Good governance matters: Part 1

The quality of government and governance matters like never before. It is the foundation stone of the institutional framework around which our economies operate, and the liberal democratic model which has done so much to generate prosperity over the last 70 years is very much in the firing line. Scarcely a day goes by without a reminder of how failure to execute good governance undermines the institutions necessary for the generation of prosperity. In the first of two posts, I will take a look at the bigger picture and why good governance matters for the economy before looking more closely at events in the UK where a series of government missteps threaten to pose major economic damage.

Different types of mismanagement but all have the same result

There have been numerous examples in recent years of the consequences of government failure. We need cast our minds back only a few weeks to the huge explosion which destroyed the port of Beirut. This was attributable to a government which in 2014 confiscated a large quantity of ammonium nitrate and failed to store it properly. Clearly the safety of the people was not high on its list of objectives and the episode demonstrates what can happen if governments pursue their own interests rather than those they are paid to represent. In the wake of this disaster, many people now see Lebanon as a failed state.

There are many slower-burning examples of what can happen when a prolonged period of mismanagement results in decay which can be covered up for a long time but eventually results in an inevitable collapse. An example of such a process is evident in Venezuela following the catastrophic failure of governance under the Chávez and Maduro presidencies. Another example is the policy paralysis and corruption in South Africa following years of misrule by President Zuma who mismanaged the economy to such a degree that it has registered an economic and social collapse comparable with wartime. Neighbouring Zimbabwe provides another example, where the Mugabe government ran the economy into the ground many years ago.

All these cases have one feature in common: The government in question used the resources of the state to personally enrich its members whilst ignoring the interests of the people they were put in office to serve. Government failure can also occur through the pursuit of ideological objectives, such as nationalist politics or a religious agenda, which also result in the erosion of the institutional framework. We see this in a number of countries where, as FT columnist Gideon Rachman put it the likes of India and Turkey are pursuing policies that “seek to fuse religion, the nation and the leader.”  For example, Narendra Modi has long campaigned in India on the basis of Hindu nationalism whilst in Turkey, Recep Erdogan’s government has moved away from the secularism of the country’s founding father, Kemal Atatürk. China and Russia have eschewed the religious element but both are engaged in a process of fusing the nation and the leader. We thus see Chinese nationalism expressed in the form of the “great rejuvenation” whilst the recent claims by Vladimir Putin that Russia has developed a COVID-19 vaccine reflect his efforts to score propaganda victories reminiscent of the Soviet Union.

The west is not immune to mismanagement and the US and UK have fallen prey to a nationalist/populist agenda which threatens to impose significant long-term damage to the institutional framework. Words barely do justice to the ineptitude of Donald Trump with Barack Obama criticising him for turning the presidency into “one more reality show that he can use to get the attention he craves.” The United States is the biggest economy and most technically sophisticated nation in the world, and is home to a great number of very smart people. Yet the government is headed by a man who cannot engage in intellectual debate and appears to have nothing positive to offer the electorate. Trump got by in 2016 on the back of the slogan “make America great again” by dog-whistling to an angry electorate that felt it had been left behind. The polls do not suggest he can pull the same trick in 2020 although we should not rule him out just yet.

Why government matters

Most of us in our day-to-day lives do not notice governmental ineptitude until it becomes a critical systemic problem. We are too busy just trying to get by. But the institutions which underpin our economy are often taken for granted and we only notice them if they are no longer there. Take, for example, access to the legal system. Article 7 of the Universal Declaration of Human Rights (UDHR) states: "All are equal before the law and are entitled without any discrimination to equal protection of the law.” But if access to the legal system is prohibitively expensive, as it is for many in poorer countries, they are unable to enjoy that equal protection. Restricting access in this way means that the legal process becomes the preserve of the well-off and entrenches inequality of opportunity. This does not just happen in emerging economies. In the UK, the government took the decision to restrict access to Legal Aid in 2012 which has reduced access for many lower-paid workers and resulted in many charities having to step in to help out those with problems related to housing and access to social benefits.

