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"Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice" - Adam Smith

Was there really a Cuban Missile Crisis?

Written by Ben Southwood | Thursday 17 April 2014

Lars Christensen, aka the market monetarist, has a great post over at his blog on whether or not the Cuban Missile Crisis should really have been so worrying. A stupid question, you might think, but he shows that the equity markets did not crash anything like as much as they would have been expected to do if a true catastrophe was likely.

What really happened, however, was that S&P500 didn’t drop – it flatlined during the 13 days in October 1962 the stand-off between the US and the Soviet Union lasted. That to me is pretty remarkable given what could have happened.

Why didn't the markets think the world was going to be destroyed—and with it the value of big companies. Why didn't investors rush to put all their money in gold, underground bunkers, canned goods and guns?

There might be a number of reasons why we didn’t see a stock market collapse during the standard-off. Some have argued that the crisis was an example of what have been called Mutual Assured Destruction (MAD). Both the US and Soviet Union knew that there would be no winners in a nuclear conflict and therefore none of them would have an incentive to actual start a nuclear war. It might be that investors realised this and while the global media was reporting on the risk of the outbreak of the third World War they were not panicking (contrary to popular believe stock markets are a lot less prone to panic than policy makers).

Another possibility is of course that the markets knew better than the Kennedy administration about the geopolitical risks prior to the crisis. Hence, the stock market had already fallen more than 20% in the months prior to Kennedy administration’s announced that the Soviet Union was putting up a nuclear missiles in Cuba.

And it's worth reminding those who are sceptical what actually happened.

And the market was of course right – there was not third World War and after 13 days of tense stand-off the crisis ended.

For more commentary, read Pete Spence at City A.M. and the rest of Lars' post.

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Should libertarians care about Brendan Eich's resignation?

Written by Ben Southwood | Friday 04 April 2014

Mozilla CEO Brendan Eich has resigned his job after just 10 days in the role. This came after it was rediscovered that he gave $1,000 to Proposition 8, a direct democratic move to ban gay marriage in California, that narrowly passed. Upon discovering this, twitter and other areas of the internet mobilised, with 72,000 supporting a petition to the board to sack him.

One libertarian perspective might be that, since no negative rights were infringed, this was an entirely defensible use of social pressure to enforce social norms—Eich contributed to a proposal that many libertarians believe would restrict the rights of gays. For this perspective, the Eich situation is proof that state intervention is not needed to achieve socio-political equality for groups considered oppressed. It's very very interesting that many progressives are actually using the rhetoric of thin libertarianism, which they would usually abhor, to defend their position on the issue.

Contrariwise, an alternative "thick" libertarian perspective would hold that people have the right not to be hounded out of their job for opinions they hold and do not enforce on others—by all accounts Mozilla is a highly equal-opportunities place for LGBT people. For this perspective, Eich's resignation is a worrying indication that First Amendment—freedom of expression—rights are disappearing.

A third perspective might say that although this resignation, considered alone, might not be regrettable, because it advances gays' freedoms, as a rule people should not lose their job for holding certain political perspectives and even actively supporting them. This would hold especially strongly if we agreed that the small donations Eich made were unlikely to actually change anything.

I think all of these perspectives have merit as libertarian responses to what's happened. But whatever the normative issues here, I think the whole situation is much more interesting as an illustration of a positive (i.e. descriptive, not morally loaded) historical trend and tendency that is becoming, in my opinion, more and more obvious. Gay marriage was on almost no one's radar in 1990. In 2000 it was still only an utterly minority idea even among gays.

In 2008 (the same year as Prop 8, and the end of the google ngrams data range in the previous link), US President Barack Obama was elected and specifically opposed gay marriage. Between 2008 and 2014 gay marriage has gone from something a liberal Democrat felt he could not guarantee election without opposing to something that a chief executive (admittedly a Silicon Valley chief executive, of a particularly "socially aware" firm) has to favour, or at least not oppose, to keep their job. This is astonishingly rapid.

And various issues suggest that maybe this ousting had little to do with a cost-benefit analysis. Let's assume the best argument in favour of ousting him is that (a) he tipped the balance in favour of anti-gay marriage in the past, and this delayed gay people gaining their deserved marriage rights, and (b) his position at the top of Mozilla will stop it being truly equal to gay employees and consumers. That is, let's assume that the left-leaning people who got Eich overthrown do in fact wish Eich to have meaningful freedom of conscience and speech, but they also think it's fair to censor him if he acts based on those in ways which increase oppression or reduce social welfare.

