20 January 2015

Why Financial Bubbles Are Becoming More Common (and Dangerous)


“Between June 1998 and June 2008 the notional[1] value of outstanding over-the-counter derivatives exploded from $72 trillion to $673 trillion … just under eleven times global gross product.”[2]
“The gross debt of the US financial system grew from 20 percent of GDP in 1979 to 120 percent in 2008. In the UK, the gross debt of the financial system reached two and a half times GDP in 2007.”[3]

How is it possible to have so much capital?

One theory offered by people like former Fed Chairman Ben Bernanke and Europe’s most respected financial commentator, Martin Wolf, is that we have a savings glut. There is no way to distinguish between a savings glut and an investment dearth but in either case, the supply of capital is great enough that interest rates hit zero. (When something is scarce, its price goes up. When there is a glut of it, the price goes down. Interest rates are the price of capital and interest rates have been at or near zero for most of this new century.)

A glut of capital would have seemed like a fantasy to people living in the second economy (1700 to 1900) when capital was the limit in the same way that an all-you-can-eat buffet would have seemed like a dream come true to medieval peasants. But excess can bring its own problems and the financial crisis of 2008 that triggered the Great Recession was a reminder that a financial system can be weakened by either too little or too much capital. 

Capital was the limit to progress in the second economy. Capital made the biggest difference and was the source of the most new jobs and wealth. In most – but not every – instance, more or better capital was the answer to the question of how to make progress. If we imagine the economy as requiring four factors of production, the second economy looked like this.

During the second economy, to make more capital was to make more progress. Limits define the output of a system. The two-lane stretch of highway  determines how many cars pass through in rush hour, not the three-lane stretch beyond it. In 1700, there were hardly any machines able to do work. Instead, work was  manual. More machines, more factories, and more stocks and bonds to finance them all increased total economic output.

But with an investment dearth, capital is no longer the limit. In the fourth economy, the new limit is entrepreneurship. Our economy looks more like this now.

To create more credit, to generate more capital, is like building up a glut of products between your second and fourth machine in the factory. It is the equivalent of increasing the capacity of the capital without a corresponding increase in knowledge workers or entrepreneurs. In the bubble leading up to the financial crisis of 2008,  financial markets were wildly productive. That would have been a good thing had entrepreneurs been hiring workers at record levels, but they were not. The result was a huge bump in capital that simply bid up the price of existing assets (like homes and stocks) rather than creates them.

This is akin to an increase in the rate at which we build up inventory (the product that passes through machine two) without increasing the rate of products that leave the factory (product that passes all the way through machine four). Inventory can only stack up for so long before the second machine has to halt production. This becomes the cycle of booms and busts when the second machine is capital. More capital at the dawn of the fourth economy created bubbles. Once we popularize entrepreneurship, this rise in capital output will be hugely beneficial.

For now, though, we have trillions in capital sloshing about the globe in search of returns that, like waves in a bathtub, can only go so far in one direction before it will reverse direction. In the late 1990s, it flowed into the stock market and drove up prices there, first creating a bubble and then a bust in 2000 when it left. In the mid-2000s, it flowed in the housing market, driving up prices there, first creating a bubble and then a bust in 2008 when it left. Capital has become dangerous, driving up the price of assets every time it sees one as key to returns and then driving down their price once it realizes the gains are the result of a surplus of capital bidding up the price of a scarcity of assets.
That dynamic was at work in the 2008 financial meltdown. When markets fell, assets as varied as real estate and stocks dropped tens of trillions of dollars. About 30 million people around the world lost their jobs and millions lost their homes.

Until we get better at developing entrepreneurs and making employees more entrepreneurial, we will have an investment dearth. We continue to get better at making capital but that is no longer the limit. Once we get better at making employees more entrepreneurial, we will have a good use for such huge amounts of capital. At that point, we might even shift from an investment dearth to an investment glut (or savings shortage). At that point, there will be an abundance of opportunities for capital. Until then, an excess of capital will continue to create a series of bubbles and busts.

