Going, going ...

“He's a most notable coward, an infinite and endless liar, an hourly promise-breaker, the owner of no one good quality worthy your lordship's entertainment”

All's Well That Ends Well, Act III, Scene VI

Nothing became his tenure like the leaving of it

Six years ago Boris Johnson made the fateful decision to back Brexit, giving a rocket-propelled surge to his career which eventually led to Downing Street. The rocket has now run out of fuel. His career, having reached its zenith, is plunging back to earth and the blond bombshell who has run roughshod over Britain’s constitutional niceties for three years finally exhausted the patience of his Tory Party supporters. All this was predictable. As I pointed out three years ago when Johnson took up residence in Downing Street, “sometimes you need adults guarding the liquor cabinet. Johnson is akin to the alcoholic who has just been given the keys to a brewery and I fear it will not end well.”

Johnson has now resigned as party leader but plans to remain in place as Prime Minister until a new leader is elected, which could take a couple of months. Given the magnitude of the economic problems Britain – indeed, the world – faces over the coming months, this is not a satisfactory arrangement and there is a large swathe of the party which finds it unacceptable. Contingency plans are required to deal with the prospect of recession and the impact that sky-high energy prices will have on living standards, not to mention the very real prospect that European economies will face serious gas shortages over the winter. The likelihood that the Conservative Party will be absorbed by the contest to choose a fourth leader in six years suggests it will be all too easy for the government to take its eye off the ball.

At least an end to the chaotic Johnson government is in sight. Like Silvio Berlusconi, who dominated Italian political life between 1994 and 2011, Johnson sucked all the air out of the room by being the centre of attention rather than the calm centre of competent government. Indeed, his resignation speech was, in the words of journalist Paul Waugh, “a study in reluctance bordering on petulance.” Unlike Berlusconi, it is difficult to imagine Johnson returning as PM. 

But the extent to which matters will improve once he is gone is an open question. A large proportion of moderate Tory MPs who urged a softer Brexit than Johnson’s government delivered were expelled from the party in 2019 and the current intake reflects a more ideological strand of Conservatism. We should also not forget that many Tory MPs aided and abetted Johnson as he lied his way through three years of “getting Brexit done”, mismanaging a pandemic and straining the very fabric of the United Kingdom. This excellent post by Philip Stephens reminds us that the next Prime Minister has a big job on their hands to restore some of the trust in government that Johnson managed to squander. Nonetheless, a disciplined government which is focused on the job at hand will be a great improvement on the car crash approach adopted by Johnson over the last three years.

A new start

Whoever the next PM is, whether Conservative or even a Labour representative following a snap election, the process of political and economic healing begins on Day One of their term. The first task should be to start repairing relationships with the EU. This may be easier said than done, depending who succeeds Johnson. Whilst some of the likely candidates continue to espouse hardline positions on relations with the EU, the easiest fix would be to call a halt to prospective unilateral changes to the Northern Ireland Protocol. Although a Bill proposing such changes is proceeding through parliament, there is nothing to stop a new administration pulling it from the agenda. At the very least, adopting a more conciliatory approach will make it slightly easier for the UK to achieve any changes it may wish to make.

Taxation is a big issue for many Conservative MPs and many were deeply concerned that former Chancellor Rishi Sunak raised taxes to their highest level since the 1940s. They are consequently desperate to see a return to a “traditional Tory” low tax regime. A responsible Chancellor should resist calls for radical tax cuts. The release yesterday of the OBR’s Fiscal Risks Report made it clear that a “riskier world and ageing population ultimately leave the public finances on an unsustainable path.” Demographics will prove to be a major long-term fiscal headwind as the population ages, whilst a fall in the birth rate and the expectation that Brexit will reduce immigration will combine in the long-term to raise the old-age dependency ratio. In addition, the commitment to net zero will result in lower hydrocarbon taxes (notably fuel duty and vehicle excise duty). Whatever the UK’s current economic ills, and there are many, as Chris Giles put it in his latest FT piece, “cutting taxes will not magically improve the UK’s economic performance. Any politician suggesting otherwise is lying to you."

