More Lemming than Chicken

Posted on December 29, 2012 | 2 comments

The US fiscal cliff negotiations are running down to the wire. Surprising? No. Simple models from game theory suggest we’re heading for the edge.

The term “fiscal cliff” refers to a collection of mammoth tax increases and spending cuts that are due to come into effect in early 2013. The measures imply a significant contraction in government spending, which commentators are worried would send the US economy back into recession. A bad thing for the world, not just American’s. Good summary pieces to look at on what exactly the fiscal cliff is include this CFR piece and the BBC Q&A.

The cliff has been likened to a game of chicken, an important model of conflict from game theory. This model captures the idea that neither party wants to be the one to back down, although the worst possible outcome occurs when neither yields. Although “chicken” goes some way towards representing the current situation, it omits some key features that suggest we’re going over the edge.

tumblr_m6qvvmFSWC1rpl1oeo1_500The game of chicken has its origins in a game where two drivers speed towards each other on a collision course destined for death and destruction. This terrible fate can only be averted if one driver swerves and accepts the (socially crippling) shame of being labeled “a chicken”. The simple game alone does not tell us which party will duck out: there are multiple “Nash equilibria”. However, restricting ourselves to consider “pure strategies” only (i.e. as a driver I can either choose to swerve or not serve), then the equilibrium outcome is for one party to backdown and be labeled a chicken. In our case, this would amount to one party conceding to the other’s fiscal demands and crisis being averted at the last minute.

Yet, the chicken analogy, although helpful, does not go far enough. Let’s take the car example. Imagine you’re a driver involved. Before starting the face off, you’d really like to give your opponent a look and say: “Just so you know, there’s no way I’m backing down. So matey, swerve.” However, this threat isn’t credible. You’re opponent would be silly to believe you. Conditional on my opponent staying the course, it’s best for me to duck out and face poultry related stigma.

However, I could take actions before getting into the car to make my not-swerving-claims credible. Take a look at the film “Footloose” to get the idea (no, really do look at this scene: Kevin Bacon driving a tractor with Bonnie Tyler playing in the background). In the film, a dare results in two teenagers playing a game of chicken. The boy played by Kevin Bacon ends up winning, not because of any braveness on his part, but because a tangled shoe lace prevents him from bailing. Knowing that Bacon is unable to get off the tractor, his opponent ducks out. An example that shows greater foresight rather than just lazy shoelace tying, is that of Hernan Cortes, who scuttled his ships during the conquest of Mexico in 1519 to prevent his soldiers deserting. The key idea is that you can limit your action set ex ante to put you in a better bargaining position. Applied to the fiscal cliff, one can argue that the Republican party’s claims regarding inability to compromise are credible. Given the current make up of the House, legislation implying tax rises for the wealthy is a no go here. The fanatical element of the Republican party thus lends their claims weight. Taken alone, this suggests compromise on the Democratic side.

tlav1-21However, another difference between the current situation and the simple model is that falling off the cliff doesn’t necessarily represent the worst outcome for Democrats (although, to be sure it would be bad). If this is true, then off the cliff we go. In fact, they are making parachute/landing preparations. More negotiations will follow if agreement is not reached this weekend. We are operating in a repeated game context, not the “one-shot” scenario in a chicken world. Thus, the cliff metaphor isn’t really accurate. A better one would be a really-difficult mogul-ski-course (although, granted, this isn’t super catchy). Once over the cliff, the “status quo” point will be different: taxes will be higher across the board and spending slashed. On the tax front, Democrats will be in a more favorable bargaining position as they will be rooting for lower taxes for certain portions of society. It is likely to be easier to muster Republican support for such measures. However, to be sure, this strategy is risky. The Republican party will still have the bias towards inflexibility and lack of compromise, but, arguably, the ill that can come of this will be more salient, giving Democrats greater room to poke the pointy stick of public opinion at their opponents in the next round.

Therefore, in my opinion, it looks like the US is going over the cliff. The Republican’s are not going to yield and the Democrats could potentially do worse. A game of lemming rather than chicken seems more apt.

PS Footloose link.

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Still waiting.

Posted on December 18, 2012 | Leave a comment

bored pugProgress is to the UK economy as words have been to my blog. Lacking. News on economic fundamentals, and the associated policy discourse, have consistently underwhelmed. Government concern remains fixed on the same, narrow goal of fiscal consolidation, with inadequate regard of how this consolidation is achieved. 2012 bears evidence to the claim that this concern is misdirected and that the derivative economic strategy is self-defeating. December has born witness to yet another downgrade in UK growth prospects and the rise of measured government debt has only been slowed by the inclusion of projected departmental underspends and the proceeds from the 4G license sales to projections. This post is a summary piece on the the state of the UK recovery and outlines the economics behind why the policies pursued to date have been unhelpful (at best).

The economy, …. 

The underlying picture remains much as it has been for the past two years: one of persistent weakness. Fifty shades of grey minus anything remotely stimulating if you will. The economy performed less strongly in 2012 than anticipated. The OBR cut its growth forecast to predict a 0.1% fall in output this year, followed by growth of 1.2% in 2013. Output is thus at roughly the same level as 2 years ago, 4% below that in 2008. This recession by now far exceeds the “Great Depression” in length. The graph below from the NIESR illustrates the point nicely.

Screen Shot 2012-12-17 at 18.27.43

It is unclear whether below par growth this year derives from “cyclical” (temporary) or “structural” (permanent) weaknesses. Cyclical weakness sits on the “demand side” of the economy– people and businesses just aren’t buying enough stuff–, whilst structural weakness is more pernicious and difficult to tackle, the result of a “supply side” contraction — we can’t make as much stuff. The two are related as cyclical weaknesses can be locked into structural ones via a process called “hysteresis” — see this post for more. There is disagreement as to how much of our current troubles to attribute to one or the other but, regardless, the OBR now forecasts systematically weaker economic growth for the coming years than it previously predicted in March.

Screen Shot 2012-12-18 at 11.00.08

Difficulties (understatement) in the Eurozone have continued to depress net exports and confidence. However, our lacklustre performance is by no means implied by the economic woes that plague Europe and other Western countries. Growth in the US and Germany has consistently dominated that achieved on these shores, and the UK pales in comparison to a host of countries in any ranking of capital investment.

And what of the lauded deficit reduction strategy? Despite (because of?) Plan A(usterity), good news isn’t forthcoming in this domain either. The size of the of the public finance hole is of a similar magnitude to that of 2011. However, even this underwhelming achievement is sullied by the knowledge that without the inclusion of funds from the one-off 4G licensing auction and the predicted “underspends” by certain government departments, the funding shortfall facing the government would have grown this year.

… stupid. 

In his Autumn statement, Osborne upped the dosage of existing prescriptions to cure the UK economy and added a few new measures to the mix. However, don’t expect a return to health soon. Policy remains inadequate and misdirected. There continues to be insufficient concern about the ends that sustainable public finances are supposed to advance. This has contributed to a lack of attention surrounding the composition of the policy mix conjured up on order to coax fiscal sustainability back to UK shores.

Just to remind ourselves, what is a budget deficit? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources (call this amount “T”) and what’s being spent (amount “G”).

Budget deficit = G – T

We care about the size of the budget deficit because of the impact that unsustainable public finances have on the economic prosperity of a country and the wellbeing of its citizens. It is not of value in and of itself to pursue low government borrowing (see this post for more on the cost of a deficit). Therefore, the obsession with fiscal consolidation is misguided and has resulted in a misdirected, overly narrow economic strategy. The size of the budget deficit is not the most salient economic ill plaguing the UK at present. If financial markets were overly concerned with the sustainability of the UK fiscal position, we would see interest rates rising with market risk. We have not witnessed this, the opposite in fact, suggesting that indebtedness is not the primary concern in financial markets (see this piece by Adam Posen, former MPC member, for more evidence on why reducing the debt should not be the top priority right now).

A blinding focus simply on the extent of the debt reduction required, without much regard to the how’s and why’s, has promoted a self-defeating economic strategy. The experience of the last 12 months is testament to this. Given that what we actually care about is general prosperity and wellbeing, we should aim for a deficit reduction strategy that protects these ends as far as possible. This demands a detailed analysis of the composition of spending and taxation changes, rather than just a pure focus on levels. This is because the austerity-growth dichotomy often presented in the media and by politicians is a false one. By reallocating government resources to activities with a high “fiscal multiplier” (to be explained!), growth can be supported whilst the budget deficit is reduced.

The Fiscal Multiplier

What does it mean to reallocate spending to activities with a “high multiplier”? The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by £1. This additional £1 then represents income for someone that can be spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c2 + c3 + …

Therefore, there can be a more than proportionate increase in demand for an increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. The introduction above was clearly overly simplified; there is not one fiscal multiplier but a set of them associated with different government programmes. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. To illustrate, imagine a balanced budget policy, that simply takes income from one group in society and transfers it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. This helps to highlight that through redesigning the austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated, and output protected, without a need to increase the debt burden.

