Breakthrough, breakdown or breakup?

Boris Johnson has long promised that he would deliver Brexit by 31 October and today’s agreement between the UK and EU has opened up the possibility that he can now deliver on his word. But in doing so, he has effectively thrown the DUP under the bus and raises the question of how likely it is that the deal will be ratified by the British parliament on Saturday. 

I have long suspected that Johnson would ultimately sell out the DUP. Aside from the fact he is not trustworthy, when you are prepared to withdraw the whip from your own MPs and operate a government with a minority of 45 seats, the loss of a further 10 is probably not going to make that much difference. Let us also not forget that in June 2016 Northern Ireland voted 56%-44% to remain. There was never really much chance that the Tories would allow the province to stand in the way of what increasingly looks like an English nationalist movement. Recent opinion polls now suggest that the electorate is roughly evenly split between remaining as part of the union and joining the Republic and I am increasingly of the opinion that a United Ireland will eventually be formed.

Ironically, the deal struck between the two parties today ensures that Northern Ireland remains in the British customs union even though EU regulations will continue to apply to all goods in the province. This implies there will be border checks, with the customs border between the UK and the island of Ireland running down the middle of the Irish Sea. Britain will be responsible for collecting VAT and excise duties in Northern Ireland but revenues resulting from transactions taxable in the province will accrue to the rest of the UK. The Northern Irish Assembly will be given a chance to decide whether these arrangements remain in place four years after they come into effect. Johnson had originally suggested that the agreement would only be implemented once the assembly had ratified it, which would have given the DUP a veto. 

There are two problems here: (i) the fact that the arrangements will be subject to approval every four years means that they could break down, and are far from the permanent solution to preventing the imposition of a hard border that the EU was looking for; (ii) the Assembly has been suspended since January 2017 with the DUP at least partially responsible. This  raises the suspicion that the UK has little interest in allowing the Assembly to have much meaningful influence over the Brexit process given the dysfunctional nature of Northern Irish politics.

For all the optimism regarding the prospect of a deal between the UK and EU, the initial enthusiasm has been tempered by the fact that it is far from certain it will be ratified by parliament on Saturday. Clearly, the DUP has no incentive to provide any support, so that is ten votes gone. The Conservatives have two additional problems. One is to ensure that the 21 MPs who were suspended last month will lend their support to the Johnson plan. The other is the question of how the ultra-hard-line Brexiteers (the so-called Spartans) will vote. In the past, they have tended to side with the DUP but there is no guarantee that will be the case this time around (further enhancing the DUP’s view that they have been thrown under the bus). The Spartans number around 30 so if they all vote for Johnson’s deal and 20 of those who had the whip withdrawn do likewise, on the basis that they will be readmitted to the party, that adds up to 307 votes (287 Conservative MPs are eligible to vote and a majority requires 320 votes). 

To make up the shortfall requires the support of any Labour MPs prepared to defy their leadership’s order to vote against the agreement since the Lib Dems, SNP and large numbers of independent MPs will certainly hold out against it. If we can find 13 Labour rebels, it might be possible to ratify the deal by the thinnest of margins.

But this assumes that the number of Tory (and former Tory) rebels is limited to one (the one is Ken Clarke, who I assume will not sign up to it). The more Tories who vote against their leadership’s wishes, the more support from outside the party will be required to pass it. There is an argument that the number of Labour rebels might be bigger than we think because many of them sit in Leave voting constituencies and they might feel obligated to enact the “will of the people”. Indeed, many MPs – on both sides – only rebelled against their party leadership’s wishes in order to avoid a hard Brexit. But this prospect is no longer on the table. Thus whatever happens, it is likely that any vote on Saturday will be very close. 

If the vote does go through, the UK will leave the EU on 31 October. If the vote fails, it is likely that the EU and UK will try to find another solution next week in time for an emergency summit before month-end, but departure on the 31^st would then be unlikely. That may not be a problem if the UK applies for a 3 month extension but manages to deliver Brexit in (say) early November. Johnson could still sell the process as a great triumph. However, none of this is the end of the story. The UK remains traumatised by the Brexit process and delivering an EU departure may exacerbate divisions rather than heal them. 

Indeed, the great irony is that MPs are being allowed their fourth Brexit vote in nine months whereas the public – in whose name all this is being conducted – got one vote three years ago. As US President Woodrow Wilson said many years ago, “the government, which was designed for the people, has got into the hands of the bosses and their employers, the special interests. An invisible empire has been set up above the forms of democracy.” A century on, it feels very much like we are there again.

Don't give up on inflation targeting just yet

The Money, Macro and Finance Research Group (MMF) annual policy conference is one of the best places to gain an overview of current issues in monetary policy and I was fortunate to attend this year’s event to hear presentations from the likes of St Louis Fed President Jim Bullard, former Fed Board member Frederic Mishkin and Riksbank governor Stefan Ingves (and not forgetting a useful contribution from the MPC’s ever-thought provoking Gertjan Vlieghe). Mishkin’s presentation won the prize for the most entertaining. In addition to being a very accomplished speaker, his was the first presentation I have heard which incorporated a reggae track, produced by the Bank of Jamaica to highlight its new inflation targeting regime (here – and it’s well worth a look).

