There is no sector more important to the prosperity of the UK economy than the financial services sector. Together with related professional services like legal, accountancy and management consultancy, the sector accounts for 12% of UK GDP and employs 2.2 million people. It also accounts for some £67bn or 11% of total government revenues, and generates £77bn in net exports - making UK the world's largest net exporter of financial services.
The realisation that the government is pursuing a hard or as I prefer to call it clean Brexit that involves the UK leaving the single market (and customs union) has raised fears that financial services will be severely damaged especially if also there are no transitional arrangements.
But it may surprise many to know that there is no single market for services and certainly not in financial services. There is no single banking market, no single insurance market, no unified capital market, and no European stock exchange.
The issue of passporting has received a lot of publicity when discussing financial services post-Brexit. Passporting was designed to overcome the lack of a single financial services market by allowing a financial institution authorised in one EU member state to market financial products in other EU countries. It is open to non-members states too in theory at least, and after Brexit, UK and UK-based banks and finance companies would be free to set up subsidiaries (if they have not done so already) in the EU to trade throughout, though the presence would have to be meaningful, something to be debated. Another route to maintaining business in London will be so-called "equivalence" of regulation. This will be useful for the City in any transitional arrangements agreed, though I do think we should not be tied to this in the longer run, particularly as we will have no say on the regulations, and also that we will likely go down the path of greater deregulation.
Even under this passporting system, retail financial services remain virtually entirely national and heavily protected. So leaving the EU will have no impact here for the UK. With respect to the wholesale sector, banks do not need a passport to access the City's foreign exchange market or it's interbank market, while companies can buy reinsurance at Lloyd's or do business with corporate financiers in London. It has been estimated that just 20% to 25% of wholesale business is related to the EU and only part of that is facilitated by passporting.
So what about the issue of the settlement and clearing of euro-denominated instruments I here you ask? The trading of such business would stay in London, as this is where the liquidity and infrastructure is. Europe is just not a credible competitor. But the eurozone has long coveted the euro-denominated clearing business which - along with non-euro clearing - is dominated by the LCH clearing house in London. The European Central Bank previously attempted to take such activity back in a failed landmark legal case in 2015. But there are now potentially renewed attempts to do so. Yet there are real dangers to moving the business within the eurozone. Many experts have noted a forced repatriation of the clearing would increase systemic risk and substantially increase the costs of clearing. Economies of scale allow for so-called "netting", a process that reduces margins. Also such denying of London the right to clear euros would have to be applied globally, but this would likely lead to retaliation especially from the US.
Despite the jostling among European cities including Paris, Frankfurt, Berlin, Luxembourg and Dublin, there is no real rival in Europe to London as a global financial centre. It's dominance is only threatened by New York as one can see in more detail From Z/Yen's excellent Global Financial Centres Index report. London is supported by its expertise and knowledge in financial services and key support services such as Law and accountancy; by the use of the dominant English language and the attractions of living in a vibrant and exciting city; by its infrastructure; by low taxation; and the sheer size, depth and liquidity of its financial markets. The biggest challenge remains from New York which is supported by a larger domestic economy, and could get a boost from new US President Trump's plans for greater deregulation including getting rid of Dodd-Frank which was imposed seven years ago, and by lower taxes.
There is a growing realisation in some quarters of the continent that trying to hurt the only large financial centre in Europe will damage the EU perhaps as much as the UK. Germany's finance minister Schauble warned against punishing the UK generally not least because of the unrivalled London financial centre. A leaked European report warned that failing to protect the City would indeed hit Europe's economy.
The City of London is very resilient, agile and great at adapting. It survived the 1930s and two world wars. It prospered after Big Bang and was unaffected by the UK's decision to not join the Euro, becoming the undisputed financial centre of Europe despite the fears of many. I remain optimistic even if the EU does its best to undermine it, that the City will remain pre-eminent being highly innovative and doing what is necessary to retain its competitiveness perhaps through lighter regulation and lower business taxation. It can escape EU regulation on Bankers' bonus caps and the financial transactions tax and perhaps impose lower capital buffers. It will be important however to remain open and in particular retain full access to talent overseas which has been acknowledged by the government, with even the Labour opposition realising this with its purported plans to introduce regional immigration plans.
There will certainly be some shifting of business but it will be on a small scale compared with the impact of other developments and evolving new areas of business and new products eg renminbi-related products or in the already thriving fintech (financial technology and innovation) industry. London will remain one of the two global financial centres.
Thursday, 23 February 2017
Thursday, 2 February 2017
UK economic growth prospects rosy in the short-term and in the long-term
Late last year I wrote that UK GDP would grow by nearly 2% a figure that compared with a consensus of some 1.2% then and as of yesterday about 1.3%. My optimism surprised many. Today I am a little nervous as the notoriously inaccurate/pessimistic Bank of England revised up its forecast to 2% also, having forecast it at 1.4% in November and just 0.8% in August. Who knows they might even hike it back to the pre-referendum forecast for 2017 to 2.3%! And now watch the consensus forecast rise too because of the classic group mentality.
