UK economic policy – Page 9

The GDP obsession

Today initial estimates of Britain’s quarterly GDP figures have been published. It has become a very silly circus. The BBC Today programme was giving it a lot air time this morning, in spite of not knowing what the crucial number was. Instead they made do with economists’ guesses. This is what they usually do, in spite of the fact that the guesses are often very wrong – though this time they were spot on. A much more informative discussion will be possible once the figures are released, and experts have had a chance to root around the detail. But by then it won’t be news, and the BBC won’t cover it. Meanwhile some even more meaningless political posturing is taking place. I just wish economists, journalists and politicians would show a bit of humility on the topic. As a measure GDP is not all it is cracked up to be.

The first problem is that, although it is quite a simple concept in theory, it is very complex in practice, making the implications of movements difficult to understand. In the UK economists have been puzzling over the fact that the current economic downturn (often trumpeted as being one of the worst in history) has not affected jobs nearly as much as previous downturns. This is often articulated as a “productivity gap”, since if income, and hence production, is falling faster than the number of jobs, productivity (production divided by jobs) must be falling. The Institute of Chartered Accountants’ Economia magazine ran a vey interesting article on this (Measure for Measure), which simply asked a whole series of prominent economists what they thought was going on. It was very revealing. Quite a few took a very superficial view, without probing behind the numbers much, speculating a bit, and then launching into some hobby horse or other, such as the need to stimulate aggregate demand, or let companies go bust more readily. But a number had clearly taken some trouble to get behind the numbers to understand what was going on. And when they did this, they picked up a very complicated picture, and they started to worry that the numbers were at all meaningful or accurate. Several speculated that the official figures were understating the level of GDP because they were not measuring some aspect of the economy properly, usually associated with services and new technology. They further speculated that, though GDP was artificially low now, this would be corrected in due course, when artificially high growth numbers would come through.

Another point that came through was that a large part of the “gap” arose from the fact that North Sea oil and financial services had shrunk. These sectors gave rise to a lot of product (albeit largely fictitious in the case of financial services) but not many jobs. Which leads me to a second problem with GDP: it doesn’t measure economic wellbeing very well. If these two sectors shrank, and it mainly affected a small number of very wealthy people, surely we can take its loss with a bit of a shrug? A big problem with the growth before the downturn in 2007 was that it benefited so few people (especially a problem in the US). Median real incomes and unemployment levels tell you a lot more. (There is an interesting article in todays FT by Richard Lambert on this). And, of course, there is the whole issue of wider wellbeing, which depends on the quality of personal relationships, the environment, and so on.

So, where does that leave any assessment of the current state of the British economy? The first point is that, although GDP numbers may not be as bad as we thought, economic wellbeing is not good for large parts of the population. Pay is not keeping up with prices. It is particularly hard for those with public sector jobs or dependent on benefits. A little bit of confidence is returning, and this will be good if, and only if, it leads businesses to invest more. If ordinary people simply decide to save less, and spend more, we will get a short-term lift to economic wellbeing, but it will not be sustainable.

Well, that is my personal view. Optimists, like the Observer commentator William Keegan, who also writes an article in Economia, think that there is a lot of spare capacity in the economy (people who are underemployed, for example, and working part time) so that any lift in demand will be self-sustaining, and that it doesn’t matter where it comes from – his preferred choice being from government, by cutting VAT and slowing down government cuts. Once this capacity is being used, we will be in a better position to reduce the size of government, if that is what is needed to make the economy sustainable in the long term. You hear a lot of this sort of view from professional economists, even very distinguished ones. To such an extent, indeed, that austerity policies are described as “discredited” by many, on the grounds that they have not delivered the steady GDP growth that these economists say is feasible.

Supporters of austerity are gloomier about the longer term economic outlook. The spare capacity highlighted by Mr Keegan and his friends is illusory: it is mainly in the wrong places. The economy before the crisis was unsustainable: too dependent on borrowing and a trade deficit. Furthermore, there are huge headwinds, in particular from an aging population and a workforce that will shrink (though Britain is not as badly off in this respect as many other economies, thanks in large part to a more liberal view of immigration, which politicians now regret). The economy has to be rebalanced and made more efficient: that means destroying a lot of the less efficient jobs, and creating new ones elsewhere. The wrong sort of economic growth will slow this down and simply create a bigger crisis later. There is no alternative to a slow and painful path of adjustment.

It is an old argument, with resonances of that between Keynes and the Treasury in the 1930s. Keynes is usually held to have been right then: the main problem was lack of demand, and it just needed to be kicked into place by government action. Many economists use this as evidence that we should repeat that prescription this time. But the world was a very different place then; there is no equivalent of the incipient manufacturing revolution to sustain growth now.

And this seems to be the biggest cost to an obsession with GDP. It gives economists the illusion that the issues are much the same, regardless of what is happening in the real economy. It is only when you try to get behind the numbers and ask searching questions, that you can start to understand the real policy options. Today’s figures will tell us very little.

Where Keynes and Beveridge turned out to be wrong

The Spring 2013 edition of the Journal of Liberal Democrat History has a fascinating article on the role of Maynard Keynes and William Beveridge in developing Liberal Party policy, culminating in the party’s manifesto for the seminal election of 1945. These men took the party’s thinking decisively into what is now called “social liberalism”. Their vision was inspiring and coherent; much of it is now simply accepted wisdom. But I detect a tendency to treat these men’s ideas as holy writ. But nobody can be right on everything, and the world was changing fast. It is interesting to pick out the places where they got it wrong. This will perhaps help us to reflect on the challenges we face today.

Beveridge (in his report to the wartime coalition government) memorably set out the challenges to society presented by the “five giants” of Want, Disease, Ignorance, Idleness and Squalor. The answer was to extend what we now call the Welfare State, establish the National Health Service, nationalise a series of critical industries (railways, coal and power in particular) and to adopt a system of macroeconomic demand management, which we know as “Keynesianism”. These policies were largely adopted by the subsequent Labour government, albeit with more enthusiasm for their collectivist aspects, and retained by the Conservatives that followed them. The success of their ideas on the wider political stage contrasts with the Liberals’ disastrous performance in the 1945, when Beveridge lost his seat, and the Liberal Party faced extinction – in a crisis that makes its successor party’s current woes look like a picnic. Which only goes to show that winning the battle of ideas and having coherent policies is on a small part of how a political party succeeds.

