Central banks face an inflation dilemma

Over the course of recent weeks there has been a shift in the message communicated by monetary policy makers. The monetary authorities on the other side of the Atlantic have long been ahead of their European counterparts, with the Fed having raised rates four times since December 2015 and three times in the last six months. But it has now gone further and announced in mid-June that it “expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.” A week prior to that the ECB changed its assessment of the balance of economic risks to “balanced” rather than “tilted to the downside” whilst only last week, Norges Bank removed its previous guidance that interest rates could be cut this year. Also this month, the Bank of England only narrowly voted to hold rates at their all-time low of 0.25% with three members of the Monetary Policy Committee pushing for a 25 bps rate hike.

The narrowness of the BoE vote came as a surprise with the dissenters concerned that inflation had overshot relative to expectations, reaching a four year high last month, at the same time as the margin of spare capacity in the economy has clearly diminished. My initial reaction to this reasoning was that it was flawed: Inflation has surged largely because of the impact of currency depreciation and so long as this does not impact markedly on inflation expectations, which leads to faster wage growth, the BoE may simply have to swallow the problem. Indeed, with wage growth slower today than before the EU referendum, higher interest rates at a time of falling real wages will not do anyone any favours. That said, with the unemployment rate close to the BoE’s estimate of the NAIRU, such concerns are understandable.

My own view is that the uncertainties surrounding Brexit will suffice to keep UK inflation expectations in check for some time to come. Indeed, across much of the industrialised world, it is proving difficult to drive up inflation: In both the US and euro zone inflation is struggling to reach the central bank’s 2% target – a trend which will not be helped by the recent decline in oil prices which has supported headline inflation in the past year. Although central banks have a mandate to control inflation, and in many cases have to meet particular targets, it is difficult to explain to the wider public that there is no automatic link between price growth and interest rates – just as there is not, and never has been, one between inflation and money supply growth, despite the best efforts of many politicians and (some) economists to convince us otherwise. As if we needed proof, consider the case of Japan where despite running a balance sheet equivalent to 90% of GDP – almost four times that of the Fed, ECB or BoE – inflation has only exceeded the BoJ’s 2% target for three months during this century (once we strip out the distortionary effects of consumption taxes, see chart).

There are numerous reasons why inflation today is much lower than during previous periods when prevailing economic circumstances were similar. A much more globalised economy, in which value chains stretch across international borders has been one of the key factors holding down price inflation over the past decade. This has been accompanied by technological change which has depressed wage expectations. In effect, the pricing power of labour has been reduced as wages are increasingly set according to international conditions rather than those in local labour markets. Moreover, as the BIS reminds us in a message that too many economists often overlook, “wage growth is not necessarily inflationary: whenever it is supported by productivity gains, it will not lead to rising production costs.” And as I never tire of pointing out, although the UK’s productivity record has been dismal since the great financial crisis, it has still been stronger than real wage growth.

In an environment where the link between the domestic economy and wages has weakened, this makes it difficult for central banks to justify raising rates based on the threat of more rapid potential wage growth. But low interest rates have contributed to the asset bubble which has forced – or perhaps facilitated – investors to take risks in order to generate faster rates of return. Some form of monetary tightening is thus desirable. It is for this reason that the BoE today announced that it will raise banks’ countercyclical capital buffer – a measure of mandatory additional capital holdings – from zero to 0.5%, with a view to raising it to 1% in November in a bid to curb excess credit growth.

I must confess to some mixed feelings on the situation we now find ourselves in. On the one hand, central banks are concerned about the impacts of low interest rates on credit and asset price growth. Yet on the other, they wish to ensure financial stability which appears to be at odds with the current loose monetary stance. The case for higher rates based on price inflation or wage growth is weak. But there is an argument to suggest that the wider impacts of running a loose monetary policy require some tightening. For the moment, the likes of Norges Bank and the ECB can get away with merely talking about it. The BoE fiddles around the edges by adjusting macroprudential measures. But before long, they may all be forced to follow the Fed – everyone does in the end.

(Un)happy anniversary

They say that time flies as you get older. That must make me positively ancient, as I can so vividly recall the events of 23-24 June 2016 as if it were yesterday. I am referring, of course, to the EU referendum. The effects of that vote have been socially and politically profound, and although the economic impacts have so far been modest they will make their presence felt over time.

For a vote which was designed to heal divisions within the Conservative Party over Europe, it was a catastrophic failure. It still threatens to tug at the unity of the UK: even though the pressure for a second independence referendum in Scotland has diminished in the wake of the election, it has not gone away completely and the position of Northern Ireland within the union may be called into question in the longer term, even though a split appears unlikely in the near future. There is a clear split between the aspirations of younger and older generations, as evidenced by voting patterns last June and again in the recent general election. And the intervening twelve months have done nothing to lessen the differences of opinion between those who wish to leave the EU and those who wish to stay. In short, the referendum resolved nothing – as I never thought it would. Indeed, I have always believed that whatever the outcome, the UK would remain semi-detached members of the EU and I stand by that view today.

Regular readers of these pages (and thanks to you all for sticking with it) will know that my anger at the Brexit issue is less about the result itself than about the lies used by self-serving politicians to serve their own ends, aided and abetted by sections of the media which have an ideological agenda. Politicians simply invented economic facts which to me is unacceptable (the most famous of which was the claim that leaving the EU would allow the government to direct an additional £350 million of extra resources per week to the NHS). They lied on immigration by failing to point out that more than half of the immigrants into the UK over the past decade came from non-EU countries, where the UK has control over its borders (they omitted to mention that a large number of these non-EU immigrants were students  who support British universities).

But the biggest lie of all was that the EU needed the UK more than it needed the EU and that the EU27 would beg to do a deal which would give us exactly the same conditions as we enjoyed previously, but with extra flexibility to do great deals with non-EU countries. None of these assertions was backed up by evidence. Indeed, the only economic study showing evidence in favour of Brexit was based on assumptions so heroic it makes Superman look like a coward (notably the idea that the EU would be forced to halve the levels of protection on imports from outside the bloc – see here for further detail).

