A NICE chart from Dylan Grice of Societe Generale shows the relationship between health spending per capita and life expectancy in the OECD. Most countries are grouped around a 45 degree line with life expectancy duly rising with spending. Japan is a good way above the line, with better life expectancy than its spending would suggest; most people think that's down to diet.
The huge exception is the US, which spends $7,000 per head, twice as much as Germany, to get a mediocre life expectancy of 78. Chile gets the same life expectancy for $1,000 each. Before people set about blaming "Obamacare", these numbers wouldn't reflect the effect (if any) of reform. It probably relates to a whole bunch of things, from greater inequality (the poorest die soonest, on average), a higher murder rate and spending on expensive (but unnecessary) procedures like plastic surgery. Perhaps if Cher and Joan Rivers were excluded, the figure would be halved. But I shall flourish the chart next time my American relatives go on about the inadequacies of "socialised medicine".
UPDATE: I wanted to deal with the issue of longevity, raised by one or two commenters. It has not topped out at all but is increasing in Britain by around two years every decade, or if you like five hours a day. What I found interesting from my work on pensions is that life expectancy at 65 used to be lower in Britain and France than in the US, but in our case we have caught up, and in the French case, they are ahead. The data, from AON Hewitt, is that in 1940, the average US 65-year-old male could expect to live 12 years, the Briton 11 and the Frenchman 10; now the Frenchman has 18 years to look forward to and the Briton and American 17. For women, the pattern is similar but the French are now two years ahead. American longevity is not advancing as fast as European, despite the amount of money spent on health.
There is no sign at all of the European improvement slowing down; indeed actuaries have been continually caught out, one reason why pension schemes have struggled.
In the earlier draft, I should have referred to primary care and testing. A free at point of treatment system does not discourage patients from seeing their doctors, and thus may catch symptoms early. in the US, those without insurance may wait too long before seeing a physician. Those who have insurance will turn up but the legal liability of doctors forces them to do a lot of tests at enormous cost. It may be a problem of too little or too much treatment.
APOLOGIES for returning to the issue of pension funding but it is an important, if complex, issue. Yesterday, I argued that there were economic reasons in favour of DC pensions, not least the cost of employing older workers. Mr Johnston of tax.com challenged my reasoning. So I checked with Mercer, the benefit consultancy and their Christine Mahoney replied that
The difference in the accrual rate for a 60-year old is significant depending on whether the delivery is defined benefit or defined contribution. Assuming that the two plans are similar (i.e. provide a similar benefit at age 65 for a career employee using return assumptions for the DC plan), the age 60 accrual rate for the defined benefit plan costs the employer almost twice as much as the accrual rate in the defined contribution plan. We modeled a typical defined benefit plan (1.5% career average plan), to replace that benefit at age 65 (assuming 6% investment returns annually) we needed a 6% defined contribution plan, and at age 60 the defined contribution plan costs 6% (as you would expect intuitively) and the defined benefit plan accrual costs 12%.
In short, the employer's pension cost is halved in a DC scheme.
Now as for DC schemes being more expensive than DB schemes, I had coffee this morning with Morten Nilsson of the Danish ATP scheme; its costs are 0.04% a year. A collective DC scheme can reduce costs, both in terms of administration and fund management where employees are defaulted into an index fund. They don't have to choose their asset allocation at all.
Thanks to underfunding in previous years, the cost of pension provision is going to rise sharply; by 40-80% in the case of California funds. Yes, the right measure is to use annuity rates but on that basis the shortfall is $3 trillion, as calculated by Robert Novy-Marx of the Booth School of Business and Joshua Rauh of Northwestern. Who is to pay this? If public sector workers "fund 100% of their own pensions", as proclaimed by Mr Johnston, then presumably the answer is them. That would seem to suggest higher employee contributions. Except that he argues employees have already paid for the benefit, since it's deferred pay on previous earnings.
In the absence of a magic money tree, the bulk of the money will come out of general taxes. Is this a "gift"? Well, if you're a private sector taxpayer in a DC scheme, you might consider it an imposition, especially as, thanks to the Government Accounting Standards board, the true cost of this promise has never been explained to you.
IT IS not quite as bad as the apocryphal EU ruling (a little joke by British tabloids) that bananas must be straight. But the European Court of Justice ruling on sex discrimination in insurance is pretty bonkers all the same. Companies cannot discriminate, the court has ruled, in favour of young female drivers who tend to have fewer accidents than their boy racer counterparts. The result will be that women may have to pay a lot more for their insurance (perhaps 25%) whereas men will pay a bit less (10%). But why shouldn't insurance companies be allowed to reward women for their better habits? And why shouldn't they be allowed to discriminate on grounds of risk which is what insurance is all about; after all, they reward people for having burglar alarms and penalise those who use their cars for more dangerous jobs?
For Britons the knock-on effect of this ruling is that men will no longer receive higher annuities than women. This piece of "discrimination" was based on the undeniable fact that women live longer, and thus providing them with an annuity is, on average, more expensive. The result will be a cut in income for many male employees who, as previous blogs have discussed, are increasingly reliant on DC pensions and who in Britain have not much choice about buying an annuity. (The answer will be for married men to opt for joint life annuities where there should be no change in rate. But that won't help single men or widowers.)
Ignoring the facts of demography is a very strange approach. Does the court have a secret plan to reduce female life expectancy? Ah yes, by increasing the cost of car insurance for women, they will force them into being passengers in cars driven by testosterone-fuelled young men. See, it's joined-up thinking, after all.
ONE other point that leaps out from David Cay Johnston's post on pensions reporting is his comparison between DB and DC pensions. He writes that
Traditional or defined benefit pension plans, properly administered, increase economic efficiency, while the newer defined contribution plans have high costs whether done one at a time through Individual Retirement Accounts or in group plans like 401(k)s.
Efficiency means that more of the money workers contribute to their pensions - money that could have been taken as cash wages today - - ends up in the pockets of retirees, not securities dealers, trustees and others who administer and invest the money. Compared to defined benefit pension plans, 401(k) plans are vastly more expensive in investing, administration and other costs.
