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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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Markets are good, but we need clear signals

Markets are good, but we need clear signals

Perhaps the most enjoyable aspect of the general election result is the abuse which is now being heaped on the metropolitan liberal elite from many quarters.  Theirs is truly a difficult mind set to comprehend, based as it is on an unshakeable belief in their own omniscience. Yet this is confounded on an almost daily basis by the response of ordinary people to incentives. The central planning mentality is simply not able to imagine all the ways in which markets operate.

Orlando Figes gives an illustration in his excellent book on the Russian Revolution, A People’s Tragedy.  Shortly after coming to power the Soviets imposed strict price controls, on vegetables. They forgot to include onions in the list. The result was a massive glut of onions, this being the only vegetable on which the growers might conceivably have made a profit. Admittedly, this was a simple bureaucratic mistake. But at the moment, Venezuela is imposing price controls, and the economy is being devastated, with many basic commodities, even lavatory paper, being virtually unobtainable. Many African countries, in the first flush of independence, did the same thing. A friend of mine went to work in Tanzania in the 1970s, full of idealism. Confronted by massive queues for almost everything, it did not take him long to respond to incentives and do what every other ex pat was doing. He sent his servant to queue for him instead.

The incentives created to get people to switch to diesel, such as lower vehicle taxes, proved very effective, and over the past 20 years the number of diesel cars in the UK has risen from just under 2 million to 12 million. Yet the consequences were unforeseen. It has only emerged this year that diesel engines create much more pollution than petrol ones. Environmentalists bullied the government some years ago to cut the speed limit to 20mph in Richmond Park, near where I live. It turns out that this is much worse for the health of the numerous cyclists than when cars are allowed to run at the more efficient speed of 30mph.

Gordon Brown epitomised this view of the world. Under his control of the economy, the tax manual more than doubled in size. Regulators came to see their jobs as devising more and more rules to try and anticipate every eventuality. It was a doomed mission, as the complete failure to anticipate the financial crisis shows.

But there is an important flip side to this. If we are to rely more on markets and incentives than on tomes of regulation to produce reasonable outcomes, it is essential that markets are seen as giving reliable information. The Americans understand this, hence the massive fines just imposed on banks. There are also serious questions to be asked about the increasing dominance of algorithmic trading in financial markets. Not only are the chances of ‘flash crashes’ increased many times, but it becomes less clear what information is being signalled by market prices. This is something useful for the regulators to examine.

As published in City AM on Wednesday 27th May 2015

Image: 20mph by Edinburgh Greens under license CC BY 2.0

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Bribing the electorate: new rules of the game thanks to zero inflation

Bribing the electorate: new rules of the game thanks to zero inflation

The temptation to believe in the concept of a free lunch is one which has proved irresistible to numerous governments through the ages. Henry VIII, for example, has seized popular imagination once again through the brilliant portrayal of him by Damian Lewis in Wolf Hall. Bluff King Hal is the nickname often associated with the King. But to his subjects, especially towards the end of his reign, he was more usually called Old Coppernose. He debased the silver coinage with so much copper that, when the coins were used, the copper shone through the flimsy cover of silver onto his portrait.

The Office for Budget Responsibility has recently produced an excellent little document which shows how post-war governments in the UK have indulged themselves in the modern equivalent of coinage debasement. The dry title is ‘A brief guide to the UK public finances’, but it contains fascinating material.

Since 1948, British governments have run deficits on the public finances in 54 out of the 66 financial years.  In the most recent four decades, surpluses have been registered on only five occasions.

It all started off so well. The post-war Labour government of Clement Attlee was heavily interventionist, nationalising the mines, socialising health care in the NHS. But it was a model of fiscal rectitude. It ran a surplus in every single year until its defeat in 1951, including what is by far the largest post-war surplus in 1948 itself, amounting to nearly 5 per cent of GDP – getting on for £100 billion in today’s terms.  The Conservatives carried on in the same way. From 1948 until the election of the next Labour government in 1964, public sector surpluses and deficits more or less cancelled each other out over time.

This is exactly how it was meant to be. Keynesianism, as it was originally conceived, required the government to run deficits when the economy was slowing down, to boost demand, but to offset these by surpluses in the good times. But since 1964, the cumulative size of the annual deficits comes to no less than 160 per cent of GDP. A nice little earner with which to bribe electorates.

Governments have got away with it thanks to inflation. The bonds they issue to finance deficits are denominated in money terms. When they mature, they simply pay back the face value, regardless of what has happened to prices in the meantime. Even with only 3 per cent inflation, prices double in just 23 years. And this doubling halves the real value of debt issued at the time.

