The curse of interesting times

 

We have started 2021 where we left off last year with Covid by far and away the most important factor shaping events but US politics continuing to dominate the headlines. It seems we say every year that the coming twelve months are the most uncertain we can recall, but this time it really is true. In my view, whilst the US political reverberations will eventually fade the scars of Covid will prove longer lasting.

 

The ongoing impact of Covid

 

Not only do we not know what impact the 2020 Covid-induced collapse will have on the economy this year but matters are being complicated by a big rise in infections at the start of 2021. Although a vaccine is now being rolled out, the fact that many European countries are tightening lockdown restrictions in the early weeks of the year means that we will see bigger output contractions than previously supposed. It will thus take longer for many economies to get back on their feet and we are unlikely to see a significant turning of the economic tide before the spring.

Growth forecasts made at the end of last year are likely to be significantly revised down in the course of January. If the vaccine rollout proves to be successful, we can expect a strong recovery in the second half of the year. But if it does not go as planned (perhaps because the virus mutates faster than the vaccine can keep up or distribution proves to be slower) any recovery is likely to be muted. Indeed I can well foresee a situation where a significant recovery in UK GDP growth is postponed until 2022 and it is hard to see any circumstances in which output in the larger European economies will get back to pre-recession levels in the course of this year.

From a market perspective, the dominant theme will once again be the hunt for yield. Central banks have pumped huge amounts of liquidity into the global financial system and will continue to do so in 2021. As a result downward pressure on bond yields will remain in place, forcing investors into riskier assets such as equities. That said, concerns that Joe Biden’s economic plans will result in higher government spending and higher inflation might put a floor under bond yields. Whilst I have lost count of the number of times I have indicated that equities look expensive when measured on the basis of conventional metrics, I have also pointed out on numerous occasions that measures such as the P/E ratio are not especially informative when interest rates are so low. I will thus repeat my prediction from last year that in the absence of an unexpected shock, investors can be expected to continue buying equities.

The politics will remain interesting

There is a lot to look forward to on the political front. Although the Washington unrest is a big deal and will echo throughout the generations to come, its impact on the economy is likely to be limited. We can expect a less rumbustious tone from the White House as Joe Biden settles in as US President although today’s storming of the Capitol in Washington reminds us that the fault lines running through US politics will not easily be healed. Biden is likely to adopt a more conciliatory tone towards his European allies, thus reducing some of the strains in the western alliance which have been a feature of the last four years. Moreover, the Democrats have won control of the Senate following the run-off in Georgia after the indeterminate result in November. As a result, the Senate is split 50-50 which will allow Vice President Kamala Harris a casting vote. This in turn will allow the President a much better chance of pushing through some of his domestic legislative agenda since initiatives in areas such as healthcare, the environment and government reform are less likely to be blocked.

This does not necessarily mean that Biden will be able to push through his more ambitious programmes such as the Green New Deal but at least some of the Congressional logjam will ease. This may not be altogether good news for markets which liked the idea of a Democratic President but a Republican-controlled Senate as a check on some of Biden’s harder-to-swallow ideas, but it is unlikely to cause more than a temporary market wobble.

Here in Europe, Angela Merkel is not expected to contest the German election in the autumn after her decision two years ago to stand down as Chancellor. This would be a real game-changer not only for Germany but also for the EU. At home, Germany’s handling of the first wave of the pandemic was reflected in a significant surge in the opinion polls for the CDU and even though the polls have softened a little since the summer, its 35% share is still ten points higher than in March. Merkel has presided over a number of difficult issues during her 15 year tenure as Chancellor and is seen as the ultimate safe pair of hands. If she does depart the scene as expected, she will be a hard act to follow.

But Merkel will be particularly missed at the EU level. Since she took office in 2005 the character of the EU has changed immeasurably, following the scarring experience of the Greek debt crisis and the departure of the UK. One of the biggest future challenges faced by the EU is how to deal with the political difficulties posed by Poland and Hungary, which were newbie members when Merkel became Chancellor but are now running in a different direction to the rest of the EU. Merkel's trick has been her ability to smooth over those issues which pose challenges to the political integrity of the EU. Her successor will have their work cut out to deal with the politics so adeptly. Of course, there is still an outside chance that Merkel will change her mind and contest another election but I would not want to put money on it.

Not forgetting Brexit

And then there is Brexit to look forward to which from here on becomes an economic rather than political issue. The UK is now completely outside the orbit of the EU which will give us a chance to assess whether the much vaunted economic benefits will materialise this year. Things have not got off to a great start. Under new tax rules, which admittedly are not directly Brexit related, the UK now requires foreign mail-order sellers to register for UK VAT for any items sold to British customers. They are required to collect the tax on behalf of the government and pay the money to HM Revenue & Customs. A number of small businesses have decided that it is not worth the bother to continue shipping to the UK with Dutch Bike Bits arguing it was “ludicrous for one country” to insist on these conditions and it would, in future, “ship to every country in the world . . . except the UK”. There is also the small matter of this week’s collapse of share dealing in the City of London prompted by a large-scale shift in euro-denominated shares from London to exchanges such as Amsterdam and Paris. The sky may not have fallen in but these are indications of changed post-Brexit circumstances which we were promised would not happen. As the year unfolds, a number of unexpected consequences are likely to become manifest.

