All 38 entries tagged Economics

The EU Shows the Risks of Selective Intervention

Writing about web page http://www.bbc.co.uk/news/world-europe-16803157

As Europe's leaders leave Brussels with a new fiscal treaty, I found myself thinking back to last June when Nicolas Sarkozy said:

Without the euro there is no Europe and without Europe there is no possible peace and security.

It makes you wonder how we got to this. If true, it would make the well-being and security of all Europeans hostage to the future of the Euro. Yet the euro is a relatively recent invention. It was not around for the first half century of the postwar era. Europe was peaceful and the European Union was working effectively long before the euro was brought in.

Given the model was already working reasonably well without the euro, you could understand Sarkozy to mean that Europe's architects willfully introduced a new feature that, if then removed one day, would bring it crashing to the ground. How dangerous is that!

Confronted by the possibility of eventual Eurozone disintegration, which the new fiscal treaty does not remove, I caught myself thinking:

If only Europe's builders had stopped with the single market.

The single European market, enacted between 1987 and 1992, was a huge achievement. The single market eliminated physical, technical and tax-related barriers to free movement [of goods and people] within the Community. The single market was enforced by tough laws that improved competition. In turn, competition and free trade within the community raised average productivity and incomes.

The European economy wasn't perfect. The common agricultural policy remained a blot on the European rural landscape. There was continual pressure on the member states to harmonize national social, employment, and fiscal policies. Within the single market itself there were still national currencies. The single market was marked by regional price differences arising from exchange rate fluctuations, currency exchange costs, and the lack of transparency associated with pricing in different currencies. The transaction costs alone might have been worth a few billion euros.

But perhaps it would have been better to have stopped there with the single market, and gone on paying those billion-euro costs, than to move on to the next stage of currency unification, ultimately facing today's trillion-euro costs of Eurozone bailouts and possible collapse.

Why didn't we hold the line there? What I forgot for a pleasant moment was the logic of the time. This logic led remorselessly onward from the single market to the single currency.

With hindsight the logic is sometimes portrayed as a simple economic inevitability, as if the single market just demanded to be made even better by a single currency, and would have been forever incomplete without it. "Without the euro there is no Europe"? Not so. There was an inevitability at work, it's true, but this was determined by politics, not economics.

You can think about it on the lines of what Oliver Williamson once called the impossibility of selective intervention. We'd like selective intervention to work like this. We live in a market economy, but from time to time the market fails. Then, when it fails, and only then, we'd like the government to step in and sort it out. When they've done that, we'd like them to stop.

In other words, in the best of all possible worlds, government intervention would be limited selectively to those measures that can improve social welfare over the results of the market economy. That way, surely, we would have the best of everything: the market when it succeeds, and government intervention to fix it when the market fails.

What could be wrong with that? Why can't we have the best of everything? The fundamental reason why selective intervention is impossible can be put like this:

A government that has the power to intervene when it chooses in the interests of the community also has the power to intervene when it chooses to serve its own interests.

In the case of the single market, Europe's leaders once saw an institutional deficit. For centuries, the competing nations of Europe were sources of technological, cultural, commercial, and industrial revolution. Revolution was spurred by rivalry. Too often, rivalry led to war. There was an institutional deficit, Adenauer, Schuman, and Spaak believed, that led European countries to make war, not trade. They decided to intervene to fix it.

The solution they sought was to bind Europe's nations together commercially. The European Economic Community, the forerunner of today's European Union, was the means to fill the institutional deficit that they perceived. But that turned out not to be enough. The next project was the European Union and the single European market.

In the process, they created a self-serving international bureaucracy. The European Commission in Brussels was supposed to oversee the single market. A legislature in Strasbourg was supposed to oversee the bureaucracy. But the lack of a strong popular European identity that could frame political competition on a continental scale led to Europe to exchange one institutional deficit for another.

Instead of an institutional deficit there was now a growing democratic deficit. That deficit became a refuge for politicians that had failed on the national stage or, as we sometimes call them, "elder statesmen." Defeated in a national election? Stand for the European Parliament. Just lost your party leadership? Become a European Commissioner. With a few exceptions these were vain, limited people. Unlimited only in their ambition, they tried to take control of Europe's destiny and shape it in their own interests.

What were the interests that the single currency served? It was another grand project. The worst fate of any political bureaucrat must be to enter office and be told there's nothing to do. Whoever got reelected or promoted by doing nothing? Every politician needs a stream of projects to oversee, institutions to build, offices to fill, and funding to allocate.

For such people, building the single market could never been enough. They needed something more to build after that. The single market was just a phase that added to their momentum. The logic of selective intervention is that nobody tells you when it's time to stop, and there is always good reason to go on. We could never have just "stopped there."

Not knowing when to stop is at the core of the impossibility of selective intervention. Selective intervention is supposed to improve things. And it can do this, up to a limit. But in the real world the limit of improvement is always fuzzy. If the government fixed one thing that needed fixing, this creates the justification for it to go on to fix something else. If that turns out to have made things worse, then this too becomes justification for another fix. There's never a reason to call a halt.

This is how a beautiful dream went too far, and so became a bit of a nightmare.

Mark Harrison : 31 Jan 2012 08:41 |  Tags: Economics Euro Politics |  Comments (1) |  Close comments |  Report a problem

A Flood of Cheap Chinese Goods

Writing about web page http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1964156

Late in the Old Year, I listened to a radio interview. The question was: "What has the world gained from China's emergence into global trade?" The response was something like this:

A few countries have gained by selling raw materials to China -- Australia, Canada, parts of Africa.

