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Perhaps more surprising than the results itself was the market’s reaction to Britain’s exit from the European Union: for such a momentous event, it was very mild, not getting materially out of recent trading ranges, and with the FTSE100 (though a poor proxy for the British economy) back where it was before the vote at the time of writing, with only the rather modest GBP re-rating remaining material.

Portfolios almost unchanged

I couldn’t find any noticeable distressed prices in my watchlist(s) and only sold Panmure Gordon, in the Stamp collection, on the grounds that being a small broker focussed on the London small cap market may not be very promising, as business is delayed or shifts to other places. Companies I hold are are biased towards exporters and  otherwise not UK-centric stocks, which has worked reasonably well despite the London listing bias.

Is the market right?

Is the market dominated by trading noise, or is it successfully predicting that Brexit will have little negative impact? Uncertainty will certainly be there but the outcome is hard to predict. Negative scenarios are all other the press, but one can imagine a few positive ones as well:

  • On consumer confidence, ex-UK consumers will probably ignore it, or plan holidays to the UK. UK consumers might prove stoic, optimists perhaps balancing pessimists. It’s hard to imagine that it wouldn’t at least slow down the housing market (in transaction volumes if perhaps not prices).
  • Business investment should be down, from some plans being frozen or moving elsewhere, though the outlook seemed pretty positive before the vote, down a bit from there may remain positive.
  • Sterling devaluation, if it persists, which is not a given, may help a bit. It could also remain at a sweet spot: big enough to help but small enough not to trigger enough inflation for the Bank of England to have to tighten monetary policy. Indeed, business investment slowing down may be all the tightening that’s needed.
  • Last but not least, there may be positive impact from EU re-focussing (see below).
Doc Marteens with Union Jack toe

Britain kicks arse? (credit: I Ransley via Flickr)

The European Union becomes the Eurozone

A potential positive side-effect of Brexit is that it might help refocus the European Union on improving its institutions, in particular finishing off building the Eurozone.

The United Kingdom was perpetually only half-way in, making the whole system an unwieldy variable geometry construction, both adding complexity and slowing down integration as exceptions piled up, and other member states had a strong incentive to get their own special case deals. When membership was irreversible this made sense, but if it turns out leaving has a precedent, that is not an unmitigated disaster, then there’s a way out. Then, variable geometry need not be inside the EU but between EU membership and the various forms of association around it (e.g. Norway or Switzerland style deals).

This enables the EU to become the Eurozone: the Eastern European states are committed to join; Denmark is de-facto in economically as they operate a fixed exchange rate system with the Euro; Sweden entry seems permanently suspended due to a failed referendum, but then they, or other reluctant members, could choose to either come in or leave and get a UK style deal.

So we have both a simpler and clearer framework institutionally, and an incentive to escape the current deadlock on Eurozone construction, as the choice between further integration or dismantlement becomes clearer and clearer. If this works out, it could be of great benefit to everybody, including the UK, which would be (much) better off with prosperous partners.

As a short term little bonus, if some business, financial or otherwise, moves from London to the continental financial centres, it’s a mini-Keyneysian stimulus programme for the Eurozone, which may help accelerate the recovery process.

Maybe the whole world will in the end need to thank UK voters for their selfless, if unwitting, sacrifice.

The various basic income proposals floating around are often criticized for being unrealistic, and let’s face it, they often are. In a recent column, John Kay is asserting that “either the basic income is impossibly low, or the expenditure on it is impossibly high.”

This includes an implicit dismissal of the Keynesian arguments — that the basic income would create demand that would snowball into economic growth — of some basic income proponents. I happen to agree that this aspect is unlikely to deliver miracles, so let’s assume no such effect here.

Too high

It’s easy to agree that spending half of GDP on basic income would not be acceptable, but it’s also a good problem to have: humans are scarcity animals and do not work well when too far from need, as can be seen in the often sorry state of people benefiting from windfalls (third generation heirs, lottery winners, small “first nations” in rich and guilty countries, etc). Thus a basic income should probably be high enough to remove fear of survival (food and shelter) but not to so high as to remove the need to get out to the world to improve one’s lot.

