Rigorous Thinking

Sustainability a Fad?

2011-12-05T14:48:00.004-06:00

A book review in today's Wall Street Journal (http://tinyurl.com/7w5m5ho) had an "interesting" reference to corporate Sustainability efforts:

"For all the talk of a "triple bottom line"—targeting people, planet and profits—few companies, in the U.S. at least, have truly taken their eyes off their stock price and quarterly profit."

The author's implicit assumption is highly problematic. Of course companies are interested in making money! Far from being mutually exclusive, sustainability, when done right, can and does actually enhance shareholder value.

Both the sustainability advocate and the corporate executive should realize that their efforts need not be at odds. In fact, a management focus on shareholder value is highly consistent with our extensive research into the impact of sustainability performance. Our analysis indicates that US capital markets assign a price premium to companies that embrace certain sustainability practices. Specifically, the markets reward adherence to sustainability initiatives that offer the potential to improve cashflow or reduce risks.

Capital markets are becoming much more sophisticated about ESG/Sustainability issues and, today, they usually see through "greenwashing" and punish companies for the practice. They also appear to be skeptical of "greenmongering" efforts which push companies to adopt "feel good" programs and practices that actually increase costs without, at least, some evidence of direct or indirect corporate benefit. Bottom line, sustainability will become increasingly mainstream as companies learn to identify those practices that truly enhance shareholder value.

Although there is much still to do before ESG/Sustainability behavior is fully and universally integrated into corporate best practices, it is clear, at least to us, that the market as a whole is leading companies solidly in that direction.

A Fad? No.

Evolution? Yes.

Corporate Moneyball: Why the Right Metrics Do Matter

2011-11-06T07:16:00.006-06:00

Guest Post by Clyde Rettig, Director, CharterMast Partners LLC

The popular movie, Moneyball, based on Michael Lewis’s equally popular 2003 book of the same name, tells the true story of how the 2002 Oakland Athletics nearly made it to the World Series after applying nontraditional criteria to select new players. GM Billy Beane was trying to rebuild a team that had been decimated by departures of its best players to richer, big-market teams. The criteria the Athletics used, which can be characterized as actual performance metrics, were based on statistical analyses of target players’ historical on-base and run-scoring results and their ability to “control the strike zone” (i.e. get walks) during a game. These statistics produced an entirely different and less expensive roster than one based on the subjective, nonquantitative measures long used by scouts and coaches such as “Good Face,” “Great Body,” “Foot Speed,” and the relative attractiveness of wives and girlfriends. This new approach has now taken hold in major league baseball, although remnants of the traditional hodgepodge of subjective biases are still around. The new metrics are even credited with overcoming the Boston Red Sox’s long curse of the Bambino with a World Series win in 2004.

What is crucial in both corporate business and baseball is using metrics that maximize the chances for competitive success. In baseball, metrics that identify players who can get on base and then score runs are the most critical. For the corporation, the metric that can highlight businesses that generate real returns in excess of the cost-of-capital while providing value-adding growth opportunities can make the biggest difference in an enterprise’s value.

Unfortunately, the metrics commonly used to evaluate the performance and direct the strategy and operations of many large companies are as misguided and defective as the ridiculous, but time-honored biases of baseball scouts and coaches. Like baseball’s traditional practices, most accounting-based metrics are at best irrelevant and often totally misleading and damaging, both for the operating managements of companies as well as their boards of directors and shareholders.

On the other hand, CharterMast Partners (CMP) has pioneered a real-world measure that accurately explains stock price performance, enterprise value, and shareholders’ returns using rigorous financial data and analysis. Corporate managements can use this metric to guide many important strategic decisions, such as which business units to back with capital (or not), determining what acquisitions are really worth, and assessing the real value of various initiatives, business plans, and growth opportunities. CMP’s metric has proven to be statistically superior to the set of classic, but ineffective, measures that includes RONA, EBITDA multiples, EPS, P/E, and EVA, measures that are commonly applied in many businesses today.

Why the “Classic” Performance Measures are Flawed

One of the best examples of a flawed business metric is Return on Net Assets (RONA) and its variants such as ROIC. It is not an exaggeration to say that RONA helped destroy the US steel industry and dulled the competitive edge of the once-dominant US chemicals industry. How can this be? Simple. Rigorously employing RONA to make capital allocation decisions systematically drives companies to under-invest in their most promising new business opportunities. It favors mature businesses by valuing their highly depreciated capital assets rather than the high future revenue growth of currently less profitable fledgling enterprises that require the latest (often expensive) equipment to compete. As a result, RONA can often guarantee a going-out-of-business scenario.

Why this is true is quite obvious. First RONA uses net assets rather than gross assets as its denominator. This, of course, distorts its perspective by including tax-purposed depreciation calculated according to one of several approved standards. Second, RONA never adjusts its asset component to account for currency inflation’s impact on the value of existing assets. Hence, in the RONA world, old assets generate increasing return values over time as they become both worn out and obsolete in reality. Also, RONA’s numerator uses GAAP profits rather than cash profits, further distorting the report of actual performance with an accounting artifact: depreciation.

Finally, and amazingly, RONA contains no factor to capture the obviously different value of high-growth versus low-growth enterprises thereby reinforcing its bias for the outmoded. A zero revenue growth business with a 10% GAAP return on highly depreciated, fully utilized assets appears more valuable than a business growing 25% per annum while delivering an 8% return from a brand new, technically advanced plant with plenty of available production capacity.

Another example of a familiar, but ineffective metric is the EBITDA multiple frequently used by investment bankers as a tool for valuing private companies and business units. EBITDA itself (earnings before interest, taxes, depreciation, and amortization) is really not a bad measure of earnings although the logic for removing cash taxes from the total is questionable (since taxes are unrecoverable cash going out the door).

To create an “EBITDA multiple,” however, requires both an EBITDA calculation and the creation of a multiplier. The technique for doing so is to find several “peer” companies, calculate an average of their implied multiples (from their stock prices), and use that number to value the target company. The problem is, in a world of corporate complexity, what is a “peer?” What companies today have the same or even similar business models, growth prospects, capital structures, costs-of-capital, strategic environments, asset profiles, competitive environments, technology patent estates, etc.? And, why should a company’s multiple be the average of its “peers” if it is a better performer than most?

The whole peer group multiplier exercise delivers what one would expect: the standard deviation around the calculated average is often very high. Hence, the accuracy of the calculated average multiplier is highly suspect. Thus, in spite of the intensive efforts by the investment bankers to measure EBITDA to the gnat’s eyelash, a value calculation is only as accurate as its least accurate parameter. The typical EBITDA multiplier-based valuation estimate is, at best, a shot in the dark.

The metrics commonly used to provide a market value perspective are equally uninformative and often misleading. For example, EPS is purely a particularly empty metric. It simply states GAAP net earnings divided by shares of stock outstanding. EPS can’t be used to compare one company with another because the number of shares is arbitrary. Furthermore, EPS has nothing to do with performance: both Berkshire Hathaway’s share price and its earnings-per-share are very high because Berkshire hasn’t split its shares or issued more of them.

The much touted P/E ratio is also irrelevant. As with the RONA metric, P/E’s use of GAAP earnings means that it does not measure true economic performance, which is presumably what folks investing in stocks are after in the first place.
Finally, the very popular and heavily touted metric, EVA, again fails to deliver insight into real value. It does not take revenue growth into account, it operates with GAAP rather than cash profits, and it makes no inflation adjustments. And, EVA provides little direct linkage to stock price and its statistical accuracy in estimating share prices is very low.

The Right Metric: “CMP-Q”

CharterMast Partners has developed a direct measure of enterprise value that is markedly superior to all the more common metrics. Just four variables drive the algorithm: cash profits, real fixed assets, growth, and an accurate, not a discredited CAPM, cost-of-capital. This metric, CMP-Q, equals the market value of a company’s debt plus its equity divided by the amount of its real net assets. It is highly accurate whether explaining past, current, or future valuations.
Cash profits are not artificially inflated by the deduction of accounting artifacts such as depreciation and amortization. An inflation adjustment to fixed assets takes into account the impact of inflation on the current real value of that asset base. The asset growth factor recognizes that stagnant businesses with zero or limited revenue growth don’t create value over time especially in very competitive environments. And, finally, a company-specific cost-of-capital employs the market’s implied discount rate on future earnings to account for perceived differential financial and business risk.

The proof of CMP-Q’s superiority, however, is really in the pudding. Statistics show that predicted CMP-Q is highly correlated with actual market value across companies, industries, and time:

At the corporate level, CMP-Q makes it possible to assess overall company shareholder value performance over time as well as in comparison to competitors at any given time. At the business unit level, CMP-Q provides an accurate picture of individual business unit differences versus the company averages, current versus desired or forecasted performance, and estimates of the actual corporate value that will be added by specific investments in each unit.

CMP-Q provides the means to assess strategic options, to accurately price acquisitions and ventures, and to value new business opportunities and operational improvement initiatives by comparing incremental corporate value-added with the incremental investments involved. It also makes it possible to objectively allocate capital resources among business units and other investment options based on their relative contributions to corporate value.

Finally, the CMP-Q metric can be approximated in a simplified form so that line managers can use it to both manage their businesses in a manner consistent with corporate value objectives and to assess subordinates’ performance contributions against personal, business unit, and corporate goals.

Just as in baseball, in corporate business, the right metrics do matter!

Contact: Clyde E. Rettig, Director, CharterMast Partners LLC
clyde.rettig@chartermast.com
(o) 781-239-8920

Time to limit the free riding in Asia

2011-10-14T10:23:00.009-05:00

Time to limit the free riding in Asia

By Robert Z. Aliber, Professor emeritus, University of Chicago
September 25, 2011

The single most important explanation for the U.S. unemployment rate of 9 to 11 percent is that Americans spend $600 billion more a year for imported goods than foreigners spend on U.S. products. Most U.S. imports are of manufactured goods — autos, electronics, apparel, many of which are or were made in America.

If foreigners were to spend $1 million more a year on U.S. goods, American employers would
hire more workers. Each employee in U.S. manufacturing on average produces $80,000 of goods a year. One million divided by 80,000 is 12.5, so a reduction in the annual U.S. trade deficit of $1 million would lead to an increase in domestic employment of 12-plus workers. A $1 billion reduction would mean 12,500 more jobs in American manufacturing and one of $100 billion would lead to 1.25 million more jobs. If the U.S. trade deficit declined to $300 billion, the U.S. unemployment rate would fall by nearly 4 points, putting the country at or close to full employment.

The United States has a trade deficit primarily because many countries have manipulated their trade and currency policies to expand employment in manufacturing. China, for one, is extremely protectionist; it consistently exports to the U.S. about five times the amount of goods it imports from us. It also maintains an exceptionally low value for its currency so it can increase its exports and provide employment for the millions that move from the farms and villages to the factories and cities.

General Motors builds Buicks in Michigan and China, and though the models are not identical, U.S.-made cars would sell for 20 to 30 percent less in Shanghai than the autos produced there. Because state-owned enterprises in China follow a "buy national" policy, they are reluctant to import if a comparable product is made at home — unless they need several samples to copy the technology.

China manipulates the value of the yuan through its purchase of massive amounts of U.S. dollars to reduce the upward pressure on its currency from its very large trade surplus. U.S. officials and various senators and congressmen want China to allow the yuan to appreciate. But they have confused the target, a reduction in the country's trade surplus, with an instrument, the value of the yuan. The likelihood is low that an appreciation of the yuan by 20 or 30 percent would significantly impact its trade surplus.

Countries such as China want and achieve trade surpluses; other countries must have the counterpart trade deficits. The U.S. trade balance passively adjusts to mirror the changes in the combined trade balances of other countries; if their exports increase and they buy U.S. dollars to limit the appreciation of their currencies, their trade surpluses will increase and the U.S. trade deficit will increase by a comparable amount. If as a group these countries achieve surpluses by managing their trade and their currency policies, the United States, by default, will have the counterpart trade deficits — and the associated job losses as cheap foreign imports undercut the prices charged by U.S. firms to cover their costs.

The claim that U.S. goods are not competitive in global markets is nonsense. The U.S. is one of the leading exporters in the world. Europeans, Asians and Latin Americans fly to the United States to shop because the prices in the U.S. department stores are much lower than in their domestic markets.

What should the United States do to rectify the loss of millions of jobs in U.S. manufacturing because of the "beggar thy neighbor" policies of China and other trading partners? The U.S. should induce these countries to reduce their trade surpluses from 3, 4, 5 or even larger percentages of their GDPs to no more than 2 percent. If they are unwilling to do so, the U.S. government should adopt an across-the-board tariff of 10 percent to achieve this target. The tariff should be eliminated when the target is achieved. And the tariff rate may need to be increased if some countries are unwilling to reduce their protectionist
policies.

Robert Z. Aliber is an emeritus professor of international economics and finance at the Booth School of the University of Chicago.

Outside Opinion is a forum for local business executives, economists, analysts and academics to discuss their take on the business topics of the day. Send suggestions, questions or comments to businessvoices@tribune.com.

Copyright © 2011, Chicago Tribune

Fascinating Times - Robert Z. Aliber

2011-08-16T09:51:00.001-05:00

A fascinating last several months. The parallel between the problems in Athens and those in Washington centers on the arithmetic of government debt and the ratio of government debt to GDP. Greece surrendered its ability to manage the competitiveness of its economy when it decided to join the European Monetary System, while the United States long ago surrendered its ability to maintain its competitiveness when it implicitly did not contest the policies of currency undervaluation of Japan, Malaysia, Singapore, and China. Greece won’t be able to get out of its fiscal bind as long as it adheres to the euro, and the United States won’t be able to get on a sustainable fiscal trajectory until it adopts measures to counter the beggar-thy-neighbor policies of its major trading partners in Asia.

Now for the catechism. When the issues are many and related, the Q and A format is useful.

Q. Is it a coincidence, or is there a connection between the crisis involving Greece and the euro, and the debt crisis in Washington?

A. More than a coincidence, even though the two crises are very different. Greece has a severe credit crisis, evidenced by the very high interest rates on Greek IOUs. In contrast, the United States has a political crisis that has constrained the U.S. Treasury from selling more of its IOUs. Both crises are the aftermath of an extended period when credit was readily available and governments could readily finance increases in spending because the “money was there.” The crises in Greece, Portugal, Ireland, and Spain follow three or four years when the borrowers in these countries were engaged in Ponzi finance—they obtained the money to pay the interest on their indebtedness from the borrowers in the form of new loans. Then in 2009 the European bank lenders woke up to the combination of a fiscal deficit in Greece that was 12 percent of its GDP and government indebtedness that was 125 percent of its GDP. They concluded that Greece was insolvent; since then Athens has been on life support from the European Central Bank (ECB) while the European officials figure out who will take the “haircuts” on Greek government debt. In contrast, the U.S. crisis was precipitated by the combination of a debt ceiling, a Congress divided among Republicans and Democrats and hard-nosed Tea Party types, and lame White House leadership. The inference from the low interest rates on U.S Treasury securities—short term, medium term, and long term—is that there is no credit crisis in the United States.

GREECE IS BANKRUPT

Q. You say Greece is broke. But the government of Greece hasn’t yet defaulted, has
it?

A. You might want to talk to the German, French, and other banks that own the bonds of the Greek government. They have been arm-twisted to accept new bonds in an exchange, and the present value of the debt service payments they will receive has been reduced by 20 percent. The owners of Greek government debt inevitably will take more “haircuts”—probably a series of small haircuts rather than a large one.

Q. Will the ECB take a haircut on its loans to Greece?

A. Great question. The ECB probably has priority in securing repayment, which
means that the private lenders will be at the back of the queue—a 50 percent haircut of total debt of the Greece would mean that the private lenders would lose two-thirds or more of their money. Note that some of these private lenders
are Greek banks and pension funds. Ugly, very ugly.

Q. What is the current financial situation in Greece?

A. Greece has a primary fiscal deficit of five percent of its GDP, which means that government payments exclusive of interest payments on the debt exceed government receipts by five percent of GDP. (The secondary fiscal balance includes interest payments on the government debt, and is probably 13 percent of GDP.) The government of Greece is much better at making promises about how it will reduce its primary deficit than it is at delivering on these promises. In the absence of money from the ECB, the Greek government would not be able to meet the payroll, pay the firms that sell pharmaceuticals to the government-owned hospitals, and pay for the gasoline used by the army and the tear gas used by the police.

Q. What will happen if the ECB stops providing more money to Greece while the Greek government still has a primary fiscal deficit?

A. For a while the Greek government would issue “scrip” to pay various venders;
scrip is a piece of paper that would say, “The Government of Greece promises to pay 100 euros to the bearer of this paper in three months.” Some of those who receive scrip in payments from the government would in turn use the scrip in payments or they might sell the scrip to buy euros, because of the fear that in three months they would receive another piece of paper that would say, “The government of Greece promises to pay 100 euros to the bearer of this paper in
three months.” Subsequently Greece would declare a “bank holiday,” the banks would be closed for a week, and then the government of Greece would legislate that all bank deposits and all other financial contracts within the legal jurisdiction of Greece that had been denominated in the euro be redenominated in terms of the euro drachma—think euro-lite. Greece would then have two monies (or three if scrip is considered a money), euro coins and currency notes, and euro drachma deposits. The price of euro currency notes in terms of the euro drachma deposits would increase.

Q. What about the austerity measures that the Greek government has been adopting at the behest of the ECB and the IMF? And what about the money that Greece would receive when it privatizes more of the phone company and other government firms?

A. Let’s deal with the second question first. The government of Greece can only sell these firms if there are willing buyers. These government-owned firms operate at a loss; no sane foreign firm is going to pay more than a nickel for the right to deal with the Greek unions that effectively are the “owners” of these firms. The Papandreou government doesn’t have enough political clout to transform these firms so they are profitable. Greece has a bloated public sector and many pockets of protection—limits on entry into a large number of economic activities.

Q. What will happen if the money from the ECB runs out before Greece eliminates the primary fiscal deficit?

A. That would depend on how large the primary fiscal deficit would be—if Greece is close to a primary fiscal balance, then it might scrape by. Possible, but unlikely. Greece has had very little success in reducing its primary fiscal deficit.

Q. What about the sale of assets owned by the Greek government?

A. Any money from debt sales might finance some of the primary deficit, but the
money would not reduce the primary deficit (except as the government-owned firms had been operating at a loss).

Q. What would happen after Greece achieves a primary fiscal surplus?

A. Assume Greece has a primary fiscal balance of zero—neither a primary surplus nor a primary deficit. The debt of the Greek government then would increase at the interest rate; to keep the arithmetic easy, assume that the debt of the Greek government is 150 percent of its full employment GDP. Assume that the interest rate is four percent—a heroic assumption, because the interest rate is likely to be higher. Assume that the Greek economy grows at three percent, another heroic assumption; the growth rate is likely to be lower. Then the ratio of government debt to GDP would increase by three percent a year. The implication is that Greece cannot outgrow its debt, unless it can achieve a primary fiscal surplus of at least three percent. That would require a decline in household consumption of eight percent without any reduction in the ratio of government debt to GDP. The miracle that would have to happen for the lenders to Greece to avoid a massive decline in the value of their Greek government bonds is that the government of Greece would be able to achieve a shift in the primary fiscal balance from a deficit of five percent of GDP to a surplus of five percent of GDP.

Q. How did Greece get into this mess?

A. There are two elements to the story. One is that sometime around 2000, perhaps a year or two earlier, the government of Greece began to fudge the data about its deficits and its debt so it would satisfy the Maastricht criteria for joining the euro. The second is that there were a large number of European banks that were happy to buy the bonds of the Greek government because the interest rates were attractive and they believed that Greece had satisfied the Maastricht criteria. Did any of these lenders know that the data on the finances of the Greek government had been fudged? Who knows?

Q. How would Greece leave the euro, since there are no provisions in the Maastricht Treaty for a separation?

A. Put the issue the other way around: how could Greece stay in the Eurozone if it runs out of money to pay the government workers? Greece would have to leave the euro so that its central bank would be able to print the money to finance the fiscal deficit. The euro drachma would depreciate sharply, and the price level would increase—but by less than the depreciation in percentage terms, so that there would be a real depreciation of 20 to 30 percent. Both measures would lead to a decline in living standards in Greece, especially the consumption levels of those in the government sector. After the separation of Greece from the euro, the lawyers will be brought in to deal with the damages, etc.

Q. Why have the Germans and the French been so accommodating in providing more money to the government of Greece?

A. The answer involves a complex economic and political rationale. My guess is that these government bureaucrats haven’t done the arithmetic on Greece’s primary deficit and the scope of depreciation necessary for Greece to become competitive. They are waiting for a “Hail Mary” pass. Moreover, they think that Greece has a fiscal problem, whereas the underlying problem is that costs and prices in Greece are too high by 20 or 30 percent. Some want to help the Greek government make the changes that will enhance the competitiveness of its economy. Some are worried about the contagion effect, and the impact of the separation of Greece from the euro on Portugal, Spain, Ireland, and Italy—which might have been news a year or so ago. Some are using the crisis as a way to enhance and strengthen European institutions.

Q. Okay, so what is the end game for Greece?

A. At some stage in the next few months, there will be a run on the Greek banks at the retail level. There already has been a run at the wholesale level; few corporate firms hold significant amounts of money as deposits in banks in Greece, both banks chartered in Greece and foreign banks. Greek households will move money from deposits in Greek banks and foreign banks in Athens and Thessalonika to German and Swiss banks in Rome and Frankfurt. The liabilities of the Greek banks will decline, and they would normally sell assets or borrow from the central bank. But few are likely to buy any of the assets that the Greek banks would want to sell, and the Greek banks cannot borrow from the country’s central bank. Greece will leave the euro, at least temporarily. A separation, not a divorce. The separation and subsequent deprecation will enable Greece to become more competitive. Greece now has a large fiscal deficit because it has a large trade deficit, and it has a large trade deficit because its prices and costs are too high.

Q. What are the implications of Greece’s departure for other members of the
Eurozone?

A. At least three. The impacts on other members of the Eurozone with troubled finances have been noted. The surge in the indebtedness of the governments of Ireland and Spain resulted from the bailouts of failing financial institutions, and not because their costs and prices were too high—both countries have a broad
range of exports. Italy has a primary fiscal surplus and has had a very high level
of government indebtedness to GDP since the early 1990s. The fiscal
institutions at the supranational level are being strengthened. The euro will appreciate. The idea that the crisis in Greece means the end of the euro is nonsense.

Q. What is the take-away from the Greek crisis?

A. One take-away is that countries cross the “date of no return” on the trajectory to a crisis long before they realize they have made that transition. The Greek crisis hit the newspapers at the end of 2009, but this date of no return may have been in 2005 or 2006. There was then a large primary fiscal deficit, and no attention to how Greece would move to a sustainable fiscal trajectory.
THE U.S. FISCAL CONUNDRUM

Q. Okay, enough on Greece already. What is your understanding of the current fiscal
deficit situation of the U.S. government?

A. The take-away from the very low level of interest rates on short-term U.S. Treasury securities, and especially on securities with maturities of 10 years and 30 years, is that the prospect of a credit crisis even in the distant future seems low. If the prospect for a crisis in 10 or 15 years seemed high, the interest-rate yield curve on U.S. dollar securities would be much more positively sloped. The connection between the posturing and political theater in Washington and the bond markets in New York is slight. There is a large supply of saving in the United States and the world, and a shortage of attractive outlets for the money—hence the interest rates on U.S. dollar bonds are very low.

Q. But what if Moody’s and Standard and Poor’s had reduced the credit rating of the U.S. government?

A. Yes, what if? Typically credit rating agencies rank the risk of default of various corporate bonds relative to the benchmark of U.S. Treasuries. The U.S. Treasury will NEVER default in the traditional sense; instead, the debt burden would be inflated away. Assume the debt of the U.S. government is downgraded. Where are those with large holdings of liquid short-term wealth going to park their money? Are the Chinese likely to increase their purchases of euros? Maybe slightly on the margin. There are no attractive alternatives to the U.S. dollar at this time. (To the readers—this paragraph was written three days before the Standard and Poor downgrade of U.S. Treasury debt. Greece has defaulted because its central bank is impotent, and cannot buy Greek government debt. In contrast, the Fed can always buy the U.S, Treasury debt. If the Fed refused, the Administration would “pack” the Fed. Of course there is a currency risk, but there is no credit risk.)

Q. Why are interest rates on U.S. Treasury debt so low?

A. Assume that you won a gigantic lottery. Interest rates are low in all stable areas because at the global level there is an excess supply of saving and inflation is virtually zero. And the Fed has followed a super-expansive monetary policy.

Q. Would the U.S. government have defaulted if the debt ceiling had not been
increased on August 2, 2011?

A. The chatter about default on the U.S. Treasury debt was hocus pocus, a smoke screen, a henny-penny alarm that the sky was falling. The U.S. government would not have defaulted; it would have continued to pay interest on due dates. Interest payments on the U.S. Treasury debt are $300 billion a year or $25 billion a month (remember, most of this debt is short term, and short-term interest rates are very low). The U.S Treasury takes in nearly $200 billion a month—more in some months, less in others. The Treasury will always have enough cash to make the interest payments. Moreover, the U.S. Treasury would be able to roll over maturing debt without violating the debt ceiling. It would be able to sell $1 million of new debt for each $1 million of maturing debt. But there wouldn’t be enough cash to pay all the salaries and all the vendors to the government and to make the large transfer payments to the states, so some of these payments would be delayed. Vermont, for example, is scheduled to receive $50 million from Washington in August; that payment would have been delayed.

Q. Does that mean that the U.S. government doesn’t have a financial problem?

A. Yes and no. There is no immediate financial problem, at least in the absence of the debt ceiling, but there is a long-run financial problem in that if and when the U.S. economy were to approach full employment, the U.S. Treasury would “crowd-out” private borrowers because the U.S. fiscal deficit then would be three or four percent of U.S. GDP.

Q. Okay, why is there a long-run U.S. fiscal problem?

A. The U.S. fiscal deficit now is nine percent of U.S. full-employment GDP. There have been four major contributing factors—one was the Bush tax cuts of 2001 and 2003, which increased the annual U.S. fiscal deficit by two percent of GDP. These reductions in tax rates were based on the belief that there was a structural fiscal surplus, which would lead to an increase in government spending. (One line in the Republican playbook is “starve the beast”—the government can’t spend the money that it doesn’t have. That line was falsified in the Reagan presidency; taxes were cut, and government expenditures were increased and financed by a sharp increase in borrowing. Similarly, the line was falsified in the Bush II presidency.) The second contributing factor was the increase in defense expenditures—wars are expensive, and two wars are more expensive than one—say another two percent of GDP. The third is the cyclical downturn that began in 2007, which increased the fiscal deficit by four percent of U.S. GDP; the U.S. output gap is also about 10 percent of GDP. The fourth is that the stimulus program adopted by the Obama administration added about two percent a year to the U.S. fiscal deficit. Two percent plus two percent plus four percent plus two percent equals 10 percent.

Q. Is a debt ceiling a “good thing”?

A. A debt ceiling is a form of “pre-commitment.” In the past, the debt ceiling was raised when it was reached, and without any fuss. I used to think that the debt ceiling was a silly idea, a childish construct. But I have flipped 180 degrees. The politicians need to be reminded that there are limits to the amount that the U.S. government can borrow. When the gods are unkind or mischievous and a government has a primary fiscal deficit, it needs to develop a plan to achieve a primary fiscal surplus. Better to have a self-imposed limit than encounter a limit like the one imposed on Greece. The debt limit is like a stop sign at a railroad crossing—stop, look around, and determine whether it is safe to go ahead. Consider what would have happened if Greece had had a debt limit. (Yes, I know that Greece had a debt limit, but it evaded that limit.)

