Friday, 28 February 2014

Deflation is not benign

In an economy where the money supply depends on the production of debt, deflation can never be a good thing. In fact as any cyclist can tell you, deflation means you aren't going anywhere.

More on this here.

Wednesday, 26 February 2014

An attempt to explain Europe

Europe is like a Russian doll. Really. But that doesn't mean Russia is part of Europe. And what about its former satellites? The Baltics are part of the European Union, so they are now firmly "in Europe" - but the future of Ukraine is not so clear.

Here is my attempt to explain how Europe, the European Union and the Euro differ from each other but are all related to each other. And all are subject to change.

Related reading (suggested by Twitter followers):

Does Central Europe exist? - Timothy Garton Ash
The puzzle of Central Europe - Timothy Garton Ash
Europe: A History - Norman Davies (book)
Europe Europe - Enzensberger (book)
Also Patrick Leigh Fermoy's books.

Monday, 24 February 2014

The long decline of the Great British Pound

This chart caught my eye:

It's the GBP/USD exchange rate from 1915 to the present day. Accompanying this chart on Twitter was the comment "quite shocking though how much the pound has been devalued since 1945".

This is a fine example of the way in which economic indicators can be misinterpreted when the historical narrative underlying them is ignored. What this chart shows is indeed shocking, but not because the value of the pound has fallen. It is shocking because it graphically depicts the decline of British global influence. And it charts the desperate attempts of British politicians to maintain global dominance by propping up the value of the currency. 

The start point of this graph - 1915 - was during the First World War and immediately after the failure of the classical gold standard in 1914. Britain borrowed heavily and suffered high inflation during the First World War, and was forced to devalue the pound considerably towards the end of the war. You can see that drop clearly. But instead of accepting devaluation of the pound as part of the cost of fighting a ruinous war, British politicians decided to try to restore the pound to its pre-war value. They imposed severe fiscal and monetary austerity upon the war-damaged British economy, causing a depression that lasted for much of the 1920s. The pound did indeed recover most of its pre-war value, and Britain returned to the gold standard at the 1915 rate in 1925. You can see that the graph flatlines from 1925 to 1932. That was the last time Britain was on a gold standard. 

But if Murray Rothbard is to be believed, the price the world paid for Britain's determination to restore its former glory was the Wall Street Crash and the Great Depression. Rothbard claims that the Fed loosened monetary policy at Britain's behest, and in so doing caused a credit bubble that burst in 1929. I think blaming the Wall Street Crash entirely on Britain's need for loose monetary policy is rather far-fetched: Rothbard seems to have a bit of a chip on his shoulder. But Britain's ill-judged return to the gold standard was almost certainly a contributory factor. 

The onset of the Great Depression following the Wall Street Crash placed the British economy, like everyone else's, under great pressure. Like everyone else, initially Britain tightened monetary policy to preserve the value of the pound. But eventually it was forced to devalue. It came off the gold standard in 1931 and the pound promptly dropped considerably. Barry Eichengreen has documented the role of the gold standard in the Great Depression: it seems clear that those countries that came off the gold standard early, such as Britain, fared much better than countries that remained on it for longer, such as the US. The lesson from this is that a fixed currency regime after a financial crisis and recession is economically disastrous. Sadly we don't seem to have learned from this. The Euro area is busy repeating exactly the same mistake - it isn't called a gold standard, but it behaves much like one. 

The pound did recover its value as Britain came out of the Depression. But it's worth remembering at this point that there are two sides to any exchange rate. This is GBP versus USD. The strength of the pound in the later 1930s was due to the weakness of the US dollar as the US first reflated (FDR's New Deal) and then dipped back into recession again. 

Not surprisingly, the value of the pound fell sharply on the outbreak of World War 2. It is quite normal for currencies to devalue in wars: the currency itself becomes riskier because of the uncertainty around the outcome of the war, and economic fundamentals in the countries concerned usually worsen considerably despite the fiscal stimulus caused by the war effort. Wars are expensive: GDP collapses, inflation rises and countries become highly indebted. Britain was no exception. It ended the war heavily in debt to the United States and with a massive balance of payments deficit. This was ON TOP OF the outstanding debt it was still carrying from WW1, which it had never managed to unload. Two world wars and a depression had caused enormous damage to the British economy. It was in pretty poor shape. 

In 1944, Britain entered into the Bretton Woods managed exchange rate system. This fixed the pound's exchange value to the dollar, which in turn was linked to gold. Once again, British politicians were determined to show that Britain was still a force to be reckoned with, so the exchange rate was set too high for such a damaged economy. Britain was forced to devalue the pound by 30% in 1949. But even that was not enough. The next 18 years were characterised by persistent balance of payments problems and sterling crises: Britain was forced to seek assistance from the IMF more than once. Wilson finally devalued the pound again in 1967. But by this time, inflation was already rising and was made worse by the devaluation. The next 15 years were to be a period of high inflation and dismal economic performance.    

In 1971, Nixon suspended convertibility of the dollar to gold, effectively ending the Bretton Woods system. But even after this, Britain continued to prop up the pound against a market that clearly wished it to be lower. The currency simply did not warrant the value that Britain wished it to have, yet successive Chancellors* refused to allow it to float freely, fearing a sterling collapse. In 1976, the Chancellor of the Exchequer called in the IMF to help arrest persistent runs on sterling. On the advice of the IMF, the Chancellor imposed austerity measures, which reduced inflation and improved economic performance. The IMF's loan was never fully drawn. The pound recovered - but only temporarily. Against a background of rising unemployment, the famous "Winter of Discontent" in 1978 sounded the death knell for the Labour government. In 1979, the Conservatives under Margaret Thatcher won the election. 

1979 was a turning point for the pound. Exchange controls were lifted, and for the first time it was allowed to float. And it promptly fell. It takes a great deal of nerve for a Chancellor to allow a previously managed currency to fall freely, but Geoffrey Howe allowed it to do so. But again, we should be mindful that there are two sides to any exchange rate. The fall of sterling in the 1980s was due to the growing strength of the dollar, which climbed steadily against all currencies (not just the pound) until 1985. But in 1985, currency management started again. The Plaza Accord of 1985 introduced active depreciation of the dollar against all major currencies including the pound, a strategy which only ended with the Louvre Accord of 1987. 

Howe's successor, Lawson, was - and remains - a fan of managed exchange rates. From 1987 onwards he unofficially pegged the pound to the German Deutschmark. This caused inflation, a credit bubble and a property market boom which eventually crashed in 1990, followed by a recession. Despite this, Lawson's successor, John Major, continued to shadow the Deutschmark and eventually joined the European Exchange Rate Mechanism (ERM) at what it soon became clear was too high a rate. 

But it didn't last. Britain's brief membership of the ERM ended ignominiously when the pound was forced out by sustained speculative attacks. Major's successor, Norman Lamont, reportedly said he was "singing in the bath" after the pound crashed out of the ERM. It promptly sank to an exchange rate more appropriate for the state of the economy.
The independence of the Bank of England in 1997 removed the value of the pound - both its domestic value (inflation) and its external value (exchange rate) - from direct political control. The Bank of England now primarily manages the domestic value of the pound and allows the international value to adjust to domestic economic conditions. 

