UK economic policy – Page 8

Is austerity an economic failure or a fact of life?

The British Labour Party conference proved a bit of an anti-climax. After the excitement of the last week’s Scottish referendum this was probably inevitable. All the more so since the Labour leadership did not want to talk about the important issues that referendum has raised on for the British constitution. But this conference marked in important stage in the evolution of the Labour leadership’s policy platform. They have finally, publicly and unequivocally accepted austerity as the centrepiece of their economic policy. This is rather muted, of course. The right wing press, who still set the country’s news agenda, do not want to give Labour any credit for this. Labour’s left wing supporters still think that austerity is a failed economic strategy, promoted by a “neoliberal” elite as a means of shrinking the power of government. These supporters do not want to be too vocal this close to a General Election; besides they were soothed by some diversionary promises regarding Britain’s National Health Service (NHS) and the minimum wage. But this left wing critique of austerity bears further examination.

It is expounded with some clarity in today’s Guardian by the journalist Seumus Milne: Austerity has failed, and it isn’t only Labour’s core voters who want change. To start with Mr Milne points out that Labour’s core voters, working class people, are unhappy and Labour can’t take them for granted. In Scotland they defected en masse to the SNP’s Yes campaign – and its claim that Scottish independence meant that they could roll back austerity. In England Ukip is making inroads into Labour’s core vote. Labour can’t simply take these voters for granted and then go after the “centre ground” voters who are liable to be swayed by the right wing press. This is perfectly true, of course, but not very helpful in its own right.

He then goes on to the familiar critique of austerity (cutting back public expenditure), which is that it has failed both in Britain and elsewhere in Europe. In Britain, growth is based on shallow foundations: unfunded consumer expenditure; average living standards are still sinking and many poorer people are suffering real hardship. In other European countries, notably France, there is no growth at all. This critique builds on that of Keynesian economists. In the earlier years of the government’s austerity programme they suggested that by cutting demand, or refusing to stimulate it, austerity simply created a doom-loop of shrinkage – or failed to ignite a virtuous circle of positive demand. The cuts were simply too early. This critique was eagerly seized on by the left. The trouble is that in Britain it has been overtaken by events. Growth has returned, mainly as the result of increased consumer borrowing, but also through higher business investment. There is not need to use public money to stimulate the economy further. Now is the “later” that the Keynesians were talking about when they said the cuts should be made later. It is does not matter that the initial spurt of growth was based on shallow foundations, as Keynesian fiscal stimulus is open to exactly the same criticism.

In fact the government’s application of austerity never lived up to the rhetoric. The cuts have been relatively modest, and as a result the deficit (excess of government expenditure over taxes and other income) has not been reduced by anything like as much as the original plans. The government finances still look very shaky and unsustainable. To a large extent things have been propped up by the Bank of England buying up government debt (“Quantitative Easing”, or “printing money” as some economists would have it). This only works when inflation is not a serious threat, and the Bank has indicated that continued purchases are no longer sustainable.

Things get worse when you look at the details more closely. The Economist points out that the country’s tax revenues are not keeping up with the country’s growth rate, making the deficit harder to cut. The reasons are not entirely clear, but two contributory factors should cause those on the left to worry. The first is that the government has been rapidly advancing tax free allowances, a flagship policy of the Liberal Democrats. This has helped relieve the economic pressure on the oft-forgotten marzipan layer of Britain’s poor. Those who are working and do not qualify for state benefits. But it also means that if wages are stagnant the government sees little benefit from growth. The second, related, factor is that Britain’s tax take is heavily dependent on the very rich. The Economist says that the top 1% of earners are thought to contribute 28% of income tax receipts. The position of other taxes may not be so very different. That means that pressure on the very rich, and notably the banking sector, is choking off tax receipts. All this suggests that raising taxes without hurting the ordinary working classes will be very difficult to achieve.

The serious economic case against austerity is not quite dead, though. The FT’s Martin Wolf, for example, suggests that prolonged fiscal (and trade) deficits may be required to counterbalance the insistence of some countries, notably China, to run export surpluses, and so create a surplus of savings. But his suggestion is that state funded investment is the best way of achieving this, not the continued propping up of the benefits system and a high volume of public services. That still leaves the most painful aspects of austerity intact.

The fact is that some very powerful forces, global and local, are bearing down on economic growth. These include demographics, the evolution of the Chinese economy (reducing the supply of cheap exported manufactured goods – so important to developed world living standards in the 1990s and 2000s) and (perhaps) by a focus amongst the slightly better-off on quality of life rather than income maximisation. It was once thought that any well-functioning developed economy could grow at 2% a year. That now looks infeasible. Which makes the management of government debt (and private debt for that matter) a serious long-term problem. It gets worse, as to achieve any sort of growth requires the economy to become more efficient, not least in public services. This involves the sort disruptive changes that the left’s core supporters hate most of all.

To be fair on the left, though, one of the causes of low growth is the excessive accumulation of wealth by the very rich – and this can only be tackled using an agenda that looks leftwards. But chasing down this wealth is increasingly a global problem, that needs global solutions, and not socialism in one country. This is ironic, as one of the symptoms of working class disillusion is a rejection of internationalism. It is no coincidence that the right wing press is happy to undermine international institutions, though.

Mr Milne calls for some kind of post capitalist economic reform, with increased state intervention. It is hugely unclear what this reform agenda would comprise, and whether it could work. The last country to vocally reject capitalism was Venezuela, whose oil wealth allowed it to cock a snook at the capitalist world. That is ending in utter economic and social disaster. Starvation and oppression in North Korea, and terminal economic stagnation in Cuba offer no better way forward.

The world is changing, and many Britons hate it. But with large trade and fiscal deficits Britain must embrace change or face economic catastrophe. That is the truth that Labour’s leaders are facing up to – and it is not a spineless surrender to the forces of big business.

The revenge of the 50-somethings. Is this why productivity is sinking?

