The Decline of Europe - Not

From time to time over the last few years I have heard serious pundits bemoan the relative decline of Europe. It is a sentiment which infuriates me.

It is true that Europe commands a declining share of global GDP. That is a fact we should welcome not fear. For at least 50 years the rich countries of Europe have promoted the development of the poor countries in other continents. The fact that so many are now making progress is a cause for celebration not anxiety.

The thought is prompted by an execrable book I picked up in Waterstones while Christmas shopping. For Europe is a federalist manifesto which declares on page one that:

We are being overtaken by the emerging economies at lightning speed.

The first problem with this perspective is that it is morally and politically wrong. The fact that poor countries are catching up is a major human achievement.

Source: IMF

The second problem is that the statement is factually wrong. Per capita GDP in the EU is double that in Russia, 4 times that in China and 8 times that in India. Even fast growing China will need decades to catch up.

Don't get me started on this one:

...we are still required to compete against economic and political powerhouses of the calibre of China, India, Brazil, Russia or the United States.

There is so much nonsense in that phrase I don't know where to begin. I'll just point out that the rise of poorer countries does not harm us and indeed holds many opportunities for developed countries.

The authors of this terrible book are serious politicians: Guy Verhofstadt, leader of the Liberal faction in the European parliament and former prime minister of Belgium and Daniel Cohn-Bendit, leader of the Green faction in the same parliament and former soixante-huitard.

Angela's Ashes (and Sackcloth)

My nomination for scariest comment of the year is by Angela Merkel in an interview with the Financial Times:

“All of us have to stop spending more than we earn every year.”

Who does she mean by we? If it is countries then the comment is nonsense. As I mentioned recently, countries can sustain a stable debt level while spending more than their income. So long as the deficit is less than the nominal growth rate multiplied by the debt ratio, the debt will not increase as a proportion of GDP. For example keeping the debt below 60% of GDP in a country with 5% nominal growth means keeping the deficit on average below 3%.

If she means businesses then how are they to finance investment? A small business with an opportunity to expand typically borrows from a bank. A large firm may borrow by issuing bonds. Without "spending more than they earn", businesses would have trouble to grow, modernise or innovate.

If she means households, then it is sensible not to spend more than you earn, but only measured over a lifetime. In youth, people borrow to fund education, buy a house, etc. In middle years people may save to fund retirement when spending is based on past income.

Even stranger was her claim that East Germany failed due to a lack of competitiveness:

“We witnessed in the GDR and in the entire socialist system that an economy which was no longer competitive was denying people prosperity and ultimately leading to great instability.”

I can think of many reasons why the GDR economy collapsed, but wrapping them up in one portmanteau word is a feat beyond even Humpty Dumpty.

Finally, Mrs Merkel hinted at even scarier ideas to come:

Although Ms Merkel stopped short of suggesting that a ceiling on social spending might be one yardstick for measuring competitiveness, she hinted as much in the light of soaring social spending in the face of an ageing population.

The right is out to cut the welfare state and Mrs Merkel is aiming to cut social spending in pursuit of the chimera of competitiveness.

Deficits For Ever

If Dean Baker were writing this blog, the headline would probably be "Janan Ganesh doesn't know that the national debt has fallen in the last 50 years."

At the weekend Janan Ganesh, an FT columnist, argued that Britain can no longer afford the welfare state. Underlying the deficit hysteria there lurks a right-wing ambition to roll back the welfare state. Unfortunately the case for blaming social spending for debt and deficits doesn't hold up, not in the UK nor anywhere else.

Government deficits exploded after and in response to the financial crisis.

Now right-wing pundits are making the argument for cutting the welfare state more directly. Sadly, the same flawed understanding of the economic facts wounds their case. Mr Ganesh, for example claims:

"The Treasury has run budget deficits for much of the postwar period.

"...Not even Labour entertains the notion that, once the current crisis is over, deficits can again become as common as they were in the last half century."

Deficits have indeed been the norm in the postwar period; but that is not a problem. Mr Ganesh seems to be unaware that government net debt 50 years ago stood at 99.9% of GDP. Forty five years later, in 2007, it was 36% of GDP. It has gone up since the crisis and is now around 66%. If we go all the way back to the start of the postwar period we find debt at 237% of GDP in 1946.

So governments have run deficits more often than not and the national debt has come down. How is this possible?

The answer lies in this equation: d=gD.

