Stay positive or turn negative?

In recent weeks the Bank of England has given the impression that it may be prepared to take interest rates into negative territory. Although the debate has gone a bit quiet of late, it has not gone away, perhaps because the BoE believes the economic collapse in April was not quite as bad as previously expected or, and this is my preferred take, it was only ever a device to jawbone market interest rates as low as possible.

The economist Silvio Gesell was one of the first proponents of negative interest rates in the nineteenth century when he proposed a tax to dissuade people from hoarding cash. But it was never seriously tried in a policy context until the Swiss introduced a policy of negative rates in the 1970s in a bid to prevent foreign investment flows from driving the franc higher. However the policy was deemed a failure and the idea was eventually abandoned in 1978 after an experiment lasting six years. In the wake of the 2008 financial crisis the idea came back onto the agenda with Denmark being the first mover, again as a means to hold the currency stable. This time, other countries followed suit with the likes of Switzerland (again), the euro zone, Sweden and Japan all driving rates into negative territory. Both the US and UK have resisted the charms of negative rates, largely because there is a presumption in the Anglo Saxon world that the monetary transmission mechanism ceases to operate properly with interest rates below the lower bound.

There are many good arguments against negative rates

In the current policy framework, the banking sector is charged a negative interest rate on its cash deposits at the central bank. Banks have an incentive to run down their cash holdings and either lend more into the wider economy or pass on the negative cost to their customers who run down their money holdings, and in the process stimulate the economy as they spend their cash. However, low interest rates and flat yield curves distort time preferences for households and companies, which results in sub-optimal resource allocation (e.g. they allow zombie companies to operate which would otherwise cease trading). Central bankers who have observed the experience of Japan over the last two decades cannot be blamed for calling into question the usefulness of ultra-lax monetary policy. Ironically, in the late-1990s I remember half-jokingly suggesting to a Japanese economist that the BoJ should consider negative rates. It was probably not my greatest idea in retrospect.

Furthermore, ultra-loose monetary policy distorts markets. By reducing the returns to cash holdings, investors have an incentive to seek higher returns by loading up on risky assets, which in turn results in widening disparities between market prices and fundamentally justified levels. No investor would question the view that low rates have helped markets to blow out.

For all that, there is no good reason in theory why interest rates should not go negative.  After all ancient mathematicians regarded negative numbers as “false” and it was not until the late seventeenth century that respectable mathematicians such as Leibniz began to take them seriously in Europe. Today, however, we are all familiar with the concept and we might wonder why they were ever regarded with such suspicion.  Moreover to the extent that real economic quantities respond to real interest rates, we have long become used to the notion of negative real rates with nominal interest rates lower than inflation.

Yet there is something of the taboo about a negative nominal interest rate. Perhaps one reason is that the interest rate represents the cost of time: it represents the return derived from waiting; from saving rather than consuming. Perhaps it offends the Puritan streak in the western psyche. Or maybe because the arrow of time only runs in one direction, a negative interest rate somehow inverts the cost of time and is therefore perceived as unnatural. Whatever the reason, many people have difficulties with the concept of negative central bank rates.

For all the evidence amassed by the likes of the ECB suggesting that negative rates have helped to stimulate the economy, we should treat the arguments with a pinch of salt. Without any doubt, negative interest rates penalise savers. Unless we are forced to work long past our planned retirement date, we all need to make provision for old age and this is made all the harder by low or negative interest rates. There may be an argument in favour of temporarily trying to boost the economy by cutting rates into negative territory but the ECB has held the depo rate below zero for six years. I fear that a prolonged period of negative rates will ultimately prove counterproductive as individuals attempt to raise their precautionary saving.

But consider this …

One of the key features of all the countries that have experimented with negative rates so far is that they run a current account surplus i.e. there is a surplus of domestic saving with respect to investment (chart). Both the UK and US run current account deficits – they suffer from deficient domestic saving. At first glance, you may ask whether negative rates in these economies are such a good idea if they encourage further dissaving. In a static framework, they are not. But let’s try to think through the dynamics. Encouraging households to bring forward spending should widen the current account deficit in the near-term and ought, in theory, to result in currency depreciation. This in turn should generate higher imported inflation, which after all is how central banks have justified their actions, and allow them to respond by returning interest rates towards positive territory.

