A Bumpy Landing For China?

I have just finished watching Robert Peston's excellent programme on China, entitled How China Fooled The World. It explains that China is unlikely to carry on growing at the breakneck pace it has over the last few decades The problems are so numerous that it seems highly likely that they will combine in some way soon to ensure that the Chinese economy suffers at least an extremely bumpy landing. They include: huge and growing debt levels; massive, unsustainable levels of investment, much of which has gone into vanity projects; inefficient state enterprises; low levels of consumer spending caused by the high savings rates due to the lack of a western style welfare state; a residential property boom fuelled by debt and the view that an apartment is an asset rather than a home to live in; and, of course, wide spread corruption. One problem that the programme didn't cover is China's rapidly ageing population, exacerbated by the regime's one child policy, which means that the ratio of economically active to inactive citizens is low and declining year on year. 

Peston's programme reveals nothing new. Reports of China's problems have been in the financial and economic press for many years. A more detailed account of the prospect of China's economy running out of gas is contained in a recent book, entitled The Great Rebalancing by Michael Pettis, an economist at the University of Peking. In short, it would seem that many people who look at this matter closely feel that China is where the US and Europe were in 2005/6. This analysis suggests that all those charts that extrapolate China's double digit growth into the future and showing it eventually overtaking the US to become the world's biggest economy are unlikely to be proved correct.

If these warnings prove justified, China will be the last in a list of three countries who were once wrongly tipped for world economic dominance since the end of WWII. When I worked in the City in the late 1980,s the talk was all about the rise of Japan. Japanese industry had come to dominate world export markets for manufactured goods by employing revolutionary new production methods and, on the back of this, Japanese banks were becoming the biggest in the world, setting up offices in all the big financial centres and paying record amounts for French Impressionist Art and Van Goghs. You would see Japanese bankers in London every day. It was believed that Japanese banks paid the best and they were the first to introduce the practice of paying bonuses of up to 10% of anything you made above budget, in order to attract the best talent. The Japanese economy seemed unstoppable. It had high growth, high pay, no unemployment and electronic consumer products that everyone wanted and with which others couldn't compete. It became the most expensive place to live. Traders told me that they had to take the bus from the airport to their hotel when they flew to Tokyo because a taxi was too expensive (this was the London branch of a triple A rated Swiss bank). Wild comparisons were made between Japanese and US real estate prices: The Imperial Palace in Kyoto was worth as much as the whole of New York; Tokyo was worth as much as the whole of California. How odd it now seems, in the light of her two lost decades, that it was once seen as inevitable that Japan would supplant the US as the world's largest and most powerful economy.

Yet this is as nothing to the humiliating embarrassment that must be felt by those who seriously propounded the case of the third country on my list. I remember listening to an interview with two leading economists recently who were expressing scepticism about China's ability to overtake the US. During the discussion, one of the contributors pointed out that in the middle of the last century, graphs showing the USSR overtaking the US some time before the new millennium were common. Although this now seems farcical, it was a perfectly correct extrapolation in the 1960s. It is easy to forget that the USSR had been transformed by the Communists from a predominantly feudal economy under the Tsar, to an industrialised superpower that crushed the Wehrmacht and put the first man in space, all in around 4 short decades. 

So, first the USSR failed to match up to its early promise, then Japan and now China by the look of things. However, although China's economic future is unclear, there is one thing we can say with certainty. America's place as the world's no. 1 economy is assured. Pax Americana is going to be with us for some time yet.

Its About Downton Abbey, Stupid!

During the last few days I have heard Downton Abbey mentioned twice in relation to current levels of inequality in contemporary society. The first was a negative connotation and appeared in an article written by economist and former US Treasury Secretary, Larry Summers, for the FT. In his piece, entitled America risks becoming a Downton Abbey economy, Summers says:

The share of income going to the top 1 per cent of earners has increased sharply. A rising share of output is going to profits. Real wages are stagnant. Family incomes have not risen as fast as productivity. The cumulative effect of all these developments is that the US may well be on the way to becoming a Downton Abbey economy. It is very likely that these issues will be with us long after the cyclical conditions have normalised and budget deficits have at last been addressed. 

