When is financial democratisation simply speculation?

Financial democratisation refers to the process of removing control of the finance industry away from a small number of financial institutions and distributing the power among the general public. Over the years this has taken a number of forms. Back in the 1980s in the UK, the Thatcher government pursued a policy of liberalising the financial services industry and attempted to widen the distribution of share ownership throughout the economy. More recently, advances in fintech have allowed individuals easier access to the financial markets which has in turn allowed them to more easily manage their own portfolios and give them a bigger slice of the action.

Every so often this debate breaks out of the narrow confines of management consultancies and academia and impacts on public consciousness in a big way. The most recent manifestation was the massive rally in GameStop shares driven by a wave of online activism on the Reddit platform. To give the backstory, a group of online investors had been making the case for investing in GameStop, a video game and gaming merchandise retailer. Institutional investors believed there was no future in the business and a number of hedge funds had big short positions on the stock. However, a number of day traders realised that if they could force the price higher they would inflict heavy losses on the short sellers. In this way the GameStop case quickly became a cause celebre for activists looking to deal a bloody nose to the financial professionals. If one of the features of democracy is the right to protest, this event can be viewed as the investment equivalent of taking to the barricades.

One of the notable features of the GameStop saga is that it was exacerbated by the use of options. Day traders who were organising their activities over Reddit bought short-dated call options in GameStop with the result that the market makers who sold the options were essentially taking short positions in the stock. As a result the sellers of options were forced to buy it in order to hedge their positions, driving the price ever higher. This is a so-called gamma squeeze – a measure of the change in the value of the option with respect to the change in the price of the underlying security – and is an inevitable consequence of the structure of the options market (this article on Yahoo Finance gives a great overview of how the options market worked in this case). The whole affair resulted in two of the hedge funds betting on a fall in the price of GameStop being forced to cut their positions as the price climbed ever higher. In the case of one of these funds, Melvin Capital, its backers were forced to inject almost $3 billion in order to keep it afloat. One-nil to the activists.

Comes a day of reckoning

Whilst it is true that markets should not just serve the interests of the wealthy, and it is a great spectator sport to watch David winning out over Goliath, the episode does raise a number of worrying questions to which there are as yet no answers. Most obviously, do the small investors really understand the risks inherent in options trading? At the end of January there were 9860 open contracts, each one requiring the holder to buy 100 GameStop shares at prices between $300 and $320 per share. Investors were no longer merely the holder of a financial instrument – they were potential shareholders who had to find $312 million in order to exercise their option. Since the small investors did not have that kind of money (they have merely bought an option to purchase the stock, they do not have to buy it), the market makers issued a margin call. Since the investors struggled to find the funds to even meet this call, the issuers of the options closed out the position by selling GameStop stock. Surprise, surprise, the price of GameStop then collapsed thus demonstrating the dangers of an options-fuelled surge in prices and highlighting the old adage that if something is too good to be true it probably is.

Those who bought call options will lose a few hundred dollars which they may justify as a small price to pay for poking the hedge fund community in the eye. But anyone who rode on the coattails of the surge by simply buying the stock in the expectation of further gains could have suffered an unexpectedly nasty shock as the price collapsed. It was not for nothing that Warren Buffett once called derivatives “financial weapons of mass destruction.”

Another point worth noting is that the band of investors who got together on Reddit’s rWallStreetbets page engaged in the kind of collusive activity which if institutional investors did it would see them prosecuted by the financial authorities. It seems evident that some form of regulatory response is necessary. But what exactly? After all, it would merely inflame those activists who believe the system is rigged against them if actions were taken to inhibit their access to markets. 

A team of journalists at the New York Times came up with a series of reform suggestions which, as they readily admit, are “conversation starters, not endorsements.” Their approach is to raise the barriers faced by institutions rather than keeping out the hoi-polloi. Amongst the measures put forward are the introduction of a transaction tax which could “reduce the attractiveness of the high-speed trading that gives sophisticated Wall Street firms a huge advantage.” In addition, there is a case for a debate about forcing hedge funds to disclose their short selling positions and forcing an end to private meetings between companies and investors which gives “the biggest financial players information that the general investing public lacks.” One of the more controversial proposals is the resurrection of the Buffett Rule that “effectively imposed a 30 percent income tax on anyone who earns more than $1 million. This wouldn’t address the markets, necessarily, but would boost perceptions of fairness in the system as a whole, which is partly what the GameStop trade is about.”