The likes of Boris Johnson, Nigel Farage, Michael Gove, Daniel Hannan and Matthew Elliott portrayed themselves as economic liberators who could lead the UK to the sunny uplands of a brighter economic future. I note that none them studied economics or business and only Farage has any claim to a business career. Nor is there a scientist amongst them who appears to recognise the value of hard evidence. On the basis that the dictionary definition of treason is “the crime of betraying one's country”, those who promoted the economic case for Brexit are closer to traitors than liberators.

As for where we go from here, that is all still up in the air. The government has been forced to backtrack on many of its initial Brexit positions. Theresa May herself was nominally a Remainer who appears to have become a champion of hard Brexit; parliament was originally to be denied a vote on the terms of the Brexit deal once it had been agreed with the EU27 (now it will be allowed a vote); the government also initially planned to invoke Article 50 without a parliamentary vote but was forced by the courts to do so and a suggestion that that companies would have to publish figures on their number of foreign workers was also quickly dropped. Add in the fact that only this week the UK quickly caved in to EU demands on the sequencing of the Brexit negotiations, and large parts of the government’s manifesto did not make into the Queen’s Speech (meaning that it will not be enacted during this parliamentary term), and you have to wonder how many other red lines will be crossed.

A survey published in The Times this morning (here for an overview ) suggests that a 58% majority wants a deal in which the UK continues to have free access to trade with the EU whilst allowing EU citizens the right to live and work in the UK. Only 42% preferred the alternative of full control over immigration but British businesses having no access to the EU single market. This was actually the choice we were faced with a year ago, only it was not put this way. Bottom line: There is no appetite for a hard Brexit, and it is becoming increasingly apparent that the government misread the message delivered by the electorate last year, which I maintain was more a howl of rage than a desire to pull up the drawbridge.

My preferred solution is that the UK does not leave the EU at all. I don’t wish to sound like a disaffected Remoaner but it is not impossible that if the negotiations drag on for a decade or more, resulting in a second referendum given that many people will have forgotten why the UK voted to leave in the first place, the generational shift in the electorate may produce a different result. The sensible strategy from the EU’s perspective would thus be to offer a deal in 2019 which the UK finds unacceptable but be willing to extend the negotiating period indefinitely. If Theresa May’s government wishes to do a deal more quickly than that (and it does) I suggest that the EU offers the UK access to the single market at a price which is lower than that which it currently pays but with correspondingly reduced rights. Indeed, I have made this point before but have since read that the German government takes a similar view.

As for where we will be in a year’s time, I suspect not much further forward. If the EU plays hardball on the Brexit bill and the UK refuses to back down, the clock will be running down without any tangible sign of progress on the trade deal which the UK so badly wants. This is all so unnecessary because it’s self-inflicted and was predictable all along. For those who led the Brexit campaign, I say only this: Judgement Day is coming.

Austerity: A local government perspective

Austerity has been very much in the UK public eye over recent weeks. It was a major topic during the election campaign but the tragic fire at Grenfell Tower, where the final death toll has not yet been confirmed, has thrown the issue into stark relief. Moreover, this is not just an austerity-related issue because it raises questions regarding inequality, the like of which we have not heard in the UK for many years.

There is certainly mounting anger at the circumstances in which this awful disaster took place. The Royal Borough of Kensington and Chelsea (RBKC) is, after all, one of the richest parts of London which in turn is significantly richer than the rest of the country. The argument runs that the poor people in North Kensington – the part of the borough perceived to be less salubrious – were ignored in a way that their richer counterparts elsewhere in the borough were not. There is, in some quarters, an attempt to pin blame on the Conservative Party for their stewardship of the economy which promoted the cost cutting culture which allowed the tragedy to take place. Without wishing to delve too deeply into the politics of this extremely sensitive issue, it is certainly worth looking more closely at the issue of local government financing to shine some light on the difficulties of running a local authority in the current hostile fiscal climate.

In fiscal year 2010-11, central government funded 76% of local authority (LA) spending. Since then the value of the transfer has fallen by 32% and the share of local spending funded from Westminster has fallen to 57% (chart). By way of compensation, local authorities are now allowed to retain a higher proportion (50%) of what they collect locally in the form of business rates (a levy on local businesses). Nonetheless, total LA spending has fallen by almost 10% over the last six years. Across the country as a whole, the budget for 2016-17 imposed the largest cash reduction on education services compared to 2015-16 (£765 million) whilst the biggest proportional reduction fell on highways and transport services (-10.6%).

Matters are not going to get any easier in the years ahead: By 2020, the government has committed to phase out its transfer to local government, which will be compensated by the fact that local authorities will be able to keep 100% of business rates revenue. As it currently stands, only 12.3% of revenue is derived from business rates. Even assuming this doubles by 2020, this will in no way be enough to compensate for the elimination of the central government grants, which will still be required to fund 45% of local spending unless there is a correspondingly huge decline in total outlays. For this reason, the system which gives protection to those authorities with lower levels of business rate income looks likely to be heavily utilised. Nonetheless, given this difficult backdrop, it is hardly surprising that local government spending is being slashed.

Although it is the smallest of London’s 32 boroughs, RBKC’s gross outlays in 2016-17 amounted to £680 million. On a net basis, the borough’s net spending undershot its budget by around 4% (£8.2million) in fiscal 2016-17, and the accounts show that in each of the last two fiscal years, the borough has recorded a surplus on the Housing Revenue Account (£12.2 million in 2016-17 and £19.6 million in the previous year). On the basis of these numbers, this appears to be a LA which has put the squeeze on. For comparative purposes, I looked at the accounts of the City of Newcastle partly because they are similar in scale to those of RBKC, and also because the leader of Newcastle council, Nick Forbes, was one of the first to advocate cutting frontline services in the wake of the London-imposed fiscal squeeze. Interestingly, the Newcastle HRA showed an even bigger surplus in 2015-16 than RBKC of over £26 million.

