30/04/2010: When riskless returns mutate into returnless risks

With the news that Greece has been downgraded to "junk" status by Standard & Poor's, it now looks almost certain that investors in Greek bonds will have to book major losses on their positions. Meanwhile, intervention by the International Monetary Fund and the European Monetary Union to stave off a Greek liquidity crisis has become unavoidable. While Greek sovereign bonds were never thought to be completely “riskless” like bonds issued by the US, Germany or the UK (as reflected by their relatively higher coupons), one could until recently assume that they were a safe investment. However, over the past eight months, Greek sovereign yields have moved from 4.5% to 10% for the 10-year benchmark and even beyond 10% for shorter maturities.

Even more important than Greece's fate, however, are the dire implications the current crisis has for the Eurozone and, indeed, for the rest of the world. The first wave of contagion from Greece has hit that unfortunate group of Eurozone countries known by the acronym PIIGS (Portugal, Ireland, Italy, Greece and Spain). The next victims are likely to be Portugal (which was also downgraded along with Greece but is still investment grade) and then probably Spain.

However, amid all this negative news for the PIIGS, we still remain puzzled why the bond vigilantes have not spotted some of the other big elephants in the room of fiscal profligacy. In the Eurozone, for example, it is a bizarre fact that there is very little scrutiny of Belgium, which has a debt to GDP ratio above 100% and a government that has just resigned amid concerns the country could break apart, or France, which is likely to see its debt to GDP ratio hit 100% in the next two to three years.

Moreover, outside the Eurozone, investors do not seem bothered by Japan's 200% debt to GDP or the fact that both the US and the UK are galloping toward the 100% debt to GDP mark while keeping interest rates very low. It seems as though the famed riskless asset of yore is mutating into a returnless, and rather risky, asset instead.

Interest rates will certainly go higher for a number of reasons: First, in some countries the printing press will be used to inflate away some of the debt. Second, rates will have to rise in order for the bond market to clear the USD 5 trillion in new sovereign debt expected each year for the next five to ten years. Third, in the case central banks are serious about fighting inflation, they will have to hike, moving the whole yield curve higher.

How should investors react to such an odd environment? First off, they should look for less risky alternatives to the returnless but risky government bonds. For example, a better risk-return tradeoff may be available via bonds from supranational or sub-national entities, or from government agencies. High-quality corporate bonds might be another alternative. And then there is, of course, the equity market. Stocks with high dividend yields, especially those that deliver better returns than many bonds should be considered, as should consumer staple stocks of companies with high pricing power.

Many investors think of consumer staple stocks as boring, because they are less volatile than your average stock. In a bull market they go up less than cyclicals, but in a bear market they fall along with everything else. One thing that makes consumer staple stocks dull is that those companies sell the same things every year. At the same time, they sell a little more (almost) every year, and improve their operating processes as well. The result is higher profits and bigger dividends almost every year. Hence, you can compare a consumer staple stock to a perpetual bond with an ever-increasing coupon. But there is one caveat: there is no guarantee that as earnings and dividends grow (effectively providing a rising coupon), the shares also gain in value every year.

Be it by finding alternative bonds or be it by looking after categories of safe stocks, in this highly contagious financial world we live in, one needs to explore new paths because nothing can be taken for granted anymore - not even the idea that government bonds are riskless.

22/04/2010: Should we be worried about public debt?

The financial crisis has left many nations with mounting public debt, and Greece is just the tip of the iceberg. According to a recent study by the International Monetary Fund, the public debt to GDP ratio in developed countries will surge from 80% before the financial crisis to 120% within the next couple of years. Many investors and the broader public are worried. Are they right to be concerned?

Intuitively, the case against excessive public debt seems quite clear: It must be something bad as it would appear likely to depress growth and increase inflation pressures to boot. Moreover, there is no shortage of economic theories that back up our intuitive foreboding about excessive debt.

The "crowding out effect" states that the higher the public debt, the higher the pressures on interest rates to rise – thereby raising borrowing costs for the private sector, which in turn reduces private investment activity. Slower growth is the end result.

Yet another theory - the Ricardo equivalence theorem - stresses that the higher the public debt, the more likely households are to expect future tax increases. This leads households to save more and to consume less. This also depresses growth.

These effects are not limited to households – governments are not immune either. The higher the public debt, the more government resources must be devoted to service this debt and the less money governments have for discretionary and growth-enhancing spending.

Finally, the "unpleasant monetarist arithmetic assumption" speculates that government debt and money are equivalent. Hence, the higher the debt, the more implicit money is available and the higher the likelihood of inflation pressures.

