Look who's back

A couple of years ago I suggested that Nigel Farage had passed the high point of his influence and that history would judge him as a useful idiot for those pushing to get the Brexit referendum over the line (here). It looks like I was wrong. The latest opinion polls put Farage’s new Brexit Party at over 30% – well ahead of either the Conservatives or Labour, with a double-digit lead. He has brilliantly tapped into the dissatisfaction with the main political parties, telling his supporters that they have been betrayed over Brexit and that the establishment is out to crush them. As is always the case with Farage, there is a tiny grain of what almost passes for truth in his argument surrounded by bombast and obfuscation. He remains what he has always been – a political irritant, a rabble-rouser and a liar. But underestimate him at your peril.

The fact that he is back on the political stage at all is because he is right about one thing – the political establishment has played a bad Brexit hand in the worst possible manner. Both the main parties are split and there is no indication that the two parties which together hold more than 85% of the seats in parliament will be able to agree on a Brexit deal. Since the autumn our TV news bulletins have featured late night parliamentary sittings which have shown that the only thing MPs agree on is to disagree. In this febrile atmosphere, almost 100% of MPs’ time is taken up with Brexit-related issues with no substantive progress on the things that matter to most people’s lives (the health and education systems, environment, transport and housing to name but five). Farage’s Brexit Party has grown because it feeds on popular discontent with the political establishment – a concern even felt by members of the main parties, with large numbers of Conservative members reportedly ready to vote for Farage’s party.

Try as people might, it is very hard to lay a glove on Farage who is a brilliantly elusive operator. Last Sunday, for example, Farage went on the BBC’s main weekend political show (here for the full interview) where he was confronted with some of the things he said – and we saw the clips – but when faced with those issues that he would rather not be reminded of, Farage responded with denial followed by bluster and anger. He went on the offensive to accuse the BBC of being “in denial” and later justified his response by saying “The idea was to use up all the time talking about irrelevances and inaccuracies, rather than talking about a major election taking place next Thursday. That's why I took the attitude that I did.” Arguably, there was a good reason for holding him to account in this way because his party has not actually produced any form of manifesto. Farage is the party and the party is him and in order to understand something about the issues on which they are standing it is right to pose the questions.

His response split viewers, with roughly half suggesting that he got a grilling from which he did not emerge well whilst the other half thought he gave more than he got. In short, it had no impact on the debate. Farage is undoubtedly a charismatic politician and an effective media performer but he has no answers to any of the questions about how Brexit can be made to work. More importantly, people do not want to hear them. It has become an article of faith amongst people who support the Brexit Party that it can be made to work. As Farage put it “we can be better than anybody if we just believe in ourselves.” There is no sense that the economic damage resulting from leaving the EU can only be minimised if some form of accommodation can be reached with the EU.

And this is where things start to get dangerous. Farage and his ilk do not believe that they have any duty to deliver Brexit – their role is merely to demand that government delivers it for them. When the policy proves impossible to implement, the hard core Brexiteers cry betrayal, thus further whipping up public resentment. This is not the conventional evidence-based policy which many of us have grown up with. It is dog-whistle policy designed to appeal to a core group of supporters to serve whatever purpose the leader has in mind. And it is not just a UK problem. Donald Trump dismisses inconvenient facts as fake news and populist leaders across Europe are similarly capable of ignoring facts in favour of lowest-common denominator politics.

But Farage is a league apart. Unlike Trump, who at least had some family money to fall back on (though quite how much is disputed) Farage never made a huge amount of money before going into politics. He now earns between €147k and €197k per annum from his media work alone, according to records covering the first four years of the current European parliamentary session and in the year to May 2018 he reportedly earned almost £400k. In an interview two years ago, Farage claimed to be “53, separated and skint … there’s no money in politics.” Whatever else he might be, he is not short of money.

Of course, Farage is not the only representative of the people whose financial interests have improved during his term of office. But more than most, he is a snake oil salesman posing as a man of the people when his background and lifestyle suggest he is anything but, and who peddles a policy he has no idea how to implement. But large numbers of people don’t care. They see him as a refreshing antidote to the political establishment, telling it as it is. Consequently, his party will almost certainly do well in next week’s European parliament elections.

