I am covering a few topics today, given that I used yesterday's post space to…
Earlier this month (March 5, 2019), the Governor of the Bank of England fronted the House of Lords Select Committee on Economic Affairs for his annual grilling. The details of his evidence, covered in the transcript produced – Uncorrected oral evidence: Annual session with the Governor of the Bank of England – should have generated headlines in all the major British press outlets but the UK Guardian, noticeably, avoided reporting the details. The Guardian has jumped on every negative projection since before the 2016 Referendum and published volumes of Op Ed pieces from various correspondents amplifying the negativity. But it largely failed to report the Mark Carney’s backtracking. Turns out that the Bank of England thinks Brexit will be considerably less damaging than its headlined Project Fear estimates published last November, And that is without factoring in any fiscal response from government. It seems that the Bank now believes that a no-deal (disorderly) Brexit won’t be all that damaging at all and an orderly Brexit would be associated with an over-full employment boom over the next three years. Quite a different story to that offered in November 2018. The latest revelations will give Remainers some headaches – their collapse scenarios are evaporating.
I have long held the view that the real problem confronting the British economy has been the neoliberal policy positions taken by the current government which has reduced the incentive of British firms to invest in new productive infrastructure and equipment.
While the Remainers have been hysterical in their focus on the damage that the Brexit decision has ’caused’ (their assertion), and, seize on all the ridiculously overblown estimates coming from the likes of HM Treasury, the Bank of England and other private groups, such as the NIESR, to prosecute their case, the real game has been the decline in business investment and the reliance on increasing household debt as the austerity straitjacket has been tightened.
Note, that, unlike many of the Remainers who just want to overturn the Leave decision in any way they can, I distinguish between the decision to leave (the Referendum result) and the incompetent process that the Tories have pursued in implementing that decision.
I continue to fully support the Leave decision but find the process so ridiculously mismanaged that it is little wonder that the long-standing pessimism of investors (firms), driven by the painful austerity, has been exacerbated.
In other words, I do not believe the decision to leave, itself, would not have undermined confidence in any significant way had the British government displayed even the most basic of negotiating skills against the EU, which was intent on making it as hard as possible to leave.
Before I consider the Governor’s remarks, I recap what the real problem in Britain is – and it is not Brexit!
The British Investment ratio
The next graph shows the UK investment ratio (total capital formation as a percent of GDP) from the March-quarter 1997 to the December-quarter 2018.
The dotted red line is the average ratio over that period.
The drop associated with the GFC is quite stunning. It went from 18 per cent of GDP in the December-quarter 2007 to 14.8 per cent by the December-quarter 2009.
This huge cyclical swing tells us how deep the GFC recession was in the UK. Real GDP growth was negative for 5 successive quarters starting in the June-quarter 2008.
The British economy shrunk by 6.3 percentage points between the March-quarter 2008 to the September-quarter 2009.
But the current sluggishness does not bode well for future growth, given that potential GDP growth will be slowing as a result of the weak investment performance.
Investment expenditure contributes to aggregate demand (spending) now and builds productive capacity (supply) for the future.
The investment ratio, however, is around the same level as it was when the Brexit referendum was held in June 2016. It has fallen from 16.9 per cent to 16.7 per cent since the Referendum and is now at the average level for the period shown in the graph.
So while the GFC and subsequent austerity certainly has damaged the investment ratio, it is hard to implicate the Brexit decision and subsequent process in the performance of the investment ratio to date.
The British Productivity Slump
How has the investment slump impacted on productivity growth?
While not part of the current National Accounts release from the ONS, their January 9, 2019 update of the productivity data is related to the investment slowdown. Note that this data only goes to the third-quarter 2018. The next update will be on April 5, 2019.
I analysed the productivity slump in Britain in this blog post – British productivity slump – all down to George Osborne’s austerity obsession (October 18, 2017).
I have updated that analysis today using the latest ONS data available – HERE.
The following graph shows UK Whole economy output per hour worked from the first-quarter 1990 to the September-quarter 2018. The same sort of pattern emerges if we use the output per person employed measure.
The cyclical swings throughout this extended period are evident and the size of the GFC downturn is obvious.
The point is that British labour productivity growth slumped during the GFC, and, then stalled as a result of the austerity that was imposed in the aftermath of the recession.
A shallower slump followed and pre-dates, by some years, the Brexit referendum.
Further, in recent quarters, British productivity has actually been rising steadily and has consistently done so since the June 2016 Referendum, albeit at a modest rate, although it fell slightly (0.4 points) in the September-quarter 2019.