The Autumn statement flirted with this principle by earmarking funds for capital spending and investment. These are potentially “high multiplier” activities given the employment and productive projects they facilitate. However, the scale of proposed new capital spending is insufficient. £5bn over the next two years. An amount that, at best, is expected to add 0.1% to GDP. Not exactly pushing the boat out… Secondly, and more importantly, the funding source for the proposed investments has the potential to undermine their (already small) impact. Cuts to welfare and tax credits will be used to fund these measures. However, such cuts will have a significant negative impact on demand in the economy given that they fall on those at the lower end of the income distribution. Such households tend to have a high marginal propensity to consume and little way of smoothing their spending. Therefore, the policy is largely funded by those who’s incomes the government should really be trying to protect if it is to be true to a multiplier guided philosophy. (Note that this is before any equity based arguments are even considered.)

A new voice

“For last year’s words belong to last year’s language

And next year’s words await another voice.

And to make an end is to make a beginning.”

— T. S. Eliot

In the next few weeks, I will write a number of more targeted posts on specific policy proposals and Eurozone developments. However, hopefully this post will have equipped you with some background knowledge on the economy and convinced you that a significant shift in economic strategy and dialogue is required in the UK. The singular focus on austerity has been self-defeating and has contributed to the prolonging the country’s economic woes. We’re long overdue a change in vision and vocabulary. The Autumn statement highlighted some appreciation of the arguments laid out here. In 2013, the government must go further to nurse the economy back to health.

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Understanding Eurozone Imbalances II: Talking TARGET

Posted on March 11, 2012 | 3 comments

More time is only good if it’s used for something. The success of the Greek debt swap this week staved off chaos but is not a solution to Europe’s problems or a signal that an end to the crisis is in sight.  Recent weeks have seen a growing awareness of the accumulation of imbalances in Europe’s central payment system, TARGET. These imbalances are yet another reflection of the fundamental asymmetries at heart of Eurozone crisis and are analogous to build ups that destroyed the Bretton Woods system.

The commentary and debate on TARGET is currently overly technical. This post explains and analyses the nature and origin of these imbalances, and asks what they mean for the Eurozone (for some background on the link between budget and current account deficits see here and the crisis in general here, here and here!).

What are TARGET imbalances?

TARGET is an acronym standing for Trans-European Automated Real-Time Gross Settlement Express Transfer. Fog lifted?! It’s basically a system through which commercial (‘normal’) banks in one Eurozone country make payments to commercial banks in other Eurozone countries. Importantly, TARGET balances can be interpreted as a measure of the accumulated deficits and surpluses in each Eurozone country’s balance of payments with other Eurozone countries, reflecting the amount of ‘extra’ money circulating in a country over that created inside the country by it’s own national central bank.

Until mid 2007, TARGET balances netted out at zero; there were no deep asymmetries in financial flows within the Eurozone. This is no longer the case.  Prompted by the financial crisis, imbalances in the TARGET system have ballooned. This is shown in the graph below, taken from Sinn and Wollmershaeuser (2011) (GIPS refers to Greece, Ireland, Portugal and Spain).

TARGET imbalances have gone under the radar because they do not show up on the ECB’s balance sheet. However, this is not to say they are inconsequential.  Researchers have commented on the similarities in the imbalances captured by the TARGET balances and those that destroyed the Bretton Woods system. Therefore, understanding what these balances reflect, how they have arisen and how to fix them is of crucial importance.

Something for Nothing

Let’s build up how these imbalances have arisen in stages.  To understand the full story, we need to look at how payments are made between banks. When customers make transfers between commercial banks, in effect, it is actually central bank money, or ‘base money’, that actually flows between them.

Consider a Greek factory owner wanting to buy a new machine. If she buys from a vendor within Greece, funds need to be transferred between bank accounts within the same country. To affect the transfer, base money is taken out of the central bank account of the purchaser’s bank and put on the central bank account of the vendor’s bank. The purchaser’s bank then charges the checking account of our factory owner, and the vendor’s bank credits the vendor’s account with the payment amount.

If our factory owner instead buys from a machine vendor in another country, say Germany, a similar procedure occurs but payments now flow via the Target system of the European Central Bank (ECB). When the Greek National Central Bank (NCB) debits the account of the commercial bank of our Greek factory owner, it takes money out of the Greek economy and sends a payment order to the Bundesbank. In so doing, it acquires a liability to the ECB. On the other side, the Bundesbank creates new money and transfers it to the German producer’s commercial bank, acquiring a claim on the ECB.

Target balances reflect these liabilities and claims on the ECB. Until 2007, payments between countries cancelled out as they flowed in both directions. This is despite the huge asymmetries in intra-Eurozone trade because importing countries paid for their imports with foreign money received from asset sales to exporting countries. Thus, private capital flows financed trade flows. Target imbalances have arisen because trade and asset flows no longer net out at zero, causing a build up in claims and liabilities. A Target deficit represents a net outflow of money to pay for an inflow of goods, and a Target surplus can be thought of as an accumulation in a stock of ‘outside money’ within a country.

Look like loans….

Target balances are best thought of as loans given that they reflect the fact that economic goods are moving between countries without movements of goods or other assets in return. They represent real claims and liabilities on the ECB. To affect our machine payment transfer, the Greek NCB destroyed money without its assets becoming any smaller and in so doing acquired a liability to the ECB. This Greek Target liability can thus be thought of as a public debt provided to the country by the Eurozone. On the other hand, the Bundesbank created money without actually receiving any tangible assets from commercial banks. The Target claim it acquires compensates for that and thus can be thought of as a public credit given to the Eurozone, allowing recipients to buy foreign goods.

The Rescue facility before THE Rescue facility

To get at the full picture, we need to add another level of complexity. As described above, Target balances shift money from Greece to Germany. The Greek NCB destroys money when a payment request to buy the German machine comes in, and the Bundesbank creates money to wire to the vendor’s commercial bank in return. If this was the end of the story, there should be no money left at all in Greece. Their coffers should have been emptied long ago. Yet, the monetary base of periphery countries has actually grown slightly since the start of the crisis. What is going on?!

The money flowing out of the periphery countries via international transactions has been fully offset by the creation of new money by their NCBs. In effect, these NCBs have been issuing new money as a form of credit to finance the purchase of foreign goods, taking the place of the private credit that was free flowing before the financial crisis.

Likewise, in Germany, we should have seen an explosion in the monetary base given that the payment process demands the Bundesbank creates new money and this new money has not been used to purchase foreign assets. No such explosion has occurred. German commercial banks have not needed all the additional money flowing into them and thus have either reduced the amount they tend to borrow from the Bundesbank or have placed the unneeded liquidity at the ECB to earn interest.

Therefore, we have witnessed a huge shift in refinancing credit from Germany to Greece without any change occurring in the monetary base of these countries. This credit reallocation represents a capital export from Germany to Greece, a loan given by the Bundesbank to periphery countries, enabling them to buy more German goods than would otherwise be the case.

This public credit provision can be thought of as a hidden rescue facility, propping up the economies of the periphery countries long before the creation of official rescue provision. Sinn and Wollmershaeuser (2011) argue these flows are analogous to Eurobonds, the only difference being that Eurobonds imply transfers of existing money, while the Target credits imply a reallocation of money creation activity. Target credits thus also involve liabilities. If the periphery states go bankrupt, all Euro countries are liable for losses in proportion to their capital shares in the ECB. No wonder the Bundesbank has started to worry about Target imbalances…

We’ll take the Parthenon (and everything else)

In theory, given sufficient appetite, peripheral and core countries could go on swapping Target claims for real goods indefinitely, with imbalances becoming more entrenched over time. However, this is unsustainable. These imbalances reduce the ability of the ECB to influence the Eurozone economy and preserve and perpetuate the structural asymmetries at the heart of the crisis.

Given that Eurozone countries, by definition, operate within a single currency union, there are no automatic mechanisms to force the system back into balance. If we want adjustment, explicit policy action to tackle the heart of the problem is called for, i.e. credible steps to harmonise structural policy and reduce the asymmetries in productivity and demand across the Eurozone. We are yet to see believable policies to this effect, especially those that would challenge German dominance.

Rather, what we have seen in the last few weeks are moves by the Bundesbank to insure the €500bn Target claims it has built up against the Euro system. Given that these claims represent public loans to the periphery, they stand to loose a lot if the Euro was to suddenly collapse, some 20% of GDP in fact. The head of the Bundesbank has proposed that these claims be securitized, or in other words, he demands access to the Periphery property and asset markets to cover losses in the event of a Euro collapse. Wow. Shame we’ve already snatched the Elgin Marbles. Finally, the fact that this proposal has even been raised signals that the Bundesbank is deeply worried about the death of the Euro. For them to seek this kind of insurance, demise is still most definitely on the cards.

