Friday, January 12, 2007

Barbary Apes & the Art of Central Banking

Anyone who's visited the UK lately can see that London is bubbling and frothing. House prices are, once again, vaulting upwards, restaurants and airports are jammed, and all manner of high-end product or service retailer are replacing the tired bookie on the high street. Even the ubiquitious corner shops are being remodeled replete with a zillion watts of halogen, uncluttered aisles more akin to Waitrose than Londi's. Vertical tower cranes adorn the London skyline as new skyscrapers dwarf the once-dominant Centrepoint Tower, whilst rents are increasing smartly too, according to CB Richard Ellis's latest report. Housing affordability? Ha! It'd so unaffordable that few Brits outside hedgies and merchant bankers own (or even live) with the Congestion Zone. So the Bank of England has raised rates, and rightfully so. Granted, London can be deemed pseudo-idiosyncratic since it does prey upon the rest of EC by generously allowing tax refugees to live there without paying Inland Revenue. And Hedge Funds are popping up and multiplying like mushrooms in a cow pasture after a spring rain due to the lack of the SEC, and a subtler, more level-headed approach to fighting terrorism. Most major metropli share the feel-good of London. New York is the same. As is Tokyo, Moscow, Rio, Khartoum, as are Dubai, Mexico City, and Caracas. In fact the whole world - save Zimbabwe, Mogadishu, North Korea, Dresden, and yes, Detroit - is booming and building.

The ECB has been raising rates, though they remain comparatively and historically low. And despite jawboning by the Trichet, higher VAT in Germany, and higher energy prices, European real estate is rising, unemployment is falling, speculative building continues apace, and estate agents and stock brokers are more ubiquitious than engineers or machinists. Liquidity is growing. And it it growing significantly. Assets of all types are being sold by old long-standing owners to new owners, and used as collateral in this transfer of ownership. It leaves the old owners with paper, while the new owners put up a bit of equity and borrow the rest, often collateralized by the assets themselves, the newly collateralized and rated paper that then is used as equity, near-equity or faux-equity for creation of further credit. But while there IS indeed real growth in eastern europe, and encouraging recovery in old europe, this boom, it would seem to me, is decidely financial. And this has been rewarding for owners of assets, and doubly so for owners that are geared. But make no mistake: the feel-good is the result of leverage and debt. And the source of such funds and the ease with which one can borrow them - i.e. the grease - is I suspect still coming from "liquidity" created by loose fiscal policies (deficit spending) of what's been 3% of GDP in the EU, 4%+ or so in the US (taking into account SS and other OBS obligations), and 4 or 5% in Japan, on top of still-easy money in the EU, very cheap money from Switzerland, and still almost free money from Japanese ZIRP, now, (called nearZIRP in my lingo). Asian savings, and GCC petrodollars further enable it. And with still-easy money, and the dollars from US nearZIRP of 02-to-05 still sloshing about unspent by the neo-mercantilst trade financiers excepting US TBills, Bonds & MBS, and the deficits continuing to add many zeros to the cumulative figures, speculators have, to say the very least, been emboldened.

So emboldened have they become, that everyone has become a spec. Whether individual home buyers in America using floating, IO mortgage product, or formerly staid folk that traded on connections and information (like Carlyle), professional specs are now seizing everything in site, whether alone or through consortia. TPG, KKR, CINVen, GS, and a hundred others all borrowing to buy assets. And Morgan Stanley, manager of the largest levered real estate fund no longer is content or satified by buying buildings. It's appetite has gotten so big, and apparent bullishness on assets so whetted, it's taken to feasting upon entire listed REITs, swallowing them whole with some equity and a lot of debt. Where is all this money emabring upon leveraged asset acquisition pecadilloes coming from??!? Is the market THAT ineffficient, that it's got the prevailing price so so wrong? Are the debt-to-equity ratios of companies that ineffciently underleveraged? Or is there something more nefarious going on? Have smart people simply figured out how to manufacture paper money at low cost in order to buy very real assets and things? Probably, the answer is "No", "No", "Yes", and emphatic "Yes". And the culprits are a combination of globalization, open-capital flow, large differentials in interest rates, and a purgatory-like stasis that is preventing adjustment in the relative value of currencies. If in fact it is so, is this bad? And If so, what is to be done?

