Building a sustainable recovery
I’m rather keen, as regular readers will know, of ‘big picture’ macro posts on the UK economy.
I’m often at my happiest when writing about the need for ‘renewal rather than recovery’, talking about rebalancing as effectively transforming the national business model or when noting that political economy trumps macroeconomics.
I really do think this is all important stuff. But also I understand that some people get very turned off by it all.
Some commentators on the right seem to think any talk of these issues is basically watered-down Marxism and even some on the left see them as distraction from core issues.
Some believe that Labour’s talk of ‘responsible capitalism’ is either all about simply bashing business or just a wishy-washy plea for firms to be a bit nicer.
I disagree; much of the detail of the agenda actually strikes me as crucial to delivering a sustainable economic recovery rather than a simple ‘nice to have’.
As a useful mental trick if you’re the type whose eyes glaze over whenever anyone talks about ‘reforming British capitalism’, think instead that the speaker is saying ‘rebalancing the economy’ and if even that is too speculative imagine that they have said ‘increase investment and savings to ensure a more sustainable recovery’.
In today’s FT Philip Stephens writes about George Osborne’s decision to target a budget surplus as the latest in series of Treasury quests for the ‘holy grail of macroeconomics’ – following on from narrow money targets, broad money targets, shadowing the Deutschemark, inflation targeting and an independent central bank. As he writes:
The money supply, exchange rate, inflation and fiscal balance are all intermediate targets. The goal that matters is that of a well-functioning economy that raises living standards for the greatest number of people.
He is of course correct – increasing living standards in a sustainable manner is the goal of macroeconomic policy, everything else is a means to that goal.
The Chancellor now appears to believe that central to this goal is running a budget surplus (I’m half tempted to call this a ‘fiscalist’ view of the economy) and that from this will flow rising GDP which will filter down to living standards.
I’m not so sure, in fact I think both parts of this argument can be challenged – running a fiscal surplus is not the best way to ensure the economy grows (indeed at times it can be actively counterproductive!) and nor am I sure that the benefits of growth will automatically find their through to median living standards.
But even leaving aside that second point, what can be agreed by most economists is that increasing productivity is crucial if we want living standards to continue rising. (And again, I think this is necessary rather than sufficient step but I’ll not focus on that today).
One crucial long term driver of rising productivity is higher investment. Philip Collins was rather good on this in the Times last week:
In short, Britain needs more investment, the decline of which could yet be the coalition’s damaging legacy…
In the absence of a clear investment plan, the recovery is creating too many throwaway jobs. Some sectors of the economy are now dominated by low-paid work. In hotels and restaurants 68 per cent of workers earn less than the living wage. In retail the figure is 39 per cent. It is good that private sector employment is up by1.6 million since its nadir in 2009 but worrying that this has been bought at the cost of per capita productivity in a labour market that is more and more reliant on part-time workers and very short-term contracts.
The UK’s investment record is poor (all the data in the charts below is from the IMF world economic outlook database). The chart below compares it (as a share of GDP) to the G7 average.
Not as often commented on, but also just as importantly, our national savings record is even, if anything, more abysmal.
To summarise these two charts – our investment record was poor by international standards before the crash and was weakened further since, our savings record was even weaker and has now hit new lows.
As International Macro 101 teaches us the balancing factor between domestic savings and domestic investment is the current account. (In really simple terms – if domestic investment is greater than domestic saving, then foreign savings are required to finance it and this is funded by a current account deficit).
Putting this all together on a chart, gives the following picture of the UK economy since 1980.
I think there are three episodes worth picking out here. First the period in the late 1980s, the Lawson Boom, really stands out. There is a very evident pick-up in investment and a big deterioration in the current account position, this looks in hindsight that a classic unsustainable boom.
The second is the period from the late 1990s until the crisis, Mervyn King’s NICE decade (non-inflationary, continuous expansion – by the standards of economics witticisms, this is pretty good).
Whilst growth was good and inflation low (neither shown on the chart), the UK economy became unbalanced. Investment (whilst still weak by international standards) was well above savings and the UK ran a persistent current account deficit.
Whilst there is nothing especially worrying about a current account deficit (nor virtuous about a surplus) in of itself – I am inclined to think that persistent surpluses or deficits are a sign of a fundamental imbalance in an economy.
To me the second period of interest on the above chart is one key reason why we should not be aiming to simply return to the old growth model.
The economics profession is in broad agreement that the recovery will only be sustainable if it is accompanied by an internal and external rebalancing of our economy: in other words a higher savings rate, more business investment, and rising net exports.
Which nearly leads on to the third period of interest in the chart above – the time since the crash. Not only has investment crashed but gross national savings have fallen by even more leading to a late 1980s level of current account deficit.
This is the opposite of what the Chancellor said was needed for a ‘sustainable recovery’.
So, if a ‘sustainable recovery’ will rely on increasing investment, savings and net exports, how do we get one?
This where I think it call gets interesting and where, in one manner of speaking, ‘boring old macroeconomics’ meets ‘responsible capitalism’.
George Osborne was totally correct in his desire to rebalance the UK economy in 2010. The problem was that he was totally wrong in terms of how this could be achieved.
Reading his Mais Lecture, linked to above, it is striking how ‘easy’ he seemed to think this would be – cut government spending, cut corporation tax, keep interest rates low and business investment, savings and net exports will all rise.