What about the rest?

The rest of us have just had to face a flood of cheap Chinese goods.

To me this neatly encapsulated one of the central tenets of Do-It-Yourself Economics:

Production (and exports) good. Consumption (and imports) bad.

The mixed feelings with which the world's media greets the deluge can be readily illustrated by Googling the search terms "flood" and "cheap Chinese goods." On a recent morning, the first page of search results yielded the following:

Brazilian factories tested by Chinese imports - FT.com
But a growing flood of cheap Chinese manufactured goods into Brazil is testing the relationship. “The relationship with China is important but, ...

Why do we allow cheap chinese goods to wreck the western economies ...
Why do we allow cheap chinese goods to wreck the western economies? we sell them very little where they flood our markets with cheap products that used to ...

artificially cheap Chinese goods « Savvy Writers & e-Books online
What many American, Canadian and European citizens don't grasp is this: The flood of artificially cheap Chinese goods, putting America out ...

UK retailers tell Brussels: we want cheap Chinese goods | Business ...
UK retailers tell Brussels: we want cheap Chinese goods ... He has warned that a flood of cheap T-shirts and flax yarn is harming producers in Italy, ...

Chinese tyres cause accidents: police | The Zimbabwean
The flood of cheap Chinese goods has also retarded the reopening of many industries which cannot compete with the goods of cheaper quality. “I urge people to ...

CHINESE IN AFRICA: ON ASSIGNMENT: PHOTOGRAPHY BY PER ...
has created a Chinese market in Luanda flooded with cheap Chinese goods. The Chinese are currently working on two major railway renovation projects ...

It's good to talk - even better to sell
Cheap Chinese goods are flooding into Africa's markets. China's trade with Africa has increased from $900m (about £500m) in 1990 to nearly $30bn last year ...

Involvement of the People's Republic of China in Africa ...
China does not purchase manufactured products from Africa, while cheap Chinese imports flood the local marketplace, making it difficult for local industries...

Indonesian Study Shows Trade Pact Led to Flood of Chinese Goods ...
A wide range of Chinese goods has flooded Indonesia since the ... that cheap Chinese goods are swamping Indonesia under the free-trade ...

China Ties Aiding Europe to Its Own Trade Goals | Think on That!
Nevertheless, Europe must consider the effects of very cheap Chinese goods that some consider “unfairly priced” flooding their markets. ...

The reality is somewhat less dramatic than these quotes would suggest. What proportion of the goods that our firms and households buy is actually sourced from China? Almost certainly, less than you think.

In 2010, for example, the UK imported goods from China worth £30.6 billion (see the 2011 edition of the Pink Book published by the Office of National Statistics). This sounds like a lot, but is only two percent of the UK's £1.5 trillion national expenditure, or three percent of household consumption. Even this will overstate the proportion of British expenditure originating within China's borders since many Chinese exports incorporate components previously imported into China from abroad. In short, the Chinese economic tsunami is really more of a ripple, although a growing one.

Why is the perception so much more dramatic than the reality? Several reasons.

• China sells things that nearly every household is likely to buy, such as clothes, toys, and consumer electronics.
• These things are especially salient because they are sources of pleasure.

Oh -- and the domestic firms that are displaced by the Chinese goods we prefer then noisily beat the drum of "unfair" competition by tricky foreigners in pursuit of a clever plan to wash away our industries. You can hear that drumbeat clearly in the Google search results above.

Anyway, never mind the facts. Just how bad is this and how much worse can it get? We can learn something from a historical parallel: the tale of Indian textiles in the nineteenth century.

The last time we saw a flood of cheap goods from a single country was in the nineteenth century. At this time British factories sent a tidal wave of cheap textiles across the world. By 1913, Lancashire was providing four yards of cotton cloth for every man, woman, and child on the planet. The world price of textiles came crashing down.

Who lost and who gained? Most obviously, they gained whose labour and capital was employed in the Lancashire cotton mills. At its peak, cotton employed half a million English workers. These won a living wage, while the profits went to the Manchester millocracy and their agents overseas. At the same time the English cotton interest took only a small fraction of the total gain. They had to share the rest with 1.8 billion global consumers, many of whom found they could afford comfortable, washable, durable clothing for the first time. The mechanism that distributed this global gain was the market: as prices plummeted, more and more people in distant lands could pay for a cotton shirt or even a suit.

There were a few losers. These were the world's artisan spinners and weavers. The products of their hand labour were previously a luxury; only the well-to-do could afford them. When a new product came along that consumers preferred and could pay for, the same market mechanism that shared the gain from Lanchashire's high productivity across the world told the handloom weavers: "Stop now. You can find something better to do."

When the history England's industrial revolution came to be written, Lancashire's contribution was well remembered. But its gift to the world was little emphasized or ignored. Instead, what was remembered was the destruction of Indian hand spinning and weaving.

How were Indian consumers affected by the destruction of native artisan textiles? Did the flood of cheap British goods wash away the basis of Indian economic life? It should be possible to tell. A simple test would be this: Whatever happened to India's production of textiles, what happened to consumption? If the Indian economy was truly wrecked by imported cloth, then India's masses would surely have been excluded from the benefits.

A new paper by Tirthankar Roy tells the story. It comes in two parts:

Part 1. 1820 to 1860

• The Indian price of imported cloth relative to prices of hand-spun cloth fell by 80 percent.
• The outputs of Indian hand spinning and weaving did not change.
• Cloth imports into India rose from nothing to around four fifths of the level of domestic cloth production.
• Consumption of cotton cloth per head of the Indian population rose by about 60 percent.

