Friday graph: Sue Bradford’s legacy

Eric Crampton of the economics department of the University of Canterbury is a fine economist. Some months ago he estimated conservatively that the abolition of the youth minimum wage has cost the country over 9000 jobs.

Eric noted that youth unemployment during the current recession, relative to adult unemployment in prior recessions, seemed very high.

More evidence on this point is shown in the graph below (taken from The Economist).

It indicates that New Zealand’s current youth unemployment rates are an outlier relative to other OECD countries.

 Click to enlarge
The further north a country is, measured on the perpendicular from the ‘four times as high’ line, the worse youth unemployment is relative to adult unemployment. Only Sweden and Luxembourg have worse youth unemployment outcomes than New Zealand relative to adult rates. 

That is former Green MP Sue Bradford’s legacy to New Zealand.  We are talking here about the most marginal low-skilled young people.  Firms will pay young workers the minimum wage or higher wages if their productivity warrants it.  Indeed they will be forced to do so because of competition for labour by other firms.  But they won’t if young workers’ productivity doesn’t warrant it – they will make losses if they hire such workers.

Sue Bradford may have been well intentioned but it is outcomes that matter.  This outcome is tragic.  How does she sleep at night?

The government’s Welfare Working Group will have failed if it turns a blind eye to this appalling situation.

How economics saved Christmas

 I noticed Cactus Kate blogged recently – albeit in a most flattering way – that I suffer random bouts of ‘Kiwiblogitis’ (an urge to over-quote other people’s work).

I take her point on overzealous cutting and pasting, but I make no apologies for sharing other people’s work that I admire – or indeed sharing and commenting on work I disagree with. That was a significant reason for starting this blog.

So, in the spirit of Christmas sharing, I will copy and paste an entire article: a poem by Art Carden that first appeared on Forbes.com (hat tip: Café Hayek).

Below is: ‘How Economics Saved Christmas’.

Season’s greetings!

How Economics Saved Christmas

From Wikipedia

 

 Every Who down in Whoville liked Christmas a lot.

But the Grinch, who lived just north of Whoville, DID NOT.

He stood and he hated the Whos and their noise

He hated the shrieks of the Who girls and boys

For fifty-three years he’d put up with it now—

He had to stop Christmas from coming, somehow.

He asked and he questioned the whole thing’s legality

Then his eyes brightened: he screamed “externality!”

He reached for his textbooks; he knew what to do

He’d fight them with ideas from A.C. Pigou

This idea has merit, he thought in the frost

A tax that was equal to external cost

At the margin, would give all the Who girls and boys

An incentive to stop all their screaming and noise

Failing that, an injunction to make them all cease

And they’d have to pay him to have their Roast Beast.

Low costs of transacting meant that if the Whos

Were the high-value users and wanted to use

All the rights to have feasts and the rights to sing songs

Then they’d have to buy them, to right their Who wrongs

They’d buy a noise easement, if they wished to sing

Until then, the Grinch could stop the whole thing.

On Christmas Eve Night, the Grinch went to town

He stole all the presents, he took their wreaths down

He stole their Who Hash, everything for their feast!

He swiped their Who Pudding!  He swiped their Roast Beast!

He looked at his sled loaded up with Who snacks

‘Twas quite an efficient Pigovian tax!

Then late in the night, when he got to Mount Crumpit

For he’d taken the load, and he threatened to dump it

The Whos, with one voice crying out in the night

Screamed “bring back our stuff!  You haven’t the right!

“We know that we’re noisy all through Christmas Day,

But if you don’t like it, it’s you who should pay!

“For we were here first, and homesteaded the rights

To sing, to make noise, and to hang Christmas lights

“The costs of our Christmas joy helped you to save!

They were fully reflected in the price of your cave!”

“We’ll all be good neighbors, and we’ll be polite

“But you’ve done us wrong on this Christmas Eve Night!”

The Grinch was crestfallen, he knew he had lost

For he was the source of the “external” cost

He’d come to the nuisance, and yes, he was wrong

He’d now have to live with their noise and their songs

He realized that day, though, that they could be friends

His heart grew three sizes (you know how this ends)

The Whos asked the Grinch to join them in their feast

And he—he, the Grinch—carved the Roast Beast.

