Tuesday, 11 April 2017

Libor and the Bank

Nearly five years ago, the former CEO of Barclays Bank, Bob Diamond, defended himself against accusations that on his watch, Barclays had deliberately falsified Libor submissions. To no avail: after widespread adverse press coverage, Diamond resigned.

Was this at the instigation of the Governor of the Bank of England and the head of the FSA? We will probably never know. But events yesterday make not only Diamond's resignation, but also the prosecution and jailing of traders and Libor submitters from Barclays and other banks, look distinctly odd.

The BBC's Andy Verity has revealed the existence of a recording which appears to indicate that the Bank of England and the Treasury pressured banks to "lowball" their Libor submissions during the financial crisis. According to Verity, the conversation, between a junior Libor submitter (who was subsequently jailed) and his manager, ran like this:
In the recording, a senior Barclays manager, Mark Dearlove, instructs Libor submitter Peter Johnson, to lower his Libor rates. He tells him: "The bottom line is you're going to absolutely hate this... but we've had some very serious pressure from the UK government and the Bank of England about pushing our Libors lower." 
Mr Johnson objects, saying that this would mean breaking the rules for setting Libor, which required him to put in rates based only on the cost of borrowing cash. Mr Johnson says: "So I'll push them below a realistic level of where I think I can get money?" His boss Mr Dearlove replies: "The fact of the matter is we've got the Bank of England, all sorts of people involved in the whole thing... I am as reluctant as you are... these guys have just turned around and said just do it."
This is not the first time that Barclays has issued material purporting to show that the Bank of England was influencing Libor rates. Diamond's submission to the Treasury Select Committee included this file note recording a phone call between Diamond and Paul Tucker, then Deputy Governor of the Bank of England:
Note the last sentence. At the time, this passed largely unremarked - but in the recording reported by the BBC, Mark Dearlove makes a similar comment. Someone very senior in the Treasury seems to have instigated the Bank of England's request for Libor lowballing. The identity of this individual has not been revealed, though the Telegraph thinks it knows.

Libor manipulation is now a criminal offence - when it is done by banks or traders to boost their own profits. So the growing evidence that the Bank of England was manipulating Libor rates during the financial crisis at the behest of the Treasury raises some very serious questions.

Firstly, why would the Bank and the Treasury have wanted to manipulate Libor? It seems highly unlikely that this "lowballing" request, made during the worst financial crisis since the 1930s, would have had anything to do with flattering bank profits. So what might it have been about?

Well, at this time banks were dropping like ninepins. Several Libor panel banks, including RBS and HBOS, were already shut out of markets: their Libor submissions in no way reflected the real cost of market funding for them (which was effectively infinite). And market rates were heading for the moon, as suspicious market participants looked for the next domino to fall. It seems entirely reasonable to me that the Bank of England, prompted by a worried Treasury, would have tried to lower Libor to something more sensible than panicky banks would charge to lend to other banks they feared could collapse at any second.

Secondly, the note from Tucker shows that Barclays's Libor submissions were among the highest at that time. Normally, high funding costs indicate that the market thinks the bank is a poor risk: for example, Northern Rock's funding costs rose dramatically in the months before its collapse. So Barclays submitting higher Libors than other banks could have signalled to the market that it was next in line for a bailout.

We now know that Barclays was indeed in trouble at that time. To avoid the same fate as RBS, it went cap in hand to Qatar. The Serious Fraud Office is now investigating the shady equity-for-loan deal Barclays did with the Qataris. According to the Independent's Ben Chu, the SFO's findings are due in about a month. If the SFO decides that the deal was fraudulent, criminal prosecutions will follow. The timing is exquisite....

Did the Bank of England - or the Treasury - know Barclays was in trouble? Or did they merely suspect it was? Either way, did they pressure Barclays to reduce Libor submissions in order to ward off a market attack on a bank perceived as vulnerable, thus buying time for Barclays to find additional funds to beef up its dwindling equity?

This raises further questions about Barclays' behaviour. If Barclays was the source of the new recording, why wasn't it released five years ago along with the Tucker file note? Why has Barclays been sitting on this evidence? Why did Bob Diamond take the fall for Libor manipulation that appears to have been instigated by public officials?

But if the source was one of the participants, not Barclays itself, why did that person sit on the recording for five years? One of the people in that conversation was jailed. This evidence could have exonerated him, and others.

I think we need to know why this evidence was withheld for so long, and by whom. And we also need to know why it has now been revealed. Please don't tell me the old team had hidden it in a vault and the new team have only just found it. I don't believe it.

There are serious questions for the Bank of England, too. Why did Paul Tucker deny knowing anything about lowballing, despite the existence of the file note implicating him? His involvement in this matter destroyed his chances of becoming Governor. Why did he sacrifice his career at the Bank? Who was he protecting - and why?

I have previously asked why the FSA went ahead with fines and censure for Barclays and, subsequently, other banks when it appears they were acting at the behest of the Bank of England. The FSA must have seen the evidence Barclays presented to the Treasury Select Committee, though it may not have been aware of the recording. It therefore knew the Bank of England was possibly implicated. Hanging Barclays out to dry for an offence possibly committed at the behest of the Bank of England and the Treasury is hardly presenting a united front. Was the FSA distracting attention from its own failures by shafting other public institutions?

There is another matter, too. Back in 2012, Joseph Cotterill reported that the Bank of England was also suspected of Libor manipulation prior to the financial crisis, between 2005-2007. This is an entirely different - and potentially much more serious - matter than attempting to cap Libor to prevent bank meltdown in the financial crisis. It suggests that the Bank may have been treating Libor as a shadow policy rate. There is some justification for this: if the main monetary policy rate and Libor become significantly decoupled, monetary policy loses traction. So it may be that the Bank leaned on panel banks to adjust their Libor submissions if Libor appeared to be becoming unanchored from the policy rate. But if this is what the Bank was doing, it didn't tell anyone.

