Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 21 November 2017

Should Labour be doing better?

To anyone who cares to look, the Conservatives are doing terribly at the moment. The most important area is Brexit, of course, where through simple incompetence they may fail to move the negotiations on to their second stage this year. But there are plenty of other disasters that would be getting a lot more coverage in the absence of Brexit, such as the Universal Credit rollout.

With such a poor performance you might think that Labour should be making even more headway in the polls. Here is Britain Elects poll tracker

Some are already suggesting that Labour have hit some kind of limit to their support, as a result (of course) of Jeremy Corbyn’s leadership.

If you are going to tell any kind of convincing story about what the polls mean you have to start by explaining the Labour surge in the few weeks before the June General Election. There is a lot of important detail, and no one does this better than Steve Richards. But important as all this is, there is something rather big that is missing. Pretty well any Labour party member will tell you this, and they are right. A central reason why Labour rose by so much so quickly is that they got to talk to the electorate directly, missing out the mediation of the media commentariat. [1]

The way I like to think about this came originally from a paper written in 1967 by the sociologist Frank Parkin, who was trying to explain the ‘paradox’ of working class Conservatives. The dominant culture, he argues, is small c conservative, and so any radical politician like Corbyn is automatically at a disadvantage. This dominant culture, of which the media is a key part, can be challenged by institutions like trade unions, but it also loses much of its hold in a General Elections, where politicians are given unprecedented access to voters, and equally important voters are unusually attentive. I have stressed the importance of the media in many contexts (such as mediamacro), I argued this is what was happening as the polls started to move before the result, and again after the result.

Of course this alone did not guarantee that Labour would do as well as they did, or indeed whether someone from the centre left might have done better still. In Heather Stewart’s excellent ‘long read’ account of Labour’s popularity transformation in the 2017 General Election (GE), she writes
“In that moment – as the exit poll showed Labour stripping Theresa May of her governing majority – this ragtag band of ideologues, who had spent much of their lives fighting on the fringes of British politics, became a government-in-waiting. Corbyn, a 200-1 outsider for the Labour leadership less than two years earlier, sat on his sofa wondering whether he was about to become Britain’s next prime minister. A hung parliament was one of the scenarios his close team of advisers had planned for, but it was at the upper end of their expectations. They hugged each other – but they didn’t believe it yet.”
The extent of the Labour surge was not inevitable, as their leadership understood. To explain the extent of the Labour surge, you need to bring in other factors that Steve Richards and others have talked about, none of which were inevitable.

After the election it was Corbyn, not May, who enjoyed the winner’s honeymoon, and Labour overtook the Conservatives in the polls, peaking at the end of June. But after that politics returned to normal, or as normal as they can be in this Brexit period. Labour’s poll rating began to fall away very slowly, as you might expect with the media now filtering the news that most people see. [2]

Anthony Wells of YouGov directly addresses the question posed in the title of this post here. He points out that many voters are just unaware of issues like Patel’s resignation, and so may not see the full extent of the government’s self-inflicted problems. He also reports a YouGov poll that asks Tory voter why they support the Conservatives. Around half said they supported their aims, even though they were struggling to deliver them. 22% said that they were competent, even though they didn’t agree with all their aims. 19% said that they didn’t agree with their aims and that they were not governing well, but that they were better than Corbyn’s Labour. Is that 19% high or low? No comparative figures from earlier times are offered. Is it surprising, given the treatment of Corbyn by the right wing press? Does that mean that Corbyn is a barrier for Tories switching? - it may, or it may not. Does it mean that Labour have hit some kind of plateau of support? Of course not: the 19% may still be persuaded, and the 22% that somehow think this government is competent are low hanging fruit.

But what about Brexit. As Jolyon Maugham reminded me, public support for the government’s handling of Brexit has plummeted. Why isn’t Labour picking up support as a result of this? YouGov asks a regular question about particular issues, and which political party would handle them best. After the election 34% said the Conservatives would handle Brexit best, but that had fallen to 26% by October. Yet the equivalent percentages for Labour were 20% and 18%. In other words the government’s bad Brexit performance is hurting the Conservatives, but not benefiting Labour. If you look at the parties that have benefited from the fall in those thinking the Conservative party are best at delivering Brexit, they are UKIP (why haven’t we left yet), the LibDems (Leave regretters), and most of all None/Don’t Know (haven’t a clue).

