My article for Business Post from Friday covering ECB's latest announcements on QE and interest rates: https://www.businesspost.ie/opinion/ecbs-shift-gears-presents-another-set-risks-418797.
Sunday, June 17, 2018
My article for Business Post from Friday covering ECB's latest announcements on QE and interest rates: https://www.businesspost.ie/opinion/ecbs-shift-gears-presents-another-set-risks-418797.
Friday, June 15, 2018
Our new article on dynamic properties and systemic risks of key cryptocurrencies is available at:
Gurdgiev, Constantin and Corbet, Shaen, Ripples in the Crypto World: Systemic Risks in Crypto-Currency Markets (June 15, 2018). International Banker, June 2018 https://internationalbanker.com/brokerage/ripples-in-the-crypto-world-systemic-risks-in-crypto-currency-markets/ . Ungated version: https://ssrn.com/abstract=3197351.
Nothing illustrates the state of asset valuations today better than the junk bonds tale from Italy. Here is a prime example from the Fitch ratings note from June 7:
"...longstanding Italian HY issuer and mobile operator WindTre sequentially refinanced crisis-era unsecured notes at 12% coupons into 3% area coupons by January 2018, despite losing cumulative revenue and EBITDA of 30% and 25%, respectively, and re-leveraging from 4x to 6x."
Give this a thought, folks:
- We expect rates to rise in the future on foot of ECB unwinding its QE, the Fed hiking rates and monetary conditions everywhere around the world getting 'gently' tighter;
- Euro is set to weaken in the longer run on foot of Fed-ECB policies mismatch;
- WindTre issues replacement debt, increasing its leverage risk by 50%, as its revenue falls almost by a thirds and its EBITDA falls by a quarter;
- WindTre operates in the market that is highly exposed to political risks and in an economy that is posting downward revisions to growth forecasts.
And the investors are piling into the company bonds, cutting the cost of debt carry for the operator from 12 percent to 3 percent.
Per FT (https://www.ft.com/content/31c635f4-64df-11e8-a39d-4df188287fff): "Lending to corporates rose 1.2 per cent in the year to February 2018, according to the Bank of Italy, and the average interest rate on new loans was 1.5 per cent — a historic low."
Say big, collective "Thanks!" to the folks at ECB, who worked hard to bring us this gem of a market, so skewed out of reality, one wonders what it will take for markets regulators to see build up of systemic risks.
Saturday, June 9, 2018
I just posted on @twitter a short thread concerning the U.S.-EU trade and payments balances from 2003 through 2017 and a trend-based forecast for same out to 2021. The thread can be accessed here: https://twitter.com/GTCost/status/1005467563034152961.
The key problem is that in his trade policy strategy, President Trump appears to be oblivious to several key factors that materially determine the true extent of imbalances the U.S. trade with the EU, including:
- Trade in services: while the U.S. is running a large (USD 153 billion dollars in 2017) deficit in goods trade with respect to the EU (and this deficit is persistent since 2003), the U.S. is running USD 51.3 billion surplus in services against the EU, and this surplus is rising (with some volatility).
- When trade balance is augmented by transfer payments (accounting for profits of the U.S. companies earned in the EU, less profits of the EU companies earned in the U.S., plus net transfers from the US to EU residents, including pensions payments, etc), the U.S. was running a surplus of USD14.22 billion in 2017 with respect to the EU. In fact, the current account balance for the U.S. with respect to the EU has been in surplus (in favour of the U.S.) since 2009, with 2008 figure being statistically zero (balance).
- U.S. net lending (+) or borrowing (-) from current- & capital-accounts vis-a-vis the EU has been in surplus every year since 2008.
- In fact, the 'New Economy' (services, IP etc) have generated a huge surplus for the U.S. when trade and income flows with the EU are accounted for.
- U.S. true exports to the EU are obscured by the U.S. multinationals accounting strategies that aim to minimise their tax exposures to the U.S. by engaging in extensive transfer pricing, shifting of tax base and complex offshoring of retained earnings. Were these factors taken into the account, the U.S.
- Over 2009-2017 period, cumulative balance on trade in goods and services, plus primary and secondary income with the EU, stood at USD 57.3 billion in favour of the U.S. and cumulative net balance on capital and current account transactions basis was USD 112.7 billion in favour of the U.S.
Prior to the G7 Summit President Trump complained in a tweet that the U.S. was running a deficit of USD 151 billion with the EU. The official figure from the U.S. Department of Commerce, however, is USD 153 billion but this figure only covers trade in goods.
The dynamics of full net cumulated 2003-207 balance in payments and trade for U.S.-EU trade, including forecast out to 2021 (pure trend forecast, not accounting for other factors that favour the U.S.) is presented below:
In simple terms, President Trump's trade war on the EU is unwarranted, dangerous, damaging to both economies and a major negative for the U.S. standing in the global economy. It is also reflective of his deeply economically illiterate understanding of the complexities of national accounts.
Friday, June 8, 2018
I have written a lot about the twin secular stagnations hypothesis that I defined few years ago as a combination of two separate secular stagnation propositions. According to my running definition:
“The Twin Secular Stagnations Hypothesis combines two sources of the statistically significant reduction in the potential growth in the economy as:
- Supply-side Secular Stagnation: a proposition that future growth is likely to be slower amongst the advanced economies due to the decline in returns to innovation and lower growth rate in the labour force; and
- Demand-side Secular Stagnation: a proposition that future growth is being pushed down by the adverse demographics (ageing population) and the legacy of the Global Financial Crisis, the Great Recession and the Euro Area Sovereign Debt Crisis, which result in lower potential investment, slower growth in demand, and the rising cost of social services, pensions and healthcare provisions.”