But what has gone wrong? The Welfare State grew to be a monster of a size that Beveridge would have been horrified at, though it made much headway in combating Want and Squalor. The contributory principle, central to Beveridge’s vision, has largely broken down, with entitlement being based on need rather than past contribution. It has never broken free from the dependency problem, where people don’t have enough incentive to sort out their own problems – an issue that Beveridge foresaw. It strikes me how Beveridge’s system was overwhelmed by the breakdown of the traditional family, and of traditional working class communities. These were inevitable consequences of economic progress, as well as the march of liberal social values. But needs that used to be met within the community were now thrown at the state’s door, and, perhaps, the breakdown of discipline in some communities (about starting families in particular) added to the problem. Beveridge’s carefully worked out system of benefits and entitlements was not equal to the task.

Nationalisation has proved another disappointment. Keynes was convinced that these critical industries would not be managed for society’s overall benefit if they continued in private ownership. He also wanted to incorporate them into his system of macroeconomic management. But the state proved inept at setting strategy, and was often a prisoner of the short term interests of managers and workers. Strategic decisions tended to be made badly, and investment declined. They were all subsequently privatised and, except arguably the railways, have performed much better since. Regulation has proved a much more effective answer than state management.

Keynesian economic management has proved highly controversial, after two major economic crises, in the 1970s and now. But it is clear that widespread adoption of Keynesianism has moderated the economic cycle, and this has been of huge benefit. We have to accept though that it cannot deliver full employment sustainably unless the overall economy is in the right shape. In the 1970s it was too dependent on cheap oil. Now it is too dependent on finance and government jobs and funding.

But it is interesting to read that in 1945 Keynes thought that the main means of managing the business cycle was investment. He understood that private sector investment tended to follow the cycle (i.e. increase in the good times, and fall back in the bad – just what we are currently experiencing), and so make it worse. Government investment should counterbalance this – and he wanted to nationalise key industries so that the scope of government investment increased. This just hasn’t happened. Instead the expansion of the welfare state has created a counter-cyclical dynamic (called “automatic stabilisers” by economists) that has proved perfectly sufficient until now, with a few tweaks here and there.

But since the size of the welfare state and government generally is now part of the problem, using it to manage the cycle has hit its limit without the job done. A lot of economists (like Martin Wolf of the FT) now urge that we go back to Keynes’s original idea and increase the level of government investment. But I suspect that the reason why governments did not follow Keynes’s original system, apart from the growth of automatic stabilisers, is that this is much more difficult in practice than in theory. Examples of where it has been tried, such as Japan in the 1990s, and China in the present crisis, are not particularly encouraging. Vested interested and construction businesses close to the government have reaped benefit, leading to wasted investment and a corrupted political system. As a developing country China’s investment needs are huge, so they may still end up ahead, but the case for developed economies is much weaker.

What does this say to us now? The five giants are still with us, although they may not loom as large as they did. But I think the era of grand political projects established by clever men from on high has run its course. What is needed is a reshaping of government to make it more local, participative and people centred. But that is a very long journey.

Nowadays it seems to be the economists who are obsessed with the short term

The relationship between economists and politicians is often strained. It’s easy to think that economists are taking a detached view of public policy and its long term effects, while politicians simply jockey for advantage at the next election. But, strangely, that doesn’t seem to be the pattern right now. It’s the politicians who are urging short term pain for long term gain, while the economists say it can all be left for another day. It is the politicians who have a better grip on reality.

The nature of the relationship between political leaders and economists has changed as economics has evolved. I think it was President Truman in the late 1940s who said he wanted to find a one-handed economist, so fed up was he with his economic advisers saying: “One the one hand this, but on the other hand that”. He wouldn’t have that problem today: there is no species of public policy commentator that is more one-handed than an economist nowadays, so confident do they seem about what they are saying.

In the late 20th century supply-side economics took hold, after the economic traumas and stagflation of the 1970s. This held that the route to economic success was in making sure that markets worked efficiently and government expenditure kept on a tight reign. Economists bewailed the fact that their advice was so often ignored by politicians, who found their prescriptions unpalatable. Only the unelected President Pinochet seemed to take economists at their word, as he implemented a series of reforms in Chile. The expression “politically impossible” was frequently used in discussions of economics. In fact politicians, starting with Britain’s Margaret Thatcher, largely implemented the supply-side economists’ advice, but this was only really acknowledged by most economists after the event.

But things seem to have moved on again. Politicians in Europe, including Britain, are grappling with the size of government in the wider economy, and pushing ahead with supply side reforms. This is hard political work, with scant reward on offer at the ballot box. But do politicians get credit from professional economists? Not a bit of it. Instead austerity policies are blamed for anaemic growth and high unemployment. Scarcely a day goes by without some economist, like Paul Krugman, Martin Wolf or Samuel Brittan thundering away that all this is foolish and bound to end badly: looser fiscal and monetary policies are needed, and the problems of government deficits can be sorted out another day.

What accounts for this? It is tempting to conclude that there is simply a time lag in economic thinking between the academics and the politicians. In academic circles the supply-side mania has run its course. It was always incomplete, and too often, not least during the great economic crisis of 2007-09, it had very little of value to say. Neo-Keynesianism had taken hold, with an updated series of macroeconomic models designed to deal with the issues that arose in the 1970s. The politicians, perhaps, haven’t moved on.

But I think there is a different explanation. It is that the politicians are much more aware of what is really happening in our economies, and the changes that are needed, while the macroeconomists are blinded by their use of aggregate statistics. The politicians can see that there are some fundamental problems with the way their economies are functioning, especially here in Europe. The first problem is that the state has become too large and inefficient. A second is that the progressive aging of populations is progressively weakening economies. A third is that globalisation has changed the rules of economic management. I could add a fourth issue, which is that the world’s financial systems have become dysfunctional, except that I think this is confusing politicians and economists alike, and is not a driver of tension between the two.

