Central banks and the digital currency revolution

In previous posts, I have argued that Bitcoin is a bubble which looks destined to burst. But bubble or no, the ideas underpinning digital currencies have piqued the interest of central banks which are aware of their potential. There are many reasons why they are interested in the digital currency revolution. For one thing, if such currencies take off as a medium of exchange, they will erode the traditional central bank monopoly over monetary issuance which in turn would reduce their control over the economy. As a result, there is an incentive for central banks to get involved if for no other reason than to head off the threat posed by private digital currencies.

Another argument in favour of a digital currency is that transactions using blockchain technology are transparent and traceable which would reduce the scope for tax evasion and illegal activity. In addition, it allows a greater degree of policy flexibility when interest rates are at the lower bound. In short, if we separate the unit of account function of money from its other functions by creating a parallel currency, it is possible to set an exchange rate between paper money and electronic money. By allowing paper money to depreciate (i.e. offering fewer units in exchange for the electronic alternative) this reduces the incentive to hold paper. In an environment where electronic currency is the dominant form, central banks have more flexibility to reduce the interest rate on deposits which does not exist in a paper cash economy. In a paper money world, if banks charge negative rates on deposits, individuals need only switch to zero interest bearing cash to avoid the negative charges.

This possibility is not available in an environment where digital currency is the only option: Account holders would have to store it in some other asset outside of central bank control.
In order for such a system to work relies on adapting a blockchain, or electronic digital ledger, which can be controlled centrally rather than relying on the distributed ledger technology currently employed by Bitcoin. As it currently stands, blockchain relies explicitly on a community of mutually distrustful parties to ensure that transactions are recorded correctly. Precisely because nobody trusts anybody else, no single individual or entity controls the digital record. Instead, the settlement technology relies on an encryption system to ensure that all users have access to the ledger simultaneously and each of them can update it. But the form of blockchain used to generate Bitcoin suffers from a number of technical limitations which will preclude the wider use of this particular digital currency.

For one thing, it can only process a relatively small number of transactions. The Bitcoin network can currently only process 7 transactions per second (tps) whereas the credit card Visa has a peak capacity of 56,000 tps and handles 2,000 tps on average. For a currency with aspirations to widespread acceptance this is a huge limitation, and is one of the reasons why I continue to believe that the upside for Bitcoin is limited. The obvious solution to the Bitcoin problem is to raise the size of the data blocks (currently, their size is limited to one megabyte which takes 10 minutes to process). Efforts to get all the Bitcoin miners to agree an increase in the size of the blocks has proved extremely difficult with the result that the blockchain has split once already this year, with one group opting to remain on the current standard and the others going off to form a parallel digital currency with fewer such technical constraints. Ironically, the Bitcoin system was initially designed to run at twice its current speed but it was limited for security reasons.

Indeed, security concerns may well be one of the issues which undermine Bitcoin. In theory, so long as no miner can control more than 50% of the network, they are unable to falsify the chain. But there have been well-publicised instances where Bitcoin exchanges have been hacked so it is clearly not as safe as its proponents believe. Moreover, if one individual or a colluding group of miners is able to gain more than 50% of the total network computing power they will technically be able to force a break in the chain, allowing them to override the rest of the community and take over the chain. Raising the size of the blocks in the chain could inadvertently lead to such an outcome. Miners with access to huge computing power and very low energy costs would be better placed to afford more bandwidth, which may lead to a higher concentration of miners.

So where do central banks come in? One possibility is that they create a centralised digitally encrypted record which would get around the security problems in the current system, Indeed, the system on which Bitcoin is based operates very much like the wild west – if there is a problem you are on your own, as there is no-one to turn to. By acting as the guarantor of the system, central banks eliminate this problem. In such a system, it is envisaged that individuals would hold a digital wallet at the central bank, with their incentive to do so enhanced by the differential rates of return offered on digital and paper money, outlined above.

But what happens to commercial banks in a system where the central bank manages the transactions and creates the digital currency? One possibility might be that banks create their own digital currency which can be exchanged for the central bank unit at a given rate. This would allow banks to create credit in the same way they do now whilst giving central banks the ability to control the overall rate of credit creation by altering the digital currency exchange rate.

