Whose Brexit is it anyway?

Although last year’s Brexit referendum was initially proposed by the Conservatives, it was conducted across party political lines as MPs were allowed to vote with their conscience. And as we all know, the question on the ballot paper simply asked whether the UK should remain part of the EU or leave the EU. No thought was given to the form which Brexit should take. For a long time, Theresa May simply relied on the slogan “Brexit means Brexit” without giving any further indication of what that meant. By the time of her Lancaster House speech on 17 January, we finally got more insight when we were told that the government’s negotiating position would be based on the principle that “No deal is better than a bad deal for Britain.”

Most economists are horrified by that stance. It is simply not credible to assume that the rest of the EU is going to back down in the face of UK intransigence. What is more, this statement has made its way into the Conservative election manifesto. So either the Conservatives are committed to driving the UK economy over the edge of the cliff in the event they do not get the deal they want, or they will be forced to break the pledge upon which basis they were elected (assuming they win next week’s election).

But rather than treat the Brexit negotiations as a single party issue, there is a strong case for cross-party representation in the UK negotiating team. Indeed, if we accept the claims of those who believe Brexit is the biggest single issue facing the UK since World War II (maybe a slight exaggeration but you get the point), surely it deserves a similarly united national response. It would certainly help to assuage the 48.1% who voted against Brexit that their concerns will be listened to.

Whilst Labour believes the UK should continue down the path which their political opponents have already carved out, it does at least believe that “leaving the EU with ‘no deal’ is the worst possible deal”. It also makes the sensible suggestion that the UK should seek to remain part of organisations such as Horizon 2020, Euratom, the European Medicines Agency and Erasmus, and advocates protecting the rights of foreign nationals already in the UK. The Liberal Democrats are even more direct and parts of their manifesto sound like they wish to overturn the result. But at least the “aim for membership of the single market and customs union” sounds like a rational economic plan. The Scottish Nationalists have not yet released their manifesto, but you can be pretty sure that their aim will be to ensure that Scotland remains part of the EU.

On the basis of these varying degrees of support for the EU, my suggestion would be for the UK government to assemble a cross-party negotiating team, perhaps weighted by parliamentary representation. Based on the latest analysis by www.electoralcalculus.co.uk, this would imply giving the Conservatives a 60% weighting; Labour 32%; the SNP 8% and the Lib Dems 0%.  I do not expect this to happen, of course. As Philip Stephens noted in the FT four weeks ago, “Theresa May is dangerously disdainful of dissent” pointing out that “Mrs May assumes a monopoly of wisdom on setting Britain’s terms for EU exit. The record suggests she can claim anything but.” Ben Chu in today’s Independent suggests that the whole Conservative manifesto strategy is designed to bolster the prime minister’s position rather than looking after the UK’s best economic interest. In effect, we face a principal-agent problem whereby the agent (in this case the prime minister) has an incentive to work in her own interests rather than the principals who commissioned her (the electorate).

One solution to the principal-agent problem is to provide a high level of transparency – the prime minister’s insistence that she does not intend to reveal details of the discussions on a rolling basis surely adds fuel to Chu’s suspicion. Fortunately, we can rely on the rest of the EU to deliver that transparency. Giving the principal a stake in the outcome is also another useful solution. The issue (as noted above) is whether May’s objective is to secure her own or the national interest. A final check is thus to impose greater accountability. Packing off Conservative party representatives to Brussels for two years who then come back with a deal which is set to be rubber stamped by parliament is simply not enough. I thus maintain that at the very least other political parties should be represented during the negotiations, who are not bound by some form of parliamentary omerta. Some issues are too important to be left to politicians. This is one of them.

Being Wayne Rooney

Wayne Rooney is one of the most famous footballers in the world. He is the record goal scorer for his club, Manchester United, and for the English national team, and has won everything worth winning at club level (including 5 league titles, an FA Cup and the Champions League). However, over the last 12 months, questions have increasingly been raised about his continued ability to cut it at the highest level which has raised speculation that he will leave Man United at the end of the season. Not that football journalists know anything – The Guardian reported earlier this month that he would leave the club at the end of the season  having suggested just three months ago that he has no intention of leaving. Meanwhile the fans, not exactly models of consistency themselves, are generally in agreement that it is time to go.

But whilst the fans treat usually football decisions in the context of the on-field activities, there are in reality a lot of other economic factors to consider. Look at it from Rooney’s point of view. He is 31 years old and reported to be paid around £300k per week on a contract  believed to run until June 2019. Even if we assume this figure is around £260k, as reported in a number of media outlets, this means he can expect a gross income in the region of £27 million even if he never kicks a ball again. From the club’s perspective, it would appear to make sense to offload their highest earner if he is no longer able to perform at the level demanded of him. Indeed, as of mid-2016, the club was paying out £203 million per annum on wages – implying that Rooney accounted for just less than 7% of the total.

But Man United also earned £268 million in commercial revenue – primarily sponsorship and retail activities (here for more detail on the club’s accounts. It is slow to load, but worth it for an in-depth look at the accounts of a major football club). We should be in no doubt that Rooney has helped sell a lot of replica shirts. But now that he is no longer in the England squad, his commercial value will undoubtedly have slumped. Footballing considerations aside, the club appears to have little to gain financially by keeping him on. Of course, no other club in Europe is going to pay Rooney £13.5 million per year so unless he decides to join the exodus to China, where silly money is apparently on offer, what to do? The rational response would be to hang around for the next couple of years and bank the cash. Fans forums would, of course, be inundated with comments suggesting that he is only in it for the money and that such actions will tarnish his legacy. But frankly, you can trash my legacy for £27 million any day.

Rooney’s logical response to this criticism should be to ask the fans what they would do in the same situation? If your employer told you not to come in to work for the next two years whilst still paying your salary, most people would say it is illogical to refuse. After all, you could travel; learn a foreign language; do further study or take up a new hobby. Failure to understand the rationality of this position is a form of cognitive bias, defined as “a systematic pattern of deviation from norm or rationality in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion.” It is not just football fans who suffer such biases, of course. Financial markets are riddled with them, which goes towards explaining why many investors make decisions which they can justify at the time but with hindsight appear ridiculous.

As it happens, the rumour mill is in full swing suggesting that various clubs are currently bidding for Rooney’s services. He may indeed be tempted to go elsewhere: It is not as if he is short of money so he can presumably afford to take a pay cut. The motivations for him wanting to do so are fully in line with evidence from psychology which suggests that factors other than money can motivate sportspeople. Like actors, sportsmen (and women) are motivated by adulation. So long as he continues to be reasonably well paid, Rooney might be tempted to trade off some of his extraordinarily high current salary for a lower one and a continued presence in the public eye.

