2001: The dawn of a new revolution?

Fifteen years ago today terrorists flew two aircraft into the World Trade Center in New York, and the world has never been the same since. Although the US economy and stock market had been weakening for some time – for example, it took the NBER until November 2001 to determine that the US economy slid into recession in March 2001 – it truly marked, in my view, the point at which the 1990s boom could be said to have ended. Although on the surface the economy recovered relatively quickly, the event proved to be a traumatic national event which saw the US unleash its military might on the Middle East and profoundly changed American politics in ways which are still being felt today.

It was around the same time that we began to take much more notice of the rise of Chinese economic power. Whilst it would be wrong to suggest that the shift away from the unipolar economic world of the 1990s began this day fifteen years ago, it is easy to understand why this parallel might be drawn. Despite the efforts of Barack Obama to heal many of the wounds which were created by 9/11, Donald Trump has tapped into a surge of anger regarding the decline of the US. There is no doubt that the relative position of the US has diminished as China has ascended: In 2001, the US economy was eight times the size of China measured in simple dollar terms. By 2015 it was only 60% larger. In PPP terms, the IMF reckons that the Chinese economy is now larger than the US. However, this is a very different thing to saying that the US is in decline:  After all, the dollar value of US output has increased by 69% since 2001.

But the ordinary working man and woman have felt the squeeze. Median US household income in 2014 was reported just below $54,000, having peaked at $57,843 in 2009. Thus the purchasing power of the average household has declined by around 7% since the end of the 1990s, and in inflation-adjusted terms, this decline is even bigger. This is attributed partly to falling household size – after all, if you only have to support one person rather than two, then life has got rather better rather than worse.  It is also partly due to a rise in the number of low-skilled immigrants who populate the lower end of the income scale. But there is little doubt that in the US – as in most other parts of the industrialised world – the majority of the working population does not feel as though they have benefited from the recovery which is apparent in the headline economic statistics such as GDP or unemployment.

One factor which has contributed to this apparent slowdown is the deceleration in productivity growth. Back in 2001 the talk was of a productivity revolution, triggered by advances in ICT. Today, we worry that these advances are about to supplant labour rather than complement it. As Paul Krugman once remarked, “productivity isn't everything, but in the long run it is almost everything.” Over history, rising productivity has gone hand-in-hand with rising living standards and if it is not growing particularly rapidly, it should come as no surprise that our living standards are not progressing at the same rate as they once did. Economists continue to debate why this should be the case. It could be that many of the advances in productivity are simply not being captured properly in the data (I’ll come back to that another day) or, as Robert Gordon was pointing out back in 2001, many of our recent technological innovations do not offer the same boost to productivity as those in the past.

Either way, the last fifteen years have seen significant economic changes. These are partly the result of geo-political changes but perhaps more importantly they reflect socio-economic shifts. We may not have known it at the time, but perhaps the years around the turn of the century marked the start of a third industrial revolution driven by the dawn of the digital age. It took 60-80 years starting around 1760 for the first revolution to fully make its presence felt, whilst the period 1860-90 arguably marked the duration of the second. On the basis of past trends, we may thus only be halfway through the transition period of the third industrial revolution. For Stanley Kubrick, 2001 was the year of a space odyssey. For Americans, it marked the first significant attack on the US mainland. For future historians, it may yet go down as the start of a new era in world economics.

It’s dusk in the second age of reason …

… is a line from Ian McEwan’s latest novel “Nutshell.” As a description of the depressing state of public debate on many of the key contemporary economic and political issues, I find it very apt. Apparently I am not the only one. ‘Enough Said: What’s Gone Wrong With the Language of Politics?’ is a book by Mark Thompson, the former director-general of the BBC, in which he analyses the current state of political discourse and the way in which we conduct our debates on issues of great public importance (click here for The Guardian’s review or here for the FT’s take on it).

One of the points which Thompson makes is that the public is no longer prepared to take the word of experts on a wide range of issues, preferring instead to rely on views distilled from the vast realms of cyberspace. He argues very cogently that far from creating a forum for open discourse, the internet has instead allowed individuals to seek out like-minded people with the result that they preach to the converted and engage in closed rather than open discussions. Moreover, the constant search for clicks has resulted in ever more shallow debate and, as Andrew Rawnsley put it, “political discourse in which there is no longer any presumption of good faith between opponents.” (The irony of making these points on a personal blog has not escaped me).

