Saturday, 20 December 2014

HMT says it has has no intention of allowing a workable system of real autonomy for Scotland

The IFS's David Phillips has a post at the Future of the UK and Scotland site, which like the post by my colleagues David Bell and David Eiser at Scottish Fiscal & Economic Sudies, describes the Byzantine, labyrinthine, systems needed to implement a system that maintains the Barnett Formula whilst implementing significant devolution of revenue powers.

There is a simpler way to do things: declare some expenditure items as UK responsibilities, with the others as devolved; declare a set of UK taxes to pay for these UK expenditures, and allow the devolved administrations to raise taxes to meet their responsibilities. The UK expenditure responsibilities would include UK debt repayments, any equalisation payments that were agreed, and fiscal transfers in response to business cycle fluctuations and asymmetric shocks.

The first step to implementing such a system (which might have a chance of being stable in the long term) is for the UK Government to recognise that it wears (at least) two hats: as the sole level of government responsible for UK functions; and as the government of England (and also the government of Wales & Northern Ireland for those areas in which Scotland has devolution but they don't). It needs to know what hat it is wearing at any one time, and what policy levers are associated with that hat.

In David Phillips' post he notes: "But what if the UK government wanted to spend more money on defence or state pensions, or wanted to increase taxes to reduce borrowing. ... One interpretation of the Smith proposals would be that the UK government could not use an increase in income tax – one of the main taxes it levies – to fund these policies. This would be absurd and the Treasury has informed us that it was not the intention of the Smith Commission to constrain the UK government in this way."

Contrary to David Phillips, I don't think that a recognition that some taxes are for funding devolved services, whilst others fund UK services, is absurd. On the contrary, it seems like a pre-requisite for a functioning system. Note also that such a recognition would not preclude the use of income tax for the funding of UK services: for example in my submission to the Smith Commission [*], I recommended that the UK Government have as one of its revenue streams the top rate of income tax (because such a tax base is likely highly mobile in response to differences in the rate). But there would have to be two income taxes: one levied by the UK government for UK expenditure, and one levied by devolved government (which in England may well be just the UK government wearing its English government hat) for devolved expenditure.

But in any case, the first step towards a workable system is for some self-awareness on the part of HMT.

[*] Shorter, and better written version is Chapter 8 of 'Beyond Smith' ebook 

Sunday, 30 November 2014

End November Links

# Chris Dillow makes good points in The Heritability Red Herring, on how cross country evidence shows that the success of the children of rich and bright parents cannot just be due to heritability. In particular the point that "The correlation between parental education and children's education is higher in more unequal countries. This is consistent with income inequality buying unequal access to education - for example, because rich parents in unequal countries buy private tuition."
This is not just private tuition or private education though. I suspect that there will be greater variance in property values in unequal countries as rich seek to cluster and so buy access to higher than average quality public education. If I'm correct about this, then it will be a multiple equilibrium effect:

   1.  house prices are highly unequal reflecting a large amenity values from good local schools, and so rich will be willing to pay (thus supporting high prices in such areas); or
   2. house prices are much more equal as are schools, and so no-one is willing to pay any house price premium for access to a specific school.

I further suspect that equilibrium 2 is more fragile, in that the dynamics around it have a much narrower or shallower basin of attraction. But not so shallow that it cannot be stable, given a relatively narrow spread of incomes: as Lesley Riddoch and others have commented, the segregation by income is much less strong in more equal countries, which I suspect means that these countries are even more equal relative to the UK than their lower GINI coefficient would suggest.

Nick Rowe is also thinking about this area, in Reverse Regression and the Great Gatsby Curve

# My Smith Commission submission is reported in the Modern Scotsman and my article in the Conversation

# Some interesting posts on English devolution:
   - The Greater Manchester Agreement is only a small step towards greater devolution in England
   - The ‘Devo Manc’ proposals represent centralisation on steroids

# Krugman resurrects a fantastic post of his from 1998 on Networks and Economic History. Basically Zipf's Law offsets Metcalf's Law meaning that increasing returns are limited. I suspect that this is relevant in domains other than the profitability of communication networks.

