Have We Seen The End Of Sound Money?

'Sound money' has been a key policy objective in the UK for over 150 years. What this means in practice is a combination of relative household thrift (savings being slightly larger than consumption), public sector thrift (taxes running slightly ahead of government expenditures), a slight positive external balance, and corporate investment just running ahead of corporate profits. This policy, given shape by Gladstone in the nineteenth century, has been the cornerstone of public finances ever since. There have been deviations from this policy over the years, but it has always been the guiding principle to which we have aspired to return when conditions allow. 

Is that still the case? The pandemic has swollen the levels of public borrowing to levels that are very high by historical standards. Borrowing at current levels are normally associated with wartime levels of expenditure. The gap between tax receipts and public expenditures is something that has the potential to destabilise the system. One wonders how they have been funded? By and large, the public debt has been funded by household savings exceeding consumption expenditure  - at least, the household savings of the wealthy and employed - and the business profits - of those businesses still operating - running ahead of business investment. We have achieved temporary stability like this, but it does not augur well for the future.

At some point in the near future we can expect the household savings glut to fall away. A combination of resumed discretionary consumption and a softening of household incomes - as the present levels of disguised unemployment become apparent - will reduce the levels of household savings. The anticipated reduction in the level of business activity is likely to reduce the level of business profitability, putting a dent into corporate savings. That creates a perilous future for public sector finances.

If the private sector is running at a lesser surplus, then only two possibilities can result. Either overseas lenders make good this reduction of funds or the public sector reduces its need for funding. The reliance upon overseas sources of funding creates an internal pressure for the exchange rate to appreciate. An appreciating exchange rate may create a need to adjust interest rates upwards to compensate overseas lenders for the reduction in the base capital value of their lending. This could have problems of its own.

Alternatively, the government could hope to reduce the need to borrow. There are two traditional routes here - tax increases and reductions in public spending. Together these are known as austerity. However, austerity can be self defeating, as we saw between 2010 and 2015. Austerity may attempt to place a cap on deficit financing, but it also reduces levels of economic activity that seriously impairs the tax base.

This leads us to a very interesting place. On the one hand, a return to sound money would suggest a period of austere conditions. Profits would be low, incomes constrained, and expenditures subdued. The political appetite for this future is very restricted. The austerity of the Osborne years is now seen as a mistake not to be repeated. On the other hand, the present policy of an expansive public sector, fuelled by borrowing, is one that resonates politically. Sadly, this leaves us vulnerable to the vagaries of overseas funders and a hostage to domestic inflation. If either of these were to occur, then we would be forced back onto a policy of sound money.

It may appear that we have abandoned sound money as a way to organise our affairs. If this could be a long term solution, then I am sure that it would be satisfactory. The problem is whether it could be a long term stable solution. On this, the jury is out. Despite appearances, it is probably too early to take the view that we have seen the end of sound money.

Stephen Aguilar-Millan

© The European Futures Observatory 2021

The Return Of Inflation?

We think that we can see the shape of the post-pandemic economy emerging. We expect levels of economic activity to be lower than before the pandemic and for rates of activity to be subdued. In the course of the series of lockdowns, the more affluent households have retained a good portion of their cash balances, whilst those businesses that continued to trade profitably have balance sheets swollen with cash. What happens next is likely to be determined by how these economic agents act.

Some households have done very well during the pandemic. If their income has held up - either through continued activity or through governmental support - the imposition of restrictions on many aspects of consumer activity have led to rather large cash balances being accumulated. The closure of non-essential retailers and much of the hospitality sector has ensured that this household disposable income has no natural outlet. How much of that will come back once lockdowns end? 

This critical uncertainty gives rise to two schools of thought. In one school of thought, it is held that this money is seen by consumers as spending money. Once they are able to go shopping again, and once consumers feel safe to do so, then there is likely to be a sharp rise in consumption, possibly triggering a bout of mild inflation. The other school of thought has it that households face considerable uncertainty over the future at the moment and that they are increasing their precautionary balances to counter this uncertainty. In this case, a relaxation of lockdowns is not likely to lead to a spending spree. Both arguments have merit. What we are likely to see is a bit of both happening, but we can't be sure of where the balance between the two will lie.

If households have this quandary, what about the corporate sector? Companies face three possibilities over the cash on their balance sheets. The first option would be to return the cash to shareholders, either as dividends or through share buy backs. Many listed companies have reduced their dividends during the pandemic. There is likely to be some shareholder pressure to restore them, particularly if corporate bonuses start to rise again. A second option would be for the companies to invest the cash in future profits. This is only likely to happen if household demand strengthens and if inflation starts to tick upwards. It is the lack of prospective demand that has held back investment for the past decade. Finally, companies can continue to sit on the cash as a policy of 'wait and see'. This has been the predominant policy over the past decade. We are likely to see a combination of each of these possibilities in practice, with, again, the key point being where the balance lies.