More thought needed on the future of the political process

The Johnson era – and to some extent the previous May parliament – highlighted the extent to which political arrangements depend on convention rather than codified rules. What the constitutional historian Peter Hennessy called “the good chaps” theory of government is well and truly dead. Whilst not necessarily arguing for a written constitution – just look at the problems that have resulted in the United States – there is a strong case for imposing limits on the power of central government. The passing of the Election Act, for example, has brought the independent Electoral Commission’s strategy and policy under government control which can only be seen as a power grab. Governments must remain open to independent scrutiny.

There is also increasingly a case for reforming the House of Lords. The current system has worked well for hundreds of years but it has increasingly become a place of patronage and the award of a peerage to Evgeny Lebedev is particularly controversial. During Johnson’s term of office, his government elevated 86 members to the peerage accounting for 11% of the total (767). During David Cameron’s six year term, his government created 243 life peers. The case for an elected second chamber has been strengthened by recent research suggesting that political donations are a strong guarantee of a seat in the Lords.

Then there is the vexed question of how MPs should be rewarded – a subject I touched on some time ago. There is a strong case for paying MPs more and banning all outside sources of income in order to eliminate disputes over conflicts of interest that dogged Johnson’s term. The funding of political parties is another issue that perhaps ought to be looked at (but almost certainly won’t be). Many European countries permit systems of public funding and whilst it is fraught with difficulties, if such a system could limit the volume of dark money flowing into British politics, it is an issue that should at least be looked at.

Last word

Over the years I have been consistent in my view that Johnson is unsuited to high office and have pointed out that his tenure has coincided with a deterioration in the quality of governance. Yet despite the relief that Johnson is about to depart, we should be careful what we wish for. I have repeatedly made the point that he is a symptom, rather than the cause, of an erosion of standards in public life. Many prominent Conservatives have noted that the party currently reflects a nationalist, ideological streak that is at odds with the pragmatism for which it was noted. This does not bode well for a restoration of better relationships with the EU. Nor is there any sign that it will take seriously the needs of the economy. But take it seriously they must, for as The Economist noted this week, “Britain is in a dangerous state. The country is poorer than it imagines ... With Mr Johnson’s departure, politics must once more become anchored to reality.”

Six years on

It is hard to believe that it is six long years since the British electorate narrowly voted in favour of leaving the EU. In the interim, many things have changed. The economy has most certainly taken a turn for the worse and although not all of the problems are Brexit-related, there is indisputable evidence that it has imposed significant costs. But for all the economic problems, changes to the political landscape have been even more dramatic. A referendum that was designed to lance the boil of Euroscepticism within the Tory Party and heal divisions within society has had completely the opposite effect: British society is polarised as never before and there are no signs of a healing in prospect as the UK’s reputation for good political governance sinks ever lower.

Assessing the hit to the economy

I recently dug out some analysis I conducted in 2018 based on a model simulation of Brexit costs which suggested that after eight years “real GDP will be 4.5% below the no-Brexit baseline level (falling to 4% after 15 years).” Analysis conducted two years later by the OBR came to the same conclusion. So where do we stand now? In order to provide an answer, I updated the synthetic control analysis I reported a year ago which tracks UK output in terms of  GDP outcomes in a control group of 23 similar countries to assess how the UK might otherwise have been expected to perform. Although we should not place too much emphasis on the exact magnitudes, the analysis indicates that the economy has underperformed. The results, shown in the chart below[1], suggest that as of Q1 2022 UK output was around 3.5% below the control value. Even without allowing for inflation (the figures are measured in 2019 prices) this amounts to around £1.5 billion of “lost” output per week. What was that about saving £350 million per week?

Nowhere is the hit to the economy more evident than in trade which has been impacted by the imposition of barriers to cross border flows. Brexit cheerleaders pointed to the fact that exports to the EU in April rose to a record high. They were less vocal about the fact that imports also reached a record high as the trade gap with the EU continues to widen. In any event, nominal trade flows have been boosted by the recent surge in inflation: latest data suggest that the volume of exports to the EU is still around 10% below previous highs.