Impossibly low is desirable…

In Western countries what some would describe as “impossibly low” does provide pretty decent survival standard. The Ikea/Lidl/Primark lifestyle is pretty okay, and way more comfortable than what the richest slice of society could afford a century or two ago. So a basic income in the region of say $500 a month for a tier 1 developed country would probably do the trick (assuming social housing and healthcare are not subsumed into it).

… and possible

Would simple arithmetic work for that? To design a realistic basic income we need some premises:

  • Assume the net expense on welfare remains constant, because it reflects what a society is ready to accept in redistributive pressure. This allows isolating the effect of the basic income as a redistribution technique from other ideas about changing the amount of redistribution (which can be done through any mean).
  • Assume the wealthier members of society (say the top half) do not get richer out of it, that is the (income) tax system is adjusted to increase the tax they pay by the amount of basic income they receive.
  • Some existing welfare mechanisms are abolished (such state unemployment benefits, child benefits) or restricted (e.g. pension age could be pushed forward) as the basic income replaces them.

Then what basic income is possible? It’s simply equal to:

basic income = removed welfare services budget + tax equalisation

Detailed number crunching would be required, but I’d expect it to come to $300-$600 per adult, again for a tier-1 developed country.

The main variable here is what services get replaced (and to what extent) by basic income so it computes at all times.

Radical realism

A realistic scenario is probably better thought with social housing, public education and public healthcare arrangements untouched, but the basic mechanism also applies should someone wish to privatise some or all of these services: then the fewer services are left, the closer you get to a basic income equal to the tax take, though the higher basic income might then buy less, depending on the distributional profile of each service (a most tricky issue on its own).

What are the benefits of a survival income?

A survival basic income wouldn’t abolish poverty, in so far as this is more or less defined as inequality — how much less one has than others, rather than the absolute level of what one has — but still have some interesting properties:

  • Improve the bargaining power of low-paid workers not forced to work for mere survival
  • Remove net tax discontinuities (being a net loser when taking a low paid job)
  • Simplified administration (some)
  • Increased acceptability of redistribution

The welfare illusion

The latter point is perhaps the most neglected while the most powerful point in favour of basic income. It makes no difference in pure economic terms whether the cash flow between the state and the citizen is done through tax or benefit payments, it’s the net that matters.

But, like with the money illusion in the monetary realm, optics matter. This can be observed today in the difference in perception between universal benefits (like child payments and some healthcare in many developed countries) and means tested ones (typically unemployment and safety net income). The former are often popular and well accepted, even by net payers, while the latter are seen as prone to abuse, and divisive. A basic income, even if compensated by tax, would probably quickly become part of the societal furniture.

Even if it was the only benefit, it’s probably worth doing for that alone.

Monetary policy’s impact is made relevant by sticky prices. The stickier nominal salaries and fixed prices for products and services are, the greater the impact of changes in nominal money quantity.

Thing is, prices are getting less and less sticky.

Long gone is the time where the price of flights was printed in a paper catalogue updated once a year. Dynamically priced flight can include changes in fuel cost, or demand and supply pressures, every few minutes, and people got used to it. You have a ballpark idea of what a flight cost, but known that the exact price will only be known at the time of booking.

Anyone who buys tech gadgets and shops around using internet comparison engines will end up paying the producer country price, as lean distributors with little stock and tight margins pass through currency impact, and this model dominates — sticky price competitors are structurally more expensive because they need  to add a buffer to both hedge currency risk, and to prevent adverse selection (people buying from them only when the exchange rate has moved favourably since the last sticky price was set). Even supermarkets now have dynamic price labels that can be updated in seconds.

What’s left of sticky prices? Wages and property are perhaps the main markets where stickiness still applies, though this too is challenged by short term rental contracts and short term employment (be it old school or gig-economy style), or variable compensation (bonus or commission based long term employment) where the net wage becomes decoupled from the notional sticky base salary. This is still a strong force, but for how long? I suspect the writing is on the wall: prices will get less and less sticky.

A possible danger for monetary policy is that backward-looking simulations use datasets from olden times, when prices were stickier than they are today, and thus unless a gradual decrease of stickiness is embedded in the model, will make increasing false predictions. More generally, monetary policy may become less and less important as nominal effects reduce, as changes to nominal quantities get absorbed by reality faster. Another reason to give fiscal policy a greater role in macro-economic management.

