Author: marshallideas

The great British economic rollercoaster (and how to derail it)

credit-suisse-heres-just-how-disastrous-a-brexit-could-be-for-the-uk-economy
Source: Credit Suisse & Business Insider

The two main challenges facing the UK economy at the start of 2017 are the much trumped-up uncertainties of Brexit and the imminent interest-rate divergence across the rich world. The intricacies and complexities of the Brexit process have the potential to upend quite a few givens in the well-oiled machine of the British economy and create many uncertainties as to the role of the United Kingdom in the wider European and world economies. The main talking points have been waning investor confidence, threatened export potential (somewhat alleviated by the commitment of behemoths Nissan and Google to expanding their activities in the UK), and the value of the British pound.

Bank angles and centrifugal forces

A dilemma that the Bank of England, which has been a favourite punching bag for populists and political opportunists of all kinds and political spectra might have to face in the coming months is whether to increase its base interest rate to defend the pound and prevent inflation at the price of pushing the economy towards recession, or to keep rates low and let inflation run its course and even cross the hallowed 2% per annum.  For now, the indications given by Mark Carney is that the Bank is not ready to endanger the carefully nurtured recovery of the British economy in the name pushing down inflation, whose stubborn bottom-scratching has been the main source of headaches for central bankers in the past decade.

Whilst China was considered the main risk for the world economy at the beginning of 2016, as its slowing economy and bubbly property markets were causing concerns of an imminent meltdown, investors have largely been assuaged that the Chinese government still has the capacity and the willingness to defend the status quo. Major risks have thus shifted from emerging markets to the big Trumpian and Brexitarian question marks in the West. The dangers lingering in the background are the French, German, and Italian elections looming in 2017, which in a worst-case scenario can see Italy and France staging a referendum to leave the Eurozone, which could spell its collapse, with tectonic consequences for European economies. They, just like Britain, will find out that tying the knot is much easier than untying it.

The rich are getting richer and the rich are getting poorer

The second main challenge is related to the divergence in the recovery dynamics of rich-world economies in the aftermath of the Great Recession. The US economy, thanks in part to the decisive actions of the Obama administration and the monetary weight-lifting of the Federal Reserve, has performed well, created jobs, and exhibited rude growth rates in the interval of 2% to 3% per annum. This has warranted the recent decision of the Federal Reserve to restart the gradual process of monetary tightening, begun at the end of 2015 but delayed by perceived market turmoil.  Whilst the UK had for some time been exhibiting similar robustness, Brexit has the potential to jeopardise that and lay bare structural weaknesses such as the abysmal growth of productivity in recent years and high private-sector indebtedness. The Eurozone and Japan, the traditional anaemic patients, have forced their central banks to stay the course of low-interest rates and experiment with unprecedented instruments designed to lift demand out of its almost chronic torpor.

klein-austerity

Source: The Brookings Institute

This divergence in recovery trends might cause instability in the global financial system as the dollar strengthens against other currencies despite the substantial current account deficit of the US. In those conditions, the role of the Bank of England, the European Central Bank, and the Bank of Japan might be constrained by the requirement to protect their ward economies against inflation without knocking out the still fragile patient into a new recession. The compromise between preventing another slump and keeping prices at bay will be finer than ever.

Donald Trump’s Economic Policy Agenda, or Can You Stimulate by Protecting?

donald-trump

Economist-in-Chief

 

The American elections were supposed to decrease uncertainty and allow markets to put one of the nastiest and most polarising election seasons in living memory behind. Donald Trump’s victory, which became an irrefutable fact by 6am GMT on November 9th, has all but made that uncertainty chronic. Trump’s economic plan, with its rather haphazard pre-election sketch, is more of a wishlist than a detailed economic policy roadmap. However, putting meat on the bones of the plan will be a key part of the transition period until Trump’s inauguration and could either herald an economic renaissance, or transpire into a terrible disappointment.

