The election is done and dusted, but many interesting questions remain. Was there a swing to the Conservatives at the very last minute, or was it indeed possible to foresee the victory in advance? Snippets are emerging which suggest that the electorate had made up their minds well before polling day. Rod Liddle, the entertaining columnist, visited his home area of Stockton on Tees a few weeks ago. Liddle, a Labour-inclined man, walked round the highly marginal seat and actually spoke to people. He wrote that it did not feel like Labour would win.
The website Labour Uncut, a place where Blairites huddled to escape persecution under the Miliband terror, carried a fascinating piece on 2 May. Local political parties are entitled to inspect the postal votes as they arrive. It is strictly illegal to count them. But it is hard not to notice the relative sizes of the heaps of votes for the parties. The information fed back to Labour HQ was that the postal votes showed no swing to Labour in the marginals. Miliband’s late night visit to Russell Brand was undertaken as a panic response. And, just in case there are devotees of efficient market theory out there wondering how this information was used, I did make a modest amount by betting on the outcome.
More importantly, a web post by the polling company Survation reveals a more general problem. They conducted a careful telephone poll on the day before the election. Survation not only named the local candidates, but they insisted on only speaking to the named person from the dataset. They called mobile and landline telephone numbers to maximise the ‘reach’ of the poll. The figures showed 37 per cent to the Tories and 31 per cent to Labour, almost exactly matching the real result. Here is Damian Lyons Lowe, CEO of Survation, on what happened next: “the results seemed so out of line with all the polling conducted by ourselves and our peers that I chickened out of publishing the figures”.
Full credit to Mr Lowe for being so open and honest. But the same thing happened in the days before the 1992 election, another so-called ‘surprise’ Conservative victory. The Labour lead appeared solid, so several polling companies adjusted their results in the Labour direction in order not to look too different from the rest.
Both are classic examples of the influence of groupthink. This is exactly the same phenomenon which led to the financial crisis. The influence of the network of peers becomes so strong that individual judgement is overridden. ‘Everyone’ knew that mortgage-backed securities were a licence to print money, ‘everyone’ knew that debt was no longer a problem in the new economic paradigm. Even the strong willed leaders of major institutions capitulated in the face of such pressure, no matter what their private doubts. Opinion polls are neither here nor there. But a major challenge for financial regulators is how to identify the signs of the next build up of groupthink in the markets. This is the most effective way of preventing crises.
As published in City AM on Wednesday 13th May 2015
An exciting email pinged into my inbox at the end of last week. It was a link to the contents of the latest issue of the American Economic Association’s journal ‘Economic Policy’. For most people these are not usually as gripping as, say, a Ken Follett novel. But there, nestling amongst thickets of algebra, is an article entitled ‘Mansion Tax: the Effect on the Residential Real Estate Market’.
The authors, Wojcieck Kopczuk and David Munroe, are both members of the prestigious economics department at Columbia University in New York. The article contains its fair share of technical material, but the main points are conveyed by some straightforward charts. The paper describes a detailed analysis of residential real estate transactions since 2003 in New York City and in the neighbouring state of New Jersey.
The mansion taxes which they examine are nowhere near as punitive as the one envisaged by Ed Miliband. But the impact of the taxes is both dramatic and detrimental. A so-called mansion tax has been in force in New York since 1989 and in New Jersey since 2004. It applies not on an annual basis to the property, but simply to transactions of $1 million and over. The tax rate is 1 percent and is imposed on the full value of the transaction so that a $1 million sale is subject to a $10,000 tax liability, while a $999,999 transaction is not subject to the tax at all.
Not surprisingly, the tax distorts the distribution of pricing, so that there is a large bunching effect just below the $1 million threshold. A plot of the number of transactions in New York City against the price, not surprisingly, slopes downwards. There are a lot more sales of properties at, say, $500,000 than there are at £1.5 million. But there is a huge spike in the chart immediately below the $1 million tax threshold. The same result is shown for New Jersey. Here, the tax was introduced during the period for which the transactions data is available. And its impact was virtually instantaneous.
