The limits of modelling

The British government has made it clear throughout the Covid 19 crisis that it has been “following the science.” But at this relatively early stage of our understanding of the disease there is no single body of knowledge to draw on. There is a lot that epidemiologists agree on but there are also areas where they do not. Moreover, the science upon which the UK lockdown is based is derived from a paper published almost two months ago when our understanding of Covid was rather different to what we know now. I was thus fascinated by this BBC report by medical editor Deborah Cohen, who posed questions of the current strategy and interviewed experts in the field who expressed some reservations about how the facts are reported. Whilst the report gave an interesting insight into epidemiology, it also reminded me of the criticism directed at economic forecasting.

One of the most interesting issues to arise out of the discussion was the use of models to track the progression of disease. The epidemiologists quoted were unanimous in their view that models were only useful if backed up by data. As Dame Deirdre Hine, the author of a report on the 2009 H1N1 pandemic pointed out, models are not always useful in the early stages of a pandemic given the lack of data upon which they are based. She further noted that “politicians and the public are often dazzled by the possibilities that modelling affords” and that models often “overstate the possibilities of deaths in the early stages” of a pandemic due to a lack of data. As Hine pointed out, epidemiological models only start to become useful once we implement a thorough programme of tracing and tracking people’s contacts, for only then can we start to get a decent handle on the spread of any disease.

This approach has great parallels with empirical macroeconomics where many of the mainstream models used for analytical purposes are not necessarily congruent with the data. Former member of the Bank of England Monetary Policy Committee Danny Blanchflower gave a speech on precisely this topic back in 2007 with the striking title The Economics of Walking About. The objective of Blanchflower’s speech was to encourage policymakers to look at what is going on around them rather than uncritically accept the outcomes derived from a predetermined set of ideas, and to put “the data before the theory where this seems warranted.”

I have always thought this to be very sensible advice, particularly in the case where DSGE models are used for forecasting purposes. These models are theoretical constructs based on a particular economic structure which use a number of assumptions whose existence in the real world are subject to question (Calvo pricing and rational expectations to name but two). Just as in epidemiology, models which are not consistent with the data do not have a good forecasting record. In fact, economic models do not have a great track record, full stop. But we are still forced to rely on them because the alternative is either not to provide a forecast at all, or simply make a guess. As the statistician George Box once famously said, “all models are wrong, but some are useful.”

Epidemiologists make the point that models can be a blunt instrument which give a false sense of security. The researchers at Imperial College whose paper formed the basis of the government’s strategy might well come up with different estimates if, instead of basing their analysis on data derived from China and Italy, they updated their results on the basis of latest UK data. They may indeed have already done so (though I have not seen it) but this does not change the fact that the government appears to have accepted the original paper at face value. Of course, we cannot blame the researchers for the way in which the government interpreted the results. But having experienced the uncritical media acceptance of economic forecasts produced by the likes of the IMF, it is important to be aware of the limitations of model-driven results.

Another related issue pointed out by the epidemiologists is the way in which the results are communicated. For example, the government’s strategy is based on the modelled worst case outcomes for Covid 19 but this has been criticised for being misleading because it implies an event which is unlikely rather than one which close to the centre of the distribution. The implication is that the government based its strategy on a worst case outcome rather than on a more likely outcome with the result that the damage to the economy is far greater than it needed to be. That is a highly contentious suggestion and is not one I would necessarily buy into. After all, a government has a duty of care to all its citizens and if the lives of more vulnerable members of society are saved by imposing a lockdown then it may be a price worth paying.

