24/09/2009: Japanese fables

For outsiders, Japan is a land of mystery, formidable but opaque. Our perceptions are often little more than clichés that we try to apply, in vain, to an uncooperative reality.

In the 1980s, with its economy firing on all cylinders, Japan was regarded with awe as the benchmark for management and productivity. Remember the wonder of just-in-time production, the much-revered circles of excellence? Back then, the Land of the Rising Sun basked in the economic glory of its crown jewels, the six Keiretsu. These vast, interlocking networks of companies – each with a big bank at the center of the web – controlled virtually all the strands of Japanese industry, guided by the omnipresent but impenetrable MITI.

Japan’s muscular business model was also feared. After all, Japanese companies had bought the Empire State Building and half of Hollywood and would soon, according to the worriers, overtake the US as the dominant global economy. In fact, the story did turn into a Hollywood blockbuster, but it was rather a disaster movie leading a prolonged period of stagnation known as Japan’s Lost Decade.

Some economists believe that Japan has still not recovered twenty years on. They attribute the country’s malaise to an economic policy apparatus that was unable to adapt to a changed environment and failed to take the right measures. Hero worship is so fickle: yesterday’s invincible model is today’s obvious loser. But, as usual, we think the reality is a bit more complex. Most specialists agree that Japan’s aging demographic profile explains a large part of the country’s perceived underperformance. Moreover, for those who have visited the country, it is very difficult to reconcile the stream of poor economic data over the last two decades with brisk and bright appearance of its cities.

Recently a new myth has emerged: With the first real change in government in more than fifty years, the way Japan conducts its economic policy will also change, so the story goes. Instead of an export-driven economy, we will see the dawn of a new age of domestic and especially private consumption. Indeed, the new Finance Minister, Hirohisa Fujii, and new the Bank of Japan Governor, Masaaki Shirakawa, at first seemed to advocate that storyline, expressing the view that a strong yen could help the Japanese economy.

While it is too soon to judge how this particular story will develop, it faces at least one daunting hurdle to a happy ending: again, demographics. We have difficulties imagining Japan’s senior citizens going on extended shopping sprees, but maybe we are too conventional. Although we will monitor Japan even more closely from now on, we remain skeptical about the country for the time being. In fact, we think it is one of the world’s most fragile economies at present. We find Japanese equities highly overvalued compared with European peers, or those of Asia’s emerging markets, even taking the latter’s higher risk into account.

18/09/2009: The US dollar's demise by 1,000 cuts

The Chinese authorities face a rather difficult, and potentially very hazardous, task. How can they reduce their US dollar dependency without hinting too much that they are doing so?

Remember, over the previous decade China has accumulated more than two trillion US dollars in foreign exchange reserves, most of it in dollar-denominated fixed-income investments like government and agency bonds. Until recent years, this dollar dependency and lack of diversification of these foreign exchange reserves were not thought to be problematic. However, the financial crisis and the way the US government and the Federal Reserve have reacted to it has made it clear that the well-being of US creditors ranks rather low on the priority list of the US authorities.

The Chinese are painfully aware of this. In March 2009, People’s Bank of China Governor Zhou Xiaochuan commented that: “An international reserve currency […] should be disconnected from economic conditions and sovereign interests of any single country.” This is clearly a requirement that the US dollar as the current major, if not only, international reserve currency is currently not fulfilling.

What can the Chinese do though? Just selling their dollar reserves for some alternative currencies and/or reserve assets, like gold, is not a viable option. Doing this in plain sight would tremendously weaken the greenback and hence the purchasing power of the accumulated Chinese reserves. This could result in a full-blown worldwide currency crisis and push the still-fragile financial markets back into a tailspin. Even worse, the surge of US and worldwide interest rates that would attend such a sell-off would increase the risk of a fall-back of the US and other developed economies into recession. This, in turn, would certainly lead the Federal Reserve to print even more money and thereby exacerbate the dollar weakness further.