My own optimism that growth would barely slow if at all in 2017 was based on a number of factors:
Firstly, consumer spending will undoubtedly slow somewhat as a result of the squeeze in real personal disposable incomes from higher inflation via a weaker exchange rate but not as much as expected. Consumers not surprisingly remain pretty confident in this new pre-Brexit world and continue to spend as we have seen from Q4 data. Expect consumer borrowing to rise and the savings ratio to fall back even more, while unemployment will remain close to current lows, facilitating a rise in consumer spending close to 2% from 2.8% last year.
Secondly expect the weaker pound to have a significant impact in raising net exports. Competitive devaluation can still be effective in driving export volumes up and I believe we can see the same positive impact as in 1991. This is likely to be reinforced as a result of only a weak upturn in inflation here and a pick up in global growth. Indeed business surveys have reported strengthening export order books.
Thirdly the drag from a tight fiscal stance was eased a little in the Autumn Statement which loosened the fiscal rules. We are seeing a modest increase in infrastructural investment spending.
Fourthly, the monetary policy stance will remain easy with base rates unlikely to be raised from their ultra low 0.25% anytime soon. The Bank is likely to remain wary of going too soon in hiking rates fearful of the consequences, and is reinforced by its relaxed views about inflation, particularly with respect to any feed-through into wages or inflation expectations.
Finally, the economy had a strong growth momentum going into 2017 with Q4 GDP up a preliminary 0.6% y/y. Simple base effects will leave average growth higher this year than if we had seen a slowdown as others expected for H2 2016.
In a future blog I will look at our longer term growth prospects which I believe are good.
My own optimism that growth would barely slow if at all in 2017 was based on a number of factors:
Firstly, consumer spending will undoubtedly slow somewhat as a result of the squeeze in real personal disposable incomes from higher inflation via a weaker exchange rate but not as much as expected. Consumers not surprisingly remain pretty confident in this new pre-Brexit world and continue to spend as we have seen from Q4 data. Expect consumer borrowing to rise and the savings ratio to fall back even more, while unemployment will remain close to current lows, facilitating a rise in consumer spending close to 2% from 2.8% last year.
Secondly expect the weaker pound to have a significant impact in raising net exports. Competitive devaluation can still be effective in driving export volumes up and I believe we can see the same positive impact as in 1991. This is likely to be reinforced as a result of only a weak upturn in inflation here and a pick up in global growth. Indeed business surveys have reported strengthening export order books.
Thirdly the drag from a tight fiscal stance was eased a little in the Autumn Statement which loosened the fiscal rules. We are seeing a modest increase in infrastructural investment spending.
Fourthly, the monetary policy stance will remain easy with base rates unlikely to be raised from their ultra low 0.25% anytime soon. The Bank is likely to remain wary of going too soon in hiking rates fearful of the consequences, and is reinforced by its relaxed views about inflation, particularly with respect to any feed-through into wages or inflation expectations.
Finally, the economy had a strong growth momentum going into 2017 with Q4 GDP up a preliminary 0.6% y/y. Simple base effects will leave average growth higher this year than if we had seen a slowdown as others expected for H2 2016.
In a future blog I will look at our longer term growth prospects which I believe are good.
Friday, 23 December 2016
A clean Brexit is likely to be the best option
I'm increasingly convinced that the best way forward for the UK will be what is portrayed as a hard Brexit, although given its negative connotations I would prefer to call it a clean Brexit. While we can't completely rule out the prospect of staying in the customs union and some access to the single market, the intransigence of the EU authorities and undoubted complexity of the negotiations with 27 countries plus other regional authorities mean a clean and swift break will probably be the best way forward. In any case I would argue joining the European Economic Area which involves continuing to pay into the EU budget and accepting numerous rules and regulations including free movement of labour would be a betrayal of the referendum result. Furthermore if we retained membership of the customs union this would preclude the prospect of securing free trade arrangements with the US, Canada, Australia, New Zealand and many others that have emphasised their keenness to do so and quickly. And remember food prices would fall if we left the customs union.
There is also a reasonable case for some ultra-Brexit whereby we trade not just under WTO rules, but with zero tariffs on all imports into the UK, yielding massive gains to consumers, although personally I would prefer to retain bargaining power in free trade negotiations.
Even hopes for an interim transitional deal involving membership of the EEA will be difficult to secure in negotiations. The EU negotiators are very keen to penalise the UK and see this wrongly as a zero-sum game hoping to take business away from us to themselves. As a result, they want to discuss payment for leaving first, then the main deal, and then any transitional arrangements. Even a deal on existing EU workers in the UK and vice versa will have to wait they say.
And I certainly do not subscribe to all the pessimism we see in much of the media regarding the result and future prospects. So far on the narrow measure of GDP, Brexit has not been a disaster as Remainers suggested it would. I personally said there would be no recession even though the economy was slowing even before the referendum. Indeed in 2016, GDP will have grown by at least 2% (with an upwardly revised Q3 GDP from 0.5% to 0.6% quarter on quarter showing there remains strong momentum) and I believe we will see growth of not far short of 2% next year despite the impact of inflation on real disposable incomes. The idea that consumer confidence would be battered by the vote was never credible. Such an outturn would leave growth higher than all major Eurozone economies, the US and Japan.
