The government’s choice: higher taxes or higher interest rates?

Britain’s Conservative government is approaching two years in office. Depending on how it amends the legislation on fixed-term parliaments, it will seek re-election in as little as a year and half (May 2023), or, more likely, in two to two and half years (later in 2023 or May 2024). The endgame of this parliament’s existence is now in sight. Tory thoughts turn to the question of how to secure a further term in office.

The 2019 election was fought largely on the question of “Getting Brexit done”, as the Conservatives successfully framed it. But they also set out a broader agenda: “levelling up” – tackling inequality by securing a better deal for the less well-off regions and groups rather than by punishing the better-off; improving public services – mainly the NHS and police; curbing immigration – the big dividend from Brexit; and keeping the country on the path to carbon neutrality. This is pretty popular and the government shows no sign of backing down on any of it. But with the possible exception of immigration, these aims aren’t notably different from the opposition’s. The Tories are further distinguished by putting more faith in the enterprise and initiative of private individuals and businesses, rather than a bossy government and government-sponsored mega-projects (even if Boris Johnson, the prime minister, has a weakness for the latter). To many observers this agenda looks impossible to reconcile – a question of “have your cake and eat it”, but it is not entirely vacuous. The left tends to underestimate the importance of setting the zeitgeist so that private initiative sets society on the right path.

Nevertheless the shallowness of most Conservative thinking is breathtaking. One example of this is the idea, popular in the party, of announcing a cut in income tax before the next election. The idea is that this would show the benefits of Tory stewardship of the economy, and drive a wedge between Labour and many of its potential supporters. It would also straighten up the record a bit after the party was forced to raise National Insurance, which it had promised not to do. It is a truly terrible idea. Basic Rate Income Tax, alongside VAT, is the the most broadly based tax the government raises, and it is therefore a valuable economic tool. And yet raising it has become a politically toxic idea, ever since Labour under Tony Blair and Gordon Brown promised not to do so in the mid-1990s. They preferred to raise National Insurance instead, even though this tax is narrower, and the employer-levied version adds friction to job creation. One of Mr Brown’s biggest mistakes was cutting the tax to 20% in 2007. The Great Financial Crisis soon after showed how much the government was relying on volatile capital taxes, and the income tax cut contributed to a dire budget deficit that panicked the subsequent coalition government into drastic spending cuts. Cutting the Basic Rate adds a level of instability to the country’s economic management.

Still, that line of argument is unlikely to appeal to Tory MPs, who seem to have a blind faith in muddling through. The bigger problem for the party is that supply and demand is out of kilter in the UK economy, and cutting taxes will add fuel to the flames. As demand recovers from the shock of the Covid pandemic, it has revealed weaknesses in the supply side of the economy, which can’t keep up. Some of the problem is worldwide, with the global trading system put under stress by problems in container shipping, for example, or the production of microchips. But Brexit, or more precisely the country’s rapid departure from the Single Market and customs union, has made the problem much worse. On top of that there is the government’s hostile attitude to immigration, especially of people on lower rates of pay. Many immigrant workers have left the country, and don’t want to come back, even if the government would let them. These problems have hit the distribution of goods particularly hard, and imports especially. That matters a lot, because the usual way for the British economy to handle excess demand is to import more. With that option closed, unless the public starts to save more, the consequence is inflation. And sure enough, inflation has risen already. The government is even encouraging it by urging businesses to pay people more.

This is bad news for the government. Inflation is a corrosive economic disease that attacks savings, and usually hits the less well-off, and those reliant on pensions the worst. These are critical parts of the Conservative base (i.e. savers and pensioners). Under the widely accepted understanding of economic policy the way to counter inflation is to increase interest rates, preferably so that they exceed the rate of inflation itself. Right now official interest rates, which drive commercial rates, are very low, and less than inflation. This has enabled many people to afford very high levels of borrowing, usually to buy houses. It also means that the high level of government debt is not actually all that expensive to service (this may not impress followers of Modern Monetary Theory very much, but it matters to the government’s political credibility). Any rise to nominal interest rates will cause widespread pain, which will create a sense of economic crisis. One thing that tends to characterise Conservative voters is ownership of property. Rising property values gives them a sense of wellbeing (even if they have paid off the mortgage), and declining values makes them thing the world is going to pot. If mortgages become more expensive, property prices are bound to fall.

To head this off the government needs to reduce demand. The best way of doing this is to increase one of the broadly based taxes: Basic Rate Income Tax, Employee National Insurance or VAT. Taxes that hit the rich, such as Higher Rate Income Tax, are much less efficient for this purpose, as the rich save more – though they would help with the national debt. The government is, in fact, increasing Employee NI (as well as Employer NI), which will help. It also also trying to cut government spending. It has made a start by withdrawing Covid emergency measures, such as the furlough scheme and Universal Credit. But the politics of large additional spending cuts is awful. Maybe this will all be enough – but I doubt it.

Doubtless the Conservatives hope that within a year the inflation scare will have blown over, and that would give them the wriggle-room they need. And yet many of the supply-side problems that drive it will take years to solve, and may only be solved with a permanent cut to consumption levels. Responding to the problems with pay rises, as the government is encouraging, will also lengthen the time it takes for any settling down.

The chances are that there will be no room to cut income tax before the end of this parliament. Tory party managers should be thinking of other ways of trying to securing political advantage.

How will Britain’s economic chaos pan out?

Britain is suffering mounting economic chaos as supply chains break down. The government shrugs – these are just teething problems, the Prime Minister, Boris Johnson, suggests, as Britain finds a new normal as a high-wage high-productivity economy. Is this the nonsense it seems to be at first sight?

It doesn’t help that reporting on the emerging problems is very superficial – simply the regurgitation of statements put out by interested parties with no attempt being made get to the bottom of things. The government chooses to dissemble rather than inform. The current petrol crisis, running into its second week here in Sussex, even if it is easing elsewhere, is a case in point.

The government blames it on consumers – or a surge in demand caused by “panic-buying”. After the first few days this was clearly nonsense. People were running out of petrol. Such evidence as we had from the queues outside petrol stations, admittedly anecdotal, was that most people had delayed filling up, and were now desperate. And yet nobody seems interested in trying to understand what was really happening. The government kept on repeating the tangential but irrelevant fact (if it is the case) that there was plenty of petrol at the depots, followed by the non-sequitur that if people simply behaved normally the situation would right itself quickly. This morning the BBC Today programme interviewed a forecourt manager in Kent – and suddenly things started to make a bit more sense. Instead of the normal four fuel deliveries in the last week he had received just two. The current situation had come about because supply problems over the summer meant that forecourt stocks had run low, so that the slightest blip was enough to knock the whole system out of kilter. He didn’t say, but it was easy to infer, that a continuing shortage of deliveries meant that the system couldn’t right itself. This is fundamentally a problem of supply, not demand. The government’s tactic of increasing the number of tanker drivers, including by the use of the army, starts to make sense. It wasn’t simply a confidence-building measure, as ministers seemed to be suggesting, but an attempt to fix a broken system.

And what is happening to motor fuel is being repeated across many other sectors. A lethal combination of a hard Brexit, restrictive immigration rules and the covid-19 pandemic is delivering a series of critical labour shortages. The most notable is that for heavy goods vehicle (HGV) drivers, which is behind the fuel crisis. But it is far from just this – there is an emerging crisis on the slaughtering of pigs, for example. Problems emerged in the summer, or before; businesses did what they could to manage, but at the cost of resilience; as difficulties arise, the system breaks down. A small uptick in motor fuel demand broke the distribution system and it requires an influx of additional resources to fix it; the large, seasonal uptick called Christmas is approaching, covering all manner of goods (though hopefully not motor fuel). Muddling through could easily tip into breakdown in many parts of the economy.

