Farewell Danny Gabay

They say that economists are accountants without the personality. That is clearly not something anyone can say about Danny Gabay, who died in May at the tender age of 47. Such was his standing in the London economics community that the turnout at tonight's memorial celebration to commemorate his life and works attracted many of the great and the good from the field of economics, journalism and policy making.

I can't claim to have known Danny well, but whenever we did cross paths he was always engaging, forthright and fearless in his commitment to rigorous and original thinking, as well as being wickedly funny. Those qualities shone through in the many tributes which were paid to him by friends and colleagues. Danny and his colleagues at Fathom Consulting always tried to keep policy makers on their toes, by posing questions which many were perhaps reluctant to ask. He was relentless in his pursuit of questions to which there were no easy answers. But, as he would undoubtedly have said, that does not mean we should not ask them. In that sense, Danny and his colleagues provided a useful sounding board for ideas that needed to be aired but somehow never found a forum, and hopefully Fathom will keep up the good work.

Danny hated consensus thinking and was never afraid to form a minority of one in the hope, maybe the expectation, that the rest of the world would come to see things his way. That he is no longer with us is unfortunate enough, but it is doubly so that he passed away before the criticisms levelled by the likes of Michael Gove during the Brexit campaign. They would undoubtedly have raised his intellectual hackles as well as offending his cultural sensibilities, and a full-throated Gabay retort would have been worth waiting for. Danny was unique amongst economists I have known. He was described by one friend as living for the intellectual fight, and at a time when the reputation of economists has been battered by their role in the Brexit debate, he would have relished the opportunity to take to the barricades. So I’ll raise a glass to Danny Gabay – a policy response of which he would most certainly have approved – and remember his maxim that economists owe it to themselves and to the society of which we are a part, to go on asking awkward questions. Even if politicians don’t like it!

Lies, damned lies and GDP: Part 2

Andy Haldane, the BoE’s chief economist, always produces speeches which are worth a read and his latest, entitled Whose Recovery? is no exception.  Although the UK has been one of the fastest growing G7 economies over the past couple of years, Haldane makes the point that not everyone has felt the benefit of these apparent gains and that “aggregate activity measures are sometimes a poor proxy for the average person’s income.“ Indeed, since GDP measures the sum of all activity in the economy, its performance is boosted by a rise in labour input. Depending how we measure it, GDP per head in 2015 was either 0.1% higher than its 2007 peak (based on total population) or 3.5% higher (based on economically active people aged 16-64). Either way, both illustrate a sharp slowdown in income (output) per head relative to pre-crisis growth rates. The simple GDP per head of population measure posted average annual growth of 2.4% over the period 1980-2007 whilst the age-adjusted activity measure grew at a 2.0% annual rate.

This clearly illustrates that productivity growth must have slowed, and we will leave a discussion of this for another time, but it demonstrates why productivity is so important in generating a rise in living standards and why GDP figures can be misleading. Moreover, the aggregate picture glosses over significant regional differences in output per head, and as Haldane notes “only in London and the South-East is GDP per head in 2015 estimated to be above its pre-crisis peak.” You will need no reminding that London voted overwhelmingly in favour of remaining in the EU on 23 June (although the rest of the south east did not). Perhaps this is one reason why the narrative of a strong UK recovery which would be jeopardised by Brexit did not wash in large parts of the country, as many people asked themselves the same question posed by Andy Haldane: Whose recovery?

It is thus evident that another in the long list of problems with GDP as a measure of wellbeing is that it is an aggregative measure which takes no account of distributive factors. Ironically, much of the evidence on income distribution suggests that the greatest widening of inequality took place in the second half of the 1980s, with a further leg up over 1997-2002, but it has since remained stable and actually come down a little in the past five years. But obviously not enough for a large section of the population to feel that they are getting a big enough slice of the pie.