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Austerity v Growth: A False Dichotomy

Posted on February 26, 2012 | Leave a comment

Politicians’ commentary on the state of the UK economy remains frustratingly tendentious and unsophisticated. The rhetoric of both the “austerity”  and “growth” camps is overly simplified and needlessly polarized. Action is needed to stimulate growth. However, this fact doesn’t necessitate adding to the debt burden. The economics of the fiscal multiplier implies greater concern should be given to the composition of spending cuts and tax rises. By designing our austerity strategy to reallocate resources to “high multiplier” activities, growth can be initiated during fiscal consolidation. Elucidating this common ground between the camps is required to move the debate forward and set the stage for the development of a credible and equitable austerity strategy.

Recession? Depression?

More than two years since the UK entered recession, the much anticipated recovery is yet to make its appearance. This week the ONS confirmed that the economy contracted by 0.2% in the last quarter of 2011, a consequence of chronically weak business investment and manufacturing. GDP remains almost 4% below pre-crisis peak. Comparing the current recovery to those following past recessions is chilling. The graph below, taken from Jonathan Portes’ blog, shows that output has already been depressed for longer than that experienced during the Great Depression, and looks set to remain so for the foreseeable future.

The current malaise is the product of weak demand, causing the economy to operate approximately 3% below its potential, and of reduced potential supply. Households and the government are set on consolidating their balance sheets and the Eurozone crisis has effectively foreclosed an export led recovery. There is thus little incentive for investment. The latest negative growth figures therefore come as no surprise.

Ongoing weak demand and reductions in supply capacity are linked, a phenomenon economists call “hysteresis”. If demand for a firm’s output is depressed for a prolonged period, machinery is scrapped and planned investments go unimplemented. Workplace skills and the likelihood of returning to work altogether decline in the length of an unemployment spell, reducing the stock of “human capital” in the economy. Not only has unemployment continued to rise in the UK, but it is increasingly long term and concentrated among the young. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics (see, for example, Gregg and Tominey (2005) and Mroz and Savage (2006)). Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair, they did not choose to be born at a time dictating they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Poor growth prospects ultimately make it harder to finance those dreaded debts. Low economic activity implies lower tax revenues, acting to undermine the UK’s fiscal credibility. In November, the OBR announced that £15bn of tightening is required in addition to what was initially anticipated to meet the deficit reduction targets. Moody’s, the rating agency, put the UK’s AAA credit rating on negative outlook, citing weak growth prospects and Eurozone exposure as justification.

Austerity v. Growth: A False Dichotomy

It seems like an impossible situation. Low growth undermines our fiscal credibility but, so we are told, raising government spending is off the cards as it will add to the national debt, spooking the markets, creating financial turmoil. With both austerity and growth strategies, it seems to be a case of damned if we do, damned if we don’t.

However, all is not lost. First, the downside risks of slowing the pace of fiscal consolidation are overblown and small relative to the costs of continued deficient demand but, leaving this to one side, the situation is not as hopeless as presented. We are not, in fact, faced with the choice of austerity or growth. This dichotomy is false and damaging. Rather than seeing this as a one-or-the-other problem, we should focus on the design of austerity strategy and how fiscal consolidation can be achieved with the lowest impact on growth and demand. It isn’t just a case of “tighten or not” but also “how to tighten”. By reallocating government resources to activities with a high fiscal multiplier, growth can be supported while the budget deficit is reduced. Enacting this principle also implies equitable policy reforms, dictating a transfer of resources from the richest to the poorest in society.

The Fiscal Multiplier

The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by 1. This additional £1 then represents income which is spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c2 + c3 + …

Therefore, there can be a more than proportionate increase in demand with increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. Imagine a balanced budget policy, taking income from one group and transferring it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. By redesigning our austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated without a need to increase the debt burden.

What could this look like?

The analysis above suggests that cuts should be targeted at those with a low marginal propensity to consume, while those with higher MPCs should be protected. We shall also see that enacting this thinking implies equitable policy changes, dictating transfers of wealth to low income groups in society.

Exploiting variation in fiscal multipliers lies behind the Social Market Foundation’s suggestion of cutting high rate income tax relief on pension savings and capping ISA contributions. Such a policy would extract more tax revenue from those in a relatively secure financial position, who are better able to smooth the impact of cuts and tax rises, thereby minimising the impact of consolidation on overall demand. The SMF calculates that halving higher rate tax relief on pension contributions would save £6.7bn annually, while an ISA cap of £15,000 would generate an additional £1bn each year. Tightening should also be done through greater targeting of benefits rather than a reduction in their general level. Families at the bottom of the income distribution, without a savings safety net, are likely to have much higher marginal propensities to consume. Their income levels should thus be protected as far as possible on efficiency, as well as equity, grounds. Therefore, greater means testing of benefits should be enacted. Making child benefit and subsidies such as winter fuel payments and bus passes only available to the most disadvantaged in society will save huge sums but protect those who need it most.

Funds from savings created by efficient, equitable redesigns of the welfare system should be used to instigate a public works programme to facilitate a transition to a new industrial economy and restore the productive capacity of the economy. There are plenty of private sector projects in the pipeline that could be quickly undertaken given government funding. For example, as mentioned by Gerald Holtham, there is a private consortium willing to build the Severn barrage, a multi-billion pound scheme to supply 5 per cent of the UK’s electricity needs, given some guarantee on electricity prices. Investment spending could be rapidly deployed on schemes such as toll roads, that produce a revenue stream, and to support the UK’s broken housing market. We face a chronic shortage of housing in this country. The number of people waiting for social housing rose by 4.5% in 2010/2011, with 1.84million on the list in April 2011. Supporting investment in the housing stock would have huge social value and give a boost to the construction industry.

Further, funds could provide an initial capital injection to a small business bank or increase the scale of the coalition’s green investment bank. A new small business bank could make use of existing agencies to allocate and dispense the loans, offering them to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. The focus on small businesses should prove especially affective at job creation given research funded by the Kauffman Foundation showing that all net new private-sector jobs in America were created by companies less than five years old.

A middle ground exists

We need to move beyond the unnecessarily polarised austerity-growth debate. Casting these aims as mutually exclusive is misleading and unhelpful, contributing to policy inertia and unnecessarily limiting debate on how we achieve fiscal consolidation. Action must be taken to improve the UK’s growth prospects. The fact that we simultaneously want to get the public finances under control does not imply nothing can be done. The government’s hands are not fully tied, it must use them.

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Incentive Pay in Education

Posted on February 17, 2012 | 1 comment

Comment on the podcast by Professor Hanushek for Sense and Sustainability.

Here are some of my thoughts on a podcast on the economics of education given by Professor Hanushek to Sense and Sustainability. They’ll be going up on that site soon but for the moment read on if you’re interested…. Check out the S&S website and podcasts too. There’s some brilliant stuff on there.

In his podcast on Monday, Professor Eric Hanushek extolled the merits of incentive based pay in education. This post critically reviews his claims, arguing that, although raising the quality of teachers is a key challenge for policymakers, performance pay is not the most effective mechanism for achieving this end. The nature of teaching jobs should be transformed, rather than just their pay. Channels for career development within the education system should be created as a means of attracting the most ambitious, able individuals. Employment contracts must also be reformed to remove poor quality teachers from classrooms, quickly.

Teachers matter but how much is not clear. Hanushek starts from the premise that teacher quality matters for educational outcomes. On the face of it, this claim is uncontroversial. However, the quantitative significance of the effect is not as clear as presented. There is debate surrounding the robustness of figures such as those presented by Hanushek. Firstly, defining and measuring teacher quality is hard. The attributes associated with being a great teacher are multidimensional, diffuse and largely unmeasured, which clearly creates difficulty for researchers. Second, good quality teachers are likely to be attracted to the ‘best’ schools, with bright students from supportive backgrounds and other favorable institutional features. Studies thus risk confounding the effect of teacher quality with other “good school” features, overestimating the magnitude of teachers’ impact. Yet, saying this, arguing that outcomes are independent of teacher quality is going too far. Studies that use variation within individual schools still pick up positive impacts of able teachers and common sense tells us that there is going to be some kind of link there. It should be known, however, that the strength of this link, and thus its policy salience, is by no means clear empirically.

Incentive pay to improve selection Taking as given that we should raise the quality of teachers to improve educational standards, how should governments do this? Haunshek argues that incentive pay schemes will help. One can consider two broad mechanisms via which this reform may be beneficial. First, motivational: incentive pay could induce greater effort on the job, making for better teachers. This is a dead-end, as Hanushek concedes. Quality in teaching among those already in the profession is at best negligibly affected by monetary incentives and at worse inversely related. Given that performance in education multidimensional and difficult to measure, tying pay to easily observable indicators such as test scores comes at the risk of distorting energy and attention within the classroom, ultimately making for a less conducive learning environment. Think greater ‘teaching for the test’ as a probable consequence.

