Archives for June 2016

Three into two doesn’t go

By their nature, if referenda are to be used only for matters of the greatest import, a clear answer must be forthcoming and therefore only binary outcomes can be permitted. In fact, though the Brexit referendum voting slip had just Remain or Leave printed on them, the Leave campaign was a coalition of two different perspectives. Michael Gove and Boris Johnson wanted to leave the loss of sovereignty implied by being a member of the EU with its automatic imposition of any Brussels regulations, but did not wish to lose the ability to trade freely with the EU, particularly in financial services where the UK dominates Europe. Many in wealthy parts of the UK voted Leave for this reason. For Nigel Farage on the other hand, the key issue was control of immigration – the EU’s freedom of movement for people in the single market was not acceptable and many in the poorer parts of the UK voted Leave for this reason.

The UK thus finds itself in a situation of intransitive preferences, known as Condorcet’s paradox. This occurs when a society prefers A over B and B over C and C over A. For a single individual this is obviously inconsistent, but in a society of many different points of view, this state of affairs is quite possible.

The referendum shows that the UK prefers Leaving the EU to Remaining in it. However, leaving the EU requires that we have to choose between continuing to be part of the Single Market with its economic benefits and having constraints of the freedom of movement of EU citizens. EU leaders have made it quite clear that this is the price to be paid to be part of the single market.

Thus it is entirely possible that there is majority preference to Remain rather than no longer be part of the single market but have control of immigration, ie Remainers plus many of the richer Leave voters, and a different majority preference to Remain rather than not have control of immigration and continue to have full participation in the single market, ie Remainers plus many of the poorer Leave voters.

Theory shows that for society as a whole such intransitive preferences have no good solution and this is where the UK finds itself today – wanting to Leave but with no plan and the world laughing at it.

Boris Johnson, now in campaigning mode to be the next Prime Minister, proclaims that the UK can have both, but David Cameron has already admitted that the UK must choose. The next Prime Minister will thus have to choose between the interests of business and the City and the poor. As a Conservative the obvious course may be to save the interests of business, but such a course of action will further alienate the poorer sections of the country and boost the support for UKIP and its anti-immigration stance.

There is already speculation that France would be prepared to offer the new prime minister zero tariffs on goods (where the Eurozone has a large surplus with the UK) and controls on immigration from the EU but no passporting rights for UK banks in to the EU. This would be exactly what the Farage wing of Leave would accept, but do great damage to the City and Conservative supporters.

As ever in politics there will likely be a compromise with some damage to the UK’s access to the single market in services in exchange for some flexibility on EU freedom of movement.

In or Out – the UK’s European hokey-cokey

For the last 50 years the UK has had a tortuously ambivalent political relationship with the rest of Europe – the referendum will not resolve this. This is for reasons of both geography and history. As an island with nothing but sea to the west but a huge landmass to the east, the UK is both naturally separated, and hence different, from the rest of Europe and at the same time ineluctably tied to and influenced by what happens there. The UK is both a part of Europe and not a part of Europe. This is reinforced by the sharing of a common language with the largest economy in the world, so providing the US with its key gateway to the European continent. Half of the UK’s trade is with Europe, emphasising the importance of the relationship, and of course the other half is not.

Post-war history has highlighted the indecision of the UK with regard to its relationship with Europe. In the early days of inter-government discussions between the nations to discuss political and economic co-operation and integration in the 1950s, the UK was largely absent and played no part, believing such plans were of little interest or relevance to them. By the early 1960s this indifference had turned to concern as it became clear that important economic decisions were being made in Europe that were affecting the UK’s interests. Macmillan changed course and decided the UK needed to join the European project, but was dismayed to find that the UK’s entry was vetoed by de Gaulle’s. So the 60s was a decade of the UK banging on the door of Europe but not being allowed in.

