No permanent friends, only permanent interests

We do not hear as much these days about the prospect of the UK falling back on WTO rules in the event that a trade deal with the EU cannot be concluded. This is partly because such an outcome is unlikely to happen in the near-term since the UK will enter into a transition agreement with the EU from February. But it also probably reflects the fact that the WTO has been severely damaged by the actions of Donald Trump which in turn has reduced its usefulness as a body overseeing international trade rules.

The problem is that Trump has consistently blocked appointments to the WTO’s Appellate Body – the high court of international trade – as the terms of sitting judges expire. The Appellate Body (AB) was established in 1995 and is comprised of seven judges who rule on trade disputes between WTO member countries. Each judge is appointed for a four year term, which can be renewed only once, and the Body requires a quorum of three in order that its rulings are accepted as valid. Following Trump’s tactic of blocking the reappointment of existing members, the AB was reduced to the minimum number of three in 2019 and with the terms of two of them expiring in December, it can no longer command a quorum. In theory, the AB can continue to hear pending appeals because members are able to rule on existing cases even after their mandate expires, but it is no longer able to hear new cases. As a consequence, a country which loses a dispute can file an appeal knowing that it will not be heard, and as a result can continue to act as before.

How have we got into this position? Quite simply, the Trump administration believes that the WTO is biased against the US. It is true that compared to the pre-1995 period the US is less able to throw its considerable weight around on international trade issues. Under the old GATT system, there was no settlement mechanism in place to hold countries to account for trade violations and in the 1980s and early-1990s the US exploited this to introduce a series of unilateral tariffs, ostensibly to force countries to open up their domestic markets. This policy, dubbed “aggressive unilateralism” by US-based trade economist Jagdish Bhagwati, served only to anger major trading blocs such as the EU and in any case its rate of success was limited. To assuage these concerns, the Uruguay Round of GATT began in 1986 which eventually led to the formation of the WTO in 1995, including the Appellate Body.

On a global basis, the WTO has been a great success in as much it has reduced the extent to which trade disputes spiral out of control. But it does constrain the US to work within the rules. However, the US wins around 85% of the cases that it brings before the AB – hardly evidence of bias against it. As long ago as 2007, the US Council on Foreign Relations suggested that “the dispute settlement system reflects a delicate balance between toughness and respect for sovereignty; rather than criticizing the result, U.S. policymakers and legislators should invest more energy in defending it.” Furthermore, the dispute settlement mechanism “curbs the protectionist instincts of U.S. trade policymakers and so underpins prosperity” by acting as a counterweight to the intense domestic lobbying by politically influential, but inefficient, domestic industries.

Ironically, the US is today reported to have reached out to Japan and the EU for support to introduce tougher WTO regulations on government subsidies in a bid to further increase the pressure on China, where the US believes state support is distorting competition. To the extent that this may be a way to bring the US back into the WTO fold, it has found support from the EU. But it comes just a day before the US and China are supposed to sign their phase one trade agreement, in which China will agree to buy at least $200 bn of US exports over the next two years whilst the US will commit to rolling back some of the tariffs it has levied on China (though by no means all).

One of the concerns ahead of the publication of the deal is the extent to which the phase one agreement will fall foul of WTO rules. If, for example, it requires China to import a specified amount of US produce, this would amount to managed trade and thus violate WTO rules. There is also a concern that China may simply import less from other WTO members whilst raising its imports from the US. All this goes to reinforce the views expressed by nineteenth century British prime minister Lord Palmerston that “nations have no permanent friends or allies, they only have permanent interests.” China is very much in the sights of the US but the EU fears that it, too, could fall foul of the Trump administration’s trade policy. Meanwhile, China may well be prepared to acquiesce to US demands for now but at the expense of trade with other nations. And who is going to do anything about it? Not the WTO, which has been hobbled by the US!

