Choose your enemies wisely

As the Brexit clock ticks closer to March 2019 the UK political landscape is increasingly fissiparous as Theresa May tries to appease both sides of her fractured party whilst managing to satisfy neither.  With regard to Brexit, her main tactic has been to play for time in the hope that something will turn up. But it is increasingly apparent that it has not, and will not, and May is reaching the stage where she will have to demonstrate some proper leadership in order to ensure that the UK gets the deal that it wants. As Simon Nixon pointed out in a recent Wall Street Journal article the PM has embraced a number of contradictory positions and she will have to decide which of them she is going to break. In doing so, the PM will make enemies – it is merely a question of choosing those who cause her the least harm.

Consider first the group of backbench MPs, led by Jacob Rees-Mogg, who regard themselves as keepers of the Brexit flame. JRM’s latest stunt has been to warn the prime minister that if she goes ahead with her plan to pursue a customs partnership with the EU, his 60-strong faction of MPs will withdraw their support. Rees-Mogg’s objection is that it would “leave us de facto in the customs union and the single market.” For many – including most economists – that is not such a bad idea. But it is (a) legally not true and (b) the EU27 is not very enthusiastic about a plan whereby the UK collects tariffs set by the EU customs union on goods coming into the UK on its behalf. If Rees-Mogg really wants to play a clever game, his best tactic would be to let the EU sink the plan without the need to create waves at home.

But whilst the pro-Brexit lobby is large and vocal, the Conservatives hold 317 seats in parliament. The awkward squad is outnumbered roughly 5-1 by more moderate MPs, some of whom are opposed to Brexit and others who are not willing to go to the barricades on the issue of the customs union. Admittedly, it would take only 48 Conservative MPs (15% of their parliamentary representation) to issue a motion of no-confidence in the leader, so incurring the wrath of Rees-Mogg and his chums would have consequences. But if Theresa May really wants to demonstrate some leadership, perhaps it is now time to face down those who continue to pursue a ruinous Brexit policy. She may not win a leadership contest, because she does not have the wholehearted support of the Remainers, but it seems doubtful that the Brexit ultras would win either. It is time to force the issue. As I have noted previously, Theresa May might have been the least worst option as leader in summer 2016 but it is not clear that she is the right candidate now to deliver the Brexit deal – at least, so long as she is not prepared to challenge her opponents.

That said, whilst it is easy to criticise Theresa May for her caution, we also have to be mindful of the wider backdrop against which she is operating. As the Withdrawal Bill proceeds through the House of Lords, the government has now suffered ten defeats on important legislative matters. The key vote took place on Monday, when peers voted to give parliament a decisive say on the outcome of the final Brexit negotiations rather than simply allowing the government to decide. Of course, this is not set in stone: When the bill goes back to the lower house, MPs will be able to vote on whether to overturn this amendment. However, it triggered much frothing of the mouth in the tabloid press with the Daily Mail accusing “the Remainer elite “ of “fighting a guerrilla war against Brexit using any weapon it can.”

We have come to expect such rabid commentaries from this particular organ over the last couple of years. Clearly, the headline writers do not appear to understand the UK’s constitutional setup in which the House of Lords has no power to block legislation. There again, the paper demonstrated a similar lack of constitutional understanding following the infamous “Enemies of the People” headline when the High Court ruled that parliament should  be given a vote before triggering Article 50. The political editor James Slack either did not realise that the judiciary is separate from government, or more likely, did know and planted a fake news story. This time around, the irony appears to be lost on the Mail that one of the key themes in the whole Brexit debate was about taking back control – British laws decided in the British parliament, and all that – and the House of Lords is giving parliament the opportunity to do just that.

It is precisely because of such vitriolic nonsense that the prime minister has to be very circumspect in how she deals with the Brexit debate. She is simply obeying the Machiavellian dictum to keep your friends close and your enemies closer. But to borrow the old SAS slogan, she who dares wins.

Beware the big data rush

Bank of England chief economist Andy Haldane today gave a speech entitled Will Big Data Keep Its Promise?  in which he assessed the contribution that big data can make to improving decision making in finance and macroeconomics. Whilst I agree that this is indeed a subject that offers significant potential, we do have to be mindful of the downsides associated with the data trails we leave as we live our lives in a digital world.