Other alternative central bank currency models appear to ignore the commercial banking system altogether, relegating them to the role of transaction processors. In such a world, banks manage a number of lower-level chains which record transactions, and which in turn feed into the main ledger to which only the central bank has the digital key. Essentially, banks would become transaction verifiers rather than account holders. Since the costs of becoming a transaction verifier are far smaller than operating a fully-fledged bank, this might be expected to raise banking competition as new entrants come into the market which will reduce the costs of banking for the wider public.

We are obviously a long way from being able to introduce this kind of system. But it does suggest that the theoretical possibilities of a digital currency system are far greater than the relatively narrow range of outcomes offered by Bitcoin. This is one of the key reasons why we should not dismiss the digital currency story. However, it does not always pay to have first mover advantage. Recall that the mid-1970s Betamax technology, which was many people’s introduction to home video, was quickly supplanted by the technologically inferior VHS system, which in turn gave way to the DVD revolution. Home video was once a big deal, but who remembers Betamax today? We could be saying the same thing about Bitcoin in the years to come.

The topsy turvy world of Bitcoin

The crazy world of Bitcoin entered new territory today following the introduction of a Bitcoin future on the Chicago Board Options Exchange (CBOE). Almost immediately, the one-month contract surged by 20% to a record high of $18,850 but by mid-afternoon the futures contract had stabilised at $17,800 with the spot price trading around $16,500. Depending on who you talk to, Bitcoin has either received an official stamp of approval which will push it higher, or recent trends confirm the madness that has taken hold which surely will hasten the crash.

The price has now increased by a factor of 20 during this year and the movements now really do mirror the price of Dutch tulip bulbs over the period 1636-37 (see chart). Like tulips, Bitcoin represents something totally new, hence the difficulty in setting an appropriate market price. Unlike tulips, Bitcoin has more than merely intrinsic value: Investors bought tulip bulbs (never the flowers) because they knew there was a demand for them amongst those wealthy people keen to adorn their gardens with rare flowers. In theory, Bitcoin is a medium of exchange so a rise in its price allows investors to buy an increased quantity of goods and services with it, although it now appears to be desired for its own sake as investors buy it in the expectation that its price will rise further. We should be in no doubt that this is a bubble: I have experienced a few in my time – though never one quite like this – and I have no doubt that this one will pop.

One question which was posed to me today was whether the establishment of a futures contract on a recognised exchange marks the point at which Bitcoin is about to go legit, which will allow it to attract institutional investors. I suspect the answer is almost certainly not. For one thing, regulators are concerned about the risks posed by money laundering. A basic definition of laundering is the process of allowing “dirty” money earned from proscribed activities to enter the legitimate economy via three main steps: placement, layering and integration. The placement stage represents the movement of cash from its source but the blockchain system underpinning Bitcoin does not allow us to identify the source, merely the fact that a transaction took place. Similarly, the layering process which is designed to make it difficult to detect illegal activity, is facilitated by the blockchain process. Accordingly, the integration stage, which is the conversion of cash earned through illicit means into a legitimate form, becomes so much easier.

Another aspect of the law which is increasingly taken seriously by financial institutions and regulators are the KYC (know your customer) regulations. The anonymity offered by Bitcoin transactions runs a coach and horses through the rules. Accordingly, no reputable institution worth their salt will want to incur the wrath of regulators by offering Bitcoin related products. Back in September Jamie Dimon, CEO of JP Morgan Chase, called Bitcoin a “fraud” and threatened to sack any of his staff who deal in it (its highest value at that point was $4880 which looked pretty elevated at the time). He subsequently said “the only value of Bitcoin is what the other guy'll pay for it.”

This strikes me as an astute assessment of market trends in recent months. This is how pyramid schemes work and in his column in the Daily Telegraph a couple of weeks ago, Jeremy Warner suggested that Bitcoin is “very probably already the biggest such racket in history.” He might want to have words with his sub-editor, though, who titled his column “Investing in Bitcoin is not idiocy but perfectly rational – it's called 'the greater fool' theory.” There is nothing rational about the greater fool theory.

That said, I have pointed out previously that I believe digital currencies have a future, for reasons I will come back to another time. But a Bitcoin collapse could set back the cause of digital currencies a long way. After the price of tulip bulbs hit their peak in February 1637, prices collapsed by anywhere from 80% to 95% over the next five years depending on the tulip variant we pick (there are significant variations in types of tulip, hence lots of price variation). A lot will thus depend on the extent of any market correction. What will help digital currencies in the long run is that they are underpinned by the blockchain which could yet turn out to be one of the most significant developments in the digital world.