But the real problem is less Farage than how the establishment responds to his success. The government will almost certainly interpret it as a strong case for delivering Brexit (despite the fact that his party is unlikely to take much more than 30% of the vote share). As we saw in 2014, when UKIP took 27% of the vote in the EU elections, this might panic the government into a wrong move, such as drifting towards acceptance of a hard Brexit. But the lesson of 2014 is that the EU elections are not a good guide to anything. A year after the Conservatives came in third in the EU election, they won their first parliamentary majority in Westminster for 23 years. The only lesson to be drawn from the European parliamentary elections is that they are a useful way for the electorate to register a protest vote. Perhaps that is why Farage has been so successful in them, despite having failed seven times to be elected to Westminster.

Trump, tariffs and beyond

As the world now knows, Donald Trump followed through on last weekend’s tweet promising to raise tariff rates on USD200 bn of Chinese imports from 10% to 25%. The fact that some of the heat appeared to go out of the tariff wars towards the end of last year suggested that both sides realised there was nothing to be gained from continually ramping up the rhetoric. After all, nobody ever won a tariff war. But once again Trump has upended conventional wisdom and those who continue to underestimate him should now be fully aware that he means to push forward with his ‘America First’ agenda, irrespective of how damaging it might appear at first sight.

We need to view Trump’s actions in a domestic context. Simply put, they can be seen as the opening shot in his 2020 re-election campaign and his strong-arm tactics are broadly popular at home. The US also has a point about technological expropriation and the requirement for the Chinese to open up their domestic markets in a reciprocal manner, in line with their WTO commitments. But we also have to view this from the Chinese perspective which sees itself as reasserting its rightful place on the world stage after two centuries of political and economic humiliation by the west. Finding a resolution that accommodates both sides will not be easy.

Market reaction to Trump’s actions has been somewhat muted. Admittedly, US equities fell 2.2% during the course of last week but that is not a huge decline and only puts the S&P500 back where it was a month ago. One interpretation is that markets are clinging to the belief that a resolution to the tariff war will somehow materialise within the next couple of weeks. After all, only goods leaving China after the Thursday midnight deadline will be subject to the new tariffs – those currently in transit will not – so if a deal can be brokered within the two weeks it takes for goods to make the journey by sea, the impact of the latest tariff spat will be limited.

That may be a very complacent view. Indeed, recent events might just prove to be another shot in the long war against globalisation from which there are no economic winners. Consider first the tariffs themselves. They are in effect a tax on imports and the one thing we do know about product taxes is that they are borne by the end-consumer. Companies that import certain items from China will now have to pay 25% more for them (although the impact so far has been partially offset by dollar appreciation). Households consuming those Chinese goods on the list will face a similar problem. But as this paper by Pablo Fajgelbaum and his co-authors point out, the direct impacts of last year’s tariff hikes cost the US economy just USD69 billion (0.3% of GDP). And once we account for the substitution away from Chinese imports towards domestic alternatives and the gains from higher prices received by US producers, the total impact is a mere USD7.8bn, or 0.04% of GDP.

But this is to underestimate the longer-term damage that an escalation of tariff wars could inflict on the global economy. Unfortunately, the recent actions might encourage the Trump administration to believe that tariff wars are indeed “good and easy to win” as the President said in March 2018 which (a) reduces the chances that the US will offer any concessions to the Chinese in the current dispute and (b) encourage the US to target European exporters, where German auto manufacturers are widely concerned that they will be the next in the line of fire.

With regard to point (a), we do not know how the Chinese will respond. Given that the US imports more from China than it exports, China’s direct ability to engage in a tit-for-tat tariff escalation is limited. It could, of course, levy additional duties on US agricultural products. But more damagingly it could target the US tech sector. China is less dependent than the rest of the world on Amazon, Apple and Google given the local dominance of Tencent, Huawei, Baidu and Alibaba. The Chinese companies start from the advantage of a bigger domestic market and are already formidable competitors in third markets. In a phrase reminiscent of the thinking during the Brexit referendum campaign, the likes of Apple need China more than the Chinese need them.

