Chris Dillow's Blog, page 179

Austerity, mechanisms & profits

Matt Mitchell (via) writes:

The types of austerity that are most-likely to a) cut the debt and b) not kill the economy are those that are heavily weighted toward spending reductions and not tax increases. I am aware of not one study that found the opposite. In fact, we know more. The most successful reforms are those that go after the most politically sensitive items: government employment and entitlement programs.

This raises the question my old economics tutor Andrew Glyn always asked: "what's the mechanism?"

I suspect many right-leaning economists have in mind some idea that lower government spending reduces allocational inefficiencies and so boosts growth (pdf).

But there's another possibility.It starts from Silvia Ardagna's finding that, when austerity raised growth in the 70s and 80s, it did so in large part because of cuts in the government's wage bill (pdf).

There could be a simple reason for this. In the 70s and 80s, profits in many countries were squeezed by wage militancy. Cuts in public sector employment helped reduce this militancy and so alleviated the profit squeeze. And higher profits, allied to the improved business confidence created by reduced wage militancy, stimulated business investment. As Alesina and Ardagna wrote (pdf) in 1998:

Both the profit and the wage shares and the ratio of the manufacturing goods exports deflator over unit labour costs in manufacturing indicate an increase in profits during successful [fiscal] adjustments, which, instead, does not occur in other episodes. 

Which brings me to my concern. Whilst this mechanism operated in many places in the 70s and 80s, it's not clear that it would operate now. Of all the things that are constraining investment, high real wages and low profit margins are surely not high among them. In this sense, the historical lessons of the 70s and 80s might not be relevant to our plight now.

I don't say all this merely to argue against austerity. I do so to remind ourselves of two other things.

One is that economics is not (just) about fancy models. It's about mechanisms. The question is: through what mechanisms can tighter fiscal policy raise growth? Mechanisms that are powerful in one time and place need not be powerful in other times and places - which is why economics has such a poor forecasting record.

Secondly, class conflict (sometimes?) matters in macroeconomics.

A Marxist dream?

Tim approvingly points us to this in the Guardian:

In a way bankers are Marx's dream, it's the workers getting the fruits of their labours. It's funny that the left is usually angry at shareholders, for taking money out of companies and thereby bringing down workers' salaries. Yet with the banks they want shareholders to press the banks to do exactly that, and curb pay.

I ignored this sort of remark when Tim made it, thinking it to be a silly Oxford Union-type debating point. But since it looks like spreading, it needs correcting. Bankers' high pay is NOT a Marxist dream at all, for at least three reasons.

1. Bankers' don't get the fruits of the labour only from shareholders. They get them from other workers generally, in two ways described by Andrew Haldane. One is through the implicit "too big to fail" subsidy, which has been worth (pdf) tens of billions a year to banks, even though it is not entirely an out-of-pocket cost to others. The other is through risk pollution (pdf); the risk of banking crises falls upon the general public, whilst the benefits of risk-taking accrue to bankers themselves. In these two senses, bankers exploit ordinary workers - and Marx hated exploitation.

2. Insofar as bankers' do gain at shareholders' expense, it indicates that there is a distinction between formal or apparent ownership and real ownership. Shareholders appear to own banks, but bankers, in effect, really do. This opposes Marx in two ways. For one thing, in one of his few programmtic statements (in the Communist Manifesto) he called for a state monopoly of banking. And for another, one of Marx's beefs with capitalism was that it created a big distinction between essence and appearance - for example labour contracts appear as fair exchanges but in essence are not. It's reasonable to suppose that Marx would have wanted to abolish the essence-appearance dichotomy in ownership structures as he did in labour markets.

3.One of Marx's most famous slogans is, of course, "from each according to his ability, to each according to his need*." This principle is obviously broken.

* Whilst bankers' technical ability is questionable, their ability to extract rent is certainly considerable.  

Why Labour disappoints

It's widely, though not universally, agreed that the Labour party has not advanced the interests of the worst off by as much as it might have. The right complains that the welfare state has created a "dependency culture" whilst the left complains that it has been insufficiently redistributive. This poses the question: why has the party not done more to help its natural constituency?

Standard accounts focus upon "betrayal" or - for the right - the unintended consequences of (mild) redistribution. However, a new paper has another explanation. Andrea Vindigni and colleagues use a game-theoretic model to show that it is in the interest of leftist party leaders to act against the interests of the poor:

Policies that reduce the income of the poor relative to the average income...paradoxically consolidate the political power of the Left. This is because these policies make the natural constituency of a left-wing party endogenously more dependent on it and, therefore, increase the support for the party itself.