What is perhaps most surprising is how little evidence there is of long-term decline in the value of the pound since exchange controls were lifted in 1979. It looks very much as if most of the needed devaluation had already happened (painfully) by then. In which case the IMF's intervention in 1976 to halt the slide of the pound was ill-judged. The pound should have been allowed to fall. It would have found its own level eventually. 

For me, what this chart proves is that provided monetary authorities are credible, a free float is far and away the best way of managing a currency. What is shocking about this chart is not how much the pound has devalued. It is how long it took to do it, and the economic cost of trying to prevent its fall. 

But the real story behind this chart is the end of the British empire and the loss of the pound's reserve currency status. Prior to WW1 Britain was the dominant economy in the world, controlling the largest empire in recorded history, and the pound was the global reserve currency. The empire gradually disintegrated over the course of the 20th Century, and the pound was supplanted by the US dollar as global reserve currency. The pound had to devalue, and substantially, because of Britain's diminishing status in the world and the US's growing dominance. But politicians were unwilling to accept this.  

Britain's history is one of constantly trying to punch above its weight internationally, even at the cost of wrecking its domestic economy. The Geddes axe and ensuing depression of the 1920s, the refusal to devalue throughout the 1950s and 60s, the attempt to prop up the exchange rate in the 1970s, and finally the disastrous entry to the ERM at too high a rate: all of these failed, some disastrously. And all of them had ghastly consequences for the economy. Even today, Britain still tries to act like a larger and more dominant player than it really is. 

Britain is no longer a superpower. Indeed it hasn't been one for a long time, though it doesn't know it. It is time people recognised this, and stopped hankering after past glories. The value of the pound in 1945 was too high even for Britain as it was then, let alone now. It is time to put the past behind us, and move on. 

Related reading:

Currency wars and the fall of empires - Pieria

* Until the independence of the Bank of England in 1997, monetary policy was under the control of the Chancellor, not the Bank. 

Thursday, 20 February 2014

Explaining the US labour force participation problem

Please note that throughout this post I take "labour force" to mean people aged 15-64, which is consistent with OECD definitions. I exclude over-65s and children under 15. 

Patrick Artus at Natixis notes that there is something “odd” about the US’s economic recovery. The labour force participation rate (or rather "activity" rate, as I am using OECD definitions) is falling for both men and women. 

The male activity rate has been falling for a long time. But until about 2000, the female activity rate was rising sharply. It levelled off during the 2000s and is now falling.

Falling activity rates are often blamed on the long-term unemployed giving up the quest for work. And indeed the US does have a long-term unemployment problem at the moment:

But of course, measures of the long-term unemployed tell us nothing at all about discouraged demand: if they are reported as “unemployed”, then they are counted IN the active labour force. If anything, the fact that that US is still reporting high levels of long-term unemployed, five years after the recession, suggests that discouraged demand is NOT the principal cause of the declining activity rate.

This is something of a pity. If the declining activity rate were due to long-term unemployed giving up looking for work, we might expect that it would improve once jobs became easier to find. A cyclical fall in the activity rate is far easier to address than a secular decline.

Research by Alicia Munnell, director of the Center for Retirement Research at Boston College, has suggested that the falling participation rate is a secular decline due to demographic changes. The story goes that labour force participation peaked in 2000, then has declined since and is now on a downward trajectory as baby boomers retire and leave the labour force. In a recent speech, the Fed’s James Bullard appeared to support this argument. (Update: To be fair to both, they include over-65s in their definitions. I've explained at the end of this post why I exclude over-65s).

But Natixis’s Patrick Auter has a different explanation (my emphasis):
Despite the decline in unemployment and the growth in employment and activity, the participation rate continues to decline in the United States, which is mainly due to the decline in activity of the young, not older workers as is often thought.
Using the data from the OECD’s Employment Review quoted by Natixis (op.cit.), I have charted activity rates for men by age decile:

There is a striking fall in the activity rate for the youngest men, together with a RISE in the activity rate of the oldest cohort.

The same features show up even more strikingly in the female chart:

Taking out the oldest and youngest deciles from both charts gives us the activity rates by decile for prime-aged men and women:



There is evidence of a small cyclical fall in the activity rate on the men’s chart, which is beginning to reverse, at least for younger men. The women’s chart also seems to show slight cyclical variation.  But there does not seem to be a crisis of activity among prime working-age Americans. There is no “outbreak of idleness” among men, as Charles Murray has suggested. And there is no outbreak of single mums depending on state benefit, either: the female cohort whose participation rate is falling the most is 45-54 – hardly the age of single parenthood.

Nor is there any evidence to support the argument that the activity rate is declining because baby boomers are retiring. On the contrary, it seems that baby boomers are NOT retiring: activity rates for older men and women are rising. The group whose activity rate IS falling – considerably – is young people.

But this is not due to idle young people living off their parents, lounging around on street corners and smoking weed. This chart from the OECD shows that the participation rate of young people aged 15-20 in education has risen 10% since 1995:

And the participation rate of young people aged 20-29 in education has risen about 6%:

According to the National Center for Education’s report “The Condition of Education 2012”, participation in education and training has risen hugely, particularly among young adults (my emphasis)
The enrollment rates for 7- to 13-year-olds and 14- to 15-year-olds were generally higher than the rate for 16- to 17-year-olds, but the rate for 16- to 17-year-olds did increase from 90 percent in 1970 to 96 percent in 2010….
Young adults ages 18–19 are typically transitioning into college education or the workforce. Between 1970 and 2010, the overall enrollment rate (including enrollment at both the secondary level and the college level) for young adults ages 18–19 increased from 48 to 69 percent. During this period, the enrollment rate for 18- and 19-year-olds at the secondary level increased from 10 to 18 percent, while the rate at the college level rose from 37 to 51 percent. Between 2000 and 2010, the college enrollment rate increased from 45 to 51 percent.
Adults ages 20–34 who are in school are usually enrolled in college or graduate school. Between 1970 and 2010, the enrollment rate for adults ages 20–24 increased from 22 to 39 percent, and the rate for adults ages 25–29 increased from 8 to 15 percent. The enrollment rate for adults ages 30–34 increased from 4 percent in 1970 to 8 percent in 2010. Between 2000 and 2010, the enrollment rate for adults ages 20–24 increased from 32 to 39 percent; for adults ages 25–29, it increased from 11 to 15 percent; and for adults ages 30–34, it increased from 7 to 8 percent.
So it is education that is primarily causing the decline in working-age labour force activity. That is not to say that ageing baby boomers won't be a problem, nor that there may not be some discouraged demand - especially since it seems jobs are rather hard to come by. But if these effects exist. they are marginal compared to the loss of young people from the workforce due to education and training.

Patrick Artus comments that:
The decline in the participation rate casts doubt on the reality of the improvement in the labour market situation in the United States.
Is he right? Well, no. A better–educated workforce should improve the quality of labour, even though it diminishes its quantity, particularly among younger cohorts. And that would be a good thing both for business and for labour.

