The political economy and worldwide implications of the Inflation Reduction Act in the US

 

In May last year I wrote about a new book by Eric Lonergan and Corinne Sawers called Supercharge Me. The book argued, in essence, that economists should stop thinking about carbon taxes as the way to tackle climate change, what we could call the big stick, and instead think about carrots in the form of subsidies and public investment designed to get green industries to a scale where their rapid growth would be inevitable.

The Inflation Reduction Act (IRA) is essentially a climate bill passed in the US that does exactly that. It is full of carrots, sometimes open ended carrots, designed to promote greener industries, financed not with carbon taxes but higher corporate taxes and lower drug prices for medicare. As I largely agreed with the central idea behind Supercharge Me, I thought it would be interesting to see how that strategy had proved successful in one of the most difficult countries to convince to go green.

The IRA started as Build Back Better, which was a massive programme of infrastructure spending with a large green component and welfare spending. Some of that was diverted into the Infrastructure Investment and Jobs Act, which was passed into law in November 2021, but the climate part became stuck because one Democratic Senator, Joe Manchin from the Coal and Gas state of West Virginia, refused to support it. (The Republican party was of course united in opposition.)

It looked as if once again the US Congress would block effective green action in the US. But then, to the surprise of many and with a name change the IRA was passed in August 2022. So why did Manchin change his mind, and what was lost as a result? What follows leans very heavily on this excellent talk and discussion, so if you want to know more than I can write here have a look.

A key idea from Supercharge Me is to use the story of solar power as a model for how to green large parts (not all) of the economy. Solar power started off as a relatively expensive form of energy that also required large capital costs to install. However, partly as a result of what the book calls Extreme Positive Incentives, costs came down, more solar power was installed which allowed costs to come down even further, until now solar is one of the cheapest forms of energy.

Electric Vehicles (EVs) are another example of where strong incentives or regulations could produce similar effects. In the UK at the moment not many people buy EVs because they cost more to buy and the charging network is far from ideal. However if the government provides incentives for people to buy EVs their costs will fall, and if they ensure the charging network is substantially improved more people will want to buy them. The IRA includes incentives to buy EVs (which are already working), heat pumps and a lot more besides.

So what made Senator Manchin decide to finally support this bill? The answer is complex, and there are certainly some changes in the bill that he insisted on which are far from progressive. One example is that green incentives no longer require union labour. No one is suggesting the IRA is everything those supporting a Green New Deal would want. But something is better than nothing, so it is interesting to see why Manchin changed his mind, and why Big Oil did not fight against the IRA.

One answer is the invasion of Ukraine. As I have already noted, green energy is now cheap energy, and that is intensified when the price of carbon based energy suddenly shoots up. That is one reason for the change of name to IRA. But perhaps more importantly, with US energy producers getting huge profits and exporting large amounts of gas to Europe, green energy seemed less of an existential threat to Big Oil. Republicans pleaded with oil companies to fight the IRA, and they refused.

There are some signs that the IRA may also be robust enough to survive a Republican Congress. There is a new ‘battery belt’ in the US in a similar position to the old bible belt: southern red states which will be reluctant to give up the subsidies the IRA has created.

The other factor that helped get the IRA passed in the Senate was China. Once you see Green Energy as at least part of the future, then most politicians will want their own country to be part of that. As with IT, there was a common concern that China was becoming too successful in providing key parts of the green revolution, and so the IRA is actually a very protectionist measure. Trump’s Make America Great Again has become an insistence that green goods should be Made in America. Again this aspect of the IRA may be far from ideal, but the link between greening the US and protection is not one I would have guessed beforehand. It has also created difficulties for the EU in how to respond.

Hopefully the Ukraine war will also accelerate the global move towards renewable energy. For any significant movement in the UK we will have to wait for a Labour government, which has pledged a substantial programme of green investment, including a publicly owned renewable energy company. The main threat to this happening on the scale required to avoid harmful global warming, both in the UK and elsewhere, is an obsession with the government’s deficit and public debt.

The IRA is fully financed by higher taxes, and that was the only political option Biden had. But whether we are talking about conventional public investment, or incentives to encourage private investment in green energy, using borrowing rather than taxes makes a lot more sense from an economic and political point of view. This is, after all, temporary government spending to spur investment with future benefits, so its costs should be spread over generations. There are strong economic arguments for higher carbon taxes because the polluter should pay, but the political constraints on achieving this seem high. In the UK at least there is a strong argument that permanent revenue from higher taxes should be used to fund permanent increases in current public spending to allow our public sector to recover from 15 years of Conservative governance.

So how do we avoid deficit targets slowing down the transition to a green economy? Once again I need to stress that in an ideal world this would not be a problem. I have argued many times that targets for the total deficit or for falling debt to GDP make no sense, because public investment should not be constrained by fiscal rules. If public investment yields a good social return then it should happen, whatever the implications are for public debt. But unfortunately we are not in that ideal world, and so we need to start thinking about more imaginative ways to get around the obsession with public debt.

One of these has recently been proposed in an interesting article by Peter Bofinger. He makes the case for funding public missions through increases in public debt, which is a kind of ‘project based golden rule’. (This idea of missions for government has recently been championed by Mariana Mazzucato, but it goes back further than this.) In the UK context this would allow the debt to GDP ratio to increase only to the extent that it represented spending to undertake a mission, in this case to green the economy. This generalises an idea I put forward in my post on Supercharge Me, which was to create a ‘green account’ that was outside normal fiscal rules. As I noted there, it would also require monitoring by the OBR to ensure mission spending was clearly defined.

