No steps forward, two steps back

As politicians go, I have a lot of time for former Chancellor Ken Clarke. Anyone who can survive the rudderless Major government of 1992-97 with their reputation intact, never mind enhanced as in Clarke’s case, is a person of substance. Clarke is also a prominent Remainer, who described himself on a Twitter account as a one-nation Tory. He is, in other words, an old-fashioned centrist who is loyal to his party but is not averse to working across party lines on issues of major importance. Indeed, Clarke was the only Conservative MP to vote against the bill triggering Article 50. This is ironic, since his constituents voted to leave the EU in last year’s referendum whereas many of his party colleagues represent areas which voted Remain yet who still voted to initiate the Article 50 process. If you are half as confused as I am by the “will of the people” argument, then I am twice as confused as you.

I had originally planned to quote some of the latest tweets from Clarke’s Twitter account but the account has been suspended, which has to raise questions as to whether it was genuine (pace this week’s big debate about whether fake tweets from Russian bots had undue influence on the Brexit referendum). Nonetheless, the sentiments expressed on the account sounded sufficiently Clarke-ite to bear repeating. One thing particularly caught my eye, which was that although many people have significant reservations about Brexit, including many MPs, the government is committed to the process. It cannot easily be stopped, however much we might wish that were the case. But that does not mean that Conservative MPs should not oppose the most egregiously stupid parts of the process.

As the EU Withdrawal Bill enters the committee stage, with MPs able to table amendments to the original bill, we are now beginning to get a more clear idea of who is opposed and what they object to. As an aside, it should be noted that twelve months ago, this piece of legislation was designated as the Great Repeal Bill which was originally designed to transpose EU law into UK law whilst giving government the powers to strike out those bits they deem inapplicable. Easy, right? Except for the fact that the process is far more complicated in practice, and there is also the small matter of parliamentary accountability. As currently envisaged, the bill gives government the power to strike out EU laws without parliamentary scrutiny (the so-called Henry VIII clause) which rather makes a mockery of the claim that the British parliament will once again take control of British laws.

Having decided on a more prosaic name for the bill, the government is finding it tough to keep its legislative process on track. Brexit Secretary David Davis has promised that MPs will be given a vote on any final deal agreed with the EU. Whilst that is a concession relative to what was originally proposed, it is meaningless, particularly in view of Theresa May’s promise to put the exact time and date of the UK’s departure from the EU into the bill. For one thing, Davis offers only a take-it-or-leave-it vote, so if MPs reject the plan, the UK will leave the EU without any deal, which would be crazy. Second, if the negotiations go to the wire then MPs will not have the opportunity to consider its content before the proposed deadline. As many MPs, including Ken Clarke, pointed out this reduces the government’s flexibility with regard to dealing with any last minutes hiccups. Better to delay a week or more to allow for more discussion than maintain an artificial deadline simply for the sake of political pride.

With 15 Conservative MPs apparently prepared to block the insertion of the specific date into the bill (or, as the Daily Telegraph would have it, "mutineers"), it is likely that the parliamentary process will be far slower than the government initially expected, and the committee stage may not be completed by Christmas as planned, which could delay its passage into law beyond next spring. Under normal circumstances, the sensible option would be to allow more time for these complex negotiations to take place. But time is the one thing the government does not have. Indeed, we have just gone past the halfway point between the date of the referendum and the proposed EU departure date, and it does not feel that we are much beyond the wish-list phase.

Ironically, Manfred Weber, the German MEP who heads the European People's Party Group in the European Parliament and is an ally of Angela Merkel, today held meetings with Theresa May and David Davis and declared himself “more optimistic” about the possibility of reaching agreement with the UK than before (which I assume means she has offered more money). But he also said “the whole idea of building up the European Union, which was supported by the British governments … was to make the lives of European citizens better. We are destroying some of the things that we achieved already. We will regret it … It is a shame there is not the will to stay together.”

