May for March

Yesterday’s speech by PM Theresa May, which outlined that the UK will begin the Article 50 proceedings no later than March 2017, left me feeling rather uneasy. It was a speech straight out of Conservative Campaign Headquarters casting, designed to give a reassuring feeling to the assembled masses at the party’s conference, but short on substance. There was a lot to be concerned about: Her statement that “The referendum result was clear” was a case in point. No one denies that the Leavers won the referendum, but it was by less than four percentage points. It was not at all “clear”, as the Leavers would agree had the result gone the other way. And unlike a parliamentary election, where you get a chance within five years to change the outcome, that is not possible on this occasion. So if there is to be a Brexit, it is absolutely vital to get it right, and I have many reservations that the government is going about it the right way. 

The prime minister also made it clear that “it is not up to the House of Commons to invoke Article Fifty, and it is not up to the House of Lords. It is up to the Government to trigger Article Fifty and the Government alone.” There are many lawyers who would dispute that, and indeed next week the High Court is due to give a ruling on this issue. May accused those who sought to challenge the referendum result of “not standing up for democracy, they’re trying to subvert it. They’re not trying to get Brexit right, they’re trying to kill it by delaying it. They are insulting the intelligence of the British people.” Some might say in response that a Leave campaign which blatantly lied about issues such as the cost of EU membership, and how the money saved could be used to fund the NHS, brought the process of democracy into disrepute in the first place. And whilst we’re at it, prime minister, your mandate as leader of the Conservative party was obtained with far fewer votes than Jeremy Corbyn when he won the Labour leadership contest. A little bit more humility regarding the nature of democracy would not go amiss. 

Even dangerous Daniel Hannan has admitted that the referendum result was so narrow that it is necessary to ensure that a peaceful coexistence can be maintained between the sides. We got no sense of inclusivity from PM May yesterday: Had she not (allegedly) been a Remain supporter, I could have sworn that we were listening to the victory speech of a prominent Brexiteer. The general tone of the speech suggested that the UK is on course for a ”hard” Brexit, a notion which May rejected: “there is no such thing as a choice between “soft Brexit” and “hard Brexit”. This line of argument … is simply a false dichotomy. And it is one that is too often propagated by people who, I am afraid to say, have still not accepted the result of the referendum … I know some people ask about the “trade-off” between controlling immigration and trading with Europe. But that is the wrong way of looking at things.” Again, we will have to agree to differ on that one. There clearly is a form of trade off, and to pretend otherwise is simply to ignore what other EU nations are telling us. 

The prime minister’s grasp of the economic realities of Brexit was, in my view, rather shaky. She suggested that “the referendum … was a vote for Britain to stand tall, to believe in ourselves, to forge an ambitious and optimistic new role in the world … And there is already abundant evidence that we will be able to do just that. Important foreign businesses – like Siemens and Apple – have committed to long-term investments in this country. With the Japanese purchase of ARM for £24 billion, we have seen the biggest-ever Asian investment in Britain. Countries including Canada, China, India, Mexico, Singapore and South Korea have already told us they would welcome talks on future free trade agreements. And we have already agreed to start scoping discussions on trade agreements with Australia and New Zealand.” 

Where do we start? How about the fact that the sale of ARM means that the intellectual capital, and the profits which flow from it, are no longer UK owned? Or that Nissan is delaying new investment in its Sunderland plant until the UK has concluded Brexit negotiations with the EU? Or that Australia has said that any trade deal will also have to wait until after the UK-EU deal is concluded? Or that there was no mention of any deal with the US?

However, May’s speech was of a piece with a lot of the statements out of Westminster in recent weeks. As one EU diplomat suggested, “she seems to be saying that regaining sovereignty is so valuable, she is willing to pay a price in terms of economic disruption.” Missing from the speech was any sense that this is a two way bargaining exercise. If the EU refuses to negotiate with the UK before Article 50 is triggered, and its demands are immediately rejected by a French or German government which is deeply involved in its own election campaign, the whole strategy falls apart. Moreover, once Article 50 is triggered, the UK loses any influence over the EU. The best we can say about the prime minister’s speech is that it was designed for domestic consumption only. It’s naïve to think that our EU partners are going to roll over and play ball and I suspect that this sunny optimism will not last beyond the first contact with Realpolitik.

Danger man Dan Hannan

More than three months since the EU vote and we are still waiting – either for the sky to fall in or for the new economic nirvana to unfold before us. But a day of reckoning is a-coming as the noises out of government suggest that a hard Brexit is the most favoured scenario for many in Westminster. This is a dangerous possibility and increasingly my concern is that those who lied their way to referendum victory will never fully be held to account.

My anger was stirred (again) after reading this profile of Daniel Hannan MEP, who is portrayed as the mastermind behind the Leave campaign. I have made the point before that Hannan's vision of a post-EU Britain is not one which the majority of Leavers voted for. Those on the front line of the campaign consistently reported that immigration was the issue which aroused most fury, but the pro-free market Hannan was motivated by the desire for a more dynamic Britain unencumbered by the constraints of an EU superstate (this clip from the BBC's flagship current affairs programme, Newsnight, on the day after the vote highlighted the difference between what Hannan thinks the electorate voted for and what the rest of us think it voted for).