As I noted in my previous post, GDP is a much used and much abused statistic. There is definitely something wrong with GDP as a measure of welfare if it assigns a positive value to pollution-emitting activities today whilst efforts to clear it up tomorrow will similarly be assigned a positive value. Surely a better measure of net social benefit would be to offset the two. It is for reasons such as this that statistical authorities are placing more emphasis on measuring things such as national wellbeing, which is an area where the ONS in the UK has done a lot of work lately. There is clearly a strong argument for economists to raise their eyes to a wider horizon. But the fact remains that it is still so much easier to measure the physical output of things, and to pretend that we have a handle on the output of services, which is why we continue to focus our attention on GDP statistics.

When discussing the use and abuse of economic statistics I am reminded of the old story of the drunken man who is found by a policeman scrabbling under a streetlight. “What are you doing down there?” asks the policeman. “I am looking for my keys,” says the drunk. After five minutes fruitless searching the puzzled policeman asks, “Are you sure you lost your keys here?” “No,” replies the drunk pointing to the darkness on the other side of the street, “I lost them over there, but the light is so much better here.” I suppose the moral of the story for economists is always carry a decent torch capable of shining a light on the statistics.

Lies, damned lies and GDP: Part 1

Gross domestic product is both one of the most useful and most useless of economic statistics. It is undoubtedly one of the most versatile, capable of simultaneously measuring the value of economic output, income and expenditure. But this versatility can also be a weakness, rendering it open to abuse by the unscrupulous.

GDP is used as a benchmark to gauge economic progress and is closely watched by politicians, policy makers and economists. If it is rising rapidly, so the thinking goes, so too must incomes and output which implies a rise in wellbeing. Well that, at least, is the theory. In essence, GDP applies monetary value to economic activities. It excludes activities for which people are unpaid (e.g. voluntary work) or domestic activities for which no monetary transactions are recorded (which is why it has tended to underestimate the contribution of work done by women, especially in the home). GDP was originally derived from a wartime need to measure the output of physical things, but as the service sector accounts for an increasingly greater proportion of output, so the shortcomings in the original concept have become even more pronounced. This is a problem which statisticians have struggled with for many years, but it has become increasingly challenging of late.

The release last week of Irish GDP data provided a case in point. The previous data release in March, indicated that the economy grew at a rate of 7.8% in real terms in 2015. But updated figures now suggest that Ireland grew at a rate of 26.3% last year (see chart). To put that into context, it would take an economy growing at a "normal" rate of 2% per annum more than 11 years to record a gain of that order of magnitude. The Central Statistics Office noted that this was due to the availability of “more complete and up to date data than … available … in March 2016.” 

Measuring Irish GDP (EUR, million)

Source: CSO

To the extent that GDP measures the value (or volume) of activity within a country’s borders we have to subtract the value of activity attributable to foreign companies based in Ireland which gives us a measure of gross national product (GNP). Real Irish GNP grew less rapidly than real GDP last year but it still recorded a sizeable gain of 18.7%. What this indicates is that companies have relocated to Ireland to benefit from its low rate of corporate tax, with the result that all of their assets are transferred to Ireland’s capital stock and the returns to those assets (a flow variable) are included in GDP/GNP. In addition to the relocation of corporate assets, the figures also include a range of one-off factors such as aircraft purchases and corporate restructuring activities. For confidentiality reasons, the statistical authorities are reluctant to give full details which has led to analysts having to fill in a large number of gaps to guess which companies are responsible for these moves. 

This illustrates a problem which bedevils the construction of national accounts data: Shifting definitions and retrospective revisions mean that the data can be extremely volatile. This in turn is a result of the fact that estimates of what we think of as the "true" data are often based on incomplete information.This is true for all countries. After all economies such as Italy, Greece and Nigeria have posted huge increases in output in recent years as a result of new information coming to light (sometimes as a result of the arbitrary inclusion of estimates of shadow activity). But the rigorous application of global rules governing the construction of national accounts, which tend to have relatively small impacts on larger economies, can have unwarranted (and unintended) consequences for smaller economies.

