Intangible Wealth

Socialists for free trade!!!

2009-02-02T18:13:00.004-06:00

From the folks over at the World Socialist Web Site (published, if you were wondering, by International Committee of the Fourth International):

While those promoting “free trade” speak for the bankers, financiers and more globally competitive sections of capital, there is a definite constituency for protectionism among less competitive industries. The whipping up of economic nationalism also serves a vital ideological function in diverting the anger of working people over job losses and the precipitous decline in living standards outwards rather than at the real source of the crisis—the profit system itself.

Not exactly the kind of defense for free trade I'd mount, but nowadays we need all the allies we can get.

One year after

2009-02-02T17:54:00.003-06:00

Blogging is an on-and-off kind of thing for me. As much as I enjoy it, a demanding job and an equally demanding family life leaves little energy for this. So, no promises, specially to myself, but here goes nothing once again.

Where did I leave off? Funny thing, my last post ended with this sentence:

"Not good news given the real potential (albeit small) for a worldwide financial meltdown."

Look, I ain't no Nouriel Roubini, but it's just amazing how ugly things have gotten, pessimistic as I was back then. Last December feels soooo long ago.

Where does the IMF stand in the world's financial pecking order?

2007-12-04T11:54:00.000-06:00

Apparently, one notch below a middle-tier, but prestigious, investment bank (see here).

Not good news given the real potential (albeit small) for a worldwide financial meltdown.

Johnny Biofuelseed's free lunch

2007-11-07T13:08:00.000-06:00

It's certainly understandable that in a time of $100 a barrel oil many laud the promise of biofuels. Yet, Ricardo Hausmann, an economist at Harvard's Kennedy School of Government is guilty of overstating the case for them. For instance, he boldly claims the following:

Peering into the future seldom produces a clear picture. But this is not the case with bio-energy. Its long-term impacts on the global economy appear to be pretty clear, making many long-term predictions quite compelling, including the demise of the price-setting power of the Organisation of the Petroleum Exporting Countries and the end of agricultural protectionism.

While no one can deny that biofuels will be part of tomorrow's energy mix, that's a stretch. Let's begin with the following claim:

Second, the world is full of under-utilised land that can grow the biomass that the new technology will require. According to the Food and Agriculture Organisation, the world has a bit less than 1.4bn hectares under cultivation. But using the Geographic Information System database, Rodrigo Wagner and I have estimated that there are some 95 countries that have more than 700m hectares of good quality land that is not being cultivated. Depending on assumptions about productivity per hectare, today’s oil production represents the equivalent of some 500m to 1bn hectares of biofuels. So the production potential of biofuels is in the same ball park as oil production today

It is very unseemly for an economist to claim that there's a free lunch to be had. After all, why is all that land being underutilized? Maybe there are good reasons for that! It's not as if there's a shortage of land hunger in those countries. Also, let's not forget the inconvenient truth that some of that land is bound to be forested and turning into cropland is, shall we say, not an attractive proposition given our climate change worries.

Let's check out another of his claims:

Fifth, the increase in the price of agricultural land and of food will relieve governments from the current political pressure to protect the agricultural sector. Governments that, as a consequence of the land glut, have been protecting and subsidising farmers will see them grow rich either because they “plant” biofuels themselves or because other producers switch into them, lowering the supply and increasing the price of other crops.

The man clearly underestimates the power of the agricultural lobby. Even at today's high prices, farmers and big agro firms are set to push through a massive farm bill that leaves subsidies intact.

And last but not least, Hausmann dismisses the impact of higher food prices by saying that will create pressures to liberalize agricultural trade. Maybe. But it's not at all clear that liberalization would lead to lower prices, specially if, as he argues, subsidies are reduced. Let's not forget that even if a biofuel boom leads to higher rural incomes overall, some groups will be net losers due to high food prices, like landless agricultural workers.

Why come down so hard on Hausemann? I'm not against biofuels. But overselling their promise will lead to unnecessary policy mistakes, with long-term negative consequences. Yes, it's certainly worthwhile to promote R&D in this area, but subsidies, mandates and tariffs should not be used to promote their use.

Is PetroChina really worth 1 trillion dollars?

2007-11-05T18:32:00.000-06:00

That's the firm's market capitalization as implied by its price in the Shanghai bourse following its IPO there (see here). But the price of its NYSE-quoted ADR's gives a market cap of "only" 398 billion.

This, of course, is the result of capital controls in China, leading to what is probably the biggest case of segmented markets in history. Of course, this is just a degree of insanity quibble, as there's no way PetroChina is worth a cool one trillion.

After all, ExxonMobil has three times the revenues PetroChina has, and twice its net income. Even if China keeps growing at its current rate, that's a big gap to overcome (and lets not forget the bulk of those profits come from upstream activities, which grow slowly if at all).

Employment: Bear trap

2007-11-02T12:01:00.000-06:00

Stephen Colbert would be pleased by the pain the employment figures have been inflicting on bears. The October figures were impressive, posting a 166,000 gain in payrolls, nearly twice the level that economists were expecting.

I should stop here, but my inner grizzly won't let me. So once again I resume my hopeless crusade and take issue with some numbers, particularly those related to construction employment.

Construction is a study in contrasts. Residential building has collapsed, with real investment falling 23% between its peak in the 4th quarter of 2005 and the past quarter, with no improvement is sight (it fell 16.4% in 3Q07 versus the year-ago period). In the same time frame, non-residential construction investment has risen steadily, a total gain of 24.5% (and 13% versus 3Q06). But given the fact that residential construction is larger than its counterpart, total construction spending has fallen over 10% over the last 8 quarters (and 6.8% in 3Q07 vs 3Q06).

And yet, total construction employment rose 1.4% between the 4th quarter of 2006 and the past quarter. During this period, residential construction employment (including contractors) fell only 3.1%, while non-residential construction employment jumped 5%. In other words, one fell very little and the other didn't rise as much as it should have. The same holds over the past year.

This graph plainly shows that the response of employment to the fall in construction investment has been remarkably muted by past standards. This is and remains very odd, in a good way, but odd nonetheless.

Economic sugar rush and other treats

2007-11-01T11:55:00.000-06:00

Well, there's no denying that the third quarter GDP advance was pretty impressive, with growth coming in at an annualized 3.9% rate. I don't want to put a bearish spin on the numbers, so let's start with the positives:

1. Consumer spending: The 3% annual growth rate is very solid. Based on modest employment growth and rising compensation, it was strong across the board. There's no sign that consumers are slowing down due to lower home equity.

2. Investment: Residential investment is still dismal, contracting at a 20% annual rate. But nonresidential construction is going very strong (12.3% growth) and equipement and software investment posted its best showing since the 1st quarter of 2006.

3. Net exports: Real export growth was a blistering 23%, more than offsetting an uptick in imports.

4. Government expenditures: They made a positive contribution by rising 3.7%.

Now, let's look at the caveats:
1. Inventories grew very strongly, adding 0.36 to the 3.9% growth rate, which may be a modest drag on growth looking forward.

2. Residential investment will fall some more and nonresidential construction has grown at what looks to be an unsustainable pace, specially considering faltering corporate profit growth.

3. Export growth looks too high, although the dollar's fall will make net exports a key contributor to growth for the near future.

4. Federal defense outlays jumped 9.7%, also an unsustainable rate, although this variable is extremely volatile.

The end result is that the 3.9% growth rate will probably be revised down. However, the underlying rate is quite likely above 3% which is still a good result. Last year's 3rd quarter GDP advance orignally came in at 1.6% and ended up revised downwards to 1.1%.

Where does all this leave us looking forward? Yesterday's 25 bp cut in the fed funds rate certainly was a signal that a significant slowdown lies ahead. How deep will it be?

The most recent analyst survey, from The Economist, places 2007 GDP growth at 2%. This would imply, given the current numbers, a contraction of 0.3% in the fourth quarter. Ouch. Given the margin of error and the fact that this year's forecast might be raised a bit, my guess is that 4th quarter growth will come in flat. The Fed is buying insurance against the possibility of the coming slowdown becoming entrenched.

As to 2008, it all depends on the consumer. So far, they have shaken off the twin blows of rising energy prices and falling home values. It seems they believe these are temporary phenomenons and are set on waiting them out. This will continue until it stops and it's impossible to forecast when that will happen (if at all). The key, in my opinion, lies in the labor market. If job growth falters, things will get uglier very fast.

The junkie's lament

2007-10-30T16:27:00.000-06:00

Forgive me, for I'm about to rant. But I, Internet junkie that I am, can't help it.

I'll be blunt. Why do bloggers and MSM publications keep talking to and giving space to people who spout total nonsense? I don't mean opinion blowhards, although god knows there are way too many of them. My peeve is against pundits who say/write things that are objectively, evidently, painfully wrong.

The object of my wrath is this interview of Newt Gingrich by William Saletan in Slate. One paragraph is enough to illustrate my point:

The problem with regulation and taxes, he argues, is that they drive business overseas. Our auto emissions standards shift car sales to foreign manufacturers. European carbon caps push industries to Africa. But Gingrich is cursed with a brain that can see the big picture. He recognizes that overfishing, for example, requires collective action, since one or two countries can ruin the ocean for everyone. We have to think of the whole planet, he observes. Which raises the question: If undercutting by other nations foils unilateral regulation, isn't multilateral regulation the answer? Business can't flee emissions caps in one country if the same caps apply elsewhere. To this question, Gingrich clarifies that he's not against international remedies, as long as they're "functional."

It's amazing. The man reels of three, count them, completely false statements in a row, followed by several painfully obvious observations masquerading as profound insights. European carbon caps driving industries to Africa? I still can't believe I read that.

Don't get me wrong. I'm not angry at Gingrich. In a way, I admire a man who, being little more than a pompous nitwit, manages to convince others that he's a profound thinker. I guess that's what narcissism can do for you!

But how is it possible that the interviewer let all of this pass unquestioned? And how did an editor publish this?
Sigh.

Home prices are irrelevant!

2007-10-30T10:48:00.000-06:00

So argues Willem Buiter, a well-known monetary economist, in his FT blog. Why? The answer is that people usually live in their own house, hence:

As long as your endowment is positive, your wealth obviously increases when the house price increases. However, an increase in house prices means that the present discounted value of future rents has increased. As a consumer of housing services, now and in the future, you are therefore worse off. On average, in a country like the UK, people consume the housing services they own. Hence an increase in house prices does not make them better off. For financial assets like equity there is no corresponding “present discounted value of future equity services consumption” whose cost increases whenever the value of equity goes up. An increase in stock market values therefore unambiguously makes you better off.

But as regards house prices, regardless of whether a change in price is due to a change in risk-free discount rates, in risk premia or in expected future rents, you are neither better off nor worse off as a result of that price change, if you consume, now and in the future, the same contingent sequence of housing services whose present discounted value is part of the wealth you own. In that case, despite the increase in your housing wealth, once you have paid for the consumption of your initial contingent sequence of housing services, there will be nothing left to spend on anything else.

Great! So today's news of deepening falls in house prices in the U.S. can be happily dismissed. Move along, nothing to see here.

Back to reality, this is one of the most striking examples of ivory tower airy-fairy thinking I've come across in a while.

Now, Mr. Buiter's argument hinges on house prices being equal to the present value of future owner-equivalent rents. This simply does not hold up in real life. Judge for yourself:

There are many reasons for this. But in essence it comes down to the fact that people believe housing is real wealth. How else can one explain the decline ins the personal savings rate to almost zero in recent years?

So, yes, house prices do matter. How much? We'll find out soon enough.

Oil reaches $92 after Iran says "Boo!"

2007-10-26T12:17:00.000-05:00

Attributing every single rise in the price of oil to some minor Middle East-related event has become one of the most tiresome parlor games in financial journalism. What's driving the jump in oil prices is supply and demand. Jim Hamilton of Econbrowser explains this eloquently.

Housing: Hope springs eternal

2007-10-25T13:54:00.001-05:00

Today we learned that new home sales rose 4.8% in September. As was to be expected, many folks see this as a sign that housing is turning the corner. Needless to say, this is more a dead cat bounce than a true rebound. As this graph shows, similar monthly bounces have been registered in the recent past during the course of a dreadful secular collapse.

As Barry Ritholtz points out, the rise is not statistically significant and that compared to year ago levels, new home sales in September were 23% below the year-ago level.

Of course, we should also keep in mind that existing home sales --which make up the bulk of the residential market--fell 8% in September and are 19% below the year-ago level.

As for prices, both the new home and existing home sale median prices are not reliable indicators, as they're not seasonally adjusted and are affected by changes in the type of housing unit sold. Also, builders have so far resorted to incentives like free plasma TV's and the like to promote sales rather than price cuts. Clearly, the stickiness of prices has made sales volumes bear the brunt of the downturn.

Yet another shocking China fact

2007-10-24T22:11:00.000-05:00

A year and a half ago, only one Chinese firm (Petrochina, at number 16) was included in the list of the 20 largest firms by market value (see here). As of mid-October, that proportion had risen to 8 out of 20, including 3 out of the top 6 spots.

