Not Learning From Our Mistakes

Over the last few years on this blog, I have often talked of the importance of understanding the problem. That is you can’t properly solve a problem unless you understand what’s causing it.

For example, what caused the financial crisis? If you want to prevent a reoccurrence, you need to understand what caused it and make sure you put something in place to prevent the same mistakes being made in the future.

The government pedals the story that the financial crisis that affected the whole world was caused by the irresponsible spending of the previous Labour government. I’ve written in detail about why that’s a fallacy here but I’ll summarise it briefly:

The banks started lending higher and higher loan-to-value mortgages to people wanting to buy houses. In older times the banks would have worried about house prices going down but house prices had not gone down for so long that banks forgot about those risks. Borrowers were able to take on bigger and bigger mortgages relative to their wealth, which in turn led to a huge increase in house prices. The huge increase in house prices led banks to lend even more irresponsibly in order to provide the now even more unaffordable mortgages to borrowers. That led to further increases in house prices. Etc. etc.

By the time the banks realised they’d made a bubble and that bubble was about to burst it was too late. Lots of people couldn’t make their mortgage repayments all at once. The banks had started by lending the money they held in savings but as the bubble took off, the money that they held in deposits wasn’t enough to finance the mortgages they wanted to give so they borrowed more and more in order to lend it out again. When the homeowners were unable to make their repayments to the banks, the banks were unable to make their repayments to each other. Like a house of cards everyone became insolvent and the governments of the world had to take on a lot of debt to bail them out. The financial crisis was upon us.

This is how house prices in the UK have compared with the median wage since 1997:

UK house prices vs median wage

UK house prices vs median wage

In the ten years running up to the financial crisis the average house price in the UK almost trebled and wages were not going up anything like that amount. This was the result of irresponsible lending and it was happening all over Europe and the US.

But now forget this for a moment and suppose that you didn’t understand what caused the financial crisis. Put yourself in the shoes of a government minister who has spent the last five years marketing the argument that the crisis had nothing to do with the banks’ private lending. Suppose instead you had put a huge amount of marketing effort into perpetuating the falsehood that the financial crisis was all down to the public spending of the previous government.

I don’t think I’m asking you to make a huge leap of faith by accepting that you that if you’d put everything behind that wrong assertion it’s quite possible you’d have come up with the wrong solutions to the problem.

Throughout his time in government, George Osborne has frequently appeared with a brand new, broken lightbulb taped to his forehead. The latest example is called his “Help to Buy” scheme. In this scheme, the government will encourage banks to offer high loan-to-value mortgages by providing guarantees for them in the case that the borrower defaults.

Yes. Read that last sentence again. That is really what they want to do.

When the financial crisis hit, the banks quickly changed their policy from lending high loan-to-value mortgages to not lending high loan-to-value mortgages, ‘cleverly’ spotting that these had directly caused their insolvency. Our government now wants to bring back this bubble-inflating, crisis-causing system and so much so that it is prepared to offer a tax-payer funded subsidy to the banks to get it going again.

Using public money to subsidise high loan-to-value private mortgage lending is really not a good idea. It is a policy that directly encourages banks to make all of the same mistakes that caused the financial crisis but (and get this) this time the banks won’t be liable and have to ask to be bailed out! This time the taxpayer will just fund the defaults directly! Ace!

When I’ve talked about bad government policy in the past, I’ve often pondered on whether the motivation has been government incompetence or something more sinister. For example, did they cut public spending in an economy suffering from a lack of demand because they didn’t understand that my spending is your income or was it because they saw a chance to evilly create a smaller public sector in order to align it with their own idealisms? Well, who knows?

In the case of the “Help to Buy” scheme though, I can really see no possible motivation, good or evil, for pursuing such a terrible strategy. In the past we could have argued that they were being clever and devious but not any more.

“Help to Buy” simply shows that they have no idea what they’re doing.

RedEaredRabbit

The Importance of Being Lucky

We have been taught that meritocratic institutions and societies are fair. Putting aside the reality that no system, including our own, is really entirely meritocratic, meritocracies may be fairer and more efficient than some alternatives. But fair in an absolute sense? Think about it. A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment; luckiest in terms of family support, encouragement, and, probably, income; luckiest in their educational and career opportunities; and luckiest in so many other ways difficult to enumerate–these are the folks who reap the largest rewards.

Ben Bernanke, 02/06/2013

This is an excerpt from a speech that Ben Bernanke, the Chairman of the US Federal Reserve, gave earlier this month. How fantastically refreshing it is to hear someone, who holds such a senior position in global economic policy-making, expressing an opinion like this. As Bernanke notes, “We have been taught that meritocratic institutions and societies are fair.” We have and nowhere can this be the case more than in the UK in the past three years. Let’s recap on why the government thinks that the poor and vulnerable are where they are today:

Don’t get a job. Sign on. Don’t even need to produce a CV when you do sign on. Get housing benefit. Get a flat. And then don’t ever get a job or you’ll lose a load of housing benefit. David Cameron

…out of work for years, playing computer games all day, living out a fantasy because he hates real life… David Cameron

…it pays not to work. That you are owed something for nothing. David Cameron

…fairness is also about being fair to the person who leaves home every morning to go out to work and sees their neighbour still asleep, living a life on benefits. George Osborne

The Conservative position has long been that those who are doing well have earned it and those who are doing badly have not. The rich are strivers (well done, have a tax cut) and the poor are skivers (must try harder, have a benefits cut). The government perpetuates this myth in order to represent a complicated problem as a simple case of an unfairness in our society, which thankfully they are on hand to address.

