That was the year that was

It has truly been a historic year, the reverberations of which will echo for years to come. Above all, 2016 was the year of politics and will primarily be remembered as the year when electorates in the west decided that enough was enough. And who can blame them? Governments have spent the past seven years trying to convince their electorates that normality is just around the corner, when in reality they should be preparing for the new normal. Conventional countercyclical policy is battling against the headwinds of globalization and rapid technological change, which add up to make this the most unsettling period that many of us have ever experienced.

The geo-political environment is in a state of flux as the tectonic plates of the post-1945 order move again. Far from this being the end of history, as Francis Fukuyama once predicted, we are closer to Yogi Berra’s aphorism that it’s déja vu all over again. Precisely at a time when strong political leadership is called for, we find it is sadly lacking.

In the UK David Cameron – a deeply flawed leader who gambled his country's economic future for short-term political gain – has been succeeded by Theresa May, who gives no public indication that she understands the complexities of negotiating Brexit. In France, President Hollande is the most disliked president in French history, to the extent that he will not stand again next year because he knows he cannot win over the people. There is indeed a non-negligible probability that the French could elect a far-right president next year in the shape of Marine Le Pen, although I would not put money on it. Italian PM Renzi quit after his proposals for constitutional reform were rejected in a referendum which ended being a plebiscite on his own term of office. Only Angela Merkel is still standing tall, but even her popularity could take a tumble in the wake of recent events, as her open borders policy is increasingly scrutinized. With an election due in the autumn, the world will be watching to see whether Germany can uphold the values of liberal democracy which are being eroded elsewhere.

Meanwhile, the political situation in the US is almost beyond parody. Although the economy has recovered more rapidly than most, Barack Obama is unlikely to go down as a great president. A great orator he may be, but he has failed to offer the leadership that the western alliance so badly needs. Whilst his policy of avoiding military entanglements was taken for sound reasons, his Middle Eastern policy has been a failure, and if anything has made a bad situation worse. His attempts to reset relationships with Russia have also been a dismal failure. Moreover, he spent a lot of time and effort battling Congress on basic economic issues such as the debt ceiling (though that is more the result of Tea Party influenced ideology than the president's stance). But as sub-standard as Obama may have been, the election of Donald Trump represents a leap into the unknown. It is a measure of the dissatisfaction which many Americans feel that they are prepared to give the keys to the Oval Office to someone who lied and exaggerated their way through the most unedifying presidential campaign in history.

Vladimir Putin and Xi Jinping can at least look forward with more optimism. Putin has restored some prestige to Russia's tarnished image, and although the economy will continue to suffer from the sanctions which are still in place, he will be taken more seriously on the global stage following Russia's intervention in Syria. China's President Xi will continue to preside over the world's most dynamic large economy as he consolidates his domestic power base. There will be difficulties ahead, however, and as both leaders look to reassert their country's position on the world stage, we will need a cool head in the White House to ensure that matters do not get out of hand. It may indeed be the year when we learn the true value of President Obama.

It is against this backdrop that the world economy will continue to operate and I will save the 2017 economic outlook for another post. What 2016 has taught us, however, is that the shape of the risk distribution has changed. Outcomes which we thought implausible are manifestly not. The good news is that there is profit in uncertainty. Apparently, the bookmakers’ joint odds that the UK would vote for Brexit; that Trump would be elected US president and that Leicester City would win the English Premier League were 4.5 million to one. Paddy Power is offering odds of 33/1 that the existence of alien life will be proven in 2017 (2016 odds are quoted at 80/1, so you have less than a day to place your bets). Meanwhile, Fergus Simpson, a mathematician at the University of Barcelona, reckons that there is a 500/1 chance of a cataclysmic event wiping out human existence in any given year during the 21st century (Don’t believe it? Go here).

Above everything else, however, we have learned not to trust bookmakers odds (a remain victory or a Clinton presidency anyone?) And as Michael Gove so memorably remarked, we have all “had enough of experts” (although only until they are proven right).

It's not only economists who see the obvious

Alan Bennett is best known as a playwright (The History Boys, The Madness of George III) although he is also a prolific screenwriter, actor and author. In addition to all this, he is an inveterate diarist and in his 2015 journal, an edited version of which was published in the London Review of Books (here), he made the following entry: 

“11 September. David Cameron has been in Leeds preaching to businessmen the virtues of what he calls ‘the smart state’. Smart to Mr Cameron seems to mean doing as little as one can get away with and calling it enterprise.“ 

In a recent TV documentary I heard Bennett repeat the comment in his cosy, affable tones which makes it even more devastating. It accurately captures the thrust of fiscal policy over the last six years and is a withering indictment of thirty years of market economics. But before we swallow this soundbite wholesale, we should acknowledge that there is a genuine discussion to be had about the role of the state in a modern economy. One of the big issues is the size of the safety net that the state should be expected to provide, and the answer will differ according to the prevailing mood. Nonetheless, according to Jonathan Bradshaw of the University of York (here) “the real damage has been done by this present government … The uprating of working age benefits by substantially less than inflation since 2010 and cuts made in tax credits has resulted in falling living standards. This was the first time that the real level of the safety net had fallen since Unemployment Assistance began in 1934. 

