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Brexit, Pound and London Lock-in

In one of his latest comments, Paul Krugman mused about the contribution of the Brexit prospects to the recent decline of the British pound. “Coming at it from the trade side” he first drew attention to what in economic research is called the home market effect. This is a phenomenon which helps explain why industries concentrate in large markets and exports occur:

“Imagine a good or service subject to large economies of scale in production, sufficient that if it’s consumed in two countries, you want to produce it in only one, and export to the other, even if there are costs of shipping it. Where will this production be located? Other things equal, you would choose the larger market, so as to minimize total shipping costs. Other things may not, of course, be equal, but this market-size effect [my emphasis] will always be a factor, depending on how high those shipping costs are.”

Krugman then argued that the smaller market may not come away completely empty-handed. It may prosper by enhancing its price competitiveness:

“In one of the models I laid out in that old paper, the way this worked out was not that all production left the smaller economy, but rather that the smaller economy paid lower wages and therefore made up in competitiveness what it lacked in market access. In effect, it used a weaker currency to make up for its smaller market.”

For Krugman, the initial situation in Europe can be characterized by this example. The two countries in question are Britain as the smaller market and Continental Europe as the larger one.

Now, with Brexit looming on the horizon, many observers are expecting a decline of the pound as a consequence of a resulting overall economic recession in Britain. But Krugman argued that a Brexit recession does not, so far, seem to be materializing. He offered an alternative explanation for the pound weakness focusing (1) on financial services as the industry in question and (2) a partial reversal of this industry’s location decisions as a key influence behind the currency decline:

“Now we face the prospect of seriously increased transaction costs between Britain and the rest of Europe, which creates an incentive to move those services away from the smaller economy (Britain) and into the larger (Europe).”

The question is: Is this a realistic scenario?

First of all, the focus on financial services in this context is a problem. Given the role the City plays for the British economy this seems to make sense at first glance. A closer look at the determinants of the competitiveness of this industry and related Brexit effects, however, calls for a different view. Neither is Europe – with or without Britain – in this context the relevant market, nor is the British pound necessarily the relevant currency.

The City of London is part of an international network of financial centres offering 24/7 services and trade in a wide variety of financial instruments. It is the world’s largest foreign exchange market – which is largely a wholesale market – with the British pound ranging behind US dollar, euro and Japanese yen. London’s main competitors are New York and Chicago as well as places in Asia such as Tokyo, Singapore and Hong Kong. Similar to New York in the United States and Tokyo in Asia London has a home advantage in Europe, but its role as a major world financial centre is not defined by its position there. Regional competitors such as Frankfurt and Paris have high hopes that Brexit will lastingly shake its status, but – beside the need to do without the European passport which inevitably will make SOME banks and other financial services companies choose to move SOME UK-based activities to the EU (Ben Martin) – most of this must be considered wishful thinking.

The competitiveness of the City as a location for international financial institutions is only marginally influenced by relative costs and prices in Britain and Europe. For their concentration in London other explanations must be found.

In the 1990s, in a little book on The Self-Organizing Economy, Paul Krugman himself laid the theoretical foundations for a more adequate description of market concentration and clustering which might well apply to the financial industry, too.

In the book Krugman chose an interdisciplinary approach which stressed the importance of concepts such as complexity and emergence, the science about “how large interacting ensembles – where the units may be water molecules, neurons, magnetic dipoles, or consumers – exhibit collective behaviour that is very different from anything you might have expected from simply scaling up the behaviour of the individual units.” His edge city model presents a most rudimentary form of spatial concentration under complexity in which locational decisions are determined by two kinds of “forces”, a centrifugal and a centripetal one:

In the model, the decision of each firm where to locate is depending on all other firms´ choices. On the one hand, firms are assumed to dislike having other businesses nearby because they compete for customers and resources. These are the centrifugal forces. On the other hand, to have other businesses close has advantages. For example, they attract customers to the place or add to the variety of local services offered. These considerations are interpreted as centripetal forces that attract businesses and make them locate in “clumps”.

For the details of this approach the reader is referred to the original source.

