​In every cycle it’s important to understand what causes the unemployment rate to rise in the first place. The next graph charts interest rates and unemployment for the same 30 year period. As you might have guessed, a sharp rise in interest rates preceded unemployment each time.

​​Consumer savings in the EU fell sharply since the pandemic too with consumption peaking around the third quarter of 2022. The money supply in the Euro area has also contracted for the first time since 2010. As interest rates rise, the demand for borrowing falls. As banks make fewer loans, money in the economy dries up.

I’ll officially complete my Masters in Applied Economics next month, on June 7th. With my final dissertation pretty much finished and written, I’m enjoying a bit of downtime now outside of my usual work commitments and reflecting on what has been a gruelling two and a half years of study.
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While it’s quite uncommon, I’m glad I had over 20 years of a gap in-between doing my BA and my MSc because I got to see whether or not the syllabus had evolved during that time. Surprisingly, I found that it hasn’t evolved much at all. Is that a bad thing? Not necessarily. The laws of physics haven’t changed either. E still equals MC squared. We are still standing on the shoulders of giants like Einstein. In economics, the law of supply and demand goes back to the early 1600’s when it was first discussed by medieval philosopher, Thomas Aquinas. Adam Smith then developed it further in “The Wealth of Nations” before Alfred Marshall invented the first supply/demand diagrams in 1890. These diagrams form the foundation of economic theory and are still included in all economics textbooks around the world today.
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The enormous response by our governments during the pandemic is a reminder too that Keynesianism is still alive and well almost 100 years on. In America especially, this in turn has invoked a critical response from the ‘Austrians’ who, like Milton Friedman in the 1960’s, warned of the inflationary dangers from increasing the money supply too much. Many of these old theories clearly remain relevant today and I count myself fortunate to be studying and applying my knowledge of economics at another unique time in history.

This brings me back to Michael D’s criticism of economics where he blamed the profession for not moving with the times and ignoring climate change. In both my undergrad and post grad programmes, the topic of pollution and negative externalities associated with economic development were extensively covered in microeconomics. Questions asked in these units included “how should we tax carbon?” and “is there a socially optimum level of tax that benefits society and the climate?” So, going back as far as the late 1990’s in my case, climate change has always been covered in economics. Michael D has, thus, got this one wrong.

What is Michael D proposing either way? Should we raise carbon taxes at all costs? Sacrifice economic growth and penalise businesses for using fossil fuels? What are the alternatives?  Some politicians have even suggested raising taxes on air travel. With fewer options available for long distance travelling, higher taxes would have little effect on demand and would be of no benefit to the climate. Consumers would bear the brunt of higher prices in the meantime.

Should we tax diesel cars out of existence, too? Again, what are the alternatives? The infrastructure to support EV demand is still too underdeveloped. How many charging points can you count on your two hands around Dublin City? Rural Ireland? Climate change is a real issue but we need to tackle it sensibly. This starts at government level where subsidies are provided to help increase the supply of alternatives, rather than taxing the things that we still need. Funding these transitions comes through economic growth and higher tax revenues. Michael D should know these simple facts.

I do have one major bone to pick with the economics profession, however. Naturally before enrolling in the masters programme I assumed that the assignments would be tougher than what I experienced at undergrad level. I was still shocked, however, at the outsized emphasis placed on mathematics in the syllabus, most of which is pure baloney if I’m being totally honest. I think most economists would agree. The maths doesn’t provide any more insight into why, for instance, monopolies charge higher prices or why technological innovation improves productivity. These same concepts that are taught in undergrad courses get overcomplicated by arduous, theoretical equations at masters level. Masters students are made suffer through pages of high level calculus and linear algebra in almost every topic throughout the syllabus that bear no extra relevance to the concepts they’ve already studied. Outside of academia and research, these equations have virtually no practical use.

In one assignment during a finance module, we discussed the issue of bank runs. Given that one of the papers we were studying had just won the Nobel Prize, The Diamond and Dybvig model of banking, this was surely a unit that I would enjoy. How wrong I was. Instead of discussing bank runs in plain English, we were bombarded with complex sets of equations to describe the simple fact that banks borrow short and lend long. To my bewilderment, our assignments nonetheless involved calculating first and second order derivatives, solving optimisation problems, plotting utility functions, setting budget constraints and eventually arriving at something as indigestible and inconsequential as the following:

Let me repeat, these equations have no meaning in the real world. They are not used by bank managers or investment firms. They are merely theoretical models to explain simple facts. Painful to say the least.
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Another bug bearer of mine was Game Theory, the mathematical application to decision making. If the previous module wasn’t bad enough, this subject is by far the most bizarre, abstract and without question the most fruitless topic in economics. I challenge anyone to justify the relevance of game theory in any practical sense or explain why it is even included in the syllabus in the first place. While the famed Nash equilibrium, a simple concept that supposes a ‘player’ cant improve his outcome by deviating from his existing strategy, is somewhat interesting, do we need complicated mathematical formulas to spell out the obvious? Rival firms, for instance, don’t need game theory to predict what their competitors will do if they lower their prices. A person bidding at an auction doesn’t need game theory to gain a strategic advantage over other bidders. Below is a sneak peak of a typical ‘game tree’. Mad stuff.
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​Aside from satisfying academic curiosity, the majority of the maths found at post graduate level have virtually no use outside of a university setting. I was really surprised by that. I had no idea just how intangible and theoretical most of these models would be.
I’m beginning to fully appreciate now why economics is sometimes referred to as the ‘dismal science.’ What’s the point in all this maths when there’s no place for it in the real world? Even the more practical topics like statistics and econometrics have their limitations.

Let me give you my own first hand example of this. The general goal of most economic research is to find relationships between certain variables, X and Y for instance. Let’s assume X is interest rates and Y is house prices. If interest rates are rising while house prices are falling, we might assume that higher interest rates cause lower house prices. But how can we be sure that other factors aren’t affecting house prices, too? What about the unemployment rate, GDP, or incomes levels? As economists often say, correlation doesn’t imply causation. Other tests are often needed to further prove a point. And still then, they may remain open to interpretation.

One of my final research assignments was a study that involved investigating the causes of inflation in Ireland between 2000-2022. In my model I included the money supply, the unemployment rate, the velocity of money (how fast money moves around the economy in a given time), short term interest rates, government spending and private consumption as my variables. By and large none of my variables seemed to be affecting inflation. The correlations were essentially zero. Understandably, inflation during most of the 22-year period remained fairly stable so, over the long term, correlations between the variables would have been quite small. But what about the years following the pandemic when inflation rose to 9%? Did my model fail to observe subtle changes within the 22-year period? That was the first alarm bell.

Slightly concerned, I explained the scenario to my professor who confirmed my suspicions. Indeed, short term variances in large datasets can sometimes be ignored. Interesting.

Determined to dig deeper, I decided to focus on just the 3 year period between 2020-2022.

I was quickly able to show that as velocity and inflation were rising during the pandemic, the money supply was falling. I found this really exciting as it contradicted standard theory. I also knew from studying QE in Japan that QE, while pushing up the money supply, was very unlikely to impact consumer prices. As we know, QE money stays largely within the financial systems in banks and government bonds because that’s where central banks park their cash. I also suspected that the money supply would shrink as soon as banks stopped lending and the demand for credit fell during the pandemic. This was indeed what my data was now showing. It was a classic liquidity trap.

While velocity slumped during the early parts of the pandemic, the economy experienced 2 velocity shocks thereafter when the economy re-opened partially in mid 2021 and then again in 2022 when the economy had fully re-opened. According to my results, velocity, but not the money supply as many people would have predicted, played a much bigger role in determining inflation in Ireland during the early parts of that period. I present graphs below from Stata to illustrate.

​Fig 1: M2 money supply in Ireland (2020-2022)

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​Fig 2: The velocity of money in Ireland (2020-2022)

​I was also able to show that although government spending soared, nominal incomes remained fairly stable. This again was consistent with what I already knew from managing my own business during the pandemic. And while the government wage subsidies were a great help to workers and firms, they also had to be paid back to the state! I concluded, therefore, that inflation in Ireland had less to do with fiscal or monetary policy and more to do with atypical consumer behaviour and supply bottlenecks, both of which were very specific to the pandemic.

But here’s the catch. While the data clearly guided me to my conclusion, a large part of my conclusion was also driven by my own interpretations and what I believed to be just common sense. Suppose someone else with a different viewpoint argued that the money supply was already very high prior to the pandemic? The lagged effects of monetary policy or bank lending in this case may have caused prices to rise either way. Which viewpoint would be correct?

The answer essentially is inconclusive because of the very complex nature of economic variables and the room for endless interpretation. Political persuasion is another factor. Admittedly, I lean more towards Keynes than Friedman. Had I taken a more Friedman-like approach I might have concluded outright that the rise in the money supply between 2018 – 2020 was enough in itself to cause inflation. If not totally impartial, a researcher will almost always find what he or she wants in the data which can help drive their agenda. Sad but true.
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Ultimately policymakers will base their decisions on a mix of reliable data with some element of common sense and plausible interpretation. And that’s what I love about economics. Unlike physics or geometry, economics is not an exact science and often requires independent and creative thinking to strengthen one’s hypothesis. Economics in this sense is like philosophy. It invites debate and intellectual discourse. It is at times as much to do about opinion, politics and culture as it is about hard data and numbers. Perhaps that’s not so dismal after all.

​In recent years productivity in the domestic economy has been fairly poor by EU standards. We are currently ranked 20th out of 28 EU countries in labour productivity terms. The divergence in labour productivity growth between SMEs and MNEs in Ireland over the last decade is also worrying which the chart below illustrates. While the foreign sector experienced significant productivity gains after the financial crisis, productivity in the domestic economy has flatlined. Not surprisingly, only a small group of multinational firms are a significant contributor to Ireland’s aggregate productivity.

While Ireland scores higher on productivity compared to the euro area, two-thirds of the gap is explained by the pharmaceutical and chemical sector and ICT services. In terms of the domestic economy, labour productivity is almost 10 times less than the foreign sector. As measured by gross value added per hours worked, the foreign sector has labour productivity of around €485, whereas the domestic sector has just €51. Productivity in the domestic economy stagnated since the financial crisis but increased dramatically in the foreign sector.​

Given these stats, I wasn't at all surprised to find a very weak correlation between GFCF investment and productivity in my regression results. Overall, only 7.9% of productivity could be explained by changes in GFCF over the past two decades.
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Consumption and domestic demand in the economy showed very weak links with GFCF as well. The relationship between these variables is effectively zero. Moreover, GFCF has followed a pro-cyclical trend meaning that the Irish government invests during good times but slams on the breaks during downturns. I provide the chart from my Stata regression results below to illustrate. Notice how the government’s investment in GFCF fell dramatically during the financial crisis and is still well below pre- crisis levels. This is in sharp contrast to the other wealthier nations in the EU and OECD who maintain steady investment throughout the business cycle regardless of recessions. Germany, France Denmark and Finland, for instance, fare far better than the Irish in this regard. 

​If GFCF investment follows boom and bust cycles it's a clear that the government lack the courage of their convictions and are far too reactionary. That won't come as a shock to Irish readers given the history of poor planning over many years. 
 
Sadly, when the government do invest, they also tend to make a mess of it. Cost overruns have plagued the Irish economy for decades. The original cost of the National Children’s Hospital, for instance, was €650 million but the final cost is estimated to be approximately €1.7 billion. Other examples of financial mismanagement include the Dart underground project which was eventually scrapped, the Luas, the Dublin Port Tunnel, the national broadband plan, and so on. Instead of providing first rate public services, the return on investment has given us poor broadband in rural areas,  inefficient public transport (officially the worst in Europe according to a report by Greenpeace) incompetence at the DAA, and of course the on-going debacle in housing and healthcare. These are not new problems.

For decades the Irish public has rightly bemoaned the government’s inability to properly manage public services and avoid cost overruns. Some of our basic infrastructure needs are still not being met, yet prices in Ireland are 25% higher than the EU average. This negatively affects our competitiveness and living standards. 
 
While we enjoy a relatively stable political system in Ireland, Irish people are growing weary of ineffective government nonetheless. The lack of real political competency in this country is obvious. To move us forward in any meaningful way we need radical thinkers, political courage and a vision for the country that spans well beyond a 4 year political cycle. If Sinn Fein are regarded as radical it’s probably more to do with their taxation policies or their vision for a united Ireland. I’ve heard very few credible policies from Sinn Fein regarding long term economic planning. They are not alone. 

Why is housing taking so long to fix, for instance? If available land is an issue, why are we not incentivising land owners through tax credits instead of  threatening them with punitive taxes? I don’t agree with other economists on this point. Human nature says "attack and I will defend." Land owners will dig their heels and use every legal trick in the book to delay paying the tax and releasing land. We need to play it another way given the urgency of the situation. Carrot over stick. A tax credit is guaranteed to produce much quicker outcomes than a “use it or lose it” approach.
 
In terms of labour supply, we have lost 40% of our construction workers since 2008 while our population in recent years has grown rapidly. It is estimated that approximately 180,000 construction workers are needed for the government to satisfy their Housing For All scheme and their National Develop Plan. If we haven’t enough builders, why aren’t we attracting immigrant workers back to Ireland to alleviate supply issues and cost pressures? This could be achieved by offering low-income taxes and rental subsidies. If we have nowhere to house these workers, prefab villages and modular homes could be erected by the state on a temporary basis. Irish immigrants built London and New York. Indians and Pakistanis built Dubai. We need similarly bold plans to fix the housing crisis once and for all and prevent the economy from overheating and eventually stagnating. That is now a genuine concern.

