Duncan’s Economic Blog

Labour Investment versus Tory Cuts

Posted in Uncategorized by duncanseconomicblog on September 21, 2009

I’m bored of the public spending ‘debate’. There are two issues which have been entirely conflated. First, was the Government right to launch a fiscal stimulus rather than aim to minimise the deficit, a la Ireland, last year? I think most sensible commentators now accept that the Government was correct. Second, a what point should the stimulus be withdrawn? Here we can have a genuine debate. I stand with Krugman (and I’ve dubbed the ‘crazy people gang’) that next year is probably too early. It all depends on when the long awaited ‘recovery’ begins. Or at least it should, but Cameron now appears to be embracing an ideologically driven, economically illiterate position.

But I want to turn to bigger issues. A while back Hopi asked:

So surely the biggest question in politics should be “What should we do to grow”, rather than “How and what do we cut”? The general consensus seems to be that recovery will be anemic and tentative, no matter what the official projections are. So why do so few politicians appear to have a coherent argument about how we can do about changing that?

Obviously, I’d be positively enthralled by a social democratic argument about what the role of the state was in priming short to medium term growth.

Chris Dillow responded by writing:

Of course, it’s easy enough to boost short-run growth – just throw enough money around. Promoting long-run sustained growth is, however, much trickier. It might even be impossible. This paper concludes:

“Except for the decades around WWII, there is no evidence of country specific effects on long run growth rates…Growth rates are determined by international factors, and are insensitive to national policies, especially for small countries. This implies severe restrictions on the ability of most governments to increase national long run growth rates.”

He used the examples of  France, Italy, Spain, Sweden, UK and the US to illustrate this point. Although late, in the comments, when asked about Japan and South Korea he noted:

Policy and institutions matter enormously for whether poor countries catch up with the rich or not. It’s just that once freeish markets and secureish property rights are in place, and a country is near the technological frontier, the ability of policy to increase long-run growth seems to diminish a lot.

I’m not sure I agree. John Ross has made a convincing case that China’s growth model has universal characteristics that can be replicated. As he wrote last month for the Guardian :

China has a series of interconnected and mutually reinforcing policies.

The first is the economy’s high proportion of exports – crucial to its “opening” process. Every economist since Adam Smith has known that the division of labour is a decisive lever in raising the level of productivity, and division of labour in a modern economy is necessarily international. A high level of exports and imports is the way of participating in such a division of labour – as well as benefiting from advantages such as economies of scale.

Economic theory therefore confirms what economic practice already demonstrated. That the alternative to China’s open approach, that of inward-looking “import substitution” policies lead to inefficiency in capital use and low productivity.

Critics of China’s “export-led growth” confuse two ideas. The first is a high level of exports in GDP, rightly integral to China’s growth model, the second is a high trade surplus – not integral to China’s model, which appeared only after 2005, and is now disappearing rapidly.

Second is China’s high level of investment. Modern econometric research shows conclusively that, following division of labour, the largest element in economic growth is the growth of fixed investment. This applies not only to a developing economy such as China but also to developed economies. Dale Jorgenson, the world’s leading expert on productivity growth, notes that “investment in tangible assets is the most important source of economic growth in the G7 nations. The contribution of capital inputs exceeds that of total factor productivity for all countries for all periods.”

Criticisms of China’s high level of investment would be valid only if China used that investment inefficiently, and contrary to claims made without evidence, all studies on productivity show that China uses that investment with an efficiency rate from respectable to high (pdf).

Third, a decisive point showing China has a “socialist market economy” and not “market capitalism”, is its method of macro-economic regulation. (My emphasis).

The second point here – investment – is crucial.  Investment in the UK economy has collapsed Taking the most recent ONS estimate:

Gross fixed capital formation fell by 4.5 per cent, following a fall of 7.5 per cent in 2009 Q1. There were sharp falls in business investment on machinery and equipment.

The level of gross fixed capital formation is now 15.2 per cent below the same quarter of 2008.

The 15.2% drop in investment is the single largest driver of the fall in GDP. What’s more this has more than a short run effect. As John notes the work of Dale Jorgenson (former head of Economics at Harvard) suggests that investment is the driver of long term growth.

So rather than talking about the deficit, shouldn’t we be talking about the level of investment? Given it’s the biggest contributor to the recession and arguably the driver of long term growth?

How though do we go about raising investment?  Ultra low interest rates and quantitative easing alone haven’t achieved it (although they have probably prevented an even worse fall).

As John has noted, Keynes dealt with this very issue.

Keynes noted in the final chapter of his General Theory, in a point highly relevant to a situation where mass unemployment is again soaring, that “a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment”.

I’m not advocating a command economy, I’m not advocating nationalising the commanding heights of industry. I’m simply arguing for direct public intervention to raise investment levels. In the short run this will raise GDP and in the long run it raises trend growth. It’s not even thst radical – it’s just a Keynesian solution.

If we embark on this policy then we can truly fight on the grounds of ‘Labour Investment versus Tory Cuts’.