But consider this: The total value of physical cash in circulation around the world is $31 trillion and the total number of Bitcoins it is possible to create is 21 million. If Bitcoin were to totally supplant cash, this would put the equilibrium price of Bitcoin somewhere close to $1.5 million per unit at current prices. The total value of all cryptocurrencies in circulation is currently around $450 bn – around 1.4% of the total value of cash. Suppose for the sake of argument that in the long run Bitcoin were to account for 5% of all cash transactions: This would still put the equilibrium unit price above $73,000. Presumably investors continue to believe this is where Bitcoin is headed – and good luck. Obviously, nobody has a feel for the equilibrium price of Bitcoin. But wherever it is, I still maintain the market price will go down long before it gets to that level and it may not survive a big crash as other digital currencies take its place.

End of part one

The news early this morning that the EU has agreed that “sufficient progress” has been made following the first phase of Brexit negotiations was initially met with a positive market response. But with sterling eventually weakening in the course of the day it is evidently not being seen as a panacea for all Brexit ills. Whilst there was compromise on both sides, the UK has moved far closer to the EU’s initial position, particularly on the question of the exit bill, which is pretty much what we thought would happen all along. Meanwhile, the Irish border question has been kicked down the road for now.

With regard to the bill, the official document released today did not attempt to put a figure on the final cost but it is estimated that the UK will pay a net amount between €40-60bn over a multi-year horizon (we assume €50bn for the sake of argument). It will also continue to pay into the EU budget in 2019 and 2020 as if it were still a full EU member. On the basis that the annual net cost of membership is around €8bn per year, this implies that around one-third of the net exit bill will be paid by 2020. But this still means that the UK will have to find an amount equivalent to €35bn after 2020 – the equivalent of 4-5 years of full membership. In practice, it will have to pay a lot more up front. Some of the reimbursements, such as the share of European Investment Bank assets, will only be repaid over a twelve year period beginning in 2019.

The fact that the UK will continue paying into the budget until 2020 resolves a major headache for the EU, since this allows it to meet all obligations in the current budget cycle which would otherwise have been interrupted had the UK ceased to pay in 2019. But it is bad news for the UK, which will become a rule taker whilst still continuing to pay full membership fees. The UK is thus moving towards the Norwegian option – at least in the short-term – which I pointed out in the immediate  aftermath of the referendum was the worst option because it imposes all the same costs without the benefit of being able to influence the rules.

It is unlikely to be a long-term solution, however, with the EU increasingly of the view that a Canadian style free trade agreement is the most plausible option. Whilst such an outcome will offer largely tariff-free trade in manufactures, replication of the Canadian option implies some tariffs would remain on agriculture and it would permit no access to EU FTAs with only a partial liberalisation of services. Moreover, there would be no financial services passporting. But it will take many years to hammer out such a final deal – do not be surprised if the EU and UK seek to extend the Norway option for another two years to 2023 whilst they continue to work on the details of the final arrangement.

Earlier this week, the Irish border question threatened to derail any prospect of reaching a deal today. No resolution was offered this morning. The issue has merely been kicked down the road. Indeed, the problem of avoiding a hard border remains incompatible with leaving the customs union and single market, and the best that the two parties could come up with was that if they fail to resolve the terms of their future relationship, the UK will maintain “full alignment” with the EU internal market and customs union rules which “now or in the future” are important for preserving north-south trade. Despite the DUP’s recent objections to treating Northern Ireland differently to the rest of the UK, that in effect appears to be what is being proposed in the absence of an alternative.

What to make of it all? Firstly, we should welcome today’s events as a first sign that progress towards a trade deal – and ultimately a softer Brexit – has been made. But it comes at a price: the UK has capitulated in the face of the EU’s demands, thus rendering irrelevant the six months of bluff and bluster by Brexit supporters. In no sense has the UK taken back control: Indeed, quite the opposite since the Norwegian solution implies giving up lots of control. Nor has it freed up the additional funds that were promised to the NHS (£18bn per year if you recall).

