The ubiquity of Coca Cola

I was perusing the Post-Courier Online - a newspaper in Papua New Guinea. The cover story with picture is as follows:

Neighbouring tribes in South Wahgi district of Western Highlands Province exchanged food at the weekend as they started negotiation to restore peace among themselves and end hostilities in their area. The Ngenika and Kisu tribes have realised that there was an increase in illegal activities in their communities and after much discussion, starting in 2007, the Kisu tribe gave 21 cows, red pandanus fruits (marita), 200 coke cartons, scone packets, sugarcane and bananas to the Ngenika tribe. They also slaughtered 100 pigs for their neighbours. Last year the Ngenika tribe gave 10 cows with the same amount of food to the Kisu.

200 Coke Cartons is part of the tribal peace offering between tribes in the Western Highlands of PNG. And you read about it on the internet.

This modern world is very strange.

Australia – the lucky but unbalanced country

I get many emails asking for my opinion as to the Australian economy and the Australian banks in particular. That is not surprising because I am probably the best known Australian writing a global investment blog. Certainly I write the best known blog by any Australian fund manager.

Answering the question in one post makes about as much sense as answering the same question regarding say Canada or France. The country is too big for an easy answer. Moreover some of my correspondents are German or American and others are Australian and I can safely assume different levels of knowledge for each party. This is a post aimed at non-Australians. Nuance for locals is harder.

Australia’s macroeconomic miracle

You can’t understand why Australia works so well without a decent statement of the Australian macroeconomic miracle. Australia is one of the smallest and most indebted nations to be given the privilege of borrowing in their own currency and floating that currency. New Zealand (across the ditch) is the smallest country with the unlikely trifecta (has run large current account deficits for a very long time, borrows in its own currency, floats that currency).

This is incredibly useful. If you are highly indebted bad things can happen to you but they are far less severe if you are lucky enough to be able to borrow in your own currency and to float that currency.

Consider the situation when the macroeconomic environment moves sharply against a country – as might happen with a rapid terms of trade change – or also might happen with if people (say due to a global fear epidemic) think its possibly you can’t repay them.

• If your currency is fixed you will get a classic monetary recession. People will speculate against the currency (or withdraw their lending to you) and (due the central bank being forced to defend the currency) the local monetary supply will crash. The extreme version is what is happening to Latvia. It’s why Latvia should float their currency.
  
  
• If however your currency is floating and you are highly indebted in foreign currency then your currency collapse will bring into sharp relief and immediately the difficulty of repaying your debt. The lower currency increases the principal and interest repayment in domestic terms of your debt. In extrema it causes almost immediate default. This is what is stopping Latvia floating their currency.
  
  
• The Argentine solution is float the Peso in a crisis – but to rejig all old debts to new pesos at some new exchange rate and formalise the default. If you do that nobody trusts you again. If you are South American you do it a few times and you wind up looking like South America rather than Australia or the United States. In 1900 the three richest countries in the world per capita were Argentina, New Zealand and Australia (in order). Look how that worked out.

Now the Australian miracle (the trifecta) means that an external crisis can hit Australia and all that happens is that the Australian currency drops until our terms of trade improve again. The classic example was the 1997-99 Asian Economic Crisis: as we export mainly to Asia this was potentially devastating to our economy. But instead it was just devastating to the currency – which fell by about 50%. I remember travelling to the New York (for work) when the AUD was trading at 48c US. It was so expensive in New York as to be completely comical. The business hotel in New York cost more than a week’s average wages per night (it was a business hotel in the height of the dot.com bubble). But the fallen currency worked. It meant local export industries ticked up – the tourist industry did not collapse despite the lesser numbers of Asian visitors. The lower currency bailed out plenty of other industries as well.

When the crisis disappeared the currency went up again - more than doubling. Then China slowed a little and the currency fell.

If we did not have a floating currency and the ability to borrow in our own currency this would not have happened. We would have been just another case of macroeconomic road-kill.

This is a deal afforded Australia only because of 100 years of fairly good management. If you stuff up you lose our trifecta ... it is worth preserving. Fiscal rectitude – especially in good times – is worthwhile because it protects this privilege. And the reason why you want to run tight budgets in good times is precisely so the world does not force you to run fiscally contractionary policy during bad times.

