Not pleasing anyone any of the time

One of the great ironies of the modern information economy is that we have more facts at our disposal than ever before, yet we are also subject to more fake news. In this environment, proponents of Brexit are able to make the most outrageous claims and brush aside objections without any regard for the facts. This is particularly annoying in the context of the phrase “will of the people” which is used to justify going ahead with a Brexit policy very much at odds with what a large slice of the electorate voted for. More importantly, the statement is statistically incorrect.

Admittedly 51.9% of those who voted did indeed favour Brexit. But this merely represents the will of those who voted: The fact that 28% of eligible voters did not even make it to the polling booth means that, by definition, the outcome cannot represent the views of all people. This is not to deny the democratic legitimacy of the vote. After all, no UK government in modern times has ever taken more than 50% of all available votes, so the process is no more undemocratic than usual. The difference is that Brexit is an irreversible process and it was therefore incumbent on the powers-that-be to make sure that sufficient checks and balances were built in to prevent it from descending into the farce we see today. This is why the  Scottish devolution referendum held in 1979 required that a threshold of 40% of all eligible voters was necessary to validate the result. Although the pro-devolution faction secured 51.6% of the popular vote, they only obtained 32% of eligible votes due to the fact that the turnout was fairly low at 63.7%. Ironically, if the turnout had been 77.5% or higher, the same final outcome would have given them victory. In 2014 the turnout was 84.6% so had people been as motivated to vote as in 1979, Scotland would long since have achieved greater independence from the UK.

A key issue of contention over the past year is whether the narrow margin of victory in the Brexit referendum is sufficient to justify the government’s gung-ho attitude. If all those eligible to vote had done so, there would be no need to have the discussion. But on a statistical basis since more than a quarter of those eligible to do so did not cast a vote, we can think of the result as representing a sample – albeit a large one – of the whole population. And as with any sample, there is an associated error. We cannot ever know how the stay-at-homes would have voted but if they had voted 55-45 in favour of Remain, the result would have gone the other way. It is thus reasonable to look more closely at the statistical evidence. 

Classical statistics suggests that a 90% confidence interval around the Leave vote share implies that they would still have swung it. But this neat little paper entititled 'What does the data of the Brexit referendum really say?, written by a couple of statisticians, uses effect size, which is a way of quantifying the magnitude of the difference between two groups without relying on sample size as in classical statistics, and this paper measures the sizes of differences between the Leave and Remain votes. The authors conclude that “a 52%-48% split represents only a spurious difference, not sufficiently different from a 50-50 split to claim a majority for either side.” They also suggest that on the basis of a 72% turnout “a minimum split required to make those claims is 69%-31%.” 

This obviously raises the question of how we should respect the result – a question posed by Simon Wren-Lewis on his blog. SWL takes the view that the lies told by the Leavers during the referendum campaign are “enough to completely discredit the referendum as an exercise in democracy.” Although he stops short of suggesting we should ignore the result, it is quite clear that many of the things which people thought they were voting for cannot possibly be achieved. For example, UK government sources suggest that EU citizens will be free to visit the UK after Brexit without having to obtain visas. Whilst this does not mean they will have the right to remain indefinitely, it is a significant watering-down of the position which many Brexit supporters thought they were voting for.

The very fact that the referendum result was insignificantly different from a 50-50 shot suggests that nobody is going to be satisfied with whatever compromise agreement is finally achieved. The UK will clearly not be able to leave the EU on the basis which many hard Brexiteers might wish but given the government’s decision to trigger Article 50 (before it lost its parliamentary majority, lest it be forgotten) it equally cannot remain an EU member. I maintain my view that for a long time to come, various elements of UK policy will be conducted on the basis of a Schrödinger’s Cat approach: Simultaneously half-in and half-out of the EU. They say you can’t please all the people all of the time. Brexit is a case of not being able to please anybody any of the time. If the current generation of politicians had a better grasp of statistics they would have known this all along.