No one should be in any doubt that life at the bottom is tough, and getting tougher. Ironically, when the German government introduced a series of welfare reforms in the first half of the last decade, which cut benefits in order to force people back into the labour force, it was lauded for the boldness of its move. Other European countries are being urged to follow suit – notably France and Italy. And with Germany today held up as a paragon of economic virtue, there does appear to be some merit in a policy of welfare reform. Indeed, the UK reforms of the 1980s are credited with kickstarting the economic recovery of the Thatcher era. But like many economic policies, there are diminishing returns to more of the same, and I wonder whether in the UK we have hit the limits of what people are prepared to tolerate.

But it is not only those at the bottom who are being squeezed: middle income groups across the industrialised world are not faring well either. According to the Institute for Fiscal Studies, real average wages in the UK in 2021 are expected to be lower than they were in 2008 and it concludes that “we have certainly not seen a period remotely like it in the last 70 years.” At issue is what the government can and should be expected to do about it. In an economy where the government’s direct role has been reduced as many activities have been privatised, it can only play a limited role by setting the framework. After all, it is no longer in a position to set wages for large parts of the workforce.

Bennett’s criticisms go deeper, however. The UK government under David Cameron adopted a laissez faire approach to many economic problems which frankly failed to deliver the desired results. Bennett was undoubtedly referring to Cameron’s flagship Big Society project which was designed to give more power to local communities by encouraging a transfer of power from central to local government. It was a nice idea in theory, but it was the wrong policy at the wrong time. Faced with the aftermath of the biggest economic crisis since the 1930s, most economists would argue that more government rather than less are what is required.

Moreover, with around 60% of UK local government spending being funded by central government, it was always a pipedream to assume that more local decision making was ever going to work without more local control over budgets. With central government funding for local activities such as the police having been cut by 22% in real terms between FY 2010-11 and 2015-16 (source: National Audit Office) Bennett’s criticisms start to hit home. It is indeed hard to avoid the suspicion that government policy in recent years has focused on shrinking the size of the state whilst telling the electorate that it is promoting enterprise or increasing choice. And I still hold the view that at least part of the reason for the Brexit vote was directed at the failure of government to manage the economy in ways that benefited large parts of the electorate.

As we look ahead to 2017, it would be nice to think that the UK government will spend less time fretting about cutting the deficit and more about how to use fiscal policy as an instrument to promote growth. But from what we have heard so far, which amount to words rather than actions, I have to say that I am not confident.

All I want for Christmas ...

… is a Ferrari 250 GTO. Admittedly it’s not a modest request – the last recorded auction price of this widely revered classic was a cool $38 million and there is one on the market today for a reported asking price of $56 million (here). When new in 1962, they cost $18,500. To put this into perspective, I have converted this using prevailing exchange rates into sterling values in order to compare with other so-called safe asset values such as housing.

According to data from the Nationwide Building Society, the average price of a UK house in 1962 was £2,600 – around one-third of the price of a Ferrari 250. By 1965, when the 250 was auctioned for the first time, the selling price was 25% of the original list price and it could be purchased for 40% of the average UK house price. Up until the early 1970s, the selling prices of the 250 were never higher than average house prices but from the middle of the decade, prices began to ramp up hugely (see chart). 

The first $1 million sale occurred in 1986 and by the late-1980s – the peak of the bubble in classic car prices – the 250 GTO was selling for prices in excess of $10 million which was 125 times the price of an average UK house. Following the early-1990s crash, which saw Ferraris changing hands for a mere $3.6 million (42 times house prices), prices began to edge up again but it took until 2010 for prices to exceed the previous 1990 peak. It is notable that the ratio of Ferrari prices to house prices has already gone above the 1990 level and if the current prospective seller realises their expectations, the buyer could in theory buy more than 200 houses for the same money.

If someone had bought this wonder of engineering new in 1962 and sold it for $38 million in 2013, they would have realised an annual average return of 16%. Had they waited until 1965 to buy at auction, they would have realised a gain of 21%. It’s a much better rate of return than housing, where prices have risen at an average rate of 8.5% since the early 1960s. However, the FTSE All-Shares index has posted an average return of 13% since 1962. Investors would not, of course, have realised such stellar gains as they would have had to adjust their equity portfolio holdings in order to replicate the index which would have resulted in transactions costs which eat into returns.

On balance, therefore, the Ferrari 250 looks like a great investment compared to other forms of asset. But we are not all fortunate enough to have the wherewithal to afford such an outlay. Most classic car enthusiasts have to start much more modestly and prices have risen much more slowly over a longer horizon. In any case, the market is highly segregated with top brands showing significant gains whereas at the lower end of the spectrum price inflation has been less dramatic. However, the Historic Automobile Group International (HAGI) index suggests that over the last five years, classic car prices have risen by between 25% and 30% per year. I would attribute this at least in part to the low rates of return on financial assets which have forced investors to look at alternative investment products. It may be a market which, when it pops, does so with a vengeance.

