Would I lie to you? Part 1

According to former US President Ronald Reagan, the nine most terrifying words in the English language are “I’m from the government and I’m here to help.” Indeed over much of the past 40 years, Anglo Saxon economies have tried to shrink the size of the state in the belief that the markets are more efficient at allocating resources. In a narrow sense this may be true since the private sector has an incentive to generate the lowest cost solution in order to maximise profit.

But it is increasingly evident that rolling back the state does not always generate outcomes that are in the interests of wider society. The Private Finance Initiative (PFI) in the UK has incurred billions of pounds in extra costs to deliver infrastructure projects for no clear benefit. Indeed, recent PFI contracts – for schools, hospitals and other facilities – are between 2 and 4 per cent more expensive than other government borrowing, and involve significant additional fees. There is also widespread criticism that the chief executives of formerly publicly-owned utilities receive huge salary packages whilst not delivering any improvement in services.

In other words, the ideological basis of Anglo Saxon economic policy over the past four decades is not all it is cracked up to be. The model took a massive hit following the financial crisis of 2008 and governments around the world are still struggling to cope with the changed economic and political realities. Efforts to resume business as usual have struggled to gain traction and governments are increasingly struggling to retain the trust of their electorates. We see it in the populist surge across Europe and in the conduct of US politics, and it is evident in the rise of strongman administrations in places such as Turkey and the Philippines. In some ways the perception of government failure is unfair – in other ways not. But the widening gap between the perceptions of politicians and the electorate is both unfortunate and dangerous.

It is unfortunate because in western democracies politicians are representatives of the people. They are us and we are them – something that is too often forgotten by the body politic. It lies within the power of the people to change the status quo. In France, this led to the formation of a new political party which in the space of a year had propelled Emmanuel Macron to the presidency, although it has proven more difficult to replicate this strategy elsewhere. But the widening gap between people and politicians is also dangerous because it creates space for populists who advocate simplistic solutions to complex problems. The inability of the established political powers to counter these problems runs the risk that nominally sensible politicians will be forced to ape populist measures in order to stay relevant, thus taking politics in an unfortunate direction. Moreover, when the populist solutions are shown to have failed how will electorates respond?

Despite the strains which have been placed on western economies in recent years, they have just about managed – and so far, at least, rather better than in the 1930s. But continued fiscal austerity threatens the social fabric in ways that will only become evident in the longer-term. Greece and Ireland have emerged from a period of EMU-imposed belt-tightening, which has left the Greeks in particular significantly worse off. And I have long pointed out that the fiscal austerity imposed in the UK is outright regressive as it takes the axe to welfare spending. But for an example of how fiscal austerity can be taken to unacceptable limits, recall the experience of the city of Flint in Michigan.

To summarise, Flint had suffered huge employment losses over a period of many years as GM, the city’s main employer, cut back on local jobs. This adversely affected tax revenues and by 2011 things were so bad that the governor of Michigan declared a state of financial emergency, appointing an emergency manager to cut costs to the bone. Alongside such measures as reducing the size of the police and fire departments, the authorities decided in 2014 to cut costs by switching the city’s water source from Lake Huron to the heavily polluted Flint River. In order to save yet more cash, the authorities opted not to add anti-corrosion agents to the water which would have prevented the pollutants from causing lead to leach into the town’s water supply.

Despite mounting evidence to the contrary, officials continued to deny that the drinking water in Flint was unsafe. When Dr Mona Hanna-Attisha published her work in September 2015 highlighting the health risks associated with high lead concentrations in the drinking water, her research was initially ridiculed. A Michigan Department of Environmental Quality spokesperson accused her of being an "unfortunate researcher … splicing and dicing numbers" and causing "near hysteria.” But she was right and they were wrong. As a result, huge amounts of extra spending were required to replace pipes and ensure a supply of clean drinking water until the operation was complete, and criminal proceedings were launched against a number of officials involved in the scandal. Ironically, the cost of adding anti-corrosion agents to the water in the first place would have cost only around $36,500 per year versus an estimated $97 million over three years to replace the plumbing.

