Paste your Google Webmaster Tools verification code here

Brexit was the final straw: it’s time to scrap the IMF

Brexit was the final straw: it’s time to scrap the IMF

Sports fans will all be familiar with the commentator who almost always gets things wrong. “Arsenal are very much on top here” he – it is invariably a “he” – will pronounce, or “Root is looking very settled”, only for the opposition to score a goal immediately and for the Yorkshireman to be clean bowled. In economics, a similar role is played by the International Monetary Fund (IMF).

In the middle of July, Remain fanatics had a field day. “The IMF has slashed its forecasts for the UK economy for next year after Brexit”, crowed the Financial Times. Maurice Obstfeld, the Fund’s chief economist, claimed that Brexit “has thrown a spanner in the works”. Global growth projections for 2017 were cut back, but most of all for the UK.

But on the first day of September, the IMF was forced to admit that growth in Britain had, in a splendidly bureaucratic phrase, “surprised on the upside”. On the same day came the news that manufacturing activity in August had posted its biggest monthly rise in 25 years. On Monday this week, the Markit purchasing managers’ index for the service sector registered the biggest monthly increase in its 20 year history.

The IMF has real form. In 1998, East Asia was experiencing a major economic crisis. Yet in May 1997, the IMF was predicting a continuation of very strong growth in most countries for the year ahead: 7 per cent for Thailand, 8 per cent for Indonesia and 8 per cent for Malaysia. They revised the projections down by December, but even these proved wildly optimistic, as the economies collapsed during 1998, registering a fall in output of over 15 per cent in Indonesia, for example, worse than America in the Great Depression of the 1930s.

Macroeconomics is the study of variables such as GDP which describe the economy at the aggregate level. Since the 1980s, it has been dominated by the concept of equilibrium. Highly mathematical models have been developed, resting on the premise that the economy can correct itself and absorb any shocks. Olivier Blanchard, the IMF’s previous chief economist, was a great enthusiast for this project. In August 2008, he published a paper which concluded with the claim “the state of macroeconomics is good”. Three weeks later, Lehman Brothers collapsed.

Apart from the European Commission itself, the IMF has been probably the biggest cheerleader for the euro. Since the inception of the single currency in 1999, a whole series of statements and technical articles from the IMF has eulogised its mystical benefits. At the end of July this year, the IMF’s own Independent Evaluation Office (IEO) was totally scathing of the Fund’s record on this. The top staff became impervious to other points of view and ignored warning signs of the financial crisis. In their view of the world, it simply could not happen.

The IMF exercises enormous influence and power. Yet its persistent ineptness makes England football managers look like world beaters. To add insult to injury, its staff enjoy tax free salaries. It’s time to close the Fund down and go back to the drawing board.

As published in CITY AM on Wednesday 7th September 2016

Image: Valsts kanceleja/ State Chancellery is licensed under CC BY 2.0

Read More

The coming explosion in natural debt is a serious risk to the economy

The coming explosion in natural debt is a serious risk to the economy

Martin Feldstein of Harvard is an economist who should always be taken seriously. Writing in 1997 about the forthcoming introduction of the euro, for example, he argued that “the adverse economic effects of a single currency on unemployment would outweigh any potential gains from trade flows”. He went on to predict that the euro was likely to lead to increased conflicts within Europe. Looking at the current state of the continent, his forecasts appear spot on.

In the latest issue of the American Economic Review, he reminds us of the crucial importance of reducing government deficits. The Brexit referendum has essentially frozen David Cameron’s government from taking almost any action at all. But despite a convincing General Election victory, the drive to cut the deficit was already slowing down. In particular, the government appears to have lost its nerve in terms of cutting public expenditure. At the slightest sign of protest or opposition, it backs down.

Feldstein’s paper on the American experience should spur Cameron to think again. Feldstein begins with an optimistic view of the US economy. Since the 1970s, the unemployment rate has only briefly dipped below 5 per cent, its current level, so America effectively is back at full employment. Inflation remains low, despite employment rising by 14m since 2010. Economic growth is limited by the absence of excess capacity rather than by demand.

In the longer term, the most serious risk to the American economy, Feldstein believes, is the explosive growth of national debt as a percentage of GDP which will happen unless there are serious measures taken to cut spending. The public sector deficit is the difference between income from taxation and public spending in any given year, and a deficit adds to the stock of debt which is outstanding.

Feldstein points out that the debt to GDP ratio has risen from less than 40 per cent 10 years ago to 75 per cent now. The comparable numbers in the UK are from 35 to 85 per cent. He suggests that a very effective way of controlling future increases is to raise the retirement age even more. He has a neat suggestion to counter legitimate worries that life expectancy has gone up more for the better off than it has for the poor. Just link the retirement age to lifetime earnings. The lower they are, the earlier you can give up work.

The shape of the recovery in the United States suggests that there is little to fear from following Feldstein’s arguments and really getting to grips with public expenditure. The trough of the recession was in 2009. By 2015, GDP in real terms had increased by 13.3 per cent. Despite scare stories that growth has been driven by unsustainable consumer spending, this rose at a virtually identical rate, by 13.9 per cent. Corporate investment, in contrast, has shot up by 51 per cent. And current public spending has fallen by 7.5 per cent.

Despite siren voices such as those of junior doctors, the UK government should keep its nerve too. The American experience shows that cutting public spending can expand the economy.