Following the events of 2008, the financial sector came to be blamed for the crash – all the more so as governments appeared willing to provide support to banks but less so to the wider economy. It is perhaps little wonder that activists have since had the financial community in their sights. Financial democratisation is a worthy goal and raising barriers to entry to the smaller investor may not be the right way to go about remedying the issues that the GameStop episode throws up. Speculation has taken place for as long as markets have existed. But failure to address the problems raised in recent weeks will simply add another layer of uncertainty to an already volatile market environment.

A border skirmish

I have spent the last five years hammering the British government for its failings in dealing with the EU so it is only fair to apply the same criteria to the EU when it gets it wrong. Both sides of the Brexit divide in Britain were critical of the European Commission’s (EC) decision to impose a border in Ireland for the purposes of halting the export of Covid vaccine. This follows AstraZeneca’s (AZ) announcement that it would only be able to deliver 25% of the planned 100 million doses of the vaccine to EU members by March. The fact that the Commission subsequently backtracked suggests it realises it made a mistake. Although no physical harm was done, it shows the extent to which relations between both sides remain tense and calls into question a number of aspects of Covid management on both sides of the Channel. 

How did it come to this? 

There has been growing discord across continental Europe about the slow pace of vaccine rollout which lags well behind the UK (chart above). For the British government, which this week came under renewed pressure as the UK death toll topped 100,000, it is important that the vaccination rollout is a success after the failings in many other parts of the Covid response programme. Indeed, despite the apparent success (so far) of the UK vaccination rollout, it cannot detract from the fact that the UK has one of the highest per capita mortality rates in the world. But this is about more than just the UK.

In June 2020 the EC set up a scheme whereby vaccine purchases are negotiated centrally on behalf of all member states. This was not a compulsory scheme but all members signed up to it on the basis that the enhanced buying power of the EC would reduce costs and ensure that all would be treated equally. Under the terms of the agreement, no member can negotiate with a supplier who is already in discussions with the EC. However, the German government did a side deal with Pfizer in September, with whom the EC was already in negotiations, by signing up for an additional 30 million doses.

The German action was in part motivated by the EC’s slow progress towards signing contracts with vaccine producers. One reason for this was that the EU insisted that the drug companies assume liability for any side effects resulting from the use of the vaccine, which slowed down the negotiation process. Accordingly, the EU signed its first contract with AZ only in August, three months later than the UK. Similarly, the EU only signed a contract with Pfizer in November whereas the UK signed up with them in July. The EU was also a bit slower to approve the first coronavirus vaccines than the UK and US. The UK approved the Pfizer vaccine on 2 December, just over a week earlier than the US, whereas the European Medicines Agency did not grant approval until 21 December. This is not necessarily a criticism of the EU approach. Its cautious approach to the science was justifiable and it was buying in much larger quantities than the UK. 

The Commission’s real problem is with AstraZeneca 

But where the EC can be criticised is that although it signed contracts with AZ much later than the UK, it still expected deliveries to be made at the same time – a point made by the company’s CEO Pascal Soriot, who is ironically a French national. At this point, the legal implications of the case start to get murky. The EU believes it has the right to insist that AZ delivers on its contractual obligations and was so convinced of the rectitude of its position that it released online a redacted version of the purchase agreement (here). The first thing that jumped out at me was the sentence “AstraZeneca shall use its Best Reasonable Efforts to manufacture the Initial Europe Doses within the EU for distribution.” This is a standard legal phrase which basically means that AZ will do the best it can to deliver but it does not specify that it must do so at any cost.

The EU’s objection is that if it can be shown that AZ is producing in the EU to satisfy orders outside the region, this constitutes a breach of contract. There is no clear cut answer to this. If there were, neither side would be engaged in dispute in the first place. But the Commission believed that a breach of contract had occurred and in retaliation invoked Article 16 of the Northern Ireland protocol which allows the EU or UK to unilaterally suspend cross border trade if either side considers that trade actions lead to “economic, societal or environmental difficulties.”

It is important to understand the implications in this case. The EC initiated trade sanctions against a third party despite no evidence that the UK government did anything wrong. AZ is responsible for the production and delivery of the vaccine and any action that the Commission wanted to impose should have been directed at the company. I am obviously not an expert on contract law but surely the EC should have taken its dispute against AZ to a court of law, arguing for non-fulfilment of contract, rather than impose border controls without having the courtesy to inform the Irish government first. After all the talk from the EU during the Brexit negotiations about protecting the open border in Ireland, as enshrined in the Good Friday Agreement, this kneejerk reaction from the EC seems rather ill-advised. The fact that the Commission quickly backed down after discussions between Brussels, Dublin and London suggests it realised it had acted too hastily. 