Unfortunately for me, I do not own a classic car, so I am speaking from observational rather than practical experience. But as a reader of classic car magazines in my youth, I used to scan the adverts to check what I may one day have been able to afford. In the late-1970s I recall seeing an ad for an Aston Martin DB5 which was described as being in need of some loving care. I subsequently came to realise that meant a total wreck which was probably held together by rust. However, it was on sale for a mere £750 (no – I have not missed a zero) which was cheap even by the standards of 1978. I barely had 75p to rub together in those days so it was a little out of my league. But a DB5 in even fair condition is today valued at £438,000 with a top notch model able to fetch £958,000. Allowing for £10,000 of maintenance to bring it up to concourse standard, that would have provided a cool annual return of 12.5% over the last 38 years.

They do say that this is the season when dreams come true, so if you’re listening Santa … Merry Christmas!

Called to account

Whilst most of us are thinking about winding down for Christmas, the UK Treasury Select Committee today decided to play Scrooge by announcing that it will hold an inquiry in 2017 into the effectiveness and impact of post-2008 monetary policy in the UK. If the timing was a surprise, then the idea of opening up the conduct of monetary policy to this kind of scrutiny certainly is. Since the BoE was granted operational independence almost twenty years ago, I cannot recall an inquiry into monetary policy on these terms.

The TSC wishes to look more closely at three aspects of policy: (i) The effectiveness of monetary policy in meeting the inflation target; (ii) The unintended consequences of policy and (iii) monetary policy prospects. All of these topics have been covered on this blog at some time or another and the issues at stake here are not simply confined to the UK. The BIS has long pointed out that monetary policy has been kept too lax for too long, and that it indeed has pushed up financial asset prices with at best a questionable impact on the real economy. Of course, the issue is not whether so-called unconventional monetary policy was the right thing to do in 2009: It is whether it is still appropriate in 2016. Indeed, the BIS titled Chapter 1 of its 2015 Annual Report “Is the unthinkable becoming routine?”

I must confess to a couple of contradictory views on the question of whether monetary policy should become politicised in this way. On the one hand, although the BoE does have operational independence it is only right that it is subject to parliamentary account. After all, the decisions which it takes affect those to whom parliament is accountable: the electorate. Yet the BoE Governor and members of the MPC appear before the TSC at least four times per year, and in the course of 2016 Mark Carney has had to endure additional sessions where he has been forced to defend at length the BoE’s conduct both before and after the EU referendum. On the other hand, it is surely no coincidence that the pressure on the BoE has mounted after it in effect backed the losing side in the Brexit debate. I wrote before the EU referendum that in the event of a vote for Brexit “Mr Carney’s position will become extremely uncomfortable given the strained relationships between himself and many Eurosceptic MPs, some of whom sit on the Treasury Select Committee to which he is accountable.”

TSC Chairman Andrew Tyrie also pointed out that “the BoE has been given huge powers but that comes with equally large responsibilities” and in exchange for BoE autonomy, the governor should stick “closely to his statutory objectives.” This follows interventions by the BoE on issues such as the Scottish referendum (although senior civil servants at the Treasury were equally culpable for opining on that issue), climate change, inequality and pensions. The question of whether BoE officials – of which the governor is the most high profile – should be given the freedom to discuss other areas outside their direct remit is contentious. The likes of Tony Yates, professor of economics at Birmingham University and a long-established blogger, has often made the point that the governor should tread carefully. As he wrote earlier this month (here) “reflecting on how to respond to [the risks of social dysfunction] is just not a job the Bank has been mandated to carry out. At least not in public.”

This is fair comment. But as I have long argued, governments are not exactly rushing to fill the gap with policy prescriptions of their own and there is a role for policy heavyweights to speak out. After all the ECB has been doing it for years, and Alan Greenspan was never short of an opinion on policy matters outside the monetary sphere. In any case, many of these issues – notably fiscal policy – do impact elsewhere because they have a bearing on the appropriate monetary policy stance. But it is hard to avoid the suspicion that the decision to scrutinise the BoE’s policy remit is at least in part a response to Carney’s speech earlier this month, in which he called for a greater contribution from fiscal and structural policy to help support growth (here).

Two final thoughts: Given the limited resources available and a pressing time constraint, surely it would make more sense to focus on the policy response to Brexit in 2017 rather than waste energy on this issue. And second, by piling ever more scrutiny on monetary policymakers, the BoE’s policy independence will, at the margin, be eroded. After all, who is going to want to take unpopular decisions if they are going to be put under the microscope at every turn? Like a Facebook relationship status, monetary policy decision-making might be about to become very complicated.