It is this environment which has allowed the likes of Donald Trump to flourish – a man whose latest outburst against Mexican immigrants ("We will build a great wall along the southern border. And Mexico will pay for the wall, 100 percent. They don't know it yet, but they're going pay for the wall”) has allowed him to narrow the polling gap with Hillary Clinton. He is even ahead in the latest CNN poll. It is this environment which allowed Michael Gove during the Brexit campaign to get away with saying “people in this country have had enough of experts” and to dismiss warnings of the economic consequences of Brexit by comparing the doomsayers with German scientists in the 1930s who were paid by the government to denounce Albert Einstein (at least he did not use the word “Nazi”).

All this is just a fancy way of saying that we hear what we want to hear, and in that sense it is not exactly a new phenomenon. But bad things tend to happen when politicians fail to engage in sensible discussions. Looking at it from a policy angle, an environment in which politicians left management of the economic cycle to central banks whilst trying to persuade electorates of their fiscal rectitude contributed to the damaging round of fiscal tightening which was implemented across Europe starting around 2010. In the euro zone in particular, it was considered heresy to even talk about any form of fiscal easing. Central banks may also be considered part of the problem, since they agreed to loosen the monetary stance as governments tightened fiscal policy and thereby encouraged governments to go further than they may have otherwise (though that might seem a harsh judgement).  

But although the language of economic policy has up to now appeared restrained and rational, a divergence between words and deeds has been growing for some time. George Osborne’s efforts at expansionary fiscal contraction were a gesture in futility designed to persuade us that economic pain today would mean better living standards tomorrow. But now even the language of policy is becoming more strained as central bankers continue to try and persuade us there is more that they can do to help ease our current economic predicament, when in reality policy has run out of road. So on Thursday, when ECB President Mario Draghi stands before the assembled representatives of the press, an honest and open assessment of the current policy environment would see him throwing up his hands and saying, “We’ve done all we can on the monetary side, and in any case we’re sick of taking the brickbats for our attempts to try and keep the euro zone together. From now on, it’s up to the governments of monetary union members to try something.” It may not be popular but it would at least convince me that the age of reason is not dead.

Skirmishes in the Brexit phoney war

It is increasingly evident that Theresa May’s July comment that “Brexit means Brexit” was simply a device to buy some time over the summer in order to allow some heat to go out of the fractious debate. Today’s return of parliament following the summer recess marks the point at which the government has to get down to some hard thinking about how it wants to implement any sort of plan.

Today’s domestic highlight was the speech by Brexit minister David Davis outlining the government’s position on Brexit. I use the word “position” because plan is too grandiose a word to describe what we know so far. The key message from Davis was that it is “very improbable” that the UK will remain a member of the EU single market. This comes a day after the US and Japanese governments warned PM May, in China for the G20 summit, of the consequences of Brexit for trade and investment. The US indicated that securing a trade deal would not be a priority for the US, which is seeking to conclude negotiations with the far larger EU, whilst the Japanese government issued a 15-page report outlining the problems which Brexit could cause for Japanese firms. It pointed out that “a number of Japanese businesses, invited by the Government in  some  cases,  have  invested  actively  to  the  UK,  which  was  seen  to  be   a  gateway  to  Europe.” In other words, you invited us in and took the money we brought but you have changed the rules of the game. The thrust of the document was a plea for business conditions to remain broadly as they are now, otherwise “this could force Japanese companies to reconsider their business activities.”

It is, of course, still very early days, but the events of the weekend highlight what many us pointed out all along: first, that changing the economic rules will have consequences for UK jobs and, second,  that the rest of the world was not necessarily going to jump at the chance to negotiate a special deal with the UK. If you can do a trade deal with a market of 500 million people, it is likely to yield far bigger benefits than negotiating one with 65 million. All this throws Davis’s comments into stark relief and highlights the rock and hard place dilemma facing the government. In order to make a success of not taking part in the single market, the UK has to secure trading relationships with non-EU nations – a process which has not got off to a good start. If it proves difficult to build these relationships, the government will find that it is in its best interests to maintain closer ties with those EU countries which it just spurned than many people might find desirable.

