Sunday, February 28, 2010

In which Paul Krugman proves he is an academic snob who argues from his prejudice rather than the data

Felix Salmon has a lovely post where he picks apart the news values of the Wall Street Journal – including picking apart differences between the front page of the WSJ and the online version. 

From this Paul Krugman argues that the New York Times rather than the Wall Street Journal is likely to wind up as the only national US newspaper (at least if the US does wind up with a single national newspaper). 

Frankly, there was a time when I thought the Journal was better on business/economic news than the Times. But no longer; and it’s not just things like referring to the estate tax as the “death tax” in news stories. Overall, coverage is getting cruder, with more tendency to report opinions as if they were news, and substitute prejudices for real analysis.

And this bad news is good news. There’s a pretty good chance that we will end up with only one great national newspaper. And I know which paper that should be …

Krugman’s prejudice matches mine.  I prefer reading the New York Times. 

But one of the things Paul Krugman does better than most is argue from data or a testable model – but he lapsed badly here.  Below are the top 15 newspapers in the US by circulation now and two years ago.  [The sources are revisions to the relevant Wikipedia page.]

 

image

No paper has – in this data – maintained circulation.  For most papers the fall has been catastrophic.  (The effects of falling circulation on pulp pricing is background to my next post…)

Nonetheless, it is pretty hard to see disaster or even the “great recession” in the Wall Street Journal numbers.  I gather of late that the fully paid circulation of the Wall Street Journal is rising again – albeit slowly.  None of this says that Rupert did or did not overpay for Dow Jones but Paul Krugman’s argument from prejudice rather than data about the New York Times possibly becoming the nations largest newspaper because of editorializing is – well – hogwash.

What sells the news?

Paul Krugman gives his view of what sells the news.  It is a view that fits the vision of the Gray Lady quite well: a clear distinction between news pages and editorial pages, facts supported by data etc.  That is also how I want my news presented.  However the evidence that that sells the news is quite thin.  Whatever Rupert did to the WSJ Journal (that which Felix Salmon and Brad Delong rail against) appears to be working. 

More generally opinion dressed up as news, especially when it panders to the prejudice of your readers or viewers works seems to sell really well.  A while back I gave a quarterly series of operating profits (in millions) for Fox Cable Networks – a business dominated by Fox News.  Here they are again: 197, 262, 211,194, 249, 275, 282, 284, 289, 337, 330, 313, 379, 428, 429, 434, 495.

There are few businesses with growth in operating profits without substantial capital expenditure that look anything like that.  Well Fox News gets even better (at least from the perspective of a News Corp shareholder).  The latest number is was $604 million operating profit for the quarter ended 30 December 2009. 

I am not a newspaper guy – but I have watched for long enough to form a supported opinion – which is that opinion and prejudice sell media – especially when they back the readers’ opinion and prejudice.*  It is respectable to present an alternative viewpoint – but only if it is a caricature – something weakly presented to rile the audience – but only till they pick it apart and make themselves feel smug.  The lightweight Alan Colmes – the token Fox News Liberal – and the equally lightweight Miranda Devine – the conservative for the Sydney Morning Herald fit this bill. 

Rupert knows this – and his news outlets all blur opinion and fact.  If his audience is left-leaning he will blur from that side (he once owned the Village Voice) and he knew enough to leave its politics alone.  He is (obviously enough) more comfortable with right-wing media markets (with a special love for “working class tories”) – but again – it might just be that is where the big markets are… 

Krugman however insists on wonkish articles arguing closely from data.  Those articles are like eating spinach.  Reading them is good for you but you would rather have ice cream.  But sometimes – as he did this time – he lets his prejudice out and argues like the Liberal equivalent of Fox News.  His prejudice matches mine – and I love him for it.  I suspect it also increases his value as an author.  Advice to Paul: get it wrong more often and ask for a pay rise.

 

 

 

John

*Local newspaper guys – who know far more about this than I ever will – say that what sells newspapers is local relevance.  All politics is local (but the internet is global).  Readers like to see pictures of themselves and their schools and teachers and articles about their roads and public transport. 

Tuesday, February 23, 2010

Submission to the Cooper Review of Superannuation

I have written a submission to the Cooper Review of Superannuation (that is privatized social security) in Australia. 

You can find it here

The submission is entirely about asset security issues – that is can you be assured that the assets are really there?  This is (obviously) of concern to people charged with looking after the (entire) retirement savings of tens of thousands of Australians.  However I have also found it is a very useful conversation to have with anyone recently finding themselves in possession or care of many millions in financial assets.  [If you run a small family office managing financial assets after you have (for instance) sold the family business then you should probably read it.]

The issues covered are broker and custodian failure (think Lehman failing and not returning assets to the clients) and also simple theft or misplacing of assets. 