This does seem to point to a weakness in Labour’s approach. The line to take, given Labour’s Brexit strategy, is the one that Corbyn has used: the government’s internal divisions and the Brexit hardliners are destroying the chance of a successful negotiation with the EU. But that message is not getting across. I personally do not see why Corbyn should be a problem in that respect. But with more fallout over Brexit very likely in the near future, this looks like an opportunity Labour are missing.

[1] To be fair, Steve Richards does touch on this in talking about how commentators, and many Labour MPs, underestimated Corbyn’s ability to campaign in a General Election.

[2] Here is just one example. How many saw the results of this medical study reported on BBC news? It took me less than a hour to read the study. The basis for the analysis can be questioned, as the authors acknowledge, but given the political controversy around similar claims on Question Time the decision not to cover the report looks very odd. To hide behind the assessment of an outside body that itself has been the subject of controversy (see here and here) seems very naive.  

Saturday, 18 November 2017

Some thoughts about the Job Guarantee

Mainly for economists

The idea of the state stepping in during a recession to offer some group of the unemployed a job was selectively adopted by the UK Labour government in 2009: see here by Paul Gregg. Richard Layard has proposed it for the long term unemployed. We can think of both schemes as providing a partial insurance policy against the failure of countercyclical stabilisation policy to completely do its job in a downturn/recession. But MMT (Modern Monetary Theory) economists go beyond that to suggest that it could be a permanent feature, which would eliminate involuntary unemployment (IU) without creating inflation.

Given our recent experience, the use of a Job Guarantee as an insurance policy for all unemployed people during a recession seems like a good idea. Unwanted leisure is replaced by labour producing useful output, and paying a wage greater than unemployment benefits would add to automatic stabilisers. The devil is of course in the detail: JG jobs need to be setup to allow job search (many jobs are created even in a recession) or (if necessary) retraining and the JG jobs would need to involve an output that was socially useful [1]. The main problem that Gregg discusses in his paper is the ‘Lock-in’ effect, where those in a JG job reduce their search activity. To combat that and for other reasons it also seems helpful to provide detailed individual advice along the lines of the Swedish scheme described here.

MMT economists have suggested extending such a scheme so that it operates at all times. As I understand it any worker without a job would be offered a JG job. It can be refused with no consequences in terms of unemployment benefit, so it that sense it is not workfare. Many people who were confident of getting another job quickly might want to focus all their spare time on job search, and so might decline a JG job. Anyone who wanted a job could receive one, so the scheme would largely eliminate involuntary unemployment (IU). [2] In the rest of this post I’m going to focus on this idea of JG as being a permanent feature of an economy, rather than just something put in place during an economic downturn.

A key issue is what the JG wage would be. In most MMT literature I have seen, the JG wage would be the minimum wage or better: see Mitchell here for example. There seems to be an obvious consequence of this. Unfortunately many private and public sector jobs are paid the minimum wage. These jobs are risky whereas JG jobs are by definition permanent. Minimum wage non-JG jobs may have compensating advantages like a career structure, but still it would seem probable that the existence of JG jobs paying the minimum wage would attract some workers from private sector minimum wage jobs.

The obvious response would be for private and public sector employers paying minimum wages to increase their pay sufficiently to stop this happening, which in turn would often lead private sector firms to raise prices. How far this ripples through the economy is not certain [3], but it is quite possible that the overall price level rises by a noticeable amount. This higher aggregate price level would reduce the real value of the JG wage. If this reduced wage differentials in the economy as a whole this process might be regarded by some as beneficial, but it is an implication that JG advocates need to acknowledge.

A perhaps more serious concern is the impact of the JG on inflation. What is conventionally believed to prevent policy makers expanding demand sufficiently to eliminate all IU is that to do so would embolden workers to ask for greater pay increases, generating an inflationary spiral. The existence of IU, and the possibility of joining their number. becomes a threat that keeps inflation stable. In a JG economy that threat is greatly reduced, both because an alternative job is always available and it will pay more than unemployment benefit. (JG and the lock-in effect will also reduce geographic mobility, although the other side of that coin is that joblessness would not be a feature of deindustrialisation.)