At present, the economy is on life support provided by the government. There has been a significant fiscal expansion, financed by the printing of money under QE. Most governments have found the magic money tree and are picking the fruit as it ripens. If households sit on their precautionary balances and if the corporate sector adopts a policy of 'wait and see', then this could be a reasonably stable outcome. The consequence would be low productivity, low growth, relative stagnation, much as we have experienced over the past decade. This is not a recipe for a dynamic economy and the pathway to increased prosperity.

If, on the other hand, the economy experiences something of a bounce back - an even greater government fiscal stimulus, an increase in household consumption, and an increase in corporate investment - then a different result could arise. Stronger demand could suck in imports and weaken the Pound. Both internal and external factors would then lead prices to harden and for inflation to start to tick upwards. At this point, the policy response is critical. If the monetary authorities respond with a monetary tightening, then inflation could abate, pushing the economy back downwards again, much as happened in the Eurozone in 2011, when the ECB tightened far too soon. If the response is not to tighten, then there could be spurt of real economic growth to close the output gap. This could continue for some time if inflation expectations don't rise too fast. The size of the output gap is such that a dramatic increase in the underlying rate of inflation is unlikely for some time to come.

The current inflation expectations are for a rate of about 3% in five years time. That would be within the collar set to the Bank of England, but at the upper end of tolerance. Would the monetary authorities be comfortable with this? Past experience - coming out of the lobal financial crisis - suggests that they would be. A short period of over-shooting the inflation target was accepted as the price for stability in the longer term. There is nothing to suggest otherwise as we emerge from the pandemic.

If all of this is close to correct, then what we can expect to see in the next year or two is an uptick in the headline inflation rate whilst the economy remains overall subdued. This inflation is likely to be temporary in nature owing to technical factors in the calculation of the headline rate. This suggests that a modest inflation may return for a while, but it will be nowhere near as high as the money hawks suggest. 

Stephen Aguilar-Millan

© The European Futures Observatory 2021

When Markets Go Pop!

Much has been made about the financial markets in recent weeks. A number of hedge funds shorting the US bricks and mortar retailer Game Stop have been seriously derailed by a horde of amateur day traders who organise on Reddit. In some narratives, this is a case of the little guy winning one over on Wall Street. In other narratives, this is a case of a serious criminal conspiracy that attempts to create a false market in Game Stop stocks. Whichever might be the case, it is worth stepping back to consider what is going on here, whether it is a portent of things to come, and how it all might end up.

What is going on here? There is no question about it, two technological trends have allowed this state of affairs to come about. One is the continued disintermediation of financial services. The growth of commission free trading, with ever lower margins on account, has increased the number of individual trading accounts. The other trend is the growth in fractional trading. Instead of buying whole shares in a company, it is possible now to buy fractions of shares, which effectively lowers the minimal value of trades that an individual can undertake. These trends were entrenched well before 2020.

What was different in 2020 was the pandemic. One of the consequences of the policy response to the pandemic was a large number of tech-savvy people with time on their hands and money in their pockets. In the UK, the furlough scheme provides employees with 80% of their salary on the condition that they don't go to work. In the US, a number of stimulus cheques have found their way into the pockets of a similar demographic. Various grades of lockdown have prevented this demographic from spending their disposable income, and the suspension of most sporting calendars have taken away opportunities for sports betting. This sets the scene - we have a body of, predominantly young, bored, tech savvy, people; who have money and time on their hands and who are looking for the thrill of the casino. Where else would they end up but in day trading?

Evidence suggests that this demographic has propelled the gravity defying rise of the S&P 500 in 2020. As a response to this, the day traders have resorted to internet forums to swap gossip about stocks over the course of the year. In some areas, it appears as if team plays have been deployed, the one in the case of Game Stop being a case in point. It is painted as striking a blow against corporate Wall Street, but it is nothing of the sort. The financial system is a complex ecosystem. Whilst some hedge funds may have taken a blow, the profits in the financial system are derived from activity, even if a trade is 'commission free'. The day traders are actually strengthening the system and pouring more profit into 'Wall Street'.

This is a situation that cannot go on for ever. There are two natural limits that need to be accounted for. The first is counterparty risk. As the trading increases in value, the potential for a default grows proportionately. In order to avoid a liquidity crunch, market makers will require trading app counterparties to lodge a larger margin against the possibility of default. This is why the trading app Robinhood had to suspend the trading of Game Stop until it secured an additional capital injection to cover this counterparty risk. Had that additional capital not been forthcoming, the bubble would have gone 'pop' at that point.

