No expectations

Inflation remains one of the big items on the policy agenda with the IMF’s latest World Economic Outlook devoting a considerable amount of space to the topic, warning that “central banks should remain vigilant about the possible inflationary effects of recent monetary expansions.” In fairness the IMF does use the stock phrase beloved of policy analysts that “long-term inflation expectations have stayed relatively anchored.” However this comes at a time when parts of the macroeconomics profession are beginning to question just how much we really know about the inflation generation process, with the role of expectations coming under particular scrutiny.

Like many areas of economics the forces underpinning inflation have been subject to various fads over the years. Between the 1950s and 1970s, attention focused on the labour market and the role of the wage bargaining process. During the 1980s monetary trends were the flavour of the period but over the last 25 years the main area of focus has been the deviation of output from the NAIRU and the determination of inflationary expectations. Given the change in fashions over the years, it is difficult to take seriously the idea that there is a generic theory of inflation: like theories of the exchange rate, different factors drive the process at different times.

For my part, I have long harboured doubts about the way macroeconomics treats inflation (see the posts Do we know what drives inflation? from August 2017 and Monetary policy complications from October 2017 for more detail). It was thus heartening to see that economists at the Federal Reserve share similar reservations. In a highly readable paper published last month, which received considerable media exposure, Jeremy Rudd of the Fed staff posed the question ‘Why do we think that inflation expectations matter for inflation? (and should we?)’

As the paper’s abstract noted, “A review of the relevant theoretical and empirical literature suggests that this belief [in expectations] rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” Rudd goes on to describe competing models of inflation used by macroeconomists over the past 50 years and concludes that the use of expectations to explain inflation dynamics is both unnecessary and unsound. In his view it is unnecessary because it can be explained more readily by other factors and unsound because it is not based on any good theoretical and empirical evidence. Moreover, the theoretical models are influenced by short-term (usually one period ahead) expectations, which “sits uneasily with the observation that in policy circles … much more attention is paid to long-run inflation expectations.”

The empirical evidence suggests little evidence of a direct effect of expectations on inflation. According to Blinder et all (1998)[1], “what little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a pre-emptive fashion.” Evidence from the Atlanta Fed survey of business inflation expectations over the past decade confirms that expectations have been remarkably constant until relatively recently with unit costs one year ahead generally expected to grow at an average rate of 2% (chart). However, it is notable that during 2021 there has been a sharp pickup as the economy suffered bottlenecks in the wake of the pandemic.

The standard central bank view of inflation expectations was highlighted in a 2019 speech by BoE MPC member Silvana Tenreyro. It is a perfectly fine piece of conventional economic analysis as befits an orthodox central bank economist. She noted that household inflation expectations are a key input into the BoE’s thinking, arguing that for any given interest rate, higher inflation expectations increase households’ incentive to spend today rather than saving. But once you start digging below the surface, the argument rests on some weak foundations. For example, the evidence from both the US and UK suggests that households consistently expect CPI inflation to average close to 3% at horizons of between one and five years ahead. In other words, despite the best efforts of central banks, households continue to expect inflation to run above their target rate. Tenreyro was also forced to concede that “households do not always adjust their expectations even when prices start rising more quickly or slowly than they had expected” which really ought to raise some questions about their usefulness.

A more serious criticism of inflation expectations came from Rudd who pointed out that “the presence of expected inflation in these models provides essentially the only justification for the widespread view that expectations actually do influence inflation … And this apotheosis has occurred with minimal direct evidence, next-to-no examination of alternatives that might do a similar job fitting the available facts, and zero introspection as to whether it makes sense.” Instead Rudd offers the explanation that the absence of a wage-price spiral is one of the key defining features of recent inflation dynamics. He goes on to suggest that “in situations where inflation is relatively low on average, it also seems likely that there will be less of a concern on workers’ part about changes in the cost of living … But this is a story about outcomes, not expectations.” In other words, when inflation is below a certain threshold level workers stop pushing for bigger wage hikes which has contributed to keeping inflation low – unlike in the 1970s.

