Tuesday, 20 September 2016

Some unpleasant trade realities

Well, this is fun. YouGov has asked the public which countries the UK's new trade negotiators (if and when they are recruited) should prioritise in their quest for free trade deals.

Unsurprisingly, the US and the EU (considered as a whole trading bloc) came top of the list. But as ever, the devil is in the detail. These charts show the difference between the public's perception of the importance of a country versus its exports and GDP rankings:

Now, of course the exports ranking is the current situation. We would expect free trade agreements to change this ranking, since countries with which the UK has free trade agreements should move up the exports ranking, and those with which it does not should correspondingly move down. The EU is currently top of the exports ranking because the UK is part of the single market. Once the UK is no longer part of the single market - as seems increasingly likely - the ranking might change. The GDP ranking is therefore possibly more important, since it indicates export potential.

But what these charts tell us about the public's preferences is disturbing.

Firstly, there appears to be discrimination against Middle Eastern Muslim countries. Saudi Arabia and Turkey are both ranked considerably lower by the public in terms of priority than either their exports ranking or their GDP would justify. Of course, the charts don't extend far enough to include smaller Middle Eastern countries, but it seems unlikely that this negative attitude is limited to those two countries.

Secondly, there is a clear preference for countries that are English-speaking and have historic colonial ties to the UK. That includes the USA, of course. But the effect is more striking for Commonwealth countries. Australia, Canada and South Africa are all significantly over-prioritised by the public relative to both their exports and GDP ranking.

Now, some of the distortion might be due to simple ignorance. Brazil is hugely under-prioritised by the public, and India is somewhat under-prioritised too relative to its GDP. This is perhaps due to public perception that these are poor countries and it would be better to target richer ones such as China and South Korea for exports. It also might reflect fear that removing barriers to imports from those countries - particularly India - would mean losing more manufacturing jobs.

But I fear much of the distortion is not due to ignorance, but tribalism. Europe and the Middle East, both of which have recently been the target of popular anger over immigration, are rejected by many in favour of older alliances. English-speaking countries are favoured over non-English speaking ones. Countries with Christian heritage are preferred over countries where other faiths dominate. Former colonies are prioritised over countries with no historic ties to the UK.

The tribal roots of the public's trade priorities are even more apparent when the voting preferences of those sampled are taken into account. Here are the top five priorities, split by political allegiance:

The split is striking. For those who voted to leave the EU (Leave/UKIP voters), the EU does not even make it into the top 5. But even among Conservative voters, not all of whom would have voted Leave, the EU is fairly low priority. Their allegiance is to what YouGov describes as the "Anglosphere". For all three groups, English-speaking countries are the top priority.

In contrast, for Remain voters and the Liberal Democrats the priority is overwhelmingly Europe. Labour voters are fairly balanced between the USA and EU, but over-prioritise Australia. Indeed the only group that does not significantly over-prioritise Australia is Remain.

Of all the groups, Remain most accurately prioritises in relation to both current export rankings and potential GDP, though it does over-prioritise the EU relative to GDP. But there is a very good reason for this, which appears to be ignored by those who voted to Leave. That is the fact that the UK currently has a free trade agreement with the EU, which it is on the verge of abandoning.

The EU is the destination for half the UK's exports. Leaving the single market without a replacement trade deal would have potentially disastrous consequences for the UK's exporters. Yet those who voted Leave appear to be blissfully ignorant of this. It is folly not to prioritise the EU in trade negotiations.

But why are Leave voters (including UKIP) and many Conservatives so unconcerned about negotiating with the EU? I don't know, but there are a number of possibilities.

Some of them seem to assume that the Article 50 negotiations will establish a new trade agreement, so there is no need for separate negotiation. I've encountered a number of very intelligent people who believe this. Sadly they are wrong. Article 50 negotiation will sort out the terms of the divorce, such as the status of EU and UK migrants and the responsibility for EU pensions. It will not establish a new trade agreement between the UK and the EU. When the UK leaves the EU, it will revert to the same position as any other non-EU country vis-a-vis the EU. There will need to be separate negotiations to re-establish free trade with the EU. These might not take place until after Article 50 negotiations have established the terms of Britain's exit.

It's worth noting, too, that although Britain's exit from the EU only requires a qualified majority vote from the rest of the EU, a new trade agreement would need unanimity. Any one country could veto the entire deal - as the French have said they will do with TTIP. Furthermore, since the precedent recently set by the European Commission with regard to the draft Canadian agreement CETA, a trade agreement with the UK would need to be ratified by the parliaments of all 27 remaining EU member states. That could take a very long time, and the eventual agreement might not be all that favourable to the UK.

Others seem to think that reverting to the EU's standard tariffs for non-EU countries would not affect UK exports. I beg to differ. It would mean an immediate price increase for UK exports to the EU. This is bound to encourage price-sensitive EU importers to look for cheaper alternatives elsewhere. We should expect therefore that leaving the single market with no equivalent agreement in place would cause UK exports to the EU to fall, possibly drastically. It would also affect the EU's exports to the UK, of course - though German cars are pretty price inelastic. There aren't too many alternatives to them at the high end of the UK market.

Finally, some seem to think that losing exports to the EU wouldn't matter because we would have all these lovely new trade agreements with other countries. Never mind the EU, bring on the Commonwealth!

