A silly graph on a serious matter

In a post at the Volokh Conspiracy, David Bernstein links to a graph produced originally by Liz Ann Sonders, the Chief Investment Strategist at Schwab. The graph strikingly shows the relationship between the NAHB housing index and the S&P 500 index, with the clear implication being that equities are due for a big fall. It's certainly striking, but it's also very silly.

It's common practice in the investment strategy field to produce graphs of this kind: superimpose two lines, shift one by a few months, and you have an immediate prediction mechanism for something or other. The problem is, these graph are seldom based on true insight, and even less often on rigorous quantitive analysis. I've seen quite a few of these peddled over the years, including some more far-fetched that this one. The guilty shall remain nameless.

Aside from the natural curiosity of what happens to the relationship on a longer timescale than the one shown, the graph cannot make fundamental sense, at least not in the way it is implying it can. The main problem is that the two lines represent totally different kinds of indices: the S&P has no maximum possible value, while the NAHB is a diffusion index that by defition will have a value between 0 and 100. If we take the graph at face value, it would imply that the S&P would have a maximum value of around 2,000, a 50% or so increase from current levels. That's clearly nonsensical.

Looking at the history of the relationship, you can see how this breaks down:

Prior to 1995, there is no relationship whatsoever between the two. But the really weird thing is that it does work very well in the period since then. Doing a regression of the NAHB against the S&P 500, you end up with an R-squared of 0.77:

That's a pretty powerful explanatory relationship. Taking it at face value, it would mean that with the NAHB housing index at 30, the S&P 500 would have to fall to 354, a drop of 74% from current levels, or 10.5% a month, every month for the next year. Using the S&P 500 total return index, which includes dividends, the R-squared is even higher at 0.80, and implies a drop of 81% in the S&P in a year, or 13.0% per month.

That's some pretty serious declines there. And they're not going to happen. At least, not in that magnitude. I think it's perfectly reasonable to predict some declines in the S&P, but relying too much on this graph and its implied message of doom is not the way to do it. As Lev, one of the commenters at the Volokh Consipracy pointed out, Schwab agrees with this as well, as they're underweighting equities by only 5%. That's hardly a message of doom.

However, it is clear that the US housing market is in trouble. That can certainly be inferred from the NAHB index. I agree that the US residential housing market has experienced a bubble, and that it is deflating, but I'm not inclined to conclude that the US economy is bound to collapse as a result. The risk does exist, but it's not a foregone conclusion.

So while using the NAHB index to predict the S&P is not going to lead to much joy, it might lead to insight into the development of house prices. Mapping the NAHB index against real median house prices (deflated with headline CPI), the relationship is still pretty weak:

Real house prices stayed flat throughout the 1980s, and only began to rise in the 1990s and seem to have peaked in the recent past. The NAHB index has been useful in picking up some of the downdrafts, but not in a truly convincing fashion.

Further declines will take place given the bubble that has developed, but I remain skeptical that it is going to derail the economy in a significant way. While there will be people who get burned badly on their speculative purchases, it takes a truly big downturn to turn this into a broad economic recession. Evidence from other countries with housing bubbles, like the Netherlands, UK and Australia shows that markets can go through step-changes in pricing without suffering crashes later. (Of course, we're not out of the woods on any of those yet, and they could yet sell off in the coming years if interest rates rise dramatically). Higher rates and slower growth led to a moderation of house prices and some falls overall, but not a crash. Median house price to median income ratios in these three countries are all higher than the US at around 3.5. (Sorry, I don't have a source at hand, so I'm typing this from memory).

The reason why people do worry that the US experience will be more painful is that US mortgage equity withdrawal has been a big factor in driving consumer spending. Should house prices fall, mortgaged home owners could end up with negative equity and become forced sellers. Less dramatically home owners might simply stop withdrawing home equity, and thereby be forced to cut down on spending. So how extended is the US homeowner?

The Federal Reserve has an amazing amount of data in its Flow of Funds data, and sometimes they calculate data for us. In the below graphs I have taken the data from the FoF unless otherwise noted.

Can consumers still pay for their mortgages with higher interest rates? The amount they need to spend on servicing their debt has been rising, although the mix has been shifting towards mortgage debt:

With both total and mortgage debt servicing costs at historic highs, it is clear that consumers will be hard-pressed to take on more debt. I have no idea what a natural and reasonable upper limit would be though. It could go even higher, but I would tentatively assume that any further increases will be limited.

A similar picture results when plotting mortgage liabilities relative to total net wealth and relative to real estate assets:

In both cases the US consumer now has reached record levels indebtedness relative to assets. With mortgage liabilities equalling about 17% of total net wealth, and about 48% of real estate assets, both measure seem to indicate that while the situation mamy be stretched historically, there is still a big buffer to eat into should things go wrong. Total real estate wealth would have to be cut in half for the market as a whole to experience negative equity.

So far, so good. But these numbers only show the aggregates. They do not show the details one would need to do a proper analysis of the situation. It'd be much more interesting to see the distribution of mortgages versus real estate assets: what percentage of households is overmortgaged? How many households have no mortgage at all? What's happening in the tails of the distribution?

Unfortunately, I don't have that data. So all I can do is ruminate vapidly on the basis of the data I do have, and the best I can do there is the following. The US housing is deflating a bubble, but the pain this will cause will not be widely distributed across the economy. As long as people have jobs, they will still be able to pay their mortgages. The problem arises when they become forced sellers (for instance, when they lose their jobs). Rather than causing a recession, it would be the recession with its layoffs that will cause the housing market really to sell off. It's a definite risk but not something I expect to happen. I won't go into the details here as it would require another lengthy post.