Though of course, the available education may not be as valuable as people think.


Matthew B (@boes_ on Twitter) points out that I have excluded over-65s from my analysis, which necessarily invalidates the research findings that baby boomers are responsible for the falling participation rate. Indeed I have, because I am interested in why working-age participation is falling. We don't regard over-65s as "working age", any more than we regard children under 16 as "working age". It is in my view perverse to include over-65s in measures of labour force participation but not children under 16. And more to the point, it is a serious distortion.

Over-65s are by far the largest part of the non-working population, and their number is growing, both because of increasing longevity and because of the retirement of "baby boomers" (people born 1946-64). Their presence in measures of labour force non-participation dominates everything else. This means that other factors, such as those I am highlighting in this post, seem much less important. With over-65s in the picture, retiring baby boomers are indeed by far the most important reason for declining labour force participation. But when we exclude them - remembering that we do not expect them to be active labour force participants anyway - it becomes clear that there is a secular change going on: young people are delaying their entry to the workforce by studying for longer, and older people are delaying their planned exit from the workforce by working for longer. Both of these are to some extent forced by legislation: young people in many states now have to remain in education until they are 18, and the statutory retirement age is gradually rising.

I would like to clarify a point I made in the post which has caused some confusion since I am excluding over-65s. When I refer to "baby boomers NOT retiring", I am referring to those older people who would have retired earlier than their statutory retirement age but are choosing not to, perhaps because low interest rates mean their savings are not delivering the returns they expected. It's also worth noting that social security changes mean there is now a considerable disincentive for people aged 62-64 to retire early, since if they do they lose substantial parts of their social security. This may partly explain the rising participation rate of both men and women aged 61-64.

I looked at the decline in prime working-age participation as well as total working-age participation. I use the OECD measure of total labour force participation or "activity", so the total working-age labour force is 15-64. But prime working-age labour force is as defined in the United States, namely 25-54. My conclusion is that the decline in total working-age labour force participation is a mainly secular trend driven by delayed entry to and exit from the workforce as described above. But the current decline in prime working-age labour force participation is almost entirely cyclical and can be expected to correct itself as conditions improve.

It should be apparent that if I had left over-65s in my analysis, it would not have been possible for me to reach these conclusions. Therefore I defend my decision to exclude them.

Related reading:

How to better understand labour force participation, eventually - FT Alphaville
Is America working? - Pieria
What accounts for the decrease in the labour force participation? - Atlanta Fed

The subprime education crisis

The NY Federal Reserve’s Household Debt & Credit Report shows that student debt is rising fast and is now at an all-time high:

Household Debt and Credit Developments as of Q4 2013:

Quarterly Change*Annual Change**Total as of Q4 2013
Mortgage Debt(+) $152 billion(+) $16 billion$8.05 trillion
Student Loan Debt(+) $53 billion(+) $114 billion$1.08 trillion
Auto Loan Debt(+) $18 billion(+) $80 billion$863 billion
Credit Card Debt(+) $11 billion(+) $4 billion$683 billion
HELOC(-) $6 billion(-) $34 billion$529 billion
Total Debt(+) $241 billion(+) $180 billion$11.52 trillion

That’s a good thing, isn’t it? It shows that lots of young people are signing up for college instead of sitting around at home doing nothing or doing dead-end jobs.

But all is not well.......

Read on here.

Monday, 17 February 2014


My post about Scotland and the banks attracted an outbreak of criticism from fervent Scottish Nationalists. I found this rather bizarre, as throughout the post I assumed there would be a "Yes" vote in the September referendum. How this translates to "Coppola despises #indyref" is a mystery.

But it raised a question. What opinion, if any, do I - a British citizen living in the south of England - have a right to express? The events of the last week have made it very clear that Scottish independence would affect all of the UK. I have no vote in this referendum, but I definitely have an interest in its outcome. It is therefore wrong to suggest (as some do) that I have no right to comment AT ALL on Scottish independence and its effects. Scottish independence would affect me. Therefore I have a right to express an opinion on it.

I am no constitutional lawyer, but it is clear to me, at any rate, that the UK must continue in some way after Scottish independence. I am a citizen of the United Kingdom, and I have no vote in this referendum. Is my citizenship to be revoked on the say-so of the Scots? Is the country in which I was born and to which I have given my allegiance to be broken up without my agreement? The claim by some that Scottish independence would mean the end of the UK cannot be allowed to stand. Breakup of the UK would need the agreement of ALL its citizens. The very fact that the Scots have been allowed to have their own referendum is a clear indication that the UK would continue in some form after Scottish independence. A "Yes" vote would be secession, not breakup. Comparisons with Czechoslovakia are moot.

The European leadership certainly seems to understand this. Jose Manuel Barroso, President of the European Commission, observed that Scotland would be "a new country, a new state, coming out of a current member state". To him, clearly, the UK would remain after independence - diminished, but still standing. Even if it adopted a new name (perhaps "the United Kingdom of England, Wales and Northern Ireland") it would still be the same country and therefore remain a member of the European Union. He also made it clear, as have other European officials, that an independent Scotland would have to apply for membership of the EU. John Swinney of the SNP described this as "preposterous" and claimed that Scotland had been a member of the EU for forty years. I'm afraid as far as I can see this is simply wrong. The EU recognises the UK as a member state, not its constituent parts. Scotland is only a member of the EU by virtue of its membership of the UK. If it leaves the UK, it is de facto no longer a member of the EU.

A similar problem arises with Scotland's claim to "a share" of sterling. Sterling is the currency of the UK, and the Bank of England is the central bank of the UK. If Scotland were to leave the UK, it would leave behind both the currency itself and the institutions that support it. Emotional shouts of "the pound is Scotland's too" and "the Bank of England was founded by a Scot" don't change this situation.

The SNP's proposal to create a "sterling area" similar to the Euro zone, thus enabling Scotland to retain sterling with Bank of England support, has foundered on political opposition in the UK and economic arguments from the Governor of the Bank of England and from the UK Treasury. The three main UK political parties have - unusually - presented a united front in opposing currency union with an independent Scotland. Describing this as "ganging up" to "bully" Scots into rejecting independence is perverse. The SNP has to make the case for currency union, not only from Scotland's perspective but also from the perspective of the rest of the UK. So far, it has failed to do so. Until it comes up with a compelling argument that currency union would be beneficial not only for Scotland but for the rest of the UK, it is is off the table. That doesn't mean an independent Scotland couldn't use sterling, and it doesn't mean that Scotland's claim on the assets of the Bank of England wouldn't be honoured. Indeed, it would not be in the UK's interests to withhold Scotland's share of the Bank of England's gold and FX reserves. An independent Scotland's new central bank would need them.

Personally I think the currency union proposed by the SNP would be bad news not only for Scotland, but also for the rest of the UK. I explained why in this post from two years ago, and John Aziz has reached similar conclusions, as has Martin Wolf of the FT - a formidable opponent. So I think those supporters of "independence" who favour a currency union are mistaken. But more importantly, they do not have the right to force an unwanted currency union on the rest of the UK.

