November 30, 2011

The Return of DIY Economics

Writing about web page http://www.ft.com/indepth/autumn-statement-growth-review-2011

Some years ago, David Henderson coined the phrase"do it yourself economics." DIY economics, he argued, was made up of the practical models of causation that ordinary people use to understand the economic world around them. In the world of DIY economics, he noted, public spending and exports are good because they create jobs;industry is more deserving of support than services; cheap goods made by foreigners are a curse, not a blessing; and whatever the problem is, the government ought to do something.

DIY economics is clearly expressed in responses to yesterday's autumn statement by the Chancellor. I'm going to comment on just one aspect: the length of causal chains. In the world of DIY economics there is never more than one step from cause to effect. I will give two examples, one concerning the burden of taxes and another concerning the housing market.

First, who bears the burden of taxes? In the world of DIY economics, if you tax the rich and give a benefit to the poor, the rich become poorer and the poor become richer. Full stop. In other words, the burden of taxes is borne by those that write the cheques. The converse must also be the case, as Polly Toynbee argues in this morning's The Guardian:

George Osborne's autumn statement blatantly declares itself for the few against the many ... What was missing from his list? Not one penny more was taken from the top 10% of earners. Every hit fell upon those with less not more. Fat plums ripe for the plucking stayed on the tree as the poorest bore 16% of the brunt of new cuts and the richest only 3%.

The chain of causation suggested by modern economics is somewhat longer, yet each step is still simple and transparent. The burden of taxes is spread beyond those that write the cheques to the government. Ultimately, who pays for a tax on profits? A tax on profits increases the cost of capital to firms, so that less capital is employed and every worker is less productive. The result is lower wages (as well as lower profits). A tax on labour increases the cost of labour to firms, so that fewer workers are employed. The result is fewer jobs (as well as lower wages and profits).

In short, who writes the cheque is a poor guide to whether a particular tax will help the poor. Whether taxes are levied on capital or labour, the workers bear much of the cost, which is likely to exceed the revenue raised.

Second, who should we blame for the mess that George Osborne is trying to tackle? In the world of DIY economics, there is only one step from cause to effect. So, if you see the effect, you only have to go one step back to find the cause. The recession began with a credit crunch, so the suppliers of credit, the bankers, are to blame for everything. Most certainly, we are not to blame. This morning, as public sector workers strike to protect their pensions, my facebook page is full of comments that replicate the following confident assertion:

Remember when Teachers, Policemen, Police staff,Ambulance staff, Nurses, Midwives, Doctors and Fireman crashed the stock market, wiped out Banks, took billions in bonuses and paid no tax? No, me neither. Please copy and paste to status for 24 hours to show your support against the government's latest attack on pensions and public sector workers.

Behind this, however, lies a longer chain of causation that implicates us all. Where did the credit crunch come from?* The sub-prime housing market. Mortgage lenders in western economies had overextended credit to households that had no hope of repaying from their incomes. What provided the impetus to excess housing credit? Well meaning government policies that had responded to rising inequality by promoting and subsidizing "affordable" housing (actually the opposite). Bankers and mortgage lenders colluded actively with this, of course. So I'm not particularly delighted that part of the British government's strategy for economic revival is new help for homebuyers. Haven't we been here before?

Then, why did the housing crash ripple so devastatingly through the economy? Because the same governments had already given up their room for fiscal manoeuvre by bloating their public sector wage bills and unfunded pension promises. (Promises to whom? Oh! Teachers, policemen, ambulance staff, nurses, midwives, doctors and firemen.)

So, Mr or Mrs Public Sector Worker: No, I don't let you off the hook. In fact, no one should feel free of responsibility. I might blame the last Labour government, but somebody must have voted them in. (It might have been me.)

Not everyone will agree with this diagnosis. In the real world, causal chains are long and complex. For the same reason, they are also generally uncertain. That is enough reason for disagreement, before we get around to ignorance, bias, and vested interests! The one claim I make confidently, however, is that one-step causation is rarely enough.

* To anyone who wants to read more, I recommend any of the following. There's an American tilt in my list; I don't think our own investigators have done a good job yet (but more recommendations are welcome).

  • Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon (Time Books, 2011).
  • Raghuram Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, 2010)
  • John B. Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis (Hoover Press, 2009).

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  1. John Dale

    > Then, why did the housing crash ripple so devastatingly through
    > the economy? Because the same governments had already given
    > up their room for fiscal manoeuvre by bloating their public sector
    > wage bills and unfunded pension promises.

    Hm. For a blog post about how causal chains are long and complex, this seems to put the blame suspiciously neatly where you want it to make your point! I’m nobody’s expert, but it seems implausible to me that our financial difficulties can be attributed in any significant measure to public sector wage and pension bills.

