With a week to go until New Year’s Eve, 2010 ends with many problems unsolved that will continue to affect the first part of 2011.
The most obvious is the European sovereign debt crisis, or, as we prefer to call it: the crisis of the euro. So far, European leaders have failed to address the underlying problem of the crisis: to really function as a currency area, the Eurozone simply needs much more economic, fiscal and social integration. Instead, they have focused on reshuffling and guaranteeing governments' debts with evermore complex schemes. Despite these band-aids, the debts refuse to disappear. Ireland’s sovereign debt rating just got downgraded again. Portugal and Spain appear next in line to tap into European rescue packages. Hence, we expect the crisis of the euro to continue making headlines in the first months of 2011.
But, momentarily obscured by the chaos in Europe, another, equally formidable monster lurks: US debt. The big difference between Europe and the US, in my view, lies in the fact that in the Europe at least acknowledges the problem and, imperfect though they may be, pursues solutions. The US, in contrast, seems oblivious to its dangerous situation. Instead of tackling its debt issue realistically, Democrats and Republicans in Congress produced a compromise that extends the Bush tax cut for another two years while introducing supplementary tax cuts and subsidies for the middle class. According to first estimates, this new stimulus package – for that is what it is – will increase the already towering US debt mountain by an additional USD 550bn. Meanwhile, Federal Reserve Chairman Ben Bernanke hinted there could be a further sequel to the quantitative easing program….
US debt problems are not confined to the federal government. In his latest report, my esteemed colleague Mike Ryan, Chief Investment Strategist and Head of Wealth Management Research Americas, notes among the things that may happen in 2011 is the default of a high-profile municipality. According to Mike: "Credit conditions within the (US) municipal market remain challenging as the consequences of the financial crisis and associated recession have continued to weigh on state and local finances. (…) Although the general obligation debt of states such as California and Illinois or cities such as New York and Chicago is secure, municipalities like Detroit and Harrisburg could be forced to defer payments on their general obligation bonds."
Finally, the latest inflation data from China, the main driver of the global economy these days, will continue to challenge authorities there. For China's policy makers, walking the tightrope between overheating and too much cooling down will be a daunting task next year.
This said, looking back on 2010, we need to acknowledge that, despite its formidable challenges, it has been a rather good year in terms of investments, especially for those who could navigate the many obstacles. Our guidance for 2010, “Stay agile and alert,” remains firmly in place.
Thursday, December 23, 2010
Thursday, December 16, 2010
16/12/2010: The twin crises of confidence
The debate over what comes next, inflation or deflation, has vexed economists for a couple of years now. Some see the promise of inflation in the vastly expanded money supply after the financial crisis. Others see deflation's shadow looming since that bulging money supply has failed to revive anemic spending levels. We say the outcome is all a matter of confidence, or its lack.
Monetary theory examines the fluid dynamics of money in an economy, analyzing its supply and demand and how it affects things like prices and employment. At a first glance, monetary theory is simple enough. It is basically explained by the following formula: over a given period of time, the value of all economic activity equals the value of the available money multiplied by the number of times that money changes hands.
So far, so good. But dig deeper and it soon becomes apparent that the individual elements of this formula – which defines the so-called quantitative theory of money – are a lot more complicated than they appear. Even the notion of money itself needs more clarity. But perhaps the most elusive concept in the formula relates to the number of times money changes hands over a given period of time. This is what economists call the "velocity of money."
The velocity of money can only be measured indirectly, deduced from the other elements of the formula. Moreover, the forces behind the velocity of money are various and often not well understood. For one thing, they generally belong to those "soft" but no less powerful factors of psychology and human behavior. This is rather frustrating since the velocity of money is an important cog in the mechanism that transforms newly created money into price inflation.
The vagaries surrounding the velocity of money are often simply ignored. The less troublesome approach, which assumes the velocity of money is constant, is usually taken. But the indirect evidence makes it clear that the velocity of money is indeed subject to long-term trends and large fluctuations. It does, in fact, change.
In the aftermath of the financial crisis, a massive drop in the velocity of money could be indirectly but palpably observed in the US and in Europe. This means that impact of the money created by the central banks to restart the various national economies somehow gradually faded. Thus, despite the printing presses running red-hot, there has been no massive upward pressure on prices, no surge in inflation despite the vastly increased money supply.
One explanation for the drop in the velocity of money is certainly the diminishing confidence people and businesses have in the economy. This leads to caution about spending, to hoarding cash instead of using it for private consumption or corporate investments. Obviously, greater confidence in the economy could reverse this economic entropy, which the slowing velocity of money reflects. In parallel, an improving economy would likely see upward price pressures starting to build. This is exactly the scenario the Federal Reserve would like to see unfold.
