You say you want a revolution

It has been a tumultuous year for those of us who spend a lot of time looking at the British economic and political scene. Recall that former prime minister David Cameron hoped a referendum would lay to rest once and for all the civil war within the Conservative Party that was being fought on the battleground of EU membership. As it turned out, Cameron’s decision proved to be the most spectacular political own goal in at least 60 years (rivalled only by the failure triggered by the Suez invasion of 1956). Consequently, this has been a year characterised by social division and political anger, with no signs that the divisions stoked by the Brexit decision show any sign of healing. It has also been a year strewn with political mistakes which have compounded Cameron’s original error, notably the government’s failure to clarify what it wanted prior to triggering Article 50 and the shocking error of judgement in calling an unnecessary general election.

Despite all this, the economy has trundled along and looks set to post a growth rate around 1.5% this year whilst the unemployment rate has fallen from 4.8% a year ago to 4.3% today. But the pace of growth is considerably slower than we might have expected in the absence of the referendum. In June 2016, my forecast called for real GDP growth of 2.2% in 2017. A direct monetary comparison of what this means in terms of lost output is distorted by data revisions and methodological changes, which have raised the current vintage of nominal GDP by an average of 1.1% since 2010 compared to the June 2016 vintage. But assuming away such matters and focusing purely on the growth trajectory, latest data suggest that real GDP Is currently almost 1% below the level expected in the pre-referendum forecast.

This is roughly what was predicted in spring 2016 in the event of a leave vote and would appear to reinforce the views of the economics profession which argued forcefully that there would be a cost to leaving the EU (bear in mind we have not left yet), whilst giving the lie to claims by Brexit supporters that such warnings were overly gloomy.  You can argue about whether pre-referendum forecasts were too optimistic, but given the pickup in the rest of the EU this year I would suggest this is not the case. And as Chris Giles pointed out in the Financial Times this week, such a shortfall amounts to lost output equivalent to £350 million per week – the amount which the Leave campaign (falsely) claimed the UK would save by leaving the EU. Given that the net savings in direct EU contributions are only half that amount, the inaugural Dixon Award for Dodgy Analysis (DADA) goes to the Leave Campaign whose referendum victory imposed a cost on the UK economy double the amount which it was claimed could be saved.

Brexit supporters will always claim that there is a short-term price to be paid but it will be worth it in order to reclaim sovereignty over UK laws. Indeed, so committed is the government to taking back control that it planned simply to enact the result of a legally non-binding referendum without any form of parliamentary debate. It took the brave efforts of Gina Miller last year to force a parliamentary vote before implementing Article 50.  Not that it mattered much in the end: the decision to trigger it was passed by a majority of 498 to 114 with 38 abstentions – or, in terms of the arithmetic applied to the EU vote, by a majority of 81.4% to 18.6% which is a rather larger margin than the actual referendum. It is also ironic that each time the degree of parliamentary unanimity on a Brexit vote is less than total, the Daily Mail takes it upon itself to denounce the dissidents as traitors (the most recent example being only last week).

Looking ahead, 2018 promises more of the same both politically and economically. The consensus view is that the UK will again grow at a rate around 1.5%, though I suspect there may be some upside risks on the basis that the inflation-induced constraint on real incomes is likely to ease. But politics will remain as fractious as ever. In my view – and one which I have been espousing for the last five years – opening a partisan debate on EU membership means that many politicians are taking positions which run contrary to the UK’s economic interests. This has met with huge pushback and continues to distort the political debate to the extent that many other pressing economic issues - such as welfare reform and overhauling the social care system - continue to be pushed down the agenda.

I would like nothing better than to write less about the politics of Brexit in 2018 but it is the dominant theme of our time which will have profound economic consequences. Brexit represents a political revolution, with many politicians apparently forced to take positions which they may not personally agree with because they are afraid of acting against “the will of the people.” In some ways I am reminded of the Iranian popular revolution, which unfolded on our nightly TV news bulletins almost 40 years ago. Years of dissatisfaction with the status quo in Iran prompted a revolution, based in this case around religion. Years of dissatisfaction with the UK political status quo has resulted in a revolution based around the cause of the EU. The Iranian case led to years of hardship and international isolation. Quite what Brexit will do to the UK will become apparent only in the years ahead.