As published in City AM on Wednesday 1st June 2016

Image: National Debt Clock by Nick Webb licensed under CC BY 2.0

Read More

The IMF is in trouble – and not just due to its poor forecasts

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by Japanexperterna.se is licensed under CC BY 2.0

Read More

China is drowning in private sector debt: there’s no telling how this one will end

China is drowning in private sector debt: there’s no telling how this one will end

The eyes of the financial and economics worlds are now fixed on China, with focus predominantly on Chinese stock markets and the country’s GDP figures.  A fascinating perspective was provided last week in the leafy borough of Kingston upon Thames.  The university has recruited the Australian Steve Keen as head of its economics department, and it was the occasion of his inaugural lecture. Keen was one of the few economists to highlight the importance of private sector debt before the financial crisis began in 2008.

The title itself was exciting: ‘Is capitalism doomed to have crises?’  Judging by the beards and dress style of the audience, many may have expected a Corbynesque rant.  Instead, we heard an elegant exposition based on a set of non-linear differential equations.

Private sector debt is the sum of the debts held by individuals and the debts of companies, excluding financial sector ones like banks.  He pointed out that in the decade prior to the massive crash of 1929, the size of private debt relative to the output of the economy as a whole (GDP) rose by well over 50 per cent.

The increase from the late 1990s onwards meant that debt once again reached dizzy heights.  In ten years, it rose from being around 1.2 times as big as the economy to being 1.7 times larger.  This may seem small.  But American GDP in 2007 was over $14 trillion.  If debt had risen in line with the economy, it would have been about $17 trillion.  Instead, it was $24 trillion, an extra $7 trillion of debt to worry about.

Japan experienced a huge financial crash at the end of the 1980s.  The Nikkei share index lost no less than 80 per cent of its peak value, and land values in Tokyo fell by 90 per cent.  During the 1980s, private sector debt rose from being some 1.4 times as big as the economy to 2.1 times the size.

In China, in 2005, the value of private debt was around 1.2 times GDP.  It is now around twice the size.  Drawing parallels with the previous experiences of America and Japan, a major financial crisis is not only overdue, it is actually happening.  And Keen suggests there is still some way to go.

So is it all doom and gloom?   Up to a point, Lord Copper.  High levels of private sector debt relative to the size of the economy do indeed seem to precede crises.  But there is no hard and fast rule on the subsequent fall in share prices.

Japanese shares fell 80 per cent and have not yet recovered their late 1980s levels.  In the 1930s, US equities fell 75 per cent, and took until 1952 to bounce back.  This time round, they fell by 50 per cent, but are even now above their 2007 high.  Equally, output responds to these falls in completely different ways.  In the 1930s, American GDP fell by 25 per cent, compared to just 3 per cent in the late 2000s.  Japan has struggled, but never experienced a major recession.    Still, Keen’s arguments leave much food for thought.

 

As Published in CITY AM on Wednesday 20th January 2016.

Image: Chinese Yuan Bills by Japanexperterna.se licensed under CC BY 2.0

Read More

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

Read More

CEO compensation and Jamaican demands for reparations: two sides of the same coin

CEO compensation and Jamaican demands for reparations: two sides of the same coin

David Cameron’s visit to Jamaica last week led to vociferous demands for the UK to pay the Caribbean island billions of pounds in reparations for slavery.  Most people here reacted with predictable eye-rolls and sighs.  Slavery was abolished throughout the British Empire in 1833, nearly two centuries ago.  Jamaica has been independent since 1962, over fifty years ago.  Surely they have had time to sort themselves out and get a decent economy?

There is much to be said for these arguments.  In the early 1960s, for example, South Korea was essentially a poor, agricultural society, only one step up the ladder from subsistence level incomes.  Now, it has a dynamic, modern economy with living standards similar to those of the West.  Countries such as Singapore have followed similar trajectories.

The demands for payment are a classic example of what economists call “rent seeking” activity.  The word “rent” here does not mean what you pay on your apartment to live in it.  The concept goes all the way back to Adam Smith himself, though the phrase was only coined in the late 20th century.  Rent seeking means trying to increase your share of existing wealth without creating any new wealth.

But we should not feel too much moral superiority over the Jamaicans.  Rent seeking has proliferated in Western society in the last couple of decades.  The US economy has performed well over this period.  Its success is reflected in the amounts paid to CEOs, with the average compensation in the top 350 firms being around $15 million a year.  This enormous sum is some 300 times higher than the amount the companies pay to the typical worker.  In the mid-1970s, the ratio was not 300:1 but only 30:1.  Even in the mid 1990s it was around 100:1.  This later figure would still hand the average CEO some $5 million today, not a bad sum to have.  It is hard to justify these payments in terms of the contribution the individuals are making to creating new wealth.  Some of it, yes, but essentially these pillars of our society have been rent seeking on a grand scale.

Rent seeking by the public sector characterised Gordon Brown’s long period as Chancellor.  Public spending rose dramatically.  But much of the increase did not go to provide better public services.  Instead, it paid for the private consumption of those employed in the public sector.  Some graduates in Hollande’s France flee abroad.  Most of the rest aspire to become a fonctionnaire.  Good pay, virtually unsackable, and with a gold plated pension at the end, it is a much sought after position.  Little wonder that France has essentially registered no economic growth since 2011.  Jeremy Corbyn eulogised the Italians for subsidising a steel plant rather than letting it go under like Redcar.  But rent seeking proliferates in Italy, and their living standards are now back to those of the late 1990s.

Economists disagree about many things, but they are united in their opposition to rent seeking, an unequivocally Bad Thing.

As published in City AM on Wednesday 7th October 2015

Image: “Street in Montigo Bay Jamaica Photo D Ramey Logan” by WPPilot – Own work. Licensed under CC BY-SA 3.0 via Wikimedia Commons.

Read More