From discussions on how the UK should reform its tax and regulatory landscape to make the most of post-Brexit opportunities, to the rallies midterm election candidates have been holding across the US championing or lambasting the President’s tax cuts, the debate is still raging about how changes to taxes impact economies.
But if you need convincing, or even if you’re just curious, events across the Atlantic provide a natural experiment in which we can observe in real time the effects of big tax cuts on an economy.
Nearly a year ago, on 22 December 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA), the most sweeping revision of US tax law since the Tax Reform Act of 1986.
Since then, economic growth has gone up. Between the fourth quarter of 2016 and the fourth quarter of 2017, GDP grew by 2.5 per cent in the US. In each quarter since, the annual growth rate has accelerated. The provision estimates for the third quarter of 2018 – the latest we have – suggest growth is now three per cent.
The jobs market is also booming. In the year to October, employment rose by over 2.5m. In that month alone, there was a rise of 250,000 jobs on the previous month.
Of course, all sorts of things can contribute to a strong economy. The headline figures simply support rather than confirm the narrative that tax cuts work.
A paper published this week in the leading Journal of Economic Perspectives focuses specifically on the corporate tax changes in Trump’s TCJA.
Beginning in 2018, the federal corporate tax rate fell from 35 per cent to 21 per cent, some investment qualified for immediate deduction as an expense, and multinational corporations faced a substantially modified treatment of their activities.
Alan J Auerbach of Berkeley sets out a detailed theoretical and empirical analysis of the Trump legislation. He is careful to qualify his findings with the usual kind of academic hedges. But they are unequivocal: tax cuts work.
The loss of revenue to the government of the various corporate tax changes in 2020 is estimated to be some $130bn. What will companies do with this money?
Auerbach concludes that at least a half of this will go on increases in wages. There are some 125m families in America, and on average they will be at least $500 a year better off.
Much of the rest will be spent on additional investment, which will further stimulate the economy.
And Auerbach cites a paper by the Harvard economist Robert Barro, due to be published in the Brookings Papers series, which suggests that the impact of the tax cuts will be even higher.
Leading American economists writing in leading academic journals are examining the Trump corporate tax cuts. They are concluding that everyone – both the companies and their workers – benefits from them.
Perhaps Philip Hammond should take a break from his spreadsheets and catch up with his reading.
As published in City AM Wednesday 7th November 2018
Image: Statue of Liberty by National Park Science
The focus this week has been on Philip Hammond’s Budget.
The opinions of the shadow chancellor have been rather in the background by comparison.
But John McDonnell is doing us all a favour at the moment. He is busily promoting a collection of essays which he edited, under the title “Economics for the Many”.
These cover a wide range of policy areas, and are written by a mixture of politicians, think-tankers, and academics sympathetic to the shadow chancellor. The book contains a substantial introduction by McDonnell himself, and so is a useful guide to his thinking.
McDonnell appears to believe that spending vast amounts of money on nationalising industries will cost the taxpayer nothing.
From a balance sheet perspective, this is technically correct. The government could issue debt to take over the rail companies, say, but this would be balanced by the value of assets acquired.
This misses the point. If someone were mad enough to lend you £10m to buy a house valued at that amount, your household balance sheet would not have changed. But how would you service the debt, and what rate of interest would you be required to pay?
The rate of interest on UK government bonds is currently low, at around 1.5 per cent. But this is determined by the markets, not by government diktat. If the markets lose confidence, the rate can change rapidly. In recent years, Italy, Spain and Portugal have all seen rates in the six to eight per cent range. And in Greece, they were as high as 23 per cent.
McDonnell is silent on how he would ensure that the same thing would not happen here.
Some of the essays in his edited volume share this silence. One of them, somewhat ironically, points out the dangers of debt levels being too high. Admittedly this refers to household debt and not public sector debt, but no recommendation is made on how the problem can be solved.
In the same way, several contributors attack the discipline of economics. We read, for example, that it needs to be “more diverse and representative of the society it serves”. Yet no argument is put forward which offers a scientifically superior explanation of events to that of standard economic theory.