In 2005 there were around 1 billion global internet users; today there are estimated to be almost 3.5 billion. Just as important, there has been a significant switch from the one-way flow of traffic from suppliers to consumers, which characterised the early years of internet use, to a more interactive medium. Today, users send around 6000 tweets, make 40,000 Google searches and send 2 million emails every second. The capacity of text on the internet is estimated at 1.1 zettabytes, which is approximately 305.5 billion pages of A4 paper and which is projected to rise to 2 zettabytes by 2019 (more than 550 billion sheets). And that is without the pictures! To take another example, the Large Hadron Collider generates 15 petabytes of data each year, equivalent to around 15,000 years of digital music.

Where does all this data come from? Some of it is merely the transcription of existing data into an electronic form that makes it more accessible. Wikipedia, for example, has helped to democratise knowledge in a way that was previously impossible. But a lot of it has come into being as a result of technological developments which allow the capture of much greater volumes of information. This has been facilitated by the rise of cloud computing which allows users to store, manage and process vast amounts of information in a network of remote servers (ironically, this is a reversal of the trend of recent decades which saw a shift from centralised towards local data storage). Perhaps even more important, the rise of social media such as Twitter and Facebook has vastly increased the volume of information pumped out (not to mention the rise of microblogging sites in China such as Tencent or Sina Weibo).

Clearly, a lot of this information does not yield any valuable insight but given the vast amount of available information even a small fraction of it is still too much for humans to reasonably digest. Even if we only require 0.5% of the information stored online, we would still need 1.5 billion sheets of A4. The problem is compounded by the fact that we do not necessarily know what is useful information and what can easily be discarded so we have to scan far more than we require in order to stream out the good stuff. As a result, much progress has been made in recent years to devise methods of scanning large datasets in order to search for relevant information.

To the extent that knowledge is power, it stands to reason that those with the data in the digital age are those with the power. This raises a big question of how much control we should be prepared to give up, and there are legal issues about who owns the information that most of us have until now simply given away for free – something that the recent Facebook furore brought into the open.

But whilst social media platforms contain huge amounts of data that can be extracted at relatively little cost, and are often a useful barometer of public opinion, they are biased towards younger, urban-dwelling high income users. Relying on Tweets, for example, without accounting for this bias risks repeating the classic mistake made when trying to predict the US presidential results in 1936 and 1948, when the polling samples were skewed by the inclusion of those picked at random from the phonebook, at a time when telephone penetration was low.

Thus, whilst I agree with Haldane’s sentiment that “economics and finance needs to make an on-going investment in Big Data and data analytics” we need to beware of the headlong rush. As I wrote in a piece last year, “before too long, there will almost certainly be a spectacular miss which will bring out the critics in droves” and it could yet be that the Facebook problems will be a catalyst for a rethink. At the present time, much of society is only operating in the foothills of the big data revolution. The real trick, as former boss of Hewlett-Packard Carly Fiorina once said, will be to turn data into information, and information into insight. We are not quite there yet.

Brexit: According to custom(s)

Discontent with the Brexit process has gathered momentum in recent weeks as the EU Withdrawal Bill is debated in the House of Lords. There are two key areas where the Lords disagree with the government’s vision of a post-Brexit Britain, having voted against that part of the bill which seeks to withdraw the UK from the customs union and also against the legislation which peers believe will result in an erosion of workers’ rights. None of this means that the government will necessarily water down its position, since the role of the Lords is primarily to scrutinise legislation and challenge anything proposed in the House of Commons and it cannot block legislation indefinitely. But it may embolden MPs in the lower house to rethink their position on many elements of the Withdrawal Bill.

The customs union issue is particularly important and has proven to be an area where Brexit protagonists have demonstrated that they do not fully understand the implications of their actions. A customs union implies the abolition of customs duties between member states and the imposition of common tariffs against those not in the union. That is not the same thing as the free movement of goods which is enshrined within the EU single market. For one thing, a customs union may not necessarily cover the full range of goods. For example, Turkey is part of a customs union with the EU but the deal does not cover food or agriculture, services or government procurement.

But failure to secure some kind of customs arrangement with the EU will almost certainly mean significant border delays. Those claiming that the Swiss and Norwegian examples show how a customs union can proceed without any such frictions are wrong. Switzerland and Norway are in the Schengen Area (chart) which allows individuals to move easily across borders, but neither are in the customs union so there can be significant delays as goods are transported across the border into the EU.

Moreover, most of the empirical work which utilises trade gravity models to look at trade flows draws the conclusion that leaving the single market or customs union will lead to a reduction in trade between the UK and EU. Such models explicitly incorporate the zero-tariff option, which can be  controlled for in simulations designed to show the counterfactual where tariff barriers exist. A customs union would, of course, be a second best solution compared to what the UK enjoys now. But it is better than no deal at all, and would go a long way towards resolving the Irish border problem.

