Wednesday, May 9, 2018

US Will Win Most Trade Wars (But Lose in a Trade War With Mexico)

This post is inspired by the Trump administration's most recent moves on trade including the steel tariffs across many countries worldwide and the particular tariffs aimed at China. There's been a lot of discussion regarding these moves by the Trump administration on whether or not we will see global trade wars. Some of my regular readers may recall my old posts on how monetary expansion is basically a way for countries to start currency wars. In a sense, currency wars are trade wars. Using this line of reasoning, the Trump administration is not the one starting the trade war.

Anyways, it's important to note that out of the entire US economy, ~13% of US GDP is from exports. This makes the US one of the least reliant economies in terms of its need for external demand to sustain domestic demand. Also note that ~45-50% of that 13% of GDP in exports is within NAFTA. As long as NAFTA is held together, the impact of large-scale trade wars on the US economy is minimal.

If we account for all non-NAFTA exports, we reach a number that yields a total of ~6-7% of GDP. Note that much of that 6-7% is also in the non-NAFTA energy market (the largest net exporters of oil/energy to the US are Canada and Mexico). That means only ~5% of the US economy is actually exposed to large, rapid shifts in external demand if we exclude energy and if we go outside of the North American continent.

What does all that mean? Firstly, it means NAFTA is so central and layered into the American economy that any large disturbance or removal of NAFTA could yield a major depression and create serious problems for Canada, the US, and Mexico. If such a scenario did occur, Canada would likely still have preferential access to US markets and would probably be mostly fine. Mexico, especially the parts of Mexico that've industrialized and seen the most foreign investment (mostly parts closer to the US), would get hammered. Canada won't be impacted much and could slightly gain (or lose) depending on how the NAFTA repeal played out.

Not only would Mexico be devastated, but the entire situation would likely cause fragmentation and a depression across large parts of the country as supply-chains fracture. The resulting impact would be very hard on US states near the Southern border--both economically and socio-politically. As a result, illegal immigration into the US from Mexico would likely rise as the rising Mexican living standards we've witnessed in the last ~15-20 years would suddenly fall apart giving migrants more of an incentive to come to the US. Drug cartels would likely gain more sway in Mexico, especially in areas further away from Mexico City (like near the US border).

NAFTA is so integrated into the economies of US and Mexico that discarding it would create real problems for both countries involved. Not only that, but it'd create a scenario where pretty much everyone in North America would be a loser. Hence, I'm highly skeptical of the Trump administration scrapping NAFTA.

The largest surplus countries/regions in the world are the Eurozone (concentrated in Northern Europe), Japan, China, Japan, and Asian Newly Industrialized Economies (NIEs; countries like Korea, Taiwan, Singapore among others). The main countries running current account surpluses are from Central or Northern Europe and the Far East.

Starting a trade war necessarily means that overall trade between the countries in question drops. So how can the US benefit much in a trade war if the overall trade between countries drops? The only way is by capturing a larger share of the trade balance.

Considering that the US doesn't export much to the rest of the world (especially if NAFTA is stripped out) and considering that the US has been far less protectionist than most of its competitors globally, a protectionist turn towards non-NAFTA members would lead to a significant rise in the US share of global exports. This would be very bad for most of the economies in the rest of the world, especially economies heavily reliant on exports to sustain their economic models.

Of course, the countries that won't be hurt very much are countries that don't rely on running current account surpluses to drive growth. What are these countries? For the most part, they're Anglo countries like the UK. You can add India, and probably Mexico (although in NAFTA), to that list of countries.

In the situation NAFTA gets smashed, everyone in NAFTA loses (except maybe Canada, but even that is dubious). The best deterrence for Mexico and Central/South American migrants is if their countries are prosperous. Any policy shift that damages Mexico and Central/South American country economies will create serious problems for the US and such a shift would not be positive for the US. The ramifications and 2nd and 3rd order consequences of such a policy benefits no one. That said, I fully expect NAFTA will not be discarded.

In the case NAFTA remains and gets renegotiated, we will likely see the US trade balance improve and we will see the NAFTA countries current account balance improve relative to the non-NAFTA part. In this case, a trade war with pretty much any non-NAFTA country would lead to a benefit for the US. The primary countries that're threatened would be large surplus countries like Japan, China, Germany, Korea, much of Southeast Asia, much of Northern Europe, and some additional countries. Those countries' economies would be hammered in a global trade war where the US goes protectionist.

The countries least affected by a US lashing out at other countries protectionist policies would be countries with relatively liberal financial systems that run current account deficits like the UK and probably Mexico and India. 

Wednesday, February 7, 2018

Manias, Panics, Crashes, Market Structures, and a Different Model of Financial Markets

This post will demarcate the first in a series of posts about the general structure and behavior of financial markets. In the first post of the series, I'll discuss the general behavior of markets and their tendency to move in between extremes. This post will include the general use of leverage while emphasizing the role of both policymakers and the psychology of market actors, but will mainly be focused on market dynamics and how to construct a model of this world. This post will have 3 parts:
1. EMH and Basic Market Dynamics
2. Flip Between Bulls and Bears
3. Different Model of Financial Markets

1. EMH and Basic Market Dynamics
Before I begin with a basic idea of how financial markets operate, I'll first discuss an idea called the Efficient Markets Hypothesis (EMH). The general idea of EMH is that markets are correct ("efficient") in the way they operate. The idea also presumes market moves are uncorrelated, independent, and "truly random" (meaning it's not possible to predict direction or size of moves). EMH also assumes that market actors do not behave based on the behavior of other market actors, either directly or indirectly. In reality, none of these assumptions actually hold.

