1968 and all that

It is interesting how society forms a popular view of recent history which is constantly reinforced by talking heads in the media, many of whom were not even born when the events in question took place. For example, many people look back to the 1950s with great nostalgia. Perhaps for Americans, looking back to a time when the country was relatively untroubled by military failure and the Great Depression was a rapidly fading memory, this may be understandable. But we tend to gloss over the fact that the country was riven by racism, particularly in the Deep South, which a decade later was to give such force to the Civil Rights movement. Continental Europeans do not have the same yearning for the 1950s, largely because their economies were being rebuilt after the shattering experience of World War II.

There seems little reason to look back to the 1950s with any great fondness in Britain either. Admittedly, the country was living in the afterglow of having been on the “right” side of history in the post-1945 era and living standards were rising rapidly. But the economy was in effect bankrupt, struggling to earn enough to pay the interest on its wartime debt, whilst food rationing continued until the middle of the decade and the Empire was being dismantled. Although people did not realise it at the time, Britain was vacating its position at the top table.

I can well recall the 1970s, which are today characterised by their uniform awfulness when workers in “broken Britain” seemed to be permanently on strike and the country was apparently convulsed by social unrest. The Conservatives have spent 40 years playing on this image to remind everybody about the terrors of electing a left-leaning Labour Party. But it was nowhere near as bad as the popular imagination now believes. Britain at the time was still a major industrial power, albeit losing ground to Japan and Germany, jobs were fairly plentiful and for most of the decade unemployment remained relatively low - at its peak it was less than half the level of the early 1980s. Inflation was a problem but wages kept pace. The downside was that the economy’s global competitiveness suffered, but this was not evident in people’s day-to-day lives.

But it is the way that the 1960s are portrayed which I find most fascinating. The enduring image is one of cultural change – a decade characterised by an explosion in music and fashion, hippies and the Summer of Love. Not so long ago I recall watching a documentary in which an American academic described 1960s Britain as a time when “everyone” was living up to the idealised picture of the time, enjoying the music and taking the drugs. That was certainly not true of the childhood Britain that I remember, many of whose social structures were more closely related to the Victorian era than those of today are to the 1960s. For anyone who doubts that view, I would recommend dipping into the book by historian Dominic Sandbrook Never Had it so Good. One fascinating fact which summarises the difference between reality and recollection is that the album which spent the longest period at number one in the UK charts came not from The Beatles or Rolling Stones but was the soundtrack to the film The Sound of Music, which spent 69 weeks in the top spot compared with 30 for the Beatles 1963 debut album Please Please Me and 23 for Sergeant Pepper’s.This was a very conservative society.

It is the events of 1968 which resound so heavily today. My own memories of that year are pretty hazy, largely because I was only five years old, though two things stand out: my first day at school early in the year and the first manned orbit of the Moon by the crew of Apollo 8 just before Christmas. Sandwiched in between, and largely passing me by, were the ongoing war in Vietnam, the assassinations of Robert Kennedy and Martin Luther King and the student uprisings across Europe and the United States. In short it was a tumultuous period when governance appeared to be breaking down. 

I often wonder how I would have perceived that period had I viewed it through the eyes of an adult. Would I have been as bemused by the events of 1968 as I am by those of today, characterised by an American President who has been accused of “glorifying violence” as the city of Minneapolis erupted in protest at the death of yet another black man at the hands of the police? Would I have felt as outraged as those members of society protesting against social injustice in 1968 as those who are affronted by a British government which appears to believe that it can adhere to one set of rules whilst the rest abide by a different rulebook? And that is without considering the divisive effects of Brexit which, as I pointed out last year, is merely one front in a bigger culture war.

Perhaps what 1968 represented above all was the revolt of youth against a system which they perceived to be biased against them. This was the first roar of the baby boomers who have been running the show for the last 30 years. But maybe their time is drawing to a close. Although US voters may yet grant Donald Trump another four years in November, the boomers will soon have to cede to a younger generation with a different world outlook and different aspirations. As easy as it is to get carried away with recent events and conclude that we are on the slippery slope to a dystopian society, the lesson of 1968 is that positive change can come from apparent chaos.

Current events come against the backdrop of the Covid-19 crisis – an unprecedented event which is going to transform the structure and operation of our economies. Add in the desire for political change and the stage is set for a radical process of restructuring. We may not notice the difference tomorrow, or even next year. But it is a fair bet that in 50 years’ time, 2020 will go down as the year everything changed.

EU expansion

After appearing to drag its feet on the issuance of joint bonds, the German government last week endorsed a French proposal to set up a fund capable of delivering €500bn of grants to EU member states suffering from the economic impact of Covid-19. This week the European Commission went further by setting out a plan to borrow €750bn by directly issuing bonds and distributing the proceeds to member states. After a decade of wrangling, this is a very important step and is vital if the EU is to hold together as a cohesive body. At last, the Commission has decided to lend its weight to a plan to issue pan-European fiscal instruments and will thus back up the ECB which has done all the heavy lifting on policy up to now. There are many who see this as a game changing event. And if implemented, it will be. But there are a number of hurdles to be crossed before the plan can be realised.

