people making the accusation, who cannot entertain the idea that there is a rival point of view to their own. Modern economic policy is no exception.

The political agenda is a bit more plausible. Perhaps governments are in hoc to big business interests and those of the wealthy? But if the last 150 years of history has taught us anything, it is that if poorer members of society are prospering, the rich will prosper also, and be left in peace. This is even more true of big corporate interests than anybody else. It is harder to make money in a stagnant economy. Those malign influences are there in politics, but their effects are altogether more subtle than doing down poor people to help line the pockets of the rich.

Sensing that these explanations don’t work, many on the left build up an idea of “neoliberalism”. This is a philosophy based on the old supply-side or neoclassical economics that may be waning in academic economics, but still holds a grip on the lesser mortals who staff finance ministries and banks, and other parts of the “elite”. But this too is inadequate as an explanation. Certainly it is possible to identify a series of beliefs and biases amongst policymakers that equate to economic liberalism. But they do not explain austerity as a macroeconomic policy. And besides, we need to understand why the hold of these beliefs is so strong. Clearly some on the left think that an outdated economic orthodoxy is to blame. But surely such theoretical constructs cannot by themselves have such a grip on so many intelligent and practical minds?

Instead of a conflict between different types of theory, what is really going on is a conflict between theory and practice. The theoreticians may be gung-ho about fiscal and monetary stimulus, but the people who implement policy are acutely aware of the practical problems and risks. There are three particular practical issues about which the theoreticians are dismissive, but which weigh heavily on the practical types: economic efficiency; public investment; and financial markets.

First take economic efficiency. Pretty much everybody agrees that, ultimately, living standards depend on economic efficiency, or productivity. This piece of orthodoxy could be challenged, but that is not what most on the left mean (traditional Greens being the exception, along with liberal voices in the wilderness like mine) when they call for fresh thinking. They see slow economic growth as a sign of failure as much as any conservative does; and that ultimately is based on productivity. But economic efficiency is hard work politically. Both businesses and workers like to protect their patches with taxes, government agencies and regulations that keep the winds of change at bay. This is especially the case in Europe and Japan. And yet, in order to achieve long-term growth, these vested interested must be tackled, and reforms enacted. This has been shown in countless contexts in both developed and developing world. Mostly reforms have an economically liberal character – but only because this approach genuinely unlocks long-term efficiency.  Far-sighted politicians and officials want to use every possible chance to advance reforms. That includes the pressures created by economic hard times. Theoretical economists might suggest that boom years are the best time to push through reforms, or that reforms can be covered by macroeconomic leniency. Politicians know that the opposite is the case – it too difficult to muster the political imperative in easy times, or if short-term macroeconomic policies take the heat off.

Reform and austerity are not necessarily the same thing, but they almost always are.  This debate, of course, dominates discourse in the Euro zone, where economic hardship is concentrated in less efficient economies. Critics of austerity there offer no way forward for improved efficiency, beyond the hope that public infrastructure investment will deliver the growth they seek.

Which brings us to the difficulties of public investment. To theoretical economists this is the magic bullet. Public investment in infrastructure both yields gains to long-term efficiency, and a short term fiscal stimulus. The economists are exasperated that so few governments seem to follow their advice. And yet public investment is a graveyard of roads to nowhere and white elephants. When the imperative to  invest is political, the choice of project becomes political too. It is very hard to make sensible choices. China was much lauded for its infrastructure investment programme following the crash. This has now turned into a major headache, as so much of the money was wasted on empty cities and useless infrastructure. Something similar happened in Japan in the 1990s. Finance ministry officials are rightly wary.

And then there are the financial markets. If I’ve heard one economist here in Britain suggest that now is a fabulous time for the government to borrow, or even “print”, money, I’ve heard it from a hundred. With so much demand for government bonds in the markets, and inflation looking mortally wounded, just what are you worrying about? But none of these economists work at the sharp end of government finance. If they did, such sanguinity would remind them of the sort of thinking that got the world’s banks into the disaster in the first place: a reckless confidence that markets would behave in future as they do now.

