Friday, April 29, 2005

Deconstructing GDP

Yesterday’s big economic news was that U.S. GDP grew 3.1% in real, annualized terms, while forecasters had pegged growth at 3.5% (see the full report here). Yet, when one takes a look at the coverage of this story, nearly all reports do a very poor job of explaining why the economy did worse than expected.

The problem is that people need a “story” to make sense of raw data. Needless to say, there’s always a strong temptation (conscious or unconscious) to twist facts so that they fit the narrative, particularly if it’s simple and compelling.

In this case, the story goes like this: high oil prices forced consumers and firms to cut spending on other items in the first quarter, resulting in weak growth. This piece by the AP offers the clearest example.

But is it true? Not really.

Personal consumption expenditures grew at a 3.5% annual clip, down from 4.2% in the 4th quarter. Meanwhile, private investment spending rose at a 12.5% rate, slightly below the 13.3% increase in the previous quarter. Actually, if you add both, they grew 5.1% in total.

Obviously, consumers and firms were just as eager to spend as ever. And let’s not forget that expenditures on gasoline and oil represent just 3% of household expenditures.

The real issue is how the money is spent. Basically, growth in the first quarter was held down by spending on imports, which rose a very impressive 14.7% and, yes, that includes oil. Even after adding exports, the trade balance subtracted 2.2 percentage points of growth, versus 1.7 percentage points in the previous quarter. This alone explains much of the slowdown between the fourth quarter and the first.

Runaway import growth was not the only troubling aspect of the GDP report. Around half of the growth in private investment took the form of inventory accumulation. If consumer spending doesn’t grow at a faster clip this quarter, high inventories may lead to production cutbacks and employment growth –the key element in sustaining consumer expenditures—will be minimal.

Wednesday, April 27, 2005

Headline fiasco of the day, II

Headline: Bush, Inventories Hit Oil Hard
Appears in:
Author: Elinor Arbel

My take:
Oil prices (or to be more precise, the price of the benchmark WTI crude) dropped nearly 3 dollars. What prompted the plonge? Most news outlets correctly credit a Department of Energy report that showed that crude inventories in the U.S. rose by 5.4 million barrels, when analysts were expecting a rise of just 650,000 barrels.

Yet, today’s featured article actually began like this:

Crude oil prices tumbled towards $51 a barrel Wednesday, beaten down by
President Bush's commitment to achieve more U.S. self reliance in energy
production and by bearish inventory data showing a surge in crude stocks.

So what momentous words did the President offer us? Let me quote the article again:

In a speech before the Small Business Administration, President George W. Bush
stressed his commitment to increasing local production of energy in the U.S.
Bush reiterated the need to pass an energy bill that would ease many regulatory
restrictions to better accommodate the building of new refineries, liquefied
natural gas terminals and for drilling in the Alaska National Wildlife Refuge.
He also lauded the merits of nuclear energy and stressed the importance of
conservation efforts.

Yada, yada, yada. Basically, he just repeated what he has said since he was a candidate and what most politicians have stated since the 1970’s. In sum, a totally irrelevant speech. In this thoroughly excellent Bloomberg piece, Bush’s speed merited one paragraph out of 18.

Ms. Arbel should learn to tell the wheat from the chaff.


The debate on the impact of P2P music downloads on record sales has raged for nearly 5 years. Strangely enough, there is no conclusive evidence that supports the view that Web downloads have depressed CD sales (not that this has stopped the recording industry from suing thousands of downloaders).

Such inconclusiveness shouldn’t be a surprise. Sure, we may listen to music everyday, read about our favorite bands, know which acts are hot at the moment and go to a concert every now and then. But most people (including yours truly) don’t have a clue about which revenue stream is more important for artists, how recording contracts are structured or why “ilegal” practices such as payola and scalping still flourish, among others.

As it turns out that the popular music industry is very complex and its inner workings are poorly understood. This is the conclusion one takes away after reading “Rockonomics: The Economics of Popular Music”, a new paper by Alan Krueger and Marie Connelly of Princeton Universidty.

It’s not exactly easy reading, but it serves as a good primer on the music industry, which is certainly more interesting and fun than, say, ball bearings.