Two unfortunate consequences: (i) Shaky UK-EU trade foundations 

There are two obvious consequences which flow from this unfortunate spat. In the first instance it acts as a reminder that the post-Brexit trade deal is built on shaky foundations. Just 29 days after the trade agreement came into force, with the ink barely dry and exporters on both sides of the Channel struggling to come to terms with the new arrangements, we have a demonstration of the weakness of the UK’s position. Such capricious behaviour does nothing to bolster confidence that there will not be similar tit-for-tat actions which will disrupt trade flows in future. Obviously the EU has no need to take account of British public opinion when taking action but the events of recent days act as a propaganda gift to Brexit supporters who have railed against the EU’s overbearing attitude and will lead to calls to revisit the treatment of Northern Ireland in the trade agreement. Admittedly the British government has form when it comes to dealings in international law, but as the old saying goes “two wrongs don’t make a right.” 

(ii) The ugly spectre of vaccine nationalism 

A second, and perhaps more worrying, aspect is that this is a demonstration of vaccine nationalism that the WHO long ago warned about. In response to concerns that AZ is prioritising deliveries to the UK at the expense of EU countries, the EC imposed controls on vaccine exports to keep track of how many doses were leaving the EU and where they were going. Although EC Vice-President Valdis Dombrovskis told the press that “The measure is not targeting any specific country," the list of countries exempt from the controls unsurprisingly excluded the UK. The EU may call this a transparency measure but in reality it looks like a targeted export ban.

Poorer countries are vulnerable to the actions of the industrialised nations. The UK and Canada have options to purchase enough vaccine to immunise their population four times over whilst the much larger EU has purchased 1.6 billion doses – more than three times the population. This has given rise to accusations of hoarding and the concerns raised by international bodies such as the WHO appear to be falling in deaf ears. Although the COVAX programme is designed to ensure access to Covid-19 vaccines for all countries, many people in world’s poorer nations will not be immunised in the course of this year. Unequal distribution of the vaccine will impose economic costs, with the Rand Corporation  suggesting it could knock $1.2 trillion off world GDP.

Whilst vaccine nationalism is understandable as governments seek to protect their populations, it is not a zero-sum game. From an economic perspective, there are spillover effects from ensuring that poorer countries also gain access to the vaccine (e.g. there will be less disruption to global supply chains from which industrialised nations benefit). From a health perspective, it helps to ensure faster global herd immunity. As the head of the WHO said last September, the vaccine should initially reach "some people in all countries, rather than all people in some countries." Viewed in that light, the actions of the EC do not look good.

Counting the early costs

It is almost four weeks since the UK’s post-EU trading arrangements kicked in and on balance the experience so far has not been good. Admittedly Nissan announced that the trade deal agreed between the UK and EU gave it a competitive advantage vis-à-vis other UK producers. But a lot of evidence has come to light over recent weeks to suggest that the new arrangements imply a significant increase in trade frictions – as many of us warned all along would happen.

Good news from Nissan. But is it Brexit-related?

Let us, however, start with the good news following Nissan’s announcement last week that it will continue production at its Sunderland operations in north east England. A trade deal was vital for the auto industry, which exports around 40% of its output to the EU. Under the terms of the UK-EU trade agreement, so long as cars meet local content rules they will avoid the 10% import tariff levied by the EU. Nissan currently makes about 30,000 Leaf electric cars per year in Sunderland, most of which are powered by a locally-sourced 40 kWh battery and as a consequence they will remain tariff-free. More powerful versions of the vehicle use an imported 62kWh battery which Nissan has decided to produce locally so that they will also remain tariff-free, and will likely create additional jobs into the bargain. But Nissan’s decision may be less Brexit related and more to do with its troubled relationship with Renault. Following the fracturing of the alliance between the two carmakers in the wake of Carlos Ghosn’s well-documented difficulties, industry sources suggest that Nissan is keen to put some distance between itself and Renault and is seeking an alternative to French production locations. If true, this makes the company’s decision less to do with Brexit and more to do with company-specific issues.

Looking across the car industry more widely, Honda announced in 2019 that it would shut its Swindon plant in summer 2021 and investment in the sector has fallen by 71% since the 2016 referendum compared with the period 2011-2016. Recent difficulties in sourcing parts, thanks to delays at ports, has posed problems for a sector that has relied heavily on just-in-time inventory management.  The more we look at the bigger picture, the more difficult it becomes to link Nissan’s decision to the trade deal, welcome though it is.