[1] Notional value inevitably exceeds the market value of a derivative. You might have a derivative based on a $100 stock price but would reasonably expect its value to move only 5 to 20% of that, a fraction that would set the market value. “Still, the market value of derivatives rose from $2.6 trillion to $35.3 trillion in December 2008, itself more than half global output,” Wolf writes.
[2] Martin Wolf, The Shifts and the Shocks: What We’ve Learned – and Have Still Yet to Learn – From the Financial Crisis, [Penguin Press, Kindle Version, 2014] p. 128.
[3] Wolf, The Shifts and the Shocks, p. 129.

09 January 2015

This Decade's Extraordinarily Good Job Creation Performance

December's job report completes the fifth year of this decade. So far, this has been an extraordinarily good decade.

First, a simple fact. The economy has now created more jobs in the first half of this decade than it did in all of the 1950s.

First, measured by jobs created, 2014 is the best year yet for the decade. This recovery is not slowing. Not yet.

The unemployment rate, too, dropped last year at an impressive rate, the second year in a row in which it dropped by more than 1 point. At 5.6%, it is back to what it was in the summer before Lehman Brothers' bankruptcy in 2008. Remember that in December of 2009, it was 9.9%. 

So how does this compare to past decades? It stands out.

Not only has the American economy created more jobs in the first half of this decade than it did in all of the 1950s, it has easily outperformed the first five years of every decade since. 10.7 million jobs is nearly double what the economy created in the first half of the 1980s.

I wonder if the pundits will change their tune about this terrible economy before the decade is over or if they're just going to leave that to historians.

22 December 2014

Why You Should Be Blown Away by Median Wage Growth of 2.1%

Wages rose 2.1% year over year through June 2014. That's been met with a yawn but it is a phenomenal number.

2.1% doubles wages every 33 years. Sustained, a wage growth of 2.1% increases wages by 8X in a century, enough to raise the median wage of $32,154 in 2000 to $256,927 by 2100. 

Does that sound outlandish? It's not. Wages grew about 8X in the 20th century. But more impressive than the increase in wages was the change in what you were able to buy over the course of the last century. At any price. I'm not sure how you would factor that into a calculation of wage growth. And the addition of outrageously cool things to buy is likely to continue. This new century has already given you new products like personal genetic analysis and a ticket for space travel. 

Here is a partial list of things that you could buy in 2000 that you could not buy in 1900. A surprising number of them are quite affordable. Any one of these would be deserving of a post that explores just what it means. (One day of travel would get you to the other side of the globe? For the average person in 1900 - very, very few had cars - a day's travel meant going into town and back.) Imagine what extraordinary things a person in 2100 with an income of a quarter of a million will be able to buy for Christmas presents.

A photocopy
Ticket to a movie
A video
Airplane ticket. To anywhere
Anything plastic
Air conditioner
Microwave oven
Electric refrigerator
Safety razor
Crossword puzzle
Hepatitis-B vaccine
Polio vaccine
The Pill
Bubble gum
Credit card
Mutual fund share
A pacemaker
Personal computer
Video game
Email account
Video conference. With anyone. From anywhere

18 December 2014

Anniversary of Verdun - Not Just Worse Than Anything We've Experienced But Worse Than We Can Imagine

Try to wrap your mind around the scale of this tragedy. 9/11 happens. 2,996 lives tragically ended on a Tuesday. The country shocked. And then on Wednesday, 2,996 more lives are taken in a similar attack. Twice in a row now, the country is incredulous. And then on Thursday, another 2,996  lives are taken. Friday, 2,996  more. Every day this happens for 100 days, from 9/11 to 12/21.

Think of how many families would be shattered, the inconceivable number of young lives cut short. The baffled and heartbroken parents and siblings. Imagine how shell shocked people would become. Think about how hard it would be for the nation to absorb a loss of that magnitude, to even make sense of it. Imagine how much it would change us.