Rather, Hanushek argues that the dispersion in rewards induced by incentive pay will induce selection of higher quality teachers into the profession. Incentive pay won’t do much for those already in the job but by paying more, and having greater differentiation in pay levels, it is thought we will attract a different kind of person into teaching. Hanushek states that the independence of pay and performance implies teaching is not thought of as a “profession” in the usual sense. Teachers do not face the same pressures of responsibility and accountability forthcoming in other careers, which puts off the most able candidates. Implicit in his argument is the idea that responsibility and recognition flows from differentiated rewards. It is then these job factors that make it more likely that able individuals will decide to become teachers.

Alternative ways to attract the best. However, pay differentiation is neither a necessary nor a sufficient means of making teaching “a profession” and attracting top people. Rather than focusing on pay, I believe it is more profitable to consider transforming the structure of the job itself, building in more channels for career progression and space for personal responsibility. My perception is that, currently, if you are a teacher the broad nature of what you do day-to-day doesn’t change much over time and it is this that is off putting to top graduates; the idea of career progression is attractive for many. Thinking creatively about how to formally build in opportunities for postgraduate study and develop interactions with government and the development of wider education policy will help to attract the most ambitious. Transforming pay alone cannot turn teaching into a profession in the sense described by Hanushek.

Further, although incentive pay is inappropriate in this context, performance evaluation is still obviously important in education. However, what we are measuring should change. Rather than using output measures, such as test scores, to evaluate teachers, more emphasis should be placed on “input” measures to raise teacher accountability and ‘ownership’ of their job. Moving away from simply looking at attainment to consider classroom atmosphere, pupil feedback and the quality and innovativeness of lesson plans should foster more imaginative teaching and greater responsibility, again making for a job which appeals to more ambitious individuals.

Raising average quality involves removing poor teachers from the classroom, in addition to attracting the best.Thus, employment contracts in teaching must be transformed. As Hanushek notes, evidence suggests that one’s ability as a teacher stays relatively constant over time. Either you’re good, or you’re not. The use of short term employment contracts in the early years of a teacher’s career thus seem like a good way of removing those at the bottom end of the quality distribution from the classroom quickly.

In conclusion, incentive pay in education is neither necessary nor sufficient for raising teacher quality. Rather than focusing on pay, I believe a creative transformation of teaching jobs, to explicitly build in greater responsibility and career progression to other spheres within the education system, is a more direct and profitable approach. More effort should be deployed considering how best to redefine teaching jobs themselves rather than their pay structure.

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Something for Nothing? Understanding Executive Pay

Posted on January 30, 2012 | 2 comments

Critiques of executive compensation don’t have to center on fairness, although, clearly, this is an important concern. Current remuneration levels are a product of market failure and executive capture of the pay setting process and can be attacked on efficiency, not just equity, grounds. However, direct regulation of wages via maximum rates or restrictions on the ratio of highest to lowest are not the way forward. Radical restructuring of the structure of executive pay and how it’s reported are achievable goals, with potentially far reaching consequences. The government must act to reduce the salience of phony “performance pay” deals and increase the bite of the ‘outrage constraint’.

To infinity and beyond

The staggering level of executive pay hit the headlines last week. Commentators were ablaze at the news that the boss of RBS, a nationalised bank, was awarded a bonus (which he declined yesterday) of just under £1million. Actually, a focus on this bonus somewhat misses the point as it misrepresents the true scale of his salary. The Independent report that Hester’s total remuneration could reach a phenomenal £50million in the next few years conditional on RBS’s share price so, in the grand scheme of things, a £1million bonus isn’t the big issue here.

However, singling out individuals or just focusing on “the bankers” underplays the extent of the issue. Executive and CEO compensation has been hurtling to heaven since the late 1980s. Average CEO compensation for the top 500 firms in the US more than quadrupled over the 1990s. Some UK bosses earn over 1000 times the national median wage. In the last year alone, a time of stagnant growth, executive pay in the FTSE 100 rose on average by 49%, compared with just 2.7% for the average worker.

Yet, such comparisons and figures may be misleading. Firms have got much bigger over the period, many (until recently) performing much better. The structure of our economy has also been transformed.  One needs to correct for these changes to ensure we are comparing ‘like with like’ across time.  However, controlling for factors such as firm size, industry classification and firm performance relative to industry average, still leaves us with staggering rises in average CEO remuneration to account for. For example, Bebchuk and Grinstein (2005) calculate that had the relationship between such factors and CEO compensation stayed constant in the US over the 90s, compensation would have only risen by half as much as what was actually witnessed.

Something for nothing?

How can these rises be explained? Justified? The orthodox view sees pay setting boards operating at “arms length” from executives, setting their pay to maximize shareholder value. Pay is set to attract and retain the best people for the job and provide the right incentives. Under this view, we’d have to look for things like big changes in the added-value of executives, the ‘cost’ they face in doing their job and the size of their ‘outside option’. However, extensive research indicates that none of these factors can account for the scale of growth witnessed. Efficient market mechanisms are not the main engines driving the growth of high pay.

The incorporation of large performance related payments has been a big contributor to the executive pay flood. In 2010, the median bonus for maximum performance of a FTSE 100 executive commanded a bonus worth 150% of basic salary. Stock options have become a central feature of remuneration packages without any offsetting adjustment of cash based compensation.

Linking pay to performance is motivated by what economists call the “principal agent problem” and provides a way of aligning the interests of agents, i.e. executives, to the owners of the company, i.e. the shareholders. However, strong incentive pay is only justified when, among many other factors, executive effort has a strong link to profitability, when high pay actually incentivises high effort and does not crowd out other “intrinsic” motivations or inefficiently distort executive attention. These requirements are not met in reality.

Experimental studies in behavioural economics and psychology highlight that high pay as an incentive mechanism is often counter productive. The link between explicit financial incentives and performance is tenuous at best, and negative at worse. As soon as tasks become complex, or even just marginally more taxing than ‘mindless’, financial rewards are consistently found to have a negative impact on overall performance. And this is the conclusion of studies coming out of Chicago and LSE, the ‘establishment of the establishment’, as Daniel Pink puts it.  Bonus culture has also been cited as a cause of dangerous short termism and unsustainable strategising. Furthermore, qualitative evidence suggests that those at the top are often motivated by things other than money. As the former CEO of Shell puts it:

You have to realize: If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.

Even if there was a strong case for performance related pay, this wouldn’t justify the size and structure of current pay packages. “Performance” elements in current packages are actually largely independent of individual action. No attempt is made to discriminate between general rises in company value and those arising from the good governance of executives. Executive influence is likely to have played a large part in this. The extreme complexity of schemes and wide freedoms to unload share based incentives have enabled executives to obtain much larger amounts of compensation than more cost-effective plans would have ever provided. Incentive payments have largely been a smoke screen, making it easier for CEOs to justify excessive pay levels even though these performance schemes are fundamentally flawed.

Bloated pay is thus a product of market failure, not the consequence of efficient procedures designed to maximize shareholder vale. Executives have substantial influence over their own pay levels and board members have insufficient incentives to engage in unpleasant haggling over remuneration packages. Complicated compensation packages have been dressed up as well designed incentive schemes to make huge payments more palatable. In general, these schemes are not cost-efficient and overstate the true value of executives to their firms.

Slimming these cats down

Government action is required to get top pay under control. However, direct wage controls, such as specifying some maximum salary, are not the way forward. This instrument is too blunt, so would be grossly inefficient, and would damage the competitiveness of the UK economy given that other countries are not about to follow suit. Further, a maximum salary rate is politically infeasible and so energy is better spent exploring viable options.

The calls to raise shareholder control of the pay setting process are valid, although, unlikely to do enough. Data complied by a leading advisory body, Pirc, demonstrates that shareholders don’t currently exercise the rights they already have to curtail executive pay. Shareholders are increasingly hedge funds and overseas investors who hold shares for such a short time that they have no interest in the inner workings of companies. Their gains are likely to come via speculation.

Raising the diversity of remuneration committees will help to guard against ‘crony capitalism’ and compensate for weak shareholder discipline. The High Pay Commission recommends that employees from lower down the firm structure have an input into the structure of remuneration. I also feel that effort should also be made for other industry professionals, and potentially academics, to play a role in the committee.

In my opinion, radical restructuring of the structure of executive pay and how it is reported are achievable and potentially very effective ways of reigning in top pay. Compensation packages must be made simpler and be presented in a standardized format. Taking first the structure of pay packages, the illusion that bonus payments and complicated incentive plans actually live up to their names must be shattered and salaries restructured accordingly. Studies highlighting the bogus nature of most performance plans should be bought to public attention. Pay packages should be restricted to contain only a single performance related element and that chosen performance measure should be in someway linked to the medium or long term health of the company to try to break the chronic short termism infecting many head offices. Enforcing a simplification of salary structure will also limit the role of compensation consultants, whose advice has been cited as a cause of the increased complexity of modern remuneration packages.