Tuesday, April 26, 2005

Headline fiasco of the day, I

On any given day, there’s a 51% chance that stocks will gain and a 49% probability that they’ll end up lower. Most likely, the loss/gain will be between +/- 1%. Over short periods, stock prices move randomly. It’s only possible to detect patterns over long horizons (which means several months or even years).

So pity the poor hacks who have to write the daily market wrap ups in the financial media. They have to assign meaning to what are essentially meaningless, random and absolutely unimportant price changes. But they can’t admit that. As a result, they’re constantly tempted to draw readers by wild exaggerations, misleading analogies and other tricks of the trade.

They face and impossible task day after day, so I figure these guys deserve a tribute. Starting today, I’ll attempt to chronicle the most outrageous, unbelievable, tendentious and, yes, stupid financial headlines I come across on a daily basis.

Today’s winner is:

Headline: Investors Lack Faith in Future
Appears in: The Washington Post
Author: Jerry Knight

My take:
Is the economy about to collapse? Did oil reach $80 per barrel? Did China say that it would no longer invest its reserves in dollars? Any of these events would certainly shake my faith in the future. But, according to Mr. Knight, investors despair rather easily. Apparently, all it takes is a drop in U.S. consumer confidence, a very volatile indicator. This piece explains what it means:

The lower confidence reading points to dimmer view of both current conditions
and more caution about the coming months, said Lynn Franco, director of the New
York-based Conference Board's Consumer Research Center.

"Looking ahead consumers do not anticipate an improvement in economic growth nor in their
incomes. And they expect an even tighter job market over the summer months,"
Franco said.

Not good news for sure, but not the kind that generates suicidal thoughts. Besides, did I mention that the S&P 500 fell just 0.9%?

Commodities vs. Stocks and Bonds

April hasn’t been the kindest month for the U.S. economy. Weak employment and retail sales reports, along with rising inflation, have raised the specter of weaker than expected growth. Some disappointing earnings news from the likes of IBM, GM and Ford hasn’t helped either.

As a result, the S&P 500 has dropped 1.6% so far this month and 10 year T-bond yields are nearly 30 basis points lower than at the end of March.

Interestingly enough, the commodity markets have been mostly unfazed. This is unusual, since commodity prices have boomed recently: the IMF’s commodity price index posted a 33% jump over the 12-month period ending this march. According to most analysts, strong demand, driven in turn by high economic growth in the U.S., China and other developing nations, explains why commodity prices have risen so much.

One would think that if U.S. growth were to unexpectedly slow, commodity prices would post steep declines. Yet, oil prices are nearly at the same level seen at the end of march. At the same time, metals prices at the LME have also stayed mostly unchanged or have posted small declines.

Given the rise in stock prices over the last few days, it seems the commodity markets were right all along, although long term interest rates haven't risen. That is, unless the scariest scenario comes to pass: commodity prices stay high despite falling economic growth (aka the stagflation scenario). It's possible, but very unlikely.

Which is a better leading indicator? Personally, I put the most store in interest rates, but the answer is open to debate.

Hollywood-style irony

Europeans frequently whine about the all-pervasive presence and influence of American popular culture, specially movies. Well, according to this Slate article, it turns out that many Hollywood productions –mostly big budget action flicks—are financed by subsidies and tax breaks handed out by European governments.

How can this be? I’m sure many of the euro intellectuals and artists who habitually bash everything American also benefit from these handouts. Obviously, not biting the hand that feeds you takes precedence over intellectual convictions.

Thursday, April 21, 2005

The joys of flat taxes

Last week, The Economist ran a lengthy article on flat taxes, making a persuasive case for them. This is not just an eccentric idea that appeals to nutty right-wingers. Unbeknownst to most, eight Eastern European nations –including Russia--have already adopted flat taxes, with good results.

No one can deny flat taxes have many things in their favor compared with the traditional multi-bracket income tax. First of all, they’re much easier to collect, which saves the government a lot of money by reducing administrative costs and tax evasion. In addition, they save the average taxpayer a lot of time, money and anguish. Last but not least, a flat tax system makes it a lot harder for politicians to intervene in resource allocation by handing out tax breaks to favored industries and constituents.

