Friday, July 27, 2012

Wealth does not trickle down...

Hat tip to David Ruccio at the RWER blog for making this graphic from The Guardian available.

Click to see from where capital flows for those at the top of the pyramid

Capitalism's enigma remains its undeniable ability to morph from one form to another.  The Hobbesian social contract of Western democracies in the period following World War II saw its "Golden Age" where labour power acted as a check to the power of corporations and the notion of a living wage was not alien. But as labour flexed its power and productivity wilted away, the commodity induced inflation courtesy of the OPEC cartel provided an in and paved the way for a newer global order of orthodoxy in the 1970s. America unwound from the gold standard --undoing Bretton Woods in the process-- and the neo-liberal policies were introduced that unleashed the power of capital globally.

Capital has effectively usurped labour over the past 40 years and the capitalist dilemma has been that in its so-called free "laissez faire" form it leads to an accumulation in fewer hands with the unintended consequence being a steady erosion of the social fabric within the state.

The result is that "trickle down" economics does not exist. The rich do not create jobs; entrepreneurs endogenous to a capitalist system with access to credit ultimately do. Stability is provided by governments, industries, labour --all of whom are stakeholders: institutions matter; they always have and always will.

The value added from business ventures --or 'surplus'-- when not dispersed in an equitable fashion amongst stakeholders does not lead the acquisitors of the surplus to enact in a manner befitting noblesse oblige. Instead, carefully crafted propaganda has left the general populace to worship at the alter of celebrity and wealth; this does not make people better off --it leaves them deluded.

Attend any investment conference and it is readily apparent that there is no lack of capital in the world but when it is an asset in the hands of the relative few it is unavoidably funneled into unproductive endeavours --think of the never ending asset bubbles we are witness to-- be it investment in luxury real estate, commodities, or the latest derivative concoction within the shadow banking sector.

When we consider the identity that within a closed global system assets and debts net out to zero, we can recognize that this capital socked away in tax havens and other exotic vehicles is mirrored by a mass of private sector household debt that must be paid down. It has been fashionable for everyone's favourite rag, The Economist, to lament the growth of Leviathan --putatively 'big' government-- in the years following the financial crisis of 2008.

Unless three inter-related things happen: (i) the credit spigot is turned on for productive purposes; (ii) the middle and lower classes share in the spoils of the surplus and (iii) the global economic order is re-worked under a new architecture whereby bad assets are written down, there is only one game in town --that is Leviathan, and it must enact pro-growth policies lest the West and the Rest suffer from Lost Decades. 

Friday, July 20, 2012

Betting against the FOMC

These two slides are from a deck by Vincent Reinhart and Harold Ford Jr. for a Morgan Stanley Conference call.

Referring to the lower chart, if there was a trade then I would take the other side of the "Target Fed Funds Rate" view for the "Longer Run" bucket; it appears (to me)  higher than the U.S. economy could sustain without significant de-leveraging of the private sector and renewed access to cheap credit to smooth consumption for the bottom quartiles of the wage pyramid. Clearly the FOMC believes --explicitly or implicitly-- in the rate normalization hypothesis rather the any manifestation of Irving Fisher's Theory of Great Depressions. Bernanke, a tried and true disciple of the Friedman and Schwartz narrative about the Great Contraction has enacted the "save the banks, save the world" form of monetary engagement but the coming 18 months will give investors, and more importantly working people, a clearer insight to the depths of the malaise. Of all the policy tools available, a form of quantitative easing for the public will not be an option. The global imbalances that have shown the circumspect nature of policy prescriptions from creditor and debtor nations alike will remain; not every nation can trade its way out of the quagmire and not every country can have a current account surplus. In time that longer run view of the target Fed Funds Rate will come down as reality hits the fantasy of Panglossian expectations.

Monday, July 16, 2012

Japanese rates look good these days...

It has come to this: negative rates testing the ineffictiveness of monetary policy.

