All the way with the BoJ

The Bank of Japan is nothing if not innovative. After all, it was the BoJ which first attempted a policy of quantitative easing in 2001, which involved buying large amounts of securities in order to flood the economy with liquidity in a bid to stimulate inflation. Central bankers in the west treated Japanese QE as an interesting intellectual exercise but never really believed that they would ever have to implement it. But some eight years later the Fed and BoE were doing exactly that.

Meanwhile the BoJ has tried everything it knows to raise inflation to 2%, which was a key element in the Abenomics strategy unveiled in early 2013. The BoJ has bought huge quantities of securities and in the process has raised the central bank balance sheet to around 90% of GDP, which is more than three times that of the Fed, ECB or BoE. But buying ever more financial assets is simply not working as inflation remains stuck at extremely low rates.

So the BoJ opted this week for a different tack: Its two-pronged approach seeks to control the yield curve by holding 10-year yields at zero and allowing inflation to overshoot the 2% target. Such an approach differs from the standard QE policy in as much as it fixes the long end of the curve, rather than driving it down. Using the standard levers to control the short end allows the BoJ to steepen the yield curve, and reduce fears that driving down short rates will hurt the banking system. The idea is that the BoJ, which already has a long track record of asset purchases, only needs to tell the market that it has a 0% target and investors will fall into line without the need for a huge rise in central bank purchases. In essence, it will be a cheaper way for the BoJ to hold interest rates down, and if it is successful in stimulating inflation, will push down real interest rates and thereby give real activity a lift. The idea of overshooting the inflation target relies on the argument that more inflation tolerance will be necessary in order to move expectations to be consistent with achieving the 2% target in the first place.

But central banks have long avoided trying to control the longer end of the yield curve, arguing that it is difficult to do so and introduces distortions into asset markets as they seek to fix the benchmark risk-free rate. Indeed, if the market decides to test the BoJ’s resolve, it may end up having to buy a lot more paper than under the current QE policy (which, by the way, will continue to run in parallel). There are other serious flaws in the strategy: The commitment to fixing the 10-year yield means that in the event of a bond market sell-off which prompts a global rise in yields, the BoJ is required to continue expanding its (already large) balance sheet indefinitely. Some analysts have pointed out that the BoJ is relinquishing control of real interest rates whilst policy becomes highly pro-cyclical. For example, if there is a negative demand shock that raises demand for JGBs (i.e. yields fall) and depresses inflation expectations, the BoJ will reduce the amount of JGBs it buys whilst falling inflation expectations put upward pressure on real rates. All in all, given the BoJ’s failure to achieve its policy objectives over the past 20 years, scepticism remains high that this policy will be no more successful than the others.

We also now run the risk of straying into the area of debt monetisation. Balance sheet expansion of the form implied by QE is meant to involve a temporary expansion of the central bank’s asset holdings. The theory is that they are run down over time, otherwise the central bank merely holds assets until such times as they mature and hands the proceeds back to the government. Nowhere are central banks talking about running down balance sheets. In theory, if the BoJ is forced to sell bonds in order to hold nominal yields at zero, this could be one side effect, but the presumption is that balance sheets should rise rather than fall. Continued balance sheet expansion creates all sorts of problems because (a) it raises governmental moral hazard risks and (b) in theory could unleash much more serious inflationary pressures than central banks are aiming for.

Whilst the BoJ’s QE policy in 2001 was an experiment which was copied by other central banks some years later, I seriously hope this is one lesson we don’t copy in Europe (for one thing debt monetisation is prohibited in the euro zone). It looks like a policy of desperation: if flooding markets with liquidity cannot stimulate inflation, I cannot see how yield curve control will. Boosting liquidity leads to higher inflation when it is transformed into the purchase of goods and services. In an ageing society like Japan, where people are content to sit on their money balances, greater liquidity provision will not prove to be the inflation stimulant which the BoJ seeks. I have long maintained that efforts to get Japanese inflation back to 2% without some help from global conditions will not work and I remain sceptical that these measures will do the trick either.