Ted Heath’s premiership in the early 70s was built around heavy diplomatic efforts aimed at negotiating the UK’s entry into the Common Market. This was finally achieved in 1973 at which point domestic politics intervened and Labour came to power with an election mandate to renegotiate the terms of entry which had only just been agreed, and then to hold a referendum. The renegotiation delivered very little and the public voted 2 to 1 to stay in.

For most of her premiership in the 80s, Margaret Thatcher was a convinced pro-European, because she saw it as good for business, and it was she who pushed hard in negotiations with the rest of Europe to deliver the European single market – the UK at this time was consistently arguing for more European integration, with opposition from much of the rest of Europe!

This reversed dramatically in the 90s as Jacques Delors led the European drive towards monetary union and the creation of the euro. In the UK this was seen as a backdoor way of seeking greater political union and sparked the rise of the Eurosceptic wing of the Conservative party, which has been the key faultline within the party ever since. Major European initiatives since then such as the Schengen free travel area and the single currency have seen the UK opt out, while letting others move forward together in greater integration.

The Blair and Brown governments in the Noughties were keen to be seen as leading Europe, with both men seeking to extend British influence by positive engagement, but increasingly the UK media railed against Brussels bureaucracy and increasing European regulation.

David Cameron was forced, for reasons of maintaining short-term party unity, to cede a second referendum, and polls, with less than a week until the vote, show a nation badly split over whether to remain in or leave the EU.

Though the shorter term consequences of the vote will be significant, on a longer term view, the UK’s essential ambivalence in its attitude to Europe will persist.

A victory for Remain will be seen as a rather grudging acceptance that the economic benefits of staying in (which have been very real for the UK economy over the last 40 years) are worth the perceived loss of sovereignty and democratic accountability, but there are few in the UK who have made an emotionally charged positive case for Europe. The UK would continue to be in but the tone will be reluctantly in – the historic ambivalence will continue.

A victory for Leave, though at first sight a clear statement that the UK does not wish to be tied to Europe, will not bring to an end the need for close understanding of European rules. The most successful UK , in services, in order to trade successfully with Europe, will be forced to comply with whatever regulations the rest of Europe decides to impose, not just with regard to those specific industries but also more generally with regard to European laws, which the UK will have no part in deciding.

The UK’s destiny with Europe is thus set to remain halfway “In” and halfway “Out” – the UK’s European hokey-cokey. The referendum will be a significant event in the UK-European relationship but will not change that fate.

Inequality – more and less

A World Bank study a few years ago concluded that the forces of globalisation prevalent in the period 1988-2008 led to the first decline in global income inequality since the Industrial Revolution. The key drivers of this were the startling economic growth in the Chinese and Indian economies, both with populations of over one billion people, relative to the growth seen in the developed economies of the world. The increase in the size of the middle classes in emerging economies has been one of the most important growth themes in global equity investing for the last decade, benefitting the share prices of many global consumer products companies.

This reduction in global income inequality has however been achieved at the expense of rising income inequality in the developed world. The same forces of globalisation that have led to the creation of many jobs in the emerging world, destroyed the jobs of many in the developed world. The much lower wages available to employers in Asia saw first unskilled manufacturing jobs move from the West, followed by semi-skilled manufacturing jobs and digitalisation has also enabled many service sector jobs also to move locations. Workers in the developed world with modest skill levels and education have discovered that the global clearing price for their labour has fallen due to the increase in supply of such labour. However, those with the skills to be in the upper management echelons of many international companies found they benefitted from their companies’ larger global markets and higher profitability. Financial market services was one industry in particular that benefitted from these trends. For the top 1% in the developed economies, globalisation has boosted incomes.

Thus income inequality in the developed world has become much more marked at the same time as global income inequality has fallen. The statistic that demonstrates this most vividly is that the real income of the median US household has barely changed from 40 years ago. All the benefits of economic growth in that period have gone to the very richest in that society and national income inequality is back at the peak levels last seen in the 1920s.

 

Does this matter?