In this framework the key transmission mechanism is the exchange rate. If the cut in interest rates is not sufficient to produce concern in the FX market, the negative interest rate policy will not have the desired effect. This might be because the pickup in consumption is insufficient to generate a current account deficit so the currency market remains unconcerned. Or it might be due to the fact that the currency in question (the likes of the Swiss franc, yen and euro) acts as a safe haven, particularly since rates elsewhere are also extremely low. In either of these cases, perhaps interest rates will have to be pushed so far into negative territory to have the desired effect that the side effects would be unacceptable. But this begs the question whether they would work better in an economy which already runs a current account deficit, and where the FX market is perhaps more sensitive to external deficit concerns. The pound would certainly be such a candidate.

I would be hesitant to advocate the BoE cutting interest rates into negative territory because the experience elsewhere shows that once they go below the zero line, it proves difficult to get them back up again. But if I were a maverick on the MPC I would at least try to ensure that this argument gets a hearing and make the case for a short, sharp dip into negative territory with the unspoken assumption that they will be raised after (say) two years. There is nothing to be gained by holding rates below zero for long. But there also seems little to be gained from a prolonged period of holding them so close to zero they might as well be negative.

Four years on

It is four years to the day since the British (or more specifically, the English and Welsh) electorate voted in favour of leaving the EU. I look back to the spring of 2016 with bemusement. An angry electorate, struggling to cope with the economic fallout of the 2008 crash, was told that Britain would enjoy a better future outside the EU. Many of them needed something to believe in, so why not wipe the slate clean and start again? As a marketing campaign, it was brilliant. As a true representation of the future facing the UK outside the EU it was a pack of lies. As with all lies, it starts to catch up you eventually. We are not quite at that point yet, but we are getting there.

Whilst Brexit has technically happened, in the sense that the UK is no longer a member of the EU, the UK has not finalised the nature of its long-term trading relationship with the EU. This despite the fact that former Trade Secretary Liam Fox told the BBC three years ago that reaching a Free Trade Agreement with the EU should be "one of the easiest in human history.” Fox is not alone in making grandiose claims that do not stand up to scrutiny and one of the least edifying experiences of the last four years has been hearing frontline politicians, including the man who is now prime minister, lying through their teeth about the benefits of leaving the EU. Many of those who suggest that leaving the EU will not be a problem for the UK are unfit for office for one of two reasons. Either they know that what they are saying is untrue, in which case their conduct makes them unfit for office, or they truly believe it in which case their competence is in question. As the Covid-19 crisis has made plain, if governments fail to prepare we should prepare ourselves for failure.

I have argued at length why the UK’s policy on immigration is misguided, and how prior to the referendum the data were wilfully misinterpreted to generate a false narrative. I have pointed out on numerous occasions how growth will be adversely affected, particularly since the government chose to interpret the result as a vote for leaving the single market, despite being assured that “absolutely nobody is talking about threatening our place in the single market.” I have also expressed concerns about how the suspension of democratic accountability to deliver Brexit sets a worrying precedent. At root, I have never understood the logic of those who want to give up the power to write EU regulations because it somehow makes the UK stronger. At least Boris Johnson can look back at the last four years with some satisfaction, for his dissembling and willingness to subvert constitutional norms has propelled him from backbench MP to the position of prime minister. He clearly backed the right horse.

Whilst the litany of errors and government overreach is now water under the bridge, there is a price to pay. It comes in the form of erosion of trust in government. Perhaps most voters take the view that governments routinely lie anyway and that Brexit was just another in a constant stream of untruths. However, the basis of a strong democratic system is an open accountable government, which is held to account by the media. Not only has the government not been open about Brexit but cheerleaders in the press have stirred the pot still further (remember this headline?) So low has the reputation of parts of the UK media fallen that it currently stands 35^th in the RSF index of press freedom, behind 19 EU countries and a miscellany of countries including South Africa. Ten years ago it could claim a place in the top 20.

