Mostly ARMless

I am not exactly sure what to make of the bid by Japanese company SoftBank for ARM Holdings, one of the few British tech successes of recent years. Indeed, the chips made by ARM are in devices across the world from smartphones to tablets. Whilst ARM is a reasonably sized UK company, with revenues of around $1.5bn and profits close to $500 million, which puts it just outside the top 20 largest British firms, it is a tiddler in global terms. For example, AstraZeneca – the last big British company to be involved in politically sensitive takeover negotiations – generates revenues of around $25bn, whilst a serious tech giant such as Google makes $75bn in revenue and net profits of $16bn.

What sets it apart is its strategic importance. The company has a 95% market share in the smartphone market and as the Internet of Things takes off, the kinds of processors which the company makes will be in high demand. Although the new Chancellor Philip Hammond insists it is a demonstration that 'Britain has lost none of its allure to international investors’, it flies in the face of the speech made last week by prime minister Theresa May who argued strongly that the government would be less keen on seeing strategically important businesses sold off to 'transient' foreign investors.

One of the founders of ARM has expressed regret that the future of the company will be decided in Japan rather than in Britain. As an economist, I ought not to care, although in these increasingly difficult geopolitical times the idea of a business world without borders is no longer as attractive or realistic as it appeared a few years ago. Perhaps more importantly, the profits made by the company will flow back to Japan thus exacerbating the UK's current account deficit, which is already one of the highest in the OECD. Regret has also been expressed in tech circles that yet again another national champion has been sold off, which will stymie European efforts to build companies to compete with the Silicon valley giants. But the company belongs to its shareholders and if they decide to cash in on a very generous offer, who can blame them?

Although the weakness of sterling in the wake of Brexit has made assets such as ARM cheaper in yen terms, the surge in the share price in pounds has gone up at an even faster rate. Thus, by last Friday ARM’s share price in yen terms was 3.5% higher than on 23 June. Moreover, SoftBank paid a premium of 43% relative to Friday’s close and a multiple of 60x 2016 earnings – way above the FTSE’s already-high average of 38x. It was almost too good an opportunity for shareholders to turn down, although it could yet be derailed by a counterbid or indeed by direct government intervention.

Undoubtedly, the issue will raise concerns about the UK’s willingness to sell out important businesses to foreign investors. But so long as the UK continues to operate an industrial policy in which companies have a duty only to their shareholders, and in which they are encouraged to take decisions on purely financial terms, we will undoubtedly see more deals such as these. This is all the more true as the collapse of the pound since the EU referendum reduces the costs of buying into the UK. It also boosts the revenue of those companies (such as ARM) which derive the bulk of their revenue from overseas, which will increase their attractiveness, and explains why the prices of those companies with a high degree of exposure to the EU have outperformed. Of course, it would be hugely ironic if the Brexit-induced collapse in sterling leads to more foreign takeovers, thus weakening the case of  those who thought that this was a chance to revitalise the economy in the interests of the British people.

When "I don't know" is the right answer

One of the questions most frequently posed of me as an economist is “what will happen to …” where the object in question is the currency, interest rates, house prices or any other variable you might like to nominate. My stock answer to this question is that if I possessed such clairvoyant knowledge, I would use it to become rich. But I don’t and I’m not. So how have we become the business world’s equivalent of Cassandra?

Modern economic forecasting originates from the pioneering work of Lawrence Klein and others in the late-1940s and 1950s, whose work in macro modelling and forecasting appeared to have successfully cracked the problem of how to predict swings in the economic cycle. As computing power improved, the models became more complex, and the technocratic approach to planning which was increasingly adopted from the 1960s onwards resulted in a huge increase in demand amongst government and business for detailed analysis of future prospects. The fact that such models suffered spectacular forecasting failures during the 1970s and 1980s did not stop economists from pontificating on the future. Even today, organisations like the OECD, IMF and European Commission devote considerable resources to their forecasting units; numerous private sector forecast outfits continue to make a comfortable living by selling projections to their clients and every self-respecting financial institution provides an economic forecast.

