Archive | April 2013

The Cause of the Crisis

Pretty much ever since the crisis of 2008, there are those who have been arguing that the sharp fall in NGDP/demand was the cause of the financial crisis, rather than the other way around. Further evidence has now come to light in both the US and the UK, courtesy of David Beckworth and Britmouse, suggesting that the causes of the crisis go back as far as 2005 at least, and largely vindicating the view that the fall in nominal incomes destroyed banks balance sheets. I strongly urge you to read the Beckworth post.

In particular, in the US, expectations of nominal income growth started falling in 2005:

By the time Lehman Brothers went under, income growth was already well below trend, with predictable results for default rates.

where as in the UK, Nominal income growth has been below trend since 2001,

That is a pretty big gap in incomes by 2010.

Interpreting why this happened is obviously tough, but I lay the blame on inflation targeting. If you wish to target the price level of outputs, in the face of real cost pressure on your inputs, you must restrict nominal wage growth. Since someones income is someone else’s expenditure, this means that you are restricting NGDP growth.

Ever since monetarism was put forward as a theory by Freidmann (and others), they have emphasised that there are two nominal variables which are important, income growth, and inflation. The first because income ultimately determines demand, and the second because nominal wage stickiness makes it hard for employers to adjust wages competitively. The first effort at monetarism, was the targeting of the monetary growth rate, the rational was that both incomes and inflation were strongly correlated to monetary growth. In the US and the UK this turned out to be a transient correlation, and money growth targeting failed (-although it largely succeeded in Germany and Switzerland for nearly thirty years, under a slightly different model, you can get a quick overview from this Mishkin paper).

The next logical step was inflation targeting. Why look to target some intermediate variable when you can target them directly. This works just great as long as the two remain strongly correlated. We targeted inflation and got stable income growth for free. :). Of course, this means that had we targeted nominal income/NGDP, we would have got stable inflation `for free’.

The graphs above demonstrate that this correlation started to break down. This is probably a result of falling world inequality. We outsourced a lot of our labour intensive manufacturing to countries where labour was cheaper. Now income in those countries are rising, and we in the developed world must therefore pay more for the basic raw materials that we use as inputs. Thus, by targeting two percent inflation under rising real costs, we crushed income growth. Over the long term this makes it harder for households to meet their debt repayments. Perhaps the small fall in income growth rate in the UK was stable enough not to contribute materially, but the much sharper fall in the US was probably the cause of the financial crisis.

The good news is that central banks can do a lot about this type of nominal problems. By expanding income growth we can put the unemployed back to work. On the other hand, rising wages in the developing world are not going away, so real cost pressures will remain, and higher inflation (in the UK) might be needed in order to keep incomes/demand on a stable trajectory. To my mind, a slightly higher price level is a small cost compared to millions sitting unemployed, so we should do that.

This picture also makes sense in of the UK’s productivity puzzle. If raw material costs increase 4%, productivity increases 2% and wage growth is 0%, we get get roughly two percent inflation. However, its not clear that this type of cost inflation is really captured by the productivity statistics. If productivity is measured by output, then it is negative in the above example, since I am producing the same amount of stuff at a higher cost, despite productivity increases.

A mixed bag for the Uk then: We must increase nominal wage growth to increase spending, and suffer slightly higher inflation as a result, since the central bank cannot overcome the real cost pressures that are a result of the rising living standards of much of the rest of the world.

The Astounding Hypocrisy of Jens Weidmann

The Eurozone crisis has been replete with politicians and ECB board members declaring victory after miscalculations of tragic proportions. We have seen plenty of congratulatory back-slapping on the Cyprus bailout, which is only predicted to destroy a quarter of their economy. We have seen pious talk of the need for “reallocation” in periphery economies, and that  only “confidence boosting austerity” will allow their economies to recover, despite virtually every reputable study showing the exact opposite. We have had Olli Rehn, EU commissioner for finance, berating the economics profession for publishing studies showing the failure of austerity, because they are destroying confidence and making the problem worse. But this weeks pronouncement really takes the biscuit. Jens Weidmann, inflation hawk extraordinaire, has topped all that.

This week he was quoted as saying:

 that eurozone interest rates could be cut, if warranted by further weakness in the region’s economic data.

Now what weakness was he referring to that day? Was it the fact that Eurozone unemployment has risen for the sixteenth consecutive month? Was it that fifteen months in a row wasn’t enough for a rate cut? But sixteen, that really shows weakness. But no, instead he was referring to a sharp fall in orders for German cars. Twelve percent unemployment is nothing to get worked up about, but if they stop buying German cars, that’s a disaster.

