A decade on ...

It is exactly ten years since the Lehman’s bankruptcy set off a chain reaction in the financial markets that prompted the biggest economic collapse since 1929. Perhaps if the regulatory authorities had been aware of the disruption that would follow in the wake of their decision to declare Lehman’s insolvent they would have thought twice about it. It proved to be the catalyst for the deepest global recession in 80 years and prompted the monetary authorities to step in to prop up the global financial system.

The prime cause of the bust was excess leverage that had built up in the banking system, aided and abetted by some irresponsible activity by banks and lax oversight by the regulatory authorities. Thanks to an unprecedented degree of monetary easing, the fallout from the crisis proved to be far less disruptive than the Great Depression of the 1930s but it nonetheless exposed the limits of the pre-2008 financial system. Despite all the hype suggesting that risk had been tamed, the opposite was true. Instead banks merely learned to hide risk using off-balance sheet vehicles, and when banks ceased to trust each other because they were not sure how much balance sheet risk their counterparties were exposed to, financial markets seized up.

It was evident during the meltdown that the motto of the London Stock Exchange “my word is my bond” counted for nothing. Trust evaporated faster than an ice cube in a heatwave. Whilst banks were clearly the catalyst of the crisis, I hold the view I expressed at the time that the whole episode reflected a systemic collapse in which regulators, central banks, governments and indeed private households all played a part. I was also initially puzzled as to why the authorities allowed Lehman’s to go to the wall when the Fed brokered a deal with JP Morgan after a similar fate befell Bear Stearns in March 2008. I rationalised it by suggesting that having acted as a backstop for the US financial system to that point, the authorities took the  view  that  they  could not continue  to  bail  out  failed  institutions  and thereby  continue  to promote  risk  taking. Which was fine, but a couple of days later they stepped in to bail out AIG.

It was nonetheless obvious on 15 September 2008, the day markets reopened after the Lehman’s announcement, that the risks to the economy had significantly risen. I noted on the day that  “On previous occasions when the US financial industry has suffered major shocks, the authorities have responded by implementing major legislative changes … We  might expect a similar legislative backlash in future with any legislation likely to focus on improving the transparency of banks' risk positions.” That proved to be an understatement. The Basel III legislation, unveiled in 2010, was a comprehensive overhaul of the financial sector which changed the way in which banks operated. The first element of this policy required banks to hold much more loss-absorbing capital, with a required minimum capital buffer of 7%-8.5%  compared to an effective pre-crisis buffer of 4%. A second element of the legislation focused on enhancing the consistency and comparability of banks’ risk weighted, assets to impose a much greater degree of uniformity thus enhancing transparency.

Although we will never fully know how successful the new legislation proves to be until it is tested in a crisis, regulators’ regular stress tests give grounds for optimism. Balance sheets have changed significantly in the past decade with a higher proportion of the asset base comprised of loans at the expense of trading securities whilst deposits make up a larger share of liabilities. But as the BIS has pointed out, a crucial area of banking resilience is profitability since this determines the extent to which banks can recover from losses. Although much progress has been made to weather-proof bank balance sheets, profitability – particularly in Europe – has not recovered. Admittedly, pre-2008 profit levels may be an inappropriate benchmark given the significant degree of risk required to generate them, but market pricing based on metrics such as price-to-book ratios suggest that investors are not very optimistic with regard to a profit recovery.

From an economic standpoint, economic prosperity is clearly growing more slowly than before the great recession. In the ten years to 2007, UK real household incomes grew at an annual average rate of 3%; over the period 2008 to 2017 the rate slowed to 0.8%. The experience across the euro zone has been similar, with average annual growth of 1.9% in the seven years prior to the crash but 0.2% in the decade thereafter.

A perception that living standards are not improving at the same pace as pre-2008 has resulted in a backlash against globalisation – a view that has been fuelled by the rise of China, which is viewed in some quarters as getting rich at the west’s expense.  Rising economic nationalism has placed limits on the EU’s ambition and although the single currency has survived intact, it survived a near-death experience in the wake of the Greek debt crisis and highlighted that a fixed exchange rate system needs much more than a single monetary policy to survive. Arguably, the problems in the EU coupled with a backlash against immigration gave rise to Brexit, whilst mounting concerns about the rise of China was the catalyst for the rise of Trump.

Just as many lessons were learned from the crash of 1929, so economic historians will have a field day with the Lehman’s bust. Perhaps the biggest lesson was that self-regulation does not work. The idea prevailing in the preceding 20 years that aligning incentives would ensure optimal market outcomes proved to be hopelessly naïve (as indeed many of us said all along). Few bankers are fans of the enhanced regulatory regime subsequently introduced but it is a necessary price to pay to ensure that 2008-style outcomes are not repeated. After all, the imposition of Glass-Steagall legislation in the US in 1933 successfully prevented banking crises until after it was repealed in 1999.

