2017 in review

After an unpredictable 2016, 2017 was unable to live up to that level of excitement – and I for one am extremely thankful for that. From a macroeconomic perspective there were certainly no fireworks: GDP growth in most parts of the world was steady, and in Europe it outperformed expectations – even in the UK, where recent data revisions suggest a growth rate closer to 1.8% in 2017 rather than the long-predicted 1.5%. Central banks did not have a lot to do, other than the Fed which raised rates in three steps of 25 bps, although the Bank of England surprisingly stepped into the ring with a 25 bps rise in November. The lack of both wage and price inflation is becoming an increasing cause for concern in many parts of the industrialised world, although policymakers hope that ongoing recovery in 2018 will eventually prompt a pickup.

In this benign environment markets continued to make hay, with equity indices on both sides of the Atlantic setting new highs. This confounded one of my predictions for 2017 which was that the ongoing equity rally would peter out in the spring. Many measures of equity valuation certainly appear elevated: Robert Shiller’s long-term trailing P/E measure for the S&P500 is currently at the level seen at the time of the 1929 Wall Street crash and is only exceeded by the levels of the late-1990s tech boom (chart). A measure of the S&P market cap relative to US GDP is also running at levels which in the past have preceded a bust. Add in the fact that measures of market risk, as proxied by option volatility, have touched record lows in the course of 2017, suggest that this is a market which looks too frothy.

That said, solid growth and low inflation add up to a goldilocks scenario for most investors, particularly with central banks continuing to offer cheap money. But if we think about equity P/E ratios, the denominator (earnings) is currently not being driven by rapid price inflation: Corporate profits generally reflect the solid growth picture. Investors are thus prepared to pay a sizeable premium for equities, which is normal in a low inflation environment. Thus, a focus on elevated P/E ratios may paint an overly pessimistic market view. This does not mean we can afford to be complacent and I will look at the 2018 outlook in my next post, but given the macro and monetary policy backdrop, we can at least rationalise market movements in 2017.

Indeed, markets have shrugged off the biggest risk identified 12 months ago: politics. In that sense, one of my 2017 predictions was borne out when I wrote in early January that “I would be surprised if Donald Trump can do much damage to the US economy in 2017.” To my surprise, the administration did manage to force through its planned tax reform before year-end, with the proposed cuts in corporate taxes giving equity markets a boost. Refinements to the package suggest that the longer-term economic impacts may not be quite as bad as initially expected, with analysis by the Tax Policy Center pointing to a short-term GDP boost and a smaller rise in the deficit over the longer-term compared to the analysis it produced in June.

On this side of the Atlantic, fears that the populist surge unfolding elsewhere would find renewed expression in the Dutch and French elections proved unfounded. Indeed, the emergence of Emmanuel Macron was one of the biggest political surprises, and a positive one at that, with Europe at last finding a charismatic centrist politician committed to the liberal democratic ideas which have underpinned the peace and prosperity of the last 70 years. But the German election did provide an upset as voters deserted the two main parties in favour of smaller groups, with the AfD emerging as a relative winner. The fact that Germany has not yet managed to form a coalition government more than three months after the election is an indication that Europe’s largest economy is not without its own political problems, and the general consensus is that Angela Merkel has entered the twilight of her political career. The fact that the twin motors of the EU project continue to run out of synch suggests that the EU reform process may not make much headway in the near term.

Which brings us to Brexit, a subject that has taken up so much of my time in recent years. I assigned a 45% probability to the likelihood that the UK government would trigger Article 50 in March without making any contingency plans in the event that discussions with the EU proved more difficult than expected. But in effect, that is precisely what happened. The UK remains a divided and polarised country characterised by an absence of effective government. On Friday, Andrew Adonis, a Labour politician who chaired the national infrastructure commission, resigned citing the dysfunction at the heart of government and accused the prime minister of being “the voice of UKIP”. 

