Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 31 January 2018

Brexit is fantastic project

Leavers often say they do not understand why Remainers cannot just accept that we are leaving. There are many good reasons, but the one that I keep coming back to is this. Brexit is fantastical. There is nothing about the case for Brexit that is based in reality. This is why everything Brexiters say is either nonsense or untrue.

Take, for example, the leaked government estimates of how much poorer we will be on average as a result of Brexit. There is no surprise here for economists, because the estimates are in line with the wide range of large negative long term impacts made by various groups or organisations before the referendum, including the UK Treasury. But these new official estimates are made by the department for exiting the EU, and if any massaging went on in producing them it will surely have been to promote Brexit. These new estimates include, for example, the impact of yet to be discussed trade deals with the US and others. The fact that they still come out with numbers that are not very different from those produced before the referendum is, in effect, an official acknowledgment that these earlier estimates were reality based, and not the Project Fear of Brexit spin.

So what do we get in response from the government? Just different varieties of nonsense. They say the bespoke deal the UK is hoping to get is not included. As Jonathan Portes notes, this bespoke deal is somewhere between Norway (2% GDP loss) and Canada (5% GDP loss). You have to be totally innumerate not to realise that this would mean a GDP loss between 2% and 5%.

And there is the good old ‘all forecasts are wrong’ line. I am tired of inventing new ways to distinguish between conditional and unconditional forecasts, but I guess I will have to continue to do so as long as some political journalists fail to understand the point, and economic journalists fail to make the point. Here is an example for Brexiters. Mr. Fox thinks making trade deals with pretty well anyone he can is good for the economy. That is a forecast. It is a forecast using many of the same elements as those behind the latest official estimates of the cost of Brexit. The reason that deals with all and sundry cannot replace being in the EU is down to gravity, which as Chris notes is one of the most successful and robust ideas in economics.

And then there is the even more tiresome “according to economic forecasters the economy was going to collapse” type of argument. I got wise to this kind of thing with austerity. A few allowed themselves to over-egg the impact of the government cuts and that allowed others to declare 2013 growth as a vindication of austerity, just as I predicted they would. In reality austerity caused years of stagnation and the slowest economic recovery in living memory. The reality of Brexit is that we have already lost about 1% of output, as the rest of the world including the EU leaves the UK behind.

Source: Jonathan Portes in the New Statesman here

So the economic arguments of the Brexiters are nonsense: describing them as fantasy gives fantasy a bad name. But why don’t Remainers like me accept that this is really a culture thing, and that Leave voters are willing to pay for their independence from the EU. One reason is that there is clear evidence that most Leave voters believed they would at least be no worse off after Brexit, which is of course why Brexiters continue to try and rubbish estimates of how bad the hit will be. I’m pretty sure those arguing that this is only about culture are not worrying each week about how to make ends meet.

But the ‘taking back control’ idea is itself a fantasy. Trade deals today, and the Single Market in particular, are about harmonisation and cooperation. Why is this such a terrible loss of independence when the cooperation is with the EU, but no problem when it is with the US? There is a real debate to be had about the extent to which globalisation erodes national democracy. But this is not the debate the Brexiters are having. Their dislike is with the EU in particular. I have yet to hear a single voter complain about the specific directives that come from Brussels: indeed the UK government often pretend ownership because they tend to be popular. The idea that Leave voters are objecting to a “remote Brussels bureaucracy” imposing standards to keep our beaches and air clean and to prevent workers being forced to work long hours is a myth. Voters would like to take back control, but not from Brussels or the EU.

There is even a large fantasy element when it comes to immigration. Yes, there are a few Leavers who would pay a large amount to avoid hearing a foreign language spoken in their town, but they do not represent most Leave voters. Instead there is the belief, carefully cultivated by the Conservative party, that immigration has reduced real wages and our access to public services. Large numbers voted Leave because they thought less EU immigrants would mitigate the NHS crisis. Now those EU immigrants who also happened to be doctors or nurses are leaving, and the NHS cannot fill vacancies. And, of course, those lower growth numbers mean less money to spend on the NHS: the Brexit dividend is negative.

To see how much of a fantasy it all was, why not take an article by Andrew Marr, who as the presenter as the BBC’s flagship Sunday current affairs programme should know what he is talking about, written just over a year ago. He writes
“some things are already becoming clearer. We will be out of the single market and will be out of a customs union – because if we weren’t, we wouldn’t be able to negotiate our own trade agreements around the world. Theresa May would hardly have created a new Department for International Trade if she intended it to have no purpose.”

