Lessons from Economic History

I am writing this post not as a Conservative activist but as a professional economist.

I am going to try to be as bipartisan as possible, and will not include any cheap jibes at the present leader of any of the main British political parties.

Obviously, when one sets out to write about the lessons we can learn from the mistakes of the past there will inevitably be comments which could be taken as implicit criticism of previous PMs and Chancellors from all parties which have been in governmentm including my own.

However, while I am not planning to ask either of them, I suspect both George Osborne and Ed Balls would privately agree with the majority of what I am about to write.

In his book on "The World's Greatest Mistakes" the late David Frost described three things as "always a mistake" ...

* Invading Russia
* Marrying Henry VIII
* Accepting a cabinet post in Iraq or Liberia

Many a true word is spoken in jest. Are there things in economics which are similarly proven to be mistakes by any objective look at the past? I believe there are.

Economists are a disputative lot, and the joke has often been made that "where there are three economists you will find four opinions." This has been known to obscure the degree of consensus which in fact exists.

Almost all economists would agree that many suggestions made by John Maynard Keynes to avoid or get out of a classic recession work in the sense that they do actually have the effect of preventing or ending a recession, provided you don't over-use them and generate an inflationary spiral.

Many of those who have heard of the statement "We are all Keynesians now" probably assumed it was a statement from the "Keynesian" school of economists.

This statement  was actually made in 1965 by Professor Milton Friedman, the arch-monetarist. He meant that all mainstream macroeconomists, regardless of political persuasion, accepted the basic aggregate income-expenditure framework that underlies the so-called "neo-Keynesian" model.

Similarly the context of the reply "We are all monetarists now" was not a triumphalist claim from one of the "Chicago school" of monetarist economists. It was a complement to Friedman by a prominent Keynesian, Franco Modigliani. One version of the full quote reads as follows:

'Milton Friedman was once quoted as saying "We are all Keynesians now" and I am quite prepared to reciprocate that "we are all Monetarists now" if by monetarism is meant assigning to the stock of money a major role in determining output and prices.'

So what can we learn from the lessons of the past? I would suggest four rules as follows

RULE ONE: Never trust anyone who claims to have found a one-way bet to wealth or any other kind of "magic bullet" which overturns all previous rules of economics or immediately solves all the problems of the past.

Sometimes there is a genuine improvement in our economic knowledge but there is always a price. Claims of an easy route to an economic miracle have a 100% record of being disasters.

* The 18th century creators of the "South Sea Bubble" were wrong when they presented investment in this stock as a one-way bet to wealth. The inevitable collapse which followed almost bankrupted the British economy.

* Over the channel John Law, a scot who was put in charge of France's finances in the same century, was equally wrong when he proposed to stimulate industry by replacing gold with paper credit and then increasing the supply of credit, and to reduce the national debt by replacing it with shares in economic ventures. At first people thought he had found a miraculous solution to the problems France was facing but just like the South Sea Bubble it went up like a rocket and down like a stick, with even worse consequences for France than the South Sea Bubble had for Britain.

* Towards the end of the last century and at the beginning of this one, people became convinced that investing in "dotcom" shares was a one-way ticket to a fortune. None of them noticed at first that although many millions of people were using the internet, very few internet companies were actually generating a profit. When this reality finally hit home the correction took down several major telecoms companies, a lot of "dotcom billionaire" fortunes vanished and many investors lost out in a big way.

* Then a short time afterwards, large numbers of banks and investment analysts from America, Britain and much of the rest of the world, who should have known better, became convinced that the latest way to generate wealth from nothing was to invest billions of pounds, dollars and euros in the "Sub-Prime" market e.g. selling mortgages to people who could not afford them. When this in turn collapsed, this of course became the main trigger for the world recession and economic difficulties from which we are slowly, with the greatest of difficulty, emerging now.

 * And of course, you should never trust a politician who claims to have abolished boom and bust ...


RULE TWO: Never allow your country to suffer a sudden massive drop in the available supply of money. If you do, recession will follow as night follows day.

The main trigger for the great depression of the 1930's was a series of bank failures following the Wall Street crash which reduced the money supply in the USA by about 30%, and touched off similar problems in much of the rest of the Western world.

This is why, while we may argue until the cows come home about the extent to which shareholders and senior management in banks should have been supported, the last government had absolutely no choice but to bail out the banks to at least the extent that bank deposit customers were protected. Personally I would have allowed Richard Branson to buy Northern Rock rather than nationalising it, but they could not allow the customers of any major banks to lose all their money.

