Financial Crashes Past And Present - 1914

This is the second of two books about financial crises that I have been studying. The first - Bagehot's 'Lombard Street' - dealt with the Overends crash of 1866, and set out the principles by which the Bank of England ought to manage the British monetary system. This book concerns itself with the first great stress test of those principles - the great crash of 1914. In doing so, it set the pattern by which the Bank of England managed the financial crisis of 2007. Disguised as a history book, this is a manual of contemporary financial management.

In the Spring of 1914, German banking and commercial interests started to draw gold out of the Bank of England. They were heavily involved in the discounting of European bills - an early form of revolving credit - and simply did not renew the lines of credit as they were repaid. This caused a tightening of credit in the London market. Onto this tight market was overlaid a series of political threats and ultimata that eventually led to what we know as the First World War.

The political turbulence spooked the markets. There was a rush to gold - Sterling being completely convertible to gold at that point - the hoarding of money, and lines of credit freezing up. As credit became frozen, firms sought to liquidate their financial assets in order to cover their positions, leading to a collapse of the stock market. The stock market closed, which accelerated the banking crisis. That rapidly fed into the real economy and firms started to lay off workers, who they were unable to pay. In the meantime, the government, who had no contingency plans, had to give thought to how they would prosecute the war. In short, things were in a real mess.

The first act was to get credit flowing again. This involved a general moratorium (the suspension of clearing), a suspension of convertibility, and an injection of fiat currency into the economy. The government injected liquidity into the economy through war purchases, then it provided a guarantee for unresolved bills - both domestic and foreign - and finally, the normalisation of commercial trading conditions, which led to the re-opening of the London stock exchange in January 1915.

In doing so, a model was established of Breakdown - Containment - Revival. This model would reappear at the next great financial crisis - that of 2007. The parallels between 2007 and 1914 are striking. So are the differences. In both crises, we see a mountain of debt that is, in essence, a house of cards. When one piece falls, everything else falls. Both systems of finance were highly inter-connected and highly inter-dependent. In 1914, the global inter-dependence was centred on London and connected by telegraph. In 2007, the global inter-dependence was centred on New York and connected by the internet. In both cases, these rapid inter-connections meant that contagion spread quickly and deeply.

In both cases, containment was a question of deciding which participants to support and which to let go to the wall. In 1914, greater use was made of the interest rate as a way of distinguishing between the illiquid (who survived) and the insolvent (who were left to go to the wall). The basis of decision making in 2007 appears less clear, and one suspects that political connections had a greater place in 2007 than in 1914. In both cases, bank balance sheets were greatly impaired and both relied upon public funds to bail them out. However, the major difference between 1914 and 2007 is apparent when we consider the recovery phase.

Recovery in 1914 involved a major increase in debt fuelled government spending to prosecute the war. The main source of funds was New York, and the price of the funding was that London lost it's pre-eminence as a financial centre. It could be argued that this was because London turned it's back on regional finance in the USA, but there simply weren't enough funds to both finance the First World War and the growth of the American economy. However, the war did act as a stimulus for the British economy, and recovery came rather quickly.

It is almost the exact opposite case for 2007. The policy response in 2007 was a monetary expansion through QE, which acted to shore up the balance sheets of the banks, but it also contained a fiscal contraction through the policy of austerity. This is not working well. Not only has it suppressed aggregate demand, the government now admits that it has led to a decrease in the trend growth rate - the ability to generate future prosperity - as well. We are now 10 years into the recovery phase and we are still trying to catch up with where we were in 2007. Living standards have declined, society has become more fragmented, and we are now talking of a blighted generation. This is a very different experience to that of 1914, where a generation was lost on the battlefields of Flanders.

The book is an academic text, and I suspect that only those with a burning desire to understand financial history would make it to the end. There is a lot of jargon and an assumption on the part of the author that the reader is conversant with the financial structure and commercial practices of 1914. This makes it a rather specialist read. The style is academic - one for the awards rather than the book sales - which means that, in places, it tends to get a bit bogged down. It is a hard read, but a very rewarding one, if you have an interest in historical financial crises.

I do, so I quite liked it.

Stephen Aguilar-Millan

© The European Futures Observatory 2018 

Financial Crashes Past And Present - 1866

This is the first of two books I am reading about financial crises. Originally written in 1873, this volume alludes to the Overends financial crisis of 1866, and sets out the prudent principles that ought to govern the operation of a central bank in the face of a crisis. In our current financial environment, it has much to recommend it.