The Bank of England may or may not have had good reasons for manipulating Libor. But its officials had no reason whatsoever to conceal the Bank's actions. Lying to Parliament is totally unjustifiable - as is allowing people to be prosecuted, and serve jail time, for offences they may not have committed. The real disgrace is the web of lies that seems to have been woven by both Barclays and the Bank of England.

We may never get to the bottom of this sorry mess. But we should give it a damn good try. Five years ago, I called for an independent judicial enquiry into the role of public institutions in Libor manipulation . I repeat that call now. Let those who really made the Libor decisions, both before and during the financial crisis, be brought to account.

Related reading:

Libor rigging and double standards
So whose fault is it, then?





Tuesday, 4 April 2017

A dangerous Eden


I have been going to the gym. Seriously. For about a couple of months now. I'm doing weight training for the first time in my life, and cardio exercises, including - wonder of wonders - short bursts of running. I'm even paying for a personal trainer. It's a shocking extravagance, but I'm likely to find any excuse under the sun not to do my workouts unless I have someone telling me what to do and shouting at me if I don't do it. As one of my school reports said, "Frances does not enjoy physical exertion". Truer words were never spoken. Sporty, I am not.

So why am I doing this? It is all because of my family. Specifically, my father. He has serious heart problems, vascular deterioration in his brain and Type II diabetes. And I am a lot like him. 

Ok, so he is 83. But he was a lot more active in his 50s than I have become. Since I reduced my singing teaching and took up writing, I have become largely sedentary. Even gardening has gone, killed by a brutal combination of severe hay fever and asthma. And although I enjoy walking, I don't do it nearly enough. It is too easy to hop into the car even for short trips, and longer ones are a rare indulgence in a life dominated by work. 

I looked at my father - now slim, after drastically changing his diet when he was diagnosed with Type II diabetes. And I looked at me. And I did not like what I saw. I decided that if I wished to avoid heart problems and diabetes, I had to slim down and get fit. So I went to the gym. 

I am far from alone. In a recent panel discussion on the future of work, I asked the audience how many of them went to the gym. A forest of hands went up. It appeared that nearly everyone in the room, young and old, visited a gym. Slimming down and getting fit is fashionable among London office workers. 

But back in the nineteenth century, there was no such thing as a gym. Nor would people have visited gyms even if they existed. Even if they could afford them, they did not need them. For the vast majority of people, work itself involved physical exertion. It did not matter whether you were an agricultural labourer, a scullery maid, a cook or one of the thousands of people who worked in factories and mines up and down the land. Work was hard. 

There was a lot of it, too. People then worked longer hours than we do now: working days of 10-12 hours were typical. Most people started work when they were children, and continued to work well into old age. The state pension introduced in 1908 set the retirement age at 70 for both men and women. Prior to that, elderly people who could not support themselves were forced into workhouses - where they were, of course, required to work. 

Even for people doing desk jobs, such as Dickens' Bob Cratchett, work was physically harder than it is now. Offices were neither centrally heated nor air conditioned, and there was no concept of "ergonomic design". And Victorian ledgers were no light weight: any clerk lugging those around would have been doing the equivalent of modern weight training. Not to mention dragging in buckets of coal and logs to feed the open fire. 

Transport to work also involved what we would now regard as hard work. Most people would have walked to work, often some distance. Even richer people regarded walking long distances as normal: in Jane Austen's Pride and Prejudice, Elizabeth Bennet and her aunt and uncle decide to walk round the Pemberley park on discovering that it is "only 10 miles round". Admittedly, 10 miles proved too much for her aunt: but when Elizabeth marries Darcy, her aunt observes that a pony and trap would be the very thing in which to tour the park. Riding in an unsprung carriage (or pony trap) might have saved her feet, but it would have used every muscle in her body. Among richer people, horse riding was a common means of transport: but that too involves using muscles that many of us today don't know exist. 

In one episode of the BBC's "Victorian Slum" - a well-constructed "living history" programme showing what life was like in the Victorian slums of East London - the historian on the programme, watching young men struggle to lift heavy sacks of meal, observed that Victorian men were fitter and tougher than today's young men. Although their nutrition was far worse than ours today, and there was next to no healthcare, they were used to lifting heavy weights and performing physically demanding manual tasks. 

So for our forebears, gyms would have been superfluous. It was the daily grind of living that kept them fit. When they stopped work, they rested. And because there was much work, and little rest, they longed for a world in which there was much rest and little work. Freedom from toil has been the goal of mankind for millenia. 

We are hardwired to use our ingenuity to find easier ways of doing things. Our prehistoric ancestors directed their efforts towards making hunting and gathering more efficient: so they invented weapons with which they could kill much larger prey (and could therefore afford to hunt less often), and they invented ways of improving the productivity of plants, so that they need not forage so widely. Eventually, of course, they learned to keep the plants and the prey close to them, so that they could tap them whenever they wanted rather than having to find them. Of course, farming did not eliminate either food scarcity or hard work: but it made them more controllable, especially as humans devised ever more imaginative ways of preserving food.

Now, we create labour-saving devices that reduce the amount of physical effort required to keep a home clean, clothes washed and dinner cooked. We invent machines that eliminate the need for humans to exert themselves physically to produce food. We develop faster and more efficient ways of moving people and goods around. We speak of the "changing nature of work", as if it were something new: but in reality, the nature of work has been changing for generations, as machines have progressively replaced human muscles. Our worry now is that machines will replace not just our muscles, but our brains. 

But progressively replacing human brawn with brain in the world of work is already creating an unexpected problem. Freedom from toil isn't all it is cracked up to be. Our bodies need physical exertion to remain healthy. Sedentary lifestyles shorten people's lives

So, do we kick out the machines and do the work ourselves? No. We go to the gym. In other words, we pay to do physical hard work for which in the past we would have been paid. Some of us (me) even pay a personal trainer to play the role of the employer that would have told us what to do and shouted at us if we didn't do it well enough. 

