Stupid After the Event

Writing about web page http://www.timesonline.co.uk/tol/comment/columnists/anatole_kaletsky/article5663091.ece#cid=OTC-RSS&attr=1882523

We're all wise after the event.

The public would have like it better if more of us had been wise before the event. The bankers that are sorry now didn't see it coming. The politicians and regulators won't say they are sorry, but they didn't see it coming either. Who else should have seen it coming? Anatole Kaletsky (in The Times, Feb. 5, 2009) says that economists should join the others in the dock; they are "the forgotten guilty men." By economists, he adds,

I do not mean the talking heads (myself included) employed by the media and financial institutions to “explain”, usually after the event, why share prices or currencies have gone up or down. Nor do I mean the forecasters whose computers churn out scientific-looking numbers about what will happen to growth or inflation, but whose figures are revised so drastically whenever something “unexpected” happens - as it always does - that their forecasts are really nothing more than backward-looking descriptions of recent events.

What I mean by “economists” are the academic theorists who win Nobel prizes, or dream of winning them.

Why economists? The financial crisis, Kaletsky notes, was caused by practical men, not academic scribblers. But Keynes wrote, as Kaletsky reminds us:

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.

This seems harsh to me. Not all economists were stupid before the event. I'm not well enough connected to have conducted a census, but Robert Shiller was writing about irrational exuberance in financial markets ten years ago. In 2002 my colleague Andrew Oswald predicted the great UK house price crash of 2003 to 2005. (If only he'd been right; we would all be hurting a lot less now.) In the same year other colleagues past and present – Marcus Miller, Lei Zhang, and Paul Weller – warned in the Economic Journal of the "Greenspan put," a "one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk." Yes, some were wise before the event. They are people I can only bow to.

What about Kaletsky himself? Two years ago, on March 9, 2007, Kaletsky gave the Colliers CRE annual economist briefing. This is just some of what he said:

Kaletsky firmly believes that there is 'good news' supporting long-term trend growth in the global economy ... A 'mid-cycle slowdown', rather than a recession, is now overdue ... Kaletsky believes that we will experience a slowdown rather than an outright recession. This means we will not see a sharp rise in unemployment and bankruptcies ... The US housing market has undergone a strong slowdown ... Kaletsky is confident that we are much more likely to see a soft landing in the US housing market than a collapse ... Kaletsky firmly believes new home sales have reached a bottom in the US and is confident that 2007 will see signs of a pickup ... The UK will stand out against the tide of slowing growth in Europe ... the financial sector - led by London - will go from strength to strength ... Although a number of commentators have focused on the risks of a house price crash, Kaletsky believes these to be overstated.

In January 2008 I attended an AEA panel in New Orleans where Shiller, along with Paul Krugman and Nouriel Rubini, academic scribblers all, acurately predicted the coming huge bust in the U.S. housing market. A month later, on February 5, 2008, Kaletsky told Colliers CRE:

We are approaching the end of the credit crisis in terms of time, if not necessarily pricing, and that it will be resolved one way or another in the next month ... The US is experiencing its worst economic downturn since the 1990s, but Kaletsky believes the worst may be over, although the risk of recession remains.

Of course, Kaletsky said a lot more than I have quoted, and I have quoted very selectively. If you prefer to read the full texts of his briefings, they are both here. Let me add that, in his 2008 remarks, Kaletsky made one other very important point: 

in 2005, the International Monetary Fund (IMF) conducted a study of recessions around the world. Of the 74 recessions studied, only four were predicted in the preceding year. Furthermore, only one third of forecasters interviewed in a recession year actually spotted the recession in that same year.

So what? Here's what.

Nearly everyone has been wise after the event, not before. Don't get me wrong: being wise after the event is very important; let's not undervalue it. Being wise before the event is best, but being wise after the event is the next best thing. And being wise after the event definitely dominates being stupid after the event. This is a danger that I'll come to.

If we want to be wise after the event, it's time to rethink. What are the parts of economics that need rethinking? According to Kaletsky it is our concepts of

the “efficiency” of markets and the “rationality” of the investors, consumers and businesses who inhabit them.

I agree! We should rethink the way we use the rationality assumption. As an economic historian, I use it in all sorts of peculiar context. I have argued (here for example ) that the value of the axiom lies partly in helping us draw a line between what we do and do not understand. If we assume that individuals behave with full rationality, subject to constraints, and our models works in terms of simulation or prediction, then we can at least kid ourselves that we have understood that behaviour in the sense that we don't need anything more complicated to analyse it. If the model doesn't work, it tells us we failed to grasp something – some constraint on behaviour or some bound on rationality – that is missing from our model. In short, the rationality assumption helps us draw a line between what we understand and what we don't.

Recent events are shifting that line, but in different ways for different people. First is a relatively narrow group, those (not all) financial economists that bought heavily into the efficient markets hypothesis and rational expectations; they have seen their frontier with the unexplained collapse inwards. Second are a much wider group, the macroeconomists that did not buy the efficient markets hypothesis, but nonetheless believed that in the event of market failure governments had the power, the monetary and fiscal instruments, the capacity for international coordination through G8, G20, IMF, and so forth, and the will to avert the worst consequences. We are watching events unfold, but I am much more pessimistic than I was.

The main problem for economics that I see is this. Most professional economists are clever people. Clever people have one weakness: they are clever in many ways. One of these is getting at the truth. Another is being contrarian. In fact, because they are clever, and often highly motivated, clever people tend to be good at denial. They can think up a thousand sophisticated arguments to defend manifestly absurd ideas. My rule of thumb is that everyone, including me, believes in at least one completely crazy idea; the trouble is, I don't know which one it is. So look out for a lot of clever economists who are going to be stupid after the event, because of some idea they are wedded to and will continue to defend while the world walks off in the other direction.

If I'm clever enough, I may well be among them.

The main problem for politics is different. It is that it is much more fun to play the blame game than to do something – something for which, in future, you may be blamed. As a result, politicians and journalists in our country (and no doubt elsewhere) are now sitting around throwing accusations at bankers, economists, journalists, and each other – particularly at bankers, which is fine in a way because monetary policy can currently do nothing more to make things better, so why not?

Except that it is a diversion from the one thing that can now make things better, the promised fiscal stimulus. We are losing 100,000 jobs a month – and unemployment is a lagging indicator. To make a difference, the fiscal stimulus was needed six months ago. It seems that we cannot even count on the automatic stabilizers that should limit recession. While local authorities lose revenue, for example, councils are cutting jobs and services that they can no longer afford but the community needs ever more desparately. The current lack of fiscal action on the part of our government is scandalous. Stupid after the event.

Mark Harrison : 12 Feb 2009 15:01 |  Tags: Keynes Politics Recession |  Comments (0) |  Close comments |  Report a problem

False Patriots

Writing about web page http://news.bbc.co.uk/1/hi/uk_politics/7866614.stm

So a lot of people would like to send them home – the foreign workers contracted to work in Britain. To judge from the tone, these people are not that interested in a level playing field. They want one that puts the foreign workers on a steep slope – preferably down to the sea.