This has a number of important policy implications:

• First, it will be important to keep an eye on whether wage settlements are responding to higher price inflation. 
• Second, because central bank economists, who are influenced by latest academic thinking, generally tell policymakers that “expected inflation is the ultimate determinant of inflation’s long-run trend, [they] implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy.” 
• Third, precisely because inflation dynamics are influenced more by outcomes than expectations, “it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “reanchor” expected inflation.” 
• Finally, “using inflation expectations as a policy instrument or intermediate target has the result of adding a new unobservable to the mix. And … policies that rely too heavily on unobservables can often end in tears.”
  

Even if you do not accept Rudd’s premise (and many mainstream economists do not) this is an important contribution to the debate. One of the criticisms being bandied around as the economy rebounds from the 2020 collapse is that there is insufficient diversity of thinking around some of the key underpinnings of mainstream macro. If nothing else, Rudd forces us to think more critically about how we think of inflation and our understanding will be all the stronger for it.

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[1] Blinder, A., E. Canetti, D. Lebow, and J. Rudd (1998). ‘Asking About Prices: A New Approach to Understanding Price Stickiness’. New York: Russell Sage Foundation.

Hiding in plain sight

They say that if you are going to lie then you might as well lie big by distorting the truth in plain sight, and by so much that people cannot possibly credit that what you are saying is false. Yet when it comes to the economics of Brexit, that is exactly what is happening. All the downsides that the government was warned about are not perceived as problems: They are now being sold as features of the new system as the economy transforms from one model to another. You have to hand it to Boris Johnson for being able to deliver his closing message at this week’s Conservative Party conference with a straight face. Indeed, I have to regularly check the calendar to make sure that it is not 1 April because the British electorate are now being taken for fools.

As a former journalist, Johnson is without a doubt a great wordsmith as his conference address demonstrated. But a journalist is meant to engage in a modicum of factual reporting: Johnson’s journalism career as a reporter from Brussels was more akin to a purveyor of fiction. His speeches as prime minister are often no different. To quote the blond bombshell himself, “after decades of drift and dither this reforming government, this can-do government, this government that got Brexit done … [is] dealing with the biggest underlying issues of our economy and society, the problems that no government has had the guts to tackle before, and I mean the long-term structural weaknesses in the UK economy.” I don’t want to be overly pedantic but the Conservative Party has held office for 29 of the last 42 years (almost 70% of the span since 1979). If there has been “drift and dither” surely they have to take some responsibility for that?

To quote Johnson further, “we are not going back to the same old broken model with low wages, low growth, low skills and low productivity, all of it enabled and assisted by uncontrolled immigration.” That is an astonishing statement – and it is wrong. The evidence suggests that economic migrants tend to be better educated than the host population. In 2016 the Rand Corporation reported that “In England and Wales, for example, 23% of the working-age, native-born population has no qualifications. This compares with only 13% of migrants from [EU12] countries.” Education and training should in theory show up in total factor productivity growth – the intangible factors which are external to labour and capital inputs. Reducing the education input by turning away better educated foreign workers ought to make productivity worse in the long run and there is some evidence from the official data to suggest that between mid-2018 and end-2019 TFP actually deteriorated (chart below).

Even before the conference, business was not happy about being lectured by government on how to deal with the reduced flow of EU workers upon which they have heavily relied. Simon Wolfson, CEO of Next plc and also a prominent Brexit supporter, has argued strongly that the UK needs to import labour. As he noted in a newspaper article, “the only thing Brexit decided was that the UK must determine its own immigration policy. The vote did not decide what that system should be; nor did it determine that only those on one side of the Brexit debate should have a say going forward.”

Johnson’s answer to the queues which have built up outside petrol stations is to pay tanker drivers more in order to alleviate the underlying labour shortages. You don’t have to be an economist to work out that a pay rise not backed by productivity improvements is inflationary. Perhaps we should not expect anything more serious from a prime minister who is known for his “f*** business” message (there was a lot more truth in that quote than we knew). Beneath the bluster, there is a more serious underlying point. Brexit was meant to set UK business free to connect with more rapidly growing parts of the world and liberate it from the constraints imposed by the EU. It was after all, heavily backed by the free market lobby. What the government has instead done is to impose additional red tape by raising tariff barriers with the EU where previously there were none, and is now telling business how to operate. As Johnson put it, companies must not “use immigration as an excuse for failure to invest in people, in skills and in the equipment the facilities the machinery they need to do their jobs.” It’s a message worthy of a Soviet May Day speech in Red Square.

