EDITORIAL: British people brave the threats.
By Christian Takushi MA UZH, 30 June 2016 – Switzerland
As we warned in Fall 2015 and more recently on 7 Jan 2016 (editorial) and 17 June 2016 (outlook), political & financial experts grossly underestimated the risk of BREXIT (Britain exiting the EU). They relied on consensus, insiders, polls and betting books. We used instead our geopolitical macro approach and drew also a parallel to Switzerland in the 1990’s. Two decades ago the overwhelming majority of Swiss political leaders, university professors and CEOs of big enterprises warned the Swiss people that if they didn’t join the EU, Switzerland would impoverish within 10 to 20 years. It was no wonder that a people mindful of their independence, treated the massive warnings as a threat and even blackmail. Big firms threatened to close entire factories and move them overseas. The Swiss people shocked the establishment and voted to reject membership in the EU. Yes, some firms moved away, but most chose to innovate. We have warned since fall 2015 of the same pattern playing out in Britain. Fortunately our clients and close followers heeded our warnings and assessment. We have maintained throughout 2015 and 2016 that investors should keep a high exposure to gold and cash and wait for sell-offs to add to risk assets and oversold currencies. This broad analytical approach is helping decision makers in their policy, corporate & investment strategy.
A word of caution: You may find our independent analysis has an overall positive conclusion for Britain long term post Brexit. But we cannot underestimate the policy risks and the many global factors that will influence the decision-making and the final outcome. Two factors that contributed to our positive conclusion exemplify the constrained relative nature of the analysis; (a) Despite the fact that Britain was a geopolitical power, the 2nd largest economy in the EU and 2nd largest net contributor, it was treated behind closed doors as an outsider, de facto subordinated to the Franco-German axis. Thus, while nations like Portugal or Poland and to a lesser extent France may enjoy the disproportionate influence they have on the world stage thanks to their EU membership as opposed to their real economic weight & health, Britain was in many ways impaired; (b) The EU is not only flawed at its core, it has embarked on a dangerous unrelenting territorial expansion into the former Soviet space, awakening Russia and helping the rise of hardliners there; at the same time the EU has dismantled its strategic Armed Forces. European bureaucrats may be good administrators and have noble ideals, but their lack of touch with reality and their citizens, are only matched by their lack of strategic foresight. It is against this predicament, that the cost and risks of an independent path was weighed by us and deemed superior for Britain, and Europe. I personally expect Britain’s role in Europe and the world to be greater ten years from now than it is today. But while Britain has opted wisely for Brexit, it is like Christmas 1939 … a step into the unknown in a dark & uncertain time. Thus, it is not a given that Britain will see it through and unfold its full potential. Britain will need a healthy economy, strong military, confidence in its strengths, strategic foresight to assess global risks, and finally wisdom. The kind of wisdom that comes from a humble heart that seeks God in prayer. Just as this great nation did in the Summer of 1940.
Initial pain: Although Britain has many of the ingredients to excel long term, it will initially surely suffer as a result of BREXIT. As I have written in other reports in recent years, too much emphasis on GDP is misleading. The superior GDP growth of Britain is masking serious deficiencies and income stagnation for the majority of Brits. Although this is a widespread phenomenon across the OECD spectrum, the new Prime Minister will need to deviate from the recent stoic frugality to support the most vulnerable households during the adjustment. The painful adjustment will come, but not so much due to the much publicised threat of big businesses to move to the European continent. Economic growth will rather slow down as the excessive mass immigration that artificially boosted the Real Estate market and Consumer Demand will be reigned in and contained. Britain will continue to welcome foreigners, but it will focus on those that can contribute, add value and it can orderly assimilate. It will be able to welcome the best in the world, not just the best within the EU. Many will blame economic pain on BREXIT, but in fact the coming contractions in the real economy will reflect the return to a more balanced growth model, normality – away from an unchecked & unsustainable influx of migrants that fed an artificial bonanza. Britain will be the first major Western economy to move away from this mass migration driven growth model – an extreme economic growth model still embraced by the EU and USA. But that painful adjustment towards a more sustainable, balanced and organic economic model, will ultimately be a blessing for Britain long term. Initially, EU member states may seem more stable as they benefit from the security and lethargy of a bureaucratic Fortress Europe, which keeps the continent from taking bold steps and addressing painful reform. Let’s be honest, mass migration of cheaper labor force has advantages for businesses and government. It can be sold politically as coming-together and its short term financial side effects are tempting. It feeds the electorate demographics of liberal parties and the profit margins of big businesses that support conservative parties. But excessive migration puts downward pressure on wages and allows businesses to cut costs, while boosting housing prices and consumer demand. In the past big businesses passed those profits unto workers and society, but with ultra-low interest rates, those big firms now buy their own shares (buy backs) and buy competitors (M&A with subsequent mass layoffs) with cheap debt. That bonanza boosts GDP, but it deepens the income gap, young Brits can no longer afford to buy a house, and all the costs & risks of assimilating the migrant influx are not born by businesses, rather by tax-payers, the less skilled and future generations. In fact the political, religious and social tensions arising from uncontrolled mass migration are significant and unquantifiable; they could well outweigh in the long run the initial GDP boost. While business, asset & home owners see their wealth soar to new highs, young citizens and workers see their real incomes stagnate.
