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.

Austerity past and future

It is tempting for journalists in particular to treat arguments against fiscal consolidation (austerity) during the depth of the recession as the same as arguments against fiscal consolidation now. Of course there are connections, but there are also important differences.

Austerity during a recession

Case against

The case against austerity in the depth of the recession is that it makes the recession worse. Because interest rates have hit their lower bound, monetary policy can no longer solve the recession problem on its own, and fiscal policy needs to help. That is what the world agreed in 2009. There are two legitimate economic arguments which, if true, would override this view.

Counterargument 1

The interest rate lower bound is not a problem, because we have unconventional monetary policies like QE. This argument’s flaw is that the reliability of unconventional monetary policy (knowing how much is required to achieve a particular result) is of an order smaller than both interest rate changes and fiscal policy.

Counterargument 2

If governments continued to borrow in order to end the recession, the markets would stop buying government debt. This argument normally appeals to the Eurozone crisis as evidence, but we now know that - before OMT at least - Eurozone governments were uniquely vulnerable because the ECB would not be a sovereign lender of last resort. Other evidence suggests the markets were totally unworried about the size of UK, US or Japanese deficits.

Austerity now

Here I will focus on the UK, because planned fiscal consolidation in the UK over the next five years is greater than in other major countries. During the recession, George Osborne had a target of current balance, which excludes spending on public investment. He now has a much tougher target of a surplus on the total budget balance, which includes investment spending.

Case against

There is a specific problem with Osborne’s current fiscal charter, which is that by targeting a surplus each year from 2020 it fails the basic test of a good fiscal rule, which is that debt and deficits should be shock absorbers. But in terms of the path of fiscal policy until 2020, there are three additional problems:

1. The policy restricts public investment at just the time that public investment should be high because borrowing and labour are cheap. It is a near universal view among economists that now is the time for higher public investment.
   
   
2. It will bring debt down too fast, penalising the current working generation who have already suffered from the Great Recession
   
   
3. Continuing fiscal austerity is keeping interest rates low, which means central banks are short of reliable ammunition if another recession happens.

I discuss these arguments, and the last in particular, in today’s The Independent. The point I want to stress in this post is that of the two arguments in favour of past austerity outlined above, only one - the lower bound is not a problem - is relevant here, and then only for the third criticism above. With debt now falling the argument about a potential funding crisis is not even remotely plausible.

You could say that the market panic argument is still relevant to Osborne’s justification for reducing debt fast, which is to prepare for the next global crisis. I think one way to show the silliness of this argument is to adapt a point I made in The Independent article. Imagine a firm which had lots of promising projects it could invest in, all of which would turn a handsome profit. Banks were knocking on the door of the CEO to offer the firm interest free loans to invest in these projects. But the CEO said no, because someday - maybe in 20 years time - there might be a credit crunch and the firm might get into difficulties if it took on more debt. As a result of the firm’s ‘prudence’, its sales stop growing and its profits fell. I wonder what the firm’s shareholders would think about their CEO’s decision?

Bringing economics back into fiscal policymaking

Today around the world the dominant framework for making fiscal policy decisions is personal finance for the overextended household. The state is like an individual who has borrowed too much, and so it must cut back on its borrowing. It is as if the basic insights of macroeconomics (let alone the more sophisticated analysis of the last 20 years) never took place. To take just one example: John Quiggin describes the success story of how Australia dealt with the Great Recession, which included a large fiscal stimulus, yet the politicians that helped achieve that success are now on the defensive because the budget is not in surplus.

As I argued in a recent post, what we have here is a combination of two things. First a strong political force that wants deficit reduction to be the focus of policy because it sees this as a useful way of reducing the size of the state. Second, public perceptions that try and understand events in terms of what they know: their own borrowing and spending decisions. So the need for immediate austerity becomes the dominant policy almost everywhere. I get frustrated sometimes that some colleagues, naturally concerned about the details of academic debate, cannot see the bigger picture here. The bigger picture is the marginalisation of our discipline - used when it suits a particular political purpose, but ignored otherwise. If policymakers and the pundits just pick up economic ideas when its suits them, and when the analysis or facts do not suit them just make stuff up (examples from US and UK), economic analysis just becomes fodder for speech writers. That reduces the discipline to an academic game, and soon those same people will ask: why are we paying people just to play games?

So how do we get macroeconomics back into fiscal policy making? First, we need to sort between politicians and political parties that are quite happy with the current state of affairs, and those who are not. Those who are not need to fight fire with fire, replacing one bit of homespun thinking with another which gets us closer to how policy should be made. One way of doing that is to replace the ‘state as an overextended household’ idea with the ‘state as an innovative firm’.

In terms of the sorting, in many cases that is pretty easy. Let’s take the example of the coalition partners in the current UK government: the Liberal Democrats. Now some might simply use guilt by association, but I prefer to be charitable. Perhaps they were bounced into supporting austerity by events in 2010 and advice they received from certain quarters. As the 2015 election comes nearer, the LibDems are trying to differentiate themselves from the Conservatives on many issues, and they do have a reputation for progressive thinking.

So have a look (pdf, page 37) at the key motion on the economy to be discussed at their September conference. It has Nick Clegg’s name on it, so we can assume it reflects the leadership’s thinking. It starts thus:

“Conference welcomes recent improvements in the UK economy, specifically that: 

I. Faced with the highest budget deficit in post-war history in 2010 as a consequence of the banking crisis and Labour’s mismanagement, the Government has managed to reduce the structural deficit by a third since it came to power.”

Point number two then talks about recent GDP growth figures. So the best thing that has happened to the UK economy recently has been that the deficit has come down. The message seems clear: reduction of the budget deficit is the number one priority and all else has to be subsumed to that.

Now you might in Clegg’s defense say that he has to put it this way, as he has been part of a government which has made deficit reduction the overriding priority. I think that is simply wrong. He could say instead that the focus on deficit reduction was appropriate given all the uncertainty as the Eurozone crisis broke. However now it is clear that this was a crisis specific to the Eurozone, and with interest rates on UK borrowing really low and likely to stay there, the UK can make reducing unemployment the priority, while still of course operating a prudent fiscal policy in the longer term. In other words, he could begin to de-prioritise deficit reduction. The fact that he chooses to do the complete opposite suggests he is content to see fiscal policy as an extension of household financial management. We will see in September whether the Party as a whole is happy to follow its leader in ignoring 80 years of macroeconomic analysis.

So how do politicians that do want to bring macroeconomics back into fiscal policymaking start to change the public debate? Knowing that the intellectual case for austerity is crumbling is reassuring, but it is not enough to make these politicians feel confident in challenging the dominant narrative. They need an alternative narrative, and a good one is the idea of investing when borrowing is cheap. In the UK the argument that there are plenty of useful infrastructure projects for the public sector to undertake has already been conceded by the government, and as Uwe Reinhardt points out here, it is also an easy argument to make in the US. So all that is needed is to see the state like a firm that decides to undertake these investments by borrowing when borrowing is cheap and there is plenty of spare labour to complete them.

As Martin Wolf wrote over a year ago: “Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way. No sane institution analyses its decisions on the basis of cash flows, annual borrowings and its debt stock. Yet government is the longest-lived agent in the economy. This does not even deserve the label primitive. It is simply ridiculous.” I think ‘borrowing to invest when borrowing is cheap’ is a message that can resonate with the public, which is why I suspect David Cameron described those pushing the idea as ‘dangerous voices’.