Rethinking low interest rates

Over the years, prevailing economic orthodoxy has tended to follow fashions with policy makers pursuing a particular course of action only to subsequently switch tack and repudiate what has gone before. Very few people today believe that fixed exchange rates are a good idea (unless you happen to be in the euro zone where the rates of member countries have been fixed against each other for more than 20 years). Quaint ideas such as targeting money supply have also fallen from favour. Even the notion of using fiscal policy as a countercyclical tool, which was banished from the lexicon in the 1980s (apart from a brief reappraisal in 2008-09), is now part of the policy armoury. I thus wonder how long it will be before central bankers revisit the question of whether low interest rates do as much harm as good.

It has long been my view that central banks around the world made a policy error in not normalising monetary policy more swiftly in the wake of the 2008 crash. Although the contraction of global liquidity in the wake of the Lehman’s bankruptcy warranted a massive monetary response, there were few good reasons to justify why monetary conditions in 2012 were required to be quite as easy as those prevailing at a time of financial Armageddon. The Riksbank was one of the few brave enough to begin a tightening cycle in 2010 but the Swedish economy was caught in the backwash of euro zone turbulence and the central bank was forced to cut rates even below post-Lehman’s levels. I have often suspected that this policy about-turn deterred other central banks from making similar moves ahead of the Fed or ECB.

This is not to say that global interest rates needed to go back to pre-2008 levels. Factors such as demographics and the sharp slowdown in productivity growth justify a lower equilibrium real rate. However, one of the things economists warned about was that holding rates too low reduced the scope for conventional monetary easing in the event of an exogenous shock. That shock duly arrived in the form of the Covid pandemic and given the limited scope for rate cuts, central banks were forced to swell their balance sheets to unprecedented levels. This has opened up a whole can of worms. On the one hand it has sparked inflation fears whilst on the other it has led to significant market distortions, pushing up both bond and equity markets.

The inflation issue

Dealing first with inflation, this is a subject which has been at the top of the agenda throughout this year with the US 10-year yield hitting a 12-month high of 1.74% in March versus 0.91% at the end of 2020. At his annual shareholders meeting at the weekend, Warren Buffett warned that “we are seeing very substantial inflation.” Joe Biden’s huge US fiscal expansion plans have further raised concerns that the economy may overheat and Treasury Secretary Janet Yellen’s suggestion that “it may be interest rates will have to rise somewhat to make sure that our economy doesn’t overheat” sent ripples through equity markets which have been driven to record highs on the back of ultra-expansionary monetary policy.

However, we may be overestimating the link between monetary policy and inflation. The academic literature is unambiguous that there has been a change in the inflation process over the past 20 years. There is less agreement on whether that represents a weakening of the link between inflation and activity growth or whether the decline in inflation volatility is due a reduction in the volatility of economic shocks. In my view the former explanation counts for more in a world in which the rise of China as a major production centre has changed the dynamics of the global economy. That being the case, central bank actions in the industrialised world have played less of a role in driving down inflation than they like to believe. Accordingly, they may have less power to prevent any significant acceleration. Furthermore, if the link between inflation and the economy is less well defined than many suppose, it is harder to justify low interest rates on the basis of low inflation.

Are prolonged ultra-low rates even effective?

Whether inflation does or does not accelerate is not the focus of debate here. The bigger concern is that central banks appear fixated only on inflation as a measure of determining whether interest rates are at appropriate levels whilst ignoring a number of other factors. Indeed whilst central banks are right to take their inflation mandate seriously, there are a number of downsides associated with an ultra-easy monetary policy.

Starting with the bigger question, how sensitive are industrialised economies to interest rates anyway? My own modelling work always came to the conclusion that the UK was never particularly sensitive to interest rate moves. More detailed academic work by Claudio Borio and Boris Hofmann at the BIS suggested that monetary policy tends to be less effective in periods of ultra-low interest rates. They noted further that “there is also evidence that lower rates have a diminishing impact on consumption and the supply of credit.” Two reasons were given for this: (i) the conditions which prompted a cut in rates to the lower bound in the first place (a balance sheet recession) generate economic headwinds which make recovery more difficult and (ii) the impact of low rates on banks’ profits and credit supply generate feedback effects which impede recovery. We only need ponder the Japanese experience of the past 20 years to realise there may be something in this.

