Generating economic policy buy-in

Just before Christmas, the FT commentator Gideon Rachman penned a column which argued very strongly that “Economics is – or should be – part of moral philosophy  …  ‘the economy’ is not just about growth. It is also about justice.” This is a very important point and one that tends to be overlooked, or at least downplayed, by large parts of the economics profession. Rachman argues – as indeed as I have done on this blog – that many voters do not buy into the economic vision offered by politicians because they do not see how it benefits them. What is even worse, they often believe they are being discriminated against in favour of other interest groups.

Making America great again speaks to the millions of voters who believe somehow that the US’s status of top dog is being eroded by emerging economies that do not play by the economic rules and that the US is being penalised for abiding by them. In a similar vein, taking back control speaks to those British voters who see the UK as being held back by a monolithic EU. As an economist, I find such statements absurd. After all, the US is still the pre-eminent economic and military superpower whilst EU membership gives the UK access to the largest and richest single market on the planet. But there is no reason why this should cut any ice with the average voter who is struggling to make ends meet at a time of low wage inflation and against a perceived backdrop of mounting job insecurity (which incidentally is not backed up by the UK evidence).

The predominant economic model in the Anglo Saxon world over the last 35 years has been a market-oriented policy in which government has tried to reduce its role in the belief that the market will provide the most efficient allocation of resources, thus boosting welfare. Prior to 2008 the evidence appeared to suggest that whilst voters were aware of the downsides of this model, the economic tide was rising sufficiently quickly to float all boats. But political and economic circumstances have changed over the past decade. Society’s sense of natural justice was offended by government actions to bail out banks whilst simultaneously imposing a policy of fiscal austerity, which sowed the seeds of a belief that the system is rigged in favour of big business at the expense of the little guy.

This has resulted in many aspects of our current model being put under the microscope and raises questions whether economic policy is going in the direction which voters are prepared to buy into. As Rachman points out, intra-generational issues are uppermost in the minds of many voters. There are concerns across the western economies that those in born after 1980 will not be as wealthy as their parents. Evidence from the UK, for example, suggests that younger adults have much less wealth to their name than previous generations did at a similar age. Over the past decade, as younger voters have gone through university and entered the labour force, many of them are beginning to question whether they will be able to reap the economic rewards they were promised. UK students no longer get the benefit of a free university education and finish their university studies with much higher levels of debt than their parents. Indeed, UK students now carry a staggering £13bn of debt – an increase of almost 190 times what they owed in 1990.

At the same time, the younger generation must pay the taxes to cover the rising costs of providing for the welfare needs of the ageing baby boomers, whilst struggling to find the high-paying jobs which previous generations were able to secure. They will also have to deal with the fallout from the populist reactions triggered by the Brexit vote and the election of Trump – both of which were propelled by the votes of the older generation. Millennials in the industrialised world can be forgiven for questioning the legacy bequeathed to them by older generations.

Policies which offer a trade-off between more market solutions and lower taxes are increasingly unlikely to find electoral favour. Nobody wants to pay more taxes, of course, but there are limits on how far countries such as the UK can continue to reduce them and still maintain the reasonable standard of public services that the public has come to expect. Scarcely a week goes by without a newspaper story decrying cuts to the armed forces or the strains imposed on a health system which struggles to cope with the strains placed upon it. It is perhaps for this reason that we are seeing renewed voter interest in “radical left” parties across Europe which promise a greater role for the state in a bid to improve the lot of those left behind (chart).

Indeed, as the IMF pointed out last week in its regular assessment of the UK economy “greater reliance on revenue measures for [fiscal] consolidation than in recent years may be warranted.” Amongst the potential measures put forward were a reduction in “the tax code’s bias toward debt” which benefits corporations, and rebalancing property taxation away from transactions and toward property values. Ironically, the US appears to have gone in the other direction with the recently unveiled changes to the tax system primarily benefiting corporates and better off individuals.

If we really are in it together (to use George Osborne’s phrase) some changes to the incidence of taxation would be a good place to start to help win over voters that the system is not biased against them. Whilst many in the policy establishment draw on the laissez-faire teachings of Adam Smith, we should not forget that “The Theory of Moral Sentiments” extensively explored ideas such as morality and human sympathy. He never advocated the devil-take-the-hindmost policy which many of his adherents claim. It is a lesson the economic and policy establishment perhaps needs to relearn.