I am sure, when he reflects on the issue, that Mr Cay Johnston will want to adjust that passage. For clearly, economic efficiency is not just a matter of the costs of administering a pension scheme*. It is also a matter of whether the pension plan encourages labour mobility and encourages people to stay in the workforce for longer, which most experts agree is the best way of dealing with our demography problem.
In a final salary DB scheme, it is very expensive to hire older workers because the cost of funding the last few years is greater. That is not true in DC. Employers have also used their pension funds to offload older workers and cut short-term labour costs. And it is hardly more economically efficient to pay people not to work. According to Alicia Munnell and Steven Sass of the Centre for Retirement Planning in Boston, DC workers tend to work one or two years longer than those in DB plans. The switch from DB to DC in the US private sector is one reason why participation rates for 55-64 year olds has increased since 1990. DB plans also tend to penalise early leavers and more mobile employees since it can be costly and cumbersome to transfer benefits; again a more mobile workforce can increase economic efficiency.
There are other factors. Creating a DB plan in effect turns an employer into a kind of insurance company, having to monitor factors such as longevity and investment risk. Changes in accounting regulations also mean that the funding status of DB plans brings volatility to the corporate balance sheet, Dealing with these issues is, at the very least, a distraction from the business of running the componay and thus hardly conducive to economic efficiency.
Of course, there is a problem with DC in that contributions are not high enough and employees are saddled with the investment risk. But there are a number of possible adjustments, including career-average schemes, notional DC (where the employee gets a degree of certainty in terms of return but the pension is linked to annuity rates, so limiting the employers' longevity risk) and hybrid DB/DC schemes, where a minimum benefit is guaranteed to protect the lower-paid but additional benefits are linked to investment performance.
* This is not an insuperable problem in any case if a low-cost index manager is used. The British NEST scheme is aiming for costs of 50 basis points.
SO MUCH in politics depends on how the issue is framed. A US writer, David Cay Johnston, has launched a (very long) attack on journalists for mis-representing the Wisconsin pensions issue. He writes that
Out of every dollar that funds Wisconsin' s pension and health insurance plans for state workers, 100 cents comes from the state workers.
How can that be? Because the "contributions" consist of money that employees chose to take as deferred wages – as pensions when they retire – rather than take immediately in cash. The same is true with the health care plan. If this were not so a serious crime would be taking place, the gift of public funds rather than payment for services.
Of course, he is right that pensions are deferred compensation. But that is hardly the end of the argument. One could equally say that 100% of Wisconsin pensions are funded by taxpayers, since taxpayers are the sole source of income for public sector workers, including the portion of their salaries that are deducted to meet pension contributions.
The key point in differentiating public sector workers from private sector workers (the majority of whom, in the US, are in DC schemes*) is the certainty of pension income. In a DC plan, a poor investment plan means a poor pension; in a DB plan, the employer (in this case, the taxpayer) has to make up the difference. This guarantee is enormously valuable. As mentioned before, the Bank of England puts aside 55% of payroll to meet its pension obligation with no investment risk. Of course, in the US Whether enough money was set aside each year and whether it was properly invested were decisions by management (in this case elected state officials) who knew the costs and obligations of the defined benefit pension plan. most employers choose to take the risk of investing in equities. But that is one reason why the pension schemes are so underfunded today.
In effect, public sector plans have taken a punt on the stock market with taxpayer funds. This is even more clear in states like Illinois which is borrowing money from the bond market to funds its pension contributions; this is hedge-fund economics. Taxpayers may have been willing parties to this bargain (on the grounds they would prefer lower taxes now, in the hope that the stockmarket will pay for a good deal of the pension promise) although it is not clear that the deal was ever put to voters in those terms.
The failure of the stockmarket to deliver has eliminated this "easy option" and the cost of pensions has also increased because of lower interest rates and improved longevity.
Mr Cay Johnston doesn't refer to this cost in his original post. But in a comment on a blog post, Mr Cay Johnston wrote that
Properly funding pensions is not a mystery. Indeed, you can go into the market any day and buy an individual pension called an annuity.
That is true. But thanks to lower interest rates, the cost of funding pensions via an annuity is much, much greater than the cost budgeted by state and governments which rely on a (largely aspirational) 8% assumed return on assets. If Wisconsin were to fund its pensions that way, the contribution from state revenues would have to rise very sharply. The money would have to be found either by; increasing taxes, cutting other services or asking employees to contribute more (if you like, asking workers to take a cut in current pay in order to meet the higher cost of funding their deferred pay).
None of the above means it is right to stop collective bargaining, as the Wisconsin governor has proposed, and which seems a wholly illiberal (in the classic sense) reform. Workers in the public sector have as much right to organise as anyone else. But it does mean that asking public sector workers to increase their pension contributions is not unreasonable.
* That statement needs to be qualified. Many workers (around half) are not in a pension scheme at all, apart from social security. The majority of private sector pension plan members are in a DC scheme.
UPDATE: Thanks to Mr Cay Johnston for responding although it's not clear what point of economics he thinks I'm missing. Where he goes wrong is in writing that
Whether enough money was set aside each year and whether it was properly invested were decisions by management (in this case elected state officials) who knew the costs and obligations of the defined benefit pension plan.
But of course, they didn't allow for the costs and obligations of the plan properly, not least because the Government Accounting Standards Board told them to account for it using the assumed rate of return. Using an annuity-based approach (which derives from bond yields) is, of course, what academics such as Joshua Rauh of Northwestern University has argued for; this puts the unfunded liability of state pensions at around $3 trillion. It may well be that Mr Cay Johnston has campaigned for this approach in the past but I am not aware that trade unions have done so; indeed I was told in the US that by one union official that such figures were scaremongering. If you do account for a pension this way, then public sector workers are much better paid than their private sector counterparts. In which case, a current pay cut (higher pension contribution) seems even more reasonable.
On the presumption that Mr Cay Johnston accepts the $3 trillion shortfall, then how is it to be covered? There is no magic money tree that can be shaken to disgorge the cash. Should the taxpayers pay, even though they were not informed of the nature of the bargain they had made, thanks to government approved accounting standards? Some of those taxpayers will receive lower pay than those in the public sector; most will have lower pension benefits. You can blame past politicians if you like and I agree you should (see Roger Lowenstein's excellent book, While America Aged); you could even sue them but you won't find $3 trillion that way. Or you can argue that if workers want to keep the DB deal, they need to pay more of the cost. If not, then the accrual of future benefits needs to be curtailed, while as Mr Cay Johnston rightly says, benefits earned to date must be protected.
