The Wages of Economic Ignorance

Robert Skidelsky.



LONDON – Politicians are masters at “passing the buck.” Everything good that happens reflects their exceptional talents and efforts; everything bad is caused by someone or something else.
The economy is a classic field for this strategy. Three years after the global economy’s near-collapse, the feeble recovery has already petered out in most developed countries, whose economic inertia will drag down the rest. Pundits decry a “double-diprecession, but in some countries the first dip never ended: Greek GDP has been dipping for three years.

When we ask politicians to explain these deplorable results, they reply in unison: “It’s not our fault.” Recovery, goes the refrain, has been “derailed” by the eurozone crisis. But this is to turn the matter on its head. The eurozone crisis did not derail recovery; it is the result of a lack of recovery. It is the natural, predictable, and (by many) predicted result of the main European countries’ deliberate policy of repressing aggregate demand.

That policy was destined to produce a financial crisis, because it was bound to leave governments and banks with depleted assets and larger debts. Despite austerity, the forecast of this year’s UK structural deficit has increased from 6.5% to 8% – requiring an extra £22 billion ($34.6 billion) in cuts a year.
Prime Minister David Cameron and Chancellor George Osborne blame the eurozone crisis; in fact, their own economic illiteracy is to blame.
Unfortunately for all of us, the explanation bears repeating nowadays. Depressions, recessions, contractionscall them what you willoccur because the private-sector spends less than it did previously. This means that its income falls, because spending by one firm or household is income for another.
In this situation, government deficits rise naturally, as tax revenues decline and spending on unemployment insurance and other benefits rises. These “automatic stabilizersplug part of the private-sector spending gap.

But if the government starts reducing its own deficit before private-sector spending recovers, the net result will be a further decline in total spending, and hence in total income, causing the government’s deficit to widen, rather than narrow. True, if governments stop spending altogether, deficits will eventually fall to zero. People will starve to death in the interim, but the budget will be balanced.

That is the crazy logic of current economic policy in much of Europe (and elsewhere). Of course, it will not be carried through to the bitter end. Too much will crack along the way – the banks, the monetary system, social cohesion, the legitimacy of the political regime. Our leaders may be intellectually challenged, but they are not suicidal.

Deficit reduction eventually will be put into cold storage, either openly, as I would prefer, or surreptitiously, as is politicians’ way. In the United Kingdom, there is already talk of Plan A +.

Those who see the need for such a growth strategy, but who also want to help their friends, like the idea of tax cuts – especially for the rich. This knocks a hole in current deficit-reduction plans, but, provided government continues to cut spending, it has the benefit (from a conservative’s point of view) of shrinking the state’s role over time.

Apart from questions of fairness, cutting top tax rates is an inferior way to increase spending, because the rich have a higher propensity to save. Tax reductions should be targeted specifically at the poor if one wants the money to be spent to stimulate the economy.

In fact, the best option of all is for the government to spend the money itself. Governments can do this consistently with a medium-term deficit-reduction plan by making a crucial distinction between their budgets’ current and capital accounts. The current account covers spending on services and perishable goods that produce no assets. The capital account is for buying or building durable assets that give a prospective future return. The first is a charge on taxation; the second is not.

If today’s accounting rules are too insensitive to make this distinction, a separate entity could do the investing. A national investment bank would be capitalized by the government, borrow from the private sector, and invest in infrastructure, housing, and “greening” the economy. This would simultaneously plug a hole in demand and improve the economy’s long-term growth prospects. There are signs that officials in the UK and the United States are starting to move in this direction.

If nothing works, it will be time to sprinkle the country with what Milton Friedman calledhelicopter money” – that is, put purchasing power directly into people’s pockets, by giving every household a spending voucher with an expiration date. This would at least keep the economy afloat pending the development of the longer-term investment program.

It would be better if such schemes could be agreed upon by all by G-20 countries, as was briefly the case in the coordinated stimulus of April 2009. If not, groups of countries should pursue them on their own.

The European Union desperately needs a growth strategy. Its current bailout schemes only help countries like Greece and Italy to borrow money cheaply in the face of prohibitively high market interest rates, while the schemes’ insistence on more budget-deficit reduction in these countries will reduce European purchasing power further. The recipient governments will have to cut their spending; the banks will have to take large losses.

