An era is ending

A year which sees Britain vote to leave the EU and the US vote Donald Trump to be their President is clearly one which could be said to be the beginning of a new era. Perhaps of equal significance is the fact that an old era is ending, which may well have played a part in enabling this new era to begin.

Jim Callaghan’s remark to the BBC in 1976 that “We used to think that you could spend our way out of a recession … I tell you in all candour that that option no longer exists” marked the end of the post-war consensus on Keynesian demand management of the economy and the primacy of fiscal policy over monetary policy in economic policy-making. Since then monetary policy has been dominant, and changes in interest rates have taken the lead in adjusting the course of the economy. Central banks have become independent given the crucial (technocratic) role they are believed to play in the modern economy.

However, recent experience shows that at very low interest rates, further monetary easing has little and arguably, counterproductive, impact on the economy and the central bankers at the Fed, Bank of England, ECB and Bank of Japan have all made it plain that they cannot deliver the faster growth that governments are depending of them. At zero or even negative interest rates and substantial Quantitative Easing, we have reached the limits of effective monetary policy. Even if the next move is “helicopter money”, this is as much a fiscal policy as a monetary policy. The era of monetary policy primacy is ending.

The era of trade policy liberalisation that started in the mid-1980s is also ending (as discussed here) – no major new multilateral  trade deals have been struck for about a decade and the recent TTP and TPP deals look like they will not survive contact with Donald Trump. In addition, NAFTA looks unlikely to survive in its current form and whatever the outcome of the Brexit negotiations, trade between the UK and the EU will be less free than it is today. 2015 marked the first year in decades that the growth in world trade was slower than the growth of world GDP – trade has acted as an accelerator for the world economy, now it is acting as a brake. The message from the successes of both Brexit and Trump is that national borders will be subject to greater controls and it will be less easy for people and goods and services to cross them. The era of greater openness is ending.

The effects of these two major eras has been most clearly seen within financial markets in the 35-year bull market in government bond markets of Western nations. The eye-wateringly high interest rates required by monetarism in the early 1980s to combat inflation have given way to the “rigged” bond markets in which central banks have become some of the largest owners of their own bond markets. It is not yet clear that this bull market is over, but a world of fiscal policy primacy over monetary policy is likely to have higher interest rates and bond yields.

This bull market has supported and inflated the markets in all other financial assets as the risk-free rate of return has declined, creating large gains both for those invested in financial assets and for those firms that aid and service them. This “financialisation” of the economy, in which the financial sector has been growing faster than the rest of the economy over this period has been a major trend.

The big winners of this trend have been the asset managers – attractive market returns have attracted strong inflows of assets and substantial economies of scale have nearly all accrued to the fund managers rather than their investors. The recent report from the FCA on the asset management industry highlighted that it was one of the industry sectors with the highest profit margins. Asset managers now top the tables of highest-paying industries, having recently overtaken investment bankers, for whom profitability has been of increasing concern since 2008. The attention of the regulators has noticeably shifted in recent years from banks to investment managers. The asset management era, which began in the early 1980s, may also be peaking.

All these trends began between 30-40 years ago, and all have showed distinct signs of ageing in recent years. The dramatic events of 2016 may represent the “coup-de-grace” for them and the conclusion must be that the future will look increasingly different from the past.

Fiscal policy will become more important than monetary policy, international trade will come under increasing pressures, bond yields will not always fall, the financial sector will fall back as a proportion of the economy and the profit margins of the asset management industry will decline.

Q to reduce bonds

In the 1970s, the British comedian, Spike Milligan devised the Q series.  This was a surreal comedy show, which when any particular sketch had come to an end without a suitable punchline, the actors would then wander around saying “What are we going to do now?”  UK economic policy seems to have reached the “What are we going to do now?” stage.

 

On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach.  This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament.  Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:

 

  • the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
  • all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy.  The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.

 

None of the Chancellor’s choices on fiscal policy are politically appealing.  Should he choose:

 

  • to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
  • to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
  • to do nothing, then he will be accused of having no ideas to boost the economy.  Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.

 

With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems.  This is somewhat at variance with his confidence in the policies when they were initially unveiled.  However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.

 

Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be.  Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.

 

The investment implications of this uncertainty and indecision have already begun to be seen.   Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds.  A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising.  The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.

Both Osborne and Cameron can count themselves a little unlucky- December 2011

As with football managers, the ability of politicians to keep their jobs can be defined by the formula – Success = Outcome minus Expectations.

A year ago, George Osborne set out his plans for getting the UK public finances onto a more secure footing. To counteract the Treasury’s longstanding record of over-optimism in forecasting trends in the UK economy, he set up the Office of Budget Responsibility, as an independent body to give greater credibility to his plans, believing that they would adopt a less rosy view of the world. Then he went further and gave himself a target of eliminating the structural budget deficit in 5 years, but his actual plans were forecast to achieve this in 4 years. His aim in all this was to maximise the expectation of the pain required in his deficit reduction plan and so minimise his chances of his plan not achieving their goals by the time of the next election. He was trying very hard to ensure that the economy and the reduction in the budget deficit actually came in better than expected in the later years of this Parliament, leaving him some scope for reining back on spending cuts or cutting taxes just before the May 2015 election.

The last year has not been kind to him. First the performance of the global economy has been much worse than was expected a year ago – this is not just the result of the mess in Europe, but also much weaker growth in the US and high food price inflation in many developing economies forcing them to slow their economies by raising interest rates – and this has contributed to a weaker than expected UK economy, making the job of reducing the deficit even m ore difficult. Secondly, the OBR made some key assumptions in its work that in hindsight were still too optimistic – they took the view that much of the reduction in tax revenues suffered in 2009 and 2010 was cyclical and thus short term rather than structural and so long term. Thus, they had tax revenues recovering quite sharply once growth got going again. This year’s deficit forecast is close to target, because there was little growth expected but the deficit forecasts for the next few years have had to be increased to account for weaker world growth and the OBR’s recognition that tax revenues from the banking system will not bounce back as fast due to the ongoing crisis and that weak productivity growth is likely to mean a slower rate of reduction in the unemployment rate.

In his first year then, Mr Osborne has not been seen as a success because he has had to reset expectations to an even lower level. From here though, it might just work out well for him. First, both he and Mervyn King have explicitly stated that all forecasts are dependent on the eurozone crisis being resolved fairly quickly, which is not unreasonable, and secondly that this time round it could well be that the OBR’s assumptions are too pessimistic in that they now assume that the loss of tax revenues were structural and long term and not at all cyclical and short term. Mr Osborne now has more pessimistic forecasts, for which he is criticised today, but which give him a greater capacity to produce a positive surprise, for which he can take credit, in a few years time.

For David Cameron, the bad luck may not be so easy to turn around. A successful resolution of the eurozone crisis requires much greater co-ordination of fiscal policy across the Eurozone. This will require tighter rules and international bodies with real power – in other words deeper political union amongst the Eurozone as Mrs Merkel has been saying for some time. The UK’s economic interests are clearly best served by a resolution of the crisis, but such a resolution is not, from a Conservative perspective, in the UK’s foreign policy interests. A deeper political union amongst the eurozone members, will lead to far larger and more powerful area, which will make policies affecting the UK but over which the UK will have little influence. It re-opens the European faultline within the Conservative Party, which Mr Cameron has worked so hard to paper over. The UK will have to make a fundamental reassessment of its policy towards Europe if the euro survives and a deeper, political union results. Such a debate has always proved to be very damaging for the Conservative Party.