It is now eleven years since the first indications of the
looming financial crisis began appearing on our radar screens. In the summer of
2007, banks began to curtail redemptions from funds which were heavily invested
in collateralised debt obligations and subprime bonds. This set in train a
series of events that culminated in the bankruptcy of Lehman’s in September
2008, which triggered the biggest economic and financial crash in 80 years. A decade
on, and we are only now beginning to see indications that the scars inflicted
upon the industrialised world are healing.
The IMF’s World Economic Outlook, released today, points to
a further pickup in global growth in 2018 to 3.9% which is the fastest since
2011. The regional composition also increasingly looks more balanced, with
slower growth in China and clear signs of recovery in the euro zone. But weak
productivity growth and wage inflation in the industrialised world mean that
workers may not immediately feel the benefit. Moreover, as the IMF pointed out,
even though the global economy is looking stronger, a combination of weak productivity
and adverse demographics means that the long-term potential growth rate in the
industrialised world will be far slower than in the years prior to 2008 (the
same also holds for China which is increasingly an ageing society thanks to the
one child policy introduced in 1979 though subsequently abolished in 2013).
This obviously poses a problem for central banks, which wish
to take back some of the monetary easing in place for the last nine years, and
although the Federal Reserve has begun the tightening process, weaker potential
growth will mean there are limits as to how far it can raise rates. But the Fed’s
actions – and perhaps more importantly, its rhetoric – have contributed to
taking some of the edge off the market rally with equity indices still some way
below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by
recent events.
Recall, too, that I expressed concerns regarding the reliance of the US equity
rally in 2017 on tech stocks, and the sharp collapse in this sector over the
past month affirms my belief that now is not the time for rational investors to
be taking risks.
However, I am less sure of my prediction that equities have
5-10% upside compared to end-2017 levels. Aside from the fact that all the good
news is already in the price, the trade dispute between the US and China has changed
the landscape somewhat and raised uncertainty levels. The actions of central
banks are also increasingly a complicating factor.
Whilst the Bank of England looks set to raise interest rates
next month, taking them above 0.5% for the first time since 2009, the weakness
of inflation and the prospect of a loss of momentum in the real economy suggests
that the case for further tightening is weaker than a few weeks ago. Meanwhile,
the ECB continues to keep its foot to the floor and its asset purchase
programme is likely to continue for another six months. The prospect of a
monetary tightening in the euro zone any time soon is remote. But as I have
noted previously, there is an argument for more aggressive tightening on this
side of the Atlantic. Forget about inflation – the strength of economic
activity alone suggests that we no longer need monetary policy on a setting
designed to cope with the problems of 2009.
But as one investor asked me today, will this not lead to an
undesirable slowdown in activity? It might, but there is a good case for using
fiscal instruments to offset some of the pain. After all, monetary policy has
done much of the heavy lifting over the past decade, and as the IMF pointed out
“all countries have room for structural reforms
and fiscal policies that raise productivity.” If we do not see some form of
monetary normalisation, central banks will not have much conventional ammunition
left to cope with the next downturn. As the IMF’s chief economist Maurice
Obstfeld wrote, “global growth is on an
upswing, but favourable conditions will not last forever, and now is the moment
to get ready for leaner times. Readiness requires not only cautious and
forward-looking management of monetary and fiscal policies, but also careful
attention to financial stability.”
Markets may not like this prescription, but they have had a
good run since 2009 and now it is time to put monetary policy on a sounder
footing. European central banks take note.
Wednesday 18 April 2018
Tuesday 17 April 2018
Nasty and brutish? Surely they don't mean us?
I recently took part in a discussion at a European forum
where I shared a platform with officials representing the UK and German
governments on the topic of Brexit, and I have to say that I was more in tune
with the German view of events than the British.
The UK government’s opening position is that Britain was always the bad boy in Brussels and that it never fitted into the EU in a constructive fashion, so that its departure should make life easier for everyone. That is an interesting sales pitch – and it is also largely not true. Whilst the British may have had a very different view of the EU and the direction in which it should head, compared to the French, that is less true of the Germans. Admittedly the UK and France have differed hugely on issues such as agriculture but the British influence has helped to reduce the amount the EU spends on agricultural subsidies from 73% of the budget in 1985 to 40% today, for which many EU members are thankful. Moreover, the UK and Germany have seen eye-to-eye on many issues and the UK played a very constructive role in making the EU a more business-friendly environment. Indeed it was a key player in helping to create the single market which the current UK government wants to leave.
The British government is also trying to sell the message to its European partners that the UK is the same country as it was before the referendum – nothing has changed and therefore it should be possible to conduct business as usual. I could not disagree more! The Brexit referendum has opened up numerous fissures in British society and in the conduct of its politics, such that this is very much a country ill at ease with itself. Leavers versus Remainers; young versus old; rich versus poor – and even the two main political parties struggle to find a common policy on Brexit. Indeed, I heard nothing to acknowledge the fact that almost half of those who voted in the Referendum wanted to remain.
Whilst the British government continues to adopt an “it-will-be-all-right -on-the-night” approach to issues such as the Irish border, the EU has adopted a rigorous legal approach which rightly points out that leaving the customs union is ultimately incompatible with maintaining an open border – a point which the German government representative reiterated. There is nothing new in any of this, of course, and I have been making many of these points for some time. But what concerns me is that the UK is holding to this fiction in the face of all the evidence. As one who does not work in the state sector I am not required to toe the government’s line, and I can afford to be free with my opinions. But it must be very difficult for those working on the inside who see the inherent contradictions in the government’s position but are not allowed to speak out.