"Why?" is still the nagging question I ask myself this question every day. And that "Why?" implies, "Why are not participants afraid of the effects of policy shifts, recession, uncertainty in their risk equations determining the pricing of risk?? Is it that one has magically found the keys to the printing press, and they are raking it in and converting it assets as quickly as possible, OR is it perhaps that the world is so awash with liquidity that delegated agent portfolio managers have it, and must use it or lose it, even if valuations are not attractive, cap rates on real estate are low, or the risk vs. reward of changes inimical to the realization of profits for investors at the end of the trade, poor. In either case asset values are rising, and price signals in both the real and financial economies are being distorted. There is no silver lining in this round of leveraged private equity as there was when Oliver Stone's Wall St. Villain shook up the sleepy New England family manufacturing firm to ostensibly make them more competitive and efficient. These buyouts are not about running the companies better, or realizing value for shareholders, whatever the rhetoric. It is about borrowing to take something private with other people's money, stripping it, and flipping it back out sans assets and with pathetic capital structures, having pried loose untoward management fees, success fees, incentive fees, directors fees, refinancing fees, handshakes, parachutes, and all manner of other freebies, goodies, consultancies, etc. before selling it back out to the public market saps. The early deals have been home-runs for investors and structurers alike, but one must wonder now with a deal-or-two-a-day being done, what the outcome of these will be. Either way, the signals and competitive incentives for the market and the immediatre future prospects for the workers and communities where these enterprises dwell is rather grim. For as leverage goes up, so all accounting conservatism goes to proverbial pot: R&D & ad spending are slashed. All but the most urgent & necessary capital expenditure is torpedoed. Working capital pared to the bone. Anything that can be levered, factored or securitized is so encumbered. Employees are laid off. Benefits and wages cut. Extra-responsiblities heaped upon non-eexecutive, non-buy-out affiliated salaried employes that are fortunate enough NOT to be fired. Good for capital. Bad for labour. Good for competitor firms, for the new owners will be in the midst of a Sherman-style march that will see the enterprise, in all likelihood marginalized and handicapped for years to come, as their competitors and nearest-neighbors invest, whistle-dixie and take "the long view".

But hey, this is capitalism, and a free market. Why should we care? And if we should care, what should we do? I think we should care because the result is inequality and further imbalance enroute to economic serfdom and marginalisation of anyone NOT already a large owner of assets or king of Wall Street. Like it or not, this will have economic, political, sociological and psychological consequences that will floor a generation, for skill-sets and compeititve market positions, once yielded, are most difficult to recapture. I am not talking central planning. I am a fan of the market, and think capitalism the lesser of evils. But I think that perverse incentives to accumulate that are granted to a limited few at the expense of the many is simply wrong, ethically speaking, for will have political manifestations, make no mistake. And when the hordes become meaningfully disenfranchised, and no longer believe the rules of the game are fair, then all manner of turn-the-world-upside-down becomes possible.

More immediately, what's to be done? The prime enablers are globalization and free movement of capital, coincidental to dramatically different national interest rates, combined with the neutering of market signals by surplus nations systematically and persistenly accumulating debtor nation reserves. The first allows "the carry trade". The second enables large imbalances - trade deficits - to persist without immediate or tangible consequence. Both of these spawn perverse outcomes and dangerous consequences to national economies and the international monetary system alike.

Now, some will say hard money is the answer. And here, I must admit to being philosophically sympathetic. BUT practically speaking, politically speaking, this is extreme, and at once difficult, at least as far as true hard money solutions go. And I will further admit to secretly having sympathy with Vickrey & discisples who mourn the social costs of lost output, as well as those who highlight the stickiness of prices on the downside, and therefore argue that cautionary erring on the side of looseness is better than erring on the side of being too scrooge like. In this sense, I am no radical. BUT I do believe that there is great moral hazard in income inequality, and in selectively giving the keys to the press to some, with a put option, and that this will cause rgeat distortion like housing bubbles, and wholesale raping of enterprises for short-term parochial gain at the expense of enlightened social policy, a balanced economy and longer-term competitiveness. This is unconscionable in a world that itself is, day-by-day becoming more competitive, and is something communities all across America and Europe will come to regret when the look back should they persiist in substituting leverage and consumption for investment, balance, a long-term view. All, which to say, in the most long-winded way that I believe, we must end the carry trade, and adopt fiscal, energy and macro policies that encourage longer-term competitiveness, balance, and fortitude and equality.

