Economic Common Sense

Popular opinion is not a good guide to economic effectiveness. In an article published by Left Foot Forward on 11 April 2017 I tried to point out that many of the ideas we find in political discourse of economic policy are wrong.

We need to free ourselves from the received ideas of the neo-liberal period if we are to design economic policies that work.

Labour needs a bold economic policy that’s electorally credible and effective in government

Labour’s economic policy needs to be both credible in an election and effective when in government. What if policies cannot be both? Sometimes the policies which will work best in practice do not chime with the common sense economic of the electorate.

Popular opinion is not a good guide to economic effectiveness. As JM Keynes said:

“Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.”

The common sense economics of practical men and women today derive mainly from the neoliberal ideas which have dominated recent decades. Such ideas are not yet defunct but in the 2008 crisis they were fatally wounded.


Policymakers whose views were formed in this period may believe that floating currencies, independent central banks, open capital accounts, inflation targets and fiscal rules are the essentials of economic success. In fact, they are the economic institutions of one period of history which may be superseded in the next.

To design effective policies, we need to free ourselves from the common sense of practical people and listen to the insights of more than one school of economic thought.

Common sense tells us that wages are a business cost which competitive firms aim to minimise, that the productive economy generates the income to pay for public services, that saving is always good and inflation is always bad, that a firm’s only duty is to its shareholders, that people are paid what their work is worth and that exports make us richer.

All of these propositions are debatable, some are just wrong.

Classical economists (Adam Smith and those who followed on) believed that labour was the source of a nation’s wealth. Rather than seeing workers as a cost to enterprise we should understand labour as the key resource and public policy should support giving workers the skills, equipment, and infrastructure to be as productive as possible.

When statisticians compile GDP figures they do not subtract the cost of hospitals, schools and police stations from the total. The value added by public services is an integral part of the estimate of national income or GDP. Public services are not a cost to the economy but a contribution to the nation’s prosperity.

Household savings we think are sensible whether it is for unforeseen events or future indulgence. However, when firms save rather than invest their income, the economy slows.

This was Keynes’s key insight. A nation’s income is equal to the demand for consumption goods and the demand for investment goods. If investment falls then so does overall income. When private investment is low public investment should rise. Governments need to rediscover the importance of effective demand and the techniques of demand management.

Keynes also pointed out that as incomes rise more is saved. Wealthier people save a higher proportion of their income. This is one reason why rising inequality leads to slower growth. If a higher proportion of income goes to richer people who then save more the result is lower effective demand.

A large part of Adam Smith’s most famous book is devoted to refuting the idea that countries grow rich on exports. To the classical liberal the purpose of exports is to pay for imports and the purpose of production is consumption.

Some countries repress wages to encourage exports, not realising that they are sending more of their output to be consumed abroad while denying consumption to their own workers.

Lessons on the true value of exports are available from the economics of development. Countries which have industrialised successfully used exports to provide a market for their new industrial production. Countries which export low value-added goods have failed to develop. The trick is to use exports to support an industrial policy which seeks to expand high productivity sectors of the economy.

Sometimes evidence is more important than theory. For example, empirical studies have shown that inflation at low levels is beneficial for growth. Up to about five per cent more inflation correlates with higher growth. Above eight per cent the negative effects set in. Governments should be cautious about setting too low a target.

We need to free ourselves from the common sense of neoliberal era to design effective policies. At the same time policies must be soundly based on economic theory. The difficulty is that while the old idea is dying no new framework has yet gained ascendancy.

If Labour is to offer a different vision for its economic policy it needs to be eclectic, taking insights from Keynes, the classics, development economics and empirical economics.

Such a vision would lead to a policy which put working people at its heart and aimed to provide the investment in skills, infrastructure and capital to increase their productivity. It would recognise the need for higher wages to incentivise investment as well as to support demand and reduce inequality.

Its macroeconomic framework would take account of demand as well as supply. Its industrial policy would seek to expand the proportion of high value-added sectors in the mix and see trade policy as a means of supporting industrial strategy.

