Are We Being Deceived by Economic Data? ft. Paul Donovan

[00:00:07] Paul

People think the Snickers bar is indicative of inflation because they buy it every day. And that’s also the problem, because if you’ve got it stuck in your mind, you know, the Snickers bar used to cost me €2. That’s the fair price for a Snickers, and now it costs €3. And every time you buy a Snickers bar, you’re thinking, the fair price is €2 and I’m paying €3.

And so that constantly irritates and it constantly gives this illusion of inflation. So, for 18 months minimum, every time you buy a Snickers bar, you’re thinking, oh, inflation’s out of control. Whereas, in actual fact, the price has been €3 for the last 18 months. It’s just that mentally you’ve still got a benchmark of €2 stuck in your brain.

[00:00:49] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:45] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:29] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Paul Donovan. Paul is Chief Economist of UBS’s Global Wealth Management business. Paul has been at UBS since 1992.

He spent a long time as the chief economist of the investment bank. Now he’s at the wealth Management side, and as part of that he’s a member of the Global Investment Committee.

He’s also written a number of books, From Red to Green?, Food Policy and the Environmental Credit Crunch, The Truth About Inflation, and Profits and Prejudice. So, there’s a lot of content there.

Paul, great to have you with us. Looking forward to speaking to you.

[00:03:05] Paul

Thanks very much for having me on, Alan.

[00:03:07] Alan

Well, as I mentioned, you’ve been a bit of a lifer at UBS, so obviously that’s gone quite well for you. But what got you interested in economics in the first place?

[00:03:15] Paul

Well, I’ve always been interested in economics. I describe myself as a political economist. I’m not one for the mathematical econometric modeling side of things.

I mean, you know, it has its role obviously, but that’s not me. So, I started out when I was a teenager. I was studying economics at school, was very interested in looking at the way the world was working.

I spent a lot of time looking at Japanese politics and economics. I started out as a Japanese economist, indeed, because in the late 80s and the early 90s that was the exciting thing. Japan was going to take over the world and all the rest of it, and then just sort of carried on from there.

I think what’s interesting about economics is, when you get rid of the jargon (which I think is the curse of the profession), you find out that people are making economic decisions all the time, they just don’t realize it. And economists just need to do a better job of communicating, I think, to make people understand the economic decisions they’re taking and hopefully to make better informed decisions.

[00:04:23] Alan

Very good. And I mean you’ve spent a lot of time on the investment bank side of UBS and now you’re on the wealth management client side. Does that add like a tangible difference in terms of the kind of conversations you’ve had and the types of research you do and the type of work you do more generally?

[00:04:38] Paul

Not a huge difference. There is obviously a great deal of overlap between investment banking and wealth management: a lot of are wealth management clients, entrepreneurs, business people, and so on, and so forth. So, there’s not a gulf between the two.

What I would say is that, generally speaking, a larger proportion of the wealth management client base will have English as a second language, for example. They won’t necessarily be following the markets on a day-to-day basis. They won’t necessarily be following macroeconomic trends on a day-to-day basis.

If you are, I don’t know, working as a manufacturer in Indonesia, you’re not necessarily going to be hanging on Fed Chair Powell’s every word, and frankly nobody should hang on Fed Chair Powell’s words. But you know, you’re not going to be that focused.

So, what that means is I have to be conscious of using sort of direct and clear language as much as possible in the work. I would also say that wealth management clients do, by their nature, tend to have a slightly longer time horizon. They’re not coming up with quarterly reports, they’re not speaking about short-term trends. They’re really looking up at where are we going to be on a 2 year, 5 year, 10 year time horizon for the most part. So, there’s a slightly longer-term bias to hatch some of my commentary.

[00:06:04] Alan

Great. Well, I mean, we definitely want to delve into kind of the more structural issues today. So that fits well.

I was thinking, before we came on, we typically start these conversations focused on the US but actually, Europe is probably more interesting, maybe from today’s perspective or more recently. And you’re a political economist, as you say, as well, so the politics has become really important in Europe. We’ve got political turmoil in France, and Germany has been struggling the same.

Going back a few weeks, we had Mario Draghi with his report on boosting competitiveness in Europe, which was all very interesting and solid, but I think a general sense of that this will be very difficult to implement.

Being on the conference circuit and talking to a lot of people, there’s widespread pessimism about Europe at the moment, I think it’s fair to say. Would you share that or how do you see the landscape, from a political economy, playing out and particularly in France and Germany?

[00:07:04] Paul

So, I think the pessimism is overdone. I think we hear a lot about American exceptionalism and Europe is dragging behind. There isn’t actually that much exceptional about the United States in terms of growth differentials. What we have to remember is that Europe has got a basically stagnating population. So, naturally, the GDP growth number should be lower. Of course it should.

Germany has got a falling population. Italy’s had a falling population for some years. So those economies are naturally going to grow more slowly. That’s just part of your basic economics. So, it’s not surprising, I think, that we’ve got lower growth numbers coming through in Europe.

I think what has happened is that there is, in the midst of all this structural turmoil, a sense that the old European model, with relatively generous Social Security payments, a focus on Exports of goods as far as Germany is concerned, things like that, that model is fading. And that change in the way that economies are working naturally creates fear of the future, a sense of anxiety, and so on. I think we’re certainly seeing that in Europe at the moment.

There’s also, I think, a general trend, because you have this in the US and in the UK as well, where the gap between perception and reality is continuing to grow. So, partly because of the rise of social media, the corresponding sensationalization of established media, there is very, very clearly this sense that, I’m all right, but the country is doing terribly, and that keeps coming through. And it comes through very much in the States as well as in Europe.

So, I think that some of the pessimism that we hear about is actually just reflecting the fact that sentiment generally is a lot more pessimistic than reality would warrant as a general global trend. And that is, I think, certainly something that we’re seeing emerge in Europe.