Undoubtedly, local authorities will say that these surpluses are ring-fenced and will be used in future for housing related activity. So they should: local councils are, after all, non-profit organisations. But in the wake of the Grenfell Tower fire, there are those who question why the likes of Newcastle are making a net return of 22% on their local housing activities. However, life is not so simple. The reason why councils run an HRA surplus is that their finances are subject to a whole host of other regulations imposed on them by central government and part of the surplus reflects precautionary saving. They have far less autonomy than is believed even in cases like this where they nominally control the budget.

However, there is a much wider issue at stake here. Whilst we spend a lot of time fretting about general public finances in the UK, we devote relatively little time to looking at local finance issues. But we should, because it is primarily at the local level that we consume public services. We see austerity all around us at the local level: A library closure here, a request to buy extra school textbooks there. It all adds up to a very stretched system.

There is no doubt that over the last 30 years, local authorities have been subject to a considerable amount of central government influence which has allowed them to deflect blame for much of their actions onto Westminster. Indeed, it is only recently that they have been given any autonomy to hold onto the revenue they generate locally. Whilst it is true that decisions taken in London have forced local authorities to squeeze local spending, as they gain an increased degree of control over local revenue generation they will be able to break free of some of these constraints.  In return, they will have to be held increasingly accountable for their actions. It will no longer be enough to say that the frequency of household refuse collections has been reduced to fortnightly thanks to central government decisions. More importantly, the prevention of disasters such as those occurring in West London will increasingly be viewed as the responsibility of local, rather than central government.

Brexit: Same stuff, different day

The UK’s Brexit negotiations may have kicked off yesterday but there is a depressing inevitability to it all. We know that the UK’s negotiating position is weak, and despite what David Davis’ demeanour suggested beforehand, he has already been forced to concede on the question of sequencing (and how many other positions will he have to retreat from before the summer is out?). We know that Brexit will be economically damaging. We know that the British government does not actually know what it wants. And we also know that it does not have a mandate to pursue the hard Brexit which the Conservatives set out in their manifesto. Apart from that, everything is hunky dory.

At least Mark Carney’s Mansion House speech this morning contained a thinly veiled jibe at Boris Johnson’s pre-referendum suggestion that his policy on Brexit is similar to his policy on cake (“My policy on cake is pro having it and pro eating it”), with Carney suggesting that “Before long, we will all begin to find out the extent to which Brexit is a gentle stroll along a smooth path to a land of cake and consumption.” Carney and the rest of the economics profession know that there is no cake at the end of this particular road.

He also implied that the idea of putting up trade barriers, which could be the result of failure to reach a Brexit agreement, was a bad idea. In his words, “Bank of England research estimates that up to one half of the post-crisis productivity slowdown could be related to the deceleration in global trade growth.” He argued that a liberalisation of services trade could be very much of benefit to the UK, given its specialisation in this area. In particular, Carney highlighted the importance of financial services: “One million people across this country work in financial services.  The industry contributes 7% of output and pays taxes that cover almost two thirds of the cost of the NHS.” He did not need to say explicitly that failure to deliver a deal on financial services was a bad idea – his audience was way ahead of him – and it was a nice touch to link it to the hot topic of NHS funding.

But already there is pushback from continental Europe. London-based banks are being asked by the EU regulator to be more explicit about their plans for dealing with customers in the EU27, and only today ECB executive board member Benoît Cœuré backed the European Commission’s call for a new set of rules to govern euro clearing. Cœuré reiterated the view that the ECB, as the central issuer of euros, should be responsible for the clearing of euro transactions and not central banks outside the region. I warned in 2015 that this was likely to happen in the event of Brexit. Having failed in 2011 to force euro clearing to be conducted on the continent, after (ironically) the European Court of Justice ruled in the UK’s favour, I noted that any future attempt to “impose limits on non-euro zone trading in the event of Brexit would be much more difficult to refute, as the UK would no longer have such easy access to the ECJ, which could have significant adverse consequences for the UK’s dominant position in the FX market.”

I also pointed out that “intra-EU barriers are likely to be reduced over time as the single market for services continues to develop – something from which the UK will not benefit in the event of Brexit and which will raise potential welfare losses.” It might have seemed a fanciful notion to many people two years ago that the EU economy would ever find its feet again, but the growth differential between the euro zone and UK is projected to narrow considerably over the next couple of years, and in 2018 it is forecast by the EC to grow more rapidly. Given the shot in the arm which French President Macron has given the euro zone, who would bet against it?

It is for this reason that even Chancellor Philip Hammond, who was conspicuous by his absence during the election campaign suggested today that the needs of UK business need to be heard in the Brexit negotiations, arguing that current trading arrangements (i.e. single market and customs union membership) should remain in place until “new long-term arrangements are up and running.” Political commentators see this as an indication of the weakness of Theresa May’s position (and she still has not yet managed to come to an arrangement with the DUP, despite the fact that the new parliamentary term is scheduled to start tomorrow). Her position on Brexit was always out of tune with European political reality and with Michel Barnier reminding the UK that it is they who are leaving the EU and not the other way round, we begin to see the flimsiness of the government’s argument.

To end with, I did come across one article recently which was worth reading, by former head of MI6 John Sawers who, writing in the FT, noted that “Britain on its own will count for little on the world stage.” It is not so much that the argument is new, but Sawers put the decision to leave in the recent historical context which showed how the UK has punched above its weight diplomatically by being part of the EU. Particularly ironic was his comment that “we had two world-class leaders in Margaret Thatcher and Tony Blair, who set us back on the path of growth at home and leadership abroad … While John Major and Gordon Brown were not of the same stature internationally, they played their cards judiciously.” Funnily enough, not a mention of David Cameron or Mrs May, who historians may yet rank highly on the list of worst occupants of 10 Downing Street. And in an echo of the first post I wrote a year ago, Sawers concludes “if we can no longer help shape the world, others will do it for us. And Britain will have to lump the consequences.”