The holiday season brings specials galore

They teach us that Christmas can’t come from a store

Reflect, as you watch them, as day turns to night

On good economics, and property rights

The Spirit Level

For some time we’ve been hearing about The Spirit Level,[1] a book first published in 2009 advancing a case for equality of income. Many enthusiasts for the book have followed the authors in promoting it as an evidence-based, ‘scientific’ statement of the case for equality, as if no right-thinking person could disagree with it.  What’s going on?

The book differs from previous literature on equality in that it doesn’t argue principally that equality of income is the only just and fair distribution of income. The authors actually do believe this, but to get the necessary political consensus for equality they set out to prove that, as the book’s subtitle puts it, “equality is better for everyone”. They want to make the case for equality universally irresistible as well as irrefutable.

The authors, Richard Wilkinson and Kate Pickett, are epidemiologists at British universities, and when they say that equality is ‘better’ for everyone they mean that it promotes our physical, mental and social well-being.  They don’t mean that it promotes ‘welfare’ in the typical economist’s sense of maximising the consumption of goods that individuals define and choose for themselves.  They are quite clear that economic freedom must be curtailed if it prevents more well-being from being realised through the equalisation of incomes.  But they are confident that the promise of greater well-being will persuade us to prefer to equalise incomes rather than to increase them.

The authors set out by asserting what they take to be two established facts.  The first is that in developed countries economic growth no longer much increases individual economic welfare.  The ‘happiness curve’ that people in poor countries ride up as they become richer eventually flattens out, as it already has in the richest countries. The second established fact is that man-made global warming threatens a global environmental catastrophe, and so economic growth will have to be ended anyway in order to control carbon emissions.  But we can still improve our well-being by moving towards equality of incomes.  The core of The Spirit Level is its presentation of research results to back up this claim.

The authors argue that a range of pathologies are all several times worse in the most unequal developed countries than they are in the most equal ones. The same pattern is evident in US states: the most unequal states do much worse than the most equal ones.  Of the wide range of indicators used, the central ones are tenfold: level of trust; mental illness (including drug and alcohol addiction); obesity; children’s educational performance; teenage births; homicides; imprisonment rates; and social mobility (this last indicator is not available for US states). Using internationally recognised definitions and comparisons of these ten indicators, and drawing on data from 23 developed countries and the 50 US states, the authors show that the problems are worst in the most unequal countries, which include the United States, Portugal, the United Kingdom, New Zealand and Australia, and the most unequal US states, typically those of the South.  They are least bad in the most equal countries, which include Japan and the Scandinavian countries, and in the most equal US states, which are geographically dispersed and include Alaska, New Hampshire, Utah and Iowa.

The authors find only a weak relationship between the indicators and average incomes among rich countries (and the US states), which suggests that it’s the inequality of incomes that’s significant; and they believe that cultural explanations of the relationships don’t stand up to scrutiny. They conclude that inequality of incomes actually causes or exacerbates health and social problems. The more unequal a society is, the less people trust one another; those at the bottom of society are more likely to feel stressed and demoralised, to engage in self-destructive behaviour and to fall ill; and everyone is more likely to seek solace in wasteful and futile consumerism.  More equal societies, in contrast, are less atomised, more socially mobile, more socially relaxed and healthier.

In the final part of their book the authors canvass policies to lessen the extremes of income inequality in the most unequal societies.  They want to raise the lowest incomes with higher minimum wages, but they’re more concerned with dismantling concentrations of wealth by, for example, taxing the very rich heavily (they entertain a top income tax rate of 60 percent – see how serious they are about ending economic growth!) and by promoting alternatives to the standard corporate model with schemes like employee share-ownership and control of companies, and, in finance, by encouraging credit unions and mutual funds as alternatives to orthodox banking.   They have no doubt that the outcome of these changes would be a great advance in well-being. They have set up the Equality Trust (www.equalitytrust.org.uk) to help get a social movement for equality going.

But they haven’t had a completely clear run. Already at least two books have appeared challenging the central claims of The Spirit Level.[2]  Their authors argue that the analysis of social problems and income inequality suffers from many defects.  For example, there is the omission of countries like South Korea, Slovenia and the Czech Republic, which are relatively equal but don’t achieve high levels of well-being, and also Hong Kong, which is, conversely, highly unequal but scores highly on the well-being criteria. The authors of The Spirit Level are responding to criticisms on the Equality Trust website.  The debate will go on. It’s quite possible that the entire Spirit Level thesis will eventually disintegrate under the weight of such criticism, and be forgotten. It’s equally possible that some of the book’s claims will survive more or less intact.  But to my mind the central problem with the book is not its possibly defective analysis of the link between income inequality and health and social problems. It is its opening assertion that in the rich countries economic growth no longer promotes welfare.  (I cannot deal here with the second assertion, about climate change, but claims about the scientific irrefutability of the fact of man-made climate change have waned as legitimate doubts have emerged both about it and about the appropriate policy response to it.)

