#103: Down and running?

STERLING UNDER THE COSH

Some months have now elapsed since the warning here about the very real risk of a run on the pound sterling (GBP). Though – thus far, anyway – the currency’s value has eroded rather than crashed, the relentless, almost daily setting of new lows is starting to look ominous.

This process has an importance reaching far beyond Britain itself. As will be explained in a forthcoming discussion, the next financial crash is likely to differ from the 2008 global financial crisis (GFC) in at least one crucial respect – this time, it’s likely to be currencies, rather than banks, which are hit by a traumatic haemorrhaging of trust.

And, if you’re looking for the likeliest candidate for a crisis, sterling stands out from all other major traded currencies.

The real problem, frightening in its implications, is that there are almost no fundamental grounds for holding the pound. The economy is weak, depending entirely on the spending of borrowed money to deliver any growth at all. The current administration has been left in office, but stripped of power, by an electoral debacle which could hardly have been worse-timed, given the immediacy of post-“Brexit” trade talks.

Even before this setback, the United Kingdom was suffering the consequences of two decades of poor leadership. Not just in economic policy, but in other areas too – ranging across the gamut from defence and foreign policy to energy, public administration and civil liberties – it’s impossible to fathom what the British people could have done to deserve such woeful governments.

In economics, where it matters most, the leadership of the UK has, time and again, proved itself almost wholly detached from reality. To a greater extent even than the United States, successive administrations have turned Britain into a poster-child for extreme ‘laissez-faire’ economics, championing the very same mistakes (such as “light touch” regulatory negligence) that led directly to the 2008 crash.

Successive promises to “rebalance” have come to nothing, leaving the economy dangerously skewed towards speculation rather than innovation. Reflecting this, productivity is dire, and vulnerabilities now include an unsustainable deficit on the current account. Hitherto, inward investment has kept the wolf from the door, but reasons for keeping capital in the UK, let alone adding to it, have become very hard to find.

After severe forex losses since the June 2016 “Brexit” vote, overseas investors must now be wondering whether putting yet more capital into the UK amounts to pouring good money after bad. If that logic becomes a consensus view, sterling could crash, in a panic dash for the exit.

A sterling slump could easily turn into a self-fulfilling prophecy, most notably through the escalating local level of debt denominated in foreign currencies. Further sharp falls in the value of the pound could push debt up to unsustainable levels.

In such situations, the standard response is to raise interest rates, in order both to defend the currency and to attract foreign capital. But there are at least two reasons why this might not be workable.

First, the sheer scale of debt might make a meaningful rise in rates unaffordable.

Second, markets might interpret rate increases as a panic measure, confirming some of their doubts about the health of the economy.

The best hope for sterling in the short term is that the authorities show at least a preparedness to consider rate rises, and – above all – that foreign investors keep putting in more capital.

The trouble with this is that incentives to invest are few and far between. Most seriously, the long-standing deterioration in average earnings, with wage rises remaining adrift of inflation, doesn’t point to vibrant customer demand. This makes it hard for an investor to expect growth in sales and profits.

Moreover, there has to be a very real danger that the British will fail to secure a worthwhile post-“Brexit” trade deal with Europe. Additionally, the fractured nature of British politics makes the election of a left-leaning, pro-nationalization Labour administration a possibility too plausible to be discounted.

When negatives outweigh positives to this extent, a relentless downwards momentum can set in. If the pound continues to deteriorate, and unless government gets a grip and puts pragmatism ahead of ideology, the risk of a sterling crisis could quickly become very real indeed.

 

 

#102: The great divide

THE EMERGING SCHISM IN CAPITALISM

In comparison with most articles here, this discussion is unusually lengthy. It has also taken longer than usual to put together, and covers some complex issues. It does, however, highlight an emerging split within the “capitalist” world – a split that we cannot afford to ignore.

In essence, it describes how a fanatical extreme has controlled “free-market” or “capitalist” economics for far too long. This fanaticism is described here as “laissez-faire”, to distinguish it from the more moderate, “popular” form of capitalist thinking which recognizes both the value of the private-public “mixed economy”, and the importance of regulation and of a strong ethical code.

If you want a shorthand term for “laissez-faire”, ‘junglenomics’ is suggested. It describes a form of near-anarchic, “survival of the fittest” thinking which is close to “law of the jungle”.

