The Welfare State: Reports of Death Exaggerated

Writing about web page http://www.direct.gov.uk/prod_consum_dg/groups/dg_digitalassets/@dg/@en/documents/digitalasset/dg_191696.pdf

Panic is in the air, especially in the British public sector. Yesterday's comprehensive spending review prompted BBC Radio CWR to ask me this morning if this marks the end of Britain’s welfare state.

There will be a major contraction, for sure. At the same time, it is far from the end of welfarism as we have known it since the late 1940s. George Osborne’s cuts, if and when they take effect, will bring the government’s share of GDP back down just below 40 percent – that is, where it was in the early 2000s. At that time, less than a decade ago, the welfare state was still alive and well.

What will have changed? Most likely tomorrow's welfare state will be smaller than it is now. And the principles on which it is based are evolving. But given the scale of cutbacks, the evolution of the principles is surprisingly slow.

Principles of the Welfare State

At their simplest, the principles of welfare that were implemented after World War II can be put like this: The state would make minimum provisions for everyone. Coverage would be universal; no one would be allowed to opt out. The insurance provided would be lifelong, from the cradle to the grave. Everyone would contribute according to their means; everyone would get the same low, flat-rate benefits in case of need at any time in their lives.

At first sight, it’s not obvious why we, as a country, couldn’t afford this now and forever. After all, the main changes that have happened since 1950 would seem purely advantageous. On average, we are several times richer now than then. On average we lead longer, healthier lives. What could spoil this?

At the core of the problem is a simple fact: while our lives have improved rapidly, our sense of entitlements has increased out of proportion. This is best illustrated by the problem of pensions.

Why Old Age has Become a Problem

Work produces the wages and profits that are taxed to pay for the welfare state. Since 1950, childhood and retirement have encroached on the years of life in between, during which most people work.

• In 1950, many people left school at age 14. Today, in contrast, many do not enter the workforce until their early twenties.
• In 1950, male retirement was normally at age 67. Today, the average age of men’s retirement has fallen to their early sixties.
• In 1950, most men died before retirement. Only a minority lived long enough to collect a pension. Today, men’s life expectancy has increased to exceed the retirement age by about 15 years.

Old age has become a joy for millions. Free of family chores and work responsibilities, still in good health, our seniors can please themselves – provided they have an income. But the proportion of retirees in the population is rising steadily while the proportion that works to pay for them is declining. It can’t go on.

The government is bringing forward increases in the normal retirement age, one year at a time. It would be more sensible to link these changes to measured life expectancy. For example, if we should expect to spend half our lives working, then the retirement age should rise by six months when life expectancy rises by a year.

From Universal Benefits to the Means Test

The principles of minimum provision and universal coverage are still surprisingly strong in the British welfare state. There is still universal health care that is largely free, and there is free compulsory primary and secondary schooling. There is still a universal state pension with universal pensioner benefits – free TV licenses, bus passes, and winter fuel allowances.

If anything, it is a problem that these benefits are too generous. They are no longer at the low level that made the welfare state affordable in the 1950s. The fault lies largely with the strength of the pensioner lobby – all those healthy voters with time on their hands and nothing better to do than demand more rights.

To me it is a scandal that, over 60, but in good health and in full time employment on a good salary, I'm entitled to a bus pass and a winter fuel allowance. We know winter fuel allowances aren’t spent on winter fuel. These benefits go to millions of people who are neither poor nor fuel-poor. The poor exist, for sure; but the idea of the "fuel-poor" is just a vote-selling scam.

Although the principle of universal benefits is still alive, the British welfare state has always imposed means tests for some entitlements. Their role has been increasing for some time; in fact, as chancellor under Tony Blair, Gordon Brown made important use of means tests to target funding on child poverty and pensioner poverty. George Osborne has now extended the practice, most notably by stopping child benefit payments to higher rate taxpayers.

it seems inevitable that high level income support and care funding will become ever more conditional and selective. This started long before George Osborne and will continue long after him. But the spirit in which it is happening right now owes a lot to the coalition government’s approach to fairness, as I see it.

The Undeserving Poor

The comprehensive spending review claims that the burden of cutbacks will fall disproportionately on the highest income groups. This claim has been criticized already on the grounds that it includes higher-rate income tax increases adopted by the outgoing Labour administration. Actually, it seems reasonable to me for the government to borrow some credit for this. Under better circumstances, surely, Conservative leaders would have liked to reverse the Labour income tax increases. To them, therefore, it was a deliberate choice to retain them. If that deserves a little credit, then let them have it.

Undoubtedly, however, a considerable burden must still fall on the poor. What I see in the spending review is a perspective on fairness that sets out to be fair to one section of the poor: the deserving poor. As for the rest, they are undeserving.

The idea of the undeserving poor goes back centuries; it is not even Victorian, although many Victorians followed it; see Alfred Doolittle’s well known definition.

Who, in George Osborne’s book of morals, are the deserving poor? They are the working parents and the pensioners that worked long and hard to save for retirement. To these will be given. To the undeserving poor, especially the parents that don’t work and the pensioners that took early retirement and didn’t save up for it, the spending review offers only tough love.

Controlling the Consequences

For a country of its size, Britain is said to have one of the most centralized systems of local government finance in the world. A significant paragraph in the spending review cuts away at overcentralization. While central government funding of local authorities will fall by one quarter, most of the ring fencing will be removed, freeing the hands of local councils to decide on local priorities.

Much of the non-cash dimension of the welfare state is decided locally through spending on social and care services, both residential and in the community. The removal of central government controls will increase local discretion over the amount of provision and the rules that say who gets it. And your local councillors, not your MP -- and not George Osborne -- will be to blame.

In Sum

The welfare state is not dead yet; managed prudently, it should last my lifetime and yours. But it will become smaller and less open handed.