The fact is that Scotland's self-determination has to be negotiated, and negotiation is a long and delicate process. The outcome of the independence referendum will set the framework within which that negotiation will take place. At present there is considerable discussion about what would have to be negotiated following a "Yes" vote. But there is no discussion about what would have to be negotiated following a "No" vote. And yet, in its way, a "No" response would have as many implications for the future of the UK as a "Yes" vote. Whatever the outcome of this referendum, the UK is set for radical change.

The independence referendum was originally intended to have a third alternative - the so-called "devo-max", under which Scotland would remain in the UK but would manage its own fiscal affairs. In the event of a "No" vote, the Scottish government would no doubt push for devo-max - indeed this was originally its preferred option.

It would be easy to see devo-max as simply a matter of devolving much more to the Scottish government. But it goes much further than that. It raises questions about the governance of the entire UK. Not only would the West Lothian question have to be resolved, and the hated Barnett Formula revised to take account of Scotland's new fiscal autonomy, but the whole relationship of the Scottish and Westminster parliaments would need to change. Would Scotland return fewer MPs to Westminster - say the same number as for the European parliament? And how would this affect the balance of power in Westminster? Would Westminster be forced to create regional parliaments in England to prevent a huge imbalance developing? Would more powers have to be devolved to Welsh and Northern Irish assemblies, and even to English regional parliaments or to large cities such as London? In short, would the UK find itself inexorably moving towards a federal model of government?

If so, then there is a strong case for a second referendum in the event of a "No" vote - a referendum in which ALL the people of the UK would decide how they wish to be governed.

Saturday, 15 February 2014

Scotland and the banks

The UK government this week ruled out any question of agreeing to a currency union with an independent Scotland. Joseph Cotterill of FT Alphaville explains why the UK unquestionably has the power to do this and there is little the Scottish government can do about it:
"From the date of the Treasury’s promise on gilts, the Scottish government effectively conceded its maximal demand already. Furthermore it couldn’t use market volatility to revive the issue: any share of the debt it paid would be to the UK government. The market itself would trade on the UK’s gilt guarantee...." 
In other words, because the UK Treasury has guaranteed to honour all existing UK debt issuance, the SNP's threat to repudiate Scotland's share of UK debt if it doesn't get currency union has no market impact. It is therefore hollow. The lesson for the SNP is - never, ever underestimate the deviousness of Treasury mandarins.  Wily though he is, it seems Alex Salmond is no match for Sir Nicholas MacPherson.

So where does this leave Scotland's currency conundrum? The following options remain (assuming, of course, that the Scottish people vote for independence on September 18th):

- using sterling without currency union ("sterlingisation"), or another currency such as the dollar ("dollarization")

- creating a new Scottish currency

- joining the Euro.

Andrew Lilico has ably discussed the third of these and I shall not cover it further here except to say that if Scotland joined the EU (or remained in it, depending on your point of view) it would have no choice but to join the Euro. That leaves Sterlingisation and creating a new Scottish Currency. As I shall discuss, there is really little difference between the two.

Full Sterlingisation

First, let me make it clear that an independent Scotland could use sterling as its currency if it so chose, with or without the agreement of the UK government, just as any foreign country can. The UK government cannot prevent it from doing so. Nor would independence mean Scottish banks having to relinquish existing holdings of sterling reserves, as some have suggested. They would simply become foreign exchange reserves on their balance sheets. Scottish banks would no longer have access to Bank of England liquidity facilities, of course, which might make payments a bit clunky until everyone adopted mobile money platforms. But as long as Scottish banks could continue to obtain sterling on the open markets, they could continue to fill their ATMs with sterling notes and issue loans in sterling. Sterling coins would remain legal tender as at present (sterling notes are not, in Scotland).

So far, this is no different from the many small countries that use the US dollar or the Euro. Sam Bowman of the Adam Smith Institute cites Panama as an example of a small country that is successfully using the US dollar as its own currency. Indeed it is. But I fear he is comparing apples with nuclear warheads.

Joseph Cotterill (op.cit) describes full sterlingisation of the Scottish economy as "rather ill thought out" (i.e. batshit insane) given the size of its banking sector. I have to agree. The small countries such as Panama that use foreign currencies do not have banking sectors that are somewhere between 8 and 12 times GDP depending on who you talk to, as Scotland's currently is. For comparison, Iceland's banking sector at the time of its collapse was about 9 times its GDP and Cyprus's banking sector was 7 times its GDP. Furthermore, Scotland's cross-border liabilities post-independence would dwarf those of Iceland. Scotland could not possibly bail out its banks in the event of a financial crisis like that in 2008. But neither the UK Government nor the Bank of England would have any responsibility for doing so either. Full sterlingisation could therefore result in the disorderly failure of Scotland's banks, with catastrophic consequences not only for Scotland but for its principal trading partner, the UK. This is indeed "batshit insane".

Scottish currency with fixed sterling peg

Sam Bowman and Lawrence White of the Institute of Economic Affairs both argue that despite the risks, Scotland would still do best to use sterling without currency union. They argue the case for use of sterling as an anchor for "free banking", in which commercial banks issue banknotes at par with sterling and there is no central bank. As this is how Scottish banking used to work prior to the 1844 Bank Charter Act (though the anchor at that time was gold, not sterling), emotionally this approach might have considerable appeal to supporters of Scottish independence.

But this is not full sterlingisation of the Scottish economy. What they are actually suggesting is a Scottish currency called the "pound" which is legally fixed to sterling at par. This is a logical extension of the present situation in Scotland. Scottish banks issue their own banknotes which are 100% backed with sterling reserves. In Scotland they are exchangeable at par with sterling notes and coins, and both sterling and Scottish notes circulate freely.

Unfortunately the same is not true south of the Border. Scottish notes are not widely accepted in payment for goods and services, although banks will accept them in exchange for sterling. But English banks only accept them because they know that the Bank of England will honour them at par - and that is because of the existing currency union. If the currency union were to end at independence, there would be no reason for English banks or the Bank of England to accept Scottish notes at all, let alone at par. They would, in effect, be a foreign currency.

North of the border, after independence, Scottish notes and sterling notes and coins would continue to circulate freely as competing currencies just as they currently do. But south of the border, Scottish notes would have much less value than they currently have - indeed they might be worthless everywhere except Scotland, just as the "Bristol pound" is worthless everywhere except Bristol. Only those who were doing business in Scotland or planning to travel there would want Scottish notes, and indeed as long as sterling was equally acceptable in Scotland, they might not bother with Scottish notes at all. So there would be a simply enormous exchange difference between Scottish notes and sterling.

This creates a massive problem with White's ideas for free banking based on Scottish currency backed by sterling reserves. White envisages banks being free to issue whatever currency they wish without reserve restriction (the existing 100% reserve requirement would be lifted). But they would be legally required to guarantee exchange of Scottish notes for sterling at par.

