Thatcherism did actually make Britain richer, compared to everyone else

A new report by economists at Cambridge University’s Centre for Business Research purports to show that the post-1979 liberal reforms introduced by the Thatcher government did not boost the British economy.

In a sense, that’s true. As the report shows, trend GDP growth and productivity were slower in the thirty years after 1980 than the thirty years before that. I hadn’t realised that this was new information, but OK.

The problem with the report is that it mostly looks at the UK in isolation. What it doesn’t mention is that this slowdown in trend growth was a global phenomenon. The real question should be how the UK did relative to the rest of the developed world.

Taking the US as a benchmark – the ‘technology frontier’ – the best any major economy can hope to do, basically – I’ve compared GDP per capita, adjusted for purchasing power parity, of France, Germany, Italy and the UK (German numbers include East Germany after 1991, so I’d more or less ignore them after that point). The UK is purple:

 

rawdata

And here’s those countries’ relative performance, indexed to where they were in 1980. What we see is the UK’s position basically not changing until 1980, with (West) Germany, France and Italy all converging on the US up to that point, then stagnating or declining slightly afterwards:

 

2indexedto1980pre1980

 

In this relative picture, the UK’s economic performance looks a lot better post-1980. There is a clear inflection point in the early 1980s where the UK begins to converge on the US, with GDP per capita as a percentage of the US’s rising sixteen percentage points from 66% to 82% in 2010. In 1950 the UK GDP per capita was 69% that of the US’s. The highest it was during the pre-Thatcher period was 73%, in 1961.

France, on the other hand, falls ten percentage points from 86% in 1980 to 76% today. Germany doesn’t do much until the end of the 1980s, when political events render the data basically useless. Italy’s decline tracks France’s closely. In every case the UK improves relatively, and of course with the US at 100 the UK is improving relative to them, too.

This is probably mostly to do with labour force participation rates, not productivity. That might mask the true welfare situation: I might be much better off retiring early, but that would make me appear poorer and reduce GDP. But it still points to a large change that seems to have happened in 1980 that the report’s authors virtually ignore.

I say “virtually” because they do, actually, show this comparison in their report, it’s just hard to find. In a report with over thirty charts, all but one start during the postwar period. The only chart that doesn’t is this one – which, weirdly, starts in 1880. I cannot understand why, but it does make the UK’s relative recovery much more difficult to spot.

It is quite interesting that the Thatcher reforms don’t seem to have boosted trend productivity by very much. As Pseudoerasmus notes, there doesn’t seem to be anything the UK can do to reach US levels of GDP per capita, and the Thatcher reforms only really brought Britain up to European levels of wealth. It looks as if boosting trend growth, not just playing catch-up, is really, really hard.

Ed Miliband is right: in-work poverty is the scourge of our time

Ed Miliband has given his first Commons speech since losing the election, where he’s focused on inequality and low pay in Britain. He’s almost entirely wrong on the first of those, in my view, not least because most of the problems he identifies come from perceptions of inequality, which are not driven by reality.

But on low pay, he makes an important point. In-work poverty really does appear to be the scourge of our time, and free marketeers ignore it at their peril.

By poverty, I do not mean relative poverty, although that is the definition the government uses to define the word. (A household is defined as in poverty if it earns less than 60 percent of the median wage.) I prefer the approach of the IEA’s Kristian Niemietz and the Joseph Rowntree Foundation, which calculates the cost of a basket of goods that most people would consider essential to living a decent life in modern Britain.

This approach is in the spirit of Adam Smith’s conception of poverty:

A linen shirt … is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably though they had no linen. But in the present times, through the greater part of Europe, a creditable day-labourer would be ashamed to appear in public without a linen shirt, the want of which would be supposed to denote that disgraceful degree of poverty which, it is presumed, nobody can well fall into without extreme bad conduct.

According to the JRF, single working-age people need to earn at least £17,100 before tax to live decently; a couple with two children need to earn £20,200 each (versus £13,900 in 2008), and a lone parent with one child now needs to earn more than £27,100 (versus £12,000 in 2008).

Because real wages have fallen across the board since 2008, and the cost of living has risen, an increasing number of people in full-time jobs are still in poverty. My fear is that this is not simply a product of the financial crisis and Great Recession, but a reflection of a longer-term trend.

Wages usually reflect worker productivity, so simply jacking up the minimum wage is no solution to this. Any worker who is less productive than the minimum wage costs will just not be able to find a job. In general, when minimum wages rise, so does unemployment. So there is no simple way to boost workers’ incomes by forcing wages up.