At the current juncture, it does look as though we are going back to an era of power politics on trade issues, with the US and China increasingly operating in their own interests. I did point out last August that this was not the right time for the UK to go it alone on trade policy and I maintain – as I have done for the last three years – that the decision to leave the European single market is a dumb and short-sighted policy. As I noted in my last post, it is imperative that the UK strikes the best possible trade deal with the EU for it cannot rely on the kindness of strangers in what looks to be an increasingly hostile trade environment.

End the politics, bring on the economics

It is a sad indictment of our times that the passage of the Withdrawal Agreement Bill through the UK parliament was relegated to the inside pages of the newspapers by the manufactured furore of Harry and Meghan’s “withdrawal” from the Royal Family. Having spent the last twelve months trying to get the WAB across the line, MPs yesterday voted by 330 to 231 to pass the legislation that will enable the UK to leave the EU on 31 January. Whilst it has yet to be ratified by the Lords, this is merely a formality. Transition phase, here we come. 

A year ago things were very different. Having ended 2018 with the government being held in contempt of parliament and surviving a Conservative leadership challenge, Theresa May began 2019 with the most heavy defeat ever inflicted on a sitting government as her Brexit deal was rejected by MPs. She then had to face down a parliamentary vote of confidence. And it never got better for her, as her battered credibility meant that she could never deliver what she promised. Having sown the seeds of her own demise, May was eventually replaced by Boris Johnson who promised to “get Brexit done” and won an overwhelming election victory as a result. How did he do it? Quite simply, he took a direct approach and the defeats he suffered along the way, on issues such as proroguing parliament, eventually played to his advantage because they demonstrated that he was prepared to do whatever it took to fulfil the wishes of the electorate (as I noted here). 

But whilst Johnson has won the political battles hands down, the economics poses much more difficult challenges – a view which has always been at the heart of my opposition to Brexit. The visit to London of the new European Commission President, Ursula von der Leyen, acted as a reminder that this is a process which will be driven by the EU, and the UK has flexibility only in as much as it can choose its degree of compliance with the EU’s demands. Von der Leyen reminded her audience that there are trade-offs – something that British politicians have failed to be honest about over the past four years – and the more the UK wishes to deviate from the rules governing the single market, the less access it will have. She also expressed her doubts that the UK will be able to negotiate a full future-relationship deal and have it ratified by the end of this year (it is, in her words, “basically impossible”). But how do we square this with the Johnson government’s stated intention not to extend the transition period beyond end-2020? 

One way is that the UK simply does not attempt to replicate the full and comprehensive relationship with the EU that it has now. Under these circumstances the UK will aim for a lowest common denominator trade deal which will allow Johnson to claim that he has fulfilled his mandate to take the UK out of the EU without extending the transition period. It is pretty likely that this will focus only on goods trade, which has been the focus of the government’s attention up to now, whilst services continue to be ignored. On the assumption that some form of trade deal is agreed, at issue is the extent to which the UK is prepared to abide by EU standards. The greater the degree of divergence, the higher will be the barriers to EU trade which will make UK manufacturing even more uncompetitive vis-à-vis other EU economies.

This, of course, is the economic calculation. The political calculation is that voters do indeed want to “get Brexit done” and Johnson’s behaviour so far suggests he will do whatever it takes to deliver this, even if there is collateral damage along the way. Indeed, it has been reported from inside government that this approach is expected to play well with those traditional Labour voters who lent their support to the Conservatives at last month’s election.

But this does not mean it is economically sensible. Whilst it is unreasonable to expect most Brexit supporters to understand the economics – this is after all a matter of the heart for many – there remains a wilful misunderstanding of trade issues amongst the better educated supporters of this policy. I was told just recently that Brexit will allow the UK to unshackle itself from a moribund EU. This is a good thing, I was told, because the share of the EU in world GDP continues to fall so it makes sense to leave and strike trade deals with faster growing regions. I intend to look at the UK’s external trade position in more detail another time, but let’s deal with these points which I thought we had put to rest years ago (clearly not).

