The BBC’s Evan Davis once again masterfully set the scene for the 2017 annual conference, looking at some of the economic challenges that have been faced over the past decade and are ongoing as central banks globally embark on a path of returning monetary policy to normal.

The first speaker introduced by Mr Davis was Pablo Hernandez de Cos, Director of Economics at Banco de Espana. Mr Hernandez de Cos began by considering the backdrop to the ECB’s exceptionally loose policy over recent years. Inflation and expectations for inflation had fallen in the euro area in 2015 while the IMF at the same time had expected weak growth relative to the US and UK. The ECB responded by lowering rates, expanding its balance sheet (to 20% of GDP) via credit and quantitative easing and providing forward guidance. Mr Hernandez de Cos discussed the transmission channels of portfolio rebalancing, the more traditional credit channel and signalling - and argued, in the Q&A, that it was the stock rather than the flow of QE that has the most important economic effect. It was estimated that the ECB’s decisions had reduced long term rates by 100bps in the euro area, with the impact on the currency having been sizeable too. But the impact on inflation expectations was seen to have been more muted.

Lower commercial bank interest rates for corporate and household loans had been seen across countries as a result, though growth of bank loans had varied depending on individual countries’ needs to delever. Corporate bond issuance had risen as yields had fallen. The negative effect of low rates on bank profits had in part been offset by rising credit volumes. All in all, Mr Hernandez de Cos believed the impact on the euro area economy of ECB measures had been sizeable, with the recovery now on track and broad based both geographically and across expenditure components of GDP (broadening from net exports to domestic demand). The tail risks of deflation had disappeared, though core and market based inflation expectations remain subdued thanks to low oil prices, weak productivity, structural reforms and continued “significant” labour market slack - despite the fall in the unemployment rate (which, it was argued, was far from a perfect measure of slack). While it was acknowledged that monetary policy had played a key role in supporting growth and inflation, it was concluded was that there was a “need for other economic policies to address the root causes of economic weakness and financial fragility in the euro area”.

Our second speaker was Gertjan Vlieghe, External member of the Bank of England’s MPC. His topic was the varying level of equilibrium real interest rates over time, arguing that the current low level was not unprecedented and that the 1980s period of high rates looked a more unusual period. His thesis is that economic growth per se is not the driver of equilibrium real rates. Rather, theory suggests that real rates should be inversely related to the volatility of economic growth. This is borne out in the data. UK real rates were notably higher during the gold standard than they were during the period off the gold standard since the 1930s. Yet during that latter period average economic growth rates were stronger. What explains the fall in real rates is the fattening of tails of real consumption growth during the second period. Indeed, a model of real risk free rates based growth volatility suggests that they should have been around 3% during the gold standard and just 1.8% on average in the non-gold standard period since. So the model can account for almost all of the fall in real rates that we have witnessed.

But there have been multiple periods during the non-gold standard years. Dr Vlieghe identifies four distinct periods for a regime-switching model: the 1910s, 1940s, 1970s and the latest decade. One key reason for fatter growth tails during these periods relates to increased levels of financial intermediation and higher private sector debt, which tend to end in financial crashes. In theory, a larger financial sector implies a more efficient allocation of resources, thereby limiting the scope for a boom to continue but amplifying potential crashes. Dr Vlieghe ended his speech by considering the current conjecture, arguing that deleveraging was no longer weighing on demand with the implication that real equilibrium rates should be rising. Deleveraging is not the only factor to consider, however, with demographics working to push equilibrium rates even lower. However, any rise in real rates was likely to be modest and the absolute level of real rates was likely to remain low. The moment at which official interest rates might need to rise appeared to be approaching with pay growth stronger, more upward pressure on inflation likely and consumption having held up better than expected. While it was questionable how long these trends might last, a rate hike might be appropriate in the coming months.

The third speaker at this year’s conference was HSBC’s Senior Economic Advisor Stephen King. The topic of his talk centred around his book Grave New World. In it Mr King argues that there are times that there are risks of the process of globalisation going into reverse, such as currently. He begins by stating that western globalisation began in 1492 with discovery of America, and that peak enthusiasm for globalisation was reached in 1989 - coinciding with the fall of Berlin Wall and the publication of Fukuyama’s The End of History - an essay in which it was argued western democracy and capitalism would spread, and that authoritarian regimes would collapse.
Populist regimes haven’t retreated, however - think Putin, Erdogan, Xi, Trump and Duterte, for example.

