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24/12/2014 07:10

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significant at a high level.   These
results contrast with Alesina's findings and amplify the views of the IMF. 
 
There is a possible reconciliation between Alesina's conclusions and those
Taylor made after the adjustments applied to reduce misallocation.   In
practice, austerity measures are systematically applied in weak economic
conditions, and, following a weak period, the economy, having spare resources,
is inherently likely to grow faster, so recovering in spite of, not because
of, the extreme fiscal treatment:  a dead cat bounces whether it jumped or was
pushed!   In technical terms an economy in recession already has an endogenous
bias to grow more rapidly.   Thus the effects of an exogenous variable, the
fiscal treatment, is not independent of the state of health of the economy, or
for Dr Hamilton, the sickness of the soldier.   Taylor summarises his
findings:  "By failing to allow for the endogeneity of treatment we could end
up with a far too rosy view of the aftermath of fiscal treatment."   Fiscal
contraction prolongs the pain when the state of the economy is weak, much less
so when the economy is strong.   In his randomised trial blood-letting, as Dr
Hamilton found, was the worst treatment, a treatment probably more damaging in
ill patients. 
 
The June 2010 OBR forecast for real GDP in 2013 was 5.2% higher than the
out-turn.   Taylor estimates that 3.0 percentage points of that shortfall were
due to the fiscal austerity, but he concludes "our estimate of austerity's
effects in the UK is probably conservative".    Since Taylor's paper was
published in July 2013, growth has continued, but not at the higher than trend
rate expected after a severe recession and, on Taylor's analysis, is in spite
of, not because of, fiscal tightening.   Fortunately, the fiscal tightening
has been far less stringent than was originally announced and many
concessions, including tax giveaways, have been made which have mitigated the
effect of the cuts - the actual austerity programme has been "Plan A minus".  
A little harm is less bad than a lot of harm! 
 
The fiscal contraction has caused specific damage to the economy because of
the nature of the cutbacks and because the cutbacks' ancillary effect on the
productive capacity and the productivity of the economy.   At the start of the
2014/15 tax year about 90%  of the cuts to investment spending had been made
but less than two-thirds of the cuts to benefit spending and less than
one-third of the cuts to "other current expenditure".   Thus, proportionately,
the greatest cuts have been to public investment ie capital goods, not to
so-called "investment" in public services that are actually current
expenditure or usually public sector losses, where the IMF contend that,
provided unemployment is high, the stimulus effect of investment is greater.  
Lawrence Summers, a former US Treasury Secretary, illustrates the benefit of
such investment by assuming, according to convention, that such investment
returns 6% in real terms and increases tax revenue by the marginal rate, say
25%, or 1.5% of the investment.   As real interest costs are currently below
1.5%, the investment is self-funding.   The return on investment is greater as
it neglects the tax revenue, and welfare saving, of putting people back to
work and the long-term benefit of combatting recession and of increasing the
economy's capacity.   Taking these and other factors into account, the IMF
finds that a unit of such investment increases output by nearly three units.  
Unconsciously, perhaps, such investments were made in the US during the New
Deal and in Germany before WWII.   Summers says:  "There really is a free
lunch". 
 
Fiscal contraction may have caused or contributed to irreparable damage to the
economy.   In past recessions output has recovered to a level consistent with
the trend line of growth before the start of the recession, which was 2.8% in
the UK from 1955 - 2007.   This difference, the output gap, is currently
estimated at between 11.5% and 15% of GDP as a result of the lowest growth
rate of productivity in peacetime for over 150 years.   In the US the trend
growth rate was 3% and the output gap at the end of 2013 was 17%.   If the US
economy continued to grow at 3% and if the P.V. of the future GNP is also 3%,
then the present value of the loss of GDP would always be 17%.   After 100
years this permanent gap would cumulate to 17 times the current GDP, a cost
greater than WWI, a hundred years ago.    A failure to regain the previous
trend line of economic growth is a large and growing loss, such is the wonder
of exponential growth. 
 