[00:09:21] Alan

Absolutely. I mean, that said, I suppose we’ve taken France, which is kind of the immediate focus, I suppose you do have an immediate problem there of addressing a fiscal deficit. So, I suppose coming out of COVID and there was a kind of a shift in thinking towards more fiscal support, which was obviously needed at the time.

But moving back to more balanced budgets has proved difficult. And I guess, in the same way as we’ve got the challenge of entitlement spending in the US, you’ve got the same with pensions in Europe and the aging population. So, there is an immediate kind of challenge there or a challenge on the horizon which is proving difficult to address.

I mean, is that just reflecting, as you say, kind of… Is that just the zeitgeist that we’ve got this unusual scenario of people feeling very pessimistic and unwilling to make personal stuff, sacrifice, or how do you read it, and do you think it will get addressed over time?

[00:10:20] Paul

So, I think it’s very interesting when you look at the media and the reporting around the situation in France, and there’s all this sort of desperate hand wringing and you know, the politics is not working, and they’re running at a 6% deficit as a share of GDP. And then you look at the United States, which is likely to run at a 7% deficit as a share of GDP and where, you know, it’s going to be very difficult to persuade Congress to do anything meaningful about that anytime soon.

So, you know, the focus is on France because I think the politics there is perhaps a little bit more dramatic. At the moment you’ve got the rise of the far right and things like that certainly contribute to the spotlight being there. But actually, again, you know, this is hardly a unique situation.

My view is that, not just because of the pandemic but more because of the enormous structural upheaval we’re going through in the global economy, that we are experiencing a period where there will be a demand that government plays a larger role in the economy than perhaps we had been used to. And again, I think this is a fairly universal phenomenon. So, governments are going to be a larger part of the economy.

That does also mean that government debts is going to be higher relative to GDP than we’ve been used to. It does not mean that government debt rises inexorably into the future. That’s not what we’re talking about.

But I don’t have a problem with France running 150% debt to GDP ratio and the government playing a larger role in the economy, if that is what is required politically to try and rebalance a very turbulent period, and to try and minimize your fear of the future anxiety about what’s going on. So, I don’t think that necessarily is a problem.

What we do have a problem with now, of course, is that the old sense of what is fair, particularly around pensions and so on, has become very, very entrenched in France in particular. I would say, and we are not seeing economic realism come through.

One of the things, as an economist, which frustrates me enormously is the number of times you look at economic analysis or reports from international organizations or from academics, for that matter, and they say the working population is 16 to 65. I’m not going to retire at 65.

My parents, their generation thought they could retire at 65 and then spent many, many years frittering away their children’s inheritance on cruises and luxury holidays. My generation is working until we’re 80. And that adjustment is coming through in a number of countries. It’s not really coming through in France.

And that does have to change. We can be quite broad in our definition of working. I think that, you know, people do carry on working after retirement, including, indeed, my parents. Whether that is in paid employment or voluntary employment doesn’t matter. They’re still contributing to the economy at large. So, we do continue to have employment and contributions to the economy.

But on the pension point in particular, there does need to be recognition that the idea that you retire at 65 is long dead, and we need to be looking at retirement ages that are mid to late 70s, at least, just to reflect the realities of modern living.

[00:13:57] Alan

Now you mentioned how this kind of perception that the model is failing. And I think that’s very apt. I mean, maybe in a couple of ways. Obviously, I touched on Draghi and the challenge around innovation. And then the second thing, I mean, obviously Germany being Europe’s largest economy, there’s a general sense that the German model, which was, you know, industrial production based on cheap Russian gas and then sell the products to China, that doesn’t work in the new geopolitical environment.

So do you think, I mean, it sounds like you’re not as pessimistic as the consensus. Do you think these issues can be worked through, that a new economic model can emerge, and can policies be put in place to stimulate productivity?

[00:14:38] Paul

So, a new economic model will emerge whether we want it or not, because that’s the nature of structural change and major upheaval.

The question is, is Europe able to adapt quickly to the changing economic circumstances or is it dragged into it, which is a more negative situation, I think. Can we put in place policies to raise productivity? No, absolutely not. And the reason for that is simple. Productivity is everything economists do not understand summarized in a single statistic. It is literally a residual.

So, we don’t even know how much productivity growth is at the moment. And we don’t know that because the only thing I am absolutely certain of, with the European economy at the moment, is that the GDP numbers are wrong, and they are almost certainly too low. So, we will all, over the course of the next few years, revise up GDP, as the United States has just done.

When we revise up GDP, we will also revise up productivity because what is happening now is that there is economic activity taking place that the statistical agencies are just not able to track. So, case in point, it doesn’t matter how much you search through employment data in any country, you will not find TikTok content creator listed as a job, yet it is. It may be a part-time job, it may be a full-time job, but this is entertainment, it is advertising, and it pays substantial amounts of money.

And so, the failure to recognize that in the data means that you are underestimating the economic activity that is taking place. And then eventually, when you get things like tax return numbers and a more comprehensive and accurate picture of the economy, you end up revising up.

So, when we look at Europe today, we know that we are probably lowballing the growth. The growth should be higher. And that also means the productivity is going to be higher. There is very little, I think, that governments can do specifically around this issue to try and improve things.

The other issue, I think which is potentially quite problematic for Europe, and I think more so than the States in terms of data reporting, is that one of the changes that is coming through as a result of the fourth Industrial revolution, the technological upheaval we have, is that we are using our existing capital more efficiently. We’ve changed the use of the capital stock.

So, for example, today, you know, I am working from home, and I work from home quite a lot these days because it suits me as an economist to do that if I’m not traveling. That means I’m using my home office.

