A Bad Week in the UK

I was shown a really interesting App (Explain Everything) when looking around a school today. The classroom seems to be ahead of the boardroom as far as interactive technology goes.

I thought I would play around with it on my phone and test it to give my personal view of things going on in the UK this past week.

This is a corrected version after the first one erroneously said that Marine Le Pen had tweeted in approval of Theresa May’s conference address. Like the Huffington Post, I had been fooled by a supporter’s account.


Still an awesome chart!

Today the Resolution Foundation released an excellent and fascinating paper looking at data behind Branco Milanovic’s ‘elephant chart’, and asking what conclusions can be realistically drawn from it.

My tweets may have played some small role in popularising the chart – the reporting of an opinion I tweeted that it is ‘the most important of the last decade’ is footnoted a couple of times in the paper, and it even appeared in a Dutch Trade Minister’s speech a couple of weeks ago.

Here’s the tweet, which I drew on my iPad of a picture that I snapped while reading Milanovic’s terrific book:

I have been thrilled to have had a role in drawing attention to the work that Milanovic’s and Lakner have conducted, a summary of which can be read here.

But judging from my Twitter feed this morning you would think that the Resolution Foundation paper has found major methodological flaws that makes a nonsense of the chart.

Not so.

To reiterate, the elephant chart is an amazing chart. It paints in one graphic a picture of the global economy that is (in my opinion) unrivalled. It is so good precisely *because* it combines income changes and demographic changes; it tells the story of recent global history and the degree to which the rise of China (and India) have changed the world. It also illustrates that lower income households in the West have largely not participated in the remarkable global growth over the two decades. The original Milanovic & Lakner paper  dwelt at length on the compositional issues behind the chart, and there was even an animated gif that @MaxCRoser put together using country-specific compositional data contained therein which is pretty stunning, and was widely distributed before inexplicably disappearing from Twitter. Luckily I have been able to find and embed a copy below: global-income

The Resolution report does the world a service by further drawing out the data behind the chart, discussing what policy implications can and cannot be drawn from the chart, and reminding people of the compositional issues.

Compositional issues are hard. And this is probably the most striking chart in the report for people interested in the impact of compositional issues. It even makes its way into the FT.


This chart is complicated. As its title suggests, it shows ‘Growth in average per capita household income of each percentile group (rolling average) if there had been no income growth and changes were solely due to uneven population growth’.

I think that this means that it imagines a situation where:

  1. every worker is put into an country-specific income decile in 1988, and the mean income of the decile is then fixed in real terms;
  2. net new workers per country are distributed evenly across these country-specific deciles;
  3. all countries for which there is data have their country-specific deciles chucked into a spreadsheet in 2008;
  4. the income required to make it into each percentile in 2008 is then compared to the income required to make it into each percentile in 1988.

The outcome is then charted. (Apologies if I’ve misinterpreted.)

If this understanding is correct, the chart then shows the impact on the elephant chart of

  1. poorer countries having had faster population growth than richer countries;
  2. starting the exercise in 1988 when the global income distribution had the following shape:


Or, as the author of the Resolution report, Adam Corlett, puts it:

“For example, the poorest decile of people in the US were in the 70-75th percentile range in 1988. But population growth among poorer countries would have pushed those Americans up into the 75th-80th percentile range by 2008. The bottom US decile would be replaced in the 70-75th percentile part of the global distribution by the richest urban Chinese, but the latter’s average income was around $1,500 compared to the former’s $2,600: producing a fall in the average income of those percentiles.”

And so, when holding constant the country population share the elephant chart looks as follows (red line):


Is this a ‘truer’ version of the original elephant chart? Not at all. In fact, holding constant population shares stable is a nonsense: it no longer shows a picture of profound changes that have been experienced across the global economy as a whole. The author both understands this and makes no attempt to conceal it, because he is trying to do something important and useful to which this new chart is particularly well-suited: to correct a misperception as to what the original elephant chart showed.

Specifically, it issues a corrective to claims that working class developed market incomes have *stagnated* in real terms during the period. And here, despite being one of the people who actually read Milanovic & Lakner, I am at least partly culpable. In a blog for voxeu among other places, I have used the elephant chart and stated “there is a large section of people who are well-off in global terms who have largely not participated in global growth over the past 20 years. That section is populated largely by the Western lower middle and working classes”.  The words may not be technically incorrect, but to say that they fail to draw attention to the compositional issues underlying the chart is more than fair. Furthermore, they mask the fact that while I have looked at US income distribution in some depth, and think myself relatively familiar with the data that is published in the UK, the impact of Japanese income data on the overall chart had passed me by.

When we look at the constant country population share chart from the Resolution paper we can see that my claim that a large section of Western lower middle and working classes largely not participating in global growth might more accurately (but not massively more accurately) be described as having experienced a cumulative real income growth of c25% (although this will vary *meaningfully* by country – with Japanese lower income deciles experiencing contraction, US lower income deciles experiencing low but positive growth, and Western European lower deciles experiencing c45% cumulative income growth). These levels of cumulative income growth have been lower than the income growth at the top of each of the income distributions for the respective developed market block (leading in many developed countries to higher levels of income inequality), and lower than the income growth of the global median or global poor (leading to lower levels of income inequality across the globe, principally due to the rise of China). And so while real incomes have risen for lower middle and working classes in absolute terms, the bottom 80% labour share of GDP in the UK and US has declined as a proportion of GDP (defined as the labour share of GDP multiplied by the proportion of labour income received by the bottom 80% of the income distribution, see chart below), while the relative cost of labour in the West vs the rest of the world has reduced. (It is also notable that the big decline in the UK occurred in the 1980s, with an evening out thereafter.)


