The Devil Usually Wins

“If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money and the other is to miss opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive. I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: «No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble». On the other shoulder is the devil in a red robe with his pitchfork. He whispers: «Do it, you’ll get rich». In the end, the devil usually wins. Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.”

- Howard Marks

japan economy

Abenomics Could Help Recover Japan’s Economy

Shinzo Abe’s Economic Reforms Could Lead To Japan’s Recovery

Abenomics is uplifting domestic confidence in the economy, and combined with right policies, it could lead Japan to its long-lost road to recovery.

However, this doesn’t imply that Japan has exactly been in the dumps for the past decade; the country has performed quite well in terms of growth of output per employed worker since 2000. Even though the labour force has been shrinking, Japan’s output per employed worker was growing by 3.08% per year before Shinzo Abe’s programme commenced. To put things in perspective, the United States output per worker grew by 0.37% in 2012 while Germany experienced a contraction of 0.25%.

Three arrows approach

Taking the situation from here, Shinzo Abe’s policies are likely to help Japan’s country, as long as the famed monetary policy is backed up by strong fiscal and structural policies. This is exactly what many economists are now wanting – including the Nobel laureate Joseph Stiglitz –  for the country as well as Europe and the US, and Abe realises this; he considers the policies as holding three arrows – if taken alone, each can be bent, but together they remain rigid.

I. Monetary policy

Haruhiko Kuroda holds the first arrow as he recently became the governor of the Bank of Japan. Investors should be confident here as he is an experienced veteran when it comes to finance; he previously served as President of the Asian Development Bank where he first witnessed the Asian Crisis of the late 90’s, and with it the failure of IMF and conventional approaches. Indeed, Haruhiko does not subscribe to the old central banking doctrines, and has committed to an inflation target of 2%, ending Japan’s history of chronic deflation.

This is important if Japan wants to recover. Deflation increases the real interest rate and the real debt burden, and even a low level of deflation can lead to significant results over a few years.

Kuroda’s announcements have already done much to weaken the Yen (JPY), allowing Japanese goods to become more competitive and boosting exports. As long as other countries do not engage in a currency war, the weakness should be remain. Maybe in the future countries will come together and and coordinate in creating a global monetary policy, but for now Japan is on the right track by devaluing its currency in the face of other devaluations.

Japan’s new monetary policy could be more effective if credit blockages are addressed. The United States did not address this issue and faced critical problems, such as lack of access to financing for small and medium-size businesses and refinancing issues for homeowners.

But Abe has another trick up his sleeve; actually, two tricks:

haruhiko kuroda

II. Fiscal policy

It is generally argued that fiscal stimulus in the past failed for Japan. However, critics fail to consider a key point; Japan faced a financial tsunami in the late 90’s as credit supply contracted following the Asian crisis in the late 90s, so they need to consider what would have happened had there been no stimulus. The answer, as it turns out, is that Japan would have been in a much worse condition. During such perilous times Japan never experienced an unemployment rate above 5.8%, and during the crisis of 2008 it’s unemployment rate reached a level of 5.5%.

This time around Abe has allocated about $100 billion to infrastructure investments as part of his stimulus. Here I do sympathise with critics, and myself argue that such money gone into infrastructure could only provide marginal benefits . After all, $100 billion represents 25% of yearly worldwide infrastructure investment needs – and Japan already has one the world’s best road and railway networks – so it could only result in the development of redundant roads and airports. On the other hand, if Japan allocates some of this capital to other industries, it could be beneficial to companies, and create jobs in the process. Abe would have to use this arrow quite wisely, or experience a few arrows in the back while launching this one forward.

III. Structural/growth policy

This arrow is the last piece of the Shinzo puzzle, which is referred to as “growth” by Abe. Policies included in this arrow aim at improving productivity, restructuring the economy, and increasing labour-force participation.

Some even call for deregulation, but this is not what Japan needs in the long term. Environmental, health, and safety regulations are needed in the future, rolling them back for short term benefits would be a huge mistake.

Abe, therefore, needs to introduce regulations that are beneficial. The government may even need to be more involved in some aspects to promote competition in the industry. In other aspects, Abe can only ask businesses to go along a certain path, rather than making them to do it. This was recently seen when he asked the private sector to increase wages, which has made many firms to increase their employees’ bonuses for the end of this fiscal year.

Japan’s productivity has already been increasing steadily, but efforts to further encourage it could make the growth arrow truly successful. The service sector could surely use a push here, while various synergies could be explored between industries. Investment into research could also boost the rate.