Now, if I was going into the UBS office in London five days a week, this office would be sitting empty, and it would be underused and the capital stock effectively would be wasted. But because we’ve moved to flexible working, UBS embraced flexible working almost a decade ago, as a result of that, we have a smaller real estate footprint and the UK economy, as a whole, is making better use of its capital stock.

Now, the problem with that is that’s not picked up in things like GDP data because GDP data is focused on output, not on efficient use of what you’ve already got. So that becomes a problem. Europe, arguably, has got a larger capital stock that could be used more efficiently.

Somewhat stereotypically, your average US building is built with an aim to knocking it down within 15 or 20 years. I’m exaggerating a little bit for effect there. Whereas in Europe, I was speaking at a conference in Rome the other day and the conference hall was built in the 14th century, again exaggerating for effect. But I think Europe has the ability to more effectively use its capital stock in a way that will enhance quality of life but isn’t necessarily going to add to GDP because GDP is not really measuring the quality of life.

[00:18:55] Alan

Now, you mentioned, at the start, about your interest in Japan, and being, originally, a Japanese economist. And for, I don’t know, going back three years, there was the theme of the Japanification of Europe, and now we talk about Japanification of China. But it was for a while, particularly when yields in Europe were so low. But we’ve got that parallel obviously with the aging population. And based on what you’re saying, we’re probably looking like a slow growth trajectory. Notwithstanding that GDP is just measuring GDP, and not measuring the quality of life. I mean, is that the parallel? Is that too extreme or do you see a parallel between how Europe is evolving?

[00:19:34] Paul

I think it’s a dangerous question actually, because having been an economist covering Japan in the early 90s, that sort of experience scars you for life. And it is too tempting to draw parallels all the time. And I do check myself on that.

I think that if you look at what went wrong in Japan in the 90s, it wasn’t just the property bubble and so on and so forth. One of the major problems was that the banking system was involved in propping up the Keiretsu, and the Keiretsu system was failing.

And so, what that meant was that entrepreneurs who had good ideas, potential for growth, were not able to get the capital they needed to develop because the banks were locked in to propping up a decaying system. I would argue that is not what we have in Europe.

I am very far from saying that the Eurozone has got a perfect banking system, because it doesn’t. And you know what, if an Italian wants to buy a German bank, they should be allowed to do so. But I think that the European system is not producing the misallocation of capital, at least not on the scale that took place in Japan.

So, if you’ve got a good idea in Europe, you probably will be able to find capital, you probably will be able to make the investment. You’re more likely to find capital if you’re a man than a woman. Then there’s a whole issue about misallocation of capital on agenda basis. But that’s a very different debate.

So, I think that that means that Europe does have the potential to avoid some of the extremes that Japan experience. At the same time, I think what Japan experienced, with regards to the nature of an aging population, does provide some hints to what we might expect in Europe.

So, I mentioned earlier on the fact that people in Japan and elsewhere do carry on working after retirement, maybe taking further paid employment or, alternatively, working in the voluntary sector.

Now the problem with the voluntary sector is the voluntary sector doesn’t exist in GDP, it’s just ignored. But actually, again, you start to see shifts in terms of how services are provided and so on and so forth. If you think about in Europe in recent years, the rise of childcare provided by grandparents, that’s an example of this sort of shift.

So, I think we can look to Japan for some guidance. But I think one of the things that was at the core of Japan’s problem, a fundamental misallocation of capital in the banking system, that is not what we’re seeing in Europe.

China is a more debatable point in that regard, I would say. But this is not what we’re seeing in Europe.

[00:22:22] Alan

Yeah, just a final one on Europe. I mean, you’d say you can get capital for a new idea in Europe, which I guess you can. But at the same time, what we’re seeing is all of the largest tech companies, the unicorns, are all being grown and developed in the US. Now, is this just a cyclical thing? If we went back 40 years ago, it might look different.

I guess the proponents of US Exceptionalism will say, well, that’s the structure of US economy. It’s more entrepreneurial. Do you believe that? Or is it just a cyclical thing where we are, in the last few years? Can it shift again, do you think, going forward?

[00:23:00] Paul

So, I think it’s really a clustering effect. And why is the City of London the City of London? Well, because it’s the City of London, and it’s sort of a giant sucking sound as aspiring bankers are pulled into the UK.

And similarly with tech. In the United States, the tech industry sort of settles in Silicon Valley. And now we are slightly broader, including Austin in Texas. And it just attracts the talent there. And it’s a clustering effect. Is that something that Europe needs to worry about? Absolutely not.

I don’t care about technology. Technology is not what’s important in the fourth Industrial Revolution. It is how you use technology that matters. I don’t care who makes the smartphone. What matters is how are you using the smartphone to enhance the productivity of your business, to get additional economic activity out of your work.

So, what we’ve really got to focus on here is less on who’s making the tech, because that will become increasingly commoditized, because that’s what happens over time. What we’ve got to focus on is, okay, we’ve got this, we’ve got AI. or we’ve got social media or whatever it is, how is that now going to enhance our business doing entertainment, or doing research, or legal work? How do we use the technology to become more productive? That’s where the focus is.

And that puts the emphasis very much on people. And here I think Europe does have an advantage. There are challenges as well. But one of the advantages that Europe has got is that the workforce is relatively well educated. You don’t have the levels of functional illiteracy and innumeracy that say, the United States or parts of Asia have got. And so that then gives Europe a potential competitive advantage because people who are better educated are at least potentially able to adapt to changing working practices, changing use of technology to enhance productivity.

Against that, the risks are the idea that, no, I’m entitled to work this way, and this isn’t going to change – the sort of rigidity of job function which does, I think, exist at least in parts of Europe. And then also the rise of more extreme politics, prejudice coming into society, which put in place barriers to employing the right person.

The more prejudiced a society is, the more difficult it is to employ the right person, in the right job, at the right time. Now that’s a global phenomenon, but Europe is clearly not exempt from that if we look at the rise of populist politics in Europe in recent years.