Policy that fudges around the edges making it look like something is being done will end in failure. Half measures won’t do. We need to allocate huge resources over the next 5 – 10 years to hard-nosed decisions as a matter of national emergency. Given record budget surpluses in recent years and more predicted in the future, for once money isn’t an issue. The only obstacle is our political will. 

The disruptive nature of dollar flows into the less developed regions of the world when interest rates are low is the primary focus of Subaachi's book. The inflow of dollars to Latin America and Asia, for example, inadvertently boosts poorer countries exchange rates and makes trade less competitive. Government deficits rise and economic growth in these countries falls.
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When interest rates eventually rise again in the US, the poorer nations then suffer capital flight when the dollars move back home. If they’ve borrowed in dollars, which they often do, the dollar repayments become increasingly harder for the poorer countries to service given weaker exchange rates. These events broadly explain the currency crises that befell Mexico and Argentina during the 1990s and early 2000's. Today, as it so happens, the annual inflation rate in Argentina is an incredible 100%.
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The cost of free money and the effects of rising interest rates are of course being felt in the developed world today, too. The so-called “risk free” rate associated with government bonds single handedly took down SVB bank last week and planted seeds of doubt about the robustness of the entire global banking system. While the risk of default from holding US treasuries is almost zero, their values like all other bonds falls when interest rates rise. Why buy a 30 year bond that yields 1.5% when newly issued bonds with the same duration yield 3.5%? When interest rates started to rise last year, SVB got stuck in a liquidity mismatch between the declining value of its long-term assets (treasuries) and its short-term liabilities (customer deposits).

Well-managed banks avoid these mismatches by hedging their interest rate risk through swaps. A swap is a derivative investment that allows investors to ‘swap’ bonds that offer variable interest rates for fixed interest rates. When rates rise, the investor with a fixed interest swap has hedged the risk and protected his/her position against rising yields. Astonishingly, it appears that SVB didn’t buy swaps which left it badly open to a run on its deposits when word got out. Rumours are now circulating that SVB closed down its risk-management department last year, just as rates were beginning to rise.

The consensus among most analysts is that SVB is an isolated case of extraordinarily bad risk-management. The larger and systemically more important banks haven’t, we hope, been anywhere near as reckless. Indeed, in light of the ECB’s 50 basis point rate hike on Thursday, Christine Lagarde must feel quite confident too that Eurozone banks are in rude health. Increasing interest rates into a creaking financial system, however, seems like a huge mistake. The trade-off between inflation and financial stability is now becoming painfully obvious. 

While pausing or cutting rates would stoke fear and cause contagion in markets, pushing rates higher also increases the probability that further cracks in the financial system could occur. In fairness central banks are in an impossible position. Just days after the SVB debacle, news broke that First Republic and Credit Suisse also required emergency lending from their central banks. Treasuries rallied and the yield on the two year note fell to six month lows as investors fled to safety. On Wednesday, the deluge in bank stocks wiped 30% off the share value of Credit Suisse.

Unlike SVB, Credit Suisse had a healthy level of liquid assets and is also reported to have had adequate risk management measures in place too. Its problems mainly stem from regular allegations of fraud in recent years and its inability to stay out of the headlines for all the wrong reasons. Credit Suisse thus became an easy target  given the wider concerns in the banking sector. Despite good liquidity coverage ratios, the bank remains practically insolvent.

Prior to the recent decline in its Tier 1 common equity, which broadly represents its share value and its ability to raise capital, Credit Suisse passed the regulators stress tests last year with flying colours. This goes to show that bank stocks and balance sheets are not always correlated. So while banks are better capitalised since the financial crisis and can cover liabilities in a major event, vulnerabilities still remain from an attack on their share values. 

While, historically, a rising interest rate environment is usually good for bank profits, today’s interest rates reflect higher inflation caused by oil shocks and supply chains, and less so from economic growth. On the one hand, central banks have been raising short term interest rates to fight inflation and on the other hand long duration government bond yields have been in steep decline. This yield curve inversion, typically between the 2 and 10 year treasury bond, is the markets way of saying “we believe economic growth will slow and inflation will fall.” 

Banks may profit from rising interest rates in the meantime but for how long? If deposits are less 'sticky' than once believed, many smaller banks could be forced to pass on higher interest rates to their customers to avoid bank runs. Their profit margins thus get squeezed.

It’s also worth bearing in mind that a lot of the bigger commercial banks nowadays generate profits  through securitization. When a bank creates new loans it quickly sells them on to capital markets as mortgage backed securities and credit card debt. As interest rates rise, however, the value of these assets falls like all bond portfolios. A case in point is the subprime market in 2008. The Fed funds rate peaked at 5.25% in 2008 before the crash. Two years previously interest rates were just over 2%. 

For the non-bank lending sector, the rising interest rate environment could pose serious challenges too. Unlike banks who rely mainly on customer deposits for funding, non-banks rely on capital markets. Non-banks make money from borrowing short and lending long. In an inverted yield curve environment, however, their business model becomes much less profitable. Earlier this year Finance Ireland suspended its fixed rate mortgage offering for durations above 10 years due to falling long term interest rates. As funding becomes more expensive and the ability to provide profitable products becomes tougher, non-banks could suffer significant losses in the short to medium term. 
 
Since the pandemic and the changing nature of work, assets linked to the commercial real estate market are another area of concern. According to the IMF, commercial property funds held by Irish investors in Ireland are valued at approximately 40% of GDP. Roughly, this equates to €190 billion, the majority of which is leveraged debt issued by Irish banks. The banking sector, along with pensions, are thus exposed to falling commercial property values which fell 6% in 2022 and are expected to fall a further 10% in 2023.  

No one knows for sure where, when or how big the next crisis will be. From UK pension funds, banks, real estate or to a major fallout from corporate (and sovereign) debt, as long as interest rates remain elevated so too is the likelihood that something else in the economy will break.

As CPI in the US slowed to 6.5% this month on a year over year basis, inflation is now proving much more (dare I say) transitory than many expected. All things being equal, inflation looks set to continue its slide this year meaning the entire period of rising prices since mid 2021 will have lasted just over 18 months. So much for the hyperinflation predicted by some analysts in the face of 'reckless' government spending and money printing. 

​As I’ll discuss in this article there are many factors that influence inflation, and not all relate to money supply or oil prices. One of these factors includes the velocity of money, or the speed at which transactions take place per unit of time, which in my view has largely been neglected from discourse. Instead, the obsession with monetary and fiscal policy has driven the inflation narrative in recent years which explains, believe it or not, only a small part of the story. 
 
Imagine a simplified economy consisting of 10 people, 1 shop and the total available spend in the economy being €50 which neither increases or decreases. What scenario would be more inflationary, 1 person spending €10 in the shop every day for 5 days or 10 people spending €5 in the shop in 1 day?
 
Let’s return to the velocity topic later, and in the meantime look at how money is created in the economy. This will give us a better understanding of the mechanics of how money works and the channels through which it flows that potentially cause or do not cause inflation along with velocity. There are 2 main sources of money creation in a modern economy for the government, quantitative easing (QE) and borrowing. 
 
QE is the process of a central bank printing money to buy government bonds. The central banks buys these bonds from commercial banks and pension funds, usually in exchange for other financial assets and collateral. Pension funds benefit from rising bond prices and commercial banks use the proceeds from the bonds to lend to other banks in the financial system. As the supply of new loans increases, the interest rate banks charge one another falls. Lower interest rates boost equities and investment banks make profit. These profits flow back into financial markets inflating commodity prices, stocks, bonds and so on.
 
The point here is that QE mainly affects asset prices because the money printed from the central bank stays largely within the financial system. The years following the financial crisis is the perfect case study. Despite large monetary and fiscal stimulus, inflation in the US remained unchanged while stock markets boomed. Despite his best efforts, President Obama’s “helicopter money” had little effect on consumer demand as many consumers chose to save their cash instead of spending it. For large periods of the recovery, inflation hovered between 1%- 2%. 
 
Japan, which invented QE in the 1990s in response to the Asian banking crisis, has been stuck in a deflationary trap for over 30 years despite its central bank pumping huge amounts of QE into the economy during that period. Ageing demographics, a lower propensity to consume and a higher savings rate (which is included in M2 money supply) have suppressed wages in Japan for decades. With a debt to GDP level of over 200%, huge government spending in Japan has failed to create inflation.

The link between money supply and inflation is thus no longer as straightforward as we once believed. Milton Friedman’s famous phrase in 1963 that “inflation is always and everywhere a monetary phenomenon” now appears somewhat ambiguous. Interestingly, in recent months Japan’s inflation rate finally rose above 2% for the first time since 1991. 
 
The latest burst of inflation worldwide, therefore, stems not from the quantity of money circulating in the economy but from the nature of how and when money is spent. Think about the early parts of the first lockdown where a large demand shock to durable goods sent prices soaring. Home appliances, garden tools, gym equipment, barbecues etc. A second demand shock took place to non-durable goods and the services sector when economies re-opened. Prices at hotels, restaurants, cafes and travel-related services all rose sharply. For much of the pandemic, supply shortages and tight labour markets struggled to match the sheer volume and speed of transactions that took place simultaneously that drove prices higher and caused the initial spike in the CPI.
 
Although QE allowed governments around the world to borrow and spend in enormous amounts, wages in Ireland during the pandemic largely remained unchanged. According to the Central Statistics Office, the median annual disposable income in Ireland in 2019 was €42,956. In 2020, it had risen to €43,092, an increase of just €136. So despite the largest fiscal stimulus programme in the state's history, the effects on incomes were almost negligible. And yet inflation still took off.
 
It’s important to note, too, that some of the world’s poorest countries experienced inflation during the same period despite receiving little or no government supports. By the middle of 2021, the inflation rate in Afghanistan for example hit 5%, roughly the same rate as most of the developed countries. Where the US had spent 15% as a share of its GDP on fiscal supports in 2020, the Afghan government had spent just 2.2% as a share of its GDP. The AFN/USD exchange rate broadly remained stable during this time too, so inflation in Afghanistan could not be explained by a devaluation of its currency.
 
Like millions of other consumers around the world, Afghanis spent whatever small amounts they had in short, quick bursts which caused domestic prices to spike. Like in many of the richer economies, inflation in Afghanistan had less to do with an increase in the level of money people held in their pockets but more to do with the speed at which their money was exchanged from person to person. In normal times the velocity of money would be dispersed more evenly over time thus preventing prices from rising so rapidly.

​With this in mind let's return to the imaginary economy mentioned at beginning of the article. Would 1 person spending €50 in the same shop over a period of 5 days (€10 per day) be as inflationary as 10 people spending €5 in the same shop in just 1 day? Very unlikely. Inflation would occur from more people spending on the same day despite the amount of money being spent being equal in both scenarios. Hence, inflation is not always the result of an increasing or decreasing money supply.
 
To be fair, this is probably why central banks assumed inflation would be transitory at the beginning of the pandemic. Even during peak inflation late last year the argument that inflation was the result of longer term structural changes in the economy was fairly unconvincing. Tighter labour markets could push wages higher; but unlikely high enough to cause persistently high inflation. China’s re-opening might cause a spike in commodity prices and the war in Ukraine may also effect the price of oil and gas. But these are all one-off events that will likely affect prices on a temporary basis only. 
 
Indeed the consensus in financial markets now is that central banks could achieve their soft-landing after all, despite all the negative commentary over the past 12 months. Stock markets rallied on the back of the Fed’s announcement on Wednesday that it would raise rates by just 0.25% in March. The S&P is up 8% since last year and the Nasdaq is technically in a bull market climbing 20%. Even Bitcoin jumped 40%. Giddy markets are the last thing central banks want right now, however, and in my view could prove costly to investors. Friday’s jobs report, for example, that showed the unemployment rate in the US falling as low as 3.4% could give more reason to the Fed to hold interest rates higher for longer. So while a soft landing is possible, it’s also very unlikely which history reveals. Since the 1950’s for instance, the US economy has entered a recession within 2 years every time inflation exceeded 4% and unemployment fell below 5%. In all cases, tighter monetary conditions were to blame for falling GDP.
 
The concern over the next year or two, therefore, will be the effects of higher interest rates on the economy. Because monetary policy acts with a lag we might only start to feel last year's rate hikes early this year and this year's rate hikes 6 months from now. It’s unlikely too, even in the case of falling inflation, that central banks will suddenly and dramatically cut interest rates. Barring another crisis, the days of interest rates at the zero lower bound are likely over for a very long time.
 
Finally, to bear in mind that banks will be in no rush to pass on rate cuts to customers when rates do finally fall. In 2002, for instance, AIB passed on 0.25% of the ECB’s 0.5% cut 12 months later. And in 2012, AIB increased interest rates even as the ECB was cutting its main deposit rate. Only market forces determine the destination of bank rates, therefore, and in Ireland with the exiting of KBC and Ulster bank, the market has never been less competitive. Irish customers can thus expect elevated interest rates for quite some time and unfortunately despite declining CPI, more pain lies ahead.
 
Should economic conditions worsen the government will at least know that generous fiscal policies that support the economy are unlikely to cause inflation. Inflation is, after all, always and everywhere a velocity phenomenon.

​​In 1974, US economist Arthur Laffer devised a novel policy that aimed to generate higher tax revenue for the government. The idea, although controversial, was simple. By cutting corporation taxes businesses would create more jobs and improve economic output. After almost a decade of high unemployment and inflation, economic policy thus shifted towards supply driven incentives. Lower taxes, Laffer believed, would kick start the economy and boost government revenue in the longer term. 