The second limit is one of fundamental value. How much is a share in Game Stop worth? For much of 2020, the market value was about $4.00 per share. That was seen as fair value given the underlying assets of the company and the prospects for the business. Trading volumes in the shares started to increase in September, leading to a frenzy of purchasing in January 2021, when the price rose to $347. At that point, there had been no material improvement in the assets of the company and the prospects, if anything, have worsened. Since the peak, the share price has fallen back to around $60 per share. This is despite that underlying assets probably being worth less than $4. At some point, those fundamentals will assert themselves, and when they do the share price will fall both dramatically and rapidly.

For this reason, it is not a portent of things to come. You can pay $60 for something worth $4 for only so long. In the last day trading frenzy - the Dot Com Bubble - the half life of a day trader was only nine months. This means that half of the number of day traders had lost all of their capital in less than a year. This is not a long term trend.

We need to be concerned at where this will all end. The case of Game Stop is neither really here nor there. We should be more concerned at the degree to which the day traders have inflated the S&P 500 over 2020. They are buying stock at inflated values and eventually the fundamentals will re-assert themselves. This is likely to be on the other side of a liquidity crunch that exposes counterparty risk. With the volumes of QE being pumped into the financial system, this isn't that much of a challenge just yet. However, should inflation start to rise, the QE money-go-round will slow, and at that point the whole system looks vulnerable to a major correction. 

It is at that point we shall hear a vast amount of popping, and it won't be champagne corks making that noise!

Stephen Aguilar-Millan

© The European Futures Observatory 2021

The Modern Tribes Of Scotland

We seem to be living through a period of constitutional upheaval in Great Britain. In the past decade, it has become apparent that many Britons do not feel that they are living in the best of states. What's more, their dislike of the present arrangements are sufficiently strong to compel them to act to change it. This has come to a head over two issues - British membership of the European Union, and Scottish membership of the United Kingdom.

We are all aware of the outcome of the review of British membership of the European Union, conveniently called Brexit. Britain marginally voted in 2016 to leave the EU and finally achieved that ambition fully in 2021. At the 2019 General Election, only one national party - the Liberal Democrats - stood on a policy of re-joining the EU, and they only attracted 11.5% of the votes. This hardly demonstrates a popular desire to re-join the EU. For all intents and purposes, we ought to treat Brexit as an established fact.

A more interesting question arises when looking at the regional votes on Brexit. In 2016, only 38% of voters in Scotland voted for Leave. 62% voted to Remain in the EU. This is an important variation on the national picture when set against the Scottish Referendum vote in 2014. In that, 45% of Scots voted for Independence, with 55% voting for the Union. In the two years between, the questions of independence and Europe became intertwined. In 2014, Scots were asked to vote for the Union as a way to guarantee continued membership of the EU. After Brexit, many Scots felt let down about the implicit promise made in 2014, which has galvanised the support for the Scottish National Party (SNP).

It would be tempting to portray the Independence faction as Remainers, but that would be misleading. There are, as it happens, four main tribes in modern Scotland. There are the Indy/Remainers, whose principal voice is the SNP. These are mainly liberal, credentialed, middle-class voters. Then there are the Indy/Leavers, whose voice used to be the Labour Party, but don't really have a home in Scottish politics at the moment. These are mainly conservative, school leaver, lower middle class and manual voters. They will be a key constituency in any future vote. Thirdly, there are the Unionist/Remainers, whose principal voice is provided by the Liberal Democrat Party. These tend to be the liberal, credentialed, more affluent voters. Finally, there are the Unionist/Leavers, who are mostly represented by the Conservative Party. These tend to be the conservative, credentialed, more affluent voters. These tribes have become more tribal in recent years. They even have their own tartans.

As we look ahead, one of the consequences of Brexit has been to open up again the question of Scottish Independence. The sides have already started to form. The Indy/Remainers are coalescing around the SNP, who are looking to consolidate their support with a commitment to seek to rejoin the EU. Ranged against this are the Unionist/Remainers and the Unionist/Leavers, who are coalescing around the Conservative Party, the rump of the Labour Party, and the Liberal Democrats. In terms of support, current polling suggests that the SNP has the edge over the Unionists, but that the lead is smaller than those who are undecided. The key uncertainty is which choice the Indy/Leavers will opt for.