In reality, the behavior of market actors does correlate with the behavior of other market actors. Market moves also have some form of predictability in both predictability and size. In other words, market movements are not truly random and markets are not efficient. On the contrary, markets are often driven by what were called "animal spirits" by the great John Maynard Keynes. The underlying idea is that market fluctuations are driven largely by emotions, which overlook rationality.

In periods of exuberance and optimism, market actors can become oblivious to reality as expectations shift. Rising markets create the illusion of expectation of further gains in price, which result in more market actors buying. Over time, this becomes a positive feedback loop where more people buying creates rising prices which increase expectations resulting in more buyers and so forth. That structure is the underlying feedback loop in a bull market.

Also note that in bull markets, leverage often comes into play (this is more true for housing booms than for equity/stock bubbles, but it can be true for both). In the case of leverage, it will increase gains in asset booms and may even allow asset booms to last longer than they otherwise would. However, all of the gains that came in the boom will soon be wiped out in the subsequent bust while someone will run the risk of not getting paid back. That tipping point is called a financial crisis. In that period, we will usually see a panic and then a crash.

In the case of a bear market, all the same elements pushing markets up reverse. Prices fall and debts have to be paid. So panic selling appears. That places further pressure in falling prices. Leverage unwinds as firms fail. Liquidations begin to occur. Usually, a lender of last resort will come in to prevent total chaos for no reason, but everything else unwinds and you get a positive feedback loop as the economy goes into a downward spiral.

2. Flip Between Bulls to Bears
In the dynamics I laid out above, we can think of financial markets as having two different states: a low-volatility state ("bull market") and a high-volatility state ("bear market"). The vast majority of any cycle will be in the low-volatility state when things are going just fine and a positive feedback loop in asset prices is forming. In this state, there's not much volatility or fluctuation while asset markets tend to rise.

In low-volatility states, not only do asset prices rise, but leverage does too. As more and more market actors forget about the last crisis and more new participants enter who never witnessed the last crisis, the stable growth begets more growth. Expectations begin to slowly shift while policymakers actively shift policy to encourage growth after the crash. In this process, it becomes financially beneficial to lever up to buy assets because of expectations of future price gains.

However, leverage and psychology introduce financial factors that induce balance sheet fragility. Market participants, on the whole, end up seeing rising leverage, rising assets, and rising income from either assets being cashed out or from cash flow or for a "wealth effect" (or for many other reasons I'm not going to get into in this post). Eventually, the boom reaches the phase where many market participants rely on further gains in asset prices in order to sustain their ability to borrow and make payments on their liabilities rather than being able to make debt service payments from existing cash flows. Hence, asset valuations become more stretched as to dissuade long-term investors from participating or taking place.

As the low-volatility state progresses, long-term investors begin to slowly drop out of markets or behave like short-term speculators that act based on short-term indicators (like liquidity). If long-term investors drop out of a market, then the only way to entice them back into the market is for valuations to drop to a level wherein it makes sense for those who dropped out of the market to come back in. In other words, the only way to "stabilize" the underlying market becomes via a market correction.

So what happens when a crash is triggered: markets suddenly switch to a high-volatility state where fluctuations are large, where there's no large buyer/fundamental investor to come in when prices begin to fall precipitously, and wherein the psychology of market actors is focused on a very short-term time frame.

The flip between a low-volatility state to a high volatility state happens suddenly (often overnight) and the high-volatility state usually doesn't last very long. However, those high-volatility states contain the highest concentration of both upward moves and downward moves in a single day. They contain wild, rapid swings that don't get resolved until some event comes along that signifies either that long-term information is viable allowing long-term investors to re-enter the market or wherein a large enough correction in asset prices prompts investors to seek out profit opportunities that give them compensation for the risks they take.

3. New Model of Financial Markets (this is mathy, skip if you want):
The traditional model of financial markets assume the movement of securities prices are like that of Brownian motion (a "random walk") wherein every price movement occurs built on a distribution of a constant mean and constant variance. This model is a direct reflection of the EMH assumptions listed above. All of those assumptions necessarily imply that volatility should be a static variable.

In reality, however, volatility is not a static variable. It's a dynamic variable that's constantly changing. In mathematical terms, volatility is a stochastic variable, not a deterministic one. If volatility is a stochastic variable, then we need a model wherein it changes. Of course, I've built the assumptions of volatility as something that switches from two states (high volatility to low volatility).

The return will depend on the asset class, but I'll set this model up for stock prices. A play on a country's corporate business over a long-term time horizon is effectively a levered convex bet on NGDP growth. So the question is what to use as that leverage. I find ~1.5-2.5 as an appropriate long-term multiple growth factor. That's an overall number, but it may need to go up (~2-4) depending on the correction mechanism you use. You can even make that number stochastic if you want to, though it adds complexity that I'm not sure will improve model performance in practice.