Both I and the government agree that things as they stand are not “fair” and we both see unfairness in the way that wealth is distributed. We do though, have opposite views on the direction that this unfairness takes. The government believes that policy has been punishing the rich and rewarding the poor. I believe that policy has had the opposite effect and is a direct cause of the growing gap between rich and poor.

So why do we have such different views? The government’s view assumes that it is a simple problem of incentives. Make being poor less attractive by cutting benefits and being rich more attractive by cutting the top rate of income tax and the problem will resolve itself. The problem with this view is that it assumes that poor people have chosen to be poor. I would like to propose that another factor be included when trying to understand why some people are better off than others. I want to talk about luck.

Like it or not, we are not all born equal. From the moment the sperm fuses with the ovum, a person’s genetic make-up is determined forever. That genetic make-up will have a huge effect on that person’s intelligence, social skills and health. The genes that we are born with, I would argue are entirely down to luck. George Osborne might argue that the sperm that make rich people are striver-sperm. Hardworking sperm who want to “get on”. Not like those other sperm who sit around doing nothing in their teste all day. I don’t buy that though. Before a person is even born, a huge factor in how lucky they might be in life has already been set.

And when that person pops out into the world, the role of luck doesn’t diminish one bit. Those of my generation probably all read the Roald Dahl book, Matilda – a story of a loving, caring, genius child who was born to parents who were the opposite of all of those things. That was just a book though and the social environment in which a child is lucky or unlucky enough to be raised does undoubtedly have a huge bearing on the opportunities they will have in future life.

David Cameron and George Osborne are themselves good examples of being lucky. They were lucky enough to be born into families who were fantastically wealthy and well-educated and who were able to send them to the most prestigious educational institutions in the country. But in spite of this they seem utterly unable to appreciate how luck affects the citizens in the society over which they preside.

I was lucky too. I wasn’t born into a rich family and didn’t go to a posh school but I was lucky in that I was born healthy and with genes that made me want to learn things. Furthermore, I was lucky that my parents had an interest in appeasing my appetite for learning. As an infant I was fascinated by magnets. My mum bought number fridge magnets and every morning the front of our fridge would display new sums for me to do. Before I’d even got to school I’d picked up a lot of maths and being good at maths ultimately got me into university, got me a job out of university, allowed me to be good at the job and allowed me to continue doing something that I’ve (mostly) enjoyed ever since. It would be very convenient for me to believe that this happened purely through my striving. It wasn’t though. If I am honest, I was just lucky.

A government who does nothing to acknowledge the role that luck plays in society will only make things worse. After all, the luckiest are likely to be born into the already lucky families and the unluckiest into the already unlucky ones. If a government did nothing then social polarisation would surely continue. What we have now though is even worse. If you accept that luck plays a major part in this, our current government’s rhetoric around rewarding strivers and punishing skivers actually means further rewarding the lucky and further punishing the unlucky.

I’m not suggesting that the notion of striving is a futile one, I don’t believe it is at all. I do however suggest that if you reduce a complex social problem into a simple debate of “strivers vs skivers” without accepting that we are not all dealt the same cards, it will lead you to implement entirely the wrong policies. The reality is that if you introduce policies that disproportionately benefit the advantaged at the cost of the disadvantaged, the advantaged will become more advantaged and the disadvantaged will be come more disadvantaged.

It really is that stark and any government who actively pushes things in such a direction must be extraordinarily detached from reality.

Unless of course, it was exactly what they were aiming for.

RedEaredRabbit

Seat Belts, Cycle Helmets and Bank Regulation

A couple of years ago I saw a study that looked at whether wearing a helmet while cycling reduced a cyclist’s chances of being killed in an accident while on their bike.

As I recall it did but there were two competing factors. The obvious one was that helmetted cyclists who suffered an impact to their heads were less likely to experience a serious injury than their bare-crowned colleagues. The other was that cyclists who wore helmets seemed to be more likely to have an accident – the theory being that putting a helmet on made the cyclists less worried about potential injury and less likely to cycle as carefully.

Whether or not that is the case, it doesn’t sound implausible. If I were driving a big, modern 4×4 with modern seat belts, airbags, side impact bars, crumple zones etc. I might well drive differently than if I were driving a rickety, 1960s rust bucket with no seat belts, no airbags and a massive spike poking out of the steering wheel, ready to impale me in the event of the slightest impact.

While adding safety features is welcome we should not discard the flip-side of the coin that attitudes could become less risk-averse as a consequence. People might well believe that the problem is solved to a much higher degree than it really is and therefore discard a risk that previously they took very seriously.

At the moment the government is looking closely into proposals by the banking commission that would bring new regulative and punitive measures to our banks. These include things like spreading bankers’ bonuses over a period of up to 10 years, and putting them in prison if they are “reckless”.

While I welcome proposals that might help to ensure a safer banking system, I don’t think either of these achieves an awful lot to prevent a future financial crisis. The primary problem that we need to address is not whether we can put a banker in prison if they bring down a bank and not whether a banker receives £1m today or £100k per year for the next 10 years.