Last weekend I met up with a number of other 50-somethings. Only one of us was still working. The universal advice to her was that she should stop as soon as she could. It wasn’t worth it. Anecdote is no substitute for serious analysis, but it can offer some interesting insights. Economists usually ignore the idea of satiation – that enough is enough – because this wrecks their mathematical models. But it is a growing fact of life in the developed world, and one reason why it is unrealistic to expect everlasting economic growth.

Of course, many 50-somethings are not as lucky as me and my friends. They have inadequate pensions and other savings; they are forced to keep working, and may well have to do so long after their state pension kicks in at 65 to 67. There were two common factors to our group: no children and property ownership – though by no means all of us had had well-paid jobs. There are plenty of others in the same boat, even if we are a minority.

What was striking was how we had found that work had become demoralising, across a spectrum that covered high-flying project management through to ordinary clerical. And looking for new jobs is even worse. The youngsters are pushing ahead, with all their politics and superficiality. Competence and people skills are devalued compared to bluff and fast-talking. Age prejudice is rife in recruitment markets, but impossible to prove case by case. Such sentiments are largely “grumpy old man” (though most of us were female…), rather than substantive; no doubt our predecessors felt the same about us. But work used to be the centre of our lives, providing us with purpose, a social life and the wherewithal to consume.

But now we’d rather move on. Even if that means constraining our consumption somewhat – though our generation are the ones sitting on high value property, which helps quite a bit. We will retire early if we can. Many of us are winding down, into part-time work, often thinly disguised as self-employment. This pattern of reduced work level can continue until well into the 60s and even beyond.

Is this showing up in the economic statistics? This is difficult to say. Overall workforce participation is increasing, including the older age groups. This suggests that the number of people who have dropped right out of the workforce is less than those who struggle on after retirement. But the number of self-employed has been rising sharply, and we have what economists call the productivity puzzle. Labour productivity is not rising in the way technological progress suggests it should. Perhaps the winding-down of the 50-somethings is part this.

Economists stress about this. They had assumed that steady economic growth, arising from improved productivity, was simply a law of nature. When growth fails to materialise, they condemn this as a policy failure, looking to fiscal or monetary policy to correct it. But when low growth arises from free choices made by the public to produce and consume less, this is not a policy failure. But it does create policy problems – especially over the affordability of debt. It would be better for all if economists would stop whinging and help us to understand and address these policy challenges. Low growth future is here to stay. Because that’s what people want.

Why Labour are losing the election in 2015

According to press chatter, there is mounting worry amongst those that surround Ed Miliband, the leader of Britain’s Labour Party. I don’t know anybody in this elite circle, and I can’t offer an opinion on whether this is true. What I can say is that it should be. After ducking hard choices when the going was good, he is now in real trouble.

The immediate cause of the Labour wobble, if that is what it was, was the poll bounce for the Conservatives after the recent Budget by the Chancellor, George Osborne. The previously secure Labour lead simply vanished. This poll bounce disappeared as quickly as it came. Clever charts showing that it was part of a longer-term trend look premature. But it did show that Labour support is not solid, and that the Tories are not quite as terminally unpopular as many suggested.

But what really convinces me that Labour are in deep trouble is this exclusive piece in yesterday’s Independent, highlighting an article Mr Miliband had written for the paper. Here’s the first paragraph:

Ed Miliband has promised to rescue Britain’s struggling middle classes by boosting their living standards as he warns that the “cost-of-living crisis” will last for at least another five years.

This seems to be part of a bid by Mr Miliband to rebuild his electoral standing; today he is launching a policy about devolving more power to “super-City” regions, building on a policy developed by the Liberal Democrat leader Nick Clegg, as he will not say.

This political drive builds on two themes that Mr Miliband has been developing. The first is “the squeezed middle” – a deliberately vague reference to people who feel they are neither favoured by government handouts, nor part of the rich elite. It is interesting that this seems to have migrated to “the struggling middle classes”, when it might just as easily refer to working classes (if you get beyond the bureaucrats’ tendency to use the term “working class” to refer to people who are not working, and entitled to state support, as an alternative to the word “poor”). The second idea is “the cost of living crisis”, referring to the fact that for most people incomes have not increased as fast as prices over the course of the last government.

No doubt Labour’s polling shows that these ideas cover a large swathe of generally unhappy people, who might therefore be sceptical of the government’s record. The problem is how to appeal to them. Almost by definition, these people are out of the scope of state benefits. In fact they tend to resent the size of the state benefits bill, apart from the old age pension, whose cost they tend to underestimate. They are not employees of the state, a separate and distinct constituency, even if they share some of the same problems). So how to address their standard of living? There are two ways: tax cuts and a stronger private sector economy. On both counts Labour’s credibility is behind that of the Coalition.

The best sort of tax cut to reach the squeezed middle is a cut to personal allowances, i.e. the point at which people start to pay tax (including its National Insurance equivalent, something all parties seem happy to ignore). But the Coalition has already been increasing this quite aggressively, mainly at the expense of higher rate tax payers, some of whom are now claiming to be part of the squeezed middle too. Worse, it is one of the few policies that is closely identified by the public with the Liberal Democrat part of the coalition, which Labour is extremely keen to denigrate – they have picked up a lot of ex Lib Dem voters. They have floated the idea of a 10% tax band, which is just a less efficient way of delivering the same policy – and has uncomfortable echoes with one of the last Labour government’s policy mistakes.

There is an even bigger problem with taxes. Labour has to convince voters that it will not put taxes up to pay for an expanded state. That means signing up to a series of things, like a cap on benefits expenditure, that will be unpopular with core Labour voters, and not even particularly sensible from the point of view of economic management.