This is a classic example of short-sighted policies that are consistent with the Bluffocracy. By focusing only on one policy objective – saving money – the authorities ignored the non-pecuniary costs associated with their strategy. Worse still, the authorities failed to address residents’ concerns – the very people who they are supposed to represent. When this happens on a national scale you get politicians like Trump filling the gap. A decade ago, we were concerned with market failure as the global financial system tottered on the brink of disaster. Today, we are more concerned with government failure and nowhere is this more evident than in the case of Brexit – the subject of my next post.

Bluffocracy

One of the more refreshing books I have come across in recent months is Bluffocracy by James Ball and Andrew Greenway in which the authors make the point that far too many people making important government or business decisions are not really qualified to do so. It is the perfect riposte to Michael Gove’s 2016 remark that “the people of this country have had enough of experts.” What experts would these be? After all, Gove was at the time Lord Chancellor – an ancient legal position whose primary responsibility is the efficient functioning and independence of the courts. Maybe his stellar legal career following law study qualified him for the post? But his academic studies in English literature followed by a subsequent career as a journalist probably suggests that his knowledge of the legal system was less than many of the hardened criminals who come into regular contact with the judicial process.

It is unfair to single out Michael Gove: Most ministers these days are generalists with little business experience before entering politics. The system of employing generalists does have some advantages. Most high ranking politicians are clearly intelligent people who have the ability to master a large amount of detail very quickly (Boris Johnson would appear to be an exception to this rule, however). As a result they are rapidly able to get up to speed with their brief and look at problems in different ways, which can result in some genuinely innovative policymaking. However, it can also result in some very bad policy outcomes.

Of course, there is nothing new in the idea of the generalist politician – it has been a defining picture of the British landscape for decades. But this is where civil servants are supposed to come into their own. Politicians may be here-today, gone-tomorrow occupants of state office but they are backed by permanent secretaries with years of experience in their field who are able to nudge ministers away from making egregious policy mistakes. Except that these days, civil servants are encouraged to broaden their experience by frequently swapping jobs, with the result that much of knowledge they build up in one role is lost as they go off to do something else.

This highlights one of the main features of our Bluffocracy – a culture of short-termism. Economic policies are often made on the basis of how they will play in the press rather than their economic impact. A case in point is the austerity programme followed by the British government over the past eight years. Continually chipping away at public outlays was always going to lead to damage to the social fabric in ways which were predictable, but which were ignored by a government whose agenda appeared to be geared towards the ideological goal of shrinking the size of the state. Faced with the crisis in the NHS; concerns about police numbers and ongoing criticism of the UK’s defence policy, today’s politicians have an awful lot to do to pick up the pieces.

Another element of the Bluffocracy is the apparent inability of the media to hold the government to account. To use the fiscal policy example once more, the electorate was repeatedly told that the Labour Party had wrecked public finances in 2008 and that if the UK did not put in place measures to cut public outlays, it would end up in the same fiscal position as Greece. Both statements are untrue: The fiscal collapse was due to the economic downturn triggered by the global recession and there was no chance of the UK ending up as another Greece since it issued all its debt in its own currency (and around 75% is domestically owned). Apart from some of the specialist economics journalists, the vast majority of journalists merely parroted the government’s words without probing the statement more deeply. One possible reason for this is that many of the journalists are generalists with no real understanding of the issues they are writing about (True story: I once had to explain to a journalist how to calculate a percentage change).

Seen in this light, Brexit is the logical conclusion of Bluffocracy. The referendum was called by a prime minister who was very able but who tended to have a better grasp of tactics than strategy. David Cameron’s famed ability to get himself out of sticky situations at the last minute – most notably during the Scottish independence referendum of 2014 – gave him a sense of confidence that he did not have to work too hard to get the result he wanted. This policy backfired disastrously in June 2016. Moreover, he was out-bluffed by bluffers who painted a picture of how wonderful life would be outside the EU and how easy it would be for the UK to get the deal it wanted. Not only did large parts of the media not hold the Brexiteers to account, they actually cheered them on.

Even now, as the reality of negotiating with the rules-based EU indicates how difficult Brexit will be, the likes of Jacob Rees-Mogg continue to blithely insist that if his plans are followed Brexit will deliver the long-promised utopia. I am not sure which one of the following statements is true, but one of them is: Rees-Mogg et al perfectly understand the difficulties associated with Brexit but choose to lie about it, in which case they should surely be disqualified from representative office on the grounds of misleading the public. Or they really believe their Brexit fantasies, in which case they should surely be disqualified from representative office on the grounds of incompetence.