Also we should not overlook the fact China is the biggest buyer of US Treasury debt. Whilst it is unlikely to sell its current holdings, a buyers strike may push up US interest rates and thus have the opposite effect to what Trump wants (he has, after all, called for the Fed to lower interest rates). However, it is widely believed that the Chinese have no incentive to exacerbate the trade dispute in the short-term – particularly since the Communist Party wants to sell a rosy view ahead of the 70^th anniversary of the People’s Republic in October and the party’s centenary in 2021. But if there is no quick fix or if they are forced to make too many concessions, the Chinese will not easily forgive or forget.

With regard to point (b) there is a relatively easy fix. The EU could adopt a policy of pre-emptive tariff equalisation by reducing the tariffs on auto imports from the US from the current 10% to the rate of 2.5% which the US levies on EU imports. But the wider concern is that the US will become a less reliable ally than has been the case over the past 80 years. Europe and the US have common international interests and cooperation has led to better outcomes for both sides. This would be put at risk in the event of policy divergence. For example, one of the biggest issues rising up the policy agenda are environmental concerns which require international cooperation – no single economy can fix things on its own.

The current environment is increasingly one of mutual suspicion which does not bode well for finding global solutions to global problems. There is also a risk that local issues could become flashpoints for bigger problems, as we experienced during the Cold War. For example, China regards the region bordering the South China Sea as its own sphere of influence and is increasingly less tolerant of US interference in the region. The US does not see it the same way. But having dominated the geopolitical arena since 1945, the US may be forced to cede some control and the manner in which it does so will have a great bearing on the history of the 21^st century. The tariff wars could turn out to be a Gavrilo Princip moment. Or they may simply be a Cuban missile experience. Either way, there is a lot more at stake than import taxes.

Markets yet to be convinced

The release of the Bank of England’s Inflation Report last week provided the usual comprehensive overview of UK economic issues. Although it makes a nice change to be looking at economics rather than politics, it did raise a number of important questions. One of the more interesting issues was the interest rate assumptions upon which the forecast was conditioned. The BoE has always made it clear that it uses current market expectations, which is perfectly acceptable, but it does raise a chicken-and-egg issue.

The problem is this: Markets currently expect only one interest rate hike of 25 bps during the BoE’s three year forecast horizon (chart). Based on this assumption, the economy grows more rapidly than the estimated rate of potential growth with the result that by 2022 the UK is projected to show a demand gap of 1% (i.e. a level of measured GDP which exceeds the economy’s potential GDP by 1%). Governor Carney made it clear that if the economy does run in line with this forecast, interest rate rises would be “more frequent than financial markets currently expect.” Naturally the headlines screamed that “UK interest rates are set to rise” but this is to ignore the fact that the market has reduced its expectations by about 50bps in the last six months. Taking Bank Rate from its current level of 0.75% to 1.5% by mid-2022, as the market was expecting in November, implies 25 bps of monetary tightening per year which is hardly going to derail the economy.

We should thus interpret Carney’s warning as an indication that he believes the markets have become too complacent – a view which is hard to disagree with – and the Bank was very clear in telling us that it is sending a message. The implication was that if the forecast is conditioned on higher interest rates, the positive demand gap would also be lower thus reducing potential inflationary pressure. However, this raises the question of whether the forecast is the BoE’s best guess of where it believes the economy is heading or whether it is merely a device to signal where interest rates are heading. If it is the former, there is an argument suggesting that the BoE should use its own interest rate assumptions in calibrating the forecast. And if the latter, why bother producing a forecast at all?