There is one glaring omission in all of the above: what about home equity withdrawal? For something that's been so instrumental in sustaining economic growth, reliable numbers are suprisingly hard to find. I've seen wildly contradictory numbers on this, ranging from a pickup to historic highs this year to a massive fall-off. I have tried to reproduce the numbers myself from the FoF and national accounts (and other sources), but without any success.

The great cathartic collapse of the bubble in real estate is unlikely to happen. It will continue to deflate, and will cause problems locally, but unless the US economy ends up in a recession, there is no reason to become despondently gloomy.

German companies looking abroad

The German economy has become the emblem of Europe's economic problems. Many of the problems that afflict the European economies are at their most acute in Germany. Compare today's Europe to that of 25 years ago and the economic landscape has changed enormously. Britain was the "Sick Man of Europe," while the German economy was invincible. While the UK economy is by no means invincible, it is one of the healthier ones in Europe. Countries can and do go through poor economic times, and the economic cycle has not been conquered. But when a spell of poor performance starts to stretch out into infinity, additional problems begin to arise. For one, if there's no hope for economic growth, both people and companies begin to look elsewhere. The outsourcing of manufacturing to lower-wage countries has been a phenomenon throughout the world's developed economies; even Japan is now succumbing the economic logic of moving production to China, for instance.

It gets worse if companies start to move higher value-added services abroad. It's the high value added part of the corporate chain that's essential to generating profits. Once you start losing those kinds of jobs, your economy has a much more serious problem. Job losses in the manufacturing sector can be accomodated more easily, as it's generally easier to find another job that pays about the same, even if it's in services rather than manufacturing (assuming there is economic growth). But job losses at the high value added end are much harder to replace. German companies said again that they're thinking of moving abroad:

But as reminder of the tough economic times ahead for Germany, the nation's Chamber of Industry and Commerce (DIHK) released a survey Monday showing that nearly one in four German companies was planning to shift production outside Germany in the next three years to escape high tax and labour costs.

This could result in the loss of about 50,000 jobs each year up until 2005, the chamber presenting a survey of about 10,000 companies.

"The alarming thing is that increasingly it is not just wage- intensive production sectors that are being transferred abroad, as it was in the 1990s," DIHK head Martin Wansleben said in a statement on a new survey of German companies.

"Our recent surveys show that areas like administration, research and development and even company headquarters are being examined," he said.

Threats of corporate flight are not new, and these things don't happen overnight either. Emigrating is not something that is undertaken lightly, but it is becoming ever easier. Modern technology makes the location of a whole swath of corporate functions increasingly irrelevant. And companies will act on their economic best interests sooner or later. If they can move, they will. Eventually. Germany still has time to avert a massive corporate exodus, but the clock is ticking. Schröder's reform plans, known as "Agenda 2010" are small step in the right direction, but don't go far enough. Even so, he's faced with massive opposition from the left wing of his own party and from the labor union movement. Labor unions have been organization mass protests against the plans, which they say will eviscerate the welfare state. If only.

June 1st will be an important date for Schröder. That's when the SPD holds a special congress to vote on the reform plans. Schröder has already threatened to resign three times to obtain backing for his Agenda 2010. Thus far, the SPD fora at which he's uttered this threat have backed him. The question is how many on the left wing will be willing to call his bluff. The weekend congress should give us a clearer idea. But with just a four-vote majority in the Bundestag, just a few defections could sink the plans (assuming the opposition votes against the proposals; they might do that if they think they can hurt Schröder, even though they might otherwise be in favor of the plans).

Government spending and GDP growth

I've written previously about the growth gap that's been opening up between the US and Europe over the last decades, and particularly Germany's poor economic performance. Digging down into the numbers, there are some more interesting observations to be made. In the following I am using annual GDP data from the OECD. The total GDP numbers are broken down into a few categories, such as private consumption, government consumption, capital formation, imports and exports. As one of the big differences between Europe and the US is the size of government, it might be interesting to look at the impact of government consumption to total GDP growth.

It should be noted that government final consumption expenditure does not cover the total impact of the government on economic growth. As the name says, it's only consumption that's covered. The difference between total expenditure and consumption goes into categories like capital formation. Government consumption as a percentage of GDP has remained fairly constant over the years for most countries, as this graph shows. In other words, the percentage of total GDP that comes from government spending has not changed much. In the US it has declined, while in Japan it has increased. Europe has been more or less constant. France has unsurpringly had the highest share of government consumption to overall GDP.

The actual contribution to GDP growth (in percentage points of overall GDP growth) is plotted in this graph. The high volatility makes it hard to deduce much from the graph itself, but in general, government consumption has had a positive impact on overall GDP growth. It has been growing as the size of the economy has increased.

To see the true impact of government consumption on growth, compare this graph of total cumulative GDP growth with the plot excluding government consumption. In both cases, the US has done best since 1991 (the earliest point for which OECD data are readily available, due to reunification). Japan has done worst, which was to be expected. But taking out government consumptionn shows just how big the impact has been. In the case of Japan, the rest of the components of GDP have contracted by almost 20% since 1991, and it's only been the enormous amounts of cash that the government has pumped into the economy that have prevented an actual contraction. But that has come at the price of running up the national debt to 140% of GDP, so it's all borrowed money that's been spent. Not on invesment, but on consumption, so it's gone.