Whether it will be more or less fair depends on your standpoint. If you care more about the equality of personal outcomes, then you'll see British welfarism moving away from fairness. If fairness is more about the balance between personal outcomes and personal efforts, however, you'll probably welcome the direction in which we are going.

There will always be unintended consequences. The process of change must create grave risks of harm to vulnerable and needy people. Against those risks is the impossibiity of continuing as we have done.

Mark Harrison : 21 Oct 2010 15:33 |  Tags: Economics Politics Recession |  Comments (0) |  Close comments |  Report a problem

Higher Education: Who Else Should Pay?

Writing about web page http://hereview.independent.gov.uk/hereview/report/

A Browne study

The Browne report, Securing a sustainable future for higher education in England, says higher education should be paid for by those that benefit from it: our graduates. It also says they should pay later, in easy instalments, and only when they can clearly afford it, with all risk transferred to the government and universities.

It looks to me like a no-brainer ... Yet lots of people are showing signs of moral outrage.

A question the critics seldom address is: Who else should pay for my degree?

The taxpayer is usually implied. But here's the problem: tax-financed higher education involves a lot of poor-to-rich redistribution.

Robin Hood in reverse

Today's students are a large chunk of tomorrow's wealthy. Today's taxpayers, in contrast, extend well into the ranks of the poor. In the UK, you start paying income tax at an annual income of just £6,475. Under the Browne proposals, student loan repayments won't kick in until annual income reaches £21,000. If the graduate's income doesn't make it to that dizzy height, you pay nothing.

Somehow or other, there are people who figure it's fair for the guy on £6,475 to start paying for someone else, but not for the guy on £21k to start paying back. (If you take expenditure taxes into account, which everyone pays, it's even worse.)

I'm sad to see clever people, like Warwick's own student representatives, dressing up in the mantle of social justice to call for poor people to go on paying to make others richer than the payers will ever be.

They say that one thing clever people are good at is defending the indefensible. Is it them or is it me? Well, the reader can make that choice!

Better than a mortgage

The private net present value of a degree, according to an interesting but underexplained chart in the Browne report, is at least £100k (the actual figure shown is a bit over $200k, which is useful for international comparisons, but still confusing). If you include the "social contribution" from today's taxpayer, then it's a little more. For the sake of argument, let it be £120k.

Warwick University Students' Union puts the likely burden of student "debt" (I'm putting it in quotes, because it's not real debt like a mortgage, where they come after you if you can't make the payments*) under Browne arrangements, at "well over £40,000."

That sounds bad. But, the last time I checked, £120k minus £40k would still leave around £80k to enjoy. Nice.

* A roof over your head is a more fundamental right than higher education. Millions of working families, who have not had the benefit of higher education, take on much larger sums of mortgage debt in order to own their homes. If their incomes fall and they have to skip payments, they must sell up or risk repossession. Don't you think they'd jump at exchanging that for "debt" on the terms proposed by Browne?

And finally

My experience is that student finance is the one topic that attracts lots of comments. Feel free to say what you think. Right now, I don't promise to reply. That's not because I don't care or don't have an answer. It's because I've got to turn away from this to earn my salary! And do some teaching!

Mark Harrison : 13 Oct 2010 11:17 |  Tags: Economics Politics Universities |  Comments (17) |  Close comments |  Report a problem

Why Bad Economics is Like Bad Art

Writing about web page http://whatpaulgregoryisthinkingabout.blogspot.com/2010/09/do-we-need-new-economics-101.html

It's economics bashing time again.

The latest to have a go is Gideon Rachman in yesterday's Financial Times. "Sweep economists off their throne!" he demands. He compares economists unfavourably to historians, "archive grubbers" who at least have a sense of modesty about their claims to rigour. He goes on to complain about the "brash certainties, peddled by those pseudo-scientists, otherwise known as economists." 

As an economic historian -- and I do grub around in archives -- I suppose I have some sympathy for this view. Only a year ago I was writing about the advantages of history in helping us see what's coming round the next corner.

But as a trained economist I think it misses the point.

Good economics isn't brash and doesn't make unjustified claims of predictive power. Specifically, good economics is not the handmaiden of the journalists and politicians who most want economics to support their nostrums and interventions. My Hoover colleague Paul Gregory makes a powerful case that what our first year students have been learning is still pretty much on the button in today's world. It is, above all, an economics that promotes scepticism, critical thinking, and the avoidance of Type I errors.

My point is that there is not just "economics." There is good economics and bad economics. I don't care if it is radical, liberal, conservative, or what. It's interesting that good economics of every school or tradition has more in common with the good economics of other schools than it has with bad economics of any school.

The problem is that there is always a demand for bad economics and there is also a plentiful supply of it. Why? We won't discuss good and bad physics, because that annoys too many people. Instead, think about bad art. On the supply side, untalented artists exceed the number of talented ones by a large margin. So, bad art is abundant. The same is true of economists; there are many more people like me that are writing about economics, for example, than there are Keyneses, Hayeks, and Friedmans. (I hope there's an even larger number of economists that are worse than me, but that's not for me to say.)

On the demand side, many people (myself included) are not really sure of the difference between good and bad art. Also, there are many reasons why we positively desire bad art: because it is comfortable; because it fits with the decor of the room we live in; because it promotes our fantasies without transcending them; and, particularly, because some critic tells us it is good when it's not. I'm sure I personally subscribe to at least some bad art for each and all those reasons.

The demand for bad economics is similar. In fact, just as critics and reviewers mediate the demand for bad art to the public, bad economics has a bunch of people that do the same job of telling the public to buy it. Who are they? Well, many of them are politicians and, er, journalists.

Since this is about economics, we should also think about price. Good economics is relatively scarce, difficult, and uncomfortable; it's designed for truth, not reassurance. In short, the price is high. Bad economics is abundant, soft, and easily absorbed. For all these reasons, it's cheap.

