How Economics Is Useful in Government?

Article excerpt

THE PRESIDENTIAL ADDRESS FROM THE EBEA ANNUAL CONFERENCE & EXHIBITION - GLASGOW

WHAT IS ECONOMICS?

It is a great pleasure to open this conference and to address teachers of economics about how economics can work in practice. I will concentrate on what I know something about. Economics in Government. But, first, what is economics?

When I was an undergraduate, I was taught that economics was what economists did. Not very helpful you might say - nor much of a guide to life.

A large number of successful men and women, trained in economics, now work in areas that involve some economics but cover finance, politics, business, administration, regulation, consultancy.... Some of them are advisers; many make decisions that, inevitably, include non-economic issues.

They think, however, that their training in economics is helpful to them in doing their jobs - and some of them, including me, try to keep up with (some parts) of the subject through the serious press, book reviews and periodicals such as the Journal of Economic Perspectives and the policy section of the Economic Journal.

There are two, perhaps overlapping, strands in economics as a discipline:

Its theoretical strand. The allocation of scarce resources to competing ends. The emphasis on decisions at the margin. The importance of opportunity cost. That bygones are bygones (most of the time). The role of comparative (not absolute) advantage.

Its empirical strand. The study of mankind's business activities. Economic organisation, Business History, Industry Studies, etc. The effect of taxes and subsidies on business operations. The effect of Government on the economy.

The two strands do not always take together well. Where they do, in the work of the great economists, the effect on the world is electric - Adam Smith, Karl Marx, Maynard Keynes, Milton Friedman. Where there is no overlap, we risk empty theorising or bare institutional facts. The economic adviser, the manager and the administrator may not be operating at the same high level as these great men, but he or she equally needs to twine the two strands together.

Knowledge in economics seems rarely to be cumulative. Economists tackle problems, but the problems twist and turn, reemerging in different guises. So a research programme arises to deal with a set of issues and dies when the issues shift. Keynes was a god to economists of the generation before mine; James Meade used that very word. We can still admire Keynes and still learn from him, there is little point now in asking economists whether they are Keynsians. In the 1980s, people used to claim to be Austrians - whether followers of Schumpeter or Hayek, I was never sure - but it is not much heard in the late 1990s. Are we now lost, looking for some elusive middle way? Or have we not yet recognised the leaders of our decade?

THE JOB OF AN ECONOMIC ADVISER

What are my credentials for talking about how economics can work in Government? I taught economics for seven years and acquired some communicable knowledge of the subject. Teaching can be an important preparation for practice. Ralph Turvey was once asked what was the difference between being a reader in economics at LSE and an economic adviser in the Treasury. In essence, not much, he said, except on the question of who wrote the essays.

I joined the Economic Section of the Treasury, for a two-year spell, half way through those seven years of teaching. I then went back to Government, first - for two years - in the Department of Education & Science (as it was then), next, for three years to the Ministry of Housing and Local Government, soon absorbed into the Department of the Environment (the first incarnation of the Department of the Environment, Transport and the Regions) and then back to the Treasury for a further spell of seventeen years. Six years were spent building up and running a Public Expenditure Economic Unit. For eleven years, I was the Deputy to the Chief Economic Adviser, taking the economic lead on a variety of supply side issues.

In all these Government Departments, I worked as an economic adviser, like other civil servants, as an adviser to Ministers. For the last ten years, I have been in an executive position, independent from Ministers with my own legal duties and my responsibility to account for decisions. This year I will concentrate on economic advice.

THE EXPOSITION OF ECONOMICS TO PRACTITIONERS

I think that the first essential for the practising economist is to be able to explain him or herself - usually to noneconomists. This is an essential element in the practice of economics and critical to success. Of course, economics can be complicated and all professionals have to cope with this. Too much complication loses any audience - but, of course, there is always the danger of over-simplifying.

`Tout ce qui est simple est faux' said Paul Valery eMais tout ce qui est complexe est inutile'. What is simple is wrong; what is complex is useless.

But the problem with economics goes further. Economics in Government is not a popular subject. It reminds people that there are costs, that benefits are relative, that people have different preferences and that there is always uncertainty. Above all it tells us that there are no solutions, only trade-offs. The only certainty is that there are no free lunches.

So the second essential for the practising economist is to be modest in order to be useful. There is much that we do not understand in economics. Our quantitative work is at best disappointing. Economics can provide only one element in a public policy picture.

