Posts filed under ‘Macroeconomy’
Thinking strategic (from organisations to the economy)
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.
Rates keep raising: is this the end of cheap money?
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.
Kohlberg, Kravis & Roberts, the three men behind private equity’s star KKR
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.”
Is Economy as a science solid enough to define what’s true and what’s not?
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?
Ex-post lag III: is the Euro too strong? Sarkozy says so.
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.
Playing with lag II: devaluations, exports and politicians
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.
Lag in economics I: changes… but not so fast
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.
In praise of Schumpeter
I’ve just reviewed the last issue of “The Economist”. It includes article about Schumpeter, a new biography, “Prophet of Innovation: Joseph Schumpeter and Creative Destruction”.
The article falls short of calling Schumpeter the ultimate prophet of capitalism. It talks about his creative destruction theory, that states that capitalism reinvents itself through destructive cycles that end up in a new beginning. Of course that means putting the weight of reconstruction on entrepreneur’s shoulders. It’s one of the most cellebrated and lucid visions of capitalism.
When Schumpeter wrote it he already knew the work of Clement Juglar who, in 1860, described three phases in every cycle: prosperity, crisis and liquidation. Schumpeter believed that entrepreneurs began the cycle of prosperity accumulating productive factors in an era of scarcity, thus paying well, and expanding productive capacity to its maximmum extent. Then there would come a time with production surpluses, which also meant that means of production wouldn’t be needed so badly, and that lead to prices going down and consumers having less purchasing power. If you add that by that time entrepreneurs would have paid most of their loans, there would be cheap money all over the system, so there would be a triple surplus, and the economy would crumble.
Of course Schumpeter explained all that in other words, but what he wrote is still valid today. The cycles were thoroughly studied and Kitchin defined the inventory cycles (40 months), Kuznets the infraestructure cycles (18 years) and Kondratev (or Kondratieff, I’m never able to know the best way to write his name) the 50-year waves. If you add them to Juglar 10-year cycles, later redefined as 8-year cycles, to hog cycles (three to four years), cotton cycles (two years), beef (five years in the Netherlands) and leather (18-month cycle)… you have as many cycles as you want to be able to prove anything (or just the opposite).
But, as the article very well says, the turbulences (that would be caused when most of the cycles were simoultaneusly in lows) would be just a small place to pay for progress. Voilà. That’s one of the reason why Schumpeter was a great economist, and still is today. And I agree.
What I don’t agree is on the fact that Schumpeter still is a great economist because of his conclusions. I think he was great because of his methodology, using sociology, psychology, statistics added to the dismal science trying to build an unified social science. So the economy would be related to everything else, such as the entrepreneurs that make this society advance.
Conclusions are not that important, IMHO. The article fails to remember how Schumpeter predicted that capitalism would collapse by itself and great corporations would take the power and lead us to the ultimate socialist state. The success would lead to absolute control.
I hope that he wasn’t that right on that too. Or maybe he is already right?
House bubble… again. Time to burst already?
If you are one of the few people that read me (thank-you by the way) you’ll probably remember the post I wrote about the Spanish house bubble about to burst. Well, there are signs that its bursting is closer now.
In fact many European countries now fear that this burst could be contagious. Probably it will be.
Did I tell you about a constructor, Fernando Martin, and how he was paying above risk-free interest rates four times than what an American constructor would? Well, the markets are going down for real estate companies, and their shares are losing ground. Looks like there’s something changing, moving down.
For a country like Spain that has grown a lot based on house building, this is a big problem.
Many of these companies have been buying around: utilities, construction, airports. Many have just bought each other. Some with their own shares, but when that wasn’t enough, with fresh cash.
Where do you get fresh cash from when you need it? Well, institutional investors, banks… there are many ways. If you can do a leveraged buy out, or just go into debt, do it. Why would you pay with your own money when you can borrow at low rates and achieve higher returns? Sounds silly.
But there comes a time when you have to repay. And no gain comes without risk. Right now the prices may go down, but debt will stay the same. That means that companies will still need to sell at the same pace. Pressure to sell means pressuring the prices down.
But now there’s a wider gap between offer and demand, a gap still getting wider. Now it won’t be so easy to repay debt. The weak are in peril, with value going down and risk going up. That means trouble.
Astroc going up, up, up… and now down
Real state companies owe 250 billion € to the Spanish financial system. That is one fourth of the gross national product. The risk naturally spreads into banks. And they also had the risk of lending to subprime consumers, remember? Add both risks and the situation, naturally, gets more risky. Add the correlation between them and then it gets even more risky.
Nothing radical has changed from some days ago. Only investors mindsets. But investors are like that: either they hate you or they love you, sometimes enthusiastic, sometimes they just panic. No inbetweens.
But what do we need to see prices fall? Just a price-falling mindset. It’s all in our minds.
Do not panic yet. If real state companies have trouble to repay the banks still have the guarantees. They can still sell them. But in most cases the guarantees are their own plunging shares. They may be worth less than they owe, they can’t even be sold without pressuring prices down more. Ooopss.
(Fortunately, there’s more to Spain than the real state sector, and the Spanish financial sector is very strong. Moody’s still keeps our AAA… for now.)
Housing bubble: almost bursting… but not yet
Does anyone still don’t know about the housing bubble? Well, looks it has not bursted yet… but some signs are worringly clear that it will soon.
First of all: there is a bubble. Look at the rise of the prices for the last eight years: (source Mortgage Bankers Association)
The US are a good example. Prices have soared and house equity has been a great business. Well, as always, its a good business if you sell higher than you bought. And that means selling and buying, not just keeping or using.
So it might be possible that homeowners are all rich now. Or maybe they are not so rich as they owe a lot of money, and their home equity is leveraged. But any way: they have been feeling rich.
Worringly, interest rates have soared too. And they keep rising. And the prices have been so high and the gap between sellers and buyers been so wide that price rises have stopped. In some places even decreased.
It’s not that the bubble has bursted. In fact most price decreases are not in the most inflated areas, but just caused by the old and classic reasons: in places where economy is not buoyant, unemployment has rised, and not enough cash is flowing to worker’s pockets.
This graphic from Standard & Poor’s illustrates the end of the cycle. The green line are the price increases, the orange one the number of housing starts:
As you can see we are back to zero. Everything is possible from here. Even the vicious circle.
For instance: think about subprime mortgages. They have been given to people that have a larger risk of default. But they have been given extensively (20%). More buyers were needed to close the gap between offer and demand. Interest rates were very low, and defaults in their historic minimum. Economy was still flourishing and growing.
But now economy has changed. Well in fact it hasn’t changed, but the expectations have changed. Now, let’s adapt to the new expectations. Let’s stop having that risky business: let’s close the door to subprimes.
Looks like a good idea: less subprimes means less defaults. And less financial distress. It’s time to tighten the rope.
But that will mean widening the gap again. That will mean additional pressure down and lower prices. That will mean less richesse effect and less spending. That will mean less jobs, and that will mean more depressed areas. And, voilà, you have the vicious circle.
Because tightening the market for mortgages means tightening a natural exit for existing subprime mortgages: refinanciation. There’s an important percentage of house owners that need refinancing, specially among subprime owners. It’s a natural way to quit being subprime, either you get rich, either you transform your mortgage into some more bearable weight. But what if that door narrows? more defaults coming.
What will happen at the end of the year when prices won’t be stable at 0% but… I have a guess to make here… hmmm… let’s say -7%. You can see the tendency in the upper graph.
You say flatliner? Maybe… nah, I don’t believe so. Let the vicious circle begin.
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