An interesting piece of evidence, supporting the ‘productivity-labour force’ nexus of the Twin Secular Stagnations Hypothesis has been recently presented by Mary Daly, the executive vice president and Director of Research in the Economic Research Department of the Federal Reserve Bank of San Francisco (full article here: https://www.frbsf.org/economic-research/publications/economic-letter/2018/april/raising-speed-limit-on-future-growth/).
First, on evidence of secular stagnation: "Average GDP growth over the 60 years preceding the Great Recession, was just under 3.5%. But if we look ahead, economists forecast numbers closer to 2%." In other words, we are looking at long term growth rate or potential growth rate that is almost 43 percent below the empirical rates of growth experienced over the last 60 years.
Next: the evidence of nexus. Per Daly, to "account for the dramatic change in prospects" for future growth in the U.S. "To explain that, we need to look at the fundamental drivers of economic growth: growth in productivity and the labor force."
Figure 1 shows the extent to which the labor force-productivity nexus drove growth over the last 7 decades, and is expected/forecast to do so in 2017-2025 period:
Daly notes that "productivity growth has varied over time, but since the 1980s has contributed on average about 1.5% to growth and is forecast to do the same going forward." This is, at best, incomplete. In reality, as the chart shows, productivity growth penciled in for 2017-2025 is slower than in the 1980s, 1990s, and 2000-2007. In fact, labour productivity growth in 2017-2025 is forecast to run roughly at an average rate of the 1970s, 1980s and 2008-2016. This is set against the technological revolution we are allegedly experiencing which should, all thing equal, be driving up labour productivity growth in 2017-2025 over and above the 1980s-1990s period. But, in fact, labour productivity growth contribution to GDP growth has shrunk in 2000-2007, and then again in 2008-2016 (the Great Recovery) and now set to be below the 1990s over the period 2017-2025. So all is NOT well with productivity growth.
The second point, well-argued by Daly is that labour force contribution to GDP growth is shrinking and shrinking catastrophically. That is clear from the Figure above.
On the latter point, Daly shows that labour force participation rates (also a subject of frequent coverage on this blog), have fallen off the cliff in recent years: "We’ve also seen a drop in the level of labor force participation among workers in their prime employment years, a pattern that does look quite a bit different from other countries. Labor force participation in the United States for prime-age workers reached a peak in the late 1990s and then took a steep dive in the 2001 recession. In the 2007 recession, it took an even steeper tumble, reaching a low point in 2015... While we have seen improvements since, they have been modest. So today, the share of men and women in their prime working years who are employed or actively searching for a job is far lower than it was in the 1990s."
So, Daly asks a very important question: "Why aren’t American workers working?" And proceeds to give an interesting explanation: "research by a colleague from the San Francisco Fed and others suggests that some of the drop owes to wealthier families choosing to have only one person engaging in the paid labor market (Hall and Petrosky-Nadeau 2016)."
Why is it interesting? Because those who can afford single-earner households today are a vast minority. The original research from the Fed cited by Daly is here: https://www.frbsf.org/economic-research/publications/economic-letter/2016/february/labor-force-participation-and-household-income/. And here is the chart that shows the key findings from the research:
Observe that the deepest reduction in labour force participation is for the 3rd quartile of income earners. How much do these families earn? "In 2013, households in the lowest 25% of the income distribution, or the first quartile, had an average monthly income of less than $1,770. The median total household monthly income was $3,430. At the top of the distribution, the lower bound for being in the highest 25% of households, or the fourth quartile, was a monthly income of $5,993." Now, can you imagine in these modern days a household earning less that $5,993 per month in pre-tax income being able to afford not to engage the second partner in work? Personally, I can't. Unless these households benefit from huge transfers via inheritance or within-family housing subsidies, etc. But... per same paper, "On average in 2013, the upper-level households derived about 96% of their monthly income from working. For households in the poorest quartile, earnings made up about 62% of monthly income, while another 23% came from unemployment compensation, social security, supplemental social security, and food stamps." Which means that these very same households that, apparently, voluntarily withdrawing labour force participation, are not gaining much from non-labour income transfers.
So, these volunatry exits from the labour force are, apparently, impacting households more dependent on labour income AND not the highest income quartile households. Something is fishy.
Second piece of evidence from the paper cited by Daly is age cohorts of 'leavers':
This too shows that something is fishy in the data. Households in 55+ age group are more likely to have higher incomes. They are increasing labour force participation despite the fact that it is harder for them to gain quality jobs due to age effects. Households in 25-54 age bracket are exiting the workforce, just at the time when their earnings from work should be rising and just in time when they need to service student loans, mortgages, schooling for kids, pensions etc.
Again, the evidence presented simply contradicts the arguments made: both age cohorts and income cohorts analysis does not appear to support the proposition that families are voluntarily exiting the labour force, reducing their labour income to single source provision.
I am not buying this. The fact that the 3rd quartile of families are exiting the workforce is not a sign of preferences for leisure or household employment. It is, rather, a sign that the jobs market is no longer promising for the upper-middle classes, especially for the younger workers. It is a sign that families are increasingly reliant on familial transfers for housing and contingent workforce employment, both under-reported to the official stats gatherers.
