Stumbling and Mumbling

Starmer's stability promise

"A vote for Labour is a vote for stability" said Sir Keir Starmer launching Labour's election campaign. This is more than just a soundbite. It opens the door for some sensible policies.

There is a solid economic logic to this desire for stability. Instability and uncertainty depress capital spending: why invest in a risky project in uncertain times if you can wait for the fog to lift? If government can offer stability - and, crucially, have businesses believe in its offer - then this alone can boost economic growth. This is why Gordon Brown famously spoke of "no return to boom and bust."

Which brings us to the problem. There are two sorts of stability, one of which governments can provide and one which they cannot. They can provide policy stability: in principle, Ms Reeves could announce Labour's tax and spending plans for the next five years within a few weeks of taking office and then promise no more Budgets. This would give us fiscal policy stability.

What it would not give us, however, is economic stability. Economies are always hit by shocks* which cause booms and slumps, as Mr Brown discovered in 2008.

The question, then, is: how can policy respond to such shocks and so create economic stability?

In the case of demand shocks, the answer is in principle simple. The Bank of England cuts interest rates and the government borrows more, thereby supporting demand. To her credit, Ms Reeves has an "escape clause" in her fiscal rules to allow current public spending to exceed taxation "if the OBR declared the UK was in an economic crisis."

Demand shocks, however, aren't the only sort. There are also supply shocks - things such as soaring oil prices** which depress both demand and the economy's supply potential. And some shocks are a mix of both supply and demand shocks - such as the pandemic and perhaps the banking crisis.

Policy responses to these have been ad hoc: after the pandemic and the surge in gas prices caused by Russia's invasion of Ukraine the Bank of England let inflation rise above target whilst the government gave one-off handouts to support demand.

But here's the problem. Shocks are unpredictable: Prakash Loungani and colleagues have concluded:

We find that the ability to predict turning points is limited. While forecasts in recession years are revised each month, they do not capture the onset of recessions in a timely way and the extent of output decline during recessions is missed by a wide margin. This holds true for both private sector and official sector forecasts.

During the financial crisis, for example, the Bank of England only cut Bank rate to what it then considered its lower bound in March 2003 - 12 months after output began to fall.

Conventional macro policy, then, can at best only ameliorate recessions after they have begun. The belief that "predict and control" can prevent economic instability is due to irrational overconfidence and the ideology of centrist utopianism, not to actual evidence.

If Sir Keir is serious about offering stability, he therefore needs to offer more than good macro policy.

But what?

One answer is to prevent shocks rather than react to them. Ms Reeves has recognised this. One lesson of 2008, she said in her Mais lecture, is that:

Stability was a necessary, but not a sufficient condition to generate private sector investment. An underregulated financial sector could generate immense wealth but posed profound structural risks too.

This is why greening the economy is so important. Doing so doesn't just (!) help save the planet. It reduces our vulnerability to one source of shocks: gas and electricity price rises.

But we cannot predict where all shocks will come from: will they be pandemics, wars, food price rises due to climate change or - quite likely - from something we've not thought of? Important as it is, prevention is not enough. We need something else.

That something, as Eric Lonergan pointed out during the pandemic, is that we have the means to react quickly and efficiently to shocks. We lacked this in 2008. And whilst help was quick during the 2020 pandemic it was not wholly effective: many self-employed people missed out on assistance whilst millions were lost to fraud.

One possibility here is to have a rule-based policy, to expand activity when GDP drops a certain amount below a pre-announced trend level (and contract it when it rises above it). The expansion, in emergencies, could take the form of tax rebates, zero mortgage rates or simply writing everyone a cheque.

There's a problem with this, though; GDP is only measured with a lag and so any such help will arrive late. One solution to this would be to develop macro markets (pdf), in which there are liquid markets in GDP-linked securities whose prices could be used to guide policy. Another solution would be to accelerate the development of nowcasting (pdf), ways of measuring GDP in real time.

But there's something else policy can do. We could have better automatic stabilizers, which include high enough welfare payments to avoid people suffering huge falls in income in bad times.

These aren't just necessary at the macro level. They are also necessary to ensure something more important than macro stability - individual security.

Even in stable macroeconomic times people suffer job losses. These are the counterpart of productivity growth. This occurs not so much because incumbent firms become more efficient but because of creative destruction, the closure of inefficient plants and firms and opening of better ones (pdf). A more efficient economy thus requires that people move job. But as Ms Reeves asked:

Without a safety net to fall back on, how can we expect an ordinary person to retrain, take a new job or change career?