While Facebook may have a crazier valuation, the sheer scale of the Chinese market's rise is breathtaking.

The socialist take on Merrill's writedown

2007-10-24T13:02:00.000-05:00

I don't have much to add regarding Merrill Lynch's 8.4 billion bloodbath. But the good folks over at the World Socialist Web Site have been reading the Asset-Backed Alert Newsletter (I kid you not) and pass along a very relevant nugget of information:

While according to ABAlert, what Merrill did with investments in the subprime market estimated at $15 billion is not yet known. “One often-cited theory is that the bank transferred the banged-up investments from an available for sale account within its brokerage unit to a hold to maturity portfolio at affiliate Merrill Lynch Bank in late June.

“Such a move,” the article continues, “would have enabled the company to follow friendlier accounting procedures, since the contents of the for-sale portfolio must be marked to market [assigned a value based on what they would fetch at current market rates] on a routine basis and the values of assets in the hold book don’t have to be updated until they come due or are sold.”

“Thanks to this accounting maneuver, Merrill posted second quarter earnings that were stronger than expected,” according to ABAlert. Moreover, “The institution reported last month that its profits surged by 31%, to $2.1 billion, during the April-June stretch.”

Merrill is the largest underwriter of CDOs, or collateralized debt obligations—securitized debt instruments into which subprime mortgages are bundled together with other asset- and mortgage-backed securities. The global market in CDOs has soared from $160 billion in 2004 to half a trillion in 2006.

Merrill is by no means the only firm resorting to accounting ploys to hide losses. ABAlert reports that “Citigroup has been making moves resembling Merrill’s. The same goes for Lehman Brothers and Morgan Stanley,” who are also hunting “for internal accounting maneuvers that can lessen the impact of the market dislocation.”

The monies correspond to multi-billion dollar mark-to-market accounts opened by the major investment banks in their role as “warehouse lenders for unaffiliated CDO issuers. The plan was for the issuers to utilize the temporary lines of funding to build up inventories of subprime-mortgage securities that could serve as collateral for future CDOs, and then use the proceeds from those offerings to repay the banks. But as the subprime-mortgage business headed south in recent months, so did the issuers’ ability to complete new CDOs,” ABAlert said.

The move raised questions about the legitimacy of Merrill’s accounting procedures and “outsiders have been plumbing into the financial statements of those institutions, among others that somehow managed to avoid reporting losses, for clues about where they’re stashing the assets and what the true effect on their financial health might be.”

Furthermore, the ABAlert report sounds an alarming note regarding the “growing urgency by investment banks... to minimize the impact on their businesses or at least dress up their books.”

I must admit that this analysis explains recent events. Investment banks swept toxic securities under the carpet hoping that the whole subprime thing would blow over quickly. Interestingly, this clearly was an open secret and clearly the market freeze shows that suspicions about where losses lay were not mere paranoia.

Now the question is whether the banks have come clean. Chances are that they have reported a good chunk of their losses, although measurment issues may delay a full reckoning. However, by having held off on reporting losses for so long they may raise the levels of uncertainty and thus make the situation worse (at least compared to a scenario where they would've reported losses gradually as they happened).

Joe Torre, executive pay martyr?

2007-10-23T18:55:00.000-05:00

Is executive pay destined to rise ever higher? The Economist's Business.view column thinks so and they turn to a rather unusual example, Joe Torre, the New York Yankee's former manager, to make its case.

To recap, Torre quit after a long, successful tenure (although his team hasn't reached the World Series for six years) after the Yankees organization offered to extend his contract one more year, reducing base pay but offering generous performance-based incentives. Torre called it an insult and quit.

The column argues that:

....Once a pay level has been reached, it becomes a minimum. Mr Torre may still have been the best paid manager in baseball under the new contract, but he would not have been as well paid as before. He is already wealthy and successful. He needs the extra money less than he needs respect—much like the typical boss of a big company after a few years in the job.

Perhaps the Yankees had decided that they really did not want to retain Mr Torre, but also did not want to be the target of abuse from supporters for firing a popular manager. So they hit on the brilliant reverse—“Godfather” strategy of making him an offer he was bound to refuse. But if they did want to keep him, they should have realised that the only executive who is likely to accept a pay cut is the one you don’t want to keep.

The same may be true when it comes to hiring a replacement—the best moment, in theory, to ratchet down excessive pay levels relatively painlessly. Of course, there is nobody available with a record like Mr Torre’s, so a little pay-trimming will be hard to quibble with.

But what self-respecting manager would settle for a pay package significantly less generous than his predecessor’s? Even if the market for executives functions better in future than in the past, when it comes to pay, the only rational way is up.

This just doesn't make any sense in any context. Here's why.

It's simply not true that a new CEO will demand, and earn, as much as a successful predecessor. GE provides a good example. This is just common sense. What high executive would not jump at the chance to run a firm even if he didn't earn as much as the previous CEO? Let's keep in mind that the gap between a CEO's pay and that of his top lieutenants is huge, so a CFO climbing to the top rung will make much more, even if pay at the CEO position is cut.

The main problem with executive pay is that incentives are not meaningfully aligned with actual performance. As a result, underperforming CEOs (which logic dictates are 50% of the total) are usually paid way too much. In that sense, true compensation reform would probably not penalize success, but rather avoid rewarding failure.

Now, the tricky bit is measuring performance, which is difficult even in baseball, the most statistically-centered sport. How much of the Yankees remarkable success over the past 10 years is attributable to Joe Torre's coaching compared to the team's overall talent level? This ultimately involves some judgement calls, although the sabermetrics crowd has developed valuable objective indicators to measure this(see here and here). It's high time boards used similar methods to set executive pay.

As for Joe Torre, this argument sounds about right.

NY Times falls victim to Woody Allen Syndrome

2007-10-23T13:40:00.000-05:00

The famous NY-centric director has a deep, long-standing dislike of all things California. Apparently and not surprisingly, so do the editors of the NY Times.

Look at today's front page. The three top stories are:
-Reports Assail State Department on Iraq Security
-U.S. Prosecution of Muslim Group Ends in Mistrial
-In Iraq, Conflict Simmers on a 2nd Kurdish Front

The first two are newsworthy items for sure, but not exactly of earth shattering importance. The story about the Kurds -placed in the most prominent position-is not fresh news and sounds more like Sunday paper fodder (although I must admit that the Kurdish guerillaette in the picture is pretty hot).

In the meantime, massive fires burn unabated in Southern California, destroying thousands of homes and forcing the evacuation of hundreds of thousands. Were does the Times inform us of this? As an item at the "INSIDE" box at the bottom.

Unmatchable as an example of obnoxious New York snootiness. Needles to say, all the other national papers do lead with the wildfires story.

Fed cut almost a done deal

2007-10-22T17:06:00.000-05:00

That is, according to options on the federal funds contract. According to the Cleveland Fed's model, the probability of a 25 basis point cut is about 57%, while a 50 bp cut is assigned a 16% probability and the no change option is given a 26% chance.

It's worth noting that there was a dramatic shift in perception last week. The 25 bp cut's probability rose about 33 percentage points, while the 50 bp cut's odds rose by 13 percentage points.

Inflamatory question of the day

2007-10-22T12:06:00.001-05:00

Why are almost all houses in the U.S. so similar? This has nothing to do with the real estate market, but with their layout and materials. From Maine to California, the typical home, built out of flimsy wood and stucco, is very similar (it seems almost centrally planned) regardless of climate or other considerations.

I ask because I live in San Diego and, while in no danger, I've seen on the television countless homes burn in minutes. Southern California has always faced severe danger from wildfires. Yet, houses are built in a manner that makes them highly flammable. Maybe wood is less expensive than brick or cement as a building material, but surely it can't be that much of a difference and, if the present value of fire insurance is added, the other options would be more attractive.

This is not the first time I've asked this. Americans build houses that the Big Bad Wolf would have no trouble blowing down in harm's way. Like the Gulf Coast. I have yet to see anyone even suggest a change in the way houses are built (in Mexico's Caribbean coast damage from hurricanes is much less severe precisely because buildings are made of sturdier stuff).

Why is this? Government doesn't help. By subsidizing catastrophe insurance and providing generous reconstruction funds it shields homeowners from the worst consequences. Nonetheless, my guess is that it's mostly a cultural thing. Americans simply can't conceive of houses build any other way. While the typical home may be well adapted to, say, New England or the Pacific Northwest, its totally out of place in West, where it would make much more sense to build the typical Mediterranean house.

Weird.

I promise not to talk about the lessons from 1987

2007-10-19T17:17:00.000-05:00

I'm sure you've had enough of that today. But there is a related point worth mentioning.

Why did the crash have so little impact outside of Wall Street (particularly compared to the 90's bubble)? A 34% drop from peak to bottom in the S&P 500 a matter of months certainly packs a punch. Surely the Fed's timely intervention helped. But by and large, it was simply a matter of the stock market being so much less relevant than today.

While in the previous five year period before the 1987 peak it had gained around 24% annually, slightly more than the comparable rise before the 2000 peak, it came from a much lower base. In 1986, stock market capitalization to GDP was merely 60%, compared to 110% in 1999, while direct equity holdings represented only 14% of household financial assets, versus 29% in 1999. Also, valuations in mid-1987 were, with a P/E of 20 times, much more reasonable than the 30+ times seen in early 2000.

Greenspan on M-LEC

2007-10-19T12:36:00.000-05:00

M-LEC, the new entity created by the nation's largest banks to provide liquidity to subprime-linked securities is off to a rough start. Many criticisms have been made, ranging from charges of possible self-dealing by banks to questions on who exactly will provide the funds. But even if you set those concerns aside, there's another issue that Alan Greenspan points out in an interview with Emerging Markets:

In the case of LTCM, “a single company” that was “excised out of the market”, there had been a potential for “a dangerous firesale of those assets”. When shareholders came in and took out LTCM, that “eliminated that aspect of market disruption”.

In contrast, “here we’re dealing with a much larger market,” he said. “They’re not talking about going in and absorbing sub-prime mortgage asset backed [securities]. They’re talking about essentially increasing the liquidity of those who have the SIVs [structured investment vehicles] and the like.”

JP Morgan Chase chief executive Jamie Dimon said on Wednesday that the fund – which will buy securities most notably ABS (asset backed securities) – could relieve some market pressure caused by the problems of SIVs. The plan is designed to prevent SIVs being forced to dump assets in a weak market because nervous investors are refusing to buy their new commercial paper.

But Greenspan argued that that a delicate market psychology could be speared by the move. “It could conceivably make [conditions affecting investor psychology] somewhat adverse because if you believe some form of artificial non-market force is propping up the market you don’t believe the market price has exhausted itself.

“What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and they’re wildly attractive bargaining prices there,” he said.

“If you intervene in the system, the vultures stay away,” he said. “The vultures sometimes are very useful.”

In other words, trying to inflate a punctured balloon is useless.

By the way, Yves Smith over at Naked Capitalism has covered this issue better than anyone. Do pay him a visit.

Brain-drained

2007-10-18T14:38:00.000-05:00

I always thought that the term "brain-drain" referred to the emigration of people with high educational and skill levels from poor nations to rich ones. But maybe I'm too narrow minded. The author of The Economist's Europe.view column takes a much broader view of this concept:

A new study by the Lisbon Council, an incisive Brussels-based think-tank, highlights some ominous trends. The ex-communist east of the European Union has backward industries, a dire demographic outlook and, for the most part, out-of-date universities. A brain-drain may be irreversible.

The study should be mandatory reading for the stubborn, complacent and squabbling politicians of eastern Europe. Only two countries are above the western European average: Slovenia, thanks to its wealth, and Turkey, because of its booming birthrate. For most of the others, the human-capital gap is large, and likely to widen rather than narrow.

(Emphasis is mine)

Well, I do suppose that, technically, death does represent an irreversible brain-drain, at least to those involved, as does being bitten by a zombie or prolonged exposure to reality TV shows.

But it does seem odd to equate more brains with more brainpower (what's the antonym of brain-drain? Brain-fill?). On that score, places like Afghanistan, Burundi, Mali and Yemen (see here) are top generators of human capital. Maybe the EU should invite them to join!

(Ed. By the way, Turkey's birth rate fell from 33.7 per 1,000 population in 1980 to 16.6 per 1,000 population in 2006 according to the U.S. Census Bureau, hardly the stuff of booms).

The other energy story

2007-10-18T13:21:00.000-05:00

The recent jump in oil prices into record territory has hogged the energy headlines. At the same time, many are wondering why sky high oil hasn't caused more economic damage. I believe part of the answer has to do with natural gas prices, which have held fairly steady for the past three years (as have coal prices). According to BP's Statistical Review of World Energy, oil represents 40% of U.S. primary energy consumption, with gas at 24%. While I'm not certain, I would guess that natural gas may actually have a higher indirect inflationary impact than oil prices.