As the IRA illustrates, the obstacles to fighting climate change can with compromise and imagination be overcome. It is a mistake to prevent such compromise when the ideal is not politically possible. Providing incentives for greener energy is politically easier than making the polluter pay. While in an ideal world fiscal rules would not get in the way of such incentives, we live in a world that is obsessed by public debt. This too requires imagination and compromise to ensure this obsession does not get in the way of tackling climate change.

In comparing prosperity across countries, productivity and inequality are almost everything

 

Paul Krugman once said that to improve a country’s standard of living over time “productivity isn't everything, but, in the long run, it is almost everything”. I want to use a recent Resolution Foundation study to examine a slightly different question, which is what determines differences in prosperity across countries. The answer is very similar, but with an important modification.

The Resolution Foundation report by Krishan Shah and Gregory Thwaites compares productivity and (PPP adjusted) incomes per household in the UK with the US, Germany and France, and with France it looks at both 2008 and 2019 so we can look at the comparison over time. But it starts with the following chart which includes many more countries.

This plots GDP per hour (productivity) on the horizontal axis against median income (both logged) for a number of countries. The line passing through the points is the 45 degree line, and the fact that the points are clustered around this line shows that differences in productivity are crucially important. However there are big divergences from that line, suggesting other factors are important.

The first key point, which can get lost in the detail of the report, is that incomes are not the same as prosperity, if you define prosperity in a more general sense. Three of the most important aspects of prosperity that are not captured by incomes are leisure, public goods and investment. Consider each in turn.

Imagine two countries. In one, people work long hours, have few holidays and have a long working life, and as a result their incomes are high. In another, people work less hours, have longer holidays and retire earlier, and their incomes are less as a result. It would clearly be a mistake to call the country where people work more hours a more prosperous country. We could ask the same question where incomes differ because of different levels of tax, where tax goes to pay for more public goods. The country where incomes are higher but less goods are provided by the state is not necessarily more prosperous, particularly if private sector provision of these goods is less efficient (think US healthcare). These are key issues when comparing the US and France, for example.

The final point is that you could raise incomes by not investing in the future. As future productivity depends on investment today, this might raise people’s incomes today, but at the expense of their incomes tomorrow. Differences in investment may occur not just in producing more capital goods, buildings etc, but also with investment in education, or simply in terms of income from overseas assets.

These factors are important to consider when we look at the relationship between comparisons of productivity and comparisons of income per household. Here is the report’s comparison between the UK and France in 2019.

On the left we have GDP/hour worked, a measure of productivity [1]. That shows that France is 17% more productive than the UK. The penultimate column is average household income, where France and the UK are almost equal. Why is France more productive but incomes are no higher? The main answer is the ‘worker/population’ column, which in this case mainly reflects earlier retirement in France (but also longer life expectancy). Does that mean that the average French person is not more prosperous than the average person in the UK, despite being more productive? Almost certainly [2] not, because people in France have decided to use their greater productivity to retire earlier.

Differences in the proportion of workers to the population doesn’t just reflect retirement. There are fewer young people in the workforce in France. This is partly an investment effect (more education) but also reflects high youth unemployment. The other big factor reducing average incomes in France is the ratio of domestic household income to national domestic income. This partly reflects the fact that French firms invest more so the share of profits in GDP is higher (and the wage share lower), but it also reflects higher taxes and (almost certainly) therefore more public goods. [3]

I hope it is now clear why I wanted to stress the distinction between incomes and prosperity. Although average incomes in France may be no higher than in the UK, the French are still more prosperous because they have used their productivity advantage to have a longer retirement, have more public goods and to invest more in the future. So productivity remains crucial to prosperity, but how people enjoy that prosperity can be quite different between countries.

A final but crucial point comes from comparing the last two columns. Median income is the income of the person in the middle of the income distribution, where you have as much chance of having an income above or below that level. If the distribution of income is very unequal, and in particular if it is skewed in favour of those at the top, median income will be below average income. Median incomes are significantly higher in France than in the UK, because the UK is more unequal. So although productivity is crucial in making cross country comparisons of prosperity, inequality is also important. (For a more detailed comparative analysis of different income brackets, see John Burn-Murdoch here. For a discussion of the impact of changes in the proportion of income taken by the top 1% in the UK over time, see here and particularly here.)

The comparison for 2008 rather than 2019 illustrates a key point that is familiar. While the productivity gap in 2019 was 17%, it was only 7% in 2009. The last 10/15 years really has been a period of UK decline. The 2019 comparison with Germany throws up similarities and differences to France that the report goes into. While the productivity gap is similar, the benefits are taken in terms of working less hours rather than less years. Turning to the US, the productivity gap with the UK is similar to the gap with Germany and France, but US income is much higher. Some of that big gap is because workers in the US work more hours, and taxes are lower because public good provision is lower, but there are also differences that must reflect problems with the data used.

This analysis by the Resolution Foundation illustrates two general points. First, comparisons of personal (post-tax) income levels are a partial indicator of relative prosperity, because they ignore leisure, investment and public goods. For that reason, a comparison of productivity levels may be a better indicator of comparative prosperity than relative income levels. Second, what productivity ignores is the often significant impact different levels of inequality can have on the prosperity of the typical household.

[1] GDP/hour worked is a very aggregate measure of productivity, and could reflect different compositions of output as well as how productive similar firms are.

[2] We could drop the almost if we could be sure that the difference in retirement ages represented national preferences, including choices about retirement incomes.

[3] In theory higher profits could reflect higher dividends rather than higher investment, of course. This links to the decoupling debate (between productivity and real wages) I talked about here, based on work by Teichgräber and Van Reenen.

Why does the current political right find it so hard to learn?