Fishing: A metaphor for all that has gone wrong

Elsewhere there are mounting recriminations regarding the impact of the new rules on cross-border trade flows. Nowhere is this more evident than in fishing – the totemic issue at the heart of Brexit. The pro-Brexit Daily Express carried a story at the weekend citing a former Brexit Party MEP who claimed that the deal "sold UK fishermen down the drain." Quelle surprise. After all, the government has form in selling out the interests of minority stakeholders in order to secure an overall deal. Moreover, fishing was never realistically going to be allowed to scupper the prospect of a trade deal given its relative unimportance to the UK economy. So much obfuscation took place during negotiations that it is important to be aware of the full facts. For one thing the UK is a net importer of fish, exporting much of its catch to the EU (France is the largest market) whilst much of the fish consumed in the UK is imported from countries as diverse as China, Germany and Iceland (the three largest sources of imports). The fishing industry was naïve to believe that it could block EU access to British waters whilst continuing to have access to EU markets, and the government was extremely cynical in pandering to these demands knowing it could never deliver.

Under the terms of the UK-EU trade deal, it is still possible for UK fishermen to export to the EU but the administrative burden of doing so has risen enormously. With fish sales to the EU falling sharply in the run-up to 31 December, prices collapsed thus reducing the incentive to put to sea. The higher administrative burden further increases the cost pressures on fishermen, making it uneconomic for many of them to remain in business. The fishing lobby has turned its anger on the government but the increase in red tape was always foreseeable given the relatively hard Brexit that the government ultimately delivered. The FT ran a piece on the travails of the fishing industry at the weekend. It is notable that the reader comments (always worth a read on FT articles) were scathing of the greed of the fishing industry, with many pointing out that they pushed for Brexit merely to serve their own purposes without a thought for other sectors which are highly dependent on EU trade.

Where are the sunny uplands?

But trade frictions are impacting much more widely. Sky News reported last week that truck traffic between the UK and EU in the first three weeks of the year was 29% below year-ago levels (chart 1). This may not all be Brexit-related given that the Covid pandemic is leaving its mark on trade flows. However more damning evidence is that the cost of moving goods from France to the UK has risen by 47% in early 2021 compared with the same period a year ago, while the rejection rate (the extent to which hauliers across the continent are turning down cross-Channel work) has jumped by 168%. Trade across the Irish border has also been impacted whilst the trade border between Northern Ireland and Britain, which runs down the middle of the Irish Sea, acts as a disincentive for producers on the mainland to deliver into Ireland.

These trade frictions raise the cost of doing cross-border business and increase delays, whilst ultimately reducing consumer choice in Britain. Those UK businesses which source items from outside the EU and sell them on to EU-based customers now have to pay duties due to the fact they no longer meet local content rules. Similarly, UK consumers buying from EU suppliers also face higher charges. Naturally, this eats into profit margins, which is a particular problem for small businesses which do not have the capacity to cope with the enhanced administrative burden. This led to the bizarre news story last weekend that advisers working for the Department for International Trade are encouraging British firms exporting to the EU to set up facilities in continental Europe. This will, of course, come at the cost of domestically-based jobs.

To some extent what we have witnessed in the last four weeks represent teething troubles, some of which will be ironed out as businesses adjust. There is no doubt that businesses were unprepared for many of the changes, largely because they did not know until Christmas Eve what sort of regulations they were transitioning towards. But the wider point is that this is a new normal to which we will have to adapt. The claims by many Brexit supporters that leaving the EU would lead to a reduction in red tape were highly disingenuous. In his speech on 24 December, Boris Johnson claimed that “in the context of this giant free trade zone that we’re jointly creating … there will be no non-tariff barriers to trade.” This is manifestly not true (nor is the notion of a giant trading zone – the UK and EU are more separated than at any time since 1972).

It is now four years since Theresa May’s infamous Lancaster House speech in which she announced the UK would leave the single market. I have always maintained that this is an act of economic self-harm because it is impossible to envisage any circumstances in which the perceived benefits of increased sovereignty will outweigh the economic costs. According to Thomas Sampson of the LSE (p106 of this report) the deal concluded in December could reduce trade flows by 13% after 10 years compared with the alternative of staying in the EU and reduce per capita incomes by 6% (chart 2). In the near-term, the dramatic costs of Covid will overshadow Brexit costs. But we should be under no illusions that the trade deal represents the sort of hard Brexit we were warning about in late-2018 – the deal served only to prevent a disorderly outcome, and delivered instead a disruptive one. I have noted previously that the only way to demonstrate to people that Brexit comes with costs attached is to implement it. It could be a very costly experiment.