How much better can that get?

As far as I can work out, there are about six million British citizens living abroad. In the countries where they live and work, they take up jobs, homes, schools, medical facilities, and even benefits – just like foreigners here. In those countries, jobs are going to be just as short as they are here. So, if we succeed in sending the foreigners home, our compatriots abroad are going to be equally vulnerable to the same pressure from the citizens of the countries where they live.

I wonder if these "patriots" are ready to see tens or hundeds of thousands of British citizens forced out of the countries where they have made their homes and sent back here to crowd the jobless queues and social security offices. That is the predictable consequence if they succeed.

We live in an interdependent world. How hard it is for us to weigh the benefits against the costs. All of us benefit, but at any one moment the benefits are imperceptible because they come in thousands or millions of tiny packages. Export industries appear and jobs are created by the invisible hand. Moreover, we do not benefit equally; some gain more than others. And some lose, but each job that is lost is clearly identifiable. At moments of difficulty, our common interest in free trade and movement can be all too easily drowned out by the vocal lobbies that want to block these things.

Take "Buy American." The current amendment to the U.S. fiscal stimulus package before Congress will protect the jobs of a few thousand American steel producers. A hundred million steel consumer in the U.S. will lose in higher prices. It's tragic, but unsurprising, that the U.S. steel lobby could win this one.

The same applies to "Buy British." If we all buy only British, that will cut our imports – but it will also cut our exports! How will foreigners have the means to continue to buy the goods and services we export if we buy nothing from them?

Worse, we will become poorer as a result. "Buy British" will make us buy more of the expensive goods that we are least good at making ourselves. It will protect the jobs that are of least value. At the same time, it will undermine the markets for the goods and services that we are best at, and so add most value.

Take Coventry, where I live. Once, Coventry was Britain's Detroit. It produced motor vehicles for a mass market and exported them across the world. No longer. But Coventry has not dropped out of the world market. Our city has a new export industry: higher education. Two universities, Warwick and Coventry, bring thousands of students from across the world to study here. They pay high fees and living costs worth many tens of millions of pounds to the local economy. The money they spend doesn't come out of thin air; it is financed by the pounds their countries earn by selling goods to us, cheaper than we can make them ourselves – Korean motor vehicles, for example.

"Buy British" means killing Coventry's new exports. It means rolling the clock back from the new to the old -- giving up on what we do with greatest success, and going back to what we once could do but then failed in.

Folly that cloaks itself in patriotism is still folly.

We need all the major countries to cooperate to keep trade and [policy coordination going. On that note, Jeff Frieden has written something that everyone should read. Frieden's point is the importance of political leadership: our governments must create social consent at home and political agreement abroad keep open the channels of international trade and movement. He says:

At the domestic level, governments need to work out an equitable and politically sustainable allocation of austerity across the population.

This means ensuring that those sectors of society hit hardest by the crisis are not also the ones asked to bear the stiffest sacrifices. ... Governments that ignore the social and distributional implications of the crisis are likely to find themselves either driven toward extreme and counter-productive policies, or swept away.

At the international level, governments need to work just as consciously to coordinate not just words, but actions.

This will not happen of its own accord ...

Mark Harrison : 03 Feb 2009 20:19 |  Tags: Coventry Globalization Politics Recession Universities |  Comments (0) |  Close comments |  Report a problem

Quiet Flows the Don: The Radice Critique of Higher Education in the UK

Writing about web page http://inderscience.metapress.com/link.asp?id=xj92884n72203v41

Hugo Radice has written a fine critique of the management of higher education in the United Kingdom ("Life After Death? The Soviet System in British Higher Education," in The International Journal of Management Concepts and Philosophy 3:2 (2008), pp. 99-120). Radice's case is that British universities work under the same centralized command-and-control regulation as the old Soviet economy, and are subject to the same perverse incentives and the same dysfunctional behaviours that arose as a result: "plan bargaining, endemic shortages, sectoral autarky, and the battle for political control of decision."

I have shared this view since I first came across Radice's paper (and another on similar lines: Ronald Amann "A Sovietological View of Modern Britain," in The Political Quarterly 74:4 (2003), pp. 468-480). Now that Radice's paper has been rightly published in a refereed journal, I find I have somewhat less sympathy for its conclusions than I expected. It hits the right buttons on many core issues. And yet ...

Radice took six years to write and revise his paper. For three of those years, I chaired my department. From my first days in that role, I found that I had an accidental advantage – one of inestimable worth – over other novice chairs: a lifetime of studying Soviet bureaucracy. The aspects of university administration that baffled others seemed natural and obvious to me: the plan bargaining that Radice describes, soft budget constraints, the importance of networks and coalitions, and so on. I felt like a fish in water.

I reminded myself of the things that Stalin thought of as critical to power. At one time Stalin said: "Politics decides everything," so I became a political animal. At another time Stalin said: "Organization decides everything," so I tried to ensure that my department was clearly and well constituted, and then to respect that constitution. On yet another occasion Stalin said: "Cadres decide everything," so I gave almost all of my time to "cadres" – the identification, recruitment, promotion, and retention of academic talent. Stalin never said: "Money decides everything," so I limited  the attention I gave to money. I didn't ignore it, but I tried to ensure that money followed academic priorities, not the other way around.

I recalled what Soviet managers said consistently when asked what was the the most important condition for them to do their jobs: "To have good relations with everyone." No Soviet manager could do their job without cultivating networks of loyalty and influence. They never knew when they would need a friend, or regret having made an unnecessary enemy. I observed how fellow chairs that gave offense or picked gratuitous quarrels with peers and superiors paid a heavy price in their ability to bargain resources for their departments.

I knew Stalin appreciated loyalty, but as a signal of loyalty he also valued the ability to speak truth to power. Showing loyalty to a university that had already employed me for three decades was not a difficulty, but I also tried to tell the truth to my leaders. I cultivated their trust, partly so that my own recommendations would be heard and my own decisions would be respected. I knew that, like Stalin, the vice chancellor could change any decision I made if he wanted to. I also knew that, like Stalin, he had limited attention; he didn't have time to manage my department himself. I wanted him not to want to manage my department; I wanted him to want me to do it, and to leave me to do it. I needed him to trust me, and I carefully monitored the signals of that trust.

I observed the continual battle for resources inside my university. It was a game instantly recognizeable to students of the Soviet economy. There was a centre, hungry for discretionary power over departmental resources; departments were continually working to pool risks and insure themselves against the grabbing hand of the centre. In this context budget constraints were continually negotiated, varied, and renegotiated, so were never hard. Conservatism and short-termism were rife, and intertemporal smoothing nearly impossible. Like the Soviet economy, our system's dysfunctions could be mitigated by intervention from time to time, but fundamental reform was out of the question. Despite the problems, feasible solutions emerged.

There were many times when I didn't know what to do. Sometimes I put myself in the shoes of a party secretary governing an important region of the USSR, or perhaps the director of a big weapons factory in the Urals. What would they do? I did the same; usually, it worked.