This isn’t a headline from the pre-Truss era, or immediately after the ill-fated Kwarteng budget - see the date. It’s as if they believe Truss was not brought down by the markets but instead by some left-wing plot. That the Mail and Telegraph could print headlines like these so soon after the Kwarteng/Truss debacle might seem extraordinary, but I fear it’s just an extreme example of something I wrote about a few weeks ago, and that is the failure of the Conservative right to learn from its own failures and events generally. This post explores why there seems to be an inability to learn and adapt on the political right in the UK.

As Steve Richards emphasised recently, the Conservatives after their catastrophic defeat in 1997 did not undergo the soul searching and upheavals that Labour had after their heavy defeat in 1983. Perhaps more surprisingly, this didn’t happen after they lost the following two general elections. Despite the GFC demonstrating the dangers of deregulation, the Conservative party continued to push for less ‘red tape’, including recently in the financial sector. Osborne was forced to match Labour’s spending plans before the Global Financial Crisis (GFC) because they were popular, but rather than accepting this he used that crisis as a device for achieving a small state (less spending, lower taxes).

This failure to learn has not always been true of the Conservative party. After the shocking (to them at least) defeat of Churchill in 1945, the Conservatives under Macmillan largely accepted the innovations introduced by the 1945 Labour government. More recently, Theresa May at least talked as if she wanted to shift the party away from the ‘government should get out of the way’ attitude that was behind austerity. (This interview between Steve Richards and Nick Timothy is interesting in this respect.) To an extent Johnson also understood that a low spending, low tax, low regulations platform would not appeal to the Red Wall voters who swept him to power.

Yet neither May nor Johnson succeeded in taking their party with them. Tacking to the centre on the economy while staying conservative on social issues makes good electoral sense, but many Conservative MPs, most Conservative members and pretty well all the right wing press want lower taxes and less regulation. Even if the Conservative party loses heavy in 2024/5, it is hard to see this party shifting its economic policy towards the centre.

I think this failure to learn and adapt is linked to another aspect of modern Conservatism, which is notable in both the UK and US, and this is a hostility to experts and science more generally. Again I don’t think this was as strong in Conservatism before Thatcher. Thatcher, and her mentor Keith Joseph, tried to abolish funding for social science in the UK. Austerity, although it had a few high profile academic supporters, went against basic and state of the art macroeconomics. More recently, Johnson began to ignore the advice on Covid that he received from his own group of medical scientists. Although Conservative party leaders sign up to the net zero agenda, their actions show a distinct lack of enthusiasm. Conservatives seem deeply distrustful of universities and academics.

Science is all about the experimental method, which in turn is all about learning. Crudely, you have a theory, do an experiment to see if it works, and if it doesn’t you dump the theory and think again. Of course scientists are more attached to their theories than this Popperian characterisation suggests, sometimes for good reason and sometimes not, but there would be little scientific progress without learning.

Right wing anti-science in the UK is not nearly as bad as in the US, where the front runners to be the next Republican President are using their opponent’s support for vaccines as a weapon against them. But using nonsense arguments to suggest pandemic lockdowns were always a bad idea, which is now just standard in the right wing press, is just one step away from where the US is right now. I have argued that the Conservative party’s obsession with tax cuts just isn’t possible without ending the NHS as we know it (see also George Eaton more recently), but the party either lies about this or is in denial. This refusal to respect basic arithmetic and evidence often initiates the party’s antagonism to democratic pluralism, and may even be a factor behind why some ministers resort to bullying civil servants.

Which brings us, inevitably, to neoliberalism ideology. Why ideology more generally rather than neoliberalism? A standard definition of ideology is “a system of ideas and ideals, especially one which forms the basis of economic or political theory and policy”. Ideology, being a system of ideas, is like a theory in that it can be right or wrong. But one characteristic of ideologies seems to be that they are particularly resistant to evidence that they are wrong.

Neoliberalism is an ideology that borrows a lot from economics, but as I have sometimes said it is the economics you get from doing a Principles (Econ 101) course and missing half the lectures. Or as Dani Rodrik explains more eloquently here, it is just bad economics. As economics is a science, we can show its wrong using evidence. That is one reason why Thatcher so early on clashed with economists, and Keith Joseph tried to cut their funding. Has neoliberalism adapted to the evidence about its errors and limitations? Of course it has not.

There are also ideologies on the left that can be just as resistant to evidence. To take just one example, after the recent energy and food price hike there are some who deny that higher private sector wages will lead to greater inflationary pressure. The lessons of the 1970s have not been learned. Ideologies often connect to specific interests, and allow these interests to be portrayed as benefiting society rather than just specific groups. One reason an ideology persists despite some of its elements being clearly wrong is that these interests prevail.

However, to say that the modern Conservative party fails to learn from and adapt to failures, and can be anti-science, because of an attachment to an ideology is only half the story, and today may be even less than half the story. While neoliberalism began as an ideology that benefited businesses and corporations as a whole, in both the UK and US it seems to have degenerated into an excuse for some rich people, a few of whom own parts of the mainstream media, to demand lower taxes and deregulation.

These monied interests connect with each other and networks of journalists and politicians (some of whom may also be pretty wealthy, while others just want to be). But the origins of these networks in schools or universities attended is less important than it might have been with the old Establishment, because what drives them is the desire of those with money to have power. Sometimes this may be a general desire for power or influence, but more often it may be much more specific, such as the ability to get a government contract for example. In this case donations to the Conservative party become little more than investments with an expected return. For the very wealthy who pay a lot in taxes, donations to politicians campaigning for tax cuts can easily repay themselves over time.