Indeed, the disarray at the heart of government was manifest once again in the great WIndrush scandal. In short, immigrants from Commonwealth countries who began arriving in the UK in great numbers in the early 1950s are at risk of deportation if they never formalised their residency status and do not have the required documentation to prove it. This is a particular problem for those brought here as children, who have grown up in the UK and regard it as their home. Lest anyone forget, this is the result of a policy introduced by former Home Secretary Theresa May in 2013 (whatever happened to her?). Naturally, the policy is an embarrassment for the prime minister. But it goes way beyond that: It is indicative of a government which pays lip service to looking after the interests of its citizens but fails to do so and hides behind the letter of the law to justify its actions. And after having apparently agreed with the EU that it will guarantee the post-Brexit rights of EU citizens living in the UK, it once again calls into question the government’s competence to do so.
It was the philosopher Thomas Hobbes who wrote in his magnum opus, Leviathan, that life in the absence of a governmental-imposed social order would be “solitary, poor, nasty, brutish, and short.” Sometimes it feels as though the third and fourth words of his aphorism apply to life with a government too.
The UK government’s opening position is that Britain was always the bad boy in Brussels and that it never fitted into the EU in a constructive fashion, so that its departure should make life easier for everyone. That is an interesting sales pitch – and it is also largely not true. Whilst the British may have had a very different view of the EU and the direction in which it should head, compared to the French, that is less true of the Germans. Admittedly the UK and France have differed hugely on issues such as agriculture but the British influence has helped to reduce the amount the EU spends on agricultural subsidies from 73% of the budget in 1985 to 40% today, for which many EU members are thankful. Moreover, the UK and Germany have seen eye-to-eye on many issues and the UK played a very constructive role in making the EU a more business-friendly environment. Indeed it was a key player in helping to create the single market which the current UK government wants to leave.
The British government is also trying to sell the message to its European partners that the UK is the same country as it was before the referendum – nothing has changed and therefore it should be possible to conduct business as usual. I could not disagree more! The Brexit referendum has opened up numerous fissures in British society and in the conduct of its politics, such that this is very much a country ill at ease with itself. Leavers versus Remainers; young versus old; rich versus poor – and even the two main political parties struggle to find a common policy on Brexit. Indeed, I heard nothing to acknowledge the fact that almost half of those who voted in the Referendum wanted to remain.
Whilst the British government continues to adopt an “it-will-be-all-right -on-the-night” approach to issues such as the Irish border, the EU has adopted a rigorous legal approach which rightly points out that leaving the customs union is ultimately incompatible with maintaining an open border – a point which the German government representative reiterated. There is nothing new in any of this, of course, and I have been making many of these points for some time. But what concerns me is that the UK is holding to this fiction in the face of all the evidence. As one who does not work in the state sector I am not required to toe the government’s line, and I can afford to be free with my opinions. But it must be very difficult for those working on the inside who see the inherent contradictions in the government’s position but are not allowed to speak out.
Indeed, the disarray at the heart of government was manifest once again in the great WIndrush scandal. In short, immigrants from Commonwealth countries who began arriving in the UK in great numbers in the early 1950s are at risk of deportation if they never formalised their residency status and do not have the required documentation to prove it. This is a particular problem for those brought here as children, who have grown up in the UK and regard it as their home. Lest anyone forget, this is the result of a policy introduced by former Home Secretary Theresa May in 2013 (whatever happened to her?). Naturally, the policy is an embarrassment for the prime minister. But it goes way beyond that: It is indicative of a government which pays lip service to looking after the interests of its citizens but fails to do so and hides behind the letter of the law to justify its actions. And after having apparently agreed with the EU that it will guarantee the post-Brexit rights of EU citizens living in the UK, it once again calls into question the government’s competence to do so.
It was the philosopher Thomas Hobbes who wrote in his magnum opus, Leviathan, that life in the absence of a governmental-imposed social order would be “solitary, poor, nasty, brutish, and short.” Sometimes it feels as though the third and fourth words of his aphorism apply to life with a government too.
Sunday 15 April 2018
Fair weather forecasting
The economics profession has had to endure some bad press
over the last decade in the wake of the global financial crisis which we failed
to foresee and, in the UK case, the dire predictions in the aftermath of the
Brexit referendum that were not borne out. But in a way these two examples are
to entirely miss the point. Economics is not a predictive discipline – as I
have noted countless times before – so criticising economists for failing to
predict macroeconomic economic outcomes is a bit like criticising doctors for
failing to predict when people will fall ill.
Another of the narratives which has become commonplace in recent years is the notion that economists predict with certainty. This fallacy was repeated again recently in a Bloomberg article by Mark Buchanan entitled Economists Should Stop Being So Certain. In fact, nothing could be further from the truth. The only thing most self-respecting economic forecasters know for certain is that their base case is more likely to be wrong than right. The Bank of England has for many years presented its economic growth and inflation forecasts in the form of a fan chart in which the bands get wider over time, reflecting the fact that the further ahead we forecast the greater the forecast uncertainty (chart). Many other institutions now follow a similar approach in which forecasts are seen as probabilistic outcomes rather one in which there is a single outcome.
Indeed, if there is a problem with certainty in economic forecasting, it is that media outlets tend to ascribe it to economic projections. It is after all, a difficult story to sell to their readers that economists assign a 65% outcome to a GDP growth forecast of 2%. As a consequence the default option is to reference the central case.
One of the interesting aspects of Buchanan’s article, however, was the reference to the way in which the science of meteorology has tackled the problem of forecast uncertainty. This was based on a fascinating paper by Tim Palmer, a meteorologist, looking back at 25 years of ensemble modelling. The thrust of Palmer’s paper (here) is that uncertainty is an inherent part of forecasting, and that an ensemble approach that uses different sets of initial conditions in climatic modelling has been shown to reduce the inaccuracy of weather forecasts. In essence, inherent uncertainty is viewed as a feature that can be used to improve forecast accuracy and not as something to be avoided.