But it could have been worse. The Brexit Secretary finally admitted this week that “no economic impact study had been undertaken before the cabinet decision to leave the customs union and no assessment had been made of the possible economic effect of a no-deal Brexit”. At least they now have the time to do some impact analysis to assess the costs of Brexit. One of the arguments often used by Greek and Italian citizens for remaining in the EU is that it forces their politicians to act responsibly. Today’s deal may have given UK politicians a lifeline they were too disorganised to find for themselves.

The cracks are showing

If ever any Brit needed reminding of the absolute indifference with which the rest of Europe views the tedium of Brexit, a glance at most European newspapers this morning would have provided it. The failure by the British government to reach a deal on the Irish border issue dominated the UK news but received scant coverage elsewhere. The travails of Donald Trump were the biggest item on most non-English language newspaper websites, demonstrating what happens when lunatics run big asylums rather than the small scale takeover we are witnessing at home. Indeed, there are plenty of significant issues going on elsewhere: The fact that Germany has not yet formed a government, almost three months after the election, is a reminder that other countries have their own political issues to deal with.

We should thus not be under any illusions that Brexit is anything other than a peculiarly British problem and as such requires a domestic solution. But finding a solution depends on being able to identify the problem. Whilst the Brexit ultras try to blame the perfidious EU for making life difficult, ultimately the issue boils down to ineffective domestic government which makes resolution far harder. But whilst I have been critical of Theresa May's handling of many aspects of Brexit, I do have some sympathy for the fact that she inherited a mess bequeathed by her predecessor. Brexit involves trying to reconcile a series of mutually incompatible positions whilst convincing the electorate that both something and nothing has changed, and at the same time trying to prevent the fissures at the heart of government from growing larger. The near impossibility of this task serves to remind us that advocates of Brexit either deliberately lied about the ease with which it could be achieved, or perhaps even worse, could not see the difficulties involved.

Much as I may have railed against last year's decision, I have never called for a second referendum. Partly because I don't think it will resolve anything, but perhaps because I have secretly believed that the difficulties in delivering a Brexit that works for the UK are so insurmountably large that it could yet come back onto the agenda of its own accord. I have little doubt that the current government is unable to deliver the "red, white and blue Brexit" promised by Theresa May. For one thing, a task of this magnitude requires a government with a common purpose but this one contains too many members with differing positions. Worse still, the government is unable to command a working parliamentary majority and as it learned to its cost yesterday, that is an impossible position from which to win a deal on Ireland.

But Brexit obscures a bigger truth. The referendum last year was a vote against the status quo. As a consequence we should not be surprised to find that the old political methods are failing to find a solution. The conventional politicians who populate the Conservative and Labour parties, and who we can broadly class as the political centre, represent the status quo against which the electorate voted. It is no wonder that they cannot imagine a solution because they cannot conceive of a world in which the old rules no longer apply. In many respects I am in the same boat although my position is based on the evidence that suggests whatever comes next will not match the deal with the EU that we have now.

Clearly, it is me who is out of tune with the Zeitgeist. But I may be wrong: After all, there is no reason why the post WWII settlement must continue to hold after more than 70 years. But precisely because half the electorate shares a similar opinion, Brexit can never work on the terms set out by its proponents. It will deliver a highly Pareto inefficient outcome because it cannot make anyone better off without making others worse off. This is not wholly a monetary issue. If we end up in a world where Britain distances itself from the values which have characterised its past, and those which large parts of Europe still hold, then this is for many (myself included) a regression to a sub-optimal position.

So how can Brexit be made to work under such circumstances? First off, it probably requires a political leader with near-unanimous support who can convince the electorate that Britain has a future outside the EU but that it still shares the EU's underlying goal of ensuring peace and prosperity across the continent. There certainly isn't anyone in the current generation of politicians with that sort of broad appeal. The closest any politician in my lifetime came to having the X-factor was Tony Blair, and look how that turned out. Thatcher never had it. Nor did Winston Churchill who, lest it be forgotten, was so revered by a grateful public that they rewarded him with an election defeat in 1945. In that light it is hard to imagine that Jeremy Corbyn is a viable political alternative, even though he offers a radically different economic policy.

