Light the blue touchpaper

Rishi Sunak’s announcement last week that the UK is to hold a general election on 4 July represents the fourth major UK plebiscite since I started this blog in 2016 and the sixth in 10 years (including the 2014 Scottish referendum). Of them all, the 2024 election feels the most necessary. The Conservatives have occupied Downing Street since 2010, chewing up five prime ministers, while contending with the fallout from Brexit, the pandemic and a rapidly shifting geopolitical world. After such a gruelling run, they look tired and bereft of ideas.

It happens: The business of governing is hard at the best of times, and these are not the best of times. All governments run out of ideas eventually but this particular incarnation of the Tory party ran out of steam earlier than most. While it can point to mitigating circumstances in the form of the pandemic, it has made a series of unforced errors that have contributed to its unpopularity. Although it made mistakes prior to 2016 (who didn’t?), the Brexit outcome changed the calculus. The government chose to accept a close-run advisory plebiscite as a winner takes all contest with no plan how to deliver. Not only did it waste considerable amounts of political capital trying to reach an accommodation with the EU but it failed to implement any of the changes that were promised by Brexit proponents. Even more egregious was its failure to understand the lessons of the 2019 election. The thumping majority gained by Boris Johnson was not a vote in favour of populist nationalism, as many in the party believed, but the imprimatur of an electorate willing to believe Johnson’s claim that he could finally get Brexit done and – equally importantly – was a repudiation of the policies espoused by Jeremy Corbyn.

There are no guarantees in politics but it is a raging certainty that Labour will win the next election. Latest bookmakers odds put the probability of a Labour win at 89.8% versus 4.3% for the Tories (and a 14.9% likelihood of a hung parliament). Although bookies odds reflect the weight of money being placed rather than an objective assessment (see this post from 2019), the fact that a record number of 83 Conservative MPs have so far opted to stand down, rather than contest their seats in July, is one indication of the party’s pessimism. Electoral Calculus currently estimates that Labour will win 479 seats (see below) which would give it the biggest majority (308) of any government since 1918 (bar the emergency National Government of 1931). For the record, I would be astounded if such a majority is achieved - Labour will do well to emulate Blair's 1997 landslide.

Defining the battleground: Recapturing the feelgood factor

The economy will be one of the key areas where Labour and the Conservatives will lock horns during the campaign. Sunak’s quite literal damp-squib announcement on Wednesday argued that: “Our economy is now growing faster than anyone predicted, outpacing Germany, France and the United States. And this morning it was confirmed that inflation is back to normal. This means that the pressure on prices will ease, and mortgage rates will come down. This is proof that the plan and priorities I set out are working.”

This is not wholly wrong, but not wholly right either. It is true that UK growth outpaced the three other countries in Q1 2024 but since 2016 has outpaced only Germany. In any case, it is not just the rate of growth which matters: IMF data suggest that UK real incomes per head are almost 30% below US levels and 12% below German levels (chart above), with the rankings not having changed much since 2010 (indeed, they have widened relative to the US). One potential cause of the dissatisfaction with government in recent years has been the extent to which voters do not feel better off. It is important to recognise at the outset that this is not simply a problem in the UK: It is an issue across much of the industrialised world, notably Europe. But this cuts no ice with voters who, not unsurprisingly, are focused on their own domestic issues. The Conservative government of 1979 to 1997 delivered real household disposable income growth averaging 2.7% per annum, while the Labour government of 1997 to 2010 presided over annual growth of 2.5%. Since 2010, this has slowed to 1.3% (chart below).

This is a reflection of changed circumstances following the GFC in 2008, with the slowdown in productivity growth at the heart of the problem, slowing to around 0.5% per year versus 1.5% pre-2008. The Productivity Institute has identified three key reasons for the UK’s sluggish performance in this regard: (i) Underinvestment, in both physical and human capital; (ii) Inadequate diffusion of productivity-enhancing practices from the innovation-driven sectors areas to the wider economy and (iii) Institutional fragmentation and lack of joined-up policies, aggravated by the dichotomous arrangement whereby the policy formation process is highly centralised but the institutional framework responsible for translating this to the wider economy is  highly fragmented. None of these will be an easy fix, but they will require a root-and-branch reform of the policy formulation process. Market solutions alone will be insufficient to deliver the desired outcomes, and certainly not on a five-year horizon.