Alas life is much more complicated than that. Grounds for confidence in the financial markets is stronger in some places than others. Japan has a massive export industry that sees to all its foreign currency needs, so that the state can borrow and even print the Yen with reasonable confidence. Which is what it has been doing, in prodigious quantities, for the last two decades, although to little apparent effect. The US is another country that can feel reasonably secure, even though its balance of trade is less benign than Japan’s. The dollar is the world’s de facto reserve currency. The United Kingdom, however, shares neither of these strengths. It needs to draw on overseas institutions and businesses, and its own private sector, in order to finance its significant current account and trade imbalances. This is not a problem that printing the Pound can help with. The state has been extraordinarily adept at handling this risk over the last few decades. But that is because of the conservatism that is currently attracting so much criticism.

To me the theoretical economists, the practical policymakers, and most of their leftist critics are all trapped by an orthodox way of looking at the world through economic aggregate statistics. This means that they are failing to take on the deeper problems that society faces: economic and environmental sustainability, alienation, and the gravitation of wealth to successful people and places. That has very little to do with the politics of austerity. People on the left who call for fresh thinking should be careful what they wish for.

 

Secular stagnation: the dark cloud hanging over the world economy

A dark mood is overtaking those who contemplate the world economy. Today Britain’s Chancellor George Osborne will join a growing chorus of worry. Weak outlook in emerging economies is undermining efforts to revive developed ones like Britain’s. So far the prognosis is stagnation rather than economic disaster – a mood caught by the FT’s Martin Wolf, who tells us not to be too pessimistic. But these are dark clouds and policymakers would do well to prepare for rough waters.

Mr Wolf bases his relative optimism on the fact that world economy has being growing steadily for some two centuries, and with particular steadiness since 1945. Until the potential for further growth is exhausted, which he doesn’t think is anywhere near the case, that growth will carry on. But macroeconomics has changed profoundly in the last ten to twenty years. And even orthodox economists are starting to appreciate this.

The leading piece of evidence is that in the developed world central bank interest rates are stuck at very low levels, even though the recession of 2008-2009 was over five years a go, and there has been steady recovery since. And inflation, as it relates to pay and consumer prices, remains low. What had once been seen as a special case and compounded by policy mistakes, Japan after 1989, has become general. The Economist’s Free Exchange column has run a couple of articles on this. Orthodox economists had simply assumed that the way out of economic doldrums was through conventional short-term policies, such as loose monetary or fiscal policy. Japan’s problem, a whole queue of people, such as Paul Krugman, said, was simply a matter of a “liquidity trap” – when interest rates become too low to reduce. By the time I was studying Economics at UCL in 2005-2008, this was literally in the textbooks. Mr Krugman suggested that the solution was to raise inflation expectations in what seemed to me, even then, as a case macroeconomics gone mad.

But even Mr Krugman now thinks something deeper is afoot. Larry Summers was the first orthodox economist to raise the alarm, and he gave the problem a name: “Secular Stagnation” – or rather he resurrected a theory of that name that had long been treated as a theoretical curiosity. The world economy is profoundly out of balance. This is because the amount people want to save is more than what people want to invest, causing aggregate demand to drain out of the system. This is an idea that Maynard Keynes made famous in the 1930s – but he assumed that such an imbalance was temporary, and specifically a feature of recessions. But what happens if the imbalance continues right through the cycle? We find that attempts to stimulate growth through monetary or fiscal policy run out of steam, and simply lead to asset price bubbles, as surplus money chases the same assets round in circles.

What is causing this imbalance? Unfortunately, notwithstanding the large number of brilliant minds devoted to economics, the massive computing firepower at their fingertips, and the size of what is at stake, there is practically no quantitative evidence. Indeed, macroeconomists actually know little about what is actually happening in the world behind the artificial creations of their aggregated statistics. Instead we have a series of speculations which people gravitate towards depending on political preferences. Here the main ones:

  1. Inequality – the popular explanation on the left, including Mr Krugman and Robert Reich. A greater share of income is going to a very wealthy minority, or is stuck in corporate balance sheets. This is saved rather than spent, contributing to a surplus of savings.
  2. Trade surpluses. China, Germany and (until recently) some oil states have been running up structural trade surpluses, which again creates surplus savings globally. This makes people like Mr Wolf hot under the collar.
  3. Excessive levels of private debt. This theory is favoured by heterodox economists like Steve Keen. Private borrowing as a ratio to income has been steadily rising and is at record levels. Bank balance sheets are clogged so they can’t lend to fund new investment. Meanwhile private individuals are spending too much on debt repayments and interest to spend on consumption.
  4. Modern businesses require less capital, reducing demand for investment. Microsoft and Google required no bank loans and little new capital to develop their businesses, unlike the industrial giants of old. This may be a function of technology, or simply “Baumol’s disease” – the fact that productivity improvements are tilted towards particular industries, whose weight diminishes as they become more efficient. Mr Summers seems to incline towards this explanation, while not dismissing the others.
  5. Demographics. The proportion of workers compared to retired people is diminishing in the developed world and some other countries, like China. This squeezes the supply side of the economy and hence investment.  It also undermines any benefits of productivity growth, the traditional engine of economic advance. This was clearly a factor in Japan, which led the trend.

