Trade, free trade, protectionism:

20 September 2017

Why did so many economists assume the worst about Brexit?

By D Paton, D Blake, K Dowd

Inward investment in the UK has been at record levels since the referendum. Photo: Peter Macdiarmid/Getty Images

• The Single Market imposes burdensome regulation on economic activity
• Scaremongering economists were wrong about Brexit
• Brexit should bring about significant economic gains for the UK

The benefits of free trade have been familiar to economists since Adam Smith. Trade encourages specialisation and leads to lower costs, higher productivity and higher living standards.

Yet for some economists, things are different when it comes to the UK leaving the EU’s customs union and Single Market. The customs union was built on the German Zollverein model of protecting domestic industries from foreign competition around the time of German unification 150 years ago. Today, free trade is promoted within the EU, which is good. But the customs union imposes barriers to trade with the rest of the world, which is not.

The Single Market also imposes a hugely burdensome regulatory edifice on economic activity within the EU. Brexit will give the UK the opportunity to pursue its own free trade policy with the rest of the world and to escape the needless regulatory burdens of the single market.

Too many economists have refused to take seriously the idea that Brexit has the potential to provide economic benefits to the UK. Before the referendum, Treasury economists assured the public that a vote to leave would cause “an immediate and profound shock to our economy” leading to recession and a large increase in unemployment.

These are predictions that have since proved to be very wide of the mark. Modelling by the LSE’s Centre for Economic Performance (CEP) predicted that leaving the EU could only have negative consequences for the UK economy.

One of the problems with much of this analysis is the apparent reluctance by many economists to model scenarios in which Brexit provides any benefit at all to the UK economy. For example, a key plank of the CEP modelling is their assumption that Brexit would cause a reduction in foreign direct investment (FDI) of over 20 per cent.

In fact, inward investment in the UK has been at record levels since the referendum, while confidence about future FDI into the UK is higher now than before the referendum. Clearly, had the CEP been prepared to model a scenario in which Brexit increased FDI, they would have come up with a much more balanced range of estimates of the net effect of leaving the EU.

Even worse, the impression is sometimes given that the economics profession is united in predicting that Brexit can only lead to significant losses for the UK economy. In fact, as a new book by economists Phil Whyman and Alina Petrescu demonstrates, this idea of a consensus is misleading.

For example, work by Patrick Minford, chair of Economists for Free Trade (EFT), concludes that embracing free trade, regaining control over the net EU budget contributions and reducing the regulatory burden could give a boost to the UK economy of up to 7 per cent of GDP – some £135 billion a year.

It has been suggested that the model used in the EFT analysis is so flawed as to be worthless in comparison to the “gravity model” used for calculations favoured by the Treasury and CEP. With the gravity model, bilateral trade and FDI flows between two countries are modelled as a function of economic variables such as a country’s economic output (GDP), demographic variables such as population size, geographic variables such as distance, and cultural variables such as a common language. A standard conclusion of this model is that it is better to be as close as possible to a big trading block.

But how well does the gravity model predict trade and FDI flows? Not that well. Britain’s main trading partners in the 19th century were the US, Canada, the West Indies, Argentina, Brazil and China. Not a near neighbour from the European continent in sight. The UK’s share of exports to the EU has fallen from 54 per cent in 2006 to 43 per cent today, whereas given the move to “ever closer union” over this period, the gravity model would suggest that the share should have moved in the opposite direction.

Minford’s work takes a different approach, emphasising rational expectations and the supply side of the economy. Now, of course, it is normal for economists to debate the pros and cons of different modelling approaches and it is quite reasonable to question them.

What is not reasonable is to dismiss out of hand any attempt to take seriously potential gains to the supply side of the economy and the efficiency gains from greater free trade. Indeed, Minford has made a detailed and robust defence of his model arguing that it fits the reality of trade flows much better than the gravity approach.

The Brexit issue has brought out the worst of many economists. In some cases, they have allowed their political prejudices to colour their scientific judgement. Whether or not Brexit leads to improvements or reductions in economic well-being remains to be seen.

What should not be in doubt is that there are sound economic reasons for believing that Brexit has the potential to bring about significant economic gains for the UK. The referendum is over and Britain knows that it will be leaving the EU. Rather than prolonging the discredited Project Fear, now is the time for economists to work hard to ensure that those potential benefits from Brexit come to fruition.