[00:25:43] Alan

Yeah, I mean, just on that, prejudice. Obviously, the solution to the aging workforce is immigration, or that’s one potential solution and that’s problematic across Europe. Will that just be an intractable problem going forward or any observations on how that could be resolved?

[00:26:01] Paul

The challenge of the last 250 years is that whenever there is technological upheaval, some people do better and some people do worse. It is the nature of technological change because you’re sort of turning society on its head. And in that situation, you get, every time, this progression. You start off with scapegoat economics.

It’s not my fault I lost my job. Well, from your perspective, it isn’t. You’ve been going to work every day, you’ve done the job to the best of your ability. Just nobody needs your job anymore because there are bigger forces in the universe that have changed what is required. But you can’t see that.

You say, it’s not my fault I’ve lost my job. It must be the foreigners have stolen it, immigrants are taking the job, too many women are working, drag queens are reading stories. It doesn’t matter. You pick on a scapegoat and you go after them. And that then very quickly lends itself to the prejudice politics.

And of course, foreigners and immigrants are very, very easy targets because they are obviously not like us. And that’s part of the problem. Prejudice has to dehumanize the target. And it’s easier to do that with somebody who has a different culture, a different accent, a different religion, or whatever it is.

So, I’m afraid to say I think that the rise of prejudice politics is something that is definitely there, and the economics is going to push, but as I said, it’s extraordinarily destructive when it happens. So, it is the job of economists and sensible politicians to push back against this.

Having said that, I don’t think that it is inevitable that prejudice marches onwards and upwards and anti-immigration continues and continues. If you look at what has happened to attitudes in the UK after Brexit, Brexit was a debate which was framed artificially around immigration, in my view. Since then immigration has increased and the hostility to migration has not disappeared. But if you look at surveys and polls, it has declined significantly.

I think partly because what Brexit did was, A, give a sense of control, you know, take back our borders was a powerful slogan, however inaccurate it might have been. But also, I think it forced recognition of just how important migrants have been to the UK economy. And that combination has then come through.

So, yes, people in the UK are still hostile to migration overall, but when you say, well, which migrants would you like to cut back on? Do you want to come back on the nurses? Do you want to cut back on the builders, the teachers? Do you want to cut back on the bankers? The answer is no. I mean, it’s remarkable.

So, I think that we shouldn’t extrapolate from the current noise about anti-immigration sentiment in Europe. Prejudice politics is real and it is economically and socially and morally very, very damaging. On the other hand, it is not inevitable that we keep going down that route.

[00:29:05] Alan

Okay, so obviously you’re based in the UK, and a lot of the problems we’re talking about, with respect to Europe, the UK is experiencing just the same, and maybe, some would argue, even more so.

Post Brexit, the view seems to have been that the UK has had, again, a productivity problem, an underinvestment problem, and obviously is dealing with something of a drag from the fallout from Brexit. And you’ve had a change of government there recently, not so long ago.

There’s been a little bit of a shift, probably relative to the Liz Truss failed budget. It was a very dramatically different approach to policy. How do you see that evolving? Were you encouraged by what you saw in the budget and are you more optimistic now about the UK or not?

[00:29:57] Paul

So, the UK, I think, we’ve discussed earlier the problems of missing bits of the economy. The UK is really plagued by this and that’s not a fault of the Office for National Statistics. The UK’s ONS, I think I can say without undue bias, is one of the best statistical agencies in the world. The main difference between the ONS and other statistical agencies is the ONS is honest about the failings of data, whereas other countries just publish regardless, even though the data has deteriorated in quality.

So, the challenge in the UK, I think, is that the UK has embraced quite a lot of structural change more rapidly than other countries. So, over 40% of the UK population work from home. A third of retail sales are online. And that’s very, very disruptive in terms of the overall economy.

We had an enormous explosion of small business startups during the pandemic and a lot of this is people sort of selling on eBay, or renting out rooms on Airbnb, that kind of thing. And again, that data is not being properly captured.

So, when we look across the major economies, the UK’s upward revisions to GDP are generally larger than those in the States or in Europe because we’ve changed more and therefore, we’re missing more in the rather old-fashioned way we try and calculate what’s going on in the economy. So that I think is an important shift. What does that mean?

That means that I think when we look at the last UK budget, it wasn’t, frankly, very surprising. There was nothing exceptional about it. It was changing existing tax rates, it wasn’t revising the tax code. There was no sort of dramatic alteration in what was coming through. It was recognition that actually we need to tax more and in certain areas of the economy we need to spend in order to repair infrastructure, shorten waiting lists, and so on, and so forth.

I think that there may have been some misguided or misfocused spending, not just with the current government, the predecessor governments have been very focused on why is the UK labor force not returning to pre-Covid levels, why are we not going back? And labor participation in the UK is very high, but it’s not as high as it used to be. And perhaps we need to spend more on health to tackle long-term health issues and so on and so forth.

And again, it’s dodgy data. There’s been some analysis recently which has discovered there’s a million people working that aren’t in the official statistics. And so, the government has been obsessing about this issue for three years under different administrations and it’s not an issue at all, it’s an issue with the data.

I think, overall, I have a sense of longer-term optimism about the UK, partly because the UK has embraced structural change quite early. So, we’ve sort of bitten the bullet and it will make things easier to adapt. Partly because I think prejudice politics has diminished in the UK post Brexit, and I would be the last person to claim that it’s gone.

Prejudice exists in the UK as elsewhere, but I think it is less toxic, at the moment, and that is helpful in terms of integrating societies, making sure the workforce is deployed as effectively as possible. And the other thing is the migration numbers into the UK.