The primary problem is that almost five years after Lehman, we still have no way to let a major bank go bust without taking down the global economy. As I said, new ideas for how to better regulate banks are welcome but irrespective of what they are, we should be in no doubt that the banks of the future will always find new and more exciting ways to go bust. Faith in the idea that we can make regulations to avoid this scenario is misplaced. A much more useful area on which to focus our attention would be a reform of the banking system in such a way that a bank is never “too big to fail” and if the worst happens and a bank does go bust, the world economy is left intact afterwards.

That is not what these proposals are addressing though and my major concern is not just that they might well be far less effective than the government thinks; it’s that if we implement them, we’ll relax, and (with our cycle helmet and seat belt in place), pat ourselves on the back and think we have truly solved the problem. We won’t have though. A bank, irrespective of regulation, will always be able to go bust. If we are going to learn just one thing about the causes of the financial crisis it should surely be this and it would be really nice if we properly addressed that problem now.

The alternative is that we wait for the next financial crisis to convince us.

RedEaredRabbit

Losing the Argument

I read Phillip Inman’s piece in The Guardian last weekend entitled, “9 reasons Keynesians aren’t winning the argument”. I always feel a little bit uncomfortable with how the term “Keynesian” is used, as it makes it sound like a bit of a cult rather than a mainstream view but anyway, for now lets go along with it.

So, as someone who falls into the category about which Inman is talking, let’s see how his arguments apply to me.

1. They think policymakers refuse to change course because they don’t understand

I disagree. Inman’s first reason implies that there are two possibilities – either policymakers don’t understand or they do understand and are doing something else anyway. My position is far simpler – whether policymakers “understand” or not is entirely irrelevant. Policymakers’ refusal to change course has nothing to do with the theory or evidence because they are not interested in the theory or the evidence. Policymakers don’t ever consider changing course because changing course is considered political suicide. Their “understanding” has no bearing on this argument.

2. They think that everyone agrees austerity is wrongheaded

I disagree. If that were the case then policymakers would probably have no option but to change course. The fact is that plenty of people still believe (in large part due to policymakers’ propaganda) that the UK’s economy works like that of an indebted household who must pay down their debt immediately in order to recover. Wrong as that is, I don’t think Keynesians believe that that isn’t a commonly held belief.

3. They think Brussels and the IMF have changed their tune

I disagree. Brussels has clearly not changed its tune and I haven’t said otherwise. Mario Draghi (President of the ECB) may not be as bad as Jean-Claude Trichet (his predecessor) but there is still plenty to criticise and I don’t recall too many people holding back. The IMF’s position has clearly moved though. Although they are not now throwing themselves unequivocally behind fiscal stimulus, they have nonetheless, amongst other things, admitted that fiscal multipliers are much higher than they initially thought, that George Osborne is “playing with fire” and most recently their admission that they had hugely underestimated the damage that austerity would do to the Greek economy. It is not in any way a total reversal of their position but to refuse to acknowledge a noted change is a bit silly.

4. They make out that a spending boost with borrowed money is risk-free

Inman doesn’t really explain what the mysterious risks are that I’m ignoring. Austerians say that the risk is that markets would lose confidence and interest rates would soar. I do strongly dispute that but that’s not a risk that Inman mentions. Inman’s risk seems to be that we might be the next Japan and that is pretty lazy journalism to be honest. I haven’t, (and I don’t think any Keynesian has), been singing the praises of Japanese economic policy over the past 20 years. A Keynesian view on Japan would be something like they should pursue higher expected inflation in conjunction with a significant and temporary fiscal stimulus. I don’t recall them doing that at any point in the last 20 years (although it looks like Abe might be starting to do that now.)

5. They think central banks can carry on printing money with no risk

Hold on a moment, why are the argument-losing Keynesians getting the blame for central banks printing money? That’s being done at the moment anyway. My take on QE has always been that the benefits have been and will always be hard to measure and that it’s almost certainly far less effective than fiscal stimulus. Of course a central bank can’t print money forever without consequence – I’ve never said that. I think all I ever said on it was that while we’re in a liquidity trap it wouldn’t be inflationary (and it hasn’t been.)

6. They think quantitative easing can be switched off and normality will return

Hold on again. In point 5 I’m ignoring the risks of carrying on printing money and now I’m ignoring the risks of not carrying on printing money? Ok, I’ll address it anyway.

It would be a bad idea if tomorrow The Bank of England decided to dump all of the debt they have accumulated back into the bond market. I don’t think any Keynesian has ever suggested they should do that though. When things are good again should we drip it back in slowly or should we just let it mature? To be honest I don’t think there is a massive problem either way but irrespective of that I don’t really understand why this is a reason I’m losing the argument – austerians have exactly the same decision to make.

7. They argue that no one should fear inflation

This is just not true. Higher inflation is bad for lots of people. If I’m a wealthy pensioner with lots of savings and inflation is higher than the interest rate I get, then that’s clearly a worry for me. In that situation I would “fear inflation”. What I’m saying is that while higher inflation has problems, it also has benefits and the benefits of higher inflation are often ignored. When interest rates are at the zero lower-bound and the economy remains depressed then what we need is a negative real interest rate and that means higher inflation. No one is saying that it’s going to be better for everyone but we should all be sensible here and understand that a 2% inflation target is not going to be the perfect rate in all economic circumstances.

