The budget, the OBR, and futurology

The OBR has followed the Bank of England and downgraded its medium/long-term forecast of the growth in the productive potential of the economy.  It now thinks only 1.6% is likely.  This comes after 10 years of zero productivity growth has disappointed forecasts that were forever projecting the old growth rate of 2.5% to resume, something at the time that had a note of pessimism to it, since it was reasonable to speculate early on in the crisis that the productivity level extrapolated out from the old trend might one day be recovered [let alone the growth rate].

But this is not itself really news.  It’s a revelation that one group of experts – who incidentally have no special insight into future productivity – have fallen into line with another.  The depressing productivity data were there before budget day.  We now know what the OBR made of them.

Another reaction that might be tempting from the Remainer tribe is:  ‘You see!  Brexit!  I told you so.’  See, for example, these tweets:Screenshot-2017-11-23 Alastair Campbell ( campbellclaret) TwitterScreenshot-2017-11-23 Polly Toynbee ( pollytoynbee) Twitter

But the forecast gloom was not really about Brexit.  The OBR’s economic and fiscal outlook explains its Brexit assumptions on page 96:

Screenshot-2017-11-23 Nov2017EFOwebversion-2 pdf

This is – unless I am mistaken – a smooth transition to a Brexit that affects nothing.  This is not on either account a Brexit that is likely to happen.  We know from previous work [for example by the CEP / OECD / IMF /BoE] that anything but continued membership of the single market and customs union, transited to smoothly, will have significant negative consequences for GDP/head over the next 10 years.  So if we layered on top of this forecast a probability-weighted sum of possible Brexits, the outlook would be substantially worse.  Perhaps by something of the order of 0.5pp on growth each year, until the transition to our new, dislocated trading state is complete, and longer if the worse surmises about whether openness affects growth are proved correct.

Brexit gloom is not entirely absent.  The Brexit story is in the depreciation of Sterling following the referendum;  the subsequent predictable rise in inflation to 3%, the protracted adjustment downwards of real wages this means;  and the slowing of growth relative to our trading partners.  And this impulse will have made itself felt somewhat in the early part of the forecast.

Another thing to take away from the day is that the institution of the OBR is doing its job.  At least, it is producing a forecast that seems plausible and unaffected by the tendency for Brexiters to taint comments about the future with unwarranted optimism.  And there have been no personal attacks – unlike in the immediate aftermath of some of the Bank of England’s interventions.  Recall, for example, these tweets:

Screen Shot 2017-11-23 at 12.50.02

Prior to the OBR, there was ample scope for fiddling the uncertain science of estimating potential output, and forecasting its expansion into the future, to make fiscal policy look more prudent than it really was.  This time around, it is easy to imagine a world without the OBR in which Brexit Jacobins putting pressure on Philip Hammond to forecast that the future will be rosey, rather than simply make relatively anodyne comments about Brexit presenting ‘opportunities’.  One wonders what fiscal policy would have been like in that world;  contrasting it with the one we inhabit would provide a measure of the added value of the OBR.

For this to work the independence of the OBR has to be credible.

But not just that.  We have to be convinced that they are not overstepping their remit.

One finance chat I am part of on WhatsApp [every self respecting economist has to WhatsApp-drop these days] included a caricature that its the OBR that actually sets fiscal policy.  One can see the spirit in which this was meant.  Imagine the government had figured out, finally, a scheme for setting fiscal policy [as it is often urged to do in these pages and those of other commentators].  In that case the OBR would come along with new forecasts, and the Treasury would simply crank the handle and set fiscal instruments appropriately.

Lurking there is the danger that the OBR might, or might be thought to taint the forecasts itself to bring about a particular mechanical following through of their consequences in fiscal policy.  To prevent that, we can observe that in practice there are watchdogs of the fiscal watchdog:  the Institute for Fiscal Studies, the Bank of England, and other external forecasters.