The UK continues to attract a disputed number of migrants, but certainly a large number of migrants in. Here’s the thing, migrants don’t move to failing economies. And that, to me, is actually quite a healthy symbol. Yes, the English language means that there’s perhaps a biased moving to the UK or Ireland or wherever, because most people have English as a second language. Nevertheless, this is, to me, symptomatic of an economy that does have potential going forwards, provided we avoid some of the pitfalls that we’ve already discussed.

[00:34:04] Alan

I mean, you mentioned a lot about the data being mismeasured, which is one thing. And then obviously you kind of talked about this misperception, you know, between people’s perception of how good things are and reality. But also, we’ve had this general sense of, if you look around the world, growth is pretty good, unemployment rates are low, inflation spiked but it’s come down. There’s a general sense of unhappiness or disquiet, I think it’s fair to say.

Even in Ireland, we’ve had an election recently. Okay, the government looked like they’re going to be returned, but the two main parties are now down to about 40%. It just strikes me, as economists, are we looking at the wrong things? You’re saying, okay, GDP doesn’t capture everything. I mean, it’s almost like macro economists assume if unemployment is high and inflation is low, people should be happy.

But actually, people want to have a house, and if they don’t have a house or if the health service isn’t working, well, that’s as important. Do you think there’s a fundamental rethink needed in that people used to focus on the misery index: if unemployment was high and inflation was high, that was really bad. But if it was the opposite, everything was fine. But clearly that’s not enough.

You know, there’s a lot more going on that makes people happy with their assessment of the economy. How do you think economists can address that or think about that?

[00:35:24] Paul

So, I think that the bottom line is that economists need to be better at communicating. I think that’s one of the big issues, and that’s hardly an original thought. I mean, the Nobel laureate, Robert Schiller, wrote Narrative Economics, basically saying the same thing. And it’s a very, very good book. And I think it’s quite right. There’s too much, I think, focus on abstract issues.

GDP is a highly abstract concept. People don’t really understand what it is. When you’re talking about GDP, what they’re interested in is, can I afford to spend more this year than I did last year? Can I get more for my money this year than I did last year? Is there ready access to healthcare? Is my job safe? It’s that kind of thing. Those are the things which people care about.

And I think it is interesting that when we look at survey evidence, as flawed as survey evidence is, people will say, well, I’m fine, but my local economy isn’t doing so well, and the national economy is doing terrible.

So, it’s not that people are necessarily misperceiving their own personal circumstances. In some cases, particularly as a result of the rise in inflation, there is a misperception there because we know that consumers focus on the wrong things when it comes to inflation perceptions. Generally speaking, people have got a reasonable sense about their own wellbeing, but they don’t somehow translate that into the wider economy. And I think that is because there is this move towards sensationalism, and bad news sells in a way that good news doesn’t. A negative story will get far more clicks than a positive story will, sort of a perverse variation on loss aversion.

And so that is part of the problem. I think economists need to be better at going out and saying, well, no, actually things are not that bad, things are fine. And the fact that somebody down the pub showed you a YouTube clip which was saying things were terrible doesn’t mean that things are actually terrible. We need to try and get a sense of perspective in that regard.

Economists have been really bad at communicating. That’s been one of the problems of the profession for a long time. A few years ago, there was some research which showed that physicists were better on social media than economists were. And if the physicists are beating you at communication, then I think we’ve got a problem.

As I’ve already said, everyone should be able to understand economics. We all make economic decisions all of the time. So, if we can try and improve the narrative, I think that then brings possibly some reset to that perception reality gap that we’re seeing. So frankly, I think we’re still going to struggle with perceptions around inflation because people always think inflation is higher than it is.

[00:38:17] Alan

I mean, that’s a good segue into, obviously you’ve written about inflation, you’ve written a book about it, and we’ve had a big inflation episode.

So, I think you wrote your book before that. So, I mean from an economist’s perspective, the inflation rate has come down, so that’s good. But for everybody who’s living in the economy, they’re still going to Tesco’s and saying, wow, I used to get a lot for €50 and I don’t seem to anymore. Which, you know, that’s the reality of people’s perception now.

You know, in theory, everybody’s wages should have adjusted. Whether that has happened, I don’t know. You’d probably have a better sense of what the data suggests on that. But that’s certainly the perception that particularly, you know, obviously energy costs are higher than they were five years ago. Food and grocery costs are higher than five years ago.

Why have those costs stayed high even though, you know, the structural problems and supply side issues appear to have been resolved. Yeah, so, what’s your read on what happened through that whole period?

[00:39:14] Paul

Well, I think what we have had is not one, but three separate inflation episodes. So, the first inflation episode back in 2021 was transitory Inflation, temporary inflation. And it was temporary.

So, this was people coming out of the pandemic with savings accumulated, eager to spend. But if you cast your mind back to 2021, you know, people were not so keen to go out to restaurants and bars, travel, not so much. There were still restrictions on travel at that time. So, people weren’t going out and spending on services. They concentrated their spending on goods.

So, you get this extraordinary surge in demand for goods. In the United States the relative demand for goods, relative to trend, was the highest it had been since 1948 when Truman ended wartime rationing.

And actually, ending rationing is not a bad parallel because it’s that sort of surge of accumulated savings frantically chasing after a limited number of goods. Now supply actually hit a record high in ’21 – global supply of goods: all-time high; global trade: all-time high. But demand overwhelmed it. And of course, up goes the price.

Now, that was clearly going to be temporary, and indeed it was, because by 2022, durable goods prices (which is what we’re talking about here, electronics, furniture, that kind of thing), they were starting to fall – not lower inflation, lower price levels, the price was actually coming down.

Unfortunately, as we move into deflation for durable goods, you get the war in Ukraine, up goes the energy price. This is the second wave of inflation, totally separate from the first wave. War in Ukraine has nothing to do with supply/demand imbalance for durable goods.

