Budget 2017: the UK chancellor has played his bad hand cleverly

Hammond could do little else in the face of fiscal constraints and grim economic prospects

Martin Wolf

© Bloomberg

The embattled chancellor was subject to conflicting pressures when he presented his Budget. Philip Hammond’s colleagues wanted him to respond to the public's desire for an end to austerity. Yet, at this very moment, the Office for Budget Responsibility finally admitted that the UK’s future is almost certainly not what it had expected it to be. Given the constraints imposed by his own fiscal targets and the grim economic prospects, Mr Hammond arguably did the best he could, at least politically. But he did so by benefiting from some accounting tricks as well as by reducing his margin of future manoeuvre. That is not surprising, but risky.

Far and away the most important development was the OBR’s decision to lower growth forecasts. It now expects economic growth to average 1.4 per cent a year over the next five years. The main reason for this is a dramatic reduction in forecast growth of productivity. This reflects no more than the reality of consistent past disappointments. The net effect of its revisions is to lower the estimated level of potential output in 2021-22 by 2.1 per cent compared to the forecast last March. But the losses — an average of 0.5 percentage points annually — will go on accumulating into the future, unless the trend shifts upwards.

In brief, output per head in the UK economy is already about a sixth smaller than it would have been if pre-crisis trends had continued. Now the OBR says the economy will continue to grow substantially more slowly than it used to do for the indefinite future. The chancellor’s rhetoric about an economy that “continues to confound those who seek to talk it down” cannot disguise the sad realities. Record employment is good. Stagnant living standards are not.

Nor, for that matter, can the realities of Brexit-afflicted Britain be concealed. On this, three points are evident. First, economic growth between the second quarter of 2016 (the time of the referendum) and the second quarter of 2017 was 0.7 percentage points below the OBR’s March 2016 forecast. Second, as the OBR states, “The slowdown in UK GDP growth so far this year contrasts with a pick-up in other advanced economies”. Finally, the medium-term impact of Brexit will, quite certainly, be one of lower net immigration and less trade. This will surely lower investment, competitive pressures and output below what they would otherwise have been.

Brexit then is already damaging. It is likely to become more so. The question is of degree rather than of direction. The OBR itself has to be agnostic on what Brexit will mean. But it is possible for us to make an educated guess. The conclusion is that its downgrades to potential growth might still not go far enough.

If we turn to the forecast for the fiscal deficit (net borrowing), we find several offsetting factors at work. The most important is the deterioration in forecast growth, which, as one might expect, worsens the forecast position from 2019-20, inclusive, onwards. Against this, we see unexpected improvements in the fiscal outcomes for 2016-17 and in the forecast for 2017-18.

Moreover, accounting changes, notably the (merely notional) shift of housing associations into the private sector, also benefit the picture. Finally, the chancellor has chosen to make a cumulative net fiscal loosening of £17.7bn (about 0.9 per cent of current annual gross domestic product) between 2017-18 and 2021-22.

Martin Wolf Budget chart

Overall, the fiscal prospects are now worse. As the OBR notes, relative to the chancellor’s targets for 2020-21 “our underlying upward forecast revision of £13.7bn absorbed roughly half the headroom against the ‘fiscal mandate’ shown in our March forecast.” Politically, this decision makes sense. Economically, borrowing more when long-term interest rates are so low is defensible, provided it goes for worthwhile purposes. Indeed, as I have frequently argued, the manic focus on headline debt, rather than on what debt is used to finance, is economically indefensible. (See charts.)

So what has Mr Hammond bought with his modest fiscal loosening? Has he in fact set out “a long term vision for an economy that is fit for the future”? Hardly: worries about the economy have most definitely not been banished.

Yet there are a number of apparently sensible measures: a bit more spending for transport and research and development; £6.3bn of additional funding for the NHS — not enough, but desperately needed, both in reality and politically; and, most eye-catching, a plan to build 300,000 houses a year by the middle of the next decade and, more immediately, a decision to exempt first time buyers permanently from stamp duty for properties up to £300,000, with purchasers benefiting from this on properties worth all the way to £500,000.

Martin Wolf Budget chart

The proposals on housing are at least aimed at one of the UK’s biggest failures: the slow growth in supply and the high prices that result. Tackling this is a political imperative for the Conservative party if it wishes to be relevant to aspiring young people. It is also a social imperative. Unfortunately, a reduction in taxes mainly raises prices, while measures to expand supply, even if successful, are far too late. It would have been good to see a radical change in incentives, including steep taxation of land with planning permission.

