Germany's political and economic stagnation

Whilst the UK political class continues to eat itself over Brexit, other European countries are increasingly having to face up to significant difficulties of their own. Nowhere is this more evident than Germany where Angela Merkel’s CDU took another significant beating in regional elections in Thuringia over the weekend, pushing it into third place behind the ultra-right AfD and the ultra-left Die Linke. This has given rise to speculation the CDU may have to hold its nose and do a deal with Die Linke, whose roots stem from the former East German communist party. Although the CDU’s leadership officially continues to rule out doing a deal with either of the other two parties, it is a sign of the times that such an idea is even being publicly contemplated.

Meanwhile, the CDU’s governing coalition partners, the SPD, are in the throes of a leadership process that could see them quit the government. Party members have long been critical of its partnership with the CDU, since it has cost them widespread popular support for little apparent gain. In a vote held over the weekend, finance minister Olaf Scholz and his running mate Klara Geywitz narrowly topped the ballot of party members with 22.7% of the vote. Scholz will now face a run-off against the team that finished second in the ballot (Norbert Walter-Borjans and Saskia Esken), with the result set to be announced on 29 November. Team Scholz is committed to the SPD remaining in government. Their opponents would almost certainly want to pull out of the coalition which would make life difficult for Angela Merkel.

It is almost exactly a year since Merkel announced that she was standing down as chair of the CDU party and the European political centre which she represents now faces even stronger headwinds than it did then. Her anointed successor, Annegret Kramp-Karrenbauer (AKK) has not pulled up any trees and German media reports suggest that she has failed to stamp her authority. She certainly does not look like a Chancellor-in-waiting. To add to the political difficulties, the German economy is struggling in the backwash of the US-China trade dispute, with the Q3 GDP figures due for release in a fortnight’s time widely expected to show a second consecutive quarterly contraction. Although Germany has grown more rapidly than the UK over the period since the EU referendum in 2016, this has not been the case of late. Indeed, in the six quarters since the start of 2018, the UK economy has expanded by 1.8% in real terms versus 0.8% in Germany.

It is questionable whether a stronger economy would have much impact on the politics, since this reflects more deep-seated issues, but it is certainly not helping. As a consequence, there is mounting pressure on Germany to ease its fiscal stance. A report in the Handelsblatt newspaper ahead of the finance ministry’s latest tax revenue estimate suggested that the budget surplus this year could be in the “high-single digits”, with tax revenues expected to be around 4 billion euros higher than in the previous estimate published in May. Furthermore, the collapse in bond yields has resulted in an estimated 5 billion euros reduction in debt servicing costs. These are not big numbers in the grand scheme of things, with the budget surplus only likely to be around 0.25% of GDP, but given where we are in the economic cycle today Germany can afford to run a small deficit and still reduce the debt burden. The condition for doing so depends on the extent to which nominal GDP growth exceeds the average interest rate on federal debt. With the latter clearly in negative territory it is evident that there is a reasonable amount of fiscal headroom.

Although it did open the taps to combat the fallout from the financial crisis of 2008, the Merkel government has never given the impression that it is willing to use fiscal policy as a counter-cyclical policy instrument. It is probably expecting too much to expect a response in the near-term as political paralysis takes hold. But if Germany does not act, it is unlikely that other countries will either – despite the calls from outgoing ECB President Mario Draghi in a valedictory speech to euro zone heads of government today. Draghi is, of course, the man who promised to do “whatever it takes” to save the euro in 2012. We need someone to demonstrate the same degree of fiscal courage today.

But Germany’s economic problems are not all about fiscal policy. It is an economy which relies heavily on the export of high quality manufactured goods and as such has been a beneficiary of the globalisation process of the past 30 years. But globalisation may well have reached its limits, as evidenced by the slowdown in world trade growth and the slowdown in the KoF Globalisation index. Incidentally, this is the sort of fate that could await the UK as it seeks to find new export markets at a time when the rest of the world is more interested in turning inwards.

Finding solutions to lance the boil of populist politics will be harder. This is not just a German problem, of course, but without Germany driving from the political centre the rest of the EU caravan is unlikely to make much progress. As we edge nearer to the end of Angela Merkel’s term of office – she has made it clear that she will be gone within two years – there are big question marks over where the EU goes from here. Does it follow the Macron recipe for greater political and fiscal integration or will the current widening of political differences continue? One thing is for sure: The EU that the UK government hopes to leave is not the one it thought it was leaving in 2016.

