Anyone looking at the UK from the outside can be forgiven
for wondering what has gone wrong with a political process that the British
like to think spawned the Mother of all Parliaments (there again, many natives
are wondering the same thing). The government is weak and divided – in office
but not in power – whilst the political establishment has been rocked by
allegations of sexual misconduct. All this is happening against a backdrop of
the most critical set of negotiations since 1945, which require the
government’s undivided attention – but which it is unable to give for the
reasons just outlined.
The obvious answer is that Brexit is the culprit. According to Philip Stephens, writing in the FT, “Brexit has broken British politics."
There is certainly a lot of truth in this. As Stephens notes, “a majority of MPs think Brexit is a mistake
but feel obliged to pursue it lest they be accused of defying what the tabloids
declare to be ‘the will of the people.’” Quite what the “will of the
people” might be is hard to discern from a referendum result which produced a
near 50-50 outcome. Consequently, and unsurprisingly, treating the result of a
(legally non-binding) referendum in the same way as a winner-takes-all election
was always going to polarise already-inflamed opinions.
But a less obvious answer is that the Brexit vote was itself
the manifestation of something deeper. Arguably – and I am in speculative territory
here – it was the result of dissatisfaction with a political establishment
which has failed to adhere to the rules and standards which it expects others
to abide by. More worryingly for an economist, there has been a steady erosion
of rules- and evidence-based policy making which has contributed to hugely
sub-optimal outcomes. We can go back to 2002 and the case which the UK
government made for involvement in a military invasion of Iraq which was not
sanctioned by the United Nations. The UK Prime Minister Tony Blair put his name
to a document that argued the government of Saddam Hussain had developed
weapons of mass destruction, despite the fact that international observers on
the ground found no such evidence. Trust in UK politicians was further eroded
by the 2009 parliamentary expenses scandal in which many MPs blatantly ignored guidelines on the use of public money in
reclaiming expenses. There were rules in place but they were routinely
flouted.
A more economically relevant case is the flouting of the
fiscal rules enshrined in the Maastricht Treaty, designed to prevent
governments from running a deficit-to-GDP ratio in excess of 3%. Moreover, the
criteria for entry into the single currency in the first place was that “the gross debt total of the general
government should not exceed the reference value of 60 percent of GDP or, if it
does, it should be sufficiently diminishing and approaching the reference value
at a satisfactory pace.” With both Belgium and Italy showing debt ratios
above 100% at end-1997 (the reference date for entry into EMU), it’s safe to
say that they were nowhere near achieving this goal. Of the original 11 members
Austria, France, Ireland, Netherlands and Spain also missed the target.
I did point out in 2003, at a time when investors were
concerned that countries were routinely missing the 3% deficit target that “by failing to force governments to comply
more strictly with the 60% deficit:GDP ratio prior to the start of Emu, the
fiscal playing field has not been levelled sufficiently to allow some countries
to easily meet the Stability and Growth Pact deficit criteria. In simple terms,
the debt targets were simply not taken seriously enough.” This is not to
say that the euro zone debt crisis could have been avoided, but had debt ratios
been closer to the required thresholds in the first place, some of the smaller
countries would have had more fiscal headroom to cope with the storms which
subsequently blew in.
The banking crisis, which resulted in many financial institutions
requiring government support, is another case in point. The public’s view is
that the taxpayer has carried a heavy burden without those responsible for causing
the problem ever being held properly to account. Again, this could be seen as a
failure to apply rules – or at least the failure to apply natural justice.
Each of the examples outlined here was avoidable. Had one
occurred in isolation, arguably we could have coped better with the fallout. But
failure to consistently apply the rules erodes policy legitimacy and invokes
greater challenges to the status quo, producing an ideal breeding ground for political
discontent. The academic literature in this area explains how policies which
are initially not popular (such as Brexit) can find broader acceptance as the public
taps into various aspects of the policy (see the introduction to this paper from The Quality of Governance Institute at the University of Gothenburg).
The authors of this paper also make the point that “public opinion changes as a result of policy
implementation.” Given the UK government’s abject failure to get its act
together on many aspects of policy, this raises serious legitimacy issues. Not
only did successive UK governments fail to deal consistently with the conditions
which provoked the Brexit backlash, but the current administration is failing
to deal with the consequences. Theresa May once promised to deliver strong
and stable government. Right now, many people would settle for one or the other.
Saturday 11 November 2017
Wednesday 8 November 2017
Breaking point
In the context of the debate on productivity, I was recently
asked by a non-economist why economists tend to assume mean reversion when it
is clear there has been a structural break in the series. It is a very good
question and goes to the heart of a major problem in the business of
forecasting. Most of our forecasting models are based on linear (or
log-linearised) relationships whose forecast performance is conditioned by historical
experience. Therefore, if a relationship has tended to mean-revert in the past,
the model will assume it does so in future. As a consequence, we cannot easily
deal with structural breaks in economic relationships. To put it another way,
even if the data deviates from past performance for a prolonged period of time,
it is dangerous to assume that there has been a permanent shift since it is
entirely possible that it will soon snap back.
It takes a lot to convince economists that there has been a change in trends. In a classic 1961 paper[1], Lawrence Klein and Richard Kosobud noted that much of macroeconomics is based on five “great ratios” in which the relationships between variables can be assumed to be stable. These five ratios are (i) the savings-income ratio; (ii) the capital-output ratio; (iii) labour's share of income; (iv) income velocity of circulation and (v) the capital-labour ratio. But what might have been true almost six decades ago is no longer the case. Labour’s share in income has fallen sharply in the Anglo-Saxon economies over recent years whilst recent experience has shown big shifts in the capital-output ratio, which resulted in the productivity puzzle. However, these old ideas die hard and whilst we try to ensure that we do not stick to outdated precepts, relationships often change so imperceptibly slowly that it is difficult to be sure whether we are witnessing a cyclical shift or a secular trend.