Emerging like a volcano

2007-10-17T15:29:00.000-05:00

Mostly unnoticed, the IMF published its semi-annual World Economic Outlook today (here's the press release), which is always makes for interesting reading. As expected, it slashed its growth forecast for the U.S. in 2008 to 1.9%, versus the 2.8% it expected as recently as July.

Apparently, the IMF is a strong believer in decoupling, as its global growth forecast for next year was slightly revised from to 5.2% to 4.8%. This reflects the strength of emerging market growth, which the IMF expects at 7.4% in 2008 (the July forecast pegged it at 7.6%), led by China's 10% expected surge.

The U.S. economy remains, by far, as the largest in the world. But at the margin (that is, in terms of its share of growth in world output) it will be eclipsed by China and even India this year. Just take a look at the following chart. One may know and understand the numbers, but it is amazing nonetheless.

Housing false starts

2007-10-17T12:54:00.000-05:00

Even if you have a pessimistic bent, the latest housing starts figures are dispiriting. They fell 10.2% in September, to 1.19 million units, well below the consensus forecast of 1.28 million units. This translates to a full 31% drop from year-ago levels.

Are we near the bottom? Not quite. If the past is any guide, they could go as low as 800,000 units. The question now is how fast we'll get there.

A couple of additional points. First, it's hard to exaggerate just how far forecasters have been behind the curve. According to the Philly Fed's third quarter survey of professional forecasters, in the fourth quarter of this year housing starts would average 1.4 million units (annual terms). Needless to say, reality has rendered this outlook worthless and we should keep this in mind when assessing 2008 growth forecasts.

Of course, this also feeds into my current pet obsession: how can this collapse in housing construction be seen everywhere except in residential construction employment?

M-LEC Toxic Disposal Co.

2007-10-16T22:27:00.000-05:00

It's a sign of the times that when the biggest banks of the land announce the creation of a fund to buy debt securities affected by the recent liquidy drought, the reaction is indifference or even outright hostility.

No wonder. The cartoonishly-named M-LEC (Master Liquidity Enhancement Conduit) will mop up securities, such as bonds backed by toxic mortgages, that would supposedly be dumped at fire sale prices, worsening the damage to balance sheets all over Wall Street.

Now, the banks in question won't put up a cent. M-LEC will sell debt to by debt to fund its purchases, although it seems that the banks will offer some sort of guarantee.

If this sounds fishy, it is. The suspicious securities are in danger of being dumped because their holders can't issue paper to fund their position. But often, it's the banks (or SIVs they sponsor) who are the holders. And if the banks can't or won't step up directly to buy them, why should anyone want to by M-LEC's paper?

Maybe there's some sense to this scheme for the banks. They don't want to buy these iffy securities because they don't want to weaken their capitalization by stretching their balance sheets. So they do a run around by creating an off balance sheet vehicle and pray that they won't have to make good on their guarrantees.

But this sound like a shell game and I simply can't see who would want to fund M-LEC given the reluctance of the banks

The one crucial issue this scheme doesn't address is the lack of transparency and information, which is what arguibly has done the most damage.

So color me skeptical. In the end, there are two possible solutions to this type of mess. One, Uncle Sam steps in by guaranteeing M-LEC's securities. Two, there's a classic reestructuring.

The Dario Fo of economics

2007-10-15T15:40:00.000-05:00

By now you've probably heard that Leonid Hurwicz, Eric Maskin, and Roger Myerson won this year's Nobel economics prize. With all due respect to all concerned, they're to economics as Dario Fo, Elfriede Jelinek and Wislawa Szymborska are to literature.

If you even want to attempt to know why they got the prize, scoot over to Marginal Revolution.

Not that I'm complaining. Part of the charm of the Nobel prizes is that every two or three years the prize committees throw a wild curveball at us, coming up with the most unexpected winners. Of course, everyone is outraged that more deserving candidates were ignored, once again. Nonetheless, it keeps the world tuned in.

My favorite Nobel peeve is that those pesky Swedes evidently have a something against Spanish-language literature. Octavio Paz was the last winner, in 1990. Since then, there have been 8 English-language winners. Does anyone seriously believe that someone like Harld Pinter is more deserving than a Carlos Fuentes or Mario Vargas Llosa? Please. Not that this problem is recent. They let giants like Jorge Luis Borges, Julio Cortázar and Alejo Carpentier die without recognition.

Even executives agree their pay is ridiculous

2007-10-15T00:08:00.000-05:00

What can I say? Lately, I've written a bit on executive compensation, noting that it seemed disproportionate and utterly unrelated to performance. But I would never have guessed that those same executives (as well as corporate directors) fully agree with all the above, as explained in this FT article (kudos for its wonderfully pithy header).

Four out of six chief executives or company presidents polled by the NACD in July and August said the compensation of top executives was high relative to their performance.

Only 2.2 per cent of the nearly 70 chief executives and presidents involved in the survey said compensation was too low, while a third deemed it “just right”.

Their views were backed up by outside directors, with more than 80 per cent of them saying chief executives were overpaid.

Why have we reached this sorry state of affairs?

Nearly 60 per cent of the directors polled by the NACD said the reason for excessive pay packages was the absence of objective ways to measure an executive’s performance. Nearly half criticised the use of options and equity awards that reward executives when the company’s share price goes up, rather than when its operations improve.

The real answer, of course, is that board members and executives make up a huge "old boy" network. No corporate director wants to take a hard line on pay because a) that would make for some seriously awkward times around the country club, b) all directors and executives make out nicely under the current scheme and c) no one likes to be subject to real scrutiny and, hence, everyone is reluctant to cast the first rock.

Saying that performance can't be objectively measured is pathetic. Sure, it's not easy, but that's what corporate directors get paid to do, along with the armies of compensation consultants they hire to design pay packages.

The Buddha as inflation fighter

2007-10-12T18:12:00.000-05:00

Every once in a while an article comes along that is so wonderfully nutty that is just makes your day. The piece, by one Chan Akya in the always eccentric Asia Times ends with this gem of a conclusion:

Buddhism is forever associated with the principles of non-violence and kindness of human beings to each other, as well as to other animals. Whilst not prescribed as a basic principle of life in the holy texts, Buddhists generally abjure meat. Their pacifist principles are broadly applicable to solving the most intractable crises in the world, including those of the Middle East. The centuries of debate between Buddhists and other religions, including Hinduism, have produced more than adequate philosophical sophistication in dealing with intellectual challenges from the well-to-do. Then again, people don't have to convert to Buddhism to follow the principles laid out.

Accepting the religion or at least its principles therefore carries with it a steady decline in the demand for meat and related products, which will help the US Federal Reserve, the Peoples Bank of China and other central banks to cut inflation expectations at home. In turn, this helps to engender greater efficacy for monetary policy. Given that markets love to listen to the Fed chairman, perhaps it makes sense for him to be the first to recommend the Buddhist way of life, in some suitably informal chat - perhaps a quiet word to Maria Bartiromo (5) would do the trick.

Maybe this isn't too far fetched. After all, the spirit of the old Zen masters seemed seemed to live on in Alan Greenspan's cryptic comments, which could rival any koan in poetic amiguity.

More executive pay lunacy

2007-10-11T14:42:00.001-05:00

The (mis)use of options is not the only problem with current executive compensation schemes. As this article explains, there's the issue of transparency. The SEC's chairman offers a pithy quote:

The rules significantly expanded the disclosures that companies are required to make about compensation for their highest-paid executives. Christopher Cox, SEC chairman, has said that investors "should not need a machete and a pith helmet to go hunting for what the CEO makes".

But it also presents a fact that is capable of shocking even a jaded veteran such as yours truly: CEOs often make as much as ten times as their top lieutenants. Wow. This is just plain nuts.

Kudos to the SEC for finally beginning to address these issues.

Executive pay: Out of the money

2007-10-11T11:37:00.000-05:00

Nowadays, options make up the bulk of high-level executive compensation. They are hailed as an efficient way to align the interests of management with those of shareholders. But is this true?

This piece in The Economist presents evidence to the contrary:

Belatedly, the evidence is now mounting that share options are not all they were cracked up to be. Consider, for example, “Swinging for the fences: The Effect of CEO Stock Options on Company Risk-taking and Performance,” a study in the October issue of The Academy of Management Journal.

The authors, two economists, Gerard Sanders and Donald Hambrick, observe that options create asymmetric incentives: they pay out when a firm’s share price rises above the option exercise price, but once they fall below the exercise price, all further falls make no difference to the ultimate payout, which is nothing. This, posit the authors, gives an incentive to take big bets, by investing in risky activities with long odds on a high pay-off. They also posit that these bets will produce more extreme losses than extreme wins.

To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000. This showed that the bigger the role played by share options in the boss’s pay package, the more likely firms were to invest heavily in risky activities. It also confirmed that high levels of share options were associated with more extreme ups and downs in a firm’s share price, and that the big downs significantly exceeded the extreme highs.

The authors conclude that “not only does this asymmetry affect the selection of strategic initiatives, as we have discussed, but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation.” Surely this is not the sort of motivational incentives that shareholders want.

These results are not suprising and my guess is that they would've been much more evident if there hadn't been a huge bull market for stocks during that period.

It's not just a question of asymmetrical payoffs. My main beef with options is that they only reward absolute rather than relative performance.

In lackluster or bear market conditions a firm may have outsanding operational and financial results and yet see its stock price fall simply due to macro factors outside its control. Conversely, in a bull market a firm's stock price may rise despite poor results relative to its competitors. Executives would receive a large payoff in the second case, but not in the first, an outcome that defies all logic.

Yet, I have yet to see a compensation plan that takes this issue (or others, such as favoring short-term appreciation versus long-term gains) into account. Strike prices are usually the price of shares at the time the options are issued.

Outrage about executive pay is misplaced. Focusing only on its level is not helpful. It may or may not be excessive. But the real problem is that the way compensation is determined makes no sense at all.

The problem with having too much money

2007-10-09T17:54:00.000-05:00

With oil at $80 a barrel, the Gulf states are drowning in money. What do you do with it? You can put most of the estimated 628 billion windfall in boring Treasury bonds and you can splurge on neat stuff like building a massive Panama Canal-sized waterway to add 500 kilometers of waterfront. I hope they have fun while it lasts.

Would you let this man manage your money? Ian Wace edition!

2007-10-09T16:55:00.000-05:00

Real asset managers should know better than to make bold, categorical statements about the future direction of stock prices. Alas, many still have to learn that lesson. Take this gem:

Ian Wace, co-founder of the $17 billion hedge-fund manager Marshall Wace LLP, expects an ``absolute explosion'' in share prices globally as company profits increase.

Given that the share of corporate profits in national income is at historically high levels in many countries and that the world economy is headed for a slowdown, that statement sounds pretty, hmm, unsound. What makes him say this?

Stocks ``offer phenomenal value,'' Wace said today at a conference in Milan. As some central banks lower interest rates, that will also help lift stocks, he said. Shares of the largest companies will benefit most, said the manager, whose MW Tops Fund Ltd. has returned about 18 percent a year since it started on Dec. 31, 2004, according to data compiled by Bloomberg.

There will be a ``massive splurge in major, liquid, large caps,'' Wace, 44, said. The money manager, whose firm bets on equities by compiling analyst research from 253 brokers worldwide, didn't say how much he expects markets to rise.

Where to begin? Central banks are cutting rates due to the risk of a falloff in growth, something hardly compatible with a jump in profits. Sure, dropping rates may provide some support for stocks based on asset allocation grounds, but it could hardly be deemed "massive". Of course, the key here is that this fund invests based on sell-side research which always, to put it kindly, has a vested interest in erring on the side of optimism.

P.S. By the way, Bloomberg states that the average P/E multple for the MSCI World Index (which has risen about 15% a year since year end 2004) averaged 29 times over the past ten years, compared to 17 times now. Needless to say, comparing valuations now to the average that includes the dot com bubble years is misleading. For the S&P 500, the 70 year average P/E is close to 16 times, close to the current level. Since when is it a reporter's obligation to support the subjects investment opinions? Shouldn't it be his job to be a tad more skeptical?

Would you let this man manage your money? Victor Niederhoffer edition!

2007-10-09T16:34:00.000-05:00

This profile of Victor Niederhoffer in the New Yorker is pretty entertaining. Clearly, a fascinating guy who could star in an Axe Shower Gel or Dos XX commercial.

But it makes you wonder who'd be crazy enough to give this gentleman a dime to manage. He doesn't have anything resembling a minimally coherent investment strategy, placing large, exposed, short-term bets on whatever catches his fancy.

I guess they do it just to have the privilege of hanging around with him. (Not as crazy as it sounds if you have enough money).

Anyway, Niederhoffer --whose funds have blown up twice now--is a walking "famous last words" factory. He reels out three of them consecutively:

“The market was not as liquid as I anticipated,” he said. “The movements in volatility were greater than I had anticipated. We were prepared for many different contingencies, but this kind of one we were not prepared for.”

