The Pin Factory Blog

Will Wilkinson points to an American behavioural economist's hypothesis that the US's compex tax code might be contributing to people living beyond their means:

What are the consequences of knowing our gross yearly income and not much else? I think it causes us to feel richer than we really are and spend accordingly. Why would this be the case? There’s a phenomenon we call the “illusion of money,” which is the idea that we typically pay attention to nominal amounts of money rather than real amounts. For example, the illusion of money means that if inflation is 8%, and you get a 10% raise, you would feel better than if there was no inflation and you got a 3-4% raise. The basic idea is that we pay attention to the nominal amount rather than the purchasing power, and don’t realize what our money is really worth.In terms of our tax code, this suggests that in the US we focus on our gross yearly income, feel richer than we really are, and consequently end up spending more money.

I wouldn't be surprised if a similar phenomenon existed in the UK, thanks to the vagaries of national insurance, inflation and other stealth taxes, albeit to a lesser extent than in the US. This isn't helped by things like the tax credit system, which make things even more confusing and difficult to navigate. PwC says that household debt stands at around 110% of GDP, compared to around 63% of GDP in 1987.

I don't want to overstate the case – I'm sure historically-low interest rates and successive bubbles have a lot to do with this – but it seems likely to me that the complexity of the tax system might have contributed here, especially in terms of high-interest credit card debt, which a lot of people use to tide themselves over to the next pay day.

So, another argument for tax simplification. Maybe not the most important, compared with the disincentive to work that marginal taxation changes create and the cost of compliance that face firms, but it might resonate more with people concerned about the high household debt levels in this country. I'd like to see how household debt breaks down by socioeconomic group – I suspect that groups at the bottom of the pile tend to have a disproportionate amount of high-interest credit card debt. That would be a bad thing, and if it's partially caused by a confusing tax system, it's one that we could fix quite handily.

Greece was bailed out, then Ireland was bailed out, and now Portugal has been bailed out. All of these countries were made to agree fairly stringent deficit and debt reduction packages. All three face years of fiscal tightness, reduced services and living standards, and low economic growth. It is by no means certain that the populations of these democracies will tolerate this for the length of time it will require to put their affairs to rights.

There is an alternative. It is to let these countries default, offering a percentage of the debts' face value as settlement. There would be turmoil. Some bondholders, including European banks, would lose substantial sums. But at the end of it confidence would return and economies start to grow again without that burden of debt.

The decision was made to protect small depositors, bondholders and to some extent bank shareholders, at the expense of taxpayers. It was an unwise decision, both morally and from the point of view of efficiency. One could argue that small depositors were not a party to the causes of the crisis, and should not be made to bear its burdens. Bondholders and shareholders, however, should have known better.

The main argument in favour of default is that it will be effective in putting a line under the crisis. Instead of limping along for years with lacklustre economies struggling to meet debt repayments, the over-indebted countries can get it over with and turn the page.

It looks very much as if the bailout option has been taken to protect the euro and European banks, but it would not be the end of the world if a few countries that should never have been in the single currency have to leave it. And if a few European banks had to restructure, recapitalize or be taken over, this, too, could be survived. Allowing the euro to lose momentum might be a setback to European political union, but this would be no bad thing.

The bailout strategy might keep things going for a while, with more patches to counter the recurring crises. Or we could take the hit now, accept the consequences of folly, and start to rebuild on firmer foundations. It looks increasingly like the better option, especially if there's a bigger storm on the way… 

The OECD’s annual Society at a Glance report was released this week. The TUC’s Touchstone blog had a post up earlier, highlighting the OECD’s claim that economic growth has not reduced poverty:

However, economic growth and poverty have not been strongly related within the OECD in the past generation. There is little evidence of a relationship between poverty and household income growth in either a positive or negative direction. For example, Ireland has had very rapid income growth over the period and a large rise in poverty, while income growth has stagnated in Belgium in combination with a considerable reduction in poverty.

There are a few problems here. The first is the puzzling assertion that Belgium has “stagnated” in the last generation. The OECD’s own figures (XLS file) say that Belgium’s per capita GDP has grown by about 50% since 1980, adjusted for inflation and purchasing power parity ($19,000 approx in 1980 to $30,000 approx in 2010, in 2000 prices). Ireland’s has grown by about 200% ($11,000 to $31,000), but it started from a base about a third smaller than Belgium’s. Belgium’s growth rate was certainly a lot lower than Ireland’s, but they’ve converged on roughly the same point.

A bigger problem is the definition of poverty, which is relative and considered within single countries. It’s quite misleading to claim that Irish economic growth didn’t reduce poverty. The OECD uses a relative definition of poverty – the "percentage of persons living with less than 50% of median equivalised household income". Poor people in Ireland (and Belgium) are a lot less poor than they were thirty years ago with regard to the options they have available to them. The gap between them and the rich might be wider, but this matters less to most people than their life expectancies, economic security levels, and other absolute values. Saying that economic growth made poor people a lot richer but rich people even more rich is quite different to saying that “economic growth and poverty have not been strongly related within the OECD in the past generation”.