Economists agree with this analysis of problems by and large, of course, except that I don’t think that most have woken up to the implications of globalisation, and its profound implications for the way prices and wages rates are set. What the politicians appreciate is that these problems are desperately hard to fix, and that putting off the evil day is not going to help. In particular the central problem is to shrink the state. Politically it is much easier to put through tough changes in hard times, and not when things seem to be ticking along nicely. And if you look at the political forces that seize on what the economists are saying, you will find that they are mainly those that do not see the need to shrink the state at all.

Alongside this disagreement about the best time to reform is an economic judgement. Politicians are sceptical that sustainable economic growth is at all easy to find. Many economists think back to the decade before 2007, when 2% annual growth was more or less taken for granted, and assume with a wave of the magic confidence wand, this growth will come back – and that we might even be able to make up some of the lost ground. Even now I have seen some economists who should know better projecting trend growth before the crisis, to estimate the true cost of the recession. So in the five years since the crisis, the economy should have grown by 10%, they say; in fact it has shrunk by 4% (I haven’t checked that number), so the crisis and bad economic management has cost the economy 14%! But what if that 2% tend growth wasn’t for real? What if it was simply pumped up by borrowing and trade deficits? And what if the progressive aging of the population makes sustainable growth of 2%, or even 1%, unreachable? Blinded by their aggregate statistics, not enough economists are asking these questions, and still less following through their implications. But it is all too obvious to most politicians, and businessmen, come to that.

The gap between politicians and economists isn’t helped by the fact that the former keep using government debt as the main driving force of their argument. This is politically convenient, but the economists rightly spot that it is insufficient of itself. If the economy could readily be kicked back into a 2% growth trend with a bit of fiscal pump-priming, then the debt argument would not hold water. In today’s FT Samuel Brittan accuses politicians of falling for the fallacy of composition: that whole economies work like family budgets. In fact there are deeper reasons for what politicians are doing.

There is further disagreement over investment spending. Many economists think that they have found the magic bullet. Government funded infrastructure investment can both act as a short-term fiscal stimulus while delivering longer term benefits to the economy. So why are the politicians so reluctant to spend more on capital projects, and even cut them back? And yet this is another blinded by aggregates issue. The economists’ argument only holds water if the investment projects actually deliver economic benefits. This is much more difficult in practice than it is in theory. Under the last government investing in hospitals must have looked a sure-fire winner, given the ever rising demand for healthcare services. But we are now finding, as hospitals are collapsing under unaffordable PFI debts, that it wasn’t so easy. Too often they built the wrong sort of facilities. This is situation normal. The usual result of a public sector infrastructure project is to end badly. Japan’s investment splurge in the 1990s, in similar economic circumstances, simply caused many “bridges to nowhere” to be built.

And so, in this debate, my sympathies are with our political leaders.

Labour will subscribe to Tory cuts: the battle for the next General Election warms up

Nobody should underestimate the Labour leadership’s will to win the next British General Election, which should be in May 2015. I have been away for a couple of weeks. Before I left I was wondering what Labour’s response would be to the current government’s public spending review for 2015/2016, which will be announced later this week. It has been clear and unequivocal: they will sign up to the deep cuts in public spending that this review is designed to produce. This is breath-taking. What does it mean for British politics?

The spending review looked like a trap being set by the Conservative and Liberal Democrat coalition for Labour. Ambitious targets for savings were set: but Labour would be left with an awkward choice. Up until now Labour has been quite happy to ride the anti-cuts anger. Public sector workers, and many people relying on benefits, and others in the general ecosystem which they inhabit, are livid. Many workers with young families and mortgages are losing their jobs and facing steep cuts in pay. This anger has been fuelled by a myth: that cutbacks in public expenditure were unnecessary and motivated by Tory ideology, with the treacherous Lib Dems meekly giving in so that they can play with the toys that being in government gives them. This myth seemed to be supported by a whole army of economists saying that the pace of the governments austerity policies was undermining growth and making things worse. The Labour leader Ed Miliband and the Shadow Chancellor Ed Balls did not quite subscribe to this view if you read their words carefully. But they dog-whistled full support. Every cut was opposed angrily; they used the slogan “too far, too fast”, and mercilessly criticised the government for the negligible rate of growth in the economy, which they put down to its austerity policies. There was a studied vagueness about what they would actually do themselves.

But the 2015/16 expenditure review presented a challenge. According to the anti-cuts movement, the best thing would be to reject it out of hand, promise to reverse the cuts in large measure, so as to stimulate the economy and set off a virtuous circle of growth that would restore government finances and get the economy back to where it was in 2008, before the bankers’ sabotage act and global crisis got started. But if Labour did this, or even if they continued with the ducking and weaving, they would be open to a counterattack: Labour will put up your taxes. And the signs are that most people do not accept the anti-cuts narrative, and are hard-pressed financially – so not in generous mood when it comes to tax rises. No doubt the memory of 1992 haunts Labour’s leaders, when Labour lost a very winnable election after the Tories attacked them in the last week with a campaign based on “Labour’s tax bombshell” by hyping up the vaguenesses in Labour’s plans. But signing up to the coalition’s cuts would be hard too. It makes the manufactured anger about their impact difficult to sustain. Many of their supporters will feel betrayed.

But sign up to the coalition’s plans, with a bit of trimming here and there, is exactly what Labour have done. First in a speech by Mr Balls, and then this weekend by Mr Miliband himself. The message in the media has been very clear. I don’t know how it is going down in Labour’s activist base. Polly Toynbee, who often rallies to the anti-cuts cause, seems be showing resigned acceptance, while hoping than the party will come up with other ideas that will motivate the left. It isn’t exactly a U-turn. The narrative is that the economy, after the coalition’s poor management, is now so weak it cannot support more spending. This is weak fare indeed, and only shows that Labour had in reality accepted the bulk of the coalition’s austerity plans, subject to really very minor variations (like a temporary VAT cut).

The political calculation is clear. The angry brigade have nowhere else to go than Labour. Lib Dems may feel vindicated by Labour’s stance, but their previous public sector supporters will still not forgive them, except maybe in hard-fought marginal seats where they are up against the Tories. Britain’s two party electoral system means that elections are won by wooing floating voters. And these seem convinced by the case for austerity, even if, like Ms Toynbee, you blame this on the relentless right-wing press and the TV coverage that tamely follows in its wake.