A world turned upside down

An asset manager recently told me that their fund has turned away clients on the grounds that they will not be able to guarantee investor returns in this low interest rate environment. As if that was not surprising enough, the fund was promptly swamped with money because clients respected the fund manager’s honesty, and obviously believed that they were a fit and proper person to manage their wealth.

This first thing this illustrates is the difficulty of generating any form of interest income in the developed world – a problem which is only going to get more acute in the coming years as increasing numbers of baby boomers retire and find that their pensions are worth a lot less than they expected. The BoE shows no sign of concern that low interest rates are a problem for savers. Last month, chief economist Andy Haldane indicated that he sympathised with savers “but jobs must come first.” Michael Saunders, the latest recruit to the BoE Monetary Policy Committee, recently noted that “If we thought the adverse side effects of monetary policy easing outweighed the potential boost, then our willingness to use the tool of easing … would be much less … I do not think we are at that tipping point, but that is something we have to be constantly on the alert for.”

In my view this is a complacent assessment of the problems we face. At its most basic, the point of reducing interest rates to ultra-low levels is to bring forward future consumption to the present. As a result, part of consumption activity which would otherwise take place in the future has simply been brought forward in time.  But if you have half an eye on retirement, it will be difficult to convince today’s consumers to spend income now rather than put it away for the future. Indeed, most modern macro models impose a lifetime budget constraint on consumers. And in a low inflation, low interest rate environment that constraint bites hard. Arguably, perhaps, one of the reasons that Japan’s low interest rate policy failed to generate a recovery in the 1990s and 2000s was because in an ageing society, consumers were looking further ahead than the BoJ. Maybe Saunders is right that we are not yet at the tipping point. But we may be a lot closer than many policymakers seem to believe.

The other point the anecdote illustrates is that savvy investors prefer the truth to spin. If an adviser tells me to find other ways to save rather than giving it to them, I am going to find them generally more trustworthy than someone who is going to spin me a line. It is heartening to know that there are honest people out there in finance and that they are doing what the regulator asks of them (I never doubted it: Pretty much all the people I know in finance are honest, but it’s the cheats who make better newspaper headlines). Traditionally in the city, a broker’s word was their bond and if they broke it, their reputation was on the line. But in the world of short-term trading, the incentives to cheat were sufficiently high that a small number of people were tempted to do so, on the basis that they could retire on the proceeds of one lucrative trade. That is less true today. And it was never really true of money management, where fund managers tended to be better rewarded the longer their track record. However, today’s world, where customers flock to those managers who cannot  guarantee above-average returns, is one which has truly turned upside down.

On (Hinkley) Point

As I suspected would be the case, the UK government last week went ahead with its plan to approve the Hinkley Point nuclear power station. I touched on some of the cost issues back in August. But what I find interesting is that no-one is talking about the demand-supply balance in the electricity market. UK electricity consumption, for example, declined by 13% between 2005 and 2015, with industrial demand down 21% and domestic demand falling by 14%, despite all those new gadgets which are now such a feature of our homes. One reason for this is that EU legislation requiring us to install low energy lighting has had a significant impact on reducing consumption (the pesky EU!). Interestingly, domestic output has fallen even faster (by 15%) and imports now make up 6% of consumption, compared with 2% a decade ago.

The collapse in demand is not just a UK phenomenon – it is evident in Germany too, on roughly the same scale. So why do we need such a costly new power station, particularly since we can get a lot of our energy from renewables? One reason is that the UK has to replace its ageing nuclear capacity and is also committed to phasing out coal-fired stations by the middle of the next decade, so it does need to bring new capacity onstream. Why not from renewables? One answer is that sources such as wind and solar cannot be guaranteed to provide the steady baseload which industrialised societies need.

Germany, for example, which has massively ramped up its renewables capacity over the last decade has experienced periods when there is so much electricity coming onstream from wind sources that other sources have to curb output in order to prevent the grid from overloading. This also means great peaks and troughs in wholesale prices, which play havoc with the planning decisions of utility companies. Moreover, the German government is granting huge subsidies to green energy, but has not been successful in reducing carbon dioxide emissions because at those times when green sources cannot meet demand, the grid has to turn to coal-fired stations.

