Liquidity quicksand

First of all lets make something clear about zero lower bounds and costs of holding liquidity, and money in general. Money, whatever form it might take, is a nominal financial asset, just as a bond, perpetuity, or T-bill. It just happens to be a zero coupon consol.

Hence, the zero-lower-bound  allpies for nominal interest rates, where at negative rates the non-financial sector can still choose the instrument with zero coupon. Actually in today’s financial world it’s not true either, since you can not use cash for all your transactions. Also there is a risk of losing the money, or the cost of keeping it safe, the “zero-lower-bound” is rather somewhere in the negative territory, I have seen various estimates, going from -2 to -6 percent.

According to classical economic theory, as real interests rates drop you hold more liquid money, as the opportunity cost is lower. Case closed.

I would disagree. The real cost of holding liquidity also depends on its return compared to alternative investments, nominal or real, inflation affects both in the same way. Liquidity traps doesn’t occur, cause real returns are near zero. They occur, cause the real return of holding money is a.) close to its alternatives b.) relatively high. By the latter I mean, that during normal times when inflation is positive you have a negative real return with this zero coupon, while at zero inflation holding money has no cost in real terms. That said lets consider the ways we can get out of such economic malaise.

Why can it be a quicksand?

In my view the best proxies as alternatives to holding cash (considering liquidity, affordability, and default risk) are safe bonds/consols. Theoretically one could consider any type of asset, but that would rule out a possibilty of negative real rates, since something (by definition) has to appreciate against everything else. It would be like saying, that you can earn double your money each year, you just have to be always at the right time and place. That would be just nonsensicle and extremly naive.

So realistically speaking safe bonds are good proxies, and even though they do not default you can earn a nice negative real return on it. That happened quite often during the last bear markets. The problem is that you have no haven option. You can stockpile into real assets (gold, REITs, stock ETFs), but that requires higher risk tolarence, and on a macro level also risks bubbles.

The problem with our current situation that IF inlfation picks up on the longer horizon, and IF central banks raise too soon they risk the offsetting of the recovery. If they are too slow noone would hold money/bonds, and an excessive amount of money would flow into commodities, raising inflation even higher. Precision will be required… for me it looks that we are in an eternal trap, where normalization is not viable in the short run.



Why has NAIRU failed us?

Recently I came across an article on Ft’s Alphaville blog, written by Matthew Klein, arguing about the uselessness of NAIRU models. I had countless similar personal arguments and discussions about the viability of economic models, which usually left unconcluded, leaving both parties disappointed. The typical critique is that one can not reduce the market to two dependent variables and expect a realistic interpretation. I personally believe that if you make this argument you haven’t quite figured out what economic modelling is about. My personal view that you are examining a causality between two variables, leaving everything else out of the correlation (using the much hated Ceteris paribus condition) is not reducing real world, but debunking it. No reasonable modelling economist would argue, that modern countries and societies are built on one or two variables.

As always I missed two parts of mathematical and logical thinking from the post. First, as in any model, here you also have a constant attached to the Phillips function, representing every other part of the system, what may affect the relationship. Mathematically speaking the partial derivative of the real world respective to one variable has to treat the rest of the system constant (ceteris paribus), but does not deny its existence, nor its importance. Logically, this means that any relationship can change, every model can shift due to an external shock, where externality stands for any change coming from the non-examined variables (but not necessarily outside of the economic system). Looking at real life data always produces the net effect of all changes, hence can mask certain relationships, but they exist nonetheless. Relying on just mechanism is just as useless, as denying their existence is ignorance.

As I promised two missing parts of the argument, let me carry on with the less econ-nerdy one. As every part of neo-classical macro modelling, PC also operates with expected inflation and inflation surprise, not merely headline numbers. If the outcome of policy changes will be expected (meaning at least the party of the transaction, who is affected adversely accounts for it) the policy may bear no fruit at all.

It’s not different this time either. Policymakers want to create larger inflation, passing purchasing power from lenders to borrowers, or cover up the losses made during the GFC. The former obviously can’t work if lenders account for higher possible inflation. The second term is more interesting though. Before GFC we, in general, regardless of social status, income, or location, lived in the illusion of wealth… and acted accordingly. I won’t blame anyone, or I could blame everyone, this happens, when group-thinking takes place. The problem is we relied on non-existing wealth, which suddenly disappeared, even faster than it built up. Someone, in real terms, has to foot the bill, and by generating higher than expected inflation the savers can easily found themselves in that undesirable position. And by savers I also mean the want-to-be pensioners.

But this for another time, lets get back to NAIRU for now. As savers are clearly the losers of the inflation surprise, and they tend to be economically more literate, the surprise factor may not materialize. Just think about it, anytime a new QE is announced markets account for the possibility of higher nominal yields, muting the intended long-term effects of the policy. NAIRU is in fact in place, only the smart money is resisting it with every tool it has.