If they had, and if other governments had done the same, we would have had a depression as savage as the one in the thirties, and which would have made the problems we actually did have over the last eight years look like a vicar's tea party.


RULE THREE: Never allow your country to suffer a sudden massive increase in the available supply of money which is disproportionate to the productive capacity of the economy. If the available amount of money increases dramatically faster that the economy can produce goods and services, inflation will follow as night follows day.

If your economy is in recession and has a lot of spare capacity, a once-off increase in spending power can help get things going again. That's why the recent policy called Quantitative Easing has largely been a qualified success. But if you overdo it, or keep it going too long, the result will be a serious inflation problem.

Governments putting too much money into circulation is not a new problem. Problems with debased coinage (pretending there was more gold or silver in coins than there actually was) goes back at least as far as Archimedes, two and a half thousand years ago - the problem whose solution caused him to shout "Eureka" in the bath was how to tell whether the gold in a crown had been mixed with less precious metal. Dishonest rulers played the same trick with the coinage of their national currency both back then and subsequently, and when they did it always caused inflation.

But too much gold can cause nearly as much of a problem. When the Spanish conquered the New World and brought massive quantities of gold and silver back to Europe, at a time when the currencies of Europe were based on these metals, and roughly doubling the amount of them  in circulation, it touched off a century of inflation.

RULE FOUR: ridiculously high tax rates do not generate more revenue.

The higher the rate of tax, the more the incentive for people to evade or avoid it, the more high-earning people go abroad, and the lower the incentives to work. Which means that above a certain point, raising tax rates does not bring in more money.

There is some scope for argument about when this applies, but none about whether it happens. My personal opinion is that the tipping point above which higher income tax rates do not bring in more revenue is somewhere between 40% and 45%.

When Margaret Thatcher and Geoffrey Howe cut the highest British tax rates at a stroke from ninety-eight pence in the pound on investment income and 83% on salaries to forty pence in the pound, did the amount or proportion of tax revenue paid by the richest people in the country go down? Absolutely not, both went up. Yes, the rich got richer - but they also paid a lot more tax both in absolute terms and as a proportion of total revenues, providing literally billions of pounds more money to spend on the things which everyone needs such as schools and hospitals.

Similarly the increase in the top tax rate from 40% to 50% under the last government brought in little if any extra revenue: and the partial reversal of that increase back to 45% under the present government reduced revenues by little if anything. It may also have assisted in getting more inward investment to Britain by sending the signal that the country was determined to be more business friendly.

Provided everyone actually pays the taxes you do impose - and in general more people will pay up rather than try to get out of it when a tax rate is 40% than when it is 80% - there will be more money to provide services for everyone including the poor if the richest 10% are paying, say, 40% of £10 billion rather than 80% of £4 billion.

Comments

Jim said…
A very good post, one of the best you have written if I may say.

I am in total agreements with both rule 1 and rule 4, they are the basis of the 100% Fail rate i mentioned the other day.

Not so sure on rules 2 and 3 though, I just cant seem to make the link between cuts to supply and raises to supply. whilst to a certain extent a sudden increase will cause massive inflation, its victim would be savers, you just pretty much lost your lives work. To people in debt it would be like all their xmas's came at once, yes you may owe a million quid but if you can sell an egg for 3 million then its not really a problem.
Same with massive deflation only the winners are reversed, if you have saved a couple of thousand then there is huge deflation, then its ok as you can live like a king on your savings.
if you owe a few thousand then your debt problems just got a lot worse.

But to those living earn and spend, i.e not saving or going into debt, just living within their means then neither are too much of a problem. if you earn 1000 per week and your cost of living is 1000 per week then thats ok.
so massive inflation hits and now you earn 100,000 a week and your cost of living is 100,000 per week then you have neither gained or lost.
deflation is the same story but now you earn 10 per week and your cost of living is 10 per week, same same.


the most likely outcome of either massive inflation or deflation is that something else will take the place of the current "money" as the universal good. thats all.
Jim said…
i guess what i am getting at is, lets say this house is worth £200,000
and a Honda Civic car is £20,000

now inflation may push up the value of the house to £1,000,000 and the cost of the Honda civic to £200,000

or deflation may push the cost of the house to £10,000 and the cost of the honda civic to £1,000.

now if i had money in the bank then i win under deflation, and i lose under inflation. but in either case the house is only ever worth 10 honda civics. at any time if i had honda civics then I could have traded 10 of them for the house.