They give the example of left parties supporting bad educational policies or free trade and migration, but we could add anti-union laws and less redistributive policies than the left would like.

And there's good evidence that, when the working class does get richer, support for the left wanes. Some of Thatcher's support came from part of the (southern) working class that had done well thanks to the long post-war boom.

Vindigni et al's analysis suggests that there are two things which make anti-poor policies especially likely. One is if left parties' leaders obtain high private benefits from being (or having been) in power. The other is if they fear an ideological shift to the right, say because they are intellectually insecure or because they fear the (perhaps mythical) power of the right-wing press. Both were features of the New Labour government.

How should we interpret this paper? It might be just another example of economists seeing something happening in practice and wondering whether it's possible in theory.

But there is another reading. The paper shows, or reminds us, that there are structural pressures upon leftist governments to disappoint their constituents - or, in other words, that we should be sceptical about the efficacy of a parliamentary road to socialism. In this sense, we have yet another example of how mainstream neoclassical economics vindicates a Marxian insight.

Some doubts about NGDP targets

Britmouse wants the UK to adopt a nominal GDP target. There's nothing cranky, partisan or new about this; Sam Brittan advocated it in the 80s and the IPPR in the 90s. However, I'm not sure it would make much difference. Here are some pros and cons.

Pro: It would permit a looser monetary policy than inflation targeting. For example, a 5% NGDP target would mean targeting 4% inflation if real GDP looks like growing just 1%.

C0n: The very fact that inflation has consistently overshot its target suggests that the Bank of England has been running a looser policy anyway. It could be a closet NGDP targeter.

Pro: The 2009 recession was an NGDP recession; it fell by 4.8% between its peak and trough. An NGDP target would thus have prevented the recession.

Con: No. The problem in 2009 wasn't so much that policy was too tight but that the Bank's GDP forecasts were too optimistic. For example, in August 2008 it was forecasting that real GDP would grow 0.6% in the following four quarters, but in fact it dropped 3.7%. Had the Bank's forecasts been more accurate, it would have run a looser policy even with an inflation target. An NGDP target would not solve the problem that forecasts are inaccurate.

Pro: An NGDP target would raise inflation expectations and so encourage people to spend rather than to hoard cash paying strongly negative real interest rates.

Con: But the public's inflation expectations have been above 2% for a long time, without unleashing great spending growth. There are many other things restraining spending that are more important than expected real interest rates.

In fact, there's a danger that higher inflation expectations might constrain growth, if they cause gilt yields and borrowing costs to rise.

Pro: Our economic problem is a nominal one and therefore the solution is nominal.

Con: Really? Are real factors such as a lack of investment opportunities, falling productivity growth and a mismatch between supply and demand really unimportant? And to the extent that our problem is a nominal one, it lies in the fact that banks are not creating money by lending. As Adam Posen said, fixing the banks is therefore a priority - more, I'd add, than tweaking monetary policy targets.

Now, I do not say this to suggest that an NGDP target would be a bad thing. Instead, I regard as a member of that very large set of policies that might not make very much difference.

Limits of QE

Chris Giles in the FT calls, reasonably, for more quantitative easing. This poses the question: aren't we approaching the limit of what QE can do?

Take as my starting point the Bank's own estimates (pdf) for what the first £200bn of QE achieved. It reckons it reduced gilt yields by 100 basis points, raised inflation by 0.75-1.5 percentage points, and boosted GDP by 1.75-2%.

This implies that if we wanted to raise GDP by 4%, returning it to its pre-recession level, we'd need another £400bn+ of QE.This, though, runs into at least two problems:

1.To achieve this, gilt yields would have to fall by 200bp, which would take 10 year yields down to under 0.2%. This, though, is infeasible. Just as there's a zero bound to short rates, so there is for long ones. This is partly because gilt investors would expect short rates to rise over the long-term, and also perhaps because they might anticipate negative QE (the Bank selling gilts) as the economy normalizes. Japan's post-1990 experience suggests the lower bound for long-term interest rates is around 0.5%; this was the low-point they hit in early 2003.

2. In 2009, QE helped boost the economy not just by reducing gilt yields but by reducing tail risk - the small risk of economic catastrophe - which improved business confidence and reduced credit spreads. It's not obvious that this mechanism would operate this time.