The problem is well-known in economics and has been much-studied. In my introductory econometrics classes one of the first statistical tests to which I was introduced was the Chow test for structural breaks which assesses whether the coefficients derived from regressions on two different parts of the dataset are equal. Although it is pretty simple stuff, a look at UK year-on-year employment and GDP growth over the period 1980 to 2016 nicely highlights the nature of the problem. A quick glance at the chart certainly suggests that there has been a change in the trend relationship (chart). But it is really not that simple.
It takes a lot to convince economists that there has been a change in trends. In a classic 1961 paper[1], Lawrence Klein and Richard Kosobud noted that much of macroeconomics is based on five “great ratios” in which the relationships between variables can be assumed to be stable. These five ratios are (i) the savings-income ratio; (ii) the capital-output ratio; (iii) labour's share of income; (iv) income velocity of circulation and (v) the capital-labour ratio. But what might have been true almost six decades ago is no longer the case. Labour’s share in income has fallen sharply in the Anglo-Saxon economies over recent years whilst recent experience has shown big shifts in the capital-output ratio, which resulted in the productivity puzzle. However, these old ideas die hard and whilst we try to ensure that we do not stick to outdated precepts, relationships often change so imperceptibly slowly that it is difficult to be sure whether we are witnessing a cyclical shift or a secular trend.
The problem is well-known in economics and has been much-studied. In my introductory econometrics classes one of the first statistical tests to which I was introduced was the Chow test for structural breaks which assesses whether the coefficients derived from regressions on two different parts of the dataset are equal. Although it is pretty simple stuff, a look at UK year-on-year employment and GDP growth over the period 1980 to 2016 nicely highlights the nature of the problem. A quick glance at the chart certainly suggests that there has been a change in the trend relationship (chart). But it is really not that simple.
Suppose in 2013 a policymaker began to be concerned about
the nature of the relationship and suspected there was a break in the
historical trend. In early 2013, the intelligent policymaker has quarterly data
through to end-2012 and decides to estimate a simple econometric equation using
the EViews software over the period 1980 to 2012 (132 observations) in order to
test their hypothesis. But conducting a Chow test for a structural break at the
end of 2008, 2009 and 2010 does not yield any evidence of a break. The
data-driven policymaker would thus conclude that this is problem to keep under
observation but it is not yet time to press the panic button. A year later, in early
2014, the policymaker runs the analysis again with an additional four quarters
of data (136 observations) but still finds no evidence of a structural break in
the relationship. But by early 2015, our policymaker runs the analysis on data
through end-2014 and finds some evidence of a break in the data at the end of
2009. By the time we get to early 2016 – three years after they suspect a
problem – the statistical evidence is unambiguous: There has been a change in
the relationship between GDP growth and employment.
The first point to make clear here is that a cautious policymaker has to wait for evidence that there has been a productivity shift – even if they suspected that something was amiss, they cannot make inferences on a relatively small amount of data because they do not know whether the shift is temporary or permanent. But even when the statistical evidence is clear, we cannot simply jump to conclusions – the blip in the productivity figures could vanish just as suddenly as it appeared. For example, if labour shortages begin to manifest themselves, companies can only increase output by increasing capital investment rather than relying on labour. This will mean GDP grows more rapidly than employment in which case labour productivity figures would begin to look much stronger.
As noted above, this is a simplistic exercise and there are better statistical ways to assess whether there are breaks in a data series, but it does highlight an important point: In a world where we require empirical evidence before making policy changes, we sometimes have to wait a long time to build up sufficient information before we are even half sure that we are doing the right thing. Whilst the BoE and OBR are criticised for failing to foresee these trend shifts in economic performance, anyone who has ever tried modelling and forecasting when trends are changing will tell you that it is much harder than it looks.
The first point to make clear here is that a cautious policymaker has to wait for evidence that there has been a productivity shift – even if they suspected that something was amiss, they cannot make inferences on a relatively small amount of data because they do not know whether the shift is temporary or permanent. But even when the statistical evidence is clear, we cannot simply jump to conclusions – the blip in the productivity figures could vanish just as suddenly as it appeared. For example, if labour shortages begin to manifest themselves, companies can only increase output by increasing capital investment rather than relying on labour. This will mean GDP grows more rapidly than employment in which case labour productivity figures would begin to look much stronger.
As noted above, this is a simplistic exercise and there are better statistical ways to assess whether there are breaks in a data series, but it does highlight an important point: In a world where we require empirical evidence before making policy changes, we sometimes have to wait a long time to build up sufficient information before we are even half sure that we are doing the right thing. Whilst the BoE and OBR are criticised for failing to foresee these trend shifts in economic performance, anyone who has ever tried modelling and forecasting when trends are changing will tell you that it is much harder than it looks.
[1] Klein,
L.R. and R. F. Kosobud (1961) ‘Some Econometrics of Growth: Great Ratios of
Economics,’ Quarterly Journal of Economics (75), 173-198
Sunday 5 November 2017
The great productivity debate remains unresolved
Over the course of the last week I have listened to
presentations from three of the UK’s most influential forecasting institutions
(the Institute for Fiscal Studies, National Institute of Economic and Social
Research and BoE) in which the common factor was the weakness – indeed lack –
of productivity growth. The ONS measures productivity using three main metrics –
output per worker, per job and per hour. In the nine years since the great recession,
these have grown by 0.8%, 1.0% and -0.2% respectively. For the avoidance of any
doubt, these reflect the absolute changes across a nine year span, not the
annual average – in other words, output per hour has declined in absolute terms
by 0.2% since Q4 2007 (do you feel as though you are working less?).