In fact, I'm fairly sure some of the journalists that are now hopping mad at economists are mad just because they themselves previously invested too much of their beliefs in bad, cheap economics. I once had a rather ill-mannered go at Anatole Kaletsky of The Times on this score. Not all of them are to blame, though, and specifically not Gideon Rachman. (I checked out what Rachman was blogging about before the crisis broke in 2007. At least, he wasn't promoting buy-to-let.)

Anyway, let's get back to sweeping the bad economists off their throne. Get rid of them; then what? Who are we going to ask about the economy? Sociologists? Some guy in the pub? Use common sense?

The trouble is, this is a surefire way of replacing bad economics with ... more bad economics. It was Keynes, himself a great economist, who wrote:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

Mark Harrison : 08 Sep 2010 18:14 |  Tags: Economics History Keynes Recession |  Comments (6) |  Close comments |  Report a problem

You Have Been Warned

Writing about web page http://www.agentura.ru/timeline/2010/profilactika/

A draft law before the Russian Parliament gives new powers to the FSB (Federal Security Service), the successor to the KGB. It allows the FSB to issue binding warnings to citizens suspected of creating conditions, through negligence, passivity, or incitement, in which crimes might be committed or facilitated. A warning that is ignored can be followed by an unspecified penalty, even though the actions that led to the warning may not be offenses in themselves.

This provision of the draft law restores the legal basis of a function once widely exercised by the KGB. This function was known in Russian as profilaktika, which translates directly as "prophylaxis" or "prevention."

Across the Soviet Union in the late 1960s and early 1970s, for example, the KGB subjected around 15,000 people a year to profilaktika, more than half of them for displaying some sort of overt political unreliability, or having connections with foreigners leading to suspicion of disloyalty (see Rudol'ph Pikhoia, Sovetskii Soiuz: istoriia vlasti, 1945–1991: Moscow 1998, pp. 365-366.) In proportion to the population, this would be about one in 10,000 adult Soviet citizens in each year.

What did profilaktika mean? Evidence of many, many individual cases can be found, for example, in the Lithuania KGB collection of the archive at the Hoover Institution, where I'm working now. How did they work? You could imagine it like this. Out of the blue, you get a call to come into your local KGB office. You really don't know what it's about, but you're on your best behaviour. Sitting behind his desk is a KGB colonel. He asks you what you think of the Soviet Union. Wonderful! You declare. Good, he says.

But in that case, he goes on: How come you told this anti-Soviet joke to your colleagues in the office on Thursday? And on Friday in the bar you repeated the news you heard the day before on Radio Liberty? And on Saturday you were heard cursing your Soviet-made automobile and wishing you had a BMW?

At first you bluster and deny everything. Inside, however, your world is collapsing. You're realizing just how much trouble you're in; your job and your home depend on the state and both are on the line. But that is only the start. Worse, it's dawning on you that your colleagues, your friends, maybe even your family members have been telling tales about you to the KGB. You're on your own.

You crumble. You start to make excuses: You were tired and under stress, you've always been a bit of an ignorant big mouth, you've been promoted above your competence and this has put you under pressure. You didn't realize how wrong it was. But you do now. Yes, you do, you do.

You promise you will never, ever do such things again. And you really mean it because, short of being physically beaten or locked in a cell, nothing is worse than the state of mind that this profilaktika has put you in. You've been exposed, hurt, humiliated, compromised, and isolated from society: From now on you will trust nobody, not even yourself. In fact, the only honest person in the room is the man in front of you.

The colonel listens as you stammer out your explanations. He is calm and nods a lot. He accepts what you say. When you've done, he closes the file. Go away, he says, and change your ways. We'll keep the information but, as long as you do the right thing from now on, we'll never have to look at it again. As you leave, you thank him for putting you back on the right track.

After you've gone, he makes a note to keep a special watch on you for a few months or a year, just to be sure that you meant it.

Profilaktika was applied to all sorts of cases, from loose morals and rowdy behaviour to indiscreet or unauthorized contacts with foreigners, petty smuggling or currency violations, and to adolescents who, in a place like Lithuania, might get caught up in the romance of anti-Soviet fly-posting or dreams of emigration. In such cases profilaktika was applied to the parents as well as the children.

More than half of all the cases of profilaktika were carried out in the privacy of the KGB offices, but there was also another version of the drama. This was enacted in public meetings. In this case the psychological beating was administered by your own colleagues, your student peers, or the pillars of your neighbourhood community.

For a police state, profilaktika was relatively humane. For hundreds of thousands of people it took the place of arrest and imprisonment, which would have been their fate in Stalin's time. It was also very effective in causing people to change their behaviour. In eight years, according to Pikhoia, out of more than 120,000 people subjected to such treatment, only 150 were subsequently taken to court for an actual offense. That's one eighth of one percent, a recidivism rate that western penal systems can only dream about.

A durable police state cannot be built out of bricks alone. There are building blocks like the security police and civilian police, border controls, the control of public assets, the distribution of taxes and resource rents, and media monopolies. In addition, binding agents are needed to assemble the blocks and glue them in place by controlling and coordinating the everyday behaviour of citizens at work, at home, and in the streets. Profilaktika was part of the mortar that held the bricks of the KGB state in position. Looks like it will do so again.

Mark Harrison : 28 Jul 2010 05:19 |  Tags: History Politics Russia |  Comments (0) |  Close comments |  Report a problem

The Return of Animal Spirits?

A student asked me recently if the economists' consensus is that deficit reduction should be delayed until private demand has picked up -- which might not be any time soon. My first response was to point out that, while this might easily be the impression gained by reading the pages of The Guardian, a number of distinguished economists take the view that global demand would benefit from a more rapid fiscal adjustment. My Hoover colleague John Taylor has listed some of them here.