The Overends crisis of 1866 bears an uncanny resemblance to the collapse of RBS 140 years later. Overends was a bank engaged in the boring, but essential, work of bill discounting in the 1840s and 1850s - the branch banking of its day. The profits weren't spectacular, but they did provide a steady return on capital. Then new management came along, and they wanted to shake things up. To make their mark. The company moved away from the steady work of bill discounting and started to take on the more heady work of railway speculation. Needless to say, the bubble of railway stocks burst, and Overends tumbled with them. However, because of their central role in the discounting of bills, credit froze in London and the house of cards collapsed.

The similarity to RBS is striking. In that case we have established banking brands (Royal Bank of Scotland and NatWest), earning steady returns from boring branch banking. New management looks to spice up the bottom line by engaging in casino banking. Everything works well until the bubble - a property bubble, in this case - pops. Credit freezes and the bank collapses. One key difference between 1866 and 2008 is that the Overends directors had the good sense to ringfence the casino operations to isolate the contagion from the bill discounting business. The geniuses at RBS didn't.

How should a central bank respond to such a crisis? That is the subject of this book. In 1866, the Bank of England made credit freely available, but at a price. Bagehot considers this to be the best possible response, and his views still dominate today. In a policy of what we would now consider as QE, the Bank of England lent freely into the banking sector, but avoided the moral hazard of cheap money by making it relatively expensive. This was to separate those institutions suffering from a liquidity crisis (owing to a mis-match of maturities) from those suffering from a solvency crisis (they were busted flushes).

The book doesn't touch upon how effective this was in 1866, but we now know that the difference between the two can be very fine at times, and that politics helps to determine which is which. Unanswered questions that remain in my mind from our own crisis include, was HBoS solvent when it was absorbed into Lloyds? Did Northern Rock have to be sacrificed? Was Lehman Bros a going concern when Barclays bought the casino banking business? I have no answers to these questions, just ill formed suspicions. What we do know from 1873 is that the resolution of the fall out took decades. Any hope for a resolution in our times, for our crisis, seems like pie in the sky to me.

One final point of interest from the book is the way in which it charts the rise of London as a financial centre. According to Bagehot, the centripetal force in the English monetary system allowed large sums of capital to be accumulated in the London banks, which were then lent to promising ventures, first in England, and then around the world. The routing of capital to find a home at the highest return, combined with the impact of leverage upon the balance sheets of the early capitalists, provided the impetus to allow London to rise as the pre-eminent financial centre in 1873. London still retains it's pre-eminence today, but one wonders if it might not be compromised by Brexit? That is a question for another day, but the start of an answer is locked away in this book.

The aim of the book was to outline the principles by which the Bank of England should assume responsibility for the English monetary system. It was quite influential in its day, and laid down the basis by which future crises were met - lend freely, but lend dearly. Of course, such principles can only be appraised when they are tested, and that is the subject of the second volume in my reading - the great financial crash of 1914.

Stephen Aguilar-Millan

© The European Futures Observatory 2018 

The Chickens Come Home To Roost

One of the features of modern commercial life is the way in which the boundaries between the private sector and the public sector have become blurred. The thinking behind this approach is that, whilst the public sector may commission work to be undertaken on its behalf, it by no means follows that the work needs to be delivered by the public sector. It is often asserted that the private sector is in a better position to deliver public services more efficiently.

It is worth unpicking this host of assumptions to look at the constituent parts. To begin with, is the private sector more efficient than the public sector? Efficiency and productivity are elusive concepts in the context of the public sector. By definition, productivity is the relationship between inputs and outputs. However, many of the outputs in the public sector are quite elusive.

For example, take the military, how do we measure the output of a battalion of soldiers in peacetime? Or to take the NHS, how do we measure whether or not it has delivered a healthy population? It is normally the case that, where outputs cannot be defined other than conceptually, we either resort to surrogate measurements (for example, grades attained as a surrogate for an educated population) or we revert to measuring inputs as a surrogate for outputs (for example, the numbers of nurses employed as a surrogate for a healthy society). 

Efficiency is the obverse of productivity. As productivity rises, ipso facto, so will efficiency. However, this is a major flaw in our way of thinking. If we can only measure public sector productivity in input terms, then we are tempted by the view that a more efficient public service is one that costs less. This is the conceptual under-pinning of austerity - ever more productivity savings to ensure less money is spent on public services - which is now starting to get us into a mess.