General observation: whilst these conditions persist (which could be a long time), Australia will have the least trouble of any major OECD economy in adjusting to external economic shocks. The United States is pegged to China (although not by their own volition). Most of Europe is pegged to each other. [It will not help so much with domestic economic shocks. But governments of both persuasions are pretty good by global standards and they don’t look like stuffing it up. I am not so cheery about New Zealand – a country I think is very badly run by comparison with Australia.]

Anyway with the recent shock (China slowing commodity demand due to global economic conditions) we had the usual currency correction (currently reversed). Again and it looks like we have avoided the shock. The Australian economy seems indecently strong.

The unbalanced Australia

Unfortunately it is not quite as simple as all that. The Australian economy is very unbalanced. It has Sydney – a huge financial city in three big rings. Inner Sydney is a financial city of very high wealth. By repute owners of almost half of the wealth of Australia reside East of the Sydney Harbour Bridge. And it is only 4 km (3 miles) to the ocean! [The entire city of Brisbane is east of the bridge too, but the wealth is in Sydney.]

The financial sector is hurt but not badly as credit markets never closed here for longer than a few hours.

Beyond this Sydney has a service ring – mostly people who service the financial city (cleaners, plumbers, school teachers).

Outer Sydney (fully an hour drive from my home) is a manufacturing centre and it is hurting – but not as badly as I thought. Indeed a falling currency seemed to keep it quite well adjusted.

Almost all of Sydney is NOT resource dependent. It is the least resource dependent city in Australia. (In order Perth, Darwin, Brisbane, Adelaide, Melbourne, Hobart, Sydney.) Hence the recession is nastiest in New South Wales – and even then it is not bad. [Sydney is the capital of the state New South Wales.]

China has taken off again – or at least Chinese commodity demand has resumed. Australia is going to have to have a big internal adjustment – which will downplay the role of Sydney. However as there has not been a financial system crash here that will be an adjustment which for the moment looks manageable. As long as the adjustment happens at less than say 80 thousand jobs per year it will happen without great financial stress. For that we need China to keep on demanding our commodities.

The insane Sydney Housing Market

I am long Sydney Housing. I own a nice house. I would prefer bet against the price of my house (a nice but not large house without beach views in the fashionable suburb of Bronte worth about AUD3 million). I assure you it is not quite as glamorous as Sheila Bair’s recently advertised palace. Really it is solid upper middle class suburbia but with a silly price tag.

Indeed I would generally prefer bet against Sydney generally as it makes no sense. Both of us at Bronte Capital live East of the Harbour Bridge. Both of us are owners of insane real estate. Australian housing is amongst the most expensive in the world relative to the incomes of the people who live in them (see this report from Demographia).

It is that insane real estate which is the risk to Australian banks – which are loaded with mortgages on overpriced housing and overpriced commercial property. Unlike in America though these mortgages are largely recourse to the other assets of individuals (there is no jingle mail in Australia).

And they are insane loans within a country that makes a lot of sense and which has a government which has been so fiscally responsible as to allow us to run deficits of 6-8% of GDP during a financial crisis without any real risk to long term solvency. [Contrast this to America which was running insane deficits in good times – and which thus runs some risk of impinging the ability to run necessary deficits in bad times…]

An adjustment path from here is easier for Australia (because of our macroeconomic miracle). But it would help a lot if Chinese commodity demand does not wane - and hence allows us time to adjust.

Anyway in summary:

I don’t like unbalanced economies. The global problems we are now having is because the economy globally had been so unbalanced for a decade before that. However we are and remain unbalanced within Australia. However a relatively mobile labour market (compared to Europe but not to the US), increasing internal migration and a common currency and language should fix that over time.

Australia – I like it. I do not like the price. As an investment we are far more likely to be short Sydney consumption – and short Australian stocks – but it is not a bet against Australia – it’s a bet against the unbalanced bits of Sydney. And none of that should be unmanageable.

As for Australian banks other than our insane housing market the biggest problems are on the other side of the ditch. New Zealand is Australia's Eastern Europe - the over-indebted place without the historical advantages and with which we are not quite politically and economically integrated. When it comes to the crunch Australia will not guarantee New Zealand's debts - but the Australian banks will - which as Europeans are discovering comes down to the same thing.

