The balance of trade does not attract much attention these days. Maybe it should. The UK has run a deficit in traded goods every single year since 1983.
In recent years, this has soared, to over £60 billion a year since 2004, exceeding 5 per cent of GDP. Fortunately, there are two substantial offsets. First, our services sector. From architecture to video game design, our exports of services comfortably exceed our imports. Second, our overseas assets bring in a comfortable flow of revenue.
Even so, there is something strange going on in trade. Between 2007 and 2009, sterling fell by 20 per cent. This was both against the dollar and the wide basket of currencies which make up the ‘effective exchange rate’.
But the trade balance has not improved. Leaving out so-called erratic items, the trade deficit was £85 billion in 2007, and is running at an annual rate of £90 billion in both 2012 as whole and in the first four months of 2013. In volume terms, exports of goods have risen in response to the devaluation, being 8 per cent higher in 2012 than in 2007. But the volume of imports is essentially flat.
The concept of the ‘J-curve’ used to figure prominently in discussions of the balance of trade. Following a devaluation, a given basket of exports earns less in foreign currency, and imports cost more. The idea was that purchasing decisions on the volume of exports and imports took time to adjust to the new prices. So, temporarily, the balance of payments would worsen, only to improve once the volume of exports rose and that of imports fell. Now, there is not the slightest sign of the J-curve existing.
We are thrown back on the so-called the Marshall-Lerner conditions, a seemingly abstract bit of economic theory which has interesting practical implications for both companies and governments. The conditions state that a devaluation will only improve the trade balance if the sum of the price elasticities of demand for exports and imports exceed one (in absolute terms). They are derived by a neat piece of simple algebra and, unlike much of economic theory, provide a genuine scientific insight into what is going on.
The failure of the balance of trade to improve after the 20 per cent devaluation 2007-2009 strongly suggests that the price elasticity of demand for both exports and imports is very low. The Marshall-Lerner conditions are not met.
Most international trade does not involve businesses selling direct to consumers but is in so-called intermediate products, business to business selling. The sophistication of many modern products means that purchasers are making their decisions on attributes of the product other than price. High quality goods in the right niche are the keys to export success. And in so far as they are able to, governments should aim for a strong rather than a weak currency. The trade balance may even improve, and we would all be richer in terms of what we can buy from the rest of the world.
As published in City Am on Wednesday 12th June 2013
FOOD banks are a rapidly growing phenomenon in the UK. A few years ago, they barely existed, but an estimated half a million people now make use of them every week. On the face of it, it seems that poverty has sadly become endemic since the financial crisis, with many families unable even to feed themselves. Real incomes have declined since 2007, putting pressure on household budgets. But the pace of increasing demand is surprising.
In fact, the food bank is a market. It is, however, complex – with particular features which mean that it is likely to grow rapidly, exactly as we have seen. The key point is that food is not the only commodity traded.
By the First World War, living standards had increased sufficiently so that everybody had enough to eat. During the really severe recessions of the early 1920s and 1930s, shortages did exist in the most depressed areas, but these were temporary. Certainly, by the early 1950s, after the end of rationing introduced in the Second World War, food was plentiful for everyone. Since then, average living standards have risen dramatically, even taking the recent recession into account. In real terms, average incomes have risen four-fold. While some people do struggle to make ends meet, the vast majority has been lifted from food poverty.
The story that, suddenly, large numbers of our fellow citizens cannot afford to eat does seem strange. The “cuts” said to have caused this situation are, in fact, really reductions to Gordon Brown’s ludicrous growth plans. Some have certainly been affected by cuts to welfare payments, and have unfortunately been forced to rely on charity. But overall public spending has risen sharply since 2010. Why then the rapid rise in food banks?
It is, of course, an article of faith among some that austerity is destroying the fabric of society. Responding to this narrative, many began to set up food banks. After all, they must be needed. Say’s Law states that supply creates its own demand. Most economists reject this idea, but food banks are a real example of this law in practice. Free food is offered, and the only cost is getting an authorisation for your voucher. Not surprisingly, this creates plentiful demand.