Changes like automation and offshoring work (to call centres in India, for instance) will raise global living standards overall, and should be welcomed for that reason, but they may hurt the incomes of low-skilled British workers by increasing competition for the jobs they have been doing and leaving only relatively unproductive work left to be done. Some people say low-skilled immigration does the same, but labour market liberalization seems to be a tidy solution to that problem.

The techno-pessimist view that machines may simply replace workers in some jobs, without creating new ones for them to move into, is not impossible or even particularly unlikely. Even if it is wrong, improvements in automation or competition from abroad may make low-skilled workers’ marginal productivity too low to earn a decent amount. Their productivity might just not be enough to earn as much as we would like them to.

As I see it, there are three possible ways we could reduce in-work poverty:

  1. Reduce the cost of living. Instead of trying to raise workers’ take-home pay, we could reduce the cost of things they want to buy. Housing and childcare are two of the most expensive things in most people’s budgets. Housing could be made much cheaper if the supply of housing was increased by liberalising planning. Britain has the tightest staff:child ratio requirements in Europe, and in a labour-intensive industry like childcare that has driven costs extremely high. Allowing as many children per staff member as they do in, say, Denmark would let costs fall considerably. However, both of these reforms, as well as most other supply-side deregulations, face considerable political opposition.
  2. Cut taxes on low-income earners. The government has already pledged to raise the income tax threshold to be close to the minimum wage level. But National Insurance payments kick in at a much lower level – £155 a week, or 23 hours of minimum wage work. Raising this threshold, ideally to kick in after forty hours of minimum wage work, should be a major priority. But the higher the threshold goes, the fewer of the poorest people it helps, because they are already earning less than the threshold amount.
  3. Just give money to poor people. Whether we do it through something like a Negative Income Tax, a Basic Income, or a significantly simplified and reformed tax credits system, direct cash transfers seem to be a good way of boosting the incomes of the poor without messing markets up in other ways. If they are only conditional on income, they can be designed to avoid severely perverted incentives that exist in the current welfare system. But paying for this would mean major changes to existing benefits system, which the Universal Credit reforms have shown are a minefield. There is also a danger that this kind of system would be implemented as a costly addition to existing welfare payments, rather than a revenue-neutral replacement.

In practice, some combination of the three is probably our best bet. There is no single political grouping that favours all three of these policies; indeed the false solution of massive minimum wage hikes is popular across the political spectrum.

This is worrying, but there is so much evidence against it that it will surely fail, and accepting that we have a problem may be the first step to solving it. So, in highlighting low pay as one of the central problems of the 21st Century, allow me to say something rarely heard on this blog: Ed Miliband is right.

The Living Wage is a false solution to our problems

I normally agree with the Centre for Policy Studies on economic issues, so I was surprised to see Adam Memon’s call for a mandatory ‘Living Wage’ last week. Philip Booth has already written a post criticising Memon’s original piece, but I’d like to add my perspective to Adam’s response to Philip, posted today.

To be clear, Adam prefers “tax cuts, deregulation and other supply-side measures to boost productivity”. He and the CPS have long argued for tax cuts for the poor. This is admirable, and as Adam says it deserves to be acknowledged.

My main contention is that Adam is comparing apples with oranges by using the impact of historical increases in the National Minimum Wage (NMW) to justify a future rise to the NMW to Living Wage levels. There is a lot of evidence against his position that he ignores.

Adam says that “an objective reading of the studies of the impact of the National Minimum Wage can only lead to the conclusion that it has boosted the incomes of the low paid without particularly damaging employment”. Correct. There does not seem to be much, if any, good evidence that the NMW has increased unemployment in the UK.

But this doesn’t tell us that employment would not be higher without rises to the minimum wage. Simply looking at times when we have raised the NMW, and looking at whether unemployment has risen or not, as Adam does once, is extremely crude – there are of course many other factors going on, and without an analysis that attempts to control for those factors we have no idea what the counterfactual would be. But, yes, there have been more sophisticated studies in the UK that do suggest that the NMW has not harmed employment compared to there being no NMW.

Adam says that “This is quite a big deal because it does rather make the traditional argument that the minimum wage would destroy jobs somewhat out-of-date”. But, unless we think there is something particularly unique about the UK’s labour market, the UK is not the only place we have to look at.

Internationally, most of the evidence is that increases in the minimum wage do increase unemployment at the margin. I looked at some of this last year:

Neumark and Wascher’s review of over one hundred studies found that two-thirds showed a relatively consistent indication that minimum wage increases cause increases in unemployment. Of the thirty-three strongest studies, 85 per cent showed unemployment effects. And “when researchers focus on the least-skilled groups most likely to be adversely affected by minimum wages, the evidence for disemployment effects seems especially strong”. There is evidence that suggests that minimum wages deter young workers from acquiring these skills that allow them to get better jobs in the long run.