This article was originally published on The Conversation. Read the original article.

David Paton is Chair of Industrial Economics at Nottingham University Business School; David Blake is Professor of Finance at the University of London; Kevin Dowd is Professor of Finance and Economics at Durham University

UK Economy - scope for optimism?

This short piece comes from the Woodford Fund. It provides some clarity on three important areas; consider the charts, and how you might incorporate this information into an essay:

UK ECONOMY – DEFIANT GROWTH
Mitchell Fraser-Jones, 20 September 2017

Much has been written over the summer about the consumer debt burden and its

implications for future monetary policy and growth. We are less concerned about this, partly

as a result of the low interest rate environment which we expect to prevail for some time.

The recent inflation data, and the Bank of England’s response to it, don’t change this view.

Clearly, the probability of an interest rate increase in the near future has increased but this

does not, in our view, herald the start of meaningfully tighter monetary policy. Indeed, the

stronger pound that has greeted the recent policy rhetoric, ironically does much to counter

the inflationary forces that prompted the talk of rate hikes in the first place.

We believe consumer debt levels are manageable in the context of household incomes.

Furthermore, as the chart below illustrates, it is evident that the growth in debt that we have

been seeing over the last eighteen months hasn’t really been the result of a pick-up in

consumer borrowing – it is corporate borrowers that have been taking advantage of the

renewed appetite for lending in the UK banking sector.

And, in the context of recent history, although the rate of debt growth has increased as the

banking sector has rehabilitated itself, it remains modest compared to the rates of growth

seen in the early years of the new millennium. Further evidence, as far as we’re concerned,

to suggest that worries about consumer debt are overdone.

Meanwhile, recent revisions to the way that the UK’s household savings ratio is calculated

should also diminish the level of these concerns. Figures released by the Office for National

Statistics last month suggest that UK household savings have been running at 8-10% in

recent years, compared to previous estimates which fell to c. 5% last year. Admittedly, the UK savings ratio has still been on a downward trend, as one might expect in a period when the value of other parts of the balance sheet, such as equities and, most households’ primary asset, the house itself, has been rising. The pace of the decline in savings, however, has been much less sharp than previously estimated.

Overall, official data confirms that the UK economy has remained resilient in 2017, despite
predictions that the Brexit negotiations would precipitate a collapse in activity. That never
seemed likely to us, and the data, thus far, is supportive of our view. Indeed, recent data,
including today’s better-than-expected retail sales numbers, suggest a modest improvement
in economic activity in recent months which, alongside renewed growth in money supply,
bodes well for UK GDP growth in the second half of 2017 and beyond.

We remain positive on the outlook for the UK economy – much more positive than the
gloomy prognosis implied by market valuations – and that is reflected in our long-term
investment strategy. The evidence that the UK economy is in better shape than many have
expected, continues to mount…

In light of our HS2 conversation...

Read this quick comentary:

India: the "almost-perfect" emerging-market investment story

Want to ride on a Shinkansen? Of course you do. Everyone wants to ride on a bullet train. But unless you get to Japan at some point in the next few years, you might find that most of India rides on one before you do. This week, Japan’s prime minister Shinzo Abe headed to India to lay the first stone in a Japanese-financed $17bn bullet train project set to cover the 310 miles between Mumbai and the industrial city of Ahmedabad. This is exciting stuff. That’s partly because bullet trains are amazing in themselves – this one will cut the journey time from eight hours to under three. It is partly because the Japanese have offered a fabulous deal on the finance – and are signing various other investment deals along the way. But the really interesting thing is the speed of delivery of the project: India’s prime minister Narendra Modi first decided to bring high-speed trains to India only two years ago. Two years from thought to first stone laying is quite something for a major infrastructure project. For comparison, you might note that the new tram system in Edinburgh, where I live, was first proposed in 2001. It was completed in 2014. It covers 8.7 miles. Very slowly. “My good friend prime minister Narendra Modi is a far-sighted leader”, said Abe this week. Such compliments are a rare thing in politics. Perhaps Modi is far-sighted; it is certainly true that he is prepared to make decisions that bring nasty short term pain – and hit growth – with a view to long-term gain. Late last year, he brought chaos to India’s economy with the abolition of two large-denomination banknotes in an attempt to move towards a clean and taxpaying digital economy. The consumer economy stalled; there were huge lines at the banks; and everyone working in the black economy found themselves having to choose between coming clean or losing their savings. But Modi held firm. He has done the same with this summer’s implementation of a national goods and services tax. It has subdued growth across the board – but should pay huge dividends as it slashes corruption, simplifies the tax system and boosts revenues. This is all good. But it is just the icing on the cake of an almost perfect emerging-markets story. India has fabulous demographics (two-thirds of the population are of working age); a booming middle class keen on consumption; a fast-shrinking current account deficit (under 1& of GDP); a government committed to housing and infrastructure spending (there is a kind-sounding “Housing for All” scheme on the go); and a low fiscal deficit (down to 3.5%). It also has a high level of foreign-exchange reserves (about $400bn) and inflation looks to be properly under control (down to more like 2% nowadays, compared to about 6% a year ago). Some of these things could reverse if the oil price rises again – the current-account deficit would rise again, for example. But for now, while there are some worries around employment and credit growth, the macro environment looks mightily impressive (imagine how thrilled we would all be if the UK’s numbers looked anything as good). India’s stockmarket looks good, too. It is one of the few emerging markets with real depth and breadth: you can get exposure to pretty much any part of the economy you want via a listed company (not all are top quality, of course, but that’s not exactly an emerging-market specific problem). Finally, it is worth noting that India’s stockmarket is supported by local investors rather than just by the fickle international investors who cause so much volatility in emerging markets (they were the ones who sold so energetically when Donald Trump was elected and when the geopolitics around North Korea started to heat up last month, for example). You will all be wanting to rush in... Read the whole of this article on the MoneyWeek website.

Meaty article on policy & inflation targets

Since the summer of 2016, the global economy has been in a period of moderate expansion, yet inflation has yet to pick up in the advanced economies. The question that inflation-targeting central banks must confront is straightforward: why? 

NEW YORK – Since the summer of 2016, the global economy has been in a period of moderate expansion, with the growth rate accelerating gradually. What has not picked up, at least in the advanced economies, is inflation. The question is why. 

 In the United States, Europe, Japan, and other developed economies, the recent growth acceleration has been driven by an increase in aggregate demand, a result of continued expansionary monetary and fiscal policies, as well as higher business and consumer confidence. That confidence has been driven by a decline in financial and economic risk, together with the containment of geopolitical risks, which, as a result, have so far had little impact on economies and markets. 

 Because stronger demand means less slack in product and labor markets, the recent growth acceleration in the advanced economies would be expected to bring with it a pickup in inflation. Yet core inflation has fallen in the US this year and remains stubbornly low in Europe and Japan. 

This creates a dilemma for major central banks – beginning with the US Federal Reserve and the European Central Bank – attempting to phase out unconventional monetary policies: they have secured higher growth, but are still not hitting their target of a 2% annual inflation rate. 

 One possible explanation for the mysterious combination of stronger growth and low inflation is that, in addition to stronger aggregate demand, developed economies have been experiencing positive supply shocks. Such shocks may come in many forms. 

Globalization keeps cheap goods and services flowing from China and other emerging markets. Weaker unions and workers’ reduced bargaining power have flattened out the Phillips curve, with low structural unemployment producing little wage inflation. Oil and commodity prices are low or declining. And technological innovations, starting with a new Internet revolution, are reducing the costs of goods and services. 

 Standard economic theory suggests that the correct monetary-policy response to such positive supply shocks depends on their persistence. If a shock is temporary, central banks should not react to it; they should normalize monetary policy, because eventually the shock will wear off naturally and, with tighter product and labor markets, inflation will rise. 

If, however, the shock is permanent, central banks should ease monetary conditions; otherwise, they will never be able to reach their inflation target. 

 This is not news to central banks. The Fed has justified its decision to start normalizing rates, despite below-target core inflation, by arguing that the inflation-weakening supply-side shocks are temporary. Likewise, the ECB is preparing to taper its bond purchases in 2018, under the assumption that inflation will rise in due course. 

 If policymakers are incorrect in assuming that the positive supply shocks holding down inflation are temporary, policy normalization may be the wrong approach, and unconventional policies should be sustained for longer. But it may also mean the opposite: if the shocks are permanent or more persistent than expected, normalization must be pursued even more quickly, because we have already reached a “new normal” for inflation. 