Then as that energy shock fades, we then come into the third wave of inflation, which took us really into the first half of this year. And that is profit-lead inflation. Now, this has a variety of sort of politically charged terms to describe it, price gouging and so on and so forth, but I think profit led Inflation is the better way of thinking about it. It is something which affects primarily the retail sector.

Retailers have a convincing story to tell their customers about why prices are going up. We’re raising prices because of supply chain disruption. We’re raising prices because of the war in Ukraine. And because the customer is doom scrolling through social media, they’re constantly being bombarded with this negative news and so they accept the price increases.

Whereas of course, what in actual fact is happening is things like supply chain disruptions, the war in Ukraine, maybe justify a 2%, 3% price increase and the retailers are raising 10%, 15%. And the difference is profit margin. And as you look in, for example, the United States, retail profits as a share of retail GDP went from 14% of GDP to 21%, 22% of GDP. Obviously, that’s going to contribute to the inflation.

Now what has happened is that the transitory inflation is long since gone. The energy inflation is largely neutral, albeit prices are at a higher level. Profit-led inflation has stopped, so we’re not seeing further expansion of profit margin. In some cases there’s been a bit of a retreat, but it’s not a full retreat. And so, you know, price levels still stay relatively high as a result.

What we are looking at, I think, as well, as you say, is going into Tesco’s and saying, well, you know, I used to get more for my money. That is really the fundamental problem because your Tesco’s bill is going to be maybe 10%, 12% of your family budget. It’s not your biggest expense by a very long way.

And when we look across the board, what has happened over the last couple of years is inflation has been brought lower by falling prices for low frequency purchases. But the high frequency purchases, food and fuel, there you’ve had prices go up by a lot more and then they stuck at the higher level. And that creates this perception problem because we are guided by high frequency purchases.

People think the Snickers bar is indicative of inflation because they buy it every day. And that’s also the problem, because if you’ve got it stuck in your mind, you know, the Snickers bar used to cost me €2. That’s the fair price for a Snickers, and now it costs €3. And every time you buy a Snickers bar, you’re thinking, the fair price is €2 and I’m paying €3.

And so that constantly irritates and it constantly gives this illusion of inflation. Now, there’s only so many Snickers bars you can consume in a 24 hour period. It’s not a dominant part of your budget. And the other problem is that €2 is a fair price. It’s sort of stuck in your mind. Typically, it sticks in your mind for 18 months to 2 years. So, for 18 months minimum, every time you buy a Snickers bar, you’re thinking, oh, inflation’s out of control. Whereas, in actual fact, the price has been €3 for the last 18 months. It’s just that mentally you’ve still got a benchmark of €2 stuck in your brain.

[00:44:33] Alan

Okay. And I mean, obviously it seems like the inflation issue. I mean, anecdotally, watching the TV during the US election coverage seemed to be part of the narrative. There were different narratives, but it was certainly one of the issues. And I mean, moving to the US, at the outset you were kind of skeptical of the expression US Exceptionalism. Obviously, US growth has been very strong, but it’s been funded by a very large deficit.

We’re at an interesting point, obviously a new president coming in, a lot of kind of optimism around the potential maybe for supply side economics, animal spirits being unleashed. Is that a reasonable expectation or is that just blind optimism?

[00:45:19] Paul

So, I mean, I think the economy has done extremely well. Real wages are well above where they were four years ago. Real income, real living standards have improved. But again, people don’t believe it because of the frequency bias and their inflation perception.

In terms of animal spirits, source of that, certainly sentiment polls are likely to surge. Sentiment polls are, however, completely useless. I mean, I really pay very little attention to them other than sort of humor value.

So, one of the things that has happened in the last four years is when you ask Americans how’s the economy doing? The University of Michigan consumer sentiment, for example, registered Democrats are saying, oh, everything’s fine. Registered Republicans were saying, oh, everything’s terrible. And then with November, Democrats are saying, oh, things are really bad. And Republicans are saying everything is for the best in this best of all possible worlds.

Now, one of the interesting things here is Republicans are more emotional than Democrats are in surveys. So, the negativity of Republicans is far more negative than when Democrats are negative. And the positivity of Republicans is far more positive than when Democrats are positive. So, what we are now going to see, I think, is a surge in sentiment not because anybody actually feels better, but because politics means that it’s Republicans turn to say they’re optimistic and they get a lot more emotional when they’re answering questions. So that’s Going to lead, I think to a surge.

In terms of animal spirits more broadly, for all the talk of deregulation and so forth, I’m not sure that we’re going to get a surge in actual animal spirit optimism and so forth coming through because the president elects has prided himself on his unpredictable management style. And the problem with that is it’s unpredictable, and so it increases uncertainty and security and so on.

What’s going to happen with trade taxes? We really have no certainty on this because the President elect is sort of coming up with random tariffs, left, right, and center, of random amounts, potentially extraordinarily disruptive to very complex supply chains. Remember, over half of global trade takes place inside companies. It’s a company moving from one subsidiary to another. So, if you’re going to start taxing that aggressively, yes, I mean the company can eventually pass it on to the consumer. It’s still going to be extraordinarily disruptive to your medium-term planning.

So, there’s that uncertainty as a negativity, also the uncertainty about workers and the labor force because the President elect has talked about mass deportation of illegal and of some legal migrants. So that also then becomes very, very problematic as you know, are you going to be able to continue to hire? Should you be investing in automation? It may be a big investment commitment, but if you are going to lose your workers, then you’re going to need to do that. But if you’re not going to lose your workers, why bother? So, it goes on and on. So, this is all very, very potentially disruptive as well.

So, I think that the US economy has got a fairly solid foundation as we go into 2025. The middle-income consumer, as I said, they’ve got low unemployment, low fear of unemployment. Their real incomes are higher. There’s more money left in their bank accounts at the end of each month. And if an American has more money in their bank account at the end of each month, they feel obligated to go out and spend it. So that’s providing a solid basis for the economy. And the politics, I think, now is going to be noise around that solid foundation.