The third essential is not to be too modest. I remember discussions in the seventies about why economics was not working (by that people meant that macro-economic policy was not working). Stagflation was often put down to 'sociology'; somehow people were not behaving in the way economists thought they understood. People wanted stable prices but made pay claims which were incompatible with stable prices. But often what was going on was that people were looking after their own interests responding to the incentives on offer.

When those incentives changed, as they did in the eighties, people behaved differently. We learned not only that private incentives were important, but that they had to be compatible with collective objectives.

So modesty, but not undue modesty. Economists may not be able to control an uncertain world, peopled by economic agents with their own priorities. But in the land of the blind, the one-eyed economist can be king, or, at least a good medicine man.

THE SKILLS OF ECONOMICS

Three skills are needed in economics. They are the skill of communication - listening as well as talking - the skill of isolating the key elements of an issue and the skill of considering which particular technique might be useful.

These are practical skills arising from practical experience rather than from a textbook. Just as the good cook uses a recipe book only to help, someone who can do no more than read a recipe is rarely more than a modest cook.

Practice in the use of economics is not only practice in using the tools of economic analysis, but choosing which tools are appropriate for a particular task. For example, was decision making in nationalised industries best advanced by teaching the application of the principles of discounted cash flow analysis or by considering the institutional structure of nationalisation and the incentives this structure presented to the key operators, to Government, to Treasury and sponsor Departments, to the managers, to the workforce, and to the customers?

The practising economist does not always have a choice. In the 1960s it was probably right to develop the techniques of investment appraisal and long run marginal cost analysis.

Significant resources went into such work. A paper first developed in the Economic Sector of the Treasury in, I think, 1961, became, five years and 30 drafts later, the 1967 White Paper on Nationalised Industries. There was little point in those days in working on the structure of the post-war nationalisation settlement. The opportunities of the 1980s were quite different. The Government wanted to roll back the frontiers of the state. The big issue became one of doing this in the best way - an issue primarily concerned with the effect of structures on incentives.

But what of the recipe books themselves? Which techniques have proved most useful in practice? What, for example, is the relative contribution of applied theory and econometrics?

I conclude, from my own experience, that the specific application of general theory, in an intelligent way, unlocks the most doors - even if only partially. Human beings need shared concepts as a guide to collective action. But these shared concepts also need to be very carefully related to specific practice.

It is a great pleasure, speaking in this City to quote Adam Smith. His great contribution, of course, was the way he saw how incentives to individuals relate to collective success. 'It is not from the benevolence of the butcher and the baker ..."' Like all good teachers, Adam Smith illustrated his principle by reference to the practical circumstances of his time. Like so many great economists, he was also a powerful policy advocate - in his case - the ending of state trading monopolies in favour of competition. It is remarkable how powerful such a set of insights can be after 200 years.

CHANGES IN THE PARADIGM

But high conceptual thinking rarely takes place within Government. It is essential to Government, but usually comes from outside. And the paradigm changes.

When the paradigm changes, it requires the practical men and women to shift their thinking. It may have been naive of Keith Joseph in the 1980s to circulate a reading list to his officials at the Department of Trade and Industry, but it was necessary for him to shift their thinking away from a corporatist Government led paradigm towards the principles of market capitalism. It was only na(ve because officials are clever and competitive and have plenty of incentives to understand where their masters are coming from. They want their advice to be accepted. And those that do not succeed, do not survive.

So while paradigm changes take place outside Government, and are often associated with a change in Government, following a General Election, the implementation - or partial implementation - of a paradigm requires much detailed work in Government, much of it inside the Administration.

Governments also need to deal with the constant pressure of events. New Governments emphasise their new approaches, compared with the previous administration. Hence the first hundred days, the appraisals of progress against the manifesto commitments. After a time, events begin to take over. They often arise quickly and require quick responses. The analysis behind these responses - in the case of economic events - involves the application of general concepts, such as comparative advantage or opportunity cost, to a particular situation. There will nearly always be some political overtones. Governments react to events by reference to their principles, or broad objectives, or, if you like, what will keep them in office.

THE IMPORTANCE OF CONSTRAINTS

As well as indicating objectives, paradigms impose constraints. A market orientated Government places very different constraints on its advisers compared with a central planning Government. Distributional issues also impose constraints on policy options. These distributional issues relate to a host of pressure groups as well as to more stable categories such as the rich and the poor.