For this reason the Truss premiership, and attempts to resurrect it, should not be regarded as some aberration but instead as the culmination of a transformation of the Conservative party that began with Thatcher and neoliberalism but has ended up with corruption and endless calls for tax cuts. Equally the scandal of the VIP lane for PPE equipment should not be seen as some oddity caused by a pandemic but instead as how today’s Conservative party thinks it should spend public money. We should not be surprised that this government seems so unresponsive to public opinion when it is monied interests that are calling the shots. In short, it doesn’t learn from its mistakes because it pays not to do so.

After 1997 the Conservative party didn’t learn from its mistakes because it was still in thrall to an ideology and the Prime Minister that championed it. If the party loses power at the next election, it will be the influence of money rather than ideology that prevents it from learning the obvious lessons, and money that stops it changing to better reflect public opinion on economic issues.

Fiscal reporting at the BBC

 

The BBC intends to commission reviews on impartiality in various subject areas, and last week it published its first on fiscal policy (taxes, spending, government debt and all that) written by Michael Blastland and Andrew Dilnot. I think it’s a good report, and the BBC’s coverage in this area would be a lot better if its suggestions were widely followed. As I coined the term mediamacro to signify the disconnect between macroeconomic knowledge and what was said in the media, I very much welcome this attempt to bridge that gap. However at the end I want to note two fundamental problems, one of which at least the authors could not avoid.

The report starts brilliantly with a chart published by the BBC. Although this just plots ONS data, it is biased. Why?

For most people this chart looks scary, and there is a danger that this is why it was presented this way. (Laziness may be another reason.) I and most other economists would say it is highly misleading because debt is not normalised (divided by some other economic variable, like GDP). The way the report describes this is that “it brings a high risk to impartiality and can lead to the appearance of bias”.

Both economists and the report are right. If you look at the path over time of debt divided by GDP (as you should) the picture looks a lot less scary, especially if you take the series back to just after WWII. By presenting this chart, the BBC was both misleading and biased, even though it was just presenting data. The report then goes on to criticise more general alarmism in reporting about government debt. In reporting there is too often a presumption that debt is bad, and more debt is always worse. I would just say that presumption is wrong, while the report would say that views differ, and that to assume its bad is therefore biased. [1]

To say that the government is not like a household and therefore household analogies should never be used is too strong. Sometimes these analogies can be useful and helpful for audiences. However at other times they can be terribly misleading, as my blog pointed out many times during the austerity period. The report rightly says that “it helps to know that household analogies are dangerous territory, intensely contested, and can easily mislead.”

Some may say that using household analogies represents deliberate political bias by journalists. The report suggests, and I think this is correct, that it normally represents ignorance. Most political reporters are not economists, and the breadth of what they cover means that they end up being experts in little except who is up and who is down in a political pecking order. It is worth quoting the report on this:

“It’s clear to us that political perspectives can be partial, neglecting others. Political journalists can likewise miss or misunderstand or underweight economic perspectives. We could simply say that’s why the BBC has other specialists. But if they’re all bound from the outset to work within a political frame that shapes the choice of subjects, interviewees, the running order, the line of questioning and the shape of the story – perhaps squeezing it into binary politics - how much can other specialists really exercise influential judgement? A risk is the BBC overlooks interests that lack current political salience.”

I think the report isolates a key problem here, and one whose scope goes well beyond fiscal issues, but it ducks exploring the fundamental reasons for it. Its recommendation here is really little more than ‘must try harder’. As I have suggested elsewhere, the problem lies in an explicit hierarchy which puts Westminster politics in the most narrow sense (who is up, who is down) above all else. To take a very recent example, the government can only get away with claiming that higher public sector pay will increase inflation because it knows that political journalists won’t subject the claim to the ridicule it deserves because these journalists don’t know it’s ridiculous (HT Tim Bale).

This may seem like bias. Journalists will too often adopt a political frame provided by the government because they are ignorant that other frames are possible. The report is rightly critical of reporting that says, for example, that a rising deficit means the government will have to cut spending. What it should do is report that a rising deficit will mean the government will say it has to cut spending, but other choices like higher taxes or accepting higher borrowing are possible.

As the reports says: “Governments often claim their choices are acts of necessity; this does not make them so.” It also points out that reference to the government’s fiscal rules can invoke similar dangers, because the rules are themselves contestable and contested. They may be rules for the government (although for this government frequently broken and revised), but not rules for society.

More generally the report talks about the dangers of journalists projecting a consensus where none exists except perhaps between the two main parties. It suggests that

“in economics we think there’s a case for a small shift in the balance of perceived risks towards more breadth of expert view. We mentioned a well-known academic who felt his views on debt were largely ignored during austerity, and who many might now say had a reasonable argument.”

That could be me, as I did give evidence to the report, but of course it could have been countless other economists. I personally would say we need much more than a small shift towards more expert views.

Now to the two elephants. The report doesn’t say that over the 2009-16 period the BBC, along with the rest of the broadcast media, made a colossal mistake in adopting the line that reducing the deficit was the most important priority for fiscal policy. This was not at first a failure of treating a political consensus as an economic one: initially Labour opposed the extent of austerity. It is possible to argue that this mistake had profound consequences, not only in pushing Labour towards the government’s position, but also in influencing the 2015 election, and after 2015 in creating the space for Corbyn to become Labour leader. Whatever you think of those consequences, it all stemmed from the broadcast media getting the economics completely wrong.

That is the first elephant in the room that the report fails to confront head on. It is important because the media’s near consensus that austerity was necessary was not just the result of ignorance on the part of political journalists. If you read Mike Berry’s book, for example, it is clear that the austerity consensus included the economic journalists at the time. As I have pointed out in my own book, the evidence suggests the majority of academic economists always disagreed with austerity, and by 2015 that majority was a consensus. The reason for this disconnect between economic journalists and state of the art knowledge over the austerity period is not addressed in the report.

