Why no one believed economists over Brexit

One of the reasons that Leave won the referendum on the EU was that no one believed the dire warnings promulgated by economists. We were told by HM Treasury, the IMF and just about everyone else who’d ever wielded a slide rule that Brexit would be a disaster. But when it comes to economic forecasting, we are right to be cynical. It wasn’t just the Queen who asked of the financial crisis, why did no one see it coming?

Human beings are quite good at microeconomics. That’s the economics asking how individual people and businesses behave. It studies why coffee shops price their beverages in the way they do. It considers the best way to get people to pay money into a trust box. It makes useful predictions about the various methods to incentivise employees. Microeconomics isn’t perfect; but it is getting better as telling us about how the world really works. You can find out a lot more in Tim Harford’s superlative book The Undercover Economist.

Conversely, human beings are quite bad at macroeconomics. That’s the economics asking how economies as a whole react to government policies and other long-term factors. It studies why unemployment goes up and down in the way it does. It considers the best ways to increase economic growth. But it fails to make any useful predictions about when there will next be a recession. Macroeconomics isn’t a complete basket case in that it has one or two successes to its name, such as the efficient markets hypothesis. Although some economists even manage to argue about that.

I’m not an economist. But as a historian of science, I have studied the history of a subject -science – that, once upon a time, was like macroeconomics is today. For centuries, scientists couldn’t make serviceable predictions or tell true theories from false ones. There were two very good reasons for this. The first was a lack of experimental data that could be used to test the theories. Experiments are difficult and easily misinterpreted. They need to give clear-cut results and to be repeatable. In any case, few saw the point of doing an experiment to prove something their theory already told them had to be correct. Early scientists lauded observation and could gather plenty of data. But their inability to test it was fatal.

The second reason early scientists failed was that no one was very interested in which theories worked in the real world. They were primarily concerned with how science could justify political and ethical conclusions. Scientific theories simply provided a way to understand nature that supported a particular moral or religious viewpoint. For example, the ancient Greek Epicurus said everything was made up of mindless atoms, which dovetailed nicely with his ethics. Christians rejected atomism because it invalidated transubstantiation.

Modern science now has enough experimental data to choose between theories and make accurate predictions. Microeconomics is like that too. Of course, it is by no means perfect. Microeconomists draw lots of false positives, make various mistakes and torture their data. But, at heart, they all agree what they are about and how the method is supposed to work. Microeconomists and scientists are successful for quite similar reasons.

Not so for macroeconomists. As a profession, they failed the call the financial crisis and, if they turn out to be right about Brexit, it will be down to luck. Admittedly, a few economists did predict the great recession, but probably fewer than you’d expect if all economic predictions were made randomly.

Macroeconomists are also divided into schools and they argue about policy according to the lights of the school to which they belong. Remember what I said about early scientists using their theories about nature to back up their political or religious agendas? Macroeconomists appear to be engaged in the same thing. Here is Andrew Lilico of Europe Economics defending the Conservative Party policy of austerity against a Keynesian. Meanwhile, this lengthy screed by Oxford’s Simon Wren-Lewis is a political polemic on behalf of the Labour Party dressed up as Keynesian analysis. I expect Ha-Joon Chang at Cambridge would call down a plague on both chez Lilico and Wren-Lewis. The mere fact that macroeconomists can’t agree on the most basic issues is damning evidence of how much trouble their discipline is in. Whatever is happening in the world, the Keynesian, the Marxist, the Austrian, the non-orthodox and the neo-Keynesian economist think can explain it in the light of their own theories.

The near-perfect correlation between the views of members of different economic schools and their political inclinations suggests very strongly that the data does not determine to which school they belong. Academic economists are often Keynesians who believe in government intervention while private sector economists are more likely to be laissez faire. This contrasts with, say, engineering where the laws of physics are understood in a very similar way at universities and aerospace manufacturers. Neither can economists say what will happen next. When they do get something right, it is simply luck. None of their theories work at the most basic level of being able to make practical and testable predictions.