U-turn if you want to: Part 2

I wrote a piece yesterday which indicated how the UK government’s position on Brexit is no longer tenable and needs to change. The extent to which this impacted on the election is questionable. But one issue which did appear to resonate during the campaign was that of fiscal austerity. Like Brexit, this is a subject where I believe the government has adopted an ideological rather than a pragmatic approach, and the evidence from the election campaign is that it is wearing a bit thin.

During the election campaign of 2010, the Conservatives portrayed the Labour Party as having bankrupted the country as the public deficit headed above 10% of GDP. Labour were admittedly fiscally profligate in the years prior to the crisis but the crash in public finances was purely the result of the massive collapse in activity in the wake of the recession. Nonetheless, the Conservatives played on the image relentlessly, usurping Labour from government in 2010 and embarking on a fiscally prudent course to eliminate the current deficit by 2016 and reduce overall borrowing to 1% of GDP.  As is well known, for various reasons Chancellor George Osborne continued to fall short of his targets and the fiscal squeeze became ever tighter.

What was deemed to be particularly unfair about Osborne’s approach is that he relentlessly targeted the welfare budget. Access to welfare has been severely restricted as those people previously judged unfit for work are subject to more stringent tests, which are almost impossible to pass unless the individual is virtually dead. Leave to appeal has been strictly curtailed, with a recent Freedom of Information request revealing that the Department for Work and Pensions has a target to reject 80% of benefits appeals. As even The Economist noted recently, welfare spending has fallen “by one percentage point of GDP, with working-age families bearing the brunt. Since 2015, however, the Tories have turned a hard-nosed welfare policy into a punitive one. Osborne used cuts in working-age benefits as a way to balance the books … A four-year cash-terms freeze on most benefits began in April last year. That policy was announced when inflation was close to zero. Now it is nearing 3%, the purchasing power of everything from tax credits (top-ups for low-paid folk) to housing benefit is falling.”

The recent tragic terror attacks on the British mainland threw the issue of public spending cuts into sharp relief. I have noted previously that politicians are quick to praise public services when they are needed but otherwise have no compunction in cutting their budgets. Having survived in government by the skin of their teeth, the Conservatives now realise that a further parliamentary term of fiscal austerity is not going to win them votes. But what exactly might that entail? Does it mean simply not reducing the share of spending relative to GDP any further? Or does it mean holding the deficit constant versus GDP, which allows scope to raise spending so long as it is funded by higher taxes? As it is, spending as a share of GDP is still high by past standards, at just over 39%, but it is 6 percentage points below the 2010 peak. But revenues, at just below 37% of GDP, are only slightly higher than their long-run average. My sense is that taxes will have to rise at some point in order to fund additional spending – and as I have long argued, the policy of cutting corporate taxes to amongst the lowest in the OECD is putting an unnecessary hole in public revenues.

But austerity is not just about making the books balance: It becomes a state of mind, whether you are in government, the private sector or making your household finances stretch further. It is in this wider context that we have to view the horrific fire which engulfed the Grenfell Tower in London yesterday. I am not suggesting for a moment that government neglect had any bearing on what happened. But abstracting from the grim horror of what happened, one of my thoughts was that 30 years ago, as the UK was going through a similar period of government retrenchment, we experienced a similar series of tragedies (the Bradford City fire; the Kings Cross fire; the sinking of the Marchioness and the Clapham rail disaster). David Aaronovitch, writing in The Times today, evidently came to the same conclusion. As he put it, these disasters “arose from the use of old, near-obsolete and dangerous infrastructure … Stuff like this usually comes down to attitude and to money.” Elsewhere in the same newspaper, the point was made that “cost-cutting by private firms brings public danger.”

This is not the voice of the Labour Party: The Times represents the voice of the political centre with a bias towards the Conservatives. This shift in attitudes must act as a wake-up call to politicians of all stripes that government – whether central or local – cannot continue outsourcing functions to the private sector. Citizens pay their not-insubstantial taxes and expect a decent level of services in return. When even the BBC news reporter covering the fire (here at 5:24 if you can play the video) – who as a rule remains impartial at all times – stated “in the 21^st century, in a country with some of the strictest fire regulations in the world, a desperate tragedy like this just should not happen,” you know that something is afoot.

U-turn if you want to: Part 1

The disastrous performance of the Conservative Party in last week's election has prompted a rethink of policy on both Brexit and fiscal austerity. This is recognition of the fact that the government has been spectacularly wrong on both – as I have long pointed out – and the scale of the U-turn reflects a certain degree of chutzpah. In this post I will focus on Brexit-related issues and leave the fiscal issues for my next post.

Whilst hopes have been awakened that we will see a softening of the terms on which the UK seeks to leave the EU, it is just as likely that we will end up instead with a chaotic Brexit which would be the worst of all worlds. I have always maintained that the Brexit referendum was an unjustified gamble with the national interest and it feels even more like that today.  Those politicians who advocated this course of action deserve all the opprobrium that is heaped upon them, and in order to highlight why Theresa May’s government is not fit to negotiate the exit, it is worthwhile recalling the series of miscalculations which has characterised Conservative policy in recent years.

First, the decision to hold the referendum at all was reckless. This was compounded by the failure to specify the terms which would make it easy for David Cameron to achieve his objective of winning. For example, the 1979 Scottish devolution referendum required that a winning margin be obtained from 40% of all eligible voters. In an uncanny echo of the Brexit result, whilst 51.6% of those who turned out voted in favour of devolution, only 32.9% of all eligible voters did so (the corresponding figure in last year’s referendum was 37%). Then there was the failure to set out ahead of the event the terms on which the UK would leave. Had voters known exactly what a hard Brexit entails, some may have thought twice. To cap it all, Theresa May gambled that the electorate would back her view of a hard Brexit. This proved to be a second successive failed gamble by a Conservative prime minister which has made the process of trying to find a Brexit deal far more complicated. Given this litany of errors, you will forgive my scepticism that the government is best placed to resolve the difficulties we now face.

