A Tale of Two Financial Crises: the 1930s and Now

Posted by on December 17, 2014 in Debt, Economic Policy, Economic Theory, Euro-zone, Financial Crisis, GDP, Recession | 0 comments

A Tale of Two Financial Crises: the 1930s and Now

As the seventh anniversary of the start of the economic crisis approaches, it is an appropriate moment to take stock. At the time, the recession was simply not recognised by conventional economic forecasts. These continued to foresee positive growth until the collapse of Lehman Brothers in the autumn of 2008. But the latest national accounts data now show that output began to fall in most Western countries during the winter of 2007/08.

The initial falls in GDP were sharp, but the overall outcome was in general better than that of 1930, the first full year of the Great Depression of the 1930s. The most dramatic contrast is America. Output was less than 1 per cent lower in 2008 than in 2007, in contrast to the 9 per cent fall in 1930. The financial crisis was a severe shock, but by the end of 2009, the worst seemed over. The standard definition of a recession is a fall in GDP over two successive quarters, and it ends when output grows again. As early as the autumn of 2009, this was the case in almost every Western country. Looking back to 1931, the second year of the crisis of the 1930s, output had continued to drop virtually everywhere, often at an accelerated rate. In Germany, for example, GDP was reduced by 6 per cent in 1930, followed by a further 10 percent collapse in 1931.

Optimism rose markedly in 2010 as a result. The nightmare of a potential repeat of the 1930s looked to be well and truly squashed. But as we move into 2015, the similarities between now and the 1930s become closer and closer. Across the West as a whole, the number of countries in which GDP is still below its 2007 peak level is almost the same as it was in 1936, seven years into the Great Depression. In Spain, output is 6.5 per cent below its previous peak, in Italy 9.5 per cent and in Greece a massive 26 per cent.

The total losses in output during the crisis in some economies are terrifying. To obtain this, every year we calculate the amount by which GDP falls short of its previous peak level, and sum these up to get the cumulative total. In Italy, the overall shortfall in output is 43 per cent of the value of GDP in 2007, and in Ireland it is 53 per cent. The Greek loss of 106 per cent may by 2016 exceed the highest previously recorded, which is the 132 per cent loss experienced by the United States 1929-1939.

The big difference between the 1930s and the late 2000s in North America and the UK is that the authorities followed expansionary monetary policies such as quantitative easing, which they did not do in the earlier period. It is hard not to conclude that the policies of the European Commission and the Central Bank have been catastrophic. The size and duration of this recession is set to break all records in several Euro zone economies.

As published in City AM on 16th December 2014

Bond market yields imply gloomy growth prospects

Posted by on December 10, 2014 in Debt, Economic Theory, Euro-zone, Government Borrowing, Inflation, Markets, Politics | 0 comments

Bond market yields imply gloomy growth prospects

Very strange things have been happening in government bond markets. The yield on 10 year US bonds is currently around 2.25 per cent. It makes intuitive sense that the Germans, with their longstanding reputation for fiscal prudence, are enjoying a much lower rate, some 0.8 per cent. Similar levels obtain in most of the countries which we might now reasonably think of as Greater Germany, those with close ties to the Federal Republic. So rates are at or below 1 per cent in countries such as Austria, the Netherlands, Finland and the Czech Republic.
Yet it seems to defy reason that rates in other EU countries are below those of America, sometimes considerably so. 10 year French government bond yields are only 1 per cent. Almost incredibly, in both Italy and Spain they are under 2 per cent, lower not just than those in the US but fractionally lower than in the UK.

The massive falls in bond yields during 2014 are of course good news for the indebted countries. And the implication that the markets consider the risk of default to have virtually disappeared seems to be to the benefit of all.
But the worldwide trend to lower yields on long dated government bonds carries some gloomy implications. In the weird and wonderful world of economic theory, there is a marvellous concept that capital is ‘putty-clay’. An institution sits on a pile of cash, which as it stands can be made into almost anything. But once it is invested in, say, a research and development project, a new Big Data base or in building a new office, it becomes much more difficult to change. The putty has become clay.