This is the view taken by the Bank for International Settlements, which argues that it is time to lower the inflation target from 2% to 0% – the rate that can now be expected, given permanent supply shocks. 

Trying to achieve 2% inflation in a context of such shocks, the BIS warns, would lead to excessively easy monetary policies, which would put upward pressure on prices of risk assets, and, ultimately, inflate dangerous bubbles. 

According to this logic, central banks should normalize policy sooner, and at a faster pace, to prevent another financial crisis. Most advanced-country central banks don’t agree with the BIS. They believe that, should asset-price inflation emerge, it can be contained with macroprudential credit policies, rather than monetary policy. 

Of course, advanced-country central banks hope such asset inflation won’t appear at all, because inflation is being suppressed by temporary supply shocks, and thus will increase as soon as product and labor markets tighten. But, faced with the possibility that today’s low inflation may be caused by permanent supply shocks, they are also unwilling to ease more now. 

So, even though central banks aren’t willing to give up on their formal 2% inflation target, they are willing to prolong the timeline for achieving it, as they have already done time and again, effectively conceding that inflation may stay low for longer. Otherwise, they would need to sustain for much longer their unconventional monetary policies, including quantitative easing and negative policy rates – an approach with which most central banks (with the possible exception of the Bank of Japan) are not comfortable. 

This central bank patience risks de-anchoring inflation expectations downward. But continuing for much longer with unconventional monetary policies also carries the risk of undesirable asset-price inflation, excessive credit growth, and bubbles. As long as uncertainty over the causes of low inflation remains, central banks will have to balance these competing risks. 

 Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Albert Edwards - yes, THAT Albert Edwards!

Serendipity (again); do read this article, it is one of those non-mainstream views that opposes current orthodoxy, and therefore gives you some really good material to impress the examiner with your evaluation skills:

Albert Edwards: I was wrong, I was too optimistic!

'Shocking slump' into outright deflation

Fed should begin to tighten interest rates

Société Générale's bearish analyst Albert Edwards has said the mounting evidence which suggests inflation has already slid into deflation will result in the US 10-year treasury yields converging with Japan and Germany at around -1%, and the next recession will be deeper than even he previously thought.

Permabear Edwards (pictured) said if one looks at core Consumer Price Index (CPI) inflation then it highlights a "shocking slump" into outright deflation over the past six months.

Despite this, however, the analyst said the Federal Reserve should still begin to normalise interest rates in order to accommodate for the next inevitable recession.

He said:  " If I were a Fed Governor I would be pretty shocked/concerned/bemused at inflation developments this year."

However confident the Fed is of a self-sustaining-recovery, there is growing evidence of a slide into outright deflation.

"Deflation did not need another US recession to emerge. It is already here. The longer the current credit excesses are allowed to continue, the deeper the next recession and deflationary bust will ultimately be."

The permabear went on to say the current tight US labour market would normally produce an upturn in wage and CPI inflation instead of the deflationary pressures which have been occurring.

Edwards said he originally believed this uptick in wage and CPI inflation would cause the Fed to raise rates which would end in a surprise recession.

However, he said: "This is exactly what I expected to occur at the start of this year and I thought it would be that recession that would tip the US into outright deflation but I was wrong. I was too optimistic!

"Although wages have accelerated due to the tight labour market, the last six months has seen consistent downside surprises."

The permabear said he still expects his Ice Age thesis, which has predicts US and European 10-year bond yields will converge with Japan, to occur with the "downward crash in US yields likely to be particularly shocking".

Furthermore, Edwards' said his prediction of a mid-1990s Japan-style crash occurring in the West will come to pass, despite the "best efforts" of policymakers.

"In the mid-1990s I witnessed first-hand the hubris of Western commentators who claimed that Japan's post-bubble slide into deflation was a one-off example," he said.

"My former colleague and Japan guru, Peter Tasker, and I came to the conclusion that hubris of Western commentators would turn to nemesis.

"Japan's post-bubble experience of sluggish economic growth was due to debt retrenchment followed seamlessly by deteriorating demographics.

"We felt both factors would also combine to push the West into a similar deflationary bust, despite the best efforts of policymakers."