In a stable state (ie the debt ratio remaining constant), deficit (d) should equal the nominal growth rate (g) times the debt ratio (D). So if nominal growth is 5% and the government wants to keep the debt to 40% of GDP then it can run a deficit of 2% of GDP (5% x 40%).

Governments do not need to balance their budgets; a little bit of inflation and a little bit of growth allow government to maintain a sustainable debt level while regularly running a deficit. Unlike Mr Ganesh, I think deficits will be just as common in future as they have been in the last half century.

Cameron Gives Eurocrats a Pay Rise

In a strange irony, the British PM who wants to cut the cost of EU administration has given EU employees a tax cut which will raise take home pay from January.

The tax, known as the solidarity levy, was imposed during the reform of Brussels administration led by Niel Kinnock. As a quid pro quo Eurocrats had their salaries linked to that of civil servants in member states. Instead of negotiating on salaries each year EU salaries were uprated according to the salary rises (or cuts) of national civil servants.

The rule expires at the end of this year. The European commission had proposed to extend the salary method and increase the levy as part of its package of reforms that would see staff numbers fall by 5%. When this was rejected by Britain and other contributors to the EU budget, the commission proposed to extend the current tax and salary method for one year. Mr Cameron and his counterparts rejected the idea out of hand.

The consequence is that take home pay will go up until there is an overall agreement on budget.

Brussels unions suspect that far from being a mistake, some governments want to use the rise to stir up antipathy the European civil servants, to soften them up for bigger cuts next year.

Doing the Same Thing and Expecting Different Results

This is a quick reaction to today's Autumn statement. I have used data from three reports by the Office for Budget Responsibility, including the one released today. In June 2010 the OBR produced its first report on the fiscal outlook which was based on the plans bequeathed in Alistair Darling's last budget. It followed up with a report based on the new chancellor's budget. I have put on a chart the projections for government debt from these two reports. I have added the projection for debt contained in today's report.



Source: OBR; click to enlarge

Where the Darling plan saw debt peak at 75% of GDP, the latest projection has a peak just shy of 80%. The excuses for this predictable failure do not stand up. Yes, the eurozone has stagnated - but they are following the same wrong-headed austerity policies.

Time for Mr Osborne to go.


"Failure was Predictable"

In anticipation of the chancellor's Autumn statement, Lord Skidelsky goes on the attack:

The chancellor’s policy is based on the wrong theory of the economy; the BoE’s on the wrong theory of money. Failure was predictable.

 His argument is simply Keynesian. Keynes would have argued that:

 ...cuts would reduce the level of total spending in the economy and thus perpetuate the slump.

As for the bank:

The BoE’s mistake has been to believe it is the supply of money that is critical for economic recovery; Keynes said it was the demand for money.

His solution is to restore the programmes of capital investment, accelerate infrastructure projects, expand the programme of the Green Investment Bank and  replace the bank's inflation target with a nominal income target.

As Will Hutton once said - Keynes is best.

What the PM Did Not Tell MPs

We already know that the PM can make free with the facts.

This is what David Cameron told the House of Commons following the summit last week:

For example, when it came to the bureaucratic costs of the European commission not a single euro in administrative savings was offered.

Not one Euro.

This is what the European commission actually proposes for EU staff:

• a 5% cut in staff numbers;
• an increase working hours (37.5 to 40 per week) without increasing salary;
• a 6% "solidarity levy" on top of taxes paid by EU officials;
• raising the retirement age to reduce pension costs;
• limiting options for early retirement;
• a reduction to the value of allowances related to staff returning home.

Would you think that these cuts - already negotiated with the unions - were in the commission's financial proposals if all you had to go on was the PM's statement? In fact they are and Mr Cameron's complaint is that he wants more cuts to staff numbers, benefits and pensions and a higher levy.

A lawyer's argument might be that he was talking about the final proposal made by the council president and so he meant "not a single euro in administrative savings was offered in addition to those already on offer". He didn't say that and so most listeners would conclude that no savings on administration had been offered at all.

Whatever you think of the idea of cutting the EU budget and whatever you believe about the good fortune of people who work in Brussels, we can agree that the PM should tell the whole truth when he speaks in parliament.

UPDATE I've seen some figures now that show the commission's proposal would cut £1Bn from the administration budget. The final plan offered a bit less due to provision for Croatia joining next year. It seems hard to ovoid the conclusion that MPs were not told the truth.