The biggest criticism must be of his caution. The first Budget in a parliament would have been the right occasion to address some fundamental policy questions, not just ones relating to Brexit, but also the balance between taxation and spending, and between investment and current spending.

It is overwhelmingly probable that, given an ageing population, rising fiscal pressures and slow growth, taxes will have to rise as a share of GDP, in the years ahead. It is also likely that public investment should rise as a share of GDP, to provide support for growth. It would be good to have seen a discussion of these possibilities. Beyond this, huge effort needs to be put into the analysis and development of policies that might raise productivity. Unfortunately, the poisonous politics of Brexit are emptying the country’s political atmosphere of the needed oxygen. A divided minority government can focus on little more than this pressing task. Given this, Mr Hammond did quite well. But the UK’s productivity performance and prospects make today’s picture look grim.

Who audits the auditors?

America’s Public Company Accounting Oversight Board gets a new boss

A new regime at America’s audit watchdog could undermine progress

THE collapses of Enron and WorldCom in the early years of this century turned book-cooking into front-page news. Investors lost over $200bn; in 2002 the stockmarket fell by over a fifth between April and July. In response, America’s Sarbanes-Oxley Act set up a new body, the Public Company Accounting Oversight Board (PCAOB), to supervise auditors.

Its quest to give auditors more teeth continues, with the introduction of new rules that James Doty, its outgoing chairman, bills as the most significant changes to reporting by auditors in over 70 years. The question now is whether Mr Doty’s successor, who was announced by the Securities and Exchange Commission (SEC) on December 12th along with four new PCAOB board members, will keep heading in the same direction.

New disclosures on auditors’ tenure and independence take effect this week. And from 2019 auditors must go above and beyond the low bar they have historically set themselves, which is a pass or fail “opinion” on whether financial statements obey accounting rules. They will have to explain “critical audit matters”, meaning occasions when they had to confront company management. Many big firms loathe these changes, warning that investors will be swamped by minutiae. Their real fear may be a loss of control over the flow of information to investors.

The rules are meant to mitigate the incentive problems that have long riddled the profession, which is dominated by the Big Four partnerships—Deloitte, EY, KPMG and PwC. To foster investor trust, listed firms must engage external auditors. But companies pay them, not investors, which may dampen the motivation to scrutinise.

In the West, stronger oversight does appear to have coincided with better quality. Accounting scandals are far from consigned to history’s ash heap. In America last year, for example, PwC settled a $5.5bn lawsuit alleging negligence when it gave Colonial Bank a clean bill of health in the years before the lender’s collapse in 2009; the bank turned out to have made loans against assets that did not even exist. Yet both the frequency and the severity of accounting restatements have fallen over time in America (see chart), and inspectors are finding fewer audit deficiencies. In Britain, where auditors have been required to discuss contentious bits of the audit for some years already, 81% of FTSE 350 audits inspected by regulators in 2016 either met their standards or had only minor problems, up from 56% five years before.

But two big weaknesses in the audit industry remain. First, at a global level, quality is still relatively low. A survey of 36 countries last year by the International Forum of Independent Audit Regulators found that an “unacceptably high” 42% of 855 audits did not meet inspectors’ standards. All of the Big Four have been caught up in scandals in recent years, particularly in emerging markets.

American regulators can lift standards. The PCAOB inspects audits for all firms listed in America, regardless of the auditor’s location (though China refuses its inspectors access). More of its sanctions have been taken against foreign firms, including affiliates of the Big Four. In its severest punishment ever, it fined Deloitte in Brazil $8m last year for doctoring paperwork and hiding evidence from inspectors.

Senior executives at the Big Four admit to embarrassment about violations abroad. But because most country firms are legally distinct affiliates, they have been able to avoid broad reputational damage. And the worry is that neither companies nor regulators can afford to discipline auditors harshly for their failings because of the second big flaw: limited competition. The Big Four dominate audit for large listed companies, scrutinising the accounts of 99% of those on the S&P 500 and the FTSE 100. Companies’ choices are even more limited because conflict-of-interest rules forbid the same firms from selling consulting and audit services. Over 85% of S&P 500 companies have been audited by the same firm for over ten years, according to Audit Analytics, a data provider. Such cosiness jeopardises objectivity.

