Soddy's Law

The name Frederick Soddy may not mean much to many people. Historians of science might recall that he collaborated with Ernest Rutherford on radioactivity and that he won the Nobel Prize for chemistry in 1921 for his research on radioactive decay. In the world of economics he occupies at best a place on the fringes despite having written four major works on the subject between 1921 and 1936. I recently dipped into his 1934 book The Role of Money (available online here) and although the prose is a little dated and some of the ideas are very much of their time (not to mention flawed), it is nonetheless fascinating to sift through his work to discover that he uncovered a number of macroeconomic ideas long before the celebrated economists of recent years. It is also worthwhile looking again at his work to determine whether it offers any insights on today's policy issues.

A man of astounding economic prescience

Although Soddy was largely dismissed as a crank during his lifetime, many of his policy prescriptions were later adopted into the mainstream. He was, for example, a great critic of the gold standard and argued strongly that exchange rates be allowed to float; he also argued in favour of using the government budget balance as a tool of macroeconomic policy and called for the establishment of independent statistical agencies to compile economic data (particularly to measure the price level). In the event, the idea of using fiscal policy as a policy tool was one of the cornerstones of the post-1945 Keynesian revolution whilst the suspension of dollar convertibility into gold in the early 1970s ushered in the era of floating exchange rates which has prevailed ever since. Moreover the UK established a Central Statistical Office seven years after Soddy first mooted the idea in 1934.

Economics as science

Soddy’s approach was rooted in physics, viewing the economy as a machine which requires inputs to derive outputs. Whilst there is a lot wrong with this way of thinking it was not out of tune with the mainstream views adopted in the post-1945 era, the echoes of which still persist today. But it is appropriate in one sense: A system which relies on such inputs will soon grind to a halt unless there is an infinite supply of them. Accordingly, Soddy’s ideas have been adopted by the modern-day ecological school of economics which views the economy less as a machine and more as a biological system.

The original motivation for his thinking was the recognition that a fractional banking system requires perpetual growth in order that the debt acquired in the process of generating today’s consumption can be repaid. As a scientist, Soddy understood that an economy based on the consumption of finite resources cannot continue to grow indefinitely since this would violate the laws of thermodynamics which prevent machines creating energy out of nothing or recycling it forever – an idea he set out in his 1926 book Wealth, Virtual Wealth, and Debt. 

Soddy recognised the fact that private sector banks create money simply by creating deposits thus inherently increasing the leverage in the system – in his memorable phrase: “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING”. He further recognised that this exacerbated the swings in the credit cycle since banks were prone to call in loans when borrowers were least able to repay whilst they were most willing to grant credit when times were good and therefore when credit was least needed. Accordingly, one of Soddy’s main proposals was that the creation of money be taken out of private hands and should instead be fully backed by government created money.

Father of the Chicago Plan

Although Soddy’s ideas were generally ignored in the UK they did find support in the US. In a review of Soddy’s 1926 work, the great American economist Frank Knight noted that “it is absurd and monstrous for society to pay the commercial banking system “interest” for multiplying several fold the quantity of medium of exchange when a public agency could do it at negligible cost” particularly where there are huge costs associated with the booms and busts of the credit cycle. Influential US economists led by Henry Simons and Irving Fisher went on to formulate the Chicago Plan which advocated wholesale reform of the banking sector, notably the separation of the monetary and credit functions of the banking system, “by requiring 100% backing of deposits by government-issued money, and by ensuring that the financing of new bank credit only took place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks.”

Needless to say the Chicago Plan did not find favour in the 1930s. However in the wake of the 2008 financial crisis the idea of full-reserve (or narrow) banking did come back onto the agenda. Institutions such as the IMF have recently given serious thought to the idea, with an influential working paper in 2012 conducting quantitative analysis which concluded that “the Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt.” The FT’s chief economics commentator, Martin Wolf, who sat on the UK’s Independent Commission on Banking, came to a similar conclusion (although he did not credit Soddy with the original insight).

Rethinking narrow banking

In recent years the debate has taken a step further with the advent of digital currencies. In theory the likes of Bitcoin represent a form of narrow banking given that its supply is fixed. However, to the extent that each Bitcoin unit is divisible into sub-units of 100,000,000 it is possible to imagine a world in which value can be destroyed by division, in which case we are no better off. But the concept of a central bank digital currency (CBDC) may be a different story. The Bank of England’s illustrative model for a Sterling CBDC utilises a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all CBDC reserves at the central bank. These PIPs may be pure payment intermediaries or may be commercial banks processing transactions but the key point is that these CBDC deposits would not be used for lending. Such a policy is not without risks (as I discussed in this post a year ago) and I retain some scepticism that a CBDC does many of the things that are claimed for it. Nonetheless, their introduction may take us a long way closer towards realising Soddy’s idea.