In the absence of the requisite leadership, is there any other way that Brexit can be made to work? I suspect the answer boils down to cold, hard economics. If the UK economy can generate prosperity in which the electorate can all share, they may be prepared to accept life outside the EU - albeit grudgingly. But as most of the economics profession (and all reputable economists) have pointed out, leaving the EU on the terms specified by the government simply cannot generate that prosperity because it entails giving up many of the economic advantages we currently enjoy, such as membership of the single market.

Having established that we don't have the political leadership and that the economic conditions for a successful resolution are unlikely to exist, I am not the only one struggling to understand how Brexit will work. It certainly will not be the success which the Brexit-at-any-price brigade believes. But then I have been saying this for nearly five years and nothing that has happened so far has been enough to persuade me I am wrong.

Bitcoin: A currency whose time has not come

If anybody needed confirmation that Bitcoin is a bubble waiting to burst, consider this: It took seven years since it started trading for it to cross the $1000 threshold, which it did in January this year. Four months later, in May, the price surged through the $2000 level. By August, it broke the $4000 barrier and … well, you get the picture. It takes ever less time to go through each successive $1000 level. Just after 1am London time this morning, it broke the $10,000 threshold for the first time. Thirteen hours later, it reached an all-time high of $11,434 and less than six hours later it was way back down, at just above $9000.

If you draw a daily chart of Bitcoin moves, this is a trend which will not show up. But these are the sort of market movements that are hard to resist – everyone loves a good boom, and before too long it is a pretty safe bet that there will be a bust from which there is no coming back. Aside from the fact that any asset which rises at such a speed almost inevitably comes crashing down again, there are numerous ironies associated with Bitcoin which make it unsuitable to be the great alternative to central bank controlled cash that its proponents claim.

Consider the fact that its initial popularity was derived from those who believed the best form of protection against an imminent collapse in civilisation was to live in a remote cabin in the woods with plenty of tinned food and a well-stocked armoury. The theory ran that central bank cash would soon become worthless as societies collapsed and alternative forms of money would come into their own. There is just one snag. Bitcoin is an electronic token which exists only on a computer. In the event that civilisation were to collapse, who would be there to keep the lights on – or more pertinently, generate the electricity required to ensure that Bitcoin could continue to be traded?

To understand why all this is an issue, we need to go to the heart of what Bitcoin is. It was designed as a peer-to-peer electronic cash system to cut out the conventional banking system. In order to make this work, transactions between holders of Bitcoin are recorded on a digital ledger known as the blockchain. In a conventional banking system, the ledger is a record maintained by the banks. To bypass this step, a ledger technology was created in the form of an electronic file which records all transactions in sequence, so we can see how title to Bitcoin passes from one holder to the next. In the absence of a centralised record keeper, it is important to ensure that people are not cheating (i.e. claiming to own Bitcoin to which they are not entitled). This is done by timestamping each transaction and linking it to each previous timestamped transaction in the form of a chain. In this way, we can trace back all transactions – there are no secrets.

But transactions are only added to the chain after a complex proof-of-work algorithm has been solved. Due to the transparency of the system, falsifying the current transaction would require falsifying all previous transactions, and because the proof-of-work algorithm is computationally onerous, there is little incentive to cheat – it is simply too expensive in terms of time and transaction costs. So once you solve the cryptographic puzzle and all users agree the solution is valid, one iteration of the proof-of-work algorithm suffices to ensure the blockchain is valid. Bitcoin comes into the equation because those who maintain the blockchain, and do the complex calculations, are rewarded by payment of Bitcoin. An additional complication worth knowing is that the supply of Bitcoin is limited to 21 million, and almost 80% of all coins likely to come into existence have already been created. Moreover, miners get progressively lower rewards for each block they “mine.”

Having completed that diversion, it raises two issues. First, the electricity requirements to run the blockchain and mine Bitcoins are enormous. Because of their increasing scarcity, miners have to expend more energy to generate each additional Bitcoin – it is an energy-inefficient process. Currently, this activity consumes as much electricity as the Turkmenistan economy and estimates suggest that by 2020 it could consume as much as Denmark. Second, the real bonus of the system is that the blockchain is applicable to a wider range of activities than Bitcoin. The real reason why Bitcoin has surged this year is that investors have been bringing blockchain-related products to market via initial coin offerings. But the Ethereum network, which is an open-source, blockchain-based platform designed for a wider range of applications and in which the digital currency (Ether) is derived as a by-product of the verification process, has been one of the fastest growing currencies this year.