Theresa May, described by George Osborne at the weekend as a dead woman walking, has to find a balance between those MPs in her party who wish to push for hard Brexit and the large number of MPs who wish to see it take place on much softer terms, if at all. I was thus somewhat gratified to see that my idea of a cross-party approach to Brexit now appears to have become a mainstream idea (you heard it here first).

But we simply should not even be having this debate. A hard Brexit is a ruinously stupid economic idea. And to compound the negotiating difficulties by calling an election AFTER the Article 50 process was triggered, thereby eating up valuable preparation time, tells us all we need to know about the Conservatives preoccupation with domestic politics rather than the wider interest. Although the government says it is ready to go ahead with the start of Brexit talks with the EC next week, it's not clear to me that this can credibly happen. Technically we do not yet have a government. Nor is it clear what the UK's negotiating position is, yet they will be facing a European Commission team which has had months to prepare its case. And just to make life even more difficult, two of the four ministers on the UK’s negotiating team have departed just days before talks are due to begin. This raises the chances that the disorganised shambles which passes for government may well crash out of the EU without any deal. The Conservative manifesto might have said no deal is better than a bad deal, but that is a level of economic illiteracy which suggests whoever wrote it has no idea how to conduct international trade negotiations.

Now you may have spotted from the tone of the post that I am a tad annoyed. Damn right! Pretty much every key decision that has been taken on Brexit has been wrong. There is no sense that those responsible for making decisions are capable of thinking strategically about how to get a deal which maximises British interests. We should be in no doubt that failure to do so will make everyone poorer and despite the talk which suggests that immigration is the biggest single issue, in the long run what people care about is their wallet. We are now hearing indications that business is becoming much more vocal about their needs post-Brexit. So it should. And If the government does not know what it wants from Brexit, it should not be entering talks with the EU. Instead it should rescind the Article 50 notice until such times as it does.

This may annoy the Brexit nutters such as Nigel Farage, who has threatened a comeback in the event that the government backslides. I say let him. Farage was a useful dupe for those who wanted something to protest against in 2016 but he would require the powers of Lazarus to restore UKIP to the position they were in last year. I also sense that some of last year’s anger has dissipated somewhat and he would find it difficult to whip up an anti-EU frenzy in the same way. I do not want Brexit to happen and nothing would please me more than if the government were to back down. But in the spirit of accepting the will of the people (even if the referendum is not legally binding) I accept this is unlikely to happen. But if it has to, then let us work out what we want first rather than trying to make it up as we go along.  That is the path to disaster.

Why do pollsters get it wrong?

Whilst the headline writers have spent the last two days poring over the entrails of the UK general election and what it means for the future direction of economic policy, I have been wondering how the pollsters could get it so wrong – again. After all, this is the third successive UK plebiscite since 2015 in which the electoral pundits have failed to call the result – not to mention their failure to call the US presidential result.  If the polls this week had been even slightly more accurate, the result would not have come as such a surprise and we would not have spent the last three days having many of the debates about Theresa May’s future.

First, however, some sense of perspective is in order. The opinion polls did a pretty good job in getting the voting shares right. The analysts at Electoral Calculus, for example, predicted that the Conservative vote share would rise from 37.8% in 2015 to 43.5% this time around whilst the Labour share would increase from 31.2% to 40%. In the event, the final vote shares were 42.4% and 40% respectively, so there was a modest overshoot on the Conservative share but they got Labour spot on. But it is a lot harder to go from there to actually predicting the election result, because the regional vote distribution matters hugely. In the UK’s first-past-the-post system, parties only need to outperform their local rivals by the tiniest of margins to win a seat (indeed, one constituency was decided by a margin of just 2 votes – 0.00478% of the votes cast). Once we start digging below the national level, the issue becomes fraught with sample size problems and the margins of error become much wider.

The opinion polls clearly narrowed over the course of the campaign. But even by the time the final polls were published on Wednesday night, the 15-poll average was still showing a Conservative lead of 6 points – down from 20 in the first half of May – with their polling share only back where it was when the election was called (43%). The central case forecast was thus not suggestive of a hung parliament. But if we apply a 5% margin of error, by adjusting down the Conservative figure and raising Labour’s polling share by this amount, although the trend does not change the extent of the lead does. Rather than a 6% margin the Conservatives went into the election with a 2% lead on this basis (see chart).

Applying this level of statistical inaccuracy in trying to predict the number of seats becomes a whole order of magnitude more difficult. In addition to Electoral Calculus (EC), I have also been tracking the results derived by the Election Forecast group (EF).  EC predicted that the Conservatives would win 358 seats whilst EF’s projection was 366 (though EF’s low case scenario did predict that the Conservatives would win 318 seats –  the right answer as it happens – whilst EC’s low estimate was 314). The central case predictions were thus off by more than 10%. They were even further off in their predictions for Labour with EC predicting 218 seats and EF (where the outturn was even higher than their upper limit) projecting 207. One group which did predict a hung parliament was YouGov whose “big data” model proved to be right, but their final call based on conventional survey methods was for a wider Conservative majority.

One of the reasons for the apparent failure of conventional methods was that most polling organisations discounted the evidence suggesting that younger age groups would vote Labour, and assumed that many of them would stay at home, as happened in 2015. This is an object lesson in the perils of manual adjustment – something which I do all the time when using structural macroeconometric models and more often than not, this turns out to be justified. It is always galling when the model beats your prior view, but ironically, the next time you let the model run without overwriting the results you often find you would have been justified in overriding it.