As it happens, I do not set much store by the latter possibility so I will ignore it. But the idea that central banks should communicate their future policy responses to a given set of outcomes is an attractive one. After all, the Swedish Riksbank sets out an indicative path for interest rates conditional on its economic projections. One advantage of this approach is that it does make the central bank reaction function totally explicit, and at a time when forward guidance is an important tool in the policy armoury, such transparency is helpful. But the difficulty is that the press and the markets will require a lot of education in order not to treat this as an unconditional forecast and in the case of the BoE, this might introduce more noise into the system than is warranted. Accordingly, the strategy of taking current market pricing and using this as a forecast conditioning assumption is, in my view, an acceptable compromise.

One other aspect of the BoE’s forecasts worth noting was that, despite the presence of a positive output gap and the forecast of an unemployment rate falling to 3.5% by 2022, the projected inflation pickup was minimal. Wage growth is expected at only 3¾% on a three-year horizon whilst CPI inflation is only slightly above target at 2.2%, and whilst the BoE argues that higher inflation will only show through with a lag, this nonetheless assumes a much changed relationship between unemployment and wages compared to the recent past. On my estimates, an unemployment rate of 3.5% would result in wage growth of 6% based on a Phillips curve estimated over the period 1998 to 2012. The fact that such a tight labour market results in sub-4% wage inflation is a good outcome for the BoE and implies labour will remain fairly cheap.

At the same time, the forecast also assumes that business investment growth will recover to a rate of 5.5% by 2022 – double the rate recorded between 1998 and 2007. To the extent that cheap labour and Brexit uncertainty has prompted firms to increase their labour hiring over the past couple of years at the expense of capital investment, this raises a question of whether firms will indeed simultaneously raise investment in future whilst continuing with this rapid pace of hiring. In other words, will firms cut back on labour input in order to expand output now that they are once again relying on capital investment? And if they don’t, might the unemployment rate not fall as far as the BoE expects? Moreover, if investment is picking up, surely this will raise the potential growth rate and reduce the likelihood that the demand gap will hit 1% of GDP which in turn will reduce the inflationary threat?

Obviously, there are lot of unanswered questions here and we will only know the answers ex post. But the point I am trying to get at is that there are some nagging issues about the nature of the forecast that don’t quite stack up. And it is for this reason that markets remain unconvinced of the BoE’s efforts to talk up the prospect of interest rate hikes. Forward guidance may be one of the new policy tools but it has to be used wisely. Markets will stop listening if central banks tell them they will raise interest rates but don’t follow through. Sometimes the best form of communication is direct action and if markets are taken by surprise, so be it!

Local difficulties

Local elections in the UK tend to be fairly parochial affairs: They do excite domestic media which treats them as a barometer of support levels for the main parties but that is usually it. This year, however, matters were very different with coverage making it into newspapers across Europe. The reason is, of course, Brexit with the elections acting as a measure of how the public has responded to the interminable political wrangling of recent months.

It did not make pretty reading for the main parties. There were 8412 local council seats up for grabs, of which the Conservatives held 58%. They lost 1334 to reduce their share to 42% of the contested seats. Labour also lost ground, but to a far lesser degree (its share fell from 25% to 24.1% of the contested seats). UKIP continued its spectacular implosion following its local council successes in 2015 whilst the biggest winners were the Liberal Democrats (up from 7.7% to 16.1%) and other parties representing a variety of local interests (up from 6.1% to 14%).

If ever politicians needed a wakeup call that their handling of Brexit deliberations has turned voters off, this was it. But what exactly did the results tell us? It is too simplistic to suggest that voters wreaked their vengeance on the Conservatives because they have changed their minds about Brexit but analysis of the results suggests that they lost one-third of the seats they contested in majority-Remain areas. Meanwhile the Lib Dems, which avowedly support a second EU referendum, picked up gains across both sides of the Leave-Remain divide. This would appear to suggest they gained as a result of dissatisfaction with the main political parties following the parliamentary debacle of recent months, in which both Labour and the Conservatives played a key role. However, the Lib Dems could also have picked up votes from potential Labour supporters who have been discouraged by the party’s attempt to back away from a commitment to holding a confirmatory EU referendum. That said, Labour performed badly in majority Leave-supporting areas, indicating voters’ dissatisfaction with politicians’ efforts to deliver Brexit.