There is a large gap in transactions in price bands just above the threshold. But this is bigger than the excessive number of sales which take place below it. More sales are lost above the threshold than are gained below it. The tax causes the market to, as the authors put it, unravel. The market ceases to function properly, and trades which would otherwise have been undertaken by willing buyers and sellers do not take place at all. This is the real subtlety to the article. Mansion taxes create costs which are not at all obvious at first sight. The people who lose out can never be identified, for the simple reason that they are unable to carry out the transactions which they would have liked to. But their losses are nevertheless real.
Markets are often imperfect instruments. If left completely unchecked, they can create undesirable outcomes. But Soviet-style diktats on markets can create costs for society which go beyond the immediately obvious.
As published in City AM on Wednesday 6th May
I am keen on dogs. Recently, I have seen an advert for a special canine toothbrush designed to get rid of the pet’s bad breath, surely a difficult challenge given what dogs get up to. Vans promoting home beauty visits for dogs have proliferated for some time now. A new service being promoted is day care for dogs, similar, one might think, to child care. The dog is deposited and entertained for the day while you go off to your meeting or out to lunch.
At one level, these stories are mere trivia. At another, they are a tribute to the continuing inventiveness of capitalism. The role of the entrepreneur is to imagine a product or service which no one, until then, realises they want, and to make a successful business out of selling it. But they are also relevant to the important policy concept of the output gap. This is defined very simply as the difference between the actual and potential levels of GDP.
Describing the output gap is one thing, measuring it in practice is quite another. The Office for Budget Responsibility (OBR) is required to provide an estimate. A key reason is that the output gap plays an important role in assessing the government’s financial deficit, once cyclical factors are taken into account. In recessions, tax receipts drop, so the deficit rises. A measure is needed which allows for this, and this is the so-called cyclically-adjusted deficit, what the deficit would be if the output gap were zero. The output gap is also crucial to central banks in judging whether inflation is likely to be a problem as the economy expands. During the past year, there has been a flurry of publications from the various Federal Reserve banks in America on the output gap.
What is the potential level of output of the various dog services described above? Dogs, of course, are just one illustration of a proliferation of inventive offers which are available in the modern service economy. Personal trainers and lifestyle coaches are other obvious examples. There is obviously a limit to the number of dogs for which any one person can provide day care. But from the point of view of measuring the value of the output of a dog caring business, a great deal depends upon what price the market will bear.
Part of the problem is that such services are not commodities like, say, gold bars, which are the same everywhere. They all have their own features, their own specialities. This introduces an inherent indeterminacy into the price, which is essentially a bargain between the seller and each individual buyer. If I can double my price, I can double the value of my output, with nothing else changing at all. And, as the economy expands, the easier I will find it to put my price up. Potential output in the personalised service sector of the economy is a very flexible and elusive concept. The idea of the output gap belongs to an economy which made steel bars and dug coal, not one which provides day care for dogs.
As published in City Am on Wednesday 29th April
The temptation to believe in the concept of a free lunch is one which has proved irresistible to numerous governments through the ages. Henry VIII, for example, has seized popular imagination once again through the brilliant portrayal of him by Damian Lewis in Wolf Hall. Bluff King Hal is the nickname often associated with the King. But to his subjects, especially towards the end of his reign, he was more usually called Old Coppernose. He debased the silver coinage with so much copper that, when the coins were used, the copper shone through the flimsy cover of silver onto his portrait.
The Office for Budget Responsibility has recently produced an excellent little document which shows how post-war governments in the UK have indulged themselves in the modern equivalent of coinage debasement. The dry title is ‘A brief guide to the UK public finances’, but it contains fascinating material.
Since 1948, British governments have run deficits on the public finances in 54 out of the 66 financial years. In the most recent four decades, surpluses have been registered on only five occasions.
It all started off so well. The post-war Labour government of Clement Attlee was heavily interventionist, nationalising the mines, socialising health care in the NHS. But it was a model of fiscal rectitude. It ran a surplus in every single year until its defeat in 1951, including what is by far the largest post-war surplus in 1948 itself, amounting to nearly 5 per cent of GDP – getting on for £100 billion in today’s terms. The Conservatives carried on in the same way. From 1948 until the election of the next Labour government in 1964, public sector surpluses and deficits more or less cancelled each other out over time.