The battle ground for the 2015 election is getting clearer. It won’t be about whether there should be cuts, but on where they should fall. For somebody like this blogger who accepts the basic logic of austerity economics in the UK, that should take the political debate into interesting and constructive territory. But others will feel disenfranchised and betrayed. Things are warming up.

How is Labour’s economic stimulus meant to work?

ON Monday at lunchtime Labour’s leader Ed Miliband was subjected to a fierce interview by Martha Kearney on the BBC Radio 4’s World at One. The main subject of contention was Labour’s economic policy, and in particular whether the party’s plan for a temporary cut in Value Added Tax would increase government borrowing. Mr Miliband did not want to say this, only that, because it would stimulate growth, it would help bring down government debt in the medium term. This was not an assured performance by Mr Miliband, but beyond that it seemed to me, perhaps unfairly, that he only had a superficial grasp of the economics involved. If so, he shares this superficial understanding with many members of his party, who lap up quotes from economic commentators such as Paul Krugman, and marry it to half-digested economic theory. So how is it meant to work? How can a temporary tax cut reduce government debt?

Let’s start with the Keynesian multiplier, which is widely taught in basic economics, and which I suspect comes to mind to most people here. You really have to do a bit of maths to understand the implications. Suppose you have an economy with a national income of £100bn a year, and an average tax take of 40%. You decide on a 1% stimulus with a temporary tax cut of £1bn. As people receive the extra money, 40% of it goes in tax, and they spend, say 80% of the rest on domestic goods and services (it doesn’t work if people use it to pay off debt or spend it on a foreign made car…). This adds £480m to the economy with extra expenditure straightaway. And this process continues in a virtual but diminishing circle, as that £480m is taxed, spent and so on. If everything turns out to be mathematically consistent the stimulus adds over £900m to the economy. You have nearly 1% growth! This has cost the taxpayer (added to national debt) of £1bn in the first instance, but a lot of this has come back in extra taxes from the growth.

This is what people half remember when economic experts like Mr Krugman say that stimulus can reduce debt. But there are two problems. First of all, although on my fairly realistic assumptions most of the cost is clawed back, about a quarter of it isn’t. Keynesian stimulus cannot pay for itself at this simple, basic level unless people increase their spending by more than the stimulus itself. And secondly, it is a one-time event, so that you get 1% growth for one year, and then it stops, unless you repeat the giveaway. This tax cut is temporary. When you put taxes back up again, the whole process goes into reverse and the economy shrinks back to where it started. Something very like this happened to the last Labour government’s temporary cut in VAT: a small bounce that was undone when the cut had to be reversed, which, of course, they then blamed on the Coalition.

All this is well known to the Paul Krugmans of this world though, otherwise they wouldn’t be writing economics textbooks and winning Nobel laureates. When they advocate stimulus they are actually talking about something else: the effect of such a stimulus on the national zeitgeist. That 1% lift may make people and businesses happier. Businesses go out and invest more money; people save less, perhaps thinking that their share and property values will go up, and consume more. If this happens then all bets are off; the economy grows further, the government gets more taxes and the stimulus can pay for itself quite quickly and easily. Investment is particularly important; Maynard Keynes’s critical insight was that recessions happen when investments don’t match the amounts people save.

What to say about this? There are two potential snags and an irony. The first snag is that the zeitgeist is a hard thing to manage. The whole thing can be undone by another crisis from the Eurozone, for example, which might reduce prospects for exports and dent confidence generally; or there could be some other crisis. The second snag is that this model of short-term growth assumes that there is spare capacity in the economy. When people and businesses go out and spend, domestic companies can readily ramp up production, employ new people and so forth. This is usually the case in a recession. But not always. In the 1970s, after the price of oil skyrocketed, the economy had to be restructured in order to grow – which was particularly hard because of the trade unions. Attempts to stimulate the economy simply led to high inflation while doing nothing for unemployment. Today, more flexible and globalised markets seem to have reduced the inflation threat – but stimulus can still be dissipated on imports and asset prices. What of the British economy now? Many commentators think that the British economy should be “rebalanced”, reducing its dependence on financial services and North Sea oil, as well as excessive private consumption fuelled by debt and property prices.

These potential snags to stimulus are why many critics of the government, such as the FT’s Martin Wolf, and many Liberal Democrats, such as the Social Liberal Forum, say that any stimulus should take the form of added public expenditure on investment, in infrastructure and homes. Since these have an inherent value, and help expand the economy’s capacity, there should be much less risk. This is a sensible idea in theory that is a lot less easy in practice. The public sector has a tendency to invest in wasteful projects for political rather than economic reasons.

This is where Labour’s plans are quite distinctive. They talk about temporary tax cuts, and hint at increased current expenditure. This is founded on a belief that there was not much of a problem with the pre-crisis economy, or unsustainable about the growth rates achieved in the years leading up to it. The crisis was simply a problem with the global financial system, and the country’s poor performance since is down to incompetent economic management from the Coalition. This is pretty much what Tony Blair said in his recent piece for the New Statesman. If you believe this then capacity is not at issue, and the zietgeist should be readily easy to fix.

And the irony? Left wing economic commentators like to laugh at the “Voodoo economics” of Laffer curves and self-funding tax cuts advocated by far-right commentators. Paul Krugman talks about their belief in the “confidence fairy”. But the left’s economic beliefs are no less dependent on their own confidence fairy.

Britain’s austerity policies under attack

Since the coalition government came to power in 2010 the British economy has been stagnant. Unlike other advanced economies, the United States in particular, national income has failed to recover back up to the level it reached before the crisis struck in 2007 (a more correct turning point, in my view, than the more commonly used 2008). In particular the government has failed to meet its own projections, with plans to reduce the government deficit behind target. A common view in the media, backed by a number of distinguished economists, is that the government’s austerity policies are “not working”, and need to be loosened. This view was strengthened this week by two events: some comments in the IMF’s World Economic Outlook, and the discrediting of an influential academic paper Growth in a time of debt by eminent economists Carmen Reinhart and Kenneth Rogoff (you can read The Econonist’s coverage here). This had put forward the idea that economic growth collapses when government debt reaches 90% of GDP, and had been used to give intellectual heft to the country’s austerity policies. Stepping back from the political ding-dong, what lies behind this controversy.