To put this into context, annual growth over the period 1980 to 2008 averaged 2% for output per worker; 1.3% per job and 1.4% per hour which means that output per worker is currently almost 13% below its pre-crisis trend (chart). You really have to go back a long way to see a sustained period of sluggish productivity as poor as this in the UK during peacetime – probably back to pre-industrial revolution times, if the BoE’s excellent long-run historical dataset is any guide.
To put this into context, annual growth over the period 1980 to 2008 averaged 2% for output per worker; 1.3% per job and 1.4% per hour which means that output per worker is currently almost 13% below its pre-crisis trend (chart). You really have to go back a long way to see a sustained period of sluggish productivity as poor as this in the UK during peacetime – probably back to pre-industrial revolution times, if the BoE’s excellent long-run historical dataset is any guide.
On the assumption that real wages grow in line with
productivity, this means that real wages today are a similar amount below where
they would otherwise be. But what makes matters worse is that, miserable though
productivity growth has been, UK real wages have lagged even further behind. Average
weekly earnings deflated by the CPI are currently 4.6% below their end-2007
levels. In other words, productivity growth has been flat but real wages have
fallen. This goes to highlight the claim made by Paul Krugman that productivity
may not be everything, but in the long run it is almost everything. It is
undoubtedly one of the reasons why we all feel so much worse off than we did
prior to the recession.
None of this is exactly news, as it has been a mounting cause for concern in recent years. Indeed, I recall looking at the problem as long ago as 2013. But the fact that productivity has remained stubbornly weak, and not recovered in line with expectations (and indeed, historical experience) clearly points to something wrong. It might be partly the result of measurement error in an increasingly digital economy; labour hoarding in a service driven economy; a lack of investment or simply an ageing demographic profile. It is, of course, not just a UK problem: It is a problem across all industrialised economies although the UK seems to have been hit relatively hard. Nonetheless it is an issue which governments have tended to downplay up to now.
Each of the three UK institutions noted above sees different aspects of the problem, reflecting their particular speciality. For the NIESR, it will contribute to weak growth and thus an ongoing squeeze on living standards. As far as the IFS is concerned, whose focus is fiscal policy, the resultant weakness of growth will put pressure on the economy’s ability to generate sufficient revenue to eliminate the budget deficit. Indeed, the Office for Budget Responsibility last month noted that it is likely to “significantly” reduce its “assumption for potential productivity growth over the next five years“ in its November forecast which accompanies the Autumn budget statement. Meanwhile, the BoE is concerned that weak productivity growth will hold back potential output growth with the result that the economy is more likely to run into capacity constraints which will generate inflation.
So far, we seem to have escaped the worst aspects of sluggish productivity growth. Inflation has only picked up because of a sterling-induced crash, not because of any underlying rise in domestic cost pressure. Public finances have improved significantly, with public borrowing declining by two-thirds between 2010 and 2017. Arguably the squeeze on living standards has been the worst aspect, and may well have contributed to the Brexit vote last year. But the sunny uplands to which politicians promise we will soon return will remain unattainable without a recovery in productivity. And the longer productivity remains weak, the more of a struggle economic recovery will be. Like a Facebook relationship status, the productivity puzzle is complicated but it is one we need to get a handle on – and fast.
None of this is exactly news, as it has been a mounting cause for concern in recent years. Indeed, I recall looking at the problem as long ago as 2013. But the fact that productivity has remained stubbornly weak, and not recovered in line with expectations (and indeed, historical experience) clearly points to something wrong. It might be partly the result of measurement error in an increasingly digital economy; labour hoarding in a service driven economy; a lack of investment or simply an ageing demographic profile. It is, of course, not just a UK problem: It is a problem across all industrialised economies although the UK seems to have been hit relatively hard. Nonetheless it is an issue which governments have tended to downplay up to now.
Each of the three UK institutions noted above sees different aspects of the problem, reflecting their particular speciality. For the NIESR, it will contribute to weak growth and thus an ongoing squeeze on living standards. As far as the IFS is concerned, whose focus is fiscal policy, the resultant weakness of growth will put pressure on the economy’s ability to generate sufficient revenue to eliminate the budget deficit. Indeed, the Office for Budget Responsibility last month noted that it is likely to “significantly” reduce its “assumption for potential productivity growth over the next five years“ in its November forecast which accompanies the Autumn budget statement. Meanwhile, the BoE is concerned that weak productivity growth will hold back potential output growth with the result that the economy is more likely to run into capacity constraints which will generate inflation.
So far, we seem to have escaped the worst aspects of sluggish productivity growth. Inflation has only picked up because of a sterling-induced crash, not because of any underlying rise in domestic cost pressure. Public finances have improved significantly, with public borrowing declining by two-thirds between 2010 and 2017. Arguably the squeeze on living standards has been the worst aspect, and may well have contributed to the Brexit vote last year. But the sunny uplands to which politicians promise we will soon return will remain unattainable without a recovery in productivity. And the longer productivity remains weak, the more of a struggle economic recovery will be. Like a Facebook relationship status, the productivity puzzle is complicated but it is one we need to get a handle on – and fast.
Tuesday 31 October 2017
The BoE and a bit of cold turkey
It is widely expected that the Bank of England will raise
interest rates this week for the first time since 2007. There have been some
influential academic voices suggesting that this would be the wrong time to
raise rates – the more I think about it, the more I disagree with them. And
before we all get carried away, the expected increase from 0.25% to 0.5% would
only represent a move from the lowest level in history to the second lowest.
The first reason for disagreeing with some of the wiser heads is purely to do with the signalling effect. Having suggested in September that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” financial markets have increasingly interpreted this as meaning that a rate move is likely in November and are now pricing such action with a probability of almost 90%. Although the BoE has suggested in the past that a near-term rate hike might be in the offing – which subsequently never materialised – not since Mark Carney assumed his post in 2013 have markets been so convinced about the likelihood of a rate hike at the upcoming meeting as they are now. The only comparable degree of market conviction was in the wake of the EU referendum, when in July 2016 markets fully priced a 25 bps rate cut at the August 2016 MPC meeting (a reduction which was duly delivered).