Still, it’s a nice problem to have. As for me, if I were faced with Rooney’s decision I’d take the money on offer from Man United. In fact, I would take a small fraction of his salary in order not to play football. Now you might say that I am not as good a footballer as Wayne Rooney so am in no way as deserving. But that is only true on the field of play. When both of us are doing nothing, I’m just as good as he is.

Age concern

Without wishing to trivialise in any way the horrific bombing in Manchester, the suspension of the UK election campaign came at a fortuitous time for the prime minister who was undoubtedly on the ropes on Monday regarding her U-turn on plans to fund care for the elderly. Dealing with old age care is an issue of major economic importance, and I did note last weekend that “tackling the problems of an ageing society will require us to think differently on tax and social insurance issues.” But it is worthwhile digging into some of the economic implications of an issue which not only affects the UK but is a problem for all ageing societies.

To remind you of the story so far, the Conservative manifesto last week suggested that those requiring long-term old age care would be required to run down their assets to “a single capital floor, set at £100,000, more than four times the current means test threshold.” The implication is that households will have to pay a lot less than they do today. Whilst that is true of the current system, it omits the fact that under legislation already on the books “from April 2020, there will be a cap limiting the amount people will have to pay for their care and support”. Moreover, the threshold beyond which people receive no financial support is due to rise from £23,250 to £118,500 (these reforms were originally scheduled for 2016 but local authorities balked at the additional costs this would impose, hence the delay until 2020).

In other words, a significantly more favourable plan is already scheduled to come into play in 2020 than that proposed by the Conservatives. As it currently stands, someone who has lifetime care costs of £150,000 could lose up to 90% of their accumulated wealth. Raising the support threshold and imposing a cap significantly reduces this proportion. By contrast, the Conservatives’ plan placed no such upper limit so that all but the final £100,000 of an individual’s assets could be used to fund their care needs. I am indebted to the FT’s economics correspondent, Chris Giles, for working out the tax rates on assets in different care systems (see chart). What is evident is the magnitude of the costs under the current system (the green area) versus the proposals set out by the Dilnot Commission in 2010 (black line). Last week’s Conservative plans (red line) help those at the lower end of the asset scale but they are far less favourable compared to what was proposed in 2010.

The idea of scrapping the cap caused an outcry for both good and bad reasons. The bad reason is the notion that today’s generation of pensioners be protected so that they can hand over their stock of assets to future generations. Whilst this may reflect an instinctive desire to help one’s offspring, there is no reason why today’s tax revenues should be used to ring-fence bequests to future generations. A better objection is that the absence of a cap promotes unfairness due to the fact that for any given wealth cohort some will be afflicted by illnesses which require extensive old age care whilst others will not. For example, an unfortunate pensioner who suffers from dementia may require many years of care whereas someone with the same assets who dies suddenly at the same age will not face the same care burden. There is no sense of social insurance: people are very much on their own.

Whether the reaction of the public and politicians was motivated more by the latter than the former matters less than the fact that the Conservatives responded to the groundswell of opposition by announcing they would indeed place an “absolute limit” on care costs (without saying what the limit would be). What is absolutely not true is the prime minister’s assertion that “nothing has changed from the principles on social care policy that we set out on our manifesto.” In fact, everything has changed. The principle of a cap means that we have some notion of risk pooling rather than one which forces individuals to bear full personal liability.

A more pertinent question is how this should be funded, which is the bit no-one talks about. The Dilnot Commission pointed out that there are three ways to fund old age care provision. The obvious way is to do what we do now – raise the additional revenue from general taxation, which will mean higher taxes. A second option would be to change the balance of spending away from other items and towards care provision. However, a third option would be to introduce a specific tax increase which should be paid “at least in part by those who are benefitting directly from the reforms. In particular, it would seem sensible for at least a part of the burden to fall on those over state pension age.” Dilnot further suggested that “it would be sensible to do so through an existing tax, rather than creating a new tax” which would most obviously suggest targeting inheritance tax.

I am not even averse to the idea of levying a specific tax in order to build up a social insurance fund, although governments are generally very bad at ring-fencing revenues for specific tasks. Whatever the ultimate outcome, the UK government clearly has to think more carefully about generational outcomes than it has up to now. The current pay-as-you-go option is not fit for purpose. But nor is a system which mitigates against a market for social insurance. There is plenty to ponder but it certainly will not be resolved before the election, and it is increasingly a problem which all industrialised countries have to face up to. Ageing societies don't come cheap.

A partial change of tack from the Conservatives

Having previously looked at the Labour Party manifesto (here), in the interests of balance it is only fair that I take a look at the economic consequences of the Conservatives’ election promises – particularly since they are nailed on favourites to win the election, so what they have to say is probably more relevant. However, since they did not offer any attempt to cost their proposals – unlike Labour or the Lib Dems – it is harder to offer a precise assessment.

What is striking is that last week’s document highlighted “Five giant challenges” in a similar vein to the famous 1979 manifesto which highlighted “Our five tasks.” But there the similarities end. Indeed, the overall tone was widely interpreted as a step back from the Thatcherite policies which have dominated the Conservatives’ agenda for almost 40 years. This view is based on an apparently innocuous couple of sentences tucked away on page 9 which suggested “We do not believe in untrammelled free markets. We reject the cult of selfish individualism.” That is most certainly not the Conservative philosophy which has been presented to me throughout most of my adult life.

So why the change of direction? Perhaps it is because, as John Kay pointed out in an FT column recently (here) , “a great intellectual failure of the past two decades is the inability to offer a more nuanced account of the market economy than that contained in the mantra of ‘greed is good.’” I could not agree more. One of the motivating factors behind this blog in the first place was to point out that systematic indifference to the fate of swathes of the British economy, which had been left to contend with the forces of free market economics, would ultimately weaken, rather than strengthen, it (see my first post from June 2016). Market self-regulation clearly produces outcomes which are damaging both to the company and the consumer (think of the scandals in banking in recent years) and as Kay points out, “the legitimacy of modern business organisation has been further undermined by continuing revelations of corporate wrongdoing … and by the disclosure of the aggressive tax avoidance.”

Does this mean that a Conservative government under Theresa May will take a step to the left (or more accurately, the centre) of the political spectrum on economic matters? Admittedly, one of its consumer protection policies was a rehash of an old Labour policy promising to introduce tariff caps on domestic energy bills. This ironically, was a policy described by David Cameron as “Marxist”. But it is not the whole story.

From a macro perspective, the Conservatives now only “aim for a balanced budget by the middle of the next decade.” At the time of the 2015 election, the budget forecast showed that the UK was on track for a budget surplus by 2018-19. One of the problems which the government has faced since 2010 is that income tax receipts have continued to fall below expectations (chart), which has blown a £30-40bn hole in the budget with the result that filling the fiscal gap has taken far longer than anticipated. At least the Conservatives have dropped the pledge not to raise income taxes or National Insurance Contributions, which caused such a controversy in March. 