Summers is clear that rising inequality is a bad thing that needs redressing. I say this because the second time I heard Downton Abbey mentioned in relation to inequality it was by someone making the point that maybe current levels of inequality aren't something we need to be so worried about. It came in what I imagined was an unguarded remark by journalist and former Tory advisor Danny Finkelstein. Baron Finkelstein of Pinner was appearing in a episode of BBC R4's A Good Read. For those not familiar with this programme, the format is that the presenter, Harriet Gilbert, and two guests talk about a book that each has chosen and then the others are invited to comment. Finkelstein had his 'Downton' moment when he was having to talk about the book choice of his fellow guest, the writer Jill Paton Walsh. This was What Money Can't Buy: The Moral Limits of Markets by Michael Sandel.

In this book Sandel argues that the market has intruded into more and more areas of life such that activities which once stood outside of ordinary commerce have now become market transactions. The result is that the exchange of money dehumanises people as it drives out altruism and legitimises the pursuit of profit and self interest. In this way the community mindedness that existed and which produced social good from human interactions, is diminished as we become rational, amoral agents acting in an economist's free market model. Sandel offers many examples of this creeping market economy. My favourite is that of the small Swiss village of Wolfenschiessen that was designated as a potential site for the storing of nuclear waste. When surveyed the residents voted marginally in favour of the proposal. Their sense of public duty just outweighed their concern about the risk. After this result, the residents were asked what their view would be if they were each offered a annual sum of money by way of compensation for the risk they were willing to bear for the greater good of the nation. The result was that support for the proposal went from 51% to 25%. Even when the sum offered was increased, support didn't increase. This result goes against basic free market theory. What appears to have happened is that what people would be prepared to accept on moral grounds for no reward, they turned against when offered a financial inducement. Cash appears to have driven out public-spiritedness. Indeed when asked, 83% of those who rejected the financial compensation, said they did so because they could not be bribed.

Finkelstein was clearly uncomfortable dealing with this subject, which perhaps was to be expected as he is a former Director of the Conservative Research Department and the current Chairman of Policy Exchange, a centre-right think tank. Sandel's academic record makes him someone whose views can not easily be dismissed. It was as Paton Walsh and Gilbert moved the discussion on to the subject of the increasing inequality that had followed the invasion of the market economy into more and more areas of life, that his guard slipped. As the other participants pressed in on him, in order to stem the flow he blurted out, 'It's also not the case that now we live in a society that is radically less equal than the society that people were living in a hundred years ago as anyone watching Downton Abbey can attest.' It's no worse than it was in 1914.

Well that's alright then.

Do CEOs Deserve Their Ever Increasing Pay?

We frequently hear how much more the pay of top executives is rising relative to that of their employees such that income inequality is growing ever greater in our society (here's an example). This is normally justified by saying that these things are determined by a free market, you have to pay a lot to get the best people and good people who create wealth deserve to be properly rewarded. Therefore it was a delight to read a short paper written by Philippe Jacquart and J. Scott Armstrong entitled, Are Top Executives Paid Enough? An Evidence-Based Review. I would recommend it to everyone who has an interest in this subject. Here's their summary of the evidence:

Our review of the evidence found that the notion that higher pay leads to the selection of better executives is undermined by the poor recruiting methods. Moreover, higher pay fails to promote better performance. Instead, it undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore other stakeholders, and discourages them from considering the long-term effects of their decisions on stakeholders. Relating incentive payments to executives' actions in an effective manner is not possible. Incentives also encourage unethical behaviour. Organisations would benefit from using validated methods to hire top executives, reducing compensation, eliminating incentive plans, and strengthening stockholder governance related to the hiring and compensation of executives.

These conclusions are based on 33 academic studies.