Migration is normally an economic blessing for a nation, but when it morphs into an uncontrolled migrant influx over many years, it can become a geopolitical macroeconomic curse. It can destabilise the very fibre of society on which Trust, Security and the Social Contract rest. Their deterioration increases political risks and lowers Potential Economic Growth. The total costs of uncontrolled migration and of an exceedingly polarised society are huge and do in most cases outweigh the initial GDP boost. At the end of WW2 Western Germany saw a mass influx of war refugees: Germans were forced to flee the former German territories in Central and Eastern Europe; up to two millions died trying to escape, often at enemy fire and retaliation. A traumatic experience. But having the same language, culture and social-religious values, those refugees who made it to Western Germany assimilated perfectly and helped power the Wirtschaftswunder (Gemany’s Economic Miracle). Migrant flows with a total different set of values can be a long term blessing, provided they want to assimilate and the magnitude of the influx does not overwhelm the host nation.
Geopolitics-influenced Economics favours Britain: Although from a broader global geopolitical-macroeconomic perspective both Britain and the EU will face a painful period of adjustment, financial markets are only punishing British assets and the Pound Sterling, as if the EU were in a much better position. Credit Rating agencies are downgrading British debt, but in our opinion they should have downgraded both British and Eurozone debt to be coherent. Observers are also focusing too much on the financial and economic impact, overlooking the superb military power projection of Britain. And the latter will play an important in the coming two decades due to unprecedented global challenges. Britain’s unparalleled network of strategic military bases helps secure the global maritime trading routes. Only the USA with its bases and aircraft carrier groups exceed that. Without Britain, the EU has become a vulnerable geopolitical dwarf that cannot defend herself nor is it in a position to come to the aid of the USA, should it need it. Without military might and strategic power projection to protect her trading routes, the EU is an extremely vulnerable economic block. Geopolitically & macro-economically more vulnerable than Britain.
Policy Mix must and can support transition: After 7 years of painful austerity and fiscal discipline, Britain is in a strong position to take policy measures to support the economy during the transition, invest in infrastructure, support research & development and lower interest rates along corporate taxes. The independent Currency and Interest Rates will be the biggest plus, though.
In my macroeconomic assessment, Britain can embark on a
- expansionary fiscal policy to support infrastructure, R&D & defence
- supportive fiscal policy to support vulnerable households
- expansionary monetary policy by cutting interest rates
- accomodative monetary-currency policy to allow the Pound Sterling to adjust freely and smooth the shocks to the real economy
- All of the above will be short-lived if not flanked by regulatory and tax measures that make Britain an open, unbureaucratic and flexible place to do business
- Last but not least, overhauling Policy Targets to embrace the new realities: shifting from the outdated binary Real GDP and CPI targets to a broader mix of targets comprising also: Nominal GDP per capita, Net Wealth per capita, Macroeconomic Efficiency (ability to translate GDP growth as a flow into Net Wealth accumulation by its citizens as a stock) and qualitative targets. In an era of ageing population and shrinking labor pools; which are deflationary factors, it would make sense to lower GDP and CPI targets. Additionally Economic Activity should be appraised in relation to Britain’s Dependency Ratio (old; number of people older than 64/working age population). It is easy to grow GDP with a young population and unchecked immigration. With a shrinking labor pool, a rising Dependency Ratio (old, above 30) and little immigration, a GDP growth of 1% to 2% p.a. along a balanced economy might be considered satisfactory and sustainable.
