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12 July 2022

Thatcherism was not about tax, but reforms

Among the three leading contenders for the Conservative Party leaders, one, Rishi Sunak, is an old-fashioned fiscal conservative; one, Liz Truss, is a fiscal earth-scorcher; and another one, Penny Mordaunt, focuses on wider economic reform. Mordaunt is a former defence secretary, and also happens to be the favourite among Conservative grassroot activists, not that this group is necessarily representative of the membership at large. She is campaigning with an argument that is close to one we have been making independently: Brexit requires structural economic reform to offset the losses from trade with the EU. This is a debate perpendicular to the standard economic discourse in the UK about taxes and spending. What we believe will be the factor that makes or brakes Brexit is innovation, or the lack of it. The biggest obstacles to innovation are not corporate taxes, or the lack of fast trains, but business regulation, immigration and education.

Mordaunt and Sunak have the largest number of MPs that support them. But we doubt that the final shortlist likely to emerge by the end of the next week will consist of two relative moderates. It looks as though Truss is emerging as the unity candidate on the right, and that Sunak will be the unity candidate of the centrists. We expect that the various other candidates will ultimately line up behind one of them. We would treat the ultimate choice by the membership as wide open.

It is a sign of modern Conservatism that it is strangely stuck in the debates of the 1980s, while failing to comprehend the innate logic of Thatcherite economics. Thatcherism was about economic reform that generated tax revenues, which in turn allowed them to lower taxes. It was not the other way round. In that sense, Sunak’s more conservative position on tax cuts is much more in tune with Thatcherism than the blind advocacy of supply-side tax cuts, proposed by the majority of the other contenders. Macroeconomics was never the strong point of Thatcherism. It was business regulation, urban planning and education reform.

The modern Tory party consists of crude supply-siders. The crudest of them all is the current chancellor, Nadhim Zahawi, who promises dramatic cuts in the basic rate of income tax and corporation tax to be funded by a generalised 20% staff cut in every government department. Anyone who has ever dealt with fiscal policy knows that it is what politicians do when they have they have reached the end of the rope. They go for some blanket spending cuts across the board: health, defence, education, no matter what.

Since the Labour Party under Sir Keir Starmer has no Brexit policy whatsoever, this Conservative leadership election will be decisive for Brexit. The new leader will have two years, in which to bring structural reforms. Or prioritise populist tax cuts. It’s a choice. If the opportunity is missed, our base-case scenario, it will be safe to conclude that the UK will end up incurring all the costs of Brexit, but reap few of the potential opportunities. In that case, it will only be a matter of time until the Brexit debate itself reopens.

11 July 2022

When stablecoins fail

Economists avoid thinking hard about crypto currencies because the whole idea of money not under the control of a central bank offends them. It is easy to dismiss what you don’t know. And your prejudices are confirmed when there is a market crash.

A noted exception to this rule is this article by Russell Wong, an economist at the Richmond Federal Reserve, who tried to understand, in forensic detail, why the Terra-Luna-UST stablecoin triangle blew up in May. We cannot summarise the entirety of Wong’s article, but the gist of it is that the stablecoin itself was not the main problem in this particular case. What blew up was a platform called Anchor which promised holders of the UST stablecoin a risk-free annual deposit rate of 19.5%. That high rate created the imbalance that led to the de-anchoring of the UST and the collapse of the system.

To unpack this information, one needs to understand the basic infrastructure of the system. The UST ecosystem was comprised of the following components. UST itself was an algorithmic stablecoin, pegged to the dollar at a one-to-one rate. Terra was the name of the blockchain, the technology behind this particular crypto universe. Luna was the coin of the system, like bitcoin or ether. If the price of Luna is $0.25, then a trader can sacrifice one UST to mint four Luna. Conversely, if the price of Luna is $3, a trader can mint one UST by burning one third Luna. Price equilibrium is restored in either case. Whenever the price of UST deviated from $1, investors had an interest to arbitrage out the gap buy by minting or burning Luna. But as any arbitrageur knows, it is the liquidity that can kill you.

It is hard to compare the various elements of the crypto-verse to existing financial structures. Anchor had some similarities to a mutual money market fund, except that investors in a MMMF would never see such high returns. The short story is that those high returns induced people to burn Luna to deposit USTs, thus creating an imbalance that led to the system losing its natural equilibrium.