But tax cuts are a fairly minor palliative. What would really cheer voters up is the prospect of incomes rising in the private sector. The trouble is that Labour has done nothing to dispel its reputation for being anti-business. Quite the opposite. Mr Miliband’s view is that there are good businesses (“producers”) and bad ones (“predators”). Wages are being squeezed by the predators to benefit their top managers and shareholders. So his anti-business policies are directed at these predators (banks and energy companies to the fore), while helping the producers. This argument is not entirely without merit, but it is a tough sell. And in practice it is pretty much impossible to create policies that discriminate successfully between the two classes of business, and all those that inhabit the grey zones in between. The result is that Labour’s policies designed to address this problem, such as the devolution to the cities, don’t look as if they will deliver much of a boost to wages in the short term – even if they are perfectly sensible. And sensible policies are liable to get matched or pinched by the coalition parties anyway.

The Conservative counterattack to Labour will point to the fragility of the current economic recovery, and say “Don’t put all this at risk”. Of course one thing that could put the fragile recovery at risk is the Conservative plan for a referendum on the EU. But does Labour want to go out with all guns blazing on that issue? Perhaps I underestimate Mr Miliband, and that is his plan. But so far he is happy for Mr Clegg to take the lead on the issue. In fact you could not inaccurately describe Labour’s emerging strategy as “I agree with Nick”. A liberal, centre-ground stance that wants more devolution from Westminster, but with a strong attachment to the EU.

So Labour is embarking on an impossible task to convince the electorate that it can out-do the coalition parties at their own policies. This won’t work. But what it will do is to de-motivate their core constituencies of public sector workers and the squeezed bottom, as I might call the voters suffering from benefits cuts.

The trouble is that Labour hoped to get the best of both worlds after Mr Miliband was elected. That they could adopt a “Blair-lite” strategy that allowed an appeal to the centre ground, while at the same time harnessing the wave of anger from their core voters at the government’s austerity policies, which, incidentally, allowed them to harvest a lot of Lib Dem voters. But Blair-lite lacked credibility as soon as the economy started to revive. There was a choice to be made for either Blair II, an unashamed dash for the middle ground, including an apology for the record of the last government’s economic policies (though that would have been too much for Mr Blair himself). Or they could have gone for unashamed social democracy, making a case for higher taxes, a bigger state, and less aggression on cutting the deficit (isn’t going for a balanced budget just willy-waving after all?). The first of these two choices might well have destroyed the party, given the depth of anger over “The Cuts” – but the second choice was never properly debated or confronted. It would have been perfectly respectable and courageous – even if expanding the state back to the size it was in 2008, or even 2010, would have taken a very long time.

The Conservative General Election campaign has not got started yet. They will allow Ukip their moment of glory in this year’s Euro elections, then quietly mug their voters by stoking up fears of Labour. Labour’s credibility will fall apart, and they will have increasing trouble fending off Tory attacks and keeping their core supporters loyal.

If I was advising Ed Miliband, I would be worried.

Pensions, savings: sensible steps forward

This week’s UK Budget has revealed the usual muddle amongst politicians, journalists and the public over the whole issue of pensions and savings – with opinion strongly favouring several flavours of having your cake and eating it. This masks some profound and sensible reforms carried out by the coalition government.

First version of the cake. We like people to save. But we want them to spend to promote economic growth. We worry that a large part of the population will become dependent on the state and taxes because they save too little. But when they do, as in the early part of the 2008/09 crisis, we bemoan that fact that people aren’t spending and so causing economic slump. So interest rates crash to the floor in an attempt to reduce savings and increase consumption (alongside the vain hope that companies will be encouraged to invest more).

Next version. We want people to save more to not be dependent on the taxpayer, but we also want target state spending on the less well off, and tax the rich to pay for it. So we encourage people to save, and then confiscate the proceeds.

Another version of this is that we love the idea of exempting pension saving from tax but think that people who have accumulated sufficient savings for a reasonable pension (a million pounds for a pension of £35,000, for example) are part of a rich elite whose broad backs should carry the largest burden.

There is a genuine dilemma at the heart of this of course. For that reason a lot of hope resides in get-out-of- jail-free cards. One of these is strong economic growth. But that requires lots of people to work – which means retiring later and allowing immigration. We are clearly entering an era of low growth, thanks to demographics, personal preferences (i.e. people choosing unpaid leisure over work) and the changing nature of technological advance and the global economy. Remarkably few people have tried facing up to the consequences of this. Even some intelligent economists think that “trend growth” is a law of nature. Another get-out-of-jail-free card is that rising property values will compensate for lack of saving. Collectively this cannot make sense, but it has worked for many individuals, who therefore don’t engage with wider worries about the future.

Now let’s consider some difficult facts. I have already mentioned that economic growth is likely to be much lower in future. The next difficult fact is that private pension saving has collapsed in the last 25 years. Generous final salary schemes have been replaced by inadequate money-purchase schemes. It is now use just blaming Gordon Brown’s tax raid on pension schemes in the later 1990s for this (or Mrs Thatcher’s ill advised liberalisation of pension selling before that) and some are prone to do when you mention this. This at worst mildly accelerated a growing trend. The economics of businesses supporting these pension schemes became toxic even without the tax changes. This means that, as a generality, most people will not now have adequate private sector pensions. Instead as they approach retirement they will have accumulated a few tens of thousands of pounds in probably several schemes.

The next difficult fact is that the economics of long-term saving are toxic for all but the very well off (liquid assets of over £0.5m, say). The poor face the prospect of losing entitlements to state benefits if they accumulate wealth. Everybody will see any savings eaten away by costs which, even without a host of rip-offs, will always weigh most heavily on those with smaller savings. It becomes perfectly rational for a lot of people to not to bother with pensions savings – unless you count trying to own your own home.

When you consider all this, the attraction of tax funded state pensions become clear. That is why the current government has been right to make it reasonably generous, notwithstanding criticism form the right that we can’t afford it. It was also right to make this pension independent of private saving.

Now, what about the tax treatment of savings? To simplify, there are three groups of tax privileged savings. The first is domestic property. To buy your own home you pay out of taxed income and stamp duty on the purchase price, but the gain is exempt from tax. The second is Individual Savings Accounts (ISAs), which, like property, are paid for out of taxed funds (subject to an annual limit) but income and capital gains are tax free. And third are pension plans, for which contributions are exempt from income tax, but it is taxable on drawdown.

