Brexit

The ECEES meeting today discussed the consequences of the UK leaving the European Union (Brexit). Half a year ago, the odds of Brexit were slim. However, due to events such as the migration crisis, public opinion is shifting in favour of a withdrawal from the EU. Recent surveys suggest that a majority of Britons want to leave the EU.

Personally, I believe that Brexit would not be beneficial for the economy. Firstly, it would negatively impact trade. At the moment, the EU is a key trading partner for Britain. Half of British exports are consumed by the EU. John Springford of the Centre for European Reform reported that Britain's trade with the EU is 55% greater when it is a member of the EU. According to the Eurosceptics, after leaving the EU, Britain could still retain full access to the single market and would be able to sign free-trade deals with countries such as America, China and India. A Tory MP, Owen Paterson claims that EU membership prevents free-trade deals from happening and as a result, trade in Asia is lower than it should be.

But this argument is flawed because if EU membership was such a big problem, why is it that German exports to China are three times larger than Britain's? In addition, post-Brexit Britain would find it difficult to negotiate free-trade deals on its own because it does not have the bargaining strength. This is because half of Britain's exports go to the EU whereas Britain takes less than 10% of the EU's exports. A free-trade deal in goods is negotiable but it would not cover services, including financial services, which take up an increasing share of British exports. Moreover, Britain would be excluded from the Transatlantic Trade and Investment Partnership that is currently being negotiated by America and the EU.

EU membership has also boosted Britain's foreign direct investment (FDI). The past 20 years have seen a sharp increase in FDI and at least some of that can be credited to EU membership. Almost half of Britain's FDI came from the EU. The financial-services industry accounts for half of all FDI into Britain and half of that comes from the EU. Given the broad integration of wholesale financial services across the single market, it is evident that if Brexit were to create any barriers to exports of financial services to other parts of the EU, some of that investment will move. Big banks such as the Goldman Sachs and Deutsche Bank have implied that they might have to move some operations out of London.

Secondly, Eurosceptics oppose EU membership because of its stringent regulations, which is bad for businesses. But once again, this argument is not convincing because the OECD has found that Britain is one of the least regulated countries in Europe (see graph). There is little to suggest that after Brexit, many of the rules would be scrapped. In fact, British lobbyists have been in the forefront of those calling for more regulation in areas such as financial services and the environment. Brexit would probably not change that. Besides, the most costly and inconvenient regulations for businesses come from Britain, not the EU. The Director of the National Institute of Economic and Social Research, Jonathan Portes claimed that strict planning rules and the new living wage proposed by the Tory government is a much bigger interference in the market than all the EU's regulations put together. Other factors such as poor education and infrastructure are bigger obstacles to growth than EU regulation.

Additionally, Britain would have to follow the EU's rules anyway if it wishes to retain full access to the single market. That is the case in Norway and Switzerland, who are both non-members but also have to pay into the EU budget. Norway pays roughly 90% of Britain's net contribution per head. Eurosceptics suggested that the 90% of small British businesses who do not export to the EU should not have to abide by EU regulation. The problem with that is that many of those businesses supply larger businesses that do export to the EU.

Thirdly, there is the issue of migration. A post-Brexit Britain would very likely choose to reduce immigration. Currently, it is not able to block the free movement of people from the EU as an EU member and migration from that region makes up half the British inflow. However, most economists and businesses agree that migration is more beneficial than harmful. The number of EU migrants is around 1.8 to 1.9 million, which is roughly the same as that of Britons living in the EU. But many of the British are retired and impose health-care costs on their hosts. On the other hand, EU workers in Britain are young and they pay more taxes than they consume in benefits. Reducing migration between Britain and the EU would result in a net cost on the economy.

Lastly, Eurosceptics claim that Britain should leave because it is frequently outvoted on policy and has a weak influence in Brussels. Yet at the same time they argue that since post-Brexit Britain is the world's fifth- or sixth- biggest economy, it would be able to punch well above its weight internationally and negotiate favourable deals worldwide, including with the EU it had just voted to leave.

Overall, the Eurosceptic arguments are riddled with contradictions. The political fallout after Brexit would be immense. Cameron would have to resign and be replaced with a more Eurosceptic leader. The first minister in Scotland made it clear that she will seek a vote for independence and she would probably win. With the prospect of the potential breakup of the United Kingdom coupled with negative economic effects, an In vote is obviously a more favourable outcome.

Volkswagen's scandal and the car industry

During the first meeting of the Economics and Enterprise Society, we discussed the recent scandal that has engulfed Volkswagen (VW).

