Helping the left behind: its (economic) geography, stupid

In our national conversation we are familiar with talking about regional divides (most famously north/south), and nowadays that tends to amount to London versus the rest. This conversation has in the past talked about the countryside and the towns (remember the countryside alliance and their march on London). But the political divide that has become clear since the Brexit vote (and which is also clear in US support for Trump) is between towns and cities (see Will Jennings here (pdf), for example).

This political divide has economic roots. Martin Sandbu points us to a report from the Brookings Institution which looks at similar trends in the US. The report says

“For much of the 20th century, market forces had reduced job, wage, investment, and business formation disparities between more- and less-developed regions. By closing the divides between regions, the economy ensured a welcome convergence among the nation’s communities.”

But from the 1980s onwards, they argue that digital technologies increased the reward to talent-laden clusters of skills and firms. The big cities started growing faster than the small cities, and the small cities grew faster than the large towns etc. This trend has continued following the GFC, as this chart clearly illustrates. (For some UK evidence on regional disparities, see here.)

This reminded me of a passage in Paul Krugman’s account in 2010 of 20 years of what has been called the New Economic Geography.

“... a fairly eminent economist challenged some of us, in belligerent tones, for any evidence that increasing returns and positive external economies actually play any important economic role. I think I replied “Cities” – to be greeted with a stare of incomprehension.”

What the New Economic Geography that Krugman helped found shows is that increasing returns and positive external economies make cities a great place to set up a new business, and rural backwaters a place where businesses stagnate. To relate back to the Brookings report, digital technologies have greatly increased the importance of increasing returns and positive external economies. This is why most big cities thrive, and many small cities and most towns fall behind.  

If that all seems terribly fatalistic, it is important to remember that something else happened around 1980. Some of us can remember before the advent of neoliberalism the effort the UK government put into industrial and regional policy. No doubt some of that effort was misdirected, but it probably had some effect at leveling out economic development. One of the key assumptions of neoliberalism is that state activity of that kind is just unhelpful messing with the market mechanism, and that messing just holds back growth.

However one of the lessons of the new economic geography is that initial conditions matter: trees from acorns grow, and the state can have a huge role in nurturing acorns. A well thought out industrial and regional economic policy, that works with rather than fights against dynamic economic forces, can make a big difference. As the Brookings report suggests (see a second article from Martin) we have successful examples to show us how it can be done.

To see how much our current economic environment in the UK is going in the wrong direction, think about post-school education. Universities are essential, and can play a key part in helping innovation, but they produce students most of whom have already become detached from their home and can easily migrate to the dynamic cities. The further education sector, by contrast, tends to provide essential skills to a local workforce. Yet this sector has lost a third of its income since 2010 thanks to austerity. What better way to turn small cities or large towns into places where the workforce is only equipped to host another distribution centre?

One final point. Brexit contributes nothing to helping small cities and towns. If you make the UK a less attractive place to set up a business by making exporting harder, and skilled labour more difficult to find, that business will move from a UK city to a city in another EU country, rather than some declining town in the UK. That is already happening, and the process will continue if Brexit is not stopped. Brexit is not only a damaging exercise which will make the lives of people in the UK harder, it distracts us from doing something positive for those left behind. 

Measuring the impact of austerity

Ben Chu has a good article disposing of some of the nonsense ideas associated with austerity (which refuse to die, because they are useful to politicians, and much of the media is generally clueless). Perhaps the most silly, which I encounter a lot, is that the UK has not really endured austerity because debt has been increasing, or some other irrelevant measure has been rising.

If trying to reduce the deficit - what economists call fiscal consolidation - had no adverse effects on the economy as a whole it would not be called austerity. Austerity is all about the negative aggregate impact on output that a fiscal consolidation can have. As a result, the appropriate measure of austerity is a measure of that impact. So it is not the level of government spending or taxes that matter, but how they change.

An obvious measure to use is the change in the deficit itself, generally adjusted for changes that happen automatically because output is changing. I have used that measure many times, because it is produced by the OBR, IMF and OECD among others. But it is not ideal, because the impact of changes in taxes on demand and therefore output is generally smaller than the impact of a change in government spending, because some of any tax increase comes from reduced saving. (This is also true, but perhaps to a lesser extent, of government transfers.)

There is no simple way of dealing with this measurement problem, because the amount of any tax increase people will find from their savings will depend in part on how long they expect taxes to be higher. As a result, some people prefer to focus just on government spending to measure fiscal impact (although the data you will easily find is government consumption, and as fiscal consolidation normally involves cuts to government investment it is important to add that on). However it is also possible to apply some simple average propensities to consume from tax cuts and transfers to get a fiscal impact measure.

This is what the Hutchins Center fiscal impact measure does for the US.

These are not multipliers (so are different from what the OBR does for the UK, for example [1]), but just the direct impact of government spending and taxes on aggregate demand and hence GDP. The average total impact is something like 0.4%, so this would be fiscal policy that was in this sense neutral.

Compare the mild 2001 recession with the much larger 2008/9 recession. In both cases during the recession fiscal policy was strongly counter-cyclical, helping to reduce the recession’s impact. After the 2001 recession ended, fiscal policy continued to support the recovery for around two years: these were the Bush tax cuts. The recovery in GDP was reasonably strong: growth from 2003 to 2005 of 2.8%, 3.8% and 3.3%.

In 2010, we had a much deeper and longer recession, but the fiscal support was only marginally greater than 2001, despite interest rates being stuck at their lower bound. On this occasion fiscal support was strongly opposed by the Republicans. It continued for another year and a quarter, and then became strongly contractionary from 2011 to 2015. GDP growth was slower than in the previous recovery, despite the deeper recession: from 2010 to 2014 2.5%, 1.6%, 2.2%, 1.7%, 2.4%. This is not surprising, as fiscal policy was reducing GDP by around 1% during 2011,2012 and 2013, rather than adding the normal 0.4%.

The speed and extent to which austerity was applied after the Great Recession was very unusual: the textbook says secure the recovery first, allow interest rates to rise, and then worry about government debt. There was no economic justification for switching to austerity so quickly after 2010: the motivation (as in the UK) was entirely political. It produced the slowest US recovery in output since WWII. (This is a very useful resource in comparing US upswings.) As I showed here using simple calculations, if total government spending from 2011 had remained neutral instead of becoming sharply contractionary, US output could easily have got close to capacity (as measured by the CBO) by 2013.

To subtract 1.5% from GDP would not matter if something (consumption, investment or net exports) filled its place. But that will only happen by chance or because of a monetary policy stimulus, and monetary policy was stuck in a liquidity trap. This is the real crime of austerity. Decreasing demand and output just when the economy is beginning its recovery from the deepest recession since WWII is as foolish as it sounds, but to do this at just the time that monetary policy was unable to effectively fight back is macroeconomic madness. As I will argue in later posts, it looks increasingly likely that this has made us all permanently poorer.

[1] If somebody publishes similar estimates for the UK, please let me know. Personally I think it makes more sense to publish data like this than use a multiplier based analysis, simply because these measures are more direct, and involve fewer ‘whole economy’ assumptions. Crucially, there are no implicit assumptions about monetary policy being made. It would be interesting to know why the OBR decided not to take this approach.