At independence, Scottish banks would retain whatever reserves they already have on their balance sheets. But after independence, banks would no longer have access to Bank of England lending facilities, so they would have to obtain sterling reserves in the open market, either by borrowing or purchasing. This raises a difficult question. FX transactions are an exchange. What would Scottish banks have to offer in exchange, if Scottish bank notes were not a tradeable "currency"? And borrowing these days is collateralised (repo). What would Scottish banks have to offer as collateral for sterling reserve borrowings in the open market? Their own government's debt is unlikely to have the standing in the market that UK gilts have. Admittedly they currently have sizeable holdings of gilts, just as they currently have large quantities of reserves. But once they started fractional reserve issuance of Scottish notes, their reserve holdings would quickly diminish. To start with they would no doubt repo out their safe liquid assets for sterling, but once they have encumbered their safe asset holdings, what then? I'm not sure exactly what line a new Scottish regulator would take on the shrinkage of Scottish bank liquidity buffers due to fractional reserve issuance of Scottish notes, but international liquidity standards are getting ever tighter: would a Scottish regulator really buck this trend in the interests of maintaining the Scottish money supply? Under regulatory pressure, the Scottish banks might be forced to restrict both note issuance and credit creation in order to avoid running down sterling reserves. And of course, they would cease to provide sterling notes to the economy at all.

White seems rather keen on this idea (my emphasis):
Should Scotland retain the sterling standard, private banknotes would continue to provide better currency (more reliably redeemable for Bank of England notes or one-pound sterling coins) than currency issued by a new Scottish central bank or currency board. A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued. A government central bank or currency board that devalues against sterling cannot. The importance of maintaining its reputation in a competitive environment would deter a commercial bank from acting in ways that might endanger its ability to maintain par redemption. A government monopoly faces no such reputational constraint, since its customers have nowhere else to turn.
So, legal enforcement of exchange parity between Scottish banknotes and sterling would be a fixed currency peg, preventing the Scottish currency from devaluing and forcing everyone in Scotland to use Scottish notes. In effect, White is saying that a democratically-elected Scottish government couldn't be trusted to protect its currency. But in proposing a fiat sterling anchor (as opposed to gold) he is implying that a democratically-elected UK government CAN be trusted to protect its currency. This is hardly a ringing endorsement of Scottish independence.

The history of the "Pound Scots" does not suggest that such an implied peg could reliably be held. Reserve-restricted banking is a profit-killer for banks when reserves are in short supply and expensive. And the resulting tight money supply and restricted credit creation can be a serious brake on economic growth. Banks would inevitably resort to fractional reserve money creation, both to improve their own profits and in response to political pressure: I have no doubt that, faced with a credit crunch due to reserve constraints, a Scottish government would want to "get banks lending" just as the UK government has done in recent years. This would implicitly devalue the Scottish notes relative to their sterling reserves. So they would not only be worthless OUTSIDE Scotland, they would be worth less than sterling WITHIN Scotland too. How long does White think the Scottish banks would remain solvent?

White is pinning his hopes on Scotland becoming an offshore tax haven similar to the Channel Islands (since Scotland would be similar to a Crown Dependency after independence). This would attract continual inflows of sterling in much the same way as a persistent trade surplus. If it worked, this would of course ensure an ample supply of sterling reserves, so the liquidity crunch I described would not be a risk. But he should be careful what he asks for. If there is one thing we have learned from the Eurozone crisis, it is that fixed currency pegs and free movement of capital can be a very bad thing. If Scotland attracted all this money, what would it be used for? And how long before private and, perhaps, public debt burdens became unsustainable, as inflows of hot money fuelled credit bubbles?

Anyway, why on earth does he think the UK government would tolerate Scotland becoming a sterling tax haven? I suppose he is looking at the UK's inaction over Ireland and assuming it would do nothing about Scotland. But Ireland is a Euro tax haven. Scotland would be a sterling one - and that is a very different matter. I can't see the UK government doing nothing about it. At the very least I would expect significant cuts in corporation tax, and possibly withholding taxation of cross-border sterling flows - especially if, like the Channel Islands, Scotland remained outside the EU.

But what about the banks?

But there is a much bigger problem here. It's not unusual for economists to take no account of the commercial interests of banks when suggesting changes to monetary arrangements. And I am always amused at their surprise when the results are not what they expected. But in this case they have failed to see a simply enormous elephant.

Although they are, perhaps without realising it, proposing a new Scottish currency, both White and Bowman assume that Scotland would not have its own central bank. Scotland has two very large banks - RBS and HBOS - and a number of smaller players, including the newly-created English bank TSB and the Australian-owned Clydesdale. The majority of both RBS's and HBOS's business is in England & Wales. If this isn't obvious, remember that by far the largest part of RBS's business portfolio is the English banking giant NatWest, and the former English building society Halifax remains the largest mortgage lender in England & Wales, dwarfing the assets of its Scottish parent Bank of Scotland.

NatWest is a wholly-owned subsidiary of RBS which is incorporated in London. Post independence, therefore, NatWest would continue to have access to Bank of England liquidity facilities. Its parent, RBS, would not. If I were running RBS, faced with loss of Bank of England support for my Scottish operations, no Scottish central bank, and a fixed currency peg that would quickly drain my liquidity reserves, I would reincorporate in England. Wouldn't you? Indeed, if the Scottish government refuses to accept a share of the costs of bailing out RBS in 2008, the UK government - currently the largest shareholder - might insist that RBS reincorporated in England, to eliminate the risk that a Scottish government might force RBS to drain liquidity from its UK subsidiary to support its Scottish operations. In fact it might push for this even if Scotland did buy some of the shares.

The other big Scottish bank, HBOS, is already a wholly-owned subsidiary of the English bank Lloyds. HBOS is currently incorporated in Scotland. But faced with the loss of Bank of England liquidity support not only for its Scottish operations, but also for its important Halifax mortgage lending portfolio, wouldn't Lloyds also decide to move its Scottish subsidiary to England? And even if it decided to leave BOS itself in Scotland, the UK regulator might force separation of the Halifax lending book into a new UK subsidiary. Scottish independence could have the perverse effect of forcing further deconglomeratisation of Lloyds.

So I question whether, in the absence of a Scottish central bank, the large Scottish banks would remain either large or Scottish. This might be a good thing for Scotland, since it would reduce the size of its banking sector to something more compatible with its GDP. But how would the Scottish government feel about Scottish currency note issuance being done entirely by foreign banks?

A genuinely independent Scottish currency 

It's entirely possible that the Scottish government would not like Scottish currency issuance to be entirely in the hands of foreign banks. Politically this would certainly be problematic, since currency is part of national identity. So I guess the answer is obvious. Create a new Scottish central bank responsible for issuing Scottish pounds, fully backed by the Scottish government. And end the anomalous creation of Scottish notes by banks.

In the interests of cross-border liquidity, it would be wise for the new currency to be tradeable. But the Scottish government would have to decide whether or not to allow the new currency to float. It might be wise for a new Scottish currency to be pegged to something, probably sterling but potentially also either the dollar or the Euro. New currencies tend to take a beating on foreign exchange markets, especially when the country's debt doesn't have a good credit rating either - which in Scotland's case it won't, simply because of the lack of any credit history. In the interests of inflation control, therefore, a peg to a stable currency in good standing would be a sensible move, although I think it should not be a fixed peg such as White suggests - a crawling peg or something similar would be more sensible.

