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Labour’s rejection of conventional economic theory ignores important insights

Labour’s rejection of conventional economic theory ignores important insights

One of the first tasks facing whoever becomes chancellor after the General Election will be choosing the next governor of the Bank of England.

Getting to make this choice would be a key step in the plans of Labour’s shadow chancellor John McDonnell to shake up the Bank of England, but his radicalism is not simply a matter of practical policies. McDonnell appears to want a new intellectual approach at the central bank and across government, one not based on existing economic theory.

Many people on the left, such as McDonnell, have criticised austerity ever since the financial crisis of the late 2000s. They often believe this to be a criticism of conventional economic theory.

But these are two different things. They are not the same. It is certainly possible to construct a coherent critique of austerity purely on the basis of standard theory.

Economists disagree on the matter because of different interpretations of the empirical evidence, rather than on the basic theory.

However, Labour’s election manifesto appears to want to ditch the most powerful insight of the whole of economic theory. Namely, that people react to changes in the incentives which they face. If incentives change, behaviour changes.

For example, even the most dedicated critic of economics will slow down when approaching a speed camera if they are exceeding the speed limit. On the open road, there is a chance of being stopped by the police, but it is very small. Yet the probability of incurring a penalty rises sharply in the presence of a speed camera. And so behaviour changes — the driver slows down.

We can apply this insight to taxation. Already, the top one per cent of earners in the UK pay well over 30 per cent of all income tax, according to calculations by the Institute of Fiscal Studies.

Before tax, to be in the top one per cent you have to earn at least £166,000 a year. After tax, the figure falls to £111,000. So these individuals — just over 300,000 of them — are already handing over one third of their income to HMRC.

We know from Labour’s manifesto that McDonnell wants to raise many billions more in tax from the top five per cent of earners.

Much of this would potentially fall on the top one per cent, where the money is really concentrated. But this would require these taxpayers to stand still and wait to be plucked like so many golden geese. Economic theory, supported by a vast amount of empirical evidence, suggests that this just would not happen.

he same ignorance of fundamental, well-supported economic theory is seen in Labour’s policy on corporation tax. The proposal is to raise the rate from 19 to 26 per cent.

The basic problem here is that if the tax rate changes, the behaviour of a company will change.

The company may hold down wages. It may not take on extra staff, or even get rid of existing employees. It may cut dividends, so that pension funds and the income of pensioners is reduced. Or it may slash investment, so that the workers in the firms which supply to the company will suffer.

Instead of jettisoning economic theory, Labour should learn from its most powerful insights.

As published in City AM Wednesday 27th November 2019 
Image: John McDonnell by Sophie Brown via Wikimedia licensed for use  CC BY-SA 4.0
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Celebrating Germany’s recession dodge? The data isn’t quite as solid as you think

Celebrating Germany’s recession dodge? The data isn’t quite as solid as you think

Ardent Remainers had a rare bit of good news at the end of last week.

The latest statistics for the German economy showed that, contrary to expectations, it had not fallen into recession in the July-September period.

Economists have come to define a recession as a period when a country’s GDP falls for two quarters in succession. There is no firm scientific basis for this — it has simply emerged over time as a consensus among the members of the profession who follow these things.

A more decisive indicator is if the economy shrinks compared to the same quarter in the previous year. A cynic might say that the less stringent definition, a fall for just two successive quarters, gives economists more to write about, as such events are more frequent than year-on-year falls.

Still, the two-quarters fall is the definition commonly used. German GDP fell in the second quarter, April to June, but it rose — by all of 0.1 per cent — in the third quarter. A recession has been avoided, and Remainers were relieved by the demonstration (if weak) that the EU’s powerhouse economy was not in decline.

Not so fast. We should take economic statistics such as the growth of GDP with a firm pinch of salt, and remember that, outside of the financial markets, almost all economic data is estimated.

We cannot put the economy onto a set of scales and weigh it. Its size has to be estimated, using a wide range of basic information and assumptions. And that means that the numbers cannot be taken at face value.