Public outrage and pressure from workers lower down the company structure can only be effectively generated with adequate information. This “outrage constraint” is an important curb on top pay but it has been weak over the last few decades, muted by the smoke screen created by complicated, ineffectual incentive plans and the rising stock market. The stock market boom has provided a convenient justification for pay inflation even though a firm’s stock market value is only weakly (if at all) linked to its earnings and performance and the actions of its executives. Steven Hester’s bonus refusal is evidence that transparency and public pressure can initiate change. The High Pay Commission found attempts to actively “camoflauge” salary packages, with ever more complicated pay arrangements often buried in the depths of impenetrable reports. It has not been easy to find out how much executives actually bring home. Simplifying pay packages as I’ve argued above, combined with a requirement of standardized reporting will make it easier for public outrage to be created and directed at excessive, unjustifiable pay deals. Further, publishing the ratio of median to top incomes should be a legal requirement for publically listed companies. The new economics foundation report covers this consideration in great detail. Making executive pay and its divergence from that of the average company worker will raise the salience of top pay in public discourse, helping to curtail capture at the top.

In conclusion, executive pay is not the product of an efficient market. Performance payments are red herrings, not structured to optimally solve ‘principle agent’ problems but to line individual war chests. The level of pay should not be regulated, but its structure should. Packages must be simplified and their reporting made more transparent. These reforms are achievable and should be swiftly enacted.

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Budget and Trade Deficits 101: Two Sides of the Same Coin

Posted on January 8, 2012 | 1 comment

The economics behind trade and budget imbalances applied to the Eurozone crisis. 

In my last post I argued that fiscal profligacy is too highly stressed as an underlying cause to the Eurozone crisis. Rather, deep rooted differences in  productivity and competitiveness have resulted in divergent trade balances and public finance disaster zones. Why have trade imbalances contributed to a government debt crisis? What does a single currency have to do with it? Let’s see….

Setting the scene

Many Eurozone countries’ budget deficits are astronomical, incomprehensibly large. Despite all the hype, they aren’t necessarily shrinking. The Greek budget deficit continued to widen throughout 2011, growing to €20.52bn in the first 11 months of 2011 (a 5.5% year-on-year increase), as did Ireland’s, widening to €24.9bn in 2011 from €18.7bn in 2010. Further, it’s not just the problematic PIGS creating trouble: Belgium, Malta, Cyprus, Hungary and Poland are all waiting to hear if they face EU financial penalties to punish for the poor state of their public finances.

Trade figures highlight significant imbalances between Eurozone countries in the run up to the crisis. To talk of a common European trade experience is grossly misleading. The pattern of imbalances across the Eurozone in the period running up to the crisis was dominated by a few outlier countries: Ireland, Italy and Greece on the ‘negative’ front and Germany and the Netherlands on the ‘positive’ (see a relevant IMF paper here). Helping to convey the power of German export machine, the WTO estimated the value of German exports at $1.334tn in 2010, placing them second in the world behind China. This is more than double the value of UK exports and 60 times larger than those of Greeks. (See the following graph from this FT article and this IMF analysis for more data and graphs).

Trade imbalances correctly identify the countries at the heart of the Eurozone crisis. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. High trade deficits going along with dreadful public finances. A coincidence? No. Exploring the economics behind trade and budget imbalances highlights that the two are intimately related.

Talkin’ the talk: trade terminology

In the global economy, countries interact via trade in goods and saving/borrowing. The “current account” records the net effect of a country’s international trade, constituted of goods and transfer payments. More often than not, commentators simply refer to ‘trade balances’, which don’t incorporate transfer payments. Exports feature as positives, and imports as negatives in these accounts. Thus, a trade deficit denotes a situation where the value of a country’s imports exceeds that of its exports.

The “capital account” records the net effect of international financial flows. Foreign investment, purchases of domestic assets and foreign loans to a country all feature as positives; they represent flows of money into the national economy. Conversely, domestic investment into foreign markets and loans made by domestic institutions abroad features as negatives, representing flows of money out of a country. Thus, a capital account surplus refers to a situation where there is a net flow of funds into a country.

By definition, the balances of the two accounts are inversely related. Given a particular level of total output, any trade deficit must be reflected in inflows of money from outside the country (borrowing basically) to fund that deficit. This is shown most easily by exploring the national accounting framework in a bit of detail. It involves a few equations but there’ll be no more after this, promise!

Total spending in the economy (Y) is made up of what we, consumers, spend (C), investment (I), government spending (G), foreign spending on our goods, i.e. exports (X) minus what is spent on foreign goods, i.e. imports (M).

Y = C + I + G + X – M

rearranging….

Y – C = I + G + X – M

The difference between total income and what households spend, can instead be thought of as what gets taken away in tax (T) and what we choose to save (S). Thus,

S + T = I + G + X – M

or….

X – M = (S – I)  + (T – G)

so….

Current Account Balance = – (Capital Account Balance)

Thus, imagine we have a current account deficit, then the capital account balance must be positive, i.e. foreign funds must be flowing into the economy to fund that deficit.

How does the exchange rate fit into all this?

Take a step back from the Eurozone, to a country like the UK, which has its own currency. The current and capital account balances measure, respectively, the demand for, and supply of, domestic currency.

Take a current account surplus. Foreigners must acquire £s to pay for all the UK exports they are buying. The current account balance is therefore negatively related to the exchange rate. The exchange rate gives the relative ‘price’ of currencies. A depreciated currency (think cheap) boosts exports and limits imports, making for a more positive current account balance.

The negative of the capital account gives the supply of a currency. A capital account deficit represents a situation where money is leaving a country to be invested abroad. To be invested abroad, these funds need to be transferred into the relevant foreign currency. Thus, domestic currency must be supplied to the market in exchange for foreign currency.

So, for a country with its own currency, the net balances of the current and capital accounts determine the net demand and supply of currency and therefore the exchange rate at which its currency trades.

Budget and trade deficits: Two sides of the same coin

How can the build up of large trade deficits cause government finances to go awry? Imagine some country, getting along pretty well by today’s standards, without a government or trade deficit: taxes are just sufficient to cover government spending, and the value of imports equals that of exports. Oh, imagine such a country!

Then, the world changes. Other countries fall into recession, reducing their demand for our country’s exports. Assuming our demand for imports is unchanged, this would cause a trade deficit to develop: exports are now lower than imports. (Alternatively, one could think of imports rising relative to exports if, for example, another country starts producing higher quality goods or invents a new products highly demanded by our own citizens). Unless something changes, this widening of the trade balance will hit total demand in the economy resulting in lower national output and higher unemployment. To prevent this, or at last cushion the blow, the government could prop the economy up by running a budget deficit, pumping money into the economy to make up for the loss of exports, borrowing from abroad to fund this build up of debt (capital account surplus). Thus, a trade deficit can prompt a budget deficit, financed by borrowing from abroad.

If a country has its own currency, exchange rate movements can also occur to stabilize the economy, reducing the extent to which a government has to get embroiled in the situation. A trade deficit implies a fall in demand for domestic currency and thus one would expect an exchange rate depreciation to follow. This depreciation makes exports cheaper, boosting their demand, helping to close the trade gap and support domestic demand and employment.

Applying to the crisis

As stated above, it’s those Eurozone countries that ran sizable trade deficits in the years running up to the crisis who have seen their government debt explode.

Building up imbalances….

There are significant asymmetries in productivity growth across the Eurozone. German real wage growth (wage growth adjusted for inflation) has been much lower than the Eurozone average. In fact, it fell by approximately 20% relative to the Eurozone average in the period 1994-2009. As a result, the labour cost of output rose by a much less in Germany, 5.8% for the period 2000-09, than in its trading partners (equivalent labour costs in Ireland, Spain, Greece and Italy rose by roughly 30% in the same period). Production costs in ultra-efficient Germany are, therefore, much lower than those of its peers.

The Euro accentuated Germany’s competitive advantage. All Eurozone countries trade in the same currency but German goods are cheaper to produce, hurting domestic industries in the other countries that cannot hope to compete with these cheap exports. The trade balances of Eurozone countries have thus been following divergent trajectories: the German trade balance shooting up to the stars, while those of the Club Med descended further into the murky depths of the underworld.

…and funding them

As explained above, trade deficits imply that foreign funds must be flowing into a country and this is what we have observed. The majority of Eurozone governments’ debt is held by nonresidents. In fact, banks and financial institutions in the advanced European economies financed a large part of the build up of debt in the periphery as noted by Blanchard and Giavazzi (2002). BusinessWeek notes that German banks are on the hook for at least $250bn in troubled Eurozone nations’ bonds.

