Doing the splits

Although I am not a political commentator, it is impossible to look at the biggest issue(s) in British economics without concerning ourselves with the political context against which they are being taken. None of these issues comes bigger than Brexit, although it increasingly seems as if the debate has little to do with leaving the EU and is more the battleground on which various factions are fighting to try and reshape the domestic political debate. Quite where the chips will fall once the fighting is over remains to be seen.

The first steps toward reshaping came this week with the news that 12 MPs have resigned from their parties (9 Labour and 3 Conservatives), with 11 joining a new movement calling themselves The Independent Group (TIG). As I noted on Monday, Labour MPs decided to leave their party for a variety of reasons but Brexit was very much at the heart of their decision. The three Conservative MPs who jumped ship on Wednesday were very explicit about the fact that the government’s handling of Brexit was the decisive factor in their decision. Anna Soubry, the redoubtable (former Conservative) backbench MP was clear about her reasons for leaving (for those with 24 minutes to spare, this Times podcast is well worth a listen). It  is evident that she does not have much time for Theresa May as prime minister, arguing that she is out of her depth, and in a TV interview earlier in the week Soubry went so far as to suggest that May has “a problem with immigration” which explains her antipathy towards the single market. That is quite a bold allegation but Soubry can point to the “Go Home” campaign carried out in 2013 by the Home Office, when May was Home Secretary, as evidence.

Obviously we are in the realms of the speculative here so it pays not to push it too far. However, it would explain why the PM has been so keen to give in to the ERG which is increasingly described as “a party within a party,” and I have long questioned the PM’s commitment to the Remain campaign that she nominally supported. Given the small number of ERG MPs, I have never understood why the PM did not try and face them down earlier if she was so opposed to their views. If there is even the slightest grain of truth to Soubry’s allegation, it calls the whole basis of the government’s Brexit strategy into question for it implies that the ideological considerations of a small proportion of Conservative Party members, which number around 124,000, are being placed ahead of the economic wellbeing of the 66 million people living in Britain.

Ideology is not, of course, confined only to the Conservatives. The opposition Labour Party is arguably the most ideologically oriented party to sit in parliament in many a year. Even in the 1970s, when Labour was swinging to the left at a rapid rate of knots, there were sufficient heavyweights in the political centre who were able to slow efforts by activists to take over the party machinery. Simply put, Jeremy Corbyn is the most left wing leader of a major political party in the post-1945 era (you can check out his voting record here). Interestingly he has “generally voted for more EU integration” – 60 votes for, 24 votes against, 47 absences, between 2006 and 2019. But he opposed remaining in the EU in 1975 and the ratification of the Maastricht Treaty in 1993, whilst backing a Conservative proposal in 2011 calling for a referendum on the UK’s withdrawal from the EU.

Whilst the right-wing of the Conservative Party wish to leave the EU to further a free-market agenda, Corbyn has been critical of the EU’s role in protecting workers’ rights. He is thus open to the charge of enabling the wishes of the Tory right via a diametrically opposed left-wing stance. Back in 2015, just after he was elected leader of the party, a senior aide was quoted as saying “I don’t think that Jeremy is going to find very many people supporting him in the idea that we should leave the European Union.” (Link here to Reuters story but it does not work in Firefox though seems to be OK in Explorer). Younger people who voted for Labour in 2017 as a protest against the Conservative’s handling of the Brexit issue have been sadly disappointed.

Despite the government’s apparent ineptitude, Labour trail the Conservatives by 4 points based on an average of the last 10 published opinion polls. At the end of December, the two parties were running neck-and-neck. Although the gap is not statistically significant, the trend is noticeable. It will be interesting to see how the recent political defections change the balance. A poll carried out before the defection of the three Tory MPs gave TIG a 14% share versus 38% for the Conservatives; 26% for Labour and just 7% for the LibDems. One poll does not represent a trend but the initial numbers suggest that Labour and the LibDems may struggle if TIG ever becomes a fully-fledged political party.

