UK economic policy – thinking liberal

An economic storm is coming – could this favour the Lib Dems?

Image: Whoisjohngalt, CC BY-SA 4.0 https://creativecommons.org/licenses/by-sa/4.0, via Wikimedia Commons

A bull market ends when the last bear has been beaten into submission. It felt that way last autumn. In 2020 I was astonished when, after an initial fall in response to the emerging covid crisis, financial markets bounced back and then became positively buoyant. How was this a rational response to the the catastrophe enveloping the world? But the bull market just went on.

Then last autumn I started to read articles suggesting that investors must fundamentally re-evaluate asset prices upwards. The argument was based on the idea that interest rates were fundamentally lower than historically, so we shouldn’t be using historical comparisons of yield and other such ratios, which were pointing to over-valuation. This felt a lot like the last bear caving in. There was certainly something crazy about financial markets at the time – shown not least by the craze for crypto-currencies. All this was reminiscent of the insane world of the tech bubble at the end of the 1990s. Loss is the new profit, and so on.

There is something very odd about the way the interest rate argument is used to justify high valuations. The logic is superficially soound. Anybody with a training in finance is familiar with valuation models based on a discount rate – which is the rate you should receive by investing your money in a zero-risk alternative. The lower the discount rate, the higher the valuation. But lower interest rates also suggest low rates of return on investing your money. So how is that investors get richer when returns fall? Common sense would suggest that a world in which the risk-free rate of return on investment is near zero (or negative after inflation) is one that is going to hell in a handcart. Something, somewhere is not making sense. In fact we should be expecting profits and rental incomes to stagnate or fall, and this should undermine valuations.

But asset prices are not set by the use of logically rigorous financial models. They are set by the laws of supply and demand. The modern economy is generating a lot of funds for investment, but there is an unwillingness for investors to use this for good old-fashioned projects that might generate a cash surplus at a future date. That leaves too much money sloshing around in bank accounts or low risk assets such as government bonds. That keeps low-risk returns down, and it also means that banks are willing to loan money at low rates of return. This generates demand for assets that might generate a return at expense of risk (though still not those boring real-economy projects, apparently). This does not necessarily lead to an asset-price bubble: investors could just be more patient. But it clearly has.

Central banks can do something to restore order by pushing commercial banks to raise interest rates, in their role as their regulator and the banker’s banker. For the last three decades they have chosen not to, using various arguments either to deny that there is a bubble, or to say that it isn’t their job to act against it – instead focusing on consumer price inflation and unemployment. It is difficult theoretical terrain, but it is hard not to see politics and the vested interests of the finance industry behind this.

What bursts bubbles? It is when the funds dry up and more people want to sell riskier assets than buy them, while demand often exceeds supply of less risky assets, causing a scramble. This is usually the result of chickens coming home to roost – high risk investments carry a high risk, after all. The great financial crisis (GFC) of 2007-09 was started by defaults in the US property market. It doesn’t help that in the modern world “funds” is a fluid thing and not the movement of fixed quantities of money as we might intuitively expect. This gives scope for chain reactions that can be global in reach. In the GFC this was truly spectacular and served to expand a minor crisis in US sub-prime real estate into a global banking catastrophe. That was the result of uncontrolled financial engineering across developed economies in the previous decade. There was something of a Ponzi scheme collapsing – but to this day supporters of Britain’s Labour government, which was an active supporter of the country’s role in building the Ponzi scheme (aka world-class financial innovation), insist it was nothing to do with them because it was all about US real estate.

The asset price bubble is clearly bursting now. The proximate cause is inflation, causde by widespread disruption to the supply side of the economy – which I discussed last week. Amongst other effects this is causing central banks to radically change course. Interest rates are starting to go up – though not by very much so far, given the levels of inflation. Perhaps more immediately threatening to markets is that Quantitive Easing (the central banks buying up bonds to keep long term interest rates low) is now moving into reverse. This upsets the balance of supply and demand in asset markets. Meanwhile the convergence of disasters affecting economic supply, from the war in Ukraine to covid in China, are clearly destined to make the world poorer, and this affects how people value assets.