Collective responsibility is one of the aspects of the Soviet command system against which its leaders fought a lifelong battle. The excess of collective responsibility in British higher education for teaching and assessment is something that drove me crazy and no doubt will continue to do so. The teaching quality people always go on about collective responsibility as though it is a good thing, a moral value in itself. To me, a little collective responsibility is a necessary evil, required to give some protection to students against sloppy teaching and arbitrary assessment and to shield academics against undue student pressure. But too much of it and no one is responsible; along with responsibility, blame is pooled, and we all end up carrying the can for a few bad citizens that few have the courage to identify and no one can manage because no one person is responsible.

And yet ...

There were some things I knew about the Soviet system, that I found I could not use. I thought of the fear that Stalin inculcated and exploited in those around him. I hoped that my colleagues respected me, but they did not fear me. I did not classify them into enemies and potential enemies (those who were my friends today but might turn against me in future). I did not order them arrested, tortured, and shot, nor did I hold their partners hostage in my Northumbrian Gulag to ensure their loyalty. When they voted me down, I served up my revenge neither hot nor cold but smiled and acknowledged the preference of the majority.

My university did not feel like the Soviet Union! I knew the Soviet Union. I had lived, worked, and breathed in it; my first visit was in 1964; I studied there in the 1970s, and have visited Moscow many times since. After 30 years, I also knew my university. It wasn't the same. But how did it differ?

The big difference was this: I had no barbed wire. With a few coils around the campus, I could have blocked off the exits. I'd have had to give guns and spotlights to the security staff. If I could have stopped my professors from leaving, I would have been able to do things to them that would lower their welfare, and they would have had to accept it. They would have grumbled, and then conspired against me, and I would have needed a political police within the department to listen, detect, and report it to me. I'd soon put a stop to that. Forced labour would be next. But I had no barbed wire. If they didn't like the pay or conditions on offer, and could do better elsewhere, my colleagues would leave. Other universities that could use their talents more productively would make them a better offer, and I would have to match it or lose them. Without barbed wire, I could not accumulate personal power by treating others badly; I could get my way only through reliance on positive motivations. 

What motivations? Here I had another revelation: if my department was like anything in the Soviet economy, it was like the parts that worked best! There were parts of the Soviet economy that didn't work; there, enterprises padded their costs and met the plan through false accounting and other manipulations. But in other branches, a relatively poor country could set talent to work and achieve great things: the best tank, the first satellite, and so on.

In those branches, what motivated people to put in effort was not cash but an inner drive to achieve something great and thereby win a prize. I had studied Soviet military engineering. The Soviet designers were motivated partly from within (they wanted to get into space) and partly by reputation (they wanted to be first into space). This motivation was extremely powerful; one finding in my work was that these designers implicitly priced the immortal reputation of being the first in the world to invent something at thousands of times their annual salary.

I saw that this also described my colleagues pretty well: each new idea they had, each new finding they reached, each new paper they wrote was like a ticket in a lottery where first prize was immortality. This motivation was also the thing that made them so hard to manage, since a manager could not easily manipulate it. As for cash, it was important mainly that cash did not de-motivate them by making them feel disrespected or undervalued. 

Putting these things together, I saw that what made my department work was competition. There were two markets in which we competed, the market for talent and the market for reputation. In the market for talent, we had to compete to hire great scholars and pay them their worth. To afford that, we had to care about costs and use all our resources productively. In the market for reputation, we were all competing for immortality. My department was competing with other departments in national and international rankings by research quality (approximated, with some error, by the quality of journal acceptances), research influence (approximated, with a variable and unpredictable lag, by citations), research inputs (QR income and competitive grants), teaching quality (approximated, with a wide error, by student evaluations and, with less error but a greater lag, by our graduates' incomes and academic placements), and (in the student market) fee income; but the income side was mainly important to my department in that it would allow us to compete more effectively in the market for talent. And, as individual scholars, we were all competing with each other for immortality (approximated by citations).

It was this competition that aligned everybody's interests. It was't perfect competition; there were clear signs of rent seeking and overinvestment. But we couldn't achieve our plan through false accounting, because we had to meet objective, externally verified criteria of our product quality. We couldn't push up costs all the time, because if we did we would lose competitive advantage to leaner departments. For these reasons, I decided, my university was most certainly not going to repeat the sad history of the Soviet economy.

We were better than that, because we had no choice but to be better.

Radice's model of UK higher education is nearly but not quite mine. In his framework, HEFCE is the funding ministry, the universities are the spending ministries, and departments are enterprises. The targets are set by the RAE and the QAA. The research councils administer the special innovation funds for which ministries and enterprises compete. Some differences are unimportant. The most important one is that university departments are not like the typical Soviet enterprise, but are more like Soviet research institutes and design bureaux. Like their Soviet equivalents they employ a mix of talented people, people that look talented but are not, and people that looked talented once and maybe still have something in them -- or maybe not. Like their Soviet equivalents, they all have a capacity to surprise the world.

Another difference between us might be over the RAE. To Radice, the RAE has us all playing a bureaucratic game. I agree there is an element of that, primarily in deciding whom to submit or exclude. But in three years of trying to recruit world-class scholars from countries that do not have an RAE, my complaints about it have met with little sympathy. Generally, scholars trying to leave Germany, Italy, and Israel, for example, wish that their country had an RAE, and expect it would be easier to stay home if it did. They would tell me that, if the RAE was bad, to have no RAE was worse. The fact is that, beyond deciding participation, there is far less to manipulate in the RAE than in teaching quality, say. And the evidence is that the RAE has been instrumental in a substantial improvement in the international standing of UK research.

Beyond criticism of the RAE, Radice claims that "ultimately teaching quality really is important" but has been bureaucratized without giving it priority. I agree about the bureaucratization; the QAA is a rent-seeking monopolist, not a true regulator. Worse, it has seeded itself into the teaching quality sections of university administrations across the country.

I don't agree about that teaching quality merits higher priority than research. The most important contribution of universities to teaching may be not to what is taught today, nor to how it is taught, but to what will be taught in thirty years' time. What comes out of the best research today will decide how textbooks will be written for the next generation of students. The most important of today's new concepts will be featured in those textbooks, named after their inventors, as the Edgeworth box, the Phillips curve, and Granger causality were in their time.

That's immortality.

Radice took time off from teaching his students to write "Life After Death." Good for him; this paper is important for both scholarship and public policy. If that is right, the education textbooks will soon feature added sections on:

The "Radice Critique" of Higher Education in the UK

Mark Harrison : 26 Jan 2009 10:02 |  Tags: Russia Stalin Universities |  Comments (0) |  Close comments |  Report a problem

Gaza: A Lesson From History

Writing about web page http://www.publications.parliament.uk/pa/cm200809/cmhansrd/cm090115/debtext/90115-0013.htm

On January 15, Sir Gerald Kaufman, MP, told the House of Commons:

My parents came to Britain as refugees from Poland. Most of their families were subsequently murdered by the Nazis in the holocaust. My grandmother was ill in bed when the Nazis came to her home town of Staszow. A German soldier shot her dead in her bed.