I used to think, like most value and fundamental investors, that market timing is difficult or impossible. I’m starting to come back on this and considering having a market timing component to my portfolio. It’s too risky to do on the market as a whole — moving one’s entire portfolio between stocks and cash or bonds — because this is undiversifiable (a portfolio dominated by whole-market timing has effectively 1 holding), but there may be opportunities for risk controlled allocations to sector or company specific cycles.

As a starting point I’m building a check list for spotting sectoral cycles. It’s a work in progress but here it is:

Bubble Bull/bear trap Bottoming
Dominant discourse “Paradigm shift” “This is a bubble!”, “This is the opportunity of a lifetime!” “Nobody ever made money investing in this!”
Volatility/volumes High/mid Mid/high Low
(Social) media interest High High Low
Closed-funds discount Premium Small/no discount Discount
Themed ETFs and retail products Launching Closing down

Why isn’t everybody doing it?

Most of these factors are reasonably easy to spot. But it’s that easy, why isn’t everybody doing it? A couple of possibilities:

  • The idea here is to capture sentiment, so it’s subject to errors if there are fundamental change that can kill an industry or are real paradigm shifts involved.
  • Knowing broadly where you are in the sentiment cycle seems straightforward, though imprecise and unlikely to find exact tops or bottom. Waiting for the cycle to turn may take longer than most investors’ attention span. Capturing a bottom or shorting a top may require more patience than most people have.
  • Intermediaries will have a hard time selling market-timing products as most clients behave like the herd (by definition).

Prospective guesses

Bubble Bull trap Bear trap Bottoming
Biotech, Internet retail, Unicorns Small caps, Equities Oil, Energy Metals mining, Airlines, Tankers/Shipping

Now the question is: is this confirmation bias? The Obliquity Portfolios have grown slight under/overweight in most of these themes — before I quite realised I was trading boom and bust cycles. I’ve also opened a little long tankers option basket a few days ago.

Much has already been said about the Greek “deal”, most of it unsurprisingly negative. No question it’s a sorry deal in many ways, but I’ll skip that today and try to cover some of the positives.

The Eurozone’s future is now on the table

It has been long known that the euro can be seen as two very different projects: one is a building block on the way to some kind of Federal Europe, the other is a purely technical shared currency, which is doomed to be a form of synthetic gold, because the strength of such a currency is the binding factor — otherwise the stronger members will leave.

Deciding where to go has been procrastinated since 1999 and absent any crises looked like it would be forever. But this crisis has put the debate back on the table. It could still simmer for a while, but I think the debate has advanced more in the past few months than in the last decade.

The historical track record of loose currency unions is abysmal, so if federalism doesn’t progress, we’re probably in for an implosion, if possibly a slow one. I would still bet on (some form of) federalism winning the day in due course.

The Greek debt sustainability debate is over

Today’s Draghi comment that a Greek debt write-off or some kind or other is “not controversial” reflects the speed at which the official consensus has changed. It’s striking that everybody, from the IMF to Schäuble, now agrees on that, despite being a total taboo at least in official speech a few short months ago. Varoufakis has at least comprehensively won the argument here, if not yet a solution.

Defaulting on the IMF was very useful

The catalyst for the above may have been the default on the IMF. Funny how now that the option is full default or a write off by other official creditors, the latter has become their top priority.

Also the silly long term GDP extrapolation modelling methodology has flipped to Greece’s advantage. Now they extrapolate 2 weeks of capital controls to an exhaustive disaster for the next umpteen years.

As such I don’t think a few weeks of capital controls are that bad. No actual production capacity is destroyed, people can go back to work doing whatever they were doing before when it’s over. It could push a few marginal businesses to bankruptcy but I don’t think you can project much out of that. Out-of-model factors will surely have an order of magnitude greater influence on the final outcome. The good thing is IMF models will now probably tend to underestimate Greek recovery, pushing for a better (than otherwise would be) deal.