I happen to believe he is right, particularly when Politico reports that the UK will at best be offered a basic Canada-style trade deal on exit, and not the broader bespoke deal that Theresa May hoped for – a view which I have heard from another senior EU policymaker in the course of a conversation this week. Indeed, the same person said that a Norway style deal would not work for the UK, given the complexity of the British economy, and since a Swiss-style deal was never going to be on the table, it’s Canada or nothing.

But the most galling part is that the government does not have a coherent plan on how to leave the EU, let alone how to deal with the aftermath. It is car-crash politics, and diminishes the UK by leaving it economically weaker and politically more isolated. But sometimes the only way people learn is through their own mistakes. Unfortunately we all suffer in the process.

It's very quiet out there

As UK political uncertainty mounts, it is striking that sterling-denominated assets have held up reasonably well of late. Sterling has traded in a relatively narrow range over the past year with the trade weighted index registering a high of 79 in May and a low of 74 in August. Surprisingly, investor net speculative positions in sterling, which were heavily negative early this year, have now turned flat to slightly positive. This reflects the fact that FX investors are currently not expecting a significant sterling collapse, although the timing of the move does appear to be correlated with changes in the market’s position on BoE rate hikes. Meanwhile, although the FTSE100 has trailed indices such as the Eurostoxx  50 year-to-date, they have moved broadly in line since May and the FTSE has managed a year-to-date return of 3.8%  – not great when set against other markets but nonetheless positive. Moreover, the weakness of sterling tends to be a positive factor for UK equities given how much revenue is booked in foreign currencies (around 70%).

Thus, political uncertainty appears to be conspicuous by its absence so far as markets are concerned, which reflects the fact that investors are looking through all the rhetoric and concluding that the likelihood of a cliff-edge Brexit is low. Since we are still more than 16 months away from the expiry of the Article 50 negotiation phase, markets take the view that there is no sense in panicking now – there will be plenty of time for that later. Nonetheless, the closer we get to the deadline without agreement, the greater the likelihood that assets will come under pressure, but that is probably a story for next year.

To get a sense of how the market and economic agents assess uncertainty in the UK at present, I constructed an uncertainty index based upon eight variables: (i) FTSE100 equity volatility; (ii) EUR/GBP FX volatility; (iii) GBP/USD FX volatility; (iv) the Baker, Bloom and Davis policy uncertainty indicator; (v) GfK survey data for expected consumer finances; (vi)  expected unemployment and (vii) expected economic situation. The final component is (viii) the CBI’s estimate of uncertainty as a factor limiting capex. Furthermore, if we strip out the equity and currency vol measures, we have a five variable index of domestic uncertainty.

The chart suggests that the aggregate uncertainty index has dipped back close to its long-term average (2000-2015). Whilst the domestic indicator has not fallen quite as sharply, it is well below its summer 2016 highs with only the Baker et al policy uncertainty index showing any extended deviation. The interesting thing is that this policy uncertainty index is based on an online trawl of newspaper websites looking for various keywords which express uncertainty. To the extent that much of the concern expressed about Brexit has indeed come via the media (not to mention the blogosphere, so I am as guilty as anyone), it highlights the noise inherent in the debate without necessarily shedding much light on how the economy is performing. Indeed, many of the other indicators normalised very quickly, which suggests that most economic agents generally got on with life in the wake of the Brexit vote.

This does not mean to say that everything will remain so quiet. The GfK survey data point to a deterioration in expectations for the future economic situation with sentiment now back at levels last seen in spring 2013. Moreover, with inflation beginning to put the squeeze on consumers, we are starting to see some deterioration in expectations for consumer finances.

It is worth noting that the indicator is not a good predictor of longer-term trends. Even in the early months of 2008, when there were signs that trouble was brewing in the banking sector and the economy was losing some momentum, both the aggregate and domestic uncertainty indices remained at low levels. A lurch towards the cliff-edge of Brexit could change perceptions quite markedly. Perhaps UK consumers and corporates need to hurt even more before they realise the potential economic consequences of Brexit. This is why just looking at the current relative stability of the uncertainty index is not necessarily a good guide to future trends. In my view – and that of most of the economics profession – a number of senior British politicians do not seem to understand the risk they are taking with the wider economy. It is incumbent upon them to get it right or the electorate may be in a less forgiving mood than it has been of late.