But this is the new Bluffocracy in which people can get away with spouting nonsense with very little sanction. As Ball and Greenway wrote in The Spectator: “Can things change? Not in Westminster anytime soon. It’s hard to look at modern frontbenchers and see much hope there in the short-run. As for Whitehall: it is 160 years since the civil service had a genuinely comprehensive look at itself, and an examination is overdue. But if history is any guide, a decent-sized war is probably the only reliable way of getting this done … We will always need generalists to master new situations quickly … But the balance of power has moved too far in the bluffers’ favour — at a time when the country is crying out for some proper expertise. It’s time to reshape our institutions to let the experts in, to reward serious knowledge. We need a system that works, and experts who are willing to join it.”

Dealing with forecast uncertainty

A few months back I produced a piece which looked at the economics of the World Cup. The fun part of the analysis was to look at the expected performance of each team based on a number of factors. Using a statistical model, based on the Poisson distribution which took account of the strength of each team and the quality of the opposition, I came up with a ranking that was pretty close to that of the bookmakers. The bit that everyone focused on, of course, was the tip for the tournament. As it happened, my statistical model made Germany favourites to win, but as we all now know Germany failed to qualify from the group stage.

Of course, the press gleefully highlighted the prediction error – as they did with all those who failed to correctly predict the winner. The only thing was, I didn’t really get it wrong. Although I made Germany the most likely team to win, I only assigned an 18% probability to their chances of tournament success, implying an 82% chance of not winning. In bookmakers’ parlance, I put the odds against Germany winning the tournament at 4-1. Sure enough, Germany did not win the tournament – the most likely outcome predicted by the model.

The idea that we apply probabilistic assessments to outcomes strikes me as a sensible way to think about an inherently unknowable future and it is a point I have made on numerous occasions previously (here, for example). At a time when macroeconomics has come in for considerable criticism for its failure to accurately forecast future events, understanding the process of how forecasts are made is worthy of further investigation.

Critical to understanding the nature of an economic forecast is that they are heavily conditional. In fact everything in economics depends on everything else, so if some of the conditioning factors change the forecast is likely to be blown off course. Consider the case of forecasting how a central bank might set interest rates on the basis that it follows an inflation targeting regime. We assume that inflation is a function of the amount of spare capacity in the economy – the less slack there is, the more competition for resources which then bids up their price. The choice of model itself is a major conditioning factor. If central banks use different metrics in making their decision, this raises the chance that the forecast will be wrong.

But let us pursue our assumption a bit further: In order to determine how much slack there is in the economy, we have to understand trends on both the demand and supply side which introduces additional conditioning factors. On the demand side we need to know what is the likely path of driving forces such as incomes, taxes (which influence disposable incomes and labour supply decisions) and wealth (which can be used to finance consumption and which also impacts on desired saving levels). On the supply side, we need to know something about changes in the capital stock, which requires assumptions for investment and the rate of capital depreciation; the size of the labour force and the path of multifactor productivity. It should be pretty obvious by now that in a short space of time, we have identified a whole chain of events which could impact at any point to change our assessment of the amount of spare capacity and thus the potential inflationary threat.

It is pretty unlikely that we are going to predict all the inputs correctly, with the result that there is a considerable margin of uncertainty associated with our projections. When the economy is subject to an exogenous shock, such as in the wake of the Lehman’s bust or Brexit, the degree of uncertainty is significantly raised. Consider the UK in the wake of the Brexit vote: There was no effective government following David Cameron’s resignation and it was totally unclear whether the UK would invoke Article 50 in June 2016, as some had advocated. In this vacuum of uncertainty, large forecasting errors were made in the immediate post-referendum environment.

But contrary to the statements made by a number of pro-Brexit politicians about how the doomsayers were wrong before the referendum, much of what the forecasting profession said has stood up to scrutiny. Notably that the pound would collapse, inflation would rise and the economy would grow more slowly and thus suffer a loss of output relative to the case of no vote for Brexit. Obviously we don’t know what will happen from here because we do not yet know the nature of the UK’s future trading arrangements with the EU. One way to proceed is to outline a number of scenarios and assess what might happen to growth in each case. If we assign a probability to each scenario then our best guess for output growth is the probability-weighted average of the outcomes.