Hey Joe

Four years ago I watched the inauguration of Donald Trump as US President with a sense of trepidation. As I noted at the time there was a lot to be fearful about as he played the America first card, particularly with regard to the economics. Today the great Trump experiment came to an end and liberals around the world breathed a sigh of relief. There was almost unanimous support at the liberal end of the social media spectrum for Joe Biden, and although he is not known for being a great orator, his calls for unity and the sanctity of truth in his acceptance speech were widely praised.

Although Trump vowed in his departure speech that he will be "back in some form", it is unlikely to be in the role of President. His age may not necessarily count against him – he will be 78 at the time of the next election which is the same age as Biden today – but a bigger problem is that many Republican donors are unlikely to want to renew their association in the wake of Trump’s role in inciting the storming of the Capitol two weeks ago. Although Trump is the only President to have twice been impeached, he is still the figurehead for a movement which has huge support in US politics. He may yet play a pivotal role in endorsing a credible nationalist candidate who will make a successful run for the White House in 2024. That, however, is a topic for another day.

As Biden settles into his new role he has his work cut out. As he acknowledged in today’s speech he takes office at a time of unprecedented disunity and the divisions which have plagued American society are not about to suddenly disappear, partly driven as they are by deep-seated economic issues that will take years to resolve. That said Biden is more likely to pour oil on the waters than oil on the flames and the absence of inflammatory messages from the White House which did so much to foment anger in US society will hopefully go some way towards lowering the temperature.

Short-term issue: Stabilising the economy

Social divisions are not the only problem facing the US. In the short-term, the Biden Administration will have to deal with the economic fallout from the pandemic which has now claimed the lives of 400,000 citizens (for the record, this is roughly equivalent to the population of Tulsa). His nomination of Janet Yellen as Treasury Secretary suggests he means business. Yellen is a heavyweight economist who knows her way around Washington and assuming she is accepted by Congress, Yellen will be responsible for implementing the $1.9 trillion fiscal package unveiled last week which will provide support to an economy battered by Covid.

In particular the Administration seeks to provide labour market support, including sending out cheques for $1,400 per person for those under certain income thresholds; extending emergency unemployment insurance programmes through the end of September and a plan to raise the minimum wage to $15 per hour. In her Congressional confirmation hearing yesterday, Yellen responded to concerns about raising the minimum wage by citing the economic literature indicating that it would have only have minimal effects on job losses. Against that estimates produced by the Congressional Budget Office in 2019 suggested that such an increase would reduce employment by 0.8% which is not exactly trivial.

Longer-term issues: China and the climate

In addition to the short-term challenges posed by the Covid crisis, some of the issues that the new Administration will face are more pressing than they were four years ago. China has loomed large in US thinking for a number of years. Trump’s solution to the problem was to confront China head-on and although Yellen called China America's "most important strategic competitor" and said the Biden administration was prepared to use a "full array of tools" to address its "abusive, illegal and unfair practices" it is an even more formidable economic power than four years ago. In simple USD terms, the US economy is now only 40% larger than China compared to 66% four years ago and measured in PPP terms is now around 14% smaller versus broad parity in 2016. Trump’s view that “trade wars are good, and easy to win” was wrong in 2018. Every year that passes disproves this assertion.

Although Chinese GDP measured in dollar terms is unlikely to exceed that of the US in the next four years, it will continue to close the gap. According to the IMF’s latest projections, the US economy may only be 12% larger than China by 2025 which could well nudge ahead before the end of the 2020s. Although it may be toppled from the number one spot before the decade is out, the US has enormous soft power that ought to allow it to continue wielding considerable influence for decades to come. The extent to which it will be able to do so depends on how it manages relationships with its allies. Biden is likely to pursue a considerably different approach to Trump who adopted the old Lord Palmerston maxim that there are no such things as permanent friends, only permanent interests. With Biden expected to signal that the US will rejoin the Paris climate accord and halt its withdrawal from the World Health Organization, this will act as an indication that the US intends to reassert its position as a constructive player on the world stage which will burnish its credentials in the years to come.

Climate change is an area where the US voice has been missing on the world stage in recent years. The Trump Administration took the view that regulations were all cost and no benefit. Yet climate change is increasingly viewed as a national security issue and was recognised by the Obama Administration as a major problem. A report issued almost a year ago by the National Security, Military and Intelligence Panel on Climate Change highlighted the damage that rising temperatures could inflict on the US economy. Efforts to combat climate change require global cooperation and without US support it would be almost impossible to make any headway. A more responsible approach by the Biden Administration would be most welcome.