The burgeoning fitness industry is a fine example of how the changing nature of work sparks new, previously unimaginable types of job. Who, one hundred years ago, would have foreseen that entire factories full of machines would be created not to produce goods, but simply to enable people to stay healthy? Even the treadmill of nineteenth century prisons and workhouses served a useful purpose: it generated energy to power mills. But as far as I know, no-one has yet tried to harness the physical energy that thousands of people waste every day in gyms up and down the country. Mind you, it is surely not going to be long before someone realises that gyms could be self-sufficient in energy and possibly even provide electricity to the local community. Who needs wind or solar, when you have a spinning class? 

We also re-create the food scarcity that was the lot of our distant ancestors. Our instinct is to seek out foods that were previously scarce but are now abundant, such as sugar and fat, but we know that indulging our preference is dangerous to our health. So we follow diet plans of varying scientific credibility, and consult dieticians who advise us on what not to eat. We voluntarily restrict both the amount and the variety of food we eat: we may even pay extra for foods that are produced in a less efficient (but more "natural") way. To the people of the "Victorian slum", this would have seemed extraordinary. 

Indeed, it would seem extraordinary to people in developing countries today. What I describe above are first world problems. At the same time as we are artificially creating hard work and scarcity to preserve our lifespans, our cousins in Africa are doing real hard work and experiencing real scarcity, both of which shorten theirs. The changing nature of work has made our lives too easy, while theirs remain as hard as ever. 

But perhaps, in the distant future, even our African cousins will be relieved of the necessity of physical toil, and benefit from the abundance that efficient machine production can deliver. Then our problems will be their problems, and they too will voluntarily pay to work and to starve. 

Who would have thought that the Eden of which we have dreamed would be so dangerous for us?  

Related reading:


Image from Wikipedia.


Tuesday, 28 March 2017

Barnier and the Tantalus game


The EU has laid out its negotiating strategy for Brexit. Well, not officially yet, of course - the letter triggering Article 50 won't be delivered until tomorrow, 29th March. But as is its wont, it has made its intentions clear in the press.

In an op-ed in the FT, Michel Barnier, the EU's chief negotiator, has stated in no uncertain terms how he expects the negotiations to proceed. He identifies three crucial issues that must be resolved before there can be any discussion of future trading arrangements between the EU and UK:

  • the rights of EU citizens living and working in the UK
  • continuing funding for current beneficiaries of EU programmes
  • the border between the Republic of Ireland and Northern Ireland. 

The first of these responds to Theresa May's continued refusal to guarantee the rights of EU citizens currently living in the UK. Tellingly, Barnier makes no mention of UK citizens living in the EU. If May won't guarantee EU citizens' rights, he implies, the EU won't protect the thousands of UK pensioners living in Spain, France, Portugal and other sunny South European countries. It will be up to the governments of those countries to decide what happens to them. Nice.

The second is code for "we want our money". This is the contentious 60bn Euros the European Commission says the UK must pay when it leaves the EU. According to the FT, the bill is for "unpaid budget commitments, pension liabilities, loan guarantees and spending on UK-based projects". Unsurprisingly, hardline Brexiters object to this: UKIP's Suzanne Evans told a BBC Question Time audience that Britain "should not pay a penny" when it leaves the EU, and prominent Tory Leaver Iain Duncan Smith outlined a UK claim to a share of EU assets that he suggested would be more than enough to eliminate any UK liability.

It seems likely that the eventual bill will be significantly less than 60bn Euros, but well above zero. This is something of a problem for Brexiteers, who have already had to row back on their promise of an extra £350m per week for the NHS and are now faced with the likelihood that leaving the EU will actually cost the UK money. I'm not sure how they will explain this to the British people, but they will no doubt find someone to blame. Probably Theresa May.

The first two negotiating conditions set by Barnier should come as no surprise. But the third is new. The UK government has so far treated the question of the Northern Ireland border and the Good Friday Agreement as entirely a domestic matter. Barnier, it seems, disagrees. And he has a point. After all, it is the EU's border too, and reneging on the Good Friday Agreement would threaten the security of one of its remaining member states. If the UK can demand control of its borders, so can the EU.

Barnier makes it clear that trade is simply not on the table until the EU's priority issues are resolved:
If we cannot resolve these three significant uncertainties at an early stage, we run the risk of failure. Putting things in the right order maximises the chances of reaching an agreement. This means agreeing on the orderly withdrawal of the UK before negotiating any future trade deal. 
Note that although Barnier has specifically cited three issues, he has not limited the conditions to these three alone. The "orderly withdrawal of the UK" can mean whatever the EU wants it to mean.

Keeping trade off the table until everything else is agreed puts the UK into the same negotiating position as Greece. Before it can have the debt relief it so desperately needs, Greece must comply with all the conditions set by its creditors. And every time Greece seems to be getting close to meeting conditions for debt relief, the creditors set more conditions, or find reasons to claim conditions have not been met. Similarly, we can expect that every time the UK gets close to agreeing terms that would enable trade negotiations to start, further issues will be raised. This is the Tantalus game - and the EU is an expert player.

But why is the EU planning to play the Tantalus game? Well, it is all because of the attitude of the Brexit camp in the UK government. From the start, they have emphasised trade over everything else. They could hardly have made it clearer that for the UK, a new trade agreement is paramount. But the EU has much less need for a new trade agreement than the UK does.

The Brexiteers have repeatedly claimed that the EU will be so desperate for a trade deal that it will give the UK special terms amounting to single market benefits without the costs. "Just think about all those German cars!" they cry. But the evidence is that the UK has far more to lose from departure without a trade agreement than the EU does. And the EU's negotiating stance, as laid out in Barnier's op-ed, confirms that view.

There are overwhelming political reasons for the EU to be extremely unwilling to cut such a deal anyway. Giving a non-EU state the same access to EU markets as EU member states would strike a mortal blow to the EU political project. The Brexiteers cheerfully assume that for the EU, the economics of Brexit would trump the politics, even though their own Leave campaign was successful precisely because in the UK, politics trumped economics. But events in the last few years have demonstrated beyond any possible doubt that maintaining the EU project will be far more important for the EU negotiators than any amount of economic pain for the member states. Politically, allowing the UK to leave the EU with no trade deal is a much better outcome for the EU than giving the UK trade terms similar to those it enjoys now.

