Free Lunch – David Smith – 2012

free lunch


Markets tend towards equilibrium, towards the balancing of supply and demand, though they may take a while to get there. Remember that and you are well on your way to understanding market economies.

Only sellers really know whether a car is perfect or not, buyers can never be certain. Economists call this ‘asymmetry of information’.

House prices rise because incomes do. The house price-earning ratio is not perfect. Incomes have risen steadily (by about 2% a year more than inflation) for as long as anybody can remember (except 2010-2011. In 1900 the average worker had to toil for a couple of hours to earn enough to buy a loaf of bread. Today, it is about 5 minutes. Supply [of houses] is inelastic – it responds slowly to rising prices – whereas if builders were able to flood the market with new properties in response to high prices it would be elastic.

While economists would regard the market of potatoes …as the preserve of microeconomics, the housing market in aggregate is so important that it makes it into the macroeconomic arena.

Gordon Brown gave the Bank of England operational independence in 1997 – which meant control over the instruments of the monetary policy to meet inflation target set by the government. It would be fully independent if the Bank would set its own target.

A low activity equilibrium: equilibrium is when demand and supply are in balance. In this case, both demand and supply were weak. Unusual things happen.

The history of English food suggests that a free market economy can get trapped for an extended period of time in a bad equilibrium in which good things are not demanded because they have never been supplied, and are not supplied because not enough people demand them.

We should always treat claims about current economic conditions that draw historical parallels with a pinch of salt. If things are bad now it is from a higher base; there is no real comparison with the 1920s or the austerity period that followed the 2nd World War. Earlier generation would not have had the luxury of devoting an eighth of their weekly spending to recreation and leisure.

Diminishing marginal utility – the more you have the less you want another one. It can even go negative. After 6 cups of coffee in the morning, I would pay someone to drink the 7th I was offered.

The idea that incentives work underpins much of economics.

Of course obesity is bad for you – but it’s not as bad for you as it used to be (thanks to drugs that cut your cholesterol and increase life expectancy). The price of obesity (measured in health risk) is down, so rational consumers will choose more of it.

Independent taxation, a separate taxation for husbands and wives (women paid tax at a rate reflecting their earning and not their husbands), introduced under Thatcher contributed a a huge increase in number of women working.

A high quantity and high quality investment has two key influences: it increases the level of input in the economy, increasing productivity and earning for workers. But it is also a vital channel for the introduction of new technology and processes.

The multiplier effect: an initial increase in government spending flows around the economy for quite a while. But a pound spent by the government does not, however, produce a pound of spending at the next stage.  Some of it will be taken by tax, some will be spent on imports, some will be saved. In 2010, America’s Congressional Budget Office had fiscal multiplier ranging from 0.2 for tax cuts for higher income individuals (i.e. a 1 billion tax cut would boost the economy by 0.2 billion) to 2.5 for certain type of spending. In UK change in VAT had a multiplier of 0.35 and infrastructure spending a multiplier of 1.

Debt: 40% of GDP rule was maintained until 2007-8 fiscal year but was quickly broken, and suspended when the crisis hit. The current budget deficit rose to 7.6% of GDP in 2009-10 while overall government borrowing hit more than 11% of GDP. By mid 2011, government debt stood at 61% GDP. Including the banks rescued during the financial crisis, the debt went up to 148% of GDP.

I would rather be vaguely right than precisely wrong” Keynes.

Keynes advocated a programme of government spending, of deliberately running a budget deficit. The additional spending at the right time would ‘prime the pump’ triggering higher growth in the economy through a multiplier effect.

For almost 2 decades  from 1990 Japan was a living example of an economy caught in a liquidity trap, where interest rates were cut to zero without stimulating the economy, not least because of falling price – or deflation.  Japan tried Keynesian policies but failed because they never followed through consistently, did not address the banking sector issues and because of loss of confidence in their political leaders.

In 1992, Sept 16th was the day the bank of England ran out of the reserve needed to prop up the pound within the Exchange Rate Mechanism (official targeting of exchange rate) thanks to George Soros and other speculators. The way in which interest rate affect the economy is called transmission mechanism of monetary policy. The maximum impact of a change in interest rates on inflation takes up to about two years. So interest rate have to be based on judgment about what inflation might be – the outlook over the coming few years – not what it is today.