The year ahead will undoubtedly be a turbulent one. Maybe the departure of Trump from the political scene will allow some healing to take place in the US. But Covid is not about to disappear anytime soon and in so many ways, we are experiencing the curse of interesting times.

The year from hell

You do not need me to tell you that 2020 was the year from hell. It will go down in history as the year of the pandemic – the biggest black swan event of our lifetimes. Even prior to the financial crash of 2008 we had some warning that problems were building up in the banking sector. But a year ago, apart from a few well-connected health professionals, the general public had not even heard of the coronavirus. Google search data reveal that it was only in the week commencing 19 January that there was a huge spike in interest in China. However, the rest of the world took another seven weeks to cotton on (chart above).

At the time of writing, almost 83 million people worldwide have tested positive for Covid-19 which has claimed the lives of more than 1.8 million. To put this into context, US deaths from Covid number almost 6 times those who lost their lives in Vietnam. In the UK, there are only 130 towns with a population higher than 72,657 – the current number of registered deaths in Britain. It became clear early on that this was a humanitarian disaster and until the vaccine is widely deployed, these numbers will unfortunately continue to rise. In this context, everything we thought might happen in 2020 was blown away by the ultimate in random events.

If we learned anything in the course of 2020 it was the distinction between risk and uncertainty. As the economist Frank Knight wrote in 1921, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.” The idea that risk is something that can be priced but uncertainty cannot is something that I have been pushing for many years. We learned in 2008 that we had been pricing risk incorrectly when the risks in the far tail of the distribution came to define the central case. But as much as we might have adjusted our subjective assessment of risks in the following decade, nothing could have prepared us for the events of 2020.

Starting with the economics, forecasts are conditional on the information set available at the time. Since we had no information on Covid in January, the economic forecasts made at the start of the year were quickly rendered meaningless. However, once governments began to implement their lockdown plans, forecasts adjusted very quickly and projections produced in the spring gave us a very decent guide as to how events turned out in 2020. For example, the consensus projection for this year’s UK GDP growth was 1.1% in January 2020. By May this had been slashed to -8.6% with the projections made by financial institutions averaging -9.3%. At that point we only had GDP data through to March and we were flying blind with regard to much of the data and I would regard this as an acceptable outcome. One thing that surprised me with regard to European economies was the extent to which unemployment remained relatively contained despite the massive collapse in output. This was a result of schemes put in place by governments to place a safety net under the economy, and very welcome it was too.

The downside is that there was a huge deterioration in government finances. Government borrowing across the EU, for example, is predicted by the European Commission to expand from 0.5% of GDP in 2019 to over 8% in 2020 (it will be even higher in the UK). In the euro zone, the debt-to-GDP ratio is projected to rise from 86% in 2019 to over 101% in 2020 and to rise further over the next couple of years. To put this into context, in the seven years following the crash of 2008 the debt ratio rose by 30 percentage points of GDP to 95%. High levels of debt are a legacy of the corona-induced recession that will be with us for years to come and will undoubtedly have a big influence on fiscal thinking in future. That said, the role of the state in providing support to the economy very much came back into fashion in 2020. I rather suspect that electorates will not take kindly to fiscal austerity in the near future, having endured it for much of the past decade.

It was certainly a dramatic year in equities. A year ago my view was that “equity markets would appear to be due a correction” but “unless we experience some form of major random shock, it might be too pessimistic to expect a bearish correction.” In early February I questioned why markets were ignoring the risks posed by the coronavirus. By March, we got the long-awaited correction as investors understandably panicked as liquidity dried up in much the same way as it did in 2008. This time, however, the authorities were prepared and pumped in liquidity as if it were going out of fashion. The surprise was just how quickly markets rallied thereafter with US markets rallying to record highs late in the year (chart below). This was in part driven by FAANG stocks as the likes of Amazon and Netflix had a “good” crisis but most sectors benefited to a greater or lesser degree. For all the concerns regarding excessive valuations my year-ahead call that “equities remain the asset class of choice” means that so long as an expansionary monetary policy depresses returns on other assets, it is hard to see why investors will dump them.