This diversity of views is not entirely the fault of the macroeconomists. They can’t do many experiments because the systems that they study are too big. A central bank won’t cut interest rates for half the economy and leave them the same for the other half just to compare the effect of different policies. That means macroeconomists have to rely on observation rather than controlled experiments to build their theories. That was exactly the methodology employed by Aristotle to construct his scientific system. The result was a system of physics that seemed so rational and convincing that it lasted almost two thousand years. But it was wrong in almost every respect. Freudian psychoanalysts and Hippocratic physicians were in the same boat. They had elegant and reasonable systems of thought with which they could explain pretty much any observation. The pathologies of their patients could always be interpreted within the bounds of their theories. And yet the their theories were completely untrue.

It may seem rather crude to compare macroeconomics to such discredited systems of scientific thought. But the problem is not confined to economics. Any subject dominated by a lack of solid data and beholden to theory will face the same issue. Within modern science, string theory is well up this particular creek. Arguably, climate science is as well. The failure of computer models to predict the climate has increased the importance of theory and hardened the political allegiance of those engaged in debates on global warming.

What is the answer? For macroeconomics, there probably isn’t one. The economy is too complicated to predict, even if we understood exactly how it works, which we don’t. So it is best to understand economic debates as proxies for political arguments. The good thing about that is we can all get involved. Macroeconomics boils down to informed opinion and when it comes to opinions, we all have one.

The Panama Papers aftermath: it’s time to abolish the withholding tax.

Originally published on Conservative Home.

When the Panama Papers were splashed back in April 2016 with breathless excitement by the Guardian and the BBC, it looked as though we might get to enjoy some juicy scandals. But now, after a few months of gestation, the leaked documents are, from a UK point of view, a damp squib. Admittedly, the name of David Cameron’s father was unfairly dragged through the mud. However, it eventually dawned on people that neither he, nor his son, had done anything remotely untoward. Other than the Cameron non-story, the 11.5 million files in the Panama Papers don’t appear to tell us much about the tax affairs of UK residents.

In any case, when it comes to tax evasion, the Government has been on the case for some time. From June, all UK companies have to publicly register their owners, while an international treaty to share information on offshore bank accounts has been agreed by over 130 countries. A string of new offences is included in this year’s Finance Bill against enabling and engaging in offshore evasion. All this was in train well before the Panama Papers hit the newsstands. Admittedly, no one will be convicted for any of these new crimes. They are intended to ensure that financial institutions stop turning a blind eye to possible cases of tax evasion. The banks themselves will enforce the new rules through enhanced compliance procedures.

With all this activity, it is worth asking how serious the problem of evasion is. Wealthy British people do indeed have billions stashed offshore, and not all of them come clean with the taxman. But, perhaps surprisingly, the vast majority of them do. For example, when HM Revenue and Customs (HMRC) obtained account details from the notorious Geneva branch of HSBC in 2011, they found information on about 7,000 British-held accounts holding in the region of £13 billion. Yet, it turned out that over 80 per cent of these didn’t owe a penny extra in UK tax.

From those that did, HMRC recovered £135 million of back taxes, interest and penalties. A significant haul, to be sure, but only enough to pay our dues to the European Union for a few days. In only one case did HMRC and the Crown Prosecution Service adjudge that the evidence of criminality was sufficiently strong for a prosecution. No doubt, the Panama Papers will reveal some more tax evaders, although the scale of wrongdoing is likely to be more modest than the trillion pounds suggested by Labour MP Dan Jarvis in the New Statesman. Nonetheless, we must be close to the point at which the myriad of new regulations and offences introduced by the former Chancellor, George Osborne, end up costing innocent taxpayers more than the Exchequer recovers from the miscreants.

Turning to legal tax avoidance and planning, the Government is implementing a series of international agreements to restrict the tax deductions that companies can enjoy for cross-border financing and has introduced a general anti-abuse rule. Perhaps more importantly, the courts have stopped finding that tax avoidance schemes work, even when the scheme follows the letter of the law.

In this new era of transparency, the Government should now start to dismantle the tax barriers that distort international commerce. Just as Nigel Lawson removed exchange controls, Philip Hammond should abolish the nineteenth-century throwback called withholding tax. This is a tax that countries levy on money paid abroad. For example, the UK charges a tax of 20 per cent on payments of interest to many non-resident recipients even though the recipients will also pay tax on the money in their own country. That’s double taxation and completely unfair.

