Wednesday 21 December 2016

Just one more thing...

This is probably my last post. Long story, not interesting (I'm not about to die, in case anyone was wondering). But before leaving, I wanted to write a summary of what I feel are my contributions to the subject. I'd quite like my kids to read it one day, and so I need to put it all together in one place.  Honestly I am very proud of this work. It is badly written, it lacks academic economic context, but in my view it understands what is going on in the economy and enables medium to long-term predictions that are more accurate than any standard equilibrium model could ever give.

For the last two years or so, it has been a great joy to me to write this blog and interact in a small way in the debate about economic policy and methodology. I have met in electronic form (and sometimes in real life) a lot of great people and it has been a fascinating and fun journey. I may change my mind about this in the future, but I think now it is time for me to concentrate on other things.

It was always a bit of a leap in the dark, not having studied economics, to start writing an economics blog. I know there have been times when my lack of knowledge was embarrassing. But, in quantitative investment management, building models is my job, and from seeing how macroeconomic models were built, I knew with close to certainty that the mainstream way was not the right way. I approached the economy like any other system, making (what I consider to be) reasonable assumptions (often built on the ideas of other heteredox economists) and checking if the empirical research backs it up and building models based on this. I then tried to fill in the gaps in my knowledge along the way.

Summary of the last two years:

I have divided this into a few sections, the largest relates to my Demand Based Cashflow Model which explains a lot of my thinking. The smaller topics are the Eurozone, then Investment Stuff, Currency and Current Accounts, Free Trade and finally Complaints About Textbook Economics.

DBCF model:


My Demand Based Cashflow Model enables a lot of the work on this blog. It is what I am most proud of, not because it is super complicated or hugely original, but because it is a model that, in my opinion,  gives a real understanding of the whole economy.

The model basically views economy as a flow of money. It shows why when private sector debt is high, when corporate profits are high and rents are high we get an economic stagnation.

The paper which explains and derives the whole model is here (link)
A non-equation version of this is given here (link)
and the simplest explanation here (link).
(the lower two of these links are my most viewed posts)

To get an idea of the types of predicion enabled by the model, this post (link) shows a simulation provided by the model. It shows how different the impacts are of monetary and fiscal policy. Briefly, monetary policy stimulates private sector debt, and fiscal policy uses public sector debt. The difference in results is huge, yet many economists treat them as interchangeable.

Predictions can be made about the kind of budget deficits that are required, enabling me to discuss how ludicrous and unattainable George Osborne's government deficit target was (I gave it a 0% chance whilst the OBR was predicting 50%). This post looks at the shrinking share of money paid as wages (after housing rent costs) and how this is related to larger budget deficits (link).

The DBCF model suggests that the productivity slowdown we have seen is not a supply side issue; far more likely, it is a slowdown in nominal demand caused by excess savings and tight government budgets. This will continue until fiscal deficits increase and more money gets to people who spend. This post looks at how the UK reduced unemployment by pushing people into low-paid jobs, but this was at the cost of productivity and not a substitute for fiscal spending and investment (link).

Total Wealth and the Obvious Effect on Yields (link) shows why we should expect lower real interest rate yields the more debt there is in the economy. It asks where does the money come from to pay high interest on ever growing debt? This is kind of straightforward when you think of the economy as a whole system, but I have not read it discussed anywhere. In this context, hearing that pension funds are expecting 7% annual return on their investments, you wonder where they think the money is coming from? Everyone would have to work for free for the pensioners.

The model is very clear that in a demand starved economy, people saving money is not a good thing. There is a lot of misunderstanding about the role of saving in an economy. People naturally equate saving with investment, maybe thanks to the S=I identity. But it is not so simple. This post questions the relation between saving and investment (link).

And on a similar theme, this earlier post bemoans the priority given to savers at the expense of workers and the damage caused by this (link).

Using the DBCF model makes you realise that technology taking people's jobs is not a threat but a real opportunity. But only if the fiscal policy is right and demand is maintained (link).

One of the practical uses of the model is calculating an affordable basic income (link).

And I discuss here, in an early post, only demand driven inflation should be taken into account when deciding on monetary and fiscal policy. Supply driven inflation (eg caused by falling currency) should be completely ignored as acting upon it is very damaging (link).

Finally, they don't have a category, but some other popular posts on this theme have been the following:

This is an early post on how inequality grows with rising levels of debt (link)

And the theme of how our aversion to government debt and over-use of monetary policy is causing low growth, inequality and eventual social unrest is discussed here (link).

Eurozone impossibility of survival:


Something else that becomes clear from the DBCF model is the impossibility of Eurozone survival.

I write about the Eurozone low inflation slow moving train crash on Coppola Comment (link)... well as in this post from during the Greek Crisis last year, in a post that was translated into Italian so obviously someone liked it (link).

I would say that it is very unlikely, given current policy,  that ECB short term rates will ever go above zero again. If they ever go above 1%, unless there is a huge coordinated fiscal boost,  I will eat my shoes (as someone else once unwisely said, but I havent learned a lesson).

Any significant inflation will come only from supply side factors - lower Euro and rising commodity prices.

Investment Stuff:


The Overwhelming Evidence that Market Leverage Significantly Destroys Shareholder Value looks at how a huge volume of evidence shows that the more leverage a firm takes, the more shareholder money is wasted. It also shows how this evidence has been ignored for years because the demonstrable bad performance had been put down to mispricing by investors (link).

Another post looks at how, unless we are to get much higher nominal GDP growth (which can not happen as long as the aversion to higher government deficits continues), US shares are clearly very much overvalued compared to thirty year bonds (link).

And this is a paper on portfolio management. To summarise, minimising correlation is a good policy (link).

Currency and current account balances:


I have actually been working on a currency model. It tries to fundamentally explain the value of a currency, and it is intended to be used in place of a purchasing power parity model. Empirically it seems to fit, although getting the right data is almost impossible. I will probably write up a paper on this eventually, but the ideas are hinted at in this post about the pointlessness of devaluing your own currency (link)

On a similar subject, see this post on the pointlessness of running a current account surplus; a post which also suggests that current account deficits, in context of free floating sovereign currencies, are usually more benign than people worry about (link).

Free Trade:


Here, I  propose argument that total free trade is not the optimal course of policy even for rich developed countries that are normally assumed to benefit (on the whole). Without fiscal transfers between winning and losing countries, it is actually in a country's interest to have a more balanced, diversified portfolio of industries than the free trade model allows (link).

This post looks at the UK in the context of EU membership, and why membership may have been bad for the UK economy (link).

Complaints about textbook economics:


Then there are just some moans about the ridiculousness of mainstream economic theory. I generally like to avoid conflict, but I can't stop myself sometimes.

On Maths and Models looks at microfoundations and use of mathematics in economics (link).

Rents and GDP discusses how rents are not consumption but a royalty paid to landowners granted a monopoly by the state. And how it has led to an overstatement of GDP growth (link).

Why Economic Modelling of Wages is so Political shows that the assumption of medium term full employment means that the effect of low wages on demand is ignored by mainnstream economic models. This is a very right-wing assumption but it passes itself off as neutral (link).

A few last points:

Well, that's about it. In some ways, maybe not having studied economics has helped me. I see so many highly intelligent people arguing the most ridiculous models of human behaviour, just because that was the model they were taught. Had I formally studied, could my medium-sized brain have avoided the fate that has befallen many greater minds?

One great mind who did avoid the indoctrination is Steve Keen, who was an inspiration with his book Debunking Economics, as well as a very kind and generous person. I am very grateful to him. Particular thanks also to Frances Coppola as well as @LadyFoHF who has also been very generous. Were it not for these people I would probably be still writing for myself and a few internet trawling bots that found my page by accident. As it is, a few randoms like you appear here now and then.

Finally, thanks to everyone who has read, commented on, shared and in some way interacted with me in the past couple of years. It has been great.

Sunday 4 December 2016

Why Economic Modelling of Wages is so Political

Noah Smith recently wrote a post about the theory of the labour market, one of the building blocks of Economics 101, and how it has been empirically falsified. He points to two pieces of evidence; first that new immigration does not push down wages as predicted, second that minimum wages do not tend to reduce employment as predicted.