It is true that the EU’s share of world GDP has fallen – on my estimates using data in real terms, which allows us to abstract from exchange rate swings, I reckon that the EU’s share (ex UK) has fallen from about 23% in 1980 to around 14% today. But the US share has also fallen, from 19% to 15% over the same period and the share of what I call “consuming countries” (Europe, North America and Australasia) has declined from 45% to 30%. What does this tell us? Simply that if one country grows more slowly than another, its share of GDP must decline as a matter of simple arithmetic. Moreover, the fastest growing economies have been enabled in their quest for growth because they are exporting countries. The UK might have a chance of boosting exports if growth in these countries is based on domestic demand, but it isn’t. The flip side of this is that the UK’s  imports from the world's fastest growing economies have been growing more rapidly than exports. As a result the UK’s trade deficit with China has increased more rapidly than that with the EU over the past 20 years (by a factor of 10 versus 8 for the EU).

We also have to account for pesky details such as incomes per capita. All of the world’s most rapidly growing economies have incomes per head which are lower than the EU. Chinese GDP per head, for example, is around a quarter of the EU average in USD terms (chart). And we can forget about the artificial construct of PPP comparisons – it is the absolute level of income which will determine whether China can afford to buy what the rich world wants to export to it (at a price that makes it worthwhile for European economies). And China is a lot further away, implying higher transport costs. It is for this reason that the analysis of trade issues based on gravity models continues to support the view that economies that are situated close to each other and which have similar levels of income tend to trade more with each other. 

Anyone believing that leaving the European single market will allow the UK to tap into more rapidly growing export markets is wrong. Doubtless there will be those who will tell me that that the Brexit issue is settled and we should all get behind making it a success. But the best way to make it an economic success is not to rush into making a shoddy trade deal by adhering to an artificial deadline to satisfy political ends. Unlike last year, when there appeared to be some grown-ups in government able to understand these issues, I fear they are fewer and further between today. But that’s what we voted for, right?

New year, new concerns

We have barely started the year and already a number of issues have surfaced which are likely to impact on the global macro picture. In the first instance, the decision by Donald Trump to order a missile strike that killed Iranian general Qassem Suleimani threatens further destabilisation in an already febrile Middle East. Markets reacted negatively, as is often the way with such events, and although nobody knows for sure what the longer term implications will be, this sort of provocative action has the potential to generate a spiral that nobody can control. At a time when the global economy has already lost momentum, a spike in uncertainty does not bode well for markets, although as I noted a few days ago, markets have developed a habit of defying bad news. 

Nonetheless, equity markets would appear to be due a correction. After a massive rally in 2019 driven by Fed rate cuts, I cannot see this being repeated in 2020. To a large extent, the rally of 2019 felt a bit like the late cycle surge of 1999 when markets were driven by irrational exuberance. With the economy in the industrialised world likely to shift down a gear, and Chinese growth at its slowest since the late-1980s, the fundamentals underpinning the markets appear less favourable. There again, equities remain the asset class of choice so unless we experience some form of major random shock, it might be too pessimistic to expect a bearish correction (in the sense of a decline of 20% or more) but upside is far more limited than a year ago. 

A second issue is climate change, which is rising up the list of things that policy makers should be paying more attention to (although in fairness, European policy makers have done more than most). The pictures splashed across our TV screens showing the extent of the bush fires in Australia are a measure of how the climate appears to be changing, and such issues are likely of be one of the key economic issues of the next decade. As long ago as 2006 the Stern Review set out the economic implications of climate change, pointing out that business as usual practices will lead to increasingly higher economic costs. The report highlighted that although the costs of climate mitigating investment are high, the costs of doing nothing are potentially even greater. When Australia’s prime minister, Scott Morrison, argues that there is no proven link between the bushfires and climate change,  it is clear that politicians have not heeded the message of the Stern Review even after 14 years. And when Donald Trump sees fit to withdraw the US from the Paris Agreement on climate change it is obvious we have a problem. Undoubtedly, we are going to hear a lot more from Greta Thunberg this year and in years to come. 

