Calm Before the Storm

It was almost impossible for investors to lose money in the first half of 2014. Take your pick of any asset class at the turn of the year and you would almost certainly be in the black. The UBS index tracking 21 commodities has shown a total return of 7.1%. Long dated US Treasuries were a great bet returning 13% year to date despite the bearishness on long term bonds at the start of the year, whilst European periphery yields have fallen almost below US Treasuries. The S&P is up 7% so far continuing its stellar performance from 2013. Furthermore the CBOE Vix Volatility index, which is Wall Street’s so called “fear gauge” (using option prices to asses market volatility) has fallen below 11 indicating a market fearlessness. All this on the backdrop of continuing geopolitical tensions, European political and deflationary risks, expectations of a run on fixed income, China liquidity and growth concerns, a UK housing bubble and US stock bubble. I find it extremely hard to justify these returns and cannot see them continuing for the rest of the year. The BIS claim markets are ‘euphoric’ due to ultra loose monetary policy whereby liquidity rather than fundamentals is driving returns. Either way, I believe it will become increasingly important for fund managers to pick winners for the rest of the year. Below I focus on five areas where risks are being overlooked and threaten to destabilise the markets.

Geopolitical Risk

The most obvious place to start is geopolitical risks, which seem to be bubbling up ever more in the last few months. Despite the developments in Ukraine, the Russian Rouble is actually one of the best performing currencies in the last few months. That was until yesterday when Mr Poroshenko said, “we will advance and free our land” after the ceasefire was broken, sending the Rouble down 0.6%. ISIS insurgents in Syria and Iraq continue to advance towards Bagdad and at the time of writing had taken over Abu Kamal on the Syrian border, having previously declared the region held as a caliphate. A lack of Western intervention in Syria now leaves the West with the impossible choice between Asad and ISIS.  Islamic Extremism continues in Northern Nigeria and in Pakistan where the government are trying to flush out the Taliban. A Libyan civil war continues, hope for Palestian-Israeli talks hit a wall as teenagers died on either side and tensions with the new Egyptian president and the West reached a toll after the increasingly authoritarian General Sisi delivered harsh sentences to two pro-Muslim Brotherhood journalists. This follows the death sentences handed down to 182 Muslim Brotherhood supporters last month. 

The surprising common feature to most of the tensions is the market calm as if ultra loose monetary policy trumps all geopolitical risks. Oil barely touched $115 before falling back towards $110 after a pause in the Iraqi insurgency, as commentators believe ISIS are still very far away from damaging exports. Although the Rouble and MICEX suffered from Western sanctions, they were far too quick to recover following the brief ceasefire. The market optimism is staggering and it is hard to believe that all of these conflicts will fade away into the dust without damaging either commodity prices, emerging markets or even developed markets in the case of sanctions and commodity importers. All this before even considering the potential of a Black Swan sending this sectarian violence into full scale international conflicts. Building portfolios for the rest of 2014 will have to account for these potentially explosive collisions in the East and take the astonishing market optimism with a pinch of salt.

European Risks

Europe faces both political and economic risks. A rise Euroscepticicsm led to a damaging European parliamentary elections for the main national parties whilst a recent embarrassment for Cameron on the appointment of the Commission President, Jean-Claude Juncker, lead to the alienation of the UK worsening the prospect for the 2017 referendum. Along with a Scottish referendum later this year and tensions bubbling over in Catalonia, the future of the European Union has been thrown into doubt.

Economically, the EU still suffers high government debt, staggering youth unemployment, double-digit total unemployment and diverging economies at its very core. Diverging economies makes policy responses that much harder. France’s stagnating economy is filled with alienated voters and is in dire need of labour market reforms. Spain is faring better although still has a 25% unemployment rate whilst Germany seems to be leading the way with more optimistic data releases. The key issue in the Eurozone however is low inflation and policy responses. Eurozone inflation was unchanged at 0.5% this month well below its 2% target despite a negative deposit rate and new LTROs. Fittingly, yields have progressively fallen across Europe. Germany sits at a low of 1.29% and France at 1.76% whilst Italy’s and Spain’s ten year government bonds yield 2.93% and 2.64% respectively closing in on the US which stands at 2.63%. Even Irish yields sit below 3%.

