Politics and Spin Over Observation

The March 30th US print edition of the Wall Street Journal carried an Opinion piece titled, “Britain’s Monetary ‘Stimulus’ Has Fed the Pension Crisis“. The article highlights the plight of many firms whose pension funds are under water and how persistently low interest rates have crippled the chances to grow the returns on a number of investment vehicles. This is due to the widening gap between the value of assets and liabilities. The article happens to highlight this plight in conjunction with true fight in Britain over a venerable old British firm, GKN, who has impressively damaging pension liability any suitor needs to accommodate.

The real point of the article however is not really about GKN. It is that the Bank of England recently published a paper that argued its loose monetary policy and massive quantitative easing were in fact good for us. The argument of the report is that things would have been much worse, therefor whatever we have must be better. This is a strange argument. Much research has been published that correlated near-zero interest rates and QE with debt and credit price distortions, record-levels of M&A, record-levels of stock buy-backs, Stu only low capital investment levels, low productivity, and to top it all off, increased inequality. To be fair, if you didn’t watch the news and all those around you, the Bank of England report might be credible. If we had had a real crash, the pain might have been worse for a while, but the economy would have recovered as fast as other recessions due to the lack of credit and debit distortions.

The article closes on a useful warning and observations. Old firms with such large pension obligations and short-falls are suffering from a double-whammy. Such firms have to divert funds to stem the pension fund blessing that might otherwise have helped source the needed growth in the future to pay for those persons. Even if central banks had not kept rates so low for so long and stuff they investor-classes pockets with cheap money, such firms might still be in trouble-or anyway.

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The Debt Chickens Are Coming Home to Roost

A story it today’s Us print edition of the financial times highlights a building ‘bubble’ of disquieting proportions. The article, ‘Britain’s Pizza Chain Boom Faces Debt Reckoning’, highlights how a large number of restaurant chains have been snapped up over recent years using debt. This might be by a private equity firm or a leveraged buy-out. In either and other cases, many acquisitions were executed using cheap debt which was facilitated by central bank policies such as near-zero interest rates and quantitative easing (QE), both of which massively distorted the price of corporate bonds and debt. Add to this public policy and pressure on banks to increase loans to help drive growth, you can see signs of a perfect storm.

The UK example is specific, but the problem is wide and applicable to most developed economies. The US has just come off a long-run marathon of high and record levels of corporate acquisitions, again much funded by cheap debt. There must be many organizations hanging by a thread, just waiting for interest rates to nudge up resulting in unsustainable debt burdens and interest payments. Unless growth drives the top-line of these businesses at a faster rate, the chances are many such firms will go to the wall.

This situation was created as an unintended consequence of near-zero interest rates for such a long time and massively price-distorting quantitative easing. Though most governments have ceased buying sovereign and corporate debt, the damage is done. Massive, trillion dollar, balance sheets at central banks need to be unwound in such a way as again, not upset the market. The act of creating the balance sheet did upset the market. In reducing their balance sheets, central banks will do it again.

And the sad part about all this, as it will play out? Smart investors with lots of money and a high risk-tolerance will hedge against such business failures and reap huge rewards. The rich investor-class will get richer, and the poor will just lose their jobs or otherwise miss out. Politicians will have a field day, calling out the failure of capitalism. Of course, it’s not a failure of capitalism since central banks and their policies are not part of any capitalist model: central bank operations are closer to a socialist model where the few take decisions to ‘help’ the many, as if they know better and how to help us.

Oh well, such is life. Just buckle down and wait the storm. The debt chickens will soon be home to roost. Maybe not by this Easter but expect them home by next year.

It Pays to Save

The UK was initially criticized for its austerity measures, employed at the height of the economic crisis that has slowly subsided now around the world. But some year’s later the UK was then lauded for being prescient. At the time, its economic growth was the fastest of any advanced economy. Things of course moved on – Brexit followed and even though the cloud did not fall in, the countries economic condition has slipped from front of the class to back. But that misses the point of this blog. The UK adopted austerity since that was the right thing to do – to reign in spending and support the natural economic rebalancing of price and supply. Other countries, when faced with economic challenges such as a slow-down or recession reach for the public sector check book.