By the early 1980’s the US economy was in a deep recession. Interest rates had peaked at 19% and in 1982 unemployment rose to 10%. Ronald Reagan, who had just come into power, hired Laffer as one of his key economic advisors and promised to put an end to big government.
 
Large deficit spending programmes which had previously defined the past decade were blamed by the Republican party for the runaway inflation of the 1970’s. Under Reagan’s watch, the US economy would be a leaner more self-regulating one, guided by the ‘invisible hand’ and the doctrine of free-markets. Trade would be liberated from state bureaucracy and the government’s role in economic management would be considerably reduced. The Keynesian era thus came to an abrupt end, replaced by a new right-leaning economic system that would focus primarily on rewarding big business.
 
Along with corporation tax cuts, ‘Reaganomics’ oversaw widespread deregulation of the banking sector. Unfettered capital began flowing between banks and financial institutions domestically and across borders turbocharging globalisation. In the period between the mid 1980’s and shortly after China joining the World Trade Organisation in 2001, the money supply in the US grew by 400%. Global credit markets boomed, fuelled by lax lending rules and giddy consumer demand. Profits on Wall Street soared coinciding with the explosion of the derivatives market that quickly began to dominate the investment industry. Today options, forward contracts and futures are valued at over $500 trillion, approximately 7 times bigger than the world stock market.
 
Indeed, the growth in mortgage backed securities and collateralised debt obligations in the early 2000’s, arcane bond investments, were instrumental in bringing down the global financial sector in 2008. Giant bailout packages for banks and insurance companies soon followed curtesy of taxpayers and sovereign governments worldwide. When the dust settled austerity, high unemployment and rising inequality were all to show for an unprecedented period of financial engineering.
 
In the aftermath of the crisis, the economic system was in dire need of a rewrite. The financialization of the economy that enriched a few left large parts of society feeling disillusioned and cheated. The capitalist system had failed and played ordinary workers in a zero sum game designed by elites. The recovery period was slow and arduous. Where public investment was needed, politicians chose spending cuts. Tax increases replaced subsidies and policies turned yet again towards reflating asset prices. Zero percent interest rates and new unconventional monetary policies such as quantitative easing pulled capital out of domestic economies into stock markets and global property funds. In Ireland, house prices and rents have since surpassed their pre-crisis levels in 2007 outlining the calamitous nature of social planning and the failure to prevent yet another housing bubble in just over a decade.
 
While globalisation lifted billions of people out of poverty in China, millions of American’s lost their jobs or saw their wages badly affected by the outsourcing of labour to cheaper regions in Asia. By 2016 Donald Trump’s “America First” campaign was well on its way to securing him an unthinkable victory in the presidential election and a year later the UK chose to leave the European Union. Living standards in the UK are now lower than Slovenia and on a par with its poorer European neighbours Portugal and Greece, a far cry from the economic powerhouse it once was some 50 years ago. Brexit is thus a symptom of a deeper malaise that has been festering for many years in the UK, namely chronic underinvestment in public services and regional neglect.

The rise in populism worldwide is of no great surprise. Stagnant wages, rising rents and the disappearance of decent paying jobs are just a few of the common themes we associate with the ‘squeezed middle’. The wealth gap is ever widening and it is now estimated that the wealthiest 10% of households in developed economies hold 50% of the wealth while the least wealthiest 25% own almost no wealth at all. 

Research by the Economic and Social Research Institute shows that the share of 25 to 34-year-olds in Ireland who own their own home more than halved between 2004 and 2019, falling from 60 per cent to just 27 per cent. For the remaining 73%, many are forced into over-crowded rent-sharing arrangements in old shabby buildings badly maintained and poorly serviced by public transport. For the first time in human history adult children are worse off than their parents.
​
Sinn Fein’s surge in popularity is a direct response to conditions young people face in Ireland today. Indeed, in an era of big government, the stage seems perfectly set for a left-leaning party like Sinn Fein to sweep into power and undertake radical reform. While tackling housing would be an obvious priority, the multifaceted issues surrounding the crisis could take years to resolve. Re-designing planning laws, stamping out nimbyism, reducing the availability of public land for foreign capital and so forth take time. Housing policy alone, therefore, is unlikely to form the basis of a winning mandate or re-election for a new government. A comprehensive overhaul of the tax system in the meantime, however, could serve as the blueprint for a new beginning of economic prosperity and fairness for all. Decades after the Laffer Curve helped benefit the rich, tax cuts for ordinary workers would ensure that a wider demographic get a more equal slice of the economic pie.
 
One idea would be to increase the threshold where a person starts to pay the higher rate of tax from €40,000 to €50,000. Any earnings up to €50,000 would thus be taxed at 20%. These adjustments would mostly benefit 60% of the salary distribution in Ireland. Approximately 6 out of every 10 workers would see their standards of living dramatically improve. There would also be positive knock-on effects to VAT receipts for the government since most of the spending in the economy takes place within this income range. Given that their needs have already been met, higher incomes have a much higher savings rate than lower incomes. The highest 10% of incomes, for instance, allocate a higher proportion of their earnings in non-productive areas of the economy such as stock markets.
 
For the purposes of the exchequer and to close the short fall in income tax revenues, the government could introduce wealth taxes. As attitudes towards wealth and inequality have soured, these policies would be widely welcomed. Wealth taxes would consist of both a higher band of income tax plus higher property taxes. In Ireland, approximately 12% of households are defined as millionaires where the value of their labour income plus returns on investment and property, less what they owe, is valued at over €1 million. In the past decade the number of Irish millionaires has doubled, largely due to rising property prices and booming stock markets. On average, owners of capital with assets valued above €1 million earn over €200,000 per annum from their labour income plus around 5% -7% on financial assets. It is now estimated that the top 1% of Irish society own 25% of Irish wealth, two-thirds of which is tied up in property.
 
In response, a new tax rate of 50% for labour incomes above €200,000 per annum would be applied plus a ‘millionaire’ tax of 55% on any individual with net worth exceeding €1 million. Property taxes would also increase for homes valued at over €1 million. Currently, local property taxes in Ireland for homes in that range are taxed at approximately 0.1% 0.15% per annum. Adjusting the rate to 0.5% would mean a household that paid €1,000 per annum on their €1 million home would now pay approximately €5,000 per annum. Spread out over 12 months and divided by 2 working adults per household a repayment of approximately €208 per month seems an affordable outlay.
 
Critics will no doubt argue that taxing high worth individuals discourages entrepreneurs or damages businesses. Entrepreneurship, however, is a natural instinct that can’t easily be switched on or off. The unrelenting drive to seek market opportunities is a distinctive characteristic of an entrepreneur which is written in their DNA. During the 1960’s, for instance, the golden age of economic expansion and invention in America, income taxes were as high as 77%. People adapted and businesses flourished. The introduction of relatively small wealth taxes in Ireland will do little to subdue animal spirits. The world will go on. 
 
The world will indeed go on and perhaps take a brave new direction. The enormous fiscal packages unleashed by governments during the pandemic may have been the inflexion point that inadvertently catapulted society forward towards a form of ‘social capitalism’. Responsive governments, workplace empowerment and a general shift in the axis of power from capital to labour forms the fabric of today’s post pandemic world. Politics will blow with the wind, as it always does, and choose the path of least resistance. Political incumbents and challengers alike will curry favour with popular opinion while desperately grappling for power. That power now lies firmly in the hands of the proletariats while the elite classes look on, forced to pay their fair share as a new economic order unfolds.

​I remember around the middle of last year, Gorilla Post Production, the company that I founded in 2009, hit an extremely busy period. It was by far the busiest period we’d ever had in 13 years since we started. In the final two quarters of 2021 our revenue almost doubled compared to the same period a year earlier, and was 35% higher compared to the same period in 2019 before the pandemic. Over all, our revenue in 2021 and 2022 will be roughly 25% above pre pandemic levels on an annualised basis. 

Like so many other businesses in recent years, demand for our services skyrocketed. While our costs increased significantly, higher volume ensured we remained profitable. The past two years will be our best by far by any measure in over a decade. And that’s what has me worried. 
 
I wrote here in January and discussed in my first podcast that despite impressive economic growth for most developed countries since 2021, I felt that the rebound was temporary and would precede another downturn. The sudden surge in consumer demand was bound to be short-lived, as was the historic level of government spending and provision of subsidies. Abnormal profits and soaring share values were just some of the tell-tell signs of a classic bubble. Over-hiring and obscene wage demands in some cases reflected the irrational exuberance that often accompanies an overheating economy. The laws of diminishing returns are rarely betrayed, however, and so it came to pass in recent weeks. The mass redundancies in Big Tech is an astonishing case of misjudgement of the economy by some of the brightest minds in business.
 
Aside from falling profitability, share values in these large tech companies have come under severe pressure since inflation and higher interest rates. When interest rates are low, the cost of capital falls and stocks rise. When the tide turns, higher interest rates reduce investment and drag down share values. Tech equities and risk assets such as Crypto are first in the firing line.
 
But even in my own line of work, in the TV and film industries, streamers have started downsizing and are turning to ad revenue in a desperate bid to tackle rising costs and boost share values. Post lockdown demand for content has significantly fallen from its high in 2020 leaving a glut in expensive programming and fewer subscribers. In an increasingly competitive market, and in an environment with higher interest rates, a reduction in spend is the obvious response. Investors now expect film studios to provide more value added to their consumers and a higher return on capital. The race for content in the ‘golden age of television’ has likely come to an end.
 
While equity markets rebounded on the back of a 0.5% monthly fall in inflation between September and October of this year, rate hikes are far from over. Speculators beware. Monetary policy will remain tight until central banks believe inflation is on a sustained downwards trajectory towards their 2% targets. At best the Fed will pause indefinitely at the so-called "terminal rate" of around 5% next year to keep inflation at bay. While not overly restrictive by historical means, 5% is still a significant jump bearing in mind, for instance, that mortgages could get re-priced at 7% or 8% after factoring in bank margins. Pivoting too soon, though, would be a huge mistake by central banks which history  reminds us of. 
 
In 1974 US inflation and interest rates hit 11.04% and 10.51%, respectively. The following year the Fed reduced rates to 5.81% thinking inflation was under control but by 1980 it had jumped even higher to 13.5%. Soon afterwards Paul Volcker, the then chairman of the Federal Reserve, quipped, “even a little inflation is still too much inflation.” In 1981 he took no chances and raised interest rates to 18% which eventually crushed prices and caused a deep recession.
 
Jerome Powell makes no secret of being a huge fan of Volcker’s and has regularly signalled to markets that rates will keep rising until “we get the job done.” Getting the job done means a considerable cooling down of labour markets and causing a rise in unemployment. Incidentally, there has never been a time when inflation has fallen back to target without a recession.
 
The ECB announced this week too that it would continue raising interest rates despite worsening economic conditions in the Eurozone. Average inflation is currently 10.7%, much higher than the US reflecting the Euro’s relative weakness against the dollar and higher gas prices. Reducing inflation to 2% will require even tougher decisions by the ECB. The deposit rate at the ECB is still only 1.5%.
 
While real wages adjusted for inflation have fallen over the past 12 months, demand for everyday goods and services has remained extremely robust. Although no one likes it, most consumers will put up with a few extra euro added to their grocery bills each week or 5 cents to their cappuccinos. The real pain will come from higher mortgage repayments which are inevitably coming.
 
The OECD estimates that Ireland’s economy will grow at less than 0.9% in 2023 and 2024. This compares to 5% forecasted for 2022 and 15% in 2021. This is a significant fall in economic output despite the strength of our multinational sector. Indeed, a general fall in corporate earnings is now likely the next phase in the economic cycle, meaning further pull backs in stock markets and rising unemployment over the next 2 years. For bullish investors hoping that the end of 2022 is a ‘buy the dip’ moment, the reality is it's probably not.
 
I came across an interview with Robert De Niro the other night when scrolling through YouTube. In it he says “when things are going well just be calm. Don’t think you’re on top of the world and don’t get ahead of yourself. No one is indispensable.” I immediately thought of Ellon Musk and the recent chaos in Big Tech. I also thought of my own business. When something seems too good to be true it usually is. Buckle up. Leaner times are ahead.

The drag on consumer demand from rising prices and energy bills is causing public outcry across much of the developed world. Naturally the policy response from governments has been to offer large fiscal packages to sooth the effects of soaring inflation. In the short term, subsidies and price caps will undoubtedly help cash strapped households and businesses navigate a gruelling winter. 

But policymakers should take caution before over priming the fiscal pumps. As interest rates have been rising in the US to tackle inflation, global capital has shifted towards the dollar as a safe haven, strengthening its value and rewarding bondholders with higher yields. The Fed’s tight monetary policies and its winding down of QE programmes means that there is now a growing global shortage of dollars in financial markets. With increased demand and falling supply, the value of the dollar rises higher. Since August this year the dollar has reached a twenty year high against all major currencies. For some weaker countries, a watchful eye on government spending will be needed to preserve their exchange rates and avoid higher inflation. 
 
In the past year alone, the Japanese Yen has suffered a 20% devaluation against the dollar, mounting pressure on the Bank of Japan to raise interest rates and end its decades long QE programmes. Given weak economic growth and relatively lower inflation, the response by Japanese policymakers, however, has been a promise to keep interest rates  close to 0%. 

​Instead, to protect the Dollar/Yen exchange rate from rising further, the Bank of Japan will directly intervene in foreign exchange markets for the first time since 1998. By using dollar reserves to shore up the Yen, the BOJ hopes to cap the dollar exchange rate without having to raise its interest rates. US Hedge funds with sizeable short positions in the Yen will be watching closely. Should the $1/Y145 threshold be breached the BOJ could be forced to fight the markets, which it is unlikely to win. For now, at least, it is a gamble the BOJ is willing to take. 
 
