Book review: The Ascent of Money

This blog post is my review and notes on “The Ascent of Money: A Financial History of the World” by Niall Ferguson. It’s a thematic run through the key elements of our current global finance system which ends with subprime mortgages and the present day.

Money, tokens representing value, started with the clay tablets of Mesopotamia as “promissory notes” for goods some 4000 years ago. For a very long time the basis of all money was precious metals such as gold and silver, it’s only been in the last 40 years or so that the link to gold has been broken for major currencies. The Spanish were burnt by metal coin when they started extensive mining for silver in South America – devaluing the coin in Europe through excess supply.

Fibonacci helped to introduce Hindu-Arabic numerals to Europe in 1202 through his book, Liber Abaci, which contained commercial calculations including currency and interest rates. Many of the early bankers were Jewish, they were legally restricted from taking part in many sorts of commerce and, through usury laws, the Christians were unable to lend but Jews could (their usury laws restricting lending to other Jews). Banking really took off with the Medici family during the 15th century, originally they dealt in foreign currency but diversified and, critically, became big. Size was important, because large size reduces risk.

Banking innovation then moved north from Italy with three innovations: the Amsterdam Exchange Bank (1609) introduced a standard currency, the Stockholm Banco (1657) started lending and then the Bank of England (1694) started issuing notes which meant there was no need for an account with the bank.

This is followed by the issuing of government bonds, these are essentially the way governments raise debt. Bonds have a face value – and an annual percentage return on their face value but the price at which they are sold in the market may vary. They were initially used by governments to raise money for wars. Rothschild bank made it’s money in this way in the early 19th century. Bonds are seen as very secure investments, but governments do default – most recently the Russia government in 1998.

The final innovation was the limited-liability company, a way by which individuals could band together to undertake longer term projects without risking everything (they only risked the value of their shares). The first of these was the Dutch East India Company founded in 1602 – formed to conduct the spice trade with the Far East (a risky and expensive business). In theory the directors and shareholders hold the company to account but in practice the value of the company shares on the stock market is the real control.

The first great stock market bubble was the Mississippi Company in France and was led by a Scotsman, John Law. Along with with control of the company he also exerted considerable control over the Banque Royale – the French national bank. The result was a system of share sales which spiralled completely out of control with the central bank making almost daily changes in its rules to enable the sale of more shares in the Mississippi company or to support their price. Ultimately the whole system crashed in 1720; Ferguson argues that this led in part to the French Revolution since the whole performance put the French off exciting financial innovations which could have lead to a more stable system.

Ferguson identifies five stages to a speculative bubble:

1. Displacement – something changes which leads to a new economic opportunity.
2. Euphoria – prices start to spiral upwards.
3. Mania – first time buyers rush in and fall prey to swindlers.
4. Distress – insiders realise the game is up and start to leave.
5. Revulsion – everyone else realises the game is up and try too leave too. The bubble bursts.

The depressing thing is that people have been dutifully following these five steps for nearly 300 years!

Next up is insurance, and scientific developments in statistics make an appearance. Ferguson focuses on the Scottish Widows insurance scheme, set up in 1744, to pay pensions to the widows of Scottish clergymen. Although he introduces a wide range of statistical developments including work by Pascal, Bernoulli's (Jacob and Daniel), de Moivre and Bayes it seems to me the key development were the mortality tables compiled by John Graunt in 1662.

The presence of numerate scientists should not be seen as a panacea though, the Black-Scholes equation for pricing options looks like a piece of thermodynamics: Merton and Scholes won a Nobel Prize for it (Black missed out having died) nevertheless over-enthusiastic application of this equation lead to a fairly serious crash.

Ferguson comments that we are currently in a second round of globalisation, prior to the First World War financial markets were already fairly globalised although quite often under circumstances of colonisation. The outbreak of war necessitated a substantial increase in government support and intervention in the markets and after the war difficult economic circumstances made it easy to continue with this.

It’s interesting to note that the idea of the property owning democracy grew out of the New Deal in the US in the 1930’s prior to that time only 40% of householders in the US were homeowners – the figure now approaches 70%. The same has happened in the UK, although somewhat later with fewer than half of people homeowners in 1970 and a level of approximately 70% now. In a sense the subprime mortgage lending that led to the recent recession is the final playing out of this policy. Ferguson is clearly not too enamoured of the property-owning democracy – seeing it as an over-concentration on a single asset class.

I found this a nice background to understanding economics, it shows how various financial innovations were introduced and how they can contribute to a successful economy. It also highlights how the misuse of such innovations can lead to financial disaster, and does so with depressing frequency. The chronology through the book is not very clear, I suspect he expands on particular instances that best illustrate his point rather focusing on first introduction. Although it has extensive notes and indexes, it could do with a glossary.

Deficit reduction through growth

This blog post seeks to answer the question: what economic growth rate does the UK need to sustain in order to reduce the deficit to zero?

This seems like a relevant question at the moment, and I’ve not seen a straightforward calculation of the answer – so I thought I’d give it a go myself. The idea being that even if the end result is not particularly informative the thinking behind getting the end result is useful.