On the politics front, the UK left the EU as expected and did so with a trade deal that at various stages throughout the year appeared very elusive. The year also marked the end of Donald Trump’s tenure in the White House. A year ago I was unsure how the US election would pan out: The polls suggested Trump would lose but it was never certain that the Democratic challenger would be able to pull off a win. Now that Joe Biden is about to move into 1600 Pennsylvania Avenue this will likely mean an end to the Twitter-based policy environment that has characterised the last four years. It is unclear whether this will be bad news for Twitter Inc. On the one hand they have lost one of their highest profile brand ambassadors. On the other, it may take some heat out of the fake news allegations that have dogged the company thanks to the President’s unfiltered use of social media. 

There are now just a matter of hours to go until we can say goodbye to 2020. I am sure I speak for everyone when I say the end can’t come soon enough. Here’s wishing us all a happier new year.

Over the line

Four and a half years after the Brexit referendum, the UK and EU finally reached a trade agreement originally described as the easiest in human history to achieve. It proved quite the opposite but the fact that such a comprehensive deal was achieved in a relatively short period should be seen as a positive result. It calls to mind the line from Macbeth, a play which according to acting folklore is cursed: “If it were done when 'tis done, then 'twere well it were done quickly.” The fact that there is any deal at all is good news. After all, there were real fears that talks could have failed at the last minute which would have meant recourse to WTO rules. Despite what British politicians might have said, this would have been a very painful economic outcome.

As for the timing, although I had long expected talks to go to the wire – and well beyond the October deadline which both sides originally aimed for – the announcement of a deal on Christmas Eve was a lot closer to the year-end deadline than even I had anticipated. From an optics point of view, there were good domestic political reasons for dragging out the discussions for as long as possible as it gave the impression that the British were fighting their corner until the very end. An even more cynical view is that by hurrying it through whilst the British parliament is in recess, this reduces the time available for scrutiny ahead of 31 December and limits the prospect that MPs might find reasons to delay its implementation. After all, there is a lot that Brexit supporting MPs can find to object to.

Win, loss or draw?

Boris Johnson was quick to portray this as a win for the UK. In the 34 page explainer of the deal, a signed foreword by the prime minister argued that “the UK will fully recover its national independence … we will take back control of our trade policy and leave the EU customs union and single market. We will take back control of our waters … We will take back control of our money by ending vast payments to the EU … Most importantly, the agreement provides for the UK to take back control of our laws ... The only laws we will have to obey are the ones made by the Parliament we elect.” It is precisely this sort of nonsense that raises my hackles by distorting what the UK could and could not do whilst a member of the EU. There is, however, a particular irony in the last sentence given that Johnson himself presided over a government that tried to circumvent parliament in a bid to get Brexit done.

The EU’s response was more measured with Michel Barnier suggesting in a TV interview that there were no winners – both sides lose something. We should be in no doubt that the UK’s trading arrangements with the EU will be far less advantageous than they were when the UK was an EU member. And of course, EU companies exporting to the UK are subject to similar disruption. Moreover this is a harder Brexit than that envisaged by Theresa May’s government, which planned that the UK remain in a form of customs union with the EU. Although this avoided a border in the middle of the Irish Sea, as Johnson’s deal implies with the result that goods entering Northern Ireland from Britain are now classified as imports, the quid pro quo was that Northern Ireland would have remained aligned with certain EU legislation. As we all know this fell foul of those who prioritised sovereignty (or to be more accurate, the impression of sovereignty) over the economic well-being of the UK, and did for May’s career what the EU question has done to a number of her predecessors.

A closer look at the detail

A closer look at the agreement indicates that it provides a comprehensive set of rules for sectors such as autos,chemicals and pharmaceuticals which was in line with prior expectations. On the surface the general absence of tariffs means that this is a deal which minimises the direct cost to UK consumers, which can only be good news. One of the key sticking points in negotiations was how to monitor and resolve disputes. The final outcome means that although the UK has avoided being subject to the oversight of the ECJ, it is still subject to arbitration panels in the event that it is deemed to have strayed too far from EU standards on environmental or labour market standards. Consequently, the EU still holds a lot of sway on the imposition of standards which may not be the kind of freedom from EU legislation that some of the Brexit purists were hoping for. After all a 1246 page document packed with dense legal language covering various aspects of a detailed trading relationship does not exactly scream liberation from red tape.

A special mention is due for the vexed issue of fisheries which is a totemic symbol of Brexit. EU access to British waters is to be reduced by 25% over the next five and a half years but thereafter access to territorial waters will be subject to annual negotiations. The EU will have a lot of leverage in such negotiations and has the power to take retaliatory action should the UK curtail access to British waters. Were it minded to do so, the EU could well turn the screw on this issue in 2026.

The new arrangements imply considerably more delays in cross border trade flows – more red tape rather than less – but this should be no surprise in a trade agreement which takes the UK out of the single market. In the words of Pascal Lamy, former head of the WTO, this was “the first negotiation in history where both parties started off with free trade and discussed what barriers to erect.” Quite how much impact this will have on cross-border trade and overall GDP growth in 2021 remains to be seen. However, the BoE predicts that export flows in 2021 will be smaller than in 2020, despite the expected recovery in the EU economy, with the worst of the impact concentrated in the early weeks of 2021 as exporters adjust to the new rules.