The first and last of these are problematic. Domestic property because its tax exempt status has made it a highly attractive investment – but instead of this fuelling much in the way of building new, efficient property, it has simply driven prices up, making ownership out of reach for many younger people and driving a wedge between families with property and those without. Pensions are a problem because that particular route for providing tax exemption makes for maximum complexity. In fact they have become so hedged about in rules that most people don’t understand them.

ISAs, on the other hand, have an elegant administrative design which makes them easier to own than even taxed assets. They also have more chance of channelling investment into more productive parts of the economy.

Here’s why this week’s proposed reforms make sense. Currently money purchase pensions are forced to buy annuities, except in some carefully crafted circumstances, which tend only to apply to the better off savers. The original fear behind this annuity rule was the worry than pensioners would blow their savings quickly and then throw themselves into the arms of the state. But the state of private pensions is such that most people will rely on the state anyway, and most pension pots are so small that the amount of income that would be derived from an annuity would be derisory (and, presumably, a lot of value would be lost in administration costs). And those with larger pots are likely to be prudent with their wealth. If done properly, this will simplify the pension system, and make private pensions more attractive.

Extending the ISA allowance is more controversial. Many simply view this as benefiting the wealthy, as nobody else can save up to the £15,000 a year limit. There is some truth to this, but it will help level the playing field between financial investments and owning your own property. Since it is unthinkable to tax capital gains on homes, it may help to make other assets comparable in their tax status.

A lot of nonsense has been uttered as commentary: fears over people blowing money on cruises and fast cars – or rushing into buying property. My main worry is that the reforms will make it easier for better off people to save for their children, to pass on at death. This could reinforce the effect of inherited wealth, which is already growing. There may be mounting pressure to reduce Inheritance Tax.

But overall this looks a sensible step forward – and actually quite brave. It is surely no accident that unlike its predecessors the current government’s Pensions Minister, Steve Webb, really knows his stuff, and has been kept in post for the whole period. Liberal Democrats can take pride that he is one of theirs. There is strong political consensus in his reforms, and no party political benefit. But it is nice to feel that our party has contributed something useful to the process of government.

Re-shoring: good news that does not make us feel better

The British economy is perplexing economists. The economy as a whole is growing but we as individuals don’t seem to be any better off. Unemployment tumbles but pay stays rooted to the spot. This is called the “productivity puzzle”. Added to this puzzle is the phenomenon of “re-shoring”: the reversal of offshoring, the process by which manufacturing and services were migrated abroad, typically to China or India. David Cameron, the Prime Minister, made a speech promoting it last week. It is worth stepping back to think through just what is going on.

After all, when offshoring was popular, in the years of the Labour government from 1997 to 2010, it was hailed as a good thing in the long term, worth a little disruption in the short run. It meant that prices for goods and services were kept down, and therefore our collective living standards improved. Looking at the components of retail price inflation in the 2000s told quite a startling story: prices of manufactured goods were actually falling. Locally produced services could advance in price by 4% or so, and the Bank of England could still meet its 2% inflation target. That 4% reflected the advance in average pay – so advancing living standards were largely explained by lower priced imports. Offshoring was a very important part of this phenomenon.

And this conformed very neatly to the elementary economic theory of Comparative Advantage, first explained by 18th century economist David Ricardo, and part of any first-year economics course. This says that the benefits of trade arise from differences in opportunity cost, or comparative advantage, and not actual cost, or absolute efficiency. The Chinese had a comparative advantage in basic manufacturing; Britain had a comparative advantage in high-end services. So, even if British workers were more efficient than Chinese ones in basic manufacturing, it still made sense for Britons to import from China – and both countries drew benefits. Trade between the developed and developing world follows the predictions of Ricardo’s theory very closely. And supporters of globalisation, like the Labour big beast Peter Mandelson, pointed this out endlessly.

But economists rarely follow through the logic of Comparative Advantage. If two identical economies have identical opportunity costs for different goods, there are no gains from trade (not on the basis of this theory, anyway). Trade arises from differences in the shape of economies. Since developed and developing economies are very different, big gains from trade are to be expected. But what happens as the developing economy starts to catch up with, and resemble the developed one? The gains from trade reduce. I have taken the trouble to work this out with a crude model of a developed and developing economy. The catch up process is marked by an appreciation of the developing country’s exchange rate, so that it converges with purchasing power parity. The interesting thing is where the loss in gains from trade falls. The developing economy becomes more productive and efficient, so its losses from reduced trade are made up for by gains in productivity. But for the developed economy, there is no corresponding level of compensation; the gains from trade disappear and the economy is worse off as a result.

And this is exactly what seems to be happening now. China and (in a rather different way) India are catching up; their exchange rates appreciate relative to ours. Their wages rise faster than ours. The gains from trade disappear, and it is the developed countries (us) that pay the price. Re-shoring is simply part of this process. The great gains from globalisation prove to be quite temporary, in this respect at least.

But as China and India catch up with the West and Japan, won’t other developing countries take their place, just as China and India took the place of South Korea and Taiwan? Vietnam, Indonesia and African economies stand ready. But these emergent economies are as interested in dealing with China’s and India’s vast economies as they are with the developed world’s. The world is rebalancing and the old economies of the west cannot expect to stay in the driving seat.

So, what’s the bottom line? I think re-shoring is one of the factors that explains Britain’s productivity puzzle. We had outsourced lower productivity jobs abroad, and they are returning. It is good news for employment, and will help balance the country’s trade. It will make the British economy more sustainable. But it will not make us feel any better off.

Britain’s improved growth points to more government austerity

The UK economy has improved dramatically in the last six months. This is one of the most important developments in British politics. This week’s good news on employment is just part of a wide spectrum of measures showing the economy’s improving health. Economic commentary, with its narcissistic obsession with monetary policy, has concentrated on the implications for interest rates. But a more important question I whether the economy’s recovery is sustainable. And the answer to that seems to be… not yet. And while it isn’t government austerity has to be the priority.