The pot is often further stirred by a media which has a fascination for pinning down economists for their views on a diverse range of subjects, most of which we cannot possibly have had time to analyse properly and we end up instead with a sound bite which can often backfire spectacularly. One of my own favourite quotes, which I use to demonstrate the limits of economic forecasting comes from the great American economist Irving Fisher, who, days before the crash of 1929 opined in the New York Times that “stock prices have reached what looks like a permanently high plateau.” He is, of course, not alone. None of us has perfect foresight and every economist who has ever made a forecast knows that reality can bite hard.

I was first awakened to the idea of probabilistic forecasting some 25 years ago after reading Stephen Hawking’s classic book A Brief History of Time. Hawking explained how “quantum mechanics does not predict a single definite result for an observation. Instead it predicts a number of possible outcomes and tells us how likely each of these is.” It sounded like an ideal way to present economic forecasts, and the Bank of England was one of the first institutions to formalise such analysis in the form of a fan chart which assigns probabilities to the likelihood that variables will fall within a particular range.

The chart below shows the range of outcomes which the BoE assigned to its May 2016 inflation forecast, with the cone-shape depicting the range of outcomes that would be expected to occur with 90% probability. The darkest shaded area around the centre of the chart represents the outcome which the BoE would expect with a 30% probability and the lighter shaded areas represent a wider range of outcomes which encompass an even higher likelihood of occurring. But the higher the probability you attach to an inflation outcome, the less precise you can be about what the inflation rate will be. In effect this is akin to Heisenberg’s uncertainty principle which states that “the greater the degree of precision assigned to the position of a particle, the less precisely its momentum can be known (and vice versa).” To say that in three years’ time, you would assign a 90% probability to the likelihood that inflation will be between 0% and 5% may not be the kind of analysis which people will pay good money for, but it is a far more accurate representation of our ability to see into the future.

The BoE’s inflation forecast fan chart, May 2016

Source: Bank of England

The events of recent weeks should by now have awakened us all to the limits of our forecasting prowess. Most rational analysts believed that Brexit was the least likely outcome, but now that the referendum result is known we are all trying to figure out what it means for the economy. Consensus forecasts suggest that UK GDP growth in 2016 and 2017 will come in around 1.6% and 0.7% respectively, versus 2.0% and 2.2% before the referendum. This accords with pre-referendum analysis indicating that the economy would suffer an outcome loss of around 2% in the event of Brexit, relative to what would otherwise would have occurred. But as we learned in the wake of the Lehman’s crisis, economic forecasts made right after big shocks can turn out to be highly inaccurate. 

In truth, we do not really know how the economy will fare over the next two years. If we are honest, we do not know whether Brexit will actually take place at all, particularly in the wake of Theresa May’s recent suggestion that she “won’t be triggering Article 50 until I think that we have a UK approach and objectives for negotiations.” It is not a 100% probability event, and I continue to hold the view that on the basis of current evidence, it’s a 60% event. That view will continue to change as more information becomes available. Those who ask economists to make black-and-white predictions regarding complex events such as these should be met with the response “I don’t know” or at least add the rider “… with any degree of certainty.” That of course is not what we get paid for. So either we adhere to the Mark Twain view that it is better to be thought a fool and stay quiet than open our mouths and prove it beyond doubt, or we should adopt the Heisenberg doctrine that “an expert is someone who knows some of the worst mistakes that can be made in his subject, and how to avoid them.” Perhaps by reminding our interlocutors that if our answers are wrong, it may be as much to do with the nature of their question.

All change

It has been a momentous day, to be sure. No sooner did David Cameron depart the scene than Theresa May became the 54^th person to occupy the role of prime minister in a line stretching back to 1721. We also have a new Chancellor of the Exchequer, Home Secretary and Foreign Secretary (Boris Johnson of all people). There are thus new incumbents occupying all the so-called Great Offices of State. But on a day such as this, it pays to pause and reflect.

My own view is that the end of David Cameron’s career in front line politics is a waste of good political talent. He certainly comes across as a decent man who is a great communicator. Yet historians may reflect that the balance of his achievements did not weigh too heavily in his favour. Admittedly the economy has recovered nicely over the past three years, but it has been a slow haul and the austerity inflicted by his Chancellor did a lot to stir up the passions which culminated in the Brexit vote. For a man who apparently believed in one nation Toryism, Cameron managed to sow domestic divisions with his ill-judged referendum in Scotland and the disastrous referendum on EU membership. Foreign policy has not been a raging success either, backing intervention in Libya which served only to cause the country to implode. For some, his biggest mistake occurred even before he came to office when he removed Conservative MEPs from the centre-right faction in the European Parliament, thus damaging attempts to form decent relationships with key European allies.

