Saturday 31 May 2014

European Union: the 2-in-1 Nobel Prize

We are in Europe in 1945. The second world war just ended. And the question in many peoples' minds is: since, let's say, the beginning of the renaissance in the XV century, how many 50-year periods of peace did we have in Europe? How many 25-year periods?

The answers are: zero. And zero.

How comes that the highly civilized Europe is constantly at war? How can we stop the recurrent suffering, destruction and losses?

The answer to the last question was a visionary strategy:

1. Create a strong economic interdependence between the European countries and give them free access to each others markets, i.e., free movement of goods & services and capital within Europe

2. Create the conditions for ordinary Europeans to get to know and regularly interact with each other, i.e., allow for free movement of people and labour within Europe

3. Allow membership to the "club" only to fully democratic countries and create supra-national decision making bodies on which all member-countries are represented and have veto rights on strategic decisions

The strategy was compelling because it was based on very sound logic:

a) By creating a large common European market the economic incentives for territorial expansion and disputes, which are at the origin of all wars - even when the official motives and "selling points" are others - were eliminated. Why start a war with a neighbouring country to expand your internal market and have access to additional resources if you have free access to that market and resources, under the same rules and conditions that apply in your original home market anyway? With a large common market, the national economic elites stopped having any kind of incentive to finance wars. Why would they be willing to finance a war with a neighbouring country when they have subsidiary companies, suppliers and clients in that country - on whom they depend on and with whom they have very close relationships - which are subject to the same rules and regulation as the ones applying in the home country? "Lebensraum"-type nonsense arguments stopped having any persuasive power to the economic elite. And without the backing of an important part of the economic elite, the chances of a country going to war are slim

b) By creating the conditions and incentives for ordinary Europeans from different nationalities to interact and get to know each other better, by travelling to, studying and working in different countries, effectively what was being created were the conditions for European citizens to realise, based on personal experience, that there is much more that unities than separates them. Once this is achieved, and cross-country personal friendships exist, the chances of a significant part of the general population supporting a war against a neighbouring country disappear

c) By imposing that all member countries of the "club" were democracies, a compliance of political decisions with the populations majority view was made more likely. By creating supra-national decision-making bodies, continuous interaction, debate and collaboration between national governments became mandatory. Interaction, debate and collaboration identify common interests, solve differences and create trust. Trust - the key to avoid wars: you will not go to war with someone you trust.

Not less important: by only allowing fully democratic countries into the "club", internal political stability in each member-country was massively enhanced. Military coups d'etat became an almost impossibility. For a coup d'etat to take place, its leaders must be able to deliver an improvement in living standards for significant parts of the population in the short-term - or at least a "realistic illusion" that an improvement can be delivered. Otherwise, the new regime will quickly collapse. Given that a coup d'etat would lead to a member country being expelled from the "club", and its economic / trading ties with its main economic partners cut-off, no short-term improvement or "illusion" of improvement could be delivered for a significant part of the population as a result of one. And the economic elites, highly integrated into the "club's" economic space, would be the first to suffer. No support from a significant part of the economic elite, no support from a significant part of the general population, means no coup d'etat.

Finally, a prosperous and peaceful "club" of sovereign states would act as an attracting force for countries living under dictatorships. And the hope of belonging to the "club" and enjoying its benefits provide an anchor of social stability in the transition phase to democracy.

The result of the visionary strategy as we all know was the construction of the European Union, kicked-off with the signature of the Treaty of Rome in 1957.

- How many wars did we have among European Union member states since 1945? Z-e-r-o.

- How many coups d'etat in European Union member states since 1945? Z-e-r-o.

- How can the peaceful transition in the former east European communist countries, now EU members, be explained - when there were so many from the former ruling communist elite set to lose their power and privileges - but for the expectation that the integration in the EU would open many new opportunities for everyone that more than offset the losses?

However you look at it, almost 70 years of peace among EU-member countries - something never experienced before - is indeed a spectacular achievement at all levels. And surely generated a massive economic "peace dividend". How much is it worth? To answer the question we just have to answer the following underlying questions: how much higher is today's EU's GDP (remember: GDP is an annual concept. Whatever the benefit, it occurs year after year after year) as a result of the EU

- having a much larger population vs. what it would have if recurrent wars had continued to happen?
- a healthier population?
- a better educated population?
- a longer working population?
- no destruction of infrastructure?
- more resources being channelled to education, R&D and leading to higher productivity?