Then, I'd use a valuation driven model that uses at least 80-90 yrs of data to determine the potential for correction dynamically. For my stock models, I use >100 year datasets and adjust them to account for more uncertainty, especially on the downside. Then, I take the long-term return, use a normal volatility average, add in some uncertainty, and add in a correction mechanism from the valuation based model. For the valuation based model addition, I prefer using bootstrap methods.

Note: I'm purposefully not going into detail in this model and am not being 100% rigorous cuz I'm here to give a vague, general description of something to follow. Many ways to adjust this model to your liking. 

Tuesday, November 28, 2017

American Current Account Deficits in Relation to Taxes and Capital

This post will be with regards to the issues the US faces due to its large, persistent current account deficit (CAD), what causes that deficit, and how it can be resolved. I have previously written a good deal about what drives the American current account (mostly balance of trade from Eurasian capital flows) and why it's a concern. This post will begin where the last post ended and will be split up accordingly:
1. Why has US run large, persistent CAD going back 40 years?
2. How US corporate tax law results in more total debt?
3. Reversing these structural imbalances can be relatively painless

1. Why Has the US run a Large, Persistent CAD for 40 Years?
As I began earlier, the US has been running LARGE AND PERSISTENT current account deficits almost continuously since the late 70s/early 80s. Also note that the US is the world's reserve currency, which means other countries need to accumulate USD or USD assets in order to make payments to one another. Due to the fact that they need to accumulate net USD assets, that implies the rest of the world has no choice but to run a capital account deficit.

Now that we've established how the rest of the world runs a capital account deficit, that implies the US must run a capital account surplus since those two must net out to zero (the world cannot export capital outside of the planet). We also know that the capital account balance plus the current account balance must net out to zero by definition. Hence, the capital account surplus ran by the US implies the US has no choice, but to run current account deficits.

That said, the US can run current account deficits to ensure other countries can accumulate USD assets without those deficits being large and persistent like they've been for most of the past 40 years. Problem right now is that some countries abuse the system by taking up policies to turbo-charge capacity and recycle the excess savings they don't invest by capital exports.

When Asian (and European) countries run those surpluses, someone else must pick up the slack. The only economy that is both large enough, willing enough, and flexible enough to absorb those corresponding surpluses is the US. There are, quite literally, no other options because every other country is either not large enough or is too unwilling to run those deficits (i.e. the other countries generally run surpluses).

2. How the Structure of US Tax Law Results in More Debt?
Note that US tax law provides friendly deductions for things like interest on mortgages for homes, which increase consumption. That pushes upward pressure on current account deficits and funnel them into housing booms. There's many such provisions in the US tax code that create a misallocation of capital and need to be removed.

US tax law also has a very high statutory corporate tax rate with somewhat high deductions. Eliminating all deductions from corporate tax law would fully fund a shift in corporate tax rate from 35% to ~26%. If we compare OECD statutory corporate tax rates, we see that ~20% is the middle of the pack. High corporate tax rates create many economic and financial distortions--we are comparing corporate taxes relatively and not talking about absolute terms.

In a nutshell, high corporate taxes creates the following distortions:
1. Incentivizes companies to offshore (why stay when they can pay lower tax elsewhere)
2. It's double taxation cuz income taxed on corporate side is also taxed as individual income
3. Labor or consumers usually eat the tax, and when they don't, it shows up as lower profit margins
4. Incentivizes companies to register export income in other countries (cuz they pay less tax)
5. Companies end up holding cash abroad that's technically tax-deferred

As a direct result of high corporate taxes, we witness American companies like Apple registering >60-70% of their export earnings offshore. Due to the fact that their export earnings aren't showing up as American exports, the US current account (trade) deficit shows up as higher than it otherwise should be. We also have a policy that taxes capital gains and dividends at a preferential rate to income. A better policy alternative is to simply eliminate the corporate income tax and finance it by taxing capital gains and dividends as income.

Identity: current account balance=private sector balance+public sector balance.
Given the identity above, we can pretty easily show that a larger current account deficit either has to show up as a private sector deficit (borrowing) or a public sector deficit (higher public debt). There is no other option. Any policy that either expands current account deficits directly or directs capital flows into private sector or public sector deficits (like the mortgage interest rate deduction) automatically increases debt for the economy as a whole.

3. Reversing Structural Imbalances Painlessly
It becomes very important to recognize that global structural imbalances, and US domestic imbalances, are not due to the US running current account deficits. These imbalances are driven due to the fact that the US is running LARGE AND PERSISTENT current account deficits. If current account deficits are either relatively large, but not persistent; or persistent, but not large; we do not have a problem.

Hence, correcting these imbalances necessarily means either reducing the overall size of the current account deficit or it means reducing the persistent nature of the large current account deficit. There's two aspects to this. One is the large surpluses coming from most of the Eurasian landmass due to the high savings rates of Eurasian economies which gets recycled into the purchase of USD-assets and results in the accumulation of USD-assets in foreign banking systems, often by central banks. The other factor is tax law. High corporate tax rates encourage companies to shift export earnings abroad which pushes upward pressure on the current account deficit longer-term due to lower exports from global tax minimization efforts by corporations. Also, policies like the mortgage interest rate deduction.

Offshore earnings show up as "reinvested earnings receipts" abroad. The gross amount of reinvested earnings receipts abroad annually amounts to ~1.5-2% of GDP for the last ~7-10 years, but we're more interested in the net reinvested earnings receipts because that's what determines the impact of high corporate tax rates on the current account. If we look at that, we see that net reinvested earnings receipts add up to ~1-1.5% of GDP for the last ~7-10 years.