The deal is technically pretty open

The deal is actually quite open. Everybody seems to expect Greece to get smashed, and it could, but if the politics follow it’s also possible for the deal to produce a reasonable outcome, e.g. the open-end negotiation on debt rescheduling going somewhere decent.

The deal does buy time

As a 3-year deal, if it doesn’t fall on some technical hurdle or outright sabotage, it does leave time for European politics to mature. It would get a bit easier if Tsipras’ Greece wasn’t the only unorthodox (in being of a Keyneysian and somewhat federalist inclination) government in power. In a positive scenario you could imagine both a shift in PIGS and greater tolerance in the Northern countries. It is still pretend and extend, but if we can pretend and extend until the next treaty, and that’s in 2 rather than 20 years, good.

Here and in its open-ended character, it is better than the “referendum question” deal.

Merkel has still not spent any political capital on this

Merkel’s approval rating hasn’t been dented at all and she has effectively not used any of her large stock of political capital, indeed may have again increased it. That can be seen negatively — reward for being tough — but also positively — the “kick the Greeks out of the Euro” constituency may be losing out in Germany.

It also means she’s got capital left for an actual compromise and or federalist steps. Not a given she will use it, but the outlook could be worse.

Benefits of capital controls

As a parting shot I’ve noticed a few positive side effects of capital controls:

  • people with some savings allegedly accelerated paying off debts or taxes, as a bail-in risk mitigation, thereby improving the position of the state and banks, contributing to offsetting some of the negative impact
  • nearly everybody in Greece now has an ATM card (some bank branches were open for that issuing cards) and greater access to online banking
  • it shows how an emergency (semi-)exit could work in a currency union: keep the union currency for paper cash, and use trapped banking currency as a new digital-only currency, by just replacing the exit/ATM limits with an auction system, aka a forex rate between the trapped digital deposits and the union currency

Frances Coppola tries to understand why Greece’s creditors are apparently so stuck into recommending policies that are economically irrational for all parties. Her hypothesis is that the main players see the current programme as punishment — on a moral level — for Greece’s past misdeeds. While some people certainly think like this, it seems a far fetched idea that this explains the situation, or that it is the majority view of the main players.

Theoretical Plurality

First, while I broadly agree that a debt reduction and a stimulus programme (or at least no more austerity) would be best in the current circumstances, I don’t think that this view is universally agreed. Macro-economics is the study of complex highly interdependent systems and our analytical toolset, both theoretical and empirical, is extremely inadequate. Nobody knows for sure what works and what doesn’t. Everybody is making educated guesses, often tainted by ideological bias — when competing models are a draw based on facts, it’s only human to choose based on ideology.

So I believe it’s still possible for some to believe fiscal rectitude and austerity work. It’s all a question of degree: every measure under consideration, taken in isolation, works some of the time to some extent. Is it unbelievable that the like of Wolfgang Schäuble still genuinely believe more austerity would produce the best long term outcome for the Greek and European people? A hint is in the whole ‘schwarze Null’ nonsense, which is about applying a similar medicine to Germany itself. The negative effects are less drastic given Germany is doing okay at the moment, but are still negative in what Frances sees as ‘obvious’ economics. How to explain it then? Self punishment? I don’t think so. One can be rational — as much as one can be talking about economics — and accept the Washington Consensus, as one can be rational and reject it.

Institutional Inertia

Still, is this view that of a majority view of European policymakers, or even the insiders in the institutions? It’s not so obvious, many insiders, prominent academics and finance professionals are on record supporting what we could call the Varoufakis View. Still the institutions remain inflexible. My bet here is that the main culprit is institutional inertia. There’s nobody in the IMF, or in the European Commission, who is in charge of Theory.

Weak leaders like Lagarde, Moscovici or Juncker seem to consider it’s above their pay grade to discuss theory or make any change to the orthodox models their institutions have been using for the past few decades. Everybody under them follows — while on official business, despite some being critical in research papers or in op-eds as ex-staffers — and there’s nobody above them. Minister or head of state level meetings, as Varoufakis has reported, are not places where theory is debated. My view is thus institutional inertia is the main culprit here. The IMF is on autopilot, and it will take some grave trouble for someone to look at the settings of the theory autopilot. A little default on June 30 could well be cathartic.

