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In such volatile times, the safest assets aren’t necessarily what investors think

In such volatile times, the safest assets aren’t necessarily what investors think

Given the climate of intense uncertainty, the FTSE index remains remarkably resilient.

It currently sits almost bang in the middle of the 7,000-7,600 range, where it has been since the beginning of January 2017.

Brexit does not seem to trouble share prices. Nor do the threats by John McDonnell, Labour’s shadow chancellor, to carry out extensive raids on shares and put workers on the boards of companies.

These risks and uncertainties are “priced in” by the market. The concept of market efficiency, revered by economists, means that all available information is taken into account in the process of setting share prices. The implication is that pension funds and traders alike appear to attach only a small probability to a disruptive Brexit or to Labour forming a government.

Of course, it is precisely when an unexpected disruptive event takes place that the market ceases to be efficient. Market participants need time to absorb and process the implications of the new environment, and do so at different speeds. There is widespread disagreement about what the “rational” price of an asset is, and as a result volatility abounds.

So despite the sanguine way in which the market is currently behaving, there must be many investors in shares of various kinds who are casting anxious eyes back over their shoulders.

They can take comfort from an article published in the latest Quarterly Journal of Economics by Oscar Jorda, of the University of California, and colleagues. Its findings represent an important addition to scientific knowledge.

The authors publish estimates of the annual total returns on equities, housing, long-term government bonds and short-term fixed interest government securities (three-month Treasury bills in the UK). The impressive nature of the work is not simply that it covers 16 advanced economies. Data is provided for every year between 1870 and 2015.

Government debt in countries like the US and the UK is considered a “safe” asset. But one of the most remarkable findings of the research is that the real return (in other words gains after allowing for inflation) on such assets has been very volatile, often even more so than the supposedly “risky” assets such as equities.

This is quite contrary to the conventional view of how the world is supposed to work. If one asset gives a higher return than another, the expectation is that its price is more volatile. There is a trade-off between risk and return. But this seems not to be the case in reality.

Intriguingly, both equities and residential real estate have yielded total real gains of no less than seven per cent a year. Housing outperformed shares from 1870 until the Second World War, and the position has been reversed since then.

Governments come and go, as indeed have two major world wars. But over the course of well over a century, holding equities and not worrying about short-term fluctuations has yielded rich rewards.

Obviously, the past is not necessarily a guide to the future – but the past here spans evidence from nearly 150 years. Something to think about if you’re looking to invest at a time of such global political uncertainty.

As published in City AM Wednesday 25th September 2019
Image: Investment via Pixabay
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Why the economics profession remains blind to the benefits of Brexit

Why the economics profession remains blind to the benefits of Brexit

The office for National Statistics last week estimated that the UK economy grew at an annual rate of 2.4 per cent in the final quarter of last year. This is slightly above the long-term average growth of the past three decades.

But a Financial Times survey this month showed that the majority of economists remain just as pessimistic about Brexit’s likely effect on Britain’s economic prospects as they were a year ago.

Most have not changed their minds. But of those who have, the more pessimistic outweigh the more optimistic by three to one. Almost incredibly, economists do not generally feel they were proven wrong by events following the vote.

How can this be? Why is the economics profession so overwhelmingly opposed to Brexit?

The reasons rest on two important underpinnings of the discipline. First is a belief in the benefits to society of free trade. There is substantial empirical evidence which backs up economists’ views on this matter.

The majority opinion among economists, however, is that the UK leaving the EU will necessarily lead to our trade becoming less free. This is a judgement about political economy, on which standard economic theory is silent. Simply put, they agree with Remainers that we cannot negotiate better trade deals on our own than we can from within the European Union.

As the referendum showed, this is a contested issue. The Cambridge economist Bob Rowthorn has pointed out that “there has already been a sharp fall in the size of the Euro-area economy as a proportion of the world economy, and it is hard to see how this trend will not continue”. The deals we need are with fast-growing countries like India and China, and with enormous and innovative markets like the United States. Whether we can get a better deal in or out of the EU is a matter of judgement, not theory.

But the more important reason is that economic theory is in essence about equilibrium. It is about how best to allocate a fixed amount of resources in a static world. Economics has relatively little to say about dynamic processes, about change, about disruption, evolution, innovation, about behaviour out of equilibrium.

This emphasis on a static world leaves many economists unable to see the serious failings of the EU, both actual and potential. In the 1970s and into the 1980s, before the impact of the Thatcher reforms had been felt, it was indeed sensible to look to Europe for inspiration. The UK was plagued by high inflation and low growth.

But now we have had nearly two decades of the euro, one of the most efficient job destruction machines ever created. The combined impact of the euro and their own internal corruption has led output in Italy, Portugal, Spain and Greece to be much lower now than it was 10 years ago. This is a recession without parallel in economic history in its length and severity.

The ability to innovate is the key to long-term growth, as America has shown with Microsoft, Google, Facebook and others. Economic theory has very little to say about innovation. And this blinds the economics profession to the failings of the EU.