But Scotland's government should understand that this dilutes its independence. In effect, it would be giving up control of monetary policy to the country whose currency it is using as its anchor. And this would also to some extent dictate its fiscal policy too, since monetary tightening or loosening due to changes in the value of the "anchor" currency would require a fiscal response that might not be what the Scottish economy needed or its people voted for. Is this what the SNP really want?

If it really wants independence, then the only alternative is a new tradeable Scottish currency floating freely against all others (although it could be pegged to a commodity such as gold or oil). Whether it is issued by a Scottish central bank or by commercial banks in a "free banking" model is really not that important. What matters is that the currency should be genuinely independent. If it is not, then neither is Scotland.


For those who are not clear why a fixed currency peg combined with free capital flows necessarily means that monetary policy cannot be independent, I am adding this link about the so-called "impossible trinity" or "trilemma". It's Wikipedia, but pretty clear and about right, and has a handy diagram.


Here are two further links, respectively from pro-independence and anti-independence writers, both arguing that currency union is not a flier. Sillars (pro-independence) is strongly in favour of a Scottish currency. Tomkins (anti-independence) is more noncommittal but gives a very good explanation of the reasons why the UK will not agree to currency union.

Time for wise leadership on currency - In Place of Fear (Sillars)
The SNP's currency nightmare - Notes from North Britain (Tomkins)

And here is the BBC's writeup of Andrew Marr's discussion with Jose Manuel Barroso, President of the European Commission, in which Barroso confirmed that an independent Scotland would have to apply for EU membership and might find it difficult.

Tuesday, 11 February 2014

It's the Euro, stupid

A few days ago the German constitutional court referred the question of the legality of the ECB’s Outright Monetary Transactions (OMT) to the European Court of Justice (ECJ), claiming that the ECB was straying into fiscal policy that was beyond its mandate and that OMT breached EU treaty directives outlawing monetary financing of governments.
The question of the legality of OMT has been a running sore ever since it wasfirst mooted in August 2012. The ECB has clearly stated that it regards OMT, or rather the threat of OMT, to be part of its monetary policy toolkit. It has nothing whatsoever to do with bailing out Eurozone sovereigns, although that may be an incidental effect. It’s all about the Euro.....
Read on here.

Monday, 10 February 2014

Is America working?

My latest post at Pieria looks at labour market trends in the United States. Male employment is declining, and has been for half a century. But does that justify the claim that there is something fundamentally unhealthy in the American labour market? Is it really true to say "America isn't working"?

Read the article here.

Saturday, 8 February 2014

Incentives matter

"Rule number one in economics: incentives matter".

So says Tim Worstall, in this post criticising me for claiming that state investment is not necessarily any less efficient than private sector investment. And he goes on to say that politicians and bureaucrats have different motivations from "profit-mad capitalist bastards" like him.

I don't disagree in the slightest. But that doesn't invalidate my argument. 

Tim's argument essentially is that the profit motive always results in better investments than philanthropic or public service motives. The idea is that people who want to make as much money as possible for themselves will make more efficient use of resources than people who want to help others. But why should the motivation to serve others necessarily make one less concerned about efficient use of resources than the motivation to make money? In short, why should selfishness necessarily ensure better outcomes FOR OTHERS than altruism? 

On the face of it, this seems illogical. If people who work in the public sector genuinely are motivated by the desire to provide the best possible services for others, why would they be any less efficient than private sector actors motivated by the desire to make as much money as possible? There is really only one possible explanation for this, and that is that is that those who work in the public sector are less able than those in the private sector, so are inherently incapable of deploying resources to their best effect. This amounts to saying that selfish people are cleverer than altruistic people. Really?

I suppose it is possible that the dim-witted self-select to work in public service, and are never weeded out because, er, their managers are dim too, but to me this seems rather far-fetched. So what other reasons might there be for inefficiency in public service? There are a number of possibilities. 

The first is that those who work in public service actually aren't genuinely motivated by altruism. And this is indeed possible. But is someone necessarily less efficient because they get their rewards in non-monetary forms - whether personal recognition, the satisfaction of a job well done, or the warm feeling that comes from seeing the lives of others made more comfortable? Or is someone necessarily less efficient because they are motivated by the desire to work locally, have a secure job and earn a comfortable living? Again, this looks far-fetched. 

Some claim that that anyone who works in public service - and in particular, anyone who goes into politics - is doing so because they expect to benefit personally and not out of any genuine public service motive. At its most extreme, this amounts to saying that all politicians and bureaucrats are corrupt. Some are, for sure - but all of them? This is not remotely supported by the evidence. The UK's record on corruption is rather good, actually. No, if there is waste and inefficiency, it doesn't stem from corruption. 

But it might stem from bureaucracy. Indeed there is a strong argument that the natural tendency of  managers in the public sector to build empires increases bureaucracy at the expense of efficiency. The public sector is not homogenous, but it is very large, and size and bureaucracy definitely go together. But the same argument can be made about any large organisation, private or public sector. The profit motive is no stronger for the thousands of employees of say, Barclays, than it is for the thousands of employees of Her Majesty's Government: they are all simply doing jobs for wages. But the empire-building incentive is at least as strong. It is illogical to assume that a private sector firm of a similar size to a public sector organisation is more efficient simply because it is in the private sector. And it isn't supported by the evidence, either. Large commercial organisations can be astonishingly wasteful. I have never seen so much money wasted in my life as I did in the finance department of Midland Bank. Though admittedly, Midland suffered the fate of large inefficient commercial organisations - it was taken over. Which brings me to the next criticism of the public sector: lack of competition. 

The story goes that private sector actors make efficient use of resources because otherwise they will be forced out of business by more efficient players. So a public sector organisation that has no competition will inevitably become inefficient, simply because it lacks the discipline of competition. 

But the discipline on the public sector is the democratic vote. Politicians that have presided over profligate spending programs can be voted out of office, and politicians can be elected on a cost-cutting mandate. Indeed successive governments, of both colours, have pursued the objective of "eliminating waste" in the public sector, cutting costs, privatizing functions and outsourcing services at an astonishing rate. The belief that profit motivation ensures efficiency has been the driving force behind public sector reforms for the last thirty years. 

As a consequence, there is now significant competition in the public sector. Both central government and local put out services for competitive tender: these are fought over fiercely by a mixture of profit-making and non-profit-making providers, and it is not always the profit-makers who win. Nor is competitive tendering the only source of competition in the public sector. Failing schools are taken over by other schools in much the same way as failing companies are taken over by their competitors. Failing hospitals are heading the same way. Yes, it seems brutal: but it is a necessary discipline on the public sector. 

The growth of competition in the provision of public services is actually as much a discipline on the private sector as the public sector. This is because the need to make a profit is itself an inefficiency*. Public services are not necessarily provided by either the public sector or the private sector: the non-profit-making sector (the "third sector") is an immensely important provider of public services. If there is competition between profit-making and non-profit-making providers, the non-profit-makers should always win. If they don't, it could be due to bureaucratic inefficiency. Or it could be due to other factors. 

