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Asset management

25 March 2013

Economist Insights Assume a can-opener
Economists are famous for making assumptions to simplify complex systems. The UK Budget delivered last week contained a number of assumptions, one of which, on total factor productivity, may be a little too convenient. It allowed the Chancellor to avoid tightening fiscal policy further, which may be a good thing as there comes a point at which austerity will be self-defeating. The Budget also contained measures to stimulate the housing market and changes to the remit of the Bank of England, to allow more flexible policy. The latter may prove to be the most useful of these measures. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management

Gianluca Moretti Fixed Income Economist UBS Global Asset Management

There is an old joke in economics: a physicist, a chemist and an economist are stranded on a desert island when a tin can of food washes ashore. The physicist says ‘let’s use force to open it’. The chemist says ‘let’s heat it up first’. The economist says ‘No, no. Let’s assume a can-opener’. Economists are famous for making assumptions, which are convenient for looking at complex systems like economies, but one should always be on the lookout for assumptions that are a little too convenient. UK Chancellor George Osborne and the economists at the UK Office for Budget Responsibility (OBR) were forced to make numerous assumptions in the Budget released last week and at least one of these assumptions may appear a little too convenient. The assumption is on the somewhat arcane but hugely important question of total factor productivity (TFP). The UK economy is experiencing what has been called “the productivity puzzle”: why has employment been surprisingly strong despite very weak growth? GDP comes from the combination of labour and capital as well as all the things that cannot be directly observed: technology, management techniques, culture etc. These unobservables make up the aforementioned TFP. In other words, TFP is everything about output that cannot be explained by the labour supply and the capital stock. As a result of the UK productivity puzzle, the TFP must have plummeted (see chart). The OBR finds that hard to believe so they decided instead to assume that it has been flat for the last year. This may sound like a lot of academic quibbling but it made a big difference to the Budget. If TFP is not falling (as the OBR assumes) then the gap between the potential growth of the

economy (if all the factors of production were being used) and the actual performance would be larger. This output gap is how we define the cycle, so faster TFP growth means the cycle is longer and slower TFP growth means the cycle is shorter. Chancellor Osborne has set himself a rule that he needed to balance the budget over the cycle. In other words, the OBR’s assumption allowed the Chancellor to avoid tightening fiscal policy further after growth was weaker. To many economists, ourselves included, this is a good thing. While the bond market’s newfound fear of sovereign default after Greece meant that fiscal tightening in the UK was unavoidable, there comes a point at which austerity will be self-defeating. We do not know where that point is, but since the bond market seems happy with the UK at the moment there seems little gain in pushing it further.
Unproductive UK total factor productivity (TFP), 2007 Q1 = 100 102 101 100 99 98 97 96 2007 2008 2009 2010 Trend TFP OBR assumptions
Source: Office for Budget Responsibility



This assumption does not call into question the impartiality of the OBR; after all, it is not called a “productivity puzzle” for nothing, and the OBR could have chosen an even more optimistic assumption if they really wanted to help the Chancellor. It is interesting to note, however, that the OBR is effectively calling into question the real-time accuracy of the official statistics. But it worked so well last time… The Budget may have been presented as fiscally neutral, but quite a lot of money was shifted around. Much of this money was shifted towards housing. The Chancellor announced a new shared equity scheme where the government basically lends people the deposit on a newly built home at zero interest (which of course in real terms is an outright payment). An existing scheme to guarantee new mortgages was extended to cover up to GBP 130 billion for the next three years. The ultimate impact these measures will have on house prices and house-building is debatable, but the thrust of the economics is clear: the government is using taxpayer money to subsidise borrowers who otherwise would not be able to afford to buy. Put it another way which should resonate: they are subsidising ‘sub-prime’. One wonders why the government is so keen to re-inflate a housing bubble. After all, the housing bubble did not work out so well for the UK the last time we tried it (or the time before that, or the time before that…). Even the model being used is a repeat of something that did not work out well previously. The off-balance sheet contingent liabilities that the mortgage guarantee scheme would create are parallels to the mortgage guarantees provided by Fannie Mae and Freddie Mac in the US. When the housing bubble crashed, these quasi-government bodies had to be fully nationalised. At least the Chancellor has put a cap on the lending that would make the problem more manageable (provided he doesn’t increase it). Furthermore, incentivising already indebted households to take on more debt seems at odds with the idea that the UK economy needs to rebalance towards more exports.

Aside from vote-winning explanations, it is hard to see why politicians want house prices to rise for their own sake. It is about the only thing that people buy that for some reason people think should be more expensive. It is good for homeowners, but bad for first-time buyers and for those who want to upgrade. House prices do tend to be stronger when the economy is doing well, but it is more likely that a growing economy pushes up incomes which pushes up housing demands. Politicians may be mistaking the symptom for the cause. At a moment when bank lending is constrained by weak balance sheets and new regulations, there may be further unintended consequences. If banks find it safer and more profitable to lend to homeowners than firms, then that is what they will do. So the part of the economy that uses loans to actually generate growth could end up being further squeezed for credit. The Chancellor also announced changes to the remit of the Bank of England (BoE). The somewhat awkward phrasing of the new remit can be easily simplified: what the BoE had been doing (allowing inflation to be high for a while because the economy was weak) is OK. The change is really a permission for incoming Governor Mark Carney to pursue ‘flexible’ monetary policy (see Economist Insights, 11 February 2013), and even for the BoE to announce intermediate targets like the Fed (see Economist Insights, 17 December 2012). All of this is fine, assuming that the inflation expectations stay well-anchored. So that makes three ‘can-openers’ that the Chancellor has assumed. Firstly, that productivity growth is actually higher than the data says. Secondly, that promoting housing will be good for the economy. Thirdly, that giving more free rein to the Bank of England will work out well. The first is convenient, the second is dangerous and only the third is potentially useful.

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