The Donald and the past

Throughout his campaign, Trump has taken the position that the economic policies of the Obama administration had failed in bringing about the Promised Land of recovery. Whilst achieving a growth rate of 1.5%-2% after the most severe economic crisis since the Great Depression is no small feat, for Trump and his advisors this is not nearly good enough. US policymakers and the Obama administration have followed the monetarist dictum of decreasing the budget deficit and using monetary policy tools to reflate the economy. Donald Trump has criticised the independent Federal Reserve, voicing the views of many hawkish conservative analysts who believe low interest rates distort incentives, inflate bubbles in non-productive asset markets, and punish frugality by diminishing returns on savings. Whilst it is highly unlikely that Janet Yellen, the current governor of the Fed, will leave before her term ends in 2018, Trump might try to replace her with a more hawkish policymaker who might be willing to risk a recession but return monetary policy to normality.

The trump card

Trump’s strongest economic idea seem to be his proposal of massive new spending on infrasstructure projects, coupled with a sbstantial decrease in corporate taxation. The United States have for years been suffering from chronic underinvestment in infrastructure, a problem that has long been recognised but not resolved by presidential administration, including that of Obama which was forced to work with an uncooperative Senate.

Apart from infrastructure spending, Trump has promised tax cuts for individuals and a decrease of corporate taxes from 35% to only 15%. He has also promised to cut red tape, especially post-crisis legislation such as the Dodd-Frank Act, that according to him are chasing businesses away from the US and stalling job creation.

Economists have been anxious that Trump’s spending stimulus and tax cuts would increase the national debt by more than $5 trillion, whilst pushing up inflation. Indeed, GDP growth figures of 4% to 5%, which Trump has promised as an answer to the supposedly negative comparison with China, which is growing at more than 6%, could not realistically be achieved without the government’s helping hand, whose borrowing will almost certainly stoke inflation. Whilst the Fed can act to parry inflation by hiking up interests rate, the chronic issue of the America public debt will only be exacerbated. If Trump’s rhetoric on China translates into similarly-minded policies, a trade war with China could be sparked, which will affect the American economy’s growth in the medium term.

Paving the road to hell

Trump’s economic success crucially depends on the assumption that his expansionary fiscal policies will spark growth which will be sufficient to increase the tax base and not necessitate any extreme levels of borrowing.

Markets initially reacted with shock and dismay as news of  Trump’s win circed the globe. However, given the chance to digest Trump’s policies with the hope that the most etxreme ones will be checked by a mature and experienced team of advisors, the US stock market recovered, reaching an all-time high on November 9th. Copper prices, which is used as a benchmark by many investors for its predictive abilities, incresed by as much as 3 percent.

Make the world small again

Although Trump’s impact on the American economy could be viewed with cautious optimism, his impact on developing markets and trade is highly uncertain and hinges critically upon the extent to which Trump’s policy will match his protectionist rhetoric. In an ominous sign of what lies ahead, the Mexican peso tumbled by 15% the morning after the election. Oil prices fell to a monthly low on the same day, reflecting fears about global demand spurred by hypothetical American’s protectionism.

Donald Trump comes to the Presidency with the profound chance and opportunity to upend the secular stagnation trends reigning supreme since the Great Recession. However, it seems that success can only come by very narrowly avoiding stagflation, trade wars, a new setback to globalisation that has already been battered by Brexit, the travails of the Eurozone, Russian sanctions, and the politcal backlash against liberalism.

The emancipation of the mind

Some of you may be wondering why we choose to study the evolution of economic thought. Is it just out of sheer interest? Or are there deeper reasons? John Maynard Keynes, one of the most highly-regarded economists of our time, said it best.

“A study of the history of opinion is a necessary preliminary to the emancipation of the mind.”

That is to say, without knowledge of the history of economics, we cannot even begin to understand contemporary economics or its relation to modern-day policy. It is for that reason that we are inviting a number of distinguished guests to speak about this very topic at the Marshall Society Annual Conference.

Picture1.jpg

The award-winning labour economist

One of our most renowned speakers is Sir Chris Pissarides. Now a professor at the LSE, his most impressive accolade was being awarded the 2010 Nobel Prize in Economics along with two other labour economists, for their work on search theory in the labour market.

