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It is not just the Euro. Southern Europe faces a major structural crisis

It is not just the Euro.  Southern Europe faces a major structural crisis

Major shocks to social and economic systems ruthlessly expose weaknesses which can be contained in more normal times.  When the price of oil quadrupled in 1973/74, the different levels of resilience in the labour markets of Western Europe were quickly revealed.  Inflation initially rose sharply everywhere.  By 1976, it had fallen to 4 per cent in Germany, but was still 14 per cent in the UK.  German workers realised that the oil price rise was out of the control of their own government.  Demanding bigger money wage increases would be self defeating.  It took the deep recession of the early 1980s, when unemployment rose to 3 million, and the defeat of the miners to bring British inflation back under control.

In the same way, the financial crisis of 2007 to 2009 uncovered deep structural faults in most of the economies of Southern Europe.   The recovery in the UK took a long time to get hold, and it was only really in 2013 that we began to get over the shock.  But GDP here is now 6 per cent higher than it was at the start of 2008, when output began to contract.  In contrast, in Spain GDP is now 5 per cent lower than it was nearly eight years ago, and Portuguese output is 6 per cent lower. In Italy, the fall in GDP is as much as 9 per cent.  So between 2008 and 2015, a dramatic gap of 15 per cent has opened up between the levels of GDP in the UK and Italy.

Membership of the Euro does not help.  But there are much more fundamental issues.  A fascinating paper by Gianluigi Pelloni and Marco Savioli in the latest issue of the Economic Affairs journal focuses on why Italy is doing so badly.  A crucial reason is that Italy has a high level of corruption.  Transparency International ranks the countries of the world on this measure.  The least corrupt is Denmark.  Germany and the UK come into the charts at 12 and 14 respectively.  Italy is at number 69, along with Greece, Romania and Senegal.

Italy has suffered from a lack of restructuring of production.  The products in which Italy specialises are very similar to those of twenty years ago.  And the economy continues to be populated by vast numbers of tiny firms, specialising in commodities with low technological content in both the manufacturing and service sectors.

There are many barriers to both innovation and expansion.  For example, access to credit is difficult and complex, as a 2013 World Bank study highlights.  Start up costs are high.  The average number of years of tertiary education in the population aged over 25 is only half that of France, Germany and the UK, so the workforce is less capable of dealing with technological advances.

Pelloni and Savioli do detect some positive signs in sectors such as chemicals, food and pharmaceuticals.  But mere tinkering will not be enough.  Drastic reforms are needed to deal with the structural weaknesses exposed by the financial crisis.

As published in City Am on Wednesday 25th November

Images: Euro by Images Money licensed under CC BY 2.0

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Integration won’t save the struggling Eurozone

Integration won’t save the struggling Eurozone

Olivier Blanchard, the recently retired Head of Economics at the International Monetary Fund, has something of a track record with his predictions.  In 2013, he warned George Osborne that he was “playing with fire” with the UK’s recovery from the financial crisis.  Austerity had to be relaxed. We now know that we were actually nowhere near a drop in GDP.  Growth has been unequivocally positive in every year since 2009.  Compared to the year immediately before the crisis, 2007, GDP is now 6 per cent higher, a recovery of similar strength to that of America, with US GDP being 8 per cent up on its 2007 level.

In August 2008, only a few weeks before the collapse of Lehman Brothers, Blanchard published an MIT Discussion paper on the state of macro-economics.  This is the part of economic theory which tries to explain how the economy as a whole moves, why variables such as GDP or unemployment go up or down.  The state of macro-economics, Blanchard opined, as the most serious crisis since the 1930s was about to burst upon the world, was “good”.

But his pronouncements this week on the Eurozone deserve to be taken seriously, not merely because a stopped clock occasionally tells the correct time.  There is real substance to them.  Blanchard warned that the planned moves to closer integration within the Eurozone would not solve its fundamental problems.  Very powerful figures such as Mario Draghi, President of the European Central Bank, and Jean-Claude Juncker, head of the European Commission, are heading the drive to full fiscal integration of the Eurozone.

Under the plan, member countries of the Euro would pool funds to a Euro Treasury in Brussels.  This outfit would have the ability to transfer funds from strong to weak economies.  The UK Treasury has similar powers to move money around within the UK, which is a monetary union based on sterling.  Huge amounts have been taken from London and the South East and given to the rest of the UK over a period of decades.  But the gap in performance remains.

