A Big Week for Central Banking

Will the Draghi bounce last? US stocks closed up for the fourth week in a row on Friday. But here in the UK, it’s a big week for policy and data and the pound. I’ll get to the central bankers in a moment. But let’s begin with George Osborne.

The chancellor presents his budget on Wednesday at 12:30pm GMT. Before he does, it’s worth wondering whether Britain has real Conservative economic managers at the helm. They’re Tory in name. But are they really Conservative? I’m talking about men and women who genuinely believe that free enterprise, private property, sound money and the rule of law create wealth, not a government budget.

To the chancellor’s credit, he’s halfway to his target of eliminating the budget deficit he inherited. When he took the helm, the annual deficit was over 10% of GDP. It’s now around 5% of GDP. His target for this year was to run a deficit of around £75.5 billion. The early numbers leaked to the press look like it might come in about £5 billion higher than that.

But here is an important point to remember: lower deficits don’t reduce the total debt. They add to it. It seems like an obvious point to make. But smaller deficits are still deficits. And every month Britain’s government runs a deficit, the long-term deficit grows larger. See below.

Click to enlarge

When debt grows faster than GDP, the net debt as a percentage of GDP gets larger. If only GDP were growing faster, then maybe the debt wouldn’t be such a drag. It certainly isn’t stimulating the economy. And it complicates Osborne’s pledge to run a surplus by 2020.

Given that he’s a politician, the simplest course of action is to renege on the pledge. He could blame China and its currency devaluation. Or the Bank of Japan and negative interest rates. Or the European Union and the huge trade deficit the UK runs with a slow-growing, sclerotic economy. Most people would accept that and move on.

But if he’s fair dinkum about hitting his smaller deficit targets then he must either raise taxes or cut spending. In November, the chancellor was saved from a costly political decision by the Office of Budget Responsibility (OBR). Thanks to lower interest rate charges and a change in the way in calculated future returns from VAT, the chancellor found a mere £27 billion extra he hadn’t expected.

This time around it may not be so easy. OBR is set to revise down its expectations for 2016 GDP growth from 2.4% to 2.2%. The debt may once again grow faster than the economy. Osborne’s response, reportedly, is to go after tax evaders. That’s always popular!

It’s also a bit ironic. You have a Conservative government going after people who are minimising their tax. And the people minimising their tax appear to be mostly people in the public service!

These normally public-spirited servants of the BBC and NHS have set themselves up as ‘personal service companies’. As such, the papers report that they pay less in income tax and national insurance than they would as full-time employees. It’s a clever and perfectly legal tax dodge, so far as I can tell.

But Osborne knows an easy target when he sees one. Just remember this, under a Conservative chancellor, the UK’s net debt stands at £1.58 trillion. Deficit reduction is not the same as debt reduction. Meanwhile, total spending climbs each year. More on that tomorrow.

A big week for central banking

Osborne may be overshadowed by Bank of England (BoE) Governor Mark Carney. The bank’s Monetary Policy Committee has to walk a high wire when it meets Thursday. The bank reckons Brexit risks a much bigger trade deficit and a crash in the pound. That could trigger a blow out in the current account deficit, where foreign direct investment in the UK dries up. Why would that happen?

If Britain does vote to leave the European Union, Article 50 of the Treaty of Lisbon says the negotiation to exit could last up to two years. It’s a pretty one-sided negotiation as well. The rest of the EU states decide on the terms. And then Britain can either take it leave it. But if Britain’s already left, then taking the deal would appear to be the only option – no matter how bad the deal is.

But a discussion of the Lisbon Treaty is beyond the scope of today’s report anyway. The point I wanted to make is much more direct. UK shares will have trouble following US shares higher as long as the Brexit uncertainty lingers. And it’s going to linger until at least 23 June.

The bank also has to reckon with the impact of potentially higher oil prices. The International Energy Agency surprised markets last week when it said that the oil price had ‘bottomed out’. That announcement was followed by news that the Baker Hughes rig count in the US – a measure of oil production – had declined to its lowest level since 2009.

The oil price, then could get a boost from a reduction in supply. But keep in mind Iran. Now that it’s back on the global oil scene, the Islamic Republic wants to produce four million barrels of oil this year. That’s supply the market hasn’t had to reckon with in recent years. It also makes the recent rise in the oil price a bit suspect.

Good luck to Mark Carney in figuring out what inflation will do this year!

Poor trade figures and below-par economic growth would argue for a rate cut. But if the Federal Reserve talks about ‘normalising’ US rates later this year when it meets on Tuesday and Wednesday, and if the bank is worried that inflation will pick up later this year, a rateRISE would be the prudent call. Carney’s job would be much easier if he quit and let the free market decide what the price of money should be (and what money itself IS).

Alien intelligence is the new AI

Last week’s podcast featured another discussion on artificial intelligence (AI). But maybe the correct term is ‘alien intelligence’, with an important distinction: alien doesn’t mean extraterrestrial.

A thinking thing that learns to think in an entirely different way than you and I think, can be both intelligent and entirely alien in how it approaches the same problems. That thought occurred after reading the excerpt below from a comment on the Hacker News website.

It shows that ways of thinking that are natural to you and I – because we’re biological thinking things with a bias toward pattern recognition – may not be natural at all to an intelligence that is NOT biologic and which ‘learns’ to think in a different way. From the post by a Go player:

‘When I was learning to play Go as a teenager in China, I followed a fairly standard, classical learning path. First I learned the rules, then progressively I learn[ed] the more abstract theories and tactics. Many of these theories, as I see them now, draw analogies from the physical world, and are used as tools to hide the underlying complexity (chunking), and enable the players to think at a higher level.

‘For example, we’re taught [to] consider connected stones as one unit, and give this one unit attributes like dead, alive, strong, weak, projecting influence in the surrounding areas. In other words, much like a standalone army unit.

‘These abstractions all made a lot of sense, and feels natural, and certainly helps game play — no player can consider the dozens (sometimes over 100) stones all as individuals and come up with a coherent game play. Chunking is such a natural and useful way of thinking.

‘But watching AlphaGo, I am not sure that’s how it thinks of the game. Maybe it simply doesn’t do chunking at all, or maybe it does chunking its own way, not influenced by the physical world as we humans invariably [are]. AlphaGo’s moves are sometimes strange, and couldn’t be explained by the way humans chunk the game.

‘It’s both exciting and eerie. It’s like another intelligent species opening up a new way of looking at the world (at least for this very specific domain). And much to our surprise, it’s a new way that’s more powerful than ours.’

It’s certainly exciting. But eerie may not be the right word. An ‘alien intelligence’ is unlikely to value the same things we do — and that’s allowing for the wide variability in things that human beings value. Would an alien intelligence value life?

There is an application for all this to financial markets by the way. RBS announced its laying of 550 staff, 200 of which are in the ‘advice’ portion of the business. It’s replacing them with a ‘robo adviser’. The ‘adviser’ puts a prospective client through a series of questions and then churns out an investment plan. Et voila!

You can still get advice from a real person. But you’ll need £250,000 in order to speak to a flesh and blood adviser. Under that threshold, and it’s telephone prompts and surveys for you.

Would an ‘alien robo adviser’ come up with the efficient market hypothesis? Would it employ a balanced portfolio? Diversification? Asset allocation? Or would it find the entire idea of spending the last 30 years of your productive life living off the income generated by your investments completely preposterous?


Dan Denning,

Contributing Editor, Money Morning

Ed note: Long time readers will remember Dan Denning, former Publisher of Money Morning. Dan has now gone on to the UK, where he writes for our friends at Capital and Conflict. The above article is an edited extract from that publication.

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