But there is another market in operation – less easy to spot. The supply is moral superiority. Some of those who set up food banks are undoubtedly sincere, and think their efforts are needed. But an opportunity exists for others to show conspicuously their concern for the poor, and at the same time demonstrate opposition to austerity. There is always ample demand in some circles for this type of commodity.
These two markets, for food and sanctimony, operate in symbiosis – an example of George Soros’s principle of reflexivity. Positive feedbacks between them reinforce their growth. A supply of free food is offered, which creates its own demand. A niche opens up for the supply of moral superiority, and the supply of food increases. This dynamic reinforcement between markets explains why the number of food banks has increased so quickly.
IT’S not all fun and games at the Co-op Bank. Just over a month ago, the bank was serious about acquiring 632 branches from Lloyds. Now its debt has been downgraded six notches to junk status, and veteran HSBC banker Niall Booker has been brought in as replacement chief executive after Barry Tootell resigned.
Inquests have begun, and it is only human nature to look for a scapegoat other than the large amount lost on the bank’s new IT system. Management has delved into its hat, and, hey presto, here is the old Britannia Building Society, merged with the Co-op in 2009. It is, we are solemnly told, the bad debts on the Britannia’s commercial property portfolio which are the problem.
But is there more to this than meets the eye? At a time when other UK banks are rebuilding their balance sheets, the Co-op’s has worsened. In 2009, in the depths of the recession, the bank made a profit. Its write-off of bad debt was only £112m compared to the £24bn impairment figure at Lloyds. This comparatively excellent result was claimed to be due to the “cautious approach taken by both heritage businesses”. Now, instead of being described as cautious, Britannia’s portfolio is portrayed as being very risky indeed.
It is hard to see, on the face of it, how a loan portfolio can survive 2009 in good shape and now be seen as a wreck. It does seem as if the Co-op has relatively recently taken a particularly gloomy view of UK economic prospects over the next five years or so. Commercial property values are sensitive to the state of the economy and, on a sufficiently pessimistic view of the next few years, almost every bank in the UK would be in serious trouble. Of course, the official Co-op view of this crisis could be completely correct. Only time will tell.
But the bank’s current predicament does raise the wider issue about the evolutionary fitness, as it were, of the co-operative structure as way of doing business. Co-ops have been with us since at least 1844, when the Rochdale Pioneers were founded, but have never come close to being the dominant species in the corporate environment. For well over a century, the shareholder-based organisation has reigned supreme.
Organisational structures do not spring fully formed into the world. Like almost everything, they evolve over time by a process of natural selection. In principle, any variant or any mutation might be thought to have a chance, however small, of becoming dominant. The weird and wonderful variety of things that have become Top Boy at some point suggests that this is true.
But a recent scientific paper in the august journal Nature on 16 May provides evidence against this idea. Some variants can indeed become successful and survive, but there may be inherent limits on how much fitness they can develop. The co-operative form of organisation may fit this bill.
As published in City Am on Wednesday 29th May 2013
According to the Scottish National Party, after the referendum on independence next year, Scotland will be a land of milk and honey. The highest per capita levels of public expenditure in the UK can easily be sustained. The whole of the revenue from North Sea oil and gas will belong to Scotland, regardless of the wishes of England and the Shetland Isles. Scotland can remain within the EU, despite clear statements from Brussels that it would have to reapply for membership, and the near certain Spanish veto this would attract.
None of the massive debts incurred by the Bank of Scotland (the BOS bit of HBOS) and the Royal Bank of Scotland will be allocated to the Scots. And the Bank of England will continue to support sterling as the Scottish currency, whilst at the same time the Scottish government will have complete freedom on economic policy.