The zero inflation world in which we now live changes the rules of the game. Any debt which is sold to finance public sector deficits will have to be repaid for real. Both George Osborne and Ed Balls are smart enough to understand this. The same cannot necessarily be said for many of their senior colleagues. And the biggest task is to convince the electorate, especially in the subsidised areas, that their living standards from now on will depend upon their productivity. No more free lunches.

As published in City Am on 22nd April 2015

Image: dice another day by topher76 under license CC BY 2.0

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The 38 per cent tipping point on tax

The 38 per cent tipping point on tax

Ed Miliband’s proposal to tax non-doms more harshly may be good, populist politics. But does it make economic sense? At most, the yield will be around £1 billion, even if people do not alter their behaviour in response to the change in policy. The actual amount generated could even be negative if enough non-doms leave the country. Most commentators recognise this.

The history of tax wheezes dreamt up by governments is a litany of the eventual tax take falling short of its anticipated level because of changes in behaviour. In 1795, Britain was engaged in a titanic struggle for survival against revolutionary France. The sheer scale of the war put the public finances under unprecedented strain.  The then Prime Minister, Pitt, invented the Powder Tax.  Anyone wishing to buy powder for his wig had to register and pay a tax of a guinea (£1.05), a non-trivial amount in those days.  Wigs rapidly went out of fashion, and the tax yielded very little.  The diehards who persisted with wigs became known as ‘guinea pigs’, the origin of the modern phrase.

There does seem to be a limit to the amount of tax which British governments are able to raise.  Fifty years ago, a new Labour government, headed by Harold Wilson, had just come to power, determined to transform the British economy.  In the financial year 1964/65, the total amount of tax and National Insurance payments raised came to 36.2 per cent of GDP.  In the final year of office of this highly interventionist government, 1969/70, this figure had risen.  It had increased to the dizzy height of 37.4 per cent!  A government which by today’s standards was radical and left-wing felt able to put taxes up by all of 1 per cent of GDP.

The 1969/70 level is almost the highest ever recorded over the past five decades in the UK, being fractionally higher in the recession of the early 1980s at 37.6 per cent.  Gordon Brown controlled domestic policy in Britain from 1997 onwards.  The tax manual doubled in size thanks to the huge number of new schemes Brown introduced.  But when he was booted out by the electorate just after the end of the tax year 2009/10, tax and social security receipts were only 34.5 per cent of GDP.

Elected authorities at all levels in the UK seem to be reluctant to increase tax beyond a certain point.  The Scottish Executive has had the power to raise the basic rate of income tax by up to 3p in the pound.  But despite the fact that the body has always been controlled by parties of the Left, Labour and the SNP, neither has used the power.  Local authorities can hold referenda to put up council tax, but they don’t.

The 38 per cent threshold is not an immutable physical law.  But no UK government of whatever persuasion in the past 50 years has been either willing or able to raise more tax than this as a percentage of GDP.  This sets clear limits to the ambitions of any government during the next Parliament.

Paul Ormerod

As published in City Am on Wednesday 15th April 2015

Image: “Look after the pennies and the pounds will look after themselves” by Tristan Martin under license CC BY 2.0. 

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Open borders or fair wages: the left needs to make up its mind

Open borders or fair wages: the left needs to make up its mind

As published in the Guardian on Tuesday 24th March 2015 as part of their ‘Economics – Immigration Special’

Mass immigration increases inequality. This is the unpalatable fact the liberal left in Britain refuses to accept. Markets are imperfect instruments. But it is not necessary to subscribe to free market economic theory to believe that large increases in supply tend to drive down the price. And the price of labour is the wage.

Last Friday, the Guardian front page carried a report from the Office for Budget Responsibility, claiming that higher net immigration increased the UK’s economic growth rate. According to the mainstream theory of economic growth, this is undoubtedly true. Higher growth can be created by sustained increases of either capital or labour.

But underlying the theory is the assumption that supply and demand balance in these markets, that the prices of the inputs are set at levels such that all available capital or labour is in fact employed and does not remain idle. So this “flourishing modern economy” with high immigration celebrated by the Guardian is based on persistent large wage inequalities.

A powerful force in the global economy is driving the increase in inequality that has been seen in western economies over the past few decades. In essence, there has been a massive increase in the effective supply of labour. Over the past three decades or so, China and India have gradually been absorbed into the network of international trade.

This puts pressure on European labour markets. Many call centres, for example, have been relocated to India. But much of the impact of this is indirect, operating via trade flows, and is only really felt by certain sectors of western economies.

Closer to home, the opening up of eastern Europe in the early 1990s has had a strong effect, especially on countries that are their immediate neighbours, such as Germany. Employers soon realised that economies such as Poland and the Czech Republic possessed educated labour forces, whose productivity potential had been suppressed by the gross inefficiencies inherent in planned economies. German companies opened up new production plants in the old Soviet bloc countries in Europe, rather than at home.