Looking at the US, the recession of 2001 and 2002 is clearly visible, and the increase in government consumption has only partially offset these losses elsewhere in the economy. But there are some surprises in Europe. Germany and the UK have seen the economy grow to roughly the same cumulative gain since 1991 if government consumption is taken out of the equation. The UK had built up a lead from 1991 to 1998, after which it remained stagnant. (This incidentally coincides with the tenure of the Labour government.) The German economy has managed to grow during that time, but for the very large part that's due to exports. In 2002, exports amounted to 36% of GDP. Taking exports out of the picture, the German economy would have contracted by about 3% cumulatively since 1991 (this still includes government consumption). Over that period, the export contribution grew from 24% of GDP to the above-mentioned 36%. The strong euro is a real headache for the German economy, because it undermines the one sector that has actually been doing well.

Going back to the ex-government consumption numbers, the graph shows that net cumulative economic growth in the Eurozone in the period 1991-2002 was close to zero. In other words, if it had not been for government consumption, the Eurozone economies would not have grown at all in this period. That's a pretty glaring indictment of economic performance.

The total cumulative contribution to GDP growth from final government consumption expenditure is plotted here. It shows that the net contribution in the US has not been very different from that in the Eurozone. The difference in economic performance is largely due to growth (or lack thereof) in the other components of GDP, which will largely be due to private enterprise.

The total cumulative outperformance of the US economy relative to the Eurozone does not change if you take government consumption out. This is a somewhat surprising result, in that one might have expected the gap to widen. But the spending binge by the US government since 1997 has led it to pull even with the Eurozone in this regard. However, the crucial difference is that the US economy has been able to grow in its other GDP sectors too, whereas all the Eurozone growth since 1991 has been due to government consumption growth. That's not a sustainable or healthy position to be, witness the plight of Japan. Moreover, the share of GDP coming out of government consumption in the US has been declining, although the recession has nudged it back up. In th Eurozone, the share has remained constant.

Europe desperately needs to get its real economy going again. But it's facing the headwinds of the strong euro and the suffocating regulatory environment. As the Japanese experience has shown, hoping that government spending will kick-start the economy is not a wise strategy. So it's back to the old mantra: Europe needs economic reforms. But somehow they never quite seem to happen.

Monetary union and economic flexibility

The question whether the euro will in the long term benefit Europe or harm it cannot be answered at this point with any certainty. I have been skeptical about monetary union in Europe as it is constituted now, as there are serious divergences undermining EMU. There is no agreement between economists (is there ever?) on whether even in theory it is better to have fixed exchanged rates or floating ones. And the split goes right down the middle of the free market camp too, with both views represented by the Big Names of Economics.

So I was very interested to find a discussion between Milton Friedman and Robert Mundell on this very issue. (I came across it via Arnold Kling, whom I found through this post at Asymmetrical Information). The discussion goes around in circles to a certain extent, but in the end it boils down to the issue of economic flexibility. As exchange rates are prices, they convey information on supply and demand of currencies, which again is based on numerous other factors in the real economy. By shutting down a mode of expression for the information by fixing currency prices, you can't make the information go away. It will have to express itself by other means, and that's where economic flexibility comes into play.

Mundell argues that having a sound monetary policy is of vital importance, and that economic benefits will follow if only there's stable money. In fact, he takes the argument to its logical conclusion and advocates having a world currency. The larger an area a currency covers, the greater the stability will be. Mundell does say he does not advocate a single world currency, but just a world currency; the difference though seems to be semantic rather than substantive. He says:

My ideal and equilibrium solution would be a world currency (but not single world currency) in which each country would produce its own unit that exchanges at par with the world unit. We could call it the international dollar or, to avoid the parochial national connotation, the intor, contraction of “international” and the French word for gold. Everything would be priced in terms of intors, and a committee—in my view, say, open market committee designated by the Board of Governors of the International Monetary Fund—would determine how many intors produced each year would be consistent with price stability. Every country would its currency to the intor following currency-board system principles.

This is different from having a single world currency only in that it retains the option of re-floating national currencies, which would be harder if they were abolished altogether. And the practical difficulties are enormous too, as its ultimate viability would depend on the proposed "G3 Open Market Committee" being able to determine the right amount of intors to issue. In effect, this creates a single fiat currency for the whole world. I get nervous with three fiat currencies being dominant. The art of central banking has not evolved to the point where one would wish to bet the world's economic future on central bankers getting it right.

Friedman argues for flexible exchange rates, arguing that they provide an important escape valve for the adjustment of prices within an economy. Mundell counters that the same adjustment can take place by changing domestic price levels, and that it can be done more effectively that way. In theory, Mundell is right, but in practice it does not work that way, and this is what Friedman argues too. The case of Argentina is instructive in this regard, as it had a fairly orthodox currency board which ultimately failed. The discussion between Friedman and Mundell took place before the Argentinian currency board collapsed in late 2001, so there are no port-mortems of this event, nor do they spend much time discussion the Argentinian situation.

By tying the peso at parity to the US dollar, Argentina did get the immediate benefit of vastly improved monetary policy in 1991, just as Mundell argues. It also introduced thitherto unheard-of macroeconomic stability, and the Argentinian economy prospered. But Argentina was pricing itself slowly out of the market by maintaining convertibility with the dollar. It simply wasn't producing enough economic added value to justify charging the prices in a convertible peso, nor did it have the productivity gains that would allow the economy to remain competitive internationally. The 2001 collapse in Argentina came after Brazil had unpegged the real from the dollar in 1999, which added to the competitive pressures on Argentina. At this point, Argentina had the choice of adjusting its domestic price level downward, or achieve a similar result by devaluing the peso and thus breaking the currency board. In a very messy process that exacerbated the outcome manifold, it ultimately defaulted on its debt and devalued the peso. It sank from parity with the dollar to 4, essentially wiping out 75% of Argentina's wealth if measured in dollars.