I don’t think that all these things are disconnected, and I’m pretty sure that the Resolution Foundation report isn’t arguing that they are disconnected. Instead, it is seeking to quash a meme that real incomes have stagnated for developed market middle class workers on account of globalisation. It does so with aplomb. As Torsten Bell, also of the Resolution Foundation, blogsboth those saying globalisation automatically benefits everyone and those saying that developed world middle classes have seen no income growth are wrong. Perhaps most crucially, where individual countries lie in between those extreme positions is to a significant degree down to policy choices.”

Given that I read Milanovic & Lakner’s compositional discussions in the original paper, why did I not major on these compositional discussions? Well, I didn’t think that they change the use to which I put the chart (discussing the global labour glut that came about with China joining the global trading system, the associated substitution of capital for labour, and the loss of labour bargaining power in a variety of developed market economies). Although I was not aware of the contribution the Japan had made to the distribution until reading the report.

I tend not to be accused of oversimplifying things. But given the reaction to the Resolution Foundation report, I certainly feel complicit in propagating the end-product of a complex piece of analysis without due caveats.

However, it’s still an awesome chart.

You break it, you pay for it

So we’re a month into the post-EU referendum period and the lights have not gone out. Yes, we’ve gone through a pretty shaky political patch for the Conservative Party leadership which was unnerving to say the least. And the Labour Party is either nearing the point of exuberant rebirth or self-immolation depending on your perspective. But things seem somewhat more stable than they did a month ago.
From an economic data perspective we are still an essentially pre-data period, or at most a period of anecdata, collected/ assembled with various levels of formality. The Economist put together a piece about data it had scraped from the web which was interesting, but really illustrated how little data we really have. 
We have seen data from a few forward-looking surveys come out, the sort of which market-folk like me digest when trying to understand likely developments at a macro level. They are, by definition, snapshots taken at a point in time. 

Here is a quick recap of what we have seen:

  • The GfK consumer survey data, which was dire. However, this was taken during the period of peak national political insanity. So perhaps it should be taken with a big pinch of salt.
  • The RICS survey fell sharply, and tends to lead house prices by around six months, a point made by Sam Tombs here:

  • The Bank of England Agents’ summary of business conditions which was widely interpreted as being more positive, painting a picture as it did of firms somewhat in shock but trying to get on with life. This bullet point is a fair summary of the post-Referendum part of the report, but you might as well read the whole report. It is only three pages in total, so shame on you if you discuss it without having bothered to read it.

  • The Markit survey of Purchasing Managers (the UK PMI) released today, which was pretty awful, although contained an important caveat from its chief economist Chris Williamson that signs of confidence began to lift later in the month as the new government took shape.

  • The CBI Business Optimism index fell sharply, although the orders component was decent and the survey was taken between 27th June and 13th July (recall that May became PM on 13th). [This bullet added 25th July.] Here’s Samuel Tombs again:

But to reiterate. This is not hard data. And without hard data we risk projecting our priors onto the straws in the wind that so far exist, as Tim Harford wrote most eloquently here
And so it is perhaps natural to see a variety of commentators seizing on individual bits of information that *proves* that the UK is either booming or collapsing. Perhaps the whole thing looks rather emotional to the outside observer, and perhaps it is.
But the truth is that we simply don’t know. We each have guesses. Furthermore, we can infer from market prices the degree to which our guesses are more or less consensus. But we don’t know and we won’t know (unless the bottom falls immediately out of the economy) for a little while.
But the reason I’m writing this blog is that I’ve started seeing snippets of commentary from folks who supported Leave that I find somewhat disturbing. I’m happy for them to point to data that they reckon proves a UK boom. I’m happy for them to change their mind and say that they were wrong (although would be surprised if this should happen since we are still in the pre-data period). But I am not happy for them to say that the economy was already broken before the Referendum. And this is what I’ve started to see sneak in.

Similarly, I’ve seen folks who supported Remain appearing to relish the bad pre-data that we’ve seen, perhaps seeing it as enhancing their reputation for analysis. This is really distasteful. There is nothing to celebrate about a downturn.

I was one of the 288 signatories of the letter organised by Paul Levine, Tony Yates and Simon Wren-Lewis.  I stand by its wording, but I very much hope that I’ve been wrongly pessimistic on the impact on the UK of voting to leave the EU. The prospect of eating humble pie is wildly attractive because I want the UK economy to blossom. In fact I am working bloody hard to play my part in ensuring that it thrives. Economic recessions are frankly awful. They carry a distinctly human cost.

But if it does turn out that we have scored an economic own goal by voting to Leave I’m simply not having those who belittled the prospective economic costs of Leaving wash their hands of their responsibility and telling the rest of us that the UK economy was already broken. It wasn’t.

Liberal Cosmopolitanism & Cognitive Dissonance

I read Branko Milanovic’s new book over the Bank Holiday weekend. I think that it is very good and appears to have been written to be read. It has data that surprises and challenges, but is devoid of any traces of data geekery that might put off the casual reader. And it doesn’t shy from challenging the reader to think for themselves about some quite fundamental issues with which I at least have struggled without resolution for some time.

There is a lot in the book about endowment. That is to say, stuff you are born with. Endowments are massively important in determining people’s ultimate income. And while income doesn’t buy happiness, it does make unhappiness less uncomfortable.At a domestic level, we think of endowment as a form of inheritance. For the purposes of public policy discussions, this is often narrowed down to discussions of inherited wealth and maybe the way institutions selling education services are taxed. And wealth tends to cascade down through generations – think interesting work by Piketty, Saez & Zucman, Corak etc. As an individual you can take a personal view on whether it is right that the economic life chances of unborn children should be determined not by their own aptitudes and application but by their parents’ wealth. Your views on inheritance tax, the way in which welfare states are organised etc may be informed by your view on this question.