There is then an issue of the judiciary’s honesty and independence. In many emerging markets, the integrity of the judiciary is questionable. But even in the US, where honesty is not in question, successive US presidents have packed the Supreme Court with nominees reflecting their own ideological bent, thereby ensuring that their political philosophy can echo long after they have left office. This ideological stance matters because it shapes the way people behave which then impacts on the operation of the economy.

Restricting equality of opportunity, either indirectly by hindering access to the legal system or directly via other forms of discrimination, soon translates into inequalities in wealth and income. This has far wider reaching economic consequences. The economic literature suggests that high levels of income inequality have adverse consequences for health, particularly for those lower down the income scale. There are also impacts on educational achievement which is vital in delivering the skills relevant for modern, service oriented economies. Segregating children on the basis of parental income tends to perpetuate educational underachievement for poorer families since the evidence suggests children’s school success depends at least partly on the interests and aspirations of their peers.  

These examples clearly demonstrate the history of post-industrial revolution economies whereby they become richer when equality of opportunity is enhanced, thus generating positive externalities for the economy as a whole. It is thus no surprise that poorly governed economies, in which the government is focused on maximising its own interests at the expense of the electorate, tend to be economically poor. Western economies are not immune. Although Donald Trump has not been in office long enough to do real damage to the US institutional framework, his actions have damaged the US’s standing on the world stage. At least the damage caused by Trump may partially be reversed if he is voted out of office after four years. But in the UK, where the government imposed a permanent shift in the institutional framework on the basis of a dubious referendum, the economic and political damage will be longer lasting. That will be the subject of my next post.

Caution: Data in use

Data are the lifeblood of analytical research. If it were not for people willing to go out and track the positions of the stars in the sky, the theories of Nicolaus Copernicus would remain unproven and we would be operating on the misconception that the Earth was the centre of the universe. Albert Einstein would just be another clever theorist with some whacky ideas unless people were able to validate his theories by observation and measurement. On a more prosaic level, data matters hugely for modern policy issues as we need some form of benchmark against which to judge whether a policy is working.

As an economist I spend my professional life assessing economic issues on the basis of the evidence in front of me. I may not always be able to foretell the future but I can make a pretty good fist of understanding what is going on based on the data at my disposal. The data may not always be accurate or may be distorted by factors which hide the true message and one of the keys to decision-making is to understand how the evidence is compiled upon which decisions are based. This matters because decisions taken on the basis of faulty data risk making outcomes even worse. Two pieces of evidence released this week highlight the problems inherent in making policy based on uncertain data. 

(i) Covid data

The first instance is the measurement of Covid-19 deaths in England. It is well known that the UK has reported the highest number of deaths in Europe. But what is less well known to the casual observer is the figures assume that once a person is diagnosed as Covid-19 positive, their eventual death will be attributed to Covid-19, irrespective of the manner of their demise and how long after the initial diagnosis. For example, if a person was diagnosed as Covid-19 positive this year but dies a year later as a result of a grand piano landing on their head, they will technically still be classified as a Covid death. The rationale for this approach was that the authorities did not know much about the incubation period of the disease and did not want to be accused of under-reporting mortality figures in the early stages of the pandemic. Incidentally, this explains why, in contrast to many other countries, the UK did not report figures on recoveries. Once you have had the disease, that’s it – you are marked for life.

Obviously this is not particularly sensible. Consequently Public Health England this week imposed a limit of 28 days from diagnosis as the basis for measuring Covid-19 mortality, bringing it into line with Scotland, Wales and Northern Ireland – and indeed the international consensus. This makes a lot of sense: Broadly speaking, if you have not died 28 days after diagnosis, the odds are very much in favour of you remaining alive. This also changes the UK’s position in an international comparison. By my reckoning, the mortality rate is reduced from 70 per 100,000 of population to 62, which is much closer to the figures for Italy, Sweden and Spain. The UK still has the fifth highest global number of deaths but it no longer looks quite the outlier that it did earlier this week. Not that this is to excuse the government’s many failings in the way it handled the Covid pandemic, but by treating the figures on the same basis as other countries we have a more fair picture of how the UK stacks up in an international context.