It puts its faith in “caveat emptor” rather than regulation.

It argues that private ownership (rather than free and fair competition) is the essence of the market economy.

And it scorns government (except when it needs to be rescued by the taxpayer, of course).

This thinking, manifested through deregulation, created the debt explosion and the escalation in risk which caused the global financial crisis (GFC) of 2008. We are still paying for that crisis, and should anticipate a sequel, especially if the supporters of laissez-faire succeed in repeating the recklessness of deregulation.

Given President Trump’s deregulatory agenda, such a repetition seems increasingly likely.

This time, however, some perfectly decent “capitalists” are likely to pursue a very different course, with Europe providing the lead. In the European Union (EU), the emphasis increasingly is on macroprudential regulation, enforcement of competition, and the protection of consumers and workers.

As this schism widens, the previously-consensus “Anglo-American economic model” could become exactly that – a model supported only by America and Britain (and, conceivably, by the United States alone, if British voters oust the economic “liberals”).

In memoriam

Perhaps because so many of my forebears went off to fight in the First World War – though fewer returned – I’ve been more than usually interested in the commemorations that have been taking place since 2014. Last year we had the Somme and Jutland, and this year, Passchendaele.

But another anniversary looms a couple of years ahead, and it’s to be hoped that this one is celebrated to the full, not least because of its huge contemporary significance. That anniversary is the bicentenary of the first Factory Act, which became part of British law in 1819.

The scope of that law was extremely limited, and its enforcement left a great deal to be desired. It’s important, though, because it is established the principle that the state has a duty to protect working people from the worst excesses of unscrupulous employers.

Over the intervening years, in Britain and around the world, this principle has been extended, to the point where workers in most advanced economies enjoy substantial protection from exploitation and unfair treatment, as well as from hazards in the workplace. In parallel with this, we have enacted a great deal of legislation to protect customers from unscrupulous practices.

The result is that, today, both workers and consumers benefit from extensive protection. Safety at work is part of this, as are entitlements such as sick-pay and paid holidays, and provisions guarding against unfair dismissal. On the consumer side, protection is equally extensive. For example, the roadworthiness of taxis is generally tested to levels more demanding than those which apply to private cars, and the licensing of drivers includes criminal records checks. Hotels, too, are extensively inspected, over vital issues such as food hygiene and fire precautions.

All of this adds costs, which taxi firms, hoteliers, and employers in general, must pass on to their customers. We pay a little more, but what we get in return is worth it. We can step into a taxi knowing that its brakes work properly, and the driver isn’t a convicted rapist. The hotel that we choose for our holiday or city break mightn’t be perfect, but we can be pretty sure it isn’t a twin of Grenfell Tower.

For the proprietor, this regulation can be irksome – but is made less so by the knowledge that all his competitors, too, are regulated in exactly the same way. If some players could evade the regulations, of course, they could cash in, offering lower prices to attract unwary customers, and putting the law-abiding supplier at an unfair competitive disadvantage.

A further stage in the protection of the consumer has become topical in recent years, and that is the regulation of financial services. When we buy a fridge or a car, we have the assurance that the product is safe, but, beyond that, most of us also have a pretty good idea of what the product does, and how it does it. Even the most informed lay person has much less knowledge of financial products, though, so additional protection is required. This extends into macroprudential regulation, because a dishonest or reckless financial firm can endanger, not just the customer, but the broader economy as well.

So customary are these protections that we take them for granted. They’re not perfect, of course – nothing can be. But, when something does go wrong, the focus immediately falls on regulation, and three questions tend to be asked.

Did someone break the law?

Was enforcement faulty?

Or do we need to tighten the rules?

The fact that the focus automatically turns to regulation shows quite how ingrained our assumptions about the benevolent role of oversight have become.

Turning back the clock

There are, however, some who don’t share the widespread acceptance that regulation is a good thing. Bizarre though this may seem, it doesn’t seem to matter to these people whether your hotel is safe, your taxi is driven by a convicted criminal, your employer tramples all over you, or a bank or insurer exploits your comparative ignorance of financial products. Neither, it seems, are they much concerned about practices which create a systemic threat to the system.