The future is yet to be written

There are conflicting schools of thought as to what the departure of Donald Trump from the White House will mean for the future of the US. Optimists such as Max Hastings argue that just as America was able to put the turmoil of the 1960s behind it and reinvent itself to become the world’s undisputed superpower, so it will similarly be able to overcome the unrest of recent years to become the confident, outward-looking power that we have grown up with. More pessimistic commentators, such as the prominent conservative Andrew Sullivan, believe that the fissures opened up by the Trump era represent a permanent shift in the US political scene as America adjusts to a new world order. We can only wait for events to unfold.

Twenty years ago it was inconceivable that a populist such as Donald Trump would ever have got near the White House. The classic TV drama, The West Wing, portrayed the US as it liked to see itself – a benevolent superpower acting as a force for good, led by an exceptionally smart president with a positive view of what it could achieve (if you haven’t seen it, it is worth watching and viewers in the UK can catch it here). As the fictional President Bartlet once said “We will do what is hard. We will achieve what is great. This is a time for American heroes and we reach for the stars.” Joe Biden is no Jed Bartlet but if he can put the US back on an even keel he will be hailed – perhaps at home but certainly abroad – as the man who rescued the US from itself.

What price fairness?

As a football fan I have always had time for Marcus Rashford, the Manchester United and England striker. Ever since he made his playing debut five years ago the quality of his play marked him out as a special talent. Over the past year, however, his efforts to raise awareness of the issue of child poverty have elevated his profile beyond the realms of the footballing world. He belies the stereotype of overpaid young footballers and is a credit to his generation.

The school meals debate

In recent days Rashford has lent his support to the campaign against the meagre food parcels provided to low income families whose children would otherwise be receiving free school meals were the schools not closed due to Covid restrictions. The parcels supposedly contained five days’ worth of food valued at £30 but after a social media campaign which highlighted that the value of the parcels fell far short of this, the company providing them was forced to apologise and admit they had failed to meet expected standards. This incident raises a number of issues regarding deficiencies in the UK social welfare system which really ought to be high on the government’s to-do list, with some obvious short-term fixes required but a longer-term overhaul is also necessary.

In this particular case, it is notable that the government fell into line only after Rashford offered his high profile support. Having attempted to ignore Rashford’s intervention on this issue last summer, the government realised very quickly that public opinion would side with the footballer and this was not an issue in which it would prevail. It also shines a light once again on the links between the political system and companies which win government outsourcing contracts. Paul Walsh, the former chairman of Compass Group, which provided the food parcels, and who stepped down last month, donated to the Conservative Party in 2010 and publicly backed David Cameron for prime minister in 2015. Since 2016, Compass Group is reported to have won contracts worth almost £350m for school catering. The almost incestuous relationship between business and politics is not going unnoticed abroad, with the New York Times reporting last month on “Waste, Negligence and Cronyism: Inside Britain’s Pandemic Spending.” 

The bigger picture

But arguably a bigger problem is the threadbare state of the UK social safety net, even before its shortcomings were exposed by Covid. It is the weaknesses in the system and the consequences they have for people lower down the income scale that have prompted the likes of Rashford to get involved. The state of the welfare system is an issue that I have written about quite a lot over the years but when even the Financial Times points out the deficiencies in the system the government really ought to take note. Concerns over the alleged generosity of the UK welfare system have been a staple of the popular press for years. Indeed, one of the issues during the Brexit campaign was concern that the UK’s generous welfare benefits attracted a lot of economic migrants who threatened to overwhelm the system. I pointed out five years ago that claims made for the generosity of the UK system were untrue. UK in-work benefits are less generous than the EU average for families with children (around 3-4% lower). Moreover, only those entitled to make a claim can actually receive them and recipients must demonstrate a sufficient degree of attachment to the host country.

For those without children, unemployment benefits are parsimonious in the extreme. According to OECD data, a single person without children in the UK whose previous earnings were two-thirds of the average wage earns 17% of their in-work wage after one month of unemployment compared with an OECD average of 67%. Although this figure tapers away in many countries in a bid to discourage ongoing benefit claims, even after one year the OECD average benefit payment is 43% of previous wages (chart). Not only is the system particularly stingy but claimants for Universal Credit (UC) have to wait five weeks after their first claim before receiving any money, which is quite a problem for those living a hand-to-mouth existence. Just after the last election I did suggest that eliminating this lag would mitigate the worst of the problems and would go some way towards rewarding low income voters who had voted the Conservatives into office. We are still awaiting a permanent fix although the government has temporarily raised the UC payout by £20 per week. Whether it will be extended beyond March remains to be seen.

