Much heat, not much light - yet

Media coverage focuses on privately developed cryptocurrencies …

The debate over digital currency has proceeded by leaps and bounds in the last couple of years. Although Bitcoin (BTC) continues to grab the headlines, largely due to its position as the original disruptor, I have long maintained that it is unlikely to be the currency of the future. Indeed I pointed out in 2017 that although there may be a future for digital currencies, BTC may go down as the currency equivalent of the Betamax video system – the first mover which was supplanted by a cheaper, more flexible alternative. Nothing that has happened in the interim has caused me to change my view.

The price of BTC has fluctuated in line with comments by high profile proponents such as Elon Musk, further making it hard to take its claim seriously to be a currency that will one day supplant the fiat money issued by central banks. Earlier this year I noted that a reasonable guess for BTC “fair value” was somewhere below $10,000. Although it has subsequently fallen by 40% from its mid-April highs, it remains well above these levels at just below $40,000.

But the real action in the digital currency space has concerned Dogecoin (DOGE) – currently the sixth largest digital currency by market cap which has increased by a factor of almost 67 since the start of the year versus 33% for BTC, and whose price versus the USD has massively outstripped that of BTC (chart). Ironically, DOGE initially began life as a spoof with the purpose of breaking the stigma surrounding cryptocurrencies. It is designed to be unattractive to investors by keeping a permanently low value due to its mining algorithm which is unlike BTC in that it is not subject to a limit for the number of coins mined. It is also more energy efficient, both in the amount of computing power required to mine each unit and the power consumed in doing so. Although DOGE is accepted as a means of payment by a small number of merchants, it is hard to see it making significant ground as a challenger to BTC let alone conventional forms of money.

… But there are more cons than pros

At the current juncture digital currencies face great difficulty in breaking out of the niche position which they currently occupy largely because they are regarded as extremely volatile vehicles for speculative investment. BoE Governor Andrew Bailey told a parliamentary committee earlier this year, “I'm sceptical about crypto-assets, frankly, because they're dangerous and there's a huge enthusiasm out there.” He went on to say “they have no intrinsic value” and investors should “buy them only if you're prepared to lose all your money.”  

This has not stopped El Salvador from adopting BTC as legal tender, partly to facilitate foreign remittances which are equivalent to 20% of GDP. However, the IMF has pointed out that there are “macroeconomic, financial and legal issues that require very careful analysis.” There certainly are! As this article in Foreign Policy notes, “El Salvador runs on physical cash; 70 percent of the adult population don’t even have a bank account … Only 45 percent of Salvadorans have internet access, and around 10 percent in rural areas.”

… And it may be that central banks will be the saviour of digital currencies

Whilst cryptocurrency proponents continue to extol the virtue of a currency system outside the control of central banks, it is difficult to avoid the conclusion that their breakthrough into the mainstream will be facilitated by central banks themselves. China has already begun experimenting with a digital yuan, having expanded its pilot programme in the spring. Central banks in the UK, US and euro zone are running much more slowly, largely because financial systems are rather more sophisticated and as a result there are huge implications for settlement systems, the nature of the banking  system (issues such as funding costs and balance sheets) and the smooth operation of financial markets – and that is before we consider privacy concerns.  

The BIS recently published a paper which argued that any central bank digital currency (CBDC) should be “minimally invasive.” This is an important issue because a digital currency “represents a claim on an intermediary, [whereas cash] is a direct claim on the central bank” thus changing the fundamental nature of the claims process. As the BIS points out, the Wirecard fraud last year highlights the problems of relying on an intermediary.

Whilst a CBDC would avoid relying on an intermediary it would create other problems. For one thing the conditions required to ensure that a central bank can guarantee the security of a digital asset would be very onerous (quite the opposite of “minimally invasive”). Secondly, as I highlighted last year, the adoption of a CBDC could lead to increased systemic volatility if asset holders opt to seek the safety of central bank-backed assets at the expense of bank deposits at times of financial stress. Faced with these concerns, it is perhaps no surprise that central banks are being forced to proceed relatively slowly.

The race to be first

My view a year ago was that the case for a CBDC was weak from a consumer perspective. However, there are good reasons why central banks in the industrialised world do not want to get left behind in the race with China to develop one. For one thing there are concerns that a digital yuan could undermine the dollar’s role as the global reserve currency. A large proportion of international transactions use the dollar as an intermediate currency which requires access to the SWIFT system. In recent years, the US has increasingly politicised access to SWIFT and efforts to bypass it by using a digital currency such as the yuan would reduce US leverage over the global payments system, particularly since China is the biggest trading partner for a growing number of countries.