This is exactly how it was meant to be. Keynesianism, as it was originally conceived, required the government to run deficits when the economy was slowing down, to boost demand, but to offset these by surpluses in the good times. But since 1964, the cumulative size of the annual deficits comes to no less than 160 per cent of GDP. A nice little earner with which to bribe electorates.
Governments have got away with it thanks to inflation. The bonds they issue to finance deficits are denominated in money terms. When they mature, they simply pay back the face value, regardless of what has happened to prices in the meantime. Even with only 3 per cent inflation, prices double in just 23 years. And this doubling halves the real value of debt issued at the time.
The zero inflation world in which we now live changes the rules of the game. Any debt which is sold to finance public sector deficits will have to be repaid for real. Both George Osborne and Ed Balls are smart enough to understand this. The same cannot necessarily be said for many of their senior colleagues. And the biggest task is to convince the electorate, especially in the subsidised areas, that their living standards from now on will depend upon their productivity. No more free lunches.
As published in City Am on 22nd April 2015
Ed Miliband’s proposal to tax non-doms more harshly may be good, populist politics. But does it make economic sense? At most, the yield will be around £1 billion, even if people do not alter their behaviour in response to the change in policy. The actual amount generated could even be negative if enough non-doms leave the country. Most commentators recognise this.
The history of tax wheezes dreamt up by governments is a litany of the eventual tax take falling short of its anticipated level because of changes in behaviour. In 1795, Britain was engaged in a titanic struggle for survival against revolutionary France. The sheer scale of the war put the public finances under unprecedented strain. The then Prime Minister, Pitt, invented the Powder Tax. Anyone wishing to buy powder for his wig had to register and pay a tax of a guinea (£1.05), a non-trivial amount in those days. Wigs rapidly went out of fashion, and the tax yielded very little. The diehards who persisted with wigs became known as ‘guinea pigs’, the origin of the modern phrase.
There does seem to be a limit to the amount of tax which British governments are able to raise. Fifty years ago, a new Labour government, headed by Harold Wilson, had just come to power, determined to transform the British economy. In the financial year 1964/65, the total amount of tax and National Insurance payments raised came to 36.2 per cent of GDP. In the final year of office of this highly interventionist government, 1969/70, this figure had risen. It had increased to the dizzy height of 37.4 per cent! A government which by today’s standards was radical and left-wing felt able to put taxes up by all of 1 per cent of GDP.
The 1969/70 level is almost the highest ever recorded over the past five decades in the UK, being fractionally higher in the recession of the early 1980s at 37.6 per cent. Gordon Brown controlled domestic policy in Britain from 1997 onwards. The tax manual doubled in size thanks to the huge number of new schemes Brown introduced. But when he was booted out by the electorate just after the end of the tax year 2009/10, tax and social security receipts were only 34.5 per cent of GDP.
Elected authorities at all levels in the UK seem to be reluctant to increase tax beyond a certain point. The Scottish Executive has had the power to raise the basic rate of income tax by up to 3p in the pound. But despite the fact that the body has always been controlled by parties of the Left, Labour and the SNP, neither has used the power. Local authorities can hold referenda to put up council tax, but they don’t.
The 38 per cent threshold is not an immutable physical law. But no UK government of whatever persuasion in the past 50 years has been either willing or able to raise more tax than this as a percentage of GDP. This sets clear limits to the ambitions of any government during the next Parliament.
As published in City Am on Wednesday 15th April 2015
The financial crisis did succeed in creating one dynamic new industry. Since the late 2000s, there has been a massive upsurge in op-ed pieces, books and even artistic performances offering a critique of capitalism. A founder member of the Monty Python team, Terry Jones, is the latest to get in on the act with his documentary Boom, Bust, Boom. The film makes use of puppetry and animation to argue that market-based economies are inherently unstable.
In the opening scene, Jones appears on Wall Street. ‘This film is about the Achilles heel of capitalism’, the ex-Python solemnly proclaims, ‘how human nature drives the economy to crisis after crisis time and time again’. The intellectual underpinnings of the movie are the theories of the American economist Hyman Minsky. Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the private sector. Although he never constructed a formal model, Minsky’s ideas are clearly relevant to the run up to the crash in 2008. They at least deserve to be taken seriously.