This is also true at the Eurogroup or European Commission level. The orthodox model is embedded in treaties and the rule set underlying the Eurozone. And renegotiating treaties is hard. Still, it will have do be done, or undone, some day. The current setup is extremely fragile, and if it doesn’t fail during this crisis it will fail during the next.

Both the IMF and the Eurozone are in dire need of structural reforms.

Where’s SuperMario?

The ECB has been remarkably neutral. This can be seen when both sides claiming to have it against them. The Greek side complains being on a tight leash, and they are (no short term financing tricks allowed, ELA allowance always kept to a few days’ worth) but then the orthodox side sees an ever increasing ELA liability — that can be defaulted on in case of exit — that they think should have been suspended, and capital controls introduced, long ago. The official ECB position that Greek banks are solvent with a liquidity problem is a bit farcical to be honest. But maintaining that farcical position seems an astute way to spend the minimum political capital required until a deal is made at the political level. My bet is that Mario Draghi may have taken Varoufakis’ side, but his hand depends on everyone — including Varoufakis himself — not realising it.

It’s to note that a Greek IMF default may be considered a positive for the ECB, as it may help push the commission/eurogroup to do the obvious debt swap and move the shortly expiring Greek bonds off its books and onto the EFSF/ESM, giving more room for manoeuvring by eliminating the risk of outright default on the ECB — which would make it possible to do whatever it takes to keep Greece in the euro.

German bonus ball

It’s really a sideshow, as only some of the players in the Greek drama are German, but I think there’s a great cultural misunderstanding when outsiders blame Germans for being moralistic in a punishing way. First, the whole idea of being externally moralistic towards other cultures is quite alien to the whole postwar German culture, for very obvious reasons. Second, there seems to be a weird Germanic view of causality that’s easily mistaken for morality but is really purely functional. In a nutshell, the person who causes damage pays for it, regardless of whether the damage was intentional or accidental. It’s pure causality, free of moral loadings. Third, the bias towards austerity and balance sheet prudence can be observed in many aspects of German life, including people’s sex and love lives. And who could argue that excess savings in the bedroom are directed from the Bundesministerium der Finanzen?

Chaos German Style (paperclips) Advert

A sense of humour

The general assumption in the Greek crisis is that, in so far as there is one, plan B — Grexit — is the introduction of a new currency. I think that actually Greece using the euro outside of the Eurozone is more likely as plan B. It’s still very unlikely because it doesn’t make sense at all from the point of view of the Eurozone, but it’s fun to play with as a thought experiment, and discussing it may help understand why it won’t happen.

There are well known advantages to having your own currency, but in this case a new currency would have big problems,:

  • Risk of non-adoption by people on the street because they don’t trust it
  • Inflationary spiral caused by the economic situation, the sudden introduction and the above
  • Logistic issues (printing new banknotes, converting contracts) which is essentially impossible to do over the weekend, and impossible to announce in advance

The alternative is just to keep using the euro while being outside of the Eurozone. Like Kosovo does, or like Ecuador does with the US dollar.

Map of euro adoption

Going lilac? (source: Wikipedia)

How would it work out?

Paper money

According to the Greek central bank there are about €2000 of paper euros in ciculation for each person in Greece (the actual number may be more or less depending on net flows of notes and coins from other Eurozone countries, but you’d expect this to be a conservative estimate because of net incoming tourists presumably arriving with more euros banknotes than they leave with). These are not going anywhere in case of Greek exit from the Eurosystem, so Greeks have more than enough paper banknotes to go round for a long time, even if they can’t print their own new ones.

(Note that this abundance of paper euros also makes the risk that nobody is interested in new drachmas higher than it would otherwise be.)

No central bank

Grexit would happen through the suspension of the ELA, which would in turn push all Greek banks into bankruptcy (as a liquidity problem at the very minimum) which in turn would exclude them from the electronic payment systems (SEPA, etc). This would also make the Greek central bank insolvent. They could just close it down, which would allow them to default on €50-100 billion worth of Eurosystem liabilities. If you’re a unilateral adopter of the euro you don’t need a central bank, the ECB remains your central bank, at arm’s length.