This approach is known as Keynesian demand-management. The idea is simple, if not well understood as a simple idea from the practices namesake. When there is a shortfall in demand in the economy, the public sector increases spending to help fill the gap. Public spending, like any spending, creates knock-on effects whereby a dollar spent creates more than a dollar in ongoing spending. This simple idea became common thinking and the pain of the 1970s and 1980s were required for governments to learn that this approach has issues. First, Keynes had suggested that such spending should be temporary – since private sector spending was more efficient. However, even though Keynes noted this, it was left off the memo and his name became associated with “spend”, not “spend for a short while only”. As a result, governments spending increases were rarely ever temporary.

Secondly, and as we have seen in spades since the recent period of near-zero interest rates and QE, public sector spending crowds out private sector spending. The entire bond market has been distorted due to massive government intervention and spending. The whole pricing process has been disrupted. This is the same with the economy. As demand-management kicks in it forces normal public sector behavior to change. And so the economy is knocked off kilter even further.

So it was interesting to read some new material from the IMF that demonstrates that austerity is not the bad-boy all the politicians make out. The interesting article is called, Climbing out of Debt, and was published in the March edition of the IMF’s Finance and Development magazine. The actual data shows that countries that exploited tax-based austerity, versus reduced spending austerity, suffered deeper recessions. This is a kind of “devil you know” point in that first one has to prefer austerity over increased spending. Then, once austerity is accepted, one has to make a choice between increasing taxes (keeping public spending as-is) or reduced public spending. That is the key. Well worth reading to defend against the nay-sayers.

Of Guns and Data

I compare two phenomena that are unrelated: the US and their guns and the Europeans and their data.

See Digital privacy rights require data ownership and Mark Zuckerberg apology: ‘I’m really sorry that this happened’.

The mass shootings in America are terribly sad.  The US is wracked with grief periodically and at the same time an inability to address the primary cause – guns are part of the way things are in this country; and access to them remains an big issue.  Guns are accepted, even respected, and are encoded into the country’s psyche via the Second Amendment.

At the same time many Europeans and others can’t understand the logic.  Many other counties have banned many kinds of firearms in their wider populations and such counties suffer far fewer mass shootings.  As such, those folks can’t get their heads around the argument for protection of the second amendment.  It is like two speakers in front of each other and neither understanding the other.  I have stood on both sides and seen the gap.

While in London, UK, this week I watched the frenzied coverage in the media about the Facebook data exploitation by Cambridge Analytica.  It seems, if one understands the story, that a vendor or app explored a loophole that came about due to a lapse in forward thinking by Facebook some time ago.  It seems the gaps have since closed, but the data trove had already been taken.

In Europe GDPR is big news: some recent surveys by Gartner showed that spending on governance related data and analytics initiatives have increased significantly in the last two years in the UK (as the example), far in excess of US spending habits.  The European media is incensed at the lazy attitude of American firms: how could they have allowed such a use of data without citizen consent?  The media is painting the US as Luddite-like for not realizing the obvious and for not reacting earlier to protect consumer data.  The US, at the current time, is reacting but more so in terms of the Facebook stock price rather than in media incredulity.

Even though there is no connection between guns and data, the intensity of the emotional response on both sides of the pond to each issue is palpable and an almost mirror image.  I have sat on both sides in each case and it is fascinating to observe.

One wonders if the US will ever adopt its own GDPR-like rules.  Harmonizing with the EU would be a logical and likely beneficial step, at some point.  Simplicity of equivalent rules would make business and IT costs bearable.  Should the US respond with different rules over time, costs will likley escalate as rules start to overlap and conflict.  But there are no signs the US – at a federal level – will seek anything like GDPR.  I just wonder if some enterprising, populist politician won’t pose a stalking horse.  I guess someone will, and of course it won’t survey engagement with reality.  But it might presage the first of many such attempts to test the popular perception.  Over the long haul, will the popular feeling converge with those of Europe?