But the really interesting thing about Milanovic’s work is that it looks at data from an global perspective. Milanovic estimates the degree to which income is a function of the country in which someone is born, and in so doing asks us a second question about endowment. Is it right that the economic life chances of unborn children should be determined not by their own aptitudes and application but by the state in which they are born? And the answer you give to this question has somewhat more profound policy implications. Actually, it’s the combination of your two answers can point to quite radical policy preferences or maybe highlight to you your own cognitive dissonance.

As I was reading I tweeted this matrix I drew using iAnnotate:

Yes, they do sound like expensive cocktails.

And then – and this is why Twitter is actually awesome – Milanovic responded, suggesting that the matrix worked and would be populated by political affiliations as follows:

Paul Mason suggested that there should be additional boxes to reflect some of his thoughts that he outlines in his book Postcapitalism, but having not yet read it I didn’t follow sufficiently well to make another diagram.

Anyway, I ran a Twitter poll with the genuine interest in where folks saw themselves in the matrix.

I was really surprised that the Liberal Cosmopolitan category won out. Policy associated with that category could include (variously) free movement of people, global rather than national government redistributing wealth from the global rich (pretty much everyone in developed markets) to global poor in an effort to offset national and familial endowments. And I would expect it would be pretty hard to rationalise welfare states enjoyed by the likes of the UK – given as they might be understood as offering social protection only to those who were lucky enough to be born in the right country. I have met someone who lives there life true to these beliefs, but, to my knowledge, only one person.

I kind of thought that Natalie Holman sought to explain this is a masterful and funny subtweet:

But actually, I think that the truth is that few self-professed liberals (I am very much including myself here) are properly clean of cognitive dissonance. I see top right as the ‘correct’ box, but find in myself an attachment to nation as an exceptional community. I’d like to think that this is a transient thing while the rest of the world gets up to speed (with our support). But that just sounds like a way of rationalising cognitive dissonance.

Brexit and Freedom

I think that folks who follow me on Twitter will have worked out by now that I plan to vote Remain in the EU Referendum, and furthermore think that calling the whole thing in the first place was something of an economic own goal. The consequences appear to me extremely likely to be economically and financially negative for the country, which is why Remain are so keen to focus on the economics and Leave are so keen to move the debate on to anything but.

Despite news media saturated with coverage, I listened today to an old podcast (16th March) of Radio 4’s excellent Moral Maze that discussed the morality of Brexit, during which Michael Portillo put the moral case for Brexit as ‘What Price Liberty?’. (He actually asked an American whether there was a price at which Americans would give up independence, but it comes to the same thing.) This is both a really good way to argue for Brexit, and also a really good general question. It asks you to look deep into yourself and decide whether you are sufficiently mercenary as to put your freedom up for sale. Posing this question as a Brexiteer puts you on the side of principle, and I have no doubt that many if not most on the Leave side see themselves as freedom-fighters even if I don’t see them as anything of the sort.

It is also a wonderful question because it asks us to think about what liberty actually means to each of us. Sounds pretty basic, no? Freedom is the ability to do what you want to do, right? Perhaps, but this is a question with which I have struggled since an undergraduate, despite being lucky enough to attend a lecture course by the awesome Quentin Skinner on the subject and having read many of the texts to which he refers. A couple of years ago I downloaded Skinner’s iTunesU lecture ‘What is Freedom’ which seems like a potted version of the whole course and drew from it the following diagram:


Starting at the bottom right, we begin with Hobbes, for whom freedom is lack of physical interference. To Hobbes, the Highwayman’s question ‘your money or your life?’ was fair – you were free to choose and as such could never be made unfree in the experience of being robbed (or indeed tortured into confessions etc). Locke then comes along and asked how interference might be extended beyond the physical, and with Bentham we have a more formulated version as to how the will (rather than just the body) might be coerced. At this point liberty is still an interpersonal notion. As we move to the top right bubble we then progress to the idea used by Mill and Marx: that liberty is not necessarily interpersonal and that the agent restricting the self may actually be you (through false consciousness or Mill’s idea of inauthenticity). These echo ideas advanced by Plato, and – away from tracts on liberty – were also worked on by folks like Freud. All this so far describes only what is known as ‘negative liberty’ – aka freedom to do what you want to do – and not its ‘positive’ moment (where freedom consists in essentially fulfilling your mission, however described), outlined on the left hand side of the diagram.

What is absent from this diagram is Skinner’s rather fascinating third leg of liberty, which comes from neo-Roman understandings of freedom that are based on absence of dependence (eg, you are subject to the arbitrary will of another agent), rather than on any absence of interference. It’s not that you can’t do what you want to do, but rather you know that another agent has the power to arbitrarily interfere if it so sees fit, and as such you self-censor. This neo-Roman understanding of liberty can be deployed extremely powerfully against monarchy, colonialism, gender inequality, and the modern day state’s interception of electronic communication. I may well have misunderstood, but as far as I can tell it is also the most powerful argument in the Brexiteer’s intellectual arsenal.

What can be said against such a noble argument? Plenty of things, although some are conditional on different understandings of liberty. Folks who appeal to the UK’s EU membership enabling the UK to better collectively combat climate change, international terrorism etc are sort of relying upon an understanding of a collective shared project – kind of leaning on a positive concept of liberty. I can see why this doesn’t wash with them. And folks who talk about economic impact of Leave are perceived to be speaking a utilitarian dialect that is equally impenetrable to intellectual fans of Leave.