Of course, it is not the MPC’s job to reinforce the market’s conviction. But to the extent that the strategy of forward guidance relies on the predictability and credibility of central bank communication, any decision to hold interest rates unchanged in view of current market expectations would seriously undermine this plank of monetary policy because it would suggest that communication has not been sufficiently clear.
Another strong argument in favour of raising interest rates is that they are (arguably) too low given where we are in the economic cycle. Much of the academic opposition to a rate hike stems from the fact that wage inflation remains low, and uncertainty surrounding the Brexit decision suggests that this is not a good time to tighten policy. I have sympathy with these views. Indeed, I have argued recently that the inflation excuse used to justify the need for higher interest rates does not wash because it reflects a one-off spike triggered by currency depreciation. But opponents of a rate hike may be guilty of confusing the impact of interest rate levels and a change in rates. Even though the UK economy has lost momentum over the course of this year it is still growing at a rate of around 1.5% in real terms. Inflation, at 3%, is right at the top end of the threshold above which the BoE Governor has to write to the Chancellor explaining what he intends to do in order to bring it back towards target. Moreover, monetary policy is still operating on a setting designed to promote recovery in the wake of the 2008 financial collapse, with an additional bit of Brexit insurance thrown in. The UK simply does not need rates at current levels.
Arguably, the BoE should have raised rates in 2014 or 2015 when growth was back at trend and house price inflation was running at double-digit rates. However, the global interest rate cycle was not then supportive of a unilateral move by the BoE, with the Fed not yet having commenced its rate hiking cycle and the ECB beginning a phase of more aggressive monetary easing. As it turned out, with UK inflation running close to zero during 2015 and H1 2016, the BoE would have run the risk of repeating the mistake of the Swedish Riksbank which began tightening in 2010 only to have to reverse course in the face of a collapse in inflation.
As for Brexit risks, the BoE has been clear all along that this represents an economic shock against which interest rates can only provide limited insulation. In any case, taking back the precautionary 25 bps rate cut implemented in summer 2016 makes sense in view of the fact that the worst case scenario did not materialise. But a wider point is that ultra-expansionary monetary policy can inflict just as much harm as an overly restrictive stance – perhaps in ways we do not yet fully understand. We do know that low interest rates have helped to propel equity markets to record highs and produced an unjustified tightening of credit spreads. To the extent that investors have become less discriminating about what they buy when they are simply chasing yield, low interest rates distort normal market behaviour. And as the Japanese experience has shown, a lax monetary stance is no guarantee of economic recovery.
Rising interest rates will hurt – mortgage payments, for example, will go up which is no fun at a time when real wages are falling. But as those professionals treating drug addicts will tell you, sometimes it is necessary to take a clear look at where we are, how we have got there and accept that a bit of cold turkey is necessary for the longer term good.
The first reason for disagreeing with some of the wiser heads is purely to do with the signalling effect. Having suggested in September that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” financial markets have increasingly interpreted this as meaning that a rate move is likely in November and are now pricing such action with a probability of almost 90%. Although the BoE has suggested in the past that a near-term rate hike might be in the offing – which subsequently never materialised – not since Mark Carney assumed his post in 2013 have markets been so convinced about the likelihood of a rate hike at the upcoming meeting as they are now. The only comparable degree of market conviction was in the wake of the EU referendum, when in July 2016 markets fully priced a 25 bps rate cut at the August 2016 MPC meeting (a reduction which was duly delivered).
Of course, it is not the MPC’s job to reinforce the market’s conviction. But to the extent that the strategy of forward guidance relies on the predictability and credibility of central bank communication, any decision to hold interest rates unchanged in view of current market expectations would seriously undermine this plank of monetary policy because it would suggest that communication has not been sufficiently clear.
Another strong argument in favour of raising interest rates is that they are (arguably) too low given where we are in the economic cycle. Much of the academic opposition to a rate hike stems from the fact that wage inflation remains low, and uncertainty surrounding the Brexit decision suggests that this is not a good time to tighten policy. I have sympathy with these views. Indeed, I have argued recently that the inflation excuse used to justify the need for higher interest rates does not wash because it reflects a one-off spike triggered by currency depreciation. But opponents of a rate hike may be guilty of confusing the impact of interest rate levels and a change in rates. Even though the UK economy has lost momentum over the course of this year it is still growing at a rate of around 1.5% in real terms. Inflation, at 3%, is right at the top end of the threshold above which the BoE Governor has to write to the Chancellor explaining what he intends to do in order to bring it back towards target. Moreover, monetary policy is still operating on a setting designed to promote recovery in the wake of the 2008 financial collapse, with an additional bit of Brexit insurance thrown in. The UK simply does not need rates at current levels.
Arguably, the BoE should have raised rates in 2014 or 2015 when growth was back at trend and house price inflation was running at double-digit rates. However, the global interest rate cycle was not then supportive of a unilateral move by the BoE, with the Fed not yet having commenced its rate hiking cycle and the ECB beginning a phase of more aggressive monetary easing. As it turned out, with UK inflation running close to zero during 2015 and H1 2016, the BoE would have run the risk of repeating the mistake of the Swedish Riksbank which began tightening in 2010 only to have to reverse course in the face of a collapse in inflation.
As for Brexit risks, the BoE has been clear all along that this represents an economic shock against which interest rates can only provide limited insulation. In any case, taking back the precautionary 25 bps rate cut implemented in summer 2016 makes sense in view of the fact that the worst case scenario did not materialise. But a wider point is that ultra-expansionary monetary policy can inflict just as much harm as an overly restrictive stance – perhaps in ways we do not yet fully understand. We do know that low interest rates have helped to propel equity markets to record highs and produced an unjustified tightening of credit spreads. To the extent that investors have become less discriminating about what they buy when they are simply chasing yield, low interest rates distort normal market behaviour. And as the Japanese experience has shown, a lax monetary stance is no guarantee of economic recovery.
