The Chancellors review – A must-read let down by one-sided thinking
Sir Howard Davies has probably the best calibrated political antennae of anyone I’ve ever met. His political judgements are invariably shrewd and he fully understands the interplay of politics and administration, having worked in the Foreign Office, Treasury, McKinsey, CBI, the Bank of England and the City.
He is, then, ideally placed to write about some of the key economic controversies of the past quarter-century in his new book, The Chancellors. And he has the connections to have interviewed all the key players, both politicians and officials.
In some ways, this makes the book a successor volume to the late Sir Samuel Brittan’s classic The Treasury under the Tories (and its own updated volume Steering the Economy), which was a key textbook for those of us (including Davies himself) who studied economics in the early 1970s. His new book partly fills the same role, being extremely readable and covering much of the same ground as Brittan’s.
However, anyone wanting fully to understand the economic issues of the period would need to supplement the book. Davies handles the main left of centre criticisms of policymaking adequately and by implication of the “Treasury view” (too much austerity, not enough borrowing while money was cheap, rising inequality etc.). Academics like Simon Wren-Lewis and the Institute For Fiscal Studies (IFS) get quoted frequently in the book, as does the left-wing lobbying organisation the Resolution Foundation. But there is a much wider range of critiques of policy, particularly from the centre-right of British economic policy making, of which Davies seems unaware.
The biggest problem of the book is that it treats the UK as if economic policy could be made in a vacuum. In my Gresham Professorial Lectures in 2011/12, I explained how the impact of globalisation and changing technology on the relationship between the UK and world economies has been seismic. Without explaining or understanding that, judgements about optimal policies have an element missing.
For example, one of the consequences of China’s advance from being 3.6 per cent of the world economy in 1990 to about 18 per cent today is that Chinese savings have grown from below 2 per cent of world GDP to 8 per cent today. The consequent rise in the global savings rate has contributed to a demand deficiency in the West, to which the authorities have responded with ever lower interest rates.
When sitting on the Bank of England’s Monetary Policy Committee from 2006 to 2011, Andrew Sentance (who was, like me, a former economic advisor to Howard Davies when he was Director-General of the CBI) made the, in retrospect, correct case that low-interest rates — except as a short term temporary cyclical response to circumstances —when persisted with over the longer term, eventually damage the structure of the economy by more than enough to offset any short-term benefit to demand. When he first made the criticism, he was a lonely figure, and now his views are shared by many.
Davies compliments Gordon Brown’s management of the economy as Chancellor without giving much heed to the problems that were being papered over. I pointed out consistently in the early 2000s that excessively loose monetary policy — resulting from the Bank of England too slavishly following an inflation target in the special circumstances of a time when the terms of trade had adjusted dramatically in the UK’s favour as a result of cheap goods from China — was creating the problems in the housing and assets markets which eventually spilt over into the Great Financial Crisis (GFC).
In his evidence to the House of Commons Treasury Committee in 2007, Tim Congdon offered a similar perspective to mine, that excess monetary growth had created an unsustainable asset price boom, though his criticism related to the policy regime and its failure to incorporate monetary growth targets, whereas mine had related to the interpretation of the inflation target.
For Davies, the financial crisis seems to come as an extraneous event out of the blue that has little relationship with the policies that had preceded it. To be fair, the initial triggers for the crash came from the US, when the collapse of the subprime mortgage market led to the deleveraging that in turn led to the need for bailouts of banks (mainly commercial banks in the UK where, in effect, Robin had tried to play Batman and indulge in high paying risky lending without the shrewd instinct for self-preservation of the mainstream investment banks) and the collapse of institutions like Lehmans.
But in the UK, these problems had been building up in the preceding years in all the assets markets, especially housing, as a result of loose monetary policy and weak regulation (for which Sir Howard Davies himself had a degree of responsibility) and the crisis would have occurred at some point anyway.
One of the most interesting passages in the book comes from the fact that Davies, who tries hard to be fair-minded with the criticisms of the “Treasury view”, largely accepts that the increases in public spending during the period leading up to the GFC led to an unbalanced fiscal policy. But what Davies doesn’t cover is how little value was achieved from the increase in public spending.
The data on public sector productivity is imperfect, though the UK has tried harder than most to make it accurate. But over the period when New Labour was in power from 1997 to 2010 the currently available data shows that public sector per capita productivity fell by 2.3 per cent, while productivity in the market sector rose by 23.6 per cent. One of the reasons that Margaret Thatcher kept the public sector on such short rations was that she feared that in the absence of credible public sector reform (and Brown resisted such reform) much of any increase in spending might be wasted.
Davies relies heavily on international comparisons for investment and R&D statistics. Here his lack of practical economics knowledge shows up. Besides globalisation, the other seismic change that has affected the economy and how it is measured is the rise of technology. Davies appears to be unaware that the UK’s main growth sector is what I have called the Flat White Economy. This has accounted for around half of GDP growth since the financial crisis and is now bigger even than manufacturing.
It is not so much a tech sector but a tech-using sector. It is astonishingly badly measured — a study carried out by my Cebr colleagues for the Creative Industries Federation discovered that creative exports were understated by at least 30 per cent. The sector is probably responsible for the bulk of UK investment and yet, since most of its investment is software and is typically expensed, it largely fails to get into either the investment or the R&D statistics.
Even the GDP from the sector is normally understated, often being treated as an input rather than as an investment. Since most of the companies are fairly new they often take years to get into the measurement net. Practical working economists tend to be aware of statistical deficiencies and know when either not to rely on the relevant statistics or when to adjust them.
One suspects that Davies’ former Treasury colleagues are similarly unaware. The author quotes former Chancellor Denis Healey as claiming that “the Treasury commands the best brains in a civil service that has no intellectual superior in the world”, yet the same Denis Healey was quoted in the Observer in 1975 pointing out that the then CBI Economic Adviser Sir Donald MacDougall and his team of six (actually there were only three of us) were “running rings round the Treasury”.
I’ve generally been impressed by the intellect of my friends in the Treasury, but many of them lose many of the benefits of this intellect to a combination of lack of practical knowledge and being too arrogant to learn from people who know different things and have a different experience.
This is currently showing up in the explosion of inflationary pressures. Both the Treasury’s forecasting arm, the Office for Budget Responsibility and the Bank of England have consistently failed to predict this and the subject is barely touched on in this book. There needs to be an investigation into why official forecasters have done so badly at a time when plenty of us in the private sector have foreseen the problem.
Inflation is now likely to reach five times the target level. My own guess is that the forecasting failures result from arrogance and groupthink. For example, there has never been a monetarist appointed to the Bank of England’s Monetary Policy Committee. Major efforts have been made to promote diversity of ethnic origin and gender (and for all I know sexual orientation). It appears that the diversity of economic opinion is less highly prized.
For all this, Sir Howard Davies’ book is worth reading. But to get a full understanding of recent macroeconomic issues, a student would have to combine reading it with a book by someone with a different point of view. There is a clear gap in the market — I wonder who will fill it?