All this, of course, was based around the fantasy of invisible customs posts on the Irish border. The UK committed to staying in the Customs Union when it signed the first stage agreement, but yet still clings to the fantasy that it has not. And then
“The logical conclusion is that we will see sector-by-sector agreements to allow in X thousand electricians, or Y thousand careworkers, with industry bodies given coupons by the government and allowed to issue the work visas they require.”

which fails on the simple logic that the EU could never allow such a thing. And then
“Some of the measures the left would like to take to support and protect the steel industry, or engineering, or to enhance our growing advantage in robotics, are made impossible not by British Conservatives, but by EU regulations on competitiveness and state funding. Make no mistake: an awful lot is back in play. Rail renationalisation, for one …”

Again, a fantasy, this time from the left. He then goes on to list lots of exciting things we can do, most of which we can do more easily inside the EU.

For all those who will tell me that the British people knew what they were doing (or rather the 52% who voted Leave), I ask did they really know more than Mr. Marr writing six months later? I suspect you could still find far greater flights of fancy among Leave voters. This is not because people are stupid, but because they soak up the propaganda in their newspapers, propaganda which the BBC is too timid to contradict. 

In the end, the economics is key to how the Brexit fantasy will end. No sane government or parliament will allow an outcome that makes people on average 8% worse off. That is why we have to make a deal with the EU, and the only deal the EU will allow is one that prevents a hard Irish border. That means staying in the Customs Union and much, possibly all, of the Single Market. Brexit will end with the UK becoming what Rees-Mogg describes as a vassal state. It will not be the fantasy people voted for, nor the fantasy the Brexiters had in mind. 

When reality bites, almost no one who voted Leave will be happy with the result. So should Remainers stay quiet and just wait for this disappointment to sink in, just for the sake of a particularly partial concept of democracy? To allow peoples lives to be impoverished and their opportunities to be diminished because of a referendum based on lies? There are democratic ways out of this fantasy turned nightmare, and we should take them.

Postscript (1/02/18)

Rees-Mogg suggested today to minister Steve Baker that the forecasts produced by government economists made Brexit look costly because civil servants had deliberately designed them to do just that, and Baker made no attempt to defend his civil servants. While this attack on the integrity of the civil service has gone unremarked by No.10, when minister Philip Lee said that the Brexit process needed to take account of "evidence not dogma", he was reprimanded. It is almost as if the government had decided that it needed to show that Brexit was indeed a fantasy project in which evidence, alongside 'saboteur' MPs, 'enemies of the people' judges, 'in the pay of the EU' economists and now 'conspiratorial' civil servants, are not welcome.     

Monday 29 January 2018

Will the Conservative party ever recover from Brexit?

I am sure many sensible Conservative MPs and supporters hope that once we leave the EU, the nightmare of Brexit will pass, and they can continue to be the natural party of UK government. They know that Brexit is an advanced form of irrationality, but they hope that once the Brexiters have achieved their goal the fever will pass and it will be business as usual. In particular they can elect as their leader someone who has both an appeal to voters and an ability to take sensible decisions, neither of which Theresa May or her Brexiter usurpers is capable of.

This Brexit syndrome, which infects nearly half the Conservative party MPs and most of its membership, is a visceral dislike of the EU in all its manifestations. I am not talking about why most voters chose to leave, which was an unfortunately all too familiar reaction to a public campaign that has blamed immigrants for every grievance and fear they have. Brexit syndrome is instead manifested in a belief that you must leave a customs union with your overwhelmingly biggest trading partner so you can seek inferior trade agreements with other more distant countries. The only explanation for that belief is a deep irrational dislike of all things EU.

For those Conservative MPs not subject to Brexit syndrome I have bad news. Leaving the EU as planned is not a cure. The nightmare of Brexit will not pass. Whatever deal the UK eventually concludes with the EU, it will be unacceptable to the Brexiters. Only a clean break with all things EU will satisfy them.

Many people still write as if the nature of the final deal is still wide open, ranging from Canada to Norway, and they are encouraged to do so by the government and to an extent by the EU. But this, like the government’s position, seems to me to ignore the political imperatives. One of these imperatives is the agreement the UK has already signed, which precludes a hard Irish border. There is no good reason why the EU will go back on that agreement. Yes of course the EU is quite capable of ignoring the wishes of one of its smaller members if that conflicts with the wishes of the majority, but that is not true in this case. The Irish border problem forces a deal that involves the UK staying in the customs union and at least parts of the single market, and that is the type of deal that most of the actors within the EU would also like.

It is only a matter of time before this reality becomes clear to Conservative party members, most of whom are infected with Brexit syndrome. That will be the point at which Brexit MPs will feel confident enough to challenge for the leadership. They will have a powerful song to sing: how we are still obeying rules set in Brussels, but without any say in what those rules are. No sovereignty of the simplistic kind that appeals to nationalists, and no ability to pursue all those wonderful trade deals that Mr. Fox was going to obtain for British business. If only politicians had had the courage to go for a clean Brexit, and had not been dissuaded from doing so by treacherous civil servants. There are plenty more verses with a similar theme.

