THE ECONOMIC Affairs Committee of the House of Lords has got its bovver boots on. Last week, the government was given a sound kicking.
The issue was the seemingly esoteric one of how to measure inflation. Inflation tells us how much the prices of goods and services are going up. The question is: what do we put into the basket when we are working this out?
The most general measure is the consumer price index (CPI). This takes into account literally everything which individuals in the UK buy. Something which is widely purchased, such as rail journeys, will carry more weight than, say, spending on parts for model railways. But they all count. The percentage change in the CPI is one measure of inflation.
Gathering all this information obviously takes time. In contrast, the retail price index (RPI) is quick and easy to calculate. It is, quite literally, based on a basket of products available in shops. The basket gets changed from time to time to reflect changes in spending patterns. The disadvantage of the RPI is that it is much more focused on goods than on services.
In recent years, inflation as measured by the RPI has been higher than the CPI. Between 2014 and 2018, the respective rises were 9.7 and 5.9 per cent.
These differences have important practical consequences. All sorts of things get increased each year by the “rate of inflation”.
The Lords accused the government of using the RPI for uprating stuff like rail fares and student loans, where directly or indirectly the government rakes in money. But it uses the CPI when it comes to paying out on pensions and benefits. “Index shopping” was their Lordships’ neat description of this practice.
But in top academic circles, much more fundamental attacks have been made on both these traditional metrics.
Measuring inflation faces a very difficult problem. How do you take into account changes in the quality of goods and services?
A simple example is a car. A particular model may cost exactly the same as the identical model last year. But suppose that, unlike last year’s model, this car has heated seats and parking sensors. The measured price has not changed, so inflation is zero. But you are getting more for your money.
The problem becomes acute in any area of new technology. Smart phones did not exist 30 years ago, and the internet was not yet developed for general use. How much have their prices changed since then? We have only to ask the question to see the problem that the vast advances in technology pose.
Even back in 2003, the top MIT econometrician Jerry Hausman estimated that the CPI was systematically overstating inflation by as much as two per cent each year, because of this quality issue.
Measured correctly, inflation could well have been negative in the current decade. But it will be hard to get politicians to take an interest in this. Imagine having to tell people that their pensions would be reduced because prices were falling.
Even if we could improve the measurement inflation, as the Lords demand, politics is forever likely to trump science here.
As published in City AM Wednesday 23rd January 2019
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The Economic Statistics Centre of Excellence created a bit of a stir at the end of last week with its estimates of growth in the regions of the UK.
Since the recovery from the financial crisis began during 2009, London’s economy has grown by 26 per cent.
At the other end of the scale, output in the north east has expanded by only six per cent, less than one per cent a year. Yorkshire has grown by just eight per cent, and the north west, which includes both Liverpool and Manchester, by 11 per cent.
The economies of the Eurozone show a similar pattern. Since 2009, Germany has expanded by 20 per cent, growth in Spain has only been six per cent, and the numbers for Portugal and Italy are even lower, at just two and one per cent.
The regions of the UK and the Mediterranean economies of Europe have an important feature in common: both groups are in a monetary union with more dynamic and innovative economies. Newcastle is in the sterling monetary union with London, and Portugal is in the euro with Germany.
The weaker economies are not sufficiently competitive to produce enough goods and services that others want to buy. They run a balance of payments deficit with the world outside their borders.
And in a monetary union, a balance of payments deficit translates into lower growth and higher unemployment. Standard trade theory in economics shows this clearly.
At least in the UK, the poorer regions get compensation in the form of large transfers of money from the more successful ones to finance their trade deficits.
London generates a fiscal surplus – the difference between income raised by taxes and public spending – of £3,700 per head, according to the latest Office for National Statistics estimates. But only two other regions – the south east and the east of England – run surpluses. The rest are in deficit – they spend more than they raise in tax.
Northern Ireland gets the biggest per capita subsidy, to the tune of £5,000 a year for every single person living there. The DUP might usefully contemplate the fact that the rest of us would be better off if we got rid of the province altogether.
A devaluation for the UK’s regions against London and for the economies of southern Europe would help to make them more competitive. In a monetary union, this is simply not possible.
The problem goes deeper than a simple lack of price competitiveness. The British regions just do not attract enough high-skilled workers to produce the quality goods and services which are in demand in the twenty-first century.
We might imagine that low housing costs would attract people, but the price mechanism works very slowly and imperfectly in this context. Over the past couple of years, there has been a trickle of people out of London to the regions, while the inflow from them to the capital has been halted. But there is a long way to go.
And that means that, whatever form Brexit takes, the economic trends of Britain’s monetary union are such that the future for Britain’s regions still looks grim.
As published in City AM Wednesday 29th November 2018
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From discussions on how the UK should reform its tax and regulatory landscape to make the most of post-Brexit opportunities, to the rallies midterm election candidates have been holding across the US championing or lambasting the President’s tax cuts, the debate is still raging about how changes to taxes impact economies.
But if you need convincing, or even if you’re just curious, events across the Atlantic provide a natural experiment in which we can observe in real time the effects of big tax cuts on an economy.
Nearly a year ago, on 22 December 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA), the most sweeping revision of US tax law since the Tax Reform Act of 1986.
Since then, economic growth has gone up. Between the fourth quarter of 2016 and the fourth quarter of 2017, GDP grew by 2.5 per cent in the US. In each quarter since, the annual growth rate has accelerated. The provision estimates for the third quarter of 2018 – the latest we have – suggest growth is now three per cent.
The jobs market is also booming. In the year to October, employment rose by over 2.5m. In that month alone, there was a rise of 250,000 jobs on the previous month.
