Some time ago I was sitting in a meeting in which the
discussion turned to administrative and procedural matters, none of which
affected me. I realised that if I left the room I would not be missed and I
could use the time to do something more productive. This is, of course, an
experience familiar to many millions of people. Once we add up the amount of
person hours wasted in processing apparently trifling administrative matters, we
begin to understand the magnitude of the economic costs imposed by red tape.
Like many people, I tend to think of this problem as one
which others should deal with. After all, I am not paid to be a bureaucrat – surely
there must be someone else to take care of this. But so long as we are
operating on the company's time, our employer has a right to ask us to deal
with processes which make the company's life easier. In any case a lot of
regulation is necessary. We cannot hope to operate in a complex economic system
without a set of detailed rules governing the underlying processes. Indeed,
without a lot of these rules, we would experience market failures far more
frequently than we do. But that does not mean we should accept all regulation
as good, or even necessary.
An example of "good" legislation is that designed
to tackle the problem of environmental damage. It has a transparent aim of
reducing the wider social costs associated with pollution, which yields obvious
benefits to society. Of course producers have to adapt their production
methods which can act as a spur to innovation but it also raises costs which
are ultimately passed on to the consumer. Society thus has to carefully weigh
the costs and benefits of regulation. One of the problems we are now beginning
to understand is that as circumstances change, much of the regulation that sits
on the statute book becomes outdated.
To this end, President Obama signed executive orders
requiring federal agencies to review existing legislation to “determine whether any such regulations
should be modified, streamlined, expanded, or repealed” with the purpose of
making the “regulatory program more
effective or less burdensome in achieving the regulatory objectives.” Consider
the situation we are in today in which governments are increasingly concerned
about the nitrous oxide emissions caused by diesel engines – the very same
technology which was once seen as the solution to the problem of CO2
emissions. That solution is increasingly being seen as a problem and regulation
is being amended accordingly, with the likes of the UK and France planning to
ban the sale of new cars powered by the internal combustion engine within the
next 25 years.
Financial regulation is another case in point. Much of the
legislation implemented in the past decade is designed to reduce the risks to
society from the socialisation of a private sector problem (i.e. governments do
not have to bail out banks) by preventing the emergence of banks which are too
big to fail. Globally, banks now have to hold bigger capital buffers and are
subject to much greater regulatory oversight. We will only see how effective
the legislation has been over the longer term if it reduces the frequency of
banking crises. What we do know is that the short-term adjustment costs are
high, as banks increase the size of their compliance budget whilst getting out
of, or being forced to turn down, business which was once extremely lucrative. In
effect, a tax is being imposed on banking activity whose incidence falls mainly
on the banks themselves: The wider social costs of this legislation are minimal
and it satisfies society's demand for justice in the wake of the crash of 2008
by clamping down on banks’ activity.
But is it all good or necessary? The US Dodd-Frank Act, for
example, comprises almost 14,000 pages and 15 million words. Nobody can possibly
know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically
the US Constitution, upon which a nation was built, contains just 4,543 words. Consider
also the EU’s MiFID II legislation due to come into effect next year which is designed
to offer greater protection for investors and inject more transparency across
the financial services industry. EU financial instruments which fall within its
scope will have to comply with the new regulations, irrespective of where they
are traded. One of the other aspects of the regulation is that it forces
sell-side institutions to charge money managers for their research, rather than
bundling it in with transaction fees, in order that money managers’ clients have
greater transparency over the fees they are charged (a topic I will deal with
another time).
Suffice to say this is a big deal for the European financial
services industry and has cost a lot of time and effort as banks and asset
managers gear up for it. But according to a recent Bloomberg report (here),
a lot of countries are struggling to be ready to implement the law in January. It
will potentially change the nature of the industry – never mind Brexit – and before anyone suggests that the UK will benefit by leaving the
EU, may I remind you that the UK was instrumental in driving through large
parts of the MiFID II legislation.
I confess that I have a vested interest in
this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry
anyway, it reinforces my view that large elements of the non-EU financial
services industry may simply expand their businesses in less heavily regulated
areas. Frankfurt may grab a piece of the London pie but in the longer term it
may well turn out only to be crumbs compared with what eventually relocates to
Singapore and Shanghai
It has been pretty evident to anyone with even a passing
interest in the subject that the Brexit negotiations are not going as planned.