The key parameter of interest here is the gross domestic product (GDP): the amount of goods and services produced in a year in the UK; it’s a measure of how wealthy we are as a nation, how it increases with time is a measure of economic growth. Also important are the deficit (how much the government’s annual spending exceeds its income) and debt (how much the government is borrowing).

Inflation means that the GDP can appear to grow each year with no increase in real economic activity, therefore I decided to use “inflation adjusted” GDP figures. I also preferred to use annual GDP figures rather than quarterly ones.

To model this I took a starting point of a known GDP, debt, deficit and government spend which I then propagated forwards in time: I made the GDP grow by a fixed percentage each year, and assumed that government spending would be flat (I’m using GDP adjusted for inflation so I think this is reasonable). Assuming that the total tax take is a fixed proportion of GDP I can calculate the deficit and hence increasing debt in each year, I add the debt servicing cost to the government spending in each. Since I’m doing everything else in the absence of inflation I’ve used a debt servicing rate of 2% rather than the 5% implied by a £43bn debt interest cost in 2010 – this makes my numbers a bit inconsistent.

I’ve put the calculation in a spreadsheet here.

Given this model my estimate is that the UK would need to sustain GDP growth of 4.8% per year until 2020 in order to reduce the deficit to 0%. This 4.8% GDP growth brings in approximately an additional £30bn in taxes for each year for which the growth is 4.8%. During this time the debt would rise to nearly 80% of GDP and so the cost of servicing the debt will double. These numbers seem plausible and fit with other numbers I’ve heard knocking around.

To get a feel for how GDP has varied in the past, this is the data for inflation adjusted annual GDP growth in the UK since 1950:

The red line shows the “target” 4.8% GDP growth, and the blue bars the actual growth in the economic, adjusted for inflation. The data comes from here. What’s notable is that GDP growth has rarely hit our target and what’s worse, over the last 40 years there have been four recessions (where GDP growth is negative), so the likelihood must be that another recession before or around 2020 is to be expected.

In real-life we are actually using a combination of GDP, government spending cuts and tax increases to bring down the deficit. These calculations indicate 0.5% GDP growth is approximately £7bn per year which is equivalent to a couple of pence on basic rate (see here) or about 1% of government spending (see here).

Doing this calculation is revealing because it highlights why there is an emphasis on cuts in government spending as a means of reducing the deficit. This had been a bit of a mystery to me with the figure of 80:20 cuts to taxes ratio being widely quoted as some sort of optimum, although there is some indication of other countries working with a ratio closer to 50:50. The thing is that when you cut your spending, you are in control. You can set a target for reduction and have a fair degree of confidence you can hit that target and show you have hit that target relatively quickly and easily. On the contrary relying on growth in GDP, or taxes, is a rather more unpredictable exercise: taxes because the amount of tax raised depends on the GDP.

The Office for Budget Responsibility (OBR) published uncertainty bounds for it’s future predictions of GDP in their pre-budget report last year (see p10 and Annex A in this report), their central forecast is for growth of 2.5% but by 2014 (i.e. in only 4 years) they estimated only a 30% chance that it lay between 1.5% and 3.5% actually they only claim a 40% chance of being in that range for this year (2011).

At the risk of being nearly topical, GDP is reported to have shrunk by 0.5% in the last quarter of last year, 2010. This is largely irrelevant to this post, although forecasts for GDP were growth of ~0.5% which supports the idea that GDP is not readily predictable. It’s worth noting that the ONS will revise this figure at monthly intervals until they get all the data in – the current estimate is based on 40% of the data being available.

Given this abysmal ability to predict GDP I suspect that there is little governments can do to influence the growth in GDP. It would be interesting to estimate the influence government policy has relative to prevailing global economic conditions, and what timelags there might be between policy changes and growth.

I think these calculations are illustrative rather than definitive, and what I’d really like is for someone to point to some better calculations!

Which country is the UK like economically?

This blog post attempts to answer the economic question: What country is the United Kingdom like economically?

The question arises from discussions of deficit (how much the government’s annual spending exceeds its income) and debt (how much the government is borrowing). To use a digging analogy: debt is a hole, deficit is how fast you are deepening the hole. We can get a feel for how countries compare in this sense by plotting them as a function of their deficits and debts on a graph. I’ve done this for the countries of the OECD (data here). The horizontal axis tells you  the deficit, whilst the vertical axis is the debt. These values are plotted as a percentage of the gross domestic product (GDP) so we can compare big countries and small countries, rich countries and poor countries on an equal footing.

As we go to the top left area of this graph we find countries which are in the deepest hole, digging fastest. Out of the extreme left we find the UK – it is digging its hole fastest at the moment, but it is not in the biggest hole – that honour currently goes to Japan. On this graph our nearest neighbours are Ireland, the United States and Iceland, with Greece and Japan having higher debt but lower deficit. France and Spain have similar debts but rather lower deficits.

Norway is actually bringing in more money than it spends and building a surplus, they have large oil revenues and are saving against the day when it runs out. Korea is doing this too but to a far smaller extent.