The problem isn’t the debt limit, but rather that there is now a large ideological gulf between the Democrats and the Republicans on the limits of government spending, as well as a stubborn reluctance to compromise. The Tea Party has sprouted like mushrooms in a soggy forest because the Obama administration had such a cavalier attitude toward the increase in government indebtedness; for better or worse, many of the Tea Party aficionados were seriously concerned about the growth of government debt. There are about 60 Tea Party members in the Congress—about 15 percent of its membership—but they have used the debt ceiling to get strong commitments about reducing the growth of expenditures.

Q. What about the chatter about compromise between the Democrats and the Republicans?

A. You may remember President Obama’s statement that there would be $1 of revenue increases for each $3 of spending cuts. The revenue increases have been compromised away. Now Harry Reid indicates that the Senate will agree to a reduction in expenditures—primarily a reduction in the increase in expenditures—without any increase in fiscal revenues. The Republicans have won most of the contested space in the sense of a reduction in the growth of expenditures or an actual decline in expenditures without any commitment to increase taxes—although on January 1, 2013, tax rates are scheduled to return to 2000 levels.

Q. How large is the difference between the Democrats and the Republicans on the growth of expenditures?

A. That’s a difficult one to assess, because there is no accepted baseline for the
growth of expenditures over the next ten years. Expenditures in 2012 will be reduced by $25 billion. This is not a misprint.

Q. What about the proposal for a constitutional amendment that the federal budget be in balance year by year. There’s a lot of rhetoric that families have to live within their means, and that state governments balance their budgets.

A. Silly rhetoric, wrong on the facts and wrong on the logic of the role of the central government. Many families live beyond their means when they borrow to finance the purchase of homes, autos, college, etc. State governments do not balance their budgets every year; each has a rainy day fund and builds up its cash reserves in the fat years in anticipation of revenue shortfalls in lean years. Moreover, state governments have capital budgets to finance their infrastructure investments; these capital expenditures are between five and 10 percent of their total expenditures. Neither family budgets nor state government budgets are a useful analogy. The role of the federal government is that of a massive counterweight; in the fat years when the economy is prosperous, the federal government should have a fiscal surplus, and in the lean years a deficit. Moreover, federal debt can increase over time as long as the increase in debt is not exceptionally large relative to the increase in GDP. The issue is not the level of debt, but the ability to make the debt service payments.

Finally, there needs to be recognition that households want to save, and a significant part of their saving takes the form of purchases of government debt. If the U.S. government were to balance its budget every year, household saving would be much, much larger than business borrowing.

Q. Could you return to the idea of a balanced budget amendment? I think I’m lost.

A. Sure, I like the concept of a limit to the growth of government indebtedness in the long run, but it would be very costly to seek a balanced budget every year.
Assume—just assume—that the balanced budget amendment were passed next year. The sudden sharp decline in the fiscal deficit would trigger a massive depression. When the economy is strong and the unemployment rate is below six percent, the U.S. government should have a fiscal surplus. In contrast, when the unemployment rate is north of seven percent, the government should have a deficit. This is the concept of the automatic stabilizers, and results primarily because tax receipts rise relatively more rapidly than GDP.

Q. What’s your advice on the fiscal balance and deficit reduction?

A. Look, I am an analyst—I gave up policy advising a long time ago. There was too much competition, and it didn’t pay enough. Nevertheless, the place to start is to develop a trajectory for the growth of government debt in the hands of the public but at a declining rate—$800 billion next year, $600 billion the following year, $400 billion the third year. And then the parties can decide on the adjustments between revenues and expenditures within that constraint. The current expansion of the U.S. economy is fragile.

Q. What about the arguments of Paul Krugman and Joe Stiglitz that there is need for
another stimulus program because of the jobs deficit?

A. Sympathetic in principle. Both Paul and Joe are Nobel prize winners for major contributions to economics. Joe seems to think that more spending is the solution to every problem. Perhaps he has written about the end game—when will the fiscal deficits decline to a sustainable level—but I am not aware that he has. Household savings is not the explanation for the large U.S. jobs deficit.

Q. What about the increases in tax rates that are scheduled for January 1, 2013?

A. My objective is to minimize the shocks to the economy from Washington. The
return to the 2000 tax rates should be phased in over two years.

Q. What about limits on the growth of expenditures?

A. Sure, let’s hold expenditures constant in nominal dollars.

Q. While we are on the topic, how large is the jobs deficit?

A. The posted unemployment rate is just over nine percent, and the civilian labor force is 120 million, ball park; the product of the two numbers 10.8 million. The labor force participation rate is exceptionally low, because of drop outs from the labor force; add another two percentage points for a total of 13.2 million. But remember that full employment is associated with a five percent unemployment rate, so the “excess unemployment” is 7 million—a massive number.

The unemployed can be placed in two groups: the structurally unemployed and the cyclically employed. The structurally unemployed probably are in the range of three to four million, and have been without work for more than six months, which is very debilitating to family life, etc. Think auto workers in Detroit. But there is always a lot of churning in the labor market; more than two million people lose their jobs or change jobs every month. When the unemployment rate is five percent, the average period of unemployment is about 13 weeks. Now the average length of unemployed is about 22 weeks.

Q. What about the claim that government spending has increased too rapidly?

A. Yes and no. The ratio of government spending to GDP has increased by several percentage points relative to GDP, largely due to the stimulus program. President Obama loves new social spending programs, but together the dollar value of these
programs is nickels and dimes in terms of spending by the Pentagon, Social Security, and Medicare. The single most important factor that explains the surge in the deficit has been the reduction in tax receipts as a result of the sluggish performance of the U.S. economy.

Q. You’ve mentioned the primary fiscal deficit of Greece some time ago, what about the primary fiscal deficit of the United States?

A. The U.S. primary fiscal deficit is about eight percent of GDP. Thus the target is to
change the U.S. fiscal balance by eleven percent of GDP. Think of the problem in the following way. The U.S. Government should be on a long run sustainable trajectory that would be keyed to a fiscal surplus of $100 billon when the economy is fully employed. The rationale is that a fiscal surplus and a reduction in the government’s debt when the economy is fully employed will partially offset the deficits and the increase in the debt when the economic growth is below trend or average.

Q. Fine, where is the U.S. economy now with respect to this sustainable trajectory?

A. Far below the trajectory. Assume full employment means an unemployment rate of five percent. The measured unemployment rate is nine percent but the “true” unemployment rate is 11 percent—the difference of two percentage points reflects that two-plus million people have dropped out of the labor force (some have taken “early retirement,” etc.). The output gap in the economy—the difference between the actual level of GDP and the potential output at full employment—is $1,000 billion. If U.S. GDP were $15,000 billion instead of $14,000 billion, fiscal revenues would be $300 billion higher, and expenditures would be lower. The fiscal deficit now is $1,200 billion. Subtract $300 billion and the result is $900 billion.

Q. That is helpful—does that mean that if the relationship between fiscal revenues and expenditures changes by $900 billion that we will have achieved our target?

A. Not quite. First remember that the objective is a fiscal surplus of $100 billion
when the economy is at full employment. So bump the $800 billion change in the expenditure-revenue relationship up by $100 billion to $900 billion. One more adjustment; the first is the long-run target is a constant ratio of government debt In the hands of the public to GDP. If GDP increases by three percent a year, then
debt in the hands of the public can increase by three percent a year. Debt in the hands of the public is now $9,500 billion, so the debt can increase by $285 billion in the next year without leading to an increase in the ratio of debt in the hands of the public to GDP. Subtract $285 billion from $900 billon and the result is $615 billion—about five percent of U.S. GDP at full employment. Helpful, I now understand the arithmetic—but the economy seems stuck in low gear, and the pickup in the expansion that you promised six months ago has faded.

Q. Why has economic growth been so sluggish?

A. The cryptic answer is that there hasn’t been enough spending. Government spending is declining as the stimulus money is spent. Households have been saving because they are trying to rebuild their net worth.

Q. Okay, what is your view of the spending deficit?

A. I was hoping you would ask. We know that Americans like to spend--it is not that Americans are not spending enough but rather that they are spending $700 billion more of their money on foreign goods than foreigners are spending on U.S.-produced goods. Petroleum is one of these foreign goods and bananas and brandy are others; most are manufactures—autos, electronics, shoes, apparel.

Q. What is the arithmetic of the relationship between a change in the U.S. trade deficit and a change in the U.S. output gap?

A. We’ve been over this before. Value added per worker in the tradable goods sector
is $80,000 a year. Each reduction of $1 million in the trade deficit would mean an
increase in U.S. employment of 12 ½ workers; each reduction of $1 billion in the
trade deficit would mean an increase in U.S. employment of 12,500. Assume a reduction in the U.S. trade deficit of $700 billion; the increase in employment
would be 8,750,000. Voila, the output gap would be closed, the jobs deficit
would disappear, and there would be a super boom and inflationary pressures because of excess demand, especially if this happened in one year or two.

Q. Anything else??

A. Sure, assume that the U.S. trade deficit declines by $150 billion a year, more or
less at the rate of $12.5 billion a month. U.S. employment in manufacturing would increase by nearly two million—that’s a big number, a very big number. Consider the impacts of the increase in spending by those who will be newly employed; each would spend more on food and clothing and other necessities. These workers had been spending money on food and various services even when unemployed, using the money from unemployment compensation payments and from their savings and from incomes of their significant others. Assume that each of the unemployed had been spending $25,000 a year. Then these newly employed would increase their spending by $55,000, but they would have to pay taxes and repay loans, and they will increase their saving. Assume each increases spending by $40,000. Most of this money will be spent on domestically produced goods and services, which will increase employment in U.S. factories and other business establishments—call this the second round. Similarly, there will be a third round, and a fourth round, etc. Moreover, as domestic employment increases, business firms will spend to expand productive capacity.

Q. What are the implications of these second order spending impacts and these third order spending impacts associated with the reduction of the U.S. trade deficit?

A. A reduction in the U.S. trade deficit of $300 billion to $400 billion would close the U.S. output gap. And closing the output gap would reduce the fiscal deficit by $300 billion in a very painless way. But that still leaves a shortfall of revenues relative to expenditures of $600 billion plus or minus. Reducing the U.S. trade deficit and closing the output gap is the single most important measure to reduce the U.S. fiscal deficit.

Q. Why does the United States have such a large trade deficit?

A. Great question. The United States has a unique role in the global economy; the U.S. trade deficit is the mirror image of the trade balances of all other countries as a group. A few oil-producing countries—Norway, Kuwait, the United Arab Emirates—have concluded that the rate of return on money in the bank is higher than the rate of return on oil in the ground, so they are transforming the composition of their wealth. Or maybe they want larger diversification. Some countries—China, Malaysia—want to increase employment in manufacturing, and so they want large trade surpluses. Germany wants a large trade surplus. There is an adding-up problem: the number of countries that want trade surpluses and the size of the trade surpluses they want is significantly larger than the number of countries that want trade deficits and can finance these deficits.

Q. Which countries want trade deficits?

A. Often the countries that want trade deficits are those with fiscal deficits. The
money that Greece borrowed enabled it to finance its fiscal deficit as well as its trade deficit.

Q. You seem to be the only analyst—other than Donald Trump and Lou Dobbs—who makes a connection between the U.S. trade deficit and the U.S. output gap.

A. Yes, I’ve noticed that very few others make this connection. Trump may be a charlatan, but he is no fool.

ECONOMIC GROWTH AND THE MENU OF INVESTMENTS

Q. How well is the U.S. economy doing relative to your earlier upbeat forecasts?

A. An embarrassing question, at least for me. I was too upbeat earlier in the year. I greatly underestimated the handicap of the housing problem—the excess supply of completed and unoccupied homes as well as the impact of the several million homes in foreclosure on home prices. Housing starts are in the range of 500,000 to 600,000, whereas the demographic demand is 1,500,000. If housing starts were at the annual rate of 1,500,000, the annual U.S. growth rate would be more than two percentage points higher than it now is. At the beginning of 2007, the excess supply of homes was about two million; by now the excess supply would have been fully exhausted. But obviously that hasn’t happened—yet. Demand growth has been exceptionally slow. The would-be buyers are on the sidelines as the foreclosure process continues. The New York Times carried a story about a surge in demand for vacant properties in the South Florida area. Market by market, region by region, housing will come back. As it does, the growth rate will increase.

Q. Any other observations about the data on the economy?

A. Yes, there is a contrast between the anecdotes and the data. The anecdotes suggest a stronger economy than the data do. Auto sales are brisk. Harley Davidson reported that sales were up nine percent. The inference is that there has been an increase in the supply of credit. Yacht sales are up. Restaurants seem to be flourishing. Flights appear fully booked, and airline companies are ordering new aircraft. New claims for unemployment compensation have declined below 400,000. The financial crisis of state governments is history; their revenues from sales taxes and income taxes have increased significantly.

Q. Can you explain the contrast between the data and the anecdotes?

A. These burps suggest that the data for the next quarter will be above trend. Hence I am still bullish about the second half of 2011, with growth about 3.5 percent. Americans have been discomforted by the Washington circus, but the impact on their spending is likely to be modest.

Q. Okay assume that you won the $10 million lottery prize. How would you invest
the money?

A. Thanks, I was hoping you would ask. First, we refinanced our home mortgage
several months ago, a 10-year conforming mortgage at an interest rate of 3.75
percent. That’s almost free money on an after-tax basis. This may be the sixth or
eighth time we have refinanced in the last 20 years—and it is probably the end of the bull market in bonds. Interest rates are exceptionally low because of the aggressive policies of the Federal Reserve. (The local mortgage broker is now offering 10-year conforming mortgages at 3.25 percent,) Those policies will end, and interest rates will increase. So it is risky to buy or hold bonds as long as the Federal Reserve continues to follow the policy of excessive monetary accommodation. The Fed thinks the “best of all possible worlds” would be an inflation rate of two percent a year.

Q. Okay, if you rule out bonds, then the choices are between cash and stocks.

A. That’s a statement, not a question. You’re right. And the only reason for not
holding stocks is that one believes that there is a non-trivial likelihood that stock prices will decline by 10 or 15 percent or even more in the next year or two.

Q. What about foreign stocks?

A. Yes, but I am not a stock picker, and this Q. and A. is already much too long.

Q. What keeps you up at night?

A. China, China. It is inevitable that trade tensions will rise as China’s growth slows.

Enough, already.

A Real Return on Sustainability Webinar

2011-08-10T12:53:00.003-05:00

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Manias, Panics, and Crashes by Robert Aliber

2011-08-02T11:39:00.007-05:00

To be published in paperback 5th August 2011

Aliber has succeeded again, producing the eagerly anticipated next edition of this definitive guide to the financial crisis; highly respected by economists and academics across the globe.

The sixth edition of this bestselling classic on the history of financial crises over the last two centuries, explores the most recent events leading up to the financial crisis including the four waves of credit bubbles over the last thirty years. With polish and style, it analyzes the reasons behind each of these credit bubbles and why ultimately all of them have led to economic disaster. Updates include a chapter on Lehman Brothers.

'Underneath the hilarious anecdotes, the elegant epigrams, and the graceful turns of phrase, Kindleberger is deadly serious. As he so effectively demonstrates, manias, panics, and crashes are the consequence of an economic environment that cultivates cupidity, chicanery, and rapaciousness rather than a devout belief in the Golden Rule.' - From the Foreword to the Fourth Edition by Peter L. Bernstein, author of The Power of Gold

‘An easily accessible book, filled with fascinating historical vignettes.' - Charles Goodhart, London School of Economics 'Every so often financial markets fly off the rails of rationality. Manias, Panics and Crashes brilliantly explains these crises and warns us that as each one fades into the past, the lessons are eventually lost, and investors again come to believe that trees grow to the sky.' - David Laibson, Harvard University

CHARLES P. KINDLEBERGER was the Ford Professor of Economics at MIT for 33 years. He was a financial historian and prolific writer who published 30 books.

ROBERT Z. ALIBER is Professor of International Economics and Finance Emeritus at the University of Chicago Booth School of Business. He writes extensively about currencies and international monetary issues.

For Marketing & Publicity enquiries please contact:

Ria Purser, Senior Marketing Executive at r.purser@palgrave.com | 01256 302890

Praise for the previous edition:

'Charles Kindleberger has written, with great polish and style, an analysis of the stages of financial crises over the last two and a half centuries.' - Patrick Minford, Economic Journal

'Manias, Panics and Crashes is a scholarly account for the way that mismanagement of money and credit has led to financial explosions over the centuries.' - Richard Lambert, Financial Times

'Professor Kindleberger has the welcome gifts of carrying lightly an immense weight of learning and of always using his imagination in deciding how to deploy it. These gifts are as evident as ever in his latest book.' - W.Ashworth, Economic History Review

'Robert Aliber has produced a superb update of the classic book by Charles Kindleberger which remains as relevant as ever.' - Martin Wolf, Financial Times
'…if what you're after is a comprehensive guide to financial crises since the dawn of the modern era, buy Charles Kindleberger's Manias, Panics and Crashes: a History of Financial Crises…an excellent read.' – Edmund Conway, The Telegraph

Aliber - U.S. Economic Developments and General Update

2011-06-06T13:21:00.003-05:00

On Saturday, June 4, Bob Aliber presented the following remarks at the University of Chicago. His talk summarized his recent publishing and research activities, as well as providing an overview of U.S. Economic Developments, The Dollar, and Dysfunctional International Monetary Arrangements. In addition to being Professional Emeritus of International Economics at Chicago Booth School of Business, Bob is also a member of Ativo's Advisory Board.

Dear Members of the XP Class of 1986

Many thanks—you honor me with this invitation to speak to you at this reunion.
I hope that you will invite me to your second twenty fifth.

It’s been a busy year. One activity was the shepherd for four books in their final stages before they went to the printer. In November Stanford University Press published Your Money and Your Life, the second book on personal finance with the same title. Basic Books published a very different book in 1982, which was written in response to the shock when I realized that I “would die with money in the bank.” The theme of that book was the financial life cycle, wealth accumulates rapidly in the last ten or fifteen years of active employment—most middle class Americans will have a positive estate when the train hits. The genesis of the 2010 volume was that staff benefits at the University asked me to talk to retiring faculty about financial planning in retirement. This time the shock was the recognition that many of my colleagues from all parts of the university would have a much higher ratio of assets to income at the time of retirement that they had contemplated ten and twenty years earlier. These individuals wanted and needed help in wealth management. 30,000 or 40,000 individuals a year in the TIAA system retire each year, many of these people buy books; if I could capture ten percent of the market, I would have a modest annuity.

The book is consumer friendly, full of practical advice—when is renting a living unit preferable to buying and owning, the true costs of different types of insurance, the “best buys” in colleges, how to arbitrage the tax system. The chapter on bonds and stocks indicates why the conventional wisdom that the real rate of return on bonds is four percent and the real rate of return on stocks is seven percent overstates both real rates of return, much more so on stocks than on bonds. The chapter “Why Are There 10,000 mutual funds in the United States and only two and one half auto companies?” reviews the cons practiced by the firms that own these funds and why many mutual funds can be costly to your financial health. And when should you begin to take your Social Security benefits—62, the normal retirement age, or 70?

A great read, lots of practical advice, and a marvelous gift for children, friends, etc.

In February 2011, Palgrave published Preludes to the Icelandic Financial Crisis; the co-editor is Gyfli Zoega, a professor of economics at the University of Iceland. We had visited Reykjavik in June 2007 on the intuition that an asset bubble was underway; I spoke to ten or twelve economists in the central bank, the private banks, and the universities, and met Gyfli. In December 2007 Gyfli invited me to give a public lecture at the university on the financial market developments in Iceland—he more or less sensed that I had a strong conviction that the country was sitting on a massive asset price bubble. The lecture was in early May 2008. The situation was delicate; all the data suggested a massive bubble in stocks. (What I had not realized at the time was how much corruption there was at the highest levels of the banks.) There were several diverse motives for collecting these papers—the first was to provide an opportunity to summarize the model that I had been developing about increases in cross-border money flows to a country, increases in the value of the country’s currency and increases in asset prices in the country—either real estate prices or stock prices or both real estate and stock prices. (The attachment to this letter is my introduction to the Icelandic crisis volume.) The second was to provide a vehicle for the paper that I had written for the May 2008 lecture. The third was to ask why the IMF and the OECD completely missed the implications of the massive imbalances in Iceland; staff from both institutions visited Iceland once or twice a year. Another was to ensure that the papers prepared by Frederic Mishkin of Columbia University and Richard Portes of the London Business School were more widely available; both Mishkin and Portes had collaborated with Icelandic co-authors and concluded that the Icelandic banks were in good shape. The Icelandic Chamber of Commerce was the ostensible sponsor for both papers, but the Chamber was a front; most or all of the money came from the Icelandic banks. Mishkin and Portes “rented their names”. Mishkin testified that he received more than $100K for his role. (Okay, I’m envious.) Mishkin and Portes were either dupes or knaves.

One of my economist-banker friends commented “Darwin had to visit the Galapagos to see phenomena that he might have been observed in his backyard if England if they had not been obscured by a lot of clutter. And you had to go to Iceland in your hunt for a bubble and to identify its origin”.

In May 2011, Palgrave brought out the seventh edition of The New International Money Game. The first edition was published by Basic Books in 1972. The book—like many of us--has become heftier over the years. The seventh edition has five new chapters; three focus on crises and their antecedent bubbles. One new chapter “The Silk Road and the Sahara Salt Caravans were Globalization 1.0” is a dig at Thomas Friedman’s The World is Flat. Another new chapter centers on the Reverend Thomas Malthus, OPEC, Peak Oil, and the real price of energy in the long run.

Seventh editions seem like exercises in the vanity of authors. I will be lucky to earn a nickel an hour.

In late June 2011, Palgrave will publish the sixth edition of Manias, Panics, and Crashes. Charles P. Kindleberger had brought out the first edition in 1978, and the subsequent three editions. I inherited the book from Charlie, and brought out the fifth edition in 2005. Charlie was an “ideal” co-author; he died in 2002. My self-imposed rule was never to omit an important idea of Charlie’s, although his criticisms of Milton were toned down. Repetition was reduced, sentences were shortened, and the action in the sentences was moved toward the front end. Charlie was a “clipper”, lots of notes from newspapers, etc. One of the challenges was to combine his approach, which a friend described as “cubist”—Charlie would take an idea as the basis for a chapter, and look at it with from six or seven different perspective in different historical episodes. My approach in contrast was to develop an international monetary history of the last forty years, more or less beginning with the end of the Bretton Woods arrangement of parities for currencies.

The narrative is that there have been four waves of financial crises in the last thirty years; the first involved Mexico, Brazil, Argentina, Nigeria, Indonesia, South Korea, and six or so other developing countries in the early 1980s. Most of the banks in these countries failed, and the governments defaulted on their U.S. dollar loans from the major international banks. Several of the large U.S. international banks would have failed if the U.S. regulatory authorities had not shown “forbearance” toward the recognition of losses on these loans. Japan was the central country involved in the second wave of crises, although Finland, Norway, and Sweden in this wave. Most of the banks in these countries tumbled into bankruptcy and had to be bailed out by their governments. The Asian Financial Crisis that began in July 1997 involved Thailand, Indonesia, Malaysia, and then South Korea was the third wave, although the crisis in Mexico during the presidential transition at the end of 1994 was a prelude to this wave because the antecedents were more or less identical. Again the banks in most of these countries failed, Singapore is one of the main exceptions. The fourth wave of crises involved the Untied States, Britain, Ireland, Iceland and Spain—and Greece and Portugal.

Each of these waves of crises followed a wave of credit bubbles when the indebtedness of a group of borrowers increased by twenty to thirty percent a year for three, four or more years.

The term “bubble” is not popular among many economists, especially in Hyde Park, both because it implies irrationality and it challenges the view that “all the information is in the price”. But the term is descriptive of the pattern of changes in the prices of currencies and assets. Consider the pattern of cash flows between the lenders and the borrowers in the two or three years prior to several of these waves of crises. In the 1970s bank loans to the governments and government-owned firms in Mexico et al increased by thirty percent a year for ten years, and the external indebtedness of these countries increased by twenty percent a year. The increase in the annual flow of money to these borrowers automatically led to the appreciation of their currencies. The interest rates on these loans averaged eight percent, although these rates trended upward during that decade of accelerating inflation since they were priced off LIBOR. The money that the borrowers received on new loans was much larger than their interest payments on the outstanding loans. This pattern of cash flows was not sustainable, since the debt of the borrowers was increasing two to three times more rapidly than their incomes or GDPs. At some stage it was inevitable that the lenders would become more reluctant to extend credit; when the pace of the money flows to these countries declined, their currencies would depreciate. That depreciation might start slowly, and then cascade, since investors would be more reluctant to buy securities denominated in currencies that were depreciating.

The lenders had failed to ask, “Where will the borrowers get the money to pay the interest if we stop providing the money in the form of new loans?”

Bank loans for real estate in Japan increased at the annual rates in the range of twenty five to thirty percent in the second half of the 1980s —and real estate prices increased at about the same rate. Interest rates on these loans were six percent plus or minus. The loans were collateralized by real estate and hence did not appear risky.
But again it was inevitable that at some stage the lenders would reduce the rate of growth of credit for real estate—and then some of the borrowers would have to scramble to get the money to pay the interest.

In February 1997 a student brought a clipping from a newspaper about a real estate transaction in Hong Kong; the most expensive residential property on Victoria’s Peak had been sold by the owner of a department store in Tokyo to the owner of department store in Hong Kong. The story was intriguing. I flew to Hong Kong a few weeks later; a former student arranged a meeting with four individuals involved in real estate. The first question was “What is the rental rate of return?” The answer, “Three percent.” The second question was “What is the mortgage interest rate?” The answer, “Seven percent.” The third question was “How can you make money if you earn three and pay seven?” The answer, “The price of real estate always rises.” It was clear there was a bubble; I visited KL and Bangkok on the trip, and the same phenomena were observable.

The minimum condition to motivate or stimulate a bubble in a currency is that the rate of growth of the borrowers’ indebtedness is several times higher than the interest rate—and by extension, the rate of growth of the borrower’s income or GDP.

The second feature of the period is that the pattern of increases in asset prices induced by the money inflows was not sustainable because the pace of money inflows would inevitably decline. My analysis suggests that the increase in money flows to a currency when its currency is floating must inevitably lead to an increase in asset prices. This explanation was inspired by Keynes’ analysis of the transfer problem associated with post-First World War reparations; he asked what adjustments must both Germany and France make if reparations were to be paid. My variant is “How does an economy adjust to an autonomous increase in money flows from abroad?” One part of the adjustment story is that its currency appreciates, the story of the previous several paragraphs. The second part is that asset prices in the country must increase, since investors buy the currency as a necessary intermediate step before they can buy assets. The surge in asset prices is an integral part of the adjustment process, since the country’s imports must increase so that there is an induced increase in its current account deficit that corresponds with the autonomous increase in the capital account surplus.

The likelihood that these four waves of crises are independent and unrelated seems low. The competing view is that there is a systematic relationship about one crisis and the foundation for the next credit bubble.