Globalisation: The good and the bad

Around fifteen years ago I was asked by the late Ulric Spencer to review a book for the Society of Business Economists  journal. The book in question was entitled “Localization:A Global Manifesto” by Colin Hines, a former head of economics at Greenpeace. I am rather afraid to say that when I first read the book in 2001, I did not particularly enjoy it and summed it up thus: “ultimately, it is difficult to escape the feeling that the book is a diatribe against the evils of capitalism.” But in the spirit of intellectual flexibility based on empirical observation, I may have been too hasty in my dismissal of some of Hines’ observations.

The basic premise of the book is that the global economic order “must reduce inequality, improve the basic provision of needs and adequately protect the environment.” There is nothing wrong with that, of course, but Hines’ proposed solution is a process of localisation in which policy actively discriminates in favour of the local. It is essentially the polar opposite of globalisation and can (in his view) be brought about by imposing restrictions on global capital flows and using the tax system to discriminate in favour of local interests.

I still think that his economic analysis is naïve and that it is essentially a late-twentieth century first world view of global problems. Nor am I sure that many people in less developed countries would thank Hines: After all, World Bank data suggest that poverty rates (defined as those living on less than $1.90 per day) have fallen from 42% of the world population in 1981 to below 11% by 2013. It is notable, too, that the book was written before China became the global powerhouse which it is today. Arguably, China has used elements of this localisation strategy to benefit the local economy. For example, many of the mighty western multinationals which Hines criticises have been forced to transfer their technology to local Chinese partners in order to be able to conduct business in the Middle Kingdom. Indeed, China has perhaps conducted the biggest poverty reduction policy of all time precisely thanks to globalisation, which has boosted incomes based on exports.

But where Hines’s views may carry more weight is in the process he described which might lead to a pushback against globalisation. In his words, “global deflation is being driven by relocation to cheaper labour countries, automation and public spending cuts.” This in turn results in significant under-utilisation of labour resources in western economies. He could well have foreshadowed the process which has led to the upsurge in anti-establishment political movements in recent years. There is more than an echo of Donald Trump in his assessment that the rolling back of the state has led to a vacuum which has been filled by multinational corporations, which have usurped government’s role in many areas of policymaking.

Part of the Brexit campaign’s appeal was to idealise a version of Britain as a powerhouse of world output, which was wiped out by government’s willingness to sell out the UK’s interests to the EU. I have a different take on it: The anger manifest during the Brexit campaign was partly the result of the failure by successive governments to promote local interests, at a time when the threat posed by globalisation did indeed mean that a lot of British jobs were exported to lower cost locations (a view echoed in the US election campaign). This was given full expression in the immigration debate. But as Beatrice Weder di Mauro points out (here), German immigration numbers are roughly similar to those of the UK. Yet the degree of anger in Germany towards the EU is a lot lower than in the UK. You might conclude from this that the real problem in the UK is not so much the EU, or immigration, but general dissatisfaction with the economic status quo - a view which is increasingly the consensus.

But although Hines appears to have correctly identified the process triggering the backlash, this does not mean that his solutions are necessarily the right ones. Localisation essentially places limits on trade but all economists would agree that trade does lead to higher living standards, although as BoE Governor Carney noted recently, “the benefits from trade are unequally spread across individuals and time.” Hines may be wrong to simply dismiss “the flawed theory of comparative advantage” but he is right in that much greater emphasis must be placed on the negative consequences. The events of 2016 should act as a wakeup call for western governments to look more closely at their policy prescriptions. This does not mean that protectionism is the answer, but it does mean a rethink of a policy which allows markets to provide unfettered solutions may be in order.

Fail to prepare and prepare to fail

I was heartened this week to read the article in The Times by veteran (I hope he will forgive me for saying so) commentator David Smith in which he defended the role of economic forecasters (here). As he pointed out, forecasts may be wrong – indeed, they often are – but they need to be made. In my view, the trick is to know how to present the central case as one outcome amongst many possible paths, rather than focus solely on the one deemed to be the most likely.

This is a critical point. Indeed, part of the frustration which economists have is that their forecasts are often misrepresented. We know we don’t know precisely what the future holds and we are more than happy to say so – it’s just that quite often, that is not what people want to hear (I refer you to my post from July, here). Frequently, economic forecasts are treated with a reverence which they do not deserve. Indeed, this takes us to the heart of one of the subjects I have written about extensively on this blog: The criticisms levelled at some areas of macroeconomics and the degree of attention which we should pay to the work of economic practitioners. They are two different issues and we must be careful not to mix them up.

Whilst I admire the intellectual content of a lot of academic work, my criticism is that it too much of it is arcane and tries to dress up simple analysis in abstract mathematical terms. Practitioners tend to eschew the overly complicated – not because we don’t understand it (though sometimes that might be the case), but partly because we operate under greater time and resource constraints which mean that our analysis falls short of the standards which academics set for themselves. Most of us do have an understanding of the academic material but choose which parts we can use and which parts we can afford to ignore.