But how useful is the single point estimate for annual growth over the next five years in the case of Brexit? The answer, I suspect, is not much. We are more interested in the cost of our forecast being wrong (i.e. whether we are too optimistic or pessimistic relative to the outturn). We thus should focus on the loss function, which measures the cost of being wrong. This is not something that gets the attention it perhaps deserves because it can be a costly and time-consuming exercise. Instead we generally define a range of forecast extremes which encompass a median (or modal) forecast. The extent to which this forecast lies in the upper or lower half of the range determines the extent to which forecast risks are asymmetric, giving us some idea of the costs of being too optimistic versus being overly pessimistic.The Bank of England has long been an advocate of this approach (see chart, which assesses the range of outcomes for the August 2018 inflation forecast).
  
My efforts at forecasting future economic events are guided by Niels Bohr’s quip that “prediction is very difficult, especially if it's about the future.” Experience has taught me that we should treat our central case economic predictions as the most likely of a range of possibilities, and nothing more. After all, there is no certainty. When Germany can underperform so spectacularly on the international football stage, even the most confident of forecasters should take note.

This currency is a turkey

The top market story of the day has been the collapse in the Turkish lira which went from 5.60 against the dollar on Friday to around 7.00 at the time of writing – a collapse of 25% in one session. It is not as if the lira is coming off a period of overvaluation – quite the opposite in fact, since the currency has been sliding throughout much of the year. The root cause of the lira’s initial weakness was the failure of the central bank to tighten policy earlier this year. This resulted in the currency coming under pressure over the first four months of 2018, followed by a sharper depreciation following President Erdogan’s remark in May that “I will emerge with victory in the fight against this curse of interest rates … Because my belief is: interest rates are the mother and father of all evil.”

In short, Erdogan has peddled the view that rising interest rates result in higher inflation. To say the least, it is unconventional (though not necessarily wholly wrong if you have interest-rate linked products such as mortgages in the CPI basket, as the UK discovered 30 years ago, though that is not the case in Turkey today). As a result, Erdogan has browbeaten the central bank into holding off from monetary tightening. To make things worse, the political standoff between the US and Turkey has intensified in recent weeks, culminating in Friday’s response by Donald Trump to double the tariffs on imports of metals from Turkey. It is thus understandable that investors are feeling nervous and as a result Turkey has come into the market’s cross-hairs. But with the central bank’s credibility having been badly battered by its actions this year (or more precisely, by its inaction) it is difficult to see what it can do to stem the lira’s decline. It could jack up rates but once market confidence has been lost in the way that Turkey has experienced, this is nothing more than a futile gesture. Even a 100% annual interest rate amounts to just 0.19% on a daily basis. This is equivalent to trying to stop an elephant with a pea shooter. In other words, futile when the currency can decline by 25% in one day.

The other alternative is capital controls. One of the basic axioms of international economics is that economies cannot simultaneously run an independent monetary policy, a fixed exchange rate and free capital movement (the famous trilemma). On the assumption that Turkey wishes to regain some control over its currency, and on the basis that domestic monetary policy is likely to prove ineffective (as noted above), some restrictions on capital outflows appear to be necessary. Bear in mind that Turkey already runs a current account deficit, equivalent to around 5.5% of GDP last year. It thus has to borrow from the rest of the world to cover the fact that domestic investment is greater than domestic saving. Foreign investors are not going to be keen to lend to Turkey if they cannot get their money out. Theory would thus suggest that Turkey will have to deflate its economy in order to redress the savings-investment balance whilst the capital controls are in place.

This is exactly what the Asian Tigers did in the 1990s when currencies in the region came under speculative attack (though to be more precise, the policy was forced upon them by the IMF as a condition for financial assistance). Obviously, this does not bode especially well for Turkey’s near-term growth prospects, but people said very much the same regarding Thailand and Korea in the 1990s – and look at them now! There again, it did take five years for real GDP in Thailand to get back to pre-crisis levels.

The full effects of the Turkish lira collapse will continue to play out over the longer-term. Perhaps the Russian currency collapse of 2014-15 can offer some pointers. Ordinary citizens certainly did not escape unscathed, with consumers required to tighten their belts considerably. As in Russia, Turkish inflation is set to spike much higher. But whereas Russian inflation surged from 8% to 17%, Turkey is starting from an already-high rate of 16%. And the Russian central bank emerged with great credit as it managed the currency shock – the Turkish central bank’s stock is not exactly high.