The Battle of Verdun ended on this day 98 years ago. In this single battle, 300,000 were killed.

By the time that World War 1 was over, 16 million people had been killed, 7 million of them civilians. 16 million is the equivalent of a 9/11 every day for nearly 15 years. This in a world where total population was about one-fourth of today's population.

It's not just that we really have no equivalent experience in our lifetime. We can scarcely imagine it.

Thank you Thomas for the reminder.

13 December 2014

Halfway Point of the Decade that Will Transform the Middle East

Arab Spring seems to have begun with Mohammed Bouazizi, a 26-year-old Tunisian with 6 kids. Police had confiscated his vegetable cart – his livelihood - in December of 2010. When officials refused to hear his complaint, he protested by setting himself on fire. Within a month protesters had ousted Tunisia’s government.[1] 

This was the start of Arab Spring, a contagion of protest and revolution that swept through the Middle East. By 2013, the heads of state in Tunisia, Egypt, Libya, and Yemen had been chased from office and civil wars had started in two countries and protests in half a dozen others. These were protests orchestrated through Twitter and Facebook and played out in the streets with guns and tear gas. Secularists and religious groups have agreed to oust dictators but now have to agree about how to govern.

For me, this picture of the Camel with Google camera mounted on it seems to capture the Middle East's current, odd juxtaposition of old world and new better than anything I could imagine. 

Evolution is hugely defined by environment. The Middle East is going through democratic revolution and reform in such a very different environment than did the West that it will be fascinating to see what it produces. Hopefully, among the things it produces there will be at least a few more pictures like this. 

[1] Jim Clifton’s The Coming Jobs War, (New York, NY, Gallup Press, 2011) Kindle location 558. 
Picture from Slate, video here.

10 December 2014

Post- 9/11 Interrogations

This week's release of information about the CIA's torture glosses over something fundamental about the interrogations.

Kurt Eichenwald, in 500 Days: Decisions and Deceptions in the Shadow of 9/11 recounts how American interrogators worked at Guantanamo Bay. Reading it, I was struck by how odd their assumption was about the folks they'd captured. The prisoners at Guantanamo were - most of them - soldiers of some kind. Many were from Afghanistan, a place where 92% of the people don't even know about 9/11. (This is not a place where the average person watches the evening news or surfs the Internet for investigative reporting. And where - between Russians and the Taliban - they've had their own atrocities to deal with.)

Imagine that al-Qaeda soldiers captured some American soldiers, took them to an island in the Middle East, and interrogated them about Bush's secret plans for fighting Islam or details about Cheney's underground bunker. It wouldn't even matter if these al-Qaeda interrogators were polite when they asked questions of the American soldiers. It would still be stupid. It wouldn't matter if the al-Qaeda interrogators offered the Americans access to American football games and BBQ or tortured them. No kindness or threat would change the fact that these men were ignorant of what al-Qaeda wanted to know.

These prisoners at Guantanamo Bay were largely low-level soldiers who were nonetheless interrogated daily, as if they had great secrets to reveal. They didn't. The men working at Guantanamo were under pressure to produce results and they tried everything from kindness to threats to torture and nothing worked for the simple reason that the men they'd captured didn't know anything useful.

As with so much in the wake of the Bush Administration's reaction to 9/11, the folks executing policy were struggling to build a skyscraper on a foundation of reinforced cardboard. Even on a good day, when you're given an impossible task, what you try may be unreasonable. And on really bad days, what you try may be immoral.

08 December 2014

Needs No Further Explanation

Or perhaps more precisely, I couldn't provide any explanation. This just seems to capture something perfectly.

The Arguments About Keynesian Economics Are Almost Never About Keynesian Economics

Keynes had a major insight into economics that people still seem to miss. It has to do with equilibrium and it plays out something like this.