The fiscal constraint

One of the key issues that voters care about is the state of the UK health and social care sectors. Public dissatisfaction with the NHS reached an all-time high in the 2023 Social Attitudes Survey, reaching 52% compared to the previous peak of 50% in 1997. Ironically, given the current government’s desire to reduce taxes, almost half of voters support a policy of raising taxes to provide additional NHS funding. With an ageing population placing increased strain on the health services at a time when post-pandemic strains and funding challenges have raised pressure on the system, there may be little option but to test the public’s willingness to pay higher taxes. The alternative may be to explore more radical funding options, such as a continental European-style social funding model; increased hypothecation; raising NHS charges or relying on greater private sector provision.

None of these are likely to be very palatable to the electorate but with the UK’s debt-to-GDP ratio already at its highest in 60 years, at around 100%, and competing demands from defence and managing the green transition, the fiscal constraint is increasingly biting. It is thus clear that the UK will require a serious debate about its policy choices in the next parliament. At the very least a radical reform of the tax system should form part of the political and economic debate with nothing off the table. Even if they are not adopted, it is necessary to have a debate about the pros and cons of wealth taxes and land taxes, if only to widen the nature of the debate.

Final thoughts

In some ways, the 2024 general election will not be a good one to win. Many challenges lie ahead and they will require the next government to make some unpopular choices. Just as 1979 marked a break with the post-1945 political consensus, so it is time to make a break with the post-1979 settlement which has peddled the view that it is possible to reduce the size of the state and reduce taxes while simultaneously driving up living standards. Achieving the latter will require compromises with regard to the former and more radical thinking on a whole range of issues. But as this bitter election campaign gathers momentum, voters will do well to remember that there are no quick fixes to the economic problems facing the UK. Liz Truss reckons there are Ten Years To Save the West, and while I am not in the habit of taking lessons from one who failed to outlast a lettuce, ten years to fix the economy might not be too far wide of the mark.

Error correction (or blame deflection?)

For anyone interested in the practice and methodological issues associated with economic forecasting, you could do a lot worse than read the Bernanke Review of forecasting at the Bank of England. According to the FT, the former Fed chair who was commissioned to produce a report on the BoE’s forecasting practices after its failure to predict the rise in inflation in 2022, was “brutally honest about [its] failings.“ Brutal might be overstating it, but it was an honest assessment that one feels is shared by many BoE insiders. As one might expect, not all economists agreed with all of its conclusions but there was a lot to like about it.

The fact that Bernanke outlined many shortcomings in the BoE’s practices should come as no surprise. No system is ever perfect, and the fact that the current monetary framework has been in place for almost 30 years does suggest that it is time to have a close look. There are a number of questions around the whole process, however. Why was it necessary to have such a review in the first place? If the processes really are as poor as Bernanke highlighted, why did it require an external review to point it out? And if the purpose of the exercise was to address policy errors, should we not be spending time looking at the policy making process rather than putting a lot of effort into the forecast generation process? I will deal with these points below.

What were the conclusions?

It is perhaps instructive first to reflect on Bernanke’s main process recommendations. One of the most widely trailed in advance was the suggestion that the BoE publish scenarios alongside the main forecast. This would “help assess the costs of potential risks to the outlook” and “stress test the judgements made by the MPC.” There is a lot of merit in doing this: The experience of recent years which has produced the Covid-19 pandemic and the oil price shock, suggests that a single forecast with a univariate central case cannot adequately capture all future states of the world. Even allowing for risks in the form of a fan chart, no forecast could capture shocks of the magnitude of 2020 (see chart below). The Bernanke Review went as far as suggesting that “the fan charts as published in the MPR have weak conceptual foundations, convey little useful information over and above what could be communicated in other, more direct ways, and receive little attention from the public. They should be eliminated.” While there is some truth in this, it may be going too far to eliminate them, as fan charts are a very useful way of conveying risks around a central case in a stable environment, and there is a case for retaining them.

