A Bit of Reality

The advent of the Kevin Warsh Federal Reserve with its first meeting last Wednesday, very likely heralds a new departure in American central banking. The Warsh Fed will likely be less effusive in its communication (notably there will be less public defending why the Fed doesn’t hit its forecast levels of rates and inflation), will be more closely coordinated with the Treasury, and if the track record of the new governor is to be believed, will be much more reluctant to use the balance sheet of the central bank to support markets and the animal spirits of the economy. The real test of this will be next economic crisis, potentially a public debt crisis that starts in the next couple of years.

In the medium term, the backdrop to the Warsh Fed will likely be characterised by tighter liquidity conditions. Warsh will likely slow the Fed’s reserve accumulation program, equity issuance by tech firms, IPOs, new bond issuance (again, for AI infrastructure) will also mop up market liquidity and following a bout of bond retirement in the second quarter owing to a bumper tax take, the US Treasury will increase debt issuance from the end of June onwards (up to USD 600bn in Q3).

So broadly speaking from a ‘plumbing’ view of markets, there will be less liquidity shooting around the pipelines of markets. Ordinarily, this is not great news for risky assets like equities, especially with valuations at the very top of 100-year ranges. However, the asset class that intrigues me, is bitcoin, already a significant underperformer this year. The mystery being that bitcoin has yet to reveal its true identity as an asset class, let alone a money.

Bitcoin was established in the aftermath of the global financial crisis, as an alternative to paper money and the institutional framework around that money (i.e. the Fed and the ECB), but has failed in this aim. Bitcoin is not a money. It is simply far too volatile to act as a reliable store of value or basis for payment. Also, the technology associated with cryptocurrencies is also complex enough to dissuade most households from using them.

As a case in point, I can recall that in bitcoin’s early days (2016), train stations in Switzerland’s ‘Crypto Valley’ had a facility to exchange swiss francs for bitcoin, and the canton accepted bitcoin as payment for taxes and services. But transaction fees were very high, and this experiment hasn’t caught on. In fact, only some 0.1% of tax settlements in the canton of Zug were paid in bitcoin.

While the Swiss authorities were happy to give bitcoin the benefit of the doubt, most institutions in the old-finance world, primarily central banks who plan their own digital currencies, have an incentive for it not to succeed, and famously in 2021 Christine Lagarde referred to bitcoin’s ‘funny business’.

Reflecting this, the weakness of bitcoin has not been the technology, but rather the infrastructure around it, and the people who have used it as a means of payment. In the past five years, a good number of exchanges (in Asia) and brokers have collapsed or been shut down, and the entry and exit points to the crypto world are under examination from tax authorities. Also the anthropology and sociology of those who populate the crypto world is crucial to how these assets behave and subsequently to their risk characteristics. In this light the, fact that the biggest holder of bitcoins is apparently the FBI says a lot.

Bitcoin, and the broader crypto world, now face two new competitors of sorts. One is the growth of stablecoins (which are based on the Ethereum blockchain), which may facilitate ‘grey’ economy transactions far more efficiently than bitcoin. The other is AI, whose claim on the electricity and energy sources of the world, makes the production of bitcoin more expensive. Lurking in the future is quantum technology, which some fear could break the bitcoin protocol.

So, bitcoin is far away from meeting the objectives of a ‘money’, and in my view is a ‘tulip’, a speculative, trading asset. It also seems to me that many people are increasingly happy with bitcoin being assigned this role, and much of the interest and eco-system that is developing around it underpins the role of bitcoin as a speculative asset rather than as a bona fide currency.

As such, this points to bitcoin and crypto currencies being ushered into the corner of eclectic trading assets – though less of an experience than horse racing, with none of the aesthetic bonus of art and not quite the fun of collecting wine.

These assets tend, in my experience, to be driven by waves of liquidity, and surges in wealth, as opposed to more fundamental factors. Thus, with the prospect of weaker liquidity ahead, bitcoin is in for a test. It has been claimed that bitcoin is a safe haven, or digital gold, but in general its tendency is to weaken as macro uncertainty rises. It might be the first victim of the Warsh era.

