The Old Austrian Had a Lot of Fight in Him

The summer of 1978, I was 16 going on 17 and getting Keynes dunned into my skull for A'level economics. Britain was truly bust, with the IMF trying to pull it around: inflation and unemployment were both soaring.  That was the point at which my father sent me the only book he ever bought for me: Hayek's 'New Studies'. Sometimes the book you need finds you. Anyway, I devoured it.  At the time, it was 'The Campaign Against Keynesian Inflation' that gripped me, as it argued its way straight through the micro distortions. My family used to run textile mills, and I knew, absolutely knew, he was right. This was the stuff I'd known all my life.  

In retrospect, though, its the short 12-pager, 'Competition as a Discovery Procedure, ' which still strikes me as absolutely fundamental.  

Anyway, armed with my newly-found microeconomic foundations, I came to my lessons with a new enthusiasm. My teacher dismissed Hayek as 'some very old fashioned Austrian, I think,' with the assured put-down Hayek must eventually have wearied of. 

I spent the rest of the year arguing the undiluted Keynesian curriculum into the ground, and eventually the teacher handed me the class and made me teach it.  And so on to university . . . . 

There is a dreadful prequel to this story. My father was a bright boy, and won a place at the LSE to study economics. But his father - my grandfather - marched into the headmaster's study, slammed his fist on the desk and pronounced: 'No son of mine is going to the LSE.' Stuffed with Lefties, of course. And the irony? Had he gone, my father could have been taught by none other than Friedrich von Hayek. 

Enough personal stuff - here's a video I enjoyed  a lot . . . . 

   

About Economic Transitions

You've read all about it, I've read all about it. I've talked to the economists and think-tanks in Beijing who wrote the message in the first place, and felt the sincerity and conviction with which they deliver it. I've gone through their numbers, and tried to understand what they actually mean. So yes, everyone is agreed that China is embarking on a change of economic model which will shift the dynamic of growth from investment and exports, to domestic consumption.

But there are three obvious problems. The first is that these transitions are incredibly hard to achieve:  the economic and political history of the last 100 years is littered with examples of economies which tried and failed. The second is that, as they say, 'you wouldn't want to start from here' - the transition China intends is probably the most extreme ever envisaged and even with the best policy-settings and initiatives, would take not years but decades of sustained effort to accomplish. The third is that the immediate and compelling responses to China's current economic challenges can only entrench the existing model deeper than ever.

Let's take these three separately. The pattern of economic history has been repeated several times now. I wasn't around at the time, but the history books tell me unequivocally that in the early 1950s the Soviet Union  had achieved economic miracles and looked economically invincible. People looked at the extraordinary  mobilization of resources, and wondered what the US could offer in response. Richard Nixon's 1959 answer - way-cooler kitchenware  -  hardly seemed plausible, but turned out to be right.  Japan has attempted it at least twice - once in the aftermath of the first oil shock, the second with the implosion of the bubble economy. (Three times actually, if you include the Taisho democracy of the 1920s.)  How's it going?  Well, Japan is determined, organized and deploys an astonishing accumulation of social capital, but its nominal GDP last year was just about what it was in 1992.  South Korea talks a good game about making the transition, but  devalues the Won at the whiff of economic grapeshot.

The reason that these transitions are so rarely achieved is bound-up in the very foundations of economic success. For simplicity's sake, let's say that the transition being attempted is one from an 'exogenous growth model' to an 'endogenous growth model.'  Exogenous growth models are in essence rather simple and can be quite wildly successful. The recipe is this: muster savings ruthlessly and pile them into industry. You'll produce far more than you can consume, but don't worry, because you can always export the surplus (that's the 'exogenous demand' bit of the 'exogenous growth model').  On the assumption that exogenous demand is inexhaustible, you'll be able to do this right up to the point at which adding up-to-date capital, technology and management techniques stop raising productivity levels. Or savings run out.

If you are a political leader, you'll pick up above all on two aspects of this model. First, it justifies enduring financial repression, in which consumption is discouraged, savings encouraged, and the financial system heavily monitored/regulated.  You'll  like that, not least because it'll pay your bills.  Second, in the short, medium and even long term, it can be wildly, unbelievably successful in terms of growth and employment. And everyone'll like that.

So why bother to change? Good question - and one which the Japanese still haven't managed to answer. But we  know that when a country approaches the technological frontier, the going gets a lot tougher. By which I mean, returns on capital fall, cashflows begin to dry, the failures of resource allocation become more noticeable and costly, and finally investment opportunities dry up, and growth with it. (Probably around the time your people are beginning to want that way-cooler kitchenware.)  

But here's the rub. The very success of the exogenous growth model over decades will have taught the political leadership that beyond any shadow of doubt they know how to make things work. Save harder. Invest more.  Keep your currency competitive. Not only does your experience tell you this, so does every businessman and financier who comes through your office door.  To do anything other than double-down goes against every instinct in the body politic.