I think that he is completely correct here. The strange part really is how this could have been taught for so long as standard theory. The root of the problem is that Econ 101 teaches the job market like it is a market for goods. If the price is low, demand for the goods will be higher. Ditto, therefore, for workers.

The reason that it is wrong, is that, as Kalecki wrote so well about, workers are also consumers. Not only are they consumers but they are consumers who spend nearly all of their income on consumption. This means that the more is spent on wages, the more will be spent on goods on services, thus increasing demand for labour. This is exactly the opposite effect that Econ 101 teaches. Although higher minimum wages may mean some people lose jobs, they also potentially create more jobs.

Standard labour theory actually argues that there is no such thing as medium term involuntary unemployment, only people choosing more leisure time. It is one of those things that is funny when you read it, but has very serious consequences. The model says that real wages will fall to a level where everyone who wants to can be employed, therefore involuntary unemployment is impossible.  When faced with real life job queues, the answer given by the basic model is that it is because of labour market frictions. For frictions read that wages are artificially high. If only wages were allowed to fall low enough, everyone would be employed.

This is patently not true. Although lowering wages is often suggested/forced on countries in crisis, as Greece shows, the result is to depress demand further into a downward spiral. The only possible way it can work is in a very open economy, where lowering of wages and a devaluation of currency crush workers wages to an extent that exports can make up for lost demand. However the cost of this policy is that the country is poorer by the end.

In response to Smith's post, some economists did argue that he was misrepresenting what they actually teach; that this goes beyond the basic theory. That they use a 'general equilibrium model' in which, for example immigration can increase demand as well as worker supply.

However, this really doesn't go far enough. To explain why, you need to look at the basic equilibrium model that mainstream economics uses. It says that an economy is always at full employment, with the exception of short term shocks to the system. There is a natural rate of unemployment, for every economy and this depends on the frictions caused by unions (or sometimes employers to retain staff) making wages too high and achieving workers rights.

How did they just assume full employment, you may ask? Well, the model was built looking at the time since 1945 when Keynesian fiscal policy allied to large private sector credit expansion, meant that the economy more or less was always running at full employment. But they didn't realise it was because of credit expansion that they were getting the full employment, so instead they just assumed it was natural.

Incredibly, credit expansion is not in mainstream economic models as a driver of growth. Inflation comes from increase in the base money supply or something. This is a major problem, as the economy is a flow of money and new credit is the main driver of growth. Steve Keen's graphs where he plots credit expansion against unemployment, house prices and GDP growth (eg here) are eye-opening in this regard.

So they assumed full employment. This is a very pernicious assumption. Why? Because it laid the groundwork for the financialisation of the economy and for the rentier-capitalist economy that we appear to have been working towards since the 1980s.

The assumption of full employment means that wages can be kept as low as you want without affecting demand. If demand is assumed then the only thing that is important is that supply is kept high. The eventual conclusion from this is the Chamley Judd theorum, which states that taxes on capital should be zero as the more money that goes to investors, the more they will invest and the more supply we will have. The same is true for the rich, a.k.a. the 'Wealth Creators'. Reaganomics is given backing by the economics profession.

Supply side stopped being about building infrastructure and education, and became about giving tax cuts to rich people.

In this model, fiscal deficits are only necessary to counteract short term shocks and monetary policy (private sector debt) must be used instead.
What was the effect of this? Demand shrank even further. Economic growth since the 1980s has been considerably slower than the period between 1945 and 1975, and the growth that was achieved required larger and larger (eventually unsustainable) private sector debt.

So the problem with Econ 101 goes much deeper than that it gets wages wrong. The assumption of full employment is the one that gives free reign to rentier capitalism. Why do economists teach it? Kalecki has a theory here too.

Thursday 10 November 2016

The Economic Consequences of Trump

On a personal level, I am appalled by President Trump. His personality has no redeeming features. He is vain, petty and nasty. His stirring up of racial tensions risks creating a monster. His misogyny is particularly unbecoming. His authoritarian impulses can only be described as fascist (although fortunately without a personal army). His habit of lashing out every time he feels personally slighted is dangerous. Honestly speaking, the thought of him as president makes me feel physically sick.

On a policy level I am particularly worried about the damage done to the environment by the combination of Trump and a Republican congress - which could undo the fragile progress made in Paris towards reducing global greenhouse gas emissions.

But economically I think there is a reasonable chance that he will bring large economic growth and I can see him being seen to be a great success based on this alone. For me the real shame is that some of his policies were not enacted sooner; if so we would not have seen Trump (or Brexit in the UK, or any of the right wing leaders who have been gaining popularity in the austerity world).

People argue that the US has been running government deficits already but the problem is that the size of deficits required to keep the economy growing has increased a lot with the increase in private sector debt and inequality. In fact Obama's deficits, although higher than Europe (hence the greater GDP growth in the US than Europe since 2008) have been lower than required. The economy is still running a long way under capacity, as evidenced by the marked decline in the productivity growth rate since 2008.

No-one really knows exactly what he will do, and for this reason this is somewhat speculative. But if we divide his actions into three main categories we can look at potential impacts of each one.

1) Deficit Infrastructure Spending: There is talk of a 2 trillion infrastructure project. This works out as around 3% of GDP each year spent. If this were done alone with no offsetting policies, then even ignoring the increase in future capacity, I think we would be looking at a minimum of 2% more real GDP growth per year. Trump's 4% per year growth figure is very much achievable and would bring great benefits to the nation as a whole - improving the lives of many of the people who voted for him.

2) Very Large Tax Cuts: Here the outlook is not so good. Some of his proposed tax cuts - for low earners - would have a very high multiplier on growth and would stimulate the economy. These would be very beneficial.

However, the cuts in taxes for rich people, corporations and on inheritance tax would have minimal effect on demand. They would not increase growth and they also build up problems for the future. The problem is that all of the inequality in wealth created by this makes the economy's saving rate higher. More of the return from GDP goes in interest, rentals and dividend payments for those who do not spend. This means that a) the government debt increases today, and b) the size of government deficits required in the future will be larger.

A big question will be how are the tax cuts and infrastructure spending funded. If it is not with new debt, as assumed above, but actually with reduction of spending on other programmes, then the benefits will be mitigated or even could be negative. A small increase in demand from tax cuts to the rich combined with a large decrease in demand from cutting social security will be net negative.

3) Protectionist Trade Policy: This is a lot more uncertain. Marginally higher tariffs overall do not greatly reduce growth, despite the rhetoric on the subject. The main problem would be in transition from one system to another - causing large disruption. The US is in a fortunate position here, because it is large enough to dictate terms.

There may be some inflation in the US from the supply side, as imports get more expensive or firms re-shore their offshore operations with increased costs. But this will somewhat be offset by greater job opportunities in the US, and in any case the economic growth from the fiscal policy should dwarf this.

Overall, if Donald Trump doesn't mess this up, he could easily be returned for another 4 year term in a landslide in 2020.

Update 12 Nov 16:  Looking at Trump's actual plans I think I was totally over-optimistic. They appear to be a turbocharged  domestic neoliberalism, with a protectionist trade policy.

Trump appears to be doing the bad parts of the above (tax cuts for the rich, protectionist disruption) without much of the good (tax cuts for the poor and middle class, infrastructure building). The infrastructure plans are 'revenue neutral' and not as large as thought. Probably this involves some of the disastrous public private partnerships we have seen in the UK which pay large profits to private companies while loading all the losses on the government.

I think that with a Republican congress, there is a great opportunity for Trump to do what Obama couldn't and run deficits for infrastructure. Unfortunately it appears at the moment that the priority is increasing the gap between rich and poor and making the economic situation worse.

Anyway, we still don't know so hopefully there will be some good surprises to come.

Thursday 27 October 2016

The Overwhelming Evidence that Market Leverage Significantly Destroys Shareholder Value

I have recently written a paper, entitled 'Leverage as a Weapon of Mass Shareholder-Value Destruction; Another Look at the Low-Beta Anomaly' which can be downloaded here.