The falling spreads between peripheral Europe and the US partly reflect economic outlook and diverging policy. The US is currently tapering off its QE and the UK is expecting a rate rise in the near future whilst a strong euro and threat of deflation has lead the ECB to expansionary monetary policy and the potential for its own form of QE. That said, these yields seem to be mispricing the inherent default risk in these countries. Low DM rates, high liquidity and high inflation in EM have lead the search for yield to Europe. Investors are betting on EU QE and a smooth recovery.  Yet Greek debt and Italian debt still stand at 175% and 132% of GDP respectively to name a couple. To give an example of the risk-off attitude, in April, Greece raised 3 billion euros after a five-year bond sale attracted 20 billion in orders leading to yields of 4.95%.

Investors know and understand these risk but excess liquidity is pushing yields down regardless. A change in sentiment is not the only inherent risk here but also low yields encouraging governments and corporates to scramble for debt can ironically amplify the debt crisis further.

 

Bubbles

A London housing bubble continues to threaten the UK’s recovery and has most recently been addressed by new powers handed down to the Bank of England. A bigger concern is the much-debated US stock bubble.  The 12 month forward p/e ratio stands at 15.6 compared to a 10 year average of 13.8. More striking is the Shiller p/e ratio (that compares prices to 10 years of profits) which is at levels only seen before the 1929 and dotcom crashes. Gains in US stock markets have been evenly distributed which is indicative of global liquidity rather than fundamentals driving prices. Despite the S&P at record highs the US economy shrank at an annualised 2.9% in the first quarter mainly due to bad weather. The concern however is if the market is attributing too much of the decline to bad weather and overestimating the size of the US recovery. If revenues and earnings do not rise in line with predictions we will surely see a large correction at some point. 

Even if 2014 returns are justified, it is unlikely this broad based rise will continue as US liquidity is reduced (especially if it is not replaced by Eurozone QE). It will be much more important to pick winners in the second half of the year which is all the harder when most stocks seem expensive.

Fixed Income & Commodities

The biggest surprise so far this year is the gains made on US 10 year Treasuries. Consensus was to avoid long dated US bonds at the start of the year as the Fed taper off their asset purchases. However long term yields have managed to stay low. The question on investors' lips is whether the second half of the year will bring lower bond prices (and higher yields) as the US finishes its taper and begins to think about rate rises. Intuition says losses are afoot as the US tightens but it is becomingly increasingly apparent that there is a disconnect between monetary policy and US Treasuries. Fed demand for Treasuries has been replaced some way or another thanks to geopolitical risk, emerging market sell offs and matching of long term liabilities at pension funds. Taking a step further, if you believe Dooley, Garber and Folkerts that the world still follows a Bretton-Woods system whereby periphery countries (such as Asia) are happy to underwrite US deficits to focus on export orientated growth then US bond yields may stay low for the foreseeable future as these countries target US capital.

As for tapering on emerging markets, focus will eventually be shifted back to the Fragile Five (India, Indonesia, South Africa, Turkey and Brazil) who have been rewarded since the summer sell off last year for improving their current accounts and productivity. Indonesia had gained a lot of ground thanks to a big step towards a current account surplus as well as optimism regarding the leading candidate and reformist Joko Widodo in the elections. That said, the country still suffers from high inflation and the nationalist Prabowo Subianto is narrowing the gap in the polls. High inflation reducing real rates of return and current account deficits may lead to capital outflows as global rates rise and the US reduces liquidity. Turkey seems most a risk having recently reduced their interest rate by 0.75% to 8.75% with the independence of the central bank being thrown into question. India has made huge gains since Modi’s win in the national elections but could face capital outflows if his reforms do not begin to meet expectations. The big issue facing fixed income markets is a run could cause a collapse in prices. ETFs with illiquid assets are eligible for daily redemptions and regulation in banking has reduced market making in these industries. Investors heading for the exits could cause huge panic and massive capital losses; hence the talk of imposing exit fees on fixed income funds.