By overemphasising trade, discounting political imperatives and overstating the UK's position, the Brexiteers have played right into Barnier's hands. Hello, Tantalus.

Unfortunately, the UK cannot afford to play Tantalus.There was no end to his misery: but for the UK, there will be an end, and it is all too soon. Article 50's hard deadline means that the UK is negotiating with a gun to its head. It is more Tosca than Tantalus. Barnier (perhaps we should call him Scarpia?) spells this out:
The sooner we agree on these principles, the more time we will have to discuss our future partnership.
You only have two years, Theresa. If you wish to save the UK from the trade firing squad, just agree to our terms on everything else.

But the firing squad might proceed with the execution anyway. Even if the EU could agree the terms of a new trade agreement within two years - which is doubtful, since getting EU member states to agree is like herding cats - enacting it on the UK's exit may be impossible for legal reasons. The EU is hoist by its own Treaties.

Article 50 has not even been triggered yet, but the Brexit team has already managed to compromise the UK's negotiating position with its toxic combination of ignorance, arrogance and foolishness. This is a very bad start, Theresa.

Related reading:

Game theory in Brexitland


Saturday, 18 March 2017

Of cars and tariffs, and Brexit fantasies




"The Germans won't want tariffs on their car exports to the UK", said my father the other day.

I have to agree. No-one likes tariffs, especially when they are used to having none. But it was his next comment that made me pause. My father's idea is that the EU will allow the UK to have tariff-free access to the EU's markets after Brexit in order to placate the powerful German car manufacturing lobby. He's not alone in this view: it has been repeatedly stated by Brexit promoters, both during the Leave campaign and since the vote last June.

The obvious rejoinder is that the EU (ex-UK) is 27 countries, not one, and although Germany is powerful it does not call the shots with regard to trade. Although a qualified majority vote is sufficient to allow the UK to leave the EU, a new free trade deal between the UK and the EU post Brexit would require the agreement of all 27 members, and in some cases sub-sovereign agreement too. The recent trade deal between the EU and Canada was nearly derailed by Wallonia, a sub-sovereign of Belgium.

Nor could there be a deal specifically between Germany and the UK regarding car exports. The UK is leaving the EU, but Germany is not. And members of the EU are not allowed to negotiate their own third-country trade deals. If it tried to enter into a separate agreement with the UK, Germany would be breaking EU treaties. However powerful its car manufacturing lobby is, undermining the EU is not in Germany's interests. The car manufacturers know this. To my knowledge, they have never suggested that Germany should negotiate directly with the UK, nor are they ever likely to do so. That is a Brexiteer fantasy.

Of course, Germany does sell a lot of cars to the UK. But the UK certainly isn't the destination for "most of" its car exports, as some Brexiteers have asserted. Full Fact, debunking Louise Mensch, gives us the figures:
Germany sells about 14% of all the passenger cars it makes domestically to the UK, a little over one in seven. (That makes up about 18% of the passenger cars it exports, a little under one in five.)
So - assuming the UK did impose a tariff of some amount on car imports from the EU - 18% of German car exports would suddenly become more expensive (unless German manufacturers absorbed the tariff as a hit to profits). UK consumers might not like this price increase. But just look at German cars sold in the UK. Mercedes, Audi, BMW.....they are luxury cars. Even the Volkswagen Golf is a status symbol. If British people want cheap runarounds, they don't buy German. They buy Japanese or American cars manufactured in the UK. German cars already command higher prices than these: it is hard to see that British purchasers of German cars are suddenly going to exhibit extreme price sensitivity because of an import tariff. Top-of-the-range luxury marques might even benefit from a price rise, since they are Veblen goods. And some German cars are manufactured in the UK - Minis and Rolls Royces, for example: these would not incur the UK's tariff at all if sold in the UK, though they would incur EU tariffs if exported to the EU.

But where do the rest of Germany's car exports go? Well, a lot of them go to the rest of the EU. In general, the rest of the EU is a much bigger destination for German exports than the UK. And the rest are exported to the rest of the world. According to Eurostat, in 2015 exports of new and used cars made up 11% of the EU's total exports. Of those, over half came from Germany.  Interestingly, the UK is the EU's second largest exporter of cars, at 12% of total car exports. This contribution to EU exports will of course be lost post-Brexit. The EU's trade surplus in cars versus the rest of the world (exports exceed imports by a considerable amount) will therefore fall somewhat. But Germany's trade surplus in cars versus the rest of the world will actually increase, since it is a sizeable net exporter to the UK. The chances of its UK car exports collapsing sufficiently to eliminate this effect is vanishingly small.

The largest export market for EU car exports is the USA, which in 2015 took 26% of EU cars. The US imports more German cars than the UK does. The EU has no free trade agreement with the USA, so sales of these cars incur the US's WTO "most favoured nation" tariffs, which are about 2.5%. The second most important export market for EU-manufactured cars is China, which also has no free trade agreement with the EU. Clearly, not having a free trade agreement is not a great obstacle for German car exporters. There is no particular reason to suppose that the UK imposing tariffs on imports of German cars - or Italian, French and Swedish cars, for that matter - would be a major obstacle either. Admittedly, grandfathering EU WTO tariffs, which is how the UK is likely to do tariffs in the short term, will cause some pain, since the EU's tariffs are rather high. But given the relative price inelasticity of German cars in the UK market, the pain is likely to be limited and short-lived. So Germany is not likely to take fright at the prospect of UK import tariffs. German manufacturers may moan, but the response from the German government is likely to be along the lines of "if you can cope with tariffs elsewhere, you can cope with UK tariffs".

Some have suggested that threatening the EU with a trade war - "if you impose tariffs on our Nissan exports we will impose bigger ones on your Volkswagen exports" - might secure tariff-free access. This is foolish in the extreme. The UK has far, far too much to lose.

