Brexit and the Unforecastability of Demand-Side Recessions

Simon Wren-Lewis claims the Brexit slowdown is about to begin because its negative effect on the economy is no longer masked by unusually strong consumption. Hence, GDP is going to take a hit.

The thing is: all the effects the Brexit vote could conceivably have in the short-run pertain to aggregate demand (AD). Since AD is controlled by the BoE, there is no reason to assume that Brexit will have any short-run consequences on GDP – as I already pointed out immediately after the Brexit vote.

One may argue that at the Zero Lower Bound (ZLB) and under strict inflation targeting, the central bank might lose this control. But since monetary policy in the UK is not even at the ZLB, this theoretical possibility does not apply in the case of post-Brexit Britain.

In general, if the central bank is doing its job properly, any slow-down or reduction of GDP caused by demand-shocks is impossible to predict ahead of time.

Why has this basic fact been ignored by so many economists in the case of Brexit?

Well, most of the economists who have been predicting a negative effect of Brexit on GDP in the short-run believe that Brexit will have a negative effect on the long-run supply side of the British economy. Whether the long-run effect of Brexit will be negative or positive is debatable but taking a pessimistic view is certainly not inherently flawed.

Since economists are human and few humans are immune to the passions involved in political arguments, I guess that, being of the conviction that the long-run effects of Brexit will be negative, these economists have been tempted to loosen their intellectual standards and to sex up their arguments by making gloomy predictions about the short-run as well.

That so many economists have been making these predictions may make them seem respectable. It doesn’t make them well-reasoned or correct.

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The Inexact Science of Economics – and Brexit

Some argue that economics is not a science because it is not able to prove  theories ‘beyond doubt’ the same way as the hard sciences can. Or put another way: most economic theories cannot be disproved in the same way that Popper thought scientific theories could be disproved.

Simon Wren-Lewis objects, defining economics as an inexact science, but science nevertheless. He concedes that in economics no single experiment or regression can kill a theory but points out that economists “[…] have accumulations of evidence that confirm the applicability of some theories and reject the applicability of others. Economists’ views about what models are applicable change as this evidence accumulates.”

I find the term inexact science very fitting and basically agree with Wren-Lewis’ remarks on the topic. But then he ruins it in the last paragraph of the post:

This is why economists views about the (negative – ed) long term impact of Brexit should be treated as knowledge rather than just an opinion. Here knowledge is shorthand for the accumulation of evidence consistent with plausible theory. Sometimes the theories are common sense, like making trade more difficult will reduce trade. Estimates of the size of trade reduction based on evidence are uncertain, but they are better than estimates based on wishful thinking. Empirical gravity equations consistently show that geography still matters a lot in determining how much is traded. Finally there is clear evidence that trade is positively associated with productivity growth. To say that all this has no more worth than some politicians opinion is ultimately to degrade evidence and the science which interprets it.

Not so fast. Economists indeed know that making trade with EU countries more difficult, which Brexit undoubtedly will, will have a negative effect on British incomes. However, the EU is not only a free trade area but also (and arguably more importantly) a political union, producing a large amount of legislation each year.

For example, banking regulation is basically completely defined at the EU level, with national discretion restricted to a couple of unimportant parameters and risk-weights.

That is, Brexit will also have an effect on the laws and regulations under which the UK economy is going to operate. Will this legislative effect of Brexit be positive or negative for British incomes? As I said before, nobody can know for sure.

However, EU legislation certainly has room for improvement (to put it politely) and, in general, smaller political entities tend to be governed better than larger ones. Hence, the legislative effect on British incomes may well be positive. Furthermore, the legislative effect of Brexit might not only be positive but also strong enough to more than offset the negative effect of making trade with EU countries more difficult.

In short, the net effect of Brexit on British incomes may well be positive.

The undue certainty with which many economists have made their predictions on the economic consequences of Brexit is based on ignoring its legislative effect. This effect is, of course, more difficult to measure and to predict than the effect of restrictions to free trade with EU countries. That doesn’t mean it’s not important.

Why the Eurozone will break apart

The basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

If, for example, the monetary union’s central bank has an inflation target of 2%, this means that the price level in each of the member states is to increase by 2% each year.

This fundamental basis for the functioning of a monetary union has been utterly disregarded in the case of the European Monetary Union (EMU), resulting in a huge gap in competitiveness between Germany on the one hand and Southern European countries on the other.