In fairness, economics has already made some progress on this front in recent years. We can think of forecast error as deriving from two main sources: parameter uncertainty and model uncertainty. Parameter uncertainty is derived from the fact that although we may be using the correct model, it may be misspecified or we have conditioned it on the wrong assumptions. We can try and account for this using stochastic simulation methods[1] which subject the model to a series of shocks and gives us a range of possible outcomes which can be represented in the form of a fan chart. Model uncertainty raises the possibility that our forecast model may not be the right one to use in a given situation and that a different one may be more appropriate. Thus the academic literature in recent years has focused on the question of combining forecasts from different models and weighting the outcomes in a way which provides useful information[2], although it has not yet found its way into the mainstream.
Therefore in response to Buchanan’s conclusion that “an emphasis on uncertainty could help economists regain the public’s trust” I can only say that we are working on it. But as Palmer pointed out, “probabilistic forecasts are only going to be useful for decision making if the forecast probabilities are reliable – that is to say, if forecast probability is well calibrated with observed frequency.” Unfortunately we will need a lot more data before we can determine whether changes to economic forecasting methodology have produced an improvement in forecast accuracy and so far the jury is still out. Unlike weather forecasting which at least obeys physical laws, economics does not. But both weather systems and the macroeconomy share the similarity that they are complex processes which can be sensitive to conditioning assumptions. Even if we cannot use the same techniques, there is certainly something to learn from the methodological approach adopted in meteorology.
Economics suffers from the further disadvantage that much of its analysis cuts into the political sphere and there are many high profile politicians who use forecast failures to dismiss outcomes that do not accord with their prior views. One such is the MP Steve Baker, a prominent Eurosceptic, who earlier this year said in parliament that economic forecasts are “always wrong.” It is worth once again quoting Palmer who noted that if predictions turn out to be false, “then at best it means that there are aspects of our science we do not understand and at worst it provides ammunition to those that would see [economics] as empirical, inexact and unscientific. But we wouldn’t say to a high-energy physicist that her subject was not an exact science because the fundamental law describing the evolution of quantum fields, the Schrödinger equation, was probabilistic and therefore not exact.”
As Carveth Read, the philosopher and logician noted, “It is better to be vaguely right than exactly wrong.” That is a pretty good goal towards which economic forecasting should strive.
Another of the narratives which has become commonplace in recent years is the notion that economists predict with certainty. This fallacy was repeated again recently in a Bloomberg article by Mark Buchanan entitled Economists Should Stop Being So Certain. In fact, nothing could be further from the truth. The only thing most self-respecting economic forecasters know for certain is that their base case is more likely to be wrong than right. The Bank of England has for many years presented its economic growth and inflation forecasts in the form of a fan chart in which the bands get wider over time, reflecting the fact that the further ahead we forecast the greater the forecast uncertainty (chart). Many other institutions now follow a similar approach in which forecasts are seen as probabilistic outcomes rather one in which there is a single outcome.
Indeed, if there is a problem with certainty in economic forecasting, it is that media outlets tend to ascribe it to economic projections. It is after all, a difficult story to sell to their readers that economists assign a 65% outcome to a GDP growth forecast of 2%. As a consequence the default option is to reference the central case.
One of the interesting aspects of Buchanan’s article, however, was the reference to the way in which the science of meteorology has tackled the problem of forecast uncertainty. This was based on a fascinating paper by Tim Palmer, a meteorologist, looking back at 25 years of ensemble modelling. The thrust of Palmer’s paper (here) is that uncertainty is an inherent part of forecasting, and that an ensemble approach that uses different sets of initial conditions in climatic modelling has been shown to reduce the inaccuracy of weather forecasts. In essence, inherent uncertainty is viewed as a feature that can be used to improve forecast accuracy and not as something to be avoided.
In fairness, economics has already made some progress on this front in recent years. We can think of forecast error as deriving from two main sources: parameter uncertainty and model uncertainty. Parameter uncertainty is derived from the fact that although we may be using the correct model, it may be misspecified or we have conditioned it on the wrong assumptions. We can try and account for this using stochastic simulation methods[1] which subject the model to a series of shocks and gives us a range of possible outcomes which can be represented in the form of a fan chart. Model uncertainty raises the possibility that our forecast model may not be the right one to use in a given situation and that a different one may be more appropriate. Thus the academic literature in recent years has focused on the question of combining forecasts from different models and weighting the outcomes in a way which provides useful information[2], although it has not yet found its way into the mainstream.
Therefore in response to Buchanan’s conclusion that “an emphasis on uncertainty could help economists regain the public’s trust” I can only say that we are working on it. But as Palmer pointed out, “probabilistic forecasts are only going to be useful for decision making if the forecast probabilities are reliable – that is to say, if forecast probability is well calibrated with observed frequency.” Unfortunately we will need a lot more data before we can determine whether changes to economic forecasting methodology have produced an improvement in forecast accuracy and so far the jury is still out. Unlike weather forecasting which at least obeys physical laws, economics does not. But both weather systems and the macroeconomy share the similarity that they are complex processes which can be sensitive to conditioning assumptions. Even if we cannot use the same techniques, there is certainly something to learn from the methodological approach adopted in meteorology.
Economics suffers from the further disadvantage that much of its analysis cuts into the political sphere and there are many high profile politicians who use forecast failures to dismiss outcomes that do not accord with their prior views. One such is the MP Steve Baker, a prominent Eurosceptic, who earlier this year said in parliament that economic forecasts are “always wrong.” It is worth once again quoting Palmer who noted that if predictions turn out to be false, “then at best it means that there are aspects of our science we do not understand and at worst it provides ammunition to those that would see [economics] as empirical, inexact and unscientific. But we wouldn’t say to a high-energy physicist that her subject was not an exact science because the fundamental law describing the evolution of quantum fields, the Schrödinger equation, was probabilistic and therefore not exact.”
