The pros and cons of returning to the office

Governments face one of their biggest economic dilemmas of recent times: How quickly should they withdraw the support provided to the economy during the Covid-19 crisis in order to minimise the hit to public finances, in the knowledge that this risks derailing the nascent recovery? However there are big question marks as to whether they should even be thinking on such lines in the current climate. Indeed, the French government last week launched a €100bn (4% of GDP) plan to boost investment in green energy and transport and support industrial innovation to help the economy recover from the recession. In recent days, governments in Austria, France and Germany have announced plans to extend their labour market support programmes to prevent a big rise in unemployment as activity levels prove insufficient to support pre-recession levels of employment.

It is against this backdrop that the start of the new school year in the UK has prompted a debate about how to get employees back to their workplaces after more than five months working from home (WFH) or on furlough. A month ago, a survey by Morgan Stanley suggested that UK workers were slower to return to their offices than in other European countries. According to the survey evidence, only 34% of white-collar employees had gone back to work compared to a European average of 68% (in France and Italy these figures were 83% and 76% respectively). More recent evidence suggests that British workers are now returning to the workplace, with the ONS reporting that 50% worked exclusively in the workplace in the last week of August compared with 30% in June.

Nonetheless, the data indicate that British workers lag behind their continental counterparts in this respect. Google mobility trends data (chart) bear out the view that between May and July fewer British workers had returned to their offices than in other European countries (the recent dips in Spain, Italy and France represent a holiday effect rather than a Covid-19 effect). This is sharply highlighted in the residential data where UK home footfall remains higher than elsewhere, implying a greater degree of home working.

The British government is currently advocating that workers return to their offices as it seeks to get the economy on a more solid footing. We should acknowledge that large numbers of workers were unable to work from home in the first place, with essential staff continuing to travel to their place of work throughout the pandemic. But of those who were able to work from home, the bigger question is whether they need to return to their offices. After all, many of us manage quite happily with an internet connection which allows us to do our jobs whilst remaining connected with the outside world. Whilst accepting that it is not to everyone’s taste, since a lot of people require the buzz of interaction with their colleagues, the idea that white collar workers need to be in the office to do their jobs is increasingly anachronistic. That said, there are positive externalities associated with workplace clustering so it is premature to conclude that office working is finished.

Consider the evidence

The demand by the head of the civil service that 80% of civil servants should be back at their desks at least once a week by the end of September needs a stronger economic rationalisation. According to Sir Mark Sedwill (who is technically the outgoing head, as he was effectively sacked by the government in June) “getting more people back into work in a Covid-secure way will improve the public services we deliver.” That is a bland statement which may or may not be true. But the limited evidence available on the benefits of WFH suggests that there are many upsides. 

A reputable study conducted on Chinese travel agency workers in 2014 and published in the Quarterly Journal of Economics (if Nick Bloom has his name attached to it, it’s worth taking seriously) found that “home working led to a 13% performance increase, of which 9% was from working more minutes per shift and 4% from more calls per minute. Home workers also reported improved work satisfaction, and their attrition rate halved.” The study went on to point out that: “The overall impact of WFH was striking. The firm improved total factor productivity by between 20% to 30% and saved about $2,000 a year per employee WFH. About two thirds of this improvement came from the reduction in office space and the rest from improved employee performance and reduced turnover.”

So why the rush to get people back to their offices? On the one hand, those businesses which depend on passing trade in crowded city centres are struggling. The proliferation of sandwich bars, coffee shops and pubs in our city centres rely on the lunchtime or evening crowd for their revenue and nobody wants to see our town centres becoming more hollowed out than they already are. But as Sarah O’Connor recently pointed out in the FT “Britain’s economic geography was under strain even before coronavirus. Good-quality jobs had grown ever more concentrated in London and a few other big cities like Manchester. That didn’t work for the rest of the country, and it didn’t work particularly well for the city dwellers either.” Her argument is that crowded city centres lead to spiralling accommodation costs, which is a particular problem for the low-paid, and those seeking to avoid them move further out and thus face long commutes on overcrowded (and expensive) public transport.