Surely Weidmann just believes that Germans are in need of some belt tightening to improve confidence. Austerity is for the periphery, if the German economy is slowing, obviously monetary stimulus is the answer.

Its an outrage.

Fund Managers and Passive Investing

The fund management industry has been getting a lot of bad press recently. Firstly because so many of them fail to beat simple strategies like investing in a FTSE100 index tracker. Of course, in aggregate the fund universe is the stock market, so its clearly impossible for them to beat the stock market in aggregate. Ironically, if all the funds controlled by active fund management where placed in passive funds, it would create exactly the situation needed for the fund management industry to create alpha and thrive.

However, its especially hard to understand, because almost every other passive strategy, e.g. buying an equal weighted portfolio instead of a cap weighted portfolio like the FTSE100, will massively outperform a cap weighted index. The Nasdaq-Apple phenomenon illustrates precisely the danger of Cap weighting. At one point Apple comprised nearly 40% of the index (it was later limited to 20% by official decree), which means that you are not getting the benefits of diversification that you would expect in a portfolio, since most of your value is in a handful of positions. The top ten positions of the S&P500 have 20% of the value, you need just 32 to companies to have half the index by value. The bottom fifty companies make up just 1% of the market cap. Is it really worth the trading costs to rebalance 50 positions worth just 0.02% each? Its trivial to see that if every company has identical profiles, the minimum variance portfolio will be equally weighted.

We have not even talked about Fee structures. Many funds have total expense ratios exceeding two percent. Truly awful. Investment trusts as a group seem to do better, averaging about 1%. Still, in all this, I came across a surprising graph in the small cap sector:

Virtually every small cap fund substantially outperformed the FTSE small cap benchmark.

Virtually every small cap fund substantially outperformed the FTSE small cap benchmark over three years. That blue dot over on the left is the benchmark. Risk is vertical and return is horizontal.

I have no idea how this can even be true. Perhaps the FT is selecting only the best performers. Perhaps many or most small cap funds are actually only partially invested in small caps? Here is the graph for Flex cap equity.

Again the Benchmark seems to be a bizarrely low performer.

Again the Benchmark seems to be a bizarrely low performer.

These graphs were quietly snipped of the FT website, but again, the FTSE all share has indeed managed just 2.5% annualised, so it seems plausible that their `flex cap’ index might have done this badly. But how can every fund outperformed so massively? A quick check on my morningstar driven research platform finds 28 small cap funds, but only 9 of them are more than three years old.

Does the fund industry routinely close and reopen funds in-order to erase the memory of bad performance? This is really the only possible explanation. No wonder funds look attractive to retail investors when fund managers continually erase fund that under-perform the index, and only those that look good survive.

If that is what is happening, the regulators ought to step in, as these graphs are deeply misleading, despite being superficially accurate.

However, there is a slight  upside in this for the retail investor. If funds are killed of for relative under performance (and your money returned), then sooner or later you will end up in a fund that is beating the index. Of course, if that out performance is essentially random, then you would be better off indexing and saving your fees, since it is impossible to generate useful work from a random process*. On the other hand, if manager out performance is persistent, and there is reasonable, though not conclusive, evidence that it is, then sooner or later you are likely to end up in a winner. This is interesting enough that I would like to model it. Does anyone have access to fund data including funds that were closed? Ten years would be enough.

*Yes, I did just apply the second law of thermodynamics to Finance. It really works too. Try this brain teaser: suppose you wish for a population to have more boys than girls, is there any strategy which can produce this result? Strategies like: I will keep having children till I get a boy. I will continue having children till I have more boys than girls, etc. Strategies involving killing people are not allowed.

Economist Hulk, and other musings

I have never really been into Twitter, but Economist Hulk is really pretty awesome. The perfect mix of humour and economics. In fact I like him so much that I am now signed up on Twitter under @phil_20686. We will see how it goes.

Today Hulk SMASHED Tory headquarters. Shortly after Hulk SMASHED Ed Balls’ comments in his interview last week. Here is a selection of quotes where Hulk sets out his view of the UK economy:





So we have talked in several previous posts about the equivalence of fiscal and monetary policy, and that wishing for more fiscal stimulus and the BoE to hit its inflation target is self defeating. I wanted to talk mostly about point (5). Milton Friedman once said that “Inflation is everywhere and always a monetary phenomenon.” In an important sense this is true, as by controlling the money supply, a central bank can, in the long run, hit any inflationary or deflationary target that it wishes to. However, there is an important sense in which it is not true: not all changes in the price of goods are due to changes in the value of money.