Economically it is often said that the PIGS or PIIGS countries are in most trouble in Europe, these are Portugal, Ireland, (Italy), Greece and Spain.

But is it true to say we are like Ireland, the US and Iceland? Ireland and Greece have much higher levels of unemployment than us, whilst the US has slightly higher levels and Iceland’s levels are comparable. Iceland has very high inflation (12%) whilst most other countries have moderate inflation including the UK, with a few countries having moderate deflation including the US and Ireland. We have moderate levels of unemployment, with Ireland, Greece, the US having much higher levels. It’s also worth pointing out that the UK has a population of 60,000,000 whilst Ireland only has 4,000,000 and Iceland a mere 300,000.

So whilst in deficit/debt terms we may resemble other countries in other, economically relevant ways, we are quite different.

From a mathematical point of view there are methods for measuring the closeness of things based on large numbers of variables, called clustering algorithms. These algorithms amount to our eyeballing of the debt/deficit data – they are a measure of distance. However, in economic problems things aren’t so simple. The economy is described by many variables and I don’t know their relative importance in determining economic similarity. The problem that the numbers involved may vary tremendously in size is trivially solved. My suspicion is that economists have probably spent a great deal of time arguing about economic similarity and haven’t come to a definitive answer.

So in answer to the question: What country is the United Kingdom like economically? Although the UK may be most like Ireland, the US and Iceland in debt/deficit terms. In terms of many other economic factors such as inflation, unemployment and so forth it is quite different. I suspect the real answer to this question is that the UK is most like France, Germany and Italy economically: these countries are of similar size, have similar unemployment rates, have inflation of the same sign, usually run public sector/ private sector ratios of similar size furthermore given their common membership of the EU their economic behaviour is probably similar. Of this group of countries Italy has the largest debt and we have a largest deficit.

Why the other ways don’t work

In my last blog post I calculated how to raise money for various things (getting rid of tuition fees, avoiding any benefit reductions and so forth) using income tax; originally the more ranty bit to be found in this post was included, but it was getting a bit long so I separated analysis and rant.

Since the election there’s been a great deal of discussion of cuts, largely this has been framed in terms of a cut to X being apocalyptic where X is some area supported by its interest group. There has been rather less focus on what should happen in place of such cuts, proposing an alternative area for increased cuts has generally been tried: “waste, foreigners in the form of international development, benefit scroungers, Trident“ are ever popular – each of these contributes about £1bn or so per annum in spending – the gap we’re trying to match is about £80bn per annum. There have been some proposals for increased taxes to be paid by “someone else”, an increase in VAT met with considerable opposition (VAT is the third biggest element of tax – the change would raise about £13bn per annum), as was an attempt to cut child benefit for higher rate tax payers, raising about £2.5billion per annum.

The favoured targets for increased taxes are “the rich” and “tax avoidance”. “The rich” are normally defined as “richer than me and the people I know”, which is a poor definition. Tax avoidance, according to an HMRC report under the last government the size of the tax gap – the sum of avoidance (legal) and tax evasion (illegal) was around £40bn per annum. This is disputed with Tax Research UK giving a figure three times larger at £120bn. It’s difficult to see exactly how they manage such a high estimate – it’s seems to be based around the size of the “shadow economy” – things like illegal working. Regardless of this actually collecting the money involved in the tax gap would appear to be difficult: as announced by Danny Alexander there’s a hope that spending £200million per year will result in a tax recovery of £7bn per year. There’s an implicit assumption in tax avoidance that again it’s “the rich” who are responsible but it seem clear from reading the HMRC document that successfully addressing the tax gap would probably impact quite broadly. For example, buying wine in Calais is a tax avoidance; as is paying the builder, decorator and so forth in cash; as is purchasing items in Hong Kong via ebay. The company I work for has changed the way it pays some of my pension contributions to reduce the tax paid – presumably this would count as a tax avoidance too.

Vodafone is in the news at the moment for a £6bn tax avoidance. The £6bn figure is as calculated by Private Eye and is described by HMRC as “an urban myth”; Vodafone appears to have made provision of £2.2bn to address this issue and ultimately paid £1.25bn. It’s worth pointing out that the £6bn figure, accrued over 10 years is typically compared by protestors with a *yearly* benefit cut of £7bn. This sort of presentation leads me to believe that the proposer is somewhere on the innumerate-dishonest scale and discount whatever else they are saying. Taking the Private Eye “high” estimate this is £600million per year, taking the difference between the amount actually paid and the “low” estimate it amounts to £100million per year. Vodafone appears to have paid around £1bn tax on profit in 2009 amounting to a rate of 25% in that year, so it is not true that they pay “no tax”. It’s also worth noting that Vodafone appear to have the legal upper hand in the situation, given a judgement in the European Court of Justice.

At one time Trident or its replacement were cited as a source of ready cash – again the presented cost of up to £100bn is for the entire lifetime of the system of up to fifty years or so i.e. between £1bn and £2bn a year, regardless of this the decision on Trident has been pushed into the future (i.e. beyond the next election). A more likely figure for the Trident replacement is £20bn, or at most £34bn. I’ve said previously that I consider Trident to be Cold War willy-waving but scrapping it is not a big impact – particularly if there is any sort of replacement.