Another reaction to the forecast gloom was from Iain Martin.  ‘Futurology is futile’ he tweeted above his Times piece.  Unfortunately, futurology is essential.  Why?  Because there are long lags between deciding to do something with fiscal policy [or monetary policy for exampe] and those decisions having their full effect on the things that we care about [like growth, debt, inflation, cost of finance].

In the case of fiscal policy it can take quite some time between making a decision to spend more and having any effect on anything whatsoever [viz the myth of ‘shovel ready projects’].  So, in order to make sure that your fiscal instrument settings are doing the right things to what you care about you have to line up candidate alternative fiscal plans against what you forecast will happen to what you care about.

The OBR forecasts will no doubt prove to be wrong ex post.  All forecasts are.  But that won’t invalidate them as forecasts now.  [Tired example:  when I roll a six sided dice 10 times and get a total score of 60, my forecast of a 35 is not proved wrong].  If you are a technological pessimist, you might plausibly be tempted to extrapolate flat productivity from the last 10 years very far out into the future, and get forecasts that are much more gloomy than the OBR’s.  If you are an optimist and think that the data is missing digital miracles, or that a stimulative fiscal policy could unleash a return to the old trend line, or at least its old slope, you would have a much more optimistic perspective.  The OBRs forecasts are a finger in the air, but a reasonable one at that, and necessary.



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Brexit/Ireland conundrum

In a short table.  Caveat:  Declan Gaffney tells me Ireland are not ok with turning a blind eye to smuggling people and things, as indicated below.

Screen Shot 2017-11-17 at 13.58.15

The argument for the Y is that it allows Ireland a de facto frictionless border, even if not one in law.   Declan’s point is that the smuggling funds end up in the hands of former terrorists.  At least that is what I read into his tweet.

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Another lump of the lump of labour fallacy

Owen Jones writes in the Guardian that we should consider mandating a compulsory maximum 4 day week.  One of the hopes is that this would ‘slash unemployment and underemployment’.

This is a common example of what economists call the ‘lump of labour fallacy’.  The idea that there is a fixed amount of work to be done in our economy, and if we could take some from those who have a lot of it – perhaps more than they really want, which would be a bonus – we could dole it out to those who have too little.

The same fallacy rears its head in debates about Brexit and ending the free movement of labour within the single market.  In this example, the hypothetical Brexiteer without enough work decides that the reason is that immigrants have come into this country and gobbled it up, leaving insufficient to go around.  But this is not correct.  Immigrants coming into this country and working [they were more likely to work than domestic residents] were also spending, raising the demand for other labour.

What about the case of rationing work to four days a week?  Where does the lump of labour fallacy come in here?

Restricting how / how much you can use labour makes it less attractive.  Why?  Perhaps many reasons.  One:  in order to cope with fluctuations in work, you have to have a larger reserve of labour, which is expensive.  Another:  there are fixed costs of managing employees, which need a longer working time to pay off.  This is likely to reduce the demand for labour and lead to firms substituting for capital, or shrinking, or both.  So the work taken from former 5-day-a-week workers will not be replaced in full by others who previously had too little work.  That is, there may be less employment in hours in aggregate.

The fallacy operates less eggregiously here.  There surely would be some sharing out of work.  Just not all of it.  Perhaps that explains why Owen has campaigned for free movement, but is enthusiastic about chopping up the lump of work done by part-timers.

To the extent that unemployment is frictional – due to sand in the wheels of the job matching process, or monopoly power by workers – redistributing work won’t affect unemployment.  The same sand is going to operate matching the larger number of heads seeking the same number of hours.  Cutting the working week will probably reduce employment;  and it certainly won’t ‘slash unemployment’.

There may also be detrimental effects not only on labour demand but on labour supply:  there are fixed costs of going to work.  Being unable to work 5 days may make many jobs unviable.

Owen explores other motives for the policy;  reducing stress at work;  rebalancing the gender division of home labour and childcare.  Even increasing productivity.  But the evidence for this seems mighty flimsy to me.  And for such an extraordinary act of social engineering.