The government’s problems are both in ideology and competence. Ideologically the government wants to move to a different sort of economy, less reliant on cheap, imported labour. Its leaders also believe in the problem-solving capabilities of free markets and private enterprise, and the need for government to step back. They fully expected teething problems following Brexit and the roll back of immigration, but they expected that businesses would adapt and solve these problems without the need for government intervention. So they shrugged off the early warning signs. And for the most part ministers lacked the competence to see how problems could become unmanageable, and what the best interventions might be. It doesn’t help that the public appears unwilling to hold the government to account, and seems happy to accept that “stuff happens” and that it is all somebody else’s fault. So we have strategy but no tactics.

Does this strategy make sense? I always felt that the strongest case for Brexit was what I called “the hair shirt” one – that Britain had it too easy in the EU, and was relying on cheap imports of both goods and labour. Brexit could force the country to raise its game, and move to higher productivity. Living standards would fall in the short-term, but the result would be more sustainable. What other countries have succeeded in reaching this high-wage high-productivity model? Not the US, where high levels of inequality make cheap labour plentiful in many places, and where the currency can be kept at a high level to make imports cheaper. The most obvious examples of the are in Scandinavia, and Denmark and Sweden in particular. These are obviously not such good exemplars for Conservatives, as they have achieved this within the European Union. Switzerland may be a more a congenial example, though it has opted for a higher level of European integration than Britain has. However there are also the examples of Canada, Australia and New Zealand – which are doubtless more acceptable. Japan, perhaps, is another case. But all these countries have built their success on strong exports, in agriculture, manufacturing and mining. Britain no longer has the potential for agriculture or mining exports on the scale needed; its manufacturing has been hollowed out. There may be alternatives, perhaps based on the country’s world-class university sector. Various aspects of health technology seem to me to be the most promising – especially since the centralised structure of the NHS provides opportunities for data mining (if that’s the right word). There could be a path through to the sort of wealthier and more equal society that the government seeks, or says it does.

But it is hard to see how the country can get there without serious investment, led by government. The education system is an obvious case in point. Universities look to be in relatively good health, so long as the supply of foreign students can be maintained, which means allowing successful graduates to stay in the country if they wish. The obvious gap is in technical education, to fulfil the many mid-level jobs that a high-productivity economy needs, as well as making the best use of the country’s Human Resources. Clusters of technical excellence also need to be developed across the country – this is best led regionally by empowering regional and local government. I also think that a better-resourced health service is required, both to supply the quality of service a country of Britain’s income level should expect, and to be the anchor for an expanding private health economy, developing new treatments and technologies that can be applied worldwide. These investments would need to be financed. If a government had the courage of its convictions, it would do a lot of this through borrowing – as the investment should yield a bigger money economy to tax in future. But doubtless more tax income would be needed too.

And yet the government has no such clarity. Rishi Sunack, the Chancellor of the Exchequer, talks of fiscal prudence and even future tax cuts. Unless he means to do the opposite of what he says (a possibility that this government is quite capable of), this is a bad place to start. A period of cuts to areas that need more money is beckoning. Meanwhile the government urges businesses to overcome labour shortages by raising wages. This at a time when one of the government’s key policies is a public sector pay freeze. Wage rises may be a good thing, but they are also liable to lead to price rises for the goods that people buy – a process that could lead to intolerable pressure through the economy. It is all very well to hope for higher productivity, but this is hardly feasible in many of the areas under stress – such as HGV drivers.

Where is this heading? The government has already been forced to “temporarily” relax immigration rules for HGV drivers and some others. Much more of this is likely – the government will try to tackle the shortages of “low-skilled” workers though temporary immigration visas. This is a strategy that many countries have followed, and it rarely goes well. It either fails because the jobs aren’t attractive enough, or more likely, it will simply draw in an underclass of highly exploitable workers from poorer countries, which could form the basis of poorly-integrated immigrant communities of the future, as the idea of “temporary” gets ever more stretched. To its credit, the government is clearly alive to the dangers, but it may find it has little choice. Another safety valve for the economy is increasing imports – though this won’t reduce the dependence on HGVs – as the country proves too small to sustain productive supply chains by itself, it can make use of those from abroad. That can be financed by the sale of ever more assets such as property and businesses to foreigners – perhaps the real meaning of “Global Britain”. This will be no more appealing to patriots.

And meanwhile in one part of the country an interesting economic experiment is taking place. Northern Ireland has one foot in the EU single market, and an open border with the Union. This has created supply chain problems with the mainland and empty supermarket shelves. But they didn’t suffer from petrol shortages (or not to the same critical extent). As the province’s supply chains become more integrated with the Irish Republic, and thence the wider EU, perhaps it will find things easier than its compatriots over the water.

I shouldn’t underestimate the resilience of Britain’s economy. Perhaps the stresses will indeed push the country towards a more modern economy – electric cars certainly look more appealing now. But for once I’m not optimistic.

Should we be worrying about inflation?

Now is a very interesting time to be a macro-economist. The shock arising from the covid-19 pandemic is unprecedented in its extent (barring world wars, maybe) and its economic effects. Government responses, with very loose monetary policy combined with generous fiscal measures, is similarly unprecedented. The latter is remarkable in that its generosity is far greater than that shown by governments following the Great Financial Crisis that started in 2007. Economic conservatives have been routed and are grasping for evidence that their once confident assertions about the public debt and deficits have a basis in fact. These generally turn on the question of inflation.

Inflation plays a critical role in macro-economics. In theory it is what happens when supply fails to meet demand across an economy. There a number of reasons that this can happen but the most important, to macroeconomic commentators, is when a when aggregate demand is boosted by a government spending too much or taxing too little. Or, putting the same idea in a slightly different way, when too much money is being put into circulation by government policy. It is one of the points of agreement between orthodox conservatives, whose narrative is that bad things happen when governments intervene, and advocates on the left for Modern Monetary Theory (MMT), whose narrative is that governments can and should spend freely so long as inflation is kept at bay. Things get more complicated when you try to apply the theory to an open economy – one that trades substantially with others – that issues its own currency, but this is usually glossed over.

The theory of inflation had to be redeveloped after the 1970s, when inflation (excess demand) and high unemployment (inadequate demand) co-existed in so-called stagflation. The new theory, working its way through such ideas as monetarism, a craze of the 1980s, to the Neo-Keynesian consensus of the 1990s, built on the idea of inflation expectations. This suggested that inflation could happen simply as a function of the zeitgeist. The standard theory was that therefore it was essential that inflation expectations were “anchored”, and that it was the central bank’s job to do this. This theory has become so embedded that organs such as The Economist, who should know better, report it as fact.

In the first two decades of the 21st Century inflation in the developed world has been stable and quite low (around 2% per annum and often less). This has been hailed as a great success for central banks, who have firmly anchored those expectations. It has also been taken up by MMT enthusiasts as evidence that reticence over government spending and national debt, and especially the demon “austerity”, is vastly overdone.

And so here we are now. Many developed world governments, led by the United States, have thrown caution to the wind in response to the pandemic. This appears to have been remarkably successful in in that the economic impact of the calamity has been relatively limited. But now inflation seems to be breaking out everywhere. Optimists say that this is just the result of temporary supply bottlenecks, pessimists say that over generous economic policies are coming home to roost. Commentators pore over the available data and argue like mad.