If you keep wanting something that is so impossibly bad for the UK that no sane leader would ever enact it, then you can go on agitating for it forever. The Brexiters will not stop when we leave the EU, precisely because the terms under which we are almost certain to leave will give them even more cause to complain. Ironically leaving the EU makes the Brexit problem worse rather than better for the Conservative party.

There is no quick solution to this problem. If a Brexiter was able to capture the Conservative party leadership, they could only get their clean Brexit through parliament by achieving a Conservative landslide: that was what May hoped for and failed to get. As long as the Conservative party is in government, the chaos and fantasy politics that the UK has suffered since June 2016 will stay with us. Even if a Brexiter did not replace May, the party would be paralysed by Brexit syndrome to a degree that would make John Major’s difficulties seem trivial.

It seems to me that there is only one way the Conservative party can go. There is no cure for Brexit syndrome, so those that have it must become irrelevant. That requires a long period in opposition, like the period Labour suffered from 1979 to 1997. A period long enough for the current Brexit membership, plus defectors from UKIP, to be replaced by more sensible people who can see that a party that suffers from Brexit syndrome is a party that can never govern effectively, and which is always in danger of doing the country great harm. 

It says a lot about so much of our political commentariat that so many words have been written in horror about how Labour is ‘suffering’ from an influx of new idealistic members who just want to make things better, while so few have been written about the very real danger caused by a moribund Conservative membership that just wants to break off all relations with our nearest neighbours.

Thursday 25 January 2018

The fatal inconsistency within neoliberalism

The collapse of Carillion had some important implications for public sector outsourcing, as I discussed here, but I tend to agree with Will Hutton that the real lessons lie elsewhere. He writes
“While some public sector delivery is outstanding, notably in parts of the NHS, the general pattern is more patchy. It is for this reason that governments for decades have been contracting the private sector to deliver goods and services. Trying to extend that principle is not unreasonable if high-quality private sector partners step up to the mark: the problem is they are in such short supply.”

In other words the problem is not so much with outsourcing, if sensibly done by a government that does not automatically think private is best and a civil services able to write good contracts and effectively monitor quality. The problem is with the poor quality of so much British capitalism. Carillion is not just one bad apple, of course: this is a lesson that should have been learned from the financial crisis, and RBS in particular,

But how can that be, when the market ensures that only the most efficient firms survive? That idea, that the market ensures that only the most efficient prosper, is a central message of neoliberal ideology, and it has held UK and US governments under its sway since the time of Thatcher and Reagan. But that ideology contains a large and deep internal contradiction, which applies particularly to large firms like Carillion. To see what that contraction is, we need to talk about ordoliberalism and Ronald Coase.

Ordoliberalism is widely known as the German version of neoliberalism. It too celebrates the benefits of the market. It, like neoliberalism, ignores many of the failures of markets that Colin Crouch eloquently outlines and which economists spend a lot of time studying. But ordoliberalism does recognise one potential problem with their market ideal which neoliberalism ignores, and that is monopoly. Crouch makes a similar distinction in talking about market-neoliberals and corporate-neoliberals.

This distinction is important for reasons that go way beyond the textbook problem with monopoly: that prices are too high and output is too low. To see why it goes beyond that we need to turn to Ronald Coase. He was a British economist who subsequently worked at Chicago. His first major article was "The Nature of the Firm" written in 1937 which introduced the concept of transaction costs to explain the nature and limits of firms. The key point that Coase made relevant for our discussion is that, in theory, much of what firms do could instead be done by markets. For a non-economist this probably sounds strange, so I will briefly try and explain the idea.

In principle the activities of any firm could be duplicated by all its employees, including managers, becoming self employed. The worker who worked for a firm would become a self employed person who signed a contract with the self-employed manager. Furthermore, the self employed manager would not have to work with a fixed set of self employed workers, but for each task they could create a market for the task which any self employed person could bid to fulfil.

Coase asked why we have firms rather than this more market based setup. His answer is transactions costs. A typical worker employed in a firm has to do whatever (within reason) a manager asks them to do. This can vary, often at very short notice, depending on the needs of the firm. Replacing this with a large number of specific short term contracts would be very inefficient, because it takes time to write and read contracts (transactions costs). You could add search costs and many other costs that make the self employed contracting model normally inefficient.

You can see exactly these tensions, between the advantage of the market versus internalising activities within a firm, played out when a firm decides to outsource any of its activities. But these tensions have a darker side. To what extent have firms internalised the market so that they can exploit customers (traditional monopoly), exploit workers (if one large firm is the only potential employer for many workers i.e. monopsony), or as a vehicle for managers to exploit shareholders.