The key again is economic flexibility here. Had Argentina possessed an economy flexible enough to adapt quickly to competitive pressures by improving productivity and reducing the domestic price level, it would have been able to keep the peso convertible to the dollar at parity. Looking at a single dimension of productivity, it might have had to reduce aggregate labor costs by, say, 25% in the mid-1990s. Firing 25% of all workers is one way of doing that, or by all workers taking a 25% pay cut. Neither is very appealing.

One of the architects of the Argentinian currency board, Steve Hanke, defended the currency board against the critics (such as Paul Krugman):

And how did the Argentine economy fare during the Menem decade? As Table 1 shows, Argentina responded with a growth spurt that left its neighbours in the dust. All this is not an anomaly. Since 1950, countries with currency boards have realized average GDP growth per capita that is 54% higher than comparable countries that had central banks with discretionary monetary powers.

This is not to say that a sound currency is everything. Indeed, Argentina desperately needs a good dose of supply-side economics. Unemployment is high because labour market regulations are burdensome and taxes are too high and complex. Bring on deregulation and a flat tax. Clone Hong Kong, please. And that's not all. The government apparatus needs a complete overhaul. The only way to attack the endemic corruption spawned by the state is to shrink it. Those reforms, on top of its sound money, would put Argentina back on a high-growth track.

The table at the bottom of his article shows that Argentina's economy grew by 230% in the years 1989-1999 in US dollar terms. The devaluation of the peso (now trading at about 3 to the US dollar) means that all that growth and then some has been wiped out if measured in dollars. In fact, in dollar terms the Argentinian economy contracted about 25% in the period of 1989-2002. Hanke actually sees the seeds of demise for the currency board when he argues for structural reforms. (As an aside, the picture for the Asian economies he mentions would now be different, as some floating-rate countries like South Korea have done pretty well since the crisis of 1997.)

Using the currency board as both the carrot and the stick in Argentina failed to get the necessary structural reforms get implemented. The members of the European Monetary Union are no Argentinas, but there are a number similarities. Structural problems are contributing greatly to the current economic weakness in the entire Eurozone. The problems are the same as in Argentina, although probably not as severe: rigid labor markets and high non-wage costs are preventing European companies from adjusting to the weak global economic environment (and the strong euro too). Mundell's argument is that the single currency will be a driver of reforms, making it more likely that these structural problems will finally get tackled. Are reforms a necessary precursor for monetary union, or is monetary union a catalyst to bring these changes about?

There has been some progress in Europe on structural reforms, but overall far too little has been achieved. While there is a reasonable single market now in goods, the services sector is still highly fragmented. And even the European directives establishing the single market for goods are poorly implemented, with France being one of the biggest offenders. Not very surprising, that. It does show that there is a difference between the Single Market on paper and the reality on the ground. But the intentions here of the EU are good for a change, and Brussels will be trying to create a true single market for services. It's not going to be easy:

A commission report published last year listed 92 barriers encountered by businesses wishing to offer their services in more than one EU country.

The report found problems began with the founding of businesses, which can be hindered by local and national requests for several authorisations.

The distribution of services was also made difficult by laws forcing the provider to have a physical base in the country.

The advertising industry was hampered by a maze of different national regulations.

Belgian electricians have to pay three times the Belgian rate to register with the authorities in neighbouring Luxembourg for a one-day job. And Austrian bakers need eight different licences if they want to set up in Italy.

If the euro is to become successful, it is vital that the internal market be as free as possible. This still does not address the issue of structural reforms within member countries, though. Eurosclerosis is a problem that won't go away easily. Having a true single internal market will make cross-border competition more intense in many more areas than is possible now. This could be one of the great strengths of the European Union, by allowing countries to experiment with their domestic economic policies by competing against one another. Competition is an essential tool in the economic discovery mechanism of what works and what doesn't. But competition is scary to those who like the status quo, and especially those who like the power they wield in their own countries. So plans are afoot to stifle competition between countries, because it's so unfair:

Plans to scrap the national veto on tax to eliminate "unfair" tax competition in Europe will this month be proposed by Valéry Giscard d'Estaing, the man drawing up a new EU treaty.

His plan, designed to stop some EU members poaching inward investment and savings by setting very low tax rates, has the backing of most member states, including France and Germany.

According to aides, Mr Giscard d'Estaing is determined to press the issue, even though Britain and Ireland are opposed to deciding any EU tax issues on the basis of majority voting.

The former French president believes that without reform, the EU's single market will be distorted as countries embark on a damaging race to undercut one another's company tax rates.

It's the same old argument against capitalism and competition, but transported into a different context. It shows that the European elites still don't understand why an economy works and prospers. It's not a new insight, but it's the statists of d'Estaing's ilk who are drawing up the new EU constitution. That does not bode well for the future, but that's not news either.

There is some evidence that the euro has indeed spurred greater economic integration and flexibility in Europe. But this enforced discipline has not extended very far, nor is it making much of a difference in the discussions about structural reforms. My view remains that European Monetary Union is currently doing more harm than good.

Meanwhile, in Latin America, the idea of monetary union seems to be catching on. Brazil and Argentina have floated the idea of moving to a joint currency. Coordinating economic policy is one thing, but moving to a joint currency at this stage seems foolhardy in the extreme. Moreover, one report quotes deputy foreign minister Martin Redrado as saying:

"The currencies are worth almost exactly the same, this is the time,"

Yes, the exchange rate between the real and the peso happens to be close to one at the moment, but that is utterly meaningless. You could multiply either currency's nominal value by a constant and it would not change underlying economic reality one bit. If they're going to base a single Latin American currency on this kind of reasoning, it's doomed before they even start.

