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

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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

Depression and Optimism

George W. Bush once famously said:

Fool me once, shame on you. Fool me… errr… twice…. errr.. umm…..

He was great, wasn’t he? I suppose the irony of that statement was that there are probably very few people in the world that you could fool more times than George W. Bush.

Just over a year ago I wrote a post called Economic Bloodletting in which I made a comparison between the government’s economic policy and the ancient medical practice of bloodletting, where doctors would try to cure an illness with a treatment that made the patient worse. Each time the patient had a a few glugs of blood removed their condition would deteriorate and in response the doctors would prescribe more bloodletting.

Fortunately our health service has moved on a lot since those days but what of the other side of that comparison? How has the government’s austerity policy served us over the twelve months since I wrote that? Do I have egg all over my face now? Have I been shown to be a scaremongering charlatan?

Let’s find out by updating the Depression Tacker!

Depression Tracker

Depression Tracker

For those of your unfamiliar with the Depression Tracker – I am comparing the current UK depression with the one from the Great Depression of the 1930s (until recently the benchmark for economic catastrophes). What’s worth noting is the position of the blue diamond on the graph. That’s when David Cameron came to power. You can see that at that time, the UK economy was doing much better than the equivalent period in the Great Depression, having never sunk as far and having been in recovery for the previous 12 months. After that point you can see that the recovery ground to a halt and in comparison, the economy during the Great Depression caught us up, passed us and kept on going. Five years after the economic collapse that started the Great Depression, the UK economy had not only recovered but was 4% larger than it was before the depression started. In comparison, our economy today is still 3.2% smaller than it was five years ago.

Now that’s a pretty stark difference and it’s not like I’m comparing things with a small economic hiccup – that green line is The Great Depression.

So what did the government do back in the 1930s to achieve the recovery? Yep – government spending. The government built a load of houses, employing a huge number of otherwise unemployed workers in order to do so. With the prospect of war on the horizon they increased military spending and built tanks and guns and planes and things. What they spent money on back then is not really important to the comparison, (I’m not suggesting we start a world war to end the depression). The important thing was the government spent money and when the government spends money in a depression they will get an extremely good return on it in terms of economic growth.

Since I wrote that post on Economic Bloodletting though, our current day government has done the opposite. They have continued to maintain their belief that decreasing spending during a depression will somehow magic up lots of growth. As you can see in the Depression Tracker above that has not happened and all they have actually achieved is the setting of a new benchmark to replace the Great Depression as the darkest point in our economic history.

Last week the ONS released its quarterly report showing that the economy is shrinking again. As I’ve said before, the results of one individual quarter is not the story here. The story is the longer term picture and when we look at that we can see that our economy has basically flatlined since the current government took office almost three years ago.

If the subject matter that I am discussing were something of a trivial nature then I would now be happily strutting around and saying, “I told you so!” but this subject is anything other than trivial. This failed experiment has meant a million people sitting at home waiting for work when there were no jobs for them. It has meant businesses going bust that could have otherwise continued and thrived. It has meant hundreds of thousands of students graduating into an economy that has no use for them. When you look at it like that you can understand why I would rather have been wrong.

Yet, I said in the title of this post there was optimism too and for the first time in years I do feel some. This is why:

One of these days, and probably sooner than you think, those people who stuck by the government when they said austerity would mean growth are going to run out of patience. Nick Clegg and Boris Johnson have both made comments in the last week to say that we need more government spending to get a recovery. They didn’t seem to want to expand too much on why they had been directly opposing it until last week but I have a theory on that – rats leaving a sinking ship.

Despite weak opposition, those who previously believed that austerity would create growth will not believe it for much longer and when this happens the government will have no choice but to do something sensible instead. Every quarter since the government came to power they have expressed solemn disappointment at the latest set of weak growth figures and sagely told us that more bloodletting is needed to cure the economy. The reason I’m optimistic is simply that I can’t see that there is any way people will continue to swallow it.

Fool me once? Fool me twice? Fool me thrice?

Seriously – even George W. Bush would have worked it out by now.

