Changing of Lagarde

Arrivederci Signor Draghi

The changing of the guard at the ECB has been well documented recently with numerous articles looking back over Mario Draghi's tenure as President. Opinions are mixed, depending on where one stands on the question of QE. A large part of the German economics profession believes he has followed an unsound monetary policy, with QE serving only to swell asset values whilst having little overall impact on the economy. A more sympathetic view is that Draghi is the man who saved the euro zone following his 2012 promise to "do whatever it takes" to support the single currency.

For my own part, I give him great credit for his actions in 2012. Without his decisiveness, in the face of significant internal opposition, there is a serious risk that the single currency could have collapsed. Odd though it may seem now, given the relatively small size of its economy, the raging Greek debt crisis laid bare the fault lines underpinning the euro zone. Draghi was able to put a sticking plaster over the gaping wound and prevent a bad situation from becoming worse. Had he listened to other voices which argued against taking action, things could have been very different. Indeed, many have pointed out that Draghi is a very adroit politician. He did not have the policy tools to back up his 2012 promise and who knows what would have happened had markets tested him out. Indeed, it took almost three years before the ECB embarked on a policy of asset purchases.

The fact that the euro zone remains stuck in low gear reflects a combination of political intransigence on the part of euro zone governments and changed economic circumstances which have put downward pressure on global inflation, and make the euro zone economy appear more sluggish than it really is. Governments have offered the ECB no real support. The fact that they continue to sit on their hands with regard to fiscal policy makes the ECB's job harder. And as the ECB's first President, Wim Duisenberg, pointed out almost 20 years ago, governments need to do more to restructure their economies in order to remove growth obstacles. In so doing this would remove the reliance on the central bank to support growth. But aside from Germany, whose Hartz IV policies in the mid-2000s proved to be a successful package of labour reform measures, most governments have done little or nothing.

That said, the ECB's policy stance of further cutting interest rates into negative territory and continuing to buy huge quantities of government bonds are the actions of an institution that has run out of ideas. Indeed, the September decision to resume QE caused huge dissent within the Governing Council and prompted the resignation of German representative Sabine Lautenschläger. It is not the first time a German representative has quit in protest. In 2011 both Axel Weber and Jürgen Stark walked the plank. However it is significant that the most recent dissent was not only confined to German board members with French, Dutch and Austrian members expressing doubts about the policy stance.

It is well known that QE has an increasingly smaller marginal impact - the greater the volume of asset purchases, the smaller the impact. A recent research paper suggested that asset purchases produced an average increase of 0.3 percentage points in annual GDP growth between 2015 and 2018 and 0.5 percentage points in CPI inflation, with a maximum impact in 2016. Interestingly, when the working paper version was published the impacts were assessed to be rather larger. Either way, with the central bank balance sheet already at 40% of GDP it is questionable whether the benefit of increasing asset purchases is worth the cost. But whilst this is a valid concern, the simple fact is that the euro zone is still afloat because of Draghi’s actions. He has expanded the ECB’s policy toolkit and given his successor a fighting chance of moving the economy along.

Bienvenue Madame Lagarde

The appointment of Christine Lagarde as Draghi's successor was initially a controversial choice and she faces a number of challenges going forward. I have no doubts about her ability to do the job but she was clearly a political appointee, as Emmanuel Macron sought to shoehorn a French candidate into one of Europe's top jobs. As the head of an independent central bank, Lagarde will have her work cut out to maintain the impression that it is not simply an institution designed to maintain the cohesion of the EU – a view prevalent in some quarters which judges the ECB's monetary policy as a way of keeping Italy afloat.

Lagarde probably has little choice initially but to continue with the policy initiated under Draghi, but her challenge will be to keep the representatives of northern countries onside. The last thing she needs are further damaging splits amongst council members. However the fact that she represents one of the powerhouse economies means her views may carry a bit more clout. Bigger challenges will come later. It is unlikely that a loosening of monetary policy will have any significant impact on growth, and the debate is increasing likely to turn to the damaging side effects of low interest rates.

Low rates work by shifting consumption and investment patterns across time. If consumers are spending today they are not saving for later. But if they are forward looking, as modern macro theory assumes, at some point they are going to change their behaviour in order to build up precautionary savings balances - perhaps for pension purposes. Moreover since interest rates are so low, the amount they will have to save to build up a decent pension pot is likely to be quite substantial. In other words, a policy of low rates forever could start to prove self-defeating. I would not be surprised if at some point in future, the debate starts to shift towards raising interest rates in order to boost long-term growth prospects. Of course, it will not be put in such terms; central bankers will simply talk about policy normalisation.

Recent comments by Lagarde suggest that she will continue to be outspoken on policy issues. In comments earlier this week, she suggested that “those that have the room for manoeuvre, those that have a budget surplus, that’s to say Germany, the Netherlands, why not use that budget surplus and invest in infrastructure? Why not invest in education? Why not invest in innovation, to allow for a better rebalancing?” and suggested that both “have not really made the necessary efforts.” This is pretty powerful stuff and although it is unusual to name individual governments, it chimes with the view I have held for a number of years that governments need to get involved on the fiscal front. There are those who say that central bankers should focus on monetary policy issues. Whilst I respect that view, it is also the case that when fiscal inaction impacts on monetary policy they have a duty to speak out.