This is frankly delusional. Firstly, countries such as Australia are simply too small to replace the export potential of a trading bloc the size of the EU, depressed though it is. The EU currently accepts 50% of the UK's exports: Australia, 1.6%. Admittedly, these percentages would change if the UK left the single market and agreed a free trade agreement with Australia: but no way could rising exports to Australia compensate for falling exports to the EU. Australia has 23m people: the EU (minus UK), 680m. Australia's GDP is $1.56tn: the EU's (minus UK) about $14tn.

Secondly, despite all the rhetoric, the fact is that the UK is just not that important to countries such as Australia. For some years now, Australia has been establishing itself as one of China's key trading partners. It is one of the very few countries that has a free trade agreement with China, and it is a major partner in Asia's Regional Comprehensive Economic Partnership programme, which would establish a free trade area in the entire Asia-Pacific region. This is bound to be far higher on Australia's priority list than a bilateral trade agreement with a country on the other side of the world. India, China , Japan, South Korea and Indonesia are also partners in this programme. The UK is not going to be high on their priority lists, either.

For the USA, sorting out trade relationships with the Asia-Pacific region and with the EU is far more important than a bilateral trade deal with the UK. The TPP and TTIP are both in deep trouble, TPP because of opposition in the USA and TTIP because of opposition in Europe. Deciding what to do about these will be the top priority for the incoming President, whoever that may be.

So that leaves Canada, really. But their principal trading partner is the USA, and they also are trying to finalise a trade deal with the EU. The UK is simply going to be an annoying distraction.

Furthermore, even if the UK could persuade some of these countries to give a bilateral trade deal priority, trade negotiations take a very long time. Agreements with minor countries desperate to trade with someone could perhaps be established quite quickly. But it will be literally years before the UK can establish trade agreements with any major countries or trading blocs.

If the UK ends up leaving the single market, therefore, its future looks bleak for many years to come. It will face tariffs and barriers to trade everywhere in the world, including in Europe where it currently faces none.

The fact is that where global trade is concerned, the public does not know best. Ignorance, tribalism and prejudice are no basis for trade agreements.

The UK's decision to leave the EU is unbelievably stupid. All we have done is "taken back control" of our own decline.  And we will be the poorer because of it.

Related reading:

Modelling the long-run economic impact of leaving the EU - NIESR
Brexit, trade and GVA - NIESR

Image courtesy of the US Treasury. 

Monday, 12 September 2016

Are inheritance taxes unfair?

Are inheritance taxes unfair? Many people think they are. "Why should I be taxed twice on money I've earned during my lifetime?" they say.

This is, of course, a fallacy. Dead people don't pay taxes. Living ones do. So inheritance tax is not double taxation of money the dead person earned while they were still alive. It is taxation of an unearned windfall for the people to whom they leave their assets, usually their children. Other forms of unearned income, such as interest on savings and capital gains, are taxed. Why should someone be taxed on unearned income they receive as a result of investments made from their own earnings, but not on unearned income they receive as a result of investments made from someone else's earnings? That doesn't look very fair, does it? Surely taxing that unearned windfall must be fair. 

No. According to the economist Greg Mankiw, taxing inheritance is fundamentally unfair:
From my perspective, the estate tax is a bad way to tax the rich because it violates the principle of horizontal equity. The basic idea is that similar people should face similar tax burdens.
This opens a whole new can of worms. After all, if the rich and the poor are similar, then a 20% basic rate of tax rising to a 45% top rate of tax is unfair to the rich. Those in favour of flat taxes usually raise this point. Perhaps Mankiw is one of them. But there are very good reasons for taxing the rich more highly than the poor, not least of which is the fact that a similar burden of taxation lies much more heavily on those struggling to pay for essentials than it does on those who want for nothing. "Similar" is in the eye of the beholder.

But let's stick with inheritance tax. Mankiw goes on to provide an example to show why inheritance tax is unfair:
Consider the story of two couples. Both start businesses when they are young. They work hard, and their businesses prosper beyond anything they expected. When they reach retirement age, both couples sell their businesses. After paying taxes on the sale, they are both left with a sizeable nest egg of, say, $20m, which they plan to enjoy during their golden years.
So we are not talking about unfair taxation of the rich versus the poor. We are talking about unfair taxation between rich people. And we are not talking about unfair taxation of one couple's nest egg over the other, either. Inheritance tax would equally be charged on what is left of each couple's nest egg when they die. So what is unfair about that?

One couple lives frugally in order to be able to pass the majority of their wealth on to their children and grandchildren. The other couple has a lavish lifestyle. They have a great party in their declining years, but they leave much less to their descendants. According to Mankiw, these differences in lifestyle choice make inheritance taxes unfair:
So here's the question. How should the tax burdens of the two couples compare? Under an income tax, the couples would pay the same, because they earned the same income. Under a consumption tax, Mr. and Mrs. Profligate would pay more because of their lavish living (though the Frugals' descendents would also pay when they spend their inheritance). But under our current system, which combines an income tax and an estate tax, the Frugal family has the higher tax burden. To me, this does not seem right. 
Now, of course Mankiw has conveniently ignored the existence of state-level sales taxes (or, in Europe, VAT), which would disproportionately be paid by the Profligate family. But he approves of unequal taxation anyway. He is happy for the Profligate family to pay disproportionately higher taxes because of their lavish spending, but not happy for the Frugals to pay disproportionately higher taxes because of their excessive saving.