What the results do suggest is that voters want an end to the political wrangling. But it is less clear that they want the sort of Brexit that Theresa May has in mind – it is far from clear that they want Brexit at all. And it remains highly disingenuous of the prime minister to accuse the Scottish First Minister of wanting to "re-run the independence referendum because she did not like the decision of the people of Scotland" and to "re-run the EU referendum because she did not like the decision of the people of the UK" when that is exactly May has tried to do in ramming her deal through the Westminster parliament. And the prime minister knows only too well that the electorate can change its mind. After all, there were only two years between the general elections of 2015 and 2017 when voters changed their mind about electing a majority Conservative government, and we are now almost three years on from the EU referendum. And as the arch-Brexiteer David Davis once said, ”if a democracy cannot change its mind, it ceases to be a democracy.”

What the results also suggested is that voters are currently not aligned along party political lines and instead have become more issue-driven. That is not the same thing as saying the two-party hegemony is over for good, as some of the more excitable political commentators have suggested, but party loyalties are currently being tested. Brexit obviously tops the domestic political agenda but the strong performance of the Greens might indicate that environmental issues are playing a bigger role in voters’ thinking following the recent publicity surrounding 16-year old Greta Thunberg’s castigation of politicians’ treatment of climate change issues. Indeed, intra-generational issues are likely to be high up the UK agenda as issues such as health funding, access to education and affordable housing are all items which have been pushed down the political agenda in favour of Brexit.

As for where we go on the Brexit debate from here, both Labour and the Conservatives realise it is in their interests to find an agreement before the October deadline. Theresa May could thus be tempted to accommodate Labour demands for a customs union with the EU whilst Jeremy Corbyn shows every sign of wanting to back away from the commitment to a second referendum. Of course, neither of these options would please members of their respective parties, with large numbers of Labour Party members particularly in favour of a second referendum.

The debate is only going to heat up as we are less than three weeks away from European elections in which the UK believed it would not have to participate. Nigel Farage’s Brexit Party is currently polling at 30% making it the largest single party although we should not overstate this result. It merely tells us that large numbers of Brexit supporters have found a new home. However, if repeated in the European elections, this will reaffirm the government’s view that it is required to deliver some form of Brexit and preferably sooner rather than later. Most people I speak to share my view that the last three weeks have proven to be a welcome Brexit-free break. Unfortunately, it might be about to come to a noisy and fractious end.

The US: As good as it gets?

For all the recent concerns about the global economic slowdown a lot of the data released in the last couple of weeks supports the view that the world economy is, for the most part, enjoying a decent run. Despite the government shutdown around the turn of the year and concerns over the ongoing trade dispute with China, the US posted an annualised GDP growth rate of 3.2% in Q1. Whilst inventories contributed almost 0.7 percentage points to this figure, the GDP outcome was still significantly better than expected at the start of the year. As Mohamed El-Erian pointed out in a Tweet, “the 2s-10s US yield curve has steepened quite a bit in the last two and a half weeks” which has received far less attention than the flattening which preceded it, which was viewed in many quarters as a harbinger of recession (chart).  

Just to show that the good news is not confined purely to the US, the Q1 euro zone GDP data out this morning pointed to a rise of 0.4% q-o-q (around 1.6% on an annualised basis). Whilst this was considerably slower than US growth rates, it was again rather stronger than might have been anticipated a few weeks ago. Next week’s Q1 UK figures are also likely to come in at 0.4% q-o-q with the possibility of an upside surprise on the back of pre-Brexit inventory accumulation.

With the US economy continuing to look solid, and no sign that the cycle is about to turn down as it is set to become the longest cyclical upswing on record, equity markets continue to power ahead. That said, Q1 earnings have been rather disappointing on the whole and earnings per share on the S&P500 are currently running around 6.5% lower than Q4 levels and 9.5% below the Q3 2018 peak. Based on consensus estimates, it thus looks likely that barring a miraculous surge US earnings in 2019 may only register a small positive gain of around 2.5% following a hefty 23.7% last year (the biggest gain since 2010). Naturally, this reflects the fact that the 2018 numbers were flattered by corporate tax cuts, and some weakness was always likely given that last year’s one-off boost could not be repeated.