However, a true picture of the UK’s economic position is only realised by looking at a comparison with other countries. Here is where it gets interesting. German data (based on my own seasonal adjustment estimates) suggest that merchandise export volumes in April were 9% below the 2019 average versus a decline of 11.7% in the UK. A similar analysis suggests that French goods exports volumes are 16% below 2019 levels. In fact, the UK’s performance relative to world trade trends (measured by the CPB’s World Trade Monitor) is not significantly worse than either France or Germany (chart above). The French and German data may be biased down by a reduction in trade with the UK. In 2014, for example, the UK was Germany’s third largest export market: by last year it had slipped to eighth. We thus need more time to assess whether the UK’s trade figures have suffered permanent Brexit damage. But it has impacted on cross-border activity, with bigger queues at border crossings and a rise in bureaucracy. And the UK has still not signed trade agreements with the US or China. There are no trade positives flowing from the decision to leave the EU.

In the domestic economy it is a different story with the latest reading, for the first quarter of 2022, showing that the volume of business investment is 9.5% below its pre-Brexit referendum levels. Whilst the extent of the decline has been exacerbated by the pandemic, even before 2020 there were signs that corporate investment activity had tailed off (chart above). This is despite the government’s introduction of a ‘super deduction’ in 2021, designed to boost capital spending until 2023. Although the latest Bank of England Decision Maker Panel, based on data through May 2022, indicates that Brexit-related uncertainty has fallen to its lowest level on record with just 1.2% of survey respondents citing it as the biggest source of business uncertainty, it should be interpreted with care. To the extent that Brexit is expected to result in a permanent 4% loss of output, the capital stock is likely to adjust accordingly. Moreover, since uncertainty reflects indecision as to whether projects should go ahead, a decision to abandon capital investment plans will be reflected in a reduction in uncertainty just as much as the decision to go ahead. Scepticism is warranted that investment will bounce back any time soon.

Can’t work, won’t work

Whatever the damage inflicted by Brexit on the economy, its impact on the political landscape has been even more profound. Much of what has happened in the last six years bears repeating as politicians continue to gaslight us as to the process which got us here. The campaign was built on lies (here or here) and it is questionable whether it ever represented the will of the people given that only 37% of eligible voters were in favour of it. The Vote Leave campaign broke funding rules which, according to one legal expert, would have invalidated a legally binding plebiscite (the referendum was merely advisory). Nor was leaving the EU Single Market ever on the ballot paper and Theresa May’s time in office was characterised by efforts to placate the Brexiteers in her party rather than find an agreement that minimised the damage to the UK.

Under Boris Johnson, things have got worse. His government prorogued parliament in 2019 in order to avoid scrutiny of his Brexit Bill and was only prevented from doing so by the courts, and in 2020 the government threatened to break international law. Johnson’s government ripped up Theresa May’s agreement with the EU and replaced it with one which placed a customs border with Ireland (north and south) in the middle of the Irish Sea, despite his promises to the contrary. He fought the 2019 election on the basis that his deal was “oven ready” – so much so, in fact, that even now the government is desperately trying to rewrite the Northern Ireland Protocol, claiming that they signed it under duress.

These are not the bitter ramblings of a disaffected Remoaner. The fallout from the referendum matters profoundly for the conduct of democratic processes. The government called a referendum which allowed voters to directly participate in a democratic decision but gave them no direct say in the terms of departure which is profoundly undemocratic. Worse still, Brexit is the Conservatives’ signature policy and it is failing to deliver on its promises. A defining feature of the current government’s approach to Brexit is persistent victimhood – only this week The Sun reported that “Britain is failing to reap the benefits of Brexit because of the defeatist mindset of ruling elites” citing a report by the Centre for Brexit Policy. Never mind that Brexit has been passed into law, that the government won an 80 seat majority at the last election on the back of its Brexit promise and that its key members were educated at some of the country’s elite institutions – it’s always somebody else’s fault.