His vital contribution was developing a concept called the matching function whereby the number of vacancies in the labour market was modelled as a function of the number of unemployed, incorporating factors such as the degree of incomplete information, government policies, and external shocks to the market. In fact, it proved crucial when it came to understanding the movements of the labour market in the aftermath of the Great Recession;  as the economy came out of recession, although unemployment fell in tandem with a rise in job vacancies, the economy did not recover as quickly as expected as the Beveridge curve looped out to the right, as shown below. 

However, his work did not just improve the policymakers’ understanding of the labour market, his work actively helped to shape policy. The DMP model, named after the three Nobel Prize winners, explains that policies designed to protect workers from unemployment may have the effect of reinforcing unemployment. By making it harder to dismiss workers so as to reduce job destruction, it also depresses job creation and makes for a less dynamic labour market with a higher average duration of unemployment.

With the Nobel Prize being awarded in a year when American and European unemployment were at their zenith following the Great Recession, the award to Pissarides and his colleagues was well-deserved.

Picture3.png

The ObamaCare architect

Not to be outdone however, is Jonathan Gruber. Named as one of the Top 25 Most Innovative and Practical Thinkers of Our Time” by Slate Magazine in 2011, the MIT professor has been played a big part in helping to write the Affordable Care Act, something that he himself called “the single most important piece of government legislation perhaps since World War II”.

Having spent decades modelling the intricacies of the health-care ecosystem and building up his reputation in health economics, he worked as a technical consultant to the Obama Administration in 2009-10 and worked with both the administration and U.S. Congress to help craft the Patient Protection and Affordable Care Act. Despite being highly controversial, the ObamaCare act has survived several repeal attempts and has been noted for its effect in reducing the uninsured rate in the US.

The guardian of the financial system

Knighted for his services to central banking, Sir Paul Tucker has spent most of his life staving off financial crises and ensuring financial stability. With 33 years of experience at the Bank of England, he has always had his finger on the British economy’s pulse.

In particular, he received great praise for his role as Executive Director for Markets during the financial crisis of 2007-8 when he led the charge in urging the central bank to provide emergency lending to help shore up liquidity shortages in the banking system. This resulted in the creation of the Special Liquidity Scheme under which the Bank of England lent £185bn of Treasury bills to 32 UK banks and building societies, and was subsequently dubbed as ‘the single most successful crisis response deployed in the U.K’ by the Wall Street Journal.

Having left his role as Deputy Governor of the Bank of England for Financial Stability in 2013, just under a month ago, he took on a new job as chair of the Systemic Risk Council. An independent organisation that monitors and encourages regulatory reform to help mitigate systemic risk across global capital markets, it further demonstrates his commitment to safeguarding the stability of the global financial system.

The happiness expert

Also an expert in the field of labour economics is Professor Richard Layard. As a Programme Director at the LSE’s Centre for Economic Performance, he has been responsible for exploring the causes of happiness.

On top of regularly co-editing the Annual Happiness Reports, he and his colleagues on the Wellbeing research programme released a highly controversial paper in 2014, looking into what leads people to be satisfied with their life. Despite the traditional wisdom being that academic achievement as a child or income are critical to achieving happiness later in life, the paper stressed the importance of one’s “emotional health”. In fact, the paper completely dismisses the importance of income as it “only explains about 1% of the variation in life satisfaction among people in the UK”. It is for this reason that Layard proposes that countries should be focused not on GDP but on GWB, general well-being.

With the conference set to take on the 30th Jan, our distinguished guests will have a great deal to discuss so make sure not to miss out! For more information, visit this link.

Week in review: Learning from history

This week, we have come to realise the importance of learning from history. With the British MPs choosing to bomb ISIS in Syria, they are promising to right the wrongs of the Iraq War. With Brazil embroiled in economic turmoil and political chaos, it is clear that President Rousseff has not learnt the value of sound economic governance. With the ongoing UN climate change conference, there is hope that the lessons have been learnt from the Copenhagen Conference in 2009 which ended with little to show for it. Finally, as the US prepares for its first rate hike in over half a decade, we hope that they have learnt from the ECB who tried to raise interest rates in 2011 despite the ongoing debt crisis and even today, is still paying the price.

Yuan be with us?

