A Decade of Bizarre UK Economic Policy

If you want to beat the markets, the old adage of "buy low, sell high" is not a bad place to start. To sum up a decade of Conservative economic thinking, they appear to have gone for "sell low, buy high".

The conservative party under Cameron ran the 2010 election on the idea that Labour crashed the economy. The idea was that Labour had spent too much which led to unsustainable levels of debt. Although it was somewhat true that the debt to GDP ratio crept upwards during the New Labour years, the biggest jump occurred during the bail out of the banks as a result to a sub-prime mortgage crisis which started within the US.

"The spent too much" part is debateable and depends a lot on your politics, the "crashed the economy" part was a lie. Blaming the previous government for economic woes is nothing new. New Labour frequently referred to previous conservative government as "the boom and bust years".

Cameron's soundbite was appealing to responsible voters everywhere: we all know someone who is bad with money, gets into lots of debt and struggles to pay bills. I vaguely remember Sky news running a ticker of government debt writing it out in its full 1,500,0000,000 or whatever. 

There was a view at time that the UK could end up like Greece, which was going through a crisis of its own due to lying about the levels of government debt. In reality, this was an existential crisis of the Eurozone: why should Germany bail out the Greeks? Eventually the European central bank would step in to help Greece. But the idea that the Bank of England would not immediately be the lender of last resort to the UK was as absurd then as it is now.

In normal times, the economy is "managed" by the Bank of England who set interest rates. For example, increasing rates when inflation is high, decreases demand in the economy which should help lower prices. 

The huge recession that followed the financial crisis led to rates at extremely low levels to try and increase demand within the economy. The problem thought was that it is difficult to decrease rates lower than zero. There was, however, another way we could have increased demand in the economy...government spending.

Now many people will have certain moral and political views about austerity. From an economics point of view, austerity is simply a way for governments to reduce their budget deficits. It is now, for better or worse, associated with spending cuts. But tax rises would have the same effect. Either way, you are taking money out of the economy which will reduce demand.

So at time when demand was very low, the Cameron government decided to pursue austerity which took demand out of the economy. The rate at which the government could borrow at was extremely cheap and economic orthodoxy* would say it would have been a good time for the government to spend. Now, this "spending" didn't have to come through investment. It could have been tax cuts!

Then there was Brexit.

Brexit is a tricky one because in terms of the economic impact of Brexit, the consensus was clearly it would make the UK poorer. But economics is not just about incomes, it's also about preferences. If people were willing to trade-off sovereignty for income then so be it.

Fast forward to the present day and we are faced with a different situation. Inflation is high and the Bank of England has raised rates at the fastest we have seen for 30 years. Interest rates are no longer at zero and the debt to GDP is near 100%. 

Whether the high levels of government debt is a concern or not all depends on whether lenders think the path of debt is sustainable. There is no optimal level of debt as such but the general consensus is that it should come down. How fast this process needs to be is again something up for debate.

Truss has argued that the only way out of this mess is growth. In order to repay back the debt we need the economy to grow so we get more tax receipts and pay down the debt. This requires a bit more steps in logic from voter. It is also a complete shift in what they were told by the Cameron government 10 years earlier. It does, however, happen to be true.

Truss has gone about seeking this growth through tax cuts. Now one would think that tax cuts would simply add to demand and thus add to inflationary pressures that the UK is already seeing. But her argument is that these tax cuts increase supply. These supply-side measures are meant not only to grow the economy but also reduce the price. If you magically found a way to increase the amount of apples that would grow on trees, we would have more apples at lower prices.

The difficult here is that not many people actually believe these tax cuts will increase growth as the evidence for them is weak. Even if you an ardent supply-side supporter, will these tax cuts translate into the large increases of growth needed? I very much doubt it.

This is possibly why the markets have reacted badly to the budget - the tax cuts will do little and lead the government on an unsustainable path of debt. 

There is a case (from an economic management perspective) that it would have been much better if Cameron and Truss would have swapped places. Rather than "buy high, sell low" it would have been a lot better if we "bought low and sold high". Which is why I find the whole thing utterly bizarre. 

*I know there is some debate here over economic "orthodoxy" as some economists in the profession were concerned about debt levels. 

Vibes vs Size: Bacon, Lightbulbs and £15,000,000

Last week I was amazed to read an article in the Guardian which talked about a pub "cutting energy costs" by switching off their lights and using candles instead. Throughout the article there was absolutely no mention of the fact that this could save the pub probably no more than 1-10p (without even factoring in cost of candles). 