(This isn't entirely accurate: some do think that people shouldn't be able to be both employed and hold personal anti-gay marriage perspectives. But I see personal opinions (which are very likely genetically heritable and uncontrollable) as a much weaker justification for the hounding and the principle of charity dictates I tackle the strongest possible opposing argument here.)

The fact that showing neither (a) nor (b) has even been attempted in any of the myriad of news and commentary I've seen on the issue is telling (I'm open to being refuted here). But more telling is the fact that none of the commentary I've seen has even mentioned these issues. And what's more I bet Eich-resignation-advocates wouldn't change their minds if we discovered that Mozilla's currently pro-LGBT policies were impervious to CEO influence, and that his $1,000 did pitifully little to change the outcome of Prop 8, never mind the overall progress of gays' marriage rights.

This suggests to me that this is about policing heresies. This is a doctrinal dispute. I wonder if Eich would still be in his job had he publicly stated regret at his old anti-gay marriage perspective and repudiated it forcefully. I bet he would. And this brings me to the final point: libertarians should care, but not because the instance itself is necessarily a bad thing—an ugly, base, low, cowardly, mean thing certainly, but it might pass a cost-benefit analysis if we really did one—but because of this trend. Progress appears to be an unstoppable juggernaught, and it might be speeding up.

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Should the government play the stock market? Or the gold market?

Written by Ben Southwood | Thursday 03 April 2014

A recent report from the National Audit Office found that the government could have made £750m more from the sale of Royal Mail if it had sold at the highest price the shares reached on its first day. This has led many to blame the government for selling off the family silver at the bottom of the market. Others have pointed out that the reason for privatising Royal Mail was to subject it to the disciplines of the market, not to raise money. And that no one knows in advance what a share will be worth. Grey markets undervalued the share as well—and of course some advisers said it would rise higher, just as others said it wouldn't. Perhaps government politicking prior to the sale caused some of the problems. In any case, the value has not disappeared, it has just been distributed differently. There may be weak reasons to question the profile of the distribution (e.g. will it be spent more progressively or efficiently by government?) but realistically we're talking a small amount of the budget and bear in mind that investors who ordered more than £10,000 of shares were shut out completely.

But one interesting angle is whether this is like Gordon Brown's gold "sell-off" of 1999-2002. As everyone remembers, Brown, as chancellor of the exchequer, sold off the government's gold at what turned out to be the bottom of the market, losing out on potential gains easily ten times more than available with Royal Mail. He is widely criticised for this, but I can't quite see why. I can't think of any good reason why the government should hold any assets whatsoever. On top of this, there are at least four reasons why the state should not hold any specific assets:

1. The government is not well placed to play asset markets. So there's an interesting question as to whether the government should hold net wealth. Maybe there are shocks where easy sources of income will evaporate and the government will need to instantly liquidate some assets in order to pay its normal bills, defend the country against external aggressors, enforce the law etc. This might suggest the government needs to hold net wealth. But we know that even very smart and knowledgeable fund managers with all the right incentives only consistently outperform the market due to luck. So what would make us think, outside of one issue I'll deal with later, that the government's agents, so universally derided for competence in most contexts, could succeed in this either impossible or just really really really hard task? The UK government's Royal Mail and gold holdings were vastly out of proportion to those assets' size in relation to all wealth. If the government wants to hold wealth we know that it should hold a low cost exchange-tracker, as broad-based as possible. Otherwise it will effectively be handing over taxpayer wealth to traders in the markets.

2. Playing asset markets may directly distort those markets. If governments hold given assets (e.g. Royal Mail shares or gold) then it might be because there are social welfare reasons for doing so. It's at least possible that people have the specific desire for the equity of companies to not be held privately or to be held by the state and this something worth at least factoring in. When it comes to gold then individuals might be glad the government has it as a backstop. And of course the state could just be holding these assets on behalf of its citizens, perhaps because there are economies of scale in so doing. Even if there aren't benefits to the state holding assets on behalf of citizens, individuals may take these holdings into account as if they were their own, thus causing only small inefficiencies. But I take most of these considerations to be of minuscule empirical importance. Mainly the government's holdings of assets cannot be justified by these reasons. But since the market will be influenced by their holdings, they will reduce the supply of certain sorts of assets for the market to hold, leading to price shifts and portfolio rebalancing. Since this will be away from the ideal portfolio firms would have held (I can imagine exceptions but none of them are relevant here) this reduces social welfare.