How this should be addressed, if at all, is unclear. Mr Doty reckons independence of auditors must be the priority; if that is assured, a lack of competition, in itself, is less worrisome. In any case, the PCAOB has little scope to act, since the House of Representatives voted in 2013 to ban mandatory auditor rotation. In contrast, European regulators now require firms that have used the same auditor for ten years to put their contract out to tender. Nevertheless, the four remain dominant.

That concentration worries some. What happens if another scandal were to sink one of the firms, turning the Big Four into the Titanic Three? European regulators are now monitoring risks to audit firms; in Britain, audit-firm boards must include independent non-executive directors. Steven Harris, an outgoing PCAOB board member who helped to draft Sarbanes-Oxley, would like to see similar rules in America.

That seems unlikely, because of a new risk to audit quality: a possible relaxation of American policy. Many bosses hope for looser rules. That would fit with the Trump administration’s deregulation agenda. Although Sarbanes-Oxley has not ranked highly on the list of rule books to be burned, Mr Doty’s successor, William Duhnke, a former Republican Senate aide, is thought to favour deregulation. Two of the four other new board members are former Big Four auditors. Reassuringly, the SEC’s chair, Jay Clayton, has said he is not looking for radical change. He would be wise to consider how much progress has been made since the dark days of Enron and WorldCom before consigning audit regulation to the flames.

The Platform Economy


A GrabBike rider uses his mobile phone

WASHINGTON, DC – Hardly a day goes by without another article, conference, or research initiative devoted to the future of work. The robots are coming, or they’re not coming as fast as we think; when they do come, they’ll put everyone out of work, or they’ll create as many jobs as they destroy. Thus the conversation goes. But what if, instead of trying to predict the future, we look at realities that exist today for billions of people?

Some 80% of the global population lives in emerging economies – defined by informal markets and fluid employment structures. The SHIFT: Commission on Work, Workers, and Technology invited groups in five cities across the United States to imagine four scenarios along two axes of change – more or less work, and more jobs or more tasks. Participants were divided as to the amount of future work, but almost all foresaw the continuing disaggregation of jobs into tasks in both low- and high-end work, from driving to lawyering. That is the reality in emerging economies today.

Examining work patterns in these diverse countries yields three key lessons. First, people layer multiple work streams and derive income from more than one source. Second, platform economies are emerging rapidly and build on traditional networks. Finally, these work patterns often go hand in hand with dramatic income inequality.

Flexibility and uncertainty define informal markets in developing countries. Those lucky men and women who have formal jobs (less than 40%) often have “side hustles” through which they sell their time, expertise, network, or ideas to others in an effort to hedge against an uncertain labor market. A Nigerian saying – “you have a 9 to 5, a 5 to 9 and a weekend job” – aptly describes the environment of layered work.

The same pattern is starting to emerge in developed countries. A report by the JPMorgan-Chase Institute concludes that platform jobs are largely a secondary source of income, used to offset dips in regular income.

A key difference, however, is that in emerging economies flexible networks of individuals or small businesses take the place of formal employers. Kenya’s informal sector – called in Kiswahili the Jua Kali (“hot sun”) – is the country’s main job creator. The 2017 Economic Survey in Kenya showed that the Jua Kali generated 747,300 jobs the previous year, whereas the formal sector added only 85,600.

The Jua Kali comprises sector-based associations among workers and artisans that harken back to medieval guilds. The associations – of carpenters, mechanics, plumbers, and so on – enable pooled savings, provide opportunities to upgrade skills, and create a form of market regulation.

As technology has been added, many of the associations are going online to match supply and demand in the informal labor market more effectively. Go-Jek in Indonesia (named as a pun on ojek, a motorcycle taxi) is a $2.5 billion company that delivers everything from food to hairdressers by motorbike through an app. The company, with more than 200,000 drivers on the platform, boosts Indonesians’ productivity in the face of snarling traffic.

The market for low-cost legal services in Accra, Ghana, provides another interesting example. Journalist Joseph Warungu describes a “narrow alleyway at the back of the court buildings” teeming with notaries, commissioners for oaths, letter writers, and lawyers offering services from witness statements to contracts, all “processed efficiently and at a pocket-friendly rate.” That alleyway is a platform, bringing together multiple sellers of separate legal services together with buyers, in contrast to a traditional law firm, which requires clients to purchase multiple services from the same source. It simply needs to migrate online.

