Metro Bank and the challenges facing it

Featured image licensed under the Creative Commons Attribution-Share Alike 4.0 International license. Image author: Philafrenzy

As is often easy to forget, humanity never really progresses in a straight line. From unpredictable conflict to unexpected technological advancement, the road of history is far fuller with roundabouts and U-turns than we often feel in the modern day. That is why when the Financial Services Authority granted Metro Bank its license just over 9 years ago, some degree of apprehension would be appropriate regarding its future growth path. This would prove to be well-placed, as just a few months ago Metro was embroiled in an accounting scandal that rocked the firm to its very foundations.

The issue arose in Metro’s miscategorisation of some loans in its commercial loan portfolio. Many commercial property loans and loans to buy-to-letters were deemed as less risky than they actually were, when they should have been among the bank’s risk weighted assets. Around 10% of Metro’s loan book was affected. The significance of this cannot be understated; it implies that Metro had far lower capital ratios than initially thought, and so the firm was more prone to default risk. Even at the end of March, the company’s tier 1 capital ratio sat at 12.1%, only a tenth of a percentage point above the company’s self-imposed guidelines. The events triggered a 75% decrease in share price within a few months of the announcement of the miscategorisation. Metro’s share price currently sits at around £6.30 a share, having dropped to lows of £4.75.

The question, now, is what will become of the challenger bank, now that the dust of the cataclysm that befell them is somewhat settling on the horizon. Metro did indeed raise £375m in equity finance in the span of three hours to help them meet regulatory requirements, however to say the company has been unaffected would be a gross understatement. Deposits at the firm fell by 4% in the first quarter of 2019 to £15,095,000,000, and for a business in an industry that is so reliant on customer sentiment, that spells worrying news indeed. Although the raising of capital may assuage some of this fund outflow, it may take quite a while before the firm can recapture the confidence (and thus, the funds) of the public in the way in which it once did. Whether it is able to do this is soon to be seen, and if it does (as we can see from when its next quarterly results come out) we may be more confident of a turnaround.

Moreso, although a pioneering entrepreneur in his own right, Vernon Hill (the co-founder of Metro) does not exactly have a squeaky clean resumé. He has often been criticised for using Metro Bank funds to pay family members, and the recent fiasco will help convince no-one of his abilities to manage shareholder capital. Having already just recently survived a shareholder revolt, the 73-year-old is not the most popular man in any room. How he navigates this personal mini-crisis of investor confidence and whether he can convince existing shareholders that he is the man to lead the company into the future is a key issue to be wary of before investing in the firm. It should be noted that only 12% of shareholders opposed his re-election as chairman, indicating that this issue may not be as significant a factor to consider as the one that preceded it. However, in the event of another gaffe this would again come into the limelight, almost definitely with far more severity.

Finally, an existential issue to bring up relates to Metro’s customer service. The bank was set up to challenge existing paradigms of how retail banking “should” be in the UK. For an organisation like this you’d expect it to have pretty good customer service (at least in comparison to its rivals). This makes it all the more surprising that Metro Bank, along with Barclays, ranked lowest of all lenders on customer service and the propositions they offer. This issue is so serious because it fundamentally challenges the notion that Metro are executing their disruptive business model with any degree of success. Vernon Hill would be the first to tell you that acquiring fans is more important than making profits in the short run, however it’d be hard for him to be able to do either when customer service threatens both acquisition and retention of depositors. This is a key indicator of whether the bank can reverse its fortunes in the future; its customer service ratings will be a key barometer of whether it can successfully execute its business model in the long-term.

Overall, then, the loan misclassification fiasco at arguably the UK’s most prominent challenger bank has damaged its credibility with shareholders and depositors alike. The three factors described above, namely total deposit numbers, Vernon Hill, and customer service ratings are in my opinion the three biggest issues to consider when debating investment in the firm. At this critical juncture in Metro Bank’s history, all is to play for, however that can be as much a curse as a blessing.

 

Santander delivers a shock

The additional tier 1 (AT1) market for bonds is a relatively new addition into the world of finance. They are a mix between debt and equity, essentially meaning that when a bank’s capital ratio falls below a certain level, the AT1 bonds are converted to equity, or shares in the bank. They were introduced by regulators during the 2008 financial crisis, where worries about both banks’ solvency and liquidity brought the global financial system to its knees [1]. So far, coverage on them has been limited, given that fortunately we have yet to see another major event of the same proportions as the financial crisis. However, last week we saw a relatively unusual event, that had not been seen since more than a decade ago.