For example, commentators noted that the fall in German GDP in the second quarter had been revised, from minus 0.1 per cent to minus 0.2 per cent.

Changes of this magnitude are small fry. The US has probably the most sophisticated system for estimating the so-called national accounts — the maze of economic statistics which make up the economy. Yet during the depth of the financial crisis, in the fourth quarter of 2008, American GDP was initially estimated to have fallen by 6.4 per cent at an annual rate. As more information came to light, over a period of years, the figure is now believed to be a drop of 8.2 per cent.

And this is by no means the biggest revision which has been made. In the recession of early 1975, for example, GDP was initially thought to have fallen 11.4 per cent in the first quarter.  The figure was eventually revised to just 4.7 per cent.

These revisions are inevitable given the assumptions — many of them arbitrary — that have to be made in economic analysis. How do we measure the output of the armed forces, for example, or civil servants? There is no market in which these outputs are sold which might give us some clue. The answers are provided by a set of conventions.

Economic statistics therefore paint a broad picture and do not have the precision with which the media has come to treat them.

As a rule of thumb, quarterly GDP growth of 0.5 per cent or above is a sign of a healthy economy. The German data shows that, in terms of the big picture, the economy is currently struggling, regardless of whether an individual estimate is plus 0.1 or minus 0.1.

As published in City AM Wednesday 20th November 2019 
Image: The German Volke via Pxhere licensed for use  CC0 1.0
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Today’s apologists for socialism still won’t acknowledge the lessons of the Berlin Wall

Today’s apologists for socialism still won’t acknowledge the lessons of the Berlin Wall

The media has been awash over the past week with stories about the thirtieth anniversary of the fall of the Berlin Wall.

My favourite vignette concerns a couple living in East Berlin who were delighted to have a telephone installed in their apartment only weeks before the Wall came down. They had been on the waiting list for 19 years.

This captures the essence of socialism. The system could generate a tolerable standard of living for citizens, but it was grossly inefficient and run for the benefit of the producers rather than the consumers.

The old nationalised industries in Britain also offered us a glimpse of what life would be like under socialism. Under British Rail, new heating stoves really were installed in station waiting rooms on the very day that the line was closed to traffic for ever.

In the 1970s, people routinely waited at least six months for the nationalised telecoms company to install a domestic phone line.

This “producer-just” attitude persists. Today’s Labour leadership has, for example, defended firefighters in the face of the recent damning criticism of their performance in the Grenfell Tower tragedy. For Jeremy Corbyn and John McDonnell, the interests of the producers — the public sector workers, even the fire chief who could retire at 50 with a pension of £140,000 a year — come first.

Some will feel that this is unfair to socialism. Socialism in practice may have had its faults (such as the liquidation of nearly 100 million people by their own governments), but a better, different kind of socialism is apparently on offer in the future.

Remarkably, the leaders of the Communist Parties in Eastern Europe appear to have believed the same thing. The ideologists in their Politburos described countries such as East Germany as examples of “actually existing” socialism — in contrast to the nirvana which would exist at some unspecified time in the future.

But we can only judge a system by its performance in practice, not by some Platonic ideal of what true believers imagine it might do. Everywhere it has been tried, socialism has been a failure. This simple fact cannot be repeated too often, particularly to younger generations to whom 1989 may seem as remote as the days of the Roman Empire.

Modern history has provided us with a whole series of what are termed natural experiments.

We cannot set up (as in the natural sciences) a laboratory in which one society is started up on socialist lines and the other on capitalist ones, and then observe their performances over time.

But we can observe the United States and the Soviet Union, West and East Germany, South and North Korea, China when it was purely socialist and China when it subsequently embraced a market-oriented economy.

In every single case, capitalism has delivered better outcomes: higher living standards, longer life expectancy, more holidays, more provision of health and education — more of almost everything except slave labour and environmental pollution.

Capitalism can be criticised, but its faults are nothing compared to those of socialism.