What they didn’t say

But it is what is not in the agreement which is really telling. There is, for example, no mutual recognition of professional qualifications. The likes of doctors, architects and engineers must now apply to have their British qualifications recognised in each of the countries where they intend to work. This is hardly designed to enhance the strength of the service sector where the UK runs a trade surplus with the EU. And as I have long pointed out, financial services have largely been ignored. Johnson indeed admitted in a newspaper interview at the weekend that the deal “perhaps does not go as far as we would like” regarding access to EU markets for financial services, which is an understatement. This will be a subject for heated discussion in 2021 and beyond.

British travellers, whether for leisure or business, will feel the pain of longer queues to enter the EU and a more onerous administrative burden. Students will no longer be able to participate in the Erasmus scheme which seems a particularly petty act, particularly since the government stated in January that participation in the scheme would not be affected and is yet another Brexit action which disadvantages the young. Ironically the Republic of Ireland has guaranteed that it will pay the costs of Northern Irish students wishing to participate, which has led many to speculate that this could be the thin end of a wedge which ultimately results in a United Ireland.

The bottom line

All told, the EU has granted the UK some concessions in areas such as goods trade, where it holds most of the economic cards and has offered little to nothing in services where the UK has many advantages. This is not to deny the fact that any deal is better than no deal. But this is sub-optimal compared to what the UK enjoyed previously. As for any gains in sovereignty, they are offset by the fact that trade rules are more heavily proscribed than before and the government continues to give no recognition to the fact that the UK has willingly given up its role in setting the rules for EU trade. It is as much a rule taker as it ever was – maybe even more so – as I warned all along.

For all the talk that Brexit is done, nothing could be further from the truth. Negotiations over areas such as financial services and fisheries will drag on for years. It may start to fade from the front pages as politicians try to talk about something else but from here on the economics starts to assert itself. Nothing I have heard from many Brexit supporters in the last five years suggests that they understand the full economic implications of the course they have pursued. Whenever I raise this point I am told that it is all worth it to regain sovereignty. Having seen what is on offer in the trade deal, if I were a Brexit supporter I would be asking whether I have been taken for a ride.

Bad but by no means the worst

By the standards of our lifetimes this will be one of the more unusual Christmases we have ever experienced. Large parts of Europe are living under lockdown conditions and many millions of people will be separated from their extended families, in many cases not having seen them since last Christmas. Undoubtedly many of us have been inconvenienced but spare a thought for those who have lost loved ones during the year. Spare a thought, too, for those in front line service jobs who have worked to look after us and provide the services that have kept the economy afloat. Health professionals (doctors, nurses and the ancillary staff who keep the system running) have had a tough year and they will continue to work over the holiday season. Special thanks are also due to those who have kept the lights on, delivered the goods to our doorstep and the countless other services which have allowed us to maintain a semblance of normality in 2020.

All of this did get me wondering how badly this year’s Christmas stacks up against past years. It certainly will not be the worst in history. The outbreak of bubonic plague in Europe between 1346 and 1353, which is estimated to have killed 60% of the population, would have made for a truly frightening experience. In a forerunner of today's social distancing, cities such as Venice and Milan put emergency public health measures in place to limit personal contact whilst the Adriatic port city of Ragusa (modern-day Dubrovnik) was the first to pass legislation in 1377 requiring the mandatory quarantine of all incoming ships and trade caravans in order to screen for infection. Well-documented outbreaks of bubonic plague afflicted large European cities over the next 300 years with outbreaks in London in 1563 and 1665 particularly noteworthy. Ironically, plague outbreaks tended to subside during the winter months as the disease vectors (rats and their fleas) retreated in the wake of colder weather. Christmas may thus have seemed a miraculous interlude in an otherwise endless cycle of misery.

Christmas during periods of war are also dreadful. We have been regaled over the decades with stories about how bad Christmas was in the UK during World War II with 1944 described as “the most joyless Christmas of the war.” One amusing anecdote from that period is that such was the lack of alcohol that year “that, of the half million inhabitants of Kensington, Hammersmith, Fulham and Chelsea, in London, only one woman was arrested that year for drunkenness over the holiday.” There was nothing to laugh about in Germany in 1944. Supply shortages were almost intolerable in cities which were ruined shadows of their former selves whilst weekly working hours had recently been increased to 60 hours to free up labour for the war effort.