The burning question is just how big will this financial crisis get, and what will its consequences be? I will focus on the UK – as we may find that things unfold quite differently in different countries. On the one hand the financial system is not as dangerously wound up on itself as it was during the GFC, limiting the chain reaction. The world banking system does not look in imminent danger. On the other hand, the outbreak of inflation knocks away one of the props upon which the financial system has been based for 30 years or so – the prospect of ever-lower nominal interest rates. This suggests that the crisis will be slower but longer-lasting. The most sensitive part of this is house prices. In the GFC prices dived rapidly as the financial system froze over and it became very hard to arrange mortgage finance. But conditions quickly eased, and prices bounded back. This time it looks as if nominal interest rates will rise steadily and may well stay up. This will impact new mortgages rather than existing ones, as most mortgages these days are fixed rate. So prices are likely to decline more slowly, but the effect could last longer. It is hard to tell about the wider economy. It depends n the state of business finances. If a harsher financial environment causes widespread bankruptcies, we could experience a significant recession. Otherwise things will be much slower moving and the economy will experience a long period of doldrums.

What will the political impact of these be? The accepted story of politics since the GFC is that the crisis provoked a backlash against metropolitan elites, which were seen as having caused the crisis and escaped its worst impact. It was the political right which managed to exploit this the best, with the rise of populist policies. In Britain this focused on Brexit. The Conservatives were the ultimate beneficiaries. Politically the old liberal elites have taken a pounding, though, and they are not such an obvious target for a backlash. An obvious culprit for the trouble is Brexit but the main opposition parties, Labour and the Lib Dems, are reluctant to invoke the B-word. Their sense is that Britons (especially the English) are reluctant to re-enter the polarisation and political warfare set off by the referendum in 2016. They were accused of trying to overturn a democratically fair decision, and many politicians in these parties have taken this message on board. Anyway, both parties want to win back voters who supported Brexit, as well as those who do not want to reopen the wounds.

But as yet I do not see a clear alternative line of attack. What should the government be doing to face the crisis that it is not? It is not obvious to the public whether the answer is more or less austerity. Swing voters tend not to been drawing non-pension benefits, which look inadequate. As yet there does not seem to be a tide of anger about the failure of the state pension to keep up with inflation. Immigration has failed to present as a burning concern to most. The opposition has to content itself with complaining that the government is incompetent and out of touch. But the public has to be convinced that they would do a better job.

But the point is that public anger is likely to gather pace, and it will attach itself to something – but we don’t know what yet. Where will angry, property-owning former Tory supporters go? Labour has not been positioning themselves for these voters since the departure of Tony Blair in 2007; it may forgotten how to. This could yet be a propitious moment for Lib Dems, who are increasingly focusing on this demographic. They have been courting these voters in by elections and local elections, with some spectacular successes. It is early days. No clear national narrative is emerging from the party. But it is too early for that. They need to understand how resentment at failing house prices and a stagnant economy translates into specific demands. But for the first time in a long time, the period the party spent in coalition with the Conservatives in 2010-15 might be an asset. From the vantage point of 2022, with some selective memory, many Tory voters might remember this as a golden age.

Levelling up from a government that won’t let go of centralised power

Last week Michael Gove, Britain’s cabinet minister for “levelling up”, published a white paper to set out government strategy, building on what had hitherto been not much more than a slogan. It attracted predictable howls of derision, not all of which were deserved. If it is disappointing it is because it presents no real sign of challenge to Britain’s highly centralised political culture.

The good points about the strategy are its ambition, and is aim to make levelling up, or equalising geographic opportunities, a central priority across all government departments. There are two main areas of public criticism. Firstly that there is not much public money attached to the transformation process. Secondly that it advances the idea of political devolution within England only a fraction. I have some sympathy with the government on the first count. It is clear that the problem of regional inequalities has deep causes, and it is not just a question spreading public investment more equally. And yet this all most people want to talk about. We need to move the conversation on. The second criticism is much more pertinent. The Economist suggests that the policy is reminiscent of the Labour government led by Tony Blair and Gordon Brown from 1997 to 2010: the introduction of regional mayors to provide a new, more local focus for policy coordination, combined with a lot of centrally designed targets and centrally controlled pots of money for local bodies to bid for. Serious devolution would entail local revenue-raising powers, something that is clearly still as much anathema to Whitehall now as it was back then.