The Indy/Leaver vote, although small, may be pivotal in deciding a future Independence Referendum. Many voters in this group are hostile to the idea of rule by Westminster, but also have reservations over taking on rule from Brussels instead. The SNP are struggling to make the case with this constituency. If the Unionist/Leavers can make the case that Westminster is the lesser evil when compared to Brussels, then the SNP may not win the day.

Of course, this assumes that the national government agrees to allow a second Independence Referendum. The government in Westminster is no longer the liberally inclined conservatism of the Cameron years. Westminster is now controlled by a virulent form of English Nationalism. Already Westminster has signalled that it will not grant a legally valid second referendum. If the SNP received a mandate from the Scottish people in May 2021 - if the elections aren't postponed because of COVID - it remains to be seen how the SNP will convince Westminster to pass the necessary legislation.

One inducement could be the Barnett Formula. This was a funding formula that was devised in 1978 to buy off the vote on Scottish Devolution at that time. It permanently enshrines higher levels of public spending per capita in Scotland when compared to England. In 2018-19, that equated to an additional £2,000 per capita. If the SNP were to offer to give this up in return for a second referendum, that might be palatable for the English Nationalists. It would be a gamble on the part of the SNP. If they won the referendum, they would lose the additional funding in any case as an independent nation. If they lost the referendum, the spending cuts associated with the loss of funding would generate a grievance to be nurtured over the long term.

Whatever happens, change is coming. All parties are unhappy with the present situation. All parties have their ideas about how the future should unfold. These ideas are generally mutually exclusive, which means that a degree of conflict is inevitable. How it actually unfolds is anyone's guess. At present, the numbers are with the SNP. However, their position is so tenuous that, on a binary issue, the opposite could be true at any time.

Stephen Aguilar-Millan

© The European Futures Observatory 2021

Where Are The Robot Overlords?

It is now a decade since the publication of 'Race Against The Machine' by Erik Brynjolfsson and Andrew McAfee. This is seen as the seminal work that highlighted the possibility of the increased use of robotics and automation leading to a significant displacement of labour in the economy. Some of the wilder forecasts suggested that up to a half of all jobs could be lost to automation and AI. We are now a decade further down the road, which gives us an opportunity to take stock of how accurate some of those forecasts have been.

How far down the road could we expect to be in ten years? The main factor underpinning this view is the operation of 'Moore's Law'. This establishes that the speed and power of computers doubles roughly every two years. The way this works is that, over a decade, if Moore's Law still holds, the speed and power of computing would increase not by five times, but by a factor of five. Such is the power of the exponential. Whilst there have been significant increases in the speed and power of computers in thet past ten years, to suggest that this has happened by a factor of five is a bit of a stretch.

The key to increased automation and use of robotics is the further development of Artificial Intelligence (AI). It seems that AI is one of those promised technologies - it has great promise for the future, but that future never quite arrives. Once again, it is wrong to say that no developments have been made. There have been developments in AI that have formed part of our contemporary every day experience. The use of Chat Bots in customer service might be an example here. However, these developments represent incremental change rather than the radical change originally forecast.

It also gives a clue to how we are likely to experience the greater use of robotics. In the 1950s, the view of how we would use robots today was very much along the lines of domestic servants. What has actually happened is the robots have been incorporated into the appliances that the domestic robots would have been operating. It is the internalisation of automation, robotics, and AI that we can see all around us rather than the creation of some huge army of 'Robbie the Robots'.

There is one further factor that argues against the narrative of the robot overlords - demographics. Western societies are currently ageing. Older workers are leaving the workforce in increasing numbers. This is starting to have an impact on the pool of labour and is set to increase across the course of this decade. It is entirely possible that any increase in automation could be the result of the displacement of labour - from the workforce into retirement - rather than the cause of it. If the currently tight labour markets tighten even further, employers may well experience a cost advantage to invest in automated systems. In this case, the use of robots would be to augment the workforce rather than to replace it.

Which brings us back to the original question. Where are the robot overlords? They are obviously not as evident as forecast ten years ago. The original forecast was flawed because it didn't allow for the long term impact of the global financial crisis. It was also seduced by the promise of potentially disruptive technologies. That promise has not fully materialised. The technology that has been developed has been used to augment existing systems rather than replace them. And the workforce is reducing as part of a natural process in any case. 

To many observers, the wild forecasts of job losses from ten years ago did seem a bit extreme. The numbers suggest that caution should have been the order of the day. More jobs were created than lost in the past decade and the future visions of mass unemployment now seem rather fanciful. However, having said that, this view of the future does still creep into the work of some members of the futures community. This is more to serve a political narrative of the future. It is really a question of belief. If someone really wants to believe in robot overlords, no amount of persuasion will help to change their minds. 

Stephen Aguilar-Millan

© The European Futures Observatory 2021