Negative interest rate: penalizing those who hold deposit at the central bank, mainly commercial banks, by charging them for keeping their fund there. This hardly seemed sensible in the middle of the financial crisis. Instead they used quantitative easing or electronically creating money (to reduce cost of borrowing and boost assets prices). First implemented in Japan in 2001, in UK in 2009…there is little consensus on whether it worked.

Few economist would dispute that there is a relationship between the money supply and inflation, although many would question whether that relationship could ever be precise.

A government that introduce ‘tax and spend’ policies, raising tax to increase public spending will boost the economy. Government spending provides the economy a greater stimulus – it goes directly into extra demand for goods, services and people. Tax however is subject to various leakages (savings, imports). Therefore £1 billion spent by Government will have a bigger impact than £1 billion used for tax cuts.

Supply side economics goes beyond tax cuts. Supply side economics embraces anything that raises the economies’ long-run, or sustainable, growth rate.  It can be tax cut, increasing competition by breaking up cartels, attacking restrictive practice of trade union, improving climate for business, making it easier to hire and fire workers.

Milanovic: inequality have increased sharply from the early XIX century until around 1950, then stabilized. Most inequality though is now between countries (not within countries). Landes estimated that the income gap between Switzerland and Mozambique is 400 to one. Prior to the middle of XVIII century it would been about 5 to one.

Why such disparities? Three broad explanations. 1. The late developer thesis. Prosperity and success will come to all but for some it takes longer than others. Anti-globalisation critics argue that rich countries have effectively kicked the ladder away. Certainly rich country have tended to control the rules of global trade. 2. The location: poor countries tend to be in tropical zones. There diseases tend to be rife, agriculture more difficult, trade more difficult. Sachs attributed Africa’s economic failure to climate, disease, geography and poor policies. 3. Culture makes all the difference. Division of labour, work ethics, organization was key to harnessing and advancing the powerful force of industrialization. The message is positive: culture can change, adapt.

Lord Bauer who died in 2002 pointed out that over decades indiscriminate aid did poor countries more harm than good. Douglas North, Nobel Prize in 93, considers that institutions provide the basic structure by which human beings throughout history have created order and attempted to reduce uncertainty in exchange.

Paul Collier, oxford economist, identified a range of explanations:  conflict trap, resource curse, corrupt governments. Not only are they stuck in poverty but their situation and prospects diverge so dramatically from the rest of the world. The challenge for development is not to reduce global poverty: it’s to replace divergence by convergence. Reducing poverty in not enough, the bottom billion have to catch up with the rest of mankind.

Dani Rodrick on globalization : There is no global anti-trust authority, no global lender of last resort, no global regulator, no global safety net, and, of course, no global democracy. In other word, global markets suffer from weak governance and therefore weak popular legitimacy.

Tanzi and Schuknecht wrote “perhaps the level of public spending does not need to be much higher than 30% of GDP to achieve most of the important social and economic objectives that justify government interventions. However this would require radical reform, well working private market and efficient regulatory role of the government”

Robert Mundell: an optimal currency area requires all participants not only to be closely interlinked through trade, but also broadly similar in structure.

In 2007, the potential losses for the banking system were unknown (and difficult to know) but estimated at $4 trillion by IMF in 2009.

The Credit Default Swap (a type of insurance contract: a firm wishing to minimize its credit risk would get somebody else to get on that risk, and pays a premium to it to do so. In 2007 the CDS market was worth $55 trillion (almost the world GDP) in a global market of so-called derivative of $500 trillion. Derivatives are any instruments to transfer risks from those who should not take them to those who care willing and are capable of doing so. (unfortunately the financial markets were willing but not capable…)

Countries like China where consumer spending is low and saving high were generating surplus that washed around the world economy. The surplus kept interest rate low, fuelling the credit boom. China is the biggest international owner of US treasury bonds.

Lord Saatchi : the crisis was not the fault of the bankers, regulators or borrowers but a misguided faith in inflation targeting. All were lulled into a false sense of security by the idea that if policy makers could maintained low inflation then all good things would follow. It encourage the view that it was safe to borrow, safe to invest. Some suggest the problem that the inflation target did not include house prices. The boom in asset prices told a story of a very rapid credit growth…(while inflation was low). Two lessons for the banks: ultra-low interest rates might not be enough. Central bank buying government bonds pushed up their price and contributed to lower their yields (the interest rate on them) – an effect that replicated on the market of corporate bonds.