Wong’s main conclusion is that the system collapsed due to rookie design flaws, but it was not a Ponzi scheme. Ponzi schemes work by defrauding new investors, to the benefit of existing investors. That was clearly not the case here.

This passage in Wong’s article captures the dynamic, and draws comparison with other financial crises:

UST was backed by Luna but the price of Luna was backed by its option value of converting to UST. When the confidence of this circular backing is shaken, the liquidity of algorithmic stablecoin becomes flighty...When market liquidity evaporated, UST and Luna ultimately relied on the issuer’s equity to support the prices, similar to the backing of a more traditional currency as seen in the Asian financial crisis. It is the part of economics cannot be replaced by technology.

We have previously warned economists to take this technology seriously because it is the technology of the future, and it has characteristics that traditional money lacks. Likewise, the crypto-fanboys should learn lessons from traditional economics, not so much to dissuade them, but to understand how to design crypto-systems properly. As students of financial crises, we know that for all their specific differences there are elements common to all, including the high-tech 21st century variants. The most important ones are exuberance, together with a denial of intruding dynamic effects. 

8 July 2022

Sinn Féin seizing the moment

The Irish government is likely to face a no confidence vote next week, brought forward either from Sinn Féin or the People before Profit party in the last week before the summer recess.

Sinn Féin, the party that surprisingly won the 2020 elections in percentage terms but not in seats, will decide today whether to table a motion of no confidence, and urges independent MPs not to support the government in votes anymore.

The coalition of Fianna Fail, Fine Gael and the Greens lost its majority in parliament yesterday after one of its MPs voted against its bill. The coalition government is still operational, as it is also supported by independents. But its own majority has been dwindling, down from an initial 84 out of 160 MPs to 79. It is this trend which Sinn Féin is riding on.

Will Sinn Féin get a motion of confidence through? This still looks unlikely based on the number of opposition votes. But not doing anything in an occasion like this is simply not an option. Under Mary MacDonald, the party is building up on its momentum since the last elections, broadening its appeal and shaking off its militant past, a legacy of the Troubles in Northern Ireland. Sinn Féin has been vocal on the failure of the government in education and housing, in a country where house prices are soaring, putting tenants and first-time house buyers into difficulties. This is a popular theme.

The numbers do not add up to sink the government. But let’s go to the unlikely scenario where a no confidence vote is won. This does not automatically mean new elections. In Ireland it is the president who decides whether the dissolution of parliament will warrant new elections or not. He may ask instead parliament to come up with a new government proposal.

The more likely scenario is for the coalition to stay on for now and muddle through. Governing without a majority will become more difficult, with further troubles in autumn when it needs parliament supply for its spending budget. In this context we note a warning from the Irish Central bank saying that structural public spending plans are too dependent on 10 multinational companies that bring in half of the country's corporate tax revenues. Just to get a sense of the magnitude: the government predicts a budget surplus of €2bn this year due to excess corporate tax receipts. Without those, the government would run a €7bn  budget deficit. The central bank has called on the government to put money into the rainy day fund, which they repeatedly deferred, writes the Irish Times. With Sinn Féin breathing down their neck, we also would not hold our breath that it is going to happen for the 2023 budget.

7 July 2022

Energy in the food chain

Two years of the pandemic and the war in Ukraine revealed our supply chains exposure to global shocks. After the financial crisis in 2008 revealed the interconnectedness in the world of finance, it is now the production sector that has discovered its own version.

The food industry, for example, depends on gas and diesel for its fertilisers, tractors and irrigation. Energy costs can represent up to 50% of its variable costs. Add to this the price hikes for grains, packaging, and transport, and food producers are now facing a cost increase of 60%, according to Ania, the French food industry association. Nitrogen fertilisers also depend crucially on gas. Some fertiliser plants have announced temporary closures, citing spiralling natural gas costs as the cause.

Exploding prices for containers, energy, fertilisers, raw materials and food prompted calls to bringing production back home. But this is easier said than done. It requires a rethink in production and logistics on an unprecedented scale. New plants and warehouses have to be built, and new energy sources have to be sourced and developed for the production of fertilisers and transport. These are long-term decisions with immediate cost implications. Governments are designing policies that replace fossil fuels in the food chain. Poorer households will need some support, while care is to be taken at least not to worsen the market conditions for those countries in Africa that are much poorer and more dependent on grain imports than Europe.