Why is it not well known that lightbulbs, especially LED lightbulbs, don't actually consume that much energy?* 

I recently ran a couple of workshops on statistical literacy and science communication with people from different academic backgrounds and one thing that came up was effect size.** 

When people read in the newspaper, about say bacon being linked to cancer, what do people actually do with this information? Do they eat less bacon as a result? Because even if bacon is linked to cancer, you have to eat an awful lot of bacon for there to even be a small risk and it still won't get anywhere near to the effect size of smoking.***

So one theory we came up with is that people essentially just work off vibes. That is, in order to understand the world they categorise things into simple "good" thing or bad" thing. Seeing the world this way is much simpler and easy to remember than effect sizes. We all doit. There are just so many things in the world we have to remember so we have to find some simple heuristics to help us.

For example: Fruit, fish, red meat, vegetables. I am pretty sure in your head you already categories these things into "good" and "bad". 

If you have ever been on a diet, counting calories is a real pain. To do it properly you have to not only look up the calories of each ingredient but weigh them out. This is why people often use a simple good/bad heuristic to make decision when they are on a diet. Fruit and vegetables are "good" so people on diets eat lots of them, even if that fruit is orange juice (which can have more calories than coke). 

If you think this is easy and it's just that people are stupid, how many calories would you say are in a large Domino's garlic and herb dip? And even if it is easy for you to quantify and remember effect sizes, for a large population it isn't. The thing that often happens in these sorts of situations is that the people who find it easy just say "look, it's easy" and think the people who find it hard will magically find it easy too.

This is why we need to think of ways to make heuristics as easy as possible based on the way people actually behave rather than trying to change the way they behave. If people work off vibes, then maybe think about the vibe that will be most effective. Tom Forth suggested electric things that get hot use a lot energy which is not a bad vibe to put out.

It would be good therefore if the government were to put out some simple heuristics so people would have a good grasp of effect sizes. But as my showbiz cousin pointed out, the government seemingly don't understand effect sizes themselves if it thinks £15 million is a huge amount of money to spend on an energy saving campaign (it is the equivalent of 0.0025% of the energy bills bail out). 

So in short: if people make decision based on vibes rather than size, we need to find the vibes that reflect the size.

*When you point this out to people they say "Yes, but every little helps". It is quite difficult to change someone's mind on this. To them doing a bit of good is better than doing no good at all, which is true. But in reality, it is just cope to make themselves feel better about putting on the heating rather than wearing a sweater. People like to feel good about themselves and you are just pissing on their chips.

** I think the lack of attention to effect sizes is partly down to academia. We are so concerned with establish correlation and causation that we forget the most important thing to people is often effect size. 

***I actually know someone who became a vegan for health reason and still smoked!

Why did the £ drop to its lowest ever level against the dollar?

Right, I am not going to lie. To understand what happened last week is extremely difficult to explain as you need to understand a few things before we even get to fully understand what happened. By a few things, I mean you would have to learn half of my 2nd year economics undergrad course and even then it would be hard going.

Firstly, I think it is helpful to read about how interest rates are used to control the economy, managing the trade off between inflation and unemployment. 

I then think it would be useful to understand what quantitative easing is  and money creation in general but not as important. 

These two things are hard enough as it is, before we get to the world of exchange rates and gilts.

Why do exchange rates move around in the first place? Well an exchange rate is simply the amount of one currency you would exchange for another. So at it's lowest last week, £1 would at point get you around $1.04. We tend to usually pay attention to this when we go on holiday. But primarily the exchange rate is important for trade and investment, it also works a lot like any other good.

Let's say pork pies become the must have global item and NY fashion models are demanding them on their riders along with champagne and caviar. As demand rises for pork pies from the US, they obviously can't pay the good people of Melton Mowbray in dollars, so they need to obtain pounds in order to pay for their gelatinous treat. As there is a fixed supply of pounds circulating, this leads to an increase in the price of the pound to dollars, this price is what we call the exchange rate.

What effects exchange rates frequently is interest rates. If the UK decided to raise interest rates, then people from abroad would want to take advantage of this higher rate and buy government bonds. There would be a demand for pounds which would increase the exchange rate and strengthen the pound. 

In the UK, we call government bonds "gilts" (as a result of the paper contracts having a gilded edge, apparently). These usually work a lot like the fixed-term bonds you can take out with your bank. The longer the bond, the higher the interest rate you would get. The "yield spread" is an important indicator. It measures the pay-out difference between short-term bonds and long term-bonds. A higher spread indicates the investors are more concerned about the economy in the long-run, and makes it more expensive for the government to borrow.