The first thing to note is that these AT1 bonds have perpetual maturity; in essence, there is no “maturity date” for these bonds so a sum needs to be paid each year, in theory, in perpetuity, unless the bank pays the whole amount in advance. However, a convention is in place whereby investors in these bonds acknowledge that they will be repaid at the earliest possible date, usually around 5 years after the bond has been sold [2]. However, last week Santander opted to roll over an AT1 bond, which is highly unusual given what has been happening for the past 10 years [3]. The news spooked investors in Santander as they sent Santander’s share price falling lower on Wednesday morning. While the decision makes sense for Santander for purely economical reasons, it jeopardises the global AT1 market as investors no longer can claim almost absolute certainty that these bonds will be called on their redemption date. The bond in question’s value fell two percent rapidly following the news, falling to 96.75 cents on the euro.

Moreso, the news sparks fear in some investors that banks are hoarding capital for longer durations due to falling liquidity. In addition, given that the assets and liabilities of investment banks, being so complex and interconnected, are very difficult to value (let alone quickly in a financial crisis), it is very difficult to determine if a bank is solvent in the event of a financial crisis. Given that Santander is such a large and systemically important bank in the financial system, concerns surrounding it inevitably turn to concerns regarding the financial system as a whole. Since the market for complex financial instruments may only have a few financial institutions in it to begin with, many of the assets and liabilities of major banks are interconnected. Hence concerns understandably amplify, explaining the decline in Santander’s share price but also explaining broader investor uncertainty, especially since we are a decade off the financial crisis and a recession is expected in major economies in the next few years, with Italy already having fallen into one [4].

Overall, then, this case represents an example of why always going for the most purely economical option may not always be the best thing to do for a firm. In their actions Santander upset global investors and, significantly, the AT1 bond market, as yields rose on AT1 debt with falling investor confidence in banks’ ability to repay. While the financial system in at least developed countries is in theory much safer (with more stringent capital requirements), the ability of financial institutions to create complex and murky assets knows no bounds. Given this, valuation of these is inevitably going to prove difficult and so caution still needs to be taken with regards to how banks finance themselves. The AT1 debt instruments were a noticeable step forward in handling this but it also goes to show how quickly the market for these sorts of instruments can change, even in seemingly calm conditions.

In future, given that it seems Santander has no actual issue with paying off their debt the impact of this news will be muted. However, whatever reaction there has been will prove an additional disincentive for other banks to undergo similar kinds of action, for fear of not only unsettling their own investor base but also unsettling the market for AT1 (or CoCo) debt instruments. The news enhances Santander’s own reputation for ruthless frugality but they may indeed regret the move in future.

Bibliography

[1] Euromoney. (2018). AT1 capital/CoCo bonds: what you should know. [online] Available at: https://www.euromoney.com/article/b12kqjlwvsz26k/at1-capitalcoco-bonds-what-you-should-know [Accessed 15 Feb. 2019].

[2] Ft.com. (2019). Santander shocks market with bond decision | Financial Times. [online] Available at: https://www.ft.com/content/8539f7b4-2ad9-11e9-a5ab-ff8ef2b976c7 [Accessed 15 Feb. 2019].

[3] Bloomberg.com. (2019). Santander’s CoCo Bond Creates All Kinds of Trouble. [online] Available at: https://www.bloomberg.com/opinion/articles/2019-02-13/santander-s-coco-creates-all-kinds-of-trouble [Accessed 15 Feb. 2019].

[4] BBC News. (2019). Italy in recession amid sluggish eurozone. [online] Available at: https://www.bbc.co.uk/news/business-47068401 [Accessed 15 Feb. 2019].

This article, along with others from my peers, is on the LSE Business and Finance Guild website.

Is Donald Trump right in his assessment of Jerome Powell?

Featured image is in the public domain. Author: Federalreserve

As with so many of these “is Donald Trump right” type questions, you probably already know my answer! However, there is a great deal of nuance to the question at hand that concerns the impact of Jerome Powell’s projected 3 interest rate rises next year. Already in 2018 the Federal Reserve has raised the federal funds rate three times, and the financial markets expect another hike in December, making it a grand total of 7 rate rises in 2018-2019. Donald Trump has gone on record saying that he was “not even a little bit happy” with the selection of Powell as the Chairman of the Fed, primarily due to the number and pace of interest rate rises that are projected to occur under his watch. However, with interest rates still very low (the federal funds rate sits currently at 2.25%) relative to their post-financial crisis levels, one question remains: Is Donald Trump’s annoyance simply due to his spending-driven boom being stymied by Powell?

Looking at the argument from Trump’s perspective, you could make the argument that such quick rate rises are highly risky. This is due to the formation of asset price bubbles that have grown in size ever since the dramatic cuts in interest rates that happened during the financial crisis. Reportedly the US stock market is the most overvalued on record – more so than in 1929, 2000 or 2007. The metrics used for this are indicators such as price to earnings ratios, which are almost at the highest levels seen since 1870. Moreso, the “Buffett indicator”, or the total market capitalisation of the US stock market divided by US GDP, lies at 138%. This compares to a peak of 105.2% during the financial crisis and 136.9% during the dotcom bubble.