What does the plan entail?

Ursula von der Leyen, the Commission President, outlined a programme dubbed Next Generation EU. This is very apt because if it can be made to stick the EU could be about to take the first steps on the way to a fiscal union. Who knows, but this plan may be to the formation of a common fiscal policy what the snake in the tunnel was to the single currency. If nothing else it would break the taboo on fiscal cooperation which has long been one of the structural issues which has prevented the euro zone/EU from becoming the economic entity that the 1990s generation of leaders envisaged. That said, this measure is viewed as a one-off plan, nor will the Commission take any responsibility for debt already incurred by member states.

The idea is that the Commission will use its strong credit rating to borrow €750bn on international capital markets and recoup the funds though future EU budgets “not before 2028 and not after 2058”(i.e. not within the current budgetary period). Of this total, €500bn will be distributed in the form of grants whilst the remainder will take the form of loans. But the Commission is not simply proposing to write blank cheques: The funds will be distributed via EU programmes designed to achieve specific goals such as boosting competitiveness, supporting a broader green agenda and building the digital economy.

In order to facilitate repayment, the Commission suggested that a number of additional revenue raising items could be agreed at the pan-European level with each country paying the revenues from these streams into a centralised budget. “These could include a new own resource based on the Emissions Trading Scheme, a Carbon Border Adjustment Mechanism and an own resource based on the operation of large companies. It could also include a new digital tax … These will be in addition to the Commission’s proposals for own resources based on a simplified Value Added Tax and non-recycled plastics.”

In terms of the entitlement of individual states, the Commission has set out a formula based on three main economic factors: (i) population; (ii) the inverse of GDP per capita and (iii) the average unemployment rate over the past 5 years compared to the EU average. Based on this formula, Italy would be entitled to the largest share of the grants (20.5%) followed by Spain (19.9%), whereas France would only be able to secure a maximum of 10% and Germany 7% (chart).

What are the obstacles?

The first obstacle, and the most difficult, will be to convince the ‘frugal four’ (Austria, Denmark, Netherlands and Sweden) to sign up. The plan requires unanimous approval from governments, primarily because it entails structural changes in the EU budget that demand ratification by national parliaments. The frugal four have consistently opposed the creation of a debt union and have led the opposition which the German government is not willing to explicitly lead but which its electorate supports. But although Germany may have come somewhat reluctantly to the table, the government realises that failure to take action will ultimately weaken the ties that bind the union. After all, rising euroscepticism in Italy risks taking the EU in a direction it would rather not go and Germany certainly does not want to be the trigger for a breakup of the union. Arguably, however, the frugal four have less to lose and since they do not have the clout to bring down the union on their own, they act as a useful sounding board for the fears of all the northern countries.

A second concern is whether the establishment of an EU-wide fund will prompt individual governments to reduce their own efforts to put in place measures to combat the economic crisis. There has long been a concern amongst northern European members that an EU-wide safety net would result in moral hazard issues.

There are also some concerns with regard to fiscal legitimacy. One of the biggest problems is that only national governments have the power to levy taxes on their citizens since the government derives its tax-raising power from its electorate. Although there is a European Parliament which derives its legitimacy from citizens of the EU, it looks after pan-EU interests rather than the local interests which are generally more important to electorates. The levying of specific taxes for pan-European purposes might thus be seen as problematic.

But a brave attempt for all that

A decade ago it was clear that the euro zone is not a proper economic union – it was effectively a fixed exchange rate system in which debtor nations had to bear the brunt of the necessary economic adjustment. Greece and Ireland learned this lesson in a very painful way as the global debt crisis unfolded. It was also equally clear that some form of fiscal transfer mechanism would be necessary if the euro zone were to survive in the longer term, but efforts by Emmanuel Macron to make headway over the last three years largely fell on deaf ears. Now the tide has turned. That said, the Commission’s proposals are unlikely to be accepted in their current form and a compromise will emerge instead. Nor do the proposals outlined this week constitute a fiscal union. But they do mean that some form of countercyclical transfer mechanism could be in place sooner rather than later. In my view it is a very heartening move – at least from an economic standpoint although we can argue about the politics. The only disappointment is that it took so long to get here.

The Great Repression

Economic policy is about to take a turn for the weird. UK government borrowing in April 2020 was as high as in the whole of fiscal year 2019-20, at over £62bn, whilst the Bank of England is now seriously considering reducing interest rates into negative territory. Such is the precarious state of the economy as measures to combat Covid-19 take effect that all of the things we previously took for granted are about to be turned upside down.