One of the reasons why economists remain sceptical of narrow banking is the conventional view that it will reduce banks’ lending activity which will in turn act as a brake on economic growth[1]. But a lot of modern macro theory increasingly calls this view into question. This paper published in September 2020 by Hugo Rodríguez Mendizábal makes the case that a “fully reserve-backed monetary system does not necessarily have to reduce the amount of liquidity produced by depository institutions.” Space considerations mean that we cannot do justice to the full implications of the case for narrow banking and it is clearly a topic for another time. Suffice to say that it is a very active research area these days.

Last word

For a man who was regarded as a crank operating at the margins of respectable economics, many of Frederick Soddy’s “crazy” ideas have subsequently found a surprising degree of mainstream acceptance. Almost a century after he sowed the seeds, the idea of a full reserve-backed banking system refuses to die and has now become a respectable topic of research. It is perhaps not surprising that many of his ideas have such modern day resonance since many of today’s global economic problems echo those of the 1920s and 1930s. Indeed, as he wrote in 1934: “There is a growing exasperation that an age so splendid and full of the noblest promise of generous life should be in such ill-informed and incompetent hands.”

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[1] Diamond, D. W., and P. H. Dybvig. 1983. ‘Bank Runs, Deposit Insurance, and Liquidity.’ Journal of Political Economy 91(3) pp401-19

No vaccination against politics

Doing drugs may be a lifestyle choice for many people but for pharmaceutical companies there is little choice – if they are not in the drugs business, they are not in business at all. But the drugs business is not quite like any other. Although pharma companies are similar to other private sector companies in trying to make a profit from their work, they are also very different in that much of their input yields very little return. The industry also runs into a host of ethical problems. One of the trickiest issues is whether it is right that they should generate abnormal profit at the expense of the sick? Yet over the last 12 months we have been very glad of their efforts as the industry has produced a number of vaccines against Covid-19. But even these heroic efforts have not prevented companies from being drawn into major controversies as the politics of vaccination starts to kick in.

Four vaccines have been authorised for use in the EU: Comirnaty (aka the Pfizer-BioNTech vaccine); the Moderna vaccine; the Janssen vaccine and Vaxzevria (known until yesterday as the AstraZeneca vaccine). It is the latter of these which has fallen foul of vaccine politics to a far greater degree than the others.

The (drug) trials and tribulations of AstraZeneca

Since the start Vaxzevria (known hereafter as the AZ vaccine) has suffered from the perception that it is less effective than its competitors. Back in November Pfizer was the first producer to announce the results of its clinical trials, suggesting that its vaccine had an efficacy rate around 94% whilst Moderna made a similar claim. Initial trials of the AZ vaccine suggested an efficacy rate of just 62%. But AZ subsequently announced that the efficacy rate amongst participants who received a lower amount of the vaccine in the first dose and then the full amount in the second dose rose to 90%. For the layperson, the suspicion was sown that AZ had somehow tried to “fix” its results to bring them into line with those from other producers. The waters were further muddied when it subsequently came to light that the low dose trial did not include anyone over the age of 55, raising concerns that the higher efficacy was merely a by-product of excluding an age group that is particularly vulnerable to Covid. This led to a situation whereby many EU countries initially refused to licence the AZ vaccine for older age groups. Bizarrely, Germany has now licensed it only for the over-60s. 

Although the EU and UK did grant a form of authorisation to the AZ vaccine, it had until recently still not received a licence for distribution in the US which is critical to global acceptance. The US Food and Drug Administration (FDA) had asked AZ to conduct a larger trial in order to get clearer data than they obtained in their first rounds of testing. In late March, AZ thus released data showing that its vaccine is 79% percent effective at preventing symptomatic disease. But in an unprecedented move the National Institute of Allergy and Infectious Diseases (NIAID) released a letter stating that the AZ results were based on outdated data. Within 48 hours AZ released an updated set of results stating that the vaccine has 76% percent efficacy in reducing symptomatic Covid-19 overall, and 85% in people 65 years old and older.  

To make matters worse a number of countries suspended the use of the AZ vaccine altogether on reports that a number of patients suffered blood clots (thromboembolic events) as a reaction. Although the European Medicines Agency subsequently stated that “the number of thromboembolic events in vaccinated people is no higher than the number seen in the general population” this is just another example of the reputational damage which has been inflicted on the AZ vaccine.  

Was it worth it?

AstraZeneca’s management can be forgiven for wondering whether their efforts to develop a vaccine which is significantly cheaper than its competitors and which will be sold at cost to developing countries were worthwhile. There is considerable evidence that people in many countries much prefer to be injected with the Pfizer vaccine rather than the AZ version with Germans and Canadians showing a clear preference for the former. As a result AstraZeneca’s share price has underperformed that of Pfizer in recent weeks.