Relevant experience comes from across the channel, where France legislated to reduce the working week to 35 hours, first for large firms only in 1998, and then for small firms too.  This study by Estavao and Sa reaches rather negative conclusions.  There is no evidence that subjective happiness with working hours increased in France relative to other countries without this law;  many circumvented the legislation by moving to smaller firms, not initially covered, or having second jobs;  suggesting that they were not previously being compelled [except by financial necessity] to work long hours.  And, incidentally, there was no detectable increase in employment in the firms studied.  [Though this last result leaves it open as to whether employment rose or fell elsewhere].

If legislation of this kind were contemplated, what next:  limits on consumption?  Rules banning second jobs?  Regulations restricting how much we drink, or how late in life we play football?  Rules to free us from the shackles of fashion norms allowing us to relax and wear Marks and Spencer slacks?


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BoE day. Justifying a hike is an uphill struggle

The Bank of England’s Monetary Policy Committee raised interest rates for the first time today since 2007.

So here is a quick post-mortem on the November 2017 Inflation Report.

I would have voted against a rate rise today, for a few reasons.

First, it’s possible to read into the Inflation Report [and some commentators have, and anticipated this argument] that a reason to begin hiking is a change of view about the pace of growth of future output over the future.  If this is the case, then this is not itself a motivation for tighter policy, unless for some reason the path of demand for a given policy is to be judged to have stayed where it was.   But in the kind of models the BoE uses for forecasting, this would not generally be correct for a slow accumulation of potential output shortfalls.  Demand would be expected to be correspondingly muted.

Second, the effect of Brexit on inflation via Sterling’s depreciation – expected as it is to be temporary, even if persistent – can be entirely discounted and the remit gives the MPC leeway to do that.  [This was the justification – only in reverse – for tolerating the very large undershoot of the target that preceded it].

Third, if we strip out the temporary effects of the Sterling depreciation, we go back to the old position that the MPC are hoping to return inflation from below, to target ‘in a sustainable manner’.  This was code language for discounting concerns that at the zero bound, when uncertainty is heightened, MPC should set policy so that the most likely outcome is to overshoot the target, and not to hit it.  These arguments are old, but they were made lucidly by FOMC member Charles Evans.

Fourth, the pivotal judgement seems to be that slack is being used up, judging from extremely low levels of unemployment.  [As MPC note in the Report, it fell to a 42 year low].  Yet this evidence is not as decisive as it first seems.  Whole economy nominal earnings growth is flat at about 2%, and much lower at that than would be consistent with trend [1.5 plus 2 for inflation=3.5].  Private sector earnings growth has increased, but over a very short period, and from a very low base.  The policy decision rests almost entirely on future growth materialising as a result of forces that take hold now and in the future.  As the ever doveish Danny Blanchflower puts it crisply:Screenshot-2017-11-2 Twitter Notifications

A few other points arising today and recapping after dripping them out onto Twitter hour by hour.

First, today reinforced my feeling that the MPC would be better to move to publishing unconditional inflation report forecasts that are based on what MPC feel is their preferred interest rate path.  Today’s Press Conference seemed to have won over Chris Giles at the FT to this view.

Screenshot-2017-11-2 Twitter Notifications(1)This debate deserves its own post – and I was planning to write-up a slide show I did last month doing just this.

But, in brief…..   the imprecision about what happens next – the intended pace and eventual resting point for rates – seems to confer very little or no benefit.  And do no more than make it harder to figure out what they intend to do, and to judge subsequently whether MPC are being consistent in following through what they had previously intended or not.  We must presume that the MPC have thought about when the next rate rise will come, and where rates will settle.  And on what these views depend.  Why not tell us?

One of the benefits was always said to be that MPC avoid presenting something that is misinterpreted as an unconditional promise [in this case to raise rates], which causes reputational damage and volatility when the non-promise is ‘broken’.  But Carney and the MPC’s yield curve talking already incurs this cost.  What else is stopping them?