This viewpoint, which we can label “laissez-faire”, is the fanatical end of the capitalist spectrum. It states, mistakenly, that private ownership (rather than free and fair competition) is the core principle of market economics, and that government is, in effect, a necessary evil, to be minimized wherever possible. This makes advocacy of privatization a matter of principle, coupled with a sometimes visceral dislike of the public sector.

With private enterprise, always and everywhere, labelled “good” – and the public sector labelled “bad” – this is a very black-and white worldview. In fact, if capitalism can be likened to a faith (which, for extremists, it can), the “laissez-faire” persuasion is a hard-line sect within that faith. Though philosophically a sect, laissez-faire puritanism has long since ceased to be a fringe group. Indeed, it has dominated capitalist thinking for far too long.

To extend the faith analogy a little further, the laissez-faire domination of capitalism is equivalent to the Inquisition taking over the sixteenth-century Vatican. That never happened, of course. But, if it had, Protestants would not have been the only victims of Torquemada’s wrath – equal venom would have been directed at “compromisers”, meaning anyone having the temerity to suggest that the Lutherans might not be wholly bad, and that an accommodation could be reached with the followers of Calvin.

Where this is particularly relevant right now is in the field of regulation. For the zealots of laissez-faire, minimizing government also means minimizing regulation.

In particular, they argue that no good can ever come of government interference in contractual arrangements between employers and employees. Customers, meanwhile, don’t need the sort of protection they have today, because self-interest, in the form of caveat emptor (“let the buyer beware”), is a better defence than regulation.

Over an extended period, the hard-line laissez-faire persuasion has taken over the commanding heights of capitalism. Sometimes known as “the Washington consensus” and “the Anglo-American economic model”, it has long been established as orthodoxy, not just in America and Britain, but in many other countries, and in important transnational organizations as well.

Trump and the zealots

The United States has long been the home of laissez-faire extremism, and never has this been the case more emphatically than under Donald Trump. The wave of deregulation which rolled on under Bill Clinton and George W. Bush was stemmed by the Obama administration, which favoured a more proactive role for government. To the zealots, this was tantamount to betrayal, and many of them regard “Obamacare” as something not far short of treason.

With Mr Trump in the Oval Office, economic zealotry is back – with a vengeance. Most significantly, the emphasis is on weakening regulatory oversight, including rolling back the 2009 Dodd-Frank Act, and the related “Volcker rule”. Instead of doing something really useful – like, for example, “trust-busting” market-dominating players in the tech space – the focus is firmly back on “deregulation”.

In anyone who understands how economics and finance really work, hearing gleaming-eyed fanatics talking about “deregulation” provokes a frisson of fear – because it means that the lunatics, far from being chastened by past experience, are on the loose again.

Because, of course, we’ve been down this road before.

We’ve heard all the gibberish about “light-touch” regulation.

We’ve heard how banks can be trusted to be the wisest custodians of their shareholders’ best interests.

We’ve heard the rabid advocacy of “animal spirits”.

Worst of all, we’ve heard the rants about how all things government are bad – rants which didn’t stop until the laissez-faire zealots found themselves on their knees, begging for rescue from the very same state which they had spent a decade and more denigrating.

The peril of extremes

If there is a single lesson that we should all have learned by now, it is that all forms of economic extremism lead to disaster.

After collectivism crippled the Soviet Union and its eastern bloc satellites, most sensible people thought we’d learned a decisive lesson about the dangers of fanaticism. It turned out, however, that the laissez-faire extremists were plotting catastrophe on a scale dwarfing the localised disaster of Soviet communism.

This really got under way in the second half of the late 1990s, and the tragedy is that so many were taken in by the fanatics.

We accepted the nonsense that low wages could make an economy prosperous, an imbecility addressed in the previous discussion.

We believed the gibberish which said that there was no danger in using cheap and easy credit to fill the gap between high consumption and low wages.

We listened open-mouthed, in the midst of the biggest credit-fuelled bubble in history, to declarations that “boom and bust” had finally been buried.

And we watched as the fanatical pursuit of debt-financed “growth” brought the world financial system to the brink of catastrophe.