The relative performance of the Eurozone economies in recent years highlights the problems faced by the zone.  German GDP is now 6 per cent higher than it was in the year just before the crash, 2007.  Positive gains have been registered in countries like Austria, Belgium. France, too, is up, though here growth has more or less stalled since 2011.  Even Ireland, which was very badly hit, is now registering strong growth and the economy is larger than it was in 2007.

But there is another group where growth has been disastrously bad.  The Italian economy has shrunk by 9 per cent since 2007, Portugal by 7 per cent and Spain by 5 per cent.  These economies just do not seem to have the enterprise and the resilience to bounce back in the way in which Germany and its immediate economic satellites have done.   Closer integration may make sense for the successful countries in the Eurozone, but not for the rest.

As published in City AM on Wednesday 14th October 2015

Image: Euro Sign by Alex Guibord licensed under CC BY 2.0

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Whatever it is, Corbynomics is not mainstream

Whatever it is, Corbynomics is not mainstream

A group of economists hit the headlines last week with their claim that Jeremy Corbyn’s policies are supported by mainstream economics.  Perhaps the best known of them is David Blanchflower, a Monetary Policy Committee member when Gordon Brown was Chancellor.  He predicted before the 2010 General Election that under the Conservatives, unemployment would rise from 2.5 million to 4 million, even 5 million was ‘not inconceivable’.  The actual number now is 1.85 million.  Still, economic forecasting is a notoriously difficult exercise.

The claim that Corbyn represents orthodox economic thinking is not easy to sustain.  It is not possible to find a single article in a leading academic journal which recommends nationalising large swathes of the economy, particularly without compensation.  Indeed, completely opposite themes are stressed, such as the importance of competition and markets, and respect for the principle of contracts and the rule of law.

To be fair, the Corbynistas only endorse his tax and spend policies.  They claim that support for fiscal and monetary expansion is now the economic mainstream.  But they fail to take into account one of the most fundamental concepts in mainstream macroeconomics, the so-called Lucas critique.  This esoteric idea, quite unknown to the general public, has profound practical implications.  

Many Keynesian economists try and assess the impact of policy changes in the following way.  They take the key aggregate variables in an economy, such as personal consumer spending, exports, unemployment and the like, and use advanced statistical techniques to correlate them to other variables.  Data is used over the past twenty or thirty years, to get enough observations.  What emerges is the average impact over this period of changes in one variable on another.  To take a simple purely illustrative example, we might find that if sterling fell by 10 per cent, on average over the past the value of exports increased by 5 per cent.

All these statistical relationships are bundled together in a computer, and questions can then be asked.  What might happen if public spending were increased?  The complex interrelationships in the programme are calculated, and the answer pops out.  Forty years ago, Chicago based Nobel Laureate Robert Lucas made his critique.  Changes in policy may very well change the average relationships which previously existed.  The past is not necessarily a guide to the impact of a policy change.  President Hollande discovered the practical power of this point when he put tax rates up to 75 per cent.  He was presumably advised, on the basis of evidence from the past, that this would raise revenue.  But hundreds of thousands of the most enterprising French citizens did not pay the tax at all.  They simply left the country.

The idea that Corbyn’s policies on state control of enterprise can be separated from his fiscal and monetary proposals is not one which bears more than a moment’s scrutiny.  The Lucas critique applies in spades. Any analysis which pontificates on the effects of the latter without taking into effect the whole gamut of his polices can hardly be taken seriously.

As published in City AM on Wednesday 2nd September 2015

 

Image: “Jeremy Corbyn” by Garry Knight is licensed by CC BY 2.0

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Keynesians are wrong: Cutting public spending can boost economic growth

Keynesians are wrong: Cutting public spending can boost economic growth

The key aim of George Osborne’s economic policy has been to eliminate the financial deficit of the public sector.  The main way of trying to achieve has been to squeeze public spending.  The orthodox economic textbooks maintain that this withdraws demand from the economy, and so leads to the growth rate being slower than it would otherwise be.

But can contractionary fiscal policy of this kind actually expand the economy?  At first sight, it seems something of a contradiction, the concept that spending less might cause higher growth.  An oxymoron, one might say – where I am using the word in its regular sense and not referring to those Greeks who voted ‘no’ in the referendum.   The very idea provokes howls of derision and outrage, from leading Keynesians such as Stiglitz and Krugman downwards.