A useful rule of thumb for all these situations seems to be:

1. Check that tax gain and spending are being compared on the same time period.
2. Divide quoted tax gain by at least three since that will get you back to a more generally accepted figure.

The latest wheeze is chasing George Osborne for a £1.6million tax bill. Referring to our list above, (1) is met admirably this bill would be payable once, on the death of his father. Experience suggests the figure of £1.6million is fanciful. David Mitchell puts this so much better than me here in the Observer. It’s not that I am in favour of tax avoidance I just see efforts to address the problem by individual harassment as pointless. What is needed, as Mitchell points out, are changes in the law so that tax avoidance becomes tax evasion and is then illegal. It’s ridiculous to expect people to pay tax that they don’t legally have to – it’s not what the great majority of the population do – why expect companies and the rich to do any different?

I’ve yet to see any figures on the “cut avoidance through growth scheme”, a priori I’m dubious since the ability of government to influence growth seems marginal and any scheme would need to stretch out beyond the 10 years that even Labour were planning to cut the deficit in by which time using my state-of-the-art recession prediction algorithm we will have experienced another recession, and another addition to the deficit.

I’m uncomfortable with the idea that we should demand services (no tuition fees, protected benefits) but rather than seeking a way to contribute to paying for these services personally try to push the payment for them onto a small fraction of the population. If you demand more money for X but don’t expect to pay any more for it then frankly I don’t think you’re committed to the idea.

Yields from income tax

This post is a tour of income tax and personal national insurance yields, it’s motivated by an interest in seeing how one might pay for a part of the reduction in the deficit through taxation. The reason for focusing particularly on income tax is that it yields a fairly large fraction of the total tax income (28.7% in income tax and 46.6% income tax and national insurance combined), as discussed in a previous post; this means that relatively large amounts of money are raised by relatively small changes when compared to other taxes. Furthermore it’s relatively easy to calculate: I can work out how much income tax I pay in a year but would struggle to tell you how much VAT I pay per year, the impact of a tax on insurance premiums the effect of a change on duty and so forth. Thirdly, it is the tax that is most transparently progressive, in the technical sense that the more you earn the greater the fraction of your income you pay in tax.
This calculation is based on a calculation of personal tax rates from wikipedia, this figure generates the tax rates programmatically and I simply translated the code to my computer language of choice – I thought about doing it in a spreadsheet but that turned out to be a bit brainbending. The second component of the calculation is the number of people in each income bracket: this information along with further information on incomes can also be found on wikipedia. Ultimately the data come from the HMRC. I’ve put these two bits of data together into a program which enables me to fiddle with tax rates, tax thresholds and so forth. It appears to be approximately correct since it matches roughly HMRC’s own figures on the effects of small perturbations to the tax system (pdf). This also tells you it’s possible to look this stuff up – but I find it more fun to calculate it myself! It’s also a good illustration of the general process of how to go about repeating someones calculations from literature sources: try to reproduce their graphs; try to match the summary numbers they produce.
This first figure shows the income and national insurance payable as a fraction of gross (total) pay as a function of pay. The thing I hadn’t appreciated intuitively is that the tax banding system gives quite a smooth increase in percentage tax take, this is because you only pay raised rates on the fraction of your income that lies above the threshold:

Extending the horizontal scale out towards incomes of £1,000,000 and the rate tends to 50%. The next figure shows the distribution of incomes, in the UK:

You can see the same information in text form here. The area under this curve between points on the horizontal axis tells you the number of people in an income band. The median income in the UK is £26k per annum – half the population earn more than this, half less. About 1% of the population earns more than about £100k per annum. This final figure shows the amount that each income band pays according to the latest tax rates.

To summarise this final figure in tax bands, the 20% band accounts for about 57% of tax paid, the 40% band for 26% and the 50% band for 17%. These bands contain respectively 90%, 9% and 1% of the income tax paying population.
In case you’re curious my salary puts me close to the top of the basic rate tax band.
To apply the knowledge embedded in these graphs to some recent problems:
As a rule of thumb: 1p on basic gives about £4bn, 1p on upper rate gives £0.75bn, 1p on the new 50% band gives £0.31bn. The reason for this sharpish dropoff is that relatively few people are effected by the upper rate tax changes so to yield a large tax income the rates have to be changed by a relatively large amount.
Reducing the threshold of the 40% tax band to £40k from £43k yields about £3bn.
The £20billion cut in welfare benefits is equivalent to approximately 5p on the basic rate of income tax, taking it to 24.5% from 20%. This would cost me about £1700 per year.
Tuition fees cost about £7.5billion (based on 1.5 million students each requiring an average £5k tuition fees per year), this is about 2p on basic rate. This would cost me about £800 per year.
The £2.5billion income gained from cutting child benefit from those in the upper tax band could be paid for with an increase in the upper rate to ~43% from 40%. Although it seems the £2.5billion figure is dubious. I can’t help thinking simply increasing the upper rate by this amount, rather than a convoluted attempt at clawback would be simpler. This isn’t to say I support the idea of paying child benefit to all regardless of income, just that implementing withdrawal in this way is technically complicated. This tax rise wouldn’t cost me anything!
I’ve not seen anybody volunteering for these tax increases to support their favoured causes, rather they prefer a range of schemes of dubious value impacting other people to avoid the problem falling upon themselves – a subject for my next post.
Note
This modelling was done using Visual C# running under Windows 7, if you’re interested either in the code or in just the application then let me know in the comments below (or on twitter). There are a couple of minor bits of tidying I’d like to do before release. Please note that the application is “good enough for blogging work” and should not be considered an accurate tool for tax calculations – it’s a toy to help me understand things!