Have a great week ahead, Mike

A Very British Coup

Ireland is known for its high-profile actors, from Liam Neeson to Cillian Murphy. But readers might also want to search out the work of actor Ray McAnally, one of Ireland’s best but slightly forgotten actors. Anyone curious to sample his talent should watch the 1992 thee part series ‘A Very British Coup’. It is based on the book of the same name by Chris Mullin, the former Labour MP, Birmingham Six campaigner, and someone who was regarded as one of the most likeable MPs in Westminster. His political diaries are also appreciated as the best in the genre.

‘A Very British Coup’ appeared around the same time as Michael Dobbs’ ‘House of Cards’, which is now famous in its American incarnation, though the British version is far better. In Mullins’ book, the central character is Harry Perkins, a newly elected left wing prime minister from Sheffield, and someone who wears his man of the people identity proudly. As soon as Perkins takes power, he runs up against the establishment, the press, the City, security services and the American government. Despite a valiant resistance, Perkins is eventually forced from power.

The book and tv series came to mind for two reasons, both of which concern next week’s Makerfield by-election on June 18, which could vault Manchester’s mayor Andy Burnham into Downing Street. The resignation of defence secretary John Healey last week ups the ante in this contest.

The first reason is that this manoeuvre is a particularly British one in terms of the logistics of the electoral process and consistent with the tendency in Westminster to discard prime ministers as if they are football managers. No wonder that some commentators refer to the Italianisation of British politics (in the 1990’s the average duration of an Italian government was one year, and we may now be on the brink of the seventh prime minister in ten years). To succeed, Burnham will need a comfortable victory in Makerfield, and a groundswell of support from Labour MP’s.

The second issue relates to the inbox of prospective prime minister Burnham. He is known to be far more political and personable than Starmer, and his mixture of ‘Irish blood and English heart’ (to quote Morrissey) will equip him for the challenges ahead.

Oddly, given the magnitude of change in the world order, some of the challenges that a possible prime minister Burnham will face, are like the ones that confronted Harry Perkins – a gloomy public mood and atmosphere of economic decline, trouble with the Americans and a pressing need to keep up with new technologies.

The special relationship between Washington and London is, like many other institutions of the post Bretton Woods era (NATO, the UN, World Trade Organisation), in real trouble. Senior American politicians like JD Vance and Elon Musk think little of inserting themselves into the debate on immigration and identity in the UK. The NHS is on the verge of cancelling a large contract with Palantir, and the White House has managed to push the UK back towards the EU politically. It has done much the same for Iceland, Norway, Ukraine, Hungary and even Canada.

Then, there is the gloom of the economy. In recent months a series of books has been published about the UK economy, the general tenor of which is captured by AG Hopkins’ ‘The Land Where Nothing Works’. There is a very clear, though frustratingly long-term (for politicians) policy recipe that might allow the UK to lift its sluggish trend growth rate. It involves an overhaul of the education system, far greater state funding of the universities, reform of the welfare state and labour market, and cultivation of broader private investment. Chatter on the left wing of the Labour party suggests that this may not be the chosen path of a Burnham cabinet.

The other related element is technology. In ‘A Very British Coup’, computers were edging into the mainstream, now robots, humanoids and AI are the mainstream. Thanks to the work of a few talented private sector entrepreneurs the UK last year launched its AI Opportunity Plan, which in my view is one of the most coherent strategies for the build-out of a national AI plan.

Last week, the Starmer government followed this with the AI Hardware Plan, which leans heavily on the development of British super computing and next generation semiconductor capabilities. In both cases, Britain has the talent, the vision, but lacks real capital (two months ago the capitalisation of the Taiwanese and South Korean stock markets passed out the FTSE 100), and very markedly, the execution from politicians is missing.

If Andy Burnham becomes prime minister this summer, the risk is that he stops at the political coup of winning power, like the six prime ministers who have preceded him. A real coup would be to restore confidence and momentum in the economy and make Britain a relevant power in the 21^st century.

