Gabriel’s scarcity rent - it’s management stupid!

Following with the article Financial weapons of mass destruction unleashed in the US (the party is over) that I recently wrote, it seems like the liquidity storm is enjoying some calm. Not a bad thing when liquidity is the tip of the solvency iceberg, and when investors need a break in the increasingly bearish market.

Yes, it all began with an excess of funds that permitted spending in excess. And from that excess, excessive and ultra sophisticated imaginative investing products were made. The trouble is that they were so complicated that the risk wasn’t understood enough, or simply ignored. Now the risk has resurfaced again and debt ratings are on its way down.

In that scenario we had several options: to cut the excessive spending or to find new lenders. Looks like we’ve encountered some new ones.

The first are the public lenders, also known as monetary authorities. By increasing the monetary mass, and providing low-term credit to low rates, we have financed ourselves. Not a bad thing to do if we were a socialist economy, which we are not. But time will say if we have many other options. I fear we don’t.

Wait, there’s still another option. The ones that actually created the liquidity bubble are coming to our rescue. After all they are the ones benefiting from selling 100$ barrels of dark oil. And now they can come to rescue our banks, our real state using sovereign funds. Suspiciously these new lenders remind me a lot of the old ones…

Both refuel the shrinking bubble in the hope of inflating it again, but in the meantime the true inflation is rising and growth going down the slope. Either we finance ourselves or we trust in opaque investment artefacts coming from non-democratic countries.

But this time, if we are being refinanced, it will be either at higher rates or lower prices, there’s no way to ignore the risk.  Are we really aware of the costs of refinancing? Are we facing the real issue here? Reality tends to be stubborn.

It supposedly began with a bubble. Just another bubble like the one I described on The South Sea Company (or how Sir Isaac Newton spurned the dismal science). The bubble was fuelled by an excess of liquidity. It had to end someday. We learned the word subprimes. We knew it had to mean trouble.

Liquidity injections were administered and succeeded. But they were just patches for a bigger problem. And then they asymmetrised the risk: there were institutions willing to provide liquidity when needed, to reward higher risks, to stimulate the economy further up and away from reality. Until the moral hazard was too huge.

And then it ended too abruptly. The wells of money simply drained and, those whose business was to ensure the efficient distribution of liquidity between the different players just became inefficient. From excess to world wide scarcity, even for sound projects. It became a financial crises.

Few crises have been so focused on the financial system like this one. Because that’s what’s really in trouble here, the whole financial system. I began in the UK with Northern Rock, now nationalised thanks to Alistair Darling. In the meantime Daniel Bouton from Societe Generale didn’t know what was happening in his bank until he lost more than his reputation. And the Swiss face value is also in an all-time-low: just take a look at UBS and Credit Suisse (also First Boston).

But where really is too darn hot is in the US. Bearn Sterns is in flames, expiring his final breath. Bought by $270 million, it was valued about $20.000 million one year ago. A 85-year-old Wall Street institution simply died.

And those that bought companies using leveraging, namely private equity, now see the liabilities piling on top of the roof. Take a look at Blackstone: their profit for the last quarter was less than a half of what was expected, and dropping. Of course its value is dropping too.

We gave it complete freedom. They took it. They invested again and again in the same risky assets, albeit chopped and transformed so they didn’t look like they were the same: collateralised debt, mortgage insurances, mortgage reinsurances, credit swaps and all kinds of derivatives that were the same dog, different collar.

And when the system was in trouble: more liquidity. Await for some more in the next days. New bolts and flashes from the Fed to try to contain it all. But no regulations… in any case it would be too late for that. And always paying a huge price in inflation… until that game is not longer possible.
The dollar’s dropping. The safe heaven for savings all over the world that financed the US debt has ended. If you add up the soaring energy prices, and the huge public deficits, the US credibility is under minimum. The country risk is dangerously rising… no more overspending, no more cheap financing, the party is over.

One of the great aportations of Schumpeter was his approach to the Economy from different points of view, not just from a mathematical, technical or mechanical one, but from the diverse social sciences: human history, sociology, anthropology and even psychology.