In other words, the poor British productivity performance has little to do with the Brexit referendum outcome or what has followed.
Structural explanations of this slump are also unlikely to have traction. The massive cyclical contraction pushed British productivity growth of its past trend. Structural factors work more slowly and we would not witness such a fall if they were implicated.
Why would that cause productivity growth to slump then fail to recover?
A major driver of productivity is investment – both public and private.
While business investment is cost sensitive (so may respond to interest rate changes), mainstream economists usually ignore the fact that expectations of earnings are also important as are asymmetries across the cycle.
Cyclical asymmetries mean (in this context) that investment spending drops quickly when economic activity declines and typically takes a longer period to recover. So fast drop and slow recovery.
The cyclical asymmetries in investment spending arise because investment in new capital stock usually requires firms to make large irreversible capital outlays.
I also discussed that phenomenon in detail in the blog post – British productivity slump – all down to George Osborne’s austerity obsession (October 18, 2017) – which gives additional references to earlier academic work I have published on this topic.
The point is that when the economy experiences a sharp contraction, there is a necessity for strong fiscal support to rebuild confidence among firms that it will be worthwhile investing in new capacity.
Exactly the opposite happened in the UK with George Osborne pursuing his ideological obsession for fiscal surpluses (and failing).
Imposing pro-cyclical fiscal austerity of the scale that George Osborne initiated when the Tories came took government in May 2010 is the last thing a government should do when non-government spending is in retreat.
Fiscal austerity in these circumstances exacerbates the typical asymmetry associated with investment expenditure and is a major reason why business investment in the UK has been so weak.
We often focus on the short-term negative impacts of fiscal austerity, but in this case, it also has serious long-term impacts on both the rate of business investment and the potential growth rate (which falls as capital formation stalls).
The longer it takes for business investment to recover, the worse will be the long-term impact on potential GDP growth. In turn, this means that the inflation biases are increased because full capacity is reached sooner in a recovery – often before all the idle labour is absorbed.
So, while George Osborne is long gone, the negative impacts of his policy folly will reverberate for a long time to come. His failings will continue on for many years and the flat productivity growth is one manifestation of that failing.
What the Governor said
During his oral evidence to the Lords Select Committee on Economic Affairs, the Bank of England governor was interrograted about the Bank’s view of the Brexit situation.
In the – Transcript – we read that:
1. “the bulk of the speech was about the global outlook” – in other words, the Governor thought the fact that “the global economy has been slowing over the last half of the year” was a more significant focus for attention than being sidetracked by domestic issues (Brexit).
2. He noted that “Less than a third of the globe is growing above trend, investment growth is quite modest and indeed is stagnant in some economies, and trade growth has slowed quite markedly as well.” – which mostly explains, together with the on-going fiscal austerity in Britain, why British growth has been stalling.
3. He mentioned Brexit in the context of “the short-term global outlook”.
4. He noted that “Any trade globalisation creates tensions in terms of inequalities; there are winners and losers and there is a requirement for redistribution or, at a minimum, reinvestment” and that fiscal austerity, of the scale introduced in Britain, exacerbates these losses for some workers and their communities.
5. He agreed that his preference was that the UK becomes “a rule-setter” rather than “being a rule-taker within an international context”.
The discussion then focused on the Bank’s own Brexit assessments.
It was noted that “in November the Bank published its assessment of different withdrawal scenarios for Brexit” which I considered, in part, in this blog post – Britain’s austerity costs are larger than any predicted Brexit losses (March 4, 2019).
On November 28, 2018, the so-called independent Bank of England published its own horror story to go with the HM Treasury’s report released in the same month – EU withdrawal scenarios and monetary and financial stability.
The Report presented various “scenarios” relating to Brexit – a “disruptive” scenario and a “disorderly” scenario (distinguished by the extent to which trade agreements were sustained) – with the real GDP loss of 5 per cent and inflation rising to over 4 per cent in the first case; and real GDP contracting by 8 per cent and inflation rising to 7.5 per cent in the second case.
The period over which these losses would be sustained over a period of “up to five years”.
In formulating these ‘scenarios’, the Bank assumed that:
1. “no discretionary changes in spending or tax policy are assumed” – in other words, the Government passively watches the economy plunge into recession.
2. The central bank hikes interest rates “mechanically” and in some scenarios the interest rate rises to 5.5 per cent.
It was, of course, a ridiculous exercise but fuelled the Remain hysteria.