The claim that in the rich countries economic growth no longer promotes welfare indicates how irrelevant The Spirit Level is to the central political issue now confronting all developed countries, which is how to cope with the huge and growing demand for government spending brought about by demographic change. The global fiscal crisis is not just a short-term matter of closing structural budget deficits and stopping the rise of national debt; it is a long-term one of financing the pensions and health care of populations that are ageing as life expectancy rises, fertility rates are low, and the ratio of dependants to workers grows.  Economic growth is an indispensable part of the policy mix that governments are devising to meet the challenge. This has nothing to do with satisfying a taste for ‘consumerism’ or vainly pursuing more ‘happiness’; it’s about preserving existing standards of living and well-being which, without economic growth, would soon start to slip back, threatening vulnerable groups with poverty. This is well understood in Sweden, which the authors of The Spirit Level consistently find to be among the most equal and healthiest of countries. The election there on 19 September 2010 confirmed the conservative government in a second term of office after it implemented a programme of tax cuts, which beat the recession by reducing unemployment and creating about 100,000 jobs.[3]  Sweden’s economy is now growing at the impressive rate of about 4 percent a year.  The country may be somewhat less equal as a result of the tax cuts; but who apart from the authors of The Spirit Level would deny that the cuts were good policy?

Another relatively equal and healthy country is Japan. It faces perhaps the biggest demographic challenge of all the developed countries. Unlike Sweden, it allows in very few immigrants to boost the workforce.  A sizable immigration programme would doubtless increase inequality.  But if the Japanese nevertheless implemented one, how many observers would think they’d made a mistake?

By dismissing economic growth so brusquely from the outset, the authors of The Spirit Level exclude from their analysis any possible links between continuing economic growth and well-being even in relatively unequal developed countries. But such evidence exists. Writing recently in The Australian, Michael Stutchbury summarised the Australian Bureau of Statistics’ latest snapshot of Australia’s national progress during a ten-year period in which Australia’s per capita gross domestic product grew by 23 percent in real terms. He wrote,

A key indicator of health – life expectancy at birth – confirms Australians are living longer. In the decade to 2008, life expectancy for girls rose 2.2 years to 83.7 years and by 3.3 years to 79.2 years for boys. The suicide rate, which the ABS classifies as an indicator of social cohesion, has fallen even amid concerns about worsening mental health. The suicide rate for men aged 20 to 24 halved during the same period. And volunteering, seen as an indicator of social networks, has increased, up from 24 per cent in 1995 to 35 per cent in 2006.[4]

This last item in particular – the growth of volunteering – shows how utterly misguided the authors of The Spirit Level are to dismiss economic growth as the search exclusively for ever more material wealth.  On the contrary, economic growth makes it possible to pursue ever more non-material goods.  Higher productivity progressively reduces the time that has to be devoted to meeting material needs, so allowing more scope for other activities, including those of a social nature that the authors of The Spirit Level value.

I share much of the aspiration of The Spirit Level for more equality although I worry more about poverty and hardship and how to alleviate it.  A simple thought experiment shows that promoting income equality per se is not a sensible social goal.  Consider what would happen if Bill Gates and Steve Ballmer decided to move Microsoft’s Seattle headquarters, and all its US million dollar employees, to New Zealand.  Income inequality would ‘worsen’.  But how many New Zealanders would regard that as a bad thing?

Experience suggests that the compulsory imposition of economic  equality can eventually be self-defeating and impoverishing – which is why Sweden is rowing away from it.  Yet economic and social reform often promotes equality as an unintended but desirable side effect of promoting freedom and efficiency. Thus, educational reform to enhance national skills could improve the performance of the poorest social groups most, since they have the most to gain. Welfare reform would free the poor to take advantage of opportunities to rise up the income ladder and to escape the physical and mental health risks of dependency. At the other end of the scale, the global financial crisis has exposed the enormous incomes of some bankers as symptoms of barriers to entry into finance (allowing bankers to consume the implicit government subsidy arising from banks being ‘too big to fail’) and also of management domination of financial institutions.  Improvements to financial regulation, competition policy and corporate governance would help to spread the profits of finance more widely, crucially to shareholders, which include superannuation funds.  A shift away from the prevalence of bank credit towards other, possibly safer forms of finance might well see the growth and spread of mutual funds, credit unions and still other kinds of financial institution, like the internet bank Zopa.  And where economic freedom prevails, non-corporate forms of economic governance can be tried.