Part 2. 1860 to 1900

• The price of imported cloth relative to those of hand-spun cloth fell by a further 50 percent.
• Hand weaving fell by one third and hand spinning disappeared.
• But it was new Indian cotton mills, not English mills that displaced the products of Indian handloom weaving; the total output of Indian cloth did not change.
• Cloth imports rose by two thirds, reaching around twice the output of domestic weaving.
• Consumption of cotton cloth per head of the population rose by a further 40 percent.

What's important here? Two simple facts:

• First, the flood of cheap English textile did not destroy the Indian textile industry. Native spinning and weaving were restructured by competition and became much more efficient.
• Second, however difficult was the transition, Indian consumers became better off on average at every stage of this process, and were markedly better off at the end compared with the beginning.

To summarize, innovation is local but the gains from innovation are global. Adjustment to changes in national competitive advantage is psychologically painful and economically difficult, as the English textile industry discovered in the twentieth century. But the same competition in international trade is the mechanism that redistributes the gains from innovation in one country to consumers in all countries.

In conclusion, whatever you think of Chinese politics or nationalism, the flood (or floodlet) of cheap Chinese goods is not a threat. Those whose business competes directly with Chinese products should aim to beat the competition or get out of the way. Whether they succeed or fail is up to them, and that's how it should be. Either way, there is a gain to be won from China's entry into the world market, and the gain will accrue to all the world's consumers, that is to say, to every one of us.

Mark Harrison : 03 Jan 2012 13:03 |  Tags: China Economics India Politics |  Comments (0) |  Close comments |  Report a problem

The Euro: What If …

Writing about web page http://blogs.ft.com/the-world/2011/12/eurozone-crisis-live-blog-19/#axzz1fweCvEJB

What if the Euro collapses? There's already more than enough speculation about that. I'm wondering what will happen if the Euro survives.

Since survival is always conditional, let's ask: What happens if the Euro survives the next three years, which should be enough to take us into the next upswing. Also, we know for sure that the Euro cannot survive in its present form, but let's say there is just enough peripheral shake-out (say, a Greek exit), enough extra liquidity (a "wall of money" to shield the other vulnerable countries from contagion), and enough institutional reform (movement towards a fiscal union) that in 2014 a currency union is still in place with most of its current members.

What then? With all eyes focused on financial and fiscal turmoil, the underlying problem is being forgotten: The Eurozone is still not an optimum currency area.

Robert Mundell (1961) first set out the conditions for a group of countries to benefit from monetary integration: He argued that, to make an optimum currency area, the member states must be convergent in at least one of the following:

• They should experience similar shocks, and respond similarly to them.
• Or. they should have flexible (high-mobility) labour markets.
• Or, they should have competitive (flexible-price) product markets.

If these conditions were met, the real exchange rates of the different member states of a currency union would remain aligned. Without them, a structural mismatch would inevitably evolve. Full employment with low, stable inflation in all parts would be impossible. Unless some parts of the currency union would accept rising inflation, other parts would risk permanent depression.

Using forecast bilateral exchange rate volatility with Germany to measure convergence, Bayoumi and Eichengreen (1997) showed that, from the start, many current Eurozone member states did not not "fit" the Eurozone. Encouragingly, they did find a pre-existing trend towards convergence on the part of countries like Greece, Italy, Spain, and Portugal (but not France or the UK).

There was then a short debate about whether the Eurozone might experience continued convergence so that, although not an optimal currency area at the outset, it might become one. Frankel and Rose (1997, 1998) were for. Feldstein (1997) was against. Then, the Euro was launched. For a while everything seemed fine. But we know now that Feldstein was right.

Behind the scenes, with the Euro in place, previous efforts towards convergence stopped. Greece, Italy, Spain, and Portugal moved further and further away from Germany, not towards Germany. This is shown by statistical series from productivity growth to real exchange rates, trade integration, and fiscal imbalances.

In other words, the Eurozone today is no more of an optimal currency area than it was in 1999 when the Euro was launched. The peripheral countries have not made their markets more competitive. With rare exceptions, labour is unwilling to move across frontiers. The economies of the Eurozone remain "otherwise different" in fundamental ways.

Behind current efforts to save the Euro is still the theory that Greece and Italy can eventually be made more like Germany. If fiscal union is not to commit Germany to subsidize the periphery forever, then it can only mean the application of ever more pressure. German prices must be allowed to bear down cruelly on Mediterranean costs. Their public finances must be topped and tailed to fit the Procrustean bed of German frugality. In the face of ever increasing pressure, the culture of the periphery must surely give way.

But this is almost exactly the same theory that was applied from 1999 to the present, and was found wanting. Pressure was tried before; the only difference in current efforts is the addition to "pressure" of the words "ever increasing."

In other words, whatever their short run expedients, in the long run, Merkel and Sarkozy plan to hold the Eurozone together by the exercise of pure will. Just as Europe's leaders ignored the Mundell criteria in 1999, they will continue to do so. They believe politics can trump economics.

Leadership matters. The price tag of a disorderly collapse of the Euro looks large enough that its leaders should try to avoid our having to pay it. But what can one say of leadership into a cul de sac? The willpower required to hold the Euro together in anything like the form currently envisaged is completely lacking in any Europe-wide popular mandate. The belief that Europe's leaders can look each others' national cultures in the face and remake them arbitrarily goes against all evidence.