A curious element of PM May’s speeches in China was that she ruled out the adoption of a points-based system to manage immigration flows, despite the fact that this was a key element of the Leave camp’s plan, and left her open to the charge of backsliding (though she never advocated it, so that charge seems rather spurious). She argued that they are not an effective means of controlling migrant inflows. I am less sure about that – as a means of controlling absolute inflows they have their uses. But they do have other shortcomings, as even the Australian government admits. For one thing, many of those coming in on such schemes often tend to be under-employed which drives them down the value chain to compete for unskilled jobs, and for another they allow government to dictate labour supply rather than the needs of employers.

But by torpedoing one of the key planks of a policy advocated by Boris Johnson and Nigel Farage, PM May is sending a signal that some of the simple ideas put forward by the Leavers will not be implemented. Maybe this is clever politicking designed to restrict the Brexiteer’s options in a bid to expose some of the fallacies inherent in the case for leaving the EU. It will certainly make life harder for David Davis as he puts together his plan to take the UK to the next level. However, much that we have heard so far tells us only what the government is opposed to, not what it is in favour of. Brexit may indeed mean Brexit. But it may also end up being a slogan designed to hold the Conservative party together in much the same way as David Cameron’s pledge to hold a referendum in the first place.

It was twenty years ago today ...

It dawned on me this morning that it is twenty years since I packed myself off to Germany to start a new job. Two whole decades! As I reflect on where the time has gone, and why English football is in an even worse state than it was then, I am struck by how much simpler the world economy appeared back in 1996. The world's economic power was concentrated in Europe and the US, which meant that keeping track of the fundamental issues driving markets was a relatively simple task. European monetary union remained an aspiration for policymakers whose aim was to meet the qualification targets for entry into the single currency. Central and eastern European economies were still adjusting to the post-Communist world and were early converts to go-go capitalism which promised a massive rise in living standards. In Japan, we were awaiting a recovery following the bursting of the bubble economy in 1990, whilst southern and eastern Asian economies were regarded as a dynamic, but very unsophisticated.

How times have changed. Two market booms and busts later – the most recent being the most far-reaching since the Great Depression – the position of the US as a kick-ass superpower has changed. It is still the strongest military power in the world but its economic supremacy is no longer unchallenged. European monetary union did happen as promised, but as recent events have shown, it is far from a one-way ticket to prosperity. Many of the smaller nations in southern and central Europe are struggling under the weight of the massive rise in debt accumulated during the boom; we are still awaiting a solid Japanese recovery following 25 years of stagnation and Russia looks more like the old Soviet Union than the engaged partner the west hoped it would become. But the biggest change has been in the perception of Asia, particularly China, which is reclaiming its historical importance as a big player on the world stage.

Of all the events which have taken place over the past two decades, perhaps the most emblematic was the Lehman’s bankruptcy of 2008 which marked a seismic shift in the western world. This signalled an end to the fantasy world of debt-fuelled prosperity and the dawn of a day of reckoning. No longer would we be able to build our monetary Tower of Babel all the way to Heaven (to use Jens Weidmann’s analogy). We would have to be content with a smaller place with fewer floors (or should that be flaws?). As it turned out, the foundations  of our tower were pretty rotten and even now we are still digging them out, trying to construct a more sustainable structure.

In retrospect, we should have foreseen many of the problems which hit us, but most of us did not. As Martin Wolf noted in his book, “The Shifts and the Shocks”, we “lacked the imagination to anticipate a meltdown of the Western financial system.” Perhaps that is because we had created a system which had proved pretty robust to all that had been thrown at it and we simply became complacent. But an additional reason is that we failed to understand the significance of the change in the world economic order. Ben Bernanke argued as far back as 2005 that excess saving in surplus countries such as China was a contributory factor to the boom which preceded the western bust. It is not the whole story, but it indicates that the changed dynamics of the global system meant that western economies were potentially subject to forces which they had not been designed to withstand.

