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Master the art of brinkmanship to run Brexit rings around Barnier

Master the art of brinkmanship to run Brexit rings around Barnier

Michel Barnier invokes a wide range of emotions this side of the Channel.

To his credit, the EU’s chief Brexit negotiator appears to have a stronger grasp of the insights of game theory than his UK counterparts.

Thomas Schelling, the polymath winner of the Nobel Prize in economics, advanced the science of game theory in many ways. Funded by the US security forces at the height of the Cold War, Schelling formalised the concept of credible threats.

How could America convince the Soviet Union that, if necessary, it would launch a nuclear strike? This would have been a highly irrational act, and game theory is meant to be played by entirely rational people.

One way to do this is by brinkmanship, defined by Schelling as “the tactic of deliberately letting the situation get somewhat out of hand, just because it being out of hand may be intolerable to the other party and force his accommodation”.

This seems to be exactly what Barnier is doing. His draft document published last week includes a so-called punishment clause that would allow Brussels to ground aircraft and block trade if the UK failed to obey EU rules during the transition period.

The counter ploy to such an irrational move – which would harm the EU as well as the UK – is not to cower and capitulate. It is to play brinkmanship yourself.

A threat to, say, drop a tactical nuclear device on Hamburg would not work. This would be unbelievable.

But we could threaten to walk out of the talks all together. Several European countries such as Poland appear to be seriously concerned about this prospect.

But we need back-up material for this to seem like a real threat; Barnier has to think that we would really do this.

Much of the doom and gloom from the Remain camp is all about short-term economic prospects if we leave. Our negotiating team should make it clear that in the longer run the UK would be better off outside the grip of the central planning mentality of the European Commission, even if there were transitional costs.

The Markets in Financial Instruments Directive II (Mifid II), designed to offer greater protection to investors, is a perfect illustration.

Introduced at the start of this year, and at least seven years in the making, Mifid already runs to several thousand pages of regulatory requirements. In this mindset, both bureaucracy and rules can eliminate risk.

But it is so complicated that it is virtually beyond the powers of a human to grasp. Certainly, experts like Phil Treleaven at University College London believe that it is riddled with contradictions.

We do not need the madness of Mifid II. The EU is frightened of an innovative, lightly taxed UK, which embraces, rather than resists, the rapid pace of change in the world economy.

If the government really believed this itself, we could play brinkmanship to our heart’s content and run rings round Barnier and his cronies.

As published in City AM Wednesday 14th February 2018

Image: Regulatory Documents via Max Pixel is licensed under CC by 0.0
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How European commissioners really allocate EU funding

How European commissioners really allocate EU funding

“Pork barrel” has been a theme in American politics for almost as long as the United States has existed.

Many members of Congress work hard to secure public works projects, agricultural subsidies and the like for their own districts, almost regardless of the economic arguments for and against.

Surely the European commissioners would rise above such petty behaviour? After all, the European Union claims that they “represent the interests of the EU as a whole”.

It turns out that many of them have had their noses in the trough, both literally and metaphorically. A new scientific study shows that the agricultural commissioners have systematically over the years ensured that their own country receives more than its fair share of funding.

This cannot be dismissed as the product of some swivel-eyed Brexiteer. The findings are published in a paper in the latest issue of the American Economic Review (AER), probably the most prestigious academic economics journal in the world.

Kai Gehring of Zurich University and Stefan Schneider of Heidelberg find that “there is a significant positive relationship between the commissioners’ country of origin and the agricultural fund spending these countries receive during their terms in office”. Their highly sophisticated statistical analysis concludes that “this translates on average into about €850m per year for the country of origin of the respective commissioner”.

There are many anecdotes along the same lines. One which is very relevant in the light of the current Volkswagen emissions scandal is how, in 2007 and 2008, the German commissioner for enterprise and industry, Gunter Verheugen, repeatedly opposed a planned commission proposal to reduce new cars’ carbon dioxide emissions.

As Gehring and Schneider state, “his success in weakening the initial proposal was widely perceived as support for the German car industry”.

The current study is the first in-depth scientific analysis of the allocation of funds by the commissioners.

In economic terms, the Commission structure is a principal-agent one. The national government which makes the nomination is the principal, and the commissioner is the agent of the government. It would be surprising if their interests were not aligned to some extent, particularly since many commissioners want to return to political life in their own countries.

Tellingly, the authors note that they had to restrict their investigation to agriculture because “a lack of data and transparency” did not allow them to quantify the effects for the other directorates general. But it does not seem unreasonable to believe that they operate in a similar way to agriculture. The overall effect is to divert some €1.5bn a year to a few select countries, those which hold the big-spending portfolios.

The AER paper analyses almost three decades’ worth of data. So we might plausibly conclude that this has been going on ever since we joined the EU in 1973.

If we add back in the interest on the extra monies we have had to hand over as a result, even though the cost to us may be difficult to estimate, the study gives plenty of scope to come up with a big number.