And so, you double down . . . . and lose. It's the hardest lesson in economics: it is only by ruthlessly repudiating the lessons learned in the decades of success that you can transcend the model's limitations.  More later. . . .

 

What The Street Isn't Telling You About China

The thing is this: more than at any time in the recent past, the economic signals coming out of China are  contradictory, incomplete, wildly and inexplicably volatile and ultimately incoherent.   I've been watching China's data for - oh god - decades now, and I don't honestly think it's ever been as weird as this.  I cannot confidently tell you what China's economy is going to look like in six or nine months time, let alone in two or three year's time. But I'll tentatively say this: that unless things change swiftly and radically, the much-heralded and desired shift to an endogenous growth model (consumption allied with innovation-inspired productivity gains) and away from the exogenous growth model (massive investment, financial repression and US-devil-take-the-surplus) isn't going to happen. Indeed, if you have to straightjacket the current mess of data into a coherent pattern, it's one in which the investment & exports model is back big-time, mandated and reinforced by the choice of monetary policy instruments. (I'll explain how monetary policy choices are forcing this in a later post.)

Let's talk first of the gaps in the data. Here are just a few of the things we don't know about the 1Q. We don't know whether the government was running a surplus or a deficit - that's right, we really don't know the fiscal position. We also don't really know anything about retail consumption apart from the national total (up 16.3% in 1Q) because we have no by-province breakdown.  We think we know what's happening now to  property prices and sales, but we've no good way to interpret them because all the indexes have been abandoned or rebased.  We don't really know what's happening to liquidity, because PBOC has (wisely) started tracking a broader measure of credit, but (unfortunately) without also giving us some historic perspective. And, of course, we don't really know what's happening to inventory.

We do know what's happening to investment spending, because at least we have both national and provincial data. But of all the data, the fixed asset investment data is the ropiest in China because, like local authorities in the UK, it's wildly seasonal in order to satisfy various budget mandates.  What we do know, however, is that  the seemingly smoothly-growing national investment spend conceals unprecedentedly wild geographical swings. I regularly break down China's economy into seven different regions, and when you do that, you'll find that investment spending in the NW in March was 5.75 standard deviations above its historic seasonalized trends; spending in the Industrial NE was 4.5 standard deviations above; in the Yangtze Delta it was 3.9 standard deviations above.

Really?

But then March's data generally - particularly the industrial sector data - doesn't look right. Yes, January to March is the Dark Side of the Lunar New Year as far as data is concerned. But this year shouldn't have been too anomalous, since the holidays began on 3 Feb this year, compared to 14 Feb last year. But in fact, the seasonal anomalies were the most extreme in recent history:  exports fell 35.8% MoM in February and jumped 57.3% MoM in March - whereas normally (including adjusting for CNY) you'd expect a contraction of around 12.9% in Feb, followed by a 27.5% jump in March.  The anomaly was a full 2 standard deviations above where one would expect it.  Does anyone know why? I don't.

I also can't explain where the export growth came from.  In Guangdong, the pattern conformed pretty much to seasonal type, with March's exports up just 0.6 SDs from seasonalised trends. But in the Yangtze Delta . . . good lord, exports were 2.8 SDs higher than you'd expect them in March; in the Industrial NE they were 2.6 SDs above seasonalized trends, and in the Central Provinces they were 2.7 SDs.

How come Guangdong missed out on the fun?

Now I know what you're thinking: it must be the labour shortage. But I have news for you: I can track national employment totals monthly for 39 industries - it comes to about 80 million employees. And when I do that I find that in  February employment 1.6% lower YoY - ie,  these industries have shed about 1.3 million employees over the last year, mainly right at the end of last year. The figures tell me this: you can forget about the 'labour shortage' in the textiles, garments, paper, chemicals, plastic products, metal products, machinery  and nonmetal minerals industries, because they're all shedding workers fast.  Lucky the auto sector is still hiring (but what's this, auto sales up only 2.6% in Feb, whilst sector employment is up 5.2%?

Must be seasonal . . . touch wood.

And so on. We have tangled wreckage where we'd like to have data. Yet the question of whether China is overheating or heading for a hard landing has to be addressed. And, presumably, responded to by fiscal and monetary policies.  And that's what we'll look at next. As a sneak preview, though, I feel it fair to warn you that the likely outcomes of current policy settings are rather different from the ones you have been encouraged to contemplate and invest in.

Reconstruction Maths for Naoto Kan

Take a look at the chart below. It is the calculation I make of how much 'spare cash' the Japanese economy is spinning off every month.  That is, when each household has paid its monthly bills, how much - if any - of its wage packed is  left over to be banked. Plus the positive cashflow after investment - if any - of  corporate Japan.   This is the private sector savings surplus (or deficit), and it's the crucial cashflow indicator of any economy.  Why? Because it monitors the net cashflow of the private sector into, or out of,  the financial system. Over the last 12 months to Feb 11, Japan's net cashflow came to just under Y48 trillion. Hang on to that number.  