But does life really imitate art? Is capitalism genuinely unstable in the way in which Jones alleges in the film? An immediate problem for this view is that there have only been two global financial crashes in the past 150 years. The early 1930s and the late 2000s are the only periods in which these were experienced. So an event which takes place approximately once every 75 years is hardly convincing evidence with which to indict an entire system with the charge of instability.
One way of looking at the stability of capitalism is through the labour market. If the system experiences frequent crises, the average rate of unemployment will be high. But this does not seem to be the case. From the end of the Second World War until the oil price crisis of the mid-1970s, unemployment averaged just under 5 per cent in America and was less than 3 per cent in the UK and Germany. Even during the more turbulent times since the 1970s, prior to the 2008/09 crisis, the unemployment rate averaged 6 – 7 per cent in the three economies. Higher, but by no means catastrophic given that Keynes himself thought it was very unlikely that the rate could be much less than 3 per cent over long periods of time.
It could be argued that since 1945, the state has intervened much more in the economy, and it is this which has kept unemployment low. But over the 1870-1938 period, the numbers are very similar to those seen post-war. In the United States, it is 7 per cent, 5.5 per cent in Britain, and under 4 per cent in Germany.
Most recessions are in fact very short lived. Since the late 19th century, 70 per cent of all recessions lasted just a single year. The distinguishing feature of capitalism is not its instability, but its resilience. Markets are not perfect, but unemployment is usually low. Crises happen, but the system bounces back.
As published in City Am on Wednesday 8th April
Zero inflation is trending. The consumer price index in the UK was at the same level in February as it was a year earlier. The reporting of this figure on the BBC website created some unintended amusement, however. The drop to zero, we were told, was “sharper than many analysts had expected”. And what was this expectation? All of 0.1 per cent, almost identical to zero and, given the margins of error around these estimates, to all intents and purposes essentially the same figure.
Not only that, but the BBC solemnly informed us that the figure was the “lowest since records began in 1988”. Yet the Bank of England has recently released data which contains estimates as far back as the early nineteenth century.
To be fair, we do have to go back a long way to find an example of an entire year in which, on average, prices fell compared to the previous one. To 1934, in fact, though it was then nothing unusual. Inflation had been negative in every year since 1927. In the two other largest economies in the world at the time, America and Germany, inflation was below zero in every year from 1930 to 1933. Remember, though, that this was exactly the period of the Great Depression, when output fell by over 20 per cent and a quarter of the US workforce was unemployed. So we can see why prices fell. Demand for many products and services had collapsed.
The attitudes of the current batch of commentators and policy-makers have been shaped by the experiences of their formative years in the 1970s and 1980s. Inflation really was the number one problem then. Even in Germany, with its enormous fear of inflation ever since the early 1920s, when it briefly hit millions of per cent a year, prices doubled between 1970 and 1985. In Britain and the US, prices rose by more than 10 per cent a year quite frequently.
This was a very unusual period indeed. Sharp increases in prices were also experienced in the two world wars, when the economies were being run absolutely flat out. But over the past 150 years, during peace time in the US, UK and Germany, inflation close to zero has been the normal state of affairs. The basic reason for this is competition. Competitors are everywhere. They may be competitors which already exist, or they may only be potential competitors. In supermarkets, for example, Aldi and Lidl entered the UK relatively recently, spotting an opportunity to compete on price.
The downside of zero inflation is that it does nothing to erode the value of debt, much of which is denominated in money terms. If your mortgage is £100,000 and the price level doubles, its real value has fallen to only £50,000. The world is still burdened with excessive debt, which is a worry for policy-makers. But a low inflation world forces them to confront this issue honestly, and not try to evade it by using the subterfuge of inflation.
As Published in City AM on Wednesday 1st April 2015
Economic statistics are the bane of forecasters’ lives. Cynics might say that this is because the data reveal how bad their predictions are. But a big practical problem is that initial estimates of the state of the economy can be revised substantially.