The market impact

Although the economy in the industrialised world has not boomed in the last decade, equity markets clearly have with the Shiller 10-year trailing P/E measure on the S&P500 last month trading at a 20-year high of 36.6x. Prior to the March 2020 collapse I did note that the prevailing level of 31x pointed to a market that was too expensive but we are now at the second highest levels in history (chart below) – lower than in 1998-2001 but above 1929 levels.

This in turn raises a question whether central banks have a duty to take account of financial asset prices in their monetary policy deliberations. Former Fed Chairman Greenspan used to take the view that we could not spot a market bubble until it had burst and that the role of monetary policy was to mop up after the fact. That view no longer holds since we can clearly identify that US markets are in bubble territory. To the extent that central banks are increasingly responsible for financial stability it is incumbent upon them to ensure that the banks which they monitor will not be adversely impacted by a market correction. In fairness, banks are subject to regular and rigorous stress tests and central banks are confident that capital buffers are sufficiently large to withstand a major market shock.

However, the gains from high asset valuations generally accrue to high income households which has distributional consequences for the economy. Central banks can rightly argue that this is not part of their mandate and is therefore not something they have to worry about. But to the extent that governments, which set the mandate, do care about distribution there is a case for central banks to at least think about this problem before it is forced upon them. Then of course there is the ongoing problem of what low interest rates do to savers, particularly those with an eye on retirement – a problem I have highlighted on numerous occasions. Most people do the bulk of their retirement saving in the last ten years before they leave the workplace – precisely the time when they are advised to reduce equity holdings and overweight their pension portfolio towards fixed income. Pension annuity rates remain nailed to the floor in this low interest rate environment (chart below) which means that retirees get a much smaller payout for any given pension pot than they did in the past. Low rates clearly have generational consequences.

Last word

I am not advocating that central banks should imminently raise interest rates. Indeed any such move is only likely to occur well into the future. But in a post-Covid environment where fiscal policy is likely to be much looser than in the wake of the GFC, there will be less need for monetary policy to do most of the heavy lifting. This should at least stimulate a proper debate about the pros and cons of ultra-low (and in some cases negative) interest rates which has been lacking over the past decade.

Is anybody happy?

My original intention in writing this post was to look at the trials and tribulations in British politics as allegations of financial impropriety raise major question marks against the conduct of senior politicians which in turn has stirred a major debate about standards in public life. This is a theme to which I may yet return but I realised that this political split reflects a much deeper social schism and one which is not merely confined to the UK. Ultimately the issue is whether the economic system is working for the majority of voters or is it a system which is rigged in favour of political insiders. Simply put: Are electorates happy, and if not why not?

Measuring the mood

It is very difficult to put one’s finger on the national mood and measure the extent to which society is at peace with itself. Indicators such as consumer sentiment do not really do the trick for although they capture economic well-being, society can still be restive even when the economic indicators appear strong (and vice versa). In the 1970s and 1980s economists popularised the misery index (the sum of the inflation and unemployment rate) to try and provide a link between economic and social well-being but this has fallen out of favour in recent years as both inflation and unemployment have fallen. Ironically the US misery index during Donald Trump’s term of office posted the lowest average of any president in the post-1945 era. But as the Capitol demonstrations indicated in January, US society is far from being at ease with itself.

In recent years, economists and statisticians have attempted to broaden their measurement of well-being beyond looking at GDP growth, unemployment or inflation. One of the limitations of these standard measures is that they take no account of distributive aspects which have become an important agenda item since the GFC of 2008-09 and which were given additional prominence by the work of Thomas Piketty. Indeed, the perception that the benefits of economic recovery over the past decade have accrued to an economic elite (the haves) at the expense of the rest (the have-nots) was one of the driving forces behind the election of populists such as Trump and Bolsonaro, and was very much at play during the Brexit referendum in 2016.

An alternative to using GDP which has become popular in the academic literature is the Genuine Progress Indicator (GPI). This attempts to measure economic welfare and differs from GDP in as much as GPI attempts to distinguish between welfare enhancing and welfare-reducing activities whereas GDP simply assigns a positive monetary value to all activity irrespective of its social welfare impact. GPI starts with the national accounts measure of consumer spending and adjusts for a range of 24 factors including income distribution and environmental costs, and also accounts for negative activities like crime and pollution.