The think tank and business community did not respond positively to the message they heard from Johnson. The free market Adam Smith Institute, which has traditionally been a supporter of the Tory agenda, described it as “bombastic but vacuous and economically illiterate ... It’s reprehensible and wrong to claim that migrants make us poorer.” The similarly free market Institute of Economic Affairs noted: “Boris Johnson’s rhetoric is always optimistic and enterprising, but insofar as there were actual policies behind it, they seemed to involve yet more state intervention and spending.” The CBI commented, “what businesses urgently need are answers to the problems they are facing in the here and now … The economic recovery is on shaky ground and if it stalls then the private sector investment and tax revenues that the prime minister wants to fuel his vision will be in short supply.”

We always have to take conference speeches with a huge pinch of salt. They are designed to appeal to the party faithful and are not a platform for delivering policy prescriptions. But even against this low benchmark, Johnson’s vision of the post-Brexit UK economy was heavy on the feelgood factor and light on the specifics of how it can be realised. But maybe this is to miss the point of what Johnson is trying to do. As the Frankfurter Allgemeine Zeitung noted, maybe he “is not striving for Thatcherism 2.0, but for an almost Rhenish capitalism, with a caring state at the top. A Tory government under Johnson no longer wants to see itself as an extension of business, but as a "people's government" that also seeks conflict with business.”

There is no doubt that in order to deal with the economic challenges which lie ahead Johnson will have to get a large slice of the electorate onside. Whilst his economic position looks very difficult today, and it is one which has felled prime ministers in the past, we should not dismiss Johnson’s ability to generate a feelgood factor when there is little to feel good about. He is a political phenomenon. Admittedly economics is not his strong point but this has never been a hindrance to those seeking high office, as the Brexit referendum showed.

The Labours of Keir Starmer

A few months ago I pondered on the fate of the centre left in Europe and suggested that it “will struggle to remain relevant unless there is a radical change of tack.” Last week’s strong showing by the SPD in the German election demonstrated the unerring (in)accuracy of my political predictions. Against that backdrop, the Labour Party in the UK held its annual conference last week, giving Keir Starmer his first opportunity as leader to speak to the party faithful in person. As with most political events these days it polarised opinion. Unfortunately for Starmer, the polarisation came from within his own party with a significant minority unable to forgive him for usurping the sainted Jeremy Corbyn who was always ever one last push away from delivering the socialist utopia that the British electorate has spent the last forty years rejecting.

It has indeed been a bleak couple of years for Labour. In December 2019 they suffered a historical election defeat, registering their lowest number of parliamentary seats since 1935. Following Corbyn’s resignation he was later suspended from the party on anti-Semitism grounds. Although he was subsequently readmitted, Corbyn remains suspended from the parliamentary party (he is not counted as a Labour MP, despite having won his seat in the 2019 election). This triggered an internecine conflict between the faction supporting Corbyn and the group of centrists backing Starmer who realise that he is Labour’s best chance of being re-elected to office. It has been an unedifying spectacle at a time when the UK has been convulsed by the pandemic and when the economic costs of Brexit are becoming more evident. This navel gazing has contributed to Starmer’s poor approval ratings, with only 20% believing him to be doing a good job compared with 59% who disapprove, whilst Labour trails by 5 points in the overall polls (chart).

Starmer inherited the leader’s mantle in April 2020 as the pandemic was taking hold, at which time the Tories had a poll lead in excess of 20 points. It is a well-worn political phenomenon that incumbents tend to enjoy a popularity surge during times of national emergency. But Labour did sufficiently well that by November 2020 it had reduced the Tories’ double digit poll lead to zero. Within six months, however, the Tories had widened their lead back out to 12 points. Obviously the vaccine bounce gave the government a boost but there was more to it than that. Starmer was open to the charge that Labour did not have clearly defined policies on a lot of issues and the internal splits within the party were playing badly with the electorate.

Holding office but wielding little authority

At one point, following the loss of a critical by-election,Starmer removed his deputy from the position of chair of the party only to have to appoint her to another high-profile position following unrest from the left-wing. During the conference, unions voted against a motion that would have committed the party to pushing for a change in the UK voting system towards proportional representation. This was widely seen as one of the few ways that Labour has a real shot at getting into government now that it can no longer rely on winning seats in Scotland.