* 22 August 2017: I subsequently amended this piece to correct a couple of errors. Thanks to those who pointed them out

How to learn from your mistakes

There are many things to admire about modern Germany and a lot of them were evident during a recent visit which, unusually for me, was a private rather than business trip. One of the things that always strikes me is the sense that Germany is still a big manufacturing economy. You notice this in the vicinity of all the big cities, where there is always lots of traffic and a large number of lorries delivering industrial goods. Indeed, a high proportion of the lorries are themselves German made. 

But perhaps the thing that always impresses me the most is the sense that it is a prosperous country where the wealth is shared relatively evenly. According to OECD data, Germany’s income Gini coefficient in 2014 was 0.289 (the lower the number, the higher the degree of equality) which ranks it 13 out of 33 OECD countries. It is certainly well below the UK with a Gini coefficient of 0.356, ranking at 29. We should also not forget that it was Bismarck who introduced the first national pension scheme in Germany in 1889, almost 20 years before the UK followed suit. Travelling around northern Germany, through the smaller towns, they appear solid and well cared for, which in my view is a sign of communities that display a sense of civic pride. Many German economists complain that the infrastructure is crumbling and that the government does not spend enough on maintenance and renewal. I can safely say this is not something which is evident in the same way as it is in Britain, although I guess you have to live there to notice it on a day-to-day basis. 

This is certainly not evident in Hamburg, where the magnificent new conference venue, die Elbphilharmonie, is a symbol of modern German economic confidence. In a sign of the difference between the German and British economic systems visitors are able to visit the Plaza for free, giving a magnificent view of the harbour, whereas comparable venues in London such as The Shard or London Eye levy hefty visitor charges.

There are some things which still grate on the modern traveller. Deutsche Bahn's inability to accept certain forms of plastic payment card is an oddity which I thought had been confined to the past. Even stranger is that a card which works perfectly well in Frankfurt will not work in Hamburg. Indeed, cash is much more widely used in Germany than in Britain, where I rarely carry very much, and cash in circulation across the euro area relative to GDP is three times that in the UK.

During the course of my recent travels, one question which inevitably came up was that of Brexit, with many Germans puzzled as to why the British voted as they did. It is hard to explain to them that the Brexit vote occurred in large part because the UK has rejected many aspects that German society takes so seriously. I have long extolled the virtues of German inclusivity. That is not what we have in the UK where we operate a system in which the devil increasingly takes the hindmost, as the safety net which underpins the more vulnerable elements of society is withdrawn. Many people in the UK simply do not see that the government is acting in their interests and this is something which is hard to explain to many Germans.

We also should never underestimate the desire of modern Germany to learn the lessons of the past. “Never again” means exactly that. I was fortunate enough to speak to people who were children in the immediate post-war period, who told me what it was like to grow up hungry and how they experienced permanent stomach pains without knowing why. The story of how the women and children used to work in the fields removing Colorado beetles to ensure that the potato crop provided sufficient food for the population was a fascinating vignette of how it was back then. Faced with such hardships, it is no surprise that modern Germany has no desire to go back there.

Germany is far from perfect: No modern society is and it may yet find that the great humanitarian gesture of opening its borders to countless numbers of immigrants causes more problems than currently imagined. But its determination to learn from the mistakes of the past is admirable and something the British can themselves learn from. Many people who voted for Brexit, especially older voters, are guilty of looking back to a Britain that never really existed. It may have emerged on the "right" side of history, but we should not forget that once Lend-Lease was terminated in 1945, economic circumstances changed overnight. Nor should we forget that the UK received more Marshall Aid than Germany in the immediate post-war period, but it was wasted by successive British governments trying to cling on to superpower status rather than modernising the domestic economy. The grim period of rationing and slow post-war reconstruction in the UK was at least partly the result of policy failure. Brexit may not be of the same order of magnitude but it still threatens economic hardships which are avoidable and which people may not be ready for. 

As one older German said to me, Brexit is a betrayal of future generations. I happen to believe he is right. Better to try and reform the EU from the inside than cut and run. When even a Guardian journalist points out that the potential loss of banking jobs will put a big hole in government finances, you realise that people are starting to wake up to the fact that Brexit will have real economic consequences. Many of us told you so all along.