Clearly, we have come a long way from the original purposes of measuring widgets. Moreover, recent Irish changes have major consequences for the wider economy. At a stroke, Irish residents are significantly better off with GDP per head of population now almost €9,000 higher than we thought last week. But the reality is that they have no more money in their wallets (or bank accounts). Moreover to the extent that contributions to the EU budget are based on national incomes, Irish taxpayers are now on the hook for additional payments to the EU. Unless the additional output can be taxed to fund this payment – which it almost certainly will not – this implies that Irish taxpayers will be called upon to find the extra funds. It may only amount to an extra €60 per head per annum but that is roughly 11 pints of Guinness which each Irish person will have to forego. And all because the statisticians have determined that the economy is bigger than anyone thought.

Mostly ARMless

I am not exactly sure what to make of the bid by Japanese company SoftBank for ARM Holdings, one of the few British tech successes of recent years. Indeed, the chips made by ARM are in devices across the world from smartphones to tablets. Whilst ARM is a reasonably sized UK company, with revenues of around $1.5bn and profits close to $500 million, which puts it just outside the top 20 largest British firms, it is a tiddler in global terms. For example, AstraZeneca – the last big British company to be involved in politically sensitive takeover negotiations – generates revenues of around $25bn, whilst a serious tech giant such as Google makes $75bn in revenue and net profits of $16bn.

What sets it apart is its strategic importance. The company has a 95% market share in the smartphone market and as the Internet of Things takes off, the kinds of processors which the company makes will be in high demand. Although the new Chancellor Philip Hammond insists it is a demonstration that 'Britain has lost none of its allure to international investors’, it flies in the face of the speech made last week by prime minister Theresa May who argued strongly that the government would be less keen on seeing strategically important businesses sold off to 'transient' foreign investors.

One of the founders of ARM has expressed regret that the future of the company will be decided in Japan rather than in Britain. As an economist, I ought not to care, although in these increasingly difficult geopolitical times the idea of a business world without borders is no longer as attractive or realistic as it appeared a few years ago. Perhaps more importantly, the profits made by the company will flow back to Japan thus exacerbating the UK's current account deficit, which is already one of the highest in the OECD. Regret has also been expressed in tech circles that yet again another national champion has been sold off, which will stymie European efforts to build companies to compete with the Silicon valley giants. But the company belongs to its shareholders and if they decide to cash in on a very generous offer, who can blame them?

Although the weakness of sterling in the wake of Brexit has made assets such as ARM cheaper in yen terms, the surge in the share price in pounds has gone up at an even faster rate. Thus, by last Friday ARM’s share price in yen terms was 3.5% higher than on 23 June. Moreover, SoftBank paid a premium of 43% relative to Friday’s close and a multiple of 60x 2016 earnings – way above the FTSE’s already-high average of 38x. It was almost too good an opportunity for shareholders to turn down, although it could yet be derailed by a counterbid or indeed by direct government intervention.

Undoubtedly, the issue will raise concerns about the UK’s willingness to sell out important businesses to foreign investors. But so long as the UK continues to operate an industrial policy in which companies have a duty only to their shareholders, and in which they are encouraged to take decisions on purely financial terms, we will undoubtedly see more deals such as these. This is all the more true as the collapse of the pound since the EU referendum reduces the costs of buying into the UK. It also boosts the revenue of those companies (such as ARM) which derive the bulk of their revenue from overseas, which will increase their attractiveness, and explains why the prices of those companies with a high degree of exposure to the EU have outperformed. Of course, it would be hugely ironic if the Brexit-induced collapse in sterling leads to more foreign takeovers, thus weakening the case of  those who thought that this was a chance to revitalise the economy in the interests of the British people.

When "I don't know" is the right answer

One of the questions most frequently posed of me as an economist is “what will happen to …” where the object in question is the currency, interest rates, house prices or any other variable you might like to nominate. My stock answer to this question is that if I possessed such clairvoyant knowledge, I would use it to become rich. But I don’t and I’m not. So how have we become the business world’s equivalent of Cassandra?