# On oil prices and prosperity is a generally good article. But I'm more pessimistic than the following paragraph since the rate of innovation must be related in some way to the price of fossil fuels. "The only real concern ... is in regard to the viability of alternative energy. Renewables have become significantly more competitive ... in a world of expensive fossil fuels. ... But the falling price of solar energy is ultimately a long-term trend driven by technology. ... cheaper oil prices could push adoption back to some degree, especially in regard to electric vehicles. But it can't hold back the broad strokes of history, either." I think it is possible that these broad strokes of history could either feature or not feature the adoption of alternative energies. It is possible that, as a species, we may make catastrophic choices, and the current state of incentives for the development of alternative energy technologies is in no way helpful.

Thursday, 30 October 2014

Is regional policy inefficient?

The basic argument for centralising decisions over public investment, for example the UK's £300bn plus National Infrastructure Plan, is that projects across the country can be assessed, and scarce funds then directed, on the basis of which are most valuable compared across the whole portfolio of potential projects.

A further advantage for centralised decision making is that interregional spillovers can be consider. For example, a project that should be high on Scottish priorities list is upgrading the A1 trunk road in Northumberland north of Newcastle, but it would be hard for Scotland to act on this preference if it only controlled spending in Scotland.

Centralised spending decisions are current practice in the UK. But what are the arguments against this centralisation, and instead having both a regionally balanced portfolio of public investment (which must, at the margin, lead to lower expected return projects being invested in at the expense of higher expected return projects), and local decision makers?

# Congestion:

If factors are complementarity but there are costs of congestion, then a project can easily have the highest expected return (measured by willingness of the beneficiaries to pay for this improvement divided by its cost) but not be the efficient choice. Congestion (of fixed non-reproducible factors, typically land; and also of hard-to-adjust-in-the-short-term factors like space on a road, or bandwidth on a network) causes real losses in economic output, and a project that in the absence of congestion would be highly valuable (because it is complementary with all the other factors located in the congested region) may not yield greater real output than a similar cost project in a less congested region which is less valuable in terms of the willingness of the beneficiaries to pay.

A recent article in the FT, 'London’s $8.5bn traffic jam slows down growth' viewed further investment in the South as the solution to congestion in the South. It cites Edmund King, president of the AA, claiming support for this from those furth of the region: "“Anyone who regularly commutes on the M25 ..., knows it’s an absolute nightmare, ... But it’s a key link to airports and ports – and not just for drivers in the south. If you ask Scottish hauliers what’s the most important road in the UK it’s the M25.”" And obviously, once the airports and the ports are in the South, the value of the road network in the South is increased. But instead of constantly increasing capacity in the South to deal with the use of this network by those not from the South (and to deal with the population growth in the South induced by everyone crowding round these assets), it may be more efficient to invest in capacity elsewhere. Project evaluation should not always take demand as given, but instead should countenance that supply lead demand. And project evaluation should not always be conducted on a marginal basis: investing in infrastructure in the North may lead to increased values on future investment in the North, and perhaps some of this additional value should be recognised when evaluating the first project.

If congestion's economic impact is high enough then this could strengthen the case for targeting public infrastructure investments in highly productive and congested areas, precisely to limit congestion problems. However - this simply may not be possible in the medium and long run. If you alleviate the congestion through public investment London then, given the income differentials across the UK, London's population will grow until the congestion is recreated. If the costs of fighting congestion at a given location are convex (this may or may not be true, but it's certainly true that the level of congestion given fixed infrastructure is convex in the number of users), then this is, eventually, an inefficient use of public capital.

# Network effects and lock in:

This complementarity between factors of production can lead to "lock-in" when the situation changes (technological changes, changes in the terms of trade, etc). A great example is Michaels & Rauch (2013) (described in VoxEU) which discusses the positions of medieval towns in England and France.  Three facts underpin their analysis: (1) Both England and France had urban networks created by the Romans, based on complementarity with the Roman road network; (2) Roman civilisation collapsed much more strongly in England than in France; (3) The dominant transportation technology of the middle ages was by boat. They find that medieval urban locations in England were sited much more appropriately with the prevailing technology than those in France were. This suggests that France suffered from lock-in: it was never worth it to rebuild all their infrastructure at a more appropriate site because every new investment must be optimal conditional on the locations of all existing assets with which they are complementary. England benefited, in the sense that it could re-optimise, from having its slate wiped clean.