Equality in America

Brad DeLong, the Berkeley economist, has a fascinating post on inequality in America, taken from a conference presentation at his university:
Three Dimensions of Inequality: Global, Educational/Technological, and Plutocratic

He is concerned not just with the increase in inequality but with the political impacts on democracy and equality of opportunity. The fascinating bit is his commentary on the rise of plutocratic inequality since about 1980.

And there is a third dimension, for the rise of the 0.01% produces not just a plutocratic over-class in the United States but a transnational global plutocratic over-class. ... How is (sic) social democratic politics and equality of opportunity going to be attainable in the world of the future? We know that money speaks loudly in politics, but plutocracy seems to be acquiring so much money that speaks very loudly indeed.

His thesis has implications, then, not just for the US; it matters for the rest of us too. It reminds me of similar concerns raised in Robert Peston's book Who Runs Britain?: and Who's to Blame for the Economic Mess We're inwhich also warns of the danger of a new class using its inherited wealth to dominate political decision making.

Price Discrimination and the Cameron Rule

Gas is a commodity. Electricity is a commodity. If a commodity market is efficient there should only be one price: one price for gas and one price for electricity. Either there is a competitive market or there are several energy tariffs.

The energy bill announced yesterday will allow each supplier to offer households four different core prices.With six suppliers that could mean up to 24 different prices for the same basic commodity. There could be even more if discounts can be offered on the core prices.

The energy bill will not create a competitive market leading to lower prices. The oligopoly of six firms will be allowed to compete by appearing to offer different products to their customers. They are in effect pretending to offer a choice between an "Armani" kilo-Watt-hour or a "Top Shop" kilo-Watt-hour.

Is some social purpose served by allowing different prices? Lets say, cheaper tariffs for customers who pay in advance using pre-pay meters? Lower prices for poorer customers who do not have bank accounts? In fact, the outcome is the opposite; it is better-off customers who are able to use the cheaper tariffs.

Price discrimination is the trick used in this kind of market to extract above normal profits from customers.


Price discrimination

The diagram shows how it works. The dotted line represents the cost of supply and the solid blue line is the demand curve. When the price is set at T1 the company makes a small profit above its cost. Some consumers are willing to pay more, and so if they can be induced to pay T2 the firm will make additional profits (equal to the light shaded area). Some consumers are still able to pay a higher price, T3, which would yield even more rent to the lucky firm (the darker shaded area). Imagine how the diagram would look with 24 prices.

A Cameron Rule would help - all customers must be given the most favourable tariff offered to any customer. The rule should apply to core tariffs and discounts. A special offer to one customer should be applied to all energy bills. Effectively each firm would sell at one price, and the greater price transparency would enable competition between the big six to focus on price.

Of course, it will still be an oligopoly and there is no guarantee that the price will fall to the lowest level compatible with an ordinary level of profit. The regulator would still be need inter alia to ensure no tacit collusion on price and to act against barriers to new entrants.

Cameron Rules

The government's energy bill is due to be published in the next few days. Despite not yet knowing what it might contain, this is a good opportunity to talk about what consumers pay for gas and electricity.

The prime minister drew attention to the issue when he announced that the energy firms should be compelled to give the lowest tariff to their customers. we are waiting to see how that will appear in the bill.

In my view, Labour should support the "Cameron rule", and be prepared to amend the bill if the government tries to walk away from its proposal. To me the Cameron rule sounds a bit like the WTO principle of "most favoured nation", which means that if trade barriers are lowered for one country then the same treatment should be available to all WTO members. As with customs tariffs so with energy tariffs; all residential customers should receive the most favourable tariff on offer to any customer.

Reading the press reaction which followed the PM's announcement led to a moment of revelation. Some commentators assumed that privatisation had created a free market in energy. Really, they think consumers benefit from competition in energy supply! At best they acknowledge the information gap when it comes to pricing; at worst they blame customers for not switching suppliers often enough.

The first clue that there is not a free market in energy is the existence of of Ofgem. A competitive market wouldn't need its own regulator. To explain further we need a bit of economics.

Here comes the economics bit
The key idea is the law of one price; in a free market identical goods have the same price. One kWh should not cost more from one supplier than from another. So the fact that customers are charged different prices is a sign that the market is not free or competitive or efficient.

Privatisation swapped a state monopoly for a private oligopoly. Energy supply is now in the hands of six large companies. This kind of market does not operate like the competitive markets of the textbooks. The firms do compete but rarely on price. More usually they compete through marketing and indeed the complex pricing arrangements offered by the companies is a form of marketing.