Public or private: The debate continues

The debate on whether a free market or state enterprise is the superior form of economic governance is an old one which comes to the surface every now and again. It is currently being rerun once more, with numerous plebiscites across the industrialised world making it clear over the past 18 months that voters are keen to explore alternatives to a system which is perceived to have failed following the global financial collapse of 2008. The popularity of Bernie Sanders, particularly amongst younger voters, during the US presidential primaries last year testifies to the fact that there is a market for politicians prepared to speak about collective solutions to many of society’s current economic ills.

Nowhere is this debate more pronounced than in the UK where Labour leader Jeremy Corbyn has called for “21^st century” socialism in an echo of the slogan used by Hugo Chavez in Venezuela. Following on from the relative success of the Labour Party in the June election, Corbyn’s speech to his party faithful last week called for higher taxes and more government spending in a bid to differentiate Labour from the free market policies of the Conservatives. Ahead of her own party conference, Prime Minister Theresa May hit back in a speech by declaring the free market economy “the greatest agent of collective human progress ever created.” Neither is wholly right or wrong: there is some merit in both systems. But in reality, in a modern economy neither the total primacy of markets nor the heavy hand of government can hope to deliver the outcomes which their proponents believe. Mixed economies are the ideal – the hard part is to get the balance right.

Many free market idealists point to the success of the industrial revolution which was characterised by a market economy comprised of large numbers of small companies. But whilst this did deliver a significant increase in material living standards, it also had adverse side effects in the form of wealth and income disparities as some people became exceedingly rich at the expense of those who did back-breaking manual labour. Another side effect was that many small companies grew large enough to attain monopoly positions, which in the US triggered action by the government to rein in the “robber barons” via antitrust laws. There is no small irony in the fact that the US government’s action represented interference by the state in the operation of private sector companies. It pulled the same trick in the 1980s by forcing the breakup of AT&T at a time when the pro-market Ronald Reagan occupied the White House.

What this highlights is that governments do have a role to play in market economies by ensuring an institutional framework in which the interests of the consumer are best served. Ironically, the EU has been one of the great guarantors of consumer interests across Europe. Those of you who travel throughout Europe can thank the European Commission for the abolition of mobile roaming charges and for the widespread adoption of the European Health Insurance Card. The Commission also forced Microsoft to unbundle Internet Explorer from the Windows operating system because it “harms competition between web browsers, undermines product innovation and ultimately reduces consumer choice.” Those who criticise the EU for its stifling bureaucracy perhaps ought to look again at its record in championing competition which promotes consumer welfare.

This is not to say that a system of central planning will necessarily work either, as the examples of the Soviet Union and pre-Deng Xiaoping China have shown. In a less extreme example, Britain in the 1970s was characterised by institutional rigidities which overrode the operation of market forces, notably in the labour market, which held back growth and resulted in high inflation. It was thus not hard to make the case at the end of the 1970s for applying a new economic broom and applying the ideas advocated by Milton Friedman and his Chicago colleagues. It was argued that the prevailing problems could be cured by allowing the market to eliminate rigidities (restrictive practices, credit rationing etc.) and that a bright new dawn of prosperity lay ahead. And for a long time it worked. Voters got used to relative stability and rising incomes, until one day Lehman’s went bust.

Arguably, this was the point at which voter tolerance for the free market snapped. The popular narrative is that bankers played in a system without any rules and in which market forces ruled. Worse still, the private sector losses were loaded onto the public balance sheet and the system was reset to continue on its way, whilst the austerity required to get public finances in order hit the poorest disproportionately hard. Whilst this is a stylised version of what happened, enough people believe it such that they want change.

What this does highlight is that all economic policies have a limited shelf life as the downsides begin to show through. Corbyn’s call for a renationalisation programme taps into this wave. Thirty years ago, it was argued that opening up former state-owned utilities to competition would boost efficiency and improve choice for the consumer. I never fully bought that argument: Selling utilities off to the private sector was never going to automatically increase real choice. We still buy many of the same products delivered via the same distribution network – it’s not like competitors entered the railway market offering us new routes. The one stand out example where the policy worked was in telecoms but that was only because the mobile revolution changed the face of the business.