The cause or causes of damage to the structure of the economy which has
occasioned such a failure are not clear.   Indeed, it has been argued that the
loss is overstated as the recent underlying growth rate may have been
exaggerated or enhanced by the credit boom preceding 2007 and the accompanying
atypical rise of the financial sector.   However the growth in output in the
credit boom preceding 2007 was not appreciably different from that previously.
  Moreover, when the crash came declines in employment did not vary among
sectors, implying no one sector had been especially developed.   Wage and
price inflation did not increase prior to the crisis, and so it is
unreasonable to assume that there was a general pre-2007 output boom. 
 
The output gap, the difference between the level of output had the growth
trend line been recovered and the actual output is estimated at between 11.5%
and 15.0% of GDP.   However, the existing gap is estimated to be only 2.5% for
the UK (2013) and 3.0% for the US and it is argued that the output gap has
been incorrectly estimated.   However, as inflation has been steady, and has
not given way to deflation, or at least not yet, it is unlikely that there are
such vast unemployed resources available, as surplus capacity of that scale
would have surely triggered falls in prices even with the traditional
inviolability of wage levels and prevailing expectation of inflation.   A
probable explanation for the difference between the existing gap and the
output gap is that the economic crisis and the long ensuing depression have
damaged both potential output and its rate of growth.   The imposition of the
extra burden of "expansionary fiscal contraction", extending and deepening the
depression, will have had more than an additive effect:  many more economic
activities can withstand the first round of stress than the second - the level
of pain is exponential, not arithmetical. 
 
The depressing effects of expansionary fiscal contraction are demonstrated in
the elegant statistical analysis by Taylor.   The effects of a prolonged
depression can be induced by observation:  skills atrophy;  the long-term
unemployed become unemployable;  credit is abnormally restricted causing
closures and inhibiting investment;  businesses operating on written-off
capital plant close and cannot compete at replacement cost;  vital links in a
production chain are lost and cannot be replaced;  alternative overseas
supplies are sourced;  and, crucially, people simply give up;  a six-year
depression is a long time! 
 
The Bank have held a contrary view since 2008, contending every quarter that,
inter alia, economic performance will spontaneously improve or return to
normal, and that low productivity is a temporary measure due to labour
hoarding.   Giles, the FT columnist, compared this attitude with that of the
English football fans who, almost half-a-century after the 1966 World Cup
triumph, exude continued hope for World Cup domination over experience, only
to be beaten into the reality of mediocrity.   But, like England, there is
continuing failure to recover the past position and, indeed, as economic
activity has increased unemployment has gone steadily down as more are
employed while productivity, output per person, improves little.   Lord King,
adopting a theoretical view, together with some members of the MPC, maintain
that there is an inherent, underlying rate of productivity increase which is
unchanging:  Adam Posen's populist explanation of this view was that a
proportion of the workforce had not  "woken up in the morning to find that
their left arms had fallen off". 
 
Unfortunately, productivity increases are not inherent - arms may no longer be
required or may not be sufficiently dextrous, or more arms may be needed.   
Specifically, extra staff per unit of output are now required in North Sea oil
and gas extraction because of  diminishing returns, in the financial and
auxiliary industries because of more onerous compliance procedures, and in
transport where extra security measures are required.   Ian McCafferty, an MPC
member, concluded that these and other non-cyclical factors accounted for some
60% of the decline in productivity.   Perhaps he also should have included the
increased staffing of the public sector where productivity growth has been
spectacularly low.   Unfortunately, the improvements accompanying the
manufacturing sector earlier last century, and the oil and finance sectors
later, have now been largely exhausted and the levels of productivity growth
then cannot be replicated at the present time. 
 