The problem lies in a market structure that leaves the big six with considerable market power. Hence the need for Ofgem and also support for the idea that gas and electricity utilities belong in the public sector. Unfortunately that option will not be in the coalition's bill. However, a Cameron rule imposing  the law of one price on each supplier would lead to one price for consumers. When they complain that the rule will end the free market in energy, we can say, "there never was a free market  in energy."

The US has a Volcker rule for banks and a Buffett rule for tax, can't we have a Cameron rule for energy prices?

Thinking About Rude Books

When I studied mathematics, many years ago, we began by doing analysis on the real number line. The course proved all the fundamental theorems of calculus on real numbers. In the second year I studied analysis on the complex plane and learned the proofs of the same theorems for complex numbers. The next year I moved on to n-dimensional space and, yes, the same theorems work in n dimensions. In my final year I took an optional course which proved the same theorems on topological space*.

When I went on to study economics I learned all sorts of results in simplified worlds where there were two goods and a budget constraint or a production possibility frontier. I assumed that the same results could be demonstrated for worlds with n goods and n-1 hyperplanes as budget constraints or PPF. Strangely no-one bothered to show that they did.

Thanks to Steve Keen's book, I now know the answer. Serious economists have indeed checked whether the simple models can be generalised. For example, the consumer theory model (the one with two goods where the consumer has a budget constraint) is used to demonstrate the downward slope of a demand curve. It might work when there are more than two goods but it falls apart once there is more than one consumer. Consumer theory only gives the traditional downward sloping demand schedule under conditions which amount to there being only one consumer.

Keen's book goes on to demolish the traditional supply curve. Some  simple mathematics (which was first published in 1957 but still doesn't feature in the textbooks) shows that the idea that firms have zero market power in a competitive market is false. Consequently, price does not equal marginal cost. To be fair, when I first studied economics in the 70s we were aware of the empirical work which showed that the textbook equation was not how real firms set their prices.

In the first part of Debunking Economics Keen uses the results of economic research to show that most of microeconomic theory has been tested and found wanting. This matters for macroeconomics as the last few decades have been dominated by an approach which insists that macro has microfoundations. In effect, modern macro is built on crumbling foundations.

The second part of the book does the same wrecking job for macroeconomics. The argument here is more complex and demands more from the reader. One difficulty is that macro models are less well known than supply and demand. Few outside the economic profession understand the DSGE models used, nor even the simpler IS-LM model. Nevertheless, it is worth persevering; Keen is writing for a general audience. He points out the failures of conventional macro to deal with the nature of money and credit, the effect of time, and the analysis of disequilibrium. By the end the case for abandoning neoclassical economics is made.

In a final part, Keen sets out the alternatives. This section sits less well with the overall argument and has the effect of making the volume read like two books joined together. Perhaps it is, as the earlier version of the book - published before the crises - did not go into the alternatives in such detail.

I strongly recommend this book to anyone interested in how economics has failed in predicting or dealing with the current depression. It is an angry book which pours scorn on the mainstream economics profession. If you would prefer an less polemical approach, then I would point you towards a book by Marc Lavoie, Introduction to Post-Keynesian Economics.This is a short book with a more academic approach which covers similar ground.

*A topology is defined in such a way that it has all the properties needed to make calculus work, and no more.

More or Less Wage Equality

Pay is not the only source of income and the ONS survey only covers pay and not overtime or bonuses. However the picture that emerges from the ONS report issued today shows income rising in the last 25 years but rising faster at the top of the scale. It also shows that the minimum wage has been successful in reducing the gap between the very bottom and the very top since its introduction in 1999.



The top 10% has seen wage growth of 81% in real terms compared with the average rise of 62%, and 47% for the bottom 10%. The top 1% has benefited by growth of 117%.

The good news in the survey is that the bottom 1% has seen a rise above the average, of 70%. The analysis by the ONS gives the credit entirely to the introduction of the minimum wage.

Pay Paradox

David Smith in the Economic Outlook column of the Sunday Times (£) asks:

Public sector pay has risen nearly twice as fast as in the private sector in this supposed time of cuts. How can that be?

Despite the freeze on public sector pay average pay has risen from £448 to £491 since April 2009, while the private sector average has gone from £446 to £469, a rise of 9.6% compared with 5.2%. How come? David Smith looks for the answer in flexibility and unionisation, but misses the obvious cause of this statistical puzzle.

The number of employees in the public sector has fallen by 648,000 (including the 198,000 college staff now counted as private sector). The private sector has added 1 million jobs.