I will come back to why I think that matters. But first I want to take issue with the way that government policymakers, and many of those that critique them, like the journalists at The Economist, are thinking about regional development. And that centres around productivity. To them the central problem is low productivity in English regions outside the South East, and Wales – the picture is a bit more complicated in Scotland. By this they mean a concentration of better-paid jobs and profitable businesses in the South East. That is fine as far as it goes, but their suggestion is that this needs to be corrected by making regional businesses more efficient and productive. But what if the main problem is that more productive businesses (i.e. the most profitable ones, or those with best-paid employees) are attracted to the South East. If you improve the productivity of a business in Yorkshire, say, you may find that all that happens is that it moves to near London, or outside the UK altogether, or at least the more profitable elements of it. Often this happens through the business selling out, especially hi-tech businesses.

Regular readers of this blog will know that I have huge reservations about the way most economists think about productivity. They are guilty of a fallacy of composition, by assuming that the way you manage an individual business is analogous to the way you run the whole productive side of an economy. This is ironic because economists love to complain that the public suffer from a similar fallacy about household budgets and the national budget. An economy contains a wide variety of businesses with different rates of productivity, as economists measure it. Some are more susceptible to productivity improvement than others. Some are positively inimical to productivity (consider status goods, for example). As productive businesses become yet more productive the resources released tend to move to less productive businesses. This is well-known to economists as the Baumol Effect (or Baumol’s Cost Disease), which doesn’t stop them from ignoring it.

So the key question to me is not why regional businesses are relatively unproductive, but why well-paid jobs tend to gravitate to London and its environs. Political connections are surely part of the answer. Decisions over the allocation of vast public resources are made there, to say nothing of decisions on laws and regulations, and taxes. Physical proximity makes a big difference to the political influence you can wield. That is why countries with more devolved decision-making (my favourite example is Switzerland – but the same applies to Germany) have more equal regional productivity, and why small, independent countries often perform better than non-central regions in large countries. Yorkshire isn’t physically or culturally very far from Denmark or the Netherlands after all, but income per head does not bear comparison. The Irish Republic has overtaken the initially more developed Northern Ireland. The government’s proposed reforms will do very little to change London’s gravitational pull. Regional politicians still will have to travel there to bid for the new funds on offer, employing London consultants to hone their bids to match the fashionable ideas and buzz words that hold sway there.

Still, that can’t be everything. The British regions have suffered enormously from the collapse of old industries, devastated by the march of technology and globalisation. There may be interventions that can push back against this tide. Universities are amongst the few bright spots of regional development. The South East has very strong universities, especially if you include Oxford and Cambridge, which are on the edge of the Midlands, but no monopoly. Perhaps more regional centres can be established for medical research, surely a promising avenue for the country, based on these universities and local NHS institutions. Better intra-regional transport would surely help. Better transport links to London, on the other hand, are more ambiguous in their impact. But such initiatives would be easier to get off the ground if local leaders were not constantly having to appeal to London for permission to proceed, but something could still be done.

An interesting question is whether the green economy can be used to promote regional development. Renewable energy has a strong regional element, but its impact on jobs looks quite limited, especially compared to the old fossil fuel industries. Can a change in focus in agriculture, to turn the land into a carbon sink, generate a healthier rural economy? This must surely be a critical part of any zero carbon strategy. This is interesting because it might entail a reversal of agricultural productivity, as conventionally measured anyway, as some of the interventions could be more labour intensive. Agricultural productivity has always been a prime driver of economic development, as workers are released from the land to work in factories. But we are now appreciating its huge hidden costs. There would be a rather wonderful symmetry if the development of a more sustainable post-industrial economy involved reducing nominal agricultural productivity. It is not incompatible with improving wellbeing, though attitudes to the consumption of “stuff” and, indeed, meat, would have to change. It entails placing a financial value on environmental assets.

Such ideas seem far away from current government thinking, though some ideas on agricultural finance are starting to move in that direction, and have also been promoted by Mr Gove. It is one of the few positive possibilities arising from Brexit, as agricultural reform in the EU proceeds at a snail’s pace.

Meanwhile some good-old fashioned “levelling-down” should not be ruled out. This means taxing excess wealth and high incomes harder, and using this to make investments in regional infrastructure. That, at least, is something Britain’s highly centralised government infrastructure is well-designed for.