Here a quick of the envelope calculation:

- Over 2% of European Union's member countries population was killed during the the first as well as second world war. Taking into account that the overwhelming majority of those killed was part of the labour force and assuming a labour force participation rate of 65%, this accounts for circa 3% of annual GDP

- Given that the vast majority of those who died were young adults and therefore the main source for future productivity enhancements and innovation, it is reasonable to add 50% to the 3%. This leaves us at 4.5% of GDP

- If we add those who suffered war injuries and became permanently (to a less or larger extend) handicapped, less productive and with a shorter working life, it is surely reasonable to double the 4.5% to 9%.

- If we add (i) the benefits of not having to regularly channel resources to rebuild destroyed infrastructure, care for the handicapped and have more of the available resources being channeled to education, R&D, productive investments, (ii) the benefits of a faster and more sustainable accumulation of human capital and (iii) the benefits of a long-term oriented mindset, stable institutional framework and investment projects that will only be pursued, and whose fruits can only be fully reaped, if regular recurrences of war are highly unlikely to occur, what will happen to the 9%? Will they double or triple?

In short: saying that the European Union's annual GDP is 20%-25% higher as a result of the "peace dividend" it created is a perfectly sound statement to make.

And finally: how much is a saved human life worth?

On the other side of the balance, how much does the EU generated "peace dividend" cost us? The answer is: the "monstrous" European Union budget accounts for 1% of European Union's annual GDP. Seriously. It's really just ONE percent! (By the way, the "infamous" Brussels- and Strasbourg-based EU bureaucrats' share of that is 6%, i.e., 0.06% of EU's GDP)

The conclusion of all this is therefore pretty straightforward: those who have criticised the Nobel committee for awarding the Peace Nobel Prize to the Europen Union in 2013 were right in doing so. The European Union should have been awarded two Nobel Prizes instead: Peace and Economics.



PS As an European Union citizen living in London, what can I say about masterpiece Nigel Farage (UKIP's leader)? As usual, my respect and admiration for British pragmatism and humour is endless: British people keep sending to the European parliament someone they never wanted to elect to their own national parliament. Well done - noisy troublemakers are always best dealt with by sending them away.

Sunday 11 May 2014

Piketty: right or wrong?

In his book "Capitalism in the Twenty-first Century", Thomas Piketty claims that capitalism has an embedded inequality feature. If not corrected by government intervention, a socially unsustainable level of inequality will be reached, putting not only democracy at risk but eventually leading to the collapse of capitalism.

Marx had argued something similar in the second half of the XIX century. He was proven wrong. Does it mean that Piketty is wrong as well?

He is wrong and right:

1. Piketty is wrong

His assumption that r > g, can't hold true in the long-run (note: r = return on capital; g = economic growth) unless the savings rate is zero and the capital stock stays constant over time (meaning: all income from both capital and labour would be spent on consumption), which in a society with a high concentration of wealth can't be the case - capital owners will save and reinvest part of their capital income leading to an increasing stock of capital.

Keeping in mind that GDP is the sum of the production factors' remuneration - remuneration of capital (including remuneration of land) and remuneration of labour - let's assume (an extreme example, but in-corrections are always easier to detect at the extremes) that

g = 0

and

r > g
(with part of the income from capital being saved and reinvested leading to a continuous increase in the stock of capital).

This would mean that the share of the remuneration of capital in GDP would increase steadily over time until it reached 100%, leading to a 100% unemployment rate in the long-run. Put differently: all the productivity gains - generated by the increase in the stock of capital (e.g. investment in technology) - would be passed entirely to the owners of capital, who would save and reinvest them and keep substituting labour with capital, people with robots, until there were no more people to be substituted (let's forget for an instance that capital can never fully substitute labour).

This is not possible.