An Englishman's Home is his Castle

Corfe Castle*

Back to rant for the blog post, this time on housing.

A house is like a millstone around your neck, once you're in it the reluctance to do anything that might cause you to move out is massive.

I've been somewhat itinerant since leaving university after my degree, I lived in Durham, in Cambridge and then in Poynton and now in Chester. It goes with the job, I'm sufficiently specialised that I need to travel to find work. For families containing two academics this leads to an even greater "two-body" problem; not every town or village needs a research scientist of my ilk. The downside of this is a degree of rootlessness and a lack of a handy family network. I'm not sure how common this rootlessness is across the population as a whole, it's true for many of the people I know.

It was when I was house hunting in 2000 that I got some hint of the credit crunch, I'd gone off to see the financial advisor upstairs from my estate agent to ask about offset mortgages (having been mildly burnt on payment protection insurance, I was trying to work out the hitch on offset mortgages). We had a bit of a chat; after some reassurance on what I was trying to get he pointed out that I was ultra-cautious and if I wanted he  could get me a x4 joint salary mortgage. I'd done the sums on this, and frankly it was scary but clearly a lot of people were doing this.

People often have a go at estate agents but personally I think it's the other punters that really fuck you up. Estate agents at least have to make some pretence of professionalism whilst the punter is free to do as they see fit and since they're unlikely to have bought and sold more than a couple of houses they can either by malice or ignorance make your life miserable. The bank and the solicitor's ability to find another little fee to slice off you on the way irritated me too. "Searches" caused me particular ire - it's not like they actually went and "searched", they got someone else to do an indexed retrieval, it's not like they went rummaging anywhere for something lost. Searching for documents these days takes bugger all time and effort. It's perhaps for this reason that I thought HIPS were a good idea, because I was pretty unimpressed by the system currently in place.

House price inflation is apparently the only good sort of inflation: no one is pleased if cars, carrots, or computers get more expensive every year but for houses it's different. For those of us on the housing ladder this inflation is no problem, for those not on the ladder it is the sight of the bottom rung being wound up beyond reach. Compared to the 1950's houses are about x4 more expensive in real terms today, they're about twice as expensive in real terms as when we bought our first house, about 12 years ago.

The real point of this post was a mild bit of ranting about care for the elderly and the sale of houses. Houses appear to be sacrosanct, you can be sitting on a house worth half a million pounds but rather than sell that to pay for your care the expectation is that the State should provide. Personally I'm hoping for my parents to piss away the inheritance in their twilight years and leave nothing to me - this includes the house. This attitude to housing and inheritance seems to affect every strata of society:

Owners of country estates apparently expect the public to pick up the cost of maintenance. And in the news this week, council houses - I must admit I didn't realise that council house tenancies were for life and potentially beyond. This strikes me as a nightmare for those responsible for the councils responsible for social housing provision, particularly given the 'right-to-buy' legislation. An obligation to provide housing for all is a good thing, the mechanism that via council houses, housing associations and housing benefit doesn't look like a great way to do it. Actually, housing associations do look like a good idea to me. If you were a company with this obligation you'd want to make bulk arrangements with landlords, and you'd be fantastically nervous about handing over valuable assets for decades. 

The move towards mass ownership of housing is relatively recent - mainly post-war in the UK (see page 12 here), and around Europe home ownership rates are broadly comparable, there are a couple of anomalies. I guess the reason for this is that home ownership fulfils a deep need for security, and literature and recent history reveal plenty of evil landlords.

I suppose the general point I'm making here is that we all want to pass on an inheritance, this is a very natural feeling but the effect of this desire impacts those that are still living and don't benefit from an inheritance. I actually quite like Billy-Gotta-Jobs proposal on taxing all houses as capital gains on death, as a way of cooling house price inflation.

Update: as supergoonybird points out in the comments, BillyGottaJob's proposal is actually for capital gains tax on *all* house sales - not just on death. This is a radical idea - but certainly one that strikes in the right place.

*Corfe castle because it's close to where I was born and lived until I was 18. Image from here.

A brief return to politics - the Budget

Following on from my pre-Budget "Sceptical look at the economy", I thought I'd return to politics and the Budget.

The financial position seems to be largely what was expected before the election and the size of the proposed cuts seems consistent with the scale of cuts in Spain, Greece and Ireland.