First, some perspective on this week’s two events. I have had a look through the IMF report to see what it says about the UK economy, and it is … almost nothing. With a world perspective it is, of course much more interested in the US, the Euro zone, and even Japan, never mind less developed economies, whose influence on the world economy is growing. There is a single sentence that causes the furore, repeated in the executive summary: “Greater near-term flexibility in the path of fiscal adjustment should be considered in the light of lackluster private demand.” Still, the IMF will be looking at the UK in more detail shortly, and today’s Financial Times, no less, is billing this as a major confrontation. Does the IMF matter? IMF analysis is academically rigorous, politically neutral and based on detailed factual analysis. This stands it apart from most economic comment, even that from distinguished economists, which is little more than grandstanding. It also has an institutional bias towards conservative financing of government. Criticism from that quarter saying that the government should relax fiscal policy lends weight to the notion that the government’s economic policy is based on a naive Treasury orthodoxy that has changed little since Maynard Keynes railed against it in the 1930s.

As for the Reinhart-Rogoff paper, I give this a lot less weight. Its core claim is based on the statistical analysis of past episodes growth and debt. Such regressions used in macroeconomics are always flaky, never mind any mathematical errors, as the various assumptions needed to give them validity rest on wishful thinking. We looked at a few when I was an economics student, and noted how no two independent statistical regressions came close to agreeing with each other. There are no economic laws of motion out there waiting to be discovered by careful data analysis. And if there were, their validity would generally be broken by the act of discovery and its effect on people’s behaviour. The value in such studies is in posing questions, not answering them.

So what issues of disagreement might there be between supporters and critics of the government’s policy in terms of generally accepted economics? First let’s start on the points what they should agree on. The reason why the UK has not met government forecasts made in 2010 has been weakness in demand from two areas: exports and investment. Consumer demand has been fairly much as expected. It is difficult not to see the shadow of the Euro crisis in both, though a case might be might be made for a weak banking sector causing lack of investment (though I wouldn’t buy it). This weakness in demand is damaging because it causes persistent unemployment, which in turn may damage the economy’s longer term prospects as longer term unemployed people become unemployable. Meanwhile living standards are being squeezed by the depreciation of the pound, which is spreading hardship and pain far and wide. A further point of agreement amongst most is that the economy needs to rebalance: for some areas of the economy to shrink relative to others, in particular towards areas of the economy that strengthen exports, rather than just fuel borrowing. This point is not accepted by many Labour politicians, especially those close to the last government though (for example Tony Blair in his recent New Statesman article). It implies that the last government’s economic strategy was mistaken in causing these imbalances. However I suspect most neutral observers accept that substantial rebalancing is needed.

There are probably two important points of disagreement. The first is the extent to which any fiscal relaxation will slow or prevent rebalancing. Will it just prop up areas of the economy that will need to be shrunk for the economy to progress? This line of argument is particularly strong when it comes to the expenditure side of the austerity policy. Cuts to government services and reform to the benefits system are not just about cutting the deficit: they are about making the economy more efficient. However, when it comes to temporary tax cuts, it is a lot less clear that it has anything to do with rebalancing. Also expenditure to invest and improve the economy in the long term is not affected by this line of argument.

The second area of disagreement is the ability of the government to borrow money to finance fiscal stimulus, and the effect of borrowing on growth. This was where the Rienhart-Rogoff article was deployed. I won’t attempt to explain it in today’s blog: it gets fiercely technical. In the more public arena both sides like to deploy spurious arguments on this topic. I disagree with most of the arguments used by government supporters, but that does not make them wrong in the round.

Government supporters, especially of a Lib Dem hue, will suggest that the government has already been flexible by stretching out its targets in face of the disappointing economy. There remains a case for some kind of shock treatment, though: a change in policy that is a pleasant surprise to people, and which will improve confidence.

And that is an issue that is at the heart of the matter in my view, but which economists don’t like talking about because it seems so ephemeral. The economy is driven more than they will admit by the zeitgeist: common expectations, confidence, mood, world view, etc. There is little fiscal and monetary policy can do in the face a determinedly depressed outlook that increases saving but reduces investment. That is what we have now. One aspect is welcome: it means that inflation is unlikely to take off. A positive shock can change the mood: but Britain is a small country which depends a lot on what goes on in the rest of the world. There is a real risk that what goes on in the wider world undermines domestic attempts to change the mood, which means that the whole exercise makes things worse. The outlook remains grim, I’m afraid.

Monetary policy is a useless collective noun

At the time of the financial crisis of 2007 and 2008 it was commonplace to say that modern economics, especailly the macroeconomic variety, was in crisis, and needed a fundamental rethink. Alas, the vested interests of established economists have prevailed. Very little rethinking has occured, and this mainly tweaking rather than anything big. This is most striking in the area of monetary policy. The debates now going on in Japan and Britain remind me of the academic papers and discussions that I read about while an economics undergraduate at UCL in 2005-08. Circumstances have changed (in Britain anyway) but not the economics.

Economists of complain that amateurs are guilty of the fallacy of composition: to assume that was is true for a household, say, is also true of all households grouped together in a single economy. It may sensible for a single household to save more of its income to repay debt: but if a whole economy tries this at once, it could be disastrous. But economists are guilty of their own fallacy, though one for which I have not found a commonly used name. I will call it the fallacy of collective nouns. It is idea that by collecting together a group of disparate elements and giving them a name, that you have created a new entity that allows you to ignore its component parts. Most macroeconomic concepts are such collective concepts: GDP, inflation, and so on. Such collectives are useful only up to a point, and then you have you have to look at their component elements. And yet most macroeconomists, even very intelligent and distinguished ones, can’t bear to let go of their collective concepts and carry on using them long after their usefulness has ceased.