To be fair, most of the essays do put forward proposals. But the striking feature is not their radicalism – it is how dull and unimaginative they are.
So, for example, when new firms are launched based on new technologies, they should be set up as cooperatives. Cooperation as a form of business model has been around since the Rochdale Pioneers in 1844. It has not exactly set the world alight.
There is much talk in the media about how Jeremy Corbyn’s Labour party has captured the zeitgeist. This is not reflected in the opinion polls, where the Tories remain obstinately in the lead.
But if it has, these essays suggest that we are not in for an exciting and innovative future. Rather, we will be condemned to a repeat of the dismal and depressing 1970s.
As published in City AM Wednesday 31st October 2018
Image: John McDonnell by Rwendland via Wikimedia is licensed under CC BY-SA 4.0
The media seems full of gloom at the moment. Chaos over Brexit, Saudi Arabia, potential nuclear escalation between the US and Russia – you name it, people are worried about it.
A ray of light is shone – an apt phrase as you will see – by the work of Bill Nordhaus, a Yale economist who was the co-winner of this year’s Nobel prize in economics, along with Paul Romer.
Over the past two decades or so, Nordhaus has worked mainly on integrating climate change into macroeconomic models, and was awarded the accolade for this research. He is no knee-jerk lefty in this respect. For example, he was a prominent critic of Nick Stern’s report on climate change, which was commissioned by Gordon Brown.
But in my view, Nordhaus should have been awarded the Nobel prize years ago for his brilliant work on measuring how well-off we all are.
The conventional measure of GDP per capita is widely criticised these days. But instead of just whinging from the sidelines about how economics is wicked and useless – sadly a common feature in modern critiques – Nordhaus actually tried to do something about it.
In 1972, he and James Tobin (another future Nobel laureate) developed the Measure of Economic Welfare. The two economists took GDP as their starting point. They adjusted it to include, for example, an assessment of the value of leisure time and the amount of unpaid work in an economy.
Taking these factors into account means we are better off than the conventional GDP measure suggests.
The most dramatic paper by Nordhaus, published in 1996, is on the seemingly obscure topic of the history of lighting. He analysed the topic over a vast time span, from the first sources of artificial light – the fires used by humanity around one million years ago – to the modern fluorescent bulb.
The focus of the paper was not the technology as such, but whether the standard ways of measuring the price of lighting captured the massive improvements in quality which have taken place, particularly in the twentieth century.
Nordhaus concludes that the traditional price indexes of lighting vastly overstate the increase in lighting prices over the last two centuries relative to quality. So the true rise in living standards has consequently been significantly understated.
The magnitude of the difference is vast. Nordhaus estimates that the price measured in the conventional way rose by a factor of between 900 and 1,600 more than the true price.
Bodies such as the Office for National Statistics receive information about the economy in current prices. If output in any particular sector has increased, a key task for them is to decide how much of that is due to a rise in prices and how much to a genuine increase in output.
Rapid quality change means that the conventional ways of doing this simply cannot cope. Price rises are overstated, and in consequence “real” changes in output and living standards are understated.
The implication of the apparently esoteric work Nordhaus did on lighting is that modern technology such as the internet has increased living standards far more than the official statistics indicate. Finally some news to be cheerful about.
As published in City AM Wednesday 25th October 2018
Image: Lightbulb by lenavasilevs via Pixaby is licensed under CC0 1.0 Universal
Gordon Brown’s time as chancellor will be remembered for many things.
A sense of humour would be conspicuously absent from this list.
But he provoked a great deal of mirth unintentionally in a speech shortly before the 1997 General Election on the theme of “post-neoclassical endogenous growth theory”.
Perhaps the last laugh is with Brown. The person who invented the concept, the New York professor Paul Romer, is a joint recipient of the 2018 Nobel prize for his work in this area.
The standard economic theory of growth was set out over 60 years ago in a brilliant paper by the MIT economist Bob Solow.