We'll settle for either strong or stable

Anyone looking at the UK from the outside can be forgiven for wondering what has gone wrong with a political process that the British like to think spawned the Mother of all Parliaments (there again, many natives are wondering the same thing). The government is weak and divided – in office but not in power – whilst the political establishment has been rocked by allegations of sexual misconduct. All this is happening against a backdrop of the most critical set of negotiations since 1945, which require the government’s undivided attention – but which it is unable to give for the reasons just outlined.

The obvious answer is that Brexit is the culprit. According to Philip Stephens, writing in the FT, “Brexit has broken British politics." There is certainly a lot of truth in this. As Stephens notes, “a majority of MPs think Brexit is a mistake but feel obliged to pursue it lest they be accused of defying what the tabloids declare to be ‘the will of the people.’” Quite what the “will of the people” might be is hard to discern from a referendum result which produced a near 50-50 outcome. Consequently, and unsurprisingly, treating the result of a (legally non-binding) referendum in the same way as a winner-takes-all election was always going to polarise already-inflamed opinions.

But a less obvious answer is that the Brexit vote was itself the manifestation of something deeper. Arguably – and I am in speculative territory here – it was the result of dissatisfaction with a political establishment which has failed to adhere to the rules and standards which it expects others to abide by. More worryingly for an economist, there has been a steady erosion of rules- and evidence-based policy making which has contributed to hugely sub-optimal outcomes. We can go back to 2002 and the case which the UK government made for involvement in a military invasion of Iraq which was not sanctioned by the United Nations. The UK Prime Minister Tony Blair put his name to a document that argued the government of Saddam Hussain had developed weapons of mass destruction, despite the fact that international observers on the ground found no such evidence. Trust in UK politicians was further eroded by the 2009 parliamentary expenses scandal in which many MPs blatantly ignored guidelines on the use of public money in reclaiming expenses. There were rules in place but they were routinely flouted.

A more economically relevant case is the flouting of the fiscal rules enshrined in the Maastricht Treaty, designed to prevent governments from running a deficit-to-GDP ratio in excess of 3%. Moreover, the criteria for entry into the single currency in the first place was that “the gross debt total of the general government should not exceed the reference value of 60 percent of GDP or, if it does, it should be sufficiently diminishing and approaching the reference value at a satisfactory pace.” With both Belgium and Italy showing debt ratios above 100% at end-1997 (the reference date for entry into EMU), it’s safe to say that they were nowhere near achieving this goal. Of the original 11 members Austria, France, Ireland, Netherlands and Spain also missed the target.

I did point out in 2003, at a time when investors were concerned that countries were routinely missing the 3% deficit target that “by failing to force governments to comply more strictly with the 60% deficit:GDP ratio prior to the start of Emu, the fiscal playing field has not been levelled sufficiently to allow some countries to easily meet the Stability and Growth Pact deficit criteria. In simple terms, the debt targets were simply not taken seriously enough.” This is not to say that the euro zone debt crisis could have been avoided, but had debt ratios been closer to the required thresholds in the first place, some of the smaller countries would have had more fiscal headroom to cope with the storms which subsequently blew in.

The banking crisis, which resulted in many financial institutions requiring government support, is another case in point. The public’s view is that the taxpayer has carried a heavy burden without those responsible for causing the problem ever being held properly to account. Again, this could be seen as a failure to apply rules – or at least the failure to apply natural justice.

Each of the examples outlined here was avoidable. Had one occurred in isolation, arguably we could have coped better with the fallout. But failure to consistently apply the rules erodes policy legitimacy and invokes greater challenges to the status quo, producing an ideal breeding ground for political discontent. The academic literature in this area explains how policies which are initially not popular (such as Brexit) can find broader acceptance as the public taps into various aspects of the policy (see the introduction to this paper from The Quality of Governance Institute at the University of Gothenburg).