An employee counts Chinese one-hundred yuan banknotes in an arranged photograph at the Bank of China Hong Kong Ltd. headquarters in Hong Kong, China, on Thursday, Nov. 12, 2015. The People's Bank of China's 2015 edition of the 100 renminbi banknote, with new anti-counterfiting features, starts circulating today. Photographer: Xaume Olleros/BloombergRenminbi

What happened? The Yuan, finally gained approval this week to be included in the IMF “Special Drawing Rights” (SDR) Basket. The Chinese currency is the 5th to be included in the basket, along with the Pound, the Dollar, the Euro and the Yen, and cements the Yuan’s place as a global reserve currency.

What’s going behind the scenes? As noted by Christine Lagarde, Managing Director of the IMF, this marks a major ‘milestone’ for China in its steps to integrate with the global financial system. In including the Yuan in the SDR basket, the IMF is acknowledging that the Chinese currency plays a major role in global trade and is “freely usable” for fund transactions, the two conditions required for approval. Consequently, it signifies the IMF’s recognition of China’s efforts to liberalise its financial markets and allow for the free flow of capital across its borders; most notably, its August devaluation of over 3% where the Chinese central bank allowed the market to have a greater say in setting the daily trading band for the currency.

Why is this important? Within the SDR basket, the Yuan has a weighting of just over 10%, making it the third biggest currency in the basket after the Dollar and Euro. Its inclusion is no small matter, as the SDR is a very important asset which is traded internationally for the freely exchanged currencies that make up the basket and at the same time, the weightings of the SDR basket determine the interest rates that the IMF charges for loans to members. Nonetheless, as the Yuan will only be officially included in the basket from September 2016 onwards, the significance of this announcement lies in its symbolism.

A wild week adds to Brazil’s woes

President Dilma Rousseff

 

What happened? It’s been a truly tumultuous week for those in Brazil; even more corruption charges were thrown at the country’s biggest firm Petrobas, the economy apparently shrank at a record 4.5% year-on-year in the third quarter and to top it all off, its president  Dilma Rousseff is facing impeachment for playing with the national accounts.

What’s going behind the scenes?

  • For over a year, Petrobas has been at the centre of what is Brazil’s biggest corruption scandal in history and this week brought even more allegations. At its heart, Petrobas executives have been accused of bribing politicans for contracts, using company profit. Prominent Brazilian politicians and businessmen have already been arrested for their involvement; most notably, billionaire André Esteves who was chief executive of Brazil’s investment bank, BTG Patual, was arrested this week along with Delcídio Amaral, the first sitting congressman to be detained in Brazil’s democratic history.
  • Opposition politicians this week began impeachment proceedings against President Dilma Rousseff over claims that she used accounting tricks to make the state finances appear less dire than they actually were. This simply adds to the state of political chaos that Brazil is currently in, as it is the Speaker of the lower house Eduardo Cunha who is calling for the impeachment, likely to save his own skin as he also faces calls to be unseated.
  • Unsurprisingly then, the Brazilian economy is doing horrifically as all of the economic indicators are in free fall. Latin America’s largest economy is contracting at the fastest rate since the Great Depression, unemployment has almost doubled since last year to 8%, inflation is in double digits for the first time in over a decade 2012 and the budget deficit is now at 9.5% of GDP.

Why is this important? This simply demonstrates the importance of economic competence; voted in on a platform to raise standards of living in Brazil, Rousseff has catastrophically failed to meet that expectation and from there, everything has unravelled. The economy is in a dire state of affairs due to her economic mismanagement and overspending in her first term, and although she is now trying to pass spending cuts and fiscal reforms through Congress, her loss of popularity is preventing her from passing able to pass those measures, further exacerbating the problems.

The spectre of Iraq, Afghanistan and Libya looms

What happened? This week, the House of Commons debated a motion to extend air strikes against Isis from Iraq into Syria and after a gruelling parliamentary session of 10 hours, 397 MPs backed the motion with 223 against, a majority of 174 MPs.