Nominal GDP per capita data will allow policy makers to assess how well they are doing without the bias of migrant influx. Otherwise they run the risk of seeing a disproportionate contraction in economic activity and overreacting to it. To avoid that, the national statistics for real and nominal GDP time series should be re-calculated backwards over at least two full business cycles to have GDP per capita Time Series at quarterly frequency. As said earlier, part of the GDP growth of the past decade was induced by unchecked migrant influx. There are econometric methods that under some constrains would also allow isolating that migration factor to see how the UK’s real GDP may have behaved in the past.
Having excellent and seasoned experts, I have confidence, Britain will use all of the above to smooth the transition and lay the foundation for a more balanced, sustainable and organic economic path.
Although both Britain & Europe will face pain, Britain is in a more enviable position than the EU, one that is in denial about her failures and shortcomings. Rather than soul-searching, she relies these days on her economic size and protectionist nature. The mere way of thinking so prevalent among EU leaders “If you dare to do this and don’t abide by our rules, we will punish you with tariffs ..” says everything you need to know about what is wrong at the heart of a vastly undemocratic and unaccountable EU commission. This will only force EU companies to pay a higher price for added-value British services and goods, and will also force British firms to focus on more dynamic regions of the world. Indeed, the rest of the world is growing faster than the EU and specially the Eurozone. Thus, the to some extent vindictive reaction of the EU is a blessing in disguise for Britain. Additionally, BREXIT should not be seen solely as a negative shock, but as a disruption that could unleash innovation, renewal and economic growth.
Looking out beyond this decade
I believe BREXIT is not the end of the integration process in Europe. Cooperation and Integration are necessary and worthwhile. But the current EU is a flawed institution at its core; unwilling to be reformed. Europe is still in transition. The coming confluence of crises in the political, economic, religious and geophysical realms will overwhelm individual nation states and allow the rise of a European Federation. Finally I foresee the rise of Super States on all continents, the European one being probably the first or second to be formed. (Kindly see other research reports on our website where we write about our long term strategic forecasts for the world)
2. The Risk for Britain longer term is a sustained weak Pound Sterling
The case of Switzerland doesn’t mean in a mono-causal way that any nation staying out of the EU will prosper and outperform the EU. It shows only that it’s possible to prosper outside the EU. Traditional factors believed to be behind the Swiss success so far focus on its efficient & lean government, political stability, pro-business regulation, multi-lingual pool of skills, innovation, high turnover of researchers & intensity of research etc. But what mainstream often overlooks is the powerful role of the strengthening trend in the Swiss Franc since the 1970’s. Post-modern economic consensus often stresses that a stronger currency is bad for an export-oriented economy. This is a rather financial-accounting profits oriented view of the currency impact, a shortsighted view that has even spread in academia where Macro Economics has to a large extent been replaced by Finance. The macroeconomic view is clearly different: A sustained upward trend in the value of a currency (Term of Trade deterioration weighted against its major trading partners) forces firms to innovate and cut costs organically. We see this wonderfully exposed by Japan, Singapore, Taiwan, South Korea and Germany (until the Euro crisis). Barring the demographic tipping point of 1998, Japan did very well despite the tremendous appreciation of the Yen. That was the case, until policy makers came under pressure by ever larger exporters to put an end to the strengthening Yen. Tokyo’s competitive devaluations artificially boosted corporate profits and consumer prices (inflation) for one year, but reduced the pressure to innovate. Once policy makers give in, a vicious cycle of moral hazards sets in: the demand for currency devaluations re-emerges as soon as the accounting profit effect fades away. We have seen this even in Switzerland, where the SNB gave in to the pressure of large Swiss exporters in 2011. This was in my view the tipping point for Switzerland’s rise in competitiveness; possibly the peak in the Alpine nation’s rise. Since August 2011 Swiss firms are tending to rely on policy makers’ protection instead of assessing macro risks by themselves, and preparing for a stronger Franc. Why do policy makers give in? Drastic appreciation allows exporters to call for policy interventions. An upward move in the currency of a dynamic nation is seldom steady. Short term currency shocks will accelerate the exit of barely profitable firms and accelerate innovation. There is nevertheless the short term pain: profits get squeezed and terms of trade erode price competitiveness. Policy makers have to exercise sound judgement and strategic foresight in order to avoid giving business leaders what they demand. Macroeconomically policy makers have to weigh between short-term accounting profits and longer term sustainable economic profits. The Bank of England (BoE) can enter this uncertain journey with a great advantage: they can benefit from the mistakes made by their Japanese and Swiss policy makers.