As Carveth Read, the philosopher and logician noted, “It is better to be vaguely right than exactly wrong.” That is a pretty good goal towards which economic forecasting should strive.
[1]
Blake (1996) Forecast Error Bounds by Stochastic Simulation
[2]
Bayesian Model Averaging is one of the favoured methods. See this paper by Mark
Steel of Warwick University for an overview
Tuesday 10 April 2018
Revisiting Brexit demographics
Even some of those who believe Brexit to be a thoroughly bad
idea are beginning to realise that it is a process that cannot now be stopped.
Indeed, I have long believed that full EU membership will end in March 2019
because of (a) the investment that the UK government has sunk into delivering
Brexit, which will likely preclude parliament overturning the decision, and (b)
the sheer cost in terms of time and effort required to deliver a second
referendum which rules out the option that people will be given a chance to change
their mind.
Wolfgang Münchau in his FT column last week gave four reasons why The time for revoking Brexit has passed: (i) both sides have made significant progress towards an agreement; (ii) domestic opposition to Brexit remains fragmented, which means that it has been hard for Remainers to find a credible figurehead to get behind; (iii) the UK economy has held up better than expected thus reducing the extent of buyers’ remorse and (iv) the EU has itself moved on, and having accepted that Brexit is inevitable is now turning to the issues which matter for its own future (relationships with the US and Russia and reforming EMU). Obviously this has not gone down well with hard core Remainers but sane commentators, such as the lawyer David Allen Green, increasingly point out that the energy would be better spent trying to shape the post-2019 transition rather than fight battles that have already been lost.
In order to consider what should be the appropriate strategy – fight Brexit or shape the future – consider the demographic evidence. The ONS’ population projections suggest that the 55+ cohort which voted predominantly for Brexit will have declined by almost 1.6 million between mid-2016 and mid-2019 (chart). To put this into context, the margin of victory for Leave was slightly less than 1.3 million. Not surprisingly, the further ahead we roll the numbers the bigger the decline, such that by 2026 the 2016 cohort aged 55+ will have declined by 5.3 million (a 27% reduction). This raises the obvious question: In whose name is Brexit being conducted? It is all very well older voters opting to leave the EU but useless both to them and younger voters if they are not around to see it. So on that basis, there is an argument in favour of continuing to oppose Brexit.
Wolfgang Münchau in his FT column last week gave four reasons why The time for revoking Brexit has passed: (i) both sides have made significant progress towards an agreement; (ii) domestic opposition to Brexit remains fragmented, which means that it has been hard for Remainers to find a credible figurehead to get behind; (iii) the UK economy has held up better than expected thus reducing the extent of buyers’ remorse and (iv) the EU has itself moved on, and having accepted that Brexit is inevitable is now turning to the issues which matter for its own future (relationships with the US and Russia and reforming EMU). Obviously this has not gone down well with hard core Remainers but sane commentators, such as the lawyer David Allen Green, increasingly point out that the energy would be better spent trying to shape the post-2019 transition rather than fight battles that have already been lost.
In order to consider what should be the appropriate strategy – fight Brexit or shape the future – consider the demographic evidence. The ONS’ population projections suggest that the 55+ cohort which voted predominantly for Brexit will have declined by almost 1.6 million between mid-2016 and mid-2019 (chart). To put this into context, the margin of victory for Leave was slightly less than 1.3 million. Not surprisingly, the further ahead we roll the numbers the bigger the decline, such that by 2026 the 2016 cohort aged 55+ will have declined by 5.3 million (a 27% reduction). This raises the obvious question: In whose name is Brexit being conducted? It is all very well older voters opting to leave the EU but useless both to them and younger voters if they are not around to see it. So on that basis, there is an argument in favour of continuing to oppose Brexit.
As an aside, I did do some back of the envelope calculations
a few months ago which bear repeating. If we were to apply a weighting
structure based on the fact that younger voters have more to lose from leaving
the EU and therefore we allow their votes to count for more, it is possible to
come up with a scenario in which the June 2016 vote would have produced a
Remain vote. Assume (arbitrarily) that votes account for a positive weight so
long as voters are under the age of 90, with the weight derived as follows (90
– age / 90). For those in the 18-24 age group, if we assume a median age of 21,
applying the formula gives their vote a weight of 0.7633; for those in the
25-34 bracket, the median age is 29.5 and the weight declines to 0.672. As age
rises, so the weight declines. Even allowing for a low turnout amongst younger
voters, survey-based evidence of voting patterns indicate this would be enough
to give Remain a 52.5%-47.5% majority. Whilst such an idea should not be taken
too seriously, as it cuts across the principle of one person-one vote, it does
at least try to introduce some inter-generational fairness which many people
claim is lacking in the whole debate.
The case for instead campaigning for the best post-Brexit settlement is also supported by the fact that the constituency most in favour of Brexit will soon become less politically relevant. The likes of Nigel Farage, who did so much to whip up Brexit support, might bewail the nature of any agreement hammered out between the UK and EU27 but he is increasingly becoming a political irrelevance as those who bought into his vision of a backward-looking Britain become less active (look out for UKIP to take a serious beating at the local UK elections on 3 May). The same may also be true for Jacob Rees-Mogg and Boris Johnson, the hardliners on the front line of Conservative politics, who belong to a party with an average membership age of at least 57 and whose numbers are only around 20% of their Labour opponents. The point, of course, being that Conservative parliamentary MPs will not in future have to be quite so beholden to their increasingly ageing party membership.