Mankiw's comment "To me, this does not seem right" exposes the real basis for his opposition to inheritance tax. We have departed from the realm of economics. His argument is a moral one. Frugality is good, profligacy is bad. Tax policy should reward the good and punish the bad. Therefore the Frugals should be excused from taxation on their saving habit, even if the Profligates are taxed on their spending.

The moral belief that saving is inherently good and should be rewarded is deeply ingrained. And in the distant past, when eating the seed corn meant famine next season, there were very good reasons for rewarding saving and punishing consumption. Indeed, that is still the case in many developing countries today.

But in a world where there is not only too much capital floating around but widespread unwillingness of the owners of that capital to put it to productive use, rewarding excessive saving and the transmission of wealth down the generations is counterproductive. In developed countries, there are now very good reasons to tax excessive saving and reward consumption - and indeed this is what the very low interest rates of central banks around the world are doing. We don't view negative interest rates as a tax on saving, but that is what they are.

Mankiw's view of the "family" is perhaps counter-intuitive. He treats the family as an infinitely-lived unit, not as a series of overlapping generations. Inheritance tax is thus taxation of the family's wealth, not its income.

If we were to do a discounted cash flow analysis of the returns from the Frugal family's nest egg out to infinity, we would see that their returns are far higher than the Profligate family's returns. This is due to the Frugal family's patient lifestyle, which Mankiw wants to reward. But I am struggling to see why we should not tax these higher returns. Indeed, I can see some extremely good reasons not only for taxing them, but for taxing them rather highly.

Of course, Mankiw's model is fundamentally flawed. Families are not infinitely-lived, and preferences are not uniform across the generations. The children of Frugals can be Profligate: the children of Profligates can be Frugal. But whatever their own preferences, the fact is that because they inherit wealth, the children of Frugals have a financial advantage that Profligates will never have.

The different lifestyle choices of the Frugals and the Profligates thus create wealth inequality, not for themselves but for their descendants. However hard they work, the descendants of the Profligates will never be as wealthy as the descendants of the Frugals, unless at some point a future Frugal becomes Profligate and blows the lot.

Looked at in this way, we might take the view that NOT imposing inheritance taxes is fundamentally unfair, since it gives an unearned advantage to future generations and progressively widens wealth inequality. Perhaps 100% would be a little steep, but given the compounding effect of intergenerational wealth transfers, inheritance taxes can in my view be pretty high without being remotely unfair.

There is an even more vital reason to tax intergenerational wealth, too. Humans are naturally selfish, envious and belligerent. Those who have wealth tend to hang on to it like mad, while those who don't have wealth tend to try to take it from them. If there is no mechanism for dampening the tendency of wealth inequality to widen down the generations, eventually we have a reset. Usually that takes the form of war, which wipes out lots of wealth (and people). Sometimes we have a revolution, a form of war which explicitly targets the holders of wealth for retribution.

I don't know about you, but I would much rather have explicit taxation of intergenerational wealth than an unstable political economy that generates wars and revolutions because of the buildup of wealth inequality over the generations.

Related reading:

Wealth inequality in the United States since 1913 - Saez & Zucman (pdf)
Capital in the 21st Century - Piketty (book)

Monday, 5 September 2016

Austerity and the rise of populism

This post has been brewing for a long time. It reflects my attempt to make sense of the growing political confusion and chaos in the world today. William Butler Yeats's poem The Second Coming well expresses what I see:
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity. 
But how have we come to this pass - and where are we heading?

Post-crisis panic

In the deep recession that afflicted the Western world after the 2008 financial crisis, government debt built up as financial and other corporations were bailed out, tax revenues fell and unemployment benefits rose. Government debt is usually quoted in relation to GDP: the recession knocked a huge hole in the GDP of many Western countries, inflating the debt/GDP ratio.

Suddenly, countries that had previously looked like paragons of fiscal rectitude found themselves with rising government debt/GDP and stubbornly high fiscal deficits. Others, more fragile before the crisis (though not necessarily worse managed), needed the help of the IMF. Advanced economies suddenly looked at least as risky as emerging markets. Investors took flight, forcing Western governments to support asset prices with extraordinary measures such as QE.

Into this cauldron, someone lobbed a research paper purporting to show that government debt/GDP ratio above 90% spelled disaster. The paper turned out to be fatally flawed: but that information did not come to light until some years later.

Other research papers were added to the toxic brew. Among them, the clever models of Alesina and Ardagna supposedly proved that fiscal consolidation could restore growth. The empirical evidence presented in support of this claim was later shown to be seriously inadequate, relying on inaccurate data and omitting important factors. But in the chaos and panic of the post-crisis world, any prescription was better than none. At least they had a treatment plan.

The final ingredient was the Greek debt crisis. It scared the world. Suddenly, high government deficits and debt were terrible things. We had to get them under control. That meant deep cuts to government spending, if necessary including raising taxes and cutting benefits for the most vulnerable in society. Government after government in the developed world, and especially in Europe, accepted this harsh medicine. After all, we were told, Alesina & Ardagna had promised it would restore growth.

A political paradigm shift

To be fair, Alesina himself never claimed there was strong empirical evidence for his theory, and did not push it as a solution to the post-crisis slump. The push appears to have been political. Iyanatul Islam and Anis Chowdhury wondered whether the theory unwittingly played to a small-state political ideology:
One plausible answer lies in collective and wilful ignorance driven by an ideological aversion to counter-cyclical fiscal policy because fiscal interventions are seen as an enlargement and encroachment of the state on the functioning of the private sector. As Simon Wren-Lewis (2011) points out, and as Romer (2011)concurs, one can find eminent economists objecting to counter-cyclical fiscal policy based on ideological proclivities, even though such economists support the idea of using monetary policy to stabilize business cycles. 
But the question is, why was a small-state political ideology suddenly in the ascendant? It had not been, prior to the crisis. Somehow, the crisis itself had shifted the political paradigm.

