Duncan’s Economic Blog

Osborne: Neo-Classical Nonsense

Posted in Uncategorized by duncanseconomicblog on October 6, 2009

I just read Osborne’s speech. Despite the headline grabbing stuff (cutting a third of white hall, public sector pay restraint, the raising of the retirement age, etc) it was actually fairly light on detail.

As Osborne said:

I can’t give you the 2010 Budget in 2009.

Quite right. Which makes his calls for Labour to be ‘more honest’ about future plans even more infuriating.

What the speech did contain was some idea of the basic ideas behind Tory economic policy. The central thrust was:

We want to turn an economy that borrows into one that saves.

At every stage we will support the culture of saving, and for those who show responsibility for themselves and others.

Encouraging savings is why I made my promise that only millionaires would pay inheritance tax.

Of course this financial crisis means it cannot be a priority for our first Budget, but in the lifetime of a Parliament we will honour that pledge.

A savers society is our ambition.

I’m starting to think that Osborne actually doesn’t understand economics at all. What does he think will happen if people spend less and the government spends less?

I’ll tell you what will happen in one word: Ireland.

Nearly one year on, what has been the effect of these polices? Irish GDP is expected to fall by 12%, a staggering decline. Unemployment has reached 12.4% and is still rising. The economy is now in the grip of a severe deflation (minus 5.9%). Finance Minister Brian Lenihan openly talks of the need to “get our cost base down” in order to regain competitiveness. A policy of aiming to balance the budget and drive down wage costs is a throwback to the so-called Treasury View of the 1930s, a policy rejected then by progressives and rightly rejected now. The final irony is that, despite all of this needless suffering, the Irish Government will still be running a budget deficit of 12% of GDP this year while the ratings agencies have already cut Ireland’s sovereign bonds from AAA to AA.

To me the question is not how do we pay down debt, it is how do we return to growth. As I’ve made clear my preference is for higher investment.

Now, I should imagine many ‘informed’ Tories would accuse me of inconsistency here. A basic accounting relationship in economics is that savings are equal to investment.

But ‘savings = investment’ doesn’t really tell us much. As Paul Krugman has argued:

The effect of this upward shift in desired savings at any given level of GDP is, paradoxically, a fall in actual savings and investment.

One key implication of the fact that we’re living in a paradox of thrift world is the folly of demands that we reduce budget deficits in the near term. Slashing spending or raising taxes right now wouldn’t just deepen the slump — it would actually make us poorer in the future, too, because it would lead to lower overall saving and investment.

In other words raising the savings rate (as a % of income) can actually lead to lower savings as the reduced spending in the economy causes income to fall.

As I’ve noted before:

Thus, Post Keynesians and neoclassicists can pretty much agree on definitions of saving and investment, for example. They can also agree that in a simple economy with no government and no foreign trade, savings must equal investment. This is, in fact, a basic national income accounting identity. Where these two schools differ is not here, but in how they see the causal nexus between the two. For neoclassicists, savings cause investment; it provides the funds needed to build new capital equipment. In contrast, Post Keynesians hold that investment determines savings. Investment can be financed by borrowing from banks, which does not require savings because banks create money by lending. Investment, in turn, generates jobs and incomes. Some of this income will be spent, and the rest saved; thus, at the end of the process, savings.

 

Empirical Post Keynesian Economics, Holt & Pressman (Emphasis mine).

 

This is more than an academic economic theory debate. George Osborne is pushing a neo-classical (almost classical!) line that the government spending less and people saving more, will lead to high investment and higher growth. That’s been tried before in the real world – in the 1930s. The result was depression.

The UK economy is far from out of the woods and quite frankly, I’m scared of what an Osborne Chancellorship would be like. 

What is need are policies to raise investment, not policies aimed at removing demand from the economy.

21 Responses

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  1. newmania said, on October 6, 2009 at 2:45 pm

    What is need are policies to raise investment, not policies aimed at removing demand from the economy

    Let us go then, you and I, When the evening is spread out against the sky Like a patient etherized upon a table

    Spend spend spend again , put it all on red eh ? I saw Krugman having a whine about the Republicans being nasty in the Guardian I had not realised he was quite such a partisan lefty . You are wrong , this is an academic debate , in the real world you need to create value not throw easy credit at worthless scams . Printing money might stop the plane falling out of the sky ( dubious ..myself ) it cannot help growth which requires productivity efficiency competitiveness et al . In fact it can easily stop all this happening shoving monopoly money into play just makes the economy( Like a patient etherized upon a table)
    I see Iceland is roaring back into life , Australia still going well , we still in the shit despite all this judicious debt acquisition we spent years planning for by being so careless of tax payers money .

    By the way Duncan I wronged you and I feel really guilty about it , you have a big eared Spaniel-esque charm and I `d hate you to think I was ill mannered .. you do not always say ‘spend spend spend’ …sometimes you say’ regulate regulate regulate’

    There now I feel better , phew ….

    • duncanseconomicblog said, on October 6, 2009 at 4:03 pm

      What would you rather happened?