Blockchain: A solution looking for a problem?

I have long argued that the blockchain – the system that underpins Bitcoin – is a real fintech innovation_,  whereas Bitcoin itself is a by-product. But not everyone agrees that blockchain is such a wonderful idea and that it is a flawed system. It is thus worth digging a little deeper into the workings of blockchain to assess some of the pros and cons.

There are two key elements associated with blockchain: How it works and why it works. The ‘how’ is a routine process of transaction verification designed to ensure that each transaction is valid. One way to do this is to add a timestamp to each transaction and adding it to a chain of time stamped transactions. This is validated by a complex proof-of-work algorithm that cannot be changed without redoing all previous steps in the proof-of-work chain. This makes use of an algorithm known as a ‘cryptographic hash function’ which converts a numerical input of arbitrary length into an output of fixed length. This process is resource intensive and has to be run numerous times before the hash function generates an output that is accepted by the rest of the blockchain community. One feature of the system is that it is difficult to work back from the output to the input, thus preventing miners from working out how to falsify previous blocks. This is similar to procedures used to encrypt website passwords which prevent hackers from being able to work out users’ passwords by viewing the encrypted data.

The ‘why’ of blockchain is also interesting. It effectively offers a solution to the long-standing game theory puzzle which has bamboozled generations of computer scientists – the Byzantine Generals problem. Cracking this problem offers an insight into how a decentralised ledger system can operate. To get a handle on it, consider a thought experiment in which a group of generals (>2) are assumed to be outside a city, each with an army, and all want to invade the city. It is known that if at least half attack at the same time, they will be successful. But if they do not co-ordinate their plans to ensure they can muster the requisite number for the assault, they will be unsuccessful. They must thus collude in planning their attack, but the generals face three problems: they must (a) know whether their messages get through in the first place; (b) receive an acknowledgment indicating that the plans have been accepted and (c) verify that the information passed between them is true.

Computer scientists have struggled for 40 years to derive a network solution which will overcome all three of these problems simultaneously but finally the blockchain appears to have managed it. Since the blockchain is arranged on a peer-to-peer basis, messages are transmitted to a user’s immediate peers and the information disseminates quickly through the system. Thus, unless the user’s connection is faulty, condition (a) is satisfied. Condition (b) is satisfied once all other users in the system validate the proposed change to the ledger.

But before users are prepared to validate these changes, they must be sure that condition (c) is satisfied. The trick to ensuring that people send true information across the network is to make the history of all transactions publicly available and the cost of providing false information prohibitively high. In the case of our Byzantine generals, in which they are each shuttling messages back and forth between themselves, a potential traitor must be able to falsify all messages – including those in which he had no hand in writing. If we impose a constraint on the time each general has to reply to the message sent from one of the others, it becomes ever more difficult to falsify the results of communication between third parties.

In the case of Bitcoin miners, the costs of doing the number crunching in order to falsify all historical transactions is so high that there is no apparent gain from doing so. In short, if we attach a cost to sending a message and ensure that only one person can send a message at a time, the authenticity of the blockchain is guaranteed.

So far, so good. Moreover, the blockchain offers the security advantage that information does not sit merely on one system, but is distributed across many, and may thus be less susceptible to denial-of-service attacks. But it may not be immune to hacking. For example, if sufficient computing power can be corralled to gain access to more than 50% of the systems linked to the network, the integrity of the chain will be compromised. This is not believed to be possible at present, but there may come a day when the power unleashed by quantum computers is such that it can overwhelm existing networks.

