Non-linearity in economics

Gertjan Vlieghe is characterised as one of the more dovish members of the Bank of England MPC, so his recent speech in which he suggested that “the evolution of the data is increasingly suggesting that we are approaching the moment when Bank Rate may need to rise” was indeed noteworthy. It is thus a pity that the rest of the speech was overlooked for it was a fine exposition of the factors driving real interest rates. But it was his dismissal of the “fairly deeply rooted, but wrong, notion in modern macroeconomics, namely that real interest rates are primarily driven by the growth rate of the economy” that really got me thinking.

Vlieghe pointed out that “the idea persists, because of commonly adopted – but misleading – practices in solving macro models.” Modern macroeconomics is based on highly non-linear models but in order to make them more tractable for solution purposes, we use logarithmic transformations to linearise them. Vlieghe uses the example of how the linear transformation of the standard method of discounting future consumer utility results in “a tight relationship between the real interest rates and growth, and nothing else ... it kills off, mechanically, anything that might have been interesting about risk … In the linearised world, there is no risk-free real interest rate.” For those interested in the detail, the relevant part of Vlieghe’s speech is reproduced in a footnote[1].

As it happens, this is perhaps an overly-rigorous theoretical interpretation of the relationship between growth and interest rates. Admittedly, the fact that there is a strong correlation between (real) short-term interest rates and (real) GDP growth does not necessarily imply a causal relationship. But the work of the late-nineteenth century economist Knut Wicksell postulated that there is a ‘natural’ interest rate which is determined by the real disturbances affecting the economy. To the extent that these disturbances are manifest in output growth and inflation, it is clear that nominal GDP growth and interest rates ought to be closely related. It is not a 1:1 relationship, but over the long-run the rate of return on real assets ought to be similar to that on financial assets in order to satisfy equilibrium conditions. Not for nothing have many economists argued that there is a strong case for using nominal GDP growth as an anchor for monetary policy.

That said, Vlieghe’s point on how linear approximations can result in specious outcomes was well made. All students of econometrics spend a lot of time learning about the properties of linear regression models which partly explains why grubby practitioners like me are comfortable applying linear transformations in order to easily apply linear estimation techniques. Another reason for preferring linearity in econometrics is that non-linear solutions can be indeterminate because we do not know whether they are the universally right answer, or whether they apply only under certain conditions. The reason for this is that many of the common solution techniques rely on grid searches conducted over a range of values. In the jargon, we do not know whether we have found local maxima only within the range in which the search is conducted or whether the “true” answer lies outside it. Our models may thus be biased – in other words, deliver the wrong answers under certain conditions – and as a result many economists stick to what they know in the form of linearity.

But this bias towards linearity, tempting though it is, can be applied to situations in which it is not appropriate. The authors of a paper in experimental psychology[2] assessed the accuracy of long-term growth estimates by panels of “experts” and laypeople. Whilst both groups tended to underestimate growth at rates above 1%, the degree of underestimation was greater for “experts” because they ignored exponential effects more often than the group of laypeople. Another paper by DeBock et al (2013) is interesting because it provides a literature review of the reliance on linearity and reports the findings of an experiment amongst business economics students who were confronted with correct and incorrect statements on linearity in economic situations. The authors concluded that many of the students showed over-reliance on linearity in their analysis.

An interesting paper on nonlinearity by Doyne Farmer (here) looks at various aspects of nonlinearity and complexity in economics. He makes the point that DSGE models are too highly stylised to say anything useful about the behaviour of economies in the real world. Instead, economics might start to take lessons from areas such as meteorology which builds very complex data-based nonlinear models. This has been enabled by the significant increase in computing power which allows simulation analysis to be conducted much more cheaply and effectively than in the past.

For policymakers, the fear is that linear approximations in a nonlinear world lead to distorted policy conclusions. One problem is that economics tends to focus on equilibrium solutions. But as noted above, there may not be a single equilibrium. Indeed, the impact of the financial crash of 2008 was an object lesson in how nonlinear feedbacks can produce outcomes far beyond our expectations.