One of the problems with recruitment is that companies rely on the expert advice of recruitment consultants. The problem with this seems to be twofold. Firstly, the fact that decades of research have found that 'beyond a basic minimum, expertise has no value for forecasting outcomes in complex, uncertain situations'. Secondly, because human beings, even expert ones, have a bias towards attractive looking men and against women and the overweight. This is the case even though 'intelligence is the single best predictor of job performance.'

Another factor that undermines the notion that high pay leads to high performance is that CEOs seem to be rewarded for things outside their control. For example, if the price of oil goes up on world markets, CEOs of oil companies are rewarded. Essentially top executives get the credit and the rewards for being lucky, while employees do not. 

Linking financial rewards to improved performance seems to be counterproductive. One reason for this seems to be that the prospect of getting a bonus takes up too much attention leaving less to concentrate on doing the actual job. Also, the creation of financial incentives appears to have unintended consequences. They make executives pursue more short term strategies to inflate their companies' share price rather than seeking to insure the long-term profitability and sustainability of their businesses. Sadly, it can to lead to unethical behaviour, lying and outright fraud:

'Incentive plans are likely to tempt executives to engage in fraudulent behavior. For example, school superintendents in Philadelphia were asked to improve their students' standardized test scores. Some superintendents were highly successful and were sought after by other schools. However, the key factor to their success was that they put a program in place to erase wrong answers on student exams and insert correct answers.'

The paper goes on to describe the Mondragon Cooperative Corporation based in Spain's Basque region. It has a very democratic structure where employees elect managers and the ratio of compensation of the highest paid to the lowest is capped, currently at 11:1. Yet between 1996 and 2008, its sales increased by more than 213% while sales at its Spanish rivals increased by only 140%. This reminded me of Waitrose and John Lewis in the UK, firms that do very well with their partnership structure. Indeed, in every Which survey that I have ever seen they beat their more 'commercial' rivals for customer satisfaction.

The authors make a number of suggestions for improving executive recruitment and performance. Two struck me in particular. The first was that recruiters should not meet candidates until they had decided to make them a job offer. This would make them rely more on objective measures of intelligence and avoid the kind of bias mentioned earlier. The second, which resonated because it is so market-based and therefore the kind of thing that should appeal to any budding red in tooth and claw capitalist, is to make applicants for top executive jobs submit sealed bids, setting out how much they were prepared to do the job for. Now this would be an initiative I would love to see trialled.

PS Here is another interesting post on this issue from Simon Wren-Lewis 

The Enduring Myth Of Labour's Financial Mismanagement

Last week I heard yet another member of the Coalition government saying that they were sorting out the financial mess left to them by the last Labour government. This time it was Danny Alexander talking on BBC Radio 4's The World At One. In response, Chris Leslie made the point that the economic crisis that led to the Great Recession was global in nature and that Gordon Brown wasn't flying around the world making foreign banks fail and undermining confidence in the Euro. One point he didn't make and one that I haven't heard made very often, is that debt as a percentage of GDP in the UK was lower under Labour in 2008, before the crisis really started, than it was under the outgoing Tory government in 1997. Blair inherited a debt ratio of 42% from John Major and by 2008, following 11 years of so-called unfunded, reckless expenditure, Labour had reduced this to 35%(ONS, chart at the bottom of page 2). That's a reduction of almost 17%. I don't remember any Tories saying that 42% was a dangerously high level of debt at the time. Indeed, during the early years of the Blair administration, leading Tories, including Ken Clarke, the last Chancellor under Major, sought to take credit for the economic success Labour was enjoying by claiming that it was due to the golden economic legacy bequeathed to them by the outgoing Conservative government. You can't have it both ways. Either 42% is perfectly serviceable and reasonable so 35% is even more prudent, or 35% is profligate in the extreme whereby 42% must be even more so. 

Simon Wren-Lewis has written a number of times of his exasperation with Coalition myth making on this issue (see an example here). His view is that the worse you could say about Labour's record of managing the public finances is that fiscal policy was a bit too tight at the beginning of their term in office and maybe a bit too loose at the end.