But the criticism of economics by outsiders is different. They argue that because we get things wrong, our forecasts are not to be trusted. And that is why (to quote Michal Gove) "we've all had enough of experts." I thus took great exception to an argument used by the FT journalist Wolfgang Munchau who suggested that "Because of a tendency to exaggerate, macroeconomists are no longer considered experts on the macroeconomy." Let's just stop and think about this. Exaggerate what exactly? The pre-Brexit exaggeration came from politicians (George Osborne in particular) who blew up work by the likes of the Treasury to imply it said something it did not. The analysis said that UK output would be anywhere between 4% and 7.5% below that which would otherwise result if we stayed in the EU, over a 15 year horizon. That is a significant welfare loss, but it probably means that the UK would grow at around the same rate as the euro zone rather than what we have experienced here in recent years.

The press is not immune from the tendency to exaggerate. Economists are routinely described as "experts" and forecasts treated with undue reverence – until they turn out to be wrong and are dismissed with Gove-like contempt. Indeed, this term "expert" appears to have a recent provenance and I don't remember being described as such until relatively recently. As a case in point, consider this quote from The Observer suggesting that "Ongoing uncertainty over the manner of the UK’s departure from the EU is likely to weigh down the property market in 2017, say experts, who predict little or no growth in prices amid a slowdown in sales." (here). It is more accurate to say that those who work in the property industry have given an educated guess, based on their experience and knowledge, of what they expect to happen. It’s not as sexy as being an expert but it’s closer to the truth.

Whilst I have done my fair share of forecasting over the years – some of which was accurate, a lot of which was not – we have to recognise that economics is not a predictive discipline. Economists have no better idea than the next person what will happen next week or next year. But what we can do is put issues into context, based on past experience, and we try to offer an evidence-based view of what might happen in future. That does not guarantee we will be right. But as director of the NIESR, Jagjit Chadha, has pointed out “It is quite obvious that we cannot know the future. But it is equally obvious that we cannot afford not to think and plan for the future.” In other words, fail to prepare and prepare to fail.

Think healthy

The journalist AA Gill died at the weekend after a short battle with cancer. His final article was published posthumously in the most recent issue of The Sunday Times, describing how he coped with his fatal illness. What was particularly striking about the article (the gist of which you can get from the BBC here or The Guardian here) is the description of how cancer survival rates in the UK are the lowest in western Europe. The doctor who treated him noted that the reasons for such a poor performance are due to “the nature of the health service” which imposes such a huge administrative burden that it hampers early diagnosis of the disease which is so vital to successful treatment.

Many foreign people of my acquaintance do not share the same reverence which the Brits show for the National Health Service. This is in no way to denigrate the professionalism of those who work in it. The doctors, nurses and all other medical staff do a wonderful job saving lives and healing the sick – but they work in a system which is dysfunctional, as many NHS employees readily admit. As Gill himself noted, the Brits lie to themselves about the quality of the service they receive. “We say it’s the envy of the world. It isn’t. We say there’s nothing else like it. There is. We say it’s the best in the West. It’s not. We think it’s the cheapest. It isn’t … You will live longer in France and Germany, get treated faster and more comfortably in Scandinavia.”

When it was founded in 1948, it offered a genuinely revolutionary approach to health provision in the west. But precisely because it is free at the point of consumption, it has always struggled with questions of “how best to organise and manage the service, how to fund it adequately, how to balance the often conflicting demands and expectations of patients, staff and taxpayer [and] how to ensure finite resources are targeted where they are most needed.” (source: Geoffrey Rivett, here). As treatment becomes more expensive and the population gets older the pressure on resources becomes more intense. The current government has opted to ring-fence NHS spending (but not welfare spending – we’ll do that another day) but continues to struggle to reform the system. No politician has yet had the courage to impose charges as a means of regulating near-infinite demand, such is the totemic importance of the NHS to the British electorate.

Precisely because resources are finite, Gill was denied treatment on the NHS which may well have prolonged his life because it was deemed too expensive. The cost of providing him with a drug called Nivomulab would have amounted to between £60k and £100k per year – four times the cost of traditional chemotherapy. And this is where economics comes in. Health economists are employed in the NHS to ensure that best use is made of the resources available. It is a job which needs to be done. After all, if economics is (at least partially) about the study of the allocation of scarce resources, then health issues would appear to be highly amenable to the scrutiny of economists.

But Johannes Bircher at the University of Bern argues that we do not actually know what health is (here) and therefore it is not a commodity which can be priced: After all, we cannot produce, obtain, exchange, sell or store it. Such an approach rather undermines the assumptions underlying Kenneth Arrow’s classic 1963 paper (here) which treats health as a commodity – albeit one with different characteristics to normal consumer goods.

My own issue with the field of health economics stems back to my undergraduate days and questions of cost-benefit analysis, because I have always struggled with the question of how you put a price on life. No matter what form of valuation you use, no amount of money can ever compensate for the very essence of being. This is not a question for economists – it is one for the philosophers. 