Whilst my objections to Brexit have been set out on this blog in detail, I hope I have made it clear that my concerns relate primarily to the economic consequences and the lengths to which the government will go to deliver an ideologically driven policy that flies in the face of the economics. Simply put, I do not like being lied to by those whose salary I pay to represent me. I have never been a great fan of a second referendum and I can live with leaving the EU if many of the economic advantages of membership are maintained. Had the UK approached the process of leaving differently, by setting out a clear plan of what it wanted and not engaging with the EU in an antagonistic manner, the process of leaving could have been so much easier. As it is, the British government has officially ruled out any extension of the transition period beyond the end of the year, in line with its previous promises, which means that either it must form a trade deal with the EU by the autumn or leave without one, which implies relying on WTO rules.

Any agreement that is likely to be reached in the course of the next few months will be at best a “goods lite” deal. It will be far less comprehensive than membership of the single market and will not cover services. The government’s preoccupation with fishing over financial services does not sound like very credible economics. As for trading on WTO rules, it was a bad idea in 2016 and it is an even worse one today, now that Donald Trump has effectively neutered the WTO’s ability to arbitrate on trade disputes.

This brings me to my biggest current concern. Whilst it was misguided, not to mention undeliverable, a policy based on making trade deals with countries outside the EU could just about be sold as a bold step forward. But the election of Donald Trump has changed all that. The global institutional order has been badly damaged by his actions and the process of globalisation upon which Brexit was based is crumbling. The UK now finds itself caught between a nationalist US, whose policy towards China is unlikely to change whoever occupies the White House following the election, and China, which the UK no longer sees as a reliable business partner. As I warned in 2016, China will set the international trading rules to suit itself, and without the heft of the EU behind it the UK is about to set sail into the teeth of a global trade storm. All this, of course, is happening at a time when the economic impact of Covid-19 will make its presence felt.

The bottom line is that Brexit is no longer a policy fit for purpose (in my view it never was). It now represents the wrong policy at the wrong time. If the Conservative government feels compelled to deliver on the will of the people expressed four years ago, then so be it. But having consumed two prime ministers and requiring two general elections to get this far, the political costs of delivering Brexit are proving very high. In 2017, Boris Johnson wrote an article for his favourite daily newspaper arguing that “we will be able to get on and do free-trade deals, to campaign for free trade … We will be able to intensify old friendships around the world, not least with fast-growing Commonwealth economies, and to build a truly Global Britain.” He has to start delivering on his promises if Brexit is not to be seen as a self-indulgent policy which appeals to a small section of a dwindling part of the electorate - the Conservative party.

Labour pains (revisited)

I have been very critical of the UK Conservative government over the years – and with good reason – but just to show my even-handedness, I thought it worthwhile to reflect on the performance of the opposition Labour Party following the recent publication of its 2019 election review. According to the authors of the report, Labour suffered a heavy election defeat because Jeremy Corbyn was a deeply unpopular leader amongst the wider electorate and its policy on Brexit was confused. The authors also referenced deeper seated issues, as the party increasingly lost touch with its core support – a problem which was masked by the relative outperformance relative to expectations in 2017 – with the result that “Labour has a mountain to climb to get back into power in the next five years.” 

But cast your mind back five years, and three elections, ago and Labour had just lost a general election in which they were expected to run the Conservatives very close, running neck-and-neck in the opinion polls right up until election day. Although it was anticipated they would win the most seats, the Tories were expected to fall short of a majority and would be forced to form another coalition with the Lib Dems. In the event, they won a majority of 12 seats. Whilst the Tories then unleashed Brexit on an unsuspecting British public, Labour went into full introspective mode and decided that the key reasons for their defeat were: (i) the fact that they remained tarnished by the myth the previous Labour government was responsible for crashing the economy; (ii) an inability to deal with “issues of connection” like immigration and benefits and (iii) Ed Miliband was judged to be not as strong a leader as David Cameron. 

