Globalization critques – don’t get too excited

After recent election and referendum outcomes (I believe I don’t have to name them) people often made conclusions as the ‘losers’ of globalization are revolting against the old world order, or that globalization and neoclassical economics are failing us. I believe there were instances where these motives are in place. However, one can not make this simple conclusion as a one-size-fits-all reason.

Economists often make the mistake to confuse homo sapiens with homo economicus. Eventhough financial numbers often capture well-being and satisfaction (I always found ‘utility’ a wierd, extremely rational term), they don’t and in fact can not account for all factors. For example, why did the majority of Northern Irish farmers, the main beneficiaries, vote against open borders, when the urban population in Belfast, the main benefactors, favoured it? Why did Brexiters had ‘elite’ leaders when they revolted against this ‘elite’? Why does millions of republicans expect change when they elect a government led by bank executives and millionaires? Several contradictions sorround this simple argument about mere financial interests; no wonder they do not fit into social sciences.

For further thoughts regarding the topic please read these really insightful articles here and here.

As a person of numbers and figures I would rather focus on the quantitative side now on. In order to support the argument, that there are losers of globalization several good-looking graphs were produced too. My problem is that if you think about the methodology they doesn’t make sense, and  I believe most of you have heard/seen the globalization elephant graph, what is often used to justify why Western middle-classes are upset. In categorizes income brackets into percentiles, and shows the change of real income in each group.

Now think about this. I choose 20 people and rank them according to their real income. 30 years later I do the same and find that the 3rd richest guys income did not change in real terms. Then I draw the conclusion that the 3rd guy must be upset about it… I hope you see the problem. It not Bob, or Steve, or Kate; no, it’s the 3rd richest guy, whoever he/she is. The chart is pretty much the same, it doesn’t account for composition changes, labour mobility, demographics or any other influencing factors.

My other personal favourite is wealth distribution, when they take the whole as 100 percent, and make time series of a group’s share. It easily could be the case that there income rose too, but now it’s just X percent of the whole pie? How terrible. Aggregate income is not fixed, never been, comparing shares on a standalone basis doesn’t bear much fruit.

On the contrary, the ones who favour gloablization could easily make statements that it is unquestionably beneficial, since the number of people living in extreme poverty fell both in absolute and relative numbers. However, this is a fine achievement of globalization, the phenomenon is about much more than just combating one problematic aspect.

If there is any takeaway points you will have after reading this, then please let that be this: don’t fall for good looking pictures or rely on a simple figure.

What will make loans pricey

As I established in my previous post a loan is basically the present value of your future income. From the bank’s perspective they are buying an annuity, where the price is depending on interest rates, risk premia, maturity; ordinary debt market metrics.

After the recent Fed interest rate hikes some articles surfaced which predicted a new credit crisis, similar to the one we had in 2007-08. Sometimes I couldn’t decide whether the authors actually meant what they claimed, or just wanted to create a good clickbait by using people’s fear. Either way, here are two points why I find it unlikely that such collapse could happen anytime soon.

Firstly, after the last crisis there has been a serious deleveraging among the households. Secondly, household debt servicing-to-income ratio is at historical lows (however the series are only going back a couple of decades), and expected to stay low, partly because of our first point.

At this side of the yield spectrum (and will decrease as yields rise) each quarter percentage point of increase in borrowing costs increases debt servicing between 0.7 and 3.8 percent (calculated on a 5 and 30 year loan respectively). However, the other side of the equition, namely household (median) income is increasing 4 percent annualy too, meaning that the difference between the cost of maintaining your household balance sheet, your own personal enterprise, and what it yields for you (given that you are working) do not rise until the Fed hikes only once or twice a year.

Please do not be decieved by the numbers; again, this does NOT mean that all your additional income goes to debt repayments, only that your debt servicing / income ratio will stay constant with having more disposable income in nominal terms.

What will eventually do the tightening is the expected rate of hikes. As banks account for future financing costs too, more hikes will translate into higher current loan yields.

Lastly, higher yield might actually mean lower savings, giving an extra impulse for the economy. The rationality behind this is the big comeback of compunded interest. As rates got lower in the last couple of years savers were only able to get back what they put into their accounts, meaning that you had to save more to reach your future target (e.g. pension).

Rethinking wealth

Wealth and income distribution have been in the social scientists’ focus since the dawn of modern economics. However, discussions on such topic often fail right at the definition of the invisible reference point of equal distribution. On the one hand, it is often interpreted as the equal distribution of goods between individuals; on the other hand, it can be also meant as equal number of people within certain income brackets. Even though these arguments would be worth a book, if not a small library, I would like to take the argument one step back to measuring wealth.

As easy as it is to observe capital-related wealth by using share or bond price indices, labour-related wealth remains hidden when we account for wealth distributions using classical models. No wonder that wealth numbers indicate a more unequal, highly dispersed scale compared to plain vanilla income figures.

In the case of a financial claim the market simply calculates a net-present value of it, and right away we know the immediate wealth of the individual(s). But what does this really mean? According to Benjamin Graham’s famous metaphor Mr. Market tells us a price where he is willing to buy our future cash-flow. There is no difference in the case of labour-related income either. The market or bank gives us a quote on which we can exchange our future earnings for a certain amount of money. Yet this kind of wealth is not accounted for, a missing element of household balance sheets which distorts overall numbers when compared to capital instruments.

In its nature this invisible wealth, or labour stock is very similar to share prices: its value is positively correlated with earnings growth, negatively with required returns. Let me express it with less econ-finance nerdy words. With increasing wages one could afford higher instalments, hence is eligible for a higher amount of principle. Given lower debt servicing costs our fixed income can finance a higher amount of debt.

Credit issuance makes this invisible element of household balance sheets observable through debt markets. However, market creation always helps optimal allocation, each coin has two sides. On the one hand, we are able to exchange these future earnings for another asset (e.g. real estate), while we are also make changes on our liability side, converting invisible equity into visible liabilities. (See picture below) On the other hand, this conversion of the invisible part of the balance sheet might create false assumptions, as physical balance sheets expend, but in reality the economy does not necessarily follow as the potential were there all along.

After all this theoretical discussion lets see how much money are we considering. If the labour force of the US would exchange their future earnings to a fixed amount of money they would receive an eye-watering 338 230 billion US dollars… plus change. The number is derived by using the Gordon growth model on wages and salaries as they were dividends, data retrieved from the Fed. So let me put it into context: this is 19 folds the GDP, or 14 times the S&P market capitalisation (all at the end of 2015). The growth rate of this stock is also remarkable. In the last half of a century the value growth of labour stock outpaced S&P 500 returns by an annualised 48 basis points.

My point here is not to support one or the other perspectives when it comes to considerations of what is just. My aim is rather to say that before we get ourselves into such discussion get the right numbers and use apples-to-apples figures, before we make false claims or assumptions. Because of this invisible part of the economy I would certainly prefer income numbers over wealth.