Clearly, the debt ratio exploded across the developed world during the Great Recession, but this wasn't due to excessive government spending commitments coming home to roost. Mark Blyth in his excellent book, Austerity – The History Of A Dangerous Idea, exposes this other myth:

'Again, according to the IMF, of the near 40 percent average increase in debt across the OECD countries expected by 2015, half has been generated simply replacing lost revenues when tax receipts from the financial sector collapsed. To put it bluntly, the state plugged a gap and stopped a financial collapse. It did not dig a fiscal ditch through profligate spending.

In the United Kingdom, in particular, the collapse in tax receipts was especially alarming since nearly 25 percent of British taxes came out of the financial sector. Little surprise then that Britain's debt ballooned. Of the rest of the increase in government debt, some 35 percent is the direct cost of bailing out the banks. Meanwhile, that antistate whipping boy for the growth in the debt, the fiscal stimulus, amounts to a mere 12 percent of the total. So if you want to blame the stimulus for the debt, you are going to try to account for the missing 87.5 percent of the effect.'

So, the public sector debt crisis was well and truly born and raised by the private sector. It's quite a charge sheet. Yet the former head of Barclays, Bob Diamond, said some time ago that the time for apologies was over. Some of us would be happy to see an end of bankers' apologies if we thought we were seeing the beginnings of the restitution of the 87.5%.

The Economist tweeted yesterday that 'Labour's growing contempt for capitalism is dangerous for Britain'. Contempt is a strong word. But I think any objective observer would feel sympathy for those who expressed some discontent with today's free market capitalism given its recent record.

Is It Time For Another Windfall Tax?

Just over a week ago, the FT reported that corporations across the world were sitting on record amounts of cash. By the end of 2012, the non-financial members of the global S&P 1200 index, which comprised 975 of the world’s biggest companies, including household names like Apple, Pfizer, Toyota, Google and Microsoft, had accumulated $3.2tn in cash. This was 62% up on the $1.95tn they held in 2008. Goodness knows what the figure would have been if financial firms had been included. Various figures get quoted for the size of UK firms’ cash piles, but £440bn seems to be a fair assessment. To put this figure in some context, the British Government’s annual deficit is around £100bn, while the national debt weighs in at about £1,200bn.

What’s going on?

The economist Richard Koo coined the phrase ‘Balance Sheet Recession’ having looked at corporate behaviour in Japan during the 1990s. He observed that when debt gets so large a crisis occurs that forces companies to address their liabilities. In these circumstances businesses cease to behave like the profit maximisers of standard economic theory. Instead, the focus of their operations becomes the generation of cash to pay down their debt to what they consider safer levels. The Great Recession appears to be this type of recession, with companies, and indeed consumers trying to hoard cash to reduce their debts and form a safety barrier to protect against further economic bad news.

UK Business investment

Source: Quarterly Survey of Capital Expenditure - Office for National Statistics

The fact that companies have ceased to be profit maximisers in the conventional sense is borne out by the figures for business investment. Although this rose 1.4% between Q2 2013 and Q3 2013, it’s lower than it was a year ago. In fact it’s been pretty flat for 4 years and would need to increase by over 25% to get back to the level it was at the beginning of the crisis at the start of 2008. Clearly, although we saw modest growth return to the UK economy in 2013, private sector investment played no role in this. We can’t say we have balanced, sustainable growth until it does. Projections for rising growth in 2014 and beyond appear to be based on an assumption that it will. It remains to be seen whether such a belief proves to be well-founded.

Keynes famously wrote about the ‘animal spirits’ that were necessary to generate confidence, optimism and the investment and risk-taking that were essential to propel growth in a capitalist system. He argued that when the ‘animal spirits’ of the private sector failed, as manifested in recession and depression, they had to be replaced by the sober resolve of the public sector to spend to restore growth and generate employment. So far, it would appear that the ‘animal spirits’ of UK Plc are flagging and this at a time of record low interest rates. Essentially the private sector is saying that for 4 years they haven’t been able to find enough profitable projects to invest in, even though their captial is free. Instead they would prefer to sit on it and see its value eroded by inflation. This is hardly a ringing endorsement of free market captialism.