What’s going behind the scenes? The build-up to the decision was not without drama; Prime Minister David Cameron was strongly criticised for making some highly personal attacks by suggesting that those who opposed the bombing were “a bunch of terrorist sympathizers”. At the same time, the very issue of bombing Syria created a sharp divide within the Labour party as their leader Jeremy Corbyn, who is strongly anti-war, backed down from his intentions to whip the Labour ministers into voting against the motion and gave in to pressure to give his cabinet ministers a free vote.

Why is this important? As mentioned by Jeremy Corbyn, “the spectre of Iraq, Afghanistan and Libya looms” over this decision and although the vote was technically voting for action in Syria, it was more a vote about the role of Britain on the world stage. The debate about British interventionism has lasted decades as back in the 1990s as it was the slowness of the Western allies (including Britain) to intervene in Bosnia that allowed war crimes to be committed, thousands to die and millions to become refugees. The stance on interventionism has changed dramatically over the years; from being pro-interventionism following the successes in Kosovo and Sierra Leone, Britain has been against it as the Iraq War and intervention in Libya have become engraved into the conscience of the public as a grave mistake. Perhaps, now with terrorism as a resurging threat, that mood has changed once again.

Other News:

Mark Zuckerberg, Priscilla Chan and their new baby, Max. (Screenshot from Facebook.com)

As mentioned in our previous blog posts, December is set to be the crucial month for monetary policy and just a few days in, there are clear signs that this is the case. Mario Draghi extended the timeline for the ECB’s QE programme to March 2017 and the asset purchases would be extended from just sovereign debt to municipal debt (i.e. debt issued by regional and local governments) but disappointingly, the pace of monthly purchases was maintained at €60bn a month. Nonetheless, the ECB did cut deposit rates even further to 0.3%. Meanwhile, on the other side of the ocean, Janet Yellen made the case for a rate hike as she stated that the US economy has “recovered substantially” from the Great Recession and is set for further growth and firmer inflation.

Delegates from 195 countries descended on Paris this week for the United Nations Climate Change Conference (COP21) to discuss the best way to tackle what is regard by the some as the biggest threat to humanity in history, climate change. After the failure of the Kyoto protocol to force countries to cut emissions, the focus is now on voluntary action plans where countries make pledges to do their part to save the environment. The key issue at the heart of the talks is that rich countries grew rich from exploiting fossil fuels during the industrial revolutions and poor countries who are now trying to do the same, are being told not to.

Mark Zuckerburg, founder and CEO of Facebook, made a bold statement by outlining a plan to donate 99% of his $45bn wealth in Facebook shares to charity, following the birth of his daughter Maxima this week. Nonetheless, the entrepreneur has attracted criticism because by donating the shares through the Chan Zuckerberg Initiative, a Limited Liability Company, Zuckerburg can avoid tax on the sale of his shares but he stresses that using this corporate structure gives him the flexibility to fund non-profit organizations and make private investments on issues of public policy.

Week in Review: Tensions flare

This week saw tensions rise up in all different areas of the world. Anger is being channelled by the French and Russians into their efforts to take down ISIS, with some blowback. Similarly, Pfizer provoked outrage by announcing their intentions to relocate from the US to Ireland through the acquisition of Allergan, mainly for tax reasons. On the other hand, George Osborne helped to settle tensions after he backed down from his plans to implement £4.4bn worth of public spending and tax credit cuts, which would have disproportionately hurt the poorest families.

The daddy of all megadeals

pfizer take over

 

What happened? So far this year, we’ve had the biggest tech deal in history, the biggest beer-brewing deal in history and the biggest hospitality deal in history. And now? The biggest pharma deal in history. That’s right; Pfizer, known for its production of Viagra, has agreed a deal to purchase Allergan, which makes Botox, for a record $160bn, to create the world’s largest pharmaceutical company.

What’s going on behind the scenes? Rumours had been circulating about whether this deal would actually go through for several month but after all of the anticipation, this deal has certainly made a splash. Not just for the size of the deal (it is set to be 2nd largest in history), but also for the motivations behind the deal; Brent Saunders, CEO of Allergan, has highlighted the “highly strategic” nature of the deal. This mainly stems from the tax inversion that Pfizer is desparately seeking; Pfizer is currently domicilied in the US where the corporate tax rate is 26% compared to the 17-18% that Allergan pays in Ireland, helping to save the company $2bn over the course of the first three years. Some analysts also believe this deal is simply a play to replenish Pfizer’s branded drugs portfolio before divesting its generics business, to leave the firm more streamlined.