If we accept this view, one consequence of the pandemic will be to allow us to rethink the world of work and how we use our city centres. Assuming that at some point the social distancing measures are relaxed, businesses will need less expensive city centre real estate which will reduce costs. There will be losers, of course: property developers for one, and companies which rely on passing traffic for another. As noted above, however, this does not mean that there is no need for office working. Aside from the social aspects, office working does promote a greater delineation between work and leisure time; it allows the creation of more robust networks via face-to-face interaction; it creates a sense of belonging, which is important to company attempts to create a corporate culture, and it is a more efficient way of passing on experience as staff of different levels of seniority mix together. It is thus possible to imagine a world in which workers will be encouraged to spend some, if not all, of their working time in the office. The era of hot desking may be at hand (though not under current Covid restrictions).

Ultimately, how the world of work develops will depend on the needs of companies and their employees. It is possible to imagine a world in which the Covid crisis has accelerated a move away from the 9 to 5 drudgery although long-term predictions of working practices are fraught with uncertainty. Back in 1930, the economist John Maynard Keynes predicted that technological change and productivity improvements would eventually lead to a 15-hour workweek. Despite significant productivity gains over the past few decades, on average we work more than double (and in some cases treble) that. Nonetheless, if governments are so keen to allow market forces to operate, maybe they should let private sector companies figure out what works best for them and not impose 20^th century working practices on a 21^st century workforce.

A new monetary paradigm

Last week marked a big event in central banking history and economists will look back at Jay Powell’s speech on 27 August as the point at which the parameters of the three decade experiment with inflation targeting were changed. Central banks have tended to adopt a numerical target for inflation, usually centred around 2%, but in recent years inflation has undershot this target. A variety of reasons have been put forward for this. Many central bankers will argue that the adoption of inflation targeting was one of the factors which squeezed the high inflation of the 1970s and 1980s out of the economy. However, we can also add a number of exogenous factors such as the opening up of China as the workshop of the world, the end of the Cold War and more flexible labour markets.

Whatever the reason, there is a strong case for suggesting that the current regime which emerged in the wake of the high inflation of the 1970s and 1980s is no longer appropriate. For one thing, as currently practiced, inflation targeting contains an inbuilt asymmetry since central banks are more likely to react to inflation overshoots rather than undershoots for fear of being seen as soft on inflation, despite the fact that the target usually allows for some leeway around the central case. But we find ourselves today in an environment in which economies have taken the biggest hit in at least 90 years and inflation concerns are rapidly being put on the back burner as policy makers start to concern themselves with issues such as unemployment. Accordingly, the Fed announced last week that it will in future target maximum employment and “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In effect, it will adopt a medium-term price level target – something many economists have devoted time to thinking about over the past decade.

This has a number of important implications for monetary policy in future. For one thing it effectively means that the Fed will be less likely to pre-emptively tighten policy in response to a perceived inflation pickup after a period of below-target inflation. At a time when real economy concerns are paramount this makes a lot of sense. But questions arise as to what the Fed means by the two parts of the phrase “inflation moderately above 2 percent” and “for some time?” Much of the early discussion about price targets tended to focus on short-term deviations of inflation from the target. Thus if an exogenous shock results in inflation averaging 1% over a year, inflation can run at 3% the following year in order that it averages 2% over the whole period. But if inflation averages 1% over a 10-year period, this would require a 3% rate over the next ten years in order to get the long-run average inflation rate back to 2% (chart). In such a case is 3% “moderately above 2%?” And does a ten year period represent “some time” or does this represent a whole different paradigm?

As I argued in this post once we start to tolerate higher inflation the concept of price stability begins to become eroded. There is thus a concern that the price level targeting regime could result in inflation expectations becoming de-anchored. We might not worry about this any time soon but it is a discussion which will doubtless be taking place within the Fed. That said, at a time when government debt levels have gone through the roof in many countries, no government is going to complain about a little bit more inflation if it helps to alleviate the debt burden.

One of the less discussed aspects of the change was that on the rules versus discretion spectrum, which has been a feature of monetary policy over recent decades, the Fed’s policy announcement is very much a step in the direction of discretion. It ascribes a greater weight to “the shortfalls of employment from its maximum level” where the Fed freely admits that “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time.” Full employment has always been a nebulous target, but it is about to become even more so and runs the risk of being whatever the Fed believes it to be in order to satisfy its current policy stance. For markets which have become used to interpreting mechanistic rules, this implies a rather more opaque central bank than we have become used to. It also suggests an enhanced role for forward guidance which is likely to become even more important as a policy tool.

