Mad world

Ahead of Theresa May’s long-awaited speech outlining the nature of the Brexit deal which the UK government wants, the past few days have seen a certain amount of poker playing. I was somewhat discomfited by remarks by Chancellor Philip Hammond to the German press over the weekend, who suggested to Welt am Sonntag that although “most of us who had voted remain would like the UK to remain a recognisably European-style economy with European-style taxation systems, European-style regulation systems etc …  if we are forced to be something different, then we will have to become something different.”

In response to a request to clarify his remarks, he noted “we could be forced to change our economic model, and we will have to change our model to regain competitiveness. And you can be sure we will do whatever we have to do. The British people are not going to lie down and say ‘too bad, we’ve been wounded’. We will change our model and we will come back, and we will be competitively engaged.”

That sounds like a threat to engage in tax competition with the EU in the event that the UK does not get the deal it wants. I know I should not be surprised by chancellors who demonstrate their economic illiteracy in public – he would not be the first after all – but this argument does not work on so many levels. First, days ahead of Theresa May’s speech, it does not strike me as a sensible policy to antagonise one of the key negotiating partners, let alone one whom the British government hopes will be sympathetic to its aims. Not surprisingly, EU politicians did not react very favourably. The new Dutch Labour party leader, Lodewijk Asscher, has already suggested that The Netherlands will block any EU trade deal with the UK unless it signs up to tough tax avoidance regulations preventing it from becoming an attractive offshore haven for multinationals.

What I found particularly interesting, however, were the below the line comments from German online newspaper readers who offered a more balanced view of the pros and cons of the Brexit debate than I get from most British newspapers. At the risk of over-simplifying the views, there is a large constituency which understands why the Brits have had enough yet also believes that the UK government is behaving irrationally. And there is also a large group which says “go if you must. It’s a pity but that is your choice and you will have to live with the consequences.”

From a domestic British perspective, Hammond’s comments make little sense. For one thing, UK policy over the past seven years has been to eliminate the fiscal deficit. Further cutting taxes is not exactly a clever way to further that aim. Moreover, the average working man (and woman) will not benefit from lower taxes. Hammond is talking about cutting corporate taxes. Reducing the tax burden on corporates – precisely the group which has been in the firing line in recent years for not paying their share of tax – does not sound as though the will of the people is being taken into account on this issue. Indeed, to the extent that at least part of the Brexit vote was triggered as a reaction to the impact of globalisation on UK regions outside the south east, a policy of attracting footloose international capital means more rather than less dependence on globalisation.

Unless the government is simply prepared to ignore the domestic fiscal constraint, cutting corporate taxes means either taxes will have to rise in other areas, or spending will have to be reduced further. And this at a time when the National Health Service is widely reported as creaking at the seams due to an ageing population, which will require additional resources to be spent simply to maintain the current level of service. We all know by now that we cannot expect Scandinavian-style public services if we are prepared only to pay US tax rates. But Hammond has simply taken a leaf out of his predecessor’s book by claiming that what the UK needs is more of the Thatcherite medicine which involves cutting taxes, public services and privatising state resources. However, as with any medicine, the more you take, the more it loses its potency. I would very much like to see some alternative policy prescriptions.

And as if matters were not bad enough, the UK’s Brexit vote has been endorsed by none other than Donald Trump – the model of policy consistency destined to end the week as US President. If Trump does what he says and cuts the UK some slack in getting a trade deal with the US, it would be a step forward. But given his problems with NAFTA, which is of great benefit to US manufacturers, why should he care about the UK?

To quote the Tears for Fears song, “I find it kinda funny, I find it kinda sad/ The dreams in which I'm dying are the best I've ever had/ I find it hard to tell you, I find it hard to take/ When people run in circles it's a very very/ Mad world”

Crisis? What crisis?

David Miles, former Bank of England MPC member and now professor of economics at Imperial College, this week issued a clear rebuttal (here) of Andy Haldane’s charge that economics is in “crisis” (here). Miles makes the point very bluntly: “If existing economic theory told us that such events should be predictable, then maybe there is a crisis. But it is obvious that economics says no such thing … In fact, to the extent that economics says anything about the timing of such events it is that they are virtually impossible to predict; impossible to predict, but most definitely not impossible events.” 

He then goes on to point out that basic economics, in which organisations act in their own best interests, explained perfectly well why the financial crisis happened. In a world in which banks knew that they would face only a limited liability for the losses they created, and where the tax system favoured debt over equity, they had every incentive to increase their leverage. He also reminded us that there is a whole literature on market failure and that economists have won the highest academic honours for “exploring the ways in which free market outcomes can sometimes generate poor results.”