John

Disclosure: I have worked for both Australian and New Zealand Treasuries. I have very strong views – perhaps little jaundiced by personal experience – about which is run better. The voting system in New Zealand is insane – whereas Australia’s parliamentary democracy is amongst the finest in the world. The Treasury has an easier time in Australia and is far more talented. For macroeconomic management this matters. But not as much as the resources that Australia has and New Zealand does not.

PS. I should link to this - which makes a fair point about just how far Australian and New Zealand housing prices have run - but without the necessary observations about recourse.

The second derivative is bad

I have been firmly in the “second derivative is good” camp for some time. Green shoots were few and far between – but the economy no longer appeared to be in free-fall. When the free-fall stopped it was time to buy equities – and whilst it was not time to ease up on the looser monetary and fiscal policies – it may have been sensible to limit them somewhere near the levels that they now are.

The data I considered most persuasive was the delinquency data at Fannie and Freddie. It gets worse every month, but until the last data point it was getting worse at a decreasing rate (especially if you adjusted for the foreclosure moratoriums they implemented).

Today I am more worried. My favourite data point (rate of increase of Freddie Mac delinquency) has deteriorated – especially in their insured portfolio. Its not sharp deterioration – and it is possible – even likely – that Freddie Mac will have end credit losses considerably lower than the bears anticipate. But as a second derivative bull I am feeling just that little bit less certain.

Contra: the usually bearish calculated risk has a fairly good data point here.

John

For the real masochists – here is the monthly data from Freddie Mac. The brilliant interest rate management I identified recently has continued albeit not with the panache of the previous month.

Finally BondInvestor has not contacted me as requested. I really would appreciate it.

Creation Science, oil drilling, naked shorts and constitutionally protected stock fraud

I once – unfairly perhaps – questioned what passes as mainstream conservative thinking as anti-scientific. The real target was greenhouse gas denial where the debate has gone (a) the greenhouse effect is not real to (b) yes – it is but it not caused by humans and then it will go to (c) but we can’t do anything about it anyway. I figured (fairly) that if you deny the science you wind up getting counted out of the debate. The “conservative” line was a fast-track to irrelevancy.

The reason why my criticism was unfair was that I used “creation science”, a realm of pure science denial, as a club to beat conservatives with. And I was rightly pulled up.

However I had what was – in my view – a market test of whether creation science was garbage. And that was that there were plenty of oil companies spending cumulatively billions of dollars on oil exploration using methods of finding oil (eg fossils of seeds and weeds) that were consistent with evolution and inconsistent with creation science. However I could find nobody who spent even a few million drilling for oil based on creation science.

This blog however corrects its mistakes. There is a serious oil company that does drill based on biblical texts and creation science. I was plain wrong.

So I give you one of the promotional websites of an oil company (Zion Oil and Gas) with a market cap of about $100 million.

www.OilInIsrael.net

And – just because these things should not go to waste – I give you one of their many YouTube promotional videos. In that video they got to ring a stock exchange opening bell. Creation Science is – it seems – at the heart of American Capitalism.

This ungodly liberal with his own creation myth (evolution) stands corrected.

John

PS. Don’t bother looking – you can’t short the stock. There are no securities available to borrow – and naked short selling – that just isn’t allowed.

If you need to know who is behind this then Mother Jones started the work, and Richard Bartholomew nailed it. It turns out that it is promoted in religious publications by the well known preacher and Christian Zionist Hal Lindsey who does not dislcose his family's substantial holdings.

I will refrain from again making a case for naked shorting because I can't see any real social benefit in aggressive hedge fund managers sharing when Hal Lindsey fleeces his flock. We can keep the losses in the fundamentalist family without any major social detriment.

And on this - I pity the SEC. If the promoters hold the belief in oil in Israel as true religious belief it will be very hard for the SEC to go after them. Even if this is as transparent a scam as Mother Jones thinks it will be hard to prove. Did the Founding Fathers mean to constitutionally protect stock fraud?

Request to BondInvestor from the comments

Can the person who comments under the name BondInvestor please contact me through the email on the blog.

Thanks in advance.

John

Brad DeLong and the fairy tale of Wall Street

This is a great read from Brad DeLong: A_Wall_Street_Fairy_Tale

I think it is also wrong in a solvency sense but spot on in a liquidity sense.