So why aren’t people in the rich nations clamoring for them? As any self-respecting liberal (in the American sense) will tell you, flat taxes seem unfair. For decades, the idea that the more you earn, the more you should pay in taxes has been firmly rooted in the Western world. This is so despite mounting evidence that the rich end up paying about the same share of income as the middle class since they have the resources to exploit the mind-numbing complexity of the tax code.

When simplicity and efficiency battle fairness, the latter wins hands down in most people’s minds. However, is this perception justified?

The main problem in all debates concerning the fairness taxes is that they ignore the flip side of the coin: public spending. Clearly, having a “progressive” tax system is of little use is spending is regressive. In other words, taxing the rich doesn’t advance the cause of social justice if they end up receiving most government spending. Admittedly, this is a rather extreme case (in the rich world; my impression is that in many developing nations this may be sadly true).

Thinking along these lines offers a solution, a “third way” so to speak: adopt flat taxes, but at the same time review and change public spending to make it more progressive. This is a win-win solution: everyone benefits by having simpler taxes and the needy get more public money.

In addition, this idea will also have an additional benefit. Incredible as it seems, today, hardly anyone knows the general distributional impact of government spending nor is it a point taken much into account by policymakers, despite its obvious importance. By linking tax policy to spending in terms of fairness, this will have to change.

Wednesday, April 20, 2005

The deflation blues are back

I’ve followed the markets for over ten years. Rarely have I seen a shift in sentiment as sudden and dramatic as the one that has taken place over the last two weeks. Let me elaborate a bit (a bit?!? Ok, this will take a while, so bear with me).

Last month, everyone was worried about high oil and raw material prices –the by-product of strong growth in the U.S. and China—and the impact they were having on inflation. As a result, interest rates rose significantly in the U.S.: the yield on 10 year T-bonds went from 4% to 4.6%. By itself, this didn’t do too much damage. Equity prices hardly budged, which proved that investors were mainly concerned with the growth prospects for profits. However, higher rates did have an impact on rate -sensitive sectors, such as emerging markets and financial stocks.

Also, the jump in interest rates finally put an end to the downward trend in debt risk premiums (a definite negative for stocks), a point emphasized by GM’s warning on its financial outlook.

In April, this scenario changed radically. A string of negative economic reports –led by lower than expected growth in U.S. payrolls and retail sales, as well as underachieving earnings numbers in some leading firms (IBM)—led investors to question the growth prospects for the U.S. economy. Consequently, stocks plunged and bond yields drifted lower, along with energy prices.

How could the economic picture change so suddenly? After all, short term economic indicators are notoriously noisy and it may well turn out to be an unfounded panic sell-off.

Yet…I don’t know. A good starting point is to go over some facts:
1) The U.S. consumer, literally the linchpin of the world economy, is tapped out. Personal savings have fallen to nearly zero. This means that from now on consumer spending can only grow in line with employment and earnings growth. These two variables in turn depend on the willingness of firms to hire workers.

2) Private investment picked up last year, but still seems sluggish. Firms will not invest much unless they expect consumer spending to grow, specially when many sectors are still burdened by excess capacity left over from the 90’s.

3) Rising labor fixed costs (mainly healthcare premiums) and strong productivity growth have limited payroll expansion.

This looks like a vicious circle. In the last two years, the U.S. economy managed to lift itself in large part due to massive fiscal and monetary stimulus. These options are not in the cards today.

What will happen? Richard Berner of Morgan Stanley argues that underinvestment and underhiring in the US over the 2001-2003 period has left firms with pent-up demand for real assets and workers. He has long argued that it’s just a matter of time before these needs are reflected in the relevant macro stats. If he’s right and hiring picks up, then consumer spending will grow at a moderate clip and investment will follow.

This is a sound and reasonable point of view. However, I have my doubts. The main issue, I believe, is that the U.S. economy needs a spark to get Berner’s virtuous circle going. That’s not going to be easy. For some time now, everyone has been bombarded with articles that talk about how the structural imbalances in the U.S. economy (fiscal/current account deficits) will have to be unwound sooner or later. If you were a CEO at a large firm, does this talk inspire confidence in the future?