The political debate around the economy has focused on the wisdom or otherwise of the government’s austerity policies, designed to fix the country’s massive gap between public expenditure and tax. The Labour opposition suggested that there should be less austerity, and even some temporary tax cuts to try and push the economy into a virtuous circle of growth. But the country is now embarked on just such a virtuous circle without the need for any fiscal stimulus. Additional private consumption is the main cause of this stimulus, according to the latest bulletin from the Office of National Statistics (ONS). This shows that the Labour policy might well have worked (i.e. that a bit of stimulus could set off a virtuous circle), though in the event proved unnecessary.

So intellectually developments have far from proved Labour wrong. But they are the big political losers. Labour’s policy might have been sensible in the circumstances, but they also suggested that the Coalition’s policies were doomed to failure, which has proved not to be the case. It gets worse for them. This level of growth undermines the case for any reduction in austerity polices – which could cause inflation. And yet their hard-core supporters have been rallying to the idea that the cuts in government services and benefits are ideological and unnecessary. Labour have switched their attack to the cost of living, which is still running ahead of personal incomes, but this too runs the risk of being undone by events. Politics is a momentum business, and all it would take is a general improvement in wage levels before the election in 2015 to sink their propaganda offensive. Their poll lead has already shrunk.

Meanwhile press attention has switched to the Bank of England, which has embarrassingly been taken by surprise by the growth spurt. It is not long ago that it suggested that unemployment would not fall to 7% until 2016 – we are nearly there now. I find the focus on monetary policy very irksome though. It allows commentators to pontificate well inside their comfort zone, and talk about short-term developments in financial markets. But, as longer term followers of my blog will appreciate, I think that the usefulness of monetary policy is exaggerated, and the theory behind it has been comprehensively shredded.

Instead the big question should be sustainability. Mainstream economic commentators don’t seem to be that concerned by this. Their analysis is based on the idea that sustainable growth depends on whether or not growth exceeds the trend rate. This trend rate, about 2% per annum, is the average rate of growth since the 1950s, and is primarily driven by a steady increase in productivity. Up to 2007 the UK economy was neatly conforming to this trend. Then the recession hit, putting it well behind the trend rate, with a lot of catching up to do. This sort of commentator often mentions a large gap between the current size of the economy, and what it would have been if it had stuck to the trend – with the implication that this gap is a matter of policy failure. Chief amongst these commentators in my eyes is the FT’s Martin Wolf. In a recent article he dismissed the idea that growth up to 2007 was unsustainable.

This is macro blindness: a failure to question the neat patterns created by aggregate economic statistics. In my view the UK economy cannot sustain a growth rate as high as 2% in the long term, hasn’t been able to do so since perhaps 2000. The reasons are demographics, the changing impact of technology, and a reversal of the gains from trade achieved with the rise of China and India. The main evidence, not mentioned by Mr Wolf in his article, was provided for me in a lecture in 2007 by Professor Wendy Carlin, my economics tutor at UCL. It is the combination of an appreciating real exchange rate and a wide trade deficit. This provides an illusion of growth, but it is not supported by the advances in productivity that are required to sustain growth in the longer term. It was not fashionable to say this at the time, but it proved prophetic. Productivity, incidentally, is an almost impossible factor to measure satisfactorily, and can only really be inferred indirectly. It is my feeling, not sustained by hard analysis, that a lot this growth illusion was from the reduced costs an increasing amount of goods, and some services, bought from China and India, and an important element of that trade deficit. This boost to the economy had “temporary” and “reversible” written all over it.

And the bad news is that the current spate of growth has suspiciously similar symptoms. The trade balance reported by the ONS deteriorated from under negative 2% of the economy in mid 2013 to over negative 3% in November (the latest data). I don’t have direct figures for real exchange rate (a rather tricky calculation), but sterling has appreciated since a low in about March. There seems to be no offsetting productivity gain, since employment figures have been very positive (a very good thing, in spite of some economists moaning about productivity). So we’ve just reverted to the unsustainable growth patterns of the early 2000s, without the benefit of cheaper imports to sustain living standards.

What, of course, we need to see is a rebalancing of the economy to something more sustainable. This will show through in increased levels of investment (still low) and a stronger trade balance. The confidence engendered by the recent spurt of growth may help with this. Meanwhile the government’s austerity policies need to be strengthened, if anything – otherwise the economy will be even less sustainable. Grim news for politicians of all persuasions.

Inequality should be at the heart of the economic debate

Today the eminent US economist Larry Summers writes in the FT. His subject is the US economy, but the problem he addresses affects most developed economies in some shape or form, and the British economy quite closely. Unfortunately, so many economists of his generation, an obsession with short-term macroeconomic theory means that he doesn’t seem to get the big picture. Inequality lies at the heart of our economic malaise.

This debate is being conducted by academic economists in their own language, but it matters to all of us. I will summarise. Mr Summers’s starting proposition is that the US economy is suffering from “secular stagnation”. What this means is that the economy is stuck in a pattern of slow growth that does not fulfil the potential that population growth and advances in productivity should give it. This certainly seems to be true, though I think that the ability of developed economies to grow consistently at 2% per annum, the “trend rate”, must be subjected to critical analysis, rather than simply assuming it can be continued indefinitely because it has been achieved in the second half of the 2oth Century.

Mr Summers then says that there are three basic ways of trying to tackle this. First is “supply side” reforms; this means trying to fix fundamental bottlenecks in the economy, such as education. Worthy though he says these ideas are, the problem with this is that it does not fix a lack of demand in the economy; there is no point in producing more if nobody buys. This line of reasoning is very much behind the Keynesian critique of austerity economics. While there is a certain logic to it, it sounds too much like saying these problems are too much effort to fix, so let’s try something else – which is a road to nowhere. It used to be that economists blamed politicians for being too short-termist; now it is the other way around.