The short term BREXIT aftermath: From a macroeconomic perspective it should be expected that Britain will see a weaker currency reflecting an initial painful adjustment. But medium-to-long term the open & flexible British economy backed by its financial & geopolitical power should adapt fast and flourish again, eventually outperforming the EU economy. That British economic stabilisation and unfolding prosperity along deeper crises in the EU may lead to a stronger Pound Sterling versus the Euro. A stronger Pound to the Euro will force British firms to invest more in research & development in order to innovate faster. In the long run a strong Pound Sterling will be Britain’s best friend. Free floating Currencies exposed to a multitude of traders in Foreign Exchange Markets are by far one of the greatest strengths of Capitalistic Free Market Economies. Bureaucrats could never achieve that economic efficiency even if they’d plan for it. It is therefore sad that EU regulators have focused on the excesses and the black sheep among traders to declare war against risk-taking traders & fund managers. The Western free market economies owe a good deal of their prosperity to those risk-taking traders and fund managers. This is already reducing the efficiency of resource allocation and potential growth in the Eurozone. Britain outside of the EU has now a great chance to be that highly efficient market for the world and Europe. The EU may put hurdles and tariffs against London, but no amount of bureaucratic effort can decree a London-like success in Paris or Frankfurt. The good news for Britain is that efficient added-value services & products find their way to markets. Paris & Berlin are wishful thinking if they think they can replace London as the world’s financial & currency trading capital. That cannot be decreed by bureaucrats. Trade deals can ease and smooth business, thus, they are important. But their importance has been blown out of proportion during the recent BREXIT debate.
How the Bank of England (BoE) will allow rational expectations to develop around the Pound Sterling will be key for the future success of the British economy. Fact is, not many firms innovate unless they have to. This is especially true for firms led by profit-seeking executives rather than family owned enterprises. The former seek generally to maximise accounting profits and returns for shareholders, the latter seek long term competitiveness which can only be achieved by benefitting all key stakeholders over time. A weaker currency gives corporations windfall profits, without any effort from their side. A weaker currency kills the need to innovate. Yes, a weaker currency spoils corporate leaders – reason why they also lobby for it. Countries that tend to use competitive devaluations to improve their corporate profits end up with mediocre or even uncompetitive swaths of industries. Reason why I am concerned for the future of Japan since 1999 and that of Switzerland since 2011.
Ceteris paribus, I currently see the German and British economies as the most dynamic and innovative ones in Europe longer term. They will both drive the European economy and shall be at the heart of a renewed & completely overhauled European project. Because of the dynamism & adaptability of the British economy, its global geopolitical influence and the much sought-after strategic network of British military bases around the world overseeing the world’s maritime routes, I am convinced that an independent Britain will have a much bigger voice and influence in Europe and the world than within the EU. Within the EU, Britain would be much contained and tied to the watered-down consensus of over 25 members, most of which are uncompetitive, in need of protection and should have never joined the EU according to a strict application of the Maastricht criteria.
The message for decision makers and leaders is this: BREXIT does not guarantee the future success of Britain, the triangle of “democracy-accountability-capitalism” is not the guarantor but rather the most necessary condition for prosperity. The above-mentioned triangle is necessary, but not enough. The future prosperity of Britain may actually lie in soft factors such as confidence and unwavering faith. Factors many economists fail to consider, because they can hardly be quantified and tracked on a monthly or quarterly basis.