The fiscal position

Dealing first with fiscal issues, the Office for Budget Responsibility reckons that UK public borrowing will reach 15% of GDP in fiscal 2020-21 which would represent the biggest peacetime deficit on record (chart below). Governments have no choice but to pull out all the stops given that they have imposed measures which impact on people’s livelihoods. With governments having shut down large parts of the economy, those affected by the measures need some form of support as a quid pro quo. The question remains as to how we will pay for it. In the short-term governments have no choice but to borrow more. Although the UK did not enter this crisis with a great deal of fiscal headroom, it does have some. The ratio of net debt to GDP ended fiscal year 2019-20 at 93.3% but as a result of the surge in borrowing in the first month of the fiscal year it jumped to 97.7% in April – the highest since 1963 - and it seems only a matter of time before it exceeds 100%. 

A decade ago, Carmen Reinhart and Ken Rogoff, in their famous 2010 paper, Growth in a Time of Debt, argued that a debt ratio in excess of 90% has major adverse consequences for economic growth since an increasing amount of resources is then devoted to debt servicing. The low level of interest rates today means that debt servicing costs are at their lowest in history so the 90% threshold may be less binding than in the past (if indeed it ever was, as there remains a lot of controversy regarding this figure). Ironically, on data back to 1700 the UK’s average debt ratio is 99% (chart below). Evidently imperial expansion and the financing of wars did not come cheap. But at the beginning of this century, the debt ratio was around 30% of GDP and whilst the financial crisis of 2008 did a lot of damage, it is notable that the debt ratio has continued to climb during the Conservative government’s term of office. Having spent the past decade telling the electorate that the deterioration in public finances was all the fault of the previous Labour government, even before the Covid crisis, the Tories have not exactly had a great record on managing public finances.

That said, even a net debt ratio of 100% is likely to be easily fundable. Despite what the ratings agencies may say, the UK has a long track record of not defaulting on its debt and it issues in its own currency. Nonetheless, no government will be comfortable with debt ratios at current levels and this partly explains why many policy makers want to reopen the economy as soon as possible in order to get some tax revenues flowing into the Treasury’s coffers.

The monetary response

Whilst I have long been an advocate of a more activist fiscal policy, it is equally clear that fiscal policy alone cannot do everything and needs to be backed up by monetary policy. It is presumably for this reason that the BoE is discussing the merits of cutting policy rates into negative territory. Although there are some circumstances in which they might be useful, I have never been persuaded of the merits of negative rates (a view summarised here).  In very simple terms, they are designed to persuade households and firms to bring forward activity and represent an attempt by central banks to alter the time preferences of economic agents. For those with an eye on their retirement funds, the idea of negative rates is anathema and the impact on savers is one of the reasons why a case has been brought before the German Constitutional Court.

As I have mentioned numerous times before, one of the problems with the negative interest rate policy is that it operates only on the supply side of the credit equation. Reluctant borrowers cannot be forced to take out loans and in the current environment, where uncertainty is at a maximum, households and corporates will not borrow under any circumstances. A bigger concern is that once rates fall into negative territory, they will stay there for a long time. That has certainly been the experience in Japan and the euro zone. Indeed, the experience of the last decade has been that central banks never seem to believe that the economy is strong enough to support monetary tightening. Consequently if interest rates do fall into negative territory, I fear they would not quickly rebound. As the respected head of the BIS research department, Claudio Borio, noted last year, “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”

As to whether a policy of negative interest rates has much economic effect, the jury is still out. Evidence from ECB researchers suggests that negative rates have boosted economic growth in the euro zone, although Italy might beg to differ. But no central bank is ever going to produce evidence that says its signature policy is not having the desired effect so we should treat the results with some caution. However, it does have a real impact on the banking sector. I do not expect the vast majority of the public to shed any tears for banks, which emerged from the 2008 crisis in better shape than they dared hope, but negative rates will squeeze margins. At a time when the BoE is exhorting banks to continue lending because “it is in their interest to do so”,  a policy which makes banks think more carefully about who they lend to is inconsistent with this strategy. Evidence from Sweden suggests that initial moves into negative territory do get transmitted to lending rates but subsequent moves do not. In other words, the monetary transmission mechanism can break down quite quickly. 

We should be under no illusions that policymakers will have to take all available measures to get the economy back on its feet. Given the huge surge in sovereign debt, governments and central banks are about to embark on a prolonged period of financial repression in order to reduce the cost of debt servicing. By doing so, governments will be able to reduce the extent of fiscal austerity required to control public finances when the economy finally recovers. If this means a period of negative interest rates, so be it. However, there is nothing to be gained from doing so for a prolonged period although if asset bubbles, screwing future generations of pensioners and failure to use the market mechanism to discipline risk taking are your thing, be my guest.