Another important aspect of the new policy is that the central bank will be even less concerned in future with trying to fine tune the economy via monetary policy, since shortfalls imply a persistent deviation from the nebulous concept of maximum employment whereas deviations imply cyclical divergences. Whilst the Fed’s moves make a lot of sense from an inflation perspective, it also fits with the new realities of the post-Covid economy in which central banks will have to play their part in dealing with the resulting economic scarring. By explicitly committing to keeping rates low(er) for longer, the Fed is perhaps taking the first steps along the path towards financial repression. 

However, it is important to be aware of some of the downsides. For one thing a policy of targeting price levels implies the potential for short-term inflation volatility if economic agents are not sufficiently forward looking and base their inflation expectations on extrapolation of current rates out into the future rather than the longer term goal of ensuring that price levels will eventually return to target. In addition, the standard objection in the literature is that there is likely to be greater output volatility under a price level targeting regime as the central bank does not attempt to moderate cyclical swings as frequently.

Nonetheless, it is likely that other central banks will eventually follow in the Fed’s footsteps and adopt a version of an average price level target with a focus on the real economy. However, it is unlikely to find much favour in the euro zone where the focus on short-term price stability remains paramount. But as Martin Sandbu points out in the FT the ECB has “treated its own legal mandate far too narrowly … There is a widespread misperception that the ECB is treaty-bound to the single duty of ensuring price stability … But beyond this, the ECB has a legal obligation to ‘support the [EU’s] general economic policies’” (a point I have made repeatedly in the case of the BoE). The ECB may not be a slave to monetary policy fashions but it is not the Bundesbank and has proved itself pretty flexible in its monetary dealings in the past. It just might take a while to get there.

A highly technical rally

As the summer draws to a close the S&P500 continues to power to new highs, contrary to expectations earlier in the year when it looked like the corona effect would change the business model, if not forever then for a very long time. The benchmark US index looks set to post its best August performance since 1986. But trends in aggregate indices are not necessarily a good guide to what is happening in corporate America.

The focus of attention of late is the contribution of tech stocks to the surge in US markets. This was brought into sharp focus last week when Apple became the first company ever to post a market cap of USD 2 trillion. The company’s market cap has increased by almost 118% since the March trough, followed not far behind by Amazon whose market cap is up by 104%. At the start of the year, the FAANG sector accounted for 14.1% of the S&P500 market cap; today it stands at 19.8% and since March these five companies have contributed 25% of the increase in the index.

That is a very powerful motive force behind the surge in the aggregate index but the S&P average increase is a much lower, although still-healthy, 65% from the trough. The recovery since March has been described in some quarters as a K-shaped recovery with an increasing divergence between the top performing stocks and the worst performers. It is thus becoming increasingly obvious that this is an unbalanced US rally which is dependent on a small number of stocks. In that sense it is reminiscent of the surge in the late-1990s which proved unsustainable when the tech bubble burst.

One key difference, however, is that the FAANG stocks today have a deliverable product and a proven business model. Investors are not buying companies that offer the promise of a product at some point in the future. Amazon acts as the world’s global market place with a delivery system that can ensure that nearly anything you want can be brought to your door. That said, investors are prepared to pay a very high price to hold the stock of these digital disruptors and price metrics paint a more nuanced picture of the sector. The S&P500 as a whole is trading on a P/E multiple of 27.2x expected 2020 earnings, well above the 21x at the start of the year, but this is distorted upwards by the tech sector. Whilst Google and Facebook are trading at current year multiples of 32x, Apple is at 39x and Amazon and Netflix are running at 71x and 74x respectively (chart). Clearly the surge in FAANG is being driven by a strong earnings performance in recent months, but a lot is priced in for the future and some parts of the tech universe look more expensive than others. I can see why investors are keen to pay a premium for Amazon given the way it is shaping the face of retail, even though it looks very expensive, but Netflix?

From an investor perspective, current trends do not suggest buying an aggregate index tracker since a FAANG index contains all the stocks which are driving the market. Against that, a portfolio diversification argument would caution against putting too many eggs in one basket. Nonetheless it puts the European performance into perspective and perhaps the apparent underperformance of the FTSE100 is a better reflection of average corporate performance than the red hot S&P500.  In that light, it is notable that a recent report from Bank of America pointed out that the market cap of the US tech sector alone stands at $9.1 trillion, which is bigger than the market cap of all Europe ($8.9 trillion).