Why did most economic journalists adopt the media consensus that reducing the deficit was more important than ensuring a swift recovery from the deepest recession since WWII? I have written about the influence of economists employed by City firms in my book, and I have also written more recently (at the time I talked to the authors of this report) about the origins of mediamacro. But the fact remains that, even after publishing my blog, none of the economic journalists working for the broadcast media ever contacted me about austerity. [2] That either suggests huge arrogance by journalists about their own intellectual abilities, or more probably it reflects that getting the economics right was both not important and also possibly dangerous for the journalists concerned. [3]    

The second elephant is one which the report could not avoid, and that is in adopting impartiality as the overriding frame of reference. I have written about this in detail here, but its biggest problem is that the truth becomes of secondary importance. Impartiality seems to be defined in terms of what people think, even if what they think is just wrong. So under impartiality, anti-vaxxers should get some air-time, as should climate change deniers.

To see how disastrous this impartiality framework is, you only need to look at the Brexit referendum. The BBC, following impartiality, gave equal airtime to both sides whenever the economic consequences were discussed, and drew back from calling out obvious lies that largely came from the Leave side. On the economics of Brexit there was as close to a consensus among academic economists as you will ever get, and the BBC mostly ignored it. Arguably the consequences of that failure have been with us ever since, because the academic consensus was right. [4]

So it is quite plausible that two major errors in the way the BBC has treated economic issues have had a crucial role in political developments since 2010, with the terrible consequences we see today. If the BBC follows the report’s recommendations its reporting will certainly improve, but it remains only a first step to correcting the disastrous errors that the BBC and others made over the last fourteen years.

[1] There is a way of making this point, popular among some, which carries risk. The argument is that government debt represents someone else’s wealth, and we normally think wealth going up is a good thing, not a bad thing. All true, but most people do not own government debt directly, and even those who own it indirectly may be unaware of that, so it remains the case for these people that government debt is a potential liability and not an asset.

[2] Why should they have contacted me? Because at the time I was one of a small number of senior UK academics working on monetary/fiscal interaction, and austerity was all about monetary/fiscal interaction. I had a track record of advising the Bank of England and the Treasury, and on major policy issues my advice had been right.   

[3] If you think dangerous is too strong a word, can I remind you what happened to Stephanie Flanders when she made the obvious point that strong employment growth coupled with weak output growth was problematic because it implied weak productivity growth. I'm also fond of this post I wrote on that.

[4] I used to think the media making political impartiality more important than knowledge was peculiar to economics, but the pandemic showed it was not. 

Sewage in rivers and on beaches may sink the Conservatives at the next election

 

I have always found psychological analysis of voting behaviour interesting, but was never sure where it led. So what if research suggests conservatives tend to desire security, predictability and authority more than liberals do, and liberals are more comfortable with novelty, nuance and complexity. These psychological differences may tend to make liberals more concerned about the welfare of minorities or immigrants than conservatives, but that has no bearing on whether it is right or wrong to care about the welfare of minorities.

Where it does matter, however, is in understanding what issues resonate with particular groups. Winning elections is normally presented as persuading undecided or floating voters to vote for a particular party. It is also important for political parties to get their own vote out by either attracting or scaring them. But it may be just as important to persuade the other side’s voters not to vote for their natural party, and instead vote for another party (not necessarily your own) or not vote at all.

A good example of the last point were the claims of antisemitism within the Labour party when Corbyn was leader. Precisely because those with socially liberal views tend to be more concerned about discrimination against minorities, this issue was ideal for peeling off what might otherwise have been natural Labour voters. In this post I want to suggest that the controversy over sewage being continuously released by the privatised water companies into rivers and onto beaches could become a voting deterrent for natural Conservative supporters.

One of the pretty robust findings linking political preferences to psychological traits is that conservative voters react more strongly to what we might call disgusting images or descriptions. As Kathleen McAuliffe describes in the Atlantic, “the brains of liberals and conservatives reacted in wildly different ways to repulsive pictures: Both groups reacted, but different brain networks were stimulated.” High sensitivity to disgust tends to go hand in hand with a “conservative ethos.” Whether this correlation reflects the reaction of disgust in general, or disgust to particular things, is an interesting issue but not relevant in the current context. What the research does seem to suggest is that Conservative voters, or more generally socially conservative voters, may be more affected by stories of sewage pollution than voters of a more liberal persuasion. [1]

Linking the pollution of beaches and rivers (and, after floods, even streets) to the Conservative party is very easy. Those immediately at fault are private water companies, but the privatisation of water has always been championed by the Conservative party as a clear improvement over public ownership. If the news is full of examples of beaches and rivers polluted by these private companies, alongside the usual leaks and occasional gaps in supply, the advantages of privatisation are far from obvious.

Of course just because water companies were privatised does not mean the government is powerless to act. The problem the government has is their actions seem to be more sympathetic to the water companies than the environment. In August 2021 Conservative MPs voted to make the release of sewage by water companies into the environment legal, and gave them until 2050 to completely deal with the problem. The government has also deprived the Environment Agency of the resources and leadership needed to effectively monitor water quality. They, along with previous governments, have sat back while the regulator allowed these companies to pile up debt in order to pay large dividends to shareholders, rather than use an era of low interest rates to invest in the infrastructure needed to avoid pollution.