Daly hints at this in her reference to the 'second factor' driving decline in labour force participation: the disappearance of the mid-level skills jobs, including the decline due to automation: "A growing body of research finds that these pressures on middle-skilled jobs leave a big swath of workers on the sidelines, wanting work but not having the skills to keep pace with the ever-changing economy". Now, that hits the target far better than the argument that people are just exiting workforce to have good times and home-school their kids.
And worse, Daly is also on the money when she points out that the U.S. system is woefully inadequate when it comes to provisions for investing in human capital: "Like in most advanced economies, job creation in the United States is being tilted toward jobs that require a college degree (OECD 2017). Even if high school-educated workers can find jobs today, their future job security is in jeopardy. Indeed by 2020, for the first time in our history, more jobs will require a bachelor’s degree than a high school diploma (Carnevale, Smith, and Strohl 2013)." Yet, "although the share of young people with four-year college degrees is rising, in 2016 only 37% of 25- to 29-year-olds had a college diploma (Snyder, de Brey, and Dillow 2018). This falls short of the progress in many of our international competitors (OECD 2018), but also means that many of our young people are underprepared for the jobs in our economy."
There are added dimensions / nuances to this. Some of the U.S. college education is of questionable quality, compared to more evenly-distributed quality of college education in Europe, Japan and Australia. Top Universities deliver top tier output. But for-profit colleges and some lower-end school deliver nothing worth talking about. A 4-year system of undergraduate education is effectively a correction on already poor quality high schools output, requiring the first year of college to be a remediation year to compensate for the lack of proper standards in secondary education. Two-year masters programs are, then, designed to take the first year to correct for the shortfalls in education quality in undergraduate levels. And so on. In effect, the U.S. higher education system is designed to inflict maximum financial damage (via costs and debt of year 1 education in undergraduate and post-graduate systems), while taking a cut of two years from the graduates careers. This is similar to what Italian system delivers, except in the case of Italians, it delivers also higher quality content in secondary and undergraduate education, taking longer time to learn more.
And so on. In simple terms, as Daly tacitly acknowledges, the U.S. economy is racing toward higher degree of automation and greater skills intensity, while running low on human capital investments. The solution to this historical problem has been to import younger, smarter foreigners via a range of schemes - from graduate schools admissions to H1Bs. But this solution is not sufficient to correct for the rate of acceleration in skills intensity. And it is not functioning in redressing training and skills gaps that already exist in the economy.
Daly notes that one important aspect of change must touch upon the need to "equalize educational attainment across students of different races and ethnicities." This, undoubtedly, is one key factor in attempting to address the human capital investment gaps. The problem, of course, is how does one achieve this? Historically, the U.S. States have gone about the problem by lowering standards and quality of secondary education curriculum for all students. They also increased quotas-based admissions for minorities. The former does nothing for actually stimulating investment in human capital. The latter creates a zero-sum game out of education system, unless new investments go into college education provision. Which is not happening, despite rampant price inflation in higher education.
Daly makes a strong case for more investment in college education. But she does not make the equally important case that such investment must start at pre-primary level and work through a combination of increased resources and higher standards across all grades and for all students. She correctly states that "In the parlance of economics, education is incentive compatible, good for everyone involved", when it comes to students, taxpayers and the economy.
But she does not recognise that better education is not incentive-compatible for one key set of participants in the market: teachers and schools administartors. In fact, in primary and secondary education systems, in the U.S., incentives for teachers are aligned toward delivering more standardised, less rigorous, less-transparent in quality, outcomes, such as rota learning and teaching-to-test. Daly says nothing as to how this problem can be addressed, despite the fact that all past reforms of the U.S. education system were led by teachers and their Unions, not by parents or other economic agents.
Finally, there is a problem of generational cohorts. Any investment in education system today will hold promise of altering the status quo of human capital investments for the cohorts of those under the age 30 (given the levels of debt accumulated by the recent graduates, probably for those under the age of 25). Which leaves the rest of the households - the vast majority of them, in fact - just where we have them today: under-skilled, facing the risk of their existent human capital depreciation to automation, etc. Formal education cannot address these problems systemically. Take an argument ad absurdum as an illustration. Suppose we invest enough funding into the current higher education system to provide 100% college graduation for those current under 25 years of age. Suppose we even fix the quality vs quantity problem in the U.S. education system. This will improve the productivity and jobs prospects for the very young. But it will make the older generations of workers (older = 25 years of and above) even less competitive, leading to further reductions in their incomes, career prospects and labor force participation rates.
Have we fixed anything when it comes to the Twin Secular Stagnations Hypothesis? Not really. Have we addressed the polarisation gap between life-cycle earnings of the lower earners and higher earners (the dropping-out of the U.S. middle class)? Not really. Have we done anything to alleviate political disillusionment amongst the U.S. voters with the economic system that reduces their social and economic mobility? Not really. So even in ad absurdum case of Daly-proposed solution success, we have fixed little if nothing at all. We, in fact, might have made the disease more deadly.
In sum, we do need more investment in education. But we also need smarter education systems reforms. And we need a parallel investment in increasing human capital investments for those already in the labour force, and those of older age cohorts who have been dropping out of it. We need a systemic approach to addressing skills depreciation arising from automaton. And we need a systemic approach to tackling economic value-added displacement away from labour, toward pure profits and technological capital. The longer we delay these major, pivotal reforms, the bigger the problem of the secular stagnation gets.