The three years of various crisis highlighted interdependencies in the manufacturing sector and the food supply chain. As much as this is a challenge it is also an opportunity to explore new ways of doing things in farming or manufacturing. It is an opportunity to use the savings glut in Europe to create a different future. But the process is likely to be chaotic, especially if every EU country is doing its own thing. It is the combined effect of the different measures that counts, and this also takes time to work its way through.

6 July 2022

Next comes the drought

One crisis is often followed by another. In Europe, we experienced the Covid-19 pandemic and its lockdowns, the war in Ukraine and its ramifications for migration as well as supply chains for energy and grains. And climate change has produced a severe drought not only in India and Africa, but in southern Europe too.

In Italy the government announced a state of emergency in five regions over water shortages until the end of this year. Scarce winter rain and spring droughts lowered the water level of the Dora Baltea and the Po, the largest river in Italy, down to eight times lower than usual. Both rivers feed one of the most important agricultural regions in Europe, with 30% of production currently threatened by drought. In about 100 cities water use is restricted to reserve enough for drinking.

Portugal is small by comparison and comes better prepared for water shortages. They already started preparing for a dry season in the winter, restricting the use of hydroelectric power plants to two hours per week, thus saving water reserves. The drought hit in May, when 97% of the country was affected. Local farmers' organisations also rolled out emergency plans to limit irrigation of some crops.

Spain is the third largest producer of agricultural products in the EU. At least 70% of all fresh water is used for agriculture. Some communes have been restricting the use of water since February, after the second driest winter since 1961. At risk of desertification, the country still needs to come up with a plan on how to preserve its water reserves.

This drought is certainly nothing compared to east Africa, which has barely had any rain for four years. Millions of people face dire water shortages. Food prices have risen rapidly, worsened with the fallout of grain imports from Ukraine.

Those different crises have taught us to live with constraints. The pandemic restricted our social interactions, and the war in Ukraine triggered an energy and grain shortage, both flagging up supply chain shortages for our industries. There are restrictions on how people use water in their daily lives, and how farmers are using it.

Those crisis have redistributional effects: young people who had to stay in under lockdown to save the lives of the more fragile in society; poorer households affected most by the rise in energy and food prices as measured in proportion to their income; a south afflicted by drought, heatwaves and wildfires versus the green northern EU countries.

The upshot is that these serial crises are forcing a big rethink about solutions. It could, for example, force European farmers to learn techniques usually applied in Africa to adapt to new climate patterns and become more resilient in the long term. Crises often come in clusters, but so do policies and technologies to overcome them.

5 July 2022

Three reasons to distrust Sir Keir on Brexit

Sir Keir Starmer last night pledged pledged that a Labour government would not return to the EU, or try to re-enter the single market or customs union. It was as clear and unambiguous as such a pledge can be. We have three reasons to distrust it.

The first is that he shifted his policy position on Brexit before. Labour-supporting Brexiteers still remember this vividly. The Labour Party went from an official position of accepting the referendum result during the 2017 election campaign to open advocacy of a second referendum in 2019. Sir Keir, then Labour’s Brexit shadow secretary, was the most prominent voice in the second referendum movement, and instrumental in persuading Jeremy Corbyn to accept it as the party’s official campaign promise. Yesterday’s news broadcasts were full of pictures with him on pro-second-referendum demonstrations.

We recall the flimsy argument on which that shift was based: the Conservative government had not delivered a viable withdrawal agreement. The argument was dishonest because Sir Keir was instrumental in frustrating a compromise offer by Theresa May, shortly before her downfall. We recall this period vividly, and argued at the time that the Labour party should have kept to its previous pro-customs-union position. The second referendum crowd entered a period of delirious delusion that they could win. When the situation changed, Sir Keir changed his mind. And we all know that situations keep changing all the time.

The second reason to distrust the statement is that Labour, like the Conservatives, does not have a strategy for Brexit Britain. We don’t mean a good strategy. We mean any strategy at all. A strategy would require a focus on new sources of economic growth to compensate for the fall in trade. All the trade shocks currently recorded in the statistics are not due to Brexit. Oil price shocks and the global supply chain crises, and transitional Brexit-related red tape shocks are muddying the picture. But there can be no doubt that Brexit will have a lasting impact on trade. A promise not to reopen the Brexit debate would have been more credible had it been accompanied by a strategy for a post-Brexit growth model. There are interesting parallels between the UK’s paralysis on this issue and Germany’s failure to deliver an alternative business model, as discussed in our lead story. Old instincts are kicking in. The Labour Party, once in power, will realise that the only source of an economic recovery will be the only one they have ever known.