8. They argue that stock market and house price rises are benign

Really? I seem to recall that I wrote a fairly damning post about the latter’s role in the economic crisis. “The London stock market recently neared its all time high”, warns Inman. Not when you take inflation into account it didn’t, and let’s be clear here – the potentially catastrophic effect of bubbles are well known and well appreciated by Keynesians. Paul Krugman spent five years before the crisis warning that the dotcom bubble had been replaced with a housing bubble.

9. They believe politicians can be trusted to spend stimulus funds in the best way

This really is a load of poo. When have I, or any other proponent of fiscal stimulus ever said, “the government should borrow money and I don’t care what they spend it on because they’ll know best”? I think a more familiar argument is, “the government should borrow money and spend it on those infrastructure projects that will increase employment, boost growth and need to be done anyway”. Rebuilding old schools, investing in renewable energy, replacing old bridges and roads that are falling to bits – that’s money that we need to spend soon anyway – all the Keynesians are saying is let’s spend it now when the economy is suffering from a lack of demand and borrowing is really cheap rather than after a recovery when unemployment is low and borrowing is more expensive.

Conclusion

Inman’s article really isn’t very good. It contains a couple of validish arguments that are badly represented but mostly it’s a list of things that really aren’t important in understanding why the argument is where it is. We can of course faff around, quibbling about what happens when quantitative easing is switched off but do you really think that this is the reason that public opinion has not unanimously fallen behind Keynesian policies? No.

As I mentioned earlier, our politicians have rejected reasoned arguments, economic theory, and the damning evidence that followed because to them, these things just weren’t relevant. Our politicians wanted low public spending and so they cut public spending. They then misrepresented the situation in order to make it look like their policies were good and with their charming little analogy about how we were just like an indebted household, they did a very effective job of perpetuating this fallacy within the masses. That is the important point and it’s one that Inman completely misses. The Keynesians have been trying to fight an economic battle but they are doing so against politicians who, with their weapons of spin, misdirection and misrepresentation, are simply too strong.

Inman doesn’t just misunderstand what the argument is he also misunderstands where the argument is. Keynesians are not losing this argument – Keynesians lost this argument a long time ago.

For three years we have pursued austerity. For three years we have failed to deliver economic growth. We have created the longest depression since the 1800s. We have created a society in which people unnecessarily lost their jobs and their houses. We have created a society in which people who want to work are forced to sit at home because there are no jobs for them to go to. We have created a society in which our school-leavers and university graduates go forth into a job market that has no use for them.

That is what Keynesians predicted that austerity would give us and this is what austerity has given us but winning the argument wasn’t about being able to stand around afterwards saying, “I told you so.” Winning the argument was about preventing this disaster from ever happening and we didn’t and therefore we lost.

To those of you who think I’m being overly defeatist, I ask this – take a good look at the state of our country today and then tell me that austerity hasn’t already won.

RedEaredRabbit

The Immigration Fallacy

Immigration has been a hot topic recently. UKIP, (who seem to be founded on nothing more than the principal that British people are the best), did extremely well at the recent local elections. The Conservatives then panicked and decided that UKIP’s popularity showed that they must become even more tough on Europe and immigration themselves.

(Ed Miliband, being as always one headline behind everyone else, proposed a government subsidy for the living wage.)

I don’t think that Ed’s policy has much going for it but that’s not the subject of this blog. Today I’d like to talk about immigration – or more specifically the main arguments against it. They seem to fall into two categories:

  • Immigrants steal our jobs!
  • Immigrants just live on benefits and don’t contribute to the economy!

I’ll take each in turn…

Immigrants steal our jobs!

The arguments goes something like this.

In the UK we have net immigration – that is, we have more people arriving to live here than we have people leaving the UK to live elsewhere. The people who arrive from overseas take jobs away from those who were born here.

It’s understandable how you would draw that conclusion. Imagine a country who has a working-age population of 20 million people of whom 1 million are unemployed. Over the next five years the working age population increases by 500,000 due to immigration. At the end of the five years there will be 1.5 million unemployed people and because people move into and out of work during this time, lots of the immigrants will have jobs and those jobs will have come at the expense of a lot of the people who had jobs before those immigrants arrived.

Simple enough, right?

Wrong. Things are not that simple. It is, in fact, perfectly possible to add people to the working-age population without increasing unemployment. How? Trickery? Sleight of hand? Government statistics? No.

During the 20th Century, the UK population increased by about 21m people. We have, in fact been adding more people without increasing unemployment for a very long time. When we add more people to the economy, more goods are made and more services are provided and this leads to economic growth and to the creation of more jobs. It is easy to think of the economy as having a finite number of jobs and employment as a “one-in, one-out” market but that is not the case.

A much more useful way of looking at it would be this:

For every 100 people I add to the population, by how much does unemployment change?

Or to move the argument back to immigration:

For every 100 immigrants I add to the population, by how much does unemployment change?

It’s an intriguing question. Fortunately, NIESR has done the analysis and guess what they found out?

(UKIP, Tories, Daily Mail – you might want to look away now.)

The results show a very small negative and generally insignificant correlation between the migrant inflow rate and the change in the claimant count rate. A hypothetical example can help give a sense of how small this coefficient really is. A 2 percentage point increase in the migrant inflow rate, akin in magnitude to the large and sudden inflow of A8 migrants in the years 2004-2006, would, according to these estimates, be associated with a fall in the claimant count rate in the order of only 0.02 percentage points.