The strong growth in private sector employment in the past three years has a lot to do with wage flexibility...the lack of pay flexibility in the public sector - and the large increase in the wage bill - has been the prime reason for the big public sector job losses.

Does he have the causality the wrong way round? The higher average pay could be a consequence of the lower number of employees. The cuts have fallen disproportionately on the low paid, rather than managers in the public sector. Every employee earning less than the average who leaves the public sector nudges the average upwards. Salary bands, which he mentions, also play a part as fewer new staff are recruited and so fewer are on the lower steps of the salary ladder. By contrast the private sector has been recruiting but recruiting more at the bottom end and so pushing down on the average.

It is a pity he didn't consider whether the statistics were comparing like with like between 2009 and today. This kind of story can turn into conventional wisdom and become lodged in the political discourse. It needs to be challenged from the start. Careless use of statistics can lead to poor policy.

More Fibs

John Rentoul spotted another fib; one I missed. Both Mr Cameron and Mr Osborne in their conference speeches claimed that:

In every single year of this Parliament the rich will pay a greater share of our nation's tax revenues than in any one of the 13 years that Labour were in office.

In fact the only year for which figures have been published is 2010-2011 which show the top decile paying a smaller share than previously. It seems the government are relying on figures for the proportion of income tax receipts paid by the top decile. It is not what they said but even that fails if 2010-2011 is included.

The claim is a fib.

Afterthought: if the top decile took a larger share of income then they would pay a larger share of income tax. Is increasing inequality something the government should be boasting about?

When a Recession Ends

The recession is over. It's official. Even the BBC and the FT say so.

But, does one quarter of positive growth really mean that the recession is finished? I posed this question some time ago, before the end of the first dip. Then I argued for three alternative ways of judging the end of a recession:

• the level of at GDP rather then the rate of change
• when the annual growth rate turns positive
• quarterly growth to return to (or exceed) the trend rate (0.6% a quarter)

How are we doing on those criteria?

The level of GDP is still more than 3% below the peak reached before the recession. If anyone tells you that the recession has finished, tell them that the depression goes on. According to the ONS the annual growth rate is zero, "GDP in volume terms was estimated to have been flat in Q3 2012, when compared with Q3 2011". Only the third criterion is met, the quarterly rate is above trend. 

So on two out of three of my criteria, it is still too early to call the end of the recession.

Simple Keynesian Political Economy

The real question behind the prime minister's fibs at his party conference, just like last year's fibs by the chancellor of the exchequer, is this: why does the Labour Party let the Tories define the narrative?

Last year Mr Osborne's fibs were in the service of creating a version of history in which the crisis was caused by too much debt. (Respectable Keynesians might agree that the explosion of debt was a cause but it was mainly household and businesses who were running up the debt.)

In Mr Osborne's version the borrowers were the British government, European governments and (bizarrely) the banks. This was and is nonsense. Before the crisis the government's net debt ratio was 36.4% of GDP. European countries which are now highly indebted include Spain and Ireland who, before the crisis were paying down their national debt, which was already very low. The banks were culprits not because they borrowed too much, but because they lent too much.

Mr Cameron returns to the theme by painting Labour as inveterate borrowers.

This alternative history needs to be countered. The opposition must create a different narrative, and one which is more honest. Against the Tory story of a debt crisis which must be cured by austerity we need a narrative to explain that the problem is a financial collapse and the solution is  investment.

Simple Keynesian analysis reminds us that the stimulus the economy needs is investment rather than general government spending or tax cuts. The investment may be in the public sector or the private sector or done by the public sector because the private sector is unwilling.

Investment should raise the potential of the economy and so provide more jobs and output in future and reduces the structural deficit. Investment should provide future income streams and so it is usual to fund investment by borrowing.

This is not the time to be slashing government investment in half, as Jonathan Portes of NIESR argues.

Source: Jonathan Portes blog, Not the Treasury View

To boost private sector investment a future Labour government will need to fix the still broken financial sector to provide the economy with the kind of banks which supply credit to small and medium sized businesses. New lenders will be needed, such as regional enterprise banks, and barriers to entry for new retail banks should be removed.

These then should be the themes of a new narrative to explain the crisis and its resolution. They are easily understandable. People remember that the crisis began as a financial crisis, but perhaps need to be reminded of collateralised debt obligations, shadow banking, securitisation, special investment vehicles, sub-prime lending and all the other instruments of financial destruction. Investment too is an attractive concept which points to a brighter future.

