Lies, damn lies and statistics - from covid to GDP data

 

In today’s blog I want to talk about the abuse of statistics in the media with a focus on UK GDP. We have got used to the media blasting us with statistics during the covid-19 pandemic, as journalists with little statistical knowledge use the data without interpreting or analysing them properly. The best example relates to the covid data, whether it is cases, hospitalisations or deaths. Much of the media has used them for their own agenda to attack the government to portray it as incompetent and the sole reason why in their eyes the UK has had a “bad pandemic”.

 

The reality which has become clearer over time is that there are a plethora of reasons for the UK’s experience including mistakes made by the UK government but also by the health authorities (NHS and PHE), by scientists and as a result of underspending on health over several decades. However there is also the health of the nation in respect of obesity and related diseases such as diabetes, cardiac disease, cancer, asthma etc with the UK considered one of the worst in Europe. Then there are non-health factors such as population density and global connectivity, where the UK and particularly London rank at the very top. And finally the data is not compatible on a country-by-country basis anyway with countries using different definitions of for example when a person dies of covid (think Spain with its very narrow definition of a covid death when compared with the UK or other European countries) or because a country is either incapable of recording all or the vast majority of deaths (think India, Mexico or Brazil or indeed most African countries) or deliberately under-records such data (think China, Russia, Iran or North Korea). The WHO estimates that up to 8 million deaths can be attributed to covid globally, which would represent a massive under-recording on the official 3.4 million death toll.

 

In the case of the UK, this under-recording is a relatively small number. In any case latest official data shows the UK does not even make the top 15 countries on deaths per capita, with many mostly East European, and some West European and Latin American countries comprising the top 15. And if we focus on excess deaths per capita which can overcome some of the data issues previously mentioned. the UK is not even in the top 25 worst performing countries for which data exists – The US, Russia, Brazil, Mexico, South Africa, Italy, Portugal and a plethora of East European and other Latin American countries are all above us!

 

However my blog today intended to concentrate on GDP and in particular in challenging the media consensus that the UK government’s “bad pandemic” was also reflected on the economy and in particular in GDP growth. One frequently still reads headlines saying that the UK economy was the worst performing country in the EU or the G7.

 

For 2020, official ONS data shows that UK GDP fell by 9.9%, which by the end of Q4 left the economy some 7.8% below its level prior to the pandemic at the end of 2019. This would represent a collapse without modern precedence – even during the Global Financial Crisis, UK GDP fell by a mere 4.3% in 2009. Moreover, Eurostat data shows us that EU GDP fell by an average 6.1% (and Eurozone GDP by 6.6%) with only Spain, down by 10.8%, worse affected than the UK. However the compilation of these statistics is not comparable as I will explain below. Once adjusted for a fairer comparison, GDP in the UK is estimated to have fallen by a more modest 7.5% leaving it in a better position than not only Spain, but a number of other EU countries including Italy, France, Greece and Croatia.

 

The need for a sizeable adjustment has arisen because of the different ways the UK and the EU treat so-called non-market output - approximately the output of the public sector. GDP, which for all its faults remains the single best summary of national economic activity, effectively measures the aggregate output of all sectors of the economy. This is easily measured in the case of the private sector where we can look at the turnover of a business. But in the public sector, particularly in health and education, it is very difficult to measure output. In the UK, the ONS overcomes this by looking at a wide range of detailed data such as the number of pupils attending school, the number of hours teaching in schools, the number of people visiting a GP, and the number of operations taking place. These measures were introduced to better measure not only output but to assess productivity in these sectors and whether the UK was getting good value for money for any increased government spending.

 

During the pandemic, schools were closed for a prolonged period and many operations were postponed. As a result we saw a big fall in the output of public services here in the UK. Indeed some 2.4 percentage points of the 9.9% fall in GDP in 2020 can be attributed to a fall in public sector output. Within public output we saw Education output fall 16.4% and Health & Social Work output by 8.2%. Nevertheless the UK data greatly exaggerated the fall in output so the ONS has been adding new indicators since to take account of pupils working from home as well as test & trace activity and covid vaccinations, although they are yet to be applied to 2020 data – only current monthly data

 

By contrast in many other countries such data is still not available or not used by national statistical agencies (despite the urging of various international institutions) so they estimate the output of such services by measuring the input ie looking at how much money was spent on them even if fewer services were provided. This is the approach taken by nearly all EU countries and meant we did not see the dip in the output of public services that genuinely did happen during 2020 throughout most of the EU.

 

Another useful measure to use that largely overcomes these intra-country comparison issues is nominal GDP growth, although they miss important volume movements seen in real GDP data. Nevertheless, we can see for the G7, the UK GDP fall is in fact less than in Germany, Italy and Canada, albeit higher than in France. In the US and Japan where the lockdowns were far less severe, overall economic activity was affected much less. So the bottom line is that UK GDP was badly affected by the pandemic particularly as our lockdown was notably long and tight, but the fall was not the worst by any means in the EU or G7.

 

In my next blog I will talk about UK GDP in 2021 and the expected sharp bounce-back in growth which is likely to be the fastest in the EU or the G7. 

