The end of May

Game of Thrones, the TV series which ended its 8-year run this week, followed the fortunes of various political dynasties as they pursued their claims to the Iron Throne which would allow them to rule all the seven kingdoms of Westeros. The path to the top was brutal with various leading contenders beng executed, murdered or dying in battle. As a piece of television fiction it was compelling but it is highly improbable that such levels of brutality could be sustained in real life. That said, the behaviour of the Conservative Party increasingly resembles a GoT plot line which is unlikely to end well.

It appears that MPs believe compromise is for the weak

As regular readers of this blog will know I have been highly critical of the way in which Theresa May has conducted Brexit policy over the course of the last three years. She has tried to "own" the issue, pandering to the right-wing of her party, when in reality cross-party support was always going to be required in order to find a consensus, particularly following the needless 2017 general election which cost the Conservatives their majority. When May finally cottoned onto the need for a cross-party solution last month, her political position was so weak that the Labour Party had little incentive to cooperate in order to get the Withdrawal Agreement ratified by parliament. But the reaction this week to May’s ten-point plan to get the Withdrawal Agreement Bill through parliament said more about MPs than it did about the prime minister. Having listened to what the right-wing of her party want, what Remainers want and the issues raised by the Labour Party, the PM offered something for everyone and ended up pleasing no-one.

So it came to pass that the day before the European Parliament elections, the UK news was dominated by stories discussing how long the prime minister was likely to keep her job. As a campaign message it was the most spectacular of own goals: Not that the Tories have bothered to campaign for an election in which the PM promised the UK would not have to take part, and they could well trail a distant fourth in terms of the vote share. Yet as ineptly as May has handled Brexit – so much so that she has created space for a Nigel Farage resurrection – and as inflexible as she is on policy issues, the problem is less the prime minister than an inability of MPs to compromise. Whilst there are many good reasons for not liking the Withdrawal Agreement negotiated with the EU last November – it essentially compels the UK to be an EU rule-taker during the transition period, which runs to end-2020 – it is still the least worst outcome that the UK could have obtained.

It has now become an article of faith amongst the ultras that the only good Brexit is a hard Brexit, yet three years ago even the most ardent proponents of leaving the EU were not advocating such a policy. Somewhere along the line, the Brexiteers have convinced themselves that leaving the EU at any cost is the only goal worth pursuing and it is impossible to convince them otherwise. This is not a rational, evidence-based policy: It is faith-based zealotry. And the more the faithful proclaim their litany, the greater the pushback by their ideological opponents. Indeed, in the fly-on-the-wall documentary, Brexit: Behind Closed Doors, in which cameras followed the EU Parliament’s Brexit representative Guy Verhofstadt for two years, the former Belgian prime minister warned that the Remainers were increasingly becoming a problem due to their inability to know when to compromise.

Who really wants to take on the impossible job?

It has thus become impossible to meet in the middle and it does not matter who is the prime minister in the current environment. At the time of writing, it is reported that May is likely to announce her departure within the next 24 hours. Her successor, who is expected to be a Brexiteer, will inherit a minority government reliant on the DUP and a party divided over Brexit. If, as widely tipped, that person is Boris Johnson it is difficult to imagine any improvement in the current parliamentary impasse. Johnson is widely loathed by large numbers of Conservative MPs who do not trust him due to his duplicity during the Brexit referendum campaign and his dreadful tenure as Foreign Secretary. His advocacy of a no-deal Brexit will not win him any friends outside the coterie of backbench Tory MPs who believe such an outcome is somehow in the UK’s best interests. This is to say nothing of the fact that he is also reviled by many European leaders and he would be the last person to send to Brussels to plead for any concessions. 

However, Johnson is not guaranteed to get the top job. Although he is the favourite, we all know what happened in 2016 and Oddschecker.com is offering odds on dozens of MPs so it is a crowded field. But none of them set the pulses racing and none have the brand recognition that the Tories need. If he does beat off the challenge of MPs to go forward as one of the two candidates from which members of the Conservative Party will choose a new leader, he will probably win a majority of the 120,000 party members eligible to vote. Johnson will then have a maximum of three years before he faces the 46 million eligible to vote in a general election which will determine whether he is the Heineken candidate of old (reaching the parts other mainstream politicians cannot reach) or whether he is now Marmite Man (loathed at least as much as he is loved).