It is easy to see how this could happen. In the aftermath of a monetary crisis, people are angry with those they believe caused it and fearful of losing their money and assets. They reject the existing political regime in favour of one which promises safety. They will accept harshness in the short term if they are sufficiently convinced that this will eventually bring back prosperity. Liam Byrne's tongue-in-cheek note to incoming UK chancellor George Osborne captured the political mood: "I'm afraid there is no money", he said.

"There's no money" is the psychological framing of both Reinhart & Rogoff's flawed paper, and Alesina & Ardagna's theory. The model is one of scarcity. No money is available, so we have to manage without. Belt-tightening is in order. Together, these two papers not only supported the small-state ideology of the UK's Conservative chancellor, but justified extreme fiscal tightness in the Eurozone. Reinhart & Rogoff's paper creates the justification for cuts and tax rises: Alesina & Ardagna promise the "sunlit uplands" necessary for people to accept the harsh medicine.

But the prescription turned out to be voodoo. Seven years on, prosperity has not returned: many countries in Europe are still mired in austerity, some are deeply depressed, government debt is higher than ever and unemployment is still painfully high. Failure of austerity measures to deliver the promised prosperity is toxic: popular anger and fear fuel the rise of populist politicians. Rudi Dornbusch, in a wonderful paper about debt crises and populism in Latin America, observed that the roots of populism lie in austerity, often imposed by an external agent such as the IMF. Chancellor Brüning's austerity measures in the German Great Depression, designed to end Germany's debt crisis and restore foreign confidence, led to the rise of Hitler.

The profligacy-austerity cycle

We endlessly cycle from profligacy to austerity and back again. The shift from profligacy ("the money will never run out") to austerity ("there is no money") is triggered by a monetary crisis of some kind: austerity is imposed by technocrats. And the shift from austerity to profligacy is triggered by a political crisis fuelled by popular unrest: profligacy is reintroduced by populist politicians.

In 2008, the monetary crisis that triggered the shift to austerity was the abrupt bursting of a debt bubble, leading to unpopular bank bailouts and a deep and prolonged recession. In the early 1970s, it was the collapse of the Bretton Woods fixed exchange rate system.

After the fall of Bretton Woods, rising oil prices and a global recession fuelled rising inflation. In the UK, successive governments imposed spending cuts and interest rate rises to try to arrest the fall of sterling and get inflation under control. The response to this was popular unrest led by the big unions, with continual strikes causing further economic damage. The UK was dependent on coal for electricity generation, a fact exploited by miners' unions in their claim for large wage rises: strikes caused damaging power cuts.  For the UK population, inflation that eroded pay packets, economic stagnation and rising unemployment caused misery - and growing anger.

In 1976, Dennis Healey called in the IMF: the condition for the loan was further fiscal restraint, though the loan was never fully drawn. The fiscal consolidation contributed to the famous "Winter of Discontent", when the country was riven by strike after strike in opposition to government pay caps.

By 1979, the people of the UK had had enough. The Conservative party's famous posters with pictures of dole queues and the slogan "Labour isn't working" touched a nerve. Margaret Thatcher's brand of populist politics ensured that the Conservative party won the 1979 election - and kept Labour out of power until 1997.

Populist politics works by directing popular anger towards an "enemy" who can be blamed for people's woes. The enemy must be capable of catching the public imagination, so usually it is a defined group of people who can be cast in the role of scapegoat. Blaming the "other" is a powerful way of creating a sense of common purpose. Often, the "enemy" is external: there are numerous examples throughout history of populist politicians distracting attention from domestic troubles by starting a war. In Thatcher's case, though, the enemy was internal, at least to start with. She was elected on a mandate to break union power - and in particular, the power of the miners' unions.

Thatcher's government is widely remembered for the harsh anti-inflation measures, deep recession and very high unemployment of the early 1980s. But people will accept austerity in the short-term, if they are promised that it will bring prosperity. The trick is to deliver the prosperity - and that means profligacy, but targeted at those who support the populist regime. And to ensure that the regime is not blamed for the preceding austerity, the "other" must be broken.

So the unions were defeated by heavy-handed policing following extensive anti-union legislation. Breaking the unions also involved dismantling the UK's coal industry and much of its heavy industry: the areas most dependent on these industries have never really recovered. Thatcher is hated to this day in the former industrial areas of the Midlands, the North and South Wales. But we should not forget that in in other areas, especially the South East and London, she was immensely popular. Populist politicians are divisive.

The destructiveness of Thatcher's industrial policy was coupled with the return of profligacy. The Right to Buy scheme for council housing was extraordinarily expensive. So too was the Falklands War. As interest rates fell, the UK economy got a big fiscal boost - and the result was the "Lawson boom", which ultimately ended in the property crash of 1990. Prosperity for "us", destruction for "them"....that is the goal of populism.

Since the financial crisis, "bankers" have been the "other" in the popular mind - but so have "scroungers and shirkers", who are seen as taking much-needed money from "hard-working people". In an interview with the Guardian, the former Deputy Prime Minister Nick Clegg said that George Osborne deliberately targeted the poor and vulnerable for cuts because this would be popular with Tory voters. This is populism at its worst. And like Thatcher before him, Osborne combined harshness towards the "other" with generosity towards supporters, especially the old and the well-off. The UK's recovery in recent years has been primarily driven by profligate support of the housing market.