What is particularly ironic is that the customs union has only become an issue following the referendum. It has been seized upon by those leavers who believe that it is an obstacle to signing trade deals with third countries, but was barely mentioned during the referendum campaign and was certainly not on the ballot paper. There is a sense that some in government are beginning to understand the difficulties involved in the customs union discussion with rumours earlier this week that the prime minister would seek to back away from her previous position (which were denied, of course). This would be the sensible economic decision, although so closely is Theresa May identified with this policy that it would likely spell the end of her tenure in Downing Street. But her departure may be a small price to pay to secure the national interest.

Looking at the issue from outside the UK, financial services remain an area of contention. Two senior EU officials this week rejected the UK’s case for continued post-Brexit access to EU financial markets under something approximating current rules. The EU’s chief Brexit negotiator, Michel Barnier, argued that since the UK would no longer be within the EU’s single market, it would not be covered by its regulations and oversight – a view reiterated separately by Valdis Dombrovskis, the European Commission’s finance chief. This may all be part of the normal poker playing during negotiations, but it highlights that despite the late-March optimism that we may be close to an agreement on a transition period, there are still plenty of areas of disagreement.

Indeed, the Bank of England recently concluded that the transition period would allow non-UK financial institutions operating in the UK to conduct business until the end of the proposed transition period (end-2020) without any change in their regulatory status. But there has been no reciprocal arrangement from the ECB, so firms licensed in the UK are not guaranteed to be able to conduct business in the EU under the current passporting arrangements after March 2019. If ever we needed a reminder that nothing is agreed until everything is agreed, this is it.

Silence can be golden

If you had asked me a week ago, I would have said that a rate hike of 25 bps by the Bank of England in May was a high probability event. However, I had reckoned without the intervention of BoE Governor Carney who warned in a BBC TV interview last week that any such move was not a done deal. In his words, “there are other meetings over the course of this year” at which a rate hike can be delivered. As a consequence, the implied market probability attached to a 25 bps hike collapsed from 80% last Thursday to 52% today, thereby turning a near-certain rate hike into a toss-of-a-coin event (chart).

It would appear that Carney was trying to warn the market that a string of weaker data argues against treating a May hike as a given. On the one hand, CPI inflation has slowed more rapidly than the BoE expected in its February forecast, coming in at 2.7% in Q1 versus a predicted 2.9%, with the March rate slowing to 2.5% - the lowest in twelve months. Then there is the likelihood that Q1 GDP growth will come in weaker than expected, posting a rate of 0.2-0.3% q-o-q (an annualised rate of 0.8% to 1.2%).

Whilst these are mere statements of fact when viewed in isolation, in my view neither are good enough arguments to postpone the rate hike. For one thing the weak activity data are largely the result of cold weather at the beginning of March (remember the Beast from the East?). In the sense that this is a temporary factor, we should be looking through it to assess the underlying strength of the economy especially since: (a) there may well be a partial countermovement at the start of Q2 and (b) previous attempts by the ONS to measure the impact of a cold spell on activity growth have tended to be revised away (as occurred in Q1 2012 for example when the initial GDP estimate posted quarterly growth of -0.2% but now shows a rate of +0.6%). As for inflation, it has long been known that it would begin to slow after peaking in the early months of 2018. The BoE has been softening us up for a monetary tightening on the basis that inflation is above target but now that it is less above target than expected, it seems they are backing away from their long-held view.

Around the same time as Carney was making his comments, MPC member Michael Saunders argued forcefully that “the economy no longer needs as much stimulus as previously” and that in terms of the pace of hiking “’gradual’ need not mean ‘glacial’”. That was a direct contradiction of Carney’s view – as is the right of external MPC members – but it sends a conflicting message to both markets and individuals and very much calls into question the usefulness of forward guidance as a policy tool. 

Forward guidance is designed to provide greater clarity about the central bank’s view and reduce uncertainty about the future path of monetary policy whilst delivering a robust policy framework. The Governor’s intervention just three weeks before the May rate decision does nothing to enhance clarity; has introduced more, not less, certainty about the path of interest rates and the differing messages from policymakers suggests that the policy framework is anything but robust. It is not as if this is the first time the Governor has blown a hole in the communications strategy. His comments at the Mansion House speech in June 2014 hinted strongly at a rate hike that did not materialise and led MP Pat McFadden to dub Carney “the unreliable boyfriend.”