76 years after the battle for Britain decided the fate of Europe, Britain has once more braved all odds and threats to set forth a framework of democracy, accountability and capitalism. This became necessary, because democracy and accountability at the heart of the EU, Brussels, became too rare. The European parliament compared to the powers of the US Congress is indeed a kind of mock parliament.
3. Queen Elizabeth II may influence the aftermath of BREXIT as much or even more than the Bank of England
Geopolitical Economics wouldn’t be what it is without the influence of history. What does June 2016 have in common with June 1940? During both fateful months millions of Britons prayed fervently for God to lead their nation on the right path. I, personally, wouldn’t be surprised if faith in God would experience a revival in Britain just as it did 76 years ago. In this unprecedented time of uncertainty, Europeans can easily be tempted to rely on a mighty Brussels for protection, pensions and guidance. There is surely presumed security within a protectionist Fortress Europe (EU) indeed. The more shocking and refreshing therefore that the British people chose to stand on their own feet to step into the unknown. They will be soon forced to look in the mirror, only to be humbled by their limitations and shortcomings, but also – if history is any guidance – to be stirred by the courage and faith in God that spurred King Richard the Lionheart and her Majesty Queen Elisabeth II.
I was touched by the foreword that Her Majesty Queen Elizabeth wrote for the book The Servant Queen and the King she serves*. There she writes these moving words:
… As I embark on my 91st year, I invite you to join me in reflecting on the words of the poem quoted by my father. King George VI, in his Christmas Day broadcast in 1939, the year that this country went to war for the second time in a quarter of a century.
I said to the man who stood at the gate of the Year “Give me a light that I may tread safely into the unknown.” And he replied, “Go out into the darkness, and put your hand into the hand of God. That shall be to you better than light, and safer than a known way.”
Although, this poem was read some 76 years ago as Britain stood alone and the current book was published before the BREXIT referendum, it is so powerfully pertinent for British citizens in this Summer of 2016, when they once more step into the unknown. Deep in my heart, I feel as if Queen Elizabeth II may have written this to address the British people post BREXIT with words of encouragement. What a humble yet powerful way to lead your subjects.
* the book was a tribute for Her Majesty’s 90th birthday
4. A second crucial decision looms on July 18th, just three weeks after the BREXIT vote
I am convinced the House of Commons will say yes to “Successor”. Successor nuclear-armed submarines & Queen Elizabeth-Class Aircraft Carriers will allow Britain to be a much sought-after and reliable partner around the world.
A major Strategic Risk for Britain, specially post BREXIT, would be not to renew the Strategic Nuclear Submarine Fleet. Because Britain has shrunk part of its military capability due to budget cuts, and is facing shortages & limitations in specific tactical areas, the vote on continued Nuclear Deterrence is crucial for Britain’s interests.
Indeed Britain is making two historic decisions this Summer of 2016: First, BREXIT, then SUCCESSOR. On 18 July 2016 the House of Commons will make the final vote whether to approve or reject the complete renewal of the British Nuclear Submarine Fleet. That is the cornerstone of Britain’s strategic defence.
The House of Commons will vote this month of July on accepting the new Successor-Class Fleet (renewing this old submarine fleet). Successor is critical for British Continuous At Sea Deterrence (CASD). Without CASD, Britain would be as vulnerable as the European Union to a nuclear First Strike or another weapon of mass destruction attack.