The Risks of Leaving

I've expressed my scepticism about the predictions of dire economic consequences resulting from the decision to leave the EU. It will be bad, but not catastrophic.

That does not mean that there are no risks of a major impact on the economy. Just that to see the risk we need to look elsewhere than the macroeconometric analyses that get attention. The problem lies more in industrial structure and the unpredictable consequences of adjustment.

I explain this in more detail on Left Foot Forward.

Time Is A Great Healer

There is a little too much pessimism in the Labour Party right now. The problem is that the party seeks to represent both Remainers and the "left behind" who voted Leave. The party is at risk of being squeezed between a Lib-Dem revival hoping to grasp the mantle of the 48% and UKIP targeting working class voters.

If the election is not held until 2020, then will Europe still be the dominant issue?
I think not and I said so in this piece on Left Foot Forward.

https://leftfootforward.org/2017/02/brexit-wont-dominate-politics-forever-and-that-gives-labour-reason-to-hope/

Recession? What Recession?

I've been puzzled that so many of my friends and comrades are expecting an economic catastrophe to follow the referendum to leave the EU. I've written before about how the long term cost of EU exit will not make itself felt as an obvious disaster. Part of the reason for the continuing expectation of some kind of immediate economic shock comes from the exaggerations made in the referendum campaign that a Leave vote on its own would be damaging.

I've taken a look at the predictions of a recession following the referendum result. What I've found is that the memory of a consensus among the experts is false. On the whole there were not the universal forecasts of recession that we think we remember.

I wrote up the detail in an article published by Left Foot Forward on 14 February 2017.

Did the experts really predict a post-Brexit recession?

There was a moment after the Iraq war when we were waiting for the allies to uncover the weapons of mass destruction stockpiled by Saddam Hussein. While the generals asked for more time — they would turn up eventually — some brave souls like Robin Cook, called it correctly; they were never there in the first place.

Waiting for the post referendum recession feels like waiting for Saddam’s WMD. Last May we were told that the Bank of England, the Treasury, the IMF and others forecast an imminent recession if Britain voted to leave the EU.

Other studies of the long term impact of EU exit added to the gloom with predictions of a loss to GDP varying from 3 percent (London School of Economics) to 7.5 percent (HM Treasury)

It is not surprising that many remainers are still expecting an economic catastrophe while smug leavers feel their distrust of experts has been vindicated.

Robin Cook knew early on that no WMD would be found because he had paid close attention to the original evidence. A careful reading of the economic evidence would have shown that the recession story was just as over hyped. While Mark Carney, George Osborne and Christine Lagarde were all reported as predicting a recession, their organisations’ analyses said something else.

Bank of England

The Bank of England’s Inflation Report in May 2016 pointed to the downside risk of a leave vote including ‘a materially lower path for growth and a notably higher path for inflation’. The press conference is a classic example of reporters in pursuit of a preconceived story.

After repeated questioning, Mark Carney finally used the r-word:

“There’s a range of possible scenarios around those directions, which could possibly include a technical recession — possibly include that.”

He emphasised that the Bank had made no formal forecast but the press had their headline.

Treasury

Misleading reports of the Treasury forecast should not be blamed on the press. ‘Scrupulous with the truth’ is not a quality we associate with George Osborne. Indeed the BBC deserves credit for fact-checking the recession claim.

The Treasury analysis included a ‘shock’ scenario and a ‘severe shock’ scenario. The latter included as a kind of sensitivity analysis. Under the first GDP would be 3.6 per cent lower and under the second, six per cent lower after two years. A 3.6 per cent fall in GDP would be a major recession and a six percent fall would be another great recession. That is not the Treasury claim.

A close reading of the document shows that these are projected falls from a ‘baseline’ case where Britain voted Remain. Since the economy normally grows by more that 3.6 per cent in two years the shock scenario is not obviously a recession.