Policymakers have taken note of the recent bubble with the BoE’s Jon Cunliffe reassuring the public in a radio interview this morning that it is too small to hurt the wider economy. Indeed, the global market cap of all digital currencies currently stands at $283 billion – less than 0.5% of world GDP. But central bankers have taken note of digital currencies and have been thinking about central bank controlled cryptocurrencies for quite a while (I will deal with this another time). I do believe that there is a future for digital currencies – it’s just that I don’t believe Bitcoin is the vehicle to take them forward.

The dawning realities of Brexit

If nothing else, the exceptionally weak growth projections released by the OBR on Wednesday should make people realise the scale of the economic challenges the UK will face in the wake of Brexit. It really ought to be the sort of wake-up call that forces people to ask themselves whether leaving the EU is such a good idea after all.

In fairness, the huge downward revision to growth, which now looks for real GDP to average growth of 1.4% per annum over the next five years, was triggered by a downward revision to productivity growth – not wholly related to Brexit. But the OBR did highlight that Brexit-related uncertainty was likely to impact on business investment and assumed that the UK’s “share of EU market in global markets would also fall.” The OBR, whether wittingly or not, provided a scathing indictment of the government’s failure to plan for Brexit: “We asked the Government if   it wished to provide any additional information on its current policies in respect of Brexit that would be relevant to our forecasts. It directed us to the Prime Minister’s Florence speech from September and a white paper on trade policy published in February. We were not provided with any information that is not in the public domain. As in our previous two forecasts, we have not therefore been able to forecast on the basis of fully specified Government policy in relation to the UK’s exit from the EU.”

In the course of this week I have become engaged in a couple of debates about the economic wisdom of Brexit. In the first instance, my interlocutor asked me why I hold the view that the UK needs a trade deal with the EU and why instead we should not simply forge trade deals with the US, China and India. I pointed out that the EU is the UK’s largest single trading partner and that countries located in close proximity tend to trade heavily, which is why the UK exports more to Ireland than to China and India combined. His follow-up question was why the rest of the EU would put up trade barriers against the UK. My response was that if we resort to WTO rules, this will be the default position and because those countries which export a lot to the UK will not be able to do a bilateral deal, we need one with the EU.

The second issue regarded the usefulness of economic forecasts with regard to Brexit, which was particularly appropriate in the wake of the OBR’s assessment. I pointed out that in broad terms the economy is now where most forecasters assumed it would be based on their pre-June 2016 Brexit scenarios. A-ha, said my correspondent, but didn’t most forecasters assume the end of the world in the wake of the referendum. I have to admit most of us were overly gloomy based on our post-referendum forecasts. But as I have noted before, these were made against a backdrop of huge uncertainty: (i) no effective government; (ii) the assumption that Article 50 would be triggered immediately (as David Cameron had indicated) and (iii) some dire survey evidence in the immediate aftermath of the referendum. If you look at what most forecasters (including the Treasury’s longer-term analysis) indicated in their pre-June projections, it was generally assumed that the UK would grow by between 0.5% and 1% more slowly than otherwise – a view which is now being borne out.

Admittedly, the Treasury did not help matters with the dire warnings contained in its publication warning of the short-term implications of Brexit. But most economists dismissed these as being over the top and in retrospect should be viewed as part of the much derided Project Fear. More generally, if we take a medical analogy, and assume that an overly-cautious doctor quarantines a suspected infectious patient, do we then cease to listen to all medical advice? On the whole, I am comfortable with the consensus economic view that, at least over the next couple of years, the UK economy will underperform relative to its developed world peers.

Regarding questions on Brexit, I do welcome the fact that people challenge my views and even if we are unable to persuade each other of our respective case, it is important to have a civil debate about the consequences. I am not sure of the extent to which buyer’s remorse has set in with regard to the Brexit vote. Some people may have changed their mind, though I suspect the numbers are small. But 17 months after the vote and with 16 months until the UK leaves the EU, the understanding of the implications and the degree of preparedness for what follows are shocking. Anger is currently directed at the media (even the pro-Brexit newspapers are focusing on foreign disinformation campaigns), whilst both Leavers and Remainers point the finger at each other (those Leavers arguing that if we all got behind Brexit we could make a success of it, really ought to engage their brain).