My grandmother did not die to provide cover for Israeli soldiers murdering Palestinian grandmothers in Gaza. The current Israeli Government ruthlessly and cynically exploit the continuing guilt among gentiles over the slaughter of Jews in the holocaust as justification for their murder of Palestinians. The implication is that Jewish lives are precious, but the lives of Palestinians do not count.

On Sky News a few days ago, the spokeswoman for the Israeli army, Major Leibovich, was asked about the Israeli killing of, at that time, 800 Palestinians—the total is now 1,000. She replied instantly that "500 of them were militants.”

That was the reply of a Nazi. I suppose that the Jews fighting for their lives in the Warsaw ghetto could have been dismissed as militants.

Let's think about this.

The recent Israeli incursion into Gaza lasted 23 days (December 27, 2008, to January 11, 2009). Ten Israeli soldiers were reported killed in action.

The population of the Gaza Strip is currently in excess of 1.4 million. Estimates of the Palestinian death toll during the Israeli assault range from 1,330 (Hamas) to 500-600 (an anonymous Palestinian hospital doctor, reported by the Italian journalist Lorenzo Cremonesi). We can't verify either figure. For the sake of argument we'll take the higher figure; it suggests a death rate of around 1 per thousand of the population "at risk," about half of them unarmed civilians. (The lower figure would suggest less than 0.5 deaths per thousand with few unarmed civilian deaths among them.)

The Warsaw Ghetto uprising of 1943 lasted 120 days (January 18 to May 16, 1943). Sixteen German soldiers were reported killed in action.

The initial population of the Warsaw Ghetto is not known. Between 1939 and 1942, the German occupation concentrated between 300 and 400 thousand Jews in Warsaw. In addition to an unknown number of deaths from hunger and disease, between 250 and 300 thousand were deported to Treblinka and murdered over the summer of 1942. Jewish deaths during the uprising itself amounted to 13,000; after the insurgents' surrender, the 43,000 survivors were deported for extermination. The final death rate amongst the population "at risk" approached 100 percent.

On these figures, the fate of the Warsaw Ghetto in 1943 does not look like a close parallel for that of the Gaza Strip today.

That's enough about outcomes. What about intentions?

In Warsaw 55 years ago, the intentions of the two sides were clear. The Germans intended to exterminate the Jews regardless of age, sex, or combatant status; the ghetto uprising simply forced them to accelerate the process. The intention of the insurgents, who had a good idea of what had happened to those deported to Treblinka in 1942, was to resist otherwise certain death.

In Gaza this year, the intentions of each side are open to more than one interpretation. The Israelis said they intended to avoid civilian casualties as far as possible, but "as far as possible" is a difficult phrase. Certainly, civilians were killed, certainly in dozens, possibly in hundreds. Setting moral feeling aside, most of us (including me) have no practical idea of what words like "possible" or "necessary" mean in that context. But we can turn the question round. If the Israelis had intended to cause civilian casualties, was it within their military-technical capacity to do so on the scale of the Warsaw Ghetto? Without doubt, yes. If an army fighting in a crowded city with the military technology of the 1940s could kill tens of thousands of civilians in a few weeks, then surely it can be done again today; but that is not what happened, as we see.

As for the intentions of the Hamas militants, they were defending ... hmm. Not sure. The right to fire rockets freely across the border into Jewish settlements, I think.

To make sure you understand me, let me add: Crime deserves trial and punishment. If Israeli troops behaved badly in Gaza, what happened in Warsaw more than half a century ago does not justify it. (And exactly the same applies to those who organize indiscriminate suicide or rocket attacks against civilians.) Things that were done to us in the past do not remove anyone's moral responsibility for what we do in the present or plan for the future.

In fact, in solving conflict, history is generally not much use. It is part of the problem more often than of the solution. As Ed Glaeser has written, the memory of past crimes, real or imagined, fuels the fear of crimes yet to be committed, and so hatred, and encourages people to feel justified in committing more crimes themselves! Usually, nothing positive can be achieved unless all sides can learn to forget a whole lot of the past. 

But history that is manipulated, or distorted, or misremembered, is worse than anything, because it adds the petrol of hatred to the fire of conflict. So, for as long as we have to have it, let's try to get the history right.

Mark Harrison : 23 Jan 2009 14:57 |  Tags: History Israel Palestine Using-Data |  Comments (0) |  Close comments |  Report a problem

The Fiscal Stimulus: Catch 22

Writing about web page http://krugman.blogs.nytimes.com/page/2/

Paul Krugman has made the following point: for the United States, one dollar added to the federal debt by new public spending will save three dollars' worth of jobs. This is despite the fact that the Keynesian multiplier for the United States is only about 1.5. Why? Because every job saved will generate tax revenues that should offset some of the implied increase in the federal deficit.

There's a couple of assumptions in that. One is that interest rates won't change much, which makes sense because right now they are on the floor and likely to remain there. Another is that, oddly enough for a guy that won the Nobel prize for contributions for trade theory, Krugman doesn't mention foreign trade. That makes sense because the United States ratio of trade to GDP is only 10% (exports) to 15% (imports).

The same idea should work for Britain. But it is much less favourable, because we are more heavily taxed and also have a much more open economy. Unless I misled several generations of first-year students, the Keynesian multiplier for an economy with direct and indirect taxes and foreign trade is 1/(1 - c(1 - t₁) + t₂ + m) where c is the marginal propensity to consume (say 0.6 in the short run), t₁ is the direct tax rate (say 0.25), t₂ is the indirect tax rate (say 0.15 since Darling's VAT reduction), and m is the import propensity (say 0.25). That gives us a Keynesian multiplier of 1/0.95 which for present purposes is about 1.

Let's assume that interest rates stay low, and the exchange rate stays where it is. Then, every extra pound of public spending generates about one pound of effective demand for goods and services. But then, each extra pound spent will bring back 40p to the Treasury in direct and indirect tax revenues, raising the national debt by only 60p. That makes 60p of new indebtedness the price we will pay to create one additional pound of GDP.

Think about jobs. In the UK economy each person employed generates about £50k of GDP. We are currently losing around 100,000 jobs a month from the economy; to be conservative let's put that at a round million jobs over the next year. To save those million jobs should take a fiscal stimulus of £50 billion a year, starting now, but it will add only £30 billion to our national debt, because if those jobs can be saved there will be a clawback to the Treasury of £20 billion in tax revenues.

There are some catches.

Catch 1. The government is proposing a stimulus of £20 billion over the next two years. Oh – and it hasn't even started yet. Jobs are being lost now. A fiscal stimulus doesn't work instantaneously. Fixated on blaming the banking sector for what is about to happen (in addition to what has happened already), the government is still trying to revive lending rather than to revive spending directly. 

Catch 2. Britain, unlike America, can't ignore the rest of the world. The reason exports don't figure in the Keynesian multiplier is that they're outside our economic system: if our export markets are falling off the same shelf as us, that will have an adverse multiplier effect that works against the multiplier effect of our own public spending.