If one thought about it for a second: the scenarios posited that external trade would collapse, credit availability would tighten, macroeconomic uncertainty would increase and choke off household consumption spending and business investment, and, as a result GDP growth would nose-dive and inflation would rise.
And while that was happening, they were assuming that the Treasury would sit idle while the Bank of England would hike interest rates to 5.5 per cent.
It was not believable.
In reply to the question about the November ‘scenarios’, the Governor noted:
1. “these are scenarios, not forecasts”.
2. “we did the scenarios, apart from the fact that we were asked to divulge them. The reason we do the scenarios is to test the system … so we can be assured that financial institutions will be in a position to withstand a shock like that, however unlikely.”
I found that interesting – the Treasury required the Bank to “divulge” the scenarios and knew them to be highly political. This demonstrates the obvious point I make often that the central banks are not independent institutions.
Claiming independence is just an act of depoliticisation. The Treasury knew that their own estimates would be given a credibility boost if the Bank was forced to disclose similar estimates.
It was a jointly coordinated stunt to put further pressure on the Brexit process.
3. The Governor then disclosed that:
Since we released those scenarios in November, there have been some constructive developments in preparedness … procedures-have been put in place, plus an initial approach in the UK, which would reduce security and other checks at the border, in effect creating the prospect of roll-off behaviour at the border for a period of time …
There has been progress on the financial side: material progress in the derivative markets. Alongside the ECB and ultimately the Commission, with the Treasury’s help, there has been important progress on cleared derivatives, which has reduced some of the financial risk …
And the implication of these developments?
… would pull back somewhere between 2% and 3.5% of those losses depending on the scenario … My point is that there has been progress in preparedness, which reduces … the level of economic shock. Again, it is a matter of judgment. There is false precision in all these numbers.
In other words, even on the Bank’s own terms a disorderly, no-deal Brexit would be only result in 50 per cent of the GDP losses predicted in November 2018.
A Lord Kerr noted that “the labels ‘disruptive’ and ‘disorderly'” should be dropped because they “may be a bit emotive” and then asked Carney “which of the scenarios now seems more plausible”.
The Governor replied:
… it depends on the extent to which we are in control of events … whether … clear steps are taken to mitigate and manage it.
So if the assumptions noted above relating to government inaction did not hold, and the Government, instead, used its fiscal capacity to support aggregate spending, it is entirely possible (and likely) that real GDP growth would remain positive even with a no deal Brexit.
The Bank can no longer rule that out.
He was also asked about the inflation estimates in the November Brexit scenarios.
Lord Sharkey noted that “in the Bank’s February inflation report suggested an interest rate rise of 0.25% over the next three years compared to the 0.75% rise that was expected in November 2018”.
The Governor responded by saying that the global slowdown has altered the expected trajectory of inflation for Britain and created “a degree of slack … in this economy” which “would be consistent with a reduced degree of interest-rate tightening”.
But then he said that:
In our forecast, inflation is above target throughout the horizon and remains above target at year 3. By the end of the forecast, which of course is presumed on some form of Brexit deal and a smooth transition to that, the economy is growing at 2%, above our estimate of trend; the economy is in excess demand, so it is more than in full employment and factories are running hot, if I can put it that way, and inflation is above target. In other words, the path of interest rates is not firm enough or quite high enough to be consistent with us fulfilling our mandate, which sends a broad signal about the stance of policy.
So while he admitted that it would be “foolish” for the bank “to raise interest rates … when the economy was weak and inflation was under control” the likely outcome is that once Britain transitions to “some form of Brexit deal” the economy will be growing strongly and all the rest of it.
So the Remain argument that Brexit per se is a disaster for the British economy is not shared by the Bank of England. In fact, Carney claims the economy will be “running hot” under an orderly exit.
The UK Guardian did not give this evidence much scope at all whereas The Times and Bloomberg featured the hearing.
That should pose questions for bias in the editorial policy of the UK Guardian. They are quick to headline doomsday scenarios such as when the Bank first published its November ‘scenarios’ but reluctant to give space to pro-Brexit or nuanced-Brexit analysis.
The fact that in the Bank’s assessment, a worst-case Brexit scenario would lead to 3.5 per cent GDP loss over three years, without any government response, suggests that with a strong government intervention, the losses would be small if at all.
And, with an orderly Brexit, the Bank estimates boom-time conditions.
Where is the Remain argument then?
Of course, I don’t see any of these impacts. The real problem is not Brexit (one way or another) but the austerity bias choking the economy.
That has to be relaxed for Britain to return to more robust growth.
That is enough for today!
(c) Copyright 2019 William Mitchell. All Rights Reserved.