The authors of this paper also make the point that “public opinion changes as a result of policy implementation.” Given the UK government’s abject failure to get its act together on many aspects of policy, this raises serious legitimacy issues. Not only did successive UK governments fail to deal consistently with the conditions which provoked the Brexit backlash, but the current administration is failing to deal with the consequences. Theresa May once promised to deliver strong and stable government. Right now, many people would settle for one or the other.

Breaking point

In the context of the debate on productivity, I was recently asked by a non-economist why economists tend to assume mean reversion when it is clear there has been a structural break in the series. It is a very good question and goes to the heart of a major problem in the business of forecasting. Most of our forecasting models are based on linear (or log-linearised) relationships whose forecast performance is conditioned by historical experience. Therefore, if a relationship has tended to mean-revert in the past, the model will assume it does so in future. As a consequence, we cannot easily deal with structural breaks in economic relationships. To put it another way, even if the data deviates from past performance for a prolonged period of time, it is dangerous to assume that there has been a permanent shift since it is entirely possible that it will soon snap back.

It takes a lot to convince economists that there has been a change in trends. In a classic 1961 paper[1], Lawrence Klein and Richard Kosobud noted that much of macroeconomics is based on five “great ratios” in which the relationships between variables can be assumed to be stable. These five ratios are (i) the savings-income ratio; (ii) the capital-output ratio; (iii) labour's share of income; (iv) income velocity of circulation and (v) the capital-labour ratio. But what might have been true almost six decades ago is no longer the case. Labour’s share in income has fallen sharply in the Anglo-Saxon economies over recent years whilst recent experience has shown big shifts in the capital-output ratio, which resulted in the productivity puzzle. However, these old ideas die hard and whilst we try to ensure that we do not stick to outdated precepts, relationships often change so imperceptibly slowly that it is difficult to be sure whether we are witnessing a cyclical shift or a secular trend.

The problem is well-known in economics and has been much-studied. In my introductory econometrics classes one of the first statistical tests to which I was introduced was the Chow test for structural breaks which assesses whether the coefficients derived from regressions on two different parts of the dataset are equal. Although it is pretty simple stuff, a look at UK year-on-year employment and GDP growth over the period 1980 to 2016 nicely highlights the nature of the problem. A quick glance at the chart certainly suggests that there has been a change in the trend relationship (chart). But it is really not that simple.

Suppose in 2013 a policymaker began to be concerned about the nature of the relationship and suspected there was a break in the historical trend. In early 2013, the intelligent policymaker has quarterly data through to end-2012 and decides to estimate a simple econometric equation using the EViews software over the period 1980 to 2012 (132 observations) in order to test their hypothesis. But conducting a Chow test for a structural break at the end of 2008, 2009 and 2010 does not yield any evidence of a break. The data-driven policymaker would thus conclude that this is problem to keep under observation but it is not yet time to press the panic button. A year later, in early 2014, the policymaker runs the analysis again with an additional four quarters of data (136 observations) but still finds no evidence of a structural break in the relationship. But by early 2015, our policymaker runs the analysis on data through end-2014 and finds some evidence of a break in the data at the end of 2009. By the time we get to early 2016 – three years after they suspect a problem – the statistical evidence is unambiguous: There has been a change in the relationship between GDP growth and employment.

The first point to make clear here is that a cautious policymaker has to wait for evidence that there has been a productivity shift – even if they suspected that something was amiss, they cannot make inferences on a relatively small amount of data because they do not know whether the shift is temporary or permanent. But even when the statistical evidence is clear, we cannot simply jump to conclusions – the blip in the productivity figures could vanish just as suddenly as it appeared. For example, if labour shortages begin to manifest themselves, companies can only increase output by increasing capital investment rather than relying on labour. This will mean GDP grows more rapidly than employment in which case labour productivity figures would begin to look much stronger.