As published in CITY AM on Wednesday 1st February 2016

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Why do bad companies stay in business for so long? Just ask an economist

Why do bad companies stay in business for so long? Just ask an economist

A bookseller in the Yorkshire Dales has hit the headlines, branded a “shopkeeper from hell”. He called a customer a “pain in the arse”, and has been the subject of numerous complaints to the local parish council about his rudeness. To complete the outrage, he charges 50p as an entry fee to his shop.

The incident is at face value simply an amusing and trivial story. But it also raises interesting issues in economic theory.

In principle, if the bookseller kept on offending potential customers, he would be driven out of business by market forces. People would no longer use his shop and would take their custom elsewhere, thereby costing him potential sales.

In a much more important context, Milton Friedman made a very similar argument about discrimination in employment in the United States. In the process of hiring, Friedman believed that a profit maximising company would always choose the best person for the job, regardless of his or her background. To do otherwise would impose unnecessary costs on the firm, and it would be driven out of business by its non-discriminatory competitors.

Discrimination of all kinds does appear to be much lower in capitalist economies than under other forms of social and economic organisation. But it is not at all clear how much of this is directly due to market forces.

Economic theory focuses on equilibrium, the situation which notionally exists when all the various incentives, costs, profits and so on have worked their way through the system.

But economics says very little about both the process by which equilibrium is reached, and how long it takes to get there. A very distinguished British economist, Tony Atkinson, died at the start of the year. A brilliant paper he published when in his early 20s showed that, in the core model of growth in economic theory, moving from one equilibrium to another would take over 100 years.

In practice, market forces do work. But they are an imperfect filter of firms’ evolutionary fitness to survive. Numerous studies show that the most efficient firms in an industry often record productivity levels three of four times higher than the least efficient. And these differences persist. Inefficient companies can survive for a long time.

The 50p entry fee, refunded if a purchase is made, raises a further issue for economics. The shop is next to a bus stop, and the owner believed that many browsers were simply taking refuge from the wind and rain, with no intention of buying.

So the proprietor was simply creating a market, in this case proper shelter and warmth for bus travellers. But the entry fee generated general outrage. This is clearly not an area in which the use of markets is believed to be appropriate.

The same sentiment is behind the otherwise inexplicable support for a return to state ownership of railways. Anyone who can remember British Rail will shudder at the memory of just how awful it was. Yet, like health, many believe that it is not morally correct to use markets in this context.

Economics and experts are under attack. But economics can illuminate many aspects of everyday life.

As published in CITY AM on Wednesday 18th January 

Image: Closing Down by Philafrenzy is licensed under CC by 4.0 

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The death of cash, the rise of trade unions and other eclectic 2017 predictions

The death of cash, the rise of trade unions and other eclectic 2017 predictions

It’s certainly been an eventful year. But rather than dwell on the past, what sort of things can we expect in 2017? Here are a few eclectic predictions.

Sweden may become the world’s first cashless economy. Notes and coins are already fast disappearing as a means of payment, and retailers are legally entitled to refuse to accept them. Cash transactions make up less than 2 per cent of the total value of transactions in the Swedish economy. Over half of bank branches have no cash in hand and refuse to accept cash deposits. ATMs are increasingly hard to find.

The central bank, the Riksbank, is well advanced with its plans to launch its own digital currency, the e-krona. If this idea is adopted more widely by central banks, and it certainly feels like one whose time will come, where will this leave Bitcoin? Possibly as the international criminal’s e-currency of choice, possibly for use as baby sitting tokens, or equally possibly, it will become extinct.

Switching tack, there may be quite a lot of sympathy for the antics of the rail unions next year, certainly more than the Tory MPs demanding government curbs imagine. The long-suffering commuters of Southern will disagree with this point. Others, however, might look at South West trains, their near neighbour, and wonder how they manage to run a successful and profitable franchise without having driver-only operation of trains.

More widely, anti-globalisation sentiment is unequivocally on the rise. Any liberal still baffled by the US election might usefully read a paper in the July 2016 American Economic Review by Justin Pierce of the Federal Reserve and Peter Schott of Yale. They show that the sharp drop in US manufacturing employment after 2000 can be attributed to a change in US trade policy that eliminated potential tariff increases on Chinese imports. The electors in the rust belt states are the ones who suffered most.

The trade unions in recent decades have often been their own worst enemies, and have behaved stupidly. But sentiment is shifting, and the Prime Minister needs to be cautious.

Thinking of trade unions, readers of a certain age will recall the miners’ leader, Arthur Scargill, and his ludicrous attempts to conceal his essential baldness with a comb-over. President-Elect Trump, in contrast, has a truly marvellous barnet. His front-combing appears to defy the laws of gravity, just as his election appeared to defy the conventional laws of politics. Perhaps with Trump’s stylist, Scargill would have won the miners’ strike.

The crucial question is the hair style of Mark Carney. The crisp short-back-and-sides, with the immaculate side parting, is the epitome of the Daddy on the Daddies Sauce bottle of the 1950s and 1960s. Is this the real forward guidance which the governor of the Bank of England is trying to convey to us? That he expects a restoration of the economic conditions of those decades? GDP growth averaging 3 per cent a year, the government finances in balance, booming living standards, and unemployment of only 2 per cent. After Brexit, anything is possible.