One of the lessons we have learned from past currency crises is that what matters for the future is the nature of the policy response: Credibility can be regained if the authorities are prepared to make some hard choices. Moreover, despite the chatter suggesting that this could mark the start of an EM rout, we should not forget that Turkey’s problems are largely homemade. This is an object lesson of what happens when we try to run economic policy along populist lines, with Erdogan’s attempt to hold down interest rates to make life easier for his supporters about to backfire spectacularly. Populists of the world take note.

Howay the lads: The economics of Newcastle United

Less than four weeks ago global audiences were gripped by the World Cup, which attracted a global audience of 3.4 billion people who watched at least some of the tournament on TV. But it is back to the grind of the domestic scene as the first round of English Premier League matches kicks off this weekend. This is where players, who just a few weeks ago were gracing the world scene, earn their corn: Footballers in England can look forward to 38 league games and numerous domestic cup games, whilst the top players must also face up to the rigours of the Champions League.

The best players get well paid for their trouble. According to the Global Sports Salary Survey for 2017, the average salary for players at the two Manchester clubs, United and City, was £5.2 million ($6.8 million) per year. Clubs such as Barcelona, Paris St. Germain and Real Madrid shell out even more, with the average Barca player earning 25% more than their counterparts in Manchester. If a top flight player can expect to play 60 games per season, an average player in Manchester earns around £87,000 per game – or nearly £1,000  for each minute they are on the pitch. Clearly, that is an awful lot of money to shell out but the simple truth in sport is that if you want to win, you have to pay.

Contrary to the view on the terraces that clubs have to spend in the transfer market to be successful, the academic evidence clearly shows a stronger correlation between the wage bill and football success. This reflects the fact that clubs which spend most on wages tend to attract the best players. As the chart below shows, there is a decent linear relationship between the average wage per player and Premier League position in season 2017-18. Those clubs lying above the line underperformed relative to their wage bill whilst those below the line outperformed. This brings me nicely to one of own personal pet peeves since I am a long-suffering fan of Newcastle United – a club that is perennially perceived to be one of the great underachievers of modern English football.

As is evident from the chart, Newcastle significantly outperformed its wage bill last season largely thanks to the outstanding performance of the manager Rafa Benitez, who has an impressive managerial CV at some of Europe’s top clubs. Although it is only one data point, it is testimony to what a good manager can achieve without spending huge amounts of money. But it is hard work to operate like this on a sustainable basis and Benitez is used to competing at the top of the table with clubs like Liverpool, Inter Milan and Real Madrid (his last job before Newcastle). Like most Newcastle supporters, I am frustrated at the refusal of the club’s owner, retail magnate Mike Ashley, to loosen the purse strings which would allow Benitez to strengthen his squad to improve the chances of winning something. Indeed, there is a common perception that Ashley is the root of all evil at the club (see, for example, this article from the German magazine Kicker). But a closer look at the club’s finances make it clear that matters are far more complicated than they appear on the surface.

At first glance, the club would appear able to spend more. Since he took the job in March 2016, Benitez has recouped almost £58 million in net transfer fees alone. Moreover, since Ashley took control of the club in 2007, he has sanctioned an average net spend of just £11 million per year which is around the going rate for one player these days – one new player per season is just not going to cut it. This failure to invest means that in the last nine years the club has suffered two of the six relegations in the club’s 126 year history. And the costs of relegation are significant. Relegation in season 2015-16 cost the club £40 million in lost revenue with the result that a modest profit of £4.6 million in 2016 was transformed into a loss of £41 million. Were Newcastle to have spent more than one season in the Championship (the second tier), parachute payments available to relegated clubs would have dwindled and revenue losses would have been even higher.

Doubtless Ashley would retort that increasing outlays would bring in little additional revenue. Each gain in league position only generates an additional £1.9 million in prize money. In order to justify spending an extra £10 million would require the club to improve its position by 5 places. Having finished 10th last year it would be a tall order for the club to be in the running for a Champions League spot. But this penny-pinching approach is at the extreme end of the feast or famine approach which characterises football finances. Once we factor in TV revenue, Newcastle generated a total of £123 million last year purely from being in the Premier League.