Solow’s theory was not concerned with the short-run fluctuations in GDP growth over the course of the business cycle. He set up a framework for thinking about what determines growth in the longer run.
Solow argued that the growth in output was related to the growth of inputs of labour and capital into the productive process.
This seems obvious. But there was an extra ingredient: innovation.
This embraces a wide range of concepts, from becoming more efficient at producing what you already do, to major scientific breakthroughs.
Economists quickly used Solow’s model to estimate empirically what was really driving economic growth. In western economies, the answer was almost always the same. The amounts of labour and capital used had risen, but nowhere near enough to account for how much growth had taken place.
So the key factor in economic growth in the longer run is the amount of innovation which is carried out.
This insight is directly relevant to the debate over Brexit. Over a 10 or 20 year horizon, the key question is not the terms under which we leave – it is whether we will be able to innovate more effectively in or out of the EU.
The basic shortfall of the approach is that innovation itself is not explained by Solow’s model. Innovation is, in the jargon, “exogenous”. In other words, it is determined externally to the model.
This is where Romer enters the stage. His seminal paper in the Journal of Political Economy in 1986 is full of heavy-duty maths. The crucial difference with Solow is that the rate of innovation is determined within the theoretical model itself – hence the phrase “endogenous” – by profit-maximising firms.
Physical capital such as machinery, warehouses, and roads play a role in both the Solow and Romer theories of growth. But Romer introduced the key concept of knowledge as the basic form of capital.
Policymakers across the west in the past two decades have been obsessed by the “knowledge economy”. This is not, as Tony Blair and many others believed, simply a matter of sending more and more people to university. It is about how to encourage innovation.
Both the Solow and the Romer models are highly abstract – Solow, for example, began his article with the phrase “all theory depends on assumptions which are not quite true”. But both have been highly influential with policymakers, and illustrate the vital economic importance of ideas.
As published in City AM Wednesday 18th October 2018
Image: Gordon Brown by World Economic Forum via Wikimedia is licensed under CC-BY SA_2.0
The fire and the fury rage from day to day around the outcome of the Brexit process.
The discussion has lost sight of the longer-term context in which both the UK and the EU will operate, regardless of the precise deal which is or is not struck.
In the 1960s, the countries which are now in the EU-bloc represented just under 30 per cent of world output. This has already fallen to less than 15 per cent.
And on any reasonable extrapolation of trends, it will dip under 10 per cent at some point in the next two decades.
This does not mean that Europe is getting poorer. Far from it. It means that the rest of the world, especially Asia, has been becoming richer much faster.
The Brookings Institute calculations released last week were a marvellous piece of news.
For the first time in human history, just over 50 per cent of the world’s population, or some 3.8bn people, live in households with enough discretionary expenditure to be considered either “middle-class” or “rich”.
This has been achieved by capitalism. Until the 1980s, for example, in their own ways both India and China were centrally planned economies. Once they shifted to the principles of market-based economies, they have boomed.
The Brookings authors estimate that in 2030 – just a decade and a bit away – the middle-class markets in China and India will account for $14.1 trillion and $12.3 trillion, respectively.
This compares to their projection of the US middle-class market at that time of $15.9 trillion.
Okay, so their decimal points give an air of spurious accuracy to the forecasts – but the general point is clear. Whether Europe likes it or not, the vast majority of world trade will take place outside the EU.
The second key point to note is that Europe has hardly been a major economic success story. The narrative peddled by Remainers seems stuck in the past.
If we travel back in time to, say, 1970, it becomes easy to believe that the European economies are so dynamic that it is essential for us to have the closest possible links with them.
In the 1950s and 1960s, annual real GDP growth in the economies which then made up the EU averaged over seven per cent. In contrast, the UK barely scraped above three per cent.
Since then, the long-term average growth rate of the original EU countries has fallen more or less continuously to less than two per cent a year.
The UK’s has also dropped, but not by much. Over the past 20 years, our GDP has risen by 2.1 per cent a year. France registers 1.6 per cent, Germany 1.5 per cent, and Italy a mere 0.6 per cent.