The argument often used by environmental groups that the planned output of Hinkley could be met by building four large offshore wind farms is arithmetically correct, but it is unlikely to operate at the same efficiency and would thus not be able to meet baseload demand. It is thus illustrative to look back at the British experience with nuclear generation plans to see that much of the over-optimism which accompanied plans for nuclear expansion in the 1970s is being rehashed today. Thirty to forty years ago, the CEGB (which was then responsible for the UK’s electricity output) argued that many of the overruns in completing nuclear plants on time, which was responsible for so much of the cost overrun, could have been avoided if the UK had bought the US pressurised water reactor rather than developing its own. The PWR has always been dogged by safety concerns (Three Mile Island, anyone?). And plans for the European PWR, expected to be used at Hinkley, are experiencing similar concerns. One of the suppliers at EDF’s facility in Flamanville in Normandy, has already informed the French nuclear inspectorate that anomalies have been detected in the nuclear reactor vessel, resulting in “lower than expected mechanical toughness values.”

Such issues contribute to the cost problems associated with nuclear generation. In 1967, the CEGB argued that nuclear could deliver energy for as little as 0.48p/KWh. By 1979 that estimate had more doubled. Today, EDF is being guaranteed a minimum of 9.25p/KWh – roughly double the current wholesale price. One reason for the substantial markup is to allow for the almost inevitable cost overruns: EDF’s Flamanville facility is already six years and three times over budget.

Then there is the issue of importing and disposing of the fuel used in the process. Security of supply used to be one of the main considerations determining whether to choose between coal and nuclear. With no large scale coal mining now occurring in the UK, this has dropped off the agenda as most solid fuel now has to be imported (the UK currently imports most of the uranium used in power generation from Australia). Getting rid of spent fuel is more problematic: High level waste is stored for 50 years at the Sellafield plant in north-west England and it is planned to be deposited in a deep mined geological facility. Unfortunately, no suitable site for such a facility has yet been found. We may enjoy the benefits of Hinkley Point’s electricity today (or more likely tomorrow) but it is future generations which will have to work out what to do with the waste.

What a state

This week’s State of the Union address by European Commission President Juncker contained an admission that the EU faces an existential crisis. As he put it, “it is as if there is almost no intersection between the EU and its national capitals anymore.” Whatever people may think of Juncker – and there are many who do not hold him in high regard – his analysis of what ails Europe was spot on. His comment that “we Europeans can never accept Polish workers being harassed, beaten up or even murdered on the streets of Harlow” was a justified dig at the apparent rise in xenophobia and racism on the streets of Britain in the wake of the EU referendum, where figures show a significant increase of late.

Yet I could not help thinking that his plan of action was an appeal to the high minded ideals which drove the EU forward in better times, with its calls for solidarity and tolerance, rather than any significant change in direction. Whilst I am convinced of the ideals which Juncker espoused, there are many millions who are not, and I am not sure that he devoted enough thought to the issue of why people are not buying into his ideal. Part of the problem stems from the fact that many nations have little time for the political union aspects of the project, and see it more as an economic enterprise. That is certainly true of the Brits and is probably also true of the 13 nations which joined after 2004. And I would argue that economics is the EU’s weak spot.

Even today, the EU spends almost 40% of its budget on agriculture. Admittedly that is a long way short of the 73% in 1985, but it has been a consistent source of annoyance to countries such as the UK which have a much more efficient farming sector than many other EU nations. The good news is that the EU is reducing its real outlays on this sector but I am not convinced that it is an industry which deserves the priority which Juncker gave it in his speech. More worrying is that free movement of labour is a policy whose implications were not fully thought through. It was the issue at the heart of the UK referendum campaign and it is not too far from the surface in countries such as France.

