Thursday, 2 September 2010

Bread today can bring hunger tomorrow

The above phrase is a literal translation of a Spanish saying: “pan para hoy y hambre para mañana”. The closest sensible translation I can think of is “laugh now, cry later”… a typical Southern European attitude to problems which makes this part of the world a great place to live in. Sometimes, however, we can get carried away with “laughing” by adding a few boosters (such as consumer or housing debt) so that the “crying” can almost develop into “dying”. While I write this facetiously, I think we have experienced too many excesses in Spain over the last decade.

How have we Spaniards managed to focus on today at the expense of tomorrow? Here go three of my favourites:

1. Dependence on the construction and housing sectors

This is a sector that cannot be competed away via trading and has thus avoided the impact of globalisation. It also happens to be low value-added labour intensive so that job-creation was an added bonus. Politicians of all sorts became chummy with construction “entrepreneurs” in a fatal embrace which was to show itself to be unsustainable. There were few incentives to improve education and competitiveness to face increasingly assertive emerging markets.

“Pan para hoy y hambre para mañana”

2. The use of deferred payment mechanisms to finance the above

The main constraint to the above policy is the availability of finance. Fortunately, central bank policy across the Euro area meant that money could be thrown at the above sectors in the form of both development grants from the European Union as well as financial debt provided by foreign financial institutions and other long term investors. To ensure that the volumes of debt being thrown in did not scare these foreign investors away, the funding was conveniently disguised into debt issued by local financial institutions, infrastructure “public-private project financing” and corporate debt of construction companies. I will not provide figures in this post but take my word for it. The volumes involved are huge. One flaw in this policy- debt has to be repaid and we cannot devalue our currency.

“Pan para hoy y hambre para mañana”

3. The restricted list method for choosing political representatives

The intellectuals who designed the post-dictatorship constitution decided that they wanted to strengthen political parties in the light of the inherited power of the Armed Forces, the Catholic Church and other reactionary elements. This might have made sense at the time, but it has since developed into a mockery of democracy where candidates owe their loyalty to the party that includes them in the list and not to the electorate. As a consequence, political parties have become so strong that they have weakened the very fabric of society. There are few, if any, genuinely independent institutions in Spain, including the judiciary and the press.

“Pan para hoy y hambre para mañana”

Change is necessary but I don’t think that change will come naturally. Those that benefit from the status quo will not voluntarily become the agents of change. Change will only come about if forced by circumstances or outsiders. This was and still is my great hope for the crisis. A renewed commitment to envision, propose and create a genuinely liberal society where basic rights are enforced, responsibility is assumed, and creativity and freedom from coercion genuinely flourish. After all; who wants to build a house on sand?

Wednesday, 15 July 2009

The Big Lie

Yesterday's Goldman Sachs results have been illuminating. The investment bank that everyone loves to hate produced record returns for its shareholders (and management) with a quarterly profit of USD 3.4bn . Its prowess in financial markets trading is unparalleled in the finance world and they certainly deserve it...or do they?

An institution that was on the verge of bankruptcy just nine months ago and required public financial assistance is now producing record profits and paying oversized salaries to its top management. It seems that many financial institutions will follow suit in the coming quarters. Where are the returns on the public investment?

The “Big Lie” that we have been fed by a compliant press is that the stimulus packages which have been implemented in major economies were designed to support the real economy. In fact, these packages have been used primarily to prop up the banking system, a worthy aim in itself had not the main beneficiaries been shareholders, bondholders, and management. In plain English, taxpayers have had their pockets picked to support investors and top management in financial institutions.

I think that no reasonable economist can disagree with the need for the government to step in to save the money centre function of banks by safeguarding retail deposits and clearing relationships, but I can see no worthy use of taxpayer funds in supporting the financial rewards of institutional investors and management. The latter, after all, are trading risk for return. In 2008, after many years of return, risk reared its head and proceeded to destroy the value of financial instruments in a violent and unprecedented move. In my opinion, it is only fair that financial rewards for shareholders and management should have been wiped out. It is a basic premise that owners and management are responsible for the actions of the financial institutions they control.