This goes to the heart of the problem: Brexit was only ever a campaign – its existence was defined by the journey rather than arrival at the destination. Having got what it wanted, the Conservative government cannot make Brexit work because it involves trade-offs they promised we would never have to make. Partly because it is chasing shadows in trying to implement its Brexit policy, it has taken its eye off the ball on almost everything else. As Samuel Earle wrote in the New York Times, “the truth is that Conservatives gave up on governing long ago – a fact that accounts both for Britain’s current mess and Mr. Johnson’s appeal in the first place.”

There is no appetite to reopen the debates of recent years, which explains why the Labour opposition has avoided talking about the problems caused by Brexit. However it need a realistic plan if it wants to form the next government. Aside from a pledge to “make Brexit work which is, make sure we've got a better deal that works” it is far from clear what the alternatives are.

Brexit was supposed to lead the UK to a new economic nirvana. Instead, as Samuel Earle put it, “each one of [the government’s] proposed solutions, offered in the name of national renewal, has made the situation worse … An economy predicated on low productivity and low investment, buttressed by a self-defeating lack of seriousness about Britain’s condition” is now where we are. Six years ago, economists warned this would happen. What was derided as Project Fear is now reality.

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[1] It is notable that UK GDP fell by more than most countries during the initial stages of the pandemic but subsequently rebounded much more sharply. One possible explanation for this are differences across countries in the way non-market services are measured in the national accounts. Here for an explanation.

More thought, less groupthink

Assessing today’s rate hike

In light of the Fed’s 75 bps hike yesterday, the BoE had little choice but to raise rates by 25 bps today with the case for action strengthened by the fact that it now predicts inflation will reach 11% before the year is out. The markets were split 50-50 between a 25 bps and a 50 bps rise - either way they will still be at record lows in real terms - but the less aggressive option has left many dissatisfied. The hawkish camp believes that rates must rise more quickly to bear down on inflation – incremental hikes of 25 bps just do not cut the mustard. Conversely, the dovish element – admittedly a minority at present – believes that aggressive rate increases are misguided at a time when the economy is clearly slowing (the BoE predicts that Q2 GDP will contract by 0.3%).

This is a genuine conundrum and there are many question marks as to whether rate hikes are the right way to deal with inflation caused by a supply shock. Higher interest rates act on inflation by curbing demand: The magnitude of the contraction required to rebalance supply and demand in such circumstances is probably much bigger than politicians, and indeed central bankers, are prepared to accept. After all, higher rates are not going to result in more oil being pumped or an increase in Asian semiconductor supply. I was thus taken by the Tweet from the journalist Ryan Avent, who noted “I feel like there's a good chance we're reading macro papers in 20 years which are like ‘the recession of 22-3 was yet another case of Fed overreaction to energy-price shocks.’”

Moreover the linkages from the real economy to prices are highly imprecise. Given that it takes up to two years for tighter monetary policy to impact on the economy, it is likely that a host of other factors will swamp price trends in the interim. Clearly, central banks are using monetary policy to try and influence inflation expectations, particularly wages. However, this is a risky strategy. Faced with rising food and energy prices, the like of which we have not seen for 40 years, workers are not going to sit idly by whilst the prices of goods and services which they consume are going up. And when central bank actions impact on their interest costs, it is no surprise that trade unions respond with industrial action.

This is not to say that central banks should necessarily refrain from hiking rates. But it is an illustration of how the textbook models used by economists to describe the workings of the economy often fall apart when circumstances change. Just as the 1970s sounded the death knell for structural macro models which did not incorporate forward-looking expectations, it will be interesting to see whether the current vogue for forward-looking DSGE models emerges unscathed from today’s events. After all, one of the criticisms levelled at central banks is that they failed to foresee the inflationary shock.

As it happens, I have sympathy with central banks’ position. Random shocks are by their nature unexpected and although central banks did highlight that inflation would rise in the course of 2022, they could not reasonably have predicted the impact of the war in Ukraine. That said, the likes of the BoE probably should have curtailed their QE programmes once it became clear that the economy was recovering. However, even by summer 2021 they had already pumped significant amounts of liquidity into the system and the effect of calling a halt earlier than planned would have had a marginal effect on inflation at best.