(ii) Assessing exam data

The second data issue concerns the way in which school leavers’ ‘A’ level results were graded following the cancellation of this year’s exams. For those readers outside the UK, I should point out that the reporting ritual of exam results has become a staple of August news bulletins when there is nothing else for the media to focus on. Until recent years, the cry was that exams were becoming too easy and too many students were achieving top grades. In response to this media outcry, the marking was toughened up. So you can imagine the field day the media have had when it was impossible to hold exams at all.

There was never a satisfactory way to go about assessing what grades students would have achieved in the absence of exams. The starting point was to ask teachers to predict grades, but as Ofqual (The Office of Qualifications and Examinations Regulation) pointed out  teachers tend to offer optimistic predictions of their students’ ability. Teachers were thus also asked to provide “a rank order of students for each grade for each subject” on the basis that empirical evidence suggests people are better at making relative judgements than absolute judgements. Having collated all the evidence, Ofqual concluded that this would “likely to lead to overall national results that were implausibly high.” Accordingly, it had to find a way of normalising the results.

Unfortunately the model it chose is primarily based “on the historical performance of the school or college in that subject.” Even allowing for numerous tweaks, the system contains built-in discrimination against bright students from schools which in the past may not have delivered great exam results and is particularly biased towards independent schools which have a tendency to deliver above-average results. Ofqual argues there is “no evidence that this year’s process of awarding grades has introduced bias.” The data suggest otherwise: The number of A and A* grades awarded to independent schools increased by 4.7% compared to 2019, whereas the increases awarded to sixth form colleges, which tend to be attended by more disadvantaged students, was just 0.3% (chart). The data also show that the most disadvantaged students were more likely to have their predicted grades marked down: The proportion of pupils achieving a C or above fell by 10.4 percentage points among the most deprived third of pupils, compared to 8.3 percentage points among the wealthiest third. For anyone interested in an expert view of the problem, this series of Tweets is worth a read.

For a government that is trying to level up the life chances of those outside the south east of England (if you recall that was the promise in the 2019 election campaign) the 2020 exam process seems to be an odd way to go about it. Moreover, to the extent that young people’s exam results are one of the benchmarks which determine which university they attend, which in turn has a bearing on their future employment prospects, the importance of their exam results matters. Unfortunately, it is difficult to justify the rationale behind the algorithm which predicts exam grades thus devaluing their usefulness as a predictor of student ability. This in turn means that the data generation process becomes more important than the data which it turns out and is an example of why we should not always take data used to feed into policy decisions at face value.

As for the students, it is hard not to feel sympathy for them. They may or may not have gone on to achieve the grades predicted for them. But had they fallen short during the exams, they would at least have done so on their own terms. As it is, they have had grades imposed upon them by what appears to be a flawed data generation process, and judging by the popular outcry, it is not a decision that has played well with the public.

Taking stock of markets

It may be the dog days of summer but financial markets are still busy as we digest the implications of the dramatic second quarter earnings season. Latest estimates suggest that more than 80% of the S&P500 companies reporting so far have beaten earnings expectations, although this has a lot to do with companies issuing very pessimistic guidance in a bid to ensure a positive surprise and hopefully a boost to equity prices. It is an old trick but it seems to work and one of these days investors will get wise to it. Nonetheless, it has helped equity markets along with the S&P500 now just 1% shy of its mid-February peak.

Regular readers will recall I expressed concerns prior to the March sell-off that equities were overvalued. You might therefore think that the recent rebound is a cause for concern. But I am less concerned about the recent rally than I might once have been. For one thing, although risk indicators such as equity option volatility continue to edge lower, the VIX is still trading above its long-term average. It is notable that the VIX has come off its mid-March high of 83 to current levels of 22 (long-term average: 19.4) far more rapidly than in the wake of the 2008 collapse when it took 13 months to fall from the September 2008 high around 80 to levels around 22. This is one illustration of the impact that central bank liquidity provision has had on markets. In 2009 it took a while before markets realised that central banks were serious about ongoing liquidity provision. A decade on, markets have accepted the message that central banks mean what they say about providing all monetary support necessary and are investing accordingly. With no sign that central banks are about to pull the punchbowl, the liquidity support underpinning markets will be in place for a while.