In addition, it is clear that there is a demand for digital currencies but they are subject to all sorts of security concerns which would be better managed in the public interest if central banks had a stake. There is also the not-inconsiderable threat that if digital currencies were to increase in popularity, they could threaten the control that central banks are able to exert via traditional monetary policy instruments. As it happens, this is not an argument that rates high on the list of central bank concerns but it cannot be totally discounted.

It is clear, however, that the race to develop a CBDC has gained momentum in recent months and it is not a topic to be dismissed lightly. I remain of the view that Bitcoin will not be the digital currency of the future and agree with the BIS that careful consideration has to be given to the design of a CBDC. But if digital currencies are a fad which is not about to disappear, I am increasingly of the view that society is better off if they are regulated by central banks rather than allowing even less accountable market forces to make our monetary choices for us.

Bordering on the bizarre

Editorial policy at the Financial Times has taken a strange tack of late. A sensible, sober newspaper has published two opinion pieces in recent weeks illustrating the lack of knowledge displayed by policymakers on matters of real economic importance. Last week’s piece by former German finance minister Wolfgang Schäuble on euro zone fiscal issues was followed by UK Brexit minister David Frost’s call for a rethink of the Northern Ireland protocol (NIP). The latter is part of a government media blitz to convey the message that the NIP has not panned out as expected. It is difficult to buy that view given the warnings which were issued ahead of Brexit.

All this was very predictable

To remind people of what was said at the time the agreement was signed, the deputy leader of the Democratic Unionist Party warned in October 2019 that, “You are really in danger here of causing real problems with the Belfast agreement … and political stability in Northern Ireland.” The charity Fullfact.org reported in December 2019 that Boris Johnson’s claim that there will be “no checks on goods going from GB to NI” was false. They also reported that “it’s not correct, as Mr Johnson said, that if there are any terms of the Withdrawal Agreement that people in Northern Ireland don’t like that they would lapse automatically after four years.” Everything that has happened in recent weeks was thus entirely foreseeable. 

I noted in April that “the contradictions inherent in the Brexit deal regarding Northern Ireland are becoming more evident by the week.” Of all the problems inherent in Brexit, the Northern Irish border issue can be laid directly at the door of Boris Johnson’s government. British MPs simply would not sign up to the “backstop” arrangement negotiated by Theresa May’s government. Johnson’s alternative, which was acceptable to parliament because it prevented the UK from being trapped in the EU’s embrace, imposed a border where previously there was none. Indeed the one thing which the British government has always refused to acknowledge is that there must by definition be a border between UK and EU customs territories. In this case it runs down the middle of the Irish Sea. Anyone who thought otherwise is being disingenuous.

The government adopted a "sign now, deal with it later" approach

According to Frost, “when we agreed this new protocol in 2019, we did so in order to remove the old disastrous “backstop” and to enable Brexit to happen, but to do so in a way that maintained our overriding priority of protecting the Belfast (Good Friday) Agreement and avoiding a hard border.” As to whether it was “disastrous” the Irish government did not think so, nor did Northern Irish nationalist politicians who won more seats than unionist politicians at the 2019 general election. Unfortunately, nobody thought to directly ask the Northern Irish people (who, by the way, voted 56-44 in favour of remaining in the EU in 2016). The protocol was passed through parliament primarily by English Conservative MPs because this was the least objectionable option “to enable Brexit to happen.” 

Frost goes on to say “we underestimated the effect of the protocol on goods movements to Northern Ireland.” Again, I am not sure who is the “we” referred to but the government was warned for years, both before and after the referendum, that imposing frictions to cross-border EU trade would come at a cost. Frost concluded his missive by suggesting that “we agreed … to control certain goods movements within our own country and customs territory. If that situation is not to be totally unsustainable we need to be able to do so in ways which do not disrupt everyday life and which respect everyone’s identity and interests. We continue to work for negotiated solutions which achieve this.” Most rational people believe that the protocol represents just such a negotiated solution and it increasingly looks like the UK government signed on the dotted line simply to get Brexit “done” with the intention of trying to renegotiate the details later.

And now it is paying the price

The international community has little sympathy for the UK’s position. Unsurprisingly, Emmanuel Macron is not to be moved. As he told journalists earlier this week, “We have a protocol. If after six months you say we cannot respect what was negotiated, then that says nothing can be respected. I believe in the weight of a treaty, I believe in taking a serious approach. Nothing is negotiable. Everything is applicable.” More seriously news reports have emerged to suggest that the US government privately rebuked the British for endangering the peace process over the NIP, although both sides have been careful to keep this out of the public domain.