But now he’s gone, and in his place comes a prime minister who has inherited what might appear to be a poisoned chalice. Mrs May certainly has her work cut out. Her speech in Downing Street this evening was described by a friend whose judgement I trust as one which sounded more Labour-like than any current Labour politician could credibly deliver. It was, as the journalist Polly Toynbee tweeted a “devastating analysis of UK social injustice.” It was a clear recognition that the economic policy of the previous regime has helped to exacerbate many of the social tensions which exist outside the London bubble, and it is why George Osborne is no longer Chancellor of the Exchequer.

Osborne was committed to balancing the budget. He failed. Public borrowing in the last fiscal year was almost four times what had been predicted at the time of the June 2010 budget, and whilst not all of this was his fault the Chancellor promised too much too soon. There was a general failure amongst all politicians to recognise the severity of the crisis which hit in 2008 and that it was always going to take at least a decade to try and fix the public finances. But instead of trying to take it slowly, the government frontloaded a significant amount of austerity in the form of a squeeze on public spending. Unfortunately this was insufficient to get the deficit down as rapidly as desired, and Osborne was forced to continue asking for more. By the time the 2014 Pre-Budget Report was released, the OBR’s projections suggested that the share of government spending in GDP was set to fall to its lowest level since the 1930s.

It is notable that Ireland introduced a savagely tight fiscal policy following the financial crisis, which at least succeeded in eliminating the public deficit. There was widespread unrest, and it did result in a backlash following the 2016 election, but Fine Gael remains the largest party in the Dáil, and the government has taken the foot off the brake now that the job has been done. In the UK, there is a sense that the job is far from done. So the government must stick or twist: try harder to eliminate the deficit and risk further unrest, or ease off and accept that the current timetable of achieving a current surplus by 2020 is unrealistic. All the noises we have heard so far suggest that the latter will be the most likely course of action.

But this raises another problem: If the government scales down the tightening in a bid to heal some of the divisions which have occurred recently, what was the point of the last six years of austerity? It appears to have achieved very little: Yes, the deficit has been reduced but by far less than planned, and at the cost of widespread dissatisfaction with the thrust of policy which prompted the electorate to stick up two fingers on 23 June. As I wrote in October 2010, ahead of Osborne’s first Comprehensive Spending Review, “Spending cuts are a gamble which must work. It is not the rating agencies which the government has to fear: It's the electorate.” It proved to be far more prophetic than I could ever have imagined.

Rules of the game

Playing by the rules is an important element underpinning the economic system in which we operate. Indeed, it was to avoid a repeat of lawless behaviour in the increasingly globalised world of the 1930s that prompted the design of many elements of the current international order (trade agreements, international supervisory bodies and the safety mechanisms designed to prevent conflict). But we should not make the mistake of believing that all rules are good rules.

I was reminded of this when reading an article in The Economist recently which illustrated the case of the US Fourth Amendment bar on “unreasonable searches and seizures.” The article pointed out how the US Supreme Court has ruled that loopholes in the law make it admissible to use evidence gathered in one legal case to prosecute another. As one of the Supreme Court judges who opposed the ruling warned, “Do not be soothed by the opinion’s technical language. This case allows the police to stop you on the street, demand your identification, and check it for outstanding traffic warrants.”

Now you may be wondering what this has to do with economics, but it is just a fancy way of saying that the law of unintended consequences can do an awful lot of damage. Think of the operation of the Stability and Growth Pact in the euro zone. It was originally designed to prevent taxpayers in Germany from having to bail out their less fiscally rigorous neighbours in southern Europe. This seemed like a good idea at the time but the adherence to strict fiscal rules has been one of the factors exacerbating the extent of what can only be called a depression in places such as Greece. Indeed, the rules are inherently deflationary and, as Keynes put it, make the process of adjustment compulsory for the debtor and voluntary for the creditor.

Worse still, although there were explicit rules for the ratio of public deficits and debt relative to GDP, to which economies were supposed to adhere, they were observed more in the breach. By 2001, two years after the euro came into being, Germany had already pushed its deficit through the 3% of GDP level (as indeed had Greece and Italy) with France following a year later. Once Germany and France had breached the deficit targets it became difficult to ensure that other countries could be forced to comply. So not only were the rules ill-designed, but they quickly became non-credible.