Perhaps a diversity of locations should be maintained, and their varying idiosyncratic characteristics can provide insurance against secular changes. By having multiple centres that each have a full suite of infrastructures and assets, the costs of switching focus from one to another as external changes occur are minimised and so we do not become locked in to using a location that is eventually sub-optimal.

# Information

The power of markets to aggregate widely dispersed knowledge is justifiably lauded. Given this ideal however, we should not want the projects assessed by a single body with monopoly power to decide which get funded or not. This single decision making body will have a particular set of preferences, a particular information set, a particular expertise, and a particular method of analysis. As Chris Dillow says "Let's suppose that we want to find the best possible policy, according to some objective criteria ... Suppose too that there is bounded rationality and limited knowledge and that each individual selects the best option using his own information set and decision rule. In these conditions, each individual, if s/he is moderately competent, will find a local maxmimum - the best option, given his/her information and decision rule. But local maxima aren't necessarily global maxima. ... experts might well not find that global maximum because their decision rules and information sets might not be wide enough to encompass the best option: this might be because of deformation professionnelle, or groupthink or simply because their Bayesian priors limit the number of options they search for. Instead, widening the population of searchers increases our chances of finding that global maximum, because doing so brings more decision rules and information sets to bear on the problem. Cognitive diversity - in the sense of different ways of thinking - can therefore beat experts. It increases our chances of finding the best option."

In this context, multiple decision making bodies, each finding their own constrained local maxima, may bring us closer to the global maximum than a single decision maker (who does admittedly operate with fewer constraints).

# Fiscal transfers and stability

Presumably public investment opportunities in the highest yielding projects are lumpy over time. This could represent a big swing in fiscal transfers, and there is always a balance of payments (even if no-one is measuring it regionally). Any sudden positive (negative) impact on fiscal transfers would need compensating outflows (inflows) of private capital, increases in net imports (exports), appreciation (depreciation) of land values & other fixed assets, or labour in(out)-migration - all of which can be destabilising with associated losses. Conversely, if public investment were stable regionally then it would contribute to the automatic stabiliser effect of public spending and countercyclical policy.

# Distribution of gains

Even ignoring all the points above and assuming that a single decision maker can accurately select the highest yielding projects, everyone agrees on these, and there are no negative effects from congestion, then it is still not the case that we should automatically use public funds, raised from general taxation, to invest in a regionally unbalanced portfolio of projects. This is because the returns are not necessarily equitably shared. The obvious case is that of land-owners: those situated around the newly created public capital likely capture some of the value; but this is also true of workers. It is clearly the case that public funds can be used to systematically and predictably favour citizens in one part of the country over another. That public funds should be so used must be a matter for democratic debate, not necessarily the outcome of a spreadsheet calculation.

And the sums involved are not small: Wings Over Scotland estimates that investment in Scotland under the NIP will be £1bn from a publicly funded total of £136bn, to which Scotland will have contributed approximately 1/11th from tax revenues. If the populace as a whole agrees with these priorities and recognises these regional transfers, then fine. However, dressing this decision in the language of cost-benefit analysis overestimates how sure we can be that the selected projects are the optimal choice, and obscures the important distributional decisions that have to be more democratic than technocratic.


Given these points, there is clearly a case to be made in favour of some local decision making, and for reasonably regionally balanced public investment, on efficiency grounds. I believe that the balance in the UK at the moment is far too far away from regional balance, and towards centralised decision making. There is scope for benefits from a presumption in favour of a regionally balanced public investment portfolio. A centralised decision making body which has such a regionally balanced portfolio objective, would deal with all the headings other than "Information". Given this information point, there is definitely space to enhance local control over some public capital spending. Regional balance should not be perfect, since there is some value to picking high marginal value projects, and local control of investment budgets should not reach 100% since there is value to considering interregional spillovers.