Many of the more deluded on the Brexit spectrum cannot bring themselves to admit that there are big costs associated with their signature policy and continue with the narrative that the NIP was somehow “imposed on the UK by Brussels at the moment of our greatest weakness” (I will leave it to you to decide whether it is fortunate or unfortunate that it is behind a paywall. Ironically the same author extolled the virtues of the NIP less than two years ago). It beggars belief that the British government finds itself in such a position. Johnson promised “an oven ready deal” just 18 months ago which was meant to lead us to the sunny uplands. Instead we find that the deal does not do what it said on Johnson’s tin. To add insult to injury, Frost is not an elected politician – he is an unelected (recently ennobled) member of the House of Lords. The British government has thus appointed an unelected trade novice to oversee trade policy. Brexit is not yet at the stage of devouring its own children but the pot may be about to be readied.

A wider problem is that if the government has treated major issues such as trade policy in such a cavalier fashion, can it be trusted on other issues? As the OECD put it, “trust is the foundation upon which the legitimacy of public institutions is built and is crucial for maintaining social cohesion.” So far there has not been any significant loss of domestic trust with Johnson’s act continuing to play well at home but the UK’s reputation in international dealings is not exactly being burnished by recent events.

The EU is not blameless either but the UK government must shoulder the blame

This is not to say that the EU is entirely blameless. Its actions regarding the NIP reflect a tendency to hide political problems behind technical issues, arguing that the purity of the single market must be protected at all costs. This intransigence is what caused the Swiss to recently walk away from seven years of negotiations to achieve a framework deal with the EU to replace the patchwork of deals currently in place. Of course, one of the great ironies of the current situation is that Brexiteers always argued that the EU was an excessively bureaucratic institution that the UK was well advised to leave whereas the truth was that as a member, the UK was shielded from the worst of it.

We can debate the extent to which the EU needs to change its policy towards its neighbours – and this argument is not without merit. However, the recent spat demonstrates that the UK government’s casual approach to legal details over the past five years does have consequences. I have made it clear for many years that there is no such thing as British exceptionalism, which appears to be the leitmotif of many hardline Brexiteers. As it is, the Northern Irish problem, serious as it is, affects a relatively small proportion of the UK population. Over time, a larger proportion of the population may begin to become aware of the damage that Brexit has inflicted upon them. Only then might we start to have the debate we should have been having five years ago about the price of the policy.

That sinking feeling

Are we really talking about fiscal consolidation already?

Former German finance minister Wolfgang Schäuble is known for his adherence to monetary and fiscal rigour and a recent opinion piece in the Financial Times confirmed his reputation. He argued for a “return to monetary and fiscal normality [and that] the burden of public debt must be reduced.  Otherwise, there is a danger that the Covid-19 pandemic will be followed by a “debt pandemic”, with dire economic consequences for Europe … Thus, all eurozone members must engage in efforts to return to stricter budgetary discipline.” It is striking that following the biggest economic hit since WWII we are already hearing calls for fiscal tightening. Whilst acknowledging that there will come a point when fiscal support will have to be eased back, such calls require more nuanced thinking than Schäuble tends to apply to fiscal issues.

In what sounded suspiciously like a lecture to the finance ministers of euro zone member states, notably Italy, Schäuble noted that “the need to pay back the debt later is often overlooked. Many governments focus on the “easy” bit of Keynesianism – borrowing – and then postpone repayment of their debts.” This is, of course, not true. If bond investors were worried about not getting their money back they would cease purchases of euro zone debt. Aside from the obvious case of Greece (of which more later) that has not happened. Indeed, many EMU member states have agencies dedicated to managing the national debt which is an indication of how seriously they take the problem.

The article appeared to be based on a misunderstanding of how fiscal policy works, which is somewhat unfortunate from a former finance minister. For a start, he makes the amateur mistake of treating public finances in the same way as those of a household. In other words, he fails to account for the near-infinite lifespan of a government which allows debt to be repaid over multiple generations. And if he is worried about governments borrowing but not repaying debt, Schäuble might want to take a look at the level of German public debt which has doubled in the past 25 years at roughly the same pace as Italy (chart below).