If each country had its own currency, trade deficits and excessive foreign borrowing witnessed would have put pressure on the exchange rate, helping to restore the export-import and borrow-lend balances between European states. For example, we would have expected to see the Greek drachma fall in value relative to the German Deutsche Mark, effectively raising the cost of German goods and helping to rebalance the European economy. This has not happened, allowing imbalances to get out of control and the single currency has also eliminated stabilization mechanisms which would have provided additional routes, other than higher government spending, to prop up the economy.

Missing the heart

Thus, although financial mismanagement and recklessness have had parts to play in the Eurozone crisis, fundamental structural imbalances between Eurozone economies lie at the center of the mess. The singular prescription of harsh fiscal discipline thus does not hit at the heart of the matter. Not even the stomach. Adjustment on the part of creditor nations is also required. At present there is nothing to temper the onset of austerity across Europe. All adjustment is being forced through by depression and default. This is far from efficient. Germany has benefited enormously from Euro membership, taking advantage of an undervalued currency and low trade costs. Others have not been so fortunate, shackled with an over-valued currency and the withering of domestic industries.

Can such adjustment and rebalancing be achieved? Can the Euro be sustained in the long run given the imbalances and limited mobility within its domain? Oh I wonder, I wonder….

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To Be or Not To Be?

Posted on December 31, 2011 | 10 comments

European leaders face an acute existential migraine this New Year. If only AlcaSeltzer could help them.  

Gone are the days when “greek spread” referred primarily to tzatiki and taramasalata. The eurozone crisis is now generally regarded as a problem with a solution “technically and politically beyond reach”. The evidence certainly supports this dour viewpoint. Fifteen summits, seven changes of government and five master plans later, we are left with precisely zero in terms of substantive achievements. €457bn of European government debt must be refinanced by April, thus few grains remain in the hourglass. In the near term, ‘now’ in other words, European governments’ must acknowledge that contractionary fiscal policy is, yes, contractionary and revise the quack medicine of austerity that is currently prescribed to assuage our economic ills. In the longer term, the failure of the neoliberal underpinnings to the Euro must be acknowledged and institutions redesigned accordingly….if democratic support for a fiscal union is forthcoming.

What started as “the Greek problem” is now a fully fledged “Europe” problem. The credit rating of the entire European Union, not simply those of the pesky PIGS, is under threat of downgrade. Output and employment remain depressed. August witnessed the largest monthly decrease in eurozone industrial production since 2009 and many are predicting a slide back into recession in 2012. Unemployment in the region has soared to a new euro-era high, reaching 10.3% of the labour force in October. Joblessness has remained highest in Spain, where a staggering 22.8% (!!!) of workers are without jobs.

Rebalancing, not retribution, required

The strategies currently pursued by Eurozone institutions either do not go far enough or are opposite to what is required. Further, faster fiscal tightening continues to be dictated. Only yesterday, Spain announced plans to cut €8.9bn from public spending in 2012. Amartya Sen, a Nobel laureate in Economics, described austerity in the current climate as a “snake” within the wider metaphor of the game “Snakes and Ladders”. It is getting us further from where we want to be.

Austerity continues to be prescribed because fiscal profligacy is too highly stressed as an underlying cause of the debt crisis. Inexcusably poor financial discipline, in part a consequence of the moral hazard generated by Euro membership (see previous post), clearly played a role in the Greek debacle, however, fundamental imbalances in competitiveness across the Eurozone cannot be ignored as a salient causal factor.

The health of government finances pre-crisis provided little clue as to which countries would be sucked into economic chaos. As Martin Wolf notes, “fiscal deficits were useless as indicators of looming crises”.  Trade imbalances, on the other hand, correctly identify the countries at the heart of the problem. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. A trade deficit occurs when the value of what a country imports exceeds that of its exports. In contrast to these tales of woe, Germany has experienced an increase in its trade surplus since 1999. The asymmetries in competitiveness and economic strength between Germany and the ‘peripheral’ states really are stark. Joblessness in Germany has been falling for the last 2 years and the financial market turbulence that is wreaking havoc in many European countries is said to have had “little impact” on the country’s economy. In Europe it really isn’t a case of ‘all in it together’.

It is an accounting identity that a country with a trade deficit must be a net borrower in order to fund that deficit. Within the Eurozone, surpluses in Germany and the Netherlands were previously channeled through the financial system to fund deficits in others, i.e. Greece Ireland, Portugal and Spain. The credit crunch caused these channels to seize up, eliminating this flow of funds, and also initiated a collapse in private borrowing, prompting government deficits to go through the roof.

Acknowledging that deep rooted differences in productivity and competitiveness have played a role in the crisis, leads one to the conclusion that reforms cannot simply be piled on debtor countries. Retributive justice, in the form of harsh spending cuts, is misapplied as reckless profligacy has had but a minor role to play. Rather, shifts in external balances across the eurozone are called for. As one country’s trade deficit is another’s surplus, this calls for adjustment and transfers on the part of surplus countries such as Germany. It is reckless to hold deficit countries to pro-cyclical austerity without countervailing measures to boost import demand elsewhere in Europe. In the absence of demand and credit expansion in healthy eurozone nations, fiscal tightening will continue to have the same impact that it has had up to now: to prolong and intensify the downturn.

Furthermore, not only does ‘more austerity’ inadequately deal with the root causes of the crisis, it is also aggravating our woes and is thus ultimately self-defeating. The Keynesian “Paradox of Thrift” is relevant here. To reduce the size of a budget deficit, a government must increase the size of tax receipts relative to its spending. Governments’ have focused their energies on fashioning large reductions in government spending as opposed to playing around with tax receipts. Public sector layoffs and pay freezes, cuts to departmental budgets and welfare bills are thus the name of the day. However, such coordinated, fierce austerity across the Eurozone is hampering growth and recovery, reducing tax revenues by more than the cuts in spending. Thus, paradoxically, the current austerity measures are ultimately making it harder for governments to repay those dreaded debts .

Eurozone countries are facing an even harder time of it than the UK as, for these countries, there is no exchange rate mechanism through which austerity and low domestic demand can boost exports to their main trading partners. Further, as implied above, credit and demand expansion among creditor nations has not been sufficiently boosted to provide any countervailing force to the cuts made in the peripheral countries.

ECB to the rescue?

In short, the fiscal policy of eurozone countries is a disaster zone: off target and self-defeating. What of monetary policy, that concerned with interest rates and money supply? The ECB has raised its game in the last few weeks but, by only offering credit to commercial banks, has not done enough to pull Europe back from the brink. Basic interest rates have been lowered to 1% and unlimited cash offered to commercial banks for up to three years. These actions will help to alleviate short term liquidity problems in the banking system but will not have any noticeable impact on the real economy or the debt crisis. Banks are adding this additional cheap funding to their capital buffers, compensating for the losses they face on their holdings of government bonds and household mortgages. Therefore, very little of this additional cheap capital is being devoted to easing the funding pressures on households, firms and their governments.

The hope was that, despite only offering credit to commercial banks, these banks would in turn buy the bonds of European governments, thereby easing the sovereign funding crisis. This has failed to occur as commercial banks are unwilling to purchase further government debt. The European Banking Authority recently announced that European banks still need to raise €115billion in additional capital to offset the falling value of government bonds they currently hold. Unsurprisingly, it is the Spanish, Greek and Italian banks with the biggest capital shortfalls. Thus, the banks in the most financially fragile countries are likely to go to their governments for assistance rather than with fresh funds. The ECB’s current actions are thus unlikely to do much to ease the debt crisis: banks are still turning to governments to bail them out, rather than the banks bailing out the governments as was hoped.

Sideshow Summit

The last Europe wide effort to produce a grand plan was, sadly, another grand waste of time. It was attention grabbing for the wrong reasons, bringing the continent no closer to a workable resolution. The fallout between the UK and its European peers may have some unpalatable consequences for us but is really a minor pothole in the road to Eurozone recovery. David Cameron’s actions did nothing positive to protect the City, it will now be harder for EU rules to be negotiated in our favour, and served to marginalise us within the European Union.

However, Mr Cameron’s mistakes are a mere sideshow. Of much greater importance was the failure of European leaders to acknowledge the arguments above that imply the need for reform that is balanced across creditor and debtor nations. Rather tougher controls on budget deficits, written into individual country constitutions, were focused on, with no countervailing measures to boost demand and credit availability at the eurozone core. It was agreed there is to be no fiscal union, only greater fiscal discipline. Therefore, Europe remains decidedly doomed. This summit got leaders no nearer to a credible cure to the continent’s troubles.

A New Year’s Resolution?

A tourniquet must be quickly applied, and life support machine turned on, to prevent the death of the Euro. Leaders must immediately acknowledge that further harsh austerity is wrongly targeted and self-defeating. The focus must be on growth and reducing unemployment. Public sector layoffs must be put on hold and tightening strategies rebalanced to put more weight on tax rises. Effort should be focused on designing a stabilisation strategy that expands import demand and credit supply among those eurozone countries that can afford it, i.e. Germany and the Netherlands.