Indeed whilst it is easy to make a case that prices are out of line with fundamentals, an environment of zero interest rates renders conventional metrics such as price-to-earnings or price-to-book ratios meaningless. This appears to be a market where investors feel they need to be invested in order to get some returns – after all, dividend yields continue to look attractive. It is possible that investor positioning will change once fund managers get back to work after the summer break, which is one reason why we see so many equity crashes in the autumn. But it is difficult to see where else investors can put their funds to work for a better return.

For all that equities might appear excessively valued, estimates of the equity premium are on the rise. The ERP reflects the required excess return over and above the risk free rate and past experience suggests it declines at a time when investors become less discerning about what they buy. On my estimates, which assume long-term dividend growth rate of 3.6%, the UK ERP is running at 820 bps. This is slightly down on the March peak of around 920 bps but is nonetheless high in the context of the past 25 years (chart 1). To a large degree, the rise in the ERP reflects the fall in bond yields whilst investors have not yet adjusted down their required earnings in view of the changed macro environment. Indeed, in a world in which trend GDP growth is lower due to slower population growth and limited productivity growth, and in which the Covid crisis will impact on earnings, so expected equity earnings are likely to adjust downwards. It appears we are in a world where investors expect a return to some form of “normality” as the current crisis passes. But just as the 2008 crash pre-empted a change to a new normal in the equity world, so Covid may be the catalyst for a “new, new normal.” Bottom line: Look for the ERP to edge lower in the medium-term.

However, we cannot afford to be complacent. Mounting fears of a second Covid spike, which could impact on the economy, and rising geopolitical tensions are good reasons for investors to raise the weight of safe assets in their portfolios. Nowhere is the flight to safety more evident than in gold where the price has established a new record in recent weeks above $2000/oz. I do have some concerns about how much further it can go. According to the World Gold Council, there were record flows into exchange traded funds over the first half of the year. To the extent that ETFs represent shadow demand for gold, and to the extent that a change in risk perception could see a sharp reversal of investor positions, there is a nagging sense that we are operating in elevated territory. That said, as with equities, there are no good reasons to expect an imminent downturn. After all, one of the conventional arguments against holding gold is that it is a non-interest bearing asset. But so, too, is cash these days. If the opportunity cost of holding gold is effectively zero it makes sense to overweight it in these turbulent times.

As a final thought, I have read a lot recently suggesting that investors’ fear of inflation as a consequence of recent central bank liquidity provision is one of factors driving gold higher. But evidence in support of the view is lacking. The break-even yield on 5-year Gilts, which reflects the difference between yields on conventional and index-linked bonds is currently running in negative territory at -8bps versus 60 bps at the start of the year (chart 2). Even the 10-year breakeven is trading at just 13 bps. To the extent that the breakeven rate reflects expected inflation over the lifetime of the bond, the data suggests that investors currently fear the current crisis will be disinflationary – or even outright deflationary – rather than adding to price pressures. In my view, the gold price surge reflects ongoing global uncertainty. It makes sense after all – an unprecedentedly high gold price reflecting unprecedentedly uncertain times.

Is the tide turning?

One of the mounting concerns over the last four years has been the extent to which policy is being conducted on the basis of belief rather than evidence – particularly in the Anglo-Saxon world. The danger was always that at some point those who ignored the evidence would start to come unstuck. We appear to be reaching this point. The question is whether voters are beginning to see through the bluster.