As published in City AM Wednesday 13th November 2019
Image: Berlin Wall by Ira Gorelick via Pixabay
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From World War II to the financial crisis, our institutional memory is fading fast

From World War II to the financial crisis, our institutional memory is fading fast

The young contestants on Lord Sugar’s reality TV show The Apprentice sparked outrage last week.

They appeared to have virtually no knowledge about the Second World War.

The online clips of the sequence capture to perfection their expressions of bovine outrage at even being expected to know such an esoteric thing as how long the War lasted. For many viewers, it was a powerful argument for an immediate raising of the voting age to at least 35.

Trying to be fair, I reflected on my own knowledge of the Boer War. The gap between that and my birth is not that much more than the one between World War II and Lord Sugar’s wannabes.

I have to confess that it is very sketchy. I know it was around 1900. The Boers nearly pulled off a shock victory, but our boys pipped them in extra time. And there was a siege at somewhere called Mafeking.

That said, the Second World War is of far more historic significance than Britain’s colonial skirmishes. The participants in The Apprentice might, one would think, be expected to know more about it.

Their ignorance reflects a more general trend towards what can be described as a shortening of cultural memory.

This can be seen in many seemingly unrelated ways.

Baby names, for example, are important indicators of culture. The example may seem slightly frivolous but, as the American polymath Stephen Pinker has written, the choice of name “encapsulates the great contradiction in human life: between the desire to fit in and the desire to be unique”.

Whenever there is a royal birth in the UK, the name given to the new baby enjoys a surge in popularity as people copy what is fashionable. But there is also the desire to give your baby a distinctive name.

In the twenty-first century, the turnover in popularity of names has increased dramatically.  It was steady for almost the whole of the twentieth century – once a name had made it into the top 10, say, it tended to stay there a long time. But the “churn” is now running at a rate nearly 10 times greater.

The outcomes of behaviour on the internet provide a more obvious example. At any point in time, the most popular memes on Twitter or the most viewed videos on YouTube are often millions of times more popular than the average. But their popularity is ephemeral.

In what many would regard as far more serious areas of economic activity, away from popular culture, this shortening of collective memory may have disturbing consequences for all of us.

In financial markets, for example, there is a traditional tale that a crisis happens precisely when the institutional memory of the last crisis has faded. But if traders and decision-makers develop shortened memories, crises could become more frequent.

Already bodies such as the International Monetary Fund are warning about the build-up of private sector debt, even though it is scarcely a decade since such debt precipitated the global financial crisis.

The apparent ignorance of The Apprentice candidates offers a warning to us all.

As published in City AM Wednesday 6th November 2019 
Image: World War Two posters by Andrew Curtis  via Geograph licensed for use CC BY-SA 2.0
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The economic impact of Brexit tariffs only tells us half the story

The economic impact of Brexit tariffs only tells us half the story

Brexit is about much more than the economic costs and benefits, but the idea that the former dramatically outweigh the latter has become the received wisdom in much of the media.

Report after report emerges which purports to show that, under any of the various trade arrangements envisaged, the UK will be worse off as a result of Brexit.

These studies are not wrong. They all use perfectly standard economic theory to arrive at their conclusions. But they are misleading.

The real problem is that they miss out key bits of the story. We can think of the classic tale of the person dropping his car keys in the street at night. He only looks for them under the street lamp, where the light is.

In the same way, standard economic analysis of Brexit only illuminates part of the landscape.

The explanation of why trade occurs between countries was given 200 years ago by the great English economist David Ricardo. It is still the basis of the modern economist’s understanding of trade.

Ricardo imagined, to illustrate his theory, a world with just two countries and two products. His examples were England and Portugal, and cloth and wine – but they could have been any countries and any products.

Ricardo asked a simple but profound question. If England could produce both cloth and wine more efficiently than Portugal, why would trade take place at all? How could the more efficient country, England, benefit from trade?