Financial derivatives

I am still trying to catch up with my backlog of blogging; work as been interfering rather drastically of late, and by the time I got home I seldom had the energy to blog. Hopefully this week will be better. One of the loose ends are comments on financial derivatives, which I referred to recently. I said that I was surprised that we had not seen (publicly) any major blow-ups of equity CDOs. A CDO is a Collateralized Debt Obligation, and comes in many forms, ranging from the harmless to the volatile. The riskier ones are backed by high-yield bonds (more commonly known as "junk bonds," but "high yield" sounds so much better). These are the bonds rated below investment grade, i.e. lower than BBB-. The default risk of these bonds is much higher than for safer bonds with higher ratings. But even high-grade bonds can default. WorldCom's debt was rated AA when it defaulted, for instance.

Let's take a junk bond CDO as an example. What you do is you borrow a chunk of money in the markets and use to buy a portfolio of junk bonds. You want it to be well-diversified so that any one default won't blow your portfolio out of the water while you still profit from the higher yields of these bonds. Now you start redistributing the risk of this portfolio. You create a synthetic AAA-rated bonds for instance, which pays a spread of government bonds of, say 200 basis points. In order to get that AAA rating, you need to overcollateralize it with junk bonds. Essentially the holders of the synthetic AAA bond get first dibs on any cash flows coming from the underlying junk portfolio. Then the buyers of the AA-rated synthetic bond get their share, etc. What's left at the end is the equity portion of the CDO. It concentrates the risk of the junk portfolio in a small part of the capital; the overall aggregate risk of the bits and pieces into which you've sliced the underlying junk remains the same (otherwise you could make risk evaporate), and if some parts have much lower risk than the underlying, some other parts must have much higher risk. And that's the equity portion of the CDOs.

Junk bonds have not done well in the last five years. The spreads over government bonds have widened dramatically, far more than nominal yields on government bonds have fallen. Coupled with increasing default rates, this has meant that junk bond portfolios have had negative returns for several years now. Credit spreads have started to tighten again in the fourth quarter of 2002, so the worst may be over now. But institutions who bought equity CDOs have seen those investments get marked to zero. Individual investors will not have been affected, since you typically need tens of millions of dollars to buy into such a structure. In some cases, the issuing investment bank will keep the equity CDO on its own books to show its commitment and confidence in the deal. In many cases, equity CDOs have been sold on to third parties. Big buyers in Europe have been primarily insurers and some banks. I've talked to some people who've been involved with CDOs over the last years, and they say that it has hurt the equity CDO buyers, but that they were generally well diversified and did not invest too much of their portfolios in these things. But it's hard to tell; these deals are very private, and nobody likes to talk about them in the first place, let alone when they go sour. So we're unlikely to see these deals reflected explicitly in the investment results unless some institution really blows up in a big way. The losses are there, but CDOs have not been big enough (yet?) to cause a blow-up. I sincerely hope it stays that way.

Japan's two faces

Some time ago, Samizdata linked to "Is Japan Faking It?", an essay by Eamonn Fingleton arguing that Japan's problems were nowhere near as bad as we here in the west seem to think. It's about as contrarian as you can get these days without completely losing sight of reality, but it was worthwhile reading nonetheless. Not because I agree with it, but because it's plausible enough to be true, which in turn forces you to think about what's really going on the Japanese economy. It is certainly true that the reflexive reaction to Japan now consists of chanting the from the Holy Basketcases Hymnbook, starting with "All Debts Great and Small." This is an abrogation of thought and analysis in favor of convenience. I too have often been guilty of this, so I took Fingleton's article as a starting point for re-examining Japan, focusing in on some of the out-of-consensus calls he makes.

In terms of fundamental data, I find the article wanting. To get an overview of macroeconomic data, I highly recommend the OECD's database. All data I will be using here is taking from the spreadsheets you can download from that page, unless otherwise noted. To start, there's this claim in Fingleton's article:

The latest "disaster" is Japan's allegedly out-of-control government spending. But Japan's budget problems are grossly exaggerated. OECD figures show that in the first eight years of the 1990s, Japan actually ran large budget surpluses. Since then the government's position has deteriorated somewhat but is still no worse than many other nations.

This is relatively easy to find in the OECD data, and it's simply not true. This graph shows the government balances as a percentage of nominal GDP for the US, Eurozone, UK and Japan. As you can see, Japan has been running a budget deficit since 1993. This also holds true if you look at the other OECD budgetary indicators, such as cyclically adjusted deficits and the primary budget balance. This latter is the deficit the government is running excluding debt servicing. The very low interest rates that the Japanese government is paying on its debt have kept debt servicing from becoming an additional problem. Even looking at gross or net financial liabilities his line of reasoning does not hold up. The footnotes the OECD provides in its spreadsheets note that these latter number are not necessarily comparable across countries due to differing methodology. Still, even if the level is not perfectly comparable, the first derivative is. Fingleton also claims that:

Living standards increased markedly in Japan in the so-called "lost decade" of the 1990s, so much so that the Japanese people are now among the world's richest consumers.

Japan's consumer have been amongst the world's richest, although perhaps not on a purchasing power parity basis. However, the OECD does provide data on this as well. Net household wealth as a percentage of disposable income has been shrinking in Japan over the last decade. What's missing here are the disposable income numbers, and unfortunately the OECD does not provide them. However, this data we can find in the Statistical Handbook of Japan 2002. Scroll down to figure 12.2, where you will see that real disposable personal income saw its last significant increase in 1991, and even that was less than 2%. In comparison, real DPI in the US has been growing at a 3-6% pace over the last ten years. So here too Japan has been losing ground, rather gaining it.