Not content with direct assistance to the industry, monetary authorities have also stepped in to ensure that banks quickly start making money. How is this achieved, you may ask? It is as simple as enabling the carry trade...central banks have flooded markets with liquidity so that short term interest rates have collapsed. Banks can then borrow cheap short term money and lend longer term without taking on much risk. Call it a licence to print money.

Ostensibly, the policy of cheap money was designed to save the real economy but I don’t believe that a real investment project is sensitive to rates at levels below 5%. The only institutions that measure returns in basis points are financial institutions, given their high leverage and portfolio of financial assets. The fact is that rates have been reduced with massive liquidity injections because they assist in the repair of banks’ balance sheets by providing access to carry trade income. Again, governments have used public policy tools to protect well connected shareholders and top bank management.

Further evidence of mis-use of public funds is implicit in the conflict of interest of regulators. Ask these questions: How many of the financial sector regulators own or have friends/relatives that own substantial stakes in bank shares? Are they chummy with top management or do they get access to perks? I suspect that regulators are responding to hidden incentives in many your friends and they will help you; with a job in the future, or maybe access to holiday homes, yachting holidays and “business” opportunities.

In Spain, the lack of freedom of press has led to few and far between debates about the convenience of using tax-payer funds to save bank shareholders and stakeholders in Cajas. When referring to stakeholders, I include management and the political establishment which has benefited from the largesse provided by directing savings from depositors. Much in the same way that industrial companies used to own banks in order to provide cheap funding for their industrial activities, politicians have continued that ancient tradition to channel funds to pet projects. The lack of debate regarding the recent restructuring fund set up by the government has been egregious.

We live in a world in which society at large has been skimmed to pay for the returns of stakeholders in banks: so called sophisticated investors and management. Once more, prudent economic agents have had to bail out the aggressive imprudent agents, reinforcing the moral hazard which will inevitably encourage the next financial bubble under this “let’s socialise the losses and privatise the profits” policy.

Friday, 16 January 2009

Spanish party politics...and I'm not referring to "fiesta"

Let’s take a look at why Spain is going the way of Citigroup. I think it is important so that once the crisis is over, politicians and institution builders are able to recall history and avoid past mistakes.

First, the Spanish political system is reminiscent of nouveau riche antics. It was developed and executed in the latter part of the 1970s, when the combination of ideological enthusiasm and democratic inexperience led to the creation of a political system that has outlasted its usefulness. The ideologues of the system wanted strong parties, regional representation and democratic principles as the basis of the system. Over the years, strong parties and regional representation have cast out principles-based management to create a system that is on the verge of moral bankruptcy. Check out this link:

Today, over 30 years after the death of Franco, the key indicators of health of a democracy such as voter turnout and strong independent institutions are weaker that at any time in recent history. A primary reason for this democratic deficiency is the Spanish electoral system. Numbers always help; let’s look at the results of the March 2008 elections (click on image):

Several conclusions can be drawn from this table. The first column in red provides the percentage number of total seats assigned to each party. Note that PSOE and PP each were assigned 48.3% and 44% of the seats, despite obtaining only 43.9% and 39.9% in number of votes, respectively. Note also that Izquierda Unida was assigned only 0.6% of the seats despite obtaining 3.8% of the popular vote. Therefore, large parties and strong regional parties are over-represented, which inevitably leads to under-representation of dispersed national parties such as Izquierda Unida and UPyD. Another disturbing fact is that 4.1% of the people who voted had no representation whatsoever. When you add this voter base to the 24% of registered voters who abstained from voting, an astounding 27% of registered voters are not represented in the Spanish parliament. Surprised?

