Wednesday, 1 April 2015

Talking About the Economy

There are a number of confident predictions we can make about the general election campaign. Many journalists and media commentators will obsess about the pivotal role of Scotland, which has apparently transformed itself by an act of will from a post-industrial basket-case into "the warm south of Scandinavia" ("Choose life! Choose Ikea!"). Immigration will have a topicality it has never had before and may never have again, even in the event of an EU referendum, though most people will quickly tire of what will undoubtedly be a sterile debate, reduced by May to Nigel Farage barking the single word "immigration" at every photo-op. Finally, and most predictably, both the Tories and a compliant media will equate cutting the government deficit with a "long-term economic plan".

While many economists are bothered by the idiocy of "mediamacro", it strikes me as perfectly logical given the continuing hegemony of neoliberalism: the private and household sectors require "freedom", the public sector requires close and unforgiving scrutiny. From next week, retirees can blow their pension fund, while whoever forms the next government is already committed to cuts in benefit spending. But while these will be significant - even traumatic - for many individuals, both are trivial for the economy as a whole. For many, a genuine "long-term economic plan" would address the UK's low levels of productivity, relative to other advanced economies, though the persistence of the problem (arguably going back 130 years) raises the question as to whether government policy can do much about it. That said, productivity has a bearing on three other structural deficiencies of the economy that any self-respecting "plan" would seek to address.

The first is the low level of capital investment. Starting in the late nineteenth century, there has been a persistent reluctance by British capital to invest domestically in productive industries, as opposed to higher-yielding foreign markets (the empire was a drug that proved hard to kick). Deindustrialisation in the 80s caused a pickup in investment, but this was more than matched by similar improvements in other developed economies, while the impact of IT in the 90s was noticeably weaker in the UK than the US. Since 1990 UK capital investment has been trending down. Parallel to this, foreign markets and the domestic property market continued to attract capital to the detriment of domestic productive sectors. The political response to the productivity problem was a focus on education and training. In other words, we avoided blaming capital by blaming labour.

Even allowing for lower levels of capital intensity and labour skills, UK productivity is still lower than it should be, which points to a weakness in total factor productivity (i.e. everything other than capital and labour). TFP includes more or less objective factors such as competition, innovation and entrepreneurialism, but the idea that our post-Thatcher, business-friendly economy is constraining any of them is dubious. The more likely suspect is poor management, which means we are not exploiting our capital and labour as efficiently as other countries, such as the US, Germany, France and Japan. This suspicion is borne out by the fact that foreign direct investment (largely by those same comparators) has been better at increasing UK capital intensity and thus productivity, for example in the car industry, oil & gas and pharma.

A possible demand-side solution to this problem would be state investment, not in the usual high-profile infrastructure projects, but in a deliberate attempt to "pick winners" in specific industrial and commercial sectors where the multiplier effects would be high (stimulating local supply chains, training workers for the benefit of others, encouraging the spread of better working methods etc). The ideological challenge of such a policy is obvious, though it's worth noting that attracting foreign firms to commit to large-scale investments normally requires direct government negotiation, guarantees and rule-bending. There is little competition in these cases, except between countries as destinations for inward investment. Overall, FDI falls into the category marked "central planning" not "laissez-faire". Extending this logic to the cultivation of "domestic champions" is routine in other countries.

A possible supply-side solution would be to increase the penalties for poor use of capital - in other words, drive low investment  (and poorly managed) companies out of business and thereby improve the market average. This would incidentally encourage new (and potentially innovative) market entrants and thus greater competition. The best way to do this is not to increase capital allowances, but to increase business rates and employer NICs to prompt productivity investment. Another tough sell. The fundamental British problem is not so much the reluctance of small capital to consider such Darwinian measures - you will find the same attitude among small capitalists in all advanced economies - but the dominant interests of finance capital and its ability to "crowd out" more patient domestic investment. Given the higher yields on quoted stocks in the UK compared to France and Germany over the twentieth century, this "short-termism" is perfectly rational if you are an investor.

The second deficiency is the UK's worsening balance of payments. This partly reflects weak productivity growth relative to our trading partners (i.e. imports become progressively cheaper and exports more expensive), but it also reflects the growing deficit on investment income in recent years. Foreign direct investment earnings (which flow out) now exceed income on UK capital invested abroad (which flows in). This is attributable to a number of factors, including the write-down of bank assets  and the compositional shift of savings from funds (which may invest a percentage abroad) to UK-based assets such as property. The collapse of foreign property markets in 2008/9 resulted in capital being repatriated, which simultaneously boosted London property prices and reduced foreign income. Whereas a government deficit can be financed indefinitely (if you can print your own currency), a persistent trade deficit must be settled sooner or later by selling foreign assets.

One solution would be a massive housebuilding programme. This would depress returns on UK property and thus prompt private capital to move elsewhere in search of higher returns. This could both increase capital intensity and so productivity in domestic industry and expand foreign holdings and thus current account income. But don't hold your breath. Even assuming the political will to reverse the historic inflation in house prices, the demand for high yields would likely bias most of the capital towards foreign rather than domestic investment. As both the 1997 Asian financial crisis and the 2008 crash showed, modern investors are often unconcerned (or just ignorant) about where their money is ultimately invested. This means that low productivity, in the form of the deficit in traded goods and services, will continue to be a problem. While rentiers will benefit from foreign income, domestic workers will continue to suffer poor wage growth.

