What would Margaret do?

Post-truth is a phrase which seems to have gained a lot of currency in recent months. Or, as President Trump’s aide Kellyanne Conway would have it, the new president’s press secretary did not lie about the size of the crowd for Trump’s inauguration, he merely presented alternative facts. The presentation of alternative facts is rather how I felt when I went back again over Theresa May’s speech last week which contained a phrase so outrageous that the PM had to hide it in plain sight.

To recap, May told us that the UK is leaving the Single Market. And not only that but “both sides in the referendum campaign made it clear that a vote to leave the EU would be a vote to leave the single market.” As lies, sorry alternative facts, go that is a whopper. I don’t recall anywhere on the ballot paper being asked my opinion on this. Or did I just get an alternative ballot paper? Indeed, the lobby group British Influence has launched a legal bid to force the government to separate EU membership from the question of Single Market membership. Good luck with that, as I have no wish to rake over the coals of legal challenges to the referendum once again.

But there is a wider economic point which has not been made often enough – namely, that those elements of the Conservative Party calling for an exit from the Single Market are simply ignorant of their party’s history and do not understand what they are getting rid of. A great article by Ben Chu in The Independent (here) hit the nail on the head. He argues forcefully that many Conservative MPs do not appreciate the role played by their political heroine, Margaret Thatcher, in helping to bring about the Single Market in the first place. Indeed, whilst Thatcher was no fan of a federalist EU, she understood the benefits of free trade well enough.

In assessing what Thatcher’s views on Brexit might have been, we have to weigh her views on EU unity against her economic liberalism. The great irony is that they are not mutually exclusive, as might have been thought 30 years ago. Thatcher’s famous Bruges speech in 1988 ("We have not successfully rolled back the frontiers of the state in Britain, only to see them reimposed at a European level, with a European superstate exercising a new dominance from Brussels") resonates as powerfully today as it did then (here for a link to a contemporary UK newspaper report). As The Guardian put it at the time: “Dismissing as irrelevant proposals for a European central bank, Mrs Thatcher said the EEC should remain committed to a free market economy. ‘The basic framework is there: the Treaty of Rome itself was intended as a charter for economic liberty … But that is not how it has always been read, still less applied’."

One of the key lessons from last week’s speech by Theresa May was that she wants to open up the UK and make free trade agreements with the rest of the world. The crucial bit here is “free trade.” What is it that Brexiteers think we have now? The logic of their argument is “leave the EU to get more free trade.” Our PM believes that she will get “a new, comprehensive, bold and ambitious free trade agreement” with the EU. But what if she doesn’t? The UK will then have walked out of the comfort of the Single Market in the hope of being able to get better deals elsewhere. As dumb economic gambles go, this one is up there.

Thatcher used a speech at Lancaster House in 1988 – ironically the same venue used by May – to make the point that the EU offers “A single market without barriers – visible or invisible – giving you direct and unhindered access to the purchasing power of over 300 million of the world's wealthiest and most prosperous people. ” Perhaps the EU did move too close to being the federalist state so opposed by many UK politicians. But I find it bizarre that a government which nominally extols the virtues of free trade should walk away from one of the world’s great free trade areas, in the pursuit of the chimera of better trade prospects elsewhere. And for what? Even Judas was rewarded with 30 pieces of silver.  

Donald's rhetoric trumps rationality

I have no axe to grind regarding President Donald Trump. I am not a fan but unlike the Brexit issue I have no skin in the game. So when I say I don't like much of what I heard during Trump's inauguration speech, I say it as an economist and a citizen of the world (which in Theresa May's eyes makes me a citizen of nowhere).

I tuned in just as Trump got into full flow. But I shuddered at the passage which contained the phrases: 

"We have defended other nations' borders while refusing to defend our own ... One by one, the factories shuttered and left our shores with not even a thought about the millions and millions of American workers that were left behind ... From this day forward, it's going to be only America first, America first ... Protection will lead to great prosperity and strength." 

I am critical of British politicians who play the nationalist card and I am not impressed by leaders of other major nations who do the same. Imagine what the reaction in the British press would be if German politicians said similar things. But when an American president takes such a tack, we know that this could be very damaging to the world economic and political order upon which our prosperity has depended for so long.

As an economist, I question the notion that protectionism will make the US economy stronger. My immediate reaction was "has he learned nothing from long dead US politicians Smoot and Hawley?" Standard economics states that raising tariff barriers simply increases the costs to consumers who ultimately have to pay. It's the same reason I am so concerned that the UK will fail to get a deal with the EU and we have to fall back on WTO rules which raises the costs of most imports.

Yet there is an argument that this is conventional thinking and we should be approaching the problem differently. Indeed, a young journalist asked me this week if tariffs are such a bad thing. In effect, he was asking whether the pursuit of economic efficiency really is the be all and end all. Given the times in which we live, it is a question which deserves an answer. I suspect the answer lies in the extent to which they serve the national interest. The national interest in this case is not simply about the economic costs and benefits, because on these grounds there is no case. It is about taking back control – a slogan we heard so often during the Brexit referendum. Ironically, the message from Theresa May was that the UK wants more free trade, rather than less, which seems to contrast with the Trump view. Trump’s appeal is to those who believe that the pace of change has been too rapid, and my guess is that American voters might tolerate higher import tariffs for a while but ultimately realise they are economically self-defeating. But tariffs may simply have to be tried to remind a new generation of why the world has spent 70 years trying to reduce them.