The second strategy is to loosen monetary policy. The problem is that monetary policy in the US (and the UK) is technically very loose as it is. I say technically, because in some respects monetary policy is quite tight in fact (because banks are reducing their balance sheets) – though there is little the authorities can do about it. Further loosening of policy (as advocated by the likes of Paul Krugman, for example) will simply inflate bubbles and get us back to the fix we found ourselves in 2007. He is surely right here – though I would add that I think that monetary policy is massively over-rated as a policy instrument by conventional economists anyway.

The third strategy is to use government spending to keep up demand, preferably by spending on infrastructure, that will be of long term benefit to the economy. He also says that governments should try to persuade the private sector to spend more, by which he mainly seems to mean the corporate sector to invest more.

The problem I have with this is its superficiality. The “secular stagnation” problem Mr Summers describes is a serious malfunction of the economic machine. This can be seen most clearly if you follow Mr Krugman’s logic. He says that the way out is to reduce interest rates to the point at which investment gets stimulated. And since interest rates are currently low, that means that we should have an effectively negative rate by stoking up inflation a bit. In other words, he is saying that the problem is that profitable investment is impossible, so we need to encourage investment that is marginally unprofitable. How on earth can an economy grow on that formula?

Surely we need to spend a bit more time getting to the bottom of exactly why are in this fix, and then trying to direct public policy to fixing it. Here I follow another prominent US economist: Joseph Stiglitz (or I think I do). The culprit for lack of demand in the economy is quite clear: it is lack of investment, especially from the private sector. You can make up for this shortage of investment by running government deficits, but you are in trouble if this is more than a temporary measure. The problem is that there is systemic reason for the shortage of private sector investment, which running government deficits does nothing to fix. It is rising inequality. Big surpluses are accumulating in some parts of the economy: in the personal wealth of the very rich, and on company balance sheets. This is not being spent on investment, but being held in cash to spend later, or chasing a merry go round of assets, real estate and shares, whose overall quantity is not expanding.

There are two problems here: inequality and the fact that savings are not translated into proper investments. The first of theses is the more fundamental. The Economist published an interesting article on the subject, reviewing the work of a French economist, Thomas Piketty. They point out that the inequality problem has been with us before: in the period up to 1914, giving rise to the critique of Karl Marx, amongst others. Mr Piketty thinks that developed economies are reverting to the 19th century type. The problem is slowing population growth, combined with technology that makes it easy to substitute people with machines. If he is right, the problem is not about to go away. It is the central political question of our time.

So what are the answers? First of all we need to tax the rich harder. Given that so much wealth ends up in slippery multinational networks, this means international cooperation. It also means rebalancing industry and jobs so that we are less over-supplied with unskilled workers. The pressure on the finance industry, especially investment banking, needs to be maintained. All this means reversing the conventional wisdom of the Ronald Reagan and Margaret Thatcher years – but not a recreation of the failed policies that preceded them.

This is an agenda of the left. It will be vigorously opposed by the right. Perhaps at long last the consensus that has ruled developed world politics will break up. But economists like Mr Summers do us no favours by concentrating on palliatives rather than solutions.

Labour can win in 2015. A disaster beckons in 2020.

Is it just me, or can I see a certain spring in the step of Britain’s national politicians? Ever since the party conference season last September they have been focusing on one thing above all: winning the General Election due in May 2015. The perplexing state of the country is now simply a source of ammunition to batter the other side. Actually solving the problems can be left until afterwards. What a relief!

The Labour leader, Ed Miliband, is having the better of it, if the relentlessly superficial media chatter is to be believed. This is quite a turnaround, since the same chatterers had him as toast as late as August. He has abandoned his party’s “too far, too fast” criticism of the government’s austerity policies, which helped rally the faithful (and rattle Lib Dem activists) but cut little ice with the country at large. The recovery of the country’s economic statistics has not invalidated their argument, but it has made it far too complex a proposition to argue, especially since their rhetoric had placed far too much reliance on these “flatlining” statistics in the first place. Instead they are focusing on living standards, and things, like fuel bills, which affect them.

From a campaigning perspective, this change of tack is astute on at least two counts. First, it appeals to direct personal experience, rather than the ephemeral world of economic statistics, to which the country’s GDP growth statistics belong. Second, it is such an intractable problem that the government is unlikely to be able to neutralise it. All that remains is to find some eye-catching policies to embarrass the government and keep the political debate on their ground. The centrepiece of this is the pledge to freeze energy prices for two years if Labour takes power, while they put in place a longer term fix to limit the damage inflicted by the greedy energy businesses they blame for the problem. A second push has been to enforce a “living wage” significantly higher than the legal minimum wage, through government procurement, and a tax break for employers who raise their wages.

In this line of attack Mr Miliband is the first of our national politicians to make political capital out of one of the most important developments in the British economy, along with many other developed economies, notably America’s. For the majority of people, wages are not keeping up with growth in the wider economy. In Britain this trend was clearly established, I read in this piece by Chris Giles in the FT, 2003/04; since 2010 (i.e. when the current government took over) wages have not even kept up with average prices. The benefits of growth are going to mainly to a privileged elite, while government interventions tend to be focused on the other end of the spectrum: the very poor. While the main economic issue is slow growth of pay, the main flashpoints are in taxes (especially for things like fuel) and energy costs.

There is, however, a snag. How on earth to actually fix it? This does not seem to bother Mr Miliband too much. His policy proposals are at best ineffectual, and at worst will actually make things worse. In the field of energy Britain is being overtaken by a crisis, as old nuclear and coal-fired power stations are shut down, and replaced by renewable energy sources that place wholly different strains on infrastructure. What the country badly needs is investment, in new capacity, and, especially, in distribution infrastructure (e.g. moves towards a “smart grid”). Just how Labour’s attack on the energy companies is going to solve this problem is, to say the least, unclear. And, if some of what I read is true, the pressure will break out into real problems in two or three years time. Labour’s living wage policies are no better thought through. Using government procurement to do heavy lifting in this area, along with many others, risks weighing it down with compliance costs – a process that tends to push out smaller businesses, as well as inviting scandal and fraud. The tax break looks totally unsustainable and an invitation to unscrupulous companies to manipulate the system.