You can never say never on Brexit-related matters. But if there is to be any subsequent vote it will most likely only take the form of a parliamentary vote on the terms of the final agreement offered by the EU. After all, the will of the people has already been heard so there is no need to ask them again. It’s just a shame that large numbers of those who voted for Brexit will not be around to enjoy it.
The case for instead campaigning for the best post-Brexit settlement is also supported by the fact that the constituency most in favour of Brexit will soon become less politically relevant. The likes of Nigel Farage, who did so much to whip up Brexit support, might bewail the nature of any agreement hammered out between the UK and EU27 but he is increasingly becoming a political irrelevance as those who bought into his vision of a backward-looking Britain become less active (look out for UKIP to take a serious beating at the local UK elections on 3 May). The same may also be true for Jacob Rees-Mogg and Boris Johnson, the hardliners on the front line of Conservative politics, who belong to a party with an average membership age of at least 57 and whose numbers are only around 20% of their Labour opponents. The point, of course, being that Conservative parliamentary MPs will not in future have to be quite so beholden to their increasingly ageing party membership.
You can never say never on Brexit-related matters. But if there is to be any subsequent vote it will most likely only take the form of a parliamentary vote on the terms of the final agreement offered by the EU. After all, the will of the people has already been heard so there is no need to ask them again. It’s just a shame that large numbers of those who voted for Brexit will not be around to enjoy it.
Sunday 8 April 2018
Don't be casual with words
They say that the pen is mightier than the sword.
Consequently, it is incumbent upon us all to use our words judiciously. But it
is also important that those consuming any given message are careful to interpret
the information given to them without extrapolating beyond what is in
front of them. This is particularly important in a world riddled with fake news
in which messages can be subtly tweaked to say something that was not in the
original communication, which is then passed on down the chain like the old game
of Chinese whispers. It is also an issue for policymakers, particularly central
bankers who are trying to communicate with markets and the wider public.
This issue was thrown into sharp relief by the recent TV interview by British Foreign Secretary Boris Johnson, who in response to the question of whether Russia was the source of the poison used in the Salisbury incident replied: “When I look at the evidence, the people from Porton Down, the laboratory… they were absolutely categorical, I mean, I asked the guy myself, I said, 'are you sure?' and he said 'there's no doubt.'” Only this week, Gary Aitkenhead, the chief executive of the government’s Defence Science and Technology Laboratory stated that whilst the government combined the laboratory’s scientific findings with information from other sources to conclude that Russia was responsible for the Salisbury attack, “we have not verified the precise source.”
It would appear that Johnson jumped to a conclusion that may not (yet) be supported by the evidence – statistically known as a Type I error. Meanwhile, the more cautious Aitkenhead refused to deal in speculation – as befitting someone leading a team of scientists. But whilst there is a discrepancy between these two versions of events, which has raised question marks against Johnson’s judgement, it is important to note that Aitkenhead did not say that the source was not Russian, as some of the more excitable media commentators have suggested.
I was similarly struck by a Twitter exchange involving the physicist Brian Cox who noted that “we have a generation of senior politicians who were not taught how to think properly - more science in their education would have helped. They use imprecise, woolly language, which is symptomatic of woolly thinking.” Cox was careful not to dismiss the arts and social sciences but was nonetheless inundated with comments accusing him of doing just that, thereby rather proving his point. People may disagree, but what I interpreted Cox as saying was that science demands very high levels of certainty and many people could benefit from understanding what constitutes a reasonable degree of proof before making pronouncements in public.
But perhaps the problem is as much to do with the medium through which many of our news stories are filtered. Take, for example, the way in which the actions of central banks are reported. In August 2013 the Bank of England unveiled a forward guidance strategy based on the unemployment rate. It announced that Bank Rate would not rise from its then-current level of 0.5% until the unemployment rate fell to 7%. This strategy was conditional upon ‘knockouts’ designed to allow for rate hikes if certain threats to inflation became evident.
Although in fact unemployment fell well below 7% over the next twelve months, the Bank did not raise rates for a variety of reasons – domestic inflation was falling whilst the international environment was plagued by euro zone uncertainty and concerns over Chinese events. Nonetheless, many people fell into the trap of arguing that the Bank’s intentions did not match with its actions which rather destroyed its credibility. But it is important to look at exactly what the BoE said: “the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the … headline measure of the unemployment rate has fallen to a threshold of 7%.” This was not a commitment to raise rates once unemployment hit 7% – only a commitment not to do so as long as it remained above the threshold, which is a very different matter.
Despite the best efforts of the BoE to explain the conditional nature of economic forecasts and the risks surrounding the central case projection, the subtleties of this message are often lost in media translation. Thus the mechanistic nature of the initial forward guidance rule was always given more prominence than it deserved. Perhaps the BoE should have been more aware that the issue would be construed in this way, and framing a rule based on the unemployment rate laid it open to more criticism than was necessary. I am not convinced that the BoE did a great job of communicating its message at the time, but it certainly was not helped by some of the reporting surrounding its commentary.
