Back to the future (again); how does economic theory assist us?
The title of this week's blog is part in homage to the trilogy of films starring Michael J. Fox and in acknowledgement of having used a variation previously.
The dream of being able to travel in time is a long-cherished theme of literature and, of course, film-makers.
Knowing precisely what is going to happen in the future is a seductive thought and would confer incredible power on anyone able to do so.
Economic theory is, according to many, meant to provide us with predictions of the way in which markets will 'behave' in the future.
However, the problem with this notion is that 'markets' are a complex amalgam of a multitude of factors in which it assumed that collective behaviour can be studied and better understood through the formulation of theory (explanation).
And so the belief goes, once you have sufficient 'economic' data it becomes a simple task of extrapolating whatever the trends are so that it is possible to make accurate predictions.
Well that's the theory.
When any commentator talks about how we make predictions concerning the future I always think about the ex-baseball player and pundit Lawrence Peter 'Yogi' Berra who became famous for his use of malapropisms and once famously quoted, 'It's tough making predictions, especially about the future.'
Even though he probably meant to say something entirely different, Berra is right; making predictions about the future is fraught with problems!
However, that doesn't stop 'classical' economists believing that they can do so successfully.
Let's consider the GDP figures which will be published this Thursday and are predicted to show that we are out of recession.
They are a nice example of how no-one is exactly sure what they will show though it is believed that it will be somewhere between 0.5 and 0.8%.
This undoubtedly will provide a fillip to George Osborne especially given that unemployment is falling.
For the advocates of austerity a rise in GDP coupled with a fall in unemployment is welcome news and allow them to proclaim that this is the way to return to economic health. Crucially, they argue, slashing government spending is essential to the country's future economic well-being.
However, it is not all so easy or straightforward as the advocates of austerity would like to pretend.
For a start there is in the GDP figures as, according to most commentators, any growth in GDP that may be announced on Thursday is due to the spending associated with the Olympics.
Remember, the Olympics were largely finance by us, the taxpayer.
And there is irony contained within the employment figures.
On the basis of previous data and experience, economists, would if they had they been able to forecast the 'double dip' recession experienced for the last nine months, have predicted a rise in unemployment to at least 3 million.
Curiously, employment statistics indicate that some 500,000 jobs have been created in the last year. Indeed, some 212,000 jobs have been created in the latest quarter alone.
Given that youth unemployment was down by 50,000 in the three months to August the underlying narrative is good.
The trouble is, once you start unpicking the data different stories emerge.
Given the importance that is attached to increasing GDP through increased spending, it is to be noted that many of the jobs created in the last quarter are not full time and certainly not well paid though I fully accept any reduction in the benefit headcount is good for the country economically and beneficial for the individually emotionally.
It is important to look at the sort of jobs being created.
For example, of the 212,000 created in the last quarter, roughly a third are what is known as 'mini-jobs' which result in the person being employed for less than 15 hours a week. And over half of the 212,000 (54%) require the person for less than 30 hours a week.
Interestingly, it seems, the Olympics may have played a part in the reduction in employment.
According to Scott Corfe of the Centre for Economics and Business Research, half of the jobs created in the last quarter were in London and he notes that the decrease in claimants in the six boroughs that hosted Olympic events was twice that which had no involvement in the games.
What is also very significant is that we are seeing a shift in the way people are employed. In the twelve months those working part-time is now 8.1 million; an increase of 353,000.
This may represent a significant alteration to our working preferences and align with patterns that are better suited to differing lifestyles.
However, it is estimated that about a fifth of part time workers, over one and a half million people, do so simply because they cannot find full time employment.
This can be looked at as being a mixed blessing. It means that many organisations are shifting to a flexible labour workforce to deal with fluctuations which avoids the need for redundancy.
Correspondingly, though, it depresses pay levels which reduces aggregate demand through reduced spending power.
Inflation is always a curse for those on low income.