Everything in proportion

A couple of weeks ago I wrote a piece looking at the ruling by the German Constitutional Court (GCC) which suggested that the ECB should demonstrate proportionality in the conduct of its asset purchases. It is worth revisiting the question to focus on the legal issue of proportionality, which is not well understood by non-lawyers in the Anglo Saxon world (including me). The reason for doing so is that the objections raised can be applied to the conduct of monetary policy around the world, not just in the euro zone, and goes to the heart of my criticisms about the overly lax monetary policy followed by central banks over the past decade.

Proportionality is not a concept which is enshrined directly into English law, which instead leans more heavily on the principle of (un)reasonableness. English law uses a standard known as Wednesbury unreasonableness to determine whether an action is such that “no reasonable person acting reasonably could have made it.” In case you are wondering, it gets its name from a 1948 legal ruling on a case between Associated Provincial Picture Houses and Wednesbury Corporation. Proportionality, on the other hand, is designed to check the infringement of citizens rights by legislative, administrative or judicial authorities and is enshrined in German law as far back as the 1880s. Without being an expert on law, my understanding is that reasonableness is concerned with the process by which outcomes are derived whereas proportionality is concerned with the outcome itself.

The GCC made the point in its ruling that the ECB’s Public Sector Purchase Programme (PSPP) has a number of economic side effects to which the ECB has not apparently given sufficient consideration. Asset purchases result in low interest rates which produce “considerable losses for private savings” and allow “economically unviable companies to stay on the market.” I would not contest these views but the complainants who brought the case argue that the ECB has not provided evidence to suggest that these costs are outweighed by the benefits of its actions. With the ECB having held policy rates in negative territory since 2014 and buying assets since 2015 in a bid to hold down bond yields, the extent and duration of monetary easing is increasingly a cause for concern because it magnifies the adverse consequences of the policy.

This goes to the heart of my own criticisms of central bank actions over the past decade. Indeed, I have made the point repeatedly that once the economy started its recovery from the 2008-09 recession, there was a case for central banks to take back some of the emergency monetary easing, if for no other reason that they would have more scope for policy easing when the next downturn hit. I have also argued that low interest rates have side effects which central banks have studiously ignored, particularly when it comes to their impact on future pension income. I once raised this question directly with the central bank governor of one of the smaller European nations, who admitted that he was aware of the problem but had come to the conclusion that the short-term considerations were more important. Arguably, the current generation of central bankers has displayed a lack of proportionality in their approach to monetary policy and we may only be aware of the impact of recent actions in the long-term. Admittedly, the Covid-19 outbreak has changed the calculus as central bankers are forced to take unprecedented action but it does not excuse their actions over the past decade.

The complacency in this regard was highlighted in Mark Carney’s last speech as BoE Governor when he suggested that society as a whole has not lost out from low interest rates because “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus, since only 2% of UK households have material deposit holdings without material financial assets or property wealth.” As I have pointed out before, a large part of society may indeed have seen an increase in the value of their wealth holdings, but since a significant part of it accrues in the form of housing, it is not easily realisable. Nor does it benefit those at the lower end of the income scale who are unlikely to have a large stock of assets. Carney’s post-hoc justification for the actions taken during his time as Governor would fail the GCC’s proportionality text.

When it comes to central bank decisions to ramp up asset purchases, it is not just the ECB which shows a lack of proportionality. Central banks argue that their inflation mandate gives them scope to boost asset purchases in a bid to return inflation to the target. But the evidence suggests that the policy has not worked because the likes of the ECB and the BoJ, which pioneered the policy almost 20 years ago, have singularly failed to boost inflation back towards 2%. Monetary theories of inflation have simply not worked over the last two decades – there has been no evidence that increasing the volume of liquidity in the economy has boosted prices (other than for financial assets), as the chart below indicates for the euro zone. If that remains the case, the good news is that central banks can continue creating liquidity without any adverse consequences for their inflation mandate. The bad news is that it undermines the case for the policy.

Nor should we necessarily buy the argument that central bank actions do not represent deficit financing simply because asset purchases are not taking place at the behest of the government. It would be naïve in the extreme to think that central banks and finance ministries do not coordinate their policies, particularly when in the UK the Treasury indemnifies the BoE’s bond purchases. None of this is to say that central banks should not buy bonds. However, the excuse that this being conducted for inflationary purposes is starting to wear a bit thin. It is really about creating space in the bond market to allow them to digest the huge flow of debt issuance which, as I argued here, does not have to constitute monetary deficit financing.

But if you believe that central banks have no other mandate than controlling inflation, this is a difficult case to make. Indeed, in the euro zone it is legally impossible. However, if central banks can argue that their actions are designed to prevent a breakdown of the sovereign debt market, which would have significant implications for the operation of economic policy, this would be a more proportionate response than hiding behind the inflation smokescreen. It would also be more honest.