For now, the Chinese seem to have decided to take small, almost innocuous steps. At the beginning of 2009, the Chinese started to sign swap agreements in yuan with several countries including Argentina, Indonesia, Malaysia and South Korea. In May, the Chinese and Brazilian Presidents, Hu Jintao and Luiz Inacio Lula da Silva, signed an agreement to drop the dollar for use in bilateral trade and instead use their local currencies, i.e., the yuan and the real. Finally, at the beginning of September, China announced it would buy notes issued by the International Monetary Fund and denominated in Special Drawing Rights (SDRs).

Another less direct way to reduce the dollar dependence stems from the fact that the Chinese government now explicitly encourages its domestic companies to use their earned dollars for mergers and acquisitions of overseas companies (especially in the energy and commodities sectors) instead of parking those dollars into US fixed income investments.

For the time-being, the sums involved are relatively small. The swap agreements involving yuan amount to roughly 100 billion US dollars, the bilateral trade between Brazil and China was somewhere north of 25 billion US dollars in 2008, the SDR investment will be around 50 billion US dollars and the ten largest Chinese direct investments overseas so far in 2009 were according to our estimates slightly below 25 billion US dollars. Those numbers are obviously dwarfed by the trillions of US dollars in Chinese foreign exchange reserves.

Nevertheless, one should not underestimate the power of symbolic measures. Following China’s SDR investment announcement, several other emerging markets, among them Brazil and Russia, also expressed an interest in an alternative reserve currency. While the days of the US dollar’s dominance as the unique world currency are not over yet, 1,000 small cuts have begun to scratch its shine.

04/09/2009: Hunting black swans

Parlous times often breed towering personalities. The Great Depression saw John Maynard Keynes become the leading economist and one of the most prominent public intellectuals of his generation and beyond. So far, the current crisis hasn’t produced anyone whose stature is comparable to that of Keynes. But there is one candidate who may someday join him in the economists’ pantheon, an individual who in any case will surely have a lasting influence on the profession of economics: Nassim Nicholas Taleb.

Taleb is one of the very few pundits who can fairly say, “I told you so,” in the wake of the financial crisis. His books, “Fooled by Randomness” and “The Black Swan,” have not only been bestsellers; they are truly seminal works in the theory of finance. Especially with “The Black Swan,” whose title has entered our everyday language, Taleb has become required reading for anyone who wants to dismantle the inherited inaccuracies of financial theory.

The main message of “The Black Swan” is that improbable, exceptional and extreme events occur far more often than we dare to think. The potent consequence of this conclusion is that reality is more complicated and unpredictable than we generally assume it to be. Black swans, by the way, were discovered in Australia in the 18th century and the book’s title plays on the assumption, employed in treatises on logic since Aristotle, that “all swans are white.”

The financial crisis is a splendid example of a fully-fledged black swan. Few thought such a meltdown was possible in the developed economies of the modern financial system; even fewer saw it coming. And now, after the fact, many economists are trying to save face by employing the kind of logical gamesmanship that Taleb so coolly punctures.

For example, some economists have adopted “hindsight bias” to suggest that the crisis was, of course, predictable; or they have succumbed to “narrative fallacy,” wherein an inexplicable event is folded neatly into a fluid story line to make it seem self-evident, albeit after the fact. Taleb’s point is that people, including economists, actively resist acknowledging that events can overwhelm their comfortable cognitive preconceptions; they (we) are highly creative and all-too-successful at painting any disturbing black swans white, which is how we like them to be, after all.

Add to this the media’s penchant for airing extreme opinions rather than more moderate views, and the aftermath of the financial crisis has the punditocracy spouting a steady stream of doomsday scenarios. It seems that since most economists were wrong-footed by the crisis, none wants to miss the next black swan, which is certainly swimming out there somewhere.

But this creates a paradox: If black swans really are sighted everywhere, then they are no longer exceptional. Grim predictions invoking runaway high inflation, or a deflationary, Japanese-style paralysis, or the impossibility of central banks smoothly exiting their stimulus programs, or the catastrophic consequences of the massive new debt on government balance sheets are becoming the norm. But the norm, by definition, cannot be a true black swan.

Indeed, the black swan today would be the scenario of a seamless return to the “great moderation” of the previous 25 years, with low inflation and high growth. Admittedly, this is a highly improbable, even extreme prospect after such a profound crisis. But bear in mind, extraordinary events are not necessarily negative in nature and black swans must not always be bleak.