The Tories must choose between lower taxes or the NHS

Discontent in the British Conservative party goes beyond frustration with the erratic leadership style of Boris Johnson, and his low poll ratings. Many feel that the government is failing to deliver on a distinctly Tory vision of how to run the country – one that is business-friendly with light regulation and low taxes. Shadow leadership contenders, the Chancellor Rishi Sunak, and Foreign Secretary Liz Truss are both trying to capitalise on this discontent. But there is no way out, which is why Mr Johnson may yet limp on until the next election.

Item One in this discontent is the government’s covid strategy. Many Tories feel that it is too heavy-handed and too beholden to cautious experts. Leave the public to make up its on mind on precautions and take the consequences, they suggest. Their thinking is plainly muddled, and out of touch with most voters, but at least as the virus morphs into something a bit less deadly, so policy can move on in their direction.

Item Two is Brexit. In Tory eyes this was meant to be a great liberation from bureaucracy, which would allow “buccaneering” British business to achieve its full potential. And yes, one prominent Tory did use that word, referring to licensed pirates on the high seas back in the 17th and 18th centuries, at whose modern equivalent the Russians’ advantage is surely unassailable. In fact businesses have been mired in even more form-filling, associated with imports and exports to the European Union, which surrounds the country, and is thus its readiest partner for both. Some remember that it was much simpler back in the 1960s before Britain entered the Common Market – failing to understand how the world has moved on. Meanwhile rolling back regulations has been happening at a snails’ pace, as the regulations were more than a bureaucratic whim, and aimed to achieve a public good – which has to be achieved in an alternative way. Downing Street has resorted to pointing to crowns printed on beer glasses and the changed colour of passports as among the main achievements of Brexit. And that is before the insoluble problem of Ireland is brought into the picture, ever capable of exploding with dire consequences. In fact most Brexit voters, including the former Labour-voting ones that Mr Johnson so successfully courted in the 2019 election, never much cared for deregulation as a reason for Brexit. They wanted to see more restrictive immigration policies – which the Tories have indeed delivered. But that has brought more bureaucracy, and snarl-ups due to labour shortages. Tory MPs’ business friends are not particularly happy, even as Tory voters are now a lot less worried about the issue.

And Item Three is taxes. They are going up, both corporate taxes and national insurance, levied on people in work and their employers. This is nominally to pay for grasping the nettle on the emerging social care crisis, but in fact the money will disappear into the National Health Service, which has been completely disrupted by the covid crisis, and now has massive backlogs for routine care. The Tory discontents say that above all they should be a party of lower taxes (especially on businesses and the rich, sotto voce) – and that this is a betrayal. Mr Sunak hints that if it was left to him, he would be cutting taxes soon. Most people outside the Conservative Party wonder if he can possibly be serious. With little room for manoeuvre on the budget deficit and national debt (and if you don’t think such things are relevant, high inflation suggests fiscal excess) the only way this vision can be delivered is by cutting government spending.

At the heart of this is rising spending on the NHS. Since the party regained power (in coalition) in 2010, the government has attempted to cap NHS spending so that it just about kept pace with inflation. But as the baby boomers age, and skew the ratio of older people, demand has been rising at a higher rate. The financial pressure has caused system resilience to be reduced, and this is one of the causes of the now alarming backlogs. Tory hopes that NHS costs are containable are based on two fallacies and a misconception. Fallacy One is that demand can be met through making the service more efficient. Any user of the service can point to inefficiencies in this massive, bureaucratic behemoth of an organisation. But that comes with the necessary scale and complexity of what the healthcare sector is trying to do – international comparisons show that Britain’s health services are amongst the world’s most efficient. But these same comparisons also show that in many areas Britain’s health services less effective. We are, to quote The Times columnist Matthew Parris, “getting a second-rate service for the cost of third-rate one.” This is not what the public wants, and further cost restraint is liable to mean the service becoming third-rate all round.

Fallacy Two is that faster economic growth can allow spending to keep up with demand. Alas the headwinds against growth in a modern, developed economy are many, and I have written about these many times. That demographic problem that is stoking up demand is not least among them. Besides there is plenty of evidence to suggest that the wealthier people become the more demand there is for health services. Which leads me to the misconception: which is that excess demand for the NHS arises because it is free. That suggests that there should be ways of persuading the public to make do. But the problem is that the effective NHS monopoly on health care limits supply. Other systems are much better at mobilising private money – and where they do, demand is higher, not lower. A large and growing healthcare sector is one of the features of any modern, developed economy, however it is financed. Resisting it will breed discontent.