I cannot help thinking that his notion is (to be charitable) a romantic ideal of what Britain once was – a dynamic economic superpower. The prosaic economist in me thinks his ideas are ludicrously naive and I would barely trust him to run a bath, let alone any form of national policy. Let us also not forget that he has worked for the European Parliament since 1999.  The hyperbolic chutzpah of someone who can accept EU taxpayers money to cover his salary whilst failing to act in the interests of the institution which he represents beggars belief (the same applies to Nigel Farage). It would be no less than justice were he to be sued by EU taxpayers for a return of his salary over the past 17 years (and will he forgo his pension?) Moreover, it is claimed in the article that he plans to leave politics in 2019 when his term in Brussels ends. That being the case, he will be another of the Brexiteers who cut and run just as the battle to determine Britain's political and economic future begins.

Hannan has been likened to the militants who infiltrated the Labour Party in the 1970s and condemned it to the political wilderness. One minister described him and his ilk as not "builders. They are destroyers." Another MP called them "grammar school imperialists", who "a hundred years ago ... would have been able to vent their rather bizarre beliefs bullying people in a nether-province of India." The respected Conservative commentator Matthew Parris noted "I don’t think he sees himself in politics to give effect to what the public thinks, but to what the public ought to think, which is quite different.”

Parris went on to argue that Hannan exploited for his own ends the xenophobic tendencies in large swathes of the electorate. Indeed, I have made this point myself (here) arguing that Hannan was careful to distance himself from any charge of xenophobia or racism. Ironically, Hannan and Farage fell out over different aspects of the Brexit debate, with Farage (a man for whose views I have no time) suggesting that Hannan's vision of a free market Britain is not one that he heard on the doorsteps during the campaign.

The extreme free market policies espoused by Hannan (who like another right wing Brexit supporter, Allister Heath, did not spend his early years in the country they want to make great again) are misguided. The logical conclusion of the policies being espoused imply a UK which will have to scrap many of the laws and social protections which have made life relatively tolerable for most. If you think George Osborne's fiscal policy was regressive, wait until you see what Hannan-style economic liberalism requires.

Politicians will be forced to adopt a position between the Scylla of minimising economic pain by allowing some form of immigration (which is Hannan's preferred position), and the Charybdis of putting up the barriers and taking the risk of a big hit as economic relationships with the EU change irrevocably. As a very interesting blog post in The Spectator pointed out, Brexit could well result in the rise of the politics of resentment. If we are no longer able to blame the EU for our ills, "there is no other ‘other’ for the populist right to turn on except immigrants. They will be blamed if Brexit brings job losses and falls in living standards."

This may be alarmist but it's plausible. And it reminds me of the words of Pastor Martin Niemöller who could have been describing the position of many Brexit voters: 

“First they came for the EU supporters, and I did not speak out -
Because I was not an EU supporter.
Then they came for the immigrants, and I did not speak out -
Because I was not an immigrant.
Then they came for me - and there was no one left to speak for me.”

The economics of Bake Off

Those of you not in the UK may wonder what the relevance of a popular BBC television programme has to do with economics, but please bear with me. The story concerns a programme called the Great British Bake Off, which has been poached by Channel 4, a rival domestic channel. Big deal, right? Yet it has commanded a lot of newspaper column inches over the past week or so, suggesting that it is an issue of cultural significance. It is also a story of great economic significance.

To recap, The Great British Bake Off is a show in which ordinary members of the public compete against one another in a baking contest. It has struck a chord with the viewing public who like the idea of a wholesome TV show with four presenters who are down to earth, generally sympathetic characters. One of the undoubted stars is its 81 year old presenter Mary Berry, who has become the nation's favourite grandmother and endeared herself to millions. In these troubled times, the show has captured the imagination of the viewing public for its sheer ordinariness.

Imagine the horror when it was announced that the independent production company which makes the show asked for more money from the BBC than it was prepared to pay. So it was picked up by its commercial rival Channel 4. However the show's three female presenters have announced that they will not go with the show when it switches channels and only one (who is male) will transfer.

Despite all the ballyhoo, it is after all just a TV show. But it demonstrates a number of features of how modern economies work. For one thing, it provides a test of the power of franchising. It is one thing for McDonalds to set up thousands of franchises in order to provide the same meal experience across the world, but does it work quite so well in services, particularly when they are personalised in the way that TV programmes are that rely on its presenters? Having lost 75% of the onscreen team, will the new programme be able to retain the same appeal? We have already had the experience here in the UK of Top Gear, a product sold around the world, which lost all of its presenters and the new team was simply unable to recreate the chemistry of the old one. In a wider context, this raises the question of whether any personalised service can be treated as just another commodity? The argument underpinning much of the UK's market economy over the past 30 years is that they can. But if you are unable to replicate exactly the same conditions under changed circumstances, what you actually have is a different product.