All this has given rise to a perception of a leader who holds office but does not wield control. So it was that Starmer’s conference speech was widely recognised as vitally important if he was to generate any form of cut through with the wider public. In the event it was well received (although at 90 minutes, it was long by any standards). However it cannot gloss over the fact that a significant swathe of the Labour Party prefers slogans to election winning policies. The left-wing element which continues to follow the Corbynite policy stance so heavily rejected in 2019 has given no sign that it is prepared to make the necessary comprises required to defeat their political opponents. So long as this is the case, Labour will remain a party of opposition rather than government.

What can they do?

UK elections are usually lost by the incumbent rather than being won by a coherent opposition, and with three years until the next scheduled election it is too soon to write off Labour’s chances. However, it is clear that they need to offer a compelling vision for the future and for all the positive noises surrounding Starmer’s conference speech, there was little of any substance. Perhaps this is partly because in recent years the Conservatives have appropriated many of Labour’s policy ideas, but not before first denigrating them and then repackaging them as their own. In this context it is therefore understandable that Starmer does not want to give too much away. Moreover, the Conservatives, who for years sold the idea that Labour was the party of big government that would “bankrupt Britain”, have moved into Labour’s territory with their huge public support schemes and recently-announced tax rises. So what can Labour do to differentiate themselves in areas that will make a difference? I offer four simple prescriptions:

1. Repair relations with the EU by committing either to rejoining the EU Single Market or establishing a customs union (assuming, of course, that the EU is willing to open negotiations). In doing so, Labour would have to be quite clear that this does not mean rejoining the EU – that idea would be a sure-fire vote loser. Tactically, such a policy would open up some clear water between them and their political opponents and highlight that the form of hard Brexit adopted by the current government is making life more difficult for the UK. 
2. Fix the Universal Credit system. As I have outlined previously, there are two quick fixes that can be made: (a) reduce the waiting time between claiming state assistance and actually receiving any funds and (b) reducing the taper rate at which benefits are withdrawn when people transition back into work. Such a policy would be of most benefit to those at the lower end of the income scale – precisely those who Labour say they most want to help (I will come back to this in a future post). 
3. Commit to not raising the rate of corporation tax following the hikes implemented by the current government. This would go some way to allay fears that Labour will take measures that weaken the UK’s international competitiveness and, in Starmer’s words, will help reset “the relationship between the government and business.” 
4. Invest in the infrastructure necessary to meet the aim of transitioning towards electric cars. I have long been of the view that this needs to be done well ahead of the point at which the sale of vehicles powered by petrol or diesel is phased out. With the deadline for this having been brought forward from 2040 to 2030, we have only eight years left and arguably the network needs to be substantially completed within six.

Why this matters

You do not have to be a supporter of any particular party to realise that a credible opposition is required to keep the government on its toes. Without this moderating factor, governments become complacent and formulate policies to suit the interests of their supporters rather than the country as a whole. Keir Starmer may yet be the man who can drag Labour back to the centre of the political spectrum and make them a credible political force again. But if he is to be successful at the ballot box, his party members have to get behind him and start to sound like they want to govern rather than merely act as a protest movement.

15 rounds with reality

Leon Spinks was a former world boxing heavyweight champion who gained the title in 1978 by inflicting only the third ever defeat on an ageing and complacent Muhammad Ali. Ali regained the title later that year and Spinks went on to an undistinguished career which saw him win only 26 of his 46 professional fights. The moral of the story is that it is possible to trigger an upset if the opposition is complacent, as Ali was, but success on that one day will not guarantee future success if you merely got lucky and fail to prepare properly for the challenges which lie ahead.

As queues build up outside filling stations as lorry driver shortages hamper deliveries of fuel, I was reminded of the Spinks effect in a Brexit context. The Remain campaign was clearly complacent in the conduct of its 2016 campaign, allowing Leavers to win a narrow points decision. But the Brexit cheerleaders have clearly failed to prepare for what comes next, and even though it is possible to blame Covid for the magnitude of the problem, it is hard to avoid the view that after going 15 rounds with reality, the economics of Brexit is now getting the pasting that all the knowledgeable pundits said would happen.