Spain has 52 electoral districts (or circunscripciones) with 2 representatives allocated to each and 248 distributed on the basis of population, for a total of 350. The d’Hondt method of seat allocation ensures that the strong candidates within these electoral districts get elected. As a result, strong national parties and regional parties are over-represented in contrast to parties which have a voting base spread across all the electoral districts. The d’Hont method works like this:

-Within each electoral district the first seat goes to the most voted party
For calculation of the second seat allocation, the party that obtained the first seat divides its number of votes by the number of seats obtained plus one (i.e. two).
-The second seat is then allocated to the most voted party (note that, under 2 above, the party that got the first seat has halved its votes for calculation purposes)
-For calculation of the third seat, the party that obtained the second seat divides its number of votes by the number of seats previously obtained plus one (i.e. if it is the same party that got the first seat this would be three, otherwise it would be two)
-The process is repeated until all the available seats are assigned.
-For mathematical minds the test for allocating each seat is based on: V/S+1; where V= number of votes and S=seats previously obtained

Therefore, we have an electoral system that is not representative, at least for many people. Strong parties and regional parties have run the country for 30 years and made it what is now, a nation which is close to becoming a banana monarchy.

To add insult to injury, a closed list system has also been implemented. In closed list systems the party has pre-decided on who will receive the votes in the elections, that is, the candidates positioned highest on this list tend to always get a seat in the parliament while the candidates positioned very low on the closed list will not. There are no prizes for guessing to whom candidates owe their loyalty. It’s not to the voter.

The outcome of this electoral system is plain for all to see, yet the players involved have no desire to change a system that works to their benefit. Why would the PP or PSOE want to change a system that allocates them disproportionate influence? Regionalists, in turn, have wielded their power in national politics to force the central government to transfer power to the regions, regardless of whether this was efficient or effective. Why would the regionalists want to change this system?

Therefore, it is highly unlikely that the system will change, unless a political crisis forces change and the current economic and financial crisis seems to be brewing future strife. Our current rulers have managed to dispense enough mortgage debt and football entertainment (“panem et circenses”) over recent years to keep the populace quiet, but as defaults soar incentives will change....and they call this a democracy.

Wednesday, 14 January 2009

From the fire into the frying pan

As I reflect on the course of action that governments around the world have taken in addressing the current financial crisis, I realise that there is something profoundly disturbing in these actions. If the underlying problem is an investment bubble financed by savings which have been invested into projects that are based on wildly unrealistic expectations, then shifting these inflated assets from the balance sheets of the private sector to the balance sheet of the public sector is not going to solve anything. It will buy time for a short period until investors realise that the underlying premises which supported the valuation of these assets are still as wildly unrealistic as they were before, only now a government guarantee has been slapped on. Governments, however, will still have to pay for the bill... and how will they do that? As little, if any cash will be forthcoming from these investments, my hypothesis is that they will either: (i) eventually raise taxes or (ii) print money which will lead to inflation (another form of tax). As a consequence, the losses will have been transferred from those who held the risk of these inflated assets to society at large.

Losses, like the previous 15 years of profit, should accrue to those that took the risk in investing in these assets. Share and debtholders in financial intermediaries should be wiped out where appropriate, shareholders in general should also suffer from the new revised valuations, and real estate should similarly adjust (these are, after all, risky assets). The necessary wealth destruction and consequent deleveraging should take place, fast. I suspect, further, that bearing these losses will not lead to serious social unrest as most of these investors have alternative sources of wealth. The only part of the financial system that, in my opinion, merits government intervention is the payments system and commercial bank accounts. Another possible alternative, if the level of uncertainty is such that a liquidity freeze sets in, could be for the government to set a floor at, say 25-30%, of peak prices in certain markets. It is highly unlikely that this level would ever be reached but it would provide support and comfort to an unstable market.