As noted above, this is a simplistic exercise and there are better statistical ways to assess whether there are breaks in a data series, but it does highlight an important point: In a world where we require empirical evidence before making policy changes, we sometimes have to wait a long time to build up sufficient information before we are even half sure that we are doing the right thing. Whilst the BoE and OBR are criticised for failing to foresee these trend shifts in economic performance, anyone who has ever tried modelling and forecasting when trends are changing will tell you that it is much harder than it looks.

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[1] Klein, L.R. and R. F. Kosobud (1961) ‘Some Econometrics of Growth: Great Ratios of Economics,’ Quarterly Journal of Economics (75), 173-198

The great productivity debate remains unresolved

Over the course of the last week I have listened to presentations from three of the UK’s most influential forecasting institutions (the Institute for Fiscal Studies, National Institute of Economic and Social Research and BoE) in which the common factor was the weakness – indeed lack – of productivity growth. The ONS measures productivity using three main metrics – output per worker, per job and per hour. In the nine years since the great recession, these have grown by 0.8%, 1.0% and -0.2% respectively. For the avoidance of any doubt, these reflect the absolute changes across a nine year span, not the annual average – in other words, output per hour has declined in absolute terms by 0.2% since Q4 2007 (do you feel as though you are working less?).

To put this into context, annual growth over the period 1980 to 2008 averaged 2% for output per worker; 1.3% per job and 1.4% per hour which means that output per worker is currently almost 13% below its pre-crisis trend (chart). You really have to go back a long way to see a sustained period of sluggish productivity as poor as this in the UK during peacetime – probably back to pre-industrial revolution times, if the BoE’s excellent long-run historical dataset is any guide.

On the assumption that real wages grow in line with productivity, this means that real wages today are a similar amount below where they would otherwise be. But what makes matters worse is that, miserable though productivity growth has been, UK real wages have lagged even further behind. Average weekly earnings deflated by the CPI are currently 4.6% below their end-2007 levels. In other words, productivity growth has been flat but real wages have fallen. This goes to highlight the claim made by Paul Krugman that productivity may not be everything, but in the long run it is almost everything. It is undoubtedly one of the reasons why we all feel so much worse off than we did prior to the recession.

None of this is exactly news, as it has been a mounting cause for concern in recent years. Indeed, I recall looking at the problem as long ago as 2013. But the fact that productivity has remained stubbornly weak, and not recovered in line with expectations (and indeed, historical experience) clearly points to something wrong. It might be partly the result of measurement error in an increasingly digital economy; labour hoarding in a service driven economy; a lack of investment or simply an ageing demographic profile. It is, of course, not just a UK problem: It is a problem across all industrialised economies although the UK seems to have been hit relatively hard. Nonetheless it is an issue which governments have tended to downplay up to now.

Each of the three UK institutions noted above sees different aspects of the problem, reflecting their particular speciality. For the NIESR, it will contribute to weak growth and thus an ongoing squeeze on living standards. As far as the IFS is concerned, whose focus is fiscal policy, the resultant weakness of growth will put pressure on the economy’s ability to generate sufficient revenue to eliminate the budget deficit. Indeed, the Office for Budget Responsibility last month noted that it is likely to “significantly” reduce its “assumption for potential productivity growth over the next five years“ in its November forecast which accompanies the Autumn budget statement. Meanwhile, the BoE is concerned that weak productivity growth will hold back potential output growth with the result that the economy is more likely to run into capacity constraints which will generate inflation.

So far, we seem to have escaped the worst aspects of sluggish productivity growth. Inflation has only picked up because of a sterling-induced crash, not because of any underlying rise in domestic cost pressure. Public finances have improved significantly, with public borrowing declining by two-thirds between 2010 and 2017. Arguably the squeeze on living standards has been the worst aspect, and may well have contributed to the Brexit vote last year. But the sunny uplands to which politicians promise we will soon return will remain unattainable without a recovery in productivity. And the longer productivity remains weak, the more of a struggle economic recovery will be. Like a Facebook relationship status, the productivity puzzle is complicated but it is one we need to get a handle on – and fast.