One of the reasons for the parsimony of the benefits system is that government policy is designed to persuade people that they are better off working rather than claiming benefits. This is not a bad policy in itself. However, there are a rising number of people who are struggling to keep their head above water even though they are in work. According to the Joseph Rowntree Foundation’s latest annual report on poverty in the UK, the proportion of workers who live in poverty has risen in recent years and stood at almost 13% in 2018/19.

As the economist Paul Johnson has pointed out, until fairly recently poverty was an out-of-work phenomenon. The traditional route out of poverty for most people was employment. However this part of the social contract has broken down as far too many people are in jobs that do not pay them enough to allow them to change their circumstances. The reasons for this are complex but they include factors such as the widespread adoption of so-called zero-hours contracts, particularly in low-paid sectors, in which the employer does not guarantee a minimum number of working hours. As a result, many people find themselves income constrained and suffering the uncertainty of not knowing from one day to the next what their income will be. The lockdowns introduced in a bid to curb Covid have made matters worse, since they have impacted most heavily on those low paid workers in sectors such as leisure and hospitality.

What to do?

As for where we go from here, it is too easy simply to say throw more money at the problem. But the JRF recommends that “at a minimum, we need the temporary £20 per week increase to Universal Credit and Working Tax Credit to be made permanent … We also need to shift public thinking so that a poverty-reducing social security system is seen as an essential public service and receives sustainable investment.” Another big problem for those at the low end of the income scale is the cost of housing. A huge rise in house prices over recent years has priced many low earners out of the market and forced them into the expensive private rental sector. The JRF calls for more investment in social housing “as part of a stimulus package, and to reverse the long-term trend of falling availability of social housing.”

The JRF’s demands argue for a greater role for government which would be a reversal of the broad direction of travel of the last 40 years. Perhaps the Covid crisis will indeed be the trigger for a rethink of the primacy of market over state. But recent indications that the government is more concerned to roll back much of the legislation enshrined in the EU “working time directive” rather than reform the welfare system does not fill me with a lot of hope. As Mark Carney noted in his Reith Lecture series last month, the drift “from a market economy to a market society” suggests that issues of distribution and fairness are often overlooked. What the Covid crisis has demonstrated is that we are not all in this together with low earners taking a bigger proportional hit. Economic fairness may well become one of the big social issues of the 2020s and the government would be wise to think about fixing some of the holes in the welfare safety net before it is too late.

The second Covid crisis

As the second wave of Covid intensifies and with the WHO about to send a team to China to examine the origins of Covid-19, it is interesting to reflect on where we stand in the current cycle and what we know from past pandemics. To date, more than 1.9 million people worldwide are estimated to have died during the current pandemic which has now entered its second year (the first death in China was recorded on 11 January 2020). This compares with the inappropriately named Spanish Flu epidemic of 1918-19 which is estimated to have claimed more than 50 million lives. 

Comparisons with the Spanish Flu 

Evidence based on records back to the sixteenth century suggests that the influenza virus mutates relatively slowly with a dominant strain emerging only every 2-3 years. Since each variant tends to adapt to prevailing climatic conditions, seasonal weather patterns and the associated change in human behaviour reduce its ability to thrive thus limiting its spread and the potential for rapid mutation. This was not the case in 1918-19 when there were three waves of the disease within a relatively short period (chart 1). In the words of Jeffery Taubenberger and David Morens in this excellent paper, “Acquiring viral drift sufficient to produce new influenza strains capable of escaping population immunity is believed to take years of global circulation, not weeks of local circulation. And having occurred, such mutated viruses normally take months to spread around the world.” Even now it is not clear that virus mutation was responsible for the spread of the disease but it remains the most plausible explanation.

Just as was the case a century ago, a second wave has emerged very quickly and it is almost certainly the result of virus mutation. Developments in genome sequencing mean that we can now identify new strains more quickly. The variant of Covid-19 that spread across the world last spring (D614G) was already different from the initial SARS-CoV-2 strain identified in China, and new strains have since been identified in the UK, South Africa and Japan. The UK variant is known to be more infectious than previous strains of the virus, raising the R (reproductive) number in Britain by between 0.4 and 0.7 with latest estimates putting the R value between 1.0 and 1.4 (infections will only tail off if the R number is below one). For the record, at its peak the Spanish Flu virus was estimated to have an R number between 2 and 3.