3. Government holding assets means they're unlikely to be used with allocative efficiency. This depends on some of the considerations in 2, but again they're very very unlikely to have empirically large impacts. By contrast, there are probably some very empirically large impacts from the fact that few of the government's assets—totting up to about £600bn, according to a recent ASI report—are ever marketed. As we know from Friedrich A. Hayek's most important work, market pricing is how we rationally allocate resources in society. This was why Hayek and Ludwig von Mises won the socialist calculation debate as even noted Marxist G.A. Cohen agreed. What this means for assets is that we don't know whether they are properly used unless we trade for them. An illustration: if the government sold off all its army barracks the army might then rent the selfsame barracks from their private owners. But it's possible that they would rent somewhere else, and someone might set up a factory or a farm or a theme park on the original site. Without the market competition process we have no idea what would happen and we have no idea what the best use of the land and buildings would be. This applies to big nebulous assets like Royal Mail just as it applies to land and as it applies to gold.

4. If the government holds assets it may have incentives that distort its policy-making decisions. Why does the UK have such an appallingly tight planning regime even though basically all economists think it's extremely inefficient and damaging? It's probably because lots of people own houses and these groups tend to be disproportionately likely to vote and are otherwise politically well-connected. If these groups rented their house and owned the same amount of wealth spread across a wide range of assets it's very unlikely we'd see such economically unjustifiable policies. The same goes, potentially, for government-held assets. After all, the government will be blamed not to mention having less ability to achieve its policy goals if assets it holds lose value. It's not so much that they're likely to directly pursue policies designed to boost the value of state assets. But acts of commission are treated differently to those of omission. It seems highly likely that the government will treat policy changes that affect these particular assets' value differently, just like housing.

So maybe the government should hold some wealth, I can see the arguments for and I can imagine some arguments against. But if it holds wealth it ought hold assets as broadly as possible: because it's not placed to take gambles on particular assets; because doing so may distort markets directly; because holding assets takes them off the market and reduces allocative efficiency; and because holding particular assets may distort the incentives facing policymakers. Thus we should praise Gordon Brown for selling off gold just as we should praise Vince Cable and George Osborne for selling off the Royal Mail.

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Five intriguing papers I discovered this week

Written by Ben Southwood | Friday 07 March 2014

In what might become a recurring feature, I am going to summarise the findings of a few research papers, potentially of interest to ASI blog readers, that were either first released this week, first published this week, or first come upon by me this week.

1. Fernandes, D., Lynch, J. G., and Netemeyer, R. G., "Financial Literacy, Financial Education and Downstream Financial Behaviors" (Jan 2014)

This paper is a large meta-analysis of 168 other papers, which in turn refer to 201 different studies and experiments. They find that at least 99.9% of financial behaviour in life cannot be explained by differences in financial education, or conversely at most 0.1% of the difference in people's financial decision-making and choices is down to education interventions designed to improve their financial literacy. In the words of their abstract: "even large interventions with many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention".

While other correlational studies appear to show some relationship between financial behaviour and educational schemes (i.e. one explaining more than 0.1% of the variance between individuals) they explain that this is only because those typically getting financial education already have various psychological traits associated with careful management of finances. They therefore suggest that big schemes designed to improve lifetime financial decisionmaking are futile and a waste of money; the best we can hope for is "just in time" interventions, perhaps at the point of financial transactions, that are more likely to be taken in and not forgotten.

2. Wang, M-T., Eccles, J. S., and Kenny, S., "Not Lack of Ability but More Choice: Individual and Gender Differences in Choice of Careers in Science, Technology, Engineering, and Mathematics" (May 2013)

In this paper the authors find that a substantial fraction of the male-female "gap" in STEM (Science, Technology, Engineering and Medicine) fields can be explained by the fact that women who are talented at maths tend to also have high verbal skills, skills that mathematically talented men are much more likely to lack. This means they have a wider range of choices available to them, and also possibly identify less closely with maths as part of their personality, and it is this choice not to pursue STEM further that drives the gap, rather than, for example, discrimination in the area or a perceived unfriendly atmosphere.