I love his concept of the business cycles. They are based on the creative destruction idea. That’s the process that the entrepreneur leads, supported by innovation, to destroy the old way processes were run and substitutes them for new ones. Destruction and creation both at the same time. That means a whole cycle: birth and death. That was in 1911.

But Schumpeter wasn’t the only one talking about cycles. Kitchin also did, in1923, from Harvard. His cycles were bigger than the already well known seasonal cycles, lasting for approximately four years. They were to be known as stocking/destocking cycles.

The legend says that Rothschild had already discovered the cycles before, on Wall Street, around the beginning of the XXth Century. But, instead of making his name famous, decided to use them to fill his pockets. A group of investors followed and, with the help of mathematicians, they found a 41-month investing stock cycle in 1912. If they became rich, they didn’t become rich enough: as of today we don’t know their names. And the cycles are still named after Kitchin (slimmed down to 40 months).

Later, new longer cycles were supposedly discovered: Juglar cycles, around 9-10 years and Kuznets cycles, around 15-20 years…

And there are also Kondratiev waves, around 48-60 years, and the most disputed of them all. There are supposedly a few Kondratiev cycles identified: The Industrial Revolution (1787-1842), The Bourgeois Kondratiev (1843-1897), The Neo-Mercantilist Kondratiev (1898-1950?) and the The Fourth Kondratiev (1950?- 2010?). The numbers with interrogation marks are of course just approximations written long ago. Could we be close to the end of the Fourth Kondratiev? In any case the projections didn’t know anything about subprimes, wars or energy prices. And Nikolai Kondratiev was a Soviet economist (not that the fact discredits him but he was kind of eager to prove that Western capitalist economies were susceptible to high performance volatility opposed to planned ones).

But, even not having any cycle under his name (an injustice from my point of view) it was Schumpeter who already identified and described the four phases of every cycle: boom- recession-depression-recovery. It’s the existence of the four phases that converts a fluctuation into a cycle. A stubborn aspect of reality that tends to repeat itself (not only in Economy though). This page of the National Bureau of Economic Research about Business Cycle Expansions and Contractions is interesting enough.

Yet again cycles catch so many off-guard. It’s interesting to see…

Coming from strategos, the greek word for general or commander, this is one of the most used -and missused- words all around. People use the world strategy to make their position more sexy, combining it with words like direction, information, product, customer or even online, web 2.0 and blog. Always followed by strategy. That way you can give your card proudly.

In this card you can also read the strategy!!!

The Chinese had their say with Sun-Tzu, that was the first strategy writer ever to be known. He was so good that his book, The Art of War, is still widely read today. His ideas are about winning the battle before the battle is even fought. For that you need to convince your enemy that you’re strong in places you are not, and hide your strongest points, so that he is moved to a position of weakness. In this position of weakness you can overcome a stronger enemy.

And then, when the battle is fought, we move from strategic to tactics. That means we associate the strategy concept with planning, and tactics are closely related to execution. Long run against the short run.

Another point of view, strategy sees the big picture, the systemic view. (See the Why systems thinking? post). Tactics seek to optimise locally, in execution, right now. Tactics are operational. Think about allocating resources, doing the most of what you scarcely have. Some things that come naturally, decisions you just have to make.

While strategy is not obvious at all. It’s necessary to forget your day-to-day, step back, try to see it all, reflect, interiorise, learn, generate new ideas, evaluate them, multicriterise them, plan.

I’m not going to focus on Ansoff (or Porter afterwards) that are always referred as father (and nourisher) of strategy. Tracing the roots of economic thought, we can find someone in the 19th century that was already grasping the idea. It was Germany and later in the US, and this man is an economist: Friedrich List. He didn’t live long. After a fortune reversal in America, he committed suicide in 1846.

List defended the idea of national economics, an important rule for the state in the economy. He proposed high tariffs on imported goods to protect the local industries, that is protectionism, plus the government implication building infrastructures and the need for a national central bank. Do those ideas sound familiar to you? In fact, with Alexander Hamilton, he cofounded the American School of Economics that is still alive today, only to be confronted by Keynesianism in the mid-twentieth century.