End October Links

# Another in Vox´s series of maps: 38 maps that explain Europe

# Fracking's not a bridging fuel: Fracking May Be Worse Than Burning Coal; and true low carbon investment may be best for the economy:  Want to grow the UK economy? Invest in green energy

# Interfluidity on The political economy of a universal basic income

# The IMF has produced a couple of politically charged research reports, showing:
    - public investment really is a free lunch: a dollar of spending increases output by nearly $3
    - lower inequality is robustly correlated with faster and more durable growth, and redistribution appears generally benign in terms of its impact on growth

# The BBC reports that
"Chancellor George Osborne says the figures [UK inflation fell to a five-year low of 1.2% in September from 1.5% the month before] are a "dose of good economic news""
In what way is this good news? The BoE has a symmetric target - below target is as bad a policy failure as above target. And low inflation is only good news for individuals to the extent that their incomes are unaffected. If low inflation is accompanied by a lack of wage growth, which it is, then this is in no way good news. Given high debt levels, lower than expected inflation and income growth is unambiguously bad economic news.  

"[To t]hose dismayed by Britain’s wide disparity of individual wealth ... The overriding reason is the gulf between the prosperity of London and the provinces. This must in part result from a shift in power from local to national government, a perverse consequence of a “single state” constitution. Every year 30,000 graduates flow from provincial universities to jobs in London. Barely 11,000 go the other way. This crippling drain of talent and earning power is one reason why cities in Germany and elsewhere in Europe are richer and more robust than in Britain. Inequality starts with power."

# Henry Overman of the LSE's Spatial Economics Research Centre in his post, Why are the poorest regions in the UK the poorest regions in Northern Europe?, comments on data similar to my post, A conversation, between economists, on the economics of independence. He looks at the NUTS2 regions of Northern Europe and points out the problem of splitting inner and outer London, but his main critique of the claim that there's something unusual about all the poorest regions of Northern Europe being in the UK, is that this is to be expected given that the UK is the poorest country in Northern Europe. My chart was based on NUTS1 regions, and still the UK has the highest region inequality. But also we have to ask why the UK is the poorest country in Northern Europe, when London and the South East manage to be compare well with this group. It's not soil fertility, remoteness, or population density, or else the rest of the UK would not be getting beat by Ireland and Scandinavia. My conjecture is that it's about power, and Henry Overman's piece does not change my view.

Thursday, 23 October 2014

Economic journalism cop-out extraordinaire

BBC Scotland today reports on developments at Grangemouth. I have no quibble with the content of their piece. However it states "Grangemouth is already said to be responsible for about 10% of Scotland's gross domestic product (GDP)" - note the weasel-words "is said to be"; translation: "I overheard someone say this, it may or may not be true, but sounds impressive and I can't be bothered investigating". This is unacceptable journalism.

Let me help the BBC out: I have no idea about the profit and loss accounts that could be attributed to the Grangemouth plant; but I can at least do back of the envelope calculations.

# Scotland's GDP is approximately £150bn so 10% is around £15bn

# Country GDP, as a concept, is analogous to Company operating profit (before depreciation). Wikipedia makes this clear in 2nd paragraph on GDP.

# Grangemouth has 800 employees and so its wage bill is highly likely to be substantially less than £100m. Simply the payments to capital would then have to be approaching £15bn for this plant to be "responsible" for 10% of Scotland's GDP.

So whilst Grangemouth may be "said to be responsible" for 10% of Scotland's GDP, this is only "said" by people who don't know what they are talking about. Business and economics journalists do not (or should not) have this excuse.

Now perhaps the value of Grangemouth's sales approaches £15bn (this may or may not be true). So what? It will have paid £14bn-odds for the raw materials and its value added (operating profit before depreciation) will be much lower. Even if it is true that Grangemouth's revenues are 10% of Scotland's GDP, comparing these figures is meaningless. This is like saying there are roughly the same number of nano-meters in 10cm as there are miles in the Earth-Sun distance: it's a true statement, but comparing these numbers without noting that they measure different things adds no information.

Monday, 22 September 2014

Post Referendum Policy for the SNP

Scotland will never be independent until currency is not an issue that concerns people over the transition. People were too scared, and will be too scared. The Scottish Government's proposal of a currency union was clearly sub-optimal economically and was rightly attacked by many economists. But alternative proposals of joining the Euro or creating a separate Scottish currency were never going to fly given voter psychology.

I think there are two routes for currency becoming a non-issue at a future putative referendum: the first is for the UK to join the Euro. This I don't see happening any time soon.

