Error correction (or blame deflection?)

For anyone interested in the practice and methodological issues associated with economic forecasting, you could do a lot worse than read the Bernanke Review of forecasting at the Bank of England. According to the FT, the former Fed chair who was commissioned to produce a report on the BoE’s forecasting practices after its failure to predict the rise in inflation in 2022, was “brutally honest about [its] failings.“ Brutal might be overstating it, but it was an honest assessment that one feels is shared by many BoE insiders. As one might expect, not all economists agreed with all of its conclusions but there was a lot to like about it.

The fact that Bernanke outlined many shortcomings in the BoE’s practices should come as no surprise. No system is ever perfect, and the fact that the current monetary framework has been in place for almost 30 years does suggest that it is time to have a close look. There are a number of questions around the whole process, however. Why was it necessary to have such a review in the first place? If the processes really are as poor as Bernanke highlighted, why did it require an external review to point it out? And if the purpose of the exercise was to address policy errors, should we not be spending time looking at the policy making process rather than putting a lot of effort into the forecast generation process? I will deal with these points below.

What were the conclusions?

It is perhaps instructive first to reflect on Bernanke’s main process recommendations. One of the most widely trailed in advance was the suggestion that the BoE publish scenarios alongside the main forecast. This would “help assess the costs of potential risks to the outlook” and “stress test the judgements made by the MPC.” There is a lot of merit in doing this: The experience of recent years which has produced the Covid-19 pandemic and the oil price shock, suggests that a single forecast with a univariate central case cannot adequately capture all future states of the world. Even allowing for risks in the form of a fan chart, no forecast could capture shocks of the magnitude of 2020 (see chart below). The Bernanke Review went as far as suggesting that “the fan charts as published in the MPR have weak conceptual foundations, convey little useful information over and above what could be communicated in other, more direct ways, and receive little attention from the public. They should be eliminated.” While there is some truth in this, it may be going too far to eliminate them, as fan charts are a very useful way of conveying risks around a central case in a stable environment, and there is a case for retaining them.

Another very important consideration was the nature of conditioning assumptions, particularly for the future path of interest rates. There are a number of reasons why using market rate expectations as the appropriate starting point is less than optimal. For one thing, “forward rates implied by the market curve are not pure forecasts of future rates, because forward rates may incorporate risk and liquidity premiums.” In addition they may not reflect the MPC’s best judgement of the path of rates, meaning that “a forecast conditioned on the market curve may be misleading.” One alternative is for the central bank to give a preferred path for rates, much as the Riksbank does, although as I argued in this post in 2019, this could simply create a hostage to fortune. Instead, the practice of offering alternative scenarios based on different rate paths will probably suffice.

A final big point, and one that is close to my heart, is that the software required to manage and manipulate data “is seriously out of date and difficult to use” and should be upgraded and constantly monitored. I don’t know which systems Bernanke is referring to but my own experience with languages such as R and Python, now en vogue in economic circles, is that they are far less user-friendly and flexible than some of the systems designed in the 1970s. The review was also critical of the BoE’s macro model, COMPASS, unveiled to great fanfare in 2013. Bernanke did not explicitly say that DSGE models may not be up to the job of forecasting but he offered the view that structural models (of the kind I have long advocated) still have a role to play in forecasting – after all, the Fed still uses them.

Policy considerations

The elephant in the room, however, is why it was felt that such a review was required in the first place. The answer, to put it bluntly, is that it was designed to keep politicians off the BoE’s back after it was accused of failing to predict the huge rise in inflation in 2022 (true) and the fact that its policy response was too slow (less true). In fact, the BoE's inflation forecast in February 2022 was above that of the consensus, predicting end-2022 inflation at 5.8% versus a consensus expectation of 4.6% (outturn: 10.8%) and end-2023 inflation at 2.5% versus the consensus prediction of 2.1% (outturn: 4.2%). Thus, while the BoE forecast was a significant under-estimate, it was less so than most forecasters.