I know that the value of one commodity against another is never quite that clear cut, even the value of any object in money terms is not, but you see if you treat money as just another commodity, then its only money that lost or gained value. Not everything else. Any single commodity can suffer this raise and gall in value due to its supply and demand and quality, so if that commodity is not what you have or want then it makes little difference.



Jim said…
So if the last government had not bailed out the banks, then ok, it would be been rather rough going the last few years, but, so long as its left alone, barter would have taken the place of current monetary exchange, which would have naturally lead to a new "universal good" usually a precious metal has taken this role, but not always, other things from salt, to sea shells, to cattle have fulfilled it. but the fact remains that only the £ would have became worthless, something else would eventually have taken its place, and in the mean time trade would have continued even if it was only as barter
Chris Whiteside said…
That's interesting Jim, I had expected your response to my rule three might be that I had not gone far enough.

Yes, in the long run things would adjust and balance out, and quite possibly some new currency might emerge.

The problem is that things could be very "rough going" indeed in the meantime, and that could take quite a long time.

It was in this context, responding to people who said that the economy would right itself in the long run, that Keynes said "In the long run we are all dead."
Jim said…
A while ago i tried a little test. I would look at my wage slip and convert it to 3 different "things" then figure out the exchange rate of those 3 things that month.

so it may be "tanks of petrol", "kenwood mixers" and "kilograms of beef"

so i would see that this month i earned 10 mixers, or 40 tanks, or "300kgs beef". or "x pounds"

Whilst exchange rates could be set, i noticed that on the whole the most volotile of the goods was actually the pound. not the goods, and that was quite a liberating thought.

My old granny used to say "dont put all your eggs in one basket", and this just brings it to a whole new level,

so you have to ask, if all my "eggs" were not in the form of £'s sterling, would it have been that rough going?

Now there is a thought experiment for you
Jim said…
its generally only when there is a monopoly on a single good, that the rules somewhat change. ezpecially if its a good people need, or even just think they need.

the movie "total recall" looked at this issue, in this case it was an essetial - air. if you wanted it then you had to buy it from one person.

now look at the pound sterling, its actually a useless good, but people believe they need, and where is it controlled or monopolised? an interesting perception shift occurs doesn't it.
Jim said…
lets just go back to the movies and see how quickly money can lose its value.

for example in titanic, all the money in the world would not have got you onto a lifeboat would it.

or in plays, what's the cash value of a horse and a kingdom to Richard III?

Chris Whiteside said…
But for all the issues with money, it is very difficult to operate an advanced technological economy on the basis of a barter system.
Jim said…
yes, thats true, but but and but again, it all boils down to what is money?

basically its a universally accepted good for barter, which has an independent use other than that of money, holds its value, and is divisible.

so you can have the best of both worlds, you can have said commodity acting as "money" for "advanced trading" buts whats to say you cant use something else in other transactions you may chose to make?
Jim said…
For example gold is good, but historically in the uk pesky silver would not go away, but hey, where is the problem?

and thats just it, sure its all historical and things, but horses still trade in guinea's, so trade can take place in more than one unit at any one time, just so long as both parties agree on what it is they are trading for.

The only problems are that its hard to regulate, hard to tax, hard to control and hard to monopolise, so again where is the problem?
Chris Whiteside said…
Don't entirely agree with your definition of money, Jim.

Or to be precise, I would accept most of it, but I would not have included the qualification that it has to have an independent use other than as money.

In many periods of history people have used things which do have such an independent use, but in others, including the present, I cannot see that this qualifier applies.

When I was much younger I was of the opinion that we should back the currency by some unit of energy such as the Kilowatt-hour.

Mind you, if our present system of money collapsed it is very likely that something with independent value would for a time emerge as the main replacement currency.
Jim said…
Its very unlikely that something with no other use, other than of money would ever become a universal good for exchange.

some goods work well, usually as I said precious metals, but anything can take their place, but to emerge in the first place they must have another use. I also should have added that they are relatively rare. thus its easy to carry the amount of it you need.

look back thtough history and its the same story, it took years to finally break the link between a comodity that had an independent use, and just use the useless counterpart. so something that has not other use is unlikely to emerge.

you could argue your case in terms of say bitcoin, but even then, that idea is not taking off so well, 2 reasons. 1. it spiked in value and became a "bubble", 2. it never had intrinsic value, or it had no other use.

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