That said, there are undoubtedly serious problems with corporate tax regimes across the developed world. The increasing complexity of the legislation offers many opportunities for ingenious but perfectly legitimate avoidance schemes, such as Google’s “double Irish Dutch sandwich” described by Zucman. We can go down the route of trying to get greater international consensus on the treatment of tax, and steps have certainly been made in this direction. But it is a long and arduous process with no guarantee of success.
Recently, we have seen a very effective piece of forward guidance. Ed Miliband’s statement that Labour would bring in a mansion tax on properties worth more than £2 million has had a dramatic impact. The market for expensive properties in London has more or less ground to a halt, with very few transactions taking place. The tax would, of course, reduce the value of the properties, so waiting to see the result of the election before buying a property is sensible.
This is an example of what economists call rational expectations, a concept of fundamental importance to modern economic theory. People are assumed to have a reasonably good idea of how the economy works. In scientific terms, they have a good model, and they all have more or less the same one. When they need to make predictions about the future, they use their model, their concept of how the economy operates. So, when Ed Miliband says there will be an extra tax on certain houses, the model which most people have in their heads is that this will cause their prices to fall.
This seems plausible enough. But by no means all markets work in this particular way. A gang has been jailed in France for conducting a very profitable operation which ferried illegal immigrants into the UK. We might think that this would be a textbook example of a free market, in which price is determined by supply and demand. But the feat of the criminals was to set up a fixed price offer, in which the different categories had different prices. For the 800 Euro economy package, you would be smuggled into the back of a lorry with many others, and the driver would probably not know you were there. The 4000 Euro luxury offer provided a personalised space in a car boot, and the complicity of the driver.
The gang took advantage of the fact that in this situation it is effectively impossible for the consumers – the would-be entrants to Britain – to form rational expectations. How can a Somali, say, arriving in Calais after a long and arduous journey put together a good scientific model of the decision which he or she faces? There are just too many imponderables. But the fixed price, branded nature of the product made it very attractive to potential customers. It seemed like a regular retail offer, like the suppliers really knew what they were doing. It enabled the clients to construct a narrative, to tell themselves a story, that the gang would get them into the UK successfully and that they would not, for example, risk death in the process.
Many decisions have to be made in situations even more complex than this. For example, should HS2 be built? Should Britain pull out of the EU? Here, the policy maker is faced with different opinions from different experts, each using a different model of the economy with a different view of what the impact might be. Rational expectations just do not apply.
As published in City AM on Tuesday 11th November
Is there a secret Leninist cell operating at a high level in the European Commission’s headquarters in Brussels? One which is dedicated to the overthrow of the capitalist structures of the European Union? The evidence from this past week is certainly consistent with this hypothesis. The demand for an additional £1.7 billion payment from the UK is based on calculations backdated to 1995. Revisions to the way in which GDP is constructed means that Britain is better off than was previously thought, so we have to pay more. A pure gift to anti-EU political parties.
The saga does not end there. If the UK’s success is to be punished, it is perhaps logical, in this twisted view of the world, to reward the failing French economy with a rebate. But Germany, too, is due a repayment. Incredibly, Cyprus and Greece, catastrophic basket cases, have to pay more.
The fundamental problem with the EU is that the basic virtues of a successful capitalist economy are being repressed more systematically across the board. There is a strong consensus amongst economists, based on firm evidence, that the main determinant of long-term growth in developed economies is innovation. The European Commission pays a great deal of lip service to this, but Europe in general still lags considerably behind America in terms of innovation. The concept covers a range of factors. One is learning how to produce more of the same kind of output from a given set of inputs, which is an ongoing process throughout the economy. Much more importantly, inventions create the possibility of developing entirely new kinds of output, whether goods or services. Inventions are necessary for growth, but even more important is the ability of an economy to turn inventions from being ideas which enable the creation of new products, to the actual creation of the products themselves.
The massive companies created in the information and communications technology sector (ICT) in recent decades have almost all been American. And to the list which includes Microsoft, Google and Facebook can now be added Alibaba, the new ICT giant from China. An important article by Bart van Ark and colleagues in the top ranked Journal of Economic Perspectives in 2008 examined the widening productivity gap between Europe and the United States in the two decades immediately prior to the financial crash. Their conclusion was unequivocal: “the European productivity slowdown is attributable to the slower emergence of the knowledge economy in Europe compared to the United States”.