Of course, war and disease were not the only dampening factors on Christmas celebrations. Before the Reformation in 1560, Christmas in Britain was celebrated as a religious feasting day. But the rise of the Puritan movement in the seventeenth century meant that the season was increasingly frowned upon as a frivolity associated with Roman Catholicism. In 1640 the Scottish Parliament passed a law that made celebrating ‘Yule vacations’ illegal. In 1643 the English parliament followed suit, passing a law calling on the people to treat the mid-winter period 'with the more solemn humiliation because it may call to remembrance our sins, and the sins of our forefathers, who have turned this feast, pretending the memory of Christ, into an extreme forgetfulness of him, by giving liberty to carnal and sensual delights'. In 1644, parliament followed this up by abolishing the feasts of Christmas, Easter and Whitsun altogether. From this point until the Restoration in 1660, Christmas in England was officially illegal. Even after the law was repealed in Scotland, Christmas celebrations were frowned upon for a long time afterwards. It was not until 1958 that 25 December became a Scottish public holiday.

Many of the non-conformist Puritan movements which left Europe for the New World in the seventeenth century carried this attitude with them. The Plymouth Pilgrims in 1620 spent their first Christmas Day, in what later became the United States, building their first structure. The following year new arrivals, who spent Christmas Day celebrating rather than working, found themselves at odds with the original settlers. It was not until 1681 that laws forbidding the celebration of Christmas were repealed. But “as late as 1870, classes were scheduled in Boston public schools on Christmas Day and punishments were meted out to children who chose to stay home beneath the Christmas tree.”

However inconvenient this Christmas will turn out to be, for the most part it pales into insignificance compared with past privations. Stay safe and enjoy the festivities as best you can – even if is only via Zoom. All the best to you and yours at this very unusual time.

There may be trouble ahead

It's not what was done ...

I have never known such a sombre mood in the UK as that which prevails today. As if 2020 has not been bad enough, the weekend news that the government has cancelled the planned five day relaxation of social distancing restrictions over Christmas in response to rising infection rates has thrown the plans of millions into chaos. This was done with the best of intentions in the face of a new variant of SARS-Cov-2 which appears to be more infectious than previous strains. But in response more than 40 countries have, at the time of writing, placed bans on travellers arriving from the UK to limit the spread of the new variant. The most serious of these is the French decision to impose a 48-hour ban on passengers and freight entering from the UK which will severely disrupt cross-border trade.

The first reaction of many people was to direct their anger at the government. After all they were promised just three days earlier by Boris Johnson that it would be “inhuman” to ban Christmas as he defended plans to allow households to socialise over the festive period (the fact that local lockdowns in late July were announced hours before the start of the Eid festival did not go unremarked on social media). That said, we should cut the government some slack regarding the decision to impose new restrictions in the face of the most serious health crisis in a century. Many people may disagree, but the experience of the first lockdown was that it did result in a significant reduction in the spread of the disease, albeit at a very high economic cost. Those arguing that the UK should have followed the Swedish model are less vociferous in the face of mounting acceptance in Sweden that the government’s strategy was a mistake, with even the King suggesting that the policy has “failed”.

... but how it was done

A far bigger problem has been the government’s communications strategy. The decision on Saturday afternoon to add a fourth tier of restrictions to the 3-tier system with just a few hours’ notice seemed very rushed. Worse, it flew in the face of the message given just three days earlier. Since the government has known about the new Covid variant for some time, it calls last week’s comments defending previous Christmas plans into question. However, this is in keeping with the pattern which Johnson has followed throughout the year. He was late in implementing the first lockdown in March; he resisted the scientists’ calls for a national lockdown in September, instead opting for a series of badly implemented regional lockdowns, before being forced to bow to the inevitable and implementing a second lockdown in November and now the latest U-turn.

Preparing for border disorder

But it is the restrictions on the flow of goods and people across borders which are the most sobering aspect of the whole issue. Even before the events of recent days queues were mounting on both sides of the Channel as firms attempted to build up stocks ahead of disruption in the event of a no-deal Brexit. One of the consequences has been that the cost of transporting a container of goods has significantly increased, with reports that a container of goods from China to Felixstowe now costs $10,000 per load – four times the usual rate. The French border closure has made the problem significantly worse because hauliers have no incentive to enter the UK for fear of being stuck on this side of the Channel. None of this should come as any real surprise. I did point out two years ago that problems at the ports would quickly lead to large queues.

It may be that the border closure is partly motivated by the desire of the French government to fire a warning shot at Downing Street to indicate what could happen in the event of a no-deal Brexit. Contrary to what the diehards have maintained over the last four years, the UK really does not hold all the cards – it is questionable how many it holds at all. In the absence of either a Brexit deal or an extension of the transition period, this could be just a foretaste of what is to come. Latest reports from within government suggest that the UK has ruled out any Brexit extension. Given Johnson’s record on U-turns, we should not necessarily take this at face value. But if this really is the government’s position, it should brace itself for the mother of all political backlashes in 2021. It is extremely difficult to believe that voters will stand idly by whilst restrictions on cross-border traffic cause such inconvenience, resulting in higher prices and a reduction in the range of goods available for purchase.