Modern economic forecasting originates from the pioneering work of Lawrence Klein and others in the late-1940s and 1950s, whose work in macro modelling and forecasting appeared to have successfully cracked the problem of how to predict swings in the economic cycle. As computing power improved, the models became more complex, and the technocratic approach to planning which was increasingly adopted from the 1960s onwards resulted in a huge increase in demand amongst government and business for detailed analysis of future prospects. The fact that such models suffered spectacular forecasting failures during the 1970s and 1980s did not stop economists from pontificating on the future. Even today, organisations like the OECD, IMF and European Commission devote considerable resources to their forecasting units; numerous private sector forecast outfits continue to make a comfortable living by selling projections to their clients and every self-respecting financial institution provides an economic forecast.

The pot is often further stirred by a media which has a fascination for pinning down economists for their views on a diverse range of subjects, most of which we cannot possibly have had time to analyse properly and we end up instead with a sound bite which can often backfire spectacularly. One of my own favourite quotes, which I use to demonstrate the limits of economic forecasting comes from the great American economist Irving Fisher, who, days before the crash of 1929 opined in the New York Times that “stock prices have reached what looks like a permanently high plateau.” He is, of course, not alone. None of us has perfect foresight and every economist who has ever made a forecast knows that reality can bite hard.

I was first awakened to the idea of probabilistic forecasting some 25 years ago after reading Stephen Hawking’s classic book A Brief History of Time. Hawking explained how “quantum mechanics does not predict a single definite result for an observation. Instead it predicts a number of possible outcomes and tells us how likely each of these is.” It sounded like an ideal way to present economic forecasts, and the Bank of England was one of the first institutions to formalise such analysis in the form of a fan chart which assigns probabilities to the likelihood that variables will fall within a particular range.

The chart below shows the range of outcomes which the BoE assigned to its May 2016 inflation forecast, with the cone-shape depicting the range of outcomes that would be expected to occur with 90% probability. The darkest shaded area around the centre of the chart represents the outcome which the BoE would expect with a 30% probability and the lighter shaded areas represent a wider range of outcomes which encompass an even higher likelihood of occurring. But the higher the probability you attach to an inflation outcome, the less precise you can be about what the inflation rate will be. In effect this is akin to Heisenberg’s uncertainty principle which states that “the greater the degree of precision assigned to the position of a particle, the less precisely its momentum can be known (and vice versa).” To say that in three years’ time, you would assign a 90% probability to the likelihood that inflation will be between 0% and 5% may not be the kind of analysis which people will pay good money for, but it is a far more accurate representation of our ability to see into the future.

The BoE’s inflation forecast fan chart, May 2016

Source: Bank of England

The events of recent weeks should by now have awakened us all to the limits of our forecasting prowess. Most rational analysts believed that Brexit was the least likely outcome, but now that the referendum result is known we are all trying to figure out what it means for the economy. Consensus forecasts suggest that UK GDP growth in 2016 and 2017 will come in around 1.6% and 0.7% respectively, versus 2.0% and 2.2% before the referendum. This accords with pre-referendum analysis indicating that the economy would suffer an outcome loss of around 2% in the event of Brexit, relative to what would otherwise would have occurred. But as we learned in the wake of the Lehman’s crisis, economic forecasts made right after big shocks can turn out to be highly inaccurate. 

In truth, we do not really know how the economy will fare over the next two years. If we are honest, we do not know whether Brexit will actually take place at all, particularly in the wake of Theresa May’s recent suggestion that she “won’t be triggering Article 50 until I think that we have a UK approach and objectives for negotiations.” It is not a 100% probability event, and I continue to hold the view that on the basis of current evidence, it’s a 60% event. That view will continue to change as more information becomes available. Those who ask economists to make black-and-white predictions regarding complex events such as these should be met with the response “I don’t know” or at least add the rider “… with any degree of certainty.” That of course is not what we get paid for. So either we adhere to the Mark Twain view that it is better to be thought a fool and stay quiet than open our mouths and prove it beyond doubt, or we should adopt the Heisenberg doctrine that “an expert is someone who knows some of the worst mistakes that can be made in his subject, and how to avoid them.” Perhaps by reminding our interlocutors that if our answers are wrong, it may be as much to do with the nature of their question.