Quantitative Easing and its dangers in an inflationary environment

Does a large budget deficit and the associated public debt burden really matter that much if the Bank of England finances it through asset purchases?

 

It is generally agreed during this pandemic that the government should spend vast sums of money to maintain income levels and prevent unemployment rising as much as possible so avoiding potential “scarring” of the economy ie a permanent reduction in productive economic output. There are also times dependent on the state of the economic cycle but also when investment in infrastructure and other forms of capital spending including on humans that means it may be appropriate to run a significant deficit.

 

If a budget deficit is financed through the issuance of government bonds which are purchased by investors (pension funds, insurance companies, households and overseas investors) then the degree to which one can do this successfully will depend on the existing policy credibility of the country, how much more is to be borrowed, the potential growth rate and the global background including the level of world long term interest rates. If a country has to borrow at very high interest rates (whether it is from abroad or not) then the debt burden could escalate and the interest payments will account for an ever higher portion of government spending so potentially squeezing out other spending.  Indeed a simple equation used in economics proves the debt burden will likely “snowball” ever higher if the (real) average interest rate of borrowing is greater than the (real) GDP growth rate.

 

In the UK, the government was in a very strong position to borrow coming into the pandemic aided by strong policy credibility thanks in part to its actions to tackle the deficit previously as well as by the very low global long term interest rates. Moreover, it has not had to borrow from abroad, and the borrowing has been very long-term so avoiding any rollover risk, reducing interest rate sensitivities and maximising the use of low borrowing rates now. Average debt maturities are around 13 years albeit on the decline.

 

It was conventional theory (as I learned it) that a country should borrow to fund any fiscal deficit (i.e. debt financing) if it can rather than finance it by printing money (ie monetary financing). Printing money was a sure way to generate inflation and lead to all the adverse consequences associated with inflation. The extremes of such a path which resulted in hyperinflation were of course seen in the Weimar Republic and in more modern times in Zimbabwe and Argentina.

 

However there are now new arguments which are complex and controversial, that says Bank of England purchases of assets, principally government bonds, known as Quantitative Easing (QE) may be a sort of free lunch. It is also referred to as “unconvential” monetary policy. As a result, increasingly, the UK deficit (and elsewhere) is being financed by QE. It still entails the creation of (electronic) money known as Reserve Money which is part of MO base or narrow money. However, it might not translate into M2 broad money (i.e. remaining largely within the financial sector) preventing it from largely entering the real economy and which is used to buy goods and services, and therefore affecting inflation. Such funding is approaching one-third of the gross public debt burden and being in the form of central bank reserves they only pay an interest rate of some 0.1% much lower than gilt yields.

 

The empirical evidence from the first big wave of QE after the global financial crisis (GFC) is that QE was not inflationary with M2 growth not growing excessively. However, the GFC was a deflationary phenomenon. And particularly important was that banks did not create new bank loans so preventing the operation of the classic money multiplier – they preferred to shore up their own balance sheets and regain profitability. 

 

However, there are real dangers that this will not be the case this time after the pandemic. The world is a potentially much more inflationary place after the initial deflationary impact of the pandemic itself. This reflects explicit coordination of expansionary monetary and fiscal policies (led by the US, but also the UK and the EU), the increased bias it seems of  central banks towards inflation including higher inflation targets (underpinned by a reluctance to raise bank rate given the massive amount of QE), the move back to de-globalisation (and no favourable China deflationary effect) and the disruption of international production chains. Indeed evidence is already concerning. Most notable and most importantly is the US, where M2 growth exceeds 20%yoy, input prices and commodity prices have surged, there are supply constraints and shortages (even in the labour market), and retail price inflation is also now picking up markedly. Nevertheless, some prominent economists still think inflation will not persist with classic “wage-price spirals” not taking off. I am not convinced.

 

So to sum up QE is really an experiment. Under the right circumstances it looks like it can play an important positive role, but we are now in different times than after the GFC and there is a real risk that inflation will not only rise to higher levels but stay there without tough action.

 

 

 

 

UK financial services post-Brexit

 

Prospects for the UK financial services sector remain rosy.

 

The UK financial services sector (including related professional services) accounted for over 10% of GDP and employed more than 2.3 million people at the end of 2019 (Source: CityUK). Moreover the financial services sector is the largest UK taxpayer (more than 10% of all tax revenues) and the biggest exporting industry generating a trade surplus of US$77bn in 2019 (including related professional services some US$102bn) - the largest in the world.

 

Yet in contrast to goods and manufacturing, and even the tiny fishing industry (accounting for 0.02% of GDP according to the ONS) there was barely a mention in the Trade and Co-operation Agreement (TCA) bar a Memorandum of Understanding which so far has largely been limited to derivatives so as to maintain EU market liquidity. This was no oversight. The EU has a large goods trade surplus amounting to £97bn in 2019 with the UK but a services deficit of some £18bn with us (rising to £44.3bn for financial and related services alone, according to the ONS). In fact over a third of our financial services exports currently go to the EU.