Constraints are rarely absolute. They may be shifted by the way policies are implemented. But they are ignored at the analysts' peril. Some things, however desirable they may seem to some people, are just not on the map.

In analysing decision-making, I think more attention should be paid to constraints than is usually allowed for in economic models. Some of the constraints are, like everything else, time dependent.

Sometimes what is completely out of court becomes a possibility and then a reality. For example, I argued for years that mortgage interest relief was an undesirable departure from a neutral tax system because it had little effect - given the low elasticity of supply of building land - other than to raise house prices to the benefit of existing owners, without achieving its declared objective of increasing access to owner occupied housing.

In the early 1970s, however, mortgage interest relief was sacrosanct. There was a conceptual sea change when it was capped at 25,000 (very few cash losers at the then level of house prices) by Denis Healey, and raised to only 30,000 by Geoffrey Howe after several years of high inflation.

By then there was a growing lobby against it. After further capping it has now gone. A long haul, but worth it! Like the repeal of the Corn Laws, it could not have been done by economics alone. The economic case was a strong one, but it needed consistent reiteration and growing political support to succeed.

LIMITS TO QUANTIFICATION

Nowadays in Government, issues are quantified where possible. There has been a great change in this respect over my years in Government. Some Departments, even outside the Treasury, are now highly numerate - a far cry from the days when Churchill's scientific adviser, Lord Cherwell, could dominate by the use of a slide-rule.

Quantification is not the same as econometrics. I think of it more as quantitative history. In this, I am comforted by developments about which I know all too little - in chaos theory. Economic time series often seem to exhibit chaotic characteristics. There are patterns, but they do not repeat exactly. Much seems to depend on starting positions (where we are now - or where we came in) or are time dependent (how events unfold) or both.

There is no substitute for detailed knowledge of the situation. Outsiders rarely know where the bodies are buried. There is rarely enough time to put all the material together from scratch. Decisions need to be made quickly and if anyone wishes to influence them they must put their arguments in place in a hurry. Sometimes you may have to make bricks with very little straw. (If you worry too much about this, remember that Poulet Marengo was created by Napoleon's chef on the battlefield, not in well equipped kitchens in Paris.)

TWO CASE STUDIES

May I now turn to illustrate what I have been saying by two episodes in my own work in the Treasury? The first concerns export credit in the early 1980s; the second the use of dcf investment analysis in nationalised industries.

EXPORT CREDIT: THE ISSUES

Export credit, where Government provides subsidised finance for exports, usually capital goods, usually to developing countries, has long been a bone of contention in Whitehall. The case for export credit rests on three intellectual pillars. First, that economic policy is constrained by the balance of payments. Secondly, that the alternative to making the capital goods concerned is under-use of domestic resources, including unemployment of labour. Thirdly, that any shortfall in benefit in the recipient countries was offset by the low resource cost of acquisition.

All are elements of market failure, in both the donor and recipient countries. They are, of course, the way the arguments would be put by economists. The advocates of the policy used a trinity of rather simpler arguments. First, that exports were good for the donor country, secondly, that investment was good for developing countries and thirdly, that international competition was best conducted on a 'level playing field' where each country should be able to match each other in the level of subsidy given to exporters of capital goods. These arguments are good examples of what David Henderson has neatly called DIY economics economics employing ad hoc propositions, untutored by the basic economics of opportunity cost and comparative advantage.

In Whitehall terms there was also a trinity of interests. The Treasury opposed the public expenditure consequences of the subsidies concerned, but the scale of expenditure was not very high compared with other pressures on the budget. The Department of Industry, as it than was, wanted to support manufacturers of capital goods without using the selective assistance budget and the Ministry of Overseas Development wanted to maximise aid to the third world. Trade and aid seemed such good bedfellows - and other countries were said to be supporting their own exporters on a massive scale.

EXPORT CREDIT: THE THATCHER GOVERNMENT

A special set of circumstances came together in the early 1980s, which provided an opportunity for change. The Government which came into power in 1979 was committed to rolling back the frontiers of the state, especially where public expenditure was concerned. Export credit was growing rapidly. The Ministry of Overseas Development had recognised that aid was not an unalloyed benefit; in particular that large capital projects showed poor cost:benefit ratios because more driven by prestige - or benefits to special groups than by the broader interests of the populations concerned.