I don’t think I am doing them a disservice here if I summarise that if we are worried about unemployment, we can quickly exclude immigration as a significant factor. The effect is nigh on nothing.

(UKIP, Tories, Daily Mail – you can look again now, it’s gone.)

Let’s look at the second argument.

Immigrants just live on benefits and don’t contribute to the economy!

Well that would account for the fact that immigrants don’t take people’s jobs. Perhaps they just turn up, don’t attempt to get a job and just claim benefits?

You might believe that if you base your beliefs on what you read in certain newspapers but the reality is clearly going to be more complicated. A better way of looking at this question would be:

Is the overall contribution of immigrants to the economy positive or negative?

Fortunately the Centre for Research and Analysis of Migration have done a comprehensive study that answers this question.

(UKIP, Tories, Daily Mail – you might want to look away now.)

Yes, it’s positive. They found that immigrants on average paid 30% more into the economy via taxes than they took out through public services. But not only was it positive – the analysis found that on average, immigrants contribute more and take away less than non-immigrants. Jonathan Portes discusses it very well here.

Conclusion

So what can we conclude? Firstly, we have very good data that shows that not only does immigration not increase unemployment but also that immigration does boost the UK economy. Although the UK economy is doing badly at the moment it isn’t the fault of immigrants – we would actually be doing even worse if it weren’t for them.

Given this, it’s bizarre that these days we always seem to find ourselves surrounded by politicians wanting to show how “tough” they are on immigration. Given the facts it’s hard to understand – but when were politicians ever concerned by those?

The UK economy is in the longest depression in living memory, longer by far than The Great Depression of the 1930s and throughout it, unemployment has remained stubbornly high.

When such a situation occurs people naturally want to look around for someone to blame and, shameful as it is, politicians have done their upmost to direct that rage onto immigrants (and the recipients of benefits). But why would they do that, given that such a campaign is completely contradicted by the facts?

To win votes by explaining the benefits of immigration takes more time and effort than it does to win votes by saying that immigrants are job-stealers and benefit scroungers.

Politicians care far less about doing the right thing and far more about winning easy votes

Oh, and regarding why they want to blame these easy targets specifically for the depression? Well that one’s easy – the depression was created by the politicians themselves.

RedEaredRabbit

A Problem of Politics

I don’t have children. I’ll be honest – I don’t like them very much. Many of my friends however, hold the opposing view and over the past four or five years, I have seen many of them pair off and then unfortunately, find out what happens when they combine their DNA with one another.

Before Christmas, I was out with a few such couples and their resultant chimera and at some point during the meal, two of the latter had a minor disagreement over toy-ownership and proceeded to attack one another. Their parents quickly broke up the melee and each offspring was separately told that if they behaved in such a way, Father Christmas would not bring them any presents. The threat had the desired effect and good behaviour was quickly restored.

Sometimes I wonder how future generations will look back on how we dealt with the current economic crisis. As I have mentioned on here before, I don’t think we are now dealing with an economic problem – the economics that would have engineered a recovery long ago are well understood – what we are dealing with now is purely a political problem.

At the moment we have a right-wing government whose political ideals are to seek a smaller government sector. In certain economic circumstances that kind of ideal is easier to achieve than it is in others. At the moment, as we have seen, achieving it is very difficult. When the economy has high unemployment, low demand and interest rates at the zero lower bound, cuts to public spending will not be offset, in the short-term by increases in private spending. That is, if the government makes a bunch of civil servants redundant, the private sector won’t immediately expand and give them jobs. The private sector will probably eventually adjust and take them on but that could take (and has already taken) years  to happen. While we wait for that adjustment to occur people remain unnecessarily unemployed and long term damage is done to both the well-being of those people and the economy as a whole.

As I’ve mentioned more than a few times in the past, cutting government spending under such circumstances is nothing other than negligent but if the economics says one thing, how can the government continually get away with doing the opposite? It’s not an easy question but I think I have an answer. My answer is simply the difference between economics and politics:

  • Economics is a discipline that helps us to understand the best policies to pursue in order to improve the economy
  • Politics is a discipline that helps its proponents win the next general election

But surely they would align themselves? Surely the easiest way to get elected at the next election would be to fix the economy? Right?

Wrong.

Let’s take ourselves back to the story with which I started this post. My friends could have dealt with it by explaining to each of their spawn, the importance of sharing and two individuals working together to achieve the best overall outcome for both parties. Or they could just say that Father Christmas wouldn’t turn up.

The former is a harder message to convey. The latter was much less effort to explain and much less effort for their audience to understand.

It’s the same with the economy. Explaining to people why cutting spending leads to more debt is a hard sell because it involves giving the public a basic understanding of macroeconomics and while it is only a basic one they need, it is still far easier to do this:

  • The previous government went on a spending binge that caused all of this!
  • Our country is just like an indebted household!
  • We need to immediately pay off our debts in order to recover!

And that’s an easy sell. None of those things are actually true but the truth is harder for people to understand.

Democracy has a lot going for it but never for a moment believe it’s perfect. Look at the range of subjects over which a voter has to preside. The economy, education, foreign policy, immigration, the environment, health, crime. The list goes on and on. These are not simple things to understand and yet we are all asked to decide on them every time we vote.