Another very important consideration was the nature of conditioning assumptions, particularly for the future path of interest rates. There are a number of reasons why using market rate expectations as the appropriate starting point is less than optimal. For one thing, “forward rates implied by the market curve are not pure forecasts of future rates, because forward rates may incorporate risk and liquidity premiums.” In addition they may not reflect the MPC’s best judgement of the path of rates, meaning that “a forecast conditioned on the market curve may be misleading.” One alternative is for the central bank to give a preferred path for rates, much as the Riksbank does, although as I argued in this post in 2019, this could simply create a hostage to fortune. Instead, the practice of offering alternative scenarios based on different rate paths will probably suffice.

A final big point, and one that is close to my heart, is that the software required to manage and manipulate data “is seriously out of date and difficult to use” and should be upgraded and constantly monitored. I don’t know which systems Bernanke is referring to but my own experience with languages such as R and Python, now en vogue in economic circles, is that they are far less user-friendly and flexible than some of the systems designed in the 1970s. The review was also critical of the BoE’s macro model, COMPASS, unveiled to great fanfare in 2013. Bernanke did not explicitly say that DSGE models may not be up to the job of forecasting but he offered the view that structural models (of the kind I have long advocated) still have a role to play in forecasting – after all, the Fed still uses them.

Policy considerations

The elephant in the room, however, is why it was felt that such a review was required in the first place. The answer, to put it bluntly, is that it was designed to keep politicians off the BoE’s back after it was accused of failing to predict the huge rise in inflation in 2022 (true) and the fact that its policy response was too slow (less true). In fact, the BoE's inflation forecast in February 2022 was above that of the consensus, predicting end-2022 inflation at 5.8% versus a consensus expectation of 4.6% (outturn: 10.8%) and end-2023 inflation at 2.5% versus the consensus prediction of 2.1% (outturn: 4.2%). Thus, while the BoE forecast was a significant under-estimate, it was less so than most forecasters.

As for the policy response, as I (and many others) have noted previously there was little anyone could have done to prevent an inflation spike in the face of an external oil price shock. Recall that the UK had just come off the back of a pandemic which had resulted in the steepest decline in output in 300 years and whose long-term effects were at that time still unknown. It did not feel like the right time for a sharp tightening of monetary policy. However a review of process is a standard response to issues that are more a matter of policy. Simply put, it is a way to deflect attention.

Another issue worth addressing is the question raised by the Sunday Times economics editor David Smith as to why it took an external review to highlight these shortcomings, which were well known internally. We are very much in speculative territory here, but since Bernanke took a lot of evidence from BoE insiders – past and present – it is hard to avoid the conclusion that this review offered an opportunity to tackle internal inertia. This may be the result of senior managers lack of knowledge of the issues involved; the fact that their attention has been diverted by other policy matters in recent years (Brexit, the pandemic) or simply a lack of budget resources. Either way the Review is a good way to get their attention.

Last word

It is always a good thing to review forecast models and processes, especially when they have been in place for so long and the Bernanke Review put the BoE’s process under a lot of scrutiny. In many ways it simply came across as a call to modernise a system, which in the grand scheme of things was already pretty decent but perhaps had been neglected a little over the past decade. However, the one thing it will not fix is that the future is inherently unknowable. No matter how state of the art, no forecasting system can cope with the kind of shocks to which we have been subject of late. Give it another decade and we will be having this debate all over again.

Water, water ...

One of the motivations for setting up this blog eight years ago was to highlight that continued reliance on the private sector for solutions to economic problems is a far from optimal strategy (see my June 2016 post, here). The recent furore regarding the failings of the UK water industry, along with the vexed problem of how to organise the rail network, are examples in a long line of businesses which have failed to live up to post-privatisation expectations. At a time when government is vexed by the problem of persistently low productivity, this makes it all the more important that infrastructure works efficiently.

Looking back to the 1980s and 1990s, you might recall that one of the main arguments advanced by the Conservative governments of the time was that the private sector would run businesses more efficiently and productively than the public sector. By introducing market discipline, competition, and incentives for innovation, this would lead to cost reductions and improved performance. In addition, private companies would have stronger incentives to improve service quality and customer satisfaction in order to attract and retain customers. While there were examples of industries which did benefit from a return to the private sector – telecoms being the prime candidate, which gained from a technological revolution – in many instances, privatisation simply meant swapping a public sector monopoly for one in the private sector. As a result, they had little incentive to innovate and could rely on a captive market to sustain revenues.

Where did it all go wrong?