A new political paradigm

Greece was the archetype for the post-crisis "there is no money" paradigm. This paradigm still holds - but it is beginning to fracture. A new, darker paradigm is beginning to emerge. The new paradigm is nationalism ("take back control"). And the archetype for the new paradigm will be my own country, the UK. I never, ever thought this could happen here.....

The populist paradigm shift started with the EU referendum. This time, the enemy was external. The EU was vilified as the "other" by Leave campaigners. Leave the EU, all your troubles will be over....This is a false promise, of course. Leaving the EU is likely to cause at least as many problems as it solves. I fear for those who have been promised prosperity by the sellers of snake oil. It will be a long time before they see it - and as many are old, they may never see it at all.

But it is not the rejection of the EU that horrifies me: many people voted for Brexit for good reasons. No, it is the emergence of a small-minded, "Britain for the British" mindset, coupled with hate speech and even physical attacks on ethnic and religious minorities that are seen as "foreign". If Brexit does not deliver the closed borders and cherry-picking of immigrants that these people want, what will they do?

We have seen the darker side of nationalism before, of course, though it has been hiding under a rock for a long time. Outright racist views are not widely accepted, but there is plenty of toxic "othering" along the lines of "I'm not racist, but I hate Muslims/Poles/Lithuanians/Syrians/immigrants [choose as many as you like]". Some groups are demonised: refugees, for example, who are often described as rapists and murderers despite the lack of any convincing evidence.

Creating groups of "others" who can be demonised is the essence of toxic nationalism. To their credit, the current UK government is attempting to stamp on this unpleasant behaviour.  But they are trying to hold back the tide. I think this is the manifestation of the breaking of a long political and economic cycle - the release of pent-up anger and frustration built up over decades. And it will not be limited to the UK. Nationalist forces are rising all over the world.

The "golden age" of globalisation

Thatcher's generation of populist politicians discarded the big state, "Keynesian" model that had dominated since WWII. They replaced it initially with austerity (to break unions power and defeat inflation). But in any democracy, austerity is short-lived unless you can find a way of convincing your supporters either that they are not really suffering (so you protect people who will vote for you) or that the good times will return "any day now". Thatcher's generation - or perhaps more correctly, Reagan's generation, since this comes from economic thinking in the USA - promised that globalisation would bring prosperity for all. We could say that they replaced a "big state" model with a "big world" one. Free trade, free movement of people, free movement of capital: these were the pillars on which the new golden age would be built.

And golden it was, for many. Branko Milanovic has shown how, along with the top 1% who always benefit from everything, the rising Asian middle class benefited from globalisation. The last three decades have seen more people lifted out of poverty than ever before.

But the Western middle classes saw no benefit. For them, globalisation brought stagnation and decline, as their jobs were offshored and their wages fell to the global mean. Their prosperity turned out to be an illusion, built on an insubstantial debt bubble. The promise made to them in the Reagan years has been exposed as a lie. And they are angry. Globalisation has failed - now it is time to "take back control".

As with all long-cycle paradigm shifts, few saw this coming. We are short-lived creatures, and we see only our own small part of the web of time. And just as in the paradigm shift of the 1980s the economic theories of the past were discarded in favour of something new and untried, so now the mainstream economics of the last 30 years is under attack, not just from those who want to reform it but also from those who want to reject it entirely. "I think people of this country have had enough of "experts", said Michael Gove.

Rejecting existing "experts" is a feature of populist politicics. But unlike the 1980s, when populist politicians could claim the work of Milton Friedman and Friedrich Hayek as an alternative to Keynes, this time there is nothing much to replace them. Few economists, either mainstream or heterodox, would support return of general capital and exchange controls, tariff and non-tariff barriers to trade and significant restrictions on the movement of people, let alone the unfairly skewed versions of these that the new nationalists seem to want ("we expect to export to you tariff free but we will impose tariffs on imports from you"; "we can live and work in your country but you can't live and work in ours": "when we devalue our currency that is monetary policy, but if you do the same you are a currency manipulator"). So although, after six years of painful soul-searching, mainstream and heterodox economists now seem to be singing from the same hymn sheet in many respects, people are no longer listening. Populist politicians deride "experts", and pursue divisive policies designed to appeal to protected groups of voters.

The terrible lesson of history

Historically, resurgent nationalism has always led to war. I see no reason why this time should be different. We scared ourselves silly at the end of World War II: the memory of Hiroshima has kept the world in an uneasy peace (though with numerous local breaches) ever since. But as the memory fades, and old tribal loyalties reassert themselves, the world enters a new and dangerous phase.

There is a fine line between nationalism and imperialism, and at some point, someone will cross that line. I don't know who, or where, that will be. But when they do, there will be war.

Related reading:

When the world turns dark
What have we learned from history?
A Latin American tragedy
Currency wars and the fall of empires - Pieria

Vortex star trails image from www.sgarciarill.com with thanks. 

Wednesday, 24 August 2016

Maslow's hierarchy of money

A new study shows that the form of shadow "money" used in US prisons is changing. For many years it has been cigarettes (tobacco), and to a lesser extent stamps and envelopes. But now it seems the popularity of these in the prison black economy is declining - in favour of food. Specifically, Ramen noodles, a high-calorie, substantial foodstuff.