But it nonetheless raises a question of the way in which potential outcomes are reported. I have made the point (here) in an economics context that whilst we need to focus on the most likely outcomes (e.g. for GDP growth projections), there are a wide range of possibilities around the central case which we also need to account for. Institutions that prepare forecast fan charts recognise that there are alternatives around the central case to which we can ascribe a lower probability. Whilst the likes of the Bank of England have in the past expressed frustration that too much emphasis is placed on the central case, they would be far more concerned if the worst case outcomes grabbed all the attention. The role of the media in reporting economic or financial outcomes does not always help. How often do we see headlines reporting that markets could fall 20% (to pick an arbitrary figure) without any discussion of the conditions necessary to produce such an outcome? The lesson is that we need to be aware of the whole range of outcomes but apply the appropriate weighting structure when reporting possible outcomes.

None of this is to criticise the efforts of epidemiologists in their efforts to model the spread of Covid 19. Nor is it to necessarily criticise the government’s interpretation of it. But it does highlight the difficulties inherent in forecasting outcomes based on models using incomplete information. As Nils Bohr reputedly once said, “forecasting is hard, especially when it’s about the future.” He might have added, “but it’s impossible without accurate inputs.”

More courtroom drama

As central banks and governments around the world battle to put in place measures to mitigate the worst of the Covid-19 economic fallout, the euro zone once again finds itself in an extremely difficult position. Whilst EU governments have done much to provide a range of packages to support workers who would otherwise lose their jobs, the only pan-Emu institution capable of looking at the regional picture is the ECB which is, to use the English cricketing parlance, batting on a sticky wicket.

Yesterday’s ruling by the German Constitutional Court (GCC) ordering the German government to ensure the ECB carries out a “proportionality assessment” of its debt purchases threatens to open a new front in the dispute between northern and southern members of Emu. The GCC is concerned that the “economic and fiscal policy effects” of the bond purchases should not impinge upon the ECB’s policy objectives and it has threatened to block Bundesbank purchases unless the ECB completes a review within three months. Having watched the UK Supreme Court intervene in Brexit-related issues, rightly in my view, it is difficult for me to say that the GCC is wrong. It is, after all, merely acting in what it perceives to be Germany’s national interest according to domestic law.

But this is not the first time that the GCC has become embroiled in the euro zone debate, having generally taken a dim view of Mario Draghi’s “whatever it takes” policy to keep the euro zone together. A case was first brought to the GCC in 2015 when a group of concerned citizens claimed that the ECB was engaged in monetary deficit financing which runs contrary to the Maastricht Treaty. This was subsequently referred to the European Court of Justice in 2018 which ruled in favour of the ECB. However, the GCC has now ruled that the ECJ’s earlier ruling is “untenable from a methodological perspective” which is a much stronger tone than anything it has delivered previously.

Had the ECB not recently ramped up asset purchases, the GCC would not have had to reopen the debate. But it did, and we could now be looking at a major constitutional problem. In effect the GCC has questioned the primacy of EU law, which takes precedence over national law and was such a bone of contention for Brexit supporters in the UK. Panos Koutrakos, professor of European law at City University in London is quoted in the FT as suggesting this represents “the first case where a German court says the European court has no jurisdiction.” One does not have to be a lawyer to realise that if the court has no jurisdiction, the legal basis of the single currency is under threat. It could get a lot worse for the EU if this encourages other governments to ignore ECJ rulings. For example, it has raised fears that the Polish government, which is engaged in a dispute with Brussels over the independence of the judiciary, could continue to defy the ECJ which would undermine the basis of the EU itself.

The GCC’s actions serve further to underscore the notion that there is one law for the prosperous north and another for the highly indebted southern Emu economies. If Germany is going to chafe at the actions of the ECB, the likes of Italy are less likely to accept lectures from other Emu members regarding fiscal policy. German politicians are likely to argue that both the actions of the ECB and the Italian government are in breach of the legal foundations of the euro zone. They may even be right. But that is not how the episode will be seen in Rome which is already disgruntled by the apparent lack of solidarity regarding support for those economies hardest hit by Covid-19.