In his latest speech, MPC member Gertjan Vlieghe suggested that in his view it is “useful to provide a snapshot of how today’s central growth and inflation forecast map into my view of the likely central path of interest rates.” This is exactly the approach adopted by the Swedish Riksbank which sets out an illustrative path for the policy rate conditioned upon its economic forecast. Vlieghe pointed out that “if growth and inflation turn out differently from this central forecast, the path of interest rates will be different too. That should not be seen as a mistake, or a breaking of an earlier promise. It should be seen for what it is, namely an appropriate response to a changed economic outlook.“
Whilst this is totally correct, past UK experience suggests that if the BoE were to adopt such a strategy, a large number of people will misunderstand the nature of conditional versus unconditional forecasts and use this as a stick with which to beat the central bank when it is unable to deliver on its forecast. We all have to choose our words carefully, but it seems that central banks have to do so almost us much as foreign secretaries
This issue was thrown into sharp relief by the recent TV interview by British Foreign Secretary Boris Johnson, who in response to the question of whether Russia was the source of the poison used in the Salisbury incident replied: “When I look at the evidence, the people from Porton Down, the laboratory… they were absolutely categorical, I mean, I asked the guy myself, I said, 'are you sure?' and he said 'there's no doubt.'” Only this week, Gary Aitkenhead, the chief executive of the government’s Defence Science and Technology Laboratory stated that whilst the government combined the laboratory’s scientific findings with information from other sources to conclude that Russia was responsible for the Salisbury attack, “we have not verified the precise source.”
It would appear that Johnson jumped to a conclusion that may not (yet) be supported by the evidence – statistically known as a Type I error. Meanwhile, the more cautious Aitkenhead refused to deal in speculation – as befitting someone leading a team of scientists. But whilst there is a discrepancy between these two versions of events, which has raised question marks against Johnson’s judgement, it is important to note that Aitkenhead did not say that the source was not Russian, as some of the more excitable media commentators have suggested.
I was similarly struck by a Twitter exchange involving the physicist Brian Cox who noted that “we have a generation of senior politicians who were not taught how to think properly - more science in their education would have helped. They use imprecise, woolly language, which is symptomatic of woolly thinking.” Cox was careful not to dismiss the arts and social sciences but was nonetheless inundated with comments accusing him of doing just that, thereby rather proving his point. People may disagree, but what I interpreted Cox as saying was that science demands very high levels of certainty and many people could benefit from understanding what constitutes a reasonable degree of proof before making pronouncements in public.
But perhaps the problem is as much to do with the medium through which many of our news stories are filtered. Take, for example, the way in which the actions of central banks are reported. In August 2013 the Bank of England unveiled a forward guidance strategy based on the unemployment rate. It announced that Bank Rate would not rise from its then-current level of 0.5% until the unemployment rate fell to 7%. This strategy was conditional upon ‘knockouts’ designed to allow for rate hikes if certain threats to inflation became evident.
Although in fact unemployment fell well below 7% over the next twelve months, the Bank did not raise rates for a variety of reasons – domestic inflation was falling whilst the international environment was plagued by euro zone uncertainty and concerns over Chinese events. Nonetheless, many people fell into the trap of arguing that the Bank’s intentions did not match with its actions which rather destroyed its credibility. But it is important to look at exactly what the BoE said: “the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the … headline measure of the unemployment rate has fallen to a threshold of 7%.” This was not a commitment to raise rates once unemployment hit 7% – only a commitment not to do so as long as it remained above the threshold, which is a very different matter.
Despite the best efforts of the BoE to explain the conditional nature of economic forecasts and the risks surrounding the central case projection, the subtleties of this message are often lost in media translation. Thus the mechanistic nature of the initial forward guidance rule was always given more prominence than it deserved. Perhaps the BoE should have been more aware that the issue would be construed in this way, and framing a rule based on the unemployment rate laid it open to more criticism than was necessary. I am not convinced that the BoE did a great job of communicating its message at the time, but it certainly was not helped by some of the reporting surrounding its commentary.
In his latest speech, MPC member Gertjan Vlieghe suggested that in his view it is “useful to provide a snapshot of how today’s central growth and inflation forecast map into my view of the likely central path of interest rates.” This is exactly the approach adopted by the Swedish Riksbank which sets out an illustrative path for the policy rate conditioned upon its economic forecast. Vlieghe pointed out that “if growth and inflation turn out differently from this central forecast, the path of interest rates will be different too. That should not be seen as a mistake, or a breaking of an earlier promise. It should be seen for what it is, namely an appropriate response to a changed economic outlook.“
Whilst this is totally correct, past UK experience suggests that if the BoE were to adopt such a strategy, a large number of people will misunderstand the nature of conditional versus unconditional forecasts and use this as a stick with which to beat the central bank when it is unable to deliver on its forecast. We all have to choose our words carefully, but it seems that central banks have to do so almost us much as foreign secretaries
Thursday 29 March 2018
Article 50: One year on
It is now exactly a year since Theresa May stood before UK parliament and announced that she was triggering the Article 50 mechanism that would sweep the UK out of the EU within two years. Halfway through the mandated two year time period, the UK has made more progress with regard to negotiating a deal than I believed possible at the time. Nonetheless many mistakes have been made along the way, and there is still much work to do before UK is able to arrive at a deal which will minimise the damage caused by what I still consider to be an act of economic self-harm. Perhaps more significantly, the country remains as split as ever on Brexit. The ultras still want it at any price whilst there is still a significant core of Remainers who want to prevent it altogether.
Looking back over the past 12 months, there is certainly a lot less gung-ho from the prime minister. The idea that “no deal is better than a bad deal” has been quietly dropped and some of the more strident rhetoric which was designed to keep the pro-Brexit faction of her party onside has been toned down. Of course, this is in large part the result of the ill-judged election call which cost the Conservatives their parliamentary majority last June, and which has weakened the prime minister’s position. More significantly, parliament has exercised a greater of control over the domestic legislation process than was initially envisaged. The government’s original plan was that it would be the prime driver of Brexit legislation but the Withdrawal Bill has been the subject of numerous amendments during its parliamentary passage and may not be the all-encompassing piece of legislation that was envisaged a year ago.