The impact on wage rates of this increase in competition was dramatic. Christian Dustmann at University College London has provided clear evidence on the evolution of wage rates in the former West Germany. The 15th percentile of the wage distribution is the level at which only 15% of wages are lower. In West Germany, at the 15th percentile, real wages have fallen almost continuously since the mid-1990s. At the 50th percentile, where half get more and half get less, the reduction has been less sharp.

But the fall had set in by the early 2000s. At the 85th percentile, the mirror image of the 15th, real wages grew strongly, reaping the benefits of the recovery of the economy created by the increase in competitiveness.

It is against this background that New Labour opened up Britain’s borders in the late 1990s. It was a major betrayal of the very people the party purported to represent.

In addition to the global competition from countries such as China, in addition to competition closer to home from the economies of eastern Europe, New Labour allowed direct competition to enter the UK labour market on a scale unprecedented in our history.

Not surprisingly, the distribution of wage rates has evolved in very similar ways to those of West Germany. It is the relatively unskilled in the bottom half of the distribution who have lost out. The liberal elite do not suffer.

Indeed, they benefit because many of the services they consume are provided at lower prices than would have been the case without mass immigration. It is sometimes argued that immigrants do jobs that native British workers are unwilling to take.

Very well then, without mass immigration, employers would be obliged to raise the real wage rate to induce these people to take the jobs.

The effects of this extend to benefit levels. With at least half the population facing at best stagnant and often falling real wages, basic political economy requires benefits to be squeezed as well. Hostility to benefits is strongest precisely in the bottom part of the wage distribution. It is political suicide to increase real benefits in this context, regardless of who is in power.

In the so-called neoclassical growth theory of economics, whether of the pre- or post-endogenous variety, by far the most important source of sustained growth is innovation. The age structure of immigration means that it does make a change to per capita economic growth, but one that is barely perceptible. Moreover, immigrants themselves age eventually, so eventually even this tiny benefit disappears.

A truly modern economy does not rely on more and more capital and labour being fuelled into the machinery of production. That was the old Soviet model.

A modern economy relies instead on innovation. This should be the focus of policy. The potential gains are huge, not marginal and ephemeral.

Image: Budget by Simon Cunningham under license CC BY 2.0

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Do Budgets really matter?

All eyes will be on George Osborne’s Budget today. An immense amount of media attention and serious commentary will be devoted to it. But do Budgets really matter? How much difference would it make if successive chancellors simply did nothing, apart from indexing various allowances and benefits in line with inflation?

From time immemorial, British governments of all shapes and sizes have had to present their finances to Parliament for approval. For centuries, there was a constant struggle between the monarch, who almost invariably wanted more money to pay for the court or foreign wars, and the elected representatives, who were usually unwilling to vote for the taxes such policies required.

After the Second World War, however, the annual ritual of the Budget took on a completely different character. Armed with what were then seen as the insights of Keynesianism, successive chancellors regarded the Budget as a means of announcing policies which would control the economy in the forthcoming year. Even now, Osborne will spend time discussing the short-term predictions for UK GDP growth, inflation and the like. These are now produced by the Office for Budget Responsibility rather than by the Treasury itself, but they still form an important part of the Budget speech.

To be able to make meaningful interventions in the economy and bring about better outcomes over the short term, it is absolutely necessary to have reasonably accurate forecasts. Unless you have a good idea of where the economy is going to be this time next year, you have no clue about what actions to take now to get it into a better place.

It is well-known, however, that economic forecasts are – to put it charitably – poor. Even in the United States, where the economy is more insulated from unexpected external shocks, the record is pretty shocking. The Philadelphia Fed publishes the consensus forecasts made by economists for a range of variables. For GDP growth one year ahead, the forecasts, looking over several decades, are actually on average correct. But this conceals large errors in many years – it is just that, over time, the errors are cancelled out. And the forecasts are particularly bad at capturing tipping points, when there is about to be a boom or a slump.

This was the question the Queen put to the faculty at the LSE. Why had they not foreseen the crisis? To be fair, economic forecasting is a very hard scientific problem, which does not readily admit a solution.

So while the forecasts themselves are questionable, Budgets nevertheless remain important because of the narrative which the chancellor tries to portray about the economy. Nigel Lawson’s Budget of 1988 is rightfully famous. Not because it failed to predict the looming crisis in 1990, but because it set the tone in which enterprise was celebrated, thereby laying the foundations for the long boom of the 1990s. Osborne in 2010 seized the imagination of the markets and persuaded them that the public finances were sound. It is the narrative about the medium and longer term which matters, not the illusion of short-term control.

As published in City AM

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