Perhaps the biggest gamble of all, however, is taking place in the UK. The economic response to the cost of living crisis by new prime minister, Liz Truss, of £45 billion is the largest giveaway by any British government in fifty years. In 1972, at a time of similarly high inflation and an energy crisis, the then chancellor, Anthony Barber, introduced a budget that at first led to a temporary uplift in growth but was soon followed by even higher inflation and a currency crisis. Two years after the so-called “Barber Boom”, the UK applied for an IMF bailout.
 
The current UK chancellor, Kwasi Kwarteng, is claiming that his mini budget marks a new era for British economic policy; but the similarities between his budget and the one in 1972 are striking. Given how tax cuts and excessive borrowing measures led to economic calamity in the 1970’s, Kwarteng’s budget might be mistaken for, at best, an act of desperation or worse political point scoring rather than sound economic planning.
 
Since the budget was announced on September 23rd, the Sterling has fallen to its lowest level against the dollar since 1985, reflecting a number of growing headwinds for the UK economy that financial markets now clearly recognise. Among these include Brexit and a widely held view that the UK, given its poor trade relations worldwide, political instability and mounting deficits, now resembles an emerging market economy in Latin America  rather than a fiscally responsible first world nation.
 
While cutting the higher tax band from 45%-40% is aimed at jobs growth and boosting GDP, these measures clearly only favour higher earners. In addition, a reversal of the previous government’s plan to increase corporate taxes to 25%, Liz Truss’s U-turn promises to keep corporate taxes at 19%. Overall, factoring in the various tax cuts and subsidies, the budget dividend for a worker on £20,000 per annum will be just £186, while a worker earning £200,000 per annum will be better off by £2,000. An extreme case would see a worker earning £1,000,000 a year better off by an eye-watering £50,000.
 
Subsidising high worth individuals in the hope that businesses create new jobs may seem intuitive. But these ‘trickle-down’ economic policies have, over the decades, often failed. For one, higher profit margins from lower corporate taxes tend to get re-invested in stock markets and corporate share buyback schemes, not in job creation.
 
Second, studies show that high earners spend far less of their income than the lower or middle classes since their needs have already been met. As consumption makes up roughly 70% of GDP in most modern economies, tax cuts that benefit the rich are unlikely to have any measurable effect on UK economic growth.
 
In his seminal book, “Capital In The Twenty-First Century, French economist Thomas Piketty shows that since the early 1980’s, a decade that defines the trickle-down economic policies of Margaret Thatcher and Ronald Reagan, the return to capital has outpaced the growth rate of output in most of the advanced economies. Due to corporate tax cuts, deregulation of the banking sector and diminishing influence of trade unions, the wealth gap has widened to all time highs.
 
Since the late 1970’s, the effective corporate tax rate has been steadily declining, most noticeable in the US and the UK. Nation states have themselves become pauperised by falling corporate taxes. In the UK the main corporate tax rate has fallen from 52 per cent between 1973 and 1981, to 30 per cent in 2008 and to the current day 19%. Many public services remain under funded and social inequality has been on the rise. The UK is now one of the most unequal societies in the OECD in line with Slovenia and the Czech Republic. According to an article published in the Financial Times last week, the poorest Irish person has a standard of living almost 63% higher than the poorest person in the UK.
 
The pound’s recent fall reflects not just a rising dollar but the harsh realities that now face a desperately divided post-Brexit economy struggling to pay its way and creaking under civil unrest. The current cost of borrowing for the UK government over 5 years is 4.52% and rising. This compares to 1% a year ago. With worsening inflation, a weakening pound, and yet another Tory government refusing to accept its economic realities, the probabilities of a bond crisis in the UK are increasing.
 
In 2012, the ECB’s response to the Euro crisis meant buying massive amounts of government bonds. This drove down long term interest rates on government debt and reassured markets that the central bank would act as a stop gap should any debts turn sour. Bond yields eventually stabilised and the crisis was averted.
 
But the economic environment today is vastly different than the one in which Mario Draghi delivered his famous “whatever it takes” speech. During the great financial crisis, a period when central banks were fighting deflation, US interest rates remained low and the dollar remained relatively weak. Higher interest rates in the US today, however, and a strong US dollar are acting like a wrecking ball against global currencies. This severely limits the central bank's ability in some of the weaker economies to ease monetary conditions when bond yields rise. Today, any divergence in monetary policy away from the Federal Reserve's could badly backfire given weak exchange rates against the dollar. 
 
The Bank of England has no choice, therefore, but to continue tightening financial conditions in the UK. This flies straight in the face of the new government’s borrowing plan however, and illustrates a total mismatch of policy between fiscal and monetary authorities. On the one hand, the government wants to borrow its way out of a crisis, while on the other the central bank wants to raise interest rates. Liz Truss’s appointment as the new prime minister, instead of giving much needed stability to the UK, looks certain to exacerbate deep rooted social and political tensions leading the UK down a path towards greater economic misery. 

Given the UK economy’s structural weaknesses, namely falling tax revenues, rising debt and a potential balance of payments crisis, investing in UK gilts is becoming an increasingly risky trade. Bond yields could rise far higher than the government expects. In the short term, the Bank of England could put a lid on rising yields by increased bond purchasing. The effects, however, could be devastating on the pound leading first to a buyers strike on bonds followed by an ever weakening currency and spiralling inflation.
 
The extent to which the UK is now backing itself into a very tight corner financially, suggests that fiscal restraint and structural reforms are its only credible response should it wish to avoid further punishment from financial markets. Despite the populist free-for-all budget of Liz Truss, the prospects of austerity and harsher budgets in the coming years looks inevitable. Should the hard medicine be ignored the indignity of another IMF bailout, the UK’s second in less than fifty years, may yet be forced upon it. In recent times, going it alone hasn’t served the UK well after all.

US CPI is now virtually unchanged from last month, falling only .1% to 8.4%. In response, the Dow Jones fell by 4% and bond yields soared. Faced with the reality of sticky inflation, investors are pricing in more rate hikes over the coming months by central banks who will perhaps start to tighten monetary conditions further still. Hopes for a 'Powell Pivot' are fading.
 
When a central bank increases short-term interest rates, the so-called ‘risk-free’ rate associated with government bonds also rises. This is the fixed income return investors receive from lending to the government. For much of the past decade after the financial crisis, the risk-free rate as measured by a 3 month treasury bill hovered around 0%, pinned down by central banks' loose monetary policies. In response to lower yielding bonds, investors shifted in droves towards stocks and risk assets including crypto.
 
In the period between 2009-2021, lower rates and the glut in the money supply from quantitative easing drove stock valuations to all-time highs. While US GDP grew by just 2% per annum, stock markets boomed.
 
But that’s all changing now due to inflation. Tighter monetary policy by central banks is pushing up short-term interest rates in the fight against rising prices. In the past year the yield on the 3 month government bond has increased from 0% to 2.75%. Longer term government bond yields are also rising. The 10 year US treasury bond currently yields 3.43% compared to 1.35% a year ago. Safer assets are now making a noticeable comeback from the lows of the previous economic cycle, slowly closing the gap on returns provided by stocks. 
 
Since inflation began to rear its ugly head last year, the S&P and the Nasdaq have fallen over 20% from their previous highs. Equities are currently in bear market territory.
 
How further can stocks fall? Since the 1940’s, studies show that on average stocks fall another 13% after crossing the initial 20% threshold, usually bottoming out after six to nine months. Based on these stats, stocks have another leg down to go before levelling off.
 
While it’s unlikely interest rates will jump as high as 20% as they did in 1980, a view of the past may give a helpful glimpse of the journey that lies ahead. As interest rates steadily rose in the 1970’s, a period like today consisting of energy shocks, higher inflation and declining growth, markets fell by almost 40% between 1973-74 and again by 30% in 1981. It wasn’t until inflation and interest rates started to fall in 1983 that stocks began to recover. Given that today’s central banks have only just started quantitative tightening, and bearing in mind that inflation remains stubbornly high, equities are expected to continue their downwards trend in the near term. As Mark Twain once said, "History doesn't repeat itself but it often rhymes".
 
The effects of higher rates on corporate bonds is also concerning. Notwithstanding the probability that economic conditions could soon worsen, the ability to issue new debt at reasonable rates will be a major challenge for many corporations.
 
As mentioned in this blog previously, the level of debt in the global economy of $226 trillion now exceeds anything seen in recorded history. Since the financial crisis alone less than fifteen years ago, non-bank corporate debt in the US has risen by 60%. As a proportion of US GDP, corporate debt currently stands at approximately 105%. Put another way, for every $1 earned, $1.05 is owed in debt. 
 
Last week on September 17th, the Financial Times published an article called ‘The Debt Monsters.’ The article lists some of the world’s most indebted companies including ASDA, Iceland, Metro Bank, AMC Entertainment, and Irish-owned Digicel.
 
Digicel, which is located in Jamaica and has debts denominated in dollars, is offering interest rates on its bonds roughly 2,000 basis points above government treasuries. In short, due to over-indebtedness, a strong dollar, and a rising risk-free rate, Digicel bondholders are being offered a 20% premium on their bonds to invest in Digicel compared to US treasuries. Such high rates seem unsustainable.
 
While Digicel is an extreme case, most junk bonds with 10 year durations are yielding between 8%-10%, up from 5% a year ago. As the credit spread (difference) between the risk-free rate and corporate bond yields narrows, corporate bonds must continue to rise higher to attract investors. As one in five large US corporations is categorised as a ‘Zombie’ firm with a junk bond credit rating, it doesn't bode well for a corporate sector languishing in debt.

Indeed, assuming an economic slowdown in the US occurs, many corporations could be locked out of bond markets from prohibitively high costs of borrowing. A sell-off in corporate bonds by nervous investors sends bond yields soaring while bond prices fall, badly effecting both the issuer and the holder. Over-leveraged bondholders facing margin calls will be particularly hit, as will corporations facing bankruptcy. The safety net of rolling over debt at cheap rates is no longer an option.
 
Last week FedEX CEO, Raj Subramaniam, announced that due to worsening global economic conditions, FedEX missed its quarterly targets for 2022. The firm has since put a freeze on recruitment and withdrew from providing projections for the rest of the year. FedEx shares tumbled by 21.4% shortly after the announcement. As a global shipments company, FedEx is an excellent barometer of consumer sentiment and business activity around the world.
 
Amid recession fears, the traditional response from central banks is to cut interest rates when the economy hits choppy waters. But given how far inflation is from their 2% target, interest rates are expected to continue rising even into a recession. Barring an unexpected improvement in geopolitics, the outlook for stocks is very much tilted to the downside. 

In 2012, for instance, when the US placed sanctions on Iran for abandoning its nuclear plan with the West, it pressured SWIFT to ban Iran from its payment system. The results at first were catastrophic for the Iranian economy. The rial collapsed as bank runs and hyperinflation ravaged the country. But Iran fought back and its economy soon made a quick recovery. By exporting oil to India in exchange for gold, Iran used its gold to buy food and manufactured goods from China. Gold became its new currency and the attack on the rial was short lived. 

Although the ban from SWIFT affected Iran's ability to transact with Western banks, its allies refused to join the sanction regime given their dependence on Iranian oil. As a result, the sanctions didn’t have the desired effect on the Iranian economy as the US had hoped. Sanctioning China for its role in facilitating Iran was also out of the question, as it is now too in the case of Russia.
 
Indeed, China’s trade relations with Russia is a big factor in explaining Russia's recent turnaround in good fortunes. Chinese imports of Russian oil have already risen by 20% in 2022 compared to a year ago. According to Kitco News, Russian gold exports to China have increased by a staggering 750% in July on a month to month basis. 
 
Reluctantly, Europe itself is playing a major role in propping up the Russian economy. Helsinki based Centre For Research On Energy And Clean Air note that €93 billion worth of energy was exported to Europe from Russia during the first 100 days of Russia’s invasion of Ukraine - 20% higher on the same period a year ago. It is also estimated that Russia exports €930 million worth of energy per day; €100 million more per day than it spends on the war. As the largest gas producing country in the world, Russia enjoys a privileged position of having inelastic demand for its energy from its trading partners.
 
Seen in this light the remarkable recovery of the Rouble should be no surprise. Even as sanctions closed off foreign exchange markets to the Russian central bank, Russia simply responded by creating a loophole in existing energy contracts and demanding payment in Roubles. Much to the annoyance of Europe, these new arrangements forced ‘unfriendly’ buyers of Russian gas to open a Rouble account at state-owned Russian bank, Gazprombank. As one of the few banks that are not sanctioned by the West, Gazprombank now exchanges Euros for Roubles and transfers them back to a foreign bank in Europe. From there, the buyer transfers Roubles to Gazprom, Russia's energy provider, in exchange for Russian gas. This financial trickery has pushed up the Russian exchange rate and strengthened the Rouble.
 
In the longer term, however, the economic problems facing Russia in future will stretch far beyond its oil revenue or exchange rates. Rather, the drag to its domestic economy from a lack of vital imports will be a major concern for Russia in the years ahead. Without a steady supply of raw materials and technology, Russia’s manufacturing base risks grinding to a halt. 
 
According to the Russian statistic agency, Rosstat, industrial output in locomotives is down 63% in 2022. Manufacturing of minibuses is down 77%, cast sheet glass is down 60%, domestic refrigerators and freezers are down 58%, internal combustion engines are down 57%, freight cars are down 52% and AC and TV receivers are down 50%.
 