At least, that is, for the time being. Given sufficient time, the clay can be transformed back into a much more flexible form. If we pull an even more fundamental tool out of the box of economic theory, that of long-run equilibrium, this tells us that the rate of return on all types of assets should tend to be the same. For the economy as a whole, where investments are made in machines and buildings, the rate of return is simply the rate of inflation plus the real rate of growth. And the same formula applies, in the long run, to government bonds. In the long run, both bonds and fixed investments are putty, not clay.

No-one ever made money using this simple algorithm, but in a mad sort of way it makes sense. Bond yields of 1 per cent or less do not just tell us that inflation is expected to be very low. So, too, is economic growth. Intriguingly, the yield on bonds in Poland, which is just as closely tied to Germany as the countries mentioned above, is some 2.6 per cent. And Poland has been the most successful EU economy in terms of growth over the ‘long run’ of the past twenty years. But for the rest of the EU, the message from the bond markets is gloomy.

As published in City AM on 9th December 2014

The Ferguson riots: economics and bias in the American justice system

Posted by on December 3, 2014 in Economic Theory, Inequality, Politics, Public Policy | 0 comments

The Ferguson riots: economics and bias in the American justice system

The riots in Ferguson, Missouri continue to dominate headlines around the world. Even the brutal dictatorship of North Korea has got in on the act, accusing the United States of being a ‘human rights tundra’. The disturbances follow a grand jury decision not to indict a police officer for the fatal shooting of a black teenager, allegedly because of racial bias.
Liberal opinion everywhere appears to regard the American judicial system as being irredeemably racially biased. Amnesty International, for example, proclaimed that ‘African Americans are disproportionately represented among people condemned to death in the USA. While they make up 12 percent of the national population, they account for more than 40 percent of the country’s current death row inmates, and one in three of those executed since 1977’. But simple declarations such as this are no real use as evidence of bias. Violent crime rates are much higher amongst ethnic minorities than they are amongst whites. So the former will be convicted more frequently than the latter.

A sophisticated analysis of the decisions of courts in the US is published in the latest issue of the American Economic Review. Alberto Alesina of Harvard and Elena La Ferrara of the Universita Bocconi in Milan examine sentences of capital punishment for evidence either that blacks convicted of murder are more likely to be sentenced to death or, importantly, that such punishment is more likely if the victim is white. They use a very neat approach, which takes advantage of the appeal system in America. Capital sentences imposed by the initial court are automatically appealed, first to the state court and then, if they are upheld, in a federal habeas corpus petition. If the initial court is unbiased, Alesina and La Ferrara argue, the reversal rate of sentences by the upper courts should be the same, regardless of the race of the accused or the victim.

The overall finding is that there is indeed evidence which is consistent with racial prejudice. The lower courts do give more death sentences which are then reversed in cases which involve a minority defendant killing white victims. The reversal rates are 3 per cent higher for minority defendants at the first level of appeal than they are for whites, and 9 per cent at the highest level. These are not dramatic, but they do indicate some bias exists. The authors carry out extensive checks to make sure that their results are valid. An interesting one is that it does not matter whether the judge in the higher court has a Democrat or Republican background.

The most intriguing aspect is that the bias is entirely confined to the Southern states. Cultural attitudes can be remarkably persistent. It is 150 years since Americans fought each other over slavery, but the echo of the differences can still just be heard today. In the rest of the United States, justice is indeed blind.

As published in City AM on Tuesday 2nd December

What the Emily Thornberry saga tells us about macroeconomic policy

Posted by on November 26, 2014 in Government Spending, Politics, Public Policy | 0 comments