It’s the interest rate, dummy!

Since the US elections the dollar bull carried on its way towards its historical highs. Seeing this several columnists and analysts expressed their concern regarding the effect of strong US dollar on the emerging markets. At first glance it could be confusing why people are fearing a strong greenback. For years everyone wanted weaker domestic currency (stronger foreign ones) to boost export margins or domestic inflation, what could have changed?

First of all, as weaker domestic currency indeed boosts margins (expressed in local currency terms) one should not forget, that not all companies are exporters. During the recent years more and more emerging economies grew to a size, where simply relying on external demand to generate growth is not sufficient. With a struggling internal supply chain and eroding purchasing power it would be hard for policymakers to recourse their economy onto a more domestic reliant way. This is especially true, if the given economy is less diversified, and pricey exports would crowd domestic goods out.

Secondly, it’s not just about running costs. As it has been nearly a decade of cheap money lots of emerging economies relied on foreign funding. If foreign investors start to pull out of the economy, being afraid, that their investment would lose money as emerging currencies depreciate it would be even harder to pay the principle back, resulting in a self-fulfilling expectation and fire sales.

Thirdly, its more about the interest rates, than the currency itself. The most powerful tool, which sets the course for currency trend is the interest rate differential (in my experience you ought to look at the two-year differentials for a more precise correlation). In their current state, most emerging economies are between a rock and a hard place.

Due to the maturity of the US cycle and future policy expectations US rates started to rise. If emerging central banks hike rates to protect their currency they have to increase debt servicing costs for the already indebted private sectors. If they let their currency depreciate they have to risk the fire sales.

If this wouldn’t be bad enough, there is an additional factor to the equation: the emerging countries running a biggest ever interest-rate swap with the us, and they are on the wrong side. On the one hand, many of them have reverse assets in US dollars, however, these are mostly in fixed yielding government bonds. On the other hand, as emerging banks acquired funding through the interbank market they offered loans with floating rates in order to hedge against fluctuating rates. Many private companies feel the pain of rising rates right away, while others only take the bitter pill at refinancing.

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. Even though 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, so we don’t make false claims or assumptions. Because of this invisible part of the economy, I would certainly prefer income numbers over wealth.

Hitchhikers’ guide to instant wealth

A penny saved is a penny earned. It is especially usuful when companies are struggling to generate higher earnings during recessions, when demand and market expension are scarce commodity. Fortunately, nowadays it only takes four letters to achive higher returns: WACC. (Weighted Average Cost of Capital)

Thanks to cheap credit many of the hedge funds and activist investors could buy firms (usually using some credit in the first place), replace some equity with cheaper loans, and get the money out of the company while earnings numbers have been boosted too.  However, higher leverage or gearing on the balance sheet should make the investment more risky and cheap, higher earnings and multipliers compensate for the effect. Veni, vidi, vici; too good to be true.

The eye-watering returns seen on stock markets recently are fueled by these takeovers, or as a metter of fact, why would the management wait until the takeover, they can initiate share buyback programs too. Financial engineering within and higher multipliers outside the firms.

Luckily, we can not say that the market went full nuts. The widening spread between equity and debt returns reflects the understanding of this situation, and also indicates some kind of market efficiency. But back to the original question…

Is this kind of financial engineering essentially wrong? Boosting the ‘wealth-effect’ or decreasing savings through buying back equity could be beneficial for a troubled economy. Could be…

The problems with the argument is that it is superficial. First of all, the majority of these shares are held by higher income classes, whose marginal propensity to consume is naturally lower. Secondly, the lack of interpretable interest payments demolish the effect of compounded interest.For example, since the low interest policy savings rate has actually risen in the US. Low interests not only increase the NPV of assets, but also liabilities… pensions for instance. Last but not least, the combined effect of the last two factors can easily lead to overvaluation (let’s not overuse the ‘B’ word). After the buyback it is plausible that our investor would like to buy more shares using the returned money. The real economy would not see a dime before the prices of financial instruments are over the roof.

Why is it important now? Recently the S&P 500 buyback index once again surpassed its older brother. With a US fiscal expension on the horizon monetary policy could pass the baton to the fiscal policy, and switch into tightening mode. Taking away the punch-bowl would certainly hurt today’s valuations and ratios. There are no instant riches, and there is no free lunch. The tailwind of cheap credit can easily turn into a headwind.



Investors got really excited about Trump’s fiscal policy proposal lately. It seems that the 30 years of bond bull market might reach its end, or at least take a break, as investors started to dump bonds on higher inflation expectations. While global central banks tried to generate economic growth and higher inflation for years now, they might not be satisfied with the outcome.