Of course there are times when this does not happen, but most of the time it does. Most of this evidence is based on US data, and much of it compares employment rates in similar US states where one has had a minimum wage rise and the other has not.

Though UK evidence might be the most relevant evidence we have, we would need a very good reason to completely ignore the international evidence and suppose that the UK experience is all that we should look at.

I am certain that Adam agrees, because he has cited international evidence in discussions about the UK in the past. And rightly so.

Is the UK special? Maybe. But the Low Pay Commission seems to disagree, because its recommended increases have been very low compared to what Adam is proposing. Similarly, the Living Wage Foundation does not call for a mandatory Living Wage.

Distributionally, if some people are put out of work but others receive pay rises, this may well be a negative. Adam says that “There are of course some who lose out from the minimum wage but there are many more who benefit”, but concludes that “broadly speaking the minimum wage is a net positive.”

But taking all of one person’s earnings and distributing them among other people who are already in work is likely to be harmful overall, because of diminishing marginal utility. If there is an unemployment effect it may well be an upwards income redistribution from now-unemployed people to the people who hang on in their jobs.

I do think the Low Pay Commission has done a good job at keeping NMW increases quite restrained. That’s why I suspect they would balk at the idea of raising the NMW to the Living Wage level for the foreseeable future. It’s simply not convincing to compare previous rises that the Low Pay Commission has deemed safe with a future rise that it presumably deems unsafe.

Note that productivity has been very low recently, and the Low Pay Commission has barely raised the NMW as a result.

I find it extremely implausible when Adam defends his claim that the Living Wage might lead to extra productivity gains from workers. This concept is known as ‘efficiency wages’ – a well-paid worker is often a more profitable one.

But firms are profit-seeking, so wouldn’t they be doing this already? Adam addresses this by saying that “often some of these productivity gains through eg reduced absenteeism are unanticipated by firms because unsurprisingly, they don’t always have perfect information” – fine, but these firms will be the exception, not the rule. Yes, firms sometimes miss out on profit opportunities – this doesn’t mean that I or Adam or anybody else knows better.

I enjoyed Alex Tabarrok’s recent post on this, “The False Prophets of Efficiency Wages”. He points out that ‘efficiency wages’ were actually studied by economists as a way of explaining unemployment:

In the original efficiency wage literature there is no wishful thinking–no idea that we can have more of everything that we want without tradeoffs. Instead of being desirable, the efficiency wage is a problem because lower wages would reduce unemployment and be better for the economy as a whole.…

Firms routinely track turnover and productivity and they are well aware that higher wages are a possible means to reduce turnover and increase productivity although, as it turns out, not necessarily the most effective means. Indeed, the whole field of workforce science deals with retention, turnover and job satisfaction and the relationship of these to productivity and it does so with more nuance than do most economists. Thus, it’s simply not plausible that large numbers of firms on the existing margin can increase wages, profits and productivity.

To be fair, Adam suggests that his Living Wage rise would be offset by cuts in taxes for business. If these were specifically cuts to the cost of hiring workers this may actually work: cutting employer NICs for NMW workers workers might offset the extra cost of paying the worker the Living Wage. But this would just be a roundabout way of cutting the income taxes or employee NICs of those workers. The Living Wage would be doing none of the heavy lifting, and would still exclude some workers from jobs.

Adam claims that tax credits and other in-work benefits subsidise employers by letting them pay their workers less. I’ve always found this a strange claim. Why would workers’ wage demands fall just because they’re getting top-up money from elsewhere? Do lottery winners ask for lower wages? In any case, he does not provide evidence of this. The consensus from the literature I have seen is that both payroll tax cuts and wage subsidies go to the workers, without driving down wages. So there is no subsidy effect.

In light of all this, my basic view is that raising the minimum wage always risks creating unemployment, and raising it as high as Adam wants would run a very large risk of creating unemployment. I believe that low pay will be the economic problem facing my generation, as unemployment was for my parents’ and grandparents’ generations. To address it, I prefer cash transfers like the Basic Income and anything that boosts innovation, so we can improve people’s productivity and the total stock of wealth.

At best the Living Wage will act as a roundabout way of cutting taxes on workers. At worst it will put many people out of work. I admire Adam’s willingness to challenge the orthodoxy on our side, but in this case I believe that the bulk of the evidence in favour of the free market orthodoxy. The Living Wage is a siren call – a seductive but false solution to the problem of low pay. We should reject it.