Of course not. Not that the analysts in question are wrong: the imbalances are a very serious issue. Things are made much worse by the fact that the U.S. government doesn’t have a real strategy for dealing with these issues seriously. And let’s not forget that there are many other worrisome flash points in the world economy: Europe and Japan remain stagnant and unwilling to reform, the EU may be thrown into a crisis if French voters reject the proposed European constitution, China and Japan are screaming at each other, etc.

BOTTOM LINE: Unfortunately, I’m a pessimist by nature, so it’s hard for me to see the glass half-full. My guess is that U.S. growth will disappoint this year. Given that, will Asian money keep flowing to the U.S.? In the end, the world economy can only attain a more sustainable position if Asia saves less/consumes more. Lower U.S. growth will eventually force them to this, but frankly I don’t know how they’ll be able to pull it off.

Friday, April 15, 2005

Expensive Oil: The Saudi side of the story

During the past couple of years, oil has constantly been in the news. Just about 99% of the coverage has centered on price trends, OPEC and the impact of expensive oil on the economies of rich nations. There’s a glaring gap here: what about the impact on the economies of producing nations?

Obviously, these come in all shapes and degrees of dependency on oil. Some, like Mexico, have large, diversified economies where oil plays a minor part. Others, such as Saudi Arabia, the world’s largest producer, basically live off the black stuff (in 2003 oil production represented nearly 40% of its GDP) and thus make for interesting subjects of inquiry.

Needless to say, the Saudi kingdom did very well last year. According to the IMF, it’s dollar-based GDP grew 16% last year. Given that inflation was non-existent and the exchange rate held steady, this increase pretty much reflects how much their purchasing power rose in 2004.

(As an aside, this stat also shows why one must not exclusively rely on real variables. The IMF estimates that in real terms Saudi GDP rose 5%, but this figure clearly does not reflect the true rise in that nation’s income).

The most interesting question is how all that money was spent. According to the data, the stereotype of huge petro-dollar funded shopping sprees in Harrod’s is rather dated.

Total demand, made up of consumption and investment, rose 7.7% in dollar terms last year in Saudi Arabia. Obviously, it’d be much better if that money was spent on infrastructure and such, but one couldn’t blame the Saudis if they splurged a bit (the available information doesn’t break down total demand). Nonetheless, national saving rose 66%, which shows that the government/royal court has learned something about the value squirreling away some money for low oil price days.

All in all, as a nation, Saudi Arabia spent only 80% of its available income last year (English to wonk translation: the current account surplus stood at 19.8%), up from 86% in 2003.

One can only hope that all that extra income will temp aspiring jihadis to pursue worldly affairs rather than martyrdom.

Thursday, April 14, 2005

Face to face with globalization

Globalization has been a hot topic for many years. In rich nations, people vaguely recognize that it’s mostly a good thing: more choice, lower prices, etc. Yet, they also worry about losing their job to a foreigner who will do the same thing for much less pay. For now, this seems mostly a distant and faceless threat (that is, unless one works in manufacturing).

Well, the other day I came face-to-face with globalization. I ended up both scared and fascinated, even though I’m a skilled professional living in a middle-income country.

My encounter took place in a site called Elance Online. Basically, it’s a market place where firms put up for bidding small, independent projects that need to be done. Independent contractors from any nation can participate in the auction. Most are software-related, but there is a wide variety including editorial work, accounting, etc.

Take a look at this project for translating 51,000 words of English text to Spanish (and other languages). My wife has worked as a translator for over 10 years and she told me she would charge around US$ 3,000 for a job like this. Her rate is not low, but it is competitive for high-quality work. Now look at the bids: nearly 20, from places in Russia, India, the U.S., Argentina, Uruguay, Britain and Portugal, with the lowest at US$200 and the highest at US$ 1,450 (the average would be around US$1,100).

Obviously, it’s difficult to evaluate how serious some of these proposals are. However, many state that they include proofreading and quite a few have positive reviews for previous Elance projects.

I’ve seen many other examples. On average, qualified U.S. contractors’ bids were nearly three times higher than those provided by Indian and other foreign sources. Needless to say, quality and language are important issues that may justify higher prices, but the differentials are pretty large.