As for commodities, gold is up 6.4% since the start of June due to geopolitical tensions, US inflation expectations and a weaker dollar. Copper shot up after concerns regarding Chinese financing deals faded and platinum saw some gains after the South African strike ended. Commodities are a real opportunity for the remainder of the year as their correlation (and general downward trend) from last year is broken down and investors can focus more on how supply and demand will be affected by these geopolitical risks.

Currency

Logic and reality do not always meet eye to eye when it comes to currency. The most recent bet is to be long the pound given the recent hawkishness of Carney and a strong UK PMI release. Sterling reached a six-year high yesterday. Expectations of rate rises this year have lead to a surge in short sterling contracts (i.e. bets on rate rises). That said, a week later the governor of the Bank of England released a dovish tone explaining rates will not rise unless wages advance. Perhaps he is trying to inject some unpredictability into the central bank to pop the housing bubble (in stark contrast to forward guidance). Either way, the UK is looking most likely to be the first to tighten hence the currency gains. That said, the pound trade is already looking overcrowded especially given the mixed signals from the central bank.

The Euro, whose strength was continuing to threaten a Eurozone recovery, was expected to fall dramatically after the ECB introduced expansionary measures. That said, the fall in the euro-dollar has almost been entirely wiped out due to poor first quarter results in the US  (weaker dollar) and reduced likelihood of QE in the Eurozone. It seems intuitive to believe that as policy diverges in the US and Europe that the dollar will strengthen against the Euro but this logic has been proved wrong again and again.

As for China, the recent depreciation of the Renminbi was a shock to all. The easiest trade last year was a carry trade in low yielding currencies, such as the Yen, to the Renminbi. Gains due to interest rate differentials were amplified by the appreciating Renminbi. The source of the depreciation is key to understanding the direction of the currency for the rest of year. It could be that the fall is market related. China is suffering from sliding house prices and slackening investment. Overcapacity in old-fashioned industries, dangerously high local government debt and a clamp down on corruption may be sending billions of dollars of capital out. More likely however is that is was a manoeuvre by officials to prevent a one way bet on the currency as they attempt to liberalise. After all labour costs are much more important in determining overall costs rather than a slight depreciation, China is still a large importer of inputs and officials would prefer to move up the value added chain boosting domestic demand rather than export orientated growth. Furthermore, growth was 7.4% is Q1 against the target of 7.5% and a Chinese liquidity crunch has been tackled by mini stimulus packages. Recent PMI data also shows expansions in manufacturing, all providing optimism that China’s growth run is not over yet. Strong data in China also benefits Australia and Canada. In fact a new carry trade from the US to Australia has been a big winner this year. The Australian and New Zealand dollar have gained 5.7% and 6.8% against the dollar respectively this year.

Conclusion

Investors and fund managers know and are concerned by these risks. Yet global liquidity, as the BIS argue, is driving returns. Broad based rises across all sectors and asset classes will surely have to end at some point this year, especially if the US finishes its taper and UK raises its base rate. It is time for fund managers to start earning their money…

The Dangerous Rise of Eurosceptiscism

As an Economist it frustrates me when anyone suggests an exit from the EU would benefit the UK. In a truly integrated world where 30 countries can take part in the manufacture of one t-shirt, it is absurd to believe general increases in protectionism can improve welfare. Nigel Farage’s (UKIP’s) xenophobic, blame-thy-neighbour rhetoric is currently gaining a lot of attention. I thought it was time I laid out my beliefs regarding the EU. I first look at the insurmountable costs of an EU exit and then discuss some of the so-called benefits of leaving the EU.