If you find all this rather perplexing, you should. Macro-economists inevitably deal in simplified models that represent the actual world but imperfectly. The statistics they deal with, such as income and, indeed, inflation, are similarly imperfect representations of a complex reality. They all know this, but instead of taking on an air of humility, they find it easier to gloss over the difficulties and wallow in the vicarious power of dealing in the fate of millions. In the process most of them have become completely detached from reality.

Inflation is a case in point. What most economists seem to mean by the term is a devaluation of money: the price of everything going up without anything deeper going on. One of the 1980s economists suggested that “Inflation is everywhere and always a monetary phenomenon,” because it couldn’t happen in that favourite fiction of conservative economists, a barter economy. But a general rise in consumer prices may simply be part of a widespread balancing out of things across different markets. In the 19th Century, according to statisticians who estimate these things, there were many surges in prices, but compensated by falls at other times, so that there was no overall rise over the long term. Not coincidentally, money was closely linked to gold at the time, though that is incomplete as an explanation. A more recent example is the inflation that accompanied the economic boom in Ireland after it joined the Euro. This rise in prices was the only way an open economy could respond to a surge in productivity without a now-impossible currency revaluation. That didn’t stop the European Central Bank ticking the Irish government off. Another example came during the austerity years of the British Coalition government after 2010. There was persistent (though not especially high) consumer price inflation. But this wasn’t matched by wages, and it was simply the economy reflecting the reality of lower living standards. I remember one commentator suggesting that the inflation would make debt easier to pay off; nonsense because you pay debts out of income. Inflation then was not reflecting a devaluation of currency.

So what is happening now? Prices rises genuinely seem to reflect shortages in supply relative to demand, both in goods markets and labour markets. These may well reflect temporary bottlenecks. We can expect this to go on for some time as the pandemic has had far-reaching impacts on many supply chains and labour markets. Yesterday our local picture framer was complaining on behalf of his glass supplier that the cost of hiring a container from China had risen from £500 to £8,000 (or something like that), because all the containers are in the wrong places, not to mention the disruption to the Suez Canal. In Britain we have the added complication of Brexit disrupting both goods and labour markets; in that case when the dust settles most people are bound to end up a bit poorer. But the pessimists have a point too. The entrenched inflation of the 1970s started with similar temporary shocks, to the oil market in particular. If it really is all about expectations, this is how it starts. But there is so much noise in the statistics that it is really very hard to see what is going on.

Personally I am less concerned about inflation that many. I think the 1970s-style inflation was mainly a product of unionised labour markets and less flexible supply chains, which gave labour much more power. This certainly had a good side in ensuring a fairer distribution of wealth, but it prevented adjustment to economic realities. In today’s much more open world economy there are other ways than inflation for unsustainable excess demand to play out, in the most developed economies anyway. In the 1990s it may have been right to talk about inflation expectations being anchored by the central bank, but the world has moved a long way since then. Inflation is held in check by the forces of global trade. The stress is taken in the financial system through higher levels of debt and international capital flows. This is likely to end in financial busts rather than 1970s stagflation.

So if there’s trouble ahead we are looking in the wrong place. Is there trouble? Financial asset markets certainly look as if they are in a bubble, but the banking system looks a lot healthier than it was in 2007, when the last great financial crisis started to gather momentum. In Britain I think things are going to get much bumpier as the government tries to bring its budget deficit (currently an eye-watering 11.5% of GDP, though less than America’s 13.9%) back to a new normal. But there are so many uncertainties as to what a sustainable new normal will look like, that this very hard to predict. This is going to dominate politics from 2022 on as there is no coherence to the government’s message on this.

Interesting times indeed.

Rishi Sunak shows a sure touch with 2021 Budget

Yesterday Rishi Sunak, the British Chancellor of the Exchequer (though that job title belongs to no other country so far as I know), showed why is considered to be the country’s top performing minister after Boris Johnson, the Prime Minister. It was Budget Day; he got most things right, while putting off a lot of decisions for another day.

The central issue for the government is, of course, dealing with the pandemic. His decision was to continue with a whole raft of fiscal support measures, such as the furlough scheme, until the end of September. This is well after the vaccine programme is supposed to have brought society back to normal, sort of. This shows that Mr Sunak has learned from his mistakes. Last year he was too eager to hurry things back to normal and withdraw fiscal support. Like his boss, he seems to have effortlessly risen above the mistakes of 2020.

But how is this to be paid for? Government finance does not work like household finance, and especially not for a medium-sized developed country with its own currency, like the UK. Mr Sunak has simply added the costs to the national debt without any serious plans to repay it. After dealing with short-term support for the stricken economy, Mr Sunak’s next priority is to show how he will stabilise government finances in the new, shrunken, normal by reducing the budget deficit. He did this by freezing tax allowances and raising the rate of corporation tax (from 2023). The former will allow the government to benefit disproportionately from incomes increasing through inflation. This allows the Conservatives to stick to their pledge not to raise personal tax rates, nowithstanding the hurricane that has hit the economy.

A lot is missing from this plan. Public spending plans have not been changed once the emergency subsides, though it isn’t hard to see many ways in which the stress on public services will rise; some are painting this as strategic choice for a return to austerity, but surely it is too early to say for sure. The long-promised solution to social care funding did not materialise. The temporary increase in Universal Credit, which many want to make permanent, has been prolonged only until 30 September. There were various gimmicks under the heading of “growth strategy”, i.e. measures to encourage business investment, but nothing major. Tax advisers will indeed get an economic boost, especially from his 130% capital allowance scheme for “productive” investment. So the Budget was not the long-term strategic rethink many had been hoping for. The big question is whether the government has such a rethink in mind at all, or whether it is saving it for later. Saving it for later would be perfectly sensible in the current fast-changing environment. A lot of criticism is focused on these missing items, however. Another line of attack, notably from the Liberal Democrats, points to gaps in the emergency support, especially for smaller businesses. This is valid, but it is a bit late for a government rethink.

The leaves two bigger questions: is it sensible to put off dealing with the expanded national debt? And is it sensible to raise the rate of Corporation Tax? My answer to both is “yes”. The limits to government finance are very tricky to assess. On the one extreme we have countries like Argentina, constantly overdoing it and stuck in a world of inflation and debt crisis; on the other we have Japan, whose mountainous public debt and frlarge budget deficits are simply shrugged off. A large national debt needs to be refinanced over time, as the bonds that finance it mature. For now this is cheap and there are plenty of buyers. But that can change; interest rates can rise; investors can be scared off. There’s no sign of this at the moment, but this debt will be with us for a long time. Can’t the Bank of England take on the debt that the markets can’t digest anyway? Yes, but this is a bad idea if inflation is in the system, especially wage inflation. But some wage inflation is good – it is the process by which living standards increase, especially in poorer households. Another problem is if the country requires a lot of foreign currency (the position Argentina got itself into); this is a risk if the country has a large current account deficit. But there are no warning lights flashing on either inflation or currency needs. If that changes the government might need to raise taxes further – but not yet.

And as for Corporation Tax, the government’s reversal of strategy is spectacular. Starting with the Coalition with the Lib Dems in 2010, the rate has been steadily reduced to 19%; the plan now is to bring it up to 25%. This rise is widely portrayed as an attack on business. But that isn’t the right way to look at it. As a tax on profits, rather than on sales, employment or property occupation, it is a very efficient tax. The incentives to run a business efficiently remain unchanged by the rate. It is better regarded as a tax on capital. It is certainly one of the things that companies look at when deciding where to locate a business internationally – but it is still quite competitive at 25%, and basing attractiveness to business investment on tax rates is an invitation to footloose capital, not secure growth. Capital is already cheap, and the story of this century has been the rise of rewards on capital compared to labour. This looks like a good place a tax hike. There are problems with the tax, especially in its treatment of foreign trade and borrowing, but the rate is surely not too high.