It challenges the idea that adding debt to a balance sheet in any way makes a company more efficient - in fact it suggests that it leads to significant loss of shareholder value. It uses the fact of the (very well researched) 'low-beta' anomaly, which shows that higher risk stocks significantly under-perform lower risk stocks in the long term; the current explanations for which are based on the idea that investors mis-price these stocks for behavioral reasons. I show that this can not possibly explain the anomaly and that there must be a destruction of shareholder value of the order of around 8-10% per year between the highest and lowest leveraged stocks.

This goes against all shareholder activist lobbying that adding debt is good. It is good for management, and it is good for the financial sector but it is not good for shareholders.

A quote from the paper explaining possible reasons is included below:
Whatever the source of the market leverage, some effects are the same. Since the market tends to rise in the long run, a firm with more market leverage would expect higher profits per share and larger share price increases. These expected higher profits and higher share prices have nothing to do with the skill of the company's management; they are merely a consequence of higher leverage.

Unfortunately, history shows that managers as a group tend to lack the necessary humility to identify leverage as the driver behind their better returns. If hubris is not a universal trait amongst managers of a leveraged ship riding a rising tide, at the very least one could point to numerous examples where it exists. Over-confidence in one's managerial skill can result in sub-optimal decision making, perhaps culminating in purchases of other companies at inflated valuations in the belief that the magic touch can be applied to them too. There is no doubt that many mergers and aquisitions are value destroying (see Moeller et al. 2004 for market reaction to acquirers); it would make sense that the ones most likely to be most value destroying are the ones where managers had false belief in their skill. Easy success can definitely lead to sub-optimal decision making, and it would be no surprise if it turned out that this were the case in practice.
Unearned success for the company may lead to other suboptimal decisions. The board may decide they need to travel by private jet. The CEO may want to sponsor a Formula One team. Offices may be upgraded. If a company is doing better than its competitors, very few people will notice that it is not doing quite as well as it should be, given its leverage. 
On top of this, manager compensation is often linked to share price or profit targets. This means that even though managers display no more skill, in a company with higher leverage, shareholders will pay more money to executives. These payments are not recouped if the share price then falls, so even if the market as a whole does not go up on average, the higher the leverage, the higher the expected payouts. This pay structure intrinsically encourages more leverage, since the managers are effectively being given an option whose value, like that of all options, is higher under conditions of higher volatility.
Similarly costly, debt issuance means large fees to bankers. In general, financialisation of a company in this way can result in higher fees paid to intermediaries. These arise both as direct charges for debt issuance (with the initial debt offering and subsequent refinancing), and from increased need for costly underwriting of rights issues or other equity capital raising.
High interest payments can often lead to a company cannibalising research and longer-term investment in order to meet payments and maintain dividends. High debt companies may be more short-term in their outlook. And although dividends are more flexible in a downturn, linking company payouts to performance of the company, debt interest must always be paid regardless of the longer-term consequences.

Another possible reason for suboptimality of high beta portfolios comes from the idea that the market volatility of a company can be a lot higher than the fundamental volatility of the company’s prospects. The fact that many CTA funds successfully trade momentum strategies suggests that this is the case for indices. The momentum of single stocks relative to the index is documented by, for example, Moskowitz et al (2012). The tendency of share prices to overshoot on both the upside and the downside is a result of of investor herding and risk aversion, as well as general uncertainty and the impossibility of accurately identifying fundamental value. At the same time, the future of a company's share price is path dependent. If the share price comes close to zero, bond holders will force the company into administration. If it subsequently turns out that the market had moved too far, it is too late for the shareholders. Rising leverage therefore increases unnecessary bankruptcies. If it is true that market volatility is higher than fundamental volatility, then the bond holders' option is worth more and the shareholders (who are writing the option) lose out.
Often there may be tax benefits for choosing debt over equity (eg. Graham 2000). Whatever benefits these give to shareholders, however, appear to be dwarfed by the costs.
It should be noted that the argument here is not whether returns can be increased by taking on debt. In general, taking on moderate levels of debt will increase company profitability per share. But if an investor wishes to take higher risk and make higher returns, then they can do this by borrowing money on their own account and investing in lower-risk shares. The point is that investors may be better off borrowing themselves than allowing the company to borrow on their behalf. In fact, fund managers can often borrow at a lower rate than corporates because of the liquidity of their underlying positions. The evidence appears to suggest that by borrowing on behalf of the investors, managers are increasing their own compensation and possibly running the company suboptimally. 

The abstract is as follows:

The 'low-beta' or 'low-volatility anomaly' is one of the most researched in the field of 'alternative beta'. Despite strong published evidence going back to the 1970s that high beta/volatility stocks underperform relative to expectations generated by the Capital Asset Pricing Model (CAPM), the anomaly still persists. The explanations given for this are all behavioural; that investor biases lead to overpricing of high volatility stocks. This paper shows that investor biases cannot be the explanation for the anomaly. Instead, it is proposed that the anomaly stems from a destruction of shareholder value. The strong implication is that the more market leverage a firm has, the more shareholder value is destroyed. Although the prevailing view for a long time has been that adding debt is good for shareholders, making balance sheets more 'efficient', there is in fact a considerable volume of evidence that the opposite is true; evidence which has been incorrectly interpreted for many years. Some possible mechanisms for this shareholder-value destruction are proposed. 

Tuesday 27 September 2016

On Currency Devaluation (Deliberate and Otherwise)

It is an unstated central bank policy in many parts of the world to reduce the value of their currency to below its fair value. The reason for doing so is 'competitiveness'. A weaker currency means lower global prices for your goods and hence increases your exports, while at the same time reducing imports. Since a fundamental equation of economics says that GDP = C+I+G+X, or consumption plus investment plus government expenditure plus net exports; it would appear self evident that an increase in net exports would increase GDP.

This is, unfortunately, completely wrong. There are two ways that it is wrong, both pretty fundamental:

  1. As a recent Bloomberg report discusses, a reduction in currency does not necessarily increase net exports.  
  2. Any increase in net exports comes at the expense of an offsetting decline in domestic consumption/investment (C+I+G). Thus giving no net economic growth.

In this previous post, I give empirical evidence that there appears to be no benefit to running a current account surplus in terms of GDP growth, or even any benefit regarding private and public sector debt build-up. In this post, I really just want to show how theoretically false the whole paradigm is.

This post will be divided into 5 short sections. The first discusses how a sovereign government already has all the tools it needs to run an economy at capacity. Section 2 will discuss the circumstances in which a reduction in currency will or won't increase net exports. Section 3 discusses how an increase in net exports reduces domestic demand. Section 4 discusses reasons for running a surplus/deficit, then 5 discusses what to do if a deficit is forced upon you.

1. The Capacity of an Economy

The capacity of an economy is how much it can produce if everyone is employed in their most productive roles. For example if an economy consists of a shoe factory that has space for 1000 workers, each of whom can produce 1000 shoes; the capacity of the economy is 1,000,000 shoes and there are jobs available for 1,000 workers.

The factory can run under capacity by employing only 800 workers and producing only 800,000 shoes. On the other hand, capacity can be increased by investing in new machinery that enables workers to produce 1200 shoes per worker. 

Next, we can look at the role of demand. If people want to buy 1m shoes, for the price they cost to make plus a markup, the factory will be able to employ all 1,000 workers. If there is only demand for 800,000 shoes it must lay off workers and run below capacity. If there is demand for 1.2m shoes then initially the price will go up (inflation) but eventually investment will be made to increase supply capacity.

The role of demand here is extremely simple and very obvious. Demand must be high enough for the factory to run at capacity. If demand is higher than supply we get inflation but also an increase in supply in the future.

Unfortunately much of the discussion about a productivity slow-down seems to focus on supply issues rather than the obvious demand issues. And still the lack of demand goes unaddressed.

If a government (which has control of its own currency) wants to increase demand so that an economy runs at capacity and invests in increasing capacity, what does it need to do? It needs to make sure that the government deficit is high enough to get enough money flowing through the system to keep inflation at its target (note that inflation in this context means inflation of prices of domestic goods and services, not inflation imported because of falling exchange rate etc).