Under normal circumstances this would normally be (very) dry reading.  However the events of the last two years have driven home the relevance. 

Monday, February 22, 2010

Weekend edition: an old Astarra marketing leaflet – and some comment on Astarra’s very peculiar asset base

The Astarra funds were amongst the top performing sold retail in Australia. 

According to the advert below it is because of market timing.  Shawn Richard knew when to go to cash. 

This suggests that his asset base was highly flexible – able to be converted into large licks of cash on market turns.

He says (in the picture) and I quote:

People ask me all the time how we do it.

To me it’s simple…  why be fully invested in a deteriorating asset class?  Investors don’t pay me to invest in cash, they pay me to get out of assets at the right time.

I believe that every asset class should be treated from an absolute return philosophy.  If that means higher cash weighting for a short time then so be it. 

Shawn Richard, Chief Investment Officer

image

Now if it was easy to shift Astarra funds to cash then it should be easy now.  Alas Peter Johnston in an article in Investor Daily suggests otherwise:

AIOFP chief executive Peter Johnston said he disagreed with [the administrator’s plan of liquidating the funds] and that the AIOFP intended to voice its opinion on the matter.

"Because these assets of hedge funds are off-market assets ... if there's a fire sale, in other words if the administrator wants to get in there and just wants to wind it up in a bloody-minded sense, you're going to find they run the risk of devaluing the assets," Johnston said.

"We just disagree with their strategy. So we intend on voicing our opinions on this because they don't have any experience in dealing with hedge funds at all.

These are very peculiar assets.  They can be liquidated in response to a market turn – but they can’t safely be liquidated in response to a court order.

Enough said.

Friday, February 19, 2010

Surprise: Peter Johnston still has not taken my bet…

Nobody has taken my bet.

But another fund manager across town is offering a derivative bet (in smaller denomination) that nobody will.  And nobody has taken that either. 

Thursday, February 18, 2010

My proposed bet with Peter Johnston from the Association of Independently Owned Financial Planners: an Astarra follow up

The Association of Independently Owned Financial Planners is a rival to Financial Planning Australia as an umbrella group for financial planners in Australia.  Financial planning in Australia is a big business because Australia – unlike America – has a privatized social security system called “superannuation” and financial planners are the front-end for the sale of many superannuation products.

The industry has had its share of scandals (see Storm Financial and Westpoint) but there are many fine operators in the industry and I am unashamedly admit that some of my best friends are financial planners.

That said – the AIOFP was closely associated with Astarra – a fund of funds and distributor of funds which was closed recently by the Australian securities regulator after a whistle-blowing letter from your blogger.  [I wrote about Astarra and my role in precipitating the investigation here though I can’t claim too much credit – a reader of my blog suggested that I look at it.]

Anyway – back to the AIOFP.  According to this article four financial planning groups – all members of the AIOFP – represent about 90 percent of the funds in the “Astarra Strategic Fund” (now known just as the ASF).  The strategic fund is the main black hole in Astarra – and the administrator has said that they cannot prove the existence or value of the foreign assets of the ASF.  They said this possibly to quiet media claims by the AIOFP that the assets have been found.  The AIOFP just wants the strategic fund taken out of liquidation – and presumably valued on the the basis of assets that they claim they can find. 

Now my guess is the administrator – who intends to liquidate the ASF – is accurate.  The assets of the ASF are pieces of paper which state that there are assets there but real proof of the existence of the assets cannot be found and liquidation is the only way to determine what is recoverable.  But as said – the AIOFP has a different opinion and wants to sack the administrator.

Peter Johnston of the AIOFP suggested that I wrote my letter to regulators motivated by “professional jealousy”. 

This is of course defamatory. 

I am a hedge fund manager: I am motivated by money. 

Professional jealousy is a counter-productive (and defamatory) motive because – frankly – it just stands in the way of what I should be doing.

And so – being motivated by money - when Peter Johnston offered me a bet on whether the money would turn up I leapt on the chance.  I offered $100 thousand to be escrowed either by Morningstar or the Sydney Morning Herald.  [I have since offered Peter three for two odds.]  And he backed out.  (The Sydney Morning Herald CBD gossip column reported the story this morning.)

Peter is of course a coward – he backed out of the bet – but that has not stopped him from boasting to the press about how his organization has found the ASF money and that all is well.  Worse – his members have been telling their clients that their money will turn up and their superannuation (meaning their entire retirement savings) will be unimpaired. 

Now this article names the financial planning companies that have – as Peter Johnston notes – about ninety percent of the claims against the ASF.  I know many victims do not know they are victims because their financial planners say that they are going to be alright.  And maybe they will.  Maybe the money will turn up as Peter Johnston says it will.