Therefore, the recent announcement that inflation is reducing will undoubtedly be welcome news to people who real spending power has been significantly diminished in the last few years.
There are many who would advise George Osborne to alter his strategy of austerity. We know only too well that public investment in infrastructure is not only good for jobs, particularly in the construction sector, but that it creates the so called 'multiplier effect' as the money flows through the economy.
Indeed, the recent announcement by the IMF that it believes effectiveness of the multiplier has been underestimated and could potentially be as high as 1.7 suggests that any public investment is hugely beneficial to the economy.
Equally crucially, investing in the infrastructure is absolutely essential if we are to create an economy that is forward-looking and capable of matching the other emergent countries that we will be competing against.
Anyone who analyses infrastructure spending in China, for example, will be amazed at the amount that is being spent and the sheer audacity of their ambition; though probably not at their disregard of the wider impact on society.
In his recent BBC2 television programmes, Evan Davis examined the history of infrastructure construction in this country and showed that we have unrivalled experience and expertise.
As George Osborne might ask, how can I find money in such projects when I am trying to reduce overall public spending?
The riposte to that is that who else will invest?
Whilst I would happily accept that there are historical examples of private sector investment, particularly the early lines on the London Underground (see Christian Wolmar's excellent book The Subterranean Railway: How the London Underground Was Built and How it Changed the City Forever, Atlantic Books, 2005), this is largely not happening.
We need the government to take the lead.
There are a number of economists who believe that George Osborne has some latitude to alter his belief that austerity is the only 'medicine' that will work.
The assumption is that the chancellor has zero chances of meeting his fiscal targets for 2012/12. However, the need to maintain growth means he should feel liberated.
Martin Beck of Capital Economics believes that public borrowing for 2012/13 will exceed the OBR's prediction of £120billion by about £7billion.
As a result Beck contends, Osborne may be 'compelled to alter his fiscal rules' when he makes his autumn statement in December.
Writing in Sunday's Observer, William Keegan argues that though the current cutbacks are not the cause of problems, they are making the situation worse than it needs to be; a view increasingly shared by all many influential economists and the IMF.
As Keegan makes plain, it was the financial crisis that caused the problems we are experiencing but which are being 'aggravated' by higher prices for oil and other essential.
Having attended a recent discussion at the houses of Parliament involving Professor Paul Krugman, Jonathan Portes (director of the National Institute of Economic and Social Research), Stephen King, chief economist at HSBC, and Bridget Rosewell, chair of the consultancy Volterra Partners, Keegan provides interesting arguments of the for and against austerity as the way forward.
King and Rosewell, who are advocates of austerity, use the fact that "taking public and private debt together", debt in the UK is 250% of GDP of which the public sector accounts for 80%.
Keegan believes that this figure is "not especially high by historical standards."
Indeed, he quotes from Krugman who has coauthored a paper with Professor Richard Layard of the London School of Economics, 'Manifesto for Economic Sense' in which they argue that the current crisis was the result of "excessive private sector borrowing and lending, including by over-leveraged banks."
In their paper Krugman and Layard state their belief that stagnation has created the fiscal debt and increased austerity to reduce them can only result in a further slowing down of economic recovery.
The consequence of the madness, they stress, caused the financial bubble to burst has been the reductions in output, spending and, most significantly for Osborne, a serious decline in tax revenue:
"Thus to add the public and private sector figures together is pushing things a bit, because the rise in the public sector debt has been necessary to offset the deleterious effects of the financial crisis."
Significantly, Keegan points out, though Krugman acknowledges the need to reduce government deficit "eventually", he believes that the current climate has caused 'deleveraging' in which everyone cuts back, including those who do not have excessive debt.
This makes a bad situation worse.
We are in a vortex of decline in which Krugman asserts governments have a responsibility to use their ability to invest as the private sector reduces its willingness to do so:
"The tragedy is that each player is trying to do what makes sense, but this is collectively disastrous. This is why we have governments: to serve as a stabilising force."