I also considered how to explain the wide range of disagreement to my student. Model uncertainty is part of the story, reflected in divergent views about the value of the government spending multiplier. According to President Obama's advisers, a government consumption stimulus of 1% of GDP will add 1.55% to U.S. GDP over 16 quarters, i.e. every $1 of federal spending should create another 55 cents of private consumption and investment. A recent IMF paper, in contrast, estimates that the effect goes nearly to zero over the same period, i.e. the same $1 of federal spending eventually reduces private consumption and investment by an equal amount.

Just as importantly, I wondered whether, in addition to differences between models, there is also inconsistency within models -- specifically, within the Keynesian model as some are applying it currently.

Think of Keynesian economics as incorporating two key insights. One is the problem of effective demand, and the spending multiplier that augments the effect of any income shock on aggregate demand. The other is the problem of unpriced uncertainty and the human reaction to this problem, which Keynes called "animal spirits." It seems to me that Keynesians are sometimes unjustifiably selective in applying these two insights.

To simplify, the Keynesian narrative of the crisis should have both main elements. On the way down they work like this. Borrowers and lenders failed to price the uncertainty in asset markets. Animal spirits soared, then collapsed as reality struck home. When animal spirits collapsed, they took down effective demand and there was a sharp multiplier contraction. It's a coherent and interesting diagnosis. Now we have the problem of getting back up. What should the Keynesian narrative of the recovery look like? Here the prescription of leading Keynesians (I'm thinking of Paul Krugman, Brad deLong, and my Warwick colleague Robert Skidelsky) becomes curiously one sided; there's the multiplier -- and just the multiplier. Animal spirits aren't in the picture, so private demand is destined to be flat. In this view, the only thing that can get us back up off the floor is discretionary government spending. That's why, they argue, deficit reduction right now is crazy.

On top of that are the politicians and the journalists. There is a lot of Keynesian-inspired "never again" publicism around at the present time. This might be stretching it a bit, but the spirit of it is pretty much: Animal spirits got us into this mess -- never again! Animal spirits are bad -- let's kill them off, once and for all! We need rules that will put a stop to irrational behaviour! Let's appoint sensible people to take charge and just not let that happen any more!

This is absolutely not the spirit of Keynes. Keynes did not say that animal spirits are a bad thing or that we should get rid of them. He said that animal spirits are a source of instability, and they are hard to manipulate; but they are also the driver of capitalist enteprise and we cannot get away from them or do without them. Here I'm going to quote a few sentences from Keynes's General Theory of 1935 (which is on line here). First, Keynes suggests that enterprise relies on animal spirits as much as business calculation:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.

When animal spirits falter, so does enterprise:

Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; — though fears of loss may have a basis no more reasonable than hopes of profit had before.

Without animal spirits there is no progress:

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

Policy makers must legitimately reckon with the effects of politics and policy on animal spirits:

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; — it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

It's Keynes's last point that so-called Keynesians should pay more attention to. Reckoning with animal spirits does not mean that we are now somehow ruled by "the markets," as Robert Skidelsky suggested recently. It does mean giving thought to how policy can encourage animal spirits to revive -- and how policy mistakes can do further damage.

At the core of today's policy dilemma is this question: How does the government's budgetary policy influence animal spirits? It's a difficult question because it cuts both ways. Deficit spending by the government is good for animal spirits, other things being equal, because it floods the economy with demand and floats us all upwards. But other things are not equal. The deficit adds to the debt. Public debt must be financed, and a growing debt implies a rising tax burden that, looking to the future, must depress animal spirits.

So, there are two effects: deficits are a positive, but debt is a negative, and you cannot have the deficit without adding to the debt. Of the two effects, which today is the greater? It's hard to be sure, because animal spirits are as incalculable as the uncertainty to which they respond. In fact, we don't really know. On top of that, when policy outcomes are uncertain, and we fail to make a clear choice, we have policy uncertainty. As Robert Higgs has shown looking at the Great Depression, policy uncertainty is more bad news for animal spirits.

In short, there exists a Keynesian argument for decisive fiscal retrenchment now -- and it is more coherent and truer to Keynes than the positions adopted by some latter-day Keynesians. Deficit reduction is likely to take away from demand now via the spending multiplier (which may however be small, or become small or even go to zero over a few years). At the same time deficit should add to demand to the extent that it slows the accumulation of debt and encourages business confidence in the future, and also because a clear choice in favour of enterprise also builds confidence.

Contemplating deficit reduction, can we be sure of the results? No. Past behaviour gives us only rough averages as a guide; for example, Reinhart and Rogoff suggest that the median long term growth penalty for pushing debt above 90% of GDP is 1% a year. There's a lot of variation around that figure, which reduces the predictability of the outcome. So, is there an element of gamble in debt reduction now? Absolutely. But is there a safe or low-risk alternative? No.

The jobs and welfare of hundreds of millions of people are at stake in the fiscal policy game being played out now in the capitals of the West. But it's not a game we can refuse to play.

Mark Harrison : 26 Jul 2010 19:36 |  Tags: Economics Keynes Politics Recession |  Comments (0) |  Close comments |  Report a problem

Israel and Gaza: When Sanctions Fail

Writing about web page http://news.bbc.co.uk/1/hi/world/middle_east/10195838.stm

Israel's deadly assault on the SS Mavi Marmara, the Turkish aid ship bound for Gaza, has evoked worldwide protests and condemnation. Not only that, it promises to undo Israel's three-year blockade of Gaza. Egyptian President Mubarak has ordered the reopening of Egypt's closed border crossing to Gaza. U.S. Secretary of State Hillary Clinton has called the situation in Gaza "unsustainable." Israeli relations with Turkey are clearly at risk; responding to popular protests, Turkish Prime Minister Erdogan has called Israel's raid a "bloody massacre."