History shows that there is a considerable element of persistence and inertia in the rise and decline of financial centres. From Amsterdam in the 17th century over London in the second half of the18th century and New York after World War I, and again in the postwar years, it took always great upheavals for a centre to lose its dominance (See, for example, for the early history of financial centres Paul Einzig, 1970).

Many observers think that Brexit is comparable to those upheavals. But, from Krugman we learn that no development – not even the most dramatic one – is influencing the rise or fall of markets single-handedly. The big merit of the book is that, although not dealing explicitly with the financial industry, it is drawing attention to the complexity of the processes involved.

At this point, it is worth making a little effort and having a closer look at the evolutionary nature of spatial concentration in international finance.

As Krugman wrote, quoting Philip Anderson, the Nobel laureate physicist: Complexity is the science of “emergence”.

Considering complex financial markets as emergent systems has two aspects. One is, as already mentioned, spatial self-organisation. Under certain circumstances the interactions of many people taken together – of individuals, firms and financial institutions as well as the administrative and political environment – are able to create a new quality or “culture” of a market place allowing it to become a truly international centre. Then, in principle, what needs to be explained is that process as well as the emergent quality.

The second aspect is path dependence. Broadly stated, path dependence means that a system’s current state is a function of past initial conditions and developments. This stands in contrast to traditional equilibrium models in economics which take as given that their results are generally valid, holding independently of past trajectories. The term is closely related to another one which is lock-in: A system which has once reached a particular state may at times stay there even if this does not appear an optimum to outside observers. Path dependence and look-in are strong arguments for a financial centre to maintain a once-reached dominant position even if its competitiveness is in decline. On the other hand, it may also condemn a lagging place to stay behind forever.

Emergence refers to the “organic” change in nature by which a financial place becomes an international centre. Banks deciding to establish their business in the same location do not constitute a centre in this sense. There are many markets and places in the world fulfilling functions and offering kinds of services that can be found in London, Tokyo  or New York as well. And many of the banks in London, Tokyo and New York have businesses elsewhere which are, in principle, engaged in the same kinds of activities.

What can be thought to make the difference is that with the growth of a market and increasing complexity sometimes – to draw an analogy to the natural sciences – a kind of self-organized criticality is reached after which the place is not the same as before. Slowly and perhaps imperceptibly an adaption process to the needs and demands of internationally active participants in the market takes place meeting more and more the criteria of an international financial centre. Respective facilities grow, and norms, rules of conduct, attitudes and behavior patterns become established.

Nowadays, in economics there is a wide variety of evolutionary theories searching explanations for all kinds of social and economic change. Most of them share several characteristics which constitute a kind of common basis on which the followingconsiderations are founded, too. For example, there is an emphasis of dynamics. None of those concepts is interested in simply explaining something being but is asking how it becam what it is. Theories are explicitly microfounded. There is no “macrobehavior” without “micromotives”. And, in a very broad sense, rationality is “bounded”. Agents are assumed to have at best an imperfect understanding of their environment.

In general, evolutionary theories consider three factors as decisive for evolution. Those are mutation, natural selection and chance.

Mutation provides the material, i.e. the genetic difference, on which natural selection acts. As one famous geneticist put it: Mutation proposes but selection decides (Cavalli-Sforza and Cavalli-Sforza 1995: 102).

Natural selection enables a system or an organism to adapt to its environment driving it toward fitness maximisation and reproductive success.

Chance comes in in several ways. On the one hand, there is a statististical effect known as genetic drift. The carrier of a mutation may die without passing the mutation on to subsequent generations. Or, in contrast, the mutation may bespreading widely due to casual events. On the other hand, mutation itself occurs randomly. Chance makes evolution not just the survival of the fittest but also the survival of the luckiest.

For evolution to take place by natural selection there must be replicators and interactors. A replicator passes on its structure intact in successive replications. Genes are replicators. Interactors are by their very name entities that “interact as a cohesive whole with their environment in such a way that this interaction causes replication to be differential.” (Rosenberg 1994: 403) In biology, this can be organisms, but also cells, genes, tissues, organs and the like.

