Priti vacant

The Home Secretary, Priti Patel, sits on the right-wing of the Conservative Party and can best be described as socially illiberal (see this clip from one of the BBC’s flagship current affairs programmes in 2011 in which she quite clearly advocated the return of the death penalty). She also backed Theresa May’s hostile environment immigration policies, presented in the immigration bills of 2014 and 2016. But Patel is nothing if not entrepreneurial although her efforts to go off-piste by holding unauthorised meetings with Israeli politicians and businesspeople in 2017 did result in her being sacked from May’s government. Nonetheless, her voting record marks her out as an economic liberal, generally voting against policies such as higher taxes.

This week’s announcement by Patel that British businesses will effectively be barred from hiring “unskilled” workers from outside the UK after the Brexit transition process ends, is both socially and economically illiberal. The policy, which is outlined here, will bring in a points-based system “that will attract the high-skilled workers we need to contribute to our economy” whilst keeping out those the government presumably deems undesirable. Undoubtedly there is a preference amongst some voters for this kind of policy, as this clip reporting the views of a BBC Question Time audience member makes clear (the fact that it is both offensive and inaccurate is beside the point – this is what some people believe). However, the policy suffers from a number of theoretical and practical limitations that potentially threaten to introduce yet more economic disruption.

Starting with the macroeconomic implications, the fact that business investment has been so weak over recent years underlines the importance of labour input in driving growth. In Q4 2019, business fixed investment volumes were only 1.3% higher than mid-2016 levels – an annual increase of less than 0.4% per year. To put that into context, the average annual growth rate over the period 1966 to 2015 was 2.9% – and even that is widely considered to be too low in comparison to other European economies.

My calculations suggest that since 2015, the contribution of capital to potential GDP growth (currently estimated at around 1.5% per year) has fallen by 0.2 percentage points to 0.5 pp per annum largely due to a lack of investment which has resulted in a less efficient capital stock. Total factor productivity, which accounts for factors such as technical progress and other intangibles, has recorded a dreadful performance since 2008 and is currently not giving any boost to potential growth (chart). Thus the labour contribution accounts for a good one percentage point per annum. This can be broken down into the increase in the overall working population (0.2 pp); participation (0.2 pp); the employment rate (0.4 pp, defined as the extent to which available labour resources are being used) and hours worked (0.4 pp).

Other things being equal, measures that disrupt labour supply will act to curb the economy’s growth rate. As it is, the population is ageing and the retirement of the baby-boomers means that the working age population is growing at a slower rate than in the past. Moreover, the big boost derived in recent years from an increase in hours worked and the employment rate (number of employees relative to the total working age population) appears to be losing momentum (cf chart). Patel’s response to this problem was to suggest that any shortfalls can be met from the 8.5 million people currently classified as “economically inactive” which effectively means raising the employment rate. But of that figure, 2.3 million are classified as students; 1.9 million are looking after their family and 2.1 million are registered as long-term sick. Only 1.9 million are classified as looking for a job. This implies that the employment rate can only rise from current levels of 79.5% to a theoretical maximum of 81% – the 1.5 percentage point rise represents the amount by which it has increased over the past four years. There is a lot less slack in the labour market than the Home Secretary seems to think. 

As for a points-based system (PBS), the report from the government’s non-partisan Migration Advisory Committee (MAC) released last month was less than enthusiastic. The Committee chairman’s comments indicated that whilst he understood the government’s need to communicate complex issues to the electorate, PBS currently only represents a “soundbite” with no coherent plan as to how it would work (surprisingly enough, his contract as chairman of the MAC was not renewed). The biggest criticisms include the inconvenient fact that countries which do rely on a PBS, such as Canada and New Zealand, only use them in parts of their immigration system – it is not the bedrock. Moreover, when the UK experimented with such a system to recruit non-EU workers between 2002 and 2006, it did not attract the highly-skilled workers which the government hoped for. And as the MAC report notes, the current system to attract highly skilled workers from outside the EU “does not work well … [because] the skills bar for entry is set far too high, targeted at those at the very top of their field and is too risk averse.”