When it leaves the EU, the UK will face the EU's WTO "most favoured nation" tariff of 10% on its entire car exports to the EU. In 2015, that was 57% of its total car exports. And British car exports, with few exceptions, do not carry the "luxury" premium of many German marques. It is British car manufacturers, not German ones, who have the most to lose from Brexit. It is British car manufacturers who have lobbied most heavily for UK trade with EU to continue to be tariff-free. And in any trade war over car exports, it is the UK that would suffer most. Ratcheting up tariffs on EU car imports could reasonably be seen by the EU as unfair competition and met with retaliatory action. In a trade war, those that have the greatest exposure suffer the most.

Sterling weakness, if it continues, would also raise the UK price of imported German cars. If the combination of depreciation effects with new import tariffs raised the price enough, German exports to the UK would fall. But just as Brexiteers like to assume that the UK can readily substitute cheaper rest-of-world destinations for the expensive EU after Brexit, so too can Germany. Germany's engineering is respected worldwide. If the UK made exports difficult, Germany would simply seek markets elsewhere. It can well afford the short-term hit to its net exports: it has already weathered worse in the Eurozone crisis. In contrast, even with the assistance of a debauched currency, UK exporters to the EU might find it difficult to find new markets. 57% of total car exports is an awful lot to relocate to lower-tariff destinations.

It doesn't take much fact checking and common sense to debunk most Brexiteer fantasies. This is simply the latest in a long line of myths, legends and outright lies that crumble when exposed to the harsh light of reality. Sadly, though, in this age of fake news and the dominance of opinion, facts and sense are massively devalued goods. The Brexiteers will discover in due course the folly of their ideas. But by then, it will be too late.

Related reading:

Game theory in Brexitland

Image from www.car-brand-names.com



Sunday, 12 March 2017

Game theory in Brexitland



"No deal for Britain is better than a bad deal", says Theresa May. Her Brexit sidekick David Davis appeals to MPs not to "tie her hands". And that master of flannel, trade secretary Liam Fox, says that leaving without a deal would be "not just bad for the UK, it's bad for Europe as a whole".

These three statements sum up the hopes of the Brexiteers. The idea seems to be that if the UK adopts a really strong stance in its forthcoming negotiations with the EU, the Europeans will be so horrified at the prospect of the UK leaving without any agreement that they will cave in and give the UK what it wants. Welcome to the Brexit game of chicken.

On the face of it, the UK government's negotiating principles appear sound: set out your red lines, make it clear that you won't tamely agree to everything the other side wants and that you will walk away rather than give ground on things that really matter. But if you are going to play brinkmanship, you really have to understand your opponent. The EU is well versed in this game - and it knows how to win.

So, how credible is May's threat to walk away from negotiations? Davis's intervention is clearly intended to make it credible. If Parliament can overturn her decision and send her back to the negotiating table, then her position is much weaker. On this occasion, therefore, perhaps they are right. Parliament cannot be allowed to veto a "no deal" exit. To do so would indeed tie Theresa May's hands. She must have the freedom to end negotiations without a deal.

But Parliament is the least of her problems. Theresa May's real difficulty is that she is dealing with a hardened opponent that is not afraid to take pain in order to get what it wants. And to make matters worse, she has a hard deadline. The UK will leave the EU two years after Article 50 is triggered. The deadline can be extended, but it would require agreement from all 27 EU countries. There is no guarantee that in the event of no deal, they would agree to extend the deadline. In fact, there would be a strong incentive for them not to do so. If negotiations ran to the wire, the EU would need to concede virtually nothing. All it would need to do is put its terms on the table and say "take it or leave it".

And if you think the EU would not do this, you have learned nothing from the last few years. In 2015, Greece thought it could negotiate a new deal with the EU. So it set out its red lines, made it clear it would not accept the EU's terms, and threatened to walk away from negotiations - and indeed, from the Euro - if it didn't get what it wanted. For a while, it looked as if it might follow through on its threat: the resounding "NO" to the EU's terms in the Greek referendum should have led to exit from the Euro. But when the European Council explicitly faced Greek prime minister Alexis Tsipras with a choice between accepting their terms or leaving the Euro, he balked. And at that moment, he lost the game. The Greek government's threat to jump over the cliff was exposed as a bluff.

From that moment on, the end was inevitable. In a bruising overnight negotiation, Tsipras conceded almost everything that his government had previously rejected. And since then, further concessions have been made. The "red lines" have been repeatedly crossed. The Greek government is tamely accepting everything the EU demands - because the only alternative is jumping over the cliff edge that they stepped back from in July 2015.

The lesson is clear. If you are going to play the cliff edge game, you must be prepared for the possibility that the other side will push you over. Especially if your opponent is the EU.

Of course, the UK has already decided to jump over the cliff. Indeed, that is what the negotiation is about. It wants to negotiate a soft landing. Clearly, therefore, a European Council "accept our terms or leave" confrontation is not going to happen in this case. But that doesn't mean that the UK has a strong position. It doesn't.

To understand this, we have to consider the nature of the beast. In theory, the negotiations could be limited to the terms of the "divorce" - the status of EU nationals in the UK and UK nationals in the EU, the division of assets, the dismantling of common agreements, the final bill for ongoing responsibilities such as pensions. Leaving the EU without agreement on these would be horrible for everyone.

The UK's attempts to use security, intelligence and the status of EU nationals in the UK as bargaining chips have already been criticised. In all of these, it is hard to see that the "cliff edge" game is remotely credible: unilaterally ending cooperation over security, policing and intelligence would be utter folly, while the humanitarian cost of deporting EU nationals would be appalling. I think it is unlikely that the EU will play brinkmanship over security and intelligence: the EU has as much to lose as the UK, so agreement seems likely early in the negotiation. And the easy way of defusing the "hostages" problem is for the EU to offer UK nationals right-to-remain unilaterally, and then dare the UK to deport EU nationals. The UK government is already facing strong criticism at home for its attitude to EU nationals: international opprobrium as well might be a bridge too far. Nor is the EU likely to go into an exit with no agreement about the 60bn Euros it says it wants from the UK. Once the UK was no longer a member of the EU or under the jurisdiction of the ECJ, the EU would have no power to force it to pay up. No, there will be a deal on all these matters.