17 Responses

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  1. Tim Worstall said, on September 21, 2009 at 8:56 am

    Odd that you accept the international division of labour as the most important thing: but then go on to recommend dealing with the second most important thing.

    Why not address the most important thing: the international division of labour? Ie, get out of the EU and it’s trade barriers and declare unilateral free trade?

    • duncanseconomicblog said, on September 21, 2009 at 10:42 am


      I support free trade in general (not always, but in most cases).

      And yes, I’d rather the EU as a whole was a more open economy.

      But in the real world if we left the EU our economy could become more closed.

    • Andreas Paterson said, on September 21, 2009 at 11:35 am

      Tim – I think your confusing whether or not we partcipate in the international division of labour with how we participate (how free or not our trade policy is). It’s of vital importance that we participate (and we do), it’s not so important that we partcipate under a policy of free trade.

  2. charliemarks said, on September 21, 2009 at 10:33 am

    An expansion of the cooperative sector is what we need. Discuss.

  3. Tim Worstall said, on September 21, 2009 at 10:45 am

    “But in the real world if we left the EU our economy could become more closed.”

    That would be up to us to decide. Simple Adam Smith: unilateral free trade.

  4. Andreas Paterson said, on September 21, 2009 at 11:42 am

    Good post Duncan, my personal take on this would be that we need some kind of policy tool that ensures that bank lending is directed towards the kind of investment you’re talking about. Is this what you had in mind?

    • duncanseconomicblog said, on September 21, 2009 at 12:08 pm

      Thanks Andreas,

      It’s certainly one way to tackle this issue. Another is direct government infra spending.

  5. duncanseconomicblog said, on September 21, 2009 at 12:05 pm

    John Ross has responded in a typically detailed manner via email (he’s having trouble posting comments). Well worth reading:

    I think the argument on this post is correct. But I think it is also useful to define clearly a few terms and clarify a few points. This helps explain why the Chinese economy works successfully – it is not very interesting that calls idrlft a ‘socialist market economy’ whereas others see it as an extension of Keynes. What is important is what is the actual character of the economy. China’s economic policy is not, contrary to general belief, some sort of hodge podge. On the contrary it is well thought out and corresponds to fundamental economic principles
    First consider the contrast to a ‘command economy’. In this the mechanism of economic regulation is that resources are allocated by administrative decision and not by a market. There are two classic case. An economy of the type introduced by Stalin – in which it is literally illegal to sell a pencil at a different price in Moscow or Siberia and resources are distributed by plan. Second, virtually any economy in a major war – when the government allocates the majority of economic resources to military projects without any regard to market conditions. Command economies are probably indispensible as short term expedients in war but they are damaging as a long term economic mechanism for a whole series of reasons. They are nationally enclosed (as trade cannot be planned) which cuts the economy off from international division of labour and economies of scale producing low productivity of capital, they do not respond to consumer signals, leading to shoddy low quality production etc. etc. etc.
    Now consider Keynes own views in the General Theory of Employment, Interest, and Money – which are not, of course, the ‘Keynesianism’ that is generally taught to undergraduates as Keynes’ work did not centre on budget deficits at all. The key relevant points are:
    1. Keynes understood that the proportion of the economy devoted to investment historically rose with time:’ A poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment.’ General Theory Chapter 3)
    2. As investment was controlled by profit, including expectations of profit, and not by the desire to consume this constituted a potential element of instability as lack of investment would lead to lack of effective demand and the higher the proportion of the economy devoted to investment the greater was such a threat: ‘The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by as much as income… Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment.’ (Ibid)
    3. Including for reasons of liquidity preference there was a danger the anticipated rate of profit would fall below the rate of interest – leading to a fall in investment and therefore lack of effective demand: ‘the amount of current investment will depend… on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.’( Ibid). And: ‘the extent of effective saving is necessarily determined by the scale of investment and… the scale of investment is promoted by a low rate of investment.’ (General Theory p24)
    4. Therefore a policy of low interest rates was required to stimulate. That would however necessarily lead to the subordination of banking to the productive economy – i.e ‘the euthanasia of the rentier’. (Ibid)
    Therefore, the core of Keynes policy flowed from his central concern of monetary policy and was low interest rates to stimulate investment – not budget deficits.
    However, and this is where China intersects, there may be conditions under which either even low interest rates are insufficient to relaunch investment, or the time period for low interest rates to take effect is too slow compared to the severity of the sharp downturn in effective demand (the situation post-September 2008 being an example) and in this case direct measures to sustain investment must be taken. This is in accord with the conclusion of Keynes: ‘it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.’ (Ibid)
    In order for such a policy to work the state must, of course, have sufficient levers to be able to break the downward turn in investment and increase effective demand by raising it – this is, of course, what China possesses with its significant state owned companies and state owned banks. But the aim of this state intervention is to affect effective demand by preventing a fall in investment, and not administratively run of the economy.
    This system appears to me to be entirely in accord with the fundamental principles of economics. As noted above it is termed by China a ‘socialist market economy with Chinese characteristics’ but if someone else wants to call it ‘Keynesianism with Chinese characteristics’ that is scarcely the most important thing! It is a genuinely alternative system of macro-economic management to either neo-liberalism or a command economy and it is highly successful. Such a system can be understood in either a Keynesian or a socialist framework.
    What should be the balance between interest rates, public spending, and direct state action on investment naturally depends on the precise situation, how serious the downturn is etc. In the UK, we are not at the point where such a total collapse of investment is taking place that total state intervention in all sectors of the economy is required to deal with this, but the conceptual framework is clear from the above. In addition to low interest rates and public spending the decline in investment in some specific areas in the UK (e.g. housing and transport) is so severe that measures of direct state intervention to sustain investment is required.