For a further international perspective on income inequality see this paper by Will Wilkinson of the Washington-based Cato Institute.  The summary reads as follows:

Recent discussions of economic inequality, marked by a lack of clarity and care, have confused the public about the meaning and moral significance of rising income inequality. Income statistics paint a misleading picture of real standards of living and real economic inequality. Several strands of evidence about real standards of living suggest a very different picture of the trends in economic inequality. In any case, the dispersion of incomes at any given time has, at best, a tenuous connection to human welfare or social justice. The pattern of incomes is affected by both morally desirable and undesirable mechanisms. When injustice or wrongdoing increases income inequality, the problem is the original malign cause, not the resulting inequality. Many thinkers mistake national populations for “society” and thereby obscure the real story about the effects of trade and immigration on welfare, equality, and justice. There is little evidence that high levels of income inequality lead down a slippery slope to the destruction of democracy and rule by the rich. The unequal political voice of the poor can be addressed only through policies that actually work to fight poverty and improve education. Income inequality is a dangerous distraction from the real problems: poverty, lack of economic opportunity, and systemic injustice.

My bottom line is that income equality may or may not promote well-being in the manner claimed in The Spirit Level.  Economic growth certainly does promote it. Attempts to promote well-being by engineering equality via the compulsory curtailment of economic growth and economic freedom can fail, by gradually undermining prosperity.  But the authors of The Spirit Level have more scope than they realise to promote their egalitarian ideals within the framework of economic freedom.

Some useful New Zealand data and perspectives on income inequality were contained in this recent presentation by Ben Gleisner of the Treasury.  His conclusions on trends are:

1.    Income inequality in New Zealand grew sharply between mid 80s and mid  90s, but stabilised recently

2.    Including government support, growth is less

3.    But still high inequality relative to other OECD countries

The first point is crucial.  The strongest driver of income inequality is usually unemployment.  This rose steeply in the 1980s with the refusal of the Labour government to free up the labour market.  It fell sharply from the early 1990s following labour market reforms.  There has to be a worry that the recent rise in unemployment, especially the loss of employment opportunities for many young people with the abolition of youth wage rates by the last Labour-led government, will see unemployment rise again.  The youth wage decision has been estimated by Eric Crampton of the University of Canterbury to have cost at least 9000 jobs.

Ben Gleisner also makes the point that educational outcomes and benefit dependency (as well as wealth inequality) matter for future equality.  An interesting slide shows that New Zealand scores the worst of all OECD countries for the variance in educational outcomes – the so-called ‘long tail’ of under-achievement.  Another slide highlights the problems of benefit dependency, with 25 percent of the Maori working age population on welfare benefits (2006 figures).  Typically people are better off – in income, health and other terms – by being in the workforce, even at low initial wages, rather than being on benefits.  This point is especially important from a long-term and intergenerational perspective.

---

1. Richard Wilkinson and Kate Pickett, The Spirit Level: Why Equality is Better for Everyone. Allen Lane, 2009; Penguin Books, 2010.
2. Christopher John Snowdon, The Spirit Level Delusion: Fact-checking the Left’s New Theory of Everything, Democracy Institute/Little Dice, 2010; see also http://spiritleveldelusion.blogspot.com. Peter Saunders (ed. Natalie Evans), Beware False Prophets: Equality, the Good Society and The Spirit Level, Policy Exchange, 2010; see http://www.policyexchange.org.uk/images/publications/pdfs/Beware_False_Prophets_Jul_10.pdf
3. Fraser Nelson, ‘Swedish conservatives bucked the recession by lowering taxes – and won re-election’, The Spectator, 25 September 2010, p. 12.
4. Michael Stutchbury, ‘Plain old economic growth is good for society’, The Australian, 21 September 2010.

 

A Perspective on Ireland’s Economy

Philip Lane is Professor of International Macroeconomics at Trinity College Dublin.  He is also a managing editor of the journal Economic Policy, the founder of The Irish Economy blog, and a research fellow of the Centre for Economic Policy Research.  His research interests include financial globalisation, the macroeconomics of exchange rates and capital flows, macroeconomic policy design, European Monetary Union, and the Irish economy.