As it happens, I find it hard to believe that the GCC really wants to cause the single currency project to unravel. Consequently I expect that the ECB will come back with a justification for its actions which satisfies all parties and the single currency will remain intact. But this is perhaps the most serious illustration yet of the flaws of the project. There are no instances of a single currency project holding together in the long run without some form of fiscal union. It is precisely because no such fiscal body exists within Emu that the ECB has to act as it does. History records that the Gold Standard lasted for almost a century whilst the Latin Monetary Union endured for 50 years. But the Bretton Woods System fell apart after 26 years. The common factor in the demise of each of these systems were the strains inherent in maintaining fixed exchange rate parities without any instruments other than monetary policy. Moreover, Bretton Woods fell apart because the US, as the biggest economy, was no longer prepared to subordinate its domestic policy to maintain the international order. The lesson from history is that the longer term future of the European single currency remains in doubt unless reforms are made to the institutional architecture.

But are the German critics right in their view that the buying of assets represents monetary deficit financing? The ECB has always been careful to emphasise that its balance sheet expansion has been driven by the need to raise inflation to meet the 2% target. If we accept this as true, then it is acting in accordance with its monetary mandate and not out of any fiscal concerns. Furthermore, the ECB buys in accordance with the capital key which means that it has bought more German Bunds than corresponding securities from other Emu members.

However, the lingering suspicion remains that there is a gulf between what the central bank says in public and the underlying motivation for its actions. But as Gertjan Vlieghe of the Bank of England pointed out recently, looking merely at the balance sheet transactions is not a good guide as to what a central bank is doing because “when a central bank issues reserves, the main counterpart asset on the central bank balance sheet is generally some form of government financing … in a strict sense some part of government spending is always financed with central bank money.”  The crucial determinant of the action is “who makes the decision and with what objective.” Given the separation of powers between Emu governments and the central bank, it is hard to make the case that the ECB is directly engaged in monetary financing. However much the judges sitting on the GCC may know about the law and however much they may suspect the actions of the ECB, they cannot prove anything beyond reasonable doubt. This may be an instance where the court has bitten off more than it can chew.

Central bank digital currency: More thought needed

The issue of digital currencies has been bubbling away for a few years, even after the initial hype surrounding Bitcoin dissipated in early 2018. I wrote a series of posts in late-2017 pointing out that the Bitcoin rally was unlikely to be sustained. Nonetheless, it has not collapsed into oblivion as I feared possible. Indeed, over the last 15 months the price of Bitcoin relative to the US dollar has traded around the levels which prevailed immediately prior to the peak of the boom in December 2017 (chart). The announcement last year that Facebook was behind a proposal to introduce Libra has given new impetus to the concept of digital currencies, whilst one of the side effects of the current social distancing regime is that many retailers prefer electronic payment rather than handling physical cash.

There are in essence two proposed types of digital currency – one which is operated by the private sector free from central bank interference, whilst the counter proposal is that central banks should engage in this area themselves. Recall that the original idea behind digital currencies was to break away from a money creation process controlled by governments and central banks which were perceived as having debased the value of money by inflating its supply. It is thus ironic that central banks have entered into the debate with increasing urgency in recent years. The cynics argue that this is because the rise of a privately run digital currency would rob central banks of their raison d'être. Central banks argue that the private sector either cannot or will not provide the security that individuals demand of the medium taking the place of physical cash and that it requires some form of oversight to protect the interests of society.

In my view, central banks have not yet made a sufficiently convincing case for the introduction of a digital currency under their control. In a paper issued last month, for example, the Bank of England suggested that a central bank digital currency (CDBC) “could support a more resilient payments landscape. It also has the potential to allow households and businesses to make fast, efficient and reliable payments, and to benefit from an innovative, competitive and inclusive payment system. It could help to meet future payments needs in a digital economy by enabling the private sector to create services that support greater choice for consumers.” All of these are true if the alternative is a privately owned digital currency or a payments system based on blockchain. But in effect we already have a highly developed system of electronic money transfer in the industrialised world based on existing currencies. Payment systems run by the likes of Visa or Mastercard are already highly regulated and the various deposit guarantee schemes in operation across Europe are sufficient to protect most customers against bank default.