But Peter Johnston is a coward and will not carry through with his bet.  That however does not stop at least one financial planning group (or at least some financial planners) telling their clients that their money is safe.  If they believe that maybe they could take the bet Peter Johnston backed out of.  If they are certain enough to tell their clients that their money is safe then they should be certain enough to take that bet.

The Sydney Morning Herald has said they are willing to be the escrow service. 

And I look forward to spending the winnings.

Wednesday, February 10, 2010

The final failure of the Meiji right-wing ideology … Japan fades into the future with a walking stick…

This blog does not usually play war with other bloggers – but something in Ampontan’s criticism of me has got my goat.  So if you do not want to indulge me a little flame-throwing just skip this post. 

Ampontan (AKA Bill Sakovich) writes a wryly amusing but deeply nationalistic Japanese blog.  He is – as far as I know – the only English language exponent of the virulent Japanese nationalism that initially gained power with the Meiji Restoration, waged and lost the second world war and – unlike the German equivalent – respectably survives to this day.  My favorite comment on his blog – and one I do not think he resiles from is that he has “Hirohito’s nutsack lodged so far down his throat its amazing he hasn’t asphyxiated himself long since.”

Ampontan is surely the only native English speaker who simply denies the Japanese (war crime) of mass forced prostitution as “comfort women” happened (more precisely he endorses deniers).  He regularly defends the Yakasuni Shrine (and by extension the visits to the shrine by any serving Japanese Prime Minister). 

Not that I can complain about that.  The Shrine was on my must-visit places list when I went to Japan.  It is a dull Shinto shrine with a bizarre attached museum which with thoroughly revisionist history absolves Japan from all and Nazi Germany from much responsibility for any atrocities committed in the Second World War.  I paid my admission fee – and by extension I supported that nonsense.  The Shrine also memorializes war dead including those who died at the gallows after being convicted of war crimes. 

It is not that Meiji era Japanese nationalism has nothing to recommend it.  That view of Japan, how it should be administered and Japan’s place in Asia and the world is one of the most successful industrial-development ideologies ever invented.  Not only did Japan grow into an industrial superpower twice (once before and once after the war) but the system was copied by Korea and it worked there too.   Nazism too was a successful economic system in that it allowed Germany to build an industrial base large enough to wage total war from a relatively small country.  Germany and Japan (and Italy) took on the UK (then the largest empire the world had ever seen), the US, Russia and China, and a host of other countries and had a military-industrial establishment that made more than a show of it.  These ideologies worked at producing industrial goods (and a military-industrial complex). 

They were also of course deeply nationalistic and racist ideologies.  Colonialism always had an undertone of racism (as any modern reader of Rudyard Kipling should not fail to notice) but these ideologies were far more murderous than anything imposed by the Brits or French (even though the Brits occasionally and the French more often were murderous).  The scale of the atrocities committed by the Japanese in China were only exceeded by Hitler at his worst (though they have also been exceeded by some murderous Post War regimes).

I said I find Sakovich’s blog wryly amusing.  I would not find a German equivalent amusing but that was because I was raised to vicariously remember the holocaust.  My grandmother ran a safe house in Warsaw and a man who was by repute her husband and my grandfather was murdered at Auschwitz.  I was not raised to remember Japanese slave drivers on the Burma Railway, comfort women or Nanking – and so an unapologetic Japanese blog is amusing whereas an unapologetic Nazi one would be offensive.  Propaganda about Asian co-prosperity zones was pure propaganda.  The truth was that much of occupied Asia was a Japanese rape-and-plunder zone.   

I can’t envisage a German leader visiting a memorial to Nazis hung after Nuremburg whereas Japanese Prime Ministers make a show of going to Yakasuni.  But then that particularly rabid Japanese nationalism survives whereas the German equivalent is dead.  Denazification is a word that appears in many modern history books (see for example Tony Judt’s excellent history of Post War Europe).  I do not know the equivalent Japanese word…

That said – this is an economic/finance blog and not one to inclined to debate with a heartless denier of Japan’s less-than-glorious Imperial history.  And I should outline the good-bit of the Meiji industrial system.  I have done it before in a stylistic history of industrial Japan (one that a few Japanese economic professors endorsed as simplistic but essentially accurate).  I will just repeat the key bits modified to fit the narrative (but you can find the original here):

First however I need a stylised history of Japan starting with the arrival of Commodore Perry’s black ships in 1853.

Before Perry Japan was almost autarkic. There was a relatively weak central government and about 300 “han” – being relatively strong feudally controlled districts. The Emperor did not effectively speak for Japan when Perry came in, guns blazing.

The Meiji Restoration changed this. Japan was reformed as a centrally controlled empire – with a ruling oligarchy ruling through the Emperor who claimed dominion over all of Japan. The “han” were combined to form (75?) prefectures with a governor appointed centrally.