Interestingly, a recent IMF working paper looked at pandemics across a range of countries over the period 2001 to 2018 to assess whether they lead to higher inequality and increased social unrest. It concluded that “the results from local projections show that social unrest increases about 14 months after pandemics on average. The direct effect peaks in about 24 months post-pandemic.” Add in the self-inflicted pain of a senselessly hard Brexit and I would not want to be in Johnson’s shoes in 2021.

It's nothing  personal - I just oppose incompetence

I was recently accused of peddling Anti-Tory propaganda. Since the respondent was anonymous I am sure they will not remind me repeating their response to one of my blog posts: “From the very first words of this article, it's glaringly obvious that the writer is a remoaner. The colouring of the language clearly lays a foundation for the rest of the article to be another Brexit/Tory-bashing tiresome monologue. So, it puts me off. It didn't start as balanced, so I (and I'm guessing many others) didn't read through, because they already knew the theme and conclusion of the story. Shame. There may be many salient points buried within these 1489 words, but I won't go in search for them. I have better things to do with my time.”

Whoever they are, they have missed the point of everything I have written over recent years. My criticisms are not party political (they should read what I wrote about Jeremy Corbyn). They are a response to government incompetence. It is not my intention to take pot shots at the government for the sake of it – I leave that job to the professional columnists with this article by The Observer’s Andrew Rawnsley neatly summarising Johnson’s unsuitability for leadership at a time when more than flowery rhetoric is required. As Rawnsley put it, if there is light at the end of the tunnel it  “will have to be exceedingly bright to wipe away all the memories of how long and dark, stumbling and flailing has been the nation’s journey through the tunnel.”

Something of value

The Reith Lectures are a long-standing tradition in British radio broadcasting, running back to 1948, in which a leading figure of the day tackles a subject of contemporary interest. One of the consequences of the lockdown is that I had a chance to listen to this year’s lecture series given by Mark Carney, former BoE Governor, and very interesting it was too, for it tackled the issue of how financial value has usurped human value and what we can do to turn this around (the transcripts of his lecture series are also available at the link shown above).

What is value?

This subject is of relevance to all economists, but it is of particular interest to me because as I have noted previously, it is one of the motivating factors behind starting this blog in the first place. Carney’s jumping-off point is to acknowledge that the moral sentiments espoused by Adam Smith, the father of the invisible hand, have become financial sentiments and that “societies’ values became  equated  with  financial  value.” I have raised similar points over the years, arguing in 2017 that Smith “never advocated the devil-take-the-hindmost policy which many of his adherents claim.” Indeed, Carney notes that Smith uses the phrase “invisible hand” only once in his magnum opus The Wealth of Nations. My own introduction to Smith’s work (more years ago than I am prepared to admit) focused on his role in developing the idea of comparative advantage in trade rather than his espousal of free markets – a point that Carney reiterated: “the central concept that links all of Smith’s works is the idea that continuous exchange forms part of all human interactions.”

A few weeks ago I referenced a study conducted by the ESCoE into public attitudes towards economics in which those questioned “often associated the economy with money.” Carney highlights that “Smith’s writings warn of the mistakes of equating money with capital.” Somewhere along the line we appear to have drifted a long way from the original ideas sketched out by one of the founding fathers of modern economics. One of the underpinnings of this shift has been a change in the nature of value. In Carney’s interpretation of Smith’s world, value is derived from our desire to be well regarded by others which creates “incentives to achieve mutual sympathy of sentiments.” In recent years, however, value has taken on a more subjective hue as the neoclassical revolution has gone mainstream. In this scheme, people are encouraged to assign a value according to the utility they assign to a particular good (or service). In other words, value becomes what people are willing to pay. What complicates matters enormously is that since tastes can change very quickly, these values are not stable over time. But following the Reaganite/Thatcherite revolution of the early-1980s which unleashed the power of markets as the ultimate arbiter of choice, this model of value generation has become extremely well entrenched.

However, markets are underpinned by the laws and values of the society in which they operate. They do not spring out of nowhere – the invisible hand must be attached to an invisible arm. A good example of this is the Glass-Steagall Act of 1933, which separated the deposit taking activities of US banks from more risky investment banking operations. It came into being because society was not prepared to condone a repeat of the 1929 Wall Street Crash and the associated economic hardship. Fast forward to 1999 and society’s concerns about the risks associated with banking had diminished to the point at which the US Congress felt able to repeal it. Quite clearly the law operated in the context of the prevailing social norms.