Indeed this unwillingness by the private sector to invest lies behind the idea recently popularised by the economist Larry Summers that perhaps the world economy has entered a period of ‘secular stagnation’. If businesses cannot or will not raise their investment spending, then there is no foundation to the belief that capitalist economies will, if left alone, return to levels of full employment following a crisis.

We know that the UK economy is around 15-20% smaller than it would be if it had grown at its pre-crisis trend rate and that we still have high levels of unemployment and underemployment. Yet companies are sitting on large quantities of unemployed capital. In these circumstances hasn’t the time come for us to start to consider levying some form of windfall tax on corporate cashpiles? In 1997 the new Labour Government raised a windfall tax on the privatised untilities that raised around £5bn. This was used to fund the New Deal which was a successful welfare-to-work programme designed to tackle long term unemployment. It was also used to fund captial investment for schools. If the case for a one-off levy was compelling then, it must be even more so today.

Now Even George Osborne Is A Friend Of The Minimum Wage

Few can doubt that Labour's Cost Of Living Crisis Campaign is making headway following George Osborne's volte-face on the Minimum Wage last week. On the 10th January the Chancellor was warning against a 'self defeating' inflation busting increase in the Minimum Wage. However, last Thursday he was trying to grab the limelight by calling for, er, an inflation busting increase in the minimum wage. In 6 days what had been seen as 'self defeating' had transformed into something that the 'economy can now afford'. You could hear the irritation in Business Secretary, Vince Cable's voice as he sought to explain this development in an interview on BBC Radio 4's Today Programme. What could have happened in less than a week? I suspect the arrival of the latest Tory Party focus group polling on attitudes towards falling living standards, rising inequality and fairness.

Before the Minimum Wage was introduced we heard dire warnings that it would cost jobs. This proved to be unfounded and those Conservative MPs who opposed its introduction now seem to be in favour of its retention. Nonetheless, every year when it becomes time to review its rate, various business leaders and their supporters in Parliament and the media warn us that if it is increased too much then jobs will indeed be lost, often citing the fact that we are in a global marketplace therefore not insulated from competition. I think this argument is overdone. 

The economy is split into 2 categories, the tradable sector and the non-tradable sector. The tradable sector refers, as its name suggests, to those areas of the economy whose output can be internationally traded, or exported. It is made up largely of manufacturing and business, including financial, services. The non-tradable sector relates to those businesses and organisations that produce goods and services for domestic consumption as they can not be exported. These include areas like government, care, hospitality, food service, education, retail, and construction. If someone is working in the non-tradable sector, then their job is not exposed to international competition. Home-helps for the elderly can not be outsourced to a firm in China and customers in UK pubs can't be served their drinks from a call centre in India. Yet where do the majority of people on the Minimum Wage work? In the retail, hospitality and care sectors.

So how would a substantial rise in the Minimum Wage lead to a loss of jobs due to the workings of free markets in a globalised economy? Its hard to see how paying someone £6.50, £7.00 or even £7.50 an hour rather than the current £6.31 would suddenly cause an upward push in wages rates that would suddenly make UK-based hedge fund managers, investment bankers, lawyers and accountants internationally uncompetitive. It is perhaps easier to imagine a detrimental effect at the marginal end of UK manufacturing as these firms would be forced to pay more to retain staff, pushing up costs and thereby reducing competitiveness. 