The mathematician Stan Ulam used to give lectures on nonlinear mathematics and apologise that the title was a misnomer, for all interesting maths involves nonlinearity. As Farmer put it, “just as almost all mathematics is nonlinear, almost all economic phenomena are complex … A more tractable topic would be whether there are any problems it does not illuminate, or should not illuminate.”

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[1] 

[2] Christandl, F., and D. Fetchenhauer (2009) ‘How laypeople and experts misperceive the effect of economic growth’, Journal of Economic Psychology (30) pp 381–92

Theresa and Florence

Theresa May's speech in Florence yesterday was supposed to be the big one – a chance to articulate what Britain wants from Brexit. Perhaps because it was so hyped up in advance it failed to live up to expectations. For my money, it was a grade C: Not absolutely terrible, but nowhere near good enough. Journalists have convinced themselves that they heard the PM promising to stay in the EU for a two-year transition period and the promise to pay into the budget during that period. I heard her asking the EU27 for a transition period and no mention of any figures.

As for the speech itself, it was long on waffle and short on content. To be sure, it was less strident than her dreadful performance to the Tory faithful last October and the Lancaster House speech in January. But it contained many of the same appeals for unity: "If we were to ... be divided, the only beneficiaries would be those who reject our values and oppose our interests." So we should all get behind Brexit because otherwise you don't share "our" values? As for the "concrete progress on many important issues" during the negotiation period, this amounted to a recognition that "there are unique issues to consider when it comes to Northern Ireland." As Michel Barnier noted in his response, that does not amount to providing any solutions. There was one jaw-dropping phrase which acts as a reminder why the PM managed to alienate large chunks of the electorate in June: "throughout its membership, the United Kingdom has never totally felt at home being in the European Union." The PM may speak for many in the Conservative Party, but she clearly does not speak for the near-half of those voters who took a totally different view 15 months ago.

However she was more emollient on the granting of rights to EU citizens in the UK and there was a recognition that the ECJ judgements should still be taken into account by British courts. Although the PM suggested that neither EEA membership nor a Canadian style free trade agreement are appropriate for a future relationship, May did not outline what sort of relationship she does want. EEA membership was ruled out because it "would mean the UK having to adopt ... EU rules ... over which, in future, we will have little influence and no vote." Meanwhile, an FTA is a far less beneficial arrangement than the UK enjoys now. Of course, many of us have been pointing this out all along. Everything that was wrong with the speech was summed up in the PM's phrase "We can do so much better than this." Unfortunately she neglected to explain how.

With regard to the transition period, it seemed to be apologetically sneaked into the speech near the end: "a period of implementation would be in our mutual interest. That is why I am proposing that there should be such a period after the UK leaves the EU." Substitute “proposing” for “asking” and we are closer to the mark. As the PM noted, this "can be agreed under Article 50." However, that is true only if there is unanimous agreement amongst the EU27. And that is not guaranteed. So far as budget commitments are concerned, the PM said “the UK will honour commitments we have made during the period of our membership.” Whether that covers contributions during a transition period or a nod to the exit bill is unclear to me. What it most certainly was not was a commitment to pay a figure of €20bn, as many journalists have assumed.

The Daily Mail didn't like it. "May is accused of BETRAYING referendum by effectively keeping Britain in EU until 2021 as she climbs down on citizens' rights and borders with €20bn bung for Brussels in bid to revive Brexit talks." The rating agencies didn't like it either with Moody’s downgrading the UK’s credit rating by one notch to Aa2 – two below the AAA rating it enjoyed for 35 years until 2013.