The German carmaker was found to have installed hidden software on 11 million of its diesel cars worldwide in order for them to pass America's strict nitrogen oxide emissions test. But after passing the test, the software would deactivate their emission controls, causing them to spew up fumes at up to 40 times the permitted level. As the authorities investigate the matter further, it is probable that this could provoke a wider range of claims about emissions and fuel efficiency. This could, therefore be a blow to much of the industry that might be large enough to reshape it. This scandal will affect other car producers, other countries and potentially the future of diesel itself.

The chief executive of VW, Martin Winterkorn has stepped down and the company is setting aside €6.5 billion to cover the coming financial hit. Regardless of whether Winterkorn was personally involved in the scandal or not, it was appropriate that he should lose his job over it. This is because he is an engineer renown for his attention to detail. He should have known that this was going on. The sale of 'Clean Diesels' was at the heart of VW's plan to crack the American market, which in turn was part of the strategy to surpass Toyota as the world's largest carmakers. Winterkorn's grand plan is now in ruins. Besides that, VW's share prices have fallen by one-third (see chart) in the first four trading days since the scandal broke out on September 18th, cutting its value by €26 billion. America's Department of Justice decided to conduct a criminal investigation into the company, and rightly so. Other countries should follow South Korea and investigate what VW has been up to on their patch.

A change at the top and a large fine must not be the end of the matter. The prosecutors in America should chase those responsible for corporate crimes, instead of only punishing the companies' shareholders by imposing huge fines. Earlier this month, the Department of Justice made public a $900 million settlement with GM, the largest carmaker in America, because they didn't recall cars with an ignition-switch defect that caused crashes which killed at least 124 people and injured 275. Prosecutors claimed that the managers had put profit before safety and ignored the defect. Despite this, they announced no charges. Luckily, American authorities recognise that this needs to change. Sally Yates, America's deputy attorney-general, said that from now pursuing criminal and civil charges against individuals would take priority over fining businesses.

Yet the effects of the scandal will be most felt in Europe. VW's mischievousness raises the question of whether other carmakers have been up to similar tricks. Carmakers such as Mercedes and BMW insist they have not. However, the emissions testing system in Europe is a joke. Carmakers can commission their own tests and regulators allow them to do things like removing side mirrors during testing and taping the cracks around doors and windows to minimise drag and make the cars burn less fuel. Regulators also tolerate software similar to VW's that detects when a car is being tested and goes into "economy" mode.

At least unlike Europe, America's regulators perform their own tests to confirm the carmaker's findings. But with outrage at its peak, this is the moment to act. The system should be replaced with independent testing in driving conditions that are realistic. European regulators must change their attitude to diesel, which is what half of the cars sold in Europe runs on. The problem with diesel is that although it can be economical on fuel (therefore less carbon dioxide), the trade-off is that nitrogen oxide emissions will increase. That trade-off has been decided in diesel's favour by Europe's poor testing system and more lenient standard of nitrogen oxide emission.

Even if other makers of diesel cars did not get involved in the same scandal as VW, the scandal could mean that diesel cars will find it difficult to reach standards applied rigorously to both carbon dioxide and nitrogen oxide emissions. There are those who claim that this may be the "death of diesel". But there is still scope to switch to clean-energy cars that run on electricity, methane, hydrogen or are hybrids. A multi-billion-dollar race is under way between these various technologies. VW's scandal may finally lead to the beginning of the age of the electric car.

An analysis of the budget

According to George Osborne, Britain had the fastest growth rate compared to the other economies in the G7 in 2014. He boasted that the rate of employment was at an all time high at 73%. Inflation has been reduced primarily because of the falling oil prices and this will have the effect of ending a seven-year stretch of a drop in real wages. Other than that, the government is saving money on inflation-linked debt interest payments and on benefits, which are linked to prices. Due to the fact that the UK largely imports oil, domestic tax receipts have not been affected.

This means that Mr Osborne is nearing his goal of closing the deficit. When the coalition came to power in 2010, the Conservatives argued that Britain's structural budget of 9% of GDP was a danger to the economy and vowed to close it. Along with the Liberal Democrats, they undertook austerity measures which saw a fifth of departmental budgets being cut.

The euro zone crisis and an economic slump in Britain resulted in the chancellor discarding his plan of closing the structural deficit by 2015. The date has been pushed to 2018 instead. And there was some good news on that score. Britain's fiscal watchdog, the Office for Budget Responsibility (OBR) revised down its prediction for borrowing by £1 billion- 2 billion a year for most of the next parliament. The national debt as a proportion of GDP would come down in 2015-16. Mr Osborne was adamant that this budget was fully funded.