It is far from perfect; for example, it is not a measure of sustainability, therefore activity which adds to social welfare today but which subtracts from it in future is still classified as a positive addition to GPI. Nor does it capture all types of social benefit; for example, it omits factors such as political freedom which can substantially add to social welfare. Nonetheless, it is a useful first attempt to account for welfare issues and is vastly superior in this regard to GDP. One of the great ironies is that a study conducted almost a decade ago[1] concluded that the quality of life in Britain based on the GPI reached a peak in the 1970s – a period which politicians have told generations of voters was actually one of great economic hardship.

Another problem with what we might call indicators of material well-being is that they are not necessarily correlated with quality of life indicators. Precisely because quality of life measures are highly subjective, with different people assigning different weights to the same factor, it is not easy to devise an aggregate measure of well-being. However, the OECD has created a website which allows users to create their own index based on three indicators of material prosperity and eight quality of life measures. The results can be broken down into detailed geographical regions and those based on participants in three global cities are shown in the chart above. It is interesting that the most important factors for Berlin and London are broadly similar, with safety a top priority in both cases but across the Atlantic in Washington DC, survey respondents prioritised income.

Whilst the idea of creating an index on a snazzy, easy to use website may look like a fluffy exercise in optics, the results are far from trivial. If society is to repair some of the divisions which have been allowed to fester over recent years it is important to understand what factors are important to people and how well their objectives are being met. The results of the OECD analysis suggest that a government which places its focus in improving the quality of health outcomes or social safety will do well in Europe but US governments have to prioritise policies which deliver strong incomes.

Energising younger voters will be crucial

All this was brought into focus by an article in the FT by the always excellent Sarah O’Connor who looked at the challenges facing younger people in the wake of the pandemic. The article references a global survey which the FT conducted of those aged under 35 which canvassed the opinions of 1700 people (the results are summarised in the chart below). Two issues particularly stood out from the reader comments: the cost of housing and the burden posed by student debt (a topic I looked at here). One survey respondent noted that “most people my age are paddling so hard just to stay still … and many are losing faith in the system.” Another commented “it feels as if “we are drowning in insecurity with no help in sight.”

The political angle to all this is that western governments have for many years prioritised average income, as represented by GDP, at the expense of distributional issues. In the Anglo Saxon world, governments have slashed taxes for the wealthy over the past four decades, which has allowed the rich to become richer whilst the middle earners have been squeezed and those at the bottom have done extremely badly as the welfare safety net is eroded. The perception of extremely wealthy capitalists rubbing shoulders with politicians at venues like Davos has contributed to the sense – real or imagined – that public service is increasingly a licence to make money. The likes of Tony Blair and Gerhard Schröder, for example, became very wealthy after they left office by taking on a variety of different jobs.

Moreover, it is a well-worn political “fact” that older voters are more likely to head to the polling booths than younger ones. Accordingly the economic and political system is biased towards older voters for it is their votes that keep politicians in office. However today’s younger generation will be tomorrow’s mature voters but it appears they have little incentive to engage with the system as it stands today. Stories of rows amongst government ministers and the chummy relationships between senior politicians and private sector companies do nothing to persuade young voters in particular that the system has anything to offer them. The post-Covid response will demand politicians engage with the electorate in a different way to that of recent decades in order to tackle issues of importance to a new generation of voters, such as climate change and securing long-term prosperity. On the basis of recent events in the UK, politicians seem to be making little headway on this front.

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[1] Kubiszewski, I., R. Costanza, C. Franco, R. Lawn, J. Talberth, T. Jackson, and C. Aylmer (2013) ‘Beyond GDP: Measuring and achieving global genuine progress,’ Ecological Economics, 93, 57-68

 

The not-so-super league

Regular readers will know that I have a long-standing interest in football (or soccer as American readers know it), partly driven by the extent to which it is an area ripe for economic analysis. The recent attempt by 12 of Europe’s top football clubs to join the breakaway European Super League (ESL) in opposition to the Champions League is thus a fascinating topic, as well as a major sporting/cultural issue. As I started writing this piece the news came through that all six of the English clubs which signed up have pulled out with two Spanish clubs reportedly considering following suit. The project thus seems destined to collapse - a conclusion I came to in my original (non-published) post. But by shining a light on the reasons for the collapse we can illuminate more clearly some important aspects of the economics of football.