There are two paths you can travel once you recognise all this. The first, and more ordoliberal, is to distrust monopoly of any kind, and be highly skeptical of large firms and their creation through mergers. The second is to assume that firms are always right, and that large firms exist simply because they are more efficient at doing what they do than the same firm broken up. Given the darker side mentioned above, there is no logical reason to take the second path. Skepticism about large firms is the right path to take. The second path, where you presume that there are always good reasons why large firms exist, makes no logical sense, unless your goal is for whatever reason to defend these large firms. It is the path that neoliberalism took.

Will Davies has a fascinating paper of how ideas about the virtues of competition, and the need to break up monopolies, changed within the University of Chicago from the 1930s until the 1980s under the influence, among others, of the work of Ronald Coase. It shows how many of the leading actors during that period chose the second path. Economics is rich enough that, if they so wish, an economist can always invent reasons why monopolies might be efficient, and so earn lucrative fees for so doing.

Thus neoliberalism that might have started as extolling the virtues of the market ends up as “a consultancy racket, in which corporations purchase complex models to justify their chosen strategy”, to quote Will Davies more recently. This is what I meant when I wrote back in 2016.
“It is important that those who use the term neoliberalism today recognise this contradiction. It does not mean that using the term neoliberalism to describe the dominant ideology is wrong, but it is a mistake to assume the ideology has not be moulded/adapted/distorted by those in whose interest it works. These changes have made it intellectually weak at the same time as making it politically strong.”

There are important mistakes that those opposing neoliberalism can make if they do not see this point. They involve opposing anything your opponent appears to favour. Thus, for example, because neoliberals preach the virtues of the market but in practice are normally simply pro-business, this does not mean that you should always oppose markets: you can be pro-market and anti-neoliberal. More generally, just because neoliberals can use ideas from economics to argue their case does not mean there is something wrong with economics (as opposed to some economists). Louis Zingales, from Chicago, exemplifies both points, and is not afraid to make the distinction between pro-market and pro-business in public.

This is all related to the distinction between ideas and interests. While it is right to recognise that interests are to some extent based on ideas, it is also important to see that ideas can change in time to reflect interests. How an ideology based on seeing markets through rose colored spectacles turned into an ideology justifying crony capitalism is at least part of the story of neoliberalism. These compromises with power allowed the ideology to become dominant, but at the same time it also made it rather easy for it to be subverted by different kinds of plutocracies, such as those represented by Brexit and Trump.

Monday 22 January 2018

The unanswerable democratic case for a second referendum

Much discussion, including my most recent post on Brexit, argues that a second referendum is unlikely on political grounds. But that is very different from the question of whether there should be a second referendum. That is what this post is about.

A few days ago the Guardian published a piece by Simon Jenkins arguing that there should not be a second referendum. The argument is essentially this. The people have already voted to leave, and “effectively” delegated to government/parliament the choice of how we do it. All we should be talking about now is how to get the best deal. He writes:
“There are no rules for referendums because they do not feature in any constitutional edict, but convention dictates a second one would be justified only if the circumstances of the first have radically changed. The Danes (in 1993) and the Irish (in 2009) held second referendums, after renegotiations, to stay in the EU. Circumstances do not include second thoughts.”

There are so many problems with this argument that it is difficult to know where to start. Let me begin at the end. Now occasionally second thoughts arise through deep contemplation about your original decision, but most of the time second thoughts arise because circumstances change. The information people have about what leaving means has changed. Democracy is all about letting people change their minds because circumstances have changed. [1] 

Jenkins implies that holding a second referendum after a renegotiation is fine. What on earth does he think has been going on for the last year and a half. The conceptual difference between a negotiation and a renegotiation is zero. People may well have voted Leave because they believed, as they were encouraged to do, that the UK could get all the benefits of the single market after leaving. Finding out this isn’t possible is not some whimsical second thought, but exactly equivalent to an agreement being renegotiated as far as voters are concerned.

Jenkins does concede that “there might, just, be an argument for a referendum after a final deal, purely to confirm it.” You have a choice, as long as you say yes. This accepts the absurd framing of the government that the referendum fixes the decision to leave for all time, whatever the circumstances. There are no conventions that say that. The obvious choice to put to people once the deal is done is whether they still want to leave, now that the best feasible terms for leaving as approved by parliament are known.

The argument that this must be the convention because we have not had a referendum since 1975 is nonsense. The first point to make about 1975 is that we had already joined, so the negotiation had already been done. Second, there was a sort of understanding among politicians that we should only have another referendum if the nature of the EU changed, but (a) there was no referendum after the Single Market was established, and (b) we had a referendum in 2016 years after any conceivable change. So as conventions go this one has been honoured in the breach, for the straightforward reason that it makes little sense. Information about the benefits of being in a club of nations changes for many reasons besides treaty change. I think it is best to forget about conventions and just use common sense. [2]

The vote in 2016 was pretty close, and was based on no clear understanding of what leaving would actually involve. So common sense says that the democratic thing to do is revisit the question once the terms are known. People should be allowed to change their minds. If people are not allowed to do so, and must be bound by that one vote for a generation, then we are no longer a democracy. 