But we may not get to find out. If TIG damages Labour more than the Conservatives, and on the assumption that (i) the government can deliver a soft Brexit (this week’s votes will be interesting and may force the government to delay the Article 50 deadline) and (ii) the number of defections to TIG is limited, a sensible strategy on the government’s part might be to try and hold an(other) early election. There is certainly lots of chatter suggesting that a summer election is a possibility. It would, of course, make a mockery of the Fixed Term Parliaments Act, designed to prevent governments from controlling the timing of elections, but that did not prevent just such an outcome in 2017. As a reminder, the Act requires two-thirds of MPs to vote in favour which, given that Labour have been pushing for such an election, is likely to be achievable. If TIG proceed to split the Labour vote it might allow the Conservatives to regain the parliamentary majority they squandered in 2017 whilst also seeing the nascent TIG all but wiped out as they lose their seats to representatives from the main parties.

If this strategy does play out it will simply reinforce the political status quo and leave those voters hoping for an alternative to the ideological convictions of the main parties with nowhere to go. Moreover, a third general election in four years would be too much for most voters to swallow. But much as Brexit gives a uniquely British dimension to the political debate, the tectonic plates are shifting in many other countries too. They say that the four most dangerous words in markets are “this time it’s different.” But as regards politics today, this time it really is.

Assessing recession probabilities

Over recent months I have spent far more time than is healthy looking at political issues and I will return to them again. But for a pleasant change I wanted to look at some economics, specifically some quantitative analysis of the outlook for the UK. Brexit considerations aside, the UK faces headwinds from the global economic cycle which has lost significant momentum in the last couple of months – indeed the slowdown has come upon us more quickly than imagined. Within Europe, Italy fulfils the technical definition of recession, having posted two consecutive negative quarters of GDP growth in the second half of last year whilst Germany has only just avoided the same fate, with a flat Q4 growth rate following a contraction in Q3 2018. Despite all the concerns regarding the gilets jaunes protests, France did not do badly with quarterly growth of +0.3% in each of Q3 and Q4. The UK did even better, with a +0.6% rate in Q3 followed by a more modest expansion rate of 0.2% in Q4.

But that is all in the past. What about the outlook for the remainder of 2019? Obviously Brexit remains the elephant in the room as far as the UK is concerned, so it is impossible to be precise about what is likely to happen. In terms of what the evidence tells us so far, we know that business fixed investment fell in each of the four quarters of 2018, and in the second half the pace was particularly rapid with spending down 2.6% in real terms in Q4 relative to Q2. By end-2018 the volume of activity was thus the lowest since Q3 2015, and the second lowest quarter in four years. It is possible that it will rebound in the absence of a no-deal Brexit but latest CBI survey evidence continues to suggest that companies are likely to cut capital investment over the next twelve months.

However, declining business investment is not necessarily a good indicator of what will happen to overall GDP. In 14 of the last 53 years business investment has actually fallen at the same time as GDP has expanded. For four consecutive years between 2001 and 2005, when GDP growth averaged 2.7% per annum, business investment declined at an average annual rate of 2.8%. It is thus illustrative to look at the information content in other data to see what it tells us. In doing so, I have relied on the literature on qualitative choice models which tries to find leading indicators to predict recession probabilities (see this New York Fed paper for insight into how such models have been applied in the context of the US).

In applying the analysis to the UK, the object of the exercise is to find indicators which have decent predictive power. I finally opted for the CBI’s business optimism index and the Conference Board’s leading indicator, which is in turn comprised of eight variables (order books, expected output, consumer confidence, bond prices, equity prices (All Shares), new orders, productivity and corporate profits). Although the leading indicator does contain financial variables, equities have a weight of less than 4% so I added a series for real equity prices (using the consumer spending deflator as the relevant price index) to specifically account for the fact that markets often spot downturns in the economic cycle more quickly than the published economic data.

As noted above this methodology uses models of qualitative choice. Such techniques are used to model outcomes where the dependent variable takes a binary 0,1 value depending on the contingent state. In this case the dependent variable is the year-on-year rate of real GDP growth which takes the value 1 when it falls into negative territory and 0 otherwise. Thus what the model tries to do is assess the likelihood that annual growth will turn negative [1]. Based on data back to 1973, we have 184 quarters of data, and on 25 occasions GDP growth turned negative. Using a basic probit model, I estimated a relationship between lagged values of the three explanatory variables and the binary dependent variable to give an assessment of recession probabilities six months ahead.