But the real culprits are in government. It was David Cameron who took the gamble and failed. It was the Conservative government which adopted a winner-take-all strategy in autumn 2016, and polarised the country rather than seeking to heal divisions. It was Theresa May herself who called an unnecessary election which weakened the government, allowing ministers to intensify their in-fighting. Not that the Labour Party are much better. A large chunk of those who voted for Corbyn in June as a protest against the pro-Brexit Conservatives seem not to understand that he has no  intention of halting Brexit. More damningly, the government has no plan for the future, as the OBR told us last week. Unless the EU takes pity on the UK and agrees in December to start trade talks, the outlook is starting to look pretty dire.

Budget round-up

In my day job, when called upon to provide commentary for clients, I essentially face two choices: Either inform them as quickly as possible, sure in the knowledge that you are not going to cover all bases, or provide the most in-depth piece looking behind the data for things that are not obvious at first sight. It is a difficult trade-off, particularly when you know that your better-resourced competition is capable of producing in-depth analysis at speed.

Analysis of the UK budget always falls into the category of issues where you know that there are nuggets waiting to be mined but if you spend too long looking for them, the commentary will soon be out of date. After all, the volume of material available online once the Chancellor’s speech has finished is huge. The OBR’s Economic and Fiscal Outlook is a guide to all aspects of the UK macro economy that you would ever need to know (and many that you didn’t). It is all a far cry from the days when the best we could do was run down to one of London’s mainline stations to pick up a copy of the Budget Red Book.

With some hours having passed since Philip Hammond presented his parliamentary statement, did I discover anything obvious that I missed? Nothing really springs to mind, although one nugget which jumped out at me after having looked through the EFO  was Box 2.1 on pp27-28 which highlighted that real GDP in 2012 is today assessed as being more than 2% higher than was measured at the time (see chart). This matters because the starting point against which forecasts were made five years ago was better than anticipated and goes some way towards explaining why the deficit in recent years has come down so sharply.

Turning to the overall content of the budget, much has been made of the significant downward revisions to the GDP growth forecasts, which constrain expected revenue growth and mean that the deficit at the end of the forecast horizon (extended to 2022-23) is projected at 1.1% of GDP versus 0.7% in March. So it’s been revised up a bit? So what? As I pointed out in a recent post, what really matters is debt stability and both the OBR’s and my own forecasts suggest that the debt-to-GDP ratio is likely to start falling in the next year or two. I would in any case be tempted to treat the significant downward productivity revisions with a degree of caution. It may not take much to persuade firms to slightly raise their capital investment and thereby substitute capital for labour, which may make the overall labour productivity figures look better. As the data revisions example shows, if current data are not measuring the true state of the economy accurately, this introduces major uncertainty into the fiscal projections.

Digging through the Budget Red Book, Table 2.1 suggests that today’s fiscal giveaways total £25bn over the period to 2022-23, with spending increases of £18bn and tax cuts of £7bn. Of the measures announced today, 30% is accounted for by additional NHS spending and a further 37% by measures to boost affordable housing. Almost a quarter is accounted for by pre-announced (but not costed) policy decisions and a further 12% from Brexit-related spending. The net effect of the remainder is small change. It all feels a bit underwhelming. Moreover, Table 2.2 indicates that £19bn will be clawed back from measures announced in previous budgets (with most of this occurring from a change in the discount rate applied to public service pensions). Thus the net effect of the fiscal plans announced today is minimal – £6bn over the next five years is peanuts – and clearly policy is not as bountiful on the surface as it appears.

This brings us to the politics of the budget. If the Conservatives hoped to deliver a big bang to impress the voters, they are going to be sorely disappointed and if Philip Hammond’s position was insecure ahead of the budget, I don’t see how it can be much more secure now. But it was the best he could deliver given the constraints under which he was operating. It is not the big bang package his party wanted and arguably he could have done more. Indeed, by pursuing the policy of corporate tax cuts and refusing to uprate fuel duties in line with inflation, there is some low-hanging fiscal fruit to be picked if he is serious about closing the fiscal gap. But to the extent that this budget was about trying to repair trust after the election, such items will have to remain hanging on the tree for now.