But the funny thing is that he also had a big influence on the other side. He was offered the editor post of a new liberal newspaper in Cologne, Rheinische Zeitung, that he didn’t accept for health reasons. Guess who accepted? Karl Marx.

Why is that important? List saw the need to plan by the state. There could be no nation letting individuals seek their own interest when that interest could harm colective interests. Freedom meant suicide for nations. There was a need to plan and decide thinking of the big picture: the state.

When Ansoff wrote about strategy in the mid-1960s, those ideas were heavily assumed by society. Democratic countries also needed central planning. Even companies did. Igor Ansoff, an American professor of Russian origin was the one to collect the imputs of those diverging currents and wrote the first book on strategy planning. Engineer and mathematician, overly analytical, he defined strategic decisions as those that would not generate themselves, opposed to operational and administrative decisions.

Yes, interest rates are soaring. The ECB raised rates two days ago 25 basic points to 4% as expected. That was the highest rate in six years. You know how I like using images, here is the picture of the last year:

Why has the ECB risen the rates again? Fear of inflation as usual. Europe has been growing faster than the US and that means that industries will approach production peaks and probably companies will face more pressure to drive salaries up. But only probably, because that hasn’t happened yet. The European Central Bank bets to put pressure down even before it’s needed. Or is it?

We’ve seen so much liquidity lately, so many money. The quantity of money has been growing steady, more than ever. You can see it in this graph I made with data from the US Federal Reserve, 1959 to 2006:

M2 and M3 are common metrics or measures for money. While M2 represents physical currency, bank reserves, current accounts, saving accounts and small deposits, that is the money that is available to domestic economies, M3 also includes bigger certificates of deposits (above $100,000), Eurodollars and repos.

You might ask, where has that liquidity gone? That’s why I chose to draw the red curve: M3 without M2, that is the money that is not in the hands of domestic economies. As you can see it has been growing at a hectic pace. This is the money that has been refuelling the economy, making stocks soar, gone into funds, hedge funds, private equity or debt.

So maybe, after all, central banks were not thinking of us when raising taxes, but in those huge quantities of money that are not in the hands of domestic economies.

And with money being more expensive, we’ll probably see trouble in junk bonds, too-risky capital and excessive leverages, subprime mortgages, the riskiest places where the bulk of the money has gone to.

Rising taxes mean that the most vulnerable parts of the economy may suffer. We’ll see the definitive end of many bubbles, maybe mortgages, junk bonds, overpriced shares or excessive debt can be the match that lightens the next crisis. And that can mean trouble for our pockets too.

One thing for sure: rates will keep soaring, I have no doubt. One way to know what the market thinks about it is using the Euro Interbank Offered Rate, Euribor. If you follow that link you can get the daily Euribor rates in a range from one week to twelve months, that is the rates that first class Euro banks offer each other. Euribor is representative enough of the Euro money market.

The red curve was in January, the blue curve is now. So far the market has been predicting well the increases for the last six months. The arrow marks the value for borrowing Euros for six months six months ago and compares it to the actual value. As you can see, it’s rather close to the current value.

Well, in fact it’s higher because there is a smoothing effect: when you are paying to borrow for six months you are paying higher (or lower) for the last months, but closer to the current rate for the first months, so you get an average of both.

So, looking at the blue curve, the market predicts additional increases for the next months. And the slope is even steeper slope, that means no sign of stopping to be seen in the next year. The rates will keep rising on the long run.

It’s been ten years from the last monetary crisis. Maybe the next one is getting closer. That would have central banks change their mind about rates.

As you probably know, private equity firms are hot. And as they get more and more funds (remember how the Chinese government decided to invest in Blackstone) they become even more desirable.

KKR used to be the Holy Grail of private equity. KKR stands for Kohlberg, Kravis & Roberts and was founded in 1976 by Jerome Kohlberg, Henry Kravis and George Roberts. KKR specialised in leveraged buyouts and starred with the buy of RJR Nabisco in 1988 for $31.4 billion. There’s a must-read book about this buyout: Barbarians at the gate, by Bryan Burrough and John Helyar. And a movie too.