Think of the US auto industry. The area around Detroit declined (as did the British Midlands) because the cars built there were more expensive and technologically inferior to those produced by the foreign competition. Domestic consumers took the view that they got better value for money by looking elsewhere. Imagine they didn't have that choice. Imagine that instead US workers continued producing cars and stayed put in Michigan. This would have reduced the internal migration of skilled workers, with the result that currently-dynamic urban areas would have grown more slowly and there would be fewer resources available to be allocated to higher value-added sectors such as tech or fracking. In short, there would have been less dynamism. If that is what the public wants, that is their choice. But as my friends on the other side of the Atlantic tell me, that is not the American way.

Then there is the problem of retaliation. If the US erects barriers, you can bet its trading partners will respond. American companies have pinned their hopes for many years on the Chinese market – whether those hopes have been realised is another matter. But they will be shut out of the world's most dynamic major market and will lose global market share as a consequence, especially if China were simultaneously to open up to the Europeans. And it is not as if the US does not have world class companies which compete globally. Microsoft, Apple, Google and Amazon have revolutionised the world, and did not arrive in their present incarnation behind tariff barriers. They depend on being able to sell around the world, and rely on global supply chains to stay competitive. Its global banks have survived the financial crisis in far better shape than their European counterparts and still play a huge role in the global financial architecture.

We should also not ignore the soft power which the US enjoys. Netflix is changing the way the world watches TV; Hollywood blockbusters are still the films most people talk about; its universities are ranked as amongst the best in the world. Moreover, the US issues the world's pre-eminent reserve currency. This should not be underestimated: Controlling access to dollar markets gives the US unprecedented economic and financial leverage.

All told, the US is in a far stronger position than Trump’s supporters believe. Admittedly, we no longer live in a world of unchallenged American power – the rise of China has seen to that. But the US has more to lose than gain if Trump really does set off down the protectionist path. We can only hope his team is less impulsive than he is.

Is it just me?

Sometimes you just have to admit that you are out of tune with the Zeitgeist. Having endured Theresa May’s speech yesterday when she set out her vision for a post-Brexit Britain, it seems that there is little point in engaging in rational debate. After all, nobody else seems to be interested. Donald Trump won an election in this fashion; Boris Johnson went from being the ex-Mayor of London to UK Foreign Secretary via a Brexit campaign and Vladimir Putin invaded a sovereign state – the common denominator being that all of them spun a web of lies and deceit in order to ensure that the debate was conducted on their terms rather than the awkward reality which we used to call facts. They say you can fool some of the people all of the time, and all of the people some of the time. But in our post-truth world, it feels like mainstream politicians are trying to fool all of the people all of the time.

When the PM opened yesterday’s speech with the line “A little over 6 months ago, the British people voted for change. They voted to shape a brighter future for our country. They voted to leave the European Union and embrace the world,” I had to pinch myself to ensure that I was not dreaming of the occasion when the electorate overwhelmingly rejected EU membership. When May noted that "after all the division and discord, the country is coming together," I wondered whether she had bothered to consult with Scottish MPs who clearly do not share the same desire to exit the EU. 

As she went on to outline that one of the reasons why British citizens have a problem with EU bureaucracy is that “supranational institutions as strong as those created by the European Union sit very uneasily in relation to our political history and way of life,” I realised I had it all wrong. Clearly, the fact that the UK has one of the most centralised governments in Europe is a figment of my imagination. The European Economy Discussion Paper published by Charles Wyplosz in 2015 (here) citing research which showed that UK sub-central government spending as a share of total public outlays is (along with the Netherlands) the lowest in the EU, is obviously fake news.

And then it really went downhill. The UK government intends to leave the Single Market in an action which I can only describe as one of economic self-harm. But that’s OK because “we will take back control of our laws and bring an end to the jurisdiction of the European Court of Justice.” That would be the same ECJ which ruled in favour of the UK in 2012 when the ECB tried to ensure that the clearing of all euro denominated transactions should take place in the euro zone, rather than in the London financial market. May must have forgotten the court’s ruling that “the ECB lacks the competence necessary to regulate the activity of securities clearing systems as its competence is limited to payment systems alone.” A small oversight, I’m sure.

Moreover, the UK will obtain the benefit of being able to control immigration. Hoorah, I hear you cry. The woman who failed to control immigration when she was Home Secretary will be given the opportunity to do so at the expense of the UK’s economic self-interest. It is evident that the PM is happy to trade off access to the Single Market against the ability to control our borders. And if someone can enlighten me as to what the benefits of this are, please feel free to leave a comment.

As if this were not enough, the prime minister urged the EU to accommodate the UK’s demands wishes because not to do so would be “an act of calamitous self-harm … Britain would not – indeed we could not – accept such an approach. I am equally clear that no deal for Britain is better than a bad deal for Britain.” This was translated by the headline in The Times this morning as “Give us a fair deal or you’ll be crushed”, and by the Daily Mail as “Steel of the new Iron Lady” as memories of the blessed Margaret were rekindled (here if you must).

But as the eminently sensible Rachel Sylvester pointed out in The Times yesterday, May is looking at a still image of the EU when in reality it is a moving picture. She has “a two-dimensional view of the EU negotiations but she risks being skewered by her own inflexibility” as the debate regarding immigration changes across the continent. Sylvester also quoted one senior businessman who said, “They are living in a fool’s paradise. There’s still a belief that the Europeans will blink, that they need us more than they need them, and I don’t believe that for a second.”

I wrote in a note yesterday that May’s speech does not constitute a plan: It is a wish list. It is an opening gambit in a poker game where the UK does not hold many good cards. Worse, the hand is being played by a bunch of bluffers. When it comes to the crunch, the UK negotiating team will have to step up to the big league where they will learn when to fold and when to hold. Meantime, the economy (i.e. the voters) will pay the price for such arrogance. But what do I know? I am clearly thinking in the old ways and we should never let the facts get in the way of a good story.

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.