Is this just a developed world problem? Surely, with so many countries still poor, there are opportunities to raise productivity, and hence global growth in poorer countries? The growth of developing East Asian economies, starting with Japan, and latterly dominated by China, has been an important component of recent world growth. And yet there are few signs than other developing economies can move much beyond exporting natural resources, while China is picking up some distinctly developed world issues. India may be an exception, but the jury is out there.

So what is the solution? That, of course depends on how important each of the above factors is. But there is a big question behind this. Most economists assume that economic growth is a natural state of being, and simply want to remove obstacles to future growth, by raising the level of investment, for example. Others feel that slowing growth is part of a bigger development cycle and something we had better get used to. I incline to this second view.

But the way forward surely does not lie in grand, sweeping policies based on a single, overarching theory. We have to tackle smaller problems as they arise, bearing in mind the overall sense of direction. With that in mind, I think these are the main areas to watch:

  • Private debt. You don’t have to subscribe to Mr Keen’s ideas to understand that growing levels of debt are part of the problem, whether symptom or cause.
  • Big business. These are accumulating too much power, and skewing the distribution of resources.
  • Asset values. In much of the world, excessive asset values, especially land values, are a sign of economic dysfunction. This is especially the case in Britain. This is not a simple matter of supply and demand – excessive debt is part of the problem.
  • Migration. This is one of the ways that economic pressures can be relieved. But as we know all too well, a host of problems follow in its wake.
  • Government debt. In the short to medium term, for most developed economies, high levels of government debt will be much easier to sustain than conventional wisdom suggests. And yet in the long term this could lead to economic breakdown, as is happening in some South American economies.  The left have a strong theoretical case in opposing austerity, but undermine it by opposing almost any reform designed to improve economic efficiency and promote sustainability.

It is also important to point out the dogs that won’t bark. These are things that economists bang on about which don’t matter so much in our “new normal”:

  • Free trade. Free trade is an important part of the current global system, and it won’t help to reverse it. But the rapid globalisation of supply chains which was such a feature of the last two decades, is going into reverse, as the East Asian economies mature. This is one reason why growth is slowing – but it is the reversal on a phenomenon that was always going to be temporary. Further liberalisation of trade poses challenging questions, as TTIP and TPP are demonstrating, and may simply benefit big business.
  • Inflation. It used to be thought that inflation was a matter of managing expectations by the central bank, and of paramount importance. This is still true in some less developed economies. But in those exposed to global trade this is an entirely unhelpful way of looking at things. More powerful forces are keeping prices stable and inflation is less and less an issue that central banks need to act on.
  • Interest rates. These are set to stay low for a long time yet. The betting is that the recent rise in the US will be just one of a long line of failed jail-breaks, started by the Bank of Japan in the 1990s.

We live in interesting times.

 

 

 

Osborne uses an accounting trick to implement People’s QE

When Jeremy Corbyn, was running his successful campaign for the leadership of Britain’s Labour Party, he floated the idea of “People’s QE”. “QE” stands for Quantitative Easing, the means by which central banks try to loosen monetary policy in an economy without reducing interest rates – handy when interest rates are near zero. It attracted quite a bit of attention from economists, much of it quite approving. That is because the idea touches on one of the most important aspects of modern economic policy: the suggestion that governments can sustain quite big deficits simply by “printing” money. In the end we find, not for the first time, that the current Conservative government acts much further to the political left than it talks, as did its Conservative-Liberal Democrat predecessor.