Schäuble’s Italian concerns

That said, Germany’s performance in holding down its debt-to-GDP ratio is far better than that of Italy (chart below). Whilst the level of gross debt has increased at roughly the same pace since the mid-1990s, the fact that Italian GDP has grown more slowly than Germany means that there has been a significant divergence in the debt ratio performance. Italy has struggled to generate decent growth in the two decades since it joined the single currency. This can partly be ascribed to low productivity growth in a fixed exchange rate environment and there are many who believe that Italy’s days in the euro zone may be numbered.

The travails of the Italian economy can wait for another day but you can be sure that if Italy proves to be the catalyst for another euro zone debt crisis it will shake monetary union to its foundations. Precisely because it is in nobody’s interests to allow the euro zone to fall apart, the economy has to be managed in a way that accommodates the fiscal position of southern European countries. Whilst this is not what Germany signed up for, and Schäuble’s views are coloured by those of the people he serves – the electorate – politicians across the euro zone have to take some of the responsibility for allowing Italy into the single currency knowing that it failed the excessive debt criteria.

And he has form on Greece

For all Schäuble’s concerns about Italy, his role in the Greek crisis as German finance minister highlighted the perils of adherence to economic orthodoxy. After Greece was forced to put in place stringent austerity measures in 2010 in return for an emergency loan that was sufficient only to pay interest on existing debt and keep banks capitalized, his insistence on further measures in return for additional aid were more than savage. Former US Treasury Secretary Tim Geithner has recorded how Schäuble was willing to sanction Greece being kicked out of the euro zone, and he continued to hold Greek feet to the fire even in the face of IMF concerns that Greece would be crippled by its ultra-high debt.

The cost to Greece of the fiscal measures forced on them by other euro zone states has been high – even before the pandemic Greek real GDP was almost 30% below mid-2007 levels. In anyone’s book that has to go down as a depression. We can argue about how Greece found itself in such a predicament in 2010 and the extent to which it was the author of its own demise. But the actions of the German government, spearheaded by Schäuble as finance minister, illustrate that the costs of applying orthodox solutions at the wrong time can inflict huge damage. Anyone tempted to heed the siren calls for fiscal consolidation would do well to ponder the Greek case.

He ain’t no Keynesian

In his opinion piece Schäuble invoked the spirit of Keynes. Unfortunately he seems not to have understood Keynes’ prescriptions. He noted that “Keynesian economic experts like Larry Summers or Olivier Blanchard lament the crossing of red lines on public debt and point to the increased likelihood of runaway inflation.” But there is no clear link from high debt to inflation, other than that it is to the debtors advantage if the debt burden can be inflated away. High levels of debt do not, per se, result in high inflation – just ask the Japanese. The criticism levied by the likes of Summers and Blanchard is that a US economy with little spare capacity which receives a big fiscal boost may be prone to inflation, but it is not a question of the debt level itself.

In any case, the treatment of debt did not get a lot of attention in Keynes’ most famous work. In The General Theory of Employment, Interest and Money, I counted 22 uses of the word “debt” and one of them was to point out the perils of reducing it too quickly. As Keynes pointed out, “the desire to be clear of debt” may exacerbate existing economic problems by stimulating more saving than would otherwise occur, resulting in “a diminishing … propensity to consume” – the famous paradox of thrift argument. This is not merely a 1930s problem. IMF simulation analysis conducted in the wake of the GFC pointed out that when all countries are involved in fiscal consolidation with interest rates at the lower bound, the costs of lost output are twice as large as when one country performs fiscal contraction in isolation. If Keynesian analysis offers any insight, it is that there can simply be too much fiscal consolidation.

But we do agree on one thing

Despite the fact I disagree with most of his policy prescriptions Schäuble did make one argument that I found very appealing, suggesting that “a promising approach for Brussels to take would be a eurozone debt redemption pact, similar to the sinking funds devised by Robert Walpole and Alexander Hamilton.” Indeed, I made this very proposal some years ago (here). As I pointed out at the time “few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB.” Last year’s joint borrowing plan suggests that maybe the European Commission itself might be an appropriate guarantor. There are many issues regarding how such a fund might work. Would all countries place debt in the fund or simply those with excessive debt (anything above an arbitrary limit such as 120% of GDP)? The issue of guarantor would almost certainly provoke a political storm.

However we are at the stage where the old pre-Covid orthodoxy no longer holds. As the last decade has demonstrated, unsophisticated consolidation is not guaranteed to produce good outcomes. If Europe is to emerge strongly from the pandemic it cannot afford to be encumbered by navel-gazing over appropriate debt levels. A sinking fund in which a large proportion of debt can be converted into undated consols might be one way to deal with the problem. If even someone as orthodox as Schäuble is talking about it, maybe this is an idea whose time has come.