But one lesson has remained unlearned. Many believed that the Keynesian policy prescriptions which worked well in the 1930s, coupled with massive monetary easing, would help economies to recover relatively quickly. Although we got the monetary easing, governments have conducted a prolonged period of fiscal austerity after a brief stimulus. The economy has thus struggled to recover and financial markets are less dependent on the economic pickup than on the cheap liquidity provided by central banks. In that respect perhaps we will only know the extent to which we have fully recovered from the crash of 2008 when we see how markets and the economy cope with monetary tightening. The US seems to be doing fine on this front but Europe remains a long way behind.

Jacob's adventures in Wonderland

The Economists for Free Trade (EFT) group (formerly Economists for Brexit) today released their latest unfortunately-named  publication  “A World Trade Deal – The Complete Guide” which is not much of a guide and is in no way complete. Moreover “A World Trade Deal” is no deal – it is the default option in the event that the UK is unable to agree an arrangement with the EU. Given this starting point, expectations for the rest of the publication were pretty low and it more than lived down to them. But let’s focus on some of the details.

Trading under WTO rules implies imposing tariffs on EU trade where there are currently none. This is in no way a “deal” as EFT would have us believe: The WTO represents nothing more than a lowest common denominator set of rules to reduce trade frictions. EFT also believe that the UK can simply continue trading on the basis of these rules as soon as it exits the EU. There are one or two issues to iron out, such as agreeing on the division of quotas for goods which have already been agreed at the EU level (the US, Australia and NZ have already objected to the proposed divvying up of agricultural quotas). Incidentally, EFT believe this “should not cause great difficulties … the EU and the UK have been working harmoniously in this regard for some time” although The Guardian reported in the spring that “in recent months the united EU and UK front has splintered.”

EFT then poses the question “Does the WTO require physical customs checks, meaning lengthy delays at our ports and borders?” and in their view the answer is negative. But the delays come when other countries impose customs checks on goods entering foreign markets, and then some! According to the WTO, “high levels of bureaucracy and unnecessary costs” result from document requirements that lack transparency and involve duplication; a lack of cooperation between traders and customs agencies and lack of automatic data submission with the result that “at some border crossings, cargo can take up to 30 days to be cleared.”

Against this backdrop, EFT continue to argue that the economic gains to Brexit outweigh the costs. “Those who have modelled a Clean Brexit properly report long-term gains from free trade alone of 2%-4% of GDP.” You have to laugh at the chutzpah. Those who have modelled Brexit “properly” certainly do not include EFT. “The long-term negative outcomes claimed by the Treasury and the January Cross Departmental Brexit Analysis were produced by assuming implausibly high (and illegal) frictional UK-EU border costs.” Yet the bulk of the academic evidence finds that border costs are far higher than often supposed. It is not tariffs that are the problem; rather the costs associated with transacting across borders (legal, contract enforcement, transport and distribution expenses). Indeed, they are generally larger than the marginal costs of production[1].

Then EFT simply descend into fantasy. They reckon that in addition to the positive effects of free trade, the UK will save “approximately £12 billion a year” by cutting payments to the EU. Finally, “because we will be doing all this without the encumbrances and constraints of the Withdrawal Agreement … we can … withhold most or all of the estimated £39 billion divorce payment.” The upshot will be a “long-term gain to GDP of …  about 7% over the next decade and a half” which will “allow enhanced spending on public services and tax cuts by the early 2020s, further boosting the economy.” To sum this up, EFT reckon that a system of imposing additional tariffs on EU trade is going to somehow boost GDP and find a Brexit  dividend that the OBR says does not exist. As the kids would say, LMAO.

And we’re not done yet. EFT argue that “the economically optimal trade strategy in most circumstances for the UK would be to eliminate all tariff and non-tariff barriers unilaterally with respect to all our trading partners.” The elimination of all non-tariff barriers implies the complete deregulation of all product standards. And since non-tariff barriers exist primarily due to differing regulations between trading partners, unless we suddenly converge on a set of global standards (e.g. China and the US adopt the same standards), it will be impossible for the UK to eliminate non-tariff barriers on all imports. Moreover, there is no reason why the rest of the world should reciprocate, particularly if the UK is a relatively small export market (which it is for most countries).