These issues are as nothing compared to statistics on crime. The Crime Survey of England and Wales shows that crime fell by 11 per cent in the year to September 2014, and was at its lowest level since the survey began in 1981. In contrast, police recorded crimes show no change at all during 2014. The ONS does point out that there had been a “renewed focus on the quality of crime recording”. In plain English, the police were starting to do their jobs properly and actually record the crimes reported to them. Even the police figures, however, suggest a drop in every previous year as far back as 2003.
So we do know that crime is much lower than it was 10 years ago, and probably less than it was in the 1990s. Why is this? A few years ago, I was at a seminar where a professor from a criminology department at a former polytechnic in North London claimed he knew why crime took place. It was, he pronounced, the fault of capitalism. Well, capitalism seems to have become even more capitalist in recent decades, yet crime has fallen. So this particular Dave Spart idea can be kicked into touch, though taxpayer funding for similar rubbish continues.
In recent years, the success of the UK labour market in creating jobs has undoubtedly been a factor in helping to reduce crime. The plain fact is that most crime does not pay. The rewards are often meagre, and persistent petty criminals face constant pressure from their local police. It might be thought implausible that semi-literate low skilled young men, the group which commits most crime, are capable of such rational analysis. But the evidence is pretty convincing. Stephen Machin at University College London, for example, did a very sophisticated statistical analysis of crime in the police areas of England and Wales when the minimum wage was introduced in the late 1990s. He found that it had a clear impact on cutting crime.
Another factor is the complex evolutionary game played between criminals and respectable citizens. Cars get broken into and stolen, so technology which makes this more difficult is gradually discovered. People become more security conscious about their homes, making burglaries more problematic.
A recent survey of 500 police officers claimed “there are just not enough of us to cope”. But despite this moaning, a constant theme in recent years, crime has fallen. Some increases in the efficiency and productivity of the police force have taken place, but there is a long way to go. And the culture is still too focused on the political correctness inherited from the Blairite era.
Sharp reductions in crime have been experienced in America and elsewhere in Europe as well as the UK. The explanation remains a key challenge for serious social science.
As published in City AM on Thursday 26th March 2015
As published in the Guardian on Tuesday 24th March 2015 as part of their ‘Economics – Immigration Special’
Mass immigration increases inequality. This is the unpalatable fact the liberal left in Britain refuses to accept. Markets are imperfect instruments. But it is not necessary to subscribe to free market economic theory to believe that large increases in supply tend to drive down the price. And the price of labour is the wage.
Last Friday, the Guardian front page carried a report from the Office for Budget Responsibility, claiming that higher net immigration increased the UK’s economic growth rate. According to the mainstream theory of economic growth, this is undoubtedly true. Higher growth can be created by sustained increases of either capital or labour.
But underlying the theory is the assumption that supply and demand balance in these markets, that the prices of the inputs are set at levels such that all available capital or labour is in fact employed and does not remain idle. So this “flourishing modern economy” with high immigration celebrated by the Guardian is based on persistent large wage inequalities.
A powerful force in the global economy is driving the increase in inequality that has been seen in western economies over the past few decades. In essence, there has been a massive increase in the effective supply of labour. Over the past three decades or so, China and India have gradually been absorbed into the network of international trade.
This puts pressure on European labour markets. Many call centres, for example, have been relocated to India. But much of the impact of this is indirect, operating via trade flows, and is only really felt by certain sectors of western economies.
Closer to home, the opening up of eastern Europe in the early 1990s has had a strong effect, especially on countries that are their immediate neighbours, such as Germany. Employers soon realised that economies such as Poland and the Czech Republic possessed educated labour forces, whose productivity potential had been suppressed by the gross inefficiencies inherent in planned economies. German companies opened up new production plants in the old Soviet bloc countries in Europe, rather than at home.
The impact on wage rates of this increase in competition was dramatic. Christian Dustmann at University College London has provided clear evidence on the evolution of wage rates in the former West Germany. The 15th percentile of the wage distribution is the level at which only 15% of wages are lower. In West Germany, at the 15th percentile, real wages have fallen almost continuously since the mid-1990s. At the 50th percentile, where half get more and half get less, the reduction has been less sharp.