In the long run, the eurozone must be recognized as a failed experiment. It should be reconstituted with far fewer members, including only countries that do not run persistent current-account deficits.

Everything else that has been proposed to save the eurozone in its current form – a central treasury, a monetary authority that does more than target inflation, fiscal harmonization, a new treaty – is a political pipe dream.
Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

Note from the editor

The case for gold in the eurozone bail-out

By Jack Farchy

Tuesday November 22 2011

Ever since the eurozone bond markets first started to get the jitters, hedge fund managers have been whispering that gold could play a part in resolving the crisis.

Until recently, this discussion has mainly been the preserve of gold market conspiracy theorists and backbench German politicians.

But now the use of gold to fund a eurozone bail-out is coming closer to reality. Buried within a draft of the European Commission study on jointeurobonds’, reported by the FT this week, is the suggestion that yellow metal could be used as collateral for these bonds.

In order to “enhance” the guarantees on the eurobonds, the draft says, governments could provide collateral, including “gold reserves which are largely in excess of needs in most EU countries”.

Between them, the central banks of the eurozone hold 10,792 tonnes of gold6.5 per cent of all the yellow metal that has ever been minedworth some $590bn.

Let’s be clear: this does not imply central banks are getting ready to sell gold to bail out the eurozone. Beyond the numerous legal problems (selling reserves to fund government borrowing contravenes the Maastricht treaty), gold disposals just looks too desperate.

But bullion could be used as collateral. In fact, if Europe’s politicians truly believe that the problems of larger eurozone countries such as Italy are based on liquidity rather than solvency, the use of gold as collateral could be a neat way to regain the confidence of the bond markets.

For prospective investors (no doubt including emerging market governments, sovereign wealth funds, and the like) the appeal comes from the likely hedge that the gold would provide against a default. If a country like Italy were to default, most analysts believe, the price of gold (certainly when denominated in euros) would go sky high.

For eurozone countries, gold-collateralised bonds could unlock a large pool of new financing. Italy’s central bank, for example, holds 2,451 tonnes of gold, worth roughly €100bn. While that pales in comparison to its total debt stock of nearly €2,000bn, it could alleviate some of the short-term funding pressure.

Italy needs to raise about €600bn over the next three years. If it used the gold as collateral for the first 20 per cent of the new bonds, therefore, it could cover its needs until mid-2014. A successful sale of the gold-backed debt would create a virtuous circle, making it easier to raise money through non-collateralised borrowing.

Such a deal has precedents. Indeed, Italy has done it before, when it received a $2bn bail-out from the Bundesbank in 1974 and put up its gold as collateral.

In 1991, India used its gold as collateral for a loan with the Bank of Japan and others.

And in 2008, according to the World Gold Council, Sweden’s Riksbank swapped its gold to raise cash and provide liquidity to the Scandinavian banking system.

As Paul Mercier, then deputy director of market operations at the ECB, told a gold industry conference in 2009: “In a generalised crisis that leads to the repudiation of foreign debts or even the international isolation of a country […]gold remains the ultimate and global means of payment that is still accepted and it is one of the reasons used by some central banks to justify gold holdings.”

The problem is, as that statement implies, that countries have historically turned to their gold reserves only in the direst of situations. And lenders are likely to require that the gold is moved to a neutral location. India’s move to ship 47 tonnes to the Bank of England in its 1991 deal caused outrage within the country.

Nonetheless, as the eurozone crisis grinds into its third year, it might just be time to dust off those Roman coins in the Banca d’Italia’s vaults.

November 20, 2011

How China Can Defeat America


WITH China’s growing influence over the global economy, and its increasing ability to project military power, competition between the United States and China is inevitable. Leaders of both countries assert optimistically that the competition can be managed without clashes that threaten the global order.

Most academic analysts are not so sanguine. If history is any guide, China’s rise does indeed pose a challenge to America. Rising powers seek to gain more authority in the global system, and declining powers rarely go down without a fight. And given the differences between the Chinese and American political systems, pessimists might believe that there is an even higher likelihood of war.

I am a political realist. Western analysts have labeled my political viewshawkish,” and the truth is that I have never overvalued the importance of morality in international relations. But realism does not mean that politicians should be concerned only with military and economic might. In fact, morality can play a key role in shaping international competition between political powers — and separating the winners from the losers.