The construction employment puzzle, redux

2007-10-06T12:52:00.000-05:00

Unbeknownst to me, during my summer break many bloggers commented on the construction employment puzzle (see yesterday's post). Brief recap: housing construction has, by all measures, fallen more than 40% from peak while residential construction employment has barelly budged.

Here's Nouriel Roubini's take and Jim Hamilton's is here. The WSJ's Economics Blog also has good info on this (see here and here).

Severl months onwards, the original mystery has only deepened and no one has provided a convincing answer.

I will say that the argument that states that employment hasn't fallen that much because the workers fired so far have been off-the-books illegals is nonsense. Construction employment rose sharply over 2001/2006 tracking housing construction and it should follow it on its way down.

Also take into account that the underlying force driving housing demand, household formation, is expected to be pretty steady over the next decade (a bit less than 1.5 million annually). Thus, it wouldn't make much sense to argue that residential construction employment registered a permanent jump in employment over the past few years and builders are "hoarding" employees while the storm passes.

Death according to the IRS

2007-10-05T20:55:00.000-05:00

What is death? This question has occupied philosphers and religious figues since the dawn of mankind. Jack Bogdanski provedes us with his take on what our beloved tax authorities would define as "separation from life" (hat tip: Argmax):

[T]the Treasury will consider a service provider to be dead if the service provider’s death meets the criteria necessary for a separation from life. ... A service provider separates from life with the service recipient if the service provider has a termination of all mental and bodily functions. However, the service provider’s life is treated as continuing intact while the individual is temporarily unconscious, having an out of body experience, cryogenically frozen or experiencing another bona fide leave of absence from the individual’s conscious state, if the period of such leave does not exceed ten minutes, or if longer, so long as the individual retains a right to regain life and/or reanimation under an applicable contract (with the devil or otherwise) or other arrangement.

If the period of leave exceeds ten minutes and the individual does not retain a right to regain life and/or reanimation under an applicable contract or otherarrangement, the death is deemed to occur on the first minute immediately following such ten-minute period. Notwithstanding the foregoing, where a leave is due to any medically determinable physical or mental impairment that can be expected to result in death, where such impairment causes the service provider to be unable to perform the essential functions of life without mechanical support, a 525,600 minute period of absence may be substituted for such ten minute period. ...

Employment crow for breakfast

2007-10-05T15:08:00.000-05:00

My gloomy outlook for today's payroll figures was, to put it charitable, quite misplaced. The 110k jump in September and the upwardly revised August figures certainly demonstrate a surprising degree of resilience. Which, I might add, is welcome news.

Yet....

My skepticism is not totally unfounded. Just take a look at the following graph, which charts residential construction employment and housing starts.

The relative strength of residential construction employment has been downright freakish considering that housing starts have pretty much fallen of a cliff. Yes, there are lags, but housing starts have fallen for a year and a half, while employment has fallen less than 5% from peak levels. Real estate sales and credit employment has held up just as well.

Something does not compute. In any case, Dr. Gloom himself, Nouriel Roubini, argues that the payroll figures hide some underlying weaknesses.

Unemployment Friday

2007-10-05T00:53:00.001-05:00

Is poised to be more entertaining than usual, and I don't mean that in a good way. Apparently, the consensus expects payrolls to rise by 100,000. Now, this is not an outlandish possibility, given that unemployment claims have been pretty steady.

Nonetheless, as I argued last month, there's something very, very fishy about the employment numbers. Sooner or later they'll catch up to a rather unpleasant reality. Will it be this month? I don't know, but my hunch (yes, hunch) is that the payroll number will come in flat to slightly negative, like September. The carnage will probably start this quarter.

It'll be interesting to see how it plays out with long term rates and stocks. A flattish figure probably won't cause stocks or rates to fall much, given that most investors know that the balance of risks is tilted to the negative side.

Sexy dividends

2007-10-04T14:39:00.000-05:00

In this age of massive stock repurchases, dividends have a distinctly stodgy, old-fashioned air about them, despite the fact that over the past few years they've been taxed at the same rate as capital gains. Yet, according this paper (PDF) published by fund manager Tweedy, Browne Company (ed. man, that's about the stodgiest, WASPiest name I've come accross in a long while).
(Hat tip: Abnormal Returns)

It concludes that there's plenty of evidence that high dividend yield stocks outperform market averages. (Not surprisingly, Tweedy, Browne recently launched a fund with this investmen strategy).

Needless to say, this is interesting. I must confess that I'm rather partial to dividends, as they're the most transparent way to return cash to investors. However, the paper solely emphasizes correlation and does not delve into causation, which is very unsatisfactory.

There are many possible explanations to account for the apparent success of a high dividend yield strategy. Maybe it's a sector effect. That is, perhaps firms in successful sectors happen to pay dividends. Or it could be that dividends are indicative of some positive trait, such as high capital spending discipline. I'm sure the academic literature has many other theories.

Also, the paper neglects to present studies that fail to support this conclusion (such as this this one).

As always, beware of research with deep conflicts of interest, no matter how academic it may look.

What mutual fund flows say about rising stock prices

2007-10-03T14:37:00.000-05:00

Given all the negative economic news, many are wondering why stock prices are rising (the S&P 500 has jumped 10% from its August 15th low and has gained 6.3% from its end of July level).

Valuation factors certainly don't seem to justify this rise. After all, many forecasters are slashing U.S. growth forecasts significantly. Goldman Sachs reduced expected 2008 growth from 2.6% to 1.8%. And long term interest rates haven't changed much, although certain credit spreads have eased.

Most likely, stocks are benefiting from asset allocation changes, as noted here. Lower short-term interest rates make money market investments less attractive, while corporate bonds don't look very attractive given the recent turmoil. That leaves stocks as pretty much as the less ugly alternative.

Capital flow data from mutual funds (a less than perfect indicator, but the only current one we've got) backs this up, to a degree. In August, according to AMG Data, equity funds received a net inflow of 5.7 billion, while taxable bond flows saw an outflow of 0.8 billion. However, money market funds saw a staggering inflow of 156 billion.

In the second quarter, taxable bond inflows were twice as big that equity inflows.

More recent weekly data has been seen similar trends, although it seems that taxable funds are attracting some interest again.

No wonder I'm not rich: Grooming edition

2007-10-03T13:10:00.000-05:00

As a proud customer of $7 a haircut shops, who spends around 3 seconds a day combing and believes that shoes need shining every couple of weeks (give or take 4 weeks), this article is rather distressing.

Then again, on your death bed would you regret having spent insufficient time grooming?

Nokia's content gamble

2007-10-02T21:27:00.000-05:00

Nokia announced yesterday that it was spending a cool 8 billion to acquire Navteq, a provider of digital maps and navigation solutions. This is just part of a shopping spree that has seen the Finnish giant buy a mobile ad firm and a provider of navigation software.

The deal will only make sense if the value added to Nokia's phones and mobile services derived from the Navteq purchase outweigh the value destruction resulting from clients (existing and potential) turning away from Navteq as a Nokia subsidiary. In other words, I doubt that Motorola, Samsung or Sony Ericsson will be very enthusiastic about purchasing Navteq's maps from now on (Gamin, a leading GPS device maker, saw its stock drop sharply after the announcement).

I don't have an answer. However, these hardware/software synergies are often elusive. Just ask Sony how the Columbia Pictures acquisition worked out. But they're not doomed to failure, as the IPod/ITunes combo has shown, although ITunes is more a distribution platform than content per se.

Having said this, there is a wilder, intriguing possibility. Maybe Nokia wants to reinvent itself as a mobile services and software firm, eventually selling its hardware biz. This is not as crazy as it sounds. Competition in the handset market is intense and all firms have seen wild variations in their market share. Services are a higher margin, more stable business. And Nokia has undergone a radical transformation before (it used to be mainly a manufacturer of forest and rubber products).

GM: The free lunch that isn't

2007-10-01T18:16:00.000-05:00

Last week, the deal between GM and the UAW to end the strike was hailed in the press almost as a miraculous solution that will save health benefits for current and retired workers and resotre the automaker's competitiveness.

The UAW will manage the health benefits plan as a trust separate from the firm, which won't have to pay those crippling health care contributions from now on. This article by The Economist illustrates the tone followed in much of the coverage.

Sounds like a free lunch? We should know better and so should the press.

To get rid of its health care obligations, GM will have to deposit a lot of money into the VEBA trust. Where will it come from? From its shareholders' pockets, as its contribution will be paid in GM stock (thorough convertible notes).

Would it be any different if the firm made a secondary share offering and kept managing the health plan? Nope, unless I'm missing some sort of fiscal angle. Nor are workers much better off risk-wise, since they will still be tied financially to GM's stock performance.

Actually, the fact that this deal wasn't struck long ago (it's not as if this problem is a recent one) is telling. It's another sad reminder of the low quality of most financial journalism that even The Economist falls for this smoke-and-mirrors trick so easily.

The euro kicks sand in the dollar's face

2007-09-21T14:50:00.000-05:00

There's hope for the greenback yet! Sure, by reaching 1.42 against the euro, the dollar sure looks like a 90 pound weakling at Muscle Beach. But take a look at this 30 year graph (before 1999, the ECU --the euro's shadow predecessor--is used):

It looks like 1.4 dollars per euro (approximately) is a pretty hard ceiling!

Just kidding. It's most likely coincidence, unless some strange technical analyst voodoo is taking place.

But there's a real pattern here: dollar lows coincide with U.S. recessions AND oil price surges (in 2001 the first condition is met, but not the second). Correlation is not causation, but this certainly seems to support the dollar-oil price link many have been talking about lately.

I forgot to mention that.....

2007-09-20T12:13:00.001-05:00

If the 23% fall in house prices in the 10 largest metro areas that housing futures are indicating comes to pass, that spells recession.

Wondering how low house prices will fall?

2007-09-20T00:40:00.000-05:00

Some interesting results are coming out. Moody's expects prices to fall, peak to trough, 7.7% nationally (hat tip: Calculated Risk).

According to Moody's, the bulk of the adjustment will be over by late 2008. This does not square with previous housing downturns, which played out over many years (check this post).

Sounds nasty? Moody's seems positively euphoric compared to the prices quoted in the CME's recently introduced housing price futures, based on the Case-Shiller indices (hat tip: Housing Wire). The 10 city average (includes the largest urban areas) will accumulate a drop of 23% over the next four years.

Scary stuff indeed.

Robert Lucas doesn't get it

2007-09-19T11:33:00.000-05:00

Via Mark Thoma, we learn that Robert Lucas, Nobel laureate, wrote a rather incoherent opinion piece on the WSJ. This paragraph left me dumbstruck:

It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates. ... [But] I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.

Where to begin? Sure, housing construction won't drop to zero, but housing starts have fallen from 2 million in 2005 to just 1.3 million (annual rate) this August, dragging down the economy. And then there's the slight detail of falling house prices and negative payroll growth.

It's amazing how many people are still in denial about the severity of the housing-led threat.

Cutting rates on 'potential' economic slump? The horror!

2007-09-19T10:51:00.000-05:00

Sarcasm is hard to avoid after reading a Bloomberg article titled "Bernanke Cuts on Slum 'Potential', Adopting Greenspan Approach"

After all, isn't avoiding 'slumps' the main job of central banks? Or do they have to wait until a full-blown recession to start cutting rates?

The problem, as always, is semantics. As George Orwell noted long ago, sloppy language leads to sloppy thinking. This is very much in evidence in this article, as in most financial journalism. Concretely, one has to determine what is understood by 'potential slump'

I'm pretty sure that the author meant was that Bernanke sought a rate cut to insulate the economy from the turbulence in financial markets, much as Alan Greenspan did by cutting rates after the Russian debt/LTCM debacle in 1998.

But that analogy is incorrect. In 1998, the U.S. economy was cruising along, growing at an annual rate well over 3% in the first half of that year. Thus, the rate cuts were purely preventive in the sense that market turmoil might have led to a downturn if no action had been taken.

The situation is very different this year. A sharp slowdown, though not a recession, in the economy was pretty evident well before turmoil hit the markets. In fact, while the credit crunch will certainly aggravate the recession in the housing sector, this downturn mostly reflects an imbalance in housing supply and demand that, while obviously related to financial factors, is not determined solely by them.

Thus, the rate cut is not 'preventive': the threat of a housing-led recession is very real and growing, with the current market turmoil clearly contributing to it.

With all due respect, the persons that question the rate reduction on moral hazard (bailout) grounds are nuts, as they're asking the Fed to not do its job. The other set of critics, who state that the Fed is underestimating the risk of inflation, are on firmer ground, but not much. After all, core PCE inflation is below 2%, within the Fed's informal range, and the economy is growing below potential.

Ben's Soothing Tonic

2007-09-18T15:40:00.000-05:00

It seems Dr. Ben decided that the patient was best served by having the patient down his medicine in big gulps rather than sips.