But trade is an entirely different matter. The EU and the UK appear to be poles apart. The EU negotiators seem to be intent on keeping the negotiations narrowly focused on the terms of the "divorce" and kicking trade discussions into the long grass. In contrast, the UK government has said it intends to forge a "new customs arrangement" with the EU, though it has not as yet defined what it means by that. And it lays claim to tariff-free trade:
We do not seek to adopt a model already enjoyed by other countries. The UK already has zero tariffs on goods and a common regulatory framework with the EU Single Market. This position is unprecedented in previous trade negotiations. Unlike other trade negotiations, this is not about bringing two divergent systems together. It is about finding the best way for the benefit of the common systems and frameworks, that currently enable UK and EU businesses to trade with and operate in each others’ markets, to continue when we leave the EU through a new comprehensive, bold and ambitious free trade agreement.
Eh, what? The UK government thinks the UK can have the benefits of Single Market membership without actually being a member of it? This is not remotely credible. Zero tariffs on trade and a common regulatory framework are not a side effect of the Single Market, they are its very nature. It would not be in the EU's interests for a non-EU member to have the same benefits as EU members. When the UK leaves the Single Market, therefore, there will no longer be zero tariffs and a common regulatory framework. The costs of doing business with the EU will go up.

How much they will go up depends on what deal the UK government manages to do with the EU. I confess I am not hopeful. The EU drives a very hard bargain. So, what happens if May ends up saying "no deal"?

Leaving the EU with no trade deal would mean that the UK would immediately revert to "most favoured nation" (MFN) status under the World Trade Organisation's rules as far as the EU was concerned. Much nonsense is talked about this, mostly by people who don't know what they are talking about. The "Clean Brexit" economists at the Policy Exchange, for example, blithely say this:
“WTO rules” is often presented as “deeply damaging” and “the hardest of hard Brexits”. We disagree. Tariffs under WTO rules are relatively low and falling. We already conduct around half of all our trade under WTO rules - beyond the Single Market or other formal free trade agreements (FTAs) - with the rest of the world. Both the US and China trade heavily with the EU, under WTO rules and we can do the same. Already, our WTO-rules trade is not only the biggest part - it is also fast-growing and records a surplus.
Aarrggh. There is a world of difference between trading with countries under existing trade tariffs which have been reducing in recent years, and introducing new trade tariffs where currently there are none.

The potential impact on the UK's trade with the EU from introducing new tariffs is considerable. I've reproduced here the WTO's table showing the current EU MFN tariffs:


Remember that the UK currently faces no tariffs on trade with EU countries. Chemicals are one of the UK's principal exports to the EU: after a "no-deal" Brexit, their export price would rise by 4.5%. This might be offset by a further fall in the value of sterling, but that creates problems on the import side. Few manufacturers are immune from import price rises, these days.

These are, of course, goods tariffs. The picture for services is much less clear. The WTO framework for services is at best a work in progress: flawed though it is, the EU's single market in services is far more developed. The "common regulatory framework" mentioned by the UK government is one of the principal benefits of the single market in services. Immediately on exit, this would be unlikely to change much, though the UK government's plans to impose restrictions on the free movement of people will negatively impact services trade right from the start. But over time, as EU and UK law and regulation diverged, services trade would become more and more difficult. The UK is also a major exporter of services to the rest of the world: the US is its largest trade partner in services. Much of this is because it is used as a gateway to the EU by service industries, particularly financial services. Once the UK can no longer perform that function, those service industries might disappear for good. So reverting to WTO rules could cause not only services trade with the EU to decline, but also services trade with the rest of the world.

The EU's MFN tariffs are also currently applied by the UK on its trade with non-EU countries with which the EU has no separate free trade agreement. The UK enjoys WTO membership by virtue of its EU membership, so as part of the Brexit process it will have to negotiate separate membership of the WTO, including setting up its own tariff schedules. Although there are calls for the UK to unilaterally abandon import tariffs, it seems much more likely that the EU's current WTO tariff schedule will form the basis for the UK's own tariff schedule post-Brexit.

After a no-deal Brexit, the UK would have to impose on imports from the EU the same MFN tariffs as it imposes on imports from non-EU countries. If the UK's new WTO schedules were based on the existing EU ones, then the impact on some agricultural imports, in particular, could be rather high, according to a study produced for the National Farmers' Union in April 2016:
.....a tariff of 30-40% would be applied on wine and cheese - two items for which the UK runs a significant deficit with the EU (net-imports of about 2,200 million and 1,250 million euro respectively, see Figure 3.1). In addition, imports of several meat product items would become subject to tariffs that could exceed 30% and might be even close to 70% or 90%, depending on the type of meat. All in all, the UK consumer will face higher prices for many items that are imported, which will only alter, if the UK government negotiates preferential access with the EU when leaving the Union. 
Goodbye to cheap Prosecco, then. And that's without considering the impact of the UK's exclusion from the EU's "tariff-reduced quotas" - see the top RH corner of the table above for the likely excluded rate on agricultural products
.
There would also be WTO tariffs on trade with countries such as South Korea with which the EU has free trade agreements, since it is highly unlikely that these countries would allow grandfathering of EU free trade agreements. 

None of this is good news for the UK. They are not great for the EU either, but EU countries could be forgiven for thinking that the loss of one country from the trading bloc would not make a great deal of difference - after all, there are still 27 of them and they can all trade freely with each other, as well as with the rest of the world under existing tariff arrangements. The UK, however, would be facing new tariffs on at least 45% of its exports, and it also would be obliged to impose MFN tariffs on over 50% of its imports.

The truth is that May's threat to leave the EU on WTO rules is no more credible than Alexis Tsipras's threat to leave the Euro. Leading the UK over the cliff edge onto a pile of jagged rocks is not delivering the best outcome for the UK. She would pay the price for that folly at the ballot box in 2020, or earlier if she lost the support of her (already restive) back-bench MPs. She has no choice but to try to negotiate some kind of soft landing. So the attempt to stifle Parliament is, once again, wrong. She must be chained to the negotiating table, even if it takes a Parliamentary veto to do it.

