UK economic policy – Page 9

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.

Taxing multinationals – after the sound and fury we need solutions that work

Multinationals like Starbucks, Amazon and Google has been on the wrong end of publicity in recent weeks here in the UK. They don’t seem to be paying very much corporate tax, in spite of well established and successful commercial operations here. But there is something missing from the debate: nobody seems to be offering much of a solution to the problem of taxing multinationals. There’s a lot of sound and fury, but it all ends in a bit of a whimper. We can do better than that – but only by adopting policies the government’s Conservative members will be deeply uncomfortable with.

The problem is easy to see. If a multinational makes something in one place and sells it in another (to take the simplest possible description of a multinational supply chain), then it has the opportunity to apportion profits to more then one place…and to manipulate this to where tax rates are lowest. This has always been so, but with an increasing proportion of costs being attributable to soft things like intellectual property, this is getting much easier to do. The traditional way of fairly attributing profit is through establishing a fair “transfer price” for goods or services as they move between countries along the chain – based on open market value. The idea of open market value has always existed more in theory than practice, and the process often ends up in endless bickering between the company and the tax authorities of the various countries it operates in. And in the end the results are often hard to justify. What are the alternatives? There are two main approaches.

The first approach is to reduce corporate tax rates to make the issue irrelevant, and along the way to make your own jurisdiction very attractive to investors. This is not as crazy as it sounds, and has quite a respectable intellectual pedigree. Companies aren’t people, and ultimately taxation is about people. Taxes are charged whenever people try to extract money from a company, through salaries, dividends and what have you. Money that is left in companies is reinvested, and taxing it merely reduces the amount available for reinvestment. This is an example of the idea that tax should be based on expenditure rather than income and capital. It encourages saving and investment, and most of the time economists think that economies would be healthier if more resources were invested rather than consumed.

This line of reasoning was very popular in the late 20th century, but has since lost much of its appeal, except amongst the very rich. Something has gone wrong with the savings and investment cycle. The amount of constructive, worthwhile investment that comes out of savings is not what economists used to think. A lot disappears into various forms of financial engineering that fatten up an overpaid finance industry and not much else, inflating selected asset values into unsustainable bubbles along the way. Overall savings, especially by the very rich, seem to be a drag on an economy – often requiring “negative savings” from government deficits to keep the economy on track. This process was described by Maynard Keynes in the 1930s and it is still true today.

Low capital taxes, including company taxes, simply seem to exacerbate a growing gap between the very wealthy and everybody else, without generating the needed investment. Profit taxes have a particular attraction: they are economically efficient and do no distort ordinary business decisions, outside the allocation of capital.

So what’s the alternative approach to taxing multinational businesses? This is what we should be talking about a lot more: the top down apportionment of profits. Under this system you establish a business’s worldwide profits, and then apportion it to national jurisdictions by a formula which measures activity: a combination of sales, employees, pay or suchlike. Those jurisdictions can then decide what rate they want to charge.

The idea of top-down apportionment has been developed for some time by US states for allocating profits between the states of that country. In the 1980s California tried to extend the idea to global operations, but was forced to back down, mainly after furious international lobbying from our own British government. There is a nice irony if American companies are now runiing rings rounds us British.

But that example shows the idea’s main weakness: it needs international cooperation to get going. It helps if all countries are doing it, and using the same formula. There is an obvious first step for the British government though: to agree and apply such a system to the European Union. I don’t think there would be much difficulty in mobilising the other EU countries; Ireland, a traditional advocate of tax sovereignty, is not in a particularly strong bargaining position these days, and we can let them keep their low rates. Once the EU has an agreed system for recognising and apportioning profits, we would then need a treaty with the US. Since that country is already a wide practitioner, there is good reason to hope for progress there too. With the EU and US on board, a global critical mass starts to build.

But Britian’s coalition government does not seem to be thinking along these lines. For its Conservative members, no doubt doing deals on tax with the EU is anathema. Instead they are happy to quietly go down the first route and cutting business taxes, in spite of little evidence that this is stimulating investment. Of the Liberal Democrats, however, I had expected better.

The imperial illusion of macroeconomics

Once again the UK Chancellor of the Exchequer’s Autumn statement has provoked a storm of claim and counterclaim among economics commentators. The particular breed of expert whose voice is loudest is the macroeconomist. They have a lot of important things to say. And yet their analysis is often superficial. We end up talking about the wrong things.