Unfortunately, sorting this double taxation out gives rise to all sorts of administrative problems. So, if you want to set up a fund that caters for international clients, you can’t do it in the UK because of the withholding tax. That’s why Ian Cameron set up his trust abroad and why so many European funds, holding €3.5 trillion in 2015, are actually situated in Luxembourg, which doesn’t withhold tax. The vast majority of money held in countries like Switzerland, Luxembourg and elsewhere is kept there specifically so that it is taxed once, but no more often than that. Abolishing withholding tax would see some of that money returning in the UK. And much of the business of law firms like the Panama Paper’s Mossack Fonseca would dry up.

Luddites and the internet

When I was young, Yellow Pages was ubiquitous. Businesses paid a modest fee to appear in the directory (or a less modest one if they wanted a bigger notice). The big yellow books of listings were delivered free to almost every household. The company brought together Balham’s plumbers with its inhabitants’ leaking taps; and summoned minicab drivers wheresoever they were needed at 2am on a Sunday morning. So Yellow Pages made a healthy profit by providing a valuable service. They also produced some outstanding television advertisements. No more. The internet has seen to that. Hibu, as the company is now called, is now effectively owned by its lenders and doesn’t publish directories anymore.

Has the internet destroyed the value in this once profitable company? It has certainly destroyed many viable businesses.  And not just Yellow Pages. It has done the same to bookshops and it is beginning to eat into other retailers as well. So where has the value gone? The answer is that it has moved to you and me. We find it more convenient to do things online. It frees up time and saves us money. But our extra free time isn’t immediately monetised and we might not spend the cash we save. Eventually, we’ll reassign our time and resources to more profitable activities, but that isn’t much comfort if you publish a telephone directory.

It was the same in the late eighteenth century. New machinery like the spinning Jenny and the mule meant that fewer workers were needed to produce the same amount of cotton fabric. People saw the machines as a threat to their livelihoods. And they were right. A few went so far as to try to hold back progress by force. My old friend Jenny Jones, a Green Party member of the House of Lords, described the luddites as fiery and reasonable. You can see her point, even if the Luddites turned out to be on the wrong side of history (although when household appliances made domestic service obsolete, no one seemed so worried).

Productivity is a good word. Businesses and governments strive for it. But basically, it means fewer people doing the same amount of work. An increase in productivity removes money from the pockets of workers and deposits it in the pockets of consumers (as well as companies’ coffers). The service sector used to be immune to this effect (which is why the number of jobs in the manufacturing sector always seems to be shrinking relative to the services sector). No one ever managed to automate salespeople or waiters. But the internet has begun to increase productivity (or destroy jobs, depending on your point of view) in the service sector as well. For instance, I’ve stopped using my firm’s helpline when I have an IT problem. Just logging into a chat room is so much easier while the worker at the other end can manage multiple queries at the same time.

But of course, this is only part of the story. Markets reassign resources, including workers, to where they are needed. We can enjoy our extra free time or work even harder if we want to. We can write blogs, play computer games and read to our children. The hole in GDP left by the loss of telephone directories is filled by App designers and delivery drivers. Companies invent things like iPads that we never knew we wanted or needed. Making things more efficient is ultimately good for all of us. Doing away with Yellow Pages increases the demand for other things. But we should not forget that, even though capitalism’s destruction is creative, the destruction is still real.

The cause of recessions

There’s been a lot of talk about whether or not Brexit will cause a recession. Most commentators seem to imagine that recessions can be avoided if we do the right think. The former British Prime Minister Gordon Brown even turned this delusion into a political slogan: “No more boom and bust”. Of course, particular recessions have particular proximate causes. The subprime crisis was the catalyst that kicked off the great recession of 2008 that we still have not quite got behind us. But that was not why it happened. After all, the sovereign defaults and the LTCM collapse in 1998 didn’t cause a recession. Nor did the dotcom crash of the early noughties. So you need to look a bit deeper to understand why recessions happen and why they cannot be avoided.