No-one should be in any doubt that “deregulation”, and related excesses, caused the global financial crisis of 2008. Deregulation undermined the monitoring of what banks were up. A more robustly-regulated system simply wouldn’t have tolerated sub-prime mortgages, the packaging of toxic debt products, and other techniques for driving a wedge between risk and return. “Cash-back” mortgages, and excessive loan-to-value and debt-to-income ratios, would not have been acceptable in an earlier era of more robust oversight.

As we now know, taxpayers around the world had to step in to rescue the laissez-faire fanatics from the consequences of their own hubris. This showed up their self-serving hypocrisy for what it was, because, if they had really put their faith in market forces alone, they would have accepted the wipe-out of banks and bankers as the logical consequence of “animal spirits”.

Instead, of course, they ran for whatever cover the much-derided state could provide.

The continuing high price of folly

Moreover, the billions spent by governments rescuing banks was just the tip of an iceberg of consequences created by deregulatory madness. Worst of all, the sheer scale of the debt burden created by these fanatics has forced us into an era of unprecedented low interest rates, with no prospect whatsoever of restoring normality any time soon.

By ‘normality’ is meant interest rates that are at least two percentage points higher than inflation, giving investors a real return on their capital. Anything less than that is both abnormal and destructive – and an unacceptable price to pay for allowing the lunatics to take over the asylum.

Of course, policies of ultra-cheap money have pushed debt to levels far higher than they were in 2008 – but the damage has extended very much further than that. For a start, cheap money has stymied ‘creative destruction’, keeping alive businesses which really ought to have disappeared to free up both capital and market space for new, more dynamic players.

The effect on saving, and on the broader issue of futurity, has been devastating. Just as debt has escalated, pension provision has collapsed. According to a recent report, the aggregate pensions shortfall in eight economies – Australia, Canada, China, India, Japan, the Netherlands, the United Kingdom and the United States – stood at $67 trillion in 2015, and is set to reach a mind-boggling $428 trillion (at 2015 prices) by 2050.

The eight-country pension shortfall is growing by $28bn per day, and, in the United States alone, is expanding at the rate of $3 trillion per year, roughly five times what America spends on defence.

Essentially, what this means is that the recklessness of the past fifteen years has made it impossible for people to save sufficiently for retirement.

Calculations for this paper indicate that the collapse in returns on investment has multiplied savings requirements by about 2.7x. So, to get the same return that he or she would have earned by putting aside 10% of income before the crash, someone now has to save 27% – and that’s simply impossibly unaffordable.

The shortfalls in provision which have arisen so far represent just the slump in returns on investment made previously, during the pre-crash era. The dramatic rate at which shortfalls are escalating, on the other hand, reflects the sheer impossibility of saving enough in an environment in which returns have been crushed.

Economic distortion

Another dire consequence of the policies forced on the authorities by previous madness is the distortion of the relationship between assets and income. Because asset values have soared – into, and arguably beyond, bubble territory – whilst returns have crashed, the balance of incentives has tilted dramatically, in favour of speculation rather than innovation and investment.

Given the sheer inability of many governments to understand this concept, it needs to be spelled out.

Imagine you have, say, $500,000 to invest. If you put this into a business, you’ll struggle to earn a decent return in a depressed economy in which demand is dependent on ever-expanding credit.

In certain pivotal sectors, the struggle is made even harder, for two reasons. First, cheap money is keeping afloat competitors who really ought to have gone under.

Second, some governments are unwilling to break up either cartels or market-controlling giants, which – amongst other negatives – have enormous predatory pricing power. To cap it all, if you do make a success of your investment, you’ll be taxed pretty heavily on the income that it generates.

Given this, wouldn’t it be better – and easier – just to put your capital into property or other assets? Their values are unlikely to fall – because governments shamelessly back-stop them – and the capital gains that you accumulate will be taxed at rates lower than income.

Many governments are incapable of understanding this process – let alone of doing anything about it – so are baffled by the resulting symptoms. As the centre of gravity of activity swings from the innovative to the speculative, sectors like real estate and financial services expand, whilst activities like manufacturing shrink. Because of the growth in sectors which generate money but don’t add much value, both real wages and productivity trend downwards. Debt escalates as both households and governments struggle to make ends meet. In the worst cases, the current account deteriorates as outward flows of income to overseas investors escalate.