If we look at US current account deficits for the past few decades, we notice that they've been ~3% of GDP ever since the 2008 crash (which makes sense since a housing investment and consumption boom collapsed). Due to the fact that net reinvested earnings abroad have been ~1-1.5% of GDP for since 2008, we can definitively say that US current account deficits would be ~1-1.5% lower if the US did not have a corporate income tax because all that profit registered abroad would now be registered here.

There is one caveat to the directly lower current account deficit: if companies that do register these export earnings in the US and they invest more as a result, there is no reason for the current account deficit to fall by that much. Instead, the current account deficit would fall by the difference between the exports now registered in the US and the amount of new investment.
Note: That said, I do not buy the idea that reducing corporate tax rates will create more investment. Private investment is driven by demand for goods and services in a normally functioning market economy and corporate tax rates do nothing to increase demand for goods and services.

If NGDP growth is ~4%, the US can run current account deficits of ~4% of GDP without having total debt grow faster than the economy as a whole. So even slicing the current account deficit from ~3% of GDP to 1.5-2% of GDP via elimination of corporate tax rates could easily bring down the growth of debt to levels low enough to allow the US economy to deleverage very rapidly (both public and private sectors). These are MEDIUM-TO-LONG-TERM effects, not short-term.

So the simplest ways to rebalance are to:
1. Eliminate corporate taxes and replace revenue stream by taxing capital gains/dividends as income
2. Eliminating mortgage interest rate deduction and other similar policies
3. Taxing the accumulation of USD-assets in foreign banking systems, especially by central banks

If we only care about reversing the large and persistent nature of US current account deficits going back 40 years, then any one of those policies could do the trick (especially (1) and (3)). If you'd like to see the current account deficit eliminated completely, then all three of those policies outlined above would do the trick if put into practice.

Wednesday, October 4, 2017

US Healthcare Structure, Costs, and Potential Solutions

In this post, I'll discuss the financial structures of American healthcare. This post will mainly be about the cost structure and also relative comparisons to the rest of the developed world. First comes first: the US healthcare system is mostly private (unlike most OECD). Secondly, the US spends more on healthcare as a percentage of its income (GDP) than any other country in the planet. And when we look at absolute costs, there's only 1-2 countries that have higher healthcare costs and that's only because they're smaller and much wealthier per capita--largely cuz those aforementioned places are international financial centers (ex. Switzerland).

The basic structure of US healthcare is that it's mostly driven by employers providing health insurance for their employees. In addition to that, the US government provides health insurance for the elderly (those >65). The bill passed in 2009 called the Affordable Care Act ("Obamacare") set in place some set of laws that banned insurance companies from discrimination for those with pre-existing conditions, it forced employers with >50 employees to provide health insurance for their employees, it forced all insurance companies to cover some basic services called "Essential Health Benefits", set up state exchanges where insurance plans could be purchased, and set up an insurance mandate so that everyone who doesn't buy insurance must pay a fine.
Note: There were many other changes in the ACA, but they're way too long to cover. If you care that much, just read the entire bill.

Problems and Cost Structure of US Healthcare:
As I said, the primary problem in US healthcare is the cost. In relation to every other OECD country, the US is the only country to not have a universal healthcare system. Not only does the US not have a universal healthcare system, but the US also pays more for healthcare per capita by any other country BY FAR. It is not close (as seen in the chart below).

If we look at the cost of health care as a histogram of the population, we notice something very interesting about the US. It turns out that the total costs of the American healthcare system are actually quite low for most of the population, BUT a small percent of the population every year accounts for a disproportionate amount of total cost. I have found distributions for 1996, 2002, 2009, and 2012 and virtually all of them look almost exactly the same in terms of the structure of the histogram. Since 2012 data is the closest to today, I'll use 2012 data.

As we can see from the histogram above, ~1% of the population accounts for ~22% of total cost, ~5% accounts for ~50% of total cost, and ~10% accounts for >65% of total healthcare costs. What does that mean? It means that most of the cost is only accounted for by a few percentage of people. If we look at spending on sicknesses like heart disease, cancer, asthma, trauma, and mental disorders, we see that most of the spending from those key factors are from only 5% of the population.

On top of this, we have a rapidly aging population that's relatively unhealthy. Naturally, there'll be more sick people as a population ages. That will mean total costs will rise unless there's some kinda cap or government directed rationing or something of the sort put in place (which can happen by high prices for certain treatments). We've also seen a rise in the amount of administrators relative to doctors and medical practitioners. The rise in administration as a part of healthcare is also a part of what's driving rising costs.

So that brings me to my final point: the biggest problem with US healthcare is THE COST. It is extremely expensive and there isn't much bang for our buck. Due to the fact that employers pay for most of their employees' healthcare costs, it becomes very costly for businesses and employers to ensure that their employees have decent insurance. I have spoken before about wage stagnation in the US for the past ~40-50 years. If we include wages and fringe benefits as employee compensation, they have risen but most of those "fringe benefits" are healthcare costs. When we add in that corporate margins have been rising for ~35 years and have effectively tripled in the last ~30 years.