There were a significant number of issues raised and I will undoubtedly come back to many of them in the course of future posts. If there was an overarching theme from the whole event, it was the general agreement that monetary policy has reached the limits of what it can do to support the economy without some additional fiscal support. Not that central bankers would ever admit they are out of bullets, but it seems obvious they cannot go on doing what they are doing in the expectation that things are going to change. There was also a lot of head-scratching as to why inflation continues to undershoot central banks’ 2% target and Mishkin’s presentation on inflation targeting is a good starting point to think about the inflation framework adopted by most central banks.

In my view, Mishkin started from the wrong place. He started by pointing out that inflation in the Anglo Saxon world started falling in the early-1990s at the same time as central banks began to directly target inflation. Although he did not say so in as many words (although it was explicitly stated by some in the audience), the underlying message was that central banks’ focus on reducing inflation was the key factor in quelling the rampant inflation of the 1970s and 1980s. This idea has been bandied around by numerous central bankers over the years, although it is heard less frequently today. And with good reason: it is far from the whole truth.

Inflation expectations took a battering following the early-1990s recession, the second in a decade, whilst intensified competition – itself the product of the 1980s deregulation regime – also acted to depress expectations. I heard nothing about the impact of the end of the Cold War or the rise of China, both of which increased the global economy’s productive capacity with consequent dampening effects on inflation. The reason why such denial may be a problem is that if central bankers really believe they have curbed inflation, when in fact it is largely the product of exogenous forces, they may not be best equipped to force it back towards target and may understand the inflation process less well than they think.

This raises another question. If inflation is persistently below target, what is the point of maintaining the target? In the case of the ECB, for example, CPI inflation has averaged 1.0% since 2013 which is well below the target rate of below, but close to, 2%. In order that the ECB’s inflation rate averages 1.9% over the ten-year period 2013 to 2022, it would have to average 3.9% between now and December 2022. Such arithmetic has prompted luminaries such as Olivier Blanchard, the IMF’s former chief economist, to suggest raising central bank inflation targets to 4%. But there are good arguments against such a strategy.

In the first place, it is more difficult to stabilise inflation at 4% than 2% because the former figure is not consistent with the definition of price stability in which inflation is not a big factor in economic decision-making. An inflation rate of 4% implies that the price level doubles every 17.5 years versus 35 years in the case of 2% inflation. If you are making long-term calculations, such as investment or pension planning, there is a big difference between these two figures. Moreover, once we start to deviate from a 2% inflation target, why stop at 4%? Why not raise the target to 6% or 8%? Before too long, we could very easily get back towards 1970s territory.

But there is an argument suggesting that central banks could allow temporary deviations from the 2% target. Rather than target the inflation rate, an alternative would be to target the price level on (say) a two-year horizon. One of the disadvantages of targeting inflation (i.e. the rate of change of prices) is that shocks which impact on prices – and therefore temporarily raise the inflation rate – become fully embedded in the price level. But in a price level targeting regime, they are not.

We can illustrate this graphically (below). Consider the case where there is a shock to prices which causes them to fall by 1.5%. If the central bank does not attempt to compensate for this, in the knowledge that this is a one off impact, the price level is permanently lower and the rate of change eventually rises back to the 2% target (grey line). But if the central bank attempts to restore the price level to its steady state path on a 2-year horizon, it can tolerate much higher inflation and it is only three years after the initial shock that the inflation rate returns to the steady state rate of 2% (black line). One clear advantage of this regime is that it acts as an anchor for long-term price levels, and thus provides more certainty for inflation rates used as a basis for long-term wage and pricing contracts.

This sounds good in theory but does it work in practice? Much of the literature is based on the assumption that inflation expectations adjust relatively quickly and in a pre-defined manner. However, the experience of the last decade suggests that expectations adjust much more slowly than is often assumed. Nor do we know the functional form of the expectations formation process. This means that central banks may have to allow inflation to run further ahead of target for longer than they would like in order to give time for expectations to normalise. This in turn runs the risk that central banks may be perceived as having made a permanent adjustment to their inflation target.

Much as we may be critical of central banks which bang on about their target even though inflation continues to deviate from it, the constant repetition serves a purpose of reminding us that this target exists. If they stop talking about it, we might start to pay less attention to it and eventually forget about it altogether. And if we get to this point, there is a real fear that expectations could become unanchored and move around wildly as economic conditions change.

You might argue that in a world of exceptionally low inflation, there is no need to worry about any pick up in the pace of price growth. But central bankers can counter, with some justification, that just as the exceptionally high inflation of the 1980s quickly gave way to lower inflation within the space of five years, so the process could just as quickly run the other way. It is thus important to try and ensure that expectations remain anchored and it may be too soon to call for radical changes to the inflation framework.