Look ma, no debt!

While we’re defaulting, given a primary surplus the Greek government can operate with no debt at all, and will be better off than the status quo, even if they can’t borrow for the foreseeable future. So they can default on the whole debt stock from the Troika lenders, and why not the private sector as well given under a balanced budget they don’t need borrowing at all, so maintaining a good credit rating on the markets is pointless.

Having no central bank, the Greek treasury can operate their payments by opening commercial bank accounts (with no overdraft needed!) like any business, with Remnant Eurozone banks, e.g. Deutsche Bank. They can use online banking to manage it, no need for the banks to have branches in Greece. They can also use new Greek banks (see below).

Capital flight is good for you

With no central bank, the Greek banks would have no access to clearing accounts in the Eurosystem. But there are several options here. First, we can assume they would lose all their Eurozone assets (most being owned by the ECB as collateral, and Remnant Eurozone governments could enact special confiscation legislation for local law assets owned by Greek banks, fair game), as well as their liabilities (ECB funding, etc). What is left is basically the local Greek-law loan book, and local Greek euro deposits. As of late December this was approximately balanced. With capital flight it actually improves every day: the loan book can’t walk away, but the deposits (liabilities for banks!) shrink, and capital = loans – deposits, which gets more positive with every euro leaving. Assuming the impairments on the loans are not too far off fair value, and the Eurosystem exit doesn’t create too much new defaults (arguably a risk, but much less so in the Kosovo scenario than in the own currency one), we have solvent banks. If all else fail, a haircut on remaining large deposits should help rebalance.

Liquidity for non-Eurosystem euro banks

These Greek banks are illiquid outside the Eurosystem though, with no access to clearing accounts, but there are solutions:

  • Sell the solvent domestic loan books + domestic deposits to Remnant Eurozone bank(s) for €1. E.g. National Bank of Greece could become part of, say, Santander, who can get liquidity for their new Greek subsidiary operations from the Spanish central bank, still a Eurosystem member, and they have spare borrowing power there given their large balance sheet. Problem sorted. And Greek depositors get their €100k guarantee backed by Remnant Eurozone taxpayers as their deposits are fungible with domestic Eurozone deposits!
  • With the same solvent loans + deposits as above, perhaps less crap stuff sent into a bad bank type entity, reopen the (New) Greek banks as corporate entities which use Remnant Eurozone corporate accounts in lieu of central bank accounts for clearing. This needs a stop gap for liquidity, by either converting the deposits to term deposits (a soft form of capital controls arguably) or possibly finding bridge loans from external private entities. Given the entire deposit base is below €150 billion and may be much less by the time this scenario would unfold, and not all of it will move after an exit (too late), it should not be that hard to find hedgies to provide the financing.

The first variant brings a more generally interesting question: in a currency union, should financially weak regions have their own banks, or should they bank using the institutions from financially strong regions within the union? The answer is probably the latter, as happens in most centralised countries (e.g. most people in Cornwall do not bank with Cornish banks, but freeload on London banks, and quite rightly so; at an (ex-)country level the ex-GDR part of Germany has a weak indigenous banking sector and banks with West German banks, and quite rightly so).

What are the risks of Kosovoisation?

I may have missed something, but I don’t see many problems with this scenario, from Greece’s viewpoint. Long term, Greece would have no indigenous monetary policy, but they were never particularly good at it and monetary policy is of limited use anyway for a small country. They would loose access to EU structural funds, but then they save €400 billion of debt so net positive here surely. The main short term problem is if the Remnant Eurozone tries to cut private Greeks and private entities from their (non-overdraft) mainland Eurozone bank accounts. Possible but pretty hard, and mean. And hard to justify given all this would be triggered by the ECB pulling the plug in the first place.

Why this won’t happen

It should be obvious now that this won’t happen, precisely because it would probably be an okay deal for Greece, while costing the Eurosystem dearly both in nominal terms of treasury + ECB write-offs, in possibly collateral damage, and a very high risk of an associated cataclysm for the European project. The ECB will just not pull the plug unless Greeks do something really stupid (like printing their own unauthorised euros, they do have a print works I think).