Low interest rates boost prices of asset such as stocks because they decrease the risk-free rate of return, leading to a greater incentive to invest in these riskier assets. Hence the prices of these assets (at least in theory) should rise in response to falling interest rates. The issue comes when rates rise again. If Powell is too quick in his rate rises the risk-free rate of return rises too quickly which potentially siphons funds away from stocks. Now, if stock prices drop too quickly then we see a rapid decline in the wealth of millions of Americans holding their funds, in some way or the other, in the stock market. As theory and practice have shown the likely outcome of this is then a rapid decrease in consumer spending, which leads to a decrease in business investment (through a decrease in retained earnings) and eventual recession. If this is what Trump is getting at, though, the question remains: how quick is too quick for Powell?

Taking a directly contrasting perspective, Powell also has a strong case for raising interest rates. Logically, the longer the period of time for which the risk-free rate of return is so low, the greater the asset price bubbles become in size. This indicates rapidly rising property and stock prices and thus high levels of inflation. With interest rates being one of the main tools the Federal Reserve has at its disposal to combat inflation, the most rational choice seems to be to stem the asset price bubbles before they get any bigger. If the bubbles pop, so be it: the alternative is to push the popping of these bubbles further down the line and eventually increase the severity of a recession. As mentioned before, given that we are already so far down the cycle, it makes sense economically to raise interest rates and cut the damage from a recession that may already be in the pipeline.

To summarise both arguments, the truth is that no one knows precisely how quick the Fed can raise rates before triggering a recession. However the heart of the matter lies in the rift between raising interest rates now or raising interest rates later. While true that raising rates now makes it far likelier for another recession to occur in the near term, the asset price bubbles that have built up across the US economy in asset classes such as stocks and property near guarantee another recession sooner or later. Trump’s dispute (in my opinion) exists because of his political self-interest; of course raising rates while he is in power dampens any economic boom currently existing, and thus his popularity. Economically, however, it remains the case that for me Powell is justified both in the existing rate rises he has carried out and also his forward guidance for the future. The decisions show prudence and responsibility, and whatever Mr Trump may think, I feel that this is what is best for the USA at this time.

On Tesla and the efficient market hypothesis

Featured image is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic license. Author: einstraus

Recently, one of the big stories in the world of finance has been Elon Musk and Tesla. Following a declaration from the Tesla CEO that he was willing to take Tesla private at $420 a share, Tesla’s share price soared and then fell almost as quickly following a lack of substantial evidence that he could, indeed, secure the funding to actually put this plan into action. However, this is not the main focus of the article; my main focus is instead the market reaction to Elon Musk appearing to smoke marijuana during a discussion with popular podcast host Joe Rogan on The Joe Rogan Experience. My argument, in a nutshell, is that such reaction to Musk’s activities in itself disproves the efficient market hypothesis, and moreover that other readily obtainable evidence cements this point of view as correct. Before I start, I’ll explain the efficient market hypothesis as an idea that states market prices readily reflect any publicly available information in the market, so any movement in the price of a security is the result of changing market information regarding a particular security, or securities.

According to this model of market behaviour, when Musk smoked marijuana there should have theoretically been no effect on Tesla’s share price, given that marijuana has been proven to actually be less harmful to the body than alcohol. This is because you would expect less of a negative movement in Tesla’s stock price due to Musk doing this than if he drank alcohol, which he has admitted to doing in the past with no noticeable impact on Tesla’s share price. However, on the day that Musk admitted smoking marijuana Tesla shares fell by as much as 9 percent, with the only other notable news on the day being the resignation of two C-level executives in the company. This very event shows that the effect of investor psychology (i.e. animal spirits) on security prices can indeed be substantial, and a company’s share price is not always solely a reflection of all available information about it. In addition to this, if the efficient markets hypothesis is so correct, how have numerous investors consistently made significant profits by “beating the market”?

For example, the well-known investor Warren Buffett has amassed a fortune of almost $90 billion dollars value investing (essentially believing that in the short term the market underprices certain stocks relative to their fair value, and that substantial profits can be realised by investing in these stocks and waiting for them to return to their fair value in the long run). Over a career spanning over half a century, the probability that all Buffett’s amassed fortune is down to luck or chance is infinitesimally small, meaning that even Warren Buffett’s huge wealth is a strong counterargument to the efficient markets hypothesis. Expounding on this further, according to the efficient markets hypothesis it is impossible for any investor to generate alpha (or market-beating returns) in the long run due to stocks never being underpriced relative to fair value. This is in direct contradiction to the reality of the fund management industry, where many fund managers (such as Kenneth Griffin) can generate consistent alpha through, for example, extensive prior due diligence or another type of edge. If securities were indeed priced so efficiently, the opportunity for these investors to make their millions and billions would not arise in the first place.