What the Emily Thornberry saga tells us about macroeconomic policy

It has been a wretched week for Emily Thornberry. The high-flying MP for Islington was sacked as Shadow Attorney General, and widely pilloried in both social media and conventional newsprint for tweeting a picture of a white van and England flags in Strood. Yet the saga tells us more about perception, about the narrative which emerges around a story, than about the objective reality of the event itself.
One of Thornberry’s defences was that she had grown up on a council estate, and so was very familiar with the world of the working class. She had indeed successfully presented a image of herself within the Labour Party of having a humble background. This was no disadvantage in her rise, in the so-called People’s Party, to a position of being a close ally of its Leader. However, her Wikipedia entry paints a subtly different picture. Her father was a successful academic, who went on to become United Nations Assistant Secretary General. Her mother was a teacher and Mayor of their local town. Image triumphed over reality.
Her misdemeanour is an even more striking example of the importance of perception. It was a week in which the England football team had played and won two matches. Imagine if Nigel Farage had tweeted an image of the now famous white van and the three national flags draped over the house. Suppose further that the former stockbroker had posted the identical comment ‘I’ve never seen anything like it in my life’. Now, we will never know for certain what his reception would have been. But it seems plausible that it would have been seen as a eulogy to patriotism and to the success of our boys on the field. Instead, Thornberry was ridiculed as a patronising snob. Exactly the same actual event, completely different consequences.
The impact of macroeconomic policy shares this same characteristic. The narrative which evolves around an event is even more important than the facts. It was a great coup by David Cameron and George Osborne in the aftermath of the 2010 General Election to succeed in presenting the government as being financially prudent.
It is even more impressive that the markets still believe them. On coming to power over four years ago, the government projected that borrowing in the current financial year, 2014/15, would be just under £40 billion. It is on track to be around £100 billion. What is more, over the first seven months of this financial year, borrowing is even higher than it was in 2013/14. The increase is not great, £3.7 billion according to the Office for National Statistics, but it is still up, not down. The stock of outstanding government debt sits at around 80 per cent of GDP, a figure similar to that of Spain
Against this, the government suffers politically for what is believed to be its austerity programme, one which scarcely exists in reality. The increasing importance of perception and narrative confound the attempts by mainstream economics to build mechanistic models of the economy.

As published in City AM on Wednesday 26th November 2014

Corporate tax is getting easier to avoid. Time to abolish it.

Posted by on November 18, 2014 in Capitalism, Economic Policy, Taxation | 0 comments

timthumbCorporate tax avoidance is once again prominent in the news. When Jean-Claude Juncker, the new European Commission president, was prime minister of Luxembourg, the country seems to have operated as a vast tax shelter. Leaked documents have revealed that special tax arrangements were agreed by his country with over 300 multi-national companies.


Getting a handle on the scale of corporate tax avoidance across the world is tricky. A detailed study has just come out in the latest issue of the top ranked Journal of Economic Perspectives, by Gabriel Zucman of the London School of Economics. His focus is on American companies. Zucman’s thorough analysis of balance of payments statistics and corporate filings shows that US companies are moving profits to Bermuda, Luxembourg, and similar countries on a large and growing scale. About 20 percent of all US corporate profits are now booked in such havens, a tenfold increase since the 1980s. Over the most recent 15 years, the effective rate of tax on the profits of US firms has fallen by one-third, from around 30 per cent down to 20 per cent. And about two-thirds of this can be attributed to an increase in shifting profits to low-tax jurisdictions. In money terms, the loss in revenue is some $175 billion, over 1 per cent of the total size of the American economy.


It is of course the most dramatic examples which hit the headlines. But if the effective rate is some 20 per cent, and a few massive companies are paying very little tax at all, many American companies must in fact paying tax rates on profits which are close to the nominal rate of 35 per cent. Although Zucman does not repeat his detailed exercise for the UK and Europe, a clear implication of the paper is that a qualitatively similar outcome obtains here. In other words, most firms operate in a way which most people would regard as being fair and reasonable. Blanket condemnations on the lines of Ed Miliband’s ‘zero-zero’ speech are wholly at odds with reality.

That said, there are undoubtedly serious problems with corporate tax regimes across the developed world. The increasing complexity of the legislation offers many opportunities for ingenious but perfectly legitimate avoidance schemes, such as Google’s “double Irish Dutch sandwich” described by Zucman. We can go down the route of trying to get greater international consensus on the treatment of tax, and steps have certainly been made in this direction. But it is a long and arduous process with no guarantee of success.

The simplest solution is to abolish corporate taxes on profits and to tax consumption instead. Ultimately, the tax burden can only fall on individuals. Taxing profits creates the illusion amongst the electorate that there is a free lunch. But someone, somewhere, pays. Higher corporate taxes might lead, for example, to lower dividends or lower wage increases. Companies might squeeze suppliers harder or cut back on investment. Tax needs to be transparent, so people can really decide what value they get out of it.