Blackstone has broken that record this year- yes 2007- and gone from princess to queen, but that’s a story for another day.

You could say that they used junk bonds to buy underperforming companies, reworked their balance sheets, and sold them for profit, maybe as a whole, maybe not.

But who where those entrepreneurs that decided to create KKR? Where are they now?

The first, Jerome Kohlberg, was born in 1926. Unsurprisingly, he was working with Roberts and Kravis in Bear Stearns, worldwide investment banking and securities trading and brokerage firm. He left KKR in 1987 –that is one year before the Nabisco takeover- but he didn’t retire until 1994 when he created the Kohlberg Foundation. His wife has a restaurant, the Flying Pig, in Mount Kisco, NY. His fortune is approximately $1.2 billion.

Henry Kravis was born in 1944. Economist and Columbia MBA, in KKR he was the key to developing the LBO, leveraged buyout, concept, acquiring corporations they thought were under their potential, putting 10% of the price and financing the rest through junk bonds. (At that moment the concept of junk bond was still undefined, they were just high-yield bonds). The concept included selling whatever assets that could be valuable and leaning the company to a maximum before selling again with huge profits. He directed the Nabisco takeover after Kohlberg’s parting, creating the legend for KKR. He also participated in buying huge brands like HCA Inc., Texaco, Gillette, Playtex, Beatrice, Safeway, Borden and Samsonite. He is a prominent Republican and a strong supporter of G. W. Bush. (What a coincidence: Nabisco also began donating great amounts to the Republicans after the takeover) His fortune is approximately $1.5 billion.

George Roberts was born in 1945. Cousin of Henry Kravis, Law Graduate. Mentored too by Jerome Kohlberg in Bear Sterns, he cofounded KKR, participated in the Nabisco takeover –he is one of the main characters of Barbarians at the gate- until he exited in 1987. He’s been active ever since, participating in the Toys’r'us takeover by $6.6 billion with Bain Capital this year and SunGard Data Systems for $10.6 billion with Blackstone. His fortune is approximately $2.5 billion.

Well, he is the richest of all three so maybe he has something to tell. This text is from his acceptance speech at the 1998 Man of the Year’s award from the Culver Military Academy:

“I’m often asked by people, especially younger people, what do you have to do to be successful. And I assume they’re asking not what you have to do to make money, but what do you have to do to be a successful individual. Coming out here, I jotted down several examples that I’d like to share with you.

“You’ve got to work hard at whatever you do. So if you’re going to work hard and put everything you have into what you’re doing, you better find a job and a career that you love to do, because if you don’t you have no chance.

“Set your goals. Set goals that are unrealistic in some cases. Be prepared to be disappointed. One of the goals I set for myself when I came to Culver was to get into Yale. I got turned down. One of the goals I set for myself when I graduated from CMC was to get into either Stanford Law School or Stanford Business School. I got turned down. Set your goals high; reach, that way you improve our muscle tone. Don’t be afraid to fail. Our society won’t penalize you if you fail honorably, and by that I mean with integrity and honesty. Everyone who has done anything in life has failed at something. And there will be nobody in this room who is any different.

“Keep a sense of humor, that’s probably the most important thing. Be prepared to laugh at yourself a little bit, your mistakes. And when things really get tight and tense and everything else, laugh a little bit.

“Keep a perspective of what’s really important. For me, that’s been my health, the health of my family, and those intangible things that don’t involve material objects.

“Raise a family, because that’s the only way you’re going to learn to love somebody or some group more than yourself.

“Rely on yourself with both your brain and your heart. Don’t blame others for the mistakes that happen. Learn from them yourself and go on.

“And lastly, help others that are less strong and less fortunate than yourself, because you will get back many, many, many fold what you have done for yourself.”

As I wrote yesterday, ideologies and ideals do matter. And they define too the way we think and the way we use reasoning. So, if there are different ways to define justice, and each one of these ways means different ways of thinking and reasoning, each one of us might even end up with different economic conclusions. And that means trouble for Economy as a science.