More significant is that the Treasury has no figure of its own for the baseline. The Treasury analysis does not give an independent estimate of the level of GDP after a leave vote. In order to deduce a recession it switches methodology to subtract its estimate from the OBR forecast. This allowed a conclusion of four quarters of growth at -0.1 per cent.

Even if we were prepared to accept that manoeuvre the report makes the unrealistic assumption that, faced with a downturn there would be no fiscal or monetary response. The smallest stimulus would surely nudge that figure into positive territory.

IMF

The IMF also provided warnings of a post-vote recession. It too offered two scenarios. In the limited scenario GDP would fall by 1.5 per cent by 2019 and in the adverse scenario by 5.5 per cent over the same period. Again these are falls relative to a baseline of GDP after a remain vote.

Tracking down the relevant IMF staff report uncovers this useful graph. In one scenario growth dips but remains a long way from recession, in the other a recession is visible.

What can we conclude?

Firstly, the idea that there was a confident consensus that a leave vote would cause a recession is wrong. In each case the possibility of a recession was acknowledged but given too much emphasis in the reporting. A closer look shows that the Bank was not making a forecast, the IMF was more nuanced and the Treasury report lacked credibility.

Secondly, even taking account of the exaggerations, it is clear that most analyses expected a greater negative impact than has so far occurred. It may have been correct to warn of the risks which conventional economics would identify. We avoided those risks and should be relieved. Investment and consumer spending, for example, have continued better than expected.

Risks remain but they should probably be set in the context of the wider state of the economy – household leverage, low productivity and stagnant incomes. EU exit is not the only factor.

Jos Gallacher represents Labour International on the National Policy Forum of the Labour Party

Will Inflation Mean Higher Interest Rates?

There has been a lot of fuss recently about rising inflation. Each months' figures have been greeted by gloomy news stories portraying the upward drift of inflation as a problem. The odd thing is that the rate of inflation is still below the the government's target. Not one of the news stories I've seen or read has pointed out that an inflation rate two percentage points below the 2% target is a much bigger problem than a rate two percentage points above.

Will the Bank of England raise interest rates to slow inflation? Obviously the Bank will not want to push inflation down below today's level when it is below the target. The fear here is of inflation continuing to rise. The fall in the value of the pound from the middle of last year is the main reason for expecting inflation to rise. (Indeed, the exchange rate may also explain why the news reports are so gloomy. Some people are on the lookout for bad economic news to support their view of the world after the events of last June.)

Action by the Bank takes about two years to have full effect. Today's interest rate decision will influence inflation in two years time. A rise in import prices will push up the rate of inflation today and then disappear from the inflation figures in one years time. Of course the fall in the exchange rate also takes time to impact inflation, because firms absorb some of the increase in their costs and because some prices are fixed in contracts.

The conclusion is that a rise in interest rates now would have the effect of slowing inflation at the point when it would be slowing anyway. The result could be to push the economy into deflation.

I don't expect the Bank to make any serious change to interest rates in response to the exchange rate.

What would induce a rise would be if wages  began to rise significantly. Particularly if it looked like firms were paying more because labour was in short supply. Despite the gloom about stagnating incomes, we might be closer to that point than we think.

Labour's Economic Policy Commission

I've been appointed to the Economic Policy Commission as part of my work on Labour's National Policy Forum. The Commission held its first meeting in Westminster in January.

Here is the report I wrote for the CLP:
http://www.labourinternational.net/policy_commission_on_the_economy_gets_down_to_work

Political Economy and Trade Deals

Trade agreements are in the news at present; mostly because commentators think the UK is desperate for any deal it can get. I shared some thoughts on the political economy of trade deals on Left Foot Forward originally published on 27 January 2017.

Why there’s no such thing as a quick trade deal

How easy would it be to agree a quick trade deal? Do negotiations need to drag on for seven years or more? Can a UK-US trade deal really be done in three months? If trade is a win-win, agreement should be simple.

