Barack Obama was making sure he heeded Churchill’s advice to ‘never let a good crisis go to waste.’

January 2015

Health & Efficiency

 

A friend of about twenty years surprised me with a confession recently. We’ve played rugby together, got drunk together, laughed until we couldn’t breathe and generally done some really stupid things together. I thought I knew pretty much all there was to know about him. Then, as he cradled his pint, his eyes avoiding contact, he told me of his secret other life.

Apparently, it was something he didn’t really discuss with his family but on Fridays he would meet with a group of men in the heart of the countryside where they would, well, play together. It was hard to accept but he was a closet War Gamer. It turns out he’s been one for years and has a garage full of meticulously painted miniature armies that would be carefully laid out on baize landscapes in draughty village halls, re-running great historical conflicts.

I thought it sounded quite fun but equally I could sort of understand why he had kept his hobby to himself. More so than in most environments, a rugby club can be remorseless when it comes to leg-pulling if you’ve been foolish enough to give them any ammunition. Safest course of action is to follow a ‘need to know’ protocol. I’m guessing there’s not many trainspotting rugby players…

Even worthy pursuits can be targets for unfair stereotyping. Carlyle disparaged Economics as the ‘dismal science’; that the phrase appears to be the sole survivor in the public consciousness of a somewhat dubious discourse on the virtues of reintroducing slavery suggests it continues to reflect a generally held perception. 

It seems a bit harsh. I can see that the economist’s preoccupation with reducing the world to a series of mathematical models is unlikely to make him many friends at parties but it is possibly an unshakable belief in mean reversion that really makes them party-poopers. If things are going well it will be the economist who is shaking his head and muttering that it will be only a matter of time before it all goes pear-shaped. In Dad’s Army, Fraser may have been an undertaker but he had the perfect temperament for an economist.

So while the rest of the world looks at the housing market and claims it is not overpriced by reference to ‘affordablity’ (conveniently ignoring the temporary central bank market manipulation that has led to ultra-low interest rates) economists look at the longer-term ratio between house prices and earnings, fret about the dissonance between rising house prices and falling real incomes and look on with open-mouthed disbelief when the Government introduces policies that seem designed to boost house prices further. But suggesting a housing market correction is an increasing possibility wins you few friends and tends to make you seem a bit, well, dismal.

Mean reversion was the implied core of a chat I had with a client just before Christmas. He studied economics at Oxford so, ignoring the fact he is obviously a lot cleverer than me, we look at the world from a common starting point. He had noticed that for many years the value of the UK FTSE100 index was half that of the US Dow Jones index but in recent years it had slipped to around a third of the value. Mean reversion would suggest that over time the historical relationship would be restored, which would require either a significant fall in the US market (and one not also experienced in the UK) or a period of significant outperformance in the UK market. Both scenarios seemed unlikely.

I ran some numbers on what I’ll call ‘Tony’s Rule’. As you can see from the chart below it works pretty well.

 

Although the US market is dollar denominated and UK market sterling denominated currency fluctuations have relatively little impact overall – at the turn of the millennium a pound would have bought you $1.61 by the end of 2014 this had fallen just five cents to $1.56.

If we go back thirty years the two indices were pretty much equal -1286 vs 1281 and, although the US index drew slightly ahead of its UK counterpart, they were closely correlated until the dot com bubble of 2000 which saw a relatively larger correction in the UK. It was around this point that Tony’s Rule kicked in and it is remarkable just how well it holds especially in the lead up to and initial exit from the financial crisis. However, something goes awry around four years ago. The previous close correlation between the two markets is lost with US powering ahead while the UK is left floundering.

Is this simply a temporary setback or a fundamental shift in the long-term relationship between the two markets? The accepted wisdom is that the FTSE100 index is to a large degree sheltered from the UK domestic economy because most of the earnings of the constituent companies are generated overseas. Given the multi-national nature of the largest US companies it would be reasonable to apply the same logic there too. So what is driving the parting of the ways between the two markets?   I suppose the first thing to stress is that correlation does not prove causality but ….

For almost all of the last thirty years the US and the UK have followed broadly similar economic policies – until the arrival of the Coalition Government in the UK in 2010. While George Osborne was convincing us that Austerity was the only responsible way forward, Barack Obama was making sure he heeded Churchill’s advice to ‘never let a good crisis go to waste.’ Obama’s response to the financial crisis was bold, brave but most importantly economically coherent - The American Recovery and Reinvestment Act, a $800bn Keynsian fiscal stimulus, funded by increased Government borrowing. Political pragmatism meant the value of the stimulus package was lower than ideal but was the maximum deliverable. With the benefit of hindsight it is easy to say that some of the money was not wisely spent but a depression was avoided and overall the US emerges from the crisis with better infrastructure, a better educated workforce and a real competitive advantage in green energy. 

The contrast with the UK has been remarkable. Far from buckling under the weight of its additional debt the US has seen its deficit reduce from an eye-watering $1.4tn in the final year of the Bush administration to just $483bn in the 2014 fiscal year. Meanwhile, the UK (with an economy less than a sixth of the size of the US) projects its deficit to hit $150bn (£97bn) in 2014/15 and however the Coalition decides to spin its own deficit reduction, it is paltry in comparison.

So, surely all Obama’s additional public spending would have led to bloated inefficiency? Well, no, not really. US productivity has continued to improve on the back of the confidence the stimulus helped foster. Production depends on the application of two factors – labour and capital. In the short run it is easier, quicker and cheaper to increase labour in response to greater demand. If you need more holes dug, employ more men with shovels. However, if you are confident that the demand for holes is going to continue to be strong it makes sense to use some of your capital to buy a JCB and the productivity of the one man driving the digger will be hugely greater than even a gang of men with shovels.

In the US capital investment, in part via the stimulus package, has been reasonably strong. In the UK the growth in looser working arrangements and self-employment has created a flexible labour market that may be helpful in the short-run but creates a disincentive for the capital investment that would lead to long-run productivity improvements. This has been exacerbated by a squeeze on infrastructure spending that leaves us less able produce efficiently. As a result we have seen UK productivity fall to 17% below the G7 average with little obvious policy intervention to improve the situation.

Real earnings will not improve until per capita GDP (the total output of the economy divided by the population) increases but, according to figures produced by the IMF, it languishes at a lower level than even accepted basket-cases like France (see chart below) and well behind the nations we would prefer to see as our peers such as the US and Germany. It is small consolation to find we sit above Italy – unlike us they’ve got the food and weather to help them forget their troubles.

Unfortunately, Obama has found to his cost, like Churchill before him, that having the right policy at the right time does not in any way guarantee you gratitude from the voters. As Edward Luce said in his piece for the FT on the fifth anniversary of the stimulus  Rarely has the gap between the US public’s perception and that of economists been greater….Almost all economists say it was essential. Some believe it was too small. Others that it was too large. Some say it should have been skewed towards more direct spending, others towards larger tax cuts. But virtually no accredited scholar doubts a measure that saved 9m jobs, added between 2 and 3 percentage points to US gross domestic product and paid for itself in higher tax revenues. On economic grounds it is as close to an open and shut case as you get’. 

In the UK the Labour party has an uphill battle to change perceptions. That the spike in the deficit in the wake of the financial crisis was more down to a collapse in corporate tax revenues than profligate overspending is irrelevant – the mantle of fiscal irresponsibility sits well on their shoulders and is proving hard to shake off.

Which is a shame if only because it means the Coalition policy of ever-increasing cuts appears to be seen as the only sensible way forward when the US experience could suggest otherwise.


This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The information in this newsletter was correct as at Jan 23, 2015 but may not apply at the time of reading.

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