Under normal circumstances AZ’s efforts to deliver a vaccine to combat a new disease at such a rapid pace and at a low cost would be lauded as a miracle of science. Yet it has dominated the headlines for all the wrong reasons. In some ways it is hard to refute the claim made by Anthony Fauci, the US President’s chief medical advisor, that AZ has made “unforced errors” in its handling of the process. Communication of the drug trial results has been very confusing and the issues with NIAID could perhaps have better been handled had both sides liaised better before announcing the results.

Some of the issues may also stem in part from the fact that AZ does not have a lot of experience in vaccine production. According to the experts, the productivity of identical plants can differ for no apparent reason with the result that there can be considerable variation in quality across batches. The international supply chain dimension further adds to the complexities of vaccine production. As a consequence AZ may have underestimated its ability to produce the volume of vaccine which it promised. This became a convenient stick with which to beat the company, thus diverting attention away from the failures of the vaccine rollout programme in parts of the EU.

For all this, the work of AstraZeneca deserves a lot more praise than it has so far attracted from large parts of the international press. The vaccine is far easier to store than those developed by Pfizer and Moderna, making it much more useful in those countries which may not have the capacity to store it at the low temperatures which they require. Moreover it is being used and saving lives which is more than can be said for all those companies which are engaged in vaccine research and whose products have yet to see the light of day – not because they are not good at their work but because vaccine development is a difficult process.

AstraZeneca has unfortunately fallen victim to vaccine politics

Indeed, not all the blame attributed to AZ is of its own making. Whilst it is true that the EU countries have exported the AZ vaccine to the UK whereas there has been no flow in the other direction, this is partly to do with the details of the respective contracts drawn up between AstraZeneca and the UK/EU. This article, quoting a Belgian contract law specialist, explains why the UK’s legal position with regard to supply is stronger than that of the EU. Interested readers are referred to the article for the detail but the key points are:

1. The UK contract is written in English law which is quite specific about assessing whether both parties delivered the goods. By contrast the EU contract is written in Belgian law, which puts a lot of emphasis on the concept of good faith in determining whether both parties tried their best to deliver the goods; 
2. The UK contract made it clear that the whole supply chain process was taken into account whereas the EU focused only on delivery;
3. The UK contract has stricter enforcement penalties than that drawn up by the Commission which left it somewhat toothless.       
   

The influential MEP Guy Verhofstadt is quoted as saying “since the outcome of this particular contract has led to an enormous amount of public distrust, both the Commission and AstraZeneca have a lot of explaining to do.” But it rather looks as if it is the former, rather than the latter, where the problems lie since the contract drawn up by the Commission appears to be less watertight than the one AZ signed with the UK. That said, AZ has under-delivered and if it has learned anything from this debacle, it is that it needs to manage expectations more effectively.  

But we should not rush to judgement. Only once the recent teething troubles have been sorted can we can really assess whether the EU’s vaccine rollout has really been so bad (it is likely to catch up quickly) and whether AZ has lived up to its promise to deliver a low-cost vaccine that has saved the world.

24 March 2020 BC

We all undoubtedly look back wistfully to a time when we could go where we wanted and meet whom we wished. That was, of course, in the time before Covid – the ancient past we now call BC. It is hard to believe that here in the UK it is now exactly a year since the first lockdown was introduced. Following Boris Johnson’s announcement on 23 March 2020, the country changed overnight. Although there had been a reduction in activity ahead of the announcement, which was widely expected, on the morning of 24 March our once-bustling high streets resembled a post-apocalyptic film set in which our hero awakens to find everyone has disappeared. That morning, it felt as though London had become a ghost town – indeed the UK had become a ghost country.

Whilst a lot of economic activity simply stopped – we could no longer go to a restaurant or visit the cinema, for example – a lot of it was merely displaced. For many people their homes became a shelter from the ravages of Covid and for some a prison. More important economically, for many of us our homes also became our workplaces. This has had profound consequences for the shape of the economy and there have been some remarkable changes to the way in which it operates. Many of these changes are likely to be temporary but some will undoubtedly be permanent. What does the data tell us about how the economy – and indeed our lives – have changed since March 2020?