What I would have done? I suppose I prevaricated in my last post on what I would have done in the recent Budget. To be a bit more explicit: I would have put probably something like 3p on basic rate tax, lifted the lower threshold of basic rate and brought down the threshold to the higher rate. And looked to cutting something like 15% across government spending with no ring-fencing. I may have put up capital gains tax a bit more at the higher rate and not reduced corporation tax - but to be honest these measures don't bring in much cash anyway. As for benefit cuts, I'd probably have gone for means-testing things such as child benefit, winter fuel allowance and so forth. My impression is this would approximately fill the appropriate gaps (but I haven't done any calculation).

But then nobody voted for me, and the Liberal Democrat experience is if you offer the voting public an increase in income tax they say how great this is, and how they'd really love you to spend the money where you've said you'll spend it, and then vote for someone else who has promised not to raise income tax. Of the national parties the Green Party manifesto was the only one to imply they would not make any cuts, but increase overall taxation to cover the structural deficit; electorally the Green Party didn't do that well in the General Election with about 1.0% of the vote.

As it stands the Budget was somewhat different from my preferred option. There are a few mitigating factors but I'm not convinced that VAT rises are a good way to raise tax (it has been suggested that they are better than income tax rises because they do not fall on essentials and they are "voluntary" to a degree, which income tax rises most definitely are not). It seems rather notable that there was much symbolic "dipping of the hands in the blood" by Nick Clegg, Danny Alexander and Vince Cable, you'd have though the Tories would have been a bit more forthcoming about defending a budget in which they were the majority partner and which largely matched their electoral commitments.

The Labour Party has started pointing out that this is a very political Budget, that's true, and so was their idea of defering cuts into next year. For the Opposition this has the positive political benefit of not needing to be clear about what you would do until well after the General Election (and not even then) and allows you free-reign to criticise cuts by the incoming government without proferring an alternative because obviously you'd be doing this next year when things would have become magically better.

I've come to the conclusion that macroeconomics is almost entirely about politics, and the vehemence with which economic opinions are presented leads me to believe that everyone realises they don't actually know what they're talking about and that by shouting loudly they can get away with it. Presumably MP's and ministers feel they have learnt to run the economy through the odd lecture course on the infamous Politics, Philosophy and Economics undergraduate degree course at Oxford. It seems notable that prior to the election the global consensus appears to have been for "economic stimulus" and after it is for "deficit reduction" (with the exception of the US). I'm not clear how this has happened, because I can't believe it's entirely driven by the UK election.

Inferring what the voting public want from elections and opinion polls is always a tricky business but the evidence seems to be they're happy with the Budget and it's pretty much what they expected. I suspect the reason for this is that the majority of them will be in the private sector and over the past few years the companies they work in would have laid people off, been on pay freezes and, over a longer period, treated employees less generously in pension terms but this largely hasn't happened in the public sector. The same opinion poll shows fairly good support for maintaining the state pension whilst "cutting benefits for those of working age". 

The Office of Budget Responsibility is pretty upfront in saying it's estimates for GDP growth are subject to large uncertainty (see p10 of this report, and also Annex A on how figures are derived - hat-tip to Christopher Cook for that). The biggest problem seems to be that recession are utterly unpredictable. I'd be interested to see similar analysis for unemployment figures - can't help thinking they're not going to be good.

My useful pieces of contextual information for the day: UK employed population is about 30million, of which about 5million are in the public sector.

A sceptical look at the economy

This blog post was written partly because I'd got fed up with hearing about how all cuts were evil, without hearing an alternative plan. It has ended up more a collection of interesting data sources, and some mild ranting.

First to define some terms: The gross domestic product (GDP) is a measure of the total economic output of the country. It's handy because we can use it to compare any other number we come up with to see how big they are. £1billion may sound like a lot, but the GDP is £1.5trillion, so £1billion is a less than 0.1% of GDP.

The debt is the total amount of money that the state owes; the deficit is the annual gap between what the state takes in taxes and what it spends. A debt is sustainable in the long term but running an annual deficit above a certain size, for a period, is not sustainable. The deficit can be divided into two components: a cyclical component which goes up and down with current economic conditions and a structural component which is on top of this. The structural component is the bad bit. There is some dispute over the validity of this division since economic cycles are not easy to define.

As Mr Micawber says in David Copperfield: "Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

I'm a big fan of the Guardian's government spending chart (see the image at the top of page), it's a rather pretty way of seeing where government spending goes. For the year 2008/9 the total spending is £621bn, in this year the Treasury gets an enormous, anomalous amount in financial stabilisation (18%) - this will not recur in future years. Beyond this there's the Department of Health, spending about 18%, Department of Work and Pensions (22%) with the largest fraction of this going on the state pension, Department for Children, Schools and Families (10%). The key point here is that a very large chunk of the money spent is spent on things that people very vocally want (schools, health care, state pensions).

The figures for where tax comes from are perhaps a little surprising, extracting the data from table 1 in this report by the Institute for Fiscal Studies. The major chunks are shown in the piechart below:

The "other" category is made up of various minor indirect taxes (tobacco, alcohol etc) and capital taxes (3%). The surprising thing to me was the relatively low level of corporation tax. There seems to be evidence of tax avoidance by corporations amounting to something in the region of £10bn, but this would only be roughly 1.6% of the tax take.