Indeed, when you think about it, the record of economists in predicting economic shocks is no worse than that of seismologists in predicting earthquakes. There are various warning indicators which signal that an earthquake may be imminent but scientists cannot pinpoint accurately when they will happen, and certainly not months or years in advance. Or, as Miles put it, “any criticism of “economics” that rests on its failure to predict the crisis is no more plausible than the idea that statistical theory needs to be rewritten because mathematicians have a poor record at predicting winning lottery ticket numbers.”

As I have noted on numerous previous occasions, economics is not a predictive discipline so we are forced to do the best we can in order to meet the demand for predictions of future economic activity. And unfortunately, despite the best efforts of former UK Chancellor Gordon Brown to abolish boom and bust, we are faced with the problem of simultaneously trying to predict the amplitude and frequency of an economic cycle which is not regular. It can shift abruptly, which leads to structural breaks in our model-based forecasts. If there is a “crisis” in economics it is that too much mainstream policy analysis focuses on the central case outcome, which becomes a binary choice as to whether the forecast in question was attained. This raises a question of whether a forecast for 2% GDP growth in any given year is “wrong” if it turns out to be 2.2%. It is a pointless exercise to strive for that sort of precision, which raises the question of how far away we are allowed to be from the central case before our prediction is deemed “wrong”. 

In fairness the likes of the BoE have long maintained that it is the distribution of risks around the central case which is important (and many others are now catching on). By defining the probability distribution around the central case we then have some idea of the plausible range of outcomes. But we have to accept that economics cannot predict the point at which the steady state switches from one condition to another, in much the same way that quantum physicists cannot determine with any precision the degree to which certain pairs of physical properties of a particle can be known. In other words, we cannot forecast structural shifts.

But one of the things that economics can do is to figure out how behaviour will change once the structural shift has occurred. Forecasters may not have incorporated the crash of 2008 into their central case (I will expound on some of the reasons why on another occasion) but expectations adjusted quite quickly thereafter. It was treated as a structural break with profound consequences for near-term growth, and consensus GDP growth numbers were revised down sharply thereafter, as indeed were expectations for central bank policy rates. Seismologists may not always be able to predict when the earthquake will strike but they know what the consequences will be when they do

Setting the right incentives for high flyers

I have always thought that the word “incentivise” is one of the more unnecessary words in the English language as it takes a perfectly ordinary noun and transforms it into an ugly verb. Call me old fashioned, but I always thought that incentives were designed to motivate people to behave in particular ways. The verb “incentivise” first made an appearance in the US in 1968 but it did not gain currency on this side of the Atlantic until the early 1990s. Indeed, its entry into everyday language in the UK coincided with a shift to a more market-oriented economy in the post-Thatcher era. Aside from linguistic considerations, the study of incentives is one of the most important areas in economics. Setting the correct incentives to ensure the desired outcomes is crucial.

Incentives can either take a monetary or non-monetary form. Monetary incentives are well understood – people often get paid a bonus for hitting their targets, which in the case of company executives can run into the millions. But a common problem in all organisations is that people may prefer to pursue their own interest instead of the firm’s common goals which potentially leads to a conflict of interest. One resolution to this problem is to align the interests of the firm and the workers by appealing to their intellectual engagement. For example, Google is a highly innovative hi-tech company which allows its engineers to develop new ideas off their own bat because they may turn out to be game changing ideas. In other environments it may not be so easy to generate such intellectual development. Many US companies instituted employee of the month programmes to recognise particularly outstanding workers. For all the scepticism which these awards may generate, there is evidence to suggest that recognition by the management for a job well done goes a long way.

In this vein, I was struck by a neat little paper recently published on the CEPR’s Vox website which attempts to quantify this effect. The example in this instance looks at the behaviour of Luftwaffe pilots in World War II in response to the public praise lavished on high-performing pilots (i.e. those who shot down many enemy aircraft, here). Careful analysis of 5000 individual records, which looks at the impact the recognition accorded to indviduals had on their former colleagues, shows that this led to an improvement in the performance of all pilots who were known to have served with him. However, the good pilots (the “aces”) performed significantly better without taking more risks, but average pilots performed only slightly better but with a higher risk of being killed. The conclusion of this analysis is that singling out one worker for individual praise acts as an incentive for others to try harder.

