Good governance matters: Part 2

In my last post I looked at why the quality of governance is important for the wellbeing of the economy. In this post I look at some specific problems in the UK. Governance issues are something we associate with emerging markets where the institutions required to maintain the separation of government interests and those of the wider economy are often not embedded within a solid framework which protects their independence. Increasingly, however, western economies run the risk of falling into the same trap as nationalist politicians seek to undermine the framework in order that they can achieve their narrow objectives. 

This appears to be a particular problem in the UK which is undergoing a form of political revolution, though quite to what end and in whose interests is unclear. A few days ago I listened to an interview with Adrian Wooldridge of The Economist newspaper whose forthcoming book is titled The Wake-Up Call in which he explores how the Covid crisis has exposed the flaws in the model of western governance. He noted that we can trace the problems in the UK as far back as the 1960s when the hubris associated with being on “the right of history” meant governments took their eye off the ball. Wooldridge further made the point that over the past 40 years, as governments have tried to reduce the role of the state by contracting out service provision, they have also lost a lot of in-house expertise. This chimes with my long held view that the obsession with finding private sector solutions to state service provision often results in sub-optimal outcomes and is not proven to generate value for money for the taxpayer. 

Problem 1: Outsourcing government functions to the private sector 

There are numerous examples of how the outsourcing of public services to the private sector has resulted in less-than-ideal outcomes. Examples include the history of rail franchising where the main East Coast franchise covering the London to Edinburgh route has failed three times in a little over 20 years (one of these days I intend to look more closely at the issue of rail travel, since many of the flaws inherent in the current system were evident from the start way back in the 1990s). More widely, the National Audit Office two years ago issued a report on the Private Finance Initiative. Under this scheme a private finance company sets up a Special Purpose Vehicle (SPV) which then borrows to construct a new asset such as a school, hospital or road. This is repaid by the taxpayer over the contract term (typically 25 to 30 years). The NAO found “no evidence of operational efficiency” in the hospital sector and it is at best arguable whether private sector participation has delivered the benefits which its proponents promised. 

One of the biggest problems is transparency, or the lack of it. This takes two forms. The first is relatively trivial – the hidden costs associated with PFI schemes and the fact that off-balance sheet vehicles mean that debt does not appear on the public sector balance sheet. Such structures have been criticised by the OBR as a “fiscal illusion” since the debt burden associated with the provision of public services is higher than the official figures suggest. The second form of transparency is more nebulous and relates to the way in which public sector contracts are awarded. The law states that the government must produce details of any contract within 30 days of being awarded but as The Good Law Project notes, this requirement is routinely flouted. Over the course of recent months, there have been numerous examples of contracts being awarded to firms with links to government (see here for an example) whilst the FT reported last month that the government has awarded £1.7bn of contracts to private sector firms during the Covid crisis without a competitive tendering bid, as required by law. It may be that there is no case to answer here. But the evidence appears to suggest that due process is not being followed, which not only undermines the propriety of the scheme but is unfair on other companies with an interest in tendering for contracts. 

Problem 2: Pandering to special interest groups 

A further problem is that successive UK governments have allowed themselves to be distracted from the bigger picture by the demands of special interest groups which have exploited dissatisfaction with the status quo in the wake of the 2008 financial crisis. In 2014 the government was focused on the Scottish independence referendum, which David Cameron was confident he could win. But the government’s handling of the referendum betrayed the complacency of an administration that had made no provisions for what to do in the event that the result went against them. A similar complacency was evident in the run-up to the Brexit referendum but this time the result did indeed go against them.

On both occasions the government made the mistake of asking a question to which it did not already know the answer. It got lucky in 2014 but nonetheless gave momentum to the Scottish nationalists which they retain to this day. But it failed in 2016 and in so doing changed the character of the Conservative Party from a nominally inclusive party of national unity to, in effect, an English nationalist party. And it is here that the governance problem really starts to become a critical issue.

For all that Theresa May was not a great prime minister she at least tried to strike a balance between the moderates in her party and the strident Brexiteers (the nationalist wing). Unfortunately, this also meant putting the unity of the Conservative Party ahead of the national interest. But because the Brexit vote effectively ended the era of consensus politics, it also brought an end to her tenure in Downing Street. We now have a prime minister in the form of Boris Johnson who is the figurehead for the nationalist wing. Whilst Johnson may be a very effective campaigner he is not a good administrator, as foreshadowed by his tenure as Foreign Secretary. Worse still, he leads a government of campaigners rather than governors and his key advisers are radicals who want to overturn the status quo. 

Problem 3: Make sure you know how to deliver the changes you promised

There is nothing wrong in wanting change: It is how one goes about it that matters. Brexit has been the defining issue of the last four years and after three years of political wrangling, the first thing Johnson did as prime minister was to prorogue parliament in a bid to force the policy through. As I noted a year ago, this was a profoundly undemocratic action. Worse was to follow as the Johnson government took action to expel Conservative MPs – the governing party, lest we forget – who dared oppose it. This is not how parliament is supposed to work: Its role is to hold the executive to account and such actions undermine the basis of the parliamentary system.

One of the defining features of the Johnson government is cronyism – the appointment of like-minded individuals to office irrespective of their ability and who are defended to the hilt even when they make big mistakes. We see this in the Brexit debate where the negotiating team is led by those who seem to think that the EU loses more from a no-deal Brexit than the UK. Precisely because they are true believers who have never doubted the righteousness of their cause, they may simply never have stopped to consider whether they might be wrong. That in itself is a dangerous trait as it promotes ideology over rational, evidence-based policy – an approach which has a habit of ending badly.

We also see cronyism in action in two more policy areas. The first – and perhaps least important – concerns the recent exam debacle (here for a sober assessment of the issue). It now transpires that the government was warned about the problems of the algorithm used to provide grades in the absence of sitting the exams. However, the government is trying to distance itself from the problems and appears to be laying the blame on civil servants for the problems rather than accept its own failings. 

We see it in the way the government has handled the Covid-19 problem. This article from The Atlantic Magazine suggests there was institutional failure, as large parts of the state mechanism were insufficiently prepared for the scale of the crisis and were slow to adapt. Whilst it is true that the government cannot be blamed for all that went wrong,  the article fails to mention that the changes imposed on the health system by the reforms introduced in the  Health and Social Care Act of 2012  crippled its ability to respond. Moreover, the law was changed in 2012 in the teeth of opposition from health professionals who warned that it risked undermining the operability of the health service. The government’s response to the failings has been poor. It is set to abolish Public Health England in what looks like an attempt to deflect the blame onto the health service (never mind that PHE is an executive agency that actually reports to the health minister – it is not some out-of-control quango). And to add insult to injury, the new replacement body will be headed by Baroness Dido Harding - a Tory insider with a chequered business career who has no background in public health. 

At some point, however, the government will run out of ways to deflect the blame for its shortcomings. It will have to stop operating as if it were running a campaign and start to govern effectively. It cannot afford any more missteps and needs to get Brexit right. For if not, the economic as well as the political costs will be very high indeed.

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.