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.

End of part one

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

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

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

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

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

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

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

The cracks are showing

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

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

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

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

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

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

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

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