If you disagree with that, imagine the possibility that the UK ends up effectively agreeing to stay in the single market and customs union, accepting to all intents and purposes free movement and the authority of the European Court. Given the Irish border issue, and the economic advantages for the UK in staying in the single market for services, it is quite possible this is where we will end up. If this had been the choice in 2016, do you really think voters would have chosen it? Of course not, because we give up a say over the rules we have to obey. [3] That possibility shows that the case for a second referendum is unanswerable. [4]

A popular reposte to the case for a second referendum is why not make it the best out of three. An alternative way of putting it is that the elite wants to keep holding a referendum until voters give an answer they like. But this is nonsense, because in reality what is being argued by the Brexiter elite is not to hold a second referendum because it would probably give the wrong answer from their point of view. Clearly we will only have the chance of one more referendum before we leave: what can be wrong about giving people a second say on a decision that will profoundly influence their lives?

Unfortunately, because of the transition period that both sides are so keen on, we will not be able to have a second referendum on the final deal, to confirm or otherwise the first, because the final deal will be done after we have formally left. There is no inevitability about that, because extending the 2 year period for Article 50 is far easier than any transition period. But, as I have argued before, this transition is a democratic affront, precisely because it prevents a second referendum on a final deal. The only democratic response to that affront is to hold one anyway before we leave, on the basis that we now know a lot more about the final deal than we did in 2016.

If the polls were showing a larger majority in favour of leaving, then there might be a case that a second referendum was unnecessary, but of course polls are now consistently showing a majority to Remain. Insisting that despite this the 2016 referendum, which was based on almost zero knowledge of what leaving would mean, and where the majority was only 52%, denies any chance of a second referendum is, quite simply, a profoundly anti-democratic act.  

[1] We have fixed terms for governments for continuity, but Brexit is different: an irrevocable decision which will be with us forever. That makes it imperative that we allow people to change their minds before we leave.

[2] The underlying reason why it is a waste of time talking about conventions is that conventions are simply a cover for political expedience. In the UK at least, we have had referendums when the government is hopelessly divided about what to do. 

[3] Jenkins thinks this possibility is fine because “any trader can influence rules”. Not if they are outside the EU. The naivety here about the influence of the UK outside the EU is worthy of any Brexiter. I have argued that a Norway type deal for the UK is unlikely to be sustainable in the long run precisely because our influence on the EU and world stage generally once we leave will be much diminished.

[4] Some people object to a second referendum on the grounds that referendums are generally a bad idea. That is not a debate I want to address here, so it is best to take the statement that the case for a second referendum is unanswerable as contingent on parliament approving any final deal because they do not think they can override the 2016 referendum. 

Saturday 20 January 2018

Microfoundations and the values of policymakers

For economists

This post started an interesting discussion, directed largely by Beatrice Cherrier‏ (@Undercoverhist), about how economists are increasingly tending to hide the value judgements they make. By value judgement I do not mean the trivial, like why did you get interested in this area rather than others, but more serious issues like what values are assumed as part of their analysis. (The distinction between the two was the point of my original post.)

It occurred to me that microfounded macro has an issue that is related to that discussion. It is in fact discussed in my OXREP paper, but used there as an example of where microfoundations had gone one step backwards, with only the prospect of going forwards in the future. The example is the derivation of a benevolent policy maker’s preferences from the utility function of the representative consumer assumed as part of the model, a line of research initiated by Michael Woodford.

Before getting on to the values point, let me note that it is a good example of the primacy of internal consistency in microfoundations rather than the Lucas critique. Before Woodford’s work, microfoundations macroeconomists were embarrassed that they typically assumed an ad hoc objective function for the policy maker choosing between the bads of deviations in inflation from target or deviations of output from its natural rate. Typically, results were presented with alternative values for the policy maker’s preferences between the two. But if the policy maker was benevolent and the model is internally consistent, shouldn’t this objective function reflect the utility function of the representative consumer in the model? What Woodford showed was how this could be done, and better still how it implied the form of objective function, quadratic, that had previously been used on an ad hoc basis. The preference between output and inflation deviations was now an implication of the model.

It was, it is important to admit, an exciting breakthrough. We could now tell policymakers that, if this is the utility function of the representative consumer, and the model was a good representation of reality (yes, I know), this is how you should be trading off output and inflation losses. It was a literature I participated in with colleagues. The derivations were hard and tedious to do, and could take pages of algebra, but within a year every macro paper of this kind had switched from ad hoc objective functions to derived objective functions. If you were doing macro and wanted the paper published in a good journal, this is what you had to do. 