As published in City AM Wednesday 7th February 2018

Image: EU Flags by Thijs ter Haar is licensed under CC by 2.0
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The UK could teach the Eurozone a thing or two about successful monetary unions

The UK could teach the Eurozone a thing or two about successful monetary unions

The Office for National Statistics (ONS) published last week some figures which show how a successful monetary union works in practice.

It is not obvious at first sight, from the dry heading: “regional public sector finances”.

The ONS collects information on the amounts of public spending and money raised in taxes across the regions of the UK. The difference is the so-called fiscal balance of the region.

Only three regions generate a surplus. In London, the South East and the East of England, total tax receipts exceed public spending. The capital has a healthy positive balance of £3,070 per head, followed by the South East at £1,667 per head.

Essentially, these two regions subsidise the rest of the UK. Public spending in the North East, for example, is £3,827 per person above the level of taxes raised in that region. In Wales, it is even higher at £4,545. No wonder that one of the first things Carwyn Jones, leader of the Welsh Assembly, said after the Brexit vote was: “Wales must not lose a penny of subsidy”.

The region which benefits most is Northern Ireland, which gets £5,437 per head more than it generates in tax. Scotland, to complete the picture, receives around half of that, at £2,824 per person.

There is a lot of debate around Brexit and the border between the North and the Republic of Ireland. There is even talk of reunification, but on these numbers the Republic would be mad to want it.

Essentially, the regions receive these subsidies because they are running deficits on their trade balance of payments. The exports of goods and services from the North East, for example, to the rest of the UK are much less than it imports. In balance of payments jargon, the subsidy it receives is a monetary transfer from the rest of the country, principally from London and the South East.

The ONS does not actually produce regional balance of payments statistics. But the fact that most regions receive these large transfers implies that they are just not productive enough to sustain their living standards by their own efforts.

All the regions are in the sterling monetary union. Those running trade deficits cannot devalue to try to improve their position. They must instead rely on subsidy.

Exactly the same principles apply in the Eurozone. The massive difference of course is that there is no central Eurozone government to make sure the weaker performing regions receive the necessary funding.

This is why President Macron and Chancellor Merkel announced they will examine changes to treaties to allow for further Eurozone integration. Even the hardline German finance minister, Wolfgang Schauble, said: “a community cannot exist without the strong vouching for the weaker ones”.

To be sustainable, a monetary union needs large transfers between its regions. London and the South East already put their hands deep into their pockets for the rest of the UK. Gordon Brown did get one thing spectacularly right. He kept us out of the Euro.

As published in City AM Wednesday 31th May 2017

Image: Euro sign by Alex Guibord is licensed under CC by 2.0
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Anti-growth Welsh leaders are denying their voters prosperity by opposing shale

Anti-growth Welsh leaders are denying their voters prosperity by opposing shale

Leading Welsh politicians seem to be getting ideas above their station. Fifty years ago, Labour held all but four of the Parliamentary seats, and had over 60 per cent of the vote. Now, the Conservatives are by a large margin the second party in terms of votes, and are within hailing distance of Labour. They gained 3 seats in the 2015 general election, and hold 11 compared to Labour’s 25.

Yet in the media, it is the Labour First Minister in the Welsh Assembly, Carwyn Jones, and the Plaid Cymru leader, Leanne Woods, who grab all the attention. They are highly critical of the Prime Minister over Brexit.

Jones in particular keeps insisting that Wales should not lose a “penny of subsidy”, despite the fact the Principality voted strongly for Leave. Readers in London and the South East will be only too well aware of just exactly who is meant to keep handing over the monies.

Labour and Plaid Cymru together have controlled the Welsh Assembly since its inception in 1999. But just how well have they served the interests of Britain’s poorest region?

The Welsh government is opposed to fracking, for example, despite the considerable potential which exists.

A paper in the latest American Economic Review by a team from the Ivy League Dartmouth College examines the local economic impacts of fracking in the Unites States. Using detailed data from the Bureau of Labor Statistics and the Internal Revenue Service, they assess not just the overall impact, but how much of any benefits are retained locally.

Their geographic unit of analysis is the US county, which broadly corresponds in British terms to the local authority in terms of their respective average populations. The authors, Feyrer, Mansur and Sacerdote obtain two main findings.

First, the counties where extraction occurs enjoy significant economic benefits. Second, the effects grow larger as they widen the geographic area being examined. The regional impact on jobs and income is approximately three times as large as the immediate county effect with most of the impact happening within 100 miles of the drilling sites.

Around 20 per cent of all the total value of gas and oil extracted remains within the specific county where the drilling takes place. Each million dollars of new oil and gas production is associated with a $80,000 increase in wage income and 0.85 new jobs within the county in that year. Roughly 40 percent of the income increase is in industries not directly related to oil and gas extraction such as construction, hospitality, and local government.

The academics point out that if a region is at full employment, this additional activity will simply displace rather than add to the total. But during the Great Recession, the US was far from full employment. Fracking added a total of 640,000 extra jobs.

Wales is a long way from being at full employment. Here is a real chance to boost the region economically. But the politicians put their own right-on images above the interests of the people of Wales.