His answer introduced the fundamental concept of comparative advantage. England had an absolute advantage in producing both cloth and wine, but the country should choose to specialise in producing the one in which its advantage compared to Portugal was bigger.  Both would benefit if England produced only cloth and Portugal only wine, and they traded.

Economics has moved on in the past two centuries, but the concept of comparative advantage, modified by factors such as the distance between countries, is still seen as a key determinant of trade patterns.

In terms of Brexit, introducing complexities like tariffs into the picture essentially affects the amount which is traded, and not the structure of trade in terms of who sells what to who.

If the basic pattern of trade is fixed by comparative advantage, then if Brexit means higher tariffs for the UK, as a country we will lose out. In a nutshell, this is what lies behind all the negative assessments of the impact of Brexit.

However, the key word in the last paragraph is “if”.  Like almost all economic theory, these models are static. They assume that the network of trade is fixed, and analyse the consequences of changing prices through tariffs.

The EU has become mired in regulation and the level of innovation is low. Outside the EU, the UK could alter the patterns of trade by innovating in, say, biotech or AI-related products and services. It is this dynamic response, and not the static one, which will determine whether or not Brexit is a success.

Economic models which claim to analyse the impact of Brexit are true – but only up to a point, Lord Copper, as the saying goes.

As published in City AM Wednesday 30th October 2019 
Image: Dover by Oast House Archive via Geograph licensed for use CC BY-SA 2.0
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Until Scotland’s currency puzzle is solved, independence is economically delusional

Until Scotland’s currency puzzle is solved, independence is economically delusional

The possibility of Scottish independence is back on the political agenda once again. And one question – which currency would an independent Scotland use? – that was crucial in the 2014 referendum has still not been resolved.

The informal use of the pound is a very risky option.

To see why, the Scottish National Party (SNP) might look at the problems which Facebook is having in getting its proposed digital currency libra off the ground. Already, companies like PayPal, Visa, Mastercard and Ebay have withdrawn as potential sponsors.

While Facebook is a company and Scotland is a country, the issue is how the currencies are backed.

Facebook proposes to back the libra by its accumulated profits held in a portfolio of “low volatility assets”. But as Barry Eichengreen of the University of California points out, “anyone who lived through the 2008 global financial crisis will know that low volatility is more a state of mind than an intrinsic attribute of an asset”.

In the face of an unexpected adverse shock to the values of these assets, Eichengreen notes that these will be subject to the equivalent of a bank run. But there is no lender of last resort able to simply print money.

By simply using sterling, as many Latin American countries do with the US dollar, the Scots would have no means of printing money if their banks were attacked in a financial crisis. Taxes would have to rise massively to support the banks.

The Scots could instead apply to join the euro. An immediate problem with this would be the rule in the Stability and Growth pact that countries in the Eurozone should keep their budget deficits below three per cent of GDP.

The UK spends only 1.1 per cent of GDP more than it raises in taxes.  Ironically, this would make us a shoo-in for euro membership, if Britain as a whole wanted to join.

In contrast, the latest figures produced for Government Expenditure and Revenue for Scotland show the nation running a public sector deficit of seven per cent of GDP.

This is obviously much higher than would be allowed in terms of membership of the euro.  It is, in fact, the highest in the whole of Europe, the next highest being Cyprus at 4.8 per cent. So to join the euro, the Scots would have to make large cuts in public spending.

If instead they decided to set up their own currency, the markets would almost certainly force similar public spending reductions on them. After all, small countries running large public deficits tend not to be viewed kindly.

This problem has been magnified dramatically by the statement by Derek Mackay, the Scottish government finance secretary, that an SNP government in an independent Scotland would refuse to repay its share of outstanding UK debt.

A massive public sector deficit and defaulting on government debt is hardly a very sound basis on which to launch any new currency.

The desire for independence is often driven by emotion rather than rational calculation. But unless the currency question is addressed and solved, an independent Scotland would live to rue the day.

As published in City AM Wednesday 23rd October 2019
Image: Scottish Independence March by Christine McIntosh via Flickr licensed CC BY-ND 2.0
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