The biggest intellectual challenge of our age?

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My latest Forbes article is here. This is an extract from the following, fuller, version.

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The biggest intellectual challenge of our age is one that has bemused economists for years. With unemployment rising rapidly, how do we release the potential of people within our economy without ruining its finances?

Keynes tackled this very effectively in the 1930s, and in the short run his solution of spending our way out of a recession remains the only viable course of action in the current crisis.

Keynes did not, however, solve the problem we’ll have once the short-term crisis is over. That problem is how we are to pay for the services society needs without relying, in the long run, on taxes from an overblown and over-paid finance system?

I’m not going to solve that conundrum in 800 words, but I will offer a suggestion for the direction in which thinking should go. First, Keynes did not have to contend with a finance sector grown out of all proportion to meet the needs of the economy. Second, he didn't have to deal with the perception, now completely dominant in economics and finance, that value is determined by an arithmetic formula where the future cash flows of an asset are discounted at an agreed interest rate to compute a current worth with all future flows added together as if they occurred in the present moment.

This approach may have a computational neatness but its impact has been pernicious. Firstly it is open to abuse in finance because if the answer is not the number you first thought of, simply change one of your assumptions about the future and it soon will be whatever you desire it to be – and who’s to prove you wrong? As a result, the objectivity of financial valuation by which well being is supposedly recorded has been built on a myth that requires a degree of honesty that few of us attribute to those who practice the art.

Secondly, and more importantly, the idea of discounting the future is fundamentally subversive. Once you have assumed that you can discount the future consequences of current decisions into a current cash value, which you can engineer to be positive on all occasions by manipulating the data, what’s to stop you paying yourself the whole of that supposed value that you claim to have created in those future periods to yourself as a bonus, to reflect the value your own maths says you’ve created?

This has been happening on an enormous scale and the consequence is obvious. Those who arrange financial deals pay themselves the full value today of the benefit they claim their mergers, acquisitions, pension fund investment allocation decisions and other programmes will create in the future.

If you discount the future by deeming it to have a cash value today, which you alone can determine using models you create, the value you can pay yourself knows almost no bounds. And as finance is most susceptible to such analysis, unsurprisingly the bonus culture in banks has been huge. Wherever there’s been mark-to-market or fair value accounting, executives in the financial world have used this technique to book profit and pay the bonuses made for themselves.

The weaknesses of this pervasive model of valuation are obvious. Things may not work out as planned, but the bonus has still been paid. We shouldn't invest for reward today, but for future return. If that future return has already been paid out by way of up front bonus to the creator of the scheme there’ll be no profit left over when we get to the future. That’s why your pension scheme has made nothing for a decade or more: a banker claimed the growth in your pension scheme as the basis for their bonus many years ago.

That is also why state finances have been distorted by an inevitable boom and bust cycle. In boom years the state is paid taxes on profits that are completely illusory: this is tax paid on the current benefit of future investment returns. That creates an illusion of boom which evaporates when the returns do not live up to expectation, having been over-hyped by their purveyors in the first place. Bust follows, of course.

So what’s the solution to the conundrum of wealth creation without dependence on the finance sector? Living in the present and recognising it is quite different to, and separate from, investment in the future would represent a major step forward on the way to a solution, I suggest.

That, though, would require a fundamental reform of economics. Are economists up to doing that? There’s my cause for doubt, when they’ve been so well rewarded for telling a few they can live today off the jam that should be other’s tomorrow. The trouble for you is that unless you’re a banker you’re one of the others that has been exploited. It’s not a nice feeling, is it?