But equally important is that the referendum settled once and for all our status with respect to the EU. It has given us back our sovereignty. Already we see this in parliament with the debates about Article 50. In addition it importantly gives us back control of borders. Of course we need to have access to top talent from overseas to sustain our financial services industry and even labour from the Balkans to maintain our fruit picking, but we need to maintain controls to avoid the destabilisation of the society and diminishing of British values. Although we also need to improve British education and labour skills. Finally we need to prevent the awful terrorist activity seen in Germany, France and Belgium and thankfully largely avoided here. This is due partly to our superior security services and somewhat better integration, but also so far to largely avoiding the ridiculous open refugee policies of Merkel.
And I'm also optimistic because we will be able to be a champion of free trade again as happened in the nineteenth century after the abolition of the Corn Laws. There is no doubt that the Anglo-Saxon world is desperate to negotiate trade deals with us. And further down the line once the EU realises its mistakes of protectionism and unneccesary rules of free movement of labour we can secure free trade deals with them too.There is no doubt that the UK is well-placed to take advantage of a post-Brexit world. For example according to the Indigo Index, which seeks to measure a country's entrepreneurial eco-system, and therefore it's potential to adapt and develop, it is ranked fifth out of 152 countries - only behind small countries in Scandinavia as well as Switzerland. This does not mean we should stop still. We need to go further in boosting infrastructure and education, but also cutting taxes and shrinking the public sector.
Anyway I wish you all a merry Christmas and another successful and happy new year!
There is also a reasonable case for some ultra-Brexit whereby we trade not just under WTO rules, but with zero tariffs on all imports into the UK, yielding massive gains to consumers, although personally I would prefer to retain bargaining power in free trade negotiations.
Even hopes for an interim transitional deal involving membership of the EEA will be difficult to secure in negotiations. The EU negotiators are very keen to penalise the UK and see this wrongly as a zero-sum game hoping to take business away from us to themselves. As a result, they want to discuss payment for leaving first, then the main deal, and then any transitional arrangements. Even a deal on existing EU workers in the UK and vice versa will have to wait they say.
And I certainly do not subscribe to all the pessimism we see in much of the media regarding the result and future prospects. So far on the narrow measure of GDP, Brexit has not been a disaster as Remainers suggested it would. I personally said there would be no recession even though the economy was slowing even before the referendum. Indeed in 2016, GDP will have grown by at least 2% (with an upwardly revised Q3 GDP from 0.5% to 0.6% quarter on quarter showing there remains strong momentum) and I believe we will see growth of not far short of 2% next year despite the impact of inflation on real disposable incomes. The idea that consumer confidence would be battered by the vote was never credible. Such an outturn would leave growth higher than all major Eurozone economies, the US and Japan.
But equally important is that the referendum settled once and for all our status with respect to the EU. It has given us back our sovereignty. Already we see this in parliament with the debates about Article 50. In addition it importantly gives us back control of borders. Of course we need to have access to top talent from overseas to sustain our financial services industry and even labour from the Balkans to maintain our fruit picking, but we need to maintain controls to avoid the destabilisation of the society and diminishing of British values. Although we also need to improve British education and labour skills. Finally we need to prevent the awful terrorist activity seen in Germany, France and Belgium and thankfully largely avoided here. This is due partly to our superior security services and somewhat better integration, but also so far to largely avoiding the ridiculous open refugee policies of Merkel.
And I'm also optimistic because we will be able to be a champion of free trade again as happened in the nineteenth century after the abolition of the Corn Laws. There is no doubt that the Anglo-Saxon world is desperate to negotiate trade deals with us. And further down the line once the EU realises its mistakes of protectionism and unneccesary rules of free movement of labour we can secure free trade deals with them too.There is no doubt that the UK is well-placed to take advantage of a post-Brexit world. For example according to the Indigo Index, which seeks to measure a country's entrepreneurial eco-system, and therefore it's potential to adapt and develop, it is ranked fifth out of 152 countries - only behind small countries in Scandinavia as well as Switzerland. This does not mean we should stop still. We need to go further in boosting infrastructure and education, but also cutting taxes and shrinking the public sector.
Anyway I wish you all a merry Christmas and another successful and happy new year!
Saturday, 22 October 2016
Time for the "Baby Boomers" to give something back
While there is little doubt that it will be Brexit - and the success thereof - that will define Mrs May's administration, a secondary theme will be that of how far she succeeds in implementing greater fairness in the country - in her own words "a country that works for everyone". While every PM in the last 25 years has made similar noises she has seemed to have a greater commitment. And there is evidence that the policies of the last Cameron government are all being reevaluated not least in terms of their fairness. But, no doubt though that any politician should be judged by actions not words!