As to the second amendment; I don’t think anything will change on that front for a long time.  It is a political argument – one steeped in a time long past when citizenry needed to arm itself from rampant enemies in the forests, and the possibility of a corrupt government.  Since democracy seems to be alive and very well, I am surprised that the Second Amendment has survived as long as it has.  But what do I know?

What Will Go Wrong in 2018?

James Mackintosh of the Wall Street Journal posts in today’s US print edition on “The 3 Things That Can Go Awry in 2018“. The article details three dynamics that, if played out as he suggests, could cause the global economy to trip in 2018. His summaries are good and compelling and, given our amazingly positive outlook today as 2017 comes to a close with all major nations growing at roughly the same time (an odd occurrence in its own right), they come at a good time to consider conservative actions against possible shifts next year.

The three are:

  1. Monetary Tightening. The story here looks at Fed and central bank interest rate hikes. We all know that interest rate raises have started, at least in the UK and US, even though the EU remains firmly stuck taking that drug. Japan is taking it slow, even as its economy shows much signs of improved life – Japan will have to continue pushing rates up in 2018, just as the EU will have to follow the US’s lead. The problem with this item is that there are us a lot of debt out there – corporate debt, public debt and yes, some consumer debt. It is not the same kind of debt that was part of the run-up to the crash that put us where we are today, but for some firms and some governments its big risky debt. As an example, and tangentially related, another article in the WSJ reports on a few firms that are high in debt that will be financial impacted by Trump’s tax reform – see Tax Plan Downside for Dell, Others in Debt. A lot firms have issues debt in the last few years in response to QE and near zero interest rates. As rates increase, debt load and repayments will increase. If inflation were to join the party, it could be a messy time for a number of firms and governments.
  2. China. This story has been used before since China has been the source of two recent periods where the US stock market (in fact the global stock market) fell by about 10%. As such, China’s management of its economy – shifting from a producer-based to consumer-based economy – is a major challenge. Debt remains a problem, and capital controls and currency exchange rates just add more menu items for Chinese leadership to wrestle with. Should China sneeze, so the saying goes, we would all fall could of a cold or something worse. Worse, there is no coordination between east and west – so we are somewhat at the behest of the Fed and People’s Bank of China – and we all hope they do the right thing. Of course, they will both do the right thing for their own constituents – or try to. Hence the lack of cooperation.
  3. A Correlation Correction. This for me is the more interesting and most likely issue to blow up in 2018, and it is the least talked about in the press since it is not as well understood. Mr. Mackintosh states, “one reason investors hold bonds is to cushion losses in a stock-market downturn.” This approach has worked for quite a while, as prices have diverged short-term all the while converging over the long-term. The risk is that should inflation appear in 2018 the relationship between stocks and bonds may revert to how it was in the 1980s and early 1990s, with rising bond yields being bad for share prices. The problem for me is that I think inflation will rise in 2018 to just levels that this will be the catalyst for change in the markers. If you read the tea leaves, there is ample evidence of a change underway. Many commodity prices are doing very well. Copper prices are, as an example, reportedly at recent high’s due to increased production. If you look at producer prices in the US, they are inching up now over 3%. Even though wage pressures remain subdued, the pressure is building. Though participating rates for males in the US aged 25-54 are at near all-time lows, yes the employment rates seems low and may go lower, but there remains some slack to take up the growth we will see. But that pressure is there. I think that by the second half of the year, certainly by Q3, US inflation forecasts will show that 3.5-4% are on the horizon. This won’t cause a panic, but it will lead the change and correction that will come. On top of this the author suggests that the Fed may just “give in” to the needs to cap the bloated asset prices we see all around us, to nip the bubble before it becomes unsustainable. Trump’s tax deal will push this peak out a year or two, but the dynamics are in play.