Both are wrong in their assessment but it is a reflection of the rock and a hard place dilemma facing the government. The Daily Mail appeals to the hard Brexit end of the spectrum but the reality is that the head bangers who wish to see Brexit at all costs fail to see the damage that it will cause. Or don’t care. Either way, the PM could not possibly repeat the same message as she did before triggering Article 50 as she has fewer cards to play and even less authority to call the shots. That said, the hard Brexiteers in her cabinet probably prevented her from being more conciliatory than perhaps she would have liked, and Boris Johnson’s intervention last weekend may have played a role here.

The action by Moody’s was frankly a joke. I am reminded of the words of Paul de Grauwe who in 2009 posed the question “How can these agencies, which were systematically wrong in the past, have any credibility in whatever risk analysis they make?” According to Moody’s “the outlook for the UK's public finances has weakened significantly since the negative outlook on the Aa1 rating was assigned.” Just as a reminder, since Moody’s downgraded the UK from AAA in February 2013 the UK’s public deficit has fallen from 7.2% of GDP to 2.3%. On the basis of the evidence for the first five months of fiscal 2017-18, the UK deficit is running slightly below the corresponding period in 2016-17. And as one of the more pessimistic longer-term forecasters of UK public finances, I still reckon it is possible to bring it below 2% on a five-year horizon.

Furthermore, the rating agencies consistently fail to account for the fact that the UK issues debt in its own currency. There is virtually no default risk. Admittedly the political risk is higher but we don’t need a ratings agency to tell us that. If investors get cold feet, they will simply stop buying. In any case only 25% of gilts are held by foreign investors – demand amongst domestic pension funds remains high and they will continue to buy in order to match their long-term assets and liabilities.

In summary, therefore, the Florence speech was a disappointment. But hemmed in by the needs of business and those who want Brexit at any cost, the PM was always on a hiding to nothing. However, it does nothing to change the economics. If anything, a longer transition period to Brexit should be seen as a positive – if the EU 27 agrees. In that light, the actions of Moody’s should be dismissed as the irrelevance that it clearly is.

Truth, lies and Boris

Boris Johnson's extraordinary newspaper article yesterday outlining his vision for Brexit  was an outrageous piece of political opportunism. It was also a vision for the future of post-Brexit Britain that not only lacked substance but repeated a number of misconceptions about the nature of the UK’s relationship with the EU – not to mention outright lies. It was fake news writ large:  repeat the lies often enough until people believe them. But what was bad enough in the spring of 2016 becomes more politically dangerous now that the UK is in exit negotiations with the EU.

Since context is more important than content in this debate, let us start with the political background. Theresa May, the prime minister described by former Chancellor George Osborne as "a dead woman walking" following the disastrous election campaign, is due to hold a speech in Florence on 22 September. Whether it is to offer an olive branch or take a hard line does not matter at this point (we do not know the nature of the speech): The fact is it is deemed to be sufficiently important that the EU has suggested that the fourth round of negotiations could be postponed. Johnson's intervention could thus not have come at a worse time for the government.

His was an appeal to the hardline Brexiteers, and whilst it was a well-written piece as befitting a former journalist, it represented a triumph of form over content. Coming two weeks ahead of the Conservative Party conference, it is impossible to see this as anything other than a domestic power grab by a politician whose mendacity knows few limits. It never gets tiring to point out that Johnson was fired from his first job at The Times for falsifying quotes, whilst he irritated fellow journalists with his articles from Brussels for The Telegraph which portrayed the workings of the EU in an absurdly exaggerated way. It is thus hard to take seriously his claim that he is "all behind" Theresa May. If I were the prime minister, I would never want Johnson behind me: I would want him where I can see him.

That the government is in disarray is pretty evident. Not only did it trigger Article 50 before it decided what it wanted out of the EU negotiations, but it damaged its bargaining position by holding an election and losing its slim parliamentary majority. Speculation has mounted that a leadership challenge to the prime minister will come from those on the right wing of the Conservative Party who supported Brexit. More of a concern is the fact that all this in-fighting is forcing the government to take its eye off the ball. Brexit is hard enough that it will dominate pretty much all of its legislative efforts. But then to find it is being distracted from its main task by sniping from the sidelines, it is no wonder that negotiations are not going well. Michel Barnier is right: the British government simply does not know what it wants, nor how to ask for it. Their actions remind me of young teenage boys trying to chat up girls, whilst simultaneously trying to impress the group of mates who are hanging around within earshot. Oddly enough, such occasions almost never deliver the desired outcomes.