Speaking in neo-Roman terms then, our power to hold the Brexit Referendum proves the lack of dependence. The power to leave existed before the government decided to call the Referendum. The power to leave is precisely what undermines the intellectual underpinnings of the Leave campaign. If we wish to examine whether to exercise this power we should look at the costs of so doing. And the welfare costs of so doing seem great.

My daughter’s political career is already over

Unwittingly, I may have killed my 8yo’s prospects of a political career even before she could even say Hard Working Families. How? Well when she was born Gordon Brown was giving out money to babies in the form of Child Trust Funds. I did the paperwork and put the money into the most unimaginative thing possible – a cheap FTSE100 tracker fund, with the idea that I would think more about where it should be invested at a later time.

What’s the problem? Well, in short, this:

(Just to be clear, the asset line is for the whole fund, not my daughter’s holding.)

She will never be able to say that she didn’t have a trust fund.

She will never be able to say that she never benefitted from offshore investments. 

When the press has a go at her evil financier father who must’ve known what he was doing, she should best not defend me so as not to put me ‘in play’. 

It would be a real mistake for her to tell the press that commingled investment funds are domiciled offshore typically so that the owners of units don’t get taxed twice for owning underlying shares and that she would be as liable for tax through her offshore holding as she would have been by holding the underlying shares direct. 

She should by no means tell people that actively choosing to buy a product (like, let’s say, a book over the Internet, or a fancy branded coffee) is probably more ethically dubious than investing in commingled investment funds offshore that are registered with the tax authorities and push all income and capital through the tax system in *exactly the same manner as investing directly onshore* would, but at a fraction of the cost given economies of scale.

Because that would just be digging herself a deeper hole.

That’s all too complicated, and she would then undoubtedly have to apologise for a massive and self-inflicted communications failure.

On the other hand, there is the chance that if she went into politics she possibly might embark upon a programme of government that is premised on economic illiteracy, be overly political in the way she chose to distribute resources, and call periodic imbecilic referenda.

So perhaps I’ve done the rest of us a favour.

Pocket money rate cuts

Talk in the Nangle household has turned to interest rates cuts. Specifically, the prospect of rate cuts from the ‘Bank’ I run for my kids on which I pay 10% per week that I have previously described here.

As I’ve explained, I founded the Bank as a way to combat the weekly pocket money flush where money *had* to be spent on *something, ANYTHING!*. This behaviour was then followed by complaints that they could never afford things that they might actually want. Giving them APRs on balances that are enjoyed by only the more dubious loan sharks did the trick.

Those of you older than 10 will have spotted immediately the flaw in the initial design – that the Bank is a redistribution mechanism from me to them that rewards saving to such an extreme extent that it could quickly cause it (and me with it) to go bankrupt. By being the Bank, I am borrowing wonga from my kids at outrageous rates.

For this reason I was particularly careful to spend a good deal of time at the inception of the Bank talking to the kids about how the rate would be set weekly and could be changed at my discretion. I even raised the possibility of negative rates at some point in the future, which drew cries of disbelief and outrage from my 8 year old.

Fast forward a year and it’s rate cut time. Why? Because, basically, my 6 year old gets it. From his 60 pence a week pocket money he has, with the help of compound interest, amassed a fortune of £50, giving him an unearned income of £5 per week and rising that he sinks back into the Bank. My 8 year old meanwhile has maintained both a balance of between £2-15, and a healthy scepticism of the value of saving for its own sake – preferring to save for something specific, buying it, then starting again.

My 6 year old looks at my 8 year old and wonders why she doesn’t save more. My 8 year old looks at my 6 year old and wonders why he values the abstraction of a ledger entry over all the stuff she has actually bought. Differing perspectives, both valid. I am very proud of them both.

My sky high APR has crushed the kids’ aggregate demand and on my son’s current trajectory, he will soon own the house. Yes, the Bank has embedded a useful lesson about how it *might* be useful to defer consumption. But, the house. Something must be done, and it’s name is financial repression.

The motivation to cut rates comes from a desire on my part to deleverage, or at least ease the pace of leverage growth to which my children are willing counterparties. But with such different marginal propensities to consume, should I cut the Bank rate or introduce a tiered set of rates that preserves high rates of interest on small balances, is less generous to larger balances, and penalises hoarding?

I worried that a tiered rate regime might be too complicated and could incentivise odd behaviour so I asked my 8 year old what she would do if marginal rates sloped downwards and went negative from £40 out. I had expected her to say that she would keep excesses in piggy bank cash. But her answer was intriguing and, if the ING survey is to be believed, specifically Anglo-Saxon:

‘I would get mummy to start a second bank with a positive interest rate and put the extra money in that instead’.

And so it seems that, in the Nangle household at least, negative rates would be greeted principally by a portfolio balance effect and a reach for yield rather than a dash for cash.

At the end of the original pocket money blog I reflected that what I had created was less a Bank and more a defined contribution pension system. Perhaps the logical next step is to take a leaf out of Osborne’s book and introduce a Lifetime ISA to compete with the current system. But for now, we have opted for a tiered rate regime which is far from perfect. It does serve to reduce my risks, and remains more generous than anything else around.

Amount of contributions required to save a balance of £100



LDI and the Efficient Market Hypothesis – my fictional pub chat with John Ralfe

A couple of weeks back I wrote a work piece about asset allocation. John Ralfe (@JohnRalfe1) sent a mini-Tweetstorm response and invited me to have public discussion about it on Twitter. I think that this would be better done over a pint in a pub, but since John doesn’t actually live in London and I wasn’t proposing to get on the train to Nottingham I’ve written this blog.