The closeness of the referendum result in June 2016 reflected a country that
was split down the middle on the issue of EU membership, and in the subsequent
16 months the Conservative Party has all but torn itself apart. Theresa May’s
attempts to placate the hard Brexit faction within her own party has resulted
in a series of clumsy soundbites (“Brexit means Brexit” and “no deal is better
than a bad deal”) which fail to cover up the fact that the government does not
have a plan – or at least not one that is acceptable to the EU27 and the two
factions within the Conservative Party.
This has been compounded by an election which robbed the PM
of whatever authority she had, and as a result the EU27 is loath to accommodate
any demands the UK might make for fear that she will not be able to deliver at
home. With more than a quarter of the negotiation period mandated under the
Article 50 process having ebbed away, the UK is no further forward than in
March. If a scriptwriter had come up a parody of all that is wrong with modern
politics, they would have struggled to come up with a story as bizarre as the
one which is unfolding before us.
There are those who continue to believe that the EU needs
the UK more than vice versa. Indeed, a group of Brexit supporters has written
an open letter to Theresa May demanding that she commit the UK to trading under
WTO rules in the event that no deal with the EU27 is forthcoming because “no deal on trade is better than a deal which
locks the UK into the European regulatory system and takes opportunities off
the table.” Moreover, “it has become
increasingly clear that the European Commission is deliberately deferring
discussions on the UK’s future trading relationship with the EU27 post-Brexit.
The EU is taking this approach because they do not believe that the UK would be
prepared to go to WTO rules for our trading relationship with them.”
Owen Paterson MP argued in a radio interview this morning
(here starting at 1:09:10) that the EU27 has “simply
not taken up [Theresa May’s] generosity to discuss a future trading
relationship” following her Florence speech and it is time to take an
alternative approach. In Paterson’s view, this would give business “certainty”
as to the post-Article 50 trading arrangements. He also repeated the canard
that it is “massively” in the EU27 interests to do a deal on trade because “they run a huge surplus” with the UK.
Paterson argued that a fallback to WTO rules would allow the UK (and I emphasise
that I am quoting verbatim from the interview) to “immediately be able to grab the advantages of leaving the single
market, leaving the customs union and doing trade deals around the world
[and] sorting out our own regulation.” Yes, you did read correctly that
leaving the single market is somehow an advantage.
I am not sure which alternative reality Paterson (and other
signatories to the letter, including former Chancellor Nigel Lawson) are
inhabiting but it is not one that most economists recognise. When 47% of UK
exports go to the EU whilst 16% of EU27 exports go to the UK, it should be
pretty obvious where the balance of power lies – and the EU27 knows it. As for
giving clarity about future trading relationships by committing to WTO rules,
it would effectively give business the green light to think about alternatives
to investing in the UK. Moreover, on the assumption that the UK imposes
most-favoured-nation tariffs on imports from the EU, the Resolution Foundation
reckons that the basket of goods which makes up 40% of consumption would rise
in price by 2.7% which will hit the poorest households most hard. And of course
the WTO approach has little to say about how to deal with services where
non-tariff barriers are more important. Such an approach would clearly signal
to banks that the government is not serious about trying to arrange a
transition deal, which would hasten efforts to move business to other parts of
the EU – a process which is already underway.
Of course, none of this is new. These arguments were made in
the run-up to the referendum by Brexiteers who believe in the primacy of free
trade without acknowledging that the EU has other objectives and no incentive
to play ball. It is a sad indictment of the whole debate that the Leavers
continue to make the same hollow arguments. However, the evidence is mounting
that there is an economic cost. Why, for example, don’t our incomes stretch as
far as they once did? It’s mainly because the currency markets have taken a
negative view of the UK’s post-Brexit economic prospects and have forced down
the value of the pound, resulting in higher inflation and a real income
squeeze. It may not have been the economic disaster that was feared in summer
2016, but whilst we may not have dropped the frog in a pan of boiling water it
is in the pot and the heat is being turned up.