3. Liu, S., Huang, J. L., and Wang, M., "Effectiveness of Job Search Interventions: A Meta-Analytic Review" (Mar 2014)

Liu, Huang and Wang found, reviewing 47 different experiments testing if schemes "teaching job search skills, improving self-presentation, boosting self-efficacy, encouraging proactivity, promoting goal setting, and enlisting social support" could boost the unemployed's chances of getting a job. In fact, on average those in the treatment groups—i.e. those actually subject to the intervention, and not in the control group—were 2.67 times more likely to get a job. Since the studies all used randomness of quasi-randomness to assign treatment, this suggests, they say, that schemes that develop skills and self-motivation can be effective. However, the schemes were more likely to help the young than the old, the short-term unemployed than the long-term unemployed, and job-seekers with special needs, as compared to the population at large.

4. Karwowski, M., and Lebuda, I., "Digit ratio predicts eminence of Polish actor" (Jul 2014)

In a slightly surprising study, the two authors looked at 98 Polish actors, both male and female, and compared the ratio between their second and fourth digits on their hand (a measure of prenatal testosterone exposure) and their productivity and fame. For both men and women, even controlling for age, a higher ratio predicted more pre-eminence.

5. Aisen, A., and Veiga, F. J., "How Does Political Instability Affect Economic Growth?" (Jan 2011)

In a classic example where economists do extensive research to tell us what we already know, this IMF paper from 2011 shows us how bad political instability is for economic growth. Actually, the paper is a great one because it allows us to estimate the size of the impact of different political elements on instability and then the size of instability's own impact on economic aggregates.

Their findings are highly interesting: whereas primary school enrolment has a pitifully small impact on economic growth, and the impact of investment, economic freedom and the security of property rights comes out quite small, violence, political instability and cabinet changes have substantial negative effects, as does, surprisingly, population growth. And while the most productive regions in Europe are the most ethnically diverse, in this study ethnic homogeneity is very strongly associated with growth. Of course, the conclusions of the paper—that countries should address the root causes of political instability—are much easier said than done!

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Markets do set rates: A reply to Julien Noizet

Written by Ben Southwood | Wednesday 12 February 2014

Financial analyst and blogger Julien Noizet has replied to my article on mortgage rates on his blog. It is a good piece, worth reading, but I still think I am right. It is perhaps true that Noizet is right too, because my claim was really very modest: in total, mortgage interest rates do not mechanically vary with the Bank of England's base rate; we can show this because the spread between them and the base rate varies extremely widely; and since we have very strong independent reasons to expect that market forces largely drive rate moves, that should be our back-up explanation. The implication of this I was interested in was that this meant a hike in Bank Rate wouldn't necessarily drive effective rates up to a point that would substantially increase the cost of servicing a mortgage and hence compress the demand for (London) housing.

Even if the first graph in Noizet's blog post did appear to support his narrative that effective market rates follow Bank Rate moves, I'm not sure why these disaggregated numbers matter given that the spread between overall effective rates on both new and existing mortgages varied so widely. If it turns out that specific mortgage types varied closely with Bank Rate but the overall picture did not, then markets still control effective rates, they just do it via a changing composition of mortgages, not by changing the rates on particular products. The effect is the same—and it is the effect we see in the Bank's main series for effective rates secured on dwellings. But the graph, to me, looks a lot like mine, despite the effect of new reporting standards: mortgage rates are about a percentage point from the base rate until 2008, then they don't fall nearly as far as the base rate in 2008 and they stay that way until today. If other Bank schemes, like Funding for Lending or quantitative easing were overwhelming the market then we'd expect the spread to be lower than usual, not much higher.

His second big point, that the spread between the Bank Rate and the rates banks charged on markets couldn't narrow any further 2009 onwards perplexes me. On the one hand, it is effectively an illustration of my general principle that markets set rates—rates are being determined by banks' considerations about their bottom line, not Bank Rate moves. On the other hand, it seems internally inconsistent. If banks make money (i.e. the money they need to cover the fixed costs Julien mentions) on the spread between Bank Rate and mortgage rates (i.e. if Bank Rate is important in determining rates, rather than market moves) then the absolute levels of the numbers is irrelevant. It's the spread that counts. But the whole point of my post is demonstrating that the spread changes very widely, and none of Julien's evidence seems to me to contradict that claim. Indeed, Noizet's very very good posts on MMT, which stress how deposit rates are much more important as a funding cost than discount rates for private banks, seem at odds with what he's written in this post. And supporting this story is the fact that the spread between rates on deposits (both time and sight) and mortgages changes much less widely. If we roughly and readily average time and sight on the one side and average existing and new mortgages on the other, the spread goes no higher than 2.3 percentage points and no lower than 1.48.