The following chart shows the development of the prices of new, domestically produced, final goods and services in the largest economy (Germany) and the third-largest economy (Italy) of the Eurozone as well as the development of Unit Labour Costs (ULC) in these two countries.

Eurozone2

Unit Labour Cost growth, which is roughly equal to the growth in nominal wages minus the growth in labour productivity, closely corresponds with the development of the price level over time: if nominal wages grow by more than labour productivity, prices will rise. Assume, for example, that nominal wages increase by 5% and labour productivity increases by 3%. Then Unit Labour Costs have increased by (about) 2% and will eventually translate into (roughly) 2% inflation.

As the chart demonstrates, the development of Unit Labour Costs (and therefore of the prices of goods and services) within the Eurozone has been dramatically divergent. Furthermore, the European strategy of “internal devaluation”, which means expecting Italy to cut wages and thereby restore competitiveness has failed to achieve a significant reduction in the competitiveness gap vis-a-vis Germany.

The meagre results of Italian internal devaluation have been associated with tremendous economic and social costs. What would have been needed was German boom-and-inflation helping internal devaluation in Italy. Alas, Germany, which has never been big on basic macroeconomics, has been ruled by a curious obsession with fiscal probity, so the much needed German boom-cum-inflation has not happened.

Closing the competitiveness gap vis-a-vis Germany inside the Eurozone may well be too painful to be politically feasible. Already, all of Italy’s opposition parties favour exiting the euro. As is common in democracies, they will eventually come to power.

But even if the Eurozone managed to emerge from the ongoing crisis intact, the next euro crisis would not be far away because the EMU has no mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states. Instead of a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole, there is a nonsensical deficit limit of 3%.

That is, the EMU would be as unprepared for the next asymmetric shock as it has been for the last. And given how painful and costly the not-yet-completed realignment of the regional price levels within the EMU has turned out to be, I cannot imagine Europeans would be willing to go through that all over again.

Competitive Governance, Seasteading and Free Private Cities For Dummies

If you are interested in economics and/or political thought, you may have come across the following three terms:

  • Competitive Governance
  • Seasteading
  • Free Private Cities

The purpose of this post is to explain in a clear and concise manner the economic and political thought behind each of these terms. Of particular importance is to understand how these terms, respectively, the ideas behind them relate to each other.

The Market for Governance

In contrast to other markets, the market for governance has been producing meagre results. Products (the bundle of rules and public goods provided by governments) are low-quality, prices (taxes) are high and the customers (the citizens) are generally unsatisfied.

The reason for this is lack of competition. In a competitive market producers of bad products are weeded out by natural selection. In the governance industry, producers (governments) are not subject to this selection mechanism. Instead, the market for governance is dominated by a series of large geographic monopolies.

There are two reasons for the lack of competition in the governance industry:

On the supply-side there are high barriers of entry. Imagine you have a new idea that would revolutionise the governance industry. In any other industry you would have to convince some investors to give you the necessary capital. Then you could start producing and selling to customers. As things stand today, market entry into the governance industry would be significantly more difficult. You would have to win either an election or a revolution.

On the demand-side there are high barriers of switching. Switching your internet provider means something like having to send an email to customer service. Switching governance providers means either emigration or the election of a new government within your current jurisdiction.

Obtaining permission to immigrate into a country can take years. On top of that, since today’s governments often cover a whole language area, emigration may well entail having to learn a new language. The problem with elections, on the other hand, is that neither you nor anybody else has an incentive to put any effort in making a good choice – as illustrated by David D. Friedman in The Machinery of Freedom:

Imagine buying cars the way we buy governments. Ten thousand people would get together and agree to vote, each for the car he preferred. Whichever car won, each of the ten thousand would have to buy it. It would not pay any of us to make any serious effort to find out which car was best; whatever I decide, my car is being picked for me by other members of the group. Under such institutions, the quality of cars would quickly decline.

If high barriers of entry for producers and high barriers of switching for consumers are causes for the dysfunctionality observed in the market for governance, then it becomes clear that there cannot exist a solution that does not tackle at least one of these causes.

Competitive Governance

The idea underlying Competitive Governance is to minimise the cost of switching governance providers by switching between geographic jurisdictions.

This is to be achieved by geographically decentralizing political power, i.e. increasing the number (decreasing the size) of units of governance among which people could move. Low barriers of exit would mean higher competitive pressure for governments and therefore better governance.