This is a complex subject, but I discuss it more in a blog post here and in my paper on the subject here. Using monetary policy is a terrible idea as I discuss here (with simulations). Fiscal policy is the only way to do this without creating bubbles, exacerbating inequality and damaging future growth.

So there is a very simple way for the government to ensure full employment and an economy running at capacity. It involves investment to increase capacity and enough deficit spending to keep demand high enough to fill the capacity. There is no reason to try to take demand from abroad.

This does not stop countries trying it though.

2. Does an fall in currency increase net exports?

To answer this question, we need to differentiate between different types of devaluations of currency. In order to do so, we need to look at a simple identity that a current account surplus is equal to your capital account deficit; the only way to run a current account surplus is to net invest your savings in another country (this subject is very well described by Michael Pettis). Likewise the only way to have a current account deficit is if people in other countries invest their savings in your economy.

This means that in the absence of any saving in foreign economies, the current account balance (which in the absence of any previous investments is equal to the trade balance) must be zero. The only change to net exports (ignoring exchange of foreign investment income) will come if there is a change in the net amount of capital invested in the country.

So, to give an example quoted in the Bloomberg piece, Pound Sterling fell by 19% against the US dollar in the two years to 2009. What was the reason for this change? The productivity, and expectation of future productivity, of the UK economy fell vs that of the US economy. Was the exchange rate in 2009 artificially low? No. Was there more money being taken out of the UK than put in as investment? No. In fact, there was still money coming into the UK from countries pursuing policies that lowered their own exchange rate. So should there be an increase in net exports? No,

Regarding the fall in GBP caused by Brexit, what are the causes? If it is a withdrawal of investment from the UK, or if it is caused by speculative bets against the Pound, then we would expect to see the trade deficit narrowing. I don't believe that this will prove to be the case, as the surplus countries still need somewhere to put their savings. If it is just caused by an expectation of weaker economic performance in the UK then there is no reason for the current account deficit to narrow.

Looking at the fall in the Japanese Yen caused by the monetary policy of the Bank of Japan (BoJ), we need to look again at the reason for the fall.

The important thing I want to say here is that quantitative easing policies should not much weaken the currency. In practice they have caused very large fluctuations (the USDJPY exchange rate at one stage went up by 65%), but I would argue that these are market over-reactions. The reason is that all QE does is to swap one form of savings (cash) for another (government bonds). To the extent that it reduces the real interest rate (It slightly increases inflation and slightly lowers the interest rate) it should have a moderate impact. But the size of the move in Yen was much to large for the impact of the actual  QE (as I said in February last year when I said Yen was the most undervalued currency in the world). As such, the move was largely driven by speculative flows, not fundamental changes in the value of the output of the two countries.

If hedge funds were building up short positions in Yen then this is a reason for a short term current account surplus, which will be reversed as hedge funds take opposite positions. The longer term impact would come from investment flows going out of Japan and into the rest of the world.

To find the sure-fire way to increase your net exports, one need look no further than the Swiss National Bank (SNB). The simple and reliable way to increase your net exports is to print your own currency, sell it and buy foreign currency with it. By investing in the foreign economy you are increasing your capital account deficit, thus increasing your current account surplus. This also involves a weakening of the currency. By directly investing abroad, this is the only method of the three discussed that definitely increases net exports relative to the baseline.

To summarise, a change in net exports can be approximated as a change in investment out of a country. Thus simply doing economically poorly will not increase net exports. Nor will making good products (people seem to think that Germany's surplus is because of the quality of their exports rather than their saving abroad) or engaging in QE. But direct investment abroad both weakens currency and increases net exports.

3. Does an increase in exports increase GDP?


In order to increase exports, more savings need to flow out of the country than flow into the country. This means that relative to the baseline scenario, more money needs to be saved. There are a number of ways to do this; by suppressing worker share of GDP, by use of tariffs, by use of sovereign wealth fund. But however it is done, this subtracts from domestic demand. It keeps consumer buying power lower. Looking at the equation above, if X goes up (C+I+G) must go down to compensate.

An artificially low exchange rate is bad for the people of the affected country. The goods they import cost  more and their wages are relatively too low for their productivity. Overall they consume and domestically invest less than they would have. It is good for exporting companies, however, who benefit from more sales abroad in domestic currency terms, and higher profit margins.

As such it is just a transfer from workers and other consumers to exporters. There is no empirical link between higher current account surpluses and higher real GDP growth.

4. So is there any point in a surplus?

There are some occasions when a surplus is appropriate. If you are a commodity producer, whose commodity is running out, there are two reasons to run a sovereign wealth fund. The first is to build up savings in other countries, claims against their future production, that can be spent when the commodity runs out. This smooths consumption so that you save when times are good and spend when times are not so good. The other reason is that it lowers the currency so that other industries become more competitive than they otherwise would have been. It helps to mitigate 'Dutch Disease'.

A small country that is not that diversified in its industry may also wish to build up a buffer in case of cyclical or structural decline in that industry. This is understandable and not too destabilising for the rest of the world.

Who should run a deficit then? This would be countries that are starting with a low industrial base, whose productivity can be largely increased by capital investment. By intelligently using capital, they can increase future productivity by enough to pay back the loans. Note that this should always be either in equity or domestic currency. Foreign currency loans are a disaster waiting to happen when downturn strikes.

5. Help, I have a current account deficit, what should I do?

This is actually a simple problem to solve for any country with control of their currency. The deficit is caused by other countries' savers investing in your economy, building up claims on your future production. In fact, most of these claims will never be claimed - savings have a way of just accumulating indefinitely - but you are feeling a bit uncomfortable about the situation where you owe so much.

All you have to do is

  1. Build up your own sovereign wealth fund whereby you print the equivalent of the deficit in your own currency and sell it to buy foreign bonds and stocks. This is exactly what the SNB has been doing. This lowers your currency to fair value and removes your deficit.
  2. Make up for the lost demand with a government deficit large enough to keep domestic inflation at target.
This is all. Philip Hammond, you're welcome. I doubt the advice will be followed though.

Saturday 20 August 2016

On Maths and Models

Every now and then a debate seems to flare up about economic models. A recent one started with Noah Smith arguing (in reply to Frances Coppola), that heterodox economics does not have the tools to replace mainstream economics. Steve Keen gave an excellent point by point reply about the mathematical quality of heterodox work. Then Frances also wrote a reply and then another, which  I agree with, pointing out that an understanding of the economy does not require maths. Where maths can be used to formalise this understanding, it is very useful. But economics is not a mathematical equation.

I say this from the point of view of someone with a PhD in mathematics, but whose job is to predict the behaviour of systems, specifically financial systems. And I know that in describing a system, parsimony is king. One should use as much maths as is necessary and not a bit more. The more complex the maths, generally the worse the predictive power.

The economy is a very complex system. It is non-linear with a huge number of unknowns. For this reason prediction is difficult. This seems to have meant that any degree of poor prediction is excused on the grounds that no-one can predict the future. I recommend everyone read this excellent Noah Smith blog post from 2013 which was only let down by the somewhat cowardly conclusion.  It shows DSGE models are not useful as predictions - he points to this paper showing that DSGE models are no better than simple univariate autoregression (AR) models at predicting inflation and GDP growth. Bearing in mind AR models are just simple mean reversion models this is a pretty categorical failure. He then argues that they are neither good for policy advice nor even for communication of ideas, before concluding that we should continue with them as the are the 'only game in town'.

Saying that the economy can't be predicted because it is too complex and no-one knows the future is a big cop out for me. No-one could have predicted with any degree of certainty that the global financial crisis would happen in 2008. This is because it is impossible to predict the timing of events of this nature that depend on triggers and positive feedback loops. It also depends on policy reaction. For example, a possible crash in China early this year was averted by a large government spending programme. But what heteredox economics has done is give keys to understanding the nature of the economy.