Those people who want Brexit at any price are blind to the
consequences of their actions. But equally, they fear that the UK will not
leave the EU as planned because they underestimated the complexities of doing
so and will be trapped in the exit lounge for longer than they desire. But even
if a transitional period is eventually granted which will give the UK an extra
two years to finalise a deal, it will not be long enough. As Joachim Lang,
managing director of the BDI, Germany’s chief business group told the FT, “it’s unrealistic to expect that we could
renegotiate rules within two years that evolved over the 40 years of Britain’s
EU membership.”
Theresa May will be told at today’s summit in Brussels that
“insufficient progress” has been made during the first phase of Brexit
negotiations and that the UK will not be rewarded with the start of any
discussions on trade. Brexit supporters are fearful because if no such deal is
forthcoming, their lies during the campaign will be found out. Many of us would
be only too happy to see them drive off the much-feared cliff edge – we just
don’t want to go down with them.
With interest rates trapped at the lower bound central
banks have in recent years adopted a policy of forward guidance to help markets
interpret what they were likely to do in the face of the incoming data flow. Its
success has been mixed. Recall the bond market “taper tantrum” in 2013 when the
Federal Reserve announced that it was about to slow down the pace of asset
purchases - though in fairness, this was more the result of a market which
panicked rather than the fault of the central bank. But so far this year the Fed has
more or less adhered to the message contained in the dot plot (see p3 here)
despite the market’s initial scepticism.
Arguably, the Bank of England’s efforts at forward guidance
have not been quite as successful, and in a week of important UK data releases
which may determine whether the BoE will soon raise rates, it is important to
understand the nature of the forward guidance message. In August 2013 the BoE
pledged “not to raise Bank Rate from its
current level of 0.5% at least until … the unemployment rate has fallen to a
threshold of 7%.” The BoE was clear that this was a conditional target,
subject to (i) CPI inflation 18 to 24 months ahead no more than 0.5 percentage
points above the 2% target; (ii) medium-term inflation expectations no longer
remaining sufficiently well anchored and (iii) the stance of monetary policy
posing a significant threat to financial stability. Even though unemployment
fell more rapidly than the BoE – and indeed, most other forecasters –
anticipated, none of the knockouts were ever triggered. Thus although policy
was conditional, it was never fully clear why the BoE did not raise rates once
the unemployment rate fell below 7%. Good arguments could be made for leaving
rates on hold but it rather defeated the purpose of the forward guidance
framework.
By February 2014 the BoE abandoned the simple mechanistic
link between monetary policy and unemployment in favour of a less easily defined
policy based on the nebulous concept of spare capacity. Since the measure of
spare capacity was determined by the BoE, this meant that outside observers
became increasingly reliant on the information feed from the MPC to determine
the future policy stance. The clarity of rule-based forward guidance policy was
lost. Later in 2014, at his Mansion House speech, Governor Carney suggested
that the first rise in interest rates “could
happen sooner than markets currently expect.” It didn’t. And to this day it
is difficult to explain why the rate hike did not happen other than the fact
that the BoE simply did not want to act before the Fed.
Last month “a majority
of MPC members judged that, if the economy continued to follow a path
consistent with the prospect of a continued erosion of slack and a gradual rise
in underlying inflationary pressure then, with the further lessening in the
trade-off that this would imply, some withdrawal of monetary stimulus was
likely to be appropriate over the coming months.” We know from this morning’s
parliamentary testimony that two Committee members (Dave Ramsden and Silvana
Tenreyro) are not part of that majority. We also know that four other members appear
to be edging towards an earlier rate increase whilst the view of the other three
is unknown.
Arguably, given the clarity of the message given in recent weeks,
the MPC needs to deliver sooner rather than later after having left markets
hanging in the past. Of course, “coming months” does not necessarily refer to November
(the next month in which an Inflation Report is released) – it could just as
easily be February (the following Inflation Report month). But the fact that
little has been done to dissuade the market of this view suggests that November
would be a good time to act. Leaving the door open until February runs the risk
that events could transpire which change the Bank’s priorities, and despite the
conditional nature of the policy decision, markets will see this as another occasion
on which it has cried wolf.