Regardless of the eventual Brexit terms, successful economies in the future will simply have to engage with the rest of the world, rather than depend upon the EU.
As published in City AM Wednesday 10th October 2018
Image: Chinese Girls by David Stanley licensed under CC-BY_2.0
One of the most dispiriting aspects of the Labour Party conference, which ended last week, is how deeply conservative the political left has become. Its remedies for Britain’s problems look to the past and not the future. Far from embracing new technology, the left is hostile to it.
This was not always the case. Labour under Harold Wilson won a closely contested election in 1964. Wilson’s key phrase – “the white heat of the technological revolution” – became the butt of parodies. But it encapsulated Labour’s appeal. Tony Blair, for all his faults, projected an image of modernity with his “Cool Britannia”.
Now, we have the grim pledge to turn the clock back and renationalise the railways. This was first done in 1948. But there is no sense that anything innovative will be done.
In fact, the old British Railways, as it was then called, was subsequently plagued by massive underinvestment in modern technology and equipment.
Ironically, given Labour’s attacks on the short-termism of the City, it was precisely in the nationalised industries that such behaviour was rampant.
If fares had to rise to fund new investment, the political incentive facing the Minister of Transport was to refuse the increase. Given the choice between political popularity in the here and now, and the longer-term benefit to the industry, guess which one usually won.
Labour argues that the profits currently being made by the private rail companies would be ploughed back to improve the service. The much more likely outcome is that the money will be used to featherbed jobs and boost the pay of those employed in the sector.
Let’s leave aside the fact that Network Rail, the one part of the railways still in public ownership, has shown itself to be unfit for purpose.
The problems started immediately after nationalisation 70 years ago. The historian John Bew published a magnificent biography of Clement Attlee in 2016. Attlee led the 1945-51 Labour government, by far the most radical in British history. Attlee himself served with great bravery in the First World War, was a fervent patriot and supporter of the monarchy, and stressed individual responsibility as much as individual rights.
An ordinary railwayman features in a snippet in the book. He had been a keen supporter of nationalisation, but six months after the event, he had changed his mind.
Why? Because “where there used to be one inspector, now there are two” – jobs for the public sector middle class. Little wonder that Corbyn’s Labour is so keen on the idea.
The left in general seems bereft of new ideas and lives in fear of new technology. They want to ban Uber and AirBnB. They want to bring Google and Facebook to heel not by innovation and competition, but by regulation. Their house journal, the Guardian newspaper, is filled with savage attacks by liberal arts graduates on “algorithms”.
To make a success of Brexit, we need to embrace innovation. As far as the future is concerned, Labour is just sticking its head in the sand.
As published in City AM Wednesday 3rd October 2018
Image: Jeremy Corbyn by Rwendland licensed under CC-BY_SA 4.0
This month saw the tenth anniversary of the collapse of Lehman Brothers, a collapse which precipitated one of the only two global financial crises of the past 150 years.
The late 2000s and early 1930s were the only periods in time when capitalism itself has trembled on the edge of the precipice.
It was in November 2008 that the Queen put her famous question about the crisis to the academics of the London School of Economics: “Why did nobody notice it?”
The answer is simple. In the models of the economy at the time, finance did not matter.
Mainstream economists did not notice the massive financial imbalances in the economy, because in their models, any problems that might link to these imbalances were assumed away.
To be of any use, all scientific models have to make simplifications of reality. But orthodox macroeconomics took a step too far. It assumed that the workings of the whole economy could be explained by analysing the theoretical behaviour of just a single decision maker. In the jargon, this is the “representative agent”.
The agent is a device which economists used to model the economy. It was extremely clever, and could solve hard mathematical problems – calculating how the decisions of average consumers and companies would affect the macroeconomy.
These kinds of models go by the splendid name of “dynamic stochastic general equilibrium models”, or just plain “DSGE” to their friends. But at its most basic, the problem with such economic models was that there was only one decision maker in them.
Having just two, a “creditor” and a “debtor” for example, would have helped a lot.