This safety net must not only be high but must be stable and be genuine help, rather than harassment by a cruel bureaucracy. Which is one reason why some of us favour a citizens basic income.

Serious thinking about economic stability, then, requires a focus on big policy questions: how to go beyond "predict and control" macro policy; how to regulate key industries properly whilst ensuring resilience elsewhere; how to have a welfare state that supports incomes and facilitates necessary job moves.

Of course, you'll object to all this that it is not what Sir Keir has in mind at all. Maybe not. My point is that once we start talking about economic security, some sensible ideas naturally emerge. And this is one reason why leftists should welcome a Labour government, especially one with a big majority - because it would change the agenda away from media-inspired Tory drivel and towards more serious issues.

* I'm following economists' standard terminology here. In truth, some of the things that cause recessions aren't exogenous bolts from the blue but are in fact the product of developments within the system: I'd argue that the banking crisis of 2008 was one such, but that's another story.

** Some people prefer to call rising oil prices a terms of trade shock. Nothing I say hinges on this distinction.

Strong links vs weak links

The general election should rid us of one of the most vicious, corrupt and incompetent governments in our history, but it will probably not install a government able or willing to meet the huge challenges of a failing economy, wrecked public services and climate change.

With players of the quality of Saka, Foden, Rice and Bellingham, England have a great chance of winning the Euros this year, but with players like Maguire or Dunk they do not.

These two paragraphs seem very different. But they have something important in common. They illustrate the distinction between strong-link problems and weak-link ones.

A weak-link problem is where success depends upon the quality of the worst component, whereas a strong-link problem is where it depends upon the quality of the best. So, if you're looking at Foden and Saka, you're thinking in strong-link terms whereas if you're looking at Maguire and Dunk, you're seeing through a weak-link lens. Similarly, the election should solve the weak-link problem of ridding us of a terrible government, but it will not solve the strong-link one: it'll not give us the best possible government.

This distinction is ubiquitous.

If you're running an airline, oil rig or nuclear plant your focus must be on eliminating the weak-links that can cause catastrophes. Other businesses, though, have strong-link problems. It doesn't much matter if there's a lot of rubbish on Netflix as long as there's sufficient good stuff to attract customers. It has the strong-link problem of how to find good shows and can ignore the weak-link one of what to do about rubbish*.

Many growing companies face strong-link problems - how to stand out sufficiently to win new customers. Mature ones, by contrast, have weak-link problems: they must avoid doing anything which alienates existing customers.

The distinction also matters in investing. Many retired people have the weak-link problem of how not to lose money - a problem which is surprisingly easy to manage for sterling-based investors. Venture capitalists, however, have the strong-link problem: they must find one or two companies with massive payoffs to cover the inevitable losses of failing companies. This is why a state investment bank is a good idea economically speaking - because the state can better throw money around than the private sector - but a bad idea politically because the shitmedia will brand the inevitable failures as a waste of taxpayers' money.

By contrast, economic development can be a weak-link problem. Poor countries are poor often because important things are lacking - reliable electricity, roads, ports, property rights and so on. They can achieve growth therefore by improving these weaknesses. As Charles Jones puts it (pdf):

In any production process, there are many things that can go wrong that will sharply reduce the value of production. In rich countries, there are enough substitution possibilities that these things do not often go wrong. In poor countries, on the other hand, any one of several problems can doom a project. Obtaining the instruction manual (the “knowledge”) for how to produce socks is not especially useful if the import of knitting equipment is restricted, if replacement parts are not readily available, if the electricity supply is erratic, if cotton and polyester threads cannot be obtained, if legal and regulatory requirements cannot be met, if property rights are not secure, or if the market to which these socks will be sold is unknown.

It's not always the case, however, that rich countries do have enough substitution possibilities to prevent trouble when one element fails. As we saw in 2008, the collapse of banks led to big falls in GDP. The crisis taught us that when thinking about banks we have a weak-link problem: the priority is to avoid disaster.

What's true of one industry, however, isn't true of others. Whilst the collapse of NatWest triggered a crisis that of Wilko, Debenhams, Woolworths or Cazoo did not. Which tells us that in well-functioning markets we have strong-link problems: we needn't worry about the existence of bad companies because the market will - eventually - select for good ones.