An important aspect of the fairness agenda, but one not as often mentioned as others, is what economists call intergenerational equity - a concept of fairness between children, youth, adults and seniors. It is a term often used in investment management but has become more prominent in the world of economics in recent years because governments have run up large deficits and debts which have benefited a current generation through welfare benefits, tax cuts and government jobs, potentially at the expense of future generations.
Baby boomers refer to a cohort of the population born between 1946 and 1965 when the birth rate materially accelerated. It was thought that because this cohort was very big, a person born then would suffer in terms of greater competition for jobs and housing. But the reality has been that they have been the beneficiaries of a number of developments and events at the cost of other mainly future generations.
The welfare system may be seen as having a natural life cycle. Thus we tend to mainly benefit from it in our youth and in our old age. Conversely our contribution to government revenues tend to occur during our working life in between. Keeping this in mind, baby boomers, as the biggest group, when they started working, they tended to push the dependency ratio sharply down, ie the number of people earning rose relative to the number of dependents, whether the young or retired. During this period, roughly from Thatcher to the coalition administration, the government was able to spend more freely because of this, and also over and above this they spent during the Labour government years stacking up debt for future generations to pay for. But now that the baby boomers are increasingly retiring, the dependency ratio has in the last couple of years increased significantly. Immigration actually delayed this phenomenon, but it will continue rising for a long time yet. This means that those working now have to pay for more dependents than in the past and for excess spending in the Labour years.
This demographic trend is storing up massive problems for governments not just in this country but most of the developed world, most notably in Japan and Germany. Moreover, baby boomers have benefited from a number of other events.
In the housing market, baby boomers were relatively easily able to afford to get a deposit and buy a house. Today so many people cannot do so. In fact on average it takes them 22 years to save for a deposit! In pensions they have done well too. Pensions have been heavily protected from welfare cuts, by the infamous triple-lock, while other pensioner benefits have been protected too. Furthermore, the massive rise in the pensions deficit (notably due to low long term interest rates) has been primarily responsible for driving a wedge between productivity growth and pay growth. Companies have had to pay into their pension funds, so that people working today are not benefitting from rising productivity.
Only in one respect are pensioners losing out, that is in terms of very low savings rates, while mortgage holders, who tend to be workers from generations after the baby boomers, have done very well. Nevertheless, overall the baby boomers have done exceedingly well.
It is time that government policy looks at rectifyting this siuation. This includes reducing pensioners benefits, increasing inheritance tax, and raising housing supply at a more rapid rate.
An important aspect of the fairness agenda, but one not as often mentioned as others, is what economists call intergenerational equity - a concept of fairness between children, youth, adults and seniors. It is a term often used in investment management but has become more prominent in the world of economics in recent years because governments have run up large deficits and debts which have benefited a current generation through welfare benefits, tax cuts and government jobs, potentially at the expense of future generations.
Baby boomers refer to a cohort of the population born between 1946 and 1965 when the birth rate materially accelerated. It was thought that because this cohort was very big, a person born then would suffer in terms of greater competition for jobs and housing. But the reality has been that they have been the beneficiaries of a number of developments and events at the cost of other mainly future generations.
The welfare system may be seen as having a natural life cycle. Thus we tend to mainly benefit from it in our youth and in our old age. Conversely our contribution to government revenues tend to occur during our working life in between. Keeping this in mind, baby boomers, as the biggest group, when they started working, they tended to push the dependency ratio sharply down, ie the number of people earning rose relative to the number of dependents, whether the young or retired. During this period, roughly from Thatcher to the coalition administration, the government was able to spend more freely because of this, and also over and above this they spent during the Labour government years stacking up debt for future generations to pay for. But now that the baby boomers are increasingly retiring, the dependency ratio has in the last couple of years increased significantly. Immigration actually delayed this phenomenon, but it will continue rising for a long time yet. This means that those working now have to pay for more dependents than in the past and for excess spending in the Labour years.
This demographic trend is storing up massive problems for governments not just in this country but most of the developed world, most notably in Japan and Germany. Moreover, baby boomers have benefited from a number of other events.
In the housing market, baby boomers were relatively easily able to afford to get a deposit and buy a house. Today so many people cannot do so. In fact on average it takes them 22 years to save for a deposit! In pensions they have done well too. Pensions have been heavily protected from welfare cuts, by the infamous triple-lock, while other pensioner benefits have been protected too. Furthermore, the massive rise in the pensions deficit (notably due to low long term interest rates) has been primarily responsible for driving a wedge between productivity growth and pay growth. Companies have had to pay into their pension funds, so that people working today are not benefitting from rising productivity.
Only in one respect are pensioners losing out, that is in terms of very low savings rates, while mortgage holders, who tend to be workers from generations after the baby boomers, have done very well. Nevertheless, overall the baby boomers have done exceedingly well.
It is time that government policy looks at rectifyting this siuation. This includes reducing pensioners benefits, increasing inheritance tax, and raising housing supply at a more rapid rate.