Policy credibility remains important to policymakers. An
absence of such credibility defeats the purpose of forward guidance. Whilst the
BoE can justifiably argue that forward guidance is conditional on economic
circumstances, it cannot continue to hide behind the Augustinian clause forever
(allow us to raise interest rates, but not just yet). Whether or not it is the
right time to consider a rate increase is almost irrelevant – my own view is
that the recent surge which has taken CPI inflation to 3% is not a good
justification for a policy tightening, driven as it is by a one-off sterling
depreciation. However, what matters is the consistency of the message. The
markets are hearing a very clear message: It would require a lot of explanation
on the BoE’s part if it were to pass up on a rate hiking opportunity.
In his poem The Second
Coming, WB Yeats wrote “Things fall
apart; the centre cannot hold; Mere anarchy is loosed upon the world.” It
was written in 1919 as an allegorical description of the state of European
politics in the wake of World War I. It is an apt description of where we are
today. Over recent years I have consistently made the point that the failure of
western governments to be honest with their electorate about the scale of the
economic challenges they face will ultimately be to their detriment. We have
seen this writ large in the form of the Brexit referendum and the election of Donald
Trump but it has also been seen in the strong performance of populist parties
in Dutch, French and German elections this year. It is thus interesting to look
at the vote shares of populist parties over recent years to assess the scale of
the problem.
The Swedish think tank Timbro notes that the share of the European populist vote, whether to the left or right of the political spectrum,
rose from around 8% in 2004 to 20% today (chart). As the authors of the study point out “in the 33 countries included in this index, there are a total of 7843 seats
in national parliaments … representatives
of illiberal and/or anti-democratic parties today hold 17.5% of all seats
within European national parliaments.” It is popularly believed that
populist parties advocate right-wing solutions – low taxes, smaller government
and opposition to immigration – but as Timbro points out, there has been a resurgence
of so-called radical left parties, particularly in those southern European
countries so badly affected by the euro zone crisis.
The flip side of the rise of radicalism, of course, is that
centrist ideas are squeezed out. To the extent that this has proven to be the
bedrock upon which the economic successes of the past 70 years have been based,
this has to be a cause for concern. Moreover, political extremists do not have
to hold office in order to wield influence. In Germany, for example, votes
gained by the AfD ate into the SPD’s vote share and prompted it to stand aside
from the coalition government, raising the likelihood that the FDP will form
part of the government. To the extent that the FDP does not necessarily share
Angela Merkel’s future vision of the EU this could have a major bearing on
whether Emmanuel Macron’s ideas on European reform will find acceptance in
Germany.
We see the same forces at work in the UK. UKIP has had very
little success in securing parliamentary representation yet it was one of the
prime grass roots motivators behind the Brexit referendum. The wider
consequences of the Brexit vote have yet to be realised but as Simon Nixon pointed
out in the Wall Street Journal last week,
whilst the Brits may have voted to leave the EU, they did not vote for a
revolution. But in effect, that is precisely what they have got. In his words “what makes Brexit so destabilizing is that
it shares two features common to revolutions. First, it has created a parallel
legitimacy, pitching the supposed ‘will of the people’ expressed in the
referendum against the traditional sovereignty of Parliament … Second, it has
created a power vacuum … [Brexiters] shook the economic order but without a
coherent plan as to what to put in its place.”
This resultant power vacuum at the heart of the UK government
is a major problem, for it is diverting energy away from the most pressing
issue of the day – how to ensure that Brexit does not tip the economy over the
cliff. Instead, we hear a constant stream of press stories suggesting that
ministers are fighting amongst themselves. Such is the apparent disarray that
the prime minister, who would like to see some form of transitional agreement with
the EU, cannot get her colleagues to fall in line. David Davis, the UK’s chief
negotiator, has thus been allowed to hold to his hard line in the negotiating
chamber with the result that at next week’s summit, the EU27 will almost
certainly decide that “insufficient progress” has been made during phase 1 of negotiations
to allow discussions on a trade deal to begin.