All this matters because the government will increasingly have to face up to the problem of rising healthcare costs resulting from an ageing society as baby boomers retire in droves. One of the ways which the Conservatives have tackled this is to propose a reduction in the cap on welfare spending for the elderly, which means that those receiving social care must fund the entire cost until they reach their last £100,000 of assets. This is hugely unpopular amongst traditional Conservative supporters and it also flies in the face of the Dilnot Commission recommendation that a limit be placed on lifetime social care contributions (a review body set up by the coalition government in 2010). Nobody likes the idea of running down their childrens’ inheritance to pay for care costs, hence its unpopularity, but it is a recognition that tackling the problems of an ageing society will require us to think differently on tax and social insurance issues in future.

I have managed to get this far without talking about Brexit, primarily because there is nothing new to say. The Conservatives continue to believe “Britain needs a strong and stable government to get the best Brexit deal … delivered by a smooth, orderly Brexit.” But it also remains committed to reducing annual net migration to ”the tens of thousands, rather than the hundreds of thousands we have seen over the last two decades.” Having failed for the last seven years to deliver this pledge I remain unconvinced that it is achievable any time soon (never mind the fact that the figures are almost certainly wrong, as the UK’s sample based system has huge margins of error). Moreover, it continues to target a net figure whilst only focusing on migration inflows. Even more strange is that whilst the manifesto states a desire to ensure that the flow of skilled migrants continues, in the next paragraph it announces a plan to ”double the Immigration Skills Charge levied on companies employing migrant workers.”

This highlights the lack of joined-up thinking on immigration and highlights why businesses are increasingly expressing disquiet about the costs of immigration curbs.  Moreover, in its Fiscal Sustainability Report, released in January, the OBR assumed long-term net immigration of 185,000 per year. Its low immigration scenario, which assumed a net figure of 105,000 per year, reckons that in 30 years’ time the UK’s net debt to GDP ratio will be 11% higher than in the already unfavourable baseline, rising to 20% and 30% higher on a 40 and 50 year view respectively. Obviously, we should take long-term forecasts with a huge pinch of salt but they should remind us that immigration curbs come at a substantial economic cost.

Quite clearly, Theresa May is banking on the idea that she can win a large enough majority to silence the hardliners within her party who believe in the primacy of free markets and Brexit-at-any-price. She will have to, because there is enough material there to enrage the old-school Thatcherites who have a habit of making life hard for vulnerable prime ministers. As an economic plan, aside from the immigration pledge (and maybe the energy caps), it has its good points. But by pushing out yet again the point at which the UK balances its fiscal budget, I do question whether the last seven years of austerity have been worth the cost.

On Trump, risk and uncertainty

As if Donald Trump’s tribulations were not bad enough, we learned today that Brazilian President Temer has been caught on tape endorsing bribery payments. The net result was that Brazilian financial markets took a hammering with the equity market opening 10 per cent down, which triggered an automatic halt in trading, whilst the currency wiped all its year-to-date gains. This comes a day after US – and by definition global – markets suffered heavily in the wake of mounting disquiet regarding the conduct of President Trump.

Without making any comment on the rights and wrongs of their respective actions, what is most fascinating was the market response which has been extremely negative. We should not overlook the fact that the VIX index – a measure of option volatility on the S&P500 – was at 24 year lows at the start of last week. This index is often referred to in the financial press as the “fear index” because the extent to which volatility changes is associated with changes in market sentiment. As it happens, this is a little misleading because the VIX is a measure of market perceived volatility in either direction. But a surge from a low below 10 last week to above 15 today is a measure of a market which is nervous.

What has struck many investors as odd over recent months has been the extent to which markets have been able to shrug off the uncertainties in the wake of Donald Trump’s election, driving US equity indices to record highs and volatility to multi-year lows. The surge in prices has clearly been driven by expectations of the Trump reflation trade. But as I noted at the start of the year, “I suspect markets will not get the benefit of the hoped-for fiscal stimulus” and I still stand by that view, primarily because the president’s difficulties will make it much harder for him to drive through his economic agenda. Predicting that markets will correct is a mug’s game but in the absence of a tailwind from expectations of stronger growth, it might be harder for equities to make big gains from here, particularly when valuations are already high and the Fed is raising rates.

Last week’s interview by The Economist of the President, which resulted in a scathing assessment of Trumponomics, did not fill me with much hope that a growth plan is forthcoming. The Q&A transcript struck me as a rambling and superficial overview of his plan. However, none of this should have come as any surprise. So it always felt strange to me that markets could be so sanguine and, despite the fact we are living in some of the most extraordinary economic times in recent history, that equity volatility could decline so far.

This supports the view which I have held for many months that whilst markets can price risk they cannot price uncertainty, and as a result have simply given up trying to do so. This difference between risk and uncertainty is a long-held tenet in economic and financial circles and stems from Frank Knight’s 1921 book “Risk, Uncertainty, and Profit” which made a clear distinction between known unknowns and unknown unknowns (long before Donald Rumsfeld picked up on the concept). It does go a long way towards explaining why markets can suddenly switch from a stable state to an unstable one. In the wake of both the Brexit referendum result and Trump’s election, markets realised very quickly that sharp sell-offs were unnecessary and that there was potential for a rally. Investors knew full well that it could all go wrong but probably rationalised the view that there was no point in waiting for the other shoe to drop. Far better to ride the cycle on the way up and deal with the consequences of the sell-off as and when it happened.

But just as many of us failed to pick up the tail risks last year, so investors have to beware the possibility that these risks begin to manifest, perhaps in the form of no Trump reflation trade. If we can’t price uncertainty, then maybe investors will be forced to pay more for risk protection. That alone might take the edge off the recent US rally. Of course, it may not, but if and when the correction finally does occur, it could be all the more painful.

Labour's fiscal policy: Marks for effort

The UK election campaign, which is being met with indifference at home never mind abroad, took a radical turn today with the publication of the Labour Party’s manifesto. Much of what was leaked last Thursday was included in today’s plan, with one or two additions, and it is very much a series of tax and spend proposals which offers a radical alternative to the economic status quo of market over state. It is, I suspect, the economic plan of a party which does not expect to win an election: Many of the proposals would simply not be acceptable to higher earners or corporates, which will bear the brunt of additional tax rises. At a time when companies have to think about where they want to be located post-Brexit, it is a plan which will encourage footloose capital to move elsewhere. Nonetheless, it does raise very big questions about the nature of the state and the role of fiscal policy, which have been neglected for too long.