The bottom line is that Brexit has indeed upended politics in a way that even Nigel Farage did not envisage in 2016. It has certainly changed the Conservative Party and severely damaged its reputation for competence. Worse still, it has completely eroded many people’s faith in politics, the echo of which will resonate for many years.

Sometimes it pays to pass up the top job

I have often used the Alex Ferguson syndrome to describe the poisoned chalice of taking on the prime minister’s job in the current circumstances and it is a metaphor worth revisiting. Recall that following Ferguson’s departure as Manchester United manager in 2013 his replacement, David Moyes, seemed to find the job too daunting and was gone in less than a year. It was thus decided that a bigger, more well-known figure was required to fill the post and the board duly appointed the highly acclaimed Dutch manger Louis van Gaal. He lasted two years before being sacked with the board deciding that insufficient progress was being made. May reminds me of Moyes – a low profile character who is out of their depth in the top job. Johnson has many of the characteristics of van Gaal – confident and up for the fight. Yet the Manchester job proved to be van Gaal’s last in football.

The moral of this story, and indeed the same is true of Game of Thrones, is that being in the right place at the right time is important and even extraordinary people will struggle with mammoth tasks if they find themselves in the wrong place at the wrong time. Succeeding Theresa May will be like walking into the lion’s den. I suspect whoever they are they will eventually be chewed up and spat out by the complexities of Brexit.

Should British Steel be nationalised?

The recent problems encountered by British Steel, which today entered insolvency, is an echo of the case three years ago when Tata Steel announced it was to pull out of its UK operations. In the end a rescue package was agreed, based upon a reform of the company’s pension scheme which was acting as a serious drag on the profitability of steelmaking at Tata's Port Talbot facility. Faced with a similar situation at British Steel’s Scunthorpe plant, the Labour Party has called for the company’s operations to be nationalised in a bid to save the jobs of 5000 workers who are directly involved in production, and a further 20,000 who are employed in the supply chain.

The threat to the Port Talbot production facilities in 2016 was one of the first topics I tackled on this blog. Indeed, this blog is partially motivated by concerns that successive governments’ adherence to the untrammelled operation of free markets results in market failures that have wider social consequences. It is not just me who expresses such concerns. Whatever else people may not like about the Labour Party’s economic policy (and there is a lot to dislike) the electorate does like the idea of renationalising industries such as the rail network. One reason for this is that the electorate is opposed to the idea of private investors creaming off monopoly profits whilst walking away from their obligations if events do not run as planned (as happened on one of the country’s main rail routes in late 2017).

People also do not like the fact that markets fail to adequately price the non-financial costs associated with industrial restructuring. Whilst the costs associated with any job losses in Scunthorpe and other towns are of no direct concern to British Steel, they are a huge problem for the local community suggesting an unequal distribution of the costs and benefits associated with closing down the plant. However, this alone is not enough to justify nationalising the steel industry.

A much better case can be made that industries such as steel represent industries of strategic national interest where the economy has an interest in ensuring that the skillset embodied in the industry can be maintained. An example of why it may pay to retain the skillset is provided by the construction of the controversial Hinkley Point power station: The government claimed that since the UK has not built any nuclear power stations in thirty years, the skills required to build the station could not be found in the UK, forcing it to turn to a state-owned French company to supply the reactor. The steel industry is more than just about turning out metal rods – some very complex metallurgy is involved in making some of the high-spec alloys required in advanced industrial applications. The issue facing the UK is whether it wants to remain involved in this business or whether it is prepared to outsource it to foreign suppliers.

This highlights two of the concerns I expressed three years ago: First, the government’s repeated policy of non-interference in corporate actions means that the decisions which affect people’s lives will increasingly be taken outside the UK. In addition it raises the question whether countries like the UK can continue to rely on the stability of the international order to ensure that it will always be able to source its needs from foreign suppliers. If we have learned anything since 2016 it is that the global order is anything but stable, as the likes of Donald Trump continue to rip up the rule book. Indeed, steel was one of the first product groups to be hit by higher tariffs as the US introduced a 25% levy on imports. But it is China that has disrupted the global steel market, having produced more steel in the last two years than the UK has done in its entire history (see chart for data covering the last three decades). Ironically Mao Zedong’s stated aim in the 1950s was merely to boost annual Chinese steel output above that of Britain’s – things have moved on a long way since then.