How can we know if the things taught at business schools are true? Some used to be true, from a classical point of view, like Say’s Law: there can be no supply without demand.

Then keynesianism sent them back to the closet: supply creates its own demand. And the economy will keep growing until full use of resources: full employment.

Until 1929, something went wrong and that didn’t happen. Keynes himself realised. (I’ll write another day about liquidity traps and monetary policy)

But one of the essential instruments of keynesianism was the Phillips curve, remember it? More trouble.

The Phillips curve revealed: let’s reduce unemployment just changing prices!

It relates unenployment and inflation. It used to be said that raising inflation then the actual value of salaries go down and unemployment goes up because you have a cheaper workforce. (As a curiosity Samuelson and Solow were the ones to grasp the concept, not Phillips who had only collected data, and there was another previous economist: Fisher, who had understood the concept first)

Another of the advances of economy in post second world war, along with the IS-LM model of John Hicks, that of course is taken for granted in schools and its the foundation of what we call Macroeconomy.

Seen it before? The IS-LM model

But, although they didn’t know it, the Phillips curve was born already dead.

Milton Friedman and Edmund Phelps realised that the fact that people knew about the Phillips curve rendered it unusable.

Why? If prices were expected to change, salaries would change accordingly. We change our wages taking into account the yearly change of prices. (At least that’s what my contract says)

The death of the Phillips curve gave birth to the theory of expectations: there is a natural rate of unenployment and you can have some effect on the short run, but not on the long term because *people do know what you’re trying to do*.

Monetary policy (remember my blog about Euro exchange rates?) or fiscal policy? The war had begun and it’s still not over.

It is Robert Lucas who said that people’s behaviours change in response to government policies. (In other words, we citizens are sort of numb, but not too dumb.) And the Lucas critique says that you cannot make political decisions solely based on series of historical data, because when you change the rules things won’t happen the same way.

And back to the beginning, how many sciences do you know whose rules can be changed by politicians?

Following the previous thread about lag, devaluations and j-curves now there is a real case of politicians versus economists. In this case France’s brand new president: Sarkozy and the European Central Bank (ECB).

I don’t want to appear one-sided with this guy. There are many likeable things in him, but there’s something bonapartist about him (yes, Napoleon Bonaparte was one of the predecessors of populism, IMHO). Even Angela Merkel, the gal that has raised the German’s economy and self-esteem, is a bit anxious about him.

different leaders, different perceptions

Sarkozy has decided to erode the ECB’s independence. In fact that’s a long tradition in French politics and Sego wouldn’t have done otherwise. I’m not the one to say that ECB’s decisions, taken by some economists inside that fortress, cannot be improved. (Wish I knew better than them) But i can see something inherently good from having economists insulated from politics.

Sarkozy is a clear opposer of a strong Euro. In his campaign he claimed he’d pressure ECB to force a devaluation and blamed the current exchange rate of all evils. It’s getting boring to hear that Brussels is blamed for everything local politicians don’t want to assume.

It’s true that the Euro is expensive and that hurts exports, but it is also true that means cheap energy, which Europe is highly dependent on. If the high exchange rate was a problem, it’d be only part of it.

Exports have been bad for France, but not that bad for Germany which is back in the road to growth (one million jobs created in the last year and a new exportation record), and they share the same exchange rate. Maybe there’s something related to a strong participation of the state in the economy, an inflated welfare state that makes for a nice way of living but leaves a huge bill to pay, or simply resistance to change, a very well known fright to loose a higly secured way of life that is not compatible with much needed reforms. (3 hour week, low spending in research and development, low inflation control…)

Don’t forget that most of exports and imports of the Euro zone are between member countries. And those interchanges are not affected by exchange rates. And many of the other countries, such as Spain (wish we had the strength of the French economy), have made steep reforms and changes, opening the economy, growing strongly (of course with a lot of structural problems but nonetheless strong growth), and reducing unemployment. Euro devaluations won’t help the French compete with the Germans or stop the relocation of industries that move to Eastern Europe seeking lower wages.