The groupthink criticism

At least we cannot criticise the BoE for sitting on its hands. Rates have risen at five consecutive meetings for the first time since the MPC was established in 1997. It was not always this way: After unprecedented policy easing in the wake of the Lehman’s bankruptcy, the BoE (in common with most other central banks) kept interest rates at their 2009 emergency settings for the next nine years. This contributed to excessive asset price inflation, notably for housing, and gave rise to criticisms of groupthink as the MPC ignored all the concerns surrounding a prolonged ultra-loose monetary stance and focused purely on the near-term inflation outlook.

Former MPC member Danny Blanchflower has been one of the strongest critics of groupthink, pointing to the lack of intellectual diversity on the Committee and arguing that there are fewer independent thinkers who are drawn from an increasingly narrow talent pool. As he noted in a Tweet in May, “still nobody on the MPC lives or comes from north of the Watford gap so diversity means only London  (8) & USA (1) are represented? No Birmingham Leeds Belfast Glasgow Newcastle Cardiff Liverpool Manchester representation? No representation of business?” Blanchflower may sometimes be overly critical of the BoE but he does have a point. For example, there has never, to my knowledge, been a Scottish representative on the Committee during its 25 year existence.  Given that Scotland accounts for 8% of the UK population, one would have thought they deserve some representation. Indeed, there have been more representatives born in Argentina, Belgium, India and the United States than those born north of the border.

Assessing the evidence

To assess Blanchflower’s claim that the Committee is drawn from an overly narrow pool, it is instructive to examine the universities from which MPC members graduated. Taking their highest university degree as the relevant benchmark, 12 of the 46 past and present members obtained their highest qualification from Oxford whilst another 9 were graduates of the LSE and 7 were from Cambridge. Only thirteen universities are represented in the list, which will rise to 14 when Swati Dingra replaces Michael Saunders in August. Widening the list to include those who attended British universities as an undergraduate reveals that 16 MPC members attended Oxford (almost 35% of the total) whilst 12 have Cambridge connections (26%) and 5 have an LSE-only affiliation. The response to this is that these universities attract some of the brightest and the best. The fact that they have strict entry criteria means that those with the best academic performance are more likely to study there. But by any standards this is a small sample from which to draw and does nothing to refute Blanchflower’s suspicions of selection bias.

The old joke has it that if you ask a question of nine economists, you will get nine different opinions  and another of Blanchflower’s criticisms is that there is simply not enough dissent from the majority view on the MPC. We are on more solid ground here. I have applied two ways to measure the independence of individual voting patterns: One is the proportion of times an individual votes for an option other than the committee consensus – for example, a person who votes for a 50 bps hike rather than the majority view of 25 bps is a dissenter on this measure. Another metric is the number of times an individual votes in the opposite direction to the majority, which is a stricter measure of dissent.

Based on 25 years of MPC voting, the dissent measure, which calculates the proportion of members voting for something other than the committee average, is recorded at 14.4% over the period 1997 to 2008 versus a post-2009 figure of 6.5%. Obviously times were different in the wake of the 2008 crash when there was a universal belief that an expansive monetary policy was required. But it is notable that this dissent measure recorded a figure of 16.5% during Eddie George’s term as Governor, falling to 9.3% under Mervyn King and just 6.9% under Mark Carney. Whisper it quietly, but under Andrew Bailey’s tenure the dissent measure has crept up to 7.8%. But the numbers do back up Blanchflower’s claim that there is a lot less dissent in the voting patterns.

On the stricter measure of directional dissent, a similar pattern applies. Pre-2009, on 12.9% of occasions MPC members pushed for directional rate moves which were out of line with the committee consensus versus 5.6% post-2009. The post-2009 figure is low and would appear to confirm the fact that MPC members were reluctant to stick their head above the parapet and call for rate hikes.

Last word

For all the criticism that the BoE kept rates too low for too long in the wake of the 2008 crash – a view with which I concur – and that it has been dominated by groupthink, the events of recent months appear to have shaken the MPC out of its complacency. Although there are those who believe that it should have been more aggressive today and hiked by 50 bps, my own view is that the 25 bps increase was the right move. Doing nothing was not an option but acting too aggressively would exacerbate recession concerns, which is the last thing beleaguered households need now.