As Tim Harford concludes in an FT article on privatisation, “the picture is mixed, the details matter, and you can get results if you get the execution right.” The flipside of Harford’s conclusion is that the promise by Jeremy Corbyn to renationalise a significant proportion of the utilities will not necessarily produce better results. Equally, Theresa May’s push for the free market is not guaranteed to produce better outcomes either. There is a role for both systems: It is not clear whether the two competing political versions in the UK have the balance right.

Let's hear it for the Anglo Saxon model

During the 1990s the phrase "Washington Consensus" was increasingly used in policy circles, particularly in the context of the IMF when applying conditional aid packages. It was another way of saying, particularly to developing economies, that countries should liberalise markets; reduce taxes and trade barriers and put in place a governance structure that promotes openness. The ethos was that open and competitive markets would allow the private sector to operate in a manner that acted as a dynamo for economic growth which would ripple throughout the economy. It would also bring them closer to the orbit of the Anglo Saxon economies. Successive US Presidents from Bill Clinton onwards bought into the idea as did UK prime ministers Tony Blair and Gordon Brown. But it was generally resented by those countries which found themselves on the receiving end of IMF requirements.

Indeed, the words Washington and consensus appear rather hollow these days, particularly when mentioned in the same sentence. The events of the past week have painted a picture to the world of a chaotic White House failing to grasp how to run government, and suggests that consensus is the last thing on the minds of many in Washington. Meanwhile, on this side of the Atlantic, the UK government is failing to get to grips with the niceties of Brexit negotiations in a way that makes many of us fear for the outcome. Whatever else the Anglo Saxon model stood for, it was meant to be pragmatism over ideology. Admittedly, there were those who believed that the insistence on the primacy of free markets was an ideological stance, but on the whole it seemed to be backed up by a body of evidence. Then 2008 happened.

Ironically had the free market proponents been allowed to apply their doctrine to its logical conclusion, banks would have been allowed to collapse and the swamp would have been drained in a way that would almost certainly have proved ruinous. Fortunately, governments stepped in to put a backstop behind the system. Contrary to popular belief, markets did not fail. The mechanism worked exactly as the textbooks said it would: boom follows bust. It's just that it did not produce outcomes that societies found acceptable.

I have long maintained that the apparent governmental chaos in Washington and London stems from the events of nine years ago. Unlike continental Europe, where memories of the post-1945 economic ruin were still part of collective memory (albeit distant), neither the US nor UK have any social memory of economic hardship. The experience of the 1930s was too far beyond the memory of most, and had in any case been wiped away by the post-1945 glow. Perhaps it was this factor which meant that US and UK governments were unable to effectively communicate the severity of the economic situation to their electorates (though full marks to Ben Bernanke at the Fed who recognized the collapse for what it was). As time went on, and governments were unable to generate the recovery which they promised, their message was increasingly not heard by an electorate that felt it was being lied to. As a result we got Brexit and Trump.

The problem that governments on both sides of the Atlantic face is that evidence-based policy making appears to have taken a back seat to ideology. Take the Obamacare debacle. President Obama’s Patient Protection and Affordable Care Act is designed to provide health insurance to the estimated 15% of the population who lack it. Moreover, it is designed ultimately to rein in the surge in healthcare spending. But the right-wing Republicans hate it because it is seen as a “job killer” by imposing too many costs on business and is seen as an unwarranted intrusion into the affairs of businesses and individuals. But far from being a job killer, health sector jobs have increased by 9% since the legislation was introduced.

Moreover, Senate voted not to repeal it last week because politicians know that large parts of the current system work for the electorate. As Vox put it, “No legislative strategy can skirt around the fact that millions now rely on the health care law for coverage, and do not want to lose their benefits.” Nor is it clear what the replacement legislation would look like. There are numerous flaws with the Obamacare legislation which need to be fixed in just the same way as there are flaws in the way that the EU operates. This does not mean that it is sensible to overturn the status quo without an alternative plan. There is no evidence that Brexit is a policy that will increase the UK’s economic welfare. And just as certain elements of the US media were able to distort the terms of the presidential debate, so the same thing happened in the UK ahead of the EU referendum.