As published in City AM on Tuesday 18th November

Is Ed Miliband secretly a Rational Economic Person?

Posted by on November 12, 2014 in Economic Policy, GDP, Politics | 0 comments

Ed MilibandRecently, we have seen a very effective piece of forward guidance.  Ed Miliband’s statement that Labour would bring in a mansion tax on properties worth more than £2 million has had a dramatic impact.  The market for expensive properties in London has more or less ground to a halt, with very few transactions taking place.  The tax would, of course, reduce the value of the properties, so waiting to see the result of the election before buying a property is sensible.

This is an example of what economists call rational expectations, a concept of fundamental importance to modern economic theory.  People are assumed to have a reasonably good idea of how the economy works.  In scientific terms, they have a good model, and they all have more or less the same one.  When they need to make predictions about the future, they use their model, their concept of how the economy operates.  So, when Ed Miliband says there will be an extra tax on certain houses, the model which most people have in their heads is that this will cause their prices to fall.

This seems plausible enough.  But by no means all markets work in this particular way.  A gang has been jailed in France for conducting a very profitable operation which ferried illegal immigrants into the UK.  We might think that this would be a textbook example of a free market, in which price is determined by supply and demand.  But the feat of the criminals was to set up a fixed price offer, in which the different categories had different prices.  For the 800 Euro economy package, you would be smuggled into the back of a lorry with many others, and the driver would probably not know you were there.    The 4000 Euro luxury offer provided a personalised space in a car boot, and the complicity of the driver.

The gang took advantage of the fact that in this situation it is effectively impossible for the consumers – the would-be entrants to Britain – to form rational expectations.  How can a Somali, say, arriving in Calais after a long and arduous journey put together a good scientific model of the decision which he or she faces?   There are just too many imponderables.  But the fixed price, branded nature of the product made it very attractive to potential customers.  It seemed like a regular retail offer, like the suppliers really knew what they were doing.  It enabled the clients to construct a narrative, to tell themselves a story, that the gang would get them into the UK successfully and that they would not, for example, risk death in the process.

Many decisions have to be made in situations even more complex than this.  For example, should HS2 be built?  Should Britain pull out of the EU?  Here, the policy maker is faced with different opinions from different experts, each using a different model of the economy with a different view of what the impact might be.  Rational expectations just do not apply.

As published in City AM on Tuesday 11th November

All we are saying: give capitalism a chance

Posted by on November 6, 2014 in Economic Policy, Economic Theory, Euro-zone, Government Spending | 0 comments

Euro ZoneIs there a secret Leninist cell operating at a high level in the European Commission’s headquarters in Brussels?  One which is dedicated to the overthrow of the capitalist structures of the European Union?  The evidence from this past week is certainly consistent with this hypothesis.  The demand for an additional £1.7 billion payment from the UK is based on calculations backdated to 1995.  Revisions to the way in which GDP is constructed means that Britain is better off than was previously thought, so we have to pay more.  A pure gift to anti-EU political parties.

The saga does not end there.  If the UK’s success is to be punished, it is perhaps logical, in this twisted view of the world, to reward the failing French economy with a rebate.  But Germany, too, is due a repayment.  Incredibly, Cyprus and Greece, catastrophic basket cases, have to pay more.

The fundamental problem with the EU is that the basic virtues of a successful capitalist economy are being repressed more systematically across the board.  There is a strong consensus amongst economists, based on firm evidence, that the main determinant of long-term growth in developed economies is innovation.  The European Commission pays a great deal of lip service to this, but Europe in general still lags considerably behind America in terms of innovation. The concept covers a range of factors.  One is learning how to produce more of the same kind of output from a given set of inputs, which is an ongoing process throughout the economy.  Much more importantly, inventions create the possibility of developing entirely new kinds of output, whether goods or services.  Inventions are necessary for growth, but even more important is the ability of an economy to turn inventions from being ideas which enable the creation of new products, to the actual creation of the products themselves.