The analogy is extended to suggest that such praise which encourages risk taking is a major problem in the financial services industry if it encourages traders to take ever bigger bets without understanding the risks they are running. Whilst there is some merit in the conclusion, it is not the whole story because traders received monetary rewards for the results which they generated. Indeed, most good traders I have ever known may be susceptible to a bit of flattery but they were very clear-eyed about the monetary rewards flowing from the actions they were taking (economists on the other hand are suckers for flattery). Nonetheless, the paper does provide a neat insight into the statistical analysis of the risk-taking business.

But if you get the incentives wrong, the consequences can be catastrophic. During Mao’s Great Leap Forward in late-1950s China, the government aimed to transform a largely agrarian economy into an industrial powerhouse. But in the dash for modernisation too many resources were diverted away from farming, which resulted in a catastrophic collapse in agricultural output and a famine which killed at least 20 million people. One of the reasons why provincial governments continued with their disastrous policy, despite evidence that it was not working, was because Mao himself lavished great praise on those who followed his instructions.

It is often claimed that monetary incentives can distort the behaviour of firms, so that they follow policies which maximise the utility function of those receiving the incentives rather than the wider constituency of shareholders. There is a substantial amount of evidence to show that companies have pursued short-term policies to inflate share prices, which benefits senior management who are paid in stock options, but which tend to have serious adverse longer-term effects. But as the Chinese example shows, it is important to ensure that we align non-monetary incentive structures too, for they can potentially inflict even more damage.

Brexit Mayhem?

The year has not started particularly brightly for UK prime minister Theresa May. Last week's resignation of Sir Ivan Rogers, the UK's ambassador to the EU who cited "ill founded arguments and muddled thinking" in his resignation email, suggests that all is not well at the heart of government. The Economist was also critical of the prime minister, arguing in an editorial this week that the fact she has not yet articulated a vision regarding Brexit, other than soundbites, means there is a "growing suspicion ... that the Sphinx-like prime minister is guarded about her plans chiefly because she is still struggling to draw them up." To compound it all, her comment in a TV interview at the weekend suggesting that the UK would not try to keep “bits of membership” of the EU, further spooked markets into fearing that the UK is heading for a hard Brexit.

This is all rather worrying and chimes with the view I expressed at the end of December that what is lacking is any form of leadership. Eleven months after David Cameron suggested in parliament that the UK should trigger Article 50 as soon as possible in the event of a leave vote, we are no further forward. Three months after the car crash which was the Conservative Party conference, I had hoped that senior politicians would row back from some of their less aggressive rhetoric, but what we have heard from the PM suggests that she is quite prepared to trade off control of UK borders for any form of access to the Single Market. For a long time, I was never quite sure whether May was playing some sort of double game to try and lull the Brexiteers into a false sense of security. But now I have little doubt that she really means it when she says "Brexit means Brexit."

Lest we forget, almost half of all voters did not vote for Brexit, but it appears to me that the terms of the debate are being framed in favour of the just over half that did. In that sense, the outcome is a very binary one: There is no sense of compromise and there is apparently little attempt to pacify the pro-remainers that their concerns will be listened to. Matters would not be quite so bad if we thought that the political opposition was in any position to put pressure on the government to act in the interests of those who did not vote for a "red, white and blue" Brexit. But the Labour Party leadership has been so silent on the issues that matter that it is legitimate to question whether Jeremy Corbyn deserves the title "Leader of Her Majesty's Loyal Opposition." Indeed, his speech today was rather lukewarm on the subject although not quite as pro-Brexit as many of the newspaper headlines suggested (here).

All this political uncertainty forms the backdrop against which economists are required to offer some form of projections for 2017 (although much of the recent popular commentary suggests that maybe we should not bother). Given that politicians do not seem to know how to proceed, it should not be surprising if economists do not either. I am as concerned today as I was throughout 2016 that the government's plans take no serious account of the economic consequences of Brexit. And as much of the commentary in the wake of Rogers' resignation highlighted, the government does not seem to be interested in hearing of the dangers. Although the post-referendum car crash may not have happened, the economy may have suffered serious internal injuries, the consequences of which may only be evident later.