There was only one problem. The simple version of a New Keynesian model that most researchers used implied that inflation deviations were much more important than output deviations. This was very different from the adhoc objective functions that had been used before, where equal weights were commonly used. It also appeared unrealistic: not only did policy makers not act as if inflation was all important in reality, but consumers in happiness studies tended to rate unemployment as more important than inflation. That was the step backwards that I mentioned earlier.

But what it also did, I think, was to make less transparent the value judgements that the researcher was implicitly making. Everyone, including policymakers, know that macro models are huge simplifications, but to get interpretable results that is what you have to do. Yet they also have some idea of their preferences between excess output and inflation. But if the policymaker’s preferences were now endogenised, they would generally get welfare results presented to them with no choice to make involving their own preferences.

Researchers were not hiding anything. The utility function of the representative agent was there to see, and most papers would show the derived objective function with a low relative weight on output deviations. But what was often not shown was how the results would differ under alternative objective functions: why would you as a modeller committed to microfoundations, as to use any other weights than those implied by the model was internally inconsistent. Thus internal consistency took a value judgement away from policy makers.   

Thursday 18 January 2018

What Carillion tells us about public sector outsourcing

Jeremy Warner, an editor at the Telegraph, once said there are either big state people or small state people. I felt the same way following the reaction to the collapse of Carillion: there are either private good, public bad people or public good, private bad people. Of course, reality is somewhere in between.

Corillion went bust because of cost overruns or delays in three large construction projects. The nature of such projects involve that kind of risk, but clearly the company - despite its size - was not resilient enough to withstand those failures. It did not go bust because of privatisation of public services, unless you think the government should build its own hospitals or roads. If anything, it shows that those contracting out public contracts were getting a good deal.

There will always be public projects contracted out to the private sector. Much of the increase in public investment planned by Labour if it wins the next election will be undertaken by private firms. Getting the contracting relationship right is difficult and fraught with dangers.

The government clearly has questions to answer about why it continued to award contracts after the profit warning, and we need some informed analysis to determine whether the government, as they claim, had fully protected all but one (!) of these projects and will not lose any money as a result of the collapse. As David Allen Green suggests, this smacks of ministerial failure. (The link also shows public procurement can have its funny side.) Also why was the position of the “crown representative” who was meant to be overseeing scrutiny of, among others, Carillion left vacant? The government should also ask whether companies should be allowed to pay large dividends when their own pension fund is underfunded. And why Carillion's auditors, KPMG, gave it a clean bill of health when its balance sheet was already showing signs of stress
To see what lessons the collapse of Corillion does have for the debate over whether the public sector should privatise certain of its activities or do them in house, we need to go through some of the pros and cons

There is one main benefit of contracting out public services, which is that it can save money. To mention ‘the market’ here is not very helpful, because with one buyer and only a few sellers for something (the contract) agreed once every few years, this is hardly a normal market. [1] It is instead about the incentives faced by managers and workers, both in achieving efficiency and fostering innovation. Managers have a clearer incentive system in a private sector firm to maximise profits, and that incentive is provided by the need to bid low to win the contract and nevertheless make a profit. As Carillion shows, margins on most public sector outsourcing are not large. In that sense Carillion confirms that part of this mechanism is working. A single public sector entity cannot replicate this advantage, unless it too is in competition with private sector firms. In short, competition improves incentives.

One important qualification to this argument involves information. The temptation of a bidding system based on the lowest price is to cut quality. So the public sector has to have a clear means of not just specifying quality in the contract, but of ensuring the contract is being fulfilled once it is awarded. Sometimes politics can get in the way of that happening. For activities where quality is difficult to observe, contracting out is not a good idea.

Another qualification involves the attitude of public sector workers before privatisation. If they, for whatever reason, internalise the need for efficiency and innovation, because for example they can see how both improve the outcome for customers, then contracting out to the private sector will achieve little. The NHS could be a case in point.

A further problem with privatisation is finance. When people argue that public money should not be wasted paying the shareholders or creditors of private firms, they are both right and wrong. They are wrong in the sense that without contracting out the same amount of money has to be raised by the public sector, and so it “wastes” money by having to pay interest on government debt. But they are right in that the rate of interest on government debt is much less than the rate of interest a private firm has to pay on any debt, or in the form of dividends to shareholders. The reason for this is that investors do not like risk: people who lend to the UK government know they will always get their money back, while as the shareholders and creditors to Carillion have just found this is not true for private sector firms.