The view of the new oligarchs was that Japan would get rich through (a) industrialization and (b) unequal trade treaties to match the unequal treaties imposed on Japan by Perry et al. To this end they invaded Korea and started the military industrialization that ended eventually with World War 2. There were major wars in Korea and against an expansionist Tsarist Russia (especially 1904-1905).

Ok – that is your 143 word history of Japan from Perry to World War 2. Like any 143 word history it will leave out important stuff. I just want to focus on how this foreign policy adventurism was financed.

Financing Japanese expansionism - and that financial system until today

Firstly it is simply not possible to expand heavy industrialization of the type required by an early 20th Century military-industrial state without massive internal savings. Those steel mills had to be funded. And so they set up the infrastructure to do it.

Central to this was a pattern of “educating” (the cynical might say brainwashing) young girls into believing that their life would be happy if they had considerable savings in the form of cash balances at the bank (or post office) or life insurance. Japanese wives often save very hard – and are often insistent on it. The people I know who have married Japanese women confirm this expectation survives to this day.

Having saved at a bank (and for that matter also purchased life insurance from an insurance company loosely associated with the bank) the financial institutions had plenty of lendable funds. 

The financial institutions by-and-large did not lend these funds to the household sector. Indeed lending to the household sector was mostly discouraged and was the business of very seedy loan sharks. To this day Japan has a relatively undeveloped credit card infrastructure with very high fees. These high fees are a throwback to the unwillingness of the institutions to lend to households. [The Japanese establishment are willingly forcing these consumer lenders to bankruptcy as any Takefuji shareholder will tell you…]

Japanese banks instead lent to tied industry – particularly heavy industry. It was steel mills, the companies that built power plants, the big machine tool makers. Many of the companies exist today and include Fuji Heavy Industries, Kawasaki Heavy Industries and other giants such as Toshiba. Most of these super-heavy industrials were tied to the banks (and vertically integrated) called Zaibatsu.

Now steel is a commodity which has wild swings in its price. Maybe not as ordinarily wild as the last five years – but still very large swings. And these steel mills were highly indebted to their tied banks. Which meant that they could go bust.

And as expected the Japanese authorities had a solution – which is they deliberately cartelized the steel industry and used the cartel (and import restrictions) to raise prices to a level sufficient to ensure the heavy industry in question could service its debt.

The formula was thus (a) encourage huge levels of saving hence (b) allow for large debt funded heavy industrial growth. To ensure it works financially (c) allow enough government intervention to ensure everyone’s solvency.

When the Americans occupied Japan their first agenda was to dismantle the Zaibatsu. They were (in the words of Douglas McArthur) “the moneybags of militarism”.

Like many post WW2 agendas that agenda was dumped in the Cold War. The owners of the Zaibatsu were separated from their assets and some cross shareholdings were unwound – but the institution survived – and the Zaibatsu (now renamed Keiretsu) remained the central organizing structure of Japan. Dismantling Japan’s industrial structure did not make sense in the face of the Korean War.  The pre-war Zaibatsu had more concentrated ownership than post-war Keiretsu. 

Unlike in Germany there was no real attempt to dismantle the establishment ideology.  Douglas McArthur may have appeared to tower over the Emperor in the famous photo – but Hirohito was not tried as a war criminal – even though he would certainly have been hung if put to a fair trial. 

The point is that it was the similar structure before and after the war – and it allowed massive industrialization twice – admittedly the second time for peaceful purposes.

Now the system began to break down. Firstly by 1985 steel was not the important industry that it had been in 1950 or 1920. Indeed almost everywhere you looked heavy industry became less important relative to other industrialization. By the 1980s pretty well everywhere in the world tended to look on such heavy industries as “dinosaurs”. This was a problem for Japanese banks because they had lent huge sums to these industries guaranteed by the willingness of the State to allow cartelization. You can’t successfully cartelize a collapsed industry.

Still the state was resourceful. Originally (believe it or not) they opposed the formation of Sony – because they did not know how to cartelize a transistor industry. Fifteen years later the French Prime President would refer to his Japanese counterpart as “that transistor salesman” and he was not using hyperbole. Still the companies coming out of new Japan – technology driven mostly – did not require the capital that Japan had in plentiful supply. If you look at the companies coming out of Kyoto (Japan’s Silicon Valley) they include such wonders as Nintendo – companies which supply huge deposits to banks – not demand huge funds from them. [Incidentally in typical Japanese fashion the biggest shareholder in Nintendo is Bank of Kyoto. Old habits re-cross shareholdings die hard.]

The banks however still had plenty of Yen, and they lent it where they were next most willing – to landholders. The lending was legion and legendary – with golf clubs being the most famous example of excess. [At one stage the listed exchange for golf club memberships had twice the market capitalization of the entire Australian stock exchange.]