      The government and consumers cut spending, leading to less investment as companies have no incentive…

      or

      … the government trys to raise investment levels and maintain demand?

      I’m not saying that ever rising public spending is the answer to all economic problems! I’m just saying that currently, the polciies of Osborne would be bad for the economy.

      Glad you feel better. But big-eared Spaniel-esque charm? Low blow.

      I don’t note your ‘dripping at the mouth, rabid terrier like charm’ do I?

  2. dannyboy said, on October 6, 2009 at 3:00 pm

    Duncan, it seems increasingly clear that the business community are getting scared of an osbourne chancellorship too. The question is whether it is osbourne or tory policy that they fear most.

    Would replacing osbourne with hague make real businessmen worried about their bottom line feel any better I wonder?

    Seems to me there is still evrything to fight for.

  3. Tim Worstall said, on October 6, 2009 at 4:12 pm

    “What is need are policies to raise investment”

    That’s what you want? Simple, straight (neo) classical micro. Remove the constraints to investment (for after all, incentives matter). Lower capital gains tax, lower corporation tax, bonfire of the regulations, near abolish the planning system, abolish the minimum wage, ….come on now, any fool can raise investment.

  4. freethinkingeconomist said, on October 6, 2009 at 4:19 pm

    By the way, Duncan, Tim’s also tried his hand at Keynesianism 101 on his blog – trouble is, the “look what the real world is actually doing” asspect is missing.

    http://timworstall.com/2009/10/06/oh-dear-trouble-for-tmultiplier/comment-page-1/#comment-35159

    Tim, classical micro fails in an insufficient demand situation. This is not a right-left thing. People don’t invest just because you make it cheaper, if there are no eventual customers. No doubt you’ve run a business: you don’t just borrow and invest for the hell of it. See this post on Charlotte Gore for a micro-perspective

    http://charlottegore.com/2009/09/27/responsible-lending-nationalised-bank-style.html

  5. Tim Worstall said, on October 6, 2009 at 4:37 pm

    “People don’t invest just because you make it cheaper, if there are no eventual customers.”

    There are never “no eventual customers”. There are only no customers at a price. Reduce the price of production and it’s possible to reduce the sale price and still make a profit.

    Yes, I have run a buisiness. Still do. If someone told me my next scandium factory (something I am indeed interested in building) cost $10 million, I’m less likely to build it than if it cost $5 million. And that’s actually about what the price difference is given planning, enviro and all the other regulations.

    BTW, that “look at what the real world is doing” bit is in the paper I’m quoting from. Empirical measurements of what has actually been happening 1960 to 2007.

    • duncanseconomicblog said, on October 6, 2009 at 4:43 pm

      Tim,

      But surely you’d also ask – ‘what is the likely market outlook for scandium? How much demand is out there? How much can I sell it for?’.

      And if the answers to that where not to your liking, then surely the difference between $5mn and $10mn matters a lot less?

  6. Tim Worstall said, on October 6, 2009 at 4:51 pm

    “How much demand is out there? How much can I sell it for?’.”

    Demand will of course rise the lower I can sell it for and still make a profit, won’t it?

    As it happens there are broadly three markets: one extant and two that could be gcreated. The markets that could be created depend heavily on what the sales price would be. So the cheaper the factory the more likely I am to invest as I’m more likely to be able to meet the price points which will spark off those two new uses, no?

    • duncanseconomicblog said, on October 6, 2009 at 4:59 pm

      “Demand will of course rise the lower I can sell it for and still make a profit, won’t it?”

      Oh dear, Well in terms of pure theory yes.

      But surely most business people don’t respond to low demand by increasing supply?

      And good luck raising a loan for that one. ‘I want to borrow $5mn to build a new factory. Demand is currently very weak but I beleive that by adding to capacity I can drive down prices further and maybe, just maybe, increase volumes’.

      Should the response of automakers to the demand drought (before the various cash-for-clunkers schemes) have been to build more capacity?

      In general business invests when it feels confident. And confidence in this case is related to likely demand.

    • Cian O'Connor said, on October 7, 2009 at 9:43 am

      Such as shipping companies during the recent crisis, you mean?
      If people don’t want the product you’re selling because it has little utility in the current situation, then it doesn’t really matter what price you sell it at. Similarly if supply is oversaturated.

  7. Tim Worstall said, on October 6, 2009 at 9:36 pm

    “But surely most business people don’t respond to low demand by increasing supply?”

    John D. Rockefeller did. He, like most business peoplle, was entirely happy to lower prices in order to increase demand: so as to maximise profit.

  8. Will M said, on October 7, 2009 at 8:16 am

    “I’m starting to think that Osborne actually doesn’t understand economics at all.”

    Starting? STARTING?!!!! The man doesn’t have a clue. Not a clue. You could hand him a clue, with a great big label wrapped around it saying “this is a clue”, and he still wouldn’t have any idea whatsoever.