This is why PFI projects undertaken just so that the borrowing is done by the private rather than the public sector are costly from an economic point of view. It is why it makes sense to exclude public investment from any fiscal rule: fiscal rules that restrict public investment are an open invitation to politicians to undertake PFI type financing. In my view the best constraint on public investment is the expected social return, assessed with the help of an independent body. It is often said that PFI type projects ‘avoids risk to the taxpayer’. Again this is the wrong way round. It is far easier and cheaper for the public sector to take risks than the private sector, so PFI projects are paying far too high a price to avoid risk to the public sector. 

Another problem related to risk is the interrelationship between what the private company contracts to do and what actually happens when government forecasts go wrong, as they always will. This may have happened with the East Coast line “bailout” (but if it was, we should be told), and it did happen with privatising the probation service. Public sector contracting out forces each side to commit to guesses about the future, whereas if everything remains in-house there can be much more flexibility. There is also the cost of having to train more civil servants in the art of writing good contracts.

One further problem that Carillion reminds us of is that privatisation runs the risk of a degree of interruption if the company goes bankrupt. Disruption is nothing new. If privatisation is to have any benefits, the contract from the public sector has to come up for renewal every few years, and if the private sector provider is changed that will involve some dislocation of service.

One final point, which is contingent on what I hope will be a temporary state of affairs. Nowadays the management overheads for private sector firms are likely to be far higher than in the public sector, for reasons that have little to do with management quality. Ben Chu sets out how much management was being paid at Carillion compared to equivalent public sector managers. And what on earth were shareholders doing allowing the directors to relax clawback conditions on management’s pay if things went wrong, which even the Institute of Directors described as “highly inappropriate” and “lacking effective governance”. In truth the public sector is much better at stopping managers using their monopoly power to be paid over the odds than the private sector appears to be.

So the economist’s answer on public sector outsourcing is, it depends: on all the factors outlined above and probably more I have momentarily forgotten. (Like economies of scale and expertise: no one would ever suggest the public sector makes its own paperclips.) Where the balance will be is bound to be case dependent. But it would be incredibly surprising if at least some of the outsourcing undertaken by this government was not ideological rather than evidence based. This suggests that Labour, if it wins the next election, should undertake a thorough independent review when it has all the facts at its disposal. That at least might ease fears that we will lurch from one ideological position to its opposite.

[1] This is an interesting example of a longstanding debate with myself. If you want to claim that much of this kind of outsourcing represents neoliberal ideology at work (which it probably does), and also that neoliberalism is all about the market, then your definition of a market has to be pretty wide. But of course a large firm like Carillion, as Ronald Coase said, involves the large scale supersession of the price mechanism. By which he meant that firms are an alternative to markets, and large firms suppress what would be market activity if it was replaced by lots of smaller firms buying and selling to each other. This is a contradiction at the heart of neoliberalism as market worship: firms are alternatives to markets. 

Tuesday 16 January 2018

The problem with a second referendum

My last post upset a few people who are campaigning to reverse Brexit, because I was so pessimistic about the chances of a second referendum before we leave in early 2019. They mistook my pessimism for defeatism. I would never suggest that those fighting for a second referendum, or an end to Brexit by any other means, should give up, just because the outlook looks bleak. You can never be certain about how things will turn out.

The path to a second referendum is clearly laid out by Andrew Adonis in this Remainiacs Podcast. Two things have to happen. First Corbyn needs to start arguing for a second referendum, which Adonis thinks he will do in the summer or autumn. I think this is conceivable, although far from certain. I would merely note that Remainers who declare that Corbyn will never do so because he is a Brexiter at heart are not only wrong, but are therefore by implication far more pessimistic about Brexit than I am, because this first stage is a necessary condition if a second referendum is going to happen.

The second thing that has to happen is that a majority of MPs write in the need to hold a second referendum as an amendment to the Brexit bill, a bill which thanks to rebel Conservative MPs is now a requirement. Yet there is a world of difference between demanding a proper bill before leaving, and demanding a second referendum. The Brexiters will ensure the government throws everything into preventing a second referendum, including perhaps its own survival. As I said in that earlier post, I cannot see it happening in the current environment, and this is the source of my short term pessimism.

One of the reasons I am so pessimistic is related to an earlier post, where I talked about how anti-democratic the concept of the transition period is. I could imagine at least some Conservative MPs arguing for a second referendum when the exact nature of the final deal is known. The first referendum was a decision to put an offer in for a new house: now the surveys and council searches are in we can take a final decision.

But, because of the transition period, what the final deal will be remains unclear, at least to most of the media and the public. The transition allows the Brexiters to continue to live in a fantasy land, where the final deal keeps all the advantages of being in the EU without any of the costs. I have argued, as have others, that the first stage agreement restricts the scope for what the final deal could look like, but this is denied by the government who are still busy eating cake. There is no reason for this to change in the next year, because the focus will be on the government’s futile attempts to avoid transition on EU terms. In this sense a second referendum will be just like the first: the realists will argue as hard as they can for reality, but reality will either not get a look in with the right wing press, or be balanced against fantasy by the broadcast media.