Thursday, June 7, 2018
I have recently written about rising firm power in labour markets, driven by monopsonisation of the markets thanks to the continued development of the contingent workforce: http://trueeconomics.blogspot.com/2018/05/23518-contingent-workforce-online.html. In this, I reference a new paper "Concentration in US labour markets: Evidence from online vacancy data" by Azar, J A, I Marinescu, M I Steinbaum and B Taska. The authors have just published a VOX blog post on their research, worth reading: https://voxeu.org/article/concentration-us-labour-markets.
Monday, June 4, 2018
Cyclicality in markets returns and political environment is an interesting and under-researched topic. Here is a great post on the subject: https://fat-pitch.blogspot.com/2018/05/trading-worst-6-months-and-presidential.html.
In my previous post, I talked about the Too-Big-To-Fail Euro state, #Italy - a country with massive debt baggage that is systemic in nature.
Here is Project Syndicate view from Carmen Reinhart: https://www.project-syndicate.org/commentary/italy-sovereign-debt-restructuring-by-carmen-reinhart-2018-05.
An interesting graph, charting a combination of the official Government debt and Target 2 deficits accumulated by Italy:
Quote: "With many investors pulling out of Italian assets, capital flight in the more recent data is bound to show up as an even bigger Target2 hole. This debt, unlike pre-1999, pre-euro Italian debt, cannot be inflated away. In this regard, it is much like emerging markets’ dollar-denominated debts: it is either repaid or restructured."
The problem, of course, is the ECB position, as mentioned in my article linked above. It is more than a reputational issue. Restructuring central bank liabilities is easy and relatively painless when it comes to a one-off event within a large system, like the ECB. So no issue with simply ignoring these imbalances from the monetary policy perspective. However, the ECB is a creature of German comfort, and this makes any restructuring (or ignoring) of the Target 2 imbalances a tricky issue for ECB's ability to continue accumulating them vis-a-vis all other debtor states of the euro area. Should a new crisis emerge, the ECB needs stable (non-imploding) Target 2 balance sheet to continue making an argument for sustaining debtor nations. This means not ignoring Italian problem.
Here is the picture mapping out the problem:
Reinhart warns, in my opinion correctly, "In the mildest of scenarios, only Italy’s official debt – held by other governments or international organizations – would be restructured, somewhat limiting the disruptions to financial markets. Yet restructuring official debt may not prove sufficient. Unlike Greece (post-2010), where official creditors held the lion’s share of the debt stock, domestic residents hold most of Italy’s public debt. This places a premium on a strategy that minimizes capital flight (which probably cannot be avoided altogether)."
In other words, as I noted years ago, Italy is a 'Too-Big-To-Fail' and a 'Too-Big-To-Save' or TBTF/TBTS problem for the euro area.
My article on Italian (and Spanish and Dutsche Bank) mess in Sunday Business Post: https://www.businesspost.ie/business/italys-problem-europes-problem-417945.
Unedited version of the article here:
This fortnight has been a real roller-coaster for the European markets and politics. Only two weeks ago, I wrote about the problems of rising political populism in Italy and Spain as the signals of a broader trend across the block’s member states. This week, in Spain a no confidence motion in Mariano Rajoy’s rule played a side show to Rome’s drama.
The timeline of events in Italy provides the background to this week’s lessons.
The country has been governed by a lame-duck executive since mid-2016. Fed up with Rome’s gridlock, in March 2018 general election, Italians endorsed a parliament split between the populist-Left M5S and the far-Right group of parties led by the League. Month and a half of League-M5S negotiations have produced a shared policies platform, replete with radical proposals for reshaping country’s Byzantine tax and social welfare systems. The platform also contained highly controversial proposals to force the ECB to write down EUR250 billion worth of Government debt, a plan for restructuring fiscal rules to allow the country to run larger fiscal deficits, and a call for immigration system reforms.
On Monday, the President of the Italian Republic, Sergio Mattarella, a loyal Euro supporter, vetoed the League-M5S candidate for the economy ministry, Eurosceptic Paolo Savona. The result was resignation of the League-M5S Prime Minister-designate, Giuseppe Conte, and a threat of an appointment of the unpopular technocrat, Carlo Cottarelli, an ex-IMF economist nicknamed Mr. Scissors for his staunch support for austerity, as a caretaker Prime Minister. By Thursday night, Conte was back in the saddle, with a new coalition Government agreed and set to be sworn in on Friday.
Crisis avoided? Not so fast.
Risk Blow Out
The markets followed the political turns and twists of the drama. On Tuesday, Italian bonds posted their worst daily performance in over 20 years. The spike in the 2-year bond yield was spectacular, going from 0.3 percent on Monday morning to 2.73 percent on Tuesday, before slipping back to 1.26 percent on Thursday. The 10-year Italian bond yield leaped from 2.37 percent to 3.18 percent within the first two days, falling to 2.84 percent a day after.
To put these bond yields’ movements into perspective, at the week’s peak yields, the cost of funding Italian EUR2.256 trillion mountain of Government debt would have risen by EUR45 billion per annum - more than the forecast deficit increases under the reforms proposed in the League-M5S programme.
Thus, despite the immediate crisis yielding to the new Coalition, a heavy cloud of uncertainty still hangs over the Euro area’s third largest member state. Should the new Government fail to deliver on a unified platform built by an inherently unstable coalition, the new election will be on offer. This will likely turn into a plebiscite on Italy’s membership in the Euro. And it will also raise a specter of another markets meltdown.