The case against caring about inequality at all

Readers of this blog will probably not need convincing that inequality is not something to worry about. We’re more interested in reducing absolute poverty. If you become £100 richer, and I become £50 richer, I say that’s a good thing. But because we’ve become less equal, someone who is concerned with inequality alone would not.

But even given this, inequality might matter. Whether we think they should care about it or not, people do, and it makes no more sense to think of that as a ‘bad’ or unimportant desire than thinking a passion for expensive or high-tech watches is bad.

And because people care about it, they might act on it. If inequality makes a revolution or populist, anti-market governments more likely, as Noah Smith suggests it does, then it might reduce investment and growth as well.

Crucially, these harms from inequality come from people’s perceptions of inequality, not necessarily actual inequality. Which makes a new NBER working paper, “Misperceiving Inequality”, rather interesting (hat tip to Bryan Caplan, who quotes some of the key parts directly).

The paper shows that most people know very little about the extent and direction of income inequality in their societies, or where they fit in to the income distribution. This holds for wealth as well as income.

Screen Shot 2015-05-28 at 14.32.55

This isn’t a pedantic complaint about imprecision. One question asked people to choose which of five diagrams, above, best described where they live. Responses differed significantly between different countries (68% of Latvians chose Type A, 2% of Danes did), but in almost every country a majority got it wrong.

Globally, respondents were able to pick the “right” diagram only slightly better than randomly – 29% got it right, compared to a random baseline of 22.5%. Accuracy differed significantly between countries: 61% of Norwegians got it right, 40% of Britons did, 5% of Ukrainians did. In only five countries out of forty did more than half of respondents guess correctly. (All this uses post-tax-and-transfer data; people’s accuracy is much worse if you use pre-tax-and-transfer data.)

And respondents weren’t even close – looking at how many people were only one diagram off the right one, respondents only did one percentage point better than random (69% versus 68%). As the authors note, “with only five options to choose between, getting within one place of the correct option is not a very difficult task”.

The paper also shows that people are terrible at judging where they fall in the income distribution – 40% of British second-home owners said they were in the bottom half. 3% said they were in the top 10%.

Crucially, given worries about investment and political instability, “In countries where inequality was generally thought to be high, more people supported government redistribution. But demand for redistribution bore no relation to the actual level of inequality.”

There’s too much in the paper to cover in one blogpost, but the results are extremely clear: people’s perceptions of inequality are really, really inaccurate – that holds globally and in all but a handful of Scandinavian countries.

There are some good arguments in favour of reducing inequality based on how people perceive it – that it makes people unhappy, more left-wing, more prone to revolution, more hateful to the people around them.

But this paper shows that those perceptions are related to the realities of inequality only very slightly, if at all. Redistributive policies that reduce actual inequality are costly, and because actual inequality is barely related to perceptions of inequality they may do little to make the country more stable or market-friendly. If these are important problems, we can only solve them by making people feel less unequal – not by making them less unequal in fact. In short: even if people’s perceptions of inequality matter, the reality does not.

When a fossil fuel subsidy is not a subsidy

You may have seen an IMF report in the news last week claiming that fossil fuels are subsidised to the tune of over five trillion dollars every year. This made good headlines, but only because the IMF chose to describe untaxed externalities as ‘post-tax subsidies’. This is unusual and misleading. I wrote about why in The Daily Telegraph:

The IMF’s idea of “subsidies” to fossil fuels refers to something completely different. They have taken the indirect costs to society of using energy – air pollution, traffic congestion, climate change – and, if governments haven’t imposed special taxes on one, called it a “subsidy”. The problem is, we already have a word for these things: externalities. And there is something rather Orwellian about describing a failure to tax something as a subsidy. Here’s an example of what we’re talking about: when my neighbours play loud music at night, it makes me worse off. I’d pay, maybe, £20 for them to shut up, if it wasn’t so awkward to go to the flat downstairs, knock on their door and start negotiating prices. Economists would say that they are imposing a £20 externality on me, and that in a perfectly efficient world, my building would charge residents around that much to play music, and give it to sleep-deprived neighbours like me. But, in the absence of that charge, nobody would say that those neighbours are being subsidised by me. It’s just not what the word means. Except, apparently, to the IMF.

That isn’t to say that externalities should never be taxed, if a private solution can’t be found. But we already have high fuel taxes in most of the developed world, and in the developing world these taxes will hold back growth. Since economic development has positive externalities, it’s not obvious that the negative externalities of fossil fuels outweigh the positives. You can read the whole piece here.