The new economics: what does this mean for liberals?

My previous article on the changing world of political economy generated more interest than usual. It was, of course, a small dip into a large and complex topic. Given the interest shown, I feel the need to expand on it a bit.

The first thing to say is that what I am calling “the new economics” is based on standard economic principles, and the ideas aren’t new. The departure from political policy norms may be radical, but the departure from mainstream economic theory is not. This is partly how I have chosen to frame it. The heterodox idea of Modern Monetary Theory (MMT), popular in some parts of the left in the US and UK, is in fact not at all far from my new economics. But MMT advocates have, generally, chosen to frame their arguments as a radical challenge to conventional economics, and have a tendency to be very rude about mainstream economists. They have in turn drawn lots of rude comments from mainstream economists. A lot of this dispute, from both sides, is manufactured and I think that is a pity. Clearly some facts are in dispute, but it would be better to narrow these down and focus on the evidence rather than indulge in slanging.

Instead I take inspiration from people who are clearly on the mainstream spectrum. The main one is Adair Turner (whom I found going through some of my old papers was a Cambridge contemporary of mine: we were both members of the Conservative Association in 1976-1979). I haven’t read anything more than the Economist review of Dietrich Vollrath’s Fully Grown: Why a Stagnant Economy is a Sign of Success, but he is clearly another mainstream economist developing the same sorts of ideas. Mr Vollrath’s contribution is to bring rigorous numerical analysis to the table, where I have been plying with airy ideas.

Which brings me to my next point. A modern, developed economy will not show much in the way of GDP growth. We have become so conditioned to thinking that growth is a sign of economic health that this takes a lot of getting used to. But it is perfectly consistent with human wellbeing advancing. People may consume less stuff per head, but they can still have increasing levels of physical and mental wellbeing, and live in a nicer, friendlier and healthier environment. Mainstream economists have a tendency to suggest that people are being irrational if they consume less, work less, buy organic vegetables and have a healthier lifestyle, but the irrationality is theirs.

But a “stagnant” economy does bring a problem in its wake, and that problem is taxes and funding the public sector. GDP measures the size of the money economy, and the money economy is central to way governments operate. Indeed you can make a good case that money was invented so that the state could organise armies, build infrastructure and hoard surplus food. While the state could, and did, do this through forced labour and the appropriation of harvests and other goods, a system of taxation and wages is much more flexible. The rival idea that money was invented to facilitate trade is harder to sustain, though it used to feature a lot in economics text books. Of course the two functions of money, taxation and trade, fed off each other in a virtuous circle.

This all matters because there is no sign that the role of the state (in the broadest sense of collective public action) is about to diminish. The expansion of the state is one of the most important developments of the 20th Century, starting in large part with the creation of war economies, and then a dramatic expansion of the state role in education, healthcare and pensions and other welfare payments. To many on the right, this expansion of the state is seen as a hideous intrusion on human freedom that needs to be reversed. In fact it is a response to two important developments. The first is the tendency of capitalism to self-destruction, as noted by Karl Marx. If the capitalists succeed in creating too much profit, which is then hoarded, fewer people will benefit from the possibilities that the economy offers, and the system stagnates and collapses. If the state taxes those profits and hands them out to the less well off, this creates demand for capitalism’s products and the system is saved. (This is not the only way: capitalists being more generous with paying their workers has a similar effect, though it usually it takes organised labour to make this happen).

The second development causing the increased size of the state is the good old Baumol effect, which is the main driver of the new economics. The private sector is becoming so efficient that the relative cost of public goods is rising compared to what gets traded in private markets. Everything is more expensive in defence, law enforcement and healthcare. This issue is getting more acute. Public services are generally overstretched and many of their employees are underpaid. Stinginess on welfare benefits is creating knock-on problems elsewhere in society.

But this creates a political challenge. Public services need to be funded through taxes (it is possible to have a theological debate on this with MMT advocates, but let me duck that for now – without taxation public spending leads to inflation). People are generally willing to pay quite a bit of tax, but this comes at a political cost. Politicians have tried to sidestep this through economic growth. If the money economy is growing, then the state collects more money while keeping the tax rates the same. Those familiar with Baumol thinking will realise that this always was flawed thinking, as productivity in the public sector lags that in the private sector. But now we are in the stagnant phase of our economic evolution, the argument collapses completely.

That points to the raising of taxes, and all the political problems that come with that. But behind this there is a bit of a puzzle. For now state budget deficits look quite sustainable, as do higher levels of state borrowing. The fear is that deficit spending will create inflation, and high levels of public debt create financial instability – and that the risks are higher if the economy isn’t growing. But there is no sign that inflation is close to be awakened in developed economies, while monetary policy can be used to manage high levels of government debt, provided that you are borrowing in your own currency, and inflation is dormant. Meanwhile private sector demand for public debt remains very healthy. So just when do we need those higher taxes?