Clearly the UK, nor indeed any European country, can compete with this kind of industrial muscle which suggests that if governments want to retain the industrial skills inherent in the steel industry, the state may have to play a bigger role. This does not necessarily mean that steel-making facilities should be directly taken under state control. But efforts to relieve some of the industry’s burden in the form of lower business rates or energy costs are measures that might need to be considered. Environmental issues are a further complicating factor – indeed, British Steel has already been loaned a considerable amount of money by the government to pay an EU bill for its carbon emissions. Environmentalists would say that this is not an industry that we need to save but the people of Scunthorpe may have a different view.

We also cannot ignore the fact that British Steel’s current woes have been hugely exacerbated by Brexit, and Brexit-related uncertainty is blamed for a significant drop in orders. The good people of Scunthorpe voted 2-1 in favour of Brexit so it is highly ironic that the policy they voted for looks set to impose significant harm on the local economy. Moreover, one of the reasons cited by the UK government for not providing additional finance is that it does not want to fall foul of EU state aid rules. But even if the UK were to leave the EU, it is doubtful that it would stump up to support British Steel, since the bills would start to run up very quickly if every region that suffered as a result of Brexit were to receive public support.

This leaves the steel industry between a rock and a hard place. There is a good case for state intervention to support an industry of critical national importance and there is also an environmental case for letting it go. But since the problems have been exacerbated by Brexit, with the result that British Steel’s overseas customers do not know what tariffs will apply to any steel they buy – nor indeed when the UK will leave the EU – and to the extent that this has been exacerbated by the government’s indecision, there is a stronger case for support from the public purse. Having seen at first-hand what deindustrialisation did to the part of the world where I grew up, I understand the fears of the local community – and they are right to be afraid.

Are the rich getting richer?

The English FA Cup has a long tradition extending all the way back to 1872, and no team has secured a greater winning margin in the showpiece final than Manchester City, which on Saturday beat Watford by 6-0 (though in 1903 Bury  beat Derby County by the same score). Indeed, City’s performance was superb although given the quality of footballers at their disposal this came as no real surprise. City’s position at the top of the English football tree bears no comparison to Bury's in 1903. City became the first club to win the domestic treble of trophies in the same season and as a measure of their current pre-eminence it is worth noting that although the club has existed in its current form since 1894 and won a total of 18 domestic trophies, 10 of them have come in the past 8 years.

Whilst football success is often cyclical, the key ingredient in City’s success is money – and lots of it. According to transfermarkt.co.uk, Manchester City has spent a whopping £1.35 billion on transfer fees over the last 10 years – 13% more than their nearest domestic rivals Chelsea. They have also recouped significantly less in transfer fees with the upshot that their net outlays over the past decade exceed £1 billion – 90% more than Chelsea. The club is owned by Mansour bin Zayed Al Nahyan, a member of the Abu Dhabi royal family whose personal net worth is estimated at £17 billion whilst his family fortune is reckoned to be around $1 trillion. It thus comes as no surprise that City can afford to buy the best.

Of course, clubs that spend most on transfer fees are not guaranteed to be the most successful. Neither Manchester City nor Paris St-Germain (the next largest net spender over the past decade) has ever won the Champions League. The relationship between wages and trophies won tends to be much closer (here) since it a better reflection of a players’ quality. Ironically, latest data suggest that average wages at Manchester City are around 8% lower than at their cross-town rivals Manchester United (which won nothing this season). But City’s manager Pep Guardiola, widely regarded as the best in the world, is the highest paid manager in English football earning £15.3 million per year (and a recent report suggested that the club’s hierarchy are considering raising that to £20 million if he signs a new 5-year contract).

In short, Manchester City has bought its success by purchasing the best players, paying them well and employing the world’s best coach to manage them. A similar pattern is observed across the other four major European football leagues with the club that paid the highest average wages winning the title in 2018-19.  Even more astonishing is that in all five major leagues, the club winning the championship this season also won it last season (Barcelona, Bayern Munich, Juventus, Manchester City and PSG). Last year’s champions in Austria, Scotland and Switzerland also retained their titles. For the record, in Scotland average player salaries at champions Celtic, which recently claimed its eighth successive title, were 84% higher than those at second-placed club Rangers. It appears that money doesn’t just talk – it screams loudly.

