Eight years on

Eight years on from the Brexit referendum, the world looks a very different place. While in 2016 it was the UK which had to deal with an onslaught of rampant populism, it is now a feature of the political landscape across the industrialised world. The European Parliament elections made it clear that electorates across the EU are running out of patience with centrist governments which have failed to deliver on promises to make life better for long-suffering voters (chart above). Meanwhile on the other side of the Atlantic, Donald Trump has every chance of getting back into the White House as he feeds on the discontent of an America unsure of its place in the world.

As we head towards a UK general election that looks set to banish the Conservatives into the political wilderness, it is possible that the UK may be one of the few western democracies about to swing back towards the political centre. Yet it is notable that the policy which helped Boris Johnson win an overwhelming majority in 2019 has not even figured on the 2024 campaign trail. The Tory party cannot bring itself to admit that its signature policy has failed while the Labour Party is so fearful of alienating voters in Red Wall seats that it simply will not go near the issue of Brexit. But it is the Tories who will have to carry the can, since this is a policy with which they are closely associated, and spent so much political capital delivering the hard Brexit that many of us warned against that it has become an albatross around their neck. Moreover, it absorbed so much political bandwidth that the party was unable to deal effectively with the other tasks involved in governing. This included managing the pandemic and ensuring compliance with the basic standards required for governance in modern democracies which is one reason why they lag so far behind in the polls (chart below).

Look beyond the 2024 election

However, just because the electorate is about to hand the keys to Downing Street to a party of the centre-left does not mean that they are about to repudiate some of the more extreme versions of nationalist politics. If the performance of Reform UK in the polls is to be believed, quite the opposite. Recent history suggests that political turnarounds are very much in fashion. Back in 2021, not long after Labour had taken an election hammering and lost one of its safest seats in a by-election, it seemed that the centre-left was on the ropes. When the SPD unexpectedly won the German election in 2021, it was not long before sentiment turned against them, while Emmanuel Macron’s 2022 election triumph is a distant memory as the right-wing Rassemblement National is currently the most popular party ahead of the snap French parliamentary election. Life, as they say, comes at you fast. And just as Brexit was a cry of rage against the prevailing status quo in 2016, so we should interpret any (potential) Labour landslide as a rejection of years of Conservative government incompetence rather than a general buy-in of what Labour are offering.

If a week is a long time in politics, as former UK PM Harold Wilson once remarked, a couple of years is an aeon. Thus, to the extent that politics is a long game, we have to look beyond the upcoming election and think about what the future of politics will look like. Labour’s ability to deliver any form of economic improvement over the next five years will determine whether they stand a chance of winning a second term. Labour will have to manage expectations in such a way that they can deliver some progress and that they are not swept away in a tide of disappointment later in the decade. But if they do not deliver, what might the options look like in five years’ time? This in turn depends on how the Conservatives respond to what currently looks like being a very heavy defeat. Will they double down and move further towards the populist end of the spectrum? Or will they do what Labour did in the wake of their heavy defeat in 2019 and tack back towards the political centre?

It is currently difficult to envisage the latter option, partly because many of the more moderate members of the parliamentary party were purged by Boris Johnson in 2019. The alternative is thus a shift towards right-wing populism of the sort espoused by many prominent government ministers of recent years, and the non-negligible possibility of a tie-up with Nigel Farage’s Reform UK. It may sound far-fetched – a wild fantasy dreamed up the political commentariat – but as the rise of RN in France and the AfD in Germany illustrate, if the traditional parties cannot enthuse and inspire voters, they will look for alternatives.

The case for tax reform

It is thus evident that Labour will have to deliver something tangible in order to pacify the electorate and generating faster growth is a priority. In contrast to 1997, the economy's trend growth rate has slowed considerably (chart below) which is excerbating the fiscal constraints under which the government will be forced to operate. Labour's manifesto offers nothing particularly interesting in terms of economic thinking, with a very limited set of fiscal promises. Obviously, Labour does not want to give too many hostages to fortune but if I were the new Chancellor, one of the first things I would do is to announce a review of the tax system, building on the excellent and under-appreciated Mirrlees Review of 2011. One reason for doing this is that the government needs to quickly find some fiscal space. In much the same way as the Blair government announced reform of the monetary policy framework in 1997, a fiscal reform is overdue. It may not deliver a significant amount of revenue immediately but if a new government is serious about tax reform, it may be able to open the fiscal taps halfway through its first term on the basis that the returns will come through later.

What might tax reform look like? It certainly will not be a radical big-bang on day one. It is likely to take the form of a Royal Commission which will report after two years with a view to implementing changes in 4-5 years’ time. A more detailed look at possible measures is a subject for another day, but one idea whose time may have come is a land value tax which is a more economically efficient form of property tax than is currently in place today. There is also scope for reforms to the taxation of savings, carbon, wealth, corporates – you name it, and it can be done better. There is also a political dimension to this. Shifting even a tiny bit of the burden away from wage earners (i.e. voters) onto less heavily taxed areas of the economy would go some way towards making voters feel a bit better about things, without necessarily reducing the tax take.

Last word

But whatever the next government wants to do on the economic policy front would be made a lot easier if there were fewer trade frictions with the EU. Although Labour has promised that the UK will not rejoin the EU, it does want to “reset the relationship and seek to deepen ties with our European friends, neighbours and allies.” While it has ruled out rejoining the single market, it does want “to improve  the UK’s trade and investment relationship with the EU, by tearing down unnecessary barriers to trade.” Whatever one’s views on Brexit in 2016, and whether or not they have subsequently changed, the UK does need closer economic and political ties with the EU than we have had in recent years. Those politicians who promised a brave new post-Brexit economic world have been found out. It is time to hit the reset button.

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.