That is the central problem at the heart of the modern political economy. I don’t have an answer. But longer term there are three important things about a liberal approach to the new economics that I do hold on to:

  1. The government’s extra flexibility on fiscal deficits and debt should be exploited through investment programmes, creating assets that can be separately financed if necessary. These include social housing and renewable energy infrastructure. We need to be more careful with hospitals and transport infrastructure, but there are doubtless opportunities there too.
  2. The day when extra taxes will be needed to fund more public services will arrive. When it does the level of public accountability will need to improve substantially. This points to the need for a profound devolution of power, and especially the power to raise taxes, backed up greatly improved public governance.
  3. Meanwhile public services will need to be more efficient and effective (which is not the same as being more productive in my vocabulary). That means a profound switch to preventing and solving problems rather than service delivery and ticking boxes. That will require specialised services to work in a much more integrated way with much more delegated authority – and that means that services. mainly, need to be more localised. Which, of course, fits neatly with point 2.

I think this could be the basis for a grand bargain between liberals and either the left or, even, the right. The signs that either end of the political spectrum, or indeed liberals, are up for this are mixed. But there are some stirrings. On the other hand unscrupulous forces of the right or left could exploit the extra flexibility on public finances to line their friends’ pockets and consolidate political control while pretending to address the needs of “ordinary people”.

3 thoughts on “The new economics: what does this mean for liberals?”

  1. ” A modern, developed economy will not show much in the way of GDP growth. ”

    I’m not sure this is true. If you Google {USA GDP} you’ll see a graph showing a “healthy” looking steady growth trend compared with the not so healthy and jerky growths and non growth periods experienced by any of the EU countries.

    But let’s take this to be the case for the moment.

    “a ‘stagnant’ economy does bring a problem in its wake, and that problem is taxes and funding the public sector.”

    Surely if the economy is exactly the same from one year to the next the problems also remain exactly the same from one year to the next?

    “Those familiar with Baumol thinking will realise that this always was flawed thinking, as productivity in the public sector lags that in the private sector.”

    If both sectors are stagnant then there won’t be any productivity rise in either sector. So, doesn’t the Baumol effect then tend to zero?

    I would say the problem stems from your original assertion that we can do without GDP growth. Possibly we can but we need to consider how that’s going to work. Humans are inventive creatures so we’ll always find a way to do the same thing with less effort. Or, do it more efficiently if you prefer to put it that way. It won’t be too long before a truck is loaded up with agricultural produce in Spain and it will then drive itself to a Supermarket warehouse in the UK. So how do we plan for that and find a meaningful purpose in life for all those ex lorry drivers who no longer have a viable occupation?

    1. A lot of the US growth arises from population increases. The per capita figures are much closer. Or that was the picture recently – for some reason it quite hard to get proper per capital growth figures by a quick Google search, and nothing later than 2018.

      Surely if the economy is exactly the same from one year to the next the problems also remain exactly the same from one year to the next?

      The economy isn’t exactly the same from one year to the next. It is divided in a productive sector and an unproductive sector (not the right words, but that will have to do for now). The former continues to develop, as productivity continues to grow (robotics, AI, etc.) – but it shrinks as it becomes more productive (just as agriculture dominated economies a century a go and has now nearly disappeared in the stats). The benefits of higher productivity are being spent in the non productive sector, which expands. This includes leisure time (literally unproductive), status goods (where low productivity confers value) and things like medical care where productivity growth doesn’t happen (new treatments improve life expectancy, usually, but tend to be very expensive). The public sector is dominated by such “unproductive” services, whose relative cost to tradeable goods simply rises. And it tends to be tradeable goods that dictate the money economy. Or if the volume of “unproductive” services keeps the labour cost down, than the “productive” economy piles up profits, which can be hard to tax.

      So how do we plan for that and find a meaningful purpose in life for all those ex lorry drivers who no longer have a viable occupation?

      Not for the first time, I think we may be ending up in the same place via different routes. The volume of goods transported won’t necessarily go up by much. The ex lorry drivers will find work in the “unproductive” economy, and increasingly in the public sector, by my analysis. But how does that work?

  2. @ Matthew,

    I see what you’re saying. I don’t agree that we can’t increase GDP in what you term the ‘productive’ or private sector. The graph of {gdp per capita usa}looks a lot different from any of the EU countries, which would suggest that it’s the different macroeconomic policies of the two which is responsible – rather than some fundamental economic law of what happens when we get richer as suggested by Dietrich Vollrath and possibly others.

    But we can certainly choose to do that. In which case it will shrink, as you suggest, in terms of the numbers of people working in it. The political right will, no doubt, make the same argument ie that Govt “couldn’t afford” to finance health, education, social care etc and expect everyone to pay for it themselves.

    In principle this could work. It’s possible in theory. In total, we’d still be producing the same number of goods and providing the same level of services. Therefore, if they were divided up as previously, then we could end up no worse off. But, in practice, we know this is unlikely to happen.

    So how to ‘finance’ the public sector? Let’s look at a different way. We want to induce more people to work in it, now that the ‘efficient’ private sector needs fewer people. The way to do that is impose a general tax on the population which is payable in the currency of issue. To get the money to pay the tax we will need to do the jobs that are required in the public sector.

    You could tax the output of the efficient private sector a little more but there are limits. If you raise VAT too high, for example, there will be large scale tax avoidance/evasion. So, we need to think up some new unavoidable taxes! Like using the roads. More property taxes. More taxes on Co2 emissions maybe.

    It looks like Govt is trying to “find the money” to “pay for” the public sector. In reality it’s just looking for ways to make sure that people turn up to do their new jobs in the public sector – which, incidentally, don’t have to be 40 hours per week for 48 weeks of the year.

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