Getting worse before it gets better

It now appears that countries which escaped relatively lightly during the first wave of the pandemic are being more heavily affected this time around. At the start of November, Germany and Switzerland reported mortality rates of 13 and 27 respectively per 100,000 of population. Latest statistics suggest the German mortality rate has almost quadrupled to 49 whilst the Swiss figure has risen to 94. Mortality rates in the US and UK, which were running at 70 per 100,000 in early November, have risen to 114 and 122 respectively whilst Italy is running at 130 and Belgium has spiked up to 175 (chart 2). There will be a time to discuss what different countries did right and what they did wrong which has led to such differing incidences of the disease. But that time is not now: We can leave the recriminations until later as governments put their efforts into bringing the spread of Covid-19 under control.

Lockdowns: Harder or smarter?

There are high hopes that the vaccines which are now being rolled out will help limit the spread of the disease, reducing the strain on the health system and ultimately mortality rates. But these will take time to work through the population and we must thus continue to rely on lockdown measures. Lockdowns remain highly controversial almost ten months after they were introduced across Europe and not surprisingly the longer they last, the more people begin to get fed up. Psychologists argue that they can only work on a sustainable basis when there is a partnership between governments and the people. There must be no “them and us.” It is thus vital to get the tone of the message right when asking society to make significant sacrifices.

The approach by the UK Home Secretary, Priti Patel, who noted in yesterday’s daily briefing that a minority of people are “putting the health of the nation at risk by not following the rules … If you do not play your part, our selfless police officers... will enforce the regulations and I will back them to do so” is precisely the wrong way to go about ensuring compliance. The psychologist Stephen Reicher, who is part of the government’s Scientific Advisory Group for Emergencies (SAGE), argues that blaming the public for non-compliance undermines trust and threatens the success of the measures He noted in a Tweet that, “Patel is disastrously wrong in nearly every way: Lack of public compliance is NOT the problem: by and large people ARE complying.” He further noted that “the real problem is not that people are 'flexing’ the rules but that the rules are too flexible … And harsh enforcement only makes a dire policy still worse … Certainly use enforcement as a last resort, but engaging explaining and encouraging the public works far better.”

Harsh enforcement measures serve to stir up public anger and give oxygen to the anti-lockdown campaigners, who argue that Covid tends to be of greatest harm to the elderly and those with pre-existing health conditions and that the disease is little more deadly than normal seasonal flu (even now, this kind of false message is being peddled on websites such as lockdownsceptics.org). The fact that this view is widely held has forced the media to confront the issue. But as this BBC interview from last week demonstrates, the debate continues to be held in an echo chamber. Since neither the pro- nor anti-lockdown protagonist have a background in epidemiology, most people were left with the impression that the interview was designed merely to stoke up debate rather than shed any light. Moreover, the below-the-line comments on YouTube were overwhelmingly in favour of the anti-lockdown proponent. The government’s message is clearly not getting through.

Whilst there is a growing body of empirical work to support the notion that lockdowns work, they do impose a large economic cost. This raises the question whether it is possible to impose lockdowns whilst minimising the degree of disruption. A paper by Chen et al in the CEPR’s large and expanding collection of Covid economic research (here), which suggested that the type of lockdown matters, thus caught my eye. Their empirical analysis across 75 countries which tracks changes in the R value against the Oxford COVID-19 Government Measure Tracker (OxCGRT) and the Google mobility indices concludes that “gathering bans appear to be more effective than workplace and school closures.” They also offered empirical support for the belief that larger household sizes tend to diminish the effectiveness of mobility reductions which mitigates against the effectiveness of such measures in developing countries.

This is an important insight ahead of suggestions that the UK government may be considering an even stricter lockdown. However, the evidence suggests that the rate of infections may be slowing down – the number of positive tests on 11 January was more than 20% below the levels a week earlier. We may be able to get away without any appreciable tightening of the restrictions. Indeed, based on the OxCGRT data Germany, the Netherlands and Sweden are amongst the few countries to have a stricter lockdown in place today than in the spring of last year and the strictness of the European average lockdown index is somewhat lower than at its 2020 peak (chart 3).

Even if lockdowns are not tightened, they are almost certainly not going to be eased anytime soon. The German government has suggested that lockdown measures could remain in place for another 8 or 10 weeks whilst the Dutch national lockdown has been extended by three weeks to the end of the first week of February. As a result the pain experienced by the services industries, which are most heavily impacted by social distancing rules, will continue into the early months of 2021. It is increasingly looking as though the early part of the year will register significant output contractions across Europe as the hoped-for economic recovery remains elusive.

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.