Stressful times

This morning’s financial pages are full of coverage of the European bank stress tests, which were released yesterday evening. The good news is that with two exceptions, the regulators were broadly satisfied that the 51 European banks under scrutiny would be able to withstand severely adverse market conditions, in the sense that they would be able to hold their common equity tier one (CET1) ratios above the absolute minimum of 4.5%. In plain terms, this means that banks should be able to maintain a sufficiently large capital cushion in order to continue operating during times of market stress and thereby remain solvent.

In the wake of the problems resulting from the Lehman’s bankruptcy in 2008, it makes sense for the authorities to pay greater attention to the risks posed by the banking sector. Indeed, the lack of regulatory oversight magnified the extent of the post-Lehman’s distress so it is a positive step that problems are being addressed. But previous efforts to stress test the European banking sector were criticised for not being stringent enough, and the same familiar refrains are being heard again this morning. It is true that the risks appear to have intensified in the wake of the Brexit referendum and it is also true that different countries face different degrees of macro risk, which makes it difficult to compare the impacts of the adverse scenarios across countries. 

But these criticisms are to miss the point. We can never know exactly what kinds of shock will materialise and the best that we can do is give a hypothetical benchmark against which to judge a range of possible outcomes. Like any forecast, they will probably prove to be wrong but if we get the broad direction of travel right, we can be satisfied (though we can only hope that we never have to find out).

In any case, as the European Banking Authority pointed out, banks are far better capitalised today than they were five years ago. The CET1 ratio at the end of 2015 across the panel of 51 banks was 13.2 % versus 8.9% at the end of 2010 (albeit on a slightly different definition). The rules have been tightened up and banks have done their best to comply with regulators’ demands for a broader capital base. There is little doubt that banks were under-capitalised pre-Lehmans and it is only right that they should be forced to build a better stable door, even though this has forced them to pull out of capital intensive businesses which has had a notable impact on profitability. 

However, this does not excuse the fact that regulators were far too complacent about the risks which banks were running prior to 2008. Public calls to send bank chiefs to jail were never matched by calls to jail regulators for neglect! Indeed, whilst disgraced RBS chairman Fred Goodwin was stripped of his knighthood, former BoE Governor Mervyn King was ennobled and, it was noted this morning in the FT, “has quietly taken up a role as a senior adviser to Citigroup.” Lest the irony of that should escape anyone, Lord King argued in his recent book that the structure of the financial system in flawed and that “without reform of the financial system, another crisis is certain.” 

Back in 2011, former Barclays chairman Bob Diamond argued that it was time to end the criticism of banks over their role in creating the recession of 2008-09. He was ahead of his time: There were many problems with the banking system in 2011 which needed to be resolved, and there is still a lot to do today. But banking recovery is not being helped by the fact that interest rates are at all-time lows, making it harder for banks to generate profits and rebuild their capital base. With the Bank of England widely tipped to cut interest rates deeper into all-time low territory in the course of next week, that is an issue to which I will return,

London calling

As I write this, it is exactly four years since I was sitting in a restaurant watching the opening ceremony of the 2012 Olympics in London. It seems like an awful long time ago. Although there is a sense looking back that things were improving, following the savage recession of 2008-09, the economic data released at the time suggested that the UK economy was struggling to gain traction, although a more solid recovery was just around the corner. That said, there was a feelgood factor in the air, at least in London, and surveys conducted at the time pointed to a more general feeling of national wellbeing. 

Fast forward four years and things feel rather different. The national mood remains sullen in the wake of the EU referendum, although perhaps not quite as fractious as a month ago, whilst regional disparities have widened if anything. Economically, at least, London’s relative importance continues to rise, with a recent report suggesting that it contributes almost one-third of the UK’s tax receipts. It is to the UK what Germany is to the euro zone – it accounts for roughly the same share of output and is the UK’s paymaster in the same way that Germany is for the single currency region. 

Back when I was a lad, as they say, it all felt rather different. I was reminded of this by a number of films, which can be found on the British Film Institute website and on the North East Film Archive site which extolled the virtues of living in the thriving north east of England. The films were shot in the 1960s and were designed to convey the impression that the old days of flat caps and whippets were no more, and that the region was looking ahead to focus on the high tech and light engineering industries of tomorrow. It all seemed so optimistic and modern. As someone who grew up in the region around that time, I can relate to the sentiments portrayed. 

But I was also struck by the fact that within a decade, much of that optimism had crumbled as the heavy industries on which the region relied were wiped out, taking away the bedrock of support for the newer industries. Indeed it is from around the early-1980s that we became ever more aware of the inexorable drift southwards in the UK’s centre of economic gravity. 