The project has been heavily criticised for a number of reasons – the most common being that it reflects greed on the part of the owners who wish to maximise their income irrespective of the consequences for grassroots football (including the women’s game which is now gaining traction across Europe). It is indeed notable that no German clubs signed up, which may have a lot to do with the ownership structure (the 50+1 rule which gives fans majority voting rights). Support for the ESL appears to be confined to the board room as players past and present, football administrators from across the continent and, most importantly, fans lined up to condemn the idea. Obviously UEFA was not pleased that some of the continent’s best-known clubs are planning an alternative to its money-spinning Champions League competition and threatened the imposition of retaliatory sanctions. But there are a lot of issues at play here, not to mention a nice line in hypocrisy from many of those in football who have suddenly discovered an interest in the welfare of fans.

The financial angle

Looking first at the finances of the G12 (or the dirty dozen), 11 of them occupy the top 14 places in the annual Deloitte’s Football Money League revenue ranking (the 12^th is AC Milan which occupies 30^th spot). But according to Swiss Ramble (one of the best commentators on European football finances), the G12 made a financial loss of £1.2 billion (€1.05 billion) in season 2019-20 before player sales were taken into account. He also calculates that they owe a “staggering” €7.4 billion of debt (chart) on €5.59 of revenue (my calculations), implying a debt-to-income ratio of 132%. On that basis it is not difficult to understand why they are keen to take part in a competition which increases their revenue stream, particularly in the wake of Covid which has had a dramatic effect on finances.

But whilst the elite clubs have the option of being able to join a super league which protects their revenue stream, most do not and the enforced absence of spectators since March 2020 has had a major impact on their revenues. Even before Covid struck, the finances of English Premier League (EPL) teams were shaky. The top teams in England have generated a huge rise in income over the last 30 years thanks to the money pumped in by TV companies keen to secure the broadcasting rights. Some of this has been used to fund the construction of more modern stadiums fit for the 21^st century but to a large extent it has ended up in the pockets of players with wages making up an average of 65% of clubs’ income.

The finances of teams lower down the pyramid have not kept pace as the gap between the rich and poor continues to widen. We should not kid ourselves that top-level football is an altruistic institution with clubs at the top looking out for those lower down the scale. In 2019 Bury FC, one of the oldest professional clubs in England, was forced into bankruptcy over a debt of less than £2 million. The two EPL clubs closest to Bury, Manchester United and Manchester City, have a combined weekly wage bill of over £6 million. Indeed, for all the outrage generated by the EPL over the breakaway league, we should not forget that the EPL itself was formed in 1992 as a breakaway from the Football League (the administrator of league football in England) to allow clubs to maximise revenue from the sale of TV rights and sponsorship arrangements. As I noted in this post, its record on financial probity is spotty and it cannot be said to be looking after the interests of fans.

Business or sport?

The advent of the ESL is perhaps an inevitable consequence of allowing the big clubs to grab an ever larger slice of the pie. This prescient film clip from 1994 accurately foreshadowed the consequences for the sport of allowing TV to call the shots, with participants in the documentary predicting with uncanny accuracy how little the voice of the fans would count in the brave new footballing world (although the extent of fans’ discontent did clearly convince club owners that the ESL was a step too far).

Football is not a conventional business and it is therefore difficult to ascribe standard business practices. I have long characterised football as operating in an imperfect oligopolistic market in which the products are differentiated by branding and where there are significant barriers to entry. Matters are made more complex by the fact that it is a product which has global appeal but is rooted in domestic structures. This makes valuing the ESL a difficult prospect. However, I would argue that the owners of elite clubs have miscalculated the value of their brand and arguably they do not understand the underpinnings of their industry.