As for the content of Johnson's article, it was designed to put some steel into the backbones of those who voted leave. The implication was that the current government has not done what it planned but he was the man to deliver. "I detect scepticism about whether we have the stamina, the guts, the persistence to pull it [Brexit] off ... I am here to tell you that this country will succeed in our new national enterprise, and will succeed mightily." Classic Johnson guff. You don't have to go too far in to find the first lie: "Before the referendum, we all agreed on what leaving the EU logically must entail: leaving the customs union and the single market." But as Brexiteer-in-arms Daniel Hannan said before the referendum "absolutely no-one is talking about threatening our place in the Single Market."

However, Johnson goes on to repeat the most egregious of all the lies told during the campaign: "once we have settled our accounts, we will take back control of roughly £350 million per week. It would be a fine thing, as many of us have pointed out, if a lot of that money went on the NHS." This prompted a response from the head of the UK Statistics Authority who responded today with a letter which stated: “I  am  surprised  and  disappointed  that  you  have  chosen  to  repeat  the  figure  of  £350  million per  week, in  connection  with  the  amount  that  might  be  available  for  extra  public  spending when we leave the European Union. This confuses gross and net contributions. It also assumes that payments currently made to  the  UK  by  the  EU,  including  for  example  for  the  support  of  agriculture  and  scientific research, will not be paid by the UK government when we leave. It is a clear misuse of official statistics.”

A Brexit piece of this nature would not be complete without conflating the failings of UK government and the EU. "We should use the opportunities afforded by historically low interest rates to give this country the infrastructure it deserves." And there was me thinking that it was George Osborne's policy to pass up this once in a lifetime opportunity. Finally, there was the appeal to nationalism. "I look at so many young people with the 12 stars lipsticked on their faces and I am troubled with the thought that people are beginning to have genuinely split allegiances.”  

The whole 4000 word essay was, in the words of my American friends, a crock. It is an appeal to emotion over reason, the sort of thing we put up with during the referendum campaign. But the time for posturing is over. It was an appeal to the sunny uplands vision of what might be possible, but which made no recognition of the fact that you might have to go deep into the valley first. I thought we were over this kind of nonsense. Dammit, you won the vote. Show us you have what it takes to get the deal you promised.

Remember how Brexit was all about taking back control? It increasingly looks as though the prime minister is not in control of her government. If she wants to assert her authority, Johnson should be sacked. If she fails to do so, it will confirm the suspicions of the EU that it is facing a weak and divided government and will be even less minded to begin talking about trade anytime soon. We know that Brexit is not a viable economic prospect and that it is purely a political exercise. But it appears that the politicians cannot even get the politics right at present.

Taking back control

It is convenient to link the current state of the UK’s relationship with the EU to the events of 25 years ago today, when on 16 September 1992 the UK suspended its membership of the European Exchange Rate Mechanism (ERM). This is not as ridiculous as it sounds: 1992 proved to be a liberating experience for the UK which some have argued could be achieved on an even bigger scale by leaving the EU. The event was also significant from a policy perspective in that it marked the end of British attempts to peg the exchange rate. The ERM departure marked the third devaluation of a fixed peg, following those of 1949 and 1967. It finally proved to policymakers what many economists had said all along, that it was impossible to simultaneously operate a fixed exchange rate and an independent monetary policy whilst allowing free capital movement.