If we know that a crash is going to come if we let private sector debt build up, then we will try to reduce the build up of private sector debt. If we know that government debt is benign, then we will use that to grow the economy rather than private credit, share buybacks and house price rises. We don't need any maths to understand this. As I said in a tweet, in my opinion the main thing maths has given macroeconomics is the ability to be more precisely completely wrong.

Defenders of the economic orthodoxy generally say that they understand that their models have not done the best in the past, but that they are flexible so can be adapted to include whatever you want. This is sort of true, but to start where they are starting from is insane.

As a builder of models I would like to humbly offer this advice to macroeconomists about building a model to describe the economy. I have made my own attempt here, and obviously I think it is a pretty good description. But in any case, I would advise the following:

How Not to Build a Macroeconomic Model

1) Microfoundations: Would a pollster make a prediction for an election based upon what they thought each rational voter should do, and building up to the whole population assuming they all think independently? Of course they wouldn't. They model it by asking people and then using known relationships between people you ask and the population as a whole. There is no reason whatsoever to model the economy as individual independent rational agents and in fact it is completely incorrect to do so. People do not behave independently and the aggregate must be modelled not the individuals.

2) Rationality: Why would you assume rationality? It is completely unnecessary and also completely false to suggest that people act rationally at all. It is certainly false to assume that rationality includes perfect knowledge of the future and that Ricardian equivalence holds. All assumptions about peoples behaviour should be testable.

3) Loanable funds: It is completely wrong to model money as if there is a finite amount of it that is simply loaned by more patient people to invest. Banks create credit, corporations and governments issue bonds. This expansion of the money supply allows growth to happen. And also can create instability. Any model that misses this out will be unable to describe the economy correctly.

4) Interest rate effects: interest rate cuts boost the economy through two main channels. First, they increases the amount of private sector debt, meaning more money in the economy. Second they boost asset prices, because lower interest rates (increasing bond prices) and reduce the discount rate for risk assets thus making their price rise.

The problem with loanable funds is that if interest rates are cut, it means all growth in spending must now come from rational agents choosing to spend more of their income rather than save - the 'rational' logic being that they will save less if they get less interest as it means future consumption is higher (and their target is to maximise their utility from consumption). As Eric Lonergan argued recently there is not even any evidence for this. One could argue that if people save for a target then the opposite is true - lower interest rates mean a rational person saves more. Any model needs to correctly account for why changes in important variables work. Being wrong about this particular one has led to a spectacular build up in private sector debt over the past 40 years.

5) No financial sector: the growth of debt has led to a huge increase in the size of the financial sector. Or maybe partly the other way around. Whichever it is, there are both distributional impacts and stability impacts. The instability is very well covered by Steve Keen with his Minsky model. The distribution impacts are looked at in my paper but involve interest payments going from those with a high marginal propensity to consume (MPC) to those with a lower MPC. Also included in this could be the increase in corporate profits as a share of GDP - something that has the same effect. The instability and inequality must be a part of the model or the economy can not be properly understood.

What does this mean? 

Yes, it may be possible to adjust the current models to include all of these things, but really why bother to try? The difficulty of trying to adapt a completely inappropriate and incorrect model to reality is much higher than simply starting again. And the starting point in my view must be a stock flow consistent money approach as pioneered by Wynne Godley.

Addendum: Noah Smith replied to a few responses to his post, including this one and he made a fair point. In criticising microfoundations, I am apparently also ruling out agent-based models. I am not meaning to do this as these types of models, where individual agents interact with each other, are excellent for studying the emergent properties of certain systems. If I could divide economic modelling into two separate themes, it would be 1) models used for short term prediction (these should be as simple as possible) and 2) models used to help understand the system. Into category 2 would fall Steve Keen's Minsky model and as well as these agent based models. I think that Smith is right that one day the type 2 models could become type 1 models. Unfortunately standard mainstream models are of neither type.

Also, he is right that the Financial sector is something that should be included so doesn't really fit under the heading. So I have changed the sub-heading to to 'No Financial Sector'.

Monday 4 July 2016

The Incalculable Cost of our Aversion to Government Debt

I was speaking to Tom Streithorst at the FT Festival of Finance last week and he was pointing out that almost every single person there knows that the government needs to run larger deficits and invest more. But what we don't know is how to get that idea into the public consciousness. The public, by and large, along with the departing Conservative administration, see the government budget as like that of a household. One should not live outside of ones means, the argument goes.

It came to me that if I were forced to choose just one thing that I wish could be conveyed and understood, it would be that in a sovereign money state (a state that can print its own currency) the size of the government debt is more or less irrelevant.

Why is this? Simply speaking, a government can print its own money, through its central bank. The government produces money so it can never run out. It has no need to ever default. Assuming that the buyers of bonds have confidence that inflation will not devalue their savings, the government can always borrow to pay the interest and to keep spending. And in the last resort, the central bank can buy the bonds. Markets know this, which is why the interest rate on 10 year UK government debt fell below 1% per year after Brexit. Time and time again, the market proves that credible sovereign governments can borrow as much as they want at a reasonable rate; Japan being the obvious example with over 200% government debt to GDP (note that this is not true in the Eurozone, where the governments negligently gave away their necessary central bank functions to the ECB and now effectively borrow in a foreign currency). Frances Coppola actually argues that more government debt can be actually better than less because it allows savers safe assets to put their savings into.

Does that mean that the government can spend anything it wants? Absolutely not. There is a real resource constraint. In the end, the available labour in a country must be allocated somewhere. If a government, for example, spends more on the NHS then it must take labour from elsewhere. If the government spends too much money overall, then wages will rise and, in turn, so will the price of goods and services; we will get inflation.

But there are two important points here. The first is that the constraint on government spending is only the constraint on inflation. If domestic inflation is under 3% then, although one could argue that the government mis-spends (eg. too much on defence and not enough on education, or that it should spend less and tax less), one should not (in my opinion) argue that the government is running too large a deficit. Whatever deficit exists is a necessary deficit because it keeps enough money flowing through the economy to keep economic activity running smoothly. This idea is explained in more detail in this post.

If one accepts that the size of the debt doesn't matter assuming bond buyers are confident that the government keeps its inflation credibility, then it logically must follow that hitting the inflation target is the right level of borrowing.

Some people worry about huge inflation in the future if we keep borrowing. All this money is produced, they argue, so when people decide to spend it, it will cause hyperinflation. This is to misunderstand what is happening.

The economy is structurally saving money every year due to a large share of the product of the economy going in dividends, rentals and interest to people who save most of their income. A shrinking share is going in wages to workers who spend most of their income. For more money to be spent, this structural shift will have to reverse. This is a very slow process. Hopefully this shift will happen, and at that time the government can reduce its deficits and possibly one day run a surplus again. But there can not be a sudden change where everybody decides to spend all of their money. A possible exception to this would be if everyone expected hyperinflation, but certainly it will not happen if the government keeps its credibility regarding inflation.

The second point is to do with productivity. It is not a zero-sum game. At the aforementioned FT Festival, there was a panel discussing the productivity puzzle, or why productivity has declined. Typically all sorts of reasons can be found, from demographics to the fact that many services are now free (like Wikipedia) which do not show up in GDP. All of these are valid, but at the same time we have great hubs of technology and our world networks are more connected than ever before. Information spreads faster than ever and thus so should the rate of progress. I can't believe that all productivity improvements have been given away for free.

But regardless of what I think about this, I would like to ask you to look at the below graph (from this post on the UK productivity puzzle). It can be clearly seen that productivity, far from slowly declining, was all going well until 2008. Then, suddenly, it stopped. Did suddenly everything become free in 2008? Did everyone become old in 2008? The only thing that really changed in 2008 was that we stopped sending enough money around the system. First with the financial crisis, and then with the austerity imposed.

The gap between where we should be now and where we actually are is huge. The economy could be producing 15% more now if we kept up the trend. I was speaking about this to Steve Keen at the weekend and neither of us can see any reason why, given enough money to keep demand up, the productivity of each working person in the UK should not keep smoothly rising. If there is enough demand, enough money running through the system, then wages will go up and businesses will invest in new technology that increases productivity. If demand is low and wages are low, there is no point in investing in improving productivity. The fact that productivity is so far below trend is a failure of government.