Moreso, there are more examples than just Tesla of how security prices rising or falling can be more a result of fear and greed than any sort of fundamental shift. The dotcom bubble is another example of how businesses like Pets.com had their market capitalisations rise (and then fall even quicker) despite any significant change in their balance sheet, suggesting the initial rise was due to irrational exuberance. Again, with efficient markets these same sorts of market bubbles would not exist and the only time stock prices would rise and fall with such ferocity is if something about a company actually changed that quickly (for example if their CEO or CFO left). To conclude then, over the course of this article we’ve taken a look at why, to me, the efficient market hypothesis is flawed using three key examples. The first is recent, explaining that under the efficient market hypothesis the response to the Tesla CEO smoking marijuana in their share price would not be so severe. The second explores the idea that with efficient markets investors such as the famous Buffett would not have been able to amass such large fortunes at all, and the third explains that financial market bubbles as we know them today would not exist in a world of efficient markets. These proofs by contradiction illustrate why, for me, why the efficient market hypothesis is heavily flawed and does not provide an accurate indicator of financial market behaviour.

The merits and drawbacks of a potential “Amazon tax”

Featured photo licensed under the Creative Commons Attribution-Share Alike 4.0 International license. Photo author: Txllxt TxllxT

In response to the struggles of the department store group House of Fraser (that culminated in a successful bid for the firm by Sports Direct billionaire Mike Ashley), the Chancellor of the Exchequer Phillip Hammond reported that he was considering a new set of taxes to tackle online businesses. Commonly referred to collectively as an “Amazon tax”, these taxes can be understood to be online sales taxes which would have the effect of reducing the after-tax revenue of e-commerce retailers such as Amazon, which typically enjoy relatively high per unit net margins compared to their high street counterparts. The idea of this system of taxation is to, in the Chancellor’s words, “support the high street” through the process of change characterised by a change in British consumer preferences from the high street to online shopping. This can be taken to mean slowing the pace of transition from high street firms to online retailers in the retail marketplace and thus cutting job losses due to high street bankruptcies. In principle the idea reduces the profitability of these online retailers through causing a reduction in demand for their products as consumers switch back to high street shopping. In turn, this raises the profitability of high street retailers and reduces the risk of redundancies. Not such a bad idea on the face of it!

However, there are a few qualms I have with this proposal. The first of these is that such an idea ignores the fact that this will result in increased prices for the consumer. Essentially, one of the reasons why online retailers prosper is because they have a lower average cost per product sold, thus enabling them to charge lower prices than high street firms in order to achieve the same profit per unit. Already, this gives an advantage to the online retailer in the form of lower prices, which in theory the sales tax should be able to solve. However, what about on the demand-side? UK real wages have remained almost stagnant and actually have fallen in some time periods, and policies which increase the cost of everyday shopping squeeze the consumer further. In an economy characterised by falling living standards, is a further reduction in the purchasing power of income really worth delaying some redundancies till later? This brings me on to my next point – is interfering with the free market a sensible decision in this case?

My answer would be no. The reason for this is that while implementing re-skilling programs and helping those made redundant to find alternative employment would indeed cost a great deal of money to the government, the high street (in my opinion) doesn’t exactly have a bright future either way. The convenience of shopping online as opposed to making a trip out represents another major plus that no system of taxation can take away from online retailers. This advantage, coupled with the fact that online retailers have almost no cost of selling more products (apart from actually storing these products), makes it relatively likely that either way the high street will see a significant reduction in its size. This presents us with a choice: redundancies now or redundancies later? The idea of the collapse of the high street being inevitable allows us to make a more rational decision, which is to not employ such a tax. Instead, the additional time can be used to employ workers with new, more relevant skills and/or help them find alternative labour – both strategies that serve to improve the future standard of living of British citizens. As opposed to delaying the inevitable, this seems like a far better option.

To conclude, analysing the merits and drawbacks of a proposed “Amazon tax” indicates that, in this case at least, interfering with the free market and delaying redundancies that are likely to anyways happen is not the best possible option. While it is true that the profitability of high street firms may rise in the short run due to such action, online retailers have numerous advantages (as listed above) over their high street competitors which enables them to sustain a competitive advantage in the industry. Hammond’s plan, while noble in principle, actually works against the utilitarian idea of raising living standards for the greatest number of people through raising prices for consumers already squeezed financially. For this reason, the proposed “Amazon tax” to me should not go ahead under any circumstances – the average Brit seems to have already had enough.

Does technical analysis actually work?

Photo Attribution-ShareAlike 4.0 International(CC BY-SA 4.0)

Many traders have claimed to use technical analysis to guide their forecasts and hence make money on the financial markets using this method of analysis, however in this article I will actually argue my case against it. But firstly, what does it actually mean?