But confidence in the economy is not the only thing that drives this situation. The confidence people have in money itself, in its basic role as store of value, also influences the velocity of money. The less confident they are in the money they hold, the more quickly they will try to get rid of it. In a phase of hyperinflation, the velocity of money is extremely high since no one wants to hold cash – which loses its value by the hour. They prefer to exchange the cash against virtually anything.
So there is a dark side to an increase in the velocity of money that the Fed would so warmly welcome. If the cause is not renewed confidence in the economic prospects, but instead reflects a loss of confidence in money itself as store of value, we could return to a 1970s-style scenario with low growth, high unemployment and, despite these constraints, mounting price pressure.
Such a resolution would deliver a verdict – both Solomonic and Pyrrhic – on the debate between those who take the fading confidence in the economy as a sign of impending deflation and those who think the waning confidence in money as a store of value augurs that inflation is just around the corner. We are beginning to wonder whether both sides are right. Perhaps the debate's ultimate outcome will deserve that ugly description of a chronically sick economy: stagflation.
Monetary theory examines the fluid dynamics of money in an economy, analyzing its supply and demand and how it affects things like prices and employment. At a first glance, monetary theory is simple enough. It is basically explained by the following formula: over a given period of time, the value of all economic activity equals the value of the available money multiplied by the number of times that money changes hands.
So far, so good. But dig deeper and it soon becomes apparent that the individual elements of this formula – which defines the so-called quantitative theory of money – are a lot more complicated than they appear. Even the notion of money itself needs more clarity. But perhaps the most elusive concept in the formula relates to the number of times money changes hands over a given period of time. This is what economists call the "velocity of money."
The velocity of money can only be measured indirectly, deduced from the other elements of the formula. Moreover, the forces behind the velocity of money are various and often not well understood. For one thing, they generally belong to those "soft" but no less powerful factors of psychology and human behavior. This is rather frustrating since the velocity of money is an important cog in the mechanism that transforms newly created money into price inflation.
The vagaries surrounding the velocity of money are often simply ignored. The less troublesome approach, which assumes the velocity of money is constant, is usually taken. But the indirect evidence makes it clear that the velocity of money is indeed subject to long-term trends and large fluctuations. It does, in fact, change.
In the aftermath of the financial crisis, a massive drop in the velocity of money could be indirectly but palpably observed in the US and in Europe. This means that impact of the money created by the central banks to restart the various national economies somehow gradually faded. Thus, despite the printing presses running red-hot, there has been no massive upward pressure on prices, no surge in inflation despite the vastly increased money supply.
One explanation for the drop in the velocity of money is certainly the diminishing confidence people and businesses have in the economy. This leads to caution about spending, to hoarding cash instead of using it for private consumption or corporate investments. Obviously, greater confidence in the economy could reverse this economic entropy, which the slowing velocity of money reflects. In parallel, an improving economy would likely see upward price pressures starting to build. This is exactly the scenario the Federal Reserve would like to see unfold.
But confidence in the economy is not the only thing that drives this situation. The confidence people have in money itself, in its basic role as store of value, also influences the velocity of money. The less confident they are in the money they hold, the more quickly they will try to get rid of it. In a phase of hyperinflation, the velocity of money is extremely high since no one wants to hold cash – which loses its value by the hour. They prefer to exchange the cash against virtually anything.
So there is a dark side to an increase in the velocity of money that the Fed would so warmly welcome. If the cause is not renewed confidence in the economic prospects, but instead reflects a loss of confidence in money itself as store of value, we could return to a 1970s-style scenario with low growth, high unemployment and, despite these constraints, mounting price pressure.
Such a resolution would deliver a verdict – both Solomonic and Pyrrhic – on the debate between those who take the fading confidence in the economy as a sign of impending deflation and those who think the waning confidence in money as a store of value augurs that inflation is just around the corner. We are beginning to wonder whether both sides are right. Perhaps the debate's ultimate outcome will deserve that ugly description of a chronically sick economy: stagflation.
Thursday, December 2, 2010
02/12/2010: Beware of economic idols
Eamonn Fingleton's 1995 book Blindside never fails to remind me of that famous verse from the Book of Ecclesiastes: "Vanity of vanities, all is vanity." Published just one year after the release of Hollywood blockbuster Rising Sun, Blindside reflects the decade's conviction that Japan was on a one-way path to global economic domination. Its subtitle – “Why Japan is still on track to overtake the US by the year 2000” – says it all.
Back in the early 1990s the world looked to the Japanese economy as its ideal: from keiretsu, the uniquely Japanese structure of large conglomerates, to the volunteer problem-solving groups known as quality circles. And yet this valorization reached its peak just before Japan's stock and housing market bubbles burst and ushered in the country's lost decade(s). Today, no one views Japan as a role model for economic policy: In fact, it haunts the global economy as a cautionary tale of mismanagement.