Alright, lets see the facts first. Real money supply doubles since the Great Financial Crisis, mainly due to QE programmes, partly to higher money demand on behalf of households, and deleveraging of the advanced economies. Meanwhile, output gaps are closing. However, overall demand is still sluggish, rather the lack of investments, demographics, and human capital depreciation contributes to a lower potential GDP level and narrowing the gap. One way or another, extra capacity shrank in the economy, easing deflationary pressures, which isn’t homogen in the first place. For instance just take a look at housing, education, or health care numbers.

Subsequently, on top of all of this, comes the new fiscal stimulus, promising infrastructural developments (roads, bidges, The Great Mexican Wall, etc.), and tax cuttings. Eight years after the GFC, economy at full employment, output gaps shrinking. However, one shouldn’t be blinded by the macro picture, the manufaturing sector (consisting of many of the new President-elect’s supporters) still struggling with a production slack. The sector still recovers from cyclical(?) unemployment, low labour force participation rates, and high overcapacity.

Although the fiscal spending could consume much of this overcapacity, benefiting the sector, but again, the rest of the economy is running on (nearly) full steam. The spillover effects would just increase the prices through economic bidding, but wouldn’t bring any significant amount of new products on the market in the short run given the constraints. In real terms manufacturing workers would bring less home, which would certainly increase employment, but the overall sector would almost certainly be worse off. The already working people would give up more than the new entrants earn.

Conclusively, the policy can more than easily end up harm the economic interests of the people it aimed to help, and could cause a spike in short term inflation number, since the rest of the economy is facing constraints. Or maybe I totally misunderstood the new policies intention, and it only wants people to look at nice big numbers.

Capacity and despair

After Brexit the big money got it wrong again, and mispriced the odds of a Trump victory. The primary reason is that betting odds are ‘not democratic’, if one has ten times the money as the average it takes ten others to even up the odds. However, during the election/referendum the rich guy will still only worth one, he might be enough to give a false impression about chances and ‘public opinion’.

“How could this have happened?” millions asked around the world after the results came in on the 9th of November. My short answer: capacity constraints.

Since the dawn of time and economics the workers had to compete with technology. Don’t get the wrong idea, this has nothing to do with capitalist institutions, or free trade, nor modern economics. There is only one ultimate goal here: produce more with the least possible effort made. Wheel, plow, sails, spinning jenny, just a couple of capital instruments which made tens of thousands people’s labour redundant (and the individual more efficient), but, over time, this spare capacity can be used in other sectors of the economy. Unfortunately, this restucturing and retraining can not happen overnight.

That was the capacity part, now lets see the constraint. Because of certain compensating effects capacity gains have to be mean reverting over time. If there is a sudden change in technological progress and the structure of the economy the pool of workers contributing will shrink rapidly, compensating for the efficiency gains. Redistribution will become more problematic, and the redundant workforce will advocate the return to the old world order.

This helplessness and despair are surfacing on nowaday’s political stage, and it seems to be gathering momentum, even if the idea goes against centuries of economic progression.

Between a rock and a hard place

Following the result of Brexit referendum in June the Bank of England did not hesitate to implement further steps in monetary easing (further in the meaning of additional to already loose conditions after the great financial crisis). The pound, already nose-dipping to multiyear lows, fell further, stemming inflation in prices denominated in pounds.

The spiking inflation got Britain into an interesting situation. While the rest of the world is struggling with zero lower bounds of nominal rates in order to lower the real rate, the British economy has the inflation card, which (given the constant nominal policy rates) can lower real rates and support business investment. However, even with lower real rates, incentives to invest in an economy potentially losing its passport to the world currently biggest free trading bloc are deteriorating. I believe the main driver of business investment will be the conditions of access to the single market and/or the availability of labour, not the rate of interest in the upcoming years.

On the other side though, low real rates and spiking inflation could harm consumption. First of all, as the referendum result ‘came out of the blue’ with financial markets not pricing it, higher inflation erodes real savings, resulting in a higher propensity to save in the long run to make up for the loss in retirement savings for instance. Secondly, higher inflation adversely affects real income. During the recent weeks several other journals, blogs, and articles argued that increasing price levels would hurt real income, hence depressing the engine of growth: consumption.

Even though, it is difficult to argue against the conclusion that higher inflation has a gross negative effect on real income, since the terms of Brexit are still unknown, I think it is a bit premature to make a call on future real income trends. Labour demand depending on business investments, and supply influenced by immigration are just as crucial in determining real wages as inflation rates. Consequently, we are dealing with (gross) negative influence on consumption, and positive on business investment, but the big question mark is still there regarding the eventual terms and conditions of Brexit.

Given that consumption accounts for 60 percent of GDP in Britain (making it one of the least open economies among G7) one should keep a keen eye on real rates and currency movements. Since British people voted for isolation future economic planning should primarily focus on keeping domestic purchasing power high. In today’s business environment, where nominal yields are scarce, a small increase in policy rates could suffice to support the pound, without making credit terms significantly worse. Dealing with such circumstances and uncertainty it is not straightforward whether easing or tightening monetary conditions would benefit the economy on the long run.