To quote Adonis, “I do not think there has ever been a period when the civil service has been more disaffected with the government it serves. I do not know a single senior civil servant who thinks that Brexit is the right policy, and those that are responsible for negotiating it are in a desperate and constant argument with the government over the need to minimise the damage done by the prime minister’s hard-Brexit stance. It is an open secret that no one will go and work in David Davis’s department, and Liam Fox is regarded as a semi-lunatic.”

Whatever one’s views on Brexit, Adonis’ comments highlight what many of us have suspected for a long time: The government does not have a plan, without which Brexit will be an utter car crash. And to think, the Conservatives remain the largest party in parliament (despite losing their majority following a spectacularly incompetent election campaign). What does that say about the opposition? Or indeed us? We deserve better in 2018.

Generating economic policy buy-in

Just before Christmas, the FT commentator Gideon Rachman penned a column which argued very strongly that “Economics is – or should be – part of moral philosophy  …  ‘the economy’ is not just about growth. It is also about justice.” This is a very important point and one that tends to be overlooked, or at least downplayed, by large parts of the economics profession. Rachman argues – as indeed as I have done on this blog – that many voters do not buy into the economic vision offered by politicians because they do not see how it benefits them. What is even worse, they often believe they are being discriminated against in favour of other interest groups.

Making America great again speaks to the millions of voters who believe somehow that the US’s status of top dog is being eroded by emerging economies that do not play by the economic rules and that the US is being penalised for abiding by them. In a similar vein, taking back control speaks to those British voters who see the UK as being held back by a monolithic EU. As an economist, I find such statements absurd. After all, the US is still the pre-eminent economic and military superpower whilst EU membership gives the UK access to the largest and richest single market on the planet. But there is no reason why this should cut any ice with the average voter who is struggling to make ends meet at a time of low wage inflation and against a perceived backdrop of mounting job insecurity (which incidentally is not backed up by the UK evidence).

The predominant economic model in the Anglo Saxon world over the last 35 years has been a market-oriented policy in which government has tried to reduce its role in the belief that the market will provide the most efficient allocation of resources, thus boosting welfare. Prior to 2008 the evidence appeared to suggest that whilst voters were aware of the downsides of this model, the economic tide was rising sufficiently quickly to float all boats. But political and economic circumstances have changed over the past decade. Society’s sense of natural justice was offended by government actions to bail out banks whilst simultaneously imposing a policy of fiscal austerity, which sowed the seeds of a belief that the system is rigged in favour of big business at the expense of the little guy.

This has resulted in many aspects of our current model being put under the microscope and raises questions whether economic policy is going in the direction which voters are prepared to buy into. As Rachman points out, intra-generational issues are uppermost in the minds of many voters. There are concerns across the western economies that those in born after 1980 will not be as wealthy as their parents. Evidence from the UK, for example, suggests that younger adults have much less wealth to their name than previous generations did at a similar age. Over the past decade, as younger voters have gone through university and entered the labour force, many of them are beginning to question whether they will be able to reap the economic rewards they were promised. UK students no longer get the benefit of a free university education and finish their university studies with much higher levels of debt than their parents. Indeed, UK students now carry a staggering £13bn of debt – an increase of almost 190 times what they owed in 1990.

At the same time, the younger generation must pay the taxes to cover the rising costs of providing for the welfare needs of the ageing baby boomers, whilst struggling to find the high-paying jobs which previous generations were able to secure. They will also have to deal with the fallout from the populist reactions triggered by the Brexit vote and the election of Trump – both of which were propelled by the votes of the older generation. Millennials in the industrialised world can be forgiven for questioning the legacy bequeathed to them by older generations.

Policies which offer a trade-off between more market solutions and lower taxes are increasingly unlikely to find electoral favour. Nobody wants to pay more taxes, of course, but there are limits on how far countries such as the UK can continue to reduce them and still maintain the reasonable standard of public services that the public has come to expect. Scarcely a week goes by without a newspaper story decrying cuts to the armed forces or the strains imposed on a health system which struggles to cope with the strains placed upon it. It is perhaps for this reason that we are seeing renewed voter interest in “radical left” parties across Europe which promise a greater role for the state in a bid to improve the lot of those left behind (chart).