Do we know what drives inflation?

A few years ago, I recall attending a seminar in which a microeconomist gave a fascinating presentation explaining how supermarkets set prices. The process involved looking at margins and assessing competitors actions in order to set prices sufficiently low as to attract custom but high enough to generate decent revenue. This was followed by a presentation from a macroeconomist outlining the standard macro model of inflation involving inflation expectations, output gaps and employment conditions. The contrast between the two notions was so stark that it was at this point I realised that economists do not fully understand the inflation generation process.

I should qualify this: Obviously, we broadly understand the principles of inflation but in practice we run into difficulties. It is generally believed that inflation is, to quote Milton Friedman, always and everywhere a monetary phenomenon. For obvious historical reasons many German economists, and indeed many elsewhere, still believe that excess monetary creation will lead to a rapid pickup in prices (I recall hearing a prominent monetary economist saying in 2009 how QE would lead to higher inflation within months). However, this model was largely discredited in the Anglo Saxon world during the early 1980s when the naïve quantity theory of money was debunked by the fact that monetary velocity was found to be unstable. In other words, the ratio between GDP and monetary aggregates changed due to the financial deregulation taking place at the time, which reduced the usefulness of monetary targeting as means of controlling inflation.

We should not dismiss monetary theories of inflation completely because, as the German hyperinflation of the 1920s demonstrated, a huge increase in the supply of money will reduce its value. But in the western world over the past eight years we have had one of the most aggressive periods of monetary easing in history without any significant pickup in inflation. Why?

Central banks’ quantitative easing policy which injected huge amounts of liquidity into the economy did not result in a wider spillover into prices because: (i) the liquidity was deposited in a banking system which at the time was not best placed to distribute it more widely throughout the economy; (ii) the liquidity was delivered directly to asset holders who sold bonds to the central bank, and it did not accrue to households and businesses and (iii) there was plenty of spare capacity in economies, with demand muted and the private sector engaged in deleveraging, with the result that we never got into a situation where too much money was chasing too few goods. Thus the conditions for the simple monetarist model of inflation have not held in recent years.

It is also the case that the pre-crisis literature was based on relatively closed economic systems, in which economies would more quickly run into capacity limits. In today’s globalised world that is no longer true, and the rise of China as an economic superpower has hugely increased global productive capacity. As a result, global production costs and prices have been driven down, which has encouraged consumption. Economies such as the US and UK are more likely to experience a rising external deficit as a symptom of excess demand, rather than rising prices as once would have been the case.

The Japanese case is perhaps the most extreme example of an economy which has failed to generate inflation, despite the best efforts of the central bank to get it back towards 2%. The BoJ continues to buy huge quantities of securities, sending its balance sheet to 90% of GDP in the process. No thought has been given to the longer term consequences of this policy, but suffice to say that if the BoJ were forced to run down its balance sheet, the effects on markets would be dramatic. I have long believed that the Japanese policy of trying to push up inflation is misguided in an economy where an ageing population is reliant on its savings. It does seem odd that the central bank is engaged in a policy which has not worked for 16 years and does not appear likely to do so anytime soon. It is probably a measure of desperation that it does not know what else to do. Unfortunately, the higher it drives the balance sheet today, the more difficult will be the process of unwinding it in future – all the more so if it does not generate the desired inflation.

There is not one single reason why inflation remains so muted. I suspect that structural changes are helping to depress inflationary forces – globalisation; the effects of the recession on inflation expectations and the substitution of capital for labour to name but three. Our standard inflation models, in which tight labour markets and excess liquidity creation will lead to higher prices, are currently not working. This is not to say they never will again. It is just that for the foreseeable future, we are going to have to learn to live with lower inflation.

There are pros and cons of such a situation. On the plus side, we will be spared the destabilising effects of a 1970s-style pickup. But it also means that we will find it harder to run down our debt burdens than we have become used to, and that might be one of the reasons why people feel more miserable than they once did. Back in the day, we used to construct misery indices as the sum of unemployment and inflation rates: the higher the index, the more “miserable” we are, but as the chart shows, the UK misery index is near to multi-decade lows. Maybe what we need is a dose of inflation (especially wages). Quite how we can generate that is a matter of much debate.