U.S. ECONOMIC DEVELOPMENTS, THE DOLLAR, AND DYSFUNCTIONAL INTERNATIONAL MONETARY ARRANGEMENTS

Since the late 1990s, I have made three or four BFL presentations a year for Chicago Booth clubs, mostly in second-tier cities like Denver and Boston and Washington; the focus has been on developments in the U.S. economy and changes in asset prices, including the price of the U.S. dollar in terms of the Euro, the Japanese yen, and other foreign currencies. In December 1999 the statement was that there was a bubble in the U.S. stock market, that it would soon implode, and that the relative price of stocks and bonds “would change by eighty to ninety percent”. In February 2006, at the BFL in Denver, the statement was that there was a massive housing bubble in the United States, which would soon implode, and a recession would follow.

A brief detour. One of my minor passions is the language—the choice of words—used to describe international monetary developments. The press is full of chatter that the U.S. dollar is “weaker” or “stronger”. The dollar is the yardstick. As Gertrude Stein would have said, a yardstick is a yardstick and always 36 inches long; the lengths of different objects increase or decrease in terms of the yardstick. No one would ever say, “The yardstick is shorter or the yardstick is longer. The statement that the U.S. dollar is weaker is a statement that the Japanese yen and the Euro are stronger. Foreign currencies appreciate when central banks in Asia and Europe allow their currencies to strengthen, presumably because they are concerned that their inflation rates are too high; similarly these currencies depreciate when the central banks in these countries want larger trade surpluses as a way to increase employment and the growth rate. The unique U.S. role in international monetary arrangements is to provide global consistency; if all other countries as a group manage their economies and their currency intervention policies to achieve trade surpluses, the United States will have the counterpart trade deficit.

Or consider statements like “The United States is borrowing $250 billion a year from China” or “China is financing the U.S. fiscal deficit.” (Fifteen years ago, the rhetorical question was “Where will the U.S. Treasury get the money to finance the U.S. fiscal deficit if the Bank of Japan stops buying U.S. dollar securities?”) Consider the first of these statements, which suggests that President Obama and Secretary of the Treasury Geithner went to Beijing, kowtowed, and said “President Hu, we want to borrow $250 billion.” Obviously, this didn’t happen. The Peoples Bank of China buys $250 billion of U.S. dollar securities each year because China wants a large trade surplus with the United States, and the PBOC can’t find any international reserve assets that are more attractive than the U.S. dollar. The President and the Secretary of the Treasury would be very happy if China bought more U.S. goods and fewer U.S. dollar securities. China “finances” fifteen or twenty percent of the U.S. fiscal deficit, but its protectionist trade policies cause ten or fifteen percent of the U.S. fiscal deficit because they induce lower levels of employment and profits in the U.S. industries that produce tradable goods.

In the 1990s much of my attention was on the impact of market developments in Japan on the U.S. economy. Subsequently the attention has been on global imbalances, and most recently on the flow of money from China to the United States. Something dramatic happened in China soon after the advent of the twenty first century; in the previous several decades China’s imports and its exports were more or less in balance. About 2001, China’s exports surged and it developed a very large trade surplus because of the combination of its massive barriers to imports (trade protectionism) and the reluctance to allow the yuan to appreciate (currency protectionism). China’s trading partners, primarily the United States, have adjusted to the surge in China’s trade surplus and in the counterpart money inflows from China.

The prelude to the U.S. financial crisis in September 2008 is more or less comparable to the prelude to the crisis in Iceland. The sharp increase in money flows to the United States meant that the U.S. dollar had a higher value than it otherwise would have had, and induced an increase in prices of U.S. assets, especially real estate. (The U.S. experience differed from the Icelandic experience in that the Fed was following a low interest rate policy as the U.S. economy recovered from a modest recession, while the Central Bank of Iceland followed a high interest rate policy to dampen the inflationary pressures associated with the surge in household and business spending.)

My story for the U.S. real estate boom is very different from the popular explanation in Washington, which centers on the misbehavior of the banks, greed, the compensation arrangements for bankers, the failure of the regulators, the corruption of the credit rating agencies, etc. These explanations are arguments by association; none can explain why the banks and the regulators began to misbehave in 2004 or 2005.

Currently the United States has an output gap of four or five percent of GDP, say $800 billion to $1,000 billion, a trade deficit of $700 billion, and a fiscal deficit of $1,300 billion. The U.S. trade deficit is the autonomous factor and led to the large output gap; much of the U.S. fiscal deficit followed from the U.S. trade deficit. The primary cause of the U.S. trade deficit is that China and a number of other Asian countries follow export-led growth policies; they maintain undervalued currencies to ensure that they have significant trade surpluses.

If the value of the U.S. trade deficit is taken as given, the United States can have a low unemployment rate only if it has a large fiscal deficit, or a sub-target level of household saving, as in the 2003-2007 period. If measures are adopted to reduce the U.S. fiscal deficit while the U.S. trade deficit remains more or less unchanged, household saving and household income will decline.

Each decline of $100 billion in the U.S. trade deficit will lead to a decline of $250 billion plus or minus in the U.S. output gap and a decline of $60 billion to $70 billion plus or minus in the U.S. fiscal deficit. The appropriate target is ensure that the ratio of U.S. Treasury debt in the hands of the public, now about $10,000 billion, is more or less constant as a share of U.S. GDP; since U.S. GDP increases by two and one half percent a year, a fiscal deficit of $250 billion is consistent with a stable value for this ratio. The difference between the increase in the U.S. Treasury debt and the U.S. Treasury debt acquired by the public represents the U.S. Treasury debt acquired by the Federal Reserve and the various U.S. government trust funds; together the Fed and these funds own about one-third of the Treasury debt and appear likely to acquire about $400 billion of debt in the next several years, especially if the output gap declines. If the U.S. trade deficit declines to $300 billion, the U.S. fiscal deficit will decline by $200 billion. Now add $250 billion, $400 billion, and $200 billion for a total of $850 billion. The difference between $1,300 billion and $850 billion is $450 billion, which is a minimum estimate of the necessary change in the relationship between federal taxes and expenditures.

President Obama wants to increase tax rates paid by those who earn more than $250 thousand a year to their 2000 level, which would bring in $20 billion a year. Great. Either the taxes paid by the great middle class will increase, or the expenditures that benefit the great middle class must be reduced.

One of my major concerns is with the “declinists”; many misunderstand the nature of economic growth in the global economy. The United States was in a unique position at the end of the Second World War, Germany and Japan were in shambles and lacked the capacity to be competitive. It was inevitable that the U.S. share of world GDP and world exports and world auto production would decline as these countries rebuilt their productive capacity. The Japanese growth experience in the 1960s, 1970s, 1980s, and 1990s conformed with the “Andy Warhol theory of economic growth” that I had developed in the early 1990s. Japan grew rapidly for three decades and then it experienced “the mother of all asset price bubbles” in the 1980s; once the bubble imploded, its growth rate has been modest.

Now the declinists focus on China, whose GDP is projected to exceed U.S. GDP in 2019 or 2020. Maybe.

The Chinese growth performance has been very impressive, both visually and in terms of the data, several hundred million people have moved into the middle class. In the early 1980s, DengXiaoPeng went to Tokyo and returned with the Japanese model for financial regulation. Set low ceilings on the interest rates that banks can pay household savers, and set modestly higher ceilings on the interest rates that banks can charge borrowers. Recognize that the demand for credit at these low interest rates will exceed the supply, and authorize the mandarins to tell the banks who should be the first to receive credit.

Moreover Deng invited the multinational firms from the United States, Japan, Europe, and Taiwan to invest in China because he saw that they would distribute goods sourced from Guanchou and Xiamen and Wuhan through their supply chains. China’s exports increased at a rapid rate.

The counterpart of the surge in living standards is that hourly wages have increased at a rapid rate and are now much higher than wages in Vietnam and Indonesia and Bangladesh and India. These multinationals are shifting their sourcing to the lower wage and cost neighbors. Chinese manufacturers then will be without the institutional arrangements for export sales, and their brand names will be unknown. The Chinese are entrepreneurial, and eventually the gap will be closed.

China has a massive real estate bubble, much larger than the one in the United States; perhaps twenty percent of the homes constructed in the last three years were acquired as investments, many remain unoccupied. The combination of low nominal interest rates and increases in the inflation rate—the government says five percent, taxi drivers say ten percent—has encouraged real estate investment. The government is tightening interest rates to curb the inflation, which is likely to puncture the housing bubble. Auto sales are slowing, and as they slow further, the excess capacity throughout industry will become evident. Then the very high savings rate in China will be a curse, and the problem of excess supply will become dominant. Chinese firms will seek to increase their exports. The dilemma for the United States is whether to give priority to maintaining the openness of the international systems despite the provocations from the second largest economy or whether instead to give priority to maintaining the growth of the domestic economy.

THE AGENDA

The primary item is completion of a new book on international monetary developments of the last forty years that will bring together several themes. There are at least five innovative ideas in this book.

One focuses on the surge in the supply of international credit—money “sloshing” across national borders. There is a massive amount of credit parked in international banks that can be readily accessed for funding loans in various countries. Money from this pool money sloshed into Mexico and Brazil in the 1970s, into the Nordic countries in the late 1990s, in the emerging market countries in the early 1990s, and into Greece and Portugal and Ireland in the last several years. The supply of money in this global pool is massive relative to the economies of these small open economies. Much of the money in this pool has resulted from the large payments imbalances; the countries with the payments surpluses have parked some of this money with the major international banks.

A second chapter develops the narrative about the transfer problem process, and its application to a number of countries beyond Iceland. In some countries including Greece and Portugal the recipients of the money inflows were the governments, which financed much larger fiscal deficits; in these cases there was a credit bubble but not an asset price bubble. (In these cases, the supply of assets and the foreign demand for these assets are increasing at about the same rate.) In Ireland and Spain the recipients of the money inflows were the domestic banks, which increased their real estate loans; the increases in the demand for real estate led to increases in the prices. Jon Johnsson in Iceland sold his Icelandic securities to American and European investors; Jon then had to decide what to do with the money received from the sale. He could either buy more consumption goods or he could buy other securities from other Icelanders. And he could do both and he did both. His purchases of other Icelandic securities from other Icelanders, including Sven Svensson, meant that Sven had the same choice—the money became like the proverbial hot potato. Asset prices increased. What I want to explain is why asset prices increased so much more rapidly in some countries than in others.

A third chapter focuses on the role of the changes in the prices of currencies on the domestic economies when currencies are not pegged. One of the vivid debates when I arrived at Chicago in 1965 was whether a floating exchange rate regime was preferable to the IMF arrangement of adjustable parities. Milton Friedman and then Harry G. Johnson at Chicago, Gottfried Habeler at Harvard, Fritz Machlup at Princeton, developed a powerful set of arguments in support of a floating exchange rate arrangement. Consider some of the assertions advanced by the proponents of floating in the 1950s and the 1960s. One was that changes in currency values would be small and continuous, rather than large and abrupt, as when Britain devalued in November 1967. Another was that because changes in currency values would track changes in the differences in national inflation rates, the scope of overvaluations and undervaluations would be smaller than when currencies were pegged. A third was that countries would be able to follow independent monetary policies; under the adjustable parity system, foreign countries could not allow their interest rates to differ by more than a smidgen for interest rates on U.S. dollar securities. Milton et al asked, “Would you prefer the prices and incomes in various countries adjust so the established parities could be maintained, or would you prefer that the currencies adjust so that the required adjustment in prices and incomes would be smaller?” When the question is posed in this way, the answer is obvious--let the currencies adjust.

The data on changes in the values of currencies and cross-border money flows challenge the preview of floating that was presented in the 1960s. The changes in values of currencies have been much larger than they were when currencies were pegged; at times, currencies have depreciated by sixty or seventy percent. The scope of overshooting and undershooting has been much larger than when currencies were pegged. The proponents of floating suggested that changes in currency values would be like a buffer and provide insulation to countries from a shock that might originate in their trading partners; instead these changes in currency values are a shock; although perhaps more appropriately, the changes in the cross border money flows constitute the shock.

Some of the assumptions in the arguments developed by the proponents of floating were—let’s say faulty. They believed that the shocks would develop in the goods market, and that the cross-border money flows would dampen the movement in the value of the currencies. Instead many of the shocks have developed in the money market. One reason some of these proponents preferred a floating currency regime was that central banks would be able to follow independent monetary policies; however they neglected to ask, “If central banks follow independent monetary policies, what will be the impact of changes in monetary policy on cross border money flows and the value of currencies?” There have been many more shocks when currencies have been floating, and most of these shocks have been monetary.

Another feature of this period is that the variability in cross border flows of money has been much larger than when currencies were pegged. These flows are responsive to changes in the difference in anticipated returns on domestic and foreign securities. But why should the changes in these differences be larger than when currencies were pegged. One plausible story is that the cross border movements of funds have an impact on the rates of return, perhaps because they trigger an economic boom as a result of the positive wealth effect.

One feature of the thirty years since the early 1980s is that the trading revenues of the large commercial banks, the investment banks, and the hedge funds have soared; the rate of increase in these revenues seems many times larger than the rate of increase in cross-border trade and investment. At the same time, competition and technology have led to a decline in bid-ask spreads. One story that reconciles the previous two sentences is that the volume of assets and securities that these firms trade has increased, as if the increase in the quantity of items traded is larger in percentage terms than the decline in revenues per trade. An alternative story is that the much greater volatility in the prices of assets and securities has encouraged momentum traders who follow the cliché that the “trend is my friend.” These revenues of the traders reduce the incomes of the non-traders who buy and hold these assets and securities. Still waiting for an insight on this problem.

The narrative about the role of the changes in currency values may evolve into two chapters.

One chapter is directed at the source of the increases in the supply of credit available for the purchase of real estate in various countries. There are two different models—the increase in the supply of credit in Japan resulted from domestic monetary expansion. The increases in the supplies of credit in Ireland and Spain resulted from money inflows to these countries—the central banks in Ireland and Spain effectively are branches of the European Central Bank. The increase in the supply of credit to the United States was primarily a result of money inflows.

Consider Lehman, not a bank. Did Lehman create credit or was Lehman a channel that allocated credit to subprime borrowers in Southern California? Lehman is a financial intermediary; Lehman could not extend credit to these subprime borrowers unless someone else was willing to extend credit to Lehman. Similarly Fannie Mae and Freddie Mac are financial intermediaries; they could extend credit to buyers of real estate only to the extent that they could induce someone to buy their IOUs.

One part of the chapter on the credit allocation process will deal with “bailouts” and the moral hazard problem—although this might be a separate chapter. I have in draft an “interview” between Congressman Barney Frank and Walter Bagehot, editor of the Economist from 1861 to 1877 and author of Lombard Street, 1873; this interview was observed on C-Span 10 at 4AM six months ago. The Bagehot doctrine is to lend freely but at a penalty rate, the rationale is to ensure that a liquidity crisis does not escalate into a solvency crisis. My supposition is that Bagehot would say, “Do Not Lend to an Insolvent Institution—Like a Lehman.” Yet the argument for lending to an insolvent firm is identical to that with lending to an illiquid firm that is solvent, namely to ensure that the scramble for liquidity leads to a decline in asset prices, so that the solvency of some institutions that previously had been well capitalized is threatened. When Lehman failed, the bankruptcy court began to dispose of its assets, however one of its great assets, its knowledge of the creditworthiness of various borrowers, was lost.

The failure to “save Lehman” is the single most costly error in U.S financial history. Saving Lehman would have involved dilution of its shareholders so that each share was worth a nickel. Fuld would have been banished to Inner Siberia, the directors would have been placed in the stocks in Central Park, and some legal stratagem would have been invented to void employment contracts. Saving Lehman would have meant that the bondholders and those with counterpart risk would have been made whole. The argument for saving Lehman is the cost of externalities of failure. Public credit needs to be promoted when the private suppliers of credit are hiding in the trenches. The U.S. Government is the ultimate vulture investor; TARP has made a profit on its bank loans, and it appears as if the Fed and the Treasury investments in AIG will prove profitable or nearly so, even though AIG was forced to sell some jewels of assets in distress circumstances.

Another chapter involves the role of international banks and the competition for market share among them. When I was in Brussels in February, I learned that the last surviving Belgian bank, Kreditbank, had extended extensive loans to the Irish banks and to banks in Poland. What advantage does Kreditbank have in lending to Irish banks and Polish banks? Kreditbank had “excess capital” that it did not want to use in competing for a larger share of the Belgian market for bank deposits. Banks headquartered in many different countries have excess capital that they do want to use in their domestic markets. Something is happening that we do not fully understand and is captured by Chuck Prince’s remark “You have to keep dancing as long as the music is playing.” Maybe, but where is the music coming from? Presumably the music refers to the increases in the supply of credit. The banks that sit out some of the records conserve their capital relative to those who rush to capture market share, and then are burned when asset prices tumble. The puzzle is that the bankers never ask, “Where will the borrowers get the money to pay us the interest if we stop lending them the money in the form of new loans?”

Energy, Housing, China, Competitiveness - Bob Aliber's Latest Economic Update

2011-03-26T13:12:00.003-05:00

Guest post by Robert Z. Aliber
Board of Advisors, Ativo Capital Management LLC
Professor of International Economics and Finance Emeritus
Chicago Booth School of Business
University of Chicago

Two major energy related shocks in the last month, first the political turmoil in Tunisia, then Egypt and their neighbors, and then the earthquake, the tsunami, and the disaster at the Fukushima Daiichi nuclear plant. “Going nuclear” had seemed one way to reduce dependence on fossil fuels. It is almost as if the chance pairing of these events had been staged by the proponents of renewable energy sources, although the surges in the prices of corn, grains, and foods suggests the limits on the reliance on corn-based ethanol.

The oil price has surged by twenty five percent, even though the supplies have not declined and demand has not increased. Japanese stocks declined by more than fifteen percent, and the yen has appreciated by three percent.

Markets seem fragile—a little news, a little no-news—and prices move by a very large amount.

For most of 2010 the U.S. economy was trapped in a Catch-22 situation. Corporate profits were exceptionally high despite the large output gap and firms were cash rich, but they were reluctant to expand their payrolls because households were sitting on their money. Families lacked the confidence to spend more because the economic recovery seemed fragile with a lot of chatter about a “double dip recession” and frightening newspaper headlines about the stubbornly high level of unemployment.

Still, the U.S. economy grew by three percent, which would be considered remarkable if the unemployment rate had not been north of nine percent.

Traditionally recoveries from recessions have been robust and resulted from surges in spending on real estate as credit became more readily available. By contrast the recovery from the 2008–2009 recession was tepid, despite very low interest rates, because of three factors. The overhang of unsold homes that were constructed in the bubble years and the hundreds of thousands of properties in foreclosure have meant that housing starts have been one million below the long-run trend value, which probably depressed the annual U.S. growth rate by nearly two percentage points. The damage to household balance sheets from the declines in real estate and stock prices led many households to become more cautious spenders. The drag of a massive U.S. trade deficit meant that a significant part of any increases in U.S. spending on manufactured goods created many jobs in China.

The excess supply of houses now is concentrated in Florida, Arizona, and Nevada; many properties are for sale at prices far below the cost of construction (which suggests that the land has a negative value but really means there are tens of thousands of desperate sellers). Vulture investors now are buying these properties in anticipation of price rebounds; in the meantime these houses are rented to families that have lost their homes to foreclosure. Housing starts will increase in response to the low interest rates and as population growth absorbs some of the excess supply. Household balance sheets have been repaired, and families are increasing their credit card debt.

The annual bilateral U.S. trade deficit with China is $260 billion—nearly two percent of U.S. GDP. If Americans spend $1 billion more on Chinese goods and $1 billion less on U.S.-produced goods, 15,000 individuals lose their jobs in U.S. manufacturing and total employment declines by many more thousands—and the lower levels of U.S. GDP would mean smaller U.S. tax revenues and larger U.S. fiscal deficits. If Americans spend more on imports from Vietnam and Indonesia and less on imports from China, the U.S. trade deficit and the U.S. fiscal deficit also would decline, since Vietnam and Indonesia would increase their imports as their exports increase on a one-for-one basis, whereas China increases its imports modestly as its exports increase.

One topic in these quarterly letters has been the expansion of asset price bubbles in the United States, Britain, and Iceland; most of these bubbles have involved surges in real estate prices. The increase in the flow of money from China to the United States that began around 2002 contributed to the sharp increase in the supply of credit that led to the bubble in U.S. real estate. This bubble began to implode when the flow of money to the United States declined at the beginning of 2007; during the next twelve months the impact of the reduction in housing starts on U.S. GDP was largely offset by the decline in the U.S. trade deficit.

Curiously, it seems like the real estate bubble in China accelerated in 2007 as the U.S. bubble was deflating. Investment in real estate in Shanghai, Beijing, and the other major cities in the last three years has been a major driver of economic growth.

Developments in China’s urban housing market are summarized in the next section of this letter. The story is primarily anecdotal because the data are unreliable. Then I discuss the U.S.-Chinese trade imbalance and President Hu’s visit to Washington; the key question involves American policies in response to the large trade imbalance that results from protectionism in China. The third section focuses on increases in U.S. competitiveness, the thrust of President Obama’s State of the Union message. The last section provides projections for the growth of the U.S. economy in 2011.

THE BUBBLE IN THE HOUSING MARKET IN URBAN CHINA

Yogi Berra’s remark that “it is so expensive no one can afford to live there” applies to Beijing, Shanghai, Shenzen, and about ten other cities in China. Some families spend 60 or 70 of their incomes on housing There is a bubble in the housing market in urban China, which is based on an exceedingly high a ratio of home prices to household income, several million unoccupied apartments that are held as investments, and rental rates of return in the range of one to two percent. Real estate has been one of the few investments with a positive real rate of return.

When I was in Beijing last March, a former student said he was the only person living in his new apartment building--the other apartments had been purchased as investments. I visited a real estate office in Beijing in November; the standard 100-square-meter two-bedroom, two-bathroom apartment cost the yuan equivalent of $600,000. The real estate agent said that the income of those buying this apartment was $20,000—and that they had “other income”. The ratio of house prices to household income was 30.

The standard feature of a bubble is that investors project future prices based on recent increases in prices. Until the mid-1990s, living accommodations in China were communally owned, either by governments or by the employers. Then households were gifted ownership of their apartments in exchange for a nominal payment. Household wealth increased immediately; individuals owned their apartments debt-free. The prices of these apartments were low relative to annual household incomes. These apartments could be traded. Some individuals inherited several apartments, which they sold; they used the cash to buy more expensive new apartments that were constructed by private developers and in some cases by local governments.

Migration from the countryside to the major cities has been massive in the last fifteen years, which has led to surges in the demand for homes—and for land that can be used for new construction. Apartment prices have increased much more rapidly than household incomes. The rapid increase in prices has led to large number of purchase as investments, which in turn has contributed to a higher rate of growth of GDP.

The major uncertainty is the how many apartments are owned as investments rather than as personal accommodations. China produces 10 million new living units a year—and most of these units are in the cities and provinces that have experienced the most rapid economic growth. Assume that urban China accounts for one-third of the population and produces two-thirds of the country’s GDP. Perhaps nine million of the new living units are produced in urban China. Many of the newly purchased apartments are owner-occupied, some on a full-time basis and others on a part-time basis. (Business people from various provinces want a base in Beijing for the days when they visit the government regulators, and individuals want apartments in areas with highly touted schools and near prestigious universities.) Some of these newly purchased apartments are rented. Many of the owners have concluded that it is not worthwhile to rent because buyers want “virgin apartments” and rentals depress future selling prices.

Perhaps one-quarter of the newly constructed units in each of the last three years have been acquired as investments. (This assumption seems conservative in terms of anecdotes like “I am the only one living in the building,” “The new buildings are mostly dark in the evening,” and estimates that “30 to 40 percent of the apartments are unoccupied.”) These assumptions lead to the conclusion that five million units are now owned as investments.

What is the end game for the property market? What will happen to prices, and what will happen to number of units constructed in each of the next several years?

One outcome is that prices stop increasing and stabilize at current levels. In the long run, house prices have to adjust to household incomes; it would take 10 or 20 years for household incomes to increase so there would be an equilibrium relationship between household incomes and house prices. This outcome seems very unlikely.

Another outcome is that house prices decline modestly, which will lead to a larger decline in production of new apartments than in the first scenario. Few households are likely to commit to buy apartments as long as prices are falling —which suggests the likelihood of this outcome is low.

A third outcome is that prices decline sharply. The demand for new apartments and hence construction will fall as the economy begins to digest the several million unoccupied apartments that had been acquired in anticipation that prices would increase and increase further. The GDP growth rate will decline sharply. Households will reduce their expenditures on durables, including autos. Property developers will go bankrupt. Unemployment will surge. The major Chinese banks will incur massive losses and will become wards of the government once again.

The Chinese government will respond to the economic slowdown with a big spending program. The likelihood is low that China will then achieve a growth rate of eight or ten percent in the post-recovery period. The basic problem is that Chinese households have very high savings rates—the plague is too much saving relative to profitable investment opportunities.

PRESIDENT HU’S VISIT TO WASHINGTON AND THE U.S.-CHINESE TRADE IMBALANCE

The press chatter surrounding President Hu’s visit to Washington in late January highlighted that China’s growth rate of ten percent for 30 years has been three to four times higher than the U.S. rate. Some observers are skeptical of the data and its year-to-year stability, but no matter: The changes in the landscape— roads, railroads, airports, the buildings constructed for the 2008 Olympics, and the traffic jams—are impressive.

Several polls suggest that Americans believe that China is more of an economic powerhouse than the United States. Some analysts have projected that China’s GDP will exceed U.S.GDP in 2019. Maybe, maybe not.

Economic growth in most developing countries has been constrained because of the shortage of foreign exchange; these countries encountered constraints in “growing their exports.” In contrast, Chinese exports have increased at a very rapid rate. Most of these exports have been arranged by Japanese, American, South Korean, Taiwanese, or European multinationals. In the early 1980s Deng Xiao Peng invited these foreign firms to come to China with the idea that they would fill their supply chains with goods produced by low-wage labor for foreign markets. Seventy to 80 percent of the value of Chinese exports involves embedded imports of high-value components; Chinese value added is about 20 to 30 percent. Most of the Chinese value added involves the contribution by unskilled labor—the metaphor is that the assembly lines in China consist of young ladies with soldering guns and lots of screwdrivers of different sizes.

Between 1980 and 2000, China’s imports increased about as rapidly as its exports. China’s trade surplus began to increase after 2000 as a result of the sharp increase in exports that followed from an effective decline in export prices as productivity in manufacturing surged.

Usually the surge in exports of a country leads to a nearly comparable increase in its imports, primarily because of the increase in household incomes that follows from the increase in exports. In the last ten years Chinese imports have increased less rapidly than exports because China’s tariffs and non-tariff barriers to imports are prohibitively high. State-owned enterprises are directed to buy from Chinese suppliers even though the prices of comparable foreign goods are lower than the prices of Chinese goods. One fascinating aspect of the bilateral trade between the United States and China is that the data suggest that the bureaucrats in Beijing manipulate trade arrangements so that China’s imports from the United States each year are 25 percent of U.S. imports from China.

China now produces more automobiles than the United States. GM sells more automobiles in China than in the United States; Buick is a best-seller in China. The Buicks made in Shanghai are not identical to those produced in Michigan—my bet is that on a quality-adjusted basis, the price of the US-made Buick would be lower in Shanghai than the price of a Shanghai-made Buick after adjustment for subsidies that reduce production costs in China.