Evidence to suggest that the water industry has not generated the post-privatisation efficiency gains that were claimed for it comes from a study by the consultancy Frontier Economics published in 2017 (chart below). Their analysis suggests that total factor productivity in the water industry did pick up immediately after privatisation but that it quickly slowed thereafter, doing nothing to dispel the suggestion that the industry has lived off the assets it inherited at the time of privatisation in 1989.

Yet the failings of the privatisation model introduced in the UK over the last thirty-odd years go far beyond the shoddy way in which customers are treated (overpriced train journeys, effluent being dumped in rivers, electricity companies that went bust at the first sign of trouble in global energy markets). One of the issues that privatisation was meant to tackle was reduced reliance on a pay-as-you-go model, in which the current generation of taxpayers stumped up for investment from which the next generation would benefit. Under a pay-when-delivered model, it was planned that balance sheets be used to pay for the initial cost of investment and future customers pay for the services they consume and so long as prices were set appropriately, the business would generate a decent rate of return. In addition to this being a sound economic basis, there was also a political motive for doing this as far as water was concerned. Planned EU legislation in the 1980s and 1990s required a significant rise in future investment which the government did not want to pay for, nor did it want customers (aka voters) to have to pay for it either. Getting private companies to use their debt-free balance sheet to pay for investment seemed like an expedient solution (water companies were debt free on privatisation).

But as the Thames Water debacle shows, that is not what happened. Newly privatised companies resorted to borrowing against assets on the balance sheet, much of which was ultimately used to pay shareholder dividends. As a result, Thames Water now has huge debts which threaten it with bankruptcy. This has forced a return to a pay-as-you-go model with today’s customers being asked to fund investment while servicing today’s debt.

Regulatory failure

While the public rightly puts most of the blame for the failures of privatised utilities on its managers, we should not ignore the fact that in many cases regulators have been remarkably complacent. First off, regulators in the electricity and water industries failed to stop companies from leveraging up their balance sheet from the 1990s. The companies perhaps ought to have behaved more responsibly but it is the duty of regulators to step in when irresponsible behaviour occurs.

Second, regulators did what they often do, and conduct regulation by rule book. As the economist Dieter Helm points out, the periodic reviews they conducted generated huge amounts of admin which companies struggled to process. As Helm notes: “company boards find that they are essentially asking the regulators to make decisions for them. In recognition that the “customer” is Ofwat rather than the household and business users, utilities engage in lots of lobbying, and try to work out what answer the regulator wants, rather than what their customers want and the wider environment needs ... Utilities start by trying to guess the answer the regulator (and the government of the day) might want, and then shape their business plans around them.” Both these elements chime with the situation in the financial services industry pre-2008 when regulators failed to rein in the (dubious) actions of many banks and issued vague directives without giving clear guidance as to whether institutions were compliant. And as we know, the UK regulator ended up being abolished and a large part of its responsibilities transferred to the BoE.

A final problem, though one which is perhaps only recognisable in hindsight, was that regulators applied the wrong cost of capital – a key metric used in determining the allowed rate of return and thus the appropriate prices for consumers. They applied a weighted average cost of capital (WACC) averaged across all areas of the business, rather than looking at each individual area separately. As a result, for each individual business WACC turned out to be too high for the cost of debt and too low for the cost of equity, providing an incentive for privatised utilities to switch from equity to debt and encouraging the gearing that proved to be so problematic for Thames Water (for more detail, see the work by Helm here or here). Here too, there are echoes of the failures of the VaR models which so underpriced financial risks prior to 2008.

 

Nationalisation is not (necessarily) the answer

Not surprisingly, this has caused a political uproar which threatens to rebound on the Conservative government which has long been an advocate of privatisation, while giving ammunition to those at the other end of the political spectrum who advocate taking assets into public ownership. However, nationalisation is not necessarily the best solution (it might be for rail, but that is a subject for another time). The arguments continue to rage as to whether renationalisation would result in an industry which is better aligned with customer interests. But the biggest argument against it is the fact that the state currently does not have the funds available to buy the utilities without issuing significant amounts of additional debt, and certainly does not have the cash available to fund the necessary investment. Many utilities are foreign owned (over the last 20 years Thames Water has had German, Australian and Canadian owners) and nationalisation would sit uncomfortably with efforts to attract foreign investment. As Helm has consistently pointed out, the UK suffers from a sizeable savings deficit – the current account deficit is a measure of the excess of domestic investment over savings – which implies that it is already reliant on the kindness of strangers to fund investment.