The country’s exchange rate slumps as investors start to question the validity of a national business model based on the speculative use of cheap capital. This in turn sparks inflation – and will in due course force up interest rates, finally killing the cheap-money economic fallacy.

This is now happditening to Britain. If the dollar were not supported by the “commodity prop” of dollar-denominated commodity markets – which means you have to buy dollars before you can purchase commodities – it would probably be happening already to the United States as well.

Wisdom fights back

The good news is that some countries are beginning to recognize the folly of laissez-faire and the finance-based economy. Chief amongst these realists are the Europeans. The EU has shown itself prepared to support what really matters in free-market economics, which isn’t private ownership, or a small state, but free and fair competition. That’s why Europe’s regulators are toughening their stance over market distortion – and the investigation of alleged cartel activity between German car manufacturers underlines that this policy isn’t specifically anti-American.

The next thing that Europe is likely to do is to clamp down hard on the “gig” economy.

Its supporters like us to call it the “sharing” economy, but then the laissez-faire camp need no lessons from George Orwell on the usefulness of euphemism.

When the aim is to drive down wages and undermine working conditions, this is called “reform” of the labour market. “Liberalization” is the laissez-faire term for undermining consumer regulation, and going soft on market concentration. “Light-touch regulation” means turning a blind eye to dangerous practices in the financial sector. “Freedom”, as the laissez-faire camp uses the word, means allowing the powerful to trample roughshod over everyone else.

We should be in no doubt about what the “sharing” concept really amounts to. On the labour side, it means taking away both job security and the protections which, over two centuries, have become synonymous with working conditions in a civilized economy.

For the customer, it means circumventing regulations designed to protect the public, simultaneously under-cutting traditional businesses operating under established rules.

Though some European leaders – such as M. Macron in France – might hold out for laissez-faire, they’re unlikely to succeed.

As far as Europe is concerned, laissez-faire – or economic “liberalism” – has been rumbled.

The politics of sanity

This, of course, also highlights political choices. Voters – who are also both consumers and, usually, workers as well – have three main choices.

The first is to defy recent experience and enlightened self-interest by letting the laissez-faire camp swing the wrecking ball again.

The second is to ignore precedent and elect collectivist politicians.

The third, rational choice is surely to choose a “popular capitalist” form of free-enterprise politics which dismisses both laissez-faire and collectivism, and puts the emphasis on tight regulation, robust ethics, the mixed economy, and a fearless defence of free and fair competition.

Unfortunately, because the label “capitalist” is applied without discrimination to both the laissez-faire and the popular strands of market-favouring thought, the probabilities are likely to swing increasingly towards collectivism.

In America, it was Wall Street excess which took Bernie Sanders remarkably close to the Democratic nomination and, in Britain, it is laissez-faire fanaticism which could put Jeremy Corbyn in power.

Faced with an incumbency which wants to give the green light to undercutting wages, taking away employment rights, undermining consumer protection and scaling back public services, a vote for Labour can seem highly rational. Mr Corbyn must be cheered every time he reads an article praising the “gig economy”, or advocating yet more privatization.

Finally, in this context, the negotiation of post-“Brexit” trade deals gives the British authorities a temptingly easy way to make matters even worse than they already are. A trade deal with the United States, if slanted towards laissez-faire, could make it impossible to reach a constructive agreement with Europe.

If, for example, the British decide to admit chlorinated chicken, genetically-modified produce and hormone-treated meat – even after a transitional period – their farmers would find themselves barred from European markets.

Much more seriously, the British (and the Americans) already completely fail to understand European intentions on financial services, where the aim is not to rival London and New York in third-party markets.

Rather, the erection of compliance barriers to Anglo-American finance would create more than enough scope for Frankfurt, Paris and other European financial centres to expand to the point where they supply the entire internal needs of European commerce.

World-changing

What we are witnessing, then, is an emerging schism within the “capitalist” world.

Whilst America (and perhaps Britain) persist with laissez-faire “junglenomics”, Europe is opting for a “popular capitalist” version, with the emphasis on regulation, ethics, free and fair competition, and the mixed economy.

Ironically, the result is likely to be that “the Anglo-American economic model” becomes exactly what it says on the tin – a model supported by Britain, America, and hardly anybody else.