The government has accepted one of the MAC’s recommendations, to reduce the annual salary threshold from £30,000 to £25,600. Workers who do not meet the points requirement to qualify for entry must therefore meet this salary threshold – the idea being to dissuade “lower-skilled” workers from entering the UK (though as the government points out “under the points-based system for skilled workers, applicants will be able to ‘trade’ characteristics such as their specific job offer and qualifications against a lower salary”).  As if the other aspects were not contentious enough, this element threatens to open up a new can of worms. Many jobs in the health and social care area are not low-skilled at all, yet do not offer a salary which meets this threshold. A phlebotomist, for example, will struggle to earn £20,000. Full-time social care workers, of which around 20% are foreign nationals, earn around £19,500 per year – 24% below the recommended limit.

The government plans to introduce these new rules once the transition period with the EU expires at the end of this year. Not only is that not a lot of time to adjust but as Tom Hadley, director of policy at the Recruitment and Employment Confederation, said: “Jobs the government considers ‘low-skilled’ are vital to wellbeing and business growth. The announcement threatens to shut out the people we need to provide services the public rely on. We need access to workers that can help us look after the elderly, build homes and keep the economy strong.” What the policies amount to is an upgrade of the state-sponsored hostile environment which the Conservatives have pioneered over the past decade. Such an unwelcoming environment runs the risk that the UK is no longer the first port of call for talent in a world where other countries are desperate to import skills which are in short supply at home. If the government does go ahead with its introduction, my guess is that within a couple of years it will be forced to water down the restrictions.

And for all the contradictions inherent in the new rules, the biggest of them all is that Patel’s parents, who migrated to the UK from Uganda in the 1960s, would not have qualified for entry under the rules their daughter has drawn up. You could not make it up. Except that the government is indeed making it up as it goes along and runs the risk of strangling itself in a knot of contradictions.

Frost in Brussels

I am far from sure whether yesterday’s keynote speech in Brussels by David Frost, Boris Johnson’s policy adviser on Europe, was an opening gambit in what is likely to be a long and bitter negotiation between the UK and EU or was really the statement of intent it was made out to be. It was provocative, as might be expected from one who is a self-confessed supporter of Brexit as he made it clear that the UK will not accept supervision from the EU as part of a post-Brexit free trade deal. Worse still, Frost airily dismissed the economics with an “it will be all right in the end” attitude, without putting forward any evidence to support his claims. Perhaps it’s all an act or maybe he really has no idea what he is talking about. But if this is to be the tone of the British government’s approach to Brexit throughout 2020, it is going to be a long, hard year.

Frost’s attempt to rationalise Brexit

Frost’s justification for Brexit leaned heavily on the work of Edmund Burke who, despite being “one of my country’s great political philosophers”, was born and raised in Dublin where he spent the first 21 years of his life. Burke was a student of the French Revolution and one of his most famous works, Reflections on the Revolution in France, argued that the revolution would end in failure because its foundation on the abstract notion of rationality ignored the complexities of human nature and the institutions which were built around it. Academics struggle to interpret this work. This paper by David Armitage notes that there is ongoing debate about whether Burke “was a realist or an idealist, a Rationalist or a Revolutionist.” Frost chooses to interpret him as a realist by invoking the premise that the formation of the EU constitutes a revolution in European governance which overrides national institutions serving the people of individual countries. But whilst Frost’s view of a monolithic EU has some foundation, his interpretation is not one I recognise.

He argues that “if you can’t change policies by voting, as you increasingly can’t in this situation –  then opposition becomes expressed as opposition to the system itself.” But this is to ignore the fact that whilst EU laws are drafted by the Commission, they are passed into law by the European Parliament – comprised of the MEPs we vote for. And whilst it may be true that “the key [EU] texts are as hard to read for the average citizen as the Latin Bible was at the time of Charles the Bold” I can attest that British laws are equally hard to understand for non-lawyers such as myself. After all, I have (tried to) read a lot more British law in the last two years than is good for me.

Where Frost does have a point is that European institutions are, in British eyes, “more abstract, they were more technocratic.” There is not the drama associated with the European Parliament that is associated with Westminster, but as the lessons of the last twelve months have shown that is not necessarily a bad thing. Where I do not agree is the coda to the sentence in which he states European institutions “were more disconnected from or indeed actively hostile to national feeling.” They were perceived as hostile to national interests, it is true, but that is largely thanks to the disinformation (or lies, if you will) pumped out by journalists like Boris Johnson during his time in Brussels.