The Italian Contagion Problem
The lessons from this week’s spike in political uncertainty are three-fold. All are bad for Italy and for the entire euro area. Firstly, after years of QE-induced amnesia, the investment markets are now ready to force huge volatility and rapid risk-repricing into sovereign bonds valuations. Secondly, despite all the talk in Brussels and Rome about the robustness of post-2011 reforms, the Italian economy remains stagnant, incapable of withstanding any significant uptick in the historically-low borrowing costs that prevailed over recent years, with its financial system still vulnerable to shocks. Thirdly, the feared contagion from Italy to the rest of the Eurozone is not a distant echo of the crises past, but a very present danger.
Italy’s debt mountain is the powder keg, ready to explode. The IMF forecasts from April this year envision Italian debt-to-GDP ratio dropping from 131.5 percent at the end of 2017 to 116.6 percent in 2023. However, should the average cost of debt rise just 200 basis points on IMF’s central scenario, hitting 4 percent, the debt ratio is set to rise to 137 percent. This Wednesday bond auction achieved a gross yield of 3 percent on 10-year bonds. In other words, Italy’s fiscal and economic dynamics are unsustainable under a combination of higher risk premia, and the ECB monetary policy normalisation. The risk of the former was playing out this week and will remain in place into 2019. The latter is expected to start around November-December and accelerate thereafter.
With the government crisis unfolding, the probability of Italy leaving the Euro within 12 months, measured by Sentix Italexit index jumped from 3.6 percent at the end of the last week to 12.3 percent this Tuesday before moderating to 11 percent at the end of Thursday. This puts at risk not only Italian Government bonds, but the private sector debt as well, amounting to close to EUR2 trillion. A rise in the cost of this debt, in line with Government debt risk scenarios, will literally sink economy into a recession.
As Italian Government bonds spreads shot up, other European markets started feeling the pain. Based on the data from Deutsche Bank Research, at the start of 2018, foreign banks, non-bank investors and official sector, including the Euro system, held ca 48 percent of the Italian Government debt. In Spain and Portugal, this number was closer to 65 percent. In other words, the risk of falling bonds prices is both material and broadly distributed across the European financial system for all ‘peripheral’ Euro states.
As a part of its quantitative easing program, the ECB has purchased some EUR250 billion worth of Italian bonds. A significant uptick in risk of Italy’s default on these bonds will put political pressure on ECB. Going forward, Frankfurt will face greater political uncertainty in dealing with the future financial and fiscal crises.
Research from the Bank for International Settlements puts Italian banks’ holdings of Government bonds at roughly EUR 450 billion. Ten largest Italian banks have sovereign-debt exposures that exceed their Tier-1 capital. As the value of these bonds plunges, the solvency risks rise too. Not surprisingly, over the last two weeks, shares of the large Italian banks fell 10-20 percent. These declines in equity prices, in turn, are driving solvency risks even higher.
Beyond the Italian banks, French financial institutions held some EUR44 billion worth of Italian bonds, while Spanish banks were exposed to EUR29 billion, according to the European Banking Authority.
The second order effects of the Italian risk contagion play through the other ‘peripheral’ euro area bonds. As events of this week unfolded, in line with Italy, Spain, Portugal and Greece have experienced relatively sharp drops in their bonds values. All three are also subject to elevated political uncertainty at home, made more robust by the Italian crisis.
Thus, if the Italian government bond yields head up, banks’ balance sheets risks mount through both, direct exposures to the Italian Government bonds, and indirect effects from Italian contagion on the broader government debt markets, as well as to the private sector lending.
At the end of this week, all indication are that the Italian contagion crisis is receding. The new risk triggers are shifting out into late 2018 and early 2019. The uneasy coalition between two populist moments, the M5S and the League, is unlikely to survive the onslaught of voter dissatisfaction with the state of the economy and continued immigration crisis. At the same time, the coalition will be facing a highly skeptical EU, hell-bent on assuring that M5S-League Government does not achieve much progress on its reforms. All in, the new Government has between six and twelve months to run before we see a new election looming on the horizon.
The Italian crisis might be easing, but it is not going away any time soon. Neither the Spanish one. Oh, and with a major credit downgrade from the Standard & Poor’s and the U.S. Fed, here goes the systemic behemoth of European finance, the Deutsche Bank.
Friday, May 25, 2018
One of the key promises of cryptocurrencies to their 'users'/'investors'/'gamblers' has been that of security of data stored on cryptos-backed blockchains and crypto 'assets' held by their owners. Yet, scandal after scandal, the myth has been deflated by the news flows, with security breaches, theft and fraud hitting the cryptos markets with frequency and impact not seen in traditional investment venues and asset classes.
Research by the Anti-Phishing Working Group released on Thursday shows that criminal activities have resulted in a theft of some $1.2 billion in cryptocurrencies since the beginning of 2017 (https://www.reuters.com/article/us-crypto-currency-crime/about-1-2-billion-in-cryptocurrency-stolen-since-2017-cybercrime-group-idUSKCN1IP2LU). Which is a significant number, but most likely an under-estimate to the true extent of theft and excludes fraud, especially fraud relating to the notorious ICOs.