Justin's case

Justin Gatlin’s win over the great Usain Bolt in last night’s 100m final at the World Athletics Championships is a reminder that life does not always run to the script that the majority of people might wish. For those of you not athletics aficionados, Gatlin has twice been banned by the IAAF for doping offences. As one person tweeted last night, once is a mistake but twice is a choice. There are lots of allegations surrounding Bolt himself: Maybe he has doped, maybe not. But he has not been caught let alone banned (TWICE!!). Without wishing to turn all moralistic, there is a serious point about credibility here. Unless the rules are applied effectively and sanctions imposed which make cheating an unattractive option, there will always be a temptation to push the boundaries.

The same could be said of any organisation which knowingly breaks the rules. An obvious example is the conduct of banks, many of which have been heavily fined for transgressing sanctions rules (German automakers who falsified emissions data find themselves in the same position). In the UK, the FCA has levied fines totalling £3 billion since 2013 (of which only around 0.6% has been levied on individuals). Over the period since 2008, banks globally have paid $321 billion with the US regulators particularly adept at forcing banks to pay up by threatening to curtail access to the global dollar payments system. Depending on which side of the divide you sit, the actions of regulators to extract large sums of money from the banking system either represent an extortion policy of which Al Capone would be proud, or it is a genuine attempt to hit banks where it hurts in a bid to force a change of behaviour (I suspect both are true).

However, behaviour is changing. Banks are much more careful these days about the kinds of business they undertake as the compliance burden rises. According to Boston Consulting, the number of regulatory changes per year more than tripled between 2011 and 2016. Each individual regulation effectively represents a tax on activity, because it requires additional oversight with an associated implementation cost and failure penalty. Regulators are currently particularly keen to clamp down on money laundering in a bid to combat terrorist financing, and as a result banks are actively turning away customers if it means that the potential risks exceed the potential gains. Mis-selling risks are another area of particular scrutiny, and given the concerns surrounding the accuracy of Libor submissions in recent years the FCA recently announced that the system whereby Libor is set by quotations will be replaced by a transactions-based system (a sensible move, even if it is not quite clear how this will work in practice).

It is interesting, however, to note that the period of punitive regulation appears to be drawing to a close. BoE Governor Carney warned in March about regulatory fatigue and in its latest Financial Stability Report, the BoE noted that “given the progress made and the lessons from work to date, the FPC is now moving to the next stage. Its focus is on systemic risk, rather than risk to individual companies or consumers.” Carney also warned last week that there should be no rolling back of regulation. In other words, a lot has been done in recent years and banks need time to adjust to the higher costs of regulation which have done a lot to shore up banking sector stability.

In the case of financial regulation, it thus appears that the regime of punitive sanctions has had a significant impact on banks’ behaviour and they will emerge stronger and safer. This is akin to the situation in which Justin Gatlin finds himself. He broke the rules, was caught and banned for a total of five years but has since run “clean.” Like the banks, Gatlin profited from cheating and indeed his current physical condition, which means he is still able to run world-class sprint times even at the age of 35, may have something to do with the drugs he took earlier in his career. But there are differences between the two situations. Gatlin’s actions were those of an individual who took a conscious decision to cheat in order to benefit his career. Whilst there were individuals within banks who made similar decisions, it is fair to say that institutions did not (to my knowledge) engage in systematic cheating, though they can be accused of turning a blind eye to certain actions for which they have been punished.

I don’t like the fact that Gatlin won last night and many people (of which I am one) believe he forfeited his right to compete at the highest level following his second drugs offence. He demeans his sport and sets a bad example for others to follow, especially younger athletes. In this sense the IAAF fails to police its sport adequately. At least the financial regulator will come down hard on individuals which it finds guilty of breaking the rules as new regulations come into play. Indeed, over the last three years more individuals have been fined by the FCA than firms. In this area, IAAF President Sebastian Coe perhaps has something to learn from financial regulators.