After some dispute between Departments, the Chancellor proposed that there should be a study of the issues by an interdepartmental group of economic advisers and proposed that I should be the Chairman of the group. (I had spent a good deal of my time in the 1970s strengthening the interdepartmental relation between Government economists and so I knew the people concerned.)

EXPORT CREDIT: THE ECONOMISTS' REPORT

The group included economists from the Departments of Trade & Industry and the Ministry of Overseas Development as well as from the Treasury. We produced a standard piece of economic analysis arguing:

that the macro-economic constraint on the economy derived from the conditions of supply generally (the exchange rate was floating and controls on the movement of capital were removed in 1979);

that an economy would best exploit its comparative advantage by trading at unsubsidised prices;

that the benefits to recipient countries from such tied aid were usually greatly overestimated when compared with multi-lateral, or even bilateral aid;

that resources could be redeployed at home, and that, in so far as there were constraints in the speed with which this would happen, the implied costs per job of export credit greatly exceeded the costs of the other employment preservation policies then in place.

The general arguments were difficult to refute - except for those who believed that market prices were systematically misleading as a guide to a sensible allocation of resources. Ministers believed no such thing, nor has any British Government after the experiences of the 1970s. The cost per job figures were a critical part of the work. We did not argue that they were irrelevant - as we might have done - but that they were very large compared with other programmes. So we gave ourselves space to argue that while some Government subsidy in the form of export credit might be appropriate, what was happening in this area was excessive.

The report, submitted by me to the Ministers concerned, was quickly acted upon. Treasury Ministers approved of the conclusion and the recommendations were on the Prime Minister's desk before the Departments of Trade and Industry could turn round. The division of the Department of Industry sponsoring the policy bitterly opposed to our

recommendations. So was the export promotion division of the Department of Trade.

DID MANUFACTURING MATTER?

By then, it was too late. The climate had changed and the hurdles for export credit raised. The episode was an element in the great debate about whether 'manufacturing mattered'. What 'mattered' meant, then as now, was whether it mattered more than other economic activity, and so was deserving of special Government attention. In so far as the debate was resolved, it was resolved in favour of treating manufacturing like other industries, despite the high level of the exchange rate in the early 1980s. (This was the time, remember, when Michael Edwards said that if the exploitation of North Sea Oil raised the exchange rate, we should 'leave the stuff in the ground' and when Terence Beckett, President of the CBI promised a 'bare knuckle' fight with the Conservative Government.)

Export credit was particularly important for some companies and they were not slow to lobby on their behalf. The report was, initially, simply an internal Whitehall report. The Department of Industry chose to start leaking it selectively to interested parties - ie those who might lose out. Before long, James Prior, a former member of Mrs Thatcher's Cabinet, by then Chairman of the General Electric Company, sought an interview with the Chancellor. Perhaps to his surprise, he got nowhere.

Our report was a technical one, abstract and economic in its style. But it was also a political document. It stood on one side of the fault line between the vision of a market economy - where the function of Government was to make markets work better - and the vision of a corporate society where the big players came together to 'sensible' arrangements about economic matters. So although, in many ways, export credit is a peripheral matter, for a brief moment it played its part in revealing the gulf between those two views of the world. While the report was applauded by the advocates of the free market, it was condemned by both the CBI and the TUC.

It was not long before the arguments came out into the open. The selective leaking of the report led to demands from Parliament for publication.

EXPORT CREDIT: THE LONG TERM RESULTS?

So all can now read it and perhaps wonder why it caused such a stir. I asked 'how I could come to such conclusions?' Yet the opponents of the report found it difficult to challenge its logic. Whether they were convinced, I know not, but possession of the intellectual high ground had its power - the power of curbing the more outrageous use of self-interest.

What was the long-term effect is difficult to judge. Large projects, such as the Bosphorus Bridge, or a power station in the Philippines, always interest the political establishment Ministers and Government Departments in both the donor and recipient countries. Large sums of money are at stake. There is intense international competition for such projects and the main battle is often fought over the financial package, in particular the cost of servicing the loans. Large financial institutions are involved. I found myself as unpopular in the City as among the contractors.

The odds are stacked against anyone who ventures to question the use of public money to support what powerful people see as the national interest. Put into the terms of the history of economic thought, the influence of Sir Thomas Munn still predominates over the influence of David Ricardo. Although I would claim only partial victory for our work it did have some influence at the time. As for long-term influence, I still think of it as a positive, if small, step in improving the working of markets.