Another study by Yale University shows that since sanctions began in February, imports have fallen by 50%. One thousand Russian businesses have curtailed their operations and half a million Russian citizens, vital human capital for a growing economy, have emigrated. The study estimates that three decades of foreign direct investment have now been erased as a result of sanctions. 

Since the invasion of Ukraine commenced, the Russian government ended its publication of economic statistics. Like China, official data on unemployment and GDP in Russia are likely fudged. The common narrative that the Russian economy is weathering the storm, therefore, should be taken with a large pinch of salt. 
 
There is no official data available on foreign trade, for instance. Inflation, productivity, and exchange rate calculations are thus unreliable, skewing the harsh realities facing many Russian businesses and households. Indeed, considering the capital controls in place that prevent large amounts of Russian cash leaving the country, the exchange rate looks suspiciously overvalued. In time, however, this will change as businesses fail and unemployment rises. The real effects of the sanctions, should they persist, will eventually be laid to bare. 
 
While Russia’s relationship with China is undoubtedly important, China too depends on many of the same raw materials from the West as Russia. Copper, iron, steel, chemicals, car parts, textiles, semi conductors and so on. In 2022, there has been a 90% fall in semiconductor exports to Russia from Western allies due to sanctions. The rollout of Russia’s 5G network has since been postponed as a consequence. While China can import Russian oil, it can't export many of the necessary goods to Russia to sustain its domestic economy or save it from industrial collapse. 
 
Russia’s dependency on Western markets should not be understated, therefore. Its prolonged technological isolation from the world could be fatal to its weakening economy. His promise to reopen the Nord Stream pipeline on condition that Western sanctions are relaxed suggests that Vladimir Putin knows this himself too. His recent citing of a Russian fairy tale in which a fox lets a wolf’s tail freeze is a clear signal of his intentions over the winter months. By inflicting enough pain perhaps Europe will flinch. “Freeze, freeze the wolf’s tale!” he declares. As Western sanctions bite, however, and leave everlasting scars on the Russian economy, it could become less clear who plays the wolf in Putin's fairy tale. 

And yet, the talk of recession rambles on. How do we make sense of this contradictory data?
 
As July’s job figures in the US were not factored into Q1 and Q2 of GDP, it’s possible that the economy may have shrunk between January and June of this year but then rebounded shortly after. This will be very welcomed news to President Biden but less so to Jerome Powell, the chairmen of the Federal Reserve, America’s central bank, in light of soaring inflation.
 
As of August 10th, US CPI is 8.5% on a year-on-year basis when compared to July of last year. This is lower than June's figure of 9.1% compared to June 2021. Inflation, therefore, seems to be headed in the right direction thanks mainly to falling oil prices. Further price pressures on energy may yet occur, however, as China exits lockdown and Russia weaponises its gas supplies in Europe this winter. Some analysts are predicting inflation could hit 11% or 12% over the coming months. 
 
Bear in mind the extraordinary measures by the Fed in 1981 when inflation hit 14%. Paul Volcker, the then Fed chair, increased interest rates to an astonishing 18% and purposely engineered a deep recession. Unemployment rose to 11% the following year and inflation fell to 3.2%. With labour markets tightening and inflation still well above target, today’s central banks may be forced to act with similar resolve. 
 
While interest rates are rising many economists believe they are still too low given the level of inflation. Currently the Fed funds rate is 2.5%, arguably far below the ‘neutral’ rate (neither stimulative or contractionary) as recently suggested by Jerome Powell. Such analysis will do little to improve waning confidence and credibility at the Fed since inflation is over three times higher than nominal interest rates. The real interest rate in the US when adjusted for inflation is -6%.
 
In Europe, the main deposit rate at the ECB is 0% despite a 50 basis points increase in July from -0.5%. Adjusted for inflation, the real rate of interest in the Eurozone is -8.6%. Central banks, therefore, have lots of ground to make up to get inflation under control. The longer they wait the bigger the risk of inflation becoming entrenched and even more tightening needed at a later date.
 
At present, wages are not rising as fast as inflation so in real terms incomes are falling. This should, in theory, have a dampening effect on demand in the short term and inflation may fall. The Bank of England, however, is taking no chances. Andrew Bailey, the BOE’s governor, published on Aug 5th a very gloomy outlook for the UK economy projecting four quarters of negative GDP growth between 2023 and 2024. Given its concern about inflation, which it thinks could hit 14%, the BOE is determined to continue raising rates and live with the consequences.
 
In the US as jobs growth continues, the path towards a 'soft landing' is ironically becoming much narrower. As prices increase and demand for workers continues, higher wages feed into higher costs which firms pass on to consumers. The result is even higher inflation.
 
In normal times, central banks target an inflation rate of 2% by adjusting interest rates and to a lesser extent controlling the money supply. Through careful manipulation of its monetary levers, the central bank achieves a ‘goldilocks’ zone where the economy is neither too hot nor too cold. This anchors the public’s expectations of inflation at relatively low levels. Wage-price spirals are thus a rare occurrence.
 
But given the exogenous supply shocks from the pandemic followed by a demand shock when the economy rebounded, the inflation genie is now well and truly out of the bottle. Keeping a lid on 8% or 9% inflation when the economy is still growing becomes extremely challenging. Added to that is the central banks’ inability to directly control food and energy prices. Central banks can influence demand but not supply. With inflation nearing double digits, interest rates are the central banks main policy tool to reduce demand and bring down inflation. As rates rise, households, firms and governments face higher debt servicing. Along with reduced purchasing power from higher prices, demand is expected to significantly fall. This ‘demand destruction’ is precisely what the markets are now pricing in over the next few years.
 
Consider the inversion of the 10 year yield curve below in July 2022. An inversion occurs when yields at the longer end of the yield curve fall below the short end reflecting where investors believe future interest rates will go. During the lifespan of a bond, if rates rise the value of the bond falls. Investors therefore buy bonds at an interest rate they believe protects their future returns. Buying long bonds at a rate lower or close to short term rates is a sign that the market believes the economy is headed for a recession and a period of much lower inflation. Inverted yield curves have preceded each recession since 1955.​

​With the value of its exports as a percentage of its GDP at 135%, Ireland will hardly be immune from adverse conditions facing the global economy. Europe’s woes including the possibility of another debt crisis are also a major concern; not to mention escalating tensions between China, the US and Taiwan. Our economic fate over the next number of years, therefore, may be out of our hands.​

​As inflation rises, central banks raise short term interest rates to dampen demand. As rates rise, bond prices fall as investors opt for higher yielding bonds. The rout in bond markets has left fixed income investors 11% worse off this year following $2.5 trillion in drawdowns.  
 
While the ECB’s short term deposit rate will increase this year in increments of just 25 basis points (a quarter of a percent), the knock-on effects to long duration bonds have far reaching consequences. The yield on the benchmark 10 year Irish treasury has almost doubled from 0.17% to 2.03% over the past 12 months. Borrowing costs for the Irish government are now twice as expensive than this time last year.
 
Rising government bond yields push up mortgage rates too as banks now factor in higher risk free rates associated with lending to the state, plus bank margins. Standard variable rates could rise as high as 4%-5% next year if the ECB continue to raise rates. Business lending could become prohibitively high too given some Irish banks charge a margin of 5%. That could push rates up to 8%-9% next year for many businesses unless the ECB intervene.
 
In Italy, the Eurozone’s third largest economy, government borrowing costs have trebled over the past 12 months. The yield on the 10 year Italian bond is now over 4%, its highest level since 2014. In 2012 during the height of the Eurozone debt crisis, the yield on a 10 year Italian bond was 6%. The yield on Greek debt reached a whopping 30%. Unable to service their debts, Portugal, Italy, Ireland, Greece and Spain, the so-called PIIGS of Europe, were forced into restructuring programmes. Years of austerity followed and the Euro flirted with collapse.
 
In response, the EU’s “do whatever it takes” approach led to massive quantitative easing programmes (QE) that allowed its central bank, the ECB, to directly monetize EU sovereign debt. These large bond purchasing programmes drove up the price of bonds and pushed yields lower. Interest rates in Europe fell close to zero percent which allowed debt strapped countries to slowly begin re-building their economies. 
 
Given sovereign debt is now even higher than a decade ago, however, the ECB faces a very difficult trade-off between inflation and presiding over another debt crisis. Pivoting so early in its tightening cycle won’t be popular among inflation hawks but the ECB could be forced nonetheless to restart large QE programmes to keep a lid on rising yields. The spread (difference) between German and Italian 10 year bond yields is now 2.25%, over 100 basis points higher than the start of 2022.
 
By careful yield curve control the ECB can still raise short term rates while pushing down the cost of long term sovereign debt via bond purchasing. It's likely this is what the ECB will be forced into doing. Even in the face of high inflation the EU will not risk fragmentation or spreads from widening much further between rich and poorer member states. As the lender of last resort, the ECB will act as a backstop to bond investors effectively guaranteeing a risk-free environment for high yields. Investors who get ahead of the market could benefit enormously from rising bond prices.
 
Interest rate futures are betting on short term rates in the Eurozone to reach 1% by the end of 2023. Although still extremely accommodating at that level, Italian yields could rise to 4% or 5% before the ECB intervenes. It might pay for investors to lock in these higher yielding assets at low cost over a short 2-5 period in the meantime. When QE eventually kicks in there would be no shortage of demand for higher yielding bonds when newly issued bond yields fall.
 
With slowing global growth and a bear market for equities likely to continue this year and beyond, owning higher yielding EU government debt could prove to be the trade of the next few years. PIIGS will fly after all.

With little breakthrough in peace talks between Russia and Ukraine, and fresh restrictions in major cities across China, the inflationary pressures worldwide are likely to get worse before they get better.
 
Clogged supply chains and growing geopolitical tensions are leading some countries to reconsider their borders and trade policies. Many economists believe, a period of de-globalisation could follow.
 
Being less dependent on others for energy, food or medical equipment might circumvent future supply shocks and lessen the risks of inflation. But such protectionist policies may also reduce incomes worldwide and embolden populism.

As France goes to the polls, far-right leader of the National Rally party, Marine Le Pen will be hoping her ‘France first’ and anti-immigrant policies can gain enough support to defeat the incumbent and centrist president Emmanuel Macron. One would hope given the atrocities in Ukraine and the resulting humanitarian crisis, that the French far-right might soften their stance on immigration. Polls show, however, Macron has just a slim 2 or 3% margin over Le Pen heading into the second and final stage of the presidential election on April 24th.
 
Immigration and housing
 
Closer to home, Ireland may face political challenges of its own with regard to immigration policy. The so-called “prefab villages” being discussed by government to house Ukrainian refugees are likely to cause controversy given, among other things, the cost to the state of over €2 billion.
 
While it’s clear an increase in immigrant population could severely worsen the current housing crisis in Ireland, policy nonetheless needs to recognise that in order to build more houses the economy needs more builders. Currently, due to acute labour shortages and high input costs for developers, Ireland’s housing crisis is at a dead-end.
 
One possible solution would be the immediate allocation of existing resources towards building major social housing schemes for immigrant workers. Workers with the required skillsets would be enticed to relocate to Ireland by paying subsidised rent to the state and very low-income tax. Such measures would also help drive down the costs of construction.
 
These programmes, radical as they might sound, have been common place throughout history. Ancient Egyptians, for instance, attracted labourers from different parts of the Middle East to help build the pyramids over 4,000 years ago.
 
Contrary to popular belief, these labourers were not used as slaves but as skilled architects, builders, painters and craftsmen according to research by BBC’s Science Focus. Animal bones found at archaeological sites show that the workers were getting the best cuts of meat while bread jars were also found, hundreds and thousands of them. Such “luxury” foods suggest that workers were very well treated by the Egyptians, the research shows.
 
In more recent times it was Irish, Italian and polish immigrants who built New York City during the early parts of the 20th century. The development of Dubai, now a global region for business, trade and tourism is another example of where immigrant workers, in return for a better life, relocated and built whole cities.
 
As it stands, the viability of the Irish government’s two flagship programmes, ‘Housing For All’ and ‘Slainte Care’ look destined for failure due to the acute lack of builders, doctors, nurses and medical staff. Indeed, the on-going staff shortages at Dublin airport, which is leading to long lines of passengers forming outside terminal buildings, is another reminder of how fractured some labour markets are in Ireland.
 
According to research by the United Nations, net migration in Ireland fell by almost 50% between 2019 and 2022. Since the pandemic, critical sectors such as housing, medical care and hospitality, have experienced the worst of the worker shortages. Policies that attract skilled labour back to Ireland are now vital to Ireland’s economic well-being.
 
Exports
 
Ireland also needs to think big with regard to its exports. While close ties to the US and Europe have benefited its export industries, Ireland should now be turning its attention to the emerging markets in Asia and South America. This is where the next economic superpowers are likely to emerge.
 
India, Vietnam, Brazil and Singapore, for instance, have been enjoying major growth in the last 10 years. New relationships within existing EU trade agreements, should be put in place between Ireland and these growing economies so Ireland benefits from their continued expansion. 
 
It’s no coincidence for example that Australia avoided the last 2 global recessions prior to the pandemic due to its close relationship with China. Australian economic policy shifted in the late 1990’s when it recognised China’s growing economic significance. In 1995 Australia’s exports to China were AUD $1 billion (or 3% of its total exports) but had grown to AUD $80 billion in 2019. Exports to China now account for over 30% of Australia’s total exports.
 