Politically, though, this Budget is part of a general revival of the Conservatives’ fortunes. Mr Johnson and Mr Sunak are often painted as rivals, and doubtless they are, but so far this year they are working well together, promoting a narrative of a sure-footed, cautious but fiscally generous recovery from the pandemic. Labour, who had opposed the rise in Corporation Tax, are floundering.

The pendulum swings rapidly in politics, but Rishi Sunak is showing a sure touch. Later this year, as his bluff is called on public spending, it will be interesting to see what he and the rest of the government do.

The economics of the pandemic: don’t panic

One of my favourite subjects in ten years of blogging has been economics. But for the last year I have hesitated. There has been a lot to write about, but somehow I did not have the confidence to say anything. A couple of weeks ago I got as far as writing an article, but it just meandered. But this week I have been bombarded with different opinions on the impact of the pandemic and what to do next, so I feel I must try to make some sense of it.

Most recently there were a couple of articles in the FT. There was an interview with economist Dani Rodrick, in which he urged that the left should make up for its attachment to neoliberalism in the 1990s and 2000s and meet the challenge of right-wing populism with a sort of left-wing populism. The focus of this should be the creation of decent jobs (the populism bit being the blaming of everything on plutocrats and bankers). He has certainly hit on something important, but to me left-wing populism brings to mind the late Hugo Chavez, and the creation of useless jobs given to political cronies, the running down of productive industries and bankrupting the economy on welfare programmes used to shore up politically compliant communities. This is where the policies of Labour’s former leader Jeremy Corbyn would have led in my view (he is a fan of Chavez after all). On the same day the neoliberals fought back with a piece by Ruchir Sharma, a banker, who claims that emerging market economies have responded to the crisis by pressing forward with supply-side policies, rather than splurging on stimulus. These are IMF-style programmes without the IMF – he points to China and India, amongst others. With developed economies resisting such reforms, he says these emerging economies will be better placed to overcome the shock. This is an interesting take on what is happening, but the conclusion is facile. Developed economies are at the productivity frontier, and they are not in need of many neoliberal reforms (with some exceptions such as Italy) – I agree with Mr Rodrick here, even if his picture of left-wing populism sends shivers down my spine.

And then we have some writing about President Joe Biden’s proposed massive stimulus for the US economy (£1.9trn is the headline). Left-wing commentator Robert Reich launched into enthusiastic support on Facebook. The Economist thinks it goes too far, and should be better targeted, echoing criticism from former adviser to President Clinton, Larry Summers. They fear that it will trigger inflation, and then rising interest rates, and a financial crisis. Meanwhile, also in FT, Gillian Tett has written about the remarkable stance of Chairman of the Federal Reserve Jay Powell, whom she thinks is being far to aggressive on the length of time he suggests interest rates should stay low. Meanwhile there is a lot of fretting about signs of overheated financial markets, with the popularity of crypto “currencies” like Bitcoin eliciting much angst.

There is quite a lot of agreement that governments are right to spend to support the economy, but a big concern on how far this should go. Critics of stimulus worry about setting off inflation. But conservatives have cried wolf on inflation many times in the last few years, and yet it remains stubbornly low. Most commentary on inflation misses the mark.

What is inflation? It is a devaluation of the currency, so that the same nominal units income or savings buy less, but that a fixed nominal amount of debt becomes easier to pay off. The focus of commentary tends to be almost entirely on the first, measured by overall movement in consumer prices. But if wages do not rise to match prices, then debts are not depreciated. It isn’t really inflation, in my books, but a structural adjustment. The three main reasons for this can be worsening terms of trade (i.e. imports becoming more expensive, usually because the exchange rate is depreciating), a decline in productivity, or a shift of bargaining power from labour to capital. None of these require the same policy response as inflation proper (i.e. higher taxes or reduced public spending, or higher interest rates). And in the 21st Century consumer prices and wages have rarely moved in line with each other in developed economies. Before the financial crisis of 2007-2009, wages trended ahead, largely because of improving terms of trade from cheap imports, mainly from China. After the crisis wages have usually failed to keep pace with prices, as the terms of trade moved against developed countries (Chinese products stopped getting cheaper), unmasking a steady process of the balance of advantage moving from labour to capital. All this is very different from the later 20th century, when most of the current theories of economic management were developed. Then wages and consumer prices usually moved in lockstep. The breaking of the link between prices and wages is one of the critical things to understand about the modern economy.

So what happens when demand runs ahead of supply? Inflation remains stuck because rising prices choke off demand, because wages for most people do not keep up. The typical response is for imports to rise. At least that is what I suspect from the limited times where this has happened in the 21st Century (I believe Britain in the mid noughties was a case in point). But a feature of modern developed economies, especially since 2007, has been a chronic lack of demand, while conservative government fiscal policies were the accepted wisdom.

So what will happen if President Biden’s stimulus gets going, with the Fed minded to keep interest rates low? I don’t think it will lead to more than a slight increase in inflation, largely because of the disconnect between prices and pay, but also because of the nature of the recovery. The Economist refers to some supply bottlenecks, such as in microchips, but these relate to distortions in demand arising from lockdowns. Assuming that the US comes out of lockdown, then the main rise in demand will be for services, rather than such manufactured goods, where there seems to be quite a deep pool of unemployed or underemployed labour. And doubtless imports will rise too, and the US dollar will strengthen relative to other currencies. Also much of the excess demand will be funnelled into asset markets, so the current distinctly bubbly markets could well continue. If there is trouble it will come from some kind of breakdown in financial markets. But they do not seem to be as vulnerable as they were in 2007. All this rather supports Mr Reich’s optimistic outlook. As the stimulus plays out things become a lot less predicable, but that is a couple of years away and not necessarily unmanageable.

What should the British government do? It has run up an astonishing budget deficit in its largely successful attempt to keep the show on the road in the crisis – unemployment is remarkably low I the circumstances. According the Economist the deficit is nearly 20% of GDP, the largest of any of the economies it follows. But the same statistical table shows something rather interesting: that the current account deficit to has fallen to 1.3%, and is unremarkable by international standards. Not long ago it was one of the highest. This, together with very low interest rates, suggests that there is no financial crisis, and therefore no need to panic, as the country did in 2010, when the budget deficit was 11%, though the current account deficit was a bit higher at 2 to 2.5%. The government’s main problem is its own rhetoric about government finances.

How quickly could things turn nasty in the UK? We are much more vulnerable to a financial crisis than the US, because we lack financial clout. But again we look much less vulnerable than in 2007. A big question is what happens if the current account goes sharply negative again. That is not necessarily unsustainable (it can be financed by selling property to foreigners). But if world interest rates should start to rise then problems might spiral. But my guess is that the country is safe for a couple of years at least.

There are some much deeper economic questions emerging from the covid crisis, which point to a major change in direction for economic management. These should occupy us more than short term government finances.

You don’t run a national economy as if it was a business – understanding the productivity “crisis”

Economists, especially the macro sort, look down on ordinary members of the public when they suggest that a nation’s finances operate in the same way as a household’s. They have a grand name for it: “the fallacy of composition”. And yet most of them suffer from very similar fallacious thinking. They imagine that running the production side of the economy is like running an individual business.