As one who has watched markets boom and bust a few times over, the surge in tech stocks should remind us of Stein’s Law, articulated by the economist Herbert Stein, that “if something cannot go on forever, it will stop." Or to paraphrase, if a trend can’t continue, it won’t. What this ignores, however, is the timing problem. You bet against a bull market like this at your peril because, as the old adage has it, “the markets can remain irrational longer than you can remain solvent.” With yesterday’s news that the Fed is effectively committing to low interest rates for a very long time to come (I will come back to this another time), debt is simply not going to act as a major constraint on company actions.

At some point, there surely has to be some form of reckoning even if monetary policy is not going to be the catalyst for a market sell-off in the coming years. But what might be the trigger? It is possible that investors will simply rotate out of tech at some point, especially if Covid becomes less of an economic threat (perhaps because a vaccine is developed). This might lead the tech sector to underperform vis-à-vis the “old economy” rather than collapse outright. Geopolitics could play a role if the US-China spat were to heat up. But perhaps the most likely catalyst is that governments start to make good on their promises to introduce a digital tax, particularly in Europe. The US also has a history of breaking up monopolies and history buffs will recall the breakup of Standard Oil which fell foul of anti-trust legislation in the early twentieth century whilst as recently as the 1980s, the Reagan administration took the axe to AT&T.

That certainly will not happen if Donald Trump is re-elected and it is even doubtful that a President Biden would want to go down that path, especially since his running mate Kamala Harris is perceived as very tech friendly. But in this crazy world, we have learned never to say never.

Good governance matters: Part 2

In my last post I looked at why the quality of governance is important for the wellbeing of the economy. In this post I look at some specific problems in the UK. Governance issues are something we associate with emerging markets where the institutions required to maintain the separation of government interests and those of the wider economy are often not embedded within a solid framework which protects their independence. Increasingly, however, western economies run the risk of falling into the same trap as nationalist politicians seek to undermine the framework in order that they can achieve their narrow objectives. 

This appears to be a particular problem in the UK which is undergoing a form of political revolution, though quite to what end and in whose interests is unclear. A few days ago I listened to an interview with Adrian Wooldridge of The Economist newspaper whose forthcoming book is titled The Wake-Up Call in which he explores how the Covid crisis has exposed the flaws in the model of western governance. He noted that we can trace the problems in the UK as far back as the 1960s when the hubris associated with being on “the right of history” meant governments took their eye off the ball. Wooldridge further made the point that over the past 40 years, as governments have tried to reduce the role of the state by contracting out service provision, they have also lost a lot of in-house expertise. This chimes with my long held view that the obsession with finding private sector solutions to state service provision often results in sub-optimal outcomes and is not proven to generate value for money for the taxpayer. 

Problem 1: Outsourcing government functions to the private sector 

There are numerous examples of how the outsourcing of public services to the private sector has resulted in less-than-ideal outcomes. Examples include the history of rail franchising where the main East Coast franchise covering the London to Edinburgh route has failed three times in a little over 20 years (one of these days I intend to look more closely at the issue of rail travel, since many of the flaws inherent in the current system were evident from the start way back in the 1990s). More widely, the National Audit Office two years ago issued a report on the Private Finance Initiative. Under this scheme a private finance company sets up a Special Purpose Vehicle (SPV) which then borrows to construct a new asset such as a school, hospital or road. This is repaid by the taxpayer over the contract term (typically 25 to 30 years). The NAO found “no evidence of operational efficiency” in the hospital sector and it is at best arguable whether private sector participation has delivered the benefits which its proponents promised. 

One of the biggest problems is transparency, or the lack of it. This takes two forms. The first is relatively trivial – the hidden costs associated with PFI schemes and the fact that off-balance sheet vehicles mean that debt does not appear on the public sector balance sheet. Such structures have been criticised by the OBR as a “fiscal illusion” since the debt burden associated with the provision of public services is higher than the official figures suggest. The second form of transparency is more nebulous and relates to the way in which public sector contracts are awarded. The law states that the government must produce details of any contract within 30 days of being awarded but as The Good Law Project notes, this requirement is routinely flouted. Over the course of recent months, there have been numerous examples of contracts being awarded to firms with links to government (see here for an example) whilst the FT reported last month that the government has awarded £1.7bn of contracts to private sector firms during the Covid crisis without a competitive tendering bid, as required by law. It may be that there is no case to answer here. But the evidence appears to suggest that due process is not being followed, which not only undermines the propriety of the scheme but is unfair on other companies with an interest in tendering for contracts. 