Government ministers have been out in force on social media telling us that there is no fuel shortage. The new culture secretary Nadine Dorries reinforced the message in a Tweet in capital letters, thereby convincing people of the exact opposite. There may well not be a fuel shortage, but there is a delivery problem and people increasingly do not take the government on trust. And as I pointed out at the start of the pandemic, “If you believe that a major problem is about to be visited upon you … a sensible forward-looking economic actor will make some sort of contingency rather than trust to luck.” 

But the bigger point is that this is not just about fuel shortages. It primarily concerns the British government’s blithe dismissal of the economic consequences of Brexit that they were warned about. What was dismissed for years as Project Fear has now become reality. And before people get on my case about the fact that Covid is really to blame – as the government is trying to tell us – I invite you to point me in the direction of media stories around the EU of empty supermarket shelves and fuel shortages elsewhere.

What they said

To put some flesh on the bones of what Leavers said, it is worthwhile visiting the BrexitCentral archive of articles written by prominent supporters of the Leave movement to remind us of what they promised, how Brexit could be delivered and why the Remainers were wrong to oppose them. It represents a litany of all that was wrong with the debate – a group of believers preaching a misleading message to those who were already committed to the cause. But it is important to remind ourselves of the economic benefits that Brexiteers promised would flow from leaving the EU, and equally importantly, what would not happen in order that they be held to account. 

In November 2017, for example, David Davis told us to “stand firm in the face of the onslaught of Project Fear propaganda.” The article was a one-sided view of the gains to be derived from a go-it-alone trade policy which dismissed all the evidence on the other side of the ledger. Davis reminded us of the “hysteria over the rationing of food and medicine.” The empty shelves and strains on an underfunded NHS are evidence that Brexit has made a bad situation worse.

The economist Graham Gudgin told us “why a UK-EU customs union remains a terrible idea” arguing amongst other things that “there is not much evidence that a customs union would be more beneficial for UK-EU trade than a standard free trade agreement.” The likes of Gudgin have been less forthcoming on the question of why the UK looks set to drop out of Germany's top 10 trading partners for the first time since 1950. Julian Jessop, another Brexit supporting economist, noted in 2019 that “some have seized on the one-liner that ‘low income groups will be disproportionately affected by any price rises in food and fuel’. Equally, of course, these groups would disproportionately benefit from any reductions in the prices of food and fuel.” Try telling that to poorer households bracing themselves for a double digit rise in domestic fuel bills next month. Peter Lilley argued that “EU economic policy has held the UK back and cost us £82 billion over two decades.” It’s barely worth even responding to such trite nonsense, but suffice to say that my analysis using synthetic control methods pointed to a GDP loss in excess of £100bn in the 3 years following the vote to leave the EU.

One of the central tenets of Brexit economics was that the UK would be free to sign trade deals with third countries which would allow the UK to tap into more rapidly growing markets. Key to this was the prospect of a trade deal with the US. Brexit ultra, Iain Duncan Smith wrote that “achieving a Free Trade deal with the United States alone would be equivalent economically to achieving Free Trade deals with the entire world … This is because the vast US economy could supply virtually every good that the UK currently imports.” Brexiteer economist par excellence, Patrick Minford, wrote in 2019 that “Boris Johnson has already made it clear he will urgently look for a trade deal with President Trump.” This week Johnson visited the US, holding talks with President Biden who played down hopes of a UK-US trade deal, whilst the US Ambassador to Britain recently told Sky News that a comprehensive UK-US free trade deal is “not the be-all and end-all”.

It’s just not happening

The Brexiteers made great play of the fact that forecasts which portrayed a gloomy economic future were made by institutions such as the Treasury whose forecasts, in the words of David Davis, ”have almost never been right and have more often been dramatically wrong.” Words of contrition from those who peddled this view have been conspicuous by their absence. And in one of the great ironies of the current situation, the government is being forced to issue temporary visas to lorry drivers from other EU countries to alleviate domestic shortages. Remember they need us more than we need them? In any case this will not resolve the underlying problems, as the road haulage industry has made clear, and presupposes that they would want to come given that shortages are a Europe-wide problem.