But the EU can walk away. After all, if it does nothing, the UK leaves on WTO rules that are a lot more damaging for the UK than they are for the EU. So the EU holds the upper hand. And the EU likes to play brinkmanship, especially when invited to do so by a foolhardy government. So my guess is that there will be a transitional deal. It will be hashed out in a brutal all-nighter just before the Article 50 notice expires. And in that meeting, May will agree to every single one of the EU's terms - because although they will fall a long way short of the benefits the UK currently enjoys, they will be better than the alternative.

The game will play out for the UK just as it did for Greece and Cyprus. And if any other governments are thinking of playing chicken with the EU - be warned. You will end up as roadkill.

Related reading:

Greece: The Game Is On Again - Forbes
Greece, the EU and the IMF are dancing with death - Forbes
Tsipras in the crucible
Sowing the wind
UK Perspectives 2016: Trade with the EU and beyond - ONS

Image by Gerald Scarfe. 




Friday, 3 March 2017

Adam Smith's Destructive Hand



Adam Smith's "invisible hand" is perhaps one of the most misunderstood concepts in economics. It is usually interpreted to mean that when individuals all operate according to their own self-interest, their actions somehow combine to create a well-ordered, well-functioning society "as if guided by an invisible hand".

To be fair, this statement about the "invisible hand" (from the Theory of Moral Sentiments) does seem to mean exactly that:
[The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity…they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.
This should have been challenged long ago on the lack of counterfactual evidence. It is an assertion, not a fact. Nonetheless, despite the glaring inequalities in our world today, it could be true. The history of the command economies of the 20th century is not a happy one: attempts to equalise the distribution of resources created poverty for (nearly) all, and the natural human desire to seize resources for oneself at the expense of others was inevitably strongest among those tasked by the rest with ensuring equitable distribution. No socialist revolution in history has succeeded in raising the living standards of all by killing off the rich: but the last 20 years, in which "communist" states have adopted capitalist practices and the number of billionaires in developing countries has risen to an all-time high, has seen the greatest rise in living standards for the world's population in recorded history.

The problem with Smith's statement is that it gives the impression that equitable distribution is not only possible, it is inevitable. The "invisible hand" guides the human species ever closer to complete equality of distribution. Marx would have been proud of him. But I don't think this is what Smith meant. I think he meant that the best distribution of resources we can have as a species is achieved when each individual pursues their own self interest. Unequal distribution of resources is inevitable, but because it is not possible for the rich to hoard everything they have - since ultimately, hoarding is death - the poor benefit from the selfishness of the rich. That is the implication of this paragraph from Smith's better-known work, The Wealth of Nations:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.
The poor are fed not in spite of, but because of the selfishness and greed of the rich.

But that is only half the story. This, also from The Wealth of Nations, is the other half:
Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.
For Smith, self-interest is inevitably benevolent in effect, whatever the intention. He does not consider the possibility that self-interest could have malevolent effects. Nor does he consider the possibility that short-sightedness and stupidity may have unexpected consequences. And this is because he is thinking in aggregates. Smith's "invisible hand" applies not to the individual, but to the group. The individual does whatever he wants: but the collective actions of thousands or millions of individuals together bring about a better society.

Here is Adam Smith's "invisible hand" at work:



(YouTube link for this video is here)

Beautiful, isn't it? Millions of individuals all looking for dinner. They are all pursuing their own gain, but they look as if they are organised and directed to create wonderful patterns. They fly as if guided by an "invisible hand". Note that we can see those patterns, but they, individually, cannot.

For Smith, people are like starlings. People pursuing their own self-interest fly as if directed by an "invisible hand", and together, unknowingly, make beautiful patterns. Individually, we cannot see the pattern of which we are part: but when we look back through history, we can see how patterns form and shape themselves from the actions of our forbears. Smith's observation is positive, optimistic, and for a swarming species like humans, accurate. So long as the majority of people are peacefully pursuing their own gain, the outcome for society must be beneficial.

But this is also the "invisible hand" at work:


(YouTube link for this video is here)

Millions of individuals, all looking for dinner - but this time, they make not a benign, beautiful pattern, but a terrifying, destructive one. Locusts are not the only species that can ruin an entire economy when they swarm. Some birds do, too. A small bird known as the "quelea" is feared all over Africa because it arrives without warning in huge flocks and eats everything in sight. The now-extinct "passenger pigeon" was a swarming bird that was feared by farmers in the American Mid-West for the same reason.

This is the part of the story that Smith omits. Humans are a swarming species. Swarms can be benign - or they can be destructive. And importantly, people do not know when they are swarming. Even if they are part of a very large movement of people that is feared by those in its path, they are still pursuing what they perceive to be their own self-interest. It's worth remembering, too, that when people swarm, an individual's own self-interest is to stay with - or join - the crowd. It is a brave person indeed who defies a crowd. And when people are caught up in a swarm, they behave in uncharacteristic and sometimes destructive ways. The "madness of crowds" drives berserker behaviour.

Malign swarms are deliberately whipped up by powerful individuals in pursuit of their own self-interest: the most destructive form of malign swarm is imperialist expansion (think of the Golden Horde, for example). But some swarms are destructive without being malign. The transatlantic credit bubble was a case in point: it was not deliberately whipped up to bring down the financial system, but it very nearly did so anyway. Everyone was pursuing their own interest, but collectively, their own interest, far from being benign as Smith assumes, was highly destructive. We do not see the patterns of which we are part.....

We do not yet know what triggers human swarming behaviour, though research is continuing in this area. But whether a human swarm is benign or destructive is a matter of perception. We don't see the starling swarm as destructive, because we are not being eaten. But the insects that the starlings are eating might (correctly) see the murmuration as a terrifying destructive force that aims to wipe them out. Similarly, people in China don't fear their annual migration home for New Year, which is the largest movement of people on the planet: but people in the West fear the influx of migrants from war-torn Middle Eastern countries.

The swarms we fear are those we believe could destroy our means of survival or wipe us out. And we have reason for our fear. Humans are a swarming species, and swarms can be destructive. Even though individually we may only be looking for a better life, the "invisible hand" is capable of guiding us to destruction.