The big picture

Turning to the aggregate economic picture, over the last twelve months the UK economy has suffered an impact similar to that of a war. GDP in 2020 slumped by 9.9% – the biggest drop in over 300 years – whilst latest monthly GDP data to January show that output is still 10.6% below its October 2019 peak. Contrary to expectations, the labour market has held up relatively well. Although the unemployment rate has risen to 5% versus 3.9% a year ago, employment is down “only” 1.9% which is a considerably smaller decline than the collapse in output. In this sense the labour market support measures put in place by the government have done their job by preventing a much bigger labour market shakeout (so far, at least). Whilst evidence suggests that payroll employment has increased in each of the three months to February, it remains well below the January 2020 peak. What is more, two-thirds of the decline in jobs has been concentrated in the under-25s with over half occurring in the hospitality sector.

But the devil is in the detail

Over the past year we have had to cope with conducting our lives in a very different way compared to the pre-Covid era and economists have devoted a lot of time to looking at non-traditional data to measure changes in the composition of activity. One of the first things we noticed last year was the sharp decline in the number of people on the streets as they obeyed the call to stay home. This was reflected in a sharp drop in the number of car journeys and the numbers using public transport (chart 1). The number of car journeys, which dropped to 20% of normal levels as the lockdown was introduced, got back to more normal levels by the summer but rail journeys never returned to anything like BC levels. Similarly UK air passenger numbers as of last month were almost 88% below year-ago levels. This has major implications for companies that rely on fare-paying passengers. For example, the government has provided £10bn of funding to the railways whilst the London transport network has only been kept afloat thanks to a government grant which will entail measures to recoup additional revenue in future.

Traffic congestion data also reveal some interesting insights into commuter behaviour. A couple of things stand out from a year’s worth of hourly data on London traffic congestion. First, congestion levels have increased more quickly than the numbers travelling by train or bus. One takeaway from this is that people are more prepared to drive to work in order to reduce their Covid infection risk on public transport. Another noticeable trend is that the peak of the evening rush hour – at least in London – has shifted slightly forward from 5pm to 4pm as workers are encouraged to spend less time in the office during lockdown.

The retail sector has been hit hard by measures which have required most non-food establishments to close. Many of them will not reopen once restrictions are lifted. According to the Centre for Retail Research last year’s trends were a continuation of those in 2019 with almost 183,000 retail sector jobs lost versus 143,000 in 2019. As the CRR points out, the industry has been under pressure for years due to high costs and increased pressure on margins. But an additional threat has been the rise in online sales which have boomed over the last year. Prior to the lockdown roughly 20% of retail sales were conducted online. Latest data to January show that in the depths of the second lockdown the share rose to 36% (chart 2). This is a trend which is likely to remain in place.

By far the most radical economic change during the pandemic has been the huge shift towards working from home. According to ONS data, almost 50% of workers did so from the comfort of their own homes last spring – a figure which was replicated again during the most recent lockdown. As I noted in this post, although there are many advantages associated with working in an office – most notably the creation of network effects – many people do not miss the downsides, particularly the commute. One advantage of doing away with the commute is that it gives us extra time in bed. Evidence that we are starting our day a little later can be gleaned from electricity generation data which suggest that in the first 12 weeks of 2021 electricity generation measured at 0700 is running at an average of 2GW below corresponding levels a year ago, whereas generation over the rest of the day is broadly unchanged (chart 3).

Improvements in communications technology in recent years mean that it is now relatively straightforward to remain in contact with office colleagues without having to meet in person. As a result, many of us are convinced that remote working will be a part of the labour market in the years ahead, even if people do spend at least part of their week in the office.

The extent to which we quickly got used to dealing with this way of working can be seen from Google searches for the term “Zoom” in the UK. This hit a peak in late-March/early-April 2020 but subsequently tailed off quickly (chart 4) indicating that large numbers of people are now familiar with the technology. Looking more widely, web searches give an insight into the things people are interested in and Google’s analysis of UK search trends in 2020 is a mine of useful information (readers can go to the link and change the country of interest if they so wish). Not surprisingly, coronavirus topped the list but amongst the top-5 “how to” searches were “how to make a face mask” and “how to cut your own hair” (and for some bizarre reason “how to cook eel” made it to number six).

Last word

As Covid cases rise across Europe we are clearly not out of the woods, despite the fact that the UK numbers so far have been running in the right direction. However, after a year of restrictions on their way of life the vast majority of people are looking forward to a return to something closer to BC normality. Quite when we will get to that point is unknown. England’s chief medical officer, Professor Chris Whitty, has warned that there will “definitely be another surge” of Covid and while “the path from here on in does look better than the last year [there will be] bumps and twists on the road.” He went on to say that “the chances of eradicating this disease – which means getting rid of it absolutely everywhere – are as close to zero as makes no difference.”

In such a case, it is likely that the economic upturn will be slower than many suppose and in keeping with my prediction from a year ago, there will be a lot of economic scarring to contend with. The economy in the AD (after danger) era is likely to be very different to the BC world as the trends that have emerged over the last year become a permanent feature of the landscape.