When you have an explosion in employer side costs for employment due to rising healthcare costs and combine that with surging corporate margins, that means it'll be very difficult for wages to rise. Increases in nominal income, in the end, have to end up in either business profits or higher wages unless they're sucked up by costs. It's commonly thought that the problem with wage gains and the economy in the US is a demand-side issue. That is not correct. The problem with wage stagnation in the US is actually a supply-side issue.

Due to the structure of the American healthcare system and the structure of American business, we've seen wage stagnation driven by supply-side factors. The first factor in driving these costs is rising healthcare costs that're primarily borne by employers. The second factor is rising corporate margins for 30 years that've happened for a whole host of reasons. If we look at inflation, US inflation has been well below the Fed's 2% target but it's also been entirely driven by housing costs, healthcare costs, and education costs. If it weren't for the skyrocketing cost of healthcare and education, US inflation would be close to 0% and we might even be seeing deflation and falling prices. Note that all of this excess cost in healthcare reduces labor productivity and total factor productivity.

Possible Solutions:
Single-payer--The basic premise of a single-payer system is that the government nationalizes health insurance to some degree. This can happen to various degrees. For something like the NHS in the UK, almost all of health insurance and health care is nationalized wherein doctors are actually employees of the government. In Singapore, there's catastrophic single-payer which means that it's a single-payer program with high deductibles. So this would be like a Medicare for All system of health insurance with $5,000 or $7,000 or $10,000 deductibles. For procedures or medical appointments below that threshold, there's other options like HSAs or reimbursements or whatever. One possible solution in the US is some kind of government nationalization of health insurance that allows the government to capture the tail of the cost distribution (or more) and then crush costs by direct rationing or government decisions.

Individual Mandate System--The ACA was designed to be an individual mandate system, but the design of the ACA from 2010 (along with its sabotage) was inherently unstable. As discussed earlier, most of the costs are in the tail of the distribution, so if you place a ban on companies discriminating against those with pre-existing conditions, companies can no longer remove themselves of the costs of clients in the tail of the distribution. So now the costs must be borne by everyone across the distribution, which means the healthy will see their coverage drop and their premiums/copays rise substantially. In essence, we now have a private sector rent-seeking insurance oligopoly of a few large providers that's effectively acting like a monopolized cartel. In that, there's large amounts of rent-seeking which's affecting consumers overall. The most common parallel of an individual mandate system working properly is Switzerland. In Switzerland, they effectively restrict insurance companies from increasing in size and force them to work with healthcare providers in local networks to keep a lid on costs.

Hybrid (Government Tail Support) System--The basic idea here is to use private insurance as the norm for low-risk cases and public support for those who're very sick or have high-cost pre-existing conditions (like cancer). So in other words, the essential idea here is a "high-risk pool" separate from the rest of the insurance pool. There's several ways to design this. One way is to just let anyone with high-cost pre-existing conditions enroll into a single-payer government program (like Medicare) and let everyone else be on private insurance. Then use government bargaining power and direct rationing to bring down costs. Another way to ensure the same thing is to effectively separate the population by age. So older people are either on a direct single-payer program (like Medicare for those >65) or are allowed to buy into Medicare if they're >50-55. Considering most of the healthcare costs are in the tail of the distribution and older people are far more likely to be in the tail, such a system is a way of splitting up the federal insurance pool into two groups: a relatively healthy one consisting of mostly younger people and a sicker one consisting of mostly older people. The latter group will have a single-payer program while the former will be on private insurance. In essence, you'd end up creating a high-risk pool on one side and a low-risk pool on the other.

Hybrid System (Bismarckian social insurance)--The basic idea here is that there's a few things that're necessities which everyone needs and other things are simply things that we want or may desire, but aren't necessities. So in the set of "necessities" like emergency room care or preventative coverage or so forth, the government will provide those to everyone at either affordable levels or totally free of charge at the point of service (it usually depends on income). For all of the healthcare that isn't a "necessity", the system is entirely private. So it's usually the upper-middle class, upper-income, and the wealthy who use the partially private part of the system and the rest is public.

Note: There are many ways to design and structure such systems, but that'd entail a very long, long list that I do not have the time for. Not only that, but it seems rather pointless when I outlined the basic ideas of each solution.

Saturday, September 9, 2017

Real Growth, Nominal Growth, Productivity, Demographics, and Inflation

Usually, most of my blog posts are pretty structured into key parts. This post will be a bit different. It'll be more of a rant that flows through the parts outlined in the title: real growth, nominal growth, productivity, demographics, and inflation. The rant will detail my view of why inflation, growth (both nominal and real), and productivity will lag across the world going forward.

In the global economy today, we're in a period of low productivity growth across the developed world. In combination with that, demographics in the developed world are aging rapidly while little inflationary pressure exists. Global growth has been very slow in this period. In response to all of these issues, we've seen governments take up policies of low interest rates and central bank balance sheet expansion.

With the exception of the Federal Reserve at the US, almost every single major OECD country has a central bank either a zero interest rate policy or actively expanding its balance sheet including the ECB, Japan, Canada (which just increased interest rate to .75%, but is still effectively close to 0) and others. The countries who aren't at the ZLB or at low interest rates more generally are in bubble territory including Sweden, Australia, and some others (see chart below for bubble economies). Of course, there's also countries that crossover between these groups.