Let's hear it for the Anglo Saxon model

During the 1990s the phrase "Washington Consensus" was increasingly used in policy circles, particularly in the context of the IMF when applying conditional aid packages. It was another way of saying, particularly to developing economies, that countries should liberalise markets; reduce taxes and trade barriers and put in place a governance structure that promotes openness. The ethos was that open and competitive markets would allow the private sector to operate in a manner that acted as a dynamo for economic growth which would ripple throughout the economy. It would also bring them closer to the orbit of the Anglo Saxon economies. Successive US Presidents from Bill Clinton onwards bought into the idea as did UK prime ministers Tony Blair and Gordon Brown. But it was generally resented by those countries which found themselves on the receiving end of IMF requirements.

Indeed, the words Washington and consensus appear rather hollow these days, particularly when mentioned in the same sentence. The events of the past week have painted a picture to the world of a chaotic White House failing to grasp how to run government, and suggests that consensus is the last thing on the minds of many in Washington. Meanwhile, on this side of the Atlantic, the UK government is failing to get to grips with the niceties of Brexit negotiations in a way that makes many of us fear for the outcome. Whatever else the Anglo Saxon model stood for, it was meant to be pragmatism over ideology. Admittedly, there were those who believed that the insistence on the primacy of free markets was an ideological stance, but on the whole it seemed to be backed up by a body of evidence. Then 2008 happened.

Ironically had the free market proponents been allowed to apply their doctrine to its logical conclusion, banks would have been allowed to collapse and the swamp would have been drained in a way that would almost certainly have proved ruinous. Fortunately, governments stepped in to put a backstop behind the system. Contrary to popular belief, markets did not fail. The mechanism worked exactly as the textbooks said it would: boom follows bust. It's just that it did not produce outcomes that societies found acceptable.

I have long maintained that the apparent governmental chaos in Washington and London stems from the events of nine years ago. Unlike continental Europe, where memories of the post-1945 economic ruin were still part of collective memory (albeit distant), neither the US nor UK have any social memory of economic hardship. The experience of the 1930s was too far beyond the memory of most, and had in any case been wiped away by the post-1945 glow. Perhaps it was this factor which meant that US and UK governments were unable to effectively communicate the severity of the economic situation to their electorates (though full marks to Ben Bernanke at the Fed who recognized the collapse for what it was). As time went on, and governments were unable to generate the recovery which they promised, their message was increasingly not heard by an electorate that felt it was being lied to. As a result we got Brexit and Trump.

The problem that governments on both sides of the Atlantic face is that evidence-based policy making appears to have taken a back seat to ideology. Take the Obamacare debacle. President Obama’s Patient Protection and Affordable Care Act is designed to provide health insurance to the estimated 15% of the population who lack it. Moreover, it is designed ultimately to rein in the surge in healthcare spending. But the right-wing Republicans hate it because it is seen as a “job killer” by imposing too many costs on business and is seen as an unwarranted intrusion into the affairs of businesses and individuals. But far from being a job killer, health sector jobs have increased by 9% since the legislation was introduced.

Moreover, Senate voted not to repeal it last week because politicians know that large parts of the current system work for the electorate. As Vox put it, “No legislative strategy can skirt around the fact that millions now rely on the health care law for coverage, and do not want to lose their benefits.” Nor is it clear what the replacement legislation would look like. There are numerous flaws with the Obamacare legislation which need to be fixed in just the same way as there are flaws in the way that the EU operates. This does not mean that it is sensible to overturn the status quo without an alternative plan. There is no evidence that Brexit is a policy that will increase the UK’s economic welfare. And just as certain elements of the US media were able to distort the terms of the presidential debate, so the same thing happened in the UK ahead of the EU referendum.

What is most worrying about the debate on both sides of the Atlantic is that a short-term political agenda is being pursued which will have longer term economic consequences. Both Trump and Theresa May will one day just be another in a long line of ex-politicians. But the damage to their respective countries may well outlive them. In the case of the US, the policy vacuum will create more space for the likes of China to create a global structure designed to maximise its influence. The UK’s position is even worse for it does not have the economic and political heft of the US. The reputation of both countries as economically successful bastions of freedom and tolerance has taken a beating, and the rest of the world may in future only look to them for lessons in how not to manage affairs.