What is most worrying about the debate on both sides of the Atlantic is that a short-term political agenda is being pursued which will have longer term economic consequences. Both Trump and Theresa May will one day just be another in a long line of ex-politicians. But the damage to their respective countries may well outlive them. In the case of the US, the policy vacuum will create more space for the likes of China to create a global structure designed to maximise its influence. The UK’s position is even worse for it does not have the economic and political heft of the US. The reputation of both countries as economically successful bastions of freedom and tolerance has taken a beating, and the rest of the world may in future only look to them for lessons in how not to manage affairs.

Now what?

Today’s delivery of the letter triggering Article 50 has set the UK on a road to a far less certain future. I have been through the economic arguments countless times as to why Brexit is a thoroughly bad idea – indeed I have been making them since January 2013 – but that is an argument which has been lost and there is no point in raking over old coals. Theresa May’s speech to parliament tried to sound convincing but I suspect it fell flat on the near half of voters who do not share this government’s vision.

All the challenges it faces were contained in one sentence from the prime minister: “I want this United Kingdom to emerge from this period of change stronger, fairer, more united and more outward-looking than ever before.” It’s hard to see how we will emerge stronger given that most of the evidence suggests that there will be significant economic costs. Unless, of course, any trade deal with the EU offers most of what we have already, in which case what is the point? More outward-looking? We have just announced a withdrawal from the largest, and arguably most successful, single market in the world. I am not sure how that is consistent with the outward-looking vision she espouses. As for being united, that is a bitter irony. Almost half those who voted do not want this policy at all, and the Scots want to secede altogether. The UK will have to negotiate a hell of a deal with the EU to persuade the disaffected minority that Brexit is a risk worth taking.

The biggest problem that the government will face in the long-run is how to take back control in an increasingly globalised world. One of the great ironies of the post-Brexit world is that sterling is around 10% weaker than it was pre-referendum. Aside from the fact that this impacts upon the living standards of ordinary citizens by raising the costs of imported goods, it also makes British companies more attractive takeover targets by reducing their price in foreign currency terms. An article in The Economist noted three weeks ago that although the UK accounts for 3% of world GDP and its companies account for just 5% of global market cap, UK corporates have accounted for a quarter of all cross-border M&A activity since 1997.

This is a result of the laissez-faire approach of successive British governments towards market intervention. Moreover, over the last 10 years, foreign companies have bought significantly more UK companies than the other way around. The most high profile of these cases was the purchase of Cadbury’s plc by Kraft Inc in 2010. Just a week after promising to keep one of Cadbury's local plants open, Kraft backtracked and said it would close it. Although this resulted in a major revamp of the takeover code in 2011, it came too late for Cadbury’s workers and prompted howls of popular outrage. But here’s the rub: The UK is running out of attractive takeover targets. Admittedly, it still has attractive companies such as AstraZeneca, which beat off a bid from Pfizer in 2014, or the London Stock Exchange, whose proposed merger with Deutsche Börse was today blocked by the EU competition commissioner (of all people).

All this is a prelude to the question of what will attract global capital to the UK in future? It has fewer takeover targets and it is about to leave the EU, which will make it less attractive to firms which want a European base when they can go elsewhere. The attractiveness of London as a business location will not diminish easily: It is still a world-class city with all the amenities that the global community requires. The attractiveness of the legal system and use of the global lingua franca are added bonuses.  But depending on the nature of the deal with the EU, the London financial services industry may be in for a torrid time which will impact on the ancillary services that depend on it. Only time will tell how the likes of the Japanese and Americans will react to the prospect of having their European headquarters located outside the EU. Tax competition would certainly be one option to enhance the attractiveness of the UK but that is a race to the bottom which could put even bigger holes in the public finances.