RedEaredRabbit

The Interest Rate Fallacy

I wrote recently of The Debt Fallacy – the widely held belief that the financial crisis was caused by government debt. If you read it you’ll recall that it’s fairly easy to prove this as a fallacy because figures for government debt are easily available. Nevertheless it’s a myth that is widely believed because the government puts a lot of effort into propagating it in the knowledge that most people won’t actually check.

Another fallacy that the government often uses hand in hand with this is one regarding interest rates. It goes something like this:

Interest rates on UK debt are low because the markets have built confidence in the UK’s economy because of the austerity measures. If the government were to increase public spending, the markets would lose this confidence resulting in the UK losing its AAA credit rating and interest rates on our debt soaring.

This, ladies and gentlemen, is the Interest Rate Fallacy – the widely held belief that interest rates are low because of the market’s confidence in our economy. To show why this is a fallacy is a little harder than it was with The Debt Fallacy because I can’t just download a graph from the IMF website. So before reading on you might want to get a cup of tea and an exciting type of biscuit, such as a Jammy Dodger.

All settled? Then let’s get started. Before we tackle the fallacy we need to look briefly at what government debt is and why people buy it at all.

How does the government borrow money?

The government borrows money by issuing bonds. A bond is essentially an IOU, which anyone can buy. It will say something like, “I will borrow £100 from you for 10 years and at the end of the 10 years I’ll pay you back your £100. As compensation for you not having access to your cash for 10 years, I will additionally pay you interest at an annual rate of 5% for those ten years.”

Why does someone lend money to the government?

Imagine that I have £100 in cash. I could keep the £100 as cash or use it to buy a bond. Cash is good because I can do useful things with it like buy stuff. However, I need to think about my future and if I want to save money for later rather than spend it now then I would be better off buying a bond because I get paid interest as compensation for me not having access to my money. If I want to spend now then cash is good. If I want to save now then bonds are good.

What determines the interest rate on my bond?

The interest rate on a bond is determined by the rate that savers are willing to accept in compensation for not having access to their cash for the period of the bond. So if I want to invest my £100 for 10 years what are the factors that will influence the rate I am prepared to accept?

Probability of default

If I tie up my money with someone for 10 years then it’s quite important to me that they don’t go bust during that time because if they do I will lose my money. If I am lending to someone risky I might decide to ask for a higher rate of interest in order to compensate me for the risk that they might not be able to repay me.

Demand for bonds vs Demand for cash

If I want to save money and everyone else wants to spend money then I can probably get a high rate on my investment. If there are few savers and lots of spenders in the market (i.e. the demand for bonds is low and the demand for cash is high) then the government will need to offer better rates to attract investors. Conversely if there are lots of people who want to save money and few who want to spend, the government can offer much lower rates knowing that there are still lots of people who will invest anyway.

Expected future short-term interest rates

That’s a mouth full isn’t it?

Short-term rates are set (in the UK) by the Bank of England. These rates determine the rate I can get for investing money for a short period of time.

If I am going to invest for a longer period of time, my expectation of what the Bank of England will do with short-term rates in the future is important. This is all sounding a bit wonkish so I’m going to explain with an example. Imagine the following scenario:

  • I live in a country where the government offers two different types of bond
  • One lasts for one year
  • The other lasts for 10 years
  • I have £100 that I would like to invest for ten years

I have a choice:

  • Invest my money once in the 10 year bond
  • Invest my money ten times (once every year) in one year bonds

If I choose the first option then my money is tied up for ten years at the pre-agreed rate of interest. If I choose the second option then every year when I invest my money again I get whatever the new short-term rate set by the government is. Supposing that short-term rates are 2% but I expect them to rise by 0.25% every year. My expectation of what the second option looks like is this:

Year Interest Rate Value of Savings
1 2.00% £102.00
2 2.25% £104.30
3 2.50% £106.90
4 2.75% £109.84
5 3.00% £113.14
6 3.25% £116.81
7 3.50% £120.90
8 3.75% £125.44
9 4.00% £130.45
10 4.25% £136.00

Therefore for me to decide that investing in a 10 year bond is worth it, I need a rate of at least 3.1225%, otherwise I expect to lose money on it.