All that aside, Gill showed a remarkable degree of stoicism in facing up to his fate and wrote that he was happy for the last 30 years of life, having broken his alcohol dependency cycle in the mid-1980s. For a man who wrote so wittily and so scathingly on a range of subjects, it is only fitting that we leave the last word to him on a subject we all know and love so well – Brexit. “We all know what ‘getting our country back’ means. It’s snorting a line of the most pernicious and debilitating Little English drug, nostalgia. The warm, crumbly, honey-coloured, collective “yesterday” with its fond belief that everything was better back then, that Britain (England, really) is a worse place now than it was at some foggy point in the past where we achieved peak Blighty.”

The beatings will continue until morale improves

The ECB’s decision to extend its asset purchases beyond next March, albeit at a slower pace, is seen in some quarters as a tapering announcement and is viewed by others as a further round of monetary easing. To recap, the ECB announced that it will extend its asset purchases to December 2017, rather than end in March, but at a rate of €60bn per month rather than the current pace of €80bn. Technically, a reduced pace of asset purchases is a form of tapering. But let us not forget that when the ECB began its purchases last year, it was initially buying at a monthly rate of €60bn. I am inclined to view the announcement this week as continued monetary expansion rather than a precursor of tapering.

Looking more closely at the statement issued by the ECB (here) the presumption is that it will have to do more rather than less. Purchases will continue to December 2017 “or beyond, if necessary” and “if … the outlook becomes less favourable … the Governing Council intends to increase the programme in terms of size and/or duration.” Nowhere does it say that the central bank will scale back purchases if the outlook improves or if inflation picks up more quickly than anticipated. In that sense, it is an asymmetric commitment.

Increasingly, I get the sense that the ECB is out of step. It came late to the QE party, beginning asset purchases only in 2015 whereas the Fed and BoE started in 2009. The Fed has long since ended its asset purchase programme, and the BoE announced only a modest expansion in August in the wake of the EU referendum, having been on hold for much of the preceding four years. There is also clear evidence that the bang for the buck (or euro) diminishes the more QE is undertaken. Indeed, the BIS made precisely this point in its 2016 Annual Report (here, see p72). As it pointed out, “there are natural limits … to how far interest rates can be pushed into negative territory, central bank balance sheets expanded, spreads compressed and asset prices boosted. And there are limits to how far spending can be brought forward from the future. As these limits are approached, the marginal effect of policy tends to decline, and any side effects – whether strictly economic or of a political economy nature – tend to rise.”

The problem is not all of the ECB’s doing. Successive Presidents have been making the point since the ECB’s inception in 1999 that governments need to do more to reform their economies. And they simply have not done so. This mirrors comments by BoE Governor Carney who made a similar point regarding the UK (as I noted here). But the need for reform is far more acute in the euro zone. In a fixed exchange rate system, the burden of adjustment for economic problems falls squarely on the domestic labour market; No longer can countries rely on a weaker exchange rate to bail them out. Italy is a case in point, where the economy has barely grown in the last 16 years, and where politicians have been frustrated in their efforts to reform the domestic economy by groups with a vested interest in preserving the status quo (notably the unions). Whilst you have to feel a bit sorry for well-meaning politicians such as Matteo Renzi, it is hardly a surprise when electorates turn on their politicians as the Italians did last weekend in the constitutional reform referendum.

However, there is growing concern in Germany that the euro zone is morphing into a transfer union, as surplus countries continue to prop up the ailing southern peripherals. Technically, this is true. But this is also a necessary condition for the euro zone to survive. Not all countries can run external surpluses, and they certainly cannot all run surpluses against each other. In the absence of these transfers, the euro zone is just another fixed currency regime which will inevitably fall apart. Suggestions last week from German Finance Minister Wolfgang Schäuble that Greece must carry out structural reforms instead of receiving debt relief are to entirely miss the point about the nature of the problems which it faces. Greece is labouring under such a huge debt burden (182% of GDP) that unless part of it is written off, it will simply default. Period! And most people know it.

ECB President Draghi may be pilloried for running a policy which appears to benefit “profligate” southern European countries, but he is stepping into the void created by politicians who are not doing anything to support the economy via fiscal policy or structural reform. Without his efforts, the euro zone would be in an even sorrier state. But as the BIS analysis suggests, economies cannot live on monetary policy alone. And all this does raise genuine existential concerns for the future of the euro zone. We used to talk of Grexit long before we had even heard of Brexit but all the problems which the region has dealt with in the last seven years are still there. The beatings will continue until morale improves.

Those sixties weren't so great

Bank of England Governor Carney delivered an interesting speech this week (here) in which he took a closer look at the reasons behind the rise in populist responses to our current economic ills. None of it was particularly new, but it was illuminating for the fact that a heavyweight economic policymaker addressed the issues in a more rational fashion than I have yet heard from most politicians.