This lack of dynamism shows itself in the shorter term inability of many European economies to recover from the crisis. Of course, a key reason for this has been the macroeconomic and financial policies of the Commission and the European Central Bank. But the EU has increasingly become an area in which it is much easier to make money by what economists call rent seeking than by innovation. Exploiting a monopoly, lobbying the regulator, ticking some boxes, these are what pay. Innovations are disruptive, but Europe needs to encourage them more than ever.
As published in City AM on Tuesday 28th October
Why can’t the UK government get its deficit down? This question has been exercising commentators recently, in the light of the latest assessment from the Office for Budget Responsibility (OBR) that George Osborn will once again miss his target for the deficit in the 2014/15 financial year. Of course, the size of the deficit has fallen, from the £157 billion which Labour bequeathed in 2009/10 to £108 billion in 2013/14. But it does just not fall as much as either the OBR consistently predicts it will or the Chancellor would like it to. This limits the ability of the government to deliver tax cuts in advance of the election next year.
A common, and plausible, reason is that there has been a shift in how the economy operates. Output has recovered strongly, but earnings have not. The bargaining power of employers is stronger, many members of the workforce have a more flexible attitude to how much they work, so take home pay rises remain below inflation. As a result, the amount of tax flowing into the government’s coffers is not as much as would be expected on the basis of evidence from previous economic recoveries.
But the fundamental reason is that remuneration in the public sector remains too high. The recent strikes by Unite and other unions show that many people on the conventional Left seem to believe that the purpose of public expenditure is to boost the private consumption of those employed in the sector. The continued existence of annual increments in much of the public sector has no counterpart in the private sector. In the latter, pay increases have to be earned. In the former, for many workers they are automatic.
An argument which is used to justify the gap between pay in the public and private sectors is that the level of qualifications of public sector workers is on average higher. This is entirely spurious. What counts is not what goes into the production process of an organisation, but what comes out at the end. Countries in the former Soviet bloc, especially the East European satellites, had high levels of educational attainment. But the quality of much of what they produced was very low. The Trabant, for example, was a very popular car made in the old East Germany. But once trade with the West was opened, its value fell to essentially zero.
Gordon Brown started off well as Chancellor. He kept us out of the Euro and kept a grip on public spending. But he began to have delusions in the early 2000s that he had solved the problems of boom and bust and could do anything. Brown started to stuff money into the pockets of Labour’s core vote in the public sector. The result was that a structural deficit emerged in the UK’s public finances before the crisis of 2008 struck. Any Chancellor who is serious both about fairness and about eliminating the deficit needs to cut make serious reductions in public sector pay and pension entitlements.
As published in City AM on Tuesday 21st October
How many workers does the typical American firm employ? Actually, it is a trick question. The answer is ‘zero’. More than 50 per cent of all companies in the United States are one person operations – the owner, and no-one else.
This fragmentation of size is increasingly reflected in the UK. Here, the main growth is in self-employment rather than through one-person companies, but the principle is the same. According to the Office for National Statistics, in 2014, 4.6 million people were self-employed in their main job, accounting for 15 per cent of those in work, the highest percentage since data were first collected 40 years ago. Total employment in the second quarter of 2014 was 1.1 million higher than in the first quarter of 2008, just before the economic downturn. Of this increase, 732,000 were self-employed. So the rise in total employment since 2008 has been predominantly among the self-employed.
Good news, of course, which reflects the flexibility of the British labour market, though it seems to come at a cost. The ONS estimates that the average income of the self employed has fallen by no less than 22 per cent since 2008. Ed Miliband and the conventional Left denounce these developments. Proper jobs have not been created, and people have been forced against their will to take large cuts in pay.
Earlier this year, a major study by the Royal Society of Arts exploded this as a myth. Only 1 in 4 who started up in the recession said that escaping unemployment was a key motivating factor. A much more common answer was to achieve greater freedom. The self-employed are also happier than typical employees. Eighty-four per cent agreed that they were more satisfied in their working lives than they would have been in a conventional job (66 per cent completely or strongly so). The RSA argued that forgoing material benefits for more meaningful returns is a sign of a new ‘creative compromise’ at work.