A string of economic idols came and went throughout the 1990s: first Japan, then the US, and finally “new Europe” with its Spanish economic miracle and Celtic tiger. Labor flexibility and deregulated financial markets became the new paradigms as allegiance shifted toward service economies at the expense of economic models based on manufacturing and industry. Alan Greenspan and Lehman Brothers CEO Dick Fuld – who was winning management awards right up until Lehman's collapse – were lauded as heroes.
Now yet another crisis has left a cherished economic model in tatters, and the world already seems to be on the hunt for new economic idols. We currently have two prominent front runners: Germany and China. Germany's proponents claim that its strength comes from its solid industrial base: In contrast to the US, the UK and the European periphery, tangible goods give German exporters their competitive edge, not intangible services. This view has its roots in a quite traditional Marxist worldview where only "things" matter.
But this overlooks the tremendous sacrifices Germany has made over the last decade in order to conserve its industrial base in a globalized world. German workers, for example, have not gotten any serious wage increases since 2000. These low labor costs would keep Germany ultra-competitive in Europe even with a stronger euro, but we cannot ignore the extent to which Germany benefits from the currency's weakness. Add to this the current Eurozone interest rates, which are far too low for the booming German economy, and we begin to see the danger of new bubbles fueled by cheap credit.
China, the other new economic role model, occupies a similar situation in terms of monetary policy. Its peg to the US dollar means interest rates are too low, and the country is already experiencing inflation pressures and a few real estate bubbles. Furthermore, China's much-praised long-term planning – which is not subject to short-term considerations like elections or quarterly corporate results – could soon outlive its usefulness. Long-term planning may be appropriate for an emerging market, but for a developed economy it can lead to overinvestment in losing sectors or hamper technological progress by underemphasizing competition and creative destruction.
Economic idols rise and fall like any other fad, and investors show a marked tendency to burn what they have adored and adore what they have burned. Yet careful analysis shows that all economic models have certain weak points, and their benefits come at the cost of corresponding drawbacks. The more openly these problems are discussed, the more likely we are to find workable solutions. Ironically, it is often the willful ignorance of idolatry that takes ordinary challenges and turns them into fatal flaw.
Back in the early 1990s the world looked to the Japanese economy as its ideal: from keiretsu, the uniquely Japanese structure of large conglomerates, to the volunteer problem-solving groups known as quality circles. And yet this valorization reached its peak just before Japan's stock and housing market bubbles burst and ushered in the country's lost decade(s). Today, no one views Japan as a role model for economic policy: In fact, it haunts the global economy as a cautionary tale of mismanagement.
A string of economic idols came and went throughout the 1990s: first Japan, then the US, and finally “new Europe” with its Spanish economic miracle and Celtic tiger. Labor flexibility and deregulated financial markets became the new paradigms as allegiance shifted toward service economies at the expense of economic models based on manufacturing and industry. Alan Greenspan and Lehman Brothers CEO Dick Fuld – who was winning management awards right up until Lehman's collapse – were lauded as heroes.
Now yet another crisis has left a cherished economic model in tatters, and the world already seems to be on the hunt for new economic idols. We currently have two prominent front runners: Germany and China. Germany's proponents claim that its strength comes from its solid industrial base: In contrast to the US, the UK and the European periphery, tangible goods give German exporters their competitive edge, not intangible services. This view has its roots in a quite traditional Marxist worldview where only "things" matter.
But this overlooks the tremendous sacrifices Germany has made over the last decade in order to conserve its industrial base in a globalized world. German workers, for example, have not gotten any serious wage increases since 2000. These low labor costs would keep Germany ultra-competitive in Europe even with a stronger euro, but we cannot ignore the extent to which Germany benefits from the currency's weakness. Add to this the current Eurozone interest rates, which are far too low for the booming German economy, and we begin to see the danger of new bubbles fueled by cheap credit.
China, the other new economic role model, occupies a similar situation in terms of monetary policy. Its peg to the US dollar means interest rates are too low, and the country is already experiencing inflation pressures and a few real estate bubbles. Furthermore, China's much-praised long-term planning – which is not subject to short-term considerations like elections or quarterly corporate results – could soon outlive its usefulness. Long-term planning may be appropriate for an emerging market, but for a developed economy it can lead to overinvestment in losing sectors or hamper technological progress by underemphasizing competition and creative destruction.
Economic idols rise and fall like any other fad, and investors show a marked tendency to burn what they have adored and adore what they have burned. Yet careful analysis shows that all economic models have certain weak points, and their benefits come at the cost of corresponding drawbacks. The more openly these problems are discussed, the more likely we are to find workable solutions. Ironically, it is often the willful ignorance of idolatry that takes ordinary challenges and turns them into fatal flaw.
Subscribe to:
Posts (Atom)