The Tyranny of Nostalgia

The new classical school’s theories possess logical consistency and mathematical elegance, but they are also arcane – even faintly absurd – when viewed through the lens of the enduring vicissitudes of the business cycle, the historical struggles of the trade union movement, the poverty and human suffering of major recessions, and the intermittent episodes of mania and panic in financial markets. Indeed, where some aspects of new classical theory are concerned, one is drawn to [John Maynard] Keynes’s withering critique of Friedrich von Hayek that ‘how, starting with a mistake, a remorseless logician can end in Bedlam’.¹²

The EMH [efficient markets hypothesis], for example, is itself built on a logical inconsistency. If stocks always reflected all the relevant information available about them, then investors would have no incentive to seek out that information and process it. But if no one undertakes this task, the stocks will not reflect that information, and the market will not be efficient. There must therefore be some inefficiency for the market to work.

There is overwhelming evidence, moreover, that at least beyond the short-term, there is a predictable component to movements in share and other asset prices. In particular, periods of high returns are likely to be followed by periods of low returns. There is low-frequency negative serial correlation.

More broadly, markets are not universally efficient, and they do fail. In this, Keynes was correct. They fail because of imperfect information and the inevitability of unquantifiable uncertainty about the future. Monopolistic or oligopolistic power is a fact of life. Price signals get distorted. Externalities arise – both positive and negative. Discontinuities, herding, tipping points and price cascades are observable. Positive and negative feedback loops develop.

Equally, the reality is that people are not always rational in the sense defined by [John Fraser] Muth [American economist] and [Robert] Lucas [former student of Milton Friedman]. They are social animals driven by context. They might not be stupid, but they take time to learn from some of their mistakes. They do not instantaneously know what they want and where their best interests lie. They can struggle even to grasp the range of things they might be confronted with in the future.

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The policy implications of these developments in economic theory during the 1960s and 1970s significantly influenced the manifesto of the Conservative Party ahead of the 1979 general election. Party leader Margaret Thatcher was no trained economist but, tutored by Keith Joseph, the economic philosophy she instinctively cleaved to was drawn from the monetarism of Friedman and the new classical school’s restatements of pre-Keynesian principles, together with Friedrich von Hayek’s exaggerated claims that attempting to deliver social justice in a market economy was a chimera, and that economic planning was a slippery slope that would inevitably lead to dictatorship.¹⁴

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Thatcher came to power in May 1979, determined to control inflation, create a more stable macroeconomic environment, roll back the borders of the state and promote self-reliance, thereby transforming the country’s economic performance for the better and reversing its relative decline. She also saw herself as something of a teacher, or even a preacher: someone who could enlighten the masses and bring them round to her way of thinking through persuasion – or failing that, through determination and ruthless singlemindedness.

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Thatcher presented her initial economic programme as one of self-evident common sense, and of applying the rules of good housekeeping to the nation’s finances. There was a strong moral – indeed Victorian – element to the counter-revolution, albeit a selective one. Her philosophical outlook notably omitted Dickens, Disraeli, Arnold and Ruskin, among others.

The underlying belief was that people had been sheltered from the consequences of their own actions for too long. The dependency culture of previous decades had left the country ethically compromised. Markets, on the other hand, were a realm of freedom. Thrift, enterprise and self-reliance were the fundamental pillars of prosperity. Inequality was a necessary dynamic force for change and renewal. A return to these fundamental values could restore Britain to its nineteenth-century position of economic pre-eminence.

Notwithstanding her narrow view of the EEC’s raison d’être, Thatcher believed that being part of this single market was in the UK’s interests. The necessary legislation to incorporate the Single European Act into UK law was passed in a mere six days, even though it also embodied increased powers for both the European Parliament and the European Commission, together with the extension of qualified majority voting in the Council of Ministers on single market issues. Thatcher seems to have believed that if countries surrendered their vetoes, the single market that ultimately emerged would be more open to competition and cleansed of government interference. By signing up so readily, she probably gave away more British sovereignty than did Heath in 1973.

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It was not widely known or advertised that Britain had committed in principle to monetary union in both its initial EEC accession treaty and when it signed up to the Single Market Act. However, neither Thatcher nor [Nigel] Lawson saw these as binding near-term obligations. Rather, they each viewed monetary union as a dangerous and unwarranted step towards political union, and a threat to the British nation state. Nevertheless, the long-buried issue of British sovereignty in the context of a maturing and evolving European community was beginning to rear its ugly head, and it would subsequently blight Conservative Party politics for more than thirty years.

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North Sea oil revenues rose from 0.3% of GDP when Thatcher came to power to peak at almost 3% of GDP in 1984-85, before falling to trivial levels in the early 1990s. But for ideological reasons and political expediency, Britain’s energy bonanza was frittered away on tax cuts skewed towards the upper income brackets rather than, for example, being invested for the future through infrastructure upgrades or the mechanism of a sovereign wealth fund.

The government failed to grasp the full consequences of financial deregulation. In particular, it underappreciated its distortionary effects on the monetary aggregates; the onus it left on official interest rates for macro-stabilization; its role in stoking an unsustainable housing boom; the perverse incentives it encouraged in banks and investment banks; and its damaging longer-term implications for financial stability.