The Conservatives are planning their counterattack. There is growing talk of 1992 (which this blog has long been banging on about), when a well-funded late campaign destroyed what had seemed to be an inevitable Labour victory. They will focus, probably, on frightening voters about the economy and taxes; their newspaper allies will concentrate on personal attacks on Mr Miliband to undermine his credibility as a prime minister. The Lib Dems are crafting a “centre ground” campaign, no doubt hoping to benefit from the damage the big parties will do to each other.

I have urged my readers not to underestimate the Conservatives. That advice still applies. But my current instinct is the Labour will weather the storm enough to form a minority government. That is when Mr Miliband’s problems will start. The country will face electricity shortages; clever schemes to enforce the living wage will unravel; living standards for the majority will stay under pressure; Labour activists and trade unionists will be on the government’s case to raise benefits and expenditure. The calamity that has struck Nick Clegg and the Lib Dems will visit Labour, for very similar reasons. I understand Labour’s strategy for winning in 2015; how on earth are they going to win in 2020?

Can we learn from the 1930s?

Liberal Democrat conference goers are shaping up to a confrontation in three weeks’ time over economic policy. On the one hand the leadership wants to defend the current coalition government’s record; on the other many activists feel that this policy has been a dismal failure. This confrontation has been brewing for some years. It reflects a wider controversy in the country at large, though one senses that most people are now moving on. In this argument it does not usually take long before the government’s critics refer to the experience of the 1930s recession, or Depression, to back up their case. It’s worth unpicking that a bit.

My main source on this is a pamphlet produced by the think tank Centre Forum: Delivering growth while reducing deficits: lessons from the 1930s by Nicholas Crafts published in 2011. This concentrates on the experience of the UK. The first thing to point out is that the UK experience of the Depression is very different from the US one, though they are often conflated when people refer to the Depression now (just as the current experiences of the UK and US get conflated, especially noticeable when critics of UK policy quote U.S economist Paul Krugman in their support). The U.S. suffered a banking collapse, which then caused a catastrophic collapse in the rest of the economy, with real GDP falling by as much as 36% (hitting bottom in 1931); it only got back to its 1929 level in 1940. Behind the US collapse was a structural transfer of economic activity from agriculture to manufacturing, which it took the war economy to complete. Britain’s crisis was much less severe; it suffered a major loss of exports and economic shrinkage, but no banking collapse. The economy hit bottom also in 1931, just over 7% down from 1929 and was back to 1929 levels in 1933; by 1940 it was over 20% ahead. By comparison with the U.S. the structural move from agriculture to manufacturing was much more advanced when the recession struck. Britain was, however, struggling to adjust to a world where it could not rely on its Empire to drive its economy.

In fact, after flatlining in 1930 and losing over 5% in 1931, the UK made rather a successful recovery from the recession, as Mr Crafts (a professor of economic history at Warwick University) points out. This was achieved in spite the government cutting expenditure and raising taxes – austerity policies in today’s talk. Mr Crafts is very clear as to why: loose monetary policy. Specifically interest rates where kept low, and the authorities persuaded people that inflation would be persistent (at about 4%), giving negative real interest rates, while the pound was allowed to devalue. Something similar happened in the U.S in the New Deal era. Mr Crafts suggests that this formula should be repeated now, if the Bank of England could credibly suggest that inflation would increase to about 4% for the medium term, instead of its 2% target. This is quite topical, as this is almost exactly the strategy of the current Japanese government, the so-called “Abenomics”.

One point of interest in this is the rival claims of “Keynesians”, who advocate fiscal stimulus (extra government expenditure) and monetarists, who advocate loose monetary policy – though quite a few, like Mr Krugman, advocate both. Both groups refer back the Depression for support. In fact fiscal stimulus was not much used in the 1930s, while loose monetary policy was. Fiscal stimulus only came into its own at the end of the 1930s and in the 1940s, when it was led by rearmament and provoked by fears and then the reality of war.

I must admit that I find the parallels with the 1930s, especially in Britain, to be entirely unconvincing. The one clear lesson I would draw is that a banking collapse, as happened in the US in 1929, can be catastrophic. The world’s authorities were absolutely right to head this off in 2008-2009, even if that leaves awkward questions over how we got into the mess in the first place. That lesson was well learned, but there the lessons pretty much end. Further lesson-drawing leans on a species of macroeconomic blindness, a sort inverse of the composition fallacies that macroeconomists like to accuse their critics of. This entails taking false confidence by examining a collection of aggregated statistics, dipping down only selectively into the realities that lie behind them.

Consider some important differences between the world of the 1930s to the 2010s, for Britain in particular:

Britain’s banking sector was in much better shape in the 1930s. It was less dominated by big institutions (there was a thriving building society movement) and these institutions had not overreached in the way they had in 2008. The main barrier to borrowing was lack of demand for loans, which lower real interest rates incentivised.
There were many fewer barriers to house building in the 1930s. The main source of investment in the 1930s recovery was private sector house building. It clearly helped then that there was a severe house shortage, and inflation encouraged people to bring forward building projects. There is a housing shortage now, of course, and to be fair Mr Crafts says that barriers to house building would have to be tackled. But more than planning barriers are involved here. There is the general zeitgeist around the future direction of property prices; this is largely founded on the idea of restricted supply. Currently developers are holding back on many projects not because of finance, or lack planning permission, but because of doubts over the future direction of property prices.
Nowadays we live in a world of highly integrated financial markets and global trade. This has changed the way fiscal and monetary policy work. It is by no means certain (and in my view highly unlikely) that loose monetary policy would work itself out in such a benign way as in the 1930s. Would inflation in fact increase? If it did would wages stay ahead of prices? And if wages did not stay ahead of prices would companies invest their profits so as to boost domestic demand? (There is a fascinating aside in Mr Crafts’s pamphlet here. In the 1930s the Treasury assumed that prices would indeed run ahead of wages, boosting corporate profits, which would boost the economy. In fact wages kept pace with prices and the domestic demand was behind the growth). And bumping up inflation would quite likely cause the price of government gilts to plummet, making it harder to finance the national debt: in this day and age it is not as easy to inflate your way out of debt as many economists assume.