As the chart shows, on the four occasions since 1973 that growth has gone into negative territory, the model has predicted this six months ahead of time with an accuracy rate of at least 90%. The model suggests that on the basis of current data there is a probability of around 33% that GDP growth will turn negative by mid-2019. In order for that to happen by Q3 would require a sluggish Q1 growth rate and modest declines in Q2 and Q3 (i.e. a technical recession). Absent a Brexit-related collapse, this would appear to be a stretch. Thus the model likelihood of around one-third appears reasonable – an unlikely, but not impossible, scenario.

In contrast to conventional forecasting techniques, we do not attempt to quantify the rate of GDP growth. But the probabilistic approach outlined here gives a sense of the risks surrounding the outlook and thus some steer on how much preparation may be required to offset the worst-case outcomes. Obviously, the analysis is based on the information content in current data and is subject to changes resulting from random shocks. Brexit could thus significantly change the picture, but that is a subject for another day.

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[1] Strictly speaking we ought to be looking at quarterly GDP growth to define those periods where there are two consecutive quarterly declines, but there is such a lot of noise in the quarterly data that the equations do not fit the data particularly well.

Truce or dare?

With every day that passes the economic case for Brexit crumbles before our eyes. Sensible politicians look on in horror as the zealots pursue a Brexit that satisfies “the will of the people” despite the fact that the Brexit they are proposing is nothing like the one promised almost three years ago. People were asked to vote on where they wanted to go, but not how they expected to get there. As we are now learning, the journey is likely to prove far more damaging than they were led to believe. I, for example, would very much like to climb Everest and would happily cast my vote for someone who could promise to get me there easily and safely. I am less keen on slogging up 8848 metres in the teeth of some of the worst weather on the planet whilst running the risk of hypoxia.

The events of today have made it clear just how the path towards the sunlight uplands of Brexit is crumbling beneath our feet. Let’s start with the politics and the news that seven MPs have resigned from the Labour Party to set up The Independent Group. This is a measure of the sheer helplessness felt by many Labour MPs who see their party drifting away on a sea of left-wing irrelevance following Jeremy Corbyn’s unwillingness to use his position to stand up to the damaging form of Brexit proposed by many on the opposition benches. Let us not forget that in summer 2016 Labour MPs called a vote of no confidence in leader Jeremy Corbyn following the EU referendum, which he lost by 172 votes to 40. However, he remained as party leader by a margin of 61% to 39% following a ballot of all party members in September 2016.

But we have been here before. In 1981 four MPs left the Labour Party as it drifted inexorably to the left, to form the Social Democratic Party. Whilst this was instrumental in forcing Labour to confront its internal issues, it was a multi-year process which succeeded in splitting political opposition to the Conservative Party which remained in office until 1997. As it is, current opinion polls suggest that the Conservatives are marginally ahead and unless the new political centre can rapidly gain significant momentum it is hard to see how this will change the political dynamics, unless it can gain support from Conservative dissidents (which currently looks unlikely).

It is far from sure that this will have much impact on the Brexit debate either. Seven MPs are hardly enough to change the world and there are just 39 days (936 hours) until the default option is triggered which will force the UK out of the EU unless something changes radically. Perhaps they will be able to put forward parliamentary amendments (e.g. attempts to postpone the Article 50 deadline) which will be easier to accept on a cross-party basis as they are seen to come from independent MPs and not those attached to any of the major political parties. But I will not be holding my breath. Nonetheless, as I noted in my previous post, today’s move is a belated recognition that the established political parties are more interested in appealing to the ideologues who form the core of party membership than the interests of centrist voters (something which is true of both parties).

However, it was the news that Honda is planning to shut its Swindon plant in 2022 that really should cause eyebrows to be raised. Local MP Justin Tomlinson noted in a tweet that Honda “are clear this is based on global trends and not Brexit, as all European market production will consolidate in Japan in 2021.” I refuse to accept that it has nothing to do with Brexit but there is a very good reason why Honda might want to consolidate production at home: Towards the end of last year Japan signed a trade deal with the EU that removes the 10% import tariff on Japanese cars and the 3% tariff on most car parts. So they don’t need the UK any more. And don’t say you weren’t warned. I pointed out in 2015 that “international companies already have to carefully balance the net benefits of operating in the UK given that business operating costs are higher than in the EU8 countries. Brexit may make this calculation more clear cut.”