The Federal Government will lose big money on AIG - but the money lost - after all asset sales - is unlikely to exceed $300 billion. Huge money - but only about 6 months of pre-tax, pre-provision profits for the global financial market. And AIG insured the GLOBAL financial market.

An AIG failure would have made the crisis more difficult - but it fundamentally did not change what happened. The losses were HUGE - but the deepest part of the crisis was about liquidity. Nobody trusted any wholesale financed financial institution and they would have all failed without government support. With liquidity support (which has been forthcoming) the pre-tax, pre-provision profits are bailing out the banks.

If AIG had been let fail the losses would have been larger - but not critically so - and the government support would have been required for longer. But it would not have fundamentally changed the world.

John

PS. Huge losses are still to come - but so are vastly increasing pre-tax, pre-provision profits.

Mr Krugman and Mr Ferguson: a suggested interpretation (very long and ultra wonkish)

This post has an ultra-wonkish warning. Unless you enjoy graduate macroeconomics (soemthing I have never formally done) then you will probably not get many of the short-hand arguments in this post. For that I am sorry.

The main purpose of the post is to provide a basis for discussion amongst button-down modelling macro-economists.

I have just finished reading the blog exchange between Paul Krugman (the Nobel Prize winning economist) and the Niall Ferguson (the historian). As I consider myself a passable economist and a second rate historian this had me enthralled. Moreover, it had me reaching back into the dim recesses of my economics degree for a model. I have one which I will outline below.

The debate is about the meaning of recent kick up in long term interest rates. Mr Ferguson suggesting that it indicates that serious inflation is afoot – or else that the government will shortly have difficulty funding its debt. Mr Krugman has different interpretations – essentially coming down to the stimulus working. For Mr Krugman (the most famous torch bearer for academically rigorous Keynsianism) this debate is central to his world view.

The model needs to deal with the crisis as it is. It needs to be consistent with the facts on the ground of the crisis. It needs to include some kind of difference between real and nominal interest rates (that is some kind of measure of inflationary expectations). And it needs to build into it some kind of rationality for participants in the bond market – otherwise we are assuming away any meaning for the long term interest rate kick up.

It does not need to include a foreign sector or exchange rates because – well – this crisis is remarkably not driven by currency.

The model here – and several of the lemmas – come from Ted Sieper who showed me them during an undergraduate macroeconomics course in 1991. I figure Ted only invented some of it though I do not know who to credit beyond that. Some of it I invented.

I have titled this blog post “a suggested interpretation” after JR Hick’s classic 1937 paper because – well – I use an ISLM model. However it is a very-non-standard ISLM model so I will beg you sit with me through the introduction. I have not written out an ISLM model (or any other macro model) since 1992 – so if this is a little laboured it is because my macroeconomics is rusty. Moreover this model is presented at first away from the zero bound for nominal interest rates. I did not think about the zero bound much when I first looked at this sort of model – because (frankly) it was 1991 and the Great Depression and liquidity traps were an artefact of history. I build in the zero bound in the second part of this note – and that is where the really interesting observations start.

Let’s start.

A standard IS/LM model puts nominal interest rates (i) on the vertical axis and real income (Y) on the horizontal axis. I am going to change it up front (following Sieper) and put both nominal interest rates (i) and real interest rates (r) on the vertical axis and the log of the price level (log p) on the horizontal axis. Distances between nominal and real rates (that is vertical distances) measure expected inflation. For example if expected inflation is 5%, nominal rates are 8% then real rates are 3%.

Distances on the horizontal axis are changes in prices which is the whole point of putting logarithms of the price level on the horizontal axis.

You have to get the axis trick right from the beginning because the rest of my model will not make any sense without it. So just to hammer it home here are the labelled axes. Please do not think this is a standard ISLM model because you will not get anything that follows without noticing this.

Ok, now I am going to put in a Phelps-Friedman supply function. There is a natural level of income (Y) which is a function of real wages (w/p). There is a level of real wages which clears the labour market. However we assume [under most circumstance] that nominal wages (w) are more sticky than the price level (p) at least in the short run. If there is unexpected inflation then the price level is too high, real wages are lower than the “natural level” and there is “excess” employment. If the price level is too low then real wages will be too high – and there will be some unemployment. However as the wages and prices adjust to natural levels we wind up with the natural rate of employment.