With short-term Treasury rates near 4.2% at the end of last week, the markets were pricing a full percentage point cut in the Fed's reference rate over the next few months. So today's decision was merely a question of how quickly the Fed would deliver. Apparently, it is alarmed enough (not surprisingly given the run on Northern Rock in the U.K.) to prescribe a large, 50 basis point dose, even if that means losing some face.

The statement offered little insight. More surprising was the massive reaction in stock prices (the S&P 500 ended 2.9% higher). I think there are two possible explanations for this reaction:

1) Lowering the cost of credit will ease losses and restore liquidity to the markets. Everything will be sunny and it'll be like the two past months never happened.

2) The economy is in danger due to the woes in the housing sector. It's good that the Fed recognizes the magnitude of the threat and is beginning to act accordingly.

Obviously, numero 1 is mucho more likely than 2, as far as investor opinion is concerned. Needless to say, I'm in the #2 camp.

Actually, make that #3: the economy is in much worse shape than generally assumed and things will get a lot worse before Ben's Magic Tonic begins to take effect in a few months. Today's reaction in stock prices was not warranted.

Before calling me Dr. Tangible Gloom, chew on this: everyone has massively, consistently underestimated the problems in the real and financial sides of the housing market, as well as their impact, over the last couple of years. I don't see that changing, yet.

The logic of bank runs

2007-09-17T22:46:00.000-05:00

As it turns out, there is anarchy in the U.K.! The run on Northern Rock has intensified and threatens to expand to other financial institutions. As a result, the British government has had to step in and guarantee the value of all deposits in Northern Rock. The full story is here.

This is not a surprise. I predicted that the Bank of England's credit lifeline wouldn't stop the crisis. This is not the result of special insight, but of having lived through the 1995 Mexican financial crisis, when the whole system went belly up. A key lesson was that once confidence was lost in a bank, the government has to step in massively and decisively, taking over the institution or lining up an emergency buyer.

Why? Well, if everyone knows the bank is insolvent, there will be a run. And runs, even in fairly small banks, tend to undermine confidence in the whole system, specially in unsettled times like these. Without confidence, a bank is worthless.

The question is why did the government/regulators wait so long to take action? There is nothing so dangerous as a bank in desperate trouble. Facing bankruptcy, executives and directors only have one course of action: double down the bets to gamble for salvation (or, as happened in Mexico, looting the bank mercilessly). Of course, this usually fails, but not before hugely increasing the losses.

Thus, either they were inexcusively asleep at the wheel or, as usually happens, forgot the lessons of past banking crises.

Could it happen elsewhere?

2007-09-14T14:41:00.000-05:00

As a consequence of the housing/mortgage crisis in the U.S., suspicious glances are being cast to other countries that have seen big rises in housing prices over the past few years. Will it prove contagious?

As I've argued before, the fundamental problem in the U.S. was a disequilibrium in housing supply and demand. Too few houses were build in 2002-2003 when demand boomed due to rock-bottom rates, leading to huge price rises. In 2005/2006, too many houses were built given underlying demand. Normally, temporary excess supply or demand is no big deal. The problem turned nasty due to subprime mortgage financing, which artificially boosted demand, made prices jump higher than they would've and now are corroding the markets.

Subprime financing is, as far as I can tell, mostly limited to the U.S.. But that doesn't mean that other countries will be exempt from falling prices due to overbuilding and excess demand. This week, The Economist summarizes a Morgan Stanley study which concludes that many countries have seen house appreciation far in excess of what fundamental factors justify, including the U.K., Spain and Sweden.

Let's compare the U.K. to the U.S.. Now, this is tricky because they have very different demographic profiles, circumstances and tastes. Nonetheless, I believe we can get some idea of housing trends comparing the number of housing unit completions to the estimated increase in the population (people have to live somewhere).

This graph shows that since 2004, more housing units have been built in the U.K. than the increase in population. While it can be argued that foreigners may be buying second homes in London, this situation obviously cannot last. The last time this happened house prices tumbled.

In the U.S. there's a clear, secular downwards trend in housing units per change in population (probably reflecting smaller families and more immigrants, who tend to be single upon arrival). Nonetheless, excess housing demand has obviously contributed to this ratio's fall over the last few years.

I don't know about the other countries, but things look bad for both the U.S. and U.K. Yet, maybe the fallout in Britain will prove less damaging due to less use of "creative financing". We'll see.

Anarchy in the U.K.!

2007-09-14T14:31:00.000-05:00

Well, ok, not quite. But in the case of Northern Rock, a British mortgage lender, a liquidity shortfall has led to and ol'fashioned bank run, complete with people queuing in the street to withdraw their money. The Bank of England is stepping in with an emergency loan. This is probably a waste of time and money, as it will not likely stop the panic; only a full-blown rescue/buy out will.

A humorous aside from The Economist:

Customers queuing up in its home town of Newcastle reportedly burst out laughing when bank staff asked if anyone wanted to deposit money

Oil at $80 is no surprise

2007-09-13T16:07:00.000-05:00

Oil at a (nominal) record of $80 a barrel? Shocking! So say many OPEC members and ExxonMobil chairman Rex Tillerson, who are most puzzled that prices stay so high given that the market is well supplied with crude. Must be those pesky financial speculators!

This, of course, is nonsense (and predictable self-interested nonsense at that). While it's possible that investors may affect the price of oil in the short-run, prices have been high for many years, which surely means that the fundamentals are really in command.

And speaking of those fundamentals, let's see what the International Energy Agency expected for all 2007 back in January. Basically, demand was forecast at 85.77 millon barrels per day, while non-OPEC supply was expected to be 50.6 million barrels per day. In the most recent forecast, demand is now set at 85.9 mbpd, while non-OPEC supply is estimated at 50 mbpd.

In other words, demand has been higher than forecast, while supply has come up short (OPEC output has been broadly flat). That sounds like an Econ 101 recipe for higher prices to me.

I don't believe

2007-09-07T14:17:00.000-05:00

That the payroll numbers released today, bad enough as they were, bear any resemblance to reality. It's simply not possible. To see why, let's just review some numbers related to construction and real estate activities.

First, a quick review of the most recent housing and residential construction data:

Housing starts: -20.9% (July 2007/2006)
Housing units under construction: -16% (July 2007/2006)
Housing units completed: -22.2% (July 07/06)
New residential sales: -10.2% (July 07/06)
Existing home sales: -9% (July 07/06)

And yet, the Bureau of Labor Statistics (BLS)wants us to believe that employment in real estate services rose in August (600 new positions) and is up 1.5% versus year-ago levels?
Am I expected to think that residential construction employment has only fallen 3.5% in this period?

It gets worse. BLS data shows that employment in the offices of real estate brokers and agents has kept on rising, growing 3% in July over the year-ago level.

My head feels like exploding.

But even if we take these figures at face value, it's clear that eventually payrolls will catch up to activity levels, meaning that over the next few months and quarters the employment numbers will look very, very grim. And if analysts were surprised now, I can't imagine how they'll react then.

Bubble dilema for central banks

2007-09-04T21:22:00.000-05:00

Morgan Stanley's Richard Berner reports on the ongoing debates in the Fed's annual Jackson Hole powwow. My heat-impaired self hasn't gotten around to reading all the speeches, but Berner does touch a very important point: should central banks preemptively try to prevent bubbles from appearing?

Historically, the Federal Reserve has taken the hands-off approach, just standing by to clean up the mess once bubbles burst. Fed governor Frederic Mishkin has been an outspoken defender of this asymmetric intervention policy.

Yet, as the current and previous episodes illustrate, "cleaning up" is easier said than done. One mistake and you're into "Japanese lost decade" territory. Hence, some European central bankers have come around to the intervene-early camp.

There are no easy answers, but this is a crucial debate. Let us hope it doesn't fade away as it did after the last bubble was cleaned up (sowing the seeds of the current one).

Subprime mess good for stocks?

2007-09-04T21:16:00.000-05:00

So argues Jeremy Siegel. Key paragraph:

I think the Fed made the right moves at the right time. But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.

In the long run, all this is a good development for the stock market. In the last decade, more than one trillion dollars has migrated to hedge funds and untold billions to complicated debt and derivative securities. Who will buy those assets in the future? I believe quite a few investors will return to stocks and general obligation bonds - assets that they can buy and sell at any time they want.

Wall Street has rediscovered liquidity and transparency. Stocks and old-fashioned bonds have them; new-fangled collateralized debt obligations and hedge funds do not. A return to basics will be good for both the economy and the financial markets.

While he's obviously exagerating a bit, the point is taken.

When the U.S. gets a cold, the rest of the world.....

2007-08-31T14:58:00.000-05:00

Stephen Jen tries to complete that sentence in an interesting note that reviews the academic evidence on contagion. Historically, U.S.-based shocks have had very different impacts on the rest of the world. For instance, the 1990-1991 recession hardly affected Europe or emerging markets, while the 2000-2001 shock certainly did.

While trade is the most obvious channel for contagion, evidence suggest that confidence and financial markets have a greater, and certainly speedier, impact.

In the end, Jen believes that any U.S. slowdown will only have a limited impact on the rest of the world. I hope he's right.

Bwana, me no understand that swap thingy

2007-08-31T00:46:00.000-05:00

The World Bank has a problem. Its list of clients is rapidly diminishing as many middle-income emerging economies have put their financial house back in order and, in any case, prefer no-strings-attached financing from the capital markets to heavily-conditioned loans form the World Bank.

Under new president Robert Zoellick, the Bank is looking to for a new line of business: getting emerging nations to use more extensively risk-management tools, such as insurance, futures, swaps, etc. Examples cited are risk pooling among Caribbean nations for hurricane damage and currency swaps.

Pretty tame and sensible stuff, much along the lines of what Robert Schiller, he of bubble-busting fame, has promoted for helping individuals hedge macro risks like, say, falling real estate markets (see here).

But that's not how Andrew Leonard of Salon sees it. He links these products, stangely, to the current subprime meltdown. This makes no sense, as derivatives haven't really played much of a role in it, as it has been a case of bad lending practices, misjudgin risk and excessive leverage. With a very, very patronizing attitude --quite unbecoming in a liberal, I must say-- he questions the capacity of emerging nation governments to understand and properly use these financial products. (One would hope the World Bank can provide adequate advice on this, in an case).

Talk about throwing out the baby along with the bathwater. But it does remind one of the seemingly innate suspicion that even smart lefty types (such as Leonard, whose work I admire most of the time) have regarding financial markets. Sure, derivatives can be abused and misused, but they haven't been around for hundreds of years for nothing.

That said, it doesn't help the World Bank's case at all to have a treasurer named Kenneth Lay (any relation to Enron's disgraced founder?).

How low will house prices go?

2007-08-30T11:30:00.000-05:00

According to an FT/Thomson poll of economists, median house prices will fall a total of 3% between 2006 and 2009. This is an unprecedented fall.

Unusually for the FT, the article is very confusing. Median house prices is a statistic put out by the National Association of Realtors, not the government as they imply. In addition, the figure they give on median house prices for 2009, 235 K, makes no sense, as it is substantially higher than current or past levels.

Anyway, the point stands. Of course, this is only one out of a series of house price measures (see my guide). For example, the Case-Shiller index has already posted a decline of over 3%.

Not all bubbles have popped

2007-08-29T19:02:00.000-05:00

At least modern art seems to be going strong, judging by the $100 million paid by an unidentified investment group for Damien Hirst's famous diamond-studded platinum skull (which I like, truth be told). It will be interesting to see whether these prices hold up, as Wall Street bonuses are set to drop sharply in the coming months.

Woe is carnivorous short persons

2007-08-29T12:32:00.000-05:00

At least as far as intelligence is concerned. Steve Levitt of Freakonomics refers us to a paper which "establishes"* a clear link between height and intelligence, which would explain the long-observed correlation between how tall you are and how much you make.

But here's hope for the vertically-challenged. You may not be able to do much about your height, but according to this research, you can be smarter if you become a vegetarian!

*Skepticism is always warranted in these studies, even if the authors are academics in good standing

Comparing real estate cycles

2007-08-28T13:29:00.000-05:00

Today's news form the housing front is rather grim. The Case-Schiller national index fell 3.2% in the second quarter versus the same year-ago period, the steepest drop in the index's 20 year history (write up here, PDF press release here).

What does the future hold? I don't have a formal forecast model, but I believe it's useful to compare the current cycle (with a peak in the second quarter of 2006) to the previous one (rising prices in the late 80's, reaching a peak in the 2nd Q 1990).

Comparing the periods before and after the peaks clearly shows that during this cycle prices rose much more steeply. Interestingly, after a moderate decline, prices moved laterally in the previous cycle before starting the definite uptrend began in 1994. I doubt that this will be the case now. The price curve shows every sign of taking a nasty parabolic shape.