I came to this conclusion from studying ancient Chinese political theorists like Guanzi, Confucius, Xunzi and Mencius. They were writing in the pre-Qin period, before China was unified as an empire more than 2,000 years ago — a world in which small countries were competing ruthlessly for territorial advantage.

It was perhaps the greatest period for Chinese thought, and several schools competed for ideological supremacy and political influence. They converged on one crucial insight: The key to international influence was political power, and the central attribute of political power was morally informed leadership. Rulers who acted in accordance with moral norms whenever possible tended to win the race for leadership over the long term.

China was unified by the ruthless king of Qin in 221 B.C., but his short-lived rule was not nearly as successful as that of Emperor Wu of the Han dynasty, who drew on a mixture of legalistic realism and Confuciansoft power” to rule the country for over 50 years, from 140 B.C. until 86 B.C.

According to the ancient Chinese philosopher Xunzi, there were three types of leadership: humane authority, hegemony and tyranny. Humane authority won the hearts and minds of the people at home and abroad. Tyranny — based on military forceinevitably created enemies. Hegemonic powers lay in between: they did not cheat the people at home or cheat allies abroad. But they were frequently indifferent to moral concerns and often used violence against non-allies. The philosophers generally agreed that humane authority would win in any competition with hegemony or tyranny.

Such theories may seem far removed from our own day, but there are striking parallels. Indeed, Henry Kissinger once told me that he believed that ancient Chinese thought was more likely than any foreign ideology to become the dominant intellectual force behind Chinese foreign policy.

The fragmentation of the pre-Qin era resembles the global divisions of our times, and the prescriptions provided by political theorists from that era are directly relevant today — namely that states relying on military or economic power without concern for morally informed leadership are bound to fail.

Unfortunately, such views are not so influential in this age of economic determinism, even if governments often pay lip service to them. The Chinese government claims that the political leadership of the Communist Party is the basis of China’s economic miracle, but it often acts as though competition with the United States will be played out on the economic field alone. And in America, politicians regularly attribute progress, but never failure, to their own leadership.

Both governments must understand that political leadership, rather than throwing money at problems, will determine who wins the race for global supremacy.

Many people wrongly believe that China can improve its foreign relations only by significantly increasing economic aid. But it’s hard to buy affection; such “friendship” does not stand the test of difficult times.

How, then, can China win people’s hearts across the world? According to ancient Chinese philosophers, it must start at home. Humane authority begins by creating a desirable model at home that inspires people abroad.

This means China must shift its priorities away from economic development to establishing a harmonious society free of today’s huge gaps between rich and poor. It needs to replace money worship with traditional morality and weed out political corruption in favor of social justice and fairness.

In other countries, China must display humane authority in order to compete with the United States, which remains the world’s pre-eminent hegemonic power. Military strength underpins hegemony and helps to explain why the United States has so many allies. President Obama has made strategic mistakes in Afghanistan, Iraq and Libya, but his actions also demonstrate that Washington is capable of leading three foreign wars simultaneously. By contrast, China’s army has not been involved in any war since 1984, with Vietnam, and very few of its high-ranking officers, let alone its soldiers, have any battlefield experience.

America enjoys much better relations with the rest of the world than China in terms of both quantity and quality. America has more than 50 formal military allies, while China has none. North Korea and Pakistan are only quasi-allies of China. The former established a formal alliance with China in 1961, but there have been no joint military maneuvers and no arms sales for decades. China and Pakistan have substantial military cooperation, but they have no formal military alliance binding them together.

To shape a friendly international environment for its rise, Beijing needs to develop more high-quality diplomatic and military relationships than Washington. No leading power is able to have friendly relations with every country in the world, thus the core of competition between China and the United States will be to see who has more high-quality friends. And in order to achieve that goal, China has to provide higher-quality moral leadership than the United States.

China must also recognize that it is a rising power and assume the responsibilities that come with that status. For example, when it comes to providing protection for weaker powers, as the United States has done in Europe and the Persian Gulf, China needs to create additional regional security arrangements with surrounding countries according to the model of the Shanghai Cooperation Organization — a regional forum that includes China, Russia and several central Asian countries.
And politically, China should draw on its tradition of meritocracy. Top government officials should be chosen according to their virtue and wisdom, and not simply technical and administrative ability.

China should also open up and choose officials from across the world who meet its standards, so as to improve its governance.