Another place of excessive lending was to people consolidating (or leveraging up) the property portfolios of department stores. Think what Bill Ackman plans to do to Target being done to the entire country – and at very high starting valuations.

Meanwhile the industrial companies became zombies. I have attached 20 year balance sheets for a few of them here and here. These companies had huge debts backed by dinosaur industry structures. They looked like they would never repay their debts – but because they were so intertwined with the banks the banks never shut them down. As long as interest rates stayed near zero the banks did not need to collect their money back from them. As long as they made token payments they could be deemed to be current. There was not even a cash drain at the banks at low rates. The rapid improvement in the zombie-industrial balance sheets in the past five years was the massive boom in heavy industrial commodities (eg steel, parts for power stations etc). Even the zombies could come alive again…  only to return to living dead status again quite rapidly with this recession.

Anyway – an aside here. Real Japan watchers don’t refer to the banks as zombies. They refer to the industrial companies as zombies.  (Although most of the Western blogosphere does.) 

Most of the banks had plenty of lendable funds and a willingness to lend them. They did not have the customers – and the biggest, oldest and most venerable of Japanese companies were zombies. So were the golf courses, department stores and other levered land holders. I get really rather annoyed when people talk of zombie banks in Japan – it shows a lack of basic background in Japan.

Note how this crisis ended.

1). The bank made lots of bad loans – firstly to heavy industrial companies and secondly to real estate related companies (golf courses, department stores etc).

2). The loans could not be repaid.

3). The system was never short of funding because the Japanese housewives (the legendary Mrs Watanabe) saved and saved and saved – and the banks were thus awash with deposit funding.

4). The savings of Mrs Watanabe went on – indeed continued to grow – with zero rates.

5). Zero rates and vast excess funding at the banks made it unnecessary for the banks to call the property holders and (especially) the industrial giants to account for their borrowings. Everything was just rolled.

6). Employment in the industrial giants of Japan thus never shrank (Toshiba alone employs a quarter of a million people). The economy continued to sink its productive labour force into dinosaur industries and dinosaur department store chains.

7). The economy stagnated – but without collapse of any of the major banks and without huge subsidies to the banking system. [The number of banks – mostly regional banks – that failed during the crisis was not large given the depth of the crisis.]

They system is very good at funding heavy industry – but it is less entrepreneurial than you would want in a modern economy.  The best Japanese tech companies tend to come from Kyoto (which is outside the Tokyo establishment).  Toyota – what I think is Japan’s finest company – is in Aichi prefecture – well away from Tokyo.

Anyway – this industrialization structure worked brilliantly and the Koreans copied it (with radically different banking outcomes).  It however is less good at low-capital but high-innovation industries.  The tech-boom was an American phenomenon – encouraged and nurtured (for better and for worse) by the American system.  It was not nurtured by the Japanese establishment though Sony and Toyota most certainly are by now…  Many of the most innovative Japanese companies started away from the bosom of the establishment – though the establishment later embraced them.

The Japanese industrial structure and the ideology that drove it produced industrial goods really well – and innovation based goods less well.  But – the system works. 

Economic stagnation is not the greatest of Japan’s problems.  Many a UK visitor has gone to Japan and observed that if that level of economic activity (and living standards) represents stagnation they they wanted some of it. 

The real threat to Japan is demographics.  Mrs Watanabe saved and saved and had fewer than two children.  (Children are expensive – especially housing them in a place with land values where they were in the 70-90s).  So an aging population became a dramatically aging population.  Here is a projection of the median age of population in three OECD countries.  Australia is an aging population offset by immigration, Italy an aging population exacerbated by emigration and Japan is a result of Japan’s military industrial policy and the booms and busts it has caused.  The chart is from the Australian Treasury intergenerational report – but the numbers are broadly accepted:

image

 

Japan will have a median age of about 55.  This means that the vast bulk of the Japanese population (or more precisely Japanese women) will be well beyond child-bearing age and given low fertility rates anyway (below 2.0 per woman) the population will crash.  That is more-or-less baked in.  Simple equation – most the women past child-bearing age and very low fertility amongst those who bear children anyway.

There is a solution – immigration.  There are an endless supply of well educated and skilled young people (mostly) from the subcontinent who would happily move to a developed country.  There are more than a few from China too.  Australia will import them.  Ampontan rhetorically asked where I expected them all to fit into Japan?  Well that is easy – with a demographic like that I expect them to fit into the slots left by the dying warriors of Japanese industrialization.

If Japan does not do it then aging and death is inevitable.  The working population will be stuck looking after and funding the huge numbers of retired.  Japan’s industrial growth – now anemic – will collapse entirely with its population.  The great Japanese industrialization experiment will walk slowly into the setting sun aided by a walking stick.