On the other side of the global economy, we've seen a huge over-investment in emerging market production (especially China). Also note that ~45-50% of the German economy is exports while much of Northern Europe runs large current account surpluses. So in effect, we can say that this part of the world has excess capacity. Due to excess capacity (overproduction), there's enough supply for industrial good globally to keep a lid on prices. This has been a key factor in low inflation.

As I've explained in other posts, shutting down excess capacity isn't easy. In a normally functioning liberalized economy, excess capacity gets shut down cuz investors or banks start closing production facilities and factories that operate at a loss. Then, they consolidate resources, streamline production processes, and crush costs while choosing to not run what operates at a loss. However, we have many countries across the globe (especially China) that don't have liberalized markets or financial systems. So instead of having waves of takeovers and corporate consolidation, they're actively encouraging excess capacity via policies that continue to drive and perpetuate imbalances for social reasons.

What do I mean by social reasons? Shutting down factories or production facilities operating at a loss, streamlining production processes, and increasing efficiency in supply-chains by crushing excess cost are all policies that increase unemployment and place downward pressure on wages. Instead of taking up these policies and dealing with the social unrest they create, we have many governments across the globe actively engaged in supporting these supply-side structures. How do they support them? It varies from country to country, but all of the primary mechanisms fundmentally transfer resources to producers--usually implicitly.

In essence, policies like ZIRP or NIRP (negative interest rate policy) effectively let zombie companies roll over excess capacity at little to no cost. Central bank balance sheet expansion creates liquidity expansion that shifts risk profiles of portfolios creating a rotation to higher risk assets. In other words, the policy of QE effectively causes risk spreads to converge. By doing this, it allows firms using items like junk bonds to get much lower yields. Deflationary pressure pushes down yields more generally as does low growth overall.

What ends up happening is that more and more capital gets (mis)allocated into share buybacks or into supporting excess capacity for firms that effectively become zombie companies. In Germany, excess capacity is being sustained by a very weak currency (Euro) and policies to basically drive down wages that make German manufacturers high competitive. That also applies to Northern Europe, albeit to a lesser extent than Germany.

In open economies, firms stay competitive due to advances in technology or through human capital investment. In closed economies, firms profits come from either suppressed wages, undervalued currencies, or through interest rate policies designed to prevent unemployment or other social issues. In effect, entire countries are refusing to adjust economic imbalances in order to not create social dislocation. As we all know, this comes at an economic cost.

When firms using bad production methods are not being closed down, when inefficient supply-chains continue to persist, and when production is sustained via government policy to make corporate financials seem okay, there are real costs to be borne. Rather than the traditional policy of creative destruction in capitalism where bad firms are shut down and production processes are streamlined, there's none of that. That's a key factor in driving low productivity. When a firm has no incentive to increase the level of technology it's using, it doesn't improve its productivity. It doesn't produce more outputs per input. Instead, it keeps doing what it's doing knowing that the government will provide it a backstop.

In terms of inverted demographics, resources must be diverted from future investment to take care of the elderly. That creates a productivity drag. Not only can aging demographics create a productivity drag, but they also necessarily imply a large portion of your populace is shifting from a very high income base to a lower income base--almost necessarily meaning lower consumption levels. That places downward pressure on demand for consumer goods. If we see rapidly aging populations in economies with real consuming power, that acts as a deflationary force globally as well as internally.

In other words, we have structural forces across the global economy that create both deflationary pressure and lead to low productivity across the OECD. Considering real growth is a function of workforce size and productivity of the workforce, it's no surprise real growth rates are low. Low inflation means relatively low nominal growth as well.

The idea of inflation magically appearing with high growth in this kinda economic environment, especially when we consider the fact that the world is basically in depression, is pie-in-the-sky thinking. These are things that will not happen anytime soon. The world will not magically see significantly higher growth or significantly higher inflation unless there's some serious correction of structural global imbalances first.

Tuesday, June 27, 2017

20th Century Economic Models (ex. Fascism, Communism) Fail in 21st Century

Recently, one of my personal favorite historians (Adam Tooze, whose books are excellent and what all of you should read) had a great post on the structure of the Phillips curve today. That is an excellent start to transition to the topic for this post: traditional 20th century economics (ex. Phillip's curve) may not apply in today's world. I will hammer this point home in this post and how the difference in structures has created a totally different kinda world.

I'm gonna use three key cases to demonstrate where the old models don't work:
1. Impact of Global Supply-Chains and Falling Transport Costs
2. Phillip's Curve Doesn't Exist
3. Increasing Productive Manufacturing Capacity Needs Private Capital and Labor Partnership
4. Conclusion

1. Impact of Global Supply-Chains and Transport Costs:
First off, we live in a world where transport costs have collapsed. What does that imply? It means that, as a result, supply-chains have become very elongated--especially in technology. If you take a look at your typical smartphone or computer, it's constructed in ~800-1,500 factories across ~30-50 countries. In other words, supply-chains are constantly reorganizing and capital has become global.

So if we were to look at 20th century economic models that were used by many governments (notably most common in authoritarian regimes) as a way to mobilize a large industrial workforces as a way to deal with unemployment, they basically used excess labor for direct increases in infrastructure and manufacturing capacity. Supply-chains were relatively small and short, so that means it's easy to redirect production to the whims of the government without huge disruptions provided you could secure the raw materials.

