Dragonstrike Revisited

Recently I was asked to umpire an economic wargame that sought to model the impact upon the global markets of a diplomatic incident in the South China Sea. The markets in question were the financial markets, the shipping markets, and the real economy. The time frame was short - about six months in game time - and the horizon was the very near future. This framework was very familiar to me because it came close to the scenario outlined in the book 'Dragonstrike'.

Dragonstrike was a scenario written by Humphrey Hawksely and Simon Holberton in 1997. It was set in the then near future (February 2001) and was about the rise of China as a modern great power. In the book, China fabricates a diplomatic incident in the South China Sea to disturb the financial markets, from which it gains a significant financial and commercial advantage.

The book has been quite influential in my thought. It brought to my attention the possibility of the rise of China, years before the concept of the BRICs took root. It brought to my attention the disputed nature of the islands and reefs in the South China Sea, and their importance. It added the Paracel Islands and the Spratly Islands to my strategic awareness. And it inspired a whole raft of spin off games, ranging from our 1999 megagame modelling the issue (100+ players using the Senkaku Islands as a flash point) to our 2004 matrix game examining some of the features of the issues involved (how could the EU have an impact on events in the South China Sea?). In their day, each of these games had their influence, some of which still can be seen today.

When I was offered the chance to revisit Dragonstrike, I jumped at it. It allowed me to focus on an update of the material, to see how things have developed over the past 20 years, and to project ahead along the current trajectories. There were about 30 players, which made the event a bit too small for a megagame and a bit too large for a matrix game, so we developed a hybrid form of game that contained elements of both.

The client gave us a fairly tight brief. The Thucydides Trap is to be sprung, but the conflict was not to include either kinetic or cyber means. The conflict would be conducted entirely in the financial markets, with consequential impacts on the shipping markets and the real economy. We were to assess those impacts on a number of key indices as outputs of the game. The players were senior members of the security and financial community in New York, London, and Hong Kong; and we were to assume that they had a good acquaintance with the subject matter. Our role was to stir the pot to see what happened.

The game progressed more or less along the lines of my expectations. We spent a good deal of time focussing on relatively inessential matters, but I found that quite useful. In a conflict, it is often the case that the inessential captures the attention of the press and the public mood. That provides a degree of misdirection which creates the opportunity for the actors to do some unpalatable things. A good day to bury bad news, as they say.

I did come away from the game with some useful takeaways. The China team wanted to dispose of their holdings of US Treasuries to de-stabilise the bond market sufficiently to induce a sharp downturn in the US real economy. We had a long and well informed discussion about their ability to do this, and what defensive measures the monetary authorities in the US might be able to take to counter the move. This is a theme to which I shall return at a later date.

The US team wanted to exclude the China and Russia teams from the global payments system. This called forth an interesting discussion about their ability to do so and the potential consequences of such an action. The conclusion that I drew from this is twofold. First, sanctions can only be effective if they are applied by all of the major players. If a single player, such as the US, attempts a sanction regime unilaterally, it will do more harm to that single player than the intended target of the sanctions. If sanctions are to work, then they need support of friends and allies. Second, if sanctions are over-used, then they create an incentive for the targets of the sanctions to develop alternative systems to render them ineffective. Once sanctions become a tool in general use, their effectiveness will diminish quite rapidly. 

There was a discussion around the shipping markets. In particular, there was a discussion about the degree to which the Chinese team could purchase spare shipping capacity to keep up the trade flows in the real economy. The discussion  about containerised shipping capacity wasn't settled in the game. It was only afterwards that I found out that the pre-purchase of options on shipping capacity is possible, and would be made visible in the movements of the Shanghai Container Index. The discussion, however, drifted into the 'Belt and Road Initiative' and gave me an important insight into the strategy of China. The strategic perspective is continental and looks westward into the Eurasian land mass. The conventional wisdom about the strategic perspective is that it is oceanic and faces eastward. If so, we ought not to worry about conflict between China and the US, but be concerned about conflict between China and Russia. This puts Russian strategic concerns into a new light.

The original Dragonstrike gave me enough to think about for 20 years. The more recent update has extended that process. It is unlikely to resolve itself in my time because it has the potential to run for quite a number of decades yet. It is a space that we need to keep watching and updating.

Stephen Aguilar-Millan

© The European Futures Observatory 2018

Strange Weather For The Time Of Year

In February, it was colder in Italy than in Iceland.

We have just experienced some unseasonably cold weather. In broad terms, we have just experienced a week in which the temperature was somewhere between 10ºC and 15ºC below the average we could expect for this time of year. This was accompanied by a high pressure cell originating in Siberia, along with a good deal of snow. There was considerable disruption to our daily lives, and invariably GDP will be weaker this quarter as people couldn't get to work, and tax revenues will be down because people weren't earning and spending. Needless to say, this was all greeted with the chorus of, "What's happening to our weather?"

The simple answer to that question is climate change. Perhaps we might expand that answer. The climate in the UK is much milder than the latitudinal mean. The UK is on the same latitude as the prairies of Canada and the wilds of Siberia. It is kept warm by the Gulf Stream. This is a warm current originating in the Caribbean and flowing up to north west Europe. The key to the Gulf Stream is it's high salinity. This winter, there has been unusually low ice formation in the Arctic. The fresh water that, in previous years would have formed this polar ice has remained in the North Atlantic, lowering it's salinity. It has caused the Polar Vortex usually present over the Arctic to slip onto Siberia. A few years back, the Polar Vortex slipped onto North America, with similar results.