For quite a long time now, developed economies generally, and the UK, as a small island economy, in particular, have been exporting the more labour intensive parts of industry to regions of the world where labour is cheaper, while we concentrate on higher value manufacturing. Despite a political discourse centred on the `hollowing out’ of UK manufacturing, we remain the sixth largest manufacturer in the world by output value. However, we can think of the economy in the following way: we have inputs, then we have labour, and then we have outputs. We call increases in the price level of outputs `inflation’, and wage increases `nominal wage growth’. However, if the price of inputs rises, then the price of output can rise even in the absence of wage growth. For the UK, whose economy is largely centred on domestic consumption,  this is a problem, as wage growth is needed to ensure there is sufficient demand.

There is pretty good evidence that this has been happening in the US since 2000 or so, cannibalising a graph of inputs to manufacturing from an earlier post (courtesy of BLS),

Note the steadily rising `materials share’. We should really consider this `the wages of Brazilian Miners’. Increasing productivity has been captured by the workforce of developing nations, who do most of the basic material manufacturing that we use as inputs to developed world manufacturing.

Inflation targeting is identical to targeting nominal wage growth provided that the price of inputs remains broadly stable, or at least changes slowly compared to the rate of inflation and the rate of productivity increases. Since the financial crisis, this has no longer been true. Indeed, it may not have been true before that. The lesson should be that in the case of increasing cost of inputs, nominal wage growth can decouple from `price inflation’. That is the position that the UK finds itself in right now, with high inflation and essentially zero wage growth.

Fortunately for us, this `Factor Price Equalisation’ has happened once before, when, following the end of the Bretton Woods agreement, Japan, South Korea, and Taiwan were integrated into the global economy, they got rapidly improving living standards and increasing cost of labour, and we got cheap imports. Evan Soltas provided an excellent analysis of those events here. The BRIC’s are the same story again. Labour costs will remain depressed roughly until their work force becomes fully urbanised, at that point the bargaining power of labour improves, and unit labour prices rise, dramatically increasing the cost of inputs to developed world manufacturing and putting pressure on the price level of the outputs.

In such a world, targeting inflation in the price level deliberately suppresses nominal income growth and causes unemployment, or at least very slow recoveries. In one sense, a fall in relative living standards (at least compared to the counterfactual of benefiting from cheap labour forever) is the price of falling world inequality, in the long run, when catchup growth has run its course and the whole world is `developed’, larger markets will lead to more technological innovation.

I brought up the global context, because I think it makes it easier to see why the UK monetary policy is failing. At the end of the day, input prices are beyond the control of the central bank. Output prices are within the control of a central bank only in so far as it can constrain the growth of nominal wages. As wages are sticky, a central bank can control inflation if and only if changes in inputs are small compared with the desired inflation target. The good news is that because these `inflationary factors’ are real, they are largely independent of monetary policy. Thus, if we opt for monetary expansion, we will get rising employment, and rising demand, but probably not a lot of extra inflation. I point this out because many pundits are drawing exactly the opposite conclusion, that the fact that inflation is high and demand is weak points to the failure of monetary policy.

Doubtless, there are some among you who doubt that the UK inflation is not caused by the BoE’s `loose policy’. I point you to my earlier post on this topic. I also point you to the excellent Britmouse post on the seven offical measures of Uk inflation. Note that since money is a common element of all price indexes, if changes in the value of money dominated real factors, all these measures would be identical. Instead of varying by about 15% cumulatively since 2009.

This post has meandered a little bit. It was meant to be short and snappy, but that didn’t really happen. 🙂 So, to summarise,


Good News: BOJ comes to The Party in a Big Way.

Since the 2008 financial crisis, Global monetary policy has been a smashing disaster, so it’s nice to occasionally have good news. This morning governor Kuroda, of the bank of Japan, announced a series of monetary measures aimed at curing Japan’s chronic deflation. These are measures are far more radical than anyone expected, further even than the Fed has gone. It took decades, but they are now to listening to Milton Friedman’s recommendation from 1998. He stated that monetary expansion and the purchasing of government bonds in sufficient quantities could always cure deflation and therefore a hit any given inflation target.

The most important measure announced by the doubling of the monetary base, this is pure monetarism and demands that the economy should find a new equilibrium where the demand to hold base money has doubled. In the long run the quantity theory of money will dominate and the price level will consequently double. However in the short run as economic agents attempt to offload their excess cash spending will rise, short term interest rates will fall and spending will rise. Only over several years will inflation expectations become embedded in the price level. Since the Japanese economy remains below potential, the increases spending will lead to increased output. This increased output will ameliorate the inflation predicted by a straight application of the quantity theory of money. It is hard to predict in advance quite how much output will increase in the Japanese situation, but having had stagnant output for several decades, there must be the possibility of significant catch-up growth, despite the unfavorable demographics.