A counterargument is that the payments network is a critical piece of the financial architecture where failure could prove catastrophic. The problems faced by Visa a couple of years ago, when the payments system across Europe was knocked out for a number of hours, demonstrated the risks inherent in the system. A CBDC could effectively act as an alternative means of payment in the event of a more prolonged outage. But the introduction of a CBDC would mean a significant amount of disruption to the payments system, which would have to be redesigned. That would entail a lot of effort and cost for a mere backup product.

It also raises a question of where the banking system fits in. In the model proposed by the BoE, banks would be relegated to the role of Payment Interface Providers (PIPs) whose role, amongst other things, is to “provide a user‑friendly interface” to the CBDC platform. But the very existence of banks could be threatened by the introduction of a CBDC. Imagine that customers switch their deposits away from their commercial bank to hold CBDC. Banks could lose low cost stable forms of funding which would threaten their existence, to which they may respond by raising interest rates to counter deposit outflows which in turn would destabilise asset portfolio decisions. In such a case banks would face the potential threat of a huge contraction in their balance sheet, resulting in a fire sale of assets as deposits disappear. As the BIS warned in a more sober paper than that produced by the BoE, the role of banks in providing financial maturity transformation services is “not clear.” Indeed, far from enhancing the stability of the financial system, a CBDC that competes with existing financial institutions could amplify instability if solvency/stability concerns at times of stress prompt a switch away from bank deposits towards the CBDC.

In my view, there are a lot more questions than answers regarding the introduction of CBDC. It is hard to avoid the sense that the debate is at least partly fuelled by the fact that this is a fashionable topic driven by the declining use of physical cash. Moreover, significant technological advances mean that things are now possible which once lay only in the realms of science fiction, and as I noted of blockchain back in 2017 it may be that this particular aspect of the digital currency debate is simply a solution looking for a problem to solve. 

But there is also the possibility that in a world where interest rates are low, and likely to remain so for a long time to come, a CBDC would give central banks more control over the monetary policy transmission mechanism if they can persuade the private sector to give up cash. After all, you cannot impose a negative interest rate on cash because you can simply store it under the mattress, but the interest rate on digital deposits at the central bank could be tweaked at will. It could be that I am missing something but if central banks want us to swap existing financial products for a CBDC it strikes me that they have to make a much stronger case than they have up to now.

Stresses and strains

Was the government too complacent?

The outbreak of Covid-19 will go undoubtedly down as one of the most traumatic social and economic upheavals of our time. At the time of writing, more than 200,000 people worldwide are recorded as having died and the true figure is undoubtedly higher. More will undoubtedly succumb. But as tragically high as these figures are, it is possible to imagine a far worse pandemic. A typical pandemic would be expected to strike more evenly across the age spectrum than Covid-19 which has predominantly impacted on those aged over 50. You do not have to be a virologist to imagine an even more terrifying disease which is more virulent and infectious than Covid-19. Indeed, the threat of such a pandemic is one of the natural disasters which form a key element in national disaster planning across the world.

Fortunately, such outbreaks are rare but precisely because of that it is so easy to become complacent about the risks which they pose. However, in what now seems like propitious timing, a year before we had even heard of Covid-19, a group of epidemiologists conducted a study to assess the preparedness of global health systems in the event of a global epidemic. They constructed an Epidemic Preparedness Index (EPI) covering 188 countries and based on five key metrics:  overall economic resources; public health communications; infrastructure; public health systems and institutional capacity. According to the authors, “the most prepared countries were concentrated in Europe and North America, while the least prepared countries clustered in Central and West Africa and Southeast Asia.”