As is stands only 11% of Irish exports are sold to Asia and remarkably just 1% to Latin America. This is in contrast to 30% of exports going to the USA and 35% to Europe. There is clearly room for growth in these emerging markets especially considering that both India and Brazil are large importers of agri-goods and biomedical products - two of Ireland’s largest exports.
 
While some countries may choose to protect their borders, Ireland must do the opposite and pursue even greater openness. Over the next 5 -10 years the aim of the Irish government should be to encourage immigration and continue expanding trade routes overseas. Globalisation need not be a thing of the past.
​

As the heavy bombardment of Ukrainian cities continue, the Russian invasion could yet prove to be Putin's biggest own goal. 

​The internal conflicts within America and Europe in recent years - caused mainly by the shambolic regimes of Donald Trump and Boris Johnson - were the perfect backdrop to Putin's  invasion from a Russian perspective. Indeed, President Biden’s seeming lack of appetite for war in Afghanistan and the subsequent withdrawal of US troops from the region in late 2021, must have signalled to Russia that Western hegemony in geopolitics had reached an historical low point. 

The war in Ukraine, however, has managed to reignite Western influence on the world stage, galvanising a united response to Russian brutality against a European state. Putin may have underestimated this. 

Europe, including Great Britain, seems far more aligned now than in recent years, collectively buoyed to defend one its own from a Russian invasion. Since the war broke out less than a month ago, the EU has committed €1.2 billion in financial and military aid to Ukraine. America has pledged $6.5 billion in defence spending and other measures. More may follow. 

While the West rightly refuses to engage in military conflict with Russia, its economic sanctions have been brutal and could prove fatal to the Russian economy. No other country including Iran has received tougher sanctions from the West than Russia.

The most effective of these sanctions has been the cutting off of the Russian central bank from international markets. Approximately 50% of Russia’s $600 billion war chest of gold, dollars, and other foreign reserve assets have been seized by US and European banks. As the Russian economy falters and its currency weakens, Russia may soon run out of ammunition to defend the Rouble. Central banks maintain exchange rates by buying or selling domestic currency with foreign reserves. When the domestic currency falls in value relative to another currency, the central bank buys more domestic currency using its foreign assets, mainly US dollars.

The Rouble has been in free fall since sanctions began and on February 28th when the West first announced it was cutting Russia off from SWIFT, the global banking messaging system, the Rouble tanked losing 26% of its value. 

Domestic inflation in Russia currently stands at 11%, twice the EU average. But most economists predict Russian inflation could reach 20% by the end of the year. Russia’s central bank has raised interest rates from 9.5% to 20% to stem capital flight and prevent a collapse of the Rouble. Interest rates are likely to rise much higher, however, should sanctions continue. Such high interest rates are a massive burden on ordinary Russian citizens who could yet default on loans and mortgages and cause an internal banking crisis.

The glaring weakness of the West’s economic war with Russia, however, is how badly dependent Europe is on Russian oil and gas. 40% of German energy, for example, is sourced directly from Russia. It is estimated on a daily basis that $1.5 billion flows into Russia from Europe, providing Russia’s central bank with vital supplies of foreign reserves. If the West has any chance of toppling Putin’s regime in the long term without military conflict, it must put an end to buying Russian oil and gas.

Headline inflation in the EU, which includes food and energy prices, now stands at 5.8%, the highest in over 40 years. Taken on its own, energy inflation is 30% on an annual basis when compared to this time last year.

If Europe, like the US, were to stop its consumption of oil and gas from Russia, the estimated increase in energy prices in Europe could treble given the likely delays of sourcing energy elsewhere in the world.

Oil, which is mostly transported by tankers, could be supplied by Norway, the US or the Middle East. Natural gas however, which is the predominant source of energy in Europe, is mostly supplied via fixed pipelines from Russia and constitutes 40% of the continent's energy requirements.

European refineries that convert crude into gasoline are designed for denser Russian oil and would face challenges switching to other kinds of oil sourced from other regions. Countries such as Poland and Hungary who purchase 60% and 90% of their gas from Russia respectively could find any such changeover especially challenging.

Further supply constraints on top of existing shortages could cause a devastating hit to disposable incomes in Europe, which are already feeling the pinch from current inflation. A deep recession could follow. 

But Europe has options. Its co-ordinated and unprecedented fiscal response to the pandemic is an indicator of its financial might and the strength of its currency. The vast majority of the EU’s €2.3 trillion covid fund was spent on furlough schemes and business supports. Mass unemployment on the continent was subsequently avoided. Despite entire industries and businesses closing for the the best part of 2020 and beyond, the global economy rebounded from the deepest economic contraction in recorded history after just 2 months.

The difference in Europe has undoubtedly been the power of its central bank, the ECB, and its commitment to print vast amounts of money and buying government bonds. In the latter stages of the financial crisis 10 years ago, and most recently during the pandemic, newly printed money flowed into financial markets preventing interbank lending from freezing and allowing European governments to borrow cheaply on financial markets.

The idea of excessive borrowing and money printing in the face of existing inflation may seem reckless. The current inflation issues in Europe, however, exist primarily from an explosion of consumer demand and a shortage of goods including oil and gas. 

Even countries as poor as Afghanistan whose government spent only a fraction of its GDP (2.2%) on the pandemic relative to richer countries are experiencing the same inflation as the rest of the world. According to the World Bank, the Afghan currency, the Afghani, has remained broadly stable relative to the US dollar meaning its 5% inflation rate cannot be blamed on a currency crisis either. 

Current inflation, therefore, is largely supply driven. When too much demand meets too little supply, inflation is the result. In good times, consumers spend more than they save. In a war scenario, consumer demand evaporates. Add in higher energy prices and the knock to consumer confidence could be detrimental.

Instead of stoking the inflationary fire, further fiscal support from governments would avoid a massive deflationary shock during an economic depression. Should Europe boycott Russian oil and gas, large state subsidies in response to rising energy costs could soften the blow to European households and businesses. We’ve seen how effective these measures have been during the pandemic. There is little reason to suggest these measures can’t be as effective again.

While further government borrowing would cause deficits to rise and worsen the existing debt pile within the EU, member states can roll over debts if required. The US and Japan have been doing this for decades. If no buyers are willing to lend to these countries (which has yet to happen), their central banks pick up the tabs.

Since the start of the pandemic, 70% of Irish government borrowing has been directly facilitated by the ECB. The EU will never allow smaller nations to be locked out of capital markets again. The so-called ‘PIGS’ of the financial crisis over a decade ago, Portugal, Ireland, Greece, and Spain, are unlikely to ever experience the same economic indignity and isolation at the hands of their own neighbours.

The pandemic has brought much needed fiscal union among member states. It’s hard to imagine that the EU will revert to old austerity policies and risk a collapse of the Euro.

The war itself is likely to delay the ECB's plan this year to raise interest rates. Pinning rates down allows government’s to continue borrowing at very low costs. Despite inflation, raising rates would only worsen the economic environment by making borrowing and investment more punitive on consumers and businesses. Politically, this would be extremely unpopular during a crisis.

For reasons beyond the scope of this article such as demographics, technology and the slowing down of the Chinese economy, the long term outlook for future inflation is that it is likely to remain low. The bond markets seem to agree. 

The yield curve on long US treasuries started to flatten before Russia’s invasion of Ukraine. Many analysts now believe yield curves in the West may actually invert as the risk of a recession seems greater. A yield inversion is when short term interest rates rise above long term rates. Put simply, investors have been increasing their lending to governments in the long term despite receiving very low yields and interest rates. If they believed inflation was here to stay, they would reduce their holdings of long bonds until interest rates rise high enough to compensate for higher inflation and economic growth. But this is not the case.

In war times, even in the face of soaring inflation, investors rush to safe havens such as government bonds. There will be no shortage of buyers of government debt so long as the conflict continues. Europe has the financial wherewithal, therefore, to significantly soften the blow of rising energy costs. 

In Ireland, if the Irish government decided to subsidise all household energy bills by 50%, the rough costs to the exchequer would be €456 million per annum based on the average monthly bill of €160 trebling. That's less than half of what is spent on national defence every year or 0.4% of Irish GDP. The government can well afford it. 

In many regards, recent events have brought nations closer together in solidarity for the greater good. Europe in particular has been made stronger by its adversaries. Brexit, a pandemic and now a war. The solidarity and support shown to Ukraine is a timely reminder of this. 

​One of Putin’s biggest miscalculations may have been to assume the US and Europe would lack the stomach for war. While current sanctions have been bruising to the Russian economy, Europe’s greatest ever show of solidarity would come from its boycotting of Russian oil and gas. That it could be led by Germany, a country where war and inflation are so deeply woven into its past, would be the sweetest of ironies. This would be a monumental moment in European history and one that would surely crush Putin’s regime and bring an end to war without violence. 

Last week’s 22% fall in the share value of Netflix is a symptom of this pessimism shared by many investors. The streaming giant announced that higher business costs will mean higher subscription fees for its customers and growth projections for the year ahead are being revised downwards as a result. Millions of SME's around the world are also facing rising business costs and even greater pricing pressure from its competitors. Paradoxically, inflation is causing some firms to reduce their pricing just to stay in business. 

So far, 2022 has not been a good year for tech companies in particular. The Nasdaq is down 14% since November last year. Global stock markets have had their worst week since the start of the pandemic. Covid-related businesses that relied on 'lockdown demand' are hardest hit. Netflix, Zoom, and even producers of home gym equipment, Peloton, have recently experienced sharp declines in their share values.

Cryptocurrencies such as Bitcoin and Etherum suffered 27% and 38% devaluations respectively since the end of 2021. These recent corrections in financial markets signal that investors are worried about the future. 

What’s causing these concerns? Firstly, inflation. As input costs rise for businesses, many firms may become less competitive and less profitable. Despite its huge market share, Netflix is no exception. Investors also believe that the end of central bank support and the introduction of higher interest rates will badly effect future returns. Up until recently, equities in particular have benefited massively from low interest rates, low inflation, and cheap borrowing costs since April 2020.

By the end of 2020, the S&P gained 18% despite unemployment in many OECD countries rising to 8%. The following year, the S&P gained a further 26%.

At Goldman Sachs, full-year net profit for 2021 came in at $21.2 billion, more than double what it was in 2020 and the bank's biggest-ever year.

The worry now for central banks is that markets have become overpriced. Worse, inflation in most consumer goods has also risen to unacceptably high levels. Supply chain bottlenecks and an explosion of consumer demand has led average prices of goods and services to soar to over 7%. This is the highest inflation reading in the US for over forty years. If kept unchecked, central banks fear the costs of living could spiral out of control as workers and firms bid up prices in the expectation of even higher prices in future.

In response, the Fed (US central bank) is now withdrawing liquidity from markets by reducing the amount of its asset purchasing. When central banks change their policy from quantitative easing (buying bonds) to quantitative tightening (selling bonds), they create dollar shortages in financial markets and interest rates rise. The less money in circulation, the higher the interest rate. Debt servicing becomes more expensive, business investment falls, and investors choose risk-free rates at commercial banks or government bonds as an alternative to stocks. 

It could take much more than three or four gentle rate hikes by central banks to bring down inflation from 7%, however, especially when considering savings in most developed countries are already at an all-time high. And because inflation is largely supply driven, higher rates may prove ineffective either way.  

So why is the the Fed increasing rates? Partly to dampen inflation expectations and to change the appetite for risk among investors. Being less accommodative in their policy says to markets that 'the party is over and we no longer have your backs.'

If over the next six months, inflation fails to come down and the Fed needs to tighten further, it’s credibility will be tested as they carefully balance the trade-off between a large collapse in markets and achieving their ultimate goal of price stability. Some analysts point out that the Fed came to the rescue in 2019 when, after raising rates by 1-2% in 2018, markets fell by 10%; but they weren't tackling inflation at that time. Emergency stimulus seems more and more unlikely if inflation is not firstly brought under control.

The imbalance in labour markets has also exacerbated inflation. General attitudes towards work have changed due to the pandemic. As is being reported by firms in almost all sectors, the so-called ‘Great Resignation’ is seeing millions of workers quit their jobs or go freelance. The gig economy is expanding. In response, many businesses are offering improved terms to retain staff, namely higher wages and more flexible working hours.

While productivity in most unaffected industries remained high during lockdowns, the concern in the long run would be that time away from the office could cause larger staff turnovers if work-from-home measures become increasingly widespread. Human behaviour is difficult to change once habits are formed. As the demand from workers for more flexi hours increases, while having clear benefits to workers, they may also weaken their connection with their employer and tempt them away from their current positions into new roles elsewhere.

How long will these trends last is the question. Businesses will find it difficult in the meantime. A lack of workers threatens output and can drive up costs. If interest rates rise, this will dampen business investment further and add higher costs to mortgage repayments. While labour shortages have caused wages to rise, wages have not risen as fast as inflation, however. Both businesses and workers could find the next year or two very challenging.

For example, the price of most consumer goods has risen as much as 20% since the pandemic, and even higher when accounting for energy prices. Coffees, sandwiches, meals out, rents, house prices, gas bills, and more recently alcohol, have even eroded the purchasing power of improved monthly pay cheques. These prices wont suddenly fall overnight regardless of an improving inflation situation. At best they will stop rising. 

While inflation has risen across all goods and services, wages in comparison have risen by far less in most SME's. According to the latest Conference Board Salary Increase Budget Survey in the US, firms intend to increase their salary budgets by just 3-5% in 2022.  

Barring even worsening supply shocks or geo-political tensions in Russia or China, as wages fail to catch up with inflation, and government spending slows to normal pre-pandemic levels, global economic growth is likely to slow. While large consumer savings built up during lockdowns may keep the party going for a short while, it's likely that consumers will eventually reject higher prices in the longer term. The antidote to inflation may well be inflation itself.