Developed economies are only beginning to catch up. Bliss Lawyers has “a bench” of more than 15,000 lawyers across the US who are paid over $200 an hour for “work on an engagement basis for in-house legal department and law firm clients.” More broadly, the Business Talent Group provides “in-demand business talent on-demand,” across a wide range of professional services.

Emerging markets also offer a cautionary tale concerning the downside of the on-demand economy.

They have some of the highest levels of inequality in the world. The world’s 50 most unequal economies are in Sub-Saharan Africa and Latin America, with South Africa taking the prize for the highest income inequality.

Informal markets, lack of access to finance, and poor educational opportunities in these countries continue to trap most people in relative poverty. Gig economy platforms that provide small jobs without benefits or career progression can supplement income and buffer other employment, but they do not add up to the security and advancement opportunities of a formal job. Indeed, most emerging-market workers turn to the gig economy not out of a desire for flexibility or to follow their passions, but simply to make ends meet.

Nonetheless, informal markets in developing countries provide a vast field for experimentation to transform a patchwork of jobs into a steady upward path for workers. Tailoring education to allow workers to get the on-demand skills they need when they need them, and creating verifiable work histories through blockchain, are two ways to help gig economy workers find suitable opportunities more efficiently and capture more value from selling their labor.

While developed countries in Europe, North America, and Asia are rapidly aging, emerging economies are predominantly youthful. By 2040, one in four workers worldwide will be African. They are products of dynamic informal markets, and that should ease their absorption into a tech-enabled gig economy. Nigerian, Indonesian, and Vietnamese young people will shape global work trends at an increasingly rapid pace. We can learn from them today to prepare for tomorrow.

Anne-Marie Slaughter, a former director of policy planning in the US State Department (2009-2011), is President and CEO of the think tank New America, Professor Emerita of Politics and International Affairs at Princeton University, and the author of Unfinished Business: Women Men Work Family.

Aubrey Hruby is co-founder of the Africa Expert Network and Senior Fellow at the Atlantic Council.

It’s Not the Leverage, It’s the Illiquidity That Will Hurt

How insurers and pensions could give investors a fright in the next market downturn

By Paul J. Davies

European insurers are putting more of their equity holdings into private companies

Too much short-term debt backing long-term assets fueled the last credit bubble a decade ago.

This time round, investors are hunting for yield in hard-to-trade, often private assets. As a Goldman Sachs economist put it recently: “illiquidity is the new leverage.”

The natural buyers of illiquid assets are in many ways insurers and pension funds. With rates low, they have moved further into assets with a limited market, which includes private bonds or loans, private equity, large real-estate assets, or even lightly-traded, very long term government debt.

Such assets aren’t necessarily worse quality than liquid debt or equity, but they can be very volatile. And in times of strain, their values highly uncertain. For shareholders in insurers or in companies responsible for large pension funds, that can be a major worry.

This uncertainty is why such assets typically pay a higher return, or a so-called illiquidity premium, which is what many insurers are chasing.

Insurers’ investment portfolios are very large, so their positions change slowly. But the share of European insurers’ equity holdings that are unlisted, for instance, has grown to 34% at the end of 2016 from 28% in 2011, according to European insurance and pensions regulator, EIOPA.

Investing in loans, rather than more-liquid bonds, has also become more popular.

In the U.S., Moody’s Investors Service has found similar trends. U.S. insurers’ holdings of private bonds grew to 22.5% at the end of 2016 from less than 21% of all assets in 2013. Commercial mortgage holdings also rose to 11.9% from 10.8% of assets in the same period.

Individual insurers echo the trend. MetLife has 15% of its fixed-income portfolio in private bonds, while private equity accounts for 35% of its equity holdings. German giant Allianz, has €101 billion, or 14%, of its assets in alternative investments and wants to increase that by €40 billion in coming years. U.K. annuity companies are furthest down this path with a quarter of all assets already in illiquid investments, according to the International Monetary Fund, with plans to lift that to 40% by 2020.

Anecdotal evidence suggests pension funds are making similar moves. And investment banks are exploiting the trend, by creating and selling long-term illiquid products.

Insurers and pension funds need long-term assets. The better they match the maturity profile of their assets and their long-term liabilities, the more stable their capital needs will be. Also, because they can’t typically suffer a run on funding as banks do during crises, they should be able to ride out market ups and downs.