Some 35 years on, even senior civil servants now admit that the UK is one of the most centralised economies in the developed world. And this is a problem since, as the Institute for Economic Affairs has pointed out, “decentralisation promotes … better matching of services to local preferences.” To the extent that many people outside the London bubble feel that they have increasingly been marginalised by their own government, which focuses ever more on the needs of the capital, this degree of centralisation may have been one of the contributory factors encouraging the electorate to stick two fingers up to the government last month. In fairness, there have been efforts to devolve powers back to the regions, with the creation of the Greater Manchester Combined Authority in 2011 the first attempt to give more control over planning and spending decisions. But the scheme is not without its critics and it is unclear to what extent it will be rolled out elsewhere, partly because not all cities want to follow the same model. 

It is thus ironic that during an EU referendum campaign in which one of the key slogans was “taking back control,” the government recognised the UK regional control problem, tried to do something about it (albeit perhaps too little too late) yet many were hesitant to grasp the opportunity when it was offered to them. It does make me wonder how we will be able to resolve many of the contradictions which dot the policy landscape. For an escapist reminder of how we see ourselves, you could do worse than go to Youtube and relive that Olympic opening ceremony. Indeed, maybe the Remain campaign would have done better to entrust their strategy to Danny Boyle. He certainly convinced me that things are better than they are.

Farewell Danny Gabay

They say that economists are accountants without the personality. That is clearly not something anyone can say about Danny Gabay, who died in May at the tender age of 47. Such was his standing in the London economics community that the turnout at tonight's memorial celebration to commemorate his life and works attracted many of the great and the good from the field of economics, journalism and policy making.

I can't claim to have known Danny well, but whenever we did cross paths he was always engaging, forthright and fearless in his commitment to rigorous and original thinking, as well as being wickedly funny. Those qualities shone through in the many tributes which were paid to him by friends and colleagues. Danny and his colleagues at Fathom Consulting always tried to keep policy makers on their toes, by posing questions which many were perhaps reluctant to ask. He was relentless in his pursuit of questions to which there were no easy answers. But, as he would undoubtedly have said, that does not mean we should not ask them. In that sense, Danny and his colleagues provided a useful sounding board for ideas that needed to be aired but somehow never found a forum, and hopefully Fathom will keep up the good work.

Danny hated consensus thinking and was never afraid to form a minority of one in the hope, maybe the expectation, that the rest of the world would come to see things his way. That he is no longer with us is unfortunate enough, but it is doubly so that he passed away before the criticisms levelled by the likes of Michael Gove during the Brexit campaign. They would undoubtedly have raised his intellectual hackles as well as offending his cultural sensibilities, and a full-throated Gabay retort would have been worth waiting for. Danny was unique amongst economists I have known. He was described by one friend as living for the intellectual fight, and at a time when the reputation of economists has been battered by their role in the Brexit debate, he would have relished the opportunity to take to the barricades. So I’ll raise a glass to Danny Gabay – a policy response of which he would most certainly have approved – and remember his maxim that economists owe it to themselves and to the society of which we are a part, to go on asking awkward questions. Even if politicians don’t like it!

Lies, damned lies and GDP: Part 2

Andy Haldane, the BoE’s chief economist, always produces speeches which are worth a read and his latest, entitled Whose Recovery? is no exception.  Although the UK has been one of the fastest growing G7 economies over the past couple of years, Haldane makes the point that not everyone has felt the benefit of these apparent gains and that “aggregate activity measures are sometimes a poor proxy for the average person’s income.“ Indeed, since GDP measures the sum of all activity in the economy, its performance is boosted by a rise in labour input. Depending how we measure it, GDP per head in 2015 was either 0.1% higher than its 2007 peak (based on total population) or 3.5% higher (based on economically active people aged 16-64). Either way, both illustrate a sharp slowdown in income (output) per head relative to pre-crisis growth rates. The simple GDP per head of population measure posted average annual growth of 2.4% over the period 1980-2007 whilst the age-adjusted activity measure grew at a 2.0% annual rate.

This clearly illustrates that productivity growth must have slowed, and we will leave a discussion of this for another time, but it demonstrates why productivity is so important in generating a rise in living standards and why GDP figures can be misleading. Moreover, the aggregate picture glosses over significant regional differences in output per head, and as Haldane notes “only in London and the South-East is GDP per head in 2015 estimated to be above its pre-crisis peak.” You will need no reminding that London voted overwhelmingly in favour of remaining in the EU on 23 June (although the rest of the south east did not). Perhaps this is one reason why the narrative of a strong UK recovery which would be jeopardised by Brexit did not wash in large parts of the country, as many people asked themselves the same question posed by Andy Haldane: Whose recovery?

It is thus evident that another in the long list of problems with GDP as a measure of wellbeing is that it is an aggregative measure which takes no account of distributive factors. Ironically, much of the evidence on income distribution suggests that the greatest widening of inequality took place in the second half of the 1980s, with a further leg up over 1997-2002, but it has since remained stable and actually come down a little in the past five years. But obviously not enough for a large section of the population to feel that they are getting a big enough slice of the pie.