Doubtless you will read newspaper headlines from equity bulls suggesting that around 80% of S&P500 companies have beaten earnings expectations of late. But we should not place so much emphasis on a metric which companies use to game the system in order to flatter their earnings profile. The simple truth is that despite the strength of the economy, corporate USA is unlikely to repeat last year’s stellar numbers. That is not necessarily a bad thing: If the market consensus proves to be right, US earnings growth over the period 2018-19 will still cumulate to 27% which translates into 12.6% per annum versus an annual average of 7.4% since the turn of the millennium.

But there are some indications that the dynamic that has driven the US market over the past couple of years may be fraying at the edges. First quarter earnings at Alphabet (the company formerly known as Google) undershot relative to expectations thanks to weak revenues whilst Netflix’s forecasts for subscriber numbers also trailed estimates during Q1. Admittedly Netflix has aggressive targets for the remainder of the year and a track record of delivering, so as a result the price has held up pretty well since the start of the year. But such has been the strength of the FAANG (Facebook, Apple, Amazon, Netflix and Google) sector that any downside surprises may catch the market unawares.

The Fed, which meets tomorrow, is likely to keep rates firmly on hold for a long time to come and reiterate that it is in wait-and-see mode. Whilst this has helped drive markets higher, I can’t help wondering whether the decision in March to announce a pause may have been a tad premature particularly given the strength of activity in Q1. Call me old-fashioned but it is not the job of central banks to support the markets, which after all have had a great run over the past decade. And given the extent to which equity markets and economic fundamentals have been running out of line, a further modest monetary tightening – or at least the impression that the Fed might do so – may be enough to take some of froth out of the markets without unduly derailing the economy.

Nonetheless, the macro data are probably as good as we are going to get – this is the ultimate Goldilocks scenario, with the US economy neither too hot nor too cold. The labour market data suggests that the job machine is running smoothly and consumer confidence has recently spiked to near all-time highs. Donald Trump’s recent exhortations to the Fed to cut interest rates and engage in more QE is thus completely the wrong advice right now. But if past experience is any guide, we should enjoy the current conjuncture while we can. It may not last.

The market for central bank governors

The search for a successor to BoE Governor Carney kicked off last week, ahead of his contract expiry next January, whilst jockeying for the top job at the ECB has also got underway with Mario Draghi due to stand down in November. Naturally the press has had a field day looking at the possible candidates for both positions. But less attention has been paid to the qualities necessary to be an effective central bank governor.

Over the last 30 years there has been a tendency to appoint economists to the top job. It has not always been the case, of course. Whilst former ECB President Trichet and BoE Governor Eddie George both had academic qualifications in the subject, neither would be regarded as front-line economists. But compare them to contemporaries such as Alan Greenspan, Ben Bernanke, Janet Yellen, Wim Duisenberg, Mervyn King and Draghi it is clear that a strong economics background has been viewed as an advantage. The reason for this is simple enough: Over recent years, central banks have been given a mandate to target inflation which means that they have a much closer focus on economic issues than has historically been the case.

However, I do wonder whether the unwillingness to raise interest rates – particularly in Europe – reflects the overly cautious nature of a policy-making body in which economists hold the upper hand. It was not for nothing that President Harry Truman reputedly demanded a one-handed economist in order to eliminate their tendency to say “on the one hand … but on the other.” More seriously, since the financial crisis central banks have acquired additional responsibility to manage the stability of the financial system which means that a macroeconomic background may not be the advantage that it once was.

Perhaps the most important job of any CEO, whether of a central bank or a listed company, is institution building. Mark Carney promised to be the new broom at the BoE who would bring the bank into the 21st century, getting rid of many of the arcane practices which had become institutionalised over the years and improving diversity. I am not qualified to say whether he has succeeded in this goal but we hear good things about the working environment within the central bank. More importantly, perhaps, the BoE has taken on the regulation and supervision of around 1500 financial institutions over the past six years as the responsibilities of the central bank have evolved and the head of the Prudential Regulation Authority occupies one of the most senior jobs in the BoE.