The renewal of the soon-to-be obsolete Vanguard-Class strategic submarine fleet is key for Britain’s security and economic future. Global geopolitical power underpins British strategic economic interests and supports the development of the UK long term. Thanks to the superb location of British military bases, the strategic location of allies, the nuclear submarine deterrence and the new Aircraft Carriers, Britain is the leading geopolitical power in Europe. Also able to project influence across the world, especially the seas. All this coupled with the fact that Britain is by far the closest US strategic ally (within and without NATO), makes Britain a global geopolitical-financial power. Britain’s influence in the world goes far beyond its economic weight (GDP) and its permanent seat in the U.N. Security Council. Britain has made mistakes in the past, but it is still a highly respected global power. In Europe, only Germany can match Britain’s power to some extent thanks to Germany’s impressive economic power. Nevertheless, Germany lacks a network of strategic military bases, allies, nuclear submarines for deterrence and aircraft carriers. That means that in the event of a serious global crisis Germany can neither defend herself nor can it protect the extensive Maritime Routes on which global trade depends. Germany, like most other European states, has only brigade-size effective military units. Most military divisions of the EU exist only on paper and have obsolete equipment. The EU is utterly dependent on the USA and partly Britain for its defence.
After declaring the state of war and emergency in late 2015 it took France a shocking 3 days to mobilise a mere 3’000 soldiers – that fact speaks for itself. Germany, France and other European powers have been led by Pacifist leaders that lacked strategic vision. Out of touch with reality (the world is in the 2nd decade of an unprecedented Global Arms Race), European bureaucrats have believed the world has entered a period of prosperity and peace, relying on the naive idea that economic growth & trade will render wars a thing of the past. As a result, European states dismantled their military; keeping superbly-trained brigades that are only good for small to mid-sized peace-keeping operations overseas. Only with the reality of BREXIT, the EU will rearm. But it will take 10 years for it to be a serious global military power.
During the UK-EU negotiations that preceded the BREXIT referendum, the European Union vastly underestimated the importance of Britain’s geopolitical & military power for Europe. As a result, EU leaders focused exclusively on trade, financial and GDP flows, and ended up treating Britain almost like Switzerland, harshly. A tragic mistake for the EU. Only in the aftermath of BREXIT European leaders are grudgingly listening to their strategic and military advisers. But it is too late. The slogan in Berlin, Paris and Brussels was “don’t give in to Britain’s key demands, otherwise other European states will demand the same”. The EU’s problem is that Britain is not like some other European state. It is a global power in several respects. It is my personal assessment, that despite all the talk of fraternity, peace and unity, most EU member states are in the EU out of fear; fear of having to face global competition and this exceedingly uncertain times alone. Here again, Britain shows it is somewhat different. Although divided and troubled, it can step forward into the unknown. Just like in the Summer of 1940, not unafraid, but overcoming great fear. Many will think it far fetched in this Summer of 2016, but I am convinced that in the years to come, Europe will be in need of Britain’s help and support. I believe an independent Britain is the best for both Britain and Europe. Britain is no longer a world dominating empire, but its independent thinking, strategic assets, influence and commonwealth connections make it an attractive partner.
Because of Britain’s uniquely located military bases & allies, credible nuclear deterrence & power projection, many nations will now seek a closer geopolitical or economic relationship with it. London’s preeminence in the financial world and specially as the Currency Trading Capital only adds to that attractiveness. Something Britain could not fully entertain in the past, hindered by Brussels. It is amazing to see so many experts in unanimous agreement that Britain will become little & unimportant after the BREXIT vote. But leaders of rising powers like China, India, Brazil, Nigeria etc. and blocks such as the Pacific Alliance (comprising the most successful Lat-Am economies of Chile, Mexico, Peru and Colombia) are discussing with their geo-strategic advisers on how to secure closer ties with Britain after this referendum. Of course, to avoid upsetting the EU, much of it will be done quietly. For many rising economies around the globe, Britain will be a much sought after partner and ally. Those nations are well aware that the security of the Maritime Routes is crucial for their trade and development. Only the USA and Britain can provide along with their allies a credible protection of crucial Maritime Routes around the globe. And even these two are seeing increased Access Denial by rising powers to some waters.