The philosophy which the UK electorate has bought into since Thatcher’s time is that a relatively small state is a good thing and that markets provide freedom of choice. But this is not always true. For one thing, private companies are not always as efficient as their proponents claim because they waste resources in the competitive process which could otherwise be used more effectively for service provision – a bit like moving parts which generate heat rather than mechanical energy. Whilst on the whole, they do deliver lower cost services there are real questions as to whether private entities are run for the benefit of shareholders or their customers.

In a competitive market the two sets of interests are aligned, but certain industries are best viewed as natural monopolies. Gas, electricity and water supply all fall into this category and so unpopular is the notion that private sector energy companies are ripping off the consumer, that the Conservatives have stolen one of Labour’s old ideas by planning to impose price caps (what price free markets?). Nor are huge infrastructure projects  necessarily suited to a private sector which does always not have the scale to manage them properly. For example, the UK has outsourced the construction of the Hinkley Point nuclear power station to EDF – a French state-owned company – and a state-backed Chinese entity. The first decade after the privatisation of the UK rail network was characterised by a shambolic series of events which means that today, the Labour Party’s policy of re-nationalising the rail network is actually very popular (it plans to do this as local franchises expire which means that the cost to the Exchequer is limited).

Of course, not all privatised utilities are bad. No-one would seriously advocate renationalising the telecoms network. But it is right to have a debate about which industries require more state involvement, and we should not dismiss the issue as being one for the socialists. Incidentally, the privatisation programme sparked by the Thatcher government in the 1980s was designed to create a nation of small shareholders, in which households held a stake in the nationalised utilities. But that idea faded quickly as shares were snapped up by institutions which in turn sold out to foreign utilities. Whatever the rights and wrongs of today’s energy and water markets in the UK, what we have now is not what was envisaged in the 1980s.

Looking more closely at Labour’s plans, there was more detail on the tax and spending pledges which will result in a tax rise of £48.6bn by the end of the next parliament, or just over 2% of GDP. According to the sober analysis of the Financial Times, this would put taxes relative to GDP at their highest since 1949. But even then, the state will still be significantly smaller than in many other European countries. As I noted last week, a large chunk of the additional taxes will fall on corporates, which are expected to contribute almost £20bn of the £48.6bn increase, and another £6.4bn from higher income taxpayers in what the Daily Mail helpfully described as Corbyn’s class war. What was truly radical was the idea that a Labour government would “consider new options such as a land value tax” which ironically was supported by the likes of Adam Smith, a hero of many on the Conservative right.

It is questionable whether these figures would ever be realised, however. Raising taxes changes the behaviour of those on whom the tax is levied so if tax elasticities are high, revenues may well be far lower than anticipated. Nonetheless, Labour did a good job of allaying fears of an unfunded rise in current spending, even if many people will be less than happy about the prospect of higher taxes. A potential Labour government will, of course, have to borrow to fund its capital spending plans. That is normal. At issue is how much it would need to borrow and what would the market charge. I suspect we will never get the chance to find out.

Even if one does not like the ideas presented today, they represent a rather more grown-up approach to the question of fiscal policy than we have become used to in recent decades. If we want a better healthcare system, we are going to have to pay for it. More policemen? Fine, but the money has to come from somewhere. There is, however, a whiff of the 1970s about the plan. It fails to account for the fact that more money does not necessarily mean better services. It also treats the UK as a small closed economy whereas in reality a globalised environment will pose limits on the government’s ability to operate the fiscal levers. A former Labour prime minister, Jim Callaghan, recognised as such in 1976 when he said “We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists.” Still, I will give Labour marks for trying, and we should not be too surprised if some its ideas ultimately end up being adopted by the Conservatives. It would not be the first time.

The case for a National Investment Bank

One of the policy proposals put forward in the leaked Labour Party manifesto last week was the establishment of a National Investment Bank (NIB) to facilitate £250bn of spending on infrastructure over the next ten years. There was no detail in the document about how this might be set up, but there is some merit to the idea if done properly and in this post I offer a look at how it might work.

It is important to be clear at the outset what it should not be. It should not be a conduit for monetary creation by the Bank of England – the so-called People’s QE plan proposed by Jeremy Corbyn when he took over as Labour leader in 2015. PQE essentially requires the central bank to buy the bonds necessary to capitalise such an institution. But this policy is fraught with danger primarily because it erodes the boundaries between government and central bank to an unacceptable degree. In the form envisaged, it allows government to force the central bank to create money to finance whatever projects it deems fit. Moreover, a policy which requires monetary creation on such a scale would also have potential inflationary consequences and no central banker worth their salt is ever likely to endorse such a plan.

That said, there is no reason why a NIB should not work. The UK has tried it before and it was remarkably successful though perhaps not in the way initially envisaged. The Industrial and Commercial Finance Corporation (ICFC) was set up in 1945 by the Bank of England with funding from major commercial lenders to provide capital to small and medium-sized companies. In order to free itself from the constraints of relying on the clearing banks for funds, the ICFC began to tap the market to raise capital. This had an adverse side effect in as much as it raised pressure to generate greater returns on equity, which in turn led to a shift away from longer term, less attractive returns which its core mission delivered, to shorter term higher return projects, which caused problems during times of economic downturn. But by the 1980s it had shifted focus to become a leading provider of finance for management buyouts and had expanded internationally. It became a public limited company in 1987, when the banks sold their stakes, and it was fully privatised in 1994.

Currently, the UK is the only G7 economy not to have an institution which provides finance to the SME sector. In Germany, the Kreditanstalt für Wiederaufbau (KfW) has supported industry since 1948 and in the US, the Small Business Administration (SBA) has operated since 1953. Admittedly, the UK government did dip its toes into the water recently when it established the Green Investment Bank (GIB) in 2012. But despite apparently being successful, it was sold to Macquarie Bank last month for a price (£2.3bn) less than the initial £3.8bn of capital injected by the government.

In an excellent paper commissioned for the Labour Party in 2011, the lawyer Nick Tott outlined the case for a NIB.  But just to show that the case was not party political, former MPC member Adam Posen made a similarly excellent case in a 2011 speech which suggested that not only was there a case for a NIB, but that there was a need for an “entity to bundle and securitize loans made to SMEs … to create a more liquid and deep market for illiquid securities.” The biggest question remains how to capitalise such an institution. The government could commit up to £5bn as initial seed capital – after all it put almost £4bn into the GIB – and it could issue another (say) £5bn of bonds backed by Treasury guarantee. In future years it could divert part of the income generated by National Savings and Investments (NS&I) which raised £11.3bn for the Exchequer in 2015-16 and has assets of £120bn.