Quite how the election of Jeremy Corbyn as leader following Miliband’s resignation was meant to address any of those issues was lost on me – and indeed most voters. In the words of The Economist “Mr Corbyn has been the party’s most disastrous leader ever – not just useless … but positively malign.” That he was unelectable as prime minister was obvious from day one. In a client note I put out in September 2015 just after he was elected leader, I wrote “Simply put, Mr Corbyn is an old-fashioned socialist and is a throwback (at least in British terms) to a political group which was believed to have become extinct in the 1980s … Mr Corbyn is unelectable. None of the analysis performed in the wake of the May general election suggests that Labour failed to win a majority because it was not sufficiently socialist – indeed, quite the opposite.” I take no pleasure in being right. 

Worse still, Corbyn was one of the facilitators of the breakdown in current British politics.  To quote The Economist again, “his failure to throw his party’s weight behind the Remain campaign contributed significantly to Britain’s decision to leave the EU, which most of the membership opposed. His refusal to meet Theresa May half-way during the dying days of her administration killed off any chance of a soft Brexit. His extreme politics and sanctimonious style drove traditional Labour voters into Boris Johnson’s arms.”

It is hard to disagree with any of this. Indeed, a lot of the blame for the fact that Boris Johnson’s inept government can theoretically continue in office for another four years can be laid at Corbyn’s door. But bygones are bygones and the big question for Labour is whether the party can recover. For my money, it can. For one thing, the election of Keir Starmer as party leader has put a centrist politician in charge. I have noted previously that Labour performs badly when it tacks too far to the left and Starmer will drag them way from some of the positions supported by Corbyn which were guaranteed vote losers. For the record, I am a university contemporary of Starmer and remember him standing as a student politician on a moderate Labour platform at a time when the party was run by left-wing zealots.

Whilst I maintain no party political affiliation it is important for the health of democracy that a strong opposition is able to put pressure on the government to act in the interests of all the people and not just its supporters. The abject performance of Johnson and his government is a reminder what happens when the opposition enables a poorly organised government and fails to hold it to account. But as bad a prime minister as Johnson is proving to be, few people believe that Corbyn would have been any better. Aside from having to deal with the Covid-19 crisis, which would try any leader, Labour’s position on Brexit was extremely muddled and it is far from clear how they would have handled it. Politicians on all sides are to blame for the disjointed position in which the UK finds itself. Naturally the government has to carry the can. But Jeremy Corbyn’s failure to provide leadership when it was most needed should neither be forgiven nor forgotten.

Get a grip

I received a text yesterday from an old friend who was incensed at the conduct of Boris Johnson’s government over the provision of free school meals to the children of poor families during the Covid-19 crisis. For those not following the story, the Man United footballer Marcus Rashford issued a plea to the government to continue the practice during the summer but the government announced on Monday that it would not do so. Following a host of bad publicity on social media, the government yesterday reversed its stance. In the words of my buddy, “The PM, no. 10 and the whole government have been made to look useless by a 22 year old footballer.” He went on to make the point that the government’s inability to make decisions on key policy matters is increasingly harming the electorate be it health, the economy or Brexit.

He speaks for many. Indeed, the United Kingdom could not be a less appropriately named country at the present time. For one thing the fact that the monarch is a woman makes it a Queendom, but perhaps more importantly it is far from united. It is fighting what appears to be a culture war in which the respective factions see only the righteousness of their arguments whilst dismissing those of their opponents. What passes for public debate takes place in an echo chamber in which the volume is being cranked ever higher (viz. the demonstrations in the streets last weekend) and matters have come to a stage where people appear to identify more with what they oppose than what they support. As an economist who still believes in rational evidence-based policy, this is all very disheartening. 

The origins of (culture) war 

Like many wars, the origins of the present conflict lie deep in the past and people may differ as to the proximate causes. For my money, a key turning point occurred around 1979-80 with the election of neo-liberal governments in the US and UK which subsequently gave primacy to the markets over the state and heralded the breakup of the post-1945 consensus. It unleashed a conflict between traditionalists and progressives, conservatives and liberals, hawks and doves etc. The shared values which had characterised the reconstruction of the post-war global economic order began to fray, particularly following the collapse of the Soviet Union. 