Considering this large number of theories, it may surprise many that the empirical evidence relating public debt to growth or to inflation was rather unsatisfactory until recently. Most of the work in this area relied on case studies and few observations. This changed in 2009. Two US economists, Carmen Reinhart and Kenneth Rogoff, made the first thorough empirical study of financial crises - be they in banking, credit, exchange rates or sovereign debt. In their book ("This time it’s different – Eight centuries of financial follies") and in their subsequently published scientific articles, they explored an impressive database and came to several interesting conclusions, two of them addressing the macroeconomic impact of public debt.

According to their research, the relationship between public debt and growth is non-linear. This means that it doesn’t matter for growth whether you have a public debt to GDP ratio of 20% or of 60%. However, if you cross a certain threshold, which the two economists estimate to be around 90%, then the impact of public debt on growth becomes significantly negative. Currently several very large economies - the US, the UK and France - are on the verge of crossing this threshold. Hence, there is a risk that in the "new normal" of the post-financial crisis era we might see much lower trend growth rates for several important countries than the ones we were used to.

Reinhart and Rogoff also contend that there is no empirically significant relationship between public debt and inflation. While this might be puzzling at first glance, it will not surprise monetarists, who see inflation always and everywhere as a monetary phenomenon. According to this view, inflation should only occur with regard to public debt if this public debt is monetized, i.e. if the printing press is used to reimburse the debt. Given the current size of their debt problem, several countries, among them the US, might be tempted if the growth problem hurts too much to inflate their way out.

Summarizing all those findings, we must sadly conclude that yes, the size and evolution of the public debt are worrisome.

16/04/2010: Währungsreform

The German language has some interesting words, while only unsatisfactorily translatable, have made it into other languages: “Gemütlichkeit”, which is a typical German quality moment, “Schadenfreude”, taking joy in the misery of others, or “Weltschmerz”, the sadness, when faced with the cruelty of the world.

In economics one of those words is “Währungsreform”. Here also the translations “currency reform” or “monetary reform” only unsatisfactorily render the meaning of Währungsreform. In Germany during the 20th century, two and a half of those have been implemented. Two of them were rather painful for savers. No wonder hence that among all Europeans, the Germans are the ones, which raise this issue quite often when talking about the Euro.

The first German Währungsreform, and still the most severe, occurred in November 1923 when the Rentenmark replaced the Mark, whose value had been eaten away by the most famous hyperinflation in history. The conversion was one Rentenmark for one billion Mark. During this period of hyperinflation, the wealth of the German middle class, if it wasn’t in tangible assets, was completely wiped out.

The second German Währungsreform occurred in June 1948, when the Deutsche Mark replaced the Reichsmark (the Rentenmark was renamed the Reichsmark in 1924) at a de facto exchange rate of 0.65 Deutsche Mark for 10 Reichsmark. Prior to this the Reichsmark, due to massive money supply creation during World War II, had lost almost any confidence as an accepted mean of exchange. Again, for savers it felt like a wiping out of wealth despite the fact that the introduction of the Deutsche Mark turned out to be one of the building blocks of the post-war German economic miracle.

A third partial Währungsreform occurred during the German unification, when the East German Mark was exchanged against the Deutsche Mark at an exchange rate of 1:1 respectively, 2:1 conditional on flows and assets characteristics. For East Germans, depending on the eyes of the beholder, it was either perceived as wealth destruction or wealth creation (the official exchange rate between East and West was 1:1, while the market exchange rate was more 10:1).

The introduction of the Euro was not a Währungsreform as such since the Deutsche Mark was change into the Euro at the then official and market exchange rate of 1.95583:1. But thinking the unthinkable, a break-up of the Euro would certainly amount to a new Währungsreform.

Would it destroy wealth in Germany? It could, if the Euro were to be exchanged into a new Deutsche Mark at a lower rate than the one used during its introduction. But digging deeper, we should also take the relative value of the new Deutsche Mark against the rest of the Eurozone partner currencies into account. To assess this, we can use unit labor costs as guidance. According to the OECD, Eurozone’s costs relative to Germany have increase by 14% over the last ten years. Hence, any exchange rate below 1.70 new Deutsche Mark per Euro would definitively be detrimental for Germans.

09/04/2010: It's so sad we can't trade with Mars

One can always doubt economic theory. There are many reasons why, for example, a seemingly logical concept like purchasing power parity (exchange rates should equal price differences between countries) does not hold true most of the time. However, accounting rules (even macroeconomic accounting rules) are a much different matter because they are tautologies. In rhetoric, a tautology is a repetition of the same: “blue is blue”. In logic, a tautology refers to a universal truth that is always valid and therefore has no exceptions. This is the stuff that accounting rules are made of.