Without examining the reasons for this change, it would be easy to assume that this is a matter of relative scarcity. Perhaps Ramen noodles are cheaper and more widely available than cigarettes, so inmates are turning to them because they are easier to obtain. If so, then Gresham's Law tells us that Ramen noodles would eventually become the principal medium of exchange. Cigarettes would gradually disappear from circulation, becoming an increasingly expensive store of value.

Of course, rich prisoners might worry that lack of demand for cigarettes would reduce their value - after all, if you can't sell your ciggies, you might as well smoke them. So they might hoard Ramen noodles in order to restrict the amount in circulation, or they might try to force up the value of Ramen noodles by artificially pinning their price to cigarettes. We might end up with something akin to a bimetallic standard, with Ramen noodles being the "silver" used by the poor and cigarettes becoming rich prisoners' "gold".

This would create hardship for poorer prisoners, some of whom would be unable to obtain the noodles needed to buy other near-essential goods such as hygiene products. Perhaps there might be some enlightened prison officer who would deliver an inflammatory speech demanding the free circulation of Ramen noodles. "You shall not crucify prisoners on a cross of cigarettes"......

Alternatively, prisoners could be taking to Ramen noodles because they are all giving up smoking and want a new, healthier type of money. "Maybe Ramen noodles are the prison equivalent of Bitcoin", said one bright spark on Twitter.

Umm, no. The change is being driven by a fall in supply, not demand. And it is not the supply of cigarettes that is falling. According to Michael Gibson-Light, the author of the new study, the change is caused by deterioration in the supply of food:
"Prisoners are so unhappy with the quality and quantity of prison food that they receive that they have begun relying on ramen noodles -- a cheap, durable food product -- as a form of money in the underground economy," he said. "Because it is cheap, tasty, and rich in calories, ramen has become so valuable that it is used to exchange for other goods."
The US's prisons are overflowing with people, as politicians insist on more and longer prison sentences. But the funds to run the prisons are not keeping pace with the increase in inmates. Consequently, prisons are being forced to cut back on basic provisions, such as prisoners' food.

So the change in prisons' "shadow money" is being driven not by Gresham's Law, but by Maslow's hierarchy of needs. The lowest level on Maslow's hierarchy (see the image at the head of the post) is physiological needs - air, food, water, shelter, warmth, excretion.* Inadequate food within US prisons has financialised prisoners' physiological needs. It has turned food into money.

Tobacco addicts may claim that they have a physiological need for a smoke, but the widespread substitution of Ramen noodles for cigarettes suggests that for most prisoners, the need for tobacco is higher order. It is easy to see that stamps and envelopes belong in the "love and esteem" section, since they enable prisoners to communicate with family & friends. But where does tobacco fit in? Perhaps there is a hierarchy within a hierarchy, a relative ranking of physiological needs. Tobacco is only a driving physiological need until a greater need shows up.

There is of course a positive effect from this change. If cigarettes will no longer be so freely available, fewer prisoners will smoke them. But against that we must put the health effects of restricting food. What kind of society is it that will provide so little food to prisoners that a black market food supplement becomes money?

Food, of course, does not only feature at the physiological level. Few would argue that caviar and truffles are a physiological need: they belong in the "esteem" section, three levels higher. And in some forms of "self-actualisation", food intake can be severely restricted - ideological veganism, for example. Food features at every level of the hierarchy. And so does money, in one form or another. Money is the facilitator, the means by which people are able to meet their needs, including many of their higher-order needs: after all, self-actualisation is a bit irrelevant when you don't have food or shelter, and relationships can be broken beyond repair by failures at the physiological or safety level.

But Maslow's hierarchy applies to the individual, whereas what constitutes "money" is a collective decision. As Hyman Minsky said, anyone can create money, the problem is getting others to accept it. Money is a social construct. And yet - just as in Maslow's hierarchy, lower-order needs drive out higher-order ones, so when a whole community is distressed, lower forms of money drive out higher ones. Silver replaces gold, paper replaces silver....but when people are starving, gold, silver and paper become worthless, and food becomes money. We can, in a way, regard Gresham's Law as the social equivalent of Maslow's hierarchy.

This touches on fundamental questions about the nature of money. Food-as-money works for those who need food: inflation is benign, since it ensures that all those who want food can have it. Grain standard currencies are very good for agricultural communities, since they ensure that the price of food naturally adjusts to production and wide fluctuations in food prices are avoided. But for those who want to save for the future, food-as-money has serious downsides, including the fact that it can be eaten. When times are hard, the temptation to eat the money and leave nothing for the future can be very high. You can't eat metal or paper.

There is a vast ideological gulf between those who regard money as primarily a store of value, and wish to fix its supply to prevent the value falling, and those who regard money as primarily a medium of exchange, and wish its supply to respond flexibly to demand. In choosing Ramen noodles over cigarettes, it seems that prisoners prefer to regard shadow "money" as a medium of exchange.

But it is early days yet. There may still be a backlash from those rich in cigarettes. And you never know, they might even start using Bitcoin.

Related reading:

The nature of money
The golden calf
Ultra-liquidity - Pieria

Image from Wikipedia.

* The image at the head of the post shows sex as a physiological need, but this is disputed.

Sunday, 21 August 2016

The art of economics

Collected here are my posts about the changing nature of economics. Olivier Blanchard says "there is room for art as well as science". In these posts, I develop the concept of economics as art: vague, conceptual, imaginative, complex, and subjective. In other words - human.