Even by the standards of politicians, these are fairy stories pedalled on an epic scale. The Scottish electorate are being treated like children by the SNP.
In the unlikely event of this massive confidence trick working, there will be a great opportunity to conduct a real life experiment with monetary policy. If Scotland chose to remain within what would then become the Sterling Zone, the Bank of England would of course set interest rates and English regulatory bodies would control Scottish banks. The Scottish government would be no more able to set its own fiscal policy than the Greeks or the Portuguese are at the moment. If they tried to be too profligate, the Bank could step in and appoint an unelected Prime Minister, just as the European Central Bank did with Italy, a far larger and more important country than Scotland.
So the obvious answer would be to allow everyone in Scotland to choose their own currency. The idea is not ludicrous. In 19th century America, many different currencies were in circulation, especially in the West, and it was not until the creation of the Federal Reserve as late as 1907 that the dollar became the sole legal tender.
Scottish banks could continue to issue their own colourful notes, but without the back up of a lender of last resort. Economists of the Austrian School in particular argue that this would lead to banks being much more prudent, and that what the world needs is much less, not more, banking regulation. Scotland would be a test bed for the theory.
Why stop there? Bitcoin could be used for transactions, as could air miles or vouchers at supermarkets. Gresham’s Law says that bad currencies drive out the good, but does this law still apply in the modern era? Masses of data would be generated about how trust, in the competing currencies, spreads across networks of individuals.
Regrettably, the majority of the Scottish electorate seem too level headed to vote for independence. But from a purely scientific perspective, this will be a loss to the world.
As published in City AM on Wednesday 15th May 2013
Spotting and identifying new species is always exciting. And the last couple of years has seen the emergence of a new type of economic commentator, the recovery denier. Paul Krugman, the Nobel prize-winning economist, wrote a piece at the end of last year in which he compared the current situation to that of the 1930s. On Newsnight recently, another Nobel economist Joseph Stiglitz poured scorn on my assertion that the US economy has recovered.
But what does the data tell us? In the 1930s, output in America fell by nearly 30 per cent from its 1929 peak. This time, the fall was only 3 per cent, and the level of output is now higher than it was below the crash. The latest US labour market figures show continued growth in employment. Over 5m net new jobs have been created over the past three years, all of which have been in the private sector. Unemployment has just fallen to a four year low.
Elsewhere in the West, the recovery continues, although it is nowhere as strong as people would like. The crisis of 2007 to 2009 was very severe. But in the clear majority of OECD countries, the level of output is now at its highest ever. There are three geographic areas where the recovery seems to be consolidated: North America, Australasia, and what we might loosely term “Middle Europe”. The temptation to translate the phrase into German is difficult to resist, for this group comprises Switzerland, Austria, Germany, and their immediate neighbours Poland, Slovakia and the Czech Republic.
In the UK, GDP growth admittedly remains fragile, but the Office for National Statistics is in the process of revising up its recent estimates, leading to the distinct possibility that the double-dip recession was avoided. Further upward revisions to the GDP figures seem likely.
Yet another example of the exotic species of recovery deniers is David Blanchflower, briefly a member of the Monetary Policy Committee under Gordon Brown. In the autumn of 2009, Blanchflower attacked George Osborne’s proposals, if he were elected, to reduce the then £175bn public sector deficit. The plans would mean that “unemployment could easily reach 4m,” he said, and indeed that “5m unemployed or more is not inconceivable”. Our current level of unemployment is 2.5m.
Of course, economic forecasting is an inherently difficult exercise. So when Will Hutton argued in June 2008 that “a British version of Fannie Mae and Freddie Mac must be created now,” he could not have imagined that, in September of the same year, these mortgage institutions would collapse and have to be nationalised by the US authorities.
Western economies are not recovering as quickly as they normally would following a recession. The readjustment of balance sheets in the personal and public sectors is taking longer than expected, although the corporate sector is in rude good health. But it is inappropriate to deny that a recovery really does exist.