Politicians could spend lots of time explaining these things to people and honestly giving the pros and cons of a particular policy but it’s much easier to just go ahead and do what they want and then give us a few simple, misleading soundbites as to why it is right. When you look at it in these terms it isn’t hard to understand why politics continually fails us so badly.

It’s not just the government though. A big part of UKIP’s recent successes is because they understand this and do it better than anyone else. They say that climate change is all made up. That’s much easier than explaining that driving an SUV burns a lot of petrol and that when petrol is burnt one of the consequences is releasing carbon-dioxide into the atmosphere and that carbon dioxide in the atmosphere causes a reduction in the amount of the sun’s energy that is reflected away from the Earth and that such a reduction causes the temperature of the planet to increase. And even if you got that far, you haven’t even started on the consequences of that temperature increase.

Immigration is another example. An easy sell is telling the electorate that the economy is broken because there are hoards of foreigners arriving on our shores every day and stealing our jobs or sitting around claiming benefits. Although that isn’t true, it is much harder to educate the public on all of the very real economic benefits of immigration and so the xenophobic soundbites win and such policies become popular and everyone loses out because of them.

Our politicians owe us more than this. They should appreciate the weaknesses in the democratic system and make it their absolute duty to clearly explain the realities of the situations that we face. They should not, as they do currently, exploit the weaknesses in the democratic system for their own gains.

So anyway, what then became of my friends’ recently-created miscreants? Well they took onboard the threat, behaved as they were told and got their Christmas presents (none from me, I might add). That said, three years after the country chose to go along with the current government’s economic plan, our Christmas presents still haven’t shown up.

And when we look at what politicians are all about, should we really be surprised?

RedEaredRabbit

The Things We Used to Know

Last weekend when discussing the Reinhart-Rogoff mess I wrote this:

We never needed “new cutting edge research” to solve this problem. The problem we have and the solutions to it are all covered in the first year of an undergrad economics degree.

On the following Tuesday (Economics Nobel Laureate) Paul Krugman, on the same subject, wrote this:

Econ 101 macroeconomics, as I often point out, has worked pretty well…The point is that radical new theories haven’t been needed at all; off-the-shelf economics, tools we already had, provided plenty of guidance.

He probably reads my blog.

So what are those things that first-year economics students know that should have stopped the depression happening? Before we look at those, let’s step back in history and remember how we got here:

The Financial Crisis

  • Banks borrowed lots of money and then lent it out, a lot of it to risky borrowers
  • Banks also encouraged individuals to build up debt through cheap loans and credit cards
  • This not only led to a huge increase in private debt, it helped fuel a housing bubble in much of the developed world
  • The banks had no plan-B if the housing bubble burst
  • The housing bubble burst
  • Oops

When people couldn’t make their debt repayments the banks suddenly became insolvent. Governments borrowed huge sums of money to bail them out and prevented a full collapse of the global banking system but were left with weak economies and high debt. Due to high levels of personal debt, rising unemployment and an all round lack of confidence in the economy, people switched very quickly from spending to paying off debt and saving. In the economy, my spending is your income and your spending is my income. Spending disappeared and a severe recession resulted.

Turning a Recession into a Depression

Governments initially responded by cutting interest rates. Low interest rates make saving less attractive and spending more attractive and in a normal recession this is enough to engineer a recovery. This was not an ordinary recession though and governments found that even with interest rates at almost zero, people continued to save and pay down debt rather than go back to spending. Low interest rates were not enough to fix the economy.

As any first-year economics student can tell you though, monetary policy is not the only tool a government has to boost growth. If the people don’t want to spend, the government can increase spending and fill the gap. Many governments, either through incompetence or the blind pursuit of their political ideals did the opposite and cut spending, which had the predictable effect of exacerbating the problem.

Governments likened their situation to that of an indebted household who must pay off their debt as fast as possible but the analogy, although easy for the public to understand, was disingenuous. In the economy spending and income are two sides of the same coin and in an economy suffering from a lack of demand from the private sector, cutting government spending was only ever going to lead to one thing.

A recession, which we had all of the knowledge and tools to turn into a recovery, turned instead into a depression. Here’s what happened in the UK when the current government took over and slashed public spending. The green diamond shows the point when they were elected:

UK Depression

UK Depression

The amazing thing is that this is all basic, textbook macroeconomics. It is hard to comprehend how the government could try the opposite of what this stuff said they should do and then, when the economy entered depression, just sit around scratching their heads wondering why things didn’t work out.

But anyway – the damage is done now and the government would commit political suicide if they ever admitted that their policies, far from creating a recovery, had in fact caused a wholly unnecessary economic depression. From the day they chose austerity in the face of basic economics, they have had only one way forward: Wait until the economy sorts itself out anyway and then market this as absolution. I’ve come to terms with that now but I really hope we could all at least agree on this:

In 20, 30, or 40 years time when then next big recession happens, could we all take a look back on this period in history when our politicians, with their poo-pooing of basic economics, failed us so badly? Could we all take a look back on this period in history and say that we will never again make mistakes such as these? Let’s instead choose those basic economic rules that have, during this depression, continually got things right.

Let’s remember the things we used to know.