There is a magnificent imperial power about macroeconomics. It looks at economies in aggregate, and develops a broad sweep. It deals with national income, growth rates, productivity, inflation, unemployment – all concepts that are represented by neat numbers. Their policy instruments are referred to as fiscal and monetary policy – policies that are meant to influence these aggregates in a fairly direct way, and which

For me, the metaphor of imperial rulers to represent these experts has strong appeal. It conveys the right sense of arrogance. I conjure up pictures of imperial aides to the Russian Czar (or his Soviet successors) implementing arbitrary policies to be implemented across their domain. They deal in the big picture – and refuse to hear the special pleading of provincial representatives. Of course things don’t work out in every detail, they say, but the reach and sweep of their rule means that much more good than harm is done.

Macroeconomists themselves no doubt would prefer an analogy with classical 19th century scientists. They did not concern themselves with the movement of individual atoms, but derived physical laws that worked at a higher level. In aggregate the behaviour of atoms and people are predictable.

The idea that leaders deal with big strategic matters, and leave the details to their underlings is an old one, that has enduring appeal. It enhances the egos of the leaders. It doesn’t work, though. The best leaders find themselves having to command both the strategic sweep and the tiny detail. The Russian Czars came acropper. And the theroties of 19th century scientists turned out to have much less value than they thought in the real world.

This is true of macroeconomics too. In the first couple of years of taking an Economics degree, you learn about macroeconomic models – about the use of fiscal and monetary policy to guide the aggregate movements of an economy. It is tremendous fun – but by the third year you really should be growing out of it. In the end economies are driven by what is happening at the level of individual people and businesses – and as people are highly adapable, and behaviours change – never mind the evolution of technology – what works one year may not the next. Unfortubately too many economists can’t seem to get past the imperial illusion.

Take the current furure over the British economy. It’s full of growth rates, deficit levels – and demands for this and that on fiscal and monetary policy. Two elements of the macroeconomist’s stock in trade are prominent: international comparisons (the British growth rate is less than Germany’s, etc.) and comparisons with the past, going all the way back to the Great Depression of the 1930s. And the analysis usually stops there – few attempt to pick apart the differences and similarities that these comparisons invite.

And yet there are a number of big changes taking place in the British and world economies that are bound to affect the choices open to our policymakers. These get superficial coverage, if at all. Here are a few:

Finance’s role in the economy is diminishing, as we understand that much of its alleged value is illusory. This means that a sector that appeared to be highly productive in macroeconomic terms is shrinking. That is not a bad thing – but people seem to be screaming blue murder when the national income figures suffer the inevitable outcome.
Likewise the benefits of North Sea oil are fading – another statistically highly productive sector shrinks, though this one has more underlying substance.
Banks’ lending practices are changing, as credit to private individuals becomes less easy, and loans to property developers more difficult. This is inherently a good thing, as it helps get the economy onto a sustainable path – but it is playing havoc with the macroeconomic statistics.
The gains from globalisation are going into reverse. For years in Britain the prices of imported goods fell or stayed the same while wages and domestic prices rose steadily at 3-4%. These “gains from trade” added a lot to the feel-good factor and growth before the crisis- even though we whinged about loss of manufacturing and overseas call centres. Now import prices are rising steadily while pay remains frozen. These gains from trade were not permanent, bankable changes – but reversible. This is nothing to do with protectionism, by the way, but arises from the perfectly predictable workings of the economic law of comparative advantage.
Meanwhile “additive manufacturing” and other technology changes mean that fundamental technological change is alive and well, bringing both new opportunities and continued obsolesence – but of quite unknown impact on conventional economic measurements.

I could go on. These factors, and others, should be very much part of the discussion. They invalidate historical and international comparisons – until and unless we dig a lot deeper. To me the wider message is that we can’t simply wind the clock back to where we were in 2007, and it is not self-evident that a sustainable growth rate of 2% or even 1% can be regained just a lifiting levels of confidence a bit. Therefore using fiscal policy to stoke up aggregate demand may simply bring short-term relief followed by an even bigger crisis. Increasing government sponsored investment is almost certanly a good idea, but it matters where this goes. But neither the government’s critics, nor even its defenders seem interested in such details.

In an excellent article in this week’s FT, Sebastian Mallaby shows how macroeconomic success leads to microeconomic complacency, which in turn leads to breakdown. The developed world has just gone down this route. Now the BRICs are doing it. China shows no sign of dealing with the baleful influence of its state owned enterprise; India is content to let curruption and inadequate infrastructure go unaddressed; Russia sees no reason to change its contempt for the rule of law; and Brazil’s government is releuctant to take on vested interests. All these economies are now slowing.