Admittedly, this is pretty small scale stuff and would be in no way able to fund the £25bn per annum of infrastructure which the Labour Party is calling for. This is probably a good argument in favour of limiting the remit of such an institution to SME lending rather than big public infrastructure projects. That, after all, is what such institutions do in other countries. Moreover, as Tott points out, it “would need a wide measure of independence from government.” It cannot simply be an arm of government to finance all sorts of pet projects, otherwise those who brand it a return to 1970s-style profligacy will likely be proved right.

A NIB would have to be run along commercial lines. As Posen pointed out, “The existing banks will scream about the unfair cost of capital advantage such an institution would have, but ... since the major banks in the UK have benefitted from a too-big-to-fail situation, any disadvantage they have in funding conditions is offset by the funding advantage they have over smaller or newer financial institutions, which they have gladly accepted. [Admittedly] public sector banks do tend to underperform private banks in credit allocation, and do tend to erode private banks’ profits. Yet most if not all countries have ongoing public lenders of various types (even the US has the SBA), and their existence on a limited scale, while perhaps wasteful at the margin, does not lead to the destruction of the private-sector banking systems in those countries … Let us remember that the UK and other western private-sector banks did that themselves during a period of financial liberalization and privatization unprecedented in postwar economic history.”

There are good reasons why the UK needs to do something to raise investment. For one thing, it is about to lose its EU funding which will put a hole in the transfers to many of the English regions (places like Hartlepool, which were very much pro-Brexit, have received considerable funding in recent years). A more generic macroeconomic problem is that the rate of business investment growth has been below the rate of depreciation since the great recession. This is not an issue which gets much airplay in the big picture story, and I am not sure of the extent to which it represents a change in business behaviour or whether it is a measurement problem. But it means in effect that the UK capital stock is declining, which may be one explanation behind the slowdown in potential growth in recent years. The UK needs to raise its investment levels. Whether a NIB is the right way to go about it remains to be seen. But it is an idea which should not be dismissed out of hand.

High Labour costs

Four weeks from today, the main UK political parties will go head-to-head in an election we do not really need to have. No prizes for guessing that Brexit will be the key battleground on which it will be fought. But with changes in the leadership of all main parties since 2015, this really should be an opportunity to address many of the key economic issues which have plagued the UK over the last seven years. The lack of investment; the over-reliance on austerity and a chance to reset the terms of the EU debate which David Cameron got so totally wrong and which Theresa May is not helping to improve. One might have thought that by now, the parties would have their economic plans ready to roll in order to give us time to assess the issues. Well, not exactly. The Conservatives are not planning to publish their manifesto until next week, and the best we have from Labour is a leaked draft which was splashed all over the press, framed as a socialist document worse than the longest suicide note in history, as their 1983 agenda was dubbed.

If you actually read through the leaked draft of the Labour Party manifesto, rather than rely in the headlines which tell us how very socialist it is, there are some rather interesting ideas in there. Jeremy Corbyn, for all his many faults, is trying to fight an election on issues of fairness and responsibility. The key message is that the vast majority of the electorate has been squeezed since the financial crisis-induced economic collapse, and Labour wants to do something about rectifying it. Thus the plans outlined so far indicate more spending on the NHS and the creation of a National Care Service; the building of more new houses; the scrapping of university tuition fees and the reintroduction of student maintenance grants. Add in the prospect of establishing a National Investment Bank to facilitate £250bn of spending on infrastructure over the next ten years (which is not a bad idea and I will deal with it another time), and you have what sounds like a classic fiscal stimulus. I would use the phrase “pump priming” but Donald Trump has apparently just invented it. (“Have you heard that expression used before? Because I haven’t heard it. I mean, I just…I came up with it a couple of days ago and I thought it was good”).

There is just one tiny problem: The plan sounds horrendously expensive – and that is before we even talk about the renationalisation of rail and energy. Let’s start with education. The Institute for Fiscal Studies reckons that Labour’s Higher Education policy would raise the deficit by over £8bn (about 0.5% of GDP at current prices). Investing £250bn in infrastructure over a ten year period implies a boost equivalent to 1.5% of GDP per year. To secure the financing, taxes must inevitably go up. Labour has suggested that it will raise income taxes on those earning over £80,000 per year (the top 5%), though has not said by how much, and “will ask large corporations to pay a little more.”

Some back-of-the-envelope calculations suggest that there are 1.1 million taxpayers earning between £80k and £150k per year paying higher rate tax at 40%, and 0.3 million earning above £150k paying a 45% rate. This means that only 25% of all higher rate taxpayers earn more than £80k. We can thus take the HMRC’s tax rate elasticity multiplier which calculates the full effect of raising higher rates taxes, and assume a 25% efficiency rate compared to the full impact. Running through the numbers, each 1% rise in tax on those earning above £80k per year will yield around £0.5bn in revenue per year. If the tax rate is whacked up by 4 to 5 percentage points, we could thus fund the education costs. The ready reckoner also suggests that each 1% on the corporate rate will reap around £2.4bn per annum. Thus, reversing the planned 3 percentage point cut in corporate taxes by 2020 yields another £7.2bn over three years. A Labour government could even raise corporate taxes back towards 25% over (say) five years, yielding an extra £12bn by 2022. Adding up these numbers (an effective 8 percentage point rise in corporate taxes and 5 points on taxes for higher earners), we thus start to get close to the £25bn needed for annual infrastructure spending.

But funding the reprivatisation would be enormously expensive. A brokerage report by Jefferies in 2015 put the cost of renationalising the energy sector at £185bn (~11% of GDP). They also pointed out that “if a future Labour government restricted itself to just acquiring the UK assets of the big six generators plus National Grid, the cost would be £124bn.” I have no idea what renationalising the rail sector would cost but let’s say £60bn for the sake of argument. An increase of £184bn in public outlays would raise the debt-to-GDP ratio by 11% at one stroke. Even assuming this is not a problem, the markets would almost certainly demand a higher risk premium on gilts, so debt servicing costs would rise. But here is the kicker: Labour has proposed a Fiscal Credibility Rule which plans to reduce the current balance to zero on a five year rolling timescale (which sounds to me like a never-never rule), but also that the debt-to-GDP ratio be lower at the end of the parliamentary term than at the beginning. Nationalising rail and energy would blow a hole in that, but fortunately Labour proposes to suspend the operation of the rule so long as monetary policy is operating at the lower bound. So that’s all right then!

All of these numbers are back of the envelope calculations and in no way constitute a detailed analysis of the costs.  Although many commentators liken this document to Labour’s 1983 election manifesto, its 1974 document which called for “more control over the powerful private forces that at present dominate our economic life” was at least as damaging because the party was actually in government. Labour’s main failure in the 1970s was to recognise that the poor performance of the British economy was not due simply to the failings of the capitalist system: It was largely due to an insular view of the economic problems. It feels very much like we are at that point again today.