In January-April 2018, ICOs raised some $6.6 billion, marking a 65% increase on 4Q 2017 ($3.9 billion in ICOs funding). Based on WSJ report that surveyed 1,450 ICOs, roughly 20 percent of the new offers raise major red flags for scams, including “plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams”. Again, this is just a part of an iceberg. Ca half of all ICOs projects had no actual service or product offer behind them. In other words, investors in more than half of all ICOs were backing nothing more than a technological white paper, absent even a rudimentary business plan.
While there have been a lot of discussion in recent months about the potential Ponzi-game nature of the cryptos markets, irrespective of where you stand on the issue, there are two questions every investor must ask before dipping into the cryptos waters:
- Do I, as an investor, really comprehend the risks, uncertainties, complexities, and ambiguities imbedded in product offers I am considering investing in? and
- Do I, as an investor, have meaningful avenues for monitoring, hedging and/or ameliorating the above risks, uncertainties, complexities, and ambiguities imbedded in product offers I am considering investing in?
Now, without any sense of irony, when it comes to cryptos and ICOs, for any, even the most-informed and seasoned investor, the answers to (1) and (2) are 'No'. Which means that cryptos and ICOs are not a form of investment, but a form of speculative gambling. Nothing wrong with playing some chips at an unregulated casino, of course. Feel free to do so at own risk.
Update: A new research report (https://cointelegraph.com/news/ethereum-classic-51-attack-would-cost-just-55-mln-result-in-1-bln-profit-research) estimates that "it could take just $55 mln to hack a major cryptocurrency network for $1bln profit", providing yet more evidence that a "successful 51% attacks to control hashpower" previously deemed "too expensive and would result in making the attacked currency worthless" is no longer 'too expensive' and can deliver signifcantly higher profit margins than mining. So much for 'secure decentralized un-hackable' assets, thus.
Thursday, May 24, 2018
A recent paper by Luigi Zingales of the University of Chicago, titled "Towards a Political Theory of the Firm" (NBER Working Paper No. 23593, July 2017: http://www.nber.org/papers/w23593) deals with the issue of rent-seeking behavior by monopolistic firms through political influence. "Neoclassical theory assumes that firms have no power of fiat any different from ordinary market contracting, thus a fortiori no power to influence the rules of the game," writes Zingales. "In the real world, firms have such power. I argue that the more firms have market power, the more they have both the ability and the need to gain political power. Thus, market concentration can easily lead to a “Medici vicious circle,” where money is used to get political power and political power is used to make money."
In his opening to the paper, Zingales notes 2016 report by Global Justice Now showing that 69 of the world’s largest 100 economic entities are now corporations, not governments. Using "both corporation and government revenues for 2015, ten companies appear in the largest 30 entities in the world: Walmart (#9), State Grid Corporation of China (#15), China National Petroleum (#15), Sinopec Group (#16), Royal Dutch Shell (#18), Exxon Mobil (#21), Volkswagen (#22), Toyota Motor (#23), Apple (#25), and BP (#27). All ten of these companies had annual revenue in higher than the governments of Switzerland, Norway, and Russia in 2015. ...In some cases, these large corporations had private security forces that rivaled the best secret services, public relations offices that dwarfed a US presidential campaign headquarters, more lawyers than the US Justice Department, and enough money to capture (through campaign donations, lobbying, and even explicit bribes) a majority of the elected representatives. The only powers these large corporations missed were the power to wage war and the legal power of detaining people, although their political influence was sufficiently large that many would argue that, at least in certain settings, large corporations can exercise those powers by proxy."
Despite this reality, economic theory largely ignores the issue of political power of the firms despite the fact that throughout modern history, "the largest modern corporations facilitated a massive concentration of economic (and political) power in the hands of a few people, who are hardly accountable to anyone." And despite the well-established fact (including through the precedent of the U.S. sanctions), that "...many of those giants (like State Grid, China National Petroleum, and Sinopec) are overseen by a member of the Chinese Communist party." Worse, as Zinglaes notes, "In the United States, hostile takeovers of large corporations have (unfortunately) all but disappeared, and corporate board members are accountable to none. Rarely are they not reelected, and even when they do not get a plurality of votes, they are coopted back to the very same board (Committee on Capital Market Regulation, 2014). The primary way for board members to lose their jobs is to criticize the incumbent CEO (see the Bob Monks experience in Tyco described in Zingales, 2012). The only pressure on large US corporations from the marketplace is exercised by activist investors, who operate under strong political opposition and not always with the interest all shareholders in mind."
So Zingales argues "that the interaction of concentrated corporate power and politics it a threat to the functioning of the free market economy and to economic prosperity it can generate, and a threat to democracy as well." Which, of course, is simply consistent with existence of the set of market-linked trilemmas, such as The International Relations (Order) Trilemma that implies that in the presence of perfect capital mobility, the nation states can either pursue a democratic sovereign political set up or an objective of international stability/order, as well as. (see more on these here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2786660).
Logically, thus, economics need to be asking the following questions, largely ignored in the neo-classical theory of the firm: "To what extent can the power firms have in the marketplace be transformed into political power? To what extent can the political power achieved by
firms be used to protect but also enhance the market power firms have?"