By the way, as a physicist, I look down on piecharts!

The total tax take of around 36% of GDP puts the UK roughly in the middle of the OECD table of taxes, with countries like New Zealand and Germany taking very similar levels of tax, France, Italy and Finland taking rather more (at around 44%) and countries like Ireland, Switzerland and the United States taking rather less at ~30%. The full OECD data is here, and wikipedia has a sortable list for all the countries of the world. An interesting exercise is to consider this list, and think in which countries you might want to live.

Of income tax the top 1% of earners pay nearly 25% of all income tax, you can see the full breakdown in this article on the BBC website. Put another way, the 40% tax band covering perhaps 15% of tax payers provides nearly 40% of income (here). This does exclude National Insurance contributions though. I was surprised by these figures, I'd assumed that the relatively small number of higher tax rate payers would result in a much lower total take.

The net result of these incomings and outgoings is that we had a national debt of 68.1% of GDP at the end of 2009, and a total deficit of 11.4% of GDP. (According to the Office of National Statistics). According to the newly formed Office of Budget Responsibility  (table 4.5) the national debt (which they call net debt) is 53.5% this year and the deficit (net borrowing) is 11.1% of which 8.8% is structural. 

Numbers without context are meaningless: a priori I have no idea how these numbers for debt and deficit compare to the past. However, help is at hand: this report shows how they have varied over the past 100 or so years. I've copied the key figure for national debt below:

At the end of the second world war the UK had a national debt of around 250% of GDP, much larger than our current debt (and even our predicted debt over the next few years). Interestingly we see in the same report (figure 1) that the deficit is rarely negative (i.e income greater than expenditure), hovering around 2% (i.e. still a deficit) debt is still paid off via growth in the economy and inflation.

I suppose the purpose of all of this preamble is a discussion of cuts, or if you prefer tax increases. Prior to the election everyone seemed to agree on the size of the gap to be filled but none of the parties managed to fill more than 25% of the gap, as evidenced in this report by the Institute of Fiscal Studies, the Guardian's data blog had a nice breakdown of the measures proposed by the three main parties. The major political point of departure was when cuts should start (not if cuts would start), and my view prior to the election was that whoever won broadly similar levels of cuts would be made although there was some evidence that the balance between taxation and cutting would be different depending on party but since none of them revealed (or had) much of their plan it's rather difficult to say.  It is a very minority view that no cuts are required, although I see the unions are trying that one out today along with threats if there are any cuts.

YouGov,  for the Sunday Times, helpfully asked the public:

"The government has asked for public advice on where it should cut public spending. Which, if any, of the following areas do you think should be targeted for cuts? Please tick up to three". 

And the public demonstrated that if you ask a stupid question, you get a stupid answer (or, being generous to the public, if you ask a question without providing contextual information you get a stupid answer). I considered trying to find a fancy way of presenting this information, but in a nutshell: by far the most popular area for cuts (61%) is in international aid whose total budget is 0.8% of total spending (i.e. pretty much the smallest bit of the budget you can find).

To be fair to the public, many of them will be working in the private sector and will have variously experienced pay cuts (or at least freezes), reduced working, redundancies, budget reductions and frozen recruitment and they may well be feeling it's someone else's turn.

You can experiment with cuts yourself with this handy tool from the FT, have a play and think about how you'd stand up and justify the cuts you've made. To paraphrase Polly Toynbee: "Don't be young, old, vulnerable, one of our brave boys, sick etc".

The alternative to cuts are tax increases, but nobody seems keen to talk about them. Prior to the election there was a report stating that the deficit was equivalent to about 6p on the basic rate of income tax. Proposals to raise tax were normally described as a "Tax on jobs" or "Death tax", which is unhelpful to say the least. Another popular idea is to tax the bankers, one option here is the Tobin or Robin Hood Tax which puts a small tax (typically fractions of a percent) on every financial transaction, because there are very many of these transactions potentially the amount raised could be large this would seem to require international coordination and it isn't clear where the money raised would be spent (climate change, international aid, fund for future bank collapses have all been suggested). The banking sector contributes approximately £70bn to GDP, or 6.8%. The structural deficit isn't about any money spent rescuing banks though, it's about an ongoing gap between spending and taxation.

My personal view is that we should be talking about taxation, and where the balance between cuts and increased taxation should lie (currently it looks like 80/20 cuts to taxes). There should be some discussion of where tax rises are best levied : "on someone else" isn't really a proper answer. Income tax seems like the best place to me, probably at basic rate with uplift of the lower threshold to protect some of the least well off, but possibly lowering the threshold to the upper tax bracket. In the longer term making the public sector more flexible to economic hardship would be nice, this time there seems to have been much more flexibility in how companies have approached recession - not necessarily painless, but better than losing your job. One element of this could be variable pay in the public sector (or bonuses as we colloquially call it) this provides two things to an employer: the ability to vary pay when income to the company is poor and some decoupling of current salaries from pension entitlements (since bonuses are typically not counted towards pension payments).