As for the policy response, as I (and many others) have noted previously there was little anyone could have done to prevent an inflation spike in the face of an external oil price shock. Recall that the UK had just come off the back of a pandemic which had resulted in the steepest decline in output in 300 years and whose long-term effects were at that time still unknown. It did not feel like the right time for a sharp tightening of monetary policy. However a review of process is a standard response to issues that are more a matter of policy. Simply put, it is a way to deflect attention.

Another issue worth addressing is the question raised by the Sunday Times economics editor David Smith as to why it took an external review to highlight these shortcomings, which were well known internally. We are very much in speculative territory here, but since Bernanke took a lot of evidence from BoE insiders – past and present – it is hard to avoid the conclusion that this review offered an opportunity to tackle internal inertia. This may be the result of senior managers lack of knowledge of the issues involved; the fact that their attention has been diverted by other policy matters in recent years (Brexit, the pandemic) or simply a lack of budget resources. Either way the Review is a good way to get their attention.

Last word

It is always a good thing to review forecast models and processes, especially when they have been in place for so long and the Bernanke Review put the BoE’s process under a lot of scrutiny. In many ways it simply came across as a call to modernise a system, which in the grand scheme of things was already pretty decent but perhaps had been neglected a little over the past decade. However, the one thing it will not fix is that the future is inherently unknowable. No matter how state of the art, no forecasting system can cope with the kind of shocks to which we have been subject of late. Give it another decade and we will be having this debate all over again.

Water, water ...

One of the motivations for setting up this blog eight years ago was to highlight that continued reliance on the private sector for solutions to economic problems is a far from optimal strategy (see my June 2016 post, here). The recent furore regarding the failings of the UK water industry, along with the vexed problem of how to organise the rail network, are examples in a long line of businesses which have failed to live up to post-privatisation expectations. At a time when government is vexed by the problem of persistently low productivity, this makes it all the more important that infrastructure works efficiently.

Looking back to the 1980s and 1990s, you might recall that one of the main arguments advanced by the Conservative governments of the time was that the private sector would run businesses more efficiently and productively than the public sector. By introducing market discipline, competition, and incentives for innovation, this would lead to cost reductions and improved performance. In addition, private companies would have stronger incentives to improve service quality and customer satisfaction in order to attract and retain customers. While there were examples of industries which did benefit from a return to the private sector – telecoms being the prime candidate, which gained from a technological revolution – in many instances, privatisation simply meant swapping a public sector monopoly for one in the private sector. As a result, they had little incentive to innovate and could rely on a captive market to sustain revenues.

Where did it all go wrong?

Evidence to suggest that the water industry has not generated the post-privatisation efficiency gains that were claimed for it comes from a study by the consultancy Frontier Economics published in 2017 (chart below). Their analysis suggests that total factor productivity in the water industry did pick up immediately after privatisation but that it quickly slowed thereafter, doing nothing to dispel the suggestion that the industry has lived off the assets it inherited at the time of privatisation in 1989.

Yet the failings of the privatisation model introduced in the UK over the last thirty-odd years go far beyond the shoddy way in which customers are treated (overpriced train journeys, effluent being dumped in rivers, electricity companies that went bust at the first sign of trouble in global energy markets). One of the issues that privatisation was meant to tackle was reduced reliance on a pay-as-you-go model, in which the current generation of taxpayers stumped up for investment from which the next generation would benefit. Under a pay-when-delivered model, it was planned that balance sheets be used to pay for the initial cost of investment and future customers pay for the services they consume and so long as prices were set appropriately, the business would generate a decent rate of return. In addition to this being a sound economic basis, there was also a political motive for doing this as far as water was concerned. Planned EU legislation in the 1980s and 1990s required a significant rise in future investment which the government did not want to pay for, nor did it want customers (aka voters) to have to pay for it either. Getting private companies to use their debt-free balance sheet to pay for investment seemed like an expedient solution (water companies were debt free on privatisation).

But as the Thames Water debacle shows, that is not what happened. Newly privatised companies resorted to borrowing against assets on the balance sheet, much of which was ultimately used to pay shareholder dividends. As a result, Thames Water now has huge debts which threaten it with bankruptcy. This has forced a return to a pay-as-you-go model with today’s customers being asked to fund investment while servicing today’s debt.