More fundamentally, the failure of the neoliberal underpinnings to the Euro must be acknowledged. The existence of pervasive market imperfections implies the need to transform the design of eurozone institutions, promote greater fiscal integration and change the role and mandate of the ECB. A single currency eliminates a number of stabilisation mechanisms for individual economies, creating the need for much larger wage and price movements to prevent recessions, especially given that labour and capital are far from perfectly mobile (see my previous post). In this imperfect world, fiscal union is the essential counterpart to a monetary union. Fiscal transfers can then provide a counter-cyclical mechanism to support regional economies in tough times. This is what occurs in the United States, with Virginia playing the role of Greece.

Further, the ECB’s role and mandate must be reviewed. The ECB is not simply independent of European governments, as the Bank of England is to our own, but is ‘detached’. There is full separation of central bank and government finances, with the ECB legally forbidden from buying large amounts of government debt. This again reflects the euro’s neoliberal birthright, subordinating fiscal policy and the role of the state to the market. The neoliberal school of thought sees the sole role of central banks as inflation control. In the future the ECB must be mandated to target wider aggregates than just inflation, unemployment a key indicator. Further, the full detachment of the ECB from the governments it is supposed to serve must end. One potential institutional solution is given by Thomas Palley, who suggests the creation of a European Finance Authority that issues collective Eurozone debt on behalf of member governments which the ECB could then buy.

However, it must be noted that closer European fiscal integration requires the mandate of European citizens. In the short term, the advantages of installing technocrats and making executive decisions outweigh the cost of temporary infringement of democratic rights. However, these rights must not be continually subordinated, especially when it comes to thinking about the future of Europe more generally. It is far from clear that the necessary support for a more integrated Europe is there. Populist parties are increasingly sceptical of the Europe project and extremist politics appears to be making a comeback in a number of nations.

I remain sceptical that there is sufficient support for the extent of fiscal integration required to sustain the Euro. In my opinion, a common European identity is insufficiently forthcoming to motivate popular support for a United States of Europe, especially given the build up of anti-Europe and anti-Germany sentiment currently occurring. The unbalanced prescription of austerity and the stark asymmetries in adjustment pain across the continent is fuelling resentment and riots. Without adjustment by creditor nations who have benefited enormously from Euro membership, unemployment will continue to rise and times toughen in peripheral countries. Without a fiscal union to accompany the monetary union, wage falls and large variation in growth will continue to be the norm. This is a far from ideal backdrop to popular debates on the future of Europe.

In conclusion, we end 2011 with no end in sight to the eurozone debt crisis. Proposed solutions will continue to be off target and inadequate so long as fiscal mismanagement is stressed as the root cause of our woes. Although the consequences of a eurozone break-up will surely be enormously damaging, so too is the continued, futile application of austerity. Especially given that, if leaders continue in 2012 as they have done up to now, a disorderly disintegration looks inevitable. Happy New Year!

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Desperately Seeking Stimulus

Posted on September 20, 2011 | 3 comments

Plan B is for Bankruptcy? Bullshit. Bold, government backed programmes are needed to kick-start the economy and stem the jobs crisis.

No, we are not out of the woods. The green shoots of recovery still remain smothered by a thick layer of mud. UK unemployment rose to 2.51million people in July. That’s 7.9% of the workforce. A fifth of UK youths are now jobless. These dismal figures are a consequence of hefty falls in public sector employment and pathetic rates of private sector job creation, much lower than that expected by the Treasury and OBR. Furthermore, the UK ranked a pitiful 25th out of 27 countries for growth over the past year, only Romania and Portugal did worse. The Institute for Fiscal Studies shovels more gloom into the mix with the news that median net household income suffered its largest one-year drop since 1981 in the last financial year, battered by the real falls in earnings, benefits and tax credits.

These are not transient troubles. Martin Weale and co authors estimate that the current recession will be the longest since the war, highly likely to lead to a greater cumulative loss of value than the Great Depression. Martin Wolf in the FT argues that it is probable for the depression to last 72 months, making it 50% longer than its longest predecessor in a century. Furthermore, the singular focus on austerity across Europe will act to black out any light at the end of the tunnel. Cameron’s description of the current figures as “disappointing” is, therefore, a gross understatement.

You would think that the continued flow of feeble figures would trigger a revaluation of the current macroeconomic strategy. But no, “Plan B is for BANKRUPTCY” we are told, “The UK will be able to ‘weather the storm’”. Little convincing evidence has been supplied to support these claims. Despite all signals pointing towards a need for change, Osborne insists that no amendments will be made to Britain’s deficit reduction programme. Although Britain does need to make credible its promise to get the public finances in better shape, such policy inflexibility is reckless. We need to slow down austerity implementation to ensure that the scars this recession leaves on the economy are not deeper than need be.

The slowdown began with a collapse in economic demand. However, it is looking more and more likely that this will get locked in by a contraction of supply. A contraction in supply means that we will find it harder to produce ‘stuff’ at the same rate as before. That a fall in demand can feed into a permanent downgrade to our growth prospects is a phenomenon known as hysteresis by economists. If demand for a firm’s output is depressed for a prolonged period, machinery may be scrapped and businesses could decide not to follow through on planned investments. The chaos in the financial sector has resulted in credit being allocated inefficiently at the wrong cost. Others note that a worker’s productivity can be harmed by unemployment. If one is out of a job for a long time, workplace skills start to fade and you become less employable. In addition, the longer someone is out of a job, the more likely it is for them to drop out of the labour market altogether. For example, women may decide to stay at home, early retirement may become an option or that back pain that’s always plagued you may become a reason to seek different types of benefits.

All of this acts to depress the trend rate of growth that the economy can sustainably achieve and will ultimately make it harder to pay those dreaded debts. With slower growth, tax revenues will remain depressed for longer than the Treasury and OBR expected when making their budget projections. Preventing the temporary blemishes associated with recession from becoming permanent scars is of upmost importance.

Unemployment of all ilks is associated with economic and social ills but the current concentration of joblessness among the young and low skilled is something of particular concern. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics. For example, see the evidence in Gregg and Tominey (2005) for the UK and Mroz and Savage (2006) for the US. Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair for them, it’s not their fault that their birth date dictated they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Furthermore, as the riots bought to attention earlier in the summer, unemployed youths facing a dearth of opportunity are not guaranteed to sit quietly. Unsurprisingly, increases in youth unemployment are associated with a range of social ills. For example, Carmichael and Ward (2001) found youth unemployment is associated with a statistically significant increase in burglary, fraud and forgery, theft and total crime rates. A third of NEETs agree with the statement that their life has ‘no purpose’. The social consequences of a large number of marginalised youths, who are assess their lives as purposeless, are scary to think about.

Some argue that government led job creation is a misnomer. They are wrong. The government has a role in supporting employment through this recession. Bold, innovative programmes are required to help ease the jobs crisis. Given the uncertainty and pessimism that currently clouds private sector vision and judgement, government involvement and financial backing are required to get them started. Technological change and globalisation imply that we also need to shift are thinking on how best to deal with the current labour market woes. Public works programmes represent one strategy to be explored but they are expensive and will create far fewer jobs today than they did in the past. Quoted in The Economist, the major of New York, Michael Bloomberg, notes that new government sponsored construction works will not solve the problem. “The technology is different. If you built the Hoover dam today, you would do it with far fewer people… The average worker standing in line for benefits tends not to be muscular.”

One new idea which I find particularly attractive is the creation of a small business bank. It could either be created through an initial injection of government capital or bonds funded by the Monetary Policy Committee and make use of existing agencies to allocate and dispense the loans. Credit allocation is currently a total mess. Banks aren’t lending to solvent businesses which need cash to invest and grow. If such a bank was set up, it could offer loans to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. This strategy has a number of attractions. Easing the funding restrictions on entrepreneurs and small businesses should help to kick-start innovation and growth while supporting employment. The focus on small businesses should prove especially affective at job creation. Research funded by the Kauffman Foundation shows that all net new private-sector jobs in America were created by companies less than five years old. Further, no one can turn round and say, “Oh, think of the benefits culture you’re creating”. This strategy is positive; it’s about supporting new ideas and existing businesses to thrive. In this way, the roots of the problem, as well as its consequences, are targeted.

Over the last few decades, a polarisation of the labour market into ‘lousy’ and ‘lovely’ jobs with little in between has been noted. Many routine manual jobs can now be coded up and performed by computers and machines. Other jobs are now able to be performed by individuals on the other side of the world. These hard facts need to be acknowledged by policymakers and reflected in the design of new labour market policy. Training and education systems need to be overhauled to reflect the new set of skills needed by employers. However, we also need to sit back and think through the consequences that these developments have for our vision of the modern job market. What can be done to best prepare individuals for the new world of work? How can we make the distribution of work more equitable?