All this is dangerous, and is not the way I would go about tackling a problem as complex as Brexit which requires the gathering of as much intelligence as possible before deciding to go ahead. In the absence of some form of transitional deal, it is hard to see how the UK can conclude the Article 50 negotiations within the permitted two year window, let alone the 18 months which the EU is likely to demand. Markets are thus not hanging around, preferring to shoot first before asking questions later. If, by some miracle, a favourable deal can be reached, the markets always have the option of rallying – currency markets have a special knack of being able to shamelessly cast off their previous views. We should thus view the recent fall in the pound as a move by the FX market to raise the risk premium on the pound. Economists may be under fire for basing their models on the unfounded assumption of rational expectations, but in this instance I rather suspect that market fears are perfectly rational.

Something Fishy in the world of forecasting

The Bank of England’s chief economist, Andy Haldane, created something of a furore on Thursday evening when he admitted that “it’s a fair cop to say the profession is to some degree in crisis” following the EU referendum. Haldane suggested that this was a “Michael Fish moment[1]” for the economics community, whose models struggle to cope with irrationality. In a way this is heartening. Anyone who has read any of my posts over recent months will know that I am critical of much mainstream macroeconomic academic research, in which models are based on rational behaviour (here, for example). I am also highly wary of the output produced by economic models (including my own). What was less heartening was the way in which the press jumped all over the story and began to conflate some of the issues, which generated a number of below the line comments on many newspaper websites demonstrating widespread ignorance of the issues at hand.

The article which most raised my hackles was by Simon Jenkins in The Guardian (here), who wrote that “the profession owes the public an inquest and an apology” and accused economics of grovelling “before its paymasters in government and commerce.” Predictably, the Pavlovian responses of many reader comments were along the lines of “economics is not a science” and “experts don’t know what they are talking about”, thus confirming that Michael Gove was right all along. One small snag: Jenkins’s article was confused and wrong. He conflates the problems in economics and the issue of Brexit as though they were one and the same thing. They’re not.

One issue Jenkins failed to mention was the extent to which many mainstream macroeconomists believe that their discipline has taken a wrong turning. He only need read the blogs by Paul Krugman to get a flavour of that. You certainly won’t find me defending the use of rational behaviour in economic models (for the record, all the models I have ever built use adaptive, rather than rational expectations). His second mistake was to conflate economics as a discipline and the arcane practice of forecasting.  I don’t know how many more times I have to explain to people that economics is not a predictive discipline. We can build models which capture the aggregate performance of the economy over the past but their predictive ability depends on numerous exogenous factors which can throw the model-generated path off course.

It is true that the short-term forecasts in the wake of the referendum turned out to be wrong. But the forecasts were made against the backdrop of zero to partial information; a power vacuum at the heart of government; the expectation that Article 50 would be triggered sooner rather than later, as David Cameron had promised, and a hysterical media. They are the worst circumstances in which to make a forecast for the next two years. But as I have pointed out before, three of my four key pre-referendum predictions have been borne out: Sterling would collapse; the BoE would cut interest rates and the stock market would rally after an initial dip. I was wrong on gilt yields, which fell rather than rose. And time will tell whether my view that post-Brexit growth will slow relative to what we experienced previously will also be borne out.

Jenkins was also wrong to confuse the political and economic aspects of Brexit. The issue of Brexit is purely a political issue but it does have potentially significant economic consequences. Anyone trying to come up with a forecast for the UK over the next five years or so has to take into account the fact that trading arrangements will be different, and they will almost certainly lead to a loss of economic welfare. However, it is worth making the point (again) that most analysis produced before the referendum reckoned that a vote to leave the EU would knock an average of around 0.3% off annual growth for a period of ten to fifteen years. We will likely feel it, but it would put the UK’s growth rate more into line with that of Germany since the turn of the century, rather than the outperformance of recent years. In other words, not a headline-grabbing disaster but not a good outcome either.

Finally, it is worth repeating the point I have been making for some time (most recently last week, here) that point economic forecasts are more likely to be wrong than right and that the probability distribution of risks around that central case is a more useful metric of accuracy. In a way, it was surprising that Haldane did not mention this because the BoE has been a pioneer of probabilistic forecasting. And for all the criticism levelled at the BoE, its August forecast for Q3 GDP growth assigned a near-45% chance that it would exceed 2% - as indeed happened.

It can only be positive that economists hold their hands up and admit when they are wrong. But I am not sure that Haldane did the economics profession or the BoE many favours by giving the media a stick to beat us all with. Indeed, as Mark Harrison of Warwick University asked: “Is epidemiological science in crisis because public health officials did not predict the largest Ebola epidemic in history?”