Without wishing to compare the ideologies underlying the two processes or trivialise historical events, I have been struck in recent months by the logistical parallels between the progress of the Nazi invasion of Russia in 1941 and the Brexit process. Both were the product of an ideologically motivated desire to achieve bigger goals (the defeat of Communism/throwing off the yoke of the EU), which were preceded by intense planning but both were under-resourced campaigns (logistically in the Russia case; intellectually in the Brexit case). You can argue that both campaigns started well, achieving many of their initial goals, before becoming bogged down by harsher conditions (weather/economic reality) and the sheer weight of the opposition (Soviet troops/the EU’s economic heft). But the key point is that the military campaign ran out of steam following defeat at the Battle of Stalingrad when the magnitude of the task facing the Wehrmacht became startlingly clear.

I wonder whether the Brexit campaign has yet reached its Stalingrad moment. The Nazis clearly learned nothing from Napoleon’s attempt to invade Russia in the same way the Brexiteers appear not to have learned the lesson of those countries which tried to throw their weight around with the EU. Just to push the parallel further, both campaigns kicked off in June (almost to the day). Thirty two months after the start of the Russian campaign the tide had decisively turned in the Soviets favour, although it was to be another 15 months before the whole episode was concluded. After a similar period since the EU referendum, Brexiteers also appear to be fighting a losing battle and whilst they clearly will not give up, they cannot win. They might force the UK out of the EU without a deal, although I still maintain that they will be prevented from doing so, but they cannot deliver on their promise to deliver an economically brighter future.

Each decision by the likes of Honda or Nissan to scale back production or to abandon expansion plans represents potential jobs that will not be created. Each decision by politicians to abandon the ideological path which their leaders are trying to follow represents a step away from the cliff edge. Rather than fight Brexit battles which threaten to damage the economy, it is time to call a truce.

In search of a third way

Much has been said and written over the years about the need to find a third way in politics which advocates a synthesis of policies from both sides of the political divide. It was a term I first came across during the Swedish political debates of the 1980s but it was popularised more widely in the UK by Tony Blair’s government of 1997. It sounds like a great idea in theory but in practice it has generally only been adopted by politicians from the Social Democratic end of the spectrum and tends to fall out of fashion when they are replaced by politicians from the opposite side of the left-right divide. But now may be the time to find a genuine third way given the apparent inability of the political establishment to find solutions to the electorate’s current woes.

Andrew Heywood, in his book Key Concepts in Politics and International Relations, describes left-wing views as supporting interventionism  and collectivism whilst right-wing views  favour the market and individualism, though as he notes, “this distinction supposedly reflects deeper, if imperfectly defined, ideological or value differences.” Writing in their book The Government and Politics of France, Andrew Knapp and Vincent Wright argue that the main factor dividing the left and right wings in Western Europe is class, with the left seeking social justice through redistributive social and economic policies, while the right defends private property and capitalism. But political thinkers are increasingly questioning whether this distinction is adequate for modern industrialised economies. After all, we no longer operate in the extreme world of capitalists and serfs from which these class distinctions sprang (although it may sometimes feel like it).

Philip Collins made a very similar point in The Times last week with regard to the UK. In his view, “For most of the general elections since 1945, if an observer understood the class status of a voter then it was a relatively simple matter to predict their political allegiance.” But after the 2017 election, this view was no longer seen to work. “Party affiliation now matters less than cultural outlook and a better way to understand politics is to ask a person’s view on multiculturalism, immigration, globalisation, feminism and gay marriage.” And this goes to the heart of the problem facing politics in the developed world today – the options on offer no longer appeal to a sufficiently broad base with the result that nearly all countries in Europe are formed of coalitions. Even in the UK, which has traditionally enjoyed the luxury of a majority government, we have had a minority government for seven of the past nine years (and the one majority government delivered us the shambles that was the EU referendum).