The third deficiency that a long-term economic plan might address is the old chestnut of the "unbalanced economy". The reason nothing of substance has been done to address this since 2008 is simple: the political elite either don't want to change it (the Tories) or believe it can't be changed (Labour). It is always worth remembering that this imbalance is nothing new. There has been friction between factories and finance since the mid-nineteenth century: industry accuses the City of short-termism; the City accuses industry of poor management (i.e. weak profits). Both parties agreed in the 1970s that the way to supersede the argument was to bear down on labour. This would boost profits, allow for rationalisation, and give the City the confidence to invest for the duration. In the event, financial deregulation and globalisation presented too many other other tempting opportunities, with the result that industry contracted and much of the remainder was subject to foreign takeover (generating lucrative M&A business for the banks).

What has changed in recent years is that the periphery of the UK has given up on the illusion that anything will be done about the City or that industry will be revived from Whitehall. New Labour's Faustian pact to indulge the City in return for public sector investment in the regions is a busted flush. The attraction of the SNP for many traditional Labour voters, not just in Scotland but in the North and Wales, is that it suggests a clean break with a compromised past, even if the future is a nebulous medley of "green industries", "tech-hubs" and "social enterprises". Developing new, high-productivity industries would require a decades-long commitment and low rates of return in the meantime. The lesson of the independence referendum is that the inertia and short-termism of rentiers and pensioners means that "jam tomorrow" is not a vote-winner.

Up to 2008, the increase in "output" by the UK financial services sector boosted aggregate productivity, but much of this was illusory, taking the form of new "products" such as PPI, or fee increases for otherwise unchanged services such as fund management. Similarly, many UK commercial services are inelastic, due to weak competition or tolerant buyers, leading to above-inflation price increases in good times and flat prices in recessions. The implication of this is that productivity growth during the New Labour years was actually lower than it appeared, so the post-2008 "productivity puzzle" is partly reversion to an underlying trend, which has important fiscal implications. Stagnant wage growth, which is due as much to low productivity as employer bargaining power, leads to lower tax income and thus continued pressure on public services. I think the hegemonic acceptance of austerity can be read as evidence that the political elite are sceptical that they can substantially increase domestic capital investment by business, improve the UK's balance of payments or shrink the size of The City relative to the rest of the economy. As you were then.

The potential get-of-jail-free card for productivity is innovation, hence the ever-popular TV tropes of Graphene and Silicon Roundabout. The rate of innovation does not depend on a metaphysical concept such as "genius" but on two simple factors. First, technology is cumulative (the shoulders of giants), so the more that exists, the more that will be developed on the back of it. Technology is often complementary or recombinative, and produces positive feedbacks in terms of scientific research and techniques. This is why "picking winners" in high-tech areas actually makes a lot of sense. Second, regardless of the aggregate level of education, the number of innovations correlates to the number of innovators. Unless we have grounds to believe that there is a natural limit to their number, we should expect this subset to naturally increase with population growth. While improving tertiary education for the native-born is worthwhile as a social good, handing out free passports to foreign-born PhDs would be more likely to boost the economy in the short-term.

But innovation can be profoundly disruptive of society, not just of particular "markets". The postwar era saw the fruits of technological growth shared more equally than before due to the premium on skilled labour (i.e. distribution via wages) and the infrastructural investment and social reforms necessitated by war and rebuilding. From the 1980s, the economy gradually shifted focus from the search for increased profits through industrial rationalisation, as first globalisation and then the IT revolution kicked in and started to erode margins, to a search for yield. This produced the primacy of shareholder value, financialisation, rent-seeking and asset-price inflation. The social consequences are a lack of demand for much labour, leading to job polarisation and income inequality; a surplus of capital, which drives up housing costs; and commodity deflation, which will continue to depress median and below wages in the first world.

Clearly the UK's problems are not unique, but the political constraints on effective action are unusually strong due to the dominant role of the City. The lack of effective institutions to direct domestic investment is the consequence of a politically-mandated monopoly for the Square Mile. Other countries have employed different strategies: dirigisme in France, the regional Sparkassen in Germany, and the role of the Department of Defense in the US, to name but three. Deficit fetishism is not just about defending the interests of capital or "shrinking the state", it is a convenient distraction from the fundamental characteristics of the economy and the City's role. The media even seem to have accepted George Osborne's claim that "paying your way in the world" means cutting the government deficit rather than balancing the current account. It says something about the degradation of politics that you have to rely on a hereditary peer to point this out. I don't see the quality of debate improving much over the next 5 weeks.


  1. Herbie Kills Children1 April 2015 at 17:53

    “The political response to the productivity problem was a focus on education and training. In other words, we avoided blaming capital by blaming labour.”

    No, not in other words at all. This is merely an interpretation. Another and I suspect more pertinent explanation is that capitalism cannot provide a first class education to its people, who are served up a z class education system. So capital very much to blame for this.

    1. I don't think he's arguing this personally, merely describing the ideology behind the 'human capital' argument.
      I think 'first class education' is a very subjective term, though.