All this raises the question of whether the footballing rich are simply getting richer at the expense of their weaker competitors. There were certainly plenty of commentaries in the wake of Manchester City’s FA Cup demolition of Watford suggesting that City have ripped up any pretence at a level playing field (here, for example, or here). But to assess whether that is really the case, let us look at the evidence.

The table shows football equality indices and concentration indices in the big-5 European leagues. The equality index is defined as the number of individual clubs winning the title relative to the number of seasons contested. The higher is the index, the more equal is the competition; if a different club won the title every year the index would be unity. I use the birth of the Champions League in 1993 as the cut-off point and compare the pre-1993 and post-1993 samples. The evidence suggests small changes in England (negative) and Italy (positive) and a larger increase in Spain. But the big changes are in Germany where the dominance of Bayern, which has now won seven consecutive titles, is quite startling whilst in France it has risen sharply.

As a cross-check I created a concentration index calculated as the proportion of total league titles won by each club (again split between the pre-1993 and post-1993 samples) and the table reports the highest indices for each country (the higher the index, the more dominant is any one club in winning the league). The results show a marked increase in concentration ratios with the biggest increases in England and Germany. This is partly a sampling problem, in that the pre-1993 sample is much bigger than the post-1993 period, but the magnitude of the increase is notable. The data suggest limited evidence of increased inequality (except in Germany) but higher concentration indices, indicating a rise in the frequency with which the same teams win their domestic title. In other words, the data appear to reflect a rise in an elite group of clubs which can expect to compete for the title – generally those which also compete in the Champions League – and a widening gap to the rest. 

Given the importance of external sources of money to fund sports teams (which I will look at another time), there is a danger that broadcasters and sponsors will gravitate towards the top performing teams over the longer term. This will enable the top teams to continue paying out the most on wages and consolidate their positions. Ironically whilst this is a major concern in European football, it is less true of American football which does not even operate a system of promotion and relegation. Only seven teams have won the Super Bowl on consecutive occasions and none has managed three straight wins. Moreover, 20 different teams have won it in the last 53 seasons. In the same period only 12 clubs have won the English Premier League whereas just 7 have won Spain’s La Liga. Given the amount of money flowing into the NFL, this does not suggest that huge monetary inflows necessarily stifle competition: It is where it flows and how the authorities channel it that matters. Premier League take note.

Look who's back

A couple of years ago I suggested that Nigel Farage had passed the high point of his influence and that history would judge him as a useful idiot for those pushing to get the Brexit referendum over the line (here). It looks like I was wrong. The latest opinion polls put Farage’s new Brexit Party at over 30% – well ahead of either the Conservatives or Labour, with a double-digit lead. He has brilliantly tapped into the dissatisfaction with the main political parties, telling his supporters that they have been betrayed over Brexit and that the establishment is out to crush them. As is always the case with Farage, there is a tiny grain of what almost passes for truth in his argument surrounded by bombast and obfuscation. He remains what he has always been – a political irritant, a rabble-rouser and a liar. But underestimate him at your peril.

The fact that he is back on the political stage at all is because he is right about one thing – the political establishment has played a bad Brexit hand in the worst possible manner. Both the main parties are split and there is no indication that the two parties which together hold more than 85% of the seats in parliament will be able to agree on a Brexit deal. Since the autumn our TV news bulletins have featured late night parliamentary sittings which have shown that the only thing MPs agree on is to disagree. In this febrile atmosphere, almost 100% of MPs’ time is taken up with Brexit-related issues with no substantive progress on the things that matter to most people’s lives (the health and education systems, environment, transport and housing to name but five). Farage’s Brexit Party has grown because it feeds on popular discontent with the political establishment – a concern even felt by members of the main parties, with large numbers of Conservative members reportedly ready to vote for Farage’s party.