Now lets detail an IS curve. In traditional fashion it is a curve which plots equilibrium in the goods market. The demand for goods (again traditionally) is consumption + investment. The supply is income. Consumption (C) is a function of income (Y) which is in turn a function of real wages. Investment (Y) is simply a function of the real interest rate. So here is my IS curve.

Now in the long run my real wage is the market clearing wage and income is fixed. (It’s that Phelps Friedman supply function). That says that Consumption is also fixed and hence the interest rate is fixed at a Wicksellian real interest rate.

The Long Run IS curve is thus horizontal at the Wicksellian Natural Interest Rate (r*). This is pictured below.

This long run curve is labelled IS(L,0) because it is the long run curve in period 0.

It’s a bit strange having a horizontal IS curve – but let us live with that.

Now let’s consider the short run IS curve. In the short run we assume that nominal wages (w) are fixed, but that prices change.

If we increased prices a little we (by assumption above) drop real wages and hence raise income. Both sides of IS curve rise – because consumption also rises with income. But because the marginal propensity to consume is less than one the left hand side would not rise as much as the right hand side. Therefore there would be an imbalance. To get balance back into the goods market (ie to be on the IS Curve) we would need to raise investment. That happens when real rates fall. So – in the short run if we increase prices we have to reduce real interest rates to keep equilibrium in the goods market. The IS curve in the short run thus slopes down. [Thank god for that!]

This is pictured below – with the now usual nomenclature is the long and short run IS curves.

Ok – having got more or less traditional looking IS curves (despite the eclectic choice of axes) let us have a look at Money Market Equilibrium (ie the LM curve). An LM curve would typically have real money demand being equal to real money supply. Money demand (L) is negatively related to nominal interest rates (i) as they represent the cost of holding money and positively related to income (Y). Income – as usual – is a function of the real wage.

Real money supply is just the nominal money supply (m) divided by the price level (p).

Let’s represent that in equation form:

_{As before we consider the shape of a long run and then a short run LM curve.}

In the long run Y is determined (it’s the natural rate). Then as you increase the price level you reduce the real money supply. To get equilibrium in the money market you would also need to reduce the real money demand which you can do by increasing interest rates. The long run LM curve is thus upward sloping. (Again thank God for that.)

Just to rub that in I have drawn another picture.

Now a short run LM curve has another effect when prices rise. Prices rising drive down real wages and up income. This increases money demand – so to get equilibrium in the money market nominal rates would need to rise even further. The short run LM curve is thus steeper than the long run LM curve. I have pictured this below.

Now lets look at a long-run normal time equilibria. Assume that inflation is 5% and always expected to be 5%. As it is a long run equilibria we only need to consider the long run curves. Here is how it will look.

What we have is the LM curve shifting right by 5% per period. The gap between the nominal and real interest rates is 5%. The actual inflation equals the expected inflation.

We can put the short run curves on this – and they look as follows:

OK – now lets model a simple monetary shock. Suppose that there is a sudden and permanent increase in the rate of growth of money supply. We would then expect to be at a long term equilibria say 7% out – and moving out by 7% per year.

We have a new LM curve in period 1 which is to the right of the old one. I have drawn it below and labelled it LM(L,1*) being the shocked curve in period 1.

As we now expect more inflation the gap between nominal interest rates and real interest rates must be larger (that gap is after all inflationary expectations). The new equilibrium will have a sustained 7% gap between nominal and real interest rates. The inflationary expectations will have to equal the realised inflation to that point – so the two lines measured in blue in the above diagram should be of equal length.

Note that the inflationary shock has driven up nominal interest rates in the short run and down real interest rates. The fall in real interest rates causes an increase in income. Monetary change increases short run income. This is entirely consistent with the 80s observed data on monetary “surprises”. When there was a monetary surprise of increased money supply it was associated with increases in nominal interest rates.

I think this is a minimal IS LM model with a reasonable distinction between nominal and real interest rates and a reasonable model of a rational bond market.

Now I need to make an observation which was first made to me by Ted Sieper. I have here a model with rational expectations, a Phelps Friedman expectations determined supply curve and whoa – monetary policy has economic effects. One guy called Robert Lucas Jnr won a Nobel Prize and in part his citation referred to his (definitely faulty) proof that such a thing was impossible. That is the famous so-called “Policy Irrelevance Proposition” (PIP). Well here is the counter example. And if you go look at any proof of the PIP you will find that they either assumed no distinction between nominal and real interest rates or they assumed a vertical LM curve. No – I am not kidding. One of Lucas’s most famous results is bunkum based on faulty maths.