Financial deregulation interacted with tax reform to encourage consumerism and materialism, and together with persistently high unemployment fostered an extraordinary rise in inequality that has never been remotely unwound. The UK’s Gini coefficient* rose from around 24 to 34 during the Thatcher years, while income at the ninetieth percentile relative to that at the tenth percentile jumped from 3.1 to 4.4 and the share of income going to the richest 1% of the population more than doubled, from 3% to above 6%.
Poverty rates also increased significantly, for working-age adults, for children and for pensioners, and by considerably more than they did in other advanced economies around this time.

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In broad terms, the record of privatization was mixed. Yes, some new markets were created, people had their eyes opened to new investment opportunities, and the sale of council houses bred aspiration, even if it again deepened the divide between the haves and the have nots. Elsewhere, public monopolies or quasi-monopolies just became private monopolies or quasi-monopolies, and their subsequent regulation has left a great deal to be desired.

There were also significant gaps in supply-side policy. In particular, public infrastructure investment was neglected, active labour market policies and research and development were persistently underfunded, and the government’s record on education was poor. The share of national income allocated to public education declined throughout the 1980s and actually fell in real terms between 1979-80 and 1986-87.

Overall, however, for all the caveats and painful side effects, the new micro framework seems to have changed for the better the environment in which investment decisions and bargains between management and labour were made, and it also had direct positive effects on the use of capital and labour.

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Perhaps the best conclusion to draw about productivity is that the 1980s saw the UK regain much of the ground that was lost during the 1970s. Britain was no longer generally considered to be the sickest man in Europe, but nor had the country exactly reinvented itself.

So far, the government’s new, tighter, post-Brexit migration regime has cut the net inward flow of workers to the UK from the EU from more than 180,000 a year to closer to 60,000, although there has been a compensatory increase in immigration from other areas. The evidence is that prior to Brexit, and contrary to the common view that immigration reduced the pay and job chances of those born in the UK, migration into the UK from the EU had a positive impact on overall employment, productivity and GDP. Many of the arrivals were highly skilled, and a significant proportion were overqualified for the jobs they took on. Furthermore, European migrants paid more in taxes than they received in benefits and contributed much more financially and through work than they consumed in public services.²⁵

It appears, therefore, that there are major risks for the UK economy and for the country’s public finances from reducing EU migration, with potentially marked effects on those industrial sectors and regions where EU migrants have congregated. Offsetting these impacts by retraining British-born workers is likely to take time – perhaps as long as a decade – while recruiting substitutes from non-EU jurisdictions will depend both on future trade deals and on the appetite of the domestic population for such inflows, which so far remains limited.

The financial sector, presented by many Brexiteers as a part of the economy with the potential to flourish in the post-Brexit world, has done nothing of the kind. The UK is no longer considered to have the world’s most competitive financial sector.²⁶ Indeed, its ranking has fallen away sharply over recent years, and it now lags well behind the US. The size of the sector remains well below its 2009 peak, at some 8.3% of GDP.²⁷ Its growth rate slowed sharply after 2016, and it actually contracted for three successive years between 2018 and 2020. Financial service exports have flatlined since 2017, as has the trade surplus in financial services. At the same time, the BIS has reported that, while the UK remains the most important hub for currency and interest rate derivatives trading, its share of both markets has declined over recent years. London accounted for 38% of foreign exchange market turnover in early 2022, down five percentage points since 2019. Its share of over-the-counter derivatives trading fell from 51% to 46% over the same period. 8 Meanwhile, the market capitalization of the Paris stock exchange has caught up with that of London’s.

And then there is the impact on young Britains entering the labour market.
Since a UK passport is now of less use in the single market than a Bulgarian or Latvian document, it is harder for UK citizens to get taken on, trained or promoted by transnational firms, which generally treat the EU as a single commercial and human resources space. Over time this will limit the skillset of UK nationals.

A further important handicap of Brexit is a loss of policymaking insight.
All EU policy areas – energy, consumer protection, research priorities, updated regulation for data or the tech sector, new qualifications, anti-dumping and so on – have EU working groups that allow the relevant officials in member states to exchange the intelligence, ideas and practical solutions that are being used within their countries. Moreover, there has been evidence that the European Commission has deliberately avoided informal policy discussions with UK officials because of the lack of trust that now exists.

Brexit also appears to have exacerbated the UK’s recent inflation problem. The decision to leave the EU, together with the related advance of populist politics, has undermined trust in the government’s ability to run a disciplined economic strategy; has added to selling pressure on the pound; and, as a result, has loosened the mooring of inflation expectations. At the same time, the reduction in the level and elasticity of labour supply in the context of the exclusion of European migrant workers has encouraged a growing mismatch between available workers and jobs while enhancing the bargaining power of domestic labour.

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The UK policy response to these circumstances has been inadequate on many levels. This was especially the case in late 2022 when Johnson’s right-wing populist successor, Liz Truss, and her chancellor, Kwasi Kwarteng, effectively took leave of their senses when they sought to push through a range of iniquitous, unfunded and inflationary tax cuts at a time of acute market unease. But perhaps this should not come as a surprise. British economic policy has hardly covered itself in glory over the past half century. To have expected it to have responded to recent events in an optimal manner was always likely to prove wishful thinking.

Against this background, it is little wonder that at the time of writing the polls indicate a growing sense across the population that Brexit was a dreadful mistake.