Thus the fiscal contraction is being undertaken at a vast cost to the economy
and to its productive potential with irrecoverable long-term costs.  
Fortunately, the original plan, Plan A, has not been rigidly adhered to and
concessions from it and delays to it have occurred.  The recent autumn
statement in which the Chancellor announced yet another missed
deficit-reduction target and allowed further relaxations including stamp duty
reductions, costing about £800m, and useful, primarily middle-class,
concessions on taxes, children's flights, savings and pensions all exemplify
such derogations from Plan A.   The Economist comments:  "The real test - the
additional pledges to slash public spending - is yet to come ...", but on the
other side of the May 2015 election!   That, no doubt, is too distant a
prospect for the Chancellor as, based on the November Calculus poll, the
current probability of a Conservative majority is less than 10%;  while a
Labour majority is about 40% probable:  ...... a week is a long time in
politics ......... ! 
 
The Chancellor, with the necessary nod to political expediency, has identified
the UK's overriding economic problem as fiscal to which he seeks to apply an
overriding solution:  "Our first benchmark is to cut the deficit 241 quickly
to safeguard Britain's credit rating." A fiscal deficit may have many causes,
as a headache may be caused by a transient hangover or a serious meningitis,
the significance of the symptom depends on the circumstances, and, according
to the circumstances, the appropriate treatment varies.   In Dr Hamilton's
experiment the use of the scalpel cured 88 soldiers but 34 died.  
Bloodletting as a medical cure persisted right into the 19th century "to clear
out" infected or weakened blood and "to cause haemorrhages to cease" 342 for
which it is difficult to contemplate a less suitable treatment!  
Interestingly, Harvey, the discoverer of the circulation of the blood in the
early 17th century, rejected it as a medical treatment but its practice
persisted long after its efficacy had been disproved.   Similarly, clinical
medical trials continued to be conducted until as late as the 1940s whose
results were invalid because they neglected the simple statistical sampling
requirements followed by Dr Hamilton in 1809. 
 
In economics as in medicine, the treatments don't always fit the disease, the
sample is incorrectly drawn, or the diagnosis is wrong:  moreover, outwith the
abstract nature of a controlled experiment, the salient points are easily
obscured.   At present, the use of fiscal austerity expansion is not the
optimal way to cure the fiscal deficit, if that is the overriding objective.  
Similarly, as Dr Hamilton might have surmised, the optimal way to ensure the
health of the soldiers in his care was not to cure them of Typhus but to
eliminate the conditions that led to their disease.   The UK's underlying
economic problem is not fiscal, but financial, as the economy is not operating
at full capacity and the rate of change in productivity is low, resulting in
reduced rates of increase in the output of the economy and the increased tax
derivable from that higher output.   The Chancellor is currently using an
inappropriate remedy to treat a condition that is primarily a symptom of a
greater hindrance to economic growth. 
 
Krugman's criticism of one specific economic policy blunder:  "Most modern
economists - to the extent that they think about it at all - regard the Great
Depression (in the 1930s) as a gratuitous, unnecessary tragedy ...  ... a
nightmarish slump thanks to the stupidity (or at least ignorance) of
policymakers" is far too strong for the current circumstances, but illustrates
the scope for policy errors. 
 
In contrast two very good other political choices have mitigated the potential
damage to the UK economy.   The decision not to join the Eurozone has been
wholly vindicated, as the current UK growth rate is 2.2 percentage points
higher than the Euro area and its growth prospects are considerably better.  
The Euro periphery is locked in a fiscal contraction and has separate
economies requiring separate policies with no means of effecting these.   A
less obvious but more dangerous risk is that of political instability
resulting from perceptions of inequality, inadequate representation,
frustration and inequity.   Underlying and reinforcing instability are
tensions caused by prolonged unemployment, especially amongst the young, and
the distillation, fuelled by envy, of frustration into racialism or, worse,
radicalism.   At present, as the FT comments, the Eurozone occupies the
no-man's land between systemic cohesion and political disintegration. 
 