There again the club’s wage bill in 2017 was around £112 million so a large part of the Premier League revenue is eaten up by costs. And the club is also heavily indebted (as indeed are many top flight clubs in England) with the total amountng to £144 million as of mid-2017 which is more than 100% of income. Fortunately, the debt is held by Ashley and is not subject to interest charges, and the owner’s strategy appears to be to manage the club such that current costs are met out of current income. Whilst this is a laudable aim – and debt has been broadly stable over recent years – it is not enough to satisfy fans who want to see the club actually win things. Winning the FA Cup would generate £6.8 million in prize money (even reaching the final would bring in another £5 million) plus gate receipts. However, the EFL Cup (as this season’s League Cup is called) is not even worth bothering with on a financial basis (here).

As a Newcastle fan, I want to see my club win things or at least make a decent attempt at doing so. But the economics of running a football club mean that unless you have ultra-deep pockets it is difficult to compete on a consistent basis. In many ways, Ashley has not been a good steward of the club: He is a lousy communicator, is overly parsimonious and fails to appreciate the importance of the club to the local community. But it is hard to disagree with the underlying business ethos that the club must live within its means. The romantic in me harks back 20 years to the days when Kevin Keegan’s team swashbuckled their way up the league, spending huge amounts of money in the process. But the legacy is a large debt which, two decades on, continues to constrain the club’s ambition.

The reality of real interest rates

With interest rates having been so low for so long in the industrialised world, policymakers are increasingly waking up to the need to take away some of the monetary stimulus put in place almost a decade ago. The Federal Reserve started its tightening process in December 2015 and it was joined last week by the BoE which nudged the benchmark rate above 0.5% for the first time in over nine years. But it is generally recognised that although central banks are beginning to take away some of the monetary stimulus, they are not heading back to pre-2008 levels any time soon.

In a bid to understand how much headroom there is for monetary policy, central bankers are increasingly paying attention to the neutral real interest rate, described by former Fed Chair Janet Yellen as “the level that is neither expansionary nor contractionary and keeps the economy operating on an even keel.” More formally, it can be thought of as the rate which balances desired wealth holdings with desired capital holdings. This is the theoretical framework attributable to the Swedish economist Knut Wicksell in which equilibrium in both the goods and financial assets market is simultaneously derived.

The analysis published last week in the BoE’s Inflation Report explained this framework very nicely (see chart) and noted that we can think of the rate as being driven by long-term secular factors (R*) and a short-term component reflecting cyclical issues (s*). John Williams, recently elevated to the role of President of the New York Fed, noted in a speech earlier this year that in his view the real neutral rate (R*) in the US is around 0.5%. The BoE comes to a similar conclusion for the UK, pointing to R* in the range 0%-1% (with a modal estimate of 0.25%).

These estimates are around 200 bps lower than those prevailing 20 years ago. So what has changed? One of the key secular factors is demographics. As people live longer they have to save more for retirement with the resultant increase in savings putting downward pressure on interest rates (a shift in the red line to the right in the BoE’s chart). Another important factor is the increased demand for safe assets which has driven down returns on government bonds relative to those on riskier assets, and which also has the effect of driving the red curve further to the right. A third factor is the slowdown in productivity which has reduced business demand for capital, thus putting additional downward pressure on the interest rate (the blue line shifts to the left). Finally, a rise in the government debt-to-GDP ratio may depress the real rate via a crowding out effect since this reduces the quantity of capital available to finance an expansion of the business capital stock.

As to how these factors will play out in future, there is general agreement that slower population growth in the western world will not reverse the current trend ageing of the demographic profile. Consequently, retirement saving is likely to remain a key driver putting downward pressure on the equilibrium rate. It is less clear what will happen with regard to productivity. It may recover, or it may not, but we cannot say for sure that it will remain as sluggish as it has over the last decade. In any case, as labour force constraints begin to bite, it is possible that demand for capital will rise which will act to raise the neutral rate. But it is unlikely that government debt-to-GDP ratios will decline rapidly any time soon, which argues for continued downward pressure on the equilibrium rate.

However, some doubt has been cast by the BIS on the link between interest rates and the observable proxies that are conventionally used to measure the savings-investment balance. Part of their argument rests on the fact that much of the analysis is based on data only back to the 1980s and that taking the data back to the late nineteenth century suggests a weaker link between them. That said, the BoE’s analysis is  based on a long-run of data extending back more than 100 years and they come to much the same conclusion as the rest of the academic literature, which weakens the BIS criticisms to some degree.