In short: What if the Euro survives its present stage? Current efforts will buy time, at best. When time has been bought and paid for, the original flaw will still be there. A Eurozone that is sustainable indefinitely will be limited perhaps to Germany, Austria, and Benelux. It might not even include France, however hard that is to imagine. It will not include the UK.

References

• Bayoumi, Tamim, and Barry Eichengreen. 1997. Ever Closer to Heaven? An Optimum-Currency-Area Index for European Countries. European Economic Review 41:3-5, pp. 761-770.
• Feldstein, Martin. 1997. The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability. Journal of Economic Perspectives 11:4, pp. 23-42.
• Frankel, Jeffrey A., and Andrew K. Rose. 1997. Is EMU More Justifiable Ex Post Than Ex Ante? European Economic Review 41:3-5, pp. 753-760.
• Frankel, Jeffrey A., and Andrew K. Rose. 1998. The Endogeneity of the Optimum Currency Area Criteria. Economic Journal 108:449, pp. 1009-1025.
• Mundell, Robert. 1961. A Theory of Optimum Currency Areas. American Economic Review 51:4, pp. 657-665.

Mark Harrison : 08 Dec 2011 12:18 |  Tags: Economics Euro Greece Politics |  Comments (1) |  Close comments |  Report a problem

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).

Mark Harrison : 30 Nov 2011 08:14 |  Tags: Economics Politics Recession |  Comments (7) |  Close comments |  Report a problem

Plan B or not to B

Writing about web page http://clients.squareeye.net/uploads/compass/documents/Compass_Plan_B_web.pdf

Plan B was launched over the weekend to much fanfare. There was much excited analysis in The Guardian. In The Observer, one hundred economists told George Osborne that Plan A is failing.

I will focus on one small aspect, the Plan B critique of current fiscal policies. Behind Plan B is the idea that "current policies … may do the very opposite of their avowed intention, by actually increasing the deficit." The logic underlying this argument extends he Keynesian multiplier: public spending cuts put people out of jobs and reduce their incomes, so that they pay less in tax; if taxes fall by more than spending, the deficit will widen, ending in higher, not lower public debt. Turn this argument around and there would be scope, apparently, for Britain to spend its way out of debt.

Another idea behind Plan B is that "the UK national debt is not large by long-run historical standards." Judging from the historical record, it seems, Britain can easily afford a higher public debt. While debt reduction may sound virtuous, it is suggested, it is currently unecessary (and the policies designed to achieve it may be actively harmful).

The outcome of Plan A, according to Plan B, is economic "sado-masochism": We are enduring the pain of public spending cutbacks to no purpose (since the cutbacks will not reduce the deficit) when the purpose (to reduce the public debt) is not even necessary in the first place. Or is there pleasure for some in the pain of others?

This weekend, by coincidence, the Royal Economic Society Newsletter (no. 155, October 2011) published my short paper Surely You're Joking, Mr Keynes?This paper makes two points.

First, it's true that Britain has carried much larger debts relative to its GDP in the past, but this was almost entirely the result of wars; do we have a comparable excuse today? It's completely unhistorical, moreover, to compare Britain's credit today with that obtainable when Britain was the world's dominant economic and financial power. The world has changed; is that something we still need to get used to?

On this, I conclude:

Historically, having a debt twice the size of the national income has been a sign that something went terribly wrong: a run of major wars, for example. Faced with the worst recession in 80 years, the British government was right to let its budget go into deficit temporarily. At that moment an increase in Britain’s debt was inevitable. Now it looks essential to bring it back under control over a few years.

Second, there is no robust evidence in the historical data that deficit reduction is self-defeating. There is claimed to be evidence, but I show that it crumbles when you touch it. On average, in fact, deficit reduction has reduced the national debt -- as one would expect.

Here, I conclude:

It remains true that, once the public debt is set on a particular course, it is hard to change that course quickly. But this is only momentum that takes time to reverse; there is no evidence of destabilizing pushback from Keynesian multipliers.

To sum up: I have taken aim at two common beliefs about the British public finances. One is that we should borrow our way out of recession; the other is that we can spend our way of debt. These beliefs are based on intriguing stories. But, like many good stories, they are fictions. Our country cannot spend its way out debt. In today’s world, we can afford to borrow much less than in the past, and that may be just as well.

Mark Harrison : 31 Oct 2011 15:26 |  Tags: Economics Politics Recession |  Comments (4) |  Close comments |  Report a problem

Predator v Wealth Creator … Or Not?

Writing about web page http://www.bbc.co.uk/news/uk-politics-15081234

"Are you on the side of the wealth creators or the asset strippers?" Ed Milliband asked the Labour Party conference (September 27, 2011).

Milliband tells a morality tale with two sides. On the good side are the producers, who "train, invest, invent, and sell." On the bad side are "the predators ... just interested in the fast buck, taking what they can out of the business." The example is "what a private equity firm did to the Southern Cross care homes. Stripping assets for a quick buck and treating tens of thousands of elderly people like commodities to be bought and sold. They may not have sold their own grandmothers for a fast buck. But they certainly sold yours."

In reality, the Southern Cross story is not one of asset stripping. There are two ways to think about this, one simple and one more complicated, but they lead to the same conclusion.

Here's the simple story. In 2004 Blackstone, a private equity firm, bought Southern Cross for £160 million. When Blackstone sold its last stake in 2007, Southern Cross was profitable, solvent, and worth £770 million. This was a story of asset growth, not assets stripped.