Labour-force participation remains the only issue here. This is highly needed as Japan labour force continues to decline, and could be addressed if the government introduces policies to change the private sector’s hiring practices and improve women’s labour force participation. A drive to encourage people to learn English could also be beneficial, as the language acts as the lingua franca of global commerce.

Shooting like robin hood

One could be optimistic about Japan’s strategy to get back on the road to recovery, especially since the country has strong institutions, a highly literate labour force, advanced technical skills, and a location near emerging markets. Furthermore, its inequality is lower than many developed nations.

All Abe needs to do now is shoot like robin hood, but that’s much harder than it looks on paper. The weakest link of the Three Arrow Approach lies in its fiscal policy – specifically, its overcommitment to infrastructure spending – which could be partially diverted into other areas. Nevertheless, confidence is high and Abe’s aims even higher – there is every reason to believe that this can be achieved.

Technology has a tendency to create inequality

Technology and Income Inequality

Is Technology Creating Inequality?

The pursuit of technology and globalisation has been favourable to highly skilled labour, generating record levels of income and inequality in the world. Contrary to popular opinion, this is not likely to continue in the long run, and will not require state intervention to redistribute income.

Income inequality is widely considered the greatest threat to social stability in the modern world, whether it’s in Ireland or Iran. What’s usually left out of the debate is that market forces, when left to their own device, create an equilibrium which promotes equality. In short, if the premium for high skilled labour rises, there is a higher incentive to find methods to economise their talents.

Post-modern serfdom

Could it be that technology could actually lead us to a social system similar to that of the middle ages? One could image a perfect sci-fi scenario: a post-modern world where we could produce intelligible robots to do all of our work, so that one class would entirely own this technology (instead of land), creating a high GDP per capita (within the class). This class would rule over the post-modern serfs who would not have access to modern technology, thus creating the highest levels of inequality.

star wars stormtrooper cartoon

Let’s come back to a realistic scenario. We can substitute robots with any current technology that increases our productivity which increases our GDP per capita (within the group). On the other hand, we have people who do not have access to such technology, and have to resort to menial labour to earn their bread. While the former class increases its productivity exponentially over time, the other remains stagnant. That’s how technology is increasing inequality, or so the argument goes.

Populist market forces

If innovation has led us to this situation through the past three decades, it may well lead us out of it. The answer lies in chess.

Around the turn of the eighteenth century, The Turk, a chess-playing “automaton” toured Europe and beat renowned chess masters. While no one could figure out its mechanism at the time, it was later found that the chess machine actually consisted of a human player inside a shifting compartment, hidden by impressive-looking gadgetry.

Today, computers pretend to be us in the world of chess. PC chess programs outsmart the best of players, and have even caused people to cheat when they play – only this time cheating is done by using the assistance of computers. The French chess federation recently suspended three renowned players for using computers, and the more interesting part is that a computer program detected that the players’ moves resembled those of top computer chess programs.

Chess was once thought of as an activity best left to humans, but we have found out that computers do it better. Other highly skilled and highly intellectual tasks are also increasingly being done by computer programs; teachers now use computer software to check for plagiarism, for example. Computer grading is being taken further, and recent tests have found out that they evaluate more consistently, fairly, and use more information than an average teacher would.

Computer systems are also taking over the domain of finance, law and medicine, among others. Those three professions are considered to be highly skilled and qualified professionals often demand high wages, but technology is on the path to commoditise even them.

Return to normalcy

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, and his colleague Kenneth Froot once studied the relative price movements of a number of goods over a period of 700 years. This is what they had to say about it:

To our surprise, we found that the relative prices of grains, metals, and many other basic goods tended to revert to a central mean tendency over sufficiently long periods. We conjectured that even though random discoveries, weather events, and technologies might dramatically shift relative values for certain periods, the resulting price differentials would create incentives for innovators to concentrate more attention on goods whose prices had risen dramatically.

While people cannot be considered as goods, the dynamics of market forces remain the same. As skilled labour becomes prohibitively expensive relative to unskilled labour, firms have a high incentive to substitute high-priced labour with other alternatives. Technology may provide us with these alternatives in the coming decades, or perhaps even sooner.

The free market could be distorted by unionisation of skilled labour or an attempt to persuade governments to promote protectionism. But if the global trading system remains competitive, we can expect skilled workers’ efforts to delay disruptive technologies indefinitely be as unsuccessful as similar attempts made by unskilled workers in the past.

Technology may also create a level playing field in education. Currently, the quality and quantity of education – particularly tertiary – is largely concentrated in the West and to those who have the means to pay for expensive tuitions fees. This has largely excluded those in poor countries to benefit from the resources, and the internet and computers have further added fuel to the fire.