YouGov provided a non-technical summary of their Multilevel Regression and Post-stratification (MRP) model which seemed to work so well (here). It takes polling data from the preceding seven days to estimate a model relating interview date, constituency, voter demographics, past voting behaviour and other profile variables to their current voting intentions. This is used to estimate the probability that a voter with specified characteristics will vote for a particular party. Obviously, it is not infallible: It is a snapshot of intentions at the time the survey is made. In addition, the models are based on very small sample sizes so they suffer from the usual bias problems. Like all models, they are subject to significant margins of error, and as this blog post highlights they need to be treated cautiously. Indeed, I assign a huge degree of mistrust to regression models for predictive purposes because, as noted in the post, MRP “is a useful tool, but potentially misleading if used carelessly or indiscriminately.”

Ultimately, I suspect that trying to predict the detailed results of elections in the multi-media age is going to become ever harder. As information is thrown at us ever more rapidly, we will have to learn to assimilate it more quickly, and our quantitative models will have to take on board information from sources such as Twitter (already possible in statistical packages such as R). I am sure that in the course of the next week, some bright spark will ask me why I failed to get the election result right. The simple answer is because it’s hard to do, so I leave it to those with the expertise, time and resources to do it. And even they struggle, so what chance have I got?

Reflections

After a slog of a campaign which broke the mould for both the Conservatives and Labour, the election we didn’t need produced the result that the Conservatives didn’t want; it will potentially change the thrust of economic policy and may have far-reaching implications for Brexit negotiations. Without necessarily having any truck for Labour, I must confess to some satisfaction in seeing the Conservatives run aground on the Brexit issue. Almost twelve months after the searing experience on that sunny Friday morning of 24 June 2016, the hard-liners on the right-wing of the Conservative Party who lied their way to victory on Brexit, were chastened by the message handed to them by the electorate, whilst UKIP’s brief spell as a serious political force was effectively terminated.

I have pointed out many times that the efforts by Theresa May and the rest of the Conservative Party to interpret the Brexit vote as a mandate for a hard Brexit were misguided. Their efforts to take ownership of the issue, as if Brexit was a topic only for Conservatives, were way off. The irony is that whilst the election was all about Brexit, it was not even the most important issue of the campaign. Austerity policy was the big story and Conservative efforts to smear Labour’s tax-and-spend policy largely fell on deaf ears.

I have spent the last seven years trying to get people to understand that a fiscal policy based solely on cutting spending is only half a policy. We have witnessed a huge rolling back of the state in recent years, and a withdrawal of the safety net which has genuinely left a lot of people with nowhere to turn. Jeremy Corbyn’s message was that a country which forces its poorest people to get by on charity was failing in its duty to its citizens. You do not have to be a bleeding heart liberal to ask what happens to all the taxes we pay if we have slashed the social welfare safety net so much. People clearly buy into this and I suspect it is the reason why Labour made such gains at the expense of the government.

But before we get too carried away, we should remember that Labour did not win the election. They outperformed expectations, for sure, and in the battle of the leaders came out on top. As in 1974, when Conservative Prime Minister Edward Heath ran on the slogan “who runs Britain,” the electorate has delivered an answer that politicians did not expect. All this raises a question of whether politicians, particularly the government, really are in tune with the public mood. Or are they lost in the bubble of focus groups and Daily Mail headlines which do not paint a sufficiently accurate picture? Past experience suggests that governments which lose touch make mistakes, and they are usually punished at the ballot box.

The Conservatives were punished yesterday but escaped with serious, rather than fatal, injuries – at least for now. They have to learn from those mistakes. I have to confess I did not hear much contrition from Theresa May last night. For an obviously intelligent woman, she needs to get with the programme – for the sake of her career if nothing else. One of the more enlightening interviews I heard overnight was given by former Cabinet Secretary Lord Turnbull on the radio (here 7:48:25 into the recording) who was scathing about the way May has run her government and accused her of running it as a “fiefdom” without the necessary experience to manage the many tasks which modern governments need to take on. In particular he was critical of the lack of economic expertise and directly suggested that she was not up to the job of prime minister.

As a man of great experience at the heart of government, Turnbull’s view should be taken seriously. In his view she is not the right person to lead the country into Brexit negotiations and when asked whether she should stand down, his response was “absolutely” – an extraordinary thing for a man of his stature to say. At the very least, the prime minister will have to compromise on the Brexit strategy. Turnbull pointed out that by entering into a coalition with the DUP, the government should abandon the policy of leaving the EU Customs Union and thereby resolve the Irish border problem, which is high on the list of things the European Commission cares about.

If no such compromises are made, the UK will be driven ever closer to the cliff edge that the prime minister has said she wishes to avoid. And if we are pushed into that position, it will be an act of supreme economic vandalism. I fear that the prime minister will not change course, as she is fearful of the wrath of large swathes of her party if she does. But if she does not, the electorate will also wreak its vengeance. Faced with these twin evils, I would be surprised if the prime minister lasts in office much longer. As the hapless David Moyes found out when he succeeded Alex Ferguson as Manchester United manager, sometimes the better strategy is to avoid taking the top job under the wrong circumstances. Theresa May might have been the least worst candidate for the job as prime minister last summer, but it does not mean she is the best person for the job.

A last word on election economics

I was asked last week by the Sunday Telegraph to rank the economic policies of Labour and the Conservative parties as part of a larger survey group. The story duly appeared under the heading “Economists back the Tories - but remain underwhelmed” in which it was suggested that while Dixon’s “criticism of the Tories centres around their fixation on austerity, he is more scathing about Labour’s plans.” Whilst I am grateful for the press coverage, and my comments were reported accurately, I do believe they were given a spin which was not warranted by the totality of my remarks. In the interests of balance, therefore, I reproduce below the full transcript of my answers to the Telegraph’s survey. 