Last week he visited New Zealand as a guest of the Treasury, the Reserve Bank, and Victoria University.  During his visit he presented this guest lecture on the troubled Irish economy, drawing on his recent report to the Irish Parliament’s finance committee on ‘Macroeconomic Policy and Effective Fiscal and Economic Governance’.

Some highlights from his talk (also reported here by Brian Fallow in the New Zealand Herald) were:

• Ireland’s is a real depression: 15% fall in GDP 2007-2010
• The Celtic Tiger 1994-2001 was no mirage
• The domestic bubble (2003-2007) was partly the result of Ireland’s membership of the Eurozone, which produced interest rates that were too low for a booming economy.  When it burst, the problems were compounded by the global crisis
• The banking crisis followed.  The excessive government guarantees to subordinated and senior bondholders were a major mistake (although bank shareholders were punished)
• This precipitated the fiscal crisis, with successive austerity budgets and ultimately the EU/IMF bailout
• Ireland has ‘bitten the bullet’ with cuts to public spending, wages, the minimum wage and welfare (although the cuts return most payments to around 2006 levels).  This amounts to an ‘internal devaluation’ given the fixed currency, and has boosted prospects for the real economy
• The consensus in Ireland is to return to the core principles of the ‘Celtic Tiger’ era.

Asked whether Ireland would raise the 12.5% tax rate on inward investment, Professor Lane’s answer was, “never, ever”.

His account of Ireland’s rise and fall contrasts starkly with those of critics who saw Ireland’s predicament as a failure of ‘the neoliberal model’.

An example is this article by New Zealand journalist Alison McCulloch (‘Folly of Tiger is a warning for New Zealand’, New Zealand Herald, 24 April 2010).

I wrote this article in reply but the Herald declined to publish it.

Richard Epstein on Barack Obama – his former colleague

Professor Richard Epstein, a former Business Roundtable Sir Ronald Trotter Lecturer, is interviewed here on the US economy, stimulus, regulation and his former Chicago Law School colleague President Obama.  

Richard has a fierce intellect and, as usual, delivers wide ranging and rapid fire observations:

Below are some examples of Professor Richard Epstein’s work – for many more visit www.nzbr.org.nz and enter his name in the search field.

What Do We Mean by the Rule of Law? 

Understanding America

A Country is Not a Company

Affirmative Action: The US Experience and Implications for New Zealand

Successful reform: past lessons, future challenges

Gary Banks, the chairman of Australia’s highly regarded Productivity Commission, is a valued colleague and good friend of New Zealand.

Last week he gave an important speech with the above title on economic reform in Australia.

It comes at a time when the Gillard government is struggling to establish its reform credentials.  Both major parties in Australia compete to embrace the Hawke-Keating-Howard reform legacy, unlike their counterparts here which often distance themselves from a similarly successful reform programme (even though they have kept in place its main elements).

Gary began by reflecting on the current climate of opinion about reform:

Paul Kelly, Australia’s pre-eminent policy journalist and chronicler of our reform history over the past three decades, asserted earlier this year that “the historic post-1983 reform era is terminated”. Ross Garnaut, one of the most policy-influential academics of that era, recently made the following assessment: “Economic policy since the GST [2001] has been characterised by change, rather than productivity enhancing reform”. He went further: “Attempts at major reforms have failed comprehensively and poisoned the well for further reform for a considerable while”.

 He observed:

If ‘productivity enhancing’ reform is indeed becoming a no-goer, Australia is in for a tough time. For a start, this would make it harder for us to meet the fiscal challenges of the Global Financial Crisis in the short term and, in the long term, the ageing of the population. We would also struggle to meet the demands and costs of more sustainable resource use and desirable environmental rectification. Australians may again start to see international competition and globalisation as threats rather than opportunities. And our capacity to raise the living standards of Indigenous and other disadvantaged members of the community would be weakened when it needs to be strengthened.

Explaining the importance of productivity growth, he said:

Productivity enhancing reform is so crucial to our economic (and social) futures because productivity growth itself – the ability to get more out of a country’s resources – is the mainstay of economic progress …  If, as the Nobel Laureate Paul Krugman has famously put it, ‘in the long run productivity is nearly everything’ Australia’s prospects currently may not appear very promising. Following a stellar performance in the 1990s, driven in large part by the structural reforms initiated in the previous decade, our productivity growth in the early 2000s fell back to its long term average.