In many ways Israel's use of sanctions to isolate and weaken the Hamas rulers of Gaza has followed a predictable course, up to and including its calamitous denouement. In the last hundred years trade sanctions and blockades have been employed in many conflicts, from World War I to Iran and North Korea today. It's possible to draw three lessons from this experience:

• Trade sanctions are generally slow to take effect on the country that is sanctioned and have fewer economic effects than expected. This is because, when a country is denied access to commodities that were previously imported, new ways of living without them turn out to be available. Economies are made or substitutes found. There are few limits on the ingenuity that can be brought to bear, provided the will is there. Even poor communities find workarounds. Of course, trade sanctions do make everyday life more difficult and raise the costs of resistance.
• Trade sanctions are usually very costly to impose. The country that imposes them has to meet the economic and political costs of enforcement. The economic costs alone can be large or small depending on the particular situation, but these are at least fairly predictable. The political costs are rarely foreseen beforehand, but can turn out to be even more important. For example, trade sanctions generally have strong political effects that are negative from the point of view of the blockading country. Within the blockade, the effect is to stiffen national feeling, which consolidates support around the government. As a result, the will to maintain resistance turns out to be there, whether or not it was there previously.
• Trade sanctions can also have strong political effects on the international community, and these too can be counter-productive. This is because trade sanctions cause collateral damage, some of which hurts the commercial interests and citizens of neutral countries. In turn, this affects neutral opinion. In some circumstances, the result can be to convert neutral countries into allies of the country that is sanctioned. This is not inevitable, however.

Trade sanctions are often imposed in the expectation that they will quickly cause the adversary's economy to break down or, failing that, to cause the adversary government to reach an acceptable compromise. Alternatively, they are advocated by well meaning humanitarians who prefer non-violent ways of changing the adversary's behaviour. But it is hard to think of a case where trade sanctions actually worked in that way.

Historically, trade sanctions generally did worsen the economic conditions of the sanctioned population and signficantly increased the economic costs of maintaining resistance, as intended, although by less than expected. The political effects, in contrast, tended to work in the other direction, making it easier for the sanctioned government to impose the economic costs on its community. Any payoff to the sanctioning power did not materialize in less than several years and often, even then, only when combined with direct military action.

A clear illustration can be found in World War I. From an early stage in the war, Germany imposed a submarine blockade on the British Isles. Since Britain imported more than three quarters of the food calories consumed in peacetime, German naval strategists believed this was a war winning weapon. Eventually, however, the blockade may have done more damage to Germany than to Britain.

How did Britain survive the blockade? Countermeasures included wartime expansion of home agriculture, its restructuring away from meat to cereals, and rigid prioritizing of convoy shipping space. These measures, although costly, were so effective that, despite a large reduction in food imports, there was no deterioration in wartime nutritional standards for the British population. This illustrates well how the principle of substitution can lessen the effectiveness of blockade in comparison to what is expected beforehand.

The blockade was extremely costly for Germany, which had to build and operate hundreds of ocean-going submarines and replace heavy losses at sea in order to sustain a blockade that was only partially effective. The political costs to Germany were even more disastrous. Within Britain, the political effect was to stiffen patriotism and national resistance.

Internationally, Germany's efforts to tighten the blockade led to the sinking of neutral ships, with their cargoes, crews, and passengers, and to the deaths of neutral citizens carried by British ships. As a result, the neutral community became more sympathetic to Britain. In the first years of the war, the most important neutral power was the United States. It was the German policy of unrestricted submarine warfare that progressively antagonized American opinion and brought America into the war in 1917. America's entry into the war ensured Germany's defeat. These effects illustrate how the political costs of trade sanctions can outweigh any benefit to the blockading power.

During World War I, Britain also blockaded German trade. This was achieved bloodlessly, by a combination of the control of surface shipping and diplomatic pressure on Germany's neutral neighbours. Of course this was very costly to Britain but one difference is that Britain did not lose as many friends as Germany. The main reason is that Britain did not need to attack neutral assets or victimize neutral citizens to enforce its blockade of Germany. In contrast, Germany could not attack British trade without sinking neutral ships and shedding neutral blood.

This is now Israel's problem with Gaza. Until recently, both Israel and Egypt had a common policy of opposing the Hamas administration in Gaza by means of trade sanctions. The sanctions have had some positive effects. Syria and Iran have not been able to resupply the Hamas militants with armaments to attack Israel, which no longer faces daily bombardment. But sanctions have not succeeded in bringing Hamas down or changing its goals. They have not freed the Israeli soldier Shalit Gilad. The economy of Gaza has been reduced to a low level but is maintained there by sanction-busting gangs of criminal entrepreneurs whose profits depend on the blockade, on smuggling through it, and on the distribution of smuggled goods.

The aid flotilla, and Israel's heavy handed response, have broken this equilibrium. The siege has been ended, temporarily at least, on the Egyptian border. Having lost the cooperation of Egypt and Turkey, Israel cannot reimpose sanctions without undertaking measures that are likely to further alienate world opinion; possibly, Israel cannot reimpose it at all. In this way the blockade of Gaza has conformed with historical experience.

I say this without considering the morality of the opposing sides and their actions. Israel has the right to defend its citizens against their enemies. But the blockade of Gaza has ceased to be a means to that end.

Mark Harrison : 03 Jun 2010 09:05 |  Tags: Economics History Israel Palestine Politics |  Comments (0) |  Close comments |  Report a problem

Fear of Floating

Writing about web page http://www.ft.com/cms/s/0/77b0362c-5cf1-11df-bd7e-00144feab49a,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html

It was intriguing to read in the FT (May 11) about Eurozone resentment at Britain's lack of participation in the Greek bailout. In fact, it goes beyond that:

Charles Grant, director of the Centre for European Reform, said there was increasing anti-British feeling across the EU, fuelled by the belief that Britain had allowed its currency to depreciate to gain a competitive advantage.