Tax & spending 

CON 3; LAB 3 (Marks out of 10 where 10 is good and 1 is poor)

There are many good things about the  Labour plans: (i) they are semi-costed so we have some indication of how much they want to spend; (ii) There  is also something to be said for establishing a National Investment Bank even though it will not be able to generate the £250bn in infrastructure spending that Labour plans. Far better to use it as a conduit to fund SME lending as in Germany and the US, where the KfW and SBA operate.  The bad news (and the reason I give the overall plan such low marks) is that too much emphasis is placed on taxing higher earners and corporates. In other words, the tax base is too narrow. For a party which seeks to promote equality, this is merely a “soak the rich strategy” which will change the behaviour of those caught in the tax net. It is thus unlikely to generate as much revenue as planned. In any case a penny on the basic income tax rate yields 4x as much revenue as a penny on higher earners. And whilst the idea of renationalising parts of the infrastructure sounds attractive, this will result in as many problems as it solves. The education pledge is too expensive given the  current numbers going into education. Abolishing university tuition fees is a good thing, but it would have been more affordable 20-30 years ago. However, Labour deserves credit for sparking a debate on the role of the state in the economy.

This is more than can be said of the Conservatives, whose economic manifesto offered nothing new. The commitment to balance the budget only by the mid-2020s does raise a question of whether the austerity of the last 7 years has been worthwhile. The public sector is creaking at the seams and it is not in any position to withstand a further round of austerity. As the Institute for Government has pointed out “the Government is struggling to successfully implement the 2015 Spending review … [with] clear signs of mounting pressures in public services.” A policy of more austerity will be self-defeating and I would like to think that Philip Hammond will take a  less draconian stance than George Osborne (the jury is out but his hands are tied by Brexit). I maintain that the commitment to reducing corporate tax to 17% is a mistake because it robs the Treasury of revenue and it is not as if HMRC is getting the corporate tax receipts it already believes it is owed. 

Immigration 

CON: 3; LAB 5

The idea that we can get net immigration back to the tens of thousands is economically illiterate and ultimately self-defeating although I understand why the Conservatives made the pledge for political reasons. However, targeting net immigration by focusing only on inflows, and continuing to classify students in the numbers makes little sense. It remains to be seen how a policy of “allowing us to attract the skilled workers our economy needs” is compatible with the targets. Labour is vague on immigration although they have sensibly resisted giving a pledge on numbers. The commitment to protecting the rights of EU workers already in the UK will play well in Brussels. 

Jobs & pay 

CON: 2 ;  LAB: 2

In this day and age, governments don’t really deliver jobs – other than by setting overall conditions – and have little influence over pay, except by controlling the minimum wage. Labour’s planned figure of £10/hour is probably not unreasonable although it is a big stretch from where we are today which will squeeze smaller businesses. The Conservative strategy which does not give an outright figure, but plans 60% of the median wage, is probably less of a hostage to fortune. The Conservatives are probably more realistic in the sense that they did not talk about creating jobs but it is difficult to give marks to either side because I am not convinced that they said very much, However, both get credit for recognising worker rights though the Labour plans have a whiff of the 1970s about them (“empower workers and their trade unions”). 

Industrial strategy 

CON: 6; LAB: 4

Both parties sound good on paper but there is little new here. Both sides offer a tinkering at the margin approach – nobody would dispute Labour’s view that we need to improve the economy’s skill levels but this will take years to show any improvement and it was vague on how to achieve it. The Labour manifesto had nothing substantive to say on productivity, which is the UK’s Achilles Heel at present and the Conservatives score a little higher, having already announced their National Productivity Investment Fund. My concern, however, is that neither party will be able to do much in an environment where global forces will play a major role (e.g. automation).

Social care & pensions 

CON: 3; LAB: 5

The Conservatives scored an absolute own goal with their initial plan on old age care provision, which was far less generous than that scheduled to come into operation in 2020. It ignored the Dilnot Commission proposal which advocated a cap on costs, thus mitigating against efforts to create a market for insurance in this area. Although they have backtracked, the damage is done. Sensible to remove the pension triple lock. Labour sound more convincing on this issue but the problem is how to pay for it. They are relying on squeezing higher earners and it is not clear whether they can afford all their commitments given the demands from other areas.

Totting up the marks, that amounts to 17/50 for the Conservatives and 19/50 for Labour (versus average marks of 23/50 for the Conservatives and 18/50 for Labour). Not exactly a ringing endorsement for either party, as the headline suggested, but not enough in my case to suggest a bias towards the Conservatives.

Trump's climate clanger

Although much of the current media attention is focused on Donald Trump’s rather unfortunate comments in the wake of the latest London terror attack, his decision last week to withdraw the US from the Paris Agreement on climate change was a much bigger deal. To recap, the agreement was drawn up in the first place in a bid to limit global greenhouse gas emissions in order to curb the rise in global temperatures and thus prevent some of the worst effects of climate change from causing even more environmental damage. There are 195 signatories to the treaty, with only Syria, Nicaragua and the Vatican not having signed up. However, the US decision to withdraw not only drives a coach and horses through global cooperation efforts on climate change, but it raises question marks against the commitment of the US to a whole range of international agreements.

Turning first to the climate issues, I am not a climate scientist so I am bound by the consensus of expert opinion which has done the work and drawn the conclusions. What everyone agrees on is that the earth is warming rapidly – global temperatures are around 2 degrees higher than when measurement commenced in the late nineteenth century. We also know that the amount of carbon dioxide in the atmosphere is at unprecedented levels (see chart, courtesy of NASA). 

The Intergovernmental Panel on Climate Change (IPCC) reckons that “anthropogenic greenhouse gas emissions … are extremely likely to have been the dominant cause of the observed warming since the mid-20th century.” Note that it does not say with 100% probability that climate change is man-made, but “extremely likely” is the sort of language scientists use when they are fairly sure. It may be that they are wrong, but until such times as the world’s most reputable scientists change their minds I’ll go with what they know, rather than what various interest groups believe to be true. And even if the scientists are wrong, it is a better insurance policy to take offsetting action rather than ignore them and find out they were right.