Moreover, the EU has also not fully got to grips with taxation policy. Indeed, it has invested huge amounts of political capital in the single currency project, yet allows individual countries to set their own tax levels without any form of transfer equalisation. This resulted in the bizarre situation whereby Ireland, which had engaged in a form of corporate tax competition, effectively declared insolvency in 2010 and had to rely on other EMU members for a bailout on punitive terms. The madness of EU tax policy was compounded by the European Commission's recent decision to force Apple to pay €13bn of back taxes to the Irish government, which neither asked for nor wants the money. As Juncker put it, “The level of taxation in a country like Ireland is not our issue. Ireland has the sovereign right to set the tax level wherever it wants. But it is not right that one company can evade taxes that could have gone to Irish families and businesses, hospitals and schools.” That is one view. Nigel Farage put it differently: “if you think the EU’s Apple judgement was bad, you ain’t seen nothing yet.  When the EU destroys your corporate tax regime, you will realise, you are better off out of the EU’s failing political union.”

But the EU’s biggest failing is its failure to understand that in its current incarnation, the single currency is fundamentally flawed. According to Juncker, “Being European, for most of us, also means the euro. During the global financial crisis, the euro stayed strong and protected us from even worse instability.” Really? I suspect the Greeks might think differently given that their economy is in not merely suffering a recession but depression. A weaker currency would actually help alleviate some of the strains facing some of the EU nations (fortunately, the ECB recognises this). But Juncker was right about one thing: “Mario Draghi … is making a stronger contribution to jobs and growth than many of our Member States.”

I regret the UK’s decision to leave the EU. But in the face of an existential crisis which is seeing the bloc split into three distinct regions (northern, southern and eastern for ease of geographical exposition), each with its own issues, we are going to need more than warm words to get all members pulling in the right direction.

With friends like these ...

I realise that Brexit-related posts are mounting up on this blog, but the Leavers provide such good ammunition to undermine their own case that it is a subject too hard to resist. The latest gaffe came in the form of recent derogatory comments by Trade Secretary, Liam Fox, who suggested that business leaders do not work hard enough. These are certainly not the most helpful comments ever to come from a government minister – let alone one tasked with boosting UK trade at this sensitive time.

According to Fox, at what he thought was an off-the-record drinks party, “this country is not the free-trading nation it once was. We have become too lazy, and too fat on our successes in previous generations … Companies who could be contributing to our national prosperity - but choose not to because it might be too difficult or too time-consuming or because they can't play golf on a Friday afternoon - we've got to be saying to them if you want to share in the prosperity of our country you have a duty to contribute to the prosperity of our country.”

Businesses can be accused of many things but I would never level a charge of laziness. As for “too lazy and too fat”, British businesses are operating in one of the most competitive markets in Europe, with the OECD pointing out that labour market regulation is the lowest in the EU and product market deregulation is second only to the Netherlands. Successful businesses in the UK have to work very hard to be successful against that backdrop. Not surprisingly the comments did not go down too well with large parts of the business community. Richard Reed, founder of Innocent Smoothies and a leading figure in the Remain campaign, hit back by saying that Fox had “never done a day’s work in business in his life” and “How dare he talk down a country that he has damaged?”

Indeed, with Fox having been a prominent Brexit campaigner, at odds with large swathes of the business community, his remarks threaten to undermine relations between business and certain elements of government. The comments were not supported by 10 Downing Street. Nor indeed were David Davis’s comments last week suggesting that it is “very improbable” that the UK will remain a member of the EU single market.  I still have not worked out whether government ministers are deliberately talking at cross purposes or whether it is all part of Theresa May’s master plan to undermine the credibility of pro-Brexit MPs.

Furthermore, Fox’s comments highlight a gross fallacy at the heart of the Brexit campaign. Recall that many Leavers argued that it was the EU’s bureaucracy that was holding back the UK. But now that the post-EU future may not be as easy to negotiate as many of them argued, there appears to be an attempt to pin the blame on corporate UK as the Leavers get their retaliation in first. I have long pointed out that it would always be difficult to secure the trade deals with the rest of the world that the Leavers promised. This view was reiterated last week by Sir Andrew Cahn, former chief executive of UK Trade and Investment, who pointed out that Fox’s claims the UK would have a network of deals in place by the time it left the EU were “highly unrealistic.” Sir Andrew noted that “trade deals are unsentimental instruments of real world economic and political reality. The more economic weight you have the better deal you get.” In the grand scheme of things the UK is a small to medium-sized open economy. Any trade deals we do get will thus be on terms which are favourable to the bigger players such as the EU, the US and China.