The toning down of domestic rhetoric is also a consequence of the Realpolitik of dealing with the EU27 across the negotiating table. For example, during her speech to parliament in March 2017, the PM promised to “bring an end to the jurisdiction of the European Court of Justice in Britain.” Earlier this month, she was forced to recognise that “even after we have left the jurisdiction of the ECJ, EU law and the decisions of the ECJ will continue to affect us.” That is a very different message to the one she tried to sell a year ago but it is a recognition that the form of close partnership that the UK wants with the EU27 will necessarily involve compromises that will not please everyone in her party. However, it raises the prospect of ongoing domestic political upheaval as it becomes clear that Brexit simply cannot take place on the no-compromise terms envisaged by many Leavers.
It was evident a year ago that the two year timeframe was never going to be long enough to ensure that the final agreement between the UK and EU27 could be ratified. And so it has proven, with the announcement last week that the two sides will implement a transition deal starting in a year’s time which runs to end-2020. The good news is that this will remove the prospect of a cliff-edge Brexit in March 2019 although does not preclude the possibility that the cliff-edge has merely been postponed to December 2020. Nonetheless, this is good news for financial institutions in particular, who until yesterday were unsure whether the arrangements that allow cross-border transactions in financial services would come to an end in March 2019. However, the Bank of England has now opined that it “considers it reasonable for firms currently carrying on regulated activities in the UK by means of passporting rights … to plan that they will be able to continue undertaking these activities during the implementation period in much the same way as now.” In other words, we now have more time to prepare, and hopefully more information on the future of financial services will be forthcoming in the interim.
As regards the three key issues that formed the basis of phase one of the Brexit negotiations, the UK and EU27 are broadly agreed on guaranteeing citizens’ rights and the final exit bill. However, whilst both sides agree in principle on the issue of maintaining an open border between the Irish Republic and Northern Ireland, the UK has not yet come with a solution which will satisfy the requirements of both sides. It is thus notable that whilst the UK and EU27 agree on 75% of the issues outlined in last week’s joint agreement document, the Irish border issue, and the thorny question of how much jurisdiction the ECJ will be allowed to have, remain to be resolved.
Compared to what was expected on the economy twelve months ago, GDP growth has been broadly in line but unemployment has fallen faster and CPI inflation has picked up more than anticipated. The threat of Brexit has clearly not derailed the economy but it has arguably underperformed relative to what might have occurred in its absence. Indeed, the UK remains at the bottom of the G7 growth league and is the only major economy which registered slower growth in 2017 than in 2016. I thus remain to be convinced that Brexit will prove a net benefit for the UK economy, for reasons that I have outlined numerous times before.
But my biggest issue with Brexit remains the way in which the Leave campaign made their case ahead of the referendum (and allegations of funding impropriety which have surfaced in recent days does nothing to assuage these concerns) and the way in which the result was interpreted as a winner-take-all event. Leave supporters continue to believe that the “will of the people” justifies Brexit at any price and precludes the option of revisiting the decision. But parliamentary democracy in the UK is founded on the principle that no parliament can take a decision that binds its successors. Yet that is precisely what Brexit implies. It is the imposition of a policy that younger generations – and perhaps those not yet born – will have to contend with. It is in many respects a profoundly undemocratic decision.
Of course, the Leave side can reasonably contend that it is undemocratic to be shackled to an institution of which they do not wish to remain part. Thus, one year after triggering Article 50 and almost two years after the referendum, the legal and constitutional implications of the decision are no nearer being resolved. Expect us to be having much the same debate about the (de)merits of Brexit in March 2019 as we did in March 2017 (or even March 2016).
Wednesday 28 March 2018
Examining the case for a wealth tax
I have pointed out previously that the huge fiscal
tightening imposed on the UK over the past eight years has come about through
huge cuts in spending and relatively little by way of additional taxation (most
recently here).
Now that the balance between current spending and revenue has been restored,
there is no serious rationale for further swingeing spending cuts. Undoubtedly
this was one of the factors supporting the announcement by Theresa May earlier
this week that additional funding will be made available for the NHS.
Whilst this is a welcome development, the pressure on public finances has not suddenly gone away now that the deficit on current spending has been eliminated. If anything, as the population ages, the demands on healthcare and social services will continue to rise. It is not just the health system that is struggling to cope: The benefits system is under pressure too, and there is a huge wedge of people at the lower end of the income scale who are struggling to gain access to the benefits to which they are entitled.
What the government has not outlined is how much additional funding will be provided nor where it will come from. After eight years of grinding austerity, raising existing taxes to fund the additional resource requirements will not be acceptable to taxpayers who would regard it as yet another kick in the teeth for the squeezed middle. Indeed, raising income taxes appears to be a non-starter. In any case, efforts to compensate low-paid workers for the curbing of their benefits via an increase in personal income tax allowances is already estimated to have cost a cumulated £12bn in foregone revenue in FY 2017-18. Having raised VAT to an already-lofty 20%, the scope for raising indirect taxes is also limited. It would thus be sensible to look for alternative revenue sources, and two apparently radical fiscal suggestions have been given more prominence in recent weeks. One is the possibility of some form of wealth tax and the other is to introduce a hypothecated tax to fund such items as the NHS.
In this post I will consider only the option of a wealth tax and will come back to hypothecated taxes another time. The rationale for a wealth tax is that incomes, which form the basis of most direct taxes, have remained stable relative to GDP over the past three decades whereas wealth holdings have significantly increased. Thirty years ago, UK household net financial wealth holdings were a multiple of 1.2 times GDP but today the multiple stands at 2.3. The picture looks even more favourable if we add in wealth held in the form of housing. Financial and housing wealth together amount to around 5 times GDP compared to a multiple of 3 in 1988 (chart).