Overall, only the USA, Russia, China and Britain can project power in a credible way spanning vast expanses, fully backed up with annihilating nuclear deterrence. As far as the Middle East and Africa is concerned though, France remains also a credible & formidable power projector. We will thus see, a shift in the balance of power within the EU in favour of Paris. Within the EU, Britain was a kind of super-power. But without it only Paris can provide credible power projection in the Middle East. One of Europe’s most important geo-strategic sources of threats and risks. And it will take Germany years to rebuild its Bundeswehr (Armed Forces). All rising economies of the world have an inherent geo-strategic interest in closer or stable ties with those five powers; they all pursue their national interests by balancing those relations. One reason why the Pacific Alliance is so successful despite their little intra-regional trade is that Chile, Mexico, Peru and Colombia have very compatible open economies and, together, a superb set of complementary geo-strategic strengths. This allows them to neutralise their individual weaknesses. Chile is a staunch ally of Britain, Colombia is a staunch ally of the USA, Mexico is economically tied to the USA, while Peru has used its economic miracle to develop close ties to China and strategic military ties with Russia. As they grow in power and influence, their alliance allows them to keep good relations to the USA, Britain, China, Russia and France.
5. How could the overwhelming majority of experts get the BREXIT referendum wrong?
Some have rushed this week to doubt their competence. That may be the case for many post-modern economists, with a much bigger expertise in finance & banking than macro economics, but I disagree otherwise with this simplification. The reality lies closer at hand. Many of the economists, CEO’s of big firms and university professors that were invited to speak in mass media can barely be neutral and objective (read: independent) in their view of the EU. Why? Their institutions are among those that have benefitted the most from the EU, EU regulation and its integration process. Tougher – albeit not necessarily useful – regulation has greatly benefitted big firms, and big financial firms in particular at the detriment of smaller competitors. Many universities have made themselves hugely dependent on EU funding. Big firms have been able to increase their profit margins by shifting production to cheaper EU nations and by hiring cheaper EU nationals. Some argue that the EU knows how to secure the support of those shaping culture & opinion: those leading in the economy, finance, education, arts, media … etc with massive money transfers, special treatment or favours. Whether true or not, many of the experts that spoke and are still speaking to the public on the need for Britain to remain in the EU cannot make the case that they are totally independent from the EU nor can they make the case that their judgement is not at all impaired by any overlap or conflict of interests.
A large number of those that today see themselves as Europe’s elite advanced their careers thanks to the EU. Their judgement is to some extent compromised or impaired by an overlap of interests. And this doesn’t mean that there were not many positive aspects about Britain remaining in the EU. Nothing against letting those benefitting from the EU addressing the public, but the media failed utterly by not openly disclosing the overlap or collusion of interests of those they interviewed, but also by failing to choose to interview experts that had nothing to lose if Britain would depart from the EU. Normal people are more intelligent than those leading in politics and media tend to think. The media is prompt to bash the financial industry, but it seems to me that the financial industry today does a better job in disclosing any material overlap or collusion of interests.
Being so sure of their case and bold enough to parade & interview those experts aligned with their pro-EU narrative without disclosing conflicts of interest, it is understandable that many exponents of mainstream media are now bewildered that millions of Britons did not buy their arguments. Many have forgotten that normal citizens cannot be easily swayed by academic rationales, formulas and big names (IMF, World Bank, President Barack Obama, former Prime Minister Tony Blair etc), and we should not forget that many well-educated and well-off people voted for Brexit too. Common people rely on their healthy common sense. And many studied people have lost it. A scientist that won a major prize for his discovery once said, (I paraphrase) during those years before my theory was proven wrong, the only people that were not convinced by me, were normal citizens. Other scientists were carried away by my formulas, title and award.
But the above does not explain the whole magnitude of the failure. Those experts that wanted to warn about the eminence of Brexit were not allowed to speak in mass media. And yet there is a large number of experts that failed for a reason that I see as systemic. The highly competitive and cost-conscious atmosphere in the current World Economy (see next paragraph) has only augmented the risk-aversion among experts and analysts. Thus, experts are tending to drift closer to the consensus mean or consensus opinion. It is preferable to be wrong with everybody else, than risking losing one’s job for being totally wrong. That is not a simple undertaking though, experts have complex ways of reducing their risk exposure and securing their jobs. Thus, some auto-correlation may not be able to be statistically separated from the opinion of the market opinion leaders.
Market consensus also missed BREXIT – Is it simply flawed or systemic?