Have a great week ahead, Mike

Russian Risks Rising

Things must be pretty bad in Russia because a few weeks ago I had an invitation to speak at the St Petersburg Economic Forum. As much as St Petersburg is one of my favourite cities, I will not be going. But, my disdain for Russian politics is almost matched by a curiosity for what is happening to the Russian economy and society.

In the past two months there have been many reports on the emerging weakness in the Russian economy, minor spats of dissent in Russian and the toll that the war is having on demographics – M16 recently released an estimate of over 500,000 deaths of Russian soldiers in the war on Ukraine so far (for context Russia suffered 450,000 deaths from combat/starvation/disease in the Crimean War and 15,000 in the 1980’s Afghan campaign), with a monthly casualty rate approaching 35,000.

As a result, the unemployment rate is close to 2%, labour shortages prevail and the growth of the economy is stalling out. Russia’s economy is now largely a war economy, defence spending is 8% of GDP but many private and state resources have effectively been co-opted to bolster the war effort. Cracks are starting to show. The budget deficit is widening despite high oil prices, shortages of goods are more noticeable I am told, and banking and taxi apps frequently don’t function.

While there are some reports of dissent amongst the Moscow elite, broad discontent is not visible, and nor should people expect to this this until things turn very bad. One memory I have is on morning runs through Moscow, passing the heaped flowers marking the spot where Boris Nemtsov, a Moscow insider but Putin rival, had been gunned down on the bridge that passes the Kremlin in a not too subtle message to anyone who thinks Vladimir Putin is not the only solution to Russia’s problems.

Putin’s predatory style is also evident across Europe in act of political manipulation (e.g. Nathan Gill the former leader of the Reform party in Wales was sentenced to 10 years in prison for taking bribes to make pro-Russia statements), sabotage and grey-zone hostile actions which we have written about in previous notes (‘Shadow Wars’ and ‘From Great War to Total War’). Europe is slowly adapting to this and there is less naivety and tolerance for Russia’s actions, amidst warnings from intelligence services of a potential conflict with Russia in the next three years.

The very striking development is how Russia’s attack on Ukraine has changed the strategic landscape around Russia. Previously neutral states, Finland and Sweden, have joined NATO and there is now a rush to increase defence spending and capabilities across the Nordic and Baltic states, not to mention Poland. Hungarians voted to jettison Viktor Orban, a friend of the Kremlin, and Hungary’s new prime minister is restoring its place as a country that other EU members can have faith in, and notably repairing relations with Ukraine. Ukraine and Moldova are now on the (slow) path to join the EU, and within the Union, defence spending, manufacturing and innovation are picking up.

It is also worth noting that Russia’s relationship with China is changing, with Moscow now very much the weaker party, and increasingly beholden to Beijing. It might well be that China is the actor to bring forward a solution to the war in Ukraine, and thereby extricate Russia from its bloody, strategic mistake.

While there is no sign yet of an economic tipping point in Russia, nor more so of a political one, the sense is that the strain is mounting, and the odds of a ‘Russia’ crisis are slowly rising. This might manifest itself within Russia, or its security state, or could express itself in a tail-risk attack on a European country. Drone incursions into Lithuania and Romania have already heightened tensions.

In terms of the Russian economy, I recall, as a young economist, attending a faculty seminar with Stanley Fischer in 1999, when (as one of the IMF chiefs) he described the urgency behind the IMF bailout of Russia, which was partly motivated by risks posed by Russia’s nuclear arsenal and the need for stability. Stability took some time to arrive and when it did, came in the form of Vladimir Putin (Catherine Belton’s book ‘Putin’s People’ is very good here).

Compared to 1998, the Russian economy is structurally much changed, but vastly behind the potential levels it might have reached. Remarkably, it is a competitive laggard in key hard technologies from semiconductors to AI, and less so in quantum computing. To that extent Putin has robbed his country of an economic future, and the consequences of his war are rising.

As I write the Ukrainian army has marked the beginning of the St Petersburg Forum with drone strikes on the city.

Have a great week ahead, Mike