It is critically important for small open economies like the UK to have a fiscal stimulus that is coordinated internationally. We all make up each others' export markets! If every country would stimulate demand at the same time, and in the same proportion, the trade balance effects would be neutral, but the collective stimulus would be far more powerful. Every country would see a double bonus, the first coming from its own public spending, and the second coming from the public spending of its trading partners, reflected in exports.

Catch 22. The European Union was constituted on the assumption that the problem of deficient demand had been solved. Coordination was needed only for monetary policy (so we have a European Central Bank) and to ensure fiscal restraint (so the Eurozone is supposedly governed by the deflationary rules of the Growth and Stability Pact). There's no mechanism to coordinate a European fiscal stimulus!

So it's up to the G8 and the G20. Let's think about that.

Generations of students of international economic history have learned that a major part of the Great Depression was the failure of international coordination. Our ability to coordinate a response to the greatest economic challenge since the Great Depression is being tested now. Until recently, we thought we knew how to avoid bank runs. Then we had the first major run in 150 years. We also thought we knew how to avoid a major recession. I was about to write: "Watch this space." Depressingly, I'm not sure you need to.

Mark Harrison : 22 Jan 2009 11:23 |  Tags: Globalization Keynes Politics Recession |  Comments (0) |  Close comments |  Report a problem

Three Myths of the Credit Crunch

Three myths are current in public discussion of the credit crunch and the recession that we face today: "We should make the banks lend out the money we've given them." "We can't spend our way out of this recession." Worst of all, "We are burdening our children with debt." What's wrong with them?

We should make the banks lend out the money we've given them.

Since November the following story has been in circulation; it started from Downing Street, but has found wide support. It goes like this: We, the government, have given the banks billions of pounds of your (the taxpayers') money. Instead of translating your cash into new lending, the banks are sitting on it. This is helping to drive cash-strapped businesses into insolvency, and is not fair. The banks are breaking a moral contract. We should now set targets for bank lending and punish banks that fail to meet them.

The story's wrong. We're forgetting something. Question: What was the worst case that the bank bail-out was designed to avoid? Answer: Bank failures on a catastrophic scale. And this has been averted. Our government bailed out the banks because the alternative was a financial Armageddon on the scale that ushered in the Great Depression. So far, this worst case has been avoided. For example, no British saver has yet lost a penny from deposits in a British bank. If the worst had happened, there would be ruined savers in every neighbourhood in the country. Conclusion: the banks are doing what the bail-out intended: they are holding our cash, because they need it to hold in order to stay afloat.

If we want bank lending to increase again, our government must increase the cash available still further, or at least extend its promises. That is approximately what the government is doing now, through credit guarantees to small businesses, for example.

Another version of the same fallacy goes like this. The Bank of England's discount rate is at a record low of 1.5%. Banks (including some mortgage lenders) are unfairly increasing the margin above this level at which they are willing to lend. Public pressure or legislation should bring lending rates down. But one cause of the credit crunch is that banks have underestimated the risks of lending. As a result, the gap between their borrowing and lending rates, which includes their evaluation of risk, has been too narrow. Restoring the banking system to health must provide for larger risk premiums than before.

At this point, pressure for more bank lending and lower lending margins may not be for the best. We are in this mess because banks lent unwisely. Pressing or guaranteeing them to do more of the same, especially for the sake of small businesses that have a high failure rate even in good times, does not seem to point a way back to prudence. As has been commonly observed, monetary policy in Britain as in the United States is simply running out of ammunition. Public spending may now be more effective as a way of keeping viable businesses afloat, and should take up the burden. Which leads us to the second fallacy:

We can't spend our way out of this recession.

In 1976, prime minister James Callaghan famously remarked: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step." This has been widely cited recently by critics of the government such as (but not limited to) John Redwood.

If more public spending is the right answer today, why was it the wrong answer then? The reason is that that our economic predicament today is wholly different from that of Callaghan's time. In the 1970s, inflation and unemployment were rising together. That was the signal that the UK economy's problem lay on the supply side, not the demand side. The economy was rigid and uncompetitive. Industry was dominated by loss-making firms that were kept in existence by public ownership and public subsidy. The difficulties of the time required supply-side solutions: better incentives through increased competition and lower taxes.

Today, unemployment is rising and inflation is falling. This signals that the UK economy faces a deficiency of demand, not supply. Moreover, the loss of demand at home and abroad is on a scale not seen since 1929. A demand deficiency can be countered by monetary measures to some extent, but for the next few months the overworked cliché is correct: cutting interest rates is like pushing on a piece of string. (The cliché is overworked because, over a somewhat longer period, the monetary relaxation should have a powerful real effect through a more competitive sterling exchange rate.)

When demand is deficient, the quickest way to restore it may be through increased public spending. Tax cuts may be preferable in theory, since each of us knows better how to spend our money than the government does, but in the grip of current uncertainties it is likely that households will save most of any tax cut will be saved, and so the tax cuts will not contribute much to higher demand.

Rapid increases in public spending are likely to be inefficient since there is not enough time to plan them. The composition of any increase is likely to be determined more by competitive lobbying than by cost-benefit calculation. There may well be some degree of consensus that we need to invest in green technology, transport, and IT. As soon as you look at these in detail, you can watch the vested interests line up -- for and against nuclear power and carbon capture, motorway and airport expansion, and so on. However, if our immediate goal is to combat the worst consequences of the crisis, it may not matter if some projects are ill-chosen; at least they will create jobs and cash flows to replace those that are now being destroyed.

Here are two things that could and should be boosted right away -- and it would be efficient to do so.

• UK local authorities are planning for catastrophic shortfalls in council tax revenues at the same time as demands on their services are multiplying from citizens faced with losing their jobs and houses. It is shameful that local government cutbacks should be contributing to the economic downturn, rather than softening it. The government should immediately commit central funding to neutralize the effects of the recession on local government revenues.
• Iraq and Afghanistan have taken a heavy toll on the combat readiness of the UK's armed forces. The Ministry of Defence surely has a long shopping list of equipment that is needed just to reset the armed forces to their pre-conflict readiness. There is absolutely no reason to think we will need our armed forces any less in the 2010s than we did in the 1990s. We should start this restocking process now, and this will incidentally make a large contribution to the revival of UK manufacturing.

Can we use public spending to mitigate the recession? The answer lies with Obama, not Callaghan: Yes, we can.

It's true that using public spending in this way will widen the excess of spending over taxes, and cause public debt to balloon. This takes us to the third fallacy:

We are burdening our children with debt.

British politics needs an effective opposition. Just when I hoped the Conservatives were becoming one, George Osborne has come up with this: "Every child in Britain is born owing £17,000 because of Labour’s Debt Crisis."