Related reading:

Here is why economics is built on a monumental mistake - Evonomics
The Invisible Hand is dead! - Evonomics
The Wealth of Nations - Adam Smith
The Theory of Moral Sentiments - Adam Smith
Twitter storms and the madness of crowds - FT

Thanks to Matt and AFP for the videos, and Evonomics for the header image. 

I have corrected the mistaken attribution of the quotations in an earlier version of this post. 








Tuesday, 21 February 2017

UK inflation and the oil price

Inflation is back.

Here is the change in the consumer price index (CPI) for January 2017, according to ONS:



Well, this doesn't look too serious. CPI is barely reaching the Bank of England's target of 2%. It has been much higher for most of the last decade, and yet the Bank of England has kept interest rates at historic lows.

But consumer price inflation - the prices that people pay for goods in the shops - is only one side of the equation. On the other side is producer price inflation (PPI), the prices that companies pay for the materials and energy they need to produce goods and services. The picture here is entirely different, as this table from ONS's January 2017 producer price inflation report shows:

Annualised producer price inflation has risen dramatically in the last six months. It reached double digits in October 2016 and currently stands at an astonishing 20.5%. Most of that is due to sharply rising import prices, of which by far the most important is crude oil, the price of which has risen by 82% in the last year. The dominance of oil imports in producer price inflation figures is evident from this chart:


Rising oil prices in the last year have added 9% to producer prices.

But inflation is a rate-of-change measure: it tells you how fast prices are rising, but not where they started from. Just over a year ago, we were looking at this chart:


In October 2015, ONS reported an entire year of double-digit deflation in producer prices, due to a 40% fall in the oil price and significant price falls in other imports:

So we could regard imports as simply returning to a more normal price level after the unwinding of the oil and commodities bubble. But what is a "normal price level"?

It turns out that import prices and the oil price are joined at the hip. So there is no such thing as a "normal price level" that ignores movements in oil prices. This chart shows producer price inflation since 2002:

And this chart shows the price of Brent crude since 2002:



Even just eyeballing these, the correlation is evident. For the whole of this century, the oil price has been the single biggest driver of producer price inflation in the UK. And judging by the CPI chart at the head of this post, it appears to be a significant driver of consumer price inflation too.

The other major driver of producer price inflation in the last 6 months has been the falling sterling exchange rate. Sterling is down by 13% against the US dollar. This explains the apparent divergence between the rate at which the oil price is rising and the rate at which inflation (PPI and CPI) is rising. Brent is quoted in US dollars per barrel, so its price in sterling is rising faster than its dollar price.

However, the rising oil price is evidently not being significantly passed through to consumer prices. A producer price rise of 20% is resulting in CPI of less than 2%. In fact the chart above shows that none of the swings in producer price inflation this century have been fully passed through to consumer prices - including the extraordinary speculative oil price spike just prior to the financial crisis and the QE-driven oil and commodity price bubble of 2010-14. Clearly, businesses have chosen to absorb the costs rather than passing them on to consumers. So where have the effects of these price rises been felt?

This is part of it:


Note the inflection point in 2007. For the next seven years, real wages fell, and they are still barely growing. Producer price inflation was not passed on to consumers - it was passed on to workers, in the form of wage growth that failed to keep up with consumer price rises.

Producer price inflation was also passed on in the form of poor productivity. Rising energy costs are particularly destructive to productivity, since rising productivity by definition increases energy usage. The picture is one of businesses trying to avoid passing costs on to consumers by restricting both wage growth and energy use. We would expect this to show up as lower output. And indeed, this is what we find:

 (source: ONS Gross Domestic Product time series January 2017)

UK output fell off a cliff in 2007, then tried to recover in 2009-10 but was clobbered by rising oil and commodity prices. I have previously observed that the UK in 2010-12 suffered double-digit inflation in energy prices, which in my view was the principal reason why the UK economy flatlined. If the QE-driven oil and commodity price bubble was the principal cause of the failure of the UK's recovery, then the prolonged use of QE by the US to restore its own economy has had terrible consequences for the UK. QE spillovers are known to be inflationary for emerging markets, but it seems that there was also an indirect inflationary effect in oil-dependent developed countries, which showed itself as stagnant output, poor productivity and flat wage growth.

If this is correct, then the falling oil price of the last two years has been the single biggest reason for the UK's improving output and wage growth. But now the oil price is rising and sterling is falling (which amplifies the depressing effect of the rising oil price on the UK economy). The little boom is over. If the oil price continues to rise, I expect wage growth to stall and output to flatline again. And if businesses do start to pass on these costs to consumers, then the Bank of England will additionally come under pressure to raise interest rates. This does not look promising to me.

However, the point of this post is not to remind everyone that my middle name is Cassandra. It is to highlight the critical dependence of the UK economy on the oil price, and to a lesser extent on imported commodities. The Bank of England's monetary policy is fairly effective at discouraging businesses from passing on import price rises to consumers. But we pay for this through inadequate wage growth, low productivity and poor output. Would it be better if businesses passed the costs on? Would significantly higher inflation in the medium-term be a reasonable price to pay for improved output and wage growth? Those who argue for a higher central bank inflation target are in effect saying that it would.

Of course, there are other moving parts in the productivity-wages-output puzzle. For example, I have not in this post discussed the effects of public sector wage freezes and the entry to the workforce of previously economically inactive people such as single mothers, sick & disabled and older women. And I have completely omitted the effect of damaged banks cutting back productive lending in order to repair their balance sheets. But the impact of the oil price on the economy is widely ignored, not least because the focus is entirely on consumer price inflation. Yes, a central bank can dampen the effect of oil price rises on consumer price inflation. But it cannot protect businesses from rising costs due to oil and commodity price rises. Perhaps, in future, we should pay far more attention to the direct effects of imported inflation on the supply side, rather than obsessing about consumer prices. After all, it is the supply side that ultimately drives economic growth and prosperity.

Related reading:

What derailed the UK recovery?
Inflation, deflation and QE
Inflation report, February 2017 - Bank of England