As Zingales notes correctly, "US economic patterns in the last few decades have seen a rise in the relative size of large companies," as also documented in a number of posts on this blog:
for example, the rise of monopolistic competition here:
monopsonistic power here:
effects on regulatory enforcement efficiency here:
effects on democratic institutions here:
As the result, Zinglaes calls "attention to the risk of a “Medici Vicious Circle.” The “signorias” of the Middle Ages—the city-states that were a common form of government in Italy from the 13th through the 16th centuries--were a takeover of a democratic institution (“communes)” by rich and powerful families who ran the city-states with their own commercial interests as main objective. The possibility and extent of this Medici Vicious Circle depend upon several non-market factors. I identify six of them: the main source of political power, the conditions of the media market, the independence of the prosecutorial and judiciary power, the campaign financing laws, and the dominant ideology. I describe when and how these factors play a role and how they should be incorporated in a broader “Political Theory” of the firm."
The driver for this 'Medici Circle' dynamic is market concentration or monopolistic competition. Product differentiation and market regulation can bestow onto a firm a degree of market power that translates into market concentration (rising and significant share of market activity captured by the firm). While in the environment of continued innovation, such competitive advantage generates only temporary abnormal profits, the degree of market power can be significant enough to provide the firm with substantial resources (profits) to engage in lobbying activities, corruption and other rent-seeking activities. There are also symmetric incentives for the firms to engage in rent seeking. As Zinglaes notes: "If the ability to influence the political power increases with economic power, so does the need to do so, because the greater the market power a firm has, the greater the fear of expropriation by the political power". This sounds strange, but it is quite intuitive: as a firm gains market power, it's prices rise above the marginal cost, yielding abnormal economic profits to the firm at the expense of consumers. The Governments can (and do) claim political mandate to limit these profits by taxing the market dominant firms' profits (either through regulation or direct taxation), thus expropriating part of the abnormal profits.
In simple terms, "Most firms are actively engaged in protecting their source of competitive advantage: through a mixture of innovation, lobbying, or both. As long as most of the effort is along the first dimension, there is little to be worried about. ...What is more problematic is when a lot of effort is put into lobbying. In other words, the problem here is not temporary market power. ...The fear is of what I call a “Medici vicious circle,” in which money is used to gain political power and political power is then used to make more money. ...In the case of medieval Italy, it turned Florence from one of the most industrialized and powerful cities in Europe to a marginal province of a foreign empire. At least the Medici period left some examples of great artistic beauty in Florence. I am not sure that market capitalism of the 21st century will be able to do the same."
Zingales relates the Medici circle concept to the modern day U.S. economy. "In the last two decades more than 75 percent of US industries experienced an increase in concentration levels, with the Herfindahl index increasing by more than 50 percent on average. During this time, the size of the average publicly listed company in the United States tripled in market capitalization: from $1.2 billion to $3.7 billion in 2016 dollars... This phenomenon is the result of two trends. On the one hand, the reduction in the rate of birth of new firms, which went from 14 percent in the late 1980s to less than 10 percent in 2014. On the other hand, a very high level of merger activity, which for many years in the last two decades exceeded $2 trillion in value per year... The market power enjoyed by larger firms is also reflected in the increasing difficulty that smaller firms have in competing in the marketplace: in 1980, only 20 percent of small publicly traded firms had negative earnings per share, in 2010, 60 percent did... Barkai (2016) ...finds that the decrease in labor share of value added is not due to an increase in the capital share (that is, the cost of capital times amount of capital divided by value added), but by an increase in the profits share (the residuals), which goes from 2 percent of GDP in 1984 to 16 percent in 2014. ...By separating the return to capital and profits, we can appreciate when profits come from (non-replicable) barriers to entry and competition, not from capital accumulation. Distinguishing between capital and share allows Barkai (2016) also to gain some insights on the cause of the decline in the labor share. If markups (the difference between the cost of a good and its selling price) are fixed, any change in relative prices or in technology that causes a decline in labor share must cause an equal increase in the capital share. If both labor and capital share dropped, then there must be a change in markups—that is, the pricing power firms to charge more than their cost."
And fresh from the presses today: "US IG Chart of the Day: Global M&A deal flow has doubled YTD for a total of $1.5 trillion of announced deals. US-only deals account for about 37% of the global total, for $555 billion of transactions."
While firms require market power to acquire political power, access to political power is required to protect abnormal profits arising from market power. Which, in a highly polarised society (aka, the U.S. system of politics dominated by two mainstream parties) can result in political representation concentrated in the hands of minorities (e.g. Trump Presidency, gained absent major corporate support), and in ineffectiveness of lobbying monitoring (As Zinglaes notes: "Even when it comes to lobbying, the actual amount spent by large U.S corporations is very small, at least as a fraction of their sales. For example, in 2014 Google (now Alphabet) had $80 billion in revenues and spent $16 million in lobbying".) Which is, of course, quite ironic, given that the ongoing Robert Mueller probe of the Trump campaign is focusing almost exclusively on the violations in the legal or declared channels of lobbying, instead of the indirect forms of political influencing.
I will quote Zingales' conclusion almost in full here, for it is a powerful reminder to us all that we live in a world where corporatism (integration of State and corporate powers) and monopolisation / concentration of the markets are two key features of our environment, not only in the economic sense, but in the political / democratic domains as well.
"In a famous speech in 1911, Nicholas Murray Butler, President of Columbia University, considered the practical advances made by large corporations in the late 19th and early 20th century and stated: 'I weigh my words, when I say that in my judgment the limited liability corporation is the greatest single discovery of modern times, whether you judge it by its social, by its ethical, by its industrial or, in the long run, ...by its political, effects.' Butler was right, but this discovery of the modern corporate form – like all discoveries – can be used to both to foster progress or to oppress. The size of many corporations exceeds the modern state. As such, they run the risk of transforming small- and even medium-sized states into modern versions of banana republics, while posing economic and political risks even for the large high-income economies. To fight these risks, several political tools might be put into use: increases in transparency of corporate activities; improvements in corporate democracy; better rules against revolving doors and more attention to the risk of capture of scientists and economists by corporate interests; more aggressive use of the antitrust authority; and attention to the functioning and the independence of the media market. Yet the single most important remedy may be broader public awareness."