One of those touted to succeed Carney is Andrew Bailey, head of the Financial Conduct Authority, an institution independent of the BoE which is charged with ensuring that “financial markets work well so that consumers get a fair deal.” Bailey is a former BoE official who has worked in an economics function, but crucially has a very strong background in regulation. It is an indication of the extent to which the BoE’s role has changed in recent years that Bailey is even in the running for the job.

The experience of the ECB President has been rather different since Mario Draghi took over in 2011. He is – probably rightly – credited with holding the European single currency bloc together during the Greek debt crisis by promising to do “whatever it takes,” despite opposition from representatives of other member states, notably Germany. Like the BoE, the ECB has also taken on greater responsibility for the regulation of financial institutions although unlike the BoE there is no suggestion that the potential successor to Draghi will need a background in financial regulation.

Interestingly, this paper by Prachi Mishra and Ariell Reshef makes the point that the personal characteristics and experience of central bank governors does affect financial regulation. “In particular, experience in the financial sector is associated with greater financial deregulation [whilst] experience in the United Nations and in the Bank of International Settlements is associated with less deregulation.” They go on to argue that their analysis “strengthen[s] the importance of considering the background and past work experience before appointing a governor.”

This is an important point. In 2012, when the BoE was looking for a successor to Mervyn King, the Chancellor of the Exchequer cast his net far and wide. Mark Carney got the gig because the government wanted an outsider to take over a central bank which was perceived to be too close to the institutions it was meant to regulate. Moreover, he had previous experience of running a central bank. But whilst Carney has done a good job over the past six years, I still believe it wrong to think (as the Chancellor George Osborne did during the hiring process) that filling this role is akin to finding a CEO of a multinational company, whose place can be filled by anyone from an (allegedly) small pool of international talent. They are an unelected official who holds a position of key strategic importance, enjoying unprecedented powers to influence both monetary policy and the shape of the banking system. In that sense it has never been clear to me that the interests of an outsider with no experience of UK policy issues are necessarily aligned with the UK's national interest.

Contrast this with the way the ECB process works. There are, in theory, 19 candidates for the top job amongst the central bank governors of EMU members, all of whose interests are aligned with those of the euro zone. In addition, there are another five potential candidates amongst the members of the Executive Board. Admittedly there is a lot of political horse-trading involved in the selection process, but there is no need to look for an outsider who may not necessarily be up to speed with the complexities of local issues, not to mention local politics which is increasingly a problem for central bankers (I will come back to this another time).

For the record, this is absolutely not an issue of economic nationalism – it is simply to remind those making hiring decisions that just because someone has done a similar job does not necessarily make them the best candidate for a position elsewhere. Indeed, if the evidence from the private sector is anything to go by, the continuity candidate may be the best person for the job: In the private sector, “firms relying on internal CEOs have on average higher profits than external-CEO firms”. And for anyone who doubts that the search for an external candidate will necessarily be an improvement over the local options, just ask the English Football Association about their experiences with Sven-Göran Eriksson and Fabio Capello.

A retrospective on macro modelling

Anyone interested in the recent history of economics, and how it has developed over the years, could do worse than take a look at the work of Beatrice Cherrier (here). One of the papers I particularly enjoyed was a review of how the Fed-MIT-Penn (FMP) model came into being over the period 1964-74, in which she and her co-author, Roger Backhouse, explained the process of constructing one of the first large scale macro models. It is fascinating to realise that whilst macroeconomic modelling is a relatively easy task these days, thanks to the revolution in computing, many of the solutions to the problems raised 50-odd years ago were truly revolutionary.