By contrast, Milton Friedman was an arch-proponent of free markets who argued that we could separate market outcomes from their social context. In a famous article published in the New York Times 50 years ago he argued that a business executive who exercises social responsibility in the course of their work “must mean that he is to act in some way that is not in the interest of his employers.” Businesses that do anything other than maximise profits are “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades” and are guilty of “analytical looseness and lack of rigor.” But Friedman’s failure to take account of social context is a major omission. What might have been acceptable corporate behaviour in  the 1970s and 1980s no longer is. Moreover, a purely market oriented policy that fails to take account of social norms would damage a company’s image and be harmful to its long-term survival prospects.

One of the problems with our current system of value setting is that since we define the worth of activity purely in financial terms, we cease to value that which we cannot price. Accordingly mainstream economics now tries to assign a price to civic and social virtues in order to give them meaning. In this way, we have gone beyond operating in a market economy and we are now operating in a market society. But as Carney points out, “there is considerable evidence that commodification, putting a good or service up for sale, can corrode the value of the activity being priced.” The standard example of this are charitable events which seek to raise money for good causes. The primary motivation is altruism, but would more money be raised if participants were paid? The answer, it turns out, is no.

Will Covid change how we value things?

These philosophical ramblings are all very interesting but what bearing do they have on the issues we face today? In a world where all members of society have been affected in one way or another by Covid, many people have done extraordinary things to help their communities, for which they received no payment. Milton Friedman might have argued that they were crazy, giving away their labour for no monetary reward. But they did so because they believed in the cause for which they were working. In a wider sense, Covid will force societies to re-evaluate their priorities. In the Anglo Saxon world, the burden of risk has increasingly been shifted onto the individual as the state has reduced its role in the economy. For example, if you lose your job, you have to find another one quickly because the state will not provide for you. But during the pandemic, that is precisely what the state has been forced to do. Does society really want to revert to what went before?

I recently gave a presentation in which I suggested we may be about to relive a 1945 moment. At that time in the UK, memories of high unemployment in the 1930s were still vivid and voters in the first post-war election opted for a government that promised radical social change. Radical post-Covid change will likely be driven by younger voters who wish to see changes to an economic model that has benefited their parents’ generation but done little for them. For example, voters may demand that the state plays a bigger role in the economy in future, since one of the things the state does well is to correct the market failure from negative externalities (e.g. ensuring widespread access to healthcare and education). This in turn could have a major bearing on the way in which society assigns values and would give the green light for future governments to adopt a slow course back to fiscal rectitude rather than a headlong rush.

Obviously we do not know what the future holds but I have long argued that more market-type solutions are not the answer to the mounting economic problems faced by European economies. This is not to say that we should revert to 1970s-style efforts to centralise economic decision-making. But as we learned in 2008 and again in 2020, markets can fail without the right kind of support. The fact that we value intervention in order to avoid worst case spillover effects suggests that we should not be afraid to impose limits on the extent to which we allow free markets to make our value judgements for us

Machine learning: A primer

Last month I had the pleasure of taking part in a virtual conference organised by the Bank of England on big data and machine learning (ML). One of the things that struck me most was the relative youth of the presenters, many of whom are still writing their PhDs. This is a clear illustration of the fact that this is a brand new field whose limits are being extended every month and which is increasingly being applied in the field of economics and finance. If ever you want to get in on the ground on what promises to be one of the new fields of economic analysis, now is a good time to get started. 

Some basics 

Big data and ML go hand-in-hand. The development of web and cloud based systems allows the generation and capture of data in quantities which were unimaginable just a few years ago. It is estimated that 59% of the global population are active internet users – around 4.66 billion people. Every second they send 3.4 million emails, 5700 tweets and perform almost 69,000 Google searches. PwC reckoned that in 2019 there were 4.4 Zettabytes (ZB) of data stored online – a figure that could hit 44ZB in 2020. A decent laptop these days will have a hard disk with one Terrabyte of storage capacity but you would need more than 47 billion of them to store the current volume of our data universe (44 x 1024³). If these were stacked one on top of another, it would generate a column over 1 million kilometres high – three times the distance to the moon. Clearly, a lot of the data stored online does not yield any valuable insight but given the vast amount of available information even a small fraction of it is still too much for humans to reasonably digest.

This is where the machines come in. Traditional computer programs represent a series of instructions designed to perform a specific task in a predictable manner. But they run into difficulties in the case of big data applications because the decision trees built into the program (the “if-then” loops) can simply become too big. Moreover, a traditional program represents a fixed structure which goes on doing the same thing ad infinitum which may not be ideal in a situation where we gather more data and begin to understand it better. A machine learning algorithm (MLA) is designed to be much more flexible. Rather than being based on a series of hard-coded decision rules, an MLA incorporates a very large number of basic rules which can be turned off and on via a series of weights derived via mathematical optimisation routines. This makes MLAs more successful than traditional computer programs in areas such as handwriting and speech recognition and are better able to deal with tasks such as driving where rapid adjustment to changed conditions is required.