That points to an answer. If Britain could move healthcare to a public insurance model, such as the Netherlands or Australia have, the public would both get a guarantee that their basic needs will be met, and the mobilisation of private money to pay for a world-class service. I have been to Australia quite a bit over the years – and one thing I hear very little of is discontent with its health system. And Aussies know how to be discontented. But such a shift, as surely almost all Tories know, is an impossibility. For all its faults, the public has become attached to the system. And trying to mix more private money into it would be seen as a betrayal of its ethos. Doing this as a open public policy is clearly suicidal. But doing so by stealth, by restraining the public service while allowing the private sector to grow, is problematic too – although exactly this has happened to dentistry and optometry already. If wealthier people are paying big taxes for a service they don’t use, it will create discontent, and reducing their taxes will starve the public service, making it even worse. Neglect of the NHS under the Conservative governments of 1979 to 1997 was one of the reasons that support for the party collapsed in the 1990s. And one of the reasons that Mr Johnson did so well in 2019 was by promising to invest a lot of public money in the NHS, amongst other public services.

But people can pay more tax. Taxation in Britain is not especially high by European standards. If the system is well-designed the harms can be limited. Tories will have to embrace this, unless they want to challenge the public shibboleth of the NHS. Instinctively many Conservative MPs understand this, and they may realise that Mr Johnson represents the best way of postponing this awkward choice, and they may well let him muddle on.

What Conservatives should be doing is developing a new vision for the 21st Century that embraces higher taxes and a well-funded NHS at the heart of a flourishing health economy, based on world-leading health research and development. This is perfectly credible, unlike world leadership in buccaneering.

Now is the time for austerity

Contrary to some of the headlines, yesterday’s British Budget was an austerity budget. Its aim was to bring current spending and taxes into balance in three years, with a capital deficit restricted to 3% of GDP. With the current budget deficit at around 11% of GDP, that is a sharp contraction. The Institute of Fiscal Studies points out that most households will be worse off next year. The ratio of tax to GDP is widely projected to be the highest since the years of postwar austerity. Austerity is what current economic conditions demand. The main risk is that it will not be enough, and that it will precipitate a recession in the run up to the next general election.

That the Budget felt the opposite is down mainly to brazen but effective news management by the Chancellor of the Exchequer, Rishi Sunak, and also to a stroke of good fortune. The main bad news was the substantial rise in National Insurance, alongside the withdrawal of most of the emergency support for Covid, notably an uplift in Universal Credit and the furlough scheme. This news had been broken weeks ago, and presented as in the former case a bold stroke to deal with the growing crisis in social care, and in the latter as the coming to an end of the pandemic nightmare. The stroke of good luck was that the independent Office for Budget Responsibility that produces the economic forecasts on which the Budget is base offered a more optimistic picture of the years ahead than hitherto. It charted a rapid recovery from the pandemic with a reduced level of long-term damage. The country is indeed rapidly recovering from the shutdowns that disrupted the economy, making the furlough scheme in particular redundant, and this does improve the economic statistics – but beyond that this all chaff. The tax rises have little to do with the social care crisis; rising prices mean that the Universal Credit cut is causing hardship; economic forecasts have a paradoxically backward looking methodology which makes them very unreliable. Mr Sunak has navigated these treacherous waters cleverly, but what does this all mean in the cold light of day?

Austerity, by which I mean the squeezing of the government deficit by raising taxes or cutting spending or both together, has a bad name at the moment. In this country it is attached to the policies of the Conservative/Liberal Democrat coalition of 2010 to 2015, after the Great Financial Crisis (GFC), and to the following Conservative-only government. The crisis had shredded government finances, but its aftermath left economic demand weak. Economists pointed out that in these circumstances it was usually wise to loosen government finances, not tighten them. Years of hardship and lacklustre growth bore this analysis out. The defenders of austerity stuck to economically illiterate but intuitively appealing arguments, making an analogy with prudent household budgeting and the idea of protecting future generations from debt. There was a literate defence of government policy to be made, at least up to 2015, but practically nobody made it – I was a lonely voice (Lib Dem Business Secretary Vince Cable also made a valiant attempt). This put the blame on the unbalanced nature of the economy before the crisis and the need to restructure it. But even I (and surely Vince) thought the austerity was overdone, especially with regard to public investment. Meanwhile the literate economic critique gave the left their opening to demonise “Austerity” as vicious crime against humanity. Loose fiscal policy and economic growth came to be seen as two sides of the same coin.