Given that my initial piece was a work thing (as opposed to a personal blog thing) I’m not going to go into it here, although you can easily read it on my employer’s website. It is basically an outline of how strategic asset allocation processes tend to operate, and active asset allocation can prospectively operate under forthcoming Local Government Pension Authority reform. Real Friday night stuff.

But John’s critique of it is not actually dependent upon the piece’s contents, so don’t worry about reading it to make sense of this blog. I understand John as instead wanting to critique the very notion that defined benefit pension funds should make ever asset allocation decisions.

For folks of you not familiar with John, he has quite a reputation in the world of institutional pension management. As former head of corporate finance for Boots (the biggest pharmacy chain in the UK) in the early noughties he was credited for shifting Boots’ pension assets out of equities and into bonds in an effort to match estimated liabilities with cashflows from fixed income securities (I am hazy on the detail, and you should ask him). This made headlines in not only trade press but mainstream press. As a 26 year old fixed income fund manager I followed the whole thing with great interest. Everyone in the industry did. Importantly, I understood his call to shift assets not as a call on the likely returns from the equity or the bond market, but rather a decision that Boots as a sponsor of a large pension fund should not be making calls on the likely returns from the equity and bond markets – even over very long investment horizons. Instead, they should be taking risks in its area of expertise (pharmacy retailing, and associated businesses).  The development of pensions regulation, invention of the Pensions Regulator and the Pension Protection Fund, the development of accountancy rules (think FRS17, IAS19 etc), and the frankly unreliable and volatile risk markets has led to the mass popularisation of this approach in the UK. I have met many a company finance director expressing the desire to want to get pensions out of the boardroom, and some of my day job involves helping them do so. So while it may not be technically true, I think of John as the founding father of LDI – Liability Driven Investment – in the UK.

LDI is a mammoth thing in the UK – so mammoth that anyone with a remote interest in finance or financial markets without a passing understanding of it should probably read up to familiarise yourselves with it. I draw a horribly crude thumbnail sketch in paragraphs below, but this is a very readable, short non-technical overview. In fact, as I’ve argued here the conditions that have led to its success are sufficiently mammoth a thing that they need to be considered when contemplating non-traditional monetary policy in the UK.

Around about the time that John invented LDI (or at least brought into the mainstream), markets were experiencing what we now refer to as the dotcom crash. This was accompanied by accountancy scandals at Enron, Worldcom, et al that ultimately brought about the dissolution of Arthur Andersen – one of what were the big five global accounting firms. Equity markets were all over the place and the vast bulk of UK defined benefit pension schemes were thrown into massive deficits. Why were they thrown into deficit? To answer this we need to step back and ask of what a defined benefit pension actually consists. The answer to this question has (I believe) changed from a legal perspective over the decades, and has ultimately landed as a form of deferred pay that ranks pari passu with senior unsecured creditors (this off-the-top-of-my-head legal definition is complicated by the creation of the PPF a few years back, and I’m happy to insert a snappy more correct definition of the legal status of someone’s defined benefit pension assets not yet in payment).

Firms that have promised to pay their retired ex-staff monthly payments until death don’t know the exact size of the final bill for which they have put themselves on the hook. They employ actuaries to estimate the size and timing of likely future payments that they have promised to make. Changes in the actuaries’ estimates of likely mortality developments will impact their assessment of payment sizes and timings; financial market volatility will not. Reasonable actuarial estimates of these likely payments can be huge for individual companies. Mega-humongous-huge for the UK in aggregate.

And so it would be weird if accountants didn’t want to represent within the financial statements of a firm some clues pertaining to these often very sizeable liabilities. But rather than reflecting the terminal (estimated) value of liabilities (eg, I owe Deborah £100 fifty years from now if she doesn’t first die), accountants decided that a more sensible approach would be to reflect the estimate of terminal liabilities discounted using market interest rates, so arriving at the present value of liabilities. So instead of showing that I owed Deborah £100, the accounts would show that I owed Deborah around [£100/(1+50yr bond yield)^50] which, when using a yield of 5% equates to me owing Deborah £8.71. This may sound barmy, but if I were to put £8.71 into a fifty year zero coupon bond at a yield of 5% I would get back £100 in fifty year’s time – just in time to pay off my debt to Deborah. So the accountants thought this a sensible approach, and put this way it does sound pretty reasonable.

What has happened in recent years is that bond yields have fallen (with my understanding of structural drivers of bond yields outlined here). Furthermore, bond yield declines have been most substantial during equity market falls (think flight to quality, anticipation of lower interest rates and lower inflation in forthcoming years due to the disruption associated with financial market crisis, etc). So using the example of my debt to Deborah, let’s say that 50yr bond yields fall from 5% to 3%, the present value of the debt I owe Deborah will have risen from £8.71 to £22.81. It is important to note that the amount I owe Deborah hasn’t changed (it is still £100), but the liability reflected in financial statements will have grown almost three-fold due to changes in market rates used to turn terminal values into present values. By discounting terminal values (estimated by actuaries) back to present values, accountants could present stakeholders with a fair picture of firms’ financial health in a manner consistent with the efficient market hypothesis which won Eugene Fama his Nobel prize.