Natural monopolies like water companies, where there is no competition or customer choice, have little incentive to invest in sewage treatment or fixing leaks. Regulators, without external pressure from politicians, may tend to go easy on firms because, in part, of the problem of revolving doors. One way to avoid this is to give groups who have an interest in better investment a say in what the regulator does. What you don’t do, and what this government has done, is pass legislation that removes what little legal incentive there was for water companies to deal with the problems they have created.

The pollution story also gets to the heart of those claims that Brexit allows the UK to make its own laws and decisions. While we were part of the EU, UK beaches and rivers gradually became cleaner in large part because EU regulations helped that happen. By ‘taking back control’, the UK government has now allowed water companies decades before we might return to standards we achieved whilst in the EU. The reality is that most of the EU regulations Leavers go on about are popular with many Leave voters, just not most Leave politicians and opinion writers.

With the government failing on major issues like managing the economy and the NHS, the problems of pollution of rivers and beaches might seem relatively small beer. Up until now, most of the political noise on this issue has come from interest groups (e.g. river fishing), ad hoc groups or individual campaigners (most noticeably Feargal Sharkey) rather than the main opposition parties. This is not to suggest that Jim McMahon, Labour’s environment spokesman, has been silent on the issue - he hasn’t. Starmer and the Liberal Democrats have also made statements on the issue; see also here. But just as the Conservatives used to get references to antisemitism into almost every statement they made about Labour under Corbyn, perhaps Labour need to do the same about how the government has allowed privatised water companies to pollute our rivers and beaches with sometimes very serious consequences (see also here).

[1] Of course these are tendencies, no more. It certainly does not mean that if you exercised by pollution in rivers or beaches you must be socially conservative!

Should Quantitative Easing be reducing public services?

 

The Autumn Statement saw yet more cuts in public services planned for after the next election in order to get the debt/GDP ratio falling after 5 years. One item of spending that is expected to be higher after the next election compared to previous forecasts is debt interest. In part this is a result of the Bank of England’s Quantitative Easing (hereafter QE) programme. This created a large quantity of what are called bank reserves (explanations to follow), which currently earn interest for the commercial private banks that hold these reserves at the short term interest rate set by the Monetary Policy Committee of the Bank of England.

The Bank of England didn’t start paying interest on reserves until 2005-6. As long as interest rates were close to zero, or the quantity of bank reserves were much smaller than now, paying the short term interest rate on reserves didn’t cost very much. However after QE, and with short term interest rates climbing rapidly, they are costing not just the UK government, but all governments that undertook QE, serious sums of money. The money markets expect UK short term interest rates to stay reasonably high over the next few years, and as the OBR's forecast is based on these expectations this means that a significant amount of the austerity in the government’s current fiscal plan is a direct result of paying interest on reserves to commercial banks. The New Economics Foundation (NEF) calculate that the banking sector could receive over £50 billion of public money by mid-2025 because of interest paid on reserves. [1] Hence the title of this post.

If this all seems rather puzzling, it is because bank reserves are not well understood, and many of the explanations you will find just make things worse (see this from Frances Coppola who points to some all too common mistakes). To make things simpler I’m going to treat the Bank of England as part of the government (looking at what economists call the consolidated public sector). This is realistic, as any profits or losses the Bank makes end up being pocketed or paid for by the government. So I will talk about the government creating reserves and paying interest on them.

Why did the government create these reserves in the first place? After the Global Financial Crisis, short term interest rates hit their lower bound. Quantitative Easing (QE) was a programme where the government bought back some of its own debt with money the government created. The government has the ability to create money, either by issuing notes and coins (cash) or by creating reserves. I will not go into why they did QE, and how successful the QE programme was, because I and many others have written a lot about this already. Even if you think QE was a bad idea, as the Bank of England is understandably reluctant to sell all its holdings of government debt at once we are where we are.

Reserves are electronic money, in much the same way as your current account is electronic money that you use in, for example, online banking. Whereas you need to initially provide the bank with money, or get a loan from the bank, to create a current account, the government can just create that money. The amount of money created is the amount of the reserve held by the private bank. Private banks can only sell reserves to each other, so banks as a whole get no choice about how much reserves they collectively hold.

If reserves are like the government’s current account, why does it pay interest on them to individual banks? You and I don’t pay interest on our current accounts. The answer is that paying interest on reserves is a relatively recent innovation in most countries, and was designed to ensure the government can continue to set short term interest rates for the economy as a whole. When interest rates were very low that didn’t cost the government much, but now it does. For the private banks, getting today’s short term interest rate paid on its holdings of reserves is a bit of a windfall.

Do private banks deserve this windfall? The short answer is no. The reason they are getting paid interest on these reserves is because it helps the government set short term interest rates, and not in return for any kind of loan from the banks. So why isn’t the government finding some way to get this windfall back from banks, just as it (reluctantly) set up windfall taxes for energy producers? The answer is that this government cares rather more about bank profits than public services, which is an example of something I wrote about last week.

To be fair, a bank might argue that it is providing some services when it holds reserves. Your bank does not ask you to pay interest on your current account balance: indeed some banks pay you interest on your main current account. Banks compete for current accounts partly because they get to use the money provided when they are set up, but this isn’t the case for reserves. There is an argument, outlined by Paul Tucker here, that over some long period paying interest rates on reserves might happen to compensate banks for the use of any service the bank provides, but this seems very unlikely. There is also the question of the services the government provides to private banks that are not paid for, which I discuss here.

So if banks don't earn the interest they receive on reserves, how should the government get that money back? Some have suggested a tax to reclaim at least some of this windfall private banks are currently receiving. The windfall tax should be based on the income banks received from interest on reserves over the past year, and could be set at 100% of that income. However creating a tax to claim back what is a subsidy seems rather convoluted, and calling it a tax hands those that oppose it an immediate advantage.