Now for the more complicated story. Over this period, Blackstone actually bought, amalgamated, restructured, and eventually sold three care providers: Southern Cross, NHP, and Ashbourne Care. Before acquisition, all of these companies were already operating predominantly on leased property. This included NHP, but the latter owned the property company as well as the care provider, with the latter leasing its homes from the property company. Blackstone separated out the property company and sold it. The care provider continued to lease the same homes, but these were now under the ownership of RBS, which sold them on to the sovereign wealth fund of Qatar. Southern Cross itself also sold off and leased back 21 properties -- a small number within its eventual total of 750 homes.

Why did this make sense? At this time the housing market bubble was inflating rapidly; a collapse was inevitable. Blackstone did exactly what my colleague Andrew Oswald was recommendingfor private families: sell property, put the proceeds into shares, and move into rented accommodation. What Blackstone did was not strip assets but change their form -- property for cash, which could go into business expansion.

In the process the Blackstone directors made a huge amount of money. Where did this money come from? It did not come from selling anyone's grandmother. Blackstone's profits came from two sources. One was a rationalization of the assets of the three care providers. On this, you'd have to say that Blackstone took a long view of the future of the care industry. You could call that view right or wrong, but it was a long view. The other source of Blackstone's profits was from selling near the peak of the housing bubble. Here there was a clear loser, but it was not the customers or shareholders of Southern Cross, who were saved from a huge capital loss. It was the Qatari investment authority, which was holding the homes when the crash came.

Why then did Southern Cross fail subsequently? As a public company, Southern Cross saw its revenue squeezed by government austerity, and allowed its occupancy rates to sag, while at the same time borrowing too much. You could blame it on circumstances, or on poor management, but it was not a result of asset stripping, which did not take place.

If Southern Cross is not a good example of asset stripping, then what of Ed Milliband's larger point? Asset stripping does happen; aren't we all its victims? Here we need a little precision. Some asset stripping is criminal. Suppose the employees of a company steal the roofing and wiring and sell off the materials on the side. The victims are the shareholders. That's rightly against the law. But that's not the point here. Milliband was talking about legal asset stripping by the owners of a business. What this means is that you buy a business and, instead of operating it, you sell off the property, the machinery and stocks, sack the employees, and take the cash.

You have the right to do it; does that make it right?

It sounds terrible.

But think for a moment: why would someone do that? You would make money on it, only if the market value of the parts of the company were greater than the value of the company as a whole. If that were not true -- if the value of the company as a going concern exceeded the sum of values of its parts -- you'd make more money by keeping the company going and either running it yourself, or hiring someone to run it for you, or selling it to someone else who would do just that.

In technical terms, when the market value of the parts of the company exceeds the value of the company as a whole, its Tobin's q is less than one. Now, any first year textbook will tell you that, if Tobin's q is less than one, you can increase the value of the company as a whole by shrinking its capital -- not replacing it as it wears out, or selling it off. Oh -- that sounds like asset stripping!

There are three points of interest. One is all the economics textbooks that tell us that what the world calls "asset stripping" is a normal response to a normal situation. Of course, that in itself doesn't make it right.

Another interesting thing is that you can't decide to become an asset stripper without taking the long view into account! How's that? Think: If the company is truly worth more in the long term as a company than the disposal value of its parts now, someone will be willing to pay you that value now, to take it off your hands as a going concern and prevent you from breaking it up. And you will make more money by selling it on than by breaking it up and selling the parts. So it is the logic of the market that makes you take the long view into your calculation.

Finally, the ability to make that hard decision -- if it's better to break up and sell the assets than manage the company for the long term -- is essential for the long term health of the market economy. If we can't run down declining industries, we would still all be mining and weaving -- and we would all be as poor as the miners and weavers of today's global economy. In fact, we would be poorer, because today's miners and weavers can at least afford mobile phones that are designed and produced by people who gave up mining and weaving long ago for something more productive.

To conclude, asset strippers are not the predators of the market economy. They are the carrion eaters, the recyclers. Nobody wants to cuddle a vulture, and no party conference will ever give them a cheer. Yet they play an essential part in the global ecology. It's not a case of predator v. wealth creator, or even asset stripper v. wealth creator. All play their part.

Mark Harrison : 29 Sep 2011 12:13 |  Tags: Economics Politics |  Comments (2) |  Close comments |  Report a problem

Britain's 50p Tax Rate: The Evidence Against

Writing about web page http://www.ft.com/cms/s/0/d92b0bc4-d7e9-11e0-a5d9-00144feabdc0.html

On his excellent blog Analysing British Politics, my Warwick colleague Wyn Grant (with whom I taught The Making of Economic Policy last year) has announced: Economists disagree shock. Yesterday, nineteen other economists and I signed a letter in the Financial Times urging a rapid retreat from Britain's "temporary" 50p tax rate on higher incomes. Today, two more economists (Alan Manning of LSE and Warwick's own Andrew Oswald) have responded, noting that the evidence linking personal location decisions to marginal tax rates is unimpressive. Wyn points out, also, that the precise fiscal effects of the 50p tax rate will not be known for some time.

It is no surprise to find that economists disagree. Wyn and I teach on our course that the world is complex; we often remain uncertain about exactly how causation works, even long after the event. Uncertainty is not the same as total ignorance, however. While the letter that I signed emphasized the tax competition argument against the 50p tax rate, I supported the argument on other grounds for which there exist clear empirical foundations. Because economic causation is uncertain, there is also contrary evidence. I place particular emphasis on the evidence I've selected, partly because I regard those that have produced it as fine scholars.