This was particularly apparent on the right of the US political spectrum, the lessons of which were absorbed by many in the UK. Remember the efforts by US Leader of the House Newt Gingrich to shut down Congress in 1995-96 purely for political reasons? Or the attempts to impeach President Clinton in 1998-99 as the political right became desperate to deliver a political knockout? This was followed by the rise of the Tea Party movement which subverted the Republican Party and propelled Donald Trump into the White House.

On this side of the Atlantic, the culture war has been fought less aggressively but it has been bubbling away nonetheless with some of the tricks from the US playbook having been adopted in the UK. The rise of the Tea Party is mirrored in the emergence of UKIP and the Brexit Party whilst the politically motivated Congressional shutdowns found expression in Boris Johnson’s attempt to prorogue parliament. The leitmotif of the UK culture war was Euroscepticism. Many Conservatives who never quite got over the deposition of Margaret Thatcher in 1990 rallied behind this cause, culminating in the Brexit referendum of 2016 and lighting the touchpaper of division which had been simmering for some time. For many on the right, Brexit represents the Trumpian equivalent of draining the swamp: It was the culture war writ large as Brexiteers made out that this was an opportunity for the politically disenfranchised to take back control. This was hogwash in 2016 and as the events of the past four years have shown, it still is.

Far from resolving anything, the divisions sown by Brexit have widened. The referendum was won by a narrow majority and the government has done nothing to assuage the concerns of those who voted Remain. And whilst it is true that in the December general election the party which promised to “get Brexit done” won the biggest parliamentary majority since 2001, much of the evidence suggests this was less due to the fact that people had a favourable image of the Conservatives than they had a negative view of the Labour Party under Jeremy Corbyn. 

Boris Johnson’s problems are piling up

Whatever else we may think of Boris Johnson he is a brilliant political salesman – he is, in short, a populist. He is also a product of the culture war in which his set of political values is rooted in a vision of a glorious imperial past. But this is where he may run into difficulty. The tectonic plates of the culture war have shifted – maybe temporarily but perhaps sufficiently to cause more permanent damage. This finds expression in the current strength of the Black Lives Matter movement, which runs contrary to the Johnson view of the UK’s imperial past and threatens to heap more trouble on a government which is now feeling the pressure (for German speakers interested in a Swiss perspective, I liked this article in the NZZ). 

His government’s handling of the Covid-19 crisis has been less than sure-footed and it has scored a number of own goals, most notably by failing to sanction Dominic Cummings, Johnson’s chief adviser, for breaking lockdown rules. It is also hard to imagine that the electorate will easily forgive the highest number of Covid deaths in Europe. We are only six months into what is scheduled to be a five year term for Johnson’s government. But the weaknesses inherent in his character mean that he has got off to a rocky start. As a populist, Johnson wants to keep as many people happy as he can but this is inconsistent with the credo of good governance which requires setting out a number of objectives and working out a plan how to achieve them.

These problems will be compounded by the fact the government will have to cope with the deepest recession in living memory. To turn things around from here requires discipline and hard work, neither of which the prime minister is noted for. I am reminded of the Conservative government of 1992-97 which was faced with an economic crisis early in its term (expulsion from the ERM) and which spent almost five years trying to get ahead of the agenda. It failed and was eventually swept aside by a Labour Party led by a moderate leader in the form of Tony Blair which condemned the Tories to 13 years in opposition.

This is not to say that we will necessarily see a rerun of the 1990s. But aside from getting Brexit done, it is not at all clear what Johnson’s government stands for. This makes it incredibly important that it gets Brexit right, by which we mean not compounding the economic damage. Failure to deliver on the signature policy at a time of mounting economic difficulties and the shifting sands of cultural change would end the career of most politicians. Boris Johnson is no ordinary politician but he has a lot of work to do to pull things around. Demonstrating leadership and running government to manage the country, rather than operating permanently in campaign mode, would be a good start.