This is clearly the case with the idea called “monetary policy”. The conventional idea is that an economy has something called a “money supply”, which can be manipulated through policy instruments under the control of a central bank. In turn this money supply affects the behaviour of the people that form the economy with fairly predictable effects on things like consumer prices,wages, investment and output. All of this is very questionable in a modern economy. It is much more helpful to think of the particular components of “monetary policy”: central bank interest rates, state purchases of its own and other bonds, bank regulation, and so forth, and how these affect the various parts of the economy acting through the financial markets.

The conventional economic thinking runs something like this: the economy (Britain and Japan in particular) is stagnating with relatively low levels of inflation, but high or rapidly rising levels of government debt. In order to pay back this government debt you need to break out of the stagnation and grow, or (whisper it) let inflation make the debt more affordable. To do this you need to “loosen” monetary policy and increase the supply of money. With more money in their pockets, people go out and spend more, leading either to growth or inflation. To do this the central bank lowers interest rates, and where this does not work, use other measures like Quantitative Easing. Cue lots of debate about the relevance of inflation targeting and its alternatives (nominal GDP targets for example), all well within the comfort zones of economists.

There are very many problems associated with this line of reasoning. It is far from clear what money is. However it is clear that commercial bank accounts form the most important part of it, and this is a function of commercial bank policies, not those of a central bank, whose influence is increasingly marginal. It isn’t clear that large bank balances lead to increased spending, least of all on constructive economic things like consumption or proper investment (as opposed to chasing up the value of assets in fixed supply). Rising prices do not necessarily make debt more affordable: that requires rising income for the people holding the debt. And it goes on.

All the verbiage around “monetary policy” is clouding the issue. There are two problems being faced the British and Japanese economies: weak output and excessive debt. Weak output in turn has two components: using spare capacity (i.e. that created simply because of slow demand) and strucural problems. In Britain there is a big argument about how much of the problem is spare capacity and how much is structural. If it is largely spare capacity then simple macroeconomic solutions may have merit: you just need to boost confidence a bit to lift demand. But even here it is not self evident that any of the loose money policies will be much help. In Japan there seems to be even less spare capacity.

I can’t help thinking that what policy makers really mean by “loose monetary policy” is higher wages. Increasing consumer spending power through increasing wages will lift confidence, and even if it is not based on increased productivity, it will make debts easier to pay off, including public debt through higher tax revenues. This lurks behind a lot of the talk about greater tolerance for inflation. But in Britain we have the wrong sort of inflation: rising import costs through a lower pound, and increased government charges. This really isn’t helping. If policymakers want higher pay it would be better to throw away the weasel talk about loose money, and talk about pay. There is some evidence for that in Japan, but this only serves to show how difficult the policy is in practice.

The Japanese government also deserves some credit for the fact that it is not advocating looser monetary policy by itself, though you wouldn’t guess that from much of the coverage here. It is one of three prongs, the other two being fiscal stimulus and structural reform. There is plenty of scope for structural reform in Japan, and this gives their economic policy some hope for ultimate success if they follow it through. But it is the prospect of quick and easy solutions through fiscal and monetary policy that is exciting people.

In Britain a chronic trade deficit shows major structural problems, no doubt partly as a result of reduced North Sea oil. This requires the economy to be producing different things, not just more all round. Loose talk using economic collective nouns is making this harder to see and address.

The public’s foul politcal mood: symptom or disease?

Is depression an illness? It can be. Many people suffer depression that is so severe that it overwhelms them. They need help and we categorise it as mental illness: a condition with a life of its own, where medical intervention is recommended.

But for most of us, most of the time depression is just part of the ordinary fabric of living. It is a necessary step in the way the mind adapts to new realities in the world around it, especially changes that are unexpected or unwelcome. We don’t understand why the human mind has evolved in this way, but it clearly is not a malfunction. We must accept it and work through it. This common wisdom is summarised in popular models such as the Kübler Ross model of the five stages of grief (denial, anger, bargaining, depression, acceptance).

We can compare this personal mental phenomenon to current public attitudes to politics, especially here in Britain, but elsewhere too. This is partly a simple metaphor; but also some of the same psychological forces are at work. The public mood with politics is foul. Is this a disease, or merely a symptom of an inevitable change that is taking place in our society, that we simply have to come to terms with? And how should politicians respond?

The latest evidence for the public’s mood comes from the recent Eastleigh by-election. The main established parties locally, the Liberal Democrats and the Conservatives, both lost votes, and much of their support was grudging, based on keeping somebody else out. The grumpy anti-establishment protest party Ukip jumped from nowhere into second place. The official opposition, Labour, made no headway. And, in more classic depressive behaviour, turnout fell significantly from the General Election in spite of an extremely intense campaign, where voters were getting daily leaflet drops and their phones did not stop ringing.

If this is an inevitable response a changed reality, we don’t have to look very far for a culprit. In the 15 years from 1992 to 2007 Britain has enjoyed steady economic growth. If the benefits of this growth have gone disproportionately to the rich, they have neverthless been spread widely. Pay-rises regularly beat inflation. The benign effects were reinforced by easy money which supported both consumption and rising property values. This didn’t seem like a golden age at the time (though there was a brief note of euphoria at the turn of the Millennium), but it served to set some fairly stable and benign expectations. Politicians squabbled of the extra things they could do with “the proceeds of growth”.

But this collapsed in 2007, when the financial crisis started, with a sharp economic contraction in 2008-09. Worse, in 2013 there seems no sign of things getting any better. While politicians on the left and right argue that growth can be restored, the public remains entirely unconvinced. You have to be a real optimist to think that Keynesian stimulus would offer more than temporary alleviation; and it could make things worse in the long run by taking the national debt sky high. The right wing’s supply side revolution would make things worse for most people in the short term, and probably only better for the already wealthy after that. Monetary loosening seems to involve sucking life out of the Pound, and so making things like energy, cars and foreign holidays yet more expensive – probably with only share and bond prices showing any benefit.

What on earth has happened? The public suspects that something has changed about the economy and society which means that the benign years before 2007 will not return. This builds on the natural human tendency to project current circumstances into the future. It so happens that I feel that this public instinct is well grounded. Slow growth is here to stay. Much of the growth before 2007 was a mirage.