Suppose we start with an economy with stable inflation, implying unemployment was at the NAIRU, and introduce JG.. As this puts upward pressure on inflation because the costs of losing a job are reduced. the only way of keeping inflation stable is to deflate demand, which of course would reduce output, labour demand and therefore increase the number of people on JG jobs. So if we were to compare two economies where inflation was stable, one with IU and one with JG, the number of JG jobs would exceed IU in the other economy.

That does not mean that output would necessarily be lower in the JG economy, because JG workers are producing some kind of socially useful output while the IU workers are not. In welfare terms you have also eliminated any non-pecuniary costs associated with spells of unemployment, and the distribution of income in the JG economy is more equal than in the IU economy. However in practice the productivity of JG workers will be pretty low, as they need to be allowed time for intensive job search and the turnover in JG jobs is likely to be high. We have a trade-off, and if anyone can point me to any analysis of this particular trade-off I would be very grateful.

Can I end with a personal plea. When I write things like this it is often assumed by MMTers that I am being critical for the sake of it. In other words they think all I want to do is attack the JG or MMT. I don’t. I have far better things to do with my time. I actually find the idea of JG appealing at an intuitive level. More generally I agree with MMT on many things, although not all. But I am also fed up with policy makers implementing bad policies just because they sound good to those policy makers, so I want to subject any policy I intuitively like to rigorous analysis.

[1] JG jobs could be as assistants in police stations, schools and other public sector institutions. Or they could be jobs in social enterprises.

[2] Keynes defined involuntary unemployment as those seeking a job at the going real wage. As JG jobs would be at the minimum wage it would not eliminate all involuntary unemployment defined in this way: as I noted those looking for a higher than minimum wage job who chose to stay unemployed would still technically be classed as involuntarily unemployed. But this is being a little pedantic.

[3] Mosler and Silipo (section 7) talk about the JG wage as a nominal anchor. This captures the idea that movements in the JG wage would influence other wages. However nominal anchors, like the money supply or the exchange rate, are often talked about as being able to control the aggregate price level in the longer term on their own. The JG wage would not be able to do this. As the authors note, active stabilisation policy would still be required to do this, although the number of JG jobs could be a useful indicator of what action was required, just as the unemployment rate is now. Another way of saying the same thing is that the JG does not supplant the need for active macroeconomic stabilisation.

Thursday, 16 November 2017

The Brexit Revolution and its source of power

What we are seeing in the UK right now is quite incredible. The referendum vote itself was quite something: people voting to make themselves poorer than they might otherwise be for some ill-defined notion of control or because of myths about immigration. But what has happened subsequently is even more extraordinary.

With a referendum vote so close, it would have been both natural and statesmanlike for the government to go with the majority in the most unifying way possible. The obvious way forward would have been to arrange a open-ended transition where we were out of the EU but still in the Customs Union and Single Market, leaving the government to see what it might be possible to negotiate as an alternative. In other words the policy the Labour party are currently suggesting. From the polls that seems to be what the majority of people want. Little would change for business, so this way forward from the vote would have caused only minor immediate economic damage.

Instead of this, it seems that the leaders of the Leave campaign have not just won that vote, but have effectively taken over the government, dictating not just the government's preferred terms and timetable of leaving but also taking away large chunks of power from parliament at the same time, Henry VIII style. A few brave Conservative MPs plea for parliament to be given just a minimal say in some of the most profound changes in the UK in decades, and their faces are put on the front page of the main ‘serious’ right wing newspaper under the headline ‘mutineers’.

How can this be happening in a country known for its pragmatism? It seems more like the revolution that happened 100 years ago, where the revolution’s leaders declare any doubt or deviation from the path they decide as treachery. Any suggestion that it might be to our advantage to conduct negotiations to Leave in a slightly different way is declared as nothing more than a plot to overturn the Revolution. At one stage business leaders had to pretend Brexit was going to be wonderful before they were allowed to talk to ministers. Anyone who dares to point out bits of reality that might get in the way of the one true path is a saboteur that really wants to overturn the will of the people. This is a regime in a democracy that seems at times more like a dictatorship.

How can this be happening? How can so few wield so much power? Why does the Prime Minister, who was a Remainer, now dance to the tune of the revolution's leaders? A referendum in which 52% of voters chose just to leave the EU, nothing more, cannot confer this kind of power. Even the right wing press are not that powerful on their own. The answer I think lies in a group of perhaps little more than 100,000 people, two thirds men and around half of whom are over 65. They are the membership of the Conservative party.