This story is misleading, rather than false -- but it is deeply misleading on several different levels. It is true that higher public debt must be repaid sometime. As I noted here, however, the implied increase in Britain's debt implied by present policies is relatively modest and sustainable. The government deserves blame for the fact that Britain entered the recession with its current deficit in a bad way, but the accumulated level of public debt was modest, and we can easily withstand a proportionally large increase in it.

But the idea that we are burdening our children with debt is misleading at a deeper level. For one thing, they will inherit our private debts too. What is happening today will eventually lead to a considerable reduction in private debt, whether through repayment or default. At the same time public debt will be higher. So our children are likely to inherit more public debt, but less private debt.

And another thing: Our children will be better able to shoulder the public debt we will pass onto them in the future, if we don't burden them (and ourselves) with a Great Depression now. The last Great Depression impoverished families and children and threw millions of workers on the scrapheap of long-term unemployment. Worse, it paved the way to global economic disintegration and global war. Do we want to burden our children with that?

And a final thing: If it works, our children will live better than we do. As adults, they should share the burdens we face today. But I won't tell my children that. They'll say it's not fair.

Mark Harrison : 14 Jan 2009 17:05 |  Tags: Economics Keynes Recession |  Comments (4) |  Close comments |  Report a problem

In 2009, Let the Poor Have Debt

Writing about web page http://www.telegraph.co.uk/news/newstopics/religion/3981635/Bishops-deliver-damning-verdict-on-Britain-under-Labour-rule.html

Too much debt is bad. There has been too much borrowing and lending. Now we are all paying the price in bankruptcies and layoffs.

Coupled with that, a big reaction is under way against the idea of debt and the people who make debt possible: the lenders. There's a lot of anger around that is being directed against bankers. There's also a lot of ex post moralizing: the recession is poetic justice, collective punishment for past collective excess.

It's transparently obvious that we need to adjust to some painful lessons. When they created assets or bought assets that others were selling on, many bankers forgot about exercizing due diligence. They misunderestimated the risk. Those that made the biggest mistakes will have made the biggest losses, so the market has now delivered rough justice. The trouble is that, because market justice is rough, we will all suffer with them.

How far should we all adjust? When people are in a fix and feelings are running high, reactions can go too far. Over Christmas there has been a lot of opinionating about debt. Interviewed before the holiday on Radio 4, the Archbishop of Canterbury said that debt cannot be the foundation of sustainable prosperity. Although he agreed it would be "suicidally silly" for him to start dispensing economic advice, this did not stop five other Anglican bishops from issuing a Boxing Day fatwa against the "buy now, pay later" society.

So, it's time to speak up for debt. Too much debt is bad. But too little debt is bad, too. Even today, if you look at economic conditions around the world, it's almost certainly the case that the damage caused by too little debt hugely exceeds the suffering caused by too much of it.

How's that?

Scattered around the world are many profitable investment opportunities. Many of these are in poor countries; these countries are poor, precisely because many opportunities are not exploited. The poor can see many of the opportunities just as well as the rich -- in fact, often enough, better than the rich, because the opportunities are close by where the poor live: the returns to educating children and to small enterprises, for example. But can the poor take advantage of these opportunities?

It's easy to see how the rich might jump in. After all, they are rich and can afford it. The rich might not want to, though. For one thing they may not see the opportunities hidden in the midst of poverty. For another, they may not see how to make a profit for themselves; it takes a philanthropist to want to educate a stranger's daughter, or fund a competitor's business.

So, if the rich people don't jump in, what about the poor? The problem of poor people is: they're poor. 

The only way the poor can take advantage of these opportunities is by borrowing. The poor need to be able to go into debt. 

In fact, often enough, it is being unable to incur debt that keeps the poor in their place. While the poor cannot borrow, their children stay illiterate, their land stays unfertilized, and their talents remain idle.

In 2006, Muhammad Yunus was awarded the Nobel Peace Prize for his work in bringing debt to the poor. Here are the opening words of the Prize Committee's citation. "Professor Muhammad Yunus established the Grameen Bank in Bangladesh in 1983, fueled by the belief that debt is a fundamental human right. His objective was to help poor people escape from poverty by providing loans on terms suitable to them and by teaching them a few sound financial principles so they could help themselves."

(Oh -- I changed one word in the quote. Where the original reads "credit," I wrote "debt." You can check the original here. Get the difference? Bring "credit" to the poor -- you're a saint. But those who bring "debt" to the poor -- which is exactly the same thing -- are often seen as in league with the devil. Hmm.)

In poor countries, bringing debt to the poor can be immensely liberating. Poor people that cannot borrow are condemned to live in impoverishment and insecurity; they must remain at the mercy of the existing power structures. Debt lets the poor invest; it has the potential to raise the poor above their station and enable sustainable, long-run development. Yes, real development! It's true, investment is risky and not all investments will pay off. But without debt, the poor will lack even a chance of escaping poverty, for it is then certain that the poor will invest nothing and get nothing.

Yes, it's still true that too much debt is a bad thing. But no debt at all is bad too! In fact, it can be even worse!

Again: in rich countries, even poor people would sometimes like the security and pleasure of living in their own homes. They can have it, but only if they borrow. If you don't let the poor borrow, what you are saying is: Hurray for the landlords! Long live buy-to-let! Keep home-owning for the rich! For people who cannot put down the full value of a house, being able to get a mortgage is productive in a real sense: it is productive of things that we all value, of security and family life, in fact, of exactly the same "non-material" values that the bishops think has gone missing from British culture.

No, it's not a great idea to give poor people borrow more credit than they can ever repay. But to go to the other extreme and tell the poor they must wait until they have earned it -- forever, that is -- is Victorian values of the wrong kind.

The main problem our own rich country will face in 2009 and the years beyond is not too little debt. It is the composition of the debt. A huge shift is under way in Britain from private debt to public debt. Households will tighten their belts, reduce their outgoings, pay down their mortgages, and rent new homes instead of buying them. As a result, private net indebtedness will fall.

Meanwhile, the government will splurge on unemployment benefits, housing support, and capital projects. Because of the expected fall in tax revenues, the government will pay for it by borrowing. Public debt will balloon. While short term interest rates are now at an all time low, long term rates will remain high. In the future this will be a barrier to renewed growth of private indebtedness.

And that's a good thing! When anyone borrows, they should do so in the expectation of a personal gain that exceeds the interest rate; otherwise, don't do it! Making everyone, rich and poor, leap over a higher interest rate hurdle before they borrow is not a bad idea when the problem has been too much debt.

But that's just to ensure that debt performs its proper function: to sustain development. If the poor are to participate in development, they must be able to borrow. The poorest places in the world are the places where the poor cannot borrow.

Mark Harrison : 30 Dec 2008 14:23 |  Tags: Economics Keynes Recession |  Comments (0) |  Close comments |  Report a problem

Conversations with Cab Drivers

Since conversations with cab drivers are becoming a minor theme of this blog, let me add two more. In March this year I visited Berlin for the first time. Flying into Schönefeld airport, I had a long ride into the city centre and another back again a few days later.