Nor am I convinced by Frost’s simplistic argument that “Brexit was surely above all a revolt against a system” where “the system” was the EU. “I don’t think it is right to dismiss this just as a reaction to austerity or economic problems” may be his view but not one necessarily backed up by the evidence. The Leave campaign made all sorts of promises that they could not deliver about the benefits of Brexit and the issues were simply too complex to be boiled down into a “yes/no” question, as even my Leave-supporting friends admit. Frost makes the mistake of drawing inferences about the 2016 vote which were not evident at the time. For an eminently clever man, Frost’s arguments were little more than a weak post-hoc justification. And if I can see that, you can bet that the smart people in the EU Commission will come to a similar conclusion. But if the justification for Brexit was weak, wait until you hear his economic arguments.

Trying to justify the economics

Frankly, the economics did not even rate a D+. His opening gambit was to dismiss the work done by the UK Government and the BoE thus: “I would question some of the specifics of all those studies. This probably isn’t the moment to go into the detail … But, in brief, all these studies exaggerate – in my view – the impact of non-tariff barriers.” Try that in an undergraduate essay and see how far you get. To apply the Farage tactic (“I could be more specific about my objections but now is not the time”) is not good enough. Economists are not interested in his view – they want the evidence that contradicts their own. Indeed, the evidence suggests that non-tariff barriers can be more restrictive for trade than actual tariffs. Simple things like technical barriers to trade (regulations on the content of products) or inspections and other formalities that require goods are checked for various reasons are pretty hard to get around. Indeed, there is a well-established literature on the empirical costs of border effects[1].

He went on to note that “many Brexit studies seem very keen to ignore or minimise any of the upsides, whether these be connected to expanded trade with the rest of the world or regulatory change.” There is a reason for that: With the exception of Patrick Minford, whose “analysis” is not worth the time of day, I struggle to think of any study which points to a net economic benefit from Brexit. Similarly, “there is obviously a one-off cost from the introduction of friction at a customs and regulatory border, but I am simply not convinced it is on anything like the scale or with the effects these studies suggest.” But that’s the sort of reasoning used by those who believe the Earth is flat: “Because I cannot see the curvature I am simply not convinced it is anything but flat.”

Ultimately, this speech contained nothing to convince any of us who believe the economic costs of Brexit are non-trivial that the government can be trusted to look after the interests of the economy. Frost made it clear that “we are ready to trade on Australia-style terms if we can’t agree a Canada type FTA”. Since Australia has not yet signed a trade deal with the EU he means the UK is prepared to trade on WTO terms at a time when the WTO has ceased to function properly. But it gets worse. “We understand the trade-offs involved – people sometimes say we don’t but we do … Much of the debate about will Britain diverge from the EU I think misses this point. … But it is perfectly possible to have high standards, and indeed similar or better standards to those prevailing in the EU, without our laws and regulations necessarily doing exactly the same thing … I struggle to see why this is so controversial.” That last line sums it up. The British government either does not understand the EU’s position or chooses not to do so. If you want to have access to the club, you simply have to abide by the rules. This is not a matter for debate.

The galling thing about the whole speech is that it echoes the tone of Theresa May at her worst. It was similarly content-light, promoted a revisionist version of history and made promises which will be undeliverable if the EU refuses to bend. Johnson will run into the same problem as his predecessor. Obviously both sides have to sound tough at the start of negotiations but it really does not have to be like this. What concerns me most is that if this really does represent the UK government’s position, we are headed for a major clash before the year is out. And despite what anyone else may say to the contrary, a hard Brexit is most emphatically not what people voted for in 2016. It’s going to be a rough ride. 

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[1] Anderson, J.E., E. van Wincoop (2003) ‘Gravity with gravitas: a solution to the border puzzle’, The American Economic Review 93 (1), 170–192

Advisers advise, ministers decide

The resignation of Sajid Javid as Chancellor of the Exchequer following the reshuffling of Boris Johnson’s government came as a major surprise since Javid had, by all accounts, been promised that he could continue in the job despite changes in ministerial responsibility elsewhere. It has emerged that Javid was offered the chance to stay in post, but only on condition he fired all his special advisers and replaced them with those appointed by the prime minister’s office (i.e. by Boris Johnson’s de facto chief of staff, Dominic Cummings). Javid had rather unkindly been labelled as CHINO (Chancellor In Name Only), and it is clear that he was not prepared to compromise any further in order to retain his position at the heart of government.