Technical analysis essentially entails the use of past price information to predict future price movements. For example, a basic (albeit crude) way to use technical analysis would be to say that if Stock A has currently established a support level of $25 a share over a period of, say, a few months, and today it reaches that level again, but breaks it, dropping to $24.50 a share, then that is a bearish signal on Stock A in the near term future. To me, the first problem with this is that you ONLY use price to inform your trading decisions.

The theory of value investing can give us a valuable lesson to relate to this point – human beings are irrational and hence the market does not always accurately value different companies. For example, during the euphoria associated with the early stages of the dot-com bubble Pets.com shares rose to a high of $14, with the company becoming defunct not even one year later. Such behaviour is indicative of the fact that share price does not always tell the full story of a company’s basic fundamentals, and simply trading on technical indicators is to rely on human emotion rather than solid fundamentals, which is a recipe for potential losses. This illustrates the first deficiency of technical analysis: the fact that the share price of a company is not the sole indicator of its business fundamentals.

However, a counterargument to this point would be that it is indeed possible to use technical and fundamental analysis in tandem to achieve profitable results. While this may be true, it’s interesting to question how much of this profitability is down to the technical analysis itself, and how much is down to just luck. Technical analysis is fraught with ambiguity; different methods of technical analysis have been seen to be contradictory to each other and, moreso, applying different methods of analysis to different financial instruments can possibly yield the same result. There is little room for nuance or financial instrument-specific related analysis actually related to the company or currency pair (for example) itself. This is surmised well in a quote from Warren Buffett, where he says “I realised technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” Much of technical analysis is also based on human psychology, which renders it increasingly invalid given the increasing prevalence of algorithm-based trading strategies in the financial markets.

Moreso, arguably for technical analysis to work in analysing different financial instruments an implicit assumption is that traders and investors have perfect information about the underlying instrument being traded. To falsify this, let’s use a case study:

Volkswagen AW

On the 21st of September, 2015, the first trading day after which the Environmental Protection Agency (EPA)’s Notice of Violation to Volkswagen (VW) was made public, the share price of Volkswagen AG fell by 20% on the Frankfurt Stock Exchange. Hence, all forecasts of this share price before the EPA’s announcement based on technical analysis were either completely wrong, or simply correct due to pure chance. While, indeed, fundamental analysis would have also been unable to predict this happening, the 24.7% decline in sales of Volkswagen vehicles in the US in November 2015 from November 2014 at least provides a fundamental indicator of a potential impact on VW’s bottom line, which share price (although it may have done in this case) is not at all guaranteed to do, as there may be other, external influences on the share price that cloud the impact of this scandal.

To conclude, in my opinion technical analysis is a flawed method of analysis of financial market instruments for three main reasons, the first of which is that price does not always reflect all information freely available. In addition to this, the fact that the analysis leaves little room for financial instrument-specific related nuance and also that there may be other information which is not freely available and thus not reflected in, for example, share prices, discredits the notion of technical analysis as a feasible method of analysing the financial markets. Although many traders claim to have successfully traded the financial markets using technical analysis, for the reasons mentioned above I personally do not find technical indicators worth the time compared to fundamental indicators.

Sorry for not writing for so long – public exams really took my time away!

Why the Dow’s rise isn’t a sign of President Trump’s great policy for me

The featured photo is licensed under the Creative Commons Attribution-Share Alike 2.0 International license, and was taken by Gage Skidmore.

Characteristically, President Trump has recently been all about showing off how well he’s performed in his first year as one of the most powerful people on Earth. While for myself and some others his first year has been unsuccessful (to put it mildly), Trump is dead set on proving us naysayers wrong largely by using the sustained rise in the Dow Jones Industrial Average (an index showing how shares in 30 of the US’ largest companies have traded over periods of time) during his presidency. While at first glance well-performing large companies may seem to indicate that the economy as a whole is performing well (which it is currently), in this article I will make and support two propositions: firstly that the current US economic boom is unsustainable (assuming the Dow is a good measure of current economic performance), and secondly that the Dow, either way, isn’t a very good reflection of how the economy is doing.

Looking more in depth at our first strand of argument, while business spending increases have allowed the US economy greater than 3% economic growth over the past two quarters, the Trumpian tax cuts for corporations and the wealthy run the risk of actually increasing the American budget deficit (exactly the opposite of what many Republican deficit hawks campaigned for). Politically, this becomes very difficult for the Republicans to justify, but more than that, the fact that that according to the Tax Policy Centre Trump’s plan actually would hurt the lower 50% of income earners represents a decrease in future consumption and thus a decrease in US short run (and long run if firms then stop investing) economic growth arising from this set of policies. Essentially, then, the point I’m trying to make here is that hurting the little guy may boost growth in the short term, but in the long term when real after-tax incomes and consumption fall, the economy might not be doing so great. This is because the rich consume less than the poor for an equal addition to income, so even though the rich get richer, it might not actually boost consumption and growth all that much. So Trump can be happy with the buoyant Dow and economy for now, but he should know it may not last long.