Second, a nit-pick, but one that might be material.  MPC condition their forecast on an average of eventual outcomes for our relationship with the EU, but on the particular assumption that we get to that outcome smoothly.  Smooth transition is one possibility, but there is another class of possibilities – one of the variety of ‘no deal’s.  So the forecast deliberately fails to weigh something that is distinctly possible [and in fact positively embraced by some prominent Brexiteers].

Missing this out of the distribution would be justifiable if either i) the range of implications for policy miraculously balanced out as neutral, or ii) it was ok to wait and see whether there was a deal or not before responding.  i) seems highly unlikely, and anyway inconsistent with the rest of the IR forecast.  ‘No deal’ is just a sharp and temporary version of the eventual outcomes, which are colouring the outlook for policy, as MPC are at pains to describe.  ii) is a stretch:  much better, at the zero bound, in the face of this uncertainty, to build in a response now.

But is this omission even internally consistent?  Presumably the chance of ‘no deal’ is weighing on actual data as firms and households ponder the future.  But MPC somehow have them slowly waking up to their assumed truth that transit will be smooth?

This odd treatment is an application of an old convention that manifests itself in other ways:  the assumption that there would simply be no disorderly workout of the Eurozone crisis;  the assumption that government will follow through with certainty on fiscal plans as they stand.

Forecasting under different assumptions is uncomfortable in each case, as it carries with it the risk that the MPC is impugning the competence or motives of other official actors.  But not forecasting how everyone else sees it leaves the forecast necessarily disconnected from the policy decision [and indeed the market rate path used to communicate their intentions].  Not good!

A third point I wanted to make is about what the MPC did not do to tighten.  They did not sell assets under the QE program.   This is what they had said they would do all along.  But I think it’s mistaken.  QE-later was initially – and later, I think – justified as a way to avoid uncertainty caused by QE [an instrument whose effects we/they know less about than interest rates] being the marginal tool of monetary policy adjustment – eg in the event that economic conditions worsened again and there had to be a reversal, a subsequent repurchase of assets.

But this gets the uncertainty argument wrong.  At least if my word-maths is correct.  If the dominant stimulatory effect of QE is via its level – and such as the evidence is that it what we should believe – uncertainty is best minimised by getting back to the neutral level of QE [granted we are hazy about that] as quickly as possible.

Additionally, if you believe that QE has costs that are greater than costs of keeping rates away from base, then QE-second also neglects this argument.

The Econ press is naturally making a big deal of today’s decision, since rate rises are so novel, and some of the writers were probably at school when the last one was recorded.  Opinion is inevitably divided [just as it is on the MPC itself].  I think the rate rise was premature, but it is hardly a mistake of historic proportions.

Monetary policy is still imparting almost maximum stimulus;  it was always going to be withdrawn at some point, and gradually, and the question was just exactly when.  If events confound the hoped for entrenchment of higher earnings growth, rates can be cut by the same amount that they were hiked today, and the reversal won’t have made much difference to the overall trajectory of the economy.

This icing-sugar time-series of Bank Rate compiled by the FT’s Gavin Jackson rather makes the point [that range of plausible alternative paths for Bank Rate is very small compared to its historical variation].Screenshot-2017-11-2 Media Tweets by Sarah O'Connor ( sarahoconnor_) Twitter


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Stopping Brexit won’t take the economy back onto its pre-referendum path

Nick Clegg’s latest article on how to stop Brexit, and the OECD report on Britain arguing that reversing Brexit would boost UK growth, prompted this post.

The OECD writes:

“In case Brexit gets reversed by political decision (change of majority, new referendum, etc.), the positive impact on growth would be significant.”
Nick Clegg writes:
“…it is parliament that can save us from the fate of Brexit and, at last, I now believe it will.”