There is of course an alternative which is modest levels of immigration.  New immigrants will – like it or not – be Asian – mostly from the subcontinent.  Over time they will also include many Muslims.  The Japanese will have to accept – as Australians have accepted – that their children will breed with these people.  As a white Australian I have fully accepted that it is likely as not that my grandchildren will arrive as little brown babies.  I do not have a problem with that. 

But Japan is a country where they won’t let their hookers sleep with foreigners because – well they are foreigners.  (It was that story in this post that got Ampontan all upset with me.)  But it does not have to be that way.  There can eventually be an Asian co-prosperity zone in Japan – it will be with Japanese children and other Asian children and eventually their joint grandchildren.  The Meiji racist ideology does not have to end with a walking stick – it can end in a truly multicultural society that will lead Japan onto greater things than the original modern revolutionaries of the Meiji era could ever have imagined.

 

 

 

John

Tuesday, February 9, 2010

A Morphology of the Sin of Bad Lending

Grace – it is said – refers to a Single State only – whereas Sin refers to a multitude.  Good Lending – like a State of Grace – is hard to maintain – but easy (and dull) to analyze if maintained.  But – at the moment – I am studying US regional banks who are – to extend the analogy – no longer in a State of Grace.

Bad Lending however – like Sin – comes in many forms.  There were bad mortgage loans with nothing down, no proof of income, no proof of assets and brokers incented to fraud.  And there were milder Sins (with much lower loss rates).  With commercial lending there were also a multitude of Sins – from lending to real-estate subdivisions in the desert (in towns with no market for the end product) to a commercial loan to a auto-mechanic to own their property.  The desert housing development loans will probably default and average severity on such loans is above sixty percent.  The auto-mechanic is probably underwater on the loan – but may have a personal guarantee and will not default even if they went delinquent as the economy soured. 

Most bloggers are righteous people – and they bang-on about the fall from Grace.  Get over it – we are not Virgins any more.  What I am trying to compile – and I want my readers to help – is a Morphology of the Sin of bad commercial real estate lending.  So I am begging for comment: I would like feedback on the state of debauchery in various markets.  Some things I am observing are surprising me.  Desert state vacant housing lot loans are – unsurprisingly – still a bust.  But much to my surprise some Midwest banks have reported that they can now sell (for non-trivial money) vacant housing land from their real-estate-owned inventory.  In that lies some redemption.

So consider this a request for recent anecdotes – by region and by commercial real estate class.  Like some good Minister I want to understand your Sin...

Saturday, February 6, 2010

Globalizing the Australian Intergenerational Report – thinking about long term sovereign solvency in Australia, the US, New Zealand, Japan and China

In the financial crisis governments seemingly regularly guaranteed their banks to stop their banks from collapse. This worked in preventing mass bank collapse and a consequent Great-Depression-Event. But it transferred the risks to government. Since then yield on bank debt has tended to converge with yield on the domestic sovereign. And the financial crisis has morphed into a sovereign debt crisis.

The crisis-of-the-moment is Greece. Greece runs a fiscal deficit which is a low teens percentage of GDP (a couple of points worse than America) but unlike America it does not control its printing press* (Greece uses the Euro) and (believe it or not) its political system looks more dysfunctional than the US.

I do not want to blog about Greece. I blogged about the issues with Spain and the issues are the similar. It is just that Greece was first to the breaking point.

This post is not about short term sovereign solvency. Short term a sovereign is insolvent when it can't find anyone to lend to it and it is seemingly impossible to pick the moment of panic. People have talked about Portugal, Italy, Greece and Spain (the so-called PIGS) being insolvent for many years. It is not as if the collapse of one was unlikely. [I thought it would be Spain first – but hey – I was wrong...] Today people add Ireland to the list (since it guaranteed huge banks) and talk about the PiiGS. If you picked that it would be Greece first and that it would be 2010 that the crisis happened then you are better a the short term stuff than me. (Italy always struck me as a marginal member of the PIGS but I could be wrong about that too.)

This is a post about long term solvency – the things that we do now that determine whether we have an economic crisis in twenty or thirty years. In that sense this is a post about Australia, the US, New Zealand, Canada and Japan and possibly even China. The PIGS have rolled their dice. Most the rest of us are still shaking the dice in the tumbler.

I will start with the Australian Treasury Intergenerational Report – a report required of the Australian Treasury every five years. Whilst the projections (including economic growth projections for forty years) are to be taken with a grain of salt the basic tradeoffs are the ones detailed in the report. Let me summarize quickly:

Australia – like much of the developed world – has a demographic problem from aging baby boomers. Our dependency ration (the ratio of people of non-working age to working age) is increasing and likely to increase dramatically. Moreover the dependent group will shift from young people (who impose schooling expense) to old people who impose nursing home and medical expense. Old people generally cost more than young people and as we live in a country with (semi) socialised medicine that expense is likely to fall (heavily) on the Federal Budget.