Way before we reached "full unemployment", either

(A) a social revolt would take place and capital start to be massively taxed bringing r down and leading to r = g (with g increasing above 0 as the additional taxes would be transferred directly or indirectly to labour leading to an increase in private consumption, aggregate demand and GDP. I.e. taxation would pass part of the productivity gains to labour)

or

(B) the productivity gains would have to be directly passed to a large extent to labour. Meaning: reduced working hours / reduced working week (e.g. 4 day work week) / more holidays for employees while keeping their salaries untouched. This would keep the share of the remuneration of labour in GDP constant and, obviously, the share of the remuneration of capital in GDP constant as well. As GDP remained constant (g=0), so would the total absolute remuneration of capital. But as r > g implies an increase in the stock of capital (part of the remuneration of capital is saved), this would result in a decrease of r until it converged progressively to g.

Yes, the law of diminishing marginal returns is like gravity: we may not notice it, but it does exist.


2. Piketty is right

Given that

i) in the long-run we are all death

ii) (A) is surely not a scenario we want to go through while alive

iii) (B) won't happen easily and fast enough on its own

we can't sit on our hands and wait that g converges to r. Otherwise, (A) will happen. And rightly so.

So, the government must act. By taxing income above USD 500k at 80%? No, the Laffer curve with income tax rates above 50% stops being Hollywood fiction to become reality, i.e., bad for growth. With an up to 10% global wealth tax? Not really a good idea. To start with, because it would never be complied with on a global scale.

What to do then? This:

1. Broaden the ownership of capital via government top-ups of pension funds and savings accounts

2. Reform the tax system to one more tilted towards a very progressive income tax instead of indirect taxation to avoid that a large, socially disruptive inequality develops in the first place.

3. More public spending on high quality education and R&D. Education is the best tool to ensure social mobility. Education and R&D combined an effective way to generate sustainable economic growth.

4. Limit the leverage in the financial system. Big capital owners are the ones that have access to large scale financing as they have the resources to put up as collateral. Nothing wrong with this, as long as the financing is used for productivity enhancing activities. However, to a large extend that's not the case and the financing ends up being used for highly leveraged, highly risky financial bets with limited positive impact on the economy's overall productivity. Then again: even this would be perfectly legitimate if when the bets went wrong - pushing their returns over the entire economic cycle down to mediocre levels - the ones pursuing them were held accountable for their mistakes. It would reduce their willingness to pursue them in the first place. Sadly however, and as we all know, when large scale systemic accidents occur, the taxpayer foots the bill - not the ones that freely took the decision to pursue the bets. Thus, creating the incentives for a large scale mis-allocation of resources in the first place. By forcing banks to have much higher equity buffers we would limit the financial leverage in the system and end up with a financial sector both more resilient as well as a more efficient allocator of financial resources to the economy. Productivity would benefit. Sustainable economic growth would be higher and so would be living standards. Socially disruptive inequality contained.

5. Making sure that a fair share of productivity gains is transferred to labour. Besides being able to pursue other interest outside work from which the whole community benefits (any hidden Shakespeares or Picassos out there?), employees with more leisure time and cash in their pockets are a nice source of consumption and aggregate demand. And therefore a positive contribution to g, making the convergence r = g happen at a higher level. And everyone happy.

6. Remember that population aging is a demographic variable. But pension age is not - it is a political one. Raising the pension age is unavoidable if our developed world welfare systems are to remain sustainable. With part of the productivity gains being transferred to labour, it will be easier to persuade employees to accept later retirement: why not work 4 days a week until 75 years of age instead of working 5 days a week until 65? The alternative is to continue to retire at 65 and transfer all the productivity gains, via taxation, to the "young" pensioners to keep the welfare system afloat. You choose.

By the way, transfer of productivity gains to labour and related higher employee remuneration, reduced working hours and increased leisure is what happened since the XIX century in the developed world. It created a broad middle class and proved Marx's prediction of capitalism's collapse wrong.

Piketty may not be right in everything he says, but the inequality debate and its impact on social stability and consequently on sustainable economic growth and general living standards was overdue. Once we understand that the market does, in general, a great job in allocating scarce resources efficiently and is therefore a fantastic wealth creation mechanism, but that it is not able to ensure on its own a socially sustainable distribution of the wealth created putting thus at risk its very and precious existence, the advise can only be one inspired by Henry Ford:

Capitalists of the developed world, unite! Let's bring on the 4-day working week and prove Marx wrong again.


PS Why Henry Ford is a true master of capitalism and source of inspiration:
http://www.history.com/this-day-in-history/ford-factory-workers-get-40-hour-week