Eyes on the prize

Boris Johnson has finally got what he wanted – a general election, to be held on 12 December. Never mind the fact that the parliament elected in 2015 should still be sitting and that the UK is headed for its third election in just over four years. Only Johnson has the chutzpah to preside over the legislative shambles that has characterised UK politics over the past two months and claim that he is trying to “get Brexit done”.

He has defied many of the conventions that underpin the UK’s political system and may have done incalculable damage. His most significant move was to try and prorogue parliament, in a move later ruled to be unconstitutional, to prevent parliamentary oversight of his Brexit bill. But in the process he served only to alienate 21 of his Conservative colleagues who were suspended from the parliamentary party for daring to vote for legislation that would prevent prorogation from resulting in a car crash Brexit.

Johnson then did what he previously said was unacceptable by drawing up a Brexit plan which involved drawing a border down the Irish Sea. It is always worth recalling that in 2018 Johnson wrote, “the fatal error was not to challenge the EU’s position that the only way of avoiding a hard border on the island of Ireland – an objective we all share – is for Northern Ireland to have the same regulations for trade as Ireland and the rest of the EU … That is obviously a non-starter.” Johnson then proceeded to sign up to an agreement in which Northern Ireland does indeed “have the same regulations for trade as Ireland and the rest of the EU” and in the process alienated the 10 DUP MPs upon whom his party has previously relied for parliamentary support.

His next trick was to try and force MPs to accept his Brexit bill without first seeing it – a measure which was rejected by parliament. The government was then forced to publish details of the Withdrawal Agreement Bill but was defeated when it became clear that it was intent on ramming it through parliament with only cursory debate. Let us not forget, however, that the WAB did pass its second reading in the House of Commons. In this sense, Johnson has already gone a step further than Theresa May by getting parliament to vote in favour of legislation enabling Brexit. From a tactical perspective, the government would have been well advised to concede that a delay of up to a month would be necessary to ensure that the WAB is passed, rather than doubling down on the 31 October deadline.

But having failed in his efforts to "get Brexit  done" by 31 October, Johnson has shamelessly pushed for an election only to fail to get sufficient support for this option under the terms of the Fixed-term Parliaments Act and has been forced to rely on circumventing it. In another of the great Brexit ironies, Conservative MPs have repeatedly told us that parliament is dysfunctional and we need a reboot in order to start passing legislation. But it is in this position precisely because of the way the executive has behaved over the past two months, potentially alienating 31 MPs who until recently were on their side. The government may want to reflect on the fact that any of their proposals that lost by a margin of less than 62 could have turned out differently had it not done its best to ride roughshod over the wishes of those who oppose it.

Early last month Johnson said he would rather be "dead in a ditch" than postpone his "do or die" Brexit beyond October. I am happy to report that the prime minister is hale and hearty, although his plans are dead from a glitch – the glitch being that MPs want to devote more care to getting Brexit done in order to serve the needs of their constituents than Johnson’s cavalier attitude will permit. But whilst what I have described so far sounds like a litany of government failures characteristic of a serial loser as it trampled over constitutional conventions, it will all stand Johnson in good stead in the December election that will clearly act as a quasi-referendum on Brexit. His pitch will be “I tried my best to deliver but I was thwarted by a Remainer parliament.”

And it will almost certainly work, for even though many long-standing Conservative voters will break the habit of a lifetime and lend their support to another party, Jeremy Corbyn is so reviled by centrist voters that Labour will not be in any position to capture their votes. In other words the swing away from the Conservatives will not follow the historical pattern of being matched by a swing towards Labour. 

But there is also another political narrative at work which is too often ignored. The conventional view is that politics is dysfunctional and we need a cleaning of the Augean Stables. Arguably, however, the institutional framework is standing up very well to the pressure exerted by government. The judiciary, for example, has consistently refused to be intimidated by the executive. Nor should MPs feel bound to support a policy proposed by their party if they do not believe it to be in the interests of their constituents. MPs are representatives of the people, paid by the taxpayer. They owe their allegiance first and foremost to the electorate rather than the prime minister, and those who appear to be blocking the path to Brexit are speaking for the near half of voters who feel they have not been heard over the past three years.

What the past three years have taught us is that the UK’s representative democratic system is not capable of dealing with an infusion of direct democracy. It is simply not acceptable for MPs, who we pay to resolve such problems, to throw an important question such as EU membership to the electorate without giving proper guidance and consideration. But having chosen to introduce direct democracy, it is equally unacceptable to then exclude the electorate from subsequent discussions. And whatever else the election may be about, it is not right to bind Brexit up with the host of other issues that need to be discussed during an election campaign.

A second lesson is that the nature of politics has changed. The two party system that has characterised British politics for centuries is currently in a state of flux. It is difficult to imagine governments being able to secure the huge majorities which have characterised the recent past (of course, that may prove to be wrong at the next election). The current system of adversarial politics may have to change to accommodate a wider polarity of views.

This year has been one of the most fractious political years of modern times in the UK and over the next six weeks it is going to become more messy and unpleasant still. And even then, as I have repeatedly pointed out, this will not resolve the Brexit problems which will continue to fester for a long time to come. A December election is a bad idea for many reasons but for those of you with an interest in historical precedent, there were three elections held in December between 1910 and 1923 (the last time it happened). On each occasion the sitting prime minister lost. Food for thought!

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.