China won't save the world

A previous post, "Is China misunderstood?" showed the opposing views of the China growth story and took the position that the sustainability of China, chief amongst the BRICS, growing at a breakneck pace should be greeted with caution at best and considered realistically sustainable only in the short term (i.e. up to 5 years). This post will attempt to flesh out a few of the reasons for the skepticism. There is no need to repeat conventional wisdom as others can state it more convincingly but here it is in essence: China is too reliant on fixed investment – be it property, manufacturing or infrastructure – and when increasing investment becomes unrealistic then the Chinese economy is vulnerable to a substantial slowing.
Moreover, as Capital Economics has shown (see chart) I/Y (Investment as a proportion of GDP) has been rising in China; this is against the edicts of the Politburo's previous 5 year plan that called for a re-balancing of the macro economy towards greater reliance on Consumption --entailing a stronger household sector-- and away from Investment and Net Exports as drivers of GDP.

The Chinese elite --be they current or past members of the Communist Party's politburo-- have been masterful in charting the growth trajectory of the state's crony capitalist structure and finely tuning its mercantilist policies; the result (in conjunction with helpful neoliberal corporate globalization policies that aid and abet the inflow of financial capital and outflow of jobs) has seen remarkable strides in material wealth, productive capacity, human capital and transfer of technology from Western to Chinese companies.

The usual reaction of criticism of China has been for uber-nationalist cyberspace lurkers to post defensive retorts on establishment sites (e.g. Financial Times, The Economist, New York Times, Foreign Policy) and the occasional less than radical blog usually with  incisive claims about China's mandarins focusing on the long-term and the inability of Western minds to comprehend the Chinese game theoretic approach which cites Go as the appropriate strategic war-gaming metaphor rather than the West's focus on Chess (which curiously has its origins in the East anyway). 

This is unfortunate: no reasonable individual questions either the ability, intent or talent of the Chinese people doing the work within the mainland or the diaspora internationally; it is the sustainability of the growth model that is rightly being called to question and this model will be under greater pressure as the imbalances between the consumptive West and the savings driven Rest continue and the household debt burdened are tackled through a steady dose of de-leveraging.

None of the concerns of shrieking Cassandras are new: in 2010 with China's Q2 GDP racing away at 10.3% Ken Rogoff warned of an impending correction in China's property market which would funnel through to its financial sector; that correction didn't happen.

At that time China's banking regulator ordered lenders to conduct stress tests where housing prices would fall up to 60%. But what point is a stress test in a country where economic policy is determined by political power? When is a stress test useful when non performing bank loans can be bailed out by the central government?

The main driver for China --as has been the case elsewhere-- has been credit: if credit is taken away then the progress from globalization is taken away as would the demand within China.

The Chinese - American relationship ("Chimerica" as framed by Niall Ferguson and Moritz Schularick) is the world's largest  vendor financing contract and is still viable for the short-term --or as long as the current account surplus remains. Fortunately for Chinese authorities, they are sitting on massive capital gains as export earnings invested in U.S. treasuries have seen rates plummet since 2008.

 China's 12th Five Year Plan reflects the goal of the Chinese government to move Consumption higher and Investment lower

In a recent Project Syndicate piece "Why China Can't Adjust" Minxin Pei argued that China's challenge is in the medium term rather than immediately. The growth model has depended upon the repression of the household sector in favour of state owned enterprises so while the financial sector is replete with npls the local governments, railway system and real estate developers are most vulnerable to serious downturns.

Is a downturn coming? Notwithstanding Li Keqiang's advice to US policymakers to follow electricity usage, rail cargo volume and bank lending as economic indicators rather then GDP, here are three leading indicator charts that presage a slowing growth outlook:

For the immediate term this should not be disastrous.

Chinese state owned enterprises exist and will be supported via fiscal stimulus and will continue to play a large role for sometime for a number of reasons: (i) they are strategic to the Politburo; (ii) they remain a self fulfilling patronage machine for the princelings, children and relatives of the CPC; and (iii) a healthy mistrust in Western style capitalists persists.