THE COSTS OF AN EXIT

1) Trade

Let’s start with the basics – trade. Regardless of what Farage claims, leaving a Free Trade Union will inevitably lead to lower trade with Europe and the rest of the world pushing us closer (even if by a small amount) to our autarkic equilibrium. You are on your own if you believe less trade with the rest of the world will improve living standards. There is as overwhelming agreement in the profession regarding the gains from trade. Trade leads to increased choice and variety, lower prices, increased competitiveness and the ability to exploit a comparative advantage. You may quite correctly argue that the gains from trade are severely unequal and globalisation leads to an increasing gap between the rich and poor. But the issue here is not with trade itself but with the subsequent redistributions. Free trade increases the size of the pie and it is up to government policies to redistribute this accordingly.

As for the firm perspective, small firms or the less productive (higher cost) firms do suffer from globalisation, being replaced be global MNCs with low costs and high market share. So perhaps leaving the EU may improve the bargaining power and market share of small businesses albeit at the cost of lower competitiveness and higher priced goods. However, in reality this is not what would happen. Large MNCs are globally integrated international firms and would brush off a UK exit, perhaps locating their headquarters elsewhere. The ones that will suffer are the small businesses and manufacturers that will see rising inputs costs and a diminishing export market. The idea that an EU exit will return the UK to a manufacturing powerhouse is nonsensical and living in the past. If anything, manufacturing will suffer the most whilst financial firms, which are the epitome of globalisation, will be just fine. As competitiveness falls, firms locate elsewhere, prices rise and incomes fall, the current account deficit will almost certainly enlarge as UK exports become less attractive whilst the needs for imports remains.

Capital and Property

What about investments? Put simply, FDI and hot money inflows will almost certainly fall. A choice between two equally productive manufacturing firms in the UK and Germany has only one winner. The firm that has access to the EU market with harmonised rules reducing uncertainty and the ability to export more cheaply will win. Being outside the EU will almost certainly lead to an increased risk premium on UK fixed income and equity as growth expectations become more uncertain and access to European free trade and all the bilateral/multilateral agreements that go with it disappear. 

As for property, the recent surge in house prices in the UK is partly driven by foreign capital, especially in London. Whilst this capital is partly responsible for creating a bubble in London, its reversal over time will cause large capital losses in the property market and we all have seen what decreasing house prices can lead to. It seems unlikely, but London property is an asset class like any other and its popularity may decrease over time as the UK shuns the rest of the world. Property prices will rise much more in line with UK incomes which in turn will be lower. Foreign capital will find its home elsewhere as other property bubbles emerge across the globe.

As capital inflows fall, the real exchange rate will depreciate making imports even more expensive. Less access to financing, borrowing and lower liquidity will hurt small businesses. Despite setbacks during most recessions, the world is only going in one direction – towards globalisation. Turning your back on it now is a mistake.

Immigration

I have written a blog on immigration previously so I will keep it short and sweet. The gist is simple. Immigration brings ideas, innovations, lowers costs, fills jobs that UK residents do not, reduces the debt burden of the economy and improves public services such as the NHS. The cited economics costs of immigration are often factually incorrect or simply xenophobic. Of course there are some costs such as welfare tourism but these must be viewed against the indisputable and overwhelming benefits of immigration.

Brain Drain

All of the effects above will lead to a brain drain where the best minds leave the UK. Those that add to the economy the most will have the incentive to relocate elsewhere where growth is higher and firms are more integrated. Movement of physical and financial capital will be followed by its complementarity in labour. Even if labour stays put, the UK will miss out on the benefits of skilled immigration that makes the UK so competitive, especially in financial services. Comparative advantages will fade away alongside skilled labour.