The case for curbing student debt

The student debt burden is increasingly a hot topic in US politics. It generates less mainstream attention in the UK but the Covid crisis, in which many students questioned whether they were receiving value for money from the system, has thrown the issue into sharp relief. Over the last decade, the UK government has slashed university funding in a bid to shift risk off the state balance sheet and force individuals to bear more of the costs. As a result students have had to shell out a lot more to fund their university education and have acquired large amounts of debt in the process. This contrasts with much of the rest of Europe where university education is viewed as a public good and the state contribution is far higher. But with UK student debt levels continuing to spiral higher, there is increasingly a case for reforming the funding system.

Counting the cost

A plan for student debt forgiveness was one of Joe Biden’s campaign promises. Self-funding has traditionally played a big role in the US system in which students take out loans, primarily from Federal government, and pay it back over time. There is a range of payback options depending on the type of loan taken out, but the general idea is that loans are repaid over 20 years for undergraduate degrees or 25 years for graduate programmes and any outstanding balance after this point is written off. As education costs have risen in recent years, there has been a huge increase in the amount of outstanding debt. In 2006 the volume of outstanding debt stood at $481 bn (3.5% of GDP). By the end of 2020 this had ballooned to $1.7 trillion (7.9% of GDP, chart 1).

Similar trends are evident in the UK - indeed are even more pronounced. But whereas the US has traditionally relied on students funding their own way through college, it is only in the last decade that this has gained momentum in the UK. Between 1962 and the 1990s higher education in Britain was effectively free and student debt was correspondingly low. In fiscal 1995-96 total outstanding student debt amounted to just 0.2% of GDP. Latest figures to FY 2019-20 put the figure at 6.3% (since 2006, the data have referred only to students domiciled in England so we should use GDP for England as the denominator which takes the ratio to 7.3%, chart 2). The rise in the UK is primarily attributable to the strategy introduced in 2012 to cut government funding for tuition and force students to bear these costs up to a maximum of £9250 per annum (this is not the case in Scotland where tuition is free). Once borrowing to fund living costs is taken into account, UK students graduate from university after three years with debts averaging £47,000 which compares with an average starting salary of £29,000.

Payback terms are also onerous. The interest rate on debt is benchmarked against the discredited RPI measure of inflation, which on average runs around 0.5 percentage points above the CPI rate which the BoE targets for monetary policy purposes. Those earning less than £26,568 per annum pay an interest rate equal to RPI inflation (in fiscal 2020-21 this was set at 2.6%). Above this threshold, students are charged a mark-up over RPI which rises as high as 300 bps for annual salaries of £47,835 or above. This currently implies a sliding scale for debt interest charges between 2.6% and 5.6% versus a current BoE policy rate of 0.1%. Moreover, British students (or more accurately those in England) have to keep paying for 30 years after graduation before they are eligible for debt forgiveness, compared to 20 years in the US.

The extent to which debt is paid down over the first 30 years of employment depends on salary and the rate of inflation. Debt principal payments are charged at a rate of 9% of gross salary above the lower threshold. Thus, if a student takes a job paying the average salary (£29,000) they pay £219 (.09*(29000-26568)) in the first year. But if inflation is greater than zero the interest on the debt will exceed this figure so the total value of outstanding debt rises. We can roll the analysis forward, changing the inflation and wage growth assumptions to derive a range of scenarios (chart 3). In the best case the student debt repayment schedule looks like a mortgage curve, with little movement over the first half of the period followed by a sharp reduction over the second half. In many instances, however, the accumulated debt is not repaid after 30 years and it ends up being written off.

This model stands in stark contrast to most parts of Europe where student fees are negligible – in Germany tuition is free whilst French universities levy a peppercorn charge averaging €170 per year for most undergraduate programmes. They can afford to do so because the government provides a huge amount of support to higher education establishments. An international comparison is provided by OECD data which shows that as of 2017 the public sector accounted for 77% and 83% of spending on tertiary education institutions in France and Germany respectively, with the private sector providing 21% and 15%. In the UK the position is reversed with the private sector accounting for a whopping 71% and the state just 25%. Indeed, the UK’s share of funding derived from the private sector is the highest in the OECD – even higher than the US at 65%. 

Reforming the system

There are major question marks against a policy which essentially entails a transfer of risk from the public sector to the private sector but from which the public sector expects to benefit. In both the US and UK, generations of people have been told that a university education is the pathway to financial security and upward mobility but this assumption is increasingly being called into question. For one thing the cost of education has risen more rapidly than prices and wages over recent years. Since the turn of the century UK average wages have increased by 75% (annual average increase of 2.8%) but education costs, as measured by the CPI component, have risen by 290% (7%). It is thus becoming ever more expensive to gain a foot on the ladder. An associated problem is credential inflation in which workers have to attain a higher educational standard to access jobs compared to previous generations. This breeds a self-perpetuating cycle in which individuals have to pay more to buy an education for jobs which do not require the level of qualifications which they have so expensively obtained.