Today, supply-chains are much longer, which means that increasing manufacturing capacity basically means onshoring more of your supply chains. Taking up nationalist policy to centrally direct and produce industrial equipment with rapid increases in manufacturing capacity by forcibly allocating savings will drive capital out of the country, leading to offshoring of supply-chains. In other words, 20th century policies to increase industrial output and manufacturing capacity sharply will actually lead to less productive output in manufacturing and industry.

Instead, the way to onshore supply-chains today is by lower regulatory costs for firms to operate, creating incentives for global capital to onshore supply-chains (like cutting corporate taxes), and by providing other incentives for domestic investment more generally (which can come in the form of financial repression, like we saw last decade in China (that no longer exists)). The nationalization of capital to be used for productive industrial build-out will fail because capital will simply fly out.

2. Phillip's Curve Doesn't Exist:
Historically, the Phillip's curve has signaled a short-term tradeoff between employment and inflation. Today, we live in a world of unwinding excess capacity (as I've written previously). So if there's excess capacity that can't be sustained with demand, it means the costs of inputs begins to come under serious downward pressure. The reason is because inputs are, by definition, used in the production process. So if input prices got bid up on expectations of rising capacity after decades of rising capacity, the minute capacity starts falling and expectations of further rising capacity shift, critical inputs like industrial commodities or energy begin to fall precipitously.

If you're in the part of the world that's undercapacity or under full utilization, expanding productive capacity modestly will place upward pressure on employment and productivity. Expanding productive capacity is also deflationary for consumer prices cuz production is rising faster than consumption. The kicker here is that rising capacity normally means rising input prices, but if the world has unwinding excess capacity, the modest input price increases that should come from rising productive capacity simply get dwarfed. In other words, input prices are unaffected, which further places downward pressure on consumer prices.

So we're in a particular situation in much of the Anglo-sphere (and India) wherein it is possible to see higher employment, higher growth, higher producitivity, and falling prices by increasing productive capacity. In other words, it is possible to see falling unemployment and falling inflation, which violates the logic expressed in the Phillip's Curve.

Another way to think about this is that the economies across much of the Anglo-sphere (and India) are in a suboptimal equilibrium where there's less growth and less employment at the same (or higher) rate of inflation. The logic and reasoning of 20th century economic ideas would tell us that this is absurd on its face. But alas, this is the world we live in.

3. Increasing Productive Manufacturing Capacity Needs Private Capital and Labor Partnership:
In the 20th century, both Communism, fascism, and many other ideas were built off labor and capital having divergent interests (in the Marx-based sense). So the political battles that were set up were those where capital and labor came into constant conflict. In today's world, for manufacturing or tech labor to do well, they must work with capital looking to invest in that. There's a need for more mutual gain than there is for animosity.

If the old movements relying on animosity are tried, capital will simply fly out because capital is global. If you want firms to hold more of their supply-chains in your country, closing off your country to capitalists, seizing their assets, and telling them to "f*ck off" will create outflows of both capital and skilled labor. Firms will simply not cooperate by onshoring part of their supply-chains. They'll go elsewhere where they're treated better. When supply-chains are small, it's easy to takeover and command where things need to go provided the resources and manpower are available. When elongated, capital has options.

If you do see governments resort to takeover of capital and over the means of production, their build-outs will not be, and cannot be, productive in today's world. Instead, they will have chosen to take their economies back by 50 years and send them into a world of permanent backwardness until those policies are reversed. It will lead to a drop in the currency, capital outflows, and the holders of monetary assets in the banking system (usually households) to take the hit. Actually, this is what's happening in Europe with these "bail-ins". That's probably what Italy's "bank bailout" will look like as well.

4. Conclusion:
To sum all of this up, the fundamental underlying financial and economic structures of the 20th century have totally fell apart. Those fundamental factors began to shift in ~1970 after the fall of the USSR and the beginning of the globalization of capital, especially American capital. The entire precipice of Bretton Woods was capital controls. When Nixon closed the gold window, we went to a world of floating exchange rates. In other words, financial openness and globalization of capital took the day.

In the mean time, transport costs (especially across oceans) have fallen precipitously. That means firms can elongate supply-chains, which means supply-side structures are much more flexible with respect to movement across borders. If any country tries to impose borders to restrict capital (provided it's not tiny or an international financial center) without giving some corresponding handout to capital, it will be tough for that country to improve its domestic manufacturing capacity productively.

The result ends up with the traditional short-term trade-off between inflation and unemployment as nowhere near reality. Instead, the possibility of multiple equilibria has been opened up. In this world, capital imbalances tend to drive trade imbalances (doesn't apply to energy and commodity imports used in production processes IMO).

In today's world, increasing manufacturing capacity requires creating a partnership between workers and capital. Using old mid-20th century tactics from fascist or Communist governments to centrally push up industrial capacity instantly and rapidly, it will fail. It will not allow any country to get high on the value-added chain and will dissuade those with knowledge or skills or access to the social networks to be able to do so.

 Note that capital today is global, not national. So it means governments need to basically work with capital and labor. For example, governments providing better education and training for capital helps firms onshore due to more accessible labor. Governments that provide health insurance take it off the back of companies to provide it for their workers, hence making firms more competitive. Other policies like liberalization and elimination of distortions in supply-side structures or distortions in the tax code and so forth. 