Given that experience, it was natural to respond very differently to the next economic crisis, brought on by Covid-19. Government coffers were immediately opened up with a number of very generous schemes to support individuals and businesses. These were successful in alleviating a lot of hardship – though economists making comparisons between different countries have struggled to draw a connection between fiscal generosity and the scale of economic damage. Britain’s government was one of the most generous, but many others suffered less economic damage. That, though, is more a reflection of poor management of public health than the economic policies. Also Britain was coping with a further disruption: dropping out of the European Single Market and customs union, and the implementation of tighter immigration controls – which collectively I will call “Brexit”. All the same it points towards a greater truth: this crisis is very different from the previous one, and that affects the economic response.

In retrospect the remarkable thing about the GFC is that it affected the demand side of the economy more than supply. Important though it may be to the functioning of the economy, the financial sector at the centre of the crisis did not have such a big impact on the “real” economy – relatively few jobs were directly impacted, and a lot of those were saved by narrow but generous government intervention. What it did was to increase the level of net saving by making it harder for people to borrow, while at the same time the shock stopped businesses from investing. Increased saving paired with reduced investment is the very definition of a Keynesian recession, to which the public policy response should be to loosen fiscal policy.

But the problem this time is very different. Demand is alive and well; the impact of the crisis on jobs has been muted, while the lockdowns have allowed many people to accumulate savings that are now available to spend. Supply, however, and especially in Brexit Britain, has been hit hard. This is particularly evident in trade and logistics, and also in energy. The problems are global, but Brexit has added an extra dimension in Britain, especially as many foreign workers went home as the lockdowns took effect. This was what the economy demanded at the time, but these workers are reluctant to come back, partly, but not only, because of immigration controls. In the last two decades Britain has relied on two safety valves to regulate its economy: imports and immigration. Mismatches in supply and demand have been met through both – and in particular the fact that the supply side of the British economy is relatively weak. Now neither is working properly – or rather they are only working in one direction – to accommodate reduced demand, as in the early stages of the pandemic, but not its increase. The result is visible: inflation.

Government politicians and economic forecasters shrug the problem off. The problems are temporary, they insist. Once more ships are back plying the seas and containers located in the right places, and businesses have adapted to the changed environment, then it will be business as usual. But this is complacent, and especially so in Britain. It reminds me of the early stages of the GFC (and has resonances with what I read of the oil shocks of the early 1970s); the crisis was evident by mid 2007 when the uncertainties arising from complex derivatives linked to the US housing market caused international interbank markets to freeze up. At the time (alas before I had started blogging) this was scary enough for me to sell all shares in my pension plan and invest in index-linked gilts. But most people were in denial, supported by the usual backward-looking economic data, which showed th problems to be limited. The metaphor I used at the time was of a ship holed beneath the waterline desperately sailing for safety. That metaphor works less well this time, but the problems with supply look deeper than most people are allowing. And in Britain the changes following from Brexit are long-term. The Prime Minister, Boris Johnson, cheerfully talks about the economy responding to the difficulties by restructuring to become a high-skill high-wage one; he is even encouraging people to push for wage rises. But such changes take time and investment – and meanwhile all putting wages up does is encourage a wage-price spiral. We have thrown away the stabilisers on our bicycle without having learnt to ride it unaided. These are exactly the conditions where governments should reduce overall demand by applying austerity.

What happens if the austerity is not enough? This was the topic of my last post. Inflation gets stuck at a high level; interest rates go up; hardship spreads across Middle England (and Scotland and Wales) and property prices dive; the costs of government spending go up. Recession follows. Most Government supporters seem to be in denial. The smarter ones (and I suspect that Mr Sunak is among them) hope that with clever footwork they can time the next election in a sweet spot while people are feeling good from inflationary payrises before the devastation strikes, perhaps supported by a (reckless) tax cut. But at least there is some appreciation that austerity needs to be the direction of travel. Alas the left have not caught up with this fact, ever unwilling to acknowledge that economic policy depends on context.

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.