There are two problems. Firstly the economics of trade deals are straightforward; the political economy is not. Secondly, modern trade deals are mostly not about trade. They are about the free movement of capital, the protection of intellectual property rents and the subjugation of regulatory policy to commercial interests.

Political Economy

The key economic fact is that the benefits of trade come from imports: consumers have more choice, cheaper goods and services become available and resources are released for more productive use. Exports, according to economists, are needed to pay for imports.

In trade talks, by contrast, the aim seems to be to promote exports. Negotiators reluctantly accept imports as the price of access to export markets. To liberal economists trade negotiations are a game where delegates pretend to care about exports when in fact they want the benefits of imports.

Political economy explains the paradox. Consumers seeking more choice or cheaper products have little power. Firms which might employ the resources freed by imports have less power than existing incumbent producers.

Incumbent firms have developed their business strategies based on a competitive advantage that wins extraordinary profits. For some trade offers the capacity to extend their competitive advantage into new territories. The more successful incumbent firms are, the greater their influence will be with governments and trade representatives. They can point to the jobs and tax revenues generated by access to new markets. Thus exports become the focus of attention.

Some incumbent firms may be threatened by competition from more efficient foreign producers. While their arguments have less appeal to policy-makers than those of successful companies, it does explain why certain favoured sectors are often exempted from trade deals. Agriculture is the obvious example.

Deals should not be called “free trade” deals. Most agreements are a mix of market opening and protection driven largely by the power and influence of incumbents.

Non-Trade Trade Issues

Protection is evident in some of the non-trade issues in modern trade agreements. Intellectual property rights were a major item in TPP, the US-Asian deal recently abandoned by President Trump. IP rights are a source of market power and so of extraordinary profits. US firms were keen to extend the generous protection offered by American rules to Asian countries.

The I in TTIP stands for investment and created one of the most controversial problems for the US-EU talks. People making inward investment decisions want to minimise the risk of their capital being appropriated or their contracts not being honoured. Special arrangements to settle investment disputes have been included in many recent trade agreements.

In countries where the rule of law is well established, courts are independent and corruption is low this should not be a concern. In fact the reputation of Britain’s courts is a source of comparative advantage much valued by the finance sector among others. Investor protection clauses are not needed in deals between advanced democratic countries.

Government procurement is another item on the agenda of modern trade deals. Government purchasing can favour domestic suppliers and so act as a form of protectionism. Equally, such purchasing can be a major tool of industrial policy not just supporting favoured sectors but also to encourage investment in innovation.

From a trade perspective, standards and regulations are seen as non-tariff barriers. For example the EU ban on growth hormones in beef production was seen by US producers as a trade barrier. The EU saw the application of the precautionary principle and the dispute was taken to the WTO.

More recent deals have sought mechanisms to harmonise standards. The problem here is that rules designed for consumer safety, public health, environmental protection and so on can all impact on trade, but they need to be set through mechanisms which are democratically accountable not frozen in trade agreements.

It is significant that when the EU created its single market it did not just have a court it created a parliament as well.

Easy

Trade deals might be easy if they were just about trade. Traditional issues of tariffs, quotas and subsidies have been joined by a vast new agenda of complex issues. With traditional barriers to trade already low, some claim that the future benefits will come from removing non-tariff barriers.

Economic analysis shows that these benefits are tiny. The extensive agreement which the EU was seeking with the US included all of these new issues. Its expected impact on the EU economy was an eventual increase in GDP of 0.5 per cent, according to the EU’s own analysis. To be clear that is not an increase in growth of 0.5 per cent but an increase after 10 years equal to about two months of growth.

Even tinier is the expected benefit of the ‘comprehensive’ agreement with Canada. The EU forecast an eventual increase in GDP of just 0.02 per cent to 0.03 per cent .

The secret to a quick trade deal is to limit it to trade. The more linkages there are with other issues the more difficult become the trade-offs and the longer the process will take.

Jos Gallacher represents Labour International on the National Policy Forum of the Labour Party.