First, those who support higher income taxation appear to ignore the price we pay in economic welfare. With rare exceptions, taxes distort the allocation of resource and worsen economic efficiency. Some do this more than others. We can rank them by the losses they cause per unit of revenue raised. It turns out that taxes on immovable property cause the smallest losses, followed by consumption taxes and taxes on movable property. Taxes on personal income cause more losses than any of these. Only profit taxes are worse from this point of view. This finding is from work by Åsa Johansson, Christopher Heady, Jens Arnold, Bert Brys, and Laura Vartia, based on data from 21 OECD countries, 1970 to 2005: "Tax and Economic Growth," OECD Economics Department Working Paper No. 620 (2008).

Second, those who think it's okay for the Exchequer to grab some extra money every now and then from the rich, or from banks or oil companies, ignore the price we pay for a volatile, unpredictable tax regime. When businesses contemplate long-lived investments, they must predict the structure of taxes five or ten years in the future. They need a clear idea of where the line will be drawn between public and private property, and where taxation and regulation will start and stop. Temporary taxes are bad, because they can be withdrawn or added to with equal probability. "Regime uncertainty" is bad because businesses lose confidence that they will be allowed to reap the benefits of their ventures. Our world is full of new opportunities, yet business investment is flatlining because of such uncertainties. The baleful role of "regime uncertainty" in prolonging the Great Depression in the United States under the New Deal has been documented by Robert V. Higgs in his article "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War," The Independent Review 1(4) (1997), pp. 561-590. From this point of view one thing that is wrong with our 50p tax rate is that it is temporary; it should not have been introduced in the first place, and our current indecision is making that worse. Another thing is what it stands for: a populist willingness to raid the rich on the pretext of collective guilt for past and future crimes.

Third, social justice is said to require tax cuts for the poor before the rich. I understand this argument but I find that it is faulty on several grounds. Richer households already pay far more than their share of income taxes. The one percent of taxpayers that pay the 50p tax rate contribute around one quarter of all income tax receipts. What is the principle of social justice that says this is not enough? Besides, the most important measures that will get low-income households out of poverty are job creation, welfare reform, and investments in the family life of children before school (because inequalities in educational outcomes are significantly formed before children ever get to school, and because higher rates of family breakdown contribute in distinct ways to both rising inequality and some children's stunted pre-school development; see The Hills Report: An Anatomy of Economic Inequality in the UK. Report of the National Equality Panel (John Hills, Chair; Mike Brewer; Stephen Jenkins; Ruth Lister; Ruth Lupton; Stephen Machin; Colin Mills; Tariq Modood; Teresa Rees; Sheila Riddell). London: The Government Equalities Office (2010)). Higher taxes on rich people are either irrelevant or harmful to these objectives.

Fourth, it has been said that the economy will benefit more from tax cuts for those on low incomes, because poor people will spend the money and the rich won't. As far as temporary tax changes are concerned there is little basis for this view in either economic theory or evidence. The best recent evidence comes from the United States where John Taylor has shown the complete lack of response of household consumption to the mailing out of millions of tax rebates in 2008 and 2009 and to the "cash for clunkers" programme. For a diagram that says it all, go to http://johnbtaylorsblog.blogspot.com/2010/10/cash-for-clunkers-in-macro-context.html.

Fifth, it has been said that the rich deserve punishment for bringing the current recession on us. I understand the sentiment but I reject it. It assumes that the only wealth is that gained at the expense of the community. This cannot be true in general: Britain is one of the richest countries in the world, despite our present troubles, because of 250 years of private enterprise, not because of government intervention or controls. I acknowledge that some people gained at the expense of others and this played a part in the financial crash that preceded and caused the recession. Some (not all) were bankers (and not all bankers were at fault in this). This is a serious issue. But the appropriate response is to punish those guilty under the law, and strengthen competition regulation and financial regulation, not to inflict arbitrary collective punishment on the entire class of people on whom we must rely to rescue our economy from its present plight. Besides, it is clear that politicians should share the blame for what went wrong. The credit crunch began in the housing market, which is already highly regulated in most western economies; politicians and regulators were deeply implicated in the overextension of subprime credit. The most convincing argument (measured by standards of evidence and logic) that I have found is that advanced by Raghuram Rajan in his book Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton: Princeton University Press 2009).

Finally, it has been said that the signatories to the FT letter are self-interested, because they are surely all 50p tax payers. On this I speak only for myself. I am not even close, and I never will be. My only reason to oppose this tax is concern about the harm done to the community in which I live.

Mark Harrison : 08 Sep 2011 22:28 |  Tags: Economics Politics Recession |  Comments (0) |  Close comments |  Report a problem

Reform of the West: Lessons from the East

Writing about web page http://keithhennessey.com/2011/07/30/risk-and-the-governments-credit-rating/

Twenty years ago, the idea of post-communist "transition" looked straightforward. There were 30 or so economies that qualified as "transitional." The starting point (communism) and the end point (a democratic market economy) would be roughly the same for all of them, with a short one-way street in between.

Looking back, what impresses is the astonishing variety of routes out of communism, more and less marketized and more and less democratic. Compare Poland with Russia, China, Belarus, and Uzbekistan, for example. Explaining that diversity is a vast and worthy undertaking.

I'm reading Timothy Frye's new book, Building States and Markets after Communism: The Perils of Polarized Democracy (Cambridge University Press, 2010). Using lots of quantitative and narrative data from the former Soviet bloc, Frye argues that post-communist reforms were faster and more consistent, with more social transfers, when the political system was democratic. He shows, however, that the benign influence of democracy was conditional on low political and socio-economic polarization. Polarized democracies pursued reforms at a slower pace, with less perseverance and more wavering, and less generous assistance for the losers. The outcomes of polarized democracy were scarcely better than those of autocracy.

Polarized democracy: What Western country does that remind you of? America springs to mind. Growing socioeconomic inequality and increasing Red-Blue polarization have made America's problems increasingly intractable. America's public finances demand reform, but reform has been delayed and inconsistent. The debt-ceiling process was just a high-profile symptom.

Before Europeans start thumbing their noses at America, remember that the reform gridlock in the European Union looks as insoluble, or worse. Europe is polarized between debtors and creditors. And, for the purposes of the only reform that looks able to solve this polarization, a fiscal union, Europe lacks democratic government at the centre.

It turns out that reform of the West could be informed by the experience of reform in the East.

An afterthought: Let me belatedly advertise the most insightful comment that I've read on America's fiscal stalemate, Risk and the government's credit rating, by my Hoover colleague Keith Hennessy, published online just before the decisive vote in the House of Representatives. He argues that American leaders were balancing liquidity risk, solvency risk, and political risks (to themselves). Did they get it right? Read and find out.

Mark Harrison : 08 Aug 2011 19:03 |  Tags: Economics Politics |  Comments (0) |  Close comments |  Report a problem

Pakistan: Is the War Contractible?

Writing about web page http://www.ft.com/cms/s/0/3574b5ee-ab15-11e0-b4d8-00144feabdc0.html

Relations between the United States and Pakistan have been going downhill since the killing of Osama bin Laden. Ex ante, it seemed likely that the Pakistan Army had offered some degree of shelter to the world's most wanted terrorist. Ex post, Pakistan has halted U.S. access to a drone base on the Afghan border; cut back on visas for U.S. training missions; and detained a doctor said to have helped U.S. intelligence identify bin Laden's family. In retaliation, the United States is now threatening to withhold $800 million in military aid.

The Pakistan response to this threat throws further light on the status of Pakistan as a U.S. ally in the war against Al-Qaeda and the Taliban. On July 10, 2011, the Financial Times reported:

Lieutenant General (retired) Moinuddin Haider, a former Pakistani interior minister, said that the halt on US aid would further strain the two countries’ relationship and called on the US to reconsider. “This move will only add to the anti-Americanism in our country,” he said.

The following day, Reuters reported:

Politically, [the suspension of aid] would be damaging to the relationship, said Pakistan's former ambassador to the United States, retired Major-General Mehmood Durrani said, reflecting a widespread view in Pakistan that it was fighting America's war, for which Washington must reimburse it.

So: Is Pakistan an ally or an enemy? Neither, it seems. There is anti-Americanism, but Pakistan is not an enemy. For Pakistan does make available services and facilities to combat AQ and the Taliban. But Pakistan is not an ally, either.

Nearly 50 years ago, Mancur Olson and Richard Zeckhauser worked out the basic theory of burden sharing in alliances. Consider two countries -- call them A and P -- that face a common enemy. A and P can fight together or separately. By fighting together, they can share the synergies from each other's efforts. For this reason, an alliance is vulnerable to free-riding: the more A contributes, the less P needs to put in. This turned out to explain quite well the pattern of burden sharing in NATO under the doctrine of massive retaliation.

The same theory leads to a straightforward prediction about what will happen if A suspends assistance to P for some reason. On its own, denied the help of A, P will put more resources into the struggle.

But what Pakistanis are saying does not fit this model. What they are saying is that, denied the help of America, Pakistan will fight less, not more. It is "America's war."

If neither an ally nor an enemy, what is Pakistan? Pakistan is a contractor. There is a contract between America and Pakistan, so that America mostly pays and Pakistan mostly fights or helps America fight. Pakistan will help resist AQ and the Taliban if America pays, and not otherwise. It is the same as a contract between me and a builder: I pay, so the builder builds, and not otherwise. There is no intrinsic common interest that we share. Incentives are aligned by agreed payments, not by anything else.

The work that my builder does, however, is contractible. That means we can write a contract that spells out the obligations of both sides with reasonable completeness, and includes most reasonably foreseeable contingencies. He works to my wife's satisfaction, I pay, and we part amicably. Otherwise, we may end up in court.

The war on AQ and the Taliban may not be contractible in the same sense. There are three reasons.

• First, there is asymmetric information. It's hard to tell whether the Pakistan Army is doing a good job, because it is hard for the Americans to monitor progress in harsh terrain among often hostile communities. As a result, America cannot know whether Pakistan is fulfilling its part of the bargain.
• Second, there is moral hazard. The Pakistan Army can explain almost any setback by "We didn't know" (that bin Laden was living under our noses) or "They got away." As a result, Pakistan has a strong incentive not to try very hard.
• Third, the Pakistan Army has residual ownership rights in the literal sense that it owns much of the Pakistani economy and is much more of a sovereign government than the nominal civilian government in Islamabad. As a result, when contingencies arise that are not in the contract, it can control its response in ways that do not formally breach its understanding with the United States over Afghanistan, yet are not ones that the United States would choose. For example, it can secure nominal improvement on the North West frontier by diverting Islamists into Kashmir or on to Mumbai.

A standard solution when a venture is non-contractible is vertical integration. In this case it would require the United States to take on the responsibilities of a colonial power. Ruling this option out on grounds that probably don't need spelling out, we are left with an interesting problem and no obvious solution.

Mark Harrison : 15 Jul 2011 21:24 |  Tags: Economics Pakistan Politics |  Comments (0) |  Close comments |  Report a problem

Russia's Crisis, Greece's Tragedy

Writing about web page http://www.ft.com/cms/s/0/4dfcca24-9e46-11e0-8e61-00144feabdc0.html

On the plane back from Moscow, I read Martin Gilman's No Precedent, No Plan: Inside Russia's 1998 Default (MIT Press, 2010). Gilman was the IMF's man on the spot during the Russian debt crisis of August 1998.

I flew into Moscow a few days after that crisis broke. Business life seemed to be paralysed. Many people that I met were panicked or in despair. But in retrospect, Gilman points out, this was the start of Russia's sustained recovery from the economic collapse that accompanied the breakup of the Soviet Union.

The crisis itself was very ugly. The disarray in Russia's public finances had built up over years, with persistent overspending, repeated failures to generate taxes, and the high inflation and high interest rates that resulted. In the private sector, Russian banks borrowed in dollars at low interest rates and bought up high-interest ruble bonds. In the crisis, the exchange rate plunged by a third, resulting in widespread bank insolvencies.

Gilman recounts the fear that Russia would turn away from a market economy and economic integration to ultra-nationalism and autarkic controls. In fact, there was no tragedy. At a lower exchange rate, the Russian economy regained international competitiveness and embarked on a decade of rapid growth that just about doubled real incomes.

As I read the story of Russia's crisis thirteen years ago, I was caught up in the parallels with Greece today. There are very important differences, of course. Greece is much smaller, with 11 million people to Russia's 140 million. Greeks are far richer on average, with $16,000 per head (at 1990 prices) compared with $5,000 per head for Russians in 1994. (And Greece doesn't have huge armed forces armed with nuclear weapons.) Surely, Greece's problems today should be more manageable than Russia's then.

In fact, Greece's crisis is similar to Russia's -- at best. When you add up all the political and financial claims on the economy, they exceed the resources available by an unsustainable margin. In Greece, people expected the public sector to guarantee jobs. They expected free services and benefits. They expected to retire early on fat pensions. They expected all this without paying taxes. The result was a growing debt, which had to be serviced. The government expected to be able to service the debt by borrowing more, so debt rose more rapidly. This was fine as long as interest rates were low, and as long as they could get away with misreporting what they were up to.

Now the only solution is to cut back on some or all claims on the economy. But whose, specifically? If Greece is not to default on the public debt at some point, there must be a huge fiscal adjustment. Back in February, the Financial Times put the tightening at somewhere between 8 and 22 percent of GDP -- and that was just to stabilize the debt, not reduce it. Greek living standards must fall by an unrealistically large amount. in fact, as Mervyn King reiterated today, Greece is insolvent. Default would at least allow Greece to transfer some pain to bondholders -- but domestic reform and retrenchment are still necessary, because who will lend to a defaulting government to cover its deficit?

In Greece now, as in Russia then, pain is inevitable but there is no prospect of agreement on how the pain should be distributed. Every group in the population -- the rich, the poor, the farmers, the business sector, the bankers, the public employees, the students, the pensioners -- looks for a way to pass the parcel onto others. The government does not have the authority to stop the game.

Moreover, much Greek debt is held abroad, so European bondholders, many of them French and German bankers, and increasingly the European Central Bank, are in the game too. The French and Germans are playing pass the parcel with the ECB; the British certainly don't want the parcel; as fast as the others pass it back to Greece, the Greeks hand it over again.

It is in everybody's interest to solve the Greek crisis quickly, but it is in nobody's interest to accept the role of victim. This must go on as long as at least one special interest inside or outside the country expects to gain by blocking a solution. Resistance will stop only when things are so bad that no one can any longer hope to derive a one-sided benefit from further delay.

In another respect, Greece's problem is worse than Russia's. The Russians could devalue. Devaluation of the ruble restored competitiveness and also cut incomes -- everyone's incomes -- by pushing up import prices. This put an end to argument over who should suffer the pain. Moreover, the pain was short-lived because recovery followed. Greece cannot copy this while it remains in the Euro zone. In fact, the only way of restoring Greek competitiveness is to wait while Greek wages and prices fall -- but this will not only take years; it would have the further highly unwanted side effect of further increasing the real burden of Greek debt.

Much good advice is being dispensed in the financial media about how to handle Greece's problems in an orderly, even optimal way. An orderly solution would mean several things at once: an agreed recheduling or restructuring of Greek obligations that decides how the pain is shared between Greece and external debtors; a fiscal programme that decides how the domestic adjustment is shared between taxes and spending, and between the various claimants on the Greek government; and a long term programme to liberalize Greek wages and prices and restore competitiveness.

There is nothing in the economic history of Russia or any other country to suggest that there can be an orderly solution for Greece. If an orderly solution was possible now, the problem would never have reached this point. Rather, it is more or less certain that the Greek crisis will break while everyone is unprepared, and it will work out in a chaotic, unplanned way, with unforeseeable consequences for Europe. For, without an exit from the Euro, the Greeks have no prospect of the rapid recovery that Russia made. An orderly exit from the Euro: what are the chances of that?

The Russian financial crisis came to a head in August 1998, unexpectedly, when many government officials, bankers, and IMF staffers were on vacation. As you pack your bags this summer, think about it.

P.S. I sincerely hope to be wrong.

Mark Harrison : 24 Jun 2011 22:33 |  Tags: Banking Economics Greece Recession |  Comments (0) |  Close comments |  Report a problem