Yet we have been here before.  In early 1981, the UK economy had moved into a deep recession, comparable in size to that which we experienced during the financial crisis.  In the budget of March of that year, the then Chancellor, Geoffrey Howe, cut the financial deficit by 1.5 per cent of GDP, or some £20 billion in today’s prices.  This prompted no fewer than 364 university economists to write to the Times in protest, explaining that the policy was completely misguided and would only serve to prolong the recession.  In fact, the economy began to recover during 1981, and posted a healthy growth rate of 2.2 per cent in 1982, followed by a boom rate of 3.9 per cent in 1983.

One swallow does not make a summer.  Is there any other evidence?  Tim Congdon, in a recent article in the journal Economic Affairs, claims that since the 1980s, ‘expansionary fiscal contractions’ have been the norm rather than the exception both in the UK and the US.  Keynesian support for fiscal activism is, he argues, unsupported by a large body of recent evidence.  To cite just one example, Congdon points to the substantial fiscal tightening under the Conservatives from 1994 and initially continued by Gordon Brown until 2000.  Over this period, the UK economy grew rapidly.

There are good theoretical reasons for thinking that cutting the government deficit could stimulate rather than contract the economy.  The classic paper was written by Robert Barro of Harvard as long ago as 1974.  Its rather mysterious title, ‘Are government bonds net wealth?’, has not prevented it from becoming one of the most cited papers in the whole of economics.  Barro, who was subsequently awarded the Nobel Prize for work such as this in macroeconomics, essentially argued that a nation cannot make itself better off by increasing its public debt. More recently, the work of the Italian economist Alberto Alesina, now also based at Harvard, has been influential in policy making circles in the European Commission and European Central Bank.

The simple view that more government spending boosts the economy appears to make common sense.   The opposing views are more subtle and complex.  But it is the latter which at present have the upper hand.

As published in City AM on Wednesday 12th August 2015

Image: “George Osborne 0482am” by alltogetherfool is licensed under CC BY 2.0

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Supply side success is a cure for the drug of deficit finance

Supply side success is a cure for the drug of deficit finance

George Osborne’s plan to run financial surpluses and use them to pay off government debt has been met with the usual set of whinges and whines, mainly from academic economists funded by the taxpayer. Of course, their arguments are based purely on what they believe to be the intellectual merits of their case.  One of the more prominent names is David Blanchflower, once a Gordon Brown favourite on the Monetary Policy Committee, who at least is based in a private university in America. Blanchflower predicted that coalition policy after the 2010 election would lead to 4 million, and possibly even 5 million, unemployed. The actual figure now is 1.8 million. Still, economic forecasting is a notoriously difficult exercise.

It is clearly very difficult for a certain kind of economist to grasp the fact that an economy can prosper whilst at the same time the government balances the books. The two decades after the Second World War were probably the most successful in the entire history of the UK as an industrial economy, stretching back to the late 18th century. From the late 1940s to 1964, real GDP grew at an annual average rate of 3.5 per cent. Today, relatively few economists believe that we can sustain an annual growth of more than 2.5 per cent. And each additional one percentage point extra on GDP represents the best part of £2 billion worth of extra output.

Over this period, successive governments added virtually nothing to the size of government debt. In some years the government ran a surplus, and in others a deficit. But cumulatively, these more or less cancelled out. At the same time, low but persistent inflation eroded the value of the outstanding stock of debt, so that as a percentage of GDP, government debt declined sharply over these 20 years. Of course, fiscal prudence did not by itself cause the strong economic performance. Indeed, rapid growth leads to a growing flow of receipts from taxation, which makes it easier for a government to behave responsibly.

The key point is that the 1950s and early 1960s were very favourable to sustained growth driven by the supply side of the economy, by companies incentivised by the prospect of profit. The controls and restrictions imposed of necessity during the war had largely been lifted by the time the post-war socialist government under Attlee lost office in 1951.  Living standards has been ruthlessly squeezed during the war in order to divert resources into the armed forces. So there was a massive pent up demand for new consumer goods. Companies had been unable to invest during the war, so they wanted to build up their stocks of capital equipment rapidly. The net result was a prolonged boom, driven by the supply side, and enhanced by the renewed opening up of world trade.

Economic theory suggests strongly that longer term growth is driven by the supply side, by investment and innovation. If Osborne can create a climate in which these flourish, he will simply not need the drug of deficit finance.

As published in City AM on Wednesday 17th June 2015

Image: Piccadilly Circus c1960 by David Howard under license CC BY 2.0

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