But a machine needs to be trained in order to progressively improve its performance in a specific task in much the same way that humans learn by repetition. In the AI community there are five broad categories of training techniques, the most common of which is supervised learning in which input and output data are labelled (i.e. tagged with informative labels that aid identification) and the MLA is manually corrected by the human supervisor in order to improve its accuracy[1]. One of the common problems is that the model might fit the training data very well but be completely flummoxed when faced with out-of-sample data (overfitting). By contrast an underfitting model cannot replicate either the training data or the out-of-sample data which makes it useless for decision making.

Our final task is to ensure that the MLA has learned what we want it to. In one early experiment, data scientists tried to teach a system to differentiate between battle tanks and civilian vehicles. It turned out that it learned only to differentiate between sunny and cloudy days and it proved to be useless in real world situations. This demonstrates the old adage that if you ask a stupid question, you get a stupid answer, and highlights the importance of setting up the MLA in order that it focuses on the question of interest. 

Applying ML to economics 

How is any of this relevant to economics? First of all ML has the potential to revolutionise our statistical analysis of big datasets. In particular, certain applications should make it easier to reduce the dimensionality of big datasets, making them more manageable whilst still retaining the meaningful properties of the original data (see below). This is important because large datasets are often “sparse” i.e. a number of non-zero observations surrounded by large numbers of zeros, which tends to be a hindrance to many traditional statistical estimation methods.

ML also theoretically allows us to estimate and compare a range of models more easily. In applied economics, researchers normally start by choosing a single functional form and putting their efforts into a statistical assessment of whether the data agree with their preconceptions. It is usual for researchers to operate with only one model given the labour intensive nature of the exercise and it becomes a laborious task to compare a range of models using traditional analytical techniques. However, ML should make it easier to compare a range of different models. In a very interesting paper on the application of ML techniques to economics, Susan Athey argues that a more systematic approach to model selection facilitated by ML, which removes the arbitrary approach to specification searches, “will become a standard part of empirical practice in economics” in future. 

An example 

In order to give a flavour of the application of ML techniques, I present here an example of a supervised learning technique known as a random forest model. This is a form of clustering model in which a large number of data observations are reduced down to a smaller number of groups in an example of dimensionality reduction.

To conceptualise a random forest model, think of a decision tree formed by splitting our dataset into two (see chart above). Both halves can be further divided into sub-categories until at some point we run out of ways to split them further (in other words there is no additional information content). In a standard decision tree model, since the trees are derived from the same underlying data, they may not be completely independent from each other. If, however, we randomly sample data from each tree created by the model it can be shown that this reduces the degree of bias compared to a standard decision tree (for those interested in a more detailed discussion, this paper from the BoE is very accessible). We “train” our model by allowing it to operate on a sub-sample of our dataset and apply the “knowledge” gained during the training period to the rest of the sample to see whether it makes accurate predictions. 

The Bank of England applied ML techniques in a paper using random forest models to predict banking distress. Based on this blog post by Saulo Pires de Oliveira, we can demonstrate exactly the same techniques used in the BoE paper to show the random forest model in action. It is written in the R software system and rather than use financial data, we use the famous Anderson iris data set which looks at the characteristics of three variations of irises (the data comes as standard in the R system). Our objective is to determine on the basis of the characteristics (the length and the width of the sepals and petals) which category of plant each observation belongs to. The code is available below and since R is free to download it is a simple matter of copying this code into R and running it to reproduce the results.

 

The model uses part of the dataset as input to a training algorithm and applies the results to the rest of the sample. How do we know whether our results are any good? Following the BoE example, we calculate the Receiver Operating Characteristic (ROC) curve which plots the true positive rate against the false positive rate (see chart below). The former is high and the latter low, suggesting that the model performs well in determining which class of iris the data correspond to. This is confirmed by a cross-check against the area under the curve algorithm which shows a value of 98% (the higher the value the better the fit).

Whilst this is a very simple example it does show the power of ML techniques. From an economists' point of view their use as a statistical technique for classifying patterns makes them an extremely powerful new tool. But we should beware of overdoing the hype when it comes to their use in some other areas. Many of the more general problems in cognition are not classification problems that MLAs are good at solving. Moreover, they tend to be data hungry whereas a human can learn abstract relationships with much less data input. One thing that humans still do better than machines is adaption and they are not going to replace us any time soon. But for the statisticians they are likely to be a boon.

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[1] The others are semi-supervised learning in which the data are unlabelled but the MLA is still subject to manual correction. An active learning approach allows the MLA to query an external information source for labels to aid in identification. Unsupervised learning forces the MLA to find structure in the input data without recourse to labels and without any correction from a supervisor. Finally reinforcement learning is an autonomous, self-teaching MLA that learns by trial and error with the aim of achieving the best outcome. It has been likened to learning to ride a bicycle, in which early efforts often involve falling off but fine-tuning actions which gradually eliminate mistakes eventually lead to success.