Accounting rules are tautologies because, for example, per its definition a balance sheet's right-hand side is ex-post always equal to its left-hand side. Unfortunately, our politicians do not appear very familiar with accounting tautologies—judging by the current economic spats between Germany and Greece or the US and China. If these imbalance problems are to be solved, the accounting rules behind them need to be understood. The distressing fact is, however, that even if our politicians achieve this understanding, they appear unlikely to address the hard choices it will lead them to.

In a closed economy, on a national level the summing up of the balance sheets of consumers, firms and the government would net out to zero. This means that the savings of consumers would be split between investments by firms and the government's deficit. If consumers are not saving but instead indebting themselves, then it would mean either that the government would have to run a surplus or that firms would have to disinvest—or a combination of both.

In an open economy, this restriction no longer holds sway. Hence consumers, governments and firms can all live above their means by indebting themselves against the rest of the world. Such an economy would then be characterized by a current account deficit. The opposite of this is an economy that is living below its means and would therefore be characterized by a current account surplus.

The recent financial crisis has affected many countries because of an excessive indebting of households, which were consuming too much and buying too much real estate. When the debt became suddenly unbearable, households started to deleverage and this sudden lack of consumption pushed the economies into deep recessions. To mitigate those recessions, governments had to step in and indebt themselves instead of consumers. Now rising government debts are also being questioned. However, the problem is neither the debt of consumers nor the debt of governments, but plain and simple the debt of countries.

Ultimately, debtor nations have to live below their means and start to pay down some of the debt they piled on during the excess years­—and the only way they can do this is by posting trade surpluses.

Before the financial crisis hit, the world was in a state of symbiosis between creditor and debtor countries. The former would drive their growth through exports while the latter would focus on domestic demand, which was partly financed by the export countries. This symbiosis has now broken down. Debtor nations need to shrink their overall debt. But creditor nations like China and Germany, while finger-pointing at the supposed profligacy of debtor nations, are unwilling or unable to run trade deficits and their domestic demand is only picking up slowly if at all. Hence, debtor nations are having difficulty trying to achieve trade surpluses.

Unless the whole world makes a trade surplus with Mars, this will remain the inescapable accounting situation. Acknowledging this instead of blame-gaming would be wise and might be the first step toward finding a solution to our current difficulties.

08/04/2010: There is only one dumb question in economics

During my time as a teacher before joining the financial industry, I always had one rule: “There is no such a thing as a dumb question.” Questions point toward flaws and caveats in a logical chain of explanations and hence contribute to enhancing both knowledge and pedagogical skills.

As an economist, I had to make an exception to this rule, which is explained by the following story: Albert Einstein dies and meets three people in his afterlife. He asks the first person: “What was your job before you died?” Answer: “I used to be a physicist.” Einstein is cheered by this and replies: “Marvelous, we will have all of eternity ahead of us to reconcile quantum physics with relativity!” Einstein then asks the second person what their job was. Answer: “I used to be a philosopher.” Again, Einstein is happy and says: “Great, we will have all of eternity ahead of us to figure out whether God plays with dice or not!” Then he asks the third person: “And what was your job?” Answer: “I used to be an economist.” Einstein looks somewhat disappointed and then asks: “And where do you see the dollar next year?”

Compared to physics and even philosophy, economics – and currency forecasting in particular – does not afford many definitive answers. First, one needs to acknowledge that the currency markets come the closest to what economists would define as a “perfect” market: a large number of market participants who are too small to influence prices, completely homogeneous objects to exchange with each other, and information transparency; that is, new information is available to all participants at the same time.

Intuitively, one would expect that forecasts for such a market should be easy to arrive at, but the opposite is actually the case. Efficient market theory comes to the conclusion that perfect markets behave like a random walk: the best forecast for an exchange rate tomorrow is to take the exchange rate today.

As Einstein's disappointment showed, this is not very satisfactory. What else can economic theory offer? Actually, there are plenty of models that attempt to explain the behavior of currencies based on “fundamentals”. However, not all fundamentals point in the same direction. Moreover, market participants will prefer some fundamentals to others and those preferences might shift over time. There are times when market participants are concerned about trade deficits and times when they are not; there are times when they focus on carry trades and times when they do not; there are times when relative productivity takes center stage and times when it does not.

The art of successful currency investing demands, among other things, an ability to recognize when fundamentals that matter to the market start to shift. Hence, the question shouldn’t be where the dollar will be in a year from now but what are the current fundamentals the market is focusing on when assessing currencies.

Obviously, Greece has been a main concern for investors in recent weeks. But Greece is only the tip of a huge iceberg of ballooning government debt. If market participants look beyond this tip and start to focus on the trillions of dollars in US debt, then the mini rally in the dollar might end more quickly than many are forecasting.