This is reinforced by the findings of Peter Sloane, one of the pioneers in the economics of football who has been studying the area since the early-1970s. In a paper published in 2015[1] he noted that there are significant differences in the conduct of North American and European team sports management: “While it is assumed by most protagonists in North America that clubs attempt to maximise profits, in Europe the most common assumption is the maximisation of playing success subject to a break-even constraint.” Sloane went on to point out that “North American leagues are closed to new entrants through the granting of exclusive territorial rights, though with allowance for some franchise mobility, whereas in Europe leagues are open to entry through a system of promotion and relegation.” It is notable that three of the English clubs signing up to the ESL are owned by Americans and arguably they made a mistake by applying the American model in the wrong setting.

Sloane touches on another interesting point: Although there may appear to be little solidarity between clubs in the same league, “mutual inter-dependence is generally regarded as a sine qua non of professional sporting leagues.” An inherent paradox of competition is that while clubs strive for playing success at the expense of the opposition, they each have an interest in the survival of rivals as they require healthy teams to play against. A revenue sharing structure, rather than a profit maximising model, best ensures this by ensuring that smaller clubs can receive additional revenue to buy better players in order to improve their performance, thereby raising the quality of the product. Although the ESL model does allow for revenue sharing, it only does so for elite clubs already in the clique. The uncertainty of result required to ensure continued consumer interest is correspondingly reduced. Accordingly, a successful league can best be described as a joint venture between the administrative body which sets the overarching competitive framework and the clubs which operate as independent entities within it. Changing this fragile balance will lead to system failure.

The future

The attempt to form the ESL is not the first time that big clubs have tried to increase their revenue at the expense of smaller clubs and it is unlikely to be the last. As I have pointed out before, if football is allowed to be conducted along casino capitalism lines with light-touch self-regulation it is inevitable that the more powerful will try to assert their market power. In its 2019 election manifesto, the Conservative Party promised to “set up a fan-led review of football governance, which will include consideration of the Owners and Directors Test.” There have also been calls to set up an independent regulator to oversee governance of the sport although past performance suggests that they generally tend to be toothless bodies.

However, football finances do clearly need to be overhauled. Some of the lessons football can learn from US team sports are the introduction of wage caps, restrictions on transfer fees and restrictions on stock market flotation. There is also a case for limiting the amount of debt that clubs are able to carry. Over the last 30 years football has failed to reform itself. Maybe it is time to impose reform upon it.

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[1] Sloane (2015) ‘The Economics of Professional Football Revisited’, Scottish Journal of Political Economy 62(1), 1-7 (available here as a download)

The jury is still out

The topic of Brexit has figured prominently on this blog over the last five years but in recent months I have resisted the temptation to look at it, primarily because there was not enough information to make an informed assessment of how much impact it was having on the economy. But more than 100 days after the UK left the safety net provided by the EU transitional arrangements, and with key data for the first two months of the year now in, it may be time to look once again at where we stand.

Trade: The story is still unfolding

It was always to be expected that trade would take a significant hit in early-2021 following the late signing of the EU deal on 24 December 2020 which meant that companies had little time to adapt to the new trade rules. Accordingly, the collapse in trade with the EU in January came as no surprise, with exports falling by 42% and imports by 30%. The question was always how quickly it would rebound in February. This week’s trade data release provided us with an answer. UK exports to the EU in February jumped by 47% versus January whilst imports increased 8%. In other words, a large proportion – but not all – of the January export collapse has been reversed but imports remain well short. Nonetheless, exports are still around 7% below levels prevailing in the second half of 2020 whereas imports are running almost 15% lower.

But this does not provide a definitive answer to the trade impact. There was clear evidence of stockpiling in late 2020 which means that companies may be running down inventories before picking up imports again. This may be one reason why imports from the EU have not rebounded very quickly. It is notable, however, that there was a sharp jump in imports from non-EU countries in February (+26%) which may be a first indication of import substitution away from EU sources although we should be wary of over-interpreting one month’s worth of data. We should also bear in mind that although full border controls have applied on British goods going to the EU since 1 January, goods coming in the other direction have benefited from a grace period.  The UK originally planned to impose regulatory checks from 1 April but recently announced it would now only do so from October 2021 in recognition of the fact that customs systems and port infrastructure are still not ready. Accordingly, we may not be able to determine the full trade impact of Brexit on UK trade flows until the end of the year. 