Conversely, if I expect interest rates to go down then I will be happy with a lower rate for my 10 year investment.

Still with me? Good. Get yourself another Jammy Dodger – you’ve earned it.

Why are interest rates low now?

The government says that interest rates are low because the markets have lots of confidence in our economy because of their austerity policy. Lots of people lap this up as gospel but let’s stop for a moment and think about that. The government is borrowing at the lowest rates in the country’s history at the same time that the economy is in the longest depression in living memory. Would this really be the point in history that confidence in our economy hit an all time high?

Umm… no. So using what we’ve learnt, let’s look at some sensible explanations instead.

Expected future short-term interest rates

Short-term interest rates are very low at the moment. We know why – in reaction to the financial crisis, the Bank of England cut interest rates in an attempt to boost the economy.  (They cut them to 0.5% in March 2009 where they have remained ever since.)

Remember though, that long-term interest rates are determined by what the market expects short-term rates to be in the coming years. One explanation (this is the right one by the way so pay attention) for low long-term interest rates would be that the markets expect The Bank of England to keep short-term interest rates low for the foreseeable future.

Why would the markets expect The Bank of England to keep short-term rates low in the future? Well remember why short-term rates became low in the first place – an attempt to stimulate a weak economy. If the market expects the UK economy to remain depressed in the future they will expect The Bank of England to keep short-term rates low. If they expect a recovery is just around the corner they will expect short-term interest rates to rise and they will demand higher long-term rates in compensation.

Demand for bonds vs Demand for cash

Ok, I said the last one was the right answer but it’s important to consider this point too. The demand for bonds is huge at the moment. Why? Because when the financial crisis struck, people who had spent happily during the good years changed their behaviour dramatically and started saving. We are living in a world of people saving money rather than spending it. Again they are doing that because of a lack of confidence in the economy.

Probability of default

Enough of sensible explanations. Let’s look at a daft one. You’ll recall that people demand higher interest rates if they think that the person to whom they are lending might go bust before their bond matures. Therefore if the markets think that there is a good chance that the UK might go bust within the next 10 years they will demand higher rates for their 10 year bonds.

Let me be absolutely explicit here. There is absolutely no chance of the UK going bust in the next ten years. Despite the least economically competent government that anyone can remember, it is still impossible.

The UK is a large, developed economy whose debt is in a currency that they control. We print our own money – we can’t run out of it. Barring alien invasion, the UK will service its debt next year, the year after, the year after that etc. etc.

What about Greece?

A common comparison, used by George Osborne amongst others, is that Greece has a weak economy that is expected to remain weak but has high interest rates on government debt. They do but there is a difference between Greece and the UK and although George Osborne chooses to ignore it, it is a very big difference. When a country adopts the Euro they give up something very important – control over their currency. The countries that have seen their interest rates rise, Greece, Ireland, Italy, Spain, Portugal all have something in common – their debt is in a currency they can’t control.

But what about Argentina in 1999/2000?

Their debt was in US dollars so the same thing applies. They borrowed in a currency they could not control.

What about Iceland? They weren’t in the Euro and their government debt wasn’t that bad.

That’s true but Iceland’s three major banks had somehow been allowed to build up about €50bn of foreign debt between them. To put that into perspective, that was about 600% (!) of Icelandic GDP. Nice one Icelandic banking dudes.

What if the UK loses its AAA credit rating? Interest rates will soar!

The first thing to mention is that this argument assumes that austerity will prevent any downgrade of the UK’s credit rating. I’ll return to that point though because I want to tell you a few things about credit rating agencies first.

A credit rating agency is a private company that expresses an opinion about a borrower’s likelihood of repaying money they have borrowed from someone else. You will note that the UK currently has a AAA credit rating, which is the highest possible. (Not all agencies use AAA as a code to signify the safest borrower but the UK has the highest rating from all of the major ones.)

For example, the biggest credit ratings agency, Standard & Poors, gives the UK a AAA rating. To understand what that rating means, let’s benchmark it against something else to which Standard & Poors have given a AAA rating.