Of course, all sorts of things can contribute to a strong economy. The headline figures simply support rather than confirm the narrative that tax cuts work.
A paper published this week in the leading Journal of Economic Perspectives focuses specifically on the corporate tax changes in Trump’s TCJA.
Beginning in 2018, the federal corporate tax rate fell from 35 per cent to 21 per cent, some investment qualified for immediate deduction as an expense, and multinational corporations faced a substantially modified treatment of their activities.
Alan J Auerbach of Berkeley sets out a detailed theoretical and empirical analysis of the Trump legislation. He is careful to qualify his findings with the usual kind of academic hedges. But they are unequivocal: tax cuts work.
The loss of revenue to the government of the various corporate tax changes in 2020 is estimated to be some $130bn. What will companies do with this money?
Auerbach concludes that at least a half of this will go on increases in wages. There are some 125m families in America, and on average they will be at least $500 a year better off.
Much of the rest will be spent on additional investment, which will further stimulate the economy.
And Auerbach cites a paper by the Harvard economist Robert Barro, due to be published in the Brookings Papers series, which suggests that the impact of the tax cuts will be even higher.
Leading American economists writing in leading academic journals are examining the Trump corporate tax cuts. They are concluding that everyone – both the companies and their workers – benefits from them.
Perhaps Philip Hammond should take a break from his spreadsheets and catch up with his reading.
As published in City AM Wednesday 7th November 2018
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The focus this week has been on Philip Hammond’s Budget.
The opinions of the shadow chancellor have been rather in the background by comparison.
But John McDonnell is doing us all a favour at the moment. He is busily promoting a collection of essays which he edited, under the title “Economics for the Many”.
These cover a wide range of policy areas, and are written by a mixture of politicians, think-tankers, and academics sympathetic to the shadow chancellor. The book contains a substantial introduction by McDonnell himself, and so is a useful guide to his thinking.
McDonnell appears to believe that spending vast amounts of money on nationalising industries will cost the taxpayer nothing.
From a balance sheet perspective, this is technically correct. The government could issue debt to take over the rail companies, say, but this would be balanced by the value of assets acquired.
This misses the point. If someone were mad enough to lend you £10m to buy a house valued at that amount, your household balance sheet would not have changed. But how would you service the debt, and what rate of interest would you be required to pay?
The rate of interest on UK government bonds is currently low, at around 1.5 per cent. But this is determined by the markets, not by government diktat. If the markets lose confidence, the rate can change rapidly. In recent years, Italy, Spain and Portugal have all seen rates in the six to eight per cent range. And in Greece, they were as high as 23 per cent.
McDonnell is silent on how he would ensure that the same thing would not happen here.
Some of the essays in his edited volume share this silence. One of them, somewhat ironically, points out the dangers of debt levels being too high. Admittedly this refers to household debt and not public sector debt, but no recommendation is made on how the problem can be solved.
In the same way, several contributors attack the discipline of economics. We read, for example, that it needs to be “more diverse and representative of the society it serves”. Yet no argument is put forward which offers a scientifically superior explanation of events to that of standard economic theory.
To be fair, most of the essays do put forward proposals. But the striking feature is not their radicalism – it is how dull and unimaginative they are.
So, for example, when new firms are launched based on new technologies, they should be set up as cooperatives. Cooperation as a form of business model has been around since the Rochdale Pioneers in 1844. It has not exactly set the world alight.
There is much talk in the media about how Jeremy Corbyn’s Labour party has captured the zeitgeist. This is not reflected in the opinion polls, where the Tories remain obstinately in the lead.
But if it has, these essays suggest that we are not in for an exciting and innovative future. Rather, we will be condemned to a repeat of the dismal and depressing 1970s.
As published in City AM Wednesday 31st October 2018
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This month saw the tenth anniversary of the collapse of Lehman Brothers, a collapse which precipitated one of the only two global financial crises of the past 150 years.
The late 2000s and early 1930s were the only periods in time when capitalism itself has trembled on the edge of the precipice.
It was in November 2008 that the Queen put her famous question about the crisis to the academics of the London School of Economics: “Why did nobody notice it?”
The answer is simple. In the models of the economy at the time, finance did not matter.
Mainstream economists did not notice the massive financial imbalances in the economy, because in their models, any problems that might link to these imbalances were assumed away.
To be of any use, all scientific models have to make simplifications of reality. But orthodox macroeconomics took a step too far. It assumed that the workings of the whole economy could be explained by analysing the theoretical behaviour of just a single decision maker. In the jargon, this is the “representative agent”.
The agent is a device which economists used to model the economy. It was extremely clever, and could solve hard mathematical problems – calculating how the decisions of average consumers and companies would affect the macroeconomy.
These kinds of models go by the splendid name of “dynamic stochastic general equilibrium models”, or just plain “DSGE” to their friends. But at its most basic, the problem with such economic models was that there was only one decision maker in them.
Having just two, a “creditor” and a “debtor” for example, would have helped a lot.
Over the past decade, economists have been scrambling to incorporate other financial factors into their models, such as household debt. Key contributions to this research are discussed in the latest issue of the Journal of Economic Perspectives.
Bizarre though they may seem, DSGE models now finally recognise the potential importance of household finance in causing crashes.
A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. They found that a rise in household debt relative to the size of the economy is a good predictor of whether GDP growth will slow down.
Rickard Nyman, a computer scientist at UCL, and I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008 could have been predicted in the middle of 2007.
Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.
A critic might say that this is simply a case of generals fighting the last war.
True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental importance of debt and finance in Western economies.