Rising interest rates will hurt – mortgage payments, for example, will go up which is no fun at a time when real wages are falling. But as those professionals treating drug addicts will tell you, sometimes it is necessary to take a clear look at where we are, how we have got there and accept that a bit of cold turkey is necessary for the longer term good.
Saturday 28 October 2017
The Bitcoin bubble in context
Over the course of recent months I have done a lot of work
looking at Bitcoin and have watched its recent sharp ascent with a mixture of
bemusement and concern. I do not intend here to go into a detailed description
of how the currency operates and refer the interested reader to the website Bitcoin.org
for an overview. Instead I want to focus on the sharp surge in the price of
Bitcoin which has seen its value against the dollar increase by a factor of
almost six since the start of 2017.
The puzzling question is why its value should have risen so sharply this year – after all, it has been around for seven years and we have already been through one boom and bust episode. In 2013 Bitcoin’s value against the dollar surged by a factor of 83, only for it to fall back by 85% over the next 14 months. What is rather more of a concern today is that the market value of all Bitcoin in circulation stands at $99 billion versus $9 billion in late-2013, and one of the questions which has been posed to me in recent days is whether an implosion of the Bitcoin bubble represents a threat to financial stability in a way which it did not in 2013.
As to the first of these questions, I believe that the rally in Bitcoin this year represents a different sort of bubble to that of four years ago. In 2013 there was genuine interest in Bitcoin as an alternative currency. Much of this optimism was misplaced, however, as the disadvantages of digital cryptocurrencies became evident. For example, the huge variability in the price of Bitcoin means that it does not represent a stable store of value. Together with security issues – the collapse of the Mt. Gox Bitcoin exchange in 2014 being a case in point – investors began to rethink their Bitcoin strategy.
But the currency is underpinned by the blockchain – a distributed ledger which potentially has a huge range of applications outside the realms of the currency world. One of the fastest growing digital currencies this year is Ether which is created as a by-product of the Ethereum network – a blockchain technology with wider applications than that used for Bitcoin. But as investors have jumped on the blockchain bandwagon so they have forced up the value of the digital currencies which these systems churn out.
In many ways, the digital currency revolution is reminiscent of the dot-com bubble of the late 1990s: There are many new and interesting applications of the blockchain technology but they have yet to be fully realised. Accordingly, investors are paying for their potential rather than their realised value, and because it is almost impossible to put a price on potential value, they are overpaying. It is thus hard to avoid the conclusion that current Bitcoin valuations represent a bubble which is set to burst at some point. As a historical guide, I have compared data for the 14 months prior to the Bitcoin peak versus the late-1990s Nasdaq rally and the Tulipmania bubble of 1636-37. As is clear from the chart, the surge in Bitcoin outstrips the surge in equity valuations in 1999-2000 but would appear not to match up to events in the Netherlands almost 400 years ago. But given the poor quality of the data for tulip prices in the 1630s and the fact that we may not be comparing like with like (different types of tulip bulb sold for different prices), we should be careful in making comparisons. But the fact that the Bitcoin boom far outstrips the Nasdaq rally of the late-1990s demonstrates that this is a boom to be taken seriously.
On its own, the bursting of the Bitcoin bubble should not in
theory impact most investors. Indeed, the market cap of all digital currencies
represents only around 0.3% of global GDP. Moreover, China is increasingly the
dominant player in the Bitcoin market, accounting for the vast majority of
coins created. It is thus likely that much of the Bitcoin wealth is held by
domestic Chinese investors who will bear the brunt of any price collapse (for a
fascinating overview of the impact of the digital currency in the Middle
Kingdom, this article from Quartz is worth a read).
However, there are residual concerns that a collapse in Bitcoin could be a canary in the coalmine for a more widespread asset price correction, following years of easy money which has pumped up equities and real estate prices. My guess is that this is unlikely and that the spillover effects will be limited, precisely because of the narrow base upon which Bitcoin ownership rests. But as IMF Managing Director Christine Lagard once said, “I'm of those who believe that excesses in all matters are not a good idea … whether it's excess in the financial market, whether it's excess of inequality, it has to be watched, it has to be measured, and it has to be anticipated in terms of consequences.” We should thus not be complacent if the Bitcoin bubble bursts. It might have a deeper meaning than we can currently ascertain.
The puzzling question is why its value should have risen so sharply this year – after all, it has been around for seven years and we have already been through one boom and bust episode. In 2013 Bitcoin’s value against the dollar surged by a factor of 83, only for it to fall back by 85% over the next 14 months. What is rather more of a concern today is that the market value of all Bitcoin in circulation stands at $99 billion versus $9 billion in late-2013, and one of the questions which has been posed to me in recent days is whether an implosion of the Bitcoin bubble represents a threat to financial stability in a way which it did not in 2013.
As to the first of these questions, I believe that the rally in Bitcoin this year represents a different sort of bubble to that of four years ago. In 2013 there was genuine interest in Bitcoin as an alternative currency. Much of this optimism was misplaced, however, as the disadvantages of digital cryptocurrencies became evident. For example, the huge variability in the price of Bitcoin means that it does not represent a stable store of value. Together with security issues – the collapse of the Mt. Gox Bitcoin exchange in 2014 being a case in point – investors began to rethink their Bitcoin strategy.
But the currency is underpinned by the blockchain – a distributed ledger which potentially has a huge range of applications outside the realms of the currency world. One of the fastest growing digital currencies this year is Ether which is created as a by-product of the Ethereum network – a blockchain technology with wider applications than that used for Bitcoin. But as investors have jumped on the blockchain bandwagon so they have forced up the value of the digital currencies which these systems churn out.