This need not be a bad thing in itself. There is plenty enough resources to ensure a decent standard of living for everybody. But the political priorities in a low growth world are very different from what they used to be. Distribution of wealth becomes a top political issue. Government must learn to be frugal. We must focus on improving wellbeing rather than monetary wealth. But these changed priorities require a big psychological adjustment, so it is no wonder that there is anger, frustration and depression amongst the public.

If that is all, then the bad mood is simply a symptom of the changing times, and politicians should see through it to focus on the changed priorities. Politicians need to show empathy with the public, but not be panicked into populist policies. Aided and abetted by an unhelpful press, much public anger is directed at such things as immigration, the European Union, health and safety legislation, and human rights. But politicians should not be fooled by this anger; the public is in fact deeply ambiguous about all of these things. Deep down they sense they are necessary to the way we want to live our lives, the odd silly excess notwithstanding. Instead politicians should focus on reform to the tax and benefits system, improving public services, developing a housing strategy, securing energy supplies and fixing the still-broken financial system.

But many thoughtful observers, Paddy Ashdown for example, are convinced that the bad public mood is much deeper than this. Its beginnings predate the financial crisis of 2007 after all. There is a deeper feeling of disenfranchisement that will not go away. This needs more direct intervention. While I am not apocalyptic as Lord Ashdown, I think he has a point. British politics is not corrupt, but it is conducted by an elite class that does all it can to avoid being held to account. Reforming this will be hard work though. Devolving more power to local level is surely part of it – though fraught with danger. Whether the current government’s localism reforms have achieved anything useful is open to doubt – though the growing number of City Deals are more promising. Taxation powers are the critical issue, and nobody shows signs of grasping this particular nettle. The opportunities to re-enfranchise voters are surely mainly at the local level – but that means the delegation real power, and responsibility for real trade-offs – rather than the one-sided lobbying of the centre that currently dominates local politics.

The public mood is both a symptom of change that is running through our economic system, and also a deeper problem in its own right. Both call for honest liberal reforms, and not the sour populism that it immediately encourages. Let us hope that the public, through its anger and frustration, recognises this. They often do, if any politician has the courage put the case to them.

Britain’s economy: is the right right?

Britain’s economic performance since the Coalition government took over in 2010 has been as dismal as today’s cold, damp and grey London weather. Negligible economic growth; government finances that stubbornly refuse to improve, even as services and benefits are cut; and although unemployment is trending down, this is at the cost of pay and hours being squeezed. In political and media circles most of the debate about this state of affairs is around managing total economic demand: the “Keynesian” critique (quotation marks since using a dead economist as a source of authority does not do justice to the critique). Much less prominent is a right-wing critique. Yesterday Allistair Heath, Editor of City AM produced a 10-point plan in The Telegraph online, which neatly summarises this perspective. It is worth thinking about this a bit.

Mr Heath’s 10 points, in his “Supply-Side Manifesto” are as follows:

1. Cut corporation tax to 11pc; abolish capital gains tax

2. Cut current government spending by 2pc this year

3. Wage war on zombie firms

4. Reform the labour market

5. Allow private sector to finance big transport projects

6. Build 300,000 homes a year

7. Scrap renewable energy targets

8. Create mini-jobs for welfare recipients

9. Allow for-profit firms to run schools

10. Make it easier for consumers to switch suppliers

The basic premise of this is that it is what Britain needs is a supply-side revolution to get going. In other words it must be made easier for businesses to grow, and there must be greater incentives for private sector investment. There is something to this. Britain’s economy before the crisis struck in 2007 was unsustainable, and much of the growth in the preceding half-dozen years was a mirage. The most convincing evidence of this is the country’s current account deficit – consistently 2-3% of the economy (and the trade deficit much worse). This seemed to be the result of an inflated exchange rate. As the crisis struck, the pound duly depreciated. And yet, as the Economist pointed out a couple of weeks ago, the current account deficit has not recovered (unlike after 1992, when the pound fell out of the ERM). This bespeaks a deep malaise in the economy. This is much more that a dip in the business cycle that can be cured with fiscal stimulus and/or loose monetary policy. Indeed both such policies could make things worse by pushing out needed investment.

It is common wisdom that the British economy needs to be “rebalanced”: but this seems to be happening only very slowly. Reduced dependence on financial services and public expenditure are clearly both part of any such rebalancing, and we do seem to be making some headway here. But what is to take their place? Thinking about the “supply-side”, or how the economy actually delivers the goods and services it needs, is a welcome relief from banging on about aggregate demand, and its assumption that all this can be left until later. But it is here that I mostly part company commentators such as Mr Heath. Let’s have a quick look at the ten points.

Cut capital taxes to encourage investment. This idea has a respectable intellectual history, but there is a problem. It tends to encourage wealth creation by the rich without much impact on the rest of society. And as the rich tend to save rather than spend their incomes, this doesn’t do much to fix the wider malaise. I’m not so sure that attracting footloose international capital will help much in an economy of our size anyway, (unlike Ireland).
More cuts to government spending: no ring-fences. I do agree that government has to be smaller and more efficient – but the country is very dependent on government sponsored services, such as education and health. We are up against what economists call “Baumol’s Disease”, as well as demographics; there is a limit to amount we can expect from efficiency savings. There is plenty to discuss about how these services are to be funded and structured, but crude cuts are a blind alley.
Allow more companies to go bust. I have more sympathy with this one, though I am not convinced that this is really what is blocking investment.
Labour market reform: reduce job protection. I am more ambiguous on this than most liberals, perhaps hardened by my experience as a middle manager. Improvements can be made, but the evidence that this is what is holding us back is weak.
Big transport projects financed by private sectors (tolls, etc). Easier said than done. The cost of big capital projects is escalating, and returns less certain. I think the current government is pushing ahead with this as fast as politics will allow.
Housebuilding. Here the right wants to unleash the private sector by overcoming planning constraints. Mr Heath is being a bit disingenuous here: he means plastering the green-belts with cheap and shoddy new housing estates. But there is a housing shortage; and we do need to compromise on the green belt. But we need good quality homes and more social housing, with development gains being used to finance social infrastructure, such as schools.
Junk renewables for coal and gas. I’m not sure that an economy built on cheap, carbon intensive energy is the right way to go. I expect that Mr Heath does not believe in climate-change. Moving away from cheap energy dependence is one of the pieces of rebalancing that has to be achieved. Green energy should be part of any growth strategy.
9., & 10. These are throwaway ideas given a sentence each. I don’t necessarily disagree, even with for-profit state schools, but I don’t think they will help the supply side by much.