The third reason we distrust the pledge is that it might not survive a coalition or confidence and supply agreement. Sir Keir also recently stated categorically that he would not enter into a formal agreement with the SNP. It is possible, but unlikely based on current polling, that Labour would win an absolute majority outright. The Liberal Democrats would be mad if they supported a Labour government programme without ironclad guarantees for proportional representation, and possibly a second referendum. The SNP will ultimately also want a second referendum, either if they don’t get a Scottish independence referendum, or if they get one and lose it. From an opposition perspectives, Sir Keir’s new found clarity on Brexit is as understandable as it is not credible.

4 July 2022

Russia, a counterfactual

In our infrequent series about plausible counterfactual scenarios relative to our base case, here is one about the war in Ukraine. We can offer no insights on military scenarios: we leave that to the armchair generals. But there is a specific counter-factual scenario we have to take seriously. Previously, we presumed that a long war would benefit Russia. Our base case, as so often, is from a macro-finance perspective. The western sanctions have driven up the price of oil and gas, as a result of which Russia’s current account position is stronger than ever. The physical sanctions, in our scenario, would constitute a Brexit-type shock, large but frictional. Eventually money always finds it way to the goods its owners want to buy.

We can, of course, not be sure that this gravity theory of Russian surpluses will work out that way. When you look under the hood of the Russian economy, things look different. What often happens after a political shock, as in Germany and Japan after 1945, or the UK after the 1970s, is that countries adopt new business models. The Russian economy, by contrast, may not be flexible and resourceful enough to develop an entrepreneurial bunker spirit.

We know that Germany is hopelessly dependent on Russian gas. But Russia, too, is dependent on the west, perhaps even more so. We heard the story of a car assembly company in Kalingrad, which suffered from the cancellation of contracts of western car suppliers and is now heading into commercial and financial oblivion. It gave its idle workers set-aside land to grow their potatoes. So it's potatoes, not microchips. The problem with countries in the grip of industrial mafias is that they are not very innovative. Vladimir Putin bet the house on fossil fuels. This was already a non-sustainable strategy for the 21st century, considering the global transition to renewable energy.

What about the idea of Russia circumventing sanctions through reliance on Asia? FAZ reports that even the Russians no longer believe that sales to Asia can compensate for the loss of European business. It quotes Valery Yazev, the head of the Russian national committee of the World Petroleum Council, as saying that the Russians were deluding themselves if they thought that India and China would buy up all of their oil and gas. He has been personally involved in negotiations with China over the Power of Siberia gas pipeline. Once the Chinese become the main buyer of Russian gas, he says, they will turn on the screws.

One of the few top Russian officials who understand the sheer enormity of the crisis facing the country is Elvira Nabulliana, the central bank chief, who told the Duma that the western sanctions necessitated a structural transformation. As this article explains, there are not many options for Russia. The following are so not much an alternative strategy, but a brainstorm list of things that spring to mind:

  • diversion of commodity flows to new customers;
  • reorientation of feedstock exports to new customers;
  • setting up an alternative financial architecture, including payment systems, to reduce the financial dependency on the west;
  • measures to provide to technological import substitutions.

The latter is crucial. There has been very little progress in the past on import substitution. The best option appears to be parallel imports from third countries that do not participate in the sanctions. But experience has shown that many companies in those countries fear secondary sanctions, and are therefore reluctant to deal with Russia.

Herein lies probably the best reasons for optimism about the long-term effect of western sanctions: that Russia’s system of state-capitalism, suitable for a fossil-fuel based exporting economy, is the worst possible economic system to enable the creative destruction that is necessary to regenerate the economy in a time of crisis. Germany, Japan and the UK were very different in that respect.

1 July 2022

Erdogan's yes, but moment

Accession of Sweden and Finland to Nato is not a done deal yet, warns Recep Tayyip Erdogan. Turkey withdrew its veto against accession talks to start with the Nordic countries in return for extensive anti-terrorism assurances that require changes in domestic legislation, and the extradition of suspected terrorists.

What matters are not the pledges they gave but the delivery of those pledges, Erdogan insisted. Both governments bent over backwards to give Turkey its anti-terrorism assurances. One of the pledges is facilitating the extradition of 76 Kurds, deemed as terrorists by Turkey. But this is not so easy. The question is whether the courts in Finland and Sweden have the same definition of a terrorist as Ankara does.