As I noted in my previous post, GDP is a much used and much abused statistic. There is definitely something wrong with GDP as a measure of welfare if it assigns a positive value to pollution-emitting activities today whilst efforts to clear it up tomorrow will similarly be assigned a positive value. Surely a better measure of net social benefit would be to offset the two. It is for reasons such as this that statistical authorities are placing more emphasis on measuring things such as national wellbeing, which is an area where the ONS in the UK has done a lot of work lately. There is clearly a strong argument for economists to raise their eyes to a wider horizon. But the fact remains that it is still so much easier to measure the physical output of things, and to pretend that we have a handle on the output of services, which is why we continue to focus our attention on GDP statistics.

When discussing the use and abuse of economic statistics I am reminded of the old story of the drunken man who is found by a policeman scrabbling under a streetlight. “What are you doing down there?” asks the policeman. “I am looking for my keys,” says the drunk. After five minutes fruitless searching the puzzled policeman asks, “Are you sure you lost your keys here?” “No,” replies the drunk pointing to the darkness on the other side of the street, “I lost them over there, but the light is so much better here.” I suppose the moral of the story for economists is always carry a decent torch capable of shining a light on the statistics.

Lies, damned lies and GDP: Part 1

Gross domestic product is both one of the most useful and most useless of economic statistics. It is undoubtedly one of the most versatile, capable of simultaneously measuring the value of economic output, income and expenditure. But this versatility can also be a weakness, rendering it open to abuse by the unscrupulous.

GDP is used as a benchmark to gauge economic progress and is closely watched by politicians, policy makers and economists. If it is rising rapidly, so the thinking goes, so too must incomes and output which implies a rise in wellbeing. Well that, at least, is the theory. In essence, GDP applies monetary value to economic activities. It excludes activities for which people are unpaid (e.g. voluntary work) or domestic activities for which no monetary transactions are recorded (which is why it has tended to underestimate the contribution of work done by women, especially in the home). GDP was originally derived from a wartime need to measure the output of physical things, but as the service sector accounts for an increasingly greater proportion of output, so the shortcomings in the original concept have become even more pronounced. This is a problem which statisticians have struggled with for many years, but it has become increasingly challenging of late.

The release last week of Irish GDP data provided a case in point. The previous data release in March, indicated that the economy grew at a rate of 7.8% in real terms in 2015. But updated figures now suggest that Ireland grew at a rate of 26.3% last year (see chart). To put that into context, it would take an economy growing at a "normal" rate of 2% per annum more than 11 years to record a gain of that order of magnitude. The Central Statistics Office noted that this was due to the availability of “more complete and up to date data than … available … in March 2016.” 

Measuring Irish GDP (EUR, million)

Source: CSO

To the extent that GDP measures the value (or volume) of activity within a country’s borders we have to subtract the value of activity attributable to foreign companies based in Ireland which gives us a measure of gross national product (GNP). Real Irish GNP grew less rapidly than real GDP last year but it still recorded a sizeable gain of 18.7%. What this indicates is that companies have relocated to Ireland to benefit from its low rate of corporate tax, with the result that all of their assets are transferred to Ireland’s capital stock and the returns to those assets (a flow variable) are included in GDP/GNP. In addition to the relocation of corporate assets, the figures also include a range of one-off factors such as aircraft purchases and corporate restructuring activities. For confidentiality reasons, the statistical authorities are reluctant to give full details which has led to analysts having to fill in a large number of gaps to guess which companies are responsible for these moves. 

This illustrates a problem which bedevils the construction of national accounts data: Shifting definitions and retrospective revisions mean that the data can be extremely volatile. This in turn is a result of the fact that estimates of what we think of as the "true" data are often based on incomplete information.This is true for all countries. After all economies such as Italy, Greece and Nigeria have posted huge increases in output in recent years as a result of new information coming to light (sometimes as a result of the arbitrary inclusion of estimates of shadow activity). But the rigorous application of global rules governing the construction of national accounts, which tend to have relatively small impacts on larger economies, can have unwarranted (and unintended) consequences for smaller economies.

Clearly, we have come a long way from the original purposes of measuring widgets. Moreover, recent Irish changes have major consequences for the wider economy. At a stroke, Irish residents are significantly better off with GDP per head of population now almost €9,000 higher than we thought last week. But the reality is that they have no more money in their wallets (or bank accounts). Moreover to the extent that contributions to the EU budget are based on national incomes, Irish taxpayers are now on the hook for additional payments to the EU. Unless the additional output can be taxed to fund this payment – which it almost certainly will not – this implies that Irish taxpayers will be called upon to find the extra funds. It may only amount to an extra €60 per head per annum but that is roughly 11 pints of Guinness which each Irish person will have to forego. And all because the statisticians have determined that the economy is bigger than anyone thought.