In a short statement, wrapped in econo-speak, and largely unnoticed in the November 2017 budget statement, the Chancellor announced that the OBR had revised the trend growth path of the economy downwards by 0.5%. This went unchallenged by the Opposition. What does it mean? In plain English, it means that our ability to grow the economy, to increase our prosperity, is lower now than it was in 2007. We needn't look too far to see why that might be the case. Funding restrictions in the NHS are leading to a less healthy workforce. Funding restrictions to transport budgets increase the time it takes to get to work and to undertake our work, if it includes travel. Funding restrictions are delivering a less well educated workforce. It is hard to avoid the conclusion that our reduced productivity has something to do with austerity.

The outsourcing of public services to the private sector has not escaped this trend. We now have a situation where the economy is more stagnant than it has been for a decade, public services have been awarded to the least cost supplier, and the suppliers of public services are now starting to run out of money. The collapse of Carillion, rather than being an isolated event, might be better seen as a portent of things to come. To date, many private sector providers of public services, mainly in the care sector, have been forced to cease supplying the public sector owing to budgetary pressures. We get a different picture if we consider Carillion as the largest to happen to date. The recent profits warning issued by Capita doesn't inspire us with a great deal of confidence.

Just under half of central government services are now outsourced to the private sector. The possibility of a good portion of that going out of business in the next few years is a scenario that we cannot afford not to consider. What will happen if the structure of outsourced services collapses? What will happen if the PFI funded infrastructure bankrupts the companies financing it? How will we cope if the state retreats away from it's core areas?

Stephen Aguilar-Millan

© The European Futures Observatory 2018 

The Future And The Multiverse

One of the more outlandish theories of modern science is that of the multiverse. This is the idea that we only inhabit one of an infinite number of universes, and that, somewhere, right now, there is an alternative version of us that hasn't made all of the mistakes that we have made in our lives. As I said, this is an outlandish idea, one more appropriate, possibly, of the realms of science fiction rather than science fact. And yet, over my lifetime I have seen a good deal of science fiction become science fact, so perhaps we ought not to dismiss the idea just yet.

The concept of the multiverse derives from the possibility of alternative futures. In the physical realm, it derives from events that didn't happen. For example, what would the world be like if the asteroid that collided with earth to render the dinosaurs extinct, actually missed the planet? However, intriguing as these might be, my attention is drawn more to the human realm, thinking abut what might have been, but didn't happen. The road not taken, if you like. There is now a well established realm of fiction - alternative histories - that deals with such cases. For example, 'The Man In The High Castle' deals with a world in which the Axis won the Second World War, or 'Bring The Jubilee' in which the Confederates won the American Civil War. My interest arises from the possibility of alternative pasts being the corollary to alternative futures.

We are accustomed to the idea of alternative futures, that the choices we make today determine the options we have in the future. But what if we could explore the choices we didn't select? Explore them in the sense of living them rather than as an academic exercise? In order to do this, we would need to tap into the multiverse. Obviously, at present, we are unable to do this. But if it is possible in theory, then it is a matter of time before it is possible to actually do so.

There are some scientists who claim to have evidence of the presence of the multiverse - the cold spots at the edge of the observed universe. The veracity of this evidence is beyond my knowledge, but assuming it to be true, the question becomes one of how to access the multiverse. It would appear that the best hope currently is through the quantum. Apparently, the quantum permits a state of being and non-being, and all stages in between, simultaneously. These ideas are currently being used to develop a quantum computer, but the idea has resonance elsewhere. If we can be and not be at the same time, the geographical space in which this happens must, by definition, be the multiverse.

This type of thinking is quite useful in developing scenarios. It is not revolutionary to think in terms of alternative futures. One way to express those alternative futures is through the construction of timelines that map events as they radiate out from the present. The timelines are a useful device to manage the future because they provide a roadmap of where we are heading, and, if we are not happy with the course of events, we can take remedial action to switch onto a timeline more to our liking.

I do feel that the development of timelines is a useful research agenda. We have started to develop some around the issue of Brexit, which we may unveil in later posts. What is most exciting, for me, is that, if we get it right, then we have taken a step towards Hari Seldon's 'psychohistory'. It is paradoxical that these ideas themselves originate in science fiction.