In purely economic terms, with the notable exception of the US economy, Andersen and Maiborn show a positive cross-country correlation between the level of GDP per capita and the rising equality of income in developed economies, in other words wealthier countries have a more equal income distribution, implying that greater inequality is negative for a country’s standard of living.

Perhaps the greater danger though is to politics and democracy. Recent political trends on both sides of the Atlantic show the poorer parts of the population of developed economies to be increasingly unhappy with the standard political approaches and type of politician. Instead more populist political figures such as Trump, Johnson and Le Pen, are on the rise with disguised and undisguised attacks on “others” in society as the source of the lack of improvement in living standards.

In a democracy the economic system must be seen to be operating in a manner that most in society believe to be fair and reasonable. If this is not the case then politicians will have an incentive to propose policies that produce better economic results for most people.

Rising inequality does matter within a democracy, and current levels in the developed economies are back at peak levels seen in the late 1920s. It may be worth a reminder that the 1930s saw the Great Depression and the rise of fascism.

 

Debt without Growth

Much has been made of the fact that the last seven years have seen one of the weakest economic recoveries from recession on record. Not only has real growth been relatively low in this recovery but inflation has also remained consistently low. The two together comprise nominal (or money) GDP, which is the growth rate of the economy in actual money terms, and is what businesses and consumers experience directly. In the UK real growth of 1.5-2.0% is coinciding with inflation of near zero, so that nominal growth has been less than 2%. This compares with typical nominal growth rates of 5-6% before 2007.

This appears to be following a worryingly similar pattern to the Japanese economy which since the early 1990s has seen average real growth of about 1% and inflation of minus 1% giving zero nominal growth over the last twenty-plus years. Such stagnant nominal economic growth, if it goes on too long, affects expectations about the economy. When companies and households expect no or very little nominal growth, they lose confidence in future economic opportunities and do not seek to invest to benefit from such growth or seek to spend since there is a fair chance that purchasing anything will be cheaper in the future and they have little confidence that their revenues or pay are likely to rise in the future.

In such conditions debt becomes a huge burden as it is a fixed nominal sum. If it was taken on with expectations of nominal growth of 5% per annum, but in fact there is very little nominal growth, the cash flow to service the debt is harder to find. The rational behaviour of economic agents is thus to save and pay down debt, further constraining the level of demand in the economy and creating a negative feedback loop.

This process terrifies central bankers for while they all know how to get inflation to fall if it is too high, they do not possess safe tools to get inflation to rise when it is too low. Thus we have been in a world of first low interest rates, then zero interest rates and now negative interest rates and several rounds of QE where money has been pushed into the financial system. By and large these have failed to get inflation rising again though financial market assets have seen price inflation. Since the Global Financial Crisis, government deficits have continued to lead to more debt being issued while companies have also increased debt, not to invest productively but in order to buy back equity. Debt has continued to grow but economies have not kept up

There are only three ways to get rid of any debt burden – Deflate, Default or Devalue. “Deflate” means to spend less than your income to provide the savings to repay the debt – this is fine for individual borrowers, but troublesome for the economy when pursued by governments or many borrowers at the same time. “Default” means not repaying – a terrible solution for the lenders who will reduce their own spending to compensate and also become far less keen to lend again in the future. Since the first two are very unattractive options to policymakers, their preference is usually for “Devalue”. This means apparently repaying the debt but doing so with money that has far less value. There are two routes to achieving this, first (for governments) by letting your currency fall on the foreign exchanges and second by creating inflation so that the real value of the debt repayment is much less. A good way to achieve both routes is to create a lot more supply of your own currency.

So the global economy finds itself in a real bind – weak growth has meant that the debt burden has increased and this has ensured that weak growth will continue. Policymakers have so far been unable to break free of this cycle.

For investors, the key actions are to be prepared for continued low growth and low inflation – which means low returns from all asset classes – until such time as policymakers panic and decide to get serious about creating inflation to devalue the global debt burden. At that point bonds and cash will lose a lot of real value and gold will find itself in massive demand as the inflation hedge and the only currency that politicians cannot create at their discretion.