There should be no doubt in anyone’s mind that Brexiteers lied about the economic benefits – their own words provide the most damning evidence. That the opposition Labour Party is unable to hold the government to account, given its preoccupation with internal political battles, is nothing short of a scandal (and the subject of another post). However, not all Brexit supporters were as deluded as the ultras. Gerard Lyons pointed out that “if we left the EU in a stupid way then there would be no dividend.” Well, we did so there isn’t.

Much like the unfortunate Leon Spinks, whose early career represented a triumph of hype over ability, the economics of Brexit is being tested by reality and found wanting. But Spinks was the one who ultimately paid the price. In the case of Brexit there are 67 million of us taking a good beating.

After Angela

The most popular politician in Germany

Three years after she announced that she would not stand again for re-election the moment of truth has finally come for Angela Merkel who will stand down as Chancellor once a government is formed following Sunday’s election (note: past experience suggests it could take a while before this is finally achieved). It is difficult to predict the election outcome: The SPD, which has been languishing in the polls for years, has enjoyed a slight lead over the CDU/CSU in recent weeks but with no party currently polling more than 25% (chart below) many different combinations of government are still possible.

The collapse in support for the CDU/CSU to its lowest recorded level on data back to 1994 is remarkable: Just six weeks ago they enjoyed a six point lead over the SPD. This is at least partly due to the fact that Merkel’s prospective successor, Armin Laschet, is unpopular. Pollsters reckon that around one-third of voters who backed the CDU in the 2017 election did so because of Merkel. Her absence from the ballot paper could cost the party dearly. Whilst Merkel enjoyed a high reputation abroad, her reputation at home looks very solid too. Indeed the latest domestic poll gives her an approval rating of 80% versus only 17% who do not think she is doing a good job. She is also judged to be far and away the most competent of all Germany’s leading political figures, scoring +2.4 on a scale of -5 to +5, compared to Laschet’s dismal showing of -0.4 and some way ahead of the SPD’s candidate for Chancellor, Olaf Scholz, at +1.6.

To some extent this is a reflection of the incumbency effect – Merkel has, after all, occupied the Chancellor’s office since 2005. She took up the post in what are now fondly described as the good old days: before the financial crash; before the euro zone debt crisis; pre-Trump and pre-Brexit. Merkel has subsequently dealt with all of these international crises in a calm, pragmatic fashion, steering Germany through the storms. For that alone, she will be missed at home. But she will also be a big loss on the international stage where leaders with a reassuring presence have been in short supply of late (think Trump or Johnson).

But it has not all been plain sailing. Germany’s role as Europe’s political and economic leader has been reinforced during Merkel’s term, largely by default as traditional international players such as the UK and France became more inward looking. However, she has appeared reluctant to embrace the role. This is in keeping with her natural caution. Merkel has never been one for the grandiose vision and as an apparently keen student of history, she is well aware of the backlash that would emerge in certain quarters if Germany were to start throwing its weight around on the international stage.

... though not necessarily the most economically astute

Her biggest policy error was the handling of the Greek debt crisis. The German government’s insistence that Greece live up to its obligations under EU law may have been in keeping with the letter of the law but was not in keeping with its spirit. Insistence on a punishing austerity programme condemned Greece to an economic depression from which it has yet to recover. For someone with an appreciation of history, this was an uncharacteristic error. As the German economic historian Albrecht Ritschl has pointed out, the cancellation of Germany’s post WW2 debt laid the foundation for the Federal Republic’s modern economy giving rise to the charge of hypocrisy. More seriously, the Greek episode raised many question marks about the future of the euro zone, few of which have been satisfactorily answered. Merkel’s tactics during the debt crisis may yet prove to be very short sighted.

Indeed, Merkel has never shown any great aptitude for economic issues. She came to office in 2005 on the back of the reforms initiated by her predecessor Gerhard Schröder who initiated a programme to boost renewable energy and introduced the painful Hartz IV labour market reforms that did so much to boost German competitiveness. In many ways Merkel reaped the reward of these policies without having to do much herself and she has been far less willing to engage in reform, preferring to maintain the status quo. On energy policy, Merkel’s government did pass legislation in 2010 in support of the Energiewende to continue the process of transforming Germany into a low carbon economy. However, in the wake of the Fukushima nuclear disaster in Japan, Merkel promised to shut Germany's fleet of nuclear reactors by 2022 which resulted in a slower phasing out of coal and fossil gas generation than originally planned. Consequently, the pace of reduction in German CO₂ emissions has slowed over the past decade compared to the previous decade.