Another useful term in evolutionary theories is lineage standing for the entity which actually evolves. In general, lineage is defined as the line of decent which can be traced from a common ancestor.

Interactors are composed of lines of descent and some proportion of types of interactors in the cohesive whole is changing from generation to generation.

In order to demonstrate the meaning of the different terms, the analogy can be tried on an example from economics. A firm which is switching to more adapted rountines is developing, growing in size and increasing its profitability. But, for evolution to take place at the firm level, it must become its own descendant, otherwise the analogy breaks down.

According to evolutionary theory, changes within one member of the lineage do not count as evolution. They are simply a matter of development. The improved adaption has to be passed on to descendants, successors, subsidiaries or the like.

Thus, each analysis of an evolutionary economic system has to find an answer to thefollowing questions:

What is it that is evolving and what is the lineage?

What are the generations?

Which are the replicators and interactors and

how is “fitness” measured?

The answer to some of these questions has been suggested earlier. The evolving entity in the analysis intended here is the international financial system consisting of various centers and subcenters of international financial activity as well as other bank places at the periphery. The interactors in this system are individuals and firms but also markets and market segments as well as institutions and other entities developing the “rules of the game” in a market place.Those rules may consist of laws and regulations but may include norms, conventions and behavior patterns passed on from generation to generation of actors as well.

In this framework, the replicators which pass on their structures intact in successive replications may be thought of, not as the banks and financial institutions and other actors themselves, but as the inherited characteristics, laws, rules of conduct and long-term behavior patterns those actors develop over time, and over generations, which eventually make up for the market “culture”. What is reproduced again and again, constantly adapting to the environment, are the interacting components of this culture which allows the place to survive.

Each financial center is distinct from another and from any other market place in the world. What determines its market culture’s competitiveness or complementarity and its ability to survive? One could think of several measures of “fitness”. One might be a place’s share, regional or worldwide, in particular market segments such as stocks or derivatives trading. Another could be the range of financial instruments available or the number of foreign institutions present at that place.

As mentioned earlier, there is one phenomenon deserving special attention in this context which is path dependence and lock-in. For the spatial organisation of financial centers this point is of special importance. Although financial services are considered widely as “footloose industries” which are not restricted in their choice of location, once established they shun changing places which then becomes costly and cumbersome. One reason for this inflexibility and the resulting lock-in and concentration of the industry in few places is found in their size and range of activities, which has at least three aspects:

First, nowadays, financial institutions depend on a vast net of suppliers of so-called producer services. Those include advertising, accounting, management consulting, legal services and many more. Central to the rise of those services was the growing size, complexity and diversification of financial firms. They have a vast diversity of separate functions, and often geographical dispersal, with the result that banks’ central headquarters are no longer simply centres for administration and control but function as centres for orientation of the firm within its business environment. They not only have to decide about overall policies concerning clients’ business, trading strategies, risk management and the like but also about product development and expansion and mergers and acquisitions in a multiplicity of situations and countries. In this environment, providing certain highly specialised services in-house is costly and often no longer possible (Sassen 1991).

Reliance on producer services is one argument against the financial industry’s being footloose. Another is dependence on the built environment. This is a rather new phenomenon. In former times, developers used to put up offices for financial institutions, which, in principle, were able to move easily in and out, on a speculative basis. Now banks’ requirements have become too specialized for this to work and for major houses the trend is to design their own buildings.15 For example, financial institutions need large trading floors – in the order of 300,000 square feet and even larger – and, depending on a certain technology to handle the huge volume of transactions traded every day, they require adequate space for cables and outlets as well as a pool of technical personnel to operate and repair equipment, including building managers who continuously upgrade the information and telecommunication Systems (Fainstein 1994).