As I have argued before (here), policymakers are making a mistake by focusing on the change in interest rates conditional on current economic circumstances when what really matters is the level of interest rates conditional on general economic conditions. Even if Brexit is curbing economic activity, as Carney argued, the economy is by no means falling off a cliff and therefore does not need interest rates at levels consistent with the threatened meltdown of 2009.I fully understand policymakers’ caution. After all, it is not just the markets that they have to convince: It is those individuals whose economic prospects are dependent on the path of interest rates. But I cannot help thinking that on credibility grounds, the MPC would be better advised to deliver the May rate hike they had strongly trailed, and allow themselves a more fierce debate about whether there is a need for additional tightening. As it is, they almost now cannot win. If they do raise rates next month it will call into question why Carney needed to wade into the debate. But if they don’t, it will raise questions about the message that the BoE was communicating in the two months prior to last week. Silence can be golden.

A shot across the bows

It is now eleven years since the first indications of the looming financial crisis began appearing on our radar screens. In the summer of 2007, banks began to curtail redemptions from funds which were heavily invested in collateralised debt obligations and subprime bonds. This set in train a series of events that culminated in the bankruptcy of Lehman’s in September 2008, which triggered the biggest economic and financial crash in 80 years. A decade on, and we are only now beginning to see indications that the scars inflicted upon the industrialised world are healing.

The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).

This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.

However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.

Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.

But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”

Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.

Nasty and brutish? Surely they don't mean us?

I recently took part in a discussion at a European forum where I shared a platform with officials representing the UK and German governments on the topic of Brexit, and I have to say that I was more in tune with the German view of events than the British.

The UK government’s opening position is that Britain was always the bad boy in Brussels and that it never fitted into the EU in a constructive fashion, so that its departure should make life easier for everyone. That is an interesting sales pitch – and it is also largely not true. Whilst the British may have had a very different view of the EU and the direction in which it should head, compared to the French, that is less true of the Germans. Admittedly the UK and France have differed hugely on issues such as agriculture but the British influence has helped to reduce the amount the EU spends on agricultural subsidies from 73% of the budget in 1985 to 40% today, for which many EU members are thankful. Moreover, the UK and Germany have seen eye-to-eye on many issues and the UK played a very constructive role in making the EU a more business-friendly environment. Indeed it was a key player in helping to create the single market which the current UK government wants to leave.

The British government is also trying to sell the message to its European partners that the UK is the same country as it was before the referendum – nothing has changed and therefore it should be possible to conduct business as usual. I could not disagree more! The Brexit referendum has opened up numerous fissures in British society and in the conduct of its politics, such that this is very much a country ill at ease with itself. Leavers versus Remainers; young versus old; rich versus poor – and even the two main political parties struggle to find a common policy on Brexit. Indeed, I heard nothing to acknowledge the fact that almost half of those who voted in the Referendum wanted to remain.

Whilst the British government continues to adopt an “it-will-be-all-right -on-the-night” approach to issues such as the Irish border, the EU has adopted a rigorous legal approach which rightly points out that leaving the customs union is ultimately incompatible with maintaining an open border – a point which the German government representative reiterated. There is nothing new in any of this, of course, and I have been making many of these points for some time. But what concerns me is that the UK is holding to this fiction in the face of all the evidence. As one who does not work in the state sector I am not required to toe the government’s line, and I can afford to be free with my opinions. But it must be very difficult for those working on the inside who see the inherent contradictions in the government’s position but are not allowed to speak out.

Indeed, the disarray at the heart of government was manifest once again in the great WIndrush scandal. In short, immigrants from Commonwealth countries who began arriving in the UK in great numbers in the early 1950s are at risk of deportation if they never formalised their residency status and do not have the required documentation to prove it. This is a particular problem for those brought here as children, who have grown up in the UK and regard it as their home. Lest anyone forget, this is the result of a policy introduced by former Home Secretary Theresa May in 2013 (whatever happened to her?). Naturally, the policy is an embarrassment for the prime minister. But it goes way beyond that: It is indicative of a government which pays lip service to looking after the interests of its citizens but fails to do so and hides behind the letter of the law to justify its actions. And after having apparently agreed with the EU that it will guarantee the post-Brexit rights of EU citizens living in the UK, it once again calls into question the government’s competence to do so.

It was the philosopher Thomas Hobbes who wrote in his magnum opus, Leviathan, that life in the absence of a governmental-imposed social order would be “solitary, poor, nasty, brutish, and short.” Sometimes it feels as though the third and fourth words of his aphorism apply to life with a government too.