Back in the 1980s, when monetary policy first became the height of fashion, we had uncomplicated views about what it was about. Although most money was in bank accounts, economists painted a picture as though it was all in notes and coins, and the various actors behaved as if they were kids spending pocket money (and even then was probably too simplistic…). They talked of a “money supply”, which could be manipulated, and the size of which affected spending behaviour. We are older and wiser now, though many economists and journalists still talk about “printing money”, even though physical money has almost no role to play, and bank accounts are different in very important ways. Even trained economists who should know better sometimes trip themselves up in this way. For example there is much excited talk about how commercial banks create money rather than the central bank – which turns out to be a red herring on reflection [That link from Paul Krugman includes a broken link to a masterful essay from James Tobin in 1963, read it here]. It is better to look on monetary policy as a series of policy instruments under the control of the central bank, which have not entirely knowable effects on the economy at large.

The most important of these instruments is the short-term interest rate the central bank charges to commercial banks in their interactions with it. These ripple right through the economy. But when they are very low, as they are now in the UK, it is very hard to lower them further. Some European banks are using negative interest rates without the sky having fallen in, but these negative rates aren’t very high – fractions of a percentage point. So how to “loosen” policy – that is encourage a greater level of economic activity? Here the invention of QE comes in, pioneered, as so much of modern policy, by Japan in the 1990s and early 2000s. This is often talked of as if it means printing physical money and handing it out to the kids to spend on sweeties. What it actually means is that the central bank goes into the market and buys bonds, usually government bonds, like British gilts.

How does that help? Well the people who held the bonds now hold cash instead, which they should spend on something else – which might include new capital investment, after it has changed hands a few times. And it might reduce bond yields, which will reduce long term interest rates right across the economy, and increase asset prices. This creates a “wealth effect” that might encourage the mass affluent to spend a bit more money on stuff that people make. Or all that could happen is that there is a merry-go-round of money chasing various flavours of pre-existing asset to create an asset price bubble. It’s not very clear what has happened to the Bank of England’s QE over the years. The bank produces various statistical associations as evidence that it has helped stimulate the wider economy. Others are sceptical.

Which is where People’s QE comes in. What if, instead of buying government bonds in the market, the money went into extra government spending, such as infrastructure investment, or even current spending. Because the Bank controls the currency in the UK, it can fund the government’s deficit without the need to borrow money from investors. It borrows money from itself. This amounts to supporting looser fiscal policy (i.e. government tax and spend), which should provide a more predictable stimulus to the wider economy.

Mr Corbyn’s advisers developed the idea with the suggestion of administrative structures to channel the extra money into infrastructural investment. This puzzled some economists. There is no need for such engineering. All the government has to do is spend the money, increasing its deficit, issue bonds as normal, which the Bank of England then buys in the existing QE programme. If the Bank is buying bonds, the government is less beholden to the bond markets. In Japan, which has been practising QE on a massive scale, the government now issues little net debt to the bond markets, making large deficits sustainable.

But how does this work? Surely it is something for nothing? The answer to that is that it only works if there is slack in the economy, and the government steps in to create demand because businesses are investing less than the public is saving, creating an imbalance. If this is not the case, you can get inflation, which is what happened to Germany and Austria in the 1920s, Zimbabwe more recently, and is happening in Argentina now. Alternatively you get a asset price bubble. Which in the modern, globalised financial and trading system is in fact more likely for developed economies – though this seems to be a blind spot for many economists, who think that asset markets are too efficient for that.

But in the developed economies, including the US, the Eurozone and Japan, as well as the UK, there does seem to be scope to do this kind of stimulus. There is a lack of business investment, while, it appears, too much money ends up in the hands of rich people, who don’t spend it. Nobody knows how long-term this problem is, but it does look as if large government deficits are much easier to sustain than before. If the bond markets refuse to fund all of the deficit, then central banks can simply “print the money” as the popularisers would put it. Prominent British economist (Lord) Adair Turner (whom I am something of a fan of) suggested that this could be a long term policy in a recent book.

In Britain there is an accounting wrinkle which is having an important impact. The Bank buys government bonds, but it holds them rather than cancelling them, so that it can sell them should it want to tighten policy. So the government still pays interest on the gilts the Bank holds, and this used to count towards the publicly declared deficit. But the Coalition government changed the rules, so that it does not count the interest on the Bank’s holdings against the deficit. That reduces the fiscal deficit and allows the government to spend money on other things instead. Also the effects of QE on longer term gilt yields reduces the deficit projected by the Office for Budget Responsibility (OBR), which plays such a pivotal role in longer term government spending plans. According to the FT’s Chris Giles £22.4bn of the £27bn that the Chancellor, George Osborne, “found” to allow him to loosen austerity measures in the Autumn Statement resulted from these accounting tricks. This boils down to People’s QE, and Mr Osborne used it to fund his U-turn on tax credit cuts, amongst other things.