On his point that
Imagine if a London business agreed to pay 4 weeks of vacation after 48 weeks of work, failed to reserve for the cost and at the end of the 47th week said, "sorry, we only put aside enough for one day of vacation." Would you blame the workers, especially if pay was negotiated by contract? Would you say that because interest rates fell the employer should be absolved?
If a private sector business went to workers and said "Sorry, but we're in financial trouble and we need you to take a pay cut or work shorter hours or lose a benefit" then the workers might well agree, if it meant keeping their jobs. Lots of workers do this; I've agreed to such deals myself.
UPDATE 2: Just in response to D Mac, I covered this issue in a previous post but the only real difference between the two schemes is the index-linking that the BoE provides. Even if we assume that is worth 25% of pay, that still indicates the value of a guaranteed DB pension is around 30% of pay.
JUST back from chairing a session at an LSE conference on the relationship between developed and developing countries, arguably the crucial issue for today's global economy.
There was a good line-up of speakers, two of whom had written books on the subject. Stephen King of HSBC wrote Losing Control, a book that has been mentioned in this blog before; George Magnus of UBS has recently published Uprising: Will Emerging Markets Shape or Shake the Global Economy? The third speaker was Mark Dow, once an IMF economist and now at Pharo fund management.
King's thesis is that economics is about the allocation of scarce resources. Part of the west's advantage was that it had a dominant position in term of access to capital; its wealth then gave it a crucial advantage in terms of access to raw materials. That position is now being challenged with effects that we are seeing daily in the commodities markets. Magnus's book recalls that the US's dominant economic position has been challenged in the past by, for example, the Soviet Union and Japan. But it is relatively easy to grow an economy from a very low base. The challenge is to maintain that growth when an economy gets richer. At that stage, the quality of institutions, including the rule of law, becomes more important; in this respect, China may still face great challenges.
The discussion was wide-ranging, covering the inflationary/deflationary aspects of the relationship, the role played by exchange rates and capital flows, and the potential for economic tensions to turn into geopolitical risk. There wasn't always agreement but to summarise:
1. Higher commodity prices are a relative price shock and thus a tax on western consumers. As for the complaint of some developing economies that the US is exporting inflation via QE, the speakers felt the Fed was right to say that emerging markets could always let their currencies rise.
2. The chances of international economic co-operation have receded long with the air of crisis. It will be hard to create a Bretton Woods Two, in which currency movements are guided by economic agreement. The Chinese are wary given that the Japanese buckled to American pressure in the 1980s and ended up with 20 years of stagnation.
3. The panel were split on whether the economic imbalances had gone away. Mark Dow pointed to an improvement but in the US current account, but Stephen King saw this as cyclical. It wasn't clear who was getting the better of the deal as the Chinese accumulated low-yielding claims in a US dollar that seemed doomed to depreciate (against the renminbi at least).
Some of these issues are playing out over decades rather than years or months and thus may not have an immediate market impact. But it is clear we are now dealing with a multipolar world which requires investors and economists to anticipate policy changes in a wide range of countries, some of which may have a quite different world view. On the one hand, this is genuine progress, as people who make up more than half the world's population are getting a greater say in the running of the world economy.
But there is clearly potential for conflict along the way. Europeans may be used to the phenomenon of relative decline but Americans are not; President Obama's efforts to sound more multilateral get more applause abroad than at home. China will naturally want its economc power to be reflected in terms of political influence but that will create the scope for a clash of interests with Japan and India, as well as America.
The commodity markets are where this may process show up the soonest. If the recent price spike is long-lasting, we may see a dash for resources akin to the late 19th century burst of European colonialism, as nations try to secure their supply of raw materials. China has already been going down this road; other nations have also imposed export bans in the face of bad harvests. Higher prices are one thing; outright shortages of goods that nations deem essential are an even greater threat.
IN A very early blog post, I proposed the "Buffett test" for books, which suggested that it was hard to take any financial tome seriously that failed to spell the name of the world's greatest investor.
The issue came to mind when reading Beyond Mechanical Markets, a book by Roman Frydman and Michael Goldberg, that is the subject of this week's column. The book is about the efficient market hypothesis, but it is tempting to talk about the efficient publishing hypothesis instead; how is is possible for two distinguished academics and a team of editors at Princeton University Press to mis-spell Buffett on four occasions?
Regular readers may accuse this blogger of chutzpah given the many typos that occur. But this blog is written with software that has small print and no spell-check function*, and is designed to appear five seconds after it is written. Books take months to emerge; Penguin says it takes a minimum of 9 months to turn a manuscript into print. Somewhere in those nine months, publishers might have the chance to use Google.
Perhaps the answer is for Warren Buffett to have his own theme song, like Liza with a Z? It's Buffett with two ts, not Buffet with one t, coz I buy shares on a hunch, don't serve you lunch.
* The satirical magazine Private Eye has a phrase for this: New Technology Baffles Pissed Old Hack
LARRY Kotlikoff of Boston University has another Bloomberg column on the state of the US national debt in which he declares that
Our country is bankrupt. It's not bankrupt in 30 years or five years. It's bankrupt today.
His calculation is that the Federal debt is not $9 trillion as the (net) figure officially states but $202 trillion. How does he arrive at that number?
In a sense, this is a process rather like the one used to derive the theoretical value of a company, involving the discounting of cashflows to a present value. Professor Kotlikoff takes the process rather further than most, tracking the revenues and expenditures all the way out to 2085 and then calculating a "terminal value" for the post-2085 numbers. The revenues and expenditures are increased at a 2% real rate, to allow for GDP growth and then the debt numbers are discounted at a 3% real rate.
He takes the underlying numbers from the alternative fiscal scenario calculated by the Congressional Budget Office. These figures are based on assumptions in the long-term budget outlook, which presuppose that tax reform does not take place (see page 3 of Chapter 1 for the assumptions, which include the permament extension of the Bush tax cuts).