In general with the post I don't feel I understand the mechanisms Noizet is relying on, perhaps I'm misunderstanding him, but the implications of his claims regularly seem to contradict our basic models of markets. For example, he says that a rate rise would lead banks to try and rebuild their margins and profitability. But I can't see any reason why banks wouldn't always be doing that. The mortgage market is fairly competitive, at least measured by the numbers of packages on offer and the relatively small differences between their prices. I don't think Julien has presented any mechanism to suggest why banks would suddenly want to maximise profit after a rate rise but wouldn't beforehand—or why they'd suddenly be able to ignore their competitors but couldn't beforehand. It's possible there is one, but I can't see that he's explained it. Overall I suspect I've missed something crucial, so I welcome any more comments Julien has on the issue.

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Interest rates are set in the market place

Written by Ben Southwood | Friday 07 February 2014

The London housing market is booming. According to Nationwide, prices rose 14.9% over 2013. According to Halifax, they climbed 9.4%. According to the Land Registry they were up 11.2%. The Office for National Statistics hasn't quite got data for the whole year yet, but their numbers show prices up 11.6% in London in the 12 months to November 2013. No doubt Rightmove, LSL, Hometrack and all of the many other indices echo this finding. While we at the ASI have pointed out how the government has jacked up demand with the Help to Buy scheme (some have quipped it might more accurately be termed "Help to Sell") the Bank of England and Treasury have dialled down the housing element of the Funding for Lending Scheme in response to worries about a bubble and unaffordability.

But however much these schemes are artificially adding to demand, it is certainly clear that London houses—a desirable place for natives and people across the world to live—face a huge demand and are in limited supply. Since this is clear, I have been loath to call the situation a "bubble"—a bubble seems bound to pop, but tight supply and ample demand suggests a situation where prices will remain high (see an excellent post from my colleague Sam for more detail). However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England's base rate, a jump in rates, something we'd expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn't chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England's data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically. For example, it was almost one percentage point in January 2004, fell to 0.5pp by July, rose to around 0.6pp where it stayed until July 2006 when it crashed to nearly zero in a year, before rising to 1pp in October 2008 and then almost 3.5pp in April 2009. Since then it has steadily trended down to around 2.5pp. There are lots of interesting and obvious stories to tell here, hearkening back to my piece about the confusion between interest rates as a stance of monetary policy and interest rates as the actual cost of borrowing firms and consumers face, but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

What this means is that the fact the Bank's base rate will almost certainly be hiked in the next couple of years if economic growth continues at its current healthy pace is not a reason to worry that London's housing bubble will pop. Indeed, the only way London house prices are likely to drop from their current stratospheric levels is if we get a good honest bit of planning deregulation. Moving the green belt out just one mile would allow us to build one million houses, after all. And it could add percentage points of pure supply-side driven growth to GDP and living standards.

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Equality: as cheap as 50p?

Written by Ben Southwood | Monday 27 January 2014

Peter Oborne argues that Ed Balls' pledge to raise the 45p top tax rate back up to 50p is a good idea. While the extremely high marginal rates (top main rate 83%, plus a 15% surcharge for "unearned income") of the 1960s and '70s might have been driven by "socialist envy", George Osborne's dropping the rate from 50p to 45p in was "profoundly shaming and offensive", Oborne contends. This is because, echoing Stanley Baldwin and his brand of Toryism, the conservatives should represent the whole country, not the rich or any other factional interest.

Apparently the Coalition has "devoted a great deal of effort to lowering the living standards of the poor", and this move to "make the rich richer" is inappropriate when the poor are getting poorer. I contend this by arguing that inequality is down to 90s levels under chancellor Osborne, while the worst-off in society are the only group to actually see their living standards improve the since the recession hit. And the (ugly, unpleasant, and regrettable) attitudes that have emerged towards benefits claimants are probably driving government rhetoric in that area, rather than vice versa.