The massive companies created in the information and communications technology sector (ICT) in recent decades have almost all been American.  And to the list which includes Microsoft, Google and Facebook can now be added Alibaba, the new ICT giant from China.  An important article by Bart van Ark and colleagues in the top ranked Journal of Economic Perspectives in 2008 examined the widening productivity gap between Europe and the United States in the two decades immediately prior to the financial crash.  Their conclusion was unequivocal: “the European productivity slowdown is attributable to the slower emergence of the knowledge economy in Europe compared to the United States”.

This lack of dynamism shows itself in the shorter term inability of many European economies to recover from the crisis.  Of course, a key reason for this has been the macroeconomic and financial policies of the Commission and the European Central Bank.  But the EU has increasingly become an area in which it is much easier to make money by what economists call rent seeking than by innovation.  Exploiting a monopoly, lobbying the regulator, ticking some boxes, these are what pay.  Innovations are disruptive, but Europe needs to encourage them more than ever.

As published in City AM on Tuesday 28th October

Public sector pay and pensions are why the deficit stays high

Posted by on November 6, 2014 in Debt, Economic Policy, Employment, GDP, Markets | 0 comments

CoinsWhy can’t the UK government get its deficit down?   This question has been exercising commentators recently, in the light of the latest assessment from the Office for Budget Responsibility (OBR) that George Osborn will once again miss his target for the deficit in the 2014/15 financial year.   Of course, the size of the deficit has fallen, from the £157 billion which Labour bequeathed in 2009/10 to £108 billion in 2013/14.  But it does just not fall as much as either the OBR consistently predicts it will or the Chancellor would like it to.  This limits the ability of the government to deliver tax cuts in advance of the election next year.

A common, and plausible, reason is that there has been a shift in how the economy operates. Output has recovered strongly, but earnings have not. The bargaining power of employers is stronger, many members of the workforce have a more flexible attitude to how much they work, so take home pay rises remain below inflation. As a result, the amount of tax flowing into the government’s coffers is not as much as would be expected on the basis of evidence from previous economic recoveries.

But the fundamental reason is that remuneration in the public sector remains too high. The recent strikes by Unite and other unions show that many people on the conventional Left seem to believe that the purpose of public expenditure is to boost the private consumption of those employed in the sector.  The continued existence of annual increments in much of the public sector has no counterpart in the private sector.  In the latter, pay increases have to be earned.  In the former, for many workers they are automatic.

An argument which is used to justify the gap between pay in the public and private sectors is that the level of qualifications of public sector workers is on average higher. This is entirely spurious. What counts is not what goes into the production process of an organisation, but what comes out at the end. Countries in the former Soviet bloc, especially the East European satellites, had high levels of educational attainment.  But the quality of much of what they produced was very low. The Trabant, for example, was a very popular car made in the old East Germany. But once trade with the West was opened, its value fell to essentially zero.

Gordon Brown started off well as Chancellor.  He kept us out of the Euro and kept a grip on public spending.  But he began to have delusions in the early 2000s that he had solved the problems of boom and bust and could do anything. Brown started to stuff money into the pockets of Labour’s core vote in the public sector. The result was that a structural deficit emerged in the UK’s public finances before the crisis of 2008 struck. Any Chancellor who is serious both about fairness and about eliminating the deficit needs to cut make serious reductions in public sector pay and pension entitlements.

As published in City AM on Tuesday 21st October

The Happy Band of the Self Employed 

Posted by on October 16, 2014 in Economic Theory, Employment, Financial Crisis, Markets, Politics, Recession | 0 comments

The Bright Side PaulHow many workers does the typical American firm employ?   Actually, it is a trick question. The answer is ‘zero’.  More than 50 per cent of all companies in the United States are one person operations – the owner, and no-one else.

This fragmentation of size is increasingly reflected in the UK.  Here, the main growth is in self-employment rather than through one-person companies, but the principle is the same.  According to the Office for National Statistics, in 2014, 4.6 million people were self-employed in their main job, accounting for 15 per cent of those in work, the highest percentage since data were first collected 40 years ago.  Total employment in the second quarter of 2014 was 1.1 million higher than in the first quarter of 2008, just before the economic downturn. Of this increase, 732,000 were self-employed. So the rise in total employment since 2008 has been predominantly among the self-employed.