Try as people might, it is very hard to lay a glove on Farage who is a brilliantly elusive operator. Last Sunday, for example, Farage went on the BBC’s main weekend political show (here for the full interview) where he was confronted with some of the things he said – and we saw the clips – but when faced with those issues that he would rather not be reminded of, Farage responded with denial followed by bluster and anger. He went on the offensive to accuse the BBC of being “in denial” and later justified his response by saying “The idea was to use up all the time talking about irrelevances and inaccuracies, rather than talking about a major election taking place next Thursday. That's why I took the attitude that I did.” Arguably, there was a good reason for holding him to account in this way because his party has not actually produced any form of manifesto. Farage is the party and the party is him and in order to understand something about the issues on which they are standing it is right to pose the questions.

His response split viewers, with roughly half suggesting that he got a grilling from which he did not emerge well whilst the other half thought he gave more than he got. In short, it had no impact on the debate. Farage is undoubtedly a charismatic politician and an effective media performer but he has no answers to any of the questions about how Brexit can be made to work. More importantly, people do not want to hear them. It has become an article of faith amongst people who support the Brexit Party that it can be made to work. As Farage put it “we can be better than anybody if we just believe in ourselves.” There is no sense that the economic damage resulting from leaving the EU can only be minimised if some form of accommodation can be reached with the EU.

And this is where things start to get dangerous. Farage and his ilk do not believe that they have any duty to deliver Brexit – their role is merely to demand that government delivers it for them. When the policy proves impossible to implement, the hard core Brexiteers cry betrayal, thus further whipping up public resentment. This is not the conventional evidence-based policy which many of us have grown up with. It is dog-whistle policy designed to appeal to a core group of supporters to serve whatever purpose the leader has in mind. And it is not just a UK problem. Donald Trump dismisses inconvenient facts as fake news and populist leaders across Europe are similarly capable of ignoring facts in favour of lowest-common denominator politics.

But Farage is a league apart. Unlike Trump, who at least had some family money to fall back on (though quite how much is disputed) Farage never made a huge amount of money before going into politics. He now earns between €147k and €197k per annum from his media work alone, according to records covering the first four years of the current European parliamentary session and in the year to May 2018 he reportedly earned almost £400k. In an interview two years ago, Farage claimed to be “53, separated and skint … there’s no money in politics.” Whatever else he might be, he is not short of money.

Of course, Farage is not the only representative of the people whose financial interests have improved during his term of office. But more than most, he is a snake oil salesman posing as a man of the people when his background and lifestyle suggest he is anything but, and who peddles a policy he has no idea how to implement. But large numbers of people don’t care. They see him as a refreshing antidote to the political establishment, telling it as it is. Consequently, his party will almost certainly do well in next week’s European parliament elections.

But the real problem is less Farage than how the establishment responds to his success. The government will almost certainly interpret it as a strong case for delivering Brexit (despite the fact that his party is unlikely to take much more than 30% of the vote share). As we saw in 2014, when UKIP took 27% of the vote in the EU elections, this might panic the government into a wrong move, such as drifting towards acceptance of a hard Brexit. But the lesson of 2014 is that the EU elections are not a good guide to anything. A year after the Conservatives came in third in the EU election, they won their first parliamentary majority in Westminster for 23 years. The only lesson to be drawn from the European parliamentary elections is that they are a useful way for the electorate to register a protest vote. Perhaps that is why Farage has been so successful in them, despite having failed seven times to be elected to Westminster.

Trump, tariffs and beyond

As the world now knows, Donald Trump followed through on last weekend’s tweet promising to raise tariff rates on USD200 bn of Chinese imports from 10% to 25%. The fact that some of the heat appeared to go out of the tariff wars towards the end of last year suggested that both sides realised there was nothing to be gained from continually ramping up the rhetoric. After all, nobody ever won a tariff war. But once again Trump has upended conventional wisdom and those who continue to underestimate him should now be fully aware that he means to push forward with his ‘America First’ agenda, irrespective of how damaging it might appear at first sight.

We need to view Trump’s actions in a domestic context. Simply put, they can be seen as the opening shot in his 2020 re-election campaign and his strong-arm tactics are broadly popular at home. The US also has a point about technological expropriation and the requirement for the Chinese to open up their domestic markets in a reciprocal manner, in line with their WTO commitments. But we also have to view this from the Chinese perspective which sees itself as reasserting its rightful place on the world stage after two centuries of political and economic humiliation by the west. Finding a resolution that accommodates both sides will not be easy.