But it’s not only a exchange rate problem: there’s a new European scepticism there, similar to that experienced by Britons, but this time french-flavoured: “faire plier le BCE” (make it bend). Something about French self-economic determination and distrust of an Euro that is not maleable to political interests. (and remember: the loss of independence and thus credibility of the ECB would come with a cost too)

Trichet says: do not mess with the ECB

It’s funny that happens while the ECB’s president is a frenchman: Jean Claude Trichet.

I promise not to bother you much with my “lag” thoughts, although I can’t help writing some more about it.

Another common situation is a devaluation. Usually when a country devaluates its currency it does so thinking about competitivity. That means it will be able to sell more and improve its trade balance.

But, it is really going to improve? Well, in the short run it’s going to have to pay more for its imports, and its exports are going to be just the same. So, while improvements still lie ahead, the short run means more trouble.

That’s what the students of international economics know as the J-curve. I’ve modelised the curve from a Poisson distribution (the inmediate effect) plus a step function (the long run) and it looks like this:

So, if politicians decide a devaluation in their second term, situation will worsen enough not to show any benefit before their reelection campaign. That means trouble: lag matters. And that means that some countries are more able to use this kind of resources than others: the ones whose rulers don’t have to face reelection.

But I bet reality won’t be so simple. Other countries are able to react and will, in time, adjust their currencies to match. That means that, on the long run, the changes will be minimal, if any. I’ve tried to modelise that too with two Poisson distributions of different parameters:

That means that there will be a net gain based on the first-mover strategy: in the example chosen the area that is below the axis is smaller than the area above (exactly one half), but there will be no yearly gain on the long run.

Going back to the point, this is a dynamic model. Things don’t happen the same day, time matters and there are several effects counteracting each other. The order matters cos there is not advantage on the long run but just gains.

And every decision will have its consequences that, in time, will mix with more decisions. If we observe economic reality we may not be able to see the consequences of just one action but a continuous mix of different decisions of several participants.

Let’s go back to our politician. He lost his reelection to his rival that decided to do the opposite and restore the previous exchange rate. Now we imagine that the same ripple effect happens the other way round and the economic system just responds the same (opposite) way:

Look from terms 4 to 8. A new boom? Did the new politician save the country? Who will be elected in next election due for year 8? What will happen in the long run? Funny how lag matters.

I’ve been studying dynamic econometric models. Yes, that sounds scary. But that lead me to a deeper degree of understanding about economic reality (understanding the first and second derivatives, that is).

Let me explain. A dynamic econometric model is a model that, to predict a dependent value, takes into account the values of past periods of time.

Why is that interesting? Well, when you are meddling with economics you find several cases:

• In the macroeconomics IS/LM model where yields are related to consumption, investment and government spending, there is a multiplier between those values, that means that, for example, with increased government spending this money will spread into the system, to consumers, to investment and ultimately to a yield increase. There will be a multiplier because of the recursive interchange of money. Even though that can mean less investment by substitution effect, the long run will be better. That’s why government deficit can help overcome recessions.
• Or when you pour more money into the system (if you are a central bank, that’s for sure) then a part of this money will go into bank accounts, a part again into lenders, and another part into reserves. But the global quantity will be higher than what you have poured into the system. Another multiplier.

But these processes have two things in common. First of all, they share the fact that the initial change is increased in effect by a multiplier, so there is some kind of amplification. And they also share the fact that these increased effects do not happen instantly but by realimentation: there’s an initial increase that is a new input to a second increase, and the process goes on an on.

The process converges, that means that there’s a point of equilibrium which it goes closer to. And it is not a short run process, but takes time to see the change.

So when we are writing the equations of those processes we are assuming that everything happens instantaneously. And that’s untrue. As we care about economic magnitudes not only on a yearly basis but for shorter periods of time, we should devise more accurate ways to describe reality.

As an engineer I can also see it from another point of view. Recursive digital filters are used in digital signal processing. Given a response there are ways to find which way the filter must be. There you have tools like the z transform. In fact you can emulate all kinds of analogic filters just with the right digital signal processing device.

That will sound strange and far-fetched for most economists but, believe me, both techniques have a lot of things in common.