Seasteading

While the focus of Competitive Governance is on the demand-side of the market for governance (the high barriers of switching faced by consumers), the focus of Seasteading is on the high barriers of entry, i.e. on the supply-side of the market for governance.

In contrast to the earth’s land, the ocean is largely unclaimed by states. Seasteaders want to develop the technology to create permanent, autonomous communities on the ocean, arguing that the creation of ocean platforms constitutes a much lower barrier to entry for forming a new government than winning an election or a revolution – or a war. And with technology advancing, the barriers of entry to the market of governance will decline year by year.

By opening up the vast space of the ocean for experimentation with new institutions, an evolutionary process will be started that will led to new and better products in the market for governance.

Proponents of Competitive Governance have argued for more competition in the governance industry, but traditionally they did not provide an explanation for how to effectuate this change. Seasteading can be considered as a a route for getting from here to there, i.e. as a proposal for implementing Competitive Governance.

Free Private Cities

Competitive Governance and Seasteading refer to the level of the governance industry and are agnostic with respect to the shape and form of the units of governance within the governance industry. Put differently: the question of how governance is to be provided is out of scope.

Titus Gebel’s proposal for the foundation of so-called Free Private Cities, on the other hand, provides one answer to this question. Gebel, a German entrepreneur, argues for private, for-profit companies to act as governance providers in defined territories (Free Private Cities) and he has started such a company: Free Private Cities Ltd.

Citizens/customers in a Free Private City would pay a fee for the governance services provided by the company. Each customer’s rights and duties would be laid down in a written agreement between the customer and the governance provider of the respective Free Private City.

Free Private Cities may be established within the territory of an existing state, whereby the parent state (hoping to reap benefits from a potential hub of growth and prosperity) grants the operator the right to set its own rules within a defined territory. Most likely though, the first Free Private City is going to be established via Seasteading on the ocean.

 

Brexit – the long run vs. the short run

There are forecasts that Brexit will precipitate a British recession or at least a significant slowdown of economic growth in the short run.

As Paul Krugman argues here and here, the assumption that the Brexit will be a major negative shock to aggregate demand does not follow from standard macroeconomic theory. Hence, according to Krugman, there is no good reason to expect a UK recession.

I agree with Paul Krugman. There is no strong reason to believe that Brexit will be a major negative shock to aggregate demand. And even if a negative shock to aggregate demand were to occur (for example, because of self-fulfilling negative expectations, i.e. firms believe there will be a recession so they reduce investment which then leads to reduced aggregate demand), monetary policy (maybe even combined with fiscal policy) could offset this negative effect by keeping nominal spending stable.

Of course, Brexit will have an effect on the British economy, namely on the long-run supply side of the economy. Krugman argues that this effect will be negative:

Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.

This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been.

Ceteris paribus, i.e. given all other trade arrangements between Britain and the rest of the world and given the current regulatory framework  in the UK (which is, to a large extent, determined by the EU), Krugman is of course right.

But why would everything else stay equal?

By leaving the EU, Britain will be free to adopt a unilateral free trade policy. Many Brexiteers favour this approach and one can only hope that they will prevail.

Britain would benefit from dispensing with barriers to trade even if other countries did not do the same. It would of course be desirable if other countries also removed their barriers to trade: in this case the gains from trade would be even higher. But moving to free trade unilaterally is the optimal policy for Britain independent of whether or not trade barriers in other countries continue to exist.

Furthermore, Brexit makes it possible for Britain to embark on a new approach to, say, financial regulation. In the UK, there was virtually no government regulation of banking until 1979. Instead, the behavior of banks was subject to tight private regulation. The private regulatory framework for banking was then substituted by government regulation in the 1980s.

This approach has not been a success. Brexit gives Britain the opportunity to return to the principles that served financial markets so well before the 1980s.

Will Britain use the opportunities presented by Brexit – or will Britain’s approach to trade and regulations be more restrictive and intrusive than before?

I don’t know for sure. Nobody knows for sure.

But on the whole I am slightly optimistic. In general, smaller political entities are governed better than larger ones. And many Brexiteers have a fairly libertarian world-view.

The most important effect of Brexit may not (directly) pertain to Britain anyway but to the rest of Europe and the world. Brexit may constitute the beginning of the end of the EU, which – by imposing a large, bureaucratic, uniform governance structure on a diverse continent – is basically the opposite of competitive governance.

Let us hope that, in hindsight, Brexit indeed turns out to be the beginning of a trend towards local autonomy and governance diversity. It would be the best possible outcome.