Theoretically, their Nato membership could still be stopped or delayed if the Turkish parliament votes against it. So, indeed, their membership is not a done deal. We also know that Joe Biden’s call to and his meeting with Erdogan played a role in what looked before like a deadlocked situation. Some argued that this is less about the F-16 fighter jet programme than about Erdogan having his meeting with the US President. Jens Stoltenberg was also instrumental in forging a compromise. But Erdogan’s warning and rumblings on the left in Sweden are a reminder that those deals may be easier announced than implemented.

30 June 2022

Where 'don't know' is the correct answer

In our irregular series on scenarios that are not our base case but plausible nevertheless, we will focus today on the impact of a Russian gas embargo on Germany. Our base case sits somewhere between the most extreme estimates of German economic institutes, as juxtaposed by Handelsblatt. But it is worth looking at those extreme scenarios in some detail. It is not what they predict that is revealing but how they think about the evolving situation.

Prognos predicts a drop in GDP by 12.7% in the second half of this year, around €200bn, if the gas stops flowing. The premise is that once the Nord Stream 1 pipeline gets serviced on July 11, and the gas flows stop during the maintenance period, it will not come back afterwards. Prognos writes that an abrupt stop would mean that half of German demand would not be met by supply. The main economic impact is through a domino effect, the kind of which Robert Habeck talked about recently. Prognos has taken a detailed look at industry supply chains to come to this conclusion. A steel company does not use much gas, and in any case is likely to be exempted from rationing. But a rolling mill needs a lot more energy, and is not exempted. The secondary effects outweigh the primary by 3 to 1 in their calculation. This is why their forecast is so pessimistic.

During acute crises, we think it is a good idea for economic analysts to try to gain a deeper understanding of dynamic effects, rather than stare at useless models. We think Prognos's method is quite good, but are moderately more optimistic because dynamic effects work in both directions. There will be offsetting trends, in terms of energy efficiency, and alternative supplies, some of which could kick in immediately.

The other study cited in Handelsblatt comes to a diametrically opposite conclusion. A joint prognosis by Germany’s leading economic institutes says the governments' efforts to diversify energy supplies were already bearing fruit, and that the effect of an embargo would be minimal. In their most probable scenario, there would be no shortages whatsoever during the winter even if Putin were to cuts the gas. They argue that the improved gas storage is the main reason. In April the gas tanks were 30% full. Now this is up to 58%. They put the probability of a shortfall of supply at only 20%. In that scenario, they arrive at a similar direct economic impact as the Prognos Institute, but they don’t go into the domino doomsday scenarios. In that scenario we are looking at a normal recession. Their most pessimistic scenario, very improbable in their view, would see output slashed at 9%.

We never cease to be amazed by how economists, and professional investors too, fool themselves by attaching precise percentages to future scenarios. There is, of course, no valid statistical or probabilistic basis behind this practice, but it is very common nevertheless.

When it comes to the future, we can rank our scenarios, and express subjective views, but that is about it. In our own subject base case, Russia will continue to supply gas at reduced volumes until the autumn. Depending on the war, and the size of their current account surplus, they might at this point take a decision to cut supplies altogether. A total cut-off in July, followed by an acute shortage in the winter and an industrial domino effect, is, however, not an improbable scenario.

What we find most useful about these extreme scenarios is not what any of them predict, but the sheer range of expectations between the two. That is telling us that we are dealing with real, raw uncertainty.

29 June 2022

Why they hate Scholz

Armin Laschet’s bid to become German chancellor ended the day he was caught giggling on stage during a meeting with victims of the 2021 floods. Olaf Scholz had such a moment yesterday at the end of the G7 summit. A journalist from Deutsche Welle asked him the following question:

“Could you say what security guarantees the G7 has agreed on for Ukraine for the period after the war?”

Scholz's response consisted of three words only:

“Yes, I could.”

The men’s arrogance, and his coldness, has to be seen to believed. We have seen milder versions of this before. Scholz is the most dangerous sort of politician: a man with an inferiority complex. 

The journalist, Rosalia Romaniec, put it well in her tweet following this incident.

“What a pity, Herr Bundeskanzler. When I learned German, I was taught to use polite questions during press conferences. This was meant as a serious question.”