Friday, 7 October 2016
A shift from monetary to fiscal stimulus a sensible one economically and politically
PM May's speech at the annual Tory party conference is being viewed as a massive change in policy direction. In a populist speech, in some ways, she talked about a need for greater fairness, to help those, the poorest that have been most affected by austerity. As well as talking about greater intervention to attend to market failures, she signalled changes in economic policy to, if you like, a greater emphasis on Keynesian policies.
Clearly her speech made sense from a political viewpoint. May is laying claim to the centre ground of politics which has been vacated by the Labour party. Labour continues to shift to the hard left, and under an unelectable leader does its best to make sure it is the case it will not be elected. Corbyn has refused to make any attempts to unify the parliamentary party with his latest reshuffle electing only his very closest allies, which is likely to lead to further infighting. Corbyn also refuses to acknowledge that the levels of immigration seen is a problem, a key issue for many traditional working class supporters. But at the same time, May's speech also tried to appeal to UKIP supporters by emphasising the importance of control of borders and by adopting about the only non-Brexit UKIP policy - namely allowing new grammar schools. UKIP continues to implode struggling with finding a raisin d'etre and a new leader to follow the highly successful Nigel Farage. But what I would say is that Theresa May should be judged not by what she says but what she does. Many new administrations start off with such sentiments of fairness but fail to follow through not least because of events as well as other priorities. This is not to say she is not committed to making a fairer society.
A shift from monetary stimulus to fiscal stimulus makes sense from both a fairness and macroeconomic point of view. When the coalition government came to power in 2010, it inherited a massive structural budget deficit partly due to the global financial crisis but largely reflecting years of irresponsible spending from the previous Labour administration. The government was left with little choice but to cut spending and raise taxes. This resulted in a greatly reduced budget deficit albeit that debt continues to accumulate and targets to balance the budget have been missed.
At the same time, monetary policy was eased. And in common with most other advanced countries we have experienced ultra low interest rates. Base rate was cut to a record low 0.5% over seven years ago and further to 0.25% in August. Quantitative easing (QE) has seen some £375bn of gilts purchased, with a further programme announced in August of an additional £60bn of gilts and £10bn of corporate bonds in response to the Brexit vote and largely unfounded fears that the economy would be plunged into recession.
Now there is no doubt that monetary policy has been overburdened and there have been many side effects from the semi-permanent monetary stimulus. One of these side effects has been the distributional consequences. Economic policy has favoured holders of fixed assets and mortgage holders as against savers and potentially pension holders. A Bank of England study found for example that QE did boost growth but that the benefits tended to go to the richest 5% who own 40% of assets. And of course spending cuts have impacted on the poorer too.
It is not good that savers cannot get a decent return as it disincentivises, especially people to do so for retirement, increasing the prospect that people will rely on the government and increase their own already high household debt. Similarly long-term investors like pension funds and insurance companies can no longer earn a real rate of return threatening their solvency. It is also not good if the burden of providing a pension falls on the government when we have an ageing population. Corporate pension fund deficits reached a record high at £459bn at the end of August due to plunging bond yields which have also raised fears that firms might cut their investment plans. Although as has been pointed out by our UK economists at Oxford Economics, assets held by defined benefit schemes have actually increased by £135bn in the four months to August. Bank's profitability have been badly impacted by low interest rates too, affecting their ability to lend.. And while most people would not be sad about bank'statement plight, it could also contribute for the need for expensive bailouts given the pivotal role that banks do play in the economy. As it is not good for savers, low interest rates are great for borrowers. However again we are storing up problems for the future in building up such debt. If and when interest rates rise again, we are likely to see many distressed borrowers given the highly leveraged position of the household sector. Finally, ultra low interest rates lead to the mispricing of financial markets pushing up equity and bond prices. In addition they lead to a misallocation of capital with a rash of low-return capital projects.
There is no doubt that monetary policy has been asked to do too much and that it has reached the end of its effectiveness. Thus for example, negative interest rates will not work in the UK. But with a greatly reduced budget deficit and long term rates close to zero, this is an ideal time to ease fiscal policy a little to meet the uncertainty regarding the medium term impact of Brexit. The government has built up a lot of policy credibility so can afford some slippage towards its aim of balancing the budget. It certainly makes little sense to remail committed to reach budget balance by 2020 at such a time. Increased spending on infrastructure can boost growth and boost the supply side of the economy without "crowding out" the private sector given the low cost of funding. But it will still be important to not waste money on cost ineffective and spurious projects which offer political rather than any economic returns. It will be important to identify "shovel ready" projects. We shall have to wait until the Autumn Statement on 23 November to see what exactly the Chancellor does to reset fiscal policy, but there was speculation already yesterday of the re-introduction of government backed high interest fixed-term bonds (and not just for the over 65s) which could be a good move.