Here in the UK, the question of rules has gained lots of prominence in recent days in the wake of the EU referendum and various leadership elections in the main political parties. Prime minister elect Theresa May has already suggested that she will not seek to overturn the result of the referendum and will adhere to the rules of the Single Term Parliament Act and not call an early general election. But if she does eventually trigger the Article 50 process, in accordance with the perceived wishes of the people, she will be unleashing a wave of consequences we cannot yet begin to predict. In economics, just as in law, it pays to be certain of the long-term consequences before  simply following a predefined set of rules.

Time for a policy rethink?

There are few indications as yet that the UK real economy has taken a hit in the wake of the Brexit vote, but the release yesterday of a snap post-referendum consumer sentiment poll does not bode well. The GfK index collapsed by 8 points, the biggest monthly fall in 21 years. It is early days yet and the initial reaction might prove an over reaction. Nonetheless, it will give the Bank of England food for thought as it meets next week to set interest rates.

It really is a toss up as to whether rates are cut in July or August, but either way the Bank looks set to react with a rate cut over the summer as Governor Carney has already hinted. But in a keynote speech last week he pointed out that "monetary policy cannot immediately or fully offset the economic implications of a large, negative shock." Indeed, it is increasingly looking as though the BoE has little real ammunition left to counter the Brexit shock, with the policy rate already at all-time lows on data back to 1694.

I have long been of the view that the BoE missed a trick in not raising rates in 2014 when it became clear that the economy was recovering faster than anticipated and the unemployment rate was falling nicely. In some ways it is understandable that the MPC was hesitant: After all, members did not want to be accused of derailing the upswing which had taken ages to get going. But however sluggish the recovery, the economy was not facing the life-or-death problems which prevailed in 2009. For that reason it was becoming increasingly difficult to argue that interest rates needed to remain at these emergency levels, although perhaps a tight fiscal stance did restrict the BoE's room for manoeuvre.

Some good news is that the BoE has an instrument  which was not available in 2009 in the form of the banks' countercyclical capital buffer, which this week was lowered from 0.5% to 0%. In principle this will raise the lending capacity of the banking system by almost 9% of GDP. But this may not do much good if the private sector does not want to borrow, as BoE officials readily admit.

So the policy cupboard looks a little bare, unless the government does what it should have been doing all along, and relaxes the fiscal stance to take advantage of the lowest bond rates in history - rates which have surprisingly collapsed further after the referendum, with 10 year gilts yields now at less than 1%. The Chancellor has tried to argue over the last 6 years that austerity is the best way to get the economy back on its feet in the long-term. But one thing we perhaps learned from the Brexit vote is that the electorate is not buying that. It may be too late to turn back the referendum vote, but it still isn't too late to have a rethink on fiscal policy. The UK's near term fortunes may depend on it.

The phoney war is almost over

The publication today of the Chilcot inquiry's report into the UK government's prosecution of the war in Iraq may at first sight have little to do with the panic gripping financial markets, but bear with me. I would contend that the Blair government's decision to go to war was one of the first signs of the rift that was to develop between the British government and the electorate, which eventually lit the fuse of the referendum on EU membership. Recall that at  least half the British electorate in 2003 was opposed to a war which turned out to be a disaster for all sorts of reasons. Now is not the time to take over these coals again but it was the thin end of a wedge which subsequently took in the financial crash, the MPs expenses scandal and finally found full expression in the Brexit vote.

Clearly the full impact of the Brexit result has yet to play out. In that context it was interesting to attend a seminar held by the Centre for European Reform which discussed the economic and political ramifications. Regular readers will know that I am contemptuous of the claims made by the Leavers on the economics of Brexit. But we have to accept that the howl of rage expressed by the electorate is based on a genuine grievance. Indeed, as Douglas Carswell, UKIP's only sitting MP, pointed out we cannot continue to dismiss UKIP as a party which desires only to turn back the clock. As he put it, UKIP is not a party which is stuck in the past. It continues to make progress - after all, it continues to increase the number of votes it wins at elections. Former LibDem leader Nick Clegg noted that it is hardly surprising people are angry when almost 4 million voters put their cross in UKIP's box at the polling booth and were rewarded with only one MP. They got the third largest number of votes in 2015 yet  nine other parties got more seats. As Clegg said, if this was not a call for electoral reform, it is hard to know what is. 