Organisations that provide a public service may additionally have other goals, such as paying living wages to their employees. This is no doubt what is behind Tim's suggestion that profit-making organisations would pay lower wages. The public sector is often criticised for high pay rates and gold-plated benefits, which is to some degree true, probably because unions have more power than in other sectors. But we do have to be a little careful with comparisons: the public sector has a high proportion of highly-qualified employees who would command good salaries in the private sector too. Most low-skill, low paid public sector jobs have long since been outsourced. 

But the third sector is an entirely different matter. It really can't be regarded as profligate with pay. In fact it can be astonishingly mean. Pay rates in the third sector are generally far below rates for equivalent jobs in the private or public sector: many charities would rather not pay their workers at all, let alone living wages. When I worked for a charity bank, I had to remind the directors that expecting to pay well below market rates simply because they were a charity did not help them to recruit or retain good staff. The existence of highly efficient non-profit-making organisations whose directors and staff are motivated by the desire to provide a good service is compelling evidence that Tim's argument is fundamentally wrong. Incentives do indeed matter, but the profit motive is no better an incentive than the desire to do some good.  

Tim comments that politicians may be more interested in creating jobs than providing efficient, low-cost public services. And Simon Cooke (a local politician in Bradford), in a comment on Tim's post, observes that: 

"The problem here, such as it is a problem, is that those “social motives” that define the objectives of state investment are ill-defined. For sure, we can look at the NHS and describe its objective as improving the health of the population, we can even quantify that objective (increased life expectancy, for example) but there is no incentive to see that objective as paramount. The result is mission creep.....
"Within the public sector decisions are compromised by this mission creep – be it environmental, ‘equalities’ or some other ‘social purpose’ that really has nothing at all to do with the real purpose of the institution. The classic examples is jobs – I was castigated at one meeting for saying that if we could run Bradford Council’s services without needing to employ a single person then, ceteris paribus, this would be a good thing – for the service and for the taxpayers who fund the service."

Here is the heart of the matter. It is not the motivation to make money that makes people efficient with resources. It is having a single clearly-defined purpose. 

When objectives are unclear, money is inevitably wasted. This is true in the private sector as much as the public sector. In the private sector, organisations that have no clear purpose eventually go out of business (Woolworth's springs to mind). In the non-profit-making sector, organisations that have no clear purpose never get off the ground - after all, who is going to give to a charity that has no clear idea what it will do with the money? And in the public sector, organisations that have no clear purpose are (we hope) eventually eliminated by politicians acting in accordance with their democratic mandate.  

Those who claim that the public sector is intrinsically inefficient and corrupt, so should be cut to the bone or, preferably, dismantled completely, are therefore doing us all a favour. Their disapproval provides the discipline for the public sector that competition provides in the private sector. And because of it, there is much less difference between the efficiency of the public and the private sectors than they think. So they are wrong, but - perversely - we need them to continue to believe that they are right.

By the way, the debate in the comments on Tim's post was one of the most interesting and good-natured online debates I have ever taken part in. I do recommend reading it. It develops the argument about bureaucracy and perverse incentives in the public and private sectors quite a bit, and concludes that actually it can be very hard to tell the difference between the public and private sectors.  

Related reading:

Public choice theory - EconLib

* Perfect competition forces down profits to zero. If costs are the same, therefore, a company that doesn't need to make a profit will always outbid one that does need to make a profit. The profit-maker's attempt to make a profit by cutting costs will be undermined by the non-profit-maker doing the same. The profit motive in the provision of public services therefore to some degree creates inefficiency.

Friday, 7 February 2014

The day after tomorrow, redux

An updated version of my post from September 2012, "The Day after Tomorrow", is now up at Pieria. Read it here.

The original is still up on Coppola Comment, too.

Monday, 3 February 2014

Capital controls or cooperation?

My latest at Pieria considers the use of capital controls to mitigate the damaging effect of sudden large capital flows such as those we are currently seeing out of emerging market countries due to the Fed's QE taper.
"Since the 2007/8 financial crisis, there has been considerable discussion about the role of capital flows in the formation of asset bubbles and their subsequent collapse, and about strategies for managing the movements of "hot money" from country to country in search of yield and/or safety. It is fair to say that there is far from a consensus: government policies around the world currently range from the extremely controlling to the totally laissez-faire.
"The outflows of capital from emerging markets arising from the Fed’s tapering of QE have raised again the question of whether capital controls would be appropriate as a short-term measure to calm markets and prevent currency collapse. So far, no country has adopted outright controls, though several are intervening in markets to support their currencies: as I write, the Turkish finance minister (on Twitter) has just ruled out any use of capital controls or transaction taxes. But it is not beyond the bounds of possibility that, faced with currency collapse and/or unsustainable rises in debt burdens, some countries may resort to direct restrictions on capital movements. Would this be an appropriate course of action?"
Read on here.

Saturday, 1 February 2014

Laffer and the Loch Ness Monster

Comments on my post "Laffer and the Yeti" forced me to look again at the way in which the Laffer curve is used to argue both for and against raising taxes for the rich. It seems it is widely - and perhaps deliberately - misused.

The Laffer curve illustrates the relationship between elasticity of taxable income and tax revenues. The peak of the Laffer curve is the rate of tax at which tax revenue from all sectors is maximised, because the cost of avoiding tax outweighs the cost of paying it. But it is an AGGREGATE measure. It says absolutely nothing about the distribution of tax rates or tax income elasticities across the population. Yet it is widely used to talk about tax rates for the rich, as if the tax rate of the rich is the same as the tax rate for the entire population. It is not. The average tax rate is much lower. Therefore it is possible for the Laffer curve to be well below its peak even when there are high tax rates for the very rich.

Laffer curves can, of course, be created for individual sectors. So it is possible to create a Laffer curve specifically for those who fall into the top tax bracket (though this is of course a moving target), and then to solve for the revenue-maximising rate of tax for those people. But this tells us absolutely nothing about tax revenues in aggregate. In fact it is sensible to assume that tax revenues are well below the revenue-maximising peak for everyone EXCEPT those falling into the top tax bracket. In which case, we are looking at a marginal effect. What we don't know is how significant that marginal effect is.

In an economy where there are a relatively large number of wealthy people, we would expect that raising tax rates for the rich would have a significant effect on tax revenues. The Laffer curve shows that there is a point beyond which tax revenues start to fall as average tax rates rise. This is not unreasonable, but we don't know where that point is, and estimates vary wildly. But for a wealthy-dominated economy, tax rates on the wealthy that are far to the right of the Laffer curve peak for that sector could indeed have a bad effect on public finances. It's perhaps not surprising that economies dominated by the wealthy do tend to have low top tax rates.