The second factor that explains why China has developed a massive trade surplus is that the Peoples Bank of China purchases US dollars from exporters to limit what otherwise would have been a significant appreciation of the yuan. If the Chinese government had not bought US dollars, the appreciation of the yuan would have been large because the extensive import protection means that purchases of foreign goods would not have increased significantly in response to the effective declines in their prices in terms of yuan.

Obviously the goods that the United States imports from China cost less than comparable goods produced in the United States. U.S. value added per worker in manufacturing is $80,000—value added per worker in export industries might be $100,000, while value added per worker in the industries that produce import-competing goods might be $60,000. (The $80,000 is a hard number, the other two are guesses.) The implication is that each increase of $1 million in U.S. imports means a loss of 16 jobs in domestic manufacturing; each increase of $1 billion in imports from China leads to a decline in 16,000 jobs in U.S. manufacturing. And an increase of $250 billion in imports means a loss of four million jobs in U.S. manufacturing—a ballpark estimate but a dramatic indicator of the costs to America of the Middle Kingdom’s protectionist policies.

The rhetoric in Beijing is that China’s purchases of U.S. Treasury securities finance the U.S. trade deficit and that the U.S. economy would be in a desperate situation if China were to stop buying U.S. Treasury securities. But as they say in the Vermont hills, this statement is ass backwards—if the Chinese weren’t buying $250 billion in U.S. Treasury securities each year, the U.S. trade deficit would be $250 billion smaller, and several million more individuals would be at work in U.S. manufacturing. Moreover, the U.S. fiscal deficit would be smaller by several hundred billion dollars because U.S. tax revenues would be higher.

The likelihood is low that there can be significant reductions in both U.S. unemployment and the U.S. fiscal deficit as long as the bilateral trade imbalance remains about $250 billion.

The conundrum is that even though China’s prosperity is dependent on the ready access of its goods to the U.S. market, the Obama administration appears like the supplicant in its negotiations to reduce the trade imbalance. During President Hu’s visit to Washington, the Obama administration stated that China would buy $46 billion more of U.S. goods, including jet aircraft, over the next five or six years—say an increase of $10 billion of sales in each of the next five years, or a reduction of the trade imbalance by four percent. Was this a joke?

Both the Bush administration and the Obama administration have confused targets and instruments in demands on China. The objective—the target—of U.S. policy should be to secure an agreement with China on an orderly reduction in the trade imbalance. A revaluation of the Chinese yuan is one instrument; another is a reduction in Chinese import tariffs; a third is a directive that state-owned enterprises buy from foreign sources; and a fourth is a reduction in non-tariff barriers. The U.S. government’s insistence that the yuan be revalued incurs the massive risk that the reduction in the trade imbalance from an appreciation of ten, 20, or 30 percent will be small or modest.

The likelihood that the Chinese now will revalue the yuan after three or four years of badgering, hectoring, threatening, cajoling, etc., seems small.

What is the “end game” for this bilateral imbalance? Some in the Beijing government— and many members of the Chinese public—must view the large and persistent trade surplus and the accumulation of massive international reserve assets as a sign of their country’s growing economic might.

A standard assumption in international economics is that the small countries adjust to payments imbalances, either because they run out of money to finance their deficits or because their persistent surpluses lead to inflation. China is a very large small country. Its efforts to suppress the inflationary impacts of its large trade surpluses have not been fully successful; the reported inflation rate is five percent, although some economists and many taxi drivers believe that the “true” inflation rate is higher—much higher—especially in the major urban centers. One scenario is that market forces lead to a significant reduction in the trade imbalance, which might occur in response to food shortages in China or to an increase in prices and costs and a decline in Chinese competitiveness. Many of the multinationals that helped China achieve a phenomenal growth in its exports are shifting to Bangladesh, Vietnam, and Indonesia because their costs are lower.

A second scenario is that the bilateral Chinese trade surplus with the United States increases in response to continued productivity gains in China as the firms move up the value-added chain, and produce more of the high-value components that they now import.

A third scenario is that the bubble in residential real estate in urban China implodes, and that the Chinese trade surplus with the United States surges in response to a marked slowdown in the country’s growth rate.

If the bilateral trade imbalance increases because of either the second or the third scenario, then at some stage the Obama administration—or the next U.S. administration— might say, “No more. Enough is enough.”

The most valuable “asset” that the United States has to correct the imbalance is that it can manage the terms of access to the American market—much as the Chinese manage the access of foreign goods to their market. The Obama administration should make it clear beyond the shadow of a doubt that if the bilateral trade imbalance does not decline by $75 billion a year, the U.S. Treasury will impose a uniform tariff on Chinese value-added on imports. Initially the tariff rate will be ten percent; if that fails to reduce the imbalance significantly, the rate will be raised to 20 percent, and then to 30 percent.

The Chinese will bluster about American protectionism, but these statements can’t be taken seriously when Chinese exports to the United States are four times larger than Chinese imports from the United States.

AMERICAN COMPETITIVENESS REDUX

The lead article in the March 14th edition of Time by Fareed Zakaria was titled, “Yes, America Is In Decline”. The response by David Von Drehle was titled “No, America is Still No. l.” Both are right, since Zakaria focuses on the rate of change while Von Drehle highlights the level. In the long run, the continuation of the decline would mean that America eventually would no longer be No. 1. But which country would replace America as No. 1, much as the United States displaced Britain in the last several decades of the nineteenth century and as Britain had displaced the Netherlands more than a century earlier?

The twin to the question of whether the United States can remain No. 1 is whether some other currency will challenge the U.S. dollar as the dominant reserve currency. France and China are concerned with the “Exorbitant Privilege” (a term used by General de Gaulle in the 1960s) that is supposed to accrue to the United States because foreign central banks have chosen to hold most of their international reserve assets in the form of U.S. dollar securities. These central banks have been “voting with their feet”; they had a large number of choices and concluded that dollar securities offered a more attractive package of risk and return than securities denominated in the Euro, or the Japanese yen, or the whatever. The Chinese have a lot of chutzpah when they complain that foreign holdings of dollars are too large even though they and their satellites are the largest holders.

The foreign challenge to what had been the dominant U.S. global economic position in the 20th century is illustrated by the Andy Warhol theory of economy growth, which highlights that every country grows rapidly for 15 or 20 years; then some other country advances to the leading position on the growth-rate hit parade. Countries grow rapidly in a sequential fashion; Britain was in front for four decades, and then the United States and Germany advanced to the top position. Japan had an exceptionally high growth rate between 1950 and 1990. The pattern is that countries that can grow their exports at a rapid rate can achieve high rates of economic growth. But the ability of a country to be at the top of the hit parade for several decades in terms of the rate of growth of exports is no assurance that the country will advance to the No. 1 GDP position.

In the 1980s the rate of economic growth in Japan was twice that in the United States. The Japanese had all the money; seven of the ten largest banks in the world were headquartered in Tokyo or Osaka. The Japanese bought lots of trophy buildings, including Rockefeller Center in New York City and the Pebble Beach Golf Course in California; they bought ten thousand items of French art. Then the bubble in real estate and stocks burst, and Japan slid into the economic doldrums, despite its advantages of a high savings rate and a low cost of capital, and a very large number of highly innovative firms.

The metaphor from bicycle races is illustrative; more energy is required to be in the lead because of the greater wind resistance. No country that has been No. 1 has been able to grow at more than four or five percent a year. Japan, China, South Korea et al have been able to achieve much higher growth rates because they have been playing “Catch up”; they rent, borrow, or steal technologies developed by the leaders, and then produce at lower cost because of their wage rate advantage, which enables them to increase market share in countries that had developed earlier and have higher costs. Japan grew rapidly from the 1950s to the early 1990s, but then its growth rate slowed significantly when its per capita income increased to about eighty percent of the U.S. per capita income. Japan has many world class firms, but its aging demographics mean that its growth rate will lag the U.S. rate. There are marvelous centers of industrial excellence in the European Union, but the populations in virtually all of the member countries are aging at a faster rate than the US population.

Several polls at the time of President Hu’s visit to Washington indicated that Americans believe China was more of an economic powerhouse than the United States. And the chatter is that China’s GDP will be larger than US GDP in 2019—or 2020. Maybe—but unlikely...

There are two groups of companies in China, the foreign multinationals and the domestic firms, which are often state-owned-enterprises. One impact of this distinction is that despite the surge in Chinese exports, it is difficult to identify a Chinese firm that is globally competitive and in the same league as a Samsung or a Lucky or a Hundyai. As per capita incomes and hourly wages in China increase, the feckless multinationals will shift to Indonesia, Bangladesh, and Vietnam as lower cost sources of supply.

President Obama’s State of the Union message highlighted the need to increase American competitiveness—the slogan “Win the Future” is compelling. But we’ve seen the competitiveness movie before; about every 20 years a new administration develops a program to enhance American competitiveness because the economy appears challenged by a country that is increasing its exports at a very rapid rate. the . Perhaps it will be different this time. Jeffrey Immelt of GE has been appointed to chair the Commission on Jobs and Competitiveness. One rationale for this commission is that America is falling behind in research and development spending, patents, and technological leadership. The infrastructure of roads and bridges and railroads is creaking and leads to higher business costs. Another rationale is that the commitment to competitiveness will enable the Obama administration to increase government spending on education, research, and infrastructure—although some skeptics will say that the only way to achieve agreement on more government spending when the deficits are exceptionally large is to wrap the proposal in the competitiveness ribbon.

How is competitiveness measured, and why are some countries more competitive than others? One measure of competitiveness is the cost of producing the same good in different countries. A more comprehensive measure is a country’s trade balance; countries with trade surpluses are competitive, and those with deficits are not. By this measure China is extremely competitive, while the United States is not.

Why are some countries more competitive than others? Low wage rates contribute to competitiveness, but many countries with low wages are not competitive. Competitiveness involves the relationship between wage rates and productivity, and the value of the currency. Taxes and regulations increase costs and dampen competitiveness. China is competitive—at least as measured by its large trade surplus—because of the package of its low wages, government subsidies to industry, tariffs and other import barriers, and currency market intervention practices.

U.S. competitiveness can be enhanced by eliminating various government policies that impede economic growth by dampening productivity. The United States may or may not need an energy policy—but the U.S. ethanol policy that requires that gasoline be blended with ethanol is stupid, since the BTU required to produce one gallon of ethanol is about equal to the BTU of the same gallon. (U.S. ethanol policy is a “tax” on food since the supply of grain available for food is reduced without adding significantly to the energy supply.) The U.S. tax system needs to be rationalized; the corporate income tax is a very uneven sales tax in drag and penalizes the efficient firms, since they pay higher taxes than their less efficient competitors in the same industries. The inefficiencies of the personal income tax are evident from the large number of accountants who make their living processing information for 1040 forms—it’s as if the U.S. Congress had legislated a full employment act for accountants.

One widely held view is that the tax system in each country handicaps domestic producers relative to foreign producers. The U.S. corporate tax rate is 36 percent—39 percent if corporate income taxes of various states are added to the federal tax. If the corporate income tax—which now generates $400 billion of annual revenues—were completely eliminated, competitive forces would lead most firms to reduce their selling prices. Lower selling prices would enable these firms to become more competitive in foreign markets and in the domestic market. U.S. exports would tend to increase relative to U.S. imports, and foreign currencies would tend to depreciate. Some U.S. firms would find that the depreciation of foreign currencies would be larger than the decline in their selling prices. (Hanover has a “dog tax” but the clever dogs in this college town have been able to shift the tax to their owners—similarly firms have shifted the burden of the corporate tax to their customers in the form of higher selling prices. We would all be much better off if the corporate tax were eliminated and a tax on value added or consumption adopted to generate the needed revenues.)

Assume that the Immelt Commission is brilliantly successful in identifying measures that will enhance U.S. productivity and in convincing the U.S. Congress to adopt its proposals. US productivity will increase; the potential U.S. growth rate will be higher. What will happen to the U.S. trade deficit?

Not much, because the U.S. trade deficit is determined by the desire of the Chinese, the South Koreans, the Singaporeans, the Malaysians to maintain undervalued currencies.

The challenge to the U.S. international competitive position comes from a dysfunctional set of international financial arrangements. When the Bretton Woods system was discarded, one view was that countries would permit their currencies to float. Some have, but many especially in Asia have not; these mercantilists have maintained currencies that are undervalued or greatly undervalued. The changes in ethanol and energy policy, as well as corporate tax and other areas, are attractive and will enhance U.S. productivity and the growth rate, but these changes will not make a significant impact on the U.S. trade deficit as long as international monetary arrangements remain dysfunctional.

THE U.S. ECONOMIC OUTLOOK FOR 2011

The U.S. recession that began in January 2008 ended on the fourth of July 2009. The U.S. economy has been in the recovery mode for the last 20 months; real GDP is now higher than the pre-recession peak at the end of 2007. Because of the sharp increases in productivity, employment in the private sector is seven million below the level of the previous peak. (The decline in new home construction from two million to 600,000 has led to loss of three million construction jobs—plus thousands of jobs in production of refrigerators, window treatment, landscaping, etc.)

The good news is that there has been an exceptional increase in productivity. Some of the productivity gains involve higher wages, but most have led to higher profits.

The economy is now in expansion mode. Corporate America is hiring. The number of those at work increased by 200,000 in February—and most of the hires were in the private sector. New claims for unemployment compensation payments have declined in three of the last four weeks. Household spending in the fourth quarter was at an exceptionally high rate relative to household income, which means that they are able and willing to borrow and spend. The increase in household spending in the last several months of 2010 led to a decline in business inventories; firms now must re-build inventories, which could add $50 billion to $100 billion to the 2011 GDP.

“Manufacturing unexpectedly accelerated in January at the fastest pace in more than six years.” The Philadelphia Federal Reserve’s index of manufacturing activity “rose to 35.9 in February from 19.3 a month earlier and is at its highest level since 2004.” Auto sales are up, perhaps by 15 to 20 percent. Ford has indicated that it is adding a third shift in its manufacturing plants.

The Washington news in the last several months has been encouraging. Bill Daley’s appointment as White House chief of staff means that there is a pragmatist close to the president who is interested in getting things done. President Obama’s op-ed in the Wall Street Journal about regulation suggests that the White House will begin to think about the costs of regulation. (New EPA regulations regarding the procedures to be followed when working around lead paint in pre-1978 structures seemed so onerous that one of our local carpenters has taken early retirement.) The appointment of Jeffrey Immelt as head of the commission on competitiveness and jobs reflects a much more pro-business view than was evident before. One of the surprise guests at the dinner for President Hu was Goldman Sachs chair Lloyd Blankfein—out of the doghouse into the White House. President Obama’s speech to the U.S. Chamber of Commerce was very conciliatory.

My bet is that the growth rate from the fourth quarter of 2010 to the fourth quarter of 2011 will be in the range of 4.5 to 5.0 percent. This growth rate isn’t in the current data, but reflects the view that optimism and confidence will be self-reinforcing. A five percent growth rate will mean two million more people will be employed, and the unemployment rate would then be bouncing around seven percent.

One of the unknowns is the impact of the political turmoil in North Africa and the Persian Gulf on oil supplies and the oil prices. The oil price is up by twenty five to thirty percent, neither because of increases in demand nor because of reductions in supply, but presumably because of precautionary purchases. The increase in price from $75 to $100 a barrel amounts to a bit more than $100 a year for those who drive ten thousand miles a year.

A second unknown is the impact of the tsunami in Japan and the problems in the nuclear reactors on economic growth in Japan and in its trading partners. The three prefectures on the northeastern coast that were directly affected by the massive tidal wave account for two percent of Japan’s GDP and a modestly smaller amount of its wealth. The clean up of the debris fields will be expensive. Several tens of thousands of new housing units must be built, and the infrastructure of roads and railroads and power lines must be repaired. Japan’s economic growth rate will increased significantly.

The second aspect is that there will be more attention to increasing the safety of older nuclear electric generators, both in Japan and in the United States and Europe

A third unknown is the implosion of the bubble in the housing market in China. The good news from what appears inevitable is that the sharp decline in the Chinese imports of basic commodities would lead to a significant decline in commodity prices and in the price of gold. The bad news is that the Chinese trade surplus would surge, especially its trade surplus with the United States, as Chinese manufacturers increase their exports to offset the slowdown in the growth of domestic sales.

Warren Buffett: Always Know What YOUR Company Is Worth

2011-01-31T14:48:00.002-06:00

We can't say it any better than Warren Buffett says it here:

I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion.

When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t ask the barber whether you need a haircut.”

- 2009 Letter to Berkshire-Hathaway Shareholders

Click here for a pdf of the entire letter.

Sunny Economic Forecast from Ativo Advisor Robert Z. Aliber

2011-01-31T14:16:00.005-06:00

Click here for a summary of Bob Aliber's current forecast.

The Country In a Funk

2010-11-01T08:33:00.006-05:00

Nov. 1, 2010
Guest Post by Robert Z. Aliber
Professor of International Economics and Finance Emeritus
Chicago Booth School of Business
University of Chicago
(Professor Aliber is a member of the Board of Advisors, Ativo Capital Management LLC)

Mid-September marked the second anniversary of the bankruptcy of Lehman Brothers, probably the most costly U.S. financial policy error ever. The sharp decline in housing starts that began early in 2007 led to a slowdown of growth. The recession started in January 2008; employment declined by 300,000 in the first nine months of that year—on average 30,000 a month. The Lehman bankruptcy triggered a panic and the most severe economic slowdown in 80 years; employment declined by six million in the last two quarters of 2008 and the first two quarters of 2009—an average of 500,000 a month.

Virtually all of the costs associated with the failure of Lehman could have been avoided if the U.S. Treasury and the Fed had been as bold as they were several days later when they put the credit of the U.S. government behind the IOUs of AIG. In effect the commitment of the U.S. Treasury to stand behind the large financial firms forestalled runs because the creditors received 100 percent deposit insurance. Saving Lehman would have cost the U.S. taxpayers $75 billion plus or minus $25 billion—Lehman’s shareholders would have been wiped out, its management banished to northern Siberia. Not saving Lehman will cost the taxpayers more than $2,500 billion. The U.S. government’s TARP (Troubled Asset Recovery Program) assistance to the banks was like a large vulture fund, and will be one of the most profitable investments that the U.S. government has made since the Louisiana Purchase in 1803. (The use of TARP funds to finance the re-start of GM and the housing market is a separate issue.) TARP provided liquidity when private suppliers were hiding under small stones. And it now appears that the investment of the Fed and the U.S. Treasury in AIG will at least break even.

Growth has been positive for the last four quarters and GDP has returned to the level reached at the end of 2007, but unemployment now is 17 million—and employment is six million less than at the peak.

The country is in a funk.

Q. Why all the angst in the country?

A. There’s a lot of unhappiness and concern that the market system isn’t working—except for the very rich—and that politicians are focused on advancing their careers rather than problem-solving. The Democrats and Republicans in Washington seem in perpetual stalemate. The prospect of fiscal deficits until the end of time indicates a U.S. government that is out of control. The spectacle is that of a rich country with many state and local governments that are broke, even though they were solvent when the country was poorer. The Chinese have all the money and seem to be eating our lunch.

Q. Okay, but are your comments reactions to newspaper headlines or the day-to-day observations about the well-being of American families?

A. Good question. Obviously there is a lot of personal grief among those who are out of work or have lost their homes. But my guess is that if you polled 10,000 randomly chosen individuals from around the country and asked whether they are comfortable in their personal circumstances, 80 percent or more would say yes. But they lack the confidence that their children will be better off, and are disheartened by the posturing in Washington and the nastiness of the political rhetoric.

Q. How well off is the country?

A. Do you believe the data or the press? The recession has been over for more than a year, yet there is a lot of chatter that a depression or a double dip is around the corner. The 2010 growth rate will be in the range of three to four percent.

Q. Anything else?

A. Glad you asked. Two members of the House Ways and Means Committee, including the chair, are under investigation for ethics violations. The House of Representatives is an old boys’ club, and it’s a safe bet that their offenses must have been severe before the members of the ethics committee blew the whistle on their colleagues. A member of the House from Texas awarded some scholarship money from the Black Caucus Foundation to members of her family. The chicanery doesn’t end there. The current governor of New York cadged free tickets from the Yankees and then denied it. And then there is the former governor of Illinois, who was convicted on one of 20-plus charges; three of the last six elected governors in Illinois have been sent to the pokey. And the current Secretary of the Treasury—who oversees the Internal Revenue Service—had some problems about 10 years ago because he failed to report all of his income when he worked for the International Monetary Fund.

Q. Can we get back to the economic issues?

A. About once a month the Obama administration seems to say, “We will have a new program to reduce unemployment.” The administration is long on rhetoric, and short, very short, on execution. The president said we will double exports in five years. Great—what has the administration done to promote exports? The promises that were made at the time of President Obama’s stimulus program about its impacts on reducing unemployment haven’t been kept. There’s a lot of uncertainty in the economy about the health insurance bill, taxes, and regulation. President Obama knows that the private sector—the business sector—creates jobs, and yet a lot his statements about the banks and the insurance companies dump on these firms. BP deserved to be spanked hard for the damage caused by the oil spill, but the company’s $20 billion commitment was a Chicago-style shakedown.

Q. Sounds like a chip on your shoulder?

A. You’re right. A lot of resentment about the rich pensions of public-sector employees—retire at age 55 after 30 years of work, collect a full pension, and move to a second career. And public-sector employees game the retirement system by taking a lot of vacation pay, sick leave, and overtime in their last year or two, to bulk up their last year’s total income and hence their pension. Public-sector employees are “monopolists” unless one wishes to move across town lines or state lines or to Brazil. The charter school movement is all about circumventing the teachers union and their protection of the tenure of incompetent teachers. The public sector accounts for a bit less than 20 percent of the labor force, but it has probably accounted for less than one percent of the increase in unemployment (after an adjustment for the temporary employees hired for the 2010 census).

Q. Is that all?

A. No, there is a more, a lot more. The rich seem to be getting richer; there is a new class of super-rich, with annual incomes that exceed $10 million. See the homes advertised in the Friday editions of the Wall Street Journal for $20 million and $30 million. I was at the airport on a Saturday in August. Chris—the lineman—was frazzled. When I asked Chris what the problem was, he responded, “Too many jets on the ramp at one time.” Why? “People taking their kids to camp.” In this new world, the cost of getting a few of the young to camp is three, four, or five times the cost of a month at camp. A lot of unhappiness about the bailout of the bankers.

Q. Sounds like the proverbial ball of wax, excuse the mixed metaphor. Can you disentangle the issues?

A. Okay, first it is important to identify why this economic recovery differs from those during previous recessions—and hence why the comparisons with the earlier recoveries are misbegotten. And then the relationship between the U.S. trade deficit and the U.S. output gap is examined, followed by the relationship between the U.S. trade deficit and the U.S. fiscal deficit. A comment on the quality of leadership at the Federal Reserve. Some observations on the China bubble, and some concluding comments on investing the $10 million lottery prize.

Q. This letter looks exceptionally long—how about a preview?

A. Great idea. Happy to oblige. America faces a “trinity” of macro problems: a large output gap and an unemployment rate that is too high by five percentage points, a U.S. trade deficit that is too large because U.S. net international indebtedness has been increasing relative to U.S. GDP, and a U.S. fiscal deficit that is much too large. The output gap could be reduced if U.S. government spending increases or if taxes are reduced, but the U.S. fiscal deficit would then increase and the U.S. trade deficit probably would increase, or the U.S. fiscal deficit could be reduced to a sustainable level but then the output gap and the unemployment rate would increase. The output gap and the unemployment rate can be reduced and the fiscal deficit reduced to a sustainable value ONLY if there is a significant reduction in the U.S. trade deficit—and that can occur only if the U.S. trade imbalance with China declines sharply.

The source of the problem is the unique U.S. position in a dysfunctional international financial arrangement. Every foreign country can manage the value of its currency to achieve the trade surplus or trade deficit that it wants—that it believes will enhance its own economic welfare. Since the sum of the trade deficits and the sum of the trade surpluses must approximate each other, the U.S. trade balance changes to ensure that there is global consistency; if foreign countries as a group want trade deficits, the United States develops the counterpart trade surplus. Conversely, for the last 30 years the United States has had a trade deficit because other countries as a group want trade surpluses. The U.S. trade deficit now is larger than the combined deficits of the next 10 countries with relatively large deficits. The Asian countries want low values for their currencies so they can grow their exports of manufactured goods, and as a result they have large trade surpluses, both absolutely and as a ratio of their GDPs. For example, China and Hong Kong together have a surplus of $298 billion (4.3% of their GDPs), Japan $177 billion (3.6%), Taiwan $40 billion (8.3%), Singapore $34 billion (12.6%), South Korea $33 billion (3.5%), and Malaysia $32 billion (13.0%). The arithmetic is that the U.S. trade deficit is not going to decline significantly unless China, Japan, et al. accept reductions in their trade surpluses. And the United States cannot reduce both its output gap and the fiscal deficit as long as the U.S trade deficit is $500 billion. The U.S. policy problem is to secure an adjustment in these global imbalances without appearing protectionist.

ECONOMIC RECOVERY AND UNEMPLOYMENT

Q. How well is the U.S. economy doing?

A. The traditional approach is to compare the pace of this recovery with those after recessions in the previous 50 years, which leads to the conclusion that the recovery is faltering. Spending is increasing by three to four percent a year, although the second-quarter growth rate was clobbered by a modest increase in imports relative to exports that was then annualized, and reduced the growth rate by 1.5 percent. Still, the recovery has been less robust than I had suggested three and six months ago because I had underestimated the extent to which previous recoveries had depended on increases in housing starts.

The competing approach is to assess the recovery in terms of the steepness and the depth of the hole that the U.S. economy developed following the Lehman panic and crash in mid-September 2008. Previous recessions generally resulted when the Federal Reserve raised interest rates and curtailed the growth of credit in an effort to restrain inflationary pressures—six or nine months later the Fed eased after the inflationary pressures had been contained. There were three exceptional features of the 2008 recession. One was the massive oversupply of housing, maybe 2.5 million units; the second was the sharp reduction in housing and personal wealth as home prices and stock prices plummeted; and the third was the de-capitalization of many large financial institutions. Most of the investment banks—Bear Stearns, Merrill Lynch, Lehman—failed, and Morgan Stanley survived only after a large capital injection from Mitsubishi. Wachovia Bank failed. Bank of America and Citicorp needed government financial assistance. GM and Chrysler went bankrupt. AIG, the largest insurance company in the world, had to be bailed out by the U.S. government. Several hundred relatively small banks failed.

The good news is that one million more people are at work than were a year ago. Auto sales are up, even though August sales seemed sluggish in comparison with those of a year ago, which were exceptionally large because of the “cash for clunkers” program. Home prices appear to have stabilized in most markets or are increasing, despite the large sales of properties that were taken over by banks. Corporate earnings are up. Airplanes are full—and airlines are hiring pilots.

The recoveries from previous recessions were led by increases in housing starts as developers responded to the decline in interest rates. In contrast, the recession that began in 2008 was a response to the decline in housing starts as both developers and lenders adjusted to the massive oversupply. The conventional assumption is that the demographic demand is 1.5 million units a year, which includes purchases of first homes by newly formed families and purchases of second homes and the replacement of the 300,000 units that have been lost to fire, floods, widening of highways and expansion of school playgrounds. During the bubble years between 2002 and 2006, housing starts exceeded the demographic demand by an average of 500,000 units a year, and the excess supply increased to 2.5 million units, which were owned by speculators and developers. House prices peaked at the end of 2006. Housing starts have been in the range of 700,000 to 800,000 units a year in the last several years.