A third argument against the footloose nature of financial industries is the ongoing need for personal, face-to-face contacts in financial markets. Although this does not only mean spatial proximity – other forms such as organisational, cultural, social, technological and institutional proximity may be of equal importance16 – the spatial aspect is the one which is a crucial argument for “clustering”. The core of financial activities can be described as “information, expertise, contacts” (Thrift 1994: 334). In general, all of these require spatial proximity although the advantages vary in their intensity from product to product. For small securities trades, interbank payments or standardised foreign exchange dealing they are probably minuscule. For mergers and acquisitions, the management of investors’ portfolios or the lead management of syndicates they are high.

Besides, there is still another argument for financial agglomeration in the big centres which is identification with a place in its broadest sense. In general, people living and working in world cities like New York, London and Tokyo are aware of their special status. They may complain about the disadvantages such as air pollution and traffic jams, but they also enjoy the advantages. Some of these are in part imaginary by nature, consisting of an experience of a certain way of life, the feeling to be part of a special culture, which differs from those elsewhere. This holds in particular for the financial community located in those cities, which has become a wholly distinct class breeding its own rules, norms, rituals and behavior patterns. Their view is largely determined by the way they see themselves and their industry and by the way they interact. Financial places in this sense are not only places of financial intermediation but interactional proving grounds, centres of representation (of “where the stories are”) as well as centres of discursive authority (Thrift 1994). They are places where individuals are bound together by a common “market  culture”, differing from centre to centre,which is not easily given up in exchange for another environment.


Krugman and other authors taught us, that, in general, there is no one-dimensional explanation for the concentration of industries. Relative costs and prices may influence the choice of a location, but they are only one element in a complex and opaque process. The same holds for instutional and political changes. The Brexit may be a good reason to reconsider the choice to locate in London, but countless lock-in effects may offer stronger arguments against moving.

But let us come back to Krugman’s initial question: What about the pound?

In my view, last months’ weakness of the British currency is rather the result of short-term reactions of the foreign exchange market on various time scales in an environment of large and growing uncertainty, with self-reinforcing elements such as market technicalities and automatic rules In this environment, policy and business actions are watched nervously, and statements and media reports which otherwise would go widely unnoticed have the quality to shake market fundaments. And, as Alex Krüger (@Trading_Macro) on Twitter reminded us:

The currency will remain volatile amid Brexit uncertainties and may even reach new extremes. The pound flash crash of October 7 gave an idea of what may be expected in this respect. To quote @zerohedge:

“At just after 7 minutes after hour, whether 7pm on the east coast, midnight GMT or early Friday morning in Asian trading, pound sterling plunged by more than 6%, in the span of 2 minutes although the bulk of the plunge took place in just 30 seconds: from 7:16 to 7:46, when the market became “disorderly” in technical parlance, or in simple terms, broke.”

Furthermore, @zerohedge pointed to the international dimension: The main currency pair affected was not the euro/pound as some observers speculated but all other major currencies – pound, euro and Japanese yen – vis à vis the US dollar. The foreign exchange market knows no boundaries. Limiting currency contagion will be one of the big Brexit challenges ahead.





Freeports, art and global finance



Getting a grip on problems such as tax evasion and money laundering has become a matter of utmost urgency. In this context, the Panama Papers drew attention to the dubious role of free trade zones (FTZs), and in particular of freeports as repositories of artworks and other valuables. Media reports pointed to the connection between the international art trade and offshore secrecy:
“The documents reveal sellers and buyers of art using the same dark corners of the global financial system as dictators, politicians, fraudsters and others who benefit from the anonymity these secrecy zones offer.” (Jake Bernstein)
But even the legitimate side of freeports is calling for greater scrutiny. With increasing regulations and sanctions in the world of finance the widely unregulated art market is attracting more and more banks, hedge funds and other financial players thereby posing new challenges to financial supervision.

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Crisis instrument central bank swaps

In a recent article, Perry Mehrling drew attention to the global network of central bank swaps:

“In the last few weeks, the ECB has been drawing on its liquidity swap line with the Fed, first $308 million for a week, then $658 million for a week, and last week back down to $358 million. What’s that about?
It’s not such a large amount. Bank of Japan borrowed more in the past, $810 million in March and $1528 million in January. But the question then repeats, what was that about?
Both of these drawings are part of the new set of central bank swap lines linking what I call the C6: the Fed, ECB, Bank of Japan, Bank of England, Swiss National Bank, and Bank of Canada. On October 31, 2013 these lines were made permanent and unlimited … Ever since then I have had a slide in my powerpoints saying “Forget the G7, Watch the C6.””