And that’s just the start. The more you investigate and think about the rights or wrongs of different policies, the less relevant the 1930s looks. It is just as bad for fiscal policy. In the 1930s and 1940s rearmament was a useful outlet. It soaked up surplus labour quickly and led to the building of industrial capacity that, as it turned out, could be readily reassigned to more constructive and benign uses. And the threat of war was horribly real, allowing the public to be mobilised behind the dislocation of the civilian economy. I cannot see what the modern equivalent is. Rearmament now, even if you can find a wider justification, would require the wrong skills and capabilities. The building of social housing is a possibility, I think, but would be insufficient in its own right.

Indeed I think the real issue of substance that divides critics of the coalition from its supporters, among Liberal Democrats anyway, is whether there is a pool of £20 billion or so of capital projects that the government can immediately and profitably get in motion. In the 1930s and 1940s it was weapons. In the 2010s it is what?

The unbearable lightness of British politics

The economic crisis in the developed world drags on, posing fundamental political and economic questions. And yet politicians here in Britain argue about not very much. The Labour leader, Ed Miliband, is currently attracting a lot of criticism for his lack of progress. But the real problem is that the political left has run out of ideas, while the Right complacently defends the status quo. This state of affairs will continue until we learn to look at our problems in a radically different way.

Nobody should doubt that capitalism is still in crisis. We have been cheered in Britain by some better economic statistics. But average wages remain stagnant, and are not keeping up with inflation. Some people are successfully adjusting to a reduced standard of living; others are running down savings or borrowing money. Private and public investment remains weak, and any benefits of a slightly stronger economy mainly accrue to a small minority of the better off, or to anybody that owns land and buildings, along with a trickle of unemployed people who are now finding rather poor quality work. Other developed economies, from the US to Europe to Japan seem locked into variations of the same dilemma: either the economy is stagnant, or it grows to the benefit of only a few people.

It is not difficult to see what the underlying problem is. Globalisation and the advance of technology are killing off industries that used to be the backbone of developed world employment, destroying lots of middle income jobs. We hear a lot about manufacturing industry, but the same dynamic applies to office jobs. There is not the same need for secretaries and administrators, with jobs tending to be either highly skilled (managers, technicians and so on) or else in soulless call centres; and some of those call centre jobs are being automated out of existence. There is a desperate hunt for the better paid careers, and many people have to settle for poorer quality jobs. In Marxist terms, the balance of power has shifted decisively towards capital and against labour. The process started as far back as the 1980s, with only temporary relief provided by the generosity of the Chinese who sold the developed world lots goods for less than they were really worth. Changing demographics adds to the difficulties of managing this problem.

Meanwhile a growing elite of capitalists and professionals are doing very well, but are under spending their incomes. More is being saved than invested, creating downward pressure on the economy as a whole. This is more or less how Marx predicted the end of capitalism. So if the traditional left-wing critique of capitalism is proving better grounded than many thought, why isn’t the Left benefiting?

The answer is that the Left have no convincing alternative to the capitalist model which does not destroy living standards. Marx could believe that common ownership of the means of production would do the trick, but we now understand that this is killing the goose that lays the golden egg. The turning point for China economically was its recognition that it needed a rampant capitalist economy to drive it forward, even if they also see the virtues of a massive state sector coexisting with it. Modern people love the benefits of capitalism, and in particular its constantly advancing technology, and constantly changing fashion – even as they struggle with capitalism’s consequences.

So what to do? There are still many on the Left, especially trade unionists, who think that the answer lies in a big public sector. This can be constructed to provide lots of well paid middle ranking jobs and, it is hoped, put market pressure on the private sector to treat their workers better. This strategy may be called “Sweden in the 1960s”, since that was when and where it worked best. But most appreciate that it is unviable. Sweden’s economy collapsed into a nasty mess after the 1960s. The state sector has no incentive to be efficient, and drags everybody’s standard of living down with it. It creates unbearable pressure on the private sector as they try to compete in world markets. Constant devaluation of the currency might provide some relief, but in the end this leads to hyperinflation and total seizure (think of various South American economies over the years). In Britain the state sector is too large for the current tax burden, so to sustain it requires putting up taxes. This does not look a realistic political prospect.

So what’s left for the Left? Mr Miliband shows a good grasp of the basic problem but has found only lightweight solutions, such as putting moral pressure on big business to behave a bit better. And without any big ideas we end up arguing about not very much. Is the government’s austerity policy slightly too severe? Should we add a little bit of regulation to this or that industry? Or else do we just moan about various symptoms of the malaise, from immigration to the misery inflected on many who rely on state benefits, without offering any constructive alternative?

It’s much easier for the Right at one level. Their sponsors are doing quite well, so they can try to create smokescreens to pretend the problem doesn’t really exist. Some go further to try and suggest that we should place even less restrictions on the capitalist economy – though that line of argument is as discredited as Sweden in the 1960s. But ultimately they will have to confront the same problem: the economy doesn’t work well enough for most of the people most of the time.

And what is the answer to the problems of capitalism? Clearly this isn’t easy. I think we have start looking at our situation in a completely different way. We are stuck on grand policies that can be implemented by governments in London, accruing lots of prestige to national politicians. But this is just sucking power into an elite based in the country’s southeast. Is it an accident that Scotland is now doing relatively better as real power was devolved to Edinburgh? We cannot continue to destroy local networks and hope that people will be better off as a result. This is completely beyond the grasp of our political elite, left or right. But until politicians start to understand that they are part of the problem, not its solution, we are condemned to an unbearable lightness in our political debate.