Most of the newspaper headlines focused on his one killer statistic that in the UK we are currently experiencing “the first lost decade since the 1860s.” (Clearly those sixties were not all about flower power). Carney used the excellent BoE database (here) to show that real wages over the last ten years have grown at their slowest rate since the mid-nineteenth century. And as I have long argued, although productivity performance has been lousy it has at least outstripped real wage growth, which suggests that workers have not been compensated for their efforts. Indeed, the share of wage and salary income in UK GDP (technically, gross valued added at factor cost, but let’s not overcomplicate things) has fallen from around 58% in 2011 to 56.5% in 2015.

Carney makes the valid point that although economists are unshakeable in their belief that society benefits from free trade, not everybody benefits equally. As he put it, “the benefits from trade are unequally spread across individuals and time.” So far as I am concerned, he is preaching to the converted: Those of us who recall the wholesale destruction of large parts of the UK manufacturing base in the 1980s need no reminding that there were significant adjustment costs as those losing their jobs had nowhere else to turn. Some people were eventually forced to relocate to find work; others had to wait for new local opportunities to arise. Viewed from 30 years on, many of the economic scars have healed as the UK macroeconomic data show that real incomes per head are almost double the levels of the early-1980s. But at the time the local dislocation was huge, and today it is not just the UK which is facing these problems: It is an issue across the whole of (what is still euphemistically called) the industrialised world.

Those who argue that markets will always adjust often overlook the fact that the longer-term gains are smaller than they appear when offset against the short-term costs. The pace of technological change magnifies these impacts. If people are concerned that their jobs can be replaced by machines, they are bound to become fearful and resentful. This is, of course, not new as the Luddite movement of the early 19^th century demonstrates (here for a quick overview). We should also take encouragement from the fact that societies have usually managed to accommodate technological advances relatively easily. But this will not happen if we continue to plod down the same unimaginative policy path that we have been following in recent decades.

Before turning to what needs to be done, Carney defended the role of monetary policy by arguing that it “has offset all of the headwinds to growth arising from private deleveraging, fiscal consolidation and subdued world growth.  People haven’t been made poorer.” But he noted that they feel worse off because productivity growth remains subdued. Recall Paul Krugman’s line that “productivity isn’t everything, but in the long run it is almost everything.  A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.” (Actually that is true only if workers are compensated for their productivity performance which, at least in the UK, has not been true in recent years).

Carney thus believes that efforts to boost productivity are an important element in generating an economic turnaround. Quite how we achieve this is not so easy to identify and we will revisit it another time. However, his conclusion was a sharp retort to the recent criticisms which have been put his way by politicians: “To address the deeper causes of weak growth, higher inequality and rising insecurity requires a globalisation that works for all. For the societies of free-trading, networked countries to prosper, they must first re-distribute some of the gains from trade and technology, and then re-skill and reconnect all of their citizens. By doing so, they can put individuals back in control.” This is an interesting twist on the take-back-control of the Brexiteers, and I have to say I agree with the Governor on this one.

It is just a pity that such a cogent analysis of the UK’s ills was left until almost six months after the referendum. But when it takes the Governor of the Bank of England to point out that “we must grow our economy by rebalancing the mix of monetary policy, fiscal policy and structural reform,” this strikes me as a sad indictment of a political class which continues to deflect the blame for years of policy neglect onto the EU.

Better not call Paul

Paul Samuelson was quite clearly a brilliant man and one of the most influential economists of the twentieth century. His magnum opus, Foundations of Economic Analysis published in 1947, was one of the first rigorous mathematical treatments of important economic concepts. But for all its undoubted brilliance, I have long thought that Samuelson's work was one of the worst things to happen to economics.

This is not to denigrate his work. Samuelson produced some original insight in fields as diverse as consumer theory, welfare economics, public finance and international trade issues. Rather the problem is that he spawned a number of imitators who, captivated by the elegance of his work, attempted to replicate his mathematics rather than his economic insights with the result that academic economics became ever more algebraically rigorous. As Lo and Mueller (2010, here) have pointed out, whilst economics has become much more rigorous and "has led to a number of important breakthroughs ...  ‘physics envy’ has also created a false sense of mathematical precision".

This level of abstraction was part of the reason why the severity of the market crash of 2008 came as such a surprise. As Goldman Sachs' CFO commented in the Financial Times in August 2007 "We are seeing things that were 25-standard deviation moves, several days in a row." Andy Haldane, the Bank of England's chief economist, later pointed out: "Assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe. A 25-sigma event would be expected to occur once every 6x10¹²⁴ lives of the universe. That is quite a lot of human histories." In simple terms, the risk models used at the time were using the wrong statistical distribution to model risk and making firm conclusions based upon it.

It is thus no surprise that attempts have been made to reclaim the centre ground of economics. A recently-published book entitled Econocracy: The Perils of Leaving Economics to the Experts (here), attempts to redress the balance. As the authors note: “Politics and policymaking are conducted in the language of economics and economic logic shapes how political issues are thought about and addressed. The result is that the majority of citizens, who cannot speak this language, are locked out of politics while political decisions are increasingly devolved to experts.”