Inexistent sales of existing homes

2007-08-27T13:29:00.000-05:00

Forgive the exageration, but no amount of NAR (National Association of Realtors) spin could soften the grim existing home sales numbers published today. In July, sales fell 9% year-on-year, couples with a 0.6% fall in the median price of homes sold and a rise in unsold home inventories to 9.6 months supply (compared to 7.3 months in July 2006). Notwithstanding, these numbers were in line with market expectations.

To give some perspective, here's the annual series of existing home sales:

Clearly, this series has seen extraordinary growth, expanding at an annual clip of nearly 3% since 1987, far above population growth. How sustainable is this? I don't have a good answer, but a good starting point is adjusting those sales by population growth (existing homes sold per 1,000 persons).

Taking the latest figure, sales per 1,000 persons stand at 19. If they fall closer to the 14-15 level seen in the early 1990's, sales could still fall another 20% or so (maybe the equilibrium level is higher due to demographic and income factors, but there's bound to be an undershoot and this was another period with soft market conditions).

This ain't over yet.

Behind the numbers: House prices

2007-08-26T14:06:00.000-05:00

House prices have never fallen since the government started keeping records in 1950, according to this NY Times piece. Actually, they have never fallen since the Great Depression, according to the National Association of Realtors. But they have, in the early 1990’s and since June 2006, according to the Case-Shiller composite index. Confused?

I am (and so is the Times, as they confuse the NAR and OFHEO measures, see below). This is not surprising. The various home price measures differ greatly in coverage and methodology. Here’s a handy guide to the main ones:

OFHEO House price indexes

Calculated by the Office of Federal Housing Enterprise Oversight (the folks who regulate Freddie Mac and Fannie Mae), this index starts in 1975 and has national coverage. It geometrically weighs changes in the price of single family homes on which at least two mortgages have been taken out and bought by Freddie Mac and Fannie Mae. These This helps ensure that the houses included have comparable characteristics over time, avoiding biases resulting from changes in the composition of sales.

It does have two main limitations. VA and FHA mortgages are not included, as are those that exceed the federal loan limit of $417,000. More info can be cound here.

Case-Shiller indexes

Methodologically, they're very similar to the OFHEO indexes (weighted repeat transactions on single family homes). However, they're based on transactions as recorded in county assesor and recorder offices. The geographic coverage is much more limited, as only the largest 20 metropolitan areas are included. It does have the advantage that it covers high-end homes. More info can be found here.

New Home Prices

Published by the Census Bureau, these prices are by definition not comparable to the previous two indexes, as they only cover new houses (a small part of the total real estate market). Information can be found here.

NAR Indexes

The National Association of Realtors publishes information on median and mean prices of existing homes sold (for both single-family houses and condos/co-ops), based on a sample of national transactions. It is subject to biases resulting from changes in the type of units sold and does not adjust for quality (comparable characteristics, as the C-S and OFHEO do by using repeat transactions). The methodology is presented here.

Summary

The Case-Shiller indexes seem to offer the most accurate measure of trends in house prices. However, it does have the drawback of having limited geographical coverage. OFHEO indexes don't have this problem, but the exclusion of high-value housing is a very big flaw. Lack of quality adjustments clearly makes the NAR median home price indicator a much inferior alternative. In the end, they're fairly complementary and should all be analyzed. The following graph shows that the NAR and OFHEO measures produce similar results that are very different from the Case-Shiller index.

This Fed paper (PDF) provides much more information on this topic.

Greece burns

2007-08-25T16:22:00.001-05:00

The recent tragic forest fires in Greece got me thinking. Yes, global warming is playing a part in this. For instance, two years ago there were huge, deadly fires in Portugal, Spain and Greece.

But surely there are other, economic factors at play. This article in The Economist lays out some of them. Developers are under suspicion for starting some fires to clear forest for construction, a result of the inefficient justice systems and weak property rights in many Mediterranean nations. It even seems that "productivity pay" for firemen may not be a good idea, as some seek to "encourage" demand for their services.

There is another intriguing angle. While the word "forest" conjures images of untouched wilderness, in reality forest in many parts of the world (and certainly in the heavily populated Mediterranean basin) have been shaped by man for ages. People cleared undergrowth for pasture and fuel, which in turn greatly reduced the risk of fires. However, rural depopulation is cutting this link between man and tree (see here), increasing the risk of fires.

Of course, the European Unions policies often don't help. Its generous agricultural subsidies are oriented to large-scale intensive farming and reforestation schemes often involve non-native species that involve highly flammable trees (eucalyptus, certain pines).

In the end, what do you do? Encourage once again the traditional agricultural practices to reestablish the previous equilibrium? I doubt that many people would like to be shepherds, even if heavily subsidized. Or do you just let the fires burn and wait until a truly wild native forest slowly establishes itself?

Biofuel madness

2007-08-25T15:23:00.000-05:00

It's amazing how the biofuels bandwagon has kept gaining strength despite the fact that it's one of the main factors behind the steep rise in food prices. (Note to The Economist: remember that oil is used to grow crops!).

People have tolerated this because biofuels have a warm, green image (not deserved in many cases). Who can possible be against the environment?

But its pretty clear that biofuels serve mostly one purpose: to benefit incumbent politicians. On production cost grounds, biofuels make no sense, with the possible exceptions of sugarcane and jatropha. Politicians love to subsidize non-viable industries with a good public image becase 1) not many objetct lest they be called anti-environment and 2) those subsidies come back as campaign contributions from agribusiness (which has no choice, given that it wouldn't exist without those politicians).

In other words, politicians subsidize themselves. Rent-seeking at its most perverse worst.

Norwegian lottery winners

2007-08-25T02:33:00.000-05:00

Don't ask how I came across this study. But it's one of the most hilarious and memorable abstracts I've seen in a long time (yes, I do have a peculiar sense of humor). It's worth quoting in full:

Abstract The study investigated 261 lottery winners of prizes of NKR 1 million (US $150,000) or more in the years 1987–91 in a postal survey. The modal Norwegian winners were middle-aged married men of modest education, living in small communities. Emotional reactions to winning were few, aside from moderate happiness and relief. Winners emphasized caution, emotional control and unconspicuous spending, e.g. paying debts and sharing with children. There was only a slight increase in economic spending. A wish for anonymity was frequent, together with fear of envy from others. Betting was modest both before and after winning. Experiences with winning were predominantly positive. Life quality was stable or had improved. An age trend was observed, accounting for more variance than any other variable. The older winners seemed to represent a puritan subculture of caution, modesty and emotional restraint. A slightly more impatient pattern of spending was characteristic of younger winners. The results support Kaplan's 1987 and others' findings that lottery winners are not gamblers, but self-controlled realists and that tenacious, negative cultural expectations to the contrary are myths, but perhaps also deterrents of uncontrolled behavior.

Culture is everything.

Surreal headline of the day: Sun Tzu's "The Art of Spin"

2007-08-23T21:00:00.001-05:00

"China: Recalled Toys Not Poor Quality"

In fact, you can see that the lead paint was applied flawlessly in each and every case.

Snark aside, the Chinese government really needs to apply the ancient sage's wisdom to the modern battlefield of damage control.

It's the house prices, stupid!

2007-08-23T16:36:00.000-05:00

That, in essence, is the message of Bill Gross's latest Investment Outlook. The top fixed-income guru (a well-deserved title, I might add) and head honcho of PIMCO estimates that house prices may fall 10% over this cycle, leading 2 million household to lose the roof over their heads.

It's a theme I've also insisted upon (see here). While the current market turbulence is worth undestanding and addressing, in the grand scheme of things the real danger lies in a housing-led spending collapse.

Gross discards the idea that rate cuts are the real remedy since their effectiveness is not guaranteed in the current panicky environment. Oh, there's also the small matter of a possible run on the U.S. dollar.

Instead, he proposes that the federal government implements a massive bailout for homeowners threatened by foreclosure.

Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?

Sigh.

Irony aside, even if we had a better president than the current one it would not be easy to design and get a program of this nature enacted. Start with the fact that U.S. is not in a good fiscal position, so offsetting spending cuts might be needed (Any volunteers? Didn't think so). But I wouldn't be surprised if this comes the top issue in the 2008 election.

In defense of bubbles

2007-08-23T13:12:00.000-05:00

The chic contrarian position nowadays is to argue that financial bubbles do have benefits. First, Daniel Gross defended the tech bubble (it was not only good, it was great!) as a means to encourage lots and lots of investment and innovation which provide long-term gains to society. Hardly a scientific argument, but it does make some sense.

Now, on these grounds it is much harder to defend the real estate bubble. Yes, there was some financial innovation involved, as Gross mentions. But it certainly was not of the life-changing variety (as were the Internet or railroads) and it was mostly already in place before the party got underway.

So did it provide benefits? Mystery blogger Knzn argues that it was the only way to ensure that a recovery took hold after the 2001 recession.

He's right, to an extent. The purpose of lowering rates to 1% was to get people to spend (the government could only do so much and firms were hungover). In a very anemic job growth environment, such as the one from 2002-2005, the only way to do that was through asset reflation, mainly residential real estate.

The real problem was that rates stayed too low for too long. In 2004 and 2005, a period in which the recovery had evidently taken hold, house prices (measured by the Case-Shiller composite index) rose 18.7% and 15.9%, respectively. And it was in 2005 and 2006 when subprime mortgage originations rocketed. If the Fed and other financial regulators had acted sooner, things woldn't have gotten out of hand to the degree that they did.

Sure, there's a fine line between asset reflation and a bubble. But it is clear that real estate bubbles are much more dangerous (they affect most people) and have a much more negative effects (depleted savings, high debt, excessive investment in nonproductive assets, screwing future hombe buyers, etc.) than garden variety stock market bubbles, with no long-term upside.

The Federal Reserve is flying blind

2007-08-22T11:19:00.000-05:00

There's no question that the Federal Reserve's response to the current market turmoil has been belated, clumsy and not terrible effective. Many attribute it to rookie mistakes by Chairman Bernanke. But I think it goes beyond that. To understand the Fed's actions, its worth exploring the way some of that institutions top officers look at these issues. From what I've seen so far (read on), no wonder we're f***d.

Let's begin with Frederic Mishkin, a noted economist and member of the Federal Reserve's Board of Governors and its Open Market Committee. Last January he gave a speech where he laid out his thinking of asset prices and monetary policy.

First, Mishkin states that he doesn't believe central banks should actively seek to puncture bubbles of any kind, but other central bankers hold the opposite position. Having said that:

There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. For example, if home prices rise above what the fundamentals would justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then return to their fundamental values. When this happens, the sharp downward correction of asset prices can lead to a sharp contraction in the economy, both directly, through effects on investment, and indirectly, through the effects of reduced household wealth on consumer spending.

This is not complacency. He knows the danger. But what should central banks do when they see frothy real estate markets?

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.

This brings to mind the joke about the economist who refuses to pick up a dollar bill on the sidewalk (see here). A rather lame argument, if I may say so myself. But let's move on to a key section of his speech (bold type is my emphasis):

A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.

Go oooon!

To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default.5 The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads.

Most, Mr. Mishkin, is not good enough. And this argument is misleading. First, we're talking about real estate, not stocks. Second, credit spreads did jump dramatically in 2001-2002, as a lot of the excessive tech and telecom investments --which were made due to the wildly optimistic assumptions that were also reflected in stock prices---went bust. Things did not get very ugly because rates were quickly cut.

There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.

Yes, residential bubbles are not common. That's precisely why the Fed should've been much more worried! But what really shocks is that time has stood still for Mr. Mishkin. He still sees a world of bank-originated plain vanilla mortgages taken out by solid, creditworthy citizens which are then are sold to prudent investors through bonds packaged by Freddie Mac and Fannie Mae. It's as if the whole subprime/Alt-A thingy never happend.

Clearly, even Mr. Mishkin grants that bubbles can exist and burst. So what happens then?

Instead of trying to preemptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.

Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future

I have a word for this: GIGO. Yes, the universal law of garbage in, garbage out has proven itself once again. Is it any wonder that the Fed's response has been slow and not very effective when it has ignored the changes in the mortgage market? Evidently, their "stress tests" were based on unrealistic/deficient/naive assumptions.

This is very, very worrisome. The Federal Reserve is flying blind through a raging storm. Better buckle-up.

Surreal economics headline of the day: BBC edition

2007-08-21T12:52:00.000-05:00

Iraqi growth 'unexpectedly slow'

Nothing else needs to be said.

The vulture of Omaha

2007-08-21T11:09:00.000-05:00

It didn't take long for Warren Buffet's name to come up in relation to the current market crisis. It turns out, according to rumors cited by the Wall Street Journal, that Mr. Buffet might buy parts of Countrywide Financial Corp., one of the nation's leading mortgage lenders (and now stuck in the subprime quicksand).

While he's not regarded as a vulture investor, Buffet is no stranger to the fine art of purchasing distressed securities. During the Long Term Capital Management Crisis in 1998, he offered to purchase its assets, an offer that was apparently rejected (this very relevant study by the Federal Reserve summarizes the episode)

Judging the Fed

2007-08-21T10:58:00.001-05:00

Naked Capitalism provides an excellent, in-depth summary of the debate on whether the Federal Reserve did the right thing by intervening in the markets (hat tip: Mark Thoma).