The Tang dynasty — which lasted from the 7th century to the 10th and was perhaps China’s most glorious period employed a great number of foreigners as high-ranking officials. China should do the same today and compete with America to attract talented immigrants.

OVER the next decade, China’s new leaders will be drawn from a generation that experienced the hardships of the Cultural Revolution. They are resolute and will most likely value political principles more than material benefits. These leaders must play a larger role on the world stage and offer more security protection and economic support to less powerful countries.

This will mean competing with the United States politically, economically and technologically. Such competition may cause diplomatic tensions, but there is little danger of military clashes.

That’s because future Chinese-American competition will differ from that between the United States and the Soviet Union during the cold war. Neither China nor America needs proxy wars to protect its strategic interests or to gain access to natural resources and technology.

China’s quest to enhance its world leadership status and America’s effort to maintain its present position is a zero-sum game. It is the battle for people’s hearts and minds that will determine who eventually prevails. And, as China’s ancient philosophers predicted, the country that displays more humane authority will win.
Yan Xuetong, the author of “Ancient Chinese Thought, Modern Chinese Power,” is a professor of political science and dean of the Institute of Modern International Relations at Tsinghua University. This essay was translated by Zhaowen Wu and David Liu from the Chinese.


The Neuroeconomics Revolution

Robert J. Shiller


NEW HAVEN – Economics is at the start of a revolution that is traceable to an unexpected source: medical schools and their research facilities. Neuroscience – the science of how the brain, that physical organ inside one’s head, really works – is beginning to change the way we think about how people make decisions. These findings will inevitably change the way we think about how economies function. In short, we are at the dawn of “neuroeconomics.”
Efforts to link neuroscience to economics have occurred mostly in just the last few years, and the growth of neuroeconomics is still in its early stages. But its nascence follows a pattern: revolutions in science tend to come from completely unexpected places. A field of science can turn barren if no fundamentally new approaches to research are on the horizon. Scholars can become so trapped in their methods – in the language and assumptions of the accepted approach to their discipline – that their research becomes repetitive or trivial.

Then something exciting comes along from someone who was never involved with these methodssome new idea that attracts young scholars and a few iconoclastic old scholars, who are willing to learn a different science and its different research methods. At a certain moment in this process, a scientific revolution is born.

The neuroeconomic revolution has passed some key milestones quite recently, notably the publication last year of neuroscientist Paul Glimcher’s book Foundations of Neuroeconomic Analysis – a pointed variation on the title of Paul Samuelson’s 1947 classic work, Foundations of Economic Analysis, which helped to launch an earlier revolution in economic theory. And Glimcher himself now holds an appointment at New York University’s economics department (he also works at NYU’s Center for Neural Science).

To most economists, however, Glimcher might as well have come from outer space. After all, his doctorate is from the University of Pennsylvania School of Medicine’s neuroscience department. Moreover, neuroeconomists like him conduct research that is well beyond their conventional colleagues’ intellectual comfort zone, for they seek to advance some of the core concepts of economics by linking them to specific brain structures.

Much of modern economic and financial theory is based on the assumption that people are rational, and thus that they systematically maximize their own happiness, or as economists call it, their “utility.” When Samuelson took on the subject in his 1947 book, he did not look into the brain, but relied instead on “revealed preference.” People’s objectives are revealed only by observing their economic activities. Under Samuelson’s guidance, generations of economists have based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.
As a result, Glimcher is skeptical of prevailing economic theory, and is seeking a physical basis for it in the brain. He wants to transform softutility theory into “hardutility theory by discovering the brain mechanisms that underlie it.
In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest expected subjective value’.”

While Glimcher and his colleagues have uncovered tantalizing evidence, they have yet to find most of the fundamental brain structures. Maybe that is because such structures simply do not exist, and the whole utility-maximization theory is wrong, or at least in need of fundamental revision. If so, that finding alone would shake economics to its foundations.