There are numerous other dodgy assertions but I will reserve some final flak for the idea that losing access to the EU market will not damage the financial  services industry. Without going through it point-by-point, I would question the assertion (provided without a reference) that “only 9% of the City’s revenues are vulnerable to the loss of passporting.” More than half the revenue generated by the City is generated from the rest of the EU according to TheCityUK, and initial estimates suggest that 20% of London revenues could be at stake. Moreover, some of the solutions proposed by EFT such as “setting up small entities in the EU that trade with EU customers and those entities entering into mirror, or “back-to-back” trades with the UK parent” would run fall foul of the ECB, which has ruled out boiler plate operations. Anyone who believes that Brexit will not have adverse consequences for financial services would do themselves a favour by talking to people in the industry who are already making their post-Brexit arrangements.

Eurosceptic MPs, operating under the guise of the European Research Group, promised earlier this month to produce an alternative to the Chequers plan but backed down when it became clear that some of the proposals were of “dubious quality.”  Given that Jacob Rees-Mogg lent his support to the EFT proposals but was not prepared to back the ERG plans, you really do have to wonder how bad they were. As trade expert David Henig tweeted this afternoon, the EFT analysis “isn't in any way a serious document. Media should treat the report, and any MPs citing it approvingly, as having nothing useful to say on the subject of post-Brexit trade.” As a drowning man clutches at straws, so the Brexiteers continue to hang their hat on sub-standard analysis such as this. They’re losing the argument because they haven’t got one.

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[1] Anderson, J. E. and E. van Wincoop (2004) “Trade Costs” Journal of Economic Literature (42), pp. 691-751

What have you got?

It is a well-known physical property that when heat is added to a substance the molecules vibrate faster and usually maintain a greater average separation. Ultimately the object expands in size and takes up more space. If we take away the heat source, the molecules move more slowly and if we were to freeze an object containing water, it would actually contract.

The Brexit debate feels a bit like that. The two years following the referendum have generated more heat than light and the whole issue has expanded to take up an increasing amount of media space. Politicians such as Jacob Rees-Mogg and Boris Johnson fan the flames by making outrageous claims as to how to achieve Brexit and what the benefits will be, generating a counter response which fills up a lot of column inches. If, however, we were to dial down the rhetoric a little and think about what the end game might be, we might be better served in terms of working out how to proceed. 

Basic premise: Neither side wants no deal 

We should start from the premise that neither the UK nor EU want a hard Brexit next March. It may not seem that way when we are assailed with stories telling us that the government recommends stockpiling essentials in the event that cross-border trade is about to come to a halt. It certainly does not seem that way when self-serving British politicians fly in the face of all the evidence to argue that “the UK has agreed to hand over £40 billion of taxpayers’ money for two thirds of diddly squat … In adopting the Chequers proposals, we have gone into battle with the white flag fluttering over our leading tank.” Boris Johnson may know how to pen a decent newspaper column but as a frontline politician with a track record of deliverance he has been found wanting and he is as guilty as anyone of pouring fuel on the raging Brexit fire.

What the Brexiteers fail to understand is that the EU has little choice but to act in the way it does. It has consistently been made clear to the British government that access to the single market is based on the four freedoms of goods, services, labour and capital. The EU cannot therefore allow the UK to pick and choose. And whilst both sides agree on the need to maintain an open Irish border, the British proposals to realise this outcome are either unnecessarily complex or unworkable. But with just over six months until the UK leaves the EU, we need to see more flexibility – ideally from both sides – in order to generate the breathing space which can keep negotiations alive.

The UK government’s Chequers Plan clearly does not satisfy anyone domestically, nor in its current form is it acceptable to the EU. But it is the only idea on the table at the moment so it is the point from which we have to start. There have been some reports suggesting that Michel Barnier believes the plan to be ”dead” whilst others indicate that he sees some possibilities. One of the biggest sticking points is that the UK is not prepared to accept free movement of labour. But it may be possible to form a basis in law for a compromise which satisfies both sides. 

A fix for the freedom of movement problem 

As it currently stands the law grants residency rights to EU citizens irrespective of whether they work. For periods of less than three months the only requirement is that they possess a valid identity document or passport (although they may be required to register with the authorities – a requirement never imposed in the UK). For longer stays EU citizens and their family members “must have sufficient resources and sickness insurance to ensure that they do not become a burden on the social services of the host Member State during their stay.” But what if we were to impose quasi-freedom of movement in which the only restriction is that EU citizens require an employment offer before taking up residency?

Admittedly, it is not free movement as envisaged by the Lisbon Treaty but it is a good compromise. Moreover, articles 48 and 49 of the Treaty of Rome make it clear that cross-border flows of people were originally supposed to be conditional on an offer of employment. To enhance the fiction of “taking back control” the government can give the illusion that EU citizens be required to register – as is the case in Germany – via an application for a National Insurance number. In that sense, EU citizens working in the UK experience no obvious changes in their circumstances but the government sells a message that it has stiffened up border controls. Granted, it is far from ideal but it is a far better option than simply throwing up the drawbridge and would at least show that the British are trying to find a solution. 