REASONS TO EXIT

National Sovereignty

It is true that globalisation and a political union leads to less national sovereignty. But for me this is not a cost. A lot of laws and decisions require international cooperation such as tax avoidance, climate change and international security. Geopolitical issues such as Ukraine and Syria rely on multilateral cooperation (even if the response is poor). Furthermore, do not get mistaken; the UK still has a lot of national sovereignty. It is the global issues that are and should be dealt with centrally. The idea of Germans setting UK law is a terrible way of viewing international cooperation and simply not true. I hope that views will change over the next few decades. Hopefully one day, people will consider themselves as much European as British. Harmonisation of laws, such as in financial services, can increase capital flows, decrease uncertainty, improve tax revenues and improve global growth. Some laws should be left to the national governments of course but the idea of solely unilateral laws in an integrated world no longer works.

Furthermore, whether you like it or not, the world is becoming more integrated and decisions are made increasingly at a cross-national level. Outside the EU, the UK will become increasingly less influential in the global arena. An outsider.

Culture

The view is that globalisation and the EU leads to increasing cultural fragmentation, changing British values and a “white middle class” that loses out the most to quote Farage. To some extent this is undoubtedly true. In the EU, the UK has and will become an ever-increasing mixing pot. Yet a mixing pot to be proud of. A mixing pot of different talents, skills and interests. A mixing pot of skilled and unskilled workers with a range of ideas, innovations and experience. My big issue with UKIP is the constant mention of this “white middle class.” If you consider being white and middle class as being British you are not living in the 21^st century.

Let’s remember that cultures have been developed over years of immigration all over the world. The idea of trying to preserve a specific culture of the past is the sort of conservatism that will stand in the way of not just economic development but also racial integration and decreasing ignorance of others. We should be happy to embrace different cultures. Preventing immigration is not the solution. The solution is breaking down the fragmentation between cultures.

What may have been very British a hundred years ago may not be very British today and the same goes for the next hundred years. Cultural changes happen slowly over time alongside increasing living standards. Do not fear them but embrace them.

Contagion

Of course being part of the EU means European recessions flow quickly to the UK increasing costs and damaging incomes in downturns. However I would respond with two points. Firstly, financial markets are highly integrated globally and therefore any financial recession is, in its very nature, contagious. The UK is one of the financial capitals of the world and hence will suffer from global recessions regardless of being in an economic union or not.

As for the sovereign debt crisis, whether we are in the EU or not, UK banks and investors will always hold EU debt. Bailing out European sovereigns will always be in the interest of the UK and its deposit holders. The recession and subsequent debt crisis led to a large blame-thy-neighbour rhetoric in many countries. It is always easy to blame outsiders and this often happens in recessions. Most of the time however these views conflict with reality.

Secondly, whilst recessions are exacerbated by globalisation so is both short term and long-term growth.

NO REFRENDUM

If the arguments are so convincing then why not let the people vote in a referendum? That would be the democratic thing to do after all. Let the voters decide. My reason for not wanting a referendum is that the public are not properly informed and the results may be disastrous. A lot of the benefits of global integration are slow and not visible until they are gone. Unless you are an economist, in finance or business, or just take a genuine interest in the subject your views may be distorted by the political rhetoric. The UKIP view is convincing if it is the first you have heard the subject. However, more often that not it is fantasy and driven far more by xenophobia than good Economics. Providing voters with a referendum is an easy way to win votes and lay blame, but it is dangerous. Furthermore, just because one party offers a referendum does not mean all the others should. A referendum can theoretically be used for any issue. The reason we don’t have a referendum on banning taxation is because the result may just be yes.

Curious Cases Of Correlation

Have a good look at the below graphs and try to explain them before reading on:

The first one, taken from one of my International Economics lectures, shows a strong correlation between US Rock Music quality and US Oil Production. What was your explanation behind this? How on earth can US Oil production improve rock music quality?? Perhaps music producers have large stakes in oil firms and higher oil profits flow through to more investment in musical talent. Maybe it’s the other way around! Perhaps listening to some really good rock music generates some of the great production innovations in the oil industry. This makes sense. Who needs fracking when all you need is just some good rock music to ensure self-reliance on oil in the US?