Fair weather forecasting

The economics profession has had to endure some bad press over the last decade in the wake of the global financial crisis which we failed to foresee and, in the UK case, the dire predictions in the aftermath of the Brexit referendum that were not borne out. But in a way these two examples are to entirely miss the point. Economics is not a predictive discipline – as I have noted countless times before – so criticising economists for failing to predict macroeconomic economic outcomes is a bit like criticising doctors for failing to predict when people will fall ill.

Another of the narratives which has become commonplace in recent years is the notion that economists predict with certainty. This fallacy was repeated again recently in a Bloomberg article by Mark Buchanan entitled Economists Should Stop Being So Certain. In fact, nothing could be further from the truth. The only thing most self-respecting economic forecasters know for certain is that their base case is more likely to be wrong than right. The Bank of England has for many years presented its economic growth and inflation forecasts in the form of a fan chart in which the bands get wider over time, reflecting the fact that the further ahead we forecast the greater the forecast uncertainty (chart). Many other institutions now follow a similar approach in which forecasts are seen as probabilistic outcomes rather one in which there is a single outcome.

Indeed, if there is a problem with certainty in economic forecasting, it is that media outlets tend to ascribe it to economic projections. It is after all, a difficult story to sell to their readers that economists assign a 65% outcome to a GDP growth forecast of 2%. As a consequence the default option is to reference the central case.

One of the interesting aspects of Buchanan’s article, however, was the reference to the way in which the science of meteorology has tackled the problem of forecast uncertainty. This was based on a fascinating paper by Tim Palmer, a meteorologist, looking back at 25 years of ensemble modelling. The thrust of Palmer’s paper (here) is that uncertainty is an inherent part of forecasting, and that an ensemble approach that uses different sets of initial conditions in climatic modelling has been shown to reduce the inaccuracy of weather forecasts. In essence, inherent uncertainty is viewed as a feature that can be used to improve forecast accuracy and not as something to be avoided.

In fairness, economics has already made some progress on this front in recent years. We can think of forecast error as deriving from two main sources: parameter uncertainty and model uncertainty. Parameter uncertainty is derived from the fact that although we may be using the correct model, it may be misspecified or we have conditioned it on the wrong assumptions. We can try and account for this using stochastic simulation methods[1] which subject the model to a series of shocks and gives us a range of possible outcomes which can be represented in the form of a fan chart. Model uncertainty raises the possibility that our forecast model may not be the right one to use in a given situation and that a different one may be more appropriate. Thus the academic literature in recent years has focused on the question of combining forecasts from different models and weighting the outcomes in a way which provides useful information[2], although it has not yet found its way into the mainstream.

Therefore in response to Buchanan’s conclusion that “an emphasis on uncertainty could help economists regain the public’s trust” I can only say that we are working on it. But as Palmer pointed out, “probabilistic forecasts are only going to be useful for decision making if the forecast probabilities are reliable – that is to say, if forecast probability is well calibrated with observed frequency.” Unfortunately we will need a lot more data before we can determine whether changes to economic forecasting methodology have produced an improvement in forecast accuracy and so far the jury is still out. Unlike weather forecasting which at least obeys physical laws, economics does not. But both weather systems and the macroeconomy share the similarity that they are complex processes which can be sensitive to conditioning assumptions. Even if we cannot use the same techniques, there is certainly something to learn from the methodological approach adopted in meteorology.

Economics suffers from the further disadvantage that much of its analysis cuts into the political sphere and there are many high profile politicians who use forecast failures to dismiss outcomes that do not accord with their prior views. One such is the MP Steve Baker, a prominent Eurosceptic, who earlier this year said in parliament that economic forecasts are “always wrong.” It is worth once again quoting Palmer who noted that if predictions turn out to be false, “then at best it means that there are aspects of our science we do not understand and at worst it provides ammunition to those that would see [economics] as empirical, inexact and unscientific. But we wouldn’t say to a high-energy physicist that her subject was not an exact science because the fundamental law describing the evolution of quantum fields, the Schrödinger equation, was probabilistic and therefore not exact.”

As Carveth Read, the philosopher and logician noted, “It is better to be vaguely right than exactly wrong.” That is a pretty good goal towards which economic forecasting should strive.

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[1] Blake (1996) Forecast Error Bounds by Stochastic Simulation 

[2] Bayesian Model Averaging is one of the favoured methods. See this paper by Mark Steel of Warwick University for an overview