Not only do incumbent government parties hold little appeal for voters but opposition parties have not been able to offer a viable alternative either. In 2017, German voters may have been disillusioned with Angela Merkel’s CDU-led government but they were not prepared to reward the traditional SPD opposition party with their votes, with the result that the AfD made up a lot of ground. This is not untypical. A study carried out for The Guardian last year shows that the share of votes gained by populist parties in Europe has tripled in the last 20 years with 1 in 4 voters now casting their ballot in favour of such parties. In other words, the political centre is being squeezed and traditionally moderate parties are increasingly finding themselves marginalised.

All this suggests that a reordering of the political spectrum is increasingly required. It has already happened in France where Emmanuel Macron’s La République En Marche swept its way to the French presidency and to victory in the 2017 parliamentary elections. Of course, things have not exactly gone his way since, with polling evidence suggesting that bar the unfortunate Francois Hollande, Macron is the most unpopular president in the last twenty years at this stage of their tenure. But that does not mean that restructuring is not required. They do say that elections are generally won from the centre of the political spectrum and as the Brexit debacle has shown, neither of the two main parties in the UK inhabit the centre ground occupied by the vast majority of voters.

Back in 1981, disaffected members of the Labour Party went off to form the SDP – a move which is today considered to have been a failure because the SDP quickly lost political momentum and was forced to join forces with the Liberal Party in 1988 to form the modern day Liberal Democrats. Collins argues that the SDP failed to build on its initial support because “it had to compete directly with [Labour] in an electorate still organised, essentially, by class structure.” I would argue that maybe the formation of the SDP was not the failure that is often painted. Even though it did not live up to initial expectations, it quickly boosted the representation of the third party to its highest since the 1930s and by 2010 it had gained sufficient momentum to post its highest representation since the last gasp of the old Liberal Party in 1923.

Today more than ever, when both the UK’s main political parties are riven with ideological zeal – the Conservatives leaning right and Labour tacking to the left – the political soil would appear to be sufficiently fertile to support a centrist party able to capture the centre ground. Confidence in politicians took a battering in the wake of the financial crisis – perhaps unfairly – but it has been justifiably shredded by the way in which Brexit negotiations have been handled. There are sufficient political dissidents in the Labour Party who might be tempted to find a new home. And as I have argued previously (here) the Conservatives also need a root-and-branch reform of their political ideology.

Inertia may be one of the most powerful of political forces. But according to one recent poll, 72% of respondents (here, see Table 43) suggested that the British political system needs a complete overhaul and 75% indicated that politicians are “not up to the job.” Those politicians so keen on listening to the will of the people might want to reflect on these findings. Surely we deserve better than a choice between hard-line right-wing free marketeers and socialists determined to create a Marxist paradise. If ever a time was ripe for a third way, it is now.

What the Hell?

I awoke a week ago with a nagging feeling at the back of my mind and it was only when the fog of sleep cleared that I realised what it was. The UK is scheduled to leave the UK next month. NEXT MONTH! For many people this may mean liberation, though from what I have long had difficulty understanding, but for many of us leaving the EU is nothing to cheer about at all. However, if we have to go then at least we can be confident that the government is doing all it can to make preparations for this leap into the dark. Right? 

It was thus rather amusing to hear the remarks from a certain Donald T. (no, not that one) who, like many of us, has spent time “wondering what a special place in hell looks like for those who promoted Brexit without even a sketch of a plan for how to carry it out.” Should Tusk have said it? Some people say not, but I am happy that he did. Was he right to criticise those Brexiteers who plunged headlong towards the cliff edge without any heed for what happens next? Absolutely. And before people get all moralistic about Tusk’s intervention in domestic affairs, let us not forget that Brexit has consumed far more of the EU’s time over the last two years than it would have wished for, particularly given all the other things it has to worry about. He is thus also an interested party. And for the likes of The Sun to suggest that “Donald Tusk’s hatred for Brexit and tantrums show his disregard for democracy” let us not forget Tusk’s background standing up to a one-party state. Recall also that this is the rag that gave us the memorable Eurosceptic “Up Your Delors” headline. So forgive me for taking no lectures from this particular Murdoch organ.