Australia's national budget will thus become a little tighter each year. [This is in contrast to the glory days of the 70s and 80s where economic growth and baby boomers going through their years of peak productivity made the budget just a little easier to balance every year.]

The net effect is that something has to give. Either

(a) Australia cuts benefits to old people (and with socialized medicine that means deciding when you turn the respirator off) or

(b) Australia sharply increases taxes or

(c) Australia sharply change the mix of our population by having more babies or importing more people through immigration.

Some smaller things can work at the margin. For instance Australia can change ages at which people qualify for various pensions. This should keep old people in the workforce longer and hence reduce the dependency ratio. Also – as the working age population become the scarce factor wage levels for those still working should rise. The higher wages will attract some older people back into or into staying in the workforce. However these are effects are likely to be too small to overwhelm the main thesis.

With a good size baby boom and old people driving government expenditure (something that is certainly the case in the US) the problem is real and will remain intense.

The problem could be solved with very rapid economic growth – but the Australian Treasury models a quite high real rate of growth and Australia still has a problem. If economic growth were to decline to Japanese levels the fiscal imbalance by (say) 2030 would become very intense. [Australia could get very lucky with sharp increases in commodity prices. That sort of luck is possible because Australia is small – however that sort of luck will not bail out the US.]

By far the easiest solution is (c) - changing the mix of the population. Societies are not good at rationing health care expenditure for the elderly and there are limits to the ability of smaller open economies (such as Australia) to keep increasing taxes. [Though in my view a little of both these things will happen.]

Everyone that matters in Australia knows that the easiest solution is (c). Peter Costello – Australia's last Treasury (in the US context read Secretary of the Treasury) knew this and advocated women having three children – one for mum, one for dad and one for the country. **

Costello had his eye on the future fiscal balance (as he should) but there is an undertone of racism in his pronouncement. Australia's population is a matter of choice because there is an endless supply of skilled and/or needy immigrants who want to live in Australia and the main case for having babies over importing people is that the babies are probably white.

Anyway the core way that Australia is balancing the long term budget is through immigration. If you want to solve the problem that way you need very large immigration now so that in 30 years the you get the right dependency ratio. That – for better or for worse – is what the government is currently doing. Australia's immigration rate is massive – roughly 1 percent of the population per year. That level of immigration will have Australia on the path to a 50 million population (currently 21 million) by the year 2050. Australia will – in resource use and population over fertile areas – look about as crowded as the US.

Obviously if Australia chooses to go the high population path (and there seems little doubt that Government is adopting that path) then environmental pressures (of almost all kinds) will increase sharply. The Report focuses on greenhouse gas pressures (population growth will make it harder for Australia to meet any given emissions target) however it could focus on almost any environmental amenity. Dr Henry (the Secretary of the Treasury) is known to be personally in favor of rationing Australia's limited water with pricing – but also said to be in favor of replacing petrol taxes with congestion taxes on Australia's (and particularly Sydney's) overcrowded roads. Whatever – the high population path will increase pressure on Sydney – a city that is becoming famously dysfunctional with poor public transport and congested road systems.

By going the high-population route Australia replaces intergenerational financial pressure with a litany of environmental and resource use problems.

But by going the high population route the government can remain solvent even with the baby boom. The government is currently running too high a deficit – but most of that is temporary. And the longer run seems to work (albeit with environmental costs described).

The same position sort of applies to the US. Medicare (the US version of single-payer socialized medicine) ensures that an aging population will put enormous stress on government finances. (Whereas US Social Security funds are nearly solvent the Medicare equivalent is unambiguously bankrupt.) However with enough economic growth and some population growth the US will get through. The starting budget position in the US is considerably worse than (say) Australia – but it is only really worse by the cost of the Bush tax cuts, the excess Bush-and-terrorism induced military expenditure and maybe one smaller tax hike. None of those would be hard to achieve with a functional political system (though it is becoming increasingly hard to argue that the US has a functional political system)...***

On the plus side, the US – more than almost any other country – has the sort of economic system that might produce the innovation-led economic growth that would help solve the problem. Australia could luck into a solution (through commodity prices). But the US has – I think – a higher background level of innovation. Not enough to solve the problem entirely – but probably enough that the current level of immigration is almost enough. Things have to give – but with functional politics solutions could be found.

On the minus side – the US with a much larger population than Australia – would require many more immigrants to adopt the population growth solution. Also the US seems very poor at pricing and protecting environmental amenity – and that is in my view a key part of the population growth solution.