A narrative is not yet a policy, but as I will argue, the policy should point in this direction.

Update: link added

Mr Cameron's Fibs

This is what the prime minister said to his party in Birmingham on Wednesday.

I honestly think Labour haven't learned a single thing. When they were in office, their answer was always: Borrow more money. ...Whatever the day, whatever the question, whatever the weather it's: borrow more money. Borrow, borrow, borrow.

Did Labour always borrow? Here is a chart of deficits during the last Labour government.

Source: Eurostat, click to open a larger view.

As you can see the deficit was under control up to the financial crisis hit in 2008. In fact, the average deficit to GDP ratio  from 1997 - 2010 inclusive was 2.2%. The equivalent figure for the Tory years, 1979 - 1997 inclusive is 3.5 %.

Source: Eurostat, click to open a larger view.

Mr Cameron's claim was always, whatever the day, whatever the weather. Well, I can see three years when Labour wasn't borrowing anything at all and another when the deficit was half a percent of GDP.

I have two conclusions:

It was the banking crisis and subsequent depression which blew up the deficit.
Mr Cameron tells fibs.

Seeking Friendship

I often wish political commentators would stay away from economic policy. Take Philip Stevens in today's FT for example. In a column arguing that Mr Cameron should kiss and make up with Mrs Merkel he makes the claim that:

 On the big economic issues – the single market, competitiveness and budget discipline – it (Germany) holds positions quite close to those of Britain.

Which is true except that on the single market, Britain is openly questioning one of its four pillars, the free movement of people. (The other pillars are the free movement of goods, services and capital.) A point recognised elsewhere in the article. On competitiveness, Germany takes a mercantilist view while Britain take a free-trade liberal view. If those positions seem  quite close then I would direct you to a book Adam Smith wrote setting out the differences. As to budget discipline, Germany has adopted a balanced budget amendment to its constitution and is pushing the policy on other eurozone states. Britain's stated policy is to abolish the structural deficit; a balanced budget law is a lunacy too far for Britain's government.

He ignores the biggest economic issues of the day, reform of finance and the consequences of monetary union. On these there is no meeting of minds.

Reading Rude Books

I've noticed that in some of the economics blogs there is a tendency to rudeness. I've started reading a book that manages to stay barely the right side of politeness as it demolishes the entire edifice of neo-classical economics. Steve Keen's Debunking Economics is my current bedside reading.

I've greatly enjoyed his wrecking ball swinging away at the pillars of microeconomics. I'm going  bit slower through the dismantling of macro. If I have a complaint so far it is that he avoids the maths and that does not always help. I have followed up on his references in order to find the mathematical explanation of some of his points. I will post again when I've finished, but so far this is a book I would recommend.

Atlas Shrugged

Samuel Brittan had a good line in his FT column last week:

When voices in Paris or Berlin say the answer to any problem is “more Europe”, by which they mean more centralised power to EU institutions, we should turn a deaf ear. And when some leaders say that “without the euro there is no Europe” we should shrug our shoulders and look at an atlas to reassure ourselves.

I like the last bit.

Jon Lord: a Tribute

Another economics blog regularly includes music clips. I take that as precedent allowing me to include this post as a tribute to Jon Lord, who died yesterday.



His passing comes just two months before the release of the studio recording of his Concerto for Group and Orchestra, a disc I was looking forward to before I knew it existed.

Rent Rebate

Simon Wren-Lewis, the Oxford economist, asks the right questions in a post on his blog defending the teaching of macroeconomics after the crisis. He says this about the use of financial economics in the finance sector:

A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking. The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?

Since he is talking about the power of the finance sector even in the economics profession, I think his last question is rhetorical. All the same I would like to know, can we quantify how much rent did the bankers extract from the productive economy.

And can we have it back, please?

Simple Keynesian Economics

One day I will find the time to write my pamphlet on an alternative economic strategy for the Labour party.

In the meantime here is one of the key ideas. In place of "crude Keynsianism", I want to offer simple Keynsianism. Keynes devised a complex and subtle theory which he laid out in a difficult book. I attempt to simplify his core idea as a base for policy prescriptions.

Simple Keynesianism can be explained in four steps and one diagram.  