Central banks have started to make lots of noise about climate issues with Christine Lagarde suggesting it should be a “mission critical” priority for the ECB. Although climate change does not pose an immediate risk to the financial system, there are concerns that rising payouts as a result of climate-related issues could pose solvency problems for insurance companies, or that loans secured against property at risk of flooding could increase the burden of banks’ bad debts. There are those who criticise the actions of central banks’ intervention in this area, arguing that if they get involved in climate issues what is to stop them widening their remit into other areas? Whilst there is some truth in the argument, it is merely another example where central banks are providing a lead on policy issues where governments are unwilling or unable to step up to the plate. 

Above all, politics will remain one of the dominant themes of the year, indeed decade. The big event of 2020 will be the US presidential election. A few months ago I would have said that the odds were in Donald Trump’s favour as he seeks re-election. I am less sure today. A lot will depend on how impeachment proceedings go; how the rest of the world reacts to the US intervention in the Middle East and who Trump’s Democratic opponent is. One thing is highly likely, however: It will be an even nastier campaign than in 2016.

Closer to home, 2020 will be the year that the UK finally leaves the EU – almost four years after the narrow vote in favour of doing so. The Conservatives’ huge parliamentary majority should prevent a repeat of the fractious discourse that characterised 2019 but many battles lie ahead. I still maintain that the economic risks associated with Brexit outweigh any possible economic benefits (which continue to elude me) but the real cost burden will only become evident in the longer term. I suspect that as the year wears on, Boris Johnson’s government will begin to find how difficult it is to deliver the benefits he has long promised. 

One of the issues which will continue to dominate the agenda in 2020 will be that of fake news. Political discourse has blurred the boundaries between fact and fiction and this will be writ large throughout the presidential election campaign. We increasingly appear to live in a series of parallel realities, with the political dimension ever more separated from the rest of the real world. A return to evidence based policy making is not something that I expect to see this year. But without it, I fear the errors that have characterised recent years will continue to mount up. If economics stands for anything it is to aid policy decisions based on the evidence before us. Many of the political debates which invoke economic arguments, notably Brexit but also the US policy on trade, are based on a fundamental misunderstanding of the evidence. Whilst they have not yet significantly impacted on the lives of voters in Europe and the US, sooner or later there will be an economic reckoning. This may not become evident in 2020 but as they fail to deliver the promised benefits the pendulum will start to swing slowly back.

Reflecting on a turbulent past

Not only is the last day of the year but it is also the end of a long and troubled decade and as usual at this time of year I want to spend a little time looking back. Looking first at 2019, how did I do in terms of my big calls?

2019 in review

In terms of the economics, I did broadly OK, arguing at the start of the year that “it is unlikely that we will see recessions in any of the world’s major economies this year.” That said, it was a bit touch-and-go in Germany for a while and the euro zone economy slowed by more than I anticipated, largely because the US-China trade dispute caused more damage to Europe than expected. Indeed, the global economy felt a bit softer than we had hoped, partly due to trade issues but perhaps because the economic expansion in place for the last decade is long in the tooth.

Whilst I was overly optimistic on the economy, I vastly underestimated the markets’ capacity to defy gravity. We have seen double digit rates of return across the equity space, with key US markets up by more than 25% year-to-date although over a two-year horizon, the gain is only around 20% (chart). I could kick myself for missing out on that opportunity but I’d probably miss! Monetary policy was the driving force here, with Fed rate cuts that were not foreseen at the start of the year giving markets a shot in the arm. Although I hold to my view that equity markets are overvalued, increasingly we cannot look at individual asset markets in isolation. Investors continue to pile into equities because the alternatives are dire. When large parts of the fixed income universe are yielding negative returns, there is every incentive to chase the higher dividend yields generated by equities – not to mention the prospect of a decent capital gain.

As for politics, I was right in predicting that the UK would not leave the EU without a deal, but that was a long and tortuous process that nobody wants to repeat. But I was wrong in suggesting that “impeachment proceedings will not be initiated against Trump”. Clearly the Democrats believe that the political calculus has changed and that it is worth their while to follow through, even though their chances of removing President Trump from office appear slim. And finally in terms of my 2019 predictions, I did not see the emergence of Christine Lagarde as ECB President, but I was glad to see that the BoE did indeed “look no further than FCA Chief Executive Andrew Bailey” in finding a successor to Mark Carney.