Reform is clearly required – a point acknowledged by the government which commissioned the Augar Review to consider changes to the system. Amongst the recommendations were:

• Reducing higher education tuition fees to £7,500 per year
• Increasing the university teaching grant to compensate for the lost revenue
• Extending the student loan repayment period from 30 years to 40 years
• Capping the overall amount of repayments on student loans to 1.2 times their loan 

In my view, there are a couple of other options worth considering: 

• Make the loan interest-free or at least change the interest rate to something closer to the market rate (e.g. targeting a markup over Bank Rate). There is no justifiable reason why the spread between the cost of government borrowing and student loans should be so high
• Offer a tax break on student debt. Students graduating with £47,000 of debt pay an additional 3% of their income towards their student loan once their salary reaches £40,000. At a salary of £60,000 the graduate tax rises to 5%. On the basis that graduates earn more than their non-university educated counterparts, the progressive nature of the tax system ensures they already pay a higher tax rate. Additional taxes eliminate a large part of the graduate earnings premium and the issue needs to be addressed (in fairness, adopting the option above would resolve it).
  

When I looked at this issue in September 2019,  I concluded that there are positive social externalities associated with higher education that ought to be encouraged. Other European countries recognise this by bearing a large part of the costs of provision. But the British system in effect allows the government a free ride on these benefits. The Covid crisis, in which the younger generation has been asked to make sacrifices to shield the older, more vulnerable, members of society has highlighted inter-generational fairness issues (particularly since anyone aged over 50 has benefited from free university tuition). It really is time that the inequalities in the funding of higher education are addressed.

Reflections in a time of Covid

A year on

Last Thursday marked the first anniversary of the World Health Organisation's classification of the Covid-19 outbreak as a pandemic. The lives of millions of people have since been put on hold as governments have been forced to lock down their economies in a bid to halt the spread of the disease. There have recently been some signs of improvement with the mortality rate across Europe significantly below its January peak as a result of renewed lockdown conditions and the acceleration of the vaccine rollout. However, daily case numbers are rising again in a number of continental European countries. They have almost doubled in Italy in the past three weeks, prompting the government to tighten restrictions, whilst in Germany the Robert Koch Institute for infectious diseases predicted that the number of daily reported cases could exceed the December peak by mid-April. The rate of decline in UK cases, which has been proceeding rapidly for the past two months, has recently slowed although there is insufficient evidence to know whether this marks a turnaround or is just a blip.

We have learned a lot about pandemics and how to manage them over the past year. The most important lesson is that lockdowns do work and in this regard the UK was slow off the mark in spring 2020. It is sobering to recollect that health experts were aware of the scale of the problem ahead of us. This edition of Question Time, the BBC’s weekly topical debate programme, from 12 March 2020 featured Professor John Ashton who delivered a withering critique of government policy and accurately predicted what was about to unfold. His efforts to highlight the extent of the disaster stood in stark contrast to the complacency of government ministers at the time. The fact that more than 125,000 people in Britain have died from Covid over the last year – the fifth highest total in the world – is testimony to policy failings. When normalised to account for the size of population, the UK’s mortality rate of 188 per 100,000 is the highest of any country with a population over 12 million (chart 1).

The more positive news is that the vaccination rollout appears to be a great success. Although Israel is well out front in terms of vaccinations delivered, the UK and US are gaining momentum (chart 2). It is sobering to recall that a year ago we were warned that it could take years for an effective vaccine to be developed. At that time the fastest any vaccine had previously been developed, from viral sampling to approval, was four years – for mumps in the 1960s. The vaccination process has not been without its controversies: Concerns persist about the effectiveness of the AstraZeneca vaccine with the most recent issues surrounding its potential side effects. In addition, there is a vaccine hoarding problem with the developed nations having bought a large supply of the world’s available stock, thereby leaving less for the poorer nations. Nonetheless, it is remarkable that such huge strides have been made in the space of just 12 months.

But we are not yet out of the woods. Lockdowns in some form or another are likely to remain in place well into April, which effectively means that economies in most parts of Europe will be operating under highly restricted conditions for up to one-third of the year. So long as concerns about new Covid variants remain a live issue, we cannot afford to be complacent with regard to the prospect of a further coronavirus wave.