These are the key steps:

1.      Income increases as employment increases.

2.      Income is the sum of consumption and investment.

3.      Consumption increases as income increases but not by as much.

4.      Investment decreases when entrepreneurs prefer to hold cash.

In step 1, income means the total of all income in the economy - ie wages and profit. Because everyone's purchases are someone else's income, income is equal to the total value of production. Step 2 means that everything which is produced is either consumed or used to contribute to future production. Investment, therefore, includes capital equipment, infrastructure, stocks of raw or finished goods and other working capital. Keynes used the term 'propensity to consume' to describe step 3. A society with a low income will use most of its income to meet immediate needs. A richer society will consume more in total but a lower proportion of income is spent on consumption. The first three steps are illustrated in figure 1.

A number of factors influence the level of investment, such as the expected return and the interest rate. Keynes innovation was to identify the importance of a psychological factor, 'liquidity preference' which means the desire to hold money rather than tie it up in investment.

In the diagram we have the economy a full employment (N₀), with a high level of income (Y₀) and consumption. Following an external shock, (for example a banking crisis) liquidity preference rises, which means that businesses postpone investment in order to hold more cash. Lower investment means lower income (Y₁) which means lower employment (N₁). At this lower level of employment consumption is also lower and so employment falls even further. The fall in employment means a fall in income which means another (smaller) fall in consumption. Employment continues to fall until a new equilibrium is reached, but now with employment (N₂) and income (Y₂) below their potential level.



That is it, the simple version of Keynes' theory of employment.

Perhaps a little algebra will help. Keynes says that income (Y) equals consumption (C) plus investment (I). Y = C + I.

At full employment Y₀ = C₀+ I₀. When liquidity preference rises investment falls, let's say by the difference between Y₀ and Y₁. Now Y₁ = C₀ + I₁. At Y₁ the propensity to consume gives a level of consumption below C₀. Thus consumption falls as does income and employment. At this lower level of income consumption falls again, and keeps falling until equilibrium is reached, Y₂ on the diagram.

I have explained the simple Keynesian theory without mentioning the multiplier. In fact the explanation is there. A fall in investment caused a fall in income more than the initial cut in investment spending.

 My idea is to argue that Keynes theory is not about boosting government spending. It is primarily about increasing investment. Part of the investment will be by government but we need to start by looking at private sector investment as well.

My first question however is does this explanation do the job. Is simple Keynesianism sufficiently clearly explained and easy to grasp?

Stiglitz on Equality

I recommend reading Stiglitz in today's FT:

Textbooks teach us that we can have a more egalitarian society only if we give up growth or efficiency. However, closer analysis shows that we are paying a high price for inequality: it contributes to social, economic and political instability, and to lower growth. Western countries with the healthiest economies (for example those in Scandinavia) are also the countries with the highest degree of equality.

He goes on:

There is growing evidence looking across countries over time that suggests a link between equality, growth and stability.

The manifesto of this blog says that equality is a cornerstone of economic stability. That argument is gaining ground, with more, and more prominent, economists taking up the theme.

Watch this space.

Who Will Buy Osborne's Pork Pie?

I have been having trouble nailing one of Chancellor George Osborne's big fibs. He claims (and he did it again on Sunday's Andrew Marr show) that interest rates for consumers are low because of government austerity, fantasising that if government borrowing costs went up then so would mortgage rates.

We know that the interest rate on government debt is currently at historically low levels. For the record just now FT gives the benchmark rate as 1.96%  (yield on 10 year gilts).

On 2 May the FT had a headline:

Households feel pinch as lenders tighten mortgages

It went on:

It is not just mortgages which are becoming more expensive. So too, are rates on bank overdrafts which, at 19.52 per cent, are the highest since the Bank began keeping records in 1995, and credit card rates are their highest since December 2001.

So there we have it; government borrowing costs extraordinarily low, consumer interest rates painfully high.

You might find a textbook which argues that consumer interest rate is made up of the risk-free rate plus a risk premium. The risk-free rate is usually taken to be the rate at which the government borrows. That might support the idea that if government has to pay more to borrow then so will a mortgage holder. Except that the case the Chancellor is talking about is when the market decides that lending to the government is risky. So the government is now paying a risk premium, and there is no reason why a house-buyer should pay for the risk of government default as well as the risk of a mortgage default.

Fix the Banks 2

I know I am not alone in arguing that fixing the broken banking system is the essential prerequisite to recovery. I want to share a thought on how to move on fixing Europe's banks which might just be politically feasible.

The problem we have is that for countries to deal with the problem by nationalising, refinancing or recapitalising their banks is massively expensive. At a time when Euroland politicians have persuaded themselves that the problem is government debt, it is politically impossible for countries to borrow to cover the cost.