To set the scene, recall that the UK had been shadowing the DM since early 1987 in a bid to hang onto the coat tails of German policy credibility. It formally joined the ERM in October 1990 at an exchange rate of 2.95 to the DM which many people, including the Bundesbank, thought was too high. It is important also to recall that in spring 1992 Danish voters rejected the Maastricht Treaty and on 20 September, the French electorate was to due vote on the issue. European tensions were thus running high and currency markets were testing European government's commitment to maintaining their currency parities. As is now well known, sterling came under speculative pressure and the British government realised that the markets could throw more capital to attack the pound than it could muster to defend it. After a day of drama, which included a 500 bps rise in interest rates, the UK decided to leave the ERM.

Many lessons were learned that day as the recriminations began to fly. The Bank of England was disappointed that the Bundesbank did not do more to provide support. This reinforced the resistance of the policy establishment to fixed exchange rates and is one reason why the BoE came out so strongly against joining the European single currency. At the time, my view was that the debacle highlighted flaws in the ERM. The Bundesbank did not have an obligation to support ERM countries in trouble and was in any case battling with problems of its own in post reunification Germany. With hindsight, the BoE was perhaps right. The Bundesbank put its own interests first and whilst it could perhaps get away with this in the ERM, which after all was a voluntary arrangement, it raised questions about its motives, which resurfaced during the euro zone crisis of 2012. If Jens Weidmann had had his way, Greece would not have received additional aid and would surely have been ejected from the euro, which might have changed the European political landscape today.

Domestically, ERM exit changed the nature of the political debate. Conservative eurosceptics were emboldened by the lack of European cooperation to start challenging the government more aggressively on its position on EU issues. Whilst many of the political class of 1992 are no longer active in front line politics, the likes of John Redwood are still around who continues to occupy a prominent position on the right of the Conservative Party. The Chancellor in office at the time was Norman Lamont, whose career was effectively terminated by the ERM affair, and he became a trenchant EU critic who in 2016 was a prominent supporter of Brexit.

However, departure from the ERM was a liberating economic experience for the UK. It literally could take back control of its monetary policy which had effectively been subordinated to maintaining the currency parity. This allowed the BoE to cut interest rates from 10% pre-crisis to 5.25% less than 18 months later which helped to propel an economic recovery that occurred without a major pickup in domestic inflation. Not for nothing did some commentators try to portray what became known as Black Wednesday as White Wednesday.

But for those who believe that leaving the EU will prove similarly liberating, I suspect they will be disappointed. The ERM was a simple fixed exchange rate mechanism with no institutional commitments. Countries could come and go as they pleased. Indeed Italy, which also left the ERM in 1992, rejoined in 1996. Leaving the EU is a whole sight more complicated, and explains why the UK is still a member 15 months after the referendum. And unlike 1992, there has been a pickup in domestic inflation in the wake of sterling's depreciation which has proven to be very damaging to household real incomes.

That there were real benefits to be had from the ERM departure is not in dispute. Although it felt painful at the time, it hardened the UK's resolve not to join the single currency which proved to be a wise decision for a country whose currency has been devalued by two-thirds over the past century. But it also arguably heightened the belief that the UK is economically better off on its own. This is a falsehood. European monetary arrangements left a lot to be desired in 1992, and perhaps still do today. But the UK has become ever more strongly intertwined with the EU over the past 25 years, thanks to the establishment of the single market, which has largely been to its economic benefit. The lesson of 1992 is that it pays to have an independent monetary policy and that taking back control can be positive. However, as the Brexit negotiations have proven, taking back control is harder than it looks.

Universities challenged

Concerns over ‘fat cat’ salaries have been a recurrent feature in the UK over the years and the issue has been raised again in the context of the earnings of university vice-chancellors. Although it has been going for a long time, my first recollection of the popular outrage associated with excessive pay was in the mid-1990s when Cedric Brown, chief executive of the formerly state-owned British Gas, was criticised for his £500k annual pay packet (equivalent to £900k today). The outrage was not so much the amount he was paid – after all, he was ranked in the middle of the range for FTSE 100 CEOs of the time – as the fact that senior managers in formerly state-owned utilities enjoyed massive increases in pay following privatisation. 