The problem, as Mr Giles points out, is what happens when the Bank feels the need to tighten policy in, say, a year or two’s time? Then the whole thing goes into reverse. Politicians have seen gain in blurring the distinction between fiscal and monetary policy. That could return to haunt them, at both ends of the political spectrum.

Slow growth is not bad. If that means debt default, so be it. The world must change

Inflation expecationsThe state of the world economy is worrying economists. GDP growth is lacklustre in the developed world, which in turn poses problems for the developing world. That’s bad enough, but the economist’s nightmare of deflation – prices dropping rather than rising – now beckons around the world. And yet the prescriptions of most economists are shaped by a way of looking at the economy that belongs to the past. A paradigm shift is needed. Debt is at the heart of it, not GDP growth.

For a clear, conventional analysis of the issue read this week’s Economist.  Here’s a brief summary. The developed world economies are suffering from deficient demand. In other words, the economies could easily churn out more goods and services, using existing capital and labour, but don’t because people aren’t asking for the stuff or can’t pay for it. Another way of putting this is that the amount of investment (people spending money on building capital rather than the immediate consumption of goods and services) is less than the amount of saving (the amount by which people’s income exceeds the goods and services they consume). This leads to low growth rates. Now inflation is falling and deflation threatens. Deflation is bad, at least when low demand is its cause, because it makes debts more difficult to repay, and this gunges up the financial system, which makes matters worse.

The conventional answer to this problem, which also goes under the name of “secular stagnation”, is to reduce the prevailing rate of interest. This will encourage people to invest more since the returns to investment, compared to simply sitting on piles of money, would then be higher. But deflation, or low inflation, makes this impossible, because it raises the floor – the lowest real (after inflation) interest rate it is possible to charge. Answer: you raise the level of inflation. The method of doing this is to increase the money supply, since inflation is a monetary phenomenon. All sorts of ingenious ways are then dreamt up of how to do this. But this is all the product of a conventional way of thinking based on aggregate economic statistics, rather than what is really happening in developed societies.

There a number of challenges to make:

  1. Stagnation, in and of itself, is not necessarily a bad thing in the developed world. Surely the current level of consumption of goods and services is sufficient, in aggregate, to secure perfectly decent wellbeing for everybody – and economic growth is not the most efficient way to securing improvement to that wellbeing. And as we judge the potentially catastrophic impact of man’s demands on the planet it is clear that a system based on ever increasing consumption cannot end well. We need to make better choices about what we consume, and distribute the consumption more evenly. But economists seem to worry about the speed of the train, rather than where it is going, or even whether it has arrived at where the passengers want it to go.
  2. Inflation in the modern, developed world does not work in the way the economic textbooks suggest. In particular the rate at which monetary wages rise has become detached from the rate of increase of consumer prices. Macro-economic policies, like monetary policy, aimed at increasing inflation may feed through to consumer prices without doing much for wages. This completely undermines the supposed benefits of a little bit of inflation.
  3. Things are no better in capital markets. Reducing interest rates seems to have little effect on levels of genuine, productive investment. Such investment is driven much more by zeitgeist than interest rates. Excess money either chases a relatively fixed pool of existing assets (land and buildings and shares), or it simply piles up in bank accounts. This makes conventional monetary policy very hard.

We can look beyond these challenges to recognise some issues that might be behind these challenges. Interestingly, these are, for the most part, not particularly controversial amongst modern economists – it is just that they seem unable to accept the implications:

  • Distribution of wealth and income matters more than aggregates. This is the complete opposite of  late-20th century conventional economic wisdom. The problem is that wealthy people have too much income to meat their needs, and that there are inadequate channels to invest the surplus productively (as opposed to bidding up property values, etc.). To try and balance out the deadening impact of this, the answer has been to get poorer people to consume more by piling up debt. That would be fine if those poorer people turned into rich people later in their lives – but that is not what is happening. This is unsustainable – and yet most conventional economic advice boils down to cranking this system around one more time.
  • Modern businesses require much less capital investment than previously. The modern business giants of Microsoft, Apple and Google never needed much debt and did not need much capital to get going. This is simply the way that technology has evolved. There remains demand for public infrastructure: railways, hospitals, power stations and so on, but the risks and returns, and their often monopolistic nature, makes this a difficult area for private businesses, as opposed to governments, to lead. This is one aspect of what economists refer to as “Baumol’s disease” – the paradox that the more productive the efficient areas of an economy become, the more the lower-productivity areas predominate in the economy as a whole.
  • Globalisation has changed economic dynamics profoundly. Amongst other things it has weakened the bargaining power of workers – one reason that prices and wages are becoming more detached from each other. Also,  less talked about and perhaps controversially, I believe that globalised finance means that developed world governments have less control over their currencies and monetary policies. This is one reason why it is more difficult to use monetary policy to manage inflation. It is also the reason that Europe’s currency union makes much more sense than conventional economists allow – but I digress.
  • Technology is changing the way the jobs market is working. Many middle-range jobs, in both manufacturing and services, are disappearing. This week Britain’s Lloyds Bank announced the loss of 9,000 such jobs in its branches and back office. This, and not the flow of immigrant labour, is the reason why the labour market has turned against so many.
  • And finally, I think that many consumers appreciate that additional consumption, and the income to support it, are not the answer to improved wellbeing. It is better to stop earning and pursue low-cost leisure activities. I notice this most in middle-aged middle-class types like me – who are retiring early. It is perfectly rational. And yet economists can’t seem to understand why reduced consumption and income might be a rational choice for an individual. There is a tendency to tell us to go out and spend more for the good of the economy. This is a perfectly liberal and rational downward pressure on national income – which surely should be encouraged for the sake of the planet.

Some of the consequences of these trends are straightforward. Redistribution of income and wealth are now at the heart of political and economic policy, rather something that can be ignored. A much greater proportion of economic investment must be government-led, which imposes a massive challenge for political management. Governments and central banks trying to tweak the inflation rate by a few percentage points is a fool’s errand. Also trying to revive the economy by getting the banks to lend more money to poorer people is unsustainable, even if the lending is collateralised on residential property. The appeal by many economists, such as the FT’s Martin Wolf, that developed country governments should borrow more to invest in infrastructure makes a lot of sense. Using monetary policy to help finance such investment makes sense too. Making sure this investment is directed sensibly is a bigger problem than most allow, though.

And the conventional economists are right to worry. A world of stagnant growth and low to negative inflation creates major problems. In particular many debts, in both private and public sector, will not be repayable. At some point there will be default, since the other options, inflation and growth, are off the table. Or to put it another way, much of the financial wealth that many people currently think is quite secure is anything but, in the longer term. This may a problem for many pension and insurance schemes, as well as wealthy individuals and corporations.

The consequences of this are quite profound. Our society must break its addiction to debt. The banks and the financial sector must shrink. “Leverage” should be a rude word in finance. If low growth is the result, or if a new financial crisis is hastened, then so be it. Let us learn to manage the consequences better. Borrowing to support genuine productive investment (not excluding the building of new houses where they are needed) is to be encouraged, including government borrowing to finance public infrastructure. But other borrowing must be discouraged. Taxation should increased, especially on the wealthy. If that causes a loss of productivity, then so be it – this should be compensated by more efficient financial flows from rich to poor. Political reform must run in parallel to ensure that public investment is conducted efficiently, rather than just disappearing into the pockets of the well-connected.

This is a daunting programme. Stagnating national income and deflation are not inevitable consequences – since these policies do address some of the causes of deficient demand. But we must not think that these statistics are the lodestars of public policy. We need a much more nuanced appreciation of the wellbeing of our planet and the people that live on its surface, and put it at the heart of economics.

Such sound eco

The complacency of salt-water economists

In his recent book on economics (reviewed by me here), George Cooper presented the discipline as being an irretrievably fracture, in need of a radical step change. There is an alternative view. This is that in fact the profession is split between two orthodoxies, with a diverse bunch of heterodox economists on the fringe, unable to get serious traction. The two orthodoxies are often given the names “salt-water” and “fresh-water”, because the former are popular in U.S. universities on the east and west coasts, and the latter with those in the Midwest – especially Chicago. This is worth picking apart.

Followers of each of the orthodoxies assume that criticism of economics is directed mainly at the other orthodoxy, and not at them. The heterodox say that the whole lot is in a mess. The fresh-water school do seem be in eclipse. This school, often termed “neoliberals” outside the US, believe that free markets are the fairest way of allocating economic resources, and that government interference almost always makes things worse. Many assume that they were cheerleaders for the rampant excesses of the financial sector before the crash, and hence have had their come-uppance. This criticism is wide of the mark, however. The banking boom arose at least as much from lop-sided government intervention as it did from “light-touch” deregulation. Fresh-water economists can plausibly blame the crisis on government intervention, not its absence – and in particular the crazy desire of politicians to boost property lending to all and sundry.