The estimate for demographic demand is long-run averages; actual demand varies from one year to the next depending on labor market tightness, interest rates, and whether the mood of the country is upbeat or downbeat. (The intuition is that because the replacement of the 300,000 units lost to attrition is relatively constant, the cyclical variation in demand around the long-run trend is much greater.) The housing starts are a measured number, although completions lag starts, especially in a down market—some large condominium projects in Las Vegas and Snowmass/Aspen have been mothballed because the developers tanked. If the excess supply peaked at 2.5 million in mid-2007, then most of the excess supply has been worked off, and it’s a safe bet that most of the remaining excess supply is in Florida, Nevada, Arizona, and parts of California. A New York Times story indicates that there are 300,000 unoccupied units in Florida. The rental rate of return has increased sharply with the 30 percent decline in house prices. Mortgage interest rates are exceptionally low. (We refinanced three months ago, a 15-year conforming loan at 4.375 percent, and we will refinance in the next week or two at 3.75 percent. The annual interest savings will be $625 per $100,000 of mortgage. The one-time refinancing costs will absorb the first year’s saving from the lower interest rate. The present value of the savings for the subsequent 14 years is $12,000.)

Sometime in the future—perhaps the very near future—housing starts will increase. Each increase in housing starts of 100,000 will lead to an increase in the growth rate of 0.20 percent. An increase in starts means more demand for refrigerators, landscaping, window treatments, insurance, the whole smear.

The press harps on the 14 million people who are unemployed. In the best of times, the unemployment rate is five percent, so the excess unemployment is seven million. Moreover, there is continuous churning in the labor market; each month more than two million people find new jobs—but about two million plus or minus lose jobs. When the economy is at full employment, two million people lose their jobs each month, remain unemployed for 12 or 13 weeks, and then find work again.

Because of the churning in the labor market, a 10 percent unemployment rate means that, on average, each individual is without work for 25 weeks. But it’s not that straightforward—there are two to three million people who are in the wrong neighborhoods with the wrong set of job skills. The incomes of many of these people will decline when they find new jobs, so they will not look for work until their unemployment compensation is exhausted. (Their marginal tax rate when they again are employed is high. Assume that someone had been earning $750 a week before losing a job and that the weekly unemployment compensation payment is $300. If this person finds work again at $600 a week, the incremental income is $300, which works out to the minimum wage, $7.50 an hour before taxes. The “marginal income tax rate” for returning to work is 50 percent—as long as unemployment checks continue, the incentive to return to work is small.)

Q. What about the chatter that the U.S. economy is in another depression?

A. The polite response is that this view is mistaken, and the less polite one is that it is stupid. The downturn in the U.S. economy in the early 1930s lasted 17 quarters; the downturn that began in 2008 lasted six quarters. The excess unemployment rate is five percent now; it was 20 percent during the Great Depression. The U.S. price level declined by 35 percent in the first several years of the 1930s, while today the U.S. inflation rate is about one percent. Corporate profits were negative in the early 1930s, whereas corporate profits now are seven percent of GDP—exceptionally high. And the likelihood of a double dip is very small.

Q. Has the Obama administration’s stimulus program been successful?

A. Yes, an unequivocal yes. The federal government wrote hundreds of billions of dollars of checks. Each of those checks increased the income of the recipients. To suggest that the program didn’t work implies that the individuals who received the money saved 50, 60, or 70 percent of the increase in their incomes—and that seems highly unlikely. The individuals who were working on highway improvements funded by the American Stimulus Act spent most of their incomes. The schoolteachers who were not laid off spent most of their incomes. Yes, the household savings rate increased, but this increase was the traditional response to the decline in personal wealth following the collapse of real estate prices and stock prices. Hence the spending financed by the stimulus prevented an increase in the unemployment rate of 1.5 percentage points.

Q. Could you expand on the income and spending cycle?

A. Most people spend 90 or 95 percent of their incomes—and a lot spend every dollar they receive. Every time they spend, they provide income to the sellers and the employees of the sellers.

Q. Okay, but why aren’t we at full employment if most of the population spends most of its income?

A. There are three major leakages in the income-spending circle. One leakage is the U.S. trade deficit of $500 billion; Americans spend more on foreign goods than foreigners spend on American goods. The second leakage—perhaps $200 billion—is in the business sector—profits are high relative to new investment spending because firms are reluctant to spend. The third leakage—probably $600 billion—is household saving; personal wealth declined massively with the fall in house prices, and many millions of families are hanging on to their money in an effort to rebuild their wealth. (Remember that the U.S. household savings rate declined as the trade deficit increased. That was not an accident or a coincidence—the increase in the U.S. trade deficit resulted from an increase in the foreign demand for U.S. dollar securities, which contributed significantly to the bubble in U.S. real estate.)

Q. What is the counterpart of the $1.3 trillion noted in the previous response, which is the sum of the savings of the foreign, business, and household sectors?

A. The iron law of double-entry bookkeeping is that for every surplus there must be a corresponding deficit. If households increase their saving, the fiscal deficit will increase as spending declines, and as income and tax revenues decline. Hence it isn’t a coincidence that the U.S. fiscal deficit is $1.2 trillion—the fiscal balance of the U.S. government has adjusted to absorb all of that saving.

Q. Why is it that the U.S. economy grew at a respectable rate between 2002 and 2007, despite the large flow of foreign saving to the United States

A. Yes, but remember that household saving declined sharply from 2004 to 2007 in response to the surge in home prices and household wealth, and Americans went on a consumption binge. Now they are rebuilding their financial wealth in response to the decline in home prices—the mirror of the consumption binge.

Q. The press says that Americans are borrowing from the Chinese. Is that correct?

A. Yes and no. Yes, there is a flow of money from China to the United States. But the initiative for that flow is entirely on the part of the Chinese. The more accurate statement is that the Chinese are forcing their money on Americans. And—more on this later—Americans would be better off if there were a steady reduction in Chinese purchases of U.S. dollar securities.

Q. But how can the United States reduce and close the output gap?

A. Closing the output gap requires a massive increase in spending; if the output gap is $1.3 trillion, then spending must increase by $1.3 trillion. Part of this increase will be primary spending, and the rest will be induced by this increase in primary spending.

Q. What must happen if there is to be a significant decline in U.S. unemployment?

A. One of the four major sectors must increase its spending—that is, reduce its saving relative to its income. Households want to rebuild their wealth and are likely to increase the fraction of their incomes that they save. Still the surge in the household saving rate is past—the rate may continue to increase, but much less rapidly. Business firms must spend more of their profits—but they don’t want to invest more because they are not confident that these new investments will be profitable until the growth rate picks up; then they will invest more. The U.S. government must spend more—but most of the public believe that the fiscal deficit already is too large. If the U.S. government reduces its spending relative to its income, then the output gap will increase unless there is a reduction in saving by one of the other sectors.

Q. And which sector is most likely to increase its spending?

A. Households might increase their spending, but they are confused because they are being told to save more and to spend more. The business sector could increase its spending, but its spending tends to piggy-back on household spending. The government sector could increase its spending because it seemingly has unlimited credit, but political factors point to smaller fiscal deficits. Which leaves the foreign sector—and the focus is on the large trade imbalance with China.

THE U.S. TRADE DEFICIT AND THE U.S. OUTPUT GAP

Q. What would be the impact of a reduction in the U.S. trade deficit on the U.S. output gap?

A. Most of the reduction in the U.S. trade deficit would represent an increase in exports of manufactures relative to imports of manufactures (or a reduction of imports of manufactures relative to exports of manufactures). Assume initially that the value added per worker in U.S. manufacturing is $100,000; then each reduction of the U.S trade deficit by $1 million means 10 more manufacturing jobs. A reduction in the U.S. trade deficit of $1 billion means an increase of 10,000 jobs—and a $100 billion reduction means one million more manufacturing jobs. A reduction in the U.S. trade deficit of $400 billion would be associated with an increase in domestic employment of four million.

Wait, there’s more. Value added per worker in manufacturing is $80,000 rather than $100,000, so the metric is that each reduction in the U.S. trade deficit of $1 million leads to 12.5 more jobs. Hence the reduction in the trade deficit of $400 billion would mean five million more jobs. Moreover, these newly employed workers will increase their spending on domestic goods and services as well as on imports, and there will be a further increase in domestic employment (this is the secondary effect noted earlier). If the multiplier is two, then the reduction in the trade deficit of $400 billion would be associated with an increase in U.S. GDP of $800 billion. Moreover, there currently is not enough excess capacity in the U.S. manufacturing industry to increase production by $400 billion, so there would be a significant increase in business investment to increase capacity. It’s hard to estimate this impact, but the increase in spending could easily be $200 billion, and again there would be a secondary impact. The increase in spending of $1,000 billion reduces the output gap to $300 billion, say to two percent of GDP—the unemployment rate would decline significantly.

Q. Okay, so why doesn’t the Obama administration do something to reduce the trade deficit?

A. The Obama administration, like the Bush administration, has been leaning on China to allow its currency to appreciate in the belief that the trade surplus would decline as the currency appreciates. Earlier I have written that both the Bush administration and the Obama administration have confused “targets” and “instruments”; the target for U.S. policy should be a significant reduction in China’s trade surplus with the United States, and the increase in the value of the Chinese yuan is one—but only one—of the instruments that might achieve this target. A reduction in Chinese import barriers is another instrument. An increase in the value of the yuan by 10 or 20 percent will have only a modest impact in reducing the large trade imbalance; the Chinese export firms will sweat costs to maintain their market share.

The basic problem is the “design” of the international monetary arrangements. The International Monetary Fund was established to reduce the prevalence of “beggar-thy-neighbor” policies, but the Fund has lost its way—many of its members are “free riders” and manage their currencies to increase the numbers employed in manufacturing exports. Few Asian countries allow market forces to determine the market value of their currencies; most maintain low values for their currencies. The U.S. trade balance is the “stub entry” and changes to take on the value necessary to ensure global consistency for all trade balances as a group. If the sum of the intended trade surpluses that China, Japan, Norway, et al. want is larger than the sum of the trade deficits that other countries as a group can finance, the invisible hands go to work to ensure that the U.S. trade deficit increases.

THE U.S. FISCAL DEFICIT AND THE U.S. TRADE DEFICIT

Q. How severe is the U.S. fiscal problem?

A. Which of the four U.S. fiscal problems are you concerned about? The immediate problem is whether to continue with the Bush tax cuts of 2001 and 2003, or to allow some or all tax rates to return to their 2000 level. The next problem is to start on the path to a satisfactory budget balance over the next four years, which leads to the third problem of determining the appropriate fiscal balance when the U.S. economy is fully employed. And the fourth problem is to design a more efficient tax system.

Q. How much of the surge in the U.S. fiscal deficit since 2006 can be attributed to shortfall of revenues and how much to the increase in spending due to the stimulus and other government programs?

A. At the beginning of 2007 the U.S. economy was at full employment; fiscal revenues were $2.6 trillion, expenditures were $2.7 trillion—leaving a deficit of $162 billion, or slightly more than one percent of GDP. (If we agree that the U.S. government should have a modest surplus when at full employment, then revenues should have been higher relative to expenditures by two percent of GDP—say, $300 billion.) Revenues now are $2,100 billion, a decline of $450 billion from the 2007 baseline. Expenditures are $3,500 billion, $770 billion higher than the baseline. The U.S. fiscal deficit is $1,400 billion. Assume that the U.S. output gap of $1,300 billion disappears and that the marginal tax rate is 25 percent. Then U.S. fiscal revenues would increase by $325 billion. Government payments for unemployment compensation would decline and the stimulus program would have ended—assume another $300 billion reduction in spending. The return to the tax rates of 2001 would reduce the fiscal deficit by $220 billion. The U.S. fiscal deficit when the economy is at full employment would be $535 billion, or nearly four percent of full employment GDP. There has been massive expenditure creep.

Q. How did we get into this mess?

A. A flip answer is that the Republicans like to cut taxes and the Democrats like to increase expenditures. The Bush tax cuts of 2001 and 2003 were based on a view—a mistaken view—that there was a large budget surplus that reflected the fact that taxes were too high relative to expenditures. The strategy was to cut taxes quickly before the Democrats increased expenditures. The budget surplus of the last several years of the Clinton administration resulted from a surge in revenues due to the bubble in the stock market, which led to an increase in revenues of about 1.5 percent of U.S. GDP. The Bush tax cuts amounted to about two percent of U.S. GDP. The Obama administration’s 2009 stimulus program contained a tax reduction of $50 billion.

Q. Okay, what about the immediate problem?

A. Everyone acknowledges that the U.S. fiscal deficit is humongous and most agree the expenditures have surged—which means that government expenditures are too high as a share of U.S. GDP. One approach is to hold expenditures constant in nominal terms, and increase tax rates slowly and steadily to the 2000 level. For example, each of the marginal tax rates could be increased by one percentage point a year for each of the next four years; the top rate in 2011 would be 36 percent and the top rate in 2012 would be 37 percent, etc., until there is a return to 2000 rates.

Q. What about President Obama’s statements that he won’t tax the middle class?

A. Demagoguery. Look, I am all for raising taxes on the wealthy and super-wealthy, but the rich and superrich don’t have enough taxable income to make a significant dent in the fiscal deficit. Taxes on the middle class must be raised.

Q. But wouldn’t increases in tax rates delay the recovery?

A. The U.S. economy has been in a recovery mode for 15 months, and the recovery is likely to pick up momentum. Eventually tax rates must be increased. The gradual approach to increasing tax rates by one percentage point a year is much less disruptive than any of the other proposals.

Q. What should be the “target” for the U.S. fiscal balance?

A. Good question. The U.S. Treasury should have a fiscal surplus of one percent of U.S. GDP—say, $150 billion—when the U.S. economy is at full employment. The rationale is that a small surplus when the economy is buoyant will reduce the indebtedness, and then the country can have larger deficits when the economy is in recession or sluggish.

Q. What do you mean by the most efficient U.S. tax system?

A. Consider how the U.S. tax system has evolved. No one in Washington sat down and said, “What is an efficient tax system?” Rather, the politicians say, “We need more money. Where can it come from at the smallest political cost?” Tax systems evolve incrementally over generations—custom duties, estate taxes, sales taxes, personal income taxes, corporate income taxes, user fees, etc. An efficient tax system is one that raises the desired revenues with minimal distortions in the way people behave and with the lowest collection costs.

Q. How efficient is the U.S. tax system?

A. Consider a few of the distortions. The corporate income tax is a sales tax in drag, one that penalizes the most efficient firms. The differences in tax rates by source of incomes are a distortion; why should dividends be taxed at one rate and capital gains at another? Why should the deductibility of some payments depend on the level of income?

THE LIVING STANDARDS OF OUR CHILDREN

Q. What is likely to happen to the American standard of living in the next 10 to 25 years?

A. The key determinant of changes in the standard of living in the long run is productivity, which has averaged --about 1.5 percent a year. That means that the standard of living doubles every 48 years.

Q. What will be the impact of a reduction and elimination of the U.S. trade deficit on the U.S. standard of living?

A. True, the trade deficit reflects that Americans as a group are consuming more than
they are producing. But the U.S. trade deficit is about one-third of the U.S. output gap. The increase in the U.S. standard of living from closing the output gap would be several times larger than the decrease from the reduction of the trade surplus. Because of the output gap, seven million Americans are consuming but not producing.

Q. What would be the impact of reducing the fiscal deficit on the U.S. standard of living?

A. The supply of resources available to Americans is unchanged, so the standard of living for Americans as a group would be unaffected.

Q. What does this mean?

A. No reason to despair. Living standards for the next several generations of Americans will increase in response to productivity—resulting in a larger GDP with the same number of man hours. Consider that most amazing aspect of the financial revolution, the ATM machine—a marvelous substitution of dumb machines for tellers. E-mail is remarkable, as is the World Wide Web. But even if annual productivity remains unchanged, standards of living for the population as a whole will increase less rapidly because the number of retired individuals will increase relative to the number in the active labor force.

THE SCORECARD ON FEDERAL RESERVE MANAGEMENT

Q. What is your view on the Federal Reserve?

A. Great question. Remember that the Fed was established to enhance financial stability. Then its mandate was expanded to include price-level stability and high employment. Let’s grade each chair of the Fed on the basis of how well the economy performed under his leadership.

• Arthur Burns earns an F-..The inflation rate surged under his leadership because he began to manage the growth of the money supply in the summer of 1971 to enhance the election prospects of Richard Nixon in 1972.
• Inflation accelerated after William Miller became chair in 1977; nevertheless, charity suggests he merits a low C or a high D because he was unsuited for the task of managing a central bank.
• Paul Volcker became chair in the late summer of 1979, when the inflation rate was 12 percent, and he left (was asked to leave) in 1987, when it was evident that he was more interested in securing a further reduction in the inflation rate than in managing monetary policy to prep the country for the election of a Republican in 1988.
• Providing a grade for Alan Greenspan is difficult because the American economy prospered from 1987 to 2006 while he was chair; hence, he merits an A grade for most of the period and then a D after 2002, when the prosperity was based on a massive bubble in real estate credit..
• Bernanke merits a low grade prior to the collapse of Lehman, and a B+ subsequently. Bernanke’s role in merging Bear Stearns was commendable—but it took him too long to recognize that there was a housing bubble, and that the structure of credit that led to the sharp increase in house prices was extremely fragile.

Q. What is the problem with the Fed leadership?

A. One problem is two of the Fed chairs—Burns and Greenspan—have been too politically involved. Burns had been closely attached to Nixon for a long time. Greenspan wanted to be well liked and he strayed into commenting on fiscal policy in the 2001 debate.

Q. Anything else you want to add about the Fed?

A. The New York Times had a recent story, more or less a bio of Don Kohn, a career Fed employee who just retired as vice-chair of the Fed. Kohn believes that the decisions of the Bush administration about which firms to save (Bear, AIG, Freddie and Fannie) and which should be allowed to fail (Lehman) were appropriate. His apparent approval of the the decision to let Lehman fail is puzzling, since this was the single most costly financial decision in U.S. history. The increase in the debt of the U.S. Treasury was larger than the increase during the four years of World War II. Kohn’s assessment is indicates how out of touch with the markets the Fed was—or is.

Q. Why all this attention to the Fed?

A. Two reasons: Fed policies have a major impact on economic performance, and the Fed seems accident prone—the average grade over the last 35 years is in the C range. The Fed seems to have blinders on when it comes to its ability to read the future and to understand the economy.

Q. Anything else?

A. Sure. In 1913, the year the Fed was established, the U.S. price level was more or less the same as it had been in 1813. In 2013, the U.S. price level will be 20 times higher than in 1913. The Fed contributed significantly to the stock price bubble in the late 1920s, just as it contributed significantly to the bubble in U.S. credit markets after 2002. Volcker gets a high grade because he corrected the costly mistakes of his two predecessors. Bernanke gets a high grade after September 2008 because he corrected the inaction of his “two” predecessors, the Bernanke that chaired the Fed from February 2006, and the last three years of Greenspan’s tenure.

WILL CHINA EAT OUR LUNCH?

Q. What is your view of China’s economic performance?

A. A marvelous success story. Several hundred million people have moved out of poverty and now have a middle-class lifestyle. This year China will produce 13.5 million cars, several million more than the United States. China has a first-world infrastructure—the rail line to Tibet may be the only one that provides oxygen to its passengers. Great airports. Promising initiatives in nuclear energy and other advanced technologies. The Chinese have the capacity to throw an immense amount of money at a problem. They aren’t worried about permitting when it comes to nuclear issues or the safety of the subjects when testing new drugs.

Q. Why has China been able to achieve such a rapid growth rate for the last 30 years?

A. Review some of its inherent advantages: a very high savings rate, a strong entrepreneurial spirit, an immensely large excess supply of labor on the farms and in the villages, competition among the provinces for leading sector firms, no rule of law and no property rights, and a powerful state.

One of the most brilliant decisions of Deng Xiaoping in the early 1980s was to invite multinational firms to invest in China, to satisfy both the foreign and domestic markets. A major constraint on the ability of a country to achieve a rate of growth much higher than those of its trading partners is its need for foreign currencies to buy raw materials, capital equipment, and technical knowledge. If a country is to grow more rapidly than its trading partners, it must capture market share from them. (The Japanese and the South Koreans stiff-armed the foreign multinationals and kept them as far offshore as possible, although they wanted their technologies and their money.) Moreover, despite all the tensions with leadership in Taipei, Taiwanese firms were invited to China. Many of these firms already were sourcing in South Korea or Thailand or Malaysia, and they shifted to China to reduce the costs of supply.

Q. What is the impact of the rapid economic growth in China on the global economy?

A. One answer to this question involves arithmetic and the other economics. China is a big country—it has a massive population and is large geographically. China passed Japan as the second-largest economy in the world a few years ago; China’s share of world GDP has grown from two to 11-plus percent—and the arithmetic is that rapid growth in China has added to the world economic growth rate.

The economics involves the impact of China’s rapid growth on different groups of countries. Australia, Brazil, Canada, and other raw material exporters have had a bonanza of larger sales volumes at higher prices. Germany, Japan, and other countries that have exported capital goods have benefited. Great news for Boeing, American consumers, and the Wal-Mart clientele, and bad news for American producers of consumer goods. Overall the rapid growth of Chinese exports has depressed the profit rates in the United States and other countries that produce the types of goods that China exports. China has added more to global supply than to global demand, and the increasingly large Chinese trade surplus has had a deflationary impact on the United States.

Q. How much of the U.S. trade deficit can be attributed to the Chinese trade surplus?

A. That’s a hard one, at least to come up with a single number. China has a trade surplus of $250 billion; the United States has a trade deficit of $500 billion. China’s exports to the United States are five times larger than China’s imports from the United States, although many of these Chinese exports are largely embedded imports from Japan and South Korea and Taiwan, so Chinese value added is significantly smaller than its exports. Nevertheless, the Chinese trade surplus of $250 billion is all Chinese value added. If value added per worker in Chinese manufacturing is the equivalent of $5,000 a year, then the Chinese trade surplus provides employment for 50 million workers. (I have checked and rechecked—there is not an extra zero in the previous sentence.) Assume, just assume, that President Lou Dobbs tells the government of China, “We love free trade and we know you love free trade, and we will buy as much from you as you buy from us.” It is highly unlikely that any other country would be willing to incur a trade deficit so that China would continue to have a $250 billion trade surplus. China’s dependence on American consumers is enormous.

Q. What about the claims that China is financing the U.S. trade deficit and the U.S. fiscal deficit?

A. Forgive me, but these claims are ass-backwards. The flow of Chinese savings to the United States is the single biggest cause of the U.S. trade deficit. And, as noted earlier, if the U.S. trade deficit were smaller, then the U.S. fiscal deficit would be smaller.

Q. What are the unique aspects of China’s rapid growth compared with the growth in Japan and South Korea?

A. The rates of return and the profit rates on new investments are high in countries that grow very rapidly—eight to 10 percent a year. (Profit rates are several percentage points higher than growth rates.) Money flows to rapid-growth countries—think America in the 19th century—and they develop trade deficits. China, in contrast, is the only rapid-growth country that has had a large trade surplus—currently about four percent of its GDP. China has been exporting 10 percent of its savings. It has accumulated an immense amount of international reserve assets, now $2.8 trillion—it’s as if each of the 1.3 billion Chinese—the two-year-olds as well as those in their nineties—owns $2,500 of U.S. Treasury securities. In fact, these Chinese hold currency notes and deposits in their banks. The Chinese economy is very, very liquid, the money holdings per capita are extremely large.

Q. Have China’s holdings of international reserve assets surged as a byproduct of its desire to maintain a low value for the currency, or has a low value for the currency been needed because China wants an “outlet” for its excess savings?

A. Great question. The engineers who manage the Chinese economy may or may not have identified this question—or maybe they disagree about whether the desire to acquire foreign wealth requires that they have a low value for the currency, or whether the desire for a low value for the currency to stimulate exports has meant that they end up acquiring a bundle of foreign assets.

Q. What is the problem of acquiring a large volume of foreign assets?

A. Compare the rate of return to the Chinese economy if on the margin one million yuan are used to buy U.S. dollar securities or if instead the same amount of money is invested in plants and equipment in China. The real rate of return on Chinese holdings of U.S. dollar securities is a nickel above zero in terms of the U.S. dollar, and almost certainly negative in nominal terms in the yuan because of the eventual appreciation of the yuan. It is very hard to imagine a scenario in which China actually spends a significant part of its holdings of foreign assets—and if that assumption is accepted then the investments are gifts to the United States. (One scenario would be a major disaster in food production in China that would require massive imports of grains—but the exporters would probably apply quotas to limit Chinese purchases.) If instead the one million yuan is invested in domestic plants and equipment, the rate of return would approximate the growth rate.

This comparison suggests that China has acquired the foreign currencies as the byproduct of the desire to grow its exports.

One unique feature of China is that its savings rate is much higher than the savings rate in the other Confucian countries in the region. Japan, South Korea, and even Malaysia have achieved 10 percent growth. The implication is that if (a big IF) the capital-output ratios in these different countries are similar, China would have to grow somewhat more rapidly—perhaps by 12 percent a year—to absorb its savings. And the higher growth rate would have led to greater shortages of electricity, clean water, etc.

Q. What is the implication of China’s exports of savings that amount to four or five percent of its GDP?

A. Consider the comparison in the answer to the previous question. One implication is that the “export lobby” in Beijing has captured control of the management of the economy—and this is the sector where fortunes are being made. Another implication is that China wants other countries to adjust to its very high savings rate.

Q. Okay, but why is the savings rate in China so high?

A. That’s a hard one. Households save, business firms save (since there is no tradition of paying dividends), and even governments save. One reason household savings are so large is that China has a one-child policy. Young Charlie Chan will need to support his own two elderly parents, and the elderly parents of his wife.

Q. But is that the only explanation?

A. No. Assume that the GDP growth rate in China is 10 percent a year (line 1 in Figure 3), and that the savings rate is 40 percent; line 2 shows the value of accumulated wealth. The ratio of wealth to income doubles every six years. That would mean that this ratio in 2010 is six times higher than in 1990. Wealth from the point of view of the Chans and other individual households is capital from the point of view of the Chinese economy. Because of the very high savings rate, the Chinese economy has become much more capital intensive. But the paradox is that the increase in capital intensity has not led to an increase in the rate of economic growth (although it probably offset a decline in the rate that would otherwise have occurred). The result is that China uses its capital stock very, very inefficiently.

Q. Okay thus far, but how do you reconcile the negative or low rate of return on investments as a group with the fortunes that are being made?

A. Obviously individual investments make a lot of money. But the economy as a whole features massive Ponzi finance—individuals borrow against the value of assets that are hugely inflated in terms of their earning power. Eventually interest rates will increase, and the bubble will pop.

Q. How much longer will China be able to grow at eight or 10 percent?

A. Remember Andy Warhol’s quip, “Every one is famous for fifteen minutes” My bastardized version is “Every country grows rapidly for 15 years—or 20.” It is as if there is a growth rate hit parade, and different countries assume the top position on the parade for a significant part of a generation. When a country is small, it can grow much more rapidly than countries that achieved high rates of growth in the previous decades. When a country is large, it is much more difficult to grow rapidly because of constraints on the supply and demand sides.