Stephen Aguilar-Millan

© The European Futures Observatory 2018 

The End Of The Asian Century

The rise of Asia is almost a cliché in current futures work. But what happens if this assumption is wrong? The development of Asia has been a feature of the past half a century, but that spectacular rise has blinded us to the risks that this progress could first halt, and then reverse. A more nuanced approach to Asia would accept this possibility and embrace it. After all, the future is not pre-ordained and we cannot take anything for granted.

The author outlines the case against Asia. In many ways, the vulnerabilities of Asia have their origin in the success of Asia. The more successful the Asian economies become, the more likely their weaknesses will come into view. Professor Auslin identifies five key risk areas:

1. The risk of economic failure owing to crony capitalism and the misallocation of resources, especially investment resources. I found it helpful to divide the Indo-Pacific area into three risk categories - the sluggish (e.g. Japan), the soon to be sluggish (e.g. China), and the vibrant (e.g. Indonesia).

2. The demographic risk of growing old before growing rich. In this case, he usefully divides Asia into three risk categories - the old (e.g. Japan), the becoming old (e.g. China), and the young (e.g. Indonesia).

3. The risk associated with unfinished internal political reform. This risk is viewed as the extent to which the various nations have moved to become liberal-democracies. The range is from the 'democratic' (e.g. India) to the 'autarchic' (e.g. China).

4. The lack of a cohesive international political community. The question here is viewed in the negative - why is there no Asian equivalent of the EU? Why is there such a divergence of nations in Asia? Why is there a general lack of cohesion?

5. The risk of war. This is a recurring factor in the international politics of Asia. There are a number of border disputes, disputes over sovereignty, and historical grievances to keep this risk high in our thinking.

Each of these could, in itself, prove very disruptive to the wider international community, but together, they would have a significant effect upon global affairs.

It is fair to say that these risks are largely hidden from current analysis and ought to be given a higher profile. The recent events on the Korean peninsula demonstrate how fragile the current order could become. The author does make a number of suggestions to manage and reduce the risk in the area, but I found them largely unconvincing. His view appears to be that if the Asian nations were to be more like America, then it would be easier for America to guide the risk. That's almost a truism, but it does not account for a situation where the United States is, itself, a dysfunctional risk factor.

The book was written prior to President Trump's inauguration. It is almost out of date before being published. The author presumes the continued certainty of American policy towards Asia, and did not account for the possibility of a complete change in policy. For example, he takes for granted the passage of the Trans-Pacific Partnership. I agree with him that this would have been a key element in shaping Asia in the image which suited America. However, by making this assumption, the book does not consider the possibility of the US surrendering the strategic initiative to China. It does not give space to America's Asian allies wondering how reliable their security guarantee might be. It does not alert us to the possibility that the risk in Asia might be increased through the effects of American policy.

The book does, however, give us a framework to view events in Asia and a model by which we can assess how risk increases and decreases. The issue of North Korea is dominating our current thinking, but there are all sorts of unresolved disputes over the sovereignty of various rocks, islands, and reefs that could suddenly become volatile. This could be exacerbated by the twin forces of ethnic conflicts and nationalism, which overlay various historical grievances. Just because the past 50 years have been relatively conflict free does not mean that we can assume that the next 50 years will be conflict free as well.

The book is a useful corrective to a blindspot in our current thinking. The analysis of the causes has much to commend it, as does the analytical framework to interpret events and the model by which risk can be assessed. The prescriptions leave a lot to be desired, but at least we have a vocabulary by which we can discuss the various options.

Stephen Aguilar-Millan

© The European Futures Observatory 2017

The Magic Money Tree

For the first time in years there are two competing and different visions of the future on offer to the British electorate. On the one hand, we have the Conservative Party, who offer a vision of a country where people who work hard can enjoy the fruits of their labour. This is a vision of a small state, with low taxation and low levels of public spending, where fiscal discipline is enforced by austerity politics. On the other hand, there is the vision of the Labour Party, which starts at the point of markets failing to deliver a fair outcome and needing corrective measures to ensure a fairer society. It is a vision of an expanded fiscal policy with greater roles for state intervention. The Conservative criticism of Labour policy is that there isn't a magic money tree to pay for all of this. Is that quite true?

To answer this question, we need to go back to the financial crisis of 2007-08. Those were desperate years. The banking system was on the verge of collapse, the money supply was falling sharply as banks stopped lending to each other, and there was a real prospect of an acute depression in the real economy. Desperate times called for desperate measures. Two such measures were adopted that had a long term significance - the bail out of the banks and Quantitative Easing.