However, insurers especially still have to keep asset values current, or mark them to market.

With really illiquid assets, there is no market and so they must mark them to modeled valuations — or educated guesses.

That’s when shareholders can get worried about an insurer’s or pension fund’s true value and head for the exit, hitting share prices. For insurers, that can cause real havoc.

The more that everyone pursues the same strategy, the more dangerous it will become.

How the Deep State Squeezed America’s Wealth

by Bill Bonner

NEW YORK – Salvator Mundi, said to be by Leonardo da Vinci, is the world’s most expensive painting.

Last Wednesday, at auction, each square inch was valued at nearly $1 million – including the bummed-up, restored, and damaged parts.

The painting may not be da Vinci’s work. Or perhaps, since it has been so heavily doctored up, little remains of his work. And whoever’s work it was must have been having a bad day.

And yet, it sold for over $450 million (including auction-house charges) – a lot of money for such a depressing work of art.

Donald Trump as da Vinci’s Salvator Mundi

The question on the table: Why?

But since we don’t know the answer to that question, we’ll answer another one: How come so many people have so much money?

Made in the Middle

The latest GOP “tax reform” proposals raise questions, too.

Though billed as a “middle-class tax cut,” the middle class gets almost nothing from the proposed plan.

Instead, almost all the benefits go to: (1) business owners, and (2) the rich.

And since the feds are unwilling to cut spending, the middle class ends up with about $2.2 trillion of extra debt, which it will have to reckon with eventually.

We bring up the tax cut because we think it helps explain the painting. Not for nothing are Republicans and the modern Salvator Himself, Donald J. Trump, setting up the middle class for a huge bamboozle.

A train ride we took on Monday – the Acela Express from Baltimore to New York – was subsidized by taxpayers from all over the country.

The train runs from one end of today’s modern economy to the other. It goes from Washington, D.C. – the center of politics – to New York – the center of money.

In between is nothing but poverty and dereliction. There are factories that last made a product in the ’50s. There are workers’ houses almost unchanged in half a century. There are abandoned warehouses… wrecked cars… junk steel… and burly men in orange vests working with machines.

The middle is where real work was done and real things were made, shipped, and distributed; it shows few signs of growth or prosperity.

It is as though a sausage had been squeezed in the middle, driving the rich meat to the ends. In between is lean… and greasy.

How come?

Deep State’s Fingerprints

Every crime scene has many fingerprints on it.

Most are of the innocent.

An aging population, for example, is not exactly something you can do anything about.

Technological innovations, too, are largely beyond public policy control.

But there’s one set of fingerprints on the tax cut flimflam… the relative poverty along the Northeast Corridor… and the $450 million painting: the Deep State’s.

The insiders use fake money – the post-1971 dollar – to transfer wealth and power from the people who earn it to themselves. It is as though they loaded up the train in Newark and Trenton… and shipped everything to Washington.

You earn real money by making real things and providing real services. But fake money is different.

You don’t earn it by adding to the world’s wealth.

You get it by subtracting from it… that is, by borrowing from future output.

Real money is not controlled by anyone. It is earned – freely – in win-win exchanges. Back in the 1950s and 1960s, it ended up in places like East Baltimore and Trenton because they used to make things people wanted.

But fake money takes a different route. It is created by the insiders… and controlled by them. It goes where they want it to go.

No Stimulus

Money always bows to politics; often, it is completely beholden to it.

In Russia, the oligarchs took government-owned property and used it to build their fortunes. In China, state-owned enterprises and favored entrepreneurs get government-backed credit to build their apartments, factories, and shopping malls.

And in America, the fake money is directed to favored sectors by 73,000 pages of the Internal Revenue Code… and 81,000 pages of the Federal Register.

So, it is hardly a surprise that the latest tax proposals favor the Deep State at the expense of the middle class.

Readers may argue that the money “stimulates” the economy… and that it “trickles down” to the common people. If so, there is little evidence of it.

As a percentage of the working-age population, fewer people have jobs today than at any time since the 1970s. Back then, the typical man had to work 900 hours to earn enough to buy a new pickup truck. Today, he has to work 1,500 hours.

Central banks have increased the world’s monetary base (and their own balance sheets) by $20 trillion so far this century.

This money didn’t go to the fellow in the orange vest. Instead, it went to Russian tycoons…

Chinese billionaires… art collectors… hedge fund managers… and rich people on both ends of the track.