All this comes less than a month before Javid was due to present his first post-election budget to parliament which was (is?) expected to include tax breaks for low income earners and a boost to social spending, coupled with measures to claw back some revenue from higher earners. His replacement is the little-known MP Rishi Sunak who has 27 days to prepare himself for the budget presentation. Clearly this will not be his budget – it will be the one imposed upon him by Downing Street and will have the fingerprints of Dominic Cummings all over it. It does appear that the current government is a highly centralised administration, offering little scope for individual minsters to set the direction of policy. But particularly in the area of fiscal policy, there is a sense of conflict between what the Johnson government wants to deliver and the caution which the Treasury reserves towards big policy initiatives which involve spending money.

The first issue is whether the resignation will have any implications for the direction of policy. It almost certainly will not derail the government’s plan to take more low-paid earners out of the tax net. The Conservative election manifesto promised to raise the threshold for National Insurance Contributions to £9,500 (currently £8,632). Using HMRC data as a baseline, which suggests that an increase of £2 per week will cost £300m of revenue, this implies an annual revenue loss of around £5 billion (0.2% of GDP). I would be surprised if that was not one of the measures to be presented by the new Chancellor on 11 March. The Conservatives also expressed an “ultimate ambition … to ensure that the first £12,500 … is completely free of tax” which on current calculations would put a £22bn annual hole in public revenues (1% of GDP). Such largesse will have to be paid for and various trial balloons have been floated, including restrictions on pension tax relief where cutting the relief rate from 40% to 20% for workers earning more than £50,000 per year could claw back £10bn. Another option which has been mooted is the levying of a tax on properties above a certain (high) value threshold. The problem is that although such policies might play well with non-traditional Tory voters who lent their votes to Johnson in December, they will not go down well with voters in the Conservative heartlands in southern England.

The alternative to a big clawback is that the government simply runs a looser fiscal stance. Prior to the election campaign, Javid announced a set of fiscal rules in which the government would seek only to balance the current budget by the middle of the decade and borrowing to fund investment would be permitted to rise to 3% of GDP – around half as high again as the previous set of fiscal rules – whilst debt servicing costs would be limited to 6% of tax revenues. These are estimated to allow for fiscal expansion equivalent to 1% of GDP. However, it would be easy enough to tweak the limits to allow for a slightly larger expansion and to blur the distinction between current and capital spending by setting even more nebulous targets for balancing the budget.

But there is a bigger issue at stake than the nature of the fiscal stance and it goes to the heart of who runs government. The prime minister is primus inter pares – first amongst equals – but he (or she) cannot control everything. And it will raise further questions about the role of Cummings, for it is known that he and Javid did not see eye-to-eye on many issues. Margaret Thatcher once famously said that “advisers advise and ministers decide” but press reports over recent months suggest that the advisers are doing a little more advising than is good for government. Ironically Thatcher made this comment in the wake of the 1989 dispute between her economic adviser, Alan Walters, and the then-Chancellor Nigel Lawson. Lawson was an advocate of the UK joining the ERM but Walters was not, and what should have been an internal government matter got out of hand when Walters published an article outlining his position. Lawson subsequently resigned (as did Walters) but the damage to Thatcher’s position ran deep and she was forced out a year later.

The lesson from that episode was that when it comes to a showdown in which a prime minister has to choose between the advice of a minister and listening to an adviser, it is usually a mistake to choose the latter over the former. It smacks of authoritarianism and does nothing to foster good relations between the prime minister and other MPs on whom he ultimately depends. We should not over-dramatise today’s events. The budget will still be delivered and many of the ideas currently on the stocks will be put forward. But it should act as a warning to Boris Johnson that he will not always get his way and although he is currently flavour of the month he must beware alienating those who may have a different point of view. As a classics scholar, Johnson will be all too aware of the fate which befell Caligula – although in fairness Johnson has not yet appointed a horse as an adviser.