This, too, shall pass. A new wave of technology would hit education as it hit the computer and automotive industries, among others. Commotidisation of education could hit lower-level colleges around the world and have an enormous impact on incomes.

Income inequality and wealth inequality

Perhaps the real debate shouldn’t be whether governments should intervene in order to promote income equality, for market forces are better equipped to do that. Wealth inequality, on the other hand, may be harder to tackle. While the commoditisation of skilled work may level incomes, technology does not directly tackle “old money”, or the historical concentration of wealth. Those with capital may finance technologies and see their portfolios inflate, while those who work may feel crowded out by computers. For that we need a progressive tax system, inheritance laws, and perhaps even generous aid programmes aimed for less developed countries. But when it comes to income inequality, governments should do what they do best; nothing.

For further reading, I recommend Steward Lansley’s book on income inequality.

Oil Refinery

US Shale Oil Production and Oil Prices

USA is looking to become increasingly energy independent as it experiences a boom in shale production. This may be too optimistic. Contrary to popular opinion, the nation will not become the new “Middle East of oil” and witness GDP growth based solely by energy. While the shale boom may be revolutionary for natural gas, oil production from shale is prohibitively expensive and exposed to price fluctuations from around the world. Reduction of oil prices in North America may take longer than the reduction of gas prices, and will be sensitive to geopolitical factors originating from the Middle East.

Oil shake-up

US energy independence may be a possibility in the next decade as the country increases its exports of coal and natural gas and reduces its net imports of oil. However, it has to be noted that USA will still need to import oil; even if we assume that the country’s oil demands enters a structural decline, and oil production increases in the next 10 years, the country would still need to import one-sixth of its oil (compared to one-half today).

The price of oil will still need to be high, and probably establish a price floor at USD 90 (real, 2011) of Brent, which reflects the cost of producing the marginal barrel of shale oil in USA at a profit, or importing it from main sovereign producers. This price would need to be sustained for a few years in order to cover the high upstream costs in the past.

Unconventional forms of energy production has boomed in the US for the past 3 years and has outpaced other non-OPEC countries, which can be attributed to high oil prices. Upstream activity has increased partly because the oil industry is running out of cheaper alternatives, and existing conventional reservoirs are experiencing steeper decline rates.

Onshore crude oil production increased by 600-700 thousand barrels per day (kb/d) in 2012 – or more than 10%. US crude oil production can continue to grow by 600 kb/d for another 8 years, assuming efficiency gains and technological breakthroughs. However, to fund this growth Brent price needs to be at USD 95 throughout 2013. On the other hand, due to increasing cash flows Brent’s price could fall to USD 80 in the next 4 years.

Moreover, shale oil production could could reach a sustainable rate by 2020, which is much less than expected. Higher decline rates (of reserves) would require oil companies to increase drilling and investment in order to sustain production levels. This sustainable rate, however, is subject to change based on the underlying assumptions. While it may be higher, many professionals believe that it may well be 20% below the levels mentioned here.

Substitution between shale gas and oil wells must also be taken into account. Drilling shale gas wells is more efficient than drilling shale oil wells; the expected ultimate recovery of gas is 5 times more than that of oil. Therefore, if oil prices decline steeply, the industry would shift to shale gas wells.

Reaching energy independence

The US could come closer to this dream if it increases natural gas consumption and reduces its need for the expensive oil. These measures could would go hand-in-hand with promoting domestic production of oil, and together would allow the region to achieve energy security in the coming years.

However, oil prices are dominated by global factors, so US supply cannot be used as a sole determinant. Major oil exporters will continue to manage supply throughout this decade, so supply-side factors will not cause oil prices to plummet. This is more likely to happen in case oil demand growth slows.


Impact on oil price

While supply from North America is increasing, non-OPEC producers are reducing their supply. Spare capacity could rise faster if Nigeria, Iran, Venezuela, and Sudan increase supply, while spare capacity would fall in case of a global economic recovery – which seems likely. US oil production growth could account for almost 80% of the global net gain in oil production capacity by 2015.

However, total spare capacity would only increase from 2% to 3% by 2015. This rate would be lower than one in 09-10 when the oil price surged.  Up to 2015, USD 90 per barrel may be the sustainable price, as going lower would reduce shale oil production.

From 2015 onwards, supply could increase from other non-OPEC producers such as Brazil, Russia, and Angola. This could finally create a strong downward pressure on oil prices, creating a floor at USD 78 (real, 2005).