I should make it clear that I am mainly talking about macroeconomics, although microeconomics is also changing for other reasons.

The problem of mathematics
When the Nile floods fail
The failure of macroeconomics
The necessary arrogance of elites
Spurious precision
No, please don't show me your model

Friday, 19 August 2016

No, please don't show me your model

Unsurprisingly, on my post "The Art of Economics", which attempted to put the mathematical models beloved of mainstream economics firmly in their place, is a comment defending mainstream mathematical models. Here it is, in part:
Secondly, you definitely don't need obscure heterodox models to predict a financial crisis. I've cited it before, but for instance Kiyotaki-Moore basically sketches out how a crisis like this can occur. There are actually plenty of examples of perfectly fine mainstream papers on this topic. And it wasn't just heterodox economists that predicted it. People like Dean Baker, Roubini or even Krugman didn't exactly rely on post-Keynesian or Minskyian economics, their logic was fairly straight forward. Stiglitz has some great models on bank failure, which are essentially mainstream info-asymmetry economics. I also think Minsky is useful but not that useful, and it's not especially scientific. He doesn't really have any kind of model, he just essentially asserts that banks will turn to speculators (and also made a lot of mistakes with regards to importance of credit cards, diminishing importance of large infrastructure loans etc..) The mechanisms aren't adequately explained. At least the Austrians, who I definitely oppose, have a mechanism for how banks turn to unstable speculators - aggressive monetary policy. 
This is bad science of the "show me your model" variety. A mathematical model may give apparently accurate results, but that does not mean it has the right theoretical foundations. Valuing the model over the theory was lampooned by the great physicist Richard Feynman, in this lovely metaphor:
[Feynman] imagines a Mayan astronomer who had a mathematical model that perfectly predicted full moons and eclipses, but with no concept of space, spheres or orbits. Feynman then supposes that a young man says to the astronomer, “I have an idea – maybe those things are going around and they’re balls of rock out there, and we can calculate how they move.” The astronomer asks the young man how accurately can his theory predict eclipses. The young man said his theory wasn’t developed sufficiently to predict that yet. The astronomer boasts, “we can calculate eclipses more accurately than you can with your model, so you must not pay any attention to your idea because obviously the mathematical scheme is better.”
In dismissing Hyman Minsky's hypothesis because the model was incomplete, my commenter has behaved like Feynman's Mayan astronomer. Never mind the theory, show me your model....

So, let's look at the mainstream model recommended by my commenter. Like all (yes, I mean all) pre-crisis economic models, Kiyotaki-Moore does not model the financial sector accurately - in fact it does not model it at all. And because of this, it models a financial crisis as starting with some kind of exogenous shock coming out of the blue, in this case a temporary shock to productivity. The model is a farming model, so a productivity shock of this kind might be an adverse weather event, perhaps.

Now, there may indeed be a shock that triggers a financial collapse, but it is not necessarily exogenous. In 2008, it was the fall of Lehman Brothers, which was by any reasonable standards an endogenous shock: similarly in 2007, BNP Paribas's announcement that it could not value subprime MBS, was an endogenous shock. Do endogenous shocks have different effects from exogenous ones? We do not know, and the model does not tell us.

But in the absence of any model explaining how debtors become fragile, we can have no reason to assume that ANY shock, exogenous or endogenous, would have destructive effects. Indeed Kiyotaki-Moore themselves say this is a weakness in their model:
A weakness of our model is that it provides no analysis of who becomes credit constrained, and when. We merely rely on the assumption that different agents have different technologies. 
"Different technologies". What a get-out line. But if you exclude the financial sector from your model, that's the kind of blanket excuse you end up with.

If your model cannot explain how people and corporations become over-leveraged and therefore fragile, it can have no predictive power whatsoever. All it can do is say "IF people/businesses are over-leveraged when a shock hits, THEN this is likely to be the effect". So Kiyotaki-Moore can neither explain nor predict a financial crisis. It merely describes how an (unexplained) shock propagates itself through an (unexplained) over-leveraged population, with long-lasting negative effects. That is useful, of course - in fact I think this model does a pretty good job of explaining the amplifying effect of collateral price falls in debt deflationary collapses. But that isn't what my commenter claimed it did.

Let me be clear. I don't have a problem with mathematical models, as long as they use appropriate mathematics and have a sound theoretical basis. But we have to respect their limitations. They don't necessarily adequately explain economic events, let alone reliably predict them. And they are never a substitute for logical thought. .

So I don't want you to show me your model. I want you to explain your thinking. What is your theory, and how have you defined it? What thought processes brought you to this point? What are your assumptions, and how have you justified them? If you cannot explain these in words, then however clever your mathematics, your model is devoid of substance. Throw away your Greek dictionary, and write me an essay in plain English.

Related reading

Photo of Richard Feynman from sciencealert.com

Thursday, 18 August 2016

Spurious precision

Over at Bloomberg View, Noah Smith has a pop at what he calls “heterodox economics”. By this he means the new ideas in economic thinking that have sprung up since the 2008 financial crisis but so far haven’t made it into mainstream economic journals.

Noah starts by admitting that mainstream economics abjectly failed to predict the crisis and gave little or no guidance on how to deal with it. Because of this, according to Noah, “many people have looked around for an alternative paradigm -- a new way of thinking about macroeconomics that would have allowed us to avoid the pitfalls of the Great Recession.”