RedEaredRabbit

Excel Mistakes are the Least of our Worries

If you follow economics outside of this blog you will no doubt have seen this week’s big hoo-har about Reinhart-Rogoff (R-R). In case you haven’t I’ll explain what happened.

About three years ago, two Harvard Economists published a paper that concluded that when a country’s debt to GDP ratio exceed 90% it caused the country to experience significantly lower economic growth (actually on average a recession). Paul Krugman describes the subsequent events here but essentially there were two immediate problems with the paper:

Correlation and Causation

A very common problem in statistics is confusing correlation and causation. Correlation between two factors means that as one changes the other does too. Causation between two factors means that as one changes it causes the other to change. This might seem like a small difference but it isn’t. It is very important.

This is more easily explained with an example. If you were to plot on a map of Great Britain the location of every mobile phone mast and then were to plot the locations that children were conceived, you would get a striking correlation. This does not mean that mobile phone masts cause conception and it doesn’t mean that conception causes mobile phone masts. What is actually going on is that both conceptions and mobile phone masts are more likely to occur in areas of high population density. However, if you didn’t know the difference between correlation and causation you could easily, (and wrongly) conclude from your research that mobile phone masts increased fertility.

There is another problem in implying causation from correlation. Even if there is a causal relationship it could run either way. Do mobile phone masts cause increased birth rates or do increase birth rates cause mobile phone masts? In the case of the R-R paper, not only did they decide there was a causal relationship in the correlation, they decided that it was high debt that caused low growth without entertaining the possibility that low growth might cause higher debt.

This was problem number one.

Peer Review

Problem number two was that with the same set of data, no one else could reproduce the result showing some special tipping point at 90%. Lots of people tried it but no matter what they did, they couldn’t reach the same conclusion that R-R managed and because R-R had not published their workings no one knew how they’d reached that conclusion.

This was problem number two.

So move on three years to the current day and what has happened? Well in the interim, pretty much every austerity advocate had used this paper as proof of why austerity must be pursued at all costs. But this week after many requests, Reinhart and Rogoff released the Excel spreadsheet they’d made and on which they had based their findings. Oops.

In addition to the previous problems there were three more very obvious problems with their workings.

Cherry-Picked Data

The analysis that R-R did was not over all of the available data. Oddly they had chosen to exclude specific countries’ performance in specific years with no explanation as to why they had done it. Worse still, if you included them the magic 90% threshold disappeared.

Bizarre Weighting

In coming to their overall conclusion, R-R weighted certain results higher than other results using a method behind which no one can quite understand the motivation. Weight the results using any conventional means and guess what? The magic 90% threshold disappears.

Excel Error

Most embarrassing of all was that there was a basic Excel error in the spreadsheet – they’d averaged over a column of numbers and got the range wrong so missed a bunch of the numbers out of the average. Guess what happens if you correct it? Yep.

As Paul Krugman concludes in his article on all of this:

So will toppling Reinhart-Rogoff from its pedestal change anything? I’d like to think so. But I predict that the usual suspects will just find another dubious piece of economic analysis to canonize, and the depression will go on and on.

And this is really the important point. The R-R paper only ever became as famous as it did because it told the “usual suspects” what they wanted to hear. It gave them some kind of economic credibility on which to base the policies that they wanted to implement anyway. R & R shouldn’t be blamed for all of the ways in which their paper was used – politicians and the media should take some of that, especially when there were so many question marks over it from the start.

But the real thing I conclude from the whole debacle is simply this. When the crisis struck, governments had the option to follow the economic lessons we had learnt from the past. Lessons which had solved previous crises like The Great Depression of the 1930s.

But they chose not to.

They chose instead to pursue the things they wanted to do anyway and then cherry-pick any bit of research they could find to support it, irrespective of how many glaring problems it might have hanging over it. In all of this, until this week, the R-R paper was really their most coveted prize.

So what have we seen in the intervening days since the paper’s public demolition? We have seen the stimulus crowd publicly claiming a massive victory over the austerity crowd and while that might well be the case, I again worry we might miss the important point here. What we’re doing here is arguing over one piddly little paper that gained fame because it formed a new economic theory that supported the policies of austerity. But that paper really should never ever have become as big as it did.

We never needed “new cutting edge research” to solve this problem. The problem we have and the solutions to it are all covered in the first year of an undergrad economics degree. Yes, if a couple of Harvard economists come up with a new idea we should have a look at it but when it clearly had such big, unexplained problems from the outset, how could governments (ours included) end up basing their fiscal policy on it?

I mean – would it really be so ridiculous to go with the things we actually know?

RedEaredRabbit

Why Trade Makes Us All Better Off

When I was just a small rabbit, I received a computer game as a Christmas present from my parents. It was good – I played it for six months or so and pretty much played it to death. Another boy in my class had also received a game for Christmas and just like me he had also played his to death.

Seeing an opportunity, I suggested we trade them. Computer games are expensive and neither of us, with our limited supply of pocket money, could simply buy all the ones we’d like so a trade would benefit both of us. We would each lose a game in which we had little remaining interest but we would each gain a new game that we hadn’t played before. We each valued the other’s game more than our own and so we agreed to trade.

On returning home from school with a new computer game, my mum was immediately suspicious.

“Where did you get that?”

“From Malcolm.” *

“He lent it to you?”

“No, I traded it for the game you bought me for Christmas.”