So whilst it may be overstretching it to argue that the 200 year dominance over the world economy enjoyed by the west is at an end, I have long believed that the high water mark of western capitalism was reached in summer 2007. As that particular tide begins to ebb, it will become ever more apparent how important the Asian economies will be to the global economic order. The US and Europe will no longer be in a position to decide for the rest of the world.

I noted some years ago that against this backdrop, Europe will have to be more outward looking; more open to hearing the voice of the electorate in order to shape its liberal democracy to cope with the demands of a 21st century world. Policymakers will have a key role to play in this debate, balancing the need to impose adjustment against the resistance of the electorate to the radical changes which are needed. The signs are not looking propitious. The stresses imposed by the euro zone debt crisis have exposed fault lines in the design of the single currency whilst the threat of Brexit may be the thin end of a wedge which exacerbates European divisions as populism rises up the political agenda.

We can be certain only that the old certainties no longer hold and for that reason it is pointless to try and predict what will happen in the next twenty years. Suffice to say that western policymakers have a lot of work to do to ensure that we will be in a position where we can feel as positive about our future in 2036 as we were in 1996. I would like to be optimistic about where Europe is headed. But until such times as we rediscover our sense of purpose, I suspect the years ahead will be politically and economically challenging.

UK: The immigration situation

It is now commonly accepted that immigration was the single most important topic in the UK’s EU referendum. The level of vitriol generated by this aspect of the campaign shocked many foreign observers, but a look back at history shows that whilst the UK has generally been welcoming to foreigners, the issue has often generated significant controversy. I was reminded of this recently when reading  the third volume of David Kynaston’s superb social history of the UK since 1945 (Modernity Britain) in which he described, using contemporary source material, the level of conflict generated by the Notting Hill race riots of 1958. And just ten years later, when Nigel Farage was still in short trousers, senior Conservative politicians were warning of “rivers of blood” if immigration was allowed to continue unchecked.

We should bear this historical context in mind when looking at the UK’s immigration data, the latest release of which occurred last week covering the period to March 2016. At the aggregate level, net immigration in the twelve months to March totalled 327,000 – down fractionally from the 12 months to December 2015 but double the levels four years ago. Excluding flows of UK nationals, the proportion of immigration from EU countries is still less than 50% of the total, though at almost 49% it is considerably higher than six years ago. Incidentally, EU citizens generally take exception to being classified as immigrants, which has connotations of forced movement similar to what we have recently witnessed from the Middle East, and probably says a lot about the different way in which freedom of movement is perceived in other EU countries relative to the UK. A more cynical interpretation is that immigrants are looked upon as coming from “poor” countries, whereas those coming from richer countries prefer to class themselves as expats.

There has, to be sure, been a substantial increase in those coming from EU15 countries, whose numbers have more than doubled in the past decade largely due to poor employment prospects in the euro zone. The numbers arriving from the EU8 countries (including Poland) are running below 2008 levels, although Poles are now the most populous group of non-UK born residents, having overtaken those born in India. But by far and away the fastest rise in immigrant numbers has come from Bulgaria and Romania, which now account for over 16% of non-nationals arriving in the UK versus 1% in mid-2011, and which has led to a predictable surge in calls for tighter border controls.

But with more than 50% of the total numbers coming from non-EU countries, I remain at a loss to understand why leaving the EU is going to lead to a regaining of control over the UK’s borders that so many apparently seek. As I have long argued, if people have a problem with immigration numbers, they might want to question why the government has failed to control its non-EU borders rather than direct their anger at the EU. It is interesting too that the proportion of immigrants arriving in the UK for study-related reasons is 35% down on its 2010 peak. This may well reflect the fact that foreign students simply do not feel as welcome in the UK following David Cameron’s ill-advised pledge in 2010 to return immigrant numbers to the “tens of thousands.” And with reports suggesting that PM Theresa May’s government is planning a further clampdown on student visas, it is likely that we will see further declines.