On the economic side, I concur with the idea that governments use their borrowing capacity to undertake investment projects which can have an effect on productivity; primarily infrastructure investments . These projects can act as a cushion on reductions in aggregate demand, temporarily alleviate unemployment and promote future competitiveness. Eventually, however, reality must kick in and economic players (capital and labour) will have to adjust to lower returns, or, better still, a new productivity model will have to be found. If the right incentives are provided, I have no doubt as to mankind’s ability to develop another groundbreaking development. Just think how much the world has changed (positively) in the last 100 years.

Thursday, 20 November 2008

Bailing out the bozos

So the great unwinding is finally happening...the time has come for the prudent and responsible to emerge from obscurity; or maybe not? As put by one reader of the FT Alphaville section ( “So I’ve cautiously decided to keep my cash on deposit in the bank - taxed at 40%, not only do I have to put up with falling interest rates and a depreciating currency but as a tax payer I will be bailing out all the people who told me: ‘You are an idiot, because what you don’t understand is that house prices only ever go up’”

Precisely. Why should the cautious now help to subsidise the fast cars and expensive holidays that certain individuals purchased with debt secured on inflated assets? Many borrowed money and overspent without regard to prudence; thus implicitly forgoing future consumption. It’s now time for these individuals to save and repay their debts. If they can’t repay with current income, then they should lower their living standards and/or liquidate their assets. However, government action across the world seems bent on bailing out these poor souls by paying their debt with other people’s money. In other words, a policy of “the gain is individual while the pain is socialised” has now been institutionalised.

Another mistake. If individuals are spared from the consequences of self-inflicted actions, the necessary learning process will not take place. Lessons must be learnt for mistakes to be avoided in the future. True, there might be grievous instances of injustice which can and should be covered by a safety net, but these represent a small minority.

Similarly, companies and their senior management have to pay for past mistakes. I remember advising corporate CFOs to lock-in long term committed facilities to finance long term assets, yet many refused because this implied a higher cost in commitment fees. Those that took such advice are sitting pretty while the ones who didn’t are now clamouring for government rescue packages. I don’t think the latter will be returning their 2003-2007 bonuses anytime soon. Why should taxpayers then shoulder the consequences of their bad management? I take the point that systemic risk should be avoided, but companies that access public funding should, as a condition precedent, remove all the top management which led them into the situation in the first place. Only then will the lessons be learnt.

Wednesday, 15 October 2008

The chickens have roosted...

Well, it has been some time since I updated this blog and many of the things that were predicted have finally occurred. However, the speed of it all has certainly been surprising. When I wrote some months ago that the virtuous circle which had fed global growth in the last few years could easily turn into a vicious one, I had no idea of the scale of this viciousness. The extent to which wealth has been destroyed is vast- pity those poor pensioners in defined contribution systems! Today, Bear Stearns, Lehman, Merrill, AIG, Fortis, Dexia, Hypo Real Estate, Washington Mutual, Wachovia, Alliance & Leicester, Bardford & Bingley, Morgan Stanley and Goldman Sachs have either disappeared or been transformed. Expect more consolidation.

Some commentators argue that there has been a complete “market failure”; I would argue exactly the opposite. There has been a clear and blatant “failure of regulation”, especially in the US, where politicians have interfered with the Federal Reserve and Government Sponsored Entities in order to pursue a lax monetary policy which would statistically noteworthy but unsustainable GDP growth data and, ultimately, votes. One only has to review past press articles on FNMA and FNMC to note how politicians took measures so that these institutions would provide access to credit to all segments of the population; including those who, it turns out, were not creditworthy.

In those jurisdictions where central bankers, in their supervisory role, were really independent, the scale of the shock has been much smaller. In Spain, for example, the central bank did not allow local players to use off balance-sheet SPVs to fund credit in order to engage in capital and liquidity arbitrage. Why? Because it was pretty obvious that this was exactly what these vehicles were engaged in. The creation of a parallel banking system was not permitted. As a result, Spanish banks have serious credit issues arising from their real estate portfolio but they have not experienced the pain of some of their foreign brethren. Some cajas or mutual savings banks, however, given their limited ability to raise capital and, in some instances, political interference, are likely to fare much worse than the banks.