Automotive for the people

In 1979, Gary Numan had hits with two songs which topped the charts around the world: Are Friends Electric and Cars. Almost forty years later, societies are asking themselves whether electric cars are their new friends as policy makers in France and the UK propose a ban on the sale of petrol and diesel vehicles by 2040 in order to encourage the sale of electric vehicles.

According to the IEA around 17% of global CO₂ emissions derive from road transport – a figure which rises to 19% in non-G20 countries (see p35, here). It is thus understandable why governments want to take action. But there are lots of issues which need addressing before we accept that this is a “good” policy, and I do wonder how much of this policy has been thought through. For one thing, it will take action by more than just the UK and France to have much impact on global CO₂ emissions. When the US and China follow suit the policy will have a lot more resonance – or if it were an EU wide initiative, it would make more sense.

The big issue at the heart of the debate is that electric cars are simply not as green as many proponents would have us believe. Sure, they emit less CO₂ but the electricity to power them has to be generated somewhere and if all we do is build more coal-fired power stations it rather defeats the object. It is unlikely, of course, that the government would permit a return to coal, so how will we generate the additional power? Let us start by trying to understand the scale of the problem. The National Grid recently estimated that raising the number of electric vehicles could increase peak UK electricity demand by 8 gigawatts (GW). That is the equivalent of building three new power stations the size of the much-disputed Hinkley Point nuclear station. Admittedly, this does represent an extreme case, with greater use of off-peak charging likely to mitigate the scale of the problem, but it nonetheless makes the point that putting more electric cars on the road requires building more generating capacity.

Having determined that the UK will require up to an additional 8GW of electricity just to keep our cars on the road, how will we generate it? We could simply build another three Hinkley  Point-type nuclear stations, but given all the concerns regarding their cost – not to mention the perennial problem of how to get rid of the waste – this would be highly controversial. We could add more wind turbines but it would mean raising capacity by 50% and we all know how intermittent wind power can be. Solar is probably a non-starter in the UK. However, tidal may be an option with a barrage across the River Severn – which has the second largest tidal range in the word – potentially capable of generating 8GW at peak flow, which would be operational for 8 hours per day, according to a 1989 study. It would be costly (up to £34bn on one estimate, which is almost double the cost of one Hinkley Point) but potentially feasible.

So let us assume that we can generate the electricity. What about the technology – is it good enough to supersede the internal combustion engine?  Only this week, Tesla handed over its first Model 3 which costs $35,000 and has a range of 220 miles (350 km) – about one-third what a larger diesel-engine vehicle is capable of delivering. A longer range version will do 450km on one set of batteries but it costs a third more and is still more limited than cars can do today. In order to manage a 900 km journey across Europe, the standard model requires two charges which, given current battery technology, is not going to be a quick process. Perhaps we could swap over the battery rig, with fully-charged batteries replacing the old ones. This would mean making a couple of quick stops whilst the batteries are swapped but it is not dissimilar to the current process of refilling our cars at a filling station. So far, so possible (at least not too impossible).

But what happens during the transition process towards our 2040 cut-off point? Relatively few people will want to buy a new petrol or diesel car after 2030 given the lack of resale value, so we will need to see significant advances in electronic car technology by then in order to convince people that the transition will happen. That is just 13 years away. And will there be a scrapping scheme to help individuals make the switch (that will be costly)? Will car companies be able to ramp up production to meet likely demand – the likes of Ford argue that Tesla will struggle to increase production on the scale required?  Indeed it is possible that until many of these questions are answered, many Brits (and French) will act like the Cubans by keeping their old cars on the road for longer than they would otherwise do (assuming that petrol stations are not phased out). And how will the oil companies respond? How will governments fill the revenue gap left by the fall in fuel duty which they currently levy on the motorist?

One standard response to these objections is to cast your mind back to 1994 to a pre-internet age when many of the things we take for granted today seemed like science fiction. But the difference is that the technology evolved, and was not imposed upon us. We can still go down to the High Street rather than rely on Amazon deliveries, but the policy as currently portrayed is a bit like abolishing the practice of letter writing in favour of email. Clearly, there are more questions than answers.