Caveat emptor

We have just finished the fifth full trading week of the year, yet it seems an awful lot has been packed into the past 25 sessions. We started with the assassination of Qasem Soleimani which spooked markets – albeit only briefly – and followed this up with the accidental shooting down of a Ukrainian aircraft in Tehran which further inflamed Middle Eastern tensions. The current big source of concern is the coronavirus which prompted a market sell-off last week but which has subsequently been reversed. Add to this the bizarre spectacle of the Trump impeachment, his subsequent acquittal and the travails of the Democrats in Iowa and you have all the ingredients for a classic risk-off market.

But not a bit of it. The US equity market reached an all-time high on Thursday, taking the year-to-date gain on the S&P500 to 2.7%. If it carries on at this rate (which it won’t) we are on track for another 20%-plus gain following last year’s 29% increase. Whilst market measures of implied option volatility are off their recent lows reported at the end of last year, they remain far from elevated (chart above). The VIX measure of equity volatility currently trades at 15.6 versus a long-term average of 19.1. A similar picture is evident in the fixed income market where the MOVE index ended the week at 61.2 against a long-term average of 92.7. Despite the recent increases, the extent to which investors have expressed their concerns about the long-term economic effects of the coronavirus suggests that recent moves look fairly muted in a wider context

Markets have thus looked through the recent concerns and appear to have concluded that the only thing they have to fear is fear itself. To the extent that the initial reaction reflected fear of the unknown, selling was a natural response but now the shock has worn off. However, it feels like the recent equity surge reflects nothing more than a relief rally. And relief rallies can run out of steam. After all, we have no idea what the near-term implications will be for the Chinese economy but it is unlikely to be good for corporate earnings. Reports from China point to significantly reduced activity as people stay at home, either by choice or as a result of state directive. Burberry has already warned about the potential hit to earnings and has closed 24 of its 64 shops on the mainland whilst ripping up its earnings guidance for the current fiscal year. They are unlikely to be alone as companies with significant exposure to the Chinese economy begin to assess the damage (other luxury goods producers and airlines are sectors which spring immediately to mind). Meanwhile, supply chain disruptions might well become more pronounced and as the hit to corporate earnings materialises, so markets will be forced to revise their expectations.

That said, if the situation mirrors the SARS outbreak in 2003, markets will be expecting a big rebound in activity in the second half of the year with the result that they may simply be looking through the (hopefully) short-term disruption. But we cannot be sure what will happen. Consequently it would seem prudent for investors to take some risk off the table. The fact that they are not doing so reflects the great faith they have in central banks to keep markets afloat with exceptionally lax monetary policy. The rational economist in me does not share that optimism, but viewed from the perspective of the market, the absence of decent financial investment alternatives suggests that any market correction is likely to be brief. If you are a forward looking rational investor, this is a good reason to stay in the market because you avoid the transaction costs associated with selling and buying back in again.

Having been burned in the past with regard to calling the market top I am reluctant to do so again. But a market where valuations look stretched is always going to be vulnerable to unexpected exogenous shocks and it may be that the coronavirus effect turns out to be the catalyst for a rethink. Even if it doesn’t – and there are good reasons to believe that much of the current concern is overblown – it should act as a warning sign that good times do not last forever. So far, the fact that the US economy is holding up continues to support the bullish case and although I do not believe that the economy will crack this year, it may pay to dance near the door in order to beat the rush if the stampede begins.

If ever an indication were needed that something is afoot, take a look at the rally in Tesla stock. Investors have shorted it for the last year, believing the company would struggle to deliver on its plans. Yet since the start of the year its price has risen by around 80% and its market cap now exceeds that of Volkswagen (chart above). Such a sea change reflects more than a simple shift in attitude towards electric cars and Tesla’s ability to deliver – that is a bubble waiting to pop. My natural investor caution is based on the premise that if something cannot continue to forever, it will stop. There again, maybe this time really is different. But they said that in 2000 and 2007 as well. Caveat emptor!

More than deregulation is required

One of my more astute colleagues, who is an ardent Remainer, recently played devil’s advocate by asking whether the UK was likely to gain anything by diverging from the EU’s regulatory regime. After all, regulation represents a business friction which raises costs and lowers output. This is an interesting question which goes to the heart of the economics of leaving the EU and it is worth setting out some of the issues in detail. 