But let’s set aside debate over absolute vs relative definitions of poverty and take the relative definition for granted. Why is relative poverty only considered within one country and not globally? Comparing a poor Irish person’s wealth level to a poor Bulgarian person’s wealth level over the last thirty years would give quite a different picture. Maybe, say, Ireland’s economic growth attracted large numbers of immigrants who were still earning far more in Irish “poverty” than in “wealth” in their own country. The figures would show an increase in Ireland’s relative poverty level, even though by any measure everybody was better off than before.

The standard measure of inequality, the Gini coefficient, gives Tanzania and Malawi a more “equal” score than New Zealand and Japan. I know where I’d rather be, rich or poor. The measure of inequality itself is not worthless, but defining poverty as inequality within one country certainly is. By any measure of actual outcomes, economic growth is good for the poor. And if a measure of poverty doesn’t reflect that, it’s a bad measure. 

It's a hard life, I know, but this week I'm in Buenos Aires at a meeting of the Mont Pelerin Society, the association of liberal and free-market scholars, businesspeople, thinktankers, politicians, journalists and others, originally founded by the great FA Hayek in 1947. The focus is on liberty and economic growth in Latin America – neither of which is in very good shape.

The Chilean historian Claudio Veliz suggested some of the reasons for this. The region had 300 years of colonial centralism, he argued, and still carries much of that centralist baggage. With its Spanish roots, it inherited the top-down, authoritarian, civil law system of continental Europe rather than the bottom-up, liberal, common law traditions of Britain. "The widest stretch of water in the world is the English Channel," said Veliz, commenting on this deep and crucial intellectual difference.

Capitalism, as Marx put it, rose from the rubble of feudalism. So the United States benefited from that common law tradition, an individualist, permissive approach driven by and created for the benefit of a rising bourgeoisie of individuals who wanted to trade and prosper without being held back by self-appointed authorities. But by the time Latin America was colonised, the prescriptive legal tradition of continental Europe had taken root among the colonizers. The most it could hope for was the Napoleonic idea of enlightened despotism.

This thesis suggests that countries with such a past could never prosper. But I am not convinced. After all, Latin American countries have been hugely rich in the past. At the beginning of the twentieth century, Argentina was one of the richest countries of the world, not far behind the United States. Venezuela grew rapidly before the Second World War, and continued growing after it to become around 85% as rich as the US in the 1950s. Only then did the rot set in. History and institutions may indeed weight down a country. But such experience shows that, if the conditions are right, ordinary people, entrepreneurs and traders, can turn around almost anywhere. All it needs, as Adam Smith put it, is 'peace, easy taxes, and a tolerable administration of justice'.

Many claims are made about the impact of voting systems on government fiscal policies, but what does the international evidence say? In this think piece, James Paton assesses the impact of coalition government and systems of proportional representation on government fiscal policies in five different countries, and discusses the implication of his findings for the US.

Perhaps the strongest argument for FPTP is that the likelihood of forming a single party government is much higher than under proportional representation (PR). Single party overall majority governments are widely seen as being more stable than coalitions. As a single party has a majority within the legislature, a government should be able to push the legislative agenda through. The thinking goes that this should keep faith with credit markets due to the lower chance of the government collapsing, and tighter fiscal policy as the bargaining process involved in coalition formation leads to higher taxes and higher government spending. (In order to buy the support of the various interest groups the negotiating parties rely on.) This has been an area that has not been discussed in detail during the debate around Britain’s possibility of changing the electoral system.

In this think piece, I will examine whether PR is more likely to produce coalitions, and if so, whether coalition governments produce more fiscally profligate governments, in terms of fiscal policy. This will be kept within the years of 1987-2007 before the financial crisis. I will examine five western parliamentary democracies that have systems based on PR to see whether there is evidence suggesting that fiscal policy is looser than in the UK: Greece, Ireland, The Netherlands, New Zealand and Germany.

This of course is not an absolute science as there are a myriad of variables that affect fiscal policy. However the evidence that I explore shows a mixed picture from around the world. From it I will consider what PR could mean for the UK. [Whole piece]

The Finnish parliamentary elections are not usually a reason to get overly excited. However, its fortunate timing coinciding with the meeting of the European Commission, the ECB and IMF in Lisbon to negotiate the third EU bailout in a year (one which is estimated to cost €80,000,000,000), meant the Finns went to the polls safe in the knowledge that they would be expected to foot, albeit not for the first time, their share of the bill.