In fact there are other fatal problems for fresh water economists. First is that they opposed serious government intervention once the bubble blew. This was self-evident nonsense, ignored to a greater or lesser degree by practically everybody – except where government borrowing presented a practical problems. There have been loud arguments over austerity that have been so loud, but these have been on degree of intervention (big or massive?) and on completely different territory to that advocated by non-interventionists. A second problem is posed by what is usually called “inequality” – whereby it appears that the benefits of growth in developed economies go predominantly to the rich – and that most people in the US have seen little or no benefit from decades of economic growth. It is a central facet of fresh-water thinking that distribution of wealth and income is not an important concern for economists and policymakers. They have almost nothing to say here. And people are starting to notice that in countries with minimal governments (Somalia, say), the economy tends to be in pretty bad shape. Of course fresh-water economists remain well funded, as their views provide convenient support to many vested interests, and they are not about to go extinct. But you don’t hear very much from them these days.

Unlike the salt-water types. These are popularly referred to as “Keynesians”, and are now very well entrenched right across the political establishment. Their most visible cheerleader is Nobel Laureate and columnist Paul Krugman. They were as wrong-footed by the crisis as any of them, but quickly found the groove again. They provided the intellectual heft required to support government intervention after the crisis, though they usually complain that this intervention was inadequate.

Salt-water types do not consider that the crisis showed that their thinking was seriously flawed. Consider this piece a few weeks ago by Mr Krugman. He simply suggests that salt-water economists were a bit misinformed – because they underestimated the practice of shadow banking. Shadow banking, in this context, refers to the practice of banks hiding their dodgier lending by creating off-balance sheet entities to take them. To be fair on Mr Krugman, in the run up to crisis his writing was hardly cheerleading for the supposed economic miracle – though that seemed to derive from his hatred of the then Republican establishment, and their attachment to fresh-water thinking.

I can understand some of Mr Krugman’s frustration with the so-called heterodox economists. They tend to be pretty unconstructive – picking at the orthodox modelling assumptions (incidentally, largely shared across both orthodoxies), without suggesting much that could replace them in a useful way, to give the discipline a better predictive power. The beauty of the salt-water orthodoxy is that it finds it easy to tack on new ideas and integrate them – they have done this quite spectacularly with many of Milton Friedman’s ideas (on money, inflation and unemployment), even though he is one of the spiritual fathers of fresh-water thinking. They are now trying to do so with ideas on inequality, an issue that they acknowledge. Thomas Piketty, the French economist who is making a splash on inequality, looks more like somebody extending the salt-water orthodoxy, rather than challenging it.

For me this is much too complacent. Regular followers of this blog will not be surprised to read that Exhibit A for the prosecution is thinking on monetary policy. Salt-water economists inhabit a world where the ideas of money supply, demand, interest rates and inflation interact in a relatively predictably way, to form an important way of regulating economic growth. Thus there is talk of raising inflation a bit, so that negative real interest rates can be implemented, which in turn will boost demand and get the economy growing. It is not that I think this line of reasoning is entirely mistaken, it is that it is an oversimplification that is more likely to lead to policy mistakes than insights.

Take Japan. This country is probably further down the path of accepting salt-water economics than any other. It has drastically loosened monetary policy (through a process of quantitative easing) with the aim of raising inflation, which in turn will help the process of managing interest rates and boosting sagging demand. But there is a snag: while prices are rising to a degree, wages are not keeping pace. Employers will consider giving employees a temporary bonus, but not raising basic pay. Without raising pay, all the nice things that are supposed to arise from inflation – like making debt easier to bear – will not happen. Economists simply assume that if inflation gets going in consumer prices, wages are bound to follow. But this does not seem to be true of a modern, globally integrated developed economy. There are plenty of other pitfalls in Japan’s strategy too.

The people at the heart of the salt-water school, like Mr Krugman, are a clever bunch. Heterodox economists do not seem to be unsettling their intellectual grip. Perhaps they are right that the orthodoxy must evolve rather than make a step-change. But if so it surely needs to evolve a lot faster.