    • Andreas Paterson said, on September 21, 2009 at 1:47 pm

      What Ross describes has a surprising number of similarities to the strategy followed by South Korea. This was largely a market economy although the nationalised banks that prioritised their lending towards investment in certain favoured industries. They also placed restrictions on which corporations (Korea’s corporations are all large conglomerates) could enter certain industries.

      More interestingly was a paper I read suggesting that the dismantling of these policies was a factor in the Asian crisis (the example given was the entry of Samsung into the already crowded automotive sector).

  6. dannyboy said, on September 21, 2009 at 12:46 pm

    I think duncan and john ross are saying growth comes essentially from increasing division of labour. If it’s growth we are talking about then by definition it must be division of labour over and above existing division of labour.

    Growing division of labour can only be sustained by a growing population, otherwise one is simply discarding old specialisms and replacing them with new ones, which is not growth, it’s change

    Are we positing unchecked population growth for the forseeable future? If so then dissappointment seems likely, sooner rather than later.

    Further I question the idea of national compartive advantage in this day and age. If we take for example the global supply chain for semiconductors, we don’t really find evidence of a comparative advantage accross national borders. What we find is a clustering effect in which what is important is a pool of good local talent at the right price point to sustain a given piece of the chain. Bristol is for example the largest hub for semiconductor design in europe, but there is nothing in theory to stop Munich or Nice or Amsterdam from taking the top spot.

  7. dannyboy said, on September 21, 2009 at 12:53 pm

    I’d also question where future demand is most likely to come from. Find below the pop pyramids for the UK.


    Note the difference of the 2010 and 2050 pictures. The transition between the 2020 picture and 2050 picture is very fast and very large. I don’t believe for one second that the demand profile of 2040 is anything like the demand profile we’ve seen for the last 20 years. The picture abroad is very similar.

    So if we need more investment, investment in what? Seems to me that in 20 years the most dominant demand is going to be for services which by necessity are generated and supplied domestically.

  8. Tim Worstall said, on September 21, 2009 at 12:58 pm

    “Growing division of labour can only be sustained by a growing population, otherwise one is simply discarding old specialisms and replacing them with new ones, which is not growth, it’s change”

    That would only be true with static technology. As we mechanise tasks then those tasks that are done by human labour can become ever more specialised.

  9. dannyboy said, on September 21, 2009 at 1:13 pm

    “That would only be true with static technology. As we mechanise tasks then those tasks that are done by human labour can become ever more specialised.”

    That’s one, quite common view. However I think it can be challenged in a number of ways.

    Firstly, machines need a design/maintainance/supply chain, so every layer of automation needs a crew, so to speak. It’s not for free.

    Secondly, historically we have always had robust population growth, and it is certainly the case that population growth supports technological development, and tech development supports increased population growth, but it’s difficult to work out which comes first. We have not yet had the chance to empirically test what if any technological progress we would make without supporting population growth. So I think your statement is a justifiably described as a hypothesis, which may or may not turn out to be true.

    Thirdly, I observe that in general new technological specialisms are increasingly beyond the wit of the average member of the population. Learning a new welding technique is largely a matter of practice. Learning to design and operate complex new technical machinery or perform surgical operations is open to a far smaller percentage of the population.

    I think we really ought to be planning for a future which is not always rescued by technological progress, just in case you turn out to be wrong.

  10. Tim Worstall said, on September 21, 2009 at 1:17 pm

    “so every layer of automation needs a crew, so to speak. ”

    Which is increasing specialisation of labour: QED.

  11. dannyboy said, on September 21, 2009 at 1:25 pm

    “Which is increasing specialisation of labour: QED.”

    Yes, assuming you can find a suitably qualified candidate not already occupied in maintaining one of the existing essential layers of technology. Clearly this is going to a much taller order as the complexity of technology increases relative to our innate intelligence, which is not increasing, and without the free lunch of population growth.

    The thing is you can use unspecified future technological progress to justify whatever you like today, including vast and never ending deficits for example.

  12. Investment versus Cuts, redux! « Hopi Sen said, on September 22, 2009 at 11:39 am

    […] Duncan Weldon points out, the most striking current feature of our current recession it the collapse in […]

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