Clearly her speech made sense from a political viewpoint. May is laying claim to the centre ground of politics which has been vacated by the Labour party. Labour continues to shift to the hard left, and under an unelectable leader does its best to make sure it is the case it will not be elected. Corbyn has refused to make any attempts to unify the parliamentary party with his latest reshuffle electing only his very closest allies, which is likely to lead to further infighting. Corbyn also refuses to acknowledge that the levels of immigration seen is a problem, a key issue for many traditional working class supporters. But at the same time, May's speech also tried to appeal to UKIP supporters by emphasising the importance of control of borders and by adopting about the only non-Brexit UKIP policy - namely allowing new grammar schools. UKIP continues to implode struggling with finding a raisin d'etre and a new leader to follow the highly successful Nigel Farage. But what I would say is that Theresa May should be judged not by what she says but what she does. Many new administrations start off with such sentiments of fairness but fail to follow through not least because of events as well as other priorities. This is not to say she is not committed to making a fairer society.
A shift from monetary stimulus to fiscal stimulus makes sense from both a fairness and macroeconomic point of view. When the coalition government came to power in 2010, it inherited a massive structural budget deficit partly due to the global financial crisis but largely reflecting years of irresponsible spending from the previous Labour administration. The government was left with little choice but to cut spending and raise taxes. This resulted in a greatly reduced budget deficit albeit that debt continues to accumulate and targets to balance the budget have been missed.
At the same time, monetary policy was eased. And in common with most other advanced countries we have experienced ultra low interest rates. Base rate was cut to a record low 0.5% over seven years ago and further to 0.25% in August. Quantitative easing (QE) has seen some £375bn of gilts purchased, with a further programme announced in August of an additional £60bn of gilts and £10bn of corporate bonds in response to the Brexit vote and largely unfounded fears that the economy would be plunged into recession.
Now there is no doubt that monetary policy has been overburdened and there have been many side effects from the semi-permanent monetary stimulus. One of these side effects has been the distributional consequences. Economic policy has favoured holders of fixed assets and mortgage holders as against savers and potentially pension holders. A Bank of England study found for example that QE did boost growth but that the benefits tended to go to the richest 5% who own 40% of assets. And of course spending cuts have impacted on the poorer too.
It is not good that savers cannot get a decent return as it disincentivises, especially people to do so for retirement, increasing the prospect that people will rely on the government and increase their own already high household debt. Similarly long-term investors like pension funds and insurance companies can no longer earn a real rate of return threatening their solvency. It is also not good if the burden of providing a pension falls on the government when we have an ageing population. Corporate pension fund deficits reached a record high at £459bn at the end of August due to plunging bond yields which have also raised fears that firms might cut their investment plans. Although as has been pointed out by our UK economists at Oxford Economics, assets held by defined benefit schemes have actually increased by £135bn in the four months to August. Bank's profitability have been badly impacted by low interest rates too, affecting their ability to lend.. And while most people would not be sad about bank'statement plight, it could also contribute for the need for expensive bailouts given the pivotal role that banks do play in the economy. As it is not good for savers, low interest rates are great for borrowers. However again we are storing up problems for the future in building up such debt. If and when interest rates rise again, we are likely to see many distressed borrowers given the highly leveraged position of the household sector. Finally, ultra low interest rates lead to the mispricing of financial markets pushing up equity and bond prices. In addition they lead to a misallocation of capital with a rash of low-return capital projects.
There is no doubt that monetary policy has been asked to do too much and that it has reached the end of its effectiveness. Thus for example, negative interest rates will not work in the UK. But with a greatly reduced budget deficit and long term rates close to zero, this is an ideal time to ease fiscal policy a little to meet the uncertainty regarding the medium term impact of Brexit. The government has built up a lot of policy credibility so can afford some slippage towards its aim of balancing the budget. It certainly makes little sense to remail committed to reach budget balance by 2020 at such a time. Increased spending on infrastructure can boost growth and boost the supply side of the economy without "crowding out" the private sector given the low cost of funding. But it will still be important to not waste money on cost ineffective and spurious projects which offer political rather than any economic returns. It will be important to identify "shovel ready" projects. We shall have to wait until the Autumn Statement on 23 November to see what exactly the Chancellor does to reset fiscal policy, but there was speculation already yesterday of the re-introduction of government backed high interest fixed-term bonds (and not just for the over 65s) which could be a good move.
Saturday, 1 October 2016
From the impact of Brexit to the prospect of a European Banking Crisis
Well it is becoming increasingly clear that the initial impact of Brexit or more strictly the announcement of a Brexit will not bring forth recession. This is indeed what I said in my blog of 14 July when it was very much a minority view. Forecasts have all been revised up by various institutions like the OECD and the IMF and by international banks to around the GDP growth numbers that I suggested back in the gloom of July, namely 1.75% for this year and 1% next year - and if anything I would say these are now on the Conservative side. Thus nearly all major indicators are doing well including retail sales and consumer confidence, house prices, services sector output, and business confidence. In addition financial market variables have generally done well, with even sterling recovering somewhat.