How much more will construction fall?

2007-08-21T01:11:00.000-05:00

So far, the only direct, significant impact of the housing downturn on the economy has been the drop in residential investment. It's certainly been a nasty fall. After representing 6.3% of GDP in the 4th quarter of 2005 (a level not seen since 1951), it stood at 4.9% of GDP in the second quarter of this year. In real terms, it has fallen 18.6% during this period.

This drop subtracted 0.3% from total GDP growth in 2006, with an additional 0.9% and 0.5% over the last two quarters. So is the bottom in sight?

Yes, according to the median forecast in the Federal Reserve's Survey of Professional Forecasters. The forecasters expect an additional 4% drop in residential investment between the second quarter and the first quarter of 2008, after which it'll start a slow recovery. That roughly implies that it'll represent, at the bottom, around 4% of GDP.

This seems a bit optimistic given recent events and historical precedent. In previous housing downturns, residential investment has bottomed at around 3.3% of GDP. In addition, housing starts are still around 1.4 million and traditionally they fall to below one million during rough times (actually, the median forecast sees this level as the bottom and sees a slow rise in 2008).

Needless to say, forecasters seem unduly optimistic on residential investment. Although they've already cut the GDP forecast for this year from 2.6% late last year to 2% currently, negative surprises seem to be, unfortunately, quite likely. (And this is not even taking into account the possible impact on consumers).

Today's word is BAILOUT

2007-08-20T20:11:00.000-05:00

Yes, it's back with a vengeance. From every corner of the kingdom (see here and here), analysts are screaming "Bailout!" in response to the Fed's reduction in its discount rate and change in policy stance.

But is it? The premise of the criticism is that the Fed has rescued Wall Street and well-heeled investors in the recent past (the 1998 LCTM debacle, the tech bubble), thereby encouraging even more reckless behavior, such as that associated with the subprime mess.

Excuse me, but this doesn't make sense. LCTM did go bust, many persons lost fortunes speculating on Russian debt, and the Nasdaq is at half the level it reached in its 2000 peak. And cutting rates now won't do much to reduce the losses in bonds backed by junk mortgages. So it's not a question of rescuing investors, but of making sure that speculative excesses don't spill over to the economy. I don't blame the Fed for doing what it's doing (albeit in a rather clumsy way).

The hissy fit over alleged bailouts is unhelpful, as it distracts from asking the truly important questions:

1) Why have there been so many speculative excesses in such a short period of time?
2) Should central banks actively try to nip bubbles in the bud?
3) Do hedge funds and other highly-levered investment vehicles need to be regulated more strictly as potential sources of financial destabilization?

Have you seen anybody discussing these points lately? Neither have I.

Is the Fed bailing out Wall Street?

2007-08-20T12:33:00.000-05:00

Now that everyone has had a couple of days to digest the Fed's actions, many have come to condemn them as the latest edition of the "Greenspan put", that is, bailing out Wall Street's scoundrel speculators. None other than the great James Surowiecki dixit.

Trends in credit spreads support this view. As James Hamilton points out, they've certainly risen, but only towards their long-term average (BAA-rated corporates are only slightly above 200 basis points above Treasuries).

While I do believe this view has a lot going for it, there are two big caveats.

First, we still don't know (and won't know for many months) where the weakest link is in the financial system and the disruption it may cause. The Fed obviously has a lot more inside info than any analyst and is in a better position to judge this. If it's worried by what it sees, a down payment on further easing makes sense.

Second, there's still the fundamental issue: house prices. While so far the adjustment is in line with the last big housing downturn in the early 1990's, leverage is much, much higher today, so things could get uglier. Certainly, the Fed foolishly downplayed the whole supbrime mess over the past few months, as many are pointing out. Nevertheless, some monetary easing might be justified to avoid a vicious circle from developing.

Talking about bailouts is not helpful. The losses for investors and homeowners are real, justified and won't disappear even if the Fed eases rates some more. The Fed's job is simply to make sure they are absorbed in an orderly fashion and we should judge it by this parameter.

Banking panic!

2007-08-18T15:07:00.000-05:00

Recently, there was a run on a bank. Didn't hear about it? Maybe it's because it had nothing to do with the current subprime mortgage crisis and because it took place in ....Second Life. Yes, the much-hyped virtual game does have a financial system of sorts and apparently it's facing very real growing pains (hat tip: Byrne's Eye View)

Mapping economic development

2007-08-18T14:14:00.000-05:00

Tim Hartford describes some very interesting work being done by physicists and economists to map out the relationship between products at global and national scale (hat tip: Marginal Revolution). The idea seems to be that poor countries have different product clusters (say, tropical agriculture and mining) from rich nations and it's not easy moving from one to another.

"The physicists' map shows each economy in this network of products, by highlighting the products each country exported. Over time, economies move across the product map as their export mix changes. Rich countries have larger, more diversified economies, and so produce lots of products—especially products close to the densely connected heart of the network. East Asian economies look very different, with a big cluster around textiles and another around electronics manufacturing, and—contrary to the hype—not much activity in the products produced by rich countries. African countries tend to produce a
few products with no great similarity to any others."

That could be a big problem. The network maps show that economies tend to develop through closely related products. A country such as Colombia makes products that are well connected on the network, and so there are plenty of opportunities for private firms to move in to, provided other parts of the business climate allow it. But many of South Africa's current exports—diamonds, for example—are not very similar to anything.

If the country is to develop new products, it will mean making a big leap. The data show that such leaps are unusual.

This is a pretty compelling argument for industrial policy (paging Dani Rodrik!). The question, of course, is what type of industrial policy is best and how it can be implemented. Needless to say, this debate has been going on for nearly 50 years and, curiously, but it's striking how little we know.

"Moronic" doens't do it justice headline of the day: AP edition

2007-08-18T14:00:00.000-05:00

As many have noted, it is becoming increasingly difficult telling apart ordinary newspaper pieces from content published by The Onion. Just take a look at this headline found in the Washington Post:

N.C. Waitress Applauds Minimum Wage Hike

So what's next? "Will from Des Moines criticises Hillary on Rush Limbaugh's show". Beyond belief.

Tinker, Tailor, Soldier....Central Banker?

2007-08-17T19:32:00.000-05:00

Today's rate cut was not exactly a surprise. Rumors were already flying about yesterday.

While I understand the need for the Fed to sometimes work in secrecy to avoid tipping-off people as to impending policy changes, it's silly for central bankers to start playing James Bond.

Half empty or half full?

2007-08-17T19:15:00.001-05:00

Everybody and their second cousin has already commented on the Fed's "surprise" cut of their discount rate and their change in outlook (summary here)

So, what's the deal? Enter the proverbial glass.

The half full interpretation: The Fed is only soothing irrational panic in the markets that could, if left unchecked, turn into a full-blown credit crunch. Once everyone realizes that the world isn't coming to an end, things will get back to normal, investors will be a bit wiser and credit spreads will return to saner levels.

The half empty interpretation: The Fed knows that there's going to be a major blowup one of these days that could maybe pose a systemic risk to the capital markets. Hence, it's paying the first installment in what promises to be a series of cuts to avoid a total meltdown. Cutting now makes sense in order to avoid a huge cut later on that will give the impression of true panic.

Which is true? I don't think anyone really knows (not even Ben Bernanke), but I lean towards the half-empty version.

Rating agencies: Déjà vu all over again

2007-08-16T00:20:00.000-05:00

As was to be expected, the bond rating agencies are catching a lot of (deserved) flack over their (abysmal) performance in the subprime mortgage mess (see here). But then again, what else is new? Ratings have been lagging indicators for as long as I can remember. After every crisis --Mexican, Asian, Russian, Enron, etc.--there's been an outcry over why S&P, Moody's and Fitch where asleep at the wheel.

The answer is obvious: incentives. Issuers pay for ratings. Thus, the agencies have a vested interest in being as nice to them as possible to keep the fees rolling in (this Portafolio piece describes this point well). As Barry Ritholtz notes, it's fundamentally the same problem that brought disrepute to sell-side research after the dot com bubble burst (if you think things have changed, just read this).

What can be done? Politicians may huff and puff, but research can't be regulated, other than by inserting ever longer and totally useless disclaimers after each report.

The only possible solution is for large institutional investors to bankroll serious buy-side ratings research. Of course, putting this into practice wouldn't be easy, as there are obvious collective action/free rider problems, but they're much smaller than those faced by individual investors (hence the private equity racket). If they can't do this, the same old rotten ratings system will continue after the storm passes and politicians get back to the latest Middle East crisis.

So why haven't they stepped up? Fear of changing a century-old system? Fear of retaliation by issuers and the investment banks (both profit from the current arrangement? Your guess is as good as mine.

Shiny happy realtors

2007-08-15T11:29:00.000-05:00

It is very easy for spin to mutate into full self-deception. Just ask any politician. Spin will only work in the long run if it is used sparingly and doesn't involve transparent falsehood. Otherwise it destroys credibility and undermines the ability to achieve long-term objectives.

Somebody should tell this to the National Association of Realtors. The other day I documented how their "house prices haven't fallen since the Great Depression" meme, which is fundamentally false, is coming back to bite them in the ass. But it seems they just can't help themselves. See for yourself at Freakonomics' real estate quorum.

Home Depot: Jumping ship

2007-08-15T01:34:00.000-05:00

By many accounts, Robert Nardelli is a jerk. But he's a jerk with pretty goood timing. After being pushed out of Home Depot for failing to deliver a rising stock price despite strong growth in January, he landed a new gig as head of Chrysler. While no one can deny that this is a challenging job, expectations are low (anything other than bankruptcy will be considered a success) and being head of Home Depot right now is not much fun at all.

Today HD published its second quarter results, which where appropriately dismal. Sales fell 3% versus 2Q06 and the operating profit sank 12%. Things will only get uglier, as the second quarter is traditionally the strongest (sales rose only 2.8% versus the first quarter, compared to 21.3% in the same period last year). Needless to say, 2008 isn't looking good either. Besides, it's having trouble selling its wholesale building materials division to a group of private equity firms.

The not so bad news: its profit margin held up surprisingly well.

Wise words from John Kay

2007-08-15T00:56:00.000-05:00

If trading was motivated not by differences in attitudes and preferences but by differences in information and understanding, risk would gravitate not to those best able to bear it but to those least able to comprehend it.

As true today as ever. Read the whole article here.

Forgive them, for they know not history nor statistics

2007-08-14T13:33:00.000-05:00

Southern California is a sunny, optimistic place. I guess that's why people here keep thinking that the bottom of the real estate market is just around the corner.

DataQuick analyst John Karevoll interpreted the prices and sales as a sign that San Diego real estate may be nearing the bottom of the post-boom period.

“Most of the declines in San Diego have happened,” Karevoll said. “Now it appears to be re-establishing a balance that we have yet to see for the (Southern California) region.”

Can't blame people for hoping, but this just goes to show how short our memories are. For example, take a look at this graph on San Diego residential real estate prices. It compares the 1987-1996 cycle (whith a peak in July 1990) with the current one (peak in November 2005) using the Case-Shiller price index.

Cycles are never identical, but they sure do seem similar so far! In the 1990's the peak-to-trough price fall took six years to be completed, so it's quite likely that the downward part of this cycle still has quite a ways to go.

P.S.: I promise that there'll be no more snarky biblical-themed titles!

Thou shalt not lie: NAR edition

2007-08-14T01:29:00.000-05:00

I've heard the meme that "house prices are falling for the first time since the Great Depression" quite a few times recently (examples here and here). The source cited is the National Association of Realtors (the phrase appears in many of their documents).

I'm not sure how these folks came up with it, but its clearly nonsense. We only have to go back to.....1991 to find widespread falling real estate prices. The Case-Shiller indices, probably the most realiable data around, show that nationally prices fell 6.8% between the peak in October 1989 and the trough in February 1994.

Ironically, the NAR has been parroting this line for quite a while now, obviously expecting people to believe that home values hardly ever drop and only do so in the most extreme circumstances. Well, the lie has come back to bite them in the ass. Nowadays, it's more likely to inspire (unwarranted) panic than confidence.

The root cause

2007-08-13T12:26:00.000-05:00

I think this graph captures it:

While the data on households seems much to noisy (taken from the Census Bureau), it is clear that starting on 2004 housing completions began to seriously outstrip demographic demand. So why did price growth take until mid-2006 to cool? Because the market had taken a life of its own with so much cheap financing availible. And it seems to me that to keep the party going, lenders had to agressively recruit ever more unsound borrowers. This explains why recent vintage subprime mortgages have much higher default rates.

The bad news is that the market will undershoot on its way down, just as it overshot on the way up.