In many ways, the digital currency revolution is reminiscent of the dot-com bubble of the late 1990s: There are many new and interesting applications of the blockchain technology but they have yet to be fully realised. Accordingly, investors are paying for their potential rather than their realised value, and because it is almost impossible to put a price on potential value, they are overpaying. It is thus hard to avoid the conclusion that current Bitcoin valuations represent a bubble which is set to burst at some point. As a historical guide, I have compared data for the 14 months prior to the Bitcoin peak versus the late-1990s Nasdaq rally and the Tulipmania bubble of 1636-37. As is clear from the chart, the surge in Bitcoin outstrips the surge in equity valuations in 1999-2000 but would appear not to match up to events in the Netherlands almost 400 years ago. But given the poor quality of the data for tulip prices in the 1630s and the fact that we may not be comparing like with like (different types of tulip bulb sold for different prices), we should be careful in making comparisons. But the fact that the Bitcoin boom far outstrips the Nasdaq rally of the late-1990s demonstrates that this is a boom to be taken seriously.
However, there are residual concerns that a collapse in Bitcoin could be a canary in the coalmine for a more widespread asset price correction, following years of easy money which has pumped up equities and real estate prices. My guess is that this is unlikely and that the spillover effects will be limited, precisely because of the narrow base upon which Bitcoin ownership rests. But as IMF Managing Director Christine Lagard once said, “I'm of those who believe that excesses in all matters are not a good idea … whether it's excess in the financial market, whether it's excess of inequality, it has to be watched, it has to be measured, and it has to be anticipated in terms of consequences.” We should thus not be complacent if the Bitcoin bubble bursts. It might have a deeper meaning than we can currently ascertain.
Tuesday 24 October 2017
Get a grip
In recent days I have come across a couple of insightful
articles which expose the lack of new thinking at the heart of the Conservative
Party which goes a long way towards explaining why the Brexit vote happened and
why the negotiations are not going as hoped. In an article at the weekend, Will
Hutton argued very forcibly that the party’s inability to consign the Thatcher
years to history is preventing it from moving forward (here).
We have to allow for the fact that Hutton has a particular political bent, with
his Wikipedia page describing him as being “widely known for his advocacy of
centre-left policies.” That said, his article did hit many issues on the nail.
Hutton was particularly critical of former chancellor Nigel Lawson who “in any league table of national figures who have been consistently wrong on almost every major judgment … must rank close to number one … Yet, extraordinarily, he is the ringleader of a group of Thatcherite ultras who now crowd on to our airwaves, exploiting the mythology of Thatcherite greatness to insist Britain must make a complete break with the EU.” In 2016, Lawson wrote an article for the FT in which he claimed “Brexit gives us a chance to finish the Thatcher revolution.” But Hutton points out that many of the supply-side reforms of which Lawson is so proud are now beginning to unravel. The tide of opinion has turned against privatisation as society increasingly questions who has reaped the benefits. The financial deregulation over which Lawson presided was one of the contributory factors to the UK banking collapse in 2008, and also helped to widen regional imbalances as London benefited whilst other parts of the country lagged behind. Finally, the labour market reforms of the 1980s, which emasculated the trade unions, are increasingly being seen as one of the reasons why workers are being squeezed despite unemployment at 40-year lows.
It also raises a question of why a politician who left front-line politics almost 30 years ago should still be invited to opine on economic matters. Is the party really so devoid of new thinking? Indeed, I still find it odd that a man who was aged 84 at the time of the EU referendum should have had such a prominent role in the Leave campaign, when he is unlikely to be around to see the long-term effects. Moreover, I do not recall that in the 1980s any of Nigel Lawson’s predecessors from 30 years previously enjoyed such a prominent media profile as he does today (still less calling for the sacking of the incumbent, as Lawson recently demanded of Philip Hammond). Lawson was a bold, self-confident reformer in his day but his time has passed. Unfortunately, many members of his party appear not to have realised that time has moved on and that the solutions of the 1980s may not be appropriate today.
This is indeed a point I have made on this blog in recent months (here, for example). But the blogger Pete North offered an impassioned critique of the problems facing the Conservatives (here – it’s a fine post which deserves a read). More to the point, it explains very eloquently how the current iteration of Conservative economic policy differs from what went before, and gets to the heart of an issue that I have spent much time trying to explain to foreign friends and family. North notes that whilst aspiration was at the centre of Conservative policy during the Thatcher era “there was also something about Mrs Thatcher's values that made her version of conservatism the definitive one. There was something more than just the slash and burn free market instinct. There was still an underlying obligation to observe that, as citizens, we are custodians of a particularly British order where enterprise sits comfortably alongside the institutions of state.” He goes on to state (admittedly in a less than temperate fashion) that “I don't see that in the modern Conservative Party. For the most part I see the dregs of Thatcherism and the second generation Toryboys wedded to extreme free market dogma - which is no respecter of anything … It is this corrosive trend that is ultimately shredding the social contract.”
You can argue about the nature of the language he uses, but his point about the shredding of the social contract is a valid one. The recent experience of having to wait almost four weeks for an appointment with my local GP is an indication that there is something badly wrong with local health provision. Indeed, North argues, as I have done, that if this were consistent with the operation of a free market policy “we should at least be seeing some sort of corresponding tax cuts” as compensation for the reduction in service.
But the wider point is this: A large swathe of the Conservative party has been captured by the ultras who see Brexit as an end in itself. This in turn has divided the party which is scared that the diametrically opposing economic solutions offered by the Labour Party are increasingly finding electoral favour. As a result, the whole government appears to have turned in on itself in a bout of vicious in-fighting and has less time (or perhaps just the stomach) to tackle the mounting economic problems caused by failed welfare reforms such as the botched rollout of Universal Credit (here and here).