On my inward journey, the driver was a young man with broken English. (I don't speak German.) I say young, but he seemed aged by anxiety. He was worried about the credit crunch, which at the time was gathering pace. The run on Northern Rock, the iconic event for British readers, was still six months in the future. My driver's worry was not about recession, which at that time lay below the horizon; it was about hyperinflation.

Central banks were printing too much money, he said, and this worried him. To emphasise this he took both hands off the steering wheel and clapped them to his head, which was balding. During our conversation he would do this again any time he was lost for words, or perhaps if he thought I was showing signs of complacency.

I wasn't complacent at all; I'd been concerned about the state of the financial world for some months already. I just thought he was worrying about the wrong thing. I tried to explain that when financial intermediation was unwinding demand would switch from other assets to cash, which only central banks could supply. The danger was that monetary conditions would become too tight, not too loose.

To support his argument my driver gave me a gift, the only one I have ever received in a taxi. This involved his taking a hand off the wheel and both eyes off the road to find his wallet in a jacket on the seat beside him and open it. He collected memorabilia, he told me, of the German hyperinflation after World War I. My gift was a 10-million Reichsmark note of 1923. I thanked him sincerely, and in truth it was kind of him, although I would have been happy for him to wait until he had stopped the car.

On the return journey my driver was wiry, short, and brown as a nut, with sharp eyes and a striking beard, white and very long. Because of the beard I thought at first he was very old, but as it turns out he was most likely younger than me. At first I thought we had no common language, but a few minutes of experimentation showed that we shared Russian. He was ready to talk, and he talked to me calmly and with emphasis. He kept his eyes on the road and his hands on the wheel; all I had to do was ask a few questions, sit back, and listen.

The driver recounted: His family had left Germany for Russia late in the eighteenth century, at the time of the Empress Catherine the Great, settling in the region of Odessa. Caught up in Stalin's deportations of national minorities before World War II, they were exiled to Siberia, eventually resettling in Ekaterinburg. In 1991 Mikhail Gorbachev and Helmut Kohl agreed on the right of ethnic Germans to return from the Soviet Union to Germany. His surviving relatives came first; he followed them reluctantly, after economic conditions in Russia had worsened.

I asked if my driver was satisfied with his life in Germany. He answered firmly: No. In Russia, as a German he had been treated with respect. In Germany, seen as a Russian, he was treated accordingly. Worse, the Germans had forgotten how to be German. Their politicians were corrupt and decadent. They were selling their own country off to the Jews. Their daughters were prostitutes, he said, waving his hand at a group of girls by the roadside. He would take a strap to them. He added, for clarity: not to the girls, but to their parents, who had failed to bring them up properly.

I asked him what he thought of Russia today. Putin, he told me, was doing the right thing for Russia. He was building a strong country that would once more command respect in the world. This was what Russia needed.

He dropped me at the airport in good time and good shape, but troubled. It was symbolic, I decided, that in Berlin, a city at the heart of Europe that already had too much history, I should find a Russian German that hated Jews and Germans and tended the flame of Russian nationalism in his heart.

Mark Harrison : 14 Dec 2008 21:19 |  Tags: Cab-Drivers Recession Russia |  Comments (1) |  Close comments |  Report a problem

Victims and Perpetrators

Writing about web page http://www.itar-tass.com/prnt.html?NewsID=13357267

I spent a long weekend in Moscow at an international conference on “The History of Stalinism: Research Problems and Results." The conference was an important public event, organized by liberal scholars to counter the conservative tendencies in government and popular culture. There were 400 participants including academicians, archive directors, professors, and members of the public. In addition to many Russians there were scholars from Britain, France, Germany, the United States, and Japan. The closing session was chaired by Nikolai Svanidze, Russia's Jonathan Dimbleby; Putin's minister for education and science Andrei Fursenko attended and spoke briefly.

Russia's citizens know little about Stalin. We are 55 years since Stalin's death, so no one younger than 60 can have a clear memory of the time when he ruled; the average life expectancy of Russian men today is 59 years. They know only what their parents and grandparents told them. A majority believes Stalin was a positive figure -- on balance, one of the great leaders of the twentieth century. There is nostalgia, inflated by conservative myth-making, summed up in the common perception that Russia needs strong, centralized leadership and should avoid the "excesses" of democracy.

My taxi driver to the airport, a man in his 50s, told me that his family was rooted in the trading class of Riazan, to the south east of Moscow. In the 1930s relatives of his grandparents' generation were arrested and executed. But when I asked for his personal view of Stalin he told me Stalin was too far away and high up for him to care. "The most terrible tsar," he said, "is the one that is nearest to you -- your boss at work or the neighbourhood bully." Between Stalin and the victims were many layers of perpetrators, who were also responsible.

That's true, of course. One statistic I heard quoted in the meetings was that, by the fall of the Soviet system, the KGB had 25 million informers -- a tenth of the whole Soviet population.

But, while true, it doesn't do justice to Stalin. One feature of Stalin is that he was an effective dictator. He had an exceptional talent for orchestrating the activities of those under him. As master of the ruling party and state, he ran an army-like command system that directed the lives of everyone. One thing that he orchestrated was the murder of three quarters of a million "potential enemies" in the Great Terror of 1937. When he gave the order, the shooting started. He ordered the creation of lists of numbers to be executed by region and category. He accepted or rejected the amendments proposed by those below him. When he was satisfied that enough had been shot, he gave another order and the shooting stopped.

So, who was more terrible: the man that fired the bullet, or the one that gave the order?

For the sake of justice, to bring the facts into the open, and to reconcile the state with its victims, both the man that fired the bullet and the man that gave the order need to be held to account. Not only Stalin but those who followed his orders. Not only those who followed orders, but Stalin himself. As South Africa has shown, it is possible to have truth and reconciliation without revenge, but without truth there can be no reconciliation.

One participant in the meeting noted that the crimes of Stalinism have produced victims but no perpetrators. Some real perpetrators were punished in Stalin's time, because Stalin was not satisfied until he had "cleaned out" his own secret police in addition to the rest of society. But Stalin is dead; since the collapse of communism not one executioner or torturer has been brought to account. The archives protect them from history, since files relating to living persons may not be disclosed and the families of dead persons retain the right to prevent disclosure.

On a different note, as an economist I was interested in discussion of the efficiency of forced labour. There is a debate about how effectively Stalin's GULAG labour camps used their resources. At various times Stalin held between a million and two and a half million people in the labour camps of the GULAG, but since most sentences were relatively short the throughput was much higher. During Stalin's time, maybe 25 million people passed into the GULAG -- and most came out again. In peacetime the annual death rate averaged around 30 per thousand, rising to 200 per thousand in the worst years of the war when there was not enough food to go round. Most forced labourers were engaged in logging and mining in the remote regions of the far north and east, and in construction around the country. A few were engaged in research and development, as Solzhenitsyn described in The First Circle.

How effectively were the forced labourers used? To some participants in the meeting, this question was clearly a source of anxiety.