Taking the issue from another perspective weakens Trump’s Dow-focused point further. If we look at who the Dow Jones’ rise actually helps, we see that it serves to increase income inequality further. A NYU report in 2013 showed that the richest 20% of Americans owned 92% of stocks, indicating that the benefits from the Dow’s rise are not equally distributed. Even if we look at the Dow’s rise in isolation as a sign that the economy is doing well, we still see numerous faults with the theory. By seeing what the Dow actually is, and how it may have been affected by recent news, we can see that it may have been buoyed by Trump’s plans to cut business taxes and not actually an improving economy. Within this plan, Trump has also presented changes to the individual tax code that disproportionately benefit the wealthy, but although the American middle and lower economic classes may not actually benefit from his plans, the Dow is rising. This one example shows the divorce that may exist between the performance of large companies and the economy in general; income inequality worsens the economy through decreasing growth, but tax cuts boost large corporations’ after-tax profits. Hence, through this example we can see that the Dow Jones may not be able to accurately gauge US economic performance, putting another dent in the logic behind some of Trump’s recent tweets.

To summarise and conclude, I have established in this piece why I think that President Trump using the Dow Jones Industrial Average to cement his claim to doing well in his new job is flawed. This is both for reasons relating to economic unsustainability, and also because the Dow doesn’t actually tell us how the economy performs all that well. On another, slightly related note, this sort of issue is why I think that the backlash against experts these days is so unhelpful. The things I’m saying here would be much more credible if an actual expert was saying it, but without experts there are no credible voices to inform people that their President may not actually be doing the wonders for the economy that they think he is. I sincerely hope that in the future we can arrive in a world where experts are given the respect they deserve, and are able to call out any figure for saying something potentially wrong without being disregarded because they can’t predict a world that is fundamentally unpredictable. Without it, well, we’ll have lost one crucial, perhaps vital, check on people in positions of great power.

On Bitcoin as a global currency

The featured photo is licensed under the Creative Commons Attribution-Share Alike 4.0 International license.

The recent bullish trend in the market for Bitcoin has seen the fledgling currency really capture the eyes of the general public. In many ways, the cryptocurrency can be seen as technology’s answer to today’s fiat money, and in the same vein it has been suggested that it could grow into a new global currency, coming into greater worldwide use for transactions. Fascinating though the prospect may be, for me there are several reasons why I doubt this could happen, which relate both to how a global shift to Bitcoin could be implemented and also to how this new economic paradigm could actually work once implemented. The first of these reasons is its volatility, and with that, I’ll begin.

Reasons why to me it is unlikely Bitcoin can become a new global currency

  1. Its volatility. It is likely that over the past few months bullish speculators on Bitcoin have made substantial profits, and if the price signal of the free market is anything to go by, the upward trend in Bitcoin price shows more people are accepting its viability as a currency. However, it is this very appreciation of the currency that is a great example of the point I am trying to make: at the current moment, Bitcoin is far too volatile to be held confidently by consumers. Take the example of the pound sterling. In the immediate aftermath of the Brexit referendum, the movements of the pound were taken as an unusual sign of volatility, perhaps signalling uncertainty regarding the future trajectory of sterling exchange rates. When we compare this with Bitcoin, which has previously risen against the dollar by 50%, 33%, and 20% in 23, 60 and 63 days respectively, we can see just how unusual Bitcoin’s price movements are compared to a widely-used currency. In a potential transition period whereby Bitcoin begins to come into common use, it may be economically rational for consumers to choose not to hold Bitcoins and instead to hold currencies that are far less volatile against others. This is because sharp rises and falls in the value of the currency can significantly reduce or increase purchasing power (in countries where Bitcoin has not become as mainstream) from one day to the next. In turn, this can create uncertainty regarding future spending and hence a reluctance to hold Bitcoins as a reserve currency due to this uncertainty, limiting its potential to be a truly global currency.
  2. Limitations of monetary policy. A potential counterargument to the point raised above is that Bitcoins will stop being produced when the supply of them hits 21 million. This actually promotes price stability, and means that in the long term, the point above is moot. Fair enough. What I would say to that is it then becomes very difficult for central bankers to use monetary policy tools (such as lowering the interest rate) to stimulate aggregate demand, in, for example, the aftermath of a recession. A big point often raised about Bitcoin is that it does not lie under the jurisdiction of any government or central bank, so therefore they cannot influence the money supply and hence it would be hard for political consensus to be reached on the adoption of Bitcoin as a national currency. For the sake of the all-important flexibility of monetary policy, then, I would argue that it is not only unlikely that bitcoin will become any country’s national currency, but it is also essential that it does not. However, it is true that Bitcoin can be widely accepted for transactions without becoming a national currency – but the point below indicates to me that this is unlikely to happen.
  3. Trust. In my previous article, I talked about how paper money nowadays was backed by the trust of its users. On the surface, bitcoin can seem somewhat familiar to the fiat money I mentioned: it is not backed by any tangible commodity and hence only relies the trust of societies that use it to function as a store of value, a unit of account and a medium of exchange. However, recent happenings make this trust somewhat hard to attain for bitcoin. Firstly, the volatility which I mentioned above can create uncertainty over the future prices of bitcoin in terms of other major currencies, potentially scuppering its use. Secondly, with figures such as Jamie Dimon, the CEO of JPMorgan Chase, claiming that bitcoin is “only fit for use by drug dealers, murderers and people living in places such as North Korea.”, public perception of the currency as a means to enable criminal activity may limit its general use. Factors such as these contribute to a general lack of acceptability in transactions, which severely limit bitcoin’s potential as a worldwide currency. Similarly, the failing of Bitcoin exchanges like Mt Gox also can contribute to this lack of trust and acceptability.