His policy announcements can confirm this but the same cannot be said about his plans for total spending. The chancellor plans on making deep cuts to public spending for the next two years. This is deeper than any annual cuts under the coalition government. The cuts will enable him to keep his promise of balancing the budget to achieve a surplus in 2018-19.

However, on Mr Osborne's new plan, daily departmental spending would rise by £24 billion in the last year of the next government (the biggest increase in ten years). In cash terms, this totally goes against the prior consolidation even though growth ensures the books still balance. Taking into account economic growth would mean that departmental spending would be 9% higher at £31 billion. This could also mean cuts that are ultimately only about half as bad as they were facing before Mr Osborne for departments outside the protective ring-fence consisting of the NHS, schools and international aid.

This is a ruse but overall good politics. The chancellor had implied in the autumn statement in December that he planned to reduce public spending to 35% of GDP by the end of the next government, the lowest since the 1930s. The Labour party pounced on that opportunity, accusing Mr Osborne of undoing the post-war welfare state. This was effective when applied to man from a well-to-do background but his plan appears to have deflected that.

The budget was more than just deception because most Britons will benefit from an increase in the amount earned before paying taxes. It will be raised to £10, 800 in 2016-17 and £11, 000 the next year, adding £80 to most pay packets. This was a popular Liberal Democrat idea. The Tories and the Lib Dems promised to raise it to £12, 500 if re-elected, which would mean that those on minimum wage would not have to pay tax at all. But the threshold is already so high that according to the Institute of Fiscal Studies (a think-tank), the poorest fifth of workers did not have to pay income tax in 2014. The latest rise benefits the middle and high income earners more than lower ones.

Besides that, the chancellor announced more sweeteners. Those saving for their first home will receive subsidies of up to £3000 each. But increasing demand without supply will cause prices to rise, benefitting homeowners the most. Other plans include a tax reduction for the North Sea oil industry (the only section of the economy to have suffered because of the falling oil prices) and a plan to devolve more tax revenue to Manchester. This would be paid for by three sources of revenue: a clampdown on tax avoidance, higher taxes on banks (these two are bound to be popular) and lower tax subsidies for huge pension pots (Labour announced this policy just weeks ago).

On the whole, the budget was an odd mix. The chancellor aimed to show responsibility by ensuring that his pre-election plans are fully funded. On the other hand, his plan will sacrifice credibility for political advantage. He formed the OBR to prevent chancellors from manipulating the growth forecasts but he has now demonstrated that the spending figures can be tampered with.

The upcoming annual budget

After the financial crisis, the Conservative-Liberal Democrat coalition formulated a plan for the British economy and stood its ground. It was intended to see unemployment plummet and rapid growth that will put Britain ahead of other big rich countries in 2014.

The 18th of March marks the day the chancellor of the exchequer, George Osborne gives his budget speech less than two months before a general election that is more likely than not to centre around the economy. He is sure to mention the words "long-term economic plan" to assert his devotion to a fiscal surplus for Britain by 2018-19. However, the sad truth is that Mr. Osborne derived his successes from abandoning his original goals rather than sticking to them. Next week, unless his budget plans are more suitable, Britain could end up paying a heavy price.

Undoubtedly, with Mr. Osborne as chancellor, the government has done reasonable things such as reducing corporation tax, increasing the income-tax threshold and hiring Mark Carney from Canada to be the governor of the Bank of England. But it operated at its best during times when it has been least consistent in three main areas.

The first is fiscal policy. In 2010, the Tories promised to get rid of nearly all of Britain's structural deficit by the end of their term, which was estimated to be at 8.7% of GDP. Currently, the coalition is only half-way there. The amount of borrowing this year would likely amount to be 5% of GDP or £90 billion. This is £55 billion higher than originally planned. The chancellor pushed back his deadline for closing the deficit in light of two years of weak growth, due to austerity measures and a European slump. This change was needed. Following the plan would mean higher taxes or larger cuts to public spending or both. It would likely result in the economy going back into a recession and might have destroyed public services. As it is, Britain has managed with deep but steady cuts. The crime level is down and the sky has not fallen on the NHS or local government.