Vive la différence

Watching the acceptance speech by the new French president Emmanuel Macron yesterday, I must confess to a tinge of envy because it represented everything which is lacking from the UK scene. The French electorate decisively rejected the knee-jerk politics of division in favour of a more inclusive EU-friendly alternative whilst at the same time electing a man who, at 39 years old, is the youngest leader since Napoleon Bonaparte in 1799. At least for now, Macron represents hope for a more positive future. His election also breaks the recent trend towards right-wing populism, as represented by his opponent Marine Le Pen.

Here in the UK an election takes place in just over four weeks’ time and the choices on offer are nowhere near as palatable. Theresa May represents a continuation of the dogmatic opposition to the EU, with the prospect of the economy moving closer to the cliff edge that she claims to want to avoid. But the opposition offers no choice at all. Even accepting that Jeremy Corbyn probably does get a bad press from a media which is viscerally opposed to the Labour Party, he increasingly appears an ineffectual leader unable to rally centrist voters to his cause and who presides over a party which has slipped so far to the left as to be unelectable. The French, of course, had just such a candidate in the first round of presidential voting two weeks ago in the form of Jean-Luc Mélenchon and he trailed in fourth with less than 20% of the votes.

Over the weekend, the shadow Chancellor John McDonnell denied being a Marxist but did suggest that “there is a lot to learn from reading Das Kapital.” Whilst recognising the importance of Marx’s tract as a seminal work in the field of political economy, it is fair to say that from an economic viewpoint there is more to disagree than to agree with, but I’ll leave that for others to debate.  However, coming just days after Labour suffered heavy losses in local elections, losing 382 council seats across the country whilst the Conservatives gained 563, it seems that this is a message which the UK electorate does not want to hear. Labour does not have a positive message to sell the voters and with UKIP all but wiped out as a political force, losing 145 of the 146 seats it held, it is difficult to see the Conservatives winning anything other than a landslide victory at the general election scheduled for 8 June.

Quite what the Conservatives’ economic policy will look like is unclear, since it has delayed the publication of its election manifesto until next week. It is likely to maintain a pledge to reduce immigration but will almost certainly not repeat the mistake made in 2015 when it promised not to raise income tax, VAT or national insurance contributions. But as Jagjit Chadha of the National Institute points out, this election should be about more than just Brexit. Answers need to be found to the weakness of UK productivity for only this way will we finally be able to make some progress on the vexed question of stagnating living standards.

Of course, Macron will face all sorts of challenges to get the French economy back on track. Like the UK, fiscal issues will be high on the agenda with Macron planning to reduce the tax burden, including a reduction in the corporate tax rate from 33% to 25%, and to simplify the tax system. At the same time, he has promised to cut public spending to a still-high 52% of GDP (though on the basis of the European Commission’s data this is not exactly a high hurdle). The new president also plans to decentralise the labour market in favour of firm-level rather than collective agreements, and a gradual loosening of the 35 hour working week. As I noted a couple of weeks ago, the extent to whether he gets a mandate to push through his plan will depend on how much support he has in the National Assembly following June elections. He will have his work cut out.

Macron’s victory yesterday took my mind back 20 years to the election of another young left-of-centre politician in the form of Tony Blair. Blair was viewed across Europe as a breath of fresh air following the fractious Conservative government of 1992-97. He promised a third way in politics which involved a bit of state intervention and a lot of market forces, and offered hope to social democrats across the continent. He took over as UK prime minister at a time when the European economy was a lot stronger than it is today and he was obviously economically successful for a long time. But the story of how he came to be reviled by his own party should be a lesson to Macron. Today’s fresh face of optimism can just as easily become yesterday’s man. As former PM David Cameron once taunted Blair in 2005, “You were the future, once.” And now Cameron, too, lies on the scrapheap of history. Nemesis is never far away

Central banks: A balancing act

One of the issues which central banks are going to have to face up to at some point in future is the question of whether and how to reduce their balance sheets, which have been swollen by the huge purchases of financial assets under the QE programme. The balance sheet of the US Federal Reserve, for example, now stands at $4.5 trillion, which is roughly 25% of GDP compared to a figure around 7% at the start of the financial crisis, with the expansion comprised primarily of Treasury and Mortgage Backed Securities (MBS).

From the outset, central banks were clear that it was the stock of assets held on the balance sheet which was important for the purpose of injecting additional liquidity, not the rate at which they were purchased. This was because the purchase of bonds has a counterpart on the liability side of the balance sheet in the form of a credit to the banking system (excess reserves), representing the transfer of funds from the central bank to the seller of the bond. To the extent that the banking system creates liquidity as a multiple of the deposits in the system, this rise in banking sector deposits held at the central bank is what ultimately determines the pace of liquidity creation in the wider economy. The Fed ceased buying assets in October 2014. But as existing bonds matured so they ceased to be an item on the asset side. In order to prevent an unintended decline in the balance sheet, it was forced to rollover maturing securities which means that it is still actively buying assets, albeit on a smaller scale than previously.

But the Fed has indicated that it will ultimately shrink its balance sheet, and thus impose an additional degree of monetary tightening, but not until “normalization of the level of the federal funds rate is well under way.” Whilst markets are concerned about when this is likely to happen, a more interesting question is how rapidly it is likely to proceed. It is widely anticipated that the Fed will allow its maturing bonds to simply disappear from the balance sheet – a form of passive (or less active) reduction compared to the alternative of actively selling bonds. Ben Bernanke (amongst others) has argued that the Fed should simply aim for a given size for the balance sheet and allow the maturing of existing bonds to continue until the desired level is reached.

It is pretty likely that wherever we do end up in the longer-term, the balance sheet will not go back to pre-2008 levels. With Fed estimates indicating that demand for currency is likely to reach $2.5 trillion over the next decade, compared to $1.5 trillion today (and $900bn before the crisis), it is evident that the absolute size of the balance sheet in the longer term will be far higher than it was 10 years ago. In one sense, this makes the Fed’s task easier because it will not have to run it down so far. Indeed, in a nice little blog piece in January, Ben Bernanke reckoned that the optimal size for the balance sheet over the next decade is likely to be in the region of $2.5 to $4 trillion. If indeed the optimal size is close to the upper end of the range, it implies that the degree of reduction will be very small indeed, and would have little impact on markets which fear that a rundown of the balance sheet will result in a sharp rise in interest rates.