The letters page of The Times yesterday was full of comments regarding Fox’s remarks, noting variously that “Dr Fox’s comments on exporters would carry more weight if the government’s policies backed them … Not only were Dr Fox’s comments ill-considered, they were unhelpful … I have spent my life exporting British-made products [and] I am incensed by his ill-chosen remarks … his support of Brexit has not done exporters any favours. Dr Fox needs to offer constructive help to the business world.“ That is the voice of business. With friends like Fox, who needs enemies?

Another one bites the dust

The news today that David Cameron is to stand down with immediate effect as an MP probably should not surprise me. He gambled on the Brexit vote, lost, stood down as prime minister and has nothing left to achieve in domestic political terms. But I was immediately transported back to his final day as PM on 13 July when he was asked by former Chancellor Ken Clarke, now a backbench MP, whether he will “still be an active participant in this House as it faces a large number of problems over the next few years?” Cameron replied, “I will watch these exchanges from the Back Benches.” So we’ll take that as a “yes” then?

However, as James Kirkup pointed out in the Telegraph, “he fought the EU referendum campaign promising not to quit if he lost, then quit when he lost.” In fact, Kirkup’s article sums up pretty well, I thought, the issues surrounding Cameron’s premiership. “Flouncing out of Parliament in this way is so telling: it speaks to something fundamental about Mr Cameron's character and his approach to politics: a lack of seriousness, the absence of real commitment.  Yes, he wanted the job and yes he put the hours in, to the cost of his family. But he would never die in a ditch for his political beliefs … It was always enough to get by, to do just enough to get the top grade and do better than the rest [although] Mr Cameron's just-good-enough performance was, in fact, pretty good, and probably better than any of the others who might have done his job at the time. Yet that lack of commitment, the sense that he never anything more than a gentleman amateur trying his hand at governing out of a combination of duty, boredom and vanity will stay with him when the histories are written.”

In some ways, perhaps, Cameron was a throwback to an earlier political age, the era of the gentleman amateur. And at a time when we criticise our politicians for being too professional and for not having had experience outside politics before entering parliament, it may seem hypocritical to criticise Cameron for not being cut from this cloth. But running away from a problem of his own making really takes the biscuit. It is one thing to quit as PM but then to disappear from politics altogether because he does not want to be seen as a “distraction” simply does not wash. In his view “leaving parliament is the right thing to do.” In what way, exactly? Although Johnson, Gove and Farage were the arsonists in chief who set the Brexit fire alight, let’s not forget that it was Cameron who supplied them with the matches. This was a problem of his creation and he owes it to the country he claims to love to help fix it.

As Cameron heads for the political exit, questions will continue to be raised about his political legacy. But in order to answer this question forces us to ask what he stood for in the first place. He came to office in 2010 promising to detoxify the Conservative brand. Arguably, he made matters worse. After conceding in 2006 that the party had alienated voters by "banging on" about Europe, he reaped the whirlwind with his Brexit promise. Promises to build a “Big Society,” designed to “generate, develop and showcase new ideas to help people to come together in their neighbourhoods to do good things” were quietly dropped. His Chancellor’s austerity policy, which Cameron failed to rein in, did the Tories more harm than good and efforts to devolve regional government are being scaled back by Theresa May’s government.

As I have suggested previously – and as James Kirkup’s article indicates – Cameron at his best was a very effective political performer. But he was always a more effective tactician than strategist and once the tactics on the EU referendum went wrong, the game was up. Prior to the 2009 election, former BoE Governor Mervyn King privately criticised Cameron and George Osborne for their lack of experience and tendency to think about issues only in terms of their electoral impact. As both men fade into political history, it is hard not to think that Cameron’s government will go down as one in which the winning of small victories was more important than getting the bigger picture right. Following his Bloomberg speech in January 2013 I concluded that it was difficult to avoid the view that Cameron was playing fast and loose with the national interest for uncertain political gains. For that, he deserves to be judged harshly.

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.