In a bid to help out Mr Tusk, it is illustrative to consider Dante Alighieri’s position on Hell set out in the Divine Comedy, in which he defines nine circles, six of which can well be applied to the hellish position we find ourselves in today. The first of Dante’s nine circles is Limbo which sounds like an accurate description of the current situation as businesses scramble to ensure business continuity with less than 50 days to go until the UK crashes out of the EU without a deal. To compound the limbo, the Brexit debate has consumed nearly all of the government’s legislative capacity with the result that many other important issues have been pushed to the sidelines.

Skipping forward to Dante’s fifth circle we encounter Anger which characterises the mood of the country today. Brexiteers are angry because they are concerned that the government is not going to deliver the Brexit they want – total freedom from the EU. Remainers are angry that the rights they derive as members of the EU will be taken away from them by the 37% of the electorate that expressed a preference for leaving the EU. What is more, neither side is able to engage with the other, such is the depth of feeling on this issue.

The next circle of Dante’s Hell is Heresy which is defined as any belief or theory that is strongly at variance with established beliefs or customs. You can argue about whether the Leavers or Remainers are the heretics, but to the extent it is the Leavers who want to overturn the status quo I will attribute the label to them. But as in any good religious war, each side believes they are in the right and the other side are heretics. If anything the intensity of the Brexit war has intensified in recent weeks. Heresy accusations will thus continue to fly. Dante’s seventh circle is Violence. Fortunately, we have been spared this to a large extent but there appears to be a lot of heavy duty intimidation going on, and the targeting of Remain supporting politicians by Leave activists suggests that outright violence is never too far away. 

Fraud is the next circle on our list. As time has passed, it has become clear that fraud was one of the features of the referendum campaign, from erroneous claims made on buses to lies about hordes of immigrants about to swamp the UK. Indeed, Vote Leave was fined after being found guilty of breaking electoral law. According to the law, if evidence of serious cheating is uncovered during election campaigns they can be scrutinised and overturned in an “election court”, overseen by high court judges. Ironically, because the Brexit referendum was only an advisory vote there are no legal channels to challenge the apparent fraud.

Our final circle of Hell is Treachery, an accusation levelled by each side against the other. Brexiteers fear that the nature of Brexit is not the one they were led to believe they signed up to, and many fear that Brexit will not happen at all, whilst Remainers believe politicians have sold out the UK’s interests by promoting Brexit.

I am not sure that this is of any help to Mr Tusk for it seems that those on both sides of the debate are condemned to live in the Hell that Brexit has created. There is no special place in Hell for the clueless Leavers – to quote former Chancellor George Osborne “we are all in this together.” Dante’s own view on Hell was to “Abandon hope all ye who enter here.” Substitute “exit” for “enter” and he could have been talking about Brexit.

Potential problems

Last weekend’s news that Nissan will not after all build its X-Trail model in Sunderland, having indicated in 2016 that it would do so, highlighted once again that there are costs associated with Brexit: Trade-offs about which politicians have not been clear. To be fair, Nissan’s decision was not all Brexit-related and is partly due to the fact that demand for diesel cars in Europe is falling. But Brexit undoubtedly weighed at the margin. After all, Nissan set up shop in the UK in the 1980s to export to the European market but now that economic ties to the rest of the continent are threatened with disruption, the case for being here is weaker.

Nissan continued to make all the right noises about its commitment to its existing UK workforce but let’s not be fooled. It has R&D facilities in Belgium and Spain, and production facilities in Spain – as well as a joint venture with Renault which gives it access to production capacity in France. Nissan has options which may not necessarily include the UK, and given excess global auto production capacity, companies are always looking for reasons to slim down. But for the moment it will continue producing in Sunderland so long as border disruptions do not become too excessive. However, this hides a wider truth about Brexit which is often lost in the hysteria – as Tom Kibasi, director of the Institute for Public Policy Research, reminded us in an excellent article in The Guardian.