What is worrying is that to quote the 1970s track by Bachman Turner Overdrive, 'you ain't seen nothing yet.'
The government has declared that it intends to radically reduce spending in the next five years.
What this will achieve is that we move from a position of being equal to Germany in 2009 to being committed to less spending than the US (which is noted for its parsimony on public spending), by 2017.
If this occurs, we will potentially have the smallest public sector of any other major developed nation.
Some might see that this is good as it will reduce the influence of what is seen as the bloated public sector with its indolent workers who enjoy pampered terms and conditions and can look forward to 'gold-plated' pensions.
Those supporting the radical slimming down of the public sector might also argue that it will create a climate of in which dynamic capitalism and entrepreneurship is stimulated.
An alternative might view could be offered in which the trend in employment noted already continues.
Namely that jobs are increasingly offered on a short-term basis providing low pay, lack of opportunity and which present little incentive to advance in either career or on the fabled 'housing ladder'.
I believe that it is legitimate to ask what the consequences of sustained austerity will have on the future; particularly the next generation?
So, back to the future and more especially the ability of economists in providing us with accurate predictions.
Classical economists will continue to argue that their mathematically-based models are the only way to understand markets and economic cycles.
Increasingly, there are many who contend that we need a better way to understand economic cycles and that it is imperative that we develop understanding to avoid another global financial catastrophe.
As Eric Beinhocker, executive director of Oxford's Institute for New Economic Thinking, believes, we need a radical "rethink" to appreciate the profound impact of one part of the economic system on the broader economy.
"Before the crisis, few economists would have predicted that trouble in an obscure corner of the US mortgage market could cascade into a global calamity."
He argues that there is lots of work going on to address these shortcomings, but "some advocate tweaking existing models, while others feel a more radical rethink is needed."
Another critic of austerity is Jonathan Portes the director of the National Institute for Economic and Social Research. He believes that we need more focus through microeconomics, what happens at the level of individuals and firms.
Portes suggests that the current crisis doesn't really tell us much about the "fundamental underpinnings of microeconomics." The big failing, he explains, is that economists assumed that finance worked just like any other market.
"When it came to financial companies, it turned out we needed to think about them completely differently. More markets are not necessarily better."
Significantly, Portes contends that economists need to recognise that their models are fallible and to better appreciate the way things really work by getting out into industry and society to see the real effects of what they profess to know so much about.
Lord Skidelsky, the economic historian and biographer of John Maynard Keynes, argues that economics should be cognisant of the fact that markets do not exist independently of human intervention; quite the opposite:
"It may be that there's no perfect model, and that the quest for one is an error. Maybe we need different models, different theories, for different situations, and that's the best we can do. Keynes said economics was a moral science, not a natural science - by which I mean that it has to take into account the variability of human situations."
What this tells us is that 'pure' economics may assist in some understanding but can never tell us the complete answers as to what will happen in the future.
Perhaps, like Marty McFly in Back to the Future, I need to find someone like scientist Emmett "Doc" Brown, who can build me a time machine.
Before that happens, we are left with the variety of views as to what will really happen to the economy in the next few years.
In the meantime, though, I remain cautious about making predictions, and given the proposed vast reduction in government spending over the next few years, I do worry about the long-term health of the UK economy.
I mentioned the effect of using the multiplier and that fact the IMF now believe it to be far more powerful than previously thought.
However, if the the multiplier works in one direction it also has an effect in reverse.
Consequently, austerity by which government spending is reduced may therefore cause far more damage through the impact in reduced aggregate consumption than would have previously be contemplated.
Austerity has the potential to create levels of misery not seen for many generations and may potentially cause an even greater chasm between the 'haves', who control wealth, and the 'have nots' whose ability and aspirations will be even more severely diminished than they already are.
Do we really want to become more like America?
This is not the way to create a better society in which there is equality of opportunity.