Clearly I am being sarcastic. I am guessing if you had a proper look at the graph, you also probably concluded that something odd is going on here. If you tried to link the two movements in the top graph, I have faith that at least you didn’t attribute higher usage of Internet Explorer to decreasing murder rates in the US in the second graph!

These are obvious cases of correlation without causation.  There are some fantastic and hilarious examples of this in the real world. Just have a look at the Buzzfeed link (http://www.buzzfeed.com/kjh2110/the-10-most-bizarre-correlations). I put a few more examples below just to drive home the point:

Clearly, in contrast to what these graphs might suggest, organic food sales do not cause autism and credit card debt does not cause obesity.

In reality something else, a factor outside the view of these graphs is affecting both the relationships. For example, increasing world GDP can have the effect of increasing access to Internet explorer and reducing crime rates in the US. All too often, the human eye sees a relationship and tries to attribute reasoning behind the relationship. In the hands of deceiving politicians, media and policymakers, graphs can be a destructive tool. Take a look at this subtler graph below:

This is a graph from Google showing the US unemployment rate in red and the US real minimum wage in black from 1990 to just before the crisis. It is sensible to associate the unemployment rate with the minimum wage. When two variables seem likely to be co-related, it is only natural to attribute causation. This graph tells us something very interesting – increasing the minimum wage decreases unemployment. Interest groups, media and politicians to a certain extent leave the story here. Armed with this graph and a convincing dialect, this is a dangerous weapon. If you have ever studied Economics, this will puzzle you. Increasing the minimum wage should increase unemployment. There should be a strong positive correlation here. From here a lot of economists and policymakers will try to explain the causation underlying the correlation. Perhaps increasing the minimum wage creates a multiplier effect driving up incomes and hence jobs. Once satisfied with the reason, a politician may decide to increase the minimum wage. After all, it has increased employment in the past. Wrong.

All too often, people forget that correlation is not causation, especially when the variables are supposed to be affected by each other.  There is a simple explanation for this graph. Improving economic conditions tend to reduce unemployment and also encourage policymakers to increase the minimum wage. Why do you think George Osborne wishes to raise the UK’s minimum wage now? It is because of a recovery that he believes it is a good time to make the political move. Take a look at what happens after the dotcom bubble. Unemployment naturally shoots up. At the same time, real minimum wages fall as politicians are less inclined to hike the minimum wage and damage employment further.

In fact, what is more likely is that the unemployment rate, in the absence of an increasing minimum wage, would have fallen even further. 

Econometrics

I have never really been a huge fan of econometrics. All this inverting matrices and proving consistency all seems a bit pointless (and still does!) But it has only been this year that I have truly realised the entire point of Economics. The role of Economics is to understand where there is and is not causation. If all graphs showed causal relationships, all economists may as well pack up their stuff and start throwing their constrained optimisations into other disciplines (perhaps physics where it belongs J). It is the role of the economist to break down these graphs and explain what is truly going on, first by creating theoretical hypotheses and secondly by robustly testing them econometrically.

I am fascinated by how often the media or a policymaker will show you a graph to convince the public. Statistics in the wrong hands can be wildly deceiving. Graphs are merely starting points.

Having said this, I want to look at some examples of where economists and the media all too often attribute causation where perhaps it is inappropriate.

Debt

The top graphs show Greek government debt alongside its sovereign ten-year yields for similar time periods. The bottom two are for the US, where the yield graph starts in 1982 just as the US debt explodes on the left hand graph.

The Greek debt crisis seems to provide concrete evidence that higher public debt increases the yield on government bonds (thanks to a higher risk of default). But if you actually look at the graphs, bond yields only began to rise at the start of the crisis in 2008. Government debt hit 106% in GDP by the end of 2006 yet markets seemed extremely calm. In 2001, debt was already above the worrying level of 100%.