So why were the forecasts so gloomy and clearly wrong? Well I think there are four reasons. Firstly the economic data underestimated the strength of the economy going into the referendum. For example, GDP in Q2 is now thought to have risen by 0.7% on the quarter well above initial estimates. Secondly it was due to the politicisation of key institutions including the IMF (see blog 29 July) and more obviously the UK Treasury and Bank of England. Thirdly, is reflects the state of macroeconomics and the herd instinct of many economic commentators (wait for a future blog here) and finally it is fair to say that the Bank of England took prompt and appropriate action in loosening monetary policy via a number of methods.
But of course I am not naive to believe it is all going to be rosy. In the medium-term there will be adverse consequences on what will be difficult and protracted negotiations with an EU which is standing firm on its unwillingness to compromise on the trade-off between access to the single market and control of borders, despite the prospect of the EU being adversely affected too. However as we seemingly move towards a hard Brexit again as previously predicted, it is hoped that these negotiations can be completed more quickly enabling us to travel to the point where we can free trade with the rest of the world and hopefully with the EU too, via being an independent member of the World Trade Organisation. I continue to have a very positive outlook for the UK in the long term, perhaps as part of a Commonwealth free trade union with Australia, Canada and New Zealand leading the way. These are countries we have so much more in common with than the EU.
Finally I would also like to mention the banking problems in Italy and now Germany. While not wanting to minimise the impact of Brexit on the UK and on the Eurozone too, the biggest immediate fear is that of a European Banking Crisis. The problems are hardly surprising in that they largely reflect the poor health of the Euro Zone and the flaws of European monetary union without fiscal and political union. At the moment the problems at Deutsche are unlikely to be Europe's Lehmann moment and a boost its capital should help. I am more concerned about the solvency of Italian banks and the not unrelated constitutional referendum in early December which will in effect be another big test for the EU and could see the Italian government fall.
So why were the forecasts so gloomy and clearly wrong? Well I think there are four reasons. Firstly the economic data underestimated the strength of the economy going into the referendum. For example, GDP in Q2 is now thought to have risen by 0.7% on the quarter well above initial estimates. Secondly it was due to the politicisation of key institutions including the IMF (see blog 29 July) and more obviously the UK Treasury and Bank of England. Thirdly, is reflects the state of macroeconomics and the herd instinct of many economic commentators (wait for a future blog here) and finally it is fair to say that the Bank of England took prompt and appropriate action in loosening monetary policy via a number of methods.
But of course I am not naive to believe it is all going to be rosy. In the medium-term there will be adverse consequences on what will be difficult and protracted negotiations with an EU which is standing firm on its unwillingness to compromise on the trade-off between access to the single market and control of borders, despite the prospect of the EU being adversely affected too. However as we seemingly move towards a hard Brexit again as previously predicted, it is hoped that these negotiations can be completed more quickly enabling us to travel to the point where we can free trade with the rest of the world and hopefully with the EU too, via being an independent member of the World Trade Organisation. I continue to have a very positive outlook for the UK in the long term, perhaps as part of a Commonwealth free trade union with Australia, Canada and New Zealand leading the way. These are countries we have so much more in common with than the EU.
Finally I would also like to mention the banking problems in Italy and now Germany. While not wanting to minimise the impact of Brexit on the UK and on the Eurozone too, the biggest immediate fear is that of a European Banking Crisis. The problems are hardly surprising in that they largely reflect the poor health of the Euro Zone and the flaws of European monetary union without fiscal and political union. At the moment the problems at Deutsche are unlikely to be Europe's Lehmann moment and a boost its capital should help. I am more concerned about the solvency of Italian banks and the not unrelated constitutional referendum in early December which will in effect be another big test for the EU and could see the Italian government fall.
Saturday, 3 September 2016
What form of Brexit becomes a little clearer.
After correctly taking her time and postponing triggering Article 50 until the government's negotiating position is settled (still expected in early 2017 despite pressures from some to wait until September after French and German elections), PM May is beginning to make some decisions and decide what form Brexit will likely take.
Mrs May has correctly ruled out another general election. She could have capitalised on her party's huge poll lead over a warring and inward looking Labour party. But people have had enough of elections and it would only add to uncertainty in the unlikely event of a Labour election. But above all there is no rationale or precedent for a new leader to go to the country. We elect a party to government in this country not a PM. Similarly, a full vote on Brexit for parliament has been ruled out quite correctly as the people have already spoken, although it will be given "a say" on the process. Furthermore, a second referendum has also been ruled out, since if the terms of exit were defeated, this at best would increase the uncertainty, but most likely leave the country in limbo.
And above all, Mrs May has made clear that the government would pursue some form of hard Brexit. And that there would be no attempts to "stay in the EU by the backdoor". A hard Brexit will be much easier to negotiate from both a political and probably a technical perspective too. As the people voted for major control of borders and to take back their sovereignty, retaining membership of the single market will very likely be a non-starter. Thus the so-called Norway option is ruled out (although there may be a role in the interim period for this option).