Northern Ireland: Contradictions unresolved

However, the contradictions inherent in the Brexit deal regarding Northern Ireland are becoming more evident by the week. During the Brexit negotiations both the UK and EU made it clear that they wanted to adhere to the Good Friday Agreement and avoid the imposition of a hard border in Ireland. But the UK’s decision to leave the EU single market meant it was inevitable there would have to be a border somewhere. Theresa May rejected the option of a border between GB and the EU running through the Irish Sea as unacceptable since it would effectively slice Northern Ireland away from mainland Britain. Unfortunately, the deal that her government agreed with the EU was not acceptable to the British parliament since the UK would have remained in a common customs territory with the EU until such times as alternative arrangements could be made. Many Conservative MPs (including Boris Johnson) refused to back this plan arguing that it would indefinitely bind the UK and the EU together since the UK would be unable to unilaterally break away.

Boris Johnson’s government subsequently renegotiated the Northern Ireland Protocol (NIP) leading to an agreement whereby the whole of the UK left the EU Customs Union, but Northern Ireland adopted EU Single Market regulations on goods and thus remained an entry point into the EU market. Whilst this avoided the imposition of a border on the island of Ireland it did introduce one in the Irish Sea, despite the fact that Johnson said last summer that such an outcome would only occur "over my dead body."

There has been a considerable amount of political fallout in recent weeks, highlighted by a significant degree of violence on the streets of Belfast. This has been attributed in large part to dissatisfaction within the loyalist community towards the provisions of the NIP as it fears a permanent separation from the mainland. It was always the case that the May government’s deal was the least-worst option since it preserved the integrity of the UK and minimised the frictions in cross border trade. It was opposed for ideological reasons by large parts of the Conservative Party which wanted a clean break from the EU. Ironically, MPs from the DUP, who between 2017 and 2019 provided parliamentary support to the minority Tory government, also voted against it. Their fear was that if Northern Ireland remained bound by single market regulations (as May’s plan envisaged) this would eventually lead to the imposition of an Irish Sea border. They also voted against the Johnson government’s plan for precisely the same reasons but following the 2019 election they were no longer in a position to demand concessions from the Conservatives and they ended up with the outcome they had feared. The people of Northern Ireland have been let down by their politicians.

There have recently been efforts to rewrite the history of the Northern Irish border problem. An article in the Daily Telegraph earlier this week was headed “Northern Ireland is paying the price for Theresa May's negotiating blunders” whilst an article published in the Daily Mail blamed the “spiteful” EU. None of this stands up to scrutiny. The problems stem from the construction of the deal signed by the UK government which has spent five years attempting to resolve the unresolvable of where to locate the border without actually putting one in place. Not that this matters to the electorate on the mainland where the majority of those believing the Brexit vote was a mistake has narrowed in recent weeks (chart 2). However this is heavily influenced by the EU’s poor performance on the vaccine rollout and will undoubtedly change again in the months ahead. Nor is it a cause for concern to Westminster politicians who, as I noted in 2019, knowingly sold the DUP down the river.

An ongoing process

I have long pointed out that Johnson’s 2019 election slogan to “get Brexit done” was disingenuous and that the process of normalising relationships between the UK and EU would take considerable time. Accordingly, the UK and EU are currently engaged in discussions on how to resolve the problems in Northern Ireland. Negotiations are also still ongoing with regard to the future of financial services although on 26 March the Treasury did confirm that technical discussions on the text of the promised Memorandum of Understanding have successfully concluded.

But it is simply too early to tell what effect Brexit is having on the UK economy which continues to suffer under the fallout from the Covid-induced collapse. According to research by John Springford at the CER, trade in February was 5% below what might have been expected had the UK not left the single market. Knowing what I do about the method he used to make this calculation we should treat this with a pinch of salt, but it does sound plausible. Nonetheless, businesses are reporting that the main challenge for companies exporting and importing is the increased administrative burden. This confirms my view that the business impact will be a boiled frog problem – it will take time for firms to realise just how much damage has been done. They will naturally adjust and probably even get used to the inconvenience but compared with the counterfactual of pre-Brexit admin, the costs to the overall economy will mount up over time.

Much of the heat and passion has gone out of the Brexit debate. Now it is up to its proponents to demonstrate that it will improve the lives of those in whose name the whole exercise was conducted. We might have to wait a long time!