All countries have expressed concerns that the outbreak of the disease would overwhelm their health systems, which is why they have imposed a lockdown to spread out the incidence of infections. Health experts are unanimous in their belief that containment and mitigation strategies are the first line of defence to combat a pandemic. Italy was one of the first countries, aside from China, to implement a lockdown on 9 March. At that time it had recorded 7,375 cases and 366 deaths. As of today, it has recorded 197,675 cases and 26,644 fatalities. The UK imposed a lockdown two weeks later than Italy, on 23 March, at which time it had recorded 5,683 cases and 281 fatalities. Almost five weeks later it has recorded 148,377 cases and 20,319 fatalities.

The debate in the UK focuses very heavily on the fact that the government was too late in implementing the lockdown and that it should have learned from the Italian experience. By the time it adopted this strategy, when its figures were similar to those in Italy two weeks previously, it was already too late and the path of the disease was effectively predetermined. There certainly does appear to be a lot of evidence to suggest the British government was reluctant to take such a dramatic measure although others suggest that the scientific advisers were slow to respond.

Either way it appears that the delay in implementing the lockdown played a role in allowing Covid-19 to become more widespread than it need have been although it is easy to be wise after the event. Indeed when Germany implemented a lockdown on 23 March, it had recorded 24,774 cases (more than either the UK or Italy at the same stage) but just 94 fatalities. It is thus likely that future research will concude that some governments were too slow to deploy their first line of defence. But this is not the whole story.

Or is it the lack of spending?

National health systems act as the second line of defence, offering options ranging from testing to intensive care. At this point the degree of funding provided to the health system really starts to come into its own. According to data compiled by the OECD, the UK had fewer medical staff per 1000 of population than many other European nations (see chart below). Although the proportion of doctors is below the OECD average, it is not too far out of line with other EU countries. But the number of nursing staff is somewhat lower. This might partially explain, for example, why the UK has been so slow in rolling out mass testing. To the extent that a shortage of trained medical staff at a time of emergency puts pressure on existing staff as overstretched resources are stretched more thinly, there is some evidence to suggest that funding constraints over the last decade have added to the strains facing the British NHS in recent weeks. Indeed, despite making great play of the fact that a number of temporary hospitals have been opened to add additional capacity to the health system, there have been complaints that there are simply not enough trained staff to provide the requisite services.

I have noted the strains on various parts of the public sector on numerous occasions in recent years and have pointed out the issues facing NHS funding (here, for example). In theory, of course, the NHS was protected from the worst of the austerity but there was still a slowdown in the rate of funding which meant that the supply of health care has not kept pace with demand. In terms of what the service offers, it can be regarded as efficient in an international context. For example, the NHS operates its critical care facilities with an 84% utilisation rate (higher than all other OECD countries bar Ireland, Israel and Canada, see chart below). But this also means that there is limited spare capacity to cope with emergencies. When it comes to the overall capacity of the system, the UK also has fewer intensive care beds per head of population than the OECD average.  

It is hard to avoid the conclusion that the NHS entered the Covid-19 crisis with the bare minimum of resources. For anyone who doubts the strains that the medical profession operate under in normal times, I highly recommend the book by former doctor Adam Kay, This is Going to Hurt, which is a litany of the humorous, bizarre and tragic circumstances routinely encountered by the medical profession. Anecdotal evidence gathered from my own discussions with medical personnel in recent years suggests that the strains intensified during the worst of the government’s austerity programme.

On the basis that demand for health services is infinite, some serious questions will have to be asked once the crisis is over as to what we require of health services in future and how we expect to pay for  them. It is pretty certain that no government will be able to deny funds to the NHS in the near future. Therefore, either spending in non-health related areas will have to be cut or taxes will have to rise. I even suggested a couple of years ago that a hypothecated tax to fund health spending might be something we need to consider. Whatever options we finally choose, the public will accept nothing less than a new deal for the NHS. The era of austerity is over although the question of how to pay for it all will be the subject of future posts.