Market reaction to Trump’s actions has been somewhat muted. Admittedly, US equities fell 2.2% during the course of last week but that is not a huge decline and only puts the S&P500 back where it was a month ago. One interpretation is that markets are clinging to the belief that a resolution to the tariff war will somehow materialise within the next couple of weeks. After all, only goods leaving China after the Thursday midnight deadline will be subject to the new tariffs – those currently in transit will not – so if a deal can be brokered within the two weeks it takes for goods to make the journey by sea, the impact of the latest tariff spat will be limited.

That may be a very complacent view. Indeed, recent events might just prove to be another shot in the long war against globalisation from which there are no economic winners. Consider first the tariffs themselves. They are in effect a tax on imports and the one thing we do know about product taxes is that they are borne by the end-consumer. Companies that import certain items from China will now have to pay 25% more for them (although the impact so far has been partially offset by dollar appreciation). Households consuming those Chinese goods on the list will face a similar problem. But as this paper by Pablo Fajgelbaum and his co-authors point out, the direct impacts of last year’s tariff hikes cost the US economy just USD69 billion (0.3% of GDP). And once we account for the substitution away from Chinese imports towards domestic alternatives and the gains from higher prices received by US producers, the total impact is a mere USD7.8bn, or 0.04% of GDP.

But this is to underestimate the longer-term damage that an escalation of tariff wars could inflict on the global economy. Unfortunately, the recent actions might encourage the Trump administration to believe that tariff wars are indeed “good and easy to win” as the President said in March 2018 which (a) reduces the chances that the US will offer any concessions to the Chinese in the current dispute and (b) encourage the US to target European exporters, where German auto manufacturers are widely concerned that they will be the next in the line of fire.

With regard to point (a), we do not know how the Chinese will respond. Given that the US imports more from China than it exports, China’s direct ability to engage in a tit-for-tat tariff escalation is limited. It could, of course, levy additional duties on US agricultural products. But more damagingly it could target the US tech sector. China is less dependent than the rest of the world on Amazon, Apple and Google given the local dominance of Tencent, Huawei, Baidu and Alibaba. The Chinese companies start from the advantage of a bigger domestic market and are already formidable competitors in third markets. In a phrase reminiscent of the thinking during the Brexit referendum campaign, the likes of Apple need China more than the Chinese need them.

Also we should not overlook the fact China is the biggest buyer of US Treasury debt. Whilst it is unlikely to sell its current holdings, a buyers strike may push up US interest rates and thus have the opposite effect to what Trump wants (he has, after all, called for the Fed to lower interest rates). However, it is widely believed that the Chinese have no incentive to exacerbate the trade dispute in the short-term – particularly since the Communist Party wants to sell a rosy view ahead of the 70^th anniversary of the People’s Republic in October and the party’s centenary in 2021. But if there is no quick fix or if they are forced to make too many concessions, the Chinese will not easily forgive or forget.

With regard to point (b) there is a relatively easy fix. The EU could adopt a policy of pre-emptive tariff equalisation by reducing the tariffs on auto imports from the US from the current 10% to the rate of 2.5% which the US levies on EU imports. But the wider concern is that the US will become a less reliable ally than has been the case over the past 80 years. Europe and the US have common international interests and cooperation has led to better outcomes for both sides. This would be put at risk in the event of policy divergence. For example, one of the biggest issues rising up the policy agenda are environmental concerns which require international cooperation – no single economy can fix things on its own.

The current environment is increasingly one of mutual suspicion which does not bode well for finding global solutions to global problems. There is also a risk that local issues could become flashpoints for bigger problems, as we experienced during the Cold War. For example, China regards the region bordering the South China Sea as its own sphere of influence and is increasingly less tolerant of US interference in the region. The US does not see it the same way. But having dominated the geopolitical arena since 1945, the US may be forced to cede some control and the manner in which it does so will have a great bearing on the history of the 21^st century. The tariff wars could turn out to be a Gavrilo Princip moment. Or they may simply be a Cuban missile experience. Either way, there is a lot more at stake than import taxes.