Economists are not good at looking beyond the aggregate statistics that describe an economy as a whole: total income (GDP or GNP), employment/unemployment, inflation, trade and current account deficits and so on. These numbers take on a  reality in their own right, rather than being statistical abstractions. This leads to a ludicrously simple mental model of what is happening behind them. It’s a bit like understanding a car through the operation of the accelerator, brake, steering wheel and gear stick, without thinking about the engine. Economists imagine a national economy to be a bit like a single business, or perhaps an aggregation of similar ones, churning out all the things the people need. The more that gets produced, the more that gets consumed, and the happier we will all be, following the ideas of classical economics. Once you have reached full employment, the only way to increase production is to make the business more efficient by raising productivity. It is one of the central challenges to economic management in this classical view. And it is one Britain seems to be failing at. Commentators from right across the political spectrum (except the Greens, maybe) seize on poor productivity performance with their own favourite explanations.

But the economy is not analogous to a single business. To understand this we need to consider the different sorts of production activity that make up our economy. These divisions are largely my invention to convey the essential dynamics. Many actual activities are in two or three categories at once.

Let’s start with the easy bit: what I will call commodities. These go beyond globally  traded things like oil and coffee to all goods and services that behave more or less as economists expect. Utilities might be an alternative name. These are most of the things sold at a supermarket, or basic cars, like a standard VW Golf, and the raw materials that make them. Services might include bank current accounts, household insurance and so on. Actual utilities a slightly more complicated, because they are distributed through networks that rarely compete with each other. All well and good, but what needs to be understood about these things is that from a consumer point of view there are diminishing returns. Your first fridge or car is really useful; your second one much less so. Not many people have three. That means demand is subject to saturation. Sales of white goods and cars rocketed in the 1950s and 1960s as people bought their first ones, but then slowed as most need came from replacements. This sea change for these and many other goods of the postwar light industrial revolution was surely one of the reasons for the economic wobbles in the 1970s, but one you will not hear mentioned by macroeconomists. A good definition of a developed economy is that it is one where most commodities have reached near saturation.

What are the consequences of this when we think about productivity? First, commodities are generally where advances in productivity have been the steadiest – production is relatively easy to automate and processes easy to redesign because there is little individuality in them. But as demand reaches saturation it means that workforces become smaller rather than more goods being produced. And that means that the weight of commodities in the total economy shrinks. First was agriculture, which used to account for the bulk of the economy, but now for about 1% or so. Next came manufacturing. And so on. How much of the total UK economy is in utilities? There’s no hard and fast definition, but it could be down to 20%.

Now let’s think about something else. Let’s call them “bads”. Direct bads are activities that are directly harmful; indirect bads are other activities we enter into to stop bad things from happening. Crime would be an example of the first, and police forces and security guards of the second. Into this category we might put armed forces and defence industries, a lot of the legal profession, regulators and compliance people, many consultants, and so on. We have little practical control over these activities, and they do not add directly to our wellbeing. An economy composed largely of security guards and armed criminals may have a decent GDP but it isn’t a good place to live. More is not better. The fewer bads overall, the better the economy will function for the population as a whole.

Productivity is clearly relevant for indirect bads. If you can treat the same danger with fewer warplanes or policemen then clearly that’s a good thing. But is this being measured in the economic statistics? And note that more productivity means the sector becomes smaller, like commodities but more so.

Next comes human services. The essence of these is human interaction. Economists’ favourite example is the hairdresser. The economy would be more productive if we all shaved our hair off, but somehow that misses the whole point. There are plenty of other examples: most of education, health care and social work, for example. One fascinating study (by BBC Horizon) showed that longer and more sympathetic consultations with doctors produced more effective treatments (the treatment in question was a placebo, which proved more effective than conventional drug interventions, but that’s an issue for another day). Productivity is a rather ambiguous concept for human services:if there is less waiting around and bureaucracy then that helps. But if you try to improve productivity by reducing the contact time with each client, you are likely to destroy the benefits of the service. This is not understood at all by economists. Trying to improve productivity in this way is how many public services are being undermined at the moment, with detrimental effects on society as a whole. But as a modern economy develops, human services, alongside hobbies and leisure, weigh higher, partly because we choose to consume more of them, and partly because there are few productivity savings to reduce the workforce. So the overall productivity of an economy (or at least the rate of productivity growth) will decline.

And then we have status goods and services. The primary purpose of these is to prove your status in society. The important point is for you own or use them when other people don’t. Think of luxury goods like smart sports cars or designer handbags. The interesting thing about these is that there is an anti-productivity factor. The more labour involved in producing the product, the higher status it confers. Improving productivity is a delicate matter. And, of course, status is a zero-sum game. Rising volumes of status goods simply lead to an arms race of expensive products that does nothing to advance human wellbeing overall.

I could go on. There are rents, public goods and finance and so on, each of which produce a different twist to the productivity puzzle, but none of which follow the classical pattern of commodities. There are two key points to make. First, improvements in productivity in a modern economy do not lead to expanded production, but to a redeployment of the workforce. That redeployment usually goes to sectors with lower productivity (status goods or human services), which means that the benefits of the original productivity gain are limited. But human wellbeing could well advance faster than overall growth, if people have more time for life-enhancing human services, for example. This isn’t a problem, it is a sign of a mature, successful economy. The second issue is that most economic activity is now in areas where productivity is practically unmeasurable because the outputs are intangible (bads, human services and status goods for example).

Look a bit deeper into Britain’s productivity statistics and both of these become important. The poor productivity growth is now attributed to a “tail” of small businesses, just as you would expect if productivity savings are being deployed into status goods and human services. Meanwhile the two sectors where virtually all measured productivity growth has happened in the last two decades are finance and business services. These are both sectors plagued by bads, the undermining of human services and rents. It is hard to argue that this growth has advanced human wellbeing. All of which leads to an alternative explanation of Britain’s low productivity. The British economy is simply further along the development path than others. In particular, unlike the Germany and France, we have run down export-focused commodity production, and that distorts any comparison.

There’s a further insight from this way of looking at things. Advancing human wellbeing in a developed economy does not come from producing ever more commodities. It derives from producing fewer bads, containing status goods, and expanding human services. Depending on how pricing works, that is unlikely to lead to measured growth in GDP. But that is not a bad thing: if it simply arises from the freely made choices of empowered citizens.

Of course productivity is an important issue for individual businesses and public agencies – at the level where managers should know whether value is being created or destroyed. But macro-economists should take their own advice on the fallacy of composition: don’t try running a national economy as if it was a business.

 

 

Was austerity a horrible mistake? Three challenges to the left’s narrative

The Prime Minister Theresa May recently suggested that “austerity” was coming to an end. That word is one of the political left’s most successful abstract nouns; that Mrs May is now using it shows just how successful it is. Alongside the word comes an austerity narrative that is nowadays largely unchallenged. This is that the programme of public expenditure cuts started by the coalition government in 2010 was economically unwarranted, and therefore “ideological”, and that this foolish policy is responsible for the UK’s weak economic performance in the years since.

Conservatives are unbothered by this austerity narrative. They peddle their own rival one: that the preceding Labour regime was profligate with other people’s money and that the cuts were needed to stop public waste. They further, and tendentiously,  suggest that this profligacy is what led to the financial crash in 2007-2009. They feel no need to challenge the left’s austerity narrative; they just ignore it. For Liberal Democrats, as part of the coalition, the austerity narrative is much more painful. They neither challenge the left’s version, nor come up with one of their own. That war is over and the Lib Dems lost, but for the small number of people who care about what happened and why, should we meekly accept the left’s version of events, and acknowledge that it was a horrible mistake?