Indeed, as the IMF pointed out last week in its regular assessment of the UK economy “greater reliance on revenue measures for [fiscal] consolidation than in recent years may be warranted.” Amongst the potential measures put forward were a reduction in “the tax code’s bias toward debt” which benefits corporations, and rebalancing property taxation away from transactions and toward property values. Ironically, the US appears to have gone in the other direction with the recently unveiled changes to the tax system primarily benefiting corporates and better off individuals.

If we really are in it together (to use George Osborne’s phrase) some changes to the incidence of taxation would be a good place to start to help win over voters that the system is not biased against them. Whilst many in the policy establishment draw on the laissez-faire teachings of Adam Smith, we should not forget that “The Theory of Moral Sentiments” extensively explored ideas such as morality and human sympathy. He never advocated the devil-take-the-hindmost policy which many of his adherents claim. It is a lesson the economic and policy establishment perhaps needs to relearn.

The costs (and benefits) of Christmas

According to a survey conducted by the National Retail Federation, the average American plans to spend $967.13 on gifts during the 2017 holiday season (defined as spending over November and December), which represents an increase of 3.4% on 2016. Cheapskates! According to the Christmas Price Index calculated by PNC Financial Services Group, the basket of goods which one’s true love can be expected to send over the twelve days of Christmas (a partridge in a pear tree, two turtle doves etc.) costs a whopping $34,559. If you follow the sequential purchasing of the presents (12 partridges in pear trees, 11 times two turtle doves etc.), the total cost amounts to almost $160,000.

Over the last 33 years, the average cost of Christmas on the basis of this index has risen by 2.9% per year. But significant volatility is introduced by the price of swans. PNC thus suggest that a core Christmas index can be constructed excluding this item, although this does rather change the nature of the index as it is by far the most expensive item, accounting for 50% of total outlays (down from 78% in 1984). If your true love is not particularly partial to swans a-swimming, this reduces the total cost of the basket to just below $80,000. Quite the bargain! In terms of inflation, however, the core index has increased at a rate of 4% per year since 1984. For the purposes of comparison, US headline consumer price inflation since 1984 has averaged 2.6% per year (core: 2.7%).

Assuming that the UK imports all of these goods from the US (I know, but we are not being entirely serious here), the total cost of Christmas in the UK has increased at an average rate of 2.5% per year. However, it probably makes more sense to focus on the core index since the Queen owns all the swans in the UK (technically, she owns any unclaimed mute swan in open water in England and Wales but let’s not split too many hairs). This measure of the UK core Christmas index has posted an average inflation rate of 3.6% per year since 1984. Last year was a particularly painful one given the collapse in sterling which raised the UK Christmas index by 20%. It has since fallen back a bit on the basis of a slight rally in sterling but clearly even Christmas is not immune to the costs of Brexit (so thanks for that Nigel and co). 

Of course you can avoid the whole rigmarole by refusing to play along. Back in 2001,the economist Joel Waldfogel argued that there is a significant deadweight loss associated with Christmas primarily because the consumption choice is made by the giver of gifts rather than the final consumer. As he put it “it is more likely that the gift will leave the recipient worse off than if she had made her own consumption choice with an equal amount of cash.” This deadweight loss is estimated at between 10% and 33% of the value of gifts. So if you are thinking about buying someone a book for Christmas, you should probably follow Waldfogel’s advice and not buy them a copy of his book Scroogenomics.

Indeed, Waldfogel is guilty of making the classic error of focusing purely on those quantities that can be assigned a monetary value. The whole point of giving a gift is a sign of appreciation that we value the recipient, and it should be seen as a signal that the giver is prepared to invest time and effort to demonstrate individual recognition that is absent at most other times of the year. It is thus probably going overboard to purchase the 364 gifts required in the old Christmas carol (assuming a partridge in a pear tree is one gift). Indeed, if someone were prepared to spend the $157,558 that PNC calculates that the basket of goods cost, I think I would rather have the cash if it’s all the same to you.

But even if Santa Claus somehow forgets to bring you an envelope stuffed with that amount of cash, I wish you and yours a Merry and Peaceful Christmas.