Another aspect of Fingleton's case rests on Japan's superior trade performance during the 1990's. He points out that the trade surplus has risen by a factor of 2.4 since 1990. Japan's current account is also showing a healthy surplus, while the Japanese savings rate is the envy of the industrialized world at 8.7% according to Fingleton, while the OECD data puts it even higher. There is a trap in talking about trade balances in terms of "surplus" and "deficit" as I have done just now (and as is usually done) because those terms have connotations of "good" and "bad." The trap is that a trade deficit is not necessarily a bad thing. It depends on the circumstances. Let's scale the example down to a household. As a result of the job you're doing, you add to your hoard of little green bits of paper. Now suppose you decide you need a new hammer. You could go to a mine, get your own iron ore, smelt it, bang it into shape and use wood you cut down to make a hammer out of it. Chances are you're going to go to yuor hardware store and choose from one of dozens of hammers someone else has produced for you. In order to obtain the hammer legally, you then hand over some piece of green paper to the store and go back home with your new hammer. You've just increased your personal trade deficit. Unless you sell more goods than you buy, you have a trade deficit. Cause for panic? Not really, as long as you continue to earn enough bits of green paper to finance your trade deficit. This applies in a wider sense to the US economy as well: as long as the sum total of value added in the US economy grows sufficiently to finance the purchases from abroad, there is not a problem. Americans give green pieces of paper to the Japanese and get shiny consumer goods in return. It's the aggregate wealth of the US economy that has made this possible. To keep this working, not only has the US economy to produce enough wealth, but it also requires a continued willingness of the part of the Japanese to trade shiny consumer goods for green pieces of paper. As long as they're happy to do that, there is no problem and both sides benefit.

A similar story also applies to the current account balance, where again the US is importing capital while Japan is exporting it. In essence, the low savings rate in the US is compensated in part by the Japanese sending their money to the US. This is one of the things Fingleton points out as a positive for Japan. The large capital outflows indeed enable the Japanese to buy stuff abroad. But they're not doing it because they want trophies on their mantlepieces (well some of them might), but because they want to earn money. And because they're sending their capital to the US, they're also giving an implicit vote of no confidence in the Japanese economy. Actions speak louder than words, and these actions mean that the Japanese think they can get a higher return on their capital if it is invested in the US than in Japan. So the current deficit could become a problem if for instance another region in the world gets its act together and becomes the preferred destination for international capital. This does not seem likely in the very short term, but you never know. Congress could suddenly raise taxes or pass regulatory bills that affect American companies' competitiveness, and money might go elsewhere. Right now, America is still the default place to invest your money though.

The high savings rate in Japan is extolled by Fingleton as a great positive. It could be, but it isn't. And the reason for that is the broken banking system. The people are saving money, but the banks aren't lending. One of the key tasks of a healthy banking system is to provide risk capital to entrepreneurs, and this is simply not happening in Japan. The banking system is seriously broken; the Bank of Japan has been printing money (metaphorically) at a tremendous rate. The monetary base has been expanding at a 30% year-on-year rate for some time now, but the broader monetary aggregates are not picking it up. M3 and M4 are growing at 1 to 2% year-on-year. So despite the creation of large amounts of additional yen, this is percolating into the broader economy. The money multiplier is dead in Japan for now. And that's because both the banks and industry are in a mess. As a final comment on the high savings rate, it should be pointed out that Japanese savers are getting virtually no nominal return on their savings, and haven't been getting return for many years now. The Zero Interest Rate Policy of the Bank of Japan has ensured that both lending and borrowing rates are very low. The real return on cash is slightly positive, but it's still puzzling that the Japanese would be so risk-averse as to put so much of their income into an essentially dead asset. As Fingleton points out, the net national savings position of Japan is considerably lower than the government's, if you count personal savings too. So he's right that there is no solvency issue at the moment, but that's looking at the country as a whole. If interest rates ever go up, the debt servicing burden on the government will become very onerous very quickly. Sure, Japan can afford it, but only by transferring money from private to public coffers. This means taking money away from the consumers and giving it to the government by taxation. This is not going be popular or short-term positive for the economy. What we're seeing is perhaps a case of Ricardian equivalance, which states that the timing of how government debt is financed has no impact on the real economy. So whether you tax now or issue debt now (to be paid later) makes no difference. A perpetuity of $50 at 5% interest has a present value of $1000. So whether you pay $1000 in tax now or $50 in perpetuity makes no difference. But the people who'll be paying off the debt will in the end be the children of the people who issued the debt and presumably benefited from it. So an intergenerationally altruistic household will put the $1000 in non-levied taxes to buy the bonds issued and then use the coupon income to pay the $50 perpetuity. Do real people really think like this? There is some evidence that in the aggregate the expectations of future taxes are influenced by current debt issuance and levels. So a high savings rate would not be a surprise in such a context.

If the monetary base is expanding so rapidly but broad money supply isn't, where is the money going then? It's certainly not going to Japanese consumers, nor does Japanese industry seem to be benefiting much from it either. It's not going into real estate or land, nor is the stock market benefiting. Instead, the money is going into funding the JGB bubble. JGBs (Japanese Government Bonds) have real yields that are surprisingly low for a country with a fiscal position as dire as Japan's. It's partially due to the structure of the Japanese savings system, which tends to invest disproportionately in JGBs, as well as the printing of money by the Bank of Japan. At some point, this bubble will have to burst, just like the Dot-Com Bubble in the US and Europe burst.