It is hard to put a price on star quality, but that is what we are talking about here. If we think of it in standard microeconomic terms, we can almost exactly replicate the supply curve, but not quite. Moreover, we don't know the shape of the demand curve for what is essentially a different product. Therefore even small changes in the position of the demand and supply curves could result in a vast change in the size of the audience.

There is also a potential problem in that Channel 4 may be considered an inferior good to the BBC, which may reflect some lingering snobbishness associated with commercial TV in the British psyche. Channel 4 does some things very well but it does not compete with the BBC for the same demographic. Older viewers, for example, are more likely to be irritated by the ad breaks. Or it may be that Channel 4 simply cannot match the BBC's brand name, which has after all been broadcasting since 1922, whereas Channel 4 first hit our screens in 1982. From an economics standpoint, you would have thought that Channel 4 should be paying less, rather than more for the product given that it has a smaller audience share.

Then there is the motivation of the presenters themselves. The three ladies opted to demonstrate loyalty to the BBC and not follow the show to Channel 4. But Paul Hollywood is following the money. This may reflect Hollywood's more entrepreneurial background. It may say something about the different attitude of men and women to brand loyalty (I'm out of my depth on this one). Either way, it says something about the different motivations that drive individual's economic decisions.

Above all else, what all these issues demonstrate is that there are numerous complex factors which determine whether changing the underlying conditions result in economic success. Brand loyalty above all explains why the Brits are attached to their National Health Service and are loth to see radical change. The fact that Bake Off is able to switch channels in this way is exactly the kind of free market in services that the Thatcher government strove for in the 1980s. But whether it is what the public wants, we shall let the viewing figures be the judge.

Labour pains

The announcement that Jeremy Corbyn has been re-elected as Labour Party leader here in the UK reflects the profoundly depressing state into which Western European politics has sunk. He professes to offer "a new kind of politics." In reality he is offering the same left wing ideas which were decisively rejected more than 30 years ago. Many people do indeed want a new kind of politics. But I suspect they don't want his.

Corbyn is nothing more than an idealist, which would be great if he were not the Leader of Her Majesty's Loyal Opposition charged with holding the government to account and seeking to form the next government. We know what he is against but less about what he stands for. Corbyn is opposed to the market capitalism espoused by the Conservatives and which so many people have railed against, and he taps into those who believe that the fiscal policy offered by George Osborne was brutal and regressive. Whilst it is perceived to have favoured the rich at the expense of the poorer elements of society far more than it actually did, it created the conditions for a political alternative to act as a counterbalance to try and heal some of the social divisions which it created. But nobody has a clue what sort of policies Corbyn actually advocates, and his leadership performance after one year in the job has been dreadful. Over the summer Labour MPs refused to back their leader following his dismal non-performance in the EU referendum and this was followed by the likes of Thomas Piketty, Simon Wren-Lewis and David Blanchflower, who all sat on Labour's economic advisory committee, distancing themselves from Corbyn’s team. 

In Blanchflower's words "Corbyn doesn't seem to care about being a leader of an opposition party. He seems more interested in addressing crowds of supporters around the country. It doesn’t seem to matter to him – although it should – that three-quarters of his MPs, who doubt his leadership qualities, rightly passed an overwhelming vote of no confidence against him. He should have quit. He doesn’t have enough MPs who support him to be able to form a complete shadow cabinet. Incidentally, if there were even the slightest prospect that he could become prime minister, the bond and equity markets would eat him for lunch."

It strikes me as bizarre that 313,000 of the Labour Party’s 600,000 members have chosen a leader who will almost certainly be soundly beaten in any election. If party members really  care about choosing someone who can achieve the things the party proclaims to stand for, they should at least choose a leader who has a fighting chance of winning the popular vote. When the majority of the party's MPs do not back their leader, they have no chance.

The UK’s domestic political shenanigans have not gone unnoticed abroad, and the German newspaper Die Welt notes that Labour's irrelevance is dangerous for Europe. At a time when the government is trying to negotiate an exit from the EU, the Labour Party is so self-absorbed that it is in no position to hold the government to account. When we live in a surreal world where  arch-Brexiteer Boris Johnson is the foreign secretary and he is still not the biggest incompetent in the House of Commons, you know that something is sadly wrong with the state of British politics. That said, when Beppe Grillo, an Italian comedian, can turn his Five Star movement into a national political force, you realise that the malaise runs throughout European politics.

Tony Blair may be reviled as Labour leader but he knew very well that British elections are won by capturing the political centre. As he put it, the Labour Party needs to be “the face on the placard” rather than the protester holding it for a chance in government. People in the party today "don’t really want to be in power, they want to make the people in power respond to their concerns." Until that changes Labour will not be a serious political party, they will simply be seen as a protest movement. And in the current political climate, that is very dangerous for the health of our democracy.

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.