Now $202 trillion looks a very scary number but how does it compare with GDP? As commenters on my original draft pointed out, there is not much point in calculating future GDP and discounting it back (my misinterpretation of the professor's complex spreadsheet). So given current GDP is somewhere north of $14 trillion, the US debt-to-GDP ratio is almost 14 times, worse even than Greece's position when calculated on the same basis.
The real problem is the issue of labelling. As Professor Kotlikoff points out, the government makes promises to pay citizens benefits in the future. If it borrows the money to fund those promises, this counts as debt and goes into the official debt-to-GDP ratio; if it simply assumes that the promises will be paid out of future taxes, the debt doesn't count.
But this an accounting trick of the sort practiced by many a public company in the past. To boost current profits, compnaies have tended to recognize revenues early and costs late. (A good example is counting the assumed rate of return on the pension fund as profit, even when it isn't achieved.)
As for the headline, it all depends on what one means by bankrupt. Clearly the US has no problem financing itself on the markets at pretty low rates. What the calculations show is that the US will eventually default on its promises to somebody - bondholders, taxpayers, future pension or healthcare recipients. The last three groups are the most likely sufferers. But it doesn't tell us when.
FRESH from a duel with Free Exchange, I now find myself compelled to add some context to a Democracy in America post on the Wisconsin situation.
The problem with public sector/private sector pay comparisons is that pay comes in two forms; current and deferred (ie pensions). A pension promise from the government is a very valuable thing indeed; some states have made it constitutionally protected. So, unlike the typical private sector employee who is now in a DC scheme, the public sector employee has certainty about his or her pension entitlement. If the equity market falters, the DC plan member will suffer; the employer of the DB member will make up the shortfall. In effect, the employer has written the employee a put option on the market.
How valuable is this option? We can make a judgment by looking at the Bank of England scheme. It avoids all equity risk by buying index-linked bonds to cover its pension liability. This costs it 55% of payroll in the current year (the ratio varies with the level of real yields). The average contribution into a DC scheme (employer and employee) is 10%, in both Britain and America. In a room full of actuaries last week, I asked whether this was a fair basis of pay comparsion and the answer was yes.
Now the Bank of England scheme may be more generous than the Wisconsin version; employees can retire at 60, with full inflation-linking. But even if one were to knock 20 points off the contribution rate to 35%, that would still suggest that public sector employees in a pension plan get a total benefit some 25% better than the private sector employee. That is a pretty good incentive to work in the public sector.
UPDATE: I have had a look at the paper which compares Wisconsin public sector and private sector pay. With respect to pensions, it seems to base its calculations on the figure that
Retirement benefits account for 8% of state and local compensation costs compared with 2.5% to 4.9% in the private sector.
But there is a big difference between how much employers are putting aside and the true cost, which is what they have promised. Wisconsin's scheme is fairly complicated but a quick perusal shows that employees can retire at 57, if they have 30 years of employment and that
There are two methods of calculating retirement benefits, the formula and money purchase methods, and you are entitled to the higher of the two amounts. A formula benefit is based on your three highest years of earnings (your "final average earnings"), a formula multiplier based on your employment category, your years of creditable service (including any creditable military service) and any actuarial reduction for early retirement.
The formula appears to be one-sixtieth for years worked after 2000 for most employees but one-fiftieth for executives and protected employees (presumably fire and police). A higher ratio applies to pre-1999 years. No way can that payout be achieved at a cost of just 8% of payroll unless the pension fund has a strategy for beating the tables at Vegas.
IT IS with some caution that I respond to Free Exchange's latest post on central bankers. On the one hand, readers may have a limited appetite for what they perceive to be internecine squabbling; on the other, life in an argumentative family taught me the importance of having the last word.
This may be a question of semantics. Free Exchange is arguing that central banks have been too hidebound by their traditions to do enough; on the contrary, it seems to me they have broken with their traditions almost entirely.
There is a potential ambiguity within the position of the central banks' critics. On the one hand, they argue that quantitative easing will be enomously destructive and inflationary; on the other, that it is entirely ineffective.
My main worry is that central banks are repeating the same mistake they have made for the last 25 years. They have intervened to support asset prices by cutting rates whenever markets faltered. This encouraged speculators to borrow money to buy assets, inflating one bubble after another. QE is just the logical endpoint of this process where central banks are cutting out the middleman and buying assets directly.
In the long run, however, asset values are constrained by the growth rate of the economy. Any attempt to maintain them artificially will either end in failure or will be successful only by inflating other prices until they come in line. Thus the high price-to-income ratio for British house prices will either end with prices falling or incomes inflating; at the moment, the odds are on the former.
If the US economy was still in the depths of recession, 18 months after the fall of Lehman, then a combination of zero rates, more QE and a huge fiscal deficit might be understandable. A huge fire would indeed be raging. But the Fed is in fact forecasting growth of 3.5% or so this year and equity markets are looking very confident about future growth prospects. There has to be some point at the firemen aim so much water at the smouldering ruins that they risk structural damage.
IT IS not often that I am inspired to respond to a colleague's post but Free Exchange has managed the trick. A recent post criticises
the failure of the major rich world central banks to react to rapidly falling expectations with overwhelming monetary force
just as the gold standard served a useful person in the late 19th century only to become a mental policy prison in the 1920s, the inflation hawkishness of the 1980s seems to have created a generation of central bankers unprepared to handle the monetary challenge posed by the Great Recession.
This seems an interesting line of criticism to say the least. Last year, I attended a lunch hosted by Mervyn King, the governor of the Bank of England, and as he spoke, I imagined that the walls, rather like the headmaster's study at Hogwarts, were full of paintings of old governors, wagging their fingers and saying "You missed the inflation target. You let interest rates fall to a record low. You let the pound fall 25%. You created money to buy a quarter of the total gilt issuance of a government running a massive fiscal deficit." By historical standards of bank governors, Mervyn has been a heretic.
Even the ECB has done lots of things it wouldn't have contemplated in the past, including buying the government bonds of member states and lowering its collateral standards to help out commerical banks. As for Mr Bernanke, the Fed is forecasting growth of 3.4%-3.9% this year, a rate above the historical trend. And yet the bank is still holding rates close to zero, and is pursuing a second round of QE to prop up asset prices.