Good news, of course, which reflects the flexibility of the British labour market, though it seems to come at a cost.  The ONS estimates that the average income of the self employed has fallen by no less than 22 per cent since 2008.   Ed Miliband and the conventional Left denounce these developments.  Proper jobs have not been created, and people have been forced against their will to take large cuts in pay.

Earlier this year, a major study by the Royal Society of Arts exploded this as a myth.  Only 1 in 4 who started up in the recession said that escaping unemployment was a key motivating factor. A much more common answer was to achieve greater freedom. The self-employed are also happier than typical employees. Eighty-four per cent agreed that they were more satisfied in their working lives than they would have been in a conventional job (66 per cent completely or strongly so). The RSA argued that forgoing material benefits for more meaningful returns is a sign of a new ‘creative compromise’ at work.

In fact, basic economic theory suggests that well-being increases when people are offered more flexibility in the trade off between work and leisure.  To caricature the old days, you were offered a 40 hour week, take it or leave it.  But being self-employed allows you to choose your own point on the supply curve.

The RSA’s ideas are being taken forward in an exciting way in a new book by Adam Lent, director of their Action and Research Centre.  The book, Small is Powerful, is, naturally, crowd funded.  Lent argues that not only is the era of big government, big business and big culture over, but that this is unequivocally a Good Thing.  Intriguingly, in the wake of the recent by-elections, Lent writes about Zombie Politics, and why big politics continues despite nearly everyone having lost the faith.  He does not really deal with the issue of how, in the internet economy, the small can suddenly become terrifyingly big, witness Google and Facebook.  But his book opens a window on how our world is changing.

As published in City AM on Tuesday 14th October


Can Nanny make you stop drinking?

Posted by on October 9, 2014 in Economic Policy, Politics, Public Policy | 0 comments

alcohol1The National Institute for Health and Care Excellence (NICE) has been the butt of much ridicule over the past week.  A pill designed to reduce alcohol consumption among problem drinkers will be made available across the NHS.  But the concept of problem drinkers is so wide that it embraces people who enjoy a couple of modest glasses of wine a day.  Indeed, the treatment is not really aimed at serious alcoholics who knock back litres of vodka with meths chasers.

There are now vast swathes of behaviour which Western governments attempt to modify.  The government has its so-called ‘nudge’ unit dedicated to precisely this end.  Obesity, smoking, the amount of exercise people take, voting registration, recycling, energy consumption are some of the examples.  On the latter, it is not just the amount but the mix.  Hectored for years that diesel fuel was morally superior to petrol, some unfortunates followed the advice and switched their cars to diesel. They now find themselves on the receiving end of a volte face on the matter by the bureaucracy.

There is a literature in top ranking economics journals on the impact of such interventions.  In general, there is a short term effect which gives the policy makers what they want, but gradually, the reactions become muted and people revert to their old patterns.  There are exceptions, but most of these attempts to change behaviour fail.

An interesting paper in the latest American Economic Review by Hunt Allcott and Todd Rogers shows the enormous efforts which are needed to alter the decisions which people make in the long term.  In the United States, nearly 100 utilities hire a company called Opower to send home energy reports every month to millions of households.  Households receive information on personal energy use, social comparisons and energy efficiency information.

The real interest in the Opower work is that some of the programmes were set up as controlled scientific experiments.  Allcott and Rogers examine three of the longest running ones, which started in the late 2000s.  Highly sophisticated metering devices were installed.  Households, from a very large sample, were selected at random to receive the information.  And after two years, some of those getting the reports were randomly assigned to have them stopped.  This way, both post-intervention persistence and the incremental effects of continued treatment can be measured.

Unsurprisingly, there is an immediate reduction in energy consumption after receipt of the first report, though this impact decays rapidly.  In households discontinued after two years, the subsequent decline is much lower.   The sheer frequency of the reports does seem to alter behaviour.   But there are further reductions in energy consumption in households who continue to receive the information, suggesting that people take a very long time to completely change their habits.

In the UK, attitudes towards wearing seat belts and drink driving did eventually change, but it took a very long time.  Short-term trendy campaigns to ‘nudge’ behaviour are just not going to work.  Governments have to be in it for the long haul.

As published in City AM on Tuesday 7th October