You say you want a revolution

It has been a tumultuous year for those of us who spend a lot of time looking at the British economic and political scene. Recall that former prime minister David Cameron hoped a referendum would lay to rest once and for all the civil war within the Conservative Party that was being fought on the battleground of EU membership. As it turned out, Cameron’s decision proved to be the most spectacular political own goal in at least 60 years (rivalled only by the failure triggered by the Suez invasion of 1956). Consequently, this has been a year characterised by social division and political anger, with no signs that the divisions stoked by the Brexit decision show any sign of healing. It has also been a year strewn with political mistakes which have compounded Cameron’s original error, notably the government’s failure to clarify what it wanted prior to triggering Article 50 and the shocking error of judgement in calling an unnecessary general election.

Despite all this, the economy has trundled along and looks set to post a growth rate around 1.5% this year whilst the unemployment rate has fallen from 4.8% a year ago to 4.3% today. But the pace of growth is considerably slower than we might have expected in the absence of the referendum. In June 2016, my forecast called for real GDP growth of 2.2% in 2017. A direct monetary comparison of what this means in terms of lost output is distorted by data revisions and methodological changes, which have raised the current vintage of nominal GDP by an average of 1.1% since 2010 compared to the June 2016 vintage. But assuming away such matters and focusing purely on the growth trajectory, latest data suggest that real GDP Is currently almost 1% below the level expected in the pre-referendum forecast.

This is roughly what was predicted in spring 2016 in the event of a leave vote and would appear to reinforce the views of the economics profession which argued forcefully that there would be a cost to leaving the EU (bear in mind we have not left yet), whilst giving the lie to claims by Brexit supporters that such warnings were overly gloomy.  You can argue about whether pre-referendum forecasts were too optimistic, but given the pickup in the rest of the EU this year I would suggest this is not the case. And as Chris Giles pointed out in the Financial Times this week, such a shortfall amounts to lost output equivalent to £350 million per week – the amount which the Leave campaign (falsely) claimed the UK would save by leaving the EU. Given that the net savings in direct EU contributions are only half that amount, the inaugural Dixon Award for Dodgy Analysis (DADA) goes to the Leave Campaign whose referendum victory imposed a cost on the UK economy double the amount which it was claimed could be saved.

Brexit supporters will always claim that there is a short-term price to be paid but it will be worth it in order to reclaim sovereignty over UK laws. Indeed, so committed is the government to taking back control that it planned simply to enact the result of a legally non-binding referendum without any form of parliamentary debate. It took the brave efforts of Gina Miller last year to force a parliamentary vote before implementing Article 50.  Not that it mattered much in the end: the decision to trigger it was passed by a majority of 498 to 114 with 38 abstentions – or, in terms of the arithmetic applied to the EU vote, by a majority of 81.4% to 18.6% which is a rather larger margin than the actual referendum. It is also ironic that each time the degree of parliamentary unanimity on a Brexit vote is less than total, the Daily Mail takes it upon itself to denounce the dissidents as traitors (the most recent example being only last week).

Looking ahead, 2018 promises more of the same both politically and economically. The consensus view is that the UK will again grow at a rate around 1.5%, though I suspect there may be some upside risks on the basis that the inflation-induced constraint on real incomes is likely to ease. But politics will remain as fractious as ever. In my view – and one which I have been espousing for the last five years – opening a partisan debate on EU membership means that many politicians are taking positions which run contrary to the UK’s economic interests. This has met with huge pushback and continues to distort the political debate to the extent that many other pressing economic issues - such as welfare reform and overhauling the social care system - continue to be pushed down the agenda.

I would like nothing better than to write less about the politics of Brexit in 2018 but it is the dominant theme of our time which will have profound economic consequences. Brexit represents a political revolution, with many politicians apparently forced to take positions which they may not personally agree with because they are afraid of acting against “the will of the people.” In some ways I am reminded of the Iranian popular revolution, which unfolded on our nightly TV news bulletins almost 40 years ago. Years of dissatisfaction with the status quo in Iran prompted a revolution, based in this case around religion. Years of dissatisfaction with the UK political status quo has resulted in a revolution based around the cause of the EU. The Iranian case led to years of hardship and international isolation. Quite what Brexit will do to the UK will become apparent only in the years ahead.