A crude conundrum

Over the past couple of days we have been treated to the spectacle of negative oil prices with the price of the West Texas Intermediate benchmark closing yesterday at minus $37.63 per barrel. Strictly speaking, it is only the price for delivery in April which has turned negative – the price for delivery in subsequent months remains positive with the May contract ending yesterday at $20.43 (although it slipped to $10 in the course of today). Nonetheless, it raises a number of interesting questions about how market-clearing prices are determined at a time of such huge uncertainty and the outlook for oil markets, in both the near-term and longer-term.

Dealing with the price setting question, in the current situation oil traders are paying prospective buyers to take oil off their hands rather than the other way around. But this is a result of the specific conditions in the oil market. Traders have to settle their forward contracts with physical delivery of crude oil and were desperate to avoid taking delivery of additional oil ahead of today’s settlement date because demand has collapsed to a far greater degree than production. As a result there is insufficient storage space to accommodate the supply glut, which has prompted the collapse in prices in order to restore market balance.

This runs contrary to the way we think of the price-setting process. After all in Economics 101 classes, the supply-demand diagrams always assume that the market-clearing price is positive. But negative prices happen frequently in the electricity market when suppliers sell their output into the national grid. For example if there is a sudden surge in electricity supply generated by renewables which exceeds current demand, the supplier has to supply it to the grid at a negative price. In time, as the generation company is able to adjust supply so the price is forced back up again. This is the key to understanding the current predicament: The burden of adjustment falls fully on prices when supply is unable to adjust (i.e. it becomes totally inelastic), which is precisely what happened in the oil market just ahead of the contract settlement date.

In the wake of the financial crisis, we learned that interest rates could turn negative and now we know that certain commodity prices can also turn negative. But it is not a sustainable situation. If you recall your basic economics, short-term profit maximisation is achieved by setting the selling price at the marginal cost of production. However low production costs may be in places like Saudi Arabia, marginal costs are not negative. In the longer-term, producers will also have to cover their fixed costs. But this raises the question of what is the longer-term equilibrium oil price?

This requires some idea of underlying demand/supply conditions. The International Energy Agency predicts that global oil demand will fall by a record 9.3 million barrels per day in 2020 relative to 2019 (a decline of around 10%). But supply is predicted to fall by only 2.3 mbpd so it is evident that the supply glut which was exacerbated by the Saudi-Russian price war is not about to get any better. The six month contract for WTI, which expires in October, is currently trading at around $25/barrel. Although this may not necessarily be a good predictor of the price six months ahead it is a reasonable proxy for how industry specialists view near-term prospects. For a number of major producers, this is too low to be profitable. According to a 2016 article in the Wall Street Journal, the cost structure of producers such as Brazil, Nigeria, Venezuela and Canada is such that they would struggle to break even if prices remain at these levels (chart below). It would also be bad news for US shale producers whose costs were estimated at $23/barrel. To the extent that shale producers have played a major role in changing the dynamics of global markets in the last decade, a reduction in US output would certainly help to put a floor under prices.

Nonetheless, it seems likely that in the near-term, global oil prices may struggle to exceed $30. That is bad news for those countries which rely on oil as a major source of revenue (it may also be bad news for Newcastle United FC which is reportedly the subject of a takeover by a Saudi-backed consortium). If low prices are sustained in the longer-term, this may act as an obstacle to weaning the world away from fossil fuels since it will be difficult to generate low-cost energy which can compete with oil. However, under normal circumstances prices would be expected to rebound quite quickly as the global economy recovers, which would render this concern redundant. But much will depend on the behaviour of the main producers. OPEC has found it difficult over the years to maintain production discipline and the recent spat between Russia and the Saudis suggests that producers want to maximise their revenues while they still can.

Maybe one day in the future we will look at the collapse in oil prices and regard it as a blip, in much the same way as the price spike of 2008 is now viewed. The savage nature of the economic collapse as the corona shutdown drags on means that many of our preconceived ideas about what is possible are having to be reviewed. However, the recent price collapse may also reflect the shifting tectonic plates of the oil market. This could be the start of a new regime in the world of fossil fuels.