These are hard questions but a few things are self evident with little deep thought. Slowing the pace of public sector redundancies will slow the rise in unemployment. Creation of something like a small business bank would not have to add to the public sector debt and could help propel the recovery forward. The government cannot afford to be complacent. A slower recovery adds to the cost of fixing their finances and creates long term hardship for many in society. The UK economy is Desperately Seeking Stimulus. Plan B is for Bankruptcy? Bullshit.

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Banking Reform: The Principles & Proposals

Posted on September 14, 2011 | Leave a comment

On Monday, a 358 page tome on financial sector reform was delivered to UK politicians and public, the outcome of an investigation into UK banks by the Independent Commission on Banking (ICB). What were the central recommendations and their motivations? Do they go far enough?

The ICB was set up by the Treasury in the aftermath of the financial crisis and is headed by Sir John Vickers, former boss of the Office of Fair Trading and Warden of All Souls College, Oxford. Achieving a stable banking sector is more important to the UK than many other countries. Britain is hugely exposed to turmoil in the financial sector. The balance sheet of banks is £6trillion. To put this in perspective, this is 4 times larger than the total value of our economic output. Incomprehensively huge. This is not the case in all Western countries. In the US banking liabilities are equivalent to ‘only’ 50% of GDP. It is thus of upmost importance that we get the structure of our banking industry right.

Some banking basics

There is a lot of jargon in this field. To help get to grips with what the reforms target, let’s briefly review the basics on the banking system.

In a simple world, one can think of banks as absorbing savings deposits and certain types of debt and transforming them into longer term investments, such as mortgages and corporate & government loans. This means that our savings do not just ‘sit in the bank’, they are re-lent out to generate profits. Banks suffer from a ‘maturity mismatch’; their liabilities are short term (we can demand our savings back right now), while their assets pay back in the long term (the flow of profits from mortgages and bonds might go far into the future).

But what happens if lots of people suddenly want their savings back? In ‘normal’ times banks satisfy the demands of their depositors by lending to each other in overnight inter-bank reserve markets. If you’ve heard the term LIBOR, this is the London Interbank Offer Rate, the interest rate charged in the London overnight reserve market. Banks short on liquidity (i.e. those that don’t have enough free cash to satisfy deposit demand) borrow from those with excess reserves. In this way, it doesn’t matter most of the time that savings don’t just stay in the vaults at the bank.

So what happens when loans go bad? When loans go bad, losses must be absorbed by past profits generated by good loans or depositors, i.e. savers, will take a hit and the bank will be judged insolvent. Thus, it is important that banks carefully monitor the loans that they make and set interest rates to properly reflect the risk they face. Regulators also require that a portion of loans are funded from equity capital. This is the stock of past profits accumulated by a bank. Then if a loan goes bad it is the bank shareholders that shoulder the loss. This is fair. They oversee the management who allowed the bad loan to be made.

Equity capital is thus a lovely safety cushion on banks’ balance sheets. The higher the equity capital relative to the total size of the bank, the safer it is. The Vickers’ report and the Basel III agreement are both concerned with increasing equity capital ratios. What they actually do is specify a minima for:

Equity capital/Loans*risk weighting

where the ‘risk weighting’ figure reflects the quality of the loans made. So, it will be high if all the loans you made were to unemployed teenagers for multi-million pound houses.

In brief, during the financial crisis banks made, or were at least expected to make, losses far in excess of their equity capital. This led to a run on savings deposits, a freeze in interbank lending (banks couldn’t tell if each other were solvent and so wouldn’t lend to one another to help meet high deposit demand), a credit crunch and severe recession. Nice.

The recommendations

The Treasury set up in ICB to help prevent a similar financial crisis from arising again in the future. One can group the ICB’s proposals under three main headings:

1. Ring fencing retail operations

This is the proposal that has gobbled up the most column inches. The ICB argues that we need to separate the retail operations of banks from investment banking. Retail operations are those which ‘normal’ people think of when you say “bank”, i.e. savings, current accounts and mortgages, while investment banking activities include things like the more exotic sounding derivative trading. Ring fencing effectively builds a sort of firewall around the crucial activities which we really care about and will result in our own savings funding the flow of domestic loans.

 2. Promote greater competition

The UK banking industry is dominated by a small number of very big players. To create greater effective competition in the sector, Vickers recommends that the Lloyds banking group be broken up in a way that creates a strong new challenger. Further, measures to make it easier for individuals to switch their accounts between institutions are outlined and the need for a greater amount of clear pricing information is pressed.

3. Raise banks’ ability to absorb losses

This proposal relates to the amount of equity capital banks hold. From above, this is key in determining how safe a bank is as it sets the degree of loss it can sustain. The ICB feels that the proposals achieved by Basel III do not go far enough and want higher equity capital ratios for retail operations.

Intended effect

Lots of our problems in the financial crisis stemmed from two main things: 1) Banks made bad loans and 2) Banks weren’t holding enough equity capital to cover the bad loans. So ideally the reforms will:

1)       Reduce the likelihood that bad loans will get made

Ring-fencing retail services should work to discourage reckless risk taking and promote more sensible lending. The ‘too big to fail’ problem is often mentioned in this context. During the financial crisis, it was felt that the government had no option but to intervene to bail out the banks. The costs of not doing so were unfathomable. However, this created a “moral hazard” problem. Banks knew that, when push came to shove, the taxpayer had little choice but to bail them out and cover their losses. This reduced their incentive to make good loans and monitor the amount of risk they took on, encouraging the dodgy lending and trading practices at the heart of the crisis. If the government could have credibly promised to stand back and watch banks fail, it is likely that many of the bad loans would never have been made.

The reforms should make it easier for the government to do just this. Stand back and allow banks, or certain parts of banks, to fail, reducing this moral hazard problem. Ring fencing allows for better targeted bailout policies making it easier to force the creditors of failing investment banks bear the consequences of their investment decisions. Not just the good ones. The government can choose if it wants to support the investment banking arms of banks rather than being compelled to do so because of the risk to the retail services it really cares about.

2)       Make banks better able to cope with losses

Raising the capital requirements of banks enhances their ability to shoulder losses and ring fencing should also help insulate the banking of the layman from international troubles as much of the complex international exposures of UK banks relate to their investment banking divisions.

Answering some criticisms

There have been noises made on the cost that these reforms will impose on the already fragile banking industry. Critics also mention that the proposals will damage the global competitiveness of the UK banking industry. Neither criticism is particularly strong.

Vickers estimates that banks will face costs in the region of £4-7billion per year as a result of the proposals. So, actually, given the total size of the industry these costs are relatively trivial. Also, these costs are nothing compared to the bill the government is footing: The New Economics Foundation argues that the 5 biggest UK banks received a £46bn government subsidy in 2010 alone. Furthermore, these costs are the result of returning risk bearing to where it should be, i.e. with investors rather than taxpayers, and so are not wholly bad. One can argue that the cost of capital has been artificially low for banks because of the implicit government bailout promise outlined above. Banks have been able to borrow at lower cost than they should have been able to because lenders have known that it is highly unlikely that they won’t get paid back. In the past it was known that the government would step in if things got bad. Therefore, interbank interest rates and borrowing costs have been lower than those which actually reflect the social risks.

On the issue of global competitiveness, the proposed regulations largely apply to high street business. By definition, the high street has to stay where it is (!), reducing the international ramifications of reform. The ICB estimates that only a relatively small portion of investment banking activity will be affected and all operations outside the ring-fence will continue to be regulated according to international standards. The enhanced equity capital ratios also only apply to the retail operations of banks. Operations outside the ringfence will continue to be policed by international standards.

Is it enough? Short answer: No. 

This is where I’m sceptical. Yes, the proposals are relatively wide reaching but they are also moderate. Meek even. The fact that there has been relatively little fuss and bother in the aftermath of the report is strong evidence that nothing really challenging has been put forward. Furthermore, implementation is far on the horizon. 2019 to be precise. That is a long time in the future. Who knows what issues will have arisen by then and this also gives the banks a long time to work out every way to minimise the impact of the proposals on their activities.

What Britain can achieve on its own is limited with respect to banking reform. Sadly, an international solution is needed. This is I think why Vickers’ proposals are not going to bring the radical change we need. The ‘sadly’ qualification is because the terms international, agreement and radical are not often found together in this environment.

I want more sensible debate and research on an international financial transaction tax. Such a tax would bring in revenue, which could then be directed to helping those in need at home and round the world, and would help to curb certain types of destabilising financial activities. For example, the growth of ‘High Frequency Trading’ (HFT), identified by the Bank of England as a serious systemic risk, could be reduced by a minimal tax on each transaction as these trades all rely on minuscule margins. However, such a tax does need to be international. The UK could not implement this on its own.

In summary, the Vickers’ report outlines sensible but mild reforms to the UK banking industry which certainly won’t make anything worse. However, they are not enough and their implementation is too far on the horizon. Creative, serious thinking on a challenging international solution is required. Sadly, I’m sceptical about what will be achieved.

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