On economic grounds this would be a good idea, as almost all economists would testify.  I would therefore gladly try whatever it is that Nick Clegg is smoking to experience the state of mind in which one believes/forecasts that Parliament will intervene.  One can conceive of scenarios in which Brexit were stopped – at least for the moment – although they seem very far indeed from the most likely outcomes.

But doing so would not take the economy back to its pre-EU-referendum path.

That referendum has widened a previously narrow fault line in UK politics, fractured both main parties, and caused an evacuation of the political centre-ground.  [Ground which has become an object of satire via the ‘centrist Dad’ meme].

Even if Brexit were stopped, the next ten or twenty years would be a tense fight between the two main parties, and the factions within them, over our future relationship with Europe.

As a consequence, uncertainty over that relationship, and thus the terms on which those who invest in capacity in the UK can trade with Europe, would be here to stay.  A further consequence is uncertainty over the shape of other aspects of public policy, resulting from the Brexit fracture.

For example, the consensus about the border line between the private sector and the state have been broken.  The prospect of that line being drawn and redrawn over the next generation may also weigh on the attractiveness of the UK as as place for doing business.  (Up to a point, the moving about of the line probably matters more than where a stable border line is drawn).

Brexit, halted or not, has also changed the set of paths on which the relationships between Northern Ireland, Scotland and England are likely to travel along, very likely not to the economic benefit of any of them.

This uncertainty is aggravated by the fact that the centre party – the Liberal Democrats – has been greatly weakened, and by the fact that centrists in both major parties seem to have weakened relative to those further left and right.  A loss of power by one party triggers a take-over by a new party much further from the incumbent than would have been the case before Brexit changed everything.

Unless ‘stopping Brexit’ coincides with Brexiteers figuring out that Remaining is in the UK’s economic self-interest, or abandoning the political ambitions for separation that they were prepared to pay the economic price for, it would not turn the clock back for the UK.

Neither Clegg nor the OECD say that stopping Brexit would work such a miracle, but it’s easy to extrapolate from their words to this effect.



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‘No deal’ spending isn’t a complete waste of money, Mr Hammond

Chris Giles, FlipchartRick and others have explained why Philip Hammond is reluctant to spend money on trying to mitigate the economic costs of failing to agree any kind of deal by the time the A50 notice period expires in March 2019.

In a nutshell, the argument is that the systems and infrastructure needed won’t be even nearly complete by that date, and half-finished preparations will not make a dent in the costs of not having a deal.

No piece of Brexitology is complete without an analogy:  if you haven’t got enough time to complete cooking your omelette, there is no point in breaking the eggs in the first place.

Chris further pointed out that architecture set up on our side of our borders can’t work unilaterally, and requires requited spending and commitment by those on the other side – our trading partners.

Pretty much everyone but the most extreme Brexiteers have accepted that there needs to be a transition period governing our relations with the EU as a prelude to settling our final status.  It seems that currently the government are minded to try to negotiate a 2 year transition.  It’s moot whether this will be granted by the EU27, because it’s moot whether the UK would accept that transition has to replicate the obligations as well as the full benefits of membership.

But even supposing a 2 year transition could be agreed, it is quite optimistic to think that in that time a final status agreement could be reached.  Even if there was agreement about the broad outlines of that deal, thrashing out its details, and the ramifications of exit for relations with 3rd parties, could easily take longer than 2 years.  Moreover, it seems highly likely that UK politics will dwell further in its current state:  one in which the different factions of Leave and Remainers resigned to Brexit cannot agree what final status we should try to seek.

So while we are now focused on the possibility that we may have ‘no deal’ by March 2019, it’s entirely possible we might get a transition deal, but face a serious prospect of ‘no final status deal’ in March 2021.

2021 may well be far enough ahead for some of that ‘no deal’ preparation to complete and be put to use.   And it’s not inconceivable that our EU partners might find it expedient to try to make it work, and to commit their own money to doing that.


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VOXEU piece on Bank of Japan equity purchases

Here’s a piece Toby Nangle and I did on the BoJ purchases of equties via ETFs.

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