The Economist notes that “even the free-market wing of the ruling Conservative Party … backs a change [to the takeover code] ... Britain’s 30-year experiment with a free market for takeovers is quietly coming to an end.” But the real irony is that if Brexit is at least in part a backlash against globalisation, this policy change could have been implemented years ago and saved us a lot of grief. And to double the irony, making it more difficult for foreign investors to buy UK companies is now precisely the wrong policy response when (a) most of the assets have already been sold and (b) the UK needs the capital inflows. You almost couldn’t make it up. Unfortunately that is the result of 30 years of short-sighted policy.

Mostly ARMless

I am not exactly sure what to make of the bid by Japanese company SoftBank for ARM Holdings, one of the few British tech successes of recent years. Indeed, the chips made by ARM are in devices across the world from smartphones to tablets. Whilst ARM is a reasonably sized UK company, with revenues of around $1.5bn and profits close to $500 million, which puts it just outside the top 20 largest British firms, it is a tiddler in global terms. For example, AstraZeneca – the last big British company to be involved in politically sensitive takeover negotiations – generates revenues of around $25bn, whilst a serious tech giant such as Google makes $75bn in revenue and net profits of $16bn.

What sets it apart is its strategic importance. The company has a 95% market share in the smartphone market and as the Internet of Things takes off, the kinds of processors which the company makes will be in high demand. Although the new Chancellor Philip Hammond insists it is a demonstration that 'Britain has lost none of its allure to international investors’, it flies in the face of the speech made last week by prime minister Theresa May who argued strongly that the government would be less keen on seeing strategically important businesses sold off to 'transient' foreign investors.

One of the founders of ARM has expressed regret that the future of the company will be decided in Japan rather than in Britain. As an economist, I ought not to care, although in these increasingly difficult geopolitical times the idea of a business world without borders is no longer as attractive or realistic as it appeared a few years ago. Perhaps more importantly, the profits made by the company will flow back to Japan thus exacerbating the UK's current account deficit, which is already one of the highest in the OECD. Regret has also been expressed in tech circles that yet again another national champion has been sold off, which will stymie European efforts to build companies to compete with the Silicon valley giants. But the company belongs to its shareholders and if they decide to cash in on a very generous offer, who can blame them?

Although the weakness of sterling in the wake of Brexit has made assets such as ARM cheaper in yen terms, the surge in the share price in pounds has gone up at an even faster rate. Thus, by last Friday ARM’s share price in yen terms was 3.5% higher than on 23 June. Moreover, SoftBank paid a premium of 43% relative to Friday’s close and a multiple of 60x 2016 earnings – way above the FTSE’s already-high average of 38x. It was almost too good an opportunity for shareholders to turn down, although it could yet be derailed by a counterbid or indeed by direct government intervention.

Undoubtedly, the issue will raise concerns about the UK’s willingness to sell out important businesses to foreign investors. But so long as the UK continues to operate an industrial policy in which companies have a duty only to their shareholders, and in which they are encouraged to take decisions on purely financial terms, we will undoubtedly see more deals such as these. This is all the more true as the collapse of the pound since the EU referendum reduces the costs of buying into the UK. It also boosts the revenue of those companies (such as ARM) which derive the bulk of their revenue from overseas, which will increase their attractiveness, and explains why the prices of those companies with a high degree of exposure to the EU have outperformed. Of course, it would be hugely ironic if the Brexit-induced collapse in sterling leads to more foreign takeovers, thus weakening the case of  those who thought that this was a chance to revitalise the economy in the interests of the British people.

We live in troubled times

More than 30 years after the Thatcher government adopted a policy of systematic indifference to the fate of British manufacturing, it comes as no real surprise that the future of the UK steel industry once more hangs in the balance. Nine years after Tata Steel bought the remnants of the industry from Corus, the company ended up losing significant amounts of money by holding onto the Port Talbot plant in the face of a massive glut of global output, triggered largely by Chinese overcapacity.The whole issue is a microcosm of the economic problems facing the UK today and raises a number of uncomfortable questions for the future of the British manufacturing sector in general, and steel in particular. First off, how much support is the government prepared to give to an industry which is potentially of critical national importance? Second, to what extent can we rely on free markets to generate the kind of outcomes which are socially acceptable? And third, to what extent can China be relied upon to play by the rules of the international trade game?