As for the golden fetters, FDR let gold rise from $20.67 to $35 an ounce in 1933-34, a dollar devaluation of 41%. Since Ben Bernanke took office, gold has risen from $566.15 to $1381.72, a dollar depreciation of 59%. Not many central bank governors in history have "achieved" so much.
THE news from the Middle East suggests that 2011 will prove to be a year like 1989, when a number of regimes in one region are swept away. There seems to be a contagion effect, with news of unrest in one country inspiring protesters in another.
Equity and bond markets are also marked by these contagion effects with risky assets tending to move together, notably in 1987, 1998, 2002 and 2008. The benefits of diversification disappear in such circumstances as correlations move to 1.
Globalisation is often used as a catch-all term to describe these trends but I think that's a bit lazy; there was less globalisation (in terms of world trade) around in 1987 than in 2008. But there are some obvious factors that might make investors react simultaneously. The US has been such a dominant economy that any evidence that it is faltering is bound to affect other countries significantly; it might thus be rational for investors to treat a sharp fall on Wall Street (as on October 19, 1987) as signalling bad news elsewhere. Similarly, many countries tie their currencies to the dollar or see the dollar rate as a signal; thus a change in Fed interest rate policy that might alter the value of the dollar would also have international effects.
The post-1971 world has also seen the abandonment of many controls on capital and, as a consequence, the development of global banks and fund managers; as their attitudes to risk change, the effects will spill across borders.
How might all this tie in to political turmoil? Some might point to the 24-hour news cycle, which translates news instantly round the globe, or to modern media like Facebook or Twitter. The problem in using the latter to explain cross-border politics is that this is not a new phenomenon. Back in 1848, regimes across Europe were swept aside in a wave of unrest; France lost a King (only to gain an emperor as a result); Austria lost its political genius, Metternich; Germany almost achieved unity; Italy attempted to turf out the Hapsburgs. The nearest equivalent to tweeting, back then, was to send a message by carrier pigeon.
If there were economic causes of that revolt, they probably had a long gestation. This was an era of industrialisation, when the growth of factories was creating both an organised working class and a politically-conscious middle-class; Marx published the Communist manifesto in 1848.
Since the regimes of the day were aristocratic and monarchical, they had been in office a long time. There was no outlet to channel the discontent; no chance for opposing parties to take power. So revolution was the only option. The same was true in 1989; it was clear communism was not delivering the promised living standards; and the ruling regimes were, by definition, responsible, since they brooked no opposition. Market setbacks also seem to follow a moment when one world view (the internet will boost stock valuations in perpetuity, house prices can never go down) seems to hold sway. This view pushed valuations to extremes; a change in view would inevitably have a substantial effect on prices, a revolution in market terms.
I would add a further factor. It is in the nature of dictatorial regimes to devote a lot of resources to oppression; this is economically inefficient. It also relies on drawing young men into the police and army; men drawn from the same class that is most likely to be discontented. When push comes to shove, rulers can find (as the Shah did in 1979, and Mubarak has just discovered) that their weapons of oppression don't work.
The Middle East regimes resemble those aristocratic regimes of 1848 and the communist regimes of 1989 in that they have been in power for a long time and that they seem to have been left behind in history. The turmoil spreads because so many countries have so much in common.
Let us hope things in the Middle East resemble 1989 more than 1848, when many of the revolutions fizzled out. Indeed, the world might have been a lot better place in the 20th century had Germany been united by 1848's liberals instead of by war and Bismarck in 1871.
THE British papers were full of the idea today that the Bank of England had dropped a broad hint that interest rates were about to rise. The governor's letter to the chancellor had referred to market rate expectations, and those were forecasting three quarter-point rises (taking rates to the giddy heights of 1.25%). But Mervyn King seemed to play down such talk at today's press conference, stating that
It may be many quarters before we do anything
Having studied economics in the 1970s, Buttonwood was brought up on Milton Friedman's dictum that inflation was
always and everywhere a monetary phenomenon
Tim Lee, an independent economist based in Connecticut, is an enthusiastic monetarist. His view, based on the data, is that
it is madness to think that central banks will be raising rates when money supply and bank credit are not growing.
Lee says that M4 broad money supply in the UK is down 1.5% year-on-year, the first significant contraction of broad money supply in modern times. In real terms, it has fallen by more than 5%. In the US, Lee looks at the change in M3, a figure no longer published by the Fed but maintained by John Williams at Shadow Government Statistics. The latter shows a 2% annual contraction in M3.
These numbers are very interesting, since there is a perception in some parts of Congress that quantitative easing has boosted money suppy enormously. To me, however, it looks as if central banks have been much more successful in pushing up asset prices than they have been in encouraging credit growth in the rest of the economy.
THE latest UK inflation measure shows the extent of the problem. The headline measure, the consumer price index, is at 4%, double the government's target. In the old days, the Bank of England used to target RPIX (the retail price index minus mortgage payments) and that rose to 5.1% (given that mortgage rates were unchanged in 2010, the standard RPI is up by the same amount). One could argue that the performance is even worse on this measure, since the standard gap between CPI and RPI is 0.85 percentage points (the RPIX target used to be 2.5%).
The VAT rise from 17.5% to 20% seems to have been passed on pretty quickly (unlike the situation last year, when a temporary VAT cut was reversed). Alcoholic drinks were an important driver of the increase (so feel doubly virtuous if you went on a detox diet last month) but restaurants also played their part (my Starbucks was quick off the mark in pushing up the price of a latte to £2.50). And of course there was oil.
Now the RPI figure may have some flaws, as one of my colleagues has argued. It certainly seems to produce some odd results for clothing. But it is pretty clear that the UK is suffering a worse inflation performance than its European competitors.
The effect is a cut in the real British standard of living; wages are rising by only 2.3% a year. Now to the extent that this is part of a process of reorienting the economy towards an export-led model, it might be a "price worth paying". Sterling's fall (back in 2008) pushed domesitc prices higher but made exporters more competitive; some countries in the euro-zone might long for this trade-off.
The trouble is that the UK hasn't seen the required trade improvement. The deficit on goods and services was £46.2 billion in 2010, up from £29.7 billion in the previous year.