The BoE and a bit of cold turkey

It is widely expected that the Bank of England will raise interest rates this week for the first time since 2007. There have been some influential academic voices suggesting that this would be the wrong time to raise rates – the more I think about it, the more I disagree with them. And before we all get carried away, the expected increase from 0.25% to 0.5% would only represent a move from the lowest level in history to the second lowest.

The first reason for disagreeing with some of the wiser heads is purely to do with the signalling effect. Having suggested in September that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” financial markets have increasingly interpreted this as meaning that a rate move is likely in November and are now pricing such action with a probability of almost 90%. Although the BoE has suggested in the past that a near-term rate hike might be in the offing – which subsequently never materialised – not since Mark Carney assumed his post in 2013 have markets been so convinced about the likelihood of a rate hike at the upcoming meeting as they are now. The only comparable degree of market conviction was in the wake of the EU referendum, when in July 2016 markets fully priced a 25 bps rate cut at the August 2016 MPC meeting (a reduction which was duly delivered).

Of course, it is not the MPC’s job to reinforce the market’s conviction. But to the extent that the strategy of forward guidance relies on the predictability and credibility of central bank communication, any decision to hold interest rates unchanged in view of current market expectations would seriously undermine this plank of monetary policy because it would suggest that communication has not been sufficiently clear.

Another strong argument in favour of raising interest rates is that they are (arguably) too low given where we are in the economic cycle. Much of the academic opposition to a rate hike stems from the fact that wage inflation remains low, and uncertainty surrounding the Brexit decision suggests that this is not a good time to tighten policy. I have sympathy with these views. Indeed, I have argued recently that the inflation excuse used to justify the need for higher interest rates does not wash because it reflects a one-off spike triggered by currency depreciation. But opponents of a rate hike may be guilty of confusing the impact of interest rate levels and a change in rates. Even though the UK economy has lost momentum over the course of this year it is still growing at a rate of around 1.5% in real terms. Inflation, at 3%, is right at the top end of the threshold above which the BoE Governor has to write to the Chancellor explaining what he intends to do in order to bring it back towards target. Moreover, monetary policy is still operating on a setting designed to promote recovery in the wake of the 2008 financial collapse, with an additional bit of Brexit insurance thrown in. The UK simply does not need rates at current levels.

Arguably, the BoE should have raised rates in 2014 or 2015 when growth was back at trend and house price inflation was running at double-digit rates. However, the global interest rate cycle was not then supportive of a unilateral move by the BoE, with the Fed not yet having commenced its rate hiking cycle and the ECB beginning a phase of more aggressive monetary easing. As it turned out, with UK inflation running close to zero during 2015 and H1 2016, the BoE would have run the risk of repeating the mistake of the Swedish Riksbank which began tightening in 2010 only to have to reverse course in the face of a collapse in inflation.

As for Brexit risks, the BoE has been clear all along that this represents an economic shock against which interest rates can only provide limited insulation. In any case, taking back the precautionary 25 bps rate cut implemented in summer 2016 makes sense in view of the fact that the worst case scenario did not materialise. But a wider point is that ultra-expansionary monetary policy can inflict just as much harm as an overly restrictive stance – perhaps in ways we do not yet fully understand. We do know that low interest rates have helped to propel equity markets to record highs and produced an unjustified tightening of credit spreads. To the extent that investors have become less discriminating about what they buy when they are simply chasing yield, low interest rates distort normal market behaviour. And as the Japanese experience has shown, a lax monetary stance is no guarantee of economic recovery.

Rising interest rates will hurt – mortgage payments, for example, will go up which is no fun at a time when real wages are falling. But as those professionals treating drug addicts will tell you, sometimes it is necessary to take a clear look at where we are, how we have got there and accept that a bit of cold turkey is necessary for the longer term good.