Yet the relationship between a developed country's wage levels and its export prowess appears to be a counter-intuitive one. According to the World Economic Forum, Switzerland is the most internationally competitive nation in the world, And it's not all cheese, chocolate and cuckoo clocks. Although it has a now rather tarnished reputation for international banking, what is not widely known is that it is a world leader in state of the art industrial machinery and chemicals. Indeed, in per capita terms, Switzerland has the highest industrial output in the world. Behind Switzerland, Finland weighs in at number 3, ahead of Germany in 4th place (the UK is back in 10th place). These are not low wage economies, seeking to slug it out with China by trying to directly compete in the low wage, low skill, assembly of consumer goods. They have managed to evolve from this sort of early state industrialisation to devote themselves to more high-skill, capitally intensive and consequently high wage, advanced manufacturing. The figures speak for themselves: Switzerland exports 52% of its GDP annually, as does Germany; for Finland the figure is 41%; for the UK its 32%. Moreover these countries were doing this while we were preoccupied with our invisible earnings and maintaining the City of London in its pre-eminent role as world leader for banking and other financial services and latterly as the global HQ for investment banking, derivatives trading hedge funds, private equity and the like.

Maybe the time has come for us to escape from our Stockholm syndrome relationship with bankers and embrace the fact that there are very real alternatives for UK PLC.

Cut Welfare By Building More Council Houses

It must be fair to say that the Coalition Government's Welfare Reform policy has encountered some difficulties over the last few months. One good thing about the ConDems attempts in this area has been that there rather ill-informed efforts have had the effect of exposing the real problems. One of these, which seems finally to be gaining some traction in our public discourse is that the lack of supply of social housing is the major cause of the now £24bn housing benefit bill. Over-occupation, unwillingness to work, claims by under 25's and immigration have been exposed as sideshows. The real culprit is private sector rents that are unaffordable even for those in full time work. This story was taken further when Daniel Boffey, writing in Sunday's Observer, pointed out that:

'Across the capital at least 36% of one-time council homes are now rented out privately but that proportion is even higher in some of the poorest areas where average private-sector rents, often paid by tenants on housing benefit cost as much as £230 a week more than council rents.'

Ed Conway, the Economics Editor for Sky news, has an illuminating piece on his blog about the role of the Thatcher government played in creating the current housing crisis. This is based on previously secret papers from 1984 that have now been released by the National Archives. Thatcher was determined to cut the Government's deficit and to that end a big cut in the housing budget was proposed such that between 1979/80 and 1985/86 the public housing programme would be cut by 52%. Both Ian Gow, her Housing Minister and Patrick Jenkin, her Environment Secretary, argued against these cuts, with Gow going as far to warn that to proceed would lead to increased homelessness. Jenkin made the point in Cabinet that at the time 'the formation of new households was running at 190,000 a year.' He estimated that 75,000 new public sector houses would need to be built to cope with this, although he was prepared to go down to a figure of 40,000. However, Thatcher thought that 15,000 to 20,000 would be adequate, egged on by her then advisor, now Tory MP, John Redwood, who wrote in a note to her that, 'We should be robust about increasing council house sales and reducing the level of new build.'

There seems to have been a firmly-held ideological belief that as the public sector withdrew from the housing market, it would create space that the private sector would quickly fill. Thus warnings about increased homelessness could be dismissed as it was believed that they would prove false because they were based on a lack of understanding of the workings of free markets. Sadly, the truth turned out rather differently than the disciples of Adam Smith had promised, as this chart, reproduced by Conway in his post, demonstrates.

It is no wonder then that, despite the Coalition's constant attempts to blame the previous Labour Government for the Deficit in general and uncontrolled Welfare spending in particular, the rapid rise of Housing Benefit came under the Thatcher and Major Governments, not under Blair and Brown, as this chart from the IFS clearly shows.

It is pretty clear now that a decision to reduce spending on council housing coupled with the Right to Buy policy, came together under the previous Conservative Government to create a perfect storm of rising prices, rising rents and rising welfare benefits to pay those increasingly unaffordable rents. Moreover, it is becoming clear that more and more housing benefit is going to relatively wealthy private landlords. In other words, it's become a tax payer subsidy to the private rented industry.

The UK is now a world where a family can be in an identical house to their neighbour, but are having to pay, with taxpayer support, 2, 3 or 4 times their neighbour's rent, because their neighbour is lucky enough to be in public housing. Surely, in these circumstances the time has come for us to borrow more to invest in Council Housing as a means to reduce the nation's Welfare bill.