Putting numbers on the productivity challenge, Gary commented:

… if (labour) productivity growth could just get back to the long-run average rate of 1.75 per cent that preceded the 2004-2008 cycle, rather than the 1.6 per cent average growth assumed in Treasury’s latest Inter-generational Report, then, abstracting from changes in the rate of employment and investment, per capita incomes would be 6 per cent higher by 2050. And if we could reclaim the 2 per cent average annual growth recorded in the 1990s in a sustainable way – admittedly a big ask – Australia’s GDP would be some $400 billion larger than otherwise, with per capita incomes 17 per cent higher (worth nearly $19,000 per person in today’s dollars).

New Zealand’s productivity growth was actually a little better than Australia’s from 1992-2000 following its earlier reforms, but declined more dramatically than Australia’s in the past decade with the changed policy approach of the last Labour government.

Gary noted that according to the dictionary, ‘reform’ means “change for the better”, but quoted Nicolo Machievelli’s famous remark about its challenges:

There is nothing more difficult to carry out, more doubtful of success, nor more dangerous to handle, than to initiate a new order of things. For the reformer has enemies in all who profit from the old order, and only lukewarm defenders in those who would benefit from the new.

He talked about where the backing for Australia’s reforms came from:

Support was strongest among the professional policy cadre – within government, academia and the ‘commentariat’, including opinion media. But there was also strong support from peak business, and to some extent from community organisations, depending on the reforms. Broader ‘public opinion’, if not actively supportive, was at least not actively hostile.

In New Zealand’s case, support from academics and the media, with some exceptions, was notable by its absence.

And a little further on in the speech, Gary Banks added:

Leaders with the right vision for a better Australia and the skills to realise it, were fundamental to all the individual ‘success factors’ just described – they could be said to be have been the ultimate success factor.

He ended by listing some of the priority areas for reform in Australia today:

One key dimension is the budgetary constraints that governments face in the aftermath of the Global Crisis.  The combination of fiscal constraints from the Global Financial Crisis and structural pressures from the mining boom suggests that the productivity enhancing reforms that deserve some priority right now are those that can reduce business costs and enhance the economy’s supply-side responsiveness, while being ‘fiscally parsimonious’.

In addition:

Regulatory proposals that would have pervasive effects across the economy need particular scrutiny, especially those impacting on the markets for labour and capital, and key infrastructural inputs to production such as transport (not forgetting coastal shipping), energy, telecommunications and water … Among these, industrial relations regulation is arguably the most crucial to get right. Whether productivity growth comes from working harder or working ‘smarter’, people in workplaces are central to it. The incentives they face and how well their skills are deployed and redeployed in the multitude of enterprises that make up our economy underpins its aggregate performance.

Practically all of this agenda and more applies to New Zealand.  (Water reform, for example, has not even got off the ground whereas it has been underway in Australia for two decades.)

The full speech is here.

A speech with similar themes is this one, Reigniting Reform in Australia and New Zealand, given by Hugh Morgan, president of the Business Council of New Zealand, to a New Zealand Business Roundtable retreat in 2004.

Friday Graph: the US Post-War Miracle

 

Today’s graph is from a fascinating paper by David Henderson, published in November 2010 by the Mercatus Centre at George Mason University.

 

Henderson writes:

We often hear that big cuts in government spending over a short time are a bad idea. The case against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, would lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression.

Second, with a major shift in demand (fewer government goods and services and more private ones), the economy will experience a wrenching readjustment, during which people will be unemployed and the economy will slow.

Yet, this scenario has already occurred in the United States, and the result was an astonishing boom. In the four years from peak World War II spending in 1944 to 1948 the U.S. government cut spending by $72 billion—a 75-percent reduction.2 It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP (see figure 1).

Yet, the economy boomed. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But during the years from 1945 to 1948, it reached its peak at only 3.9 percent in 1946, and, for the months from September 1945 to December 1948, the average unemployment rate was only 3.5 percent.

Ask people who lived through that period as young adults what economic conditions were like, and you will inevitably get the answer that they experienced an economic boom. The U.S. economy during the post-World War II years is exhibit A against the Keynesian view that economies will necessarily suffer high unemployment and slow growth when governments make big cuts in government spending. Why did the U.S. economy do so well in the years following World War II given how badly it had done in the years preceding America’s entry into the war? The answer, in a nutshell, is that dramatically reducing government spending and deregulating an economy can take that economy from sickness to health. In short, one of the main things a government can do to help a weak economy recover is to step aside.