The economic logic of the left’s case is based on the idea of Keynesianism. In 2010 Britain was suffering a recession, with a collapse in output in 2008 to 2009 following the financial crash. A recession is a temporary dip in aggregate demand which can become a doom loop: lower demand cause job losses, which in turn reduces demand further. The quickest way to counter this is to stoke up government spending: this keeps demand going, stopping the job losses until confidence returns, the economy starts growing and the excess government spending is then cut back to restore balance (funnily enough left-wing economic commentators rarely talk about that second phase). This is what Labour did to a modest extent in 2009. But the coalition embarked on a massive programme of cuts in 2010, sucking demand out of the economy when demand was already weak. Instead of bouncing back from recession, as you would expect, the economy stayed at its low level with little or no growth for years, until weak growth eventually returned – the worst performance of any major economy.  America, the argument goes, was not as severe in its cuts, and bounced back much more quickly. Some commentators go as far as to project how much the economy would have grown at the average rate before the crash, to show a massive gap between now and where the economy could have been.

One of the reasons why this narrative is largely unchallenged is that the picture is actually very complicated, so that it is not particularly easy to pursue a considered argument. The winner is goes to the person that shouts the loudest in a dialogue of the deaf. I will sketch out three challenges, however, but I will inevitably oversimplify things to keep this post a manageable size.

Challenge 1: the size of the government debt was becoming unsustainable. The budget deficit in 2010 was in the region of 10% of GDP (with estimates at the time being even higher). This is truly scary, and promised a massive rise in the size of government debt: could the financial markets absorb it? And if they couldn’t, there might be a financial crisis that would create an even deeper recession. The Greek crisis, which was emerging at the same time, was used an example. But Greece doesn’t have its own currency any more. In Britain we can simply create the extra currency when push comes to shove: the government doesn’t run out. This is what Japan has been doing for decades with little ill-effect. But Japan has a current account surplus, meaning that the Japanese spend less than they produce, and do not need foreign money to keep the system going. Britain had (and still has) a large current account deficit, which means the opposite: we are dependent on foreign money. So, the argument runs, if these foreigners lost confidence in the British economy because of an ongoing 10% budget deficit, with the free creation of money (and hence a higher risk of currency depreciation and inflation), then there would be a crunch. At best, the government, or private sector, would be forced to borrow in foreign currency, destabilising the economy. At worst imports would rapidly become unaffordable, leading to severe inflation. This is a very hard argument to get to the bottom of on either side. There was no stress in the market for government borrowing as things turned out. But was that because of austerity? Or  sign that austerity was unnecessary? There is a very good case that the government could easily have borrowed more for investment (in council housing, say), a more difficult case for simply open-ended funding of bureaucrats and benefits.

Challenge 2: the government actually moderated austerity to reflect economic conditions. The government’s plans to cut spending announced in 2010 were never adhered to; what actually happened followed the trajectory proposed by the Labour Chancellor in 2010 to tackle the deficit and included in the party’s election manifesto. Unemployment never got out of control, and overall employment recovered much more quickly than the overall income figures. A lot of the comments from left-wing writers on the scale of the recession and austerity does not follow the facts. Some even suggest that because austerity was slower than planned “it was a failure in its own terms”. This really is disappearing up your own backside. The scale of the cuts to public services simply shows how far public spending had got out of step with tax revenues. The more serious left-wing counter to this is that though employment held up, its quality did not. Pay was squeezed, and a lot of the new employment was insecure. There was scope for more demand in the economy, they say.

Challenge 3: the economy before the crash was unsustainable. To me this is the lynch pin argument, and I’m disappointed that it is so rarely made. This runs in a narrow form and a broader form. The narrow form is that government spending was at unsustainable levels, both because it was running a deficit at the top of the economic cycle, and, more seriously, because so much spending was funded by bubble taxes like capital gains taxes and stamp duty, while more reliable taxes, like income tax, were actually cut. That left a massive gap when the bubble burst, which meant that spending cuts or tax rises were inevitable even taking the Keynesian argument into account. There was never going to be a good moment to make the adjustment.

But the broader argument is more important. There was something fundamentally unsound about the pre-crash economy. It depended too much on the financial sector, drawing in foreign money to invest in British property and other assets. This drove the pound up, strangling export industries and giving us that large current account deficit. Growth in the economy depended on two very dubious sectors: finance and “business services” – the supply to services to other businesses, often in the finance sector. A lot of the reported income turned out to be fictitious, generating huge losses in the banks which the government then had to bail out. This was the culmination of two or three decades of poor economic management, when instead of modernising the economy, Britain went on an orgy of financialisation – not only pumping up a socially useless finance sector and its hangers on, but persuading people to increase consumption by borrowing more. In this light, projecting growth rates from before the crash to after it, to show how far it should have grown, is nonsense. The sustainable growth rate has been near zero for some years. And this puts a severe limit on Keynesian policies: the economy simply couldn’t bounce back to where it was before without creating another bubble. In fact with the finance sector flat on its back, such policies would most likely have done little to raise domestic incomes, but simply sucked in more imports and foreign money invested in British property. The rebalancing of the economy, advocated by politicians of the right, left and centre, is a much slower and more painful process. We simply do not have the skills that a rebalanced economy will need.

This is not to say that the coalition government did not make serious mistakes. The more subtle critique made by prominent economists is that the government should have borrowed to invest. In other words the austerity was necessary, but that it should have been balanced by building more infrastructure and (perhaps) developing schools and colleges (the universities did fine). The left-wing commentators who cite these economists (the likes of Joe Stiglitz for example) overlook this.

The problem is that the British economy is in a deep mess, and it will not be easy to break out of it. We cannot do so by trying to go back to the economies of the 2000s, still less the 1970s. We cannot even go back to how the 2000s might have been if we had been wiser (looking more like Germany for example). Trying to work out what this new economy looks like and how to get there is the big challenge facing all politicians. Meanwhile we should regard any arguments about the easy restoration of growth with suspicion.

Secular stagnation: the curse that still haunts developed economies

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The financial crash of ten years ago was something of a paradox for conventional economists. It took most of them by surprise, and dented their reputation. And yet economists became more important than ever to the running of our world. But now, to listen to most of them, the equivocation is over. We’re back to normal, as the global economy looks in much better shape. This looks complacent.

The crash was a double shock to economists. The first was how it happened at all, when most economies seemed to be purring on at a relatively steady rate of growth (often referred to as the trend rate), which seemed to relate to growing productivity, and which most economists, driving through the rear-view mirror, assumed to be a law of nature. The second shock was that developed world economies, especially the British one, were so slow to recover. Economists  simply assumed that with a bit of stimulus, economies would not just return to trend growth, but make up for lost ground too. I don’t think any advanced economy has done this – and in Britain we lag far behind. In the years after the crash an expression was coined, or rather resurrected, to describe this second problem: secular stagnation.

The person whose name is most attached to this is Lawrence Summers, who had been prominent in the Clinton administration. By it he meant that economies could only achieve growth by extraordinary and unsustainable efforts to stimulate it. And, as Mr Summers recently pointed out in the FT, you cannot say that it has disappeared. Growth has returned, but the measures required to produce it are unsustainable. What he is referring to is the extraordinarily low interest rates prevailing in the developed world.

This has been going on for so long that we have become accustomed to it. But what do negative real interest rates mean? They mean that in order to use up available savings we have to create investments that have little or no financial return. Now that is at the margin, not on average, but even so it does not suggest an economy that is at all healthy. If investments don’t produce a return, productivity will not advance, and growth will not be sustained. And in particular we will accumulate debt that cannot be paid off. Or not without inflation which destroys the accumulated wealth of the middle classes. And sure enough, many economists are warning us about mounting debt levels. In due course this will lead to a financial crisis.