Markets yet to be convinced

The release of the Bank of England’s Inflation Report last week provided the usual comprehensive overview of UK economic issues. Although it makes a nice change to be looking at economics rather than politics, it did raise a number of important questions. One of the more interesting issues was the interest rate assumptions upon which the forecast was conditioned. The BoE has always made it clear that it uses current market expectations, which is perfectly acceptable, but it does raise a chicken-and-egg issue.

The problem is this: Markets currently expect only one interest rate hike of 25 bps during the BoE’s three year forecast horizon (chart). Based on this assumption, the economy grows more rapidly than the estimated rate of potential growth with the result that by 2022 the UK is projected to show a demand gap of 1% (i.e. a level of measured GDP which exceeds the economy’s potential GDP by 1%). Governor Carney made it clear that if the economy does run in line with this forecast, interest rate rises would be “more frequent than financial markets currently expect.” Naturally the headlines screamed that “UK interest rates are set to rise” but this is to ignore the fact that the market has reduced its expectations by about 50bps in the last six months. Taking Bank Rate from its current level of 0.75% to 1.5% by mid-2022, as the market was expecting in November, implies 25 bps of monetary tightening per year which is hardly going to derail the economy.

We should thus interpret Carney’s warning as an indication that he believes the markets have become too complacent – a view which is hard to disagree with – and the Bank was very clear in telling us that it is sending a message. The implication was that if the forecast is conditioned on higher interest rates, the positive demand gap would also be lower thus reducing potential inflationary pressure. However, this raises the question of whether the forecast is the BoE’s best guess of where it believes the economy is heading or whether it is merely a device to signal where interest rates are heading. If it is the former, there is an argument suggesting that the BoE should use its own interest rate assumptions in calibrating the forecast. And if the latter, why bother producing a forecast at all?

As it happens, I do not set much store by the latter possibility so I will ignore it. But the idea that central banks should communicate their future policy responses to a given set of outcomes is an attractive one. After all, the Swedish Riksbank sets out an indicative path for interest rates conditional on its economic projections. One advantage of this approach is that it does make the central bank reaction function totally explicit, and at a time when forward guidance is an important tool in the policy armoury, such transparency is helpful. But the difficulty is that the press and the markets will require a lot of education in order not to treat this as an unconditional forecast and in the case of the BoE, this might introduce more noise into the system than is warranted. Accordingly, the strategy of taking current market pricing and using this as a forecast conditioning assumption is, in my view, an acceptable compromise.

One other aspect of the BoE’s forecasts worth noting was that, despite the presence of a positive output gap and the forecast of an unemployment rate falling to 3.5% by 2022, the projected inflation pickup was minimal. Wage growth is expected at only 3¾% on a three-year horizon whilst CPI inflation is only slightly above target at 2.2%, and whilst the BoE argues that higher inflation will only show through with a lag, this nonetheless assumes a much changed relationship between unemployment and wages compared to the recent past. On my estimates, an unemployment rate of 3.5% would result in wage growth of 6% based on a Phillips curve estimated over the period 1998 to 2012. The fact that such a tight labour market results in sub-4% wage inflation is a good outcome for the BoE and implies labour will remain fairly cheap.

At the same time, the forecast also assumes that business investment growth will recover to a rate of 5.5% by 2022 – double the rate recorded between 1998 and 2007. To the extent that cheap labour and Brexit uncertainty has prompted firms to increase their labour hiring over the past couple of years at the expense of capital investment, this raises a question of whether firms will indeed simultaneously raise investment in future whilst continuing with this rapid pace of hiring. In other words, will firms cut back on labour input in order to expand output now that they are once again relying on capital investment? And if they don’t, might the unemployment rate not fall as far as the BoE expects? Moreover, if investment is picking up, surely this will raise the potential growth rate and reduce the likelihood that the demand gap will hit 1% of GDP which in turn will reduce the inflationary threat?

Obviously, there are lot of unanswered questions here and we will only know the answers ex post. But the point I am trying to get at is that there are some nagging issues about the nature of the forecast that don’t quite stack up. And it is for this reason that markets remain unconvinced of the BoE’s efforts to talk up the prospect of interest rate hikes. Forward guidance may be one of the new policy tools but it has to be used wisely. Markets will stop listening if central banks tell them they will raise interest rates but don’t follow through. Sometimes the best form of communication is direct action and if markets are taken by surprise, so be it!