My instinct is that the noise is actually biased somewhat to the negative, slightly to the negative, but not majorly so. So, I think the US still does okay next year. I would actually expect it to slow a little low in terms of growth just because I think the President elect is serious about at least some of these tariffs. And if you’re going to tax US consumers as aggressively as those tariffs suggest, paying more tax is always going to slow an economy down a bit.

[00:49:50] Alan

Well, yeah, so tariffs are an interesting one because, I mean, you’re talking about removing the jargon from economics and making it explainable. But one of the challenges is there’s a lack of consensus with macroeconomists on lots of issues, and tariffs have been a case in point.

You know, some people say if prices go up, it’s clearly inflationary. Other people say, well, no. Scott Besson said no, people will substitute and it’ll have no impact. And some people have suggested, look at 2017, 2018, you had deflation in that period. So, are tariffs inflationary or not?

[00:50:21] Paul

There is no question they are inflationary. The question is, if you are in a deflationary or disinflationary environment, what they will do is lessen the deflation or lessen the disinflation. Well, consumers end up paying a tax to the government every time they buy a product. So, there is no way that that doesn’t come through in terms of inflation.

Now Besson’s saying they’ll substitute. There’s a problem with saying they’ll substitute. And if the Treasury Secretary nominee spent 30 seconds looking at what happened to the washing machine industry in the States, he’d realize this.

So, in his first term, President Trump put in place an aggressive tax on foreign washing machines in the United States. And the result was prices went up by about 30%. The tariff was about 30%. You got this huge increase in prices.

The thing is, domestically produced washing machines went up in price because by reducing the imports of washing machines, you reduce competition. And so domestic manufacturers say, you know what, we’re going to raise prices because we’re not being competed against by all these foreigners. And so much so (and this is one of the troubling things about tariffs), when the tariffs were lifted In February of 2023, the US washing machine prices did come down, but they did not come down to the international norm. And since then, the inflation of washing machine prices in the States has been significantly higher than in any other country.

And the reason is the competition never came back. France said, you know what, the last four years were complete waste of time. We’re not going to invest in marketing, we’re not going to invest in distribution chains, because this could happen again. We’re out. And the lack of competition has then put the US Consumer at a permanent disadvantage.

So, no, tariffs are inflationary relative to your bench-line. Consumers will pay a higher price not only for imported goods, they will almost certainly pay a higher price for domestically produced goods as well.

[00:52:22] Alan

Trump has said that tariffs are his kind of pillarstone policy. I mean, the last time he kind of dabbled with, in against China, in certain sectors, steel, etc., aluminum. Now it’s going to be more widespread. I mean, I think there’s a bit of concern, but people are not fearing the worst this time around. It’s my sense, at the moment, that it might be just a bargaining tool. How bad could it get if we got into a kind of a tit for tat protectionist war?

[00:52:54] Paul

Well, so essentially, as you say, there’s two sorts of tariffs, very broadly. There are selective tariffs, which you apply just to one country, and then the sort of the blanket universal tariff where with any import into the United States, US consumers must pay 10%, 20%. The universal tariff is a lot more scary.

Selective tariffs, they decay over time. You find a way around them. Supply chains reroute. So, you’re putting in place a tariff on China, as happened in 2018, for example. China, yeah, China loses market share in the United States. The rest of the world replaces China, and in some cases China replaced China; China just exports to Canada, say, the Canadians slap a maple leaf on the side of the box, hey, presto, it’s a Canadian export. You adjust your supply chains accordingly.

So selective tariffs decay over time. There’s an initial shock and initial economic impact on it and then it fades. The thing with the universal tariff, of course, is because you’re applying it to all imports, there isn’t a way around. And if you get a universal tariff, that would be, I think, very economically damaging.

Now, the last time that happened was 1971. President Nixon put in place a 10% universal tariff for four and a half months. That was a bargaining tool. That was him saying, “I want the yen to appreciate, I want the deutsche mark to appreciate. I’m going to put in place a universal tariff until these currencies appreciate against the dollar.” When they appreciated the tariff came off. That, I think, is not entirely Trump’s approach, because whilst in his first term, tariffs were clearly a bargaining tool. The language that he has used subsequently, and the language of a lot of people around him seems to me to be suggesting that these people think tariffs are “a good thing”. China’s going to pay for our deficit, which of course is complete nonsense, but they believe it. So that’s a risk.

Now, against that, I think the legal complexities, I mean, ultimately, under the Constitution, Congress has responsibility for trade. You know, there are various procedures that do have to be followed. What I think we will probably get is tariffs against China. I doubt 60%, probably 30%. And we will get selective tariffs on certain European, Japanese, and Canadian products.

So, you know, are European cars going to be hit with tariffs? Almost certainly, I would have thought. Are we going to get a universal tariff? I don’t think we do.

So, in my view we will get tariffs which are more enduring than in the first term. These are not just bargaining chips. They will be more severe. But we’re not going to get the full hit of a universal tariff and everything else that was talked about on the campaign trail.

Now, what that means (to come back to the question of inflation), those tariffs, I suspect, would add about half a percent to US Inflation. But at the same time the owner’s equivalent rent component of inflation is likely to come down next year and that decline will probably subtract about half a percent from US Inflation. So, a rough way of thinking about this, a very rough way, is that with tariffs inflation is 2% to 2.5%. Without tariffs inflation would be 1.5% to 2%. So that’s the sort of thing that we would be talking about.

[00:56:20] Alan

Okay, and then from a Fed perspective, if that’s your baseline scenario, it sounds like you think growth is not going to accelerate and be a little bit lower next year, and inflation will be still be okay even with the tariffs. I mean we heard from J. Powell recently, he was kind of a bit more cautious on rate cuts. Chris Waller was more full steam ahead on rate cuts.