To threaten to bring down their government by voting for a second referendum, rebel Conservative MPs need a cast iron moral case. Alas because of transition they cannot argue that the second referendum will be a vote on the final deal, because the Brexiters can still claim the final deal will be all things to all men and women.

Thursday 11 January 2018

Does Brexit end not with a bang but a whimper?

Most media commentary on Brexit makes a huge mistake. It focuses on what the UK government may wish to do or should do. The first stage agreement told us one thing that we should have known the moment Article 50 was triggered: the EU is calling the shots in these negotiations. [1] But the fact that the UK agreed to the text, and particularly the parts on the Irish border, has told the EU something important: the current UK government is not going to walk away with no deal, and even if it did the current parliament would almost certainly stop it.

That in turn tells the EU that it can get, to the first approximation, the agreement it wants. So what we should be asking is not what the UK’s next move will be, but what the preferred outcome for the EU is. My guess would be that their preferred outcome is a formalisation of the transition arrangements. This satisfies their three criteria: it avoids a hard Irish border, it imposes no additional trade restrictions, and the UK is clearly worse off as a result of leaving (because it has no control over the rules it must obey).

As Martin Sandbu points out, the first criteria could be satisfied by a deal that kept the UK in the Customs Union and Single Market for goods, but not for services. As the UK exports more services than it imports to/from the EU, the EU’s second criteria might still be roughly satisfied by such a deal. If the UK avoids accepting free movement as part of the deal, whether the third criteria is satisfied becomes debatable. Still it would be a possibility. Anything beyond this would mean a hard border in Ireland. It is difficult to imagine why the rest of the EU would want to seriously harm relations with Ireland by agreeing to such a thing.

Suppose something between these two alternatives, of staying in the Single Market and staying in it just for goods, does become the final deal. I think the Labour leadership could live with it if they are in government when the deal is done. Perhaps a majority of Conservative MPs could. But it means that dreams of doing trade deals with other countries would no longer be possible, and for that and other reasons a large part of the Conservative party would not be happy. The Conservative’s Europe problem would not be solved.

The fact that the Brexiters will still be agitating for a more pronounced break from Europe will be one reason why the UK will still suffer in economic terms (albeit much less than with No Deal), and this will be increased if we are no longer in the Single Market for services. Firms will always be reluctant to locate in the UK because trade might be disrupted if the Brexiters win again. Less immigration from the EU will also hurt the economy. And of course the Brexiters will remind everyone that the UK is having to accept rules on trade that it plays no part in creating.

All that suggests any deal will not be sustainable in the longer term. Norway and Switzerland may be able to tolerate being out of the club but obeying its rules because they would probably reason their impact within the club would be small, although what Ireland will achieve with the Brexit deal is a counterexample. An economy with the size and more importantly the history of the UK will find that more difficult to accept this. 

Does this mean that any deal will just be the first stage of breaking away from Europe? The Brexiters will agitate for this, but I doubt it will happen. The Brexit is essentially a project of the old. It seems far more likely to me that as time passes a majority for rejoining will emerge, and Brexit will come to an end. This mad period of UK politics, and all the political and economic harm it has done, will be a complete dead end, a colossal and damaging waste of time. 

This is my best guess at how Brexit will end, although I take no pleasure in that. [2] Not with the bang of a second referendum or a parliamentary vote, but slowly over time. The vote that rules them all today will gradually be seen not as the liberation and empowerment that so many now believe, but instead as just the machinations of a small number of hollow men. Hollow men who dream of empire renewed, and as a result are casting their country from the world stage. Hollow men who dream of personal power, and who instead turn out to be powerless. Their day will soon pass, as wind in dry grass.

[1] Here I think informed analysis, from commentators like David Allen Green for example, got it right. As I wrote: "Anyone who actually wants a good deal from the EU when we leave should realise that the UK’s negotiating position becomes instantly weaker once Article 50 is triggered."

[2] The Brexiters will not let the government propose a second referendum. A majority of MPs will not vote for one unless public opinion becomes much more anti-Brexit. Without something like a major recession, which looks unlikely, I fear a shift in public opinion will not happen in time for 2019. The post-Brexit Remain campaign has not ‘broken through’ because the tabloid press, and broadcasters following the wishes of politicians, will see Brexit through to completion because they made Brexit possible.

Would things be different if Labour campaigned for a second referendum? In terms of public opinion, that would make a difference to how broadcasters treated the issue. But Corbyn will only consider that if he could be sure that enough Conservative would back him, and by making the issue party political he cannot be sure of that. It is the fact that too few Conservative MPs are prepared to stand up against their leadership, and the 'will of the people', that makes leaving inevitable.