People may have differing views on immigration numbers, but it is clear that the Conservatives’ policy over the past six years is proving to be self-defeating. With the government having cut funding to the university sector since 2010, higher education institutions are increasingly reliant on the higher fees that they can charge non-EU students for the privilege of studying here. But if fewer students come to the UK, this will put further pressure on university finances. The government may end up being accused of not only creating a problem but nixing attempts to find a solution.

It is understandable, perhaps, that so many people fear the consequences of unfettered immigration – it is a problem which has echoed down the years. Indeed, it represents the flip side of globalisation which has left so many people struggling to make ends meet in their own home towns. Nor should we underestimate the problems of assimilating huge numbers of migrants with the attendant consequences for local resources and the undoubted impacts on labour markets and wages. But immigration also brings benefits: How, for example, would the NHS function if it were not for the foreign medical staff who help to keep it running? And what about the contribution made by foreigners who choose to settle in the UK and make it their home? For example, the Nobel Prize won by two physicists at the University of Manchester in 2010 (Andre Geim and Konstantin Novoselov) went to men born in Russia, who may have been denied the opportunity to work here under the proposed new rules.

Cameron’s 2010 immigration pledge made him a hostage to fortune. It was a foolish thing to have said and fanned the flames of a problem which ultimately became a fire which consumed him. As his now-reviled predecessor Tony Blair once said “A simple way to take measure of a country is to look at how many want in ... And how many want out.” It is thus ironic that more British citizens are flowing out than are returning, whereas many non-Brits believe the UK is still a land of opportunity.

Interest rates: Absolute zero

The Kansas City Fed’s Jackson Hole Symposium is closely scrutinised by market watchers for any indications of changes in the Fed’s policy stance, and sure enough, most of the headlines over the weekend focused on Janet Yellen’s comment that “the case for an increase in the federal funds rate has strengthened”. But this is to overlook a lot of other interesting material which comes out during the course of the two day session. This year’s symposium was entitled “Designing Resilient Monetary Policy Frameworks for the Future” and if there was any takeaway, it is that central bankers believe they still have sufficient ammunition to provide cover for the economic recovery. It was also evident that central bankers are aware of the impact of low interest rates on the structure of the global monetary system, and that we are not going back to a pre-2007 world anytime soon. 

Marvin Goodfriend’s paper was interesting and makes the point that we should ignore the zero bound constraint on interest rates altogether, primarily because “the effectiveness of evermore quantitative monetary stimulus is questionable.” He argues that one way to facilitate an end to the lower bound constraint would be to abolish paper money and replace it with electronic money. This is not a new idea, having been kicked around since the 1930s and gaining currency (if you’ll pardon the pun) in the wake of the financial crisis. Indeed, Goodfriend’s policy prescriptions echo those made by Andy Haldane a year ago. In brief, this policy relies on central banks making it unattractive to hold cash, thus raising the incentive to hold it in an electronic account overseen by the central bank. The downside, of course, is that this reduces the control which individuals have over their own cash balances: you no longer have the choice of the bank or the mattress – it’s the central bank or nothing, which may persuade many to shift into assets such as property or gold, thus creating bubbles elsewhere.

A bigger objection to removing the lower bound on interest rates is that it has a massive distortionary impact on expectations. Will investors be willing to fund projects if the rate of return is zero or negative? Will we be prepared to continue handing over 30-40% of our earnings in tax (more in continental Europe) when we simultaneously have to invest to provide a fund for our retirement? How does the banking sector cope in a world of increasingly negative rates? Will we eventually reach a situation where customers are charged for depositing funds (actually, yes, with corporate clients in some countries already facing this problem)? For all these reasons and more, it should be evident that a prolonged period of zero or negative interest rates may lead to consequences which we cannot yet foresee and could cause major long-term economic disruption. It is one thing to try the policy on a temporary basis but when it becomes the norm, something is wrong.


Whilst I agree with Goodfriend’s point that QE is at the limit, the notion that we should abolish the lower bound should be treated as an interesting thought experiment and nothing more. The idea that central banks can continue to operate an ever looser monetary policy, but still fail to achieve their economic objectives, should act as an indication that there are deeper seated economic problems which require alternative solutions. Indeed, former Fed governor Kroszner argues that “many central banks are being asked to do things they simply can’t do. Central banks can try to fight deflation. Central banks can’t simply create growth.” Indeed, the ECB has made the point since its inception in 1999 that it cannot create the conditions for a sustainable pickup in growth on its own. Governments need to play their part with structural policies designed to raise the economy’s speed limit.