Domestic fiscal policy has largely acted with restraint. Germany’s “schwarze Null” budget policy, which aims for balance or a small fiscal surplus, coupled with the debt brake effectively acted as a restrictive financial straitjacket at a time when the economy has tended towards deflation and when infrastructural investment needs have mounted. During a period when Germany has run a significant current account surplus, the government has come under pressure to run a more expansionary fiscal policy but Merkel’s administration has consistently rejected demands to do so. That said, she has proven pragmatic in providing fiscal support when the economy most needed it, particularly in the wake of the 2008 crash and again during the corona pandemic.

Measuring the balance

Although Merkel has not had to be a reforming Chancellor, Germans have little cause for complaint. Indeed, she should be given credit for not derailing the reforms put in place by previous governments. Perhaps one reason for Merkel’s popularity is that she has managed to maintain the status quo by insulating voters from the changes going on around them. For example, Brexit could never happen in today’s Germany whilst Merkel (perhaps reluctantly) made the call to uphold western values at a time when Donald Trump proved unable to do so. The decision in 2015 to open up Germany’s borders to refugees should also be viewed as a great humanitarian gesture. But as The Economist (slightly harshly) put it, “admiration for her steady leadership should be mixed with frustration at the complacency she has bred.”

After 16 years during which Merkel has kept the plates spinning, it will now be up to someone else to tackle the many problems which Germany – in common with all western economies – faces. Whoever the new Chancellor is will not have the personal authority or Merkel’s depth of experience in dealing with crises. They will also have to come to terms with the changed nature of the EU as neighbours such as Poland and Hungary drift away from the EU centre. The new Chancellor will be required to deal with the many issues which are likely to arise in the wake of the pandemic, particularly with regard to the euro zone which has morphed closer to a fiscal union in the last 18 months.

Merkel's successor will do well to be credited with a verb describing their mode of government – to merkeln. It may originally have been coined as a derogatory term to describe one who leads without taking decisions, but there are sometimes worse ways of doing government, as Boris Johnson and Donald Trump have demonstrated.

Supply surprise

Forty years ago most people had never heard of supply side economics. During the 1980s, however, governments in the US and UK promised a supply side revolution by cutting taxes and regulation to allow economies to work more efficiently and thus increase prosperity. Together with the extension of globalisation and advances in technology, this has radically changed the way in which companies operate.  Just-in-time inventory management is now the norm as production chains have grown to encompass the world and the manufacturing process itself is much less vertically integrated than was the case 40 years ago. But whilst the consumer has generally benefited from improved efficiency it has come at the cost of resilience as disruptions in one part of the world quickly ripple out to affect others.

Indeed the problem that supply side proponents never fully addressed was the ability of a deregulated economy to respond to shocks. As the 2008 crisis highlighted, when the deregulated banking sector encountered problems, only governments were able to marshal sufficient resources to ensure rescue packages of the requisite size. In the wake of the crisis, the business community accordingly became much more sensitive to political concerns. As the political climate became increasingly attuned to concerns that local jobs were being shifted to cheaper locations abroad, businesses began to embrace the concept of nearshoring – the process whereby supply chains are shortened to ensure that goods and services are sourced more locally. This was also facilitated by the fact that traditional offshore locations no longer offered such cheap sources of labour as global competition for local resources pushed up wages. This is one of the factors behind the slower pace of globalisation evident in recent years as evidenced by the KOF Globalization Index.

Covid has placed another spanner in the works. Supply chains have been under pressure like never before with the recent surge in global inflation largely attributable to issues arising from supply side disruption. Early on in the pandemic it was realised that Asian based semiconductor manufacturers would face significant disruptions in 2020 which would manifest in 2021, and that is exactly what has happened. This has impacted on industries such as autos, where prices have risen to such an extent that around one-third of the change in the US CPI over the summer could be attributed to second hand vehicles.

No supply network in the world could reasonably hope to escape unscathed in the wake of such a shock. But the nature of the system that has been created across the industrialised world in recent years is particularly vulnerable, and in many cases the problems are compounded by poor policy choices. We can illustrate this by looking at two particular cases.