By the end of Stalin's lifetime senior officials saw the GULAG as a financial loss-maker and an economic and social burden. They wanted increasingly to abolish it, but couldn't persuade Stalin. Conditions were awful and labourers were paid little, but even behind barbed wire it was hard to force effort out of people who had little or nothing to lose, so even in the labour camps there were cash incentives and better food for hard workers. A million forced labourers required a hundred thousand guards. In short, forced labour was not as cheap as you might think. Productivity was probably low on average, but some camp commanders may have been better at forcing or inducing effort than others. Or perhaps some were better than others at inflating reports; that is also possible. There are many details in the evidence, and as yet there is no summary.

So what? Here's what. More than 30 years ago there was a debate on the profitability of American slavery before the Civil War. Fogel and Engerman's Time on the Cross settled it, showing clearly that slavery was profitable. What did this mean? It meant that slavery would not have withered of its own accord. It was necessary to fight a civil war and spill blood to destroy it. That was how the American debate went.

Here is how the Russian debate goes: if the GULAG labourers were unproductive, if the GULAG was a burden on society, well and good that it is gone. But if it was productive and profitable -- well, then it worked! In that case, why not restore it? If only parts of the GULAG were efficient, why not study those parts to find out the secret -- and copy that? In short, on one side of the Russian debate, the price of forced labour paid in liberty lost and blood and tears spilt is seen as unimportant, compared with patriotic pride in the success of a great national effort carried out within barbed wire and under armed guard.

To conclude, we need to research the facts about Stalinism, but we also need a moral compass. A former comrade once said (I paraphrase, because neither the ideas nor the words were mine): "we study what happened in history, not to criticize history in the light of our ideals, but so that we can criticize our ideals in the light of history." I go along with that; communism is a nice set of ideals, but it is because of knowing what has happened in history that we can see its consequences. Evidently, to draw conclusions from the economic record of Soviet forced labour is a test not only of our knowledge but also of our political morality.

Mark Harrison : 11 Dec 2008 18:04 |  Tags: Cab-Drivers Forced-Labour Russia Stalin |  Comments (0) |  Close comments |  Report a problem

We are All Ricardians Now

Writing about web page http://www.economist.com/world/britain/displaystory.cfm?story_id=12707624&fsrc=rss

The country needs a fiscal stimulus. In the economics of John Maynard Keynes there is a clear rationale. The economy is going into a serious recession. When that happens, the government faces a bitter choice. It can stabilize its budget, or it can stabilize the economy, but it cannot do both.

• Stabilizing the economy means cutting taxes and increasing spending in order to compensate for the fall in aggregate demand. In addition to first-order effects, this will put more purchasing power into the hands of consumers, who will hopefully spend it, so multiplying the effect of the initial injection -- but the lower taxes and higher public spending will cause the budget to swing into deficit (in the case of the UK, it was in deficit already).
• Stabilizing its budget means that the government must raise taxes and cut spending, but this will make the recession worse, since households will lose even more purchasing power than they are already losing because of the credit crunch and the recession.

Wisely, the government has chosen to try to save the economy, not its budget. And, in fact, so has the opposition. The difference between them is that the government will spend more, and cut taxes less; the opposition would shift the focus somewhat to tax cuts. In practice the difference may not matter hugely.

In addition to bringing forward some capital projects, the government is cutting VAT temporarily, deferring an increase in corporation tax, making permanent a recent increase in the tax threshold, and increasing pensioners' and children's benefits. The total shift in the Treasury's underlying fiscal stance is a net stimulus of £21.5 billion over two years, the current year and next year. But, because the economy will go into recession anyway, eating away at tax revenues and pushing up spending on benefits, public borrowing will rise by much more.

As a result the ratio of debt to GDP will rise from 36% in the last financial year to 57% in 2012/13 (figures are in this week's The Economist). This is causing huge political concern. Who will pay for it, and how will we pay? At the moment we have only a few clues. The VAT reduction is temporary. National insurance contributions will rise for everyone, and marginal tax rates will rise for the highest earners. The capital spending that has been brought forward will also come to an end earlier than planned. Bankers are rich and unpopular, so the rich are a tempting target, but in the medium term the rich will be fewer and poorer than recently so the average tax payer will probably make the main contribution.

The concern over how to pay for the debt is odd in two ways. First, at 57% the British debt ratio would still be within the limits of the EU Stability and Growth Pact, below the current EU average, and far below today's ratios for France, Belgium, Germany, and Italy. A 57% ratio is also quite sustainable; in steady state, financed at 3%, it would imply a permanent increase in the UK tax burden of about 0.6% of GDP.

Second, the concern looks counterproductive. This is where Ricardo comes in.

Does it matter whether you finance extra government spending by extra taxes, or by running a budget deficit and borrowing to cover it? In Keynesian terms, the purpose of the fiscal stimulus is partly to replace households' lost purchasing power. If taxes rose now, that purpose would be frustrated. That is why the stimulus should be financed by borrowing.

In 1820, David Ricardo asked what difference it would make to finance a given amount of government spending by borrowing or taxation. The burden of taxes required would be £X. Alternatively, the government could borrow £X from the public as a perpetual loan. The only change in the burden of taxes then would be £X times the interest rate -- but this would have to be levied in every future year. The present value of the stream of future taxes, discounted at the same interest rate, would be ... Oh, £X.

In other words, borrowing is simply deferred taxation, and the present value of the two burdens is equivalent, so this idea is sometimes called Ricardian equivalence. (In the 1970s Robert Barro revived the idea as a major contribution to the new classical macroeconomics.) 

In Keynesian economics, households receiving the stimulus of extra government spending feel better off when it is financed by borrowing, since they have more current purchasing power as a result. Therefore they go out and spend more, and there is a multiplier effect that boosts the economy further. If Ricardian equivalence holds, however, rational households perceive that the extra borrowing arising from the stimulus is just deferred taxation of the same value as the government spending, and feel no better off as a result. There is no further boost.

Ricardo did go on to point out that households might not be fully rational; there would be a natural tendency to see £X times the interest rate (say £3) forever as a much smaller burden than £X (say £100) now. And most empirical studies of the postwar period have tended to show that the multiplier does work, in the short run anyway.

Most politicians are unlikely to know anything much about David Ricardo, and only the few that studied economics at degree-level may have heard of Ricardian equivalence. Yet today we see that politicians on both sides, apparently intentionally, are trying to instruct the electorate in Ricardian equivalence. Government and opposition are alike emphasising that today's fiscal stimulus is only temporary and must be paid for with higher taxes in the future.

To the extent that ordinary people are listening, they will surely respond less to the fiscal stimulus as a result; being told to expect higher taxes in the future, they will spend less of the extra purchasing power they receive and will save more of it than if they had not received the warning. The overall effect of the stimulus will be less.

Why are the politicians doing it? The government is doing it in order to manage expectations of its policy can achieve. The opposition is doing it to undermine the credibility of the government. It comes to the same thing. We are all Ricardians now.

Mark Harrison : 01 Dec 2008 14:01 |  Tags: Economics Keynes Recession |  Comments (1) |  Close comments |  Report a problem