Meanwhile, back in the developed world you would have thought that we had been cured of macroeconomic complacency. And yet almost nobody seems prepared to take on the deeper issues that lie behind the crisis and any solution to it.

The UK GDP figures change nothing

Today the Office for National Statistics delivered its first estimate for the UK’s GDP in the second quarter. With a fall of 0.7% they were a bit shocking – we have had a number of quarters with it being cose to no change, and this looks like a proper lurch downwards. This has provoked some predictable “told-you-sos” by the government’s critics, who say that it shows that the Coalition government’s policies are failing, and call for less austerity. But what do the figures actually mean?

Making sense of it all is not easy. The first point is that GDP is not of huge importance in its own right – only as a proxy for the population’s overall wellbeing. But in a dveleoped economy this latter is more closely tied to employment – and here that statistics seem to be slowly moving in the opposite direction. This has created a headache for economists, since this behaviour isn’t in the script. Some even say that the GDP figures may be in error. But they have been saying this for some time now, and revised estimates have not made the figures any better. We need more evidence from the real world to see if anything very harmful is going on. If, for example, the decline in GDP is a result of a shrinkage of investment banking, where they is lots of money and few jobs, we needn’t lose any sleep. Or if it results form people taking time off, e.g. for the Jubilee holiday, then again it is no real cause for concern – provided people enjoy their time off. The truth is that we don’t have a clear understanding of what is happening, and whether it is in fact particulalry bad.

Well, not quite. We rely on money income, measured by GDP, to generate taxes to fund the services and benefits supplied by the state. And to pay off the debts left by past governments. Given that taxes still fall well short of what they are supposed to pay for, this is a worry. For now things are OK. The financial markets aren’t taking fright (even as they are in Spain, whose finances are not in such bad shape). If they do then we can expect all sorts of nasty consequences as interest rates rise, and possibly inflation too.

But what of the argument that austerity is slowly strangling the economy, and we need to ease off? This is a topic that I have blogged about many times before. The austerity sceptics are those who basicly think that a sustainable economy is within our grasp, and it just needs a bit of confidence and an upward demand cycle to reach it. I remain sceptical. Slowing austerity may simply be postponing a necessary adjustment – and runs greater risks with those financial markets. These figures do not provide additional evidence either way on this debate.

The problem for the government is that GDP – and tax income – is falling behind their projections, which makes it look like a failure. But this is more a criticism of the art of economic forecasting than it is of government policy. But economic forecasting has long been known to be inaccurate, and it always will be. Many people, on both sides of the austerity argument, are not surprised that the recovery is so slow. And the forecasts weren’t even politically motivated – since the government transferred responsibility to an independent body – the Office for Budget Responsiiblity.

Still, the case for using the government’s weight to progress worthwhile investments in house building, transport infrastructure and education remains strong, and no doubt their advocates will use this data to pressure the Treasury to loosen up. But these investments must be for items that will be of genuine benefit – the right sort of homes in the right places, for example – and not just expenditure for its own sake. And that makes the process slow.

So, in short, these GDP figures are nothing to get excited about.

Why Paul Krugman is wrong

In today’s FT the economists Paul Krugman and Richard Layard (of the LSE, famous for his work on the economics of happiness) publish an article A manifesto for economic sense calling for looser fiscal policy around the world. Being in the FT it’s behind a paywall (though I have shared the article on Facebook). But the simplicity and clarity of their argument make it a particularly good pace to discuss the difficult issues of economic policy as the economic crisis rumbles on.

Back in 2005 I was contemplating taking an Economics degree, with little formal background in the subject. I asked a tutor at the university (UCL) on their advice for background reading and he said “Anything by Paul Krugman”. The Professor at Princeton, who subsequently won the Nobel Prize, was famous for the clarity of his writing on economics. I also discovered, as I devoured anything by him I could find, that he was not a shrinking violet on the subject of US politics – passionately attacking the Republican regime of George Bush. Now he is a crusader against “austerity” – the focus of governments on healthy finances even as recession stalks the world. He recently visited London, and appeared on Newsnight. I didn’t see him, but I am told he made mincemeat of his opponents – and I’m not surprised.