The underperformance gathers pace

One of the exercises I have been conducting over the past three years is to assess how the UK economy has performed relative to pre-Brexit referendum expectations. At the end of 2017 I looked at the economy’s performance and motivated by this set of tweets by FT journalist Chris Giles, I thought it worthwhile providing an update. The analysis is complicated by historical revisions to data which make it extremely difficult to compare GDP levels. But based on data for growth rates we can make some observations.

Rather than use one single forecaster as a reference, I have compared outturns against a panel of long-term GDP growth forecasts made in May 2016  which are reported in the Treasury’s monthly publication ‘Forecasts for the UK economy’. No less than 14 institutions made projections covering the period 2016 to 2020 (with a higher number providing near-term projections) providing a decent sample size. Using the current 2019 consensus forecast as a basis for this year’s outturn (we already have half of this year’s GDP figures so it is a reasonable assumption), real GDP in 2019 is likely to end up around 2 percentage points lower than predicted prior to the referendum (chart 1). That is equivalent to a year’s worth of pre-referendum expected GDP growth.

Measured in terms of constant 2016 prices this amounts to £41.5 bn. With the GDP deflator estimated to have increased by a cumulated 5.7% since 2016, this amounts to a loss of GDP in nominal terms of around £43.9 bn. For the record, that averages out at around £281 million per week. Recall Boris Johnson claimed that the UK would be better off by £350 million per week. Even on the basis of his vastly inflated figures, 80% of the gains have been wiped out by weaker growth. But since the UK’s net contribution to the EU is actually between £150 million and £212 million per week, depending on how we measure it, (here for a useful ONS calculator) the hit to growth now far exceeds any savings from ending contributions to the EU budget. The further ahead we roll the figures, the worse it looks. Comparing the current 2020 consensus forecasts with the May 2016 projections, the loss of output translates into a figure of £328 million per week.

To understand why GDP has underperformed so dramatically it is worthwhile taking a dig into some of the components. We do not have long-term consensus projections for all the components so I have resorted to using the OBR’s pre-referendum forecasts to give a feel for the underlying detail (which can be found here). This dataset does, however, allow us to look at the data on a quarterly basis so we can compare the figures from the aftermath of the referendum right up until the latest data available (Q2 2019). 

After adjusting for the change in the national accounts base year, we discover that by mid-2019 household consumption was around 1% below the OBR’s 2016 projection. Government consumption is around 3% above the OBR’s estimate, largely thanks to a huge increase in outlays over the last nine months as the government has opened the taps. But the biggest single shortfall comes from fixed investment which is 10% below the 2016 projection, with business investment falling 15% below the forecast (chart 2). Indeed, all the non-investment components broadly net out against one another leaving the collapse in fixed investment to account for pretty much all the slowdown in GDP. And why has investment proved so weak? Because companies have lined up to tell us that Brexit-related uncertainty has forced them to put their capital spending plans on hold.

We cannot say with any certainty that the outturn in 2019 would have come anywhere close to the predictions made in 2016. But the comparison does show that there was a structural break in the way the economy was expected to behave and it is too much of a coincidence to say that it was not associated with the Brexit referendum. Brexit supporters will point to the continued strong performance of the job market and argue that the UK has continued to create jobs. It is certainly true that the unemployment rate will turn out around 1 percentage point lower than the 4.9% rate predicted by the consensus in May 2016.

But in 2016, the OBR expected a cumulative increase in productivity of 5.2% between 2016 and 2019. Data released this morning suggest that output per hour worked has risen by a measly 0.9% in the last three years. Productivity is the key driving force of our living standards, and it is simply not rising fast enough. This may not all be due to Brexit – after all, productivity growth has underperformed for the last decade. However, the increase in output continues to be driven by labour input in a way which is reminiscent of less well developed economies and without any capital input to supplement it (i.e. investment), it is likely that GDP per head will continue to stagnate.

Finally, just to illustrate the UK’s economic underperformance in an international context, the ONS has compiled quarterly data on GDP across a range of countries. Using a base period of Q4 2016, the UK has underperformed against all major industrialised economies bar Italy and Japan, up to and including Q2 2019 (chart 3). You can argue as much as you like about the poor performance of Germany in recent months, but the data still show that it has outperformed the UK in growth terms since the start of 2017.

Politicians (and their advisers) focused on “getting Brexit done” are oblivious to the risks which Brexit poses to the economy. To be frank, most of them are spectacularly ignorant of even basic economic concepts so those ordinary voters who still support Brexit can be excused for their lack of understanding. But what the overall picture shows is that there was a structural break in the performance of the UK economy in the second half of 2016. It cannot be denied; it cannot be dismissed as Project Fear. It is there in the economic numbers in black and white. And the growth shortfall is broadly in line with estimates made prior to the referendum. Moreover, the UK has not yet left the EU. Things could get even worse, depending on the nature of the departure.

As I noted in a post last week, economics will ultimately determine whether Brexit is a success. The evidence so far suggests it is not going particularly well and those who continue to push this ruinously stupid economic policy will ultimately be forced by the evidence to account for their actions. Nobody has yet come up with any good economic arguments in favour of Brexit, and there is a good reason for that – there aren’t any.