However, the BIS does raise another important question:  Much of the literature assumes that monetary policy is neutral in the long run and that only real factors influence the real interest rate. But is this necessarily true? For one thing, the expected wealth demand function may be determined by the actions of central banks themselves as interest rate expectations influence portfolio choices. Another objection is that we may underestimate the key channels through which monetary policy exerts a persistent influence over real interest rates (e.g. the inflation process or the interaction between monetary policy and the financial cycle). These are serious criticisms, although the BoE’s framework introduces the short-run variable s* into the framework, and whilst we can estimate R* using conventional measures, the BoE does not try to put a numerical value on s*. However, it does suggest that in the longer-term the s* component will tend towards zero (although it may not be zero at any given time).

What are the takeaways from all this? First off, if we add a 2% inflation rate to estimates of the real neutral rate, we end up with a neutral funds rate in nominal terms of around 2.5%. With the Fed funds target corridor currently set at 1.75%-2.0%, we might only be three 25 bps hikes away from the neutral rate. Similarly, the UK neutral rate is estimated in the range 2%-3% so we do appear to have more headroom. Nonetheless both estimates suggest that interest rates will not get back to the pre-2008 rates of 5%-plus for a long time to come. Welcome to the new normal.

The case for a UK rate hike

The Bank of England is widely expected to raise interest rates by 25 bps this week, taking them above 0.5% for the first time since March 2009. The markets seem convinced, pricing such an action with a probability around 90%. It would be a major surprise if the Bank were not to deliver, with the markets so apparently sure. Indeed, if the BoE had a problem with current market pricing it would almost certainly have said something before now to try and nudge expectations. The fact that it has not done so is a strong indication in favour of a policy tightening. (If a rate move is not forthcoming … well, that is another story and we will deal with it if it happens).

There are those who believe that raising rates is a mistake (or at the very least that there is no need to act now). Their argument is sound enough: Price inflation is slowing; wage inflation is not picking up as anticipated and there are sufficient headwinds from Brexit that caution is warranted. If we were talking about an economy in which rates were a little bit higher than those introduced when the economy was about to fall off a cliff in 2009 I would be a bit more receptive to that view. But we’re not! Whilst Bank Rate of 0.5% may have been appropriate for an economy which was expected to contract by more than 3% in real terms, it is hard to make the case that is still the right interest rate 9 years later for an economy expected to grow by 1.5%.

For quite some time, I have believed that the UK rate setting process has taken an overly short-term approach to monetary policy. By looking only at short-term issues (e.g. the latest inflation or growth data) policymakers have been able to defer the need for a policy tightening. But in so doing, they appear to have suffered from what we might term “horizon myopia” without taking account of the fact that all these short terms eventually add up to an extended time horizon.

My argument for raising rates is the same as it has been for the last 3-4 years: The current interest rate is too low for general economic conditions. Those who believe that nominal GDP growth should act as a benchmark for the policy rate – and I am semi-persuaded of the merits of such a policy – argue that UK interest rates have deviated from GDP to an unprecedented degree in recent years (see chart). By itself, that is not proof of anything but it is an indication of the extent to which financial rates of return are out of line with those in the real economy which is likely to lead to economic distortions.

Arguably, excessively low (or high) interest rates distort capital allocation decisions – for example, by propping up zombie firms (though I am not sure that is a problem in the UK right now). However, they do distort savings choices. If returns to saving are low, this is a strong argument in favour of spending rather than saving. This is, of course, precisely what policy was designed to achieve during the depths of the recession but is it really necessary almost a decade on? And as I have pointed out previously, the longer interest rates are held at emergency levels, the bigger the risks to future generations of pensioners whose pension pots will not grow as rapidly as they ought. Indeed as John Authers noted in the FT last week whilst low interest rates prevented an economic meltdown, “it grows ever clearer that risk has been moved, primarily to the pension system.”

In my view, this is another strong argument in favour of modestly tightening monetary policy. At this stage we are not talking about a dramatic stamp on the brakes, but allowing rates to edge upwards by (say) 50 bps per year for the next couple of years would take some of the heat out of the problem. Whether the BoE will be in a position to do that depends, of course, on the extent of any damage that Brexit inflicts on the UK economy.