For the carry trade is the lifeblood of the Spec. There is no problem with investors from one nation desiring to invest, in another. There IS a problem with investors in one nation conjuring up financial liquidity to parasitically profit off of another while at the same time preventing it from confronting the financial issues and problems that are most pressing, like trade and current account deficits. I believe of course that our trading partners are NOT helping, and are disingenuous. ZIRP is a sham, and even if Japan experiences further disinflation or deflation (mild as it would be), they SHOULD, since they are running persistent surpluses, are demographically stagnant, undergoing dramatic producitivity increases, and situated adjacent to the largest deflationary force the world has ever seen. But leaving the cynical self-interest of MITI, MoF and BoJ, the USA can take matters into its own hands, for its own self-interest, and should NOT passively let itself be exploited for the narrow interests of transnationals, banks & finance houses benefitting most directly from the one-direction of trade and continuation of status quo and the great sucking sound that it is producing in the domestic economy.

So what specifically should do we do, since open capital flows are a cornerstone of globalisation and the international monetary system? Like many things that go awry incrementally, policy correction to fix the problem need not be intractable or even difficult. A simple statement that the speculative leveraged carry trade will not be tolerated any longer will go a long way. For this situation of the Central Bank and hordes of mischievious and clever speculators reminds me of one of my favorite anecdotes from when I visited Gibraltar some years ago. Aside from being strategically important at the mouth of the Med, and the foot of Europe, it is the home of a large troupe of barabry apes. They run wild around the place, live in caves up the side of the rock (the one now notorious by Prudential), and frequently descend upon the populated town to steal pies from the windows of old ladies, and picnic boxes from small children. Ocassionally they run amok and can truly cause chaos and mayhem, during full moons for example.

But fortunately there is a solution to help civil man and beast live side-by-side. You see, the first thing that the leader of the British garrison does when there is a leadership change in Gibraltar's British squadies, is meet with the apes, mano-a-ape-o. As the story goes, they manage to round up a great number of them into a cave, with the new British Commander. The Officer rolls up his starched sleeves. Stares the alpha Barbary male down, and proceeds to wrestle the alpha male ape down to the ground, and beat the pulp out of him thus establishing dominance. Once the Commander is ensconced atop the Barbary Ape hierarchy, he is the law, so that whenever the apes run amok, the garrison leader need only show up and tell them to "shove off" for them to run off with their tails between their legs, without screaming fuss, a fight, or tossing of bottles. Understand, that it is not out of sadistic pleasure that this is done, just as a Central Banker should take no pride in generating volatility, uncertainty, and occasional liquidation in financial markets. But, it must be understood that it IS for the greater good, else the mischievious little buggers will run amok with no apparent recourse....


john c. halasz said...

Query. Since the stock market/real estate meltdown at the beginning of the 1990's, Japan has been deficit spending furiously, to little overall avail, but has increased its national debt by ~100% of GDP, such that it is now 150+% of GDP. I take it that virtually all that public debt is held by the Japanese public/domestic institutions, since the interest rates are unattractive and BoJ/MoF do their damnedest to intimidate market speculation on a revaluation of the yen. But wouldn't an upward revaluation of the yen to somewhere south of 100 yen to the U.S.$ and a corresponding adjustment with the Euro, (which presumably would occur in tandem with similar moves by other East Asian currencies), have the effect of increasing the real value of their outstanding public debt vis-a-vis the earnings from RoW? And wouldn't that further increase deflationary pressures domestically, with reduced earnings from abroad adding to already faint, demographically constrained domestic demand? Granted domestic yen debt is paid of in yen, but the mechanism of increasing the value of public debt would be the deflationary increase in the real interest rate, while fiscal and monetary policy options have already shot their wad to little avail and couldn't be counted upon for reflating the economy once more. And all the while, the incentive would be for Japanese MNC's to further outsource production abroad, to depreciating currency countries and for domestic financial institutions to snatch up assets in those depreciated currencies. (Yet, at the same time, domestic yen deflation vis-a-vis the inflation of depreciated currency countries would be a defacto depreciation of the repreciated yen, a countervailing effect). So there seems to be some dilemma for the Japanese in all this, even if they themselves have contributed plentifully to the pickling process. I'm just wondering what you'd have to say, as a Japan specialist, about this particular piece of the global imbalances puzzle, 'cause sometimes desperation is hard to distinguish from selfishness.