Frankly, I don’t know how big or how far this trend will run. Clearly, only fairly simple and straightforward projects can be contracted out now and it’s hard to tell if this will change. Nonetheless, this means intense competition for independent professionals everywhere. But it also has the potential to make life much easier for start-ups by enabling them to contract out non-essential functions (accounting, design, etc.), spurring growth and innovation. This will benefit everyone in the long-run, but it’s bound to be a bumpy ride for many.

Friday, April 01, 2005

News Not In the News: Mexico City's mayor

With all eyes on the Vatican, I'm sure that the plight of Mexico City's mayor won't be getting much attention from the international press. However, it's bound to be a huge story in the next few months.

It's a complicated case which no one understands clearly, but here's the gist: the government, with help from the ruling party (the PAN) and the nation's largest party (the PRI), is trying to convict Andrés Manuel López Obrador (aka AMLO), the mayor, for violating a court order related to a very minor land use dispute. If this happens, he can't run for the presidency next year.

AMLO is by far the most popular politician in Mexico and polls show he is way ahead of other presidential candidates. This is why nobody believes that the accusations against him are a matter of "upholding the rule of law", as the government says. If he's out of the way, the PAN and the PRI would vastly improve their chances of winning the top prize in 2006.

Now, AMLO is a smooth and tough politician. He's already upped the stakes for his opponents by calling for massive demonstrations in the streets. Polls show that 80% of the population backs him in this dispute. It's hard to predict what will end up happening, but Mexico will certainly be rocked by an all-out political dogfight even before the electoral process starts. Things will probably get very nasty.

We're talking about one of the largest emerging markets. As it is, this asset class will have a very tough time over the next few months due to rising interest rates in the U.S. and a weaker global economy. Trouble in Mexico will probably raise its risk-premium and this may spill over, although it probably won't have a direct short-run impact on that nation's macroeconomic indicators.

But what really scares me is the medium and long-term picture. Mexico badly needs structural reforms in countless areas. AMLO is a left-wing populist (probably more Lula than Chávez, though) who will not carry them out if he wins. If he's brought to trial, this will create a climate of intense polarization which will make it impossible for important agreements to be reached even if a more pro-reform candidate wins in 2006. It seems poor Mexico is set for yet another lost decade.

Politics bites Greenspan

I don’t usually read magazines with half-naked babes on the cover, but the latest issue of GQ (thanks to Slate for the pointer) has an interesting piece on Alan Greenspan.

The main thrust of the article is that although the chief of the Federal Reserve isn’t supposed to meddle in politics (and politicians can’t mess with the Fed by law), Mr. Maestro hasn’t resisted the temptation. Allegedly, he struck deals with Bush senior and Clinton to lower interest rates in exchange for tax hikes to curb Ronnie Reagan’s monumental deficits.

This doesn’t make much sense –even though the sources look reliable—since the Fed would probably have reduced rates anyway given the economic conditions of the time. However, these “deals” do seem to indicate that Greenspan prodded these two former presidents to do the right thing in fiscal policy, pointing out that lower deficits would allow rates to fall, thus jump-starting economic growth. The recipe worked just fine for Clinton and the nation, but the benefits didn’t come soon enough to save George H. W. Bush.

One long boom later, Greenspan had to deal with the next Bush and a set of radically different circumstances. The budget was in the black, but an unusual asset-driven recession was looming. The president adamantly wanted tax cuts and got Greenspan to sign on: he firmly and publicly backed them, which everybody interpreted as an endorsement of the chief executive’s plans.

Four years later, the nation faces twin fiscal and external deficits that may lead to a nasty crisis down the road. If this happens, Greenspan’s latest incursion into politics may be the undoing of his place in history as one of the greatest ever central bank chiefs or worse.

To be fair, backing tax cuts when a recession is imminent is not bad policy per se and he probably never envisioned just how irresponsible Bush and the Republicans would be in fiscal matters. Nonetheless, Greenspan must be really, really wishing he could take those words back.

Time to backpedal and promote fiscal sanity with full-force? Seems so. He’s already started to this in some speeches, which haven’t attracted much attention, and he’ll probably give quite a few “can’t quote me on this, but here’s what I really think” interviews. However, his scope for doing this while in office is limited if he doesn’t want to undermine the Fed’s political independence.

It’ll be interesting to see what he does and what he says out of office a year from now. Hopefully, he’ll do his penance and contribute towards the reestablishment of fiscal sanity.