The government has already proposed a solution for the Irish border 

With regard to Ireland, the UK government has already proposed a solution: The backstop plan outlined in June calls for a "temporary customs arrangement" which keeps the UK in a customs union with the EU for a limited period after the end of the proposed Brexit transition period in December 2020. At the same time, the government proposes that the UK be able to sign and ratify trade agreements with the rest of the world during the temporary arrangement. There are a couple of problems with this: (i) The EU has not (yet) agreed to it and (ii) Brexiteers do not like the idea because they are sold on the idea of leaving the customs union (Theresa May has tried to pacify them by suggesting that such a solution would only need to remain in place until end-2021).

But imagine that the EU does agree. The UK will find it extremely difficult to ratify any meaningful trade deals by end-2021 and thus continues to extend its membership of this arrangement. The longer the UK remains in the customs union, the less likely it is to want to drop out, resulting in a BINO solution (Brexit in name only) which is probably the least damaging economic option. 

They may be bad ideas but show us something better 

There are all sorts of reasons why these are thoroughly bad ideas. Like the Chequers Plan, they will satisfy neither leavers nor remainers. But they represent an attempt to reconcile the demands of the EU with the apparent need to respect the referendum result. And yes, they are politically devious solutions but Brexit is nothing other than a political issue and it is going to require some chicanery to extract the UK from the mess it has created for itself. But if Johnson or any other of the Brexit zealots has a better plan, we are all ears, because all we have heard so far is what is wrong with the current set of options. C’mon, show us what you’ve got!

End of the Brexit holiday

It has been another funny old week in Brexit Britain as parliament reconvened after the summer. We were treated this week to the views of former BoE Governor Mervyn King who criticised the government’s “incompetent” preparations for Brexit. In an interview to be broadcast next week, he argued that that the government had weakened its negotiating position by “a whole lack of preparation” for a no-deal Brexit and said it “beggared belief” that the world’s sixth-biggest economy should be talking of stockpiling food and medicines.

It is hard to argue with that view. Yet at the end of 2016 King suggested that whilst leaving the EU would not be “a bed of roses – no one should pretend that – but equally it is not the end of the world and there are some real opportunities that arise from the fact of Brexit we might take … There are many opportunities and I think we should look at it in a much more self-confident way than either side is approaching it at present. Being out of what is a pretty unsuccessful European Union – particularly in the economic sense – gives us opportunities as well as obviously great political difficulties.” Maybe King retains his belief that leaving the EU is a good idea and his differences with the government are more about tactics than strategy, but he is the latest in a long line of Brexit supporters whose expectations are not being met.

But I have always struggled to see what the economic opportunities are. In an environment where trade flows are negatively related to distance – as is the case in standard trade gravity models – the UK will require a more-than-proportional increase in non-EU trade to make up for any losses with EU countries in the event of leaving the single market, as King has advocated. It is not as if King has a great track record over the years of being on the right side of the economic argument. In 1981 he was one of the signatories to a letter to The Times arguing that “present politics will deepen the depression” – just before the economy started to recover. More damningly, he was Governor of the BoE when the UK suffered its first bank run since 1866 having failed to deal with the circumstances that led to the failure of Northern Rock and was slow to appreciate its significance. So forgive me for not being a knocked out fan of Mervyn King’s forecasts.

But there is no denying that he is right about the sheer incompetence of the government’s planning so far. Yesterday we were treated to the Treasury’s secret no-deal Brexit contingency plans unwittingly being made public after a photographer snapped an official holding a letter detailing an outline of Project Yellowhammer. The briefing documents state: “The Civil Contingencies Secretariat held a two-day workshop last week to review departments’ plans, assumptions, interdependencies and next steps.” The paper reveals it is an aim of the Treasury to build a “communications architecture” that can “help maintain confidence in the event of contingency plans being triggered.” It added this is “particularly important for financial services” and seems to include a reference to “aviation and rail access to the EU.” Whilst the government is quite right to be considering the possibility of no-deal before March, this all seems a little alarmist.

Indeed, the more we think about it, the less likely is a no-deal. It is not in the EU’s interests to allow the Brexit process to collapse, particularly if Michel Barnier has ambitions to be European Commission president, as has been speculated in the press. Moreover, as recent IMF research has indicated their calculations show “EU output losses of 0.2 to 0.5 percent in the “FTA” and “hard Brexit” scenario, respectively” (see chart). Perhaps this explains why Barnier’s opposition to elements of the Chequers Plan has reportedly softened in recent days, and why Germany is rumoured to be asking for less detail from the UK at this stage, in order to get beyond the March deadline and set up a transition period during which the hard negotiations will take place.