"Cassandra" said...

Since the stock market/real estate meltdown at the beginning of the 1990's, Japan has been deficit spending furiously, to little overall avail

I do not agree with this statement. The authorities accomplished much, though it was not what "we" in the west would term good avail, though there was much avail. Despite the largest property bubble the world probably ever saw, the repurcussions were softly softly. Unemployment never rose above anything other than "full employment by western definitions. Relations between capital and labour were left in tact. Adjustments for a 50% rise in the value of the Yen a marked increase in oil prices, incessant competition from SE Asia crawling up the value chain, industrial hollowing and non-stop dancing upon Japanese heads by US trade negotiators all were navigated. And Japanese transnats globalized, didn't yield market share, continued to invest in R&D, manufacturing and vertical integration of sorts. Yeah Tokyo was "quiet" in these years by comparison to 1990, or 1999, but so was London in 1993 in comparison to 1988. They got their money's worth, but it was a Japanaese affair, with Japanese goals, and can't measured by western definitions of success.

But wouldn't an upward revaluation of the yen to somewhere south of 100 yen to the U.S.$ and a corresponding adjustment with the Euro, (which presumably would occur in tandem with similar moves by other East Asian currencies), have the effect of increasing the real value of their outstanding public debt vis-a-vis the earnings from RoW?

Japan in aggregate is in anenviable positon. While the government has accumulated much debt, the private sector is awash i savings, and the corporate sector has acquired enormously valuable globalized assets. For all their technological and manufacturing sophistication, the Japanese remain pathetic in the world of finance. By far the largest amount of savings is held in the KAMPO, or postal savings system on short term depo, that is ultiamte owner of much government paper. Given the Japanese historical experience of hyperinflation, the BoJ up til ZIRP was far more like the BubA than the FRB. But since "The People" own the deposits, and thus the debt, deflation would be "good for the people", bad for the state, but isn't that a wash, since the state is the people? Effectively, though the "the people" don;t realize it yet, The State has forcibly spent a reasonable wodge of accumulated private savings.
Would it be deflationary if the government attempted to lower its gearing (as % of GDP) and say for example raise taxes , or cut spending to pay down debt? Yes. No free lunch huh? Was the Japanese deflation "bad", unexpected, or undesirable? I have an unorthodox view on this and think it SHOULD have experienced deflation. How could it experience anything but after the property bubble, the enormous producitivty bubble, the opening of a more or less closed economy, huge demographic challenges and proximity to China and other SE Asian low-wage countries holllowing the domestic industry?? I do not believe it was the "bad" deflation of the 1930s, but rather empowered the Jpaanese consumer awash with savings, now finding that his savings goes a whole lot further and buys more for less. Ans still unemployment was never more than 5%.

So there seems to be some dilemma for the Japanese in all this, even if they themselves have contributed plentifully to the pickling process.
The Japanese have done everything possible NOT to yield any advanatge to competitors. They can couch it 1000 different ways, but do not believe for a moment that it is unscripted. TeamJapan is apt. And there is no way the US can possibly hope to compete without definitive policy. We let it slide for years because of cold war proximity to soviet union, but that over, and they are still running circles around us. Name a single trade achievement we've ever managed in Japan: Insurance? Financial markets? The Japanese are like Hasids: they would always do business with themselves of friends, or friends of friends before doing biz with an outsider let alone a goyim. I say this not as a racist (which I would vehemently deny ecause I admire them immensely),
but there is no room in good policy for apologists, since good policy is founded first upon distilling and understanding objective reality.