Getting back to pension schemes being thrown into massive deficit by the dotcom crash, we can see that while the terminal value of pension liabilities did not change (ok, they did go up a bit as actuaries have for many years increased their life-expectancy expectations) the present value of liabilities shot up as bond yields fell, and – for funds that chose to invest in equities rather than cashflow-matching bonds – asset values fell. Falling assets and rising liabilities made for a toxic mix, the result of which has been wholesale closure of defined benefit pension schemes, the diversion of large amounts of corporate income into financial assets in order to begin to plug the deficit (especially in an environment which saw the birth of the Pensions Regulator and Pensions Protection Fund in the UK). Here’s a picture of the ongoing death of DB pensions from the Pension Regulator’s excellent annual Purple Book :

Screen Shot 2016-03-10 at 22.29.00

Meanwhile Boots pension funding levels would have been largely unaffected by falls in yields and falls in equity markets from the point at which it did the asset switch. It had largely closed down the mismatch between accountants’ estimates of the present value of actuaries’ estimates of ultimate cashflows payable to defined benefit pensioners by buying long-dated cashflows (in the form of fixed cashflows associated with bond coupons and principal payments). So while the accountants’ estimates of the present value of liabilities soared, so the value of assets also soared as bond prices rose (both being a function of long-dated yield collapse).

This has been a long preamble, and could have been skipped if John and I had met in the pub. Despite it being long I have skipped any discussion of real rates versus nominal rates (more than a little important), and a whole host of other real life (but complicating from a blog perspective) issues/ factors. But we have to move on to John’s Twitterstorm that he has since asked me to answer (a few times).

Here it is in text, with links to the original tweets embedded:

1 “Strategic Asset Allocation”, as correctly applied to an individuals fund, is a category mistake when applied to a DB pension fund @toby_n

2 A DB pension fund is not a self contained economic entity, but simply part of the capital structure of the sponsor @toby_n

3 Asset/liability mis-match in DB pension fund changes capital structure & increases financial risk for sponsor just like gearing @toby_n

4 If a sponsor wants to increase gearing, then directly borrow – transparent & tax efficient – not indirectly thro DB fund @toby_n

5 If a sponsor believes in “SAA” in DB fund, then borrow long term debt & buy financial assets & explain why to shareholders @toby_n

As you can see, it’s an entirely reasonable position from the founding father of LDI in the UK. And John makes very strong points that it would be silly to refute if one accepts his premises (which I have tried to relate in paragraphs above but may have got wrong, and with no John in pub, hard to know). Furthermore, his premises (if these indeed are his premises) are tricky to theoretically refute, rooted as they are in Nobel prize-winning stuff. The issues I have with John’s position (and the whole LDI edifice) can probably be summed up in a rambling question and a couple of observations.

My question:

Given that LDI is a hedge against changes in an accountant’s present value calculation of an actuary’s estimate of terminal cash flows, what is the best way to judge the correct price of this hedge; or rather, is it ever possible to overpay for this hedge, and if so, what tools would I need to employ to understand whether I was overpaying?

I have written about this before in relation to whether house prices (as an effective hedge) can ever be too expensive. I don’t have a definitive answer, but I suspect that hedges can be too expensive and asset prices can be wrong (and have bet my career on this suspicion). But I don’t observe anything in the LDI approach to help frame this judgement. Instead I understand it placing what looks to be an intolerable burden on the efficient market hypothesis to determine that a hedge must always be appropriately priced. In other words, this approach lends itself to the conclusion that it is impossible to overpay if you are paying the market price, no matter what the market price.

This leads on to my two observations:

  1. The size of UK defined benefit liabilities is larger than the market of physical hedging instruments on a duration-weighted basis.* Simply put, while it might be theoretically possible for  DB funds to collectively go down the LDI route, (an practically possible for some of them to go down the LDI route), it is not practically possible for them to collectively so do. This will be of surprise to no one working in UK fixed income markets, but surely throws doubt on the idea that pension funds seeking to hedge liabilities can do so without distorting the price of that hedge (seeming to undermine a central tenet behind the use of the efficient market hypothesis by accountants and actuaries).
  1. While fixed rate assets can be used to match accountants’ estimates of actuaries’ estimated liabilities, this is true because of the tautological construct. And as such while I accept that the LDI approach will be the very best possible hedge against my accountants’ estimate of my actuaries’ estimates of my liabilities, I am not convinced that the reality of the tautology should define the investment structure of pension fund assets in the UK (especially given observation 1 above, and my unwillingness to believe that it is impossible to overpay for a hedge). Fixed rate corporate bonds, equities, and commercial property are all just claims on corporate profits. Despite all being but claims on future profitability/ future economic activity, only one of these claims has any place in a full LDI construct. That just seems odd to me.

If I was having my pint with John rather than answering his Tweetstorm in this overly-long blog, I would expect he would parry by repeating point 2-4 (which are super-strong points). And I would probably repeat my question and observations. And I genuinely don’t know what would happen after that. I’m fairly sure that neither of us would change the other’s mind. But I also hope that we would emerge the wiser about the other’s position (and perhaps even with enhanced respect for each other’s position). Hence the interest in the pint.



* I should share my extremely back-of-envelope workings so that they can be properly challenged.

The Pension Regulator’s annual Purple Book indicates that UK private sector DB pensions have combined liabilities on a buy-out basis of £2.1 trillion. They also say that a 10bps fall in Gilt yields increases these liabilities by 2%, inferring a duration of around 20yrs.

Let’s look at how much UK fixed income duration exists that might be used to match these liabilities. (Yes, I know that most LDI is done synthetically, but can’t get away form the idea that the duration has to reside somewhere. This may be my fatal gap in understanding.)