The science of climate change also suggests that global warming will have significant impacts on weather patterns, crop growing cycles, access to water and has the potential to disrupt the way we live our lives (for an overview of all these issues, see the Stern Review, which reported in 2006). As Stern pointed out, climate change “entails costs that are not paid for by those who create the emissions … Questions of intra- and inter-generational equity are central. Climate change will have serious impacts within the lifetime of most of those alive today. Future generations will be even more strongly affected, yet they lack representation in present-day decisions.”

Trump’s decision is the ultimate in short-term thinking designed to satisfy a tiny proportion of his country’s electorate whilst ignoring the wider consequences for their children (viz the wonderful response by Emmanuel Macron to Trump’s decision). Quite what better deal Trump has in mind for American workers by pulling out of the agreement is hard to fathom. After all, there are fewer people employed in coal mining in the US than in the green tech sector so it is not exactly a rational response to domestic issues. It is also a wider abrogation of duty to the rest of the planet, for as Stern also pointed out, solutions to the climate change problem require a global response.

There is thus general agreement that Trump’s strategy is self-defeating with regard to climate issues. But an equally serious concern is that an America first strategy runs counter to the rules-based system which underpins the world economic architecture and which has served the US so well for the past 70 years. An America which does not adhere to the treaty commitments to which it has signed up cannot expect others to play by the rules which the US flagrantly ignores. It may “only” be climate change, the implications of which will not become fully evident until after Trump is long gone, and in any case the US can always sign up again under a different president. But can the US expect all countries to adhere to the rules on global trade if for some reason it does not suit them? To what extent can the US’s military allies in Asia or Europe rely on its support?

International diplomacy is a game of give and take. Unfortunately, Trump appears to see it as a game of winner takes all. Moreover, he has not yet demonstrated that he understands the notion of cooperation on global issues (not that the British government is in any position to cast aspersions). But if Trump has any pretensions to providing leadership on a global scale, the climate change policy needs to be rethought. Future generations of voters may thank him for it.

Nearly there ...

As the UK election race unfolds, latest evidence continues to point to the Conservatives winning next week’s ballot.  However, the analysts at Electoral Calculus currently reckon that their majority will come in at 74 seats compared to an estimate of 168 three weeks ago (the current margin is 17). One poll released earlier this week even indicated that the Tories might lose their overall majority by winning fewer seats than they have now, although this was generally dismissed as an outlier. But the shift in the polls has rattled the markets, and foreign investors now see a risk that the election will not be the foregone conclusion it seemed a few weeks ago (see chart).

As I noted back in April (was it really that long ago?) this election is being fought purely for tactical reasons – and indeed the prime minister admitted yesterday that the decision to call yet another plebiscite was driven by Brexit-related reasons. In my view, this is nonsense. The rest of the EU does not care how large the PM’s majority is: The UK will still be in a minority of one in the Brexit negotiations. But the size of the majority matters for May herself. A parliamentary majority around 50 (still decent, let’s not forget) would be seen as the equivalent of a draw. Anything less would put the PM in a difficult position as she has to deal with the right-wing of her party, which has a habit of making life difficult for Conservative prime ministers. In effect, she needs a big win to give her a personal mandate.

So why are the polls narrowing? It can simply be boiled down to two factors: personality and policies. As George Parker wrote in the Financial Times today, “Theresa May thought a snap election would empower her, but what started in April as a quest for a “strong mandate” to deliver Brexit is threatening to leave her diminished. Polls suggest the more people see of her, the less popular she becomes.” Her main opponent, Jeremy Corbyn, started out as a no-hoper who couldn’t be trusted to run a bath, let alone the country, yet he is the one who has looked at ease in dealing with the hostile questioning (the odd brain fade during interviews notwithstanding). Corbyn has had to deal with questions about his past support for terrorist organisations and his willingness to press the nuclear trigger in the event it becomes necessary, and all-in-all has come out of it rather better than most people expected. This does not make him prime minister-in-waiting, however. Corbyn has spent the whole of his parliamentary career (34 years) opposing the mainstream of his party on most key issues. He will struggle to find sufficient MPs loyal to him in the unlikely event he becomes PM.

So if the personalities are not very appealing, we must judge them on their policies. Here again, both sides are found wanting. In summary, the Conservatives propose too much austerity and Labour promises too much tax-and-spend. Neither has talked enough about the single biggest issue facing the UK during the next parliamentary term – Brexit. Indeed, the prime minister seems to be asking the electorate merely to trust that she will “deliver the best deal for Britain.” That is not good enough. I would be more inclined to listen to a politician who acknowledges what economists have been saying for the last four years, that Brexit comes with a cost – a big one – and that they have a plan to deal with it. A party which proposes that “no deal is better than a bad deal” does not cut it.

Meanwhile, Labour’s tax-and-spend policy is open to the criticism levied by Conservative politicians that “there isn’t a magic money tree” to fund their plans. This is, of course, spot on although if I were Jeremy Corbyn, I would be pointing out that senior Conservative politicians such as the Foreign Secretary only twelve months ago supported the idea that leaving the EU would immediately mean that the UK could devote an additional £350m per week to the NHS.  The manifesto analysis conducted by the IFS last week provided a pretty damning assessment of the fiscal plans of both sides arguing that “neither sets out an honest set of choices.” Though as an aside, I found this blog piece by John Weeks an interesting insight into the shortcomings of the IFS’s analysis.

As we head towards polling day, I get the sense that many people are unenthused by the choices on offer. I almost have feelings of nostalgia for Screaming Lord Sutch and his Monster Raving Loony Party. Unlike Lord Sutch, the MRLP is still with us, however, and amongst their manifesto (or as they call it, manicfesto) commitments for 2017 are a pledge to “nationalise crime to make sure it doesn’t pay,” “reducing the alphabet to 23 characters. This will start by cutting the letters N. H. and S” and giving atheism charitable status on the grounds that it is a “non-prophet organization.” I’ve heard worse.