This absence of a dramatic reduction would be in keeping with past historical evidence. Analysis by Ferguson, Schaab and Schularick which looks at central bank balance sheets over the twentieth century, argues that prior to the onset of the financial crisis balance sheets relative to GDP were very small relative to the size of the economy compared to longer-term historical experience. They also note that “outright nominal reductions of balance sheets are rare. Historically, reductions have typically been achieved by keeping the growth rate of assets below the growth rate of the economy.”

Perhaps what this all means is that we should stop worrying too much about the potential impact of big central bank balance sheet reductions. But it does mean that a more permanent change in the conduct of monetary policy is about to take hold. Prior to 2008, central banks controlled access to demand for banking sector liquidity by regulating its price via the overnight rate. Now that liquidity is plentiful, both the Fed and ECB operate a floor system by controlling the rate they pay banks on reserves held with the central bank. As recently as November 2016, the FOMC described the current floor system as “relatively simple and efficient to administer, relatively straightforward to communicate, and effective in enabling interest rate control across a wide range of circumstances.”

Such a policy requires the banking system to be saturated with reserves and implies that the balance sheet may be about to assume a more important role in the conduct of policy as it becomes the tool via which bank reserves are supplied. So maybe central bank watchers will spend less time worrying about the policy rate in future and we will go back to the old-fashioned job of trying to predict how much liquidity central banks are injecting into the market. Now that takes me back a bit …

Dial it down

The rhetoric over the Brexit divorce has gone up by a few notches in the course of recent days. Leaked accounts of last week’s dinner engagement between Theresa May and Jean-Claude Juncker were splashed all over the German press at the weekend. Subsequently, the FT has calculated that the upfront cost of departure is likely to be in the region of €100bn whilst Theresa May today made the extraordinary allegation that “some in Brussels” did not want Brexit to succeed. It might be wise at this point to dial down the rhetoric before things get out of hand.

Dealing first with the politics (I know it’s dull but this whole debate is driven by it), there is little doubt that the European Commission was responsible for the leaks to the Frankfurter Allgemeine Zeitung. The details were too precise to be made up, and it is clearly designed to rattle the UK’s political cage in order to remind the government that it will not get everything it wants during the Brexit negotiations (if indeed, it gets anything at all). It is not very edifying but that’s politics for you.

As for Theresa May’s statement, she is right – except it is probably more accurate to say that “no-one in Brussels” wants Brexit to succeed. Why would they? We have known all along that the EU has no incentive to make life easy for anyone who wants to leave: If Brexit is a success the whole basis of the EU is threatened. If the EU is serious about holding together in the absence of the UK’s departure, of course it wants to see Brexit fail – to suggest otherwise is an act of incredible naïveté. The suggestion that there is any meddling in the election was, however, a step too far. In any case, this unnecessary election is all about the UK’s bargaining position regarding Brexit, so the PM’s comments were a bit rich.

Which brings us to the issue of divorce costs. I have referenced the work of the FT’s Alex Barker before, and I am indebted to his analysis of the data for an insight into where the EU’s increased bill comes from. Previously, the bill was estimated at around €70bn – a figure which included numerous questionable items. The extra €30bn is even more controversial, largely due to the demand for contributions to commitments planned for 2019 and 2020, which occur after the UK has already left the EU and which is estimated to cost between €10bn and €15bn. The EU is also believed to be demanding an upfront payment of €12bn to cover contingent liabilities rather than stumping up at the point when they arise. Finally, France and Germany are also believed to be doubtful that the UK has any entitlement to the EU’s assets – a move which is calculated to wind up the UK government.

It should be stated at the outset that the €100bn is a gross figure. If the UK is paying its full share of the budget beyond 2019, it will be entitled to its normal rebate. Once we add in farm subsidies and other items, it is expected that the final figure will be around the €65bn mark. Of course, like any good dealmaker, the EU is bound to start with a high figure in the knowledge that it will be beaten down, but the higher you bid the more chance of  getting a figure close to what you believe to be reasonable. The ratcheting up of pressure was likely also partly triggered by the recent UK government belief that it can legally walk away without paying anything at all, and this is the EU’s way of letting the UK know it is not in a strong negotiating position. After all, the UK will not get any form of trade deal if it refuses to pay anything (which, of course, the UK knows). More problematic still is that Michel Barnier, the EU’s chief negotiator, will not put a final bill on Brexit until the negotiations are complete – he simply wants the UK to agree on the methodology.

All told, this puts the UK in a difficult spot. David Davis, the UK’s chief negotiator, will not sign up to such a deal – and for once I have some sympathy. The UK will already be asked to contribute to the unattributed parts of the budget which have not been allocated on an accruals basis (the so-called reste à liquider payments), whose provenance is dubious. To deny the UK any claim on EU assets is morally indefensible, particularly since the UK is such a big net contributor to the EU budget. But to pay for budget commitments beyond the time the UK leaves is a red line. It’s like being charged in a restaurant for a meal you already don’t want to eat, but then you are being asked to pay for the next customer’s food as well.

The whole day has been one of high octane posing. As I have said before, there are deals to be done but if both sides continue to antagonise the other, the prospect of successfully concluding one will diminish. My advice would be to turn down the noise – no trade deal is ever concluded with anything other than a cool head.

Abbott without the Costello

For many years I have tried to keep politics separate from economics but these days it is virtually impossible, particularly when looking at UK related issues. Regular readers will know that I do not have a lot of time for the current UK government’s Brexit strategy. But, in the spirit of impartiality, never let it be said that I do not apply the same rigorous standards to the policies of all parties. This morning’s car-crash radio interview  by shadow Home Secretary, Diane Abbott, highlighted once again that it is not only the Conservatives who struggle to get their economic policies across.

In the interview, Abbott tries to explain how the opposition Labour Party plans to fund an expansion to the number of serving police officers. You really have to listen to the interview to do it full justice, but for the record I set out parts of the transcript below. 

Nick Ferrari (interviewer): Where will the money come from Diane Abbott? Good morning. 

Diane Abbott: The money will come from reversing some of the tax cuts for the rich that the Tories have pushed through. And the tax cut we're specifically identifying to pay for the 10,000 policemen is the cut in capital gains tax. 

NF: So how much would 10,000 police officers cost? 

DA: Well, if we recruit the 10,000 policemen and women over a four-year period, we believe it will be about £300,000. 

NF: £300,000 for 10,000 police officers? What are you paying them? 

DA: No, I mean, sorry... 

NF: How much will they cost? 

DA: They will cost, it will cost about, about £80 million. 

NF: About £80 million? How do you get to that figure? 

DA: We get to that figure because we anticipate recruiting 25,000 extra police officers a year at least over a period of four years. And we are looking at both what average police wages are generally but also specifically police wages in London. 

NF: And this will be funded by reversing, in some instances, the cuts in capital gains tax. But I'm right in saying that since Jeremy Corbyn became leader of the party, that money has also been promised to reverse spending cuts in education, spending cuts in arts, spending cuts in sports. The Conservatives say you've spent this money already, Diane Abbott. 