Why is this important? Although this deal is very atypical in its size, the two key issues that plague almost every M&A transaction are especially pertinent to this deal; concerns over regulation and culture clashes. Politicians have been quick to denounce the deal with Hilary Clinton claiming that this leaves the US  taxpayer “holding the bag”, referring to how Pfizer has long benefited from US  taxpayer-funded research and American scientists and suggests that this deal could be blocked. Also worryingly, the chief executives of the firms have a very different take on the importance of R&D in ‘big pharma’; currently, Pfizer invests heavily in R&D whereas Allergan is known for buying or licensing drugs that have already been unearthed by smaller biotech firms.

Christmas come early?

Autumn Statement chart: Fiscal forecast

George Osborne faces the biggest test of his chancellorship.

 

What happened? This week saw George Osborne deliver his first budget for a wholly Conservative government and with it, the Chancellor of the Exchequer brought a nice treat in time for Christmas; he abandoned his plans to introduce £4.4bn worth of cuts to tax credits and public spending which were widely lambasted for their harm to the livelihoods of working-class families.

What’s going on behind the scenes? It is most likely that Osborne’s change of heart has come as a result of a more optimistic forecast by the Office of Budget Responsibility for the government’s coming five-year public finances, which was improved by a health £27bn, giving Osborne more leeway in his aim to achieve a £10bn surplus by 2020. On the other hand, it could also be that public opinion is turning against Osborne’s crusade of austerity, with a Populus poll by the FT showing that fewer people now support the notion that there is a need for ‘austerity and cuts in government spending over the next five years’, down to just 48%.

Why is this important? Given Osborne’s reputation as an opportunist, showcased by his outdoing of Labour through the repackaging of their minimum wage increase into a ‘living wage’, this U-turn by the chancellor seems to be just as well-calculated. In his budget, he outlined significant tax rises in the form of an apprenticeship levy on businesses and higher council taxes, as opposed to the spending cuts he has become known for in what appears to be a move to take the centre ground that has been left open by Corbyn’s Labour.

A “grand coalition” to fight a grand enemy



 

What happened?  This week, François Hollande made good on his promise to wage ‘war against ISIS’; not only did he triple the French air-strike capacity in Syria to bomb ISIS targets, but the French President himself has met up with numerous allies to form a ‘grand coalition’ of countries that will help him to take down ISIS.

What’s going on behind the scenes? Following the Paris terror attacks, for which ISIS claimed responsibility, the French feel very strongly about retaliating to “annihilate” the terrorist organisation and this sentiment is also shared by Russia who are equally furious at ISIS’ bombing of Metrojet Flight 9268, which killed over 200 Russians who were on board. With ISIS very clearly targeting Western Europe countries, this has made the possibility a collaboration amongst the Western allies and Russia very real.

Why is this important? Whilst Hollande’s efforts of a grand coalition were occurring, the week also brought further news that highlighted the point of a coalition; Turkey had shot down a Russian fighter jet for violating its air space, the first time a NATO member had entered hostilities with Russia since the end of the Cold War. With more co-operation, it is hoped that these countries can work together as opposed to working against each otehr, in order to achieve their common goal of eradicating ISIS from the world.

Other News:

This week marked the 100 years since Albert Einstein formulated his famous theory of general relativity. Even today, it is talked about with much admiration and is seen as one of the major milestones of scientific progress. At its heart, the theory explains gravity as a curvature of spacetime and has helped to explain an array of phenomena such as the nature of black holes and the state of the universe.

The US growth rate for Q3 was revised upward significantly from 1.5% at an annualised rate to 2.1%, with the bulk of the upward movement coming from inventories being overestimated. By putting a more optimistic spin on the data, this further raises the likelihood of a Fed rate hike next month.

Having announced five profit warnings in the last 2 years, the new chief executive of Rolls-Royce, Warren East, made her attempts to win back the trust of investors by laying out her plans to restructure the British engineering company. He intends to  cut jobs and slim down management whilst transitioning the company’s focus from jet engines, which are seeing declining demand to new generation turbines.