Another direction that excites neuroscientists is how the brain deals with ambiguous situations, when probabilities are not known, and when other highly relevant information is not available. It has already been discovered that the brain regions used to deal with problems when probabilities are clear are different from those used when probabilities are unknown. This research might help us to understand how people handle uncertainty and risk in, say, financial markets at a time of crisis.
John Maynard Keynes thought that most economic decision-making occurs in ambiguous situations in which probabilities are not known. He concluded that much of our business cycle is driven by fluctuations in “animal spirits,” something in the mind – and not understood by economists.
Of course, the problem with economics is that there are often as many interpretations of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regulations, business practices and customs, and balance sheets, among many other details.
Yet it is likely that one day we will know much more about how economies work – or fail to work – by understanding better the physical structures that underlie brain functioning. Those structures networks of neurons that communicate with each other via axons and dendritesunderlie the familiar analogy of the brain to a computer networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connections.
The brain, the computer, and the economy: all three are devices whose purpose is to solve fundamental information problems in coordinating the activities of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.

Robert Shiller, Professor of Economics at Yale University, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

The ‘do nothing’ solution to America’s fiscal crisis

Bruce Bartlett

November 22, 2011

To many, the budgetary gridlock in the US may appear as intractable as that in Europe. But the reality is that the American situation is vastly more favourable. The reason is that the Congress has already passed laws sufficient to permanently fix its budgetary problem and put the nation’s finances on a stable path. All that is necessary is to do nothing and to let the laws on the books take effect.

As is well known, America’s most serious budgetary problem is Medicare, the national health programme for the elderly. Its spending has been growing faster than the economy for years, a key reason why total US health spending as a share of gross domestic product is double that of countries like the UK.

Back in 1997 Republicans and Democrats joined together to implement a programme that would permanently restrain the growth of Medicare spending. The key provision limited payments to doctors to those established by a formula called ‘the sustainable growth rate.

The SGR formula worked fine for a few years, but as soon as it began to bite in 2003, Congress intervened to prevent doctors’ fees from being cut. It has continued to do so every year since. This annual exercise is known in Washington as the ‘doc-fix.
But the original law remains in force. If it were simply allowed to take effect without congressional interference, payment to doctors for Medicare services would be cut by 30 per cent on January 1.

That’s not likely to happen. But if Congress would just rebase the SGR formula to this year, and allow it to operate going forward, it would save about $300bn over the next ten years, plus another $50bn in debt service.

On the revenue side, a large number of tax cuts enacted since 2001 are scheduled to expire at the end of this year and next year. There is also a tax provision called ‘the alternative minimum tax that has also been subject to an annual congressional fix to keep it from impacting too many taxpayers.

The largest of the expiring tax cuts are those enacted in 2001 and 2003 that cut the top income tax rate from 39.6 per cent to 35 per cent and reduced the rate on dividends and capital gains to just 15 per cent, among other things. These were previously scheduled to expire at the end of 2010, but at the last minute Barack Obama agreed to extend them for two years.

The so-called Bush tax cuts are now scheduled to expire at the end of next year. The Congressional Budget Office estimates that allowing them to expire on schedule, as well as foregoing another minimum tax fix, will raise revenues by almost $4,000bn through 2021, plus saving almost $700bn in debt service.
Finally, there are $1,200bn in cuts for discretionary spending programmes, including national security, which will take effect automatically unless Congress comes up with a different deficit reduction package of equal size. A special congressional committee has been working for six weeks to come up with such a package by November 23.
On Monday, the Joint Select Committee on Deficit Reduction announced that it could not agree on a viable alternative, thus leaving in place a $1,200bn spending cut beginning in 2013.

Thus we see that laws already in force would reduce projected deficits by approximately $5,500bn over the next ten years, plus another $1,000bn in debt service savings. This is not enough to balance the budget, but it is sufficient to stabilise the debt to GDP ratio at its current level of about 60 per cent.

The problem, of course, is that neither Congress nor the White House has shown any inclination to allow the laws on the books to take effect. There are reasonable concerns about allowing a large fiscal contraction to take effect when the economy is still fragile, and it’s not hard to come up with better ways of reducing the deficit than those now scheduled to take effect.

But the main constraint is politics. With the big scheduled spending cuts and tax increases taking effect in 2013, neither party is anxious to promise specific austerity measures going into next year’s presidential election. Everyone hopes their hand will be strengthened by voters and the burden of fiscal adjustment can be shifted elsewhere.

The fact remains that no new laws are needed to get the US on a stable fiscal course. At least as a political matter, this suggests that the prospects for deficit reduction are better in the US than Europe, where legislation still needs to be enacted to get debt under control.
The writer was a Treasury department and White House official in the Ronald Reagan and George H.W. Bush administrations. His book on tax reform, ‘The Benefit and the Burden’, will be published in January.