I therefore doubt that QE could raise GDP by as much as 4%. And even this would be no huge achievement. If employment were to rise by 4%, we'd create just under 1.2m jobs which, given that some would be filled by the "inactive", wouldn't get unemployment much below two million.

QE, then, is not enough. So, what else could be done?

There's plenty the Bank could do to force long yields down. It could emulate the Fed and pledge to keep short rates low, thus reducing rate expectations. It could commit to cancelling gilts, thus closing off the prospect of negative QE. Or it could do an "operation twist". All these, though, merely get us to the zeroish bound on gilts.

This leaves unconventional QE. The Bank could buy corporate debt, thus reducing credit spreads which would hopefully stimulate invenstment.However, the Bank has so far been loath to embark upon what would, in effect, be a partial and selective nationalization of companies; even Adam Posen has been leery of the idea, given the thinness of UK corporate bonds markets. And anyway, it's not clear how far lower borrowing costs would boost investment;if firms' £300bn cash pile (table A57 of this pdf) isn't encouraging them to invest, why should a slightly lower cost of borrowing?

Alternatively, the Bank could try an outright helicopter drop. But this runs into several problems such as how to administer it to the sheer uncertainty of its effects.

There is, of course, a simple solution to these difficulties - to use fiscal policy. There are good reasons to suspect it might be unusually helpful now.

My point here is simple. We often think of fiscal policy as being constrained, either by bond markets or by administrative problems. But there are constraints on monetary policy too. And these might be more more binding than the constraints on fiscal policy. 

"Social cleansing" and network effects

What’s wrong with “social cleansing”? This is the question raised by the hostile reaction to Newham Council’s efforts to move housing benefit recipients to Stoke.

There’s something to be said for this. It helps market forces to do what they should do - signal value. Houses should be occupied by the people who value them the most. If the state is paying for occupancy willy-nilly, the result is inefficiently high rents in some areas. Refusing to pay such rents might help force them down; remember, housing benefit is at least in part a landlord’s benefit.

The argument against encouraging* HB recipients to move to Stoke rests upon the value of social capital. In moving from Newham to Stoke, ties with family and friends are weakened. But is this a good thing or a bad thing?

One might argue that it’s an intrinsically bad thing. But I’m not sure. Yes, some people suffer from being parted from supportive family, but others might benefit from having an excuse to make a new start or move away from domineering fathers or ex-partners who harass them.

And economics tells us it’s ambiguous too. 

It’s a bad thing to the extent that social networks can help get people into work. The more friends and acquaintances you have who are in work, you more chance you have of hearing about job openings. If you have to move away to where you don‘t know anyone, you lose such chances.

However, this is only true if you have friends who are in work. If most of your friends are out of work. You might lose hope, reduce job search and so have less chance of getting a job.

There’s another potentially important effect - upon crime. It’s well-known by now that our decision to commit crime or not is strongly influenced by our peers - hence “gang culture.“ One might imagine, therefore, that removing people from a criminally-inclined peer group reduces the chances of them falling into crime. It does. But there’s a flipside to this. Peers also keep us honest; law-abiding peers, or admirable role models, can turn youngsters away from crime and towards education (pdf). Taking people away from their networks risks removing this positive influence, as well as the negative one.

If all this sounds ambiguous, that is precisely the point. Things such as crime, getting a job or pursuing education are examples of emergent behaviour. Whether people do them or not is sensitive to initial conditions - the precise structures of their social networks - small changes in which can have large, and unforeseeable, effects. This is one message of Mark Granovetter’s threshold model (pdf). And it is why riots are so hard to predict.

If there is an objection to “social cleansing”,  it lies in this - that, in breaking HB claimants’ networks, it is a form of blind social engineering - of making changes which have potentially big but unforeseeable effects. I suspect that many people are relaxed about this, because they believe that the networks of HB claimants have bad effects rather than good. What worries me, though, is that this belief might owe more to class prejudice than to hard evidence.

* I want to avoid the issue of whether HB recipients will be “forced” to move to Stoke, as this is a standard left-vs.-right question of semantics.

A cost of austerity

Might fiscal austerity have even larger costs than generally supposed? I ask because of the interaction between fiscal policy and financial regulation.

Ed Balls says: “An exclusive focus on financial stability could bring a dangerous risk aversion and stifle the real economy.” This expresses a well-known trade-off; we can prevent financial crises by stopping banks lending, but this also stops growth. Given that so much productivity and innovation comes from new companies and market entrants which are often reliant upon bank finance, this trade-off is acute.