But the fall had set in by the early 2000s. At the 85th percentile, the mirror image of the 15th, real wages grew strongly, reaping the benefits of the recovery of the economy created by the increase in competitiveness.
It is against this background that New Labour opened up Britain’s borders in the late 1990s. It was a major betrayal of the very people the party purported to represent.
In addition to the global competition from countries such as China, in addition to competition closer to home from the economies of eastern Europe, New Labour allowed direct competition to enter the UK labour market on a scale unprecedented in our history.
Not surprisingly, the distribution of wage rates has evolved in very similar ways to those of West Germany. It is the relatively unskilled in the bottom half of the distribution who have lost out. The liberal elite do not suffer.
Indeed, they benefit because many of the services they consume are provided at lower prices than would have been the case without mass immigration. It is sometimes argued that immigrants do jobs that native British workers are unwilling to take.
Very well then, without mass immigration, employers would be obliged to raise the real wage rate to induce these people to take the jobs.
The effects of this extend to benefit levels. With at least half the population facing at best stagnant and often falling real wages, basic political economy requires benefits to be squeezed as well. Hostility to benefits is strongest precisely in the bottom part of the wage distribution. It is political suicide to increase real benefits in this context, regardless of who is in power.
In the so-called neoclassical growth theory of economics, whether of the pre- or post-endogenous variety, by far the most important source of sustained growth is innovation. The age structure of immigration means that it does make a change to per capita economic growth, but one that is barely perceptible. Moreover, immigrants themselves age eventually, so eventually even this tiny benefit disappears.
A truly modern economy does not rely on more and more capital and labour being fuelled into the machinery of production. That was the old Soviet model.
A modern economy relies instead on innovation. This should be the focus of policy. The potential gains are huge, not marginal and ephemeral.
All eyes will be on George Osborne’s Budget today. An immense amount of media attention and serious commentary will be devoted to it. But do Budgets really matter? How much difference would it make if successive chancellors simply did nothing, apart from indexing various allowances and benefits in line with inflation?
From time immemorial, British governments of all shapes and sizes have had to present their finances to Parliament for approval. For centuries, there was a constant struggle between the monarch, who almost invariably wanted more money to pay for the court or foreign wars, and the elected representatives, who were usually unwilling to vote for the taxes such policies required.
After the Second World War, however, the annual ritual of the Budget took on a completely different character. Armed with what were then seen as the insights of Keynesianism, successive chancellors regarded the Budget as a means of announcing policies which would control the economy in the forthcoming year. Even now, Osborne will spend time discussing the short-term predictions for UK GDP growth, inflation and the like. These are now produced by the Office for Budget Responsibility rather than by the Treasury itself, but they still form an important part of the Budget speech.
To be able to make meaningful interventions in the economy and bring about better outcomes over the short term, it is absolutely necessary to have reasonably accurate forecasts. Unless you have a good idea of where the economy is going to be this time next year, you have no clue about what actions to take now to get it into a better place.
It is well-known, however, that economic forecasts are – to put it charitably – poor. Even in the United States, where the economy is more insulated from unexpected external shocks, the record is pretty shocking. The Philadelphia Fed publishes the consensus forecasts made by economists for a range of variables. For GDP growth one year ahead, the forecasts, looking over several decades, are actually on average correct. But this conceals large errors in many years – it is just that, over time, the errors are cancelled out. And the forecasts are particularly bad at capturing tipping points, when there is about to be a boom or a slump.
This was the question the Queen put to the faculty at the LSE. Why had they not foreseen the crisis? To be fair, economic forecasting is a very hard scientific problem, which does not readily admit a solution.
So while the forecasts themselves are questionable, Budgets nevertheless remain important because of the narrative which the chancellor tries to portray about the economy. Nigel Lawson’s Budget of 1988 is rightfully famous. Not because it failed to predict the looming crisis in 1990, but because it set the tone in which enterprise was celebrated, thereby laying the foundations for the long boom of the 1990s. Osborne in 2010 seized the imagination of the markets and persuaded them that the public finances were sound. It is the narrative about the medium and longer term which matters, not the illusion of short-term control.
As published in City AM