Paul Ormerod

As published in CITY AM on Wednesday 21st December 

Image: bitcoin by fdecomite is licensed under CC by 2.0

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Forward guidance is just another delusion foisted on us by mainstream macro

Forward guidance is just another delusion foisted on us by mainstream macro

The governor of the Bank of EnglandMark Carney, was on good form last week when he appeared at the Treasury Committee of the House of Commons.

Asked what “forward guidance” meant, he answered smoothly: “The thing about forward guidance is that it is guidance that is forward. Which is not to say it is meant to be in any way accurate. Indeed, it would be surprising if it were. The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful.” Cue collective bafflement of the assembled MPs!

But the statement actually tells us a great deal about how mainstream macroeconomists believe the economy operates.

“Forward guidance” has been the key element in policy-making by the Bank since Carney himself introduced it in the summer of 2013. It is meant to give guidance about the economic circumstances in which the Monetary Policy Committee (MPC) will start to raise interest rates.

The first attempt was certainly not in any way accurate. The governor stated that the MPC would not consider raising interest rates until unemployment fell to 7 per cent, which he predicted would take about three years. It took less than six months. By January 2014, the rate of unemployment had fallen to 6.9 per cent.

This just seems to have been a piece of poor analysis by the Bank. But it does not detract from the more fundamental reason economists think that forward guidance will not usually turn out to be accurate.

The forward guidance is deliberately based on the assumption that behaviour will not change. Yet the mere fact that the central bank makes a pronouncement about the future might induce people to alter their behaviour. And if behaviour changes, the forward guidance might very well prove to be inaccurate.

It is actually a sensible addition to the Bank’s armoury of policy levers. Properly managed, it might enable the Bank to nudge behaviour in directions which it believes will give a better outcome than would otherwise be the case.

The final part of Carney’s statement appears the most gnomic: “The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful”.

The governor meant that forward guidance should be given on the basis of a model of the economy which is correct.

In each of the various different macroeconomic models which exist, the assumption is made that consumers and firms form expectations about the future as if their particular model, and no-one else’s, were correct. Yet despite many years of intensive research, macroeconomists still do not agree on what constitutes the model of how the economy works.

There is a challenging academic literature on the theory of how people go about learning the correct model of the economy. But in practice economists are unable to apply it to themselves. We might reasonably conclude that it is the theory which is wrong. Forward guidance is just the latest technocratic delusion foisted on us by mainstream macroeconomics.

As Published in City AM on Wednesday 23rd November

Image: Mark Carney by The Financial Stability Board is licensed under CC BY 2.0

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From the NHS to Brexit, give people a choice and they’ll make a good one

From the NHS to Brexit, give people a choice and they’ll make a good one

A current headache for the government is the performance of the NHS, and whether it is running out of money. This was making the front pages until the judges’ decision on Brexit pushed it off.

Successive governments have discovered that the finances of the health service are a potentially bottomless pit. A key policy issue has been how to make the NHS more productive, to get it to deliver a better service for a given amount of money.

A paper in the latest American Economic Review provides strong evidence that extending patient choice is an effective way of getting better outcomes. In 2006, the Blair government mandated that patients in the English NHS had to be offered a choice of five hospitals when referred by their physician to a hospital for treatment. Prior to this reform, there was no requirement that patients be offered choice.

Martin Gaynor of Carnegie Mellon University and colleagues from Stanford in the US and Imperial College in London analyse, using detailed patient-level data, the impact of introducing choice in certain areas of elective heart surgery.

Economic theory regards choice as a Good Thing, but also recognises that, in complex areas like health, things might not be completely straightforward. For example, information on quality might be imperfect. Very difficult cases might be sent disproportionately to one of the very best surgeons, who, because of this, has a relatively low success rate. Understanding technical information might itself be difficult.

Even so, the authors show that the introduction of choice had unequivocally positive results. Patients became more responsive to clinical quality in deciding where to go. In turn, hospitals responded to this demand by improving the overall quality of the service. There was a small but very definite reduction in mortality. And, in the dry language of economics, there was a “substantial increase in patient welfare”.

Gaynor and colleagues make appropriate qualifications about the accuracy of their calculations, but they work out that the monetary value of the improvements in service to each patient in their sample was $6,226. The average value of each of the small number of lives saved was $300,900.

There were fears prior to the reforms that only the better off would benefit. On the contrary, those who were either more severely ill or from low-income areas benefited the most.

The importance of this evidence goes considerably beyond its immediate sphere of a single area of elective surgery in the health system. It has become an article of faith among the liberal, educated elite that ordinary people lack the ability to process information properly when making decisions about complex issues.

Whether on Brexit, on making choices about hospitals, or choices about schools for their children, the broad masses are deemed too stupid to understand. It follows that choice is bad for them and, instead, they should simply do what their so-called betters decide for them. But even in a complex area like elective surgery, given the opportunity, people can make good decisions and improve their lives.

As published in City AM on Wednesday 9th November 

Image: Surgery by Eduardo García Cruz is licensed under CC by 2.0

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