We may not yet be quite at the McCarthyism stage here in the UK but as Robert Peston tweeted today, the current state of public discourse “is redolent of a country suffering a Brexit-induced nervous breakdown.” Given the magnitude of the economic challenges ahead (Brexit, flatlining productivity, overly-indebted households, the lack of adequate pension savings for many people), the UK really needs a government that can get a grip – and fast.
Hutton was particularly critical of former chancellor Nigel Lawson who “in any league table of national figures who have been consistently wrong on almost every major judgment … must rank close to number one … Yet, extraordinarily, he is the ringleader of a group of Thatcherite ultras who now crowd on to our airwaves, exploiting the mythology of Thatcherite greatness to insist Britain must make a complete break with the EU.” In 2016, Lawson wrote an article for the FT in which he claimed “Brexit gives us a chance to finish the Thatcher revolution.” But Hutton points out that many of the supply-side reforms of which Lawson is so proud are now beginning to unravel. The tide of opinion has turned against privatisation as society increasingly questions who has reaped the benefits. The financial deregulation over which Lawson presided was one of the contributory factors to the UK banking collapse in 2008, and also helped to widen regional imbalances as London benefited whilst other parts of the country lagged behind. Finally, the labour market reforms of the 1980s, which emasculated the trade unions, are increasingly being seen as one of the reasons why workers are being squeezed despite unemployment at 40-year lows.
It also raises a question of why a politician who left front-line politics almost 30 years ago should still be invited to opine on economic matters. Is the party really so devoid of new thinking? Indeed, I still find it odd that a man who was aged 84 at the time of the EU referendum should have had such a prominent role in the Leave campaign, when he is unlikely to be around to see the long-term effects. Moreover, I do not recall that in the 1980s any of Nigel Lawson’s predecessors from 30 years previously enjoyed such a prominent media profile as he does today (still less calling for the sacking of the incumbent, as Lawson recently demanded of Philip Hammond). Lawson was a bold, self-confident reformer in his day but his time has passed. Unfortunately, many members of his party appear not to have realised that time has moved on and that the solutions of the 1980s may not be appropriate today.
This is indeed a point I have made on this blog in recent months (here, for example). But the blogger Pete North offered an impassioned critique of the problems facing the Conservatives (here – it’s a fine post which deserves a read). More to the point, it explains very eloquently how the current iteration of Conservative economic policy differs from what went before, and gets to the heart of an issue that I have spent much time trying to explain to foreign friends and family. North notes that whilst aspiration was at the centre of Conservative policy during the Thatcher era “there was also something about Mrs Thatcher's values that made her version of conservatism the definitive one. There was something more than just the slash and burn free market instinct. There was still an underlying obligation to observe that, as citizens, we are custodians of a particularly British order where enterprise sits comfortably alongside the institutions of state.” He goes on to state (admittedly in a less than temperate fashion) that “I don't see that in the modern Conservative Party. For the most part I see the dregs of Thatcherism and the second generation Toryboys wedded to extreme free market dogma - which is no respecter of anything … It is this corrosive trend that is ultimately shredding the social contract.”
You can argue about the nature of the language he uses, but his point about the shredding of the social contract is a valid one. The recent experience of having to wait almost four weeks for an appointment with my local GP is an indication that there is something badly wrong with local health provision. Indeed, North argues, as I have done, that if this were consistent with the operation of a free market policy “we should at least be seeing some sort of corresponding tax cuts” as compensation for the reduction in service.
But the wider point is this: A large swathe of the Conservative party has been captured by the ultras who see Brexit as an end in itself. This in turn has divided the party which is scared that the diametrically opposing economic solutions offered by the Labour Party are increasingly finding electoral favour. As a result, the whole government appears to have turned in on itself in a bout of vicious in-fighting and has less time (or perhaps just the stomach) to tackle the mounting economic problems caused by failed welfare reforms such as the botched rollout of Universal Credit (here and here).
We may not yet be quite at the McCarthyism stage here in the UK but as Robert Peston tweeted today, the current state of public discourse “is redolent of a country suffering a Brexit-induced nervous breakdown.” Given the magnitude of the economic challenges ahead (Brexit, flatlining productivity, overly-indebted households, the lack of adequate pension savings for many people), the UK really needs a government that can get a grip – and fast.
Sunday 22 October 2017
Regulate but don't suffocate
Some time ago I was sitting in a meeting in which the
discussion turned to administrative and procedural matters, none of which
affected me. I realised that if I left the room I would not be missed and I
could use the time to do something more productive. This is, of course, an
experience familiar to many millions of people. Once we add up the amount of
person hours wasted in processing apparently trifling administrative matters, we
begin to understand the magnitude of the economic costs imposed by red tape.
Like many people, I tend to think of this problem as one which others should deal with. After all, I am not paid to be a bureaucrat – surely there must be someone else to take care of this. But so long as we are operating on the company's time, our employer has a right to ask us to deal with processes which make the company's life easier. In any case a lot of regulation is necessary. We cannot hope to operate in a complex economic system without a set of detailed rules governing the underlying processes. Indeed, without a lot of these rules, we would experience market failures far more frequently than we do. But that does not mean we should accept all regulation as good, or even necessary.
An example of "good" legislation is that designed to tackle the problem of environmental damage. It has a transparent aim of reducing the wider social costs associated with pollution, which yields obvious benefits to society. Of course producers have to adapt their production methods which can act as a spur to innovation but it also raises costs which are ultimately passed on to the consumer. Society thus has to carefully weigh the costs and benefits of regulation. One of the problems we are now beginning to understand is that as circumstances change, much of the regulation that sits on the statute book becomes outdated.