Other commentators have mentioned diminishing competition as a concern, given the level of concentration in some markets- in my opinion, this is a minor issue. Sure, the UK clearers are consolidating but note that one of the consolidators is Spanish. It’s really about time that European countries got their act together and encouraged cross-border mergers. I would hazard that we will see more of these in the coming 5-10 years and eventually see a pan-European competitive arena.

Ultimately, however, there is still impending doom in the form of inflation. Globalisation has allowed developed economies to import deflation from low cost countries while pursuing an expansive monetary policy, but now that emerging markets are exporting inflation, it is only a question of time before it feeds into developed markets. I can only imagine that an expansive monetary policy combined with rising inflation will have serious implications on the value of money. Most people remember the 1929 US stock market crash as the aftermath of the Roaring 20s, but events in the Weimar Republic had an even more significant impact. Let’s hope we don’t end up like Germany in the 30s.

And on that happy note, hope you are all having a swimmingly good time...

Thursday, 29 May 2008

If it's free, it's not valued...

At a recent dinner, a dear friend explained to me that his views on economics were liberal (in the English sense) but that he viewed the US healthcare system as a failure in that it did not provide universal access to healthcare! The US Medicare and Medicaid programmes do provide coverage but only for retirees and people below the poverty line. He then went to defend the Canadian and Continental European systems as examples of well-run healthcare systems.

As usual, defenders of tax-funded universal healthcare demonstrate a basic misunderstanding of economics (he is a journalist). They view healthcare as a "right" instead of what it is...a transaction which is subject to the same economic forces as any other (supply and demand!). As a consequence, any service which is free or supplied at less than cost tends to lead to shortages and rationing. Both the Canadian and Continental European systems demonstrate such trends in the form of waiting lists. Hence, a patient who requires surgery has to wait for critical weeks to obtain surgery; weeks during which illness progresses and often leads to terminal conditions. It is not suprising, therefore, that many Canadians often cross the border to the US to obtain healthcare rather than be subject to potentially fatal waiting lists.

In Spain, the previous government tried to introduce a one-euro fee for visits to consultants and then rapidly withdrew its proposal after social outrage. One only has to visit a public hospital to witness the queues of patients lining up for imaginary illnesses. Many retirees often visit their consultants once a week- if it's free, why not? Like other "free goods", demand is virtually unlimited, while supply is only forthcoming at the price where it mobilises resources. Witness the recent shortage of water in Barcelona as an example. No doubt my friend would defend that water is also a "right"...which is why there are shortages. After all, someone has to pay for a supplier to offer it. There are numerous studies which show that demand for healthcare falls dramatically when a price signal is attached to it, without any impact on the overall healthcare of users. Thus, catastrophic healthcare insurance (which would cover expenses from USD 2500 onwards, say) would save governments inmeasurable resources to spend on other more useful matters (how about improving productivity?).

The problem with the "catastrophic coverage" system is that, in most countries (including the US), healthcare insurance can be provided by companies as a non-taxable payment in kind to employees. As a result, employees often choose coverage with a lower deductible, given the tax benefit (subsidy) obtained; which leads to higher demand for healthcare as well as higher (pre-tax) premiums. Thus, when a person loses his/her job, the cost of maintaining former insurance (without the tax benefit) can be prohibitive. However, the cost of catastrophic coverage is reasonable (e.g. USD 29/month with a USD 250 euro deductible and capped at USD 1 million for a 30yr old non-smoking female).

Tax-funded healthcare systems, therefore, tend to lead to lower quality and higher cost delivery of healthcare. It also leads to disincentives to care for one's health (why should I stop smoking or eating fatty foods if the consequences are paid by everyone). In my opinion, compulsory catastrophic insurance combined with voluntary supplementary care would lead to a more efficient allocation of resources. If it's free, it's not valued...