The alternative is to change the way monetary policy works, so the government no longer needs to pay interest rates on all the reserves it has created. I have seen two quite similar proposals. The first is to move to what is called a tiered reserve system. Under this interest would only be paid on marginal reserves, with the majority receiving no interest, as suggested by Karl Whelan here or NEF here for example. The second is to insist that banks hold a large amount of ‘required reserves’ [2] that pay zero interest, as described by Paul De Grauwe and Yuemei Ji here. The two schemes sound very similar, and they illustrate that paying interest on reserves is not necessary for the operation of monetary policy.

As either a windfall tax, or changing the way monetary policy operates so that interest was not paid on most reserves, involves the banks losing a large amount of money while interest rates remain high, you will see a lot of misleading arguments about why this should not happen. The silliest is that not paying interest on reserves is a form of default: silly because most governments didn’t pay interest on reserves until quite recently, and governments not banks choose the quantity of reserves. Another argument is that not paying interest on reserves is a tax on banks, and taxes create inefficiency. But why not call paying interest on reserves a distorting subsidy?

Although changing the way monetary policy operates is a more elegant solution than a windfall tax on banks, political economy factors currently favour the latter. Here we have to disentangle the Bank of England from the rest of government. The government may feel that it is up to the Bank to suggest changing how it does monetary policy, because otherwise it would appear that the government is forcing the Bank’s hand just to save money. Unfortunately the Bank in turn may be too influenced by private banks to do this in a hurry. So changing how monetary policy operates is unlikely to happen soon.

Of course in the UK our current government is also unlikely to impose a windfall tax on banks. It was eventually forced to impose a windfall tax on energy producers, but that was because consumers were paying the higher prices that energy producers were benefiting from. If Labour wins the next election it should not feel so inhibited, and should be more interested in getting better public services than giving a subsidy to banks. This suggests a windfall tax on banks to recover recent interest paid on reserves should be an immediate priority for a new Labour government.

[1] That is not the only sense in which the QE programme may end up costing public money (or taxpayers money, as the media often likes to inaccurately call it). The bank reserves created as part of the QE programme were mainly used by the Bank of England to buy fixed interest government debt (gilts), during a period in which interest rates on gilts were very low, so the price of gilts was high. Now the Bank of England has begun selling those gilts, and because interest rates have risen the price of those gilts has fallen, leading to capital losses. (As the FT headline misleadingly put it, Treasury bails out Bank of England.) However it should never be forgotten that during the period when short term interest rates were low QE saved the government a lot of interest it would otherwise have paid on its debt.

[2] The phrase 'required reserves' is in itself confusing, as the banking sector as a whole gets no choice over the amount of reserves they hold.

What makes politicians act in society’s interests, and how have these mechanisms worked since 1979?

 

A cynical view would be that politicians always act in their own interests. [1] I think that is unrealistic, in that many politicians go into politics because they want to make society better. Nevertheless it may be interesting to look at why purely self-interested politicians might nevertheless also act in society’s interest. The obvious mechanism that might achieve this is democracy. It is in a politician’s own interest to be re-elected, and to gain votes a politician needs to do things that make people’s lives better. An important qualification, of course, is that they only need to make a proportion of people’s lives better, and this could involve making a small minority of people much worse off.

The imperfections of this mechanism are obvious, but it is also clear it works. Most politicians in a democracy work hard to garner favourable public opinion. Although general elections in the UK need only happen every five years, if it looks like a Prime Minister is not going to win in two or more years time MPs may decide to replace them, as we saw happen twice last year. The major proviso is that, just as advertising can sell you things you do not need, politicians can also fool voters.

One obvious limitation of a normal democracy is that voters only get to choose between political parties rather than individual policies. Under FPTP they in reality only get to choose between just two parties, which means a ‘bad’ government may still get re-elected if the opposition appears even worse. A clear example where a politician that has not tried or failed to improve society may nevertheless get re-elected is if they can find some issue which gains support despite these failures: fighting a popular war, for example. Another reason a bad government may be re-elected is if voters are fed misinformation by a biased media.

If we drop the assumption of self-interest, it may also be useful to think about different ways in which a politician can imagine they can help improve society. They may just believe, in David Cameron’s words, that they would be “rather good at it”, which may be a belief about competence at management and decision taking, but could also be about charming or fooling people. Alternatively they may believe they have a set of ideas that will improve society. Those ideas may or may not be part of a commonly shared ideology.

At the end of last year I wrote a piece in which I tried to think about why the government that began in 2010 appeared to be particularly uninterested in making society better, at least compared to the governments that began in 1979 and 1997. The evidence that they made society worse in economic terms is almost irrefutable: the UK’s poor growth performance over the last 13 years may be partly bad luck, but it is almost surely also a consequence of 2010 austerity and Brexit. I also suggested that, in failing to resolve today’s strikes or the NHS crisis, or in demonising asylum seekers, or starting new coal mines, or in being willing to "let the bodies pile high" during the pandemic, this government seemed to be putting political self-interest above national interest.

I want to use the points above about motives and democratic constraints to explore in more depth why the government that began in 2010 stopped even trying to act in the national interest. In the earlier post I speculated that ideology played some role. All three governments (1979,1997,2010) signed up to a broadly similar neoliberal ideology, but the contexts were very different.

The government under Thatcher can be thought of as pioneering basic neoliberal ideas, initially within a society (and even party) where there was some strong resistance to those ideas. These new ideas were therefore being continually challenged and argued for, their strengths and weaknesses tested. The economic arguments for privatisation, reduced union power and reducing the top rate of tax were real and serious, even if you think there were stronger countervailing arguments. Whatever the merits of those ideas, by the end of Thatcher’s reign and during Major’s, the major opposition parties had largely accepted these key innovations.