Now some investors will want to buy and sell currency to take advantage of small differences in price. Let's say it was suddenly announced that unemployment in the US was lower than expected, immediately the dollar would rise. The reason being is that investors think it is more likely that interest rates will rise as a result (you should now understand this if you read the first link in this blog) and people from the UK will buy US government bonds.

But why don't investors just simply wait until the Federal Reserve (the name of the US central bank) actually announce an increase in rates? Well, this is because you can lose out.

Lets say the exchange rate of pounds to dollars is 1.20. We expect the pound would get weaker against the dollar if there were a rise in interest rates in the US. As demand for dollars rises, we may think the exchange rate will end up around 1.10 in the future. So if I buy it now, I get a better deal. I can get 10 cents more for every £ I buy then if I waited (I am buying at 1.20 then 1.10). But because all investors have the same idea, the exchange rate moves extremely quickly to this new exchange rate. This is because the faster you act, the better deal you can get as you can buy closer to the old exchange rate! This process is known as arbitrage. 

Now of course this is just an expectation of the way, things work. It could turn out that interest rate rises don't actually happen in the US for various reason. The point is, these currency markets take into account future information as there is money to be made. When someone says something in the future is "price in", it means markets have already taken account of this and it is reflected in the price.

So why did the pound fall to the dollar in late September 2022? Well, trying to explain movements in the market is something we should be not overly confident about. It is quite complex to unravel everything even if the narrative sounds plausible. The first thing to note, that in the US interest rates are high and increasing, so there is already a lot of demand for dollars. 

In the UK, the trajectory of interest rates also seems high. But should this not increase demand for pounds? What's more, when the chancellor announced his new tax plans wouldn't that also add a stimulus leading to inflation, hence making it more likely interest rates would increase. Wouldn't this make the pound stronger? The simple answer is, yes. This is what we should expect. However, the markets may have been concerned that these tax cuts were unsustainable as they would be paid for by borrowing. 

This is something that George Osborne was worried about and subsequently imposed spending cuts as a result. (Although the macroeconomic conditions were very different 10 years ago  - interest rates were extremely low to the extent it was causing a problem called the zero lower bound. Oddly this resulted in not borrowing when rates were low 10 years ago and borrowing when rates are high now. Yes, this is as bad as it sounds.).

When debt is sufficiently high (and I am not sure we know how high really), markets worry that inflation will happen as a result and hence your returns are not as good, so many investors start selling off UK bonds which makes the pound weaker. 

There is a strong possibility that this is what happened to the UK. This is something that usually happens in the emerging markets when governments make unfunded fiscal promises. This perhaps wasn't helped by the governments derision of independent bodies like the Bank of England or the OBR. 

The government, however, disagree. They suggest their tax cuts are not inflationary (as in just increase demand) as they are designed to increase supply. If you increase the supply of something, you not only increase output, but you also lower the price. So supply-side policies will actually help with inflation as well as debt. This is because the economy will grow and you get more tax returns as a result. This why the government are so concerned with growth.

I actually think being concerned about growth and not just debt is a welcome move. However, I am somewhat sceptical that these can come from the tax cuts proposed, which I am also guessing the market also thought as well. I don't think they are evil or doing for their mates in the city (I wish I had friends like this). I think the government are genuine believers in supply-side logic, even if you think it is a totally mad thing to believe in.

If you have got to this point, well done. You can be rewarded by now trying to work out what happened with the pensions market, and why the Bank of England had to step in. Now, many people will say the Bank of England did QE in order to stabilise the market, but I think this is unhelpful. Especially because the Bank of England of course want to do the opposite at the moment, lower demand to control inflation. Yes, they did create money out of thin air but this is not really to increase demand. It was essentially to increase liquidity as the lender of last resort.

Liquidity is all about time. If you go to the shop and find out you have no money, you can't say to the shopkeep that you own a house so you are good for the money. You need cash to pay for it. So a liquidity problem is not necessarily about whether someone can afford it, but whether they have enough time to sell assets in something they can move on quickly like money. The more liquid something is, the more freely it moves (hence the name).

Now I must admit that I actually had no idea why the pension markets was going crazy. Higher interest rates should be good, as a lot of pensions invest in government bonds. The problem, as far as I understand it, was that pension investors "hedged" against interest rates rising so quickly. A hedge is a way of insuring yourself against something happening, hence the phrase hedging your bets. For reasons, I am not au fait with (finance is boring), this created a liquidity problem. If the Bank of England failed to act, a financial crisis was well on the cards and deep recession would follow.

Anyway, I hope this blog has made things a little clearer. But I can totally understand if you want to never think about these things ever again.