So, what is going on here?

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An emergency currency regime for Greece

With the agreement of the Eurogroup to accept the Greek reform proposals the latest crisis in the euro area seems averted – for the moment. Apparently, Greece had no other option than to give in and prolong its current bailout program as requested or leave the monetary union. The latter would have been a complete surrender to the challenges of a common currency – not of Greece but of its European “partners”. All can-kicking in recent years, all refusals to face the needs of a functioning monetary system, all costly bank bailouts to prevent a destabilization of national financial markets and policy structures, and all sacrifices made by individual countries under harsh austerity constraints in order to “save the euro” might have been fruitless as a Grexit inevitably would have triggered a chain reaction among other member countries and possibly the union’s breakup.

DrachmeThe danger is not banned yet: Gabriele Steinhauser (Wall Street Journal) wrote immediately after the official consent that the IMF and others still have concerns over the seriousness of the reform measures. Alkman Granitsas (Wall Street Journal) listed five things to know about Greece’s proposed reforms which its creditors might not expect or approve. And in order for the funds to be released the program must be implemented successfully and all its conditions met.

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Perspectives on the Greek challenge

These days, there is a flood of articles and comments of varying quality and importance on Greece and the eurozone. With the following quotes I would like to draw attention to a small selection of contributions which may be relevant beyond the day.

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Black Swan, Dragon King, Greek Tragedy – Lessons from a “Diplomatic Debate”

In his Ted Talk Dragon King beats Black Swan in June 2013 Didier Sornette contrasted his ideas of market predictability to Nassim Taleb’s concept of a Black Swan. As Sornette explained a black swan is a rare bird. Seeing a black swan shatters all beliefs that swans should be white. The Black Swan stands for the idea of unpredictability and extreme events that are “fundamentally unknowable”. Sornette compared this idea with his concept of a Dragon King which is “exactly the opposite”. According to his view, most extreme events are actually knowable and – at least to a certain extent – predictable.

In May 2014, there was a very stimulating ETH-sponsored debate between Nassim Taleb and Didier Sornette which threw further light on their “Diametrically Opposite Approaches to Risk & Predictability”, so the title of the meeting. The following video is an edited version of what Nassim Taleb called a “diplomatic debate”. To him this is a conversation in which one looks for synthesis as opposed to one in which one is trying to win an argument by all means. This is surely benefitting the audience who, if they had not read their books, may know Didier Sornette and Nassim Taleb mainly from their highly technical scientific papers here and here.

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Between the years

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Tankan Japan

The Bank of Japan just published the latest results of its TANKAN survey which observers usually take as an indicator of the state of the Japanese economy and as signal in which direction future monetary policy may go. Here is some background information.

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Foreign Banks in Japan

In 2014, the International Bankers Association of Japan (IBA Japan) celebrates its 30th anniversary. For thirty years IBA Japan has represented the international banking community in Japan. Starting with 12 founding members in 1984 there are now just under 60 banking members from 22 countries and over 25 associate member firms.

In a speech at a meeting commemorating the anniversary, Haruhiko Kuroda, Governor of the Bank of Japan, mentioned the significant role foreign financial institutions played in Japan’s economy. However, relations between the banks and their host country were never free of tensions and compared to other world financial centres their influence is smaller than many believe – and in decline.

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Scotland’s currency options

One of the controversial topics in the debates of Scottish independence is the currency question. The other day, the Financial Times asked several economists to consider four options available to an independent Scotland: a currency union with the UK, sterlingisation (which would be the continued use of the pound sterling but without backing of the Bank of England), establishing a new Scottish currency, and joining the euro. Not surprisingly, opinions were divided.

However, strictly speaking, the choice is not limited to these four options. Besides, there are others which deserve a closer look as well in this context.

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