Nonetheless, it struck at the heart of the debate over the nature of market economics. The Conservative government of 1979-1997 turned state monopolies over to the market and a lot of UK households, which bought British Gas shares following its 1986 privatisation, benefited handsomely from the surge in share prices that followed. Yet still there was outrage (manufactured or otherwise) over the fact that world class companies competing in a tough global market should have the temerity to pay their management salaries commensurate with that position.

Fast forward more than 20 years and elements of the same debate are evident in the current furore regarding the salaries paid to vice-chancellors at British universities. These are very senior management positions, equivalent to the post of chief executive who essentially oversee the management of the institution. According to a survey by the University and College Union published in February, university bosses received an average salary package of £278k in the academic year 2015/16 which is “an increase of 2% on the previous year and 6.5 times the average pay of their staff.” Whilst a 2% rise sounds modest, it is double the rate of the average university employee and comes after several years of faster increases: In 2014-15, for instance, average remuneration including pensions jumped by 5.4%.

Some universities rewarded their chief executives exceptionally well: The best paid vice-chancellor was at the University of Bath who received a compensation package of £451k (an 11% increase on the previous year). Even more rapid rates of increase were reported elsewhere, with the vice-chancellor at Bournemouth University getting a 19.6% pay rise whilst Ulster University raised the value of total compensation by 16.6%. Pay increases of this magnitude have raised a lot of political eyebrows. But as has been pointed out in a number of quarters, the current government has gone a long way towards creating a market for education so should they be surprised when market forces operate in the market for talent capable of managing in the cut-throat university sector?

What has changed in UK universities in recent years is that the state provides far less direct funding than previously, with only around a quarter coming from the public purse. University managers have to rely far more heavily on private sector sources to drum up business – in other words, they have to be far more commercially minded than previously. But the main source of funds comes from tuition fees which account for around 45% of university income. UK students now have to pay up to £9,000 per year for tuition, which for most is funded via a student loan. Once we add living costs such as food and accommodation, many students can expect to graduate with up to £50,000 of debt. As monopoly suppliers of higher education, there are those who argue that universities are exploiting their clients and paying their senior management handsomely into the bargain. It certainly is not a satisfactory situation when viewed from the position of a young student who will struggle to get a well-paid job on graduation which comfortably covers their living costs and repayment of student debt (let alone some form of long-term savings plan).

Another often overlooked fact is that UK universities enjoy charitable status. Indeed, English institutions are even exempt from registration with the Charity Commission because “they were considered to be adequately supervised by, or accountable to, some other body or authority, such as Parliament.” Scottish and Welsh universities are required to register for some reason. Nonetheless, all of them are designated as non-profit organisations whose primary purpose is to promote social well-being and serve the common good. This means that the vast majority of university income is exempt from corporation tax though they do pay VAT on certain items and are liable for payroll taxes. To give some perspective, Cambridge University paid £3 million of tax in fiscal 2015-16 on profits of £287 million (including investments) and the University of Manchester paid £2 million on earnings of £61 million, both of which are lower tax rates than paid by the much-maligned Google (20%) and Amazon (41%).

The vice-chancellor of Oxford University recently expressed the view that university managers deserve their pay packages because they operate in the “global marketplace” for talent. I have no doubt that they are good at their job, but given the tax status under which universities operate and the fact that in effect these big packages are being funded by students, this came across as a very self-serving statement (and was indeed disowned by many of her Oxford colleagues).

Nobody denies that the challenges of running a university are far greater today than even ten years ago. But academic institutions are not private sector profit maximising organisations – they are non-profit organisations which still rely on the state for part of their revenue – and to argue that university bosses are poorly paid compared with footballers may be true, but the only way to earn a footballer’s obscenely high salary is to be good at football. Indeed, perhaps universities are just the latest in a line of businesses to demonstrate that the pure application of market forces can result in perverse outcomes which benefit managers at the expense of customers.