 

Goodhart’s Law: 40 years on

Few economists earn the privilege of having an economic law being named after them. Charles Goodhart, distinguished in the field of monetary policy and financial markets, is one such individual.

It was back in 1975 at the London School of Economics that he made a decisive realisation, that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”. Put simply, “when a measure becomes a target, it ceases to become a good measure”.

The most famous example of this was during Margaret Thatcher’s government, when her chancellor Geoffrey Howe observed a relationship between the official interest rate and the money supply, and the money supply and nominal incomes. This led him to mistakenly attempt to target the growth rate of the money supply (M3) by using the official interest rate, only to overshoot the target by 100% in the first two-and-a-half years whilst failing to raise nominal incomes by nearly as much. In this case, the fundamental relationship between the variables changed and Goodhart’s law prevailed.

Fast forward 40 years to today and Goodhart’s law is still very much well and alive. Here’s a more recent and vibrant example; consider President Obama’s Race to the Top programme for education reform. Teachers were judged on the test score performance of their pupil, as the rationale is that better test scores are correlated with better school
quality. However, the very act of targeting test scores changes the fundamental relationship between the variables as it gives the incentive for dishonest teachers to cheat and it forces honest teachers to devote time away from teaching the material towards passing the test. Consequently, the relationship between school quality and test scores deteriorates, proving that Goodhart’s law is both timeless and ubiquitous.

Charles Goodhart, of Goodhart’s law, is coming to Cambridge on the 24th November to speak about ‘Alternative Theories of the Determination of the Money Supply‘ in King’s College Cambridge! Don’t miss out on what promises to be enthralling lecture from such a distinguished individual in the field of economics.

Week in Review: Animals galore!

The theme of this week’s post is animals! We have animal spirits are driving even more M&A activity, this time in the hotel industry. We see a fundamental divide between the hawks and doves in monetary policy, between those who want to see less monetary stimulus and those who want more. Finally, there is a tale about the mythical unicorns, the start-ups that are valued at over $1bn before even being public listed!

Hotels are getting in on the action!

A Marriott flag hangs at the entrance of the New York Marriott Downtown hotel in Manhattan, New York November 16, 2015. Marriott International Inc will buy Starwood Hotels & Resorts Worldwide Inc for $12.2 billion to create the world's largest hotel chain with top brands including Sheraton, Ritz Carlton and the Autograph Collection. REUTERS/Andrew Kelly

  • What happened? After the last few weeks were dominated by headline-making ‘megadeals’ in the beer, tech and pharmaceutical industry, it was the hotel industry’s turn; Marriott International approached Starwood Hotels & Resorts with an offer of $12.2bn to acquire them. However, the deal is not yet done as the door is still open for other hotel chains to propose an even better offer.
  • What’s going on behind the scenes? The hotel industry is known to be widely dispersed; the combined firm would be the largest hotel company in the world but would still only have a global market share of 7%. Nonetheless, growing in scale is highly significant as Marriott hopes to gain greater bargaining power against the internet booking companies of Expedia and Priceline who together control 61% of the market, and a greater ability to compete with the likes of Airbnb who have intensified the competition that the hotel companies face. Finally, this deal is perfectly in line with Marriott’s strategy of international diversification because they are already steadily opening one new hotel in China every fortnight but through the acquisition of Starwood who sell over 20% of their rooms in Asia, they can dive straight into the Asia-Pacific markets where incomes are rising fastest.
  • Why is this important? The hotel sector had been particularly quiet in the first half of this year, even when most of the sectors were seeing large amounts of M&A activity going on but within a fortnight, that changed dramatically. Firms such as Accor, the French hotel group and Travelodge, the budget UK hotel chain, were quickly immersed in deals before this bumper transaction was announced. Ultimately, it highlights that in the face of disruptive innovation and pressures from their distributors, firms must adapt and M&A is one way to do that. Only time can tell if that is a sufficient answer.

Are unicorns even real?