To summarise, Bitcoin is indeed a hugely interesting, and potentially revolutionary, new currency. However, I hope I’ve done a good job of illustrating why I think it is unlikely to be a new global currency. Regardless, I think it’s really important to keep a huge eye out for it; to me one of the most interesting developments in the global economy is how the fledgling currency does. Let’s just wait and see.

On money and its value

Money (a good that acts as a medium of exchange in transactions, among other things) is the blood that flows through the veins of any capitalist economy. As Lord King proclaims in his book The End of Alchemy, money helps us to cope with an unknowable future by enabling us to hold a store of generalised purchasing power with which to buy goods and services that might not yet exist. A capitalist economy is inherently dynamic; after all, the innovation of economic agents is what drives its existence. Generally, the free market mechanism (using money) works to maximise sales of the goods that we feel maximise our utility, or satisfaction, with relation to their cost. Returning to King’s book, however (after reading it last year), I was struck by some of the examples the ex-Bank of England chief used to illustrate some key points about what gives money its value. Most notably, the example of the different Iraqi dinars used in two parts of Iraq before Saddam Hussein was deposed piqued my interest. Rather than trying to explain it better than Lord King did, I implore all the readers of this article to read about it in The End of Alchemy. The example, though, got me thinking – what backs the paper money of today, giving it value?

The easiest way for me to think about this was to ponder what has historically given money its value, and draw parallels with today. In the past, the widely-used gold standard meant that you could exchange your paper currency for a specific quantity of gold, essentially meaning the paper money was backed by the relevant authority’s gold reserves. Such a system was commonplace, used in both the UK and the USA. The last time we saw the pound or dollar being convertible on demand to gold (either directly or indirectly) was in the Bretton Woods system of the late 20th century, which collapsed in 1971, and it’s a relatively safe bet to say that we won’t see another gold standard anytime soon. We can see how gold is valuable, though; it can be used for a variety of things, from piping to jewellery. So, holding a quantity of gold means that we hold something of value, and exchanging a claim on this value for goods and services gives someone else a claim to that value. Perhaps, then, money must be backed with something valuable to the real economy.

What, of value, backs the paper money we use today? For one, an independent central bank (or an equivalent branch of government), present in much of the developed world today. History has shown us that central banks can, and have recently been successful in taming inflation (see below). This alleviates the probable fear that holding fiat money means rapidly decreasing purchasing power from one year to the next. Good governance, then, may give money its value. That may perhaps be why we are so quick to accept that what a central bank says is £5 is actually £5; we have confidence in the entity issuing the notes and can trust that it will continue to be worth roughly £5. This also explains why countries with questionable governance, such as Venezuela, are suffering such extreme bouts of hyperinflation (although it’s not the whole story). But is the backing of dependable monetary governance really “value”? We can’t build pipes or make jewellery with it. What we can do, however, is convince others to buy our goods and services with paper money, assuring them with reasonable certainty that the value of the money will not suddenly appreciate through a sharp bout of deflation. We trust our notes and coins to not rapidly appreciate or depreciate in value, and that’s why we make and receive payments when we do.

If trust is present, then, do we need a central bank or government to “back” the currency? History says no. Take a look back at the example above – in one part of Iraq whose currency was the so called “Swiss dinar”, there was no credible system of government or central bank, however the Swiss dinar broadly retained its value.  This proves by contradiction that we do not actually need any sort of centralised authority to give our fiat money its value. We can see, though, that we still need the trust that a centralised authority can instil.

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Source: Reproduced by moneyandbanking.com from Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking, May 1993.