Counting the economic cost

From an economic and market perspective it has been a wild ride. Last year saw the largest peacetime contractions in output in almost a century (more than 300 years in the UK case) and we cannot be confident about the pace of the rebound in 2021. In spring 2020 it was widely assumed that the contraction would be followed by a rapid recovery but a second wave of the pandemic has led to rather more muted hopes across Europe. That said, the OECD recently revised up its expectations for global growth in 2021 compared with last November with particularly rapid growth projected for China (7.8%) and the US (6.5%). Latest UK figures give some grounds for optimism, with GDP in January falling by only 2.9% versus expectations of something closer to 5%, and as a consequence it is likely that Q1 growth will turn out less bad than the 3.5% contraction currently pencilled in by the consensus (which will raise the annual growth rate, ceteris paribus).

The jury is still out as to the nature of the economic recovery. The economic shock has had implications for both the supply and demand side and the shape of the recovery will be determined by trends on both sides. Demand is likely to rebound fairly quickly, particularly given the extent of unanticipated household saving which is likely to be rapidly run down (chart 3). That said whilst spending on goods may pick up as the retail sector opens up, a lot of the spending on services which has not taken place over the last year will simply not be recouped. After all, we are unlikely to go on more holidays or make up for a year’s worth of foregone restaurant meals. It is for this reason that the damage to the supply side of the economy is hard to gauge. The future states of the airline and retail sectors are likely to be different to their pre-Covid form, whilst the leisure sector has taken a battering from which many establishments will find it difficult to recover. It is for this reason that I maintain the recovery may prove slower than a lot of projections currently suggest. 

Markets on edge

From a market perspective, in March 2020 we were about to step into the unknown – never in living memory had we experienced a global pandemic and equity markets quite simply collapsed in the face of unprecedented uncertainty. Following the actions of central banks to provide unlimited liquidity, the subsequent rebound took many by surprise – myself included. Indeed, we are now at the point where many investors believe the equity rally is overdone with the S&P500 closing last week at a record high – around 17% above the pre-pandemic high in February 2020, despite the economic collapse, and 76% above the low a year ago. This has occurred at the same time as fixed income markets have sold off as inflation concerns mount in the wake of the huge US stimulus package – a fiscal strategy which might have been better served had it been introduced last year.

It remains to be seen whether inflation fears will be realised. However, if inflation does pick up the fiscal stimulus is unlikely to be the only catalyst. Equally important – if not more so – are events in China where demographics mean that it will be increasingly difficult in future to generate big increases in output by increasing the labour contribution. To the extent that the quiescence of inflation over the last twenty years has had more to do with the expansion of low-cost global production capacity in emerging markets than anything that has happened in the industrialised world, events in China will be the key to markets in the years ahead.

One of the potential side effects of the Covid crisis is that it may serve to mask a number of secular trends that we initially ascribe to the events of the past year but are in reality due to other factors. This was the case following the bursting of the Japanese bubble economy in 1990 and the GFC of 2008-09 when a slowdown in population growth resulted in slower potential growth in the wake of the crisis, giving rise to a much slower recovery than anticipated. As we reflect on an unprecedented year, we have learned a lot about pandemics and how to combat them but we have a lot still to learn about the long-term effects on the economy and markets. There is a long way to go before we can contemplate a return to economic normality, and whatever the new normal is, I suspect it will not be like the old one.

Corporate health risks

Whilst the presentation of the government’s financial plans in many countries is often a dry affair focused on the impact of the fiscal measures on public finances, it is increasingly used as a showpiece political event in the UK as the government tries to put the rosiest possible spin on tax and spending measures. Not only does the UK budget generate a lot of commentary and analysis ahead of the event, but the sheer volume of the material released on Budget Day means that it often pays to avoid instant commentary as the full implications of the measures percolate through. The Office for Budget Responsibility’s Economic and Fiscal Outlook alone represented 222 pages of detailed analysis of the UK’s economic situation, covering everything you might want to know (and a lot that you don’t), and there is a lot more besides.

By general consent, Wednesday’s budget was a “spend now, tax later” affair in which the government plans to continue providing a significant amount of economic support in the near-term but intends to pursue a more aggressive fiscal tightening beyond 2023. Indeed, the fiscal expansion measures over the next two years are offset by a planned fiscal tightening over the following three years and by 2026 the ratio of tax revenue to GDP is projected to reach its highest since the late-1960s (chart 1). The fact that the majority of the fiscal tightening falls on tax increases rather than spending cuts is a recognition that it will be politically difficult to repeat the austerity measures that were implemented in the wake of the 2009-09 recession. Indeed, I have been pointing out for some years that planned cuts in corporate taxes were putting an unnecessary strain on the budget deficit.