One has to feel sorry for the Bank of England. It keeps missing the inflation target and risks losing its credibility but the VAT rise and higher oil prices are not under its control. It would be tough to raise rates after figures showing the UK economy contracted in the fourth quarter of 2010. There may be a broader lesson for investors to learn; they are acting as if central banks can revive the global economy with monetary policy, whilst keeping inflation low. But banks are not masters of the universe; sometimes, as the Bank of England shows, they can be helpless passengers of events.
JAPAN's fourth quarter GDP data were better than expected, which is why the Tokyo stockmarket rebounded on the news. But economic activity still declined in the last three months of the year. In nominal terms, the decline was an annualised 2.5%. Perhaps it is a blip; after all, GDP was still 2.2% higher than in the fourth quarter of 2009. But Japan is not alone.
Portugal announced today that its fourth quarter GDP was down 0.3% and Britain had previously announced a 0.5% decline that was blamed on the snow in December. Three separate blips look like a bit of a trend to me; they indicate that recovery in the developed world is not as robust as might be expected.
Investors clearly believe that central banks will simply maintain an easy monetary policy until the recovery is well-established. But the key issue is the interplay of monetary with fiscal policy. Britain and Portugal are now in austerity mode. Capital Economics points out that Japanese consumer expenditure fell 0.7% in the fourth quarter and that
A decline of this size was widely anticipated following the expiry of government subsidies for car purchases and the scaling back of the eco-points subsidies for low-energy household appliances.
In short, we are back in "Weekend at Bernie's" mode where a government can prop up the economy for a while with special schemes, but things slump as soon as the support is removed.
The world's biggest economy, the US, agreed another tax-cutting package in late 2010 so doesn't yet face the same constraints (the President's biudget proposal still has a trillion-dollar deficit next year). Investors may well be assuming that the right wing of the Republicans will not get its way on rapid fiscal tightening, nor will they shut down the government rather than let the debt limit rise. And they also assume that the Chinese authorities will manage to use the combination of higher reserve ratios and modest interest rate hikes to do a Goldilocks - achieving growth that is not too fast or too slow, but is just right. It all comes down to relying on the willingness to negotiate of the tea party and the economic skills of Communist bureaucrats. What could possibly go wrong?
TWO more thoughts on the Barclays Capital report on Malthus. The first was brought to mind by a chapter in Alan Beattie's excellent book*, False Economy; that much agricultural trade involves the import and export of water. Rice producers are clearly exporting the liquid; Saudi Arabia is importing it in the form of food. Iceland is exporting water in the sense that it can use cheap hydroelectric power to produce aluminium. If food is embedded water, then a lot of manufactured goods are embedded energy, in the sense that it takes a lot of energy to produce them. This may seem less important in a service-dominated economy but the US has clearly built its economy around the cheap energy concept; air conditioning in the southern summer, heating in the northern winter, cheap gasoline to allow all those commuters to reach work from the suburbs. Very high energy prices represent a threat to that model.
The second thought was slightly rushed in yesterday's note. Clearly, there is not enough oil for China and India to reach US per capita levels, or even European levels. But how will the choking-off process occur? It could occur as high energy prices bankrupt debt-ridden developed economies, or because they choke off Chinese and Indian growth (some people think China has already overinvested, creating wasteful capacity). Even if the optimists are right, and new sources of energy are exploited, the process could be extremely disruptive. The big energy changes of the past (electrification, the motor car) took decades to phase in and were an addition to resources. They were not really replacing old technology, except candlemakers and horses, and the latter were in no position to complain. But any future shift will involve scrapping old capacity (petrol-driven cars, for example) and seems likely to be expensive.
THOMAS Malthus hasn't had a very good press over the last couple of centuries, often being cited as a classic example of the dangers of extrapolation. The British vicar's theory was that population growth was exponential but agricultural growth was arithmetic, so that any sharp rise in population would lead to starvation and thus be self-correcting. But he published his theories just as the British economy was escaping the old constraints, thanks to the agricultural and industrial revolutions, a process that quickly spread to the rest of Europe and North America. Although Malthus-type theories have occasionally been revived (the limits to growth report, produced by the Club of Rome in the early 1970s), the dominant thesis in the late 20th century was that the market would always solve the problem; high prices would encourage producers to find new sources of supply.
Barclays Capital has a chapter on commodities in its epic research note, the Equity-Gilt study, which concludes that
Malthus may turn out to be right, but with broader implications than he may have imagined
We are depleting the global stock of natural resources, i.e commodities in the broadest sense of that term, at an accelerating pace, with the rise in per capita commodity consumption vastly accelerated by rising prosperity in the developing economies.
Were Chinese oil consumption to reach US per capita levels, its demand would rise ninefold, while Indian consumption would have to go up 23-fold. That would push global oil demand up to 260 million barrels per day, compared with just under 90m barrels a day at present. Clearly, that's not going to happen. But along the way, some combination of much higher prices, a setback to developing nation growth or a switch to alternative fuel sources might be needed; all of which could be very disruptive.
The key factor is that US demand is no longer crucial for setting the global price of all commodities. For example, China's share of global copper demand is double that of the US. In 2010, global oil consumption increased by 2.9 million barrels a day; 85% of that increase came from non-OECD countries. A fall in US demand thus does not automatically lead to a fall in price. In effect, this is a supply shock for developed economies and a supply shock is always negative. It also creates policy dilemmas as the UK is discovering, with the Bank of England torn between dealing with above-target inflation and falling fourth quarter output.
Part of the problem is that new sources of supply are more expensive to develop. (I've written about this before here and here.) One more statistic from the study is striking; the global energy industry needs to invest $33 trillion between now and 2035 to replace old sources of supply and to meet incremental demand.
A COMMENT by Pensions Actuary on a recent post inspires me to nail one particular canard; that dividends are old-fashioned and today's more progressive companies reinvest their earnings for future growth.
My simple equation, known as the Gordon growth model, is that the initial dividend yield plus dividend growth, plus or minus any change in rating, equals the total return. Expressed in this way, there are no other sources of return; the capital gain flows from the dividend growth and the change in rating. Retained earnings are the device by which companies invest, and thus increase future dividends.