This was exemplified by two items that surfaced on Twitter yesterday from people who are not known for their adherence to evidence-based analysis. The first example was provided by the current occupant of the White House whose TV interview on Covid cases in the US was a car crash of epic proportions. Amongst other things, Trump failed to appreciate the importance of normalising the number of cases and deaths to account for differences in the size of population and appeared not to understand the argument that the journalist from Axios was putting to him. As much as anything, it showed up Trump’s inability (or maybe unwillingness) to engage in intellectual debate. It was far worse than anything I remember four years ago during the presidential campaign. Having recently watched the outstanding film Hillary by Nanette Burstein, I could not help wondering why the US public hated Mrs Clinton so much that they chose a reality TV star in preference to her as president (if you are interested in recent US politics, the film is a must-see). 

The second item was as bad, if not worse in its own way. This series of Tweets by former leader of the Tory party and Brexit hardliner MP Iain Duncan Smith, explaining why the EU Withdrawal Agreement was such a bad deal for the UK, was incredible. IDS argues that the EU wants “our money and they want to stop us being a competitor.” As if that were not enough, the following statement was both wrong and a masterclass in irony: “To avoid their own budget black hole, the EU gets £39billion as a “divorce payment” from us, reflecting our share of the current EU budget. But it gets worse. Buried in the fine print, unnoticed by many, is the fact we remain hooked into the EU’s loan book.” 

It is wrong because it fails to differentiate between the liabilities incurred by the UK which it must meet on its departure and some kind of exit payment. The UK is not somehow filling in holes in the EU budget. It agreed to undertake certain projects whilst it was a member of the EU and agreed that it must pay its share of the liabilities incurred. But the supreme irony is in the phrase “Buried in the fine print, unnoticed by many.” It is the job of MPs to scrutinise legislation. The text of the Agreement was published in October 2019. It then went through the UK parliament, where bills are debated three times by the House of Commons before being passed into law precisely to avoid any hidden items from sneaking through. So what precisely had he and his colleagues been doing prior to January 2020 when they voted by 330 to 231 to pass the Withdrawal Bill? 

The sheer absurdity of the ultra-Brexiteer position is difficult to understate. They clearly seek absolute autonomy over every aspect of the UK’s legal and economic framework without ever once acknowledging that no country in the world – not even the superpowers – have that kind of control. This handy little guide gives an overview of all the areas where the Centre for Brexit Policy think tank believes the UK should simply rip up any agreements with the EU in order to obtain absolute sovereignty. The people who believe this stuff are simply zealots who have no regard for how the international economy works. I have been calling them out for the past seven years but like cockroaches their arguments just won’t die, irrespective of how much logic you apply to them. 

They share with Trump a desire to break down the status quo without giving any real thought to what might come in its place. Their various projects run on finding grievances in order to stay relevant by tapping into the perennially dissatisfied. In a way, the worst thing that could happen to them is that we give in to their fantasies because then they would become irrelevant, having nothing to protest against. But that way madness lies, so we won’t go there.

All this begs the question whether voters think differently now compared to four years ago? In the US, Trump has had worse net approval ratings over the last three years than he is polling today but you have to go all the way back to summer 2017 to find them (chart). It is not a good look just three months before a presidential election. Nor do the polls find much support for Brexit (at least not in the form proposed by the British government over recent months). According to the European Social Survey, just 35% of Brits supported Brexit, with 57% wanting to rejoin the European Union. It is just one survey and we have learned not to trust the polls but this is consistent with the message coming from a number of polling sources in recent years. There is no appetite for the hard Brexit which the UK government says it is prepared to deliver. 

The collective cries of rage on both sides of the Atlantic were hailed in many quarters as the full throated roar of a population willing to take back control and make their respective countries great again. But after giving the electorate just four months to consider the immensely complex topic of Brexit, which was decided by the narrowest of majorities, politicians have had four years to implement it and now its leading protagonists do not appear to like what they voted for. In the US, such was Donald Trump’s popularity that he actually polled far fewer votes than Hillary Clinton. Indeed the vote deficit was the largest in history of anyone going on to be declared president (almost 2.9 million). There was no huge majority in favour of the populist policies on offer. And now that they are proving difficult – if not impossible – to live up to, maybe the sound you hear is that of the tide turning.