The latter bit is still woefully lacking in the Fourth Rome of Washington DC, where the usual, tired, unrealistic narrative of American Exceptionalism reigns supreme, and where the U.S. flags at the 4th of July picnics are still confused for meaningful symbols of the U.S. meritocracy and the American Dream, the native entrepreneurialism and the social mobility. Wake up, folks, and smell the roses.
Wednesday, May 23, 2018
The promise of the contingent workforce and technological enablement of ‘shared economy’ is that today’s contingent workers and workers using own capital to supply services are free agents, at liberty to demand their own pay, work time, working conditions and employment terms in an open marketplace that creates no asymmetries between their employers and themselves. In economics terms, thus, the future of technologically-enabled contingent workforce is that of reduced monopsonisation.
Reminding the reader: monopsony, as defined in labour economics, is the market power of the employer over the employees. In the past, monopsonies primarily were associated with 'company towns' - highly concentrated labour markets dominated by a single employer. This notion seems to have gone away as transportation links between towns improved. In this context, increasing technological platforms penetration into the contingent / shared economies (e.g. creation of shared platforms like Uber and Lyft) should contribute to a reduction in monopsony power and the increase in the employee power.
Two recent papers: Azar, J A, I Marinescu, M I Steinbaum and B Taska (2018), “Concentration in US labor markets: Evidence from online vacancy data”, NBER Working paper w24395, and Dube, A, J Jacobs, S Naidu and S Suri (2018), “Monopsony in online labor markets”, NBER, Working paper 24416, dispute this proposition by finding empirical evidence to support the thesis that monopsony powers are actually increasing thanks to the technologically enabled contingent employment platforms.
Online labour markets are a natural testing ground for the proposition that technological transformation is capable of reducing monopsony power of employers, because they, in theory, offer a nearly-frictionless information and jobs flows between contractors and contractees, transparent information about pay and employment terms, and low cost of switching from one job to another.
The latter study mentioned above attempts to "rigorously estimate the degree of requester market power in a widely used online labour market – Amazon Mechanical Turk, or MTurk... the most popular online micro-task platform, allowing requesters (employers) to post jobs which workers can complete for."
The authors "provide evidence on labour market power by measuring how sensitive workers’ willingness to work is to the reward offered", by using the labour supply elasticity facing a firm (a standard measure of wage-setting (monopsony) power). "For example, if lowering wages by 10% leads to a 1% reduction in the workforce, this represents an elasticity of 0.1." To make their findings more robust, the authors use two methodologies for estimating labour supply elasticities:
1) Observational approach, which involves "data from a near-universe of tasks scraped from MTurk" to establish "how the offered reward affected the time it took to fill a particular task", and
2) Randomised experiments approach, uses "experimental variation, and analyse data from five previous experiments that randomised the wages of MTurk subjects. This randomised reward-setting provides ‘gold-standard’ evidence on market power, as we can see how MTurk workers responded to different wages."
The authors "empirically estimate both a ‘recruitment’ elasticity (comparable to what is recovered from the observational data) where workers see a reward and associated task as part of their normal browsing for jobs, and a ‘retention’ elasticity where workers, having already accepted a task, are given an opportunity to perform additional work for a randomised bonus payment."
The findings from both approaches are strikingly similar. Both "provide a remarkably consistent estimate of the labour supply elasticity facing MTurk requesters. As shown in Figure 2, the precision-weighted average experimental requester’s labour supply elasticity is 0.13 – this means that if a requester paid a 10% lower reward, they’d only lose around 1% of workers willing to perform the task. This suggests a very high degree of market power. The experimental estimates are quite close to those produced using the machine-learning based approach using observational data, which also suggest around 1% reduction in the willing workforce from a 10% lower wage."
To put these findings into perspective, "if requesters are fully exploiting their market power, our evidence implies that they are paying workers less than 20% of the value added. This suggests that much of the surplus created by this online labour market platform is captured by employers... [the authors] ﬁnd a highly robust and surprisingly high degree of market power even in this large and diverse spot labour market."
In evolutionary terms, "MTurk workers and their advocates have long noted the asymmetry in market structure among themselves. Both efficiency and equality concerns have led to the rise of competing, ‘worker-friendly’ platforms..., and mechanisms for sharing information about good and bad requesters... Scientific funders such as Russell Sage have instituted minimum wages for crowd-sourced work. Our results suggest that these sentiments and policies may have an economic justification. ...Moreover, the hope that information technology will necessarily reduce search frictions and monopsony power in the labour market may be misplaced."
My take: the evidence on monopsony power in web-based contingent workforce platforms dovetails naturally into the evidence of monopolisation of the modern economies. Technological progress, that held the promise of freeing human capital from strict contractual limits on its returns, while delivering greater scope for technology-aided entrepreneurship and innovation, as well as the promise of the contingent workforce environment empowering greater returns to skills and labour are proving to be the exact opposites of what is being delivered by the new technologies which appear to be aiding greater transfer of power to technological, financial and even physical capital.
The 'free to work' nirvana ain't coming folks.