As published in City AM on Wednesday 8th May 2013
Manchester United have walked away with the Premiership title yet again. In the last seven seasons, they have won no fewer than five times. Over the past 22 years, they have never finished outside the top three. Will they ever be overthrown, especially given the stupendous sponsorship deal the Premiership has secured from the start of next season, which just pours money into their coffers?
This type of dominance is not unusual in team sports. One of the most extreme examples is Scotland, where no team apart from Celtic or Rangers has won the league since 1985. Even at the elite level of the European Champions League, there is a concentration of success. There are several thousand professional soccer clubs across Europe. Yet in fifty-six seasons, only twenty-one teams have ever held that title. And there is a heavy concentration even within that small group of victors, with just six clubs winning a total of thirty-three times between them, the other twenty-three championships being distributed amongst fifteen other teams.
After the event, after a team has been stupendously successful, it is always possible to tell a story about why it happened. The legacy of Matt Busby, the genius of Alex Ferguson, massive income from worldwide merchandise sales, and so on. But it is not really possible to predict success in advance. There are in fact very deep-seated reasons why we observe both periods of dominance by a team, or small group of teams, and why these cannot be forecast before it happens. Team sports take place in an evolutionary context. Managers try new tactics, buy new players, discard others, and clubs innovate in how they raise income. The environment does not stand still, it evolves.
The UCLA ecologist Stephen Hubbell has an evolutionary theory which tells us a lot, not just about biology, but about our social and economic worlds. In ecosystems just as in team sports, at any point in time we observe a small number of species – teams – which are very successful, and a large number which are not.
Our natural instinct is to think that success is due to superior qualities. But Hubbell’s theory assumes, as a deliberate simplification, that the differences between species are irrelevant to their success. Almost incredibly, but backed up by some high powered maths, evolutionary situations have an inherent propensity to deliver the sorts of outcomes we observe in the real world. Massive success for a few at any point in time, and unpredictable changes over time in who is the Top Boy of the moment.
Of course, the theory is not completely true. Some teams are better than others. But self-reinforcing success followed by an unpredictable fall is entirely characteristic of all evolutionary systems. United, after all, were once just the works team of the old Lancashire and Yorkshire railway and were called Newton Heath. They had to be rescued from bankruptcy not once but twice. So supporters of Barnet and Brentford can live in hope.
As published in City Am on Wednesday 1st May 2013
There are errors and errors. Does the Reinhardt and Rogoff miscalculation mean that Osborne should change tack?
The distinguished American academic economists, Carmen Reinhardt and Ken Rogoff, have been very much in the news. Their 2009 book, This Time is Different, was a comprehensive examination of financial crises over the past 800 years. The work received many plaudits and awards. They suggested that when the ratio of public debt to GDP in a country rose above the 90-100 per cent range, the chances of a financial crisis increased sharply. And the consequence was that economic growth in the country would be adversely affected.
The finding has been queried by a trio of fellow Americans. Reinhardt and Rogoff do seem to have conceded that their own calculations contain a glitch. The new analysis has been seized on by opponents of austerity policies. But how much does it matter that an error was made? At the moment, the debt to GDP ratio in the UK is just below the crucial level of 90 per cent. Does this miscalculation mean that George Osborne should change tack and spend to try and stimulate the economy?
In defence of Reinhardt and Rogoff, they never elevated their suggestion into a ‘theorem’ or a ‘law’. They simply suggested that high levels of public debt tend to be a Bad Thing. Even the most devoted Brownite would surely accept that there is some limit to how much public debt can be incurred relative to the size of the economy. The real question is: what is this limit?
A great deal depends upon the extent to which an increase in debt leads to higher interest rates. More public expenditure financed by issuing long-dated gilts at around the current yield of 2 per cent is one thing. But if it causes gilt yields to rise to, say, 4 per cent, it is pretty disastrous.