Here’s one theory (which I very much doubt has the merit of originality). I call it the theory of crud. Actually, I don’t. But the word I use instead of ‘crud’ isn’t appropriate for a family blog.

When economies are growing, we can get away with quite a lot. If you have an underperforming employee, then firing him or her is probably more trouble than it is worth if your business is still making lots of money. Innovation is risky and there is little point in it if you can make money doing what you’ve always done. This is human nature.

Economic growth will also resist measures that might be expected to stifle it. Government regulation and taxation, as well as high debt levels, are cases in point. A growing economy allows us to feel we can take on more debt than is prudent. It encourages governments to increase public spending so as to look after their clients and stay in power. So they raise taxes, removing money from productive uses in the private sector to unproductive ones in the public sector. Governments also get themselves into debt more than they can afford. Growing economies let them (and us) get away with mortgaging the future.

Over-regulation is even worse. It is essentially a form of taxation whereby money is moved from productive sources into the hands of compliance officers and inspectors who are often, but not always, in the public sector. But regulation is also less obvious that straightforward taxation and can be disguised as a good thing when it purports to improve health and safety, or the environment, or whatever. This makes getting rid of red tape an enormous challenge. When an economy is growing, no one can be bothered. Protectionist policies have similar advantages. Free trade is a hard sell.

And it gets worse. A growing economy lets people make colossal and stupid mistakes without being punished. Utterly insane ideas, like joining Europe’s disparate economies into a single currency, can appear to be working when the damage they do is hidden under economic growth.

Crud is what I call all this taxation, petty rules, overhanging credit and stupidity. It jams the works of the economy like sand in a machine, wearing down the gears and gradually making the whole mechanism less efficient. But when the wheels are turning, they can overcome this resistance. The crud continues to build up, week by week, but while the machine turns, it is worth nobody’s while to do the hard work of clearing it out. Things are obviously much less efficient than they should be, but they still work enough for people to pretend everything is fine.

But eventually, the crud has built up to such a level that it causes serious damage. Important works clog up. Gearwheels crack under the strain of turning through the rubbish around them. The machine judders to a halt. A recession begins. Exactly where and when this happens is essentially random. But a time comes when an economy is simply not functioning well enough to overcome a shock. Only then does the clear-up begin.

That’s what makes recessions so painful. All those decisions that were put off when times were good can no longer be avoided. The shirking employees have to go; the debt must be repaid. Idiocies like the Euro show their true colours. The engine of the economy has to be steam-cleaned at vast expense and discomfort. By the way, the recession we have just had was so deep and prolonged not because of wicked bankers. It was just that long boom from 1990 to 2008 gave us so many opportunities to accumulate crud. Getting things going again with so much junk in the system is extra-hard.

And there is an added danger. A recession can lead people to demand even more regulation and red tape in the ignorant belief that this prevents rather than causes economic reverses. Keynesians cry that we have to shovel even more crud into the system to restart it. Roosevelt’s famous New Deal is now known to have made the depression of the 1930s even worse than it needed to be. And here’s why: the New Deal just showered crud over everyone. Sadly, the only way to get the economy moving again is paying down the debt, tearing up the regulations, slimming down the workforce and keeping markets open for business.

So, in summary, we get recessions because capitalism works. Capitalism generates economic growth. When things are good, human beings have a natural tendency to avert their eyes from future problems. But eventually we just have to roll up our sleeves up and carry out the necessary spring cleaning.

Will Brexit cause a recession? It might turn out to be a catalyst but it won’t be the cause.

Brexit: What on Earth Happened?

People around the world may have heard some surprising tidings from the United Kingdom over the last few weeks. As some international news reporting has painted events here as either a revolt by xenophobic peasants or just complete chaos, I thought it was worth setting down what has really happened and the reasons behind it.

First, some history: back in 1975, the British overwhelmingly endorsed their membership of the European Economic Community or EEC, the predecessor organisation of the European Union (EU). On balance, the British decided that membership of a huge market on their doorstep was worth sacrificing some of their self-rule for. Besides, back in the 1970s, the UK was in a bad way, with widespread labour disputes, high inflation and shaky Government finances.