Growth and inflation need consumer confidence and worker wages to continuously move in unison. In previous decades, high inflation and the boom experienced during the Celtic Tiger era was largely driven by prolonged bank lending and over exuberant public and private sectors. 

​As we move beyond the pandemic, a period of unusually high demand and government spending, the outlook for the economy over the next few years looks more uncertain. 

Instead of a genuine discussion on climate action, Cop26 is playing host to political opportunism and guff. The war on carbon is as phoney a war as they come. Tackling climate change should be part of every government’s key policy over the next decade, but how credible can recent events in Glasgow be when two of the largest carbon emitters, China and Russia, fail to attend?

​How genuine is Boris Johnson, the host at Cop26, who in 2015 spoke of climate change as "primitive fear"? In 2019 he referenced demonstrators as "uncooperative crusties" who should stop blocking the streets of London with their “heaving hemp-smelling bivouacs.” Given the mess of Brexit and the UK's on-going threats to abandon the Northern Ireland protocol, which it agreed late last year, the public need little reminding about taking political promises with a pinch of salt.  ​

The unveiling of the Climate Action Plan last week by the Irish government comes with promises of their own. Financial commitments to the tune of €125 billion are proposed to tackle climate change between 2022 - 2030. This roughly represents twice the annual national tax take for a small country of 5 million with an  inconsequential carbon footprint.

Being a low carbon "offender" isn’t an excuse to sit back and do nothing about climate change. Smaller nations can play their part. But the government’s new climate plan places a disproportionate burden on Irish taxpayers when the costs of living are already spiralling. The climate bill will represent the third largest government expense behind social welfare and housing.  

Given the emotive issue of climate change, the public risks being blind sided by ideology, or worse paying a very high price for political correctness in the meantime. If higher costs of living are not an agreeable trade-off for climate action, will people admit it? Being politically correct will play into the hands of politicians who can overpromise, underdeliver, but still receive public support. How achievable are long term goals when political careers are so short anyway? If a week is a long time in politics, 2030 seems like an eternity. On many practical levels, the climate plan could soon unravel in farce. 

Take for example the plan to retrofit homes at a cost of approximately €50,000 per household. Even with the promise of low interest loans and token grants, 70%  of the costs fall on the public. Who, realistically, will be willing to pay these costs? With the housing market already stretched, and the government’s new housing programme set to be unveiled next year, where is the economy going to find enough tradesmen to carry out the retrofitting in the near term? Construction costs could rise even higher.

While the government can tax petrol and diesel cars “out of existence”, as many people would like, where are the alternatives? The electric vehicle (EV) market is still in its infancy and offers very little by way of consumer choice. Higher carbon taxes are not an incentive to transition to EV’s therefore, rather an unnecessary burden on ordinary citizens. If the government is serious about tackling carbon emissions on the road, taxes should be replaced by subsidies for EV producers until an adequate supply of EVs encourages more demand. Currently, there is low supply and low demand for EVs which speaks for itself.

Government funding for subsidies could come from the extra 2.5% corporation tax soon to be available from multinationals as part of recent OECD minimum tax agreements. This money could go towards providing abundantly available electric charging points across the country. When the global supply of EV's reaches adequate levels, Ireland will be ready. 

At such an early stage of the transition, however, increasing carbon taxes on the public makes very little sense. Taxes reduce purchasing power from the public at a time when inflation is already a concern. The irony is that Budget 2022 promises to support lower incomes in the face of rising energy costs. So on one hand carbon taxes are increasing and the other hand the government is offering badly needed hand outs. Clearly, carbon taxes are not effective policy tool. 

The suggestion that public transport offers alternatives to commuters is also disingenuous. Despite more people working from home, adequate bus and rail links are not available to the vast majority of workers in Ireland who still need to travel to work. Surely there is a need to prioritise basic infrastructure first before real gains from reducing carbon emissions are achieved. Projects such as our national broadband plan, for example, should be completed along with upgrades to transportation if work-from-home measures can reduce carbon emissions in the long term. 

The projected €125 billion investment in the climate action plan will need to be revised considerably, therefore, to rebalance the reality that the government faces. A proposal that asks for the lion’s share of investment to come from the private sector is naive to say the least and should be a major red flag. Realistically, for any meaningful transition towards a low carbon economy to occur, massive on-going government borrowing will be required.

While current conditions are favourable in financial markets and EU rules on spending are suspended, the government’s ability to borrow or spend the required investment in future could be a challenge. Inevitably fiscal and monetary conditions will tighten once again as interest rates rise. Small countries like Ireland who are tied to the Euro cannot expect the European Central Bank to monetise their debts indefinitely. The majority of Irish debt is owned by foreign investors. Continuously rolling over Irish debt into the future isn’t a long term option. 

There will be growing pressure on the government over the next number of years, therefore, to reduce deficit spending and increase taxes generally. If the government proceed with their climate plan, will trade-offs in other key public services be acceptable to the electorate? 

The climate plan is estimated to cost €14 billion per year until 2030, over three times the size of the annual budget for housing (€4bn). Given the need for immediate action in other key areas, how serious can Ireland be about its climate commitments if and when faced with these trade-offs?

The approach to climate action for a country Ireland's size should be measured, and one where the economic and social costs are proportionate to its priorities and the reality it faces. Ireland can't save the planet but with a bit of luck it might save its healthcare system or build affordable houses. €14 billion will be a considerable burden on households and the state alike when a more manageable figure of say €3 billion to match transport spending would be more sustainable.

​Climate change is undoubtedly an issue we need to address. Cop26, however, is a giant PR spoof and an exercise in spin to gain public support. It’s clear from the government’s climate plan that they aren’t being honest or realistic about climate action. Perhaps the public aren’t either. 

For many economists the nature of money is still a source of great debate. Who creates it? Is it commercial banks or central banks? Are we creating too much or too little?

Due to the debasement of fiat currencies and rising inequality worldwide, supporters of cryptocurrencies believe the future of money lies outside of the traditional banking system and in decentralised finance, or DEFI. 

According to The Global Macro Investor (GMI), there are currently 150 million crypto users worldwide with that figure expected to rise to 1 billion over the next 3 - 4 years. GMI state that crypto is the fastest adoption of any technology in human history surpassing the internet in the late 1990’s and early 2000’s. With so many people entering the crypto space, prices are predicted to rise exponentially

The DEFI movement is evolving fast. One of the latest innovations is "creator coins"  which, similar to vouchers, points schemes or free miles, are digital tokens issued to customers as rewards by content creators. Spearheaded by companies such as Tilt, ALLIE, and Shank, the aim of these coins is to incentivise brand awareness and to create communities via the sharing of content. The coins are customisable digital assets that can be traded and exchanged for other tokens on decentralised networks called blockchains.

A blockchain is a decentralised database of computer systems and users that communicate and share data. The blockchain consists of everything from financial transactions, customer ID, to legal (smart) contracts. The exchanging of data or validation processes do not require banks or financial intermediaries. There are no centralised authorities such as a central bank who can manipulate the supply of tokens, or powerful social media companies who misuse customer data.

Take for example, a podcast or a video channel. Instead of relying on Youtube, Facebook or Linkedin to provide customer outreach, full marketing control and transparency is now with the content creator curtesy of Rally or the Ethereum blockchain. The video channel can observe the real number of views it receives on its platform while removing the middleman.

The content creator can also issue its own coins or tokens to its followers providing limited access to newsletters, new material, rare interviews, or merchandise. When fans make a purchase, share, like or subscribe, they receive additional tokens. This not only provides a source of funding for the channel but also an incentive for followers to continue to promote the brand while they profit from the buying and selling of the coins on decentralised exchanges. 

The higher demand for these coins, the higher its value. The higher the value, the more wealth it creates for the holder. And a higher value crucially gives greater purchasing power to buy more content at a relatively lower price. 

Unlike many cryptocurrencies such as Bitcoin which has very little use case, tokens can be exchanged for goods and services. So even as the value of a token appreciates, the incentive to sell is less. The same principal applies to traditional currencies such as the dollar or the Euro. Major currencies don’t tend to fluctuate in value when there is reason to hold them. Dollars buy things. Bitcoins don’t.

So companies issuing these tokens create wealth for themselves but also for the communities that support them. Across a whole range of different businesses in the economy such as start-ups, book publishers, video games, vloggers, and artists, the opportunities for growth could be a game changer. Due to their crowd-funding like nature, these digital assets are becoming known as  ‘community’ or ‘social’ tokens. They bring communities together to mutually share in the growth and success of new ideas and brands. 

I wonder how such a model could benefit the TV and Film industry in future. For state broadcasters, community tokens could offer an alternative route to funding, abandoning inefficient licence fees or government taxes. By engaging with the public via an incentivised business model, audiences could support local networks by consuming content in return for tokens. Audiences could then sell the tokens to make a profit or hold the tokens to access more content in future.

The benefits of a ’like and subscribe’ model could help secure commissions for a second or third season of a hit TV series, for instance. Many people believe that tokens or NTF's could revolutionise how companies do business across a wide range of sectors.

Governments too are now developing their own tokens called central bank digital currencies, or CBDC’s. No doubt they will create their own blockchains outside of Ethereum or Rally, but the same incentive structures would still exist.

Issuing CBDC’s to lower incomes, for example, as a part of an "award"-based system to encourage job seeking could be a major policy tool in future. While workers would lose their unemployment benefits, they receive an extra incentive to find work by receiving government tokens.

Likewise, central banks could choose to reward employers who retain staff during a downturn or provide essential skills training programmes. When the interest rate on traditional money (fiat) is low, central banks could offer higher rates to SME’s who exchange cash for CBDC’s at the central bank. This would not only support employment in the economy but also help small businesses.

In tackling private debt, governments could even encourage businesses and households to reduce their debt by offering higher yielding CBDC’s. The same could apply to incentivise reducing carbon emissions. 

There are so many fascinating ways that tokens could change how we live and how we use money in future. In 1942 Joseph Schumpeter, one of the great economists of the 20th century, called the dismantling of established conventions “Creative Disruption”.  These disruptive technologies have powered capitalism throughout the ages and catapulted humanity towards greater prosperity. The lightbulb, railroads, assembly lines, and the internet are just a few examples.

Scepticism regarding crypto is understandable and many will cling to old conventions in order to prevent change. History shows us, however, that technology often has different ideas.

Predicting such events with any level of accuracy is often challenging. There's a sense, nonetheless, that all is not right in financial markets despite recent optimism in the global economy.

The exiting of Ulster Bank and KBC from the Irish market earlier this year is a symptom of a larger issue. This isn’t unique to Ireland either. Over the last decade, approximately 2,000 banks in the eurozone have disappeared. 

Aside from tougher regulatory rules imposed by central banks since 2008, the prolonged period of low interest rates is likely the main reason. Lower rates are designed to make lending more affordable to stimulate consumption and investment and therefore boost economic growth.

When the central bank reduces rates, reserves held at the central bank by commercial banks earn less interest. So AIB or Bank of Ireland, for instance, have a choice. Leave their cash on deposit earning less interest or go out and lend to businesses and households at cheap rates.

Both scenarios reduce bank’s profitability. In some countries like Germany, interest rates have turned negative meaning borrowers don’t repay the full capital being borrowed. Since banks hold government bonds as assets on their balance sheets, lower yields affects their capital structures and thus their ability to create loans. 

Figures released by the European Central Bank in August 2021 show that private sector lending to SME’s in the Eurozone is at the same level as 2015. So at very low interest rates, banks have been reluctant to increase lending. Without lending, consumption and business investment falls. During the business cycle of 2010-2020, average GDP growth was just 2% in the US and Euro area.

While consumer demand has rebounded strongly since lockdowns this year, it is likely that demand will naturally fall away again in 2022. The next business cycle post-Covid could follow similar trends of low GDP growth unless interest rates rise and credit to the private sector increases for sustained periods of time.

The problem facing the global financial system, however, is that interest rates can’t rise without serious repercussions to financial markets. Globally, combined public and private debt levels since the banking crisis in 2008 and Covid-19 are now three times the size of national output. For every dollar earned, $3 are owed. Higher debt servicing for governments and corporations greatly increase the risk of defaults. As a consequence, central banks are artificially suppressing interest rates and buying more debt. How long can this continue?

Low interest rates have also caused large asset bubbles to form in financial markets. Instead of lending to the real economy, banks chase higher yields by purchasing riskier assets. The spread between safer government bonds and junk bond have thus narrowed.

Share buybacks by large corporations exacerbate the problem. As cheap money continues to flow into markets, banks and retail investors use leverage to speculate, driving up share prices further. Holders of these pricey assets, many heavily leveraged, are badly exposed to any corrections in the markets.

Acutely aware of this, central banks need to keep interest rates low to avoid a systematic collapse. Currently the Federal Reserve Bank of America (The Fed) is purchasing $120 billion of bonds and mortgage backed securities every month to keep long duration bonds from rising. Even if investors sell out of their assets and yields rise, the Fed and the ECB repurchase them on secondary markets. Bond prices go up and yields fall again.

How healthy are markets when assets are artificially supported like this? How can risky junk bonds trade at similar yields as investment-grade bonds? How is it that historically high unemployment rates are followed by record highs in equities? What’s causing currencies in emerging markets to strengthen during an economic crisis as large as the Covid pandemic? 