I am not saying that higher debt does not contribute to higher default risk and larger yields but I want to make two distinct points:

1)  Even from the Greek graphs you cannot conclude that higher debt causes higher yields.  If the relationship were purely causal, yields would have increased well before the crisis. Of course, at the onset of the financial crisis, investors reassessed the risk of Greek debt and priced it accordingly. But there were other factors driving both graphs in their respective directions. Worryingly low competitiveness in Greece drove investors to safe havens at the start of the recession simultaneously increasing yields on Greek bonds and kicking into place automatic stabilisers driving up public debt further. There is also some reverse causality here. As the interest on government debt increases (and GDP falls) so does its level as a percentage of GDP. It might be more appropriate to argue that flight to safety was the cause of capital outflows in Greece and that rising yields was a consequence leading to a subsequent sovereign debt crisis.

2) Even if the relationship holds for Greece, it would be wrong to assume the relationship is causal globally. The US is an obvious example. It is cheating to a certain extent given that the dollar has the benefit of being the globe’s reserve currency, but it is useful for this point. Yields have fallen dramatically in spite of an enormous explosion of debt to GDP in the US. In fact, during the talk of a technical default, investors could not buy Treasuries quick enough. What holds for one country may not hold for another.

Forward Guidance

A lot of people have had their dig at forward guidance (myself included) for its pitiful effect in the markets. The introduction of forward guidance was intended to reduce long-term interest rates and flatten the yield curve. However, the introduction of forward guidance was correlated with increasing yields. There is the obvious argument that forward guidance brought forward interest rate rise expectations. However, this can be seen as a case of correlation without causation.

Forward guidance is an insurance policy against rising rates in an economy that was not improving. The idea was to prevent yields from increasing in a stagnant economy. It was brought out due to the fear that rates were starting to increase damaging the recovery. But rates were increasing due to the fact that the economy was improving. It is a vicious cycle – an improving economy pushed up rates and jolted the central banks into action to prevent steep rate rises in the potential scenario where the recovery was not as good as expected. Forward guidance did not necessarily push up yields but was an insurance policy against a scenario that did not happen. If anything, it probably reduced the rate at which yields were rising.

Austerity

“Our austerity plan is working,” is something you will have heard a lot recently. This statement is usually accompanied by recent growth and unemployment figures. All too often in politics and the media, policies are linked directly to macroeconomic outcomes. If you really wanted to prove causation here you would need some counterfactual (i.e. growth in the absence of austerity) to compare with.  Macroeconomic outcomes are a function of a huge number of variables and it is extremely ambitious to claim any single policy was the cause of an uptick in growth. In reality, the benefits of austerity are strongly contested amongst leading economists. In my opinion, economies should follow a cyclical fiscal strategy, fixing the roof while the sun is shining and allowing automatic stabilisers to kick into place in busts. This is especially applicable in economies like the UK and US that are deemed creditworthy even at high levels of national debt. I believe austerity should only take place in the bad times when it is forced upon you by huge capital flight leading to high borrowing costs and untenable debt. Whilst trying to avoid a Keynesian fiscal policy debate, my point is that a lot of well-established economists would argue that austerity would only have damaged UK growth. In this case, growth may have returned in spite of austerity and not because of it.

So…. Never believe anything?

So what’s the conclusion? Graphs are useless? No. Graphs are interesting. They show us correlations. The point of this blog was to take the insights that politicians and the media draw from statistics or graphs with a pinch of salt. Usually people will use data to emphasise their point where in fact the data is caused by another reason entirely.

Austerity may very well have lead to growth. Internet explorer may in fact reduce murder rates. The point is that the graph is just a starting point and anyone claiming it shows causation is undeniably wrong. If you can think of another reason that causes both variables to increase together then you may have proved them wrong entirely.

The idea is to be cynical. Is their conclusion sensible? What else can cause the co-movements? What does common sense tell me? Next time somebody throws you a statistic in an argument, throw this back at them (or ask to see their econometric analysis!)  Correlation does not mean causation. Remember that when reading the paper tomorrow.