The 2010s in context

This being the last day of the decade, it is worthwhile examining how far we have travelled in the past 10 years. At the end of 2009 we were coming off the back of the biggest peacetime economic collapse in 80 years. The outlook for the year ahead was not especially bright but the general belief was that within a few years growth would recover to pre-crisis trends and that monetary policy would slowly normalise. Neither of these things has happened in Europe.

Although European politicians are reluctant to admit it, we are experiencing a form of Japanification. One of the defining features of the post-bubble Japanese economy was that the slowdown in population growth occurred at the same time as policy makers were struggling to cope with the after-effects of the bubble. This meant that they did not notice the slowdown in trend growth until it was too late. In Europe, baby boomers have retired in droves over the past decade, with the result that the contribution to potential growth from labour has diminished and in the absence of a boost from capital investment, European potential growth is now much slower than before the financial crisis.

However, this does not justify holding interest rates near zero for so long (let alone in negative territory as the ECB has done). I maintain, as I have done for a long time, that the costs of this policy will ultimately outweigh the benefits (if they haven't already). Over the next decade, we will feel the costs in terms of our nugatory pensions. And I continue to wonder whether part of the reason for weak investment activity is because low interest rates mean low rates of financial return.

But the biggest change over the past decade has been in the political field. Nationalism is the order of the day in many parts of the world and finds its most obvious expression in the form of Trump and Brexit but it is bubbling away across Europe and Asia. A decade ago, Barack Obama was the cool president for a new America but in less than a decade he was replaced by an angry populist with plenty to say but no clear policy ideas. Similarly, Grexit was starting to rise up the worry list a decade ago but it is the UK which is about to leave the EU.

As I have noted before, both these issues reflect the failure of centrist politics. Politicians overpromised and under-delivered in the wake of the crash but electorates now want leaders who will take action rather than offering jam to tomorrow. Unfortunately the issues we face are more complex than politicians are prepared to admit in public. Demographics are changing the face of European economies and will force politicians to take some hard choices when it comes to allocating resources. The rise of China has also changed the political calculus in the US and Europe and will continue to shape world events in the 2020s.

If you have read this far, however, thanks for sticking with it and congratulations on surviving another year - indeed another decade. I wish you all a peaceful and prosperous New Year.

Forecasting the UK economy. How did we do in 2019?

David Smith is one of the UK’s top economic journalists and his pieces for The Times and Sunday Times are always worth a read. Since the 1990s Smith has devoted his final column of the year to an assessment of how those who provide forecasts for the UK economy have fared over the past year and 2019 was no exception (here for the full article if you can get past the paywall. Otherwise here). The good news is that most forecasters did pretty well, though if anything they were too optimistic on GDP growth and the extent to which the BoE would hike rates.

Digging into the details, Smith’s methodology is based on an assessment of five indicators – GDP growth, Q4 CPI inflation, current account, unemployment rate and Bank Rate. Using the projection provided by each forecasting group to HM Treasury’s compendium of economic forecasts in the previous January, he provides a scoring system to rank how each group fared. The first caveat is that we do not yet have a full year of data for any of the items except Bank Rate so the rankings may be subject to change once the data for the remainder of the year are released. But I have always had a bigger issue with the somewhat subjective way in which points are allocated (see footnote of Table 1 for details). Moreover, there is a bias towards the growth and inflation forecasts, each yielding a possible maximum of three points whereas only one point is awarded to each of the unemployment rate, current account and interest rate forecasts. And there is always a bonus question designed to ensure that the theoretical maximum number of points sums to 10.