One strategist interviewed by an influential financial TV channel, was confronted by the TV anchor with the fact that the consensus of strategists & economists grossly missed to anticipate the BREXIT. The strategist kept his cool implying graciously that he had not agreed with the majority at all, but his opinion wasn’t included in the consensus either. This triggered a somewhat harsh reaction by the anchor, probably because his/her employer provides that influential consensus estimate and many people assume that the consensus on an important matter encompasses all economists & strategists with a public opinion on that matter. But that is not so.
The question can be asked. Whose opinion gets included in these consensus estimates? This matters, because most financial professionals tend to use market efficiency hypotheses to build their portfolios, leading many of them to replicate the market and to follow the consensus that shapes it. It is a complex world, but to some extent it is the same old problem of the financial industry that became obvious in 2000 and 2008. There is often a business relationship or overlap of interests between the parties involved. Credit Rating Agencies were assessing the risk of company products (like sub-prime structured products) that happened to be issued by clients paying big fees to those same agencies.
But we should not point fingers at any one company. Every data provider has business constraints. The current situation simply reflects the nature of the financial industry and the global investment industry in particular (a powerful one). I have been part of that industry myself for many years and I’d confess that we like to read the same papers and magazines, we frequent the same restaurants, we dress alike, we speak a highly elaborated language etc. Other industries have seen a similar déformation professionnelle (or job conditioning), but the investment industry operates with much more money, impacting all other industries.
This has shaped over the past 30 years a somewhat elitist investment industry, with two additional developments potentiating it. First, many mathematicians, engineers and physicists have migrated into the financial sector to contribute to it, but they also try to make an exact science out of it. At the same time many in the financial industry are trying to get into the buy-side or asset management industry. Second, since the year 1999, the financial & investment industries have been drifting from crisis to crisis. Once thriving firms are cutting costs and cutting off employees. Traders have been eliminated and fund managers are been squeezed by ever more complex regulatory and compliance demands. In that highly competitive environment where payrolls are shrinking and many are trying to get in, only the most experienced & cheapest employees can survive and few can afford to take unnecessary risks. When risk-taking is discouraged or punished, and all portfolios have to look alike, diversity of opinions fades away. Thus, even experienced strategists and economists are barely daring to speak out their mind or deviating too much from the consensus in the industry. And we have unwritten industry consensus ideas: If you say “the Swiss Franc is overvalued”, “never fight the Fed”, “gold is foremost an inflation-hedge for retailer investors” or “U.S. treasuries are risk free” you are in good company and safe. If you deviate from that, you are treading on thin ice. Gigantic portfolios are built upon and invested along those seemingly infallible truths.
All that has only been compounded by a difficult macro environment since the end of the Cold War in 1999. Indeed, over the past 17 years, big financial & investment institutions have been caught wrong-footed by external shocks and policy action more than 10 times already. This fast-morphing macro environment, where geopolitical-political-external factors are impacting financial markets, has potentiated the risk aversion of strategists, economists and analysts. I believe, the above explains why so many outsiders perceive a “closed ranks mentality” across the financial industry. It is important to understand this, otherwise one may have the impression that financial experts are simply incompetent, incapable or corrupt. The failure of consensus goes even beyond this analysis: the interests of institutional investors have become dangerously aligned with those of policy makers. And policy makers & regulators bare the brunt of the responsibility for this. Thus, to know whether Chinese GDP growth is in fact as high as 7.9%, is less important than sticking to the official headline number. Few investors have any interest in the magnitude of the problems to be laid bare and markets going into meltdown.
I conclude with the inference that as long as this Global Transition full of uncertainty goes on, market consensus is poised to err again and again. Consensus, structured products and conventionally diversified portfolios will fail investors when they need it the most. Why? In times of crises asset cross correlations, liquidity and financial models implode. It is rather a systemic failure and not the unilateral fault or incompetence of the investment industry.
The good news is that a growing number of decision makers are seeing the need for truly independent perspectives that can add value to them. Since a complete overhaul can be disruptive and counterproductive, complementing a well engineered but somewhat constrained investment process is an option many are pursuing.
Christian Takushi MA UZH, Macro Economist & Strategist, Switzerland – June 30 2016 (adapted for public during 1-13 July 2016)
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