So, how can we alleviate it? One way is to reduce the costs of financial crises when they happen, for example by splitting investment and retail banking so that troubled banks can be resolved, or by requiring banks to hold contingent convertible bonds which allows them to be automatically recapitalized in a crisis. In fairness, much of the Vickers report focused upon these issues.

If the costs of crises were low, there’d be less need for tight regulation of banks to prevent crises. Banks would thus be freer to lend, which would help the economy to grow.

And here’s my concern. One way of reducing the cost of crises is to have an active fiscal policy. If governments can increase borrowing greatly, the economic costs of crises are mitigated.

However, two things might prevent governments borrowing in future. One is the euro area’s fiscal compact, which limits structural deficits to 0.5% of GDP. The other - more relevant for the UK - is deficit fetishism. A financial crisis, pretty much by definition, will automatically increase the government deficit. This is because a fall in lending causes some people to become forced savers, and if net private sector saving rises, government borrowing will rise pretty much by identity. A government which takes fright at a big deficit will thus undertake less discretionary fiscal easing than it should. Which means that financial crises hit the real economy harder.

And here’s the problem. If future fiscal policy is irrationally constrained so that the costs of financial crises are greater, then there is more need to prevent them. But this means tighter financial regulation and slower growth now.

I’m making two points here, one “leftist” and one “rightist”.

The leftist point is that the costs of anti-Keynesian fiscal policy are greater than thought. This is because such policy raises the cost of future financial crises and so requires tighter financial regulation now, and hence slower growth.

The rightist point is that this implies that the conventional way of thinking about regulation is mistaken. Very often, such thinking asks: what can rational governments do to constrain the irrational private sector? But this misses the point that governments can be irrational too - not just now but in the future. And if we consider this - as we must - debate about regulation becomes more complex.

Crisis, what crisis?

The BBC’s rediscovery of the 1970s poses a question: why has this recession not produced the sense of crisis we had in the 70s?

I ask because the numbers tell us that the economy is doing worse than it did in the 70s. Between its cyclical peak in 1973 and 1979, real GDP grew by 9.2% and real household incomes by 10.3%. With GDP in 2011 2.8% below 2007’s peak, it’s quite possible that the six years from 2007 to 2013 will see no growth at all, and it‘s vanishingly unlikely that household incomes will match the 1973-79 rate.

However, in the 1970s there was a sense of decline and even apocalypse; there was widespread talk of a crisis of democracy (pdf) and of Britain being ungovernable. So, why is there no such talk now?
From the point of view of the capitalist class, the answer is simple. The 70s crisis was not so much a crisis of GDP growth as a crisis of profits. By contrast, profit rates in this recession have held up much better than they did in the 70s. When people asked in the 1970s “is Britain governable?” what they really meant was: “is the working class controllable?”

In this sense, what is in one way a parallel between now and the 70s is also a difference.  Both eras brought into doubt a dominant economic paradigm - Keynesian social democracy is the 70s and neoliberalism now. However, because neoliberalism serves the interests of capitalists in a way that Keynesianism (by the 70s) did not, there’s less of a rush among the ruling elite to look for an alternative.

But this merely raises the question. Why - given that its living standards are falling now in a way they did not in the 70s - is the working class so quiescent compared to then?

The issue here is not just political but cultural. Whereas the 70s and 80s gave us powerful images of anger and despair - punk, Joy Division, Boys from the Blackstuff - we now have, well, what?

The reason for this might be benign. Average real wages are much higher now than then, so - contrary to fears that falling off the hedonic treadmill would be painful - a squeeze on incomes hurts less.  Also, unemployment hurts a family less if one partner stays in work than it does if the breadwinner loses his job.

But there might be another reason. The working class now is more atomized. I don’t just mean in the physical sense of no longer working in huge easily unionized and militized workplaces. I mean in the ideological sense. People no longer look to collective or political ways of advancing their interests but instead to individual advancement. The 2010s version of Arthur Scargill is Simon Cowell.

Which brings me to a paradox. Although our objective economic condition brings neoliberalism into question, the political and cultural response to it shows that the individualistic rejection of collectivism is still thriving.

Law as a (low) price

The row about Abu Qatada’s extradition raises the question: what exactly is the function of the law?

We could regard it as a set of prohibitions, which is why so many people want the Home Secretary to follow due process. But there is another way of thinking about the law - to see it as merely a price list. So life in prison is the price we pay for murder, 10 years for armed robbery and so on.