In general, it annoys me when a columnist writes something apparently trading on what everyone just knows. Sometimes the common view is incorrect. Funnily enough, politics is the area where people err most profoundly and with the most regularity. And I would argue that Oborne is trading on falsehoods in his piece; would it still be a coherent argument if it started with the factual premise that inequality in the UK fell back below its 1997-8 low in 2011-12, 0.34 measured by the GINI coefficient? That the top 10% of earners endured the biggest blow to their incomes since the onset of the recession? And that the bottom 10% by income were the only one to see a rise in living standards taking inflation into account? I don't think so.

The IFS reports I link above predict that by 2015-16 inequality will rise back to roughly its pre-recession level, so perhaps Oborne could refocus his attack on the future inequality Osborne possibly has a hand in. But in all likelihood there is probably little the government can do about inequality over the long-term, caused as it is by very fundamental trends and robust as it is to institutions even such as the USSR's. Most of the extra inequality since the 60s and 70s has come from couples engaging in much more assortative mating. And very long-term trends are mainly dominated by heritability of social class—those with Norman surnames are 28% more likely than a random sample of similar others to get an Oxford place.

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What's the true free market monetary policy?

Written by Ben Southwood | Tuesday 21 January 2014

Let's imagine we are in a world where central banks are given key roles in the macroeconomy, and have been for decades or even centuries in almost every country. In this imaginary world, studies into the relative efficacy of free banking regimes have been undeservedly overlooked, and the orthodoxy among major economists, even ones otherwise sympathetic to free markets is that they are a bad idea. Major policymakers, let's imagine, are completely unaware of the free banking alternative, and most even use the term to mean something completely different. Proposals to enact free banking have not been mentioned in law making chambers for decades or centuries, if at all. It has not been in any party's policy platform for a similar period of time, in this imaginary world.

What's interesting about this imaginary world is that it is in fact our world. Economists like George Selgin, Larry White, Kevin Dowd (among many others) have done very convincing research about the benefits of free banking. And free banking may one day become a real prospect, perhaps in a new state or a charter city. But free banking has lost the battle for the time being, and abolishing the central bank and government intervention in money is as unlikely as abolishing the welfare state. Now one might say that if free banking is a desirable policy, it is worth continuing to wage the intellectual war for the benefit of future generations, who could benefit from the scholarship. Work done now could end up influencing and improving future monetary policy.

I do not discount the possibility this is true. At the same time, free banking is a meta-policy, not a policy—a way of choosing what monetary regime to enact, rather than a specific monetary regime. After all, it is at least possible that free banks could together target consumer prices, the GDP deflator, the money base, the money supply measured by M2, nominal income/NGDP. And for each of these different measures there are an infinite number of theoretical growth paths, and a large number of realistically plausible growth paths they could aim for. Now, free bankers say that the market will make a good decision, and I can buy that. But let's say we're constrained to choose a policy without the aid of the market mechanism: can we say there are better or worse central plans?

The answer is: of course we can! Old-school monetarism, targeting money supply aggregates, was a failure even according to Milton Friedman, whereas CPI targeting, for all its flaws, delivered 66 quarters of unbroken growth and a period so decent they named it the Great Moderation. The interwar gold standard brought us the stagnation of the 1920s (in the UK) and coming off us brought us our relatively pleasant experience of the Great Depression. Literally the order in which countries came off the gold standard is the order they got out of the Great Depression. And even though the classical gold standard worked pretty well, few of its benefits would obtain if we went back. Some central plans (the interwar gold standard, M2 targeting) don't work, some work a bit (the classical gold standard, CPI) and arguably some work pretty well (NGDP targeting is one in this category, according to Friedman, Hayek and I). If we are stuck with central planning, then why not have a good central plan?

And just because I'm allowing the term "central planning" to describe NGDP targeting, we needn't describe it as "government intervention in money". I don't think they are really the same thing. "Government intervention in money" brings to mind rapid inflation, wild swings in the macroeconomic environment; in short the exact circumstances that NGDP-targeting aims to avoid. Targeting aggregate demand keeps the overall macro environment stable—a truly neutral monetary policy—allowing firms and households to make long-term plans, and preventing recessions like the last one, caused as it almost certainly was by drastic monetary tightening. Indeed, as monetary policy determines the overall path of aggregate demand, we might easily call "sound money" policies aiming for zero inflation or a frozen base as dangerous government meddling—they allow the actually important measures like nominal income to fluctuate drastically.