Even now, the technological improvements have happened and a period of sustained investment in the newer technology should see considerable catch-up growth without high inflation.

The departing government claims great success with the economy, citing the lowest unemployment rates in years. But they did not create jobs by increasing demand for labour. They created jobs by a carrot and stick benefits policy forcing people into work at the bottom end of the market. They kept up demand by using monetary policy (lower interest rates and Quantitative Easing) rather than government spending, which gave money to asset holders but not workers. I talk more about why using monetary policy is so bad here. Thanks to austerity there is both a non-growing pie and workers receiving a smaller share of it (due to austerity forcing interet rates down).

So there is low demand because of low government spending and high supply of labour because of benefit sanctions.

The inevitable result of this is a low wage economy. This can be seen in the graph below (not the easiest graph to read, I admit). What it shows is that whilst Gordon Brown's economy pushed wages up and produced jobs above the living wage, the Conservative government actually greatly reduced the number of jobs above the living wage and created millions of jobs below the living wage.
This actually further exacerbates the problems of the economy. It is the reason why Osborne was never going to hit his deficit target. But worse than this, it creates an underclass of millions of minimum wage earners who are struggling to get by.

Even without the help of a scaremongering press and irresponsible politicians, it is not hard for the people on the low wages to make the link between their low wages and rising house prices, and the incoming immigrant population. In 2005, when there was a peak of immigration, wages were still rising. Not so this time. The difference; in 2005 there was enough money flowing through the economy that productivity was rising and wages were rising too. Since 2010 this money has stopped and wages have stagnated.

This is not to talk about the shutting of youth clubs, the cutbacks to education, the university tuition fees leaving our young with large debts, the rising house prices (a consequence of the lower interest rates because of the shrinking growth) and (because house prices are unaffordable) rents, the closing of libraries, the cuts to charities, the struggles of the NHS that is underfunded enough for the Leave campaign to put it on their battle bus.

The economic damage of austerity in the UK is calculable. I would put it at around 15% of GDP. That is to say that we would be 15% richer if productivity growth were to keep going as before. 

But the social damage. That is going to show up in the years to come. The EU referendum highlighted some of the divisions in society. As long as policy is run for the benefit of asset holders and the detriment of workers and the young, the discontent will, I fear, keep rising.

And a sobering thought is that the UK has not suffered the worst of the austerity by a long way. The austerity required by Euro membership is much worse than that in the UK. The Brexit vote is childs play compared to what will happen in the economically less competitive parts of the Euroland.

Thursday 2 June 2016

Rents and GDP

In my (even if I do say so myself) excellent paper on our current economic predicament, available here, I briefly discuss the problems with including housing rentals in GDP.

When a building is built, the construction should add to GDP. This could count, for GDP purposes as consumption, or could be considered an investment and depreciated over several years of consumption. One house is produced, so the construction cost of one house should be added to GDP.

Instead what happens is on construction the house counts as investment and is added to GDP. Then all future rental paid (minus depreciation) counts as consumption and is also added to GDP in addition to the original building cost. This extra addition to GDP is simply the payment of a royalty to the owner of the land due to a state given monopoly right over this land; a transfer of wealth from non-landowners to landowners. It is not indicative of any productivity and should not count as the product of the country.

I argue below that since 2008, the fact that rental prices have gone up has led to a misstatement of real GDP growth. The official figures have total nominal GDP growth at 22.7%. I argue that a more correct value is 19.6%. In other words 2.9% of the UK's GDP recovery since 2008 is an accounting trick. In real (rather than nominal) GDP terms this means maybe a quarter of real GDP growth since 2008 is illusory, and a product of the transfer from those without property to those who own. All that had happened is that the royalty payments paid for use of land have increased. There is no increase in production.

The idea of imputed rents shows how ridiculous it is. If I buy a house, built 100 years ago, then should my simply living in it count as a part of the product of the country in this current year? If rental prices across the country go up does that mean that my house is producing more? It is a stock, not a flow. And yet by my simply living in the house, the imputed rent is added to GDP.

Why is this a problem? Because increases in rental payments are actually detrimental to production. As I discuss when talking about Osborne's zero probability of hitting his deficit target, rental and interest payments drain money from workers and those with a high marginal propensity to consume, and give to those with a low marginal propensity to consume. As described in this article, an economy paying high rentals and high interest payments, especially one where the corporate sector is able to pay high dividends, will much reduce disposable income to those who spend.

The reduction in demand for real goods and services actually genuinely produced in the economy is a natural consequence of an economy that pays too much to savers and not enough to workers and others who will consume more. And when rental payments are included in GDP, this is hidden.

What is the consequence of this? Using OECD figures (HT NEF), one can see that rentals in the UK have risen a lot recently. While the economy has nominally grown around 23% since 2008, rental payments have gone up by 53%. Rent and imputed rent is now 12.6% of GDP even though nothing is produced. In 2008 this figure was 10.2%. In the 1990s it was 8-9%.

And this means that an economy that has actually nominally grown by 19.6% in terms of productivity has official nominal GDP growth of 22.7%. While those who don't own property are being squeezed, the economy looks like it is doing OK thanks to the rent extraction that is actually damaging the economy.

Note that real GDP has only grown 8%.  Without knowing the construction of the inflation basket it is difficult to be exact, but it is possible that over a full quarter of the real GDP growth since 2008 comes only from rental increase.

This, in my opinion, is something that should have more attention.

NOTE - I previously wrote that counting housing as investment and then consumption is double counting. But thanks to Diane Coyle (who wrote the excellent book, 'GDP: A Brief but Affectionate History') for pointing out that housing investment is depreciated, so it is not officially double counting. However, the cost of depreciation is much smaller than that of the rental payments.

Thursday 26 May 2016

The Problem with Ever Freer Trade

Those who keep a keen eye on the news may have noticed recently that Donald Trump is doing very well in the US Presidential election. It has been suggested that part of the reason for his popularity is that he gains the support of those in the United States who feel displaced by the forces of globalisation; those people who lost their jobs or get lower wages due to competition from lower wage economies.

The standard defence of globalisation and free trade is that it means that everyone works where they add the most value and in sum everyone ends up better off. Total productivity of the world economy is higher because everyone concentrates on their specialisation. When I say 'defence', it is not really a defence as there is not really an attack on this theory - it is so standard and accepted by economists.

But the rise of Trump has prompted some very interesting challenges to the standard dogma. This one, by Daniel Altman, is particularly good. It points out that although globalisation may be good for everyone in general, giving cheaper goods and more choice, it is not good for everyone in particular. If your industry can be outsourced to China and most people in your city work in that industry, and further if you have 30 years experience in that industry and not that many transferable skills, globalisation is undoubtedly bad for you.

So the question becomes; if globalisation is better for everyone then why can't the people who do benefit the most share some of their proceeds with the biggest losers-out? Why are there not big retraining programmes and support for industry in areas that have been damaged? Well, this goes against the prevailing idea that the free market is the best arbiter. It also goes against the idea that if you tax people too much then they lose incentive. The beneficiaries would say that if we support the losers then we are distorting the free market, we are subsidising inefficient industry and this will end badly. We are actually doing them a favour by leaving them alone to find a new niche. And also I earned this money with my hard work, so why should I pay for others who aren't producing.

Free trade does bring down prices but also hugely increases competition for labour. It is arguable that although globalisation has indeed made us all richer, in the higher income countries it has particularly made shareholders richer because wages have stagnated relative to economic growth. This exacerbates inequality, and reduces demand in the economy. This is one reason why governments need to run such large deficits these days.

I think that the free market is an incredible thing. I think it has brought wonderful variety and happiness into people's lives. I am very much in favour of a free market - but only up to a certain point. The reason is that the free market is a very short term efficient arbiter - but it has no long term view.

And free trade, up to a point, is undoubtedly a wonderful thing that has brought great success to our economies. But being a great thing up to a certain point does not necessarily mean that more of it is even better. One steak for dinner is amazing. Two steaks are arguably better. But the marginal utility of the third steak is very likely negative. This is what I feel about free trade - it is a bit like having steak at dinner - one or maybe two are great. And that anyone arguing against free trade is laughed at like someone arguing against steak. This post, which develops a theme from my last post on Brexit, questions whether ever freer trade is indeed an ideal.