I wondered what to think about this. It's true that sterling has depreciated quite substantially since the beginning of the crisis. Without that, the UK economy would be in much worse shape today, with still higher unemployment and a bigger budget deficit. So, it is true that the eurozone has been feeling some of our pain.

On the other hand, the reason Britain didn't join the euro in the first place, rightly or wrongly, was to retain the some insulating flexibility in the sterling-euro exchange rate if things went wrong. It wasn't compulsory for us to join the Euro, any more than Greece or Portugal were forced into it. They chose to and we didn't. Now this choice has proved correct, it's hard to understand why we shouldn't be permitted to benefit from it.

Some Europeans believe, apparently, that to benefit from a currency depreciation is morally wrong. In that case, what about the euro itself? The euro has a flexible exchange rate vis à vis the rest of the world. If the euro depreciates against the dollar or the yuan, then the entire eurozone will gain a competitive advantage over American and Chinese producers. In fact, in the last month the euro has depreciated by about 10 per cent against the dollar.

If it's right to avoid competitive depreciation, I expect to see the ECB intervening in the markets to sell euro denominated bonds and drive the value of the euro back up again. But actually ... Oh! I think they're doing the opposite-- on an unprecedented scale.

That's probably a good thing, at least in the short term, for Europe as a whole, even if it will do little for the long term solvency and prospects of the countries that are hurting most -- Greece, in particular.

As Barry Eichengreen and Doug Irwin have shown, in the Great Depression the countries that came off the Gold Standard earlier recovered quicker; those that prioritized exchange rate stability found little alternative to the policies of protectionism and regional autarky that eventually destroyed the global economy.

Mark Harrison : 17 May 2010 11:11 |  Tags: Economics Recession |  Comments (0) |  Close comments |  Report a problem

Poor Greece — Poor Us?

Greece at the mercy of "the markets." Hundreds of thousands faced with job cuts, lower salaries, and longer to work until retirement. It's hard not to feel sorry.

Equally, it's easy to understand the wrath of many Greeks: why should foreign bond holders have such power over the domestic policies of a sovereign state? Why should they accept the diktats of the IMF?

There is a simple answer. For many years, the Greek government spent far more than it raised in taxes. Why? It was the easiest way to buy votes. The problem was that the Greek government could not do it without the cooperation of others: those willing and able to lend it it.

Some of these were Greek financial institutions such as pension funds. But 80% of the Greek debt is held abroad, much of it with German and French banks. But these have walked away, taking the ball with them.

Now that the markets have called an end to the game, those who want to stand up for the entitlements of the Greek workers have to ask where the money will come from. Here are the options:

• Continue to borrow on the market -- but who will lend? The Greek debt is already at or beyond the margin of sustainability (on which more below). It is not an attractive prospect.
• If not borrow, then take. One option for the Greek government is to take from the lenders that previously enabled the years of pleasure and are now causing the pain. Taking without permision is normally called taxation. In this case it is called default. For Greece, default is all the easier because most of the lenders are abroad; they do not vote and are unlikely to throw rocks. Unilateral default has one problem: you can only do it once. After that, there is the same problem as before: if the voters want the Greek government to spend more than it raises in taxes, they must borrow. But who will lend?
• If neither borrow nor default, then print money. For most sovereign states, printing money would fix several things at once. The new money would cover the budget deficit. Then there would be inflation, but inflation would erode the real value of the debt. After that there would be a disaster, but hey ... But Greece cannot go down this road, even if it wants to. When it joined the euro, Greece gave away the right to print its own money.
• If neither borrow, nor default, nor print money, then ... raise taxes and cut spending, because there is nothing else that can be done.

These are Greece's options. In fact, the conditions that the EU and the IMF are "imposing" on Greece -- to raise taxes and cut spending -- are just what Greece must to do anyway, because there are no other choices that don't end in disaster.

Even that might not be enough. Government revenues are currently around one third Greece's GDP. If the debt heads for 140% of GDP and then stops, and must be refinanced at 10%, it follows that in future taxation must transfer 14% of GDP annually to bondholders in interest payments, and these alone will use up around 40% of Greece's limited tax capacity. Moreover, around 80% of Greek debt is held abroad, so those interest payments must shift more than a tenth of Greek GDP abroad each year -- just to cover the service on the debt, not to reduce it. The currrent EU-IMF bailout assumes that Greece's problem is liquidity. But what if it is solvency?

In that case, the future still holds the possibility of default. Given more time there will perhaps be an organized, agreed default. A rescheduling of repayments agreed with Greece's creditors will not kill Greece's credit ratings for ever, provided Greece adheres to the conditions imposed upon it.

One way of thinking about the Greek government yesterday, if not today, is that it stood at the centre of a web of obligations: legal obligations to bondholders, moral obligations to public sector employees and pensioners, and political obligations to voters. What the world has found, adding these up, is that they total far more than Greece's available resources. Something must give.

Greece holds one card, and it is an important one. If Greece goes down, so do its foreign bondholders. The German government has faced the choice between bailing out Greece and bailing out its own banks. It is interesting, and not inevitable, that the German administration has chosen in favour of Greece rather than to let Greece go and pick up its own pieces afterwards. This illustrates two things: the importance of politics, and the well known saying widely attributed to Keynes: "If I owe you a pound, I have a problem, but if I owe you a million, the problem is yours."

In all modesty, how far from Greece are we? Expectations of the British government, and what it can do for lenders, employees, the young, the old, the sick, and voters at large, have also become overstretched. Like Greece, the UK has a government that overspends, with a budget deficit of similar size relative to GDP. As in Greece, public spending is much more important to the UK economy than it should be. Even before the crisis, its importance was rising steadily; public spending accounted for nearly half of the entire increase in GDP over the period of the Blair-Brown government from 1997 to 2007. Since the start of the crisis, the growth of public spending has accelerated. Right now, public spending amounts to more than half of the UK's GDP.