The second route is via the creation of a confederal UK. Gordon Brown, in his seizing of the political initiative two weeks ago, has created a clear mandate from Scotland for the UK as a transfer union in which risks and resources are "pooled and shared". But given 45% of a very high turnout voting for independence with many of the remaining 55% favouring further powers under the competence of the Scottish Government, I don't think Jack Straw has any mandate for his proposal that a No vote is made permanent and that the UK becomes like Spain in its claims of constitutional integrity. Rather, the 1.6 million votes for independence, plus many more for enhanced powers, is a strong vote for confederation.

Confederation is the opposite of devolution. Currently Westminster devolves power to Holyrood. Under confederation, the Scottish Parliament would cede powers to the UK parliament. The referendum has made clear that those powers should be defence, foreign affairs, monetary policy and, thanks to Gordon Brown's intervention, fiscal policy. Confederation initially would cede exactly those powers that are currently "reserved" under devolution. This is what I feel the SNP should switch to campaigning on (perhaps they could draft the addendum that the UK Government would have to add to a forthcoming Scotland Bill on further powers) rather than any crazy suggestions like changing the mechanism of achieving a mandate from referenda to simply winning elections.

The advantage of confederation for the independence movement is that it would be clear that sovereignty ultimately rested in Scotland, and because of the current democratic will, powers were currently passed upwards to share within a supranational union. If the democratic will changed, the detail of which powers were ceded could change (even all of them, contra Jack Straw). In particular, if the democratic will at some point in the future no longer favoured a fiscal union, or representation by the UK internationally (i.e. in EU or in NATO) but still favoured a monetary union (*) then Scotland could cease to cede these powers to the UK level. This is effectively the independence of the Scotland's Future White Paper - but it wouldn't feel like it to a risk averse electorate, or to an electorate that valued a British national identity, since British institutions would always remain. It would also avoid any traumatic transition periods, eliminating the risks of capital flight and market collapse, and lowering start-up costs since the creation of institutions could be gradual.

(*) This would incorporate fiscal sharing arrangements as outlined by BoE governor Mark Carney, and crucially the laws and the detail of this fiscal sharing arrangement would be decided by UK institutions. This would be a monetary union that prescribes (G-T)/Y and specifies, ex-ante, transfers in response to asymmetric shocks; it would not prescribe G/Y and T/Y separately, or the detail of tax and welfare policy, which are prescribed in any immediate post-referendum arrangement.

Wednesday, 17 September 2014

The Economic Choice on Thursday

Over the last couple of days I've tried to lay out a series of mechanisms whereby independence - perfectly conceivably - leads to better outcomes. Mechanisms for economic gains from independence #1, #2. #3, #4 & #5.

This is partly in response to articles like this in the Daily Record in which some economists claim that the evidence all points one way. It clearly does not. This is not to say that Yes has all the evidence on its side: in particular, a currency union is bad idea; and I would hope that an independent Scotland adopts a Scottish currency. Such a currency should be pegged to Sterling initially to allow existing Sterling denominated liabilities (mortgages etc) to be paid without currency risk. New liabilities that are taken on should be denominated in the Scots currency, and when exposure to Sterling is minimal, the peg can be broken if appropriate.

I think the economic choice on Thursday can be summarised in the following way:

The Scottish economy is performing as well as the UK economy at the moment, and the Barnett Formula roughly compensates Scotland for North Sea oil tax revenues. But on the horizon are two major challenges: an ageing population, and the decline of the North Sea. The campaign pitches are both, fundamentally, about how these challenges are faced.

# The No position is to not do anything about these issues at all. What it proposes instead is that Scots can be reassured that they will start to receive transfers from the rest of the UK that allow public services, pensions, etc to continue to be paid even as economic output in Scotland falls.

# The Yes position is that we don't want these transfers and that we need to do something to make sure that economic output does not fall. This something is not exactly defined: "a government with the best interests of Scotland" is a sentiment consistent with this aspiration, but what exactly will differ policywise is not completely clear. A policy of increased immigration is clear and consistent, but other than this, little has been spelled out (which is of no surprise given that it is a matter for 2016 election).

Both these pitches have logic behind them. One is not necessarily more reprehensible or laudable than the other. An individual should vote on how appealing these pitches are (what are your preferences over them), and whether they trust them to be deliverable (how credible do you believe them to be).