Q. What are the constraints on the supply side?

A. Eventually every country runs out of excess labor, which explains why there are three million Turkish people in Germany and lots of Thais in Israel. More than 50 percent of the labor force in China remains on farms and in villages, so China is not likely to run out of labor for several generations. But China could run out of clean water and air, although these resources can be recycled, at a cost.

Q. What are the constraints on the demand side?

A. There are two aspects of this question, a foreign aspect and a domestic aspect. It will be more and more difficult for Chinese goods to increase share in foreign markets. Vietnam, Indonesia, and the Philippines are replacing China as sources of supply. Moreover, the United States will lean on China to reduce the bilateral trade imbalance.
The domestic aspect is that China’s growth may decline because domestic investment declines relative to domestic saving. Domestic demand would increase less rapidly than potential supply, much as in Japan since its bubble imploded.

Q. Why is there a bubble in housing in China?

A. The Chinese economy is all screwed up, as its centrally planned economy evolves into a market economy. It is as if Rube Goldberg had designed a system that would produce a series of asset price bubbles. (A lot of people in China have become very rich from these bubbles, especially in property.) The low value for the currency produces large trade surpluses, and the international reserve assets owned by the Peoples Bank of China and the reserves of the commercial banks increase rapidly. But the Peoples Bank doesn’t want the money supply to increase, so it sells its own IOUs to the commercial banks and then raises reserve requirements to ensure that the banks buy these IOUs. The authorities don’t want to yuan to appreciate, and they want to insulate the domestic economy from the large increases in reserves. There are interest rate ceilings on deposits, which are below the inflation rate, so individual Chinese households save a high proportion of their income to minimize the decline in the real value of their financial wealth. The demand for credit at the low interest rates is much greater than the supply, so there is some non-price rationing. The banks are told to lend to x and y, and they also lend to their cousins, brothers, sisters in-laws, outlaws, etc. A lot of people buy real estate, and they have profited enormously. (It is not a coincidence that this system is more or less like the one in Japan in the 1970s and 1980s, since the arrangement was imported from Tokyo after a visit by Deng Xiaoping in the early 1980s.) There is tremendous investment in industry, and a lot of overinvestment. But not to fear, the lenders are never asked to repay the loans, and the interest payments are added to their indebtedness.

The New York Times of Wednesday, October 19th has a front page story of a new modern city Kangbashi near Ordos, China, in the northern part of the country; Kangbashi was projected to have 300,000 residents at this time. The city is empty of residents. Real estate prices have increased from $15 a square foot in 2004 to $65 a square foot, on the basis of speculative purchases, more or less like Miami and Las Vegas in 2006. “So frenzied is the Ordos real estate market that some property developers have willingly taken out grey market loans with interest rates as high as thirty percent…….The spokesperson for one developer said “we could easily make a 300 percent return on a property development….If you think like that, paying 30 percent interest is really small.”

Q. How will the bubble in China end?

A. When a bubble is under way, virtually no one believes it will end. When the bubble in China ends, household wealth will decline sharply. Businesses will fail—or at least incur large losses. The losses that banks will incur on their loans will be immense. Households will curtail their spending—their savings will surge. Unemployment will increase sharply. The Chinese leadership will suddenly become much more humble.

Q. What are the implications of the implosion of the bubble in China for the United States?

A. The sharp slowdown in Chinese growth is bad news for the commodity producing countries and good news for consumers. The Chinese trade surplus with the United States will surge, which will mean a sharp increase in trade tensions.

Q. What about the value of the yuan?

A. That is a major uncertainty. Immediately before the June meeting of the G-20, the Chinese announced a change in their currency policy. That removed the heat that they would have anticipated at the meeting—and the yuan appreciated by 0.5 percent, and then retreated. The box is that the Chinese authorities do not want to appear to give in to foreign pressures, but they won’t budge in the absence of pressure.

Q. What should the U.S. government do?

A. The focus of the U.S. government should be to secure an agreement with the government of China on an orderly reduction in the bilateral trade imbalance. China should be free to choose how to secure this reduction. China is one of the most protectionist countries in the world; it could reduce its import barriers. If the government of China will not agree, then the United States should stipulate the targets.

Q. How would it work?

A. Lots of ways to make it work. One is that there would be a monthly quota on imports from China; quotas would be auctioned and the money used to reduce the U.S. fiscal deficit. When the quota is filled, no more imports could enter the United States until the beginning of the next month. Or U.S. exporters to China would earn vouchers that the could sell to those who want to import from China; every import from China would have to be accompanied by a voucher.

Q. Will a reduction in China’s trade surplus with the United States lead to an increase in the U.S. price level?

A. A trivial impact. U.S. imports from China are 20 percent of total U.S. imports. Imports are 15 percent of total U.S. consumption. Assume the price of U.S. imports from China increases by 25 percent. Remember that most of the prices that U.S. firms pay when they buy goods from China are like wholesale prices, a modest fraction of the U.S. selling prices.

Q. How would China respond to U.S. measures to reduce the trade imbalance?

A. Obviously much would depend on the measures chosen to reduce the large trade imbalance. Stability in the Chinese economy is very dependent on continued access to the U.S. market, China has a relatively weak bargaining position on narrow economic issues. U.S. imports from Thailand, Indonesia, Vietnam, et al. would replace U.S. imports from China—but the trade imbalance would diminish rapidly because the trade surpluses of these countries would be significantly smaller than the Chinese. The United States values cooperation with China on geopolitical issues, including stability on the Korean peninsula, weapons developments in Iran, and climate change.

Q. What about the Chinese threat that they would buy fewer U.S. dollar securities?

A. There are two possible responses. One is that China adopts measures to reduce its trade surplus with the United States. The other is that China seeks to maintain as large a trade surplus as possible, but China would then use the U.S. dollars that it earned from the trade surplus to buy the euro or the Japanese yen or the Canadian dollar. These currencies would appreciate, and the firms in these countries that produce exports and import competing goods would go bankrupt.

Q. What can the Chinese do with their holdings of U.S. dollar securities?

A. Not much, they are “locked in.” Assume they sold these U.S. Treasury securities and bought U.S. dollar deposits; these transactions would be reversed by the Federal Reserve. If the Chinese bought significant amounts of U.S. equities, the uproar would be immense. If instead the Chinese bought yen securities, the Japanese would go ballistic, and buy dollar securities to offset the Chinese purchases of the yen. If instead the Chinese sold dollars to buy the euro, the Europeans would complain. About the only transaction the Chinese might undertake that would lead to a reduction in their dollar holdings is to finance a large trade deficit that might have occurred because of a massive crop failure or some other natural disaster.

Q. Can you sum up your views on China?

A. China’s growth rate will slow as its investment bubble implodes. China’s exports then will surge, its imports will decline, and its trade surplus will increase sharply. Tensions with China over trade issues will become more intense.

INVESTING THE $10 MILLION LOTTERY PRIZE

Q. What are the key economic parameters that are the background for investing the $10 million lottery prize?

A. Moderate but accelerating U.S. economic growth. The U.S. inflation rate will remain low, in the absence of a major international political shock that would disrupt oil supplies. Short-term interest rates will remain exceptionally low for at least two years. China’s growth will slow as its investment bubble implodes. China’s trade surplus will increase, and its central bank will increase the proportion of non-dollar securities in its holdings of international reserve assets.

Q. What are the implications for commodity prices?

A. The real rate of return on a portfolio of commodities has been close to zero in the long run—over many decades. Demand increases as more and more countries industrialize; when prices increase in booms, there is a surge of investment in supply, and eventually prices decline as new supply becomes available. A key factor that had led to higher commodity prices in the last several years has been rapid rate of growth in China. The slowdown in the growth in China suggests that commodity prices will decline, and the presumption is that all of this decline has not been priced into the market because China continues to wear the halo of rapid growth.

Q. What are some of the implications of these assumptions?

A. Assume—just assume—that short-term interest rates are as low in Tokyo and London and Frankfurt as in New York; then the “carry trade” is dead. Mrs. Watanabe in Tokyo no longer has an incentive to withdraw yen funds from her account at Mitsubishi Bank to get the money to buy U.S. dollar securities. The currencies of the countries that have exported short-term money—Japan, Singapore, Malaysia, Germany and the European monetary union—will appreciate unless the central banks become much more active in their purchases of U.S. dollars. The currencies of the countries that have received this money—Britain, Australia, India, South Africa, Brazil—will depreciate.

The best bet for the carry trade is to borrow U.S. dollars to buy the Asian currencies on the assumption that the Chinese yuan will appreciate, and the other Asian currencies will appreciate with the yuan.

Q. What will happen to the euro?

A. The U.S. dollar price of the euro declined from $1.50 to $1.15 during the Greek debt crisis. Greece had a credit crisis, although some investors shorted the euro as a play on the credit crisis. The euro area as a whole has a current account deficit of $50 billion—Germany and the Netherlands have large surpluses while Spain, Italy, and France have large deficits. The adjustments in Greece, Ireland, Spain, and other euro zone members to reduce their large fiscal deficits will lead to a decline in their current account deficits, and hence the current account deficit for the euro area will decline. The Chinese will increase the share of euro-denominated securities in their portfolios. Both arguments suggest that the euro will appreciate further.

Q. And what will happen to the British pound?

A. The Cameron-Clegg Government inherited a massive fiscal deficit and is slashing expenditures, which will lead to a significant increase in unemployment; the reduction in government borrowing will lead to lower interest rates. Monetary policy will be more expansive, as long as the inflation rate is not too high. Lower interest rates will reduce the incentive to buy British pound securities. I don’t have an explanation for why the pound has appreciated relative to recently, although it may have been pulled up by the stronger Euro; my bet is that the pound will depreciate relative to the U.S. dollar.

Q. What about the U.S. dollar price of gold, now over $1,300?

Remember the cliché, “Gold is a great inflation hedge.” Between 1700 and 2000, gold was a perfect inflation hedge; the real rate of return on gold differed from zero by less than a measurement error. The U.S. dollar price of gold now is five times higher than in 2000—a rate of return of about 20 percent a year. Why? One explanation is that the convention is to price gold in terms of the U.S dollar, even though the “price makers” are in euro. Since the euro was undervalued by 30 percent in 2000, about one-third of the increase in the U.S. dollar price—say, from $300 to $400—resulted from the appreciation of the euro. The euro price of gold is three times higher than in 2000. Why? The principal explanation is that risk-averse investors believed that it was wise to hold some of their wealth as a commodity because they were concerned that financial Armageddon was around the corner and that paper money including claims on banks and central banks would become worthless. Maybe it was wise to hold a small proportion of one’s wealth in gold during the crisis—but the crisis is over.

Q. What about U.S. dollar bonds?

A. As I said earlier, we refinanced our home mortgage in April/May and intend to do so again in the next several weeks. A marvelous time to be a borrower—which means it is an unattractive time to buy long-term bonds—unless you can find some bonds that have been beaten up because they were deemed too risky.

Q. What about the stocks?

A. An immense amount of noise in the stock market on a day-to-day basis, probably because of the high-frequency trading strategies. Still, corporate profits came through this severe downturn with less trauma than in the 1980-1982 period. And the brunt of the decline in profit share was borne by the financial and the energy firms. Real U.S. GDP is likely to be 10 to 15 percent higher in 2014 than in 2010. Corporate profits are likely to be 15 to 20 percent higher than in 2010. These assumptions suggest that the total return on stocks will approach ten percent.

Q. Is your U.S. growth assumption consistent with your interest rate assumption?

A. If potential output increases by three percent a year, and the output gap is nine percent of GDP, then output could increase by five percent a year for nearly five years before the economy returns to full employment. The Fed is likely to be accommodating until the price leve l begins to increase.

Q. You are remarkably upbeat, especially for someone in your age cohort. What worries you most?

A. Thanks, I was hoping that you would ask. Trade tension with China is a major uncertainty.

Strengthening International Monetary Arrangements

2010-10-14T15:20:00.004-05:00

Oct. 14, 2010
Statement by Robert Z. Aliber
Professor of International Economics and Finance Emeritus
Chicago Booth School of Business
University of Chicago
(Professor Aliber is also a member of the Board of Advisors, Ativo Capital Management LLC)
Before the Ways and Means Committee
United States House of Representatives
March 24, 2010

I am honored by the invitation to testify before this Committee and regret that I have a long standing commitment to be in Beijing on the date of these very important hearings.

First, my background. I have studied international financial issues for more than fifty years, including currency questions and the evolution of international monetary and banking arrangements. Much of my research and writing in the last fifteen years has centered on international financial crises—the last forty years have been exceptional in terms of the waves of asset bubbles and the severity of the subsequent financial crises.

The paradox of the last sixty years has been the unprecedented global economic growth despite these waves of crises. There have been remarkable improvements in public health, longevity, education, and economic well-being in much of Asia, most of Southern Europe, and many other countries. Much of that success can be attributed to the openness of the global economy and the opportunity that the developing countries have had to sell their manufactured goods in foreign markets. Access to the U.S. market has been a catalyst for rapid economic growth throughout Asia, because this market is large and diverse. Americans have benefited from the increase in the variety of foreign goods and the impact of these goods on the quality and variety of products that American firms have developed in response.

My comments today are in three sections. The first section reviews the US role as the dominant reserve currency country for most of the last 100 years. The U.S. dollar evolved into a reserve currency because foreign central banks concluded that U.S. dollar securities were an effective store of value, more so than securities denominated in any other currency.

The second section deals with measures to enhance the reserve currency role of the U.S. dollar. The United States should adopt measures to stabilize and strengthen the reserve currency role of the U.S. dollar. The objective of stabilizing this role is to reduce and minimize the susceptibility of the U.S. economy to shocks from other countries—like the shock that has led to these hearings. China and other foreign countries want trade surpluses, and the United States has passively imported the counterpart trade deficits, at substantial cost to the profits and employment of U.S. manufacturing firms.

The third section deals with the global imbalances that have developed as a result of the industrialization in China. It is absurd that one of the poorest countries in the world has purchased $2,500 billion of U.S. dollar securities when that money could be used to help the 700 million or 800 million Chinese that have incomes that are still below and in some cases far below the poverty line. China should be encouraged to adopt measures to reduce its bilateral trade surplus with the United States. The U.S. policy objective should be to secure an orderly reduction in China’s trade surplus, which could occur if the domestic financial structure is revamped, or if imports are encouraged, or perhaps if the yuan appreciates. By itself the appreciation of the Chinese yuan by ten, fifteen, or thirty percent is not likely to lead to a significant reduction in the large Chinese trade surplus unless there are accompanying changes in financial structure in China. The Chinese economy has significant flexibility in costs and prices, and a large appreciation of the Chinese currency will induce a significant decline in costs of production, so the decline in the trade surplus is likely to be modest. A policy instrument that could reduce the Chinese trade surplus with the United States in an orderly way is presented in this section.

THE US ROLE AS A RESERVE CURRENCY COUNTRY—THE HISTORY

The U.S. role as an international reserve currency country began more than one hundred years when the term “the gold standard” described the international monetary system. Firms headquartered in other countries and foreign central banks found it in their self-interest to acquire U.S. dollar securities and U.S. bank deposits to facilitate their international transactions. These groups were “voting with their feet”; they wanted to minimize transactions costs associated with international payments and protect the value of their financial wealth.

One analogy for the evolution of the U.S. dollar as a reserve currency is provided by the development of money, which began in pre-history; coins manufactured from several different metals were developed they were costly to use in payments than barter, which was exceedingly time-consuming; comparative price shopping in a barter economy is a high cost activity. Each money has three attributes—as a unit of account or measuring rod, as a means of payment, and as a store of value. Coins made of gold, silver, and copper were among the first monies. These coins complemented each other in transactions because they had different value-to-weight ratios and they were competitive with each other as stores of value. Gold eventually dominated silver as a store of value, partly because new silver discoveries led to decline in its price relative to the price of gold.

Paper money evolved because it was less costly to use in payments than commodity monies, especially in payments of a very large amount and payments over large distances.

The U.S. dollar is a unit of account in the global economy; the prices of many commodities—gold, petroleum, coffee, palladium—are stated in the U.S dollar, even in transactions outside the United States. The U.S. dollar is a means of payment; when the Japanese importers of Mercedes and BMWs pay the German exporters, they first buy the U.S. dollars with Japanese yen and then use the U.S. dollars to buy the Euro. The U.S. dollar is a store of value; foreign central banks hold $5,000 billion of U.S. dollar securities.

The primary reason that the U.S. dollar became a reserve currency at the end of the nineteenth century was that the United States then was much the largest economy, about three times larger than the British economy. Some foreign firms and foreign central banks acquired U.S. dollar securities because they had a “short foreign exchange position” in the U.S. dollar. Some foreign central banks concluded that U.S. dollar securities were more likely to retain their purchasing power over market baskets of goods and services than securities denominated in most other currencies. The expectations of the central banks that bought U.S. dollar securities as a store of value have been satisfied. The real rate of return on U.S. bonds has averaged three to four percent over the last four decades.

During the last thirty years that the United States has evolved from the world’s largest creditor country to the world’s largest debtor country because of a surge in the foreign demand for U.S dollar securities, not because the U.S government borrowed abroad.

Moreover in the last twenty years there has been a remarkable transformation in the motives for the purchases of U.S. dollar securities by central banks in a few foreign countries. Initially, foreign central banks purchased U.S. dollar securities because they wanted to hold more international reserve assets. More recently, the central banks in China and few other countries have purchased U.S dollar securities because they wanted to increase employment in their export industries and so they maintained undervalued currencies. Their trade surpluses have been large, both absolutely and as share of their GDPs, and they have used the money acquired from their export surpluses to buy U.S. dollar securities because they concluded that they did not have any good alternatives.

There are two popular misconceptions about the relationship between the U.S. trade deficit and foreign purchases of U.S. dollar securities and the U.S. fiscal deficit. Consider the statement like “The United States receives a large volume of low cost imports from China and has gotten help in financing a significant part of its budget and current account deficits.”

First consider the relationship between foreign purchases of U.S. dollar securities and the U.S. trade and current account deficits. If foreigners were not net buyers of U.S. dollar securities, the United States would not have trade and current account deficits. It’s that simple—this statement follows directly from the balance of payments accounting identity. The United States developed a trade deficit because foreigners bought U.S. dollar securities and U.S. real assets, which led to a lower value than they otherwise would have had and their exports to the United States increased more rapidly than their imposts. If foreign central banks stopped buying U.S. Treasury securities, their currencies would appreciate and in some cases sharply, and the U.S. trade and current account deficits would decline.

Now consider the relationship between the U.S. trade deficit and the U.S. fiscal deficit, which is more nuanced, partly because the factual needs to be compared with the counter-factual. The U.S. trade deficit is four percent of U.S. GDP; prior to the financial crisis the U.S. fiscal deficit was about three percent of U.S. GDP. Consider a mental experiment, the U.S. trade deficit disappears, perhaps because the foreign demand for U.S. goods increases by $600 billion, or because the U.S. demand for foreign goods declines by $600 billion and the U.S. demand for domestic goods increases by $600 billion. The increase in the demand for U.S. goods of $600 billion would lead to an initial increase in U.S. GDP $600 billion. The U.S. government’s tax receipts would increase by $200 billion, the product of the $600 billion increase in U.S. GDP and a marginal tax rate of 30 percent. American households and firms would increase their spending by $360 billion, the product of the increase in the after-tax incomes of $400 billion and a marginal spending rate of 90 percent.

The increase in their spending of $360 billion would lead to an increase in U.S. GDP of $360 billion. The U.S. government’s tax receipts would increase by an additional $108 billion, the product of the increase in U.S. GDP of $360 billion and the marginal tax rate of 30 percent. Households and firms would increase their spending by 90 percent of the increase in their after-tax incomes of $252 billion. U.S. GDP would increase by an additional $227 billion. U.S. fiscal revenues would increase by $68 billion.

The increase in U.S. GDP from the disappearance of the U.S. trade deficit would be several times larger than $600 billion, and the increase in the tax receipts of the U.S. government would approach $400 billion. Moreover unemployment compensation payments and other government expenditures would decline.

Between 2002 and 2007, the U.S fiscal deficits were in the range from $250 billion to $400 billion. A significant part of these U.S. fiscal deficits were induced by the U.S. trade deficit, which followed from the purchases of U.S. dollar securities by foreign firms, governments, and central banks.

Obviously foreign purchases of U.S. Treasury securities have helped finance the U.S Government’s fiscal deficit, but these purchases caused the U.S. trade deficit and contributed significantly factor to the U.S. fiscal deficit. Some press chatter has raised the question, “What would happen to interest rates if the Peoples’s Bank of China sharply reduced its purchases of U.S. Treasury securities?” . The interest rates on U.S. dollar securities are the price of the stock of all debt—personal, corporate, and government— and the annual foreign purchases have been small relative to the total debt and thus have had a modest impact on U.S. interest rates. Statements that the reductions in Chinese purchases of U.S. Treasury securities would lead to a significant upward impact on interest rates also fail to recognize that these reductions would lead to a higher level of U.S. GDP and a smaller U.S. fiscal deficit.

MANAGING THE RESERVE CURRENCY ROLE OF THE U.S. DOLLAR

For most of the last one hundred years the United States could ignore the problem of managing the reserve currency role of the U.S. dollar. That luxury was possible because foreign holdings of U.S. dollar securities were small relative to U.S. GDP and to the U.S. net international investment position. Moreover, through most of this period, the United States was a creditor country

That is no longer the case. Foreign holdings of U.S dollar securities are large relative to U.S. GDP. The surge in foreign purchase of U.S. dollar securities has caused the transformation of the United States from the world’s largest creditor country to the world’s largest debtor.

International monetary arrangements often are in flux, especially as the relative size of countries changes. Some observers have concluded that the U.S. role as a reserve currency country is too costly. Perhaps. Consider the alternatives to the continuation of the U.S. role as a reserve currency country. One alternative is that some other country develops a reserve currency role, and supplants the U.S role, much as the United States supplanted Britain. That seems highly unlikely in the next ten to twenty years, although the Euro may become more of a reserve currency. The other dominant alternative is that an international institution develops its own currency, much as the European Monetary Union led to the creation of the Euro to supplant the currencies of ten or eleven of its members. That also seems unlikely.

As long as the U.S. dollar remains a reserve currency, it is a U.S. responsibility to ensure that the costs of this role to the American economy are minimized while the advantages to our trading partners remain large. The objective in managing the U.S. reserve currency role is to minimize the likelihood and the severity of the shocks to the economy from changes in the foreign demand for U.S. dollar securities Increases the foreign purchases of U.S dollar securities lead to declines in the competitiveness of American goods in foreign markets; if foreign central banks increase their purchases of dollar securities, the U.S trade deficit increases, and employment and profits in U.S, manufacturing increase. In contrast, if there were a sudden sharp decline in the foreign demand for U.S dollar securities, the U.S. trade deficit would decline sharply, which could lead to an increase in the U.S, inflation rate if the increase in demand is larger than the excess capacity in U.S, manufacturing industry.

One opportunity to manage the U.S. reserve currency role occurred in the 1960s; there was then a shortage of monetary gold. The world price level had more or less doubled in the 1940s and the 1950s, largely as a result of finance associated with World War II and the relaxation of ceilings on prices and wages that had been adopted during the war. The U.S. government was adamantly against raising the U.S. dollar price of gold, primarily for domestic and foreign political reasons. The markets brought about the inevitable, and there was a surge in the U.S. dollar price of gold. Now the United States no longer has the option to increase the U.S. dollar price of gold.

There are two different approaches to managing the foreign demand for U.S. dollar securities. One is centered on the U.S. trade account, and on the relation between U.S. imports and U.S. exports. The other is centered on U.S. financial accounts, and the foreign demand for U.S, dollar securities.

Measures to strengthen the U.S. reserve currency role could be applied to all U.S. transactions or they could applied to transactions with those foreign countries that have been large buyers—excessively large buyers--of U.S. dollar securities.

First consider several measures that could be applied to transactions in goods. One measure would apply a temporary tariff of ten percent or fifteen percent on imports from countries that have trade surpluses that are judged to be large. Another measure would require that countries that wish to sell in the United States would have to attach a coupon that they had purchased from U.S. exporters. These exporters would be given coupons when their goods leave the United States, and they would be free to sell these coupons to firms that want to import.

Now consider the range of instruments that are available to the U.S authorities that would impact the foreign demand for U.S. dollar securities. The direct instruments include changes in interest rates on U.S. dollar securities, a new issue of U.S. dollar securities that would be similar to TIPS, a tax on interest income of foreign central banks, and controls that would limit foreign purchases of U.S. dollar securities.

CHINA’S INDUSTRIALIZATION AND ITS MASSIVE TRADE SURPLUS

The ratios of the U.S. trade deficit to U.S. GDP and of the increase in U.S. international indebtedness to the increase in U.S. GDP in the last several years have been too large to be sustainable. The single most important counterpart of the U.S. trade deficit is the Chinese trade surplus. China has been reluctant to increase its imports from the United States as its exports of manufactures to the United States have increased rapidly.

China has been one of the great economic success stories of the last fifty years. Taiwan was one of the earliest, followed by Japan, and then South Korea and most recently Thailand and Malaysia. These countries experienced exceptionally high rates of economic growth when workers move from the farms and villages to the cities and the factories and initially produced inexpensive manufactured goods that were exported. Each of these countries has been able to achieve a rapid growth in its exports because of the openness of the U.S. market to foreign goods.

The pattern of economic growth in China is similar to those in other countries in Asia that have achieved high rates of growth. Productivity gains in some sectors of manufacturing have been exceptionally high, and these sectors have been able to reduce their selling prices while paying higher wages to attract labor. The high incomes in manufacturing have led to increases in demand for agricultural products and services; because productivity gains in these sectors have been modest, the prices charged by the sellers in these sectors have increased, and the real incomes of those in these sectors have increased. The increases in the prices charged by these sectors have dominated the declines in the prices charged in the export-oriented sector of manufacturing.

The pattern to money flows between countries at different stages of economic development generally conforms with economic intuition and theory. Money flows to a country during the early stages of its industrialization in response to anticipated high rates of return associated with its rapid rate of economic growth. Thus the money flows to the United States during the nineteenth century were consistent with this pattern. The most rapidly growing countries almost always have trade deficits—much like the United States had trade deficits in the first half of the nineteenth century. Then when their growth rates slowed, the pattern of money flows has been reversed, and the money flows from the countries that formerly had been growing rapidly.

China has been an exception to this pattern. China is the only country that has exported large amounts of money during the early stages of its industrialization, when its per capita GDP has been much lower than those in the countries that received this money. This perverse pattern of money flows has resulted because financial regulations have limited the interest rates that banks could pay on their deposits and quantitative restrictions set by the Chinese government that limited the ability of Chinese banks to increase their loans. This quantitative restriction appears to reflect the concern that the more rapid increase in bank loans would lead to an increase in the inflation rate. Perhaps. But if China were to re-arrange its financial structure so that its imports more or less matched its exports, the total supply of goods and services available to the Chinese economy would increase immediately by five or six percent, which would put very significant downward pressure on the overall price level The money that China has used to buy U.S dollar securities instead could have been lent to business firms in China, and China’s imports then would have increased to match the increase in its exports.

The United States is under no obligation to have a trade deficit because China wants to have a trade surplus. If the Chinese currency had been freely floating in the last ten years, then the rapid increase in its exports would have led to an appreciation of its currency, and China’s imports would have increased rapidly—and dampened upward pressure on the consumer price level. Instead the Chinese currency had been pegged, and the large trade imbalance has put downward pressure on U.S. prices and incomes.