Many analysts worry that should this regime continue long term, the bond market could run out of willing buyers. Overpriced negative yielding bonds are a poor investment. So as governments and corporations issue more debt, demand for these low yielding bonds falls causing prices to collapse and the bubble to burst. Although reluctant to do so, the central banks may be forced to start tightening monetary conditions and allowing rates to rise in order to encourage investors back into the market. This wont come without the risk, however. 

While higher interest rates make newly issued bonds more attractive to investors, existing bond prices collapse in value. If inflation continues to rise, central banks may be forced to raise rates either way. Ironically, economic growth could crash the stock market.

So it seems that central banks are stuck between a rock and a hard place trying to avoid both inflation and higher rates. Investors will be watching very closely how the Fed and ECB taper monetary policy over the next few months, given how strongly economies have rebounded.

When the economy is growing and jobs are plentiful the risk of complacency grows and people get blind sided. The economic growth and housing bubble prior to the Great Financial Crisis in 2008 is a good example of this. Most people don’t follow markets or pay any attention to things like interest rates, bonds or central banks. Understandably, there’s now a great sense of optimism from consumers and business as the economy rebounds back to life - just as there was in 2008 prior to the crash. And as we know, that all changed overnight. 

While Irish banks are better capitalised and stress tested since the banking crisis, the global financial system is careening down another potential dead end and very few are talking about it.

​The markets have become addicted to low rates and debt - and cheap cash injections are only a quick fix. Sooner or later cold turkey becomes the only alternative as the patient either refuses another hit or the doctor refuses to administer the drug. It could be next month, it could be two years away, but a significant correction in the market seems inevitable.

The furore surrounding Bitcoin in recent years has caught the attention of even the most hardened of crypto sceptics in financial markets. Rarely in recorded history has an asset returned 600% in 6 months. Bitcoin’s phenomenal rise can be largely attributed to a wave of new tech savvy retail investors who poured their discretionary incomes into crypto markets during  lockdowns. Bitcoin's price soared from $10,000 to $63,000 in a very short space of time.
​
Large institutional investors followed. Then came Tesla’s CEO, Ellon Musk who announced on Twitter in March of this year that Tesla would accept Bitcoin as payment. Retracting the statement a month later, however, citing environmental concerns, Musk earned $101 million from his Bitcoin trade while simultaneously wiping $500 billion (60%) off the market cap. Millions of small investors got caught on the downside. 

Bitcoin's bubble burst again in May, this time from an announcement by China that it was clamping down on Bitcoin mining. Much to the delight of its critics, Bitcoin’s price plummeted another 50%. Remarkably, however, it rebounded within 2 days recovering its losses. At the time of writing, Bitcoin's current price is roughly where it was 6 months ago in January 2021 at $28,000. This still represents a 300% return over the last 12 months despite all the recent doom and gloom and volatility.  Apple's share price, in contrast, grew by 'just' 50% over the same period.

Like it or not, cryptocurrencies could be here to stay. Bitcoin is as much about ideology as it is a genuine alternative to traditional money. Nonetheless the world of finance is undergoing huge change as consumer payments move increasingly online. Bitcoin supporters believe these trends will only strengthen the demand for crypto in years to come.

According to the International Monetary Fund (IMF), 80% of global transactions in 2020 were cashless and carried out using debit cards and digital wallets. Banks around the world are now looking to innovate and compete with the growth of online payment providers such as Binance, Coinbase, Revolut, and We-Pay, who eat into their market share and offer crypto services.

Central Banks in the US, China, and Europe are also developing their own central bank digital currencies, or CBDC’s. Are governments now starting to view Bitcoin as a potential threat to fiat currencies? 

Not a Currency

Unfortunately,  no matter which way you twist and turn it, Bitcoin’s volatility makes it is highly unlikely that countries will ever adopt it as a currency or allow it as a medium of exchange. Although El Salvador recently announced it would accept Bitcoin as a second currency alongside the US dollar, this is probably a short-term strategy to encourage extra spending into the economy after extended lockdowns.

That's all well and good while the Bitcoin/Dollar exchange rate is high but less so when Bitcoin falls further in value. Shopkeepers either refuse to accept Bitcoin or charge a much higher Bitcoin price for a loaf of bread. This greatly reduces the incentive for people to use Bitcoin over dollars and so defeats the purpose of having it as a currency.

Tesla

Would Bitcoin become less volatile if Tesla, Amazon or Apple started to accept it as payment? There’s a good chance it would cause even more volatility. As soon as the announcement is made (as it was by Ellon Musk), investors rush into Bitcoin and its price soars. Investors who timed it well can now buy a Tesla car, an iPhone or a book from Amazon cheaper than before relative to dollars. But what about investors who don’t need a car, iPhones or a book? Would they be willing to hold their valuable Bitcoin or sell while the going is good? The likelihood is that they would sell, causing the price of Bitcoin to fall again.

Not A Store of Value
Inflation is a hot topic in financial markets in recent months as economies finally re-open. Due to supply chain issues, extra consumer demand, and enormous government spending, many economists are predicting consumer prices to soar as high as 10% or even 20% this year and beyond. Bitcoin's limited supply, unlike fiat currencies, protects it against long term debasement and inflation. Or so the story goes.

These inflation concerns were played out recently in the bond markets where investors, fearful that inflation would spark a reaction by the central banks to increase interest rates and drive down the value of their bonds, sold out of their assets. This should have been the perfect storm for Bitcoin. Many Bitcoin supporters believed that as investors fled the bond market they would rush into Bitcoin as a supposed store of value, hedging against inflation. However, Crypto’s were the hardest hit asset in the market falling as much as 60% in March and another 50% in May when China announced its clamp down. The truth is, when the going gets tough very few investors trust Bitcoin.

Non-productive asset
Cryptos like Bitcoin are non-productive assets meaning they do not produce goods, services or products and thus have no underlying value.  Their use-case or ‘utility’ as economists sometimes refer to it, is very low.

In contrast, if Apple launch a new product, its share price usually increases. Large public companies also pay dividends from profits earned on sales. This also increases their share price. By owning crypto, however, investors earn no dividend and their values cannot be linked to any value-producing product. As soon as crypto prices rise, investors are tempted to sell. This is not true of value stocks such as Apple or Coca-Cola who pay dividends to investors for holding their assets longterm.

The economic value of crypto’s are therefore derived largely from speculation. Prices move as crypto assets are off-loaded from investor to investor, each hoping that the price they buy is lower than price they sell. It’s ‘hot potato’ economics and unfortunately someone is always left holding the can. It’s a perfect example of ‘the greater fool’ theory at play. Everyone can’t win at the same time and for every winner there has to be a loser. Parallels of course can be made with most assets. If property prices crash, however, at least the homeowner can still make use of his home. If a government bond falls in value, it means the yield is rising.

Why the crypto craze?

The vast majority of crypto investors are below the age of 35. The millennial and Generation X generation have inherited a world of stagnating wages and low economic growth. Globalisation and the free movement of capital and labour has brought intense competition for jobs and accommodation in urban areas and city centres. As house prices soar, the price of abundant labour (wages) has been falling over the past 40 years when adjusted for inflation.

According to a report by the OECD, worker share of GDP from 1980 to the late 2000’s dropped 0.3% per annum in the advanced G20 economies. In other words, a worker in 2000 was 6% less well-off than in 1980. The assumption that wealth follows a linear trend upwards in time is no longer true. Generations are now getting poorer.

The steepest part of the decline occurred in the US between 2000 to 2016 where workers share of national income fell from 63.3% to 56.7%. These statistics show how wealth has been steadily distributed away from labour towards capital. In 2020 during the height of the pandemic, unemployment peaked at 20% in many advanced economies (including Ireland) while the stock market grew by 15% on the previous year.

Technological progress, automation, robots, and the outsourcing of manufacturing jobs to cheaper countries such as China exacerbates these deflationary trends in worker’s wages. So too does the dwindling influence of trade unions. Standards of living fall and economies stutter. Central Banks print money and interest rates turn negative. Households borrow to obtain higher living standards, government’s run larger deficits and global debt increases dragging down GDP, and so the cycle repeats.

For the vast majority of millennials, wealth accumulation and growth through saving is no longer an option due to declining real wages and the low interest rate environment of the last decade. In comparison, their parents, the baby boomer generation, could have expected to earn 10-15% interest on savings during the swinging 60’s and 70s. Holding deposits in a savings account today, however, represents a loss to capital when factoring in 0% interest and inflation. For the first time in history, parents are now wealthier than their adult children.

Future Finance

The hunt for yield among younger generations continues therefore, weaponised by Bitcoin and decentalised finance (DeFi). Online Blockchain exchanges such as Binance, Coinbase, E-Toro, Houbi Global, and Kraken have gained huge momentum and marketshare in recent years. Crypto’s market cap in June 2020 was $200 billion. 12 months later, the crypto industry is now valued at $1 trillion and online exchanges are eager to profit from its growth.

One such exchange, Gemini, with offices in the US, Canada, and the UK, offers high yielding crypto deposit accounts for their customers, acting much like a traditional bank.
The main difference, however, is that banks invest customer deposits in productive projects such as business loans and mortgages. Gemini invest crypto deposits in other crypto assets. These assets are its leverage.

If all goes well the house earn their spread and depositors earn yield. But what happens when the cryptos go to zero, or 50% as they regularly do? The house folds, depositors get burned, and there is no central bank to bail out the house. Possibly fair game. Free market economics. Winners and losers. Risk / reward. But it’s a fool’s paradise and a race against time as eventually even the winners themselves become losers. Gresham's law. Bad money chasing out good until there’s nothing left for anyone. Perpetual boom and bust cycles.

If these exchanges are the future of crypto it’s hard to get excited. But not everyone dislikes casinos. Where money can be made, investment usually follows. New and improved blockchains, Stablecoins, NFT’s, tokens, decentralised apps (D’apps) and smart contracts are continuously being unveiled. Ethereum layer 2, Web 3, Filecoin and all manner of advanced algorithms purposely designed to enhance cryptography and user experience are just the tip of the iceberg. 

Economists have always scribed that 'technological progress' is one of the key ingredients of economic growth. From the naked flame to the lightbulb,  the horse and cart to the automobile, the typewriter to the word processor, and the revolutionary effects of the internet, technology has always been the great disruptor.  

The current system of low growth, interest rates and perpetual debt badly needs an overhaul of some sort. DefI may offer solutions but also many questions. As its universe expands it may even be shut down. Financial markets are volatile enough.

Until then, network effects, mass adoption, and the accessibility of crypto markets to all incomes big and small will continuously replenish the field if horses fall or quit the race. Crypto could become the unstoppable trade that some analysts are calling 'the exponential age'. 

Virtual markets could replace stock exchanges, smart contracts could replace brokers, and banks may cease to exist. 'Tokenomics' could be the new driver of growth that includes investors from all economic backgrounds. A future where the trading of celebrity coins,  personalised memes, deeds, tweets, and every gimmick in between becomes commonplace. An over-commoditised playground in sci-fi, DeFi, and BlockFi where fiction meets finance and fortunes can be made. 

​Speculative mania sugar-coated by the brilliance of technology, which very few will understand.

I've covered this topic before in recent weeks but the inflation story has since gained more momentum. As the end of Covid-19 draws closer the markets are beginning a process of repricing. 

​The sell-offs in government bonds in February and March has been fascinating to watch. It's classic game theory between the Fed (US central Bank) and the bond market. The concern among bond investors is that as economies re-open, consumer spending, in addition to continued government stimulus, will ignite inflation and erode future returns.

Bonds provide investors with regular fixed income over 3 months to 30 year durations. Higher Inflation, however, affects the price of bonds as the future value of that income depreciates. The Fed, however, remains steadfast in its conviction that inflation is transitory and rate hikes are unnecessary. Markets are not buying it though, explaining the volatility in bond markets. Inflation has the markets rattled.

An inevitable collapse in the US dollar and runaway inflation has been the narrative in financial media for almost a year since the outbreak of the pandemic. Given these sensationalist views, and a general misunderstanding of what it really means to 'print' money, many analysts have overplayed the threat of inflation even comparing the US economy to  "The Weimar Republic". 

As the US is the world's largest economy the demand for dollars ensures its status as the global reserve currency. The US exchange rate relative to the other world currencies tends to remain strong as result which allows its central bank, The Fed, to print money without badly effecting the dollar's value. 

When financial conditions become tight during a recession, the central bank's aim is to reduce the costs of borrowing and provide emergency lending to commercial banks, investment banks, and the federal government. This ensures the continued flow of liquidity and credit throughout the financial system. The central bank does this by crediting the reserve accounts of these institutions at the central bank. In short, it 'prints' digital money and transfers it to the accounts of large commercial banks.

In return for this money the banks must swap existing assets with the central bank as collateral. These assets include 10, 20, 30 year government bonds and long-dated mortgage-backed securities. In effect, the banks are giving up less-liquid assets for cash in order to meet their day to day operations. By giving up these assets they are also giving up interest rate earnings that they would ordinarily receive on those assets. As the old saying goes 'there's no such thing as a free lunch.' 

Similarly, when governments need money, the central bank buys government bonds that the Treasury department issues on the bond market. These bonds are loans that pay an investor an interest rate for buying the bond from the treasury. Usually central banks enter the secondary market and buy the bonds at a later date from other banks and financial institutions. The purchasing of these bonds drives up their values and lowers the interest rate issuers need to offer given the higher demand. These actions form the basics of Quantitative Easing and studies have shown that QE has little to no effect on consumer prices. 

​The chart below elaborates further. Notice over the last 50 years when, despite the money supply (M2) increasing, the velocity of money has been declining over time. The velocity of money refers to the speed at which money exchanges hands in the real economy i.e the rate of spending among consumers.