The second change of plans was also welcome. Previously, the coalition government followed the previous Labour government's plan of reducing capital budgets and so public investment (the easiest one to cut quickly) fell by 35%. That was a bad idea. Spending on infrastructure is crucial in ensuring long-term growth and is chronically low in Britain. Luckily, Mr. Osborne changed this starting in 2011 and once again, his change of heart was good.

The best change of course was the biggest and also the most embarrassing. Prior to becoming prime minister, David Cameron vowed to decrease the annual net migration down to the "tens of thousands". Despite this, the latest figure for net migration was at a staggering 298,000 and counting. But because immigrants are young, healthy, diligent and enterprising, they have raised growth and boosted tax revenue. A huge decline would have costed the economy because GDP has increased by 7.8% under the coalition government and GDP per person has risen by only 4.2%.

Some might say that the inconsistencies of the government are long gone or that doing the right thing is more important than saying it. But plans focus the mind and Mr. Osborne is in danger of focusing minds on the wrong matter. Britain's biggest concern is the low productivity growth, not the deficit. This has resulted in output per hour being 2% below its peak in 2008. It is probable that Mr. Osborne is aware of that and he may shift priorities later. But that might not be likely because U-turns reflect badly on the government, which means that plans have a tendency to last for too long. The best course of action is to form a plan for productivity and stick to it.

The limitations of voters in choosing economic policies

The decision about whether to modify Greece's bail-out has sparked claims about a lack of democracy. It is said that Greece's creditors are overriding the electoral mandate of the Syriza party.

In reality, voters have always faced constraints on their freedom to choose the economic policies they want. They have a limited ability to pursue redistribution of income by taxing the minority i.e. high income earners because there is a point at which higher taxes lead to lower revenues as effort is discouraged. We do not know the point at which this occurs but considering how we are now living in an era of mobile people and firms, the threshold might be lower than it used to be. Furthermore, when countries rely on international creditors for finance, they have no control over the terms on which they borrow and they cannot coerce creditors to roll over their debts. Although there is nothing stopping countries from defaulting on their debts, in the short-term default would probably lead to budgetary restrictions. Voters may end up with austerity after all.

As electorates evolved over time, economic regimes followed suit. The Depression in 1945 resulted in most governments implementing Keynesian demand management by allowing deficits to grow to avoid recession. However, the policy stopped working in the mid-1970s because of simultaneous high inflation and unemployment, also known as stagflation. The policy regime was blamed because politicians decided to set interest rates to gain electoral advantage and this caused inflation to rise. After that, central banks started controlling economic policy by using interest rates to manage the cycle. They soon became unpopular when inflation was being squeezed out of the system in the late 1970s and early 1980s. This changed when inflation declined and interest rates fell and were thought of as the 'great moderation' of low inflation and steady economic growth.

This shift was a clear deviation from democratic control of economic policy. Even though governments still dictate the mandate of the central banks and appoint the people in charge, voters who disagree with the policies of Janet Yellen and Mario Draghi (the two most prominent economic decision makers in America and Europe) cannot get rid of them. The importance of central bankers has been reinforced after the financial crisis in 2009. During that time, most politicians were not willing and able to provide fiscal stimulus. On the other hand, central banks could both deliver monetary stimulus and buy government bonds through quantitative easing (QE), which made it easier to finance deficits. Also, it appeared to run smoothly because hyperinflation was avoided, going against predictions.

However, those in Europe who voted for the single currency do not have a local central bank. The European Central Bank has only just started QE and of course, such countries have not devalued their currencies as they were unable to (a move that put Iceland on the road to recovery). Critics claimed that the single currency should not have been created without political or fiscal union. Greeks may not like the European superstate that could easily make big fiscal transfers. They might be just as powerless as how they are when negotiating with their creditors. The weight that Greece has in a euro-zone electorate is very small.

This leads on to an even bigger problem. Politicians gain power on the basis of their economic promises to their domestic electorates. But the deciding factor of whether their economies will prosper is the state of global economies, not local e.g. whether China's economy will do well or what the oil prices are like, etc. National politicians will still take the blame for the effects of those things despite it being out of their control. This will further strengthen the cynicism of voters about politics and damage the support for democracy.

The dangers of deflation

The government's target for inflation is 2%. Today, prices are falling at a rate that is below the target everywhere. This even applies to countries growing at more than 2% such as America, Britain and Canada. Inflation in China is at 0.8% and Japan's 2.4% rate is predicted to fall as it slips back into deflation. Thailand is already there. In the 1980s, countries in the euro zone had a high rate of inflation. For example, in Italy, prices rose at an average rate of 11% while in Greece the rate was 20%. Currently, 15 out of its 19 members are in deflation and the highest inflation rate is in Austria at 1%. This might seem like a good thing because goods and services become more affordable to consumers. However, the world is seriously underestimating the consequences of deflation.