Most people in business are increasingly worried about the
implications of where the Brexit negotiations are headed as pessimism mounts. There
is also some evidence to suggest that voter preferences have changed, with the
share of those believing that voting to leave the EU was the wrong choice now sharply
higher than in the spring (chart). This may have something to do with the fact
that Brexit is not the easy option which voters were promised. It is also a
warning to those who are seduced by the simple policy prescriptions of
populists. If something were that easy, it would have been done already. Now,
Mr Trump, about that wall …
Economics is a social science and although many economists
do not like to admit it, it is bracketed alongside disciplines such as
anthropology and psychology. Indeed, in the second half of the eighteenth
century, when Adam Smith was setting out the principles of the invisible hand
so beloved in market analysis, psychology did not exist as a separate
discipline. The work of many of the early economists such as Smith and Jeremy
Bentham, was closely intertwined with issues which are now the preserve of academic
psychologists. Economics thus has deep roots in the field of psychology.
Despite the best efforts of the profession to move away from
the imprecision of psychological concepts, many of the paradigms explaining
economic behaviour failed to stand up to rigorous testing. Whilst these were
initially explained away as anomalies which did not negate the underlying assumptions, developments
in cognitive psychology from the 1960s began to be seen in some quarters as better
explanations of certain forms of economic behaviour. Over the last 20-30 years,
a number of these insights, derived from experimental psychology, have been
applied to economic and financial decision making as better explanations of behaviour
than the standard model. The new field of behavioural economics, for which Richard
Thaler this week won the 2017 Nobel Prize for economics, examines what happens
when we relax the assumptions of rationality and perfect information which
underpin much of modern macroeconomics.
Amongst the range of judgement and decision biases which clearly
violate the principle of rationality, behavioural economists have focused on
factors such as overconfidence, wishful thinking, conservatism, belief
perseverance, availability biases and anchoring (estimates based on an initial,
often random, value). Using a combination of empirical evidence and thought
experiments, academic researchers have demonstrated that some of these
characteristics are at work in driving the expectations formation process. For example,
evidence for the overconfidence hypothesis suggests that the confidence
intervals assigned to outcomes tend to be too narrow. In a famous 1974 paper,
Kahneman and Tversky
find evidence that whilst individuals often start off with an initial value in
making estimates of future values, they are often reluctant to make big
adjustments to this estimate when revising their assessment (the anchoring
problem). This might go some way towards explaining why economists are
reluctant to radically change their forecasts on a regular basis.
We could go on, but the point is made that there is enough
empirical evidence to challenge the rational expectations assumption and
thereby the idea that markets are efficient. This is a problem for many
economists to deal with, for they have often spent years learning to deal with the
sophisticated mathematics underpinning their stochastic models, which use
rational expectations as a convenient simplifying assumption. It is an even
bigger problem for the finance industry which spent many decades convincing
itself that prices adequately reflect all available information.
One of the great ironies of a trading environment is that if
rationality is common knowledge, there ought to be relatively little trading
since a rational investor should be reluctant to buy if another investor is
willing to sell. But the converse is true since the trading volume on world
exchanges continues to rise. Indeed, much of the empirical evidence suggests
that traders would make higher returns if they trade less frequently. Moreover,
the same body of research indicates that investors are unwilling to sell assets
which trade at a loss relative to the price at which they were purchased – behaviour
which may well reflect an irrational belief in mean-reversion.
There are also clear patterns in purchasing decisions where
there is evidence to suggest that investors buy stocks which have previously
been big winners (in the hope that this performance will be repeated) or big
losers (in the expectation of mean reverting performance). Neither of these is
consistent with rational behaviour, but one reason why investors may follow
such strategies is that they do not have time to systematically analyse the
whole range of stocks. The choice of which to sell is limited to the range of
stocks currently owned, but the range of stocks from which investors can choose
to buy is enormous, and they are attracted to the outliers in what is known as
the attention effect.
Clearly, markets display characteristics at odds with
efficiency and expectations are not always formed rationally. The world thus
owes a debt to Thaler and his colleagues for pointing out some of the
absurdities in conventional economic thinking. Behavioural economic does not
have all the answers. In the minds of many people it is just a collection of
theories which can only ever be tested on small samples and thus its wider
applicability is limited. But to the extent that it makes us think about some
of the reasons why economics has not always come up with the right answers, Thaler’s
award is well deserved.