Capital markets are essential to a thriving economy. Without investors willing to fund new schools and factories, new businesses and non-governmental organizations, we'd have no innovation, no growth, no creation of wealth or jobs. As an economy becomes more dynamic, this steady infusion of investment becomes more important just to sustain normal growth and employment. 

During a period of healthy growth, the equilibrium for capital markets and labor markets are coincident. Letting investment markets do their natural thing will result in new jobs and economic expansion. 

The equilibrium for capital markets can shift. One day the price of capital can induce savers to invest and the next day it can convince them to hold their money in cash rather than make loans or fund new businesses. 

This new equilibrium in capital markets shifts the equilibrium in labor markets. Unemployment can spike as capital sits idle.  

This shift in equilibrium for capital and labor markets will drive down GDP. Sales will fall. 

At this point, it's perfectly rational for every sector to sustain the recession. Households without jobs won't buy. Businesses without sales won't hire. Investors without sufficient number of employed households or expanding businesses to loan to will sit on their money.

In other words, at this point every "localized" market - labor, goods, and capital - will be in equilibrium. The good news is that the economy is stable. The bad news is that it has reached stability at recessionary levels. This general equilibrium needs to shift before it will make sense for investors, households, and businesses to change their behavior. There is nothing happening in the two other markets to drive a change in the third.

Government can make changes that will shift equilibrium in all the "localized" markets. By spending more, by cutting taxes, by putting more money into circulation or lowering interest rates, it can engineer temporary growth, helping to put an economy back on track for steady expansion. It can disrupt the equilibrium in the localized markets to get things moving again.

Valid rebuttals to Keynesian economics include criticism about a governments' ability to time stimulus, the level of downturn deserving of Keynesian stimulus, and the degree to which a Keynesian style intervention needs to be coordinated with other countries to be effective. You could even argue about whether expectations might mitigate the effect of such government policies.

Invalid rebuttals include "I don't like big government." Keynesian policy recommendations are incidental to the size of a government. Countries like Denmark (where government spending is 58% of GDP), Sweden (51%), Germany (45%) the US (41%), Mexico (27%), Singapore (17%), or the Philippines (16%) can all engage in Keynesian policies. Whether you want to emulate Southeast Asia or Northern Europe is irrelevant. Whether your long-term target for government spending is 50% of GDP or 15% of GDP, government spending can still be increased in the short-term in response to recessions and downturns. You can induce capital markets to engage in ways that stimulate the whole economy. 

For me, the real genius of Keynes was his realization that reaching equilibrium in capital markets didn't automatically ensure equilibrium in the general economy. Before Keynes, we only had economics. After Keynes, we had microeconomics and macroeconomics. His policies were key to creating conditions that allowed the limit to shift from capital to knowledge workers. 

07 December 2014

The One Piece of Art that Most Defines the Renaissance

Much of Renaissance art is priceless. If you could own a work by Michelangelo or Botticelli or Raphael you would not only have sublime art to gaze on but could - any time you wanted - sell it for more money than you could hope to spend in a lifetime. And rightfully so. It's not just amazing art. As cliche as it sounds, Renaissance art changed how we looked at the world.

And on that note, I think Peter Bruegel's Landscape With The Fall of Icarus from 1555 best depicts the change from focusing on the supernatural to the natural. It shows how the Renaissance changed how we in the west looked at - and saw - the world.

The most obvious thing here is the farmer plowing the land. He's at work. Just behind him is a ship likely laden with goods from or to another land. A shepherd over the shoulder of the farmer is contemplating the sky, perhaps daydreaming or perhaps looking for signs that would help him to forecast the weather. Oh, and in the water before the ship is Icarus who flew too close to the sun.