Concluding, then, it’s clear that our paper money isn’t backed by something as physically valuable as gold, and for the flexibility of our monetary policy’s sake, that’s probably a good thing in my opinion. What I would say here is that our fiat money, today, is backed by trust, namely trust that our money will broadly retain its value from one day to the next, and continue to be widely used in transactions. Can this be instilled by centralised government or a central bank? Definitely; we’ve seen that in the UK and the USA. Does it have to be? Iraq tells us no. Social cohesion and/or a record of money previously maintaining its value, among other things, could deliver the trust that is essential to preserve money as the lifeblood of a thriving capitalist economy. Such an arrangement connecting money and trust is fragile, yes, and it is scary to think of the impact on our economy should we lose our trust in money’s ability to retain its value. It is for this very reason that I believe that sound social institutions and governance are some of the most important prerequisites for a successful capitalist economy to form. Without them, people lose trust in money, and without money as we know it, we see the end of our brand of capitalism.

 

 

Why, for me, the long-run impact of automation on unemployment has been recently overstated

Really sorry not to have written for so long – exams and general schoolwork really got in my way. For the summer, though, I think I’ll be back to regular writing! 🙂

We’ve seen in recent years a sharp rise in attention to the potential automation of a wide array of different jobs and its long-term effects on the global economy. Such concern has in part led to the touting of different hypothetical policies that could help assuage the problem, such as the famed Universal Basic Income (UBI).  Some have welcomed the idea – after all, you can see how not having to do any work may seem attractive. Others despair, fearing of widespread unemployment and subsequent social unrest compounded by economic uncertainty. However, for me, whether you’re concerned or jubilant at the idea (or somewhere in the middle), there may be reason yet to tone down your forecasts of a robot-led revolution of the labour market. This is for two principal reasons:

  1. We must never underestimate the capacity of humankind to continue innovating, while respecting the notion of Knightian uncertainty. It’s important to note that machines have been slowly gaining the ability to do more and more of the jobs we currently do since the first Industrial revolution in Britain, in the late 18th century. Even then, less than 1 in 20 of the UK’s labour force is unemployed as of May 2017. That’s why, here, I’m making a distinction: it is very possible that robots may take many of the current jobs we do, but I definitely don’t think it’s as possible that robots may take as many of the jobs we will do in the future. We can see from technology’s current progress that it may not be so long before the 9-5 office jobs of our time begin to stop becoming available to humans, however we will never be able to see exactly how many and which jobs may be created in future. We live in a world dominated by Knightian uncertainty, essentially the idea that there are infinitely many outcomes that can arise from any given situation, all of which we cannot predict. Furthermore, so many new jobs have come into existence in the last 10 years that people are making top 10’s of them. Taking the uncertain future and the unpredictable past hand-in-hand, we can see that the possibility of human ingenuity aided by automation driving job creation is a very real one, and this does provide some room for optimism. Machines such as the smartphone have driven the growth of companies like Facebook and Uber, so who’s to say we won’t see another groundbreaking development that could create scores of jobs across the globe? Of course, basing a prediction off the past can go catastrophically due to the very uncertainty outlined above. However, I can say with a reasonable degree of confidence that with the innovation seen even today, it would be unlikely that automation would take jobs from us without giving at least some of them back.
  2. Polanyi’s Paradox. This essentially means that “we know more than we can tell.” Some things we do, like writing a poem, we can understand but not explain to others the intricacies of how we actually do it. Many products intuitively require a degree of creativity to be produced, something which to this day computers or robots have not been able to fully replicate. Take the iPhone – a combination of machines could very well be programmed to assemble the iPhone from its constituent parts, but it’d be a big stretch to suggest that Steve Jobs’ initial vision of a multi-purpose device operated by touch could have come even close to being replicated by the robots of today. So while the more manual parts of production may continue to be automated, companies operating in sectors that rely on creative spark and vision would still need to employ creative thinkers, those with ideas out of the box that can revolutionise and mold entire industries. More formally, of course, what I’m talking about is known as research and design (R&D for short). As companies see a cut in costs of production arising from robots automating manual production processes, it’s indeed a possibility that they may invest more into R&D, generating significant employment. Of course, some corporations operating in monopolistic or oligopolistic markets may not, in fact do this. It’s also clear that in the short term there may be significant unemployment as people become educated and re-educated in areas where they have a realistic chance of employment. The threat of machine learning also calls this argument into question, however despite the evidence of self-driving cars, we haven’t seen much in the way of evidence suggesting robots could, in fact, disprove Polanyi’s paradox, and so for now, it’s fair to say that the Polanyi’s paradox argument does hold some weight.

The arguments now set out point to a dramatic shift in composition of the labour market, but not to a dramatic shift in unemployment numbers themselves. From history, we’ve seen that in the long-run, automation actually generates more jobs than it displaces, but in my opinion, the major concern for both developed and developing nations should be how to highly educate vast numbers of people in line with the needs of a dynamic labour market. It’s easy to see people needing to be more educated to be able to carry out jobs that machines cannot yet do, and requiring different skillsets to what the labour market generally requires now.

For this reason, it’s so, so important that more people are encouraged to seek the high-skilled professions that many feel are still only for the elite. To me, it’s not a stretch to say that the future of the global economy depends on it.

Shrey