The economics of making us poorer

Away from all the political shenanigans surrounding the politics of Brexit, too little time has been spent looking at the economics of the plans agreed between the UK and EU last week. Indeed, Chancellor Sajid Javid has refused demands that the Treasury carry out an economic assessment of the government’s Brexit deal, claiming it is “self-evidently in our economic interest”. That is not a view any economist should be prepared to take on trust. Fortunately, the group The UK in a Changing Europe has conducted some modelling analysis.

The key difference between the May plan, which was three times rejected by parliament, and the Johnson plan is that May’s plan sought as close an alignment with the EU as possible and suggested that “the United Kingdom will consider aligning with union rules in relevant areas.”  However, the Johnson plan seeks a relationship that is “as close as possible” to current arrangements. On the surface, this may not appear much different but it does open the possibility that there could be more significant regulatory divergence in future than is currently the case. This implies significant non-tariff barriers for trade because there will be extra costs for business as the UK operates its own customs regime. Moreover, even though Johnson is seeking a free trade agreement, this may still require customs checks to ensure compliance with rule of origin requirements, which will raise trade frictions between the UK and EU. 

Quantifying the impact of trade barriers on trade is a highly imprecise exercise since they can be divided into tariff and non-tariff barriers. The former are relatively straightforward to deal with but the latter are not. The good news is that an FTA implies no tariff barriers. But we then have to deal with non-tariff barriers. The simulation analysis assumes that they are 50% of those between the US and EU (i.e. smaller), but they are non-zero because FTAs imply a higher degree of trade friction than a customs union. Services trade continues to be ignored in the government’s plans, and in the absence of any other option, services tariffs are assumed to be set at WTO levels. More contentious is the assumption that the UK loses out from future reductions in intra-EU trade costs, which in this analysis fall 40% faster than trade costs in the rest of the world in the ten-year simulation horizon.

Putting all the numbers together points to a 2.5% reduction in income per head over a ten-year horizon compared with staying in the EU, versus a 1.7% reduction in the case of May’s plan. Allowing for the dynamic feedback effects whereby lower trade adversely affects productivity – the economic literature generally assumes a 1% decline in trade reduces income per capita by around 0.5% – the overall effects of the Johnson plan result in a 6.4% medium-term (10 year) decline in incomes per head relative to staying in the EU versus 4.9% in the May plan. Further allowing for lower immigration numbers, as Brexit plans advocate, results in still bigger declines in incomes, amounting to 7% in the worst case scenario versus the no change baseline (chart).

 

It is important to note that the simulation analysis does not indicate that the economy will contract by these amounts, only that it will be smaller than might otherwise have been the case. In the analysis outlined above, the Johnson plan broadly implies that the economy will grow 0.7 percentage points per year more slowly than it would had the UK stayed in the EU. In a case where the economy is assumed to grow at an annual average rate of 1.5%, this would imply a reduction to an annual rate of 0.8% which is an economic draught we are likely to feel. However, we would be well advised to treat the numbers with a pinch of salt. Modelling exercises of this type are fraught with uncertainty and highly dependent on the conditioning assumptions. Just as I have been dismissive of the results of Brexit-supporters who claim that their simulation analysis will lead to better outcomes, so we should treat the analysis of Remainers with similar caution.

Brexit supporters can claim that this kind of analysis does not account for the benefits that would come from a lower regulatory burden. In principle, there are indeed positives from such an approach. Reducing the corporate tax burden is one such option. However, the UK already has one of the lowest corporate tax rates in the EU, with a rate of 19% versus 29.8% in Germany, and with a view to cutting it to 17% by 2020. Increased pressure on public finances will make it difficult to cut further (each one percentage point reduction in the corporate tax rate reduces revenue by around 0.1% of GDP) – as I have pointed out before.

Another area of interest is the labour market where the suggestion has often been made that the UK would benefit by getting rid of the working time directive which places limits on the number of hours worked. But the UK already has the least regulated labour market in the EU, according to OECD data, and evidence produced by the UK government in 2014  suggested that the limits on the number of hours worked “had little discernible impact on total hours worked across the economy, but a small positive impact on employment.” It is thus unlikely that the UK would be able to generate a significant competitive boost from further deregulation – much of the low-hanging fruit has already been plucked.

Irrespective of whether we are looking at May’s deal or that cobbled together by the Johnson government, it is very hard to see how leaving the frictionless trade area of the EU leads to improved economic outcomes. It certainly will not be because of improved trade performance. All the empirical analysis of trade suggests that gravity effects still hold – large countries which are located closely together tend to trade more with each other. Countries which are further away do less trade because transport costs make it less attractive (here). Nor is it likely that the UK can deregulate on the same scale as it did in the 1980s – those one off gains have played out. None of this is to say that Brexit will necessarily be an economic disaster. But we will all likely be slightly poorer which is not what people voted for in 2016.

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.