Over the past decade, economists have been scrambling to incorporate other financial factors into their models, such as household debt. Key contributions to this research are discussed in the latest issue of the Journal of Economic Perspectives.
Bizarre though they may seem, DSGE models now finally recognise the potential importance of household finance in causing crashes.
A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. They found that a rise in household debt relative to the size of the economy is a good predictor of whether GDP growth will slow down.
Rickard Nyman, a computer scientist at UCL, and I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008 could have been predicted in the middle of 2007.
Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.
A critic might say that this is simply a case of generals fighting the last war.
True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental importance of debt and finance in Western economies.
As published in City AM Wednesday 26th September 2018
Image: Her Majesty The Queen by UK Home Office on Flickr licensed under CC-BY 2.0
No one can tell them quite like Mark Carney, the governor of the Bank of England.
He appears to have briefed the cabinet last week that house prices could fall by 35 per cent in the event of a no-deal Brexit.
To be fair, the Bank did try to qualify this figure by saying that it was just the worst of several scenarios which analysts had produced in order to stress test the balance sheets of the commercial banks.
But the 35 per cent house price drop has now become embedded in the public narrative about Brexit.
Just how likely is such a massive drop to take place?
We do not know exactly how the Bank did its stress tests. But, typically, the worst-case scenario in such tests is either one which is judged to have a one in 20 chance of happening, or, if you are setting really demanding standards for the test, just a one in 100 chance.
When trying to assess these odds, an important input is what has happened in the past. The past may of course not be a reliable guide to the future, but it is all we have to go on.
An analogy from the sporting world might help. Every year, three clubs from the Championship are promoted to the Premier League. What are the chances of one of them being relegated after their first season in the top league?
We can look at the historical record since the Premier League began in 1992/93, which helps us form an initial view. We might then qualify it, and set the benchmark – a 44 per cent chance of relegation, since you ask.
With house prices, we can go much further back in time, as far back as 1845 to be exact. And the source of this information on nearly two centuries of house prices data is none other than the Bank of England itself.
Over all this time, there has never been a cumulative fall in the Bank’s house price series of as much as 35 per cent.
The closest we have seen was in the opening decade of the twentieth century in the run-up to the First World War. The UK economy was pretty much in the doldrums, and between 1902 and 1909, prices fell by a total of 33 per cent.
Nothing else remotely compares to this drop.
There have been two global financial crises over this period. In the 1930s, house prices fell by only seven per cent between 1929 and 1934.
And following the most recent crash, the reduction between 2007 and 2009 was 13 per cent.
In America, the Case Shiller house price index was 21 per cent lower in 2011 than it was in 2006, but this is the largest fall in that particular database.
The governor is therefore inviting us to believe that, in the event of a no-deal Brexit, house prices may fall by more than they have ever fallen since the Bank’s own data began in 1845.
How did the Bank arrive at this figure? I think we should be told.
As published in City AM Wednesday 19th September 2018
Image: Mark Carney by Bank of England on Flickr licensed under CC-BY-ND 2.0
Rugby Union’s Premiership season is underway again.
This is yet another professional sport which operates on the principles of socialism: the money all ends up in the pockets of what we might call the “workers”.
In a sport which was allegedly only played by amateurs until the mid-1990s, earnings have boomed. The average salary in the Premiership is over £200,000, and the stars are paid around the one million mark.
As a result of such payments, most of the Premiership clubs are only kept afloat by huge loans from their owners. Their accounts for 2016/17 were released at the end of August. Bruce Craig has put £18m into Bath since 2010. Bristol owe more than £20m. Wasps have liabilities approaching £50m.
But the players’ earnings are mere shadows of those of the top American sports stars. According to Forbes magazine, in the year to June 2018, the 100 best-paid athletes made $3.8bn between them. The boxer Floyd Mayweather topped the list with $285m.
Stars of popular culture pull in similarly staggering amounts. George Clooney earned $239m and Dwayne Johnson was the second highest among male actors at a mere $119m.