    30 Nov 2011, 13:05

  2. Mark Harrison

    Public sector wages show up in the present of the fiscal crisis; pensions show up in its future because the government, as the employer, must meet any future shortfall in public sector pension funds from taxation. As for the past, think about the claims of government on resources, not on average but at the margin. Of the results of Britain’s economic growth from 1979 to 1997, public spending claimed 30 percent. From 1997 to 2008, the equivalent figure rose to 46 percent. (These figures come from the IFS Green Budget for 2008; the lead author was Robert Chote, who now heads the Office of Budget Responsibility.) Because of this, and because the Treasury under Gordon Brown and Alastair Darling was systematically overoptimistic about growth and tax revenues, we entered the crisis with the public finances already adrift. The figures illustrate the pre-existing trend that the present government is attempting to put into reverse. But, unless the government and its employees can agree to fix the looming pensions deficit, the pain we are going through currently will return in the future. Or rather, the private sector will have to bear more pain in the form of higher taxes, since this is a game of pass-the-parcel.

    30 Nov 2011, 15:46

  3. John Dale

    > the equivalent [public spending] figure rose to 46 percent

    But isn’t public spending more than just wages and pensions? Health, education, defence, welfare, etc? Did it rise from 30 to 46% solely as a result of spending more on wages and pensions, or because we decided to buy, I don’t know, expensive submarines or expensive pharmaceuticals?

    30 Nov 2011, 16:26

  4. Charles Bourne

    It seems a lot of DIY Economics is simply making counter-factual arguments. If we had done this that or the other, we wouldn’t be where we are today. There are, of course, an infinite number of ways of imagining a better course of action (and then blaming those who took the one what was taken) – but of course, no way to really measure what a different course would have resulted in - because (as you say) it would in reality involve a million variables. It is equally true that any action not capable of resulting in a direct outcome can be meshed in a million hypothetical future influences. That is one reason I favour government only taking those simple actions – e.g. we need to raise more money for x, and will do it by getting £y from tax z. Provided £y is raised and spent on x, everything is fine. But we will encourage people to do a, by affecting the amount of money they pay in tax b, provided they fall within class c, and use eco-friendly materials d - well, there is no way to know why people do a oranything else, and the whole thing just creates costly bureaucracy.

    08 Dec 2011, 17:22

  5. Charles Bourne

    REPLACEMENT FOR THE PREVIOUS POST:

    It seems a lot of DIY Economics is simply making counter-factual arguments. If we had done this that or the other, we wouldn’t be where we are today. There are, of course, an infinite number of ways of imagining a better course of action (and then blaming those who took the one what was taken) – but of course, no way to really measure what a different course would have resulted in; because (as you say) it would in reality involve a million variables. It is equally true that any action not capable of resulting in a direct outcome can be meshed in a million hypothetical future influences. That is one reason I favour government only taking those simple actions (e.g. we need to raise more money for x, and will do it by getting £y from tax z. Provided £y is raised and spent on x, everything is fine). But something more like: we will encourage people to do a, by affecting the amount of money they pay in tax b, provided they fall within class c, and use eco-friendly materials d provides no way to know why people do a, or anything else, to what benefit, and the whole thing just creates costly bureaucracy.

    08 Dec 2011, 17:24

  6. Mark Harrison

    >> John Dale wrote: “But isn’t public spending more than just wages and pensions? Health, education, defence, welfare, etc? Did it rise from 30 to 46% solely as a result of spending more on wages and pensions, or because we decided to buy, I don’t know, expensive submarines or expensive pharmaceuticals?”

    These questions proved more difficult to answer than I anticipated. In fact, on the main issue I don’t have an answer. I hoped to find some figures that would show trends in overall government spending on goods and services separately for wages and salaries (on one side) and procurement (on the other). Disappointingly, I couldn’t find these for government spending as a whole, although they seem to be available for particular ministries. There is also a big complication that would put a question mark over such figures, even if I had found them: they would not account for private-financed (PFI) procurement, which has been of growing (and more recently declining) importance. Perhaps someone who is better informed can enlighten us …

    As for public sector pensions, the most authoritative study is the Hutton Report, the interim and final versions of which can be seen at http://www.hm-treasury.gov.uk/indreview_johnhutton_pensions.htm. The interim report showed that between 2005 and 2010 public sector pension payments as a share of GDP rose suddenly from 1.5 to 1.9 percent; no doubt this was one spur to reform. The interim Hutton report also provided a forecast of public sector pension payments over the next half century; having risen sharply up to 2010, these were predicted to fall gradually back to 1.5 percent by 2040 and then remain approximately stable. However, it seems important to understand two things about this forecast. First, its central estimate already assumed many of the reforms that are now being fought over, including inflation adjustment by the CPI (not RPI); in the short term it assumed the current public sector pay freeze, and a robust recovery from the recession; and in the long term a return to 2 percent annual productivity growth. Second, as the report also noted, all the risks lie with the government. This has turned out to be the case. Where the forecast assumed a strong recovery, the recovery is weak. Where the forecast assumed a return to 2 percent annual productivity growth, it seems likely that productivity is now lower than expected and productivity growth may be slower for a number of years to come. For these reasons, questions are now likely to arise about the affordability of public pensions even after the Hutton reforms.

    20 Dec 2011, 10:11

  7. Step Ladders

    more like the past.

    17 Jan 2012, 15:51


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Mark Harrison writes about economics, public policy, and international affairs. He is a Professor of Economics at the University of Warwick. He is also a research fellow of Warwick’s Centre on Competitive Advantage in the Global Economy, the Centre for Russian and East European Studies at the University of Birmingham, and the Hoover Institution on War, Revolution, and Peace at Stanford University.



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