One last point of criticism of Fingleton's piece is his comparison of the deflation currently rampaging through Japan and the US experience in the latter half of the 19th century. There are some significant differences between the two situations. First and foremost is the structure of the economies. Even back then, the United States was attracting foreign direct investment (FDI) to finance the growth of the economy. In fact, the United States has pretty much throughout its history run trade deficits, with the exception of the depression years of the 1930's. (Sorry, couldn't find a link). While the US was importing capital, Japan is exporting it now. Furthermore, he quotes LaFeber as saying that the 25 years to 1897 were "economic hell" because of persistent deflation. The date chosen is no coincidence, as that is the year in which the US returned to the gold standard at the pre-civil war parity. During the war, the US had three currencies: the greenback, the Confederate dollar and the yellowback. The yellowback was the original US dollar backed by gold and continued to be used in the West. Both the greenback and the Confederate dollar were fiat currencies (i.e. not backed by gold or any other metal. Virtually all currencies now are fiat money). After the war, the greenback and the yellowback needed to converge again, and this process took till 1897. It took so long because to restore the price level more quickly would have caused a massive recession. This long period of deflation was engineered and deliberate, and the US economy grew during the period. Japan's economy has not grown much in the last ten years. (Data taken from this dataset compiled by NBER's MacroHistory project. More information on post-civil war currencies can be found here. Inflation data downloaded from Global Financial Data.)

I'm not impressed with Fingleton's case. Japan's economy does have serious problems, and I simply don't buy his analysis. However, this article is title Japan's Two Faces, and that's where I think he does have a point, although it is not as controversion or contrarian as his call on the economy. There are some really, really good Japanese companies, and they've been doing pretty damn well over the last ten years (and before too). Some of them are well-known names in the West, such as Toyota and Sony. Others are doing well again after having come to the brink of collapse; Nissan had to be rescued by the French, for instance. Japan's corporate landscape shows a mixed picture. In general, the companies doing best are those that have been exposed in full force to the rigors of the international marketplace. That forced them to become well-run, modern companies, exactly the kind that the rest of Japan is still lacking. As the Japanese market becomes more open (and not just to Chinese imports) and red tape is slowly abolished, market mechanisms will force more Japanese companies to become competitive again or face death. As long as bank are not willing to foreclose on non-performing loans though, this is not going to happen. So it's certainly not all gloom and doom in Japan. But it's exactly that part of the Japanese economy that has been most exposed to Western-style free markets that is doing best. Japan has a deep base of knowledge and excellence in products that need to be unleashed, quite literally. As long as the arcane, indeed pre-capitalist, structures and linkage continue to prevail, the spread of Good Companies in Japan will remain limited. The risk is rather that the bad, zombie companies will infect the good ones by undercutting them. If you're essentially dead and have no hope of paying off your debts, why not sell below cost? At least you'll get market share and you can pretend to be alive for a bit longer. Good companies are then forced to compete with the zombies, and can't last very long usually. Bankruptcies are sorely needed in Japan.

Not all of Fingleton's arguments are on the mark in the company area either. For instance, the supercomputing lead Japan has is not directly related to manufacturing expertise. Rather, the US and Japan took differing approaches to supercomputing about a decade ago. US researchers thought that by bundling together lots of cheap computers, you could create a cost-effective machine that is very fast. The Japanese continued the "old-style" supercomputing tradition, which has proven superior.

Finally, where Fingleton goes off into fantasy land is when he posits that the Japanese have deliberately been talking of crisis to get the rest of the world off their backs. It's supposed to be part of a centuries-spanning plan that would put Asia back in the number one position in the world, having been supplanted by the West, and specifically the US. That's just nonsense. Japan is not welcoming China's exports "with open arms," but instead there's an enormous amount of bellyaching about Chinese exports. Japanese versions of Ross Perot with their Giant Sucking Sounds are popping up all over the place. Instead what's happening is that Japanese companies are trying to create better profit margins, and that means shifting commoditized manufacturing offshore to China, which is becoming Japan's reservoir of cheap labor. It's benefiting both countries, of course: Chinese become wealthier and Japanese companies become more efficient. But the adjustment process is painful. Rather than a sinister long-term plot, it's just another sign that Japan is slowly rejoining the world economy by opening up a bit. It's becoming more western, more free-market, even if only at the margin. There is a core of good companies upon which Japan can build to try to regain its economic strength. It's up to the Japanese government to take further action in liberalizing the Japanese economy and opening it up to market forces.

Raising capital in Oz

Here's a new market for all those underemployed and underutilized investment bankers who still have jobs: the Daily Planet is set to go public in an IPO in 2003. What's newsworthy about this is that the Daily Planet is a brothel. The brothel is only aiming to raise 22 million Australian dollars, so it's by no means a huge IPO, but I am sure the investment bankers will be happy to take on the business. It should be enough for the Daily Planet to finance its further growth. One appealing aspect of its business that it's recession-proof, or so the proprietors claim. That will put it apart from the rest of the hospitality business, which tends to be highly cyclical. If the Daily Planet can generate a steady stream of free cash flow and return a good proportion of earnings to investors through dividends, it could be an interesting combination of a high-yielding stock with strong growth if they expand. Of course, the key question is: how will analysts investigate the Daily Planet's financials before buying the stock? Field research could become very interesting indeed. "All part of due diligence, sir!"

German stagnation and the growth gap

Germany has the third largest economy in the world after the US and Japan. And its economy has been underperforming not only the US, but Europe as a whole for at least a decade. Japan's economy is already in a deflationary slump, and now Germany is in danger of following in its footsteps. On the one hand, monetary union has forced inappropriately high interest rates on Germany, while on the other hand it suffers from deep-seated the structural problems. The ECB is not going to help out on the former, while German politicians have no clue about the latter.