These vast sums appear to pose a challenge to economic theory. These players and actors are very good, but they are not so stupendously better than others who get paid very much less. How can this be explained?
The answer was provided in a brilliant article by the American economist Sherwin Rosen as long ago as 1981, entitled “The economics of superstars”.
Rosen based his theory on the fact that activities such as watching a sport or going to a film involve what economists call “joint consumption”.
If I am watching Arsenal, say, on the television, it does not matter how many other people are viewing at the same time. The game is still available for me to watch. In contrast, if I book a table at a popular restaurant or a particular seat on a flight, no one else can use it.
In 1880, if you wanted to hear a particular singer, you had to go to a live performance. Perhaps a thousand people could enjoy the joint consumption of the product. In 1980, tens of millions could watch on television.
Rosen, writing well before the internet, argued that advances in communications technology such as radio and television increased enormously the potential size of markets involving joint consumption. As he put it so succinctly, “the possibility for talented persons to command both very large markets and very large incomes is apparent”.
For example, the football played in England’s Premier League is in general better than that in the Scottish Premiership. But the English league rakes in well over £1bn a year in television rights, and Scotland less than £20m.
It is the combination of the joint consumption nature of these services and advances in communications which mean that a relatively small number of sellers can in principle service the entire market.
The more talented they are, the fewer still are needed. And that’s how they are able to earn so much.
As published in City AM Wednesday 12th September 2018
Image: Twickenham Stadium by David Iliff licensed under CC-BY-SA 3.0
Despite the warmth of the days, there is a distinct autumn feel to the mornings.
And in the autumn, thoughts begin to turn to the Budget.
Speculation has already begun about what the chancellor Philip Hammond might or might not do.
For Labour, recent weeks have been dominated by Jeremy Corbyn’s alleged antisemitism and undoubted incompetence. So the anti-austerity tour of Britain by shadow chancellor John McDonnell, begun in Hastings in July, has scarcely obtained a mention in the media.
McDonnell obviously believes that there is a need to “end austerity”. He is far from being alone.
It is remarkable how this anti-austerity narrative continues to pervade political and economic discourse – it is as if the UK were in the grip of a massive recession.
In reality, the economy continues to do well. GDP is now over 18 per cent higher than it was at the trough of the recession in the first half of 2009. Unemployment has fallen steadily since the Brexit vote, and now stands at its lowest rate since February 1975.
The name of John Maynard Keynes is frequently invoked by those who want to “abandon austerity” and increase public spending. Yet in his major book The General Theory of Employment, Keynes stated very clearly: “when full employment is reached, any attempt to [stimulate the economy] still further will set up a tendency in money-prices to rise without limit”.
In other words, according to Keynes himself, at full employment any further stimulus will simply lead to higher inflation, with no benefit to output or employment.
Unemployment is at a 40-year low, while employment is at a record high, with 32.3m people in work – an increase of 3.4m from the depths of the financial crisis. This sounds like full employment in anybody’s language.
The overall shape of the recovery since 2009 has been balanced. Consumer spending has actually grown less than GDP, by just over 16 per cent since 2009 compared to an 18 per cent rise in GDP. Capital investment by companies has gone up by 35 per cent.
Public spending has also risen, but only by seven per cent (all figures after allowing for inflation).
This has been a recovery generated by the private sector.
The same point applies even more strongly to the US. Compared to the low point of the recession in 2009, public spending has actually fallen by three per cent, though there has been a modest rise in employment in that sector of 100,000. In contrast, the private sector has roared away: 19.5m net new jobs have been created since the winter of 2009, and GDP is up by over 22 per cent.
As in the UK, an important driver of the recovery in America has been investment by firms. This has grown by no less than 54 per cent compared to 2009.
There is no case at all for stimulating the economy by increasing public spending (funded by increased taxes) and abandoning so-called austerity, not when the private sector has done such a good job on its own.
As published in City AM Wednesday 5th September 2018
Image: Money by Max Pixel is licensed under CC0 1.0 Universal