This poses the question: is the impending collapse of Thames Water a weak-link problem like NatWest or a strong-link one like Wilko? I suspect the latter: it doesn't matter if Thames Water can't supply water as long as somebody can; the logo doesn't matter as long as the taps still run.

Yet another weak-link problem is monetary policy. For Milton Friedman good policy (pdf) was a weak-link problem: “a negative proposition: avoid major mistakes.” The strong-link problem - boosting economic growth - requires other policies.

By contrast, science and the arts are strong-link problems. It doesn't much matter if there's a lot of dross as long as people aren't daft enough to act upon bad research! What matters is that quality research is also done, as this is where progress occurs.

Strong-link and weak-link problems have very different solutions**. With weak links, we need risk-aversion and a focus on high minimum standards and safety. With strong-link problems, however, we need to embrace risk, diversity and competition.

This means that sometimes, solving a weak-link problem might exacerbate a strong-link problem. This is perhaps true of the US constitution. It has done a good job in solving the weak-link problem of protecting Americans from tyranny, but not perhaps so good in delivering effective active government. It might also be true in academia: managerialism has weeded out weak-links - academics who are idle drunks and sex pests - but has been less good at fostering strong-links; pressure to publish has given us shoddy research as academics have less time to focus on good work. Many free marketeers, such as Ryan Bourne in Economics in One Virus, add that regulation protects us from the weak-links of dangerous medicines (except OxyContin) but at the expense of slowing down the development of effective ones.

There are trade-offs here, and we must be aware of them.

Often, though, people are not. Sometimes, they have strong-link thinking where we need weak-link thinking.

Boris Groysberg has given some examples (pdf) of this. He's shown that when a good manager of growth companies takes over a mature business (or vice versa) the result is often poor performance; a growth manager has a strong-link mindset whereas mature businesses need weak-link thinking. What matters is not merely an individual's skills, but the match between them and the job requirement.

I saw other examples back in the day job: retail investors who claimed to be risk averse sometimes piled into (correlated!) spivvy Aim stocks.

We see it too in recruiting. Michael Housman and Dylan Minor have shown that companies spend too much time looking for "talent" when they should instead be screening out toxic workers such as the rogue traders who might lose billions, the sexual harrasser who attracts expensive compensation claims or the over-mighty CEO such as Fred Goodwin who could bring down the whole firm.

We also see it in academic publishing, where peer review selects for work that corroborates reviewers' prejudices and selects against heterodox ideas, thereby restricting the diversity upon which the development of strong links depends. Even papers that helped their authors win Nobel prizes have been rejected.

Politics gives us other examples. Sunak has recently spoken of how AI might quickly double productivity whilst Hunt has called for the creation of a "British Microsoft". These are examples of strong-link thinking. But in fact we can better improve our economic performance with weak-link thinking - by simply not doing stupid things such as having trade barriers with the EU or excessively complex taxes and planning rules. Governments should stop talking about being world leaders and instead set themselves the more challenging aspiration of rising to dull mediocrity.

Herein, however, lies a problem - incentives. Sometimes, bosses are incentivized to be strong-link thinkers when they should be weak-link ones. The more naive among you might think that they should ensure that their organizations solve a weak-link problem and eliminate egregious wrong-doing. But this did not happen with the Post Office. As long as the bonuses kept coming, Paula Vennells had no incentive to stop driving sub-postmasters to suicide. Similarly, you might think that police recruitment is a weak-link problem: because bad coppers can do huge harm it's important to weed them out. But because the costs of a Wayne Couzens or Cliff Mitchell and many others are borne by their victims much more than by Home Secretaries or Met Commissioners, such screening is inadequate.

We had the same problem in the run-up to the financial crisis. Banking should be a weak-link problem - stopping them cratering the economy by going bust. But bankers were incentivized to increase returns and take on risk - that is to chase strong links.

My story here is about selection mechanisms. All institutions - be they companies, markets, government departments, elections or whatever - are selection mechanisms: they select for some behaviours and against others. The questions are: what do we want our institutions to select for or against; how well do they do such selections? and; how might we improve them? Such questions are unlikely to be much discussed during this election campaign.

* This is why Disney's decision to withdraw some films from its platforms was so odd, and costly.

** Insofar as they have solutions at all which sometimes they don't: Gareth Southgate can't create top-quality central defenders.