If it's broke, fix it!

To say that Britain is a country ill at ease with itself would be an understatement. Almost every day new information comes to light which highlights that the divisions fostered by the EU referendum are not healing. Maybe my sensitivity to the issue is heightened by the fact I live in a region which voted overwhelmingly to remain in the EU and I work in an industry that depends very heavily on open borders, and now has to make preparations for the possibility that in 18 months’ time those conditions will no longer be in place. But as evidence mounts that Brexit will not be the costless process that the electorate was promised, there is some evidence of buyer's remorse. As the chart below suggests, there has been a modest, but distinct shift since May in the proportion of those believing that leaving the EU is the wrong decision. The government, however, seems intent on ploughing along its pre-defined course.

The leaked document earlier this week highlighting that the UK plans to impose tougher immigration curbs on EU citizens as soon as Brexit is implemented made for profoundly depressing reading. It certainly did not play well in Brussels and was sufficiently inflammatory that it could scupper attempts to start trade talks next month. Aside from the economic damage that migration curbs will cause, particularly in the short run, a related concern is how this changes the perception of the UK in the rest of the world. The British like to portray themselves as welcoming hosts to immigrants fleeing repression at home. It is hard to square that with the government's current policy which looks increasingly illiberal on a number of social issues.

Not for nothing did the Archbishop of Canterbury describe the current British model as "broken." I take this man's view on economics and finance more seriously than most other men of the cloth, since the Archbishop was formerly a senior executive in the oil industry and knows a thing or two about business. His comments came in the context of a report published by the Institute for Public Policy Research whose Commission on Economic Justice features senior business and public figures alongside the Archbishop. The report argues very strongly that “the British economy today is not generating rising prosperity for a majority of the population. Economic growth no longer leads to higher pay: the period from 2008 to 2021 will be the longest period of earnings stagnation for around 150 years.” The report further argues that workers are not sharing in the recovery in corporate profitability, which is furthering inequality.

Whilst this is all true, in some ways this is to miss the point. As the Chancellor of the Exchequer pointed out the Gini co-efficient measure of income inequality is at a 30-year low. There does appear, however, to be a deep-seated sense that something is wrong. For one thing, it is not income inequality per se that is the problem – everyone is being squeezed by the downward pressure on incomes as the UK economy struggles to recover from the fallout of the financial crisis at the same time as global competition is intensifying. As the IPPR points out, the UK is one of only six OECD countries where real earnings are still below their 2007 level. There is also a sense that wealth inequality is rising as younger people find themselves increasingly priced out of the housing market. In 1991, two-thirds of those aged 25-34 were homeowners: today that figure is around 36%, with the result that people of any given age cohort own less wealth today than in previous decades. But more than monetary equality measures, one of the biggest unspoken concerns is the apparent lack of equality in opportunity.

Younger generations who have entered the workforce in the last 10-15 years certainly do not have the same opportunities that their parents had. Education is a case in point. University students in the UK finish their studies with debts averaging £50,000 according to the IFS, whereas their parents educations was funded by the state. Even in the 1990s when charges were initially levied, they were relatively small and students graduated with relatively low levels of debt. Worse still, the relatively high paying jobs required to fund student loans (which, it should be noted, are subject to an almost usurious interest rate of 6.1%) are far harder to come by. This in part is the result of financial crisis of 2008-09 which has made the country poorer than it would otherwise have been. It is also the reflection of intensified global competition, which means that many skilled jobs (e.g. in manufacturing or finance) are relocating elsewhere. Automation and digitisation increasingly mean that many students emerge from education without the requisite skills. A generalist degree might have sufficed in the past as young people learned on the job, but that is increasingly no longer the case. A university degree no longer appears to be the passport to riches.