Why are we in this situation? And what can we do? There are many speculations as to why, and most commentators, including me, tend to gravitate towards the one that suits their overarching narrative. Many blame a skewed distribution of income for creating a surplus of savings that cannot be used properly. Others say that modern businesses don’t need so much traditional capital (Google doesn’t need to issue debt or share capital to keep its investments going). Then there is the gradual ageing of the population reducing the size of the workforce. Others blame the wrong sort of stimulus – if only government spending hadn’t been cut back (“austerity”), we’d have bounced back in no time. My favourite is the Baumol effect which suggests that we are in a transition towards industries, like healthcare, that are less financially productive, though still improve human wellbeing. Whatever it is (and it could be all at once) it’s a problem because it is dragging down the potential growth rate.

And what can we do? People often talk of unconventional policies, but what are they? The most interesting idea is  to run up bigger government budget deficits. Piling up government debt is much safer than piling up private debt, as we are doing now. Why? Because governments can finance that debt by a process that is usually referred to as creating money, and the burden can be shared more equitably.

But piling up debt and creating money often ends in tears. The best current example of that is Argentina, with rampant inflation and impatient foreign creditors. The problem for Argentina is that its monetary system has been mismanaged for so long that much borrowing, public and private, has to be in foreign currency, which the central bank cannot create. But there is an opposite example. Japan has been piling up public debt for decades, and the central bank has been buying up debt, with few apparent ill-effects.

So how do you know whether you are Japan or Argentina (and no doubt Argentina looked like Japan once)? The first, obvious, difference is that Argentina has had a current account deficit for some time, while Japan has generally been in surplus. That means that Argentina is importing more than it exports and requires financing by foreigners – who are less likely to be happy to take payment in domestic currency. Current account deficits usually flow from budget deficits – though not always, as the recent crisis in Spain showed. That would be a bad sign for countries like Britain that also have a current account deficit. But Britain’s standing in international markets looks a lot more like Japan’s than Argentina’s. The government has no trouble in borrowing in sterling, and the same goes for most British businesses.

So why are we in Britain so worried about budget deficits and debt? One explanation is that we have been persuaded into this view by malign political forces who use the analogy of household financial management to make their case. But there are deeper worries. The first is how do you tell when you have gone far enough with budget deficits and need to stop? The traditional economists’ answer is when inflation starts to take hold. But it might be too late by then, and anyway it is not so clear that in a modern, globalised economy inflation works in quite the way economists think. You know it is too latewhen there is a rush of people trying to change domestic currency into foreign, creating a panic and to people, including the government, having to borrow in foreign currency. That can happen without inflation.

The problem behind that is the politics of it. Opening up the possibility of more government spending is a huge boost to the power of central government politicians, who do not have strong incentives to apply the brakes when they need to – any more than those bankers did before the crash of 2008. It is too easy to believe your own hubris. I think this happened to the Labour government in the mid 2000s when the government should have started to tighten spending but decided not to. This didn’t cause the financial crisis, but made it harder than it should have been to manage. Even now, though, it is impossible to get anybody on the political left to accept that. It’s the one thing that unites Jeremy Corbyn with Tony Blair.

Still, we should be able to find ways increasing government borrowing that helps stimulate demand more sustainably. Building public housing is one idea. Other infrastructure policies should help (but not all of them). There’s also a case for taking a longer view on some public spending, like education , community policing, mental health services and public health that heads off future trouble. But not building more navy frigates or, even, hospitals. We might need these, but they need to be securely funded by current taxes. The trick politically is to create a system of checks and balances that lets you invest productively and not let central government managers run away unchecked.

Behind this lies an important but rarely acknowledged idea. It is that, in the 2010s and onwards, public investment is often more productive than private investment. And that, I think, is one of the causes of secular stagnation. So in the developed world we need more public investment, and that we can afford to borrow much more to pay for it than most people think. And we need less private investment, much of which is wasted on asset recycling schemes that will end in tears. It may well take another financial crisis before we start to realise this.

 

The Budget shows that the Tories are in a political cul-de-sac

I will break my self-imposed silence because yesterday’s British Budget is one of those great set-piece occasions which can be used as a moment of reflection. Predictably, most in the news media squander this in a silly game of speculation about the short-term prospects of political leaders. But the Budget poses more profound questions.

The government faces two profound economic problems, which it must either learn to live with or expend political capital to solve. These are low productivity and housing. There are other big problems, of course: Brexit, austerity, regional disparities and income inequalities, for example. But Brexit is more about means than ends; austerity is symptom of the productivity problem; and the other problems are not so high on political agenda right now, though they are important to both housing and productivity. Broadly speaking, the government is being forced to embrace the productivity problem, and is doing its best to confront aspects of the housing problem, without being able to do enough.

Let’s look at productivity first. This is about production and income per hour worked. Since unemployment is now low, and immigration is looking less attractive, increasing productivity is the key to raising incomes, and, above that in my view, to raising taxes. Weak tax revenues lie behind austerity – the cutting of public spending to levels which are now unsustainably low. The government is forced each year to spend extra money to fix some crisis or other brought about by austerity. This time it was Universal Credit and the NHS. Next year it will be police and prisons, after that it will be schools and student loans. And so it goes on – this is no way to build for the future. The government could try to raise taxes, but this is so politically unpopular that not even the Labour Party is talking about it – they persist in thinking that there is easy money to be raised from big business, rich people and confronting tax evasion. So growth it must be, and productivity must rise. But productivity is stuck in a rut. The big news for this Budget is that at long last the Office for Budget Responsibility has given up hoping that there will be a bounce back, and so reduced its forecasts of income growth, which are used to set tax and borrowing assumptions. The Chancellor, Philip Hammond, talked about fixing this, as all politicians do, but in practice has done very little about it. Labour, for all their huffing and puffing, are no better. Both parties propose a number of sensible small things, like increasing public investment and education, but nothing that gets to the heart of the issue.

So the political class have chosen to embrace slow productivity, by their actions if not their words. They are right, though they need to think through the consequences. My take on the productivity puzzle is different from pretty much everybody else I have read. I think that the primary cause is what economists call the Baumol Effect. The problem is not the failure of British businesses to embrace improvements, but the limited demand for goods and services that are susceptible to advances in productivity, such as manufacturing. There are things that can be done to raise such demand, but these mainly have to do with increasing incomes for those on low incomes – people with high incomes consume less as a proportion of income, and spend more on low-productivity items that confer status. Also if demand for exports could be raised, and imports diminished, that would help – international trade is mainly about high productivity goods. But nobody really has much idea how to deal with these problems beyond tinkering at the edges with minimum wage adjustments and such.

So what of housing? What, exactly, is this about? It is about high costs to both buy housing and to rent it. This is a very complex problem with deep roots. Most analysis is superficial, but this article in the FT by Jonathan Eley is a good one. Among a number of interesting points he makes is that the low number of new housing units being built in recent decades compared to earlier ones is a bit misleading. In those earlier decades a lot of housing was being destroyed: slums and temporary housing for victims of bombing in the war. It is not necessarily true to suggest that the problem is that too few houses are being built. In fact there are deep structural problems with the housing market. One is that private borrowing has been made too easy; another is that changes to housing benefit has subsidised demand for private rental accommodation. The result of this and a number of other things has forced up the price of land relative to the housing  built on it, and made trading in land central to economics of private sector developers.