The lorry driver shortage problem

Over the last few weeks the British media has been reporting on the rising trend of empty supermarket shelves as retailers are unable to secure enough produce to satisfy demand. This in turn is largely due to the fact that there is a shortage of HGV drivers to ensure delivery of the product. It is important to highlight at the start that this is not solely a British problem. According to a survey by Transport Intelligence, it is a Europe-wide problem. In fact, Poland reported the highest number of unfilled vacancies in the logistics sector, estimated at 123,000 with the UK occupying second place with between 60,000 and 76,000 vacancies. Adjusted for population size, there are around 0.33 vacancies per head in Poland compared with 0.09 in the UK and 0.05 in Germany (chart below).

This has arisen for a variety of reasons, not the least of which is that the outflow of older workers from the logistics industry is higher than the number of entrants due in large part to the poor conditions associated with working in the haulage sector. In the UK, however, these underlying structural problems have been compounded by Brexit. According to a survey by the Road Haulage Association, 58% of respondents attributed the shortage of HGV drivers primarily to the UK’s decision to leave the EU. By contrast, only 38% perceived that the problems were mainly due to Covid. That said, Covid is exacerbating the problem because it has significantly slowed the pace at which HGV driving tests can be conducted.

Whilst problems in the logistics sector are long-standing, Brexit has highlighted the lack of resilience in the sector. The UK was heavily dependent on drivers from other EU nations – the RHA estimates that prior to the pandemic around 10% of all drivers employed in the UK were nationals of other EU countries. This was in large part due to the fact that pay and conditions in the sector are perceived as poor and the jobs on offer were unattractive to locals. However, the UK industry was able to pay workers from some of the less wealthy EU countries more than they could have earned in their home market thus alleviating the shortage. But many of them recently appear to have returned home, either because of a perception that they were no longer welcome in the UK or because they feared being stranded on this side of the channel due to Covid. One thing is clear: The UK logistics sector benefited from the freedom of movement enshrined in EU membership and now it must learn to cope without it.

The energy problem

Similar supply problems are looming in the energy sector. Wholesale gas prices have risen by 250% since the start of the year and are up 70% since August alone (chart below). A number of factors are affecting prices: A cold winter in Europe last year had already put pressure on supplies and the amount of stored gas is far below normal levels. We have been warned for some time that there is insufficient storage capacity but this year it really seems to be coming home to roost. There is also increased global competition for liquefied natural gas, particularly from Asian countries. Unfortunately, too, the race to exit fossil fuels has proceeded at a faster pace than investment in alternatives. This was not helped by the collapse in investment activity in 2020 for Covid-related reasons. However as the IEA has pointed out “the USD 750 billion that is expected to be spent on clean energy technologies and efficiency worldwide in 2021 remains far below what is required in climate-driven scenarios.”

This will have a number of knock-on effects. Rising wholesale gas prices have caused producers of carbon dioxide to cease production, which will in turn have a major impact on the food and drink sector (see here for an explainer). Consumers will face a double whammy because they are set to face a huge rise in household energy tariffs which are expected to rise by around 12% next month. They may well rise further later in the winter when Ofgem further lifts the price cap on household bills. For the record, the prime minister did promise in 2016 that “fuel bills will be lower for everyone" when the UK leaves the EU.

As far as the energy industry is concerned, a number of smaller gas suppliers have already gone bust after failing to hedge the big rise in wholesale prices. It is intended that clients of these companies will be supplied by existing companies. However, this will require them to supply gas to customers for whom they have not budgeted in their wholesale market negotiations which in turn is likely to mean they will require government financial support.

What to make of it all?

To the extent that the energy problem is a global one, we cannot lay it at the door of Brexit. To a large extent, it is the result of a state sponsored dash for renewables coupled with a failure of the private sector to make the necessary investment in alternative energy sources. Similarly, the lorry driver shortage issue is not wholly a Brexit related phenomenon although it has exacerbated it. But both are examples of supply chain failures which have been made worse by government policy choices.

Irrespective of the underlying causes, the optics for the UK government are not good. Far from delivering increased prosperity, as Brexit’s proponents promised, consumers face the prospect of empty shelves in the shops and much higher energy bills. Voters may start to draw conclusions about the economic consequences of Brexit and start to ask some awkward questions of government. If and when that happens, Boris Johnson will be in need of some good news to assuage the electorate.