A bigger problem is that in the wake of the financial crisis, many European economies have been trying to accelerate with the brakes on. In other words, they have operated a very loose monetary policy and a tight fiscal stance. This reflects a misunderstanding about the nature of the shock which hit in 2008. Whilst this may have been understandable in the immediate wake of the crisis, we have had long enough to review the evidence to realise that the current policy mix is not delivering. It is clearly not creating stable jobs in sufficient quantities to allow economies to generate escape velocity, and as a result lots of people are taking out their frustration by voting for populist politicians. This is not the whole story: it certainly does not explain the rise of Donald Trump, but it is part of a wider narrative. We have already seen in the UK how this has panned out, but it is still not too late for other European countries to learn from this mistake. Failure to do so will have major adverse consequences for the euro zone in the years to come.

Brexit: An economist strikes back

One of the reasons for starting this blog was to counter some of the popular misconceptions associated with economics. Last week, for instance, I pointed out that although the UK economy has posted some decent data releases since the Brexit referendum, it was still too early to draw any definitive conclusions. One of the reasons for making this point was to set down a marker before the Brexiteers began sounding the all-clear. And sure enough, we were regaled with a couple of articles in the broadsheets suggesting that there really was nothing to worry about.

At least Larry Elliot's article in The Guardian acknowledged that much of the hysteria was whipped up by Project Fear (aka George Osborne) and that is still too early to be sure how things will ultimately turn out. However, it was interesting to note that the readers comments section noted overwhelmingly that the UK has not yet left the EU and maybe we should save the optimism for when we have.

But Allister Heath, writing in The Telegraph made the mistake of blaming economists for Project Fear. As Heath put it, economists "need to relearn a little humility, especially when it comes to trying to understand the impact of a gargantuan event such as Brexit ... As recently as a few days ago, something like 90 per cent believed that Armageddon was on the cards merely as a result of the Leave vote."

Now I know and like Allister, but on this one he is just wrong. Wrong, because just about all of the analysis put out by economists on this issue talked about the longer-term implications of Brexit. Broadly speaking, the consensus view is that it will lead to a decline in output of between 3% and 6%, relative to what would otherwise have happened, over a multi-year horizon. This does not mean an outright decline in output of such a magnitude. For example, if the economy grew at 1% per annum for five years rather than 2%, the former case delivers a 5% output loss over the five year horizon relative to the latter. The slower growth case does not necessarily mean that the economy suffers an outright recession but the output loss would be quite significant all the same, and we would certainly feel this in the labour market. It is also worth highlighting that most of pre-referendum analysis was predicated on the basis of the output loss after Article 50 was triggered, not after the Brexit vote.

As for learning humility, most economists I know realise that we cannot forecast the future with any degree of certainty and I am happy to admit that the only thing I know for sure about my forecasts is that they will be wrong.  But months ahead of the referendum, I made four predictions regarding the immediate market reaction in the event of a Brexit vote: (i) sterling would collapse by around 10% in the wake of the referendum; (ii) the BoE would cut interest rates; (iii) after an initial collapse, UK equity prices would rally due to the fact that a weaker pound would raise the sterling denominated value of foreign earnings and (iv) UK bond yields would rise. The only one of these which has not happened is (iv), the rest all came to pass. So we are not all completely clueless.

Simon Wren-Lewis in his blog makes the point that "the reporting of economics in a good deal of the UK press is hopelessly biased by politics." This is a view he has held for quite some time, but particularly since the press completely misrepresented the economic records of the Conservative and Labour parties during the last election. And in view of much of what has been produced on the economics of Brexit in certain sections of the media, I can understand where he is coming from.

I know as well as anyone that economists are not able to predict the future, but contrary to Heath’s assertion, we are not ideologues. Indeed we tend to be a pretty rational bunch. After all it was economists who, for their sins, came up with the concept of rational expectations. For some reason, the ideological expectations school failed to take off.