And I do not mean to harp on about it but Lucas’s faulty result poisoned what I think is a very productive well in macroeconomics. Lucas “proved” that rational expectations and an expectations adjusted vertical supply curve made monetary policy irrelevant. However when you looked out the window central banks were clearly using monetary policy to some effect – hence everyone concluded that rational expectations is a bad modelling tool and dumped it.

But the Lucas proof was faulty. There was no reason to dump rational expectations due to the lack of correlation between central bank action and Lucas’s theory. And we have lost the use of a very neat – and quite natural assumption in many macro models.

I need to say this because – as a simplifying assumption I am arguing in this post that the bond market is more or less rational when it is repricing the long end of the curve. [If the argument between Krugman and Ferguson comes down to one side arguing the bond market is wrong or irrational then we are truly lost…] So can all the Keynsians out there not get really annoyed when I use a rational expectations hypothesis – please… Just accept that Lucas's result is wrong...

Moreover – and it is important to observe this – monetary policy again becomes irrelevant whenever the LM curve is vertical. And guess what – the LM curve becomes vertical at the zero bound to inflation – and so we have the standard (but usually faulty) result. But I guess I should model that more formally… as in this model unfortunately the curve becomes horizontal… it does not matter how far or fast prices are falling – nominal rates don’t go below zero…

Embedding the zero bound in this model

It is commonly observed that nominal interest rates cannot rationally stay below zero. The LM curves I drew in the models above have some very strange properties at the zero bound.

I quite purposely did not have any of my curves (IS or LM) above touch the zero nominal interest rate point – but lets do it now. Here is the long run inflationary equibria curve from above redrawn with the short run LM curve actually touching zero. The rates can’t go below zero – so it does not matter how far prices fall you can’t get negative nominal interest rates… the LM curves go horizontal when nominal interest rates hit zero.

If we are being formal (dotting i’s, crossing t’s, button down macro modelling as Mr Krugman advocates every now and again) we should note that there is – in the short run – some point on this LM curve whereby price levels can’t go any lower without there being deflation. Of course that point is dependent on the previously stable level of inflation – a point that would be moving right every period. Sorry I am getting little beyond my ability to do simple sketches. But I suspect the LM Curve has a period in which it is vertical to the zero until it just becomes as drawn above. Can we ignore this until someone comes up with a better modelling idea?

Now lets seriously shock the IS curve – the sort of shock that makes the zero bound operational – which is for instance what might happen if the banking system collapses…

Ok – now here we are – and its pretty clear that fiscal policy is just effective – because it moves the IS curve right. A move of the IS curve to the right means less deflation is necessary and real wages are less out of kilt.

Monetary policy only has an effect through changing inflationary expectations. If you can induce inflationary expectations then you will need to find a gap between the IS curve and the LM curve such that the gap equals the inflationary expectations. Do that and you will wind up with a very sharply negative real rate of interest.

And you can get there only by say inducing 5% continuous inflationary expectations.

However there is a real problem here – which is that you need to induce inflationary expectations in an environment of falling nominal wages and falling prices – which is tricky to say the least.

You can do it by credibly promising to be reckless (Krugman, Hempton helicopter post). But you can’t do it by being responsible.

Then there is the question as to how reckless you need to promise to be…

If the IS curve has any reasonable slope you need to be massively reckless credibly.

If you do only small changes in money supply then you remain stuck at the zero bound – you do not credibly induce inflation and hence the monetary policy is irrelevant.

Strange result – policy irrelevance holds for small but not big changes in money conditions… and it holds ONLY if you change expectations…

Short summary…

At this point I am coming out at Krugman’s side of the argument – and I think if we model multiple periods we are firmly on Krugman’s side as the yield curve flattens above zero – which is what happened last week.

If anyone wants to do the rest of buttoning this down I will be a keen critic. However the PhD in economics did not ever beckon. I am doing the funds management thing instead...

Oh and if one of those button-down macro-modelling economists can do it thoroughly I would love to put in an external sector. I am trying to understand Spain.

John