My thought is that a banking resolution regime could be organised at the European level and financed by the issue of Eurobonds. A new institution would be needed to issue the bonds and hold the shares of the rescued banks. In time the assets could be sold and the money used to buy back the bonds.

Germany has objected to the issue of Eurobonds in the past, but this was in the context of pooling sovereign debt. Germany fears  creating "moral hazard" where profligate southerners would lose the incentives to borrow less. However issuing Eurobonds for a limited purpose, especially where the assets would be jointly owned is different. In fact Eurobonds already exist on a small scale as the European Investment Bank raises money this way.

Here Comes the Judge

Courts, no matter how Supreme, are not known for thier ability to handle scientific evidence. The economics behind Obamacare, or the Affordable Care Act, ought to be at the heart of the case currently before the US supreme court. It isn't. The Administration is not arguing the economics, perhaps anticpating that the Justices would not understand. They might be right.

ACA require everyone to buy health insurance. Otherwise something called adverse selection kicks in - only those likely to get sick buy insurance making it prohibitively expensive for those who remain. Justice Scalia doesn't get it:

You could say that about buying a car. If -- if people don't buy cars, the price that those who do buy cars pay will have to be higher. So you could say in order to bring the price down, you are hurting these other people by not buying a car. (See here page 19 line 10)

Anyone who has opened an economics text book can answer that one. If some people don't buy cars then the demand for cars falls.  The price falls not rises. (The demand schedule moves down and intersects the supply schedule at a lower point giving a lower equilibrium price.)

You might want to argue about whether supply curves really slope upward the way they do in textbooks but that is beside the point. The issue is that insurance is not like a textbook competitive market and the comparison with cars or broccoli is irrelevant. Adverse selection is a market failure and governments need to intervene to correct it.

Lord, Won't You Buy Me a Mercedes-Benz

With the budget coming up next week I've been preparing the evidence to rebut the Chancellor's porkies. His main theme for some years has been that government debt caused the crisis. (I suppose  he hopes that we will forget about the housing boom, sub-prime mortgages, collateralised debt obligations, shadow banking and the general belief that risk had been magicked out of the financial markets.)

I came across some figures for debt in 2008 in an interesting report.* UK government (gross) debt was 52% of GDP, household debt was 101% and firms outside the financial sector had debt of 114% of GDP. I've put the figures on a chart with a few other countries for comparison.

If debt was the problem then was it government who was running it up?

* Debt and deleveraging: The global credit bubble and its economic consequences, McKinsey Global Institute

Blowing Bubbles (After They've Burst)

The government has a new plan to reinflate the housing bubble. It's a complex scheme involving 95% mortgages, participation by the building industry and a public sector guarantee.

The problem with the scheme is that house prices are still too high. The Nationwide index of house prices to earnings (based on first time buyers) shows that currently house prices are 4.4 times earnings. The chart below is based on their data. I have fitted a trendline on the data from 1983 to 2003 (that is the two decades before the bubble). It shows that house prices fluctuated around 2.9 times earnings.

House prices are likely to fall, or at best stagnate for a long period. Of course lower property prices could depress household demand. Is it responsible policy to keep house prices inflated?

Lower prices would do more to help first time buyers. Building  houses should help to stimulate growth in the economy and make housing more affordable.

Neville for Chancellor

Brad DeLong, the Berkeley economist, has a nice piece on how Neville Chamberlain was right.

Britain recovered from the great depression faster than the US, and faster than we are recovering from the current depression. DeLong gives credit to Chancellor of the Exchequer Chamberlain who ignored the orthodox calls for austerity and implemented a policy of fiscal stimulus. Unlike his successor today:

The failure of expansionary austerity in Britain should give all of its advocates around the world reason to reflect on and rethink their policy calculations.

...if expansionary austerity is not working in Britain, how well can it possibly work in countries that are less open, that can’t use the exchange-rate channel to boost exports, and that lack the long-term confidence that investors and businesses have in Britain?

You don't need to be a Keynesian to get it right.

The Wrong Treaty

So the summit succeeded in agreeing a new EU treaty. I have one question. Of the 27 European leaders in the room was there not one who proposed to change the treaty to allow the ECB to buy government bonds directly from their treasuries?

Mr Draghi constantly points out that it is the Lisbon treaty which prevents the ECB acting as lender of last resort. Not only might removing this obstacle have been a reasonable quid pro quo for the restriction on fiscal freedom, it would deal directly with the crisis unlike the treaty agreed which will do nothing to ease the Euro's problems.