Blockchain: A solution looking for a problem?

I have long argued that the blockchain – the system that underpins Bitcoin – is a real fintech innovation_,  whereas Bitcoin itself is a by-product. But not everyone agrees that blockchain is such a wonderful idea and that it is a flawed system. It is thus worth digging a little deeper into the workings of blockchain to assess some of the pros and cons.

There are two key elements associated with blockchain: How it works and why it works. The ‘how’ is a routine process of transaction verification designed to ensure that each transaction is valid. One way to do this is to add a timestamp to each transaction and adding it to a chain of time stamped transactions. This is validated by a complex proof-of-work algorithm that cannot be changed without redoing all previous steps in the proof-of-work chain. This makes use of an algorithm known as a ‘cryptographic hash function’ which converts a numerical input of arbitrary length into an output of fixed length. This process is resource intensive and has to be run numerous times before the hash function generates an output that is accepted by the rest of the blockchain community. One feature of the system is that it is difficult to work back from the output to the input, thus preventing miners from working out how to falsify previous blocks. This is similar to procedures used to encrypt website passwords which prevent hackers from being able to work out users’ passwords by viewing the encrypted data.

The ‘why’ of blockchain is also interesting. It effectively offers a solution to the long-standing game theory puzzle which has bamboozled generations of computer scientists – the Byzantine Generals problem. Cracking this problem offers an insight into how a decentralised ledger system can operate. To get a handle on it, consider a thought experiment in which a group of generals (>2) are assumed to be outside a city, each with an army, and all want to invade the city. It is known that if at least half attack at the same time, they will be successful. But if they do not co-ordinate their plans to ensure they can muster the requisite number for the assault, they will be unsuccessful. They must thus collude in planning their attack, but the generals face three problems: they must (a) know whether their messages get through in the first place; (b) receive an acknowledgment indicating that the plans have been accepted and (c) verify that the information passed between them is true.

Computer scientists have struggled for 40 years to derive a network solution which will overcome all three of these problems simultaneously but finally the blockchain appears to have managed it. Since the blockchain is arranged on a peer-to-peer basis, messages are transmitted to a user’s immediate peers and the information disseminates quickly through the system. Thus, unless the user’s connection is faulty, condition (a) is satisfied. Condition (b) is satisfied once all other users in the system validate the proposed change to the ledger.

But before users are prepared to validate these changes, they must be sure that condition (c) is satisfied. The trick to ensuring that people send true information across the network is to make the history of all transactions publicly available and the cost of providing false information prohibitively high. In the case of our Byzantine generals, in which they are each shuttling messages back and forth between themselves, a potential traitor must be able to falsify all messages – including those in which he had no hand in writing. If we impose a constraint on the time each general has to reply to the message sent from one of the others, it becomes ever more difficult to falsify the results of communication between third parties.

In the case of Bitcoin miners, the costs of doing the number crunching in order to falsify all historical transactions is so high that there is no apparent gain from doing so. In short, if we attach a cost to sending a message and ensure that only one person can send a message at a time, the authenticity of the blockchain is guaranteed.

So far, so good. Moreover, the blockchain offers the security advantage that information does not sit merely on one system, but is distributed across many, and may thus be less susceptible to denial-of-service attacks. But it may not be immune to hacking. For example, if sufficient computing power can be corralled to gain access to more than 50% of the systems linked to the network, the integrity of the chain will be compromised. This is not believed to be possible at present, but there may come a day when the power unleashed by quantum computers is such that it can overwhelm existing networks.