As published in City AM Wednesday 5th April 2017

Image: Fracking Rig by David Burr is licensed under CC by 2.0
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Claims that a low tax, low regulation UK would be a disaster are rubbish

Claims that a low tax, low regulation UK would be a disaster are rubbish

Dame Minouche Shafik, Deputy Governor of the Bank of England, is leaving to become Director of the London School of Economics.  Last weekend, she gave her final interview wearing her Bank hat.

Shafik issued what was described in the media as a “thinly veiled warning” to the Chancellor, Phillip Hammond.  She stated that it was an “illusion” to believe that transforming the UK into a low tax, low regulation economy would give it a competitive advantage.  Indeed, Shafik went further and offered the opinion that such polices risked “hugely disastrous consequences for the economy”.

We have heard such prognostications before. In the run up to Brexit, the Treasury claimed that unemployment would rise by 500,000 by the end of 2016 in the event of a leave vote.  It actually fell.  The Bank signalled a similar opinion, that Brexit would be bad.  Doom and gloom was prophesised by the OECD and the IMF.

These institutions seem permeated by what we might call “Davos liberalism”, the sorts of opinions which would be congenial to George Clooney.  Of course clever, well meaning people can design policies and regulations which will benefit ordinary people, who after all cannot be expected to understand these things and might hold incorrect views!

Shafik claimed that the UK economy has lost 16 per cent of GDP relative to trend because of the financial crisis. Looser regulation would run the risk of an even bigger loss in future.  But the French economy is much more highly regulated than that of the UK.  It has lost at least 20 per cent of GDP relative to trend, some £80 billion more than the UK.  And France has at least 1 million more people who are unemployed.

Shortly after the Shafik statement, the government announced a major review of how the UK can become the world leader in artificial intelligence (AI) and robotics.  We can take with a pinch of salt the unnervingly precise estimate that £654 billion can be added to the British economy by 2035 if the growth potential of AI is achieved.  But we are clearly already a world leader in this area and, equally clearly, if we succeed in capitalising on this, GDP will be boosted by a very big number.

An essential ingredient for success is to attract the innovative thinkers who will push out the frontiers of the science, and the entrepreneurs who will help turn the ideas into practical tools.  It is of course possible that a system of high personal and corporate tax rates could succeed in attracting such people.  But it seems plausible that low tax rates are more likely to do the trick.

The high taxes imposed by President Hollande in France illustrate the point.  Young French people have flocked to the UK.  London is now the sixth largest French city in the world in terms of the population of native French speakers.

Our borders need to remain open to highly skilled individuals.  But we need policies which continue to attract them rather than drive them away.

Image: French President François Hollande by Foreign And Commonwealth Office is licensed under CC by 2.0
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Why the economics profession remains blind to the benefits of Brexit

Why the economics profession remains blind to the benefits of Brexit

The office for National Statistics last week estimated that the UK economy grew at an annual rate of 2.4 per cent in the final quarter of last year. This is slightly above the long-term average growth of the past three decades.

But a Financial Times survey this month showed that the majority of economists remain just as pessimistic about Brexit’s likely effect on Britain’s economic prospects as they were a year ago.

Most have not changed their minds. But of those who have, the more pessimistic outweigh the more optimistic by three to one. Almost incredibly, economists do not generally feel they were proven wrong by events following the vote.

How can this be? Why is the economics profession so overwhelmingly opposed to Brexit?

The reasons rest on two important underpinnings of the discipline. First is a belief in the benefits to society of free trade. There is substantial empirical evidence which backs up economists’ views on this matter.

The majority opinion among economists, however, is that the UK leaving the EU will necessarily lead to our trade becoming less free. This is a judgement about political economy, on which standard economic theory is silent. Simply put, they agree with Remainers that we cannot negotiate better trade deals on our own than we can from within the European Union.

As the referendum showed, this is a contested issue. The Cambridge economist Bob Rowthorn has pointed out that “there has already been a sharp fall in the size of the Euro-area economy as a proportion of the world economy, and it is hard to see how this trend will not continue”. The deals we need are with fast-growing countries like India and China, and with enormous and innovative markets like the United States. Whether we can get a better deal in or out of the EU is a matter of judgement, not theory.

But the more important reason is that economic theory is in essence about equilibrium. It is about how best to allocate a fixed amount of resources in a static world. Economics has relatively little to say about dynamic processes, about change, about disruption, evolution, innovation, about behaviour out of equilibrium.

This emphasis on a static world leaves many economists unable to see the serious failings of the EU, both actual and potential. In the 1970s and into the 1980s, before the impact of the Thatcher reforms had been felt, it was indeed sensible to look to Europe for inspiration. The UK was plagued by high inflation and low growth.

But now we have had nearly two decades of the euro, one of the most efficient job destruction machines ever created. The combined impact of the euro and their own internal corruption has led output in Italy, Portugal, Spain and Greece to be much lower now than it was 10 years ago. This is a recession without parallel in economic history in its length and severity.

The ability to innovate is the key to long-term growth, as America has shown with Microsoft, Google, Facebook and others. Economic theory has very little to say about innovation. And this blinds the economics profession to the failings of the EU.

As published in CITY AM on Wednesday 1st February 2016

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