First, let’s take the entire stock of UK fixed income securities (as represented in the BAML Broad Sterling Market UK00 index). This has a face value of £1.47 trillion, but a market value of £1.78tn and a duration of 10.2yrs. Leaving aside curves in our hunger for UK duration *of any description* let’s call this £908 billion of 20yr equivalent duration paper.

And let’s add on to this the entire stock of inflation-linked Gilts with a market value of £540bn and a duration of 12.4yrs and call this another £335bn of 20yr equivalent duration paper. Summing these together we get to £1.24 trillion of 20yr duration equivalent paper.

What about the missing £857bn of 20yr duration securities that needs to be bought so that DB pension funds can cashflow match? It doesn’t look like it exists.

John Ralfe has written a reply here that you should have a read of. 

A Tonic for Millennials’ Pensions Gloom

It seems that Millenials have been getting rather flustered on Twitter in response to the FT’s suggestion that they should save £800 per month if they want to get a decent pension. With the median gross wage for 22-29 year olds at around £21k pa (translating into a take-home pay of £17,500 pa) you can see why telling them they’re stuffed if they don’t save £9,600 pa might get them annoyed. So I thought I’d try to cheer them up.

About 12 years ago – when I was 28 – I went to an event in Cambridge hosted by John Eatwell at which a young Ed Balls answered questions about his career etc. Balls was excellent – engaging, articulate, and erudite. I was extremely impressed by this Number 11 SPAD and did what many young folk do in such situations: I sought to show off. So I assembled and delivered a long and pointed question about the forthcoming pensions crisis. I’d read a bunch of papers and books on the subject and so thought I knew my stuff. As such the speech I reeled out was more like a verbally-delivered data-laden op-ed than a question really – you know the type. I was *that* ridiculous idiot.* Anyway, before Balls could respond Eatwell jumped down my throat, basically telling me that I didn’t know what I was talking about and referring me to a paper he’d written. I’m glad that he did because the paper was very good.

Eatwell’s very short pensions paper contains some very very basic ideas that are so simple that they are frequently lost in plain sight. I would summarise them as follows (although do read as it has a bit more than just this):

  1. A pension pot is an asset;
  2. An asset is a claim on someone else;
  3. That ‘someone else’ – for the cohort as a whole – can only be non-pensioners;
  4. From a macroeconomic perspective that does not incorporate either distributional outcomes across income groups or differing efficiencies of state versus private investment, and implicitly assumes medium -term current account balance, unfunded pay-as-you-go state pensions and pre-funded private defined contribution pensions are identical: they are both just claims on non-pensioners.

Or to put it another way, pensioners will collectively consume output produced by the young. Money, as always, mediates – and so in place of ‘consume output produced by’, read  ‘receive income from’. Pensioners will receive an income that can come only from non-pensioners. This income could be in the form of rent, dividends, and interest only from the young, or the proceeds of asset sales made only to the young. This income could be in the form of tax transfers only from the young. Or some mixture. It was ever thus and it will ever be thus.

And so society has a choice as to what level of income pensioners should collectively receive, and how this should be distributed.** Society today includes an ever-swelling portion of pensioners. The two really big variables here that determine aggregate pensioner consumption are: 1) the collective output of the young (of which pensioners consume some slice); 2) the size of said slice. There is the (sizeable) issue of inequality among pensioners of course, but let’s park that for now.

When we move on to the pensions that millennials might prospectively receive, the two key variables determining their collective pensions will be: 1) the collective output of folks not yet born (that they will have to breed or import); 2) the size of the slice that they can persuade their unborn spawn to part with. Saving £800 per month might be one strategy to build a claim on the millennials’ unborn spawn. It doesn’t seem  bad one if they are to be raised on the inviolability of property rights and the societal necessity of monetary stability, but I’m not sure that millennials have their parenting strategies planned out that far yet.

For my part, I am doing my best to busily follow the FT’s pointers and accruing claims on millennials’ future economic output so that I can claim a decent slice of it when the time comes to hang up my boots. But I’m hedging my property rights bet by being nice to millennials.


UPDATE: Ben Southwood (@bswud) from the Adam Smith Institute has written this reply. Do read it.

* I groan every time I hear someone do this now, in the shame-filled knowledge that I was once (perhaps a lot more than once) *that* guy.

** The choice can manifest in level of state pension, tax treatment of unearned income, capital gains etc.

Policy making in an Elysium scenario

On Wednesday evening I was fortunate enough to attend the Annual dinner of the Society of Business Economists. The keynote speaker was the Ignazio Visco, Governor of the Bank of Italy,  who gave a thoughtful and wide-ranging speech covering the whole waterfront of economic challenges. The key points for me of the speech were as follows:

  • Inequality is high and rising (especially when considering the top 0.1%). And this is true in both income terms and wealth terms.
  • Technology is developing that threatens to automate a staggeringly large proportion of jobs (Visco reckons that forecasting 45-50% of total employment will be replaced outlined here would not be outlandish), delivering a rolling disinflationary shock to the economy. The poster image of this view is the chart below that comes from Frey & Orborne‘s work.

Frey and Osborne 1frey and osborne 2

  • Macroprudential policy can be expected to be increasingly relied on to stop monetary policy stimulus feeding through into reckless misallocation of capital/ poor lending to risky projects that might undermine the stability of the financial system.

The governor had plenty of other interesting things to say (competing theories of secular stagnation, and a host of other questions), and I would encourage people to read a version of his speech here. But I don’t think I’ve misrepresented the three bullets above as three of the main points.