Indeed they have.  Though some of the ideas are not so new – Hyman Minsky’s “Financial Instability Hypothesis”, for example, dates back to 1992.

According to Noah, the search for alternative thinking inevitably attracted people who – for whatever reason – “felt shut out” of the mainstream. And as an example of one of these so-called “heterodox” economists, he cites me. Here’s Noah's quotation from my post “The necessary arrogance of elites”, together with his introduction to it:
Many among the heterodox would have us believe that their paradigm worked perfectly well in 2008 and after. As an example, take a recent blog post by British economics writer Frances Coppola. Coppola likens mainstream macro to classical music, which walled itself off from the innovations of rock and jazz. Like the musical innovators of the 20th century, she claims, the heterodox have found something that works better than the ossified old ways of the elite:
Heterodox economists working in the real economy –- many of them untrained in formal economics –- not only predicted it but correctly identified the causes …
The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete.
(The post from which these quotations are taken was actually written in 2012. It was reprinted recently by Evonomics under the title “What UnpopularMusic Can Teach Us About The Future of Economics”.)

The paragraphs from which Noah has taken these quotations actually say the exact opposite of what he claims. Here they are, in full:
And as with “serious” music, when economics becomes so divorced from reality that it fails adequately to explain the real world in which people live, people reject it. People rightly ask why academic economists failed either to predict or adequately explain the financial crisis, whereas heterodox economists working in the real economy – many of them untrained in formal economics – not only predicted it but correctly identified the causes. There is a real danger that the anger people feel over what they see as the failure of mainstream economics leads to rejection of mainstream economics in its entirety and, importantly, withdrawal of funding for academic economic research. This, I feel, would be a mistake.
We may not see the relevance of dynamic stochastic general equilibrium models in a world which manifestly is not in equilibrium. But that doesn’t mean that these, and other mathematical models, have nothing to contribute. The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete: as with much of the experimental serious” music of the 20th century, they will not survive the test of time. But there will be models that remain relevant, and there will be others that appear obsolete but that will in due course be redeveloped and find new life in the new economic paradigm. If we allow them to disappear, our economic understanding in the future will be the poorer.
Contrary to the impression Noah gave, I was defending mainstream economics and its beloved mathematical models. But not because they have done a good job – they have not. And not because economics does not need a different paradigm. It does, desperately. Noah’s arrogant defence of mainstream economics shows this more clearly than anything the heterodox community could say.

We who live through this paradigm shift have a blinkered and biased view, rendering us unable to see the true value of either the old or the new. We either defend the old and reject the new, because the old is all we know and the new has yet to prove itself; or we reject the old and defend the new, because the old has failed and we need something to believe. These are, of course, extremes. The eventual synthesis will include elements of both old and new. In what proportions, history will decide.

And this brings me to my fundamental objection to Noah's post.

Noah's core proposition is that economics has no validity unless it is expressed in mathematical terms. He says that economics without mathematics doesn’t add up. But economics consisting entirely of mathematics doesn’t add up either. Exclusive reliance on mathematics as language is highly problematic, and not just because it inevitably creates a protected elite. It is because of the impossibility of precision. To explain this, here is another musical analogy.

Anyone who has ever attempted to write down, in conventional musical notation, exactly what a jazz singer does knows how imprecise and inadequate musical notation is. Yet when it is removed from the source and viewed academically, it creates a kind of spurious precision. The original intention is demeaned and deformed to fit into the straitjacket of the notation, and the notation then “becomes” the music. Gifted performers, of course, interpret the music from the notation – but in bringing it to life, they re-create imprecision.

So too, relying on mathematical models to explain how our complex, ever-changing world works demeans and deforms it. The more precise a model is, the more unrealistic assumptions have to be made to make it work, and the less likely it is to be an adequate representation of reality. Reality is imprecise and transient.

The great economists of the past knew this - which is why we do not find pages of Greek symbols even in the writings of those who, like John Maynard Keynes, were fine mathematicians. And some members of the mainstream are beginning to realise that economics is much bigger than their beloved DSGE models. Olivier Blanchard, for example, recently called for a more diverse range of models, including "ad hoc" schematics that have little precision and much imagination. "There is room for both science and art", he said. Though he can't quite let go of the DSGE dream, not yet......

Noah's post unfortunately seems to have elicited some rather defensive responses from the heterodox community, along the lines of “But we DO like mathematics!” or even, “Actually our mathematics is better than yours”. But this is to buy into Noah's core proposition. The heterodox economics community should - and, to be fair, in most cases does - reject it outright. Economics is not, and cannot be, exclusively mathematical. This is the terrible mistake that the mainstream economists of our time have made.

The spurious precision of mathematics led "serious" music down the blind alley of serialism. And it has led mainstream economics down the blind alley of general equilibrium. I defend DSGE models, yes, but for their future possibilities, not for their current application.

There is no need for the heterodox economic community to be defensive about vagueness. Vagueness is creative, and imprecision and ad-hocery are the future. The art of economics is being reborn.

UPDATE: I have removed from this post five bullet points which were intended as a very brief summary of Noah's post, and reorganised the post to compensate. Noah says that they are not what he meant, and I respect that. And anyway, they are a distraction from the core argument of this post.

Related reading:

Where danger lurks - Olivier Blanchard
Colds, strokes and Brad Delong
The Slowly Changing Resistance of Economists To Change - Steve Keen (Forbes)

Image from Sibelius.