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[1] Michael Fish is a meteorologist who in 1987 famously predicted that rumours of an impending hurricane were unfounded (here). In the event, London was hit by its biggest storm since 1703 which caused major damage and disruption. Moreover, UK markets were effectively closed on the following day (Friday) at a time when Wall Street was tanking. When London markets reopened the following Monday, it prompted a far sharper London collapse, amplifying the negative global sentiment which contributed to the severity of Black Monday on 19 October 1987.

Superforecasting 2017

Between the beginning of December and around about this time each year, we are assailed with forecasts for the year ahead. Sometimes the forecasts turn out to be right, other times they are badly wide of the mark. Years of bitter experience have taught me that making a point forecast for any economic quantity one year ahead is often an exercise in futility. But any forecast based on a reasonably well-thought out story is better than taking no view at all and trusting to luck. I was thus intrigued by the findings of the recent book by the political scientist Philip Tetlock and journalist Dan Gardner entitled “Superforecasting: The Art and Science of Prediction” (here).

Essentially, Tetlock and Gardner conclude that forecasting is a skill that can be learned although some people are better at it than others. The so-called superforecasters generally manage to outperform experts in a wide variety of fields because they adopt an eclectic approach to analysis, preferring to process information from a wide variety of sources. Tetlock assumes that forecasters can be divided into two categories – hedgehogs and foxes. Hedgehogs tend to have in-depth understanding of a small number of areas, whereas foxes believe the world is a very complex place and tend to avoid shoe-horning their ideas into a limited number of boxes. Perhaps not surprisingly, foxes make the best superforecasters.

Although they tend to be smart people, Tetlock finds that superforecasters are in no way geniuses. They tend to look at a wide range of information in making their judgements and are happy to revise their assessment if new information becomes available (in the same way as Bayesian statisticians, as I noted here). Whilst my record disqualifies me as a superforecaster, I was struck by one of the lessons which came out of the analysis, which is that they think in fine gradations. Thus, rather than offering an outcome with a probability of 60-40, a superforecaster might carefully weigh up the evidence and instead offer odds of 63-37.

This brought to mind my own deliberations in the immediate wake of the Brexit vote when I was prevailed upon to offer an unambiguous view of what would happen next, but the more I thought about the issues the less clear they seemed. I recall my assessment on 27 June was that the UK was likely to leave the EU with a probability of only 59% whereas in the wake of the Conservative Party conference in October, I raised the likelihood to 90%. As new information comes in, that figure may well change again. This highlights a view which is gaining common credence – and one which I have long been convinced by – that the central case forecast is by itself not much use unless we attach some form of weight to show the degree of conviction with which we hold to the view. Otherwise the forecast becomes a binary decision which is either going to be right or – more often – wrong, which is when forecasters open themselves up to the charge that they have no idea what they are doing.

So in the face of all these caveats, what are the key issues we should be looking out for in 2017? The biggest local risks are: (i) the UK triggers Article 50 in March without making any contingency plans in the event that discussions with the EU prove more difficult than expected; (ii) Marine Le Pen wins the French presidential election; (iii) Angela Merkel fails to win the German election.

As regards (i), I genuinely do not know how this will pan out. I am working on the assumption that the Supreme Court will uphold the High Court judgment and that parliament will be allowed a say on the triggering of Article 50 which will delay its implementation. As a result, I currently assign a probability of 45% to this outcome. On (ii), the polling evidence suggests (for what it is worth) that Ms Le Pen has no chance of winning the second round of voting, and consequently I would give this a probability of 25%. And I see no alternative to Angela Merkel continuing as German Chancellor, so this is assigned a probability of 10%. The joint subjective probability of all these outcomes occurring is just over 1% - negligible but not impossible (which is how in early 2016 I characterised the joint likelihood of the UK voting for Brexit and the US for President Trump).

On the other side of the Atlantic, I would be surprised if Donald Trump can do much damage to the US economy in 2017, although further out it is likely that greater difficulties will become evident. He is unlikely to build his wall on the Mexican border; jail Hillary Clinton; deport illegal immigrants or completely dismantle Obamacare. But I suspect markets will not get the benefit of the hoped-for fiscal stimulus and as a result I would be surprised if US equities continue rising much beyond the spring (I won’t even put a probability on this one).

We should be in no doubt (as if anyone needs reminding) that the year ahead is more plagued by uncertainty than at any time since 2009. But as I say to journalists who ask whether I expect any surprises, it is the unexpected surprises which tend to do the most damage, and since by definition they are unknowable, time has a habit of making fools of us all.