Consider an analogy: school vouchers. Many libertarians may favour a system where parents can spend as little or as much as they want on schooling (considering distributional concerns separately), rather than having central planners decide on the voucher-set minimum. But we usually see a voucher system as an improvement on the status quo—parents may not be able to fully control how much is spent on their children's education but at least they can pick their school. Popular and successful schools grow to accommodate demand, while unpopular and unsuccessful schools can be wound down more quickly. Libertarians may see this as a way from the ideal situation, but none would therefore denounce the policy. The analogy isn't perfect, but I like to see NGDP targeting as similar to school vouchers, versus status quo schooling as the CPI target. Libertarians shouldn't make the perfect the enemy of the good.

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Low rates doesn't mean low rates

Written by Ben Southwood | Wednesday 15 January 2014

I got called up last Wednesday to ask if anyone at the Adam Smith Institute would go on the Daily Politics to explain why the Bank of England should raise its base rate (not exactly in those words). The producer was familiar with common free market ideas that argue that artificially low interest rates are blowing up a housing bubble which will later burst. I had to try to explain to the producer why I both agree and disagree with these sentiments: low interest rates do underlie economic limbo, but raising the base rate is not a solution and may produce yet lower real interest rates where it matters—throughout the economy.

The problem comes from the dual use, in the popular economic press, and even by top economists, of the term "interest rates" to mean both the stance of monetary policy and the cost of borrowing. This is understandable because during the Great Moderation of 1992-2008 all the world's most important macroeconomic authorities attempted to control the overall economy through adjusting one or a small number of key interest rates to achieve a consumer price inflation (CPI) target. At the same time, we are familiar with interest rates through our normal life: on loans, mortgages, savings, credit cards and so on. But acting as though the Bank of England directly controls these rates when it adjusts policy seriously obfuscates how the macroeconomy works and contributes to a lot of sloppy thinking.

Whereas the Federal Reserve has always used a form of quantitative easing (QE) to adjust a market interest rate—the Federal Funds Rate—the Bank of England has typically adjusted its base rate, which it calls Bank Rate, instead (updated). Bank Rate is the flat (nominal) interest rate it charges commercial banks for short term funding, and pays on their excess reserves. This sets a lower bound on overnight commercial lending, since it is always an option to lend or borrow money at Bank Rate, and therefore it is included in some market contracts, like tracker variable rate mortgages. The current UK base rate is 0.5%, a nominal number which translates to a negative real rate, but secured loans charge more like 3% in nominal terms, unsecured loans 8%, and credit cards 10%.

So we've established that the Bank of England sets a lower bound on interest rates with its Bank Rate. And we've also established that Bank Rate affects some other rates directly, principally tracker mortgages. We might also expect it to affect other rates in the economy—for example a cut will "ripple out" through the economy, because all other things being equal, it is now cheaper for banks to borrow from the BoE and they will thus be more willing to do so. Economists call this the liquidity effect. They will thus be more willing to lend cheaply and less willing to borrow from savers. So one effect of lowering the Bank Rate is to directly lower some rates, put a lower lower bound on others, and make others cheaper.

However there is an opposed reaction. Lowering Bank Rate doesn't just make loans cheaper, but it increases demand. It does so by injecting extra money into the economy (from the extra loans), but more importantly by signalling to markets that it intends demand to grow faster and that it is willing to take measures (such as further lowering Bank Rate or boosting the money supply through a QE programme) to make sure this happens. This is why stock markets react so strongly to a (policy) interest rate cut—all businesses are worth a bit more because they expect higher total revenues over their future.

But if firms expect higher demand in the future they will in turn demand more investment funds to put into projects to service that demand. This means that cutting the BoE's base rate puts pressure on effective market interest rates in both directions. It is an empirical question which direction the overall effect goes in—but this means that the simple coincidence of low real effective interest rates out in the economy and a low, by historical terms, Bank Rate, shows nothing. It could be that the best way to raise interest rates out there in the economy is to cut the Bank's base rate, or, since it can't go much further now, print money to raise inflation (which would ceteris paribus cut the rate in real terms). Look at the graph above for an illustration of how the Fed's changes in their QE programme (the red line) and their Federal Funds rate (the dark blue line) don't produce big shifts in (real) market interest rates like corporate bond returns and 30-year mortgages.