Now, I’ve already put my stake in the ground about where I stand on some of this stuff, and it stands in stark contrast to the bullets presented above. (I’m more of the view that there have been waves of concern stretching back pretty much forever about the degree to which technology will deliver mass unemployment and crippling real wage cuts, but these have all so far come to nothing. Meanwhile, there is a massive demographic transition coming through in front of our eyes, the upshot of which appears to me likely to deliver labour some bargaining power.) But what if he’s right and I’m just plain wrong?

Let’s run the idea ad absurdum (yes, I know, real life has a habit of getting in the way of running ideas to the extreme conclusions). But if we did:

  1. The folks who own the robots will own the means of production (as well as the means of accountancy, the means of lawyering etc etc), and there will be no room for pontificating about labour power: labour power will be kaput. Income from the sales of robot overlord kit and robot overlord output will accrue to these members of the capitalist elite, and they shall have a fine life. But given their microscopic marginal propensities to consume (and the fact that they will have become autarkic with the help of their robots) there would be a big demand problem in the economy, and disinflation (if not deflation) is the norm.
  2. If central banks continue to shy from helicopter money, focussing instead on setting the appropriate rate of interest at the short (and perhaps through QE, the long end), the days of positive nominal, let alone real, interest rates becomes but a halcyon memory. But permanently negative real rates (as set by the economy, and implemented by the central bank) inflate further the net present value of cash flows attached to the firms that own our robot overlords (in turn owned by the ultra-rich), heightening inequality outlined in #1.
  3. Given what might be decent returns to robot overlordship you might think that the sector attracts lots of fresh capital. It does, but in the form of equity finance, given the high risks associated with technology even in the robotic sector, and the macroprudential framework that has been thoughtfully put in place to guard against financial accidents that might result from speculatively financing start-ups that challenge the big players means, on the ground, that entrepreneurs are credit-rationed for the sake of financial stability. The folks that provide this equity finance are typically drawn from #1, although periodically someone does something truly clever and special, is lionised and held up as an example of how the whole system is actually very meritocratic (further buttressed by the fact that all the professional careerists go and work in the big robot overlord firms proving that the return to education is high).

Okay, I might have stretched the whole thing a little far, but let’s continue for a moment. What, exactly, is the problem that I’ve outlined? After all:

  • The economy is larger (in volume terms) and more efficient than it would have otherwise have been (or the robots wouldn’t have been able to take over). Tick?
  • There is a dynamic form of capital allocation in play (albeit in equity finance only, but that has less financial system risks anyway) to challenge the robot overlord firms, preventing complete monopolist behaviour. Tick again?

Would policymakers sit back and let this scenario play out? What happens when this sort of plutocracy collides with democracy? Put another way, what is the likely policy response to an Elysium scenario (good Blomkamp sci-fi film, underrated in my view), in which what really matters is ‘who owns the robots?’

There are some readers who might say “open your eyes, this dystopian future has been developing for decades and the answer is obvious: plutocrats win, democratic institutions are captured, and the cultural zeitgeist is also captured into knowing that the system of the day is both economically optical and morally sound“. I would counter that while it is hard to ever step out of one’s cultural context, a whole host of measures of well-being (life expectancy, health, literacy, etc) suggest that the fruits of economic growth have to a certain extent been widely-shared, and we are nowhere near the Elysium point at a national level (although this is certainly less true at a global level).

Through the instruments of the state, we collectively have in place a structure that facilitates/ optimises capitalism (contract law, property rights, state monopoly of violence etc) so that the economy can – in aggregate – grow to its potential, and we can then deal ex post with questions of distribution. This is what I understand Lord Mandelson meant when he said he was “intensely relaxed with people getting filthy rich as long as they pay their taxes“. Sort of Rawls, if perhaps not exactly. 

It seems clear to me that addressing the dim and distant Elysium scenario with a traditional monetary policy response would be problematic (see #2 above). And given that it is a question of ‘who owns the robots’ in this dim and distant scenario, I wonder whether either (a) a wealth tax, (b) a heli-money financed acquisition of robot overlord property rights, or maybe (c) a Guardian campaign to nationalise the robots would gain popularity. Disregarding option (c), I think that option (a) would be fair, but it seems that few others agree. But option (b) rhymes with my understanding as to how assignats came into existence in France in 1789: as a way to finance the acquisition of venal offices off their pre-Revolutionary holders.* (Assignats have ultimately been associated with monetary instability and hyperinflation, although it is not clear to me that this experience serves to support the quantity theory of money as much as a view that money is a microtechnology of daily trust that is ultimately somewhat fragile.) It would be strange if we found ourselves revisiting techniques used in the late eighteenth century to deal with a twenty first or twenty second century problem.

After I wrote a draft of this blog I saw on Twitter that Andy Haldane spoke this evening on all of these issues in a reasonable amount of depth. Reading the speech I think his views are very interesting, and are of course laid out in a fuller, more eloquent, and well-contextualised manner. (To be fair, he probably spent more than two tube journeys typing them up on an iPhone.) He indicates that he, like Visco, are taking the potential implications of automation seriously as a prospective intermediate disinflationary force. He ends with the idea that there are three public policy solutions that might be put into motion (relax, retrain and redistribute), and this sounds pretty reasonable (actually, Visco did make a big play for retraining now I think about it). I would have loved to have asked Haldane a question on the prospective use of helicopter money for the Elysium scenario. I hope Duncan asked it.

*Rebecca Sprang outlines in her brilliant book that ‘no one (not even Marat or Robespierre) took the truly revolutionary position of suggesting venal offices might be illegitimate privileges that could be cancelled without payment’ (p87). It seems even in Revolutionary France that radical ideas of wealth tax were considered beyond the Pale.