Although we cannot rule out Armageddon scenarios in the event of a no-deal Brexit on 29 March, the likelihood is that both sides will take pragmatic decisions to ensure business continuity. As Kibasi points out, “in a no-deal Brexit, the EU will not place the UK under some medieval siege; there won’t be trucks filled with rotting food in Calais or shortages of medicines in pharmacies.” But the longer-term effects will hurt. Just as happened in 2016, the economy is unlikely to immediately fall off a cliff but a sharp fall in sterling – generally expected in a no-deal scenario – will produce a spike in inflation and squeeze real incomes. To put it into context, real wages – which were rising at a decent pace of 2%-plus in 2015 – have flatlined since Q2 2016. As Kibasi put it, “living standards that have barely improved for more than a decade would get noticeably worse.” 

Companies will also rethink their location decisions, as Sony and Panasonic have already done by shifting their European headquarters out of the UK. This may not matter so much if equivalent jobs can be created in other sectors, but the evidence suggests that such actions risk sending cluster effects into reverse which will have a bigger knock-on effect on employment. In effect, we will suffer a “boiled frog Brexit.” Drop a frog into a pan of boiling water and it will realise it is being boiled alive and hop out of the pan. But put it in a pan of cold water and turn the heat up slowly, and you can boil the frog without it being aware of its fate.

To assess this in economic terms, consider trends in potential GDP - the economy's underlying speed limit - and how Brexit could impact on it. The evidence suggests that growth potential has slowed anyway – the BoE estimated in this week’s Inflation Report that growth has fallen to around 1.5%, which is a full percentage point slower than twenty years ago (chart 1). In order to understand the underlying forces we can think of growth potential as being driven by three main factors: capital, labour and technical progress (or total factor productivity, TFP).

The good news is that the contributions from labour and capital have held up reasonably well. On my calculations based on European Commission data, they together contribute around one percentage point to growth potential which is not significantly different to twenty years ago (see chart 2). The real problem is the slowdown in TFP which has recorded its worst performance in a century (chart 3). Numerous possible explanations have been advanced for this slowdown. One view, promoted by Robert Gordon [1], is that the number and scope of technical innovations in the period 1870 to 1970 was exceptional in its applicability to a wide range of areas and there is no reason why this pace should be expected to continue. Another is that there has been a slowdown in the rate at which technology is diffused through the economy. Analysis conducted by the ECB [2] in 2017 suggests that there has been a widening gap across the OECD between productivity growth in so-called global frontier firms on the cutting edge of the technological revolution, and non-frontier firms which make up the bulk of the corporate sector.

What does any of this have to do with Brexit? On the one hand an ageing population, in which baby-boomers are retiring in droves, relies on immigration to expand the labour force. During the 1990s the working age population expanded at a rate of 0.3% per year. In the eight years prior to the financial crisis, this accelerated to 0.8% per annum, but over the last five years has slowed back to 0.3%. If we do not get any offsetting pickup in productivity growth, migration curbs will likely act as a drag on growth potential. Moreover, by reducing the attractiveness of the UK as a business location, the UK may not attract the technological leaders required to disseminate cutting edge technology and working practices into the UK capital stock, which will hold back any recovery in TFP.

Not all of the slowdown in potential growth is attributable to Brexit. Indeed, it is largely the result of pre-existing secular trends, but it threatens to make a bad situation worse. We may not notice this immediately but as we have learned over the last 10 years, a slower speed limit makes us all feel as though we are not doing as well as we once were.

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[1] Gordon, R., ‘The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War,’ Princeton University Press, 2016

[2] ‘The slowdown in euro area productivity in a global context’, ECB Economic Bulletin, Issue 3/2017

America first

Last month, The Economist published a couple of articles highlighting the extent of the extraterritorial reach of US policy and its implications. There has long been a supposition that the wave of bank fines issued by US regulators since the financial crisis has fallen disproportionately hard on foreign institutions, and The Economist cites evidence suggesting that over three-quarters of the $25bn it has levied in fines have been aimed at European banks. The evidence also seems to suggest that anti-corruption fines fall hardest on non-US companies, with eight of the top 10 fines levied under the Foreign Corrupt Practices Act falling on non-US companies.