This post is not really about the question Altman brings up about distribution within a country of many industries such as the United States. It is more about the idea that an individual country is best off specialising in a small number of fields of major competitive advantage. I argue that completely free trade, without fiscal transfers to the countries that lose out, is not optimal. Altman makes the same argument but for people rather than countries.

To begin, I wish to show the graph that I put into an adendum to my last post; it is a graph of the real GDP growth of High Income countries vs that of EU countries. Now, if the freer trade provided by the EU has had the great economic benefit that most economists say it has, we would expect the EU countries to have grown more than their high income equivalents:
As can be seen from this graph the growth was pretty much exactly the same until 2008. That is to say that the freer trade from being a member of the EU either had no benefit or it was offset by something else. After 2008 we can see the EU lag the rest of the High Income world thanks to the impact of the Euro and policies associated with it.

This paper looks at the impact of tariffs on growth and finds that, while there is a statistically significant worsening of GDP for higher tariffs for richer countries, the size of the effect is pretty small - maybe in the order of 0.1 or 0.2% of GDP per year for pretty large changes in tariff levels. It actually finds that, if anything, poorer countries do better with higher tariffs but this is not as statistically significant.

The conclusion I reach here is that after a certain point, the benefits of even more free trade are not large enough that we should ignore all other consequences.

The next thing I wish to look at is what makes a desireable industry. Free trade forces specialisation and countries don't often get to choose what industry this is in. For example, a country with abundant natural resources will be forced to specialise in this because the sales of these resources raise their exchange rate and make other industries less competitive. In the UK, the location between Asia and the US, the laxer regulation, as well as the fact that English is the world language of finance, meant that the UK was, in a sense, forced to specialise in finance. If a country has a strong military, then defence companies from that country, boosted by contracts from their government, can gain a competitive advantage in that field. The historic tradition of fine watchmaking gives Switzerland a competitive advantage in that it can charge higher prices for its watches.

So what sort of industries would you ideally like your country to have? For a start, you would want those that are not too cyclical. Countries with natural resources are often described as having 'Dutch Disease' because the uncompetitiveness of their other industries mean that all investment goes into the natural resource extraction. When the economic cycle turns against these commodities, the country is left with loss-making businesses and no fall-back. Specialising in cyclical industries is not necessarily in the best interests of any country.

The sensible policy for a country with natural resources is to set up some kind of sovereign wealth fund. This has two benefits. The first is that you have built up claims on the future work of those in other countries. When your resources run out, or the cycle turns, then these can be cashed in - it provides stability. The second is that it keeps the currency lower meaning that other industries are not as uncompetitive.

There is another type of industry that a country should preferably avoid, and this is an industry that accrues the benefits to a small number of people at the top. The reason for this is that it has a similar effect to running a current account deficit.

As a thought experiment, imagine I made an app that I licensed to an American company for £10bn per year. It all goes to me. What would happen? Well, for a start, I would get a lot of commendation for my helping UK exports. If I gave enough in donations I might get a knighthood for services to British industry.

But what does that £10bn do? It raises the £/$ exchange rate. This makes other industries less competitive. Think of the following identity: exports minus imports equals the trade balance. For simplicity let's assume no other flows and so that the trade balance and current account balance are the same. Now the current account balance would be unchanged, as the current account balance is equal to all the savings foreigners have put into the UK, and there is no reason for this to change. This means that my £10bn must be counteracted by £10bn of a combination of more imports and fewer exports.

Since I am unlikely to be able to spend much of the £10bn, the effect of this is similar to an extra £10bn of current account deficit. This means less demand in the UK economy, and unless counteracted by higher government deficits, more unemployment in the UK as a whole. An industry that gains exports but shares those gains between a few people who don't spend it in the economy is not a great help to the economy as a whole.

So the ideal industry is non-cyclical and shares the proceeds between a large number of employees. But there is one other target here; we do not want any industry to be too large - we would like a diversified industrial base.

A diversified industrial base means that as industries die or as economic cycles turn against them, there are other industries that can take the slack and provide support for those who have lost out. A specialised industrial base may well provide the highest overall return for the economy, but, like an undiversified share portfolio, will be a lot more volatile. And volatility for an economy is undoubtedly bad.

Central planning of an economy, deliberately putting resources to help certain industries, is much sneered at by those who believe in the free market. But in the end, the countries that don't plan their economies are left with the industries that those who do plan don't want.

With this in mind, we can look at how the economy in the EU with the freest trade has fared; by which I mean the UK. Well, by avoiding the Euro, it managed to avoid a particularly poisonous bullet that could have caused huge damage after 2008. It is a country of great variety of consumer choice. Living in Switzerland, a country with relatively high trade barriers, I now really appreciate how much choice there is in UK supermarkets and in terms of eating out and other entertainment. But I also see in the UK an economy where wages have been driven lower and lower relative to GDP and rentals higher and higher. 

I believe that of the problems in the UK are due to belief in the infallibility of the free market. That bad long-term economic decisions were taken but seen as good ones because private sector debt kept on rising and these problems were disguised by this hidden stimulus. Industries, like manufacturing,  made uncompetitive by a concentration on eg. finance were discarded as being not fit enough to survive. The South prospered, the North not so much. The owners of capital prospered, the workers not so much. But overall this idea held that we are all (as a whole) getting richer.

Is there merit in some sort of economic planning, some sort of help given to certain industries? In my opinion there is. Should tariffs be higher to protect them, maybe that is a good idea. I am not suggesting picking winners per se, maybe more just supporting industries that are almost there. My argument is that a country is better off with a diverse range of largely uncyclical industries, preferably those with a more even distribution of winnings. This is more desirable than the unplanned, short-term, profit maximising model that the UK has followed.

Wednesday 20 April 2016

On the economics of Brexit, and an argument that the UK would have been better off outside the EU

The UK Treasury recently published a report detailing the costs to Britain of leaving the EU.  It has been generally praised by economists, who take it for granted that the economics of Brexit would be bad for the UK.

I have a problem with this report, and actually I have a problem with the assumptions that are taken for granted and underpin it.

I would like to make clear that I think that it is very likely to be better for the UK economically to stay in the EU. I think that the risk of disruption on Brexit would be large, that regulatory changes would cause extra work and that investment would suffer under the uncertainty of the future regime. Financial services, for example, could be damged by the change in jurisdiction. A vote to Remain is the safe vote and sensible vote. However this does not mean that one should take for granted that the long term result of Leave would be detrimental.

Reading through the Treasury report, the first thing that struck me was the one sided nature of the language. Facts are cherry picked. Examples of damage to the UK are constantly given, along with the advantages for future growth of the Cameron negotiated settlement, which would be lost if the UK left. But nowhere is the opposite side given. Most consequences have winners and losers, and the Treasury is only listing the losers.

As a small and trivial example, at one point it talks about the possible end to Duty Free. It describes how UK consumers will no longer be able to get cheap alcohol when coming back from holidays. This is undoubtedly a bad thing for alcoholic British holidaymakers, but actually this is also a good thing for UK retailers who can now sell the alcohol at home. It is also a good thing for the UK Treasury which receives the extra duty. The one sided nature of the analysis is apparent throughout the whole report.

As a larger example where consequences are less obvious, consider the following hypothetical scenario. Brexit causes an increase in financial regulation in which half the finance industry is lost. UK GDP would go down by around 5% as this contributor to GDP was lost. However, this is not the whole story. What do the bright, educated people who lost their job in finance do next? Eventually they find other jobs. How much of that loss of production is replaced by the financiers now working in other industries? This is far from clear, but it is wrong just to focus on the 5% figure. The Treasury approach appears to be to focus on the definite negatives without taking account of the compensatory positives that an economy does in adaptation to new conditions.

In the late 1700s and early 1800s, the UK had a problem, in that it very high wages relative to the rest of the world. If a Treasury report had been made into these high wages it would undoubtedly have pointed to this source of lack of competitiveness and suggested ways to reduce the wages in order to compete in the high labour intensity work that characterised the world economy at the time.