So there’s me being very negative about a whole series of practical ideas. So what do I think? First point is that we need to accept that, for a whole variety of reasons, growth in most developed countries will be very slow for the foreseeable future. We need to adapt our expectations to this, and think more clearly on how to deliver improved human wellbeing without it. Second, we need to think hard about under-used human resources: that means mainly people living outside the English South-East and a few other hot-spots. Simply building more houses across London’s greenbelt and moving people there does not feel right. There are no big ideas here, but lots of little ones. Dumping big government agencies in these places is not one of them, though. Third we have to rethink public services. The reforms need to focus on improved commissioning and getting results. But we also need to think about such politically toxic issues as co-payment – since taxes will not be enough to fund the nation’s needs. Plenty of ideas for future blogs, but that’s enough for now.

So the left bangs on about Keynesian demand management, in the hope that longer-term problems can be solved later; the right chases a fantasy of growing businesses unleashed by smaller government. The public seems sceptical of both. Rightly so.

Growth: the deeper questions

Today first estimates of the UK’s final quarter GDP show that the economy shrank by 0.3%. There will be a lot of posturing around this but it doesn’t mean that much. GDP is not a direct measure of wellbeing (unlike unemployment, for example), and it isn’t that clear how one quarter’s statistics have a bearing on people’s day to day lives. Besides these early estimates are not very reliable. Still these GDP figures do prompt some wider questions.

The first is about short-term economic strategy. A large number of government critics, loosely referred to as “Keynesians” though no professional economist would accept that label, say that a series of poor GDP returns reflect a failure of economic management. Firstly that cutting government expenditure reduces demand, which has a multiplier effect to shrink the economy as a whole. Second that the government should in fact be doing the opposite: using fiscal policy to use the same multiplier effect to boost the economy at large. I don’t intend to discuss this much further today, except to make this point. These arguments have weight because the UK economy is in recession, with high unemployment. This means, or should mean, that there is slack. Slack is usually inefficient, especially when unemployment is involved, and evidence that the slack is being taken up would come from better GDP growth figures. But what people are talking about is a short-term effect: once the slack is taken up the economy bumps into more substantive constraints and “Keynesian” stimulus would have undesirable effects, such as inflation or an unsustainable trade deficit. But what are the prospects for growth in the longer term, and does it matter?

There is now quite widespread pessimism about the long term prospects for growth in the UK and other developed economies. Mostly this is ephemeral. People assume that current trends simply continue; a few quarters of stronger growth and the mood will lift, even if this says nothing about longer term prospects. But more serious questions are being posed. Mostly these are based on demographics – the aging of the baby boom generation – and an allegedly slowing pace of innovation. The Economist had an interesting article on the latter a couple of weeks ago. This explained the reasons why people are becoming pessimistic – but then pointed to reasons for counterbalancing optimism. I think The Economist is right as far it goes: innovation picks up in some areas just as it slows in others. But they miss an important wider question about the role of economics itself. They too easily assume that innovation will lead to increased productivity and this to growth, in accordance with conventional economics. I think this may be breaking down.

Try to think about this in terms of three ways in which economic wellbeing advances. First is the conventional consumption which dominates economists’ thought. People consume more goods and services, and the economy is able to deliver these because productivity rises. Second is the consumption of what I would describe as personal goods and services. This superficially resembles the first sort of consumption, but the very nature of these goods and services is that productivity cannot grow. Think about personal therapy – shorter sessions or sharing sessions with more people undermines the product we want to buy. Another example is status goods – often the whole point is to show status by buying goods or services that are produced at low productivity. And finally people may opt out of the conventional economy altogether: take time off, pursue hobbies and so on.

So what if people direct their energies (and use innovation) to consuming personal goods and/or opting out, rather than consuming conventional goods? Economic wellbeing advances but GDP growth does not; in the case of opting out, GDP actually shrinks. Economists tend to be very dismissive of this, and try to assume their way out the problem: in particular that than economy advances on all three fronts at once, so that conventional consumption is representative of the whole. This has worked well enough for the “opt out” option: I am assured that there is good evidence that leisure increases alongside consumption, not in opposition to it. But there is a logical problem with the advance of personal goods, and economists have a name for it: Baumol’s disease, after the economist who pointed it out. The more productivity advances on conventional goods, the higher share of the economy is taken up with personal goods – and you have to work that much harder to improve productivity on conventional goods to achieve the same level of growth. Economists may have named it, but they still usually ignore it and its implications. They usually just have a quick moan that we should spend more energy trying to improve the productivity of services (the problem is usually defined in terms of agriculture, manufacturing and services – with what I am calling personal goods being part of services).

But I think the whole balance is shifting. There are limits to the extent that people will want to improve wellbeing by simply consuming more mass-produced goods and services. An increasing proportion of the population has reached that limit (I certainly have), instead increasing leisure or buying “quality” (lower productivity) goods. And look at innovation. I consider my smartphone to be a fantastic technical advance that has improved my life a lot. But has it helped the conventional economy by helping me to produce more services for other people to consume? It hasn’t. Quite apart from the demographic issue, which is real enough (and you could say this is actually the same thing, with people choosing more leisure by retiring for longer and consuming more personal services through hospital and other care), the rate of conventional economic growth is slowing in the developed world.

Does it matter? After all economic wellbeing may still progress. Unfortunately there are two reasons that it may: debt and taxes. These two lie at the very heart and purpose of the conventional economy. Debt and credit tend to get washed away in a high growth economy – but it will get increasingly difficult for people, businesses and governments to service past debts in a low growth environment. And a lot of the personal services that take up a higher and higher proportion of our economy (like health) are funded through taxes, as well as support for leisure (pensions) – and yet if the conventional economy does not grow this will bulk larger.

Debt and taxes. These issues are destined to dominate developed world politics in the century to come.