This economistic conception of the law, embodied in the title of Gneezy and Rustichini’s paper (pdf), “A fine is a price” - is inspired by Gary Becker:

I began to think about crime in the 1960s after driving to Columbia University for an oral examination of a student in economic theory. I was late and had to decide quickly whether to put the car in a parking lot or risk getting a ticket for parking illegally on the street. I calculated the likelihood of getting a ticket, the size of the penalty, and the cost of putting the car in a lot. I decided it paid to take the risk and park on the street.

One could regard the decision on whether to deport Abu Qatada in the same way. Rather than ask: “is it legal?” the Home Secretary should follow Becker and weigh the costs of (possibly) breaking the law against the benefits of doing so.

And here’s the thing. This cost could be small. Worse violations of rights than in Mr Qatada’s case have elicited only smallish fines - “just satisfaction” - upon governments, for example:

- being raped by policemen. Fine €23,000.

- being “systematically beaten and tortured, at least six times, with electricity”. Fine €21,825.

- being “beaten, blindfolded, stripped naked, hosed with water and subjected to falaka (beating on the soles of the feet)”. Fine €43,000.

Those are for violations of article 3 of the ECHR, prohibiting torture - which you‘d think would carry especially heavy penalties. Violations of article 6 (the right to a fair trial - the one relevant to the Qatada case) - have yielded smaller fines. 

This poses the question. Given such low costs, why not simply deport Mr Qatada, have a whipround and pay the fine?

I don't think it is the case that the costs are in fact greater; it has been suggested that non-compliance with rulings might led to suspension from the Council of Europe, which some think a bad thing. Breaking a law and paying the price to do so is, in one sense, complying with the law; refusing to pay the fine would be non-compliance.

I suspect the answer is that this issue is not merely a matter of solving a problem; that could be done by bundling Mr Qatada onto the next plane to Jordan. Instead, it is about politicians’ desire to reveal themselves as particular types of characters. They want to appear like upright law-abiding citizens rather than as Beckerian economistic calculators. Sometimes, though - and not just in this case - this preference can be a positive obstacle to problem-solving.

The crisis of creativity

What do the following have in common: Peter’s question: “Just where are those institutions that harness talent and foster creativity?”; Paul’s complaint that the media and other creative industries prefer nepotism and short-termism to financing creativity; Philip Delves Broughton’s point that management is about dealing with mediocrity rather than talent; and the growing challenge to the racket (pdf) that is academic publishing?

The answer is that all pose what might be the most important question in economics - of how to encourage creativity.

I say this is the most important question because it is the main cause of economic growth. Classical economists from Smith to Mill saw growth as a contest between the law of diminishing returns, which led to stagnation, and innovation, which tended to prolong growth. Even Keynes took a similar view (pdf). He predicted in 1931 that “a point may soon be reached” when consumers would be largely satiated and so a 15-hour working week would be the norm.

When creativity and innovation slow, therefore, growth stops. And we might be at or near this point. The slowdown in productivity growth  and capital spending in recent years are both consistent with a slowdown in technical progress. This is not just afflicting old, sclerotic firms; even Apple, the greatest innovator of recent years, is returning cash to shareholders rather than investing it in new ventures.

There’s another fact consistent with this - the massive under-employment that Keynes envisaged is upon us. Not only are there 2.65m unemployed, but there are also 1.4 million part-time employees who’d like to work full-time and 2.32m economically inactive who’d like a job. That gives us 6.37 million who aren’t working as much as they’d like. That’s 15.9% of the working age population. On top of this, I suspect there are lots of self-employed who spend time waiting for the phone to ring; 1.16 million of these are working part-time. And then there are countless full-time employees who are doing routine maintenance, chatting to each other or playing Angry Birds  whilst waiting for customers.

All this means there are two questions that should be more important than they are.

1. How do we generate creativity and technical progress? The “leave it to the market” school is inadequate on (at least) two counts. First, it ignores the fact that innovation has positive externalities which mean it will be under-supplied by the market. And second, rests upon an optimism about human ingenuity which might not be fully justified and which is certainly not a necessary feature of free market thinking.

2. If we cannot generate sufficient creativity and growth, what should be done to ensure that the costs of under-employment are more equitably borne? Keynes assumed that such under-employment would be the happy work of a semi-leisured people who were rich enough to meet their basic needs and more. With a new food bank opening every week, this seems too optimistic.

Now, I’m not sure what the answers are here. But I am sure of something - that these are the important questions. And a political class that ignores them and obsesses instead about the price of pasties and the charitable donations of a few hundred people is not fit to govern.