There is also a question of what sort of transactions are suitable for recording on a blockchain which is increasingly used to design smart contracts. The smaller blockchains upon which they rely might be easier to circumvent than the huge public networks which underpin Bitcoin, precisely because the smaller number of participants makes it easier for parties to collude (this blog post discusses such an example). If the complex and expensive  proof-of-work algorithms can be undermined in small networks, blockchain may not offer the security benefits for private sector transactions which are often claimed. Consequently, as the Bitcoin experience demonstrates, it may be more suitable for large-scale networks (e.g. maintaining driving licence or social security records). But the bigger the network, the higher the energy costs of maintaining it – a cost which is an inevitable consequence of providing the desired level of security.

I still happen to believe that blockchain has a future. It may not be the all singing, all dancing product which its proponents believe, but it does represent a major breakthrough in computing technology. It may prove to be a solution which has not yet found the right problem to solve.

Irish eyes: A Dublin view of Brexit

The recent border spat between the UK and the EU regarding the Irish border has been very much in the news over recent weeks. Whilst Brexit is seen from London primarily as a problem for the UK, the view from Dublin is rather different. After all, Ireland is the only other EU country to share a land border with the UK and although Ireland is not quite as dependent on the UK as it was in  the 1970s, it remains a significant export market. Indeed, the UK is still the second largest Irish export market and remains the largest source of imports. Consequently, Ireland has a lot to lose from a Brexit which results in significant obstacles being placed in the way of the frictionless border that currently exists between the north and south.

Looking at it from another angle, the Republic is Northern Ireland’s largest external trade partner and frictionless trade is important for the wellbeing of the Ulster economy – the very same region which supports the DUP, which in turn is propping up Theresa May’s government. But Ireland is a significant export market for the UK  as a whole, and last year the UK exported more to Ireland than to China and India together. When politicians say that they do not wish to see the re-imposition of a hard border, they really mean it. The UK and Irish economies are linked in other ways, too. For example, energy markets north and south of the border are heavily integrated, with an all-island electricity market in existence since 2007 which sees Northern Ireland relying on electricity imports from the Republic to make up for insufficient local generation capacity. By contrast, Ireland is heavily reliant on the UK for natural gas imports accounting for 96% of Irish gas usage in 2014.

Whilst the single electricity market is not dependent on the EU’s legal processes, Ireland does rely on EU regulatory measures to cope with potential fossil fuel shortages. Indeed, Ireland stores its emergency oil supplies in the UK which might become a problem if the UK is no longer bound by EU legislation on resource sharing.

Having established that the economies are heavily integrated, the ESRI[1] attempted to put some numbers on the potential effect of a  hard Brexit on the Irish economy. They assumed three outcomes: (i) the UK reaches an EEA-style arrangement with the EU; (ii) a free trade agreement, in which goods are freely traded across borders but financial services are not and (iii) a “hard” Brexit in which the UK falls back on WTO rules. These significantly reduce trade between the UK and the EU, and in turn reduce UK GDP by between 1.8% and 3.2% relative to baseline “over the longer run”. The ESRI’s simulations suggest that over a ten-year horizon, Irish output is reduced relative to baseline by 2.3%, 2.7% and 3.8% in simulations (i), (ii) and (iii) respectively (see chart). In other words, the damage to Ireland is actually greater than that inflicted on the UK.

Unlike a decade ago, the Irish economy is better placed to withstand any such shock. For one thing, the extent of the downturn between 2008-11 (GDP declined by 11% from peak-to-trough with domestic demand down by 23%) was exacerbated by a huge fiscal tightening which is unlikely to be repeated. Moreover, the international backdrop is more favourable, with the euro zone economy growing more strongly and the US – upon which Ireland is heavily dependent for FDI – also on a much more solid footing. Nonetheless, the last decade has been a particularly difficult one for the Irish economy and the last thing it needs now is a further exogenous shock. Given the downside potential for the Irish economy in the event of a hard Brexit, it should come as no surprise that both the Irish government and the EU27 attach so much importance to the border question. It is an issue that the UK government cannot afford to ignore.

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[1] ‘Modelling the Medium- to Long-Term Potential Macroeconomic Impact of Brexit on Ireland’, The Economic and Social Review, Vol. 48, No. 3, Autumn, 2017, pp. 305-316

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.