China’s trade and current account surpluses are too large relative to the ability of its trading partners to adjust to the counterpart trade deficits. Moreover, the Chinese trade surplus has been increasing. Further, the prospect is that that as the growth rate in China slows, as it inevitably will, then money flows from China will increase and the Chinese trade surplus will increase further.

A larger Chinese trade surplus means that the trade deficits of some other countries will increase. The U.S. trade deficit is likely to increase. The United States has no obligation or commitment that requires that it passively accept an increase in its trade deficit because China wants to have a larger trade surplus.

The U.S. Government should seek an agreement with the Government of China on an orderly reduction in the Chinese trade surplus with the United States. Chinese officials should be asked to provide their estimates of the “end game”—how they believe that the Chinese trade and current account surplus will evolve.

The United States should indicate to China the maximum acceptable bilateral trade imbalance, and a time line for the orderly reduction in the Chinese trade surplus.

There are several different measures that China can adopt to reduce its trade surplus. One that receives a great deal of attention is to allow the yuan to appreciate. Another is to reduce its import barriers and to encourage imports, even to the extent of subsidizing imports. A third is de-regulate its financial structure. There may be other changes in policy. These measures can be used together.

The U.S. government should allow China to decide how to reduce its extraordinarily large bilateral trade surplus with the United States.

If the bilateral Chinese trade surplus with the United States remains larger than that deemed acceptable, the U.S. Government should adopt measures to supplement any that might be adopted by the Chinese to reduce its large trade surplus. One measure is ten percent tariff on imports from China; the tariff rate would be increased until the trade imbalance declines to a sustainable value.

A second measure is to link U.S. imports from China to U.S. exports. U.S. exporters would receive “trade points” for each dollar of sales from the United States; these points would be recorded at a special account in the Department of Commerce. These exporters would be free to sell these points to firms that want to import. U.S. firms that want to import from China would be obliged to acquire the appropriate number of these points in the free market before these goods would be allowed to enter the United States.

U.S. exports would be promoted by this arrangement because the revenues of U.S. firms that sell abroad would be higher because of receipts from the sale of the “trade points.” U.S. import growth would be slower because the U.S. dollar cost of imports would be higher because of the amount that importers would have to pay for these points.

U.S. exporters would receive points regardless of the destination of their sales. Only imports from countries that have trade surpluses deemed exceedingly large would be required to participate in the point arrangement.

The U.S. Treasury would change the number of points required to import goods from China to ensure that there is an orderly decline in the trade imbalance.

The introduction of “trade points” to supplement the market price is not a first best solution, which would involve measures by China to increase its imports.

Measures that the United States might adopt to reduce its trade deficit would bring forth cries of protectionism. These protests are nonsense, a country that that has a trade deficit of three, four or five percent of its GDP is not protectionist.

CONCLUSION

The focus of U.S. policy toward the excessively large bilateral Chinese trade surplus with the United States should be to secure an orderly decline in the trade imbalance to a sustainable value. The Chinese government could use several different instruments to secure this adjustment—the government can allow the currency to appreciate, or it can increase its imports from the United States or it can allow domestic prices to increase.

If the Chinese government does not adopt measures to reduce its bilateral trade surplus with the United States, there are several different measures that the United States should adopt. One is a temporary across-the-board tariff of ten or fifteen percent on all imports from China; the tariff rate could be increased systematically until the trade imbalance declines to a sustainable level. Another is to require U.S. importers from China to deposit “trade points” that they would purchase from U.S. exporters. The tariff and the trade points can be used together.

ESG/Sustainability Investors Should Engage Directly with Company Executives

2010-09-22T09:39:00.006-05:00

Guest Post by Pamela Styles, Principal, Next Level Investor Relations LLC

Investors and company executives should be concerned about the lack of time and attention investor relations officers (IROs) feel they have available to understand the constructive and rapidly evolving investor attention to ESG (environmental & energy, social issues and corporate governance)/Sustainability factors in investment decisions, especially given estimates of related global managed assets that range from $18 to $27 trillion (see Rigorous Thinking or UN Principles for Responsible Investing reports.)

Thoughtful assessments in two recent Rigorous Thinking postings do not overtly speak to the investor relations dimension, but provide good background. See American Angst, by Professor Bob Aliber and The Shareholder Value Case for Corporate Responsibility, by Aust/Allen. In American Angst, Professor Aliber stopped short of mentioning regulatory/legislative “reforms” in his economics-based commentary including the observation “There is a lot of chatter that President Obama’s stimulus hasn’t worked.” Without debating whether the wave of reforms related to stimulus efforts and attempts to “fix the system” will be effective, or will simply serve as window dressing to appease constituents, rapid reforms efforts are taking valuable time of public company executive teams, including investor relations.

Contributing factors to overcome in order for IROs to prioritize time and attention toward ESG/Sustainability related communications likely include:

Thirty years, or so, of “activist” and “gadfly” haranguing of publicly traded companies in the name of SRI (Socially Responsible Investors) - also referred to as CSR (Corporate Social Responsibility) - has left IR and other executive management skeptical and jaded.
Regulatory and reporting “reform” initiatives, and other efforts to augment additional non-financial reporting requirements, have significant practical implications for company management. The amount of time spent looking in the “rear view mirror” to expand disclosure on what has already happened may arguably be getting (or already is) unproductively disproportionate.
Institutional investors who may think they are asking companies their ESG/Sustainability related questions, but may mostly be relying on other third party ESG-focused organizations, such as ESG-focused stock indexes, ratings and collaborative groups, to aggregate the information for them. This may be the cause for why many IROs with whom I speak about ESG literally say, “…investors are not asking, so ESG can’t be that important or worth my time…” The most memorable comment to-date, “…I have too much wood to chop before I’ll ever get to ESG…”, which came from an IR colleague at a $20bn company.
The classic way third party ESG-focused organizations obtain company information through the practice of sending out overwhelming volumes of questionnaires, which land most often (directly or indirectly) with the company IR departments. The questionnaires are so detailed and specific that the vast proportion are set-aside or immediately discarded. There is also the tension between public companies and investors and politicians/regulators regarding other massive/broad new information requests. Not only may companies lack comparable and consistent information tracking across the company, the information may be considered competitively sensitive. Retrofitting information systems and communications is very time consuming and doesn’t happen “over night.”

Corporations and investor relations are simply overwhelmed. It is truly unclear as to whether the current regulatory/legislative “reforms” will actually protect shareholders and the U.S. economy from future crises and “fix the system”, or just cause costly distraction.

Productive efforts and intent by institutional investors to focus on ESG/Sustainability information in investment decisions are being frustrated by all of the above. I encourage investors to simply pick up the telephone and start engaging company IR and C-suite executives in direct ESG/Sustainability related conversation – stay focused on your few key concerns specific to each company/sector. Make it very clear that your firm looks seriously at ESG/Sustainability factors in investment decision criterion, if in fact true. Engagement in constructive dialogue is likely the best way to help corporate executives focus on the critical bits of new specific information investors need. Engagement should also help them appreciate that the new generation of ESG/Sustainability investor is now simply mainstream and conscientious in its due diligence efforts towards long-term investment.

The Outlook for Non-US Equity Markets, guest blog by William J. Cridland

2010-09-08T09:34:00.004-05:00

The outlook for non-US equity markets overall remains favorable. However, performance will diverge by geographic region. In contrast to other recoveries from global economic downturns, the US is not leading the world out of recession this time around.

Western Europe’s equity markets clearly have been buffeted by concerns about the outlook for Greece and to a lesser extent Portugal and Spain. However, there are emerging signs of economic recovery on the part of Germany, Europe’s largest economy, and the UK, where a serious austerity program could be put in place. Overhanging the region’s outlook are concerns about the banking sector largely due to capital considerations as well as the exposure of the region’s banks to sovereign risk. Importantly, the impending Basel III capital regulations are likely to be phased in so as to avoid the need for massive near-term capital raises on the part of the banks. All-in-all, the recently implemented EEC bail-out plan for Greece has calmed the European bourses somewhat, but further bouts of worry still can be expected until more clarity about Greece’s fiscal future emerges.

Closer to home, the Canadian economy, having escaped the housing downturn taking place in the US and European markets, is experiencing fairly good growth in part fueled by commodity export demand. Domestic economic growth as well as the solid performance of that nation’s banking sector continues to buoy the Canadian stock market.

Latin America taken as a whole has become somewhat a growth engine led by Brazil, the “B” in “BRIC”, as well as the worldwide commodities boom presently taking place. With a growing middle class, Brazil is experiencing a rapidly rising level of domestic consumption expansion, which is being complemented by robust growth of its export sector. Looking ahead, the outcome of the upcoming presidential election there could have a significant impact on that country’s stock market. While some Latin American economies, such as Argentina and Venezuela, are suffering from meaningful self-inflicted challenges, others, such as Chile, are doing quite well. Interestingly, despite its well understood law enforcement problems and sharp fall off of cash payments from the US in recent years, the economic prospects for Mexico are reasonably positive, which augurs favorably for that country’s stock market.

The Asia-Pacific along with India region is expected to exhibit favorable overall stock market performance going forward. Australia is experiencing a commodity export boom and was one of the world’s first economies to raise short-term interest rates, in order to moderate inflation prospects. Southeast Asia on balance is in a growth cycle, which is boosting that area’s stock market performance. In sharp contrast, Japan has slipped to the world’s third largest economy, and its stock market is likely to continue to lag. The growth driver for the Asia-Pacific region as well as the world at large is, of course, China. China implemented a highly successful stimulus program last year. The shovels indeed were ready in China and the economy responded with a strong rate of expansion. This year with concerns arising over a possible housing bubble, the central government has put the brakes on the banks and has undertaken other actions to put a brake on the economy, which is moderating to a still reasonable rate of growth.

In closing, the current global recovery differs from its predecessors in that it is not being led by the so-called Western Economies. This is resulting in a marked divergence in the pace of economic recovery in the various regions of the world, which, of course, is impacting the outlook for equity markets. These differences in the pace of economic recovery are underscored by the fact that already several central banks have begun to tighten their monetary policy, which in turn is influencing currency movements. On balance, non-US equity markets should stay on a relatively positive footing.

The Shareholder Value Case for Corporate Responsibility

2010-08-31T14:06:00.004-05:00

Aneel Karnani’s “Case Against Corporate Social Responsibility” (Wall Street Journal, 10/23/2010) misses a critical dimension of this issue. When it comes to measuring shareholder value, conventional financial metrics such as earnings and NPV fall short, failing to incorporate factors such as public perceptions, risk profiles, and investor preferences, which can have a significant impact on stock prices and the returns shareholders actually realize.

For example, the UN Principles for Responsible Investing reports that its members manage $18 trillion of assets in 36 countries, with some estimates ranging as high as $27 trillion managed globally according to these principles. Values and philosophy aside, these are serious numbers which are already impacting stock prices.

Companies whose negative CSR reputation renders them off-limits to a significant number of institutional investors risk lower stock prices due to diminished access to market capital. Conversely, companies which are attractive using such criteria may well trade at a premium, reflecting enhanced demand among influential investor groups. Conventional financial metrics lack the ability to capture this important dynamic. Measuring this effect and incorporating it into the financial analysis provides a more complete and accurate picture of shareholder value creation, giving firms a better tool to differentiate between value-creating initiatives that are shortchanged by conventional analysis vs. “feel good” projects that sound appealing but ultimately detract from shareholder value.

So instead of falling for a CSR “illusion” as Professor Karnani suggests, at least some of the firms pursing sustainable/responsible strategies may actually understand shareholder value creation extremely well.

American Angst

2010-07-27T17:42:00.008-05:00

By Robert Z. Aliber, Professor Emeritus of International Economics and Finance at the University of Chicago

There is a lot of angst in America. The persistent high level of unemployment, and especially the six million individuals who have been unemployed for more than twenty six weeks are a matter of great concern. The foreclosure rate on homes is approaching one million in 2010—a frightening number; Before this episode is over, five percent of seventy-five million homes will have been foreclosed on—and millions more will have left their homes because of short-sales and jingle mail. There is fear that the next generation of Americans will be less well off than their parents as employment in manufacturing declines. Income distribution seems increasingly warped: not only the sports heroes and the movie stars but the take-home pay and bonuses of those involved in finance on Wall Street and elsewhere. Many feel that public sector employees now have more attractive all-in compensation packages than the private sector, with more lavish defined benefit pensions and more secure tenure. Moreover there is sudden recognition that many of these pensions are under-funded—either the states like Illinois and California will go bankrupt because they can’t provide the cash to fulfill their pension obligations or the pensions will go bankrupt because the states have found some way to renege on their commitments. Or these bankrupt pensions will be taken over by the federal government, perhaps by the Pension Benefit Guarantee Corporation (which already owes more than $10 billion to the U.S. Treasury after taking over the pension obligations of GM and various auto suppliers) and become another burden on the taxpayers. The inability or ineptitude of the Congress in extending the estate tax rates and credits from 2009 to 2010 is depressing; the 4,000 estates that would have been taxed in 2010 will have a holiday that will cost the U.S. Treasury $4 billion. Millions believe that government budgets are out of control, and that the Obama Administration isn’t doing enough to bring the deficit down and reduce the burden that will fall on our children and grandchildren. The art of compromise seems lost in Washington. Health costs appear out of control, and very little attention has been given to limit the upward creep in costs. The Congress seems incapable of responding to the widely-felt need for an immigration policy.

The stalemate in Washington over the extension of unemployment benefits is a striking example of a dysfunctional government. The projected cost is $34 billion, a lot of money and yet reasonably small relative to the total fiscal deficit, and five percent of the funds that the Congress voted for the Troubled Assets Relief Program—sort of a save Goldman, JP Morgan, et al program. The irony is that some of the Congressional leaders who were opposed to the extension of unemployment compensation payments because the U.S. fiscal deficit would increase will not accept the increase in the effective tax rates that is scheduled to occur in 2011 when the Bush-inspired reduction in tax rates expires. If the next Congress does not vote to extend the Bush tax cuts of 2001 and 2002, fiscal revenues will increase by $80 billion or $90 billion.

Maybe the problems that Transocean and BP encountered with Bright Horizons were acts of God. But most of these other problems that have led to anxiety are amenable to public policy.

Some are concerned by the coarsening of American public life, the trash talk in professional athletics has spilled over into the political chatter. The feature and cover story on the July 18, 2010 issue of Forbes is “The Celebrity 100”. The industry—music, athletics, movies, authors, “personalities” and the incomes of these individuals are noted. Lady Gaga was in fourth place and earned $62 million. U-2 was number 7 on the list and earned $130 million (wasn’t the U-2 the spy plane that Gary Powers jumped from over Kazakhstan?) while Jay-Z was in spot #15 and earned $63 Million; and AC/DC was in 38th place and earned $114 million. Many of these people must be from Indonesia, since they have only one name, although it is not clear whether AC/DC is one name or two. Rascal Flats was #62 on the list, and earned $45 million. (The relationship between the ranking on this hit parade and the annual incomes is not obvious—and not worth the effort to understand.) “Judge” Judy Sheindlin earned $42 million, more than three times as much as Meryl Streep. Is this my country or is this another era?There is a concern that America’s international standing has declined, despite the affection that many of those in Europe have for President Obama. And there is a fear that the future belongs to China—the Chinese have all the money, they are buying Africa, and acquiring lots of other seemingly strategic assets.

Several of the sections of this note are based on a model of an integrated global economy that has three main sectors—households, business, and government. Traditionally, households save, and they finance the deficits of business firms and of governments. A fourth sector is introduced when the global economy is segmented into national economies, each country then has a “foreign sector”—which is an accounting device that measures the pattern of payments in money and in securities between the three sectors in one country and the sectors in other countries.

The direction of money flows between the United States and the rest of the world has changed twice in the last two hundred years. During the 130 years from the birth of the country until World War I households in Britain, France, and the Netherlands bought the IOUs of American firms and governments. Money flowed to the United States and the other “new lands” because the anticipated rates of return were higher than in Europe. Then, for the next seventy years, Americans bought the IOUs of firms and governments—of those in Canada, Europe, and various developing countries—because the anticipated returns were higher than on U.S. dollar securities. The second reversal occurred in the mid-1980s when there was a surge in the foreign demand for U.S. dollar securities and U.S. real assets. Some of this flow was motivated by higher anticipated returns but a large part of these purchases were motivated by the desire of these countries to follow export-led growth policies and maintain undervalued currencies.

If one of the sectors increases its spending relative to its income, economic growth quickens and the unemployment rate declines. If, in contrast, a sector reduces its spending, growth slows. If the foreign demand for U.S goods declines or the U.S. demand for foreign goods increases, U.S. growth slows while growth abroad increases. Some foreign countries—China, Japan, Singapore—have maintained undervalued currencies in the effort to encourage net exports and economic growth. An increase in the flow of money from a country leads to an increase in its income relative to its spending. In effect its exports increase and the flow of money represents that some of the export earnings are used to buy foreign securities and maintain the undervalued currency.

ON THE ECONOMIC RECOVERY, THE DOUBLE DIP, AND GROWTH

One of stylized facts from financial history is that the implosion of a bubble is followed by a recession—the story is always the same: households reduce spending to rebuild wealth, and lenders are much more cautious, in part because their capital has been depleted. New home construction declines sharply.

How well is the U.S. economy doing? There is a lot of negativism because the recovery in the last twelve months seems anemic in comparison with the recoveries from recessions between 1950 and 2002. The recession of 2008-2009 is unlike that of any since the Great Depression. Household wealth declined by $11,000 billion, more than ten percent. Several hundred banks failed, the investment banking industry was decimated, General Motors and Chrysler became bankrupt. (Household wealth had increased sharply after 2003 as a result of the sharp increase in real estate prices and a modest increase in stock prices, and household wealth at the end of 2010 was more or less the same as in 2005.)

The recessions between 1950 and 2000 were triggered by move to more contractive monetary policies by the Federal Reserve, which raised interest rates to dampen inflationary pressures; housing starts declined. Then when the Fed reversed policy and moved to greater monetary ease, the increased availability of credit led to sharp increase in housing starts. In contrast, this recession began when there was an excess supply of more than two million homes, which then led to a decline in housing starts.

The recession that began in 2008 differed from the earlier ones because the traditional relationships among the household and the other three sectors were warped by the surge in the foreign demand for U.S. dollar securities, which led to an increase in the price of U.S. securities and to the bubble in U.S real estate prices. The bubble began to deflate at the beginning of 2007, and the financial crisis triggered by the collapse of Lehman led to a credit crunch, and now the economy continues to adjust to the excesses of the bubble. The excess supply of houses may still be approaching two million, housing starts are down sharply but demand has declined as individuals have returned to their parents’ homes or otherwise doubled up. Household balance sheets have been clobbered by the decline in real estate values. (Several weeks ago I was in a taxi in NYC. The driver, from Guatemala, had bought a house forty miles north of Atlanta for $334K; the current market value is $185K.) More than forty state governments have fiscal deficits that are more than ten percent of their total expenditures; they have spent down their rainy day funds and face sharp reductions in their spending. One surprise is that the balance sheets in the corporate sector are in amazingly good shape. The banks have a lot of money to lend and can’t find attractive borrowers. The borrowers feel that the banks have become super-cautious.

Given this heavy ballast, the performance in the U.S. economy in the last year has been brilliant. Nearly a million more people are at work than at the trough. Moreover, the new weekly claims for unemployment compensation have declined dramatically—new weekly claims now are not much higher than they are in a normal period. Corporate profits are up. Auto sales are up, and the auto companies are hiring more workers. Ford has reported great profits. Housing sales appear to be up, although there is a problem because the April 30th expiration date of the $8,000 tax credit brought forward sales that might have occurred at a later date.

Still, the U.S. economy has slowed significantly from the fourth quarter of 2009. In retrospect the surge in the growth rate in the fourth quarter was stimulated by an inventory accumulation.

There is angst that the next decade in America will be like the last several in Japan, where the implosion of the bubble was followed by a credit crunch, deflation, and very slow growth. Maybe. The bubble in Japan in the 1980s was more than ten times larger than the recent bubble in America. Virtually all of the financial institutions became wards of the government. Population growth in Japan is trivially small, and the labor force is shrinking. The household savings rate is several times higher than the U.S. rate.

Some suggest that there is a chance of a double-dip recession. If the growth rate is three percent, then GDP has been increasing by $500 billion a year--$125 billion a quarter. A double dip would require that GDP decline by $125 billion for two consecutive quarters—one of the major sectors would have to reduce its spending relative to its income. The U.S. government might reduce its spending because of the chorus of fiscal restraint. The household sector might be scared into saving more by all the chatter about the double-dip, and the feedback effect would be like a self-fulfilling prophecy. U.S. imports would increase relative to U.S. exports, because of the depreciation of foreign currencies or because the slowdown in growth abroad leads foreign firms to increase their exports to the United States.

The flip of the conditions that would have to be satisfied if there is to be a double dip is the conditions that must be satisfied if the U.S. output gap, now $1,000 billion or seven percent of U.S. potential GDP, is to close. An increase in spending by one of the major sectors is required to reduce the output gap. The likelihood that the U.S. government will increase its spending in a significant way seems trivially small. The household sector seems more likely to increase its saving; although the savings rate has increased sharply, the current rate in the range of four to five percent is still significantly below the historic average rate of seven percent. An increase in spending by the business sector depends on the pace of the economic recovery and the ability of smaller firms to access credit on reasonable terms. The U.S. trade balance is the wild card, much more on this later. By default then the burden of growth will depend on households, and whether the savings rate will continue to increase, or whether this rate which has increased by five percentage points in the last several years will more or less stabilize. (Note this is a statement about the second derivative.)

The concern is the policy toward the high level of unemployment—more hope than plan. The implication of increasing attention to deficit reduction in the Britain and Germany and Greece is that these countries will grow their exports relative to their imports; if the United States continues with its passive attitude toward its trade balance, then the U.S. trade deficit is likely to increase.

WILL THE LIVING STANDARDS OF OUR CHILDREN DECLINE?

The primary factor that explains the long term increase in U.S. living standards is the productivity—the ability to produce more with less because of smarter and larger machines and the increase in human capital. Consider the ATMs or the self-service gas pumps or the internet or the electronic bank statements or the internet or the massive improvement in the quality of automobiles and automatic elevators—each of these innovations frees up labor. There is no evidence of a significant decline in productivity. Indeed, this sharp recent recession has increased productivity—when the economy returns toward full employment, per capita incomes will be higher.

The paradox is that households do not feel “better off” despite the increases in household incomes. Spending on healthcare and various public goods appears to be absorbing a large share of the increase in GDP. (Last week we stayed for several days at the Williams Inn in Williamstown MA, which is immediately next to the police station; there were seven police cars in the parking lot, whereas there might have been one when I was a student there fifty years ago.) Homeland security employs several hundred thousand individuals. Americans are better off because of the increase in security against another extremely costly terrorist attack like that on 9/11.

In part the increase in productivity has been obtained at the cost of a decline in job security. Fewer segments of the economy offer protection from changes in the competitive market place. The idea of a thirty-year career in General Motors or IBM is passé. Consider the U.S. Postal System, formerly secure niche for those who wanted to work thirty years and then have a secure pension. The postal system is being hammered by Fed Ex, UPS, and the internet.

Still, segments of the labor force that had formerly benefited from the lack of foreign competition are worse off because of increased competition from imports or because of a shift in location of economic activity. There are two U.S. auto industries; the old industry north of the Ohio River identified with GM and the United Auto Workers, and a new industry south of the Ohio River identified with Toyota and Honda. Workers in the old industry had incomes that were exceptionally high relative to their labor skills because they benefited from a monopoly position. Imports have weakened that position.

American living standards will continue to increase for the vast majority. Many of those who still benefit from a monopoly position in the private or the public sector are likely to find that their monopoly position is weakened. Put the decline in living standards for Americans as a group at the bottom of your angst list.

THE PUBLIC SECTOR-PRIVATE SECTOR RIFT

A long time ago the chatter was that the trade-off was that those who worked for the public sector enjoyed more attractive benefits including pensions and much greater job security to offset lower salaries. Now it seems like the employees in the public sector (about sixteen percent of the labor force) have the best of both worlds—higher salaries and richer fringe benefits. A top administrator in the school district in a posh Chicago suburb retired at 55, began to receive an annual pension of $250 thousand, and then moved on to a “second career” as a school administrator in California

It is as if the unions that formerly had monopoly power with GM and US Steel have moved to the public sector. Obviously lots of politicians and administrators still are motivated by the idea of public service, and this is especially true at the local level. But for an increasing number of others, it is the “best job they can get.”

Salary increases are taken for granted—and when there was a super-sized cyclical or transient increase in the tax base much of the increase in revenues was considered permanent and extrapolated to provide the basis for the programmed increases in expenditures. Then when the one-time surge in revenues abated, the states were caught with large deficits.

The pensions in the State of Illinois are underfunded by a massive amount—given the ages of the state employees, and a prospective rate of return on that can be earned on their investment assets, the current assets are modest relative to the assets that should be owned by the pension. Moreover, there is a strong likelihood that the pensions will not be able to earn the projected rates.

One feature of some of these pensions is that they are based on the number of years of employment and the salary for the last year or the average of the last three or five years. Some of these pension plans have been “gamed” by individuals who are about to retire in the next year or two; their last year’s salary is enhanced by overtime and taking the cash counterpart of their vacation time. The tactic is to jump the compensation in the last year or two with overtime and taking unused vacation time as salary.

These defined benefit pension plans are a strong example of “kick the can” down the road. It is as if the state governments are responding to demands for higher salaries by promising larger pensions, which are then not appropriately funded. There are three possible outcomes. Taxes will be raised to reduce or close the gap, the pension funds will go bankrupt, or the promises to past and current retirees will be broken.

THE U.S. OUTPUT GAP AND THE U.S. FISCAL DEFICIT

One of the apparent paradoxes of the last several years has been the combination of an American standard of living partly based on “other people’s money”, a U.S. trade deficit of $500 billion—say, four percent of household income. At the same time the U.S. unemployment rate is nearly ten percent, so the U.S. output gap of $1,000 billion has been twice the trade deficit. Some countries live off other people’s money when they consume more than they could produce, but that explanation is not relevant for the United States. Something has gone awry in the pricing of imports; a number of countries including China have been following “beggar thy neighbor” policies and maintaining undervalued currencies. But even if the trade imbalance were resolved, the United States would still have to cope with a fiscal deficit that is too large to be sustained.

There is a lot of chatter that President Obama’s stimulus hasn’t worked. Clearly the government spent the money, and someone’s income increased. To conclude that the stimulus didn’t work requires the assumption some individuals and firms increased their saving by a significant fraction of the increase in the U.S. fiscal deficit and their incomes—sort of a marginal savings rate of fifty or sixty percent. The stimulus hasn’t lived up to the hype promised by the Obama administration, which greatly underestimated the severity of the credit shock and the negative impacts of the excess supply of houses on home prices and residential construction.

There has been a two-stage process in adjusting to the increase in the foreign purchases of U.S. dollar securities. During the first stage, from 2002 to 2006, U.S. real estate prices increased, and the U.S. savings rate declined in response to the increase in the flow of foreign savings to the United States. Then when house prices began to decline and the economy slowed and went into recession, the U.S. fiscal deficit surged—fiscal revenues declined and the unemployment provided the rationale for a surge in government spending.