Local difficulties

Local elections in the UK tend to be fairly parochial affairs: They do excite domestic media which treats them as a barometer of support levels for the main parties but that is usually it. This year, however, matters were very different with coverage making it into newspapers across Europe. The reason is, of course, Brexit with the elections acting as a measure of how the public has responded to the interminable political wrangling of recent months.

It did not make pretty reading for the main parties. There were 8412 local council seats up for grabs, of which the Conservatives held 58%. They lost 1334 to reduce their share to 42% of the contested seats. Labour also lost ground, but to a far lesser degree (its share fell from 25% to 24.1% of the contested seats). UKIP continued its spectacular implosion following its local council successes in 2015 whilst the biggest winners were the Liberal Democrats (up from 7.7% to 16.1%) and other parties representing a variety of local interests (up from 6.1% to 14%).

If ever politicians needed a wakeup call that their handling of Brexit deliberations has turned voters off, this was it. But what exactly did the results tell us? It is too simplistic to suggest that voters wreaked their vengeance on the Conservatives because they have changed their minds about Brexit but analysis of the results suggests that they lost one-third of the seats they contested in majority-Remain areas. Meanwhile the Lib Dems, which avowedly support a second EU referendum, picked up gains across both sides of the Leave-Remain divide. This would appear to suggest they gained as a result of dissatisfaction with the main political parties following the parliamentary debacle of recent months, in which both Labour and the Conservatives played a key role. However, the Lib Dems could also have picked up votes from potential Labour supporters who have been discouraged by the party’s attempt to back away from a commitment to holding a confirmatory EU referendum. That said, Labour performed badly in majority Leave-supporting areas, indicating voters’ dissatisfaction with politicians’ efforts to deliver Brexit.

What the results do suggest is that voters want an end to the political wrangling. But it is less clear that they want the sort of Brexit that Theresa May has in mind – it is far from clear that they want Brexit at all. And it remains highly disingenuous of the prime minister to accuse the Scottish First Minister of wanting to "re-run the independence referendum because she did not like the decision of the people of Scotland" and to "re-run the EU referendum because she did not like the decision of the people of the UK" when that is exactly May has tried to do in ramming her deal through the Westminster parliament. And the prime minister knows only too well that the electorate can change its mind. After all, there were only two years between the general elections of 2015 and 2017 when voters changed their mind about electing a majority Conservative government, and we are now almost three years on from the EU referendum. And as the arch-Brexiteer David Davis once said, ”if a democracy cannot change its mind, it ceases to be a democracy.”

What the results also suggested is that voters are currently not aligned along party political lines and instead have become more issue-driven. That is not the same thing as saying the two-party hegemony is over for good, as some of the more excitable political commentators have suggested, but party loyalties are currently being tested. Brexit obviously tops the domestic political agenda but the strong performance of the Greens might indicate that environmental issues are playing a bigger role in voters’ thinking following the recent publicity surrounding 16-year old Greta Thunberg’s castigation of politicians’ treatment of climate change issues. Indeed, intra-generational issues are likely to be high up the UK agenda as issues such as health funding, access to education and affordable housing are all items which have been pushed down the political agenda in favour of Brexit.

As for where we go on the Brexit debate from here, both Labour and the Conservatives realise it is in their interests to find an agreement before the October deadline. Theresa May could thus be tempted to accommodate Labour demands for a customs union with the EU whilst Jeremy Corbyn shows every sign of wanting to back away from the commitment to a second referendum. Of course, neither of these options would please members of their respective parties, with large numbers of Labour Party members particularly in favour of a second referendum.

The debate is only going to heat up as we are less than three weeks away from European elections in which the UK believed it would not have to participate. Nigel Farage’s Brexit Party is currently polling at 30% making it the largest single party although we should not overstate this result. It merely tells us that large numbers of Brexit supporters have found a new home. However, if repeated in the European elections, this will reaffirm the government’s view that it is required to deliver some form of Brexit and preferably sooner rather than later. Most people I speak to share my view that the last three weeks have proven to be a welcome Brexit-free break. Unfortunately, it might be about to come to a noisy and fractious end.