There have been increased tensions in relation to inequality: within nations, between nations and regionally, thanks to failures in basic education and the absence of social mobility - among other reasons. But these truths are masked by a political narrative about unfair competition or inward migration. At the time of the Bretton Woods negotiations in the 1940s it was understood that dissolving borders and encouraging interdependence would be more advantageous than the separation and isolationism that existed during the world wars. Technology can be a force for greater integration (computing, for example) but also disintegration (nuclear weapons, for example).

Mr King asks us to imagine that the US were to be split into independent states. The rich state of Massachusetts, for example, would then be unlikely willing to continue making fiscal transfers - as it effectively does now within the United States - to the poorer state of Mississippi. He points out that globalisation has caused large rises in cross border capital flows and that a global organisation for financial flows should be established whose job it would be to determine - in the event of a default - how the blame (and therefore financial loss) should be shared. He expects there to be a sizeable shift in economic and political power eastwards and equates the three empires in George Orwell’s 1984 with the US, China and Russia. As for Europe - for all its internal challenges there is one big external challenge
- does its future lie with with an increasingly isolationist west or and expansionist east?

The FT’s economics editor Chris Giles was the penultimate speaker whose speech outlined four dilemmas.

1) What has changed since the Brexit vote? Mr Giles discussed the most recent Bank of England policy statement which noted that monetary policy cannot deal with the fall in real incomes that the Brexit-related fall in sterling had caused. He talked of the difference in press interpretation of the latest labour market figures in the context of Brexit: some commentary focused on rising employment at the expense of weak earnings, whereas others focused on falling real wages. UK economic growth, it was argued, had not been strong nor had it been terrible. Still, UK growth had dropped to the lower end of the G7 spectrum of growth rates recently. He also noted that the Bank of England had, since the Brexit vote, revised down its 3-year-ahead view on growth which Mr Giles argued might be a good proxy for the Bank’s view of long run growth (1.75%). The OBR’s view was similar at around 2%.

2) Mr Giles’ second dilemma a related to what economists should cheer. He suggested that it was no coincidence that weaker economic news had led the government to backtrack on Brexit brinkmanship and shift towards compromise.
His conclusion? That patriotic economists who want the best outcome for the Brexit negotiations should talk the economy down.

3) how fast can the UK economy grow? One particular concern was that echoed by the OBR - that the fiscal impact from even small changes in trend growth on fiscal outturns could be sizeable over the long term. Mr Giles’ concern is that the OBR has been persistently over-optimistic on productivity and that the risks, therefore, were for slower potential growth.

4) Why should we listen to the Bank of England? It was argued that the Bank has little idea of what generates inflation and that the Bank could have a credibility issue - particularly with its guidance over recent years.

The final speaker of the day was Diane Coyle (University of Manchester) on the topic of measurement issues related to GDP. Professor Coyle began by noting that some - the OECD for example - do not believe there are any serious measurement problems with GDP, while a Brookings paper published last year argued that even if intangibles and hedonic adjustment of information technology is undertaken correctly it would make little difference to the productivity puzzle (in fact their measurement makes the puzzle worse).

Ms Coyle described three major measurement problems with GDP. First, the production boundary. In other words, some typically household-produced goods and services are increasingly being provided by the market, the switch flattering GDP. Moreover, digitisation of the economy is leading to the reverse - households switching from doing transactions on the high street to at home (think of booking travel, insurance, online banking etc all of which reduce the need for a bricks and mortar intermediary). Second, the sharing economy. Consider doing a “home swap” rather than booking a hotel for your next holiday. While it is questionable how quickly the sharing economy might continue to expand, it is also questionable whether the lower price implications of such activities are truly being captured in the price indices. Third was the issue of voluntary digital production. This includes free entertainment such as YouTube, open source software such as R and Python in the world of statistics and programming, and medical devices/solutions (such as the far cheaper method of the 3D printing of prosthetic limbs) - to name but a few. All of this may require a rethink about the production boundary - which is becoming increasingly fuzzy - and how to use a comparable price index for the purposes of deflation.

Then there are issues related to the ‘servisation’ of the economy - typical manufacturers undertaking more services output, such as an increasing portion of Rolls Royce sales being the monitoring rather than just manufacture of engines. Consider too the intellectual property that becomes the blueprint for a new product being manufactured overseas - the IP may not be fully recorded in GDP but the overseas manufacture and import of the final product will be. Think also of all the products that are being provided as part of a package when you buy other goods - standalone watches and diaries have become less necessary now smartphones include such digital functionality. Ms Coyle concluded by noting that a more appropriate measure of the telecommunications deflator could add a full percentage point to GDP over a five year horizon - thus such measurement issues could have important ramifications for recorded output and policy.

George Buckley, SBE Council.

 

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