Jack Dorsey

  • What happened? Of course unicorns exist! No, we don’t mean the mythical horned creature, we mean the tech firms that have managed to amass a valuation in excess of $1 billion. However, one purported unicorn, the payment processing company of Square Inc, didn’t nearly as well as it hoped when it had its initial public offering last week. Its shares priced at $9, well below its indicated price range of $11-$13.
  • What’s going on behind the scenes? In its previous private fundraising round, Square had been valued at $6bn and if the IPO had gone according to plan, it would have been worth as much as $4.2bn but alas, its public valuation at debut was just a meagre $3.2bn. When we consider why the firm was valued at such a discount relative to its private valuation, there are many reasons. The most important factor to consider is almost always the fundamentals; behind all the optimism about its status as a unicorn, Square is still a loss-making financial services company and although its year-on-year adjusted revenue growth rate is high at over 70%, it is on a downward trend. In fact, in an competitive industry where there are at least 5 other unicorns, it is clear that the market has deemed Square as being simply not unique enough to command such a high price.
  • Why is this important? On the whole, tech IPOs have done rather poorly this year; there have been less than 30 tech IPOs in the US this year, the least since 2009 and there is good reason for this. Investors are suspicious of the high valuation that privately listed companies have received, as it is not clear how strong the fundamentals of the firm are and what terms private investors have been given by private tech firms. With unicorns being as illustrious as they are, just as with the mythical creatures, it seems that August’s market correction has made investors sceptical of the unicorns.

Hawks and doves
ECB president Mario DraghiJanet Yellen testifies before the House Finance Committee in the Rayburn House Office Building November 4, 2015

  • What happened? More and more evidence is accruing to suggest that the ECB and the Fed are going to change their monetary policy stance in December. The big sticking point is that the changes are almost certain to be in the opposite direction to one another.
  • What’s going on behind the scenes? The US is coming off the back of a strong jobs report in October where there was a record low level of unemployment and according to the minutes of the Fed’s October meeting, many members on the board support the view that the conditions for a Fed rate hike “could well be met”. In direct contrast, ECB President Mario Draghi echoed his famous call to “do whatever it takes” to save the Euro in 2012, by announcing that he “will do what we must to raise inflation as quickly as possible” after months of near-zero inflation rates and a paltry growth rate in Q3 for the Eruozone. As such, December looks set to be the month when the Fed finally abandons its rockbottom Fed funds rate with a hawkish rise but also when the ECB makes dovish moves to bolster its €1.1tn quantitative easing programme.
  • Why is this important? A change in the monetary policy for the two biggest economies in the world would individually be enough to attract the interest of most economists but the fact that they are set to occur in the same month and with a difference in direction has added a whole new element into the mix. This is most plain to see in currencies and bonds where the dollar is surging to a seven-month high against the Euro whilst the sovereign debt spreads on two year Treasury notes against their G7 equivalents has reached almost 80 basis points, the greatest since 2007.

Other News:

  • There were significant developments in the fight against ISIS, in the aftermath of the Paris terror attacks that killed at least 129 people and injured more than 300 others. French President Hollande declared war on ISIS and launched an air offensive in Syria against known ISIS strongholds in retaliation. Meanwhile, the US continued to launch air strikes against and claimed to have killed the leader of IS in Libya. Finally, calls have been made to restrict the flow of Syrian migrants into Europe and the US, in fear of letting in would-be ISIS terrorists.
  • Walmart reported positive results last week as its stocks rallied and its sales in its domestic stores were slightly higher in the third quarter but despite this, profit was down by 11%, owing to the poor performance of the international stores. In particular, sales at Asda were down 4.5% due to fierce competition from the discount retailers who have seen their market share double in the past 3 years.
  • The Japanese economy fell into recession in the third quarter as it saw a slight contraction of 0.8% at an annualised rate that added to Q2’s contraction of 0.7%. This is a severe disappointment for Japanese Prime Minister Shinzo Abe whose efforts to eliminate deflation and revitalise economic growth through fiscal and monetary stimulus have clearly been in vain. Fortunately, the underlying reason for the contraction was simply a sharp decline in inventories, as private consumption had actually grown by 2.1% at an annualised rate, suggesting this ‘technical recession’ isn’t nearly as bad it seems.