Regulatory failure

While the public rightly puts most of the blame for the failures of privatised utilities on its managers, we should not ignore the fact that in many cases regulators have been remarkably complacent. First off, regulators in the electricity and water industries failed to stop companies from leveraging up their balance sheet from the 1990s. The companies perhaps ought to have behaved more responsibly but it is the duty of regulators to step in when irresponsible behaviour occurs.

Second, regulators did what they often do, and conduct regulation by rule book. As the economist Dieter Helm points out, the periodic reviews they conducted generated huge amounts of admin which companies struggled to process. As Helm notes: “company boards find that they are essentially asking the regulators to make decisions for them. In recognition that the “customer” is Ofwat rather than the household and business users, utilities engage in lots of lobbying, and try to work out what answer the regulator wants, rather than what their customers want and the wider environment needs ... Utilities start by trying to guess the answer the regulator (and the government of the day) might want, and then shape their business plans around them.” Both these elements chime with the situation in the financial services industry pre-2008 when regulators failed to rein in the (dubious) actions of many banks and issued vague directives without giving clear guidance as to whether institutions were compliant. And as we know, the UK regulator ended up being abolished and a large part of its responsibilities transferred to the BoE.

A final problem, though one which is perhaps only recognisable in hindsight, was that regulators applied the wrong cost of capital – a key metric used in determining the allowed rate of return and thus the appropriate prices for consumers. They applied a weighted average cost of capital (WACC) averaged across all areas of the business, rather than looking at each individual area separately. As a result, for each individual business WACC turned out to be too high for the cost of debt and too low for the cost of equity, providing an incentive for privatised utilities to switch from equity to debt and encouraging the gearing that proved to be so problematic for Thames Water (for more detail, see the work by Helm here or here). Here too, there are echoes of the failures of the VaR models which so underpriced financial risks prior to 2008.

 

Nationalisation is not (necessarily) the answer

Not surprisingly, this has caused a political uproar which threatens to rebound on the Conservative government which has long been an advocate of privatisation, while giving ammunition to those at the other end of the political spectrum who advocate taking assets into public ownership. However, nationalisation is not necessarily the best solution (it might be for rail, but that is a subject for another time). The arguments continue to rage as to whether renationalisation would result in an industry which is better aligned with customer interests. But the biggest argument against it is the fact that the state currently does not have the funds available to buy the utilities without issuing significant amounts of additional debt, and certainly does not have the cash available to fund the necessary investment. Many utilities are foreign owned (over the last 20 years Thames Water has had German, Australian and Canadian owners) and nationalisation would sit uncomfortably with efforts to attract foreign investment. As Helm has consistently pointed out, the UK suffers from a sizeable savings deficit – the current account deficit is a measure of the excess of domestic investment over savings – which implies that it is already reliant on the kindness of strangers to fund investment.

What to do?

Since we cannot easily nationalise Thames Water, and imposing yet more red tape would not seem to be a viable option, we may be left with little option other than to place it in administration. This is effectively what happened to the privatised rail operator Railtrack in 2001. Rather than nationalise the whole operation, however, there is a strong case for splitting it into smaller parts with different regional responsibilities and maybe with different functional responsibilities (e.g. one for water supply and one for treating sewage), selling off the good bits and putting the bad bits into special administration.

Either way, it seems socially irresponsible to allow a company that has failed to properly manage the largest water company in Europe to be allowed another go at getting it right. This may be the right time to redraw the contract between the state and the market, and learn some of the lessons of the last thirty years. In short, the companies must strike a better balance between serving their shareholders and their customers, entailing effective regulation (not simply more of it, but better targeted regulation); breaking up private sector monopolies; more strict controls over pricing and more effective sanctions against those who transgress. On the assumption that a new government will have to pick up the pieces of this problem in the not-too-distant future, the Thames Water problem could provide a good opportunity to reimagine how utilities should be run in the twenty first century.