The impact of raising corporate tax rates

The primary tax measure announced in the budget was a rise in corporate taxes from the current rate of 19% to 25% in 2023 which would leave it in the middle of the range of a group of 37 countries, rather than significantly below (chart 2). This flies in the face of the low tax orthodoxy espoused by successive Conservative governments over the past 40 years and represents the first increase since 1974, when it was raised from an already-high rate of 40% to an eye-watering 52%. This week’s announcement was driven by two factors. First, in its 2019 manifesto the Conservative party committed to not raising income tax, national insurance or VAT rates, leaving it with few alternatives. Second, there has been growing disquiet in recent years that efforts to slash corporate taxes meant that many companies were getting off lightly at a time when individuals were bearing the costs of austerity.

The OBR highlighted that although the tax rate has been slashed sharply over the years, the share of corporate tax receipts in GDP has fluctuated in a narrow range centred around 3%. This reflects the fact that the tax base has been widened over time, thus offsetting the revenue-dampening effects. In theory, applying higher tax rates to a wider base ought to significantly increase revenue. One concession applied to the latest package is that companies generating less than £50k per annum in profits will continue to pay a tax rate of 19% with a graduated scale applicable on profits above this limit, to a maximum of 25%. The government reckons that 70% of companies will continue to pay a rate of 19%. The fact that the remaining 30% will contribute an extra £20bn in taxes by 2026 compared to estimates made in November (an increase of 31%) suggests that larger companies will be hit hard. Fears expressed in EU circles that the UK would embark on a regime of tax competition to undercut companies in continental Europe appear to be unfounded.

But tax increases have consequences. In the first instance, companies that may be considering whether they need to continue operations in the UK after Brexit may use higher taxes as a reason to move elsewhere. In addition, curbs on corporate profitability may have adverse effects on job creation in the medium-term. Moreover, expectations of reduced future profitability will depress the capacity to pay out dividends, fund buybacks and pay down debt, not to mention reducing the net present value of corporate earnings. All of these factors might be expected to depress UK equity valuations relative to other markets. Raising taxes will, other things being equal, also reduce the capacity to fund capital investment.

Pros and cons of generous investment allowances

In order to offset the worst of the investment problem, the government unveiled a generous two-year temporary capital allowance covering the fiscal years 2021-22 and 2022-23, in which companies will be able to offset 130% of investment spending on eligible plant and machinery against profits. The evidence does suggest that such measures have a stimulatory impact on investment since they reduce the user cost of capital (the tax-adjusted marginal cost of capital). Moreover, tax incentives tend to have a bigger impact on long-lasting assets. At a time when the UK is keen to encourage the switch away from combustion-engine vehicles, which will require significant investment in the infrastructure to support the adoption of battery-powered vehicles, the tax breaks could give this particular project a big shot in the arm.

However, temporary tax breaks suffice only to shift the timing of investment projects rather than leading to a permanent increase. The OBR’s forecast indeed suggests that a big investment surge in 2022 will be followed by only a moderate increase thereafter. Between 2007 and 2016, business fixed investment increased at a paltry annual rate averaging just 1.6%. Between 2016 and 2019, in the wake of the Brexit referendum, it barely increased at all and despite the budget measures introduced last week the OBR’s projections point to growth of just 0.8% per annum between 2016 and 2025 (chart 3).

Moreover, there are particularly high levels of uncertainty at present which run the risk that efforts to stimulate investment may not have the desired effect. Incentive measures presuppose that there is a lot of investment waiting to be brought online. As MPC member Jonathan Haskel noted in a speech yesterday, “residual uncertainty and risk aversion over the recovery are likely to continue to weigh on investment,” particularly in the wake of Brexit. There is also a lot of spare capacity in the economy at present – my own estimates suggest that the output gap this year is likely to average -2.6%, narrowing to -0.7% in 2022. In addition, the tax incentives are only useful if companies generate a profit. In the post-pandemic recovery phase profitability may remain under pressure, although to mitigate this effect the government has extended the loss carry back rules which allow companies to offset past trading losses against profits.

Whilst efforts to boost investment are welcome, one of the drawbacks associated with the tax allowance is that it is aimed squarely at tangible assets but there is no incentive for investment in intangibles which is a problem in an increasingly digital economy. This may continue to act as a drag on multifactor productivity, which in the past decade has posted its slowest growth in a century, which will in turn hold back potential GDP growth. 

Last word

When asked last year whether I expected the Chancellor to announce fiscal consolidation measures in 2021, my response was “it is likely that some form of fiscal consolidation will be announced in 2021 though may not necessarily be immediately implemented.” This expectation has been borne out. It was inevitable that corporates would be asked to shoulder a bigger part of the fiscal repair bill and the government has tried to sweeten the pill by offering generous investment allowances. But the strategy does represent a risk to the health of UK PLC. Like many aspects of budgetary policy, however, we will only know the outcome many years from now.