When the financial system gets this cash, it can, by definition, do only one of two things with it: it can use it to buy foreign assets, or it can use it to buy government bonds.

So if an economy is running a savings surplus (and almost all are right now, including the US, UK, China, and the Eurozone) then the fundamental job of a financial system is to find something to do with the cash. (Choose your bubble.) Conversely, if an economy is running a private sector savings deficit, the fundamental job of a financial system is to create a cashflow (by selling such government or foreign assets as it has) to keep the private sector show on the road.

(There's a tendency, when an economies veer from savings surplus to savings deficit, to discover  which part of the financial system has been mispricing its products. Korea is a serial offender: in every dive from surplus to deficit over the last 13 years, another bit of the financial system has dropped off - merchant banks, bond investment trusts, credit card companies and associated insurance schemes, and now savings banks.)  

Japan is in surplus to the tune of around Y48 trillion. And that is also the frame which PM Kan has to keep in mind as he ponders how to pay the reconstruction bills from the multiple catastrophes of March 11.  And it is truly finely balanced. Before the catastrophe, Kan was working with a constraint of issuing no more than Y40 trillion of new government bonds a year - comfortably, but not too comfortably within the immediate cashflow available to buy them.  But the latest estimates of the immediate reconstruction bills comes in at a further Y25 trillion, of which the government anticipates shouldering Y10t trillion.  That would take new  issuance right up to, and slightly beyond, the economy's available Y48 trillion net positive cashflow.

But that's assuming that the available cashflow stays stable. But it won't - it'll slump. After Kobe in 1995, corporate cashflows crunched hard, and we should certainly expect something similar and worse this time.  As a clue, since March 11,  Japanese companies have tried to borrow Y8.4 trillion from Japan's top seven banks - and this is in a banking market where there were Y6.9 trillion of net repayments made in the 12m to Feb 2011! Clearly, corporate Japan knows its free cashflow is drying up fast. And these cashflows can't be replaced or even significantly offset by the household sector. Last year by my calculations (from MOF's quarterly private sector balance sheets) corporate Japan generated Y57 trillion in free cashflow, whilst  private consumption in Japan is running at only around Y280 trillion a year. It would take a heck of a slump in private consumption. . . .

Conclusion? We'll see Japan's financial system selling foreign assets this year (and next) to cover the reconstruction bill.  Australia, don't say you weren't warned.

Allocation Games - April to June

It’s the first of the month, so here are my game-playing tactical allocations for the following three months.

• Developed currency markets: Long Euro, Short Yen. (Previous month was Long Yen, Short Dollar, was up 1.2% on the month)
• Developed equity markets: Long US, Short Europe.  (Previous month, I was up 1.3% MoM, or 1.9% MoM with 50% currency hedge). For the year, the 50:50 l/s strategies are up 5.6% YoY, or  7.1% with currency hedge)
• NE Asia equity markets: Long Hong Kong, Short, Japan.  The previous month’s success - the l/s portfolio was up 4.4% MoM - was entirely fortuitous, since I was fully short Japan on March 11.  The model remains so.
• I have no l/s allocations for SE Asia, since the models are stalemated, zeroing in with conviction on Indonesia for both long and short selections. It happens sometimes.
• In BRICs equity markets, last month I dipped back into India for the month – which turned out well (up 8.5% for the month) - but am back to Russia this month.  I make no short recommendations in BRICs.

For those of you to whom this is new, it’s important that you know and fully digest the following: this is a game only. The game is that these positions are determined/suggested on the first working day of the month, and are kept unchanged and untraded for fully three months.

The allocations suggested here are found solely on the basis of testing an assumption. That assumption is that relative changes in the prices of financial assets in different markets bear some explicable and reasonably regular relationship to changes in relative monetary conditions in those financial markets.  In the case of currencies, the allocations are made purely by identifying patterns of daily performance over the past three months which in mathematical terms, look unlikely to be purely random-walks (according to Shapiro-Wilks tests) – and then assuming there’s still value for the next month in that pattern.  There is nothing here of judgement - everything is determined by numbers.

I have been playing this game on the first working day of every month for a number of years now, publishing both allocations and results.  But this is not the way I manage my own money. Nor is it the way any fund associated with me manages money. Indeed, any similarity between positions suggested here and positions adopted by any funds associated with me would be purely coincidental.  I make no claims that the allocations will work, or are likely even to help.  If you’re going to use this as anything other than just another way of thinking about markets, I advise you very seriously to seek competent advice from someone who isn’t just playing. If you follow these selections and it all goes wrong, you only have yourself to blame.  

That said, I'd be interested to hear of alternative views or arguments about the positions. Good luck.