But what about the idea that companies have become more growth-oriented, retaining more of their earnings, and paying out less in dividends? As it happens, there is an excellent paper on this issue from 2002, written by Robert Arnott, a former editor of the Financial Analysts' Journal, and Cliff Asness, a hedge fund manager who co-founded AQR and was previously a quant fund manger at Goldman Sachs.
Their analysis produced a counter-intuitive result; future dividend growth rates are higher in periods when payout ratios are high (ie when a higher proportion of profits is paid to shareholders) and lower when payout ratios are low. That is because cash tends to burn a hole in the pocket of executives. As the authors write:
dividends might signal managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth.
Incidentally, in that previous post, I was being as optimistic as I could in getting future equity returns of 7.5%. But as a couple of commenters pointed out; the cyclically-adjusted price-earnings ratio is high (a sign that future returns will be low) and share option issuance often offsets buy-backs. The way that pension funds (and many companies) assess future returns is based on very wishful thinking.
THE markets eventually decided that the fall in the US unemployment rate announced last Friday was more significant than the disappointing headline increase in payrolls. But John Williams of Shadow Statistics sheds some disturbing light on the data. Mr Williams has made his name by trying to see beyond changes in the methodology of compiling the data - maintaining a Clinton-era measure of inflation, for example, which is much higher than the official number.
Mr Williams points out that
the severe decline in economic activity has overwhelmed traditional patterns of seasonal activity, destabilising the calculation of seasonal-adjustment factors using the traditional mathematical models that are based on a number of years of activity, with the greatest weighting given to the most recent period's patterns.
This is particularly true of employment. While the headline seasonally-adjusted rate fell from 9.4% to 9% in January, it rose on an unadjusted basis from 9.1% to 9.8%. Similarly, the broader rate (which includes discouraged workers) fell from 16.7% to 16.1% on a seasonally-adjusted basis, but rose from 16.6% to 17.3% on an unadjusted basis. Clearly, since seasonal adjustments net out to zero over the year, one would expect a jump in the adjusted rate in some future month. Far from recovery, Mr Williams is talking of an intensifying double-dip recession.
ENGLAND and America are two countries separated by a common language, said George Bernard Shaw. Certainly, on my trip to the US last week, I found a gulf between my natural British pessimism and the can-do American spirit. In particular, this relates to expectations of future returns.
The standard assumption for pension fund returns is around 8% per annum. This seems to be based on past experience*. Corporate pension funds have a standard 60/40 asset split; state funds may be 70/30 (instructive that they are taking more risk on the taxpayers' dime). Treasury bonds yield 3% or so, which means the fixed income portion of a state's portfolio is generating 0.9%; the equity portion has to generate the other 7.1%, which equates to 10% a year.
How likely is that? It is a truism to say that equity returns come from three sources; the dividend yield, dividend growth and the change in the price/dividend ratio. This latter figure reflects the re-rating or de-rating of the market. If the dividend is unchanged, then a shift in the market's yield from 3% to 2% means a 50% capital gain. Figures from Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, in associaiton with Credit Suisse, show that global real equity returns over more than a century have averaged 5.5%. This has been made-up of an intitial yield of 4.1%, real dividend growth of 0.8% and a re-rating effect of 0.5% a year (the US figures are pretty much the same). As you can see, the initial yield is crucial.
So can we get to 10% nominal from current conditions? The S&P 500 currently yields 2.2%. Let's add in a further 1% for buy-backs (which are highly variable). Real dividend growth? Let us assume it doubles its historical average to reach 2% a year. And let us be bold and guess that, even though the market has a lower yield than the average, it does not get de-rated back to the mean, so there is no loss from the third factor. All that gets to 5% real growth; add in 2.5% for inflation (as measured in the bond market) and we get to 7.5% nominal return, before costs. Using those numbers a 70/30 equity/bond portfolio would generate a return of 6%.
What if inflation were higher, say 5%, then could equities generate the 10% return? Alas, it's not that easy. Equities wouild be de-rate in such circumstances; even a move in the yield from 2% to 4% implies a 50% fall in capital values. The bond part of the portfolio would lose money as well.
But that kind of reasoning tended to draw blank stares from my American hosts. Their reasoning was that equities have always beaten bonds (except in the last decade) by a wide margin and will continue to do so. That has been true of the US, where equities have always produced real returns over 20 years, as the LBS/Credit Suisse data show. But it has not been true in Britain; and in France, there have been periods of 60 years or more when equities have not produced positive real returns.
In short, America is the ultimate example of survivorship bias. Go back to 1900 and you might have picked Argentina or Russia as emerging nations with the ability to rival the US but each proved to be a huge disappointment. The equity risk premium is just that; compensation for risk. It cannot be guaranteed.
*Of course, the higher the assumed return, the less the sponsor has to contribute, so there is a bias towards optimism.
UPDATE: Just to respond on the discount rate front, the unions in Illinois were very keen to tell me their pensions were constitutionally protected. In Vallejo, California, bondholders are taking a hit thanks to the ciry's troubles, but not pensioners. So a benefit that can't be cut looks like a pretty solid obligation to me and thus must be discounted at the risk-free rate. After all, companies borrow in the form of long-term bonds; doubtless they expect to invest that money and earn a higher return. But they can't say the bonds should only be valued at 50 cents on the dollar on their balance sheets, because they expect to earn a higher return; the fraud squad would be after them in 5 minutes.
UPDATE 2: On the truism point, this reasoning applies at the market level (this is known as the Gordon growth model). Yes, in terms of individual stocks, owning a dividend-less share implies that the company will start paying dividends later (as Nicrosoft did) or that the company can be broken up (or taken over) and the cash returned to investors. On inflation, the states use nominal numbers which is why I did. There are limited cost-of-living adjustments in most cases. In theory, the problem could be inflated away (creating a problem for pensioners, of course) but the states cannot generate inflation on their own.
Feb 2nd 2011, 23:08 by Buttonwood | WASHINGTON, DC
YOU leave Britain for just three days and what happens? Turn on the TV and you find that Britain is going to be part of an "Islamic caliphate". This is on the US's "most-watched cable news network". There is no mention of this at home but perhaps my wife is trying not to worry me. I am surprised the FTSE 100 and sterling haven't taken more of a hit.