I must admit to a certain nostalgia when reading through the paper because I started my career working in the field of macro modelling and forecasting, and some of the people who broke new ground in the 1960s were still around when I was starting out in the 1980s. Moreover, the kinds of models we used were direct descendants of the Fed-MIT-Penn model. Although they have fallen out of favour in academic circles, structural models of this type are in my view still the best way of assessing whether the way we think the economy should operate is congruent with the data. They provide a richness of detail that is often lacking in the models used for policy forecasting today and in the words of Backhouse and Cherrier, such models were the “big science” projects of their day.

Robert Lucas and Thomas Sargent, both of whom went on to win the Nobel Prize for economics, began in the 1970s to chip away at the intellectual reputation of structural models based on Keynesian national income accounting identities for their “failure to derive behavioral relationships from any consistently posed dynamic optimization problems.” Such models, it was argued, contained no meaningful forward-looking expectations formation processes (true) which accounted for their dismal failure to forecast the economic events of the 1970s and 1980s. In short, structural macro models were a messy compromise between theory and data and the theoretical underpinnings of such models were insufficiently rigorous to be considered useful representations of how the economy worked.

Whilst there is some truth in this criticism, Backhouse and Cherrier remind us that prior to the 1970s “there was no linear relationship running from economic theory to empirical models of specific economies: theory and application developed together.” Keynesian economics was the dominant paradigm, and such theory as there was appeared to be an attempt to build yet more rigour around Keynes’ work of the 1930s rather than take us in any new direction. Moreover, given the complexity of the economy and the fairly rudimentary data available at the time, the models could only ever be simplified versions of reality.

Another of Lucas’s big criticisms of structural models was the application of judgement to override the model’s output via the use of constant adjustments (or add factors). Whilst I accept that overwriting the model output offends the purists, it presupposes that economic models will outperform relative to human judgement. But such an economic model has not yet been constructed. Moreover, the use of add factors reflects a certain way of thinking about modelling the data. If we think of a model as representing a simplified version of reality, it will never capture all the variability inherent in the data (I will concede this point when we can estimate equations, all of which have an R-bar squared close to unity). Therefore, the best we can hope for is that the error averages zero over history – it will never be zero at all times. 

Imagine that we are in a situation where the last historical period in our dataset shows a residual for a particular equation which is a long way from zero. This raises a question of whether the projected residual in the first period of our forecast should be zero. There is, of course, no correct answer to the question. It all boils down to the methodology employed by the forecaster – their judgement – and the trick to using add factors is to project them out into the future so that they minimise the distortions to the model-generated forecast.

But to quote Backhouse and Cherrier, “the practice Lucas condemned so harshly, became a major reason why businessmen and other clients would pay to access the forecasts provided by the FMP and other macroeconometric models … the hundreds of fudge factors added to large- scale models were precisely what clients were paying for when buying forecasts from these companies.” And just to rub it in, the economist Ray Fair ”later noted that analyses of the Wharton and Office of Business Economics (OBE) models showed that ex-ante forecasts from model builders (with fudge or add factors) were more accurate than the ex-post forecasts of the models (with actual data).”

Looking back, many of the criticisms made by Lucas at al. seem unfair. Nonetheless, they had a huge impact on the way in which academic economists thought about the structure of the economy and how they went about modelling it. Many academic economists today complain about the tyranny of microfoundations, in which it is virtually impossible to get a paper published in a leading journal without linking models of the economy to them. In addition, the rational expectations hypothesis has come to dominate in the field of macro modelling, despite the fact there is little evidence suggesting this is how expectations are in fact formed.

As macro modelling has developed over the years, it has raised more questions than answers. One of the more pervasive is that, like the models they superseded, modern DSGE models have struggled to explain bubbles and crashes. In addition, their treatment of inflation leaves a lot to be desired (the degree of price stickiness assumed in new Keynesian models is not evident in the real world). Moreover, many of the approaches to modelling adopted in recent years do not allow for a sufficiently flexible trade-off between data consistency and theoretical adequacy. Whilst recognising that there are considerable limitations associated with structural models using the approach pioneered by the FMP, I continue to endorse the view of Ray Fair who wrote in 1994 that the use of structural models represents "the best way of trying to learn how the macroeconomy works."