There are two related questions. One is how much of the U.S. output gap of $1,000 billion can be attributed to the U.S. trade deficit of $500 billion, and the second is how much of the U.S. fiscal deficit of $1,100 billion can be attributed to the U.S. output gap. (This estimate of the U.S. fiscal deficit is a national income accounting measure and is smaller than the deficit of $1,400 billion reported by the Obama Administration.)

First, the metric that relates the U.S. output gap to the U.S. trade deficit. Assume that value added by each worker in the U.S. tradable goods sector is $100,000 a year. (This ballpark number facilitates the arithmetic, the number is nearer $80,000.) Then each increase of $1 million in U.S. imports relative to U.S. exports means a loss of ten jobs, nearly all in U.S. manufacturing; each increase of $1 billion in net imports leads to a loss of 10,000 jobs and each increase of $100 billion in net imports lead to a loss of 1 million jobs. The inference is that the U.S. trade deficit of $500 billion has been associated with a loss of five million jobs; the tradable goods sector has shrunken. (If value added per worker in U.S. manufacturing is $80,000, the job losses associated with the $500 billion trade deficit would total 6.25 million.) That’s somewhat larger than the job losses in U.S. manufacturing, but U.S. imports of petroleum and other commodities are about $200 billion.

Assume that the $500 billion U.S. trade deficit were to “disappear”. (One of the problems associated with a sudden disappearance is that the United States does not have $500 billion of excess productive capacity in tradable goods; it would take two or three years to increase capacity to produce more tradable goods that would correspond with the decline in the U.S. trade deficit.) The U.S. output gap, now about seven percent of U.S. GDP, immediately would decline by $500 billion assuming the capacity is available to increase domestic production of tradable goods. Those newly employed in manufacturing would spend most of their incomes, so total spending would increase by more than the decline in the trade deficit; if the multiplier is 0.5 (which seems conservative, and more likely to be on the low side), domestic spending would increase by a further $250 billion, and the U.S. output gap would decline from $1,000 billion to $250 billion.

A second metric relates the changes in the U.S. fiscal deficit to the changes in the U.S. output gap. If the marginal tax rate is forty percent and U.S. GDP increases by $750 billion, U.S. fiscal revenues would increase by $300 billion.

Moreover, business investment spending would increase. If this increase totaled $200 billion, then given the multiplier the output gap would more or less disappear. The combined increase in U.S. fiscal revenues would be $400 billion. The U.S. fiscal deficit would be $700 billion when the economy is fully employed—about two percent of U.S. GDP. (Some would suggest that the U.S. Government should have a modest fiscal surplus, say $100 billion to $150 billion, when the U.S. economy is fully employed.)

These metrics can be viewed as partial equilibrium estimates, but they do not deal with the consistency across the sectors. The savings balances of the various sectors for the year 2010 are shown in the left column in Figure 1; the output gap is $1,000 billion and the U.S. fiscal deficit is assumed to be $1,100 billion—consider this an underemployment equilibrium. (This fiscal deficit is one based on the national income accounts, and is smaller than the one reported by the Obama Administration, which includes cash transfers to Fannie Mae and Freddie Mac, etc.)

The left column shows the values for savings balances of the four major sectors for 2010. The reduction of the output gap by $1,000 billion requires a comparable increase in spending by various sectors as a group. These balances in the column headed 2012T are one configuration that is consistent with full employment. The major “autonomous change” is that the U.S. trade deficit declines by $500 billion; no explanation is provided for why this reduction occurs. (Some countries that have built their prosperity on having large trade surpluses will be reluctant to see these surpluses decline.) The U.S. government fiscal deficit declines by $400 billion as a result of the increase in the taxable income. The business sector increases its spending by $200 billion in response to the increase in household spending. The household sector increases its saving to seven percent of its income.

Figure 1

SECTORAL SAVINGS BALANCE

Assume now (column 2012H) that household sector again goes on a spending binge, its annual savings declining by $500 billion, or the same amount as the decline in the U.S. trade deficit noted in the previous paragraph. The output gap is eliminated just as it was when the trade deficit declined by $500 billion. Households save two percent of their income, much less than the historic average of seven percent. The fiscal deficit still is too large to be sustained.

Finally, assume that the deficit hawks have their way, and that federal taxes are increased relative to expenditures by $400 billion; consider this the anti-stimulus. The fiscal deficit declines, but household incomes decline, and business spending declines. Assume that the trade deficit remains unchanged at $500 billion. Now the output gap increases perhaps by two percent of GDP—but this is a guess.

THE CHINA CHALLENGE

Recently I have been dabbling in John Morton Blum’s “From the Morganthau Diaries” (volume 3 was published in 1967). One of chapters dealt with the financial relationships with the Kumintang Government of China during World War II. Washington was concerned about the U.S. dollar amount of the payment that the U.S. government had agreed to pay to the Chinese government for work on an airbase in Chengdu; the workers had been paid in the Chinese currency. The disagreement centered on the appropriate exchange rate, and the Americans believed that the currency was greatly overvalued.

Seventy years later, the United States and China again disagree about the appropriate value for the Chinese currency; now the Americans believe that the yuan is greatly undervalued. A month ago, the Chinese government announced—immediately before the meeting of the G-20 in Toronto— that it would allow the yuan to appreciate. The yuan has appreciated by less than one percent in the last month.

China’s economic achievements have been impressive—ten percent growth for thirty years—truly a marvelous achievement. The high rate of growth was possible as a result of the very high savings rate, abundant credit, a very adaptable labor force, a striking entrepreneurial tradition, the lack of private property rights, a Japanese-style credit system that in western terms taxed household savers heavily, and a beautiful decision to invite the world’s multinationals into China, including those from Taiwan. These multinationals facilitated the rapid growth in Chinese exports, which in turn contributed to the significant decline in unit production costs.

One fascinating aspect of the Chinese growth experience is the extremely high savings rate—households save, business firms save, and the governments save. Various explanations have been given for the high savings rate. One is the lack of a social safety net. Another is Chinese demographics; the one child-one family policy (there are exceptions) means that there won’t be enough younger people to support the older people. Individuals accumulate financial assets in their working years to support themselves in their retirement.

The fallacy of composition may be relevant, in that as the retirees seek to spend down their assets they may find that there are too few buyers—the asset prices will decline. But that’s another paper.

The unique feature of the Chinese economic experience of the last ten or so years is that it is the only rapid-growth country that has a trade surplus, and a very large trade surplus. Virtually every other country that has achieved high rates of growth has had a trade deficit; the story is that high growth rates are associated with high rates of return, which attracts foreign money. These money inflows led to an appreciation of the currency.

China has maintained a low value for the currency to promote its exports. China is protectionist, repeat protectionist, and abuses the infant-industry argument. The presumption that trade involves exchanges of comparable values is orthogonal to the Chinese view of the world. The rip-offs of intellectual property that are characteristic of the Chinese firms also typify behavior at the national level.

At some stage, the growth rate will decline, and perhaps sharply, because of recognition that there is too much productive capacity relative to demand. China has experienced a fantastic construction boom—a first class infrastructure of airports, roads, railroads. This public sector investment has required a lot of private sector investment in steel, cement, power, etc. Both the private sector investment and the public sector investment have absorbed the high level of saving and provided construction jobs for several tens of millions of individuals. When investment slows, the demand for construction labor will slow; household incomes will grow less rapidly, and the excess capacity in the production of consumer goods will become more intense.

Consider the possible outcomes—China becomes a massive parking lot. The need to absorb the savings and provide continued employment then requires that the planners find more and more projects, more or less like Japan after the implosion of its bubble. Another outcome is that the savings rate declines, and the demand for consumption goods increase.

The experience in Japan and other Asian countries is that as their growth rates decline, their exports increase and their trade surpluses increase.

China indicated before the G-20 meeting in Toronto that it would allow the yuan to appreciate. The yuan has appreciated—by a trivial amount. By announcing the change in policy, they more or less diverted the heat that they would otherwise have received at the Toronto meeting. But the appreciation of a nickel is not a good-faith follow-through.

President Obama indicated that he wants to double U.S. exports in the next five years--a growth rate of fifteen percent a year. Trade often has increased more rapidly than GDP. The goal of the Obama Administration should be to seek an orderly reduction in the U.S. trade deficit, which will require that some other countries accept a reduction in their trade surpluses. China is the country with the largest trade surplus, both absolutely and as a share of its GDP. A reduction in the U.S trade deficit would contribute to a reduction in the unemployment rate, an increase in the U.S growth rate, and a reduction in the U.S. fiscal deficit.

Stay tuned.

Using Tobin's Q Ratio To Assess the Market

2010-07-18T19:59:00.005-05:00

The Q Ratio has been getting more attention than usual lately (for example, articles by Smithers and Short). Conventional wisdom is that current Q Ratio levels significantly above long-term averages indicate that the market is substantially overvalued. Our view: The Q ratio is an extremely useful metric, but the conventional wisdom on the topic is wrong.

From a practical perspective, equity prices are the biggest input that determines the Q ratio. (The other two components, corporate assets and debt, are relatively stable in comparison.) And equity prices are determined by two variables, economic earnings (Cash ROI) of corporate sector firms, and the discount rate applied to these economic earnings. The proper perspective is to assess the current Q ratio not against some long-term average, but against what the Q ratio SHOULD be given the Cash ROI and Discount Rate currently applicable to the market.

Corporate earnings, Return on Equity, and other conventional performance metrics are inherently volatile. In contrast, the inflation-adjusted (real) Cash ROI for the S&P 500 has been remarkably stable over several decades, ranging between 6%-8% during the 70’s and 80’s, and gradually increasing to the 8%-10% range over the past twenty years.

The warranted real Discount Rate (Cost of Capital) depends primarily on inflation expectations, tax rates, and real interest rates. The combination of high inflation and high marginal tax rates resulted in real discount rates above 10% in the late seventies. Inflation and tax rates over the past ten years would justify a real discount rate of 3.5% to 4%, although the market pricing has reflected discount rates about 200 basis points higher. (One plausible explanation for this discrepancy might be investor assessments that current inflation and tax rates are aren’t sustainable given recent fiscal deficits and long-term funding issues with Medicare and Social Security.)

Back in 1978 inflation expectations were around 6%, with a 70% tax rate on dividends and 42% on capital gains. If you assume a long-term Cash ROI forecast of 7%, then the appropriate Q ratio would have been about .8 times assets. Compare that with today’s economy, where a long-term ROI forecast of 9% is plausible. Even with anticipated tax rate hikes, Ativo estimates that the real (inflation-adjusted) discount rate should be under 4.5%. But let’s be conservative and use 6%. The resulting Q ratio would be about 1.4 times assets.

There are enough measurement and forecast issues that we’re not going to say precisely what today’s Q ratio should be. Our key point is that the right Q ratio benchmark isn’t some long-term average, but rather depends on current economic conditions. Just remember, the full-year average temperature for Chicago is about 50 degrees Fahrenheit. But a 50 degree day in January is balmy, while a 50 degree day in May is freezing. Everything depends on context. It’s the same way when assessing the Q ratio.

Pay for Performance?

2010-05-17T13:04:00.007-05:00

It’s that time of year again. Now that the proxy statements are out and shareholder meetings are on the calendar, we’re seeing the latest round of articles and studies (such as this from Business Week) questioning whether CEO’s are being overpaid or underpaid for the performance they’ve delivered.

One major concern with many such comparisons is that they define “performance” as Total Shareholder Return (TSR) over some arbitrary period. A critical (and obvious) problem is that TSR, by definition, requires specific start and end dates for the measurement period. Moving the start date or end date by even one day often results in substantial (and meaningful) differences in TSR, which was the problem in the options backdating scandals not so long ago.

A fundamental (and more subtle) problem lies with the implicit assumption that TSR represents an accurate measure of company performance. TSR encompasses many factors, and actual company performance is just one of them. Sector rotation, a long-term pattern of specific industries falling in and out of favor with investors, represents one extraneous influence on TSR. And this is in addition to broader market trends, which reflect changes in investor discount rates overall. Factor in these two components of TSR volatility and it’s easy to see why employee stock options have acquired a reputation as “lottery tickets.”

With respect to specific firms, there’s the issue of the degree to which changing expectations (which drive TSR) reflect a change in actual performance. Some CEO’s have generated significant stock price gains by creating expectations of improved performance, although these gains quickly erode if the firm then fails to deliver. (And when evaluating CEO performance, do you start counting on the day the new CEO is announced, the day he/she reports for work, or some other starting point?)

Finally, because TSR is a measure of change, a top-performing firm that stays on top of its game may well deliver a significantly lower TSR than a poor performer that becomes less bad. It is up to the compensation committee to determine how much weight to assign to the absolute level of performance compared to changes in performance, but automatic reliance on TSR implicitly makes choices which don’t necessarily provide productive incentives for management.

Many of these factors diminish in importance over long enough time periods, but extremely long horizons are impractical for compensating the many CEO’s who may only be around for a few years. Bottom line, TSR is clearly a critically important metric, but a simplistic reliance on TSR as the sole measure of executive performance creates more confusion than enlightenment. CEO compensation is a complex and controversial subject which isn’t going to be settled in a short blog post, and it isn’t going to be resolved by focusing on any single performance metric.

Does Good Corporate Governance Pay?

2010-05-03T14:22:00.012-05:00

The Economist website recently published an article addressing the linkage (or lack thereof) between good governance and returns to shareholders. Critics of reform point to a study by Lucian Bebchuk showing that test portfolios of well-governed firms no longer earn excess returns. Although we approach the issue differently than Bebchuk, we concur (at least generally) with his conclusions.

Even though Bebchuk found no relationship between good governance and excess returns over the period studied, he did find a strong correlation between good governance and high Q ratios. This is eminently sensible. A high Q ratio is due to one of two things: either a company is earning a high Return on Investment, or investors are pricing the firm using a low implicit discount rate (or both). Abnormal returns are generated when the ROI rises, or when the discount rate falls. But once the ROI and/or discount rate have adjusted to reflect good governance, then future stock price appreciation will be much closer to market benchmarks.

But this doesn't mean that good governance counts for nothing. The high Q ratio that is associated with good governance means that Return on Investment is probably high relative to the firm's discount rate (cost of capital). Such firms have more profitable growth opportunities, happier shareholders, and the stock price premium means they are less likely to fall prey to hostile acquisition.

We've recently developed a methodology to quantify the effect of good governance, environmental practices, and social policies on stock price. Unlike other research, this approach explicitly separates the stock price impact into current financial performance vs. investor preferences and expectations. For more information on this project contact dallen@ativogroup.com or dennis.aust@chartermast.com.

Dennis Aust to Speak at Chicago Booth Finance Roundtable

2010-04-30T14:51:00.018-05:00

The University of Chicago Booth School of Business
Finance Roundtable
Enterprise Valuation: More Than Just Multiples?
May 13, 2010: 6:00 PM - 9:00 PM

In today’s “new normal” economic situation, valuation professionals are under increasing scrutiny to justify their enterprise valuations and explain the changes in enterprise value. Further, the analytical uses of enterprise valuations continue to grow beyond buy/sell transactions. What are the latest developments in financial valuation, accounting valuations, and management valuations? How do practitioners arrive at their enterprise valuations? What impact do valuations have on business activities?

Panelists:
Dennis N. Aust, Founder, CharterMast Partners LLC
Patricia Luscombe, Managing Director and Head of Valuation Services Group, Lincoln International LLC
Timothy R. O’Connor, Director, Valuation Services Group, Grant Thornton LLP
(Profiles at end of post)

Where:
Gleacher Center
Room 600 (Note Room Number
450 North Cityfront Drive
Chicago, IL

Cost:
No Charge

Program:
6:00 PM - 6:30 PM: Cash Bar and Networking
6:30 PM - 7:30 PM: Presentation and Discussion
7:30 PM - 8:00 PM: Panelist/Audience Q&A
8:00 PM - 9:00 PM: Cash Bar at the Midway Club, 5th floor, Networking and Discussion

Questions:
Vern Broders Chair, Alumni Finance Roundtable
312.405.0298

The GSB Alumni Finance Roundtable Committee
Vern Broders (1994)
Kevin Clarke (2008)
Michael Fisch (2002)
Scott Kemper (2006)
Jason Ricketts (2009)
John Salvino (2006)
Rich Thoroe (2007)
Dustin Weinberger (2006)

Speaker Profiles
Dennis N. Aust has spent nearly 30 years developing and implementing value creation strategies,frameworks, and tools for Fortune 500 and mid-cap firms in a variety of industries. In 2001, he founded CharterMast Partners LLC, which provides public and privately held companies guidance, support, and insights for developing and implementing best-in-class strategies for value creation.

His writings covering strategic analysis, financial management, and innovation have appeared in the Journal of Private Equity and Director’s Monthly (NACD). He has contributed chapters to “The Valuation Handbook: Valuation Techniques From Today’s Top Practitioners” (Wiley, 2009), “Stock Options – An Introduction” (ICFAI Press, 2005), and “Managing Innovation in the New Millennium” (ICFAI Press, 2002).

He was recently featured speaker at the 2010 National Conference of the Association for Strategic Planning, and has also spoken at the National Association of Accountants (Annual Conference), the American Management Association, and ESG Investing Chicago. He holds an undergraduate degree in business and an MBA in management science from the University of Chicago Booth School of Business.

Patricia Luscombe is Managing Director and Head of Valuation Services Practice at Lincoln International. Patricia has more than 20 years experience in financial advisory and valuation services. She has delivered a broad range of corporate finance advice that resulted in the successful completion of corporate transactions and valuation and fairness opinions.

Patricia has advised portfolio companies of private equity firms and provided them with valuation and fairness opinions for transactions, including divestitures and recapitalizations, intra-fund transfers, and mark-to-market (fair value) accounting. Patricia's clients have ranged from closely-held businesses to Fortune 500 companies, with a particular expertise serving businesses in the financial services, healthcare, consumer products, service and manufacturing sectors.

Before Lincoln International, Patricia spent 16 years with Duff & Phelps as a Managing Director in the firm’s valuation and financial advisory business. She was a founding member and Managing Director at Duff & Phelps in a management led buyout which occurred in 1995. Prior to joining Duff & Phelps, Patricia was an Associate at Smith Barney, a division of Citigroup Global Markets, Inc. where she managed a variety of financial transactions, including mergers and acquisitions, leveraged buyouts and equity and debt financings.

Patricia is a member of the Chicago Chapter of the Association for Corporate Growth and Business Valuation Association, the Chartered Financial Analyst Society of Chicago and a Board member and former president of the Chicago Finance Exchange. Patricia holds a Bachelor of Arts degree in economics from Stanford University, a Masters degree in economics from the University of Chicago and a Master of Business Administration degree from the University of Chicago Booth School of Business.

Tim O'Connor is a Director in the Economic Advisory Services practice of Grant Thornton located in Chicago. Tim is responsible for the development and provision of business and intangible asset valuation and transaction consulting services.

Tim has over 16 years of experience encompassing the valuation of business interests, capital stock, financial assets and intellectual property in connection with business combination decision support, financial reporting, corporate and estate tax planning and compliance, dispute analysis, information technology investment analysis, business plan development and ad valorem tax negotiations. Before joining Grant Thornton, Tim was a Director with PricewaterhouseCoopers Transaction Services Accounting and Valuation Advisory practice.

Tim has served private and public clients in a wide range of industries, including consumer and industrial products, publishing, automotive components, steel making and chemical processing, transportation, property insurance, computer software and telecommunications. Prior to his career in the valuation profession, Tim held positions in computer programming and systems design, and engineering consulting.

Tim earned his Master of Business Administration, with honors, from the University of Chicago Booth School of Business, and his Bachelor of Science in Civil Engineering from the University of Illinois. He is a member of the American Society of Appraisers.

The Best Way to Measure Company Performance?

2010-04-23T18:02:00.006-05:00

A recent post on the Harvard Business Review website asserts that Return on Assets is “The Best Way to Measure Company Performance.” The authors (John Hagel III, John Seely Brown and Lang Davison) correctly make the case that Return on Assets (ROA) is better than Return on Equity (ROE), but then completely miss the point that both measures are fatally flawed, leading to incorrect comparisons among companies and over time. In our experience, such accounting ratios come up short for several reasons, but the fundamental problem is that by relying on GAAP conventions they fail to capture a firm’s underlying economic performance. Cash Flow ROI addresses these issues, which is why it provides a more accurate measure of company performance and a vastly better link to market valuations.

Michael Jensen of Harvard Business School goes so far as to recommend against using any ratio-type metric to measure company performance. He observes that simply reducing the denominator provides the illusion of improved performance regardless of whether a firm does anything to increase its profits or cash flows.

Just as an outside investor uses Total Shareholder Return (TSR) to measure the performance of an investment, CharterMast defines company performance as the rate at which the firm’s intrinsic value increases over time. We still use Cash Flow ROI to assess trends and to compare firms within an industry, recognizing that profit margins, asset utilization, growth rates and cost of capital are clearly important contributors to value as well. Accounting metrics like ROA have their place, but if the ultimate objective is to create value for shareholders it is hard to see how such metrics could reasonably be considered the “Best Way to Measure Company Performance.”

The Devaluation of the Greek Euro(Originally Published on February 17, 2010)

2010-04-23T08:20:00.010-05:00

Robert Z. Aliber

Greece joined the Euro in 2001, several years after its birth. The delay of several years resulted because Greece’s fiscal deficit in 1999 was too high to satisfy the Maastricht criteria. Now it appears that Greece satisfied these criteria only because of some accounting shenanigans, somewhat remindful of the off-balance sheet activities of Enron and Citibank’s SIVs.

The basic Greek problem is that costs are too high, which has led to a massive current account deficit, and contributed to the high level of unemployment, and hence to a low level of fiscal revenues. It doesn’t help that tax evasion is extensive.

Assume a counterfactual scenario. Assume that Greece has not yet given up the drachma for the Euro; its parity is 1 Greek drachma = 1 Euro. Everything else is the same as currently, government indebtedness is 110 percent of GDP, the unemployment rate is 9.8 percent, industrial production is down 7.6 percent from a year ago, the current account deficit is 12.4 percent of GDP (whereas the average for the Euro area is 0.7 percent), and the budget deficit is 13.0 percent of GDP, more than twice the average for the Euro area.

Assume Greece were to devalue the drachma. How large a devaluation would itneed to achieve a satisfactory external balance position? Probably twenty to twenty five percent.

If a twenty percent devaluation were necessary to achieve a satisfactory domestic and external imbalance, then it would take a twenty percent reduction in wages and salaries to achieve the same improvement in the international competitive position of the Greek economy.

How likely is it that the Socialist government in Athens can bring off a reduction in wages and salaries of ten percent? Not likely, Greece got into this mess because its polity has been fractious, which goes back a long, long way.

If Greece can’t reduce wages and salaries, then it should leave the Euro for a year or two. But many observers believe that can’t happen because there are no provisions in Maastricht treaty for a divorce or separation.

That’s nonsense. International monetary treaties are good for fifteen or twenty years and when market conditions change, countries do what they believe they need to do. The Czechs and the Slovaks had a peaceful divorce. Slovenia left the former Yugoslavia Republic peacefully, but then it got ugly. Quebec came close to a peaceful secession from Canada.

The Greek competitiveness problem cannot be solved by loans or loan guarantees from Berlin or Frankfurt or Brussels. And it won’t be solved by the Athens equivalent of Chancellor of the Exchequer Churchill in 1926 who thought a little deflation would have eliminated the serious overvaluation of the pound.

Market forces are now in play, there has been a “run” on the debt of the Greek government. No one—well hardly anyone except government controlled entities—will buy the debt of the Greek government. But the Greek government has to finance a fiscal deficit of nearly fifteen percent; otherwise the public service workers in Athens and Thessaloniki won’t get paid. For a while, the Greek government may borrow from the Greek banks.

But wealthy Greeks are too smart to hold most of their liquid wealth in banks in Greece. The next shoe to drop will be a “run” on the deposits in the banks in Athens, including the foreign banks with offices in Athens. The owners of these Euro deposits in Athens will move their money to German, French, and Italian banks in Frankfurt, Paris, and Rome.

The technical issues associated with a devaluation by Athens are trivial. The Government closes the banks for several days and instructs them to re-label all deposits and loans and all other contracts as Euro drachmas. The banks are reopened and a new currency market develops as individuals buy and sell the Euro in terms of the Euro drachma. Many goods and assets then will have two prices, one in terms of the Euro and the other in terms of the Euro drachma. Initially there will be some turbulence in the currency market but prices will stabilize after several weeks, and in eight or ten months the Euro drachma will be pegged to the Euro and then the Euro drachma will be converted into the Euro.

Obviously the politicians in Brussels and Frankfurt, Berlin and Paris are petrified about the contagion effect. The cost structure in several of the other Mediterranean countries may be too high and they face the same painful choices. The financial costs of financing payments deficits while hoping that costs will decline is fanciful.

Consider the menu available to those in Athens, Brussels, and Frankfurt:

--monthly checks from the Berlin, Paris, et al that will enable the Greek government to finance its fiscal deficits.
--a decline in costs and prices in Greece that will lead to a reduction in the current account deficit and an increase in fiscal revenues.
--a devaluation of the Euro drachma.

In the end, all three will come to pass.

Robert Z. Aliber is Professor Emeritus of International Economics and Finance at the Booth School of Business at The University of Chicago. He is the author of New International Money Game (March 2010). He can be reached at RZA5638@cs.com.

Goldman Sachs, Right vs. Wrong, and How is their Business Model Sustainable?

2010-04-22T11:51:00.004-05:00

The following comments were made by a friend of mine who chose to remain anonymous.

He writes:

"I have my own experience with them but just by the numbers they post every year, people keep buying stuff from them and paying them a lot of commissions no matter how much they were hurt whether it is dot-com or subprime. The Greek thing really reminds me of what Enron did with California and the bad PR they are getting is just relentless which means their management might be completely oblivious. It seems like the firm is always pushing the boundaries of what their lawyers tell them is “legal” to make money as opposed to looking at whether, despite whatever legal loophole they think they found to find to make money, their behavior might be morally reprehensible, against the spirit of the law and a depraved way to treat their counterparts, sophisticated or not. They just don’t seem to have the intelligence to abstract things enough to understand right from wrong.

Again I might be biased because of our own personal experience with these guys, but looking at the German government, the Chinese, the SEC here and the general attitude of the public and commentators, I probably would not want to be named in the papers as the next sucker who lost money with GS as a counterpart but if you look at their earnings seems like others might not think the way I do."

Trading Errors

2010-04-16T07:40:00.003-05:00

As an investment advisor, trading errors are infuriating. They are the equivalent of unforced errors in sports: if you make too many of them (or make the "Big One"), you will be out of the game before you know it. The client, of course, is always made whole and the only bottom line that gets hurt is the advisor's. It is critical to understand what caused the error and make whatever changes are required to the system to make sure that same type of error never happens again. Trading errors are (expensive) tuition.

Santorus vs. PRX Patent Dispute

2010-04-15T10:31:00.004-05:00

Yesterday a court ruled against Santorus (SNTS) and in favor of Par Pharmaceuticals (PRX) in a patent dispute. PRX wants to produce a generic version of Zegerid, Santorus' heartburn medication. Today SNTS is down $1.73, meaning it has lost approximately $101 million in market cap, while PRX is up $1.57, giving it a gain of $55 million. The difference between the two amounts, $46 million, is presumably a net transfer of value to other competitors who may be able to also sell generic versions of Zegerid and most of all to consumers, who will benefit from a lower price for their medication. SNTS has said it will appeal, of course.