In fact, basic economic theory suggests that well-being increases when people are offered more flexibility in the trade off between work and leisure. To caricature the old days, you were offered a 40 hour week, take it or leave it. But being self-employed allows you to choose your own point on the supply curve.
The RSA’s ideas are being taken forward in an exciting way in a new book by Adam Lent, director of their Action and Research Centre. The book, Small is Powerful, is, naturally, crowd funded. Lent argues that not only is the era of big government, big business and big culture over, but that this is unequivocally a Good Thing. Intriguingly, in the wake of the recent by-elections, Lent writes about Zombie Politics, and why big politics continues despite nearly everyone having lost the faith. He does not really deal with the issue of how, in the internet economy, the small can suddenly become terrifyingly big, witness Google and Facebook. But his book opens a window on how our world is changing.
As published in City AM on Tuesday 14th October
The National Institute for Health and Care Excellence (NICE) has been the butt of much ridicule over the past week. A pill designed to reduce alcohol consumption among problem drinkers will be made available across the NHS. But the concept of problem drinkers is so wide that it embraces people who enjoy a couple of modest glasses of wine a day. Indeed, the treatment is not really aimed at serious alcoholics who knock back litres of vodka with meths chasers.
There are now vast swathes of behaviour which Western governments attempt to modify. The government has its so-called ‘nudge’ unit dedicated to precisely this end. Obesity, smoking, the amount of exercise people take, voting registration, recycling, energy consumption are some of the examples. On the latter, it is not just the amount but the mix. Hectored for years that diesel fuel was morally superior to petrol, some unfortunates followed the advice and switched their cars to diesel. They now find themselves on the receiving end of a volte face on the matter by the bureaucracy.
There is a literature in top ranking economics journals on the impact of such interventions. In general, there is a short term effect which gives the policy makers what they want, but gradually, the reactions become muted and people revert to their old patterns. There are exceptions, but most of these attempts to change behaviour fail.
An interesting paper in the latest American Economic Review by Hunt Allcott and Todd Rogers shows the enormous efforts which are needed to alter the decisions which people make in the long term. In the United States, nearly 100 utilities hire a company called Opower to send home energy reports every month to millions of households. Households receive information on personal energy use, social comparisons and energy efficiency information.
The real interest in the Opower work is that some of the programmes were set up as controlled scientific experiments. Allcott and Rogers examine three of the longest running ones, which started in the late 2000s. Highly sophisticated metering devices were installed. Households, from a very large sample, were selected at random to receive the information. And after two years, some of those getting the reports were randomly assigned to have them stopped. This way, both post-intervention persistence and the incremental effects of continued treatment can be measured.
Unsurprisingly, there is an immediate reduction in energy consumption after receipt of the first report, though this impact decays rapidly. In households discontinued after two years, the subsequent decline is much lower. The sheer frequency of the reports does seem to alter behaviour. But there are further reductions in energy consumption in households who continue to receive the information, suggesting that people take a very long time to completely change their habits.
In the UK, attitudes towards wearing seat belts and drink driving did eventually change, but it took a very long time. Short-term trendy campaigns to ‘nudge’ behaviour are just not going to work. Governments have to be in it for the long haul.
As published in City AM on Tuesday 7th October
The latest fiasco at Tesco could prove an embarrassment for more than just the retailer. There appears to have been an over-recording of profit of some £250m, and some are asking questions about the company’s auditors.
Of course, the full story has yet to emerge, and Tesco’s auditors did flag issues in their most recent report. Further, no-one is suggesting that this is remotely like the scandal at Enron, which led to the effective dissolution of that firm’s auditors Arthur Andersen, then one of the five largest audit and accountancy partnerships in the world.
But getting this sort of thing right is very tricky. Financial professionals are only human, after all, and everyone makes mistakes from time to time. Regrettably, the instinct of many people is to call for tighter regulations to “prevent this happening again”. It is a litany familiar from the long succession of inquiries into child abuse scandals, and it has hardly been a successful one.
Clamping down on the ability of professionals to make judgments, and trying to cram everything into a tick box, is a recipe for failure. This whole approach is one of the most damaging legacies of the Gordon Brown era. We also see the problem in China at the moment: the rigorous clampdown on corruption is leading to a virtual paralysis of the government machine, with no-one wanting to risk making a decision of any kind.