Icarus's story is amazing. He flew to freedom with wings his father had constructed of feathers and wax. His father warned him not to fly too close to the sun lest the wax melt and the wings be unable to keep him aloft. Of course Icarus was unable to resist the exhilaration of flying high and, indeed, his wings failed him, causing him to fall out of the sky into the sea to his death. Not only are a host of themes bound up in this story of Icarus (among other things he's a lesson in hubris) but the idea of freedom through flight is sort of amazing. Especially to ancient Greeks and even 16th century Dutch.

But what Bruegel does with this incredible story is relegate it to a corner of the painting. Myth has given way to business. The farmer could not be less impressed with Icarus's foolishness.

We can hardly imagine how completely the promise of heaven or threat of hell defined medieval life. For most Europeans from the fall of Rome until the discovery of the new worlds (about a 1,000 years, from roughly 476 to 1492) business concerns like plowing a field were a distant second to religious concerns. By the time of this painting, in more developed places like the Netherlands and Northern Italy, this had begun to shift. And Bruegel's painting rather brilliantly captures this. A great deal of how we look at the world is defined by where we look. By Bruegel's time in the mid-16th century (Columbus had "discovered" the "new" world and Magellan's crew were the first to circle the whole world), people realized that the natural world was full of the unknown, full of promise, full of riches. It deserved our full attention. At least during harvest or planting.

06 December 2014

In Which Your Blog Author Manages to Turn a Big Stock Market Prediction into a Very Small Gain

Here is the prediction I blogged about the stock market.
"The S&P 500 is up only 1.4% from the start of the year. ...
I'd look for a sharp rise in the market before year end. I think between now and December 31, the market could easily rise 5% or more. The result will be a fairly unimpressive year but it will have gotten there in spectacularly volatile fashion."

I predicted a rise of 5% or more and the S&P is up 10.7%. I'd like to file that under accurate prediction but of course the market could still fall spectacularly before 2015, so let's mark that as tentative. 

Here is the prediction I tweeted about job numbers. 
Job report for October (released 7 Nov) will be for over 300,000 new jobs."

I jumped the gun on this one. Even with Friday's upward adjustment to the numbers, it looks like the economy created only 243,000 jobs for October. It didn't break 300,000 until November. So, that's a miss on timing.

Finally, in spite of getting the market prediction right, my own portfolio limped along in that time. The S&P is up 10% since I made my stock market prediction and my portfolio is up just 2%. Pretty pathetic. So that's a big miss.

My final score on predictions:
1 right (so far)
1 right about magnitude, wrong about timing
1 major miss in applying big insights into personal victories (the sort of thing that might have happened to me once or twice before).
So, 1 for 3. That sounds better in baseball.

05 December 2014

Is This Record Streak of Job Creation Finally Raising Wages?

Today's job reports makes for some great facts.

In November, the American economy created 321,000 new jobs. 365,000 jobs were announced today, though, because the job creation numbers for September and October were revised upwards.

Since 2000, there have been only 2 months with job gains of more than 365,000.

It has been nearly 20 years since we've had 10 consecutive months in which the economy has created at least 200,000 jobs.

This month's positive number means the current uninterrupted streak of positive job numbers is now 50 months, breaking last month's record for longest streak since the US began keeping records in 1939.

Even if the economy creates zero jobs this month, 2014 will be the best year for job creation since 1999. That is, this is already the best year of the new century.

While the unemployment rate held steady at 5.8%, it is down 1.2% from last year and this sustained rate of job creation might finally be putting upwards pressure on wages.

There is also really promising news about wages. In the October report, wages were up only 0.1% from the previous month. This month, they were up 0.7%. Now 0.7% is almost surely unsustainable. (That would translate into a 8.2% raise in wages for the next year, a delightful prospect that's more fantasy than possibility in light of the last couple of decades but a rate that we actually hit in the 1970s and 1980s.) But such a sharp upwards trend in the context of lower unemployment rate and strong job growth suggests that we might finally be moving beyond the prolonged period of wage stagnation that has characterized this new century. If so, that could be the best news yet.