DA: Well the Conservatives would say that. We've not promised the money to any area, we've just pointed out that the cuts in capital gains tax will cost the taxpayer over £2 billion and there are better ways of spending that money. But as we roll out our manifesto process, we are specifically saying how we will fund specific proposals. And this morning I'm saying to you that we will fund the 10,000 extra police officers by using some - not all, but just some - of the £2 billion. 

NF: But I don't understand. If you divide £80 million by 10,000, you get £8,000. Is that what you are going to pay these policemen and women? 

DA: No, we are talking about a process over four years. 

NF: I don't understand. What is he or she going to get? Eighty million divided by 10,000 equals 8,000. What are these police officers going to be paid? 

DA: We will be paying them the average... 

NF: Has this been thought through? 

DA: Of course it's been thought through. 

NF: Where are the figures? 

DA: The figures are that the additional cost in year one, when we anticipate recruiting about 250,000 policemen, will be £64.3 million. 

NF: 250,000 policemen? 

DA: And women. 

NF: So you are getting more than 10,000. You're recruiting 250,000? 

DA: No, we are recruiting two thousand and - perhaps - two hundred and fifty. 

NF: So where did 250,000 come from? 

DA: I think you said that, not me. 

NF: I can assure you you said that, because I wrote it down.

It was shambolic and described by one journalist as the worst interview from a front line politician he has ever heard. There is, actually, a policy in there. Indeed, I have raised the issue of police funding in a previous post (here). But the whole affair gave the impression of a politician who was ill-prepared and a policy which was badly thought-out. I have done my share of media interviews in my time, and I know how easy it is to have a brain fade. But this is a politician seeking high office, trying to put across one of their key policies. Despite the fact that the apologists will say we should not allow the presentation to get in the way of the message, the fact is if a senior politician cannot prepare for a radio interview and get their facts straight, what chance would they have when faced with the difficulties of Brexit negotiations?

All this undermines the opposition’s case to be taken seriously at a time when the government is open to criticism on its track record in managing public spending, and will reinforce the media view that Labour cannot be trusted on key policy matters. Now more than ever, the UK needs effective government and a strong opposition able to hold it to account. On matters of economic policy, the government is getting off far too easily. The prime minister struggles to answer when pinned down on points of detail, but wriggles out of it by repeating to her interviewer that she will bring “strong and stable government.” It is the soundbite of the election campaign so far.

But it is a slogan, not a policy. Faced with the Scylla of the prime minister’s position and the Charybdis of Diane Abbott’s, it is hard to avoid the view that the electorate is not being well served by its politicians. Twenty years ago today it all seemed so different, when a freshly minted prime minister in the form of Tony Blair, marched into Downing Street promising to bring a fresh approach to government. Blair has come and gone, and is widely reviled - even by his own party. But his ability to communicate was first rate. The inarticulacy which characterises today's policy debate would simply not be allowed to stand.

Are we too complacent on interest rates?

One of the ongoing puzzles in the current conjuncture is why interest rates remain so low, despite the fact that the global economy has turned the corner. Indeed, central banks have recently been subject to widespread criticism for maintaining them at levels consistent with the emergency rates required in 2009 when the economy does not face anything like the same degree of danger. Despite the fact that the Federal Reserve has raised interest rates on three occasions since December 2015, yields on the 10-year Treasury note are still lower than in summer 2014 whilst UK 10-year gilts are trading just above 1% and 10-year Bunds below 0.4%.

Looking at the issue in a longer-term context, the standard approach in the academic literature is to point out that the neutral global real interest rate has fallen over the past three decades. A Bank of England Working Paper published in December 2015 highlighted that the long-term risk free real rate has fallen by around 450 bps in both emerging and developed economies since the 1980s.

The major factors which drive underlying long-term rates are expectations of trend growth and factors which impact on savings and investment preferences. The authors (Rachel and Smith) point out that the impact of a growth slowdown on lower rates is limited, accounting for less than a quarter of the total observed amount, and that the bulk of this can be attributed to changes in savings and investment preferences. Their key finding is that whilst there has been a sharp rise in saving preferences across the globe, desired investment levels have also fallen significantly. This is, of course, fully consistent with the savings glut hypothesis first postulated by Ben Bernanke in 2005. But Rachel and Smith go further by giving some quantitative estimates for the magnitudes of the quantities involved. Thus, they attribute 100 of the 450 bps decline in real rates to slower global growth; 90 bps to demographic factors and 70 bps to lower investment demand. All told, once they account for a number of other factors, they claim to account for 400 bps of the decline in real rates.

As an academic tour de force, this paper is an excellent and comprehensive overview of the factors driving rates lower. But it is not the whole story. A quick look at the data, compiled by King and Low in 2014 (chart), suggests that whilst there was indeed a sharp decline in the global real rate between 1990 and 2008 of around 250 bps, the last 200 bps has occurred post-financial crisis – a period when central banks slashed the short end of the curve to zero at the same time as they were engaged in huge asset purchases. In order to probe a little deeper, it is worth highlighting the concept of the natural rate of interest, postulated by Swedish economist Knut Wicksell at the end of the 19^th century. Wicksell argued that if the market rate exceeded the natural rate, prices would fall; if it fell below, prices would rise. Obviously, we do not know what the natural rate is but a quick-and-dirty method is to measure the difference between nominal GDP growth and the interest rate to assess the extent to which the real and financial sectors of the economy are misaligned.

In the UK, over the period 1975 to 2007, nominal GDP growth was on average within 30 bps of Bank Rate but since 2010 it has averaged a full 300 bps above, and similar deviations have been recorded in the US and the euro zone. This is not proof that interest rates are too low. After all, it is not as if price inflation is a problem for the global economy. But it does highlight the extent to which the interest rate on financial assets is too low relative to returns on real assets, which in turn has helped to propel financial asset prices to stratospheric levels. The concern is clearly that at some point asset markets will turn. But central banks will probably have no choice but to watch the bubble deflate because after having used a huge amount of monetary resources to pump markets up, they cannot realistically deploy more to cushion the fall.

Whilst I understand why central banks have been reluctant to raise interest rates so far – although the Fed is now grasping the nettle – I do detect a slight note of complacency. The fact  that (some) central bankers have justified their low interest rate policy on the basis of lower global equilibrium rates, without fully accounting for the fact that their actions have themselves pushed global rates down, strikes me as distorted logic. I am reminded of the situation a decade ago when many central bankers dismissed rapid growth in monetary aggregates as a problem not worth worrying about, when in fact it reflected the actions of banks to pump up their balance sheets. And we all know how that ended.