What to do?

Since we cannot easily nationalise Thames Water, and imposing yet more red tape would not seem to be a viable option, we may be left with little option other than to place it in administration. This is effectively what happened to the privatised rail operator Railtrack in 2001. Rather than nationalise the whole operation, however, there is a strong case for splitting it into smaller parts with different regional responsibilities and maybe with different functional responsibilities (e.g. one for water supply and one for treating sewage), selling off the good bits and putting the bad bits into special administration.

Either way, it seems socially irresponsible to allow a company that has failed to properly manage the largest water company in Europe to be allowed another go at getting it right. This may be the right time to redraw the contract between the state and the market, and learn some of the lessons of the last thirty years. In short, the companies must strike a better balance between serving their shareholders and their customers, entailing effective regulation (not simply more of it, but better targeted regulation); breaking up private sector monopolies; more strict controls over pricing and more effective sanctions against those who transgress. On the assumption that a new government will have to pick up the pieces of this problem in the not-too-distant future, the Thames Water problem could provide a good opportunity to reimagine how utilities should be run in the twenty first century.

Year ahead 2024: 2023 with a twist

They say an optimist is someone who stays up until midnight to see the new year in, whereas a pessimist stays up to make sure that the old year is finally gone. It’s an apt description of where we find ourselves now, for many of the economic and political issues we were discussing in late-2023 will still be high on the agenda in 2024.

The economics

As we look ahead, it is briefly worth reflecting on how we did in 2023 to assess whether there are lessons for our year-ahead predictions. For my part, I give myself a pass on the inflation view although it perhaps decelerated even more rapidly than I anticipated. In my year-ahead predictions a year ago I suggested that “calls for interest rate cuts will build. Central banks are unlikely to heed these calls, and maintain policy tighter than might be justified by economic conditions.” That is not too far off the mark: There are concerns in the euro area and the UK that central bank tightening has gone too far, which in turn is crimping growth and is setting us up for a difficult 2024. Markets are convinced that central banks will cut rates as inflation remain quiescent – a view with which I agree although it will not be sufficient to give much of a growth boost this year.

Indeed, although my suggestion that the industrialised world would experience a recession in 2023 proved wide of the mark, we are far from out of the woods. The energy price shock was expected to be a catalyst for a growth slowdown a year ago but in the event both the US and European economies avoided the worst case outcomes. Today, however, the catalyst is more likely to be the lagged effects of monetary tightening over the past two years. Real interest rates in the US and Europe turned positive in late-2023 and are likely to remain relatively high over the first half of 2024. In addition, many firms and households have been protected from the full impact of recent rate hikes by fixed-rate borrowing agreements. US property investors and UK households whose fixed-rate deals have to be renewed in 2024 could find themselves having to shell out considerably more in debt servicing costs, which will take the edge off activity. Whether or not the US or UK experiences a recession is less important than the likelihood that growth will be considerably slower in 2024 than in 2023.

The outlook for the Chinese economy will play a crucial role in determining the global growth outcome. It is becoming more evident that the old playbook of throwing money at an economy suffering from years of investment misallocation will no longer work. Bubbles in the property market, with the near-collapse of Evergrande and the default of Country Garden, are symptomatic of a bubble economy gone wrong. With demographics increasingly not running in China’s favour, and the population declining in 2022 for the first time since 1961, dare we whisper it but China is suffering from many of the symptoms of the Japanese bubble economy of the early-1990s. The economy will not collapse any time soon, but we should get used to annual growth with a 4-handle rather than something bigger than six.

And the politics

2024 is shaping up to be a big year for elections and they do not come any bigger than the US Presidential election which takes place in November. It seems almost certain that we will see a rematch of Trump versus Biden, barring the intervention of the courts or unforeseen health issues. I would not like to put my money on who will win, although for the record the bookies currently offer shorter odds on Trump. However, one thing is certain: This will be one of the nastiest election campaigns ever fought. It is not too much of an overstatement to suggest that the future of the western alliance hinges on Biden getting back into the White House. Europe has already experienced the capricious nature of Trump’s foreign policy and America’s global standing would not emerge well from a second Trump presidency if he uses his term to settle old scores.