The Public Benefits of Private Ownership

Karl du Fresne is one of New Zealand’s most perceptive commentators on an extraordinary range of subjects.  I call him the Sage of the Wairarapa.

In earlier years he was not always what I would regard as ‘sound’.  As editor of The Dominion he was a frequent critic, if memory serves, of many of New Zealand’s 1980s economic reforms.

But like good wine – a subject on which he writes knowledgably – he gets better and better with age.

This week he had a great column in The Dominion Post.

He began:

I never cease to be amazed by the number of intelligent people who proudly declare themselves to be socialists, as if this were a badge of honour. A recent example was Gary McCormick, a man I otherwise admire, who proclaimed his socialist leanings on Jim Mora’s radio programme.

The article went on:

Socialism has been disastrous wherever it has been tried. It is oppressive politically and ruinous economically. Why would anyone align themselves with such a failed ideology? …

Strangely, it remains unfashionable to pronounce oneself unashamedly to be a capitalist. Yet all of the world’s freest and most prosperous countries are capitalist democracies – and usually with a Christian heritage too, although it’s even less fashionable to point that out.

Unbridled capitalism is a bad thing. Even the father of capitalism, John Stuart Mill, saw the need to curb its excesses and inequalities. But history has proved that the combination of a capitalist economy and a liberal democratic state provides the best possible conditions for freedom, human rights and economic progress.

This is confirmed by the masses of people from repressive socialist states who have risked everything to migrate to the capitalist democracies of Europe and North America. They clearly recognise that capitalism works for underdogs as much as for anyone else.

How true.

At the heart of socialism is an ideological belief in “public ownership of the means of production, distribution and exchange.”

Like Karl du Fresne, I am amazed at the persistence of this belief in New Zealand.  Around the world governments have been progressively pulling out of owning commercial businesses for over 25 years.  Even Cuba has embarked on privatisation this year.

There is very broad agreement among economic researchers that privately owned businesses, on average and over time, outperform publicly owned ones.  This is an empirical finding, not an ideological one.

It is important to tease out the meaning of this finding.

It is not an assertion that state-owned businesses always perform poorly – at least for a period they may perform well.

Nor is it a statement that privately owned businesses don’t fail.  Of course they can and do: business is a risky enterprise.

Rather the statement is about the general run of performance, which is what matters for public policy.  Governments should not bet against the odds with taxpayers’ money.

The general pattern in New Zealand has been in line with international experience.  Former government trading departments were frequently loss-makers that delivered poor service to customers and were a drag on the performance of the economy.

The adoption of the SOE model improved their performance and privatisation of some SOEs improved their performance further.  The incentives for good performance arising from private ownership and capital market disciplines are stronger than the incentives of politicians.

Privatisation – at least before the event – has not been a popular policy in many countries, perhaps because of atavistic socialist instincts.

This has certainly been the case in New Zealand.  Part of the reason I think is that politicians stopped defending the policy and explaining its benefits and they vacated the field to ideological opponents.

The reality is that most of the 30-odd privatisations have been success stories and relatively uncontroversial.  Few people think the last two major ones, Auckland International Airport and Contact Energy, were mistakes and advocate renationalisation.

Most criticism focuses on Air New Zealand and Trans Rail, both of which the Labour-led government renationalised.  Even if you accept the claim that these were failures of privatisation they don’t invalidate the key finding: that privately owned businesses generally outperform publicly owned ones, and that as a matter of policy governments should not put taxpayers’ money at risk.

Personally, I do not accept the claim.

Air New Zealand was not a failure of privatisation.  Its performance improved greatly for many years after privatisation.  Then it made a disastrous business decision in Australia – something any firm can do – and was also the victim of an unexpected regulatory decision.

Even so, there was no need for the government to take back ownership.  Private solutions to its problems were available.

Since the government became a majority owner, Air New Zealand has performed well operationally under Ralph Norris and Rob Fyfe.  However, its financial performance has been dismal, as this week’s release of the 2010 Annual Portfolio Report by the Crown Ownership Monitoring Unit confirms. 

The Labour government unwisely ignored Warren Buffett’s comment that airline investors would have been spared much pain if the Wright brothers’ Flyer had been shot down when it took to the air at Kitty Hawk.

As for Tranz Rail, Victoria University research found that the financial performance of the business improved significantly under private ownership but not enough  to cover its cost of capital.