In some other important ways, we are much better placed than Greece. Our aggregate debt is smaller relative to GDP, with less need for near-term refinancing. More significantly, the UK has a much greater fiscal capacity than Greece, with better coverage of tax raising institutions and less avoidance. We will be able to raise the taxes we need to finance the debt we have. And we will raise them, for another important reason: more of our debt is held at home, so lenders are also voters.

Finally, and crucially, we are not part of the eurozone. That matters, not because it will let us print money, but because it will let us recover from fiscal adjustment. The coming squeeze on spending and tax increases will put a cramp on jobs and demand from the public sector, but further depreciation against the euro and dollar will eventually rebalance the economy, allowing exports and private spending to take its place.

If there is a parallel with Greece it is not in the national picture but the regional one. For the UK as a whole, the ratio of government spending to GDP is currently a little over one half. For Ireland, Wales, and the Northeast it is between 60 and 70 percent. These regions are not only hugely dependent on public subsidies but they have no chance of renewed competitiveness through currency depreciation because, like Greece, they belong to a currency union -- in their case, the United Kingdom. What keeps them going is an unconditional year-on-year bailout from central government revenues.

My vote is not yet decided, but these are some of the reasons why I am taking seriously what the conservatives have to say about the economy today. Darling called the first phase of the crisis far more astutely than Osborne, and labour deserves credit for that. I am not convinced that more of the same will take us into a recovery.

Mark Harrison : 30 Apr 2010 00:00 |  Tags: Economics Greece Keynes Politics Recession |  Comments (2) |  Close comments |  Report a problem

Privatized Keynesianism: Rebirth After a Life That Never Was?

Writing about web page http://www3.interscience.wiley.com/journal/122498671/abstract?CRETRY=1&SRETRY=0

"Privatised Keynesianism: An Unacknowledged Policy Regime," published in the British Journal of Politics & International Relations11:3 (2009), pp. 382-399  by my Warwick colleague Colin Crouch, has been deservedly recognized and cited by scholars and journalists. The paper starts from the idea that it is a problem to maintain stability and consumer confidence under capitalism. These were secured for thirty years after the war by Keynesian demand management. After that, Crouch writes:

In those countries where capitalism was moving into full partnership with electoral democracy, it was acquiring a new vulnerability. In a fully free market, wages and employment were likely to fluctuate; would workers, who were dependent on their incomes for their level of living and lacked the cushion of wealth of propertied classes, be confident enough to consume at levels adequate to enable capitalists themselves to sustain confidence to invest and maintain profit levels? Would the very characteristics of the market that constituted its strength—flexibility, especially of labour—undermine its own ability to thrive? It should be noted that we are not here talking of the market producing social problems of insecurity in workers’ lives—that might be dealt with by an adequate welfare state—but of its producing problems for itself through its own dependence on workers’ willingness to maintain and increase their consumption. It can be assumed that the level of living at which social policy will sustain purchasing power will be below that needed to sustain an expanding, consumption-driven economy.

And he continues:

In the 1940s it had seemed that only state action could solve this problem for the market. But now, absolutely in tune with neo-liberal ideology and expectations, there was a market solution. And, through the links of these new risk markets to ordinary consumers via extended mortgages and credit card debt, the dependence of the capitalist system on rising wages, a welfare state and government demand management that had seemed essential for mass consumer confidence, had been abolished. The bases of prosperity shifted from the social democratic formula of working classes supported by government intervention to the neo-liberal conservative one of banks, stock exchanges and financial markets.

I have thought about this a lot recently, partly because my students love it -- and reproduce it for me in their essays! I have to say I don't buy it -- at least not in this form. Why am I sceptical? Well, Crouch's argument seems to be that capitalism is vulnerable to underconsumption. From 1945 through the 1970s, the argument goes, the British government ensured demand was sufficient. After the 1970s, Crouch suggests, government retreated and banks stepped in. In his eyes, British capitalism survived on credit.

The big thing here that is clearly true is that as the public debt declined, household debt rose. My problem is with the counterfactual. Implicitly, without government spending in the first phase, and credit expansion in the second, there would have been a problem: not enough demand. In the first phase, that is for most of the period up to the 1970s, it's clear that British capitalism actually suffered from too much demand; that's why there was rising inflation. In the second phase, after the 1970s, the government didn't so much step out of the picture as try to limit demand more fiercely (and hamfistedly at first), eventually delegating the job to the Bank of England. In this phase I don't really see any evidence that British capitalism was going to fall into decline if we hadn't been able to lend lots of money to the workers that they couldn't afford to pay back.

With less household borrowing and less equity realization, what would have happened? Most likely, interest rates and the exchange rate would have been a little lower, and exports would have been a little higher. With more export competitiveness, our manufacturing sector would have declined a little more slowly (and our universities might have expanded a little more). That's about it. Oh, and I guess we would be in slightly better shape today.

Ironically it is only now, in the current recession, after a huge credit crunch and collapse of private demand, that privatized Keynesianism has truly come to life. Hence, in my view, its rebirth, after a life that never was. Here is some evidence, which you'll note is tri-partisan:

• BBC, July 23, 2009: Chancellor Alistair Darling has urged banks to lend more to small firms, during a meeting with banking bosses ... Alistair Darling has said he is "extremely concerned" that banks may be charging firms too much for loans.
• Reuters, October 26, 2009: British retail banks should stop paying big cash bonuses and use the money instead to support new lending and contribute to an economic recovery, opposition Conservatives’ finance spokesman George Osborne said on Monday.
• The Guardian, February 23, 2010: A new government should tear up "ineffectual" lending agreements with Britain's taxpayer-owned banks and force them to lend billions of pounds more to small and medium sized businesses, Liberal Democrat Treasury spokesman Vince Cable said today.