These members are far more anti-European than the party’s MPs or its current Prime Minister. The threat the Brexiters have, which Remain MPs fear and which has governed so many of the Prime Minister’s actions, is that they will force a leadership election. In any election a Brexiter is almost certain to be on the ballot that goes to party members, and given that electorate (and the influence the Tory press have on them) a Brexiter will almost certainly win. They will then go for a clean break from the EU, or what is commonly known as No Deal.

What else could explain a Prime Minister putting forward legislation involving a fixed date to leave that might make her own life more difficult, just because it was suggested (one might guess) by the editor of a right wing tabloid at his birthday party? Why else does she tolerate almost open insubordination by her foreign secretary that would in any other situation have led to him losing his job. Why is she so concerned about keeping her Brexiter ministers happy and as a result ignores the rest of her MPs and by now the majority of the country? She has focused all her energy on preventing a rebellion from her right and as a result has completely neglected the discussions with the EU.

Although the influence of Conservative party members is talked about a bit, I still find the contrast with Labour just a year or two ago extraordinary. Then all that political commentators could talk about was the malign influence that half a million Labour party members were having on the opposition party. Yet here we have a much smaller group of Conservative party members effectively holding the government, parliament, the Prime Minister and therefore the country hostage, during the most important period of UK politics in a generation. Will our political commentariat that are not part of this revolution please wake up.   

Tuesday, 14 November 2017

On free trade and free markets

Jonn Elledge had a nice piece in the New Statesman about free trade. The question he poses is how Brexiteers can exalt free trade but want to leave the most developed free trade area in the world, the EU. The answer he gives is to distinguish between ‘free to’ and ‘free from’. When economists talk about free trade they mean free to trade, which is what the EU has achieved through regulatory harmonisation in particular. Brexiteers mean ‘free from’ in the sense of trade free from government intervention.

I think we can go beyond what Elledge says and make exactly the same point about the term ‘free market’. A Brexiteer might think of a free market as a market free from government interference, including government regulations. An economist would be more likely to talk about a free market as one where people were free to trade in a socially optimal way. The state might be required to make that happen in many ways.

To take just one example, markets can sometimes not exist because of information asymmetries, but if those asymmetries are removed then people can beneficially trade. (Economists will immediately recognise this as Akerlof’s famous market for lemons.) Removing those asymmetries does not necessarily require government, but government could play that role. If it did, we would have a free market as an economist would define it, but only as a result of what some on the right might call government ‘interference’. As Mariana Mazzucato would argue, the state can also create markets through organising research and development.

Two governments that harmonise each others regulations can create better markets in both countries by increasing competition. Equally there are other government measures that make markets work better. The most obvious example is to reduce monopoly power, which reduces prices and increases the quantity traded in that market. In truth the idea of a market completely free from government is semi-mythical: all markets work within a legal framework created and enforced by the state. When some people complain about government interference in markets, and eulogise ‘free markets’, they are really just complaining about forms of interference they do not like and are using the notion of freedom to glorify their distaste.

Nevertheless, I think this distinction between ‘free to’ and ‘free from’ its perhaps a way of resolving something of a paradox that I talked about in my neoliberal overreach piece. The paradox was whether Brexit can be described as neoliberal, as it involves the apparent illiberal destruction of a free trade area. If you see neoliberalism in practice or ‘in action’ as not so much a coherent (if flawed) unified theory (as here, for example), but rather a collection of views that encompass not just free trade but also promotion of the market and dislike of certain market interference, then neoliberal overreach can occur in any of those dimensions. [1]

So those like Osborne who wanted a smaller state so taxes could be lower (and perhaps for other reasons to) went for austerity as a means of achieving that. Those, like most Brexiteers, who wanted less regulation (including no state interference in how they personally avoid paying tax) pushed Brexit, even though it involved reducing the ability to trade. What Colin Crouch calls corporate neoliberals turned a blind eye to growing monopoly and rent extraction.

While all three groups were happy to eulogise free trade and free markets, conflicts arise over the interpretation of free. For the Brexteers free trade means freedom from government interference, while for Osborne it meant free to trade. For corporate neoliberals free markets means markets that are free from government limits on monopoly and attempts to avoid rent seeking, while ordoliberals want the state to control monopoly so markets are free to work for society.