Problem 2: Pandering to special interest groups 

A further problem is that successive UK governments have allowed themselves to be distracted from the bigger picture by the demands of special interest groups which have exploited dissatisfaction with the status quo in the wake of the 2008 financial crisis. In 2014 the government was focused on the Scottish independence referendum, which David Cameron was confident he could win. But the government’s handling of the referendum betrayed the complacency of an administration that had made no provisions for what to do in the event that the result went against them. A similar complacency was evident in the run-up to the Brexit referendum but this time the result did indeed go against them.

On both occasions the government made the mistake of asking a question to which it did not already know the answer. It got lucky in 2014 but nonetheless gave momentum to the Scottish nationalists which they retain to this day. But it failed in 2016 and in so doing changed the character of the Conservative Party from a nominally inclusive party of national unity to, in effect, an English nationalist party. And it is here that the governance problem really starts to become a critical issue.

For all that Theresa May was not a great prime minister she at least tried to strike a balance between the moderates in her party and the strident Brexiteers (the nationalist wing). Unfortunately, this also meant putting the unity of the Conservative Party ahead of the national interest. But because the Brexit vote effectively ended the era of consensus politics, it also brought an end to her tenure in Downing Street. We now have a prime minister in the form of Boris Johnson who is the figurehead for the nationalist wing. Whilst Johnson may be a very effective campaigner he is not a good administrator, as foreshadowed by his tenure as Foreign Secretary. Worse still, he leads a government of campaigners rather than governors and his key advisers are radicals who want to overturn the status quo. 

Problem 3: Make sure you know how to deliver the changes you promised

There is nothing wrong in wanting change: It is how one goes about it that matters. Brexit has been the defining issue of the last four years and after three years of political wrangling, the first thing Johnson did as prime minister was to prorogue parliament in a bid to force the policy through. As I noted a year ago, this was a profoundly undemocratic action. Worse was to follow as the Johnson government took action to expel Conservative MPs – the governing party, lest we forget – who dared oppose it. This is not how parliament is supposed to work: Its role is to hold the executive to account and such actions undermine the basis of the parliamentary system.

One of the defining features of the Johnson government is cronyism – the appointment of like-minded individuals to office irrespective of their ability and who are defended to the hilt even when they make big mistakes. We see this in the Brexit debate where the negotiating team is led by those who seem to think that the EU loses more from a no-deal Brexit than the UK. Precisely because they are true believers who have never doubted the righteousness of their cause, they may simply never have stopped to consider whether they might be wrong. That in itself is a dangerous trait as it promotes ideology over rational, evidence-based policy – an approach which has a habit of ending badly.

We also see cronyism in action in two more policy areas. The first – and perhaps least important – concerns the recent exam debacle (here for a sober assessment of the issue). It now transpires that the government was warned about the problems of the algorithm used to provide grades in the absence of sitting the exams. However, the government is trying to distance itself from the problems and appears to be laying the blame on civil servants for the problems rather than accept its own failings. 

We see it in the way the government has handled the Covid-19 problem. This article from The Atlantic Magazine suggests there was institutional failure, as large parts of the state mechanism were insufficiently prepared for the scale of the crisis and were slow to adapt. Whilst it is true that the government cannot be blamed for all that went wrong,  the article fails to mention that the changes imposed on the health system by the reforms introduced in the  Health and Social Care Act of 2012  crippled its ability to respond. Moreover, the law was changed in 2012 in the teeth of opposition from health professionals who warned that it risked undermining the operability of the health service. The government’s response to the failings has been poor. It is set to abolish Public Health England in what looks like an attempt to deflect the blame onto the health service (never mind that PHE is an executive agency that actually reports to the health minister – it is not some out-of-control quango). And to add insult to injury, the new replacement body will be headed by Baroness Dido Harding - a Tory insider with a chequered business career who has no background in public health. 

At some point, however, the government will run out of ways to deflect the blame for its shortcomings. It will have to stop operating as if it were running a campaign and start to govern effectively. It cannot afford any more missteps and needs to get Brexit right. For if not, the economic as well as the political costs will be very high indeed.