Is that your baseline that we’re heading to neutral? So, more rate cuts to come next year?

[00:56:49] Paul

So, yes, I think the Fed chair Powell has made clear that the Fed would react to tariffs. They’re not going to say tariffs are coming, therefore we’re going to stop cutting rates. I think what they’re going to do is say tariffs are here and now we will stop cutting rates, if that’s what they’re going to do. Now, it depends on the severity of the tariff. It also depends on the second round effect.

The straightforward mathematics is a 10% universal tariff. I don’t think it will happen, but if it did it would raise price levels 1.25% in the States, as a first round. But then the second round is, do you get a lack of competition, which means domestic prices go up, and do you get profit led inflation?

Do companies sort of say, well you know, with the tariffs, we’ve got to raise our consumer prices by 10%, which is absolutely not the case. A 10% tariff means a 4% increase in the price of a good in the stores because of the way tariffs are applied. But companies will get away with expanding margin and putting prices up more. So, those would be the risks the Fed would be concerned about.

As a baseline though, with headline inflation coming down next year, with the economy doing fine but sort of operating at or slightly below trend, I think the Fed continues to follow inflation lower. So, I think they should cut in December. Inflation has fallen about a percentage point this year.

That means that the Fed funds rate should be about a percentage point lower just to stay neutral, not uneasing, just keeping things steady. Next year. I think a rate cut of a quarter point to quarter for the first and second quarter, I think that’s very easy to see.

After that it is going to be contingent on the tariffs. I think they can still cut if the tariffs are relatively benign. As I suggest. If we don’t get mass deportations, if we don’t get other disruptions to the economy, a quarter point to quarter is probably manageable. If you do get inflationary pressures, either from the immigration policy or from the tariff policy, then the Fed probably stops the cutting cycle and pauses to reassess.

[00:59:01] Alan

Kind of to tie all of this together in a kind of an economic view. You mentioned at the outset, you know, your clients on the wealth management side, are thinking two, five, ten years ahead. And with the 2010s, they were a decade of low growth, low inflation, very little volatility in growth and inflation as well. Now as we’ve moved into this decade, we’ve already seen more variability, particularly in inflation. So, what do you think the rest of the decade is going to look like from a growth and inflation perspective and what that means from, for kind of capital markets?

[00:59:32] Paul

So, I think inflation is going to remain relatively contained. There aren’t any significant long-term drivers of inflation. People say, well, what about the trade wars and deglobalization? And yes, that creates short term inflation bursts as we’ve discussed.

But we’re also seeing localization, that is to say, companies are choosing to produce closer to their customer base because it’s more cost effective to do that. So, some of what is happening in terms of changing global supply chains will actually lead to lower prices over time.

Technology, digitization, even aging populations, to the extent that more services are provided on a voluntary basis, older populations volunteer more, that kind of thing. You know, people are working for free. That helps to lower prices, structural change in the economy, changing expectations.

You know, this also helps to lower costs, lower prices. So, before I began my career at UBS, I was working as a checkout operator in a supermarket, and I was good. I could scan 32 items a minute. I was top of the league table, which is just as well because I’m working as a supermarket checkout operator once again.

When I go into my local food store, at Liverpool street station to buy dinner on the way home from work, there are 17 checkouts there and they are all self-service. I am working unpaid for that supermarket as a checkout operator. They are getting the benefit of my skills of 34 years ago. So, when you think about that sort of thing, these disinflation forces are fairly strong, and I think this will keep inflation relatively subdued.

On the growth side, I think growth will probably be somewhat higher, but I think we will have to wait several years to find out just how well the growth is doing. I think that that is going to be the challenge that we have over the medium-term.

[01:01:29] Alan

Okay, before we wrap up, would you like to get some perspective, I guess, from our guests? Obviously, you’ve been an economist, a macroeconomist for, I don’t know, three decades plus, and obviously it served you very well. For people who are interested in becoming better at macroeconomics or even for younger people who want to get a career as an economist at UBS, or any other investment bank, or elsewhere. Any thoughts or advice for things people should be looking at, reading or thinking about?

[01:02:03] Paul

So, I think if people are interested in a career in economics, thinking about studying economics. The Royal Economic Society has a web page, Discover Economics, which is very good.

It has a whole range of economists from various backgrounds talking about why they studied economics, what motivated them, and so on and so forth. In the interest of full disclosure, I’m one of the economists talking on a video there. But it’s a very, very good resource, I think, for just exploring the options around economics and what you might be able to do.

There’s a wealth out there of different sources. Obviously, we have podcasts and a wide range of political economics in particular that you can get from there. There are a number of blogs, Diane Coyle, who is a professor at Cambridge and a prolific author, has a very good blog covering a lot of economic issues, which I think can be helpful.

For people have an interest in financial economics, I do a daily podcast and Weekly blog at ubs.com/PaulDonovan, which is free to sign up for and anybody’s welcome. And there are a lot of resources that are out there.

Economists tend to congregate on Bluesky these days as a social media site. The profession seems to have moved en masse there. So, if you follow #econsky on Bluesky, there are a lot of interesting insights and debates in a fairly civilized way. Sometimes it gets a little bit heated, but you know, that’s economics for you.

But that’s also, I think, a great resource as well to monitor what’s going on in economics and to keep up with the current thinking both in academic economics, policy economics, and financial market economics. All three of us are there, so yeah, it’s a good place to go.

[01:03:56] Alan

Well, thanks very much. That’s very helpful and I very much appreciate you coming on today and for all of your insights. So, for all of our listeners, please stay tuned to Top Traders Unplugged. We’ll be back soon with more content and until then, we’ll talk to you soon.

[01:04:15] Ending

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