Again, however, there was no need for the government to buy back the business from Toll (at a hugely inflated price).  Rail is a difficult business in New Zealand and taxpayers are now exposed to the risk of ongoing losses.  As finance minister Bill English put it, this is “the price of nostalgia.”

A large number of other myths about privatisation persist in New Zealand.  For an elaboration and a rebuttal, see this report for the Business Roundtable by Phil Barry.

Governments have important roles to play in the economy.  We need them to focus on these roles and to perform them well.  We don’t need central and local government politicians to be distracted from them by trying to run commercial business.

Bouquets and Brickbats for Treasury

Treasury Secretary John Whitehead has given two informative speeches this month (here and here).

A pleasing emphasis in them is the urgent need to switch resources from the non-traded goods sector of the economy to internationally competing industries.  With its high levels of foreign debt arising from successive current account deficits, New Zealand is exposed to external economic shocks.

Finance minister Bill English has been emphasising the need for economic rebalancing in the light of the trends illustrated in this familiar graph used by John Whitehead.

Click to enlarge

This emphasis was not a feature of earlier Treasury advice, for example its briefing to the incoming government in 2008.  Like former finance minister Michael Cullen, it primarily associated the current account deficits with allegedly low national savings rather than a combination of factors relating to competitiveness and the extent of overseas ownership in New Zealand. .

So a bouquet for this new emphasis.

But the breakthrough is only a partial one.  This chart used in John Whitehead’s 18 November speech, which purports to show what “we have been consuming” relative to the “income that we have been generating”, is misleading.

In the conventional ‘Econ 101’ chart, point B shows domestic spending on capital and consumption goods and services.  When such spending exceeds the local supply of these goods and services, the deficiency must be met from an excess of imports of goods and services over exports of goods and services.

It follows that it is wrong to describe point B as a point at which ‘we have been consuming’.  Instead it is a point at which residents and non-residents (such as foreign-owned firms in New Zealand) have been spending in New Zealand.  

To describe point B as being a point of consumption and to position it above the point of production or income (point A) invites the unwitting reader to infer that New Zealanders have typically been dissaving.  This is not the case.  National savings have been positive annually, with very few exceptions.

But as it happens, contrary to the representation in the diagram, point B has not been above point A on average for at least the last 20 years.   A glance at this graph shows that on average over the period the value of exports of goods and services has marginally exceeded the value of imports.  This implies that on average in this period point B on the chart has been below point A, not above it. 

Or to put it another way, gross national spending has on average been less than gross domestic product.

Instead the largish deficits in the current account of the balance of payments in the last 20 years have been primarily associated with a highish proportion of New Zealand GDP that belongs to foreigners (through direct and indirect investment).  This gives rise to the gap between GDP (the income generated from production in New Zealand) and GNI (the gross national income accruing to New Zealanders.

This second chart indicates that this gap between GDP and GNI opened up markedly in the early-mid 1980s when the cumulative effects of heavy overseas borrowing following the 1973-74 oil shock, the 1984 currency devaluation and the realisation of heavy taxpayer losses on guarantees for major projects all came to a head.

Of course these two charts do not constitute a thorough analysis but they raise questions about the quality of the Treasury’s assessment of the issue.

Other aspects of the Treasury’s analysis of savings and current account issues were criticised in this  Business Roundtable submission to the Savings Working Group.

Misdiagnoses of economic issues matter because they can lead to bad policy, such as the savings interventions of the last government.

Friday graph: why Ireland is broke

This is a graph courtesy of the Institute of Public Affairs in Melbourne, an impressive Australian thinktank.

It comes from the Irish government’s own 140 page ‘National Recovery Plan‘ published last week.

It is amazing reading.

• From 2000 to 2009 average public sector salaries increased 59%
• In 2004, 34% of income earners were exempt from tax. In 2010, 45% were exempt
• In 2007 property taxes generated 6.7 billion euros.  In 2010 that figure will be 1.6 billion
• In 2009 interest on government debt was 8% of tax revenues.  In 2014 it will be 20%.

Naysayers try to tell you that the Celtic Tiger was a myth and that free-market policies brought the Irish economy down.

The truth is exactly the opposite.  Liberalisation caused the Irish economy to surge until a return to big government crushed it.  Membership of the eurozone, poor banking regulation and the government guarantee of bank depositors and creditors were also major factors.

I wrote this article on Ireland recently (Otago Daily Times, 5 November 2010).

Watch British MEP Dan Hannan talking about it in the European Parliament below: