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No more whingeing, please. The recovery is solid.

No more whingeing, please.  The recovery is solid.

Last month saw some very positive economic news. The US Federal Reserve raised interest rates for the first time in over seven years.  The Bank of England reported on the major stress test of UK banks which it launched in March 2015.  It concluded that “the banking system is capitalised to support the real economy in a severe global stress scenario”.

Yet much of the discussion on the economy remains tinged with various hues of gloom.  We expect John McDonnell, the Shadow Chancellor, to be living in the past.  So it is not surprising that he has launched a “fight against austerity” with Yanis Varoufakis, the former Greek finance minister.  But many commentators seem to find it hard to believe that the recession in the UK is well and truly over.

Some argue that the recovery has taken place, but that it is somehow “unbalanced”.   True, manufacturing is struggling, with highly publicised plant closures in what have become effectively commodity industries, like steel.  But the data from the Office for National Statistics suggests a virtually textbook example of a sustainable recovery.

The depth of the crisis was reached in the spring and summer of 2009, and we now have the initial estimates for the economy for the same period in 2015.  GDP as a whole increased by £100 billion, after allowing for inflation, a rise of nearly 13 per cent.  Companies spent an additional £32 billion on new investment in 2015 compare to the same period six years ago.  In percentage terms, this was by far the fastest growing sector of the economy, up by 26 per cent.   In contrast, consumer spending grew by only 10 per cent, less than the economy as a whole.  It has been an investment-led recovery, with the role of public spending being negligible.

From a historical perspective, the recovery profile is better than it was in the 1930s, the previous time there was a major financial crisis on a world scale.  The economic historian Angus Maddison devoted his life to constructing the annual national accounts of the developed economies going back to the late 19th century, and his work has widespread academic credibility.  Peak output prior to the Great Depression was in 1929.  In his sample of countries, only just over a half had regained this level by 1937.   This time round, taking the same group of economies, 80 per cent of them had a higher GDP than in 2007.

The only area which really continues to struggle is the Mediterranean economies in the EU.  In Spain, output is 4 per cent lower than in 2007, in Portugal it is 6 per cent down, in Italy 9 per cent and Greece has seen a drop of no less than 26 per cent.  The crisis exposed deep structural problems with these economies.

In contrast, GDP in the G20 economies has risen by 24 per cent since 2007, the last year before the recession began.  And they account around 85 per cent of world output.  The economic discourse has become disconnected from reality.

As published in CITY AM on Wednesday 6th January

Image:Yanis Varoufakis by Marc Lozano licensed under CC BY 2.0

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Technological breakthroughs will make fossil fuels unburnable – not bureaucrats

Technological breakthroughs will make fossil fuels unburnable – not bureaucrats

The Governor of the Bank of England, Mark Carney, courted the wrath of the fossil fuel industry in a speech at the end of last month.  He argued that investors in the sector face ‘potentially huge losses’.  Actions by governments to try to head off climate change could make most reserves of coal, oil and gas ‘literally unburnable’.

Tougher rules and regulations on the use of carbon based energy, along with higher taxes, could leave the assets of fossil fuel companies ‘stranded’.   ‘Stranded’ is the new buzz word in climate change circles.  Assets may be left stranded in the ground because it is no longer practical to extract them at any meaningful rate.

A fascinating and closely argued paper by Ted Nordhaus and Michael Shellenberger of the California-based Breakthrough Institute puts a different perspective on how energy assets become stranded.  They give plenty of historical examples.  In the middle of the 19th century, Americans used 13 million gallons of whale oil each year, mainly to light their lamps.  Within two years of the first oil strike in 1858, the petroleum industry achieved that level.  Whalers quit their jobs to work in the oil fields.  The asset of whale oil was left ‘stranded’ in the whales in the ocean.  From the first stirrings of industry in England several hundred years ago to well into the 19th century, wood was the primary source of energy for our factories and blast furnaces.  Coal stranded the wood fuel industry.  In 1900, just 2 to 3 percent of England was covered by forests. Today, 10 to 12 percent is.

Nordhaus and Shellenberger argue that large scale asset stranding in the global energy context will remain, as it has always been, primarily driven by technological change. Whether from wood to coal in the nineteenth century or, as is currently underway in the United States, from coal to gas in the twenty-first, the primary driver of wholesale transitions to new sources of energy has been the fact that the new source of energy was cleaner, cheaper and more useful.

This is the classic concept of a disruptive technology put forward by the great Harvard economist Joseph Schumpeter.  Such technologies are so superior they simply sweep aside competition.  Within a few years of the coming of the railways, the prestige London to Edinburgh stagecoach service disappeared.  Humanity’s quest for more heat, light, and power has been the main driver of invention and innovation.  Only this month, Bill Gates announced a project to work with the Chinese government to develop a next-generation nuclear reactor that not only cannot melt down but also recycles waste as fuel.

The demand for energy, especially in the developing world and countries like India and China with their massive, aspirant populations, will continue to grow.   Carbon pricing, emissions caps, the whole paraphernalia of regulation which Western countries might bring in, will not alter this demand.  Fossil fuels may indeed become stranded.  This will happen not because of bureaucrats, but because of innovation and breakthroughs in nuclear and alternative energy technologies.

Paul Ormerod

As published in City AM on Wednesday 21st October 2015

Image: Nuclear power plant “Isar” at night by Bjoern Schwarz 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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Forward guidance needed for companies, not consumers

Most of the commentary on the UK’s economic recovery focuses on consumers. Are they taking on too much debt again to finance their spending? Is there a bubble in house prices, as people get excited about bricks and mortar again? Certainly, in terms of its sheer size, spending by consumers is by far the biggest component of GDP, making up around 60 per cent of total domestic expenditure.

But it is much less variable than spending on new equipment, buildings and inventories by companies, which in total is less than a quarter the amount of consumer spending. It is companies who are the main drivers of the business cycle, the expansions and recession which we observe in the Western economies.

So, for example, GDP in the 17 country Euro zone reached a peak in the first quarter of 2008. It stopped falling in the third quarter of 2009, and has grown slightly since then to the most recent date for which complete data is available, the third quarter of 2013. In real terms, it is still some 3 per cent below its 2008 peak. But in each of the three quarters just mentioned, the peak, the trough and the latest period in the recovery, the level of consumer spending in the Euro zone was virtually the same. In contrast, corporate investment fell by 19 per cent during the recession. A key reason why the Euro zone as a whole has not recovered is that it has continued to fall, though at a much slower rate, to the present date.

The UK and the US tell the same story. The pre-crisis peak level of GDP in the UK was in the first quarter of 2008, and it fell until the fourth quarter of 2009. In terms of the amounts of money involved, corporate investment fell by more than twice as much as spending by individuals. In America, almost the whole of the fall in spending during the recession is accounted for by companies carrying out less investment, and it is companies which have driven the recovery.

When Keynes was contemplating the massive collapses of output which took place in the 1930s, he constructed his famous theories on the assumption that the booms and busts of the economic cycle were primarily driven by spending on investment by companies. Of course, in the Great Recession, when the unemployment rate in America reached 25 per cent, consumer spending did eventually fall sharply, but the main driver again was investment.

Keynes recognised that economic fundamentals such as profits and interest rates influence firms’ investment decisions. But he overlaid this with psychology. The same set of fundamentals are capable of more than one interpretation, more than one narrative can be constructed about them. It is this psychological factor which is the key. The Bank of England at the moment tries to give forward guidance on interest rates to reassure consumers. A much more effective target is companies. If an optimistic narrative in boardrooms is encouraged, we will see a sustainable economic boom.

As published in City AM Wednesday 26th February 2014

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Britain’s New Industrial Policy: Can We Learn from the Mistakes of the Past?

The phrase ‘industrial policy’ seems to take us decades back in time. In 1964, a powerful catchphrase of the new Labour Prime Minister, Harold Wilson, was the need for Britain to embrace the ‘white heat of the technological revolution’. Sadly, by the 1970s this vision had deteriorated into a list of institutions, stuffed with dull businessmen and trade unionists, meeting to decide how to prop up yet another failed sector of the UK economy.

But the concept is now back in vogue. Perhaps surprisingly, given the historical experience, the coalition chose to preserve Labour’s Technology Strategy Board (TSB) quango. The TSB has a budget of £400 million to “accelerate UK economic growth by stimulating and supporting business-led innovation”. A key way in which it plans to do this is through the purchasing decisions of the public sector.

In October, Sir Andrew Whitty, CEO of GlaxoSmithKlein, produced a report commissioned by the Department for Business, Innovation and Skills on how universities can better support economic growth and drive exports. Whitty calls for the creation of “Arrow Projects”, supporting cutting edge technologies and inventions where the UK leads the world, with, in an excruciating pun, “universities at the tip”. Universities and Science minister David Willets eulogised the report. In language redolent of Soviet Five Year Plans, he stated that “we are making strides to help commercialise the work of universities under the Eight Great Technologies”.

It is easy to mock both the symbolism and the content of speeches and reports such as this. But the intention deserves to be taken very seriously. Thinking back again to the decades of the 60s and 70s, far-left radicals used to denounce the ‘military-industrial complex’ of the United States. Yet it has been precisely the interplay between the defence and security sectors and high-tech commercial companies that has led to America continuing to lead the world in technological innovations.

A fascinating new book by Bill Janeway, Doing Capitalism in the Innovation Economy, gives many such examples. The creation of the internet is well known, others include automatic speech recognition and digital computing. Janeway has made a personal fortune, not by financial speculation or by trading complex derivatives, but by developing and leading the Warburg Pincus Investment team which provided financial backing to a whole series of companies which built the internet economy.

A fundamental point which he makes is that both scientific research and invention, and its subsequent exploitation through practical innovations, necessarily involves a great deal of waste. This is something which British bureaucrats have, in the past, been unable to grasp. Ideas which are genuinely path-breaking cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot be imagined before it happens. This means that many such ventures will fail. They cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot provide the box-ticking security of projects which add tiny amounts of knowledge, or which make trivial improvements to an existing technology. So, Arrow and the TSB are to be welcomed, provided that they, and the Public Accounts Committee, recognise that most things fail.

As published in City Am on Wednesday 4th December 2013

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Everything is crystal clear with hindsight

Are government bonds risky? This question arose a year ago, during a meeting with my bank. I wanted a low risk portfolio, but they noted that I did not want to hold UK government bonds. Whether it was the regulator who was insisting, or whether it was the way the bank was interpreting some Delphic pronouncement of the regulator, was not quite clear. But I could not be in both categories. Bonds were deemed low risk. So if I wanted to continue not to have bonds, my risk profile would have to change.

I did not doubt for a moment the financial probity of the British government. They were not about to default on the debt. But, at the time, long dated bonds yielded just under 2 per cent. At some point, the yield would rise, and I would be left with a capital loss. In the event, yields have recently risen, almost reaching 3 per cent on the 10 years. So a low risk portfolio would have landed me with a nice capital loss of some one third of the initial value of the portfolio. The outcome would have been very similar with US government bonds.

Looking around the world, a year ago there were many opportunities to incur large capital losses by buying government bonds. In Switzerland, the yield on 10 year bonds was just 0.60 per cent and is now, 1.10 per cent, implying a capital loss at present of almost 50 per cent. Even in Germany and its economic extensions of Austria and the Netherlands, rates have risen to give a loss of some 20 per cent on average.

Paradoxically, several economies where there has been genuine doubt about the financial stability of the government have generated very favourable outcomes for bondholders. In Portugal, yields have fallen from 8.6 per cent to 7.2 per cent, a nice capital gain of 20 per cent. In Spain, the increase in value has been one third. The stellar performer is Greece, where anyone willing to buy Greek bonds a year ago would have doubled his or her money.

Of course, all this is with the benefit of hindsight, when everything is clear. But why not? A paper recently published in Nature, one of the top two scientific journals in the world, claimed that a return of 320 per cent could have been made by trading the Dow Jones 2007-2012 using a strategy based on the number of times the word ‘debt’ appeared in the financial press. But both the rule and the trading strategy were all worked out after the event. It is perhaps not surprising that a return of 318 per cent could have been made if the words ‘colour’ or ‘restaurant’ had been used instead of debt.

Many regulators seem to inhabit this world of certainty, where everything can be known and someone is at fault if losses are made.  The real world is just not like this.  A year ago, I was lucky. Maybe I won’t be next time!

As published in City Am on Wednesday 25th September 2013

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