So to end on a happy note: I propose bonuses for the public sector!

* Update: hat-tip to AlexConner who pointed out that it is Mr Micawber not Uriah Heep who is responsible for the quote from David Copperfield. 

Economics: The physics of money?

Today I'm off visiting the economists, this is a bit of a different sort of visit since I haven't found that many to follow on twitter, instead I must rely on their writings.

I've been reading Tim Harford's "The Undercover Economist" which is the main topic of this post, in the past I've also read "Freakonomics" by Levitt and Dubner. Harford's book is more about classical economics whilst "Freakonomics" is more about the application of quantitative methods to the analysis of social data. This is happy territory for a physicist such as myself: there are numbers, there are graphs and there are mathematical models.

David Ricardo pops up a few times, it would seem fair to compare him to the Newton of economics, he lived 1772-1823.

I learnt a whole bunch of things from Tim Harford's book, including what shops are up to: working out how to persuade everyone to pay as much as they are willing to pay, by means such as "Value" and "Finest" ranges whose price differences don't reflect their cost differences, similar pricing regimes are found in fancy coffee. In a way income tax bypasses this, it replaces willingness to pay with ability to pay - I'm sure shops would love to be able to do this! Scarcity power allows a company to change more for its goods or services, and a company's profits are indication that this might be happening.

Another important concept is market "efficiency": perfect efficiency is achieved when no-one can be made better off without someone else losing out, this is not the same as fairness. In theory a properly operating market should be efficient but not necessarily fair. Externalities are the things outside the market to which a monetary value needs to be attached in order for them to be included in the efficiency calculation, this includes things like pollution and congestion in the case of traffic. This sounds rather open-ended since I imagine externality costing can be extremely disputed.

There's an interesting section on inside / asymmetric information, and how this prevents markets from operating properly. The two examples cited are second-hand car sales and health insurance, in the first case the seller knows the quality of the car he his selling whilst the buyer struggles to get this information. Under these circumstances the market struggles to operate efficiently because the buyer doesn't know whether he is buying a 'peach' (a good car) or a 'lemon' (a bad car), this reduces the amount he is willing to pay - the seller struggles to find a mechanism to transmit trusted quality information to the buyer. Work on information asymmetry won a Nobel Prize for Economics for George Akerlof, Michael Spence, and Joseph Stiglitz in 2001.

In the second case, health insurance, the buyer purportedly knows the risk they present whilst the seller doesn't, this doesn't quite ring true to me, it seems the observed behaviour in the US private healthcare system matches this model though. In a private insurance system the people who are well (and are likely to remain well) will not buy insurance, whilst those that believe themselves to be ill, or at serious risk of being ill will be offered expensive insurance because there is not a large population of healthy buyers to support them. Harford recommends the Singapore model for health care, which has compulsory saving for health care costs, price controls and universal insurance for very high payouts. This gives the consumer some interest in making most efficient use of the money they have available for health care.

You might recall the recent auctions of radio spectrum for mobile phone and other applications, this turns out to be a fraught process for the organiser - in the US and New Zealand this process went poorly with the government receiving few bids and less cash then they expected. In the UK the process went very well for the government, essentially through a well designed auction system. The theoretical basis for such auctions is in game theory, with John von Neumann and John Nash important players in the field (both recognised as outstanding mathematicians).

Tim Harford did wind me up a bit in this book, repeatedly referring to the market as "the world of truth", and taxes as "lies". This is a straightforward bit of framing: that's to say the language used means anyone arguing against him is automatically in the "arguing against the truth" camp irrespective of the validity of the arguments. The formulation that taxes represent information loss is rather more interesting and he seems to stick with this more often than not. In this instance I feel the "world of truth" is ever so slightly tongue in cheek, but in the real world free-markets are treated very much as a holy "world of truth" by some political factions with little regard to the downsides: such as a complete ignorance of fairness, the problems of inside information and the correct costing of externalities.

A not inconsiderable number of physicists end up doing something in finance or economics: As Tom Lehrer says in the preamble to "In old Mexico": "He soon became a specialist, specializing in diseases of the rich". It turns out you get paid more if the numbers you're fiddling with represent money, rather than the momentum of an atom. Looking at these descriptions of economic models, I can't help thinking of toy physics models which assume no friction, and are at equilibrium. These things are very useful when building understanding, but for practical applications they are inadequate. Presumably more sophisticated economic models take this things into account. From a more physical point of view, it doesn't seem unreasonable to model economics through concepts such as conservation (of cash) and equilibrium, but physics doesn't have to concern itself with self-awareness - i.e. physical systems can't act wilfully once given knowledge of a model of their behaviour. I guess this is where game theory comes in.

The interesting question is whether I should see economics as a science, like physics, which is used by politicians for their own ends or whether I should see them as being rather more on the inside. Economics as a whole seems to be tied up with political philosophy. Observing economists in the media there seem to be much wider range of what is considered possibly correct than you observe in scientific discussion.