In the run up to the financial crisis, banks lent money to risky borrowers in the form of subprime mortgages. Those banks would then package up a few thousand of these dodgy mortgages together and sell them on to someone else. Guess what rating Standard & Poors gave to these packages of toxic debt? Yep, AAA!

Reread that last paragraph – the largest credit rating agency in the world gave their highest possible rating to packages of subprime mortgages. I am not a credit rating agency and you are not a credit rating agency but if you and I were forced to form an opinion on the creditworthiness of 2,000 subprime mortgages all mixed together we would probably not come to the conclusion that it was the safest investment possible. The credit ratings agencies did.

If you think I am cherry picking one (albeit hugely damning) example, I’ll give you another. On the 15th September 2008, Lehman Brothers went spectacularly bankrupt. All three of the major agencies rated Lehman Brothers as a low risk counterparty.

So the upshot of this all is that no one actually listens to these people. S&P downgraded the United States from AAA to AA+ last year. Did the markets all panic and think that the US was about to go bust? No. They ignored the discredited opinion of an organisation who thought that subprime mortgages were a good investment and went their about business as usual. Interest rates on US bonds actually went down.

But wouldn’t rates go up if we abandoned austerity?

The last refuge of the “Austerity=Low Interest Rates” cult is always, “Even if your ‘economics’ mumbo-jumbo is right about the reasons for low rates, if we actually took advantage of them and borrowed some more money, those rates would not stay low for long!” I’ll address that now.

Demand for bonds vs Demand for cash

As I’ve mentioned before we are currently in a liquidity trap. In normal times, cutting short-term interest rates stimulates spending. A liquidity trap occurs when we have already cut interest rates as far as they can go but people still want to save. At the moment, no one wants to spend money but The Bank of England have already cut rates to almost zero.

Being in a liquidity trap means that we would need a significant change in behaviour back from saving to spending before it made any difference at all to actual interest rates. The interest rate we would need to get people spending is negative but The Bank of England can’t set a negative rate* so we’re left with demand for bonds far outstripping demand for cash. Being in a liquidity trap isn’t good news but it does at least mean we can increase borrowing without changing the interest rate.

Probability of default

What would happen if the markets thought the UK was about to go bust and everyone tried to sell their bonds all at once? (Yes, I know the idea of the UK going bust is stupid but people use this argument a lot so I should address it.)  Unlike Greece, Ireland, Spain, etc we have a flexible exchange rate. If the markets suddenly decided to start offloading UK government debt interest rates would not actually rise. What would happen is that the pound would just devalue** and interest rates would stay the same.***

Summary

So as we’ve seen interest rates are low because everyone wants to save rather than spend and the markets expect short term interest rates to be low for the foreseeable future because they expect the economy to remain weak.

We’ve also seen that credit ratings agencies’ opinions are not worth listening to. Despite the government claims that austerity is the barrier against a downgrade, I fully expect the UK to be downgraded next year. And you know what? If that happens the markets won’t give a toss and long term interest rates will remain low.

If you have read this whole post down to here then well done – treat yourself to another Jammy Dodger. You know now what determines interest rates on government bonds and you know that it has the opposite to do with everyone being happy about our economy. The sad reason for low interest rates is simply that the markets expect our economy to remain bad for a long time yet.

And to be honest, who could really blame them?

RedEaredRabbit

* They could in theory make interest rates negative but then people would just hoard cash instead of investing it. (You’d get a better return by keeping cash under your mattress than lending it out.)

** Although a devaluation in the pound sounds bad it would actually boost the economy. When the pound is weak then foreign goods and services become more expensive. Also our goods and services become cheaper for foreign investors. This means more money being spent on UK goods and services, both by us and our friends overseas.

*** I brushed over the reason for this because it would have doubled the size of the already too big blogpost. If you’re interested in why this is the case read this.

The Debt Fallacy

Because this blog has a strong political theme, it might surprise you to learn that I don’t watch Question Time very often. Partly this is because I’m usually in bed by the time it comes on, but if it were called “Answer Time” and the politicians were forced to give proper answers to the questions I would probably be compelled to stay up late once per week and watch it. Instead it is generally an hour of politicians indulging in their favourite pastime of evading, misrepresenting and misleading and to be honest, I get enough of that already.

Still, I did watch some of it a few weeks ago and noticed that in pretty much every answer the Conservative or Lib Dem gave they managed to blame having to take lots of “difficult decisions”, such as cutting benefits for poor people and cutting taxes for rich people, on…

The mess we inherited from the Labour government

The government seems to believe that this is some kind of carte blanche to do whatever they want without any accountability; a Get Out of Jail Free card that they never have to give back. It isn’t though. It’s the political equivalent of saying, “OH MY GOD, WHAT’S THAT BEHIND YOU?” then running away when you turn around. That particular favourite phrase is not what I am going to spend time talking about because no one believes it anyway. Despite the government’s best efforts, no one is actually dumb enough to agree that they don’t need to be accountable for their policies.

They did come up with another favourite line, however, that narks me even more than this one because a lot of people do actually believe it. When someone mentioned government spending they said something like this:

It was the irresponsible spending of the last government that got us into this mess in the first place…

And the thing that annoyed me more than them wheeling out this spin-doctor nonsense for the thousandth time was that no one else on the panel directly challenged it. If I’d been on the panel, (I was on holiday so they had to go with Steve Coogan as the non-politician), I would have directly challenged it. I would have directly challenged it because it isn’t true. It is a lie and when politicians say it they are lying. This, ladies and gentlemen is The Debt Fallacy, the widely-held belief that UK government debt caused the financial crisis.

Before we delve into what actually did cause the “mess”, let’s see why this is a fallacy by looking at UK government debt between 1997 when Labour took office and 2007 when the financial crisis started. (Source IMF)

National Debt of G7 Countries as % of GDP

National Debt of G7 Countries as % of GDP

Yes, not only was borrowing significantly lower in every single year than everyone else in the G7, it was actually lower in 2007 than when Labour took office ten years earlier. Staunch Conservatives will no doubt be hugely disappointing that there is no marked increase in UK government debt in that graph. Don’t worry, just for you I’ve done another one for just the UK with the previous five years under John Major added in. Now you can see a government who did oversee a marked increase in the national debt. I’m nice like that. Don’t mention it.

UK National Debt as % of GDP

UK National Debt as % of GDP

So you can see why the government’s claim about a debt-fuelled spending binge is a lie. This level of public debt clearly didn’t cause the financial crisis. So what did?

The cause is actually fairly simple. Banks make profits by borrowing money and then investing it. Their profit comes by getting a higher return on their investments than they have to pay on to the people from whom they borrowed the money. For example if I put £100 in a bank account the bank might pay me 1% interest and then invest that £100 in in a scheme that makes them 5%. Simple enough.

Banks though, like any other businesses, want to compete against one another – they want to make the biggest profits for their shareholders and show everyone that they are the best bank. This is what caused the crisis.

Over time, banks became increasingly competitive and concerned themselves more with trying to make the biggest profit and less with the risks associated with what they were doing. With the £100 I put in my bank account they could invest it in something safe and make 5% or they could invest it in something risky and make 10% or 15% or 25%! The more risky the investment the more return it could yield. No bank was going to invest in something risky if its likely return was less than a safer alternative and so risk equalled reward. Competition between banks, all vying for the biggest profits, led to riskier and riskier investments and nowhere was this more prevalent than housing. It became possible for people to borrow crazy amounts of money to buy a house, even if they had poor credit worthiness. This irresponsible lending fuelled housing bubbles all over the world. Here’s how Florida house prices changed in the four years prior to the financial crisis.

Florida House Prices (Q4 2002 = 100)

Florida House Prices (Q4 2002 = 100)

In just four years they increased by almost 80% and people’s wages were definitely not increasing at anything like that rate. In short it was unsustainable. There is a useful principle in economics called Stein’s Law after the late American economist Herbert Stein and I wish more people had paid attention to it in the pre-crisis years. It says simply this:

If something can’t go on forever, it will stop.