This was the theory anyway. In reality corporations have failed to increase investment despite low (BOE) rates and much lower tax bills and exports have not responded as hoped to weak sterling.
To understand why Osborne’s rebalancing failed, I think we need to think about policy in terms of mechanisms not models. As Chris Dillow has explained (in what I regard as one of the best short posts on macro methodology I’ve ever read):
I suspect it is also a vindication for thinking of economics as a bunch of mechanisms rather than as formal models.
To see what I mean, let’s concede that the pre-recession evidence pointed to lowish or even negative (pdf) fiscal mulipliers. Mechanism-based thinking would ask: what mechanisms could generate such a result? Answers would include:
– Fiscal tightening can be offset by lower interest rates.
– Cuts in the government wage bill reduce workers’ bargaining power and hence expected profit margins, which can encourage capital spending.
– Lower government spending leads to anticipations of lower taxes, which might encourage increase household and corporate borrowing and spending.
This automatically draws our attention to reasons to doubt that low mulipliers would exist now. Monetary policy is less effective now we are at the zero bound; and an inability or reluctance to borrow limits how far private spending can rise to fill the space left by public spending.
We’d therefore expect to see higher multipliers now, not because Keynesians are always right and Austerians are always wrong, but because the mechanisms generating low multipliers happen not to be powerful here and now.
Model, as opposed to mechanism, based thinking may have led the Treasury to conclude that weak sterling would boost exports and that a cut in corporation tax (by lowering the cost of capital) would increase business investment.
These models though have been proved wrong – or at the very least too simplistic.
In both cases (as I’ve rounded up in previous post here), there is a strong case that mechanistic thinking would identify corporate governance as one major factor explaining both poor investment and weak exports.
Incentives allegedly provided to align the interests of top employees with those of shareholders, such as share options, create incentives to manipulate corporate earnings, at the expense of the long-term health of the company. Shareholder control is too often an illusion and shareholder value maximisation a snare, or worse.
In order to boost share prices – and the stock-based pay of executives and other large shareholders – Fortune 500 companies have spent $3 trillion in the last decade on buying back their stock. Such value extraction has funnelled money away from areas that can increase long-term growth – for example research and staff development – to areas that only increase the inequality between the 1% (whose rewards are linked to stock price movements) and the 99% (whose rewards are linked to investments in the productive economy). Value extraction is rewarded over value creation.
Or – to put it another way – we have a real problem with short termism. An increase in short termism since the late 1970s has meant that firms are less likely to respond to low rates by increasing investment and less likely to react to weaker sterling by expanding market share.
On one side stand households and investors who are responding to the very strong liquor which the Federal Reserve is putting in the punch. By buying up bonds and keeping rates low, the Fed encourages risk taking and drives prices for assets – real and financial – higher.
That’s leading to record prices for everything from art to social media companies to Manhattan real estate. This isn’t just a phenomenon for the rich, though the rich do get the cream. Real estate is going up fairly strongly in a wide variety of markets, as are the stocks owned in so many people’s retirement funds and accounts.
On the other side are corporate executives, who don’t seem to have read their economics textbooks. Rather than responding to high profit margins by investing and competing, they seem happy to milk their cows without adding much to their herds.
Add in a banking system which generally favours property lending over lending to firms and you have an economy that can’t be rebalanced by cutting corporation tax and ‘getting the state out of the way’.
Questions about long termism, corporate governance, access to finance and banking reform are at the heart of what is sometimes called ‘responsible capitalism’. In a May 2012 article for the IPPR’s Juncture magazine, Ed Miliband identified 5 priority areas – most of them intrinsically around these themes.
Ed Balls speech to the EEF earlier this year (I suspect his most important since 2010’s Bloomberg speech), struck the same note:
…even with action now to kick-start the recovery alongside a balanced plan for deficit reduction, we cannot secure Britain’s long-term future unless we fundamentally reform the way our economy works.
In his report [George Cox], based on extensive research and consultation across British business, Sir George finds that:
- Short-termism, which he defines as the pressure to deliver quick results to the potential detriment of the longer-term development of a company, has become an entrenched feature of the UK business environment;
- He reports that short-termism curtails ambition, inhibits long-term thinking and provides a disincentive to invest in research, new capabilities, products, training, recruitment and skills. It results in drastic cost-cutting and staff-shedding whenever revenue growth fails to keep up with expectation;
- And he finds that this short-termism militates against the development of the internationally competitive businesses and industries that are essential to the UK’s future economic prosperity.
The Cox review identifies three short-termist barriers to long-term investment in our economy:
First, the way that equity markets now operate.
Second, the lack of a ‘funding escalator’ for smaller companies.
And third, the short-term focus of successive governments – with decisions on major issues such as energy policy or transport infrastructure too often shunted back from one administration to the next.
In the words – a great deal of the Responsible Capitalism agenda far from being just philosophical musings is actually about concrete ideas to ensure that rebalancing actually occurs.
This then to me is the argument – the point of economic policy is to increase living standards, doing this requires higher productivity and this can only be achieved in a sustainable manner through a more balanced recovery. But getting a more balanced economy requires changes in the institutional framework of our economy not just fiscal and monetary tinkering.
The second part of economic reform is ensuring that the rewards from rising productivity are more equally distributed – but that’s the subject of another post.