There is also a question of what sort of transactions are suitable for recording on a blockchain which is increasingly used to design smart contracts. The smaller blockchains upon which they rely might be easier to circumvent than the huge public networks which underpin Bitcoin, precisely because the smaller number of participants makes it easier for parties to collude (this blog post discusses such an example). If the complex and expensive  proof-of-work algorithms can be undermined in small networks, blockchain may not offer the security benefits for private sector transactions which are often claimed. Consequently, as the Bitcoin experience demonstrates, it may be more suitable for large-scale networks (e.g. maintaining driving licence or social security records). But the bigger the network, the higher the energy costs of maintaining it – a cost which is an inevitable consequence of providing the desired level of security.

I still happen to believe that blockchain has a future. It may not be the all singing, all dancing product which its proponents believe, but it does represent a major breakthrough in computing technology. It may prove to be a solution which has not yet found the right problem to solve.

Irish eyes: A Dublin view of Brexit

The recent border spat between the UK and the EU regarding the Irish border has been very much in the news over recent weeks. Whilst Brexit is seen from London primarily as a problem for the UK, the view from Dublin is rather different. After all, Ireland is the only other EU country to share a land border with the UK and although Ireland is not quite as dependent on the UK as it was in  the 1970s, it remains a significant export market. Indeed, the UK is still the second largest Irish export market and remains the largest source of imports. Consequently, Ireland has a lot to lose from a Brexit which results in significant obstacles being placed in the way of the frictionless border that currently exists between the north and south.

Looking at it from another angle, the Republic is Northern Ireland’s largest external trade partner and frictionless trade is important for the wellbeing of the Ulster economy – the very same region which supports the DUP, which in turn is propping up Theresa May’s government. But Ireland is a significant export market for the UK  as a whole, and last year the UK exported more to Ireland than to China and India together. When politicians say that they do not wish to see the re-imposition of a hard border, they really mean it. The UK and Irish economies are linked in other ways, too. For example, energy markets north and south of the border are heavily integrated, with an all-island electricity market in existence since 2007 which sees Northern Ireland relying on electricity imports from the Republic to make up for insufficient local generation capacity. By contrast, Ireland is heavily reliant on the UK for natural gas imports accounting for 96% of Irish gas usage in 2014.

Whilst the single electricity market is not dependent on the EU’s legal processes, Ireland does rely on EU regulatory measures to cope with potential fossil fuel shortages. Indeed, Ireland stores its emergency oil supplies in the UK which might become a problem if the UK is no longer bound by EU legislation on resource sharing.

Having established that the economies are heavily integrated, the ESRI[1] attempted to put some numbers on the potential effect of a  hard Brexit on the Irish economy. They assumed three outcomes: (i) the UK reaches an EEA-style arrangement with the EU; (ii) a free trade agreement, in which goods are freely traded across borders but financial services are not and (iii) a “hard” Brexit in which the UK falls back on WTO rules. These significantly reduce trade between the UK and the EU, and in turn reduce UK GDP by between 1.8% and 3.2% relative to baseline “over the longer run”. The ESRI’s simulations suggest that over a ten-year horizon, Irish output is reduced relative to baseline by 2.3%, 2.7% and 3.8% in simulations (i), (ii) and (iii) respectively (see chart). In other words, the damage to Ireland is actually greater than that inflicted on the UK.

Unlike a decade ago, the Irish economy is better placed to withstand any such shock. For one thing, the extent of the downturn between 2008-11 (GDP declined by 11% from peak-to-trough with domestic demand down by 23%) was exacerbated by a huge fiscal tightening which is unlikely to be repeated. Moreover, the international backdrop is more favourable, with the euro zone economy growing more strongly and the US – upon which Ireland is heavily dependent for FDI – also on a much more solid footing. Nonetheless, the last decade has been a particularly difficult one for the Irish economy and the last thing it needs now is a further exogenous shock. Given the downside potential for the Irish economy in the event of a hard Brexit, it should come as no surprise that both the Irish government and the EU27 attach so much importance to the border question. It is an issue that the UK government cannot afford to ignore.

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[1] ‘Modelling the Medium- to Long-Term Potential Macroeconomic Impact of Brexit on Ireland’, The Economic and Social Review, Vol. 48, No. 3, Autumn, 2017, pp. 305-316