Higher interest rates would have an adverse effect on business confidence. If rates doubled, the capital value of the outstanding stock of gilts held by the private sector would fall by 50 per cent – a severe negative shock to the wealth of the sector. And higher taxes will at some point be needed to meet the higher interest payments.
There is a lot of evidence to suggest that high public debt levels relative to GDP are indeed associated with higher interest rates. The Mediterranean economies are just the latest example of this. But there is no automatic connection between debt and rates. The relationships which are coaxed out of the data are not like the laws of physics.
So much depends upon psychology. Osborne pushing up debt by cutting taxes might be one thing. Balls doing the same by hiring more bureaucrats might be perceived quite differently. But at some point, regardless of who the Chancellor might be, an increase in public debt would have an adverse impact on the economy. The theoretical channels by which this happens are well understood. And an ounce of good theory is worth a ton of applied econometrics.
As published in City AM on Wednesday 24th April
Watch Paul present this argument on Newsnight in debate with Nobel prize winner Joseph Stiglitz (feature from 23:30)
Where have all the miners gone? To judge by the rhetoric of the BBC and other Leftist media outlets, whole swathes of Britain lie devastated, plagued by rickets, unemployment and endemic poverty – nearly thirty years after the pit closures under Lady Thatcher!
The reality is different. There is indeed a small number of local authority areas where employment has never really recovered from the closures in the 1980s. But, equally, there are former mining areas which have prospered.
Thirty years ago, in 1983, there were 29 local authority areas in the UK, out of a total of over 450, in which mining accounted for more than 10 per cent of total employment. A mere handful of areas still remain scarred by the closures. Wansbeck, on the bleak Northumbrian coast, had 21 per cent of its jobs filled by mining in 1983. Now, employment remains 25 per cent lower than it was then. Elsewhere, reality is not as bad as the image.
The old mining areas at the heads of the South Wales valleys are meant to symbolise industrial decay. But in Merthyr Tydfil, there are 8 per cent more jobs than there were in 1983. Admittedly, in Blaenau Gwent, based on Ebbw Vale, employment is 12 per cent lower. This is hardly permanent devastation. In Easington on the Durham coast, miners made up no less than 41 per cent of all local employment. But even after this devastating blow, losing almost half the area’s jobs, employment now is only 9 per cent lower than it was in 1983.
In contrast, there are real success stories. North West Leicestershire and South Staffordshire used to have lots of miners. But employment in both areas is now some 40 per cent – forty! – higher than it was in 1983.
The experience of the individual mining areas differs dramatically in terms of their resilience, their ability to recover economically. Three years ago, I published a short article in Applied Economics Letters on the changes in employment in all the mining areas between 1983 and 2002. Total UK employment grew by 23 per cent, and in the ex-mining areas as a whole by just 9 per cent. But it was growth and not decline.
A key influence on this has been the attitude of the workers. Statistical analysis shows that the more militant an area was in the bitter and controversial miners’ strike in the winter of 1984/85, the less well it has done subsequently. In Leicestershire, one of the success stories, only 10 per cent ever supported the strike in the first place. In Wansbeck, support was 95 per cent, and even when the strike was ending rapidly in March 1985, 60 per cent were still out.
Economies have the capacity to recover from even the most dramatic adverse shocks, both at national and local levels. But to do this successfully, the workers must be willing to embrace the future rather than cling to the past.
As published in City Am on Wednesday 17th April 2013
The recent debacle in Cyprus has essentially been shrugged off by the markets. The European Central Bank vigorously asserts the crisis in the Euro zone is over. So why is there continued unease about the financial viability of countries such as Spain and Portugal, a morass into which even the French are now being dragged?
Economic theory helps us understand a bit more about why this is the case. One thing which the last few years in Europe have shown very starkly is the massive difference between debt which is denominated in nominal terms and that which is in real terms. Nobel Laureate Chris Sims makes the point clearly in his recently published Presidential Address to the American Economic Association.