I'm just wondering what you'd have to say, as a Japan specialist, about this particular piece of the global imbalances puzzle, 'cause sometimes desperation is hard to distinguish from selfishness.
In the Bretton Woods system, there is a winners curse for those determined to play the game to the end, should market mechanisms be left to adjust properly and quickly and faster than changes in behaviour. Edith Cresson gaffingly (had she not been booted) might have said "let the ants work less and play more, and buy more Gucci, drink more foreign tipple, watch more Rambo or Terminator, or take a few more days off and like Munro's famed El Toro muy feroz, just sit and smell the cherry blossoms. Keynes and Triffin both foresaw what would happen if the winners wouldn't be magnanimous in victory, and the losers not diligent in avoiding beggar thy neighbor.

Anonymous said...

What an absolutely glorious rant!



Anonymous said...

Cassandra's rant, that is, not the gibberish immediately above ...


Murphy said...

I enjoyed that. Thanks

john c. halasz said...

Oy vey! I pressed a wrong button and my post disappeared before just before I'd finished. All is lost! Which was the substance of my post anyway.

At any rate, I was saying that I wasn't taking a nationalistic perspective and that I was just inquiring into the Japanese end of a multi-lateral global dilemma, in a forward-looking direction. And the Japanese national debt of 150+% of GDP, regardless of how it was accumulated, constrains the steering capacities/policy options of the Japanese government, even as it saddles the excess savings of the Japanese people with low-interest returns, increasing the tendency to excess saving and generating a pool of low-cost financial capital, that all-but-inevitably leeches out into the global economy and the asset inflation/excess liquidity/high profit and low real investment situation that lies behind the current trade/CA imbalances and the deflationary pressures that at once engender and exacerbate such policies. From the Japanese end, low interest/low yen policies hold at bay the deflationary pressures that might implode the remaining productive economy, even as they increase those pressures impacting it from abroad. In general, there has been a re-emergence of the famous "classical" contradictions of capitalism, productive overcapacity matched to underconsumption, in a new "globalized", technological form, as globalized finance has overwhelmed the regulatory and steering capacities of governments, which save capitalism from the capitalists. High profits/asset inflation/excess liquidity correspond to a lack of real productive investment opportunities, together with a blockage of the channels of distribution assuring adequate consumption demand. It's a monetary illusion that can not last, though how and when it will end, who knows? Only a multilateral approach to the regulation of finance, currency and production could restore balanced development, but that's little likely beforehand.

Anonymous said...

FYI in the UK the term "Paki" is a serious racial slur - perhaps you should replace with Pakistani.

Anonymous said...

"Japanese national debt of 150+% of GDP"
This is the gross figure of national debt issue. Most countries publish the net figure; but Japan doesn't have consolidated national accounts:-)
In a paper (Happy News from the Dismal Science: Reassessing Japanese Fiscal Policy and Sustainability) published a couple of years ago by Broda and Weinstein, the authors calculated Japan's net debt position as being around 70% of GDP, comparable with the major European economies (Italy excluded).
The 150% figure looks scary, which is why it gets bandied around such a lot, and it's a great weapon with which to bludgeon Japanese into accepting tax increases.
Kick the tires, look under the bonnet; things are never quite what they seem in Japan....

"Cassandra" said...

Anonymous -1 : Point taken and corrected. It was not meant as such for these small shop owners of Britain are very un-british in the kindness and warmth they extend to their customers. -ed.

Cassandra said...

Anonymous - Thank you for higlighting the treatment of net v. gross debt in national accounts (John Halasz take note). Without devolving into conspiracy theories, there IS a Kabuki-like theatric to many of the things political boffins and MoF highlight (e.g. deflation) that are used for - as you point out in respect of Gross vs. Net debt - self-serving purposes for TeamJapan.

Cassandra said...

John Halasz....bugger blogger! I just lost a monstrously long reply to you....damn! I will revert back to the old comment screen which if nothing else is more robust than the pop-up. I switched 'cause of spam, but its a mistake....-C