In 1992, the EEC was turned into the EU by the Maastricht Treaty, which was intended to be the first step towards a federal United States of Europe. The British Prime Minister at the time, John Major, declined to obtain a democratic mandate for this. The previous Prime Minister, Margaret Thatcher, had been deposed a couple of years before when she had effectively threatened to veto the plans for a federal Europe. In the same year, on 16 September 1992, ‘black Wednesday’, the German central bank provoked the markets to devalue the British pound against the will of the British Government, causing it to fall out of the exchange rate mechanism. The combination of Maastricht and black Wednesday turned the majority of the Conservative Party against the EU. These events also destroyed the credibility of Mr Major and his Government, which lost the 1997 election by a landslide.

From 1997 to 2010, Tony Blair’s Labour Party was in government and was determined that the UK would play a full part in the EU. In 2005, in an effort to increase the democratic legitimacy of the EU, a series of countries held referendums on its new constitutional treaty, which was a further step towards a federal Europe. However, when the EU lost the votes in France and the Netherlands, the results were ignored and the constitutional treaty was pushed through anyway with a different name. Both Mr Blair and the new Conservative leader, David Cameron, also promised a referendum on the constitutional treaty but both reneged when it became politically inconvenient to give the people a say. The grand plan to provide the EU with democratic legitimacy ended up destroying its credibility because the people declined to give the answer they were required to.

In 2013, now in government, Mr Cameron again promised a referendum. He said he would renegotiate the UK’s relationship with the EU before the referendum and then ask the people if they wanted to Leave or Remain, based on the new terms. He hinted that, if the negotiation didn’t go his way, he might campaign to Leave. But when his negotiations duly failed to achieve anything of substance in February 2016, he announced he would, after all, campaign to Remain. His credibility as honest broker was instantly destroyed and British voters stopped listening to a word he said. They also got sick of every international bigwig, from President Obama downwards, telling the UK was doomed if it voted to Leave.

On 23 June, we voted 17 million to 15 million to Leave the EU. Everything about the vote was a surprise. No one thought Leave would win. Even after the polls closed, the betting markets implied a 90% chance of a Remain vote. Turnout was 73%, the highest in a national vote for 25 years. In short, more of the British voted to Leave the EU than have ever voted for anything else in our history.

So what happened and what happens next? The Leave vote was a coalition of three disparate groups. The campaign was led by a relatively small group of internationalist libertarians, including Boris Johnson, Michael Gove and Daniel Hannan. They saw the EU as an anti-democratic and corporatist racket that was immune to reform, as the failure of Mr Cameron’s renegotiation had shown. The shock troops for Leave were supporters of Nigel Farage and the UK Independence Party: mainly paleo-conservatives who objected to uncontrolled immigration (the UK must accept unlimited numbers of immigrants from the EU).

The third element of the coalition for Leave was one whose participation nobody could predict in advance. This final group consisted of working class people who nominally supported the Labour Party, but in practice rarely voted at all. Sick and tired of being ignored, and not seeing the benefits of globalisation, they came out to vote on 23 June and delivered the verdict of Brexit.

Now the UK embarks on an exciting journey. We want to continue to trade freely with the EU, but also sign free trade deals with the rest of the world as fast as we can. We’ll still welcome many new immigrants to the UK, but they won’t all have an automatic right to reside here. And the democratic control of farm subsidies, fisheries and taxation (the UK currently can’t even abolish the tax on sanitary towels) will return to Westminster. Of course, plenty of people have valid concerns about the effects of Brexit. And it is to be expected that many individuals will have invested in the status quo of EU membership, especially if the status quo has lasted for over 40 years. That does not make it a good thing. Indeed, institutional inertia and the fear of short-term consequences over long-term benefits are among the most damaging of political motivations.

As for the rest of the EU, it needs to reform quickly to gain democratic legitimacy while also, somehow, undoing the immense damage done by the single currency. Is that possible? Either way, we British wish the EU well. With Brexit, we cease to be a truculent tenant and become a friendly neighbour.