A couple of months ago I wrote a post (here) which posed the
question whether we knew what was really driving inflation.
Last month, Claudio Borio, head of the Economic and Monetary Department at the
BIS, delivered a speech (here) asking a similar question.
Borio raised three key issues:
- Is inflation always and everywhere a monetary
phenomenon, as claimed by Milton Friedman? Or do real factors play a much
bigger role than often assumed?
- Are we underestimating the influence that monetary
policy has on real interest rates over longer horizons?
- If these two claims are true, does it then follow that
central banks should place less emphasis on inflation in designing monetary
policy, and more on the longer term effects of monetary policy on the real
economy through its impact on financial stability?
In short, Borio's answer to these questions is broadly yes.
In the case of (1) he argues persuasively that the forces driving inflation are
increasingly global, rather than local, with technological change and the entry
of billions of new workers into the global workforce as a result of
globalisation being primary contributory factors. Ironically, the economics
profession generally believes that immigration has little impact on local wages
but that raising the global supply of labour impacts upon global wages. That is
a circle which needs to be properly squared.
With regard to (2), Borio uses a range of historical
examples to indicate that the impact of monetary policy, via its influence on expectations,
can have far longer-lasting implications on the real economy than is
conventionally supposed. In other words the neutrality of money, which forms a
key assumption underpinning much of modern macroeconomics, can be called into
question. The logical conclusion is thus that a monetary policy purely focused
on inflation can have dangerous side effects which cannot be ignored. Indeed,
Borio argues for the "desirability
of great tolerance for deviations of inflation from point targets while putting more weight on
financial stability."
I find this set of arguments highly convincing. Indeed, it
is difficult to dismiss the thought that QE, which reduces interest rates and
prompts a bubble in the price of other assets, ultimately impacts upon decision
making in the real economy. For example, it prompts indebted firms to issue
additional debt to fund capital expansion – hence the boom in the high yield
debt market – which may ultimately come to a sticky end if interest rates start
to rise.
A further suspicion is that the current monetary policy model
is merely the latest in a long line of fads which may well be junked when (or
if) it proves not to work. This chimes with the view expressed by Charles
Goodhart
who has pointed out that since the 1950s there have been broadly three fashions
in policy. From the 1950s to the mid-1970s, monetary policy was focused on
labour markets and the bargaining power of unions. As the economics profession
increasingly realised that simple Phillips curve analysis was insufficient to
explain the relationship between inflation and unemployment, policy between the
late-1970s until the 1990s switched to looking at money and monetary
aggregates. But as this approach also failed to deliver control of inflation,
the thrust of central bank policy switched to the NAIRU and the influence of
expectations. But if Borio is right, this may simply be another in the long
line of transitory policy fashions if it proves to have adverse longer term
consequences which require more rapid-than-desired policy adjustment.
Indeed, central bankers will readily agree in private that
they do not know what are the long-term implications of the current monetary
approach. In particular, the impact of low interest rates on depressing pension
returns is a problem which will only become apparent over a multi-year horizon.
In effect, society has been forced to choose between protecting employment and
labour income today at the expense of lower pension returns tomorrow. The jury
is out as to whether it is a worthwhile trade off.
The question of whether the BoE should raise interest rates
in the near-term should be seen in this context. On the one hand, there is a
strong case for suggesting that rates are too low given the overall
macroeconomic picture which is helping to exacerbate asset price distortions.
But it is less clear that inflation should be the trigger for higher rates.
Admittedly, inflation is running well above the 2% target. But wages remain
muted and given the backdrop of Brexit-related uncertainty, they are likely to
remain so.
It is hard to avoid the suspicion that justifying a monetary
tightening on the back of inflation is a convenience which the general public
can readily understand. Whilst households may not like it, higher rates may in
fact be in the best interests of the economy. Not because there is an inflation
problem, but because it might be the first step on the road towards taking some
of the air out of the asset bubble which has built up in recent years. It may
also help to give us a little bit more retirement income too.
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 “21st 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.