The banks were bailed out through the purchase of equity by UK Financial Investments Limited - an arms length holding company that manages the government holdings of RBS along with those of UK Asset Resolution Limited (the vehicle created to unwind the Northern Rock and Bradford & Bingley mortgage books). At present, UKFI holds 72.1% of the equity of RBS, which is worth about £23 billion at current market prices, and 100% of UKAR, which has an outstanding loan book of about £19 billion. In addition to that, the Bank of England intervened in the UK bond market to purchase £375 billion of gilt edged stock. This still sits on the Bank of England balance sheet. Together, there is well over £400 billion of liquid assets sitting in public sector balance sheets, almost literally doing nothing.

UKFI and the Bank of England are public sector bodies, subject to public accountability. If a Labour government is elected, then it would be within the realms of possibility that these bodies would be subject to political review. What could happen? It is entirely possible for an incoming Labour government to set up a National Investment Bank (NIB), which is a pledge under the current manifesto. It is entirely possible for a Labour Treasury to direct UKFI and the Bank of England to transfer their asset holdings into the NIB. It could also require the Student Loan Company to transfer into the NIB their £100 billion loan book. It would be entirely possible for the NIB to re-allocate those assets in different ways.

How could it be different? Take the issue of Private Finance Initiative (PFI) assets. These are assets such as schools and hospitals which are built by the private sector and leased for use by the public sector. They have a reputation for delivering poor value to the public purse. Labour has stated that it will issue no new PFI contracts during their term of office, and will seek to reclaim the assets of existing PFI contracts. It would be entirely possible for a Labour government to enact legislation that seeks to swap out the PFI assets held by private corporations for gilt edged stock held by the NIB. The capital value of PFI contracts is estimated at just over £60 billion, which ought to be a manageable sum for the NIB.

As we hear future discussion about Labour's spending proposals, the question of the magic money tree is bound to recur. From a purely financial stand point, it would be entirely appropriate for an incoming Labour government to swap around some of the assets in the public sector. It would also be appropriate for the NIB to fund additional capital assets - bridges, roads, schools, hospitals, prisons, the list is quite large. It could also fund the human capital of the country by reaching a different settlement for the education sector.

When the critics of Labour say that the money isn't there, that statement is untrue. It is there, but isn't currently being put to any good use.

Stephen Aguilar-Millan

© The European Futures Observatory 2017

Using Megagames To Unlock The Future

All quiet on the Taiwan front!

I was recently asked to act in an analyst role in a megagame undertaken by professional wargamers. Normally I would participate as a player, but this invitation gave me an opportunity to stand back and consider the use of megagames as a technique to generate stories about the future. The game we played was 'Dire Straits', a megagame set at the beginning of 2020, that sought to explore some of the diplomatic and military possibilities that might unfold in East Asia at that point in time.

A megagame is a non-linear representation of a complex system in which the actors interact to generate a narrative about a future state. In Dire Straits, we had about 120 players, representing most of the nations on the Indo-Pacific axis, advancing what they thought to be their national interests. The game wasn't at all deterministic, which allowed the players to roam over any form of policy option. It is satisfying that, in the scenario generated, war didn't result. However, in a number of flashpoints the participants moved up to the jump point, but then backed away again. This had a refreshingly familiar ring to it.

In considering why we might want to use megagames as a tool for unlocking the future, five analytical points came to mind:

1. A ‘game’ represents a ‘system’. In the case of Dire Straits, the system being represented is the web of international relations in East Asia and beyond. This compels us to think systemically about international relations.
2. If we have a system, then we will need actors to operate the system. This compels us to identify the key actors within the system and their motivations to act within the system.
3. The system consists of a series of relationships between the various actors. The game compels us to define the relationships between the various actors and examine the modes by which they interact with each other.
4. The interactions between the actors permits us to examine the strategies they adopt in their interactions. The game compels us to adopt a strategy to play the game and to monitor the outcomes of the strategies adopted
5. From a systemic perspective, this then opens the possibility of wind-tunnelling various potential strategies from within the game framework. This can be used to identify, consider, and experiment with various policy options. 

It is my view that megagames are a valid tool for generating future narratives. They are best suited to large questions because, as a technique, they are not an inexpensive exercise. By definition, they involve a large amount of staff time. In order to yield interesting results, they need to be conducted several times. However, they can provide a way to cut through the complexity that is inherent in many systems. 

Stephen Aguilar-Millan

© The European Futures Observatory 2017