The quid pro quo from private entrepreneurs is political allegiance and no power allotted to labour unions as that would be counter to the enterprises absolute advantage in low wage labour. The price of such a Faustian pact is unclear but Pei estimates 1.1 trillion dollars paid to officials at various levels for bribes which ramps up exponentially at the age of 59 --the age where officials attempt to cash in.

Ultimately, how will China successfully rebalance from investment and net exports to consumption when the Soviet Union, Brazil and Japan failed to do so? Economic historians recount how extrapolations of Soviet growth in the 1950s and Japanese growth in the 1980s showed those nations surpassing the United States as GDP top dog; that also did not happen.

Pei's view is one of pragmatism and optimism that change will occur but not in the timeline expected by the CPC. The pessimists view, articulated by Michael Pettis, is that debt levels are rising in China and eventually the costs to service debts will outstrip the capacity to service them and that the 20 year experiment in Chinese capital misallocation  without a market pricing mechanism within the financial sector will spell trouble if growth slips below the growth in debt accumulation.

It is clear that with the outflow of financial capital from China will show in changes in the current and capital account.
Rebalancing can happen but are enterprises willing to pay households in a fairer manner or will exploitation of households in favour of subsidizing the tradeable goods sector through an undervalued currency continue?
China continues to lap many nations in terms of labour productivity a rebalancing to a consumption based model will require workers wages to grow faster than productivity unless there is a massive increase in accessible credit for the working classes.
And just as important, interest rates need to be set under a market rate mechanism so that financial repression against savers does not subsidize the borrowers in the upper classes who do not require it and are using that credit access to speculate.

High growth is intoxicating but one needs only a rudimentary understanding of compounding to understand that high single to double digit growth is either a mirage or unsustainable.

Who will take away the proverbial punch bowl and pay household fairly so that household incomes grow faster then GDP and thus make a consumption based model workable.

With the West bracing for two decades of de-leveraging thanks to private sectors repairing balance sheets, zombie banks, and a nod in favour of misguided austerity based on Ricardian equivalence policies that have no empirical justification --not even counting the demographic wall to come in this argument-- the proposal here of  expectations amongst the mainstream that the BRICS in general and China in particular will save the day is a tall tale indeed.

Wednesday, July 4, 2012

Canada will not avoid the Great Deleveraging

For a good portion of the years since the Global Financial Crisis, Bank of Canada ("BOC")  governor, Mark Carney, has attempted --through moral suasion-- to talk down the debt levels of those Canadians intent on buying homes, those renovating them, and those intent on keeping up appearances via conspicuous consumption in order to maintain a lifestyle akin to their seemingly affluent neighbours and friends. All to no avail: the BOC has known that the underlying economic strength of the macro economy --after glossing over the superficial GDP numbers that are forever subject to revision and drilling down to the real economy-- is weaker than at first blush. The path to so-called "rate normalization" touted in the investment community has not been forthcoming half way into 2012 and will not be (according to your humble scribe) as per the case that was made in a previous post and that unlike previous business cycles Canadians should brace for a new normal of low rates and lower than "trend" growth in economic activity.

One cannot overestimate the concern of household debt burden of Canadians in the context of the decisions of policy makers. Without fail, three of the BOC's periodicals: Bank of Canada Review; Financial System Review; and Monetary Policy Report have mentioned explicitly the concern surrounding household debt levels.
Canadian Household Finances and the Housing Market
The elevated level of household indebtedness continues to be the most important domestic risk to financial stability in Canada. There have been some welcome developments since the December FSR—notably, the pace of household debt accumulation has slowed and some vulnerability measures appear to be stabilizing. Nonetheless, vulnerabilities are entrenched for the most seriously at-risk households, and the Bank’s stress-test simulations continue to suggest that households are vulnerable to adverse economic shocks. Moreover, the continued high level of activity and stretched valuations in some segments of the housing market are of increasing concern. Overall, the Governing Council judges that the risks associated with high levels of household debt and a potential correction in the housing market are elevated and have not diminished since December. A reduction in this domestic risk requires a combination of deleveraging by vulnerable households and a reduction in housing market imbalances.