NATIONALISED INDUSTRY PRICES

My second example concerns the use of marginal cost pricing in nationalised industries. Sounds innocent enough, a tool of profit maximisation kind of thing businessmen understand, you might think. But quite apart from whether private sector business-men establish prices on the basis of marginal cost - on which there is, of course, an extensive literature - the whole notion was foreign to the Morrisonian public corporation.

Its objectives were to pursue what it considered to be national objectives subject to the constraint of breaking even, taking one year with the next. In the language of economic theory this came much closer to maximising consumer surplus subject to a constraint than maximising profits although it was never entirely clear whose consumer surplus was involved. Concepts of marginal cost were scarcely relevant to the pricing policy to such a body. So I should have not been too surprised when I was told that, in one nationalised industry, marginal cost was not only wrong, but wicked.

If marginal cost pricing had to be imposed on a nationalised industry by an external body, such as the Government, it had to be defined by the imposing body. This was, of course, a task welcomed by the Government's economic advisers. But rather than simply rushing off with proselytising zeal to expound the benefits of welfare maximisation as understood in economic theory, they needed to ask why their masters, the politicians, might have been in favour.

They did not have far to look. During the 1950s the Treasury had been very concerned about the pressure on resources arising from nationalised industry investment, particularly in electricity generation. Such investment had to be financed by Government borrowing or taxation. Higher prices would both restrain investment and help to finance it.

There were many discussions on the pricing of fuel in the 1950s, and Ian Little, who was Deputy Director of the Economic Section of the Treasury, wrote it all up later in a book the Price of Fuel, covering the under-pricing of coal as well as of electricity.

In 1961 the Government published the first of the three nationalised industry White Papers. Essentially an accounting approach, it argued that breaking even in an inflationary climate (although inflation was low by subsequent standards - rather like today's figures) was inadequate. The White Paper argued that provision should be made for supplementary deprecation and that nationalised industries should be set financial targets.

INVESTMENT APPRAISAL AND LONG RUN MARGINAL COST

The economists then moved in to emphasise the need for good investment appraisal to curb low yielding investment and the use of long run marginal cost pricing ie prices which would cover capital costs as well as operating costs.

Long run marginal cost is notoriously difficult to measure. Do you use a simple annuity related to the cost of additional facilities? Do you try to estimate incremental systems costs over a long time horizon? Those who did not like the implications of the application of LRMC, usually higher prices, found endless reasons why calculations were impracticable - or showed very low numbers.

And there was also an argument among the economists. The purists argued that short run marginal cost pricing was conceptually better. But the application of SRMC involves low prices - relative to average cost - at times of low demand and high prices related to average cost at periods of high demand. While public sector managers might like low prices, especially if they had access to public finance, they hate high prices, involving financial surpluses being paid back to the Treasury combined with criticism from the public for overcharging.

Not surprisingly, prices were often below average costs but never rose above them. But investment continued - never 'choked-off as you might say by higher prices. So the return on capital was systematically low - and systematically failed to cover the cost of capital.

So the arguments for LRMC. But in practice little progress was made towards economic objectives. The Government published a White Paper in 1967 - perhaps the major Government document most influenced by the micro economists in the Treasury. Initially it seemed to have some effect, but it was over-turned by the policies of price restraint introduced by the Conservative Government in the early 1970s in an attempt to curb inflation.

ECONOMICS AND ACCOUNTING

So in the mid 1970s we returned to the approach of 1961. We built the economics of LRMC - now much developed compared with ten years earlier - into the financial target with the use of a required rate of return (RRR) which used a dcf return on investment to generate a required return on the replacement value of assets. The aim was to internalise investment appraisal economic and pricing within a financial target rather than to try to impose them on unwilling nationalised industry managers.

In the 1980s we took this work further in the form of a report on Economic Costs and Charging Prices which looked in depth at how economies and inflation accounting could be linked together. This report was, predictably, attacked by the nationalised industries.

The clash between national treasuries, who wanted good returns from state industries and the managers of those industries who wanted access to finance for investment, but low prices for their products, was not unique to the UK. On a visit to talk about our work, I walked into exactly the same situation in New South Wales.

Who knows exactly what would have happened next? The edifice we were constructing was, however, overtaken by politics, and by privatisation. The incentives were changed: some important incompatibilities disappeared.

The results I will leave for next year's lecture.

[Author Affiliation]

Ian Byatt, President of the Economics and Business Education Association

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.