A letter in the Financial Times (here) recently made a similar point, arguing that "the folly of mainstream economists is their pretence to emulate the natural sciences, presuming to be value free." The author, Yeomin Yoon of Seton Hall University in New Jersey, noted that current practice increasingly deviates from the teachings of Alfred Marshall, who argued: “(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3 … I think you should do all you can to prevent people from using mathematics in cases in which the English language is as short as the mathematical.” Given that Marshall was no mean mathematician himself that is a pretty powerful argument.

Whilst it is easy to be critical of academic economics for creating a level of abstraction that so many people feel unable to relate to, and as a consequence feel able to ignore (as we saw during the Brexit discussions), the future may not be so bleak. Macroeconomics may be operating in an intellectual cul-de-sac (said the macroeconomist) but matters are not helped by the fact that too many people outside the profession expect economists to be able to predict the future with an unreasonable degree of accuracy. Rather than the study of abstract macroeconomic quantities with highly politicised connotations, the roots of economics lie in the study of how people make decisions. As a result, the discipline of microeconomics is thriving. The new and exciting field is behavioural economics where experimentation rather than algebra is used to tease out some of the newest ideas in economic thinking.

Economics is a discipline which has traditionally borrowed ideas from other areas. For a long time, perhaps, it borrowed too much from mathematics and the physical sciences, but by going back to its roots as a social science and borrowing ideas from psychology, the revolution which so many people are calling for may actually already be happening.

Don't make the same mistakes twice

"It is not difficult to indicate the reasons why business last year passed through periods of great anxiety. Under the strain of almost uninterrupted political tension … the state of the world is feverish rather than healthy; and whatever recovery may be seen is anything but steadfast, since it is dependent on the use of stimulants on the one hand and interrupted by grave disturbances on the other. In the face of grim reality in Europe there is decidedly less belief in experimentation with new methods of economic policy.”

This summary of the global conjuncture by the Bank for International Settlements sounds all too familiar. But it was taken from the Annual Report released in May 1939 (here). Indeed, although we should not overdo the parallels with the 1930s, there are a number of worrying economic developments which investors ignore at their peril – and they are not the obvious ones which spring to mind when we talk about the concerns of that particular decade.

It is, however, difficult to overlook the fact that the problems today and in 1939 were triggered by a huge financial crash and compounded by policy errors. Fiscal policy was criticised for being too tight both in the wake of the 1929 crash and again today. In 1931, President Hoover’s State of the Union message noted that “even with increased taxation, the Government will reach the utmost safe limit of its borrowing capacity by the expenditures for which we are already obligated... To go further than these limits ... will destroy confidence.” Today it is European fiscal policy which is accused of not stepping up to the plate. 

Ironically, one of the lessons of the 1930s, derived from the work of economists led by Keynes, was that government had a role to play in the economic cycle by stepping in to make up for any shortfall in aggregate demand. It has always struck me as bizarre that these insights, which prompted Keynes to write The General Theory, should be ignored at a time when the economic cycle shows some similarities with the macroeconomics of the Great Depression. There is also an irony in that both in the 1930s and again today, it is monetary policy which comes in for great criticism. Between 1930 and 1933 the Fed was accused of running an overly restrictive monetary stance. Today, the world’s major central banks are accused of being too lax.

Protectionist sentiment is also rising up the agenda once more. Donald Trump made “promises” on the campaign trail which were nothing short of protectionist (“I would tax China on products coming in … let me tell you what the tax should be … the tax should be 45 percent.”) Of course, this is a response to concerns that US jobs are being “exported” to lower cost economies in much the same way as occurred in the wake of the 1929 crash. Back then, this resulted in the signing into law of the US Tariff Act of 1930 which did a lot of damage to world trade volumes as other countries retaliated against the raising of US import tariffs. It is a sobering thought that in the last four years, the rate of global export growth has posted its slowest multi-year growth rate since the 1930s (see chart).

None of this means that current economic conditions will lead inexorably to the same outcomes as in the 1930s. But we should not ignore the role of fiscal policy in helping to promote recovery – as the OECD noted in the latest edition of its Economic Outlook, released this week. And as the discussions over Brexit continue, some British ministers appear to think that a world of tariffs (albeit low ones) is preferable to belonging to a system without any, so long as they can achieve their own version of economic nationalism. Most economists believe that this will result in a loss of British economic welfare, but just as the likes of US economist Irving Fisher were initially ignored for pointing out the same thing in 1930, so no-one in government appears willing to engage in a rational debate about the costs of Brexit.

Economists of my era were taught that the 1930s were a decade of collective madness and that we had learned the lessons of that benighted period, and would not repeat them again. But history has a habit of making fools of us all. However, we can only hope for rationality to begin to reassert itself before we make even bigger economic mistakes from which it becomes more difficult to recover.