For further reading, I recommend Daniel Yergin’s book on all things oil.

big mac economics

The Big Mac Index and Hidden Inflation

Fast Food Economics

Big Mac’s prices are rising faster than official consumer prices since the past 2 decades. This indicates that printing of money is negatively affecting the economy.

In 1998, a Big Mac used to cost $2.50 while it has now reached $4.33 – if we were to use the Consumer Price Index (CPI), it should have cost us $3.35.  The rise in the burger’s prices indicates the impact of printing of money in the following ways:

  1. the purchasing power of US citizens is declining;
  2. bond prices should be lower if interest rates accounted for inflation linked to the Big Mac Index;
  3. people are receiving less welfare money as compensation is lagging behind inflation; and,
  4. the official economic growth rate (GDP) would be lower if the Big Mac Index was used instead of CPI.

Inflation and purchasing power

The Big Mac Index was introduced by The Economist in 1986 as an alternative measure of comparing prices of currencies based on the theory of Purchasing Power Parity (PPP). While PPP takes a basket of goods in each country and adjusts for interest rates, the Big Mac Index only focuses on one item. Since the price of a Big Mac is composed of beef, cheese (dairy), wheat, real estate and cost of labour, it can considered an accurate representation of prices worldwide.

Instead of using the index to value different currencies, I took the prices of the Big Mac each year within the US to notice its increase over time. The resulting chart showed that the burger’s price rose much faster than CPI from 1986 to 2012. The Bureau of Labor Statistics (BLS) defines CPI as the average change over time in the prices paid by consumers for particular goods and services. Currently, this includes foods, clothing, housing, transportation, education, and some other goods and services. However, BLS ignores two problems with their CPI; first, CPI accounts for the substitution effect (rise in beef prices would lead to people switching to other meats), and secondly, the basket of goods and services changes over time.

 Big Mac Index inflation

Looking at the chart above, the price of Big Mac has increased by 171% while the CPI lagged behind at 109%. These prices were further taken forward by the aggressive monetary policies of the US Federal Reserve (Fed) from 1999 onwards. It all started during the Asian crisis, and followed through the dotcom bubble, the financial crisis, and quantitative easing rounds.

These aggressive policies have increased prices to almost three times as much as they were in 1986, according to the Big Mac Index. In 1986, you could have consumed 62% of a Big Mac in $1, whereas now you get a measly 23%. In short, consumer purchasing power is rapidly declining.

Big Mac price

Social insecurity

People on Social Security are provided compensation based on a cost of living index, which is related to the CPI. According to the Consumer Price Index, a person receiving $1000 in 1999 should be receiving $1360 today, whereas if the prices were linked to the Big Mac Index, the person would be receiving $1770. Therefore, the government is using the CPI to pay out less money, $410 less than they should to be precise. Governments have used this strategy throughout time to reduce their liabilities by inflation; the US government is reducing the amount owed to its people in need through inflation, thereby cutting its long-term deficit.

Government bonds are overvalued

Normally, bond prices should reflect the rate of inflation. Ed Easterling from Crestmont Research links inflation to interest rates. The Fed has printed money and bought back government bonds, thereby lowered the interest rate of 10-year government bonds to 1.7%. Ed Easterling believes that the 10-year government bond rate should be about 1% above inflation; the current rate of inflation according to CPI is 1.1%, and adding that 1% (which accounts for risk) would give us 2.1%. On the other hand, if we use the Big Mac Index we get a 3.1% rate of inflation, so the interest rate of the bond should be 4.1%. The current interest rate is 1.7%, not 4.1%, and if it were to increase to 4.1%, bond indices would decrease by 20%. Therefore, Fed’s policies have overvalued 10-year government bonds by 20%.

GDP numbers are overstated

The Gross Domestic Product (GDP) measures the economic growth of a country. GDP is adjusted for inflation, so if a government were to understate inflation, GDP numbers would look more attractive. If the Big Mac Index is used instead of CPI to measure inflation, the latest GDP growth rate of 1.26% would be reduced. CPI is making economic growth look better.

If we are to use the Big Mac Index, we would have to conclude that we are losing out due to higher inflation, lower income from bonds, and a false confidence in economic growth. Aggressive monetary policies including printing of money and lowering interest rates are supporting inflation and perhaps also fuelling bubbles. We all know how each bubble ended. Why should this time be different?

Now that the false confidence in the economy is broken, we need a solution to come out of this recession. I recommend Paul Krugman’s book for further reading on this matter.

Entrepreneur | Analyst