New Zealand – a country where I used to be a senior Treasury official – is alas long run insolvent by any count. Its population doesn't grow much even with immigration – and net migration has resulted in sharp negative productivity per head of population as skilled workers tend to move (to Australia) and unskilled workers are imported. The tax and welfare system also does not add up. [New Zealanders are paranoid about Australia as the response to this joke showed. However in truth New Zealand will one day beg to be the seventh Australian state and we will refuse. Also the Treaty of Waitangi is deeply inconsistent with the Australian sensibilities and (I think) law– but that is the subject of another post...]

Far more serious than New Zealand is Japan. They too have a baby boom – but unlike the either Australia or the US they have very limited immigration. The underlying reason is racism. Japan is a deeply racist country.

I know I am going to get into trouble for saying that – so I will defend it. I was walking through downtown Fukuoka. The area my hotel was in looked like a red-light district. I peered into a brothel (which the Japanese call “soaplands” and which was illustrated with the pictures of a Turkish bathhouse). The doorman rushed out – and almost violently – and in broken English – said “ no foreigners”. Brothels that will not take your money because you are the wrong race set a new standard for racism. A country that does that is hardly likely to solve it's demographic problem with high immigration.

Now in all of this I did not mention the country with the largest forthcoming shift in dependency ratio. That country is China – and the explosive ratio change (which will occur later than the US) was self-induced – a product of the one-child policy. China is – of course – not going to solve that problem by massive immigration. China is too big – and even with a population crash will remain too crowded. The forthcoming population crash in China is one reason why Chinese elderly can never get the sort of Western socialized medical care or old age social security that people in Australia just expect. But there is something to make the Chinese budget balance in their forthcoming population crash. And that is that the Chinese – more than all other people – have accumulated vast piles of claim-checks from rest of the world in form of Treasuries and direct ownership of equities and other property. One day they will need to cash them to produce what their aging population with its high dependency ratio cannot.

The economic problem of our time is – as much as anything – excess Chinese savings and how the world deals with them. I blogged about that – when – to slightly exaggerate the point - I blamed the financial crisis on the Chinese one-child policy. The economic problem of a future time will be huge Chinese dis-saving as they deal with a massive increase in the dependency ratio. Unlike Japan however the sovereign will not go insolvent because unlike a Western country the Chinese will never get committed to state support of the elderly.

John

Post notes:

*One of my German friends – a well-to-do guy worried about the future of Europe – notes with alarm that one of the printing presses for the Euro is physically located in Greece. He seriously believes that Greece –through control of the press – could blow apart the whole of the European economy. I have no opinion on this – other than to note my friend is nervous about European monetary zone expansion.

**Just so people get the titles right – the Treasurer in Australia is the senior political appointment in economic policy – the equivalent of the Secretary of the Treasury in the US or the Chancellor of the Exchequer in the UK. The Secretary of the Treasury in Australia (Dr Ken Henry) is the senior public servant in the area of economic policy. There is no obvious equivalent in the US but the Permanent Head is the equivalent in the UK.

***I note that almost everything I suggested to balance the budget is a tax hike. Get used to it. True deficit hawks know that you can’t fix a US budget without either large tax hikes and/or large cuts to defense and benefits to old people. There is not enough “waste” or “discretionary expenditure” to solve the problem any other way. If you are prepared to cut defense and turn the respirator off on medicare expenses then you can do with lesser tax hikes. But unless you are prepared to deal with such things you are not really a deficit hawk – more a deficit peacock.

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Finally a little post-script is required. The PIGS (or is it PIIGS) are bundled together but they look different. Greece is a fiscal disaster area. Spain looks like one now (running a large government deficit) but it has not always been one. Spain looks more like Latvia - a fixed exchange rate and a profligate private sector. Bundling them together oversimplifies the problem.

The one thing they all have in common is a fixed (Euro) exchange rate and large current account deficits.


A second postscript: Ampontan (Bill Sakovich) writes a blog about Japan which I have been (irregularly) reading for some time. He obviously has not been reading me as he refers to me as "some Australian blogger". He suggests I should observe Australian racism (something incidentally I have commented on several times on this blog). He uses the usual glass houses line.

The question in this post was whether Japan would be willing to import anything like enough people to offset its demographic crash. That looks unlikely to me. Japan is famously xenophobic (a word with lesser connotations than racist) and that xenophobia has manifested itself over very long periods of Japanese history. That said the BBC has suggested that attitudes to immigration are beginning to change for reasons outlined in this post - and if Bill Sakovich wants to take up attitudes to immigration I am very willing to listen as he knows far more about Japan than me. (He is an immigrant in Japan so his knowledge would be detailed and specific.)

Finally if you read Ampontan he lets you know his viewpoint - check out his "what readers say" section...

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.