What does this mean to us? In 2011, as part of the National Ecosystem Assessment to 2060, I produced a set of wild card scenarios to speculate about the impact of climate change. One of the wild card scenarios held that the UK would become a lot colder as a result of global warming. This is a counter-intuitive result. The changing climate is balancing a warmer planet (much hotter weather) against a reversion to the latitudinal mean temperature (much colder temperatures). Sometimes we have unduly warm winters, and sometimes we have unduly cold winters. Such is our lot. An unduly cold winter has the effect of delaying the growing season. Already, we are currently between one to two weeks behind in our planting season, which means lower crop yields this year. It will lead to higher food imports, food prices turning upwards, and a bit more pressure on UK living standards. It will take years, if not decades, for the climate scientists to model, measure, and quantify these changes. I prefer to rely upon the evidence of my own eyes.

What can I do about it? The usefulness of futuring is it's ability to warn us of an unpleasant future and to give us time to take action today to mitigate that future. A future with a changed climate has been flagged for some time. The weather experienced (stormier, more windy, colder in the winter and hotter in the summer) is consistent with the forecast trajectory. What action can we take now to prepare for this situation worsening?

In my own life, I am taking actions in three areas - transportation, energy, and food. In terms of transportation, I simply travel less. I got rid of my car some years ago, although my wife lets me borrow hers if I need to. I generally travel by public transport, which, for me, includes taxis. Inter-continental travel is now the exception rather than the rule.

We have diversified our energy supplies. We use gas for cooking, although, on occasions we revert to cooking on a wood grill. For heating, we have gas fired central heating, electric heaters for when we want to heat a single room rather than the whole house, and we have a log fire. One weakness we have is that we rely on the National Grid for electricity. We plan to address that in the near future by installing solar panels.

Although we are not self-sufficient, we do grow a good portion of our own food. This is limited by the size of our garden. We plan to downsize to a smaller house in the near future, and this will act as a trigger to get an allotment, increasing our cultivated area. Most importantly, we are re-learning how to grow our own food. This is a valuable skill set that tends to be lost in modern living.

We are at a point where a radically different future can be seen today. If the climate scientists are anywhere near correct, this will all worsen. Our weather will become more extreme and intemperate. We will have to redefine what we mean by normal weather patterns. We will also have to adapt our behaviour to adjust to this new reality. We have all been warned. I have started my journey into the future. Have you?

Stephen Aguilar-Millan

© The European Futures Observatory 2018

Financial Crashes Past And Present - 2018

This book rather continues the theme of past and present financial crises. If anything, it belongs in the category of 'financial crises soon to come'. It has been interesting to chart how financial crises arise (the Overends Crisis of 1866) and how a policy response was framed (the financial crisis of 1914). It is disturbing to see that the conditions of 1866 are not that very different to those today, and our policy response is quite timid compared to that of 1914.

The book starts by considering two shortcomings of conventional macroeconomics - the belief in the exogeneity of the money supply and the consequent setting aside of the financial sector. This provides the starting point for the book. The author demonstrates how credit conditions have a multiplier effect within the financial sector. This makes the money supply endogenous to the system, and not exogenous, as is currently assumed by the mainstream.

If we take that insight, we can derive some interesting conclusions from it. For example, one that stayed with me the most is that, if we move from the monetary economy to the real economy, purchasing power can be seen as aggregate demand plus credit growth. This helps to explain the recent bout of debt fuelled growth in China, which has been a bit of a puzzle. It also helps to explain the observation that households have been maintaining their living standards in the face of falling real incomes by taking on more debt. Our recent growth has not been propelled by growth in our productive capacity. It has been propelled by the growth in total credit within the economy.

This works fine until credit growth stops. One of the reasons why it stops is that lenders become wary about the ability of the borrowers to repay and service their loans. If credit growth just falters - a stumble rather than a fall - then the multiplier effect works in the reverse direction. Credit then becomes scarce and operational conditions in the real economy become tighter. A downturn begins. Conventional economics says that this downturn couldn't happen, which is probably why conventional economics was blind-sided by the crash of 2007.

The policy prescriptions in this case are quite clear. There is a case for the government to make up any reductions in aggregate demand through a programme of spending. Spending on investment is better, but spending on the current account will do just as well. This will help to shore up credit and help to counter the downward multiplier.

Since 2010, we have seen the exact opposite of this. Whereas trading conditions have called for a fiscal expansion, we have actually been on the receiving end of a fiscal contraction - austerity. The role of a fiscal expansion is to inject liquidity into the monetary system, as well as demand into the real economy to mop up that additional liquidity. A monetary expansion through QE serves to inject liquidity into the monetary system. Without the corresponding fiscal expansion, that monetary injection only serves to pump up asset bubbles, in our case in the stock markets and property markets. These then have the side effect of growing inequality.

It is at this point that we get to see the answer in the title. Pumped up asset bubbles have not gone any way to resolve the disruption of the credit system. We still have the global financial imbalances that gave rise to the growth of credit to begin with. This suggests that it is a matter of time before we experience another financial crisis, except that, this time around, the monetary authorities have far fewer policy tools through which they can address it.

A heavy dose of inflation would help to resolve the matter, but politics tends to get in the way here. Inflation tends to redistribute income shares from the 'haves' to the 'have nots', and the current political structure is not geared to achieve this. It is for this reason we can expect that future economic turbulence may be closely associated with political turbulence. One feels that the political pressure is rising as further austerity fails to resolve the crash of 2007.

This is a very short book, but it is very deep. It is surprisingly easy to read for an economics polemic. The author understands what he is saying, and sets it out in a very clear, logical, and methodical way. Prior familiarity with economics would be useful in reading the book, but a lay person acquainted with current affairs ought not to find it too much of a struggle. I found it to be a very useful text.

Stephen Aguilar-Millan

© The European Futures Observatory 2018

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