Reading between the lines you can see that all three of the authors ideas overlap and intersect. Inflation is mentioned directly in 2 of the 3; growth is everywhere; public policy too. As such he has hedged his bets and tried to call out the category of challenge. I will try to break the triggers into more simplistic sections.

As such, I give the following percentage probability for each driving a correction by the end of 2018:

  1. Monetary Tightening, most likely US led, due to over heating: 15%
  2. China growth, debt to currency issues: 28%
  3. EU or euro-zone debt or banking crisis: 15%
  4. Inflation-driven policy changes: 22%
  5. Japan public debt or growth challenges: 10%
  6. Emerging Market currency or debt issues: 5% (this one won’t trigger in isolation but might follow from one of the others, namely 1, causing a currency drain)
  7. Significant War triggering financial panic: 5%

Trouble for The Eurozone with Trump’s Tax Deal

There was an excellent Opinion piece in today’s Wall Street Journal that calls out the less thought through implications of Trump’s domestic tax deal on international business. The piece, US Tax Reform Has Europe Worried, by Joseph C Sternberg, explores the writings of a German research group that details some thinking suggests some organizations will think twice about new investments in Europe – specifically Germany – with the new US corporate tax rates being leveled. The research piece is from ZEW and is here: Germany loses out in US Tax Reform. This is another dimension not modeled by US economists when they try to determine the impact of the tax reform on US growth.

The more important point however in Mr. Sternberg’s piece comes toward the end of his excellent article. The author suggests that US tax reform highlights a different opinion for taxation from an ideological perspective. This point needs to be talked about more since we have lost our Mojo for ideology in favor of a left-right populist dichotomy. The US reform is being used to alter tax incentives to drive growth, investment and job creation. Most of Europe, with is more socialist (and Democratic-leaning) policies, uses tax incentives mostly as a redistributive process for sharing an assumed pie. There is much less effort in driving growth or influencing investment to grow jobs. This is the dialog we had in the 1980s and it leads to the dialog about big government versus small government.

It is about time ideology got a fair crack again!

The Republican Tax Plan – Is it a Tax Cut Too Far?

I noted recently that economist cannot agree on the good, bad or ugliness of the medium to long term impact of near-zero interest rates or quantitive easing (QE). This suggests that economics is in a sad state of affairs. Even the Republican tax deal, winding its way through reconciliation this week, continues to create fervent grounds for disagreement. The most important sticking point concerns the rate of growth the tax changes might lead to. This is critical since it is the resulting change in GDP what will spin off excess profits and therefore taxes that will go to pay for the tax breaks. If GDP does not grow fast enough, insufficient funds will be created. If GDP excels, al will be well and the Democrats won’t be happy since they may lose the next general election.

In the Wall Street Journal on December 2-3 there was an interesting opinion piece by Phil Gramm and Michal Colon titled, Don’t Be Fooled by Secular Stagnation. Mr. Gramm is former chairman of the senate banking committee and now with the American Enterprise Institute. Mr Solon works for US Policy Metrics. The article compares America’s GDP averages over recent history and the assumptions that the Republicans are making with their forecasts. The two are not that far apart at all, yet other reports from different perspectives, using different assumptions, suggest growth will not reach its goals. The COB suggests growth might make 1.9% over 10 years; the Republican’s are looking for 2.6%. It turns out that since the end of WWII to 2008, America has averaged about 3.4% and this includes 10 recessions!

Then, when you get under the hood of the various models economist use you find the strangest of assumptions. The CBO’s model does not allow for any spin off of profits generated from growth to be plowed back into the economy to drive more growth. This the model is quite limited. Why don’t our economists or civil servants update their modes? Because it would be more political than economic. The CBO, as the article suggests, has been worn more times than it has been right with its GDP forecasts in the last 20 years. We might as well just ignore them and set up a new government department. At least that adds to employment which I am sure is irrefutable.