But why should this windfall gain be subject to tax? One
strong argument is that taxes on income do not take into account the claim on
overall resources that wealth confers. For example, there is a difference in
the ability to pay a bill of (say) £1,000 between someone who earns £20,000
from labour income and someone who earns £20,000 as a return on a wealth stock
of £1 million. As a result, a wealth tax will raise the overall progressivity
of the tax system by taking account of the additional taxable capacity
conferred by wealth. But wealth holdings are already subject to tax in some
form or another. For example, liquidating wealth holdings subjects individuals
to capital gains tax. Moreover, the flow of income accruing to a stock of
financial wealth is liable to income tax. In addition, even if the wealth is
untouched and generates no direct financial benefit to the individual, if it is
passed on as a bequest to future generations it is subject to inheritance tax.
In any case, there are a huge number of practical difficulties associated with introducing a wealth tax. To name just a few: How much should it raise? On which assets should it be levied? At what rate should it be set? Should it be set at a single or graduated rate? Howmuch (if any) of an individual’s wealth should be exempt? Even if we could agree on these issues, once such a tax has been implemented, two of the biggest ongoing problems are disclosure and valuation. The disclosure problem is obvious: It is easy to hide many forms of wealth (think how simple it is to hide small but precious items such as diamonds). As a result, compliance becomes a problem and even honest taxpayers have an incentive to cheat if their fellow citizens are not playing ball. In addition, the valuation problem is often underestimated, particularly if the absence of a market transaction makes it difficult to establish an appropriate valuation metric. It is for all these reasons that the proportion of OECD countries levying a wealth tax has fallen over the last three decades. In 1990, half of them did so (17) but by 2010 only France, Norway and Switzerland levied them on an ongoing basis.
Despite all the practical difficulties, there is a genuine case for some form of wealth tax on grounds of inter-generational fairness. For example, older generations tend to hold the vast bulk of the wealth whilst benefiting from additional public spending on areas such as the NHS. It is for this reason that the Resolution Foundation recently put forward a series of proposals to reform property taxes, including the introduction of a progressive property tax to replace the existing Council Tax and raising taxes on highest-value properties.
Such measures will clearly not be popular with Conservative voters, and is one reason why they will not be implemented any time soon. But as the fiscal debate increasingly switches away from deficit reduction and focuses more on what the state can reasonably be expected to provide, the issue of inter-generational equity will inevitably rise up the list. We may not want to talk about wealth taxes today but it is an issue that is unlikely to go away.
Whilst this is a welcome development, the pressure on public finances has not suddenly gone away now that the deficit on current spending has been eliminated. If anything, as the population ages, the demands on healthcare and social services will continue to rise. It is not just the health system that is struggling to cope: The benefits system is under pressure too, and there is a huge wedge of people at the lower end of the income scale who are struggling to gain access to the benefits to which they are entitled.
What the government has not outlined is how much additional funding will be provided nor where it will come from. After eight years of grinding austerity, raising existing taxes to fund the additional resource requirements will not be acceptable to taxpayers who would regard it as yet another kick in the teeth for the squeezed middle. Indeed, raising income taxes appears to be a non-starter. In any case, efforts to compensate low-paid workers for the curbing of their benefits via an increase in personal income tax allowances is already estimated to have cost a cumulated £12bn in foregone revenue in FY 2017-18. Having raised VAT to an already-lofty 20%, the scope for raising indirect taxes is also limited. It would thus be sensible to look for alternative revenue sources, and two apparently radical fiscal suggestions have been given more prominence in recent weeks. One is the possibility of some form of wealth tax and the other is to introduce a hypothecated tax to fund such items as the NHS.
In this post I will consider only the option of a wealth tax and will come back to hypothecated taxes another time. The rationale for a wealth tax is that incomes, which form the basis of most direct taxes, have remained stable relative to GDP over the past three decades whereas wealth holdings have significantly increased. Thirty years ago, UK household net financial wealth holdings were a multiple of 1.2 times GDP but today the multiple stands at 2.3. The picture looks even more favourable if we add in wealth held in the form of housing. Financial and housing wealth together amount to around 5 times GDP compared to a multiple of 3 in 1988 (chart).
In any case, there are a huge number of practical difficulties associated with introducing a wealth tax. To name just a few: How much should it raise? On which assets should it be levied? At what rate should it be set? Should it be set at a single or graduated rate? Howmuch (if any) of an individual’s wealth should be exempt? Even if we could agree on these issues, once such a tax has been implemented, two of the biggest ongoing problems are disclosure and valuation. The disclosure problem is obvious: It is easy to hide many forms of wealth (think how simple it is to hide small but precious items such as diamonds). As a result, compliance becomes a problem and even honest taxpayers have an incentive to cheat if their fellow citizens are not playing ball. In addition, the valuation problem is often underestimated, particularly if the absence of a market transaction makes it difficult to establish an appropriate valuation metric. It is for all these reasons that the proportion of OECD countries levying a wealth tax has fallen over the last three decades. In 1990, half of them did so (17) but by 2010 only France, Norway and Switzerland levied them on an ongoing basis.
Despite all the practical difficulties, there is a genuine case for some form of wealth tax on grounds of inter-generational fairness. For example, older generations tend to hold the vast bulk of the wealth whilst benefiting from additional public spending on areas such as the NHS. It is for this reason that the Resolution Foundation recently put forward a series of proposals to reform property taxes, including the introduction of a progressive property tax to replace the existing Council Tax and raising taxes on highest-value properties.
Such measures will clearly not be popular with Conservative voters, and is one reason why they will not be implemented any time soon. But as the fiscal debate increasingly switches away from deficit reduction and focuses more on what the state can reasonably be expected to provide, the issue of inter-generational equity will inevitably rise up the list. We may not want to talk about wealth taxes today but it is an issue that is unlikely to go away.
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