So my view on low interest rates is complicated. I think the Bank should get out of the business of setting rates altogether, and vary the size of the monetary base to control nominal income in the economy. But if the Bank is going to use rates as its key policy tool, it shouldn't raise them when a recovery hasn't quite taken hold—it's uncertain whether it'll raise market interest rates, but it will certainly choke off the demand we need for solid growth.

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Old Economy Steven would have been better off now

Written by Ben Southwood | Wednesday 08 January 2014

An interesting essay from Chris Maisano over at Jacobin Magazine drifts over many topics—full employment, growth since the 1970s and neoliberalism, worker activism and the 40-hour week. Its essential case is that full employment is important, because it makes workers better off in lots of ways, including giving them more leisure time. There are some interesting points in the piece, and I agree that full-ish employment is an important goal, but overall I think it rests on a huge number of misconceptions—indeed data is used in very weird ways, with what I see as obvious questions left entirely uninterrogated.

Maisano points to the "Old Economy Steven" meme, which looks back to an idealised post-war era:

Steven pays his yearly tuition at a state college—with his savings from his summer job! He graduates with a liberal arts degree—and actually finds suitable entry-level employment! ... But Steven doesn't just enjoy the material comforts of Old Economy abundance. He possesses a degree of everyday power scarcely imaginable by working people today. Steven can tell his boss to shove it, walk out and get hired at the factory across the street.

The contrast with popular views about today's economy, at least since the recession, is obvious. But full employment policies have been demoted—indeed since the late 1970s and especially since central bank independence most developed countries have centred their macroeconomic policies around stable inflation, not high employment. In fact, central banks now see a Non-Accelerating-Inflation Rate of Unemployment (NAIRU) as the optimal situation. But is this an "ideological response" as Maisano suggests?

There will always be some unemployment, from the numerous supply side restrictions on labour, and from job switching, especially with sectoral shifts. Inducing unexpected inflation can temporarily take unemployment below this "natural" level, for example through money illusion—where workers think nominal pay is actually real pay—but it is unsustainable. Once unions and individual workers compute this level of demand growth into their calculations the natural rate will return and the monetary authorities will need to push inflation yet higher to subvert this equilibrium.

Many economists, including Milton Friedman, argue that something like this caused the rampant, out of control inflation of the 1970s, something that was only reigned in by harsh recessions in both the UK and USA (attempting to control wages and prices was an abject failure everywhere). Acknowledging this means acknowledging that aiming for unemployment as close as possible to zero is a bad idea; it is better to aim for the lowest level of unemployment achievable without acceleration inflation. It's certainly possible to argue that monetary policymakers have failed to do this—but it hardly seems like a specifically ideological development, more like progress in economics.

A second sticking point is how growth has declined since neo-liberalism replaced the post-war consensus as the dominant political framework in at least the US and UK. This is true. But it's also true that every developed country saw a growth slowdown in the 80s and 90s relative to the post-war era. Economic historians are divided on the causes but since the most neo-liberal countries grew much faster than the more left-leaning states, one'd be hard placed to see that as a key cause. But even though growth has slowed down it has not stopped—and despite a few bumps we are much much richer today than in the 1970s. Just think, if had the opportunity to be whizzed to the 1970s to have the same standard of living as someone in your income percentile did then, would you?

My third disagreement is on hours worked. Maisano heavily implies that the consistently looser labour markets since the 1960s and 1970s have resulted in workers forced to work longer hours. He's clearly looked at the numbers, since he compares the US's average 1,778 in 2010 (1,742 on the FRED numbers I've seen) worked unfavourably to "continental European and the Scandinavian social democracies". But is that a germane comparison? To me it seems like the best way to compare the wellbeing of workers now, following decades of neo-liberalism and below-full-employment, and workers then, is to directly compare them. On average, during the 1970s, an employed person worked 1,859 hours (in 1970 it was 1,912 hours), in the ten years up to and including 2011 the average was 1,772.9. Maybe Maisano believes that with a greater focus on full employment incomes would have grown even more and hours would have fallen even faster—but if he thought that maybe he should say it.

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