The European project had backing amongst  inside bureaucrats, political
elites, and "liberals" and professional and business groups with few
dissenting views.   Emphasis has always nominally been on economic argument,
which as many American economists observed, was largely fallacious, but
diffused the political ambitions of its proponents.   The UK was fortunate to
have had Gordon Brown as Chancellor at the crucial time of the recent decision
on the Euro.   His reputation was greatly sullied by the  events leading to
the financial crash, but his achievements include an immediate, effective and
correct reaction to the crash, the deflection of the pro-Euro lobby and, most
recently, a pivotal intervention in the Scottish Referendum debate, which may
have had a crucial influence in leading to the rejection of independence. 
 
The economic cost of independence would have been great.   The specifics of
the likely settlement with the rUK and the EU cannot easily be judged but
whatever they would have been the economic cost to Scotland would have been
considerable, the extent varying with the settlement and the oil output and
its price.   Without any doubt Scotland would have faced higher interest costs
on debt incurred, higher central and administrative costs due to its wide
geographic spread and layout, high social costs due to unfavourable
demographics and higher long-term unemployment.   There is no evidence to
support Scottish latent higher productivity, entrepreneurship or special
skills, leading to higher economic output, and no good argument to show how
these beneficial traits could have been nurtured in an independent Scotland; 
assertion is not argument.   Indeed, the SNP administration is committed to
the centralisation of policies within the Government, to a more redistributive
society, to higher and more progressive taxation and to increased emphasis of
the rights of the state and state officialdom over individual rights.   This
is not a textbook prescription for higher growth. 
 
Whatever the long-term effects of independence, the short-term effects, while
the transition was being effected, would have been most unfavourable.  
Inevitably there would have been a large scale move to rUK in the banking and
financial sectors and in certain technical sections relying on UK-recognised
technical standards.    Investment decisions where the balance Scotland and
rUK was close would mostly have been made in favour of rUK as the downside
risk to investment in a Scotland with uncertain currency and trading
relationships would be very large.   In the months prior to the vote and, as
the outcome became less and less clear, property transaction numbers slowed
appreciably and some were conditional on a "No" outcome.   Relocation,
diversion of investment and delay would have continued through the period of
the settlement and would have caused a recession in Scotland.   Post the
settlement Scotland would have grown at a slower pace than rUK from a lower
base following the Scotland recession. 
 
"It's Scotland's oil" has been the evocative rallying cry of the SNP since the
North Sea field was established, and the oil revenues accruing to Scotland
provided an important and substantial backing for the SNP's economic case in
which it made quite unrealistically large estimates of oil revenue accruing to
Scotland based on oil prices of around $113 and unsupported levels of
extractible oil.  However, the debate and the subsequent referendum all took
place before the recent dramatic fall in the price of oil from $115 in June to
$65 in early December.   SNP estimates of extractible oil seem equally
exaggerated.  North Sea oil production fell 8.6% in 2013 and had declined
until then without interruption by 62.3% over ten years.   The tax revenue was
almost £14bn in 2011 and was forecast then to be £11bn in 2016, a forecast
that has been progressively downgraded in each Budget statement to £4.0bn in
the 2014.   The Budget projections, like those by the SNP, were made before
the recent fall in oil price.   Due to the very high rate of tax on oil and
gas extraction, very approximately 62%, falls in price have a disproportionate
effect.   If the marginal cost of production is $50 then the tax take at a
price of $110 is $37.2 per barrel, but at $65 the tax take is $9.3 tax per
barrel.   Clearly, at current prices the tax revenue would fall substantially,
the estimated tax of £4bn for 2016 reducing to £1.0bn tax.    The tax revenue
is calculated before any allowance for loss of tax in the ancillary industries
and in their employees and "second round" effects on their suppliers. 
 
The discussion on the economics of independence, the price of oil, Scotland's
currency and the economic potential of an independent Scotland is not