Mind you, it's not the strangest theory I've ever heard. Once I had a letter from a reader warning me of an international Swedish conspiracy to control the world (sounds like a good idea; the world would be a much nicer place). But those were innocent days when people who wrote letters in green ink didn't get to host TV shows.
THERE have been some odd things going on in the markets over the last two weeks. The euro has staged a remarkable recovery, hitting $1.3760 as I write, presumably because fears about the sovereign debt crisis are receding. That looks very premature. Could it be a dollar decline, rather than euro strength? After all, even the pound has hit $1.60, despite all Britain's economic problems. But that explanation looks unlikely given the recent weakness of gold, which has usually moved in the opposite direction to the dollar; many people see it as an alternative currency. Perhaps the answer is that traders are simply unwinding their early 2011 positions, when they came into the year short the euro and long gold.
Another puzzle is why risky assets aren't taking more fright that Brent crude is at $100 a barrel, a factor that has been bad news for the economy and markets in the past.
Meanwhile, the wind outside my NY hotel room makes it sound like King Lear and my plans to investigate Illinois pensions look at risk from the "worst storm since 1967" in Chicago. We British always complain about our weather but now I'm reconsidering.
ALL the analysis of stockmarket prospects for 2011 focused on earnings, rate hikes, Republican control of the House, the sovereign debt crisis in Europe, the sustainability of the Chinese boom, high commodity prices etc etc
I don't recall anyone (including your blogger) predicting that the market might be vulnerable to riots in Egypt. Yet that's why the market seems to be falling today, as investors fret that the Middle East might get embroiled in war again. Egypt was a reliable US ally and a non-threatening presence on Israel's border, but its government has long suppressed dissent. It would be nice to think that a democratic tide is sweeping the region but instead of several post-1989 Polands, we could get a few post-1979 Irans.
Anyway, it's a timely reminder of the impossibility of stockmarket forecasting. My view tends to be that you look at long-term measures (like the cyclically-adjusted ratio or the dividend yield) and figure out that when valuations are high, future returns are likely to be low. You don't know when the bad news will come, or in what form - pyramids or profits - but you figure something will happen to disturb the rosy consensus. Back when I was on the FT's Lex column in 1990, we were bearish and looked wrong until the market plunged when Saddam invaded Kuwait. Go figure.
I'm touring the US next week (researching pensions) so blogs may be a bit intermittent.
THE pound has fallen significantly over the last three years, which is one reason why inflation is higher than in most of Europe. As Mervyn King pointed out in a speech this week, real wages are falling but that is a necessary condition for the UK economy to be rebalanced from consumption to manufacturing. Most voters won't enjoy the process.
It is easy to forget that devaluation involves a reduction in a country's standard of living; the goods one has to import become more expensive. The gamble is that exporters will gain (and domestic manufacturers will gain market share from imports) more than consumers will lose. It is akin to a temporary employee cutting his hourly rate in the hope that he will then be asked to work for more hours.
The US is shielded from this problem because so many commodities are priced in dollars. However, the US does buy a lot of goods from China, and the US is lobbying for the dollar to devalue against the renminbi. It may well be that the Chinese cost advantage is so great that the even a substantial renminbi revaluation/dollar devaluation will not make much of a difference to trade flows, but the currency change will show up in the form of higher prices for US consumers.
Historically, devaluations were seen as a foolish strategy, merely leading to inflation which would eat away the temporary cost advantage gained by the corporate sector. It was associated with banana republics; sound economies had sound currencies.
Of course, the problem arises when, as with Greece, the economy is already uncompetitive, and a devaluation is required but not an option. Under tradtional fixed rate systems, based on gold, Greece would not have got into this situation since its reserves would have run out long ago, forcing it to adjust policy at an earlier stage. The euro combines the rigidity of fixed exchange rates, without the discipline needed to prevent imbalances. Some countries thought they had a free lunch, by linking their borrowing costs to those of Germany; now they are getting the bill.
The downgrade by S&P of Japanese debt from AA to AA- only takes the country's rating back to where it was in 2007. It is worth remembering that AA- is still an extremely good credit rating, with a very low probability of default. And, of course, Japan has a long history of trade surpluses so it owes its debt to its own citizens.
Nevertheless, there is still a distributional problem; the people who own the debt and the people who pay the taxes are not one and the same. And this is a bit of a game of chicken. The total debt/GDP ratio of Japan is high but rates are low, making debt sevrice currently affordable. But if creditors think the government is likely to default (or inflate the debt away), they will drive up yields, so that the debt burden becomes less affordable. That will increase the temptation to default and bring the crisis forward.
THE decline in Britain's fourth quarter GDP of 0.5% was a nasty shock for the markets (in the US, that figure would have been reported as an annualised 2%) and a reminder that economists are pretty hopeless at forecasting. Often, the most startling numbers are revised on second estimates - but it is hard to see how that can be turned into the expected 0.5% increase.
It will be blamed on the snow in December but continental Europe was disrupted by snow too and it seems unlikely its figures will be as bad (just as high British inflation is blamed on commodity prices that the rest of Europe is also managing to cope with).
Worth remembering too that this GDP decline occurred before the bulk of the austerity programme kicks in - the Keynesians (led by Labour's Ed Balls) will be citing this as evidence that you can't cut your way to growth. This is a classic St Augustine problem - we want a balanced budget but not now, just as the world wants to see the American current account deficit eliminated but not yet.
This last point was the focus of a speech by Charles Dumas of Lombard Street Research at an Amsterdam conference I'm attending (hosted by Liability Driven Investment Europe). He thinks the US has bought the world a year in 2011 by extending the fiscal stimulus, and by extending QE. But the Republicans will try to prevent President Obama from stimulating the US economy in 2012 when he is running for re-election. As the US current account deficit shrinks, in the face of austerity, that will be bad news for the export-led models of China, Germany and Japan.
In a sense, developed world governments have a stark choice. They can prop up their economies in the short-term at the risk of making the long-term debt and trade problems worse; or they can try to be prudent, at the risk of damaging growth in the short-term and incurring electoral unpopularity.