Sunday, May 21, 2017

Demographics, Development, and Growth Models

In this post, I'll be discussing the impact of demographics on economies, development, growth rates, and economic models more generally. This post will discuss a model that uses demographics and productivity growth to determine a country's growth potential over a longer-time horizon. In order to do so, I'll split this up into the different kinda demographic profiles. Then, I'll go into development levels which'll lead me to the differing structure of growth models and their adaptability to different kinds of economies. After all that, I'll summarize the point of the model.

Demographic Profiles:
We can split up demographic profiles into three broad groups: pyramidal, stable, and inverted (as shown in chart below). A normal demography for a developing country is pyramidal wherein there's lots of young people and not many old people. Due to the cost of providing basic infrastructure and social services, countries with this demography are often in the 3rd world and poor.
Image result for population pyramid

A stable demography is most commonly seen in a developed economy or a developing economy with rising productivity. It's a population structure that can replace itself over the long-term, but the society won't see much population growth without immigration. The only OECD country in this position today is the US and France.

An inverted demography is the most common demography in the OECD today. Almost every OECD country has an inverted demography (as does China along with a few other poorer countries in Eastern Europe). The only thing that differs across the OECD, China, and the other poorer countries is the degree of the inversion. In places like Scandinavia, the demography is inverted, but not that inverted as TFR has been ~1.8 or so. So while there's an inversion, it's not that bad in places like Scandinavia.

When you're a developing country, having a pyramidal population structure makes it very expensive for the society to provide everyone with basic social services and investments in items like healthcare and education. In such a demography, it may actually be economically healthy to reduce fertility rates cuz that ensures every child basic social services and investments in health and education that can really cause productivity to soar. In this type of demography, it's very feasible to see improved growth with reductions in populations from soaring productivity of investments in health and education.

So in the 3rd world, shifting from a pyramidal population structure to a stable or inverted structure may not be bad at all. On the contrary, such a shift may actually be necessary, healthy, and positive--especially over long time horizons. In the developed world, it's a very different story.

Most developed countries will see much slower productivity increase than the developing world simply cuz they're ahead and aren't playing catch-up, so they can't import technologies and things of the sort to rapidly cause a surge in productivity. Developed countries also often have much larger welfare states (especially in Europe, though less so in Asia). What that means is that the large welfare state with an inverted demography imposes a high cost burden on those paying into those welfare systems.

In order for first world countries with inverted demographics to cope with the pressure on their working populations, they must either let in more immigrants or cut benefits or suffer from the drag of higher debt/taxes. What this does is reduce resources for entrepreneurs and risk-takers while the inverted population makes consumption led growth more difficult. Due to the inability for future consumption levels to sustain themselves, this demography leads to a drop in productive investment opportunities.

In other words, the direct conclusion of an inverted demography without mass immigration is structurally lower growth unless you see large productivity increases, which're being seen in places like Japan and South Korea largely due to a mix of their reliance on commodity/raw materials/energy imports in a time of collapsing commodity/energy prices and improvements in automation, industrial robotics, etc..

Growth Models:
Obviously, demography has a large impact on a country's economic growth. A country with a growing population can sustain higher levels of consumption, and thus absorb higher levels of productive investment whose purpose is future consumption. This is true for both a developing and developed economy with a growing population.

In a developing economy, the potential for rising productivity is much higher cuz they're playing catch-up. In such a case, it's not necessary for a falling population to lead to lower growth in consumption over a medium to long-term horizon. In the short run, very high growth rates are possible under cases when a developing economy has a growing population or a falling population. In the long-term, there will be problems in terms of the dependency ratio though.

In higher income countries, low population fertility rates and low (or the wrong kind of) immigration are a certain drag on growth unless productivity growth grows very sharply. What's the likelihood of high productivity growth in large welfare states and rigid bureaucracies? It's not very high, so growth becomes very difficult in countries with these kinds of demographics and economic models that rely on large welfare states. In these kinds of countries, future economic growth will be tough to come by without serious structural reform.

In countries with stable demographic structures, both developing and developed countries will see long-term per capita growth that stays roughly in line with productivity. For a developed economy, a stable population and well-controlled immigration will generally yield ~3% economic growth, maybe a bit higher depending on productivity increases.

Developed countries with growing populations have the institutions to absorb more amounts of investment productively than developing countries, so it's actually the developed world with stable demographics and positive immigration that's best fit for a controlled infrastructure build-out. In addition to that, a consumption drive growth model can work as well.

The fundamental point of this post is that long-term growth rates are always determined by structural factors. These structural factors are mathematically driven by productivity growth, population growth, and how people work (which's also structural, dependent on labor policy, etc). Hence, the applicability of growth models and economic models is entirely dependent on these structural factors.

What does this model of demographics tell us about future growth rates in the world today? It tells us that most of the developing world will continue to see surging productivity. That means many of them (like China) will be able to offset falling populations and falling workforce size by a surge in productivity. However, it also implies that most of the OECD will be stuck with low to no growth for decades unless productivity surges.

The primary exception in the OECD will be the United States. Another exception in the OECD may be France simply due to demographics. The rest of the OECD will see little to no growth unless they open themselves up to immigration, can filter these new immigrants effectively, have effective structural reform, and all while seeing surging productivity growth.