    E.g. national insurance tax breaks on new workers for startup businesses. If a single senior member of the Shadow Cabinet had ever started up any enterprise that wasn’t related to a leadership election they would know that startup businesses don’t generate fresh jobs in the first 6 months (most have failed by that point), and rarely in the first year. When they do generate jobs, its in piffling amounts.

    If Osbourne wants to generate jobs and growth its very easy: national insurance tax cuts for new employees for the first 6 months. Cuts unemployment, increases growth, and with a far higher multiple (I suspect, given US data) and more instant effect than government spending.
    (Not sure whether that would help your investment theme though Dunc.)

    But then, the Tories would have to care about new policies, rather than re-habilitating a lot of very old policies, to do that.

  9. newmania said, on October 7, 2009 at 8:31 am

    election they would know that startup businesses don’t generate fresh jobs in the first 6 months (most have failed by that point), and rarely in the first year. When they do generate jobs, its in piffling amounts.

    Ours did , many of our clients do . What do you know about it ?

    • Will M said, on October 7, 2009 at 8:42 am

      Not going to compare my experience for working for an SME, cos that’s only one data point, albeit one that contradicts yours. If you have any studies / wider datasets on this, very happy to look at them.

      In the meantime, in 2004 61% of SMEs had no employees: http://www.wbs.ac.uk/downloads/research/wbs-sme-exec.pdf

      Though obviously that doesn’t account for all the multi-national startups.

  10. freethinkingeconomist said, on October 7, 2009 at 9:36 am

    Tim

    I think you are confusing two types of demand movement: demand changing because you move along an unchanging curve (i.e. lower prices, higher quantity), and demand because the whole curve has gone down.

    A collapse in AD right now means that for the same price you are selling less, and you have to cut prices just to achieve the same sales though with lower profits. It is quite possible that a collapse in AD/a sudden rise in money-demand could force the individual D curves down to the point that there is no profitable price left. This, I understand, is the meaning of the phrase ‘going bust’

    In these circumstances, would you

    A. Lift up the AD curve
    B. Lower cost of financing so people can expand capacity . . ..

    I’m sure you agree which is the right answer. . . .

  11. freethinkingeconomist said, on October 7, 2009 at 9:38 am

    Oh, and “what the real world is doing” – I mean in terms of (a) global demand for GBP items and (b) the price of the currency. The zero multiplier theory doesn’t work if the currency doesn’t fall and global demand is not there.

    Whereas empirical measurement of a period that fails to include a deflationary slump and financial crisis is of limited use. It’s rather similar to the mistake the financial world made in extrapolating one set of conditions into a model, and then looking dumbfounded (’25 standard deviations’) when strange stuff started to happen.

  12. Tim Worstall said, on October 7, 2009 at 9:45 am

    You’re assuming a world of unchanging technology. I’m assuming one of changing technology.

    New technologies (like, say, solid oxide fuels cells, advances in aluminium alloys,) and other exogenous changes (like, say, a mooted chinese ban on the export of raw rather than processed rare earths. the trade offs being demanded between fuel efficiency for aircraft and jet engine noise on landing and takeoff) are far more important to me than the AD is.

    And quite possibly skewed by the area of business that I work in (weird and wonderful metals) I tend to think that business and most certainly business investment is driven by changes in technology, not by the level of AD.

    Certainly, in my business life, that’s what I see. It ain’t (to use two products that my materials go into) “will people be buying more metal halide bulbs because of AD” that interests me it’s “will the ban on incandescents lead to metal halide or CFLs” and “will those buggers ever start making solid oxide fuel cells” rather than “what is energy consumption going to be in the future”.

    As I say, my view might be skew whiff: but then again it might not. As far as I understand macro most models ignore technological change altogether which is vastly more wrong than any over emphasis that I might be putting on it.

  13. freethinkingeconomist said, on October 7, 2009 at 10:03 am

    I think your view is bang-on for the longer term supply potential of the econoomy. And that is what will ultimately matter – what will keep the line pointing upwards rather than flat. Those supply side considerations will really matter, once again. For most of economic history, your sort of considerations, not the Keynesian sort, have been relevant.

    But not in a depression.

    And your business you might be insulated from general AD fluctuations. But 100x as many people work in low-innovation retail, say, and a collapse in AD throws them into unemployment, with the hysteresis effects and so on.

    If your view is “AD doesn’t matter, coz it doesn’t for me” then I think I know why we are arguing. But you would also be arguing with monetarists, not just Keynesians. Both want AD up.

    here is a graph to keep people optimistic:

    http://finance.yahoo.com/funds/understanding_investing/article/100562/A_Long-Term_Perspective:_The_Seasons_of_the_U_S__Economy

  14. […] who are more expert in economics than I am, disagree. Duncan Weldon, for example, points out in a recent post on George Osborne’s speech that demanding lower spending across the board appeared to make the 1930s depression far worse and […]

  15. […] cuts by which the Tories are promising to outdo their Labour equivalents, against even capitalist economic […]

  16. […] perhaps more alarming – a strange, discredited reliance on neo-classical economics. I’ve blogged on this more extensively but the facts are relatively straightforward. Osborne’s plans are premised on the notion that […]


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