The German economy's underperformance is a result of an economic structure built on social consensus rather than market forces. The Weimar republic and the following Nazi era led to Germans attaching a very high premium on domestic stability. As the economic boom of reconstruction after the war produced great wealth, the predominant socialist ideology of the welfare state spread ever further. Labor unions demanded shorter work weeks without proportionate falls in pay, while the captains of industry built a cozy network of cross-shareholdings with their banks. This system worked for a while, but the ever-increasing amounts of legislation under the banner of "social protection" shackled the economy down one by one. The road to serfdom is paved with good intentions. to protect workers from getting fired, laws were passed making firing people expensive. Now the risk of hiring workers in Germany is high, because you may not be able to fire them again. The great fundamental flaw in building this system was the belief that you could legislate your way to social cohesion and prosperity. One particularly egregious example are the "Arbeitsbeschaffungsmassnahmen." This word translates into "measures to provide employment." All kinds of retraining programs fall into this category, and over the years the unemployment statistics have been massaged downward by sending people off on these projects. If the government could indeed wave its magic wand and provide employment like that, Germany would have no unemployed. Instead, the unemployment rate is around 10%.

The structural rigidity of the German economy has meant that it could not react quickly and nimbly to changing circumstances. Germany has not yet made the wholesale transition from a manufacturing to a service economy. It is not able to climb the value-added ladder, and competing in manufacturing with much cheaper labor in Poland or the Czech Republic is futile. Yet there are no politicians in Germany who really get this. Occasionally the FDP might mumble something that would be a step in the right direction, but aside from their self-inflicted implosion, they would in any case not be a major force.

Unification provided a brief boost to the German economy at the beginning of the 1990's, but that proved ephemeral. The monetary union between East and West Germany shows the dangers of joining two disparate economies. What's even worse, the worthless Eastern Marks were exchange at a one-to-one rate for Western Marks. This was a political necessity, but the long-term economic consequences are still being felt. Despite a truly gargantuan transfusion of money from West to East, the eastern part of the country is still very far behind economically. It's quickly becoming the German mezzogiorno, the name given to the destitute south of Italy, which gets huge handouts from the prosperous north.

Ever since unification, the German economy has not been doing well. Retail sales have been flat for ten years now. The only growth Germany has seen has been export-driven as it has been unable to generate self-sustaining domestic growth. While growing a little less every year may not sound like a catastrophe, the cumulative effects do add up (or rather, they multiply up). Since 1981, the German economy has grown in real terms by 54%. However, in the same period the EU economy grew by 61%, the British economy by 69% and the US economy almost doubled in size with growth of 92%. The comparison since unification 1991 is even more shocking. The Germany economy grew just 15%, beating Japanese growth by about 5% over the period. But the performance of the Anglo-Saxon economies was in a different league altogether: the US economy increased by 41% and the British economy grew by 31%. In terms of virtually every macroeconomic indicator, the US and British economies have done better than Germany.

What Germany needs is exactly what Schröder promised not to do: a strong dose of Anglo-Saxon economic medicine. The German economy needs to be unshackled, taxes need to be cut, the labor market needs to be liberalized. Without radical change, the German banking sector is heading towards a systemic crisis like the one in Japan right now.

How much pain is necessary before the changes can be made? It took Britain a winter of discontent to get serious about breaking the unions and restoring economic sanity. With the German premium on stability, the gut instinct will be to try to muddle through as long as possible, all the while making the problem worse and the eventual cure more painful. And if Germans have an economic pain tolerance like the Japanese, Europe's biggest economy will be in for a very long period of misery.

Unintended consequences

Decimalization all seemed so perfectly sensible. Stocks in the US used to be quoted in fractions: halves, quarters, eights, sixteenths and even thirty-seconds of a dollar were the fractional prices paid for equities bought and sold on the US exchanges. The rest of the world had long since switched to decimal pricing, and with ever smaller increments being quoted for US stocks too (sixty-fourths anyone?) the pressure was on to rationalize the system. No more fractions and prices for equities could be expressed in dollars and cents, just like virtually everything else. The changeover took place in April 2001.

The Nasdaq market relies on "market makers," which are big institutions who intermediate between buyers and sellers on the market. They make their money by selling the stocks at a slightly higher price than they buy them: this is called the bid-ask spread. There had been much criticism of market makers and the high spreads that were quoted on many Nasdaq stocks, and decimalization was supposed to bring spreads down. And down they have come. In fact, they have come down so far that the profitability of making markets in smaller stocks is no longer viable, or so claims Nasdaq CEO Wick Simmons. He says that the decision by some big market makers like Merrill Lynch to withdraw from smaller stocks proves the point, and he now says that decimalization was a horrible mistake. What's worse, this makes access to the trading of smaller stocks more difficult, hurting both small investors and small companies.

So is this a classic Hayekian case of unintended consequences? I'm not so sure. The erosion of the bid-ask spread is a classic case of a more efficient market. The bowing out of some players is also a market response; you can't force people to engage in unprofitable business. (Well, you can, but it's not a good idea). So thus far what we're seeing is the market changing participants' preferences. Those who find no utility in making markets in small stocks will leave, and have their place taken by competitors who think they can make a buck doing so. It's also worth bearing in mind that decimalization took place at while the big Internet Bubble was deflating, and all Wall Street firms have fallen on tough times since then. Trading volumes aren't what they used to be, and small investors' appetite for small cap tech stocks is way down too. So perhaps Merrill Lynch's decision to exit the market making business in small caps is more related to the bear market than to decimalization. It would be interesting to see some data on other market-making exchanges around the world (couldn't find hard data on this).

We'll have to see how this pans out. Based on the evidence I have seen thus far, I'm not willing to say that decimalization is at fault here. If many players exit the market-making business in small caps then spreads will start to widen again as a illiquidity premium will have to be paid. As supply goes down, prices (i.e. spreads) will go up, which will attract players until the market reaches a new equilibrium. No need to panic yet. We'll announce the proper time to panic on the PA system.