This is particularly problematic in view of rising geopolitical tensions: The Russia-Ukraine war will enter its third year in February and a Trump presidency would seriously imperil the flow of materiel to Ukraine (although this would likely only become an issue in 2025). Similarly, the Israel-Hamas war will require deft diplomacy to prevent it spilling over into a wider regional conflict. Just because it did not immediately ignite following the events of October 2023 does not mean that the risk of a wider war in 2024 can be ignored. Then there is the China-Taiwan problem. Later this month, the Taiwanese presidential election is expected to see Lai Ching-te (aka William Lai) of the Democratic Progressive Party elected to the presidency. In the past Lai has been aggressively pro-Taiwan (and by definition, anti-China). Although he is likely to be more circumspect in his comments as president, he is distrusted by China and we can expect a ratcheting up of pressure from Beijing. This will be a further headache for the US policy establishment, which will be distracted by electoral considerations in 2024.

The US election is not the only game in town: There will also be plebiscites in a number of important economies such as India, Indonesia and South Korea. It is also highly likely that there will be an election in the UK. Although legally it does not have to take place until January 2025, the smart money is on an autumn 2024 election with one prominent Labour politician recently suggesting that it was “the worst kept secret in Westminster” that a contest would be called for May. The result is rather easier to call than in the US – there is almost certain to be a change of government in the UK in 2024. Much of the discussion centres on how big Labour’s majority will be. Electoral Calculus reckons that Labour will gain a 133 seat majority which would be way bigger than Tony Blair’s government achieved in the 1997 landslide win (an 88 seat majority). For the record, I do not think that Labour will come remotely close to such a majority. In order for this to happen, the Conservatives’ vote would have to halve and Labour’s spike to record highs. I would be amazed if the majority is as high as 50 and would not be surprised if it was as low as 10 seats.

Markets in 2024

2023 was a better year for investors than 2022, when returns on both bonds and equities were negative. A so-so 2023 was transformed in the last couple of months when the S&P500 rallied by 14%, delivering a 27% return for the year – the best since 2019. Global fixed income also ended the year up 6%, having been down 4% in mid-October. The catalyst for the surge was expectations of US rate cuts in 2024 which, if delivered in line with expectations, suggests that most of the good news is already in the price. Doubtless the momentum will continue over the early weeks of 2024 and markets will exult that bonds really are back. If the US economy manages a soft landing, as is increasingly anticipated, there is scope for equities to go higher still. My own view, for what it is worth, is that the bulk of the gains will be generated in the first half and it may pay to go defensive later in the year as the rally runs out of steam.

What else?

AI was one of the buzzwords of 2023 and there will be further developments in 2024. Although ChatGPT proved to be a phenomenal success, and was one of the catalysts behind the rally in US stocks, its ability to generate plausible-sounding feedback that is often untrue means that corporates remain wary of its full-scale adoption. New iterations of LLMs are likely to be released in 2024 which will offer significant improvements in information veracity and verifiability. This in turn may encourage more widespread adoption. Reports that OpenAI is working on a powerful new tool known as Q* may take AI to another level. Nobody knows for sure what Q* is, or how it works, but these posts (here and here) suggest that it could herald a revolutionary breakthrough in the way AI handles mathematical problems. This will open up a whole new range of applications and intensify the debate about how much control we are prepared to cede to the machines.

While on the subject of matters tech, one thing to look out for in 2024 is the prospect that Twitter (sorry, X) goes bust. As I pointed out in April 2022 “the financials of Musk’s Twitter deal do not look compelling.” They look a lot less compelling today, with Musk desperate to turn a profit on his ill-advised venture into social media. As usage numbers fall and advertisers desert the platform, it would come as no surprise if Musk were to seek a buyer at a knock-down price, especially as Tesla is no longer pulling up trees when it comes to its own finances.

But as I have been telling investors for years, it’s the unknown unknowns that get you. The whole narrative could be thrown off course by a random event (Covid or Russian invasion, anyone?) so it pays to take year-ahead predictions with a big pinch of salt. As long as they are not blown off-course before end-January, I will be happy. And on that note, I will end by wishing you all a happy and prosperous new year.