To this end, President Obama signed executive orders requiring federal agencies to review existing legislation to “determine whether any such regulations should be modified, streamlined, expanded, or repealed” with the purpose of making the “regulatory program more effective or less burdensome in achieving the regulatory objectives.” Consider the situation we are in today in which governments are increasingly concerned about the nitrous oxide emissions caused by diesel engines – the very same technology which was once seen as the solution to the problem of CO2 emissions. That solution is increasingly being seen as a problem and regulation is being amended accordingly, with the likes of the UK and France planning to ban the sale of new cars powered by the internal combustion engine within the next 25 years.
Financial regulation is another case in point. Much of the legislation implemented in the past decade is designed to reduce the risks to society from the socialisation of a private sector problem (i.e. governments do not have to bail out banks) by preventing the emergence of banks which are too big to fail. Globally, banks now have to hold bigger capital buffers and are subject to much greater regulatory oversight. We will only see how effective the legislation has been over the longer term if it reduces the frequency of banking crises. What we do know is that the short-term adjustment costs are high, as banks increase the size of their compliance budget whilst getting out of, or being forced to turn down, business which was once extremely lucrative. In effect, a tax is being imposed on banking activity whose incidence falls mainly on the banks themselves: The wider social costs of this legislation are minimal and it satisfies society's demand for justice in the wake of the crash of 2008 by clamping down on banks’ activity.
But is it all good or necessary? The US Dodd-Frank Act, for example, comprises almost 14,000 pages and 15 million words. Nobody can possibly know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically the US Constitution, upon which a nation was built, contains just 4,543 words. Consider also the EU’s MiFID II legislation due to come into effect next year which is designed to offer greater protection for investors and inject more transparency across the financial services industry. EU financial instruments which fall within its scope will have to comply with the new regulations, irrespective of where they are traded. One of the other aspects of the regulation is that it forces sell-side institutions to charge money managers for their research, rather than bundling it in with transaction fees, in order that money managers’ clients have greater transparency over the fees they are charged (a topic I will deal with another time).
Like many people, I tend to think of this problem as one which others should deal with. After all, I am not paid to be a bureaucrat – surely there must be someone else to take care of this. But so long as we are operating on the company's time, our employer has a right to ask us to deal with processes which make the company's life easier. In any case a lot of regulation is necessary. We cannot hope to operate in a complex economic system without a set of detailed rules governing the underlying processes. Indeed, without a lot of these rules, we would experience market failures far more frequently than we do. But that does not mean we should accept all regulation as good, or even necessary.
An example of "good" legislation is that designed to tackle the problem of environmental damage. It has a transparent aim of reducing the wider social costs associated with pollution, which yields obvious benefits to society. Of course producers have to adapt their production methods which can act as a spur to innovation but it also raises costs which are ultimately passed on to the consumer. Society thus has to carefully weigh the costs and benefits of regulation. One of the problems we are now beginning to understand is that as circumstances change, much of the regulation that sits on the statute book becomes outdated.
To this end, President Obama signed executive orders requiring federal agencies to review existing legislation to “determine whether any such regulations should be modified, streamlined, expanded, or repealed” with the purpose of making the “regulatory program more effective or less burdensome in achieving the regulatory objectives.” Consider the situation we are in today in which governments are increasingly concerned about the nitrous oxide emissions caused by diesel engines – the very same technology which was once seen as the solution to the problem of CO2 emissions. That solution is increasingly being seen as a problem and regulation is being amended accordingly, with the likes of the UK and France planning to ban the sale of new cars powered by the internal combustion engine within the next 25 years.
Financial regulation is another case in point. Much of the legislation implemented in the past decade is designed to reduce the risks to society from the socialisation of a private sector problem (i.e. governments do not have to bail out banks) by preventing the emergence of banks which are too big to fail. Globally, banks now have to hold bigger capital buffers and are subject to much greater regulatory oversight. We will only see how effective the legislation has been over the longer term if it reduces the frequency of banking crises. What we do know is that the short-term adjustment costs are high, as banks increase the size of their compliance budget whilst getting out of, or being forced to turn down, business which was once extremely lucrative. In effect, a tax is being imposed on banking activity whose incidence falls mainly on the banks themselves: The wider social costs of this legislation are minimal and it satisfies society's demand for justice in the wake of the crash of 2008 by clamping down on banks’ activity.
But is it all good or necessary? The US Dodd-Frank Act, for example, comprises almost 14,000 pages and 15 million words. Nobody can possibly know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically the US Constitution, upon which a nation was built, contains just 4,543 words. Consider also the EU’s MiFID II legislation due to come into effect next year which is designed to offer greater protection for investors and inject more transparency across the financial services industry. EU financial instruments which fall within its scope will have to comply with the new regulations, irrespective of where they are traded. One of the other aspects of the regulation is that it forces sell-side institutions to charge money managers for their research, rather than bundling it in with transaction fees, in order that money managers’ clients have greater transparency over the fees they are charged (a topic I will deal with another time).
Suffice to say this is a big deal for the European financial
services industry and has cost a lot of time and effort as banks and asset
managers gear up for it. But according to a recent Bloomberg report (here),
a lot of countries are struggling to be ready to implement the law in January. It
will potentially change the nature of the industry – never mind Brexit – and before anyone suggests that the UK will benefit by leaving the
EU, may I remind you that the UK was instrumental in driving through large
parts of the MiFID II legislation.
I confess that I have a vested interest in this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry anyway, it reinforces my view that large elements of the non-EU financial services industry may simply expand their businesses in less heavily regulated areas. Frankfurt may grab a piece of the London pie but in the longer term it may well turn out only to be crumbs compared with what eventually relocates to Singapore and Shanghai
I confess that I have a vested interest in this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry anyway, it reinforces my view that large elements of the non-EU financial services industry may simply expand their businesses in less heavily regulated areas. Frankfurt may grab a piece of the London pie but in the longer term it may well turn out only to be crumbs compared with what eventually relocates to Singapore and Shanghai
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