The first point is that the UK is already one of the least regulated economies in Europe, with OECD data showing that it has one of the least regulated product markets and the most deregulated labour market  in the EU. The corollary is that the bang for the buck from additional deregulation would be limited. There are some who believe that legislation such as the Working Time Directive is a hindrance but I am not sure that the majority of workers would necessarily be in agreement, since it guarantees them the right to benefits such as paid holidays. In any case, measures to increase labour input do nothing to resolve one of the economy’s bigger long-term challenges of low productivity. Working longer hours allows you to produce more but does not raise output per hour.

One of the features of the forecast in the BoE’s Monetary Policy Report, released on Thursday, was the downgrade to the medium-term rate of potential growth. When the exercise was last conducted a year ago, the Bank estimated it at 1.4% but it is now put at 1.1%. Compare this with the period 1998 to 2007 when the economy was estimated to have a potential growth rate of 2.9% (my own estimates are shown in the chart below). The underlying reason for this downgrade is the rate of productivity growth which has slowed from a rate of 2.2% in the decade prior to the crash of 2008 to just 0.5% subsequently. It is notable that for many years the BoE assumed that productivity growth would recover, if not to pre-crash levels at least to something higher than of late. This time, however, it has thrown in the towel and acknowledged that a recovery is unlikely in the near-term. This partly reflects cyclical factors, with some evidence of labour hoarding, but structural factors also play an important role. Brexit is expected to compound the difficulties, with trade frictions likely to weigh on productivity, and even though a modest recovery is expected over the next 2-3 years, the economy’s speed limit is not expected to recover very far which calls into question Sajid Javid’s ambition to restore UK growth rates to “between 2.7 and 2.8 per cent a year”.

Regulatory changes are thus going to have little impact on the UK growth rate unless there is a game-changing boost to productivity growth as a result. One possible way for this to happen might be through a surge in foreign investment which significantly boosts the capital stock. If, for example, there is a huge increase in Chinese or US manufacturing capacity in the UK, it could benefit from productive FDI in a similar fashion to Ireland which has been supported by the actions of US multinationals over the last three decades. It’s not totally impossible now that China is the UK’s “new best mate” following the decision to allow Huawei a role in building the 5G network, but I wouldn’t hold my breath. 

Nor should we expect the UK to derive the same apparent deregulation boost that it enjoyed in the 1980s during Thatcher’s term of office. For one thing, the idea that the recovery in the UK’s performance was all down to deregulation is bit of a myth. It also owed a lot to the reallocation of economic resources that came about as a result of the decision to stop providing subsidies to heavy industry. When people think of 1980s deregulation they think of the privatisation programme that reduced the size of the state. But the evidence that it actually improved the economy’s performance is limited: Some things worked, some things didn’t. Admittedly the 1980s Tory administration did break the stranglehold of trade unions which did ultimately help to improve productivity. One industry that did benefit from deregulation was financial services with the Big Bang of 1986 helping to revitalise London as a global financial centre. However, one of the downsides of the reforms of the 1980s is that it was associated with a significant widening of income inequality (chart below) with the excesses in the City of London standing as a metaphor.

Furthermore, in contrast to the situation today, growth in the 1980s was helped by the last of the baby boomers entering the labour force which was a major contributory factor in helping to boost the labour contribution to growth and enabling a potential growth rate which averaged around 2.8% throughout the decade. Then of course, the economy was sheltered by the advent of North Sea oil output which provided a windfall gain to the government. And whatever else people may think about Thatcher’s economic policy, she did recognise the importance of the EU as a market for British exports and was one of the prime movers behind the creation of the single market.

The position today is much less favourable. You simply cannot deregulate your way to prosperity, particularly in a world where the Chinese can produce everything on a bigger scale and more cheaply. There are greater headwinds from demographics as the population ages and the economic speed limit is correspondingly reduced. Consequently the lessons from the 1980s are not a blueprint for the post-Brexit economy. What will mitigate the economic damage are as close relationships as possible with the UK’s main trading partners but the recent rhetoric from the government does not sound very promising in this regard. The old saying that empty vessels make most noise is a phrase we should bear in mind when we listen to the British government issue its “demands”. Its hand became a lot weaker on Friday night and if ministers have not recognised it yet, they soon will.