But what happened instead? The combination of high wages with low coal costs combined to make the early stages of the Industrial Revolution financially viable. The high wages in the UK meant that Britain was the first to industrialise and became the largest economy in the world. But this could never have been predicted just from looking at the high wages in 1790.

The point I am trying to make is that the economy adapts to new scenarios so using theoretical models does not necessarily help to illuminate the reader.

The report states, with well defined error bounds, that the expected loss to the average household in the UK in the case of a negotiated bilateral agreement is around £4,300. It does not take into account disruption here, and is based on the lost benefits of free trade, free movement, joint regulation etc. My first thought is, how can I test if this makes sense.

A simple common sense one: A 10% increase in tariffs across the board is equivalent to a 10% stronger pound for exporters. Since pound has gone both up and down by more than 10% in the last few months without dire consequences, this strikes me as not of huge significance.

If the Pound were to go down by 10% on Brexit due to withdrawal of investment from the UK, with tariffs rising by 10% at the same time, then exporters would be no better or worse off than before. Imports would be a lot more expensive and the current account would go into surplus instead of the current constant deficit. The floating exchange rate would cushion much of the economic impact - the UK would be poorer but  a) not in Pound denominated terms and b) only because it would be paying back some of the money it has been borrowing from the rest of the world.

I looked for empirical evidence of the effect of higher trade barriers on growth. I found this interesting paper. It suggests that for poorer countries, higher tariffs are, if anything, beneficial. For richer countries they are detrimental, but the size of this effect is nowhere near the sort of effect the treasury expects, and is of the order of 0.1% or 0.2% per year.  George Osborne has single handedly, through his policies of austerity cost the UK at around 1.5% per year in my opinion. Which puts Brexit at approximately 10% as damaging as Osborne.

The next test I did was to look at UK real GDP growth relative to the United States. In the period between 1946 and 1973 the UK grew at an annualised rate of 3.2% compared to the US at 3.7%. After joining the EU what would one expect? Could there be catch-up where the UK grows faster than the US? Maybe it just grows at the same speed. At the very least it should keep the same gap between the growth figures.

In fact the gap widened. In the period from 1973 to 2014, the US grew at 2.7% annualised, with the UK in the European Common Market growing at only 2%. This is extremely disappointing especially given all the clear and obvious stated benefits of free trade in the EU.

I know that this is one number and there is a lot more to it than that, but it is a pretty important number and surely this should warrant further analysis to explain why if the common market was so great, we've actually had a relative reduction in growth.

I would like to propose a possible reason for this, and once again it comes down to the unexpected consequences I describe above, and the adaptation of economies to underlying conditions.

Why is free trade good? Because it allows specialisation. If one country is slightly better at making cars and another is slightly better at making motorbikes then, if the two countries have free trade, one can concentrate on making only cars and the other on making only motorbikes. This means that between the two countries they maximise the production of cars and motorbikes, and both end up cheaper to the end consumer.

If tariffs existed, then both countries would produce both cars and motorcycles but not as efficiently as they would be partly working on something that they are worse at.

Where could there be a flaw here? Well, there are no fiscal transfers between the two countries. So supposing motorcycles go out of fashion and no-one buys them. Motorcycle country now has no industry and will have to start a new industry to replace it. This takes time and involves unemployment and retraining. The floating exchange rates between the two countries softens the blow but it is still painful.

If both countries had tariffs then the pain would be shared. If both had been part of the same country then money from the car producers could go to help the motorcycle producers. But free trade with no fiscal transfers means that each country is at risk from the specialisation it ends up having being out of fashion.

This is a general argument against free trade, but specifically I think that his may have hurt the UK in the following way.

The UK has a highly educated workforce, speaks English, has low financial regulation and sits in between the US and Asia in terms of time zones. It is the perfect combination for a financial centre. The UK thus has a competitive advantage in financial services and it brings a great deal of export revenues into the country from selling these services abroad.

That sounds great, but actually maybe it isn't. The success of financial services means that the UK Pound rises in value. This means that UK manufacturing, for example, now becomes less competitive against other countries in Europe. Because there are no tariffs there is nothing to stop UK residents buying their goods from Germany and services from the UK as this works out cheaper. Had there been tariffs then Germany would have done more financial services and the UK more manufacturing.

The result of all this is that the UK ends up specialising in financial services more than it otherwise would have done as other industry atrophies due to being uncompetitive. Other EU countries specialised in other industries - and ones that in fact are less cyclical and with more durability.

In 2008, the UK paid the price for specialisation in finance. Finance means high leverage. The cost to the UK people of the finance industry was very large. And then larger than this, the cost of the policies of austerity which followed damaged the UK economy significantly.

I am a big supporter of immigration, but another possible way that EU membership may have damaged the UK economy is through freedom of movement bringing down wages in the low skills end of the market. Traditionally economists would say that this is a good thing. But what if the low wages meant that (in an opposite way to the high wages 200 years before) low skilled jobs were not automated. People are cheaper than machines and hence productivity is damaged. High wage economies have higher productivity. Maybe if the UK had more regulation and less immigration we would have had productivity as high as our European counterparts.

So maybe EU membership and free trade actually damaged Britain. These are just musings; counterfactuals are always impossible to be sure of. But what is definitely true is that the economy adjusts to things in unpredictable ways. Low wages may be good or bad. High tariffs may be good or bad. Leaving the EU could, for example, result in the UK becoming a powerhouse in high end technology. Or could result in a £4,300 loss per household. We just don't know.

So, in conclusion, what happens if the UK leaves the EU?

I don't know but I do feel that it definitely can't be summed up in a report with definitive numbers and precise error bounds.


It is often stated that EU membership has provided great economic benefit. Most major economic institutions support this theory. However, there is no paper that I have read that has adequately shown this.

As an example, Chris Giles, in the FT, points to this paper which he calls an example of 'the best economic studies'. It states that the UK is roughly 10% better off than it would have been outside the EU. This paper bases its conclusion on two types of model.

The first is a gravity econometric model that looks at the increase in trade and assumes economic improvement. In my opinion, when increased trade and increased GDP are not proven to be causally linked this model based approach is not enough.

There is little doubt that for a small isolated economy, an increase in trade will on average improve economic growth. But does this effect continue indefinitely? Is it not possible that after a certain level of trade, further increases do not improve economic growth?

A better way is to look at actual results and compare to the closest comparators. This is the approach of this paper, also cited. This would be a very valid approach, however it appears that the data period is cherry picked, ending in 2008. This both removes the effect of the Euro crisis and also, as it measures growth as GDP in US dollars, it stops at a time when the Euro was at an all time high against the dollar. It makes the growth of Euro and £ economies look higher. Also, the estimate is very dependent upon the choice of comparator country weights.

To test if this paper is valid, I did my own test. I looked at real GDP growth for ALL EU countries against ALL high income countries using the world bank database. This is a real aggregate test, that does not allow any cherry picking.

The graph is below.

You can see that up until the Eurozone crisis, EU economies grew exactly in line with other high income economies. There is no discernible benefit from having an increased freeer trade zone. The only difference comes when the Eurozone crisis hits when, for reasons I discuss here, Eurozone countries underperform.

To everyone who says what a great economic boost it has been to be in the common market, I would ask them to explain this graph.

Incidentally I did ask this to the author of the paper above. But received no reply.

As a final aside, there is one major benefit that the UK does receive from being in the EU. It is that it does not allow the more libertarian UK politicians to erode worker rights and opt out of anti-discrimination policy.

The free market is a great thing in that it means that more gets produced of what people want, and less of what they don't want. But when it pushes down wages and increases corporate profits, as well as leading to a rise in corporate and individual debt, it becomes a damaging system. The UK has long been a major proponent of the more laissez-faire ideal of the free market and this leads to an unbalanced and hollowed out economy.

For this reason I think the UK is probably be better off in the EU. But it is definitely not due to the fear of job losses, interest rate rises and even war invoked by Osborne, Cameron et al.