 

The EU countries have longed to see EU financial market business move within its sphere having viewed the City of London with suspicion and envy, and a belief that such activity should be in the core Eurozone. Its aim in the negotiations was if possible to avoid such agreement whether this would be in terms of mutual recognition or in some form of equivalence - other than dynamic alignment - so that it could chip away at London’s dominance of the European financial markets. (The City accounted for nearly 80% of its EU foreign exchange trading, three-quarters of derivatives trading, 85% of hedge fund activity, and 60% of capital market business). It has largely viewed this strategy as based on a zero sum game when in reality there are costs associated with such a policy of market fragmentation in terms of the loss of economies of scale, and of expertise and the knowledge that London has. The EU’s approach was greatly facilitated by a poor negotiating strategy by the Tory government under PM May and a “Remainer” Parliament (and other institutions) that resulted in the UK giving into the sequencing of negotiations preferred by the EU that resulted in the Withdrawal Agreement and the loss of our negotiating strengths including payment of the £40bn divorce bill, the effective splitting of the UK between GB and NI, and the granting of freedom of EU residents to reside in the UK.

 

Anyway the damage to the City has been nothing like most commentators had predicted, just like with Brexit more generally. Many typically forecast the loss of up to 100K or even 200K jobs. A London Stock Exchange Survey in 2016 concluded that 232K financial services could leave the UK. By contrast I suggested that it would be more like 10K and that the City would continue to prosper in various reports and speeches that I have made (eg Brexit and Financial Services 2017). The reality is that some 7.5K jobs had left according to the EY Financial Services Brexit Tracker at the end of 2020. It also states though that some £1.6trn assets had been transferred – a figure that has increased since.  Moreover the number of people working in the City has continued to rise since the referendum result. An FT Survey of 24 large international banks and asset managers in December found the majority had actually increased their London headcount over the past five years.

 

There will be further negotiations between the UK and the EU on access to financial markets in the coming months that may yield further agreements in areas such as reinsurance but they are likely to be modest. The EU will only agree to anything if it clearly benefits them. The EU’s preference is for the City of London to follow EU regulations very closely. But as Andrew Bailey the Bank of England governor recently said we should not become a rule taker, which would not only lead to us losing the opportunity for better and lower regulation but also as Michel Barnier, the EU’s Chief Brexit Negotiator said any access to EU financial services is a gift from Brussels than can be withdrawn freely – clearly one cannot operate under such a threat. We should be focusing on how we can protect our position as a global financial powerhouse. And anyway despite diverging from EU rules and the loss of passporting, international law protections will still allow financial institutions to provide certain cross border services to wholesale clients

 

The City of London is one of only two leading global financial centres (See the rankings in the Global Financial Centres Index produced by Z/Yen consultancy) and its future lies in being a global centre, being innovative and not hampered by unnecessary regulation and high taxation. We are competing against the likes of New York, Tokyo, Singapore, Shanghai and even Dubai or Bahrain. Not so much against Frankfurt, Paris, Amsterdam or Dublin, none of which can be viewed even as serious rivals as a leading European financial centre. For example in the rapidly growing fintech sector, our rivals are really only Silicon Valley, Hong Kong and Singapore.

 

The best approach is what Barney Reynolds of Shearman and Sterling LLP has dubbed the World Financial Centre Model where we go it alone and design a more attractive regulatory framework, freed of the EU’s restrictive policies and process-driven approach. In light of this, UK Chancellor Rishi Sunak is promising a “Big Bang 2.0”. While good governance remains paramount there is a desire to cut unnecessary red tape with changes to the EU rulebook such as on MIFID2, and Solvency 2 for insurance companies. Also recommended as by the Institute of International Affairs is that the UK form alliances with other major financial centres through multilateral mutual recognition. Switzerland and Singapore would be two obvious financial centres.

 

Pivotal to the success of the City going forward will be the Fintech sector. It is worth £7bn employing over 60K people in the UK and includes brands such as Monzo, Revolut and Starling Bank. An independent Review of the sector led by  Ron Kalifa was launched in the Budget of March 2020 to support the City’s competitiveness through “ensuring it has the resources to grow and succeed, conditions that are right for the widespread adoption of financial technology, and that the UK’s global reputation for innovation is maintained and advanced. Also important is Green Finance where again it is one of the world leaders alongside specialist financial centres Amsterdam and Zurich. Over the last three years the amount raised in green bonds has almost tripled from £8bn in 2017 to £22.4bn in 2020 with 139 listed on the London Stock Exchange. There are also now 22 green funds listed on the LSE. Furthermore the UK is leading the world in committing to reaching net zero carbon emissions by 2050. It has committed £12bn investment in green finance over the next 5 years among other things.

 

The City has a long history of resilience, adaptability and reinventing itself. It survived the 1930s and two world wars. It saw the rise of the Eurobond market in the 1960s as a result of US balance of payment controls. And it prospered after ‘Big Bang’ which was launched in October 1986 by the Thatcher government with its extensive market deregulation. Finally, it was unaffected by the UK’s decision to join the Euro. In any case despite the lack of agreement the City prepared well for Brexit and I have no doubt that the right steps will be taken to ensure its future prospects are rosy.