Riding a wave of Euro-scepticism, the former underdog True Finn party (allies of UKIP in the European Parliament) increased their share of the vote by over 15% and knocked the ruling Centre Party into fourth place, a development which has the potential to wreak havoc on the EU's planned bailout. As one of the few countries in Europe whose parliament has the ability to scrutinise EU bailout packages on a national level, the True Finns, along with their fellow bailout sceptics the Social Democrats, could veto the bailout plan. True Finn leader, Timo Soini, has prophesied that 'the package that is there – I do not believe it will remain', to cries from the opposition of Finland having to uphold the 'common European cause'.

Just how legitimate is this 'common European cause'? Before any bailout packages, every Finn has been made €470 worse off per capita owing to EU budget contributions between 2007–2013. Although the bailout for Portugal includes allegedly radical reforms including privatisation, labour market reforms and moves to bolster fragile banks, Portugal will not rid herself of her multi-billion Euro debt by these reforms alone. Laden with debt, dependent upon a textile industry that is forever being squeezed by foreign competition and encumbered by EU regulations, a bailout will simply defer and draw out Portugal's pain. In attempting to rescue an indebted nation from economic collapse, is even more debt an effective solution?

Ultimately, Portugal should leave the EU, default, and radically restructure its economy along free market lines. But, of course, this wouldn't happen as it is politically impermissible in Brussels. Until the day that changes, it seems that the responsible nations of Europe shall continue to pay for the excesses of their EU bedfellows. However, it is clear from the recent result in Finland that dissatisfaction at the EU is on the rise once more.

Camden Council has effectively banned a street party planned by republicans to coincide with the royal wedding. This is a shame, since those opposed to the monarchic principle should be allowed to express their views. It is not as if they were trying to occupy part of a public space in perpetuity; it was just a day's party they planned.

It does highlight the debate between those who support our constitutional monarchy and those who favour replacing it by a republic with an elected head of state. To those of a libertarian bent, what matters is not how democratic or representative is either form of government, but how friendly they are to liberty.

On an empirical level, constitutional monarchies have been quite friendly to liberty. A monarch who inherits the office feels no popular mandate to impose their views on everyone else. They did not have to claw their way to the top, but simply inherited it, and are conscious of the limitations this implies.

Our constitutional monarch occupies the top slots, not only as head of state, but as head of the armed forces and the judiciary. As such, they deny these posts to ambitious self-seekers who might wish to use them to promote an agenda. A monarch who simply inherits the position can act as a focus for the nation more easily than someone elected as head of state via partisan politics.

Many, if not most, of the theoretical arguments would win the case against a head of state who came from a family that had emerged by the blood and chance of history to occupy that position from birth alone. Yet in practice the record of modern constitutional monarchies has been a good one for tolerance, for the rights of dissenting minorities to do their own thing, and for upholding the rule of law and the rights of free speech.

I am reminded of President Reagan's remark to his economic advisors: "Yes, gentlemen, that is fine in practice, but how would it work in theory?" On the whole, in constitutional monarchy I think the practice has it.

There's an idea out there I regard as pernicious. Roughly stated, it's that the economy is now so complex that we've got to guide it. Plan it, let the Wise Men in Whitehall decide where investment should go, get them to pick winners to the benefit of us all. Brink Lindsey has a paper out which argues against this case. Worth reading in full but here's the nub of the argument.

We can regard economic grwoth as coming in two forms. There's catch up growth, such as what China is doing now and Japan did 50 years ago. What to do is largely known, for there are the examples of the richer, more advanced, economies that can be followed. To an extent it's as simple as pulling people out of low productivity agriculture and into high productivity industry, raising the education levels and increasing participation in the formal economy. But the important point is, in Lindsey's view, that it is at least feasible for a government to work this out and to manage the process. Clearly not all do for not all have followed this path but it is at least possible that some will.

However, once a place has got rich the problem changes. Catch up growth is no longer possible, for there's no one to catch up with. The economy has arrived at the technological frontier so there's no one to copy. Any further growth is going to come from innovation, new ways of doing things, rather than mobilising extant resources to simply do more. At which point governments can't do that planning and directing thing.

For, as Hayek pointed out, the only information system we've got to calculate what the economy should do next in such a situation is that very economy. It simply isn't possible for a central planner to decide whether capital should be allocated to gluten free bread, discounts on golfing holidays, weird metals extraction, wedding photography or software for computer based gambling (to mention only a few businesses extant among the readers of my blog). It is only that great calculating engine of the entire economy, with that interplay of supply and demand determining prices, which can possibly give us the information necessary to direct where to go next. For none of us know what's going to be the next big thing, all we can do is experiment and find out, the experiment being the means by which we find out.

All of which means that it's the very complexity of the modern economy, it's pushing up against the technological frontier, which means that planning, the State direction of industry, cannot work and that we need to be ever more free market in our approach if we are to continue to grow.