One of the best ways of avoiding the sorts of problems which have arisen at Tesco is to try and ensure that there is diversity within management. Diversity in this context means that opinions which differ from those of the majority are encouraged rather than frowned upon. The phenomenon of groupthink can be very dangerous indeed, as the financial crisis showed. Financial institutions, regulators and accountancy firms all relied, for example, on models of risk which depended upon the assumption that very large changes to asset prices were almost never seen. Even though it had been established beyond doubt scientifically that this was not true, groupthink prevented more realistic assumptions being built into the models.
A key practical question, of course, is how to detect when diversity is disappearing within an organisation. An intriguing recent paper by David Tuckett, director of UCL’s Centre for the Study of Decision Making Uncertainty, uses the power of computer technology to shed some light on the problem. He analyses, or rather gets algorithms to analyse, very large-scale text databases to detect when groupthink is emerging and different perspectives are being squashed. One of them is the internal email database of Enron, and the other is Reuters’s’ news feeds, containing millions of articles concerning Fannie Mae. In both cases, clear early warning signals could have been identified.
I work with Tuckett on other topics at the Centre, so maybe I see the results through rose-tinted glasses. But innovative ways are needed of trying to avoid the persistent accounting problems which dog our corporate sector. Regulation alone will not work.
As published in City AM on Tuesday 30th September
Fears of deflation are rising across Europe. Inflation keeps edging down to lower and lower rates. Eurostat estimates the rate of inflation in the Euro zone in the year to August to be only 0.4 per cent, compared to 1.3 per cent in the year to August 2013. Negative rates were observed in seven EU countries. Remarkably, the rate of just 1.5 per cent in Austria and the UK is the highest in Europe.
The current inflation situation is perceived as being in some way abnormal. Such a way of thinking is understandable for policy makers whose formative years were the 1970s and early 1980s, when inflation was in double digits in many countries. But a longer historical perspective shows that inflation rates close to zero can persist for many years. We have been here before.
During the late 19th and most of the 20th century, the leading world economies were America, the UK and Germany. The general historical experiences and economic policies these three countries have followed over this period have been very diverse. Not least, America remained physically untouched by war, and Germany was laid waste in the mid-1940s. These two economies were devastated by the Great Depression of the 1930s, with unemployment rising above 20 per cent, whilst the UK escaped relatively unscathed in comparison. Germany had fascism, Britain and the US had democracy. The differences are huge.
But a striking feature is that their experiences of inflation have been very similar over the past 150 years. The one exception was the very brief period in the early 1920s when political turmoil led German inflation into stratospheric rates of millions of per cent. Those few years aside, the average rate in the US since the late 19th century has been 2.0 per cent, 2.9 per cent in Germany, and 3.0 per cent in the UK. And a relatively small number of years push the averages up. Inflation was high in the Second World War and after the quadrupling of the oil price in the early 1970s. Apart from that, the typical rate of inflation is just above zero.
The one common feature across the three economies and across time is that markets have been allowed to function, and companies have had to operate in a competitive environment. Competition in the labour market restrains wages, and competition in goods and services markets makes it difficult to enforce price increases. Of course, markets differ in practice from the competitive ideal of economic theory, but competition is the unifying theme.
The implication is that it is extremely difficult for the authorities to stimulate inflation. This would be an effective way of eroding the value of debt. It worked in the UK in the late 1940s and 1950s. Even modest rates of inflation, inherited from the Second World War and boosted by the Korean War, brought the public debt to GDP ratio of 250 per cent after the war back to sustainable levels. But low or zero inflation is a perfectly normal state of affairs.
As published in City AM on Tuesday 23rd September
After months of Trappist silence, a whole plethora of large companies has pronounced on the adverse consequences for Scotland of a Yes vote tomorrow. The sectors span the economy, from oil to banks, from supermarkets to phone companies. But what will be the effect of these interventions?
From the perspective of a rational economic person, they must make people more likely to reject independence. Jobs will be relocated out of Scotland and the prices of goods and services will rise. The public finances of the Scottish government will be weaker than is claimed, with much less oil being available. Serious doubts have been raised about the financial stability of Scotland as a whole, as problems with its currency arrangements are aired. There is a distinct impatience amongst those who operate in this rational world with how voters seem to make up their minds. Certainly, at times this can seem bizarre. On a recent visit to Scotland, I was told in all seriousness by one woman that she was voting ‘Yes’. On a recent holiday, she had noticed on her passport the Royal Coat of Arms, in which the Scottish Unicorn appears chained to the Lion of England.