Stop it did and we all know the rest. In hindsight it’s easy to look back at this and say that the banks were lending irresponsibly but much harder to say why they didn’t they realise it at the time. The only explanation I can offer is that they were too concerned with out-performing one another and not concerned enough about the risks involved until it was too late. Like a gambling addict who’s had a good night but doesn’t know when to quit, the banks didn’t want to think about Stein’s Law.

Essentially the positions they took on the housing market assumed that:

  • House prices always go up
  • Mortgage defaults are pretty rare

On the first point the banks thought, “Even if this individual doesn’t repay their 120% mortgage, the house will be worth more than that in a couple of years, so where’s the risk?”

On the second point they seem to have committed a really basic error in their probability calculations. Imagine I have lent to 5 risky individuals. The chances of any one of them defaulting on their mortgage is 5%. Therefore the risk of all of them defaulting on their mortgages is:

5% x 5% x 5% x 5% x 5% = 0.00003125%

But those of you who remember your GCSE maths will recall that you can only multiply probabilities together like this when they are independent. For example if the probability of a person having a beard is 20% and the probability of someone being female is 50% the probability of a lady having a beard is not 10%. (Unless of course you work in a circus.)

Similarly, the chances of individuals defaulting on their mortgages are not independent. When an economic downturn occurs, unemployment rises, incomes drop and lots of people all suddenly can’t repay their mortgages at the same time.

Banks, in their bid to out-profit each other, took huge positions on the housing market. They were betting that economies would grow and house prices would go up. It had been so long since the economy had been through a really serious downturn that they had forgotten the lessons of the past. The resulting crisis shows that so confident were they in endless economic prosperity, that none of them had a Plan B in the event of a downturn. The global economy isn’t like that though and if economic history has taught us anything it is that bad things have always eventually found a way to happen and by the time the banks spotted the bubble was about to pop it was too late.

Banks weren’t just lending irresponsibly on mortgages though. People took cheap loans and were able to borrow more than ever before on their credit cards. Banks were so desperate to lend that they offered amazing deals to secure our credit card debts. Fee-free transfers, interest-free balances for 12 months etc etc and the same thing happened – all of a sudden lots of people were unable to make repayments at the same time and the banks had no fallback.

This had a short term effect of making the banks insolvent and governments world-wide were forced to bail them out. While this solved the short-term problem there was another problem that almost six years later remains unsolved.

When economies around the world turned bad, people were left with mortgage debt, loan repayments and credit card bills that were ridiculously high. Those lucky enough to keep their jobs switched overnight from not worrying about their personal debt to worrying only about their personal debt. The thousand pounds they had on their credit cards was no longer something they could kick into the long grass and assume they would just pay it off later. Seeing their friends and co-workers losing their jobs made the risk of redundancy a reality.

This shock led to a very sudden and very dramatic change of behaviour. People moved almost overnight from spending to reducing their debt. Even those who had avoided running up debt became very worried about how little they had tucked away for the hard times and moved from spending to saving.

In the economy your spending is my income and my spending is your income. When everyone stops spending at the same time the consequences can be catastrophic. I say “can be” because a responsible government could plug the gap by increasing public spending but in most cases they didn’t, hence it was catastrophic, hence the depression. (I like saying “hence”. I think it makes me sound all knowledgable.)

So that’s how it happened and that’s the real reason we are in a depression and it had nothing to do with UK government debt at all.

There is a good argument that the previous Labour government should have spotted what the banks were up to and should have done something to address it. Although the banks caused the crisis, the previous government was asleep on the job while this was going on. If the current government were pushing that argument they would have a valid criticism but they aren’t because although it is the truth, it doesn’t pin all of the blame on the previous government.

Politics aside, the years before and since the crisis really are a shameful and embarrassing period in economic history. A first year economics student taking their first macroeconomics module will learn that government spending increases economic growth and that it works best of all when the economy is suffering from a lack of demand. They will learn that my spending is your income and your spending is my income. They will learn that if your spending disappears my income does too. They will learn about economic cycles – the economy will go down as well as up, so plan for it.

Sadly these are lessons that the current government has either not learned or has simply chosen to ignore. Simple enough as those lessons are, it’s sadly far more convenient for them to just propagate The Debt Fallacy.

RedEaredRabbit