As Sims puts it, real sovereign debt promises future payments of something the government may not have available—gold, under the gold standard, Euros for individual country members of the EMU, and dollars for developing countries that borrow mainly in foreign currency. Nominal sovereign debt promises only future payments of government paper, which is always available. In other words, money can always be printed. Sims notes almost in passing that ‘obviously, outright default on nominal debt is much less likely than on real debt’.
In order to be able to repay any given level of debt, a country must be capable of generating in the future what are called in the jargon ‘primary surpluses’. These are simply a surplus of government revenue over expenditures, taking interest payments out of the picture. For a country with its own currency, as long as it is capable of generating any primary surpluses at all, it need not default. In accounting terms, the present value of its debt is simply the discounted value of future surpluses. It might not be worth much, but its debt has some value. In contrast, if the debt is in real terms – in Euros for the Italians and Spanish – the country needs to be able to generate primary surpluses which cover its debt commitments in real terms, an altogether more challenging task.
There is a definite risk of the Southern European countries becoming trapped in a real debt spiral, from which the only escape is either – or possibly both – default on debt or exit from the Euro in order to be able to denominate their debt in nominal rather than real terms. France is now looking uncomfortably close to this group.
The experience of the 1930s suggests that exiting the Euro may be far from being a disaster. Once the taboo on leaving the gold standard was lifted, those countries which exited early revived earlier than those which chose to prolong the agony. One reason was that the financial position of the state was once again judged to be viable. The UK quit in 1931, and the very next year our GDP had exceeded the pre-crash peak in 1929. France waited until 1936, and even by 1938 its output was lower than in 1929.
As published in City Am on Wednesday 10th April 2013
Are economics graduates fit for purpose? This is a hot topic in policy making circles. A year ago, the Bank of England hosted a day conference on the topic. Diane Coyle has edited the proceedings in a neat little book What’s The Use of Economics: Teaching the Dismal Science After the Crisis. There was a follow up at the Treasury last month. In the meantime, a distinguished committee of academics, government and business economists has been beavering away on the content of the economics curriculum.
The question is of far more than academic interest. As Coyle points out in her introduction, the narrowness of the mainstream approach means that economics itself must bear responsibility for the crisis. Macroeconomic theory failed spectacularly. Jean-Claude Trichet, then Governor of the European Central Bank, wrote in November 2010 that ‘As a policy-maker during the crisis, I found the available macro-models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.’ Yet the pre-crisis theory still forms the core of what graduate economists are taught.
At the same time, there have been exciting developments in areas like behavioural economics, which offers a more realistic description of how people actually behave. The leading figure is Daniel Kahneman, and many will have read his recent best-seller. He was awarded the Nobel Prize in 2002, and his most important article was published as long ago as 1979. Yet I was told in all seriousness by the head of a leading economics department that they were ‘thinking’ of introducing a course in behavioural economics – in 2015!
My own recent experience suggests that the real question is whether many economics graduates are fit for anything at all. Economics students themselves are increasingly critical of the curriculum. I have recently spoken on this topic to two student economics societies. The first had to be rearranged from before Christmas, because the students had simply forgotten to book a room. This time all went well, but I had not quite finished my talk when a besuited man strode purposefully onto the stage and began setting up his own powerpoint slides. He was, he announced, about to lecture to 200 engineering students. The economists had indeed booked the hall, but not for long enough.
The second talk, in one of the North’s great cities, was even more eventful. The discussion was lively, with many of the questioners denouncing austerity policies and calling for more spending and bigger deficits. It had been a long day, and I was glad to arrive at the hotel which the students had booked, at 10.30pm in the pouring rain. But not only was there no trace of the booking, it was full. I went round the corner to a much more expensive one and sent the society the bill. They were very apologetic, but they could not pay. These dedicated opponents of austerity had run out of money.
As published in City AM on Wednesday 3rd April 2013