In my view, the trouble with this ranking is that it does not sufficiently penalise those who get one of the forecast components badly wrong – the worst that can happen is that they get zero points. Moreover, since the competition is designed to look at all five components, my system imposes a bigger handicap on those who do not provide a forecast for all of the components (which may be a little harsh, as I discuss below). My ranking system thus uses the same raw data and assumes the same outturn as Smith but measures the results differently and (I hope) reduces the degree of arbitrariness in allocating points. For growth, inflation and the unemployment rate, I measure the absolute difference of each forecast from the outturn (in percentage points). Assuming the same outturns as Smith, GDP growth in 2019 came in at 1.3%; the Q4 inflation rate at 1.5% and the unemployment rate at 3.8%. Thus a GDP growth forecast of 1.5% is assigned an error value of 0.2 (=> ABS(1.3-1.5)); an inflation forecast of 2% results in a value of 0.5 (=>ABS(1.5-2)) and an unemployment forecast of 4% produces a value of 0.2 (=>ABS(3.8-4)).

For quantities such as Bank Rate and the current account, I apply different criteria. Interest rates normally change in steps of 25 basis points so the forecast error is measured as the error in the number of interest rate moves (again the sign of the error is irrelevant). For example, if the forecast in January was for Bank Rate to rise to 1% but it in fact remained at 0.75%, the error value is one (=> ABS(0.75-1)/0.25). With regard to the current account deficit, measured in billions of pounds, I assume forecast errors proportional to each £10bn absolute error (i.e. independent of sign). The outturn is assumed to be minus £90bn, so a group whose January forecast looked for a deficit of £85bn is assigned a value of 0.5 (=> ABS(-85+90)/10).

Having summed up all the error points, I then subtract the number from 10 to derive a value in the range 0 to 10 (the figure can technically go negative, in which case I assume a lower value of zero). However, the astute amongst you may already have spotted that the units involved in the current account forecast are big, so that failure to provide a forecast will become a problem. Indeed, those not providing a forecast are assumed to have input a value of zero, giving them an error value of 9 points (=>ABS(0+90)/10). This becomes a problem for the likes of HSBC, which finishes second in Smith’s rankings but drop way down on the basis of the methodology outlined here, but also Daiwa and Bank of America. This is unduly harsh and we need a better way to take account of zero forecast entries whilst still putting them at a disadvantage compared to those groups who provided an input. One option is simply to assign an error of two points for each missing forecast, on the basis that a group which fails to provide any input for each of the five categories would score zero (10 - 5 x 2).

Having made this correction, we are in a position to look at our revised rankings. Whereas in Smith’s original article, the Santander team came out on top, my rankings give the accolade to Barclays Capital largely because Santander’s current account forecast cost them two points whereas the Barclays team lost only 0.75 points. Honourable mentions also go to Oxford Economics and the EY ITEM team. Who lost out? One of the big losers is Schroders Investment Management, which appear near the top of Smith’s rankings but the fact that they predicted four interest rate hikes when there were no changes, cost them four points. This strikes me as fair. Interest rate projections are a key component of any macro forecast so it is only right that teams get penalised for bigger errors. HSBC slip from second to eighth on the basis that they did not provide a forecast for the current account, which is unfortunate but if it is included in the assessment criteria we have to take account of this. Had the current account been excluded, Santander and HSBC would have held onto their top two places. The revised rankings also put the pro-Brexit Liverpool Macro Research group at the bottom after a poor performance last year.

As for my own performance, I must confess that I did rather better than in Smith’s original ranking, rising to fourth (last year, this methodology would have put me second). I am not going to claim that there is no element of self-justification in the rankings but I have always thought that there was a better way of using the data to derive an ordinal ranking scale over the interval 0 to 10. But perhaps a more important lesson to come out of the analysis is that for all the criticisms of economic forecasting, those involved in making projections are to be congratulated for putting themselves on the line and being prepared to show their errors in public (equity and FX strategists take note). 

Moreover, despite criticisms from the likes of Eurosceptic MP Steve Baker who once said in the House of Commons that “I’m not able to name an accurate forecast. They are always wrong”, we have done pretty well in the UK over the past 2-3 years. And whilst, like football managers, forecasters are only as good as their last projection, I will wager that growth in the UK next year will continue to underperform relative to pre-referendum rates, whether or not Brexit is “done”.