As businesses seek more clarity over the nature of the UK's future relationship with the EU, politicians and policy wonks continue to try and puzzle over the wider ramifications. The view from Europe is that it is a great pity that the UK has gone down the path it has chosen for itself, and that this does great harm to the image of both the the UK and the EU. For the former, despite what UKIP politicians say, there is a view that the UK is stuck in a time warp, harking back to better times when Britain was stronger. But as I have warned before, the damage to the EU's image has taken a hit - if it's so great, why is a big power such as the UK leaving?  

Two things immediately struck me today, however. One is that when Brexit supporters are challenged on their view that it may not be alright on the night, they resort to the excuse that this is a residual hangover from Project Fear and that we have to get over this. To this I simply respond that financial markets are not taking you on trust. International investors have genuine concerns about the lack of detail which is forthcoming. 

The second thing which I learned, whilst presenting at an event with a lawyer today, is that businesses are genuinely unsure about the legal standing of many of the contractual arrangements which they currently have or may be about to enter into. And lawyers are only able to give partial answers, with much of the interpretation depending on politics. This uncertainty is a bad sign for business activity going forward and I fear that activity could come to a flying stop in July and August. The Bank of England has warned that some of the Brexit risks are already "beginning to crystallise." Are you listening Mr Gove?

That's the way to do it

Although large chunks of the British institutional framework appear to have collapsed in the wake of the Brexit referendum result, the Bank of England can continue to hold its head high. Governor Mark Carney has offered leadership and a clarity of message which has been absent elsewhere. The irony is, of course, that Mr Carney is not even a Brit but he is showing the natives of his adopted country how crisis management should be conducted. He has obviously learned lessons from his predecessor, when Mervyn King was initially slow off the mark in identifying and then tackling the wave of problems which washed over the UK banking system in 2007-08, although he subsequently proved to be a very safe pair of hands. 

Indeed, the fact that the UK banking system has held up pretty well in the face of the Brexit uncertainty shock is partly the result of the system put in place during the latter phase of Mr King’s tenure. Where Mr Carney has scored has been his willingness to lead from the front: His presentation today of the Financial Stability Report was his third significant public appearance in the 12 days since the referendum. The tone of the FSR was cautious and highlighted many of the things which could go wrong. The BoE warned of the risks to the commercial real estate (CRE) sector which might be triggered by Brexit, noting that “foreign investors accounted for around 45% of the value of total transactions since 2009.  These inflows fell by almost 50% in the first quarter of 2016.” 

Right on cue, two more companies today announced they were suspending trading in property funds following yesterday’s announcement by Standard Life. It does appear that overseas investors are getting their money out while they can. The ban on withdrawals might appear dramatic but it reflects the fact that the funds can only repay investors by selling their property holdings, but since property is an illiquid asset this takes time. Whilst this might cause investors to panic with regard to their ability to get their money back, this is not like 2008, although it will cause jitters to ripple throughout the market. The BoE also points out that the collapse in the CRE sector could feed into the wider economy because property is often used as collateral to secure bank lending, and less collateral might result in a lower level of bank lending. In a bid to ensure that lending is not restricted by policy actions, the BoE announced it would reduce the bank countercyclical capital buffer (CCB) from 0.5% to 0% with immediate effect. In effect, the funds which banks otherwise would have been required to put away for a rainy day can now be used for lending purposes. It is now raining! 

But the BoE knows that it can only operate on the supply side of the credit market. As Mr Carney noted in a speech last week “one uncomfortable truth is that there are limits to what the Bank of England can do. In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock.  The future potential of this economy and its implications for jobs, real wages and wealth are not the gifts of monetary policymakers. These will be driven by much bigger decisions; by bigger plans that are being formulated by others.” 

The markets are taking their own view on UK prospects with the pound at 31-year lows against the US dollar. Despite the central bank’s best efforts, there exists a vacuum at the heart of policymaking. Until we have more clarity here, the pound is likely to remain under pressure. Still, it’s good news if any foreign tourists fancy a holiday break in the UK. The economy needs all the support it can get.