But at what point does the "combination of deleveraging by vulnerable households and a reduction in housing market imbalances" begin?

Where monetary policy has feared to tread at the risk of a hard landing, regulatory rules have stepped  in and stepped up in the form of tougher mortgage rules and stricter oversight of the CMHC as set out by Finance Minister Jim Flaherty.

This is a welcome move but too late. The asset bubble that is residential real estate in Canada can best be seen through the Panglossian valuations in the Vancouver and Toronto markets.
A hat tip to the excellent Irish economist and 2011 INET grant recipient Stephen Kinsella who provided the inspiration to consider real estate appreciation within the framework of traditional asset price appreciation and has framed the business cycle as being intertwined with the housing cycle.
Where do Vancouver...
....and Toronto...
fit in as per the cycle. Is it truly "location, location, location?"

An unscientific sampling of house prices (Source: Globe & Mail Real Estate Section) in Toronto neighbourhoods over various time spans. Note how the often parabolic rise in house prices is the result of mortgage financing growth; whose salaries (in a sample of median wage earners) is rising at such rates?

A rising tide lifts all boats, particularly when the great driver of housing prices in the willingness of financial institutions to lend: it is credit creation that has driven up real estate globally and the creation of credit is the purview of the commercial and shadow banking sector ("endogenous") rather than the central bank  ("exogenous").
At the risk of intolerant scepticism and pithy comments concerning "Banking Mysticism" as stated by a notable New York Times columnist earlier this year, in the real world banks are not reserve constrained (as the orthodox textbooks are wont to tell you) as they are constrained by the risk tolerance, expectation of profit and quality of capital of the said lending institution. The money multiplier, as described by radical (tongue firmly-in-cheek) economists Seth B. Carpenter and Selva Demiralp in their empirical paper "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" and by BIS and Bank of Thailand economist Piti Disytat in his paper "Monetary policy implementation: Misconceptions and their consequences" is at best completely misunderstood.
While being highly intuitive, the utilization of the money multiplier in expositions of monetary transmission can be misleading.... From a monetary policy implementation perspective, however, the problem is in assumption (i) {(i) being binding reserve requirements limit the issuance of bank demand deposits to the availability of reserves)}. This is premised on the notion that central banks set the level of reserves as the operational target of policy and that banks’ deposit base, and thus their supply of loanable funds, is linked directly to variations in reserves through the money multiplier mechanism. In fact, the true causal relationship actually runs in exactly the opposite direction. The banking system creates deposits as they are demanded by the private sector, and the central bank’s main liquidity management task is to ensure a sufficient supply of balances for the system as a whole to maintain reserve requirements, if any, associated with those deposits. It is the amount of deposits that the banking sector can attract that determines the level of reserves not the other way around.
[Bold emphasis mine and inserted for context; excerpts from pp. 14-15, BIS Working Paper No. 269, (Disytat, 2008)]
Richard Werner, Chair in International Banking at Southampton Management School describes the role of credit (productive vs. consumptive) in encouraging asset bubbles as opposed to the productive capacity of a nation's real economy in this presentation from the April Just Banking Conference at Edinburgh Business School.
The salient slides are shown below:

As the euphoria of the wealth effect from asset price appreciation has shown in the Canadian context, real estate prices and in turn mortgage debt issuance has far outstripped the income appreciations of the vast majority of Canadians. None of this is lost on the BOC.

But what next? Deleveraging is inevitable; the question is will it be the result of the soft landing that the Department of Finance and BOC wishes or will it be due to the hard landing or (worst case) crash that they fear? As the Citi charts show, as try as they might it is often the latter scenarios that prevail.