But the UK government has even more to fear. Whether or not people are changing their views on Brexit, the electorate appears to be showing rising distrust regarding the government’s negotiating approach. Boris Johnson’s newspaper article earlier this week suggesting that “The scandal of Brexit is not that we’ve failed but that we have not tried” was met with widespread derision (if only he had had a position of influence in government for the last two years!).  The British government cannot be seen to be delivering a no-deal Brexit for it would damage its credibility beyond repair. So despite all the horse trading which is likely over the next few months, and the associated adverse headlines, it is likely that the EU will bend a little in order to make way for the UK to bend a lot. And in my next post, I will look at ways in which this could be done.  

Sir James Mirrlees and optimal tax systems

To paraphrase the nineteenth century British Prime Minister Lord Palmerston, only two people have ever understood the tax system: One went mad and the other died. Indeed, one of the few people to have properly understood the tax system was the Nobel Prize winning economist Sir James Mirrlees, who died earlier this week. Mirrlees was best known in academic circles for his work on decision making under uncertainty for which he won the Nobel Prize in 1996, and his most insightful work was his 1971 paper on optimal tax systems in which he showed how and why there was a trade-off between equity and efficiency.

The paper is mathematically dense but it had a huge impact on information economics by introducing models with asymmetric information into contract theory. Until the late-1990s the results of these models were not closely connected to empirical tax studies and had little impact on tax policy recommendations. But a number of authors, including Peter Diamond and Thomas Piketty have since connected Mirrlees’ model to practical tax policy.

He was thus the obvious choice to head up a review of the UK tax system commissioned by the Institute for Fiscal Studies almost a decade ago. It was a follow-up to the Meade Committee report of 1978 which was concerned with the question of how the tax system impacted on the wider economy by distorting incentives. Thirty years later, the IFS noted that the tax system had evolved in a piecemeal fashion “rather than by strategic design” and that it had not adapted to changes in the general economic environment in which it applied. Moreover, as the IFS pointed out, “tax design has not benefited as much as it could from advances in theoretical and empirical understanding of the way features of the system influence people’s behaviour.”

Mirrlees and his colleagues took an in-depth look at the state of the UK tax system “to identify reforms that would make the tax system more efficient, while raising roughly the same amount of revenue as the current system and while redistributing resources to those with high needs or low incomes to roughly the same degree.” They noted that the UK system is “unnecessarily complex and distorting” with tax policy “driven more by short-term expedience than by any long-term strategy” in which policymakers did not seem to grasp the extent to which individual agents change their behaviour in response to changes in tax incentives. This was a damning indictment and it is still true today, with a myriad of small changes having come into effect since the report was published which impact on the way people and companies behave.

The report noted in particular that income inequality had widened, particularly during the 1980s, but that merely soaking the rich was not necessarily the way to go. In any case, corporate and capital gains taxes are at least as important as income taxes in terms of their wider impact, and certainly the combination of all three is likely to be more critical than looking at one in isolation. In this sense the Mirrlees Review took a far more wide ranging view of tax issues. Indeed, a key recommendation was that the complex benefits system should be harmonised with income taxation, in order to increase work incentives for the lower paid (something which the government has tried – and failed – to achieve with the Universal Credit System).

The report also noted that the corporate tax system favours debt finance over equity finance which in turn has increased the reliance on debt, and recommended an allowance for corporate equity (ACE) be introduced into the corporate tax system. Taxation of savings is another aspect requiring radical reform. Savings in the UK are subject to double taxation, with income tax levied on the original income from which the saving is generated and again on interest income derived as a result. With the government having for many years exhorted individuals to save more, this is an obvious anomaly. The Mirrlees Review thus recommended that standard bank and building society accounts should be entirely free of tax. Neither of these recommendations has been implemented (though the interest on bank accounts these days is so low that tax is negligible).

I was heartened by the Mirrlees Review when I first looked at it almost a decade ago because it was an accessible review of the state of the tax system, which looked at how the various parts fitted together without delving into the politics of taxation. It is a shame, therefore, that many of its recommendations have not been implemented. Perhaps it was the right report at the wrong time, with governments then too preoccupied with the day-to-day task of reducing deficits to pay much attention to reforming the tax system itself. Perhaps the passing of Sir James Mirrlees offers us another opportunity to revisit what I believe to be an outstanding piece of work, and to think again about some of its conclusions.