The reason why it is a problem is because aggregate prices are dipping in so many places at once. Deflation is affecting a wide range of goods other than food and energy as well as countries that cannot claim to be leading the charge towards the new economy. This appears to be a sign of entrenched weak demand. Besides that, consumers will put off spending hoping that prices will fall even more in the future, further decreasing demand. Also, if prices fall but wages do not, it will increase the cost of production for firms and may lead to a decline or a stagnation in employment. Another risk is debt deflation. This means the value of debt will rise because the amount that is owed remains the same even if earnings fall. This is an especially big issue in the euro zone where many banks are already stuffed with dud loans.

The most severe danger is the fact that it is already here. Deflation makes it more difficult to loosen monetary policy. When inflation is at 4%, the central bank can take real interest rates below zero, to -4% by retaining headline rates at zero. But as inflation falls and turns negative, low real interest rates get harder and harder to achieve- just when you need them most. Most rich-world central banks have reduced their main policy rates close to zero to increase demand. The use of negative interest rates in a growing number of European economies to encourage spending will backfire as charging consumers to save in banks will eventually prompt them to use the mattress instead.

This means that policymakers have little room for manoeuvre when the next recession hits, which will happen in due course. It may be caused by China's slowdown in growth, or from the effect of a rising greenback on dollar-denominated corporate debt, or possibly from a random shock. In America, the Federal Reserve reduced interest rates by 3.9 percentage points on average in the six recessions since 1971. That move would not be possible today. The emergency measure of depreciating the currency drastically against a fast-growing trading partner would also not work because not many economies are growing rapidly and prices are falling, or close to it, in so many places.

Policymakers should take this problem more seriously and take bolder action to avoid deflation. Governments ought to increase spending on infrastructure to boost demand. The central banks should err on the side of looseness. Perhaps it is time to change the central banker's target for interest rates from the inflation rate to a goal for the level of nominal GDP. With this kind of target there would be no need to differentiate between good and bad price shocks. This would also send the message that policymakers are serious about getting rid of deflation.

On the other hand, central bankers change course slowly and they are exceptionally loyal to their inflation targets. Their conservative nature often serves them well. However in this case, it could cost the world economy dearly.

The problems with teaching economics

During the financial crisis in 2007-2008, many university students of economics found it difficult to understand what went wrong in the economy and how to fix it. There were brilliant researchers in the top universities who studied financial crises. However, despite this, their work did not get showcased in lectures. Instead, the undergraduate courses mainly focussed on the basic theory that has remained unchanged for decades. 

This had consequences. Aspiring economists were ill-prepared to analyse major economic issues such as quantitative easing, the credit crunch and bank bail-outs. This led to employers complaining that although their employees were able to deal with technical things, they had problems relating it to the real world. In particular, university graduates had weak knowledge of economic history, which was important in making sense of the financial crisis as it had parallels with the Great Depression in the 1930s.

Employers were not the only dissatisfied group. Students were unhappy as well. A London-based student-led group called Rethinking Economics was formed to challenge the conventional wisdom of the classroom. Manchester University experienced a backlash from its students, causing it to have lower student satisfaction scores and as a result, it placed lower on the league tables. 

The good news is that teachers are taking action to tackle this problem. A new curriculum has recently been introduced in University College London. This was the result of Professor Wendy Carlin's project. According to her, "The old textbooks had things the wrong way around. They taught concepts like supply and demand in an abstract way and then illustrated them with simple examples, such as the market for apples and oranges. By contrast, the new material challenges students to consider real-world topics from the outset."

However, although Ms. Carlin has challenged the mainstream teachings, the course still appears to be fairly typical. Rethinking Economics desires a curriculum that teaches the more unorthodox schools of thought. For instance, economic models normally depend on the equilibrium concept but the issue with that is that it does not happen in the real world therefore, it is a bad starting point. They believe that it is better to adopt philosophical discussions about the best approach to economics and sees Leeds, Greenwich and Kingston universities as models of how this can be achieved.

There are two rather different questions that have been presented. The first one asks if university courses are able to educate students with the most important insights from academic research. The second one asks whether students should be more proactive and learn more outside the curriculum. The curriculum deviating radically from the norm will surely be considered an oddity but perhaps mainstream theory must catch up with its students.