But most economies don't have a relatively large number of wealthy people. They have a relatively small number of wealthy people and a much larger number of people on low to middling incomes. Virtually all of these people pay tax to a greater or lesser extent: indeed in the UK, tax rates as a proportion of income are highest on the very poorest even after taking benefits (negative taxes) into account, because the burden of indirect taxes falls most heavily on them:*

Embedded image permalink

(chart courtesy of Stuart Astill)

We would expect that tax rates for the very rich could be far above the Laffer peak for that sector without seriously adverse effects on the public finances. Yes, tax revenues from this group might diminish, but there could - as Simon says - be very good social reasons for allowing this to happen. We would create a slight inefficiency in tax collection, but then we have tax inefficiencies in all other sectors anyway for social reasons, so why not in this sector too? Why should revenue-maximising be the primary aim for the very rich but not for anyone else? Whatever happened to taxation as an influence on behaviour?

Indeed, high taxation of the rich has been proposed by several economists, not only to improve public finances but to reduce inequality - and to improve the behaviour of corporate executives. If they cannot keep excessive rewards, they are much less likely either to be offered them as wages (bonuses) or to extort them in the form of economic rents.

But this brings me to the second, and arguably more serious problem. It is often argued that high taxes for the rich cause GDP to fall, which hurts the poor - and conversely, that lowering taxes on the rich improves the incomes of the poor. This is "trickle-down economics", or what I dubbed the Loch Ness Monster argument.

The Loch Ness Monster argument, in a slightly different form, states that income inequality is essential for growth, because only the rich generate enough savings for there to be productive investment. If the saving of the rich is impeded by high taxation, private sector investment is also impeded, which over the long-run will reduce GDP and therefore damage the poor as well as the rich. Raising taxes on the rich to restore public finances and improve the lives of the poor is therefore counterproductive over the long-run. Is this argument correct?

There are some pretty heroic assumptions here. The first is that the rich save more than the poor. Individually - and simplistically - they undoubtedly do: the poor are forced to spend most of their income on simply surviving, so save little, whereas the rich can meet all their needs from a relatively small proportion of their income, and (it can be argued) are forced to save the rest.

But what exactly do we mean by "rich" and "poor"? If we were in a Dickensian nightmare world where there were only the very rich (who save most of their income) and the very poor (who save nothing), it would be true. But we are not. "Poor" is relative. These days, most people save to some extent, even if they don't know they do - how many people realise their pension contributions, and their mortgage payments, are actually saving? The very poorest don't, of course, but they are a relatively small proportion of the population - indeed, vanishingly small in countries that have no state pension system. The rest are savers. A vast number of poor-ish saving a little can add up to as much or more than a small number of rich saving a lot. So IN AGGREGATE, in most countries, it is by no means certain that the rich save more than the poor. They could save much less. Indeed, this paper by Schmidt-Hebble and Servern found no relationship between income inequality and aggregate saving.

If this is the case, there would be at least as strong an argument for reducing taxation at low to middle incomes as there is for reducing taxes on the rich. If what we need is more aggregate saving, it doesn't matter who saves, does it?  And we do know that those on low incomes are more likely to dis-save when times are hard. Reducing their tax burden should help them to maintain or increase their saving rate.

The second heroic assumption concerns the use that is made of savings. If the poor save primarily by stuffing mattresses or buying gold, then we would indeed rely mainly on the savings of the rich for investment. And in some countries (here's looking at you, India) this is indeed the case. But in developed countries where people place their savings with financial intermediaries, we assume that all savings are productively invested. In which case it doesn't matter whether the savings come from the poor or the rich, does it? Of course, if savings are NOT productively invested we have a bigger problem. And that brings me to the third heroic assumption.

There is an implicit assumption here that paying taxes is unproductive, and the money would have been better used for private sector investment. I won't get into philosophical and political debates about the role of the State, but it is fundamentally illogical to assume a) that all private sector investment is necessarily productive and b) that all public sector investment is necessarily unproductive. How is it more productive for someone to invest their money in government bonds than to pay taxes? It's the same money used for the same purpose! If money paid out in taxation is unproductive, then so is money lent to the government in the form of safe asset purchases. The private sector invests a considerable amount of its untaxed income in government bonds. If all government expenditure is unproductive, then this is unproductive investment.

The only "productive" form of private sector investment is investment in enterprise. It is fair to argue that as this form of investment involves taking risk, the rich are far more likely to invest directly than the poor. But most of the poor place their money with financial intermediaries, who are responsible for providing risk capital to enterprise. So it seems the risk aversion of the poor is another red herring. We are not reliant on the rich for risk capital. We are reliant on financial intermediaries who invest the savings of those on low to middle incomes.

Whether taxation (or investment in government bonds, which is the same thing really) is an unproductive use of funds depends on how the State uses the money. It is often stated that the State is unable to assess risk properly or make rational investment decisions, and that therefore any investments the State makes are likely to be inefficient relative to private sector investments. Frankly I think this is questionable: after all, the State uses the same management consultancies to advise it on investment projects as the private sector does, engages the same contractors as the private sector uses and recruits people from the private sector. Admittedly, bureaucracy can have a deadening effect, but the same is true of large organisations in the private sector. Bureaucratic inefficiency is certainly not a public sector specialism.

But even "normal" use of state funds is not necessarily unproductive. Industry wants educated workers, it wants a well-developed modern infrastructure, it wants workers mended when they fall ill.....there may well be more efficient ways of providing them than the current arrangements, but that does not mean that the State is necessarily a worse provider than the private sector would be. We have to be very careful not to argue from our priors!

The arguments supporting the idea that high taxes on the rich damage the poor are perhaps weaker than their proponents like to admit. However, we know that falling GDP does damage the poor. If higher taxes on the rich DO cause GDP to fall, then there really is a monster in Loch Ness, even if we don't know what it looks like.

Tax increases are undoubtedly contractionary. Romer & Romer show that higher taxation causes GDP to fall. But their paper considers an increase in AGGREGATE taxation from all sources, not a specific increase in taxes on one sector only. I suspect that the GDP fall they identify is caused by opportunity costs (high taxation prevents deployment of funds to more productive investments) and general disincentives to produce. But their work does not show that higher taxation of the rich causes GDP to fall. And Piketty and Saez's paper shows that there has been little if any upside benefit to GDP from cutting taxes for the rich. I suppose there could be some weird kind of asymmetry, whereby raising taxes on the rich damages the poor but cutting taxes for the rich doesn't benefit anyone except the rich, but really this is stretching credibility quite a bit.

If anyone has conclusive evidence that there is a definite causal link from raising taxes on the rich to falling GDP, I would be very pleased to see it. Until then, I remain of the opinion that the Loch Ness Monster is a myth, and so is "trickle-down economics".

Related reading:

The Peak of the Laffer Curve is Not the Place to Be - Bob Krumm
Shifting justifications for the 50p tax rate - Institute for Economic Affairs
Oh no, not again - Coppola Comment
Tax, inequality and the problem of the 50p rate - Pieria

* Indirect taxes in the UK include VAT, and "sin" taxes on tobacco and alcohol. The very poorest spend more of their income on general consumption than anyone else, so are most affected by VAT. And they also proportionately spend more on tobacco and alcohol.