The upshot of this is that it is hard to see any solution to the housing problem without a substantial intervention by the state to directly commission house building, and social housing in particular. Another issue is building on greenbelt land outside cities, which is now forcing suburbs to turn business premises into housing, and turning suburbs into an unhealthy housing monoculture. Caution on greenbelt building is warranted, of course, as suburban sprawl, as demonstrated in so many countries in the world, is not desirable either. Mr Hammond did practically nothing on either of these critical issues. He did try to tackle the housing problem, but mainly through the private sector and private markets which are structurally incapable of making things better for the growing proportion of the population weighed down by excessive housing costs.

That is entirely unsurprising. Solving the crisis, especially in an environment of low economic growth, means that current levels of house prices and rents have to fall. That is a direct attack on the sense of wellbeing of the Conservatives’ core constituency: older and better off voters. And if that isn’t enough, property developers and others with a vested interest in the current system are showering the Conservatives with money. A politically weak government is no shape to take this on.

And that, I think, is the most important political fact in modern Britain. Housing costs are not an intractable problem that we must learn to live with, like productivity. One day it will solve itself in an immense period of pain as land prices, and much of the financial system, collapses. The sooner it is tackled the less the pain will be. Labour may be useless on productivity, but they are much stronger on housing. They have a much better prospect of doing something useful. That does not mean they will win the next election – the forces of darkness on the right should not be underestimated. But it does mean that Labour is looking to be the lesser of two evils.

For my party, the Lib Dems, this is important. It means its stance of equidistance between Labour and the Tories needs to be modified. The turning point, in hindsight, should have been that moment in coalition with the Tories when the then Chancellor George Osborne said that he could not support the building of more council houses because that meant more Labour voters. The coalition should have been ended then and there. Just as in the 1990s when the Lib Dems leaned towards Labour, the party needs to accomplish the same feat now. It is much harder because Labour has abandoned the centre ground. But that is where the country is at.

Can Britain afford to abandon austerity? Maybe

Perhaps only Brexit is a more important political issue in Britain than austerity – the policy of restraint in public spending that is causing acute stress in parts of the public sector. It might surprising, therefore, that the quality of debate is so low as to be nonsensical. But then again, when things get important, truth is the first casualty. So let me attempt a dispassionate overview.

First let’s look at the case made by government supporters in favour of continued austerity. This runs at the level of household accounting. The government is outspending the revenue it collects. This means it is piling up debts which future generations must pay. How irresponsible! “There is no magic money tree,” says the Prime Minister, Theresa May. But one of the first things you learn in economics is that running a government budget is nothing like a household one. And the government does have a magic money tree – it’s called the Bank of England. It is perfectly safe for a government to create money to pay its own bills, in the right economic circumstances. Japan has being doing this for a couple of decades. Plus spending government money in the right way may generate the means to pay it back – through bringing spare capacity into the economy, or through investing in projects that generate a return. Or even both at the same time. The case made by government ministers is simply irrelevant. But that doesn’t make them wrong.

The case made by the left has more economic sophistication – and it is even nominally supported by authoritative economists like Joe Stiglitz, an American Nobel Laureate (who wrote a useful textbook on public economics). The main argument they make is often referred to as “Keynesianism” after the great Liberal economist Maynard Keynes, who offered it a the time of the Great Depression in the 1930s. Keynes pointed out that if there is spare capacity in the economy, such as during a recession, extra public spending will not displace other activity, and it will (or should) therefore cause the economy to grow, and pay for itself. But this argument is made by left-wingers regardless of the economic climate. Find me a trade unionist that has ever, ever said that because the economy is overheating, government spending restraint is required. It’s like finding a businessman who says, in any given economic conditions, that interest rates should go up. They are like barristers making a case, no matter how ridiculous. What should judge and jury think?

Two pieces of evidence may be offered in favour of Keynesian expansion now. First is that economic growth since the great financial crisis of 2007-2009 has been lacklustre, and behind many of Britain’s peer economies. Surely it needs a kick up the backside? Second is that inflation is low and looks stuck. Actually, inflation has been creeping up a bit, but that is due to the pound falling. Pay inflation – surely the critical point in this case – remains low. In classical economics high inflation is the surest sign of an overheating economy.

But two pieces of evidence can be offered against Keynesian expansion. First is that unemployment is at near record lows for recent times, and overall employment is very high (unlike in the USA, there don’t appear to be a lot of people who have dropped out of the labour market and so not treated as unemployed). Second is that Britain has a high current account deficit – at 3.1% of income it is one of the highest in the developed world, though it has been coming down since the pound fell. That means that Britain needs foreigners to pay it in its own currency, or Britons need to acquire foreign currency to finance foreign debts. This means that the country depends on “the kindness of strangers” as the Chairman of the Bank of England put it. Among other things that takes some of the magic out of the money tree owned by the Bank – and is a contrast with money-plucking Japan, which tends to run big surpluses. Money trees need net savings (or current account surpluses) to nurture them, or else their fruit turns bad, as many a horror story from South America will attest.

So there should be public debate around what these pieces of contradictory evidence mean. Unemployment is low, but the quality of many jobs is low – so would people work more productively under the right pressure? Britain has a trade deficit, but most debt (including government debt) is still denominated in Sterling, reducing risks substantially. There is much to explore, but few take the trouble. Easing austerity could simply raise growth; it could cause us to borrow in currencies that the Bank of England can’t print; it could cause inflation; it could simply stimulate more low paid immigration; or nothing much might happen at all.

The important message, though, is that it matters how any extra government money is spent. This rather goes against the flow of the usual macroeconomic debate, which likes to deal in quantities rather than qualities. But if you read carefully you will see that trained economists brought into oppose austerity policies are quite careful about the type of extra spending they advocate. They want more investment. If the government invests in things that generate financial returns by making the economy more efficient and productive, then the question of whether or not the economy is running at full capacity is side-stepped. The Labour manifesto at the general election offered this line of reasoning, and that is doubtless why the likes of Mr Stiglitz felt able to endorse it. Labour also wanted to put taxes up albeit mainly on the rich – which, nominally, at least, should reduce excess demand.

Unfortunately this can lead simply to politicians labelling all public expenditure as “investment” – a favorite trick of former Labour Prime Minister Tony Blair. We need to look at matters case by case. What if the government gave NHS employees a pay rise, which some say they are due after years of pay restraint? Some of the extra money would come straight back in taxes; some would be spent creating demand which might help local economies to grow. But some might be spent in businesses that will just put their prices up; some might simply be saved (which has no short-term economic impact) or spent on things like foreign holidays that just add to the current account deficit. Unless balanced at least some extent by tax rises the economic case for this looks unconvincing (where those tax rises should fall is not a simple question either…). But there are other benefits to increasing pay. Would it make it easier to recruit and retain top quality staff that would make the service more efficient? That mean the service could run on fewer temporary staff and make cost savings by heading off medical complications? Well that’s the key, and it depends on strong management. These benefits don’t just happen.

But what of devoting more money to public health? If done properly, this will head off demand for health services, and reduce the costs of poor health elsewhere in the economy. The case for funding this from borrowing is much easier to make. A similar case can be made for schools funding – though again this depends on good management (though personally I am more confident of that in schools than in hospitals, if only because the former are much simpler to run).

There is a lot of extremely interesting debate to be had around the economic implications of different sorts of public spending. Would forgiving student debt be a financial catastrophe? Or might it provide an economic boost in exactly the right places? We need some dispassionate analysis.

Instead we have a Conservative Party that will not engage in arguments of any economic sophistication, and is allowing some of its cost savings to do lasting damage to society. And though the Labour Party understands this, it seems uninterested in the discipline that will be needed to ensure that extra government spending and borrowing does not drag the economy down, rather than boost it. Each party is sponsored by advocacy groups who think that the overall outcome for the country is somebody else’s problem. Such is modern British politics.