Most people are prepared to do their bit to help save the planet but we need a properly thought out response to the questions raised. Announcing a plan then saying we will work out the details as we go along is not a sensible policy strategy. Let us not forget that in the UK, it was new environment minister Michael Gove who announced the death knell of vehicles fuelled by carbon. This was the same man who was fabulously short on detail as to how Brexit would work. There again, he can always go back to his team of experts to help him out – if he hasn’t had enough of them.

What does it take?

There are certain central banking events which have gone down in history. Sometimes the event was only momentous in hindsight, as with Ben Bernanke’s 2002 speech setting out the guidelines of what would later become the QE doctrine. Occasionally, as with Alan Greenspan’s “irrational exuberance” comments in December 1996, it was obvious at the time that something truly memorable had just happened. Another such event took place five years ago when on this day in 2012, Mario Draghi made his famous speech in which he promised that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

It was! Indeed Draghi deserves a lot of credit for keeping the show on the road against a backdrop which threatened to become utterly chaotic. His first act on taking over as ECB President in November 2011 had been to reverse the ECB’s misguided rate hikes earlier that year. But by summer 2012, the euro zone was experiencing an existential crisis with talk of Grexit high on the agenda. Draghi’s words helped calm a fragile market, and by subsequently stepping into the vacuum created by a lack of government clarity, the ECB did indeed do what was necessary. It pumped huge volumes of liquidity into the system and apart from a brief wobble in summer 2015, the euro zone has steadily moved forward. In the sense that Draghi’s goal was to prevent the euro zone from fragmenting, he very much did what was required. Indeed, today there is very much a sense of optimism surrounding the euro zone economy as sentiment continues to rise.

But the ECB still has its foot to the floor, buying huge quantities of government bonds as part of its QE programme and speculation is increasingly mounting as to when and how it will begin tapering its purchases. Meanwhile, the Federal Reserve has been through a tapering process culminating in a cessation of bond purchases, and has raised interest rates by a total of 100 bps since December 2015. Indeed, the Fed is actively discussing balance sheet reduction, so monetary policy normalisation is clearly underway in the US. Despite this, both the MOVE index of US Treasury market option volatility and the VIX index of equity option volatility have touched all-time lows on data back to 1988 and 1990, respectively (see chart). It may be summer, and trading vols have dwindled, but this does raise a question as to whether markets are too complacent. There again, what do markets have to fear?

Central banks have effectively anaesthetised bond markets in recent years and investors have piled into equities with impunity because (a) they don’t really have anywhere else to go and (b) they know that central banks will signal policy changes well in advance, providing them with enough time to get out. The ECB last week failed to give any hints at a policy change and is now effectively on holiday for the next month, and although there is a prospect that Draghi will try to steer market expectations at the Kansas City Fed’s Jackson Hole Symposium in late-August, the markets today seem to be in a mood to see action rather than words. Similarly, the Fed announced a steady-as-she-goes policy today, meaning that nothing will happen on the monetary policy front until September. The BoE may try to inject some volatility into the market following next week’s MPC meeting but it has limited scope to have a wider impact.

Do central banks now need to show that their bite is indeed as bad as their bark? The reason markets are idling along is an indication that they do not fear tighter policy. They should! Central bankers are aware of the dangers of allowing markets to become too complacent because the knee-jerk response in the event of an unanticipated shock will be all the more dramatic. This may explain why various BoE officials have tried to sound hawkish in a bid to jerk the markets into action. Markets may be able to live with the modest degree of tightening we have seen from the Fed so far. So long as interest rates remain low, a dividend discount model in which equity valuations are determined by the discounted value of future revenue streams, will continue to support current levels. But if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.

Unlike in 2012, words no longer appear to be enough. But my sense is that markets ought to take heed of the hints which central bankers are providing. Whatever some investors may think, central banks are not there simply to act as a backstop for market actions. If,  or when, the monetary policy cycle finally turns there is a risk that people might get hurt.