The Blair/Brown government wanted among other things to introduce changes that would reduce poverty, like tax credits, the minimum wage, sure start and so on. Later on they were able to raise taxes to expand public services, and in particular the NHS, which had been steadily underfunded under the previous government. This has been called neoliberalism with a human face, and it was broadly popular. In particular, even by 2020 only a small minority of people wanted to reduce public spending on health, education and welfare in return for lower taxes, and far more wanted the opposite.

Both governments, therefore, fought and won elections based on economic ideas that were not obviously nonsense, and which at least turned out to be popular among a majority or near-majority of voters. Labour under Gordon Brown lost power not because of incompetence at handling the economy, or the unpopularity of his economic views, but because the finance bubble - facilitated by both governments - finally broke in the United States as he became PM.

Although a larger state, and particularly a well funded NHS, were popular among voters, they were not accepted by the Conservative party at large (MPs, members, donors and the press). Before the Global Financial Crisis Osborne had been forced to promise to match Labour’s spending plans, but this was an example of voters forcing an opposition’s hands rather than an ideological conversion. The Global Financial Crisis allowed Osborne to return to the idea of a smaller state, by elevating deficit reduction as the major macroeconomic goal of the government.

If Osborne and Cameron believed this was a sensible policy, they were simply ignorant of basic macroeconomics, which suggests fiscal expansion not contraction in a recession where interest rates cannot fall further. Perhaps the idea was just too attractive for them to question. Once in government, however, and as Osborne cut taxes alongside spending, the policy surely became deceit if it hadn’t been to start with. The key motivation for focusing on the deficit was to reduce public spending.

Deficit deceit was required because of the popularity of ‘neoliberalism with a human face’, and in particular the level of spending and taxes we ended up with under the Labour government. The Conservative government was in the small minority that wanted a smaller public sector and lower taxes. As an opposition Cameron and Osborne had lost this battle of ideas, so they planned to get what they wanted by the back door, which was by manufacturing an urgent need to reduce the deficit and to achieve that goal largely by cutting public spending.

The 2010 government therefore started and continued until 2016 with its central economic policy being based on at best ignorance and more probably deceit, in pursuing an underlying goal they knew was unpopular. Whatever you might think of the Thatcher or Blair governments, that cannot be said of either. In most cases they were prepared to argue for the economic goals they wanted to achieve.

Brexit, like austerity, was based on at best ignorance (‘there will be no economic downsides’, more money for the NHS) and more probably simple lies. For many Conservative MPs, it too involved deceit, with the real aim to deregulate from EU labour and environmental laws.

In both cases (austerity and Brexit), we still see neoliberal ideas being pursued, but now they were pursued surreptitiously rather than argued for at the ballot box. It is not surprising, therefore, that after some time when the impact of either policy became clear they would also become unpopular with a majority of the public. Because the deceit involved doing things that economists knew would create economic harm, then economic growth suffered.

A basic idea of neoliberalism was that a smaller government and lower taxes, together with reduced regulation, would help the economy grow faster. But neither Cameron nor Johnson were unlucky that neither happened. By 2010 the evidence against the idea that only small states or deregulated states could grow strongly was overwhelming. The Global Financial Crisis (GFC) alone should have made politicians question the idea that less ‘red tape’ is always better. The strong and steady growth of many large and small European countries with higher levels of taxation than the UK or US, and indeed strong and steady growth under a Labour government before the GFC, should have led any politicians who respected evidence to question the social benefits of pursuing low taxes and deregulation, let alone trying to achieve those policies by the back door.

This is why in my earlier piece I called austerity and Brexit an intellectual failure. The failure is easy to understand, however. Low taxes and deregulation were still in the interests of a small but wealthy minority, who could fund political parties and think tanks, a few of whom also owned major newspapers. For most politicians on the right, there was little incentive to try and rethink neoliberal dogma after the success of the Labour years and the failure of a deregulated global financial system. Those that tried would not have been successful because their message was unpopular within the party. As I have argued elsewhere, the influence of money and media ownership can turn parties of the right away from their early conceptions of neoliberalism as an ideology designed in the interests of business generally, into neoliberal platitudes becoming a cover for government in the interests of a wealthy few. The election and subsequent demise of PM Truss exemplified this transformation of Thatcher’s neoliberalism into something more resembling a plutocracy.

There remains an important question to answer, however. If democracy was doing its job, the deceit behind austerity and Brexit should have been exposed, and the politicians pursuing the deceit should have failed at the ballot box. So why, after five years as Prime Minister and Chancellor, did Cameron and Osborne win a majority outright in 2015? Why were the lies of the Brexiters not clearly exposed when they were first proposed? To regular readers this is old ground so I’ll only give one sentence answers to both. By 2015 the mainstream media had almost completely adopted the ignorance that was prioritising the deficit, despite the weakest economic recovery on record and stagnant real wage growth. In 2016 the broadcast media, and especially the BBC, preferred providing balance to providing knowledge. In both cases, the democratic constraint on self-interested politicians failed.

Unfortunately there is a dynamic involved in these particular failures. If a party that wants to represent the interests of a wealthy few at the expense of society as a whole sees how the media can fail to hold it to account, it will naturally devote itself to trying to make this happen again. It encourages that political party to see itself as apart and above the rest of society, including society's own laws. That in turn can lead to widespread corruption, which is another feature of Conservative  led governments that began in 2010. 

[1] By own interests, I do not mean their own personal interests. A self-interested politician unconstrained by democratic pressure may still act in the interest of friends, donors or future employers.