There is obviously the wider issue as to the importance of economic factors are in how people are casting their votes. But in terms of the companies’ announcements, their impact depends upon credibility. If they are perceived mainly as scare stories, their effect may be the complete opposite of what is intended, pushing people more firmly into the ‘Yes’ camp. It is the question of credibility which makes the impact difficult to assess.
Many of these issues are difficult and complicated, where even experts may legitimately disagree. The level of uncertainty around their impact is inherently high, not least because the consequences of such actions stretch far into the future. Economists are starting to appreciate that their standard model of so-called rational behaviour may not be very helpful in describing how people actually make decisions in such circumstances. Discussion of this issue was prominent at both the Institute for New Economic Thinking conference in Toronto in April, and at the recent World Economic Forum gathering in Kuala Lumpur, each graced by the presence of Nobel Laureates. The fashionable new phrase is ‘radical uncertainty’.
An effective strategy for making decisions when outcomes are very uncertain is simply to copy what other people do. There are many nuances to this, but it is often a good rule of thumb to use. Keynes wrote about ‘the psychology of a society of individuals, each of whom is attempting to copy the other. The American economist Armen Alchian took the concept further in the Journal of Political Economy in 1950. Interest in his brilliant paper, ‘Uncertainty, Evolution and Economic Theory’, is reviving rapidly. The tools and the maths to formalise the concept did not exist in the days of Keynes and Alchian. But the question of how people decide under uncertainty is now a red hot topic in economics.
As published in City AM on Tuesday 16th September
The Euro zone lurches into yet another crisis, with fears of deflation and a further drop in output. There are several dominant explanations of why Europe has been unable to recover from the crisis. Most commentators subscribe to them either on their own, or in various combinations, depending on their tastes.
One puts the blame squarely on excessive public debt. Confidence can never be restored until this is tackled. Another perspective points to low productivity and high unit labour costs in the Mediterranean economies. Until they transform their economies, they will never be able to compete with the dynamic economies of Greater Germany – Poland, Austria, Sweden and the like. A related but separate argument puts the Euro itself in the frame. One size does not fit all, and some countries need to leave. George Soros has an original perspective on this, suggesting that Germany should exit, and a Deutschmark appreciation would make the residual Euro zone economies competitive again.
An intriguing new book by Philippe Legrain, European Spring: Why Our Economies Are in a Mess, challenges every single one of these ideas. At first sight, Legrain is the epitome of the successful Eurocrat. He is British, but his father is French and his mother Estonian. He, somewhat ostentatiously, has command of numerous languages. And he has just completed a spell as head of the strategic policy team advising Manuel Barroso, recently retired President of the European Commission.
But the first part of his book is a no holds barred attack on the two central institutions of Europe, the Commission and the European Central Bank. He documents in impressive detail mistake after mistake made by these two august bodies, before, during and after the 2007-09 financial crisis. For example, during the 2010-12 period, there were many similarities between the state of the UK economy and that of the Euro zone. Yet the latter suffered devastating financial panics, whilst we did not.
Legrain points accusingly to European level policy makers. They consistently misdiagnosed problems, treating the fact of Greek insolvency as a question purely of liquidity, and the liquidity issues of the rest of the GIPSIs (his marvellous phrase for Greece, Ireland, Portugal, Spain and Italy) as failures of solvency. Unlike the American authorities, who have closed down 475 banks since 2008, Europe continues to prop up zombie banks, which stymies the recovery. Further, they completely failed to control the narrative with which policy changes are received by the markets, and which is the key to the effects such changes have.
The second part is an impassioned plea to make Europe more competitive in ways which will gladden the hearts of many readers. Cut income taxes, scrap restrictive labour laws and revere entrepreneurs. The scale of the challenge of implementing such policies is shown by the recent decision by Luddites in Germany to ban the Uber taxi app. If Steve Jobs had been French, he would have ended up as a programmer in a nationalised industry with a job for life and a gold plated pension.
As published in City AM on Wednesday 9th September