Today for most people most of the time the idea of freedom generates positive emotions (although that itself is a social phenomenon, as Adam Curtis among others explored.) It is therefore a word worth expropriating for a political cause if you can. But by noting that conflicts arise between ‘free to’ and ‘free from’ we can perhaps see that all politicians are doing is trying to promote a form of freedom that suits their cause.
[1] In an interesting piece, Will Davies argues against the need to want to define political or social terms precisely as if they “connect cleanly and unambiguously to some object”.

Sunday, 12 November 2017

What ignoring Ireland tells you about our governing elite

The hapless progress of the Brexit negotiations continues. I do not mean the almost childish nonsense of May’s new wheeze. Instead I’m talking about the Irish border. It seems, if you read most of the UK press, that out of the blue this new obstacle has been sprung on the UK at the last minute. Some of the press talk about surprise, while the Guardian talks about it ‘emerging’. Some have even decided to cover up their ignorance by inventing conspiracy theories. With political commentary in the UK largely reflecting the beliefs of the UK side, then this also means that this surprise extends to our negotiating team.

In reality there is nothing to be surprised about. The Irish border was one of the three issues to be dealt with in the first stage. As the UK government has consistently said they are leaving the Customs Union and Single Market (CU/SM), and have failed to convince even themselves that they can invent a new magically invisible border that can police countries that have different customs and regulatory regimes, it was only natural that an EU paper would suggest that Northern Ireland stay in the CU/SM to avoid a hard land border.

So why did the UK, and its media, seem to forget about this third issue, when even I had flagged it up as the critical issue a couple of months ago. What I think happened is that the Brexit side convinced itself that, because a hard border would only arise as a result of different trade regimes, then the border was really a trade issue and so should be in stage 2. In other words the EU had simply made a mistake in putting it in Stage 1, and would therefore quietly forget about it.

That reasoning was part wishful thinking and part delusion. Wishful thinking because, as I wrote back in September, it is a problem with no obvious solution that Brexiteers would accept. And delusion because the UK side continues to imagine that the EU is governed by Franco/German interests, and why would these countries be concerned about what happens in Ireland. What it completely failed to understand, and what the EU had understood, was the importance of the border issue to the people on both sides of it. It was an important reason why Northern Ireland voted to Remain.

But I wonder if there is something deeper behind the UK attitude. For too many people in England, the ‘troubles’ in Ireland were a quarrel in a strange country between people of whom we know little, to paraphrase Neville Chamberlain. As a result, there is little comprehension of why a hard border should be such a big deal. You would think memories of bombs going off in England’s cities would change that, but I’m not sure it did, anymore than more recent terrorism has led to a better understanding among English people of tensions within Islam. In contrast, most people in Northern Ireland would move heaven and earth not to go back to those times.

Even while all this might be true, it is no excuse for the same attitudes to be held by our political leaders. John Major knew better than this, as did Tony Blair. Only the arrogant disdain for different realities displayed by Brexiteers can explain a mistake of the magnitude of ignoring the border issue. I suspect any politician that lied the way the Brexiteers lie, or lived in the alternative reality they appear to live in, would not have survived long in UK politics two decades ago, whereas now it has become a criteria for holding high office.

At the end of the day there is little difference between Brexiteers who tell people that new trade deals with countries outside the EU can make up for trade lost with the EU, and Republicans who say scrapping Obamacare will extend coverage and their tax bill reduces taxes for most people. In both countries when the ability to gain office is determined by how well you can fire up or charm a base, because a large part of the media will then assure you have a good chance of winning elections, is it any wonder the political system fails to select for competence, understanding or respect for wisdom and knowledge.

There is a simple solution to the problem of the border. It is for the UK side to commit to only negotiate new trade arrangements that would be consistent with a soft border. [1] That would mean staying in the Customs Union and parts of the Single Market, but it could leave open the possibility of negotiating over the remaining parts of the Single market and perhaps free movement. Anyone who tells you that this concession by the UK side does not respect the referendum result is once again lying: Leave won precisely because they ruled no arrangement out. Any red lines erected after the referendum carry as much weight as the Prime Minister currently has authority.