Winners and losers

2007-08-11T17:48:00.001-05:00

Which stock market sector has had the worst performance so far in August? If you answered financials, you (and I) were wrong. Taking the S&P Global 1200 as reference, it turns out that materials, energy, industrials and consumer discretionary all performed worse than financials.

This is not as strange as it may seem. Look at year-to-date results (YTD). Financials are the worst performing sector, as expected. This means that the damage inflicted by this crisis had been reflected in valuations before the lates news. Which is fairly good news. The bad news is that the sectors who fell most this month are cyclicals, which means that worries about global growth are rising.

Geographically, so far this month emerging markets have donde worse than developed markets and the US has done better than Europe. This has identical meaning to the sector breakdown above. The bad news is already in US stock prices (well, as long as more unanticipated bad comes along) and worries about growth are spreading to the stronger economies (Europe, emerging markets).

The second subprime crisis and other observations

2007-08-10T13:31:00.000-05:00

Far from being an expert on mortgages or fixed-income markets, as most people, it's not easy fully understanding what's going on. So the only thing I can offer is to share what I'm learning.

First of all, if you really want to understand these mortgages, go read this IMF study, a true eye opener. For starters, it turns out that this is the second subprime crisis. In 1998-1999 most subprime lenders went bankrupt after the Russia/LTCM crisis. The difference between this crisis and today's situation is that the total amount of subprime mortgages was much, much smaller, which is why it didn't receive much notice.

A few additional points:

1. It's rather silly blaming securitization per se for the subprime mortgage meltdown. All sorts of loans have been securitized into bonds, including risky ones such as credit card debt. So why did the supply chain break so badly in this case? It probably has to do with the bubble mentality that set in over the last few years and a lack of a coherent regulatory framework. That said, I do wonder what will happen when the loan originators/services, who supposedly manage these mortgages, go bankrupt. Who collects? This can be very tricky.

2. The real problem, as this BIS report shrewdly noted in 2006, is that subprime mortgages are a fairly recent product (mid-1980's) that came into being during a period of high economic growth, only two mild recessions, rising house prices and declining interest rates. Hence, the models for valuing likely can't handle/didn't take into account high stress scenarios, such as falling home prices, leading to over-optimistic pricing and, thus, losses when they materialize.

3. As I noted yesterday, given the lack of credible valuation models and ratings for these bonds, somebody has to step in. It could be financial firms, although they disturbingly show no inclination to do so even when their own funds and reputations are on the line. Enter the lender of last resort, aka the Federal Reserve.

4. Call me Cassandra, but I will say it once again: the current mess in the markets is serious, but its danger pales besides the one posed by the nexus between increasing foreclosures and falling house prices. I second Paul Krugman in calling for the Fed and other regulators to step in and coordinate borrowers and lenders (via Economist's View).

So how're Fannie & Freddie?

2007-08-09T19:05:00.000-05:00

They're doing surprisingly well, thank you for your concern. In one of those strange twists of history, after a series of accounting and management scandals Freddie Mac and Fannie Mae were placed under a short leash, which seems to have greatly limited their exposure (see here and here) to the subprime sector. Just look at the performance of their stocks (FRE, FNM):

This is very good news. The markets will need all the help they can get and Freddie Mac and Fannie Mae can play a crucial market making (and thus liquidity-providing and price-creating) role, hopefully coordinating with the Fed. I'm sure we'll be hearing a lot more from them very soon.

It's official: panic in the markets

2007-08-09T18:21:00.000-05:00

I somehow missed this earlier today. When central banks start injecting money into the system, you know it's getting really ugly, really fast.

Will this wall of money do any good? Well, sure, in the short run, although arguibly the signal it sends will work in the opposite direction.

What's really hurting the market is that nobody knows what those securities backed by subprime mortages are worth. If the meltdown continues, I wonder if the Fed will be willing to buy those bonds at a certain price.

Sanguine or stupid?

2007-08-09T15:20:00.000-05:00

Apropos the latest chapter in the subprime saga, Felix Salmon asks what's the big deal about BNP Pariba's announcement that its freezing some funds with investments in bonds backed by subprime mortgages. After all, the money involved belongs to others (unless the bank feels compelled to bail out investors).

He has a point, although in full-blown panics these fine distinctions tend to get lost in the rush for the exits. In this type of situation, it's worth keeping a cool head and listing the possible scenarios:

1) Systemic crisis due to the collapse of a large, well-known financial institution. Very unlikely, but not impossible. After all, the virtue of securitization is that risk is spread more widely. Just imagine how bad it would be if banks had held on to these securities.

2) Credit crunch caused by panic among lenders. This would mainly affect the US (and UK) economy, leading to further losses in the credit and stock markets and perhaps a recession. However, given the strength of the world economy, wide availibility of capital and a starting point of low risk spreads, it probably wouldn't be too bad.

3) Full collapse of house prices in the U.S., consumer retrenchment and recession if a vicious circle between asset value losses and spending establishes itself.

My take is that scenario 3) is the one we should really worry about, yet its been largely ignored. In that sense, Felix's instincts are correct; the collapse of a few funds is mostly a sideshow whose consequences are psychological. But, needless to say, psychology does play a role in the markets. If the gloom bug jumps from them to home owners, then we're in deep doo doo.

Suprime Squeak Piggy Squeak (TM)

2007-08-09T11:54:00.001-05:00

This game is about guessing which financial institution turns out to be holding lots and lots of bonds backed by subprime mortgages. There are, by some accounts, over 700 billion dollars worth out there (maybe more). Everyone knows where these mortgages come from, but after spinning the wheel of the markets, nobody knows where they are now.

To win, you must not fall for unfounded rumors and look for valuable clues.

Today's squeaker is BNP Paribas's . France's largest bank by market value is certainly not your usual suspect, but it hasn't been the first European victim.

I won't hazard a specific guess at this time, but the next victim is likely to come from a yield-hungry environment with a checkered history of risk control, such as, say, Japan. Oink!

Separating the micro from the macro

2007-08-08T17:37:00.000-05:00

Dani Rodrik's blog has become a must-read for those interested in economic development. Recently, he's been writting quite a bit on the merits of industrial policy. Contrary to most orthodox economists, he argues that extensive market failures do justify intervention, at least in some cases (see here).

Now, industrial policy models come in many flavors. There's the East Asian development model, based on exports, and the old import substitution model (ISI)followed in Latin America and in India from the 1950's to the 1980's. Results were, obviously, very different.

But, as Rodrik points out, industrial policy falls within the realm of the micro. While it does have macro repercussions, it's absurd to blame it for events such as the Latin American debt crisis of the 1980's. After all, some countries with open economies, such as Chile, experienced severe crises at that time, while ISI-followers such as Colombia and India did not.

That makes The Economist's economics blog's screed against import substitution so bizarre. One can debate ISI's merits, but arguing that ISI caused the debt crisis because it hampered the recovery that came after (which is obvious) makes no sense.

This doesn't mean the two are completely separate. An argument can be made that by the 1970's the ISI model had run against diminishing returns, lowering growth. Facing acute political and social pressures, many Latin American governments worked to raise growth by massively (and recklessly) increasing public spending. This was possible because of the abundant liquidity in the 1970's, which enabled governments go get abundant, low-cost foreign currency loans. If Latin American nations had opened their economy earlier or developed more efficient ways to combat unrest, things may have turned out very differently.

Brangelina kills Bat Boy

2007-08-08T15:38:00.000-05:00

Sad, but true. Supermarket cashier lines will be a duller, sadder place after Weekly World News recently ceased publication, although it retains a web site. Those furtive glances (it took rare courage to actually grab a copy) always brought a smile. Now, we're left only with humorless, unimaginative gossip and soap opera rags.

I did enjoy this, perhaps unintentionally poignant, op-ed by one of its contributors.

I was, at first, confused about whether I was supposed to write true offbeat news, general satire or complete fabrication. So I asked. The response was loud and clear: "complete fabrication." (In case this wasn't clear, the paper started running a disclaimer in 2004: "The reader should suspend disbelief for the sake of enjoyment.")

Yet each piece was written as if completely real. So when, for example, Bigfoot got married, launched his acting career and became involved with Kabbalah, each story got a dateline, quotes from "sources" and "experts" and followed a typical Associated Press structure. In fact, much of the original staff came from mainstream newspapers. The standard? It had to seem true.

"Half the readers realize the stories are tongue-in-cheek; the other half believe they're all true," my editor explained. "You have to write the stories to satisfy both groups."

Without such whimsy, the world is a little bit diminished.

Cemex or why geographic diversification helps

2007-08-07T12:44:00.000-05:00

Mexico-based Cemex, the world's leading construction materials firm, certainly qualifies as a victim of the U.S. housing collapse. The U.S. market represents a quarter of its sales and in the second quarter its sales fell 16% year-on-year, following a similar drop in volume. Spain, another big market facing housing woes, also saw a more modest volume contraction.

Yet, Cemex managed to squeeze out a 6% rise in sales during the second quarter. How? Well, a strong euro (the RMC acquisition gave it a strong presence in Europe) and booming emerging market sales, including Mexico, managed to compensate its troubles in the U.S.

So, its vaunted diversification is finally proving its worth. But curiously, Cemex is not the Mexican cement firm you want to be invested in. That honor belongs to Grupo Cementos Chihuahua, a much smaller produccer that has also entered the U.S. market in a big --and much more succesful--way. Just compare the performance of their stocks.

Nokia's blowout

2007-08-02T16:40:00.000-05:00

It's not every day that a company with a market cap of $100 billion plus sees its stock price jump 8% in one session. Today Nokia did just that after reporting its 2Q results.

Were its numbers that good? Yes, despite the fact that one of its four engines is not working (its network equipment division, Nokia Siemens), a strong euro and so so performance in its biggest division (mobile phones).

Leaving aside the network division numbers, which are not comparable to previous periods due to the Siemens merger, sales jumped 13% over the year-ago period. But what's extraordinary is that they rose nearly 14% compared to the first quarter. That's 40%+ annual growth going forward. It was driven by strong growth in multimedia devices (fancy 3G phones and PDA's) and enterprise solutions.

I have no idea whether they can keep up this growth rate. And it's certainly a feast and famine industry, with long stretches of little or no growth (2002-2004). Yet, at 21 times earnings, while no bargain, it's certainly not too expensive to cash in on one of the world's leading growth markets.

After all, worldwide cell phone penetration standas at 40%, according to the ITU, with Asia at 30%. So there's still a lot of room for growth.

Malthusian nonsense never goes away

2007-08-01T16:16:00.000-05:00

Over the nearly 200 years since the good Rev. Malthus published his famous hypothesis that food supply can't keep up with population growth, the facts have shown, over and over again, that he got it wrong. Yet, every time food prices rise, neo-Malthusians rise up and say that this time it'll be different.

Well, today's Malthusian Chicken Little is none other than celebrity Harvard professor Niall Ferguson (see here, hat tip to Economist's View). Sure, food prices have risen over 20% as he states. And yes, per capita grain production has not kept up with world population growth over the last two decades. So, is he right that food will be increasingly scarce and expensive in the future?

Nonsense. The IMF's commodity food price index has risen 23% over the last 24 months. (Not all atributable to ethhanol, weather and oil prices have also played their part). But they're only 7.7% above their level in 1980. So even if we assume a modest world inflation rate of 2% a year on average over the last 27 years, in real terms food prices are actually 37% below the 1980 level.

How about the grain supply? According to the FAO, world grain production rose 32.5% between 1979-1981 and 1999-2001, while the world's population rose 45% over the same period. Yet, during this time, meat production jumped 72% and fruit/vegetable production rose 91.7%. Folks, this is a sign of greater affluence and better nutrition.

While there's no denying that climate change will pose challenges, I have no doubt the world will be able to feed itself in the future, as yields rise in many emerging economies and the genetics revolution spreads. And I'm just as sure that uninformed doomsayers like Dr. Ferguson will keep appearing every time food prices rise.

Emerging markets have arrived

2007-08-01T16:07:00.001-05:00

Last week, developed world stock markets fell 5%, according to MSCI. Traditionally, emerging markets would fall twice as much on your average market panic (like this year's China scare or 2006's big May sell-off). But last week the MSCI EM index fell just 5.7%.

While I would be reluctant to declare the end of emerging market crises, this certainly shows just how much their risk levels have fallen due to fundamental improvements and, just as important, that developed nation investors have come to know and recognize this fact. As a veteran of nearly 30 years of economic upheavals in the developing world, this is as welcome as it was unexpected a decade ago.

How inept can a ruler be?

2007-07-29T22:29:00.000-05:00

No, I'm not thinking of George W. Bush right now. Guess which long-standing national leader uttered this infamous phrase recently:

"Where money for projects has not been found, we will print it," xxx was quoted as saying.

The answer is: Robert Mugabe of Zimbabwe. Not surprisingly, inflation in that country, currently over 4,500% a year, is going to infinity and beyond. If I were a betting man, I'd wager Mugabe's regime will collapse in less than a year.

If you're interested in why Zimbabwe technically got into this mess, check out this paper.