As I took my degree at UCL I read more of Professor Krugman’s work, now in academic papers and discussions, rather than the more accessible stuff I read read before. The clarity remained – but he came over as a bit wild. I remember in particular one discussion where he became obsessed with the idea that Japan needed to stoke up inflation to get its economy out of the doldrums. His wild suggestions for doing so seemed to leave his fellow economists quite exasperated. Ever since I have viewed his opinions as entertaining, but liable to be impractical, and in the end very unhelpful. So it is this time.

The article (not very long) starts its main line of argument by talking about the causes of the crisis:

The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – such as Greece – this is false. Instead, the conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.

I think it is highly significant that the authors throw this in so early. It implies, without actually saying so, that pre-crisis government expenditure in most developed economies was perfectly sustainable, if that pesky crisis hadn’t caused a dip in tax revenues. It is perfectly true that government debt was not a major problem before the crisis, which was caused by excessive private sector debt. The trouble is that the boom years gave us false expectations as to what the sustainable levels of tax revenues were. A large part of the dip is permanent, not temporary. So substantial cuts will have to be made at some point to bring government debt under control. It isn’t just a question of waiting for the economy to bounce back (in the UK, US and southern Europe, anyway).

The authors then point out that the crisis is caused by a collapse in private demand – and that it makes sense to make up the shortfall in demand by extra government expenditure until private sector confidence returns. A failure to act means that unemployment becomes endemic and difficult to put right later. They point out that monetary policy cannot take up the strain. They say that there must be a medium term plan to bring government deficits under control – but that it must not be front-loaded. I have no disagreement with any of this. Quite a few people think that looser monetary policy would help – but I agree with the authors on this (which I will say more on in a future post).

Where I differ is that I think what they suggest is exactly what governments are now doing, in the UK and US anyway. In nominal terms government expenditure has not been cut. The private sector is slowly taking up the slack. Governments may be talking austerity, to prepare the ground for the real cuts that are absolutely necessary in the medium term, but they are not practising what they preach.

The article concludes by trying to debunk two typical counterarguments to further stimulus. First is that financial markets would lose confidence and refuse to keep funding government debt. They point out that there is no sign of this in the UK or the US, where government bonds are at record low yields. They also say that there is no actual evidence that budget cuts can generate growth. On the contrary, they suggest (though don’t quite spell out) that looser fiscal policy will help restore confidence and get the private sector moving again, which would allow the deficits to be brought under control. The trouble, of course, with using past evidence to prove a point is that the current situation is unprecedented. And the global financial markets are quite unstable; who is to say that UK and US bond markets aren’t in their very own bubble that could burst very suddenly. The absolute levels of deficit, and, increasingly, overall debt are becoming so alarming that anything is possible. And what if the private sector remained sceptical in face of government stimulus?

Finally they tackle the argument that stimulus cannot work because there are structural constraints. In other words, the pre crisis economy was so unbalanced that there is in fact little spare capacity – so that a stimulus would run into trouble very quickly, leading to inflation or a currency crisis. If this were so, they say, we would see more parts of the economy at full strength. Here there may be a difference between the UK and the US. In the UK there are indeed a few signs of trouble. Inflation has been much more persistent than predicted, though admittedly not through wage rises. Export businesses complain of a lack of suitably skilled staff.

Straws in the wind perhaps. But the pre-crisis economy clearly was unbalanced, especially in the UK. Public service employment was clearly too high, and cannot be afforded at its current strength on any realistic level of taxation. Also too much of the economy is spent taking care of ultra-rich bankers and foreign exiles – whose numbers and wealth we cannot or should not expect to grow. And we still need to adapt to a lower energy economy. I can’t prove that the authors are wrong – but there is enough reason for caution.

The authors make much of not repeating the mistakes of the 1930s. But that was a very different world for two important, and related, reasons. First there was a ready solution at hand: the expansion of manufacturing industry with an abundance of good low skilled jobs. It took the war to unlock this, with the manufacture of armaments and transport, but war production could be converted to civilian use with surprising ease – as there was massive untapped demand for cars, fridges and other manufactured goods. Second we were much poorer then. Starvation was a real problem for the unemployed and poor, and the destruction of wellbeing flowing from depression was horrific. Now we define poverty as lack of access to television and mobile phones. The hardship is much less – and there is less untapped demand. Technology has put paid to the number and quality of unskilled jobs.

That bespeaks caution – something that the manifesto economic sense disregards. There is a case for some sensible investment projects – including the right sort of housing in the UK. But temporary tax cuts would be reckless, and stopping public sector cuts irresponsible.