My mum was not happy. It was a Christmas present, she said. I shouldn’t be trading presents that people had given me. She was cross. After Mrs Rabbit, my mum is the greatest person I’ve ever met but (also like Mrs Rabbit) making her angry is a bad idea. Oh well, lesson learnt.

Only the lesson hadn’t been learnt. In hindsight, this was a rare occasion when my mum got it wrong. After the trade, Malcolm* and I were both better off. We each had a new game to play and we each got another six months of enjoyment from playing them that we would otherwise have not had. I can understand the concern if there had been some emotional attachment such as if we’d traded family heirlooms or swapped cats but the computer games had no emotional investment from anyone other than ourselves.

(On a side note, I wish I had swapped our cat. It was a complete wanker.)

The other day I wrote a post about George Osborne’s recent speech on the need to cut benefits. One of the parts I took issue with said this:

We’re facing more and more competition from vast new economies like China and India. There are quite literally billions of people who are joining the world economy. That’s human progress. If we’re not careful, Britain risks being out-worked, out-competed and out-smarted by those hungry for a better life.

And the reason I took issue with it is that it suggests that the better that other countries do the worse we’ll do. Like there is a limited amount of “economy” to go around and if the Chinese get a bit more they’ll be taking that bit away from us!

It really does not work like this and George actually acknowledges this when it suits him. Ask him why our economy is weak and it’s all the fault of our European neighbours. The idea that Britain would be better off if all other countries were unsuccessful could not be further from the truth.

There’s a wonderful economics experiment a primary school teacher can do with her class that demonstrates this and it works as follows:

1. You get a bunch of children’s books (you need one per child).

2. You say that after this lesson there will be a special reading time where the children will each get to read a new book.

3. You distribute the books at random so each child has a book.

4. You ask them to each rate out of 10 how much they want to read the book they have during the special reading time.

5. You note down the results.

6. You give them 5 minutes in which they are allowed to swap books with one another if they wish to do so. It is important to point out that

a) they don’t have to swap if they don’t want to

b) swaps should only take place when both parties agree

c) they can swap as many times as they like within the time limit

7. After the swaps are done you again ask them to each rate out of 10 how much they want to read the book they now have.

What you will find is that the average score out of 10 is significantly higher the second time around. Why is that? Because the kids will only do a trade if there is a  gain for both of them. Supposing Child A has “The Gruffalo” and Child B has “The Mole Who Knew It Was None Of His Business.” Child A thinks poo is funny and Child B doesn’t (idiot). So before the trade Child A rates his book as a 7 out of 10 and Child B rates her book as a 3 out of 10. After the trade Child A rates his book as a 10 and Child B rates hers as a 6.

Note that Child B doesn’t think her book is the best in the world but she’d rather read it than read about a mole who spends the entire story wandering around with a (spoilers) dog poo on his head.

Anyway, the important thing is that both children are better off and the trade would not have happened unless both of them would have been better off.

It’s a brilliant exercise because it demonstrates why trade in the real world is so important. Take a look at Abu Dhabi for example. Abu Dhabi has lots of oil. Without trade, Abu Dhabi would be a poor country but with trade they are very rich. Lots of other countries want to use more oil than they can produce themselves and Abu Dhabi can produce lots more oil than they want to use themselves.

On the other hand Abu Dhabi isn’t very good at making the machinery and vehicles needed to get the oil out of the ground and to its destination. Luckily there are other countries who are good at that so rather than having to try to build all that themselves they can get it through trade with other countries.

Anyway, what I’m saying is that when one of our overseas friends gains economic growth it is not something we should fear. Instead we should see a marvellous opportunity for us to increase our trade with them and make both of us better off.

Sadly it seems that all George sees is another reason to cut benefits for poor people.

RedEaredRabbit

* His name wasn’t really Malcolm. I’ve never actually met anyone called Malcolm. He looked like a “Malcolm” though.

Don’t Mention the Pension

Declan Gaffney talks much sense here, showing relative spending on benefits in 1980 and 2009 and wondering why basic information such as this seems to be almost completely absent from the debate on welfare. (I strongly recommend reading that.)

Anyway, I dug a bit deeper into the OECD figures to have a look at how spending on the various branches of benefit had changed during the period in question.

So what did I find? Did unemployment benefit shoot through the roof? Did incapacity benefit become unsustainable?

UK Public and Mandatory Private Cash Benefits (1980 - 2009)

UK Public and Mandatory Private Cash Benefits (1980 – 2009)

Nothing here looks remotely scary apart from spending on the elderly and that shouldn’t come as much of a surprise – people are living longer so the number of people who qualify for a old-age benefits is increasing.

It’s not hard to understand how this situation happens though. The government wants to reduce spending on benefits but needs to ensure they can spin it into being popular with the public. Convincing the electorate that people on JSA or incapacity benefit are all work-shy scroungers is a lot easier than mounting a campaign against pensioners. The Daily Mail will be with you all the way on the former. Probably not so keen on the latter.

By the way – I’m not suggesting they should mount a campaign against pensioners, I am simply pointing out that if the government is as serious as it says about making benefits sustainable, it’s probably the important area to think about.

Still, I’m not going to hold my breath. The government’s never going to expend much effort on a responsible debate regarding benefit costs for the elderly.

Not while the other people on benefits are such easy targets.

RedEaredRabbit