Rufus Round - 1st October 2022
The last two weeks have seen decisions made by both the UK government and the Bank of England that have created turmoil in traditional finance. The Bank of England, alongside most western economies, is tightening monetary policy by raising interest rates to combat inflation. The new UK government then recently introduced easier fiscal policy with tax cuts in order to encourage spending and investment. The Bank is reducing the cash you have available to spend, and the government is trying to increase it. Confusing? Financial markets judged the incoherence accordingly, selling sterling and gilts aggressively. This sparked fears of contagion, prompting the Bank of England to support the gilt market with a move that echoes the quantitative easing spawned by the last financial crisis.
Nevertheless, every single policy maker in the world is faced with the conundrum of how to stimulate growth in an environment where both costs and interest rates are rising against a backdrop of all-time-high global debt levels. Without growth, debt cannot be serviced. Debt defaults trigger bankruptcies. Bankruptcies trigger job losses. Job losses trigger interventions from both politicians and central bankers, motivated to intervene by influential media with a grip on the electorate. The politicians never last long enough to deliver on their promises and central bankers have only one tool for any crisis – easing monetary policy. Still, an extra pound in your pocket makes you feel better, which means you become less interested in changing the status quo.
Another certainty, is that at some point the rest of the world will have to start easing policy. Theoretically, the first mover gets the advantage via a currency devaluation. The UK now has a ‘For Sale’ writ large as sterling priced assets are now cheaper than they ever have been. Promoting a fiscal policy aimed at luring the wealthy, the UK economy with its concentration of finance and legal expertise refined over 900 years of history has opened its doors to the moneyed more widely than ever. Property values in sterling will stabilise thanks to foreign buyers, further capital inflows will follow, banks balance sheets will be supported, life will go on - albeit with a wider wealth disparity than ever before.
The calculation here is that the rest of the world cannot continue to tighten policy for very much longer. By having the first mover advantage, once other economies decide to ease financial conditions, sterling will appreciate against other global currencies. If all this sounds familiar, that’s because that has generally been the cycle for decades – especially as the global economy has become more interconnected with capital free to move wherever it gets treated most favourably.
What could change or threaten this? First, the timing could be disastrously wrong. If these two polar opposite trajectories continue for too much longer, sterling will free-fall and the UK becomes insolvent due to the unaffordability of imports and confidence is completely lost. There are strong arguments that the Federal Reserve has already gone too far (central bankers usually do), strong arguments for pausing and indeed continuing.
Second, capital controls could impede this adjustment mechanism. If foreign institutions were to prohibit the exchange of currency into sterling, the game is up. Unlikely? Probably. Yet recent events have set a precedence. The pandemic created movement controls. The Ukraine war created capital controls. Both of these events have highlighted the fragile nature of not only global supply chains, but also the human psyche. The only thing that spread more quickly than covid, was the fear of covid. Rightly or wrongly – the media scared the world’s population, aided and abetted by the self-reinforcing echo-chamber of social media. This undoubtedly accelerated technology adoption with the rise of Zoom video meetings and the use of digital payments. The ever-connected information highway means the world is so awash with information only a phone tap away, we as humans don’t yet know how to process it all. Thousands of years of human evolution did not prepare us for the tidal wave of (mis)information thrown at us all day long. Is it any wonder people want to be told what to believe? Top of the current fear list is (nuclear) war and inflation – specifically energy prices and mortgage rates.
Such notions of authoritarian control were unthinkable only a couple of years ago. Whilst capital controls specific to Russia’s invasion of Ukraine are hopefully a one-off, what would it take to make this draconian tool more widespread? How about a low taxation, lightly regulated, capital-welcoming economy located right on the doorstep of a large, cumbersome, low-growth bureaucratic behemoth, grappling with huge internal distortions, already existentially threatened by its dependence on foreign energy supplies and conceptually offended by Brexit? The pandemic accelerated the use of digital cash and central bank digital currencies are coming (see view here on how that can look). Unlikely as such capital controls are, they are more conceivable now than at any time since the 1970s.
So the UK appears to be world’s economic clown, could have timed its policy decision badly, capital controls are plausible, if unlikely, and it’s a global race to devalue currency against the dollar. We’ve seen this all before. Except we’ve never gone from zero interest rates to where we are now, having so much debt, so quickly. The dollar has not been this strong against most global currencies for well over twenty year, and never has it been so with so much owing. The debt could be solved over time with financial repression - where real interest rates (the interest rate minus inflation) are negative. This serves to erode the real value of debt. In effect it means your hard earned currency has dwindling buying power over time and why the buying power of $100 in 1913 (when the Fed was created) goes as far as $3.87 today. Such policies helped to reduce the post-World War II debt hangover and is perhaps the only politically acceptable route to whatever ‘normality’ is. Inflation is sold to us as a phenomenon beyond political accountability. The debt gets inflated away. But so much debt with so much disparity and so little growth will take longer to solve in this way than the time that any political system has to endure it. How long till the world gets tired of dollar hegemony, with essential commodities priced in a currency whose dominance is a function of events beyond the control of most?
These failings are a result of a structural deficit in the accountability and transparency of money and political systems that filters down from the top and whose consequences permeate every section of society. Financial repression is not an overtly stated policy by any central banks or political party – the time it takes to be effective is generally far longer than any single electoral term and is therefore also off the radar of most politicians, yet it is function of blurred transparency. The inability of politicians to make tough decisions and deliver on promises is both structural and human. Structural because a four year political term is not really enough to see real change through. Human because no one wants to lose their job, especially when it confers power. Promises by politicians often result in policies whose long-term consequences and costs are rarely seen through and certainly never borne by those who make them. Accountability and transparency are missing. The result of this is that the short-term fixes are forced upon central bankers to make up for political inertia. The central bankers’ only tool is to manipulate the price of money. Accountability is lost.
Creating a system of financial accountability and transparency can be done with computer code. It is already here thanks to blockchain technology and the incredible rise of crypto currencies. The innovation in the sector is immense and only just in its infancy. Code (smart contracts) can create products based on these assets that include fiat currency crypto equivalents (stablecoins). Such products include insurance contracts that pay out immediately if terms are satisfied, collateralised loans with nigh-on instant approval. The potential is as unlimited as human creativity. Capital controls on a fully decentralised blockchain network can simply not happen. Expanding, contracting or fixing the money supply can be written into the code. Voting and governance protocols can determine changes.
Political systems need to adapt as the technology is coming. The technology protocols that thrive will be the ones that get the most adoption, the rates of which will be driven by us all. Don’t let antiquated systems no longer fit for purpose rob you of your wealth. Avoid the confusion and join the solution. Digital Assets, crypto.