Thanks to Colin Crouch, we know what to call it: Privatized Keynesianism. It is Keynesian because it uses debt finance to add to aggregate demand. It is privatized because the debt is private and stays off the government's books.

Now, the question is: Is privatized Keynesianism a good idea for today? Hmm. Why are we in the mess we are in? I think it might have been that we had too much private debt in the first place, so banks lent too much to firms and households that had no chance of repaying their debts unless house and stock markets floated ever upwards; and because banks did not keep enough in reserves. Where are we now? House and stock prices are still too high, and they are rising. And the solution these politicos favour is ... more private debt! The bankers are letting us down! They should be out there trying to persuade us to take out more loans! They should be keeping less in reserves! 

You couldn't make it up, could you?

At this point I am going to offer one of those dire aphorisms that runs: "The only thing worse than X is -X." I apologize in advance, but there is no alternative, so here it is:

• The only thing worse than having bankers making lending decisions is to have politicians making lending decisions.

This does not mean I am complacent about the need for better financial regulation. Politicians have a role to play, and it is in setting prudential rules, limiting guarantees to retail depositors, and removing the incentives for banks to grow "too big to fail." That is a lot, but that is all. Politicians should not be making lending decisions! That is the bankers' job; let them do it.

Mark Harrison : 16 Apr 2010 20:21 |  Tags: Economics Keynes Politics Recession |  Comments (2) |  Close comments |  Report a problem

On the Floor: What is Stopping Our Economy Falling into the Basement?

Writing about web page http://johnbtaylorsblog.blogspot.com/2010/02/one-year-later-and-more-evidence-that.html

A couple of months back, John Taylor made the point that the U.S. recovery is being led by the private sector. The vaunted $787 billion fiscal stimulus package passed by Congress has played no role. This is for a simple reason: it hasn't happened yet. This led Taylor, rightly, to wonder what will happen when it does come on stream, most likely in the middle of the recovery.

Now that the 2009 Q4 figures are available, it is interesting to ask the same question of the UK economy. Recovery has started, or at least the decline has stopped. Where is the improvement coming from? Is it coming from private demand or public spending? Is it coming from home or abroad?

The chart shows the changes in the main components of GDP, in real terms, since 2008 Q1:

Source: ONS. G is general government consumption, NX is net exports, DInvent is the change in inventories, C is household consumption, and GFCF is gross fixed capital formation. Omitted are final consumption not by households, and net acquisitions of valuables.

The main picture is clear. Domestic private demand has collapsed. Until recently our economy was being held up partly by government consumption -- and even more so by foreign demand. (You might be surprised by that, given recent doom and gloom about the UK balance of trade. And there is a downside, which we'll come to.) The fact is that, from mid-2008 to mid-2009, the biggest support for the UK economy came from net exports.

Right now, however, government consumption is what is holding the economy up. I think the John Taylor question for the UK would be: Is the action on public spending currently any more than was already in the pipeline before the crunch? In other words, is active intervention or passive drift at work? This question is answered by the next chart, which strongly suggests active intervention:

Source: ONS. G is general government consumption. The trend is log-linear, calculated over 2005 Q1 (i.e. the last quarter of the previous Parliament) to 2007 Q4 (i.e. the last quarter before the GDP decline set in).

The chart shows clearly that, from the onset of the crisis, public spending began to move sharply upward from the trend established over the previous quarters going back to the last general election.

Another question is: How can we account for the net stimulus from trade, at a time when global demand was collapsing as fast as or faster than demand at home? There are two candidates: the foreign fiscal stimulus, and the domestic monetary stimulus. The deciding factor here is the real exchange rate. If global demand did the trick, boosted by the foreign fiscal stimulus that the G20 coordinated from the G20 last year, then the improved real trade balance should have been accompanied by an unchanged or rising real exchange rate. If it was quantitative easing pursued by the Bank of England, then we should see a declining real exchange rate. In the latter case, we saved ourselves by grabbing more than our share of global demand through competitive devaluation.

The next chart shows it was the Bank of England and competitive devaluation that did it.

Source: Bank of England. The series plots the broad sterling effective exchange rate monthly average.

The 30% decline in the real exchange rate through 2008 implies UK monetary policy was doing the larger share of the work. We grabbed a lifebelt, while others were beginning to drown -- Greece, lashed fast to the Euro, among them.

At the end of 2008, however, the depreciation of sterling came to an end. As a result, we are now even more dependent than we were a year ago on public consumption to hold up the economy. As the first chart shows, since the recovery began, the contribution of the trade balance has ceased to be positive. While household consumption and inventories are now showing small positive contributions, fixed investment is falling again. It's not a good picture.

What does this mean, given the public spending cuts now in prospect, whoever wins our coming elections? In principle, the real effect of public spending cuts on aggregate demand should not be entirely negative; lower government consumption should bring down interest rates and this should stimulate Britain's export sector through further currency depreciation. The trouble is that interest rates are already close to zero, and cannot fall further. Like the real economy itself, interest rates are on the floor but, unlike the real economy, cannot fall into the basement. For this reason it's hard to see how public spending cuts will translate quickly into improved prospects for recovery.

I understand that Britain has already too much public debt, of course, and will have to add to it in order to maintain public spending. We cannot do this without the cooperation of the lenders! This is why it is essential to plan for deficit reduction over the medium term.

At the same time, it is clear that the spending cuts in prospect are likely to cause double pain: not only a reduction in the level of public services, but also damage to the recovery of the real economy. Whatever government is in power, these are reasons to be very, very careful.

Mark Harrison : 01 Apr 2010 14:35 |  Tags: Economics Politics Recession |  Comments (0) |  Close comments |  Report a problem