None of these problems are easy to resolve. However, the policy of successive governments to rely on markets rather than the state to improve the UK’s economic prosperity is being challenged as never before. Perhaps we have to accept that given the scale of globalisation, digitisation and environmental challenges, incomes in the UK (and indeed many other western economies) simply will not be able to grow as rapidly as in the past. That makes it all the more important that we get the policy mix right. A little less reliance on monetary policy in favour of more joined-up fiscal thinking would be a start. After all, monetary policy only brings forward consumption by enabling households to borrow more cheaply today but they have to repay those loans in the longer term. Fiscal policy will not resolve all the problems though we can be pretty certain that Brexit will exacerbate the scale of the challenges. It is thus imperative to get the Brexit strategy right – and I am not hearing any indications from either the British or EU side that this is likely to happen.

When boring is good

The weekend’s big TV debate between the two main candidates in the German election highlighted both the good and bad sides of German politics. It was a pretty tame affair. Even the German press called it the duel that never was, with both Angela Merkel and the challenger Martin Schulz trading pleasantries rather than political blows. In fairness, neither Merkel nor Schulz are particularly charismatic and the format was not conducive to a lively debate. For one thing there were four interviewers from rival channels, all keen to get their questions across. Moreover the interviewers were perhaps rather more respectful towards the candidates than was warranted by an occasion as important as this. The absence of a studio audience was another buzz-killer and as a result there was no interaction with the general public, which is guaranteed to keep politicians on their toes. That said, German voters like their politicians serious and sober (ironically Schulz is a reformed alcoholic) and do not expect to see their representatives treat the political stage as another branch of showbusiness, as happens elsewhere.

Merkel was deemed to have won on points with Schulz unable to land any decisive blows, and as a result she looks a shoo-in to be re-elected as Chancellor on 24 September. As might be expected, the debate was focused on those issues important to German voters so no surprise that Brexit never got a mention. Immigration topped the bill with a large slice of the available time devoted to this hot topic. But according to Thorsten Benner, Director of the Global Public Policy Institute, immigration is not the biggest problem facing Germany (see box below). Whilst acknowledging his superior knowledge of the German political scene, I am not sure I would totally agree. It is not the biggest economic issue but it remains a huge political problem. After all it has helped fuel the surge in support for AfD, and although they may struggle to pass the 5% threshold required for Bundestag representation, the fact the party has any support at all worries mainstream politicians.

Like most political debates of recent years, the economy did not figure highly. Why should it? After all, Germany is growing relatively rapidly, inflation and unemployment are low and it is an export powerhouse producing some of the highest quality manufactured goods in the world. In short, everything looks to be running smoothly. But as Benner pointed out, the car industry also enjoyed a good run, but it has recently been undone by the problems of dieselgate.

Criticism has come from many other quarters too: The newspaper Die Welt has been particularly critical of the Merkel government of late and following the debate, it pointed out that although Germany is one of the most interesting countries in Europe with the world looking to Berlin, its domestic politics is curiously austere and provincial. In an article last weekend, the newspaper highlighted that Germany has under-invested in infrastructure and education. There is some truth in this: After all, the huge current account surplus represents an excess of domestic saving over investment. But as Wolfgang Schäuble has suggested, it makes sense for an ageing society to save for a rainy day. The problem is that Germany has been running a big surplus for the past 10 years with no sign of a reduction. The fact that what are increasingly seen across Europe as excessively large surpluses are rarely spoken about at home is a sign that the savings investment problem is unlikely to be addressed any time soon.

For all that the debate was a bit dull and skirted around many of the issues which economists might wish to have seen tackled, it was also devoid of the bombast that accompanied the US election and the emotionally-charged atmosphere of the Brexit referendum. For that we should be thankful, since at least one significant western power offers political stability. From an international perspective, four more years of Merkel at the helm would not be the worst outcome in these turbulent times. Those of us dealing with dysfunctional governments in the UK, let alone the US, look to German political stability with a degree of envy.