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The only way could be down for shares – and Brexit is just the catalyst

The only way could be down for shares – and Brexit is just the catalyst

The Brexit vote creates many uncertainties, exciting or frightening depending on your predilection. One thing which is certain is that the Leave victory was delivered by the less-skilled sections of the electorate.

It seems part of a more general stirring up of what we might think of as the dispossessed, those who feel left behind by globalisation. In France the Front National, in the Netherlands Geert Wilders’s Party for Freedom, in Germany Alternative fur Deutschland – throughout Europe, in fact, these discontents receive an increasingly sympathetic hearing.

Equity markets have been very volatile and nervous in the face of the uncertainties which Brexit creates. But there may be a good reason for this from a longer-term perspective.

Compared to 30 years ago, stock prices both in Europe and the US are at much higher levels. A key reason underpinning this is the shift from wages to profits as a proportion of national income which has taken place. The share of wages in national income has fallen, and that of profits has risen. Profits have grown faster than the economy as a whole, and so the potential future dividend stream from shares has gone up. As a result, shares have become more valuable.

Measuring the share of wages in national income is not as straightforward as it might seem. Should it, for example, include self-employed income or the remuneration of chief executives? In February 2015, the OECD, along with the International Labour Organisation, published a detailed study of trends in the G20 economies since the early 1990s. No matter which measure was used, the data show that the wage share declined significantly in almost every member state of the G20, and nowhere was there a significant trend increase.

The changes themselves may appear small. On one measure, for example, the wage share fell from an average of 69 per cent of national income in 1990 to 65 per cent now. But in terms of, say, the UK economy, four percentage points represents nearly £80bn.

More recently, there has been a levelling off in the downward trend. The distribution of income between wages and profits has been stabilising. Does Brexit signify a tipping point, when the trends of the last few decades might start to be reversed?

The economic orthodoxy, not just in theory but in practice, has been one of open borders for both labour and capital. Both must be allowed to flow freely. But there is an increasing groundswell of public opinion against this. Donald Trump, for example, supports a 20 per cent tax on all imported goods to protect American jobs. Bernie Sanders has opposed every free trade deal which the United States has negotiated, and vowed to “take on corporations which take their jobs to China”.

It is much easier to protect wages in a world of tariff barriers and restrictions on capital movements. Boris Johnson sees Britain as a global entrepreneur, but most Brexit supporters do not. Brexit would not be the cause of a long-term downward revision to share prices, but more a symbol of why it’s happening.

As Published in CITY on Wednesday 29th June 2016

Image: The British Question by Andrew Gustar is licensed under CC BY 2.0

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The poor state of macro justifies scepticism with Brexit disaster forecasts

The poor state of macro justifies scepticism with Brexit disaster forecasts

David Cameron has tried to frame the Brexit debate into one based on economics.  Standing with him is the overwhelming consensus of economists themselves, from academics to the International Monetary Fund (IMF).  Their pronouncements are not having that much impact on the electorate if the polls are to be believed.

There is justification for this public scepticism. The arguments relate to what might happen to the economy at the aggregate, or macro level.  How much will GDP rise or fall, how many jobs will be lost or created, what will happen to trade, to inflation?

At the individual level, or micro level as economists call it, a great deal of progress has been made in the past twenty years or so. But at the overall, macro level, mainstream economics has if anything gone backwards. Concepts such as rational behaviour and equilibrium have been incorporated into the thinking of macro economists, at the very time that their micro colleagues are challenging them.

Olivier Blanchard, until recently chief economist at the International Monetary Fund, has real form on the perils of believing orthodox macro economics. In August 2008, for example, just three weeks before Lehman Brothers collapsed and the worst recession since the 1930s burst on the world, he published a paper claiming that the state of macroeconomics was “good”.

The relationship between inflation and unemployment is a central building block of macroeconomics.  Economists even have a special phrase for it, the so-called ‘Phillips curve’, named after the LSE based academic who discovered it in the 1950s. The curve in theory says: the lower is unemployment, the higher is inflation.  This is the subject of Blanchard’s latest offering in the American Economic Review.

The Phillips curve is not just of academic interest. The Monetary Policy Committee, for example, has an inflation target, and unless they know what the curve looks like, they are not going to be able to do a very good job.

Blanchard sets out a formidable looking mathematical model. He then employs statistical techniques in conjunction with the theory, in the same way that, for example, the UK Treasury published one with their estimates of the trade costs of Brexit, and claims that “the US Phillips curve is alive and well”.

Up to a point, Lord Copper. For one of Blanchard’s conclusions is that “The standard error of the residual in the relation is large, especially in comparison to the low level of inflation”. Translated into English, this simply means that his model does a poor job at explaining what has been going on. This is hardly surprising.  The unemployment rate peaked in the US at just under 10 per cent in 2010. Since then it has halved to stand at 5.0 per cent.  But inflation is slightly lower, at 1.2 per cent compared to the 1.6 per cent average in 2010.  The story is just the same in the UK and Germany. Since the crisis, unemployment has fallen sharply, and inflation has edged down. Macro models are by far the weakest part of economics.

Paul Ormerod

As published in CITY AM on Wednesday 8th June

Image: Exit by Shannon Clark is licensed under CC BY 2.0

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The IMF is in trouble – and not just due to its poor forecasts

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by Japanexperterna.se is licensed under CC BY 2.0

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China is drowning in private sector debt: there’s no telling how this one will end

China is drowning in private sector debt: there’s no telling how this one will end

The eyes of the financial and economics worlds are now fixed on China, with focus predominantly on Chinese stock markets and the country’s GDP figures.  A fascinating perspective was provided last week in the leafy borough of Kingston upon Thames.  The university has recruited the Australian Steve Keen as head of its economics department, and it was the occasion of his inaugural lecture. Keen was one of the few economists to highlight the importance of private sector debt before the financial crisis began in 2008.

The title itself was exciting: ‘Is capitalism doomed to have crises?’  Judging by the beards and dress style of the audience, many may have expected a Corbynesque rant.  Instead, we heard an elegant exposition based on a set of non-linear differential equations.

Private sector debt is the sum of the debts held by individuals and the debts of companies, excluding financial sector ones like banks.  He pointed out that in the decade prior to the massive crash of 1929, the size of private debt relative to the output of the economy as a whole (GDP) rose by well over 50 per cent.

The increase from the late 1990s onwards meant that debt once again reached dizzy heights.  In ten years, it rose from being around 1.2 times as big as the economy to being 1.7 times larger.  This may seem small.  But American GDP in 2007 was over $14 trillion.  If debt had risen in line with the economy, it would have been about $17 trillion.  Instead, it was $24 trillion, an extra $7 trillion of debt to worry about.

Japan experienced a huge financial crash at the end of the 1980s.  The Nikkei share index lost no less than 80 per cent of its peak value, and land values in Tokyo fell by 90 per cent.  During the 1980s, private sector debt rose from being some 1.4 times as big as the economy to 2.1 times the size.

In China, in 2005, the value of private debt was around 1.2 times GDP.  It is now around twice the size.  Drawing parallels with the previous experiences of America and Japan, a major financial crisis is not only overdue, it is actually happening.  And Keen suggests there is still some way to go.

So is it all doom and gloom?   Up to a point, Lord Copper.  High levels of private sector debt relative to the size of the economy do indeed seem to precede crises.  But there is no hard and fast rule on the subsequent fall in share prices.

Japanese shares fell 80 per cent and have not yet recovered their late 1980s levels.  In the 1930s, US equities fell 75 per cent, and took until 1952 to bounce back.  This time round, they fell by 50 per cent, but are even now above their 2007 high.  Equally, output responds to these falls in completely different ways.  In the 1930s, American GDP fell by 25 per cent, compared to just 3 per cent in the late 2000s.  Japan has struggled, but never experienced a major recession.    Still, Keen’s arguments leave much food for thought.

 

As Published in CITY AM on Wednesday 20th January 2016.

Image: Chinese Yuan Bills by Japanexperterna.se licensed under CC BY 2.0

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Supply side success is a cure for the drug of deficit finance

Supply side success is a cure for the drug of deficit finance

George Osborne’s plan to run financial surpluses and use them to pay off government debt has been met with the usual set of whinges and whines, mainly from academic economists funded by the taxpayer. Of course, their arguments are based purely on what they believe to be the intellectual merits of their case.  One of the more prominent names is David Blanchflower, once a Gordon Brown favourite on the Monetary Policy Committee, who at least is based in a private university in America. Blanchflower predicted that coalition policy after the 2010 election would lead to 4 million, and possibly even 5 million, unemployed. The actual figure now is 1.8 million. Still, economic forecasting is a notoriously difficult exercise.

It is clearly very difficult for a certain kind of economist to grasp the fact that an economy can prosper whilst at the same time the government balances the books. The two decades after the Second World War were probably the most successful in the entire history of the UK as an industrial economy, stretching back to the late 18th century. From the late 1940s to 1964, real GDP grew at an annual average rate of 3.5 per cent. Today, relatively few economists believe that we can sustain an annual growth of more than 2.5 per cent. And each additional one percentage point extra on GDP represents the best part of £2 billion worth of extra output.

Over this period, successive governments added virtually nothing to the size of government debt. In some years the government ran a surplus, and in others a deficit. But cumulatively, these more or less cancelled out. At the same time, low but persistent inflation eroded the value of the outstanding stock of debt, so that as a percentage of GDP, government debt declined sharply over these 20 years. Of course, fiscal prudence did not by itself cause the strong economic performance. Indeed, rapid growth leads to a growing flow of receipts from taxation, which makes it easier for a government to behave responsibly.

The key point is that the 1950s and early 1960s were very favourable to sustained growth driven by the supply side of the economy, by companies incentivised by the prospect of profit. The controls and restrictions imposed of necessity during the war had largely been lifted by the time the post-war socialist government under Attlee lost office in 1951.  Living standards has been ruthlessly squeezed during the war in order to divert resources into the armed forces. So there was a massive pent up demand for new consumer goods. Companies had been unable to invest during the war, so they wanted to build up their stocks of capital equipment rapidly. The net result was a prolonged boom, driven by the supply side, and enhanced by the renewed opening up of world trade.

Economic theory suggests strongly that longer term growth is driven by the supply side, by investment and innovation. If Osborne can create a climate in which these flourish, he will simply not need the drug of deficit finance.

As published in City AM on Wednesday 17th June 2015

Image: Piccadilly Circus c1960 by David Howard under license CC BY 2.0

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Day care for dogs and the output gap

Day care for dogs and the output gap

I am keen on dogs. Recently, I have seen an advert for a special canine toothbrush designed to get rid of the pet’s bad breath, surely a difficult challenge given what dogs get up to. Vans promoting home beauty visits for dogs have proliferated for some time now. A new service being promoted is day care for dogs, similar, one might think, to child care. The dog is deposited and entertained for the day while you go off to your meeting or out to lunch.

At one level, these stories are mere trivia. At another, they are a tribute to the continuing inventiveness of capitalism. The role of the entrepreneur is to imagine a product or service which no one, until then, realises they want, and to make a successful business out of selling it. But they are also relevant to the important policy concept of the output gap.  This is defined very simply as the difference between the actual and potential levels of GDP.

Describing the output gap is one thing, measuring it in practice is quite another. The Office for Budget Responsibility (OBR) is required to provide an estimate. A key reason is that the output gap plays an important role in assessing the government’s financial deficit, once cyclical factors are taken into account. In recessions, tax receipts drop, so the deficit rises. A measure is needed which allows for this, and this is the so-called cyclically-adjusted deficit, what the deficit would be if the output gap were zero. The output gap is also crucial to central banks in judging whether inflation is likely to be a problem as the economy expands. During the past year, there has been a flurry of publications from the various Federal Reserve banks in America on the output gap.

What is the potential level of output of the various dog services described above? Dogs, of course, are just one illustration of a proliferation of inventive offers which are available in the modern service economy. Personal trainers and lifestyle coaches are other obvious examples.  There is obviously a limit to the number of dogs for which any one person can provide day care.  But from the point of view of measuring the value of the output of a dog caring business, a great deal depends upon what price the market will bear.

Part of the problem is that such services are not commodities like, say, gold bars, which are the same everywhere. They all have their own features, their own specialities. This introduces an inherent indeterminacy into the price, which is essentially a bargain between the seller and each individual buyer. If I can double my price, I can double the value of my output, with nothing else changing at all. And, as the economy expands, the easier I will find it to put my price up. Potential output in the personalised service sector of the economy is a very flexible and elusive concept. The idea of the output gap belongs to an economy which made steel bars and dug coal, not one which provides day care for dogs.

As published in City Am on Wednesday 29th April

Image: Poodle Gothic by Amanda Wray under license CC BY 2.0 

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