Both the Yen and the Nikki have responded strongly to this announcement of `a new era of Japanese Monetary Policy’, with open ended QE and monetary expansion the order of the day. Those who claim that monetary policy is impotent at the Zero lower bound, are about to experience disproof by counter example. Though why a 40% move in the Nikki and a 30% move in the yen on the mere expectation of expansionary policy has not been enough to convince the doubters already I do not know.

All eyes will now be on the ECB, to see if they will change course. The manufacturing PMI out today shows that every single Eurozone country expects its manufacturing output to contract. Meanwhile the ECB continues to shrink its balance sheet, since this means, effectively, that the monetary base in the EU is shrinking, it is explicitly deflationary.

On the Causes of Inequality

So there is a new blog I have been following, dajeeps, and I saw the following post, on the causes of inequality.

The problem is not inequality of income or wealth, it is a symptom. It’s a symptom of inequality of opportunity that comes with the consolidation of investment channels to such a degree that more than 50% of the nation’s potentially productive capital is under the control of only a handful of firms.

Perhaps the proponents of wealth gap argument are too busy looking for ways government can solve the problem by sticking it to the rich to notice that government has caused the problem. In a capitalist society, no one gets wealthy by working as a wage slave.

As I see it, in so far as inequality has a cause, it is `capital accumulation’. Fundamentally, if I want to save, I need to find someone who has a productive opportunity to spend it on capital given the current interest rate. For a while, demand for capital was high, and this favored savers. Since savers are generally the better off in society, this has favored `the rich’. Now we have a situation which, potentially, favors the poor(er). Interest rates, and hence return on capital, could very well be very low (or negative) for the foreseeable future. All those owners of bonds might very well be `the rich’, and about to suffer hefty losses if interest rates `normalise’. This is why changes in inequality look pretty similar across all developed countries, even though they have wildly different tax policies.

This capital accumulation (saving) is a feature of the economy right now. Sooner or later a technology shock will come along and render a goodly proportion of the capital stock redundant, and since all that represents someone’s savings, a lot of savings will be destroyed, and many of the wealthy will lose a huge proportion of their money.

The best historical example of this kind of shock was the destruction of the aristocracy. At the turn of the 17th century in the UK, land was the capital of choice. If you wanted to be rich, you got rich by saving your money and buying land. Those who had land schemed through marriage, politics, and sometimes assassination, to acquire more land. They got a store of the profits from selling the food from that land, and that, more or less, was the economy.

Then came advances in agriculture, the seed drill was invented, and that was just the beginning. By 1850, only 22% of the UK population was engaged in agriculture. Think about what that means – in 1600 the aristocrats got a share of essentially all of the produce of the economy, by 1850 they were getting a share of one fifth of the economy. More than that, we could now produce more than enough food easily, and so food prices had fallen dramatically. The aristocracy were ruined and replaced by merchants. By 1900 this transition was complete, and merchants, ship owners and bankers were the new elite, because the economy was based around trade. Raw materials came in by sea, and finished products were shipped out. World trade volumes were growing rapidly.

In all of this, what is often forgotten, is that land was saving. If we had had a modern financial structure, agribuisness would have been the titans of the 1700’s, only to see its share price collapse and end in a messy default sometime in the 1800’s. Today, amazon is on course to destroy the entire retail sector. The internet, with its ability to organised information, might one day render all kinds of professions pointless. Already auditing has become e-auditing. How long before information technology makes accounting something that anyone can do? There is already plenty of evidence that computers do much better than most financial planners. Anyone invested in a buisness runs the risk that a new technology will render it pointless.

Anyway, the key lesson is that Technology Giveth, and Technology Taketh Away. We have lived through an age in which capital accumulation was the name of the game. The efficiencies of mass production and urbanization required large investments in fixed capital, and high demand for savings led to a healthy return on investment. If, in the future, technology means that we get buy with much lower investment in physical capital, then it will be impossible for the rich to save effectively. There will simply be no long term investments for them to buy. The investments they collectively own will fall in value, and inequality will fall.

Below, I have put a graph of investment in fixed capital as a percentage of GDP, alongside an appropriately transformed gini coefficient (just subtracted 0.35 to make them appear nicely in the same graph). This number is probably a decent proxy for the savings rate. It has been rising for decades, if it falls in the future then inequality will probably fall to (with some appropriate time lag). Just like rises in the investment in capital are associated with rises in the gini coefficient.

This shows `capital formation’ as a percentage of gdp in blue. In red is the gini coefficient, with 0.35 subtracted to make them appear nicely on the same graph. Notice how the large rises in inequality is associated with a rise in the investment in capital.