Already we have many people in the UK saying why should we adapt our policies to keep the people of Ireland happy. This is the Chamberlain type attitude that I talked about earlier. The Irish border is at least as much our creation and our concern as it is of anyone else. Maintaining peace within the UK should be any government’s top priority. The fact that it has failed to make it onto Brexiteers to do list tells you as much about their outlook and competence as you need to know.

[1] Whether the UK will be forced to take this position I do not know. I stand by what I wrote recently that there will almost certainly be a deal, one element of which will be a transition where we stay in the EU/SM. Indeed I understated my case there. First, there can be no such thing as no deal. As Davis has explained, there are things that have to be sorted to keep planes flying and the like. He has described this as “some sort of basic deal without the bits we really want”. What that remark shows is that the ‘no deal is better than a bad deal’ line is simply a bluff and he knows it. The bad deal is no deal. And finally there is parliament. I know it has been pathetic until now, but that does not mean it would sign off on the worst possible kind of Brexit. But what the border issue will most likely show is that it is unlikely we will get to a deal involving transition without cabinet resignations.

Thursday, 9 November 2017

What really caused the financial crisis

The Global Financial Crisis (GFC) defines how we think about our recent past, our present and our future, yet there is no clear consensus account of why it happened. There have been so many explanations put forward. On the US side these have included the Asian savings glut overwhelming the financial system, a failure of US monetary policy and a US housing bubble (and too much lending to poor people). [1] On the European side the focus has been on excess borrowing by, or excess lending to, the Eurozone periphery, and sometimes on the poor Eurozone architecture. Yet as I have read more and more on this, it seemed to me that we should be focusing on the financial sector in both the US and the Eurozone, and of course the UK. My view has become that the crisis happened because banks in the US and Europe became too highly leveraged, and were therefore a crisis waiting to happen.

It was for this reason that I found Tam Bayoumi’s presentation of his new book so interesting.

He argues that by 2002 almost all the ingredients for the crisis were in place. In Europe we had very large universal banks (combining retail and investment banking) which were far too highly leveraged. In the US retail and investment banking were separate, with tight regulations on retail banks but little regulation on investment banking leading to shadow banking (deposits effectively moved to investment banks, like Lehmans, that again became too highly leveraged). In 2002 these two were separated by geography, but a small regulation change in 2003 allowed linkages between the two to develop, and then it was only a matter of time before we had the GFC, where ‘Global’ here means the US and Europe.

How did these banks become over leveraged? According to Bayoumi in Europe the creation of Universal Banks represented a flawed attempt to create a single European market in banking. There were subsequent failures in regulation that allowed these banks to expand (increase leverage) by manipulating their own risk weighting. This allowed these banks to move into Southern Europe and North America in a big way. In the US investment banks were not regulated because of a firm belief by the Fed that competition provided its own regulation for this type of bank.

Thus the GFC was the story of an over leveraged, interconnected banking system on both sides of the North Atlantic, just waiting for a shock significant enough to bring the whole system to crisis point. The presumption, which history confirms, is that finance is naturally prone to such crises, which is why the sector is regulated, so this story is also one of regulation errors. Bayoumi argues that each one of these errors can be put down to genuine intellectual mistakes, but he did agree with me that it was sometimes difficult to tell to what extent they were also the result of political pressure from powerful financial interests.

Have governments and regulators on either side of the North Atlantic done enough since the GFC to correct the mistakes that were made? The answer is complex, and it is best you read the book to find out Bayoumi's answer. Instead I want to end by making one observation of my own. Whenever a crisis happens, in the immediate aftermath people bring their own biases to understanding why it happened. So those who had been writing about global imbalances re orientated their analysis to explain the GFC. Those who wanted to attack US monetary policy, sometimes as a way of distracting attention from the culpability of the financial sector, did so. Those that had designed the Eurozone in such a way as to avoid profligate periphery governments talked about excess borrowing by those governments.

You can see the same with Brexit and Trump. Although a protest by the ‘left behind’ played some role, the idea that they are the full story suits some narratives but it is simply incorrect, as the new paper by Gurminder K. Bhambra argues. Over time things become clearer. What this analysis by Tam Bayoumi convincingly shows is that finance always has to be carefully regulated, and failures in regulation can have catastrophic consequences.

[1] New evidence suggests that the housing crash may have actually had more to do with lending to property speculators than low income mortgage holders.

Tuesday, 7 November 2017

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:
“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.