Furthermore, it will be a bespoke one says Mrs May. So talk of an "off the shelf" option like the Swiss or Canada one has been rejected. Even so one might expect that the deal pursued would be close to a Canada plus deal. Under this option we would secure a free trade agreement with the EU in whatever sectors are covered by the agreement. Ideally this would cover services as well as manufacturing and agriculture. The key issue here however, is that the EU may not be willing to extend any agreement to services and above all financial services (despite the obvious benefit for consumers throughout the EU) given the UK has a large surplus and comparative advantage with the EU, so it would harm EU producers.
If the EU refused to extend to services, there is still plenty to be optimistic about in that we can revert to trading with the EU according to World Trade Organisation rules. Though we would be subject to the EU''s Common External Tariff (and to non-tariff barriers), we would cut out all the uncertainty of negotiations with the EU as well as maintain full control of borders and maintain sovereignty as promised to the electorate. But from an economic perspective we would be in a position to negotiate free trade deals with countries throughout the world much more quickly. For example, the infamous Transatlantic Trade and Investment Partnership (TTIP) free trade deal between US and EU is very unlikely to be concluded successfully ( which I hope to explain why in a future blog). The UK is much better placed to succeed in talks with the US and more speedily, contrary to the intervention of President Obama in the run up to the referendum. We could also negotiate trade deals with other countries, most notably Australia, NZ, Canada and Singapore with their shared values, but also other bigger countries like China and India again more easily.
Under hard Brexit we would be free to boost the supply side of the economy further, by lowering taxes, and reducing EU related regulations - boosting product and labour market flexibility. Our international competitiveness and growth prospects would be raised. In recent days the EU has shown it's interventionist, collectivist, centralising, protectionist and high tax tendencies through its failure of the TTIP and it's war on tax competition and Ireland. The UK is right to go it alone, particularly as it also plans to deepen European integration at the expense of non-euro zone countries. But the UK must also make sure that UK growth benefits everyone. This means getting rid of tax loopholes, perhaps as a complete overhaul and simplification of the tax system, clamping down on certain corporate behaviour, but also social justice.
Mrs May has correctly ruled out another general election. She could have capitalised on her party's huge poll lead over a warring and inward looking Labour party. But people have had enough of elections and it would only add to uncertainty in the unlikely event of a Labour election. But above all there is no rationale or precedent for a new leader to go to the country. We elect a party to government in this country not a PM. Similarly, a full vote on Brexit for parliament has been ruled out quite correctly as the people have already spoken, although it will be given "a say" on the process. Furthermore, a second referendum has also been ruled out, since if the terms of exit were defeated, this at best would increase the uncertainty, but most likely leave the country in limbo.
And above all, Mrs May has made clear that the government would pursue some form of hard Brexit. And that there would be no attempts to "stay in the EU by the backdoor". A hard Brexit will be much easier to negotiate from both a political and probably a technical perspective too. As the people voted for major control of borders and to take back their sovereignty, retaining membership of the single market will very likely be a non-starter. Thus the so-called Norway option is ruled out (although there may be a role in the interim period for this option).
Furthermore, it will be a bespoke one says Mrs May. So talk of an "off the shelf" option like the Swiss or Canada one has been rejected. Even so one might expect that the deal pursued would be close to a Canada plus deal. Under this option we would secure a free trade agreement with the EU in whatever sectors are covered by the agreement. Ideally this would cover services as well as manufacturing and agriculture. The key issue here however, is that the EU may not be willing to extend any agreement to services and above all financial services (despite the obvious benefit for consumers throughout the EU) given the UK has a large surplus and comparative advantage with the EU, so it would harm EU producers.
If the EU refused to extend to services, there is still plenty to be optimistic about in that we can revert to trading with the EU according to World Trade Organisation rules. Though we would be subject to the EU''s Common External Tariff (and to non-tariff barriers), we would cut out all the uncertainty of negotiations with the EU as well as maintain full control of borders and maintain sovereignty as promised to the electorate. But from an economic perspective we would be in a position to negotiate free trade deals with countries throughout the world much more quickly. For example, the infamous Transatlantic Trade and Investment Partnership (TTIP) free trade deal between US and EU is very unlikely to be concluded successfully ( which I hope to explain why in a future blog). The UK is much better placed to succeed in talks with the US and more speedily, contrary to the intervention of President Obama in the run up to the referendum. We could also negotiate trade deals with other countries, most notably Australia, NZ, Canada and Singapore with their shared values, but also other bigger countries like China and India again more easily.
Under hard Brexit we would be free to boost the supply side of the economy further, by lowering taxes, and reducing EU related regulations - boosting product and labour market flexibility. Our international competitiveness and growth prospects would be raised. In recent days the EU has shown it's interventionist, collectivist, centralising, protectionist and high tax tendencies through its failure of the TTIP and it's war on tax competition and Ireland. The UK is right to go it alone, particularly as it also plans to deepen European integration at the expense of non-euro zone countries. But the UK must also make sure that UK growth benefits everyone. This means getting rid of tax loopholes, perhaps as a complete overhaul and simplification of the tax system, clamping down on certain corporate behaviour, but also social justice.
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