The Deepwater Horizon disaster in 2010 added to suspicions that the playing field may not altogether be level. BP was fined more than $20bn for "gross negligence and willful misconduct”, in addition to $45bn of outlays in compensation and clean-up costs. Meanwhile, Houston-based Transocean, the company that owned and operated the oil rig which exploded, was hit with a fine of $1.4bn and Halliburton – the company responsible for doing the cement work which was the primary contributor to the well blow-out – escaped with a fine of $1.1bn.

As The Economist points out it is hard to prove that “America treads more lightly at home than abroad.” US firms generally have a pretty clean track record. But a very insightful piece into the murky takeover of French company Alstom by GE suggests that there are some dark forces at work. Alstom was already the subject of an investigation by the US Department of Justice into allegations of corruption when a senior Alstom official was arrested by the US on bribery charges. He entered into a plea bargain on the understanding that his jail term would be significantly reduced, but in the event served five years in detention. Shortly after the guilty plea, Alstom began to explore the possibility of a deal with GE. The Economist suggests that the DOJ’s investigations “distorted Alstom’s sale process, giving an edge to a potential American purchaser.” But “in order to be legitimate, a legal process must be transparent and independent – and be seen to be so. In this case, the legal process and the commercial one become uncomfortably intertwined.”

All of this goes to the heart of one of the biggest economic concerns underpinning the current shift towards economic nationalism – the idea that countries are increasingly prepared to use their leverage to secure their own interests rather than uphold the rule of law. The US is better placed than most to flex its muscle given the dollar’s position as the global reserve currency. Under the Obama Administration, which increasingly started imposing secondary sanctions, the US began a policy of issuing sanctions against any non-US individual or business which did not adhere sufficiently to US sanction regulations. Since dollar transactions ultimately almost always have to be conducted via US banks, the US authorities are in a position to obtain information on virtually all global dollar transactions and can use their leverage over access to the dollar payments system to extend their judicial reach.

I first became aware of this at a seminar three years ago which discussed business opportunities in Iran following the end of sanctions. Despite the optimism that Iran was once again being welcomed back into the international fold, many of the bankers present warned that they were very uncertain as to their position in the event they were required to provide dollar funding for Iranian projects. Although sanctions against Iran had formally ended, the US authorities even then were less willing to provide the green light. The election of Donald Trump suggested that all parties were wise to be circumspect given subsequent efforts to renew the sanctions.

Such apparently capricious policymaking raises a question of what this might do to the status of the US dollar as the world’s reserve currency? The choice of reserve currency is determined by three main considerations:

1. Size. Large economies generate a lot of foreign exchange transactions which puts a lot of currency into circulation; 
2. An advanced financial system which offers liquidity and a range of ancillary services;
3. Stability. The currency needs to act as a store of value. Political stability is another prerequisite.

The dollar continues to fulfil all these requirements. But increasingly, the likes of the euro zone and China have to weigh up whether the advantages of using the dollar are sufficient to outweigh the associated political costs. There is also a question mark on the US side. The Triffin paradox, which was first outlined in the 1960s, highlights that in order to meet global demand, the issuer of the reserve currency must be prepared to run a current account deficit. But as the current account deficit increases, so the external value of the reserve currency declines, thus reducing the willingness of creditors to hold it. In a world in which President Trump appears unwilling to sanction a rising external deficit, logically the flow of dollars into the rest of the world might be expected to slow.

Just because the dollar remains the dominant reserve currency today does not mean that it always will be. Prior to 1918, the US dollar accounted for a negligibly small share of global foreign debt with the UK accounting for 90% (chart). Within the space of five years, however, the dollar increased its share of global reserves to almost 40%. The US gained at the UK’s expense due to having a bigger economy, less indebtedness and a quantum leap in sophistication of financial markets following the foundation of the Fed in 1913. Between 1918 and 1945 there was not one single global reserve currency: The US and UK shared the burden.Who can say that we will not move towards a multipolar world in future?

I am not suggesting that we are yet at anything like the watershed moment of a century ago. But history suggests that changing trade patterns and a shift in the balance of economic power may be setting up the dollar for a reduction in status as other currencies take up some of the slack. Wielding the big stick, as President Trump is doing today, might hasten the search for alternatives.